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1 What is assurance? Upon completion of this chapter you will be able to: Explain the nature and objectives of audit and assurance: Discuss the concepts of accountability, stewardship, agency, true and fair and reasonable assurance, Explain reporting as a means of communication to stakeholders; Explain the five elements of an assurance engagement; and Explain the level of assurance provided by audit and other review assignment s.

1 What is assurance? An engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria." (International Audit and Assurance Standards Board Handbook) In simple terms, giving assurance means offering an opinion about specific inf ormation so that the users of that information are able to make confident deci sions. 2 2 The elements of an assurance engagement There are 5 elements of an assurance engagement: the three parties involved: the practitioner (i.e. the reviewer of the information); the intended users (of the information}; and the responsible party (i.e. the preparer of the information). the subject matter under scrutiny; suitable criteria against which to judge the reliability and accuracy of the subject matter (e.g. IFRS); sufficient appropriate evidence to substantiate an opinion; and a written report in an appropriate form. As an example; consider that you are buying a house. Normally members of the pub lic lack the technical expertise to assess the structural condition of property.

There is therefore a risk lhat someone pays a large sum of money to purchas e a structurally unsafe property that needs further expenditure to make it use able. To reduce this risk it is normal for house buyers (the users) to pay a property surveyor (the practitioner) lo perform a structural assessment of the house (t he subject matter). The surveyor would then report back {written report) to th e house buyer identifying any structural deficiencies (measured against suitable structural criteria). With this information the potential buyer can then make their decision to buy or not to buy with confidence that they know what the st ructural condition of the house is. Note: Ihe practitioner is offering a professional service. They must therefore: be competent; be objective and independent; and follow certain expected standards of performance. All of these issues will be considered in the chapters which follow.

Types of assurance service an audit of financial statements a review of financial statements risk assessment reports systems reliability reports reports on social and environmental issues (e.g. to validate an employer's c laims about being an equal opportunities employer or a company's claims abou t sustainable sourcing of materials) reviews of internal controls value for money audit in public sector organisations. 3 Assurance in the context of a company Who are the likely users of corporate information? Typically, the users cf corporate information are referred to as stakeholders. These are people, or groups, who are influenced by, or can influence, the company's decisions and act ions. Examples of stakeholder groups are:

3 -shareholders; -management and those charged with the governance of a business; -other employees; -customers; -suppliers; -government offices; -lenders of funds; and -community organisations. All of these stakeholders will need information about the company in order to m ake decisions. Of course, the decisions they make will all be different. For e

xample, consider the decisions of shareholders and employees; shareholders need to decide whether lo alter their shareholdings and employees need to make career decisions. One of the primary sources of information about a company is the financial sta tements. This contains information that almost all of the stakeholder groups will find useful. In parti cular, the shareholders (often considered as the primary stakeholder group) will need reliable financial statements to appraise the performance of their shareho lding. Expandable Text - Usefulness of Financial Statements Employees may be able to judge whether they think their levels of pay are ade quate compared to the directors and results of the company. Those charged with governance can see whether (they think management have s truck the right balance between their own need for reward (remuneration, share options etc) and the needs of other stakeholders. Customers, suppliers and lenders can make judgements about whether the comp any has sufficient financial strength (i.e. liquidity) to justify future trading /financial relationships. The government can decide whether the right amounts of tax have been paid e tc.

4 The development of assurance engagements Incorporation and the separation of ownership and control

4 Businesses can operate through a number of different vehicles. It is common for investors in those businesses to seek the protection of limited company status. This means that whilst they could lose the funds they invest in a business they cannot be held personally responsible for satisfying the rema ining corporate debts. The creation o- a limited company is referred to as incor poration.

Incorporation has the following implications the creation of a legal distinction between the owners of the business and th e business itself; the opportunity for the owners/investors to detach themselves from the operat ion of the business; and the need for managers to operate the business on a daily basis.

Whilst this has provided financial protection for shareholders it does lead to one significant conflict:

Shareholders seek to maximize their wealth through the increasing value of thei r shareholding. This is usually driven by the profitability (both current and potential) of the company. Directors/management seek to maximise their wealth through salary, bonuses and other employment benefits. This obviously reduces company profitability. This has lead to the legal requirement for financial statements to be produced by directors to account for their stewardship of the company. These are sent to the owners/shareholders for their assessment of the performance of management. This presents another conflict: the directors are responsible for preparing the financial statements and they benefit from reporting higher profits. There is therefore a need for an independent review of these financial statements. This i s where assurance, in particular audit, comes in. Definitions Stewardship is the responsibility to take good care of resources. A steward is a person entrusted with management of another person's property, for example, w hen one person is paid to look after another person's house while the owner goes abroad on holiday. This relationship, where one person has a duty of care towards someone else is known as a 'Fiduciary relationship'. The steward is accountable for the way he carries out his role. A fiduciary relationship is a relationship of 'good faith' such as that between t he directors of a company arid the shareholders of the company. There is a 'sep aration of ownership and control' in the sense that the shareholders of the comp any, while the directors take the decisions. The directors must take their deci sions in the interests of the shareholder rather than in their own selfish pers onal interests. Accountability means that people in positions of power can be held to account f or their actions, i.e. they can be compelled to explain their decisions and can be criticized or punished if they have abused their position. Accountability is thus central to the concept of good corporate governance - th e process of ensuring that companies are well run - which we will look at in mo re detail in chapter 3. Agency occur when ere party, the principal, employs another party, the agent, to perform a task on their behalf. 5 The role of the auditor The three parties involved in the audit process are: the preparers: management/directors; the users: shareholders: and the practitioner: the auditors.

Management prepares the subject matter, in this case the financial statements. Auditors will review the financial statements and perform procedures to obtain

sufficient appropriate evidence that the financial statements are a reasonable b asis for making decisions. This means that they are prepared in accordance with a relevant financial reporting framework (i.e. suitable criteria). In the cas e of this text it is assumed that International Financial Reporting Standards ar c the basis of preparing the financial statements. Finally the auditor prepares a written report (the audit report), which they p resent to the shareholders. This report summarizes their opinion as to whether t he financial statements are "fairly presented" (or "true and fair") The concept of "fair presentation" is explored later but i t basically means that the financial statements are: reasonably accurate; prepared in accordance with laws and regulations: unbiased: and clear/understandable.

5 Audit engagements External audit In most developed countries, publicly quoted companies and large companies are r equired by law to produce annual financial statements and have them audited by an external auditor. Other organisations (e.g. small private companies, partnerships, etc.) may choo se to be audited even if there is no legal requirement. Objective of an external audit The objective of an external audit engagement is to enable the auditor to expres s an opinion on whether the financial statements give a true and fair view (or present fairly in all material respects) are prepared, in all material respects, in accordance with an applicable fin ancial reporting framework. The financial reporting framework to be applied will vary from country to coun try. General principles to be followed The auditor should follow certain general principles in the conduct of an exter nal audit. 6 Compliance with applicable ethical principles, i.e. the IFAC Code of Ethics for Professional Accountants and the ethical pronouncements of the auditors profe ssional body (e.g. the ACCAs Rules of Professional Conduct) (See Chapter 5). Compliance with applicable auditing standards, i.e. the International Auditi ng and Assurance Standards Boards (IAASBs) International Standards on Auditing (ISAs). Planning and performing the audit with an attitude of professional skepticism that recognizes that the financial statements being audited may be materially m

isstated.

6 Types of assurance engagement The IAASB International Framework for Assurance Engagements permits two types of assurance engagement: reasonable, and limited; Reasonable assurance engagements In a reasonable assurance engagement, the practitioner. Gathers sufficient appropriate evidence to be able to draw reasonable conclus ions; Concludes that the subject matter conforms in all material respects with ide ntified suitable criteria; and Gives a positively worded assurance opinion.

Statutory audit is an example of a reasonable to these assignments must be consistent with ch as the Companies Act in the UK, and audit in accordance with International Standards on Limited assurance engagement

assurance assignment. The approach local legislative requirements, su work will need to be carried out Auditing (ISAs).

In a limited assurance assignment the practitioner: Gathers sufficient appropriate evidence to be able to draw limited conclusion s; Concludes that the subject matter, with respect to identified suitable criteri a, is plausible in the circumstances; and Gives a negatively worded assurance opinion.

An example of a limited assurance assignment is a review engagement. It is possi ble for small companies, who are not legally required to have a full audit, to have a review of their financial statements to enable them to present their ac counts to potential lenders. There is no precise definition of what is meant by reasonable or limited in thi s context. However, it is clear that the confidence inspired by a reasonable assurance report is designed to be greater than that inspired by a limited one. It therefore follows that: there are more regulations/standards governing a reasonable assurance assig nment; the procedures carried out in a reasonable assignment will be more thorough; and the evidence gathered will need to be of a higher quality.

7 What level of assurance can auditors provide? The greatest level of assurance auditors can provide is reasonable. They cannot provide absolute assurance (i.e. 100% validation) for the following reasons: the financial statements contain estimates and judgements; auditors have to test on a sample basis; fraud may be disguised; and much of the evidence obtained will be persuasive rather than conclusive.

Wording of Different Assurance Reports Statutory audit is an example of a reasonable assurance assignment. The typical wording of 'clean' audit opinion is as follows: "In our opinion the financial statements give a true and fair view of the financ ial position and performance of the company as at 31 December 2009." In comparison a limited assurance report might be worded as follows: "Nothing has come to our attention that causes us to believe that the financial statements as of 31 December 2009 are not prepared, in all material respects, in accordance with an applicable financial reporting framework." The level of assurance in the last opinion is much weaker and a user of such a report would place less reliance on this than on a reasonable assurance opin ion.

Review engagements - limited assurance engagements What is a review engagement? The objective of a review of financial statements is to enable an auditor to sta te whether, on the basis of procedures which do not provide all the evidence required in an audit, anything has come to the auditor's attention that causes the auditor to believe that the financial statements are not prepared in accordance with the applicable financial reporting framework (i .e. negative/limited assurance). Guidance on how to perform this type of assignment s given by the IAAS8 in Inter national Standard on Review Engagements (ISRE) 2400, engagements to Review Finan cial Statements. Characteristics of a review engagement Typically review engagements will be carried out using much more limited proce dures than a statutory audit. Typically the following procedures are used: analytical review, and enquiry Further explanations of these techniques can be found in chapter 9

8 7 Limitations and benefits of statutory audit Benefits High quality, reliable information circulates the market (gives investors fait h and improves reputation of the market). Independent verification {management value having their business scrutinised) . Reduces the risk of management bias, fraud and error (by acting as a deterre nt). Enhances the credibility of the information (especially for raising finance and for the tax authorities). Deficiencies may be highlighted in the management letter. Limitations Financial information includes subjective and judgemental matters. Inherent limitations of controls used as audit evidence. Representations from management may have to be relied upon as the only source of evidence in some areas. Evidence is persuasive not conclusive. Do not review 100% of the transactions.

The "Expectations Gap" There is a common misconception about the role an auditor plays. This is often referred to as the 'expectations gap.' Examples of these misconceptions include: a belief that auditors test 100% of transactions and balances: they test on a sample basis; a belief that auditors are required to detect fraud, auditors are required to offer an opinion that the financial statements are free of material misstatemen t, which may be caused by fraud; auditors are responsible for preparing the financial statements: this is the r esponsibility of management.

Test your understanding 1 What is the purpose of an audit? (2 marks) Test your understanding 2 What is the difference between a review and an audit? (10 marks)

9 8 Chapter summary

10 Test your understanding answers

Test your understanding 1

What is the purpose of an audit? To provide confidence for the shareholders that the financial statements are true and fair. To reduce the risk of misstatement, as someone independent, qualified reviews an d gives an opinion on the truth and fairness of the financial statements.

Test your understanding 2 Nature of engagement Review Audit

Amount of work done decided by whom Auditor, as much as he deems necessary to give positive opinion Reviewer, as much as he deems necessary tc give negative opinion Type of assurance engagements Reasonable, (but not absolute) assurance Limited assurance Level of assurance provided Moderate High

Type of report provided ative assurance

Positive assurance

Neg

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12 2 The rules and who sets them Chapter learning objectives Upon completion of this chapter you will be able to: Upon completion of this chapter you will be able to: Describe the regulatory environment within which statutory audits take place . Discuss the reasons and mechanisms for the regulation of auditors; Explain the statutory regulations governing the appointment, removal and resig nation of auditors; Explain the development and status of International Standards on Auditing; Explain the relationship between International Standards on Auditing and nat ional standards

13 1 The need for regulation The role of the auditor has come under increased scrutiny over the last thirt y years due to an increase in high profile, economically damaging fraud cases. T he most high profile case, and the catalyst for regulatory change, was the colla pse of Enron and its auditor Arthur Andersen. In order to try and regain trust in the auditing profession national and intern ational standard setters and regulators have tried to introduce three initiat ives. harmonization of auditing procedures, so that users of audit sendees are con fident in the nature of audits being conducted around the world; a focus on audit quality, so that the expectations of users are met; and adherence to a strict ethical code of ethical conduct, to try and improve th e perception of auditors as independent, unbiased service providers.

In order to achieve this practitioners now have to follow three sets of regula tory guidance: The Cede of Ethics; Auditing Standards (the basis of this text is International Standards of Audi ting); and National corporate law.

Examples of national laws/guidance include: The Companies Act 2006 in the UK; The Sarbanes Oxley Act in the US (enforcing standards of corporate governance ); and The Corporate Governance Code in the UK (formerly the Combined Code).

2 Setting auditing standards IFAC The International Federation of Accountants (IFAC) is the global organisation fo

r Ihe accountancy profession. It was formed in 1977 and is based in New York. I FAC has more than 160 member bodies of accountants (including the ACCA), representing 2.5 million accountants from 120 separate countries. IFAC's overall mission is to serve the public interest, strengthen the worldwide accountancy profession, and contribute to the development of strong internation al economies by establishing and promoting adherence to high-quality professio nal standards. One of the subsidiary boards of IFAC is the International Audit and Assurance S tandards Board (IAASB). It is their responsibility to develop and promote Inter national Standards of Auditing (ISA's). There are currently 36 ISA's and one International Standard of Quality Control. All audits carried out in EU member states are now carried out in accordance w ith ISA's. 14 The relationship between international and national standards and regulation ,

Because IFAC is simply a grouping of accountancy bodies, it has no legal standi ng in individual countries. Countries therefore need to have arrangements in pl ace for: regulating the audit profession implementing auditing standards National Regulatory bodies: enforce the implementation of auditing standards have disciplinary powers to enforce quality of audit work have rights to inspect audit files to monitor audit quality. There are two possible schemes for regulation at the national level: self regulation by the audit/accountancy profession regulation by government or by some independent body set up by government for the purpose. National standard setters may set their own auditing standards may adopt and implement ISAs, possibly after modifying them to suit nationa l needs. Following the decision by the EU to implement ISAs in all member states for all accounting periods beginning on or after 1 January 2005, countries with their o wn standard setting bodies such as the UK had to decide whether to: modify their own standards to bring them into line with ISAs adopt ISAs and modify them to suit national requirements. In the UK the national standard setter - The Auditing Practices Board - decided to adopt and modify ISAs. 3 The Law

Who needs an audit and why? In most countries it is possible (or businesses to operate through companies a process known as incorporation. This concept was discussed in more detail in chapter 1. In most countries companies are generally required to carry out an audit, as it is a legal requirement. However, small or owner managed companies are often e xempt (e.g. in UK. companies with annual turnover < 6.5 million).

15 Audit exemption The main reasons for exempting small companies are: for owner-managed companies, those receiving the audit report are those runni ng the company (and hence preparing the accounts!) the advice/value which accountants can add to a small company is more likely to concern other services, such as accounting and tax, rather than audit are) which may also give rise to a conflict of interest under the ethics rules the impact of misstatements in the accounts of small companies is unlikely t o be material to the wider economy given the above points, the audit fee and related disruption are seen as to o great a cost for any benefits the a audit might bring. The auditor's duties In accordance with ISA 200 the auditors fundamental objectives are to: obtain reasonable assurance about whether the financial statements as a whol e are free from material misstatement, whether due to fraud or error; express an opinion on whether the financial statements are prepared, in alll material respects, in accordance with an applicable reporting framework; and report on the financial statements, and communicate as required by ISA's, iri accordance with the auditor's findings. 4 Who may act as auditor? To be eligible to act as auditor, a person must be: A member of a Recognised Supervisory Body (RSB). e.g. ACCA allowed by the ru les of that body to be an auditor; or Someone directly authorised by the state. Individuals who are authorised to conduct audit work may be: sole practitioners partners in a partnership members of an LLP directors of an audit company.

To be eligible to offer audit services, a firm must be: controlled by members of a suitably authorised supervisory body; or a firm directly authorised by the state

NB. In some countries only individuals can be authorised to act as auditor and n eed to be directly authorised by the state. 16 5 Who may not act as auditor? Excluded by law The law in most countries excludes those involved with managing the company and those who have business or personal connections with them. For example, in the UK the following are excluded by company law: an officer (Director or secretary) of the company an employee of the company a business partner or employee of the above.

Excluded by the Code of Ethics (See chapter 5 for more detail) The IFAC and ACCA Code of Ethics require auditors to consider whether their o bjectivity and independence might be questioned by external parties because of: business relationships personal relationships long association with the client fee dependency non audit services provided. 6 How arc auditors appointed and removed? Who appoints the auditor? In most jurisdictions the members (shareholders) of the company appoint the aud itor by voting them in at the Annual General Meeting (AGM). However, directors can appoint the first auditor to fill a 'casual vacancy' this requires the members' approval at next AGM. However, in some countries the auditors may be appointed by Ihe directors as a matter of course How long for? Auditor are appointed from one AGM until the end of the next one. Private companies no longer have to hold an annual general meeting if an elect ive resolution is made, in these circumstances the auditor is automatically reap pointed unless a shareholder objects (small companies can elect to dispense with the requirement for an AGM). Removing the auditor Arrangements for removing the auditor have to be structured in such a way th at: the auditor has sufficiently secure tenure of office, to maintain independen ce of management incumbent auditors can be removed if there are doubts about their continui ng abilities to carry out their duties effectively. To enable this balance to be maintained, the removal of auditors car. Usually b

e achieved by a simple majority at a general meeting of the company. There are some safeguards, such as a specified notice period, to prevent the resolution t o remove the auditors being 'sprung' on the meeting. In practice, if the auditors and management find it difficult to work together, the auditors will usually resign. To prevent the circumstances of the resignation being hidden from the company's members, the auditors have to submit a statement of the circumstances surround ing their resignation. 17 The details which follow about the appointment and removal of the auditors ar e taken from UK law and practice, but give an example of the way these things are usually handled. The auditor's responsibilities on appointment and removal On appointment Obtain clearance from the client to write to the existing auditor (if denied , aopointment should be declined). Write to the existing auditor asking if there are any reasons why the appoi ntment should not be accepted On removal/resignation Deposit at the company's registered office a statement of the circumstances connected with the removal/resignation or A statement that there are no such circumstances Deal promptly with requests for clearance from new auditors. 7 The auditor's rights During the audit/continued appointment . Access to the company's books and records. To receive information and explanations necessary for the audit. To receive notice of and attend any general mooting of members of the company To be heard at such meetings on matters of concern to the auditor.

On resignation To request an Extraordinary General Meeting (EGM) of the company to explain t he circumstances of the resignation. To require the company to circulate the notice of circumstances relating to t he resignation.

Test your understanding 1 (1)Describe the role of the IFAC? (3 marks) (2)Describe how ISAs and national auditing standards influence each other. (2 marks)

Test your understanding 2 (1) List the statutory duties of the auditor? (3 marks) (2) Who may act as audit or of a company? (2 marks) (3) Who may not act as the auditor of a company? (3 marks) (4) Who may appoint the first auditors of a company? (1 mark) (5) What action should a company take if the auditor resigns prior to completion of his term of office? (1 mark) (10 marks)

18 8 Chapter summary

Test your understanding 1 (1) Describe the role of the IFAC? IFAC is a federation ot accountancy bodies throug hout the world. (1 mark) Through its boards and committees it aims to encourage best practice by the mem bers of its constituent bodies. (1 mark) It has developed a code of ethics for its members and through the IAAS8 it s ets standards for audit and other assurance engagements. (1 mark) (2) Describe how ISAs and National auditing Standards influence Each other? National standard-setters may adopt ISAs if they choose to do so. except that a ll audits in the EU must be conducted under ISAs. (1 mark) National standard-setters may choose to modify ISAs in order to make them more stringent or to suit national requirements. (1 mark) 19 Test your understanding 2 (1) List the statutory duties of the auditor? To form an opinion on the financial statements of the company To issue an audit report

Other duties imposed by law, e.g. to report if: returns from branches have not been received (1/2 mark per point) accounting records are inconsistent with the financial statements information or explanations have not been received proper accounting records have not been kept disclosures regarding directors' pay and balances with the company have not been made other information issued with the financial statements conflicts with those statements.

(2) Who may act as auditor of a company? An individual authorised by the state to be an auditor (1 mark) or the members of a professional body authorised by the state. (1 mark)

(3) Who may not act as the auditor of a company? Those who are unable to comply with ethics rules with respect to independence, o bjectivity and competence to act as auditor for any particular client. (1 mark) Those who are prohibited by law from acting as auditor for particular clients: (1 mark) e.g. officers and employees of the company being audited and those closely assoc iated with them - business partners, close relatives, etc. (1 mark) (4) Who may appoint the first auditors of acompany? The directors or the members. (1 mark) (5) What action should a company take if the auditor resigns prior to completio n of his term of office? Hold an AGM if so requested by the auditor (1/2 mark per point) Circulate the auditors' notice of the circumstances surrounding the resignation . (1/2 mark per point)

20 3 Corporate governance Chapter learning objectives Upon completion of this chapter you will be able to: Discuss the objective, relevance and importance of corporate governance; Discuss the provisions of international codes of corporate governance that ar e most relevant to auditors; Describe good corporate governance requirements relating to directors' respon sibilities and the reporting responsibilities of auditors; Analyse the structure and roles of audit committees and discuss their drawba cks and limitations; and Explain the importance of internal control and risk management.

21

1 Introduction In the year 2000 Enron, a US based Energy Company, employed 22,000 people and reported revenues of $101 billion. In late 2001 they filed for bankruptcy prote ction. After a lengthy investigation it was revealed that Enron's financial stat ements were sustained substantially by systematic, and creatively planned, acco unting fraud.

In the wake of the fraud case the shares of Enron fell from over $90 each to j ust a few cents each, a number of directors were prosecuted and jailed and the ir auditors, Arthur Andersen, were accused of obstruction of justice and force d to stop auditing public companies. This ruling against Arthur Andersen was o verturned at a later date but the damage was done and the firm ceased trading soon after. This was just one of a number of high profile frauds to occur at the turn of the millennium. The Enron scandal is an example of the abuse of the trust placed in the manageme nt of publicly traded companies by investors. This abuse of trust usually takes one of two forms: the direct extract on from the company of excessive benefits by management, e.g. large salaries, pension entitlements, share options, use of company assets (jets, apartments etc.); and manipulation of the share price by misrepresenting the company's profitabilit y, usually so that shares in the company can be sold or options 'cashed in'. In response regulators sought to change the rules surrounding the governance of companies, particularly publically owned ones. In the US the Sarbanes Oxley Act (2002) introduced a set of rigorous corporate governance laws and at the same time the Combined Code introduced a set of best practice corporate governance initiatives into the UK.

22 What is corporate governance? Corporate governance is the means by which a company is operated and controlled . The aim of corporate governance initiatives is to ensure that companies arerun w ell in the interests of their shareholders and the wider community. It concerns such matters as: the responssibilities of directors; the appropriate composition of the board of directors; the necessity for good internal control; the necessity for an audit committee; and relationships with the external auditors. large amounts or from pensi companies sig are traded.

It is particularly important for publicly traded companies because of money are invested in them, either by 'small' shareholders, on schemes and other financial institutions. The wealth of these nificantly affects the health of the economies where their shares 2 The OECD Principles of Corporate Governance

Although there have always been well run companies as well as those where sca ndals have occurred, the fact that scandals do occur has led to the development of codes of practice for good corporate governance. Often this is due to pressures exerted by stock exchanges In 1999 the Organisa tion for Economic Co-operation and Development. OECD. assisted with the developm ent of their 'Principles of Corporate Governance.' These were intended to: Assist member and non-member governments in their efforts to evaluate and i

mprove the legal, institutional and regulatory framework for corporate governa nce in their countries Provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance. The OECD principles were first published in 1999 and were revised in 2004. T heir focus is on publicly traded companies. However, to the extent they are dee med applicable, they are a useful tool to improve corporate governance in non-t raded companies. There are six principles, each backed up by a number of sub principles. The pri nciples, and those sub-principles relevant to the auditor, are reproduced here.

23 The Principles in Detail Structure of the Principles - The six Principles: (i) Ensuring the basis for an effective corporate governance framework

The corporate governance framework should promote transparent and efficient ma rkets, be consistent with the rule of lav/ and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement aut horities. In other words, making sure everyone involved is aware of their in dividual responsibilities so no parly is in doubt as to what they are accountabl e for. (ii) The rights of shareholders and key ownership functions

The corporate governance framework should protect and facilitate the exercis e of shareholders' rights. As we saw in chapter 1, the directors are the stewar ds of the company and should be acting in the best interests of the shareholder s. However, the existence of the corporate collapses mentioned above proves tha t this isn't always the case and shareholders need protecting from such people. (iii) The equitable treatment of shareholders

The corporate governance framework should ensure the equitable treatment of al l shareholders, including minority and foreign shareholders. All shareholders sh ould have the opportunity to obtain effective redress for violation of their r ights. (iv) The role of stakeholders in corporate governance

The corporate governance framework' should recognise the rights of stakeholde rs established by lav; or through mutual agreements and encourage active co-op eration between corporations and stakeholders in creating wealth, jobs, and th e sustainability of financially sound enterprise. (v) Disclosure and transparency

The corporate governance framework should ensure that timely and accurate disc losure is made on all material matters regarding the corporation, including the financial situation, performance, ownership and governance of the company. There fore, the annual financial statements should be produced on a timely basis and include all matters of interest to the shareholders. For any matters of signific ance arising during the year, these should be communicated to the shareholders as appropriate. (vi) The responsibilities of the board

The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board's a ccountability to the company and the shareholders. The introduction of audit com mittees and non executive directors on the board is the usual way for monitori ng management. Non executive directors are not involved in the day to day runnin g of the company and are therefore more independent they can evaluate the effec tiveness of the executive board on its merits and make sure they are carryi ng out their duties properly.

24 The OECD principles and the audit Sub principle VC An annual audit should be conducted by an independent, competent and qualified a uditor in order to provide an external and objective assurance to the board an d shareholders that the financial statements fairly represent the financial posi tion and performance of the company in all material respects. Sub principle VD 'External auditors should be accountable to the shareholders and owe a duty to the company to exercise due professional care in the conduct of the audit.' the OECD principles and the board Sub principle VI.D Reviewing and guiding corporate strategy, major plans of action, risk polic y, annual budgets and business plans; setting performance objectives; monitorin g implementation and corporate performance, and overseeing major capital expend itures, acquisitions and divestitures. Monitoring the effectiveness of the company's governance practices and mak ing changes as needed. Selecting, compensating, monitoring and, when necessary, replacing key execut ives and overseeing succession planning. Aligning key executive and board remuneration with the longer term interests of the company and its shareholders ensuring a formal and transparent board nominati on and election process. Monitoring and managing potential conflicts of interest of management, board members and shareholders, including misuse of corporate assets and abuse in related part

y transactions. Ensuring the integrity of the corporation's accounting and financial reporti ng systems, including the independent audit, and that appropriate systems of control are in place, in particular, systems for risk management financial and operational control, and compliance wi th the law and relevant standards. Overseeing the process of disclosure and communications.

The status of the OECD principles The Principles represent a common basis that OECD Member countries consider essential for the development of good governance practice. They are intended to be concise, understandable and accessible to the intern ational community. They are not intended to be a substitute for government or private sector in itiatives to develop more detailed 'best practice' in governance.

25 3 Corporate governance in action

There are a number of principles of corporate governance that are globally acce pted as essential to the effective management of companies, particularly publica lly owned ones. These are: Segregation between the roles of chairman and chief executive officer(CEO); Non-executive directors; Audit (and other) committees; Risk management; and Internal audit.

Segregation of Roles Best practice recommends that the roles of Chairman and Chief Executive Officer should be held be different people to reduce the power of prominent board me mbers. The chairman's role Head of the non-executive directors. Enables flow of information and discussion at board meetings. Ensures satisfactory channels of communication with the external auditors. Ensures the effective operation of sub-committees of the board.

The Chief executive's role Ensures the effective operation of the company. Head of the executive directors.

26 Non-executive directors Non-executive directors are usually employed on a part-time basis and do not ta ke part in the routine executive management of the company. Their role is as fo llows. Participation at board meetings. Provision of experience, insight and contacts to assist the board. Membership of sub-committees as independent, knowledgeable parties.

Advantages of participation by non-executive directors Oversight of the whole board. Often act as a 'corporate conscience'. They bring external expertise to the company.

Disadvantages They, and the sub-committees, may not be sufficiently well-informed or have time to fulfill the role competently. They are subject to the accusation that they are staffed by an 'old boy' ne twork and may fail to report significant problems and approve unjustified pay rises. Enron provides a cautionary note as its audit committee proved incapable of pre venting the wrongdoing of the executive directors. Audit comities

27 An audit committee is a committee consisting of non-executive directors which is able to view a company's affairs in a detached and independent way and liaise effectively between the main board of directors and the external auditors. Best practice for listed companies: The company should have an audit committee of at least three non- executiv e directors (or. in the case of smaller companies, two). At least one member of the audit committee should have recent and relevant financial experience. The objectives of the audit committee Increasing public confidence in the credibility and objectivity of published financial information (including unaudited interim statements}. Assisting directors (particularly executive directors) in meeting their respo nsibilities in respect of financial reporting. Strengthening the independent position of a company's external auditor by pr oviding an additional channel of communication.

The function of the audit committee Monitoring the integrity of the financial statements. Reviewing the company's internal financial controls. Monitoring and reviewing the effectiveness of the internal audit function. Making recommendations in relation to the appointment and removal of the ext ernal auditor and their remuneration. Reviewing and monitoring the external auditor's independence and objectivity and the effectiveness of the audit process. Developing and implementing policy on the engagement of the external auditor to supply nonaudit services. Reviewing arrangements for confidential reporting by employees and investiga tion of possible improprieties ('Whistleblowing'). Benefits of having an audit committee It provides the internal audit department with an independent reporting mecha nism compared to reporting to the directors who may wish to hide or amend unfavo rable internal audit reports. The audit committee will assist the internal auditor by ensuring that recomme ndations in internal audit reports are auctioned. Shareholder and public confidence in published financial information is enhan ced because it has been reviewed by an independent committee. The committee helps the directors fulfill any obligations under corporate go vernance to implement and maintain an appropriate system of internal control wi thin the company. The committee should assist in providing better communication between the d irectors, external auditors and management arranging meetings with the external auditor. Strengthens the independence of company's external auditor by providing a cle ar reporting structure and separate appointment mechanism from the board.

28 Limitations Audit committees may lead to: fear that their purpose is to catch management out non-executive directors being over-burdened with detail a 'two-tier' board of directors additional cost in terms, at least, of time involved.

The audit committee and internal audit Clearly, the functions of the audit committee are quite wide-reaching, therefor e, it may be necessary to establish an internal audit function in order to help them fulfill their responsibilities. Best practice is that the audit committee should: Ensure that the internal auditor has direct access to the board chairman an d to the audit committee and is accountable to the audit committee.

 Review and assess the annual internal audit work plan. Receive periodic reports on the results of internal audit work. Review and monitor management's responsiveness to the internal auditor's fin dings and recommendations. Meet with the head of internal audit at least once a year without the pres ence of management. Monitor and assess the effectiveness of internal audit in the overall conte xt of the company's risk management system. Risk management Companies face many risks, for example: The The The The The risk risk risk risk risk that products may become technologically obsolete. of losing key staff. of a catastrophic failure of IT systems. of changes in government policy. of fire or natural disaster.

Companies therefore need to: Identify potential risks and Decide on appropriate ways to minimise those risks.

Risk management in practice Risks can arise from many sources and be of various natures, e.g. operational, financial, legal. Companies need mechanisms in place to identify and then assess those risks. In so doing companies can rank risks in terms of their relative importance by scoring them with regard to their likelihood and potential impact. This could take the form of a risk map': 29 A risk that ranked as highly likely to occur and high potential impact on the b usiness would be prioritised as requiring immediate action. A risk that was cons idered both low likelihood and low impact might simply be ignored or. simply in sured against. Ways of managing exposure to risk include: insuring against it; implementing internal procedures and controls (e.g. training) to minimise th e risk of occurrence; discontinuing especially risky activities; and simply accepting the risk as inevitable but trivial. Internal controls and risk management One way of minimising risk is to incorporate internal controls into a company's systems and procedures It is the director's responsibility to implement internal controls and monitor their application and effectiveness. The risks considered by management are numerous. They come from both external e nvironmental sources and internal operational ones. The main aim of risk managem ent is to protect the business from unforeseen circumstances that could negativ ely impact the profitability of the company and slop it achieving its strategic goals.

However, the main controls considered throughout this text and those in relatio n to the financial frauds discussed earlier are financial ones. The main aims of financial controls are to: reduce the risk that the financial statements contain misstatement, whether d ue to fraud or error; and reduce the risk of theft, or misuse, of the company's assets. Auditors are not responsible for the design and implementation of their clients' control systems. Auditors have to assess the effectiveness of controls for red ucing the risk of material misstatement of the financial statements. They incorp orate this into their overall risk assessment, which allows them to design their further audit procedures. This concept of audit risk assessment is considered in detail in later chapters. In addition lo this auditors are required, in accordance with ISA 265. To repo rt significant deficiencies in clienl controls identified during the audit to t hose charged with governance. This is discussed in greater detail in the reporti ng chapter.

30 Test your understanding 1 (1) What is meant by corporate governance? (3 marks) (2) Why are external auditors interested in corporate governance? (3 mark s) (3) What are the key things the OECD principles are intended to deliver? (5 marks) (4) Explain the difference between a unitary board of directors and a two -tier board. (2 marks) (5) Who should make up a typical audit committee? (1 marks) (6) What is the committees role? (2 marks) (7) Why would a company need an audit committee if it has a good relation ship with its external auditors? (4 marks) (8) A company has identified one of its major risks as loss of key staff . Explain: (5 marks) (a) what they should do as a result of this (b) how they might reduce or even eliminate the risk (c) why the auditor is interested in this, given that it is not a direct f inancial risk.

4 Chapter summary

31 Test your understanding answers

Test your understanding 1 (1)What is meant by corporate governance? The term corporate governance refers to the means by which a company is managed in the interests of all stakeholders. It will include consideration of: (1) (2) directors responsibilities composition of the board of directors 1 mark

(3)

audit requirements (internal and external)

1 mark

(2) Why are the external auditors interested in corporate governance? Corporate governance is the responsibility of the company's management and not its external auditors. 1 mark However, it is the responsibility of the external auditors to form an opinion o n the truth and fairness of the company's financial statements. 1 mark If a company has good standards of corporate governance and is therefore manage d well in the interests of all stakeholders, the auditors are likely to conclude that the risk of material misstatement in the financial statements is reduced. 1 mark As a result of this they may well be able to reduce the extent of the audit pro cedures they carry out. 1 mark

(3) What are the key things the OECD principles are intended lo deliver? A framework so that companies are governed well which should be beneficial to f inancial markets. 1 mark Fair treatment of all shareholders 1 mark Companies to be run in the interests of all stakeholders. 1 mark Transparency of disclosure about the company's performance and state of affairs .

(4) Explain the difference between a unitary board of directors and a two-tier board? The management of the company should carry out its role in the interest of all s takeholders. 1 mark Unitary board Single board of directors Monitored by sub-committees and non- executive direct ors. 1 mark Two-tier board Two beards: Executive board (decision-makers) Monitored by supervisory board c onsisting of employees, investors etc. 1 mark

32 (5) Who should make up a typical audit committee? The audit committee should be made up of non-executive directors and include so meone with relevant financial experience. 1 mark (6) What is the committee's role?

The audit committee provides a channel of communication between the internal wor kings of the company and the external auditor. 1 mark It also provides a channel of communication fo' employees who have concerns abo ut the way the company is run. 1 mark

(7) Why would a company need an audit committee if it has a good relationship wi th its external auditors? A good relationship with external auditors is of immense help and support to an entity in complying with regulations, optimizing controls and generally ensuri ng good corporate governance. 1 mark However, the existence of an audit committee will enhance the company's corpora te governance profile by: 1 mark 1 improving public confidence 1 mark 2 providing further support to directors 1 mark 3 strengthening the independence of the external auditor 1 mark 4 improving internal procedures e g. management accounting, & communication generally. 1 mark

(8) A company has identified one of its major risks as loss of key staff. Explain -what they should do as a result of this? -how they might reduce or even eliminate the risk? -why the auditor is interested in this, given that it is not a direct financial risk? The risk committee should discuss the issue and assess its seriousness in rela tion to its likelihood and potential impact. They should then decide what acti on is appropriate in order to manage the risk. This risk might be reduced by: 1 mark ensuring favourable employment packages for such individuals ensuring training for other staff assists in case of succession issues ensure key tasks are not carried out by just one person. 1 x 3 marks

The auditor must consider the possible impact of all significant risks as any of these could ultimately have financial consequences or going concern i ssues, hence impacting on the audit opinion.

33

34 4 Internal Audit Chapter learning objectives Upon completion of this chapter you will be able to: Discuss the factors to be taken into account when assessing the need for i nternal audit; Discuss the elements of best practice in the structure and operations of int ernal audit; Discuss the scope and the limitations of the internal audit function; Explain the advantages and disadvantages of outsourcing internal audit; Discuss the nature and purpose of internal audit assignments including value for money. IT, best value and financial; Discuss the nature and purpose of operational internal audit assignments incl uding procurement.

35 1 The need for internal audit We have seen that Corporate Governance is about ensuring that companies are ru n well in the interest of all stakeholders. In order to achieve this companies must create a strong board of directors, structured according to the principle s discussed on the preceding pages, who have clearly defined responsibilities for risk management. However, it is not sufficient to simply have mechanisms in place to manage a b usiness, their effectiveness must be regularly assessed. All systems need some f orm of monitoring and feedback. This is the role of internal audit. Further discussion of the need for internal audit Having an internal audit department is generally considered to be 'best practic e,' rather than being required by law. This allows flexibility in the way inter nal audit is established to suit the needs of a business. In small, or owner managed businesses there is unlikely to be a need for inter nal audit because the owners are able to exercise more direct control over opera tions, and are accountable to fewer stakeholders. The need for internal audit, therefore will depend on: scale, diversity and complexity of activities; number of employees cost/benefit considerations; and the desire of senior management to have assurance and advice on risk and co ntrol. Regulatory Guidance The UK Corporate Governance Code This sets out the requirements relating to the composition and functions of the audit committee (or equivalent body). As a minimum, they must: monitor the financial reporting process; monitor the effectiveness of the company's internal control, internal audit, and risk management systems. Where there is no internal audit function, the audit committee should consider annually whether there is a need for an internal audit function and make a re commendation to the board. Where there is no internal audit function, the reasons for the absence of such a function should be explained in the relevant section of the annual report. The Sarbanes-Oxley Act (2002) Section 404 of the Act requires companies to document, evaluate, test and monit or their internal controls over financial reporting. This requires the senior ma nagement of a company to assess the design, operating effectiveness and adequacy of internal controls over financial reporting. Management often turns to intern

al audit to support compliance with these requirements. 36 Management are required to issue an annual report that addresses any material d eficiencies in Ihe company's internal controls. Section 404 also requires that t he external auditor attests to assertions made by management about the effectiv eness of the systems and controls. 2 The scope of the internal audit function In chapter 1 we explored the role of the external auditor, namely to provide as surance in the form of an opinion regarding the financial statements. The role of internal audit can be much more varied, depending on the requireme nts of the business However, the internal audit function may also provide assur ance. They would provide this assurance to internal management on issues such as: the effectiveness of systems (financial, legal and operational); the effectiveness of internal controls; whether company procedures/manuals are being followed; whether internally produced information is reliable; and whether the company is compliant with the OECD.

In addition to the above, internal audit will carry out ad hoc assignments, as required by management, e.g.: internal fraud investigations. If the internal audit department is to be effective in providing assurance it ne eds to be: sufficiently resourced, both financially and in terms of qualified, experienc ed staff; well organised, so that it has well developed work practices; and independent and objective. This last point needs some explanation. Internal auditors are (generally) emplo yed by the company they are reporting on and are often managed as part of the fi nance function. They will therefore have to report upon the effectiveness of fi nancial systems that they form a part of. It is therefore difficult for internal audit to remain truly objective. However , acceptable levels of independence can be achieved through one, or more, o f the following strategies: Reporting channels separate from the management of the main financial reporti ng function; Reviews of internal audit work by managers independent of the function under scrutiny; and Outsourcing the internal audit function to a professional third party. Expandable Text - Organisation How internal audit is organised will depend upon the scale of the organisation e mploying them, but usually it is necessary that; The head Lines of ary of them, ndependent of of internal audit has sufficient seniority within the organisation. communication ensure that internal audit reports, or at least a summ are reviewed by the audit committee or some other body which is i management.

 There should be 'whistlebbwing' arrangements so that, where circumstances demand e.g. fraud, internal auditors can report directly to the company's chairman or the c hair of the audit committee.

37 3 Limitations of the internal audit function

Reporting system The chief internal auditor reports to the finance director. This limits the ef fectiveness of the internal audit reports as the finance director will also be r esponsible for some of the financial systems that the internal auditor is report ing on. Similarly, the chief internal auditor may soften or limit criticism in reports to avoid confrontation with the finance director. To ensure independence, the internal audit should report to an audit committee. Scope of work The scope of work of internal audit is decided by the finance director in discus sion with the chief internal auditor. This means that the finance director may t ry and influence the chief internal auditor regarding the areas that the interna l audit department is auditing, possibly directing attention away from any contentious areas that :he director does not want auditing. To ensure independence, the scope of work of the internal audit department shoul d be decided by the chief internal auditor, perhaps with the assistance of an a udit committee. Audit work The chief internal auditor may audit their own work. This limits independence as the auditor is effectively auditing their own work, and may not therefore ident ify any mistakes. This is known as self review threat. To ensure independence, the chief internal auditor should not establish control systems in the company. However, where controls have already been establishe d. another member of internal audit should carry cut the audit of that system t o provide some limited independence. Lengths of service of internal audit staff Internal audit staff may be employed for a long poriod of time. This may limit t heir effectiveness as they will be very familiar with the systems being reviewed and therefore may not be sufficiently objective to identify errors in those s ystems. To ensure independence, the existing staff should be rotated into different are as of internal audit work and the chief internal auditor should independently r eview the work earned out. Appointment of chief internal auditor The chief internal auditor is appointed by an executive director/CEO. Given that the CEO is responsible for the running of the company, it is possible that ther

e will be bias in the appointment of the chief internal auditor, the CEO may ap point someone who he knows will not criticize his work or the company. To ensure independence. the chief internal auditor should be appointed by an au dit committee or at least the appointment agreed by the whole board.

38 Variation of standards Standards of audit are not uniform across the profession. This could lead to inc onsistency in the way internal audit is performed (both on a year-to-year basis and amongst different companies) and it can lead to manipulation of internal au dit aims and measurement criteria by companies. 4 Outsourcing the internal audit function In common with other areas of a company's operations, the directors may conside r that outsourcing the internal audit function represents better value than an in-house provision. Local government authorities are under particular pressure to ensure that all their services represent best value' and this may prompt th em to decide to adopt a competitive tender approach. Advantages hout Greater focus on cost and efficiency of the internal audit function. Staff may be drawn from a broader range of expertise. Risk of staff turnover is passed to the outsourcing firm. Specialist skills may be more readily available. Costs of employing permanent staff are avoided. May improve independence. Access to new market place technologies, e.g. audit methodology software wit associated costs. Reduced management time in administering an in-house department.

Disadvantages Possible conflict of interest if provided by the external auditors (In some j urisdictions - e.g. the UK, the ethics rules specifically prohibit the external auditors from providing internal audit services). Pressure on the independence of the outsourced function due to. e.g. threat by management not to renew contract. Risk of lack of knowledge and understanding of the organisation's objectives, culture or business. The decision may be based on cost with the effectiveness of the function bein g reduced. Flexibility and availability may not be as high as with an in-house function . Lack of control over standard of service. Risk of blurring of roles between internal and external audit, losing credibi lity for both. 5 Internal audit assignments Internal auditors perform many different types of assignment. Common examples i nclude: Value for money assignments; The audit of IT systems;

Financial audit; and Operational audit.

39 6 Value for money Value for money (VFM) is concerned with obtaining the best possible combinatio n of services for the least resources. It is often referred to as a review of th e three "E's": Economy - obtaining the best quality of resources for the minimum cost; Efficiency - obtaining the maximum departmental/organisational outputs with the minimum use of resources; and Effectiveness - achievement of goals and targets (departmental/organisational etc). Comparisons of value for money achieved by different organisations (or branches of the same organisation) are often made using performance indicators that pro vide a measure of economy, efficiency or effectiveness. This is particularly com mon in the 'not-for-profit' sector (i.e. public services and charities) Examples of health authority indicators might include: Economy - cost of medical supplies in a hospital; Efficiency - cost per patient on a hospital ward, average length of stay per patient; Effectiveness - absolute number of patients treated. 7 The audit of IT systems The external auditor considers IT systems from the perspective of whether they p rovide a reliable basis for the preparation of financial statements, and whethe r there are internal controls which are effective in reducing the risk of misst atement. Internal audit will also consider this. However, their role is much wider in sc ope and will also consider whether: the company is getting value for money; the procurement process was effective; and the ongoing management/maintenance of the system is appropriate.

Whilst this is an ongoing role project auditing can be used to look at whether the objectives of a specific project, such as commissioning a new factory or im plementing new IT systems, were achieved. 8 Financial audit The main aim of a financial reporting system, from a business perspective; is to create accurate, complete and timely information to be used as a basis for int ernal decision making and business planning. This information is also needed to satisfy the requirements of actual and potential investors and trading partn ers.

40 Typical examples of financial information include: annual financial statements, interim financial statements; monthly management accounts; and forecasts and projections.

The main aim of internal financial audit is to ensure that the information prod uced is reliable and produced in an efficient timely manner. If not then execut ive decisions may be based upon unreliable information or, may not be possible a t all. The other aim of financial audit is to assess the financial health of a busine ss. More importantly it is about ensuring there are mechanisms in place for th e early identification of financial risk, such as: adverse currency fluctuations; adverse interest rate fluctuations; and inflation.

In both cases the focus of internal audit will be on the processes and controls that underpin the creation of the various financial reports to ensure that they are as effective as possible for assisting the various decisions and risk mana gement processes of the company. 9 Operational internal audit assignments Operational auditing covers: Examination and review of the whole, or part of a business' operations; The effectiveness of operational controls; and Identification of areas for improvement in efficiency and performance.

General approach In operational audit a risk based approach should be used that: identifies the principal business risks involved which may prevent the organi sation achieving its objectives; and assesses the extent to which controls are in place and are operating effec tively in order to manage these risks. The outcome of each assignment should be a report to management which appraise s the control systems which are currently in place and which makes appropriate r ecommendations for improvement.

41 10 Internal Auditors and the Statutory Audit

ISA 610 Using the Work of Internal Auditors lists the main activities of the in ternal audit function as: Monitoring of internal control; Examination of financial and operating information Review of the operating activities; Review of compliance with laws and regulations; Risk management; and Governance.

Whist some of the work performed by internal and external auditors may be simil ar it must be remembered that the external auditor is solely responsible for the audit opinion. This responsibility can never be reduced by the use of the wo rk of the internal auditors and can never be delegated to internal audit. Internal auditors, by their very nature as employees of the organisation, will a lways be less objective than an external practitioner. Therefore their involvement in the statutory aud it must be approached with great care. If the external auditor wishes at any po int, to use the work of internal audit to assist with their procedures, they must firstly determine: Whether the work of internal audit is adequate for the purposes of the audit; The effect of the work of internal auditors or. the nature, timing and extent of the external auditor's own procedures: The objectivity of internal audit; The technical competence of internal audit; Whether the work of internal audit is carried out with due professional care , and Whether there is likely to be effective communication between the internal a nd external auditors. Contrasting Internal and External Auditors As assurance practitioners, both external and internal auditors will need to pla n their work so that they gather sufficient appropriate audit evidence, in keepi ng with the objectives of the assignment. External audit The focus of external audit is on ensuring that the financial statements are fre e from material misstatement; and properly prepared in accordance with a releva nt reporting framework. I herefore the planning of external audit work will be done to achieve this objective. All statutory audits must be planned in accorda nce with ISAs and other regulatory requirements. Internal audit Internal auditors plan their work so that they achieve the objectives of their a ssignments, as dictated by management.

42 Who does the planning? As we know, external auditors arc independent so they must be in control of plan

ning their own work, in accordance with the Objectives above. Internal auditors' work may be programmed for them by management so that they fo cus on the areas thought to be most important by the board and those charged w ith governance. However, t adds to the strength of corporate governance if the internal audit f unction has a degree of independence in the selection and objectives of its ass ignments. Evidence The general rule for assurance engagements is that the practitioner should gathe r sufficient appropriate ate evidence to support the opinion in the report which is the outcome of the assignment. ISA 330 stales that under ISAs the auditor gathers evidence which addresses the risk of misstatement as assessed during the planning process and in the light of evidence gathered subsequently. The external auditor, therefore is always g overned by this when deciding what evidence is appropriate. As we have seen above, the internal auditor may h ave different objectives, depending on the nature of the assignment. For example, consider the auditor's approach to non-current assets:

The external auditor is concerned with whether the figures for non current a ssets are materially misstated. So the auditor may check purchase prices agains t invoices, check depreciation is applied properly and physically inspect some assets, all on a test basis, and may therefore conclude that the figure for non current assets is materially correct The internal auditor may have an assignment to ensure that the plant registe r at a particular factory is up to date, and so will need to check that every item recorded exist s and that all machines on the factory- floor are recorded. The auditor may or may nut be concerned with values , depending on the nature of the assignment. Reporting The report produced by the internal auditor, is determined by the nature of the assignment. The eternal auditors report on financial statements is determined by atatute an d ISAs (700, 705 & 706). The external auditor must also communicate to those charged with governanc e, as discussed earlier in the text. Expandable Text Procurement Procurement Key question: Is the organisation achieving value for money in its purchases of goods and services? Is it paying: the right people? the right amount? for the right goods and services?

43 This is one area where the interests of internal and external auditors are ve ry similar and the detail of the work to be considered will be dealt with in dep th in chapter 8 Systems and Controls, chapter 9 on Audit Evidence and chapter 10 on Audit Procedures.

Expandable Text - Types of report provided In internal audit Types of report provided in internal audit assignments

Formal reports A formal written report is the traditional outcome from an internal audit assign ed A recommended structure for the report. set out in the following section.

Shorter memorandum reports for: smaller scale assignments assignments where less depth is required assignme nts where results are required urgently a shorter, less formal report may be required. Nevertheless, the same care needs to be taken with the contents of the report: Addressees - make sure it goes to the right people (especially reports deli vered by email). Subject matter - make sure the purpose of the report is clear and that the objective is addressed by the content of the report. Structure - make sure the report is laid out well so that its message is co mmunicated efficiently. Surprisingly, although this type of report is less formal, it still needs to be properly structured and lack of formality should not be taken as an excuse for sloppy drafting. Presentations An oral presentation can have a greater impact than a written document. Usually, however, a presentation will be delivered as well as the main report and used to highlight the key findings.

 Although the delivery methods are clearly different, the structure of a prese ntation has much in common with the structure of a formal written report. 44 Expandable Text - Structure of a formal report Cover of report The : Subject Distribution list Date of issue Any rating/evaluation. cover (or header for a shorter memorandum report) is surprisingly important

It makes sure the report goes to the right people. It can make the difference between the report being read or not so the sub ject needs to be expressed carefully.

Detailed findings and agreed action Setting out agreed actions, timescale for action and responsibilities for reso lution will be the meat of the report for line management. Recommendations for solving the problem. Who is to earn/ out the necessary actions. Deadlines and timescales.

Executive Summary The executive summary is like the whole report in miniature: It needs to grab the reader's attention to make sure they read the whole report. If the readers were only able to read the executive summary rather than al l the detail of the whole report, they should still be able to come to the sa me conclusion and make the same decisions. In a memorandum report, because it should be quite short to start with, there will usually be a summary of findings rather than a full executive summary. In a presentation, a very early slide should give the equivalent of the executi ve summary. If a question is asking you to demonstrate how a report should be structured al ways mention the executive summary, but it will probably bo sufficient to stat e that its content would be a summary of the rest of the report. Key findings and recommendations Summary of key findings and recommendations Short, clear summaries of the key findings and recommendations from the revie w. The main problems found. Breaches in procedures. Ineffective procedures.

45 Assessment gradings or ratings In some organisations, internal auditors provide 'ratings' of the area under r eview, indicating the extent of concern over control or the level of risk, or t he standard of performance in the area being reviewed. This can be in various forms: colors - red/amber/green numbers/letters - A, C or 1, 2,3 wording such as 'acceptable' or 'satisfactory' and 'unacceptable' or 'unsat isfactory' star ratings x, xx, xxx. Such ratings can help senior management: form an overall opinion of the organisation identify trends facilitate high level reporting.

However, they can also be seen negatively if they result in management respond ing defensively to a report on their area that will result in a poor rating. The most important consideration for rating a report is the basis on which any e valuation or measure will be carried out. This needs to be consistent and clear to ensure credibility of the ratings. The rating may be against a formal contro l or risk model that drives out the decision or opinion. Alternative formats The report can be set out either in: Paragraph format Tabular format.

Tabular format Ref 1 Finding Purchase invoices of 30 invoices reviewed, 10 had no evidence of being checked and had no supporting data to support payment. Action: All invoices will be supported by a corresponding purchase order and evidence of receipt of goods or service, with a check by the manager being evidenced prior to processing. Action: by DCXX Action Date By end of month Risk Fraudulent payment. Payment may be made for goods or services not received. Damage to reputation.

Appendices Explanations/further detail. Appropriate analysis to back up the matters referred to in the main body of t

he report. 46 Expandable Text - Process for producing an internal audit report

As we have seen, the reporl is Ihe culmination of the assignment and without T' ne report the assignment might as well never have happened. However, it is equally true to say that if the assignment was not properly plann ed and executed, there could be no report. So the production process for the report begins with the planning of the assign ment itself: At the planning stage ensure that the work to be done: will fulfill the objective of the assignment will dovetail with the requirements for the report.

After all the work has been done the report needs to be drafted: here t to It needs to be well structured. It needs to be clear and concise. Wherever possible, discuss it with those who will be affected by it so that t are no surprises. Check back with the original objectives terms of reference of the assignmen make sure that the report delivers what it was supposed to.

(1)What is the role of internal audit in maintaining standards of corporate gove rnance? (5 marks) (2)List the types of activities normally carried out by inter nal audit departments. (6 marks) (3)List and explain the limitations of internal audit. (4 marks) (4)List two types of internal audit report. (1 mark)

47 11 Chapter summary

Test your understanding answers

(1) What is the role of internal audit in maintaining standards of corporate gov ernance? Internal audit is part of the organisational control of a business; it is one o f the methods used by management to ensure the orderly and efficient running of the business as a whole and is part of the overall control environment. 1 mark A properly functioning internal audit department is part of good corporate gover nance, as recognized by national and international codes on corporate governance . 1 mark One of the objects of good corporate governance is to ensure that the needs of a ll stakeholders are met as far as possible and internal audit procedures meet the needs of the owners of the business, its employees, and the business community at large, as well as the needs of management. The main way in which internal audit exercises its functions is by enabling management to per form proper risk assessments in relation to corporate objectives by means of pr operly understanding the strengths and weaknesses in all of the control system i n the business. 2 marks The role of internal audit has expanded considerably in recent years and the s cope of internal audit is no longer routine or low level; internal audit is inv olved at all levels of management and internal audit includes non-routine mailer s such as assisting in selling corporate objectives and assessing performance a gainst them. 2 marks

48 (2) List the types of activities normally earned out by internal audit departments. The review of management, organisational, operational, accounting, internal cont rol and other business systems. 1 mark Making recommendations in relation to the improvement of systems and monitoring the performance of systems against targets. 1 mark Performing value for money (economy, efficiency and effectiveness), best value and similar audits. 1 mark Compliance work involving the review of compliance with legislation, regulations and codes of practices. 1 mark The detailed examination of financial and operating data. 1 mark Special investigations, such as fraud investigations. 1 mark (3) List and explain the limitations of internal audit. May not be independent. 1 mark There are no recognised standards for internal audit work. 1 mark There is an expectation gap in that Internal audit cannot uncover every fraud or solve even/ problem, even though others in the organisation may wish it could. 1 mark Internal audit may be regarded as management's private police force, and as a result may not receive full co- operation from those whose work is bei ng examined. 1 mark (4) List two types of internal audit report. Formal report. mark Shorter memorandum reports. mark Presentations. mark

49

50 5 Ethics and acceptance of appointment Chapter learning objectives When you have completed this chapter you will be able to:

Define and apply the fundamental principles of professional ethics; Define and apply the conceptual framework including the threats to the funda mental principles; Discuss the safeguards to offset the threats; Describe the auditor's responsibility with regard to auditor independence, co nflicts of interest and confidentiality: Discuss the preconditions and other requirements in relation to the acceptan ce of new audit engagements; Discuss the process by which an auditor obtains an audit engagement; and Explain the importance of engagement letters and state their contents.

51 1 Introduction - the need for professional ethics The purpose of assurance engagements is to increase the confidence of end users of information by reducing their level of risk. It therefore follows that the user needs to trust the professional who is providing the assurance. I n order to be trusted the auditor needs to be independent of their client. Indep endence can be defined as having 'freedom from situations and relationships where objectivity would be perceived to be impaired by a reasonable and informe d third party'. Despite this need for trust the fast thirty years has witnesse d a number of high profile corporate scandals that have had far reaching implications for com panies, economies and accountancy firms. Enron and WorldCom are perhaps two of the most high profile examples from recent times. To improve the image of the profession and to restore trust between users of accountancy services and the practitioners, it is vital that accountants operate (and are perceived to operate) according to an a ccepted code of ethics.

2 The IFAC and ACCA codes and the conceptual framework IFAC, through the International Ethics Standards Board for Accountants, has i ssued a code of ethics, as has the ACCA. The ACCA Code of Ethics is covered in this chapter however, both the IFAC and ACCA codes have the same roots and ar e, to all intents and purposes identical. Both follow a conceptual framework w hich identifies: fundamental principles of ethical behaviour potential threats to ethical behaviour possible safeguards which can be implemented to counter the threats. A conceptual framework relies on a principles rather than a rules based approac h. This provides guidance so that the principles may be applied to wide ranging and - potentially - unique circumstances. 52 Giving the framework some teeth Whilst it is expected that practitioners apply the spirit of the code to everyd ay practice the framework and principles would be of little use if they could not be enforced. Professional bodies like the ACCA therefore reserve the right to discipline memb ers who infringe the rules through a process of:

Disciplinary hearings which can result in: fines suspension of membership withdrawal of membership.

3 The fundamental principles

The formal definitions of the fundamental principles are as follows: Objectivity: Members should not allow bias, conflicts of interest or undue influence of others to overdue professional or business judgements. Professional behaviour: Members should comply with relevant laws and regula tions and should avoid any action that discredits the profession. Professional competence and due care: Members have a continuing duty to main tain professional knowledge and skill at a level required to ensure that a clie nt or employer receives competent professional service based on current develop ments in practice, legislation and techniques. Members should act diligently an d in accordance with applicable technical and professional standards when provi ding professional services. Integrity: Members should be straightforward and honest in all professional and business relationships. Confidentiality: Members should respect the confidentiality of information ac quired as a result of professional and business relationships anc should not d isclose any such information to third parties without proper and specific authority or unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professio nal and business relationships should not be used for the personal advantage of members or third parties. Practitioners needs to 'behave and be seen to behave' in an ethical, professiona l manner. This means complying with the Code of Ethics in every professional s ituation. 53 4 Threats and safeguards Expandable text - Definitions of threats The following are all examples of behaviour that could threaten the practitioner 's independence from their clients: Self Interest Threat This occurs when an auditor has a beneficial interest in a clients performance. Examples include: When the auditor or a member of their family owns shares in a client. They wo uld directly benefit from increases in client profits and would be reluctant to raise any concerns that could adversely affect the performance of the client. When a firm is dependent upon one client for a significant proportion of th eir total fee income. The firm may not raise issues with the client for fear of losing them.

 The acceptance of gifts and hospitality. This could be perceived as bribery t o keep quiet about issues in the financial statements Self Review Threat This occurs when an auditor has to review work that they previously performed. For example: if the external auditor prepared the financi al statements and then audited them. There is a risk that the auditor would not identify any shortcomings in their o wn work for fear of penalty (either financial or reputational). Advocacy Threat This can occur when the auditor is asked to promote or represent their client in some way. In this situation the auditor would have to be biased in favour of the client and therefore cannot be objective. This could happen if the client asked the auditor to promote their shares for a stock exchange listing or if t he client asked the auditor to represent them in court. Familiarity Threat This occurs when the auditor is too sympathetic or trusting of the client becau se of a close relationship with them. This may be because a close friend or re lative of the auditor works in a key role for the client. The auditor may trust their friend or relative to not make mistakes and therefore not review their work as thoroughly as they should and as a result al low material errors to go undetected in the financial statements. This can also arise after a long as sociation with a client.

54 Intimidation Threat Clients may try to harass or bully auditors into giving preferential audit repor ts. They may use the fee as leverage. The auditor should not give in to such p ressure and. in the circumstances, may choose to resign from such a client. Identifying the threats In order to guard against these threats, real or perceived, firms should establ ish procedures to enable them to: Identify possible threats: Evaluate the risk arising from the threat; Evaluate whether the necessary safeguards are in place; and Take corrective action if necessary.

Usually this will be done through the use of checklists. Whilst ethics shoul d always be of paramount consideration it must be considered at these vital jun ctures: On acceptance of a new client;

At the planning stage of any audit; At the completion stage of any audit; Whenever additional, non audit services are provided to an audit client; and If any event, or change In circumstance, occurs to either the auditor or the client.

Possible safeguards General safeguards, as recommended by ACCA Safeguards created by the profession. These include: education; training and experience requirements for entry into the profession; continuing professional development requirements; corporate governance regulations; professional standar ds; monitoring; external review of work and reports; and disciplinary action. Safeguards in the work environment. These include: oversight structures; et hics and conduct programmes: recruitment procedures: internal controls disciplinary pro cedures; strong ethical leadership; policies and procedures to promote quality control a nd culture. Safeguards created by individuals. These include: complying with professional development requirements; keeping records of contentious issues; using a mentor , and keeping in contact with professional bodies.

Specific safeguards It is important to note that the safeguards listed below are generally well reg arded principles that can be applied across a range of engagements and national boundaries. However, national regulatory authorities may have their own ethica l standards (such as the UK's Audit Practice Board's Ethical Standards) which a re enforceable nationally. In certain circumstances the limits and thresholds m ay be different 55 Common safeguards that should be employed by auditors include: monitoring fees received from significant clients in comparison to total fees to reduce perception of dependence on clients; rotating senior audit staff on an engagement after a fixed period to reduce f amiliarity threat; using separate teams (and partners) where additional services are offered t o audit clients to reduce self review threat; using independent partners to review work where any ethical threat is ident ified; not accepting gifts or hospitality, unless il is considered by a partner to b e modest: not engaging in any business or financial relationship with a client; not allowing individuals with personal or family ties to a client to be invol ved in the audit of that company: not providing accountancy or internal audit services for listed audit clients ; maintaining an up to date engagement letter; and in cases where no safeguard are considered sufficient the auditor should res ign.

5 Confidentiality External auditors are in a unique position of having a legal right of access to all information about their clients. It goes without saying that the client mu st be able to trust the auditor not to disclose anything about their business t o anyone as it could be detrimental to their operations. As a basic rule, membe rs of an audit team should not disclose any information to those outside of the audit team, whether or not they work for the same firm. There is little point using different teams for different work assignments if staff from different tea ms are disclosing information to each other! Information should only be disclosed under certain circumstances, as follows: ney If the client has given their consent. If there is an obligation to disclose, e.g. if the client is suspected of mo laundering, terrorism, drug trafficking. If it is required by a regulatory body. e.g. financial services legislation. If a court order has been obtained. If a member has to defend himself in court or at a disciplinary hearing. If it is in the public interest.

This latter point is difficult to prove and the audit must proceed with caution if thinking of disclosing information for this reason. Such examples could inc lude fraud, environmental pollution, or simply companies acting against the publ ic good. Legal advice should be sought beforehand to avoid the risk of being sued. Matter s to consider before disclosing information in the public interest are whether that matter is likely to be repeated and how serious the effects of the clien t's actions are. Conflicts of interest Any advice given should be in the best interests of the client. However, wher e clients' interests conflict (for example, clients in the same line of busines s), the firm's work should be arranged to avoid the interests of one being adversely affected by those of another. The steps to be taken by the auditor are: 56 once a conflict is noted, you should advise both clients of the situation reassure the client that adequate safeguards will be implemented, e.g. separa te engagement leaders for each, separate teams, 'Chinese walls' to prevent the t ransfer of client information between teams and a second partner review suggest they seek additional independent advice if adequate safeguards can't be implemented, the auditor should resign. 6 Accepting new audit engagements

57 Expandable Text - Procedures If offered an audit role, the auditor should: ask the client for permission to contact the outgoing auditor (reject role i f client refuses) contact the outgoing auditor, asking for any reasons why they should not ac cept appointment.

If a reply is not received, the prospective auditor should try and contact the outgoing auditor by other means e.g. by telephone. If a reply is still not rece ived the prospective auditor may still choose to accept but must proceed with ca re. ensure that the legal requirements in relation to the removal of the previou s auditors and the appointment of the firm have been met (these were covered i n chapter 2) carry out checks to ensure the firm can be independent, is competent to do t his audit and has the necessary resources assess whether this work is suitably low risk assess the integrity of the company's directors as a commercial organisation, the firm should also ensure that this is a des irable client (e.g. right industry, suitable profit margin etc) not accept the appointment, where it is known that a limitation will be plac ed on the scope of the audit. 7 Engagement letters Engagement letters - main considerations The engagement letter will be sent before the audit. II specifies the nature of the contract between the audit firm and the client and minimises the risk of an y misundetstancing of the auditor's role. It should be reviewed every year to ensure that it is up to date but does not n eed to be reissued every year unless there are changes to the terms of the eng agement the auditor must issue a new engagement letter if the scope or context of the assignment changes after initial appointment. Many firms of auditors choose to send a new letter every year, to Emphasise its importance to clients.

Expandable Text - Reasons for changes Reasons for changes include: Changes to statutory duties due to new legislation. Changes to professional duties, perhaps due to new ISAs. Changes to 'other services' as requested by clients.

The contents of the engagement letter The 210 58 contents of a letter of engagement for audit services are listed in ISA Agreeing the Terms of Audit Engagements. They should include the following: The objective and scope of the audit; The responsibilities of the auditor; The responsibilities of management; The identification of an applicable financial reporting framework; and Reference to the expected form and content of any reports to be issued.

Expandable Text - Contents of the engagement letter In addition to the above the engagement letter may also make reference to: The unavoidable risk that some material! misstatements may go undetected due

to the inherent Imitations in an audit; Arrangements regarding the planning and performance of the audit; The expectation that management will provide written representations; The agreement of management to make available to the auditor draft financial statements and other information in time to complete the audit in accordance wi th the proposed timetable; The agreement of management to inform the auditor of facts that may affect t he financial statements; The basis on which fees are computed and billing arrangements; A request for management to acknowledge receipt of the engagement letter and to agree the terms outlined; Agreements concerning the involvement of auditors experts and internal audito rs; and Restrictions to the auditor's liability.

Test your understanding 1 List and explain - the fundamental principles of the ACCA and IFAC Codes of Et hics? (2 marks) List the threats to objectivity. (2 marks) Tost your understanding 2 Client confidentiality underpins the relationship between Chartered Certified Ac countants in practice and their clients. It is a core element of ACCA's Rules of Professional Conduct. Required: (a) Explain the circumstances in which ACCA's Rules of Professional Conduct perm it or require external auditors to disclose information relating to the r client s to third parties without the knowledge or consent of the client. (8 marks) (b) A waste disposal company has breached tax regulations, environmental regula tions and health and safety regulations. The auditor has been approached by t he tax authorities, the government body supervising the aware or licenses to suc h companies and a trade union representative. All of them have asked the audi tor to provide them with information about the company. The auditor has also been approached by the police. They are investigating a suspected fraud perpetra ted by the managing director of the company and they wish to ask the auditor cer tain questions about him. Describe how the auditor should respond to these types of request. (12 marks) T otal 20 marks 59 FIXED TEST 1 - JT & Co. You are a manager in the audit firm of JT & Co; and this is your first time you have worked on one of the firm's established clients, Pink Co. The main activ ity of Pink Co is providing investment advice to individuals regarding saving f or retirement, purchase of shares and securities and investing in lax efficient savings schemes. Pink is regulated by the relevant financial services authority You have been asked to start the audit planning for Pink Co, by Mrs Goodall, a partner in JT & Co. Mrs Goodall has been the engagement partner for Pink Co, fo r the previous six years and so has a sound knowledge of the client. Mrs Goodall has informed you that she would like her son Simon to be part of the audit tea m this year; Simon is currently studying for his first set of fundamentals pap ers for her ACCA qualification. Mrs Goodall also informs you that Mr Supper, the

audit senior, received investment advice from Pink Co during the year and inte nds to do the same next year. In an initial meeting with the finance director of Pink Co, you learn that the a udit team will not be entertained on Pink Co's yacht this year as this could appear to bo an attempt to influence the opinion of the audit. Instead, he has arranged a day at the horse races costing less than two fifth's of the expense o f using the yacht and hopes this will be acceptable. JT & Co have done some consultive work previously and the invoice is still out standing. Required: (a) (i) Explain the ethical threats which may affect the auditor of Pink Co. (6 marks) (ii) For each ethical threat, discuss how the effect of the threat can be mi tigated. (6 marks) (12 marks) Expandable Text - Answer plan You are a manager in the audit firm of JT & Co; and this is your first time you have worked on one of the firm's established clients. Pink Co. The main activ ity of Pink Co is providing investment advice to individuals regarding saving f or retirement, purchase of shares and securities and investing in tax efficient savings schemes. Pink is regulated by the relevant financial services authority. You have been asked to start the audit planning for Pink Co. by Mrs Goodall. a partner in JT & Co. Mrs Goodall has been the engagement partner for Pink Co. fo r the previous six years and so has a sound knowledge of the client. Mrs Goodall has informed you that she would like her son Simon to be part of the audit tea m this year; Simon is currently studying for his first set of fundamentals pape rs for her ACCA qualification. Mrs Goodall also informs you that Mr Supper, the audit senior, received investment advice from Pink Co during the year and inten ds to do the same next year. In an initial meeting with the finance director of Pink Co. you learn that the a udit team will not be entertained on Pink Co's yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he has arranged a day at the horse races costing less than two fifth's of the expense of using the yacht and hopes this will be acceptable.

60 JT & Co have done some consultive work previously and the invoice is still out standing. Required: (a) (i) Explain the ethical threats which may affect the auditor of Pink C o. (6 marks) (ii)For each ethical threat, discuss how the effect of the threat can be miti gated (6 marks) (12 marks)

8 Chapter summary

61 Test your understanding answers Test your understanding 1 Objectivity: Members should not allow bias, conflicts of interest or undue infl uence of others to override professional or business judgements. 2x mark Professional behaviour: Members should comply with relevant laws and regulations and should avoid any action that discredits the profession. 2x mark Professional competence and due care: Members have a continuing duty to maintai n professional knowledge and skill at a level required to ensure that a client or employer receives competent professional service based on current developmen ts in practice, legislation and techniques. Members should act diligently and in accordance with applicable technical and professional standards when providin g professional services. 2x mark Integrity: Members should be straightforward and honest in all professional and business relationships. 2x mark Confidentiality: Members should respect the confidentiality of information acqu ired as a result of professional and business relationships and should not disc lose any such information to third-parties without proper and specific author ity or unless there is a legal or professional right or duty to disclose Confid ential information acquired as a result of professional and business relationshi ps should not be used for the personal advantage of members or third parties. Test your understanding 2 (a) Disclosure of information relating to clients to third parties (i) Auditors are permitted or required to disclose information about their clie nts to third parties without their knowledge or consent in very limited circumst ances. (ii) Generally, auditors can be required to, or are permitted to, disclose inf ormation to certain regulatory bodies, including certain specialist units withi n police forces under legislation. Such legislation in many countries includes financial services legislation. Leg islation concerning banks and insurance companies, legislation concerning money laundering and legislation concerning the investigation of serious fraud or tax evasion.

(iii) Auditors are also permitted or required to disclose information where th ey are personal y involved in litigation, including litigation that involves the recovery of fees from clients, or where they are subject to disciplinary proceedings brought by ACCA or other, similar professional bodies. (iv) Auditors are also permitted to disclose information where to be in the public interest' or in the interests of national s to take into account include the seriousness of the matter, repetition and the extent to which the public is involved. rarely used in practice. they consider it security. Factor the likelihood of This right is

62 (b) Response to requests (i) It is not unusual in practice for various bodies to request information fr om auditors 'infernally' because it relieves them of the obligation to obtain th e necessary statutory authorities which may be time consuming or difficult. (ii) Auditors must not disclose information without the consent of the client or unless the necessary statutory documentation is provided by the person(s) reque sting the information. (iii) Unless the auditor has reason to believe that there is a statutory duty n ot to inform the clicnt that an approach has been made, the client should firs t be approached to see if consent can be obtained, and to see if the client is aware of the investigations, as should normally be the case The auditor shoul d ensure that the client is aware of the fact the voluntary disclosure may work m the client's favour, in the long run. but if the client refuses, the auditor should inform the client if the auditor has a statutory duty of disclosure. (iv) Auditors should take legal advice in all of the cases described. (v) Where the auditor is made aware of potential actions against the client th at may have an effect on the financial statements, the auditor must consider th e effect on the audit report. It the client is aware of the investigation, the auditor will be able to seek audit evi dence to support any necessary provisions or disclosures in the financial statem ents. (vi) The auditors should consider whether the suspected fraud relating to the m anaging director relates to the company and affects the financial statements. (vii) Auditors will be in a very difficult situation if they become aware of an action that may materially affect the financial statements, but where the clien t is not. and where auditors are under a statutory duty not to inform the client. This situation will not be improved by the resignation of auditors as they may be obliged to make a statement on resig nation. This puts auditors in a very difficult position and legal advice is esse ntial in such circumstances. (viii) Tax authorities normally have powers to ask clients to disclose informat

ion voluntarily. Such voluntary disclosure is often looked on favourably by the tax authorities and the courts. Tax authorities normally also have statutory powers to demand information from both clients and auditors. The same is generally true of environmental and health and safety inspectors. (ix) The power of the police to demand information is sometimes less clear and auditors and clients should take care to ensure that the appropriate authorit ies are in place. Those sections of the police investigating serious frauds usually have more powers than the gener al police. It is unlikely that trade union representatives have any statutory powers to demand information. FIXED TEST 1 - JT & Co. THIS IS A FIXED TEST - Please answer the question in full (long form written) Th en log on to en- gage at the following address: www.en-gage.co.uk. Follow the li nk to 'Fixed Test 1' and answer the questions based on your homework answer. Once you have answered the questions on en-gage a model answer will be availab le for your reference. 63

64 6 Risk Chapter learning objectives Upon completion of this chapter you will be able to: and nd Upon completion of this chapter you will be able to: Identify the objectives of the auditor; Describe the need to plan and perform audits with professional scepticism, to exercise professional judgement; Explain the need to conduct audits in accordance with ISAs: Explain the components of audit risk; Explain how auditors obtain an understanding of the entity and environment; a Describe the risk assessment procedures.

65

ISA's and Risk One of the overriding principles of modern auditing is introduced in ISA 200 Ov erall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISA's: 'To obtain reasonable assurance, the auditor shall obtain sufficient appropriat e evidence to reduce audit risk to an acceptably low level....'

Audit on.

risk is the risk that the auditor expresses an inappropriate audit opini

This is further developed by ISA 315 Identifying and Assessing the Risks of Mate rial Misstatement Through Understanding the Entity and its Environment 'The objective of the auditor is to identify and assess the risk of material misstatement, whether due to fraud or error, at the financial statement and ass ertion levels, through understanding the entity and its environment, including the entity's internal control, thereby providing a basis for designing and impl ementing responses to the assessed risks of material misstatement.' In simple terms: the auditor identifies the risk of material misstatement and they use this to guide the design of their audit testing/procedures. To assess the risk of material misstatement the auditor first of all assesses the unique o perating environment of the client. This is the root cause of misstatement and i s often referred to as inherent risk. Secondly the auditor considers how the cl ient's control systems, particularly financial ones, prevent and detect those mi sstatements. This is referred to as control risk. 1 Risk assessment as part of the audit process Auditors are required to perform audits with an attitude of professional sceptic ism This is defined as: "An attitude that induces a questioning mind, being alert to conditions which m ay indicate possible misstatement due to fraud or error, and a critical assessm ent of audit evidence." (ISA 200 Overall Objectives of the Independent Auditor a nd the Conduct of an Audit in Accordance with International Standards of Auditing). 66 Having an enquiring mind in itself is not sufficient to comply with a risk based method of auditing. In order to fulfill this responsibility auditors must also use professional judge ment. This means the application of relevant training, knowledge and experience in making informed decisions about the courses of action that are appropriate to the unique circumstances of the audit engagement. Therefore the use of a risk based approach requires skill, knowledge, experience and an inquisitive, open mind; something that is neither gained quickly nor ea sily. 2 The importance of risk analysis Risk analysis is an important stage of the audit. In conducting a thorough asse ssment of risk auditors will be able to: Identify areas of the financial statements where misstatements are likely to occur early in the audit; Plan procedures that address the significant nsk areas identified; Carry out an efficient, focused and effective audit; Minimise the risk of issuing an inappropriate audit opinion to an acceptable level; Reduce the risk of reputational and punitive damage. Although risk assessment is a fundamental element of the planning process, it is important to understand that risks can be uncovered at any stage of the audit a nd that procedures must be adapted in light of revelations that indicate further

risks of material misstatement. It is, ultimately, the responsibility of the mo st senior reviewer (usually the engagement partner) to confirm that the risk of material misstatement has been reduced to an acceptable level. 3 Audit risk

Audit risk As slated earlier; audit risk is the risk of that the auditor expresses an inap propriate audit opinion, i.e. that they give an unmodified audit opinion when t he financial statements contain a material misstatement. It can be further defined by way of the following formula:

67 Inherent risk This is the susceptibility of a class of transaction, account balance or disclos ure to a misstatement that could be material, either individually or in aggregat e, before consideration of related controls. In other words this is the risk that a misstatement occurs in the first instance Inherent risk is often considered in relation to business risk. These are the ri sks resulting from conditions, events, circumstances, actions or inactions that could adversely affect an entity's ability to achieve its business objectives an d goals. Ultimately these business risks can lead to complications and deficiencies in the accounting process, which could lead to f raud, error or omission. Clearly this requires the audit team to have a good knowledge of how the clien t's activities are likely to affect its financial statements, and the audit team should discuss these matters in a planning meeting before deciding on the de tailed approach and audit work to be used. Control risk This is the risk is that a misstatement will not be prevented, or detected and corroded on a timely basis by the entity's internal controls. This is either du e to the internal control system being insufficient in the circumstances of the business or because the controls have not been applied effectively during the p eriod. We will consider internal control in depth later in the text. Detection risk This is the risk that the procedures performed by the auditor to reduce audit r isk to an acceptable level will not detect potentially material misstatements, e ither individually or in aggregate. 4 Understanding the Entity and its Environment Auditors are required to obtain an understanding of: their clients; their clien ts' environments; and their clients' internal controls. This is often referred t

o as Knowledge of the Business, or"KOB." This generally includes: Relevant industry, regulatory and other external factors (including the fina ncial reporting framework); The nature of the entity, including: its operations; its ownership and governance structures; the types of investment it makes; and the way it is structured and financed. The The The The entity's selection and application of accounting policies; entity's objectives, strategies and related business risks; measurement arid review of the entitys financial performance; and internal controls relevant to the audit.

(ISA 315 Identifying and Assessing the Risks of Materiel Misstatement...)

68 The purpose of acquiring this knowledge is to identify the risks that the busine ss ;s exposed to and, ultimately, how could these lead to a risk of material mis statement in the financial statements. The information used to complete these references can come from a wide range o f sources, including:

Risk

assessment procedures

ISA 315 requires auditors to perform the following procedures to understand the entity and its environment: Enquiries with management and others within the client entity (e.g. about e xternal and internal changes the company has experienced); Analytical procedures; and Observation (e.g. of control procedures) and inspection (e.g. of key strategi c documents and procedural manuals). 5 Analytical procedures Analytical procedures are fundamental to the auditing process and are used at the planning, performance and review stage of the audit. They are defined in ISA 520 Analytical Procedures as: "The evaluation of financial information through analysis of plausible relatio nships among both financial and non-financial data.

69 Traditionally they incorporate the comparison of: Current and prior year figures; Current and budgeted/forecast figures; and Client and industry average figures.

At the planning stage analytical procedures are useful for helping to gain an understanding of the client's performance over the last twelve months and to i dentify any significant changes to the business, for example: the disposal of si gnificant land and buildings. In addition, analytical procedures are also used to identify peculiar deviations (from either prior year figures, budget or the auditor's knowledge) that could indicate misstatement in the reported figure s. These must then be investigated during final audit procedures. For example; when conducting an analytical review of a current audit client y ou notice that turnover had increased by 20% in comparison to last year but del ivery costs have increased by 50%. Normally you would expect costs to rise in l ine with changes in activity but clearly delivery costs have increased at a much higher rate. Plausible reasons for this variance include: Increasing sales by attracting customers from more distant geographical location s; Reducing delivery waiting times by making more frequent deliveries; or There is an error in either sales or delivery costs.

The reason for the variance will be investigated during the audit until a satisf actory explanation is obtained. Mere recently, computer aided auditing techniques have been used to perform d

ata analysis. Example Risks Factor/ Identify Type of risk Audit risk

Lack of physical controls, e.g physical security of assets restriction of access no CCTV Increased risk of theft and damage of assets. Incorrect valuation of assets in statement of financial position. Control Risk Lack of IT based controls lack of password protection. Computer systems and financial information could be changed or modified without suitable authorization. Control Risk

70 Factor/ Identify Type of risk

Audit risk

Lack of authorisation controls. High risk transactions performed, e.g. credit sales to high risk customers: Fraudulent transactions Control Risk Lack of segregation of duties. Not identifying errors and fraud as only one person doing the job therefore concealment easier. Control Risk

Account balances for complex, judgemental areas of accounting, e.g. provisions. Due to the natures of these transactions a high degree of judgement or estimatio n I is involved and is therefore open to manipulation or error. Inherent Risk Client operates in a high tech or fast moving industry Inventory may become obsolete and may be overstated in the financial statements

Inherent Risk Client is based in multiple locations Inventory held at other locations may be omitted from year-end inventory Controls may be less effective Control Risk + Detection Risk Bank is relying on the financial statements or Directors are paid a bonus based on profits Risk of management bias Inherent Risk It is cash-based business turnover to be Understated Inherent Risk + Potentially control risk Cash may be misappropriated, causing

The company trades overseas Transactions in foreign currency may not be translated at the correct rate The company may make foreign exchange losses Inherent Risk

71 Factor/Identify Type of risk

Audit risk

New computer systems system to another

Errors in transferring the data from one

There may be inherent errors in the new system that have not yet been discovered Control risk + Inherent New audit client dge and experience may lead to increased detection risk Detection risk Lack of cumulative audit knowle

Tight audit deadline imposed by client Staff working quickly to a tight deadline are more likely to make errors There is a shorter post statement of financial position period that we can use to help with our audit

Detection risk Temporary staff used during the year Errors more likely as staff are not familiar with the client's systems Control risk A client in a specialised industry Errors more likely or fraud more likely to be missed because of the complexity of the work Inherent risk

Test your understanding 1 Nepco is a European company that manufactures high quality computer components and assembles computer parts. It has existed for some years and is part of a ver tical supply chain for a well-known brand of computer hardware. Profits are c oming under increasing pressure from manufacturers in the Far East and Asia w ith lower labour costs, and from rising raw material costs. Nepco is listed on a stock exchange. There is pressure from institutional investors for better re turns in the form of dividends and the main institutional investors are consider ing selling a proportion of their shares in the company. The directors of Nepco are considering whether to move into new ma rket areas. Nepco has good accounting and internal control systems. Inventory material to the accounts, and there is a good set of permanent inventory recor ds. No year-end inventory count is conducted. Operational compliance issues are important to Nepco as many countnes have inflexible quality standards and som e projects are being held up because of difficulties in obtaining approval from regulates for new components. All staff and directors of Nepco are remunerated (at least in part) on a performance-related basis, some with share options. Sta ff are generally highly qualified and well- paid. This is your first year as auditors. Your firm has very little experience in thi s industry. External audit costs are tightly controlled and your firm has agre ed to a budget that will allow very little flexibility. 72 Required: (a) Describe the risks relating to Nepco under the headings of inherent risk, control risk and detection risk.(12 marks) (b) In the light of the risks identified in (a) above, list the matters to which you will pay particular attention during the audit of Nepco and explain the wo rk you will perform in relation to them. (8 marks) (Total: 20 marks)

FIXED TEST 2 (a) Explain the term 'audit risk' (4 marks)

(b) You are the audit manager for Parker, a limited liability company which sel ls books. CDs, DVDs and similar items via two divisions: mail order and on-li ne ordering on the Internet. Parker is a new audit client. You are commencing t he planning of the audit for the year-ended 31 May 20X5. An initial meeting with the directors has provided the information below. The company's sales revenue is in excess of $85 million with net profits of $4 m illion. All profits are currently earned in the mail order division, although th e Internet division is expected to return a small net profit next year. Sales revenue is growing at the rate of 20% p.a. net profit has remained almost the s ame for the last four years. In the next year, the directors plan to expand the range of goods sold through the Internet division to include toys, garden fur niture and fashion clothes. The directors believe that when one product has be en sold on the Internet, then any other product can be as well. The accounting system to record sales by the mail order division is relatively old. It relies on extensive manual input to transfer orders received in the pest onto Parker's computer systems. Recently errors have been known to occur, in the input of orders, and in the invoicing of goods following despatch. The dire ctors maintain that the accounting system produces maternally correct figures an d they cannot waste time in identifying relatively minor errors. The company accountant, who is not qualified and was appointed because he is a personal fri end of the directors, agrees with this view. The directors estimate that their e xpansion plans will require a bank loan of approximately $30 million, partly to finance the enhanced web site but also to provide working capital to increase inventory levels. A meeting with th e bank has been scheduled for three months after the year end. The directors expect an unmodified auditor's report to be signed prior to this time. Required: Identify and describe the matters that give rise to audit risks associated with Parker. (10 marks)

73 Test your understanding 2 (a) With reference to ISA 520 Analytical Procedures explain (i) what is meant by the term 'analytical procedures; (2 marks) (ii) the different types of analytical procedures available to the auditor; and (3 marks) (iii) the situations in the audit when analytical procedures can be used. (3 marks) Tribe Co sells bathrooms from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Tribe's own delivery vans; most bathrooms are too big for individual's to transport in their own motor vehicles. The directors of Tribe indicate that the company has had a difficult year, but are pleased t o present some acceptable results to the members.

The income statements for the last two financial years are shown below: Income statement 31 March 2009 $ 000 Revenue 9,546 Cost of sales (6380) 5,943 Operating expenses Administration (1,853) (1,980) Selling and distribution 472) (1,034) Interest payable (152) (158) Investment income 218 2,684 (6) (1, 3,166 31 March 2008 $ 000 11,223 (5,280)

Required: Financial statement extract Cash and bank (1,425) 380

(b) As part of your risk assessment procedures for Tribe Co, identify and provi de a possible explanation for unusual changes in the income statement. (9 m arks)

74 6. Chapter summary

Test your understanding answers

75 Test your understanding 1 (a) Risks (i) Inherent risks include: -The competition from Asian and Far Eastern companies, and rising raw material p rices. This means that there is pressure on profits and the ability to reward employees and pay dividends to institutional shareholders which increases the pressure to mani pulate the financial statements to show good returns. -The potentially volatile market (computer components) in which new technology can render hardware obsolete in a very short time. This means that there is a n ongoing risk to the business as a whole (a potential going concern risk) - the company must be a daptable. -The risk that regulators may reject a product which has taken many months or years to develop. -The pressures for returns from institutional investors which means that there may be a temptation to manipulate the financial statements. -The possible sale of shares, increasing the pressure for returns in order to g et the best possible price, which increases the pressure to manipulate the finan cial statements. -The inherent risks in diversification into unknown areas (the supply of other customers) - but these are not current risks. (ii) Control risks: there are apparently very few except for the performance-re lated payment, including share options, which provides an incentive to produce ' acceptable' figures. (iii) Detection risk: this is the firm's first year as auditors and there are

tight controls on audit costs, which may lead to ss the audit is properly directed, supervised and by the firm's lack of experience in this area. It xperience are employed on this audit, at least in

inadequate audit evidence unle reviewed. This is compounded is important that those with e a review capacity.

(b) Matters to which attention should be paid and work to be performed (i) The good accounting records and internal control combined with the need to k eep audit costs down means that a compliance approach, rather than a substant ive approach will be necessary wherever possible. (ii) Audit work will need to be directed towards inventory (despite the fact tha t it is well controlled) because it is material to the accounts. There is no y ear-end inventory count, and inventory is relatively easy to manipulate. It is l ikely that there will be a substantial amount of work-in-progress and its valua tion will need to be reviewed carefully. It may be possible to rely on any inter im or cyclical inventory counting. (iii) The projects on which compliance problems have arisen should be examined carefully as the costs may be significant and there may be a temptation to unde rstate them. (iv) Overall profits and any unadjusted errors should be examined carefully be cause of the inherent risks noted above and the performance-related pay.

76 (v) The company's going concern status should be reviewed by examining its fina ncial status, financial support and likely future developments in high risk area s. Fixed Test 2 THIS IS A FIXED TEST - Please answer the question in full (long form written) Th en log on to en- gage at the following address: www.en-gage.co.uk. Follow the li nk to 'Fixed Test 2' and answer the questions based on your homework answer. On ce you have answered the questions on engage a model answer will be available for your reference. Test your understanding 2 (a) (i) Explanation of analytical procedures Analytical procedures are used in obtaining an understanding of an entity and i ts environment and in the overall review at the end of the audit. 1 mark 'Analytical procedures' actually means the evaluation of financial and other inf ormation and the review of plausible relationships in that information. The rev iew also includes identifying fluctuations and relationships that do not appear consistent with other relevant information or results. 1 mark (ii) Types of analytical procedures Analytical procedures can be used as: - Comparison of comparable information to prior periods to identify unusual chan ges or fluctuations in amounts. 1 mark - Comparison of actual or anticipated results of the entity with budgets and/or

forecasts, or the expectations of the auditor in order to determine the potent ial accuracy of those results. 1 mark - Comparison to industry information either for the industry as a whole or by co mparison to entities of similar size to the client to determine whether receivab le days, for example, are reasonable. 1 mark (iii) Use of analytical procedures Risk assessment procedures Analytical procedures are used at the beginning of the audit to help the audito r obtain an understanding of the entity and assess the risk of material misstat ement. Audit procedures can then be directed to these 'risky' areas. Analytical procedures are substantive procedures. 1 mark Analytical procedures can be used as substantive procedures in determining the risk of material misstatement at the assertion level during work on the income statement and statement of financial position (balance sheet). 1 mark Analytical procedures in the overall review at the end of the audit. Analytical procedures help the auditor at the end of the audit in forming an ove rall conclusion as to whether the financial statements as a whole are consisten t with the auditor's understanding of the entity. 1 mark 77 (b) Net profit mark

Overall. Tribe's result has changed from a not loss to a net profit. Given that sales have only increased by 17% and that expenses, at least administration ex penses, appear low, then there is the possibility that expenditure may be unde rstated. 1 mark Sales - increase 17% mark

According to the directors, Tribe has had a difficult year'. Reasons for the in crease in sales income must be ascertained as the change does not conform to the directors' comments, it is possible that the industry as a whole, has been gro wing allowing Tribe to produce this good result. 1 mark Cost of sales-fall 17% mark

A fall in cost of sales in unusual given that sales have increased significantl y. This may have been caused by an incorrect inventory valuation and the use o f different (cheaper) suppliers which may cause problems with faulty goods in th e next year. 1 mark Gross profit (GP) - increase 88% mark This is significant increase with the GP% changing from 33% last year to 53% in 2008. Identifying reasons for this change will need to focus initially on the c hange in sales and cost of sales. 1 mark Administration - fall 6% mark

A fall is unusual given that sales are increasing and so an increase in adminis tration to support those sales would be expected. Expenditure may be understated , or there has been a decrease in the number of administration staff. 1 mark

Selling and distribution - increase 42%

mark

This increase does not appear to be in line with the increase in sales - selling and distribution would be expected to increase in line with sales. There may b e mis-allocation of expenses from administration or the age of Tribe's delive ry vans is increasing resulting in additional service costs. 1 mark Interest payable - small fall mark

Given that Tribe has a considerable cash surplus this year, continuing to pay interest is surprising. The amount may be overstated - reasons for lack of fall in interest payment e.g. leans that cannot be repaid early, must be determined. 1 mark Investment income - new this year mark

This is expected given cash surplus on the year, although the amount is still v ery high indicating possible errors in the amount or other income generating ass ets not disclosed on the statement of financial position extract. 1 mark

78 7 Planning Chapter learning objectives When you have completed this chapter you will be able to: an: Define and explain the concepts of materiality and performance materiality: Discuss the effect of fraud on the audit strategy; Explain the auditor's responsibility to consider laws and regulations. Identify and explain the need for planning an audit: Identify and describe the contents of the overall audit strategy and audit pl and Explain the need for and the importance of audit documentation.

79

1 Objectives of the Auditor "The objective of the auditor is to plan the audit so that the audit so that it will be performed in an effective manner." (ISA 300 Planning and Audit of Financial Statements).

80 Audits are potentially complex, risky and expensive processes for an accounta ncy firm Although firms have internal manuals and standardised procedures it is vital that engagements are planned to ensure that the auditor: Devotes appropriate attention to important areas of the audit; Identifies and resolves potential problems on a timely basis; Organises and manages the audit so that it is performed in an effective and e fficient manner; Selects team members with appropriate capabilities and competencies. Directs and supervises the team and reviews their work; and Effectively coordinates the work of others, such as experts and internal aud it. The purpose of all this is to ensure that the risk of performing a poor quali ty audit (and ultimately giving an inappropriate audit opinion) is reduced to an acceptable level. 2 The planning process Planning consists of a number of elements. However, they could be summarised as : Preliminary engagement activities: evaluating compliance with ethical requirements; and establishing the terms of the engagement.

Planning activities developing the audit strategy; and developing an audit plan.

3 The audit strategy

81 The audit strategy sets the scope. timing and direction of the audit. It allows the auditor to determine the following: the resources to deploy for specific audit areas (e g experience level, exter nal experts); the amount of resources to allocate (e.g. number of team members); when the resources are to be deployed; and hew the resources are managed, directed and supervised, including the timing s of meetings, debriefs and reviews. Considerations in Establishing the Overall Strategy In determining the audit strategy the auditor should: (i) Identify the characteristics of the engagement. (ii) Ascertain the reporting objectives to plan the timing of the audit an d the nature of communications; (iii) Consider the significant factors that will direct the team's efforts; (iv) Consider the results of preliminary engagement activities; and (v) Ascertain the nature, timing and extent of resources necessary to per form the engagement. Audit strategy in detail Characteristics of the Engagement What is the financial reporting framework for the financial statements? Are there industry specific requirements? e.g. listed companies and chariti es; The number and locations of premises, branches, subsidiaries etc; The nature of the client and the need for specialised knowledge; The reporting currency; The effect of IT on audit procedures, including availability of data. Reporting Objectives, Timing of the Audit, and Nature of Communication The timetable for interim and final reporting. The organisation of meetings with management; The expected types and timings of auditor's reports communications; The expected nature and timing of communication amongst team members; and

Whether there are any expected communications with third parties.

Significant Factors and Preliminary Engagement Activities Materiality; Results of risk assessment; Professional scepticism: Results of previous audits. Evidence of management's commitment to internal controls; Volume of transactions: Significant business developments/changes; Significant industry developments; and Significant financial reporting changes. 82 Nature, Timing and Extent of Resources The selection of and assignment of work to the engagement team; and Budgets.

4 The audit plan

Once the audit strategy has been established, the next stage is to develop a s pecific, detailed plan to address how the various matters identified in the ove rall strategy will be applied. The audit plan is much more detailed than the overall strategy because it incl udes details of the nature, timing and extent of the specific audit procedures to be performed. Planning these procedures depends, largely, on the outcomes of the risk assessment process, which was discussed earlier. The plan itself The audit plan should include specific descriptions of: the nature, timing and extent of risk assessment procedures; the nature, timing and extent of further audit procedures, including: what audit procedures are to be carried out who should do them how much work should be done (sample sizes, etc) when the work should be done (interim vs. final). any other procedures necessary to conform to ISA's.

The relationship between the audit strategy and the audit plan

83 Whilst the strategy sets the overall approach to the audit, the plan fills in th e operational details of how the strategy is to be achieved. It is vital that both the strategy and the plan - and any consequent updates to

them - are fully documented as part of audit working papers. 5 Interim Versus Final Audits Interim audits can be completed part way through a client's accounting year (i .e. before the year end). This allows the auditor to spread out their procedur es and enables more effective planning for the final stage of the audit. Interi m audits normally focus on: documenting systems; and evaluating controls. It may be possible to: test specific and complete material transactions, e.g. purchasing new non-c urrent assets; attend interim inventory counts; and carry out an interim receivables circularisation. The final audit ( i.e. it takes place after the year-end) focuses on the remaini ng tests and areas that pose significant risk of material misstatement. This us ually involves concentration on year-end valuations and areas where there is s ignificant subjectivity. For an interim audit to be justified the client normally needs to be of a suffic ient size because this may increase costs. In argument to this, an interim audit should improve risk assessment and make final procedures more efficient. If th ere is to be an interim as well as a final audit the timing has to be: Early enough:

not to interfere with year-end procedures at the client; and to give adequate warning of specific problems that need to be addressed in planning the final audit. Late enough: to enable sufficient work to be done to ease the pressure on the final aud it. Specific planning considerations As oart of the planning process the audit must consider three specific issues to help them assess the risk of material misstatement, namely: the level of materiality; fraud; and laws and regulations

84 What is the Significance of Materiality? The bottom line is that the auditor is responsible for providing "an opinion on whether the financial statements are prepared, in all material respects, in acco rdance with an applicable financial reporting framework." (ISA 200 Overall Obje ctive of the Independent Auditor....)

If financial statements contain material misstatement they cannot be deemed to show a true and fair view and are therefore an unreliable basis for users' decis ion making. As a result the focus of an audit is identifying the significant risks of materi al misstatement in the financial statements and then designing procedures aime d at identifying and quantifying material misstatement. What is materiality? Materiality is a concept, a threshold, an intangible. What makes misstatement ma terial to one user of the accounts may not be material to another user. The pre cise definition is as follows: "Misstatement, including omissions, are considered to be material if they, indi vidually or in the aggregate, could reasonably be expected to influence the eco nomic decisions of users taken on the basis of the financial statements" (ISA 320 Materiality in Planning and Performing an Audit) How is Materiality Determined? The most significant misunderstanding about materiality is that it is a purely financial concern. However, disclosures in the financial statements pertaining to possible future legal claims, for example, could influence users' decisions a nd may be purely narrative. In this case a numerical calculation is not relevan t. The guidance in ISA 320 states that the determination of materiality is a matter of professional judgement and that the auditor must consider. The circumstances surrounding the entity; Both the size and nature of misstatements; and The information needs of the users as a group.

This is an obviously subjective and potentially complex process but is vital in ensuring that materiality is considered in light of the client's needs, instead of just applying an arbitrary calculation. However, ISA 320 does recognise the need to establish a financial threshold to guide audit planning and procedures. For this reason it does allow the use of standard benchmarks but only as a sta rting point The auditor must then consider all the factors listed above. Tradit ional benchmarks include: - 1% of turnover 5 - 10% of profit before tax 1 - 2% of gross assets

85 Material by Nature Examples of items which could be, or are generally accepted to be. material by nature include:

 Misstatements that, when adjusted, would turn a reported profit into a loss for the year. Transactions with directors e.g. salary and benefits, personal use of assets , etc. Related party transactions.

The Practical Application of Materiality It is unlikely, in practice, that auditors will be able to design tests that ide ntify individually material misstatements. It is much more common that misstate ments in aggregate (i.e. in combination) become material. Auditors also have to consider that they can only test on a sample basis, so they have to evaluate their findings arid determine how likely it is that errors identified in the sa mple are representative of material errors in the whole population under scruti ny. For this reason materiality, as determined for the financial statements as a who le, may not be the best guide in determining the nature and extent of audit te sts. To this end ISA's introduce two further concepts: performance materiality and tolerable misstatement that guide the way an auditor performs, and evaluates the results of, their tests. Performance Materiality This is defined in ISA 320 as: "The amount set by the auditor at less than materiality for the financial sta tements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality fo r the financial statements as a whole." In using this lower threshold to perform audit procedures the auditor is more li kely to identify misstatements, the effect of which can be considered in combin ation. Tolerable Misstatement This is defined in ISA 530 Audit Sampling as: "A monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set by the au ditor is not exceeded by the actual misstatement in the population." Although it sounds complex it is simply the practical application of performanc e materiality to an audit sample. If the total of errors in the sample selected exceeds tolerable misstatement the auditor considers that the risk of a materia l misstatement from the whole population is high and therefore tests a greater sample size. If the total of errors in the sample is less than tolerable misstatement then the auditor may be reasonably confident that the risk of material misstatement in the whole population is low and no further testing will be required.

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7 The impact of fraud What is fraud? Major scandals that have affected the accounting profession in recent times hav e usually been as a result of fraud. Therefore, in order to maintain confidence in the profession it is important for auditors and directors to understand the ir role in the prevention and detection of fraud. ISA 240 the Auditor's Responsibilities Relating to Fraud in an Audit of Financi al Statements recognises that misstatement in the financial statements can aris e from either fraud or error. The distinguishing factor is whether the underlyi ng action that resulted in the misstatement was intentional or unintentional. It is important to note that fraud is a criminal activity. It is not the role o f an auditor to determine whether fraud has actually occurred. That is the resp onsibility of a country's legal system. Auditors must be aware of the impact of both fraud and error on the accuracy of the financial statements. Fraud can be further split into two types: fraudulent financial reporting - deliberately misstating the accounts to make the company look better/worse than it actually is misappropriation of assets the theft of the company's assets such as cash or inventory. The external auditor's responsibilities The external auditor is responsible for obtaining reasonable assurance that the financial statements, taken as a whole, are free from material misstatement, wh ether caused by fraud or error. Therefore, the external auditor has some respons ibility for considering the risk of material misstatement due to fraud. In order to achieve this auditors must maintain an attitude of professional sce pticism. This means that the auditor must recognise the possibility that a mater ial misstatement due to fraud could occur, regardless of the auditor's prior exp erience of the client's integrity and honesty. ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Un derstanding the Entity and Us Environment goes further than this general concept and requires that engagement teams discuss the susceptibility of their clients to fraud. The engagement team should also obtain information for use in identifying the risk of fraud when performing ri sk assessment procedures. To be able to make such an assessment auditors must identify, through enquiry , how management assesses and responds to the risk of fraud. The auditor must al so enquire of management, internal auditors and those charged with governance i f they are aware of any actual or suspected fraudulent activity. Despite these requirements, owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements may not be detected, e ven when the audit is planned and performed in accordance with ISAs. The risks in respect of fraud are higher than those for error because fraud may involve sophisticated and carefully organized schemes designed to conceal it.

87 Reporting of fraud If the auditor identifies a fraud they should communicate the matter on a time ly basis to the appropriate level of management (i.e. those with the primary res ponsibility for prevention and detection of fraud). If the suspected fraud invol ves management the auditor shall communicate such matters to those charged with governance. If the auditor has doubts about the integrity of those charged with governance they should seek legal advice regarding an app ropriate course of action. In addition to these responsibilities the auditor must also consider whether th ey have a responsibility to report the occurrence of a suspicion to a party ou tside the entity. Whilst the auditor does have an ethical duty to maintain con fidentiality, it is likely that any legal responsibility will take precedent. I n these circumstances it is advisable to seek legal advice. The directors' responsibilities The directors have a primary responsibility for the prevention and detection of fraud. By implementing an effective system of internal control they should redu ce the possibility of undetected fraud occurring to a minimum. The directors should be aware of the potential for fraud and this should feature as an element of their risk assessment and corporate governance procedures The audit committee should review these procedures to ensure that they are in place and working effectively. This will normally be done in conjunction with the in ternal auditors. Internal auditors may be given an assignment: to assess the likelihood of fraud, or if a fraud has been discovered. to assess its conscquences and to make recommendations for prevention in the future

Practical Imact of Fraud As well as adopting an attitude of professional scepticism the auditor is requir ed to perform the following procedures in light of the risk of fraud: Discussion amongst the engagement team regarding the susceptibility of the c lient to fraud; Consider the risk of fraud when documenting and testing internal controls; Enquiring of management how they: assess the risk of fraud; and identify and respond to the risks of fraud; Enquiring of management whether they have any knowledge of actual or suspect ed frauds; Enquiring of internal audit whether they have any knowledge of actual or sus pected frauds; Enquiring of those charged with governance how they exercise oversight of man agement's process for identifying and responding to the risk of fraud; and Enquiring of those charged -with governance whether they have any knowledge of actual or suspected frauds,

88 8 Laws and Regulations

Responsibilities of management Management are responsible for ensuring the entity complies with relevant laws a nd regulations, including: Company law, e.g. the UK Companies Act 2006; Corporate Governance law. e.g. the US Sarbanes Oxley Act 2002; Health and safety law Employment law; Stock exchange rules; and Financial reporting regulations.

This requires the monitoring of legal requirements, the development of systems o f internal control to ensure compliance and an effective system of assessing th e effectiveness of those control systems.

89 Responsibilities of the auditor The auditor is responsible for obtaining reasonable assurance that the financia l statements are free from material misstatement. Non-compliance with laws and r egulations can impact the financial statements because companies in breach of th e lav; may need to make provisions for future legal costs and fines. In the wo rst case scenario this could affect the ability of the company to continue as a going concern. Therefore the auditor has to consider compliance with laws and regulations when planning, performing and reviewing audit procedures. In addition the auditor may also need to report identified non-compliance with l aws and regulations either to management or to a regulatory body, if the issue requires such action. An example of the latter would be when the client is in breach of money laundering regulations. Procedures ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statemen ts requires an auditor to perform the following procedures: obtaining a general understanding of the client's legal and regulatory enviro nment; inspecting correspondence with relevant licensing and regulatory authorities ; enquiring of management and those charged with governance as to whether the entity is compliant with laws and regulations; remaining alert to possible instances of non-compliance; and obtaining written representations that the directors have disclosed all inst ances of known and possible non-compliance to the auditor. 9 Audit Documentation As per ISA 230 Audit Documentation, auditors are required to prepare and retain written documentation that provides: a sufficient appropriate record of the ba sis for the audit report; and evidence that the audit was planned and performed in accordance with ISA's and other regulatory requirements. As a general rule of thumb documentation should be sufficient to enable an expe rienced auditor, with no previous connection to the audit, to understand: The nature, timing and extent of audit procedures performed; The results of the procedures performed and the evidence obtained; and The significant matters arising during the course of the audit and the conclu sions reached thereon, and significant professional judgementsmade in reaching t hose conclusions. In so doing auditors must document: the characteristics of items/matters tested; who performed the work; the date work was completed; who reviewed the work and the dates reviews took place.

A final requirement is that the auditor must document all discussions of signifi cant matters with management and those charged with governance.

90 It is vital that documentation is retained in an audit file, which should be com pleted in a timely fashion after the date of the audit report (normally not mo re than 60 days after) and retained for the period required by national regula tory requirements. Ordinarily this is no shorter than five years from the date of the auditor's report. Types of Audit Documentation Audit documentation includes: Planning documentation: Overall audit strategy; Audit plan; Risk analysis; Audit programmes; Summary of significant matters; Letter of confirmation and representation; Checklists; Correspondence; and Abstracts/copies of clients records.

For large audits much of the KOB information may be kept on a permanent file and the audit plan may contain a summary or simply cross refer to the permanent fi le. Typical information on a permanent file includes: Names of management, those charged with governance, shareholders. Systems information. Background to the industry and the client's business. Title deeds. Directors service agreements Copies of contract and agreements.

Contents of an Audit File Typically, there are at least three sections, as follows; planning; performance; and completion.

Planning The main element of this section is likely to be the Audit Planning Memorandum.

This document is the written audit plan and will be read by all members of the audit team before work starts. Its contents are likely to include: 91

background information about the client, including recent performance changes since last year's audit (for recurring clients) key accounting policies important laws and regulations affecting the company client's trial balance (or draft Financial Statements) preliminary analytical review key audit risks overall audit strategy materiality assessment timetable of procedures deadlines staffing and a budget (hours to be worked x charge-out rates) locations to be visited.

Performance Working papers are likely to consist of: Lead Schedule showing total figures, which agree to the financial statements Back-up schedules - breakdowns of totals into relevant sub-totals Audit work programme detailing; the objectives being tested work completed how sampled items selected conclusions drawn who did the work date work completed who reviewed it

Completion The completion (also known as review) stage of an audit has a number of standa rd components: Going concern review Subsequent events review Final analytical review Accounting standards (disclosure) checklist Letter of representation Summary of adjustments made since trial balance produced Summary of unadjusted errors Draft final financial statements Draft report to those charged with governance (management letter).

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Security and retention of working papers

Who owns the working papers? The auditor docs. This is important because: Access to the working papers is controlled by the auditor, not the client, wh ich is an element in preserving the auditor's independence. In some circumstances care may need to be taken when copies of client gene rated schedules are incorporated into the file. Security Working papers must be kept secure. Audits are expensive exercises. If the files are lost or stolen, the evidenc e they contain will need to be recreated, so the work will need to be done agai n. The auditors may be able to recover the costs from their insurers, but otherw ise it will simply represent a )oss to the firm. Either way. prevention is bette r than cure. By its nature, audit evidence will comprise much sensitive information that i s confidential. If the files are lost or stolen, the auditor's duty of confident iality will be compromised. There have been cases of unscrupulous clients altering auditors' working pa pers to conceal frauds. The implications of IT based audit systems are also far reaching. By their nature, laptops are susceptible to theft, even though the thief ma y have no interest in the contents of the audit file. Nevertheless, all the pro blems associated with re-performing the audit and breaches of confidentiality re main. It is more difficult to be certain who created or amended computer based fil es than manual files handwriting, signatures and dates have their uses - and t his makes it harder to detect whether the files have been tampered with.

93 This means that the following precautions need to be taken. If files are left unattended at clients premises - overnight or during lunch b reaks - they should be securely locked away, or if this is impossible, taken home by the audit team. When files are left in a car, the same precautions should be taken as with a ny valuables. IT-based systems should be subject to passwords, encryption and backup proced ures. Retention Audit files should be assembled in a timely fashion. This is, ordinarily, no lon ger than 60 days after the date of the auditor's report. Once complete the files should be retained as long as required by national law. However. ISA 230 Audit Documentation, states that this period i, ordinarily, no shorter than five years from the date of the auditor's report. This should therefore be consid ered the minimum retention penod. All of this means that firms need lo make arrangements for: secure storage of recent files archiving older files archiving and backup of IT-based files.

Test your understanding 1 Amongst the matters the auditor is required to consider when planning an audit (in accordance with the requirements of ISA 300 Manning an Audit of Financial Statements) arc those of "materiality' and the direction, supervision and revie w" of the audit. Required: (a) Explain the concept of materiality and how materiality is assessed when pl anning the audit. Your answer should include consideration of materiality at the overall financia l statement level and in relation to individual account balances. (6 marks) (b) Explain the nature and significance of direction, supervision and review bo th in planning the audit and subsequently during the performance of the audit on a particular engag ement. (6 marks)

94 Test your understanding 2 (1) Discuss the issues to be considered as part of the planning process for an a udit. (5 marks) (2) List four things which need to be done during the planning process. (2 marks) (3) List two sources of information which enable the auditor to assess risk. (1 mark) (4) What is the difference between the audit strategy and the audit plan? (1 mark) (5) Discuss aspects of the client's business which need to be explained in the a udit plan. (1 mark) (6) List possible sources of knowledge of the business. (4 m arks) (7) What is the difference between materiality and tolerable misstatement? (1 m ark) (8) List eight stages of the audit plan. (4 marks) (9) Why is it important for the auditor to plan? (5 marks) 10 Chapter summary

95 Test your understanding 1 (a) Materiality Financial statements may be misstated due to either, fraud; error; or omission. Materiality is the measure of when those misstatements, either individually or in the aggregate, affect the decision making processes of the users of the fina ncial statements. Therefore, if the financial statements contain material misst atement they cannot be considered to be fairly presented (or true and fair). ISA 320 Audit Materiality, requires auditors to consider materiality when deter mining the nature, timing and extent of audit procedures. Materiality at the overall financial statement level There may be more than one level of materiality relating to the financial state ments. For the income statement, materiality could be related to revenue or to p rofit (usually before tax). For the statement of financial position, materiality could be based on shareholders' equity, asse ts or liability class totals. Standard benchmarks are a widely accepted basis for preliminary matenality asses sments. A typical example is: - 1% of turnover 5-10% of profit before tax 1-2% of gross assets However, the auditor must only use this as a starting point The final material ity assessment must be based upon professional judgement and include considerati on of: The circumstances surrounding the entity; Both the size and nature of misstatements; and The information needs of the users as a group. Materiality at the account balance or transaction class level Using materiality (as calculated for the financial statements as a whole) when considering specific transactions, balances and samples are likely to be mislead ing. If all samples were tested and all errors assessed purely on a considerati on of materiality, then many smaller misstatements, which could become material in aggregate, would be ignored. Therefore when designing procedures they audit or uses a second measure of performance materiality. This is defined in ISA 320 as: "The amount set by the auditor at less than materiality for the financial sta tements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality fo r the financial statements as a whole."

In using this lower threshold to perform audit procedures the auditor is more li kely to identify misstatements, the effect of which can be considered in combin ation. When assessing the results of testing, performed on a sample basis, the auditor must also consider if the total of errors identified (again unlikely to be mater ial to the financial statements as a whole) could be indicative of a material mi sstatement in the population as a whole. To evaluate this the auditor uses a third measure known as tolerable misstatement. 96 Tolerable misstatement (as per ISA 530) is the maximum misstatement that can ex ist in a sample before the auditor considers the risk of material misstatemen t in the population as a whole to be significant. As long as the identified misstatements within the samp le tested are less than this balance, the auditor need to do no further testing.

(b) Direction, supervision and review Direction An important function m planning the audit is the generation of material necess ary for the direction of staff assigned to the audit. Staff needs to receive ade quate guidance as to the nature of the business and in particular as to any specific matters affecting the audit deter mined during the planning phase, such as recent or proposed changes in the natu re of the business, its management or its financial structure. Assistants assign ed to an audit must receive direction as to such matters to enable them to carr y out the audit work delegated to them. A principal substantive The results in an audit sufficient relative to Supervision The assignment of staff to the audit as part of the planning process should ensu re that they are subject to an appropriate level of supervision. The more junior or inexperienced the staff, the more supervision they will require. On small a udits supervision is usually in the form of daily contact with the staff members at the client's premises by a supervisor, usually the audit manager; with regul ar visits to the clients' premises during the course of the audit. On th ng of larger audits there will be a hierarchy of staff at different levels each wi responsibility for supervising the work of assistants assigned to them. Duri the course of the audit supervisory staff should regularly monitor the work assistants to ensure that: purpose of planning is determining the mix of tests of controls and procedures and the nature, timing and extent of those procedures. of the plan are documented program which specifies the individual procedures to be performed in detail the experience of the staff assigned to the engagement.

they understand the requirements of each procedure in the audit programme t o which they are assigned they have the necessary skills and competence to perform their assigned ta sks the work performed is in accordance with the requirements of the audit prog ramme.

In addition, supervision should ensure that any important matters discovered dur ing the audit are promptly dealt with and the audit programme modified as neces sary. The supervisor should also monitor the time spent on each phase of the aud it against time budgeted during the planning phase. Significant variances could indicate problems in the performance of the audit.

97 Review Supervision also involves review of the work performed. All work must be reviewe d to ensure that: the work has been performed in accordance with the programme the evidence has been properly documented all outstanding matters have been satisfactorily resolved conclusions drawn are consistent with the evidence and support the audit o pinion. In addition to the review of evidence obtained in accordance with the audit prog ramme, there needs to be a review at a higher level of more significant audit d ecisions made. These include a review of: the audit plan and audit programme the assessment of inherent and control risk and the proposed audit strategy reviews of the working papers undertaken by staff at an appropriate level o f responsibility the proposed audit opinion based on the overall results of the audit proces s. On smaller engagements this review may be undertaken by the manager; with oversi ght by the engagement partner that the review has been properly conducted. On l arger audits the final review will be carried out by the partner. On certain au dits it is considered desirable for a second partner, not otherwise involved in the audit, to perform an additional review before issuing the auditors' report . This is sometimes referred to as a hot review Test your understanding 2 1. People - Who should make up the audit team? Timing - What are the deadlines? Focus - What are the key aspects of the audit? 1 mark 1 mark 1 mark

Problem areas - What issues are likely to cause difficulties and how should they be addressed?

1 mark Nature of work - What audit approach should be used and what types of procedur es are appropriate? 1 mark Amount of work - Sample sizes, number of tests etc. all driven by assessment of risk and materiality. 1 mark

2. Assess risk. mark Develop the audit strategy. mark Select the audit team. mark Assess materiality. mark Select appropriate audit procedures. 98 3. Knowledge of the business. mark Analytical review. mark 4. Whilst the strategy sets the overall approach to the audit, the plan fills in t he operational details of hew the strategy is to be achieved. 1 mark

mark

5. Choose from: The industry The competition Technology Laws and regulations Stakeholders Acquisitions Disposals Financing Trading partners Related parties What the client does Management Systems Controls Significant risks

1 mark per point

 6.

Accounting policies. mark per point

Choose from: The engagement partner The engagement manager Your firm's industry experts Last year's audit team Industry sun/eys The company's registry The internet Trade press Credit reference agencies Discussions with client's staff Observation of events and processes at the client's premises The client's website Brochures and other publicity material. 7. Materiality concerns the financial statements as a whole. Tolerable error only concerns the population being tested. 8. Knowledge of the business. Preliminary analytical review. Risk assessment. Materiality. Tolerable error. Audit approach. Independence. Budget and stalling. Timetable and deadlines. mark per point

1 mark per point

9.

1 mark per point

To To To To To level.

decide decide decide decide ensure

on the audit approach. how much work to do. what type of work to do. on the composition of the audit team. that risk is reduced to an acceptable

99

100 8 Systems and controls Chapter learning objectives Upon completion of this chapter you will be able to: Explain why an auditor needs to obtain an understanding of internal control; Describe and explain the five Key components of an internal control system; Explain how auditors record internal control systems; Explain how auditors identify deficiencies and significant deficiencies in in ternal control systems; Explain, analyse and provide examples of internal controls; List examples of application controls and general IT controls; Explain the need to modify the audit strategy and audit plan following the r esults of tests of control; and Discuss and provide examples of how to report internal control deficiencies to management.

101

1 The importance of internal control systems Audit risk = inherent risk x control risk x detection risk!! In order to design further audit procedures auditors need to be able to assess the risk of material misstatement in the financial statements. They then focus their remaining efforts on those significant risk areas. Internal controls are a vital component of this risk model because they are th

e mechanisms that clients design in an attempt to prevent, detect and correct m isstatement. This is not only necessary for good financial reporting it is neces sary to safeguard the assets of the shareholders and is a requirement of corpora te governance. The fundamental principle is: the stronger the control system the lower the risk of material misstatement in the financial statements.

102 Therefore auditors can seek to place some reliance on internal control systems and. as a result, reduce the substantive testing performed. In order to be ab le to do this they need to: ns, Ascertain how the system operates: Document the system in audit working papers; Test Ihe operation of the system; Assess the effectiveness of the control system; and Determine the impact on the audit approach for specific classes of transactio account balances and disclosures.

This chapter considers the basic components of control systems and how the audi tor fulfils their objectives for assessing control risk. Control systems - basic principles The auditor's main focus is on those systems relevant to the financial statement s and, therefore, the audit. The basic objectives of these systems are to: measure the effects of transactions and other relevant issues; record those transactions and effects; summarise them into a useable form; and publish those summaries to the relevant users of the information to assist de cision making. A simple system can be illustrated as follows:

It should be noted that the illustration represents a typical manual accounting system. These are rare nowadays due to the use of readily available (and cheap ) accounting software. However, the basic principles of those systems are stil l the same and it is worth understanding how the flow of information in a system works.

103 Computerised systems There are a number of things to understand about the impact of computerised ac counting systems: The need to transfer information from one piece of paper to another is greatl y reduced. The outputs from the system - the listings, trial balances, even the financi al statements themselves - usually do not form part of a strict chronological se quence. So once an invoice is entered into the system. The TB, the ledger, the financial statements are all updated. There is no delay waiting for the purchase ledger clerk to 'do the postings'. Once a transaction is entered into the system it will be processed. Calculations will be accurate (unless someone has programmed them otherwise). Human error (inputting data for example) and fraud can still lead to misst atement in computerised systems. 2 How do internal control systems operate? The components of an internal control system ISA 315 stales that auditors need to understand an entity's internal controls. T o assist this process it identifies five components of an internal control syst em: the the the the the control environment; entity's risk assessment process: information system; control activities; and monitoring of controls.

i. The control environment The control environment includes the governance and management function of an o rganisation. It focuses largely on the attitude, awareness and actions of those responsible for designing, implementing and monitoring internal controls. Elem ents of the control environment that are relevant when the auditor obtains an u nderstanding include the following: communication and enforcement of integrity and ethical values; commitment to competence; participation by those charged with governance; management's philosophy and operating style; organisational structure; assignment of authority and responsibility; and human resource policies and practices.

Evidence regarding the control environment is usually obtained through a mixtur e of enquiry and observation, although inspection of key internal documents (e.g . codes of conduct and organisation charts) is possible.

104 ii. The risk assessment process The forms the basis for how management determines the risks to be managed. These processes will vary hugely depending upon the nature, size and complexity of t he organisation. However, larger organisations (usually listed ones) will have internal audit departments, whose roles focus heavily on risk identification and assessment. If the client has robust procedures for assessing the business risks it faces, the risk of misstatement, overall, will be lower. iii. The information system The information systems relevant to financial reporting objectives include all t he procedures and records which are designed to: Initiate, record, process and report transactions; Maintain accountability for assets, liabilities and equity; Resolve incorrect processing of transactions; Process and account for system overrides; Transfer information to the general/nominal ledger Capture information relevant to financial reporting for other events and co nditions; and Ensure information required to be disclosed is appropriately reported. iv. Control Activities The control activities include all policies and procedures designed to ensure th at management directives are carried out throughout the organisation. Examples of specific control activities include those relating to: Authorisation; Performance review; Information processing; Physical controls; and Segregation of duties.

IT affects the way in which control activities are implemented. It is important that auditors assess how controls over IT maintain the integrity and security of information held on them. Such controls are normally divided into two c ategories: Application, and General.

Application controls Application controls are either manual or automated and typically operate at the business process level and apply to the processing of transactions. Examples in clude:

105

batch total checks: sequence checks; matching master files to transaction records; arithmetic checks; range checks (to ensure that data stays within reasonable ranges); existence checks (e g. to check employees exist); authorisation of transaction entries exception reporting

An example is that Quickbooks. a small business accounting package, will not let you enter a sale until you have set up an 'item', which means you have to a llocate the sale to a revenue account, set up the customer as a receivable, deci de on VAT treatment, etc. General controls General IT controls are policies and procedures that relate to many applicat ions and support the effective functioning of application controls by helping t o ensure the continued proper operation of information systems, e.g. controls o ver; data centre and network operations system software acquisition program change and maintenance access security - passwords, door locks, swipe cards backup procedures.

A healthy IT system should include both application and general oontrol procedu res. Control Examples One way to try and remember the typical controls that a business operates is by using the mnemonic ACCAMAPS. Authorisation - e.g. of expense claims, of purchases, of cash transfers. Comput er controls - e.g. passwords, backups, virus checks, maintenance. Comparison e.g. comparing budget versus actual and reviewing for variances. Arithmetic co ntrols - e.g. recalculating hours worked on time sheets. Maintain and review control accounts - e.g. sales/purchase lodger control acco unt, bank. Account reconciliations - e.g. bank reconciliation, sales/purchase ledger reconciliation Physical controls e.g. locking mechanisms. CCTV, safes. Segregation of duties - e.g. purchase ledger clerk does not process payments t o suppliers (to reduce risk of false supplier fraud).

106 Expandable text-A changing world Rapid developments in IT have implications for systems and controls. Examples of such issues include: Transactions automatically triggered by predetermined system criteria, e.g. stock purchases, automated utility billing;

 e.g.

High volume transactions enabled through the use of barcodes and scanning, supermarkets; On-line purchasing On-line account management Automated goods delivery, e.g. Amazon Automated cash collection, e.g. Amazon On-line/virtual products, e.g. on-line gambling.

All of these modern business practices require systems that operate effectively and use the most up to date information available. Without excellence in IT s ystems and controls these businesses would simply not be possible. v. Monitoring of controls This is the process of assessing the effectiveness of controls over time and ta king necessary remedial action. Clearly if a control is not implemented properly or is simply considered ineffective then misstatements may pass undetected int o the financial statements. Monitoring can either be ongoing or performed on a separate evaluation basis. Either way. It needs to be effective for the system to work. Monitoring of inter nal controls is often the key role of internal auditors. 3 Ascertaining the systems Procedures used to obtain evidence regarding the design and implementation of co ntrols Include: enquiries of relevant personnel; observing the application of controls; tracing transactions through systems; and inspecting documents, such as internal procedure manuals.

In addition to this, auditor's can also use their prior knowledge of the client and the operation of the systems in prior years. However, it must be noted, t hat auditors cannot simply rely on their systems knowledge from the prior year's audit; much can happen in a year and systems knowledge must be updated and the systems tested once more. It should also be noted that lSA 315 specifies that enquiry, alone, is not suf ficient to understand the nature and extent of controls.

107 4 Documenting client systems Possible ways of documenting systems include:

narrative notes (which can prove bulky if systems are large or complex) flowcharts (which can make a complex system easier to follow)

organisation charts - showing roles, responsibilities, and reporting lines Internal Control Questionnaire (ICQ) Internal Control Evaluation Questionnaire (ICE).

ISA 315 states that the method adopted is a matter of auditor judgement. ICQs An ICQ is a list of possible controls for each area of the Financial Statements. The client is asked to review the list and confirm which are applicable to thei r system. ICEs In contrast to ICQ'S an ICE lists control objectives. Client's are then asked to confirm how they meet that objective. For example; an ICQ might ask a client: "does a supervisor authorise all weekly timesheets?" An ICE would ask "haw does the company ensure that only hours worked are recorded on t imesheets?" 5 Testing the system Tests of control vs. substantive procedures Having documented the systems the auditor needs to assess whether: they are actually implemented; and they are effective.

In order to assess the operating effectiveness of controls in preventing and det ecting material misstatement the auditor performs tests of controls. These are d esigned to gather evidence concerning: ude: how controls were applied during the period; the consistency of application; and who (or what) they were applied by. Typical methods of controls testing incl walkthrough tests, where a transaction is followed through the system. observation of control activities, e.g. the inventory count; and computer aided audit techniques (see chapter 10 for more detail).

Substantive procedures, on the other hand, are those procedures designed to det ect material misstatement. They include both tests of detail and analytical proc edures. These will be covered in more detail in chapter 9. 108 6 The impact on the audit approach The principle is simple: the auditor amends the audit approach in response to ri sk assessment. They can achieve this by

emphasising the need for professional scepticism; assigning more experienced staff to risk areas; increasing supervision levels, increasing the element of unpredictability in sample selection;

changing the nature, timing and extent of procedures. increasing the emphasis on substantive tests of detail.

If the risk assessment indicates significant risk of material misstatement due t o deficiencies in internal controls the auditor should respond by: increasing procedures conducted at and after the year-end; increasing substantive procedures; and increasing the locations included in the audit scope.

An effective control environment may allow the auditor to place more reliance on internal controls and evidence generated internally v/within the entity. Typic ally this increases the appropriateness of interim testing and allows the audit or to reduce the quantity of detailed substantive procedures performed. Whilst t his is true to a certain extent the auditor can never eliminate the need for substantive procedures entirely because there are inherent limitations to the r eliance that can be placed on internal control due to: human error in the use of judgement; simple processing errors and mistakes: collusion of staff in circumventing controls; and the abuse of power by those with ultimate controlling responsibility.

Expandable Text - Problems with fraud Fraud is specifically designed lo mislead people. Consider the following exampl e: A company only deals with suppliers on a list authorised by the Finance Direc tor (FD). Payments to suppliers are made after the purchases clerk identifies the mont hly payments to be made and prepares the cheques. The cheques are signed by the FD, who confirms the amounts paid and supplier names to supporting documentation: and The cheques are countersigned by the Managing Director, who does not check the details but has a good knowledge of who the suppliers are. This appears like a sensible combination of authorisation controls and segrega tion of duties. However, now consider the implication if one of the suppliers i s actually controlled by the FD. The supplier regurarly overcharges arid the purchases clerk is being bribed by the FD in return for their silence. 109 Of course, this is a potentially criminal scheme, but that is what a fraud is. T he auditor, unfortunately, would place reliance on. The control system and redu ce substantive testing of purchases. It is for this reason that the auditor must always perform some substantive procedures and must always maintain an attitude of professional scepticism. 7 The revenue cycle Objectives The objectives of controls in the revenue cycle are to ensure that: sales are made to valid customers sales are recorded accurately all sales are recorded cash is collected within a reasonable period.

This is a summary of the sales cycle, showing the possible problems and the rela ted controls: Stage es Order ing received Risks Orders not recorded accurately. Control procedur Confirm order in writ

Orders taken from high credit credit check risk customers

Order cannot be honoured All now customers subject to

Credit limits imposed on customers Orders approved by sales and production managers. Goods Goods not despatched tomer despatched s. Incorrect goods sent Sequentially numbered cus order pad

Copy of order sent to the warehouse for filing. Weekiy order check to ensure sequence is complete (i.e. none missing) Order signed by inventory picker. Goods despatch note (GDN) matched to order (staple together and file) Customer signs a copy of the GDN and returns it to confirm receipt of goods. Use sequentially numbered GDNs and review frequently for incomplete sequence an d unmatched items.

110 Stage oice

Risks Control procedures Inv Invoices may be missed. Copy of GDN sent to accounts raised incorrectly raised or sent to and matched to copy of the the wrong customer invoice. Unmatched GDNs to be periodically reviewed. Credit notes may be raised incorrectly Copy invoice signed as agreed t o original order. GDN. and customer price list Credit notes to be allocated to invoice it relates to and authorised by manager. Sale Invoices may be inaccurately Review receivables ledger for recorded recorded, missed or credit balances recorded for t he wrong customer Receivables ledger reconciliation Do uble check back to invoice Customer statements sent out (customers let you know if wrong) Cash Incorrect amounts received Agree cash receipt back to the received invoice Customer does not pay

Review receivables ledger for credit balances (customer overpaid) Review aged debt listing and investigate old balances. Debt chasing procedures/credit control

111 Stage rocedures Cash

Risks Cash incorrectly recorded

Control p

or Monthly customer statements recorded recorded against the wrong

sent cut account

Segregation of duties Sales controls tests

Cash stolen Bank reconciliation

Regular banking/physical security over cash (i.e. a safe) Reconciliation of ban king to cash receipts records Segregation of duties Tests of control should be designee to check that the control procedures are be ing applied and that objectives are being achieved. Example procedures includ e: that ived This the ed. Sequence checks on invoices, credit notes, despatch notes and orders. Ensure all items are included and that there are noomissions or duplications. Review the existence of evidence for authorisation in respect of: Orders - authorised by sales/production manager. GDN's - signed by the foreman to confirm despatch of goods listed. Credit notes signed by manager. Ensure invoices are signed to confirm that amounts have been posted and rece in cash. is often done by means of a "grid stamp" containing several signatures on face of the document. Observe that control account reconciliations have been performed and review

.8 The purchases cycle The objectives of controls in the purchases cycle are to ensure that: orders are made for valid and necessary business purchases; purchase solutions are cost effective; appropriate inventory items arc received and stored securely; purchases and related payables are recorded accurately; and cash is paid within a reasonable period and recorded accurately.

This is a summary of the purchases cycle, showing the possible risks and relate d controls.

112 Stage ol procedures Requisition ions authorised by

Risks Unauthorised purchases

Contr All requisit

raised made manager Central purchasing dept Preferred suppliers/ agreed price lists Check inventory levels first Stage Risks

Control p

rocedures Order Invalid or incorrect orders Sequentially numbered placed made or recorded requisition pads, copies filed numerically with copy of order The most favourable terms stapled to it. not obtained Request order confirmation in writing Check quoted price against supplier price list Goods Goods stolen On e secure delivery area received Goods may be accepted that Inventory records updated on a have not been ordered or are timely basis of wrong quantity or inferior quality Copy of purchase order sen t to warehouse, sequentially numbered, filed, matched to GRN Raise GRN and grid stamp it, signed as goods checked to PO and checked for quality Invoice Invoices not recorded Copy of se quentially numbered received resulting in non-payment and GRNs sent to invoicing loss of supplier goodwill department, filed and matched to copy of invoice (stapled) Invoices may be logged for goods not received If no GRN ask supplier for proof of delivery + match to PO Invoices may contain errors (authorised as mentioned above) Grid stamp invoice signed as checked items to PO, GRN, agree price to supplier 's price List

113 Stage Risks Co ntrol procedures Purchase Purchases missed or Batch co ntrols on input recorded recorded incorrectly Stamp the invoice to indicate recorded, check all filed invoices are stamped Suppliers send in monthly statements, reconcile these to suppliers ledger account Cash paid Invoices not paid or incorrect Stamp invoices when paid; amount paid check all invoices stamped Keep paid invoices separately from unpaid ones Cheque signatory to check to invoice when signing cheque/authorising BACS Have authorised cheque signatories

Purchases control tests Get invoices signed as authorised by relevant manager Obtain the ledger recording purchase orders; ensure each page has been sig ned by a responsible official to confirm all orders have been recorded and ther e are no gaps in the sequence of orders. Obtain a sample of purchase invoices; ensure each invoice has been signed b y a responsible official to confirm checks on the invoice have been completed a rid the invoice is passed for payment. Obtain a sample of credit notes; ensure each credit note is signed by a resp onsible official to confirm credit note details (goods description and 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 been reviewed and checked. Review purchase invoice for initialing of the grid stamp Review/observe the supplier reconciliation note to ensure the control has be en complied with.

114 9 The payroll system Objectives The objectives of controls for the payroll cycle are to ensure that the company: pays pays pays deals tho right the right for valid correctly people rate work done with taxes and other deductions.

This is a summary of the payrolls cycle, showing the possible risks and related controls:

Stage Risks Control procedures Timesheets Bogus employees paid or Check number of cards to submitted employees paid for hours number of employees not worked Keep all spare cards locked in cupboard Supervisor to authorise all timesheets Supervision of cocking in and out Standing Standing data could be Managers should complete a data compromised Unprocessed leavers/joiners form noting date input updates may mean of departure/arrival a nd send employees who have left are paid or joiners are missed promptly to payroll dept

Standing data files regularly printed out and sent to department managers for them to confirm Restriction to standing data files, e.g. passwords Monthly print of any changes to go to senior management for review and signature

115 Stage Risks Control procedure s processing of data Inaccurate processing data could lead to wages and taxes being incorrectly calculated Sample of wages recalculated manually Exception report produced automatically for anyone paid over Sxxx, or paid under $yyy Sample of deductions (PAYE, NIC)recalculated Managerial review of weekly payment summaries Recording of payroll Recorded payroll may not match actual payroll Nominal ledger clerk signs payroll print out to confirm entries double- checked to print Senior management review wages expenses for reasonableness Staff paid Staff may not be paid Bogus staff could be paid Have two people present where cash wages are paid. Responsible individual shou ld review any BACS payroll summary prior to paying staff -sign to confirm reviewed

116 control tests Test a sample of timesheets. clock cards or other records, for approval by a responsible official Pay particular attention to the approval of overtime there relevant. Observe wages distribution for adherence to procedures ensuring employees sig n for wages, that unclaimed wages are rebanked, etc. Test authorisation for payroll amendments by reference to personnel records. Test controls over payroll amendments by reviewing changes and seeing whethe r they have been authorised. You could print off an exception report highlighti ng changes and follow those through. You could also do a dummy transaction to s ee how the system handles change. Obtain the payment sheet for casual labour payments and ensure this has be en signed by the chief accountant to authorise the payments made. Obtain the weekly payroll and ensure this has been signed by a responsible official to approve the payments. Examine evidence of independent checks of payrolls (e.g. by internal audit). Inspoct payroll reconciliations to confirm they are done regularly tying th e PAYE liability up to the Inland Revenue records. Review the client working pap ers or observe the reconciliation process happening. Examine explanations for payroll expense variances. Test authorisation for payroll deductions by reviewing the employees records, locking at who is authorised to make amendments, and observe the process.

10 The inventory system

Objectives The objectives of controls in the inventory cycle arc 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

117 Process Risks Possible control procedure s Inventory Inventor/ stolen on arrival. All goods inward rec eived at received set locations and signed Now purchases mixed up for/logged in by stores with returns. manager. Poor quality inventory All returns sent to a returns accepte d. department for checking. Inventory accepte d that was inventory matched to orders never ordered. No record is made of its arrival. Process Risks Possible control procedur es Inventory Poor storage conditions Storage areas fitted with stored lead to damaged inventory. sprinklers. Tire alarms. temperature monitors. Inventory items not used before their usage life ends. Inventory 'rotated' to ensure FIFO usage where relevant. Inventory stolen from storage areas. Valuable inventories locked away and inventory areas limited to a single exit (security guard?). Raw Materials over-ordered to All requisitions from sto res materials enable theft accompanied by signed used in autho risation from production production manager. Use of standard quantity requirements. Inventory Wrong goods sent. Sequentially numbered despatched customer order p ads. Goods being stolen (no real sale). Order signed by inventor y picker. Poor quality sent Goods despatch note (GDN) Records not updated. matched to order (staple together and fi le) Customer signs a copy of the GDN and returns it to confirm receipt of goods

118 Process ventory

Risks Counting lacks accuracy.

Possible control procedures In All counted areas to be marked count as completed.

Staff lie about amounts counted to cover up their

Managers lo check by doing theft. random second counts.

Inventory records lost during Staff do not count areas that they count. ventory wrongly counted Counting done In ng count. counters sign out (and in) the count sheets. All inventory movements during count authorised Closure during inventory accounts to avoid problems. Inventory control tests Observe physical security of inventories and environment in which they are h eld Obtain inventory records Where quantity of inventory has been changed withou t reference to GDN and GRN. ensure that amendment is signed by a responsible of ficial to authorise that change. In the event's warehouse, observe client staff ensuring that where a movemen t in inventory occurs, that movement is recorded on the appropriate GDN or GRN. Test for evidence of authorisation to write off or scrapping of inventories ( existence of signature). Observe controls over recording of movements of inventory belonging to third parties. Observe the procedures for authorisation for inventory movements i.e. the use made of authorised goods received and despatched notes. Inspect reconciliations of inventory counts to inventory records (this gives overall comfort on the adequacy of controls over the recording of inventory). Test for evidence of sequences checks of despatch and goods received notes fo r completeness. Assess adequacy of inventory counting procedures and attend the count to ensu re that procedures are complied with. are usually responsible for. In pairs. because it is moved duri Inventory sheets sequenced and by management.

119 11 Capital expenditure Capital and revenue expenditure This area looks at expenditure on items other than purchases. However, the con trols are virtually identical to controls over purchases as seen above. Some controls may vary, such as: Capital expenditure is often for substantial amounts. As such, most companie s would require such items to be included in an annual budget and authorized b y very senior level management Regular revenue expense items may be monitored by simple variance analysis (i

.e. actual versus budget) on a monthly basis. Capital items are likely to be stored on an asset register, which records det ails of supplier, price, insurance details, current location, responsible employee, etc. Just as inventories are counted, assets are likely to be checked against th e register on a regular basis. When assets are sold second-hand, the items will be checked against similar items or price guides to ensure the company receives fair value. Ownership documents (title deeds, vehicle registration documents) will be saf ely stored.

12 Bank and cash system Objectives The objectives of controls over bank and cash are to ensure that: cash balances are safeguarded cash balances are kept to a minimum money can only be extracted from bank accounts for authorised purposes. Possible controls Objective Possible control procedures Cash balances are safeguarded. Safes/strongroom/locked cashbox with restricted access. Security locks. Swipe card access. Key access to tills. Night safes. imprest system. Use of security services for large cash movements. People making bank ings vary routes and timings. Cash balances are kept to a minimum. Money can only be extracted from bank acco unts for authorised purposes. Tills emptied regularly. Frequent bankings of cash and cheques received.

Restricted list of cheque signatories. Dual signatures for large amounts. Simila r controls over bank transfers and online banking, e.g. secure passwords and pi n numbers. Cheque books and cheque stationery lucked away. Regular bank reconciliations reviewed by person with suitable level of authority.

120 Bank and cash control tests observe that mail is opened by two staff to minimise the possibility of fraud (cash being stolen on receipt) reperform reconciliation of cash receipts to bank lodgements lesl for evidence of a sequence check on any pre-numbered receipts for cash test for evidence of arithmetical check on cash received records. inspect current cheque books for: sequential use of cheques controlled custody of unused chcqucs any signatures on bank cheques

test for evidence of arithmetical checks on cash payments records, including cashbook obtain the file of direct debit payments ensure each payment is authorised. B ank reconciliations: examine evidence of regular bank reconciliations, at least once per month, but in larger organisations this should be done daily or weekly examine evidence of independent checks of bank reconciliations (e.g. a signa ture) examine evidence of follow up of outstanding items on the bank reconciliation . Pay particular attention to old outstanding reconciling items that should be w ritten back such as old, unpresented cheques. Petty cash: Test petty cash vouchers for appropriate authorisation Test cancellation of paid petty cash vouchors. 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 cash records.

13 Reporting to those charged with governance Auditors should communicate deficiencies in internal control to those charged wi th governance and management. In particular, significant deficiencies should be communicated in writing to those chargcd with governance. This is a requirement of ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management. The forrm, timing and addressees of this communication should be agreed at the s tart of the audit, as part of the terms cf the engagement. This report, tradit ionally known as a management letter or report to management, is usually sent a t the end of the audit process. When the auditor reports deficiencies, it should be made clear that: the report is not a comprehensive list of deficiencies, but only those that h ave 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 written agreement of the auditor no responsibility is assumed to any other parties. 121 In the exam, an internal control question may require you to analyse controls a nd report deficiencies in the form of a management letter. The best Stucture is : Deficiency Consequence Clear description of what is wrong. What could happen if the deficiency is not corrected. Focus on what matters to We client - the risk of lost profits, stolen assets, extra costs, errors in the accounts.

Recommendation This must deal with the specific deficiency you have observe d! It must also provide greater benefits than the cost of implementation.

Try to suggest who should carry out the control procedures, and when.

Illustration (A table format is the best format, it keeps you structured and the markers fi nd it easier to mark.) Deficiency There appear to be purchase invoices missing from the sequentially numbered inv oice file. Consequence There is a possibility that purchases and liabilities are not completely record ed. Recommendation All invoices should be sequentially filec on receipt by the accounts department. Regular checks should be made to ensure a complete record, with any missing it ems investigated (and copies requested if necessary).

122 Test your understanding 1 Rhapsody Co supplies a wide range of garden and agricultural products to trade

and domestic customers, the company has lising in the sale of specific products, gricultural fertilizers. The company has internal audit department which provides each division on a rotational basis.

11 divisions, with each division specia for example, seeds, garden furniture, a an audit reports to the audit committee on

Products in the seed division are offered for sale to domestic customersvia an I nternet site. Customers review the product list on the Internet and place or ders for packets of seeds using specific product codes, along with their credit card details, onto Rhapsody Co's secure server. Order quantities are normal ly between one and three packets for each type of seed. Order details are trans ferred manually onto the company's internal inventory control and sales system and a two part packing list is printed in the seed warehouse. Each order and packing list is given in a random alphabetical code based on the name of the em ployee inputting the order, the date and the products being ordered. In the seed warehouse, the packets of seeds for each order are taken from spec ific bins and despatched to the customer with one copy of the packing list. The second copy of the packing list is sent to the accounts department where the inventory and sales computer is updated to show that the order has been despatched. The customer's credit card is then charged b y the inventory control and sales computer. Bad debts in Rhapsody are currently 3% of the total sales. Finally, the computer system checks that for each charge made to a customer's cr edit card account, the order details are on file to prove that the charge was m ade correctly. The order file is marked as completed confirming that the order h as been despatched and payment obtained. Required: In respect of sales in the seeds division of Rhapsody Co: (i) identify and explain FOUR deficiencies in the sales system; (ii) explain the possible effect of each deficiency; and (iii) provide a recommendation to alleviate each deficiency. 14 Marks

Test your understanding 2 You are carrying out the audit of the purchases system of Spondon Furniture. The company has a turnover of about $10 million and all the shares are owned by Mr and Mrs Fisher, who are non- executive directors and are not involved in t he day-to-day running of the company. The bookkeeper maintains all the accounting records and prepares the annual fina ncial statements. The company uses a standard computerised accounting package. Y ou have determined that the purchases system operates as follows:

123 When materials are required for production, the production manager sends a ha ndwritten note to the buying manager. For orders of other items, the department manager or managing director sends handwritten notes to the buying manager. The buying manager finds a suitable supplier and raises a purchase order. The purchase order is signed b

y the managing director. Purchase orders are not issued for all goods and services r eceived by the company. Materials for production are received by the goods received department, who i ssue a goods received rote (CRN), and send a copy to the bookkeeper. There is no system for recording receipt of other goods and services. The bookkeeper receives the purchase invoice and matches it with the goods re ceived note and purchase order (if available). The managing director authorises the invoice for posting to the purchase ledger. The bookkeeper analyses the invoice into relevant nominal ledger account code s and then posts it. At the end of each month, the bookkeeper prepares a list of payables to be p aid. This is approved by the managing director. The bookkeeper prepares the cheques and remittances and posts the cheques to the purchase ledger and cashbook. The managing director signs the cheques and the bookkeeper sends the cheques and remittances to the payables. Mr and Mrs Fisher are aware that there may be weaknesses in the above system a nd have asked for advice. Identify the deficiencies in controls in Spondon's purchases system, explain wh at the impact is and suggest improvements. 12 Marks Test your understanding 3 Bassoon Ltd runs a chain of shops selling electrical goods all of which are loca ted within the same country. It has a head office that deals with purchasing, distribution and administration . The payroll for the whole company is administered at head office. There are 20 staff at head office and 200 staff in the company's 20 shops loca ted in high streets and shopping malls all over the country. Head office staff (including directors) are all salaried and paid by direct tr ansfer to their bank accounts. The majority of the staff at the company's shops are also paid through the cen tral salary system, monthly in arrears. However, some students and part time s taff are paid cash out of the till. Recruitment of head office staff is initiated by the department needing the staf f who generally conduct interviews and agree terms and conditions of employmen t. Bassoon has an HR manager who liaises with recruitment agencies, places job a dverts and maintains staff files with contracts of employment, etc. Shop managers recruit their own staff. 124 Shop staff receive a basic salary based on the hours worked and commission ba sed on sales made. The company has a fairly sophisticated EPOS (electronic poin t of sale) till system at all shops that communicates directly with the head off ice accounting system. All staff when making a sale have to log on with a swipe card which identifie s them to the system, and means that the sales for which they are responsible

are analysed by the system and commissions calculated. Store managers have a few 'guest cards' for temporary and part time staff, wh o generally do not receive commissions. Store managers and regional supervisors are paid commissions based on the perf ormance of their store or region. Directors and other head office staff usually receive a bonus at Christmas, depending on the company's performance. This is d ecided on by the board in consultation with departmental manages and put through the system by the payroll manager. The payroll manager is responsible for adding joiners to the payroll and deleti ng leavers as well as for implementing changes in pay rates, tax coding and othe r deductions and for making sure that the list of monthly transfers is communic ated to the bank. The computerised payroll system is a standard proprietary system which is sophis ticated enough to incorporate the commission calculations mentioned above which are fed in directly from the EPOS system. The company employs an IT manager who is responsible for the maintenance of all IT systems and installing new hardware and software. Comment on the strengths and deficiencies of the payroll system at Bassoon Ltd and recommend any changes which you think are appropriate. 10 Marks

125 14 Chapter summary

Test your understanding answers

Test your understanding 1

126 Deficiency (1 Mark) Potential effect (1 Mark) Recommendation (1 Mark) Recording of orders Orders placed on the Internet site are transferred manually into the inventory and sales system. Manual transfer may result in error, for example, in recording order quantities or product codes. Customers will be sent incorrect goods resulting in increased customer complain ts. The computer systems are amended so that order details are transferred directly between the two computer systems. This will remove manual transfer of details li miting the possibility of human error. Control over orders and packing lists Each order/packing list is given a random alphabetical code. This type of code makes it difficult to check completeness of orders at any stage in the despatch and invoicing process. Obtaining payment The customer's credit eaning that goods are d. Packing lists can be customer or the customer's credit card is charged after despatch of goods to the customer, m already sent to the customer before payment is authorise lost resulting either in goods not being despatched to the card not being charged.

Rhapsody Co will not be paid for the goods despatched where the credit company rejects the payment request. Given that customers are unlikely to return seeds. Rhapsody Co will automatically incur a bad debt. Orders/packing lists are controlled with a numeric sequence. At the end of each day, gaps in the sequence of packing lists returned to accounts are investigated .

Authorisation to charge the customer's credit card is obtained prior to despatch of goods to ensure Rhapsody Co is paid for all goods despatched. Completeness of orders There is no overall check that all orders recorded on system have actually been invoiced. Entire orders may be overlooked and consequently sales The computer is programmed to review the order file and o corresponding invoice for an order, these should be nvestigation. 127 Test your understanding 2 Deficiency (1 Mark) Potential effect (1 Mark) Recommendation (1 Mark) (1) Handwritten orders are done (with no numbering). Orders for goods not required and a potential orders being missed for action. T herefore over spending or potential shock outs due to orders not being processed. Have prenumber orders which are authorised by a manager. (2) Purchase orders are not issued for all goods and services. Goods/services being purchased that are not legitimate or required. Purchase orders required for all goods, for services a budget should be set and quotes obtained the inventory and sales and profit understated. orders where there is n flagged for subsequent i

(3) No system for recording receipt of other goods and services. Goods received that are of poor quality or incorrect amounts. Count goods in before they are signed. (4) It doesn't stale that the GRN are checked to anything. Goods received that are of poor quality or incorrect amounts. Agree GRN back to the purchase order. (5) There is no review done of the bookkeeper posting the invoices into the nominal ledger. Errors could go undetected, therefore pay suppliers the incorrect amount. A review by a manager should be done on a regular basis.

(6) A list of payables is given to the managing director. The managing director will not know if payables are valid or correct therefore could be paying incorrect amounts The managing director should also review source documents before signing the list. (7) Lack of segregations. The managing director authorises invoices, approves payment and signs cheques. It is easy to place through a purchase invoice to pay himself and this would go undetected. Segregate duties by sharing the responsibility with another manager.

128 Test your understanding 3 Strength Recommendation Deficiency

Salaries are paid by direct transfer to the employees bank accounts (less chance of mis-appropriation of cash). Cash paid to part time staff (easier to misappropriate cash). No control over the appointment of head office staff the MR Manager deals with (may recruit unnecessary staff). Apply the payroll system to all employees

Head office staff should be approved by the board. No control over shop staff, the shop manager recruits own staff. Should be approved by head office. Having a sophisticated EPOS till system (unlikely for errors to occur)./Individ ual swipe cards linked to commission (you know who is doing the transaction and beca use they receive a commission it encourages the staff to recognise the sale). Guest cards, could be anybody and they could steal a card to access till at a l ater date to steal money. /Lack of segregation of duties, the payroll manager is responsible for all processing. /In the question it states the IT manager is responsible for systems, but doesn't state there is restricted access. A control system to monitor guest cards so management know who has a specific card. /Split the responsibilities up, maybe get a manager to review the payroll managers work. /Place passwords on the system and change them on a regular basis.

129

130 9 Audit evidence Chapter learning objectives When you have completed this chapter you will be able to: Explain the assertions contained in the financial statements; Discuss the quality and quantity of audit evidence; Discuss and provide examples of how analytical procedures are used as substanti ve procedures; Define audit sampling and explain the need for sampling; Discuss and provide relevant examples of, the application of the basic principl es of statistical sampling and other selective testing procedures; and Apply audit techniques to small and not-for-profit organizations.

131 1 Why does the auditor need evidence? In order for the auditor's opinion to be considered trustworthy it must be base d upon more than simple judgement and gut feeling. Auditors must come to their conclusions having completed a thorough examination of the books and records o f their clients and they must have documentary evidence of these procedures nec essary to support their conclusions in the future. Imagine a court case where someone has been accused of theft: a judge could no t simply say someone is or is not guilty based upon their appearance. They must consider evidence gathered by both the defence and the prosecution and then, based upon the evidence presented, the judge may then reach a conclusion. 2 Financial statements assertions The objective of audit testing is to assist the auditor in coming to a conclusi on as to whether the financial statements are free from material misstatement. However, the auditor does not simply design tests with the broad objective to identify material misstatement. This is a difficult conclusion to reach and can only be based upon a senes of detailed tests, each designed with a specific te sting objective relating to certain areas of the financial statements.

For example: auditors have to assess whether inventory balances are free from material misstatement. Unfortunately, there are many ways inventory could be m isstated: items could be missed out of inventory; items from the next accounting period could be accidentally included; it might not be valued at the lower of cost and net realizable value; damaged or obsolete stock might not be identified; purchase cost may not be recorded accurately; or the stock count may not be performed thoroughly.

Each of these concerns could result in misstatement, which ultimately could (al one or in aggregate) be material. For this reason auditors have to perform a range of tests on the significant cl asses of transaction, account balances and disclosures to be reasonably sure th at they arc net misstated. These tests focus on what are known as financial sta tements assertions:

132 Occurrence - did the transactions and events recorded actual occur and pertain to the entity? Completeness - have all transactions, assets, liabilities and equity interests been recorded that should have been recorded? Accuracy - have amounts, data and other information been recorded and disclose d appropriately? Cut-off - have transactions and events been recorded in the correct accounting period Classification and understandability - have transactions and events been: recor ded in the proper accounts; and described and disclosed clearly? Existence - do assets, liabilities and equity interests exist? Rights and obligations - does the entity held or control the rights to assets an d are liabilities the obligations of the entity? Valuation and allocation - are assets, liabilities and equity interests included in the financial statements at appropriate values?

Linking assertions to tests When the auditor designs further audit procedures they must ensure that they tes t a range of the assertions listed. For transactions (i.e. incomes and expenses recorded in the income statement) the auditor should test:

occurrence; completeness; accuracy; cut-off: and classification

For accounts balances (i.e. those balances recorded on the statement of financia l position) the auditor should test: existence; rights and obligations; completeness; and valuation and allocation.

Whilst the testing of accounts balances and transactions will probably be the fo cus of the audit, llie auditor must also design tests to ensure that transactio ns, balances and other relevant information/matters are appropriately disclosed in the financial statements. Assertions relevant to the disclosures are: occurrence; rights and obligations; completeness; classification and understandability; and accuracy and valuation.

To assist your studies and simplify this process consider the following four que stions that an auditor needs to answer when approaching testing: (1) Should items be in the accounts at all? (occurrence, existence, right s and obligations, cut-off). (2) Are they included at the right value? (ac curacy, valuation). (3) Are there any more? (completeness). (4) ility). Are they disclosed properly? (classification, allocation, understandab

133 3 Practical example Auditing buildings When designing a suite of tests to perform on a building, say a freehold propert y, the auditor may consider the following: Assertion Existence Inspect the property concerned. Test

Valuation Agree the cost to the original contract of purchase. In spect subsequent revaluation reports. Re-perform the depreciation calculation.

Rights and obligations Inspect the title deeds. Completeness Review the repairs account to ensure that items of a capital nature have not been expensed. Inspect correspondence with lawyers and consult ants for evidence that there are no additional properties or construction costs

4 Audit procedures We have seen that the nature of the transactions and/or balances and the asser tion being considered affects the design of an audit lest. 1 ISA 500 identifies eight types of procedures, listed below, that the auditor can adept to obtain audit evidence. In the next chapter Audit procedures' we will look in detail at how these proced ures are applied in specific circumstances. 2

Explanation of techniques Inspection of documents and records 3 May give evidence of ownership (rights and obligations), e.g. title de eds May give evidence that a control is operating, e.g. invoices stamped 4 paid or authorized for payment by an appropriate signature. May give evidence about cut-off. E.g. the dates on invoices, dispatch notes, etc. Confirms sales values and purchases costs (i.e. by inspecting the 5 invoice)

Inspection of tangible assets 6 Will usually give pretty conclusive evidence of existence! Way give evidence of valuation, e g obvious evidence of 7 impairment of inventory or non-current assets.

8 134 Observation Involves looking at a process or procedure. May well provide evidence that a control is being operated, e.g. double staffing or a cheque signatory.

You need to remember that this is only evidence that the control was operating p roperly at the time of the observation, and the auditor's presence may have had an influence on the client's staffs behavior.

Observation of a one-off event, e.g. an inventory count, may well give good ev idence that the procedure was carried out effectively. Enquiry Whilst a major source of evidence, the results of enquiries will usually need to be corroborated in some way through other audit procedures. This is because re sponses generated by the audit client are considered to be of a low quality due to their inherent bias. The answers to enquiries may themselves be corroborative evidence. In particular they may be used to corroborate the results of analytical procedures. Management representations are part of overall enquiries. These involve obtaini ng written responses from management to confirm oral enquiries. These are consid ered further in chapter on completion and review.

Confirmation This refers to the auditor obtaining a direct response (usually written ) from an external, third party. Examples include: circularization of receivables; confirmation of bank balances in a bank letter; confirmation of actual/potential penalties from legal advisers; and confirmation of inventories held by third parties.

May give good evidence of existence of balances, e.g. receivables confir mation. May not necessarily give reliable evidence of valuation, e.g. customer s may confirm receivable amounts but, ultimately, be unable to pay in the future . Recalculation This involves checking the arithmetical accuracy of the client's calculations, e .g. depreciation amounts. Reperformance This involves reperforming client procedures, e.g. test checking inventory cou nts. Analytical procedures - again! Analytical procedures as substantive tests We have already come across analytical procedures as a significant component o f risk assessment at the planning phase of an audit. Later in the text we will a lso see that they are a critical component of the completion of an audit. Here we consider their use as substantive procedures, i.e. procedures designed to de tect misstatement.

135 Analytical procedures are used to identify trends arid understand relationships between sets of data. This in itself will not detect misstatement but will iden tify possible sources. As such, analytical procedures cannot be used in isolatio n and should be coupled with other, corroborative, forms of testing, such as enquiry of management. In order lo perform a thorough analytical review auditors do not simply look at current figures in comparison to last year. Auditors may consider other point s of comparison, such as budgets and industry data. Other techniques are also available, including: ratio analysis; trend analysis; and proof in total, for example: an auditor might create an expectation of payroll costs for the year by taking last year's cost and inflating for pay ri ses and changes in staff numbers. Analytical procedures are useful for assessing several assertions at once as t he auditor is effectively auditing a whole accounting balance or class of trans action to see if it is reasonable. They can be used to corroborate other audit evidence obtained, such as statem ents by management about changes in cost structures, such as energy savings. By using analytical procedures the auditor may identify unusual items that can then be further investigated to ensure that a misstatement doesn't exist in the balance. However, in order to use analytical procedures effectively the auditor needs to be able to create an expectation. It would be difficult to do this if operation s changed significantly from the prior year. If the changes were planned, the auditor could use forecasts as a point of comparison. Although these are inhere ntly unreliable due to the amount of estimates involved. In this circumstance i t would be pointless comparing to prior years as the business would be too diffe rent to be able to conduct effective comparison. It would also be difficult to use analytical procedures if a business had expe rienced a number of significant one-off events in the year as these would disto rt the year's figures making comparison to both prior years and budgets meaningl ess. Key ratios

Profitability ratios: Gross margin: gross profit / sales revenue * 100% Net margin: profit before tax /sales revenue * 100%

Auditors would expect the relationships between costs and revenues to stay rela tively stable. Things that can affect these ratios include: changes in sales pr ices, bulk purchase discounts, economies of scale, new marketing initiatives, ch anging energy costs, wage inflation.

136 Efficiency ratios Receivables days: receivables / sales revenue * 365 Payables days: payables / purchases * 365 Inventory days: inventory / cost of sales * 365 These ratios show how long, on average companies take to collect cash from custo mers and pay suppliers and how long they hold inventor/ for. Ultimately companie s should strive to reduce receivables and inventory days to an acceptable level and increase payables days because this strategy maximizes cash flow. Any changes to this mix can impact upon the business and can indicate signific ant issues to the auditor, such as: worsening credit control and increased need for bad debt provisions; ageing and possibly obsolete inventory that could be ovcn/alued; and poor cash flow leading to going concern problems (see later notes).

Liquidity ratios Current ratio: current assets / current liabilities Quick ratio: current assets - inventory I current liabilities These ratios indicate how able a company is to meet its short term debts. As a result these are key indicators when assessing going concern. Investor ratios Geanng: borrowings/share capital + reserves. Return on capital employed (ROCE): profit before interest and tax / share capital + reserves + borrowings. Gearing is a measure of external debt finance to internal equity finance. ROCE indicates the returns those investments generate. Any change in either the gearing or ROCE could indicate a change in the financin g structure of the business or it could indicate changes in overall performance of the business. These ratios are important for identifying potentially material changes to the statement of financial position (new/repaid loans or share issue s) and for obtaining an overall picture of the annual performance cf the busines s.

The suitability of analytical procedures as substantive tests The suitability of this approach depends on four factors: The The The The assertion/s under scrutiny: reliability of the data: degree of precision possible; and amount of variation which is acceptable.

137 Some examples. (1) Suitability -Analytical procedures are clearly unsuitable for testing the existence of inve ntories. -They are. however, suitable for assessing the value of inventory in terms of t he need for provisions against old inventories, identified using the inventory h olding period ratio. (2) Reliability -If controls over financial data are weak then it is likely to contain misst atement and is therefore not suitable as a basis for assessment this may be true of manually p repared forecasts and industry data from unknown sources. (3) Precision -There is likely to be greater consistency over time in information such as gr oss margins than in discretionary expenditure that is subject to chance, like ad vertising or R&D. (4) Acceptable variation -Variations that could have a minor impact on the results for the year (such as cleaning costs, utility accruals) will be regarded differently from variation s in balances such as receivables, which could significantly affect the need fo r bad debt provisions. 5 Sufficient appropriate evidence Whilst the nature of an item under scrutiny (class of transaction, account bal ance, disclosure) and the assertion being tested affects the type of procedure performed, these issues do not necessarily affect considerations of how much evi dence to gather. This is driven by three factors: the risk assessment (of material misstatement); the quality of the evidence available; and the purpose of the procedure (test of control or substantive test?). The overall objective of an auditor, in terms of gathering evidence, is describ ed in audit standards, namely; ISA 500 Audit Evidence. "The objective of the auditor is to design and perform audit procedures in such a way to enable the auditor to obtain sufficient appropriate audit evidence t o be able to draw reasonable conclusions on which to base the auditor's opinion. " Sufficient evidence

There needs to be enough' evidence to support the auditor's conclusion. What is 'enough' at the end of the day is a matter of professional judgment. However, when determining whether they have enough evidence on file the auditor must co nsider: the risk of material misstatement: the results of controls tests; the size of a population being tested; the size of the sample selected to test; and the quality of the evidence obtained. Consider, for example, the audit of a bank balance: Auditors will confirm year-end bank balances directly with the bank. This is a good source of evidence but on its own is not sufficient to give assurance regarding the comple teness and final 138 valuation of bank and cash amounts. The key reason is timing differences. The client may have received cash amounts or cheques before the end of tne year, or may have paid out cheques before t he end of the year, that have not yet cleared the bank account. For this reaso n the auditor should also perform a bank reconciliation. In combination these two pieces of evidence will be sufficient to give assurance over the bank balances. Appropriate evidence Appropriateness of evidence breaks down into two important concepts: reliability; and relevance. Reliability Auditors should always attempt to obtain evidence from the most trustworthy and dependable source possible. Evidence is considered more reliable when it is: obtained from an independent external source; generated internally but subject to effective control; obtained directly by the auditor; in documentary form; and in original form. Broadly speaking, the more reliable the evidence the less of it the auditor will need. However the converse is not necessarily true: if evidence is unreliable it will never be appropriate for the audit, no matter how much is gathered. Relevance To be relevant audit evidence has to address the objective/purpose of a procedur e and the assertion being considered. For example: tests of control are designed to evaluate the operating effectiveness of controls in preventing or detecting and correcting material misstatement: and substantive procedures are designed to detect material misstatement.

Attendance at an inventory count provides us with a good example of the relevanc e of procedures. During counting the auditor considers the relationship between inventory records and physical inventories, as follows: identifying items of physical inventory and tracing them to inventory records to confirm the completeness of accounting records; and identifying items on the inventory record and tracing them to physica l inventories to confirm the existence of inventory assets. Whilst the procedures are perhaps similar in nature their purpose (and relevance ) is to test different assertions regarding inventory balances.

139 6 Sampling

The need for sampling It will usually be impossible to test every item in an accounting population be cause of the costs involved. Consider a manufacturer of fasteners (i.e. nuts, b olts, nails and screws): they will have many thousands, maybe millions, of item s of inventory. It would simply be impossible to test the valuation of every single one. It is also important to remember that auditors gives reasonable not absolute ass urance and are therefore not certifying that the financial statements are 100% accurate. Audit evidence is gathered on a lest basis. Auditor therefore need to understand Ihe implications and effective use of sampling. Definition The definition of sampling, as described in ISA 530 Audit Sampling is: "The application of audit procedures to less than 100% of items within a popula tion of audit relevance such that all sampling units have a chance of selectio n in order to provide the auditor with a reasonable basis on which to draw concl usions about the entire population." Statistical or non-statistical sampling Statistical sampling means any approach to sampling that uses: random selection of samples; and probability theory to evaluate sample results Any approach that does not have both these characteristics is considered to be non-statistical sampling. The approach taken is a matter of auditor judgement Designing a sample

When designing a sample the auditor has to consider; the purpose of the procedure; the combination of procedures being performed; the nature of evidence sought; and possible misstatement conditions. 140 The principle methods of sample selection are: Random selection - this can be achieved through the use of random nu mber tables: Systematic selection - where a sampling interval is used (e.g. every 50th balance); Monetary unit selection - selecting items based upon monetary values ( usually focusing on higher value items); Haphazard selection - auditor does not follow a structured technique bu t avoids bias or predictability; and Block selection - this involves selecting a block of contiguous (i.e. n ext to each other) items from the population. This technique is rarely appropriate. When non-statistical methods are used the auditor uses judgement to select the items to be tested. Whilst this lends itself to auditor bias it does support the risk based approach, where the auditor focuses on those areas most susceptible to material misstatement. This usually leads to a focus on the higher value ite ms within a population and is a common method in practice. The sample size depends upon the level of sampling risk that the auditor is wil ling to accept. This is basically the risk that the auditor's conclusion based o n a sample is different from the conclusion that would be reached if the whole p opulation were tested. In order to reduce sampling risk the auditor needs to increase the size of the s ample selected. Smaller entities Smaller commercial entities will usually have the above attributes. This can lead to both advantages and disadvantages: Lower risk: Smaller entities may well be engaged in activity that is relati vely simple and therefore lower risk. However, this will not be true for small often one person businesses - where there is a high level of expertise in a particular field, e.g. consultancy businesses, creative businesses, the financia l sector. Direct control by owner managers is a strength because they know what is going on and have the ability to exercise re al control. They are also in a strong position to manipulate the figures or put private tr ansactions 'through the books'. Simpler systems: Smaller entities are less likely to have sophisticated IT systems, but pure, manual systems are bec oming increasingly rare. This is good news in that many of the bookkeeping err ors associated with smaller entities may now be less prevalent. However, a sys

tem is only as good as the person operating it.

141 Evidence implications The normal rules concerning the relationship between lity and quantity of evidence apply irrespective of the size of The quantity of evidence may well be less than for a on. It may be more efficient to carry out 100% testing in ation.

risk and the qua the entity. larger organizati a smaller organiz

Problems Management override - Smaller entities will have a key director or man ager who will have significant power and authority. This could mean that control s are lacking in the first piace or they are easy to override. No segregation of duties - Smaller entities tend to have few accounts clerks that processes information. To overcome this the directors should authorize and revie w the all work performed. Less formal approach - Smaller entities tend to have simple systems a nd very few controls due to the trust and the lack of complexity It is therefore difficult t o test the reliability of systems and substantive testing tends to be used more. Not-for-profit organisations Not for profit (NFP) organizations include charities and public sector entities The most important differences from privately owned companies are that NFP ent ities: do not have profit maximization as their main objective These will be either social or philanthropic; do not have external shareholders; and will not distribute dividends Potential problems auditing a NFP entity Some NFP entities, particularly small charities, may have weaker systems due t o: lack of segregation of duties as the organisation will be restricted wi th the amount of staff, the use of volunteers. who are likely to be unqualified and have litt le awareness of the importance of controls; the use of less formalized systems and controls. Significantly, with many charities, much of the income received is by way of don ation. These transactions will not be accompanied by invoices, orders or dispatc h notes. Assessing the going concern of a NFP entity may also be more difficult, particul arly for charities who are reliant on voluntary donations. Many issues, such as the state of the economy, could impact on their ability to generate revenue in the short term. Audit implications

Auditors of not for profit organisations will be required to assess whether the aims of the organisation are being met in an economic, efficient and effective m anner. For this reason "value for money" audits are much more appropriate. Thes e are discussed in more detail in the internal audit chapter Testing tends to concentrate on substantive procedures where control systems ar e lacking. In the absence of documentary evidence procedures rely heavily on ana lytical review, enquiry and management representation.

142 The volumes of transactions in not for profit organisations may be lower than a private one. therefore auditors may be able to test a larger % of transaction s. Ultimately, if sufficient appropriate evidence is not available the auditor will have to modify their audit report.

Test your understanding 1 (1) List three qualities audit evidence must have? (3 marks) (2) List two reasons why audit evidence is likely to be persuasive rather than conclusive. (2 marks) (3) List two examples where it would be appropriate to use sta tistical sampling. (2 marks) 7 Chapter summary

143 Test your understanding 1 (1) List three qualities audit evidence must have? It must be: Sufficient. Relevant. Reliable. (3 marks)

(2) List two reasons why audit evidence is likely to be persuasive rather than conclusive.

(3) List two examples where it would be appropriate to use statistical s ampling. The auditor gathers evidence on a test basis (the sample may or may not be rep resentative). People make mistakes (both client and auditor). Documents could be forged (increasingly easy with digital technology).

The clients personnel may not always tell the truth. (2 marks) Purchases tra nsaction testing Revenue transactions testing Payroll transactions testing ,etc. (2 marks)

144 10 Audit procedures Chapter learning objectives When you have completed this chapter you will be able to: explain provide explain discuss experts; discuss e work of internal and discuss estimates the purpose examples of the use of the extent of substantive procedures; procedures used to audit specific balances; computer-assisted audit techniques; to which auditors are able to rely on the work of

the extent to which external auditors are able to rely on th audit; the problems associated with the audit and review of accounting

145

1.General principles Chapter 9 dealt with the principles of audit evidence. This chapter deals with t he application of those principles. Its starting point to help you familiarise with the basic auditing techniques to allow you to apply them to questions. Its not an exhaustive summary of all audit tests, this would simply not be possible in one volume. A further warning In the sections that follow, you will consider specific audit areas and suggest how these are usually tested. You may be tempted to learn these tests and repeat them parrot fashion in the exam. This would be unwise. Audit procedures are desig nated to reflect the unique risks of an audit and the nature of the items and a ssertions under scrutiny. You must always try and make your answers specific to any scenarios presented in the exam. This requires both knowledge and applic ation skills.

2. Audit and receivables

146 Key assertions Existence the receivable actually exists; Rights and obligations the company has rights to receive the benefit fr om receivables; Valuation and allocation receivables are included in the financial sta tements at the correct amount, including provision for bed and doubtful debt; Completeness all receivables relating to the period have been accounte d for; and Classification and understandability receivables (including provisions) are appropriately disclosed in the financial statements. Audit procedures Existence Perform a receivables circularization (a direct confirmation from ext ernal sources - see below). Select a sample of receivables and trace amounts due to the original sales invoice to confirm that a transaction has taken place; Rights and obligations Receivables circularization; Select a sample of receivables and confirm (he trade terms to original credit agreements and sales invoices. Valuation and allocation

Inspect the ageing profile of receivables to identify any significant, long outstanding balances that may require a provision. Analytically review the ageing profile in comparison to previous period s to identify any deterioration in credit control. Inspect post year-end cash book/bank statements and trace payments re ceived to year- end receivables to confirm that amounts were indeed collectabl e. Discuss the results of the ageing and cash receipts analysis with manag ement to identify if any further provisions are required for old, unpaid balanc es. Discuss the assumptions underlying any general provisions with manageme nt to ensure they are appropriate. Recalculate the provision based on management's assumptions and agree t o the figure in the financial statements. Inspect invoices relating to prepaid balances, agree cost to calculatio ns made.

Inspect bank statements to confirm prepaid amounts have been paid.

147 Completeness Obtain a list of receivables balances, cast this and agree it to the receivables control account total at the end of the year. Differences should be reconciled. Perform a receivables circularisation. Inspect receivables ledger for credit balances and obtain explanations from management. Inspect a sample of the last five to ten goods despatched notes immedi ately prior to the year-end. Trace these through to year-end receivables to en sure they have been recorded.

Classification and understandability Inspect the draft financial statements and agree the receivables figur es and disclosures to nominal ledger balances. Receivables circularisations If successful, circularisalions provide evidence directly from the receivables t hemselves. These are considered to be reliable because they are external, third party confirmations. Circularisalions are also written and original. Procedure Select a sample of receivables to be circularised and notify client of those selected; Extract details of each receivable from the relevant ledger and prepare letters. This should state the balance outstanding at the year-end and include a reply slip for receivables to confirm the balance; Ask the chief accountant at the client (or other responsible official) to sign the letters; The auditor posts or faxes the letters to the individual receivables; Receivables complete the reply slips, confirming the amounts they owe t he client at the year-end. and post them directly to the auditor; and The auditor investigates any disagreement by receivables. Considerations Whilst circularisations are undoubtedly a useful and efficient tool for provid ing good quality evidence., their success does depend on response rates. It mus t be remembered that the audit client's customers are under no obligation to re

ply and, for this reason, responses may be limited. If the response rate is poo r then other forms of evidence must be sought. To maximise the response rate aud itors should ensure: Letters are sent out as soon as possible after the year-end; That the outstanding balance is clearly displayed and all that; receivables have to do is confirm whether this is correct or not; A reply slip is attached to minimise the work of the receivable; and Pre-pa d return envelopes are supplied.

148 Confirmation letter example Customer Ltd Customers address Date of circularisation Dear Sirs As part of their normal audit procedures, we have been requested by our auditor s Auditor & Co to ask you to confirm the balance on your account with us at 31 D ecember 2008 on our end. The balance on your account as shown on our records, is shown below. After com paring this with your records, will you please be kind enough to sign the confirmation and retur n copy to the auditor in the prepaid envelope enclosed. If the balance is not in agreement with your records, will you please note the items making up the diff erence in the space provided. Please note that this request is made for audit purposes only and has no further significance. Your kind cooperation in this matter will be greatly appreciated . Yours faithfully,

Chief Accountant Auditor & Co Auditors address Dear Sirs, We confirm that except as noted below, a balance* of $ 10,000 was owing by us t o Client limited at 29 December 2009. (space for customer signature) *details of differences.

149 3 The audit for inventories

Key assertions Existence does the inventory recorded actually exist? Completeness have all inventory balances been recorded? Rights and obligations does the company has right to receive benefits from the inventories? Valuation and allocation are the inventories valued appropriately? (i.e. at t he lower of cost and net realisable value and net of any provisions for damaged and slow moving goods)? Cut-off are inventory movement around the year-end recorded in the correct p eriod? Classification and understandability are inventories (including provisions) app ropriately disclosed in the financial statements? Principles A typical inventory count happens year end, although continuous counting is po ssible throughout the year. The purpose of the count is to confirm that the quantities of inventory recorde d on the clients system are accurate. Whilst the count is performed items that are damaged and/or obsolete should b e identified for either scrapping or sale at a discounted price. Form an audit perspective, attendance at the count helps provide evidence re garding the existence, completeness and valuation of inventory balances. Inventory counting is the responsibility of the client. The auditor merely atte nds the count to help gather evidence to form an opinion regarding whether inven tory is free from material misstatement or not.

150 Inventory counting procedures Before the count: Obtain the client's counting instructions and review them for obvious f laws in the counting process. This iray also help identify if there are any sig nificant or risky elements of inventory that require special attention, or even precautions. During the count

Observe the count as it proceeds to ensure:

-the counting instructions are being followed -all items are being counted and recorded -there is no risk of double counting -evidence of damaged or slow moving goods is being recorded -deliveries and despatches are not being made during the count -count recording sheets are being properly controlled (i.e. pre- numbered and f illed in with ink). Conduct test counts, on a suitable sample selection basis, as follows:

-select a sample of items from the inventory records and physically observe the items on the warehouse floor to prove the items exist. -select a sample of physical items from the warehouse floor and trace them to the inventory records to ensure that the latter is complete. Record cut-off information by obtaining details of the last deliveries and despatches prior to the year-end. These will then be traced to inventory record s during final audit procedures. Continuous inventory systems The procedures suggested above apply to ail inventor/ counts, whether as a one-o ff, year-end exercise or where inventory is counted on a rolling basis througho ut the year. The objective is the same: To identify whether the client's inventory system reliably records, measures and reports inventory balances.

Where the client uses a continuous counting system lines of inventory are coun ted periodically (say monthly) throughout the year so that by the end of the ye ar all lines have been reviewed. There are both advantages and disadvantages of this for the auditor. Advantages The auditor is less time constrained and can pick and choose particular l ocations and inventory lines to count at any time to ensure the system is reliab le. Slow moving and damaged inventory should be identified and adjusted for in t he client's records on a continuous basis therefore, thus improving the valuation at the yea r-end.

151 Disadvantages The auditor will need to gain sufficient evidence that the system operates effectively at all times, not just at the time of the count. Additional procedures will need to be devised to ensure that the year- end

inventory total is reliable, particularly with regard to cut-off and year- end provisions/estimates. Inventory held at third parties Where the client has inventory at localions not visited by the auditor, the auditor normally obtains confirmation of the quantities, value and condition fro m the holder. The auditor needs to consider whether the holder is sufficiently independent to be able to provide relevant, reliable evidence. As with confirmations from receivables, the auditor requests details from th e party holding the inventory on behalf of the client to confirm its existence. The confirmation request will be sent by the client to those parties identif ied by the auditor. The reply should be sent directly to the auditor to prevent it being tampe red with by the client. Problems can occur if the third party uses a different description to that of the client and as always, a response is not guaranteed. Final audit procedures Completeness Obtain an inventory list showing each line of inventory categorised between finished goods, WIP and raw materials. Cast the list to ensure it is arithmetic ally correct. Make sure the totals agree to amounts disclosed in the financial statements. Trace the items counted during the inventory count to the final inventory l ist to ensure its the same as the one used at the year-end and to ensure that an y errors identified during counting procedures have been rectified. Cutoff Trace the GRNs from immediately prior to the year-end (identified during th e count) to the year end payables and inventory balances Trace the GRNs from immediately prior to the year-end (identified during th e count) to the nominal ledgers to ensure that the items were removed from the inventory prior to the year- end and have been recorded in receivables prior t o the year end. Presentation and discosure

Inspect the financial statements and ensure that figures disclosed agrees t o the audited nominal ledger balances have been correctly analysed between fini shed goods, raw materials and WIP.

152 Valuation Trace a sample of inventory items back back to original purchase invoice s to agree their cost;

 Trace a sample of inventory items to post-year-end sales invoices to det ermine if the appropriate cost or net realisable value has been used; Inspect the ageing of inventory items to identify any old/slow moving amo unts that may require provision; Trace the above items to any inventory provisions and, if any have not been provided, discuss the reason with management; Recalculation of WIP and finished goods using payroll records for labour cost and utility bills for overhead absorption; Calculate inventory turnover/days and compare to the last year to assess whether inventory is being held longer and therefore requires greater provisi ons; Calculate gross profit percentage and compare to the prior year to ident ify any significant fluctuations that may indicate either error or changes in in ventory holding policies.

4. The audit of payables, accruals, provisions and contingent liabilities

Key assertions Existance the payables actually exist; Rights and obligations the company has obligations to settle all payable s; Valuation and allocation payables are included in the financial statement s at correct amount; Completeness - all payables related to the period have been accounted f or; Classification and understandability all payables are appropriately discl osed in the financial statements. 153 Completeness is usually the key consideration when testing payables due to the timing and nature of the items included. Provisions and accruals accounting do o ffer an opportunity for creative accounting to manipulate reported profits. Auditors therefore have to consider indicators that additional liabilities may exist, such as: payables not including known major suppliers and those accrued for in t he prior year; payables not including the significant suppliers from the equivalent li st last year; traditionally recurring accruals not being made, e.g.: rent, utilities, telephone, etc. expected finance accruals not being made, e.g.: hire purchase, mortgag es, loans etc. non-provision of tax balances, including: corporation tax, payroll taxe s, sales taxes, etc suppliers revealed only after a review of payments after the year-end; and suppliers revealed by a review of unpaid invoices at and after the year - end. Classification and understandability

 Inspect financial statements to ensure that all liabilities from the no minal ledger have been adequately and accurately disclosed. Existence Circularise a sample of trade payables to confirm the balance al the e nd of the year (this is uncommon and would only be performed in the absence of supplier statements). Inspect year-end statements of accounts sent by suppliers. Any differe nces between the statement and the nominal ledger should be reconciled. Trace a sample of payable/accruals balances to purchase invoices and/o r contracts. In particular identify the date of receipt of the invoice and an y evidence of payment (such as signatures). Completeness Cast the payables ledger to ensure its accuracy. Inspect year-end statements of accounts sent by suppliers. Any differe nces between the statement and the nominal ledger should be reconciled. Investigate any major (by value of purchases in the year) or known reg ular suppliers that were shown on last year's payables listing but do not have a balance showing in this year's list of balances. Enquire of management why the above suppliers do not feature in this y ear's payables list. Inspect after date payments in the cash book and bank statements and ensure they have been provided for at the year end, as appropriate. Perform analytical procedures on the list of payables, such as: payab les days, payables as a percentage of purchases, monthly payables levels. Inves tigate any unusual variances. Compare the purchase ledger control account to the list of payables. R econcile any variations. Inspect the list of balances for debit balances. Discuss results with m anagement.

154 Cut-off Select a sample of GRN's raised immediately prior to the year-end and t race them through to year-end payables. Likewise, select a sample of GRN's raised immediately after the yearend and trace them to the nominal ledger to ensure they have been, recorded in the next accounting period. Supplier Statements Companies may send out monthly statements of account as part of their credit con trol procedures. Therefore it is likely that audit clients will receive a number of these statements from suppliers at the year-end These can be reconciled to t heir own payables control account to ensure that their records are correct. This is known as a supplier statement reconcili ation and are is important source of audit evidence. Like most statements sent

though the post there are a number of reasons why there may be variances: (1) Timing differences: Invoices sent by the supplier but not yet received by the client. Payments sent by the client but not yet received by the supplier.

Returns and credit notes not yet appearing on the supplier's statemen t. (2) Errors Supplier errors that 'Anil remain as part of the reconciliation until the sup plier corrects them. Client errors, which the client needs to adjust.

Auditors can inspect or reperform the supplier statement reconciliations tc ens ure the completeness, existence and valuation of payable balances. They are a r eliable source of evidence because they are produced by the suppliers, who are ( usually - intergroup trading and related parties!!) independent, external source s. Accruals Inspect invoices received after the year-end that relate to services p rovided before the year-end. Trace them to any accruals made to ensure complet eness and accuracy of the amounts. Obtain the list of accruals from the client, cast it to confirm arith metical accuracy. Agree the figure per the schedule to the general/nominal ledger and f inancial statements Recalculate a sample of accrued costs by reference to contracts and pay ment schedules (e.g. loan interest). Analytically review in comparison to previous period to try and identif y if any balances are perhaps missing.

155 Tax balances Corporation/profits taxes - agree to tax computations. Payroll taxes - agree to payroll records.

Overdrafts, loans, etc. Agree to bank letter confirmation of outstanding amounts.

Leases, hire purchase Agree details to underlying agreement/contracts and recalculate intere st amounts and the split between current and non-current. Loan payables

 Agree the year-end loan balance to any available lean statements to co nfirm obligations, existence and valuation. Agree interest payments to the loan agreement and the bank statements. Analyse relevant disclosures of interest rates, amounts due (e.g. betw een current and non- current payables) to ensure complete and accurate. Recalculate the interest accrual to ensure arithmetical accuracy. Provisions and contingencies Provisions are a form of payable where the amount or timing of payment is uncertain. As such they are harder to audit. Where the likelihood of payment is only possible, rather than probab le, no amounts will be entered in the accounts. However, the matter (contingen t liability) must be adequately disclosed. Discuss the matter giving rise to the provision with the client to ver ify whether an obligation exists. Obtain confirmation from the clients lawyers as to the possible outco me and probability of having to make a payment. Review subsequent events. By the time the final audit is taking place the matter may have been settled. Obtain a letter of representation from the client as the matter is on e of judgement and uncertainty, (see chapter 11 for further discussion). Recalculate the provision if possible, e.g. warranty provisions for r epairs.

156 5 The audit of bank and cash

Key assertions Existence - cash and bank balances actually exist; Rights and obligations - the company has rights to receive the benefit from those balances; Valuation and allocation - balances are included in the financia state ments at the correct amount; Completeness - all balances have been accounted for. Classification and understandability - balances are appropriately discl osed in the financial statements?

The bank letter This is a direct confirmation of bank balances from the bank that give s the auditor independent, third-party evidence The format of the letter is usually standard and agreed between the ba nking and auditing professions. Issues covered are: the client's name the confirmation date balances on all bank accounts held any documents or other assets held for safekeeping details of any security given details of any contingent arrangements - guarantees, forward currency purch ases or sales, letters of credit.

157 The auditor needs the client to give the bank authorisation to disclos e the necessary information (in some jurisdictions such disclosures are illegal so bank letters cannot be used at all). Ensure that all banks that the client deals with are circularised The b alances for each account should be agreed to the relevant bank reconciliation at the year end; Details of loans should be agreed to the disclosure in the statement of financial position as either current or non-current. Bank and cash - other evidence Obtain a list of all bank accounts, cash balances and bank loans and o verdrafts and agree to totals to figures included in current assets and current liabilities in the financial statements Obtain a copy of the client's bank reconciliation, cast and agree the balances to the cash book and bank letter Trace all outstanding lodgements and unpresented cheques to pre- yearend cash book and post-year-end bank statements Ensure all accounts in the bank letter are included in the financial st atements Ensure bank loans and overdrafts are not offset against positive bank balances in the financial statements Count the petty cash in the cash tin at the end of the year and agree the total to the balance included in the financial statements Presentation and disclosure Inspect the draft financial statements and ensure that amounts are disclosed cor rectly as either assets (positive balances) or liabilities (overdrafts) and that the amounts recorded agree to the nominal ledger. 6 The audit of tangible non-current assets

158 Key assertions Existence - assets actually exist; Rights and obligations - the company has rights to receive the benefit from those assets; Valuation and allocation - assets are included in the financial stateme nts at the correct amount; Completeness - all assets have been accounted for. Classification and understandability - assets are appropriately disclos ed in tne financial statements? Existence Select a sample of assets from the non-current asset register and phys ically inspect them. Completeness Select a sample of assets visible at the client premises and inspect th e asset register to ensure they are included. Examine the repairs and maintenance accounts in the general ledger for large and unusual items that may be capital in nature. These should be include d in the statement of financial position, not expenses. Valuation r. Cast the non-current asset register to ensure arithmetical accuracy. Recalculate the depreciation charge for a sample of assets. Analytically review depreciation charges in comparison to the prior yea

Perform a proof in tolal by adjusting the prior year figure for all additions, disposals and revaluations and then calculating total depreciation based upon this figure. Compare depreciation methods and policies in comparison to the previous year to ensure consistency. If any assets have been revalued during the year: agree new valuation to valuer's report verify that all assets in the same class have been revalued reperform depreciation calculation to verify that charge is based on new carrying value. When physically inspecting assets, take note of their condition and u sage in case of impairment. For a sample of asset additions, agree the cost to purchase invoices (o r other relevant documentation). It any assets have been constructed by the company, obtain analysis of costs incurred and agree to supporting documentation (timesheets, materials invoices, etc.).

159 Rights and Obligations For a sample of recorded assets, obtain and inspect ownership documenta tion: title deeds for properties registration documents for vehicles insurance documents may also help to verify ownership (and asset val ues). Where assets are leased, inspect the lease document to assess whether the lease is operating or finance (if the latter the asset should be included o n the company's statement of financial position). 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. name of valuer, revaluation policy). Agree breakdown of assets between classes with the general ledger accou nt totals. 7 The audit of share capital, reserves and directors' emoluments

Key assertions Existence - do share capital balances and reserves actually exist; Rights and obligations - the company has obligations regarding equity balances; Valuation and allocation - equity is included in the financial statemen ts at the correct amount; Completeness - all equity balances, directors' emoluments and other tr ansactions with directors have been accounted for. Classification and understandability - relevant disclosures have been made in the financial statements, particularly with regard to directors' emolume nts.

160 Share capital Agree authorised share capital and nominal value disclosures to underl ying shareholding agreements, such as company memorandums, articles of associat ion and lists of registered members; Inspect cash book for evidence of cash receipts from share issues; Inspect terms of share certificates and reconcile to cash receipts and new share capital totals; Inspect board minutes to identify if any dividends have boon declared prior to the year-end; Directors' emoluments Reconcile reported directors' salaries to payroll records; Inspect board minutes for evidence of directors' bonus announcements; Reconcile directors' bonuses to cash payments in the cash book;

 Inspect board minutes for approval of related party transactions; Obtain a written representation from directors that they have disclose d all related party transactions and director remunerations to the auditor. Reserves Reconcile closing profit reserves to: opening reserves, profit for the year and dividend paid and proposed during the year; Compare opening reserves to closing reserves reported in the prior year 's financial statements; Reconcile movements in revaluation reserves to the non-current asset re gister; Corroborate revaluations by comparing to independently produced reports .

8 Relying on the work of others

161 Why rely on the work of other people? In certain circumstances auditors may need to rely on the work of, or consutt parties not involved in the audit process. Auditors may also choose to rely on the work of others bccause they fin d it effective and efficient to do so. The need to consult others Auditors do not need to be experts in all aspects of their clients' businesses. Where they lack the technical knowledge and skills to gather evidence about t ransactions, balances and disclosures they should seek the assistance of an exp ert. For example: property valuation; construction work in progress. assessment of oil reserves;

 specialist inventory - livestock, food and drink in the restaurant trad e, jewellery; oil reserves; and actuarial valuations for pension schemes.

Using an Auditor's Expert ISA 620 Using the Work of an Auditor's Expert states that the auditor should ob tain sufficient and appropriate evidence that the work of the expert is adequat e for the purpose of the audit. In making this assessment the external auditor must assess the expert's: independence and objectivity; and competence (i.e. qualifications, memberships of professional bodies and experience) Before any work is performed by the expert the auditor should agr ee in writing: The nature, scope and objectives of the expert's work; The roles and responsibilities of the auditor and the expert; The nature, timing and extent of communication between the two parties ; and The need for the expert to observe confidentiality. Once the work has been completed the auditor must than assess it to ensure it is appropriate for the purposes of the audit. This involves consideration of: the consistency of the findings with other evidence; the significant assumptions made; and the use and accuracy of source data.

Relying on Internal Audit An internal audit department forms part of the client's system of internal cont rol. If this is an effective element of the control system it may well reduce co ntrol risk, and therefore reduce the need for the auditor to perform detailed s ubstantive testing, this will obviously be taken into account during the planning phase of the audit. Additionally, auditors may be able to co-operat e with a client's internal audit department and place reliance on their procedures in place of p erforming their own. 162 ISA 610 Using the Work of Internal Auditors stales that before relying on the w ork of internal auditors, the external auditor must determine whether it is like ly to be adequate for the purposes of the audit. This involves an evaluation of: the objectivity of the internal audit function; the technical competence of the internal audit function; whether the internal audit function is carried out with duo professiona l care; and whether there is likely to be effective communication between the inte rnal and external auditor. If the auditor considers it appropriate to use the work of the internal audit function they then have to incorporate this into their planning to assess the i mpact en the nature, timing and extent of further audit procedures. They also have to plan adequate time to review the work of the internal audit function to evaluate whether: the work was performed by people with adequate technical training and p

roficiency; the work was property supervised, reviewed and documented; sufficient and appropriate evidence has been obtained to be able to dra w reasonable conclusions; the conclusions reached are appropriate in the circumstances; and any unusual matters are properly resolved. Service Organisations The client may outsource certain functions to another company - a service organ isation, e.g. payroll receivables collection the entire finance function internal audit. Advantages from the auditor's point of view The independence of the service organisation may give increased reliabi lity to the evidence obtained: Their specialist skills tend to make them more reliable at processing information; and The auditor may be able to place a high degree of reliance on the rep orts they produce as a result (reduced control risk). Disadvantages The auditor may not be able to obtain information from the service pro vider; The auditor may not be allowed to test controls at the service provid er; This would lead to difficulties in assessing the accuracy and reliabili ty of the information produced by the service provider; and Ultimately this could lead to a lack of sufficient appropriate evidenc e and a modified audit report.

163 References to the work of others in the audit report It is the auditors' responsibility to obtain sufficient and appropriate audit ev idence in order to arrive at their audit opinion. Therefore, no reference should be made in the audit report regarding the use of others during the audit. This might be considered as some form of modifying statement, deflecting responsibil ity from the auditor to a third party. 9 Accounting estimates

Accounting estimates are of particular concern to the auditor as, by their n ature, there may not be any physical evidence to support them and they are pro ne to inaccuracy. They are also subjective and therefore prone to management bias. If the directors wished to manipulate the accounts in any way, accounting estimates are an easy way for them to do this. The auditor must take care wh

en auditing estimates to ensure this has not been the case. In accordance with ISA 540 Auditing Accounting Estimates auditors need to obtai n an understanding of: how management identifies those transactions, events and conditions th at give rise to the need for estimates; and how management actually makes the estimates, including the control pro cedures in place to minimise the risk of misstatement. In response to this assessment auditors should perform the following further pr ocedures: Review of the outcome of the estimates made in the prior period; Consider events after the reporting date that provide additional evide nce about estimates made at the year-end; Test the basis and data upon which management made the estimate (e.g. review mathematical methods); Test the operating effectiveness of controls over how estimates are ma de; Develop an independent estimate to use as a point of comparison; and Consider whether specialist skilIs/knowledge are required (e.g. lawyer ).

164 10 Computer assisted audit techniques (CAATs)

The use of computers as a tool to perform audit procedures is often referred to as a 'computer aided auditing technique' or CAAT for short. There are two broad categories of CAAT: (1) Audit software; and (2) Test data.

Audit software Audit software is used to interrogate a client's system. It can be either pack aged, off-the-shelf software or it can be purpose written to work on a client's system. The main advantage of these programs is that they can be used to scrut inise large volumes of data, which it would be inefficient to do manually. The p rograms can then present the results so that they can be investigated further. Specific procedures they can perform include: Extracting samples according to specified criteria, such as: Random; Over a certain amount; Below a certain amount; At certain dates. Calculating ratios and select indicators that fail to meet certain p re- defined criteria (i.e. benchmarking); Check arithmetical accuracy (for example additions); Preparing reports(budget vs. actual); Stratification of data (such as invoices by customer or age); Produce letters to send out to customers and suppliers; and Tracing transactions through the computerised system.

165 These procedures can simplify the auditor's task by selecting samples for testi ng, identifying risk areas and by performing certain substantive procedures. The software does not however, replace the need for the auditor's own procedures. Test data Test data involves the auditor submitting 'dummy' data into the client's sys tem to ensure that the system correctly processes it and that it prevents or de tects and corrects misstatements. The objective of this is to test the operatio n of application controls within the system. To be successful test data should include both data with errors built into it and data without errors. Examples of errors include: codes that do not exist, e.g. customer, supplier and employee; transactions above pie-determined limits, e.g. salaries above contracte d amounts, credit above limits agreed with customer; invoices with arithmetical errors; and submitting data with incorrect batch control totals. Data may be processed during a normal operational cycle ('live' test data) o r during a special run at a point in time outside the normal operational cycle ('dead' test data). Both has their advantages and disadvantages: Live tests could interfere with the operation of the system or corrupt master files/standing data; Dead testing avoids this scenario but only gives assurance that the sy stem works when not operating live. This may not be reflective of the strains t he system is put under in normal conditions. Other Techniques

There are other forms of CAAT that are becoming increasingly common as computer technology develops, although the cost and sophistication involved current li mits their use to the larger accountancy firms with greater resources. These in clude: Integrated test facilities - this involves the creation of dummy ledgers and rec ords to which test data can be sent This enables more frequent and efficient t est data procedures to be performed live and the information can simply be igno red by the client when printing out their internal records: and Embedded audit software - this requires a purpose written audit program to be em bedded into the client's accounting system. The program will he designed to per form certain tasks (similar to audit software) with the advantage that it can b e turned on and off at the auditor's wish throughout the accounting year. Thi s will allow the auditor to gather information on certain transactions (perhaps material ones) for later testing and will also identify peculiarities that req uire attention during the final audit.

166 Auditing around the computer The Practical Implications of CAAT's Planning and Risk Assessment Of course, the most obvious point to note s that CAAT's. whilst efficient, are limited in terms of their cost and the availability of resources. The software itself either has to be purchased or designed and then the accountancy firm wo uld need individuals with IT expertise to perform the tests. This may render the m inefficient for many audit procedures. The client's permission (and cooperatio n when designing bespoke software) must also be sought before programs are load ed onto the client's system. Their use must therefore be considered at the plann ing phase of the audit. If they are considered appropriate then they will have many uses when performing risk assessment procedures. One of their primary fu nctions is to test IT application controls. The results of this will then be u sed to assess control risk and design further audit procedures.

167 Further Audit Procedures As previously mentioned CAAT's will be extremely useful for assisting with samp

le selections through stratification and other techniques. For example, identi fication of: receivable, payable or inventory balances over a certain age: individually material assets and liabilities: transactions over agreed limits (e.g. customer's credit limits); changes to standing data, e.g. authorised supplier lists; credit balances within receivables and debit balances in payables; non-current asset purchases over a certain amount;

CAAT's can also be used to perform certain substantive procedures, such as: ratio calculations: recalculation of non-current asset depreciation; recalculation of employee taxes, state pension schemes and employment p ension scheme balances; confirmation of batch totals to individual records, e.g. wages and s alary payments to payroll records; casting of all ledger balances. Test your understanding 1 (1) List the audit procedures before the inventory count. (3 marks)

(2) List the audit procedures to test for existence and completeness on inventory. (2 marks) (3) Saxophone Ltd runs a petrol filling station. List the audit procedure s to test the quantities of petrol in inventory. (2 marks) (4) Flute Ltd makes large machines out of very heavy pieces of steel. Li st the audit procedures to test its inventory of sheet and bar steel. (2 marks) (5) Piccolo Ltd has a sheep farming business. List the audit procedures to verify the number of animals it owns at the year end. (2 marks) Test your understanding 2 (1) Describe the audit procedures to confirm unpresented cheques are inclu ded on a client's bank reconciliation. (1 mark) (2) List 4 things that might be included on a bank letter besides the bal ances on a client's accounts. (2 marks) (3) Describe an audit procedure to test the rights and obligations asser tion for a freehold property. (1 mark) (4) Describe an audit procedure to test the completeness of a client's hi re purchase and leasing liabilities. (1 mark) 168 11 Chapter summary

Test your understanding answers

169 Test your understanding 1 (1) List the audit procedures before the inventory count. Review the instructions to ensure valid and appropriate Confirm the date of inventory count. 1 Discuss any potential issues with management which may need addressing prior to count. 1 (2) List the audit procedures to test for existence and completeness on invento ry Select items from the client's final inventory listing and compare with the resu lts of the auditor's test counts. 1 Trace the items counted by the auditor into the client's final inventory listin g. 1 (3) Saxophone Ltd runs a petrol filling station. List the audit procedures to te st the quantities of petrol in inventory If the tank has a gauge - read the results. The accuracy of the gauge can be tested by noting the reading just before and after a new delivery of fuel is ma de and comparing with the quantity delivered. 1

If there is no gauge, it will be necessary to dip the tank' using a measuring s tick. 1 (4) Flute Ltd makes large machines out of very heavy lumps of steel. List the a udit procedures to test its inventory of sheet and bar steel. Test count bars sheets of steel. 1 Assess average weights of bars and sheets from delivery/weighbridge records. 1 (5) Piccolo Ltd has a sheep farming business. List the audit procedures to veri fy the number of animals it owns at the year end. Count them at dipping time or when they are herded together for some purpose. 1 Or (preferably) use the report of a relevant expert .1

170 Test your understanding 2 (1) Describe the audit procedures to confirm unpresented cheques are included on a client's bank reconciliation. Review post-year-end bank statements to test that al! cheques drawn before yea r end but clearing after the statement of financial position date are include d on the reconciliation.

(2) List 4 things that might be included on a bank letter besides the balances on a client's accounts. Deeds and other documents or assets held. Guarantees. Forward currency contracts. Bills of exchange and letters of credit.

(3) Describe an audit procedure to test the rights and obligations assertion fo r a freehold property. Review title deeds and register of charges, for owners details and ensure they agree. 1 (4) Describe an audit procedure to test the completeness of a client's hire pu rchase and leasing liabilities. For all assets acquired in the year review correspondence to ensure there are no hire purchase or leasing liabilities in relation to the asset. 1

171

172 11 Completion and review Chapter learning objectives Upon completion of this chapter you will be able to:

 Explain the purpose of and procedures involved in a subsequent events r eview; Define and discuss the significance of going concern; Explain the responsibilities of auditors and management regarding goin g concern; Discuss the procedures to be applied in performing going concern review s; Discuss the purpose of, quality of and procedure for obtaining written representations; Explain the significance of uncorrected misstatements; and Explain the auditors responsibilities in relation to opening balances a nd comparative information.

173 1 Introduction

After an auditor has gathered their evidence there are still many procedures t hat need to be completed before they can actually sign the audit report. Thes e include: the consideration of opening balances and comparatives; the subsequent events review; the going concern review; obtaining written management representations; consideration of misstatements; and the audit file review.

174 Opening balances ISA 510 Initial Engagements - Opening Balances requires that when auditors take on a new cliont, they must ensure that: opening balances do not contain material misstatements; prior period closing balances have been correctly brought forward or. where appropriate, restated; and appropriate accounting policies have been consistently applied, or cha nges adequately disclosed. Considerations: Were the previous financial statements audited? If the previous financial statements were audited, was the opinion modi fied? If the previous opinion was modified, has the matter been resolved si nce then? Were any adjustments made as a result of the audit? If so, has the cl ient adjusted their accounting ledgers as well as the financial statements? If auditors are unable to satisfy themselves with regard to the preceding period . they will have to consider modifying the current audit report. Audit procedures Where the prior period was audited by another auditor or unaudited, the auditor s will need to perform additional work in order to satisfy themselves regarding the opening position. Such work would include: consulting the client's management reviewing records and accounting and control procedures in the preced ing period consulting with the previous auditor and reviewing (with their permiss ion) their working papers and relevant management letters substantive testing of any opening balances where the above procedures are unsatisfactory. Some evidence of the opening position will also usually be gained from the audit work performed in the current period.

175 Comparatives ISA 710 Comparative Information - Corresponding Figures and Comparative Financia l Statements requires that comparative figures comply with the identified financ ial reporting framework and that they are free from material misstatement. The lASC's Framework for the Preparation and Presentation of Financial Statement s and IAS 1 Presentation of Financial Statements both require that financial statements sho w comparatives. Two categories of comparatives exist:

corresponding figures where preceding period figures are included as an integral part of the current period financial statements; and comparative financial statements where preceding period amounts are in cluded for comparison with the current period. Corresponding figures Audit procedures in respect of corresponding figures should be significantly le ss than for the current period and arc limited to ensuring that corresponding figures have been correctly reported and appropriately classified This involve s evaluating whether accounting policies are consistently applied; and corresponding figures agree to the prior period financial statements

Comparative financial statements Sufficient appropriate evidence should be gathered to ensure that comparative fi nancial statements meet the requirements of an applicable financial reporting framework. This involves evaluating whether: accounting policies are consistently applied: and comparative figures agree to the prior period financial statements.

176 2 Subsequent Events Review Subsequent events are events occurring and facts discovered between the period end and the date the financial statements are authorised for issue. Auditors must take steps to ensure that any such events are properly refl ected in the financial statements. This is done by events after reporting period review. Auditors responsibility

Year end Annual general 31.12.2009

Auditors sign meeting Active duty Passive duty

Authorized issue

Passive dut

y Auditors have an active Between signing the audit duty to search for all report and issuing the material events between financial statements the statement of financial position date and the date -auditors have a passive duty audit report is signed -auditors only have to act if they are made aware of something - but once they are aware, they have a duty to take necessary action Actions Actions Actions -Discuss with -Discuss with -Discuss w ith management management ask them to management but the directors will have revise -Review the financia l to recall the financial Financial Statements statements to en sure statements -If client updates the revised and redraft -Review the finan cial audit financial statements the auditor would give report statements to ensure revised and redraft a -If client refuses audit clean audit report *seek legal advice report -If the client refuses to *attend AGM -If client re fuses change the financial *resign *seek legal advice statement, the audit *attend AGM report will need to be *resign qualified

177 The auditor has done the subsequent event review and has found a material eve nt There are two types

Adjusting

Non-adjusting

Adjusting - events providing additional evidence relating to conditions exi sting at the balance sheet date; they require adjustments in the financial stat ements. Non-adjusting-events concerning conditions which arose after the statement o f financial position date, but which may be of such materiality that their discl osure Is required to ensure that the financial statements are not misleading. Examples Trade receivables going bad Credit notes relating to sale Invoices In the year end Inventory at the year end sold lower than cost Take over Legal issues after the year end A fire happening after the B/S date which had to impact on the inventory becau se it was sold prior to the fire Examples

ISA 560 Subsequent Events details the responsibilities of the auditors with resp ect to subsequent events and the procedures they can use. As can be seen above auditors are responsible for performing these procedures right up until the day that they sign the audit report. After this date they can relax a little but whilst they no longer have to perform procedures they must act if they are ma de aware of any significant subsequent events.

Audit procedures The nature of procedures performed in a subsequent events review depends on many variables, such as the nature of transactions and events and the availability of data and reports. However the following procedures are typical of a subseq

uent events review:

178 Enquiring into management's procedures/systems for the identification of subs equent events; Inspection of minutes of members' and directors' meetings; Reviewing accounting records including budgets, forecasts and interim informa tion. Enquiring of directors if they are aware of any subsequent events that requir e reflection in the year-end account; Obtaining, from management, a letter of representation that all subsequent ev ents have boon considered in the preparation of the financial statements; Inspection of correspondence with legal advisors; Enquiring of the progress with regards to reported provisions and contingenci es; and 'Normal' post reporting period work performed in order to verify year- end balances: chocking after date receipts from receivables; inspecting the cash book for payments/receipts that were not accrued for at (he year- end; and checking the sales price of inventories. 3 Going Concern

The going concern concept - definition According to IAS1 financial statements should be prepared on the basis that the company is a going concern unless it is inappropriate to do so. The going concern concept is defined in IAS1 as the assumption that the enter prise will continue in operational existence for the foreseeable future. Any consideration involving the 'foreseeable future" involves making a judgem ent about future events, which are inherently uncertain. Uncertainty increases with time and judgements can only be made on the basi s of information available at any point - subsequent events can overturn that judgement. The period that management (and therefore the auditor) is required to consid er is usually defined by financial reporting standards. Generally (but not exclusively) the period is a minimum cf twelve months from the year-end, with twelve months from the date the financial statements are published being preferred. There may be circumstances in which it is appropriate to look further ahead.

This depends on the nature of the business and their associated risks.

179 The going concern concept - significance Whether or not a company can be classed as a going concern affects how its fin ancial statements are prepared. Financial statements are usually prepared on the basis that the reporting ent ity is a going concern. IAS1 states that 'an entity should prepare its financial statements on a go ing concern basis, unless the entity is being liquidated or has ceased trading, or the directors have no realistic alternative but to liquidate the ent ity or to cease trading.' Where the assumption is made that the company will cease trading, the financ ial statements are prepared using the break-up basis under which: assets are recorded at likely sale values inventory and receivables a re likely to require more provisions, and additional liabilities may arise (severance costs for staff, the cos ts of closing down facilities, etc.).

Directors and Auditors Responsibilities Both directors and auditors of an entity have responsibilities regarding going concern. Directors It is the directors' responsibility to assess the company's ability to contin ue as a going concern when they are preparing the financial statements. If they are aware of any material uncertainties which may affect this assess ment, then IAS 1 requires them to disclose such uncertainties in the financial statements. When the directors are performing their assessment they should take into acc ount a number of relevant factors such as: current and expected profitability debt repayment sources (and potential sources) of financing. Auditors

ISA 570 Going Concern states that the auditor needs to consider the appropriaten ess of management's use of the going concern assumption. The auditors need to a ssess the risk that the company may not be a going concern. Where there are going concern issues, the auditor needs to ensure that the di rectors have made sufficient disclosure of such matters in the notes to the fi nancial statements.

180 Audit procedures

Indicators of going concern problems Typical indicators of going concern problems include the following: Net current liabilities (or net liabilities overall!) Borrowing facilities not agreed or close to expiry of current agreement; Defaulted lean agreements: Unplanned sales of non-current assets; Missing lax payments; Failure to pay staff; Negative cash flow; Inability to obtain credit from suppliers; Major technology changes; Legal claims; Loss of key staff; and Over-reliance on a small number of products, staff or customers.

181 Disclosures Where there is any significant doubt over the future of a company, the directo rs should include disclosures in the financial statements explaining:

the nature of and circumstances surrounding the doubts; and the possible effect on the company.

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 financi al statements), this fact should be disclosed. Where the financial statements are prepared on a basis other than the going concern basis, the basis used should be disclosed.

Reporting implications

182 In relation to going concern it is important to understand the following: Financial statements are normally prepared on the going concern basis; Where the going concern basis is used and is appropriate. the auditors do n ot need to mention the fact in their report. If the auditor believes that the going concern basis used in the financial s tatements is inappropriate they may have to modify the audit report; If the directors appropriately disclose an uncertainty with regard to going c oncern the auditor (without modifying their opinion) will refer to this in the audit report in an ' emphasis of matter' paragraph: and If the directors prepare the financial statements on another basis (i.e. not going concern) and this is appropriate the auditor will also refer to this in an emphasis of matte' paragraph. 4 Written representations What are written representations? A written representation is a (written) statement by management provided to the auditor to confirm certain matters or to support other audit evidence (ISA 580 W ritten Representations). The purpose of obtaining this form of evidence is twofo ld: to obtain representations that management, and those charged with governance , have fulfilled their responsibility for the preparation of the financial stat ements, including; preparing the financial statements in accordance with an applicable f

inancial reporting framework; providing the auditor with all relevant information and access to rec ords; recording all transactions and reflecting them in the financial stat ements. to support other audit evidence relevant to the financial statements if deter mined necessary by the auditor or required by ISA's. The latter point may be relevant where the auditor deems that other, more reli able forms of evidence are not available to them. Examples include: plans or intentions that may affect the carrying value of assets or liabilit ies; confirmation of values where there is a significant degree of estimation o r judgement involved, e.g. provisions and contingent liabilities; formal confirmation of the directors' judgement on contentious issues, e.g. the value of assets where there is a risk of impairment; and aspects of laws and regulations that may affect the financial statements, in cluding compliance. How are written representations obtained? As the audit progresses, the audit team will assemble a list of those items abo ut which it is appropriate to seek management representations. During completio n the auditors will write to the client confirming the issues about which they are seeking representations. The client must formally document, and sign, a res ponse and send it to the auditor. The representations themselves may take any of the following forms. A letter from the client to the auditors responding to the necessary points, (it is common for the auditor to draft the letter for the client, who simply re produces it on their own letter-headed paper, approves it and signs it). A letter from the auditors to management setting out the necessary points, which management signs in acknowledgement and returns to the auditors. Minutes of a meeting where representations were made orally, which can be signe d by management.

183 The quality and reliability of written representations Unfortunately, written representations are internal sources of evidence, and ar e therefore subject to bias, and tend to focus on contentious areas of the f inancial statements. They are therefore potentially unreliable forms of audit e vidence. They do not, on their own, constitute appropriate evidence. ISA 580 also clearly states that written representations should only be sought t o support other audit evidence. They do not, on their own, constitute sufficie nt evidence. It is clear that the quality of written representations is somewhat dubious. How ever, there are instances where no other, better quality forms of evidence

arc available to the auditor, particularly where disclosures in the financial statements are restricted to matters of management judgement. Before they can b e used the auditor must consider their reliability in terms of: inconsistencies with other forms of evidence; and concerns about the competence, integrity, ethical values or diligence of ma nagement; With inconsistency the auditor will be required to reconsider their initial risk assessment and. perhaps, perform further procedures. If the latter is true (abo ut competence, integrity etc) then the audit must consider whether the engageme nt can be conducted effectively. If they conclude that it cannot then they sho uld withdraw, where permitted by laws and regulations. If they are not permitted to withdraw they should consider the impact on the audit report. It is likely that this would lead to them disclaiming their opinion. The last point is also relevant if management refuses to provide written represe ntations. Additional matters requiring written representation in addition to the matters identified in the passages above, the following issue s may also be documented in a written representation: directors have assessed the risk of fraud and consider it to be low; directors are not aware of any actual, or suspected, instances of fraud; all related parties have been identified and transactions with them disclose d in the financial statements; directors consider the aggregate of all uncorrected misstatements to be immat erial; the directors have considered all subsequent events in preparing the financi al statements; and the directors have considered all possible events, matters and contingencie s in performing their going concern review.

184

Overall review of evidence What happens in the final review? The overall review stage of the audit is the point at which the final decisions are taken. Overall review Financial statements ok? Audit evidence ok? Other completion procedures

Does the financial statements comply with relevant reporting framework? Does the evidence gathered in the course of audit support the audit opinion? Have the necessary completion procedures have been carried out? -Law -Applicable accounting standards -GAAP -Other regulations -Does other information published within the financial statements conflict with them in any way? (e.g. Chairmans repot) -Was the audit plan followed? -Has the work been performed in accordance with professional standards and lega l requirements? -Have the matters been raised for further consideration? -Was the plan suitably modified to allow changing circumstances? -Final analytical review. -Second partner review (if applicable) -Subsequent events review -Going concern review The review is carried out by the engagement partner who has ultimate responsib ility for commiting the audit firm when signing the audit report.

What is the purpose of a final review? It is the responsibility of the engagement partner to perform a review of audit documentation (including a discussion with the engagement team) in order to sat isfy themselves that sufficient appropriate evidence has been obtained to suppor t any conclusions reached and. ultimately, the audit opinion. Considerations include, for example: has work been performed in accordance with professional standards? have the significant risks identified during planning been addressed?

 are there any critical areas of judgement relating to difficult or contentio us matters? are then any significant matters for further consideration? have appropriate consultations taken place or are more needed? have the objectives of the engagement procedures been achieved? does the work documented support the conclusions made? is there a need to revise the nature, timing and extent of procedures? is the evidence sufficient to support an opinion? Reviews are also significant for a firm's appraisal system and development of st aff. Additionally they are an important element of any monitoring system, implem ented to identify and rectify deficiencies in a firm's practices that could lead to poor quality work. Appropriate review procedures are an integral part of an audit and are a requirement of ISA 220 Quality Control for an Audit of Financia l Statements.

185 Evaluation of misstatements In accordance with ISA 450 Evaluation of Misstatements Identified During the Aud it all misstatements should be communicated to management on a timely basis, un less they are clearly trivial. Management should be asked to correct all missta tements identified during the audit. Auditors should try and obtain an understa nding of management's reasons for refusing to adjust any of the misstatements. Prior to evaluating the significance of uncorrected misstatements the auditor s hould reassess materiality to confirm whether it remains appropriate to the fina ncial statements. Then the auditor must assess whether uncorrected misstatement s are, individually or in aggregate, material. To do this they should consider the size and nature of the misstatements, both in relation to the financial sta tements as a whole and to particular classes of transaction, account balances an d disclosures. Finally, the auditor should obtain a written representation from management and those charged with governance that they believe the effect of the uncorrected m isstatements is immaterial, individually and in aggregate. Once these procedures have been completed the auditor should then consider t he impact of uncorrected misstatements on their reporting. The impact on the au dit report is considered in chapter 12 Other reports are considered below. Other Reports ISA 260 Communication with Those Charged with Governance requires the auditor lo make additional communications to managers, directors and those charged with go vernance at the conclusion of the audit of matters significant to the oversight of the financial reporting process. One of the matters requiring communication is ' significant findings from the a udit.' The existence of errors may indicate that a client's accounting practice s or policies contravene financial reporting requirements or that the internal c ontrol systems are deficient. Either way these matters should be communicated t o the client.

FIXED TEST 3 -Smithson Smithson Co provides scientific services to a wide range of clients. Typical ass ignments range from testing food for illegal additives to providing forensic an alysis on items used to commit crimes to assist law enforcement officers. The annual audit is nearly complete. As audit senior you have reported to the engagement partner that Smithson is having some financial difficulties. Income has fallen due to the adverse effect of twc high-profile court cases, where Smi thsons services to assist the prosecution were found to be in error. Not only did this provide adverse publicity for Smithson. but a number of clients withdrew t heir contracts. A senior employee then left Smithson, stating lack of investment in new analysis machines was increasing the risk of incorrect information being provided by the company. A cash flow forecast prepared internally shows Smithson requiring significant ad ditional cash within the next 12 months to maintain even the current level of services. Required: (a) Define 'going concern' and discuss the auditor's and directors responsibil ities in respect of going concern. (5 marks) (b) State the audit procedures that may be carried out to try to determine whet her or not Smithson Co is a going concern. (10 marks) (c) Explain the audit procedures the auditor may take where the auditor has de cided that Smithson Co is unlikely to be a going concern. (5 marks) 186 Test your understanding 1 The dale is 3 September 2008. The audit of Brand Co is nearly complete and the financial statements and the audit report are duo to be signed next week. How ever, the following additional information on two material events has just bee n presented to the auditor The company's year end was 30 June 2008. Event 1 - Occurred on 6 July 2008 The filaments in a new type of light bulb have been found to be defective makin g the light bulb unsafe for use. There have been no sales of this light bulb, it was due to be marketed in the next few weeks. The company's insurers estimat e that inventory to the value of $600,000 has been affected. The insurers also estimate that the light bulbs are now only worth $125,000. No claim can be made against the supplier of filaments as this company is in liquidation with no pros pect of any amounts being paid to third parties. The insurers will not pay Brand for the fall in val ue of the inventory as the company was underinsured. All of this inventory was i n the finished goods store at the end of the year and no movements of invento ry have been recorded post year-end. Event 2 - Occurred 3 August 2008 Production at the Bask factory was halted for one day when an oil truck rever sed into a metal py on, puncturing the vehicle allowing oil to spread across th e factory premises and into a local reservoir. The Environmental Agency is curre

ntly considering whether the release of oil was in breach of environmental legis lation. The company's insurers have not yet commented on the event. Required: (a) For each of the two events above: (i) Explain whether the events are adjusting or non-adjusting according to IAS 1 0 Events After the Reporting Period. (4 marks) (ii) Explain the auditors' responsibility and the audit procedures and actions t hat should be carried out according to ISA 560 (Redrafted) Subsequent Events. ( 12 marks)

(b) Assume that the date is new 15 September 2008, the financial statements an d the audit report have just been signed, and the annual general meeting is to take place on 10 October 2009. The Environmental Agency has issued a report slating that Brand Co is in breach of environmental legislation and a fine of $8 00,000 will now be levied on the company. The amount is material to the financia l statements. Required: Explain the additional audit work the auditor should carry out in respect of thi s fine. (4 marks) Total: (20 marks)

Test your understanding 2 (1) List three reasons why auditors obtain written representations. (3 ma rks) (2) List six items that could be in a written representation letter. (3 marks)

187 5 Chapter summary

FIXED TEST 3 - Smithson THIS IS A FIXED TEST - Please answer the question in full (long form written). T hen log on to en gage at the following address: www.en-gage.co.uk. Follow the li nk to 'Fixed Test 3' and answer the questions based on your homework answer. Once you have answered the questions on en-gage a model answer will be availa ble for your reference.

188

(a) Event 1

(i) The problem with the light bulb inventory provides additional evidence of co nditions existing at the end of the reporting period as the inventory was in ex istence and the faulty filaments were included in the inventory at this lime. 1mark The value of the inventory is overstated and should he reduced to the lower of cost and net realisable value in accordance with IAS 2 Inventories. 1mark An adjusment for this decrease in value must be made in the financial statements . 1mark The inventory should therefore be valued at $125.000 being the net realisable va lue. 1mark (ii) The decrease in value of inventory took place after the end of the reporti ng period but before the financial statements and the audit report were sign ed. 1mark The auditor is therefore still responsible for identifying material events that affect the financial statements. 1mark Audit procedures are therefore required to determine the net book value of the i nventory and check that the $125,000 is the sales value of the light bulbs. 1 M ark Audit procedures will include: - Obtain documentation from the insurers confirming their estimate of the value of the light bulbs and that no further insurance claim can be made for the lo ss in value. 1mark - Obtain the amended financial statements and ensure that the directors have i ncluded $125,000 as at the end of the reporting period. 1mark - Ensure that the year-end value of inventory has been decreased to $125,000 o n the statement of financial position, statement of financial position note an d the income statement. 1mark - Review inventory lists to ensure that the defective filaments were not used in any other light bulbs and that further adjustments are not required to any othe r inventory. 1mark - Obtain an additional management representation point confirming the accuracy of the amounts written-off and confirming that no other items of inventory are a ffected. 1mark Event 2 (i) The release of oil occurred after the end of the reporting period, so this is indicative of conditions existing after the end of the reporting period the event could not be foreseen at the end of the reporting period. 1mark In this case, no adjustment to the financial statements appears to be necessary. 1mark

However, the investigation by the Environmental Agency could result in legal cl aim against the company for illegal pollution so as a material event it will ne ed disclosure in the financial statements. 1mark (ii) As with event 1. the event takes place before the signing of the audit report therefore the auditors have a duty to identify material events affecting the financial statements. 1mark (b) The notification of a fine has taken place after the audit report has b een signed. Audit procedures will include:

189 - Discuss the matter with the directors to determine their course of action. 1m ark - Where the directors decide to amend the disclosure financial statements, audi t the amendment and then re-draft and re-date the audit report as appropriate. 1mark - Where the directors decide not to amend the financial statements as the discl osure the auditor can consider other methods of contacting the members. For exa mple the auditor can speak in the upcoming genera nesting to inform the members of the event. 1mark - Other options such as resignation seem inappropriate cue to the proximity of the annual general meeting (AGM). Resignation would allow the auditor to ask the directors to convene an extraordinary general meeting, but this could not take place before the AGM so the auditor should speak at the AGM instead.

Test your understanding 2 1. Formal confirmation by management of their responsibilities. 1mark Contenti ous matter where no other, better quality, evidence is available. 1mark Requ ired by ISA 580 and other ISAs. 1mark 2. No irregularities involving management or employees that could have a materi al effect on the financial statements. mark All books of account and supporting documentation have been made available to the auditors. mark Information and disclosures with reference to related parties is complete. mark Financial statements are free from material misstatements including omissions. mark No non-compliance with any statute or regulatory authority. mark No plans that will materially alter the carrying value or classification of ass ets or liabilities in the financial statements. mark No plans to abandon any product lines that will result in any excess or obsole te inventory. mark

190 12 Reporting Chapter learning objectives Upon completion of this chapter you will be able to: Describe and analyse the format and content of unmodified audit reports; Describe and analyse the format and content of modified audit reports, and Identify and explain the contents of other reports made to management.

191 1 The audit report The objectives of an auditor, in accordance with ISA 700 Forming an Opinion and Reporting on Financial Statements, are: to form an opinion on the financial statements based upon an evaluation of th eir conclusions drawn from audit evidence; and to express clearly that opinion through a written report. 2 Forming an Opinion The auditor forms an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. In order to do that they must conclude whether they have obtained r easonable assurance about whether the financial statements as a whole are free from material misstatement (whether due to fraud or error). In particular the auditor should evaluate whether: the financial statements adequately disclose the significant accounting polic ies; the accounting policies selected are consistently applied and appropriate; accounting estimates are reasonable; information is relevant, reliable, comparable and understandable; the financial statements provide adequate disclosures to enable the users to understand the effects of material transactions and events; and the terminology used is appropriate.

When the auditor concludes that the financial statements are prepared, in all ma terial respects, in accordance with the applicable financial reporting framewor k they issue an unmodified opinion if they conclude that either: or they have been unable to obtain sufficient appropriate evidence; the financial statements as a whole are not free from material misstatement:

then they have to issue a modified opinion.

3 Contents of the Audit Report ISA 700 provides guidance as to the nature and wording of the audit report. Mo st importantly the report must be in writing. In addition it recommends that the audit report be broken into distinct section s that explain the purpose, nature and scope of an audit. The main reason for th is is to ensure that the users of the audit report understand the nature of audi t procedures and that only reasonable assurance is being offered. One of the p rimary purposes of this is to reduce the 'expectations gap.' The recommended elements of the report are as follows: Title The title should be 'appropriate'. The use of 'Independent Auditor's Report' distinguishes this report from any other report produced internally or by othe r non-statutory auditors. Addressee The report should be addressed to the intended user of the report which is usually the shareholders, or other parties as required by the circumstances of the engagement. 192 Introductory paragraph Identifies the entity whose financial statements have been audited; States that the financial statements have been audited; Identifies the components of the financial statements (by name and even page reference); Refers to the accounting policies applied to the financial statements; and Specifies the date or period covered by the financial statements.

Statement of responsibilities of the auditors nce Express an opinion. The audit was conducted in accordance with ISA's; Requirement to comply with ethical standards: The fact that the audit was planned and performed to obtain reasonable assura about whether the financial statements are free from maternal misstatement.

 Audit involves procedures designed to obtain evidence about amounts and disc losures in the financial statements; The procedures are based upon auditor judgement, including a risk assessment and consideration of internal controls; Obtain sufficient, appropriate audit evidence on which to base the opinion.

Auditor's opinion (headed 'Opinion') When expressing an unmodified opinion the auditor (unless otherwise required by relevant laws or regulations) uses one of the following phrases: -"the financial statements present fairly, in all material respects...."; or -"the financial statements show a true and fair view of...."

Statement of responsibilities of management Preparation of the financial statements in accordance with the applicable fin ancial reporting framework; and Designing and implementing an effective internal control system to enable the preparation of financial statements that are free of maternal misstatement; Auditor's signature The report may be signed in the name of the firm, or the personal name of the auditor, as appropriate for the particular jurisdiction There may also be a requirement to state the auditor's professional accounta ncy designation or that the firm is recognised by the appropriate licensing auth ority (i.e. that the firm/partner is a member of a body such as ACCA and is registered to audit). Date of report The audit report should be dated no earlier that the date on which the audit or has obtained sufficient appropriate evidence upon which to base their opinio n. This requires that all the statements and notes/disclosure that comprise the financial statements are finalised and that those with responsibility for prepa ration of the financial statements have acknowledged their role. Practically this means that the auditor should sign their report after the d irectors have approved the financial statements.

193 Auditor's address The audit report should name a specific location, which is normally the city whe re the auditor maintains the office that has responsibility for the audit.

Example of an audit report

Example of an unmodified audit report INDEPENDENT AUDITOR'S REPORT (Appropriate Addressee) Report on the Financial Statements We have audited the accompanying financial statements of the ABC Company, which comprise the balance sheet as at 31 December. 20X1, and the income statement, statement of changes in equity and cash flow statement for the year then ende d, and a summary of significant accounting policies and other explanatory infor mation. Managements Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these fin ancial statements in accordance with International Financial Reporting Standards , and for such internal control as management determines necessary to enable th e preparation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor's Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those Standards require that we comply with ethical requirements an d plan and perform the audit to obtain reasonable assurance about whether the f inancial statements are tree from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amou nts and disclosures in the financial statements. The procedures selected depend on the auditors judgement, 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 interna l control relevant to the entity's preparation and fair presentation of the fina ncial statements in order to design audit procedures that are appropriate in th e circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. An audit also inc ludes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the presentation of the fin ancial statements. We believe that the audit evidence we have obtained is sufficient and appropri ate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements present fairly, in all material respect s (or give a true and fair view of) the financial position of ABC Company as at December 31 20X1, and (of) its financial performance and its cash flows for th e year then ended in accordance with International Financial Reporting Standar ds. Auditors Signature [Date of auditor's report] [Auditor's address] (ISA 700, appendix 1)

194 4 Modifications to the Audit Report So far we have explored the nature and wording of an unmodified audit report. There are two ways that the audit report can be modified: by modifying the audit opinion; or through inclusion of additional paragraphs

Modifying the audit opinion There are two reasons why an auditor would be unable to give an unmodified audi t opinion: they conclude that the financial statements as a whole are not free from mat erial misstatements; or they have been unable to obtain sufficient appropriate evidence to conclude that the financial statements as a whole are free from material misstatement.

If the auditor comes to either of the above conclusions they must then conside r how significant the matter is. If the matter is considered immaterial then i t should not affect the wording of the opinion and a 'present fairly' or 'true and fair' wording may be used. However, if the auditor concludes that the matter is material they must modif y the wording of their opinion. If. in addition to being material, the auditor c onsiders the matter to be pervasive to the financial statements, then this must also be incorporated into the audit opinion (as shown below). Pervasive moans t hat the matter is: or s on not confined to specific elements of the financial statements: if confined represents a substantial proportion of the financial statements; is fundamental to users understanding of the financial statements. The affect the wording of the opinion can be summarized as follows:

Auditor's Judgement Regarding the Pervasiveness of the Matter Nature of Matter Pervasive Material and Pervasive Financial statements are materially misstated Inability to obtain sufficient appropriate evidence Qualified opinion Adverse opinion Material but Not

Qualified opinion

Disclaimer of opinion

When the auditor modifies their opinion they have to include a 'Basis for Modif ication Paragraph' in the audit report that describes the matter giving rise t o the modification. This paragraph should be placed before the opinion paragra ph. With a qualified opinion the auditor is basically stating that whilst there ar e, or maybe, material misstatements, they are confined to a specific element of the financial statements but the remainder may be relied upon. Accordingly the opinion usually states that "except for the matters described in the basis for modification paragraph, the financial statements present fairly (or give a true and fair view of)..........." If the auditor concludes that the matter is pervasive they are claiming that the financial statements may not be relied upon in any part. Accordingly: 195 if they give an adverse opinion they will state that the financial statements "do not present fairly (or give a true and fair view of)..... " if they give a disclaimer they will state that they "do not express an opinio n on the financial statements."

Example Modified Opinion 1 Example of wording where the auditor concludes that the financial statements co ntain a material, but not pervasive, misstatement: Basis for Qualified Opinion As discussed in Note X to the financial statements, no depreciation has been pro vided in the financial statements which practice, in our opinion, is not in acco rdance with International Financial Reporting Standards The provision for the ye ar ended 31 December, 20X9, 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 deprecia tion of XXX and the loss for the year and accumulated deficit should be increas ed by XXX and XXX, respectively. Opinion In our opinion, except for the effect on the financial statements of the matter referred to in the Basis for Qualified Opinion paragraph, the financial stateme nts present fairly in all material respects (or give a true and fair view of) th e financial position...... (remainder of wording as per an unmodified report). Example Modified Opinion 2 Example where the auditor concludes that the financial statements are materiall y and pervasively misstated: Basis for Adverse Opinion As explained in Nole X. the company has not consolidated the financial statemen ts of subsidiary XYZ Company. Under International Financial Reporting Standards the subsidiary should have been consolidated because it is controlled by the co

mpany. Had XYZ been consolidated many elements in the accompanying financial st atements would have been materially affected. Adverse Opinion In our opinion, because of the significance of the matter discussed in the Basi s for Adverse Opinion paragraph, the financial statements do not present fairl y (or give a true and fair view of) the financial position... Example Modified Opinion 3 Example where the auditor concludes that they have been unable to gather suffi cient appropriate evidence and the possible effects are deemed to be material b ut not pervasive. Basis For Qualified Opinion We did not observe the counting of the physical inventories as at 31 December 2 0X9, since that date was prior to our appointment as auditor to the company. Owi ng to the nature of the company's records, we were unable to satisfy ourselves a s to inventory quantities by other audit procedures. Qualified Opinion In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly (or give a true and fair view) of the financial position....

196 Example Modified Opinion 4 Example where the auditor concludes that they have been unable to gather suffi cient appropriate evidence and the possible effects are deemed to be both mater ial and pervasive. Basis for Disclaimer of Opinion The company's investment in its joint venture XYZ Company is carried al $xxx on the statement of financial position, which represents over 90% of the company's net assets at 31 (December 20X9. We were not allowed access to the management a nd auditors of XYZ and, as a result, we were unable to determine whether any adjustments were necessary in respect of th e company's proportional share of the assets, liabilities, income and expenses f or the year and the elements making up the changes in equity and statement of c ash flows. Disclaimer of Opinion Because of the significance of the matter described in the Basis of Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate ev idence to provide a basis fcr an audit opinion Accordingly, we do not express and opinion on the financial statements. 5 Additional Paragraphs Having formed their opinion there are circumstances where the auditor must ais o draw the users attention to additional matters that are significant to their understanding of the financial statements. These circumstances are categorised a

s follows: matters already presented/disclosed in the financial statements that are fund amental to understanding the financial statements. These are presented in "Emph asis of Mailer" paragraphs; and other mailers relevant to either understanding the audit, the auditor's resp onsibilities or the audit report. These are presented in "Other Matter" paragra phs. Emphasis of Matter Paragraphs These are presented immediately after the opinion paragraph. It is important no te that they have do not affect the audit opinion, nor are they a substitute for one. These paragraphs simply draw the readers attention to a note already disclosed i n the financial statements. The matters referred to have to be fundamental to t he readers' understanding of the financial statements. Widespread use of them wo uld diminish their effectiveness. Examples of where it may be necessary to add an Emphasis of Matter paragraph in clude: an uncertainty relating to the future outcome of exceptional litigation or re gulatory action; early application of a new accounting standards that has a pervasive effect o n the financial statements; a major catastrophe that has had, or continues to have, a significant effe ct on the entity's financial position.

197 Other Matter Paragraphs Circumstances where these may be necessary include: when a pervasive inability to obtain sufficient appropriate evidence is impo sed by management (e.g. denying the auditor access to books and records) but t he auditor is unable to withdraw from the engagement due to legal restrictions; when national laws/regulations require, or permit, the auditor to elaborate on their responsibilities; when the client issues another set of financial statements (e.g. one accor ding to IFRS and one according to UK GAAP) and the auditor has also issued a re port on those financial statements; when a set of financial statements is prepared for a specific purpose and us er group and the users have determined that a general purpose framework meets their financial information needs; and if there is a material inconsistency between the audited financial statement s and the 'other information' contained in the annual report (such as the Chairman's Report).

Example Additional Paragraph

The following is an example of an Emphasis of Matter Paragraph:

Emphasis of Matter We draw attention to Note X to the financial statements. The Company is the defe ndant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The Company has filed a counter action, and p reliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot present ly be determined, and no provision for any liability that may result has been m ade in the financial statements. Our opinion is not qualified in respect of this matter

198 6 Reporting to Those Charged with Governance

ISAs, in particular ISA 260 Communication with Those Charged with Governance and ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, require the external auditors to engage in communications with mana gement. The main forms of formal communication between the auditors and management are: the engagement letter (see chapter 5); and another written communication, usua lly sent at the end of the audit, which is often referred to as 'the managemen t letter.' The objectives of these communications are:

 To communicate the responsibilities of the auditor and an overview of the sc ope and timing of the audit; To obtain, from those charged with governance, information relevant to the a udit; To provide timely observations arising from the audit that are significant to the responsibilities of those charged with governance; and To promote effective two-way communication between the auditor and those cha rged with governance. 199 Whilst a formal communication is usually sent at the conclusion of the audit th ere may be a need to communicate particular matters at other times to help mee t the third objective, for example; if a fraud is discovered. Audit mailers of governance interest include: Auditor independence; Effects of significant accounting policies and changes to them; Potential financial effect of risks/uncertainties; Material audit adjustments; Disagreements with management concerning the financial statements; Significant difficulties encountered during the audit; Expected modifications to the audit report; and Significant internal control deficiencies, including fraud.

Stage of audit Timing of communications Communication required Planning e of auditor. Expected fees. Practical matters concerning forthcoming audit. Independenc

Nature and scope of audit work. Ensure letter of engagement is up to date. During the audit If any situation occurs and it would not be appropriate to delay communication u ntil the audit is concluded. Conclusion of audit Major findings from audit work. Uncorrected misstatements. Qualitative aspects of accounting/reporting practices. Final draft of letter of representation. Expected modifications to audit report. Significant internal co ntrol deficiencies.

Test your understanding 1

(1)

List the main contents of an unmodified audit report? (3 marks)

(2) What opinion does the auditor give in an unmodified audit report? (2 m arks) (3) When should the audit report be signed? (1 mark) (4) Who should sign the audit report and what further information about the signatory should be provided? (1 mark) Test your understanding 2 (1) List four types of modified audit report? (2 marks) (2) Give an example of when each type of report would be appropriate. (4 marks) (3) What is an 'emphasis of matter' paragraph? (3 marks)

200 Test your understanding 3 You are currently engaged in reviewing the working papers of several audit assig nments recently carried out by your audit practice. Each of the audit assignmen ts is nearing completion, but certain matters have recently come to light whic h may affect your audit opinion on each of the assignments. In each case the yea r end of the company is 30 September 20X2. (a) Jones (Profit before tax $150,000) On 3 October 20X2 a letter was received informing the company that a customer, w ho owed the company $30,000 as at the year end had been declared bankrupt on 3 0 September. At the time of the audit it was expected that unsecured creditors, such as Jones, would receive nothing in respect of this debt. The directors re fuse to change the financial statements to provide for the loss, on the grounds that the notification was not received by the statement of financial position d ate. Total debts shown in the statement of financial position amounted to $700,000. (4 marks)

(b) Roberts (Profit before tax $500,000) On 31 July 20X2 a customer sued the company for personal damages arising from an unexpected defect in one of its products. Shortly before the year end the c ompany made an out-of-court settlement with the customer of $10,000. although th is agreement is not reflected in the financial statements as at 30 September 20X 2. Further. the matter subsequently became known to the press and was extensi vely reported. The company's legal advisers have now informed you that further claims have been received following the publicity, although they are unable to place a figure on the potential liability arising from such claims which have not yet been received. The company had referred to the claims in a note to the financial statements stating, however, that no provision had been made to cover them because the claims were not expected to be material. (4 marks)

(c) Williams (Net loss for the year $75.000) Three directors of this manufacturing company owed amounts totaling 550,000 at

the end of the financial year, and you have ascertained that such loans were not of a type permissible under the local legislation. These amounts had been i ncluded in the statement of financial position with other items under the headi ng 'Receivables collectable within one year". The directors did not wish to disc lose these loans separately in the financial statements as they were repaid sho rtly after the year end. as soon as they were made aware that the loans were not permissible. The directors have argued that the disclosures could prove emba rrassing and that no purpose would be served by revealing this information in th e financial statements. (4 marks)

201 (d) Griffiths (Net profit before tax $250,000) The audit work revealed that a trade investment stated in the statement of fina ncial position at $500,000 had suffered a permanent fall in value of $300.000. The company admitte d that the loss had occurred, but refused to make an allowance for it on the grounds that other trade investments (not held for resale) had risen in value and were slat ed at amounts considerably below their realizable values. (4 marks) (e) Evans (Net profit before tax $100,000) This client is a construction company, currently building a warehouse on its own premises, and using some of its own workforce. The cost of labour and materi als has been included in the cost of the non- current asset in the statement o f financial position, the total figure being based on the company's costing rec ords. The warehouse is almost complete and the cost shown in the statement of financial position includes direct labour costs of $10,000. However, during aud it testing it was discovered that the costing records, showing the direct labour costs for the warehouse in the early part of the year, had been destroyed accid entally. (4 marks) Required: Discuss each of the cases outlined above, referring to materiality consideration s and, where appropriate, relevant accounting principles and appropriate accou nting standards. You should also indicate, with reasons, the kind of audit repor t (including the type of qualification, if necessary) which you consider would b e appropriate in each case. You are not required to produce the full audit reports, and you may assume that all matters other than those specifically mentioned are considered satisfactory

. (Total: 20 marks)

202 7 Chapter summary

Test your understanding answers

203 (1) List the contents of in an unmodified audit report?

(2) What opinion does the auditor give in an unmodified audit report? Test your understanding 1 An unmodified audit report should include the following. A title identifying the person or persons to whom the report is addressed. An introductory paragraph identifying the financial statements audited and the respective responsibilities of directors and auditors. Management's responsibilities in respect of the financial statements. The auditors' responsibilities in forming their audit opinion. The scope paragraph detailing the nature of the audit e.g. ISA's followed, limitation of audit testing. The auditors' opinion on the financial statements. The manuscript or printed signature of the auditors. The date of the auditors' report. The auditors' address. Whether or not the financial statements are 'true and fair', 'or present fairly in all material respects' the financial position and performance. Whether or no t the financial statements have been properly prepared in accordance with the f inancial reporting framework and statutory requirements where appropriate.

(3) When should the audit report be signed? The audit report should be signed after the directors have signed the financial statements (4) Who should sign the audit report and what further information about the si gnatory should be provided? The auditor's signature should refer to Registered Auditor status and be signed

either by the firm or the auditor individually.

204 List four types of modified audit report? Test your understanding 2 Inability to gather sufficient appropriate evidence: Qualified opinion ("except for"). Disclaimer of opinion. Financial statements are materially misstated: Qualified opinion ("except for"). Adverse opinion.

Give an example of when each type of report would be appropriate? Examples of the above could be: Inability to gather sufficient appropriate evidence - material No inventory count carried out at a branch. Inability to gather sufficient appropriate evidence pervasive Destruction of accounting records.

Financial statements arc materially misstated material Failure to provide for a doubtful debt. Financial statements are materially misstated- pervasive Inappropriate basis of preparation used e.g. if the going concern basis has bee n used when the break up basis should have been used. What is an emphasis of matter paragraph? An 'emphasis of matter' highlights a matter affecting the financial statements and draws the reader's attention to a note that more fully explains the positi on. An emphasis of matter does not constitute a modified opinion. It is situate d after the opinion paragraph.

205 Test your understanding 3 (a) Jones Materiality The amount of the loss at $30,000 represents 20% of pre-tax profit and more tha n 4% of accounts receivable; it would therefore seem to be material in both sta tement of comprehensive income and statement of financial position terms, altho ugh it is clearly more material in relation to profit Relevant accounting principles The bankruptcy of the customer indicates that the company has overstated profit and assets as at the year-end by $30,000. This letter provides evidence of a con dition existing at the statement of financial position dale (IAS 10). It should therefore be treated as an adjusting event. The prudence concept (IASC Framework) would dictate that the loss should be provided for in full in the financial statements at 30 September 20X2. Form of audit report The management's refusal to adjust the accounts for the loss means that the fi nancial misstatements are materially misstated. In such a case, the auditor has to make a decision as to whether the

amount of the loss is 'material and pervasive' or material but not pervasive'. W ithout more facts being available, it is difficult to draw conclusions satisfact orily in this area, but on the face of it a qualified opinion would appear appropriate as the true arid fair view would not be entirel y destroyed if the loss were to remain unadjusted. (b) Roberts Materiality The amount of $10,000 represents only 2% of the stated profit before tax of $50 0,000 and does not. in itself, appear to be material in terms of its impact on the financial statements. Unfortunately, however, the potential losses may be v ery much more significant than the figure of $10,000, since other claims are now pending, and the auditor may have to conclude that the whole legal matter is potentially material. Relevant accounting principles There is clearly a contingent liability in respect of potential claims arising from the product defect. Under the IASC Framework, the prudence concept dictat es that a potential loss which is material should be accrued in the financial s tatements where it is probable that future events will confirm the loss and tha t the loss can be estimated with reasonable accuracy (except where the possibil ity is remote). The matter is also covered in IAS 37. Form of audit report There is clearly uncertainty with regard to the outcome of the pending claims a nd the potential liability which they represent. The auditor will have to dec ide whether or not the possibility of loss is likely or remote. Management has apparently chosen to ignore both the actual l oss (which is not of itself material) and the potential loss (which may well be material). If the auditor can be convinced that management's view is acceptable and the disclosure in the notes is adequate , then a modification may be completely avoidable. The auditor should be aware, however, that items which are not material when considered individually may well have a cumulative effec t which is material in total. If the auditor does not believe that the managemen t's view is acceptable, or does not think that the disclosure is adequate, then a qualified opinion due to a material misstat ement is probably sufficient. However, if the auditor believes that the claims are likely to be successful and are likely to be substantial then it may be necessary to issue an adverse opinion.

206 (c) Williams Materiality The loans are not bad debts and so have no effect on the reported loss. Howeve r, this sort of matter cannot have the same materiality test applied to it as in the cases previously discussed in this answer. We are told that amounts owe d by directors are required to be disclosed as a requirement of the local legis lation. Materiality should, therefore, not be measured in relation to profit or loss for the year or the statement of financial position position, but in relat ion to the requirements of the law. It would appear that the loans are not allo wed and that Williams is materially in non-compliance with

the local law. Relevant accounting principles As mentioned in the quest on, the loans are not allowed and disclosure should in any case be made under the local legislation. The item is required to be se parately disclosed and cannot be 'hidden' as part of a figure containing other 'receivables collectable within o ne year'. This also contravenes IAS 24 Related Party Disclosures, which requires transacti ons made with directors during the year and any related year-end balances to be fully disclosed in the financial statements. Form of audit report Given the breach of IAS 24 the lack of disclosure would lead to a misstatement. Given the nature of directors' emoluments and the fact that this contravenes lo cal laws it is likely that this would be considered material, regardless of the size of the loans or the fact that they were repaid after the year-end. Whilst material it is unlikely that this would be considered pervasive. Therefore, unle ss the directors amended the financial statements, a qualified opinion would be issued

(d) Griffiths Materiality The fall in value is clearly material. In fact, the auditor would probably have to view the matter as pervasive, because providing for the loss would have t he effect of converting a net profit before tax of $250,000 into a loss of $50,000. Relevant accounting principles Long-term investments should be written down where there has been an impairm ent in value. Falls in the value of one asset must not be offset against increa ses in the value of another asset. Each asset has to be oonsidered separately. The 1ASC Framework prudence concept requires that the directors should ensure ad equate allowance is made for all known liabilities (expenses and losses). The ac counting treatment adopted, offsetting known losses against unrealised profits, is unacceptable. As the company admits that a permanent fall in value has taken place, it should make full allowance against the loss. Further, as the other trade investments (with reputedly high realisable values) are perman ent investments not held for resale, the accounting treatment adopted for them could be amended. Form of audit report As mentioned above, it is likely that the auditor would have to view the misst atement as both material and pervasive. The auditor will probably be forced t o give an adverse opinion, stating that the financial statements do not snow a true and fair view.

207 (e) Evans Materiality The $10,000 represents 10% of the reported net profit before tax. and so would appear to be material. However, the actual materiality of this item in relation to profit is. in fact, a somewhat judgemental matter. The auditor would probab ly conclude that the possible error in calculating the $10,000 was not material in relation to the profit of $100,000. since the amoun t of any error will probably be substantially less than the full amount include d in the accounts. Further since the accounting records were only destroyed for the early part of the year, the auditor would still be able to confirm the cal culations for the later part of the year. In these particular circumstances: t herefore, the auditor may consider that the amount of any error (which is likel y to be considerably less than $10,000) is not material. Relevant accounting principles It is perfectly acceptable for the company to add the cost of its own labour an d materials in the construction of the warehouse, since these have been used t o create a capital asset. This is following the 'matching' or 'accruals' concept as set out in IAS 1 and applied in IAS 16. Form of audit report The accounting treatment is generally acceptable and the amount of any error is not likely to be considered material, the auditor will probably be able to give a standard unmodified audit report.

208

Examination standard questions are indicated by mark and time allocations. 1 Objectives, characteristics and responsibilities Your client, Mr Neville, has written to you saying he has been considering setti ng up an internal audit department but has heard from his brother that he would be better off abandoning this idea and getting the external auditor to do some a ssurance work instead. His brother also claimed that if the external auditor doe s some work for the company, there would be no need to have an external audit. Required Write a letter to Mr Neville explaining the objectives, characteristics and resp onsibilities of internal audit, external audit and assurance. 2 Audit and assurance engagements (a) Explain the difference between negative and positive assurance in the c ontext of the external audit and review engagements. State some of the limitatio ns of the external audit. (4 marks) (b) The audit opinion sets out explicit opinions which must be stated in th e audit report. State what these are and outline the possible implied opinions, which are only reported on by exception. (3 marks) (c) Auditors have certain rights to allow them to carry out their duties. S tate and explain what these rights are, using the UK as an example. (3 marks) (Total = 10 marks) 3 Standards Discuss the advantages and disadvantages of auditing standards to auditors and t he consequences of them being enforceable by statute. 4 Corporate governance The objective of a system of corporate governance is to secure the effective, so und and efficient operation of companies. This objective transcends any legislat ion or voluntary code. Good corporate governance embraces not only making the co mpany prosper but also doing business in a legal and ethical manner. A key eleme nt of corporate governance is the audit committee. The audit committee is a comm ittee of the board of directors and is of a voluntary nature regulated by volunt ary codes. Required (a) Explain how an audit committee could improve the effectiveness of the e xternal auditor's work. (b) Discuss the problems of ensuring the 'independe nce' of the members of the audit committee. (c) Discuss the view that the role of the audit committee should not be lef t to voluntary codes of practice but should be regulated by statute.

Exam question bank 5 Independence

337

It has been suggested that the most important matter affecting the credibility o f the auditor is that of 'independence'. Required (a) Discuss, giving examples, matters other than independence, which might be relevant in relation to the credibility of the auditor and steps that the acc ounting profession has taken or might take in relation to them. (b) Discuss the following situations in the context of the independence of the auditor, showing clearly the principles involved: (i) The audit manager in charge of the audit assignment of Andrew Co holds 1,000 $1 ordinary shares in the company (total shares in issue 100,000). The au dit partner holds no shares. (ii) The audit fee receivable from Janet Co, a private company is $100,000. The total fee income of the audit firm is $700,000. (iii) The audit senior in charge of the audit of Margot Bank Co has a person al loan from the bank of $2,000 on which she is currently paying 13% interest. (iv) The audit partner is responsible for two audit assignments, Harry Co an d Jean Co. Harry Co has recently tendered for a contract with Jean Co for the su pply of material quantities of goods over a number of years. Jean Co has asked t he audit partner to advise on the matter. 6 Objectivity s (a) (i) (ii) Explain the concept of objectivity, with reference to External auditors Internal auditors, who are members of ACCA, 36 min

outlining any general threats to objectivity that exist. (8 marks) (b) Scenario 1

Bakers Co is an audit client of Hinkley Innes, a firm of Chartered Certified Acc ountants. The firm has had the audit of Bakers for 17 years and the fee represen ts 7% of firm income. Bakers is considering a major new project and has asked th

e firm if it would be happy to undertake some one-off consultancy work for the f irm. It is possible that the fee income for this contract would represent 10% of that year's income for Hinkley Innes. The new business services partner, who he ads up a new division of the firm, is keen to take on the work, as this would re present his best contract yet. Scenario 2 Peter works in the purchasing department of Murphy Manufacturing Co. He has bee n instrumental in setting up control systems in the purchasing department as par t of a recent risk management exercise. He has a poor relationship with his imme diate supervisor, the Purchasing Director. Murphy Manufacturing has just adverti sed the post of trainee internal auditor. Peter is interested in the work that i nternal audit do, having liased substantially with the department during the rec ent controls exercise. No formal accountancy qualifications are required for the post, because the successful candidate will be put through accountancy training . Peter has had a chat with the head of internal audit concerning the post and i s seriously considering making an application. Required Discuss the threats and the safeguards to objectivity that could be implemented in the two situations given above. (12 marks) (Total = 20 marks)

338 Exam question bank 7 Role of internal audit

36 mins

(a) You are a member of the internal audit team at Golden Holdings, a liste d company. The board of directors wants to raise the profile of the internal aud it department in the company. They have asked the internal audit department to g ive a series of seminars on corporate governance and the role of internal audit in achieving corporate objectives to other members of staff. The head of internal audit has asked you to prepare some notes on this subject. Required Prepare the notes which the head of internal audit wants. (12 marks) You should cover the following matters: (i) The Board of Directors (ii) Accountability (iii) The meaning of risk management (b) After the seminars, the various departments of Golden Holdings have bee n asked to carry out risk management brainstorming sessions to identify risks in each of their departments and to design internal control systems to reduce thos e risks. The Sales Director, Wayne, has asked you if you will attend the brainst orming session in the sales department and whether you will assist them in the r isk identification and management process. Required Prepare a memorandum to the Sales Director, answering his questions. (8 marks)

You should cover the following matters: (i) Whether you will attend the meeting, and in what capacity

(ii) Whether you attend the meeting or not, what involvement you, as a memb er of the internal audit team, will have in the risk management exercise (Total = 20 marks)

Exam question bank 8 Glo mins

339 36

Glo-Warm Co, a limited liability company, manufactures various heating products which it sells to both High Street and catalogue retailers. The statement of financial position for the years ended 20X7 and 20X6 are set ou t below. Last year, materiality was set at $10,000. Non-current assets 20X7 20X6 $'000 $'000 $'000 Tangible non-current assets 20 Investments

$'000 21

2 Current assets Inventory 52 Receivables 78 Cash at bank 12 Cash in hand 1 143 Total assets Current liabilities Trade payables 121 Bank loan 5 126 Long-term liabilities Bank loan Provision* 20 Capital and reserves Share capital 2 Reserves (3) Total liabilities 165 373 *The provision of $20,000 consists entirely of a warranty provision. Required 208 350 165 133 5 138 20 373 1 34 136 179

25

(a) Discuss whether the materiality level used in 20X6 will be appropriate for this year's audit, giving reasons for your answer. (3 mar ks) (b) Explain audit risk. (3 marks) (c) Review the statement of financial position given above and state the ar eas in which audit work should be concentrated, giving reasons in each case. (14 marks) (Total = 20 marks) 9 Audit planning and documentation 18 mins

(a) Explain the difference between the overall audit strategy and the audit plan and state the key contents of the overall audit strategy document. (4 marks) (b) Briefly explain the reasons for auditors documenting their work. (3 marks)

(c) Many audit firms use standardised working papers. List the advantages a nd disadvantages of audit firms using standardised working papers to document th eir audit work. (3 marks) (Total = 10 marks)

340 Exam question bank 10 Audit evidence considerations

18 mins

(a) Discuss how analytical procedures can be used as substantive audit proc edures to provide audit evidence. Illustrate your answer with an example. (5 marks) (b) ISA 500 Audit evidence requires auditors to obtain sufficient appropria te audit evidence to be able to draw reasonable conclusions on which to base the ir audit opinion. Discuss the different sources of evidence available to auditor s and assess their relative appropriateness. (5 marks) (Total = 10 marks) 11 Knits mins 54

Knits Co is a small company which manufactures and sells high quality knitwear. Its customers are mainly fashion boutiques. Knits Co has two directors, one who is non-executive and the other who is involv ed in the day-to-day administration of the company. There are ten other employee s. Six of these work in the factory, one works in the warehouse, one is a sales representative and two are accounts staff. The accounts staff consist of Miss Jo nes, who is responsible for processing sales and receivables, and Mrs Singh, who is the purchases and wages clerk. Mrs Singh works part-time, five mornings a week. The companys sales representative visits shops throughout the region. He takes or ders from customers which he records on a pre-numbered two-part order form. He p asses the completed forms to the accounts department. Miss Jones files one copy of the order form in numerical sequence and passes the other to the warehouse. The completed order is despatched from the warehouse by carrier, accompanied by one copy of a despatch note. The other copy is sent to Miss Jones, who prepares an invoice based on the information it contains and on the companys price list. S he sends one copy of the invoice to the customer, and a second copy of the invoi ce is retained. Each Friday, Miss Jones inputs the weeks invoices to the computerised sales ledge r. She then files the invoices alphabetically by customer name. Despatch notes a re not retained because filing space is limited. Miss Jones opens the post daily and lists remittances received from credit custo mers. Every Friday, she inputs the information listed to the sales ledger. Chequ es received are banked daily by the executive director.

Miss Jones reviews who have not paid d out annually for Jones reviews the

the sales ledger balances every month and writes to customers within 90 days of receiving goods. The sales ledger is printe year-end purposes. Otherwise no hard copy is printed and Miss sales ledger on the computer screen.

The companys computer package includes the facility to produce a sales day book a nd sales ledger control account. These are not used because Miss Jones considers that the low volume of transactions (10-15 invoices per week) makes them unnece ssary. Required (a) Explain the particular issues relating to controls which would affect t he audit of a small company such as Knits. ( 4 marks) (b) List six control objectives of a sales system. (6 marks)

(c) State, with reasons, what you consider to be the potential deficiencies in Knits Cos present system of accounting for sales and receivables. (10 marks) (d) List and explain the controls that a small firm such as Knits Co could feasibly adopt to overcome the deficiencies you have identified. (10 marks) (Total = 30 marks) (Note: You are not required to consider the system for dealing with returns and credit notes.)

Exam question bank 12 Fenton Distributors

341 54 mins

Fenton Distributors Co is a small company which maintains its sales, purchase an d nominal ledgers on a small PC, using a standard computerised accounting packag e. The company buys products from large manufacturers and sells them to shops wh ich either sell or hire them to the general public. The products include drain c learing machines, portable generators, garden cultivators and wallpaper stripper s. You have been asked to carry out an audit of the nominal ledger system to verify that items are accurately recorded in the year. At the end of the year, the nom inal ledger produces a trial balance, which is used to prepare the annual accoun ts. The company employs a bookkeeper, who is responsible for posting the sales and p urchase ledgers, and maintaining the nominal ledger. Data is posted to the nomin al ledger as follows. (a) At the start of the financial year, all the balances on the nominal led ger accounts are set to zero (using the standard year-end procedure of the computer package). (b) The fo llowing procedures relate to purchase transactions. (i) When invoices are posted to the purchase ledger, the purchase analysis code (for the nominal ledger), the purchases value and the sales tax value are entered. The total invoice value is posted to the purchase ledger.

(ii) At the end of the month, the computer posts the following items to the nominal ledger. (1) The total of each category of invoice expense and sales tax for purchas e invoices and credit notes posted in the month (at the same time the computer p rints details of the individual invoices making up the total of each invoice exp ense and sales tax for the month). (2) The total of purchase ledger cash payments, discount received and adjus tments posted to the purchase ledger in the month (the computer prints details o f the individual items comprising the total cash discount and adjustments for th e month). (3) Where there is no account in the nominal ledger relating to the items b eing posted, the computer posts the items to a payables suspense account. Also, all adjustments are posted to the suspense account. (c) Sales ledger data is posted to the nominal ledger in a similar way to p urchase ledger data. (d) Journals are posted manually to the nominal ledger for: (i) The opening balances at the start of the year (ii) Other cash book items (other than sales and purchase ledger cash) (iii ) Petty cash payments (iv) Wages analysis (details are obtained from the computerised payroll syst em) (v) Adjustments, which include: (1) Correction of errors

(2) Dealing with items in the sale and purchase ledger suspense accounts (a djustments posted to the ledger, and items where there is no account in the nomi nal ledger) All these journals are written manually in an accounts journal book, and they mu st be authorised by the managing director before posting. The opening balances a re posted to the nominal ledger when the previous year's accounts have been appr oved by the auditors. Although the employee wages are calculated using another computer package, the total wages expense is posted to the nominal ledger manually. The wages expense is calculated from the payrol l's monthly summary, using a spreadsheet package, and the wages expense is analy sed into directors, sales, warehouse and office wages (or salaries).

342 Required

Exam question bank

(a) List three control objectives of a sales system and three control objec tives of a purchases system. (6 marks) (b) List and describe the audit work you would perform on the computerised nominal ledger system, and in particular: (i) The audit procedures you would perform to verify the accuracy of purch ases transactions which are posted to the nominal ledger.

(5 marks) (ii) The audit procedures you would perform to verify the validity and accu racy of journals posted to the nominal ledger. Also, you should briefly describe any other tests you would perform to verify the accuracy of the year-end balanc es on the nominal ledger. (15 marks) (Note. You should assume that sales transactions are accurately recorded and cor rectly posted to the nominal ledger.) (c) Explain the auditor's responsibilities in respect of opening balances. (4 marks) (Total = 30 marks) 36 mins

13 Cheque payments and petty cash

Mr A Black has recently acquired the controlling interest in Quicksand Co, who a re importers of sportswear. In his review of the organisational structure of the company Mr Black became aware of weaknesses in the procedures for the signing o f cheques and the operation of the petty cash system. Mr Black engages you as th e company's auditor and requests that you review the controls over cheque paymen ts and petty cash. He does not wish to be a cheque signatory himself because he feels that such a procedure is an inefficient use of his time. In addition to Mr Black, who is the managing director, the company employs 20 personnel including four other directors, and approximately three hundred cheques are drawn each mo nth. The petty cash account normally has a working balance of about $300, and $6 00 is expended from the fund each month. Mr Black has again indicated that he is unwilling to participate in any internal control procedures which would ensure the efficient operation of the petty cash fund. Required (a) Prepare a letter to Mr Black containing your recommendations for good internal control procedures for: (i) (ii) Cheque payments (9 marks) Petty cash (7 marks) (Marks will be awarded for the style and layout of the answer.) (b) Discuss the audit implications, if any, of the unwillingness of Mr Blac k to participate in the cheque signing procedures and petty cash function. (4 marks) (Total = 20 marks) 14 Using the work of a managements expert 36 mins

You are carrying out the audit of Ravenshead Construction a quoted company. The company's business includes large civil engineering contracts (the construction of buildings and roads). It also owns investment properties which are let to th ird parties and these comprise offices and industrial buildings. During the year ended 31 October 20X6 the company received a substantial claim f or damages from Netherfield Manufacturing for faults in a building it had constr ucted. This claim includes the cost of repairs and damages, as the customer alle ges that the building cannot be used because of the faults, so alternative accommodation has had to be found. The company has obtained advice o n the likely outcome of this claim from a local solicitor.

In the year-end financial statements the properties had been revalued by an inde pendent valuer and the work in progress has been valued by an employee of the co mpany who is a qualified valuer. Exam question bank Required 343

Describe the matters you would consider and the other evidence you would obtain to enable you to assess the reliability of the work of experts in the following cases: (a) Legal advice obtained from the local solicitor on the outcome of the cl aim by Netherfield Manufacturing (7 marks) (b) Valuation of the properties by the independent valuer (7 marks) (c) Valuation of the work in progress by the int ernal valuer (6 marks) (Tota l = 20 marks) 15 Elsams ns 36 mi

You are the auditor of Elsams Co which operates a chain of retail shops througho ut the country selling a wide range of electrical goods. Each branch has compute rised cash registers linked into the central computerised sales, receivables and inventory records. At the point of sale, the information keyed in includes the following: branch reference, product number, inventory location, unit selling pr ice, date of sale. The file of inventory records is updated daily for sales and receipts. It contai ns both cost (on a FIFO basis) and selling price information. The only regular p rinted output is sales summaries analysed by value, product and branch. Required (a) Explain the ways in which you, as the auditor of Elsams Co, could use c omputer programs to assist in the verification of inventory at the year-end, and indicate their limitations. (8 marks) (b) Without particular reference to Elsams Co, describe the objectives and principles of using test data and comment on the areas where it can be of most u se in an audit, and on the difficulties of this technique. (5 marks) (c) Describe the following different methods of sample selection: (i) Random selection (ii) Systematic selection (iii) Haphazard selection (iv) Block selection (7 marks) (Total = 20 marks) 16 Boston Manufacturing 36 mins

You are the audit assistant assigned to the audit of Boston Manufacturing. The a udit senior has asked you to plan the audit of non-current assets. He has provis ionally assessed materiality at $72,000.

Boston Manufacturing maintains a register of non-current assets. The management accountant reconciles a sample of entries to physical assets and vice versa on a three-monthly basis. Authorisation is required for all capital purchases. Items valued less than $10,000 can be authorised by the production manager, items cos ting more than $10,000 must be authorised by the Managing Director. The purchasi ng department will not place an order for capital goods unless it has been duly signed. The company has invested in a large amount of new plant this year in connection with an eight year project for a government department.

344 Exam question bank The management accountant has provided you with the following schedule of non-cu rrent assets: Land and Plant and buildings equipment $ $ $ Cost At 31 March 20X6 54,723 Additions 1,154 At 31 March 20X7 54,723 Accumulated depreciation At 31 March 20X6 25,937 Charge for the year ,367 13,081 At 31 March 20X7 39,018 Net realisable value At 31 March 20X7 15,705 At 31 March 20X6 28,786 Motor Computers $ 500,000* 659,964 250,729 500,000 911,847 128,000 221,184 8,000 51,788 136,000 272,972 364,000 638,875 372,000 438,780 29,680 8,314 252,069 7,101 28,340 73,694 24,260 2 45,354 21,893 251,883 325,763 31,361 75,034 vehicles $ 30,207 Total

*Of which, $100,000 relates to land. Required (a) Without undertaking any calculations, assess the risk of the tangible n on-current assets audit, drawing reasoned conclusions. (6 marks) (b) State the audit procedures you would undertake on non-current assets in respect of the following assertions:

(i)

Existence (3 marks) (ii) Valuatio (3 Completeness

n (excluding depreciation) (4 marks) (iii) marks) (c) ates.

Describe how you would assess the appropriateness of the depreciation r (4 marks) (Total = 20 marks) 36 mins

17 Wandsworth Wholesalers

Your firm is the auditor of Wandsworth Wholesalers Co, and you have been asked t o carry out audit checks on cut-off and verifying inventory quantities at the ye ar-end. The company maintains details of inventory quantities on its computer. These inv entory quantities are updated from goods received notes, and sales invoices. The company carries out inventory counts each month, when all the fast moving and h igh value inventory is counted, and a third of the remaining inventory is counte d in rotation so that all items are counted at least four times a year. You attend the inventory count on Sunday 13 October, and a further inventory cou nt was carried out on Sunday 10 November. The company's year-end was Thursday 31 October 20X1, and the inventory quantities at that date, as shown by the comput er, have been used in the valuation of the inventory. No inventory was counted a t the year-end. Required List and describe: (a) The principal matters you should have checked and the matters you shoul d have recorded when you attended the company's inventory count on Sunday 13 October (8 marks) (b) The tests you will perform in ensuring that sales and purchases cut-off has been correctly carried out: (i) At the date of inventory count on 13 October 20X1 (ii) At the year-end (4 marks)

Exam question bank 345 (c) The work you will carry out to test whether the book inventory records have been correctly updated from the counts at the inventory count (4 marks) (d) The work you will carry out to satisfy yourself that the inventory quan tities used in the valuation of the inventory at the year-end are correct (4 marks) (Total = 20 marks) (Note. You should assume that the price per unit of inventory is correct.) 18 Sitting Pretty 36 mins

Sitting Pretty Co is a small, family-run company that makes plastic chairs in a variety of shapes and colours for children and 'fun at heart' adults. It buys in sheets of plastic whi ch can be cut and bent into the correct shape and a plastic leg that is custom m ade by another company to Sitting Pretty's requirements. All off-cut plastic is sent back to the supplier who melts it down and re-uses it, for which Sitting P retty receive a 10% discount off their purchase price. For the inventory count, the factory manager ensures that no work-in-progress is outstanding and closes down production for the day. The factory workers come in early on the day of the inventory count to count the inventory, and they are en titled to go home as soon as inventory is counted. Good controls have always been maintained over the inventory count in previous years. There are no perpetual inventory records. Raw materials are all kept in the stores and are on ly taken out when they are required for production. Finished goods are kept in t he end of the factory, near the delivery exit. You are the audit assistant assigned to attend the inventory count. You have jus t rung the factory manager and he has mentioned that on the day of the inventory count a large consignment of plastic is going to be delivered. It is the only d ay that his supplier can make the delivery, and he needs the material to continu e with production on the day after the count. The audit engagement partner has told you that he is aware that Sitting Pretty c hanged the specification of their customised leg recently, after a series of com plaints over the stability of their chairs. Last year's inventory was valued at $200,000 in the statement of financial position, of which $30,000 related to raw material inventory. Finished goods are all carried at the same valuation as each other as there is v ery little difference between the inventory ranges. Planning materiality for thi s year has been set at $5,000 on the grounds, at this stage, that the figures ar e expected to be similar to last year. Required (a) Explain the importance of the inventory count in this situation. (3 marks)

(b) Prepare notes for your audit supervisor detailing the procedures you pr opose to undertake in relation to your inventory count attendance. (7 marks) (c) State the procedures which should be taken in relation to cut-off at th e final audit. (5 marks) (d) List the audit procedures you would carry out on the valuation of inven tory at the final audit. (5 marks) (Total = 20 marks)

346 Exam question bank 19 Bright Sparks

36 mins

Bright Sparks, a limited liability company, distributes domestic electrical equi pment from one warehouse. Customers are mainly installers of such equipment, but there is a 'cash and carry' counter in the warehouse for retail customers. The warehousemen are responsible for raising invoices and credit notes relating to c redit sales as well as handling cash sales. You have carried out your interim audit in respect of the year ending 31 Decembe r 20X0 which included a circularisation of 80 trade accounts receivable as at 30 September 20X0 selected from a total credit customer list of 1,000. Replies wer e received from all customers circularised. The interim audit work disclosed the following. (a) Of the 80 customers' accounts circularised, eight disagreed but could b e reconciled by bringing into account payments stated by the customers concerned to have been made before 30 September 20X0 but which in each case were recorded in Bright Sparks' books betw een 14 and 18 days after the dates stated by the customers as the date of paymen t. (b) Your tests suggested that some 25% of credit customers were allowed set tlement discounts of 2.5% although payments were consistently received after the latest date eligible for discount. (c) A large number of credit notes were raised representing approximately 1 2% of the total number of invoices raised. A review of the copy credit notes in dicated that they usually arose from arithmetical and pricing errors on invoices raised. You are required to explain the conclusions you would draw as a result of the in terim audit and describe the work you would plan to carry out at the final audit on trade receivables at 31 December 20X0 based upon those conclusions. (20 marks) 20 Audit of cash and bank (a) 18 mins

State the characteristics of a bank confirmation letter. (3 marks) (b) List six examples of items requested in the bank confirmation letter. (3 marks) (c) Explain the purpose and importance of the bank reconciliatio n. (4 marks) (Total = 10 marks) 21 Understatement 54 mins

Research into the distribution of errors in accounts has shown that for most ite ms on the statement of financial position the errors are normally distributed. H

owever, with payables the distribution is skewed, and there is a greater risk th at payables will be understated than overstated. Understatement of payables will lead to overstatement of profit, so auditors must design their tests to ensure that payables are not understated. You have been asked by the manager in charge of the audit of Heanor Wholesale Co to verify trade payables and accruals at the company's year-end of 30 April 20X 2. The company maintains its purchase ledger on a microcomputer, using a standar d purchase ledger accounting package. Purchase invoices are posted to the purcha se ledger after they have been checked to the delivery note and the purchase ord er and have been authorised by either the financial director or the managing dir ector. The purchase ledger can show for each purchase ledger account: (a) The unpa id invoices and credit notes (b) An ageing of the balance into current month, one month, two months and three or more months (c) The total balance on the account Also, the system is able to provide the total of the balances of all the account s on the purchase ledger. Your audit of the purchases system has revealed that t he system for recording receipt of goods is relatively weak. The company does not use goods received notes, but the supplier 's delivery note should be dated by the goods received department when the goods are received. Your audi t tests have revealed

Exam question bank 347 that some delivery notes are not dated by the goods received department. The del ivery note is filed with the purchase invoice in alphabetical order (by supplier ). A full inventory count was carried out at the company's year-end and you are sa tisfied that it was counted accurately. In the company's draft financial statements the value of trade payables and accr uals at 30 April 20X2 are as follows. $ Trade payables 509,200 Purchase accruals 27,050 536,250 Sundry payables and accruals 59,480 Current liabilities 595,730 Heanor's annual revenue figure is about $3.5 million and its profit before tax i s $190,000. The age of payables at 30 April 20X2 is 3.4 months, which is similar to the previous year. Sundry payables and accruals comprise mainly wages accrua ls (including income tax and other deductions) and a sales tax liability of $20, 000. Required (a) Consider and discuss the reasons why: (i) It is more likely that payables will be understated than overstated. (ii) It is difficult for auditors to ensure that payables are not understat ed. (6 marks) (b) Describe the audit work you will perform to verify trade payables and p

urchase accruals. Your answer should include consideration of: (i) Tests using suppliers' statements (ii) Why most auditors do not carry out a payables' circularisation, and th e circumstances when a payables' circularisation should be carried out (iii) Audit tests which are designed to detect understatement of payables (14 marks) (c) Describe the audit procedures you will perform to verify sundry payable s and accruals, including the sales tax liability. (10 marks) (Total = 30 marks) 22 'Tap!' mins 36

You are an audit assistant in the firm Rogers and Smith. You have been asked to plan the audit of 'Tap!' for the year ended 30 June 20X4. It is the first time y our audit firm has audited the charity, which has not been audited previously. T he trustees have expressed interest in receiving a 'value added' audit and are p articularly interested in business advice, especially in the area of systems con trols. 'Tap!' is a registered charity that raises money for projects building wells in Africa through musical entertainment. The group consists of volunteers who trave l around the country, putting on variety shows of music and dance, the proceeds of which are put towards building the wells. The main show is a tap dance production, acting out the difficulties many people face when they are not near a clean water supply. The administrative offices of 'Tap!' are located in a large provincial town. It owns a house, donated by legacy in the past, where the administration is carried out and where the volunteers stay during off periods. A large proportion of 'Tap!'s income comes from box office receipts which are ta ken by the theatre at which they are performing. The theatres usually waive thei r standard terms for use of the premises and merely take a 10% commission on tic ket receipts to cover light and heat and other such expenses. Income usually com es in after every booking in the form of a lump sum cheque from the theatre, tog ether with a break down of takings and commission.

348 Exam question bank 'Tap!' also receives donations towards the work. These come from a variety of so urces: x ormance x mances x Cash donations from buckets passed around at the interval of each perf Cash donations on the (rare) occasion that the team does street perfor Cash donations made over the phone or by post by interested donors

The troupe consists largely of volunteers so they are only paid expenses for the ir work. The cost of housing the group while they are on the road is borne by the charity. The charit y employs an administrator who organises bookings, handles publicity and co-ordi nates all the finances.

Required (a) . Discuss the risks arising for the audit of the year ending 30 June 20X4 (8 marks)

(b) State the audit procedures you would undertake in respect of cash incom e in the financial statements. (6 marks ) (c) List some controls over cash which the charity should implement. (6 marks) (Total = 20 marks)

Approaching the answer You should read through the requirement before working through and annotating th e question as we have so that you are aware of what things you are looking for. You are an audit assistant in the firm Rogers and Smith. You have been asked to plan the audit of 'Tap!' for the year ended 30 June 20X4. It is the First time audit for firm so little cumulated knowledge and first time your audit firm has Impact on opening balances and comparatives. experience. High degree of regulation. Do we have any experience in this field?

Where is the audit evidence? Also, is expenditure in line with the Trust Deed?

Is this common? Are there restrictions on expenditure? Also ensure accounts are correct for disclosures. audited the charity, which has not been audited previously. The trustees have expressed interest in receiving a 'value added' audit and are particularly interested in business advice, especially in the area of systems controls. Not just a simple audit. This may make the engagement too risky given the potential bad publicity that could result if there were problems with the audit. 'Tap!' is a registered charity that raises money for projects building wells in Africa through

musical entertainment. The group consists of volunteers who travel around the co untry, putting on variety shows of music and dance, the proceeds of which are pu t towards building the wells. The main show is a tap dance production, acting ou t the difficulties many people face when they are not near a clean water supply. The administrative offices of 'Tap!' are located in a large provincial town. It

owns a house, donated by legacy in the past, where the administration is carried out and where the volunteers stay during off periods.

Exam question bank Trust?

349

Cash income risky

Again cash. Also, poor in future years for analytical evidence. Lack of good evi dence available. A large proportion of 'Tap!'s income comes from box office receipts which are ta ken by the theatre at which they are performing. The theatres usually waive thei r standard terms for use of the premises and merely take a 10% commission on tic ket receipts to cover light and heat and other such expenses. Income usually com es in after every booking in the form of a lump sum cheque from the theatre, tog ether with a break down of takings and commission. 'Tap!' also receive donations towards the work. These come from a variety of sou rces:

How accounted?

Trust for completeness? Again cash. Also, what are the controls here? Completeness may be a problem. x ormance x mances x Cash donations from buckets passed around at the interval of each perf Cash donations on the (rare) occasion that the team does street perfor Cash donations made over the phone or by post by interested donors

The troupe consists largely of volunteers so they are only paid expenses for No salaries Ex penditure their work. The cost of housing the group while they are on the road is borne by the charity. The charity employs an administrator who organises issues again. Not a specialist? But drafting complex accounts. bookings, handles publicity and co-ordinates all the finances. Required You should have been noticing and annotating risks as you have worked through th e scenario. Try and categorise them in your mind (inherent, control, detection).

Note you are looking specifically for audit risks. (a) Discuss the risks arising for the audit of the year ending 30 June 20X4. (8 marks) You must tailor your answer to the scenario.

Only cash income!! (b) State the audit procedures you would undertake in respect of cash income in the financial statements. (6 marks) (c) List some controls over cash which the charity should implement. (6 marks) control objectives and then design reasonable controls that meet the ob There are more control problems in the scenario than you need to identi for the marks. 20 marks)

Think of jective. fy/solve (Total =

350 Exam question bank Answer plan (a) Audit risks

Disclosure Cash Inherent risk

Cash (loss/theft)

Charity audit Control risk Com pleteness of income Location of audit evidence Detection risk First year of audit First audit for charity (b) x x x (c) x x x Audit procedures Income from box office Income from buckets Income from other donations Controls Schedule of seats Two people to collect Pre-numbered forms No accountant

Security of cash during collection and between banking? Other income Use pre-numbered forms Periodic reviews of work by Trustees 23 Going concern 36 mins

Carrington Joinery, a private company, owned by its directors, manufactures wood en window frames, doors and staircases for domestic houses. It has prepared draf t accounts for the year ended 30 September 20X6 and you are concerned that they indicate serious going concern problems. Th e statements of comprehensive income and statements of financial position for th e last five years (each ended 30 September) are given below. STATEMENT OF COMPREHENSIVE INCOME 20X2 20X3 20X4 20X5 20X6 $'000 $'000 $'000 $'000 $'000 Sales 625 787 1,121 1,661 1,881 Cost of sales (478) (701) (962) (1,326) (1,510) Gross profit 147 86 159 335 371 Other expenses (88) (86) (161) (240) (288) Interest (6) (9) (58) (90) (117) Net profit/(loss)

53 5 (34)

(9)

(60)

Exam question bank 351 STATEMENT OF FINANCIAL POSITION Assets Current assets 20X2 $'000 Inventory 20X3 $'000 20X4 $'000 20X5 $'000 307 313 484 600 1,220 364 620 587 247 1,400 20X6 $'000 67 449 91 813 89 2

133 181 Trade accounts receivable 40 303 158 373 Net current assets 161 544 Total assets 534 1,028

Liabilities and shareholders' funds Current liabilities Trade accounts payable 317 355 490 Bank overdraft 65 211 Lease creditor 28 98 114 410 664 Non-current loan 300 114 410 964

90 641 10 269 92 851 300 1,151 300 1,365 17 17 116 18 69 247 35 534 365 14 59 1,065

Shareholders' funds Share capital 17 17 17 Reserves 107 47 52 133 124 64 Total liabilities and shareholders' funds 1,028 1,220 1,400

The company has been in business for about fifteen years. In January 20X3 it dec ided to build a new factory on a site leased from the local authority which woul d allow a major increase in sales. This new factory with new equipment was compl eted a year later. The factory was financed by a non-current loan of $300,000 from a merchant bank and an increase in the bank overdraft. The loan from the merchant bank is secured by a fixed charge on the leasehold fa ctory and the bank overdraft is secured by a second charge on the leasehold fact ory, a fixed charge on the other non-current assets and a floating charge on the current assets. The company purchases its main raw material, wood, from timber wholesalers. It s

ells around 75% of its production to about 12 local and national builders of new domestic houses. The remaining sales are mainly to smaller builders with a very few sales to local builders merchants. Required (a) In relation to the financial statements above, list and briefly describ e the factors which indicate that the company may not be a going concern. You sh ould also highlight certain figures and calculate relevant ratios in the account s. (13 marks) (Note. You will only be given credit for going concern problems which can be det ermined from the accounts above.) (b) Describe the investigations and tests you would carry out, in addition to those described in part (a) above, to determine whether the company is a going concern. (7 marks) (Total = 20 marks)

352 Exam question bank 24 Audit review and finalisation

18 mins

(a) ISA 560 Subsequent events provides guidance on the responsibilities of auditors regarding subsequent events. Briefly explain the responsibilities of au ditors for facts discovered up to the date of the auditors report, facts discover ed after the date of the auditors report but before the accounts are issued and f or facts discovered after the financial statements have been issued. (4 marks) (b) ISA 580 Written representations explains the purpose and use of written representations as audit evidence. State six items that could be included in a written representation letter. (3 marks) (c) Briefly discuss the use of analytical procedures at the review stage of the audit. (3 marks) (Total = 10 marks) 25 Wiseguys National Bakeries Your firm acts as auditor of Wiseguys National Bakeries Co. The finance director has prepared financial statements of the company for year to 31 December 20X9 w hich show a pre-tax profit of $450,000. You have been advised that the board of directors has approved the financial statements and decided that no amendments s hould be made thereto. As partner responsible for the audit you have noted the following matters during

your review of the financial statements and the audit working papers: (a) The freehold property which was included at cost in previous years' sta tement of financial position, has now been restated at a professional valuation of $1,250,000 carried out during the year. You are satisfied with the valuation, the relevant figures have been correctly adjusted and the necessary information disclosed in the notes to the financial statements. (b) An amount of $45,000 due from a customer in respect of sales during the year is included in receivables but, from information made available to you, yo u conclude that no part of this debt will be recovered. No allowance has been ma de against this amount. (c) The financial statements do not disclose the fact that a director was i ndebted to the company for an amount of $22,000 during a period of six weeks com mencing 1 February 20X9. Required Explain how each of the above will impact on the auditors report. 26 Builders Merchants 36 mins

You are the auditor of Builders Merchants, a listed company which distributes ma terials to the construction industry from eight depots in the south of the count ry, and you are currently finalising the audit for the year ended 31 March 20X1. Your audits tests have proved satisfactory with the exception of the following four matters. (a) ore they nventory ors have d in the The physical inventory count sheets for one of the depots were lost bef were made available to you, and you have not been able to confirm the i quantities and values for this depot by alternative methods. The direct valued this part of the inventory at $75,000 and this figure is include overall inventory valuation of $640,000.

(b) Included in trade receivables, which total $580,000, is a debt amountin g to $45,000 from a customer which went into liquidation on 15 June 20X1. You ha ve ascertained from the liquidator that your client is unlikely to receive a dis tribution. The statement of comprehensive income for the year shows a pre-tax pr ofit of $100,000 but the directors are not prepared to provide for this debt. (c) The financial statements of Builders Merchants do not contain a stateme nt of cash flows.

Exam question bank 353 (d) A substantial claim has been lodged against the company by a major cust omer. The matter is fully explained in the notes to the accounts, but no provisi on has been made for legal costs or compensation payable as it is not possible t o determine with reasonable accuracy the amounts, if any, which may become payab le. The directors have received legal advice which appears to be reliable in ind icating that the claim can be successfully defended. Required Explain how the above items will influence the auditors report you will issue. (20 marks)

354 Exam question bank 1 Objectives, characteristics and responsibilities

1 January 20X1 Mr G Neville 1 Any Street New Town M2 5LM Dear Mr Neville Bird & Co 1 Old Street New Town M1 3WQ In response to your queries I have produced some information on the difference b etween statutory audit, assurance work and internal audit. I have included this information in an appendix. However, it is important to note that the external audit is a legal requirement for many compan ies and cannot be avoided by employing the auditor to do other work. If you require any further details please do not hesitate to contact me. Yours s incerely A N Accountant Enclosure: Appendix External audit Internal audit Characteristics and objectives The external audit is a legal requirement for limited liability companies above a certain size. Partnerships and sole traders do not normally need to have any a udit, though some may opt to do so to give independent credibility to their fina ncial statements. In an external audit the auditor gives an independent opinion on whether the fin ancial statements are true and fair. Implied opinions may also be given on issue s such as whether the financial statements agree with the underlying records and all information and explanations which are relevant to the audit have been rece ived. External audits are performed annually, and the auditor is paid based on hours w orked. The audit fee is normally disclosed in a set of financial statements. Assurance work is voluntary for companies. Management can employ the external au ditor to report on any specific areas. Directors may employ the external auditor when they feel a specific investigation or some specific work needs to be done, e.g. in support of an insurance claim or loan application. The scope of assurance work is determined by management. Assurance work

Assurance work is a one-off specific assignment; fees are normally agreed with m anagement and based on hours worked. Internal audit departments are not a legal requirement, though the Combined Code on Corporate Governance recommends them as best practice for listed companies in the UK and other countries are followin g this model.

Internal auditors are employees of the company. They report on the internal cont rols, identifying problems and suggesting improvements. They may also report on the effectiveness of efficiency of operations.

Internal auditors are full-time employees, and as such there are ongoing costs i nvolved with setting up an internal audit department. Exam answer bank 355 External audit Internal audit Characteristics and objectives The auditors report is a formal report with standard wording, prepared for shareh olders. An unqualified auditors report indicates that the auditor believes the fi nancial statements are true and fair. Reports are tailored to the scope of work, and addressed to management. Reports are prepared for management. There is no guidance governing the wording of reports, though companies may have their own internal guidelines. Responsibilities Work and procedures are governed by International Standards on Auditing, produce d by the International Auditing and Assurance Standards Board of IFAC. Complianc e with these Standards is a good defence should the auditor end up in court. The International Framework for Assurance Engagements provides guidance on the n ature of assurance engagements. ISAE 3000 Assurance Engagements provides standards for assurance engagements other th an audits or reviews of historical financial information. Auditors are expected to comply with this standard for both reasonable and limited assurance engagements. There are no International Standards on Auditing to govern internal audit work.

Assurance work

2 Audit and assurance engagements (a) Assurance engagements are engagements in which a professional accountan t expresses a conclusion which provides the intended user with a level of assura nce about a particular subject matter. External audits and review engagements ar e examples of assurance engagements. An external audit provides only reasonable assurance because of the inherent lim itations of the audit such as the fact that not all the transactions in the acco unts can be tested and that judgement is required in the audit of provisions, fo r example. Review engagements only provide negative assurance this means that nothing has c ome to the attention of the auditor which indicates that the accounts have not b een prepared according to the applicable framework. Limitations of the external audit: Not all items in the financial statements are tested. Judgement is required. There are limitations in the accounting and control systems. The audit report is issued a while after the balance sheet date. (b) The explicit opinions stated in the audit report: The state of the companys affairs at the end of the financial year in the statement of financial position. The companys profit or loss for the financial year in the statement of co mprehensive income.

356 Exam answer bank Implied opinions are reported on in the audit report only by exception, and coul d include the following: ted. Adequate accounting records have been kept. Returns adequate for the audit have been received from branches not visi The accounts are in agreement with the accounting records and returns.

All information and explanations have been received by the auditors and they have had access at all times to the companys books, accounts and records. Details of directors emoluments and other benefits have been correctly di sclosed in the accounts. Particulars of loans and other transactions in favour of directors and o thers have been correctly disclosed in the accounts. (c) Using the UK as an example, auditors have the following rights:

Access to records: Auditors have a right of access at all times to the b ooks, accounts and vouchers of the company. Information and explanations: Auditors have a right to require from the companys officers any information and explanations that they consider necessary f

or the performance of their duties. Attendance at and notices of general meetings: Auditors have a right to attend any general meetings of the company and to receive all notices of and com munications relating to such meetings which any member of the company is entitle d to receive. Right to speak at general meetings: Auditors have a right to be heard at general meetings which they attend on any part of the business that concerns th em as auditors. Rights in relation to written resolutions: Auditors have a right to rece ive a copy of any written resolution proposed. Right to require laying of accounts: Auditors have a right to give notic e in writing that a general meeting is held for the purpose of the laying of acc ounts and reports before the company. 3 Standards The major advantages and disadvantages of auditing standards can be summarised a s follows. Advantages They give a framework for all audits around which a particular audit can be deve loped. They help to standardise the approach of all auditors to the common objective of producing an opinion. They assist the court in interpretation of the concept of 'due professional care' and may assist auditors when defending their work. They increase public awareness of what an audit comprises and the work behind th e production of an audit report. They provide support for auditors in potential disputes with clients regarding t he audit work necessary. Disadvantages It may appear that they impinge on, rather than assist, professional judgement. They are considered by some to stifle initiative and developments of new auditin g methods. They may create additional and unnecessary work and thus raise fees, particularl y in the audit of small companies.

Exam answer bank 357 If auditing standards were to be enforceable by statute it would mean that ther e would be government intervention in areas currently controlled solely by the p rofession itself. This might ultimately lead to a diminished role in self-regula tion. To be enforceable by statute the standards would have to be applicable to all circumstances and thus need to be very general and broad in their instructi ons. This might reduce their usefulness to the auditors. Auditors might spend un necessary time ensuring that they have complied with the law rather than conside ring the quality of service to their clients.

Finally, it should be considered whether full statutory backing for standards wo uld force auditors into narrow views and approaches which might gradually impair the quality of accounting and auditing practices. 4 Corporate governance (a) Improving the effectiveness of audit x Increasing assurance from stronger corporate governance and internal c ontrols x Providing an opportunity to discuss the terms and scope of external au dit in an impartial way x Strengthening the ability of the external auditor to request changes i n control systems x Ensuring that there is minimal duplication of work where internal audi tors are involved, by discussing the audit plan with the external auditors via t he audit committee x Ensuring that directors' statements on internal control as required by Cadbury are reviewed by the audit committee x Reviewing going concern issues and ensuring that appropriate disclosur es are made x Acting as a forum for resolving problems between the directors and the external auditors x Resolving difficulties over the availability of information and key cl ient personnel x Reviewing draft financial statements before presentation to the audito rs and the executive board (b) Independence of audit committees x The members should be independent and declare any interests in the com pany. x Non-executive directors often sit on several boards, so conflicts of i nterest can easily arise. x Salaries are paid by the company so financial independence can be comp romised. x Members of the audit committee tend to have other roles at the client, eg personnel. They act in several capacities and independence may be impaired. x Members may have had previous involvement in executive positions and c ould have share options or pension schemes, again compromising independence. (c) Statutory regulation

Statutory regulation could impose additional costs and regulatory burdens, which might not justify the end in all cases and could sometimes be detrimental to sh areholders. However, an argument in favour of statutory regulation is that voluntary codes o f practice may not be applied consistently by companies. Another is that the non -executive audit committee may not feel able to criticise management unless they have statutory backing. Shareholders do not readily understand the role of the audit committee. If it wa s appointed by statute and governed this role might be better understood, but th is is not necessarily the case. There is no evidence that shareholders understan d legal regulations any better than voluntary ones in many cases. It is difficul t to arrive at a 'model' audit committee suitable for all entities, as would be required if statutory regulation were introduced. Companies are unique and have unique requirements. A statutory monitoring report upon the audit committee would be required. This would further increase costs for the company. It would be very difficult to set

standards for non-executive directors on audit committees. 358 Exam answer bank 5 Independence (a) If an auditor is to have credibility then it is vital that he should be seen to be independent of any concern on which he is required to report. Howeve r, independence is but one of a number of qualities which the modern auditor mus t possess if he is to be accepted as suitable for his role. Outside of independence, perhaps the two most important qualities required of an auditor are: (i) Integrity The auditor must be seen as honest. Having formed his opinion, based on the aud it evidence he has collected, he will not allow others to sway his judgement to suit their own ends. It is the auditor's integrity which will allow interested p arties to place reliance on his reports. IFAC and national supervisory bodies do a great deal to try and ensure that the integrity of the profession as a whole, as well as that of individual members, i s maintained. This is done by laying down ethical guidelines which all members a re required to follow (disciplinary proceedings are taken against any member kno wn to have breached such guidelines). The accounting bodies also assist in this area by providing a broad framework for the training and examination of prospect ive new members, such as the ACCA's Code of Ethics and Conduct. (ii) Professional competence

Clearly the auditor must be in possession of certain technical skills. This fact is clearly recognised so far as statutory audits are concerned, as only suitabl e qualified accountants are recognised as being competent to hold office as audi tor. Examples of some of the skills required of the modern auditor are that he m ust be: x x x x Aware of and understand audit objectives Able to interpret systems Able to communicate well with others Conversant with required techniques such as sampling

x Able to cope with the impact of modern technology on accounting and in ternal control systems The accounting profession is only too well aware of the need to maintain and imp rove standards of professional competence and for this reason has issued and rec ently revised a number of International Standards on Auditing. In addition the a ccounting bodies are heavily involved in running courses to assist members in ma intaining and improving their technical skills. (b) Independence on the part of the auditor as a reporting accountant is se en by many to be a fundamental concept of auditing. It has been said that it wou ld never be sufficient for an auditor to claim that he was independent. In fact, he must always be clearly seen to be independent in practice. Given this situat ion, it would be almost impossible to draw up a set of rules to cover every conc eivable situation where an auditor's independence might be called into question. Whilst not able to provide an exhaustive list of recommendations, the main princ iples which should be applied when considering the question of independence may

be found in the relevant section of the ACCAs Code of Ethics and Conduct. With t his in mind, the following comments could be made in relation to the situations specified in the question: (i) The audit partner has no shareholdings in the client company and so, a ll other things being equal, he could be seen as giving an objective audit opini on. However, the audit manager does have a shareholding in the client company wh ich, whilst not material to the company (at 1% of issued share capital), could b e material to the audit manager and certainly might be seen to influence his abi lity to give an impartial opinion in relation to the company's affairs. As the p artner will inevitably have to rely upon the work completed and controlled by

Exam answer bank 359 the audit manager it is clearly undesirable for the manager to have such a finan cial involvement in the client's affairs. (ii) The code suggests that under normal circumstances no more that 15% of the gross fee income of a practice should come from any one client source. The r eason for this is that the fear of losing a major client, and thus a substantial proportion of fee income, could prejudice the auditor's objectivity and make him more likely to bow to pressures from the client. The audit fee from Janet Co contributes some 14.3% of the total fees income of t he practice and so is within the 15% recommended limit. It would be necessary to consider whether any other fee income was received from this client, as this could result in the 15% limit being exceeded. However, perhaps the most important point to note is t hat the 15% is merely a guide. If the figure is slightly exceeded it does not au tomatically mean that independence is impaired and it must also be appreciated t hat even if the level of fee income is below 15% the auditor's independence coul d still be seen as being prejudiced. The firm would need to keep this situation under constant review. (iii) As another instance of where financial involvement in a client's affai rs could be seen to impair an auditor's objectivity, the code recommends that be tween an auditor and a client, there should be no loans or guarantees in respect of loans either way. Any such financial involvement could be seen to impair the auditor's judgement either because of a client putting pressure on the auditor or because of the auditor's own fear of suffering some financial loss. However, the code does allow for one exception in making the above recommendatio n and that is where the loan is 'in the normal course of business and on normal commercial terms', providing it is not to the engagement partner (i.e. allowed f or other audit staff members and practice partners). It is part of a bank's norm al business to make personal loans and if the rate of interest being paid by the audit senior is the normal commercial rate of interest, this transaction is unl ikely to be seen as impairing the auditor's independence. (iv) The code also considers the problems that can be created when conflicts of interest arise between different clients and between clients and the auditor 's own business interests. It concludes that every effort should be made to avoi d conflicts of interest arising and that it would be highly unethical for an acc ountant to act in a situation where he knew that a conflict of interest existed. The situation described in the question is a good example of the type of conflic t of interest with which the code is concerned. The audit partner should not adv

ise Jean Co with regard to the contract tender received from Harry Co. The audit or should explain the professional reasons why he is unable to act on this occas ion and suggest that Jean Co seek advice from another firm of accountants. 6 Objectivity (a) Objectivity

Objectivity is defined by the ACCA as being 'a state of mind which has regard to all considerations relevant to the task in hand but no other. It pre-supposes i ntellectual honesty.' (i) External auditors. Objectivity is usually hallmarked by 'independence' in the case of external auditors. The auditor must be, and be seen to be, indep endent. ACCA provides a number of guidelines as to how an auditor should maintai n his independence. (ii) Internal auditors. Internal auditors are usually employees of the peop le they report to, so independence is a more difficult issue to understand here. However, it is vital that they maintain objectivity towards their tasks within a company, so they must avoid conflicts of interest and maintain integrity in th eir relationships with other staff members.

360 Exam answer bank In particular, as an ACCA member, an internal auditor is bound by the ACCA's Cod e of Ethics and Conduct. Objectivity is a fundamental principle of this code. Threats to objectivity The following are all threats to objectivity: x Personal interest (for example, fear of losing fees or a good relation ship with a client/fellow staff member) x Review of own work (for example, if an auditor audits financial state ments he has compiled, or an internal auditor monitors systems he has designed) x Disputes (for example, with a client, or where an audit firm advocates for its client, or where an internal auditor has a personal issue with a staff member) x Long association or undue sympathy (for example, through close persona l relationships) x Intimidation (this is linked to self-interest, for example, fear of lo sing a client or an internal auditor losing his job) (b) Two situations

Scenario 1 (i) Threats

The situation raises three potential threats to objectivity.

The first is the issue that the firm has had a long association with the audit c lient. It is unclear whether the same engagement staff have been associated with the entity in that time. The second is that the firm has been offered the opportunity to carry out work o ther than audit for the firm. ACCA guidance states that provision of other serv ices can affect objectivity. Connected to the previous point is the fact that a self-interest threat arises t hrough the substantial fee income that this client may generate in the current y ear. ACCA's guideline in respect to recurring income is that 15% of office inco me from one client is likely to adversely affect objectivity (for an unlisted co mpany). The income in this year is likely to be 17%, but much of that is not recurring. However, the firm should consider that t he result of the consultancy might be that the business expands and the audit fe e might rise in the future. They should lay down contingency plans. (ii) Safeguards

In relation to the other services, the key inherent safeguard is that it is a on e-off project, as stated above. It appears that it will also be carried out by a department other than the audit department, which will help to maintain objecti vity. In terms of the audit, as the client has been associated with the audit firm for a number of years, the firm should consider laying out procedures for rotation of the engagement partner in relation to the client, so that the relationship ca nnot become too close over time. If this is considered inappropriate, it might consider instituting a second part ner review as another measure to maintain objectivity. Scenario 2 (i) Threats

If Peter was to get the job in the internal audit department, there would be con siderable threat of self-review, as he would have to monitor the systems which h e has set up in the purchasing department. As Peter is a current employee of the company, there is also a risk that his obj ectivity towards an internal audit role would be affected by his relationships w ith fellow employees. Exam answer bank 361 This is particularly the case with regard to his relationship with his current b oss, the Purchasing Director, as he has a poor relationship with him. As a membe r of the internal audit department, Peter would in all likelihood have to report directly on matters relating to this director. (ii) Safeguards

If Peter gets the job, an important safeguard would be that he did not work on m atters relating to the purchasing department for a period of time, or perhaps un til the systems have been reviewed again and/or the Purchasing Director moves on . It would also be important to address the issue of objectivity as part of the re cruitment process. The issue of relationships with staff would have to be discus

sed and understood. Lastly, it is important to have objectivity in the recruitment process. As Peter has had an informal discussion with the head of Internal Audit, the head of Int ernal Audit should ensure that other staff members are included in the recruitme nt process. 7 Role of internal audit (a) (i) Notes on the role of internal audit Requirements in relation to the Board of Directors

As a listed company, Golden Holdings should implement the following: x x x x x The Board must meet regularly There should be a clearly accepted division of responsibilities Positions of Chief Executive and Chairman should be distinct A formal schedule of matters for referral to the Board should exist There should be a balance of executive and non-executive directors

Companies should also set up remuneration committees consisting of non-executive directors to determine executive remuneration. The Committee should report annu ally to the shareholders setting out the company's policy on remuneration and ma king disclosures about director's remuneration packages. (ii) Requirements in relation to accountability

They should also consider the following matters in relation to accountability: x x x Directors must explain their responsibility for preparing accounts Directors must report on the going concern status of the company The Board should establish an audit committee

In addition, the financial statements are likely to be required to be audited by an independent auditor who qualifies for the position under legislation. (iii) Risk management Directors should review the effectiveness of internal control systems at least a nnually. Internal control systems are maintained to enable the business to opera te efficiently, to ensure that assets are safeguarded and that reliable records are maintained. An internal control system reduces risk to a company. As such, an internal control system is part of a company's risk management. Dire ctors are required to review the system as part of their risk management exercis e, to ensure that the system is still reducing risks, and that all risks have be en considered. The directors are also required to appraise the need for an internal audit depar tment annually. Internal audit have a role in monitoring the risk management of an entity.

362 (b)

Exam answer bank Sales department brainstorming session

MEMORANDUM To: Sales director

(i) I should be able to come along to your brainstorming session in July. However, it is probably best that I attend in an advisory and interested capacit y only. As we shall be involved in monitoring s into place to mitigate risks in the t too involved in the initial systems e objectivity when monitoring how the ctives. the systems which the sales department put business, it is inappropriate for me to ge design stage, as this will impair my futur system is operating and achieving its obje

(ii) In terms of assessing risks, I am not best qualified to undertake this role. You are the specialists and should be able to identify the major risks ar ising in the department. Just to give you a better idea of what my role can be, internal audit are able t o provide three things: x Objective assurance on the operation of systems once you have them up and running x Assistance in setting up a process to help you identify risks

x Assistance in strengthening the control process once you have identifi ed risks In other words, if you are struggling to identify risks at the meeting, I can gi ve you some pointers on how to go about it, but after that my job will be lookin g at the systems you come up with, and helping you improve them continually. Internal auditor 8 Glo (a) Materiality

It is never appropriate to apply the prior year's materiality figure to the curr ent year figures. Materiality should be assessed in each year. If the financial position has not changed much, and the results are very compara ble with the prior year, it is possible that the materiality assessed year-on-ye ar is very similar, but this does not mean that the auditors should not assess i t for each audit. When assessing materiality, the auditor must consider all know n factors at the current date. In this case, the position has changed considerably, increasing the risk of the audit, which may lower materiality itse lf. As the position on the statement of financial position has changed considerably, when materiality is assessed, it is unlikely that it will be similar to the pri or year. Using the information available, materiality is likely to be assessed e xtremely low in monetary terms, due to the overall decrease in assets and the lo ss that appears to have been made in the year. It is also possible that given th e current position, the figures on the statement of financial position will not be used to assess materiality in this year. (b) Audit risk

Audit risk is the risk that the auditor will give an inappropriate opinion on fi nancial statements. It is made up of three different elements of risk: x Inherent risk: the risks arising naturally in the business and specifi c accounts/transactions x Control risk: the risk that the accounting system will fail to detect and prevent errors x Detection risk: the risk that the auditors will not detect material mi sstatements Detection risk comprises sampling risk (the risk that the auditors' conclusion d rawn from a sample is different to what it would have been, had the whole popula tion been tested) and non-sampling risk (the risk that auditors may use inapprop riate procedures or misinterpret evidence). Exam answer bank 363 Inherent and control risk are assessed by the auditors. Detection risk is then s et at a level which makes overall audit risk acceptable to them. (c) Specific audit areas of risk

A review of this statement of financial position suggests that audit work shoul d be directed to the following areas: Going concern Total assets have fallen from $373,000 to $165,000. Although the statement of co mprehensive income has not been reviewed, the statement of financial position sh ows a retained loss for the year of $211,000. Net assets show a reduction in both inventory and receivables, which suggests a decrease in activity, although trade payables do not seem to have fallen so cons iderably. However, this could be accounted for by Glo-Warm not paying its suppli ers in a similar fashion to the previous year. It will be necessary to review th e statement of comprehensive income to substantiate whether activity has reduced . The cash position has also worsened, with cash falling by $22,000. The statement of cash flows should reveal more detail about this fall. However, the company h as paid off $5,000 of its bank loan, reducing overall net debt. In summary, audit work should be directed at going concern as several indicators of going concern problems exist on the statement of financial position. This wi ll be further amplified when the statement of comprehensive income is available. Inventory Inventory has been mentioned above in the context of going concern. Audit work s hould be directed at inventory specifically as this balance has fallen significa ntly from the previous year, which seems odd in a manufacturing company. There i s no suggestion on the statement of financial position for why this should be so (for example, receivables are not correspondingly high, suggesting high pre-yea r end sales, and payables are not correspondingly low, suggesting low pre- year end purchases). It may be that the inventory count did not include every item of inventory. Alternatively it could simply point to a fall in activity (discussed above). Warranty provision

A provision of $20,000 has been included in 20X6 for warranties. The reasons fo r this must be investigated and the auditors must check that it has been account ed for correctly. It seems odd that a warranty provision should suddenly appear on a statement of financial position. It suggests a change in the terms of contracts given to cust omers, or a change in the customers themselves (with different terms then applyi ng). Alternatively it suggests that IAS 37 has been wrongly applied in the curre nt year, or should have been applied in the previous year, and was not. Other material items As stated above, given the indications of loss and the reduction in total asset value, it is likely that materiality will be assessed low in monetary terms. In this case, most balances on the statement of financial position are likely to b e material (excluding investments and cash-in-hand which appear to be very low r isk). However, as the bank loan is likely to be substantiated by good audit evidence, the most risky of the other balances are trade receivables and trade payables, f or reasons discussed above in going concern. More detail is required to make a j udgement about the risk of tangible non-current assets.

364 Exam answer bank 9 Audit planning and documentation (a) The overall audit strategy is a document that outlines the general stra tegy of the audit. It sets the direction of the audit, describes the expected sc ope and conduct of the audit and provides guidance for the development of the au dit plan. The audit plan is a more detailed document than the overall audit strategy and i ncludes instructions to the audit team that set out the audit procedures the aud itors intend to adopt. The audit plan may also contain references to other matte rs such as audit objectives, timing, sample sizes and the basis of selection for each account area. It also serves as a means to control a nd record the proper execution of the audit work. Key contents of an overall audit strategy: tem. Section on understanding the companys environment. Section on understanding the companys accounting and internal control sys Risk and materiality considerations. Nature, timing and extent of audit procedures. Section on co-ordination, direction, supervision and review. Any other matters.

(b) ISA 230 Audit documentation requires auditors to document their audit w ork. Audit work needs to be documented for a number of reasons which are outline d below.

Audit documentation provides evidence of the auditors basis for a conclusion abo ut the achievement of the auditors objectives and evidence that the audit was pla nned and performed in accordance with ISAs and other applicable legal and regula tory requirements. It also assists the engagement team to plan and perform the audit; it assists te am members responsible for supervision to direct and supervise the audit work; i t enables the team to be accountable for its work; it allows a record of matters of continuing significance to be retained; and it allows for the conduct of qua lity control reviews and inspections (both internal and external). (c) Standardised audit working papers

Advantages May improve efficiency of audit work, through the use of checklists and specimen letters, for example. Automated working paper packages may make documenting audit work easier, because they include features such as automatic cross-referencing, for example. Facilitate review. Can lead to time saving. Disadvantages May lead to a mechanical approach without applying audit judgement. May not be applicable to all clients. New audit staff will require training to use the audit documentation sys tem used by the audit firm. 10 Audit evidence considerations (a) Analytical procedures can be used at the planning stage, as substantive procedures, and at the review stage of the audit. Analytical procedures consist of the analysis of significant ratios and trends including the resulting invest igations of fluctuations and relationships that are inconsistent with other rele vant information or which deviate from predictable amounts. Analytical procedure s include comparisons with similar information from prior periods, comparisons t o budgets and forecasts, comparisons with predictions prepared by auditors, and comparisons with industry information.

Exam answer bank 365 When using analytical procedures as substantive tests, auditors need to consider the information available in terms of its availability, relevance and comparabi lity. They also need to consider the plausibility and predictability of the rela tionships they are testing. Other factors to consider include materiality, other audit procedures, the accuracy with which the expected results can be predicted , the frequency with which a relationship is observed and the assessments of inh erent and control risks. An example of an analytical procedure that can be used as a substantive test is a proof in total test on depreciation and amortisation. In this test, the audito r predicts the expected charge for the year for depreciation and amortisation by using the clients accounting policy for depreciation and applying this to the br ought forward figures for non-current assets from the prior year audited financi al statements, factoring in additions and disposals for the year. The figure obt ained can be compared to the charge in the draft financial statements to assess its reasonableness and accuracy. (b) Audit evidence is available to auditors in a variety of forms. These in clude auditor-generated evidence (e.g. analytical procedures), external sources

of evidence from third parties (e.g. solicitors correspondence, valuation reports from surveyors for land and buildings), internal sources of evidence from withi n the entity being audited (e.g. minutes of meetings from the Board of directors , reports generated from the accounting system), and oral or written evidence. A nother factor to consider is whether the evidence, if written, is from an origin al document or a copy. Audit evidence from external sources to the entity is more reliable than that ob tained from the entitys records. Evidence from the entitys records is more reliabl e when the related internal control system is operating effectively. Auditor-gen erated evidence is more reliable than that obtained indirectly or by inference. Evidence in the form of documents or writte n representations is more reliable than oral representations. Where evidence is written, original documents are more reliable than photocopies which can be alte red by the client relatively easily. 11 Knits (a) The audit of a small company such as Knits poses particular problems fo r an auditor because of the following reasons: x x x x A single individual/small number of individuals running the business Lack of segregation of staff Few internal controls in place Informal controls that can be overridden by management

Knits has two directors, one who is involved in the everyday running of the comp any. This means that internal controls can be overridden easily and may not be i n place in any case. Although the other director is a non-executive, this indivi dual may not feel confident in discussing any control issues, particularly if t he director running the business is a strong individual. It can also be seen that in the accounts department, there are only two members of staff so segregation of duties may not be possible this also can result in fr aud being easy to perpetrate. In terms of the audit, this may mean that the auditor cannot rely on the interna l controls in place, so would undertake a fully substantive audit consisting of tests of detail and analytical procedures. (b) gs. s. 366 Control objectives of a sales system Goods and services ate only supplied to customers with good credit ratin Customers are encouraged to pay promptly. Orders are recorded correctly. Orders are fulfilled. All dispatches are recorded. All goods and services sold are correctly invoiced. All invoices raised relate to goods and services supplied by the busines Credit notes are only issued for valid reasons. All sales that have been invoiced are recorded in the accounting system. Exam answer bank

(c) All entries in the sales ledger are made to the correct accounts. Potentially doubtful debts have been identified. (Note. Only six were re quired.) Internal control deficiency Reason 1 There does not appear to be any list of regular customers to be visited or timetable of regular visits. There is no credit check for accepting an order. Potential sales may be lost if customer goodwill is lost through inventory not b eing ordered promptly. Goods may be issued to a bad credit risk. 2 The order form set has insufficient copies. The customer has no co py of the accepted order, disputes at a later date when the goods are despatched may become difficult to resolve. 3 The copy of the order for use in the warehouse is not sent directly to the warehouse. 4 The order form is filed before being matched to a despatch note and sales i nvoice. 5 No copy of the despatch note is retained in the warehouse.

The accounts department, who generate and post the sales invoice have the abilit y to adjust the order before it is sent to the warehouse. Poor monitoring of accurate and timely completeness of sales orders. No documentation is available within the warehouse to support inventory movemen ts and prepare inventory records. 6 The sales ledger is only updated weekly. Customers are being giv en an additional weeks credit which does not help Knits Co's cash flow. 7 Mrs Jones has control over most stages of the sales cycle from passing the order to despatch, raising and posting the sales invoice to receiving and postin g the cash. 8 . Written customer statements are only produced for balances over 90 days old

9 There is no monthly reconciliation of a receivables listing to a control ac count balance. This is exacerbated by the fact that hard copy printouts of sales ledger balance s are not retained. Sales transactions may be manipulated and company funds lost.

The company is giving a very long credit period before chasing for payment. This causes cash flow problems for the company and given the nature of the custo mers business could easily become bad debts within a 90 day period. Errors in updating sales invoices and cash may go undetected until a customer co mplains. Lack of audit trail poses problems for the company in dealing with complaints bu t also in making year-end provisions and providing audit evidence for the extern al auditor.

Exam answer bank 367 Additional valid points 1 The sales representative does not monitor the completeness of orders. 2 There is no customer confirmation of receipt of goods. 3 There is no independent review of the sales invoices prepared by Mrs Jones. 4 the 5 ing Sales invoices are filed away, without retaining the despatch note, before customer has paid. The executive director does not appear to check the cheques received and be banked to a remittances list.

Customer goodwill may be lost as a result of errors or time delay in completing orders. Any dispute regarding receivables arising from goods delivered may be difficult to resolve. Errors in terms of prices to be charged, any discounts due to arithm etical errors may go undetected. Any customer disputes arising may be difficult to resolve without evidence of th e goods despatched. Bad debts may arise. Errors in recording and banking receipts may go undetected. (d) a) Controls to overcome the internal control deficiencies stated in part (

1 A schedule of planned visits should be prepared by the sales represent ative and completed with details of sales orders taken. This schedule should be reviewed by the executive director on a weekly basis, co mparing sales made to budgeted sales.

Any customers who are bad credit risks should be notified to the sales represent ative before his scheduled visit. 2,3,4 A four-part order form should be prepared at the customers premises, wit h evidence of approval by the customer. The parts should be distributed as follows: (1) Remain with customer (2) To the warehouse (3) To accounts to match with the sales invoice and despatch note (4) Remain with the sales representative, to be used to monitor the progres s of orders. 5 A three part despatch note system should be used as follows: (1) Copy with the goods (2) Filed with a copy of the order in the warehouse (3) Sent to Accounts 6 Sales invoices should be posted to the sales ledger daily.

7 The sending of a copy of the despatch note directly to the warehouse a nd the monitoring of the completion of the order by the sales representative wou ld help to introduce segregation of duties into the system. In addition, cash and cheque receipts received in the morning could be recorded by Mrs Singh if she was given the additional morning duty of opening the post. 8 Statements should be sent on a monthly basis. In addition the company should investigate whether the company's computer package could produce them aut omatically. 9 Printouts of sales invoice and cash receipts postings should be retain ed, to provide adequate audit trail. In addition the individual sales ledger balances should be listed monthly and re conciled to the nominal ledger sales ledger control account. This account reconciliation should be performed by the executive director.

368 Exam answer bank Additional points x A schedule of goods being despatched should be prepared and the courie r company should sign for the goods being taken to customers. x The executive director should review a sample of invoices per week, co mparing details to despatch notes, price lists and orders and checking numerical calculations. x The copy of the sales invoice retained by Knits Co should be matched t o the order and despatch note before being filed away. x Mrs Singh should prepare a list of remittances detailing the customers name, specific invoices being paid and the net and gross amounts. A copy of the form should be sent to Mrs Jones and a second copy sent to the executive direct or alongside the cheques for banking. The executive director should evidence the

form on banking the cheques to the form filed in date order. 12 Fenton Distributors (a) Control objectives

Sales system gs. s. Goods and services ate only supplied to customers with good credit ratin Customers are encouraged to pay promptly. Orders are recorded correctly. Orders are fulfilled. All dispatches are recorded. All goods and services sold are correctly invoiced. All invoices raised relate to goods and services supplied by the busines Credit notes are only issued for valid reasons. All sales that have been invoiced are recorded in the accounting system. All entries in the sales ledger are made to the correct accounts. Potentially doubtful debts have been identified.

Purchases system All orders for goods and services are properly authorised and are for go ods and services that are actually received and are for the company. Orders are only made to authorised suppliers and at competitive prices. Goods and services are only accepted if they have been ordered and the o rder has been authorised. All goods and services received are accurately recorded. Liabilities are recorded for all goods and services that have been recei ved. All credit notes received are recorded in the nominal and purchase ledge r. (Note. Only three were required for each.) (b) (i) To verify the accuracy of the purchases transactions posted t o the nominal ledger I would perform the following tests. x I would verify that the bookkeeper was up to date with the monthly pos ting of all purchases transactions to the nominal ledger. x Specific tests on purchase transactions will include the following.

(1) Purchase transactions will be traced from the invoice to the nominal le dger and the analysis and analysis code will be checked. (2) The total invoice value will be traced to the nominal ledger. (3) The category of invoice expense and the expense amount will be examined to confirm that it appears correctly on the detailed computer list for the mont h concerned. Exam answer bank 369 (4) The total of the items on the detailed list will be matched to the nomi nal ledger. (5) Transactions will also be traced backwards from the entries in the nomi nal ledger making up the monthly total posted to the purchase ledger back to bot h the detailed analysis and the individual invoice. (6) The amount of the invoice expense will be agreed with the amount posted to the nominal ledger. The tests above check accounting entries forwards and backwards within the syste

m and any errors would be fully investigated as to their type, cause, materiali ty and pattern. x The tests on the detailed list and total postings of cash payments, di scounts received and adjustments will follow the same procedure as for invoices and credit notes. The monthly cash book total will be agreed to the total posted from the purchase ledger to the nominal ledger. x An examination of the analysis and coding of purchase invoices will b e carried out to establish the level of accuracy achieved. Particular care will be taken to see that the expense category 'purchases' is correctly identified an d coded from invoices and is not confused with other categories, for example sta tionery, rates, gas and telephone. Incorrect analysis and/or coding may be indic ated where the expense category is high or low in comparison with its budget to date. Large variations between actual and budget on expense categories should be exami ned further to verify that they are not due to errors in analysis, coding or pos ting. (ii) To verify the validity and accuracy of the journals posted to the nomi nal ledger I would carry out the following tests. x Firstly, I would check the opening balances at the start of the financ ial year from the opening trial balance back to the closing entries on the previ ous year's accounts. After this, each item would be agreed to the nominal ledger ensuring that both the value and analysis are correct. These opening postings s hould be the first entries in the new year as all nominal ledger balances should have been set to zero, and this should be confirmed. x Other cash book items would be agreed to the nominal ledger to confirm that postings are correct as to value and expense category. Large items would r equire a larger sample size and large, unusual or suspicious items should all be checked and evidenced by supporting documentation or Board approval. x The year-end balances of cash and bank on the nominal ledger should be agreed with the year-end balances in the cash book. This would require the last month t o be scrutinised as the closing balances at all previous month-ends will have be en agreed already. x ing. The tests on petty cash payments transactions would include the follow

(1) Check that transactions are supported by vouchers and correctly posted to the right nominal ledger account. This would include checking that transactio ns are valid and coded to the correct expense category. (2) Check that petty cash transactions are within any limits, regarding the type of expenditure or maximum value, established by management. (3) Agree that the petty cash balance in the nominal ledger at the end of e ach month and at the financial year-end matches with the balance in the petty ca sh book.

370

Exam answer bank

x The wages expense is posted manually to the nominal ledger from the mo nthly payroll summaries by means of a journal. To verify that the journals are c orrectly posted I would select several journals and check the following matters. (1) The totals of the analysis columns on the monthly summary shown on the spreadsheet should be posted to the journal, and forward to the nominal ledger. (2) The breakdown of wages expense into directors and the several departmen tal categories will be checked. The correct identification of directors' pay is important as this requires statutory disclosure. I would obtain the current list of directors. I would add up the totals in the analysis columns to confirm the summary total, and consider its reasonableness. (3) Amounts owing at the year-end for income tax, accrued pay and other ded uctions will be verified and any reconciliation drawn up by the bookkeeper agree d. (4) Any additions to, or amendments of, weekly wages records posted to the nominal ledger through the adjustments journal will be fully investigated and t heir validity established. (5) The analysis of wages expense for the year will be compared with the bu dget and an explanation will be sought for any significant variances. x Adjustment journals are potentially a high-risk area and any tests wou ld include the following. (1) Check that all the manually written adjustment journals were authorised by the managing director and supported by documentation and proper narratives. (2) Check journals are posted in numerical order and there should be no mis sing numbers gaps in the postings. (3) Examine all large adjustments and the reasons given for the errors. The se will be traced to the nominal ledger to ensure that postings do correct the e rrors. (4) Investigate closely recurring errors to establish their cause and wheth er these can be avoided in future by management action. (5) Examine the purchase ledger suspense account (payables suspense) and tr ace all postings in and out. (6) Where there was no account in the nominal ledger, agree back to the pur chase invoice, establish the account number and verify that the item has been po sted from the suspense account to the correct account. (7) Where the adjustment is due to the wrong account number being used, agr ee that the journal correctly transfers the item to the right account. (8) Where the bookkeeper has created contra entries between the purchase le dger and the sales ledger, check that the supplier/customer company concerned is posted with a purchase ledger and sales ledger contra of the same value. (9) All other adjustments will be checked for validity and supporting docum entation. Reasons will be established for postings that increase or reduce purchase ledger balances. x lows. Year-end balances on the nominal ledger would be further tested as fol

(1) Any balances remaining on the purchase ledger and sales ledger suspense accounts should be itemised on a supporting schedule and the existence of each item justified. (2) Nominal ledger balances for the cash book, petty cash book, sales ledge r and purchase ledger should agree to, or be reconciled to, the cash book, petty cash book, total sales ledger and total purchase ledger balances at the yearExam answer bank 371

end. I will investigate further to confirm that any difference is reconciled an d explained. It may be that further adjustments are required to reduce or elimin ate a difference. (3) All non-current asset movements should be checked, including purchases, sales, revaluations and depreciation. (4) All outstanding liabilities should be verified and their size reviewed for reasonableness. (5) The bank reconciliation should establish the correctness of balances on all types of bank account, ie loan, current, deposit, special transactions and so on. (6) A review of the financial statements would be carried out to ensure th at material changes in assets, expenses, revenues, liabilities and share capital are justified and explained. Justification would be sought in both relative and absolute terms. (c) Opening balances

In accordance with ISA 510 Initial audit engagements opening balances, the audit or shall read the most recent financial statements and the previous auditors repo rt for information relevant to opening balances. The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current perio ds financial statements, and whether the accounting policies reflected in the ope ning balances have been consistently applied in the current periods financial sta tements. If the auditor obtains audit evidence that the opening balances contain misstate ments that materially affect the current periods financial statements, he shall p erform additional appropriate audit procedures to determine the effect on the cu rrent periods financial statements. If the auditor concludes that such misstatements exist in the current periods fin ancial statements, they shall be communicated to the appropriate level of manage ment and those charged with governance. 13 Cheque payments and petty cash (a) A Black Managing Director Quicksand Co 12 Kelvin Street Anytown MNO & Co 3 Green Street Anytown Date Dear Mr Black You recently requested that we should advise you on good internal controls over cheque payments and petty cash. The main objectives of control over payments are to ensure that payments are mad e only in respect of valid transactions and that they are suitably authorised. T he following control procedures will contribute toward attaining these objective s.

Cheque payments (i) Cheques should be raised only on the basis of authorisation, for examp le a purchase invoice which has been suitably authorised. (ii) Cheques should be signed by people other than those who approve invoic es.

372 Exam answer bank (iii) There should be two independent signatories for each cheque, for insta nce, two directors might act as signatories. Signatories should inspect the docu ments supporting the cheque to ensure that the details agree. They should also m ark the document so that it cannot be reused. (iv) Cheques should be restrictively crossed. (v) Unused cheques should be kept in a secure place. Blank cheques should n ever be signed. (vi) Cheques should be under sequential control and all numb ers should be accounted for. Spoilt cheques should therefore be retained. (vii) When cheques have been signed, they should be despatched immediately. Petty cash (i) Petty cash payments should be made only on the basis of suitably autho rised vouchers, which should be under sequential control. Vouchers should be ret ained for subsequent references. Where independent evidence is also available, f or example invoices and receipts, this should be retained. (ii) An imprest system should be used to control petty cash. This means tha t the petty cash float is maintained at a specific amount and is reimbursed at r egular intervals on the basis of vouchers showing the payments which have been m ade. It is suggested that the float should be kept at a level of $300 and be rei mbursed on a weekly basis. (iii) The petty cash float should be subject to periodic surprise counts by a responsible person not involved with the petty cash system. The balance in-han d should be reconciled to the imprest account by reference to the vouchers not y et reimbursed. (iv) The size of individual payments out of petty cash should be subject to a maximum to be agreed by the directors. (v) Staff should not be allowed to cash personal cheques or borrow from pet ty cash. I hope that the above information is useful to you in designing your systems of internal control. If you require any more information, please let me know. Yours sincerely, A Smith (b) Mr Black presumably feels that involvement in cash and cheque controls will be time-consuming, and that he is too busy to be involved in it. He may fee l that he does not want to play a direct part in the petty cash function. Becaus e of the small amounts involved, he may wish to delegate this function to anothe r director. He should appreciate, however, that involvement at least in the auth orisation of cheque payments would help to ensure that he is aware of major tran sactions in his business. He might consider the possibility of authorising cheques in excess of a given amount; this would minimise the demands on his time, while exercising control and keepin g him informed of significant outgoings from the business.

Auditors may wish to consider whether Mr Black's lack of involvement may be symp tomatic of insufficient attention being given to financial matters by the board. 14 Using the work of a managements expert (a) In assessing the reliability of the legal advice obtained from a local solicitor on the outcome of the claim by Netherfield Manufacturing, the auditors shall consider the following. (i) The materiality of the claim is important as the significance to the c ompany of the amount involved would clearly affect the extent of the audit work required. (ii) The qualification, experience, reputation and standing of the local so licitor would be relevant. Presumably the solicitor would be qualified, but it w ould also be necessary to consider his suitability to advise on this type of cla im. The experience of the solicitor and his firm and their reputation in this fi eld of litigation would be an important factor in determining the extent of reliance to be placed on the solicitor's advice. In pa rticular, consideration should be given as to whether the solicitor had advised the company in Exam answer bank 373 respect of similar litigation in the past and how reliable his advice had proved to be on those earlier occasions. (iii) The independence of the solicitor must be checked as any suggestion th at the solicitor or his firm had any direct connection with the company or its m anagement would tend to reduce somewhat the reliability of the evidence provided . (iv) The nature and extent of the evidence provided by the company to the so licitor, and on which he has based his opinion, should be carefully reviewed to ensure that the solicitor's decision appears to have been based upon all relevan t facts available to the company. (v) The solicitor's opinion should be examined and its reasonableness asses sed, in the light of the auditor's knowledge and experience of similar cases aga inst both Ravenshead and other clients engaged in similar activities. (vi) If the auditors consider the amount of the claim to be material, and th ere is uncertainty in relation to the outcome of the claim and/or the solicitor' s evidence, they should consider recommending to the client that a second opinio n from an independent specialist in the field be obtained. If the client was not agreeable to this action or if the auditors still considered there to be materi al uncertainty, then a qualification of the audit report would probably be requi red. (b) The factors to be considered by the auditors in assessing the reliabili ty of the valuation of properties by an independent valuer would be as follows. (i) The independence of the valuer should be considered in a similar way t o that of the local solicitor, and for the same reasons. (ii) The qualification, reputation and experience of the valuer should be c onsidered. The valuer should be a qualified member of a professional valuation b ody with experience of valuing similar properties within the same geographical a rea as the properties owned by Ravenshead. If the valuer does not have experien ce of the type of properties held by the company or of the areas in which they a re located, then the importance of his evidence is likely to be considerably red uced. The reputation of the valuer or his firm would also affect the reliability of his evidence so far as the auditors are concerned, with the likelihood that more reliance could be placed on a valuation made by a large firm with a good re putation, than one obtained from a little-known small firm.

(iii) The actual valuation of the properties by the valuer should be careful ly examined. The auditors would need to satisfy themselves that a reasonable bas is for the valuation had been adopted. Typically, an open market value based upo n existing usage would be expected. (iv) Any change in the valuation of the properties since the time of the pre vious valuation should be assessed. The validity of any significant changes in t he valuation of the properties should be considered in the light of any statisti cal or other evidence available for similar properties. (v) The reasonableness of the valuations should be considered against any p rofits or losses made on any properties disposed of in recent times, as this cou ld be a good indication of any tendency to over or under value the properties to a material extent, either being likely to distort the truth and fairness of the financial statements. (vi) The reasonableness of the valuations could also be considered by the au ditors comparing the valuations with those used by other clients holding similar properties in the same locations. (c) The matters to be considered when assessing the valuation of the work-i n-progress by an internal valuer would be as follows. (i) How material is this asset in the financial statements: as it is likel y to be highly material, it needs to be valued accurately. (ii) The basis of the valuation should be carefully checked to consider the extent to which it appears to comply with the requirements of IAS 2 Inventories . (iii) Recognition needs to be made of the fact that, as the valuer is an emp loyee of Ravenshead, this will reduce the reliability of the evidence provided. However this may be countered to a certain extent by the fact that the valuer sh ould have a more detailed knowledge of the

374 Exam answer bank work-in-progress than it would perhaps ever be possible for an independent value r to obtain. (iv) Confirmation should be sought that the valuer had actually visited all of the relevant sites, or otherwise obtained satisfactory evidence as to the sta ge of completion of the inventory in order to provide himself with a reliable ba sis for its valuation. (v) The valuer's basis of determining costs should be ascertained and the a uditor would need to be satisfied as to the reliability of the company's records in this respect and, in particular, that a consistently applied satisfactory ba sis of overhead recognition had been employed. 15 Elsams (a) Use of computer programs to verify inventory

If physical inventory counting takes place at the year-end, it may be assumed th at the results of the physical inventory count are entered into, and valued by, the computer. If so, then it is important to compare the results of the physical count with the book quantities. The client may have a computer program to make this comparison. It would be possible for the auditor to check this comparison b y re-performance using his own specially written computer audit program or a com puter audit package. The auditors computer audit program or package, when run aga inst the file of book inventory, might also be used to carry out the following t asks. x Select a monetary unit or random sample of book inventory items for th

e auditor to check the physical count quantities. x Select items with specific characteristics, e.g. no sale since a speci fic date, unit selling price over a specified figure for further testing (test c ounts or obsolescence enquiries). x Prepare an aged analysis of inventory items.

x Re-perform calculation of the FIFO cost of each inventory item, compar e with the book inventory figure and print details if there is a discrepancy. x Cast the file of book inventory and print the total.

x Print details (product number, supplier, quantity, cost, date of suppl y) for a sample of recent inventory receipts contained on the file of book inven tory for substantiation against suppliers invoices. x Prepare summaries of inventory by branch, product number and location to assist in analytical procedures on the inventory figure, especially when comp aring with previous years. x Compare the unit FIFO cost of each inventory item with the unit sellin g price and print details of all inventory items where unit selling price is the lower to assist in evaluating net realisable value. Limitations Computer audit programs specific to the client are expensive to write. Computer audit packages which are tailored to the clients computer and file structure are less expensive. However, packages are often only compatible with certain makes o f computer. The audit software can work only with the information contained in t he computer files. For example, an inventory ageing cannot be produced if the da tes of inventory movements are not available. Clearly audit software cannot perf orm audit tests where an element of judgment is involved. For example, it can pr oduce an inventory ageing analysis but the auditor must decide, on the basis of all available evidence, what level of obsolescence provision is reasonable. Audi t software requires the auditor to have a detailed knowledge of the software and of the computer files to be used. (b) Test data

Audit test data consists of data submitted by the auditor for processing by the enterprises computer-based accounting system. It may be processed during a normal production run (live test data) or during a special run separate from the norma l cycle (dead test data). The auditor predicts Exam answer bank 375 the results of processing the data and compares the prediction with the actual r esults. The primary objective of test data is to test programmed controls. For e xample, if the program contains a control which rejects overtime hours greater than 20 per week, then the test data might include the case of 21 hours overtime to see if it is rejected. The basic principle of using test data is that if the program processes the test data correctly, then the logic of the program and th e program coding works and will process the actual data correctly. Difficulties x When live test data is used there is difficulty in ensuring that the d ummy data does not become included in the actual data.

x When dead test data is used it may be difficult to ensure that the pro gram tested is identical with that used for the actual data. x The initial time spent designing the test data is excessive in relatio n to the benefit it brings many auditors would rather devote that time to substantive audit work. (c) Audit sampling (i) Random selection ensures that all items in the population have an equa l chance of selection, e.g. by use of random number tables or computerised gener ator. (ii) Systematic selection involves selecting items using a constant interva l, the first interval having a random start. When using this method, the auditor must be sure that the population is not structured in such a way that the sampl ing interval corresponds with a particular pattern in the population. (iii) Haphazard selection is an alternative to random selection, as long as the auditor is satisfied that the sample is representative of the whole populati on. This method requires care to guard against making a selection that is biased . It should not be used if statistical sampling is being carried out. (iv) Block selection can be used to check whether certain lar characteristics. However it may produce samples that are not representative of a whole, especially if errors only occurred during a certain and hence the errors found cannot be projected onto the rest 16 Boston Manufacturing (a) Risk in the tangible non-current asset audit items have particu the population as part of the period of the population.

Control risk The controls over non-current assets at Boston Manufacturing appear to be strong . The company maintains and reconciles a non-current asset register and there ar e authorisation procedures in operation. These controls should be tested, and if they prove effective, control risk could be assessed low. Inherent risk The tangible non-current assets are material on the basis of the proposed materi ality level. There has been a substantial movement on the plant and equipment ac count this year, but this appears to be supported by the information given by th e management accountant. There appear to be no disposals in the year, which may indicate that they have been omitted, or that obsolete items are included in the register. It is also unclear whether land is being depreciated. It would be ina ppropriate if it was being depreciated. Overall, the inherent risk seems to be m edium. Detection risk Given that inherent risk has been assessed as moderate and control risk has been assessed as low, detection risk will be assessed as higher. However, there is u sually good evidence in relation to the existence and valuation of non-current a ssets and these are the key assertions which the auditors

376

Exam answer bank

are interested in. There will also be scope to carry out good analytical procedu res, such as proof- in-total of depreciation. Conclusion The audit of non-current assets appears to be medium to low risk. (b) procedures (i) Existence Audit

In many cases it is self-evident that land and buildings exist. However, it is i mportant for the auditors to verify all components of land and buildings contain ed within the statement of financial position, if they are on a site different t o the one which the auditors are primarily attending, for example. Land and buil dings should also be verified to title deeds to ensure that they not only exist, but that they are owned by the client. The other classes of asset should be inspected. A sample of assets from the regi ster should be agreed to the physical asset. There may be scope to rely on the w ork that the management accountant has undertaken here. The auditor should check a reconciliation which the accountant has performed. The auditors should make u se of any identification marks on assets recorded in the register, for example, security tags or bar codes which are kept on assets to distinguish them. The aud itor should inspect the condition of the assets and ensure that they are in use. The motor vehicles should be reconciled in terms of number of vehicles existing at the opening and closing positions. Again, to ensure that they not only exist, but are owned by the company, the auditors should check the registration docume nts to ensure that the company is the registered owner. For all the above assets, the external auditor should also review the insurance provision for the assets. This gives third party evidence of the existence of as sets as the insurer would not insure an asset which did not exist. (ii) Valuation (excluding depreciation) Land and buildings appear to be stated at historic cost as the schedule does not contain the words 'at valuation'. The auditors should confirm that this is the case with the management accountant. The cost can then be agreed to brought forw ard figures as there have been no additions in the year. These figures will have been audited in the previous year. If the assets are held at valuation, the aud itors must ensure that the requirements of IAS 16 in relation to revaluations ar e being complied with. Similarly, as there have been no movements in the year, motor vehicles can be ag reed to the opening position. To audit the valuation of plant and computers, the auditors should agree the ope ning position. They should then obtain a schedule of additions to non-current as sets, which can be agreed to purchase invoices to verify valuation. Lastly, the auditors should investigate whether the cost figures include any ful ly-written down assets. This is implied by the fact that the depreciation charge on plant excluding additions is low. If so, the auditor should find out whether these assets are still in use, and if not, consider whether they should be excl uded from the cost and accumulated depreciation figures contained within the not es to the accounts. Excluding them would have a net effect on the reported figur e of $0. (iii) Completeness The schedule of non-current assets prepared should be reconciled to: x ition) x x The opening position (that is, the previous statement of financial pos The closing position (what is disclosed in the financial statements) The underlying records (the nominal ledger)

Exam answer bank 377 If the non-current asset register contains details of the cost and accumulated d epreciation of each asset, the register should also be reconciled to the schedul e. Explanations should be sought for any differences. The additions of the schedule should also be checked to ensure that the opening and closing positions reconcile within the schedule. The auditors should also carry out a test on some of the individual additions, t racing the transaction through the system, from purchase orders to delivery note s and invoices and through the ledgers to the financial statements to ensure tha t additions have been included completely. (c) (i) Depreciation Appropriateness

The appropriateness of the rates should be considered and discussed with managem ent. Relevant factors to consider are matters such as: x x x The replacement policy for the asset The pattern of usage in the business The purpose of the asset being owned

In this instance, the auditors should establish the rationale behind the depreci ation rates applied, particularly in the case of plant. In the case of the plant purchased this year, the depreciation rate applied is 10%. However, the assets have been purchased in relation to an 8 year project, so 12.5% might be a more appropriate rate. (ii) Audit proce dures Depreciation on buildings can be verified by agreeing the purchase date of the b uildings to last year's file or historic invoices/purchase documents and the val uation applied to the building portion. For the other classes of asset, depreciation should be agreed for individual ass ets, as it is not possible to agree them in total. The auditors should obtain a breakdown of the charges for the year. They should be able to recalculate the de preciation from details in the non- current asset register and compare the resul ts. 17 Wandsworth Wholesalers (a) I would have checked the following matters at the pre-year end inventor y count. (i) Counting staff, although not the usual custodians of the inventory, we re competent. They were briefed before the count and given sufficiently detailed written instructions. They were assigned marked areas to count. (ii) No inventory was moved during the count. If inventory had to be moved , then the count supervisor would make a detailed note of quantities, inventory numbers and goods dispatched notes. (iii) The inventory was clearly identified and well laid out. The counters s hould work in an organised way, with one counting and one checking. Each invento ry line or area should be marked or tagged when counted to avoid any double coun

ting. (iv) Count sheets should be pre-numbered if possible, to ensure that they ar e all returned. Numbers should be in ink, not pencil. (v) Management (or internal audit) should perform test counts throughout th e inventory count. Any discrepancies should be investigated and resolved, usually by a recount. (vi) Slow moving, obsolete and damaged inventory should be marked as such on the inventory count sheets in as much detail as possible to highlight inventory which possibly should be valued at net realisable value.

378 Exam answer bank (vii) The management present should initial all the inventory sheets after pe rforming random tests to check that all items of inventory have been counted. I should record the following matters during my attendance at the inventory coun t. (i) Perform test counts, selecting items from the floor to check to the sh eets and vice versa. I would record all these tests (including inventory numbers , inventory sheets and so on) and any discrepancies I find should be investigate d by the count staff and management present at the time. (ii) Record all the inventory sheet numbers used in the count.

(iii) Record the last goods received note number received and the last goods dispatched note number issued prior to the inventory count. (iv) Complete an inventory count checklist.

(v) Record any problems or unresolved discrepancies. This would include obs olete, slow moving or damaged inventory and any inventory movements during the i nventory count. (b) (i) To test cut-off at the inventory count on 13 October I would perform the following checks. (1) Sales cut-off. Select a few goods dispatc hed notes from immediately both before and after the inventory count. Check that they have been recorded in the book inventory records in the appropriate period as being dispatched before or after the inventory count date. (2) Purchases cut-off. Select a few goods received notes from immediately b oth before and after the inventory count. Check that they have been recorded as received in the appropriate period, either before or after the inventory count d ate. (ii) At the year end it will be necessary to perform full cut-off tests, ra ther than just a check on the computerised book records as in (b)(i) above. Afte r performing these tests for transactions about the year-end, the following addi tional tests will be carried out. (1) Sales cut-off. Trace the goods from the GDNs to the relevant sales invo ices and check that those invoices were posted to the sales ledger either before or after the year-end, as appropriate. (2) Purchases cut-off. Trace the goods from the GRNs to the relevant purcha

se invoices and check that the invoices have been recorded in the purchase ledge r in the correct period, as appropriate. Invoices which relate to the period pri or to the year-end may not have been received in time to be posted in the ledger . In these cases such invoices should be included in the purchase accruals at th e year-end. (c) The following checks are relevant.

(i) Trace the check counts I performed at the inventory count to the inven tory sheets, and from there to the book records. Some small adjustments may have been made to the book inventory. These discrepancies, if not material, may be e xplained by small differences found at the inventory count. (ii) Investigate any material discrepancies between the inventory-sheet qua ntities counted at the inventory count and the book inventory records. Adjustmen ts between the inventory count date and the year-end should also be investigated . Large differences should be explained by the results of the inventory count. Evi dence should be seen that further check counts were performed to ensure the inve ntory counts were correct. There should also be evidence that the management of the company have investigated large differences. (d) As well as the tests detailed above in relation to the inventory count and cut-off, I would perform the following checks. (i) Vouch the quantities used in the year and valuation to the book invent ory records. This test should also be performed in reverse. Exam answer bank 379 (ii) An overall check of complete book inventory against the amounts used i n the valuation might be attempted using a computer program if the book inventor y records are held on file. The program might produce all material discrepancies . (iii) Investigate all material adjustments to the book inventory records at the year-end. (iv) Investigate the level of adjustments made to book inventory records thr oughout the year. Consider whether the adjustments are small enough to give comfort that the book inventory records are reasonably accurate. (v) Review the inventory counts from throughout the year to ensure that all inventory lines have been counted at least once during the year. (vi) Review the book inventory records at the year-end and check for any neg ative inventory quantities. Where such negative figures have occurred, there sho uld be evidence that the managers of the company have investigated the reasons f or them, and that the figures have been adjusted to the actual physical amount. 18 Sitting Pretty (a) Importance of the inventory count

The inventory count provides important audit evidence as to the existence and co mpleteness of inventory included in the financial statements. In this case, the inventory count is particularly important because the company

does not maintain perpetual inventory records. As no perpetual records are maint ained, the only basis for the inventory entries in the financial statements is t he result of this inventory count. Inventory is generally material to the statement of financial position of a manu facturing company and is also one of the higher risk areas on the statement of f inancial position. The inventory count provides important audit evidence reducin g the risk of material misstatement in relation to inventory. (b) Planning for attendance

Gain knowledge: I must review the notes of last year's inventory count and I mu st contact the factory manager to obtain details of this year's. I must review t his year's details to ensure that the inventory count appears to be planned effi ciently and effectively. Assess key factors: There are various key factors given in the scenario: (i) Nature and volume of the inventory. There should be no WIP, so I will count raw materials (approximately 10% of the inventory) and finished goods. How ever, raw material plastic should be low because a delivery is required to conti nue with production. (ii) Possible obsolescence. I must make a note of the number of old chair l egs maintained in raw materials as these are now obsolete, a new specification h aving been agreed. (iii) Cut-off issues. I need to ensure that the delivery on the day is isola ted and that I obtain details of the delivery made during the inventory count. I need to determine whether this should be included as deliveries for the year, b ut most of all ensure that it does not get counted twice (as it arrives, and if it is put into stores). I should also obtain copies of the relevant documents, f or example, the last invoices in the year and the last goods received and despat ched notes. (iv) Off-cuts. I need to consider whether any off-cuts are maintained on sit e and whether these are being included in the inventory count. As the company re ceives a discount relating to them, they are unlikely to be considered Sitting P retty's legally and so should not be included. (v) Staff issues. It appears that the inventory count is undertaken by the people who work in the factory and handle the inventory on a daily basis. This i s not best practice, although in practical terms it is difficult to avoid. However, I should discuss this with th e factory 380 Exam answer bank manager to assess whether staff can be allocated to counting inventory they have not produced. Also, as the staff are allowed to go home as soon as the inventor y count is completed, there is a risk that the inventory count will be rushed an d mistakes will be made. Plan procedures: I need to determine my sample sizes and whether there is a nee d for expert assistance at this inventory count. (i) Procedures. I will carry out test counts, checking from a sample of p hysical items to the count sheets and a sample of count sheet items to the physi cal items.

(ii) Samples. There are no higher value items that I should concentrate par ticularly on. Materiality for the year has been set at $5,000 currently. Dividing last year's figures for inventory by this materiality level would give a sample size of six items for raw materials and 34 items for finished goods. I need to determine the batches in which inventory is valued to ensure that I count the correct items. I need to assess the levels of inventory when I arrive to ascertain whether this remains appropriate. (c) Cut-off at fina l audit General procedures The audit team should take a sample of delivery notes for sales and purchases on either side of the year-end and trace these to invoices and ledgers and invento ry records to ensure that sales and purchases have been included in the correct period and that inventory is accounted for where appropriate (that is, sales hav e not been counted twice and purchases have been included in inventory). As the factory has been shut down, there is a lower risk that sales cut-off is inapprop riate than purchases cut-off. Inventory count delivery Once it is determined whether this delivery should count as this year's inventor y (which it should if the inventory count was the year-end date), the delivery i nformation should be traced to purchase invoices and ledgers to ensure that the purchase is recorded in the year and that the creditor is accounted for in the y ear. The inventory should then also be included. Other matters If inventory returns are material, the returns after the year-end should be revi ewed to ensure that items are not included as sales in the year and that the inv entory is added to the inventory figure unless it is now obsolete, whereupon it should be written-off. (d) Valuation of inventory

The auditors should obtain the client's working papers relating to the valuation of inventory. Items which the auditor sampled at the inventory count should alr eady have been verified to the inventory count records as part of the verificati on of existence. Cost The auditors should then trace a sample of items to purchase invoices to ensure that cost has been correctly applied. Cost of purchase excludes trade discounts and rebates, so the auditors should ensure that the valuation cost excludes the 10% discount received for returning the off- cuts of plastic. The auditors should then ensure that for a sample of finished goods items, costs of conversion (comprising costs of labour and overheads) have been included. Th is should be on a comparable basis to the previous year and therefore can be aud ited by analytical review. Net realisable value The auditors should ensure that cost is lower than net realisable value by traci ng their sample to after-date sales. If no invoices are yet available, the auditors can make confir mations by reviewing sales orders and price lists.

Exam answer bank Obsolete

381

Lastly, the auditors should ensure by review and by discussion with management t hat inventory which has been identified as obsolete at the inventory count has n ot been attributed value and has been scrapped. Analytical procedures The auditors will undertake general analytical procedures to ensure that the inv entory figure stacks up. This could include calculating ratios such as inventory turnover and ensuring that they tally with the facts that have been presented t hem in the course of the inventory audit. 19 Bright Sparks (a) Conclusions to be drawn as a result of the interim audit

The following weaknesses exist in the company's systems. (i) In any system of internal control, one person should not be able to pr ocess a whole transaction from start to finish: (1) Authorisation (2) Execution (3) Recording The most serious deficiency in the company's system is that warehousemen can: (1 ) Sell goods (2) Receive cash from cash sales (3) Raise sales invoices for credit sales (4) Raise credit notes Moreover, there appears to be no procedures in place for checking any of their w ork. Since the accounting records are written up on the evidence of these invoic es and credit notes, any errors made by the warehousemen will be carried into th e records. It may also be the case that the issue of credit notes is not authori sed by a senior member of staff. Possible consequences (1) Errors on invoices may not be detected except by customers

(2) Risk of unauthorised or fraudulent invoices or credit notes being raise d without detection (3) Risk of goods leaving the premises without being invoiced, whether thro ugh error or fraud (this is particularly dangerous in a business such as this, w ith a variety of high-value items) (4) g Time wasted by needless disagreements with customers about amounts owin

(ii) There appears to be a weakness in the recording of cash received by th e company. The dates recorded in the books are presumably the dates when the ent

ries were written up. If so, there is clearly an excessive delay in recording ca sh received, and possibly also in banking it. There may also be no record of cas h received made when incoming mail is opened. Possible consequences (1) Errors and defalcations can arise where a cash received system is weak. (2) The longer the gap between receipt and recording, the more likely it i s that discrepancies can occur. (3) Specific possibilities:

x Falsification of records leading to misappropriation of cash (teeming and lading) 382 x x Exam answer bank Mislaying of cheques if not banked promptly Errors in the records, especially concerning dates

(iii) Stricter control is needed over the granting of cash discounts (assumi ng that it is the actual receipt of cash which is later than the due date, not m erely the late recording of same). Possible consequence Discounts given to a standard list of customers who may be friends of staff or r egular customers, not necessarily prompt payers. (b) (i) Audit work on trade accounts receivable at the final audit Second circularisation

(1) Consider circularising all trade receivables accounts, or at least a la rger sample than before of accounts not circularised at 30 September. (2) Circularise and investigate disagreeing replies. Discover if reasons a re similar to those given at 30 September circularisation. (ii) To gain further evidence about the rights and obligations and existenc e of receivables (1) Check the sales invoices which make up the balances with backing docume ntation, for example purchase orders and despatch notes (if the latter exist) (2) Ascertain extent of cash received from customers after the year-end; re concile the individual invoices to ensure that no discrepancies exist (3) Obtain explanations for invoices remaining unpaid after subsequent invo ices have been paid To gain evidence about the valuation of receivables, I would review the cash re ceived after- date and would also carry out the following tests. (1) Check calculation of outstanding invoices (2) Carry out further tests on settlement discounts and ascertain whether t he position has improved or deteriorated since the time of the interim audit (3) Confirm necessity/adequacy of provision against write-off of specific d ebts by review of correspondence, solicitors' debt collection, agencies' letters , liquidation statements

(4) Consider whether amounts owed may be not recovered where there have bee n round sum payments on account or invoices unpaid after subsequent invoices pai d (5) Review customer files/correspondence from solicitors and circularisatio n results for evidence of potential bad debts (6) Confirm any general provisions for bad debts, considering how well prev ious year's provision considering predicted actual bad debts and whether the for mula used is reasonable and consistent with previous years I would check the completeness of receivables by carrying out cut-off tests at 3 1 December to ensure that all goods leaving the premises by that date (and only those) have been included in sales. I would also check that all returns of goods after the year-end relating to 20X0 sales have been correctly recorded. Other general tests include: (1) Agree the opening balance on the sales ledger control account with the previous year's working papers to ensure all the necessary adjustments were put through last year (2) Scrutinise sales ledger control for unusual entries (3) Check list of trade account receivables balances to and from sales ledg er, and reconcile with sales ledger control account

Exam answer bank 383 (4) Carry out analytical procedures, particularly reviewing changes in the receivables turnover period, and changes in the age profile of receivables (5) Check that trade receivables have been separately disclosed in the note s to the accounts 20 Audit of cash and bank (a) Characteristics of bank confirmation letter

The client must give its permission in writing to the bank for disclosur e of information to the auditors. The bank letter must refer to the client's letter of authority and the d ate of that letter. The bank letter should reach the bank at least two weeks before the year -end date and should state the year-end date and the previous year-end date. (b) Items requested in the bank confirmation letter Balances due to or from the client on current, deposit and loan accounts Nil balances on accounts Accounts closed during the year Maturity and interest terms on loans and overdrafts Confirmation of contingent liabilities on guarantees etc Confirmation of securities and other items in safe custody Any offset or other rights or encumbrances Collateral given or received

(Note: Only six were required.) (c) The bank reconciliation is carried out because the balance on a company 's general ledger cash account is unlikely to match the figure in the year-end b ank statement because of timing differences for cheques and other payments and r eceipts clearing. The bank reconciliation is an exercise to compare the balance

per the ledger and the balance per the bank statement and therefore to confirm t he accuracy of the figure on the company's statement of financial position. 21 Understatement (a) (i) It is more likely that payables will be understated than over stated because of the nature of the evidence available to indicate that liabilit ies exist. It is relatively simple to ensure whether a recorded liability has been correctl y accrued at the year-end. However it is more difficult to identify liabilities which have been omitted from payables. (ii) The auditor's difficulty in ensuring that payables are not understated arise precisely because of the circumstances described above. The auditor can t est accrued invoices to ensure that they are a valid liability of the company at the year-end date. However, identifying liabilities which have been omitted at the year-end presents a more difficult problem. As there may be no direct eviden ce of the liability (say an invoice) understatement may have to be identified us ing indirect evidence for example unmatched pre-year end goods received notes, p ost- year end cash book entries. (b) Audit work to verify trade payables and purchase accruals would be as f ollows. (i) Purchases cut-off As goods received notes are not used the normal procedures for auditing cut-off will need to be adapted. (1) Examine purchase invoices on either side of the year-end to dated suppl iers delivery note to ensure invoices have been correctly accrued. (Where the go ods received

384 Exam answer bank department have not date-stamped the delivery date it will be necessary to use t he suppliers despatch date.) (2) Enquire if the goods received department or bought ledger department a re holding any unmatched delivery notes (those without an invoice) relating to t he period before the year-end. (ii) Completeness, existence and ownership

(1) Select invoices from the trade payables listing and trace to supporting documentation to ensure that the purchase was for the purpose of the business. (2) Reconcile a sample of suppliers' statements with purchase ledger balanc es. This will highlight any purchases that have been omitted. Where there are ma jor accruals for which statements are not available it may be necessary to carry out a payables circularisation. (A circularisation is not normally the primary procedure to be selected as the suppliers statement provides more effective evid ence and a reconciliation is simpler to carry out than a circularisation.) (3) Review balances for unusually low balances with major suppliers.

(4) Compare the ratio of trade payables to purchases and inventory with the previous year's figures. (5) Match cash payments posted in purchase ledger accounts before and after the year- end to cash records to ensure they were posted in the right period.

(iii)

Trade payables listing

(1) Agree the total unpaid invoices and credit notes to balances on the age d payables listing. (2) Agree the total of balances on the aged payables listing to the purchas e ledger control account. (3) . Agree the list of balances to individual ledger accounts and vice versa

(4) Review the listing for large payable balances and enquire into reasons for them and action being taken. (5) Review the control account around the year-end for unusual items.

(c) Sundry payables and accruals is an area that lends itself to analytical review and reconciliation techniques, except for liabilities such as income tax and sales tax which should be checked in detail. (i) From the sundry payables and accruals listing confirm that the calcula tion of accruals is reasonable and verify to subsequent payments. Income tax and related deductions liabilities should also be verified to payroll. (ii) Scrutinise post year-end payments/invoices received to check for under statement of sundry payables and accruals. (iii) Ascertain whether any expenditure is likely to be invoiced a long time after the goods or services are received. (iv) Compare sundry payable and accruals with prior year balances and inquir e into significant variations. (v) Check that the sales tax accrual is disclosed at correct amount by vouc hing to returns and accounting records. (vi) Ensure that no non-deductible tax is reclaimed on the return, by scruti nising it. (vii) Vouch payments or refunds of sales tax to cash book from sal es tax returns. (viii) Obtain sales tax returns for the period and check that they have been p roperly prepared and filed promptly. Exam answer bank 385 (ix) Test sales tax totals from prime records to monthly/quarterly summaries and test cast summaries and scrutinise for unusual items. (x) Review correspondence with taxation authority and results of any recent control visits. 22 'Tap!' (a) Audit risks

There is a higher audit risk associated with a charity as in the event of proble ms arising and litigation taking place, the audit firm could experience a signif icant amount of bad publicity. Inherent risks

(i) Cash. The charity operates with a high number of cash and cheque trans actions. A substantial part of their income comes from cash donations. Put anoth er way, it is likely that very little of their income comes from direct bank tra nsfers. Also, it is likely that many of the expenses which 'Tap!' incurs are als o cash expenses. Cash is risky for audit purposes because it is susceptible to l oss, miscounting or misappropriation. (ii) Charity. The theatre company is a charity, and is therefore subject to a high degree of regulation. This raises the risk for our audit. (iii) Accounting specialist. The charity employs an administrator, but there is no mention of an accountant. It is unclear who is going to draft the charity accounts (which must comply with specialist requirements) but it does not appea r that a specialist exists to undertake this job. This increases the risk of err ors existing in the accounts. (iv) Completeness of income. As the charity appears to have no control over the primary collection of income from box office receipts, there is a significan t risk that income is understated and that the theatres have not accounted prope rly to the theatre. (v) Disclosure of income. The disclosure of income must be considered. It i s unlikely to be appropriate to show the 'net income from theatres' figure. Rath er, the gross income less commission should probably be disclosed. (vi) Expenditure. The charity expenses may be well-recorded, or they may be difficult to substantiate this is not clear. It may also be difficult to substan tiate payments made to build wells in Africa. We currently have no knowledge abo ut how that aspect of the charity operates. It will be important to check that e xpenditure is made in accordance with the trust deed. Some essential administrat ive expense will not necessarily be conducive to the aims of the charity. We mus t ensure that it is all analysed correctly. Control There currently appear to be no controls over cash in the charity. Detection This is a first year audit, so there is little knowledge of the business at pres ent. It is also the first ever audit of the charity, so the comparatives are una udited. We must make this clear in our report, and we will need to undertake mor e detailed work on the opening balances. As the charity is to a large degree per ipatetic, we may find audit evidence difficult to obtain, if it has not been pro perly returned to the administrative offices. Conclusion This appears to be a high risk first year audit. It is likely to result in a mod ified audit opinion. (b) Audit procedures Income from box office takings Income from box office takings can be verified to the statement from the theatre and the bank statements to ensure that it is complete. The commission can be ag reed by recalculation. 386 Exam answer bank

It might be necessary to circularise a number of the theatres and request confir mation of the seats sold for each performance to ensure that income is completel y stated on the return from the theatre. (However, if theatres have been defrau ding the charity, they are unlikely to confirm this to the auditors. This may ha ve to be an area which is aided by stronger controls over income.) Income from buckets (theatres and streets) We must discover whether the charity fills out 'counting sheets' when the bucket s of money are originally counted. If so, the money in buckets can be verified f rom the original sheet to the banking documentation. However, in the absence of strong controls over the counting, it will be impossi ble to conclude that this income is complete. Income from other donations Donations made over the phone should have been noted on documents and then retai ned at the administrative offices. Donations made by post should have original d ocuments. A sample of these should be traced to banking documentation and bank s tatements. Again, in the absence of originating documentation, it will be difficult to conc lude that income is fairly stated. (c) Controls over cash

Income from box office takings It would be a good control over completeness of income to request a schedule of seats sold from the theatres for every night a performance is given. This is lik ely to be information that theatres can print off their systems with no trouble. This will lead to the theatre company having more assurance as to the completeness of income. Income from buckets As this income is highly susceptible to loss or misappropriation, strong control s should be put in place: (i) Number of people. If possible, the charity should assign two people to each bucket during the collection phase and two people should count the money i n the bucket at the end of the day. These people will act as a check on each oth er to ensure that cash is kept more secure. (ii) Security. The security arrangements for buckets should be strong. The charity could invest in a transportable safe in which to store the money between collection and banking. It might also be wise to use collecting tins rather than buckets, as this simple me asure would ensure that the cash was less open to the public. The cash should al so be banked frequently. It should not be kept unbanked for longer than 24 hours after collection. (iii) Recording. A record should be made of cash counts and it should be si gned by both the people that undertook the count. These can provide an initial r ecord of the cash takings. Other income The controls over other income will be restricted by the number of staff at the

provincial office. It appears that only the administrator may work there regular ly. If this is the case, it is going to be difficult to introduce supervision i nto the cash operations. All phone donations should be recorded on pre-numbered documentation so as to gi ve evidence of completeness. As the administrator largely works alone, it would be a good idea for the Board of Trustees to carry out a cyclical review of the work of the administrator. Thi s would provide useful protection from problems for both the charity and the adm inistrator.

Exam answer bank 23 Going concern Workings

387

The following significant accounting ratios are based on the accounts provided i n the question. 20X2 20X3 Gross profit (%) .90 14.20 Other expenses: sales (%) 14.40 Interest: sales (%) 1.10 5.20 Net profit (%) (1.10) (5.40) 0.73 0.73 Liquidity ratio 0.59 0.46 Leverage (%) 7.14 9.52 Inventory (months) .28 2.26 Receivables (months) 6 3.24 Payables (months) .43 4.43 Notes Inventory age Receivables' age = Payables' age = = 20X4 20.20 14.40 5.50 0.30 1.39 0.76 0.37 9.45 2.77 2.26 4.43 0.80 0.34 84.71 4.83 1.68 3.57 1.75 2.32 2.26 5.09 5 2 3.6 5 15.30 0.90 6.20 8.50 (1.80) Current ratio 0.91 20X5 23.50 19.70 14.10 10.90 20X6 10

Year - end inventory Cost of sales Year - end receivables

Sales Year - end payables Sales 12 12 12 Leverage Shareholders' equity Shareholders' equity = Long - term loans Bank overdraft Lease

(a) The various factors in the accounts which may be indicative of going co ncern problems are as follows. (i) Only losses or low profits are being made and the company is not gener ating sufficient funds to finance the expansion required (ii) There has been a dramatic increase in the level of overdraft over the last year and there seems little prospect of the borrowing being reduced and the security is threatened. (iii) There are signs of overtrading as the expansion has been financed by b orrowings and the increase in current assets is being financed by trade accounts payable. (iv) The leverage is low and decreasing, with very little security being ava ilable for the loans. (v) There is a low current ratio and short-term funds are being used to finance long-term assets. (vi) The liquidity ratio is low and decreasing and the company's ability to meet its liabilities on demand must be very questionable. (vii) Inventory levels are increasing, suggesting that one or more of the fol lowing problems may exist: deteriorating sales, poor inventory control, obsolete or slow-moving inventories. (viii) The value and age of trade accounts payable are increasing: some suppli ers must be having to wait a considerable time before being paid and it can only be a matter of time before pressure is put on the company by one or more of its creditors. (ix) High and increasing interest charges make the company very vulnerable, especially in a period of recession and high interest rates. (x) The fluctuating gross profit would suggest that the company's profit ma rgins are under pressure. The present level of gross profit does not seem suffic ient given the company's high level of expenses. 388 Exam answer bank (b) The other important steps to be taken by the auditors in determining wh ether or not the company may be properly regarded as a going concern at the year -end would include:

(i) Review carefully the cash and profit forecasts for the next year to se e if they suggested any improvement in the company's position (ii) Seek some evidence that the company's bank is prepared to continue sup porting the company (iii) Review the level of post year-end trading to see if this supports the forecasts and show any signs of improvement in the company's position (iv) Examine correspondence files for any evidence that suppliers might be p utting pressure on the company for repayment of monies owing (v) Consider how the company's position compares with similar companies in the same business (vi) Discuss generally the situation with management and review any recovery plans which they may have in mind 24 Audit review and finalisation (a) The auditor shall perform audit procedures designed to obtain sufficien t appropriate audit evidence that all events up to the date of his report that m ay require adjustment or disclosure in the financial statements have been identi fied. These procedures should take place as near as possible to the date of the auditors report. They would include, for example, reading minutes of meetings with shareholders and audit committee meetings, reviewing the entitys la test interim accounts, and reviewing procedures that management have for identi fying subsequent events. The auditor shall request management and those charged with governance to provide a written representation that all subsequent events r equiring adjustment or disclosure have been adjusted or disclosed. The auditor has no obligation to undertake audit procedures or make inquiries re garding the financial statements after the date of the auditors report. Between t his date and the date of issue of the financial statements, it is the managements responsibility to inform the auditors of any facts that might affect the financ ial statements. If such facts do arise which the auditor becomes aware of, he sh all consider whether the financial statements need amending, discuss the matter with management and take appropriate action. If the financial statements are ame nded, a new audit report must be issued. If management refuses to make any amend ments required, the auditor shall modify the opinion. After the financial statements have been issued, the auditor has no obligation t o make any inquiry regarding the financial statements. Where the auditor becomes aware of facts that may affect the financial statements after they have been is sued, he shall consider whether they need to be revised and shall discuss with m anagement and take appropriate action. If amendments are made to the financial s tatements, the auditor shall issue a new audit report which shall include an emp hasis of matter paragraph referring to a note in the financial statements that d iscusses the reason for the revised financial statements in more detail. (b) Written representation letter: Addressed to the auditor. Signed and dated, normally the date of the auditors report.

Acknowledgement from management for the design and implementation of int ernal control to prevent and detect error.

 A statement that management believes that the effects of uncorrected mis statements are immaterial, both individually and in aggregate. The letter should contain a summary of these items.

Exam answer bank 389 A statement confirming the completeness of information provided regardin g the identification of related parties. A statement that the financial statements are free from material misstat ements, including omissions. A statement that the management have made available to the auditors all books of account and supporting documentation and all meetings of minutes of sha reholders and the Board of directors. A statement that the entity has satisfactory title to all assets and the re are no liens or encumbrances on the entitys assets, except where disclosed in the notes to the accounts. A statement that all liabilities, both actual and contingent, have been disclosed in the accounts, as well as any guarantees to third parties. A statement that there have been no events subsequent to the year-end wh ich require adjustment or disclosure in the accounts, other than where specifica lly disclosed in the accounts. (c) The auditors must perform and document an overall review of the financi al statements before they can reach an opinion. This review gives the auditors a reasonable basis for their opinion on the financial statements. At the review s tage, the auditors consider compliance with accounting regulations, consistency and reasonableness and application of accounting policies. Analytical procedures are a very useful tool at this stage of the audit. They ca n be used to calculate important accounting ratios, changes in products or custo mers, price and mix changes, variances, trends in production and sales and varia tions caused by industry or economic factors. Any significant fluctuations and unexpected relationships must be investigated through inquiries with management and obtaining appropriate audit evidence relevant to managements responses, and p erforming other audit procedures considered necessary in the circumstances. 25 Wiseguys National Bakeries (a) Freehold property

In past years this property has been shown in the statement at its original cost , whereas it is now restated at $1,250,000 as professionally valued during the y ear. The auditor is satisfied as to the basis of the revaluation, adjustment to and disclosure made in the financial statements. As a result of the audit eviden ce obtained no further reference to the property revaluation will be required i n the auditors report. (b) Allowance for doubtful debts

No part of the debt of $45,000 due from XYZ Co will be recovered by the company. Since the financial statements which the directors have approved include no all owance for this debt, it will be necessary for the auditors report to state that:

(i) No allowance has been made against an amount of $45,000 owing by the c ustomer. (ii) They believe such amount to be irrecoverable. (iii) In their opinion, except for the failure to make such allowance, a tru e and fair view of the state of the company's affairs and its results is given b y the financial statements. (c) Loan to a director

Since the director's indebtedness of $22,000 which subsisted during a six week p eriod, has not been disclosed in the financial statements in accordance with IAS 24 Related party disclosures, the auditors are obliged to include in their repo rt an explanatory paragraph giving the required disclosure. The particulars include: (i) (ii) The amount of the loan and any interest The zero outstanding balance at the year-end

390 (iii)

Exam answer bank Terms and conditions

The auditors report will conclude with the statement of their opinion that the fi nancial statements, except for the information specified above, give a true and fair view. 26 Builders Merchants (a) This represents a potential material limitation on scope because the 'm issing' inventory represents 12% of the total. The auditor would expect all inventory counting sheets to be a vailable. The auditors opinion would be modified. The auditors report would include a basis of qualified opinion paragraph before t he opinion paragraph which would refer to the fact that the inventory counting s heets for this depot were lost. The qualified opinion paragraph would state that "except for" adjustments that may have been necessary in relation to this inven tory, the financial statements present fairly, in all material respects (or give a true and fair view). The auditors report would also state that in relation to inventory quantities: and The auditor was unable to determine whether proper accounting records we re kept. (b) This represents a material misstatement. The debt represents 8% of the total receivables balance and 45% of the profit for the year. The auditors opinion would be qualified. The basis of qualified opinion paragraph would refer to the fact that the custom er is in liquidation and there is little prospect of payment. It would also stat e that net assets and profits are overstated by $45,000. The qualified opinion paragraph would state that "except for" the absence of thi s allowance the financial statements present fairly, in all material respects (o All information and explanations considered necessary were not obtained;

r give a true and fair view). (c) As the client is listed, its financial statements should include a stat ement of cash flows. The auditors opinion should therefore be qualified as the financial statements ar e materially misstated. This disagreement is not pervasive to the financial stat ements, it is limited to the statement of cash flows, so this would be a qualifi ed opinion. The basis of qualified opinion paragraph will refer to the fact that the financi al statements do not contain a statement of cash flows and include the figures r equired, and the qualified opinion paragraph will state that the financial state ments give a true and fair view and have been properly prepared in accordance wi th an applicable financial reporting framework except for the omission of a stat ement of cash flows. (d) The auditors need to determine whether the legal claim is a material mat ter and even whether it is pervasive to the financial statements as a whole. For example, if the customer involved is a major customer, it could be that an adv erse outcome could affect the going concern basis of the company. It appears that the disclosure in the financial statements is adequate and there appears to be no basis on which to make a provision in the financial statements . However, the auditors report will be affected by the fact that there is an unce rtainty affecting the business. The auditor will have to decide whether the inherent uncertainty is fundamental to users understanding. If so, the auditors report should include an emphasis of matter paragraph beneath t he opinion paragraph with details of this matter. It should also state that the auditors opinion on the financial statements is not modified in relation to this matter.

Exam answer bank

391