Auditing Process

Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
PENGAUDITAN II
The insurance hypothesis suggests that the auditor can
CHAPTER 1 provide insurance to people relying upon the audited
Why are Auditors needed ? information, as they can recover damages from negligent
auditors. A successful damages claim against the auditor is
effectively the equivalent of a successful claim against an
Auditing insurance company.
Auditing has become headline news after recent corporate
scandals, and the competence and independence of Accuracy of accounts
auditors have been questioned, focusing attention on the Difficulties in proving the accuracy of accounts include:
purpose of audit and the way in which companies are (a)insufficient evidence;
managed. (b)judgement involved in the preparation of accounts in
such matters as: useful lives of fixed assets;saleability or
Several important auditing issues are considered: usability of stock; collectability of debtors;and profit to be
(a) the distinction between the position of manager and of taken up on a long-term contract.
owner not involved in management;
(b)audit as a search for evidence; The most that can be expected is that financialstatements
(c)the use of simple procedures to test management give a reasonable picture; what isreasonable depends on
assertions viewpoint and theinformation available to the user. In most
(d) the idea that information breeds information; bookkeeping areas accuracy is expected :
(e) the importance of management integrity;
(f) professional scepticism; (a) debtors properly recorded;
(g) the distinction between personal and business expenses; (b)stock accurately counted; and
(h) the role of the accounting system in achieving accurate (c)trade creditors and fixed assets completely and
bookkeeping accurately determined.
(i) the use of information from an independent source;
(j) actual personal experience as a valuable source of Truth and fairness is not easily defined but we expect
evidence. accounts:
(1) not to mislead the reader;
Justifications of audit (2) to contain a certain degree of accuracy;
Three justifications of audit are: (3)to be supplemented by explanatory notes;
the information hypothesis; (4)to give a reasonable view of financial affairs and results;
agency theory; (5)to be proved true and fair (or not) on the basis of
the insurance hypothesis. sufficient, appropriate audit evidence.
The information hypothesis suggests auditors are needed Framework of audit assignment
because information becomes more reliable as the result of The typical basis framework for a larger audit assignment
audit, and is therefore more useful to decision makers. comprises:
Agency theory suggests audit is justified because providers (1) preliminary stages;
of resources cannot trust managers to use resources (2) systems work and transaction testing;
properly on their behalf .Basic ideas behind of agency (3) preparation for final work;
theory are: (4) final work..
(a)principals and agents both try to maximize their own AUDIT PROCESS
wealth; Preliminary stages
(b) a monitoring mechanism in the form of a financial report
is required, and is advantageous to both principals and 30 March 2006
agents; Firm asked to carry out work.
(c) different groups of rational individuals have different
information, allowing informed individuals to profit at 3 April 2006
others expense; Meeting to discuss terms of reference; forms the basis for
(d)agents recognize that principals will be more willing to the letter of engagement.
believe performance reports if verified by an independent
party; (e) professional external auditors are the most cost- 2428 April 2006
effective monitoring device. Visit company to familiarize audit firm with industry and
company. Meet with management. Prepare first (global)
plan and free estimate.
M a t a k u l i a h l a i n y a n g b e l u m a d a d i P D F i n i a k a n s a y a u p d a t e d i www. a k u n t a n s i d a n b i s n i s . wo rd p re s s . c o m
Contac t me : muhammad.f irman177@gmail.com /@f irmanmhmd (Line) 836
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2 May 2006 An audit is an investigation or a search for evidence to

Write confirming fee estimate and proposed dates for enable an opinion to be formed on the truth and fairness of
carrying out examinations. Issue a memo assessing any financial and other information by a person or persons
matters that need attention independent of the preparer and persons likelyto gain
Systems work and transactions testing directly from the use of the information, and the issue of a
3 weeks from 9 October 2006 report on that information with the intention of increasing
Interim examination of the firms accounting and internal its credibility and therefore its usefulness.
control systems. Work directed towards this area.
Another, from the Audit of Financial Statements, is:
15 November 2006 An exercise whose objective is to enable Auditorsto express
Memo on internal control / management letter. This can an opinion whether the financial statements give a true and
be delayed until the final audit but if there are serious fair view of the entitys affairs at the period end and of its
weaknesses it would be wiser not to delay. profit or loss (or income and expenditure) for the period
then ended and have been properly prepared in accordance
Final preparation with the applicable reporting framework (for example
45 December 2006 relevant legislation and applicable accounting standards).
Review arrangements for end-of-year stock counts and
accounts; discuss any known problems and any new Fundamental Principles of Independent Auditing
financial reporting standards The Nine Fundamental Principles of Independent Auditing
cover the following areas and comprise the Auditors Code
30 December 2006 (1)accountability;
Attend stock count, observe company procedures, make (2)integrity;
test counts and write stock count memo for working papers. (3)objectivity and independence;
Event. (4) competence;
(5) rigour;
Final work (6) judgement;
3 weeks from 12 March 2007 (7) clear communication;
Carry out a review of new draft accounts and verification (8) association;
procedures on assets and liabilities, including post-balance (9) providing value
sheet events work.
EXERCISE
2 April 2007
Review working papers, discuss audit results with 1. Which of the following people do you think would wish to
management and include amendments, obtain a be certain that the financial statements of a major public
management representations letter, check records agree company had been properly prepared?
with the accounts. Directors sign financial statements.Issue (a) The ordinary shareholders.
audit report. (b) The employees.
(c) People thinking of buying shares in the company.
2 May 2007 (d) The Inspector of Taxes responsible for the tax affairs of
Send note of charges for audit and other professional the company.
work.Event. (e) A member of the public.
(f) A supplier of goods to the company.
Role of audit (g) The government
Audit may have specific roles in relation to many different (h) The council of the local Stock Exchange.
organizations: Examples might include :
local authorities 2. If Andrew and James in our simple case had said that
universities motor expenses amounted to 4000, suggest:
water companies (a) What kinds of expenditure would probably be included
hospitals in the heading motor expenses.
nuclear power stations (b) How you would satisfy yourself that the amount of each
charities expenditure heading was reasonably accurate.
Assurance services are usually held to mean a broad set of 3. Why do you consider that audit might be seen to be
services deigned to improve quality of information. necessary in the case of an engineering company whose
Auditors are in a good position to provide services such as employees operate dangerous machinery? Suggest
these but this may pose a threat to independence. appropriate audit objectives, but do not restrict yourself
Important issues are: just to financial audit.
(a) users value reliable accounts; ANSWERS

(b)auditors must be competent;
(c)audit is a search for evidence; 1. The simple answer to this question is 'all of them'. Let us
(d)auditors should adopt an attitude of professional go through the list one by one and justify this answer:
scepticism.
(a) The shareholders are the providers of capital and they
There have been many definitions of audit. One is: are entitled to know how successfully the directors have
been running the company. The accounts should also aid
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them to some extent in the decision to hold onto or to sell all instances.
their shares, although in practice they would be wise to
seek further advice before doing so. This may be particularly the case with regards to petrol. We
(b) The employees are intimately connected though their would have to question Andrew about distances travelled
employment and rate of pay is likely to be dependent on and miles per gallon. Experienced auditors would probably
the success of the company. It would seem, therefore, that be able to determine whether the figure appeared
they too have an interest in properly prepared accounts. reasonable or not, although, without more information, it is
(c) These people are potential shareholders and they want difficult to say whether they would be able to report that
to make a decision as to whether to buy shares or not. One the motor expenses figure was acceptable. However, the
of the sources of information available to them will be the above suggestions do give an idea as to how auditors might
company's financial statement so they are clearly interested proceed.
in those financial statements being properly prepared.
Again, it would be wise to seek further information about 3. Companies whose employees operate dangerous
the company before doing so. machinery are required by law to have proper safety
(d) The starting point of the tax computation of taxable procedures in force. In this case the audit helps to ensure
income is the accounting profit before taxation. The compliance with the law and identifies hazards that aid the
inspector is clearly interested in properly prepared financial protection of employees.
statements. Audit objectives would include:
(e) As an example of a major public company, British - ensuring that the company has proper rules concerning
Telecommunications plc is an important UK company. Its the use of the dangerous machinery
success or failure has a vital bearing on the success of the - ensuring that the company has training schemes for
UK economy and in view of this, all residents of the UK are employees in the operation of the machinery and in the
concerned in the proper preparation of financial statements understanding of safety measures, such as protective
by the company. (If you are not a resident of the UK, take an screens
example from important companies in your own economy). - ensuring that staff are aware of the procedures to be
(f) Suppliers of goods to a company are interested in the adopted in the case of accident
health of that company; in the short term they wish to be - being satisfied that the incidence of accidents is at a
paid for goods supplied; in the longer term to know if the minimum.
customer is a valuable long-term business partner. The
same kind of considerations apply to customers and to
competitors, all members of what the Corporate Report CHAPTER 2
refers to as 'the business contact group'). An Overview of the postulates and concepts of
(g) The Government of any country is concerned with the
success or failure of the component parts of the economy. Auditing
In addition, in so far as governmental statistics are often
based on accounting information, it will also be interested
in the validity of that information.
(h) Taking BT as an example again, its published accounting Definiton of postulate
information has a direct bearing on the quoted price of Theories underpin practice. Mautz and Sharaf (1961)
shares, and the stock exchange has a very clear interest in suggest that a philosophyhas three aspects of value:
valid accounting information. (1) it gets back to first principles;
(2) systematic organization of knowledge;
Students should refer to the Corporate Report published by (3) provides a basis for moulding and understanding social
the Accounting Standards Steering Committee in 1975 for a relationships
discussion of these matters.
Postulates are essential to the development of an
2. This is a question that is designed to start you thinking intellectual discipline and are the foundation for any
about the audit process. Andrew has stated that the motor theoretical structure. Postulates are not theories but are
expenses amount to 4,000; the duty of the auditor would the necessary basis for theory; assumptions that do not
be to prove that the assertion was a valid one. The first step lend themselves to direct verification, but are a basis for
would be to consider the types of expenditure that would inference, even if susceptible to challenge later..
be included under this heading. Suggestions are:
(a) Vehicle licence fee The chapter discusses two postulates formulatedby Flint:
(b) Insurance (a) The subject matter of audit is susceptible to verification
(c) Petrol by evidence
(d) Servicing (b)Essential distinguishing characteristics of audit are the
independence of status and freedom from investigatory and
Vehicle licence fee and insurance would be quite easily reporting constraints.
dealt with. An inspection of the relevant invoice and policy
would readily provide information about the charge to the Postulate may not hold good for ever. One example from
profit and loss account and the amount of prepayment, if Mautz and Sharaf, that may no longer be valid:
any. If there has been servicing of the lorry during the six- There is no necessary conflict of interest between the
month period, an inspection of invoices would reveal the auditor and the management of the enterprise under audit
amount. It is to be hoped that Andrew has kept the
invoices, although his system for recording income would Flints audit postulates
not give us much reason to suppose that he has done this in
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1 The primary condition for an audit is that there is a

relationship of accountability or a situation of public Credibility
accountability. Credibility is about whether people believeauditors when
2 The subject matter of accountability is too remote, too they report. Credibility concepts concern the personal
complex and/or of too great a significance for the discharge qualities of auditors: competence,independence,integrity
of the duty to be demonstrated without the process of audit and ethics .
3 Essential distinguishing characteristics of audit are the
independence of its status and its freedom from
investigatory and reporting constraints.
4 The subject matter of audit, for example, conduct,
performance or achievement or record of events or state of
affairs or a statement of fact relating to any of these, is
susceptible to verification by evidence
5 Standards of accountability, for example, conduct,
performance, achievement and quality of information,can
be set for those who are accountable: actualconduct, etc.
can be measured and compared withthese standards by
reference to known criteria andthe process of measurement
and comparison requires special skill and judgement
6 The meaning, significance and intention of financialand
other statements and data, which are audited,are
sufficiently clear that the credibility given theretoas a result
of audit can be clearly expressed andcommunicated.
7 An audit produces an economic or social benefit.
Mautz and Sharaf also suggest that:
Concepts provide a basis for advancement in the field of
knowledge by facilitating communication about it and its
problems.
Concepts of auditing
Process
Ethical dilemmas arise where damage will be caused to
someone whatever you do; they require analysis of the
situation, consideration of possible actions and
consequences, and a firm decision.Auditors should comply
with ethical guidanceissued by their relevant professional
bodies.
Process is concerned with how audits areperformed, with:
(a) seeking evidence to prove assertions by management;
(b) evaluating the risk;
(c) making judgements and assessments of significant
matters.
Communication
Communication concerns the manner in which and to
whom auditors communicate their views to other parties,
There are four parties to the accountability /audit process: whether formally or informally. Truth and fairness is an
1)preparer/source; important element, but has never been defined; basically it
2)users of accounting information; is about the validity of the message given by the financial
3)auditor; and statements....KEY POINTS pp.4546Performance concerns
4)regulatory framework. several issues that auditors are expected to perform their
work with due care; in accordance with accepted standards
There is a close relationship between accountability and and; with rigour (encompassing professional scepticism).
audit, as accounts cannot become a tool of accountability
until an independent auditor has examined and reported on Performance
them.
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The Audit expectations gap is used to describe The companies control themselves.The external environment is
difference between the expectations of thosewho rely upon also vital in influencing the kinds of controls, and
audit reports concerning whatauditors do and what they managements approaches to them, within the internal
are perceived to do. The gap consists of: environment of a company
1)reasonableness gap;
2)performance gap.
The reasonableness gap arises because people expect more EXERCISE
of audit than is possible practically.The performance gap is
that between what canreasonably be expected of auditors 1. Identification of management assertions in respect of
and what theyare perceived to do, and has two figures in the financial statements is a vital part of the audit
components: process. State whether you agree with this statement,
1)deficient standards gap; giving practical examples.
2)deficient performance gap.
2.Explain what is meant by the principle of auditor integrity.
Layers of regulation and control How do you think we should ensure that the principle is
Layers of regulation and control are described under two adhered to?
headings:
(a)external environment; 3. Auditors are expected to approach their work with
(b) internal environment. thoroughness and with an attitude of professional
scepticism. What do you think that professional scepticism
means in practice?
4 .You are auditing a company that shows a loss for the year
of 700 000. This figure is after charging impairment of
property, plant and equipment of 1 500 000. As a part of
your work you note that in the Directors Report a profit of
800 000 is quoted as profit for the year. What are your
responsibilities in respect of this matter?
ANSWERS
1 .Whether managers actually prepare a list of assertions
that they make about figures in the financial statements or
on the quality of internal controls is perhaps doubtful.
However, there are many implied assertions made by
management when they include balances or figures in the
financial statements. Thus, examples of what management
is implying in relation to trade receivables are:
a) Balances are genuine, that is, they represent amounts
legally due to the company for goods in respect of which
property has passed or for services rendered before the
balance sheet date.
b) The amounts stated as due to the company in respect of
trade receivables will be received in full, the implied
Layers of regulation and control indicate thatregulation and assertion here being that full provision for bad and doubtful
control operate at different levels both outwith and within a debts has been made.
company. The external environment includes all commercial c) All customers balances on credit are reflected in the trade
relationships the company has with competitors, customers receivables figure in the financial statements.
and suppliers.It includes other companies with which it
cooperates, and providers of funds. The value to the auditor of identifying the assertions is that
the evidence search can be conducted with specific
The external environment is a vitally important factor objectives in mind. Thus, in respect of a) above, the auditors
influencing the kinds of controls and managements will direct their attention to proving that credit sales are
approaches to them within the internal environment of completely and accurately recorded. This work would
companies.Corporate governance refers to structures include obtaining assurance that sales and inventory cut-off
within a company or imposed by society to control how is accurate to ensure that trade receivables represent
companies are governed amounts due at the balance sheet date. Specific tests would
include a credit customers circularisation. The evidence
The regulatory framework comprises controls imposed by a search in respect of collectability would start from the
wide range of bodies including parliament, stock exchanges, assumption that amounts recorded are legally receivable.
accounting and other bodies of the European Union, or
even from outside the European Union. The objective in this case would be to prove that the
valuation of trade receivables is valid. To this end, the
Commercial pressures in the external environment are auditor will examine credit customers ageing statements
important because the way the market behaves will have an and look at the past record of payment by them. Other
impact on company performance and the way in which procedures would include examining payments by credit
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customers after the balance sheet date and testing for than if you had not formed these conclusions.
adherence to properly determined credit limits.The above
argument leads to the conclusion that the statement is 4 . This matter is covered by the principle of Association.
valid. Basically, identification of assertions is important from The directors appear, on the face of it, to be misleading the
the point of view of both the effectiveness and efficiency of readers of the Directors' Report and there certainly seems
the audit process. to be conflict between the profit shown in that report and
the loss shown in the Financial Statements. The readers
2 .The Auditors Code suggests that the principle of integrity would probably be very confused in the case cited and this
means that auditors fulfil their responsibilities with honesty, might cause them to form the opinion that the auditor has
fairness, candour, courage and confidentiality. The problem not been competent. The auditors would ask the directors
with words like integrity, honesty, fairness, candour, to change the Directors' Report, and if they refuse they
courage and confidentiality is that they are all intangible would have to refer to the matter in the Audit Report,
qualities and therefore difficult to assess. In practice, the probably as an emphasis of matter.
only way that we can assess whether, for instance, people
are honest and fair is to observe their behaviour. We might
conclude that some circumstances hinder honesty in the CHAPTER 3
performance of an auditor's duties. Such circumstances The Meaning and Importance of Auditor
might include the holding of shares in the company or being Independence
a personal friend of the managing director.
This means that apart from highlighting integrity as an
important personal quality of the auditor, it is necessary to Principle of independent auditing
back up the principle by giving guidance to auditors on how A fundamental principle of independent auditing isthat:
integrity can be achieved. The question of appearance is a Auditors are objective. They express opinions independently
very important one and the profession has recognised for of the entity.Flint suggests that audit is part of the public
some time that being seen to be independent is just as and private control mechanism of monitoring and securing
important as being independent. The same applies to accountability. Two elements are present if a true bond of
integrity. It can be argued, of course, that auditor accountability is to exist:
reputation is so important that auditors will strive to
maintain their integrity and independence as a matter of (a)an account;
course. Integrity is certainly a quality that a profession (b)a holding to account.
would expect to see in its members and it could be argued
that by publishing the principle of integrity APB is merely But financial statements are only an accountability
emphasising a general professional requirement. document if credibility is added by an independent
auditor.There are five broad classifications of
3. You will have noted that the Auditors Code says that accountability:
auditors assess critically the information and explanations (1) political;
obtained in the course of their work and such additional (2) public;
evidence as they consider necessary for the purposes of (3) managerial;
their audit. The word 'critically' is in fact the important word (4) professional;
in helping us to understand what is meant by professional (5)personnel.
scepticism. The expression does not mean that auditors
should approach their work with undue suspicion, but that Lee suggests the need for independence derives from the
they should not accept statements by management or remoteness gap between managers and stakeholders. The
documentation at face value. independent and competent auditor with adequate powers
bridges the gap between them..Mautz and Sharaf identified
By way of example, let us assume that you are auditing a two types of independence.
publishing company and that you have noted that the
warehouse contains 20,000 unbound copies of one 1. Practitioner independence (a state of mind
particular book. You raise the matter with management and comprising programming, investigative and
they inform you that 15,000 copies have been sold to reporting independence).
wholesalers after the balance sheet date, showing you 2. Profession independence (the existence of built-in
orders from the wholesalers to support their assertion. You anti-independence factors).
should not assume that management is misrepresenting the
position to you, but as auditor you would need to look for Practitioner independence is basically a state of mind with
evidence to prove their assertion. three dimensions:
1)programming independence;
You might check, for instance, that the unbound copies are 2)investigative independence;
in respect of a current edition. 20,000 copies of the 4th 3)reporting independence.
edition of The Audit Process might not be saleable when the
5th edition is already available. One important point to Dimensions of practitioner independence
emphasise is that audit work does not take place in a Three dimensions of practitioner independence are :
vacuum. If you have already concluded that management
quality and trustworthiness is high and that there are no Programming independence
indications that the company might be in financial trouble, 1a Freedom fromany managerial interference aimed at
the audit work would be carried out in a different context changing the outcome of the audit
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2a Freedom fromanyinterference with regard to the

application of procedures Shockley produced a conceptual model to aid researchers
3a Freedom fromattempts to subject the audit to review and regulators, based on factors that may impact on the
other than that provided for auditors ability to withstand pressure as shown below :
Investigative independence
1b Direct and free access to all necessary information and
individuals
2b Active cooperation frommanagement during the course
of the examination
3b Freedom from managerial attempts to control what is
audited and establish the acceptability of evidential matter
4b Freedom from personal interests or relationships leading
to exclusion from or limitation of any part of the report
Reporting Independence
1c Freedom from loyalty or obligation to external parties
2c Avoidance of the need to exclude matters from the
formal report in favour an informal report Reporting
independenceInvestigative independence
3c Avoidance of the use of ambiguous language when
stating or interpreting facts, opinions and recommendations
4c Freedom from any attempt to overrule the auditors
judgement as to the appropriate content of the report
Regarding profession independence, Mautz and Sharaf
suggest that auditing suffers from built-in anti-
independence factors. Features that may affect perception
of a practitioner as a member of the auditing profession are
outlined in Table below :
Reasons to question auditor independence :
Watts and Zimmerman discuss auditors monitoring

activities in the context of manager-agents contracts with
owner-principals. To be of value the auditors must report
significant matters of concern. The probability of this taking
place is likely to be high because of adverse effects on
reputation should their failure to report comes to light.
Goldman and Barlev identify possible areas of conflict:
between auditor and client;
between professional duty and self-interest;
between managers and shareholders;
between client organization and third parties.
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4. size;
5. accounting flexibility;
6. professional sanctions;
7. legal liability;
8. fear of losing clientele, reputation.
Lee meanwhile suggests that independence depends on the
nature of the relationship between auditor and auditee and
principally on the relative size of the participants .
The fundamental principles of the IFAC Code are:.

integrity;
1. objectivity;
2. professional competence and due care;
3. confidentiality; and
4. professional behaviour.
The factors Shockley identified are as follows: Potential threats to objectivity

1. MAS; Threat
2. competition; Self-interestthreat
3. tenure; Self-reviewthreat
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Advocacy threat of the data to be made on a timely basis. The deadline

Familiarity or trust threat would be in 30 days time when the draft financial
Intimidation threat statements are due to be finalized. What issues would you
consider and what would be your response?
Other organizations issuing guidance on independence
include: ANSWERS
1. European Commission
2. IFAC 1 a) In this case, the fees are less than 15% of gross practice
3. IOSCO income, but they are far in excess of the 10% and you would
4. OECD no doubt not wish to lose this income. ES4 certainly
5. SEC suggests that this situation might threaten independence.
You might feel yourself that you are professional person
The SEC has approved several important changesto and could maintain your independence, but you should
independence rules remember that it is the perception of independence that is
(i) bookkeeping or accounting services; just as important as actual independence. There are two
(ii) audit of clients information system; important matters in relation to the scenario outlined,
(iii) appraisal or valuation services; namely, that the audit client is not a small entity, but your
(iv) actuarial service affecting amounts in financial firm has less than three partners and cannot fulfil the
statements; requirement that an ethics partner should perform a hot
(v) internal audit services relating to internal accounting and review of the audit procedures, documentation and
financial controls or statements conclusions before the audit report is finalized. However,
(vi) acting as director or employee or performing a decision- you should certainly discuss the key issues affecting the
making or supervisory function for the client; audit of your client with your fellow-partner, and perhaps
(vii) acting as a broker, dealer, investment adviser or even ask an outside firm to perform the hot review for you.
investment banker; You should also inform those charged with governance of
(viii) legal services; the audit client of the significance of the fee issue, and you
(ix) providing expert opinions on litigation or regulatory might even consider giving up some of the non-audit work,
proceedings or investigation....CHAPTER SUMMARYThis if any, particularly if the fees are likely to rise above 15% of
chapter has demonstrated: your gross practice income
EXERCISE b) The problem here is that losing this client might mean
that the office would lose its viability and your objectivity
1. Assume that you are a partner in a two partner practice might be threatened in consequence. The threat to your
with total practice income of 250,000. One of your clients independence would be particularly grave if your
(a private limited company with a turnover of 10 million remuneration was based, at least to some extent, on the
and with some 80 employees) pays ongoing fees to you fees generated by your office. This is clearly a situation
amounting in total to 35,000. Do you think that your where the matter should be referred to the ethics partner.
independence might be threatened? What steps would you However, as your remuneration is based to some extent on
take in a situation like this? the fees of this client this looks as if your firm might have to
(b) Assume that you are partner in charge of an office of consider resigning from the audit of this client, unless your
your firm. You are engagement partner of a major client firm can assign this client to another part of the firm
whose fees of 150 000, represent 2 per cent of the total
gross practice income of your firm, but 20 per cent of the c) You are clearly spending a great deal of time with the
income of your office. Consider the implications in the light client in question, and your objectivity might be threatened
of the IFAC Code and APB Ethical Standards because of the closeness of the relationship, that is, there
(c) Assume that you are a partner with a number of clients may well be a familiarity threat. Although the fee income is
for whom you are personally responsible. One of these below the limits specified in ES4 and though your own
clients is much larger than the others and you have to remuneration is not affected specifically by the fees
spend about 40 per cent of your time on the assignment. received from this client, your firm would have to have
The fees receivable represent about 4 per cent of the gross policies and procedures in force to ensure that the
practice income of your firm. Your own income is not based familiarity threat was countered. The matter should be
on fees receivable from this client. Consider the implications referred to the ethics partner, who might perform a hot
of this situation. review of the audit procedures, documentation and
conclusions, considering in particular the key inherent and
2. You have been asked by your audit partner to be senior in control risks facing the client. Consideration should also be
charge of the audit of a small public limited company. given to the period of time that you have been involved
Unbeknown to the partner, you hold 1,000 of the 100,000 with the client and in the circumstances it might be wise to
shares in the company. Do you think that you could remain consider rotation even if your period of engagement does
unbiased in relation to this client? not exceed the limits specified in ES3 (5 years for a listed
company client and 10 years for a non-listed client).
3.You have just been telephoned by the chief accountant of
a listed company client Randerston plc to tell you that 2. You might think that holding 1,000 shares from 100,000
there has been a computer breakdown and that some parts would be a matter of little importance as it represents only
of the data concerning construction contracts have been 1% of the total. However, holding of shares in the auditee
lost. He asks if two senior members of the firms company is one particular risk to integrity, objectivity and
engagement team could be loaned to enable reconstruction independence that ES2 regards as an insurmountable self-
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interest threat. You might regard yourself as a fairly lowly 4. wish to avoid public criticism if failure occurs.
member of staff and that, as your work is reviewed and
controlled by others, there would be no threat as far as Audits self-regulation
your audit firm is concerned. However, being senior in The concept of self-regulation is common in the English-
charge, you are likely to have an influence on the conduct speaking world for historical reasons (mainly the early
and outcome of the audit and you should inform the audit establishment of the accounting bodies in the British Isles).
partner of your holding. The likely action by your firm is The idea is not common in many other parts of the world
concerned would be to remove you from the audit, and, if however, principally on the continent of Europe, for
you have already been engaged in some audit work, to have example Germany
this work subjected to independent review. This is because
there are no safeguards to counter a financial interest of Functions of the Institut derWirtschafts-prfer (IdW) and
this nature (see paragraph 8 of ES2. You could, of course, the Wirtschaftsprferkammer
dispose of your shares if you wish to continue as senior on
the assignment, but even then, you might be excluded
temporarily (see paragraph 13 of ES2.
3.The general rule is that accounting services should not be
provided to listed company clients (see paragraph 117 of ES
5). However, this is clearly an emergency as contemplated
in paragraph 121 and one that might have unfortunate
consequences for Randerston plc, if it meant that it missed
filing financial statements on a timely basis, or if obtaining
further lines of credit was dependant on timely preparation
of those statements. In these circumstances you could
accede to the request of Randerstons chief accountant, but
you have to warn him that the two members of staff
seconded to the company would not be able to take any
part in the audit engagement. You might suggest that two
other members of staff with IT and accounting backgrounds
could perform the work instead. You should also say that
the help that the audit firms staff would be of a technical
nature and that they should not take part in any activity
which would be the province of management, such as
making decisions on such matters as stage of completion
and any profits or losses to be taken up.
CHAPTER 4
Audit regulation
Audit dan regulation

In many countries the auditing profession and its associated
bodies have considerable powers to determine how their
work is performed, The profession may be said to be self-
regulated. But government does not leave it completely to
them to determine all aspects of regulation. List reasons
why there is a need for Reasons for regulation include:
(a)most professions are regulated in some way;
(b) it provides some assurance to users that certain
standards are met;
(c) setting standards helps reduce the risk for users; Role of the accounting bodies
(d) regulation helps to enhance confidence and substitutes The role of the accounting bodies in regulating auditing was
for the element of trust. enhanced by the Companies Act 1989, which established
two types of body:
The power the state cedes may be dependent on: (1) Recognized Supervisory Bodies (RSBs);
1. attitude towards particular forms of political (2) Recognized Qualifying Bodies (RQBs).
economy;
2. opinion of the expertise, integrity and stage of The main accounting bodies in the UK all have RSB and RQB
development of the professional body; status. The role of an RSB is to maintain and enforce rules as
3. whether it believes a (private) professional body is to:
likely to be a more efficient regulator; and
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(a) eligibility of persons to seek appointment as company The Accountancy Foundation had three mainfunctions: .
auditors; 1)to appoint board members to its various bodies;
(b) the conduct of audit work 2)to act as the channel for finance and funding;
3)to be the key point of contact with government, the
The role of an RQB is to enforce rules, such as those relating accountancy profession and others.
to:
(a)admission to or expulsion from a course of study leading The main purposes of these bodies is as follow :
to a qualification; The Review Board was to monitor the regulatory
(b)the award or deprivation of a qualification; structure and ensure it was meeting the public
(c) the approval of a person for the purposes of giving interest, overseeing the work and the
practical training or the withdrawal of such approval. responsibilities of the various accountancy bodies.
The Ethics Standards Board was to set the agenda
Some commentators have suggested existing systems of and principles that underpin the ethical standards
audit regulation would be improved by setting up an set by the bodies and to approve them before issue.
independent Office for Auditing to oversee the framework
for large company audit appointments, auditor The IDB was expected to take over responsibility of the Joint
remuneration and audit practice of the major accounting Disciplinary Scheme and to investigate members of
firms. This would represent a clear departure from the accounting bodies where there was a public interest
system of self-regulation element. Monitoring of audit firms by JMU or by ACCA is to
ensure that companies are complying with audit regulations
The UK regulatory system remained in force until major and auditing standards. The JMU ceased to exist at the end
changes in 2003. However major changes in audit regulation of 2003
also took place prior to 2003. Examples include:
(1) recommendations of an ICAS paper of 1995 Following various scandals in the USA, the UK government
(2) a new regulatory regime decided to review the audit and accountancy regulatory
regime and set up two major reviews:
The new regulatory regime was based on six key principles: (1) Review of the Regulatory Regime of the Accountancy
(1)independence; Profession (RRRAP);
(2) public interest and integrity; (2) Co-ordinating Group on Audit and Accounting Issues
(3) transparency and openness; (CGAA
(4) proficiency and commitment;
(5) relevance; The main recommendations of RRRAP concerned the roles
(6) review. of:
(a) the Financial Reporting Council (FRC);
Regulatory system in force until 2003 (b) APB;
(c) Professional Oversight Board (POB);
(d) IDB
APB would be responsible for setting standards relating to
independence, objectivity and integrity.POB would oversee
the audit function, approve professional RSBs and RQBs and
have responsibility for ethical issues remaining with
professional bodies. A new Audit Inspection Unit would
report directly to POB.IDB would hear significant public
interest cases.
The main reasons for the proposed changes were:
(a)existing system too complex and functions and
responsibilities overlapped;
(b) the Accountancy Foundation did not have a sufficiently
authoritative voice;
(c) one regulator should cover accounting and auditing,
including setting of standards;
(d) regulatory regime should be independent.
APBis a successor body to APC, which was criticized for
serving the interests of large firms rather than the public
and because its guidelines were not authoritative. APB is
more independent (half of its members are non-auditors)
and issues auditing standards in its own right, which must
be followed by members of an RSB. APB objectives (2003)
indicate its wide role:
(a) lead in establishing auditing standards;
(b) advance public understanding of the roles and
responsibilities of auditors;
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(c) take an active role in the development of statutes,

regulations and accounting standards that alter the conduct
of auditing;
(d) support international developments in auditing
Auditing standards and audit quality
APB believes auditing standards will enhance audit quality;
reduce incidence of audit failure; increase the confidence
of users. Such standards will set a minimum level of
performance and provide a benchmark by which the quality
of audit work can be measured.
Auditing standards contain prescriptions with which
auditors are required to comply. It may not be easy to
determine compliance as standards may lack specificity and Other matters covered include
be open to interpretation. Practice notes and bulletins are (c) statutory relationships between auditors and
issued to assist with application and provide auditors with shareholders; (d) the statutory relationships between
timely advice on new or emerging issues shareholders and directors; (e) the practical relationships
between auditors and directors.Figure below provides a
Regulatory structure from 2003 diagrammatical outline
Legal and practical relationships
The main concerns for CGAA were:

(a)auditor independence;
(b) corporate governance and the role of the audit
committee;
(c) transparency of audit firms;
(d) financial reporting standards and enforcement;
(e) monitoring of audit firms;
(f) competition implications.
Further regulationincludes provisions in CA 1989. The legal
rules encompass such matters as:
(a)the individuals and firms who are permitted to act as
auditors;
(b)the period for which the auditor is appointed.
Period of auditor appointment and accounting reference
period and date
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CHAPTER 5 risk, particularly if the auditor is unaware of management

The Risk-based approach to audit : Audit deficiencies and / or unusual pressures on them
Judgement Tendering for audit services has become important and is
accompanied by lower audit fees. This possibly results in
policies to reduce the amount of audit work carried
out.Another risk factor related to lower audit fees is that
Audit Risk auditors become more reliant on non-audit services, with a
Audit risk (AR), the risk that auditors may give an consequent threat to independence.
inappropriate audit option, has three components:
(a)Inherent risk; Business risk assessment
(b) Control risk; Examples of business objectives are:
(c) Detection risk. 1. attaining a certain level of profitability;
2. maximizing shareholder wealth;
Two further elements to audit risk are: 3. ensuring efficiency and effectiveness of operations;
(a)engagement risk, arising from 4. meeting a desired market share;
(i) competitive tendering by audit firms; 5. giving customer satisfaction;
(ii) inherent risk factors not known to the potential 6. maintaining a desired level of liquidity;
auditors when tendering; 7. maintaining reputation;
(b) independence in fact risk, or the risk that auditors may 8. meeting the challenge of changes;
fail to report material misstatements in the financial 9. adherence to accepted principles of corporate
statements, detected by their audit procedures). governance.
Business risk results from significant conditions, Business risk assessment is a management technique.
events, circumstances, actions or inactions that Objectives may change as circumstances change so
could affect the entitys ability to achieve its assessment should take place regularly. The approach has
objectives. been adapted to allow auditors to provide business risk
Business risk is broader than the risk of material assessments as consultancy exercises to audit clients. There
misstatement of the financial statements. are similarities between business andinherent risk
Business risk may arise from change or complexity approaches:
or through a failure to recognize the need for
change. (a)both use a top-down approach;
(b) factors that increase inherent and control risk may make
Examples of risks it less likely that business objectives will be obtained;
Examples of risks include: (c) analysis of both helps auditors to prove that financial
(i)Changes in operating environment; statements give a true and fair view.
(ii)New personnel; (iii)New or revamped information
systems; Dissimilarities are:
(iv)Rapid growth;
(v)New technology; (a)auditors consider inherent risks in relation to the impact
(vi)New business models, products or activities; they may have on financial statements, but the business risk
(vii)Corporate restructurings; approach considers risks inhibiting the company in
(viii)Expanded foreign operations; and achieving objectives;
(ix)New accounting pronouncements. (b) business objectives and audit objectives are so dissimilar
that the above factors cannot create a similarity.
Components of audit risk
The three components of audit risk are related: Benefits of the business risk approach are that it:
(a)improves the basic audit of financial statements and
makes erroneous conclusions less likely;
Audit risk (AR) = inherent risk (IR) control (b) makes audit more efficient and therefore more
risk (CR) detection risk (DR). profitable;
(c) expands potential for giving assurance to management
to add value and to create additional sources of income.
DR relates to acquiring confidence . If the auditorneeds a
low detection risk, more transactions andbalances are This leads in turn to:
tested substantively, and the moreconfident the auditor is
that all are valid. Auditors decide initially the level of audit (d) expanded audit, which has the potential to contribute to
risk acceptable to them. Some auditors assess risk in corporate governance arrangements and disclosures;
qualitative terms low, medium and high but the principle (e) a better understanding of a clients business and its
is clear that if you wish audit risk to be low and you know risks, thus reducing auditors engagement risk
that inherent risk and control risk are both high, detection
risk will have to be low. Another potential benefit is :
(f) advances in IT have resulted in company records being
Engagement risk is when incoming auditors have little in- inherently more reliable, leaving more scope for audit effort
depth knowledge of new clients.This is likely to enhance to be devoted to higher level assessments.
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Business risk approaches The letter of engagement

Business risk approaches mean much planning work is The letter of engagement provides the audit framework and
performed by experienced staff. But knowledge about contains:
management allows auditors to form views on the reliability
of management and the control environment, and on (a)responsibilities of directors and auditors;
analytical evidence.This may lead to a loss of independence (b) scope of audit;
and, by cutting down on over-auditing in non-risk, to under- (c) other services;
auditing (d) fees.
Analytical procedures are defined in ISA 520 as: The time and fee budgets are directly dependent on
evaluation of risk, which determines the extent of
Evaluations of financial information made by a study of substantive procedures. The most important resource used
plausible relationships among both financial and non- is the time of partners and staff of the audit firm. The time
financial data. Analytical procedures also encompass the budget is designed to give sufficient time to reduce audit
investigation of identified fluctuations and relationships that risk to acceptable levels
are inconsistent with other relevant information or deviate
significantly from predicted amounts
EXERCISE
Judgement
Judgement is one of the enduring principles of auditing, 1. Consider the following statements and whether they
but it is intangible in nature. The relationship between might be true or false. Provide
judgement and risk is direct, as judgement is exercised in explanations with your answers.
the context of risk. In forming judgements the auditor a) The directors of the client company sign the audit
makes initial risk assessments, but modifies them on the engagement letter.
basis of controls in existence and on the validity of figures in (b) The auditor must always discover fraud and other
the accounting records irregularities.
(c) Fees of the auditor are based on the time taken and the
In managing the audit process there are two basic related grade of staff involved in the assignment.
objectives: (d) A business risk approach by auditors is wider than the
audit risk approach.
(a)being professionally effective;
(b) making a fair profit in performing professional duties. 2. The audit firm consists of a collection of individuals with
varying degrees of experience and expertise. Briefly
The starting point for effective management of the audit describe the role that individual staff members play in
process is to create a logical structure within the firm and to achieving audit objectives.
allocate responsibilities to partners, managers, seniors and
assistant auditors, ranging from overall professional 3. You are the senior in charge of the audit of a local
effectiveness to performing detailed audit work newspaper and have been asked by your audit assistant to
explain what kinds of income and expenditure can be
Schematic diagram of an audit firm expected to arise in the company. She is also anxious to
know if there are any particular problems that might be
faced by management and, therefore, the auditor. Think of
problems such as reporting on circulation of the newspaper
to government or independent bodies and maintenance of
circulation.
4. Discuss briefly the following statements
(a) Audit risk is the risk that control systems will not detect
material misstatements in the financial statements subject
to audit.
(b) Cumulative client knowledge enables the auditor to be
more efficient and aids effectiveness in the audit process.
Explain what you understand by cumulative client
knowledge. Ask yourself what information about an
organization would be useful to you on a permanent basis.
(c) The letter of engagement is of little value, as most clients
will not understand what it means.
ANSWERS
1. a) True
The important thing is that both auditors and client are
aware of, indeed have a full understanding of, the nature of
the assignment and the rights and duties under it. The
statement is, of course, only partially true. The fact is that
both directors and auditor should sign the letter, the
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auditor at the time of sending the letter and the directors or close contact with the Engagement Partner and the other
their representative, at the time of returning it. There is no members of the Engagement Team)
reason why the client should not send the letter in the first Other audit staff, including people with varying degrees of
place, but normally it is better that it be drafted by the experience the senior in charge who will be present
professional firm. It would, of course, be necessary to throughout the assignment - and staff with less experience
discuss it in detail with the directors before it is finalised. such as semi-senior or junior staff whose work will be
closely supervised.
b) False Other professional staff with special skills, including IT and
There is much discussion about the auditor's duty with tax experts, who will be used at particular points of the
regard to detection of fraud and other errors .Basically, the audit work.
auditor is required to focus on areas where there is risk of Apart from members of the Engagement Team, there are
material misstatement because of fraud, including other individuals and functions that play a role in achieving
management fraud and to maintain an attitude of audit objectives. These include:
professional scepticism throughout the audit. However, the Staff providing a technical advisory services, such as
primary responsibility for the prevention and detection of advice on the application of accounting and auditing
fraud rests with both those charged with governance of the standards
entity and with management. (See paragraph 4 of ISA 240 - Ethics Partner who advises the Engagement Partner on
The Auditors Responsibilities relating to fraud in an Audit of possible threats to independence, including possible
Financial Statements). breaches of the firms ethical guidelines.
Engagement Quality Control Reviewer who is there to
c) True ensure that high standards are maintained during and at the
The basis of charging fees must be such that the auditor is, end of the audit process. This person may review working
and is seen to be, independent. The preferred basis for papers and act as intermediary in the event of
charging fees is time taken and grade of staff engaged. disagreement between the Engagement Partner and the
Some firms charge on the basis of a so-called balanced Ethics Partner.
audit team. Recently there has been much more openness Others in the Audit Firms chain of command, including
in setting fees with large firms tendering at fee levels those at the top of the firm who are responsible for the
considerably less than only a few years ago. Firms Control Environment.
d) True It is important to note that the activities of the firm must be
To some extent inherent risks, which form one component organised to produce the professional service when it is
of audit risk, are similar to business risks in that they need required. It is quite likely, for instance, that there will be a
to be subjected to management controls to alleviate their partner in charge of the computer/IT services and of the
impact. Business risks are those risks that may make it taxation services. In preparing the audit plan, approaches
difficult to achieve management objectives. For instance, an will have to be made to the specialist services to ensure that
hotel might have a preferred room occupancy rate to their staff will be available when required. It will also be
achieve desired levels of profitability. We have already seen desirable that the person in charge of the typing services is
in this chapter that management may introduce aware of deadlines and other reporting requirements (for
management information systems on such matters as instance, complicated diagrams and layouts) on a timely
rooms currently unoccupied and peaks and troughs of basis.
occupancy. This information is a form of control and would
be used to inform potential customers whether rooms are 3. Typical income in a company publishing a newspaper:
available and to enable them to put in a strategy to increase - Sale of newspapers: Office sales, Newsagent sales, Street
room occupancy at less busy times. For auditors, knowledge sales
about how the company controls business risk in this area, - Sale of advertising: Classified advertising, Block advertising
would be an important element in work designed to prove (Prominent advertising of commercial and official material)
that accommodation income appearing in the profit and - Sale of photographs
loss account was true and fair in the context of the financial - Games and competitions entered by the readership
statements taken as a whole. However, inherent risk Typical expenditure of a company publishing a newspaper:
approaches are more limited than business risk approaches - Newsprint
as they are directed to the financial statements in the - Inks of various colours
context of the auditors' opinion on the financial statements. - Sundry printing costs, including repair and maintenance of
However, business risk approaches are designed to aid printing machinery
management in achieving business objectives, of which the - In a company using the latest technology, we would expect
preparation of fairly presented financial statements would to find both capital and revenue costs associated with the
only be one. Thus, it is true to say that a business risk technology
approach by auditors is wider than the audit risk approach. - Salary and wage costs of: Editorial staff, Reporters,
Photographers, Copy readers, Delivery people. Advertising
department staff (including classified advertising staff
2. There are individuals and functions involved in the dealing direct with the public, and designers and setters of
provision of audit work. These include the members of the larger advertisements), Administration staff
engagement team comprising: - Expenses connected with obtaining stories and
the Engagement Partner (who has overall responsibility photographs
for the assignment) - Distribution costs, including delivery van costs (petrol,
Manager in charge of the assignment (who has overall servicing, depreciation of vans etc.)
responsibility for supervising the assignment, staying in - Payments to free-lance writers
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- Payment of prizes to the winners of games and designed to mitigate the impact of inherent risk and the
competitions. auditor should review control systems to ascertain whether
they are likely to detect material error and irregularity
Possible problem areas for management and auditor: deriving from inherent risk. After considering the levels of
inherent risk and control risk, the auditor determines the
- Reporting on circulation of the newspaper to government scope of examination in order to reduced detection risk to
or independent bodies. The average sales over a period of acceptable proportions.
time represent actual sales (not print runs), so it is
important to reconcile print runs with recorded sales. b) Cumulative client knowledge is all the continuing useful
Typical reasons for differences between print run and information about the Client Company, collected by the
quantities sold will be: copies given to editorial and other auditor during association with the company. Much of this
staff, free copies given to libraries and other organisations, information will be included in working papers and
copies not sold, either by own staff or newsagents. There correspondence files, but some of it will be in the minds of
should thus be control over copies returned for pulping. The people. Typical useful knowledge will include:
auditor would have to find out if it is company policy not to
charge newsagents for returned copies. - Key personnel: details of position, experience and
background; personality and management style
- Maintenance of circulation. This normally has a correlation - History of company, its position in the
with advertising and the auditor would find circulation and industry/commercial sector and its strategy to reduce risk
advertising statistics produced by management for their and to meet the problems of the industry
own purposes, useful sources of evidence. - Products and their nature, major customers and suppliers
- Particular audit problem areas and how the problems
- Control of advertising to the newspaper. Classified were solved in the past
advertising consists of many hundreds of transactions each - Details of systems in use and the number of transactions
time the newspaper is produced. The control of advertising they process during an average week/month/year.
is complicated by the fact that there are often special rules
where an advertisement is placed several times in the All audit firms try to keep permanent records of cumulative
paper: 'One free for every three placed', for instance. client knowledge, by, for instance, requiring the senior to
Management will have to institute tight systems of control, copy all matters of permanent interest from the current
not only to ensure that the advertisement appears in the year's working file and correspondence files to a permanent
correct form and in the desired issue of the paper, but also file. Correspondence between the client company and the
that the income has been completely and accurately bank on new and stringent arrangements for control of the
recorded. The auditor will investigate the operation of the bank overdraft would be a typical item to be kept
control system, but, like management, should be able to permanently. It must be said that keeping the permanent
substantiate total advertising revenue on a global basis. file up to date and uncluttered with irrelevant material
Each page of classified advertising should be valued for each needs considerable discipline on the part of the auditor,
issue and reconciled to revenue. The auditor can do this although this is probably easier where the audit firm is using
sort of check on a test basis. computerised audit files. It is human nature to move to the
next assignment without dotting the i's and crossing the t's
- Control over expenses of reporters, photographers and on the previous one.
other members of staff will require the drawing up of
detailed rules and internal checks to ensure that the rules That cumulative client knowledge is important is not to be
are adhered to. The auditor would test the system of doubted. To acquire knowledge is an expensive business,
control to ensure it is working properly and check a and if you are collecting the same knowledge year after
selection of expense reports to ensure the expenditure has year, you not only run the risk of upsetting the client staff,
been incurred by the staff member, that the amounts are in you also make the audit process much less efficient and
accordance with predetermined rules and that they have profitable than it should be. The other matter of importance
been agreed by responsible officials. is the question of effectiveness. The raison d'etre of the
external auditor is the professional one of giving an opinion
This review of newspaper income, expenditure and on the truth and fairness of financial information. In
management and control problems has touched upon attaining the professional objective, the auditor has to
typical matters and is not intended to be complete. What is obtain sufficient, appropriate (relevant and reliable)
important for the auditor is to understand how to approach information. If the audit firm has not maintained cumulative
audit assignments, even in unusual industrial and client knowledge properly in previous years it is likely that
commercial sectors. the auditor will be less effective in the current year.
4 a) Failure by control systems to detect material c) If the client does not understand the letter of
misstatements in the financial statements subject to audit engagement and can prove that the auditor did not explain
will of course increase audit risk, but audit risk is affected it properly to them, the letter might indeed be said to be of
not only by control risk, but also inherent and detection little value. A court might well take the view that the
risk. The statement in the question was designed to help auditor had merely produced a document to protect him or
you to understand the nature of audit risk. As we made her and that the client had a legitimate expectation that the
clear in the text, audit risk is a concept that has been auditor had not fulfilled.
receiving greater notice in recent years and it is important
that you should understand its significance. The statement The letter of engagement should be seen as the document
is therefore incomplete. Control systems should be setting the scene for the future relationship between
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auditor and management. It should be relevant to the persuaded that objectives have been met by accumulating
company being audited and should be discussed paragraph evidence
by paragraph with the client before signature. The client
should have the opportunity to suggest amendments and to Evidence is the cornerstone of the audit processa
have any matter explained that is not understood. The prerequisite for forming an opinion.Collecting and assessing
statement in the question should be rejected it needs considerable imagination; the relevant evidence is
frequently difficult to find, being often concealed (whether
intentionally or unintentionally
CHAPTER 6
The Search of Evidence Explained Management assertions
Management assertions may be classified in thefollowing
three ways:
(1) genuine;
(2)accurate;
Search for evidence (3) complete.
The audit process is a search for evidence to forman
opinion, based on a whole series of conclusionswith regard Trade debtors exist and owe the amounts stated in the
to: debtors ledger to the company. Trade debtors balances are
(a)accuracy and dependability of the accounting records; fully collectible.All amounts owed by the trade debtors are
(b) validity of figures in financial statements; included in the amount attributed to trade debtors in the
(c) compliance with legislation and accounting and financial statements and relate to the correct period.
reporting standards.
This approach enables auditors to set objectivesand place
Relevant ISAs in the area are: evidence search in a suitable context.Guidelines for
ISA 500 Audit evidence assessing evidence are as follows:
ISA 501 Audit evidence: additional considerations (a)Audit evidence is more reliable when it is obtained from
for specific items. independent sources outside the entity;
(b) Audit evidence that is generated internally is more
The purpose of these standards is to establish standards reliable when the related controls imposed by the entity are
and to provide guidance on what constitutes audit evidence effective;
in an audit of financial statements, the quantity and quality (c) audit evidence obtained directly by the auditor is more
of audit evidence to be obtained, and the audit procedures reliable than audit evidence obtained indirectly or by
that auditors use for obtaining that audit evidence. inference;
(d) audit evidence is more reliable when it exists in
Evidence supporting reasonable conclusions documentary form;
(e) audit evidence provided by original documents is more
reliable than audit evidence provided by photocopies or
facsimiles
(f) evidence created in the normal course of business is
better than evidence specially created to satisfy the auditor;
(g) the best informed source of audit evidence will normally
be management of the company but managements lack of
independence reduces its value as a source of such
evidence;
(h) Evidence may be upgraded by the skilful use of
corroborative evidence
Business risk approaches
Business risk approaches have resulted in greater reliance
on management. As auditors align them-selves more with
management, they begin to feel that they can judge
individuals integrity. This trust can result in a reduction in
substantive testing, with a consequent reduction in audit
cost to counterbalance the increased cost of time spent at
the planning stage.
Sufficient and Appropriate Evidence
The words sufficient an appropriate are interrelated, This approach might not be justified in the light of Enronand
appropriate having two further elements: WorldCom, and the agency theorists may be rightthat it
would be unwise for auditors to accept the wordof
(a) Relevant, that is, pertinent to the matter in hand; management, without obtaining considerable
(b)Reliable, that is, trustworthy, with some grades of corroborativeevidence from elsewhere. But auditors do not
evidence more reliable than others. start from a presumption that managements lack integrity.
A major issue is that business risk may bring the auditor so
Evidence is persuasive rather than conclusiveand auditors close to management that independence may be
seek evidence from different sources to support the same threatened
assertion (that is, to corroborate it). There is a link between
persuasiveness and quantity as auditors seek to be
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Audit Engagement Your audit work has revealed the following:

Professional accountants carry out many kinds of (i) Discussions with management and other tests show that
engagement in relation to financial information.Many selling prices have been increased by more than the cost of
engagements may result in lower levels of evidence being purchases with the result that gross profit has improved by
collected, so that a true and fair form of opinion cannot 1 percentage point.
be given.. Such audits are likely to be of value to users (ii) The company maintains the following records:
nonetheless.
Purchase requisitions from stores to the purchasing
Examples of such engagements are: department (this is the request that goods be
1. compilation engagement; purchased).
2. limited assurance engagement; Purchase orders made out by the purchasing
3. agreed-upon procedures engagement. department on the basis of purchase requisitions and
files of information about suppliers (the purchase order
Compilation engagement is when professional accountants is a request to a supplier of goods to deliver them).
prepare financial statements using data and information Goods received notes made out by the goods
provided by management and a compilation report is issued receiving department when goods are received.
that gives no assurance as to truth and fairness, nor File of purchase invoices received from a supplier.
compliance with CA 1985 and accounting standards Inventory records showing quantities of receipts,
issues and balances of inventory on hand.
Limited assurance engagement is not a full audit but the Purchase journal in which all invoices are recorded.
professional accountant forms an opinion on the Purchase ledger containing personal accounts for
reasonableness of financial statements and obtains limited each supplier.
assurance that the financial statements comply with the CA General ledger accounts, containing, among other
1985 and accounting standards. The review report contains things, purchase accounts and trade payables control
a negative form of opinion account.
Agreed upon procedures engagementis similar to a review (iii) As a result of your systems work you have concluded
except that certain detailed procedures would be that each of the above records are held by different people
performed, as agreed with management, requiring the and that they are carefully and properly controlled.
accountant to seek evidence that the items subject to the
agreed procedures have been stated appropriately Required :
(a) Describe the kinds of evidence that can be used to
upgrade the various documents and records.
EXERCISE (b) Explain how the systems work and the review of the
accounts may help you to accept the figure of purchases.
1. Consider the truth or falsity of the following statements:
(a) Sufficient evidence for the auditor means having enough
to form a conclusion that an assertion made by 3 Below is a list of sources of audit evidence:
management may be accepted. (i) The chief accountant, who is a member of CIMA, explains
(b) Relevant evidence for the auditor would include the why inventory levels are higher at the end than at the
following: beginning of the year.
(i) The dates that the chief accountant goes on holiday. (ii) A storeman in the main store explaining how the store
(ii) A file of recognized suppliers. control system operates.
(iii) The place that the chief accountant chooses for his (iii) An invoice from a supplier of electricity.
or her holiday. (iv) A trainee accountant, presently studying for
(iv) Credit limits of customers buying on credit professional accounting examinations, explaining the reason
(c) Reliable evidence means evidence that has been why telephone charges were lower this year than last.
vetted by the companys directors. (v) A letter to the auditor from a lawyer confirming that, as
(d) Written evidence from a bank manager is reliable far as he is aware, there are no legal matters of material
evidence. significance.
(e) Written evidence from within the company is not (vi) A confirmation from a credit customer agreeing that a
reliable. balance in the books of the entity is correct.
(f) If differing types of evidence are consistent with (vii) A calculation of tax charge and liability made by the
each other, the auditor can reduce the amount of auditor.
evidence collected and examined. (viii) Inventory count sheets, the count having been
(g) Physical inspection by the auditor of a non-current observed by the auditor.
asset provides the auditor with reliable evidence as to (ix) The companys order book, showing orders received
its existence, but not as to its ownership, cost or value. from customers. This book is required for company planning
purposes.
2. You are the auditor of Oakshaw Ltd and are searching for (x) Estimates of useful life of newly acquired plant, made by
evidence to prove that the figures for purchases and related the production director.
creditors are true and fair in the context of the accounts,
taken as a whole. You have extracted the following Required :
information from the accounts at 31 December 2010: (a) Suggest which sources may be regarded as reliable,
Change dates to 2010 and 2009 respectively and change explaining why this is so.
stock (twice) to Inventories. (b) Suggest how you might upgrade the evidence, if
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required. or controlled by them is not as reliable as evidence obtained

from independent third parties or created by the auditor
4 Explain the meaning of the following terms: himself. It may, of course, be substantiated by evidence
(i) Interim examination. from other sources.
(ii) Final examination.
(iii) Inconsistent audit evidence. d) True
(iv) Systems-based evidence. The written evidence from the bank manager is good
(v) Third-party evidence. evidence and is reliable because it comes from an
(vi) Persuasive evidence. independent and professional source. However, the bank
manager might not be aware of all bank accounts owned by
ANSWERS the company if they had been made secret by putting them
in the name of a specified individual.
1 a) True
The statement is true in itself, although it is incomplete. e) False
Auditors must clearly have enough evidence to form their While written evidence from within the company is not of
conclusions. For instance, management might claim that the itself reliable because it comes from a dependent source, it
credit control department has checked all sales orders to comes from a very well informed source and if it is derived
ensure that the customer is likely to pay for goods and from sound systems, it can also be very reliable.
services ordered. Auditors may wish to satisfy themselves
on this point and will test enough sales orders for evidence f) True
of credit control to ensure that the risk they have not been Consistency is the basis for upgrading audit evidence, as
checked appears low. However, sufficiency of evidence is evidence corroborated by other evidence is strengthened.
only one aspect. It is necessary also that it be relevant and For instance, the signature of an employee in a personnel
reliable. It certainly appears to be relevant to ensuring record will provide evidence that a payroll entry bearing the
within reason the credit worthiness of customers. same signature is accurate, each signature adding to the
value of the other. This, of course, would be dependent on
b) i) True the personnel record being held by individuals other than
The dates that the chief accountant goes on holiday may those preparing the payroll. This is an example of synergy or
well be relevant. For instance, if he or she exercises an a situation where 2 + 2 may equal 5.
important control function, care must be taken to ensure Conversely,inconsistent evidence may result in evidence
that, when on holiday, proper cover exists. The auditor previously collected not being accepted as of value. Thus, if
might wish to test the holiday period in greater detail. the company's lawyer suggests that on the basis of previous
case law, the company has a good chance of defending
ii) True successfully a case brought against it, this apparently good
The purchasing officer needs a file of recognised suppliers, evidence may be nullified if a second lawyer contradicts the
when deciding who should supply goods and services to the first view. The auditor would then have to seek further
company. As the list would need to be accurate for this evidence to confirm or refute either view.
purpose, the auditor would find it reliable in determining
whether all liabilities have been reflected in the accounts. A g) True
typical audit question might be: 'I see that Runcorn Ltd is on If the auditor physically inspects the fixed asset, quite
your list of suppliers of Product X, but this company does clearly this will prove that it exists. The question of
not appear in the purchases record this year. Do you owe ownership, cost and value can only be answered by looking
this company any money at the year- end?' Clearly, the list for other kinds of evidence, such as original invoice for the
would be relevant as well as being reliable evidence. asset, its entry in the fixed asset register and valuers'
reports.
iii) False
We have suggested that the statement is false and to the 2 a) Oakshaw purchases and trade payables audit trail
extent that the chief accountant went on holiday to one indicates the upgrading process and you should study it
seaside resort last year and to another this year, it would carefully. Remember the various rules we discussed in the
not be particularly relevant. If, on the other hand, the text, to which you should refer if you have any difficulty.
holiday was more expensive and the chief accountant's
general standard of living higher than salary would appear b) The brief answer to this question is that the auditor
to justify, the auditor might wish to consider whether he or obtains satisfaction from a number of different sources. If
she might be misappropriating funds from the company. the systems for controlling purchase transactions is proved
to be sound, this will give some confidence that the
iv) True purchases figure is valid. Similarly, if the review of the
Debtor's credit limits may be very relevant evidence. If financial statements reveals nothing that is strange in
limits are much exceeded, for instance, this might indicate relation to what the auditor knows about the company (that
that credit control is inadequate and that more work will be is, all the figures appear consistent with each other), this
required to prove that the trade receivables are collectible. work can also support the purchases figure. Detailed
matters of significance are as follows:
c) False
While vetting by company directors may add to the Systems: We are told that different people control
reliability of evidence (for instance, directors' comments on the purchase and trade payables records. We shall
a legal claim against the company), care should be taken in see later in this book that this is a very important
accepting it too readily. Evidence originating from directors control feature. Also the auditor's work has
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revealed that the records are carefully and properly sales. Analytical review of activity levels could thus help to
controlled. Both of these conclusions will help the corroborate telephone charges. Your view of the trainee
auditor to conclude that the purchases figure is accountant's ability may also affect the credence given to
acceptable his statements.
Review of accounts: The gross profit percentage in
2007 is 30% compared with 29% in 2006 and the v) The letter from the lawyer would be regarded as good
auditor would discuss this trend in the company evidence in itself because it comes from an independent
with management to determine if demand for the professional person and has been sent direct to the auditor.
company's products is inelastic enough to allow The main problem for the auditor is identifying which legal
increases in selling prices unaccompanied by advisors the company had used. In particularly difficult
increases in costs. The auditor should supplement cases involving perhaps complex legal matters, the auditor
this work by comparing the company's margins with might wish to corroborate the opinions of the company's
those of competitors. If the increase in margin legal advisor(s) by seeking a second opinion.
appears to make sense in the light of this work, the
auditor would be more inclined to accept the figure vi) The letter from the debtor is also good evidence, coming
of purchases, although other more detailed tests on as it does from an independent third party direct to the
the purchases figure would be necessary. auditor. We would be inclined to regard it as less reliable
than that from the lawyer, however, for the reasons
3. a) i) The chief accountant is a well-informed officer of the outlined in the text. Confirmations from credit customers
company. For this reason, evidence emanating from him or would not normally be the sole evidence sought by the
her is good evidence. However, he or she is internal to the auditor in confirming trade receivables balances and sales
organisation and the auditor would seek corroborative invoices. Other corroborative evidence would include all the
evidence that the statement is acceptable. For instance, if supporting evidence .
the auditor finds that sales forecasts indicate a higher level
of sales in the coming year than in the year just ended, this vii) Most qualified auditors will have knowledge of taxation,
might help to prove the chief accountant's statement. although it is an area in which one may get rapidly out of
date. Assuming that the auditor is a tax expert or has called
ii) The storeman is again internal to the organisation and his upon expert help from within his firm, the computation of
statements should perhaps be viewed with caution. tax charge and liability would be reliable evidence for the
However, such officials are frequently a very useful source auditor, especially if the computation is checked by others
of evidence as they may be very well informed about a within the firm. Although the computation has been done
small segment of the company's activities and may, indeed, by the auditor, it would be necessary to ensure that
be much better informed about them than the chief management was in agreement with it.
accountant. For instance, the chief accountant may believe
that inventory control officials check physical inventory viii) Inventory count sheets are prepared as a result of a
against inventory records at regular intervals, whereas the physical count carried out by company staff. If the system
storeman knows that this is not the case. On the other that the company has established to control the inventory
hand, it must be said that often people in organisations are count is good and the auditor's observation has confirmed
not aware of the whole picture so that care must be taken that the count has been properly carried out, the inventory
in evaluating statements made by them. For instance, count sheets may be regarded as good evidence,
inventory control officials may carry out inventory counts at particularly if supported by the auditors own count sheets
night when the storeman is not on duty. It would therefore (that would serve to corroborate the company's figures).
be necessary to corroborate the statements made by the Remember that inventory count sheets prepared by the
storeman. company are internal documents and may therefore be
subject to manipulation.
iii) An invoice from a supplier of electricity is a document in
the hands of the company emanating from a third party. It ix) The company requires the order book for its own
may be regarded as a particularly reliable document for the planning purposes and in the normal course of business.
following reasons: Such evidence is better than evidence prepared on an ad
Electricity invoices are normally issued at regular intervals hoc basis and may be used by the auditor for testing such
during the year and can be easily compared with previous matters as the saleability of inventory. Provided that the
electricity invoices, although there is a possibility that they auditor can corroborate its accuracy by reference to
may be forged. correspondence from customers, salesmens' records etc.,
The electricity usage will be metered and meter readings the order book may be good evidence.
can easily be tested by the auditor.Electricity charges may
be corroborated in general terms by assessing general levels x) The estimate of useful life is a more difficult matter as it
of activity. relates to the future and the future is notoriously cloudy. In
itself the estimate by the production director is poor quality
iv) Invoices of the Telephone Company will support the evidence, but it may be upgraded on the basis of past
telephone charges and these invoices are as reliable as the experience, manufacturer's specifications, experience of
electricity invoice referred to above. The explanations for others in the industry and so on. Remember also that,
the charges being lower this year depends upon whether within the company, the production director may be the
they appear reasonable in the light of what the auditor best qualified to estimate the useful lives of production
knows about the company. For instance, if company sales plant. The auditor should certainly discuss the matter with
are much lower because of a downturn in economic activity, him or her.
telephone charges may be lower if they are correlated to
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4 i) The term 'interim examination' is used for that part of course obtain sufficient confidence on the basis of the
the audit carried out prior to the year-end. Normally, the persuasiveness of the evidence in the context of tolerable
interim will be used to review and test the operation of error
systems and to test the accuracy and completeness of the
recording of transactions. The results of this work and the
conclusions drawn therefore will be used during the final CHAPTER 7
examination in planning and in supporting conclusions on
the final work. In the case of large assignments, there may System work : Basic Ideas 1
be more than one interim examination, and indeed for very
large engagements, auditors may be present in the
company and its various locations throughout the year.
ii) Final examination' is the term given to the work on the Objective of company systems
financial statements after the year-end. Note that in the External auditors make a preliminary assessment of control
case of small assignments, the systems, transaction testing risk for material financial statement assertions, and plan
and work on the final financial statements are likely all to be and perform tests of control to support that assessment. A
carried out in the same period. major objective of company systems is the reduction of risk
Controls are designed to prevent, detect or correctevents
iii) 'Inconsistent audit evidence' is evidence that does not the company does not wish to happen, andto ensure that
support other evidence, thereby downgrading it and data and information are as required.Basic elements of
rendering it of less value. It may reveal that the auditor has control in the internal environmentare:
initially formed a view that is not sustainable. For instance,
let us assume that you are auditing a roofing company, (a) control environment and related components;
which makes provision for customer claims on the basis of (b) accounting and quality assurance/control systems.
3% of turnover per annum. The auditors may have satisfied
themselves that 3% is adequate on the basis of past Example of a matrix organizational chart
experience, but a recent article in the trade press has
suggested that rate of claims is likely to rise because of
problems in the use of new materials. In this case the
reliability of evidence based on past experience would be
reduced because it is inconsistent with more up-to-date
evidence.
iv) 'Systems-based evidence' is evidence that has been
produced or influenced in some way by the accounting and
control system in use by the company. For instance, a
supplier's invoice which has been checked by company
officials and stamped to indicate agreement with purchase
order and goods received note has been checked by the
system. A sound system of control tends to make such
evidence more reliable.
v) 'Third party evidence' is evidence emanating from
persons or organisations external to the company and
therefore possesses the important quality of independence.
It is usual to distinguish between third party evidence
coming from:
- Professional people such as lawyers or other accountants
- Non-professional people such as customers and suppliers
- Third party evidence coming direct to the auditor such as a
letter from a bank manager confirming a bank balance, and
third party evidence in the hands of the company, such as
the suppliers invoice referred to above.
On the whole third party evidence is reliable as far as the
auditor is concerned.
vi) The use of the term persuasive in relation to audit
evidence indicates that often (normally) the evidence
collected by the auditor is not conclusive. For instance, if
the auditor checks 10 items of inventory on hand with the
inventory count sheets and finds that the sheets are correct Auditors obtain an understanding of accounting system
in each case, this may well persuade the auditor that the sufficient to identify and understand :
inventory count is being properly conducted and that the a) major classes of transactions;
inventory sheets are reliable. Auditors would, however, be b) how transactions are initiated;
very unwise to draw the conclusion that the inventory count c) significant accounting records, supporting documents and
was 100% correct on the basis of their test. They may of accounts
d) the accounting and financial reporting process
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Classifications of control
There are two broad control classifications:
(1) general controls over the environment in which the
company operates extension of the control environment;
(2) application controls, to ensure an individual application
runs smoothly and accurately
General controls include:
(a) systems development/maintenance controls;
(b) organizational controls;
(c) security;
(d) quality assurance
Raw data to information
If systems development/maintenance controls are strong, it

is easier to control individual applications. Important
elements are :
organizational structure to ensure high standards
during development.
documentation of development process, complete
enough to allow informed persons to understand
how the system works;
testing at critical stages;
agreement in writing at each stage;
parallel developments, including staff training,
preparation of forms and file conversions;
a reliable system for reporting system malfunctions
after implementation;
steps to ensure unauthorized changes are not made
to programs;
user agreement at critical development points,
particularly of user interfaces.
Note that the same principles apply also to smaller systems
but the process is truncated.
Programme for the development of computer application in
a large-scale system
The information/audit trail should be maintained, allowing

transactions to be traced forwards and backwards through
the system
Organizational controls
Organizational controls include:
(a)organization charts;
(b) segregation of duties;
(c) authorization and approval;
(d) supervision controls.
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Organization chart (a)physical controls;

(b) controls over data.
Physical controls include controls to reduce theimpact of:
(a)fire damage;
(b)water damage;
(c)energy variations or power failure;
(d)pollution;
(e)intrusion by unauthorized personnel.
Controls over security of data include:
(a)restriction of access to data;
(b)information/audit trails;
(c)file and program libraries;
(d)holding data and programs in secure places outside of
the computer complex;
(e)use of grandfather, father, son (GFS) or file dumping
systems.
Troston payroll master file update
Segregation of duties includes the segregation of:

(a)authorization of transactions;
(b) execution of transactions;
(c) custody of assets;
(d) recording of transactions and assets.
In modern computer systems, segregation includes:
(a)operation of programs segregated from ability to change
them;
(b) alteration of master file data by responsible officials;
Finally, where control is dependent on segregationof duties
within a particular function, managementallocates duties
appropriately and instigates rotationof duties within
departments. Authorization and approval is closely linked to
segregation of duties to responsible persons, the limitations
on whose authority is specified. Allocation of authority and
responsibility is difficult in modern computer systems,
particularly where many users share a single database
Supervision controls are direct controls by authorized
officials over day-to-day transactions and their recording,
distinguished from management controls, concerned with
global or overall supervision of the control environment.If Quality of information systems is often critical to an
people work together collude segregation of duties may organizations survival. Poor information systems and
be ineffective, making fraud difficult to detect. Measures to inadequate user interfaces have an adverse effect on staff
ensure that directors and other employees act with integrity morale and on the general effectiveness of systems. The
are important quality assurance function is to ensure developed software
meets user needs, is reliable, easy to use, and efficient in
Security of information system assets is vital, whether terms of resources and ease of maintenance
physical assets or software and data. The company should
have a security policy and identify assets at risk and the The function is also concerned that documentation is clear
likelihood of risks occurring.Potential threats may be and complete and that staff are effective.Auditors consider
accidental or deliberate.Security controls include: effectiveness factors, including:
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(a) support of top management; is no one in the entity who has any specialized knowledge of
(b) high status within the organization; computers. How would you advise him? What do you think
(c) adequate resources to perform the function properly. might be the key risks in such a entity?
Auditors examine reports of the function, discuss its work ANSWERS
with major users and consider quality of staff
1 Internal control is defined in Paragraph 4 (c) of ISA 315:
The process designed, implemented and maintained by
those charged with governance, management and other
personnel to provide reasonable assurance about the
achievement of an entitys objectives with regard to
reliability of financial reporting, effectiveness and efficiency
of operations, and compliance with applicable laws and
regulations. The term controls refers to any aspects of
one or more of the components of internal control.
Note its aims:
(a) To ensure within reason that financial reports are valid
and reliable
(b) To ensure within reason, that operations are effective
and efficient
(c) To ensure within reason that applicable laws and
regulations are adhered to
(d) To address identified business risks that may threaten
the objectives in (a) to (c) above.
The main elements (or components) of internal control are:
(a) The control environment.
(b) The entitys risk assessment process.
(c) The information system, including the related business
processes, relevant to financial reporting, and
communication.
(d) Control activities.
(e) Monitoring of controls.
The reason that the auditor is interested in the
effectiveness of internal control and its components is that
good control systems reduce audit risk by mitigating the
impact of inherent risk. The auditors main interest, of
course, is in determining that the financial statements give a
true and fair view, and the existence of strong internal
control within the organization will increase the likelihood
that financial reporting is valid and reliable. If control risk is
low the auditor will be able to reduce the amount of
detailed substantive testing.
QUESTION 2. We saw in the text that the control environment can only
be effective if integrity and ethical values permeate the
1 Explain the importance of internal control within organisation. However, they CAN be just meaningless words
organizations. What are the main elements and what is the unless management makes sure that staff know what
auditors interest in them? integrity means in the context of the organisation. For
instance, management of an electrical retailer would
2 Integrity and ethical values are important factors in effectively be saying to customers that goods purchased
ensuring that internal control, including the control were safe to use. This would mean that statements about
environment is effective in reducing risk and in helping safety would have to be properly backed up by a proper
management to achieve objectives. Do you think that these testing regime. If not, the company would expect to suffer
are just meaningless words or are they really important in loss of reputation and to incur damages as the result of
the business context? Why do you think that auditors look court cases. An example like this can show us that integrity
for integrity and ethical values in management and and ethical values have a practical significance and are not
throughout the organization? just meaningless words.
3.You have recently become auditor of a small trading As far as auditors are concerned, they have to decide if they
entity whose system is based on a series of networked can rely on company systems in achieving their own
microcomputers, using bought-in software for basic objectives, the main one of which is to give an opinion on
accounting functions. During the initial meeting with the truth and fairness of the financial statement.
management, the managing director told you that he is Management is responsible for putting in systems and
really scared of all this computer stuff, particularly as there creating a control environment that will ensure that all of
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their objectives will within reason be met, including d) Risk that the company does not observe appropriate
preparing financial statements that truly and fairly organisational controls. For instance, does the company
represent the results of the organisation and its state of have a system for allocating responsibility? Are duties
affairs. If management possesses integrity and ensures that appropriately segregated? You might reassure the
company staff are aware of the ethical values needed in the managing director that in a small company where there is
context of the company, the auditor will be more confident little computing knowledge among staff and where systems
that the control environment and associated detail controls analysts and programmers are not employed there is a
can be relied on. In this connection, there have been a lower risk that people will interfere with the proper
number of well-publicised case of whistle-blowing by operation of programs.
people internal to organisations, who have objected to the
way that the organisations behave. Very often these
objections are legitimate and organisations should have a
stated policy in respect of whistle-blowing, including a CHAPTER 8
system that enables employees to discuss their misgivings
to independent people within the organisation. System work : Basic Ideas 2
3. You might have preferred not to start from here, but

rather to have been involved when the decisions were
made to install the computer system. The key risks would
be as follows: Objectives of application controls
Broad objectives of application controls are:
a) Physical risks affecting the microcomputers, the network (1) data collected is genuine, accurate and complete;
server and the people operating systems. You might suggest (2) data accepted is processed so it remains genuine,
to the managing director that he should ensure that accurate and complete;
physical equipment should only be used by authorised (3) data stored temporarily or permanently is genuine,
people and be kept secure particularly outside working accurate and complete;
hours. It might be useful to employ someone with basic (4) output data/information is genuine, accurate and
computer skills to help staff when problems arise and to complete and goes to the intended recipient;
make sure that the server is working properly when needed. information/audit trail is complete. ...KEY POINTS
It might also be desirable to shut down the server outwith
normal working hours. This person might usefully draw up a Application controls include:
code of conduct for computer users, including a restriction (a) data capture/input controls;
in the time that people sit at the keyboard. (b) processing controls;
(c) output controls;
b) Risk that the system has not been developed properly in (d) database controls;
the first place. You should ask the managing director to see (e) e-commerce controls
the documentation prepared at the time the system was
developed, including any feasibility studies, documentation Boundary of controls
concerning the desired characteristics of the systems, and Boundary controls include the following :
testing that was carried out, and by whom, prior to putting (i) cryptographic controls
the system into use. You would be particularly interested in (ii) plastic cards;
discovering if the bought-in software performs in the way (iii)personal Identification numbers (PINs)
expected, for instance, whether appropriate (iv) digital signatures;
information/audit trails are recorded. Is double entry (v) passwords;and(vi) firewalls.
properly carried through in all cases? You should also ask
what kind of training staff received at the time the system Password systems have the following features:
was introduced and what kind of ongoing training is (a)degrees of access;
provided. For instance, was staff informed of the need to (b)at least eight alphanumeric digits and combinations easy
respond to error messages, to keep passwords private, and to remember;
to report bugs in the system. (c)avoidance of passwords associated with users;
(d)staff training on keeping passwords secret.
c) Risks of loss of programs and data. The managing director (e)regular and frequent changes;and
might be particularly concerned about loss of (say) trade (f)shutdown of terminals when incorrect passwords
receivables, trade payables and inventory records, and entered.
information used to manage the business. We are not told
much about the system but we would recommend simple Access controls are important when distantterminals are
security measures, such as keeping back up copies of used to transmit data. A password system is an important
programs and data outside the operating areas, supported control, but other controls include:
by the use of grandfather, father, son and dumping systems
as appropriate. You should advise the managing director to (a)limit the use of terminals to particular functions;
establish degrees of access to data if this has not been done (b)record which terminals and employees access the system
already, supported by the use of appropriate passwords. and review by responsible persons;
You might also suggest that one person keep master copies (c)restrict use of terminals to normal working hours (not
of programs and of back-up copies of data in a computer appropriate in e-commerce environment).
library, together with a booking in/out system.
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Where the national telephone system is used totransmit after-the-event authorization is a necessary feature
data, additional controls are necessary: of database systems;
excessive power in the hands of DBA makes
(a)telephone numbers to be ex-directory; supervision of DBA staff essential, including rotation
(b)private lines; of duties and regular review of recorded actions
(c)telephone numbers restricted to certain parts of the affecting the database
system; technical features to secure safety in processing,
(a)call-back system; such as roll-back, tend to reduce control, so
(b)encryption of data. complete record of use required;
information/ audit trail is particularly important and
Audit trail a record of all interventions affecting the database
The first records of the information/audit trail are at the should be kept.
boundary where identity and authenticity of the user is first
recorded. Records include data to which access is Control over E-Commerce
requested, actions users wish to take, terminal at which E-commerce presents particular control problems.Degree of
access is sought, record of access decision, number of sign- risk depends on how the organizationuses the internet:
on attempts and time of starting/finishing (a) making information available to outsiders;
(b) exchanging information with customers and other
Input subsystem accepts data and ensures softwareis valid. trading partners;
Examples of controls are: (c) using the internet to transact business;
(a)design of source documentation; (d) full integration of the business systems with e-
(b)design of product, customer and other codes; commerce conducted through the internet, making access
(c) use of check-digits; controls particularly important.
(d) sequence checking;
(e) limit or reasonableness tests; Management has to decide whether businessconducted
(f) one-for-one checking for critical data items; over the internet is separate from thecompanys main
(g) batch controls. business or whether it is fullyintegrated. Particular risks
relate to:
Batch controls are supported by appropriateorganizational
controls, including: (a)security;
(a)formal transfers of data between data preparation (b)residence for legal and taxation purposes;
departments and data control section; (c)business and accounting risks;
(b)segregation of user departments and computer (d) e-commerce as a 24-hour business;
department; (e) risks associated with complex technology.
(c)user department retention of control over data in non-
database systems; Legal and taxation matters are important because the
(d) investigation of differences between predetermined internet is international and it may not be clear which legal
control and actual totals; or taxation jurisdiction applies. The applicable jurisdiction
(e)early verification of inputs. should be stated when the transaction is entered into, or
business might be restricted to residents of particular legal
In database systems, batching of actions by a useror or taxation jurisdictions. Arrangements for double tax relief
terminal. Controls over applications include: might have to be made
(a) run-to-run controls to ensure continuity; Other practical business and accounting problemsinclude:
(b) secondary storage media should contain both external
and internal labels; (a)is the company acting as principal or agent;
(c) master file data must be genuine, accurate and complete (b)cutoff;
before processing; (c) system for dealing with return of goods and claims under
(d) programs must be tested at the development stage and product warranties;
on a continuing basis; (d) recording bulk discounts and special offers;
(e) the information/audit trail should be updated to record (e) payment other than by monetary transfer, such as
all processing actions from the time input data is received advertising set-off;
to the time it is despatched as output; (f) browsing should not be confused with placing an order;
(f) sequence checks; (g) making sure that all aspects of a transaction are properly
(g) limit or reasonableness tests; followed through to back office systems
(h) casts and crosscasts, where appropriate
Systems objectives
Database systems Auditor ust have a structured approach to examining
Database systems provide the same data toeveryone in the systems and clear objectives. Systems objectives should be
company having authority to access them, but special broken down into stages and objectives determined for
controls are needed: each .
loss of control over data by data preparation There are six stages in a sales system:
personnel may be countered by giving ownership of (1) receipt of order;
a particular sub-schema to designated users; (2) authorization of order;
(3) despatch of goods and entry in stock records;
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(4) invoicing of goods despatched and entry in sales record; 1. organization charts;
(5) entry in debtors ledger or bank records; 2. flowcharts of various kinds.
(6) entry in general or nominal records.
Organization chartsshow the flow of authority
System objectives may be equated with management through the organization and are vital if segregation
assertions about entries in theaccounting records and of duties is to be effective, but are only a guide to
whether they are genuine,accurate and complete. The audit power within an organization.
approach to thefinancial statements comprises:
Information/ audit trail flowcharts may be useful in
(a) identification of components and related assertions, tracing data through the system and where breaks
inherent risks and controls; in the trail occur.
(b) estimating level of control risk;
(c) determination of audit detection procedures to reduce Document flowchartsshow where documents are
total audit risk. prepared, who prepares them, their characteristics,
where they are filed, how many copies are
Data flow diagram: customer order system prepared, where they are sent, any action taken on
their basis, and how they are modified. They have
become less useful as so many functions now take
place electronically.
Data flow diagrams are useful for determining what

happens to data when it is entered at the interface
and then passes through the various subsystems.
System flow chartsshow data flow through a

system, but concentrate more on the way data are
affected by the various programmed routines and
how they relate to other data input to the routines.
Program flowchartsshow detailed decision making
internal to programs
The advantages of flowcharts are that they:

(a)enable understanding of systems by auditors and client
staff;
(b)force the auditor to understand how the company
controls operations;
(c)pinpoint unnecessary procedures or documents.
The disadvantages of flowcharts are that:
(a)They can be time-consuming to prepare and may be
difficult to alter;
(b)in simple systems, narrative descriptions may be more
appropriate;
(c)there is considerable variation in use of symbols;
(d)They may not be useful in the hands of inexperienced
audit staff;
(e)in complex situations flowcharts may be too simplistic to
aid genuine understanding.
Questionnaires and checklists enable auditors toform views
about the system in use in a logical way. They include:
(a)internal control questionnaires;
Collection System Information (b)internal control evaluation questionnaires;
Collection of information about systems needs considerable (c)EDP/IT checklists.
powers of enquiry. Auditors interview a wide range of
people involved with the system from those responsible for
development to users and operators. Recording of systems EXERCISE
may be by narration, visual description, or questionnaires 1. Consider the following statements and explain why they
and checklists may be true or false:
(a) ICQs are questionnaires used to record the system in
Narrative description can be useful in small systemsand use.
may be useful support to other means ofrecording.Visual (b) ICQs are questionnaires used to evaluate the system in
descriptions include: use.
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(c) ICEQs are questionnaires used to record the system in before and after the computer.
use.
(d) The basic requirement of an accounting system is that it .2 As Ann Paterson is an established customer of the
meets the needs of the business for which it is designed. company, she would be able to identify herself and
(e) In a small organization it is impossible to have a good authenticate her status as a valued customer. She might
system of internal control. already have given her credit card number and expiry date
(f) In modern systems, a data flow diagram is more useful and an identifying word to the sales clerk before the order
than a document flowchart. was processed. The clerk would either complete a hardcopy
form or a form called up on the monitor screen. If the latter
2. Assume that Ann Paterson, an established customer, has is the case, important controls would be :
telephoned asking that she be supplied with three recently
published books. She has been passed to a sales clerk who (a) form design enabling easy completion
deals with her order. Suggest controls that should be in (b) non-acceptance unless all fields on the form were
force before her order is accepted. complete.
3. Assuming that the order is accepted and that the books Further controls would be procedures to ensure that the
will be supplied on credit, explain what records will be clerk knows if the books are available and when they would
affected by the transaction and the information/audit trail be despatched, that calculated the amount of the invoice
details that should be recorded. and compared Ann's credit limit with the outstanding
balance, adjusted for the new transaction. The clerk would
ANSWERS be prompted to inform Ann whether the order had been
accepted, and if accepted, to read the terms of the order
1 a) True and amount of the invoice to her.
ICQs are questionnaires designed to help the auditor to
understand how an accounting and internal control system The system should send a copy of the accepted order to
operates, as well as aiding evaluation. They are not always her, and, if not accepted, a letter detailing reasons for non-
useful in complex systems. acceptance. Further controls would be numbering of the
orders processed by the sales clerk and the preparation of
b) True control totals for all transactions entered by the clerk during
This statement is also true. ICQs are not merely used to the day (the clerk would also need to be identified and
record the operation of systems; they are also used to authenticated). We would expect sequence checking of
evaluate the systems. ICQs are usually designed so that 'No' orders entered by the sales clerk. Apart from these controls
answers will indicate a weakness in the systems in use. the auditor would be interested in the completeness of the
c) False information/audit trail
ICEQs, unlike ICQs, are not used to record the systems in
use, but to evaluate using key questions, supported by 3 We made the assumption above that the sale was on
subsidiary questions. credit. If so the following records would be affected by the
d) True transaction:
Accounting systems do not have to be sophisticated if the
demands of the business do not require it. In the case of a (a) The transaction should give rise to hard copy documents
small trading company, it is possible that the only records - order form (numbered), despatch note (numbered) and
required will be an analysed cash book and invoice and sales invoice (numbered)
bank statement files. You should not forget that the more
complicated the accounting system, the greater the degree (b) the following permanent records would be affected:
of expertise required to operate it. Many small businesses sales transactions record (assuming that the company sells
cannot afford to employ a trained accountant and rely on in its own name rather than on a commission basis);
professional accountants to prepare financial statements inventory record (assuming that this company keeps books
for them. on hand rather than having them supplied by a third party);
debtors ledger for transaction and amended balance
e) False
While it is true that sound systems of internal check based (c) the information audit trail should include the following
upon segregation of duties is often not possible in small features: customer name, identification word,
companies, the internal controls may be good because of authentication and credit card details; clerk and terminal
supervisory controls exercised by proprietors or owner handling the transactions; confirmation of inventory on
directors. There may be problems for the auditor, however, hand requested by clerk; calculation of invoice; the sum of
as there may be no certainty that directors are not existing balance and transaction and comparison with credit
overriding controls. limit; acceptance or non-acceptance of order together with
reasons; record of order number; update of inventory
f) True record (and despatch note number) and debtors ledger
In modern computer systems many actions are occurring (before and after balances in each case) and invoice details
electronically within the company's systems, which do not including number and duration of transaction.
result in a flow of documents, so it is more useful to show
how data flows through the system. Auditors use the
diagram to prove the audit trail and to identify control
points. This does not mean that document flow charts do
not have a role, as documents are still produced both
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CHAPTER 9 Test data

Test data are assembled by the auditor and passed through
Testing and Valuation of Systems the system to determine if the data are processed as
expected. The process can be very time-consuming and will
be used only in systems critical for the auditors.Test data
must be representative of real data, which must be
systematically analysed to determine its nature. Some
Identification of financial statements auditors use computer-generated test data.
Auditors identify components of financial statements and
related systems. They identify control points and assess the Test data may be processed during a normalprocessing run
appropriateness of controls, using key and subsidiary (live test data) or outside normal processing (dead test
questions to assist evaluation. Some components may be data), but problems are:
regarded as being of low risk to auditors, who may reduce
audit work on them 1. if used during normal processing runs, the test data
will corrupt company files unless corrective action is
Auditors obtain information to record systems by discussing taken;
their operation with a wide range of individuals, from 2. if used outside of normal processing, the results
quality control staff to users at the system interfaces. They may be artificial because of the difficulty of creating
inspect a limited number of documents of each type from normal conditions.
inception to final entry in the records, but as the scope of
work is limited, they cannot be sure that the system always Program code comparison
operates in the manner recorded. Program code comparison is used to compare the program
being tested with a program known to be the authorized
So, the auditor performs compliance tests (tests of control) version. Interpreting the results needs considerable
to confirm whether or not internalcontrols are satisfactory expertise in deciding if the discrepancies are critical or not.
and whether they can be relied upon The discrepancies might reveal that unauthorized changes
have been made to programs, but do not detect defective
Compliance test programs
Compliance tests include:
(a)extended walk-through tests of the information/audit Concurrent auditing
trail; Concurrent auditing techniques involve embedding audit
(b) block testing one aspect of the system; facilities that allow continuous review of data and their
(c) interviews with company staff; processing. Programs created by the auditor flag critical
(d) observing staff at work; events as they occur for immediate or delayed review. They
(e) re-performance of control procedures; can be useful in tracing the information/audit trail.
(f) examination of management reviews.
All data types and conditions are taken into account in
Auditing Computer systems establishing the embedded audit facility and must be
There are various ways that auditors approach auditing updated regularly. They are expensive and need
computer systems: considerable expertise, but may be useful in high risk
(a)round the computer; situations.
(b)through the computer;
(c)with the computer. Two types of embedded audit facilities are:
(a) integrated test facility (ITF);
When auditing round the computer auditors see the (b) systems control and review file (SCARF
computer as a black box and audit activity concentrates on
comparing inputs and outputs and using techniques such as The auditor, having evaluated and tested the operation of
analytical reviews.This approach was satisfactory in the systems, concludes on their efficacy. If systems and audit
early days of computing when information/audit trails were objectives have been properly set, and evidence has been
easy to maintain properly collected, concluding upon results of systems work
should follow logically. When forming conclusions on
As systems developed in complexity auditors moved systems, the auditor states the consequences of particular
towards auditing through the computer, seeing the strengths or weaknesses in the system and may suggest
computer as a tool in their hands, the audit being changes in scope in respect of them
computer-assisted.The computer may be used for
(i) testing the system
(ii) testing data held on computer file, but the audit
planning stage becomes more important. Where auditors
use the computer to manage the audit process they audit
with the computer
Code reviews
Code reviews are designed to determine if there are defects
in programs that will cause incorrect processing of data, but
tend to be costly in time and need expert knowledge, so are
only used in critical areas
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CHAPTER 10 The software can:

Substantive Testing , Computer-assisted audit (a)access files with different characteristics and manipulate
the data on them;
techniques and audit programmes (b)select data on the basis of predetermined criteria and
perform arithmetical functions;
(c)analyse selected data statistically and stratify it into
desired categories;
Substantive procedures (d)cause files to be created and updated from company
Substantive procedures are: files;
Tests to obtain auditevidence to detect material (e)produce reports for the auditor in desired format.
misstatements in thefinancial statements and are generally
of two types: Statistical Analysis
(a)analytical procedures; Statistical analysis software is used to extract important
(b) other substantive procedures, such as tests of details of ratios and balances from company records for comparison
transactions and balances, review of minutes of directors with previous periods and external data, and can be used to
meetings and enquiry. select data statistically.
Data may be tested by tests of control or by substantive Software packages with regression analysis capabilities may
tests of details. In a financial statements audit, auditors are enable auditors to form views about company and industry
principally interested in whether figures in financial trends. Generalized audit software is a useful supplement to
statements give a true and fair view. They carry out tests on statistical sampling techniques as it audits by exception,
data to prove transactions and balances are genuine and interrogating files and pulling out items possessing
accurately and completely recorded, whatever the system characteristics the auditor has selected
in use
Audit software is particularly useful when there arelarge
Regardless of assessed levels of inherent and control risks, amounts of data. The major disadvantage isthe cost of
auditors perform some substantive procedures for financial development, but, once developed, itcan be economical in
statement assertions of material account balances and audit resources and canachieve quick results
transaction classes. Substantive tests are limited or
extended depending on whether accounting and control Other disadvantages are:
systems are deemed ineffective or effective, and may (a)generalized audit software can only be used after the
include tests of detail as well as analytical procedures event;
(b)although systems weaknesses can be discovered using
Audit plan audit software, it isdifficult to assess the likelihood of error;
The audit plan might change in light of feedback, as more (c) as audit software is not used continuously, any system
knowledge of the company is gained as the audit weaknesses may not be discovered timeously;
progresses, causing risk assessments to change and (d) audit software may not be useful in detecting where
affecting scope of examination. Substantive procedures are system breakdowns are likely to occur
intended to prove that transactions and balances are
genuine, accurate and complete, but even extended tests Expert systems can be useful in certain instances.They make
may be insufficient to allow auditors to say with confidence expertise available to persons who arenot experts
that financial statements give a true and fair view themselves and are used both forevidence collection and
evaluation. They have been devised to:
Discuss the extent to which the interim audit programmes (a)evaluate risk, and the strength of systems;
should take account of the interim results of Powerbase plc (b)suggest appropriate audit programme steps based on
Auditors must be clear as to what they wish to achieve evaluation of systems; and
before designing a programme of substantive tests. (c)check compliance with the Companies Acts and
accounting standards.
Audit software
Auditors use specially designed audit software Directional Testing
forsubstantive tests of details, including: Directional testing is a form of substantive testing, which
(a)generalized audit software; tests debit balances for overstatement and credit balances
(b)software for use in specific industries; for understatement. It is useful as it introduces an organized
(c)statistical analysis software; element to setting audit objectives, but a global approach
(d)expert system software. should also be adopted to ensure that the debits and credits
give a true and fair view when taken together
Generalized audit software and software developed for
specific industries are interrogation tools used to access, Management Letter
examine and manipulate data and information on file. Used The management letter is an important means of
for substantive tests of detail, they can test the communication between auditor and those charged with
effectiveness of systems and company personnel, as well as governance and is used to inform them of matters
interrogate data held on a companys own files, or on the significant to them. When material weaknesses in
auditors own system. Audit staff can be relatively easily accounting and control systems have been identified,
trained in the use of such programmes auditors should report them in writing to the directors, the
audit committee or an appropriate level of management
timeously.
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Directional testing example (e) review and reporting activities;

(f) keeping manuals and checklists on file
Data Security
Security of data held by the auditor on computer file is vital.
Access controls, including use of passwords, should be in
place to make corruption of data less likely and to prevent
files falling into the wrong hands. Back-up copies should be
made to avoid loss of data, and printouts of hard copies of
key working papers made regularly
Spreadsheets can be invaluable tools but preparation needs
careful control. The spreadsheet should be described and
the intended purpose explained. The use of macros must
always be carefully explained, documented and tested
Questions
1 Consider the following statements and explain why they
may be true or false:
(a) Tests of controls are those tests designed to check that
the accounting and control systems are effective.
(b) Substantive tests are different in nature from tests of
control.
(c) Audit programmes should be designed to take account
of the strengths and weaknesses of the individual entity.
(d) Audit programmes are developed before the scope
decision is made.
(e) Directional tests are tests of control.
2. Assuming that your audit programme for the purchase of
non-current assets has been completed and that your
programme objectives have been met, draft a suitable audit
conclusion for audit work carried out in respect of the
period from 1 January 2010 to 30 September 2011.
Solutions
1 a) True
Tests of control are tests directed towards checking the
operation of systems. The objective of using them is to
prove that the auditor's assessment of control risk is proper
b) False
While the role of substantive testing differs from that of
tests of control in that it is directed not towards systems but
towards proving that transactions and figures are
completely and accurately recorded, the nature of the tests
may be very similar. Thus, selecting goods despatch notes
Audit Automation to prove that the entry to inventory records is accurate may
Increasingly, auditors use computer technology to manage be used to both to test the operation of the inventory and
the audit process and to increase audit efficiency and purchases systems AND in substantive testing to prove that
effectiveness.Audit automation frees up staff to perform inventory records and purchases are complete and
judgemental work rather than being engaged in repetitive accurate.
activities.
c) True
Audit programmes should be tailor-made to the
circumstances of the particular organisation. For instance, if
Examples of use are: the auditor discovered that credit control procedures were
(a)expert systems for recording and evaluating potential weak, the audit programme should emphasise steps to
problem areas; prove collectability of the recorded trade receivables.
(b)risk assessment, planning and allocation of staff and
other resources, using analytical review packages, d) False
spreadsheets, packages for allocating staff time and word Audit programmes give effect to the scope decision and
processing software; therefore must be drawn up after the scope decision has
(c) information retrieval and analysis; been made.
(d) interpretation and documentation of results;
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e) False (a)transactions not subjected to the same internal controls

The purpose of directional tests are to test for over- and throughout the period;
understatement of transactions or figures or balances and (b)balances with widely different values. Because of lack of
such tests should therefore be regarded as substantive tests homogeneity, it is commonpractice to stratify populations
of details. and to treat eachstratum as a different population.
2. Suggested audit conclusion on the purchase of fixed A sample must be taken from the whole populationand may
assets : be selected in various ways:
1. random;
On the basis of the work performed on the purchase of 2. systematic or interval;
fixed assets as set out in the fixed assets audit programme 3. block or cluster;
on working paper F100, as supported by working papers 4. haphazard sampling.
F101 to F105, I can conclude that, within reasonable limits,
all purchases of fixed assets in the period from 1 January Sample size
2011 to 30 September 2011 have been fully and accurately Audit evidence must be sufficient, so sample size
recorded and that such purchases have been made on the isimportant. Size of samples is dependent on:
basis of properly prepared budgets duly authorised at (a)level of confidence required;
appropriate levels within the company. The audit (b)expected error rate;
programme was prepared on the basis of scope decisions (c)tolerable error rate.
recorded in working paper F10, supported by systems notes
in the permanent audit files (Section F). Level of Confidence
Level of confidence is influenced by assessment of inherent
and control risks. If auditors have obtained evidence from
other relevant audit tests, such as analytical review, the
confidence they require from sampling is correspondingly
CHAPTER 11 reduced
Sampling and Materiality
The expected error or deviation rate
The expected error or deviation rate is an important
determinant of sample size, whether using the sample for
substantive or compliance testing. The greater the expected
Audit Sampling error rate or amount, the greater the sample size needed to
In performing the evidence search, auditors carry out conclude that the actual error rate or amount is less than
sufficient appropriate work to be reasonably certain that tolerable error rate or amount. Auditors must define an
audit conclusions are soundly based and at a reasonable error or deviation beforehand
cost. At the outset auditors decide what approach they will
use and when it is likely to be appropriate to use audit Tolerable error rate
sampling, taking into account the criteria of sufficiency, Tolerable error rate or amount is the maximum error rate or
relevance and reliability amount auditors are prepared to accept.When testing
controls, tolerable error rate is the maximum deviation rate
Audit sampling may be either non-statistical or statistical. In in the sample the auditors are willing to accept and still
statistical sampling, probability theory determines sample conclude their initial evaluation of control risk is valid.
size. Random selection ensures each item or 1 value has When testing for amounts, tolerable error is related to the
the same chance of selection as any other. Non-statistical level of materiality set. The lower the tolerable error rate or
samplingis more subjective, typically using haphazard amount the greater the sample size
selection and placing no reliance on probability theory
Evaluation of sample
Careful planning of the sampling process isessential: First stage in evaluation is to determine the number of
1. testing a sample increases the risk the auditors will errors in the sample. The next is to estimate, on the basis of
fail to detect matters of significance, this sampling sample results and given level of confidence, the upper
risk being part of detection risk; error rate (UER) in the population, using reliability factors
2. the characteristics of the population must be clearly and sample size
identified.
Auditors decide on appropriate action on the basis of
Non-statistical Sampling sample results, such as placing less reliance on controls and
Non-statistical sampling is often termed judgemental extending scope of substantive procedures. Auditors are
sampling. Case study 11.1 gives an example of this.The also concerned with the nature of the errors identified
sample can be used as the basis for substantive testing of Reliability factors (extract
balances or testing the operation of the system. Judgement
is a feature of statistical sampling too, but there may be a
reduction in judgement required
Population
A population is homogeneous if all items have thesame
characteristics. Factors causing lack of homogeneity include:
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the increased use of risk-based auditing, with more

emphasis given to analytical review and investigation of
large or unusual transactions or balances, detected using
audit software. There is also more emphasis on evaluating
the effectiveness of the control environment
Other statistical sampling methods are:
(a)discovery sampling;
(b) variables sampling, The latter includes:
(i) mean per unit method;
(ii) ratio and difference method.
We know come to materiality, the expression of the
relative significance or importance of a particular matter in
the context of the financial statements as a whole.A matter
Population size has little effect on sample size. is material if its omission or misstatement would reasonably
influence the decisions of a user of the financial statements
Attribute sampling Determining materiality level
Attribute sampling in testing internal control systems is Users of financial statements may be sophisticated and
important, but the amount by which an account balance is knowledgeable, or unsophisticated and naive.Auditors
in error is of greater importance therefore need to have a way of measuring when
misstatements or omissions are material enough to cause
Monetary Unit Sampling (MUS) financial statements not to give a true and fair view a
Monetary unit sampling (MUS) is used to estimate the judgemental area
amount by which an account balance is in error. Auditors
decide the maximum value of errors they are prepared to Auditor often direct attention to the profit before tax figure
accept and use MUS to estimate the most likely error (MLE) when determining materiality level, setting materiality
and the likely upper error limit (UEL, or monetary precision) levels in terms of a percentage of the figure, often on an
in monetary terms. average basis over a number of years.Auditors look at
nature and extent of errors and company context before
There are two basic ideas underlying MUS: taking a final decision about materiality.
(1)the population is divided into 1 units;
(2) should an error be found in the transaction or balance to The materiality level set and the amount of evidence
which the 1 is attached, the transaction or balance is held auditors need are related; the lower the materiality level
to be tainted. Auditors specify confidence level and the greater the quantity of evidence required.Auditors will
tolerable error,and these, together with estimate of likely set materiality levels for other figures too, including
error areused to determine the appropriate sample size. turnover, total assets and net assets and, in practice,
normally calculate materiality levels based on several
When evaluating sample results auditors calculate MLE, criteria and then decide on appropriate materiality levels
supplemented by calculating an estimate of UEL. If UEL is for different aspects of the audit
less than tolerable error, the auditors can accept the
population. If not, the auditors may adjust UEL for any Auditors may give greater emphasis to testing for over
errors found to determine if that reduces UEL below statements rather than understatements and may consider
tolerable error. If UEL remains above the tolerable error, other matters relating to profit:
the auditors carry out extended or alternative procedures 1. trend in profits;
2. effect of profit figure on ratios;
Statistical Sampling 3. external influences;
An advantage of statistical sampling is that it requires 4. poor performance and difficulties in raising finance.
auditors to make explicit their judgements on confidence
level, expected error rate and tolerable error rate. Sample Auditors set materiality levels at the audit planning stage to
size is based on statistical principles and therefore can be put audit risk into context, as there is a strong relationship
justified, and sampling risk and the evaluation of results is between risk and materiality. Most risks relate to specific
quantified and more precise financial statement headings and auditors assign a
materiality level to components of the financial statements
Statistical sampling has several disadvantages:
(a)it is time-consuming and costly;
(b) it requires documents or account balances to be held in Factors likely to influence determination of themateriality
a manner enabling separate identification; level for components include:
(c) it is more difficult to understand for non-statistician, 1. importance of the heading;
although specialized computer statistical sampling packages 2. nature of item;
are available. 3. auditors past experience;and
4. trend in the account balance.
Since the early 1990s the use of statistical sampling has
decreased and is more likely to be used in specialized audit Individual materialty levels
situations. The reason for the decrease may be attributed to
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Setting individual materiality levels is important because it (c) stages of completion of long-term contracts/assets in
influences the nature and scope of workon individual course of construction;
account balances. Auditors record themateriality levels and (d) letters to other professionals.
reasons therefor.During the audit auditors may change their
viewsabout appropriate materiality levels because of: Some time elapses between interim and final examinations
(1) changes to draft accounts; and auditors should ascertain whether conclusions formed
(2) evidence gathered during audit testing earlier are still valid and whether systems operated as
The effect of any misstatements found are evaluated and an expected during the whole year This is know as bridging
estimate made of the amount of potential errors in the work
components of the financial statements and in the financial
statements taken as a whole. If auditors find their estimate Analytical procedures.
of the misstatements is less than the materiality levels set, ASB has adopted a balance sheet approach when defining
they can conclude that the financial statements are not assets and liabilities and less attention is paid to matching
materially misstated and accruals and to the profit and loss account. It may mean
that it becomes more difficult to interpret profit and loss
Consideration in evaluating misstatements account and income/expense headings
Auditors will consider the nature of errors and, if
management decide not to adjust, the auditors should The search for audit evidence is conducted on a global and
determine the reasons. If auditors believe errors may be detailed basis and within a clearly understood risk context.
material they extend the scope of audit tests. In evaluating Analytical review is useful when reviewing the financial
misstatements auditors consider the following features : statements taken as a whole at the conclusion of the audit
1. size and incidence;
2. whether errors exhibit a pattern; Specifically, auditors determine whether:
3. whether errors relate to factual matters or (a)financial statements have been prepared using
matters of opinion; consistent and appropriate accounting principles;
4. whether the errors relate to illegal matters; (b)information published with the financial
5. whether there is suspicion of fraud; statements is compatible with them;
6. whether similar errors were discovered in (c)presentation and disclosure are as required by
previous year; law and by regulatory bodies and achieve truth and
7. whether misstatements affect only balance sheet fairness;
items or the profit and loss account too. (d)conclusions drawn from tests and overall review
of the financial statements enable an opinion to be
Qualitative issues to be considered are: formed.
(a)whether the item is required to be disclosed;
(b)whether accounting policies are improperly disclosed; Ratio Analysis
(c)where there is improper classification. Auditors use ratio analysis and other interpretativetools.
Significant changes in figures revealed byanalytical
CHAPTER 12 reviewmay result from:
Final Work : General Principles , analytical review of (a) errors;
financial statements, fixed aasets,and debtors (b) changes in accounting practice
c) changes in management policy;
(d) changes in general commercial factors;
(e) changes in commercial factors affecting the client only;
(f) fraud
Pre-final work
Discussions are held with management near the year-end to In the examination room the best approach is:
ensure that preparation of financial statements runs (a) look at the figures broadly, before calculating ratios;
smoothly and timetables are met.Auditors maintain regular (b) calculate selected ratios to confirm initial impression;
contact with management to detect problems earlyon in (c) remember many ratios are interrelated;
the process. (d) analysis of financial statements directs audit effort.
Potentially problematic areas include: Ratio analysis can be useful, but must be handled with care
(a) known problems; as ratios are meaningless unless compared with other
(b) stocktaking instructions; ratios. Auditors should ensure industry statistics have been
(c) timetable for preparation of year-end financial prepared in the same way as ratios used for the company
statements; and be aware of special measures of success or
(d) circularizations; performance indicators used in a particular industry
(e) requirements of accounting and reporting standards;
(f) new legislation; Other analytical tools include:
(g) requirements of auditing standards (a)graphs;
(b)regression analysis and multiple regression analysis;
Balance sheet date work. (c)Z-scores.
Typical audit work includes:
(a) bank confirmations;
(b) stock count observation;
True and Fair view of Financial statements
PE1
Accounting standards are designed to aid the preparation of 4. significant repairs;

financial statements that give a true and fair view. Members 5. maintenance charges.
of accounting bodies acting as auditors or reporting
accountants should justify significant departures to the Financial Statement assertions
extent that their concurrence with the departures is stated On revaluation of fixed assets, financial statement
or implied. assertions include:
1. Genuine: revaluation has taken into account real
Financial statement assertions in respect of assets, claims conditions; selected basis is appropriate;
against assets, and related revenues and costs are grouped 2. Accurate: calculation of current values
under the headings appropriately reflects underlying value in
1. genuine accordance with relevant accounting principles;
2. accurate 3. Complete: all fixed assets in a particular class have
3. complete been revalued
prompting questions about existence, condition, ownership, Substantive procedures include that the valuer isproperly
valuation and disclosure/presentation. qualified and that the valuers scope ofwork is appropriate,
including:
(a) objectives and scope;
Tangible fixed assets (b) clear statement of the matters to examine;
These vary in nature within companies andbetween (c) why work is being carried out;
industries. Inherent risk factors include: (d) information provided to the valuer, and its reliability
(a) technological changes; (from local planning and similar authorities; and from client
(b) closure of part of business; officials and solicitors);
(c) difficulties in making estimates of useful lives; (e) assumptions and methods used;
(d) revaluation of fixed assets; (f) timing of valuation.A second valuation may be
(e) existence of significant idle fixed assets; appropriate if significant
(f) significant fixed assets in course of construction;
(g) own construction of fixed assets; For disposals of fixed assets, determine thereasons if
(h) moveable, high value assets. significant and whether an impairmentreview of the
remaining assets is necessary.Substantive procedures
Specific control to minimise control risk include:
A part from a satisfactory control environment,specific (1) check number sequence of disposal approvals and to the
controls are necessary to minimise control risk over: fixed assets register;
1. acquisitions, revaluation, impairment; (2) select random sample of approvals and check
2. safeguarding; authorization signature and trace to sales despatch notes.
3. disposals;
4. maintenance, insurance; Depreciation
5. authorization of depreciation charges and Audit work on depreciation is closelyallied to work on the
accumulations. fixed assets. Specific matters of interest are:
1. useful economic lives and appropriateness of
Main control documents for acquisitions are fixed assets depreciation method;
budgets long, medium and short term.The main 2. residual values;
accounting record for fixed assets is the fixed assets 3. depreciation on revalued fixed assets.
register. To be a good control document it should be held
by persons independent of those using and having custody Trade debtors
of the fixed assets, and be compared periodically with Trade debtors are normally classified as current assets. It is
physical assets and vice versa important to determine the point at which the property in
goods is transferred or service performed. Sales of goods
Using recorded details, fixed assets should be reconciled by and services cause trade debtors to come into existence or
the company at least annually to cost/valuation, increase cash balances, so audit work on sales cannot be
accumulated depreciation and depreciation charge figures divorced from work on the assets accounts
in the financial statements. If a fixed assets register is not
kept or the register is found to be subject to error, control The auditor would expect to see a satisfactorycontrol
risk will be increased and auditors may have to extend environment and control over:
substantive tests of detail (1) creation and clearance of trade debtors balances;
(2) safeguarding of trade debtors.
Proceeds of sale of fixed assets may be misappropriated if
controls are not in place.Disposals should be authorized in Important elements when safeguarding tradedebtors are as
writing by individuals with appropriate authority after follows:
careful assessment of continuing value, with directors to (a) the rapid billing of customers;
issue guidelines for making assessments (b) regular preparation of statements and reminder letters;
(c) offer of cash discounts;
Analytical procedures on fixed assets might be directed to: (d) approval of entries reducing the stated amount of
1. significant additions and disposals; debtors balances
2. profits/losses on disposal; ,(e) ageing statement;
3. revaluations; (f) credit limits
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Loss on disposal of factory equipment

Substantive approaches cover: Inventory levels
(a) creation of trade debtors balances; Directors emoluments
(b) proving trade debtors are genuine, accurate and
complete; (c) Gas company income
(c) proving reasonable relationships between trade Number of units of gas used
debtors/sales and other figures in the financial statements; Temperature in winter months
(d) checking cut-off; Electricity company prices
(e) proving clearing entries are genuine, accurate and Number of employees.
complete, especially write-offs of balances
(f) proving accounting methods for determining sales and Solutions
related debtors are acceptable and consistent;
(g) proving that debtors represent customers who exist and 1 (a) True
amounts owed to the company; Condition must be considered in respect of any asset. Thus,
(h) proving debtors balances are collectable; an item of inventory or equipment should be in a condition
(i) checking proper disclosure of debtors receivable in the to be sold or used within the organisation. A trade
short, medium and long term, and those subject to receivables balance should be valued in the financial
encumbrances statements at the lower of its monetary value recorded
initially in the accounts and its realisable value (being the
Two useful tests are to : recorded amount less bad debts provision). A trade
(1)circularize debtors receivables balance against which a provision of this nature
(2) to test after-date receipts Testing after-date receipts has been made is clearly not in good condition. The auditor
may be more usefulthan circularization as replies from looks for evidence of collectability by assessing the
debtors maynot always be trustworthy and debtors may 'condition' of trade receivables balances. Even cash can
noteven reply. have a condition that renders it of less value. Consider a
company having cash balances in a country that forbids
Factoring remittances or taxes remittances to the company's home
Factoring means that ownership passes to third party, even country.
though the initial sales transaction had been with the
company. The auditor would examine the factoring b) False
agreement, test the system for recording factored debtors The analytical review is only one of several forms of
and obtain confirmation from the third party of debtors substantive procedure. Normally, it will not stand on its own
balances transferred. but will be interpreted in the light of other evidential
matter, including the strength of the entitys control
systems. Lack of variation from prior years may cause the
Questions auditor to enquire further if variations were expected.
1 Consider the following statements and explain why they c) True
may be true or false. Analytical review is normally a very important part of
(a) The audit approach to any asset will involve the auditor substantive procedures, the objective of which is to
in a consideration of condition. substantiate transactions and figures and the analytical
(b) If the analytical review discloses no variations from the review will aid the auditor in this respect.
previous year, the auditor need not enquire further.
(c) Analytical review is an evidence-gathering procedure d) True
performed as part of substantive procedures. Planning feedback is the term used to indicate the
(d) Planning feedback means that audit plans are altered to alteration of original plans because of changes in
take account of changed circumstances. circumstances or of events unexpected at the time the plan
(e) A genuine transaction is one that has been authorized by was originally conceived.
an independent responsible official
e) False
2. Consider the following items of income and expense and This is an incomplete statement. Authorisation is an
state: whether they bear a relationship to each other or important procedure to ensure that recorded transactions
not; if they are related in any way, in what way they should are genuine, but it is only part of the story. Thus approval of
move in relation to each other; the reasons for your answer purchase orders is an important control, but proof is also
in each case. needed that goods have been received in the quality and
quantity required and that purchase invoices agree with
(a) Sales of manufacturing concern: orders and goods received notes. 'Genuine' in this case
Bank interest means that a recorded purchase represents real goods or
Administrative expense services received, in other words that a real event has
Commission to sales personnel caused the purchase invoice to be prepared.
Distribution cost
Production royalties 2 i) The following items are likely to bear a direct or partially
direct relationship to sales of a manufacturing concern:
(b) Cost of production of a manufacturing concern: 1. Commission to sales personnel (normally bearing
Trade receivables direct relationship to sales on commission)
Cost of non-current assets in use 2. Distribution expense, except to the extent that
PE1
there is a fixed cost element

3. The following are not likely to be directly related to It is not likely that the total number of employees
sales, although there may be some relationship: will in the short run have a relationship to income
4. Administrative expense (normally containing from gas sales, as most employees will not have a
overhead unaffected by sales levels). direct role in generating income.
5. Bank interest (This is a finance expense not
normally directly related to sales, although if
turnover is expanding rapidly additional finance
may be required to finance expansion).
6. Royalties payable for use of a production process (If
royalties are paid on the basis of product sales, the CHAPTER 13
relationship would be a direct one. In this case, Final Work : Specific Problems, Related to stocks, Long-
however, they are related to production and not to
sales, although there might be a relationship if term contracts and Trade creditors
production was made to order or if finished
inventory levels were constant).
ii ) The following are likely to bear a direct relationship to Determinig Cost of stocks
cost of production of a manufacturing concern: Stocks are normally a significant asset of manufacturing
1. Cost of fixed assets in use (Depreciation of companies with direct effect on profit. They vary in
production fixed assets will be an element of cost of character and pose a variety of problems for auditors.The
production and bears, therefore, a direct examples used here are taken from the mineral oil industry
relationship.However, there are many more costs in and the manufacture of television sets
cost of production than depreciation and you would
need to analyse the cost of production figure to The costing system is important in determining cost of
establish whether the depreciation charge seemed stocks and long-term contracts and auditors pay particular
reasonable). attention to ensuring costs are genuine, accurate and
2. Inventory levels (Inventory levels of raw materials complete. Some costs are easily allocated to products, but
and components are likely to be determined on the overheads may be allocated on some arbitrary but
basis of production needs and the relationship is reasonable basis, and on the basis of production levels,
therefore a direct one. Levels of finished goods are which are normal, taking one year with another.
more likely to be related to sales needs).
Some products may be main products, whereas others
The following are not likely to be directly related to may be by-products, with income on disposal being treated
production cost: as reduction in cost of main products. Net realizable value
1. Trade receivables (Related to sales) may not be easy to determinebecause stocks may not be
2. Loss on disposal of factory equipment (This loss is used or sold orcompleted until after audit field work is
likely to be affected by the market for second- hand complete.
equipment and the skill of the person disposing of
it). Inherent risks affecting stocks include:
3. Directors' emoluments (The production director's (a)changes in demand for the companys products;
salary is likely to be a component of production cost (b)changes in production levels;
and there may be a direct relationship if his bonus is (c)defects in product lines;
production-related but directors' emoluments (d) stocks can be attractive and easily transportable;
generally are not likely to bear a relationship to cost (e) complex production process;
of production). (f) joint products;
(g) significant variances from standard costs;
The following are likely to bear a direct relationship to Gas (h) competitors providing more risky environment;
company income: (i) complex calculation of overheads
1. Number of units of gas sold
2. Temperature in winter months (This will tend to Acquisitions: it is important to determine the point
cause a higher rate of consumption of gas and have at which title passes, particularly in e-commerce
a direct bearing on income. However, cold weather relationships.
in January and February may not have an effect Safeguarding stocks: this includes physical
until March or April, when the gas usage is billed to safeguards and restriction of access via
customers). documentation.
3. Electricity company prices. (Electricity is an Disposals of stocks: normal sales are more likely to
alternative energy source to gas and the price be controlled than abnormal disposals.
charged to the consumer may, therefore, have an
effect on gas prices and on income of a gas Determining existence, condition and ownership at
company. The price of energy is often a matter of period-ends: physical stock counts, timely
political significance and the gas company may feel reconciliation to stock records and investigation of
it necessary to keep its prices in line with other significant differences.
energy sources, even if consumers are tied to the Valuation of stocks: the basic principle is the lower
company because of (say) investment in gas central of cost and net realizable value, with controls to
heating. ensure costing and other records are reliable and
prepared consistently
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Substantive testing of stocks

Substantive testing of stocks and related production costs Audit procedures include:
address: (a) stock count observations during the year;
1. existence; (b) test the accuracy of stock records;
2. condition; (c) test for cut-off at count date and balance sheet date;
3. ownership; (d) if necessary, conduct a restricted test count at the
4. cut-off; balance sheet date. There are particular problems affecting
5. production costs (genuine accurate and complete); work inprogress, stocks held at third parties and at
6. production costs (properly allocated to stocks on branches.
hand, and amount attributed to stocks is genuine,
accurate and complete) The basis of stock valuation is the lower of cost and net
realizable value.
Normal audit practice to attend stock counts to ensure the Basic rules for calculating costinclude:
stocktaking system is operating satisfactorily and to perform (a) for different categories of stock, not for the stocks as a
compliance and substantive tests. Cut-off procedures are whole;
performed at external and internal cut-off points (b) comprises cost of purchase and costs of conversion;
(c) cost of purchase comprises direct costs, less cost
Procedures to ensure stock is properly countedand reductions;
recorded are as follows: (d) cost of conversion comprises:
(a) issue of stocktaking instructions; o direct costs;
(b) person with overall responsibility, independent of stores o production overheads based on normal
personnel; level of activity, taking one year with
(c) balanced stock count teams; another;
(d) stores neat and tidy; o other overheads incurred in bringing a
(e) arrangements for cut-off; product or service to its present location
(f) issue of pre-numbered stock sheets and completeness and condition;
check; (e) costs may be allocated to production using an arbitrary
(g) stock names and reference numbers on the stock sheets; method, such as FIFO and AVCO.
(h) members of count teams count stock independently
until agreement reached; Net realizable value
(i)count sheets signed by two members of the count team; Net realizable value is actual or estimated selling price less
(j) count teams comment on items in poor physical all further costs of production and costs yet to be incurred
condition; in marketing, selling and distributing
(k) responsible officials to investigate significant
discrepancies between stock records and count; Long-term contract
(l) count teams responsible for manageable quantities of long-term contract may be defined as:
products; A contract entered into for the design, manufacture or
(m) logical system for recording stock names and reference construction of an asset or provision of a service or a
numbers; combinationsuch that the contract activity usually falls into
(n) test counts by responsible officials; different accounting periods.
(o) marking stock counted;
(p) identification of goods held for or by third parties; The major problem is that the construction period overlaps
(q) auditors available for advice; accounting periods, so a decision must be made as to
(r) briefing sessions with count teams to ensure instructions whether profits and losses should be taken up before
properly understood completion. This is subjective and auditors assess the
validity of management judgements.
Stock count observation, purposes and procedures.
Auditors attend the count to check if instructions are There are nine judgemental points, each assertion involving
properly followed, and to make test counts to ensure an audit evidence search and testing
procedures and internal controls are satisfactory.Auditors (1) costs incurred to date are genuine, accurate and
select items from count records and physical count and complete;
compare to gain assurance as to completeness and accuracy (2) stages of completion and related costs are properly
of count records, giving particular consideration to high determined;
value stocks (3) invoices issued to customers are calculated in
accordance with contract and certified by the surveyor;
Level of substantive tests of details depends on (4) cash received from debtors is genuine, accurate and
theauditors view of the quality of stocktaking complete and properly allocated to contracts
instructionsand how they are applied. Stock counts may (5) estimated total costs are genuine, accurate and
becarried out during the year and stock quantities complete;
takenfrom records only if: (6) contract prices are genuine, accurate and complete
(7) when attributable profits on contracts are taken up, it is
(a)controls over stock records are adequate; sufficiently complete to give adequate assurance that the
(b)stock records are accurate and complete; outcome of the contract is certain; losses should be
(c)significant differences between stock records and provided for when recognized
quantities counted are investigated and corrected.
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(8) the profitability of different stages of the contact has 1. Consider the following statements and explain why they
been properly determined; may be true or false:
(9) the method employed in taking up profits is comparable (a) The omission of a short-term liability from the balance
with prior years, unless appropriate and the effect of sheet will result in the acid test ratio showing that the
change is disclosed. company is less liquid than it really is.
(b) Trade payables may be regarded as complete once
Trade creditors auditors have carried out their search for unrecorded
Trade creditors are normally classified as amounts payable liabilities.
in the short term. They come into existence as the result of (c) Accurate cut-off means that trade payables are genuine.
purchase of goods or the performance of services by third (d) In valuing inventories it is permissible to include an
parties, so audit work on purchases and related assets element of administrative expense.
cannot be divorced from each other (e) In planning work on construction contracts the auditor
should identify the points where management is exercising
Inherent risks affecting trade creditors include: judgement.
(a) new or material transactions or events;
(b) material variances from standard costs; 2. You are auditing a company that operates a computer-
(c) suppliers experiencing difficulties; controlled warehouse. There is no human entry to the
(d) significant changes in terms of trade; warehouse except when essential maintenance is carried
(e) a material increase in the age of trade creditors; out and products are taken into the store and taken out on
(f) major changes in the nature of purchases; pallets controlled by an operator using a desktop computer.
(g) above-average returns of goods purchased Suggest how you might approach that section of your audit
where you are seeking to prove existence and condition of
Apart from a satisfactory control environment,auditors inventory.
expect to see controls over:
1. the creation of trade creditors; 3. The following is a record of inventory movements and
2. recorded trade creditors at year-end; recorded sales of Whygate Ltd, a company buying and
3. payment of trade creditors. selling products on credit with a December 2011 year-end.
Consider these figures and then attempt the following
For creation of trade creditors, expected controls include: questions.
(a) preparation of integrated purchases budget and
investigation of variances Figures as on page 528
(b) record the point at which title in goods acquired passes (a) Assuming that inventory was determined by count at 31
and services rendered are complete December 2011 state the adjustment required to sales and
(c) for goods accepted on sale or return, a clear statement debtors and indicate the effect on profits of the adjustment.
of company obligations to suppliers (b) Assuming that inventory was determined on the basis of
(d) where title remains with the supplier there may be recorded inventory movements, state the adjustment
special disclosure requirements; required to sales and trade receivables and indicate the
(e) purchases not in the normal purchases system to be effect on profits of the adjustment. The company carries
kept to a minimum, and specially authorized; out periodic inventory counts.
g) investigation of reasons for significant returns; You may assume in both cases that purchases have been
(h) cut-off procedures recorded in the correct period.
(c) What action would you take as auditor to prove that
For recorded trade creditors at the year-end,expected sales/inventory cut-off was accurate?
controls include:
(a) appropriate division of duties; 4. You are responsible for the audit of trade payables and
(b) regular review of suppliers statements; purchases of Powerbase for the year ended 31 May 2011.
(c) system for adhering to and renegotiating supplier credit You carried out interim audit work on purchases and trade
limits; payables at 30 November 2010 and concluded that
(d) a system for detecting unrecorded liabilities; purchases were being properly processed although you
(e) a system for enquiry into unusual features were somewhat concerned that delays in processing were
occurring. Your concern was heightened by a comment by a
For payment of trade creditors balances, expected controls member of the accounting staff: I dont know what you are
include: worried about. If we havent recorded a liability, the
(a) independent matching operation; supplier will soon remind us! You have now been given the
(b) calculations on purchase invoices checked for accuracy following figures (including some ratios) and aim to ensure
(c) evidence of controls performed that the purchases and trade payables at 31 May 2011 are
(d) cheque signatories to see supporting documentation fairly stated. Design substantive programme steps that will
(e) blank cheques never to be signed. help you to accomplish this aim. You should refer to our
comments on the Powerbase case study (10.1 on page 361).
Substantive approaches cover: Figures as on page 528.
(a)creation of trade creditors balances, including re-
performing matching operation Solutions
(b) recorded trade creditors at year-end 1 a) False
(c) search for unrecorded liabilities The omission of a short-term liability from the balance
sheet will cause liabilities to be understated, and the
Questions company will appear more liquid than it really is.
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with top management for them to be provided with proper

b) Nor True or false authority (The auditors may decide to do this on a surprise
The auditor's search procedures are designed to prove that basis). The test count should be carried out by company
trade payables are complete, so the statement is true as far personnel in the presence of the auditors, immediate
as the auditor is concerned. However, management may comparisons made with inventory records and investigation
well have formed this conclusion earlier as a result of their of differences conducted.
own procedures to ensure that all liabilities, including trade
payables have been detected. 3. (a) Inventory determined by count
(c) False At the time of the inventory count the auditors would have
Cut-off is usually regarded as an accuracy matter as it is one noted that the last despatch note number was 1460 and
measure to ensure that trade payables have been identified would test that sales attributable to that and prior numbers
at the balance sheet date. Of course, it is also true that cut- were recorded in 2011 and to subsequent numbers in 2012.
off procedures will be designed to prove that trade payables The following adjustments would be required:
represent genuine transactions.
d) Nor True or false
Generally it is not permissible to include administrative
expense in the valuation of inventory at cost as such
expense is not directly related to current production or to
getting the goods for sale to their present condition and
location. However, it may be difficult to decide in practice
how costs are to be classified (for instance as production
overhead or administrative expense). Note also that in In making the above calculation we have assumed that
certain circumstances it may be permissible for inventory despatched on 31 December 2011 has not been
administrative expense to be included in overheads (where, included in inventory. The auditor would enquire into this.
for instance, a large project is using a significant proportion The journal entry would be:
of the company's resources.
Debit trade receivables 18,945
e) True Credit sales 18,945
Judgment has to be exercised in many accounting situations
and long-term contacts are no exception. Sometimes The effect of this adjustment would be to increase profit by
judgment is about the genuineness, accuracy and 18,945. The auditor would wish to determine why sales
completeness of accounting records, such as the allocations despatch note number 1464 had been used to record a
of costs to individual contacts, but frequently judgment has movement at 31 December 2011. If it transpired that the
to be exercised in relation to accounting estimates. An movement had occurred in 2012 the sales and trade
example from long-term contacts is estimated costs to be receivables would be increased by 18,945 less 5,995 =
incurred in completing the contact. The auditor has to 12,950
identify the points where management exercises judgment,
as it is at these points that management is asserting that (b) Inventory determined from inventory records
accounting treatments are valid. As we made clear in the The inventory records will have been updated for
text, these assertions become audit objectives that set the transactions up to and including 1460, dated 31 December
scene for the efficient and effective evidence search. 2011. Inventory records should be adjusted to include
despatch note 1464, assuming the movement was
2 . Computer controlled warehouse genuinely in 2011. The sales record should be amended to
The auditors are faced with an unusual situation where record 1457, 1460 and 1464 in sales of 2011 and to remove
technology is being used to do a task formerly performed by 1461 from the sales record. Cut-off adjustments are
human beings. The first task of the auditors would be to identical to those required for inventory determined by
find out how the company satisfied itself that the goods in count. Cut-off must be tested whether inventory is
the warehouse were in existence and in good condition. It determined by count at the year-end or taken from the
may be, for instance, that the company withdraws complete inventory records.
inventories of goods on a rotation basis for test checking. If
the company does this, the auditors should enquire into the (c) Sales/inventory cut-off. Cut-off should be tested to
results of the counts and any other investigations the ensure all sales in the year have been recorded in that year
company carried out into discrepancies between count and and that no sales in the subsequent period are included. A
inventory records. useful procedure would be to record the last inventory
despatch note number for subsequent matching to sales
The auditors would also wish to ascertain that the system invoices. A suitable substantive test would be to select a
for controlling inventory movements was satisfactory. For number of despatch notes before the critical number and
instance, they would wish to find out if movements could ensure that sales invoices have been prepared and recorded
only take place as the result of properly authorised before the year-end. This is an important completeness test
documentation and if there was segregation of duties because it helps to ensure that all the sales had been
between computer operations, custody of goods and recorded and in the correct period. Of course the test would
inventory control. also help to prove that the sales transactions are genuine
because it will show that a genuine movement of goods to
The auditors may decide that a test count will also be customers has occurred.
appropriate, in which case arrangements should be made
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Further, comparing the quantities on the despatch note and CHAPTER 14

invoices will be an accuracy test. A selection of despatch Final Work : Specific Problems, Related to stocks, Long-
notes after the year-end should be checked to sales invoices term contracts and Trade creditors
to ensure they are included in the following year. Tests may
also be performed from invoices to despatch notes to
ensure that a despatch note has been raised for each
invoice issued. We looked at this in some detail when we
discussed inventory count procedures earlier. The auditor Stage 18 of the audit process is when auditors pull together
should ascertain that a responsible official is given the task evidence gathered and conclusionsarrived at earlier to form
of considering cut-off matters at the time of the inventory a view on the financialstatements as a whole
count. Sometimes the company may have a system of
continuous inventory taking throughout the year, taking They also perform the following tasks:
year-end quantities from inventory records. This is
acceptable provided that inventory records can be shown to (a)post-balance sheet date work;
be accurate. Accurate cut-off must be established at the (b)audit work on provisions and contingencies;
time of count AND at the balance sheet date. (c) final working sheet review;
(d) reviews of validity of the going-concern concept;
4. Powerbase plc. The gross profit percentage of 53.64% at (e) review work of other auditors.
31 May 2011 is much higher than the previous year-end, Finally, they obtain the management letter
and some 3 points higher than at 30 November 2010 (See ofrepresentation.
comments on case study 9.2), so it may be that many
liabilities remain unrecorded. This conclusion is supported Post-balance sheet events
by the higher number of days that inventory bears to cost of This is when auditors routinely assess:
sales at 31 May 2011 (84 compared to 75 for the previous 1. debtors collectability;
year), which suggests that inventory may have been 2. NRV of stocks;
received without a corresponding purchase being recorded. 3. useful lives of fixed assets;
You will remember that we decided at the interim that 4. potential unrecorded liabilities.
delay was occurring in recording liabilities and at the final
examination we should direct particular audit effort to Auditors review the post-balance sheet period toascertain
testing for unrecorded trade payables. Interestingly, the whether any matters should be reflectedin the accounts or
relationship between trade payables and cost of sales does disclosed in the audit report.
not provide a warning signal. Appropriate programme tests
at the year-end would include the following: The period after the balance sheet date may be subdivided
into periods as follows. Each period has its own
Assertions to be tested: characteristics and problems for auditors
All trade payables are properly recorded in the accounting
records (all purchases of goods and services have been (1) between balance sheet date and completion of draft
recorded.) accounts.
(2) from completion of draft accounts to completion of
Trade payables represent amounts due at the balance sheet audit fieldwork.
date (purchases of goods and services have been recorded (3) from completion of audit fieldwork to date of issuing
in the right period) financial statements.
(4) after the financial statements have been issued but
(1) Perform bridging tests similar to those performed at the before the AGM;
interim date to ensure purchases are being properly (5) after the AGM
processed in the whole year. This would include obtaining
assurance that goods received notes are complete. Events occurring in periods (1) and (2) are known by both
(2) Search for unrecorded liabilities by selecting all invoices directors and auditors as they occur before the signing of
recorded for one month after 31 May 2011 and checking to the accounts and completion of audit fieldwork. Regarding
goods received notes to ensure that none should have been (3), auditors, becoming aware of a material event, establish
accrued at 31 May 2011. if financial statements need amendment, discuss with
(3). Carry out a similar search in the cash book to ensure directors and consider the implications for their report.
that no payments are in respect of items purchased in the
period prior to 31 May 2011, unless in respect of purchases Regarding (4), auditors have no obligation to perform
recorded in the prior period or accrued. procedures or make enquiries, but if they become aware of
(4) Reconcile credit suppliers statements to suppliers an event that might have caused them to issue a different
balances outstanding in the accounting records. If report, they consider whether the financial statements
management have already done this you may test their need amendment, discuss with directors and consider the
reconciliation work. implications for their report.
(5) Circularise selected suppliers and ask them to inform
you of the balance outstanding at 31 May 2011 and of Regarding (5), auditors will not be expected to be aware of
invoices issued 14 days prior to and after 31 May 2011. an event in the period after the AGM, but, if they do obtain
knowledge of it, the matter should be discussed with the
directors and action, if any, they intend to take, determined
Provisions, contingent liabilities and contingent assets
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Some events, occurring either before or after the balance (b) examine minutes of meetings: shareholders, directors
sheet date, have uncertain outcomes provisions and and audit/executive committee;
contingencies as defined by FRS (c) examine management accounts/accounting records
(d) examine profit and cash flow forecasts;
Is there a legal or constructive obligation, the latter (e) Enquire of legal department and external legal
evidenced by policies or other authoritative statements representatives
from management in the past, and whether the company is (f) review known risk areas;
taking any action in respect of the event; (g) review correspondence/memoranda;
(h) confirmation from third parties;
The auditor should determine if a reliable estimate be (i) review information in the public domain;
made of the amount of the obligation. Potential losses from (j) management interviews
claims may be particularly difficult to ascertain.
2Provisions must be properly disclosed in accordance with Questions
FRS 12, sufficient to enable the reader to understand the 1. Consider the following statements and explain why they
nature of the obligation, the expected timing of transfers of may be true or false:
economic benefits, and the uncertainties about amount or (a) Audit working sheets should be a record of all evidence
timing collected by auditors in forming the audit opinion.
(b) Auditors responsibility ceases at the date they sign the
If the event does not give rise to a present obligation, or audit report.
there is no probable outflow of economic benefits or it is (c) The financial statements signed by directors on or
not possible to evaluate the timing and amount of the slightly before the date of the audit report must be identical
obligation, it may be treated as a contingency. FRS 12 and with the financial statements submitted to shareholders.
IAS 37 distinguish between contingent liabilities and (d) Oral evidence from management that can be confirmed
contingent assets from other sources need not be acknowledged in writing in
the letter of representation.
Contingent liability (e) If management refuse to sign the letter of
(a)A possible obligation that arises from past events and representation, auditors will be unable to form an opinion
whose existence will be confirmed only by the occurrence as to whether the financial statements give a true and fair
of one or more uncertain future events not wholly within view.
the entitys control. (f) FRS 12 and IAS 37 apply to provisions for accrued
(b)A present obligation that arises from past events but is electricity and telephone usage and provisions for doubtful
not recognized. debts.
In Part (b) the obligation may not be recognizedfor the 2. Show how the following events should be reflected in the
following reasons: accounts at 31 December 2011 and describe audit
(i)it is not probable that a transfer of economic benefits will procedures you would carry out to verify them:
be required to settle an obligation;
(ii) the amount of the obligation cannot be measured with (a) Company A estimated that the profits on a construction
sufficient reliability contract that was 75 per cent complete at 31 December
2011 would amount to 100 000 and had taken up 75 000
Contingent asset in the profit and loss account on the portion of the contract
A possible asset that derives from past events and whose certified as complete by a qualified surveyor. On completion
existence will be confirmed only by the occurrence of one on 21 February 2012, company records show profit on the
or more uncertain future events not wholly within the contract amounted to 30 000.
entitys control....
(b) Company B acquired non-current assets for 500 000 on
Contingencies, like provisions, are problematicbecause of 31 January 2012. The financial statements at 31 December
the varying degrees of certainty fromremote to probable. 2011 showed non-current assets at cost less depreciation
Note that: amounting to 250 000.
(a) directors consider estimates of outcome and the
financial effect of contingencies; (c) Company C has shown in its financial statements at 31
(b) directors review events occurring after the balance December 2011 an investment in another company at cost
sheet date up to the date of signing the financial of 750 000. On 1 March 2012 there is a significant decline
statements; in prices on the Stock Exchange resulting from unexpected
(c) accounting treatment of a contingency depends on its foreign exchange movements.
expected outcome and nature....
(d) Company D is in dispute with a supplier as to the quality
Going concern of goods supplied and has provided for the amount it
During the final review period the auditor considers the believes to be correct (100 000). The supplier has sued for
validity of assuming that the company is a going concern. the full amount invoiced (150 000) but on 12 March 2012
the company and supplier agree the liability out of court at
Audit work to detect post-balance sheet events and 120 000.
contingencies
(a) determine company procedures to detect material post- (e) Company E had prepared draft financial statements at
balance sheet events/ contingencies; 30 November 2011, showing an acid test ratio of 0.85 to 1.
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(The normal acid test ratio in its industry is 1 to 1.) Shortly be possible for them to confirm this by checking sales
before 31 December 2011, the company sold trade invoices and cost records and no reference would be
investments for 450 000, incurring a loss of 100 000 and needed in the letter of representation. On the other hand, if
this had the effect of increasing the acid test ratio to 0.98 to the auditors were aware that there was a pending legal case
1. On 16 January 2012, the company repurchased the trade the auditors might have concluded that the matter had
investments for 500 000. been appropriately dealt with in the financial statements
with as a provision of disclosure as a contingent liability.
3. Bandon Limited acquired a subsidiary, Gateside Limited, They would probably ask management that there were no
ten years ago and goodwill on consolidation is being written other legal claims against the company.
off over 20 years. Gateside made good profits until two
years ago, but in the year to 31 December 2010, made a You should note too that paragraph 6 of ISA 580 makes
small loss and in the year to 31 December 2011 made a clear that the auditors should obtain written
significant loss. Do you think that this would provide good representations from management and, where appropriate,
grounds for an impairment review? What audit steps would those charged with governance that they believe that they
you perform to satisfy yourself that the results of the have fulfilled their responsibility for the preparation of the
impairment review are valid? financial statements and for the completeness of the
information provided to the auditor.
4. During an audit of the cost records of Roberton Ltd at 31 e) Nor true or false
March 2011 you discover that Prospect Limited has sued It is unlikely that the auditor would be able to form
the company, claiming that it is using a manufacturing conclusions in the absence of a letter of representation
process which has been patented by Prospect. However, from management. See paragraphs16 to 20 of ISA 580. It
the directors of Roberton say that the manufacturing might be possible for the auditor to form conclusions as to
process used is sufficiently different from the one patented truth and fairness by reference to other sources particularly
and that no disclosure of any potential liability is required. where the areas of contentious judgement were slight, but
Discuss the accounting and auditing implications of this we would not be too sanguine about this. A refusal to sign
matter. the letter might indicate a breakdown in the working
relationship between auditor and management or of
Solutions problems in the company that management wish to hide.
14.1 a) True
Audit working papers should be a synopsis of the f) False
assignment. This means that all important evidential matter The word 'provision' was often used by accountants to
should be included in them, the basic rule being that they mean the setting up of an accrual or for amounts deducted
should be self-explanatory. To give only one example, if the from assets, such as trade receivables and fixed assets. FRS
auditor has discovered that not all sales orders have been 12 and IAS 37, however define a 'provision' in a very
subjected to a credit control check, the working papers particular and restrictive way, but exempts a number of
should contain identifying references to the documents in items from its application, including so-called executory
question and ideally should contain copies of some if not all contracts, except where the contract is onerous. Contracts
of them. There should also be a reference to the impact on of this kind are defined as contracts under which neither
control risk and to the scope decision on the nature and party has performed any of its obligations or both parties
extent of substantive tests have partially performed their obligations to an equal
extent. They generally relate to the delivery of future
b) False services, including electricity and telephone. This means
While it is generally true that auditors' responsibilities cease that this kind of accrual is not covered by FRS 12 and IAS 37.
on the date the audit report is signed (that is, they are not
expected to search for evidence of balance sheet after that 2 a) Company A. The discovery that the profit on the long-
date), ISA 560 - Subsequent events - makes clear that, term contract amounted to 30,000 and not 100,000 is an
should auditors become aware of such events they do have adjusting event in the terms of IAS 10 and FRS 21 as it gives
certain responsibilities. Read paragraphs 10 and 14 of ISA more information about a condition that existed at the
560. balance sheet date. It would therefore seem appropriate to
take up a profit of 22,500 and not 75,000.
c) Nor True or False
As a matter of practicality the financial statements signed The auditor would determine why the company had been
by the directors may not be in the precise printed or so wrong about the estimated profits on this contract and
typewritten form submitted to members. However, auditors might consider examining the records of the company to
should satisfy themselves that the approved financial determine extent of completion at the balance sheet date,
statements are complete in all material respects with those including the reports from the qualified surveyor. The
subsequently issued to members. costing records in the old and new period should be tested
to ensure costs (including overhead costs) and income have
d) True been properly allocated to the contract in question. The
Auditors would certainly not wish to overload the written matter should be fully discussed with management, and in
representations from management on matters about which addition, whether there were implications for other
there is little uncertainty. For instance, if management has contracts not complete at the balance sheet date.
explained orally to the auditors that the reason for a
reduction in gross profit percentage has been a decision not b) Company B. The acquisition of the fixed assets does not
to increase prices to match cost increases, it would probably appear to be a matter providing more information about
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conditions existing at the balance sheet date. The and 2011.

acquisition does seem to be very material and disclosure
should be made in the notes to the financial statements If this trend continues, Gateside may be in even more
that it has been effected. CA 2006 does require capital trouble in the year to 31 December 2012 and the auditor
commitments to be stated in the notes and there seems to would determine what actions the directors of Bandon are
be a good case for indicating the actual date of acquisition taking to remedy the situation of their subsidiary. What are
in this note. their views on why the downward trend has occurred? For
instance, has a new competitor entered the market, or has
The auditors would examine the contract for the supply of there been new legislation that has made the company less
the fixed assets, the purchase invoice and the entry in the viable, or have one or more key employees left Gateside,
fixed assets register. They would ensure that all related rendering the company less well managed. The auditors
costs (such as installation costs) had also been determined would ask management if they have a response to these
and, in view of the significance of the amount, may feel that matters that might turn the company round.
a physical inspection would be appropriate.
They may find that the directors have decided to change
c) Company C. The decline in stock market prices seems to product lines and management structures, in which case it
be a further example of a non-adjusting event, but if may become clear that the existing goodwill has little to do
material the reduction in market value by 200,000 should with the 'new' company, in which case write down or even
be disclosed in the notes to the accounts. complete write-off of the goodwill might follow the
impairment review. The carrying amount of the investment
The auditors would need to obtain the stock market in Gateside in Bandon's own financial statements should
quotation at the audit report date and ensure the disclosure probably be written down. This is clearly a subjective
in the notes reflected it. If the stock markets are volatile matter, but the auditors should find as much external
(that is, see- sawing up and down or moving downwards or evidence as possible by reviewing industry trends, reading
upwards) the auditors may feel the need to ensure that the business news and specialist industry news-sheets.
quoted value of the investment is made known to the
shareholders at the AGM. To this end they should discuss 4 . The auditors are clearly concerned that the third party
the matter with the directors to determine the action they will be successful in an action against the company and that
intend to take. They may also consider making a statement material damages may become payable. From the
to the shareholders at the AGM, depending on the accounting point of view the auditor has to decide if this is:
materiality of the matter.
- A provision in the terms of FRS 12 and IAS 37 that is an
d) Company D. This event has the hallmark of an adjusting event has occurred (the use of the patent registered by a
event as it gives more information about conditions that third party) that creates a present obligation (either legal or
existed at the balance sheet date and the amount of the constructive) that is expected to result in the outflow of
provision should therefore be adjusted to 120,000. economic benefits that can be assessed with sufficient
reliability.
The auditors would wish to inform themselves of the
background of the dispute and to examine the agreement -A contingent liability that is not remote and should
between the two parties. therefore be disclosed under the terms of FRS 12 and IAS
37.
e) Company E. This scenario looks very much like deliberate
window dressing by the company to improve the This is clearly both a legal matter and a technical matter. If
appearance of liquidity. The auditor should look carefully the patent has been infringed, then legally the company
into the circumstances of the sale and repurchase, may well be liable. However, if there is doubt that the
considering in particular if the transaction was other than patent has been technically infringed, Prospect may not be
arms length to a related party. Transactions with related able to make a successful claim for damages in court. The
parties should be disclosed and, if they are not, the auditor first step for the auditors would be to determine the facts.
would wish to qualify the audit report. The sale and
repurchase might need to be the subject of an emphasis of They would examine a copy of the patent held by Prospect
matter in the audit report. We discuss audit qualifications and determine the nature of the claims made. There would
and emphases of matter in Chapter 16. be a need to determine the nature of the manufacturing
process concerned and the technical matters that are
3. Clearly, any asset only has value if it can generate profits involved in its operation. The auditor might seek expert
and positive cash flow, so a downturn in profits and the advice about the patent and about the process and whether
occurrence of losses might indicate that impairment has the latter has or has not been using the former.
occurred. Unlike tangible assets, goodwill cannot be sold, so
an impairment review would concentrate on value in use The process may prove to be in the public domain, in which
within the company, unless the decision was made to case the claim for damages would be unlikely to be
dispose of the whole subsidiary, in which case net realisable successful and the success of the court case regarded as
values for goodwill might be appropriate if it were to be remote. If, however, thecontingency is other than remote,
sold as a going concern. The auditors would discuss the the decision must be taken whether to it is a provision in
future of Gateside and its operations with management. To the terms of FRS 12 and IAS 37 or merely a disclosable
assist in these discussions, the auditors would establish the contingent liability. Legal advice should also be sought once
trend of profits over the last ten years. It seems that the the technical matters have been clarified.
trend into a loss-making situation has been evident in 2010
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CHAPTER 15 assessing risks; responding to assessed risks; performing

further procedures (inspection, observation, confirmation,
Assurance engagements and Internal Audit recalculation, reperformance, analytical procedures and
inquiry), involving substantive procedures.
Limited assurance
Assurance engagement risk is greater than for a reasonable
Standard audit reports assurance engagement as the basis for a negative form of
Standard audit reports give reasonable assurance that expression of the practitioners conclusion. Sufficient
financial statements are free from material misstatement appropriate evidence is obtained as part of a systematic
engagement process, including obtaining an understanding
Review and other reports give a level of assurance lower of subject matter and other engagement circumstances, but
than reasonable assurance, using a negative expression of in which procedures are deliberately limited relative to a
opinion because evidence-gathering is limited reasonable assurance engagement
The International Framework for Assurance Engagements Assurance reports

defines an assurance engagement as follows: Basic elements of an assurance report comprise:
1. title clearly indicating it is an independent
an engagement in which a practitioner expresses a assurance report;
conclusion designed to enhance the degree of confidence 2. addressee;
that intended users other than the responsible party can 3. identification and description of subject matter
have about the outcome of the evaluation or measurement information and, where appropriate, subject
of a subject matter (subject matter information) against matter;
criteria. 4. identification of criteria;
5. description of any inherent or significant limitation
Elements of an assurance engagement associated with evaluation or measurement of the
Five elements of an assurance engagement are:( subject matter against the criteria;
1) the three -part relationship involving a practitioner, 6. when the criteria are available only to specific
responsible party and intended users; intended users, or are relevant only to a specific
(2) appropriate subject matter; purpose, a statement restricting use of the
(3) suitable criteria; assurance report;
(4) sufficient appropriate evidence; 7. statement to identify responsible party and to
(5) the written assurance report in the form appropriate to describe responsible partys and practitioners
a reasonable assurance or a limited assurance engagement. responsibilities;
8. statement that the engagement was performed in
Users might wish to rely on many kinds of matter, other accordance with ISAEs;
than financial statements: 9. summary of work performed;
(a) effectiveness of local authority programmes; 10. practitioners conclusion (positive or negative);
(b) systems and processes 11. assurance report date;
(c) corporate governance issues
(d) environmental matters
(e) compliance with human rights legislation Examples of reports receiving different levels ofassurance
(f) compliance with contractual terms. are:
1. no assurance;
Parties other than external auditors can provide useful 2. limited assurance;
degrees of assurance to users.Examples of such parties 3. long-form report with limited assurance or other
include internal auditors and bodies such as the degrees of assurance; and
Consumers Association. 4. positive assurance.
Characteristics of suitable criteria are: No assurance:

1. relevance; (a)compilation report;
2. completeness; (b) preparation of tax returns where no conclusion is given
3. reliability; on acceptability.
4. neutrality; and
5. understandability. Limited assurance:
(a)report on review of interim financial statements
The amount and quality of evidence determines (b) agreed-upon procedures
conclusions practitioners can draw and the report they can (c) consulting engagements where the nature and scope of
issue. Basic differences between reasonable assurance and the work is agreed between the practitioner and
limited assurance engagements are as follows management
(d) comfort letters
Reasonable assurance (e) report on corporate governance statement.
Assurance engagement risk at an acceptably low level as the
basis for a positive form of expression of the practitioners
conclusion. Sufficient appropriate evidence is obtained
through understanding of the engagement circumstances;
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Long-form report with limited assurance or other degrees Operational auditing

of assurance Operational auditing concerns itself with the whole
Long-form report on internal control highlighting organization and not just with finance and accounting.
limitations of internal control, commenting on weaknesses Management auditingdetermines whether management is
identified, but using generally accepted auditing standards. acting effectively. In VFM audits, the auditor enquires into
economy, efficiency and effectiveness, a particular
Positive assurance requirement of public sector auditing
(a)statutory audit of financial statements;(b) report on
internal control using generally accepted auditing Evaluation auditing
standards. Certain of the examples do not meet the Evaluation auditing involves internal auditors when they are
definitionof an assurance engagement in the engaged in participative auditing.Evaluation has developed
Framework,but some consulting engagements may meet along different lines, from the other types of audit,
thedefinition. independence not being so important. Instead the evaluator
brings together interested stakeholders, attempting to find
Matters to be considered before accepting anassurance a mutually acceptable solution
engagement:
(a)relevant ethical requirements; Role of Internal Auditors
(b) whether the engagement has: Internal auditors play an important role in the public sector.
(i)appropriate subject matter Types of audit they and external auditors perform include:
(ii) suitable criteria available to intended users; 1. financial;
(iii) availability of sufficient appropriate evidence to support 2. legality;
the desired conclusion; 3. regularity audits;
(iv) practitioners conclusion that will be contained in a 4. systems examinations;
written report; 5. probity;
(v) rational purpose for the engagement 6. VFM;
7. performance audits.
Importance of assurance engagements
Assurance engagements have assumed importance Factors tending to make internal audit effective are:
because: 1. support of top management;
(a) many companies have merged so the pool of large audit 2. independence of internal auditor from parts of the
clients has reduced considerably; organization being audited;
(b) substantial downward pressure on audit fees; 3. a strong ethical culture in the company and
(c) business is significantly more complicated, and more department;
risky, as a result of mergers, the technological revolution 4. appointment of motivated staff with good
and use of complex financial instruments educational backgrounds, enquiring mindsets and
(d) audit firms have taken the opportunity to open up new ability to communicate well;
markets to increase their profitability (f) continuing education and training;
(g) good staff appraisal system;
As a result of such factors audit firms haveadopted (h) good leadership;
strategies to reduce audit risk and havestarted to adopt a (i) good communication links with all parts of the
business risk approach, which involves gaining deep organisation;
understanding of a company and its industry, of company (j) steps to ensure that staff behave in a professional
objectives, of business risks that may inhibit achievement of way;
objectives, and the way in which management attempts to (k) to ensure high job satisfaction. One factor reducing
reduce the impact of risks effectiveness is the short-stay syndrome.
This approach brings auditors into close contact with Role of External Auditor
management and often results in the identification of External auditors still have full responsibility for their audit
problem areas that the firm can address. It may also lead to opinion, even if they rely on the work of internal audit. If
the provision of assurance services. external auditors are to rely on internal audit work they
assess effectiveness of internal audit, taking into account:
1. Compliance auditing determines whether the (a) organizational status;
company conducts business in accordance with (b) scope of function;
rules and regulations. (c) technical competence;
2. Efficiency auditing determines whether resources (d) due professional care.
are being used optimally within the bounds of
feasibility. External auditors fully document decisions to use internal
3. Effectiveness auditing is wider and directed towards audit work, when they intend to rely on it. Generally,
determining if resources are used to proper effect external auditors audit all material matters in the accounts
particularly where there is significant risk of misstatement.
If external auditors rely on internal audit work, they agree
Other types of internal audit include: the timing and extent of the work with the chief internal
(i)operational; auditor.
(ii) management;
(iii)value for money (VFM); Once external auditors have decided to rely oninternal audit
(iv) evaluation (a further class of appraisal activity). work they consider:
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extent and scope of the respectiveresponsibilities of the

(1) staffing, planning, supervision and review; directors and auditors, and toremove misconceptions that
(2) comparison of results of internal and external audit work users may have had.
in similar areas;
(3) whether exceptions or unusual matters in internal audit Basis of Opinion sector
reports have been resolved; The basis of opinion section refers to:
(4) whether the response by management to internal audit (a) conformity of audit work to auditing standards;
reports has been satisfactory (b) basis of the audit opinion, including that the auditors
;(5) whether the internal audit programme can be had:
completed in the time available; (i) examined evidence on a test basis;
(6) whether the work of internal audit is carried out with (ii) formed assessments of significant estimates and
economy, efficiency and effectiveness. judgements;
(iii) determined whether the accounting policies are
appropriate, consistently applied and adequately disclosed
CHAPTER 16
In the opinion section auditors express an opinionand not a
The Auditors Report guarantee an opinion of value becauseit is given by
independent and competent experts.The opinion is directed
towards two basic matters:
(1)the truth and fairness of the accounts;
(2) compliance with CA 1985.
Communicationg Audit Opinion
Auditors communicate their views on accounts in the audit CA 1985 requires companies to state whether accounts
report. If they are satisfied the accounts give a true and fair have been prepared in accordance with applicable
view and comply with legislation, they give an unqualified accounting standards and, where there is material
opinion, but, if dissatisfied, a qualified opinion may be departure from standards, that details, together with
appropriate. financial effect, are given with reasons. In very exceptional
circumstances companies may depart from a provision of
Auditing standards require reasonable assurance but CA 1985 in order to give a true and fair view, but the
other engagements may provide only limited assurance. reasons for departure and the effect should be disclosed.
The current audit report is an expanded or long-form
report Exercise of judgement is very important where it involves
uncertainty, particularly when it relates to the outcome of a
Unqualified report future event. Uncertainty only becomes a major problem
An unqualified audit report for an unlisted company has the when the extent of the uncertainty and potential effect is
following sections: fundamental to the view given by the financial statements
(a) addressee;
(b) scope and identification of subject matter Consideration of Inherent uncertainty magnitude
(c) responsibilities; In assessing the magnitude of an inherentuncertainty
(d) basis of opinion; auditors consider:
(e) opinion; (1)the risk an estimate may be subject to change;
(f) name and address of auditors; (2) the range of possible outcomes;
(g) date of audit report (3) the consequence of outcomes on financial statements.
Auditors must identify the published information upon

which they are reporting. Auditors check that information If an item affected by fundamental uncertainty has been
not audited does not conflict with the view given by the adequately accounted for and disclosed, auditors issue an
financial statements. If they believe there is an unqualified audit report with an explanatory paragraph in
inconsistency or incorrect information auditors consider the basis of opinion
whether an amendment to the other information or the
financial statements is required. Where auditors believe the directors estimate of the likely
outcome is materially misstated or disclosures are
Responsibility of an audit opinion inadequate, they may issue a qualified audit report for
Auditors state their responsibility to form an opinion onthe disagreement.
financial statements. Directors responsibilitiesinclude:
(a)preparation of financial statements that give a true and Dissatisfaction statement on Audit Report
fair view; Qualifications in the audit report indicate there arematerial
(b) selection of suitable consistently applied accounting matters about which the auditors are notcompletely
policies; making prudent and reasonable judgements and satisfied. Dissatisfaction could be because of:
estimates; following applicable accounting standards; (a) limitation in audit scope;
determining appropriateness of the going-concern (b) auditors disagreement with treatment or disclosure.
assumption;
(c) ensuring the entity keeps proper accounting records; Limitation of scope arises if auditors are unable to obtain
safeguarding the assets; taking appropriate action to sufficient appropriate evidence. If the possible effect is so
prevent and detect fraud and other irregularities. material or pervasive that they cannot form an opinion,
Responsibilities statements are to make clear toreaders the they issue a disclaimer, but if not they issue an except for
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opinion. The audit report includes a description of factors (1)the nature of audited financial statements
that lead auditors to give a qualified opinion so users can (2) the type and extent of work undertaken by auditors
more fully appreciate the implications of the limitation of (3) the level of assurance provided by auditors.
scope and why qualification is necessary.
The listing rules require the auditors report on the financial
Forms of Qualification Matrix statements to cover the disclosure of certain items affecting
directors.They also require auditors to describe their
reporting responsibilities in the corporate governance
report.
Auditors are not currently required to report publicly on
whether the directors statement on internal control covers
all risks and controls.Nor are they required to report on the
effectiveness of corporate governance procedures or its risk
and control procedures
However, in reviewing the directors statement oninternal
controls, auditors:
(a)determine how directors reviewed the effectiveness of
the system of internal control;
(b)review and evaluate documentation prepared for the
directors;
(c) determine if the directors statement accords with the
auditors knowledge of the system of internal control and
of the company.
Disagreement on Management opinion and Adverse Auditors are not currently required to report publicly on
Opinion whether the directors statement on internal control covers
Disagreement arises when the auditors form an opinion on all risks and controls, or on the effectiveness of corporate
a specific matter that differs from the opinion of governance procedures or its risk and control
management. An adverse opinion is given when the effect procedures.They also require auditors to describe their
of the disagreement is so material or pervasive that the reporting responsibilities in the corporate governance
financial statements are seriously misleading. An except report.
for opinion is used where disagreement about an item is
material but not seriously misleading. Post Financial Report
Companies often post financial reports on theweb.This
Disagreement can arise from: raises problems for auditors because:
(1)use of an inappopriate accounting base; (1)information on the web is easily changed;
(2) disagreement with client as to facts or amounts; (2) it may not be readily apparent what information has
(3) non-compliance with relevant legislation. been subject to audit
(3) information on the web can be accessed in many
ISA 260 requires auditors to report their findingsto those different countries.
charged with governance. Examples of matters that would
be reportedinclude: Where a client intends to distribute its financialstatements
(a) expected modifications to the audit report; electronically auditors should:
(b) any misstatements that have not been adjusted by (a)review the process by which the electronic financial
management in preparing the financial statements. statements are derived;
(b)check that the proposed electronic version is identical in
Where the financial statements are not adjusted for content with the manually signed accounts;
misstatements the auditors obtain written representations (c) check that the conversion of the manually signed
from those charged with governance as to why they were accounts into an electronic form has not distorted overall
unwilling to make the necessary adjustments. Even where presentation.
management have adjusted the financial statements
auditors may communicate details to those charged with CHAPTER 17
governance for their consideration. Fraud and Going Concern
Recent addition to the wording of the standard audit report
is a paragraph disclaiming responsibility to third parties,
arising from the Bannerman case.Adding this wording has
become common practice among the Big Four.
Auditors responsibility for detecting fraud
Audit expectations gap Auditors responsibility for detecting fraud has generated
APB introduced the expanded audit report as anattempt to considerable controversy and it is popularly believed that
close the audit expectations gap and reduce auditors are responsible for detecting fraud. Detection of
misunderstandings relating to: fraud and error was at one time an important function of
audit, but today auditors concentrate on assessing the
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integrity and competence of management, and the Obtaining audit evidence

effectiveness of internal control, using analytical Problems in obtaining audit evidence arise where:
procedures, and largely restricting detailed audit work to (a)external or auditor-generated evidence is not available
high risk areas. (b) the lack of evidence relates to material or unusual or
complex transactions;
The auditing standard on fraud states that it is not the (c) the lack of evidence results from managerial action.
auditors function to prevent fraud and error, but that
auditors plan, perform and evaluate their audit work in Once auditors have ascertained that fraud mightbe taking
order to have a reasonable expectation of detecting place they decide on appropriate action:
material misstatements arising from error or fraud. (a)confirm understanding of facts, nature of fraud and likely
Management has prime responsibility to prevent and detect magnitude to aid determination of additional audit tests;
the occurrence of fraud through appropriate systems of (b) discuss the fraud or error with senior management,
internal control and other means. directors or audit committee.
Auditors do plan and conduct audit tests to limit the If fraud has been discovered, auditors should:
possibility that material fraud and irregularities go (i)ask directors to consider changing financial statements;
undetected. This process starts at the planning phase when (ii) ask management to determine the extent of fraud or
auditors consider the company and its environment and the error;
risks facing it. (iii) assess the impact on other audit work.
Auditors limitation If auditors suspect non-directors may be implicated, they
Auditors argue they cannot guarantee detection ofall frauds should discuss the matter with the directors. If directors
and errors because of: may be involved, they should consider reporting to the
(1) inherent limitations in audit techniques and tests; audit committee. They might also seek legal advice and, in
(2) deceit, collusion and other means to conceal fraud make some circumstances, report their suspicions to third parties.
detection difficult;
(3) audit evidence is that required to form an opinion and If directors do not take appropriate action, it may be
not specifically to find fraud. . difficult to determine the full extent of the fraud or error,
may have implications for the audit report, and may cause
Motives and Indicators of Fraud the auditors to re-evaluate the integrity of management
Identification of motives and indicators of potential and the control environment.
significant fraud are important. Pressure to misrepresent
financial performancemay be high.In such circumstances Audit Process documentation
auditors might change theiraudit approach to reflect higher Auditors should document the process until it
risk. . issatisfactorily resolved, including:
(a) initial grounds for suspicion;
Reasons behind misrepresentation might be: (b) additional audit work;
(a) the company has performed badly or is under pressure (c) details of what, when and to whom they reported;
from markets; (d) managements response and any action;
(b) directors wish to show continuing growth; (e) implications for audit work.
(c) where the company expands by acquisition, directors
may wish to inflate profits to show success, and to sustain Board of Directrs and Internal Controls
the share price; Board of directors responsibilities include maintaining
(d) there are liquidity problems. sound internal controls to safeguard shareholders
investment and company assets, including prevention and
Characteristics of personnel, the management team and its detection of fraud and error.
structure may provide helpful indicators as to when and
where a fraud is likely: Means to achieve these include:
1. particular directors are autocratic and 1. developing an appropriate control environment;
authoritarian; 2. establishing a strong and effective system of
2. staff are poorly qualified or lack motivation; internal control;
3. individuals are paid by results; 3. encouraging a strong ethical environment and
4. individuals are allowed too much authority or developing a code of conduct;
power; 4. establishment of an audit committee;
5. turnover of staff is high 5. reporting on the effectiveness of the companys
internal control system.
Relevant individual characteristics include:
(i)integrity and sense of ethics; Auditors may report to third parties that they have found a
(ii)extent to which motivated by greed fraud, or suspect it is taking place, if it is in the public
(iii) degree of loyalty exhibited by individuals. interest to do so. They would normally discuss the issue
with the board of directors and the audit committee first,
Weaknesses in systems may: unless they believe the directors may be implicated or are
1. reduce the reliability of accounting information; aware of it.
2. allow employees to commit fraud;
3. allow management to avoid or override controls. Only after discussion, and if the directors do not inform an
appropriate authority, will auditors report the fraud.
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Auditors must use professional judgement to determine if integrity. Auditors may consider including the matter in
the matter is in the public interest, perhaps seeking legal their audit report
advice, especially as the duty of confidentiality may be
breached. Financial statements are usually prepared on the going-
concern basis because measures based on break-up values
The Audit Agenda tend not to be relevant to users.Users assume that, if there
The Audit Agenda: Next Steps did not proposechanges in is no comment to the contrary, the company will survive
auditors responsibilities for detectingfraud, but beyond the short-term.
recommended that:
(1) auditors should report to the board and audit Directors responsibilities include determining whether a
committees of listed companies on the appropriateness and company is a going concern. Auditors must satisfy
adequacy of control systems; themselves that the going-concern basis is appropriate and
(2) training and education to improve understanding of disclosures in the financial statements are sufficient. They
fraud and its detection; should determine how directors concluded the company is
(3) directors to commission forensic audits. a going concern, and assess the logic, rationale and strength
of information used.
The Audit Agenda highlighted the difficulty of detecting To do so auditors should:
fraud where it is well planned, ingenious or involving (i) make enquiries of directors and examine appropriate
collusion or top management, but noted that auditors can available financial information;
contribute to the prevention of fraud by informing (ii) having regard to the future period to which the directors
management of weaknesses in the control systems.It also have paid particular attention, plan and perform procedures
referred to the limited nature of penalties imposed on specifically designed to identify any material matters that
directors if they mislead auditors. could indicate concern about the entitys ability to continue
as a going concern.
ICAEW Audit Faculty has recommended that auditors be
prepared to take a more active role in detecting fraud, and When planning, auditors should:
has made suggestions as to the knowledge auditors should (1)assess business/inherentand control risk;
have. It was suggested that a Fraud Advisory Panel be (2)perform analytical procedures.
established. APB has admitted it is difficult to detect
management fraud, but has made proposals regarding Assestment of Inherent and control risk
potential ways in which audit could be made more effective. Assessment of business/inherent riskrequiresauditors to be
knowledgeable about the company,its products, main
Audit standard and Fraud management suppliers, competitors and itsenvironment.Assessment of
Some auditing standards might be amended but APB says control risk is important because it gives guidance on
that a significant increase in the likelihoodof detecting reliability of historical andbudgeted financial information.
management fraud requires radical change, including:
(a) increased emphasis on professional scepticism; Means to predict the future include:
(b) tighter rules on acceptable audit evidence; (1)cash flow budgets or forecasts;
(c) reporting material matters in the financial statements (2) forecast profit and loss accounts and balance sheets;
that are supported only by managements representations. (3) information on forecast sales, costs and products.
APB considers that expanding the auditors rolecould be Indicators that might suggest going-concernproblems are:
helpful in preventing and detecting fraud,perhaps by: negative cash flows;
(a) reporting to boards and audit committees on controls to 1. significant losses;
prevent and detect fraud; 2. substantial debts difficult to service;
(b) forensic fraud review; 3. substantial overdraft and overdraft limit exceeded;
(c) more reporting of suspected frauds 4. net current liabilities;
5. loan repayments or overdraft facilities
Obligations for Auditors renegotiated;
Obligations here for auditors include: 6. reduction in dividends;
(a) understanding relevant laws and regulations and how 7. longer creditor payment period;
the entity ensures compliance; 8. company has made employees redundant and/or
(b) inspecting correspondence with relevant authorities; has had to reorganize/rationalize its operations;
(c) determining if management are aware of non- 9. declining market and/or out-of-fashion products;
compliance; 10. forced sale of fixed assets.
(d) obtaining from directors written confirmation they have
disclosed non-compliance and the actual or potential Auditors obtain written confirmation of
consequences. directorsrepresentations about going concern.
When auditors become aware of possible non-compliance Where financial statements are prepared on a going-
they determine its nature and conclude on the potential concern basis, the entity is assumed to continue in
effect on the financial statements. The outcome of existence for the foreseeable future, the extent of which
discussions with management and legal representatives varies from entity to entity influenced by the nature of the
may influence auditors judgement of managements entitys business, its business risk and external influences.
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Directors judge what is an appropriate period for them to comprises programming,investigative and reporting
look into the future. If this period is less than one year, independence.
additional disclosures in the financial statements may be
required, and the auditors refer to this in the audit report Responses of the profession to apparent lack ofcompetence
even where there is little doubt about going-concern status. include:
(a)rules on issue of practising certificates;
If there is no doubt, neither directors nor auditors need (b) post-qualifying education;
refer specifically to going concern in the financial (c) monitoring audit activity;
statements or audit report. However, the Combined Code (d) disciplinary procedures.
states that
A major problem is the increasing complexity of business
the directors should report that the businessis a going and internal relationships, making management of the audit
concern, with supportingassumptions or qualifications as process difficult, especially if top management lack
necessary integrity.Strengthened internal audit may be one response
to the complexities, another the careful assessment of
Where there are doubts, auditors will consider if the business and audit risk.
directors have included sufficient appropriate disclosures
such that the financial statements give a true and fair view. Effects of lack of competence and lack of practitioner
If so, they need not issue a qualified audit opinion, even independence may be difficult to separate. Remedies for
where there is fundamental uncertainty, but include an deficient performance include those that enhance
explanatory paragraph on the going-concern problems, practitioner independence, such as monitoring. An
referring to the note disclosure in the audit report. . independent Office for Auditing has been suggested to
oversee the framework for large company audits, auditor
CHAPTER 18 remuneration and audit practice of major accounting firms.
The Audit Expectation Gap and Corporate Governance Deficien standards gap
The deficient standards gap is the gap between what
auditors can be reasonably expected to do and what the
profession and the law asks them to do. It is difficult to
assess what is reasonable, particularly as views may change
Element in Audit Expectation Gap over time. Two issues causing most concern have been
The common element in various definitions of the audit fraudand going concern, both of which have seen
expectations gap is that auditors are performing in a considerable changes in approach by auditors.
manner at variance with the beliefs and desires of others
who are party to or interested in the audit. The gap ISA 240 suggests that auditors responsibility for fraud
comprises several gaps between the views of auditors and detection is limited, despite planning to detect material
those of a number of stakeholders, some of whom are misstatements, and that management have prime
powerful, others weak, lacking economic power. responsibility for prevention and detection. Critics argue the
standard is deficient because, despite problems in finding
Powerful stakeholders can exercise political power over carefully hidden fraud, the public expect auditors to find
company directors. Often powerful stakeholders are better material fraud and report its existence. Unfortunately
informed about the nature of auditing and the audit role, so procedures to give a higher chance of detecting fraud are
expectations differ considerably. Other interested parties costly, suggesting the gap will never be closed.
include politicians, regulators and academics.
Until the issue of SAS 130, auditors were not required to
Politiciansmay feel independent auditors are search actively for evidence that companies were going
necessary where the public needs protection concerns.Critics argued that auditors were too passive
Regulators alter relationships by imposing duties on because standards were deficient.
some and giving rights to others.
Academicsmay have influenced what the public SAS 130 introduced a more active approach, but whether
think about professional bodies and auditors. The the expectations gap will be closed as a result is less certain,
gap is long-standing. particularly if companies continue to collapse after
avoidance of qualification where a fundamental
Components of the audit expectations gap uncertainty exists.Positive developments include
Components of the audit expectations gap are: requirements for directors to give their view on going-
(1)performance gap, which can be split into concern status and an increasingly active role for audit
(i) deficient performance; committees.
(ii) deficient standards;
(2) reasonableness gap. Many commentators believe the professional bodies are
insufficiently independent of their own members, that they
Two possible reasons for deficient performanceare: cannot both protect members and ensure that society is
(1) lack of competence; best served by those members, suggesting that the
(2) lack of practitioner independence. regulatory role should be removed from them. There is a
perception of closeness between leaders of the profession
Lack of competence includes lack of care, lack of knowledge and big business, although steps were been taken to
and lack of experience. Practitioner independence counter this with the establishment of FRC, ASB and APB.
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Reasonability of Audit expectations A dialogue should also be established withshareholders.

Expectations can only be reasonable if they are compatible Three main principles affect the responsibilities of
with the auditors role in society and cost-beneficial to institutional shareholders, to:
perform.But the role of the auditor is not clearly defined, (1) enter into dialogue with companies;
contributing to lack of societal awareness should it be for (2) evaluate companies corporate governance
stewardship purposes or to achieve wider accountability to arrangements;
society? (3) make considered use of votes.
Audit procedures might be unreasonable if benefits are less The boards responsibility is to present a balanced and
than cost. Costs may be relatively easy to determine, but understandable assessment, including interim and other
benefits are intangible and difficult to measure. Costs and price-sensitive public reports. Even unaudited interim
benefits may change over time because of changes in reports give information to users and will be used for
technology and in societal attitudes decision making.
It is difficult to assess how components will change. As the Audit committees may enhance auditorindependence by
audit role becomes more clearly defined, some existing providing independent bodieswithin companies. For
duties might go, and the reasonableness gap may narrow effectiveness, two elementsare:
because of greater awareness, or widen because of new (1) high quality non-executive directors;
expectations. (2) proper authority and clearly defined duties
Existing duties may widen because of regulatory and The Code makes recommendations about theconduct of the
informal pressures. Regulation may cause improvement in board:
actual and perceived performance. Increased sophistication (a) regular meetings;
of society may cause the reasonableness gap to diminish, (b) division of responsibilities at the head of a company;
but new expectations may widen it. Technological change (c) nonexecutive directors of sufficient calibre and number;
may affect costs.. (d) a formal schedule of matters specifically reserved for its
decision;
Corporate governance (e) an agreed procedure for directors to take independent
Corporate governance is closely related to the audit professional advice;
expectations gap, but is wider as it relates to structures to (f) directors to have access to advice and services of the
control how companies are governed. The Combined Code company secretary.
requires auditors to report on a number of corporate
governance matters and contains principles of good Effective non-executive directors and auditcommittees
governance. require willing support throughout the company.
The principles of good governance included inthe Code are Suggested roles and responsibilities for the auditcommittee
listed under: are:
A.Directors; (a) financial reporting, including review of important
B. Remuneration; issues/judgements;
C. Accountability and audit; (b) audit matters, including recommending appointment,
D. Relations with shareholders. terms of engagement and external audit fees; and being
involved in developing policy on the provision of non-audit
Recommendations on the effectiveness of theboard: services.
(a)division of duties;
(b)non-executive directors of sufficient calibre and number; The directors statement of responsibilities makesIt clear
(c) timely high quality information for the board; that the directors have primaryresponsibility for preparing
(d) annual performance evaluation of the board, financial statementsthat give a true and fair view..
committees and directors.
Internal Control and Corpotate objectives
The Code accepts more light should be thrown on directors The Turnbull Guidance, divided into four parts,notes the
remuneration and how it is determined. A significant importance of internal control inmanaging risks and
proportion of directors remuneration should be linked to achieving corporateobjectives:
corporate and individual performance, overseen by the (1) maintaining sound system of internal control;
directors remuneration committee. (2) reviewing the effectiveness of internal control;
(3) the boards statement on internal control;
Under the principles of accountability and audit,the board (4) internal audit.
should:
(a)present a balanced and understandable assessment of CHAPTER 19
the company position and prospects; The Auditor and Liability under the Law
(b)maintain a sound system of internal control;
(c) apply financial reporting and internal control principles
and maintain an appropriate relationship with the
companys auditors and the audit committee.
Auditor and Law liability
In recent years the prime concern of auditors in civil liability
cases has been liability to third parties, because of:
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(a) the cost of obtaining indemnity insurance; Following Hedley Byrne, counsel for ICAEW indicated
(b) the many actions brought against auditors; auditors would be liable if they had been negligent and the
(c) the level of damages; third party had relied on the financial statements,
(d) bad publicity from auditor negligence courtcases.
where the accountants knew or ought to have known that
Although rare, accountants and auditors could be liable to the reports, accounts or financial statements were being
criminal charges under the Theft Act 1968, Fraud Act 2006 prepared for the specific purpose or transaction which gave
or CA 1985. Auditors who give a clean opinion on accounts rise to the loss, and that they would be shown to and relied
that turn out not to be true and fair may be sued by users on by third parties in that particular connection.
who lose because of reliance on those accounts to
compensate them for any loss they have suffered as a result JEB Fasteners Case
of negligent work. In the JEB Fasteners case the judge held that a duty of care
would be owed by the defendants if they:
Much attention has been focused recently on auditor
responsibility for negligence.For a negligence action to reasonably should have foreseen at the time the accounts
succeed, it must be shown that the auditors owed a duty of were audited that a person might rely on those accounts for
care to the person bringing the action. Where a contractual the purpose of deciding whether or not to take over the
relationship has been established, a duty of care exists and company and therefore could suffer loss if the accounts
auditors can be sued by the company under contract law, were inaccurate
for instance, when the auditors fail to detect a material
fraud in the company owing to purported negligence. It seemed that if use of accounts plays a substantial part in
inducing the plaintiffs decision, persons associated with
The determination of whether an auditor owes a duty of negligent preparation/audit could be held liable.
care to third parties under tort has been a controversial
matter that has received considerable media attention and JEB Fasteners also emphasized the concept of foreseeability
it is necessary to understand how the law has developed but this seems to lead to the notion of unlimited liability.
and the consequences for auditors However, the judgement also made clear that specific
circumstances need to be considered, so auditors liability
Auditor case of Law in US was not as extensive as first appeared.
Early case law seemed to suggest that if there was no
contract between accountants/auditors and third parties, The concept of foreseeability was further emphasised in the
no duty was owed.This is despite Donaghue vs Stevenson in Twomax case. The court noted that the auditors should
1932, which had established that physical injury claims have foreseen that the financial statements would be used
against persons with whom no contractual relationship to assist in the acquisition of additional capital. It was found
existed could succeed) that the plaintiffs had relied on the financial statements and
hence the defendants were found negligent
This early view is typified in Candler vCrane Christmas & Co.
(1951)In this case an action against accountants failed The next major development in the law of negligence
because there was no contractual arrangement between affecting accountants occurred as the result of the Caparo
the plaintiff and defendants. case (Caparo Industries plc vs Dickman and Others 1989).
This was a very complex case and it went through a number
However, the case of Hedley Byrne & Co. vs Heller and of hearings right up to the House of Lords before the final
Partners Ltd. (1964) established the principle that an action judgement was made.
can be brought by a third party (a party other than the
shareholders) and that the third party can expect a duty of The final decision implied that the courts had gone too far
care from auditors, among others, the judgement in extending auditor liability in the JEB Fasteners and
emphasizing the concept of reliance. Twomax cases, or, at least had advanced the law too
precipitously, and that the auditors should not be held
For auditors this meant that it must be reasonable for a liable.
person to place reliance on the auditors report and that 1. During the course of the judgement the
the auditors were aware or should have been aware that followingimportant points were made:
the person would rely upon it.. 2. there is a close and direct relationship between
auditors and shareholders, but any duty owed is to
Users of Financial Statement and Law liabilities shareholders as a class rather than as individuals;
Parties who might have a legitimate interest in financial 3. on grounds of justice and fairness, liability should
statements, other than shareholders, are: not be imposed on the defendants as this would
1. investors/potential investors; lead to liability which was indeterminate as to
2. lenders; quantum, as to time and as to the identity of its
3. employees; beneficiaries;
4. government agencies; 4. examination of company legislation shows that the
5. competitors; primary purpose of annual accounts was to enable
6. suppliers; those with a proprietorial interest to exercise their
7. investment analysts/stockbrokers/share tipsters; given rights, and that, although annual accounts
8. pressure groups. could be used for making investment decisions, the
legislation was not drafted with that purpose in
mind.
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The determination of whether foreseeability is present does Limitations to the use of standards as a means ofdefence
not appear to be a particularlystringent test, but on the are:
concept of proximity no one particular test can perhaps be (a)they do not cover all areas of auditing;
applied. (b)they only contain general guidance, leaving scope for
interpretation and implementation;
The judgement in the House of Lords raised the issue of the (c) they are the auditing professions view of good practice
purpose of financial statements.The judges considered that but what the courts believe to be good practice is what
it was for shareholders to exercise control over the matters.
company, but there may be two answers to the question
concerning the function of the accounts:. As well as being subject to criminal and civil proceedings
auditors can also be disciplined by their own professional
(1) to enable shareholders to exercise their statutory rights; body, because, if accountants or auditors are to be trusted
(2) to provide information to enable shareholders to decide by clients, they must be seen to be honest and persons of
whether they should sell, retain or increase their holding of integrity. .
shares.
The accounting profession has shown considerableconcern
The House of Lords viewpoint may be out of linewith about the extent of liability to third parties,Producing two
commercial practice. major reports in recent years:
(1)Likierman Report (1989)
Cases involving alleged auditor negligence (2)Feasibility Investigation of Joint and Several Liability
Several cases involving alleged auditor negligence have (1996)
been heard since Caparo. Although thesehave not changed
the law relating to whom the auditors owe a duty of care in The Likierman Report looked into problems faced in respect
general, they are useful because they illustrate ways in of liability for negligence by three professions including that
which plaintiffs attempt to distinguish between the case of auditing.The Feasibility Investigation of Joint and Several
they have brought and the Caparo case. Liability was to determine
Cases include: whether a full Law Commission project on the law of joint
1. James McNaughton Paper Group Ltd. vs Hicks and several liability should be undertaken.
Anderson & Co. (1991);
2. Morgan Crucible Co. plc vs Hill Samuel Bank Ltd. Other representations and reports argue forchanges
(1991); relating to professional negligence. The professions claim
3. Galoo Ltd. and Others vs Bright Grahame Murray that a major problem with the present law is the concept of
(1994); joint and several liability, one effect being that if some
4. ADT Ltd. vs Binder Hamlyn (1996); parties are insolvent or have limited resources the
5. Andrew and Others vs Kounnis Freeman (1999). defendant (often the auditor) with the resources is left to
shoulder the complete burden (the deep pocket
A further recent case is the Royal Bank of Scotland vs syndrome).
Bannerman Johnstone Maclay and Others (2002).This has
resulted in action by the profession. A possible solution would be to introduce proportionate
liability, but this is rejected because it might leave innocent
One important aspect of this case was that if the parties bearing some of the loss they have incurred. CA
defendants, on learning that the plaintiffs had a right to see 1989 allows companies to purchase insurance for their
the audited accounts for the purposes of their lending directors, officers or auditors, but this is not compulsory
decision, had issued a disclaimer for the consequences of and the purchase of insurance only applies to claims made
any reliance the plaintiffs placed on the accounts, it would against the directors and auditors by the company itself and
have been impossible to infer that the auditors had not third parties.
assumed responsibility to the plaintiffs.
The Company Law Review Steering Group recommended
Shortly afterwards the Audit and Assurance Faculty of that auditors should be allowed to cap their liability, but
ICAEW recommended that the audit report should include a only if the amount of the limit was published and approved
paragraph disclaiming any responsibility to third parties, a by the shareholders. But, under joint and several liability
recommendation that has been adopted by all the Big Four auditors would still remain fully liable up to the amount of
firms their cap. An argument against this proposal is that it could
result in the plaintiff not recovering losses in full because
Compliance with auditing standards would seem to be a the agreed cap is less than the loss
logical first step if auditors are to resist a claim for damages.
CA 1989 required RSBs to Concept of contributory negligence
The concept of contributory negligence applies where a
have rules and practices as to the technical standards to be plaintiff can be said to have contributed to the loss they
applied in company audit work and as to the manner in have suffered and can be applied in cases of tort, but the
which these standards are to be applied in practice. scope for its application to negligence claims brought under
contract is less clear.
RSBs have adopted statements of auditing standards to
meet this requirement. The Company Law Review Steering Committee
recommended that where directors or employees breach
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their duties to assist auditors, this should give rise to civil rather than on other more important operational aspects of
liability and might indicate contributory negligence. In cases firms work.
brought under tort, it may be difficult to convince a court
that a third party contributed to their own loss when the Measures to enhance Auditor Independence
latter are relying on financial statements and the auditors Various measures have been taken to enhance auditor
opinion. independence, matters of concern being the weakening of a
strong professional audit culture and the increase in
Since CA 1989, accounting firms have been able to change lucrative non-audit work. Accounting bodies stress the
their form of organization from partnerships to limited importance of serving the public interest, but critics suggest
liability companies, with shareholders only liable for unpaid accounting firms look after their own self-interest rather
share capital.This might save individual partners from than that of the public
bankruptcy, although substantial damages could force the
firm itself into liquidation. The Enron/Andersen scandal resulted in the Sarbanes-Oxley
Act in the United States. Critics were scathing of the
Only a small number of firms have chosen to incorporate, relationship between Arthur Andersen and Enron,
possibly for tax and disclosure reasons. However, suggesting that pursuit of recurring fees played a major part
accounting firms have argued that the LLP should be in the Enron frauds and associated audit failures.
introduced, in which partners would not be personally liable
for the partnership liabilities, and the resources available to Following Enron, audit firm rotation, as a means to enhance
meet successful negligence claims would be limited to the auditor independence, again came to the fore, although the
assets of the partnership. profession believes it would increase the likelihood of the
auditors failing to detect material errors and misstatements.
After much argument and threats by large accounting firms In practice, rotation is being increasingly enforced on firms
to relocate to Jersey, the Limited Liability Partnership Act as companies put their audits out to tender, the current
came into force in the United Kingdom in 2001. Relatively auditor not necessarily being selected
few partnerships have taken advantage of the Act, but all
Big Four accounting firms have done so. Criticism of Regulation in auditing
Critics have made various suggestions as to theway forward:
CHAPTER 20 (1)auditors must act exclusively as auditors;
Criticism and developments in Auditing (2) auditors must be socially accountable;
(3) the institutions of accountancy must be reformed.
The accounting profession responded vigorously to
criticisms of the regulation of auditing, citing the large
Regulations of Auditing number of non-accountants on APB and regulatory and
There has been much criticism of audit practice and of the disciplinary committees. They claim that the profession
auditing profession, critics being concerned with exposing does pay due regard to the public interest, and that the
the audit profession as self-interested and arguing that their accounting bodies encourage technical competence and
own purpose is to bring about changes beneficial to objectivity which will further the public interest
society.Regulation of auditing takes a number of different
forms including the legal framework and other They note also that audit firms and their clients have to be
arrangements. Regulation of auditing is currently in a reasonably close if auditors are to perform competent
transitional phase. audits.
A number of attempts have been made to set up bodies to Responses to the charge that auditors lack independence
issue auditing standards before the current regime (still in include:
the process of development) came to existence, including 1. accepting the principle of rotation of the reporting
APC. partner;
2. a second partner checking decisions of the
Critics saw APC as not being independent of accounting reporting partner;
firms, who were setting the agenda, and criticized lack of 3. instigation of rigorous quality control procedures.
transparency in the standard-setting process. ASB is seen by
them as being dominated by accountants. The profession points out that audit failure is rare, and that
business failure and audit failure should be distinguished.
The disciplining of members is either carried out by They emphasize that the profession has supported the
individual accounting bodies or through the joint review of accounting and auditing recently carried out at
disciplinary scheme (JDS), and penalties can be levied on the behest of the government and are supportive of new
members. JDS has been criticized for similar reasons to regulatory structures proceeding through parliament
those invoked for APC and APB; it will be superseded by the
Investigation and Discipline Board. Audit Agenda : Standard proposals
The Audit Agenda: Next Steps, issued by APBmade several
Following CA 1989, accounting bodies set upstructures to proposals, some of which have beenpartially or fully
monitor the performance ofaccounting firms. JMU was implemented:
established, concentrating on accountingfirms auditing (a)audit scope for listed companies/major entities and
listed companies where there ismost public concern. It has unlisted owner-managed companies should differ;
been criticized for narrow focus on rules and procedures
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(b) the audit of listed companies should include assurance (1) the cost of obtaining indemnity insurance is very
that all textual information accompanying the financial expensive; estimates of the cost of meeting lawsuits vary
statements is consistent with the view given by them; in from 8% (audit firms) to 2.7% (critics) of auditing income;
addition auditors should report to the board and audit
committees on corporate governance issues; (2) risks of bankruptcy discourage high calibre individuals
(c) steps be taken in respect of fraud; from wanting to become audit partners. .Auditors claims
(d) audit reports to be signed by engagement partners in for reform of the law on professional negligence and liability
their own name as well as that of the audit firm; rests on two major assertions:
(e) audit committees of listed companies should be
responsible for the appointment and remuneration of Critics note that individual partners are well rewarded for
auditors and approval of non-audit services; such risks.
(f) APB should seek to limit auditors liability when
reporting on certain corporate governance issues. Critiques of the concept of Audit
A fundamental critique of the concept of audit has been
Auditing Into the Twenty-First Century published in1993 by made by Michael Power, writing on the audit society.
ICAS was an attempt to address theExpectations gap. Power sees an increase in the use of audit in many
Proposals included: aspects of everyday life, and questions why there has been
(a) listed companies should have a strong internal audit such enthusiasm to adopt a particular term and style of
department to provide the board with reassurance about activity.
management information/ internal control systems;
(b) internal audit reports should be directed to a financial Power argues that the new forms of audit are influenced
reporting and audit committee (FRAC) as well as the chief by the nature of financial audit by accounting firms, and
executive, with the FRAC to approve the that they may emphasize those aspects of performance
appointment/termination of employment of the chief which can be measured and verified, rather than attempting
internal auditor; to consider what is the best or most appropriate measure of
(c) external auditors to be called external assessors, less performance.
concerned with detailed testing and procedures and more
with judgemental issues He also argues that financial audit emphasizes the
(d) appointment/termination of employment of external relationship between principals and agents in a restricted
assessors and remuneration to be determined by an audit sense so that other potential principals, such as society, are
review panel (with input from company directors);As well as not considered. Powers work has been welcomed by many
these duties it was suggested that theaudit review panel be but others argue that we do not live in so much an audit
responsible for a number ofothers society as a performance measurement society.
(i)receiving a report from assessors on audit work; Power offers three reasons for the large increase inthe
(ii) considering requests from stakeholders for assessors to quantity of activities termed auditing:
perform additional work; (1)new form of management in the public sector;
(iii) asking assessors to carry out additional work; (2) increased demand by society for greater accountability
(iv) discussing with assessors the need for them to report to by organizations;
a third party suspicions of fraud/illegal activity by directors; (3) increased use of quality management practices and
(v) reporting on the panels activity in the year; changes in regulatory style.
Finally, directors were to report on the following: Power notes that organizations have come to rely
(i) the companys going-concern status; increasingly on control systems and that it is assumed that
(ii) whether the company has sufficiently relevant and their existence demonstrates compliance with rules,
reliable management information and internal control procedures, processes and practices with audit seen as a
systems. control of controls.This move is seen by Power as
undesirable because what becomes important is the
The external assessors would express an opinion on truth existence of a system and its auditability rather than what
and fairness of financial statements and report on the the particular system is supposed to achieve.
appropriateness of the directors assurances in respect of
management information and internal control systems, and Auditors themselves are instrumental in determining what
going concern, relying on the work of the internal audit is audited, but at the same time it is unclear what level of
team. The external assessors would only be legally liable to assurance auditors provide in their reports. The problem is
the primary stakeholders, and to the extent that they were that an audit only captures those risks that can be
negligent. identified by audit procedures and Power concludes that
the profound irony of the audit society is that
Auditor Liability
Auditor liability is a major concern of the profession and where auditing may be most desirable, it is least possible
critics claim it campaigns to limit its responsibilities without
regard to the public interest, despite significant losses Powers work is beneficial because it helps to illuminate
sustained by stake-holders in celebrated cases involving and challenge accepted practice, but it is worth examining
audit failure. Powers claim that auditing systems is not the same as
auditing the transactions themselves.
PE1
Auditors argue that there is a direct relationship between

transactions and control systems and that checking controls
can provide them with the same level of assurance about
the accuracy of transactions as checking the actual
transactions. Auditors in practice determine if effective
controls are appropriate and complete, but if there is
uncertainty the auditor will place less emphasis on controls
and more on direct testing of transactions.
Although auditing of systems may not be as substantive a
change as Power would suggest, it is true that emphasis on
the audit of systems does enable auditors to claim that the
skills required for financial audit are not very different from
those required for non-financial audits.
The purpose of Powers writings is to submit audit to a new
form of critique. For him, the notion of audit has almost
obtained a life of its own, being used in different domains
without any consideration of its appropriateness. We need
to reflect on the nature of the various types of audit and
what they achieve; to help ensure that audit is used where
most appropriate; and to allow for more appropriate
arrangements.
UTS SEMESTER GENAP 2014/2015

PENGAUDITAN II
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PE1

Auditing Process

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Auditing Process

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Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)

2 May 2006 An audit is an investigation or a search for evidence to

(a) users value reliable accounts; ANSWERS

1 The primary condition for an audit is that there is a

2a Freedom fromanyinterference with regard to the

Watts and Zimmerman discuss auditors monitoring

The fundamental principles of the IFAC Code are:.

The factors Shockley identified are as follows: Potential threats to objectivity

Advocacy threat of the data to be made on a timely basis. The deadline

Audit dan regulation

(c) take an active role in the development of statutes,

The main concerns for CGAA were:

CHAPTER 5 risk, particularly if the auditor is unaware of management

Business risk approaches The letter of engagement

Audit Engagement Your audit work has revealed the following:

required. or controlled by them is not as reliable as evidence obtained

If systems development/maintenance controls are strong, it

The information/audit trail should be maintained, allowing

Organization chart (a)physical controls;

Segregation of duties includes the segregation of:

3. You might have preferred not to start from here, but

Data flow diagrams are useful for determining what

System flow chartsshow data flow through a

The advantages of flowcharts are that they:

CHAPTER 9 Test data

CHAPTER 10 The software can:

Directional testing example (e) review and reporting activities;

e) False (a)transactions not subjected to the same internal controls

the increased use of risk-based auditing, with more

Accounting standards are designed to aid the preparation of 4. significant repairs;

Loss on disposal of factory equipment

there is a fixed cost element

Substantive testing of stocks

with top management for them to be provided with proper

Further, comparing the quantities on the despatch note and CHAPTER 14

conditions existing at the balance sheet date. The and 2011.

CHAPTER 15 assessing risks; responding to assessed risks; performing

The International Framework for Assurance Engagements Assurance reports

Characteristics of suitable criteria are: No assurance:

Long-form report with limited assurance or other degrees Operational auditing

extent and scope of the respectiveresponsibilities of the

Auditors must identify the published information upon

integrity and competence of management, and the Obtaining audit evidence

Reasonability of Audit expectations A dialogue should also be established withshareholders.

Auditors argue that there is a direct relationship between

UTS SEMESTER GENAP 2014/2015

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