The process of auditing

The audit of a limited company consists of a cycle of activities which can be broken down into a number of distinct
phases. Review the phases illustrated and discussed below to gain an overview only (each phase is covered in
more detail in later chapters).

Auditor re-
elected at
AGM

Signing audit Engagement

report letter

Planning
Obtaining
management
representations
Ascertainment of
systems

Review of
financial Testing
statements controls and
Verifying
assets and transactions
liabilities
Engagement letter. Every auditor should send his client an engagement letter which sets out the auditor’s duties
and responsibilities. If the client requires other services the scope of these can also be set out in the letter (ISA
210).

Planning. The auditor must plan and control the audit work if the work is to be done to a high standard of skill and
care (ISA 300).

Ascertainment of systems. An auditor must enquire into and ascertain the client’s system of accounting and
internal control in order to understand how accounting data is prepared and to gain an impression as to whether
systems are reliable, as it is the information generated from these systems which is summarised in the financial
statements (ISA 400).

Testing of controls. The auditor should test the controls if he intends to rely on them and he must test the records
in order to obtain evidence that they are a reliable basis for the preparation of accounts (ISA 500).

Verification. The auditor must verify the figures appearing in the financial statements (balance sheet, income
statement, cash flow statement and accompanying notes) (ISA 500).

Review. The auditor reviews the financial statements to see if overall they appear sensible (ISA 520).

Management representations. The auditor asks the management to confirm formally the truth and fairness of
certain aspects of the financial statements. This is known as “obtaining management representations” (ISA 580).

Signing of report. The auditor signs the auditors’ report once the directors have approved the accounts. Audited
accounts are laid before the members at the company’s Annual General Meeting (ISA 700).

Re-appointment. The end of the Annual General Meeting signifies the end of the auditor’s term of office. The
members of the company may decide by a majority to re-appoint the auditor if he wishes to continue to act for the
company.

AUDIT PLANNING

 The auditor should plan the audit work so that the audit will be performed in an effective
manner.
 Planning means developing a general strategy and a detailed approach for the expected nature,
timing and extent of the audit.

Purposes of planning

1 .Planning helps to unsure that appropriate attention is devoted to important areas of the audit.

2. Potential problems are identified and the work is completed expeditiously.

3. Planning assists in proper assignment to audit assistants.

4. Planning co-ordinates work done by the auditor and other experts.

Extent of planning

The extent of planning varies according to:

1. The size of the entity.

2. The complexity of the audit

3. The auditor`s experience with the client entity.

4. Knowledge of the business

Preliminary arrangements

 When planning the auditor may discuss audit procedures and the overall audit plan with
management, audit committee and the client`s staff in order to improve the efficiency and
effectiveness of the audit.

The overall audit plan

 Matters to be considered in developing the overall audit plan include:

1. Knowledge of the business

  General economic factors and industry conditions affecting the entity`s business.
 Characteristics of the entity, management structure and financial performance.
 Management competence.

2. Understanding the accounting and internal control system

 Accounting policies adopted by the entity.

 Reliance to be placed on the tests of internal control and substantive procedures.

3. Risk and Materiality

 Assessment of inherent and control risks

 Setting of materiality levels.
 Possibility of misstatements
 Identification of complex accounting areas.

4. Nature, timing and extent of procedures

 Possible change of emphasis on specific audits

 Reliance on internal audit.

5. Co-ordination, Direction and Supervision

 Involvement of experts
 Staffing and quality control
 Use of another auditor

Audit assertions

Audit tests are designed and conducted to obtain evidence about FS assertions. Fs assertions are the
representations of the directors that are contained in the FS i.e. they ‘asserts’ specific features of the FS
and the information therein.

Financial statement assertions are features relevant to items (in the FS) about which audit evidence is
required.

To form an opinion, the auditor should obtain evidence to support the FS assertions. FS assertions are as
follows:

 Existence: (of balance) of assets and liabilities or equity as at a given date e.g tangible non
currents assets, inventories, trade receivables, cash and cash equivalents exist as at 30 June
2007. Auditors should ensure that an asset or liability exist at a given date.
 Accuracy: information recorded in books of accounting should be free from error
 Rights and obligations: e.g. an asset belongs to an entity if it has legal rights over them. A liability
belongs to the entity if has an obligation relating to that liability. The auditor must ensure that
all assets and liabilities of the entity are reflected in the FS and those that are not of the entity
are excluded. E.g. asset on business premises (for repairs purpose) which do not belong to the
entity must be excluded.
  Occurrence: (transactions). A transaction or event occurred during the relevant period which
pertains to the reporting entity.
 Completeness: there are no unrecorded assets, liabilities, transactions and events.
 Valuation: (balance). Assets and liabilities is recorded at the appropriate carrying value e.g.
building carrying value= initial cost + revaluation increase-depreciation-impairment loss.
 Measurement (transactions). A transaction or event relating to the income statement is
recorded at the proper amount and in the correct accounting period.
 Presentation and disclosures (of FS) transactions and events have been recorded in the proper
accounts. All accounting treatments must be according to legislation. Accounting standards.
 Classification – information recorded in the books of accounting has been properly classified in
the respective accounts and categories to which they relate.
 Cut-off: transactions accounted for in the period in which they relate

Auditors decompose these broad assertions into a detailed set of statements referred to as management
assertions, separated into three categories:

1. Transactions (Income statement):

 Occurrence — the transactions actually took place
 Completeness — all transactions that should have been recorded have been recorded
 Accuracy — the transactions were recorded at the appropriate amounts
 Cut-off — the transactions have been recorded in the correct accounting period
 Classification — the transactions have been recorded in the proper accounts
2. Accounts balances (Balance sheet):
 Existence — assets, liabilities and equity balances exist
 Rights and Obligations — the entity holds or controls the rights to its assets and owes
obligations to its liabilities
 Completeness — all assets, liabilities and equity balances that should have been recorded
have been recorded
 Valuation and Allocation — assets, liabilities and equity balances are included in the
financial statements at appropriate amounts and any resulting valuation or allocation
adjustments are appropriately recorded.
3. Presentation and disclosure:
 Occurrence — the transactions have occurred
 Rights and Obligations — the transactions pertained to the entity
 Completeness — all disclosures that should have been included in the financial statements
have been included
  Classification and Understandability — financial statements are appropriately presented and
described, and information in disclosures are clearly expressed.
 Accuracy and Valuation — financial and other information is disclosed fairly and at
appropriate amounts.

Techniques of gathering audit evidence

 Inspection: physical review or examination of records and tangible assets. It may include
examination of records for evidence of controls in the form of compliance test. E.g. test of control:
examine sales invoice for authorization. E.g. substantive procedure: check physical existence of an
asset and inventory.

 Observation: looking at a process or procedure being performed to ensure that the process
actually works as documented e.g. distribution of wages packet, physical inventory, cash collection.

 Enquiry and confirmation: seeking relevant information (both financial and non financial) from
knowledgeable persons inside or outside the entity whether formally or informally, orally or in
writing. The reliability of this technique depends on the qualification and integrity of the source e.g.
letter of representation. Confirmation consist of seeking to corroborate responses to information in
the accounting records e.g. direct confirmation of receivable balances or payables balances.

 Recalculation/computation: checking the arithmetical accuracy of source documents and

accounting records or performing independent calculations e.g. checking the addition of the trial
balance, additions in cash book.

 Analytical procedures: analyze significant ratios and investigate material fluctuations and
variances. Analyze trends and relationships in financial and non financial data by means of plausible
relationships.

The audit report

The auditor of a limited company is obliged to produce a report, addressed to the members, which is
annexed to the financial statements placed before the members at the annual general meeting. The
report itself must refer to the following matters.
 Whether, in the auditor’s opinion, the financial statements give a true and fair view of the profitability
and state of affairs of the company.
 Whether the financial statements have been prepared in accordance with an identified financial
reporting framework.

Note first the terminology of audit reporting.

Types of audit report

Unmodified Modified

Unqualified Qualified
An “unmodified” audit report means that the auditor is happy that the accounts give a true and fair
view. The auditor has no reservations about his opinion that he wishes to share with the readers of the
audit report.
A “modified” audit report is any other report. The auditor cannot unreservedly say that the accounts
give a true and fair view as they stand.
In an “unqualified” modified audit report the auditor believes that the accounts give a true and fair
view, but he wishes to draw attention to some fundamental uncertainty surrounding the accounts. He
includes an explanatory paragraph on this uncertainty in his audit report, but the report remains
unqualified.
In a “qualified” audit report, either the auditor is uncertain whether the accounts give a true and fair
view, or he disagrees with some aspect in the accounts. He is therefore unable to give an opinion that
the accounts give a true and fair view.
ISA 700 The auditor’s report on financial statements gives the standard wording of the unmodified audit
report, as follows: