Session 28

Small Business and

Not-for-Profit Organisations

FOCUS
This session covers the following content from the ACCA Study Guide.

D. Audit Evidence
2. Audit procedures
d) Describe why smaller entities may have different control environments and
describe the types of evidence likely to be available in smaller entities.
7. Not-for-profit organisations
a) Apply audit techniques to not-for-profit organisations.

Session 28 Guidance
Read about the characteristics of small businesses and not-for-profit organisations (s.1).
Understand the specific consideration which must be given to the engagement letter for such
entities (s.2).
Read the audit approach for small businesses (s.3) noting, for example, how evidence is obtained
through accountancy work (s.3.3).

(continued on next page)

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VISUAL OVERVIEW
Objective: To identify the particular considerations in the audit of small businesses and not-
for-profit organisations.

CHARACTERISTICS
• Limited Segregation
of Duties
• Domination by Senior
Management or Owner

ENGAGEMENT AUDIT APPROACH

• Considerations • Risk Assessment
• Engagement Letter • Internal Controls
• Accountancy Work
• Completeness
• Choosing Procedures
• Management Representations

NOT-FOR-PROFIT
ORGANISATIONS
• Types of Organization
• Audit Work

Session 28 Guidance
Understand the term "not-for-profit organisation" and attempt Example 1.
Read the audit work for such organisations noting, for example, the use of analytical procedures
and the significance of cash (s.4.2).

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Session 28 • Small Business and Not-for-Profit Organisations F8 Audit and Assurance (INT)

1 Characteristics

1.1 Limited Segregation of Duties

< Fewer accounting resources may result in a lack of accounting
skills, the consequences being:

Consequences of
Limited Accounting
Skills

Record Keeping Accounts Preparation

< May be informal or
inadequate leading
to greater risk that
financial statements
will be inaccurate/
incomplete.
< Greater reliance on
auditor assistance.
< Managers may
incorrectly assume
that they have
been relieved of
responsibility for
accurate financial
reporting.

< It is often not practicable to segregate duties among different

individuals; therefore it may not be possible to rely on internal
control to detect fraud or errors. For example:
= where personnel who are responsible for accounting records
also have access to assets that are easily concealed, moved
or sold; and
= when it may not be possible to set up a system of
independent checking (giving rise to a greater risk that
errors will not be detected).
< Use of computer facilities may increase control risk. For
example, in a microcomputer environment it is common for
users to be able to perform two or more of:
= initiating and authorising source documents;
= entering data into the system;
= operating the computer;
= changing programs and data files as well as modifying the
operating systems; and
= using or distributing output.

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F8 Audit and Assurance (INT) Session 28 • Small Business and Not-for-Profit Organisations

1.2 Domination by Senior Management

or Owner
< Active participation in management may dominate the
operation of the entity (particularly the internal control *When the owner is
systems and production of financial statements).* not involved there
is greater risk that
1.2.1 Advantages employee fraud or
error may occur and
Domination can compensate for otherwise weak ICs (e.g. where the will not be detected.
owner personally signs all cheques and bank mandates).

1.2.2 Disadvantages
Ability to override ICs (e.g. exclude transactions).
Greater risk of management fraud (e.g. the owner can make
disbursements without supporting documentation).
Confusion of business and personal interests/property may be
reflected in financial statements. This may give rise to problems with
tax authorities and could result in financial penalties.
The owner may not understand the purpose of the audit:
= accounts preparation of limited relevance;
= agreeing tax liability.

2 Engagement

2.1 Considerations
< If it is not possible to obtain sufficient evidence to form an
opinion on the financial statements because of weaknesses
which may arise (e.g. inadequate record keeping), the auditor
may decide:
= not to accept the engagement; or
= after acceptance:
— to withdraw from the engagement; or
— to disclaim an opinion.

2.2 Engagement Letter

The engagement letter must be issued before work commences
to help avoid misunderstanding about the nature and scope of
services provided.
< Additional accountancy services:
= recording transactions in books of prime entry;
= posting to general ledger;
= extracting trial balance and preparing draft a/cs;
= preparing statutory financial statements; and
= providing regular management a/cs.

< Additional tax services:

= agreeing income tax liabilities with taxation authorities; and
= preparation and submission of returns.

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Session 28 • Small Business and Not-for-Profit Organisations F8 Audit and Assurance (INT)

3 Audit Approach

3.1 Risk Assessment

< Risk of material misstatements may increase ( )
or decrease ( ):*
= owner may exercise effective control ( );
= owner's close involvement may prevent/detect errors ( ); *The auditor must
= profits may be manipulated ( ).
not assume that
management is honest
< Particular difficulties include: or dishonest.
= possible misstatement of income (e.g. by the non-recording
(understatement) or recording of fictitious transactions
(overstatement));
= inclusion of expenses which should be categorised as the
personal expenses of senior management/owner.
< Need to take account of previous knowledge of proprietor/
business.

3.2 Limited Formal Internal Controls

< Extent of reliance—may be able to test and rely on controls:
= operated by the proprietor;
= established by observation (if not documented).
< Communicating weaknesses—only those which come to light
during the audit. Recommendations for improvement also
may be made.

3.3 Accountancy Work

3.3.1 Examples
< Writing up books.
< Drawing up a trial balance.
< Ascertaining end of the reporting period adjustments.
3.3.2 Evidence Obtained
< For example, from:
= examining prime documents;
= calculating balances; and
= posting entries.

< May not provide sufficient audit evidence on its own (e.g. on
recoverability of accounts receivable).

3.4 Auditing for Completeness

3.4.1 Assertion
< Understatement of income (completeness) can be a particular
risk for small business and not-for-profit organisations:
= under-declaration of income (and overstatement of
expenses) will reduce tax liabilities;
= owner-managers may treat some business dealings as
personal transactions (and not record them);

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F8 Audit and Assurance (INT) Session 28 • Small Business and Not-for-Profit Organisations

= a high proportion of transactions may be cash (which may

be misappropriated before it is recorded);
= there may be no exchange in a transaction (e.g. for
donations received) to evidence its occurrence.
3.4.2 Considerations
< Numerically based system (e.g. to control despatch of goods).
< Independently recorded population.
< Reconciliations of total goods bought/sold.
< Predictive analytical procedures.
< Review of transactions after the end of the reporting period.
< Representations by proprietor (are not sufficient on their own).

3.5 Choosing Procedures

< Generally unable to use test of controls to reduce detailed
substantive procedures due to the lack of effective internal
controls.
< Accountancy work gives some assurances; it does not need to
be duplicated.
< Writing up books and a/cs preparation is no substitute for:
= physical
inspection (existence);
= third-partyconfirmation (existence and ownership);
= work on recoverability of accounts receivable (valuation);
= searches for unrecorded liabilities (completeness);
= confirmation of terms of material loans; and
= tests to ensure completeness of income.

< Writing up books may lead to great efficiencies. For example,

if analytical procedures on margins are satisfactory, audit
procedures may be restricted to:
= bank confirmations;
= directconfirmations (if efficient) and review of old balances;
= attendance at physical inventory and review of inventory
valuation;
= review of subsequent events;
= review of accrued expenses and prepayments;
= review of minutes; and
= obtaining other confirmation letters (e.g. from co solicitor).

3.6 Management Representations

< Management representations are particularly important:
= because of the danger of the auditor's role and responsibility
in relation to the financial statements being misunderstood;
and
= to remind management of its responsibility to ensure the
completeness and accuracy of accounting records and the
safeguarding of the entity's assets.
< However, the auditor cannot rely solely on representations of
management to obtain assurance as to the completeness of
the accounting records.

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Session 28 • Small Business and Not-for-Profit Organisations F8 Audit and Assurance (INT)

4 Not-for-Profit Organisations

Not-for-profit organisation (NFP)—an organisation that does not

distribute its surplus funds to owners or shareholders, but instead
uses them to help pursue its goals.*

*These are not exactly organisations that do not make a profit,

but organisations that do not consider profit to be their primary
objective. They aim to satisfy particular needs of their members
or of society in general and usually consider financial objectives as
constraints under which they have to operate.

4.1 Types of NFP Organisation

< Examples include:
= government departments, local authorities and agencies—
exist to implement policy;
= educational establishments—note that private education has
a profit motive;
= hospitals—note that private hospitals would be classified as
profit oriented;
= charities—collect money and effectively distribute it
Candidates will not
according to a charity's aims; be required to have
= pressure groups—raise money to be able to follow a given a detailed knowledge
agenda (e.g. Greenpeace); and of any of the types
= clubs and mutual societies—organisations which raise of NFPs in order to
money directly from members to be able to provide answer a question set
under the scenario
common services to those members (e.g. tennis club,
of a not-for-profit
trade unions). organisation, which
< An NFP organisation may be: is likely to be set
around a small cash-
= incorporated (i.e. companies);
based entity (e.g. a
= otherwise required to be audited (e.g. under sector-specific tennis club or local
legislation); charity). The audit
= subject to specific accounting requirements; approach is similar
= regulated (e.g. by a Charities Commission); to that applied to
small businesses, but
= small, local, single-activity operations run by trustees (e.g. note the differences
clubs, private schools); or highlighted in
= large trading concerns with sophisticated accounting Example 1 and
systems (e.g. international charities and aid agencies). section 4.2.

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F8 Audit and Assurance (INT) Session 28 • Small Business and Not-for-Profit Organisations

Example 1 Differences Between Charities

and Commercial Entities
Suggest FOUR features of a charity which are most likely to differ from a
commercial entity.

Solution

4.2 Audit Work

< In general, the audit of a not-for-profit organisation follows
the same basic principles and programmes of any other audit,
but usually with a particular emphasis on cash.
< The following points suggest typical considerations which
may be of particular importance when auditing not-for-profit
organisations.

4.2.1 Understanding the Entity, its Environment

and Internal Control
< The acceptability of the financial reporting framework is
affected by the lack of international standards for financial
reporting for not-for-profit organisations. An appropriate
national framework should be used and must be understood *Although IFRS could
by the auditor.* be applied it is not
< Management structure and reporting requirements are mandatory.
potentially less formal than commercial organisations.
Experience of key personnel is unlikely to be commercial, as
most will be part-time volunteers. This may increase the risk
of fraud being perpetrated and hidden by those who have
financial experience.
< Regulatory and reporting requirements may be:
= specific (e.g. Charities Act); or
= general (e.g. licensing, liquor and entertainment laws
for clubs).

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Session 28 • Small Business and Not-for-Profit Organisations F8 Audit and Assurance (INT)

< Constitution and rules of entity (potential breaches of

regulations, constitution and/or rules) should be specifically
considered by the auditor under ISA 250 Consideration of
Laws and Regulations in an Audit of Financial Statements).
< Sources of income and forms of expenditure are of particular
importance where there are many sources, primarily of cash
in nature. For example, a club will have subscriptions, bar
income, gaming machine income, special event income (e.g.
discos, lotto, raffles) etc.
< The control environment is unique for not-for-profits. The
auditor should consider:
= the
roles and qualifications of management and the
governing board;
= the frequency of governing board meetings; and
= governing board involvement in operations.

< The internal controls of not-for-profit entities should include

controls related to:
= Safeguarding assets;
= Ensuring all transactions are correctly recorded and
accounting records are properly maintained;
= Completeness of income (especially cash) and the
authorisation of expenditures;
= The identification, evaluation and acceptance of donations;
= Valuing and recording promises to give;
= The valuation of donated assets;
= Compliance with donor restrictions on the use of donations;
= Meeting the reporting requirements of donors and
regulators.

4.2.2 Risk
< Inherent risk may be high because of:
= the
nature of management and key workers (see
Example 1);
= susceptibility to fraud (because of an easily manipulated
asset such as cash);
= the potential impact of a sluggish economy on income from
donations; and
= obligations to comply with regulations when funded by
government grants.
< The entity also may be considered as being a public-interest
entity (e.g. a national charity, local golf/tennis club whose
membership usually contains local business people and
dignitaries) and, therefore, high risk because of the risk
of bad publicity if inappropriate work is carried out or an
inappropriate report is given.
< Control risk also is likely to be high as, for example, formal
controls may be too expensive for the entity to operate (e.g.
employing sufficient people to have effective segregation
of duties) and/or inexperienced "volunteers" may operate
controls. There also may be overdependence on the honesty
of individuals.

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F8 Audit and Assurance (INT) Session 28 • Small Business and Not-for-Profit Organisations

< Detection risk would therefore need to be low, meaning a

high level of audit work in appropriate areas (e.g. extensive
analytical review and/or detailed testing of large samples of
transactions, possibly 100%).

4.2.3 Materiality
< As not-for-profit entities usually attempt to match their
expenditure to their income (e.g. charities collect money to
distribute to worthy causes), materiality based on any surplus
(excess of income over expenditure) generally is not a useful
materiality indicator. Income is likely to be the principal
measure of materiality.
< In addition, materiality ranges may be set lower than for
normal, commercial organisations because of the nature of the
entity (e.g. the general public would expect that all donations
to a charity are accounted for and used appropriately—any
fraud would be considered material regardless of its size).

4.2.4 Analytical Procedures

< Generally, more audit evidence can be derived from analytical
procedures because of the nature of the income and
expenditure of not-for-profit entities.
< Care must be taken to ensure that appropriate procedures
are used taking into account the nature of the entity. For
example:
= Proof in total for subscription income (e.g. number of club
members at the appropriate rate).
= Controlled usage of equipment and facilities (e.g. meters,
counters, booking schedules at the appropriate rate).
= Set percentage mark-up (e.g. bar sales taking into account
regular stock counting and allowances for spillage, set
payout on games machines, say, 80% of takings).
= Pre-numbered ticketing for events (e.g. number/range of
tickets printed per order/invoice from printers less tickets
remaining at their face value with any complimentary issues
formally recorded and authorised).
= Reconciliations (e.g. investment income to the capital
value of the investment, covenants from donors for regular
payments to the entity, costs as a set percentage of
income).
= Comparisons of key income and expenses with prior periods
(e.g. monthly expenses, monthly bar sales/gross profit,
monthly income/profit from regular events).

4.2.5 Reliance on Experts

< Experts may be used in the entity's procedures (e.g. counting
bar inventory in a club, valuation of investments). ISA 500
Audit Evidence and ISA 620 Using the Work of an Auditor's
Expert must be applied.

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Session 28 • Small Business and Not-for-Profit Organisations F8 Audit and Assurance (INT)

4.2.6 Cash
< In many not-for-profit organisations, cash transactions are a
major element and a high-risk area.
< The controls over the receipt, banking, payment and
authorisation of cash must be strong.
< A typical cash audit programme will be used but must be
tailored to suit the circumstances of the entity, for example:
= Attend fundraising events, observe procedures in collecting,
banking and recording cash and the segregation of duties
between collection, counting and recording.
= Perform cash counts at regular, unannounced intervals.
= Ensure regular rotation of staff who handle cash (e.g.
different individuals at each event).
= Ensure access to cash is strongly controlled (e.g. two keys
required to open gaming machines, keys are secure (in
a safe), opening procedures are rotated between staff/
members).

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 Session 28

Summary
< The characteristics of small businesses and not-for-profit organisations include limited
segregation of duties and domination by senior management or owners.
< The engagement letter should include details of additional accountancy or tax services.
< Involvement of owners may:
• Decrease risk of material misstatement through the exercise of effective control and the
prevention/detection of errors.
• Increase risk of profit manipulation.
< Accountancy work performed by the auditor may provide audit evidence, but cannot replace
the evidence obtained from direct confirmation, physical inspection, etc.
< Not-for-profit organisations use surplus funds to pursue goals rather than for distributions to
owners or shareholders.
< When auditing a not-for-profit entity:
• Inherent and control risk are likely to be high, therefore detection risk should be low.
• Income is likely to be the principal basis for materiality.
• Generally, more evidence can be derived from analytical procedures.
• Cash transactions are likely to be material and a high-risk area.

Session 28 Quiz
Estimated time: 30 minutes

1. Compare the characteristics of small businesses and NFPs. (4)

2. Describe the cash and analytical procedures that may typically be used when auditing
NFPs. (4)

Study Question Bank

Estimated time: 40 minutes

Priority Estimated Time Completed

Welfare Help for the
Q37 40 minutes
Aged Trust
Additional

Q38 Audit of Small

Businesses

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EXAMPLE SOLUTIONS
Solution 1—Differences Between Charities
and Commercial Entities
< Sources of income—largely voluntary income (donations), grants, etc.
Highly likely to be in the form of pure cash (e.g. street collections).
< Possible inability to assert completeness of income/revenue arising from
donations (e.g. street collections).
< Branch structure—although this may be used in commercial entities, the
"branch" operating structure with a single, centrally administered head office
is frequently used by charitable organisations.
< Tax status—there may be some reliefs available specifically to charities.
< Restricted funds (capital or revenue)—may be used only for specified
expenditure (e.g. donation or grant for a specific activity or capital item).
< Greater public accountability—is expected because their purpose is to serve
some public good.
< Presence of unpaid workers (volunteers) who may:
= lack sufficient business skills;
= possess great dedication, which may compensate for failings in internal
control.
< Executives may be part-time, retired professionals or complete amateurs.
Risk assessment needs to consider the executives' business and control
awareness. The risk of material misstatement may increase or decrease
depending on their experience, skill and commitment.

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NOTES

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