ACCA Paper F 8AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM

Lecture 1

DATE: Autumn 2008

TUTOR:

Learning Objectives

At the end of this session students should be able to:-

• Appreciate the purpose of assurance services• Have an understanding of the nature of assurance services• Distinguish between an audit, a review and agreed upon procedures. • Understand the concept of Corporate Governance including the FIRC’s

Combined Code on corporate governance and the regulatory environment in which auditing takes place.

• Have knowledge and understanding of the statutory requirements of an audit, the rights and duties of auditors and the regulatory framework which applies to auditors.

• Distinguish between the role of the internal and external auditors.

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Introduction to Paper F 8 Examination

The aim of Paper F8, Audit and Assurance is to develop knowledge and

understanding of the process of carrying out the assurance engagement and

its application in the context of the professional regulatory framework.

It will be assumed that candidates have knowledge of Paper F3, Financial

Accounting and Paper F4, Corporate and Business Law. The accounting

standards examined in Paper F3 could form the basis of questions on how to

apply auditing procedures in respect of those standards. Going forward,

candidates will take knowledge of Paper F8 into Paper P1, Professional

Accountant, and Paper P7, Advanced Audit and Assurance. It will be assumed

that candidates understand why an audit is required (for Paper P1), and

already know the basics of audit procedures (for Paper P7).

Examination Structure

All 5 Questions must be answered

1. Audit procedures, and the application of these procedures to a specific

scenario ( 30 marks)

This question will always be based on a scenario, and will be broken down

into a series of sub-questions, which will examine a range of audit

procedures. Candidates will need to analyse the scenario to identify the

appropriate points to make in their answers.

The use of computers will be present and questions on this area will be based

on computerised systems. Detailed knowledge of how to use computer-

assisted audit techniques (CAATs) will not be expected. Questions will focus

on specific income statement and balance sheet entries. Possible questions

will cover audit procedures, identification of system weaknesses, writing of

management letters, and whether systems meet their objectives (internal

audit focus).

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2. Short factual questions based on International Standards on Auditing

(ISAs) and other key areas (10 marks)

Do not rote learn ISAs, but understand the key principles underlying auditing.

3. Risk and audit approach (20 marks)4. More specialised audit areas (20 marks)

5. Collection of audit evidence, closedown, reporting (20 marks)

Examination answer style required:

A structured answer with clearly identifiable and separable points is

preferable to a continuous flow of text. However, answers in note form are

not acceptable.

Use columnar format where appropriate and break down answers into

manageable sections.

If the question requirement specifically requested a memo format please do

so.

The volume of writing does not necessarily mean a pass standard.

Candidates presenting two or three supplementary answer books do not

achieve a pass standard, but candidates presenting just over half a main

answer book can achieve a pass.

If asked to specify audit tests, candidates must also provide an explanation

and reason for these tests, and state for example, ‘checking from the invoice

back to the order to ensure completeness of invoicing’.

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The purpose of assurance for financial and non-financial information.

An assurance engagement as opposed to an audit is one in which the

professional accountant evaluates or measures a subject matter that is the

responsibility of another party, against suitable criteria and expresses an

opinion that provides the intended user with a level of assurance about the

subject matter.

Subject matter could include data, systems, processes or behavior. The

subject matter must be identifiable, capable of measurement and of being

subject to procedures.

Levels of assurance

1. Reasonable Assurance: The subject matter materially conforms to the

criteria.

“. Limited Assurance: There is no reason to believe that the subject matter

does not conform with the criteria. (Negative assurance).

What is an audit?

An exercise whose objective is to enable auditors to express an opinion

whether the financial statements are prepared in all material respects, in

accordance with an identified financial reporting framework. The auditor has

to an express an opinion, whether or not the financial statements ‘give a true

and fair view or present fairly, in all material respects.

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True = information is

1. Factual and conforms with reality, is not false.

2. Conforms with required standards and laws.

3. The accounts have been correctly extracted from accounting records.

Fair = Information is

1. Free from discrimination and bias.

2. Is in compliance with expected standards and rules.

3. The accounts reflect commercial substance.

It is not the auditor’s responsibility to prepare and present the financial

statements. This is the responsibility of the directors. There are certain

misconceptions about the role of the auditor and this gap between what

the auditors actually do and what people think they do is known as the

expectations gap.

The opinion is expressed to the shareholders. An audit provides a high

but not absolute level of assurance, expressed in the audit report as

reasonable assurance. Reasonable assurance is not a guarantee of

correctness but an assurance of truth and fairness within a reasonable

margin of error.

Materiality:

An item is said to be material if its omission or misstatement would

reasonably influence the economic decisions of the individuals to whom the

audit report is addressed. The item can be qualitative or quantitative.

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Materiality depends on the size of the item or error judged in the particular

circumstances of its omission or misstatement.

It is important that the auditors ensure that the financial statements are free

from material error for the following reasons:

– There is a legal requirement to audit financial statements and present an

opinion on those financial statements. If the auditors do not detect a material

error then their opinion on the financial statements could be incorrect

– The auditor has a responsibility to the members to ensure that the financial

statements are materially correct.

– There are also other users of the financial statements who will include the

taxation authorities and the bank that may have may have made a loan to

the company. They will want to see ‘true and fair’ accounts. The auditors

must therefore ensure that the financial statements are free from material

misstatement to avoid any legal liability to third parties if they audit the

financial statements negligently.

The limitations of an audit are:-

1. Not objective

2. Items checked on a sample basis.

3. Provides opportunity for collusion or fraud.

4. There is a time lag between preparation of financial statements and

the audit report.

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Types of Audits

1. External audit:

Gives confidence in the integrity of corporate reporting for the benefit of

stakeholders and society as a whole by providing an external and objective

view on the reports given by management. The auditor’s report is usually

addressed to the shareholders as the principal stakeholders.

Purpose of external audit

(i) The external audit derives from the separation of the ownership and

management of

assets. Those who own assets wish to ensure that those to whom they have

entrusted control are using those assets efficiently. This is known as the

‘stewardship’ function.

(ii) The requirement for an independent audit helps to ensure that financial

statements are free of bias and manipulation for the benefit of users of

financial information.

(iii) Companies are owned by shareholders but they are managed by

directors (in very small companies, owners and managers are the same, but

many such companies are not subject to statutory audit requirements.)

(iv) The requirement for a statutory audit is a public interest issue: the public

is invited to invest in enterprises, it is in the interests of the capital markets

(and society as a whole) that those investing do so in the knowledge that

they will be provided with ‘true and fair’ information about the enterprise.

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This should result in the efficient allocation of capital as investors are able to

make rational decisions on the basis of transparent financial information.

(v) The requirement for an audit can help prevent investors from being

defrauded, although there is no guarantee of this because the external audit

has inherent limitations. Reducing the possibility of false information being

provided by managers to owners is achieved by the requirement for external

auditors to be independent of the managers upon whose financial statements

they are reporting.

(vi) The purpose of the external audit under International Standards on

Auditing is for the auditor to obtain sufficient appropriate audit evidence on

which to base the audit opinion. This opinion is to the effect that the financial

statements give a ‘true and fair view’ (or ‘present fairly in all material

respects’) of the position, performance (and cash flows) of the entity. This

opinion is prepared for the benefit of shareholders.

2. Internal audit:

An independent, objective assurance and consulting activity designed to add

value and improve and organisation’s operation. Objective is to assist

management and staff in the effective discharge of their duties.

3. Value for money audit:

An investigation into whether or not the use of resources is economic,

efficient and effective. To identify and recommend ways in which the return

for resources employed may be maximised.

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An audit is distinguished from the following engagements:-

1. Review engagement. Provides moderate level of assurance, expressed

as negative assurance. Negative assurance is a statement of what the

auditor does not know as opposed to what he believes (positive

assurance.) The objective of a review is to enable the auditor to give

an opinion whether the anything has come to his attention that would

mean that the financial statements are not properly prepared (do not

give a true and fair view) on the basis of the procedures which do

not constitute an audit.

2. Agreed upon procedures or compilations. No assurance is provided. It

is only a report on factual findings. A compilation presents in the form

of financial statements information that is the representation of

management without expressing assurance. Compilation of a financial

projection involves assembling prospective statements based on

assumptions of a responsible party, considering appropriateness of

presentation, and issuing a compilation report. No assurance is

provided on the statements or underlying assumptions.

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3 Stages of an audit process:

1 1. Agree the terms of engagement.

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2 2. Understand the entity being audited.

3 3. Assess risk.

4 4. Plan the audit and make assessments of materiality.

5 5. Gather Audit evidence.

6 6. Make judgements and express opinion.

Audit Committee

- The board should establish an audit committee of at least three

members, who should all be independent non-executive directors. The

board should satisfy itself that at least one member of the audit

committee has recent and relevant financial experience.

The main roles and responsibilities of the audit committee include

• Monitoring the integrity of the financial statements of the company.

• Review the company’s internal financial controls and the company’s

internal control and risk management systems.

• Monitoring and reviewing the effectiveness of the company’s internal

audit function.

• Making recommendations to the board.

• Reviewing and monitoring the external auditor’s independence and

objectivity and the effectiveness of the audit process.

• The audit committee should have primary responsibility for making a

recommendation on the appointment, reappointment and removal of

the external auditors.

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The advantages of an audit committee:

1. Provide increasing public confidence in the creditability and objectivity

of published financial information. This will be particularly important if

listing arrangements are planned.

2. Assistance in Financial reporting. Supports the directors in fulfilling

their financial reporting obligations. The directors have to prepare

financial statements and the committee can assist by checking the

financial statements to ensure that they comply with appropriate

reporting requirements. This is especially important where the board

do not have detailed knowledge of accounting requirements.

3. Use of the audit committee will enable the external auditor to discuss

issues with the financial statements with the internal auditor, prior to

providing a final summary of key points to the board.

4. The audit committee will monitor the work of the board and provide

helpful guidance, where corporate governance requirements do not

appear to be being met. The audit committee should have detailed

knowledge of corporate governance as part of its monitoring function

of the company and can share this with the board who may not have

the time to obtain detailed information.

The disadvantages of an audit committee:

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1. As the audit committee will be made up mainly from non-executive

directors, the board may see this as a means of decreasing their power

and possibly letting other people run the company. Or the audit

committee must be seen as fulfilling a supporting role for the main

board.

2. Cost. The audit committee will increase the expenditure of the

company as the non-executive directors will require some

remuneration due to their additional responsibilities.

STATUTORY AUDIT REGULATION

1. Appointment of auditors

- The directors may appoint the first auditor until the next AGM.

- The directors have a power to fill any casual vacancy before the next

AGM as a result of death, removal or resignation of the auditors.

- The shareholders are ultimately responsible for appointing auditors at

each AGM.

- The director’s of the company on behalf of the shareholders fixes the

auditor’s remuneration.

2. Removal of auditors:

- Only the shareholders can legally remove the auditors.

- The directors cannot remove the auditors from the office.

- The procedure to follow to remove auditors is as follows:

1 (i) Those shareholders wishing to remove the auditors must give special

notice of an ordinary resolution.

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3 (ii) The auditor has the right to speak at the meeting.

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2 (iii) On removal, the auditors have a duty to make a written statement of the

circumstances connected with the removal which they think should be

brought to the attention of the shareholders’ and creditors’.

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4 (iv) The directors must circularise this to all shareholders and file a copy with

the regulatory authority.

5 (v) The ex-auditor has the right to attend the AGM at which their office would

normally have ended.

3. Resignation and retirement of auditors:

1 - The auditor may resign or retire for office at anytime by sending a

notice to the company’s registered office. This is not effective unless

accompanied by a statement of circumstances.

2 - The company must file a copy of the notice of resignation to the

registrar of companies.

3 - On ceasing to act, the auditors have a duty to make a written

statement.

4 - The auditors have a right to require an Extraordinary General Meeting

(EGM) at which they may speak and explain the circumstances of

their resignation.

4. Auditor’s duties:

- Give a true and fair view of the company’s financial statements and also the

going concern of the company.

- The auditor should consider whether the director’s report is consistent with

the information in the financial statements.

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- The financial statements are properly prepared in accordance company

legislation and relevant accounting standard.

- The auditor must form an opinion on whether:

1. The company maintains proper accounting records.

2. The auditor has access to all relevant information and

explanation.

3. The auditor has adequate information of the other branches of

the company (if any) not visited.

4. The auditor has ensured that the financial statement agree with

the underlying records.

5. Directors’ transactions have been completely and accurately

disclosed.

5. The auditor’s rights:

- Access to all relevant records of the company at anytime

- To request of any information/explanations considered necessary.

- Rights to receive notice attend and speak at the company’s general

meeting.

- To make a written representation on removal.

- On resignation, to require an EGM.

6. Qualifications of auditors:

The auditor must be members of one of the members of International

Federation of Accountants (IFAC) include:

1 1. Association of Chartered Certified Accountants (ACCA)

1 2. Institute of Chartered Accountants of England and Wales, Scotland

and Ireland (ICA )

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2

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4 - Individual should hold appropriate qualification.

5 - The audit practice should be controlled by qualified accountants who

are the members of ACCA or ICA.

6 - Must be registered as an auditor with the ACCA or ICA.

7 - The auditor should be a fit and proper person and comply with

professional rules of conduct.

Fundamental Ethical Principles -THE ACCA RULES OF PROFESSIONAL CONDUCT

In order to achieve the objectives of the accountancy profession,

professional accountants has to observe a number of prerequisites or

fundamental principles.

The fundamental principles are:

1. Integrity

A professional accountant should be straightforward and honest in

performing professional services. Members should behave with integrity in all

professional, business and personal financial relationships.

2. Objectivity

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A professional accountant should be fair and should not allow prejudice or

bias, conflict of interest or influence of others to override objectivity.

Objectivity principle requires that member’s objectivity must be beyond

question and this can only be assured if the member is and is seen to be

independent.

To be and be seen as independent and objective, the auditor or his family

must not have:

• Financial interest in clients such as shareholdings either beneficial or

non beneficial, not trade with clients, must not make loans to or take

loans from the client. Note that overdue fees are equivalent to loans.

Family include spouse, minor children, brothers and sisters and their

spouses, adult children and their spouse, relatives to whom regular

financial assistance is given and ex-employees.

The objectivity of the external auditor may be threatened or appear to be

threatened where:

1 1. There is undue dependence on any audit client or group of clients;

1 2. The firm, its partners or staff have any financial interest in an audit

client;

1 3. There are family or other close personal or business relationships

between the firm, its partners or staff and the audit client;

1 4. The firm provides other services to audit clients.

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3 5. There is undue dependence on any one audit client. Total recurring

fees as a % of gross practice income should be less than 15% for

client/group and less than 10% for public interest companies.

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4 6. There are overdue fees.

5 7. There is actual or threatened litigation.

6 8. Goods, services and hospitality accepted from the client.

ACCA’s requirements that reduce the threats to auditor objectivity include

clients to have

1. Quality control procedures

2. Audit committees.

3. Rotate auditors every 5 years.

The client will thereby ensure increased confidence in the transparency of

reporting.

3. Professional Competence and Due Care.

A professional accountant should perform professional services with due

care, competence and diligence and has a continuing duty to maintain

professional knowledge and skill at a level required to ensure that a client or

employer receives the advantage of competent professional service based on

up-to-date developments in practice, legislation and techniques.

Members should carry out their professional work with due skill, care,

diligence and expedition and with proper regard for the technical and

professional standards expected of them.

4. Confidentiality of client information.

A professional accountant should respect the confidentiality of information

acquired during the course of performing professional services and should

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not use or disclose any such information without proper and specific authority

or unless there is a legal or professional right or duty to disclose.

ACCA’s Code of ethics – Obligatory disclosure

• If the member auditor knows or suspects that client is involved in

treason, drug trafficking or terrorist offences.

• Under IAS250, when non-compliance with laws and regulations will

cause material mis-statements in the financial statements.

The actual disclosure will depend on the laws of the jurisdiction where the

auditor is located.

The auditor may also be obliged to provide information where a court

demands disclosure. Refusal to provide information is likely to be considered

contempt of court with the auditor being liable for this offence.

ACCA Code of ethics – voluntary disclosure

A member may also disclose client confidential information voluntarily, that is

without client permission

– To protect a member’s interest e.g. to allow a member to sue a client for

unpaid fees or defend an action for negligence.

– Where there is a public duty to disclose e.g. the client has committed an

action against the public interest such as unauthorised release of toxic

chemicals.

5. Adopt Professional Behaviour

1 - A professional accountant should act in a manner consistent with the

good reputation of the profession and refrain from any conduct which

might bring discredit to the profession.

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2 - The obligation to refrain from any conduct which might bring discredit

to the profession requires IFAC member bodies to consider, when

developing ethical requirements, the responsibilities of a professional

accountant to clients, third parties, other members of the accountancy

profession, staff, employers, and the general public.

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4 Technical Standards professional accountant should carry out

professional services in accordance with the relevant technical and

professional standards.

6. Conflicts of interest

ACCA’s Rules of Professional Conduct state that auditors should avoid

conflicts of interest (both conflicts between the firm and clients, and conflicts

between clients) wherever possible.

If such conflicts are unavoidable:-

(i) Full disclosure is important – both client companies should be fully

aware that the firm is acting for the other party.

(ii) One or both companies may object to the firm acting for the other

company and the auditor may be forced to make a decision as to

which company to resign from. However, this is not an attractive

course of action because the audits may already have commenced

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and it may be difficult for one of the companies to find a new

auditor, quickly.

(iii) The auditor should not resign unless forced to do so – this might be

prejudicial to the interests of one of the clients.

(iv) It is important in such cases that different teams of staff, and

different engagement partners work on the respective audits.

(v) Internal procedures within the firm should be set up to prevent

confidential information from one client being transferred to the

other and the interests of one firm damaging the interests of the

other. Such procedures are known as ‘Chinese Walls’.

Six Potential threats to auditor’s independence:

1. Self review threat: occur when results of a previous engagement needs

to be re-evaluated in reaching conclusion on the present assurance

engagement or when a member of assurance team is previously was

an employee of the assurance client(director) in a position to exert

influence over current audit matters.

Examples of circumstances that may create this threat include:

1 (1). A member of the assurance team being, or having recently been, a

director or officer of the assurance client;

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1 (ii). A member of the assurance team being, or having recently been,

an employee of the assurance client in a position to exert direct and

significant influence over the subject matter of the assurance engagement;

1 (iii). Performing services for an assurance client that directly affect the

subject matter of the assurance engagement; and

1 (iv). Preparation of original data used to generate financial statements

or preparation of other records that are the subject matter of the

assurance engagement.

Example of self review threat: If the auditors are to implement new control

systems then they will also be auditing those systems as part of the statutory

audit. They must therefore ensure that different staff implement and audit

the systems. Preferably different departments in the firm should undertake

the work. If insufficient staff are available then the audit firm must refuse the

additional systems work.

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2. Familiarity threat: occurs when, by virtue of a close relationship with

an assurance client, its directors, officers or employees, a firm or a

member of the assurance team becomes too sympathetic to the

client’s interests.

1 Circumstances that may create familiarity threat include:

1 (i) A member of the assurance team having an immediate family member

or close family member who is a director or officer of the assurance client.

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3 (ii) A member of the assurance team having an immediate family member

or close family member who, as an employee of the assurance client, is in

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a position to exert direct and significant influence over the subject matter

of the assurance engagement.

4 (iii) A former partner of the firm being a director, officer of the assurance

client or an employee in a position to exert direct and significant influence

over the subject matter of the assurance engagement.

5 (iv) Long association of a senior member of the assurance team with the

assurance client.

6 (v). Acceptance of gifts or hospitality, unless the value is clearly

insignificant, from the assurance client, its directors, officers or

employees.

3. Self interest threat: occurs when an auditor could be from financial

interest in or other self interest conflict with assurance client.

1 Examples of circumstances that may create self interest threat include:

1 (i). A direct financial interest or material indirect financial interest in an

assurance client.

1 (ii). A loan or guarantee to or from an assurance client or any of its

directors or officers.

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1 (iii). Undue dependence on total fees from an assurance client.

1 (iv) Concern about the possibility of losing the engagement.

1 (v) Having a close business relationship with an assurance client.

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3 (vi) Potential employment with an assurance client.

1 (vii) Contingent fees relating to assurance engagements.

4. Intimidation threat: This occurs when a member of audit team may be

deterred from carrying audit work or exercising professional scepticism

by threat from the directors of the audit client.

1 Examples of circumstances that may create intimidation threat

include:

1 (i). Threat of replacement over a disagreement with the application of

an accounting principle; and

1 (ii). Pressure to reduce inappropriately the extent of work performed in

order to reduce fees.

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5. Advocacy threat: This arises when member of the audit team promotes

or seems to promote an audit client opinion or position (for example

selling or underwriting in financial matters for audit client or acting as

the clients advocate in a legal proceeding).

1 Examples of circumstances that may create this threat include to:

1 (i). Dealing in, or being a promoter of, shares or other securities in an

assurance client.

1 (ii). Acting as an advocate on behalf of an assurance client in litigation

or in resolving disputes with third parties.

6. Association Threat: This arises when the audit firm is likely to associate

itself with a client whose business has yet to be confirmed as being legal or

ethical. If the client is extending their product line, the auditors will have to

determine the likelihood that the product is legal. The audit firm may not

wish to be associated with a company producing illegal products.

Appointment Ethics of External Auditors

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Before accepting an appointment, the auditor should ensure that they

• Are professionally qualified to act – The firm has existing resources

that are adequate to meet the needs of the engagement in terms of

time, staff and technical expertise. For example if the client is growing

quickly and has poor internal controls providing high risk of financial

misstatement, the auditors should ensure that they have sufficient

staff of appropriate experience available and that enough time is

allocated to the audit to complete all audit procedures.

• Obtain references and make independent inquiries if directors are not

personally known.

• Communicate with present auditors to find out whether there are any

circumstances behind the change that the new auditors need to be

aware of.

After accepting the appointment the auditors should ensure that

• Outgoing auditors’ removal or resignation has been properly

conducted.

• New auditor’s appointment is valid.

• Submit a letter of engagement.

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Letter of Engagement

ISA 210 The letter of engagement must define the terms of Audit

Engagement

Purpose:

• To define clearly the extent of the auditor’s responsibilities.

• Minimise misunderstandings between audit firm and client.

• Confirm in writing verbal arrangement.

• Confirm acceptance by the auditor of his engagement.

• To inform and educate the client.

When to send a letter:

• To all new clients before commence of audit work.

• To all existing clients who have not previously had such a letter.

• If there are changes in circumstances in the client’s company for

example a major change in ownership or management.

• In the case of groups an engagement letter should be sent to each

company member of the group that is to be audited by the firm.

Steps:-

• On or before acceptance of a new client discuss the precise terms with

the management.

• Draft and sign the letter before commencing any part of the

assignment.

• Receive the client’s written acceptance.

• Every year review and update the letter and consider if nature of the

engagement has changed.

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Contents of letter of engagement:

1. Addressed: To the directors of:…………………….

2. The responsibilities of the directors:

1 (i). Keep proper accounting records

2 (ii). Prepare the financial statements that show true and fair view.

3 (iii). The financial statement should comply with national company’s

legislation and the relevant accounting standards.

3. The responsibilities of the auditors:

(i). Report to the members whether the financial statement prepared by the

directors is showing true and fair view.

(ii). To check whether the directors keep books and records adequately and

that relevant information is received from the director’s with regards to the

branches not visited.

(iii). To check whether the financial statements are in agreement with

accounting records and returns.

1 (iv) To ensure that they have received all the relevant information and

explanation from the directors of the company before an opinion is formed.

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3 (v) To check the directors report is consistent with the financial statements.

4. The scope of the auditor’s work:

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(i). Audit work must comply with auditing standards.

(ii). Review the accounting systems.

1 (iii) Collection of audit evidence.

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3 (iv) Review of internal controls and test.

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2 (v) Prepare a letter of weakness.

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4 (vi). It is the director’s primary responsibilities are to safeguard company

assets and the prevention of fraud and irregularities.

Notes:

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• Any agreement with auditors for other services should be stated in a

separate engagement letter. When external auditors provide non-audit

services to their audit clients, it is essential that the auditors make a

clear distinction between their audit and non-audit responsibilities.

• The fees and the basis on which they are charged (based on time and

expertise used in client affairs).

• State the applicable law.

• Request for written acknowledgement of the letter creates a

contractual obligation. In the case of a company the board of directors

should sign the letter of engagement.

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Internal Audit Function

Internal audit is an appraisal or monitoring activity established within a

company or an entity as a service to the entity. Its functions include

examining, evaluating and monitoring the adequacy and effectiveness of the

internal control. It is a key part of effective corporate governance since

corporate governance objectives include the management of the risks to

which the entity is subject and that would prevent it achieving its overall

objectives such as profitability.

The internal activity is designed to add value to and improve the operations

of an organisation. The internal auditor reports to management.

The internal auditor is normally an employee of the organisation but often

their work is outsourced.

On the other hand, the external auditor expresses an opinion on the financial

statements and reports to the shareholders.

Internal Auditors should be assumed to members of the ACCA and are bound

by the rules of professional conduct.

Roles of Internal Audit Department:-

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1. Risk Management Role– this involves monitoring the overall process of

risk management and in providing assurance that the systems have

been designed to meet objectives and that they operate effectively. A

large part of the management of risks, and the proper exercise of

stewardship, involves the maintenance of proper controls over the

business. Controls over the business as a whole, and in relation to

specific areas, include the effective operation of an internal audit

function.

Fraud is a key business risk and internal auditor can assist in prevention

and detection of fraud.

The internal auditor must:-

(a) Determine company policy in respect of the risks identified.

(b) Implement strategy and ensure that strategies implemented

operate effectively and continue to match risk as intended.

Internal audit can help management manage risks in relation to fraud and

error, and exercise proper stewardship by:

1. Commenting on the process used by management to identify and classify

the specific fraud and error risks to which the entity is subject and help

management to develop and implement that process.

2. Commenting on the appropriateness and effectiveness of actions taken by

management to manage the risks identified and help management to

develop appropriate actions by making recommendations.

3. Periodically auditing or reviewing systems or operations to determine

whether the risks of fraud and error are being effectively managed.

4. Monitoring the incidence of fraud and error, investigate serious cases and

make recommendations for appropriate management responses.

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2. Monitoring Role - Value for money audit (VFM): is an assignment that

internal audit can undertake on behalf of management as part of the

monitoring role. VFM audit can be carried out on any area of the business.

Since a VFM audit is concerned with obtaining the best possible combination

of products/services for the least resources, it measures three qualities:-

• Economy - Economy relates to least cost. The organisation should

attain the appropriate quantity and quality of physical, human and

financial resources at the lowest cost. The systems in an organisation

should operate at a minimum cost associated with an acceptable level

of risk.

• Efficiency- This is a measure of the relationship between goods and

services produced (outputs) and the resources (inputs) used.

Therefore, efficiency relates to the best use of resources. The goals

and objectives of an organisation should be accomplished accurately

and on a timely basis with the least use of resources.

• Effectiveness involves determining how well an activity is achieving its

objectives and therefore effectiveness provides assurance that

organisational objectives will be achieved.

Monitoring role for local authorities:-

Besides VFM, internal audit can also monitor best value to ensure that the

authority has systems in place to achieve best value. Best value implements

4 C’s instead of the 3 E’s of a VFM audit.

• Challenge – monitor how well and why a service is provided.

• Compare – to other authorities.

• Consult – targets should be set in consultation with tax payers and

service users.

• Compete – involve in fair competition.

3. Role of performing information technology audits by monitoring and

testing controls in the areas of database management, system

31

development process, change management, networks, asset

management, capacity management, access control, operational

system and E-business.

4. Perform operational audits

Operational audits are audits of the operational process of the

organisation. These are also known as management audits or efficiency

audits. Their main objective is to monitor management’s performance and

ensure that company policy is adhered to.

The two main aspects of an operational assessment is to ensure that the

policies are adequate and that they work effectively.

Outsourcing the Internal Audit Function to an outside source. Audit firms offer

internal audit services as part of their portfolio.

Advantages of outsourcing:-

1. Service provider can provide the necessary expertise for internal audit

work. They may be able to provide a broader range of expertise and

specialist skills and as they serve many different clients therefore staff

may be available for specialist work that the company may not be able

to afford.

2. If internal audit is only required for specific functions or particular jobs

each year then the expertise can be purchased as required. This will

minimise the companies in-house costs.

3. They can direct their own work and educate management as to the

service required.

4. Provides an immediate team.

5. Can be appointed for a specific timescale

6. Outsourcing will remove the need for training internal staff. Effectively

training will be provided for ‘free’ as the outsourcing firm will be

32

responsible for keeping staff up-to-date with new auditing techniques

and processes.

7. An independent view will be provided that may identify control

weaknesses that the internal audit department may miss.

Disadvantages of outsourcing

1. Fee pressure. The relationship needs to be managed carefully to

ensure that the service provider does not decrease the quality of their

work due to insufficient fees.

2. The outsourced firm may not have any prior knowledge of the

company and will need time to ascertain the accounting systems and

controls before commencing work.

3. Continuity of service of staff at the service provider. Depends on the

retention rate. Larger internal auditing firms will be able to offer their

staff better career progression which should assist staff retention.

Internal Audit Department and Corporate Governance

Internal audit department can assist the directors with the implementation of

good corporate governance in an organisation through:

(i) Reviewing reports to the board and reports produced by the board

to ensure that they do present a balanced assessment of the

company’s position and prospects. The internal audit department

will have good knowledge of the operations of the company as well

as access to accounting information. The department can

effectively ‘audit’ board reports to ensure they are accurate and

understandable.

(ii) Internal controls. The board need to maintain a sound system of

internal control. The internal audit department will be able to

review existing controls and recommend improvements to ensure

this objective is met.

33

(iii) Application of ISA and IASs. The board need to have a policy for

applying appropriate International Statements on Auditing (ISA) and

International Accounting Standards (IAS) to the organisation.

Internal audit will be aware of new auditing standards and will have

the technical expertise to identify changes required by accounting

standards.

(iv) Amendments to control systems for new auditing standards and

financial accounting systems for new accounting standards can

therefore be recommended.

(v) Communication with external auditors. The corporate governance

code requires communications with external auditors normally be

via the audit committee, although the board must maintain an

appropriate relationship with the external auditors. However,

internal and external auditors can also work together to ensure that

the internal control system is sufficient; possibly by external audit

delegating work to internal audit, and each auditor reviewing the

work of the other auditor. The board will therefore receive reports

from both sets of auditors which will be accurate because they have

been properly checked.

(vi) Communication to the board. The internal auditor can also check

that appropriate information is provided to the board from the

external auditor. ISA 260 Communications of audit matters with

those charged with governance provides a list of matters which

should be communicated to the board and the internal auditor can

work with the external auditor to ensure that this information is

provided.

34

Role of external auditor in respect to evaluating and testing the work of the

internal auditor include:

They external auditor must:-

–Check that the work is performed by persons having adequate technical

training and proficiency as internal auditors, by ensuring that appropriate

training programmes are in place and the auditor has appropriate

qualifications.

– Ensure that the work of assistants is properly supervised, reviewed and

documented by reviewing the procedure manuals of internal audit and the

audit working papers produced.

– Determine that sufficient and appropriate audit evidence is obtained to

afford a reasonable basis for the conclusions reached, by reviewing the

internal auditor’s working papers.

– Check that the conclusions reached are appropriate in the circumstances

and that any reports prepared are consistent with the results of the work

performed by reviewing the work performed and the reports produced.

– Ensure that any exceptions or unusual matters disclosed by internal audit

are properly resolved by the external auditor and management.

35

36

ACCA Paper F8AUDIT AND INTERNAL REVIEW INTERNATIONAL

STREAM

Lecture 2: Audit Evidence, Sampling and Documentation

DATE: Autumn 2008

TUTOR:

Learning Objectives:

At the end of this session, the students should be able to:-

• Describe and illustrate the contents of work plans, work programs and working papers.

• Describe the nature of documentation required for different types of assignment.

• Explain the importance of documentation• Have an understanding of the design and documentation of

the audit program.

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ISA 500 AUDIT EVIDENCE

ISA 500.2 “Auditors should obtain sufficient appropriate audit

evidence to able them to draw reasonable conclusion on which to

base their audit opinion.” Sufficient relates to quantity. Appropriate

relates to quality.

Audit evidence is obtained by performing risk assessment

procedures, tests of controls and substantive procedures. The type

of audit procedure to be performed is important to an

understanding of the application of audit sampling in gathering

audit evidence.

In obtaining audit evidence from tests of control, auditors should

consider the sufficiency and appropriateness of the audit evidence

to support the assessed level of control risk. In test of controls the

auditor needs evidence about the operating effectiveness of the

controls.

In obtaining audit evidence from substantive tests/procedures,

auditors should consider the extent of the evidence together with

any evidence from tests of control to support the relevant financial

statement assertions made by directors.

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The directors are responsible for the production of the company’s

financial statements and also for making assertion about the items

in the financial statements.

The following SIX assertions the director makes:

• Assertions about existence: an asset and liability must exist

at balance sheet. (The key objective is that assets are not

overstated and liabilities are not understated).

• Assertions about the rights and obligation: Entities have legal

or other rights or obligations relating to the assets and

liabilities. The auditor must ensure that it is the business

which owns the assets and liabilities at balance sheet date.

• Assertions about occurrence: A financial or non financial

transaction occurred during the accounting period (Over and

understatement transactions).

• Assertions about completeness: There are no unrecorded

assets or liabilities at balance sheet. The auditor must ensure

there is no under/overstatement of transaction in the Balance

Sheet.

• Assertions about valuation: The assets and liabilities are

recorded at an appropriate value. For all non current assets

this would be initial cost plus increases or minus decreased

in value.

• Assertions about presentation and disclosures: Must be in

accordance with relevant national legislation and accounting

standard.

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Factors that influence sufficiency include:-

• Risk assessment procedures. The auditor obtains an

understanding of the entity and its environment including

internal controls to assess risk. The main purpose of risk

assessment procedures is to help the auditor obtain an

understanding of the audit client. The procedures will provide

audit evidence relating to the auditor’s risk assessment of a

material misstatement in the client’s financial statements.

The auditor will also obtain initial evidence regarding the

classes of transactions at the client and the operating

effectiveness of the client’s internal controls.

• Nature of the systems

• Materiality of the item

• Experience of the auditor in that area

• Source and reliability of the evidence

• Results of procedures.

Audit evidence should be reliable, relevant and sufficient. If

sufficient, reliable and relevant audit evidence does not exist, an

auditor should seek written management representations. This is a

letter covering general as well as specific issues. The auditors

should not use this as a substitute for other independent evidence

that may be available. The auditor should also confirm that

representations are consistent with other sources of evidence.

Reliability is affected by the following rules:-

• External evidence obtained from outside the entity/company

is more reliable than evidence obtained from within the

entity/company.

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• Evidence generated and collected by the auditor is more

reliable than evidence obtained from the entity/company.

• Written evidence is more reliable than oral.

• Original evidence is more reliable than copies of the original.

Sufficiency is assessed on the following factors:

• Nature of the business and industry

• Nature and materiality of the items

• Auditor experience of the client and staff

• Financial position of the client.

• Persuasiveness of the evidence.

• Nature of accounting systems and internal control systems.

Relevance of the evidence- the evidence gathered should be

relevant for the work carried out by the auditor.

11 Methods of collecting audit evidence:

1. Observation. This includes physical examination and

witnessing the internal control and bookkeeping procedures.

In respect of internal control, observation will only inform the

auditor that the control was effective at the time of

observation.

2. Inspection of original documents and assets to confirm their

existence. However, if internal controls are poor, the

reliability of this method is limited.

3. Inquiry or requesting information. The reliability of this

method depends on the integrity of the source from which

this inquiry is made.

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4. Confirmation. Bank letters, account receivables (debtors)

circularisation, management representations, confirmation of

inventory held by third parties. This method has limitations

and the auditor must assess the extent to which he can rely

on these confirmations. Alternatively, the auditor should test

internal controls in this area.

Limitations:-

A bank confirmation letter provides good evidence on the existence

of the company’s bank accounts as the bank has confirmed this

information in writing. A bank letter cannot necessarily be relied on

to provide complete or accurate information. Most banks place a

disclaimer on the letter of ‘errors and omissions excepted’

indicating that the auditor must review this evidence against other

cash and bank evidence obtained.

Accounts receivable letter provides evidence of the existence of the

receivable when a reply is returned from that receivable direct to

the auditor.

It provides evidence on cut-off because sales or cash receipts

recorded in the incorrect accounting period will have to be

reconciled to the balance provided by the receivable. However,

such a circularisation letter does not provide evidence of

completeness of the receivables balance because receivables may

not query balances which are understated. The letter does not

provide evidence of the valuation of the receivables balance

because the receivable cannot be expected to list all outstanding

balances and confirmation of the debt does not mean it will be paid.

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A letter from the third party holding the inventory will provide

evidence of the existence of that inventory because the third party

has confirmed this in writing. However, the letter does not provide

evidence regarding the valuation of the inventory; confirming

something exists does not necessarily mean it is in good condition.

5. Recalculation and re-performance.

6. Analytical Procedures. This involves establishing trends in

financial and non-financial information such as ratio analysis.

This method is used at the audit planning stage to identify

areas of risk and also to gather substantive evidence.

Usefulness depends on reliability of the underlying

information. If there are inherent control weaknesses, the

information obtained from analytical procedures will not be

reliable.

7. Test of controls

8. Detailed testing of transactions and balances.

9. Computer assisted audit techniques (CAATs). CAAT’s include

audit software, test data and embedded audit facilities such

as integrated test facilities (ITF) and systems control and

review file (SCARF).

Advantages of using CAAT’s :-

* Use of the CAAT enables the auditor to meet the auditing

standard requirement of obtaining appropriate audit evidence

and enables the auditor to test the actual accounting records

(the electronic version) rather then relying on printouts or other

copies of the data.

* It is always appropriate for the auditor to test original

documentation

where possible. CAATs enable the auditors to test a large

volume of data, or the operation of the controls in a system,

accurately and quickly. * They are therefore very-cost efficient

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when operated properly. CAATs reduce the level of human error

in testing and enable a very high level of audit evidence to be

derived.

* Embedded audit facilities allow continuous review of the

client’s systems.

Disadvantages of CAAT’s

• CAATs are expensive to set up and require the co-operation

of the client. It is usually necessary for a continuing audit

relationship to be present before it is worth committing the

audit resources.

• Major changes in client systems often require major changes

in CAATs, which is expensive.

10. Management representations. These are a form of

audit evidence contained in a letter, written by the

company’s directors and sent to the auditor, just prior to the

completion of audit work and before the audit report is

signed.

Representations are required for two reasons:

(i) So that the directors can acknowledge their collective

responsibility for the preparation of the financial statements and to

confirm that they have approved those statements.

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(ii). To confirm any matters, which are material to the financial

statements where representations are crucial to obtaining sufficient

and appropriate audit evidence.

Obtaining representations does not mean that other evidence does

not have to be obtained. Audit evidence must still be collected and

the representation should be used to support that evidence. Any

contradiction between sources of evidence should be investigated.

ISA 530 Audit Sampling and other means of testing.

Audit sampling is defined as the application of audit procedures to

less than 100% of the population to enable the auditor to evaluate

audit evidence about some characteristic of the items selected in

order to form or assist in forming a conclusion concerning the

population.

Statistical sampling involves the use of techniques from which

mathematically constructed conclusions regarding the population

can be drawn.

Non statistical sampling results should not be extrapolated over the

population as the sample is unlikely to be representative of the

population.

When designing the size and structure of an audit sample, auditors

should consider the specific audit objectives, the nature of the

population and the sampling and selection methods.

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When determining sample size, the auditor should consider the

sampling risk, the amount of the error that would be acceptable

and the extent to which errors are expected.

Sampling risk arises from the possibility that the auditor's

conclusion may be different from the conclusion that would be

reached if the entire population were subjected to the same audit

procedure.

Sample size is affected by the level of sampling risk that the auditor

is willing to accept.

There are two types of sampling risks:-

• The risk of incorrect acceptance - the risk that material

misstatement is assessed as unlikely, when in fact the

population is materially misstated.

• The risk of incorrect rejection - the risk that material

misstatement is assessed as likely, when in fact the

population is not materially misstated.

Tolerable error is the maximum error in the population that

auditors are willing to accept and still conclude that the audit

objective has been achieved. For substantive tests, tolerable

error is related to the auditor's judgment about materiality. In

compliance tests, it is the maximum rate of deviation from a

prescribed control procedure that the auditor is willing to accept.

There are four commonly used sample selection methods:

Statistical Sampling Methods

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(i). Random sampling - ensures that all combinations

of sampling units in the population have an equal chance

of selection.

(ii). Systematic sampling - involves selecting sampling

units using a fixed interval between selections, the first

interval having a random start. Examples include Monetary

Unit Sampling where each individual monetary value (e.g.,

£1) in the population is given an equal chance of selection.

As the individual monetary unit cannot ordinarily be

examined separately, the item which includes that

monetary unit is selected for examination. This method

systematically weights the selection in favour of the larger

amounts but still gives every monetary value an equal

opportunity for selection. Another example includes

selecting every 'nth sampling unit.

Non Statistical Sampling Methods

(iii). Haphazard sampling - in which the auditor selects

the sample without following a structured technique,

however avoiding any conscious bias or predictability.

However, analysis of a haphazard sample should not be

relied upon to form a conclusion on the population

(iv). Judgmental sampling - in which the auditor places

a bias on the sample (e.g., all sampling units over a certain

value, all for a specific type of exception, all negatives, all

new users, etc.). It should be noted that a judgmental

sample is not statistically based and results should not be

extrapolated over the population as the sample is unlikely

to be representative of the population.

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ISA 230: DOCUMENTATION (Working paper file)

This ISA states that auditors should document in their working

papers matters that are important in supporting the Auditors

Report.

- Working papers should provide evidence on how the audit

procedures were performed and how it is concluded.

- Auditors should record in their working papers their

reasoning on all significant matters that require the exercise

of judgement and their conclusions thereon.

- The auditor should maintain confidentiality and custody of

the working papers.

The Purpose of documentation:-

• To control current year work.

• Record the work.

• Evidence of work carried out.

• Verification.

• Briefing for next audit.

Two main types of documentation:-

1. The Permanent File

Includes:-

• Statutory documents.

• Company rules and regulations.

• Letter of Engagement.

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• Legal documents (e.g. debenture deeds, leases, loan

agreements etc).

2. The Current Audit file:

Includes:-

• Copy of last year’s Audited Financial Statements.

• Audit Programme & Checklist.

• Accounts schedule (Working Papers).

• Minutes.

• Copy of Management letter

• Copy of Letter of Representation.

The auditor should record who performed the work on which date

and who reviewed the work on which date.

Documents should be retained for at least 5 years from the date of

the audit report.

Types of Documentation:-

• Narrative Notes

• Flow Charts

• Questionnaires

• Checklists

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ACCA Paper F 8

AUDIT AND ASSURANCE SERVICES (INTERNATIONAL STREAM)

Lecture 3

Audit Planning and Risk

DATE: Autumn 2008

TUTOR:

1

ISA 300 AUDIT PLANNING

Auditors should plan the audit so that the engagement is conducted in an

effective manner.

The objectives of planning include:-

• Directing appropriate attention to the different areas of the audit such

as assessing materiality, so that when the detailed audit plan is

prepared, audit procedures can be directed towards the material

amounts.

• Identify potential problems or risks so that they can be resolved at an

early stage.

• Facilitate review and control of the audit.

• Assigning and briefing staff with appropriate skills, knowledge, training,

proficiency.

• Coordinating the work of others such as that of experts.

• Obtaining knowledge and understanding of the client’s business.

• Providing an economic and effective service within appropriate

timescales

Planning an audit will permit development of:-

• An audit strategy based on risk analysis

• An audit plan that addressing the risks identified.

2

Planning procedures:

• Review the previous years working papers

• Identify problem areas encountered

• Determine staffing requirements

• Obtain an indication of time required

• If the client is new, review the previous auditors’ working papers to

obtain closing balances which will affect this year’s financial

statements.

• Determine the trading pattern and problems faced by the client

company.

• Establish timetable, important dates and deadlines

• Assess the effect of changes from previous year:

1 1. Systems

1 2. Law and regulation

1 3. Accounting policies

1 4. Management

1 5. Other relevant matters

• Perform analytical review or procedures on the latest accounts.

• Request preparation of cash and profit projections where solvency

problems are foreseen.

• Review the work of internal audit.

• Evaluate whether reliance on other expert is necessary

• Allocate and brief audit staff.

3

ISA 315 UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISK OF MATERIAL MISSTATEMENT.

315.2 The auditor must obtain an understanding of the entity and its

environment, including internal controls, so that they can identify and assess

the risks of material misstatement on financial statements due to fraud or

error and design and perform further audit procedures.

The objective of this standard is to ensure that auditors obtain sufficient

knowledge of the business of the entity to enable them to identify and

understand the events, transactions or practice that may have a significant

effect on the financial statements or the audit. This knowledge of the

business helps to assess the levels of control and inherent risk and to

determine audit procedures.

Procedures to follow:-

• Enquiry of management

• Analytical procedures.

• Observation and inspection.

4

ISA 400 RISK ASSESSMENT

There are 2 main categories of risk

1. Business Risk

2. Audit Risk.

1. Business Risks

Business risk is the risk that the business will fail to meet its objective.

Elements of Business Risk include

• Financial risk which arises from the company activities such as going

concern problems, overtrading, credit risk, interest risk, currency risk

and breakdown of accounting systems.

• Operational risk arising from the operation of the business such as lost

business opportunities, loss of physical assets and lack of business

orders.

• Compliance risk arising from non-compliances with laws and

regulations such as breach of companies acts, and health and safety

regulations.

2. Audit risk is the risk that the auditor come to an invalid conclusion in

audit report and come to an incorrect opinion that either:

1 1. The audit report is unqualified but subsequently material error is

found in the financial statement.

1 2. The audit report is qualified but subsequently no material error is

found in the financial statement.

5

There are two types of audit risks:-

1. Inherent risk

2. Control risk

Inherent and control risk together form risk of material misstatement.

Detection risk mainly a part of sampling risk

1. Inherent risk is the risk that misstatement will occur due to factors

inherent in the company’s business or environment or the nature of

individual transaction or balance. It is the risk attached to an assertion

that could cause a material misstatement. Certain assertions, related

classes of transactions and account balances such as stock are more

prone to risk.

Inherent risk depends on the type of business.

1

2 The following have a high inherent risk:

• Businesses with products subject to changes in fashion and technology

business. The risk is that stock could be overstated.

• Companies with a dominant chief executive.

• Small and new companies.

• Companies experiencing going concern problems.

• Companies facing a highly competitive environment.

6

1 2. Control risk is the risk that a misstatement could occur in an account

balance or class of transactions and that could be material either

individually or when aggregated with misstatement in other balance or

class, would not be detected and corrected on timely basis, by the

accounting and internal control systems.

2 This is the risk that the client’s internal control system will not prevent

errors occurring or will not detect them after the occurrence so that

they may be prevented.

Example of control risk – corporate culture of slack control procedures,

lack of proper reconciliation of ledger balances.

3. Detection risk the risk that auditor’s substantive procedures do not

detect a misstatement that exist in an account balance or class of

transactions that could be material either individually or when aggregated

with misstatements in other balance. One component of detection risk is

sampling risk. Sampling risk is the possibility that the auditor’s

conclusion, based on a sample, may be different from the conclusion

reached if the entire population were subjected to the audit procedure.

1

7

ISA 320 AUDIT MATERIALITY

Auditors must consider materiality and its relationship to audit risk when

conducting and audit.

Information is material if its omission or misstatement could influence the

economic decisions of users taken on the basis of the financial statements.

Materiality is an important concept in the audit process and affects:-

• Audit risk evaluation

• The nature, timing and extent of audit procedures (e.g. sample sizes).

• The determination of whether the financial statements are distorted

by misstatements discovered.

The auditor’s assessment of materiality is influenced by the following:

• The overall impact on the financial statements.

• Individual account balances and transactions

• The size of the item. For example, an item may be large in relation to

certain items in the financial statements profit, turnover, gross assets,

individual assets, and liabilities.

Quantitative materiality

12 An item is material if it is :-34 > 5-10% of profit before tax

5 > ½– 1% of turnover

8

> 1 – 2% of gross total assets

> 2 -5% of net assets

> 10% of an individual asset/liability

Qualitative materiality

The nature of an item which is immaterial in size could be material if it is :-

1. Illegal payment or otherwise immaterial amounts could be material. Material contingency could rise and results in a material loss of assets or revenue.

2. Inadequate or improper description of an accounting policy could be material. Users of the financial statements could be misled.

3. The requirement to disclose information in compliance with the Companies Act or other regulations (e.g. directors’ transaction even if immaterial in size).

4. Items required to be precisely stated (e.g. share capital & reserves, dividends, audit fees).

9

Assessing Risk: ISA 330 The auditor's procedures in response to assessed risks10

ISA 330 indicates that the auditor must determine the nature and extent of

audit evidence to be obtained from the performance of substantive

procedures in response to the related assessment of the risk of material

misstatement. This varies depending on the assessment of inherent and

control risks, and that, irrespective of the assessed risk of material

misstatement, the auditor designs and performs substantive procedures for

each material class of transactions, account balance, and disclosure and that

the assessed levels of inherent and control risk cannot be sufficiently low to

eliminate the need to perform any substantive procedures.

These substantive procedures may include the use of external confirmations

for certain specific financial statement assertions.

The higher the auditor’s assessment of inherent and control risk, the more

reliable and relevant is the audit evidence the auditor needs to obtain from

the performance of substantive procedures. The use of confirmation

procedures may be effective in providing sufficient appropriate audit

evidence.

On the other hand, the assessed risk of material misstatement and the level

of inherent and control risk is low, the less assurance the auditor needs from

substantive procedures. For example, if an entity has a loan that it is

repaying according to an agreed schedule, the terms of which the auditor has

confirmed in previous years and the other work carried out by the auditor

including tests of controls indicates that the terms of the loan have not

10

changed, this means that the risk of material misstatement level of inherent

and control risk is low, and the auditor can limit substantive procedures to

testing details of the payments made, rather than again confirming the

balance directly with the lender.

In order to reduce risk to an acceptably low level, the auditor should

determine overall responses to the assessed risks at the financial statement

level and design and perform further audit procedures to respond to assessed

risks at assertion level.

ISA 240 defines assertions as representations by management that are

included in the financial statements, as used by the auditor to consider the

different types of potential misstatements that may occur.

Responses to risk at the financial statement level include:-

• Emphasizing to the audit team the need to maintain professional

skepticism in gathering and evaluating audit evidence.

• Assigning more experienced staff or those with special skills or using

experts, providing more supervision.

• Incorporating additional elements of unpredictability in the selection of

further audit procedures to be performed.

• Make general changes to the nature, timing, or extent of audit

procedures as an overall response, for example, performing

substantive procedures at period end instead of at an interim date.

The assessment of the risks of material misstatement at the financial

statement level is affected by the auditor’s understanding of the control

environment. An effective control environment may allow the auditor to

have more confidence in internal control and the reliability of audit

evidence generated internally within the entity and thus, allow the auditor

11

to conduct some audit procedures at an interim date rather than at period

end.

If there are weaknesses in the control environment, the auditor should

conduct more audit procedures as of the period end rather than at an

interim date, seek more extensive audit evidence from substantive

procedures, and modify the nature of audit procedures to obtain more

persuasive audit evidence.

Responses to risk at the assertion level include:-

The auditor should design and perform further audit procedures whose

nature, timing,

and extent are responsive to the assessed risks of material misstatement at

the

assertion level.

In designing further audit procedures, the auditor considers such matters as

the following:

• The significance of the risk.

• The likelihood that a material misstatement will occur.

• The characteristics of the class of transactions, account balance, or

disclosure

involved.

• The nature of the specific controls used by the entity and in particular

whether they

are manual or automated.

• Whether the auditor expects to obtain audit evidence to determine if the

entity’s

controls are effective in preventing, or detecting and correcting, material

misstatements.

12

The auditor’s assessment of the identified risks at the assertion level provides

a basis for considering the appropriate audit approach for designing and

performing further audit procedures.

The response must use:-

1. Test of controls

In some cases, the auditor may determine that only by performing tests of

controls will he achieve an effective response to the assessed risk of material

misstatement for a particular assertion. Tests of control are an audit

procedure designed to evaluate the operating effectiveness of controls in

preventing, or detecting and correcting, material misstatements at the

assertion level. The auditor designs tests of controls to obtain sufficient

appropriate audit evidence that the controls operated effectively throughout

the period of reliance. Matters the auditor may consider in determining the

extent of the auditor’s tests of controls include the following:

• The frequency of the performance of the control by the entity during the

period.

• The length of time during the audit period that the auditor is relying on the

operating

effectiveness of the control.

13

• The relevance and reliability of the audit evidence to be obtained in

supporting that

the control prevents, or detects and corrects, material misstatements at the

assertion

level.

• The extent to which audit evidence is obtained from tests of other controls

related to the assertion.

2. Substantive Procedures. If the auditor determines that performing only

substantive procedures is appropriate for specific assertions, he can exclude

the effect of controls from the relevant risk assessment. This may be because

the auditor’s risk assessment procedures have not identified any effective

controls relevant to the assertion, or because testing the operating

effectiveness of controls would be inefficient. However, the auditor needs to

be satisfied that performing only substantive procedures for the relevant

assertion would be effective in reducing the risk of material misstatement to

an acceptably low level. Often the auditor may determine that a combined

approach using both tests of the operating effectiveness of controls and

substantive procedures is an effective approach.

Substantive procedure – An audit procedure designed to detect material

misstatements at the assertion level.

Substantive procedures comprise:

(i) Tests of details (of classes of transactions, account balances, and

disclosures), and

(ii) Substantive analytical procedures. Tests of detail are appropriate for

matters identified as significant risks. These include complex or unusual

transactions which make indicate fraud or other special risks.

Timing of Substantive Procedures

14

In most cases, audit evidence from a previous audit’s substantive procedures

provides little or no audit evidence for the current period.

Exceptions:-

* A legal opinion obtained in a previous audit related to the structure of a

securitization to which no changes have occurred, may be relevant in the

current period. In such cases, it may be appropriate to use audit evidence

from a previous audit’s substantive procedures if that evidence and the

related subject matter have not fundamentally changed, and audit

procedures have been performed during the current period to establish its

continuing relevance.

Using audit evidence obtained during an interim period

In some circumstances, the auditor may determine that it is effective to

perform substantive procedures at an interim date, and to compare and

reconcile information concerning the balance at the period end with the

comparable information at the interim date to:

(a) Identify amounts that appear unusual

(b) Investigate any such amounts

(c) Perform substantive analytical procedures or tests of details to test the

interim

period.

15

Performing substantive procedures at an interim date without undertaking

additional

procedures at a later date increase the risk that the auditor will not detect

misstatements that may exist at the period end.

Test of Controls at interim stage:

When the auditor obtains evidence about the operating effectiveness of

controls during an interim audit, the auditor should determine what additional

audit evidence should be obtained for the remaining period.

Documentation

The form and extent of audit documentation is a matter of professional

judgment, and is

influenced by the nature, size and complexity of the entity and its internal

control, availability of information from the entity and the audit methodology

and technology used in the audit.

Must document the following:-

• Key elements of the entity

• Identified or assessed risk of material misstatement

• Responses to address risk

• Nature, extent, timing of procedures.

• Conclusions

ISA 240 The auditor's responsibility to consider fraud in the audit of

the financial statements.

External Auditor’s Responsibilities

1. The objective of the auditor is to identify and assess the risks of material

misstatement,

16

whether due to fraud or error, at the financial statement and assertion levels,

through

understanding the entity and its environment, including the entity’s internal

control, thereby providing a basis for designing and implementing responses

to the assessed risks of material misstatement.

2. In planning the audit and in performing audit procedures to reduce audit

risk to an acceptably low level, auditor must consider the risks of material

misstatements in the financial statements due to fraud.

3. Auditors must be aware of the possibility of material misstatements due to

fraud. The auditor must adopt an attitude of professional scepticism during

the audit and be alert to circumstances that may lead to fraud.

4. Risk assessment procedures for fraud:-

• Inquiries of management charged with corporate governance

• Consideration of fraud risk factors

- Changes in the entity such as large acquisitions or reorganizations or other unusual events.

- Use of off-balance-sheet finance, special-purpose entities, and other complex financing arrangements.

- Weaknesses in internal control, especially those not addressed by management

- Significant amount of non-routine or non-systematic transactions including inter-company transactions and large revenue transactions at period end.

• Consideration of results of analytical procedures.

• Non-compliance with laws and regulations that may materially affect

the financial statements.

5. Appropriately design audit procedures. Increase sample size where

assessed risk is high.

6. Obtain written management representations

* Acknowledging that it is their responsibility to prevent and detect fraud

17

* Confirming that they have disclosed to the auditor, their own

assessment of risk of fraud and any knowledge of fraud or suspected

fraud.

7. Report

* To appropriate level management if auditor has identified fraud or is

suspicious of fraud.

* To those charged with governance if fraud involves management,

significant employees and third parties.

* To regulators if there is a statutory duty.

ISA 620 - USING THE WORK OF AN EXPERT

“Expert” means a person or firm possessing special skill, knowledge and experience in a particular field other than accounting and auditing.

An expert may be:

(a) Engaged by the entity;

(b) Engaged by the auditor;

18

(c) Employed by the entity; or

(d) Employed by the auditor.

When the auditor uses the work of an expert employed by the auditor, that

work is used in the employee’s capacity as an expert rather than as an

assistant on the audit.

The auditor should obtain sufficient appropriate audit evidence that the scope

of the expert’s work is adequate for the purposes of the audit.

An expert’s work can be used :-

• At the planning stage to obtaining an understanding of the entity and

performing further procedures in response to assessed risks.

• During the audit to obtain audit evidence in the form of reports,

opinions, valuations and statements of an expert.

The auditor needs to assess 4 issues in relation to an expert:-

1. Necessity to use him

2. Competence and objectivity – is he an employee or a contracted third

party.

3. Scope of work of the expert.

4. Actual work. Consider the source data used, assumptions, methods

and results.

Reference to an Expert in the Auditor’s Report

1. When issuing an unqualified report, the auditor should not refer to the

work of an

19

expert. Such a reference might be misunderstood to be a qualification of the

auditor’s

opinion or a division of responsibilities.

2. If as a result of the work of an expert, the auditor decides to issue a

qualified audit report, it may be appropriate to refer to or describe the

work of the expert (including the identity of the expert and the extent of

the expert’s involvement). In these circumstances, the auditor would

obtain the permission of the expert before making such a reference. If

permission is refused and the auditor believes a reference is necessary,

the auditor may need to seek legal advice.

20

ACCA Paper F 8AUDIT AND ASSURANCE SERVICES (INTERNATIONAL STREAM)

Lecture 4

DATE: Autumn 2008

TUTOR:

Test of Controls

1

Control Environment: 12 The control environment is design by the senior management 3

Factors that are included in the control environment are:

11. Management's philosophy and operating style

1 Characteristics that form part of a management's philosophy and operating style and which have an impact on the control environment include the management's:

1 • approach to the taking and monitoring of business risks;

1 • reliance on informal face to face contacts with key managers versus a formal system of written policies, performance indicators and exception reports;

1 • attitudes and actions toward financial reporting;

1 • conservative or aggressive selection of accounting principles from available alternatives;

1 • conscientiousness and conservatism in developing accounting estimates;

1 • attitudes towards information processing and accounting functions and personnel.

23 2. Integrity and ethical values.

11 In order to emphasise the importance of integrity and ethical values among all

personnel of an organisation the management should:

1 • Demonstrating integrity and practising ethical behaviour among all employees of the organisation.

2345

3. Commitment to competence. Personnel at every level in the organisation must possess the knowledge and skills needed to perform their jobs effectively.

2

4. Organisational structure and assignment of authority and responsibility.

An organisational structure contributes to an entity's ability to meet its objectives by providing an overall framework for planning, executing, controlling and monitoring the entity's activities.

Methods of imposing control

The board of directors and the audit committee and the manner in which they exercise their governance and oversight responsibilities have a major impact on the control environment.

Factors include the:

1 • Proportion of outside directors and the establishment of an audit committee.

1 • Experience of members in audit committee.

1 • Extent of their involvement with and scrutiny of management's activities.23 * Degree to which they raise and pursue difficult questions with

management.

4 * Nature and extent of their interaction with internal and external auditors.

Internal audit

Internal audit function strengthens the control environment. To be effective,

internal audit auditor need to:

1 • skilled

2 • integrity;

3 • Have appropriate access to the board of directors and the audit committee,

and to the external auditors.

3

Personnel policies and practices

A fundamental concept of internal control is that it is affected or implemented by

people. For the accounting and internal control systems to be effective, human

resource policies and practices must ensure that entity personnel possess the

expected integrity, ethical values and competence.

Such practices include:

1 • Developing appropriate recruiting policies.

1 • Screening prospective employees.

1 • Developing training policies that communicate prospective roles and responsibilities.

1 • Exercising disciplinary action for violations of expected behaviour.

1 • Evaluating, counselling and promoting people based on periodic

performance appraisals.

1 • Implementing compensation programmes that motivate and reward

superior performance while avoiding disincentives to ethical behaviour.

Control procedures:

Control procedures are those policies and procedures which established to

achieve the entity’s specific objective.

1 They include in particular procedures designed to prevent or detect errors and fraud.

1 Control procedures are details check and control which are built into the system

4

5

Types of internal control

1. Segregation of duties: 12 No one person should be responsible for the recording and processing of the

complete work. This reduces the risk of fraud or error.

2. Physical: To ensure that assets are safeguard and there is restriction the access to the authorised personnel. E.g. using password locks.

3. Authorisation and approval. All transaction should require authorisation or approval by an appropriate person.

4. Arithmetic and accounting. To ensure completeness and accuracy of recoding e.g. Trial Balances, reconciliation’s and control accounts.

5. Personnel. Delegation of duties to people with appropriate skills.

6. Supervision: All actions by all levels of staff should be supervised. The responsibility for supervision should be clearly set out.

7. Management: These are control exercised by management, which are outside and over and above the day to day routine of the system.

Limitation of internal control

1. Cost of implementation internal control systems.

2. Potential human error due to stress of workload, or carelessness.

3. The possibility of circumvention of controls either alone or through collusion

with parties outside or inside the entity.

4. Abuse of responsibility.

5. Management override internal control

Methods of recording the internal control systems

1. Narrative Notes

Advantages

• Useful when systems are elementary.

• Capable of logical appraisal if properly compiled

- Documents listed in order of processing 1 - Cross-referenced to procedures performed on documents 2 - Division of duties indicated 3 - Authority levels and limit indicated

• Useful supplement to flowcharts and record exception routines (e.g. processing of credit notes in a sales system.

Disadvantages:

• Difficult to appraise complex systems.

• Difficult to highlight controls

• Changes in systems might require a complete rewrite

2. Internal Control Questionnaires

Questions determine accounting procedures, documents raised and controls imposed.

Advantages:

• Comprehensive list of questions on all sub systems and all possible aspects of

control automatically highlights strengths, weakness and omissions.

• All aspects of accounting and control are considered.

• Facilitates review and evaluation are facilitated

• Provides an easy way to cross-referencing to audit programmes

Disadvantages:

• The questions concentrate on the controls themselves rather than the error,

fraud or irregularity the control is designed to prevent or detect.

• The questions do not assess materiality or relative importance of controls.

• It is difficult to determine the existence of compensating or mitigating

controls when no answers indicate a weakness.

• Experience and judgement are required in evaluation.

• Standard questions may not apply to the specific situations of different

clients.

EXAMPLE: Internal control questionnaire for bank transactions

1. How often is bank reconciliation prepared?

2. (a) Is the person responsible for function independent of the receipts and

payment function?

(b) Alternatively is the reconciliation independently checked?

3. Does the person preparing the bank reconciliation obtain statements direct from

the bank and retain them until the reconciliation is effected?

4. Does the independent reconciliation include?

(a) A comparison of the debits and credits shown on the bank statements with the

cashbook?

(b) A comparison of paid cheques with the cashbook as to names, dates and

amounts?

(c) A test of the detailed paying-in-slip with the cashbook?

(d) An enquiry into contra items?

(e) Are items more than one month old investigated to?

3. Flowcharts

Advantages:

• Diagrammatic and shorthand symbols give perspective to the system’s

description.

• They aid understanding and communications

• The discipline of construction ensures complete recording of processes,

documents files, books and controls.

• Controls and weaknesses are easily highlighted

• Continuity of the audit is facilitated where audit staff changes take place.

• Review is facilitated by those not familiar with the client or system.

Disadvantages:

• Complex systems are difficult to evaluate by inexperienced staff.

• Changes in systems may require a complete redraft.

4. Internal Control Evaluation Questionnaires (ICEQ’s) 12 An ICQ tries to establish how good the system of controls is. The ICEQ tries to

establish if specific errors and fraud are possible.34 Method of evaluating an already ascertained system (e.g. by flowchart)

12 ICEQ is a list of supplementary questions to assess whether desirable controls

are present which individually or collectively prevent or detect the error or fraud in the key questions.

Advantages

1 ICEQ’s facilitate the determination of whether desirable are present to detect, eliminate or prevent the risk of serious error, fraud or irregularity.

1 They aid the evaluation process of complex flowchart.

1 They provide a logical basis for subsequent design and selection of detailed audit tests-they are easily cross-referenced to audit programme.

1 They encourage better comprehension of systems by more junior staff.

Disadvantages: 12 Too many supplementary questions can turn the ICEQ and ICQ and hence

cause confusion.

Purpose of Test of Controls at Interim audit:

• To obtain information about the operational system on a theoretical basis for example:

1 • Organisational chart 2 • Procedures manual 3 • Systems notes

• Gather information about the system and perform walk through test.

• Ascertain strengths and weaknesses of major operational areas for example:

• Complete internal Control Questionnaires

• Perform tests of control

At Final audit:

• Final audit of the company at year-end is to produce statutory financial

statement.

• Audit concentrates on verifying the items and management assertions in the

balance sheet and profit and loss contained in the financial statement.

• Complete substantive procedures, perform subsequent events review and

obtain management representation and form an opinion.

• Report opinion

Internal Control Tests in specific areas of a business:

Cash and Cheques received by post:

Objective:

• To ensure that all cash and cheques received by post are accounted for and

accurately recorded in the books. To ensure all such receipts are promptly

deposited in the bank.

Measures:

• Measures to prevent interception of mail between receipts and opening

1 - Appointment of a staff to be responsible for opening of the post and two

other person present at the opening of the post.

2

- All cheques and other negotiable instrument to be immediately given a

restrictive crossing “accounts payee only”.

- Immediate entry of the details of the receipts in a cash book and

independent person should be responsible for banking and recording the

transaction (Date, payer details amount either cash or cheques).

1 - Regular independent comparison of the post list with banking records. The

tests should be of total, detail and dating to detect teeming and lading at a

later stage in the processing

Cash sales and collections:

Objective:

To ensure that all cash, to which the enterprise is entitled is received, and

ensure that all such cash is properly accounted for and entered in the

records.

Measures: 12 Authorised person should be responsible to receive cash for example sales

assistants, cashiers.

1 Evidence of cash receipts for example pre-numbered duplicate receipts cash

or cash registers with sealed till rolls. The duplicate receipts form books

should be securely held and issue should be controlled.

1 A staff should be responsible for emptying cash registers at prescribed

intervals and agreeing the amount present with till roll totals or internal

registers.

2

3 Immediately banked the cash and payments for petty cash should be on

imprest system.

1

1 Independent comparison of agreed till roll totals with subsequent banking

records.

1 Persons handling cash should not have access to other cash funds or

maintain sales ledger records.

1 Rotation of duties and cover for holidays and sickness.

1 Collections by sales should be banked intact daily. There should be

independent comparison of the amount banked and records of the salesmen.

1

Cash Balances:

Objective: 12 To prevent mis-appropriation of cash balance and to prevent unauthorised

cash payments

Measures: 123 To establish of cash floats of specified amount and location

1 Appointment of staffs responsible for each cash balance.

1 Arrangement of security measures including use of safes.

1 Use of imprest system on the basis that petty cash is replenished by the amount of what the company has spent and there are specific rules on reimbursement only against authorised vouchers.

1 Strict rules on the authorising of cash payments.

1 Independent cash count on a regular and a surprise basis.

1 Insurance arrangements e.g. cash balance and fidelity guarantee.

Bank balances:

Objective:

To prevent misappropriation of bank balance and to prevent teeming and lading.

Measures:

Reconciliation should be prepared on regular basis.

1 The reconciliation should be performed by an independent person.

1 Arrangement should be made for bank statements to be sent direct to the person responsible for the reconciliation.

1 A comparison of debit and credit in the cash book with corresponding entries in the bank statements.

1 A comparison of returned cheques with cash book entries noting dates, payee and amounts.

1 A test of the details paying-in slips with cash book.

1 All outstanding cheques and lodgements should be traced through to the next period and their validity verified.

1 Any unusual items e.g. contras or dishonoured cheques should be investigated

1 The balance at the bank should be independently verified with the bank at intervals.

1 Special arrangement should be instituted on the controls and recording of trust monies e.g. employee’s sick pay or holiday funds, attachment of earnings.

Cheque payments:

Objective: 12 To prevent unauthorised payments being made from bank accounts.

Measures: 12 Control over custody and issue of unused cheque book. A register should be

kept if necessary.

1 Staff should responsible for preparation of cheques.

1 Rules should be established for the presentation of supporting documents before cheques can be made out. Such supporting documents may include GRNs, purchase orders and invoices.

1 All such documents should be stamped “paid by cheque no” with date.

1 Established who should sign cheques. All cheques should be signed by a least two persons, with no person being permitted to sign if he is a payee.

23 No cheque should be made out to bearer except for the collection of wages or

reimbursement of cash funds.

45 All cheque should be restrictively crossed. 67 The signing of blank cheques must be prohibited.

8 Special safeguards should be implemented where cheques are signed mechanically or have pre-printed signatures. Such signing is often made for dividends payments, salary cheques and for others.

910 Rules to ensure prompt despatch and to prevent interception or

misappropriation. 1112 Special rules for authorising and checking direct debits and standing orders.

Wages and salaries

Objective: 1 To ensure that wages are paid only to actual employees at authorised rates

of pay.

1 To ensure that all wages are computed in accordance with records of work performed whether in respect of time, output, and sales made or other criteria.

1 To ensure that payments are made only to the correct employees.

1 To ensure that payroll deduction are correctly accounted for and paid over to the appropriate government bodies.

1 To ensure that all transactions are correctly recorded in the books of account.

Measures: 12 There should be separate records kept for each employee. The records

should contain such matters as date of engagement, age, next of kin, agreed

wages, deduction, qualification, skill and experience.

3

4 Procedures for and specified officials responsible for engagement, retirement,

dismissals, fixing and changing rates of pay. Procedures should be laid down

for notification of these matters to the personnel and wage roll preparation

departments.

1 Time records should be kept, preferably by means of supervised clock card

recording. These should be approved and approval acknowledge. All overtime

should be authorised.

1 The payroll should be prepared by personnel unconnected with other wage

duties. Special procedures should exist for dealing with advances, holiday

pay, luncheon, new employees, employees leaving, sickness and other

absences and bonuses.

1 The preparer of pay wages should be independent.

1 Special rules should be established for distribution of wages. Surprise

attendance at payout should be made at intervals by internal audit or senior

manager.

1 Unclaimed wages should be subject to special procedures. These should

include a record to be maintained of unclaimed wages, safe custody of such

pay packets, a requirement for investigation, subsequent payout only after

proof of entitlement, breaking down and re-bank the unclaimed wage after

specified time period.

1 Payments by cheque and credit transfer should be subject to special

procedures. These could include maintenance of separate bank account with

regular reconciliation.

1 Deduction such as PAYE, national insurance, pension contribution and other

dues should be subject to prompt payment over to the relevant agencies.

1 Regular reconciliation should be made between personnel records and wage

records.

1 Wage records should conform to the requirements of statutory sick pay.

Purchases and Accounts payables

Objectives: 12 To ensure that goods and services are ordered in the quantity, of the quality,

and at the best terms available after appropriate requisition and approval.

1 To ensure that goods and services received are inspected and only acceptable items are accepted.

1 To ensure that all invoices are checked against authorised orders and receipts of the subject matter good condition.

1 To ensure that all goods and services invoiced are properly recorded in the books.

2

Measures: 12 There should be procedures for the requisitioning of goods and services only

by specified personnel on specified forms with spare for acknowledgement of performance.

1 Order forms should be pre-numbered and kept in safe custody.

1 Sequences checks of order forms should be performed on regular basis by senior person in the purchase department.

1 All goods received should be recorded on goods received notes or in special book.

1 All goods should be inspected for condition and agreement with order and counted on receipts. The inspection should be acknowledged.

1 Procedures for dealing with rejected goods or services should be include the creation debit notes with subsequent sequence check and follow up of receipts of suppliers’ credit notes.

1 Invoice should be checked for arithmetical accuracy, pricing, correct treatment of VAT and trade discount, and agreement with purchase order and good-in records.

1 Invoices should have consecutive numbers put on them and batches should be pre-list.

1 Total of entries in the invoice register or purchase day book should be regularly checked.

1 A staff should be responsible for preparation of purchase ledger and independent of other purchased duties.

1 The purchase ledger should be subject to regular reconciliation in total by or be checked by an independent senior staff.

1 Purchase ledger account balances should be regularly compared with suppliers’ statements of account.

Cut-off procedures at the year end are essential.

1 A proper coding system is required for purchase of goods and services so that the correct nominal accounts are debited.

Sales and Accounts Receivable:

Measures

1 To ensure that all customers orders are promptly executed.

1 To ensure that sales on credit are only to bona fide good credit risks.

1 To ensure that all sales on credit are invoiced, that authorised prices are

charged and that before issue all invoices are completed and checked as

regards price, trade discounts and vat.

1 To ensure that all invoices raised are entered in the books.

1 To ensure that all customers’ claims are fully investigated before credit notes

are issued.

1 To ensure that every effort is made to collect all debts.

1 To ensure that no unauthorised credits are made to accounts receivables

accounts.

1 All sales orders should be recorded and if necessary acknowledged on pre-

numbered forms.

1 Procedures on credit control for verify the credit worthiness of all persons

requesting goods on credit.

1 Selling prices should be prescribed. Policies should be laid down on credit

terms, trade and cash discount.

1 Despatch of goods should be properly authorised by senior staff and recorded

in register or use of pre-numbered despatch notes.

1 Appropriate acknowledgement of receipts of goods should be made by

customers on copy despatch notes.

1 Invoicing should be carried out by separate department or by sales staff.

Invoices should be pre-numbered and the custody and issue of unused

invoice blocks controlled and recorded.

1 The sales invoices sequences should be checked in regular basis by senior

staff and missing and or spoiled invoices investigated.

1 All invoices should be independent checked for agreement with customer’s

orders with goods despatch notes for pricing, discount, Vat and other details.

All actions should be acknowledged by signature or initials.

1 Sales invoices should be pre-numbered before entry into the sales day book.

1 Customer’s claims should be recorded and investigated and similar controls

should be applied to credit notes.

1 A control account should be regularly prepared by independent person.

1 Accounts receivables statements should be prepared by personnel separate

from the sales ledger.

1 Legal action should be taken against accounts receivables refusing pay the

debts on time.

1 List of aged accounts receivables should be prepared and investigated

outstanding balances.

1 Bad debts should only be written off after investigation and acknowledged by

senior management.

1 At the year end an aged analysis of accounts receivables should be prepared

to evaluate the need for a provision of bad debts.

1 At the year end cut off procedures will be required, particularly attention will

be paid to orders despatched but not invoiced.

Inventories and Work in Progress:

Objective: 1 To ensure that stock is adequately protected against loss or misuse of

inventory.

Measures: 123 Separate storage of different type of inventory.

1 Control over the receipts of goods.

1 Inventory should be protected from deterioration due to physical causes.

1 Inventory should be safeguarded against loss of theft by physical controls.

1 Appropriate inventory records should be maintained.

1 Work in progress and finished goods may be subject to recording by value including the charging of material, labour and overheads cost.

1 Established maximum and minimum inventory level with re-order level

26

ACCA Paper F 8AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM

Lecture 5 : Substantive Testing

DATE: Autumn 2008

TUTOR:

Rules on Materiality:-

1

Item is material if it is :-

> 5% of Profit before tax

Between 0.5% and 1% of Gross Profit

Between 0.5% and 1% of Revenue

Between 1 and 2% of Total assets

Between 2 to 5% of Net Assets

Between 5 – 10% of profit after tax.

Audit Objectives:

1 1. Existence

2 2. Ownership

3 3. Completeness

4 4. Valuation

5 5. Presentation and disclosure

NON- CURRENT ASSETS VERIFICATION

Cost/ Valuation:

1

2

2 The accounts are prepared under the Historic cost convention. The assets

and liabilities, expenses and revenues usually shown in the accounts at

actual or original cost.

Authorization:

1

2 The authorization should be obtained before any acquisition of non current

assets or disposal of non-current assets (similar for other transactions)

Existence:

1 The asset must exist, otherwise it has been misappropriated or lost and it has

been badly maintained.

Beneficial ownership:

1 Legal ownership of assets and legal ownership of leased assets.

Presentation in the accounts:

1 Comply with accounting standard and Companies legislations.

Accounting Standards:

IAS 16: Property, Plant and Equipment

3

Disclosure

For each class of property, plant, and equipment

• * Basis for measuring carrying amount

• * Depreciation method(s) used

• * Useful lives or depreciation rates.

• * Gross carrying amount and accumulated depreciation and impairment

losses

• * Loss on sale if material must be disclosed on the face of the income

statement. Also,

•

• IAS 1 Presentation of Financial statements requires material profits and

losses on disposal to be presented separately either on the face of the

income statement or as in the notes.

• * Reconciliation of the carrying amount at the beginning and the end of the

period, showing:

o additions;

o disposals;

o acquisitions through business combinations;

o revaluation increases;

o impairment losses;

o reversals of impairment losses;

o depreciation;

o net foreign exchange differences on translation;

o other movements

Maintenance expenses should be recognized when incurred.

If property, plant, and equipment is stated at revalued amounts, certain additional

disclosures are required:

4

• * The effective date of the revaluation

• * Whether an independent valuer was involved;

• * The methods and significant assumptions used in estimating fair values;

the extent to which fair values were determined directly by reference to

observable prices in an active market or recent market transactions on arm's

length terms or were estimated using other valuation techniques;

• * The carrying amount that would have been recognized had the assets been

carried under the cost model;

• * The revaluation surplus, including changes during the period and

distribution restrictions.

IAS 36 Impairment of Assets

At each balance sheet date, review all assets to look for any indication that an asset

may be impaired (its carrying amount may be in excess of the greater of its net

selling price and its value in use).

Indications of Impairment

External sources:

• market value declines

• negative changes in technology, markets, economy, or laws

• increases in market interest rates

• company stock price is below book value

Internal sources:

• obsolescence or physical damage

5

• asset is part of a restructuring or held for disposal

• worse economic performance than expected

An impairment loss should be recognised whenever recoverable amount is below

carrying amount. Goodwill should be tested for impairment annually

IAS 24: Related Party Disclosures : If sale was made to related parties disclose

separately.

IAS 10: Events after Balance Sheet Date.

Event after the balance sheet date: An event, which could be favourable or

unfavourable, that occurs between the balance sheet date and the date that the

financial statements are authorised for issue.

Adjusting event: An event after the balance sheet date that provides further

evidence of conditions that existed at the balance sheet, including an event that

indicates that the going concern assumption in relation to the whole or part of the

enterprise is not appropriate.

Non-adjusting event: An event after the balance sheet date that is indicative of a

condition that arose after the balance sheet date.

• Non-adjusting events should be disclosed if they are of such importance that

non-disclosure would affect the ability of users to make proper evaluations

and decisions. Disclose the nature of the event and an estimate of its

financial effect or a statement that a reasonable estimate of the effect cannot

be made.

6

VERIFICATION PROCEDURES (METHOD)

The non-current assets schedules will show the following and suggest the

associated verification procedures.

Opening balance:

1 Verify by reference to previous year’s balance sheet and audit files.

Acquisition:

1 * Vouch the cost of acquisition with documentary evidence.

2 * Vouch the authority for the acquisition with relevant documents (e.g.

minutes etc)

Disposal:

• * Vouch the authority for disposal

• * Examine documentation

• * Verify reasonableness of the disposal proceeds

• * Verify reasonableness of scrapping of non-current assets (e.g. scrap value)

• * Accounting policy notes.

Depreciation:

1

2 * Vouch authorization of depreciation policy

3 * Examine adequacy and appropriateness of policy

4 * Check calculations.

7

Internal control:

1 * Authorisation for Purchase and disposal

1 * Accounting and maintenance cost of assets are very relevant.

Existence and ownership:

1 * Physical inspection of the existence of the assets and inspect the title deed

and certificates of ownership.

1 * External verification e.g. bank letters, receivables circularisation

Presentation and value:

1 * Appropriate accounting policies must be adopted

1 * Appropriate accounting standards must be adopted

1 * Materiality level must be considered (e.g. in a balance sheet of large

company it would be misleading to show an asset such patent in a class by

itself it its total value was negligible in relation to other assets).

1 * The classification of assets

1 * The disclosure of an asset as separate items e.g. between non current and

current assets.

8

Other matters related to asset verification:

• Taxation

• Insurance

• Expert advise

Audit work on Land and Building:

1 * Obtain summary of all non-current assets under the categories shown in the

balance sheet.

1 * Check casting and compare the opening balance brought forward from

previous year.

1 * Obtain schedules of addition during the year for all classes of assets

(including intangible assets)

1 * Test check against the supplier’s invoices or other independent vouchers to

ensure revenue and capital are properly distinguished.

1 * Test capital expenditure for authorization

1 * If the non-current assets constructed using own labour check all the labour

cost is properly accounted.

1 * Check the accounting policies and comply with relevant accounting

standard.

1 * Obtain schedules of disposals test check the proceeds of sales with

independent evidence (Sale agreements).

1 * Check for an assets has been scrapped

1 * Verify that the original cost and accumulated depreciation have been

eliminated from non-current assets accounts.

9

1 * Check calculation of profit or loss on sales and agree with profit and loss

account.

1 * Verify the independent valuation

1 * Verify the depreciation policy

1 * Check calculations of depreciation.

1 * Confirm the disclosure requirements

1 * Physical inspection of sample of all type of assets

1 * Verify the adequacy of insurance cover on non-current assets

1 * Reconcile assets register with financial statements

10

Investments:

Objective:

1 * The proof of ownership

2 * Gain or loss arise from the investments

3 * Appropriate method of valuation

4 * Properly disclosed in the financial statements

Audit work on investments:

1 * Obtain list of investments check the accuracy of the analysis.

2 * Compare the opening balance with last year’s working papers

3 * Check the nominal accounts for recording for unusual entries

1 * Obtain third party confirmation

1 Physical examination

1 Review board minutes for authorisation.

1 Review the profit or loss on part disposals

1 Review the treatment of capital distributions, bonus and right issues.

1 Verify the interest received and dividend received and accrued by reference

to supporting documents and published data.

1 Verify quoted price for listed investments at balance sheet

1 Determine whether unlisted investments are valued on a reasonable basis.

THE AUDIT OF ACCOUNT RECEIVABLES AND PREPAYMENTS AND PROVISION

FOR BAD DEBTS

11

ISA 505 External Confirmations:

Circularization of account receivables:

It is very common in the verification of account receivables is to circularise the

account receivables or some of them for direct confirmation.

Advantages:

1 Direct external evidence

1 It provides confirmation of the effectiveness of the system of internal control.

1 It assists in the auditor’s evaluation of cut-off procedures

1 It provides evidence of items in dispute

There are two methods:

Negative:

1 The customers are asked to communicate only if he does not agree the

balance. This method is mostly where internal control is very strong.

Appropriate when:

1 Internal control systems is strong

1 Large number of small accounts

1 Errors not expected

Positive:

1 The customer is asked to reply whether he agrees the balance or not or is

asked to supply the balance himself. This approach is used when there is

weakness in internal control or suspicious of irregularities or numerous

bookkeeping errors is found.

12

Preferred when high assessed risk:

1 Weak internal control systems

1 Suspicion of theft and fraud

1 Numerous book keeping errors

Procedures:

1 Select samples from positive, negative balances and all customers can be

circularised stating the balance in circularization letter.

1 Letter sent on client’s note paper requesting reply to auditors and including

stamped addressed envelope to auditors’ address.

1 The circularization should be carried out auditors without client’s

interventions.

1 The auditors should follow up any legal disputes between the client and it is

customers.

2

Account receivables are the large item among the assets of most companies and

their verification is essential.

1 Sales to bona fide customers only

13

1 All such sales are to approved customers

1 All such sales are recorded

1 Once recorded the debts are only eliminated by receipts of cash or on the

authority of a responsible person

1 Debts are collected promptly

1 Balances are regularly reviewed and aged, a proper system for follow up

exists and if necessary, adequate provision for bad and doubtful debts is

made.

1 Test the effectiveness of the system.

1 Obtain a schedule of account receivables

1 Test balances on ledger accounts to the schedule and vice versa

1 Test casts of the schedule

1 Examined make up of balance. They should be composed of specific items.

1 Ensure each account is settled from time to time.

1 Examine and check control accounts

1 Enquire into credit balance and consider the valuation of the account

receivables.

2 Provision for bad and doubtful debts:

The valuation of account receivables is really a consideration of the adequacy of the

provision for bad and doubtful debts.

14

The auditor should consider the following matters:

1

2 The adequacy of the system of internal control relating to the approval of

credit and following up of poor payers.

1 The period of credit allowed and taken.

1

2 Whether balances have been settled by the date of the audit.

1 Whether an account is made up of specific items or not

1 Whether an account is within the maximum credit approved.

1 The state of legal proceedings and the legal status of the account receivables

e.g. in liquidation or bankruptcy

1 Compare account receivables to sales with comparison of the ration with

those of previous periods and those achieved by other companies.

1 Is there any evidence of any debt in dispute e.g. for non-delivery, breakage,

poor quality.

Prepayments:

1

2 Obtain list of prepayments

1 Verify the prepayments for the expenses

15

1 Review the income accounts for the details of prepayments

1 Review the disclosure in the Balance sheet “as current assets”.

THE AUDIT OF CASH AND BANK BALANCE

The composition of cash:

1 Cash in hand include petty cash and receipt from customers not

deposited.

1 Cash at bank include cash held in saving, current accounts (assets) and

cash overdrawn on current accounts (a liability)

16

Audit test:

1 Check the opening and comparative figures brought forwards and review the

previous year working papers.

1 Review activity in the nominal ledger for any unusual transaction requiring

investigation.

1 Obtain client summaries, check arithmetic and agree with nominal ledger.

1 Perform analytical procedures

1 Test the cut-off

1 Count un-deposited cash on hand and reconcile with imprest systems

1 Confirm bank balance by sending a confirmation request to all banks used by

the client.

1 Verify bank and cash reconciliation

1 Follow up and obtain reasons for any un-cleared items appearing in the year-

end reconciliation in the month following the year-end.

Check that cash and bank is properly classified in the balance sheet

Cash at Bank = Current assets

Bank overdraft = Current liability

1 Check disclosure of any charges on cash balances.

17

Audit of Inventories

Standard: IAS 2 Inventories

Inventories include assets held for sale in the ordinary course of business (finished

goods), assets in the production process for sale in the ordinary course of business

(work in process), and materials and supplies that are consumed in production (raw

materials).

IAS 2 Does not apply to work in process arising under construction contracts. This is

covered by IAS 11 Construction Contracts.

Inventories are required to be stated at the lower of cost and net realisable value

(NRV).

Costs include:-

1. Costs of purchase (including taxes, transport, and handling) net of

trade discounts received

2. Costs of conversion (including fixed and variable manufacturing

overheads)

3. Other costs incurred in bringing the inventories to their present

location and condition

Write-Down to Net Realisable Value (NRV)

NRV is the estimated selling price in the ordinary course of business, less the

estimated cost of completion and the estimated costs necessary to make the sale.

Any write-down to NRV should be recognised as an expense in the period in which

the write-down occurs. Any reversal should be recognised in the income statement

in the period in which the reversal occurs

When inventories are sold and revenue is recognized, the carrying amount of those

inventories is recognized as an expense (often called cost-of-goods-sold). Any write-

down to NRV and any inventory losses are also recognized as an expense when

they occur.

18

Disclose:-

• * Accounting policy for inventories.

• * Carrying amount, generally classified as merchandise, supplies, materials,

work in progress, and finished goods. The classifications depend on what is

appropriate for the enterprise.

• * Carrying amount of any inventories carried at fair value less costs to sell.

• * Amount of any write-down of inventories recognized as an expense in the

period.

• * Amount of any reversal of a write-down to NRV and the circumstances that

led to such reversal.

• * Carrying amount of inventories pledged as security for liabilities

Auditor’s duties

1

2 The auditor must satisfy himself as to the validity of the amount attributed to

inventories and work in progress in the balance sheet.

Physical inventory counts: 2 type of inventory counts

1 1. Periodical counts

1 2. Perpetual counts or continuous counts

1 Periodical counts usually undertaken at the end of the financial year of the

enterprises.

19

2 Perpetual counts is continuous count of inventories held in storage to ensure the

inventories are physically inspected to identify any slow moving items and

damaged items.

1

2

3

4

5 The key advantages of continuous counts as follows:

1 - To ensure adequate records are kept on items in storage

2 - Less disruptions to daily business of the enterprises

3 - To ensure adequate internal control systems exist to avoid any

theft and misappropriation.

Before the count

• Review previous year’s working paper and discuss with management any

significant changes from previous year.

• Discuss counting arrangement with management

• Nature and volume of inventories

• Location of store

• Consider cut off point

• Internal audit

• Confirmation from 3rd parties

• Expert advise

20

• Evaluate the client inventories counting procedures

• Review the client’s internal control procedures

• Brief audit staff and audit planning issues

During the count:

1

2 Observe the counting procedures to ascertain that the client’s employees are

carrying out the instructions.

1 Check the count of a selected number of lines and crossed reference to the

inventory records.

1 Observe and identify the obsolete, damaged and slow moving inventories.

1 Verify the inventories sequences held in store

1 Test the cut-off procedures

1 Identify any high value item

1 To obtain copies the client’s inventories records for working paper file

After the count:

1 Check the cut-off with details of the last numbers of inventories movement

forms and goods inward and goods outward notes during the year after the

year end.

1 Test the final inventories records have been properly prepared from the

count records.

21

1 Final check on pricing, casting, summaries

1 Inform the management of any problems encountered during the counts for

action in subsequent count.

Work in Progress:

1 Examine the costing systems

1 Examine the reliability of the costing systems

1 Examine systems of inspection for scarp and ratification work

1 Valuation basis on IAS 2(Inventories)

1 Determine the progress payments and profit on each contracts.

Audit test:

1 Reconciliation of changes in inventories (e.g. Purchases and Sales)

1 Compare the quantities of each kind of inventories held with purchase and

sales

1 Consider the movement in gross profit ratios

1 Consider the inventory turnover ratios

1 Review the variance report on inventories and work in progress

22

The auditor’s duty:

1 Accounting policies adopted for valuing inventories

1 Consider the acceptability of the accounting polices

1 Test the inventory records with relevant documents such as Purchase invoice

1 Check and test the treatment of overhead (WIP)

1 Check the arithmetic and accuracy of all calculation

1 Check the consistency with which the amount have been computed

1 Check the disclosure requirements

VERIFICATION OF QUANTITIES

1 An entity may ascertained quantities of inventories at it is year-end either by:

• Performing a full physical count or

• Extracting balance from its inventories records

1 The latter is acceptable to the auditor if inventories has been physical

counted during the year and the results compared with the record-any

Discrepancies must be investigated and adjusted- thus giving confidence in the

accuracy of those records.

23

1 It is therefore essential in any audit where inventories are material to attend

and observe the client’s counting procedures.

VERIFICATION OF VALUE

IAS 2 requires inventories should be valued at the lower of cost and net realizable

value.

Cost: All costs incurred in getting inventory to its present location and condition.

The cost therefore comprises:

Cost of purchase:

1 In getting the inventory to its present location, the following costs will be

incurred:

1 - The invoice cost

2 - Carriage inward

3 - Import duties and other taxes

4 - Transport and handling charges

1 Establish these costs with reference will be made to purchase and expense

invoices.

1 However where items of inventory cannot be directly related to specific

invoices (eg identical items bought at different prices and stored together) it

is necessary to make assumptions or to adopt a policy in relation to cost.

Cost of conversion:

1 IAS 2 states that this should be based on normal levels of activity in normal

operating condition, taking one year with another.

24

1 Conversion cost includes both direct and indirect cost incurred in converting

the raw material into finished product. These cost are allocated

systematically into product cost or unit cost.

1

2 In determining what is “normal” the following should be taken into account:

1 - Production capacity

2 - Budgeted production level

3 - Actual production level

Net realisable value:

1

2 NRV= What can be realised for inventory at their present condition at the

balance sheet date in the case of raw material, finished goods and WIP.

Valuation method:

1 The IAS 2 requires the inventory valuation should be determined using the

FIFO and Weighted average method.

Procedure to identity items likely to be valued at lower than cost:

1 Examine inventory records for items marked damages, slow moving or

obsolete.

1 Determine items returned by customers for faulty or damaged goods

1 Extract from inventory records, items held longer than their normal turnover

period (slow moving)

1 Consider the effects of technological developments and possibility of

obsolescence.

25

1 Check with competitors’ prices

1 Discuss with management any intended sales, special offer or discounts offer

to existing customers.

1 Determine actual selling prices realised from post balance sheet receipts.

Procedures to check NRV has been properly calculated:

1 Check post balance sheet sales for actual gross proceeds

1 Check budgets/forecast for estimated gross proceeds

1 Check the post balance sheet cashbook or nominal ledger expense accounts

for actual selling and distribution costs.

1 Check for estimated selling and distribution etc costs and for further costs to

completion.

1 Check repairs costs to put damaged inventories into a saleable condition.

Presentation and Disclosure:

Presentation:

1 The inventories should be disclosed in Balance sheet as “ Current Assets”.

Disclosures:

1 By way of note to the accounts, the following disclosures should be made i.e.

proper accounting policy adopted.

1 The categorisation of inventories into:

- Raw material and components x

- Goods held for resale x

- Work in progress x

26

- Finished goods x

IAS 11 : Construction Contracts

A construction contract is a contract specifically negotiated for the construction of

an asset or a group of interrelated assets.

Contract revenue should include the amount agreed in the initial contract

+ Revenue from alternations in the original contract work.

+ Claims and incentive payments that are expected to be collected and that can be

measured reliably.

Contract costs should include:-

Costs that relate directly to the specific contract

+ Costs that are attributable to the contractor's general contracting activity to the

extent that they can be reasonably allocated to the contract.

+ Other costs that can be specifically charged to the customer under the terms of

the contract.

If the outcome of a construction contract can be estimated reliably, revenue and

costs should be recognized in proportion to the stage of completion of contract

activity. (Percentage of completion method of accounting).

If the outcome cannot be estimated reliably, no profit should be recognized.

Instead, contract revenue should be recognized only to the extent that contract

costs incurred are expected to be recoverable and contract costs should be

expensed as incurred

The stage of completion of a contract can be determined by:_

27

• The proportion that contract costs incurred for work performed to date bear

to the estimated total contract costs.

• Surveys of work performed

• Completion of a physical proportion of the contract work

An expected loss on a construction contract should be recognized as an expense as

soon as such loss is probable.

Disclosures:

Amount of contract revenue recognised;

Method used to determine revenue

Method used to determine stage of completion

For contracts in progress at balance sheet date disclose:-

• Aggregate costs incurred and recognised profit

•

• Amount of advances received

•

• Amount of retentions

Presentation

• * The gross amount due from customers for contract work should be shown

as an asset.

•

• * The gross amount due to customers for contract work should be shown as a

liability.

28

Risk associated with holding inventories:

1

2 High level inventories held in storage resulting poor cash flow management

and financial loss for the enterprises.

1 The enterprises may have inadequate inventory records resulting in meeting

customers demands.

1 There is lack of internal control in storage area resulting in theft and

misappropriation of inventory.

1 High level damages or deterioration due poor storage facilities.

1 Lack of information on inventory held by the enterprise resulting in poor

decision and inability to meet the demands and objective of the business.

1 Holding inappropriate or inadequate inventory in storage may lead to lack of

demand from customers and from production unit.

29

The Audit of Payables

Current Liabilities falling due within one year:

1 1. Trade payables ( amount owing to suppliers)

2 2. Accrued expenses

3 3. Short term loans or borrowings

4 4. Bank overdraft

5 5. Provisions

Non-current liabilities falling due after more than one year:

1 1. Long term loan and borrowings

2 2. Debentures

3 3. Deferred tax

4 4. Pension obligation or retirement benefit obligation

30

THE CURRENT LIABILITIES VERIFICATION:

Audit procedures:

1 Request schedule of long and short-term liability from the

client.

1 Cut-off procedures are carried out properly: to ensure all

trade payable should not included unless the goods were

acquired before the year end.

1 Reasonableness: consider the reasonableness of the liability

1 Internal control procedures: to evaluate and test internal

control procedures.

1 Authority: both current and non current liabilities should be

properly authorised by directors.

1 Presentation and disclosures: Both current and non current

liabilities should be disclosed properly in the balance sheet.

1 Documentation: The auditor must examine all relevant

documents; these include invoices, correspondence, and

debentures deed.

1 Security: some liabilities are secured in various ways, usually

by fixed or floating charges.

1 Vouching: the creation of each liability should be vouched, for

example the receipt of a loan.

1 Accounting policy: the auditor must satisfy himself that

appropriated accounting policies have been adopted and

applied consistently.

1

London School of Business and Finance 2008 of 40 31

2

3 External verification: with many liabilities it is possible to

verify the liability directly with the trade payables. This action

will be taken with short term loan, bank overdraft and by a

similar technique that used with trade receivables

(circularisation).

1 Review post balance sheet events (payment made to

suppliers after the balance sheet date) IAS 10 Events after

balance Sheet Date.

Provisions:

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

Provision: A liability of uncertain timing or amount

Liability:

• Present obligation as a result of past events

• Settlement is expected to result in an outflow of resources

(payment)

Contingent liability:

• A possible obligation depending on whether some uncertain

future event occurs, or

•

• A present obligation but payment is not probable or the

amount cannot be measured reliably

London School of Business and Finance 2008 of 40 32

Contingent Asset

A possible asset that arises from past events, and

Whose existence will be confirmed only by the occurrence or non-

occurrence of one or more uncertain future events not wholly within

the control of the enterprise.

An enterprise must recognise a provision if:-

• A present obligation (legal or constructive) has arisen as a

result of a past event (the obligating event),

• Payment is probable ('more likely than not'), and

• The amount can be estimated reliably

The amount recognised as a provision should be the best estimate

of the expenditure required to settle the present obligation at the

balance sheet date.

In reaching its best estimate, the company should take into account

the risks and uncertainties that surround the underlying events.

Expected cash outflows should be discounted to their present

values, where the effect of the time value of money is material.

In measuring a provision consider future events as follows:

• Forecast reasonable changes in applying existing technology

• Ignore possible gains on sale of assets

• Consider changes in legislation only if virtually certain to be

enacted

London School of Business and Finance 2008 of 40 33

Restructuring by sale of an operation

Accrue a provision only after a binding sale agreement

Restructuring by closure or reorganisation

Accrue a provision only after a detailed formal plan is adopted and announced publicly. A Board decision is not enough

Warranty Accrue a provision (past event was the sale of defective goods)

Land contamination Accrue a provision if the company's policy is to clean up even if there is no legal requirement to do so (past event is the obligation and public expectation created by the company's policy)

Customer refunds Accrue if the established policy is to give refunds (past event is the customer's expectation, at time of purchase, that a refund would be available)

Offshore oil rig must be removed and sea bed restored

Accrue a provision when installed, and add to the cost of the asset

Abandoned leasehold, four years to run

Accrue a provision

CPA firm must staff training for recent changes in tax law

No provision (there is no obligation to provide the training)

A chain of retail stores is self-insured for fire loss

No provision until a an actual fire (no past event)

Self-insured restaurant, people were poisoned, lawsuits are expected but none have been filed yet

Accrue a provision (the past event is the injury to customers)

Major overhaul or repairs No provision (no obligation)

Onerous (loss-making) contract

Accrue a provision

London School of Business and Finance 2008 of 40 34

Disclosures

Reconciliation for each class of provision:

Opening balance

Additions

• Used (amounts charged against the provision) •• Released (reversed) ••• Closing balance

For each class of provision, a brief description of:

Nature

Timing

Uncertainties

Assumptions

Reimbursement

London School of Business and Finance 2008 of 40 35

Audit Tests:-

1

2 Any amount retained as reasonably necessary for the

purpose of providing for any liability or loss which is either

likely to be incurred or certain to be incurred but uncertain as

to amount or as to the date on which it will arise.

1 The provision is debit balance and the effect on profit or loss.

1 Is for likely or certain future payment.

1 Where the amount or the date of payment is uncertain

1 Review post balance sheet event (outcome after the balance

sheet date)

Contingences: Pending legal actions

1

2 Review the client’s records for recording of the claims and

disputes and the procedures for bringing these to the

attention of the board

1 Review the correspondences with the solicitors

1 Discuss with management regarding possible outcome of

claims (Obtain letter of representation).

1 Examine solicitor’s fees note against bank payment recording

in the client’s books and records.

1 Obtain written assurances from directors with an estimate of

the possible ultimate liabilities

London School of Business and Finance 2008 of 40 36

1 Check the disclosure in the balance sheet.

2 Debentures:

Audit of debentures:

1

2 Obtain a schedule detailing the debentures due at the

beginning of the year, addition and redemption during the

year and final debentures at year ended.

1 Obtain copies of debentures certificates and verify the details

and filed in permanent file.

2

3 Check the opening balances from previous years working

papers file.

1 Obtain copy of director’s minutes for any approvals for

addition to debentures.

1 Vouch repayments with debentures certificates, cash book to

check the correct amount is paid.

1 Vouch interest payments with debentures certificates, cash

book to check the correct interest is paid.

1 Agree total amount outstanding with register of debenture

holders.

1 If loan is secured, verify charge is registered with relevant

regulatory authority.

1 Check the disclosure requirements.

London School of Business and Finance 2008 of 40 37

Audit of share capital:

Audit Procedures:

1 Ensure the issue within limit of Memorandum and articles of

the companies

1 Ensure the issue is subject to directors minute

1 Verify the internal control procedures/Custody of unused

certificate.

1 Ensure and verify the shareholder details

1 Ensure the cash receipts for the share issue

1 Review the counter-foils for the share certificates for

sequence of issues

1 Vouch the payment of underwriting and other fees

2

3 Determine the total of shares of each class as stated in the

balance sheet and obtain a list of shareholding, which in total

should agree with the balance sheet total.

London School of Business and Finance 2008 of 40 38

Other relevant standards:

IAS 8 : ACCOUNTING POLICIES, CHANGES IN ACCOUNTING

ESTIMATES AND ERRORS

• 1. Accounting policies are the specific principles, bases,

conventions, rules and practices applied by an entity in

preparing and presenting financial statements.

•

• 2. A change in accounting estimate is an adjustment of the

carrying amount of an asset or liability, or related expense,

resulting from reassessing the expected future benefits and

obligations associated with that asset or liability.

Disclose:

• * The nature and amount of a change in an accounting

estimate that has an effect in the current period or is

expected to have an effect in future periods.

•

• * If the amount of the effect in future periods is not disclosed

because estimating it is impracticable, this fact should be

disclosed.

London School of Business and Finance 2008 of 40 39

• 3. Prior period errors are omissions from, and misstatements

in, a company’s financial statements for one or more prior

periods arising from a failure to use, or misuse of, reliable

information that was available and could reasonably be

expected to have been obtained and taken into account in

preparing those statements. Such errors result from

mathematical mistakes, mistakes in applying accounting

policies, oversights or misinterpretations of facts, and fraud.

Disclosures relating to prior period errors include:

The nature of the prior period error;

• for each prior period presented, to the extent practicable, the

amount of the correction:

o for each financial statement line item affected; and

o for basic and diluted earnings per share (only if the

entity is applying IAS 33);

• the amount of the correction at the beginning of the earliest

prior period presented; and

• if retrospective restatement is impracticable, an explanation

and description of how the error has been corrected.

London School of Business and Finance 2008 of 40 40

ACCA Paper F8

AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM

Autumn 2008 Lecture 6

Application of the Going Concern Concept to Audits.

DATE: Spring 2008

TUTOR:

ISA 570 GOING CONCERN

1

Actions that an auditor should carry out to try and ascertain whether an entity is a

going concern:-

“During planning and performing audit procedures and in evaluating the results the

auditors should consider the appropriateness of management assumptions when

preparing the financial statements of the enterprise”

Since financial statements are prepared on the assumption of going concern, it is

essential for the auditor to give positive consideration to the applicability of the

going concern basis at the planning stage and throughout the audit. Risk evaluation

and findings during the audit may uncover indicators of going concern problems:

Operational problems: 1

2 Continued Trading loss

1 Forced reduction in operation

1 Loss of key suppliers or customers

1 Litigation with customers and suppliers

1 Increased competitions

1 Dependence on one product.

Financial problems:

1 Net current liabilities

1 Funding operations from overdue VAT/PAYE

1 Excess borrowing to finance daily obligations

1 Loan defaults

1 Cancellation of capital projects

1 Inability to pay debts as and when due

2

1 Refusals to renew/extend overdraft limits Personnel problems:

12 Loss of key personnel

1 Prolonged industrial disputes

If the above indicators are detected, the auditor should seek evidence to support

the going concern assumption.

The evidence includes:-

1 Profit and cash flow projection covering the period at least 12 months from

the date the directors approve the financial statements.

1 Examine orders received and contracts signed

1 Holding company or bank support.

Directors support.

Audit Procedures (Tests) For Going Concern:

3

ISA 570 requires that the auditor, when forming an opinion as to whether financial

statements gives a true and fair view should consider the entity’s ability to continue

as a going concern and make any relevant disclosure in the financial statements.

Audit Procedures:

1 Assess the adequacy of the means by which the directors have satisfied

themselves that the adoption of the going concern basis is appropriate.

1 Examine all relevant evidences available to support the going concern status.

1 Review the director’s business review and their assessment of the future.

1 Assess the systems or other means by which the directors have identified

warnings of future risks and uncertainties.

1 Examine budgets and other future plans and assess the reliability of such

budgets by references to past performances.

1 Examine management accounts and other reports of recent activities.

1 Obtain confirmation of existing bank borrowing facilities and suppliers credits.

1 Review the board minute for any discussion of going concern matters.

1 Enquire of the director’s plan for resolving any issue that may threaten the

going concern of the company.

1 Consider obligations undertakings guarantee with lenders, suppliers and

group companies for giving or receiving support.

2 Review management’s plans for future actions based on its going concern

assessment.

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– Gather additional sufficient and appropriate audit evidence to confirm whether or

not a material uncertainty exists regarding the going concern concept.

– Seek written representations from management regarding its plans for future

action.

– Obtain information from company bankers regarding continuance of loan facilities.

– Review receivables ageing analysis to determine whether there is an increase in

days – which may also indicate cash flow problems.

Audit procedures if the company is not considered to be a going concern

– Discuss the situation again with the directors. Consider whether additional

disclosures are required in the financial statements or whether the financial

statements should be prepared on a ‘break up’ basis.

– Explain to the directors that if additional disclosure or restatement of the financial

statements is not made then the auditor will have to modify the audit report.

– Consider how the audit report should be modified. Where the directors provide

adequate disclosure of the going concern situation, then an emphasis of matter

paragraph is likely to be appropriate to draw attention to the going concern

disclosures.

– Where the directors do not make adequate disclosure of the going concern

situation then qualify the audit report making reference to the going concern

problem. The qualification will be an ‘except for’ opinion or an adverse opinion

depending on the auditor’s opinion of the situation.

Impact on the audit report:

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1

2 Based on the audit evidence obtained, the auditor should determine if in his

judgement a material uncertainty exists related to events or conditions that alone

or in aggregate may cast significant doubt on the entity’s ability to continue as a

going concern.

1 If there is a “significant level of concern” but company is still a going

concern, then issue an unqualified audit report but with explanatory paragraph in

the basis of opinion section. Highlight the existence of material uncertainty relating

to the event or condition that may cast significant doubt on the entity’s ability to

continue as going concern and draws attention to the note in the financial

statement that discloses the matter.

1 If adequate disclosure is not made in the financial statements the auditor

should express a qualified or adverse opinion as appropriate. The report should

include reference to the fact that there is a material uncertainty that may cast

significant doubt about the entity’s ability to continue as a going concern.

1 If in the auditor’s judgement the entity will not be able to continue as a going

concern, the auditor should express an adverse opinion if the financial statements

have been prepared on a going concern basis.

1 If disclosure in the financial statement regarding going concern is inadequate

then issue a qualified audit opinion based on disagreement.

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