CHAPTER 1.

0: INTRODUCTION TO AUDITING
1.1 PRINCIPLES OF AUDITING Mr. Musonda sets up a business of selling spares. For three years all goes well. The spares sell steadily and Mr. Musonda gets some income from the business. Mr. Musonda feels that the business could make more money if he invested in some new premises, bought a motor van and if he employed an assistant. He needs more money to do this. He decides to ask Mr. Banda, his rich friend and brother in law to invest in the business. Mr. Banda wants to invest in the business but does not wish to work for the business or take on any risk for the business debts. Mr. Banda suggests that Mr. Musonda converts the business into a company. This will mean that if the company becomes insolvent, he will only lose at ma!imum the amount that he has invested in the company. Mr. Musonda agrees. Mr. Banda buys "#$ of the shares and Mr. Musonda buys %#$. They both agree that Mr. Musonda is to be paid a reasonable salary as Managing &irector of the business. 't the end of first year of trading as a limited company, Mr. Banda receives a copy of the accounts. (rofits are lower than he e!pected. This means that his return from the company )in dividends* will not be as high as he had hoped. +ou should now try to answer the following two ,uestions before reading on)a* )b* .hat is Mr. Banda/s position in relation to Mr. Musonda in the business0 1f you were Mr. Banda what would you do now0

2egarding the first ,uestion, Mr. Banda is clearly a provider of capital, as indeed is Mr. Musonda. The difference between them is that Mr. Musonda is an owner3manager, whereas Mr. Banda has taken a passive role. Mr. Musonda is similar to a director of a limited company )holding shares therein* and Mr. Banda is similar to a shareholder who has entrusted his funds to the directors of such a company. 2egarding ,uestion )b* Mr. Banda will ask for an e!planation from Mr. Musonda as to why the profits are lower than e!pected, whether proper accounting records were prepared and if the profits were calculated correctly.

Mr. Musonda tells Mr. Banda that as far as he is concerned, the accounts are accurate. Mr. Banda knows that Mr. Musonda gets paid a salary regardless of what the profits are. He is concerned that this means Mr. Musonda is not as worried about profit level as he is. Mr. Banda feels he needs further assurance on the accounts, but he does not know a great deal about financial matters. How can Mr. Banda obtain the assurance that he wants0 The assurance Mr. Banda is seeking can be given by an audit of the financial statements. 'n auditor can provide the two things Mr. Banda re,uires. ' knowledgeable view of the company/s business and of the accounts. 'n impartial view since Mr. Musonda/s view may be partial.

SUMMARY OF THE PRINCIPLES .hat can we derive from this very simple e!ample0 The following matters do seem to be important)i* The e!ample may appear to be simple and perhaps of little conse,uence to us but for Mr. Musonda and Mr. Banda )two users of accounting information* the preparation of reliable accounts was a matter of great importance. Mr. Banda will carry out an investigation of the business as reflected in the accounts of course aided by a ,ualified person. This person will carry out an audit using a number of useful techni,ues. 4alculation of figures will need to be carried out by an independent person to verify the accuracy of the accounts. This independent person is the auditor. The use of information from a source independent of the person running the accounts arrive at a fairer picture. The use of actual personal e!perience in verifying the accuracy of the amounts appearing in the accounts.

)ii*

)iii* )iv* )v*

There are two important matters that should be emphasi5ed at this point. )a* )b* 1t would be seen that the auditor has to behave in a competent manner if a successful audit is to be carried out. 'n audit is clearly a search for evidence to arrive at what the auditor perceives to be the truth.

)c*

'n independent person can add more credibility to the accounts than the brother in law to Mr. Musonda who was too closely involved in the management process. 7imilarly, the inspector of ta!es would clearly prefer account that had received the seal of approval from a properly ,ualified and independent person. 8ne final matter is worthy of note that Mr. Banda on his own lacked e!pertise and e!perience to gather evidence to prove that the accounts were accurate and reliable. 1t is for this reason that he re,uested for an audit to be carried out.

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.e are now in a position to suggest a definition of an audit. 9An audit is an exercise that qualified auditors carry out in order to be able to give the legal opinion whether financial statements of an organisation give a true and fair view. :enerally speaking, it is not possible for the provider of funds to a business to carry out an audit of the type Mr. Musonda carried out. ;ormally, shareholders and other users are not competent to do this or would not be allowed to do so. 1t would be impossible for an ordinary shareholder of <4M plc to investigate )i.e. audit* the accounts of the company. However, it does seem that there may be doubts as to whether it is wise to rely on accounts that have not been audited. .e say that unaudited accounts lack sufficient credibility to form a reliable basis for decision making by users of the accounts. ;ote that Mr. Musonda had made a number of false assumptions and errors when drawing up the original receipts and payments account. Note: Do not make the assumption that business people are all engaged in fraudulent activity a common student misapprehension in the experience of the authors!. "here are probably far more incompetent people in the business world than swindlers.

' person who can add credibility to the accounts is clearly not someone like Mr. Musonda, who was too closely involved in the management process. (erhaps it is not even Mr. Banda, who nevertheless appears not competent enough to be an auditor. =ust imagine whether )say* an inspector of ta!es would be happy to accept Mr. Musonda if he were to send the accounts he has drawn up to the inspector together with a note saying that, in his view, the accounts are acceptable as the basis for the calculation of ta! liability. The inspector would clearly prefer accounts that had received the seal of approval from a properly and independent person. 8nly a person entirely independent of the management of an organi5ation and not financially involved with it can add the desired credibility to the accounts.

>

8ne final matter is worthy of note at this point and that is that Mr. Musonda felt he lacked enough evidence to prove that the accounts were accurate or reliable enough for his purposes. 1t seems that uncertainty may be, on occasion, an important matter. .e shall be discussing the above principles in greater depth in later chapters in the book, but we are now in a position to suggest a definition of auditing which will prove useful in our subse,uent discussions.

DEFINITION OF AN AUDIT ?'n audit is an investigation or a search for evidence to enable an opinion to be formed on the reliability of financial and other information by a person or persons independent of the preparer and persons likely to gain directly from the use of the information, and the issue of a report on that information with the intention of increasing its credibility and therefore its usefulness./ This definition is not the same as that which appears in the :lossary of Terms to the @!planatory ;ote to the 'uditing 7tandards issued by the accounting bodies but is in the writer/s opinion more useful for the student of auditing. For the sake of completeness, the official definition is given below#Audit is the independent examination of$ and expression of opinion on the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any statutory obligation.% The words in italics in the latter definition are not emphasi5ed in the :lossary of Terms, but we have done so here to show that the ideas of ?independence/, ?e!amination/ or ?investigation/, ?reporting/ or e!pressing an opinion/ are common to both the above definitions. The idea of ?reliability/ in the first definition is close to the idea of ?truth and fairness/ which is a statutory obligation placed on directors of limited companies responsible for the preparation of financial statements, as we shall see when we come to discuss the ?true and fair view/ in a later chapter. SUMMARY This chapter has introduced you to a simple audit situation and has suggested a number of important ideas about auditing. The principles are highlighted in the self assessment ,uestions at the end of the chapter. .hen you are doing this try to imagine what a sensible and logical thinking person would suggest. 'uditing often needs more than the e!ercise of simple common senseA it re,uires the e!ercise of reason and, in many cases, speciali5es knowledge, but common sense does help. 1t is not sufficient merely to make a guessA in each case you should Bustify your answer. .hen you have made a note of your own answers check them against the suggested solutions. 1f any of your answers are different, make careful notes of the e!planation given and re read the appropriate part of the chapter to make sure you understand where you went wrong. %

AUDIT 1.6 .e shall concentrate on the general guidance the '7B gives on what constitutes an audit. KEY TERM 'n audit is an e!ercise whose obBective is to enable auditors to e!press an opinion whether the financial statements give a true and fair view )or e,uivalent* of the entity/s affairs at the period end and of its profits and loss )or income and e!penditure* for the period then ended and have been properly prepared in accordance with the applicable reporting framework )for e!ample relevant Cegislation and applicable accounting standards* or, where statutory or other specific re,uirements prescribe the term and whether the financial statements are ?presented fairly/. 1.> ?.hat an audit is really about/ is the subBect matter of the 1nternational 'udit and 'ssurance 7tandards Board 7tatement of 'uditing 7tandards 17' 6## 8bBective and general principles governing an audit of financial statements. The first ?7tatement of 'uditing 7tandards/ in 17' 6## is as followsISA 200.1 1n undertaking an audit of financial statements auditors should)a* 4arry out procedures designed to obtain sufficient appropriate audit evidence, in accordance with 'uditing standards contained in 17's, to determine with reasonable confidence whether the financial statements are free of material misstatementA @valuate the overall presentation of the financial statements, in order to ascertain whether they have been prepared in accordance with relevant legislation and accounting standardsA and 1ssue a report containing a clear e!pression of their opinion on the financial statements. D

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1.%

The 17'/s e!planatory material highlights the credibility given to financial statements by the auditors/ opinionA it provides ?reasona !e ass"ran#e from an independent source that they present a true and fair view/. That is to say the audit report reassures readers of the accounts that the accounts have been e!amined by a $no%!e&'ea !e( )*+ar,)a! professional. 17' 6## goes on to stress further the importance of auditors acting )n&e+en&en,!- and ethically. The assurance that auditors can only e!press an opinion is governed by the fact that auditors use ."&'*en, in deciding what audit procedures to use and what conclusions to draw, and also by the limitations of every audit. )a* The fact that auditing is no, a purely o .e#,)/e e!ercise. 'uditors have to make Budgments in a number of areas including risk assessment, what constitute a significant error, what tests to perform and ultimately what opinion to give. The fact that auditors do not check every item in the accounting records. .e shall see that for tests, auditors only check a sample of items. The !)*),a,)ons of a##o"n,)n' and )n,erna! #on,ro! s-s,e*s. For e!ample, the systems may not be able to deal with unusual transactions, and may not be fle!ible enough to cope well with changing circumstances. The possibility that #!)en, *ana'e*en, or staff *)'0, no, ,e!! ,0e ,r",0, or #o!!"&e )n 1ra"&. 8ne important control may be a division of responsibilities so that one number of staff checks another/s work, but the control will be ineffective if they collude. The fact that audit e/)&en#e )n&)#a,es what is +ro a !e rather than what is #er,a)n. 7ome figures in the accounts are estimates, some re,uire a significant degree of Budgment and some are affected by uncertainty. The fact that auditors are re+or,)n' generally so*e *on,0s a1,er the balance sheet date. The client/s position may be changing, and the position shown in the accounts at the last year end may be significantly different from the up to date position. 1f on the other hand auditors had to report soon after the balance sheet date, evidence about certain figures in the balance sheet date, may be insufficient. The !)*),a,)ons of the audit report. 'lthough work has been done to make the report more informative, the standard format is likely to reflect all aspects of the audit. This is discussed further in the 4hapter on 'uditors report. "

1.D

1."

)b* )c*

)d*

)e*

)f*

)g*

Hence auditors can only e!press an opinionA they cannot certify whether accounts are completely correct. 1.E 1.F Material misstatements may e!ist in financial statements and auditors will plan their work on this basis, that is, with +ro1ess)ona! s#e+,)#)s*. 17' 6## makes it clear that, even where auditors assess the risk of litigation or adverse publicity as very low, they must perform sufficient procedures according to auditing standards. That is, there can never be a reason for carrying out an audit of a lower ,uality than that demanded by the auditing standards. This will be discussed in 4hapter D. ISA 200.2 1n the conduct of any audit financial statements auditors should comply with the ethical guidance issued by their relevant professional bodies. 1.G 1.1# +ou should be aware of H14'Is ethical guidance. 'udits are re,uired under statute in the case of a large number of undertakings, including the followingUn&er,a$)n's Cimited companies Building societies Trade unions and employer associations Housing 'ssociations Pr)n#)+a! A#, 4ompanies 'ct 1GFD Building 7ocieties 'ct 1G"D Trade Jnion and Cabour relations 'ct 1GE% Karious acts depending on the legal constitution of the housing association, including1ndustrial and (rovident 7ocieties 'ct 1G"D Friendly and 1ndustrial and (rovident 7ocieties 'ct 1G"F Housing 'ct 1GF# 4ompanies 'ct 1GFD Housing 'ssociation 'ct 1GFD Karious acts depending on the status of the charity, including special 'cts of parliament. investment 2egulations made under the Financial 7ervices 'ct 1GF" E

4ertain charities

Jnincorporated business

1.11

7mall limited companies are e!empt from an audit. The regulations are)a* ' company is totally e!empt from the annual audit re,uirement in a financial year if its turnover for that year is not more than <1 million and its balance sheet total is not more than <1.% million. The e!emptions do not apply to public companies, banking or insurance companies or those subBect to a statute based regulatory regime. ' company that is part of a group can claim e!emption provided the group of which it is a member is a small group which satisfied the conditions. 7hareholders holding 1#$ or more of the capital of any company can veto the e!emption. ' dormant company which fulfils the criteria of s 6%G'' )that is it ,ualifies for e!emption as a small company* does not need a special resolution to gain e!emption from audit.

)b* )c* )d* )e*

Res+ons) )!),1.16 ' key point that is made in 17' 6## is that auditors do not bear any responsibility for the preparation and presentation of the financial statements.

The responsibility for the preparation and presentation of the financial statements is that of the directors of the entity. 'uditors are responsible for forming or e!pressing an opinion on the financial statements. The audit of the financial statements does not relieve the directors of any of their responsibilities. 1.1> 'nother key fact about responsibility, which is often perceived incorrectly, is that the a"&),or &oes no, 0a/e an- res+ons) )!),- %),0 re'ar& ,o +re/en,)on an& &e,e#,)on o1 1ra"&. 2ene1),s o1 A"&),

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The key benefit of audit has been mentioned above. 1t is the fact that through an audit, the owners of the company ) *e* ers* are given an )n&e+en&en, o+)n)on as to the ,r",0 an& 1a)rness o1 ,0e a##o"n,s which have been prepared for them by the directors, giving them an impression of how their investment has performed in the period.

1.1D

There are a number of subsidiary benefits however. @!amples include The financial statements can be used by ,0)r& +ar,)es s"#0 as an$s( to make decisions about the company. 'n audit will give them more #on1)&en#e )n ,0e 1)nan#)a! s,a,e*en,s. However, the auditor should be aware of potential liability which will be e!plained in a later unit. The auditors can use their e!perience as business advisors to 0e!+ ,0e &)re#,ors )*+ro/e ,0e "s)ness as a by product of the audit. This can be achieved byo Management letter. o &iscussions during the audit 7pecifically, the e!istence of the auditor can help to *),)'a,e a'a)ns, r)s$s. ' key e!ample of this is the risk of fraud despite it not being the duty of the auditor to detect fraud.

L)*),a,)ons o1 a"&), 1.1" 7ome of the limitations of audit were discussed earlier. There are other provisions attached to the assurance given by the auditor. The auditors/ opinion is no, a '"aran,ee of The 1","re /)a )!),- of the entity. Mana'e*en,3s e11e#,)/eness an& e11)#)en#;o 1ra"& having been perpetrated on the company.

Non4S,a,",or- a"&), 1.1E Non4s,a,",or- a"&),s are performed by independent auditors because the owners, proprietors, members, trustees, professional and governing bodies or other interested parties want them, rather than because the law re,uires them. 1n conse,uence, auditing may e!tend to every type of undertaking that produces accounts, including 4lubs. 4harities )assuming that an audit is not statutory*. G

 1.1F

7ole traders. (artnerships

'uditors may also give an a"&), o+)n)on on s,a,e*en,s o,0er ,0an ann"a! a##o"n,s including 7ummaries of sales in support of a statement of royalties. 7tatements of e!penditure in support of applications for regional development grants. The circulation figures of a newspaper or maga5ine.

1.1G

1n all such audits the auditors must take into account any re'"!a,)ons contained in the internal rules or constitution of the undertaking. @!amples of the regulations which the auditors would need to refer to in such assignments would include The rules of clubs, societies and charities. (artnership agreements

A&/an,a'es o1 ,0e non4s,a,",or- a"&), 1.6# 1n addition to the advantages common to all forms of audit, including the verification of the accounts, recommendations on accounting and control systems and the possible detection of errors and fraud, the audit of the accounts of a par,ners0)+ may be seen to have the following advantages)a* )b* 1t can provide a means of se,,!)n' a##o"n,s between the partners. .here audited accounts are available this may make the a##o"n,s *ore a##e+,a !e to the In!an& Re/en"e when it comes to agreeing an individual partner/s liability to ta!. The partners may well wish to take advantage of the auditors/ services in the additional role of ta! advisers. The sa!e of the business or the ne'o,)a,)on o1 !oan or overdraft facilities may be facilitated if the firm is able to produce audited accounts. 'n audit on behalf of a ?s!ee+)n' +ar,ner3 is useful since generally such a person will have little other means of checking the accounts of the business, or confirming the share of profits due to him or her.

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2. CHRONOLOGY OF AN AUDIT De,er*)ne a"&), a++roa#0

1#

7tage 1

&etermine the s#o+e of the audit and the auditors/ approach. For statutory audits the scope is laid down by the 4ompanies 'ct 1GFD and e!panded by 'uditing 7tandards. The auditors should prepare an a"&), +!an, which should be placed on file.

As#er,a)n ,0e s-s,e* an& #on,ro!s 7tage 6 &etermine the 1!o% o1 &o#"*en,s and e5,en, o1 #on,ro!s in e!istence in the client/s system. This is a fact finding e!ercise which is achieved by discussing the accounting system and document flow with all the relevant departments )for e!ample, sales, purchases, cash, stock and accounts personnel*. 1t is good practice to make a rough record of the system during this fact finding stage which will be converted to a formal record at later stages. 7tage > (repare a #o*+re0ens)/e re#or& of the s-s,e* ,o 1a#)!),a,e e/a!"a,)on of the systems. The records may be in various formats )for e!ample, charts, narrative notes, internal control ,uestionnaires and flowcharts*. 4onfirm that the s-s,e* re#or&e& is the same as that )n o+era,)on. This is achieved by performing wall through tests. These involve tracing a handful of transactions through the system and observing the operation of controls over them. This check is useful because sometimes client staff will tell the auditors what they s0o"!& e &o)n' rather than %0a, )s a#,"a!!- &one. Assess ,0e s-s,e* an& )n,erna! #on,ro!s 7tage D E/a!"a,e ,0e s-s,e*s to gauge their reliability and formulate a basis for testing their effectiveness in practice. 'uditors will be able to recommend any improvements and also determine the e!tent of further tests at 7tage " and F below. 'uditors will be able to recommend any improvements and also determine the e!tent of further tests at 7tages " and F below. Tes, ,0e s-s,e* an& )n,erna! #on,ro!s 7tage " )This should only be carried out if the controls are evaluated as effective at 7tage D. 1f not, 7teps " and E should be omitted.*

7tages %

11

1f controls are effective, test should be designed to establish compliance with the system should be selected and performed. Tes,s o1 #on,ro!s, which cover a larger number of items than walkthrough tests and cover a more representative sample of transactions through the period, should be carried out. 1f #on,ro!s are s,ron', the records should be reliable and the amount of detailed testing can be reduced. 1f #on,ro!s are )ne11e#,)/e in practiceA more e!tensive substantive procedures will be re,uired. 7tage E 'fter evaluating the systems and testing controls, auditors normally send an interim re+or, ,o *ana'e*en, identifying weaknesses and recommending improvements.

Tes, ,0e 1)nan#)a! s,a,e*en,s 7tages F 7tage G These tests are concerned with s" s,an,)a,)n' ,0e 1)'"res ')/en )n ,0e 1)nan#)a! s,a,e*en,s. 7ubstantive tests also serve to assess the effect of errors, should errors e!ist. Before designing a substantive procedure it is essential to consider whether any errors produced could be significant. 1f the answer is no, there is no point in performing a test. Re/)e% ,0e 1)nan#)a! s,a,e*en,s 7tage 1# The financial statements should be reviewed to determine the overall reliability of the account by making a #r),)#a! ana!-s)s o1 #on,en, an& +resen,a,)on.

E5+ress an o+)n)on 7tage 11 The auditors evaluate the evidence that they have obtained and they e5+ress ,0e)r o+)n)on to members in the form of an audit report. The final re+or, ,o *ana'e*en, is an important non4s,a,",or- en& +ro&"#, of the audit. The purpose of it is to make further s"''es,)ons 1or )*+ro/e*en,s in the systems and to +!a#e on re#or& s+e#)1)# +o)n,s in connection with the audit and the accounts.

7tage 16

SMALLER ENTITIES

16

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The control systems in smaller entities are often not as sophisticated as those in larger entities. The particular area that can be a concern for smaller entities with few staff is se're'a,)on o1 &",)es. 1t can be impossible to ade,uately share duties between staff when there are only one or two staff. Having established that proprietor involvement is the key to internal control in the small enterprise, we need ne!t to be rather more precise and identify the types of control relevant to each principal accounting area. These controls can be referred to as ?*)n)*"* "s)ness #on,ro!s/. 1t is important to appreciate that such controls will not, and #anno,( e e/a!"a,e& an& re!)e& on by the auditors as in a ?systems/ audit approach, but they do +ro/)&e o/era!! #o*1or, to the auditors, particularly when determining whether to seek to rely on management assurances as to the accounting records. The following checklist provides illustrative e!amples of minimum control standards.

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Ma)! 1s all mail received and opened by the proprietor0 1f the proprietor does not himself open the mail, is it opened by a person not connected with the accounts and read by him before it is distributed to the staff0

Re#e)+,s 're all che,ues and postal orders received by post counted by the proprietor before they are passed to the cashier0 're all che,ues and postal orders crossed to the company/s branch of its bankers ?not negotiable L account payee only/. 're cash sales and credit sale receipts over the counter controlled by locked cash register tapes which only the proprietor can open0 &oes the proprietor reconcile the cash register totals with the cash sales receipts daily0 1s the person performing the duties of cashier barred any responsibility concerning the sales, purchase nominal ledgers0

2an$)n' 1s all cash received intact at intervals of not more than three days0 1>

&oes the proprietor reconcile all monies received with the copy paying in slips at regular intervals0

Pa-*en,s 1s all cash received banked intact at intervals of not more than three days0 &oes the proprietor sign all che,ues0 're che,ues signed by the proprietor only after he has satisfied himself thato He has approved and cancelled all vouchers supporting the payment0 o 'll che,ues are crossed not negotiable and account payee only0 o 'll che,ue numbers are accounted for0 're petty cash e!penses controlled by the imprest system0 &oes the proprietor review all e!penses and initial the petty cash book before reimbursing the cashier0

2an$ s,a,e*en,s 're bank statements and che,ues sent direct to the proprietor and opened only by him0 &oes the proprietor scrutini5e all paid che,ues to ensure that he has signed them all before he passes them to the cashier0 &oes the proprietoro (repare a bank reconciliation each month0 8r o 2eview in detail a reconciliation produced by the cashier0 Or&ers 're all purchase orders issuedo 7erially numbered by the printer0 o (re printed duplicate order forms0 &oes the proprietor approve all orders0

Re#e)+,s o1 'oo&s 're delivery notes 4hecked with goods0 1%

4ompared with the copy order0 4ompared with the invoice0

6a'es 1s a separate che,ue drawn for the e!act amount to pay wages and ta!0 &oes the proprietor either prepare or e!amine the wages records before signing the che,ue0 &oes the proprietor initial the wages records after his e!amination0 &oes the proprietor oversee the distribution of the wages packets or does he distribute them himself0

Re#e)/a !es 1f credit is granted to customers does the proprietoro 'uthorise every e!tension of credit to a customer0 o 'pprove credit limits for each customer0 &oes the proprietor authori5e allo .rite offs bad debts0 o 7ales returns and allows0 o &iscounts other than routine cash discounts0 &oes the proprietor receive a monthly of ,ra&e a##o"n,s re#e)/a !e, showing the age of the debts0 're all authori5ations by the proprietor evidenced by his initials0

Goo&s o",%ar&s 're pre numbered dispatch notes prepared for all goods leaving the premises0 're all dispatch noteso 'ccounted for0 o 4ross referenced with invoices and credit notes0 1s the proprietor satisfied that all goods leaving the premises have been accounted for0

In/en,or1D

&oes the proprietor scrutinise inventory regularly to<eep abreast of what is in inventory0 &iscover obsolete items0 &iscover damaged articles0 @nsure that inventory levels are kept under control0

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'lthough the above types of control are desirable and feasible, they are nevertheless relatively informal. 4onse,uently, evidence of their performance tends to be lacking and they may indeed be overridden as there is no check on the proprietor himself. E5a*)na,)on 1o#"s +o)n, 1n the e!amination, run the following checklist through your mind when approaching ,uestions about controls in smaller entities. 're you being logical0 4onsider the number of staff the entity is likely to employ. 2emember, top management or the owners are likely to be involved on a day to day level Bear in mind a general rule- The smaller the entity, the fewer the daybooks and ledgers..

1.2 1.6.1

RIGHTS AND RESPONSI2ILITIES OF THE AUDITOR The audit is primarily a statutory concept, and eligibility to conduct an audit is often set down in statute. 7imilarly, the rights and duties of auditors can be set down in law, to ensure that the auditors have sufficient power to carry out an effective audit.

D",)es 1.6.6 1.6.> The auditors should be re,uired to report on every balance sheet and income statement laid before the company in general meeting. The auditors may also be re,uired to consider the following1"

4ompliance with legislation Truth and fairness of accounts

.hether the accounts have been prepared in accordance with the relevant legislation. .hether the balance sheet shows a true and fair view of the company/s affairs at the period and the income statement )and a cash flow statement* show a true and fair view of the results for the period. .hether the accounts are in agreement with the accounting records. .hether the other information with the accounts is consistent with the accounts

'greement of controls accounts to records 4onsistency of other information R)'0,s 1.6.% 1.6.D

The auditors must have certain rights to enable them to carry out their duties effectively. The principal rights auditors should have, e!cepting those dealing with resignation or removal, are set out in the table below, and the following are notes on more detailed points. 'ccess to records 1nformation and e!planations 2ight of access at all times to the books, accounts and vouchers of the company. ' right to re,uire from the company/s officers such information and e!planations as they think necessary for the performance of their duties as auditors. ' right to attend any general meetings of the company and to receive all notices and communications relating to such meetings which any member of the company is entitled to receive. ' right to be heard at general meetings which they attend on any part of the business that concerns them as auditors ' right to receive a copy of any written resolution proposed. ' right to give notice in writing re,uire 1E

'ttendance at3notices of general meetings

2ight to speak at general meetings

2ights in relation to written resolutions 2ight to re,uire laying of accounts

that a general meeting be held for the purpose of laying the accounts and reports before the company )if elective resolution dispensing with laying of accounts in force*. R)'0,s ,o )n1or*a,)on 1.6." 1.6.E 1f auditors have not received all the information and e!planations they consider necessary, they should state this fact in their audit report. Caws may make it an offence for a company/s officer knowingly or recklessly to make a statement in any form to an auditor which 1.2 (urports to convey any information or e!planation re,uired by the auditor 1s materially misleading, false or deceptive.

AUDITING STANDARDS

R"!es 'o/ern)n' a"&),s 1.6.1 .e discussed in 4hapter 1 the various stakeholders in a company, and the number of people who might read a company/s accounts. 4onsider also that number of these readers will not Bust be reading a single company/s accounts, but will also be reading the accounts of a large number of companies, and making comparisons between them. 2eaders %an, ass"ran#e when making comparisons ,0a, ,0e re!)a )!),- o1 ,0e a##o"n,s &oes no, /ar- 1ro* #o*+an- ,o #o*+an-. This assurance will be obtained not Bust from knowing each set of accounts has been audited, but knowing that each set of accounts has been audited to #o**on s,an&ar&s. Hence there is a need for audits to be re'"!a,e& so that auditors follow the same standards. 's we see in this chapter, auditors have to follow rules issued by a variety of bodies. 's we saw above, some obligations are imposed by governments in law, or statute, some obligations are imposed by the professional bodies to which auditors are re,uired to belong )such as 7ICA in Hambia*. .e have already mentioned that 1nternational 7tandards on 'uditing )17's* are produced by the 1nternational 'udit and 'ssurance 7tandard Board )1'7B*, a technical standing committee of 1F'4. 'n e!planation of the workings of the 1''7B, the authority of the 17's and so on are laid out in the (reface to 1nternational 7tandards on 'uditing )17's* and 2elated 7ervices )27s*.

1.6.6

1.6.>

1.6.%

1F

Pre1a#e ,o ISAs an& IRSs 1.6.D The preface restates the mission of 1F'4 as set out in its constitution- ?The development and enhancement of an accountancy profession able to provide services of consistency high ,uality in the public interest/. 1n working toward this mission, the 4ouncil of 1F'4 established the 1nternational 'uditing (ractices 4ommittee, precursor to 1''7B to develop and issue, on behalf of the 4ouncil, standards and statements on auditing and related services. 7uch standards and statements improve the degree of uniformity of auditing practices and related services throughout the world.

1.6."

ISAs an& RSs 1.6.E .ithin each country, local regulations govern, to a greater or lesser degree, the practices followed in the auditing of financial or other information. 7uch regulations may be either of a statutory nature, or in the statements issued by the regulatory or professional bodies in the countries concerned. ;ational standards on auditing and related services published in many countries differ in form and content. The 1''7B account takes account of such documents and difference and, in the light of such knowledge, issues 17's which are intended for international acceptance.

1.6.F

T0e a",0or),- ,o ISAs 1.6.G 'n introductory paragraph is found at the beginning of each standard, as follows )with variations where necessary to suit the individual circumstance of each standard*. This lays out the authority attached to 17's in general. A",0or),- o1 In,erna,)ona! S,an&ar&s o1 A"&),)n' 1nternational 7tandards on 'uditing )17's* are to be applied in the audit of financial statements. 17's are also to be applied, adapted as necessary, to the audit of other information and to related services. 17's contain the basic principles and essential procedures )identified in bold type black lettering* together with related guidance in the form of e!planatory and other material. The basic principles and essential procedures to be interpreted in the conte!t of the e!planatory and other material that provides guidance for their application. To understand and apply the basic principles and essential procedures together with the related guidance, it is necessary to consider the whole te!t of the 17' including e!planatory and other material contained in the 17' not Bust that te!t which is black lettered. 1G

1n e!ceptional circumstances, an auditor may Budge it necessary to depart from an 17' in order to more effectively achieve the obBective of an audit. .hen such a situation arises, the auditor should be prepared to Bustify the departure. 17's need only be applied to material matters.

1.6.1# 'ny limitation of the applicability of a specific 17' is made clear in the introductory paragraphs to that 17' )see below*. Par, A: A"&),ors R)'0,s an& Res+ons) )!),)es

A++!)#a,)on ,o +" !)# se#,or The public 7ector (erspective )(7(* issued by the (ublic 7ector 4ommittee of the 1nternational Federation of 'ccountants is set out at the end of an 17'. .here no (7( is applicable in all material respects to the public sector. 1.6.11 17's do not override the local regulations referred to above governing the audit of financial or other information in a particular country. )a* To the e!tent that 17's #on1or* with local regulations on a particular subBect, the audit of financial or other information in that country in accordance with local regulations will automatically comply with the 17' regarding that subBect. )b* 1n the event that the local regulations &)11er 1ro*( or conflict with, 17's on a particular subBect, member bodies should comply with the obligations of members set forth in the 1F'4 4onstitution as regards these 17's )i.e. en#o"ra'e #0an'es in local regulations to comply with 17's*. T0e a",0or),- a,,a#0e& ,o In,erna,)ona! A"&),)n' Pra#,)#e S,a,e*en,s 8IAPs9 1.6.16 1'(7s are issued to provide practical assistance to auditors in implementing the 17's or to promote good practice. They are not intended to have the authority of 17's. +ou will mainly come across them in relation to auditing in computer information systems )417* environments )see chapter G*. 6or$)n' +ro#e&"res o1 ,0e IAAS2 1.6.1> The working procedure of the 1''7B is to select subBects for detailed study by a s" #o**),,ee established for that purpose. The 1''7B delegates to the 6#

subcommittee the initial responsibility for the preparation and drafting accounting standards as appropriate. 1.6.1% 's a result of that study, an e5+os"re &ra1, is prepared for consideration by the 1''7B. 1F approved, the e!posure draft is widely distributed for comment by member bodies of 1F'4, and to such international organi5ations that have an interest in auditing standards as appropriate. 1.6.1D The comments and suggestions received as a result of this e!posure are then considered by the 1''7B and the e!posure draft is re/)se& as appropriate. (rovided that the revised draft is approved it is issued as a definitive In,erna,)ona! S,an&ar& on A"&),)n' or as an In,erna,)ona! A"&),)n' Pra#,)#e S,a,e*en, and becomes operative. CURRENT ISAs In,erna,)ona! S,an&ar&s on A"&),)n' ;o 1## 11# 16# 6## 61# 66# 6># 6%# 6D# 6"# >## >1# >6# %## %#1 %#6 D## D#1 D#D D1# D6# D># D%# DD# D"# DE# DF# Title 'ssurance @ngagements :lossary of terms Framework of 17's 8bBective and general principles governing an audit financial statements Terms of audit engagement Muality control for audit work &ocumentation The auditor/s responsibility to consider fraud and error in an audit of financial statements. 4onsideration of laws and regulations in an audit financial statements 4ommunication of audit matters with those charged with governance (lanning <nowledge of the business 'udit materiality 2isk assessments and internal control 'uditing in a computer information systems environment 'udit considerations relating to entities using service organisations 'udit evidence 'udit evidence additional @!ternal confirmations 1nitial engagements opening balances 'nalytical procedures 'udit sampling and other selective testing procedures 'udit of accounting estimates 2elated parties 7ubse,uent events :oing concern Management representations 61

"## "1# "6# E## E1# E6# F## F1# G1# G6# G># No,es 1

Jsing the work of another auditor 4onsidering the work of internal auditing Jsing the work of an e!pert The auditor/s report on financial statements 4omparatives 8ther information in documents containing audited financial statements The auditor/s report on special purpose audit engagement The e!amination of prospective financial information @ngagements to review financial statements @ngagements to perform agreed upon procedures regarding financial information @ngagements to compile financial information

7tudents should be aware of the nature and meaning of the audit report and should be able to discuss the contents and wording of the report. 7tudents would not be asked to reproduce the audit report in full in an e!am ,uestions, but they may be re,uested to prepare e!planatory paragraphs for inclusion in the report particularly in situations leading to a modified report. 7tudents are advised that ,uestions will be based on the principles and good practice set out in the 1nternational 7tandards on 'uditing. E5a* 1o#"s +o)n, 17's are ,uoted throughout this te!t and you must understand how they are applied in practice. ;ot all the 17's listed above are e!aminableA you should look for the list of e!aminable documents in 7tudent 'ccountant. The following 17's are not e!aminable17' 66# 17' F## 17' F1# 17' G6# Muality control for audit work 2elated parties The e!amination of prospective financial information @ngagement to compile financial information

1.6.1" +ou should refer back to the definition of small entities given on page 66. 1.6.1E 'lthough 17's apply to the audit of financial information of any entity regardless of its si5e, small businesses posses a combination of characteristics which make it necessary for the auditors to adapt their approach to the circumstances surrounding the small business engagement. 66

1.6.1F The 1'(7 on the audit of small businesses, 1'(7 1##D the 7pecial 4onsiderations in the 'udit of 7mall entities was issued in march 1GGG. 1.6.1G The 1'(7 discusses how various 17's apply to the audit of small enterprises. ISA 210 Ter*s o1 A"&), En'a'e*en, 1.6.6# The engagement letter should make it clear to the owner managers their responsibility for the accounts even when they are outsourced. 1.6.61 'uditors should remember that if there is likely to be insufficient audit evidence to form an opinion because of the characteristics of the client, the auditor may decide not to accept the engagement in accordance with 17' E##. ISA 220 :"a!),- #on,ro! 1or a"&), %or$ 1.6.66 'n audit completion checklist may be particularly helpful on small audits. 1t may also be necessary to consult on comple! or technical issues with other auditors, particularly if the audit is carried out by a sole practitioner. ISA 2;0 Do#"*en,a,)on 1.6.6> 'de,uate working papers must be prepared. ISA 2<0 Fra"& an& error 1.6.6% ' dominant owner manger and management authori5ation may have a significant impact on the control environment. However, these factors may also be a potential weaknesses because of the opportunity for management override. The e!posure draft gives the following e!amples of conditions or event which may increase the risk of fraud or error The owner manager has a specific identifiable motive to distort the financial statements, combined with the opportunity to do so. The owner manager makes no distinction between personal and business transactions. The owner manager/s life style is materially inconsistent with the level of his or her remuneration. There are fre,uent changes of professional advisers. The start date for the audit has been repeatedly delayed. Jnusual transactions around the year end have had a material effect on profit. Jnusual related party transactions have occurred. 6>

@!cessive payments of fees or commissions have been made to agents and consultants. &isputes with ta! authorities have arisen and not been resolved.

ISA ;00 P!ann)n' 1.6.6D (lanning can often be started with a file note at the end of the previous year/s audit highlighting significant issues. &iscussions with the owner manager are an important part of planning. 'udit plan may be modified as a result of participation by the auditors in accountancy work. ISA ;10 Kno%!e&'e o1 ,0e "s)ness 1.6.6" 2egular discussions with the owner manager can often provide useful information about the business, particularly about the following areas The activities of the small enterprises, its main products and services, and the industry in which it operates The management style, aims and attitude of the owner manager. 'ny plans for changes to the nature, management and ownership of the enterprise. Trends in profitability or li,uidity and the ade,uacy of working capital. Cegal or regulatory issues facing the business, including its relationship with the ta!ation authorities. The accounting records The control environment

ISA ;20 A"&), *a,er)a!!1.6.6E &raft accounts will often not be available when assessing information at the planning stage. The trial balance may be used as an alternative and it may also be easier to obtain an estimation of turnover than pre ta! profit. 1n any event it may be inappropriate to assess materially as a $ of pre ta! profit when the business is operating at our near breakeven point. ISA <00 R)s$ assess*en,s an& )n,erna! #on,ro!

6%

1.6.6F 1nherent risk will not necessary be higher than for a larger business. The auditor should consider risk for each financial statement assertion rather than automatically assuming risk will be high. 1.6.6G 4ontrol risk will often be assessed as high because of the lack of independent checking and the lack of segregation of duties. 4lose involvement of the owner manager may compensate for these weaknesses but may also mean that the risk of management override and fraud is increased. There may also be a lack of evidence of supervisory controls. 1.6.># 'uditors may also feel that available audit is insufficient to support an un,ualified report, particularly where most transactions are for cash and there is no regular pattern of costs and margins. ISA <01 A"&),)n' )n a #o*+",er )n1or*a,)on s-s,e*s en/)ron*en, 1.6.>1 The use of computer information systems may lower the auditors/ assessment of control risk because the 417 used may be better organi5ed, less dependent upon the skills of the people using it and less susceptible to manipulation than a non compromised system. The auditor may also be able to obtain more easily reports and information. 1.6.>6 1t may be impractical to use 4''Ts because of the smaller volumes of technical data being processed, and the lack of technical assistance available from the client. ISA =00 A"&), e/)&en#e 1.6.>> 'uditors may have problems obtaining evidence to support the completeness of a population particularly where the owner manager occupies a dominant position and there is a lack of internal control procedures. However, auditors may be able to obtain substantive evidence form procedures such as)a* )b* @!ternal confirmation. 4omparison of recorded amounts with amounts calculated on the basis of separately recorded data, for e!ample goods issues recorded in physical inventory records may be e!pected to give rise to sales income. 2econciliations of total ,uantities of goods bought and sold. 'nalytical procedures 2eview of transactions after the balance sheet date 1nspecting numerically based systems controlling the dispatch of goods or the provision of services. 6D

)c* )d* )e* )f*

1.6.>% 1f the auditors also carry out accountancy work for the client, this work is likely only to provide some of the evidence relating to certain audit obBectives such as completeness or valuation. ISA =20 Ana!-,)#a! +ro#e&"res 1.6.>D 't the planning stage there may be a lack of available analytical evidence. However auditors can review the general ledger or other accounting records that may be available, and obtain evidence through discussions with the owner manager. 7ubstantive analytical procedures will often be a cost effective way of obtaining audit evidence on e!penses such as payroll and on the completeness of certain populations, such as rental income. ISA =;0 A"&), sa*+!)n' an& o,0er se!e#,)/e ,es,)n' +ro#e&"res 1.6.>" .ith some small clients, auditors may not use sampling at all, but test 1##$ of the population or test 1##$ of say all larger items and apply analytical procedures to the rest. 1t may also be cost effective to use non statistical methods to determine the sample si5e and select the sample items. ISA =<0 A"&), o1 a##o"n,)n' es,)*a,es 1.6.>E 'uditors may gain assurance by assisting with the preparation of accounting estimates. ISA =>0 S" se?"en, e/en,s 1.6.>F (ost year end accounting records and minutes may not have been written up at the time of the audit. &iscussions with the owner manager may therefore be particularly important and auditors may also obtain evidence by inspecting bank statements. ISA =@0 Go)n' #on#ern 1.6.>G 2epresentations from the owner manger will be insufficient by themselves. However, auditors may have problems obtaining other evidence, as detailed budgets and forecasts or other future information may not be available. The assessment of going concern may be based on a particular assumption, for e!ample the continuance of a loan from the owner manager or a trading relationship with a single customer or supplier. ISA =A0 Mana'e*en, re+resen,a,)ons 1.6.%# The auditors may obtain representations about the completeness and accuracy of the accounting records but other evidence will be re,uired if an un,ualified opinion is to be given. 6"

ISA @20 O,0er )n1or*a,)on )n &o#"*en,s #on,a)n)n' a"&),e& 1)nan#)a! s,a,e*en,s 1.6.%1 8ther information which the auditors have to read includes a detailed income and e!penditure statement.

S"**ar 1n this chapter, we have looked at the whole of the re'"!a,or- 1ra*e%or$ which has a direct effect on auditing, as well as some of the other more indirect influences. 2e,uirements for the eligibility, re')s,ra,)on and ,ra)n)n' of auditors are e!tremely important as they are designed to maintain standards in the auditing professional. These will vary from country to country and will range from direct statutory control to self regulation. +ou must be able to discuss the scope and authority of In,erna,)ona! S,an&ar&s on A"&),)n' 8ISAs9 an& In,erna,)ona! A"&),)n' Pra#,)#e S,a,e*en,s 8IAPSs9.

ASSIGNMENT 1. ;ame three characteristics of accountancy bodies. )1* )6* )>* 6. >. NNNNNNNNNNNNNNNNNNNNNNNNNNNN NNNNNNNNNNNNNNNNNNNNNNNNNNNN.. NNNNNNNNNNNNNNNNNNNNNNNNNNNN..

2eproduce the diagram the structure of 1F'4. Cist the items a monitoring regulatory body should find on visiting a firm. )1* NNNNNNNNNNNNN.. )6* NNNNNNNNN..NNNN. )>* NNNNNNNNNNNNNN )%* NNNNNNNNN.NNNNN )D* NNNNNNNNN.NNNNN 6E

)"* NNNNNNNNN.NNNNN )E* NNNNNNNNNNNNNN.. %. 17's are to be applied in the audit of financial statements. 17's are also to be applied, adapted as necessary, to the audit of other information and to related servicesTrue False

1nternational 'udit and 'ssurance 7tandards Board '77@MBC+ 8ne representative from each member Forum on @thics @lects @ducation 4ommittee 48J;41C 2epresentatives from 1F countries6O year terms @lects (ublic 7ector 4ommittee @P@4JT1K@ 48MM1TT@@ to carry out policy and decisions 1nformation Technology 4ommittee 6F Financial and Management 'ccounting 4ommittee 7T';&1;: T@4H;14'C 48MM1TT@@7

Jses 7maller working groups Membership 4ommittee

@nsure that company audit work is conducted properly and with professional integrity 1nclude rules as to the technical standards of company audit work )e.g following 1nternational 7tandards on 'uditing* @nsure that eligible persons maintain an appropriate level of competence @nsure that all firms eligible under its rules have arrangements to prevent 1ndividuals not holding an appropriate ,ualification (ersons who are not members of the firm from being able to e!ert influence over an audit which would be likely to affect the independence or integrity of the audit

1.; APPOINTMENT AND REMOBAL OF THE AUDITOR 1.;.1

1.0.1.1

THE REGULATION OF AUDITING 2Y LA6 AND ACCOUNTING PROFESSION Na,)ona! !e/e!

The accounting and auditing profession varies in structure from country to country. 1n some countries accountants and auditors are subBect to strict legislative regulation, while in others the profession is allowed to regulate itself. .e cannot look at every country, but some e!amples will show you the divergence of structure and we can make general points.
1.0.1.2

Un),e& K)n'&o*

1n the J< there are a number of different accountancy, or accountancy related, institutes and chartered associations, such as the 'ssociation of 4hartered 4ertified 'ccountants )'44'* or the 4hartered 1nstitute of Management 'ccountants )41M'*. 6G

'll these bodies vary from each other depending on the nature of their aims and the specialisms their members wish to attain. They are all, however, characteri5ed by various attributes 7tringent entrance re,uirement )e!aminations and practical e!perience*, 7trict code of ethics and Technical updating of members.

The membership of all these bodies is scattered through practice, industry, government and public bodies.

1.0.1.;

Fran#e

1n France, the accounting profession is split into two distinct organisations 'ccountants )8rdre des @!perts 4omptables et des 4omptables 'grees* 'uditors )4ompaigne ;ationale des 4ommissaires au! 'grees*

Most members of the auditors/ organisation are also members of the more important accountants/ organisation. @!aminations, work e!perience and articles are similar to those of the J< accountancy bodies. The profession/s main influence is through the issue of non mandatory opinions and recommendations of accounting principles relevant to the implementation of the ;ational (lan.
1.0.1.<

Ger*an-

The main professional body in :ermany is the 1nstitute of 4ertified (ublic 'ccountants )1nstitute der .irtschafstpruter*. Members of this institute carry out all statutory audits, and are re,uired to have very high educational and e!perience ,ualifications. The 1nstitute issues a form of auditing standard but this is cited very closely to legislation. 's well as auditing, members are mainly involved in ta! and business management, with no obvious significant role in establishing financial accounting principles and practices. There is no independent accounting standard setting body.
1.0.1.=

USA

1n 'merica, accountants are members of the 1nstitute of 4ertified (ublic 'ccountants )'14('*, a private sector body. 'lthough the 7ecurities and @!change 4ommission in the J7' can prescribe accounting standards for listed companies, it relies on the Financial 'ccounting 7tandards Board )F'7B*, an independent body, to set such standards. 1n turn, F'7B keeps in close contact with the '14(', which issues guidance on J7 standards and which is closely involved in their development.

>#

1t can be seen from the above paragraphs that the accounting and auditing profession in most .estern 4ountries is regulated by legislation to some e!tent. 1n the J< and the J7' the profession effectively regulates itself, i.e. regulation is devolved from statute to the private bodies involved in the accountancy profession. 1n many @uropean countries, statutory control by government is much more direct.

1.0.1.>

:"es,)on: Re'"!a,or- Fra*e%or$

1nvestigate the regulatory framework surrounding the accounting and auditing profession in your country.

1.0.1.@

EC *e* er s,a,es

(ersons carrying out audits in @4 member states must have the permission of the relevant authorities. 1n the J< the relevant authorities are Re#o'n)Ce& S"+er/)sor- 2o&)es )27Bs*. 's well as giving authority, 27Bs in Britain supervise and monitor auditors. 1n other countries however, supervising and monitoring is carried out by a state body or by the national government.
1.0.1.A

In,erna,)ona! !e/e!

2egulations governing auditors will, in most countries, be most important at the national level. 1nternational regulation, however, can play a maBor part by)a* )b* )c* 7etting *)n)*"* s,an&ar&s and re?")re*en,s for auditors. (roviding guidance for those countries without a %e!!4&e/e!o+e& na,)ona! re'"!a,or- 1ra*e%or$. 'iding intra country recognition of professional accountancy ,ualifications

In,erna,)ona! Fe&era,)on o1 A##o"n,an,s 8IFAC9 1F'4 came into being in the 1GE#s as a result of proposals put forward and eventually approved by the 1nternational 4ongress of 'ccountants. 1F'4/s mission is &"he development and enhancement of the profession to enable it to provide services of consistently high quality in the public interest. 1F'4, based in ;ew +ork, is a non profit, non governmental, non political international organisation of accountancy bodies. The '44' is a member of 1F'4.

>1

1F'4 co operates with member bodies, regional organisations of accountancy bodies and other world organisations. Through such co operation, 1F'4 initiates, co ordinates and guides efforts to achieve international technical, ethical and educational pronouncements for the accountancy profession. 'ny accountancy body may Boin 1F'4 if it is recogni5ed by law or general consensus within its own country as a substantial national organisation of good standing within the accountancy profession. Members of 1F'4 automatically become members of the 1nternational 'ccounting 7tandards 4ommittee )1'74*. .e can show 1F'4/s structure in a diagram, show below.
1.0.1.D

In,erna,)ona! A"&), an& Ass"ran#e S,an&ar&s 2oar&

+ou will be most concerned with the 1''7B because it sets 1nternational standards on 'uditing, which we will look at in 7ection %. @ach country which has a member on the 4ommittee has one vote. The affirmative vote of at least three ,uarters of the countries but not less than ten, represented at a meeting, are re,uired to approve a proposed pronouncement for e!posure or a definitive pronouncement for issue. Re'"!a,)on( *on),or)n' an& s"+er/)s)on @ach country/s regulation of e!ternal audits will differ. Most regimes do have certain common elements, which we e!amine in detail below. Briefly these are as follows)a* )b* )c* E&"#a,)on an& %or$ e5+er)en#e- the 1F'4 has issued guidance on this. E!)') )!),-- there may well be statutory rules determining who act as auditors. Membership of an appropriate body is likely to be one criteria. S"+er/)s)on an& *on),or)n'- these activities have come under particular scrutiny in a number of countries during the 1GG#s. Muestions have been asked about why auditors have failed to identify impending corporate failures and whether therefore they are being regulated strongly enough. The supervision regime has come under particular scrutiny in countries where regulation and supervision is by the a"&),ors3 own professional body )7elf regulation*. 7uggestions have been made in these countries that supervision ought to be by e!ternal government agencies.

E&"#a,)on( e5a*)na,)ons an& e5+er)en#e 1F'4 issued the 7tatement of (olicy of 4ouncil 2ecognition o1 Pro1ess)ona! A##o"n,an#- :"a!)1)#a,)ons primarily to tackle the problems of intra country recognition of ,ualifications. 1t sets minimum standards for accountancy ,ualifications. 1t looks at three main areas. E&"#a,)on >6

The theoretical knowledge to be contained in the body of knowledge of accountants should include at least the following subBects1.0.1.D.1

Co*+"!sor$no%!e&'e

'nalysis and critical assessment of financial statements 'udit 4onsolidated accounts 4ost and management accounting :eneral accounting 1nternal control systems Cegal and professional re,uirements relating to audit3accountancy 7tandards relating to financial statements )n#!"&e& Basic principles of the financial management of undertakings Business, general and financial economics 4ivil and commercial law 1nformation technology and systems Caw of insolvency and similar procedures Mathematics and statistics (rovision of financial services, advice, etc (rofessional conduct and ethics 7ocial security and law of employment Ta! law

Kno%!e&'e ,o %0ere re!e/an,

'ccountants should have covered these subBects in a breadth and depth sufficient to enable them to perform duties to the e!pected standard. E5a*)na,)ons 'ccountants should demonstrate that they have passed an e!amination of professional competence. This e!amination must assess not only the necessary level of theoretical knowledge but also the ability to use that knowledge competently in a practical situation. 8bBective evaluation of professional e!aminations is a key re,uirement. E5+er)en#e 1t is crucial to any professional to have not only a sound theoretical knowledge but also be able to apply that knowledge competently in the world of work. 1t is suggested that, prior to ,ualification, an individual should have completed a minimum of two years approved and properly supervised practical e!perience primarily in the area of audit and accountancy and in a suitable professional environment. >>

E!)') )!),-E)ne!)') )!),@ligibility to act as an auditor is likely to arise from membership of some kind of regulatory body. Bodies of this type offer ,ualifications and set up rules to ensure compliance with any statutory re,uirements related to auditors. 1n this way national governments will control who may act as an auditor to limited liability companies, or to any other body re,uiring a statutory audit. 1n some countries, regulation is devolved onto professional accountant bodies like the '44' by the statutory authorities, e.g. in the J<. 8n the other hand, the regulatory body could be a direct e!tension of national government. The regulatory body should have rules to ensure that those eligible for appointment as a company auditor are either In&)/)&"a!s holding an a++ro+r)a,e ?"a!)1)#a,)on or F)r*s #on,ro!!e& by ?"a!)1)e& +ersons

2egulatory bodies should also have procedures to maintain competence of members. The regulatory body/s rules should @nsure that only 1), an& +ro+er persons are appointed as company auditors @nsure that company audit work is conducted +ro+er!- and with +ro1ess)ona! )n,e'r),-. 1nclude rules as to be ,e#0n)#a! s,an&ar&s of company audit work )e.g. following 1nternational 7tandards on 'uditing* @nsure that e!)') !e +ersons maintain an appropriate level of competence @nsure that all firms eligible under its rules have arrangements to prevento 1ndividuals not holding an a++ro+r)a,e ?"a!)1)#a,)on

o (ersons who are no, *e* ers of the firm being able to e!ert influence over an audit, which would be likely to affect the independence or integrity of the audit. The regulatory body/s rules should provide for ade,uate monitoring and enforcement of compliance with its rules and should include provisions relating to A&*)ss)on an& e5+"!s)on of members

>%

In/es,)'a,)on o1 #o*+!a)n,s against members Co*+"!sor- +ro1ess)ona! )n&e*n),- insurance

Jp to date lists of approved auditors and their names and addresses should be maintained by the regulatory body. This register of auditors should be made available to the public. Membership of a regulatory body is the main prere,uisite for eligibility as an auditor. 7ome countries allow a ?firm/ to be appointed as a company auditor. ' firm may be either a body corporate )such as company* or a partnership. ' person should be ineligible for appointment as a company auditor if he3she is 'n o11)#er or e*+!o-ee of the company ' +ar,ner or e*+!o-ee of such a person ' +ar,ners0)+ in which such a person is a partner

There may be further rules about connections between the company or its officers and the auditor depending on local statutory rules. :"es,)on: E!)') )!),- as a"&),or 1n your country, are the following dis,ualified from acting as auditor to a company0 )a* ' shareholder of the company )b* ' debtor or creditor of the company )c* ' close relative )such as a husband, wife, son, or daughter* of an officer or employee of the company. Ans%er +ou may find that the regulations of accountancy bodies such as '44' and H14' applying to their own members are stricter than local statute in this respect. 1f during their term of office a company auditor becomes ineligible for appointment to the office, he should vacate office and give notice to the company. 1f an audit is carried out by an auditor who was eligible, the authorities may re,uire a second audit, or review of the first audit, to be conducted by an eligible person. 1n such a case, the company may be able to recover the costs of complying from the ineligible auditor. S"+er/)sor- an& *on),or)n' ro!es >D

7ome kind of supervision and monitoring regime should be implemented by the regulatory body. This should inspect auditors on a regular basis. The fre,uency of inspection will depend on the number of partners, number of offices and number of listed company auditors )these factors may also be reflected in the si5e of annual registration fees payable by approved audit firms*. The following features should be apparent in each practice visited by the monitoring regulatory body)a* )b* ' +ro+er!- s,r"#,"re& a"&), a++roa#0, suitable for the range of clients served and work undertaken by the practice. Care1"!!- )ns,),",e& ?"a!),- #on,ro! +ro#e&"res , revised and updated constantly, to which the practice as a whole is committed. These will include )c* )d* )e* )f* )g* 7taff recruitment 7taff training 4ontinuing professional development Fre,uent ,uality control review

4ommitment to ethical guidelines, with an emphasis on independence issues 'n emphasis on technical e!cellence 'dherence to the ?fit and proper/ criteria by checking personnel records and reference Jse of internal and, if necessary, e!ternal peer reviews, consultations etc 'ppropriate fee charging per audit assignment

Le'a! re?")re*en,s on a++o)n,*en, ,o a #o*+an- a"&), The auditors should be appointed by shareholders and therefore be answerable to the shareholders. The table below shows what the position should ideally beRIGHTS OF APPOINTMENT Members 'ppoint auditors at each 'enera! *ee,)n' where accounts are laid by +os),)/e reso!",)on )re appointment of e!isting auditor not automatic* 'uditors hold office until conclusion of ne!t general meeting at which accounts are laid. &irectors 4an appoint auditor)a* Before company/s 1)rs, 'enera! *ee,)n' at which accounts are laidA auditors hold office until conclusion of that meeting >"

)b* To fill #as"a! /a#an#-

7ecretary of 7tate

4an appoint auditors if no others are appointed or reappointed at general meeting at which accounts are laid.

Special notice of appointment 1n certain cases relating to appointment of an auditor reasonable notice is re,uired for the appropriate resolutions at a general meeting.

.hen

'ppoint auditor other than retiring auditor

To fill casual vacancy

To re appoint retiring auditor who appointed to fill 4asual vacancy

SPECIAL NOTICE RE:UIRED

.ho sent to

(erson whom intended to appoint 2etiring auditor

'uditor who resigned, if casual vacancy caused by resignation

Re*"nera,)on The remuneration of the auditors, which will include any sums paid by the company in respect of the auditors/ e!penses, will be fi!ed either by %0oe/er *a&e the a++o)n,*en, or in s"#0 *anner as the #o*+an- )n 'enera! *ee,)n' may determine.

>E

Though the auditors/ remuneration is fi!ed, in many countries it must be disclosed in the annual accounts of the company. Le'a! re?")re*en, a, ,0e en& o1 an a"&), re!a,)ons0)+ +ou will have legal re,uirement for resignation and removal of auditors in your studies for +a+er 2.2 Cor+ora,e an& 2"s)ness La%. However, it is relevant to revise them briefly here. 1t is important that auditors know the procedures because as part of their client acceptance, they have a duty to ensure the old auditors were properly removed from office.

RESIGNATION OF AUDITORS 1 2esignation procedures 'uditors deposit written notice together with s,a,e*en, o1 #)r#"*s,an#es relevant to members3creditors or statement that no circumstances e!ist 7ent by #o*+an- to regulatory authority 7ent by)a* 'uditors to regulatory authority )b* 4ompany to everyone entitled to receive a copy of accounts %. 4onvening of general meeting A"&),ors can re?")re &)re#,ors to call e!traordinary general meeting to discuss circumstances of resignation &irectors must send out notice for meeting within 21 &a-s of having received re,uisition by auditors D 7tatement prior to general meeting A"&),ors may re,uire company to circulate )different* s,a,e*en, o1 #)r#"*s,an#es to everyone entitled to notice of meeting >F

6. ;otice of resignation >. 7tatement of circumstance

" 8ther right of auditors

4an re#e)/e a!! no,)#es that relate to)a* ' general meeting at which their term of office would have e!pired )b* ' general meeting where casual vacancy caused by their resignation to be filled 4an s+ea$ at these meetings on an- *a,,er which #on#erns ,0e* as a"&),ors.

TENDERING AND O2TAINING 6ORK 7tatement >- 'dvertising, (ublicity and 8btaining (rofessional .ork :uidance is given as follows. )a* )b* )c* )d* )e*
2

Members should not obtain or seek work in an unprofessional manner. Members can advertise but should have regard to relevant advertising codes and standards. Members should not make disparaging references to or comparisons with the services of others Members should not ,uote fees without great care to not mislead as to the precise range of services and time commitment that fees are intended to cover, but they can offer free consultations to discuss level of fees. ;o fees, commission or reward should be given to third parties in return for the introduction of clients.

FEE NEGOTIATION AND LO62ALLING The audit fee is a sensitive subBect for most companies. 1t presents a cost for something the company often does not really want and the fees may be perceived as too high Bust for this reason. The auditors must ensure that they can provide a ,uality audit for the price.

TENDERING Many large companies invite tenders for their audit work. The directors then have the opportunity to compare directly a range of offers. >G

:enerally, a tender will take the form of detailed written proposals and a presentation. Factors include The level of e!pertise each firm has in the industry 7imilar companies audited by each firm )good for e!pertise, bad for confidentiality0* ;ational and international presence The proposed fee

'udit firms which tender for such audits will usually give at least an indication of the level of fees in the ne!t few years, including likely overall rate rises. Fee levels are very important to most companies, and are often the determining factor. 1n all situations, the auditors should ,uote a fee based on the estimated hours worked by each member of staff re,uired on the audit, multiplied by the hourly rate plus any travel as other e!penses to be incurred during the audit. They may also charge a premium for more comple! audits. LOWBALLING 7ometimes it appears that firms are charging less than ?market rate/ for an audit, especially when tendering for new clients. This practice is known as C8.B'CC1;:. 1t is not considered ethically wrong to charge a low price for an audit in itself. However, the auditors must ensure that they carry out an audit of high ,uality demanded by auditing standards and must ensure that the ?cut price/ audit fee does not call their independence into ,uestion. This is always going to be a topical debate but in terms of negotiating the audit fee the following factors need to be taken into account. )a* )b* The audit is perceived to have a fluctuating ?market price/ as any other commodity or service. 4ompanies can reduce e!ternal audit costs through various legitimate measures )c* @!tending the si5e and function of internal audit 2educing the number of different audit firms used world wide 7elling off subsidiary companies leaving a simplified groups structure to audit The tender process itself simply make auditors more competitive @!change rate fluctuations in audit fees.

'uditing firms have increased productivity, partly through the use of more sophisticated information technology techni,ues in auditing.

%#

1n any case, an auditing firm lays itself open to accusations of loss of independence if it reduces its fees to below a certain level, particularly it is difficult to see how such fees will cover direct labour costs. This is also true of firms which use the audit as a ?loss leader/ to obtain profitable consultancy work from audit clients. .hen such non audit services are offered to a client by the auditors, there can, of course, be an apparent loss of independence. The allegation may arise that the price of an ?acceptable/ audit opinion is lucrative ta!ation or consulting work.

FRAUD AND ERROR Many of the high risk factors listed are issues, which could potentially result in a high risk of fraud and error arising. 7ignificant control weaknesses Muestionable integrity &oubtful accounting policies Cack of finance director Jne!plained transactions Fraud is an emotive issue. 1f news of a maBor fraud on a company hits the headlines, the ,uestion that is often asked is ?how did this happen0/ 1nvariably when ,uestions like that are asked, people raise ,uestions about the audit that has taken place on that company/s financial statements. ' maBor problem for the auditor can be that the public does not understand the auditors role with regard to fraud. This forms part of and e!pectations gap/ which e!ists between what auditors actually do and what people think that they do. .e are going to briefly consider here what the auditors/ role in relation to fraud and error, and consider when the risk of fraud and error arising is too great for the auditor to accept the engagement. %1 F2'J&0

ISA 2<0 1ra"& an& error ISA 2<0.20 1n planning the audit, the auditors should discuss with other member of the audit team the susceptibility of the entity to material misstatements in the financial statement resulting from fraud and error. The sentence from 17' 6%# given above summarises the auditors/ professional re,uirements in relation to fraud and error- they must recogni5e that it may e!ist and materially affect the financial statements. The most important thing to understand with regard to fraud is that the auditor has no duty )specifically no statutory duty* to prevent or detect fraud. .ith regard to the statutory audit, the auditor must be aware that two potential causes of the financial statements being misstated are fraud or error e!isting.

KEY TERMS Fraud comprises both the use of deception to obtain an unBust or illegal financial advantage, and intentional misrepresentation by management, employees or third parties. @rror is an unintentional mistake. 1.;.@ EFAMPLES Fraud may involve Falsification or alteration of accounting records or other documents Misappropriation of assets or theft 7uppression or omission of the effects of transactions from records of documents 2ecording of transactions without substance 1nternational misapplication of accounting policies, or .ilful misrepresentations of transactions or the entity/s state of affairs

.hat this list of ?fraudulent behaviour/ might help you to see is that the detection of fraud committed by management is going to be e!tremely difficult because it is designed not to be found. (articularly where the fraud is fraud by omission, the auditor is unlikely to detect fraud as part of an audit. %6

The standard does not e!pect the auditors to detect fraud as a matter of course. 2ather, it re,uires auditors to be aware, when planning and performing their audit, that fraud may e!ist, and more particularly, it highlights a number of factors which the auditor should be alert to, which could point to fraud being perpetrated. P!ann)n' 17' 6%#.66 .hen planning the audit, the auditor should make in,uiries of management)a* to obtain an understanding of)i* management/s assessment of the risk that the financial statements may be materially misstated as a result of fraudA and )ii* the accounting and internal control systems management has put in place to address such riskA to obtain knowledge of management/s understanding regarding the accounting and internal control systems in place to prevent and detect errorA to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigatingA and to determine whether management has discovered the material errors.

)b* )c* )c*

17' 6%#.>6 .hen assessing inherent risk and control risk in accordance with 17' %##, 2isk 'ssessments and 1nternal 4ontrol, the auditor should consider how the financial statements might be materially misstated as a result of fraud or error. 1n considering the risk of material misstatement resulting from fraud, the auditor should consider whether fraud risk factors are presented that indicate the possibility of either fraudulent financial reporting or misappropriation of assets. The factors which may indicate fraud or error are given in an appendi! to the 17', which is reproduced hereFraud and 2isk 2elating to Misstatements 2esulting from Fraudulent Financial 2eporting 1 Fra"& R)s$ These fraud risk factors pertain to management/s abilities, Fa#,ors pressures, style, and attitude relating to internal control and Re!a,)n' ,o the financial reporting process. Mana'e*en,3s C0ara#,er)s,)#s There is motivation for management to engage in an& In1!"en#e fraudulent financial reporting. 7pecific indicators o/er ,0e might include the followingCon,ro! o ' significant portion of management/s En/)ron*en, compensation is represented by bonuses, stock options or other incentives, the value of which %>

is contingent upon the entity achieving unduly aggressive targets for operating results, financial position or cash flow. o There is e!cessive interest by management in maintaining or increasing the entity/s stock price or earnings trend through the use of unusually aggressive accounting practices. o Management commits to analysts, creditors and other third parties to achieving what appear to be unduly aggressive or clearly unrealistic forecasts. o Management has an interest in pursuing inappropriate means to minimi5e reported earnings for ta! motivated reasons. There is a failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. 7pecific indicators might include the followingo Management does not effectively communicate and support the entity/s values or ethics, or management communicates inappropriate values or ethics. o Management is dominated by a single person or a small group without compensating controls such as effective oversight by those charged with governance. o Management does not monitor significant controls ade,uately. o Management fails to correct known material weaknesses in internal control on a timely basis. o Management sets unduly aggressive financial targets and e!pectations for operating personnel. o Management continues to employ ineffective accounting, information technology or internal auditing staff. ;on financial management participates e!cessively in, or is preoccupied with, the selection of accounting principles or the determination of significant estimates. There is a high turnover of management, counsel or board members. There is a strained relationship between management and the current or predecessor auditor. 7pecific %%

indicators might include the followingo Fre,uent disputes with the current or a predecessor auditor on accounting, auditing or reporting matters. o Jnreasonable demands on the auditor, including unreasonable time constraints regarding the completion of the audit or the issuance of the auditor/s report. o Formal or informal restrictions on the auditor that inappropriately limit the auditor/s access to people or information, or limit the auditor/s ability to communicate effectively with those charged with governance. o &omineering management behaviour in dealing with the auditor, especially involving attempts to influence the scope of the auditor/s work. There is a history of securities law violations, or claims against the entity or its management alleging fraud or violations of securities laws. The corporate governance structure is weak or ineffective, which may be evidenced by, for e!ampleo ' lack of members who are independent of management. o Cittle attention being paid to financial reporting matters and to the accounting and internal control systems by those charged with governance. 6 Fra"& R)s$ These fraud risk factors involve the economic and Fa#,ors regulatory environment in which the entity operates. Re!a,)n' ,o ;ew accounting, statutory or regulatory re,uirements In&"s,rthat could impair the financial stability or profitability Con&),)ons of the entity. ' high degree of competition or market saturation, accompanied by declining margins. .ith increasing business failures and significant declines in customer 2apid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence. Fra"& R)s$ These fraud risk factors pertain to the nature and Fa#,ors comple!ity of the entity and its transactions, the entity/s Re!a,)n' ,o financial condition, and its profitability. %D

>

O+era,)n' C0ara#,er)s,)#s an& F)nan#)a! S,a )!),

1nability to generate cash flows from operations while reporting earnings and earnings growth. 7ignificant pressure to obtain additional capital necessary to stay competitive, considering the financial position of the entity )including a need for funds to finance maBor research and development or capital e!penditures*. 'ssets, liabilities, revenues or e!penses based on significant estimates that involve unusually subBective Budgements or uncertainties, or that are subBect to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity )for e!ample, the ultimate collectibility of receivables, the timing of revenue recognition, the reliability of financial instruments based on highly subBective valuation of collateral or difficult to assess repayment sources, or a significant deferral of costs*. 7ignificant related party transactions which are not in the ordinary course of business. 7ignificant related party transactions which are not audited or are audited by another firm. 7ignificant, unusual or highly comple! transactions )especially those close to year end* that pose difficult ,uestions concerning substance over form. 7ignificant bank accounts or subsidiary or branch operations in ta! haven Burisdictions for which there appears to be no clear business Bustification. 'n overly comple! organi5ational structure involving numerous of unusual legal entities, managerial lines of authority or contractual arrangements without apparent business purpose. &ifficulty in determining the organisation or person )or persons* controlling the entity. Jnusually rapid growth or profitability especially compared with that of other companies in the same industry. @specially high vulnerability to changes in interest rates. Jnusually high dependence on debt, a marginal ability to meet debt repayment re,uirements, or debt covenants that are difficult to maintain. Jnrealistically aggressive sales or profitability incentive programs. ' threat of imminent bankruptcy, foreclosure or hostile takeover. %"

'dverse conse,uences on significant pending transactions )such as a business combinations or contract award* if poor financial results are reported. ' poor or deteriorating financial position when management has personally guaranteed significant debts of the entity.

Fraud and 2isk Factors 2elating to Misstatements 2esulting from Misappropriation of 'ssets 1 Fraud 2isk These fraud risk factors pertain to the nature of an entity/s Fa#,ors assets ad the degree to which they are subBect to theft. Re!a,)n' ,o S"s#e+,) )!), Carge amounts of cash on hand or processed. o1 Asse,s ,o 1nventory characteristics, such as small si5e combined M)sa++ro+r) with high value and high demand. a,)on @asily convertible assets, such as bearer bonds, diamonds or computer chips. Fi!ed asset characteristics, such as small si5e combined with marketability and lack of ownership identification. 6 Fra"& R)s$ These fraud risk factors involve the lack of controls designed Fa#,ors to prevent or detect misappropriation of assets. Re!a,)n' ,o Con,ro!s Cack of appropriate management oversight )for e!ample, inade,uate supervision or inade,uate monitoring of remote locations*. Cack of procedures to screen Bob applicants for positions where employees have access to assets susceptible to misappropriation. 1nade,uate record keeping for assets susceptible to misappropriation. Cack of an appropriate segregation of duties or independent checks. Cack of an appropriate system of authori5ation and approval of transactions )for e!ample, in purchasing*. (oor physical safeguards over cash, investments, inventory or fi!ed assets. Cack of timely and appropriate documentation for transactions )for e!ample, credits for merchandise returns*. Cack of mandatory vacations for employees performing key control functionsA

%E

'uditors are therefore ?put on en,uiry/ when such factors e!ist L in other words, they have a professional duty to satisfy themselves that any concerns raised have been answered to their satisfaction. .hen fraud or error are indicated 17' 6%#.>G Based on the auditor/s assessment on inherent and control risks )including the results of any tests of controls*, that misstatements resulting from fraud and error that are material to the financial statements taken as a whole will not be detected. 1n designing the substantive procedures, the auditor should address the fraud risk factors that the auditor has identified as being present. 17' 6%#.%6 .hen the auditor encounters circumstances that may indicate that there is a material misstatement in the financial statements resulting from fraud or error, the auditor should perform procedures to determine whether the financial statements are materially misstated. 17' 6%#.%" .hen the auditor identifies a misstatement, the auditor should consider whether such a misstatement may be indicative of fraud and if there is such an indication, the auditor should consider the implications of the misstatement in relation to other aspects of the audit, particularly the reliability of management representations. 17' 6%#.%F .hen the auditor confirms that, or is unable to conclude whether, the financial statements are materially misstated as a result of fraud or error, the auditor should consider the implications for the audit. 17' 6%#.D1 The auditor should obtain written representations from management that)a* 1t acknowledges its responsibility for the implementation and operations of accounting and internal control systems that are designed to prevent and detect fraud and errorA 1t believes the effects of those uncorrected financial statement misstatements aggregated by the auditor during the audit are immaterial, both individually and in the aggregate, to the financial statements taken as %F

)b*

)c*

a whole. ' summary of such items should be included in or attached to the written representationA 1t has disclosed to the auditor all significant facts relating to its assessment of the risk that the financial statements may be materially misstated as a result of fraud. 1t has disclosed to the auditor the results of its assessment of the risk that the financial statements may be materially misstated as a result of fraud.

)d*

Re+or,)n' Castly the 17' goes on to consider what the auditors should do, or rather, to whom they should report, in the event of them uncovering a fraud. 2emember that, as you learnt in before, the auditors have a professional duty of confidentiality. 17' 6%#.D" .hen the auditor identifies a misstatement resulting from fraud, or a suspected fraud, or error the auditor should consider the auditor/s responsibility to communicate that information to management, those charged with governance and, in some circumstances, to regulatory and enforcement authorities. 7uch a discovery might also have an impact on the audit report

POINT TO NOTE .e shall consider the audit report in chapter 1G. 1f auditors do detect a management fraud, they may consider it to be so serious that it is necessary to report it to the relevant authority in the public interest. 7uch a decision would not be taken lightly, and should only be taken once legal advice had been sought. The auditors have a duty of confidentiality, but in e!ceptional circumstances, where the matter is one of public interest, they may have to make such a disclosure. 17' 6%#.DG3"#3"6 1f the auditor has identified a material misstatement resulting from error, the auditor should communicate the misstatement to the appropriate level of management on a timely basis, and consider the need to report it to those charged with governance in accordance with 17' 6"#. ?4ommunication of audit Matters with Those 4harged with :overnance/.

%G

The auditor should inform those charged with governance of those uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole. T0e a"&),ors )a* )b* identified fraud, whether or not it results in a material misstatement in the financial statementsA or obtained evidence that indicates that fraud may e!ist )even if the potential effect on the financial statements would not be material*.

The auditor should communicate these matters to the appropriate level of management on a timely basis and consider the need to report such mattes to those charged with governance in accordance with 17' 6"#, ?4ommunication of 'udit Matters with Those 4harged with :overnance/ 17' 6%#."G3E> 1f the auditor concludes that it is not possible to continue performing the audit as a result of a misstatement resulting from fraud or suspected fraud, the auditor should)a* )b* )c* 4onsider the professional and legal responsibilities applicable in the circumstances, including whether there is a re,uirement for the auditor to report the person or persons who made the misstatements 4onsider the possibility of withdrawing from the engagement and 1f the auditor withdraws)i* )ii* discuss with the appropriate level of management and those charged with governance the auditor/s withdrawal from the engagement and the reasons for the withdrawal, and consider whether there is a professional or legal re,uirement to report to the persons who made the audit appointment or in some cases, to regulatory authorities, the auditor/s withdrawal from the engagement and the reasons for the withdrawal

's stated in the ?4ode of @thics for (rofessional 'ccountants/ issued by the international Federation of 'ccountants )the code*, on receipt of an in,uiry from a proposed successor auditor, the e!isting auditor should advise whether there are any professional reasons why the proposed successor auditor should not accept the appointment. 1f the client denies the e!isting auditor permission to discuss its affairs with the proposed successor auditor or limits what the e!isting auditor may say, the fact should be disclosed to the proposed successor auditor. Fra"& an& a"&), a##e+,an#e D#

7everal issues have been raised here from the point of view of the audit firm 'uditors should plan and perform procedures whilst being aware that fraud may e!ist Fraud, however, may be e!tremely difficult to discover 'uditors must satisfy themselves if put on en,uiry 1f the auditors detect or suspect fraud, they must consider whether it is in the public interest to report it, having sought legal advice. Fraud is an emotive issue, which may bring bad publicity to the firm, deserved or not

4ast your mind back to the high risk factors which were identified before. 1t might be that an audit firm would choose not accept a client which was identified as high risk at the outset, because the chances of conducting a cost effective audit which fulfils professional re,uirements might be too low, even if the indicators were false, and there was no fraud being perpetrated at the company. 1.>.16 LA6 AND REGULATIONS 'nother issue raised by the risk factors on page G1 is the issue of the auditors/ consideration of law and regulation. This issue has two aspects 'reas of non compliance where the matter may materially affect the financial statements 'reas where the auditors could unwittingly become liable for failing to report matters arising, for e!ample, money laundering.

The auditing standard approaches this issue in a similar way to the standard on fraud and error. 1f an engagement letter is not sent to clients, both new and e!isting, there is scope for argument about the precise e!tent to the respective obligations of the client and its directors and the auditors. The contents of an engagement letter should be discussed and agreed with management before it is sent. :uidance is available in the form of 17' 61#, Terms of audit engagements. 17' 61#.6 The auditor and the client should agree on the terms of the engagement. 8bviously the agreed terms should be in writing and the usual form would be a letter of engagement. 'ny other form of appropriate contract, however, may be used.

D1

The 17' applies to audit engagements only, although the guidance may be used for related servicesA a distinction should be made between audit and non audit letters. @ven in countries where the audit obBectives and scope and the auditor/s obligations are established by law, an audit engagement letter may be informative for clients.

LETTER OF ENGAGEMENT The auditors should send an engagement letter to all new clients soon after their appointment as auditors and, in any event, before the commencement of the first audit assignment. They should also consider sending an engagement letter to e!isting clients to whom no letter has previously been sent as soon as a suitable opportunity presents itself. 'n e!ample of a letter of engagement, given by 17' 61#, is reproduced below. The form and content of audit engagement letter may vary for each client, but they would generally include reference to the following. )a* )b* )c* )d* )e* The obBective of the audit of financial statements Management/s responsibility for the financial statements The scope of the audit, including reference to applicable legislation, regulations, or pronouncements of professional bodies to which the auditor adheres The form of any reports or other communication of results of the engagement The fact that because of the test nature and other inherent limitations of an audit, together with the inherent limitations of an audit, together with the inherent limitations of any accounting and internal control system, there is an unavoidable risk that even some material misstatement may remain undiscovered. Jnrestricted access to whatever records, documentation and other information re,uested in connection with the audit.

)f*

The auditor may wish to include in the letter the following items. 'rrangements regarding the planning of the audit @!pectation of receiving from management written confirmation of representations made in connection with the audit. 2e,uest for the client to confirm the terms of the engagement by acknowledging receipt of the engagement letter. &escription of any other letters or reports the auditor e!pects to issue to the client Basis on which fees are computed and any billing arrangements

.hen relevant, the following points could also be made. D6

'rrangements concerning the involvement of other auditors and e!perts in some aspects of the audit. 'rrangements concerning the involvement of internal auditors and other client staff 'rrangements to be made with the (redecessor auditor, if any, in the case of an initial audit 'ny restriction of the auditor/s liability when such possibility e!ists. ' reference to any further agreements between the auditor and the client.

Re#"rr)n' a"&),s 17' 61#.1# 8n recurring audits, the auditor should consider whether circumstances re,uire the terms of the engagement to be revised and whether there is a need to remind the client of the e!isting terms of the engagement. 8nce it has been agreed by the client, an engagement letter will, if it so provides, remain effective from one audit appointment to another until it is replaced. However, the engagement letter should be reviewed annually to ensure that it continues to reflect the client/s circumstances. The 17' suggests that the following factors may make the agreement of a new letter appropriate. 'ny indication that the client misunderstands the obBective and scope of the audit 'ny revised or special terms of the engagement ' recent change of senior management, board of directors or ownership committee ' significant change in the nature or si5e of the client/s business Cegal re,uirements

'cceptance of a change in engagement 17' 61#.16 'n auditor who, before the completion of the engagement, is re,uested to change the engagement to one which provides a lower level of assurance, should consider the appropriateness of doing so. 1n the case of a change in the terms of engagement prior to completion, this may result from)a* ' change in circumstances affecting the need for the service

D>

)b* )c*

' misunderstanding as to the nature of an audit or of the related service originally re,uested ' restriction on the scope of the engagement, whether imposed by management or caused by circumstances

The auditors should consider such a re,uest for change, and the reason for it, very seriously, particularly in terms of any restriction in the scope of the engagement. 1n the case of )a* and )b* above, these would normally be acceptable reasons for re,uesting a change in the engagement. ' change would not be considered reasonable, however, if it seemed to relate to information that is incorrect, incomplete or otherwise unsatisfactory. 1n addition to the above, an auditor engaged to perform an audit in accordance with 17's must consider any legal or contractual implications of the change. The audit report issued after such a change has been agreed )and the relevant audit work carried out* should be appropriate to the revised terms of engagement. 7uch an audit report should not include reference to The original engagement 'ny procedures performed under the original engagement

17' 61#.1E 1G .here the terms of the engagement are changed, the auditor and the client should agree on the new terms. The auditor should not agree to a change of engagement where there is no reasonable Bustification for doing so. 1f the auditor is unable to agree to a change of the engagement and is not permitted to continue the original engagement, the auditor should withdraw and consider whether there is any obligation, either contractual or otherwise, to report to other parties, such as the board of directors of shareholders, the circumstances necessitating the withdrawal. The standard gives an e!ample of where an auditor should not agree to a change of engagementA where the auditor is unable to obtain sufficient appropriate audit evidence regarding receivables and the client asks for the engagement to be changed to a review engagement to avoid a ,ualified audit opinion or a disclaimer of opinion.
<

EFAMPLE OF AUDIT ENGAGEMENT LETTER

D%

The following letter is for use as a guide in conBunction with the considerations outlined in this 17' and will need to be varied according to individual re,uirements and circumstances. To the board of directors or the appropriate representative of senior management. +ou have re,uested that we audit the balance sheet of NNNNNNNN as of NNNNNN and the related statements of income and cash flows for the year then ending. .e are pleased to confirm our acceptance and our understanding of this engagement by means of this letter. 8ur audit will be made with the obBective of our e!pressing an opinion on the financial statements. .e will conduct our audit in accordance with 1nternational 7tandards on 'uditing )or relevant national standards or practices*. Those 17's re,uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. 'n audit includes e!amining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. 'n audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Because of the test nature and other inherent limitations of an audit, together with the inherent limitations of any accounting and internal control system, there is an unavoidable risk that even some material misstatements may remain undiscovered. 1n addition to our report on the financial statements, we e!pect to provide you with a separate letter concerning any material weaknesses in accounting and internal control systems which come to our notice. .e remind you that the responsibility for the preparation of financial statements including ade,uate disclosure is that of the management of the company. This includes the maintenance of ade,uate accounting records and internal controls, the selection and application of accounting policies, and the safeguarding of the assets of the company. 's part of our audit process, we will re,uest from management the confirmation concerning representations made to us in connection with the audit. .e look forward to full cooperation with your staff and we trust that they will make available to us whatever records, documentation and other information are re,uested in connection with our audit. 8ur fees, which will be billed as work progresses, are based on the time re,uired by the individuals assigned to the engagement plus out of pocket e!penses. 1ndividual hourly rates vary according to the degree of responsibility involved and the e!perience and skill re,uired. This letter will be effective for future years unless it is terminated, amended or superseded. (lease sign and return the attached copy of this letter to indicate that it is in DD

accordance with your understanding of the arrangements for our audit of the financial statements. P+H Q 4o 'cknowledged on behalf of 'B4 4ompany by )signed* NNNNNNNNNNNN. ;ame and Title &ate

:UESTION: Ne% a"&),ors +ou are a partner in Messrs Borg 4onnors Q 4o. 4ertified 'ccountants. +ou are approached by Mr ;astase, the managing director of ;avratilova @nterprises Ctd, who asks your firm to become auditors of his company. 1n return for giving you this appointment Mr ;astase says that he will e!pect your firm to waive fifty per cent of your normal fee for the first year/s audit. The e!isting auditors, Messrs .ade 'ustin Q 4o have not resigned but Mr ;astase informs you that they will not be re appointed in the future. Re?")re& )a* .hat action should Messrs Borg 4onnors Q 4o take in response to re,uest from Mr ;astase to reduce their first year/s fee by fifty percent0 the

)b* 're Messrs .ade 'ustin Q 4o within their rights in not resigning when they know the client/s wishes to replace them0 :ive reasons for your answer.

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C0a+,er ro"n&"+ 'uditors have guidance from H14' on advertising and obtaining professional work. The most controversial area is often fee setting, with such problems as lowballing. The present and proposed auditors must communicate about the client prior to the audit being accepted. The client must be asked to give permission for this communication to occur. 1f the client refuses to give permission, the proposed auditors must decline nomination. The proposed auditors must also ensure theyo Are +ro1ess)ona!!- ?"a!)1)e& ,o a#, o Ha/e s"11)#)en, reso"r#es o See$ re1eren#es Most firms have client acceptance procedures reviewing the management integrity and risk of the prospective client, as well as the likely profitability of the engagement. 1nvestigations may be carried out for high risk clients Two issues which may be highlighted by risk factors are fraud and error and the auditors/ consideration of law and regulation. These issues can bring such comple!ity to the audit that the audit firm may choose to decline the audit if it appears particularly high risk. 'uditing guidance in these areas re,uires auditors to place and perform their audits so as to have a reasonable chance to detecting problems which cause material misstatements. 1t also sets out the reporting re,uirements in the event of fraud or non compliance being uncovered. 'n engagement letter should be sent to all new clients. The letter shouldo S+e#)1- ,0e res+e#,)/e res+ons) )!),)es o1 &)re#,ors an& ,0e a"&),ors o La- &o%n ,0e s#o+e o1 ,0e a"&),ors3 %or$. 'uditor duties include the duties to report e!plicitly on the truth and fairness of the accounts audited and their compliance with legislation. 'uditors have a duty to report on other mattes, such as whether proper accounting records have been kept by e!ception. 'uditor rights include the rights of access to records and to receive information and e!planations, also rights relating to attendance and speaking at general meetings. 'uditors should be aware of the legal procedures to remove auditors, or when auditors resign.

DE

ANS6ER )a* The re,uest by Mr ;astase that half of the first year/s audit fee should be waived is ,uite improper. 1f this proposal were to be accepted it could be held that Borg 4onnors Q 4o had sought to procure work through the ,uoting of lower fees. This would be unethical and would result in disciplinary proceedings being taken against the firm. 1t should be pointed out to Mr ;astase that the audit fee will be determined, in accordance with normal practice, by reference to the work involved in completion of a satisfactory audit taking into consideration the nature of the audit tasks involved and the level of staff re,uired to carry out those tasks in an efficient manner. Mr. ;astase should further be informed that if he is not prepared to accept an audit fee arrived at in this way and insists on there being reduction then regrettably the nomination to act as auditor will have to be declined. )b* .ade 'ustin Q 4o have every right not to resign even though hey may be aware that Mr. ;astase, the managing director of the company, wishes to replace them. The auditors of a company are appointed by, and report to, the members of a company and the directors are not empowered, as directors, to remove the auditors. 1f the reason for the proposed change arises out of a dispute between management and the auditors then the auditors have a right to put forward their views as seen above and to insist that any decision should be made by the members, but only once they have been made aware of all pertinent issues concerning the directors/ wishes to have them removed from office as auditors.

DF

1.=

CONCEPT OF TRUE AND FAIR BIE6 Learn)n' o .e#,)/es 'fter studying this chapter you should be able to &iscuss the importance of truth and fairness in accountingA @!plain the importance of truth and fairness to the auditorA 2ecognise that truth and fairness can only be interpreted in the conte!t of the financial statements and the organi5ation taken as a whole.

T0e ,r"e an& 1a)r /)e% e5+!a)ne& +ou will have noted from your reading of 4' 1GFD that the directors of limited companies have a duty to prepare accounts that give a true and fair view of its profit or loss for a period and of its state of affairs at a certain date. The e!pression ?true and fair view/ has not been defined by the law but you should note that 4' 1GFD makes it ,uite clear that it is an overriding re,uirement. This means that, should there be any conflict between other re,uirements of the law and the true and fair view re,uirement, then the latter will prevail. 1t is our intention in this chapter to give you an introduction to the concept of truth and fairness, a concept which you will need to understand at all stages of your studies. So*e &)#,)onar- &e1)n),)ons The phrase highlighted above includes three important words. 1t might be useful to consider some dictionary definitions of themTrue4onsistence with fact or reality not fake or erroneous. 'greement with reason, correct principles or recogni5ed standard- real, genuine, correct, and properA not spurious counterfeit, hybrid or merely apparent. =ust, unbiased, e,uitable, legitimate. 7urvey with eyes or mind to form impression or Budgement of.

Fair-

NOTE 6e have highlighted some words we believed will aid understanding. The definition of the word ?view/ clearly suggests that accounts should give an important or Budgement of the company for which they are prepare. 8ur suggestion is that the financial statements should, as far as possible provide the readers with such an impression that they will be able to form a Budgment about the companyDG

's far as the two words ?true and fair/ are concerned, there would appear to be some conflict of meaning in so far as ?true/ seems to imply factual basis and correctness, whereas the definition or ?fair/ places emphasis upon e,uity, Bustness and lack of bias. However, we have to admit that both of the words incorporate subBective notions that make definition difficult. 1n a later section, we shall be looking at an e!ample to give you a feel for the true and fair view practice, but before we do this let us consider some aspects of truth and fairness that we hope will help you to understand the words when used by accountants. I*+or,an, as+e#,s o1 ,r",0 an& 1a)rness First, we can say that the accounts should correspond with reality, that is, they should reflect what is actually happening and the actual state of affairs of the company. 1n other words, if the company is doing badly, we would e!pect that the accounts would reveal this, and if it is doing well, would reveal that also. The accounts should show if a company is e!periencing li,uidity problems, if it is more or less profitable than last year or if there have been abnormal actors which have influenced its fortunes during the year. For instance, if the company has closed down a part of its business during the year and made a material loss in conse,uence, we would e!pect the accounts to disclose the impact of the closure on the profits for the year in such a way as to enable the user to see what the profits from normal continuing trading activities are. NOTE- 'n your financial accounting studies you will cover the treatment in accounts$ required by ((A) *$ of extraordinary items$ exceptional items and prior period ad+ustments. 7econdly, it is the accounts as a whole that must give a true and fair view. The auditor will, for instance, be an!ious to prove that the amount attributable to socks has been properly determined, but it is only in the conte!t of the accounts, taken as a whole, that she will be able to say that the stock figure is ?true and fair/. 's we shall see later, a normal audit procedure would be to compare the stock figure with other figures in the accounts to test that both the stock figure and the other figures appear reasonable in the light of what is known about the company )for instance, comparison of stock with cost of sales to check that stock turnover seems to be acceptable*. 4omparison of gross profit percentages for the current and preceding year can also help the auditor to ?prove/ the stock figure. NOTE: "his topic will be covered in detail in ,hapter -- where we discuss analytical reviews. .e have introduced these ideas briefly in this chapter to show that truth and fairness is to be interpreted in broad terms. Thirdly, the way in which information in accounts is presented has an important bearing on the true and fair view. There is evidence available that suggests it does not matter in what manner information if presented, but it could be argued that "#

this applies only to the sophisticated user L such as the investment analyst group L and not to typical users who may have little knowledge of accounting. NOTE: "he #efficient markets hypothesis%$ which you should have covered in your other studies$ suggests this. Fourthly, it must be said that the preparation of accounts involves the accountant in a whole series of Budgements )1s this stock saleable0 1s this legal claim likely to result in loss to the company0 1s this depreciation method suitable to the circumstances of the company0 1n view of the low profit of an investment company, is it likely that there has been a permanent diminution of value of the investment0 'nd so on.* 1n view of subBectivity of this Budgement process it is really impossible for us to e,uate the ?true and fair view/ with accuracy. The most that we can e!pect is that the accounts are sufficiently accurate to enable the user to make valid decisions. This leads to the suggestion that a set of accounts that did not give a true and fair view would cause the decision maker to behave differently than if truth and fairness e!isted.

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CHAPTER 2.0: AUDIT PLANNING

'udit planning takes place at both the long term )6 D years* and on the short term )annual* levels. .ithin these timeframes, detailed plans need to be developed to cover each individual audit assignment. (lanning is necessary to allocate audit resources )time and audit staff of appropriate technical e!pertise* to the highest risk areas. The audit plan is circulated to management for comment before being sent to the audit committee for approval. 'ny shortfall in audit resources to address risks need to be brought to the attention of the audit committee. Cong term audit planning is based on the obBectives of the organisation, the risk management system in place and the relative risks of each area to be audited. This leads to the prioritisation of each area to be audited and allocation of time )and therefore costs* to each area. The short term or annual plan sets out the areas to be audited over the ne!t 16 months or less with an e!planation as to why those areas were selected and the risks assessed for those areas. ' more detailed plan will involve a month schedule of work to be undertaken by members of the internal audit staff taking into account holidays and other commitments. @ach audit must be carefully planned. This begins with a preliminary survey to obtain background information about the area to be audited, and to Budge the scope and depth of the audit work to be undertaken, based on the comple!ity of the area to be audited. The survey will identify the obBectives, scope and timing of the audit and the audit resources available )staff days, other costs, skills and e!perience* re,uired. The survey will include 2eview of previous internal audit reports and files 4onsideration of changes in the business environment e.g. legislation, board decisions, strategy, competition, computer system changes, reorganisation of departments etc &iscussions with local managers to determine any issues of concern 1dentification of local risks 1dentification of audit obBectives

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The audit plan will also set out Terms of reference for the audit &escriptions of the system or process to be audited 2isks that need special attention 7cope of work to be carried out Milestone dates for completion and resource allocated to the audit 2eporting and review procedures 'udit programme and techni,ues to be applied 'udit staff allocated to the assignment

'udit plan has clear advantages in terms of professionalism and coordination of different audit activitiesA resource allocation and prioritisation, workload and staff planning, clear documentation of what is 3 is not to be done The disadvantages of audit planning is that it is time consuming, can stifle initiative and may lead to infle!ibility in responding to management concerns as they arise. 1. 1t is important for the auditor to be able to plan their work so that they can then adopt an appropriate a"&), a++roa#0. 6. 'n e11e#,)/e and e11)#)en, a"&), depends on proper +!ann)n' +ro#e&"res. ISA 300 planning deals with the planning aspect of an audit. ISA 300 planning states that ?the auditors should plan the audit work so as to perform the audit in an effective way/. KEY TERMS >. An a"&), +!an is the formulation of the general strategy for the audit which acts as a direction for the audit, describes the e!pected scope and conduct of the audit and provides guidance for the development of the audit program. %. An a"&), +ro'ra* is a set of instructions to the audit team that sets out the audit procedures the auditors intend to adopt and may include reference to other matters such as the audit obBectives, timing of the audit, sample si5e and basis of selection for each area. 1t also serves as a means to control and record the proper e!ecution of the work. D. 'n a"&), +ro'ra* sets out the nature, timing and e!tent of planned audit procedures re,uired to implement the overall audit program. 1t serves as a set of instructions to audit assistants who are involved in the audit and also as a means to ensure proper e!ecution of the work assigned to those assistants. ". The obBectives of planning the audit work is to ensure that A++ro+r)a,e a,,en,)on )s &e/o,e& ,o ,0e &)11eren, areas o1 ,0e a"&), ">

Po,en,)a! +ro !e*s are )&en,)1)e& 6or$ )s #o*+!e,e& e5+e&),)o"s!T0e +ro+er ,as$s are ass)'ne& ,o ,0e *e* ers o1 ,0e a"&), ,ea*

E. The audit program should be discussed with the client/s management and staff and3 or audit committee in order to coordinate the audit work, including that of internal audit. However, all audit work remains the responsibility of the e5,erna! a"&),ors. A. A %e!! s,r"#,"re& a++roa#0 ,o a"&), +!ann)n' %)!! )n#!"&e ,0e 1o!!o%)n' s,a'es: U+&a,)n' ,0e "n&ers,an&)n' o1 ,0e en,),- an& ),s en/)ron*en, 8ISA 210( Kno%!e&'e o1 ,0e "s)ness9 Assess)n' r)s$s o1 *a,er)a! *)ss,a,e*en,s Pre+ar)n' a &e,a)!e& a"&), a++roa#0 Ma$)n' a&*)n)s,ra,)/e &e#)s)ons s"#0 as s,a11)n' an& "&'e,s

?The auditor should develop and document an overall audit plan describing the e!pected scope and conduct of the audit./ D. T0e 1o!!o%)n' ),e*s 'o )n,o a s,an&ar& a"&), +!an )n or&er ,o ens"re ,0e a"&), +!an )s #o*+re0ens)/e an& re!e/an, ,o ,0e %or$ re?")re&. Kno%!e&'e o1 ,0e en,),-3s "s)ness :eneral economic factors and industry conditions. 1mportant characteristics of the client like )a* business )b* principal business strategies )c* financial performance of the entity )d* reporting re,uirements, including changes since the previous audit 8perating style and cost control consciousness of directors and management. The auditors cumulative knowledge of the accounting and control systems and any e!pected changes during the year. The setting of materiality for audit planning purposes The e!pected assessment of risks or errors and identification of significant audit areas 'ny indication that misstatements that could have material effect on the financial statements might arise because of fraud or "%

R)s$ an& Ma,er)a!),-

for any other reasons The identification of comple! accounting areas including those involving the use of accounting estimates Na,"re( T)*)n' an& E5,en, o1 The relative importance and timing of tests +ro#e&"res of controls and substantive procedures The use of information technology by the client or auditors The use of work performed by 1nternal 'udit (rocedures which need to be carried out at or before the year end The timing of significant phases of the preparation of the financial statements The audit evidence re,uired to reduce detection risk to an acceptably low level Coor&)na,)on( &)re#,)on( s"+er/)s)on an& The involvement of other auditors re/)e% The involvement of e!perts, other third parties and internal auditors The number of locations 7taffing re,uirements O,0er Ma,,ers 'ny regulatory re,uirements arising from the decisions to retain the engagement The possibility that the going concern basis may not be appropriate The terms of the engagement and any statutory responsibilities The nature and timing of reports or other communication with the entity that are e!pected under the terms of the engagement AUDIT PROCEDURES This section covers the procedures that the auditors must undertake to ensure that their appointment is valid and that they are clear to act. These matters are also covered in 7tatement D- 4hanges in (rofessional appointment in the '44'/s rules of (rofessional 4onduct. 2EFORE ACCEPTING NOMINATION Before a new audit client is accepted, the auditors must ensure that there are no independence or other ethical problems likely to cause conflict with the ethical code. Furthermore, new auditors should ensure that they have been appointed in a proper and legal manner. The nominee auditors must carry out the following procedures-

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ACCEPTANCE PROCEDURES
@nsure professionally ,ualified to act @nsure e!isting resources ade,uate 8btain references 4ommunicate with present auditors 4onsider whether dis,ualified on legal or ethical grounds 4onsider available time, staff and technical e!pertise Make independent en,uiries if directors not personally known. 7ee 7ection > of this chapter @n,uire whether there are reasons3circumstances behind the change which the new auditors ought to know, also courtesy. 7ee flowchart over page for process

@!ample letters This is an e!ample of an initial communication

&ear 7irs 2e- ;ew 4lient 4o Ctd .e have been asked to allow our name to go forward for nomination as auditors of the above company, and we should therefore be grateful if you would please let us know whether there are any professional reasons why we should not accept nominationN 'c,uiring Q 4o 4ertified 'ccountants Having negotiated these steps the auditors will be in a position to accept the nomination, or not, as the case may be. These procedures can be demonstrated most easily in a decision chart, as shown on the ne!t page. Pro#e&"res a1,er a##e+,)n' no*)na,)on The following procedures should be carried out after accepting nomination. )a* @nsure that the outgoing auditors/ removal or resignation has been properly conducted in accordance with national legislation.

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The new auditors should see a valid notice of the outgoing auditors/ resignation, or confirm that the outgoing auditors were properly removed. )b* )c* @nsure that the new auditors/ appointment is valid. The new auditors should obtain a copy of the resolution passed at the general meeting appointing them as the company/s auditors. 7et up and submit a letter of engagement to the directors of the company.

(81;T T8 ;8T@ Cetters of engagement are discussed in 7ection D of this chapter. OTHER MATTERS .here the previous auditors have fees still owing by the client, the new auditors need not decline appointment solely for this reason. They should decide how far they may go in auditing the former auditors to obtain their fees, as well as whether they should accept the appointment. 8nce a new appointment has taken place, the new auditors should obtain all books and papers which belong to the client from the old auditors. The former accountants should ensure that all such documents are transferred, unless they have a lien )a legal right to hold on to them* over the books because of unpaid fees. The old auditors should also pass any useful information to the new auditors if it will be of help, without charge, unless a lot of work is involved.

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'ppointment decision chart

'pproach by new 'udit client

1s this the first audit0

+es

;o need to follow (rofessional rules L the auditor can make own decision

&oes client give (ermission to contact old auditor0

;o

.rite for all information pertinent to the appointment section

(rospective auditor should decline appointment

&oes 4lient give 8ld auditor (ermission to 2eply0 +es 1nformation otherwise relevant to new appointment0 +es

;o

8btained

'ccept3reBect appointment decision

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CLIENT SCREENING 's well as contacting previous auditors many firms, particularly larger firms, carry out stringent checks on potential client companies and their management. There are a number of reasons for this, as we will see shortly. 2as)# 1a#,ors 1or #ons)&era,)on )a*. Mana'e*en, )n,e'r),The integrity of those managing a company will be of great importance, particularly if the company is controlled by one or a few dominant personalities. )b*. R)s$ The following table contrasts low and high risk clients. LO6 RISK :ood long term prospects .ell financed 7trong internal controls 4onservative, prudent accounting policies 4ompetent, honest management Few unusual transactions HIGH RISK (oor recent or forecast performance Cikely lack of finance 7ignificant control weaknesses @vidence of ,uestionable integrity, doubtful accounting policies Cack of finance director 7ignificant related party or une!plained transactions

.here the risk level of a company/s audit is determined as anything other than low, then the specific risks should be identified and documented. 1t might be necessary to assign specialists in response to these risks, particularly industry specialists, as independent reviewers. 7ome audit firms have procedures for closely monitoring audits which have been accepted, but which are considered high risk. ENGAGEMENT ECONOMICS :enerally, the e!pected fees from a new client should reflect the level of risk e!pected. They should also offer the same sort of return e!pected of clients of this nature and reflect the overall financial strategy of the audit firm. 8ccasionally, the audit firm will want the work to gain entry into the client/s particular industry, or to establish better contacts within that industry. These factors will all contribute to a total e!pected economic return.

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RELATIONSHIP The audit firm will generally want the relationship with a client to be long term. This is not only to enBoy receiving fees year after yearA it is also to allow the audit work to be enhanced by better knowledge of the client and thereby offer a better service. 4onflict of interest problems are significant hereA the firm should establish that no e!isting clients will cause difficulties as competitors of the new client. 8ther services to other clients may have an impact here, not Bust audit. 78J24@7 8F 1;F82M'T18; 'B8JT ;@. 4C1@;T7 @n,uiries of other sources Bankers, solicitors 2eview of documents Most recent annual accounts, listing particulars, credit rating. (revious accountants3auditors (revious auditors should disclose fully all relevant information 2eview of rules and standards 4onsider specific law3standards that relate to industry APPROBAL 8nce all the relevant procedures and information gathering has taken place, the company can be put forward for approval. The engagement partner will have completed a client acceptance form and this, along with any other relevant documentations, will be submitted to the managing partner, or whichever partner is in overall charge of accepting clients. @!am focus point 1n the e!am you may be given a ?real life/ client situation and asked what factors you would consider in deciding whether to accept appointment. The ethical considerations covered in 4hapter % and in this chapter are likely to be relevant. AUDIT RISK 1n planning the audit, the auditor will be concerned with the risks that the entity is e!posed to. Therefore, a number of tests will be carried at the planning stage in order to determine audit risk 's you know from your previous studies the auditor must be aware of two types of risk. A"&), r)s$ )sometimes known as assignment or engagement risk* 2"s)ness r)s$ E#

'udit risk R 4ontrol risk S detection risk S inherent risk A"&), r)s$ <@+ T@2M7 'udit risk is the risk that auditors may give an inappropriate opinion on the financial statements. 'udit risk has two key componentsA risk of material misstatements in financial statements )detection risk*. The former breaks down into inherent risk and control risk. 1nherent risk is the susceptibility of an account balance or class of transactions to material misstatement, either individually or when aggregated with misstatements in other balances or classes, irrespective of related internal controls. 4ontrol risk is the risk that a misstatement 4ould occur in an account balance or class of transactions 4ould be material, either individually or when aggregated with misstatements in other balances or classes, and .ould not be prevented, or detected and corrected on a timely basis, by the accounting and internal control systems.

&etection risk is the risk that the auditors/ substantive procedures do not detect a misstatement that e!ists in an account balance or class of transactions that could be material, either individually or when aggregated with misstatements in other balances or classes. In0eren, r)s$ 1nherent risk is the risk that items will be misstated due to characteristics of those items, such as the fact they are estimates or that they are important items in the accounts. The auditors must use their professional Budgement and the understanding of the entity they have gained to assess inherent risk. 1f no such information or knowledge is available then the inherent risk is 0)'0. FACTORS AFFECTING CLIENT AS A 6HOLE 1ntegrity and attitude to risk of &omination by a single individual directors and management can cause problems Management e!perience and 4hanges in management and ,uality knowledge of financial management Jnusual pressures on management @!amples include tight reporting deadlines, or market or financing e!pectations ;ature of business (otential problems include E1

1ndustry factors

1nformation technology

technological obsolescence or over dependence on single product 4ompetitive conditions, regulatory re,uirements, technology developments, changes in customers demand (roblems include lack of supporting documentation, concentration of e!pertise in a few people, potential for unauthorised access

F'4T827 'FF@4T1;: 1;&1K1&J'C '448J;T B'C';4@7 82 T2';7'4T18;7 Financial statement accounts prone 'ccounts which re,uire adBustment to misstatement in previous period or re,uire high degree of estimation 4omple! accounts 'ccounts which re,uire e!pert valuation or are subBects of current professional discussion 'ssets at risk of being lost or stolen 4ash, inventory, portable non current assets )laptop computers* Muality of accounting systems 7trength of individual departments )sales, purchases, cash etc* High volume transactions 'ccounting system may have problems coping Jnusual transactions Transactions for large amounts with unusual names, not settled promptly )particularly important if they occur at period end* Transactions that do not go through the system, that relate to specific clients or processed by certain individuals 7taff changes or areas of low morale

7taff Con,ro! r)s$

4ontrol risk is the risk that client controls fail to detect material misstatements. A +re!)*)nar- assess*en, o1 #on,ro! r)s$ at the planning stage of the audit is re,uired to determine the level of controls and substantive testing to be carried out.

E6

De,e#,)on r)s$ &etection risk is the risk that audit procedures will fail to detect material errors. &etection risk relates to the inability of the auditors to e!amine all evidence. 'udit evidence is usually persuasive rather than conclusive so some detection risk is usually present, allowing the auditors to seek ?reasonable confidence./ The auditors/ )n0eren, an& #on,ro! r)s$ assess*en,s influence the na,"re( ,)*)n' and e5,en, o1 s" s,an,)/e +ro#e&"res re,uired to reduce detection risk and thereby audit risk. KEY TERMS Business risk is the risk inherent to the company in its operations. 1t is risks at all levels of the business. 1t is split into three categoriesFinancial risks are the risks arising from the financial activities or financial conse,uences of an operation, for e!ample, cash flow issues or overtrading. 8perational risks are the risks arising with regard to operations, for e!ample, the risk that a maBor supplier will be lost and the company will be unable to operate. 4ompliance risk is the risk that arises from non compliance with the laws and regulations that surround the business. The compliance risk attaching to environmental issues, for e!ample, is discussed in 4hapter 1F. The above components of business risk are the risks that the company should seek to mitigate and manage. The +ro#ess o1 r)s$ *ana'e*en, for the business is as follows 1dentify significant risks which could prevent the business achieving its obBectives (rovide a framework to ensure that the business can meet its obBectives 2eview the obBectives and framework regularly to ensure that obBectives are met

' key part of the process is therefore to )&en,)1- ,0e "s)ness r)s$s. There are various tools used to do this such asA 7.8T analysis The five forces model The (@7T analysis (orter/s value chain E>

E5a* 1o#"s +o)n, The study guide states that you should be able to identify business risks in a ,uestion. 1f you have previously used any of the above techni,ues, they may be useful to you, but in the e!am, it will be better to use common sense as you work through any given ,uestion, bearing in mind the three components of business risk given above. Re!a,)ons0)+ e,%een "s)ness r)s$ an& a"&), r)s$ 8n the one hand, business risk and audit risk are completely unrelated Business risk arises in the operations of a business 'udit risk is focused on the financial statements of the business 'udit risk e!ists only in relation to an opinion given by auditors

1n other ways, the two are strongly connected. The strong links between them can be seen in the inherent and control aspects of audit risk. 1n audit risk these are limited to risks pertaining to the financial statements. 2"s)ness r)s$ includes all risks facing the business. 1n other words, inherent audit risk may include business risks. 1n response to business risk, the directors institute a system of controls. These will include controls to mitigate against the financial aspect of the business risk. These are the controls that audit control risk incorporates. Therefore, although a"&), r)s$ is very financial statements focused, "s)ness r)s$ does form part of the inherent risk associated with the financial statements, not least, because if the risks materiali5e, the going concern basis of the financial statements could be affected. THE RISK 2ASED APPROACH 1. 2isk based auditing refers to the development of auditing techni,ues that are responsive to risk factors in an audit. 's mentioned before, the auditors apply Budgement to determine what level of risk pertains to different areas of a client/s system and devise appropriate audit test. 6. This approach should ensure that the greatest audit effort is directed at the areas in which the financial statements are most likely to be misstated, so that the chance of detecting errors is improved and time is not spent on unnecessary testing of ?safe/ areas. >. The increased use of risk based auditing reflects two factors. E%

)a*

The growing comple!ity of the business environment increases the danger of fraud or misstatement. Factors such as the developing use of computerised systems and the growing internationali5ation of business are relevant here. (ressures are increasingly e!erted on auditors to keep fee levels down while an improved level of services is e!pected.

)b* %.

The risk approach is best illustrated by a small case study. Case s,"&-: a"&), r)s$ a++roa#0 +our audit firm has as its client a small manufacturing company. This company owns the land and buildings in its balance sheet which it depreciates over D# years )buildings only* and has always valued it at cost. The other maBor item in the balance sheet is inventory. Cooking at these two balance sheet items from the point of view of the audit firm, the following conclusions can be drawn. There is only a small chance that the audit engagement partner will draw an inappropriate conclusion about land and buildings. 1n a manufacturing company, inventory is likely to be far more comple!. There may be a significant number of lines to count and value, the ,uantity will change all the time, inventory may grow obsolete. The chance of the audit engagement partner drawing an inappropriate conclusion about inventory is higher than the risk in connection with land and buildings. The auditors will have to do less work to render audit risk acceptable for land and buildings than on inventory. The audit risk approach will mean doing less work on land and buildings than inventory.

D. 17' >1D re,uires that auditors consider the entity/s process for assessing its own business risks, and the impact that this might have on the audit in terms of material misstatements. 'uditors consider .hat factors lead to the problems that may cause materials misstatements0 .hat can the audit contribute to the business pursuing its goals0

". This ?business risk/ approach was developed because it is sometimes the case that the auditors believe the risk of the financial statements being misstated arises predominantly from the business risks of the company. ED

Business risks leading to material misstatements E. The table below highlights some of the factors that e!ist. Pr)n#)+a! r)s$ @conomic pressures causing reduced unit sales and eroding margins. @conomic pressures resulting in demands for e!tended credit (roduct ,uality issues related to inade,uate control over supply chain and transportation damage 4ustomer dissatisfaction related to inability to meet order re,uirements. 4ustomer dissatisfaction related to invoicing errors and transportation damage. Jnacceptable service response call rate related to poor product ,uality I**e&)a,e F)nan#)a! S,a,e*en, I*+!)#a,)ons 1nventory values )17' 6* :oing concern 2eceivable recoverability 1nventory values L net reali5able value and inventory returns :oing concern 2eceivable valuation

:oing concern Citigation L provisions and contingencies 1nventory L net reali5able value 8ut of date 1T systems affecting 'nywhere management/s ability to make informed decisions.

:"es,)on:

"s)ness r)s$

7tate what category of business risk each of the risks in the above table falls under. Ans%er 1 6 > % D " E Financial Financial 8perational 8perational 8perational 8perational 8perational

E"

F. The business risk audit approach tries to mirror the risk management steps that have been taken by the directors. 1n this way, the auditor will see$ ,o es,a !)s0 ,0a, ,0e 1)nan#)a! s,a,e*en, o .e#,)/es 0a/e een *e,, through an investigation into whether all the other business obBectives have been met by the directors. G. This approach to the audit has been called a G,o+4&o%n3 a++roa#0( because it starts at the business and its obBectives and works back down to the financial statements, rather than working up from the financial statements which have historically been the approach to audit. 1#. The ?top down approach/ has an effect on the procedures used in the audit, as follows.

A"&), +ro#e&"res Tests of controls

'nalytical procedures

&etailed testing

E11e#, o1 G,o+4&o%n3 a++roa#0 's the auditor pays greater attention to the high level controls used by directors to manage business risks, controls testing will be focused on items such as the control environment and corporate governance than the detailed procedural controls tested under traditional approaches. 'nalytical procedures are used more heavily in a business risk approach as they are consistent with the auditor/s desire to understand the entity/s business rather than to prove the figures in the financial statements. The combination of the above two factors, particularly the higher use of analytical procedures will result in a lower re,uirement for detailed testing, although substantive testing will not be eliminated completely.

11. The other key element of a business risk approach is that as it is focused on the business more fully, rather than the financial statements, there is greater opportunity for the auditor to add value to the client/s business and to assist him in managing the risks that the business faces. Advantages of usiness risk approac! 16. There are a number of reasons why firms who use the business risk approach prefer it to historic approaches. 'dded value given to clients as the approach focuses on the business as a whole EE

'udit attention focused on high level controls and high use of analytical procedures increase audit efficiency and therefore cost &oes not focus on routine processes, which technological developments have rendered less prone to error than has historically been the case 2esponds to the importance that regulators and the government have placed on corporate governance in recent years Cower engagement risk )risk of auditor being sued* through broader understanding of the client/s business and practices.

EF

CHAPTER ;.0: INTERNAL AUDITING

1. Us)n' ,0e 6or$ o1 In,erna! A"&), 17' "1#.6 The e!ternal auditor should consider the activities of internal auditing and their effect. 1f any, on e!ternal audit procedures. The 17' goes on to make a most important point. ?.hile the e!ternal auditor has sole responsibility for the audit opinion e!pressed and for determining the nature, timing and e!tent of e!ternal audit procedures, certain parts of internal auditing work may be useful to the auditors/. 2. S#o+e an& o .e#,)/es o1 )n,erna! a"&),)n' The scope and obBectives of internal auditing vary widely. ;ormally however, internal auditing operates in one or more of the following broad areas. 2eview of the accounting and internal control systems. @!amination of financial and operating information. 2eview of economy, efficiency and effectiveness. 2eview of compliance with laws and regulations. 7pecial investigations.

;. Un&ers,an&)n' an& +re!)*)nar- assess*en, o1 ,0e ro!e an& s#o+e o1 )n,erna! a"&), ISA >10.D The e!ternal auditor should obtain sufficient understanding of internal audit to assist in planning the audit developing an effective audit approach. 'n effective 1nternal 'udit function may reduce, modify or alter the timing of e!ternal audit procedures, but it can never eliminate them entirely. .here the 1' function is deemed ineffective, it may still be useful to be aware of the 1' conclusions. The effectiveness of 1nternal 'udit will have a great impact on how the e!ternal auditors assess the whole control system and the assessment of audit risk.

EG

ISA >10 &uring the course of planning the audit the e!ternal auditor should perform a preliminary assessment of the internal audit function when it appears that internal auditing is relevant to the e!ternal audit of the financial statements in specific audit areas. The following important criteria will be considered by the e!ternal auditors. ASSESSMENT OF INTERNAL AUDIT Or'an)sa,)on s,a,"s 4onsider to whom internal audit reports )should be board*, whether internal audit has any operating responsibilities and constraints or restrictions on the function. 4onsider e!tent and nature of assignments performed and the action taken by management as a result of internal audit reports.

S#o+e o1 1"n#,)on

ASSESSMENT OF INTERNAL AUDIT Te#0n)#a! #o*+e,en#e 4onsider whether internal auditors have ade,uate technical training and proficiency 4onsider whether internal audit is properly planned, supervised, reviewed and documented

D"e +ro1ess)ona! #are

.hen reporting, internal auditors should report to the whole board or the audit committee and should be free to discuss their concerns with e!ternal auditors. They should not report to management upon whose work or responsibilities they are likely to commentA this may mean for e!ample that they should report to the finance director. 1nternal 'udit &epartment will 2eview the business procedures and practices and ensure that the company is complying with local legislation and ensure that the company/s business activities are ethical and acceptable. F#

2eview the effectiveness of the accounting systems and whether accounts are being prepared in accordance with the latest accounting standards 'ssess the effectiveness of internal controls for the prevention of material misstatements, frauds and errors. 2eview the risks that the company is e!posed to and devise specific controls to mitigate or reduce those risks.

<. Us)n' ,0e %or$ o1 )n,erna! a"&), The obBectives of internal audit will differ from those of the e!ternal auditors. However, some of the means of achieving their respective obBectives are often similar, and so some of the internal auditors/ work may be used by the e!ternal auditors. @!ternal auditors may use internal auditors/ work on the following areas. =. Re#or&)n' an a##o"n,)n' s-s,e* The e!ternal auditor should carry out walkthrough tests on the records. "valuating and testing internal control 1f the e!ternal auditors are to rely on the work done, say the completion of an internal control evaluation ,uestionnaire, they should check that the method of evaluation is appropriate. They should confirm that internal audit has satisfactorily tested controls in detail by re performing a sample of internal audit/s testsA if internal audit/s work is satisfactory, e!ternal auditors can make a reduced assessment of control risk as a conse,uence. 1n particular e!ternal audit may be able to rely on internal audit/s assessment of computer systems, since internal audit may have carried out e!tensive testing on aspects of the system including controls over development and operation of the system and general controls such as access controls. Su stantive procedures 's e!ternal auditors are primarily interested in internal audit/s role as a control, the importance of internal audit as a source of substantive evidence will be less. However internal audit procedures may be a source of substantive evidence in particular areas, for e!ample comparing supplier statements with the purchase ledger. 1f the client has several sites, internal audit may have visited sites that e!ternal auditors will not have the chance to visit, and e!ternal audit may be able to place some reliance on the work done by internal audit on those sites. #iming of liaison and co$ordination 'll timing of 1' work should be agreed as early as possible, and in particular how it co ordinates with the e!ternal auditors/ work. Ciaison with the internal auditors should take

F1

place at regular intervals throughout the audit. 1nformation on tests and conclusions should be passed both to and from 1'. >. E/a!"a,)n' s+e#)1)# )n,erna! a"&),)n' %or$ ISA >10.1> .hen the e!ternal auditor intends to use specific work of internal audit, the e!ternal auditor should evaluate and test that work to confirm its ade,uacy for the e!ternal auditor/s purpose.

The evaluation here will consider the scope of work and related audit programmes and whether the assessment of the 1' function remains appropriate. This may include consideration of whetherE/a!"a,)on Tra)n)n' an& +ro1)#)en#S"+er/)s)on E/)&en#e Have the internal auditors had sufficient and ade,uate technological training to carry out the work0 1s the work of assistants properly supervised, reviewed and documented0 Has sufficient, appropriate audit evidence been obtained to afford a reasonable basis for the conclusions reached0 're the conclusions reached appropriate, given the circumstances0 're any reports produced by internal audit consistent with the result of the work performed0 Have any unusual matters or e!ceptions arising and disclosed by internal audit been resolved properly0 're any amendments to the e!ternal audit programme re,uired as a result of the matter identified by internal audit0 Has the work of internal audit been sufficiently tested by the e!ternal auditor to confirm its ade,uacy0

Con#!"s)ons Re+or,s

Un"s"a! *a,,ers P!an Tes,)n'

The nature, timing and e!tent of the testing of the specific work of internal auditing will depend upon the e!ternal auditor/s Budgement of the risk and materiality of the area concerned, the preliminary assessment of internal auditing and the evaluation of specific work of internal auditing. 7uch tests F6

may include e!amination of items already e!amined by internal auditing, e!amination of other similar items and observation of internal auditing procedures. 1f the e!ternal auditors decide that the 1' work is not ade,uate, they should e!tend their procedures in order to obtain appropriate evidence. @. G")&an#e 1or )n,erna! a"&),ors The essentials for effective internal auditing are as follows 1ndependence, both in terms of organi5ational status and personal obBectivity. 'ppropriate staffing and training. 4onstructed working relationships. &ue care. 'de,uate planning. @valuation of the internal control system. 8btaining sufficient, relevant and reliable evidence. (rompt reporting and follow up.

A. Us)n' ,0e %or$ o1 o,0ers as +ar, o1 a re/)e% 17' G1# states that when the auditor uses work carried out by another party )e!pert or internal auditor* as part of a review, he must be satisfied that the work is satisfactory for the purposes of the report he is issuing. This will be a matter of Budgement. D. In,erna! a"&), "s)n' ,0e %or$ o1 o,0ers The situation where internal auditors use the work or e!perts or service organi5ations is different when e!ternal auditors use them. The e!perts are contracted to provide the service to the organi5ation )of which the 1' function is part*. This gives the company contractual rights when they rely on the work. 1f the directors permit the internal auditors to use the services of an e!pert, the internal auditors may seek to rely on their work and may be able to sue for negligence if the work is not of a satisfactory ,uality. AG ;0A G")&an#e 1or )n,erna! a"&),ors The internal auditor should seek to foster constructive working relationships and mutual understanding with management, with e!ternal auditors, with any other review agencies, and where one e!ists with the audit committee.

F>

'uditing guidance >#F also advice when internal auditors are making use of an e!ternal reviewer or specialist, for e!ample, a management consultant to seeking improvements in the organi5ational performance. 1t states that the 1' department must seek management/s formal approval before releasing an audit report to the reviewer. 1t also states that the internal auditor should foster ?regular dialogue/ with the e!ternal service provider. Re/)e%s 1. 'n audit can be used to give assurance to a variety of stakeholders on a variety issues. However, an audit is an e!ercise designed to give a high level of assurance )as we shall see later* and involves a high degree of testing and therefore cost. 1n some cases, stakeholders may find that they receive sufficient assurance about an issue from a less detailed engagement, for e!ample, a review. ' review can provide a cost efficient alternative to an audit where an audit is not re,uired by law. KEY TERM The obBective of a review engagement is to enable an auditor to state whether, on the basis of procedures which do not provide all the evidence that would be re,uired in an audit, anything has come to the auditor/s attention that causes the auditor to believe that the financial statements are not prepared, in all material respects, in accordance with an identified financial reporting framework. 6. The maBor result for recipients of a review engagement is that the !e/e! o1 ass"ran#e they gain from a review engagement is not as high as from this audit. This is discussed in 7ection %. >. However, the procedures carried out in a review engagement are similar to an audit. There is higher reliance on the use of analytical procedures but otherwise, the approach is similar. POINTS TO NOTE 's the techni,ues used in audits and reviews are similar, the methods and procedure you will encounter in (arts B @ of this study Te!t are relevant to both audits and reviews. Bear in mind that for a review, less detailed procedures will be carried out and sample si5es are likely to be smaller.

F%

In,erna! A"&),)n' KEY TERM 1nternal auditing is an appraisal or monitoring activity established within an entity as a service to the entity. 1t functions by, amongst other things, e!amining, evaluating and reporting to management and the directors on the ade,uacy and effectiveness of components of the accounting and internal control systems. %. Jp to now in this 4hapter we have discussed assurance service where an independent outsider provides financial information. However, the syllabus is also concerned with the assurance that can be provided to management )and by implication, to other parties* )n,erna! a"&),ors. D. 's we saw previously as part of their corporate governance duties, listed company directors are re,uired, and all directors are advised, to review the effectiveness of the company/s risk management and internal control systems. They should also consider the need for an )n,erna! a"&), 1"n#,)on ,o 0e!+ ,0e* #arr- o", ,0e)r &",)es. ". Carger organi5ations may therefore appoint full time staff whose 1"n#,)on )s ,o *on),or an& re+or, on ,0e r"nn)n' o1 ,0e #o*+an-3s o+era,)ons . 1nternal audit staff members are one type of control. 'lthough some of the work carried out by internal auditors is similar to that performed by e!ternal auditors, there are )*+or,an, &)s,)n#,)ons between the two functions in terms of their responsibilities, scope and relationship with the company. ASSURANCE AND REPORTS 1. @!ternal auditors give an opinion on the truth and fairness of financial statements. This is not an opinion of absolute correctness. ?True/ and ?fair/ are not defined in law or audit guidance, but the following definitions are generally accepted. KEY TERMS Tr"e. 1nformation is factual and conforms with reality, not false. 1n addition the information conforms with re,uired standards and law. The accounts have been correctly e!tracted from the books and records. FD

Fa)r. 1nformation is free from discrimination and bias and in compliance with e!pected standards and rules. The accounts should reflect the commercial substance of the company/s underlying transactions. 6. The audit report refers to the fact that an auditor obtains evidence ?on a test basis/, he does not check everything. He is therefore, giving ?reasonable/ not ?absolute/ assurance. KEY TERM 'n audit gives the reader reasonable assurance on the truth and fairness of the financial statements. The audit report does not guarantee that the financial statements are correct, but that they are fair with a reasonable margin of error.

>.

8ne of the reasons that an auditor does not give absolute assurance is the )n0eren, !)*),a,)ons of audit.

L)*),a,)ons o1 a"&), %. The assurance auditors give is governed by the fact that auditors use ."&'e*en, in deciding what audit procedures to use and what conclusions to draw, and also by the limitations of e/er- a"&),. 7tudents are advised that ,uestions will be based in the principles and good practice set out in the 1nternational 7tandards on 'uditing.

D.

SMALLER ENTITIES =.= INTERNAL CONTROLS IN SMALL 2USINESS S,a,",or- an& non4s,a,",or- a"&),s KEY TERM ?The obBective of an audit of financial statement is to enable the auditor to e!press an opinion whether the financial statements are prepared, in all materials respects, in accordance with an identified financial reporting framework. The phrases used to e!press the auditor/s opinion are ?give a true and fair view/ or ?present fairly, in all material respects/, which are e,uivalent terms. ' similar obBective applies to the audit of financial or other information prepared in accordance with appropriate criteria. F"

E. The purpose of an audit is to enable auditors to give an opinion on the financial statements. .hile an audit might produce by products such as advice to the directors on how to run the business, the point of an adult is solely to re+or, ,o s0are0o!&ers. F. 1n most countries, audits are re,uired under national statue in the case of a large number of undertakings, including limited liability companies. 8ther organi5ations and entities re,uiring a statutory audit may include charities, investment businesses, trade unions and so on. G. 'udits are re,uired under statue in the case of a large number of undertakings. 1n the J<, registered companies legislation )currently 4ompanies 'ct 1GFD*, most companies are re,uired to have an audit. There are also re,uirements for Building 7ocieties )Building 7ocieties 'ct 1G"D* Trade Jnions3employer associations )Trade Jnion and Cabour 2elations 'ct 1GE%* House 'ssociations )various pieces of related legislation* 4ertain charities )various pieces of legislation, depending on status*

1#. The statutory audit can bring various advantages to the company and shareholders. The key benefit to shareholders is the impartial view provided by the auditors. However, the company benefits from professional accountants reviewing the accounts and systems as part of the audit. Benefits might include recommendations being made in relation to accounting and control systems and the possibility that auditors might detect fraud and error. POINTS TO NOTE 7tatutory audits will be discussed in more detail in later. ' chronology of a typical audit showing the auditors/ work on accounts and system is given in 7ection % of this 4hapter. The techni,ues auditors use will be discussed in (arts B @ of this 7tudy Te!t.

Ma)! 1s all mail received and opened by the proprietor0 1f the proprietor does not himself open the mail, is it opened by a person not connected with the accounts and read by him before it is distributed to the staff0 FE

Re#e)+,s 're all che,ues and postal orders received by post counted by the proprietor before they are passed to the cashier0 're all che,ues and postal orders crossed to the company/s branch of its banker ?;ot negotiable L account payee only/. 're cash sales and credit sale receipts over the counter controlled by locked cash register tapes which only the proprietor can open0 &oes the proprietor reconcile the cash register totals with the cash sales receipts daily0 1s the person performing the duties of cashier barred any responsibility concerning the sales, purchase or nominal ledgers0

2an$)n' 1s all cash received banked intact at interval of not more than three days0 &oes the proprietor reconcile all monies received with the copy paying in slips at regular intervals0

Pa-*en,s 're all payments e!cept sundry e!penses made by che,ues0 &oes the proprietor sign all che,ues0 o 're che,ues signed by the proprietor only after he has satisfied himself thato He has approved are crossed not negotiable and account payee only0 o 'll che,ues numbers are accented for0 're petty cash e!penses controlled by the imprest system0 &oes the proprietor review all e!penses and initial the petty cash book before reimbursing the cashier0

2an$ s,a,e*en,s 're bank statements and paid che,ues to ensure that he has signed them all before he passes them to the cashier0 &oes the proprietorSS o (repare a bank reconciliation each month0 8r o 2eview in detail a reconciliation produced by the cashier0

Or&ers 're all purchase orders issuedFF

o 7erially numbered by the printer0 o (re printed duplicate order forms0 &oes the proprietor approve all orders0

Re#e)+, o1 'oo&s 're delivery notes 4hecked with goods0 4ompared with the copy order0 4ompared with the invoice0 6a'es 1s a separate che,ue drawn for the e!act amount to pay wages and ta!0 &oes the proprietor either prepare or e!amine the wages records before signing the che,ue0 &oes the proprietor initial the wages records after his e!amination0 &oes the proprietor oversee the distribution of the wages packets or does he distribute them himself0

Re#e)/a !es 1f credit is granted to customers does the proprietoro 'uthorise every e!tension of credit to a customer0 o 'pprove credit limits for each customer0 &oes the proprietor authori5e all.rite offs of bad debts0 7ales returns and allowances0 &iscounts other than routine cash discounts0 &oes the proprietor receive a monthly list of ,ra&e a##o"n,s re#e)/a !e, showing the age of the debts0 're all authori5ations by the proprietor evidenced by his initials0

Goo&s o",%ar&s 're p numbered dispatch notes prepared for all goods leaving the premises0 're all dispatch notes'ccounted for0 4ross referenced with invoices and credit notes0 1s the proprietor satisfied that all goods leaving the premises have been accounted for0

In/en,orFG

&oes the proprietor scrutini5e inventory regularly to<eep abreast of what is in inventory0 &iscover obsolete items0 &iscover damaged articles0 @nsure that inventory levels are kept under control0

AUDIT PROCEDURES 1. T0e A++roa#0 ,o A"&), 6or$ 2e1ore En'a'e*en, H E,0)#a! C!earan#e 6. Before accepting an appointment to act as auditor, members of the professional accountancy bodies are re,uired, under strict ethical rules, to communicate with the previous holder of office to en,uire whether there is any professional or other reason for proposed change which he should be aware of when deciding whether or not to accept nomination. This applies regardless of whether the e!isting auditor is a member of the same professional body or not. This duty to communicate should be e!plained to the prospective new client, from whom authority to do so should be sought. 1f authority is not given, the appointment should not be accepted. ;or should it be accepted if the e!isting auditor is refused permission to discuss the client/s affairs with the proposed new auditor. ;ormally such communication takes place without difficulty but if every reasonable attempt to get in touch with the e!isting auditor is unsuccessful, it may be assumed that there is no reason for not accepting the appointment. 7imilar considerations apply in cases where the new appointment relates to professional work other than auditing. 2eference should be made to the recommendations in ,hanges in a )rofessional Appointment$ already summari5ed in 4hapter 1. Le,,er o1 en'a'e*en, )a* )b* The functions of the auditor are ,uite distinct from the provision of accountancy, ta! and other servicesA and 1t is not the main purpose of the audit to discover defalcationsA irregularities and errors in the client/s records, and the audit should not be relied upon for this purpose. The :uideline correctly relates the auditor/s responsibility under his head to the materiality of the defalcation, etc., in relation to the ?true and fair view/ re,uirement for the financial statements being audited. >. Many court cases in the past might have been avoided had closer attention been paid to this matter, and in most of these cases the courts took the view that the onus was on the accountant, as the professional party to the contract, to take the necessary steps ab iniito in order to avoid a misunderstanding as to the work, and hence the responsibilities, undertaken. .ith statutory engagements, G#

however, there is less risk of the relationship between client and auditor being misconstrued by the client, since so much of this relationship is governed by legislation. 2.<.< APPOINTMENTS AS AUDITORS 1n addition, there are certain other matters, which according to the circumstances, may need to be dealt with in our report. 1 A##o"n,)n' an& O,0er Ser/)#es 2 Ta5a,)on Ser/)#es ; Fees = A'ree*en, o1 Ter*s > A##o"n,)n' @ Ta5a,)on A Res+ons) )!),)es an& s#o+e o1 ,0e a"&), D Re+resen,a,)ons - Mana'e*en, 10 Irre'"!ar),)es an& Fra"& 11 A##o"n,)n' an& ,a5a,)ons Ser/)#es 12 Fees A'ree*en, o1 Ter*s 2.; )a* O+)n)ons an& #er,)1)#a,es ' auditor he has checked that a submission has been accurately drawn up, in a form prescribed for a particular purpose, such as when claiming an investment grantA or He as accountant to a non statutory entity such as sole trader or partnership, prepared a set of final accounts from underlying records and information supplied for the purpose, and is hence in a position to certify that the accounts are in accordance therewith, notwithstanding the fact that no audit has been carried out.

)b*

7ince the task of the auditor today is at once more onerous and more comple! than ever before, it is essential that both client and auditor should be ?of one mind/ as to the work which the auditor is undertaking. 1t is therefore the practice of professional firms to issue letter to their clients at the time of being engaged to undertake professional work, in which they set out in clear terms)a* )b* )c* )d* .hat they understand the engagement to involveA The way in which they would normally set about the work, including the assistance and co operation which they would e!pect from the clientA The basis on which fees would be calculatedA and ' brief description of the other services which the firm is able to provide, if called upon to do so by the client.

1n connection with )b* above, the letter should state that the audit will include a critical review of the system of internal control, and that tests carried out on the basis of that G1

review will be in accordance with what the auditor thinks necessary L such test not necessarily being confined to the financial records. 7ome letters, at this point, refer to specific tests such as physical verification of stocks and circulari5ation of debtors, by way of e!ample. 7ome engagement letters are detailed and specific while others are drafted more loosely, depending upon the preference of the firm in ,uestionA although any individual firm would normally standardi5e the engagement letters to be issued by it in differing circumstances. 1t is normal practice to send a copy together with the letter, re,uesting that it should be signed by the client as an acknowledgement of agreement as to terms, and immediately returned to the auditors for the latter/s records. 1n the case of statutory audits, the letters should set out the re,uirements imposed by statute, which cannot be varied by either client or auditor, with particular reference to the significance of the audit report. @ngagement letters relating to non statutory assignments, e.g work re,uested by sole traders, partnerships or unincorporated associations )such as social clubs*, which usually re,uire no more than the preparation of accounts and ta! returns, should carefully delineate the work involved as specifically as possible, since any subse,uent dispute or negligence change, possibly leading to litigation, would be decided largely on the ,uestion of)b* )c* The scope, and The depth of work, as defined at the time of engagement.

' well drafted engagement letter will, for e!ample, serve to clarify for the client/s benefit the distinction between the respective responsibilities of directors and auditors, as summari5ed in the following bo!&irectors 'uditors &evise3implement internal controls Maintain proper accounting records 2eport lapses only (repare annual financial statements @nsure accounts give ?true and fair/ view 8pinion to members @nsure accounts comply with 4ompanies 'ct 8pinion to members Cay accounts before members File accounts with 2egistrar 'ct throughout in fiduciary capacity 'ct in independent 2eporting capacity

G6

&espite the caveat previously mentioned regarding errors, irregularities and defalcations, it is important not to give the impression that no responsibility for these is assumed. The auditor should undertake to e!ercise that degree of care and competence re,uired by the circumstances, but in the conte!t of an investigation designed to enable him to e!press an opinion, rather than one specifically directed to the discovery of fraud and errors. The engagement letter should set out the directors/ statutory responsibilities for ensuring that proper accounting records are maintained and that annual accounts showing a true and fair view are preparedA the letter should mention the directors/ duty to ensure that there is a proper system of internal control. 1t is suggested that reference to 7ection G." be made for a full consideration of the auditor/s responsibility for fraud detection. 1gnorance of other services available sometimes leads to the client )especially smaller enterprises* failing to ask for help which the auditor )in his capacity as accountant* could provide if so re,uested. .here it is appropriate, and is not likely to result in a conflict of interest and conse,uent loss of independence, the opportunity may be taken in the engagement letter to mention any services, other than auditing, which are available. 1t should always be borne in mind that the letter of engagement would be looked upon by the courts as prima facie evidence of the essential contractual arrangements which subsist between auditor and client. The following is a specimen of a typical letter of engagement, appropriate to a new company client, which incorporates the matters e!plained above. 1t is based on the e!ample given in the 1GF% '(4 :uideline. The &irectors Bo!wood Timber 4o. Ctd 1vy Cane Berkamsted Herts :entlemen The purpose of this letter is to set out the basis on which we )are to* as auditors of the company )and its subsidiaries* and the respective areas of responsibility of the company and of ourselves. >.1 's directors of the above company, you are responsible for maintaining proper accounting records and preparing financial statements which give a true and fair view and comply with the 4ompanies 'ct. +ou are also responsible for making available to us, as and when re,uired, all the company/s accounting records and other records and related information, including minutes of all management and shareholder/s meetings >.6 .e have a statutory responsibility to report to the members whether in our opinion the financial statements give a true and fair view of the state of the company/s affair and of the profit or loss for the year and whether they comply with the 4ompanies 'ct 1GFD. 1n arriving at our opinion, we are re,uired to consider the following matters, and to report on any in respect of which we are not satisfiedG> &ate-

)a* .hether proper accounting records have been kept by the company and proper returns ade,uate for our audit have been received from braches not visited by us)b* .hether the company/s balance sheet and profit and loss account are in agreement with the accounting records and returns. )c* .hether we have obtained all the information and e!planations which we think necessary for the purpose of our auditA and )d* .hether the information in the directors/ report is consistent with that in the audited financial statements. >.> .e have professional responsibility to report if the financial statements do not comply in any material respect with 7tatements of 7tandard 'ccounting (ractice, unless in our opinion the non compliance is Bustified in the circumstances. >.% 8ur audit will be conducted in accordance with the 'uditing 7tandards issued by the accountancy bodies and will have regard to relevant 'uditing :uidelines. Furthermore, it will be conducted in such as manner as we consider necessary to fulfil our responsibilities and will include such tests of transactions and of the e!istence, ownership and valuation of assets and liabilities we consider necessary. .e shall obtain an understanding of the accounting system in order to assess its ade,uacy as a basis for the preparation of the financial statements and to establish whether proper accounting records have been maintained. .e shall e!pect to obtain such relevant and reliable evidence as we consider sufficient to enable us to draw reasonable conclusions there from. The nature ands e!tent of our tests will vary according to our assessments of company/s accounting system and, where we wish to place reliance on it, the system of internal control, may cover any aspect of the business operations. .e shall report to you any significant weakness in or observations on, the company/s system which come to our notice and which we think should be brought to your attention. >.D 'nd part of our normal audit procedures, we may re,uest you to provide written confirmation of oral representations which we have received from you during the course of the audit. >." 1n order to assist with the e!amination of your financial statements, we shall re,uest sight of all documents or statements, including the chairman/s statement and the directors/ report, which are due to be issued with the financial statements. .e are also entitled to attend all general meetings of the company and to receive notice of all such meetings. >.E ).here appropriate* .e appreciate that the present si5e of your business renders it uneconomic to create a system of internal control based on the segregation of duties for different functions of each area of the business. 1n the running of your company we understand that the directors are closely involved with the control of the company/s transactions. 1n planning and performing our audit work we shall take account of this supervision. Further, we may ask additionally for confirmation in writing that all the transactions undertaken by the company have been properly G%

reflected and recorded in the accounting records, and our audit report on you company/s financial statements may refer to this confirmation. >.F The responsibility for the prevention and detection of irregularities and fraud rests with yourselves. However, we shall endeavour to plan our audit so that we have a reasonable e!pectation of detecting material misstatements in the financial statements or accounting records resulting from irregularities of fraud, but our e!amination should not be relied upon to disclose irregularities and frauds, which may e!ist. >.G ).here appropriate*. .e shall not be treated as having notice, for the purposes of our audit responsibilities, of information provided to members of our firm other than those engaged on the audit )e.g. information provided in connection with accounting, ta!ation and other services*. ).here appropriate* 'ccounting and other services, and ta!ation services )either included here or set out in a separate letter* 1t was agreed that we should carry out the following services as your agents and on the basis that you will make full disclosure to us of all relevant information. >.1# (repare the financial statements based on accounting records maintained by yourselvesA >.11 (rovide assistance to the company secretary by preparing and lodging returns with the 2egistrar of 4ompaniesA >.16 1nvestigate irregularities and fraud upon receiving specific instructions.

>.1> .e shall in respect of each accounting period prepare a computation of profits, adBusted in accordance with the provisions of the Ta!es 'cts, for the purposes of assessment to corporation ta!. 7ubBect to your approval, this will then be submitted to the 1nspector of Ta!es as being the company/s formal return. .e shall lodge formal notice of appeal against e!cessive or incorrect assessments to corporation ta! where notice of such assessments is received by us. .here appropriate, we shall also make formal application for postponement of ta! in dispute and shall also make formal application for postponement of ta! in dispute and shall advise as to appropriate payments on account. a. +ou will be responsible, unless otherwise agreed, for all other returns, more particularly- the returns of advance corporation ta! and income ta! deducted at source as re,uired on Forms 4T"1, returns relating returns relating to employee ta!es under ('+@ and returns of employee e!penses and benefit on Forms (111. +our staff will deal with all returns and other re,uirements in relation to value added ta!. b. .e shall be pleased to advise you on matters relating to the company/s corporation ta! liability, the implications particular business transactions and on other ta!ation matters which you refer to us, such as national insurance, income GD

ta! deducted at source, employee benefits, value added ta! and capital transfer ta!. 8ur fees are compared on the basis of the time spent on your affairs by the partners and our staff, and on the levels of skill and responsibility involved. Jnless otherwise agreed, our fees will be charged separately for each of the main classes of work described above, will be billed at appropriate interval during the course of the year and will be due on presentation. 8nce it has been agreed, this letter will remain effective, from one audit appointment to another until it is replaced. .e shall be grateful if you could confirm in writing your agreement to the terms of this letter, or let us know if they are not in accordance with your understanding of our terms of appointment. +ours faithfully The following is a specimen letter of engagement applicable to a sole trader, partnership or unincorporated association, which no audit work is re,uired. ( Cemon @s, Friendly :rocery High 7treet Berkhamsted Herts &ear 7ir 1n confirmation of our interview with N )the client or named officials of his business* N we let out below our understanding of the services your re,uire us to perform. )a* +ou re,uire us to prepare accounts, in the form of a profit and loss account and balance sheet for your consideration and approval. .hile we shall e!amine the records and make such in,uiries as we consider necessary to enable us to prepare these accounts, we shall not carry out an audit in the sense by statute for companies. )b* The accounts will contain a declaration for your signature that you approve the accounts and have made available all relevant records and information for their preparation. )c* .e shall report with such variations and we consider necessary that we have prepared, without carrying out an audit, the accounts from the accounting records presented to us and from the information and e!planations supplied to us. )d* 's a result of our work we may be able to suggest improvements which could be made to your accounting records. However, our work should not be relied on to G"

disclose defalcations or other irregularities. 1f an investigation is re,uired specifically to discover defalcations or irregularities this can be separately undertaken on re,uest. )e* +ou also re,uire us to assist you with certain accounting services. +ou have agreed that your staff will be responsible for)i* )ii* )iii* )iv* <eeping the records of receipts and paymentsA 2econciling the balance monthly with the bank statementsA <eep posted and balance the purchases and sales ledgerA (reparing details of the stocktaking suitably priced and e!tended.

.e have agreed)b* To complete that postings to the nominal ledgerA )c* To prepare draft accounts for your considerations. +ou have authori5ed us to act on your behalf in the preparation of Friendly :rocery/s ta!ation computations and their submission to and agreement with the 1nland 2evenue, subBect to the approval and signature of the ta! return by yourself. +our staff will deal with all matters connected with (ay 's +ou @arn and K'T but we shall be pleased to advise on any aspects of this or other ta!ation matters if so re,uested. O,0er Ser/)#es .e shall be pleased to provide, if re,uested, other services such as)a* )b* )c* )d* Fees 8ur fees are based upon the degree of responsibility and skill involved and the time necessarily occupied on the work. Jnless otherwise agreed they will be charged separately for each class of work mentioned above. .e shall be obliged if you will kindly acknowledge receipt of this letter by signing and returning the enclosed copy. 1f this is not in accordance with your understanding of our agreement, we shall be pleased to receive you further observations and to give you any further information you re,uire. +ours faithfully GE 'ccountants/ reports in support of returns or claims, e.g claims for investment grantsA 'dvice on financial mattersA Management accounting services, including such matter as a review of the system of book keeping and the installation of a budgetary control system for managementA 2eports for special purposes, e.g for ac,uisition of other business, and investigations into specific aspects of the business.

.'221;:T8;, M1;:@ ';& 48. The '(4 :uideline issued in may 1GF% laid special emphasis on the following matters concerning the content and the form of engagement letters, whose importance lies in the fact that they embody the contractual terms which subsist between accountant3auditor and client. The letter should e!plain the principal statutory responsibilities of the client and the statutory and professional responsibilities of the auditor. 1n the case of a company, it should be indicated that it is the statutory responsibility of the client to maintain proper accounting records, and to prepare financial statements, which give a true and fair view and comply with the 4ompany 'ct and other relevant legislation. 1t should be indicated that the auditor/s statutory responsibilities include making a report to the members stating whether in his opinion the financial statements give a true and fair view and whether they comply with the companies 'ct. 1t should be e!plained that the auditor has an obligation to satisfy himself whether or not the directors/ report contains any matters which are inconsistent with the audited financial statements. Furthermore, it should be indicated that the auditor has a professional responsibility to report if the financial statements do not comply in any material respect with 7tatements if 7tandard 'ccounting (ractice, unless in his opinion the non compliance is Bustified. The scope of the audit should be e!plained. 1n this connection, it should be pointed out that the audit will be conducted in accordance with approved 'uditing 7tandards and will have regard to relevant 'uditing :uidelines. 1t should be indicated that)a* )b* )c* The auditor will obtain an understanding of the accounting system in order to assess its ade,uacy as a basis for the preparation of the financial statementsA The auditor will e!pect to obtain relevant and reliable evidence sufficient to enable him to draw reasonable conclusions thereforeA The nature and e!tent of the test will vary according to the auditor/s assessment of the accounting system and, where he wishes to place reliance upon it, the system of internal controlA The auditor will report to management any significant weaknesses in, or observations on, the client/s systems which come to this notice and which he thinks should be brought to management/s attention.

)d*

.here appropriate, reference should be made to recurring special arrangements concerning the audit. These could include arrangements in respect of internal auditors, divisions, overseas subsidiaries, other auditors and )in the case of a small business GF

managed by directors who are maBor shareholders* significant reliance on supervision by the directors. .here appropriate it should be indicated that, prior to the completion of the audit, the auditor may seek written representations for management on matters having a material effect on the financial statements. The responsibility for the prevention and detection of irregularity and fraud rests with management and this responsibility is fulfilled mainly through the implementation and continued operation of an ade,uate system of internal control. The engagement letter should make this clear. Furthermore, it should e!plain the auditor will endeavour to plan his audit so that he has a reasonable e!pectation of detecting material misstatements in the financial statements resulting from irregularities or fraud, but that the e!amination should not be relied upon to disclose irregularities and frauds which may e!ist. 1f a special e!amination for irregularities or fraud is re,uired by client, then this should be specified in the engagement letter, but not in the audit section. The auditor may undertake, for the company, service in addition to carrying out his responsibilities as auditor. 'n engagement letter should ade,uately describe the nature and scope of those services. 1n the case of accounting services, the letter should distinguish the accountant/s and the client/s responsibilities in relation to them and the day to day bookkeeping, the maintenance of all accounting records and the preparation of financial statement. (referably this should be done in a separate letter but such services may form the subBect of a section in the audit engagement letter. 1n the case of the provision of ta!ation services, the responsible for the various procedures such as the preparation of ta! computations and the submission of returns to the relevant authorities should be clearly set out, either in a section of the main letter or in a separate letter. .here accounting, ta!ation or other services are undertaken on behalf of an audit client, information may be provided to members of the audit firm other than those engaged on the audit. 1f this is the case, it may be appropriate for the audit engagement letter to indicate that the auditor is not to be treated as having notice, for the purposes of his responsibilities, of the information given to such people. Mention should normally be made of fees of the basis on which they are computed rendered and paid. The engagement letter should include a re,uest to management that they confirm in writing their agreement to the terms of the engagement. 1t should be clearly understood that when agreed the letter will give rise to contractual obligations, and its precise content must therefore be carefully considered. 1n the case of a company, the auditor should re,uest that the letter of acknowledgement be signed on behalf of the board. Before discussing the detailed approach to audit work it is important to establish a true perspective of what an audit is designed to achieve. The number of individual transactions undertaken by the maBority of business concerns in the course of a financial GG

year makes any e!haustive check virtually impossible. From a practical point of view, therefore, the auditor/s aim is limited to the e!pression of an opinion )as opposed to a guarantee, certificate or absolute assurance* on the view presented by the accounts of the entity which he has audited. 4ompanies/ legislation is ,uite clear on this point, using the words ?in his opinion legislation is ,uite clear on this point, using the words ?in his opinion/ in several references to the auditor/s duties. For this reason the word ?certificate/ should be avoided in this conte!t since there is obviously a very great difference between certifying the correctness of figures presented, on the one hand, and merely e!pressing an opinion on them, on the other. 'uditors in the J7' still refer to their ?certificate,/ but is the J< the term ?report/ is correctly used. The only situations in which it is appropriate for an auditor or accountant to use the word ?certificate/ arise when1t should not, of course, be imagined that the general re,uirement for the auditor simply to provide an opinion rather than a certificate in any way lightens his burden. 8n the contrary, apart from the fact that a professional opinion has inevitably to be e!pressed on the basis of a less than e!haustive en,uiry, the very vagueness of the phrase ?true and fair/ imposes particular risks. Furthermore, the ,uestion of whether or not the audit work has proceeded the e!pression of opinion satisfies current standards of re,uisite care and skill can never be answered with certainty- the unavoidable element of persona Budgement )and its associated subBectivity* which the auditor is forced to e!ercise in determining the e!tent of audit tests plays far too great a part. @!posure to potential liability therefore accompanies every audit assignment and cases of liability which have arisen in the past are often attributable to the failure, in the opinion of the court of the auditor to e!ecute a sufficient deep or e!tensive e!amination in the particular circumstances obtaining. 2.< T0e #0rono!o'- o1 an a"&),

'lthough audits will have precisely the same obBective, namely, to report to the interested parties on the results of the audit investigation undertaken within the conte!t of the engagement, it is nevertheless true that the detailed manner in which the audit is conducted will largely depend upon the si5e and circumstances of the client concerned. For the audit obBective to be achieved a systematic approach to the task is essential and, although all aspects of audit work are closely interrelated, it is convenient to distinguish the essential phases which the audit develops. 1n the 'uditor/s 8perational 7tandard the following five essential phases are highlighted)a* )b* )c* )d* The auditor should ade,uately plan, control and record his workA The auditor should ascertain the enterprise/s system of recording and processing transactions and assess its ade,uacy for the preparations of financial statementsA The auditor should obtain relevant and reliable audit evidence sufficient to enable him to draw reasonable conclusions thereforeA 1f the auditor wishes to place reliance on any internal controls, he should ascertain and evaluate those controls and perform compliance tests on their operationA 1##

)e*

The auditor should carry out such a review of the financial statements as is sufficient, in conBunction with the conclusion drawn for the other audit evidence obtained, to give him a reasonable basis for his opinion on the financial statements.

The above represents a framework, which embraces virtually the whole of normal audit work, and it therefore lends a perspective to any individual aspect of audit work being considered. Helpful though such a broad perspective maybe, full appreciation of the chronology of audit procedures re,uired considerable further subdivision of audit stages, distinguishing the audit obBective applicable at each point from the means or techni,ues whereby those obBectives would normally be achieved in practice. 1t assumes)a* That the audit is being conducted for a new client company for the first time, i.e that there is no pre e!isting accumulation of information built in the files from previous auditorsA That the client organi5ation is sufficiently large and comple! to re,uire the e!tensive use of all the usual techni,ues applicable at each stage of the audit, and employs conventional internal control systems in maBor operational areasA and That the company is of a si5e which would cause the auditor reasonably to e!pect that controls in force are basically satisfactory, and hence that a systems based audit )see below* is Bustified.

)b*

)d*

The function of the diagram is to provide an e!panded outline covering all auditing proceduresA there is virtually nothing, which takes place during the audit, which cannot be related to the procedures described in the diagram. This is of enormous practical value during routine audit work, since the ability to relate the detailed procedures to an overall plan always adds a new dimension to audit work, particularly for the clerks engaged thereon. The following points arising from the diagram should be specifically noted)a* 'lthough the e!ecution of the audit programme takes place at stage K, this obviously e!cludes such work on the verification of assets and liabilities that can be concluded only when the balance sheet has been prepared at the close of the periodA and The first two stages are concerned with obBective fact gathering and, as such, are not especially audit oriented- indeed, the information compiled could e,ually be used by 8rganisation and Methods personnel. However, whereas the letter would then proceed to use the data with considerations of efficiency uppermost, the auditor/s work during stages 111 to K is predominantly concerned with the efficacy of internal control. T0e s-s,e*s4 ase& a"&), 1#1

)b*

2.=

The systematic approach to audit work demonstrated above has come to be known as the systems based audit. The name correctly incorporates the principle that the nature and depth tests should take not into account the e!tent to which the system of internal control in operation ?audits itself/. 1t is for this reason that such a large proportion of the work described in the diagram relates to the ascertainment and evaluation of the system prior to the planning and e!ecution of the audit programme itself. This contrasts favourably with the hapha5ard approach which traditionally prevailed until, during the si!ties, the mushrooming of large groups of companies and conglomerates forced upon auditors the reali5ation that a far more scientific approach to their work was essentialA that is, if they were to Bustify the relatively small number of audit tests carried out in relation to the enormous volume of transactions falling within the period under review. However, no change in approach takes place universally, overnight. 1nevitably the large international firms are the first to pioneer new audit methodsA this involves careful research, planning and long periods of field testing if the charge of negligence is to be avoided. Many smaller audit firms, cough tuner the combined pressures of generally raised standards, professional recommendations and legal case decisions, are eventually forced to follow suit. 2elics of the old ?regime/ still persist today. However, a colleague recently related to me the scarcely credible story of two student trainees who proudly described how they had ?vouched/ no less than one million sales invoice copiesT They were obliged to e!ecute this singularly unadventurous and unrewarding feat )which occupied them for a fortnight* due to an accident instruction in their audit programme, to check the sales figures for three months from the copy documents to the sales day book. 1t is possible that at one time three month/s checking of this nature might have been appropriate, but clearly no one had taken the trouble to review the testing depth specified by the now archaic programme. 'pparently our two stalwart, who could barely have remained fully conscious during this task, discovered only one solitary ?error/- it was noticed by the clerk whose function it was to enter ?vouching ticks/ in the day book, that one entry which should have been vouched )he could tell this from the numbering se,uence* remained unticked. The other clerk, whose function was to ?bash/ each document with a rubber ?audit/ tamp, paged back through the file to see whether had been inadvertently missed L but noA the invoice was undoubtedly missing. Feeling that their unremitting labour had proved worthwhile after all, they then reported this matter to the chief accountant. He had clearly summed up the calibre of the audit staff, for his response was promptly to instruct his secretary to produce a replica of the missing item, correct in every detail, which he duly passed back to the terrible twins for insertion in the file, in its proper place. 1t seems that the duplicate was then bashed, and its counterpart entry /vouched/, thus allowing the headlong rush to continue on its way to completion, This anecdote demonstrates the futile nature of blind audit testing, no consideration having been given to )a* the number of invoices which it might have been appropriate to vouch, or )b* the way in which the recording of sales related to other associated entries in, say, the store records or remittances received. For all its apparently e!tensive coverage the test was e!ceptionally shallow, being confined to one ?hori5ontal plane/ of entries, all of an identical nature. 1#6

1t is also clear that the clerks were concerned only with outer appearances- they were completely satisfied once a duplicate voucher was placed on the file. 1t apparently did not occur to them that there might, conceivable, have been more serious implications behind the missing item, such as deliberate suppression of part)s* of the invoice set, perhaps to conceal missing goods, or a variety of other possibilities on which one can but speculate, without knowing the mechanics of the particular system. This totally hapha5ard approach, amounting to little more than guess work, is sometimes euphemistically termed ?Budgement/ sampling thereby suggesting that the auditor has carefully weighed up the circumstance and conditions in which the records are created, and then e!ercised his Budgement in determining the re,uisite volume of testing. ;o doubt this is true in a number of cases, but all too often ?Budgement/ amounts to little more than an e!cuse for testing ?the same number as last year/T 1n any event it is difficult to see how Budgement of this variety can ever be an effective substitute for a scientific approach to sample teasing which, although it too may involve a good deal of Budgement, is nevertheless based upon the mathematic laws of probability. The scientific method, employed statistical sampling techni,ues, is not always appropriate L for e!ample when items within the population being tested are not homogenous, or where the population si5es are relatively small L but it has the advantage of ,uantifying the risk that the characteristics of the sample are not representative of those in the population, and generally forces the auditor to e!ercise his Budgement in a constructive way. .hatever method is used for determining sample si5es, it is imperative that ransom selection should be employed during the e!amination process itself, otherwise personal bias affect the selection of individual items, thereby invalidating the sampling e!ercise and resulting in incorrect inferences being drawn concerning the population. 'lthough the use by auditors of statistical and other sampling techni,ues is discussed in detail in 4hapter ", it may be useful to illustrate this section by highlighting in Figure 6.6 the testing stages included in the previous ?chronology/ figure, as they would feature in the conte!t of a systems based audit. T0e Gen&4res"!,3 a!,erna,)/e The discussion on the 'uditors/ 8perational 7tandard, e!amined the predominance of the systems based approach. The vast maBority of business in the Jnited <ingdom incorporate systems of internal control which are either rudimentary )due to the limited number of staff employed*, or are dominated by proprietary directors. The application of the systems based audit philosophy in such situations is rarely possible, and the auditor/s prime concern should rather be to establish)a* )b* That all the transactions of the business have been accurately and completely recordedA and That the transactions recorded were undertaken on behalf of the business itself, rather than any individual or related party.

1#>

1n pursuing these obBectives the auditor of a small business will inevitably be forced to rely heavily on the representations and assurances of the owners of the business, and such evidence as e!ists in support of these representations will rarely arise from its systems of internal control. 1t is far more likely that corroboration will be found in radio analysis, comparisons with periods, comparisons with other businesses in the same trade, and general ?market intelligence/ L all of which is encompassed in the term ?analytical review/ L not to mention that all important )perhaps the most important* indicator of all, the auditor/s personal assessment of the character, trustworthiness and general credibility of the directors themselves. 1n practice, particularly where the auditor is familiar with the business situation as a result of many years/ e!perience, audit work will concentrate heavily on pursuing obBect )a* above, entailing e!tensive checking of the records and of the schedules supporting the figures in the final accounts L a procedure often referred to as an ?end results/ audit. 1n the circumstances of small businesses this approach is obviously more practical than attempting a systems based audit. 1t is rare for small companies to employ ,ualified accounting staff, and the auditor, in an accounting capacity, will often take on the accounts preparation work. ' reasonable degree of audit assurance may, however, be derived from this work, although this will relate to book keeping accuracy, and will of itself provide no assurance of the completeness and accuracy of source documents, nor a valid substitute for an audit. A"&), #!ass)1)#a,)ons 's has already been pointed out in 7ection 6.% above, the ,uantity, range and depth of audit work undertaken in any given set of circumstance will depend upon the auditor/s own assessment of the system which produces, in the first place, the records which he is re,uired to audit. 7ince both the comple!ity and dependability of systems are almost infinitely variable, the length of time taken to conduct an audit, and the number and level of audit personnel re,uired to do so, e,ually variable. 1t is nevertheless possible to draw up the following broad classifications;ature of audit ?4omplete/ or ?FinalU Brief description Jsually applies to smaller concerns, where the volume of transactions and comple!ity of records does not re,uire the auditor/s attendance more than once in each year. This visit normally takes place soon as possible after the business/s financial year end and continues until it has been completed and the audit report signed. 1n some cases, for mutual convenience, the records may even be transported to the auditor/s own offices for audit purposes. 1n the case of larger clients the auditor will often find it necessary to proceed with the audit on an interim basis, in view of the volume of testing which it is necessary for him and his staff to undertake in order to reach an opinion on the reliability of the records. 1nternal audits, 1#%

?1nterim and Final/

always arranged with the cooperation of the client, may be bi annual, ,uarterly, or even monthly, depending upon the volume of audit work considered necessary. 1nterim audits possess the advantage of leaving the final state of the audit relatively free for the verification of the year end accounts- the assessment of the system and most detailed checking of underlying records and documents having already been carried out. ?4ontinuous/ .here the system of internal control operated by a large company displays certain fundamental and material weaknesses, the auditor will be obliged to check a higher proportion of transactions than would otherwise be necessary and, in e!ceptional circumstance, members of the audit team may be re,uired to e!ecute checking work continuously throughout the period to which the accounts relate.

1#D

CHAPTER <.0: EFTERNAL AUDITING

PRINCIPLES OF EFTERNAL AUDITING 'uditing is an essentially practical e!ercise. 1t is a well understood process of independent e!amination with the obBective of forming an opinion on financial statements. The need for an audit could be e!plained in terms of the agency theory L the divorce that occurs between management and ownership of the business enterprise forces the absentee owners to institute control measures to ensure the honesty of their stewards )management* and the accuracy and freedom from bias of the periodic financial statements which those stewards prepare for their owners. 'n annual e!ternal audit is one manifestation of such control measures. The very e!istence of an audit like activity can then be postulated without any specific knowledge of what auditing itself entails. 'n agency theory is not limited to the private sector aloneA :overnments and local authorities become stewards by virtue of ta!es, which are levied upon the ta!payers. The citi5ens then in return demand some degree of accountability in terms of demonstrable value for money or independently certified financial returns. POSTULATES OF AUDITING Most professional activities that seek long term credibility also seek an underlying theory which can be used to Bustify the activity itself and thus legitimise the continued e!istence of the professional group. 4ountries have laws and so we must have lawyers and lawyers must have a precedent. 7imilarly people must have reliable buildings and so architects e!ist with a body of applied scientific theory at their disposal. The agency theory Bustification for the e!istence of modern auditing may be viewed in this light. The conceptual framework of auditing is called postulates of auditing. 'ccording to a Con#)se O51or& D)#,)onar- a postulate ?is a thing claimed or assumed as a basis for reasoning, a fundamental assumption or prere,uisite/ Maut5 and 7haraf )1G"1* further define the idea of a postulate- they said that postulates are essential for1#"

@ssential to the development of any intellectual discipline and a foundation for the erection of any theoretical structureA 'ssumptions that do not lend themselves to direct verification or proof. 7ooner or later one has to make )and live with* fundamental assumptions if progress is to be made. ' basis for inference. :iven the strength and acceptance of the fundamental postulates we can develop a more comple! and thus more informative and reliable picture of the activity and its purpose 7usceptible to change in light of later developments or advancement of knowledge . 'ny set of postulates or a!ioms are capable of change in the light of new discoveries and techni,ues.

The eight postulates identified by Maut5 and 7haraf are set out below1. Financial statements and financial data are verifiable 6. There is no necessary conflict of interest between the auditor and the management of the enterprise under unit >. The financial statements and other information submitted for verification are free from collusive and other unusual irregularities %. The e!istence of a satisfactory system of internal controls eliminates the probability of irregularities D. 4onsistent application of generally accepted principles of accounting results in the fair presentation of financial position and the results of operation ". in the absence of clear evidence to the contrary, what has held true in the past for the enterprise under e!amination will hold true in the future E. when e!amining financial data for the purpose of e!pression of an independent opinion thereon, the auditor acts e!clusively in the capacity of the auditor F. The professional status of the independent auditor imposes commensurate professional obligations 1t is important to note the importance of re!a,e& +ar,- &)s#!os"res and o .e#,)/),- and )n&e+en&en#e as they have become increasingly important in the light of Enron and 6or!&Co* financial scandals. FORENSIC AUDITS The following readings are biased towards the J< practice but is representative of the type of audit that may be performed internationally.
<..1

De1)n),)on

Forensic auditing could be defined as the application of auditing skills to situations that have legal conse,uences.

1#E

<..2

2a#$'ro"n&

1n a global review conducted by @rnst Q +oung, on the ,uestion of auditorsI responsibility, in 1GG", the finding wasV8ver seven out of ten of the respondents believed that auditors should have the responsibility to detect substantial fraud. 8f these eight out of ten believe that this should be part of their normal audit and not by special one off reviews.V The main theme of the last )PK1* 1;487'1, at Montevideo, in 1GGF, was VThe role of 7'1Is in (reventing and &etecting Fraud and 4orruptionV. +et, on the basis of responses received from individual 17'Is to a survey conducted in preparation for the 4ongress, it emerged thatV7'1Is generally agree that the primary responsibility for the prevention of corruption rests with the administrative authorities, the police and other investigative institutions, and cannot be counted among the main tasks of 7'1Is V. 8n this matter however a related finding was thatV'lso most of the 7'1Is make clear that they see their main goal more in preventing corruption than in the field of actually detecting such illegal activities.V 1;T87'1 'uditing 7tandards, adopted by 1;487'1 PK at 4airo in 1GGD, while stipulating standards of Idue careI provideV'uditors need to be alert for situations, control weaknesses, inade,uacies in record keeping, errors and unusual transactions or results which could be indicative of fraud, improper or unlawful e!penditure, unauthorised operations, waste, inefficiency or lack of probity.V ):eneral 7tandards, 4hapter 11, paragraph G#*. .e are faced with the inescapable conclusion that there is a difference between what is e!pected of auditors and what auditors acknowledge as being their role in relation to fraud and corruption, the so called Ie!pectation gapI. 1n the 1ndian conte!t, discussions with members of (arliament, the (ress and even civil servants in the e!ecutive arm of :overnment show the e!istence of such an e!pectation gap. @ven though no formal survey on this aspect has been carried out, it may be advisable to address the issue with a view to identifying, and to the e!tent possible, defining our positions on the several issues that are involved. 1t is in this conte!t that we need to view the adoption and use of Forensic 'uditing.
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A++!)#a,)ons o1 Forens)# A"&),

'n obvious e!ample of forensic auditing is the investigation of a fraud or presumptive fraud with a view to gathering evidence that could be presented in a court of law. However, there is an increasing use of auditing skills to prevent fraud by identifying and rectifying situations which could lead to frauds being perpetrated )i.e. risks*. 1t might be useful, therefore, to discuss forensic auditing as being either /2eactive/ or ?(roactive ?. 1#F

<..<

Proa#,)/e 1orens)# a"&),)n'

Forensic auditing in this sense could be viewed from different aspects depending on its application, some of which are discussed below<..=

S,a,",or- A"&),

1;T87'1 auditing standards prescribe that internal controls should be studied and evaluated in respect of safeguarding assets and resources when performing regularity and financial audits, and in respect of assisting management in complying with laws and regulations when performing compliance audits.
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8F)e!& S,an&ar&s( C0a+,er III( +ara'ra+0 1<29

Forensic audit methodologies can be used to obtain a more detailed understanding of the entity and its activities to identify areas of risk both in determining the direction of the audit and in e!pressing an opinion.
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Re'"!a,or- Co*+!)an#e

:overnment &epartments3'gencies could themselves use the techni,ues of Forensic auditing to assess compliance with regulations governing payments of grants 3subsidies. (erformance auditors could also use these techni,ues while auditing such governmental programs. To a large e!tent we in 7'1 1ndia have applied such techni,ues in some of our maBor audits of large government programs such as ? 1ntegrated 4hild &evelopment 7cheme/, (ublic &istribution 7cheme )for food grains*, to 4ustoms duty drawbacks and e!port subsidies.
<..@

D)a'nos,)# Too!

Forensic auditing can be used either by management or by auditors to carry out general reviews of activities to highlight risks arising either out of fraud or from any other source with the purpose of initiating focused reviews of particular areas, targeting specific threats to the organisation.
<..A

In/es,)'a,)on o1 a!!e'a,)ons

4omplaints, allegations in the (ress or in (arliament, anonymous tips from employees or others could all in their separate ways re,uire to be ade,uately addressed by investigation. The techni,ues of forensic auditing are useful in such cases. This is being cited as proactive because it is widely felt that the e!istence of a system of investigation in such cases is a significant deterrent to fraud and corruption.
<..D

Rea#,)/e Forens)# A"&),)n'

The obBective in case of reactive forensic audit is to investigate cases of suspected fraud so as to prove or disprove the suspicions, and if the suspicions are proven, to identify the 1#G

persons involved, support the findings by evidence and to present the evidence in an acceptable format in any subse,uent disciplinary or criminal proceedings. 1n such cases it is important to keep in view the following <..10

working relations with the investigating and prosecuting agencies authorisation and control of the audit investigation documentation of relevant information and safeguarding all prime records pertaining to the case rules of evidence governing admissibility3authentication of records confidentiality evaluation of the evidence to assess whether the case is sustainable legal advice where appropriate reporting the findings in a manner that meets legal re,uirements. Iss"es 1or #ons)&era,)on

8ur audits are carried out and reported within a framework which assumes that the top echelons of management both at the political and civil service levels are responsive to the need for good governance and accountability, and therefore would act upon the audit findings which indicate that there was cause for concern in the ade,uacy and implementation of internal controls, and inevitably institute en,uiries into instances indicative of mala fide action on the part of officials. 1n conse,uence our role has been limited to conducting audits on certain percentages of sampling applied in an uniform manner across departments, with only isolated e!amples of focused audit reviews conducted by 7'1 1ndia as in the case of Kalue Based 'dvance Cicensing 7cheme )for import of raw materials by e!porters* or Koluntary &isclosure of 1ncome 7cheme )for income ta! defaulters*. 1n both cases however, as also as in the 'nimal Husbandry case of the :ovt. 8f Bihar, it was established that there were clear indications of mala fide at senior levels of government and hence far from the initiation of any systematic en,uiries into audit findings, attempts were to debunk the findings presented in the audit report. The position of 7'1 1ndia is that audit against criteria of probity and compliance in themselves throw up instances of administrative actions that are not in conformity with prescribed standards, and that without the mandate to seek third party evidence, either oral or documentary, it is not possible to prove criminal mala fide. @!cepting for a very few 7'1/s, it is also the case in almost all other countries that there are other agencies responsible for investigating fraud and corruption. 8ur focus therefore could be more upon planning and e!ecuting our audits with much greater emphasis on forensic auditing and reporting such findings in a manner that places the onus for further investigation very clearly on the e!ecutive. 7ome of the areas that could be considered are

'udit (lanning-

11#

8ur audits could be planned to cover only a selected sample of offices based on an analytical review of accounts and results of past audits instead of a blanket coverage of all spending offices.

7cope of 'udit-

Jnless otherwise stipulated, audit should concentrate on regularity, probity and compliance issues. (erformance related issues could be dealt with in specific performance reviews. The role of the controlling officer, the head of department and the administrative secretary of the concerned ministry in financial administration are usually specified in the financial codes, manuals, rules and orders of government. Their actual discharge of such prescribed duties could be e!amined and the implementation of prescribed controls evaluated.

2eporting-

7ignificant failures in the application of prescribed controls and dereliction of administrative duties particularly in the areas of monitoring and stock verification at all levels, and the implications involved, could be clearly brought out in a specific chapter of our 2eports.

2elationship with investigating agencies-

The rules for re,uisitioning records by the investigative agencies should be clearly understood by the staff and middle level management in our offices as well as in those of the investigative agencies. These issues could be addressed by Boint seminars and inviting speakers to respective training institutions. The need for a set of orders laying down the prescribed procedures in an easily comprehensible manner, and circulating these widely could be considered.

(osition of the 'uditor in criminal investigations-

There is a need to provide clear and binding instructions about the manner in which audit staff are re,uired to provide information to the investigative agencies. Faced with the possibility of being ,uestioned in a manner akin to that employed for suspects, audit staff may resent, and hence avoid, being involved in criminal proceedings. .hile the possibility of auditors conniving in fraud has to be kept in view, it is necessary to ensure that unless there is prima facie evidence to this effect, the auditor must be a part of the investigative team. I*+!)#a,)ons an& "ses o1 In1or*a,)on Te#0no!o'-: The advent of large scale use of computers in processing not only accounting information but also several other transactions with direct financial implications poses a challenge to forensic auditing because large volumes are processed in a short time. 4onnectivity through internet, .'; or @&1 allows dispersed data input, processing and storage. The proliferation of platforms and software makes it possible to perpetrate frauds in new ways. ' thorough knowledge of 1T and the engagement of highly skilled professionals is 111

therefore essential if Forensic auditing is to have any meaning. 'part from this the cyber laws are very new and there is, as yet, no clear case law on various matters, this is all the more reason to insist upon great clarity in understanding 1T based operations and the evaluation of risks involved. 't the same time the ease with which data can be sorted, analysed and compared makes it much easier to identify suspect transactions either singly or as a group of similar or related ones, thus greatly facilitating forensic auditing. The availability of archived data and the ease of access also could assist forensic auditing. &ata matching and data mining techni,ues offer e!cellent opportunities.

Training-

1t is necessary to provide formal instruction in fraud awareness, investigation and reporting. The planning of overall audit coverage and individual audits on the basis of risk analyses carried in accordance with e!isting global ?best practice/ could be included in the curriculum for all management levels. 'rguably, forensic auditing without a thorough knowledge of 1T as outlined above would be meaningless, and this would have to be borne in mind while devising curricula. Con#!"s)on There is no gainsaying the fact that our audits as currently e!ecuted and reported do bring out in a wealth of detail, instances of individual or systematic fraud and corruption. There is, however, a need to provide a comprehensive framework involving the use of Forensic auditing methodology, particularly in the areas of audit planning and e!ecution, and for a uniform reporting practice that would very e!plicitly spell out the implications of control failures including failure of senior management in implementing prescribed controls. This could over a period of time assuage public concern about the e!istence of systematic audit operations addressed specifically to unearth fraud and corruption AUDIT FILES A"&), 1)!es an& %or$)n' +a+ers ;othing enhances the efficiency and maintenance of audit files and ?working papers/. From the very beginning of an audit the files should be built up systematically, and technicians involved on audit assignments should be constantly reminded of the importance of )a* recording everything of conse,uence that arises during their investigative work, and )b* ensuring that audit papers/ are kept in an orderly fashion at all times. .henever it is possible and appropriate, brief notes should be taken during interviews with company officials, subse,uently amplified and then placed in the relevant section of the audit file. 'll ,ueries arising during the conduct of the audit should be resolved as soon as possible, the answers being entered alongside the related ,ueries on schedules specially pre printed for the purpose. 116

@ach firm will design the full range of standard pre printed documentation re,uired to support its audit procedures, and completeness of files is usually assured by use of the standardi5ed 1nde!, or ?front sheet/. The :uidelines to the 8perational 7tandard included the following notes on audit working papers-

2a#$'ro"n& %easons for preparing audit &orking paper include t!e follo&ing' )a* The reporting partner needs to be able to satisfy himself that work delegated by him has been properly performed. The reporting partner can generally only do this by having available to him detailed working papers prepared by the audit staff who performed the work. .orking papers provide, for future reference, details of problems encountered, together with evidence of work performed and conclusions drawn there from in arriving at the audit opinion. The preparation of working papers encourages the auditor to adopt a methodical approach.

)b*

)c*

Pro#e&"res (ontents of Working )apers 'udit working papers should always be sufficiently complete and detailed to enable an e!perienced auditor with no previous connection with the audit subse,uently to ascertain from them what work was performed and to support the conclusions reached. 'udit working papers should be prepared as the auditor proceeds so that details and problems are not omitted. 'udit working papers should include summary of all significant matters identified which may re,uire the e!ercise of Budgement, together with the auditor/s conclusions thereon. 1f difficult ,uestions of principles or of Budgement arise, the auditor should record the relevant information received and summari5e both the management/s and his conclusions. 1t is in such areas as these that the auditor/s Budgement may subse,uently be ,uestioned, particularly by a third party who has the benefit of hindsight. 1t is important to be able to tell what facts were known at the time the auditor reached his conclusions and to be able to demonstrate that. Based on those facts, the conclusion was reasonable. 'udit working papers will typically contain)a* )b* 1nformation which will be of continuing importance to the audit )e.g. Memorandum and 'rticles of 'ssociation*A 'udit planning informationA 11>

)c* )d*

The auditor/s assessment of the enterprise/s accounting system and, if appropriate, has review and eventually of its internal controlsA &etails of the audit work carried out, notes of errors or e!ceptions found and action taken thereon, together with the conclusions drawn by the audit staff who performed the various sections of the workA @vidence that the work of the audit staff has been properly receivedA 2ecords of relevant balances and other financial information, including analyses and, summaries supporting the financial statementA ' summary of significant points affecting the financial statements and the audit report, showing how these points were dealt with.

)e* )f* )g*

S,an&ar&)sa,)on o1 6or$)n' +a+ers The use of 7tandardi5ed working papers may improve the efficiency with which they are prepared and reviewed. Jsed properly they help to instruct audit staff and facilitate the delegation of work while providing a means to control its ,uality. However, despite the advantages of standardi5ing the routine documentations of the audit )e.g. checklists, specimen letters, standard organi5ation of the working papers*, it is never appropriate to follow mechanically a ?standard/ approach to the conduct and documentation of the audit without regard to the need to e!ercise professional Budgement. O%ners0)+ an& C"s,o&- o1 6or$)n' Pa+ers .orking papers are the property of the auditor and he should adopt appropriate procedures to ensure their safe custody and confidentiality. 'lthough the above :uideline has superseded the 14'@. 7tatement J16, the latter included certain important points relating to working papers, as followsThe subdivision of the working papers between current and permanent files will, in practice, be a matter of convenience and the suggested allocation, given below, should be interpreted in this light. C"rren, 1)!e The current year/s file, which will relate primarily to the set if accounts or statement being audited, should normally contain the following)a* )b* ' copy of the accounts or statement on which the auditors are reporting, authenticated by directors/ signatures or otherwise. 'n inde! covering all the working papers unless they are cross referenced to the relevant items in the accounts. )ii* 'n internal control ,uestionnaire or other record, including flowcharts if appropriate, designed to ascertain the ade,uacy of the system of internal control, and 11%

)iii* )d*

'n audit programmed supplemented by particulars and dates of the work carried out and precise details of audit tests and their results.

' schedule for each item in the balance sheet, preferably including comparative figures, showing its make up and how e!istence, ownership and value or liability have been verified. These schedules should be cross referenced to documents arising from e!ternal verification such as bank letters and the results of circulari5ation of debtors and attendance at physical stocktaking. ' schedule supporting each time in the statutory profit and loss account, preferably including comparative figures, and such other items in the trading or subsidiary accounts as may be necessary. ' checklist concerning compliance with statutory disclosure provisions. ' record showing ,ueries raised during the audit and their disposal, with notes where appropriate for attention the following year. Mueries not cleared at the time should be entered onto a further schedule for the attention of the person reviewing the audit and for reference to the client if necessary. Material ,ueries, which cannot be settled satisfactorily be immediate reference to the client, may re,uire a ,ualification of the auditors/ report and should be fully documented and supported by a note of all discussions with the client and any e!planation given. ' schedule of the important statistics or working ratios, comparative figures being included where appropriate. Jseful ratio may include:ross profit percentages 4urrent assets to current liabilities 7tock turnover Trade debtors and creditors average period of credit (rofit to capital employed

)e*

)f* )g*

)h*

)i*

' record or e!tract of minutes of meetings of the directors and shareholders. These should be cross referenced where relevant to the auditors/ working schedules. 4opies of letters to the client setting out any material weakness or matters with which the auditors are dissatisfied in respect of the accounts or control procedures. 7uch letter should be sent even where the particular matter has been discussed informally with one or more of the company/s official. Cetters of representation, i.e. written confirmation by the client of information and opinions e!pressed in respect of matters such as stock values and amounts of current and contingent liabilities.

)B*

)k*

11D

Matters which, while not of permanent importance, will re,uire attention during the subse,uent year/s audit should be listed, with reference to the relevant working papers, and this note should be transferred to the ne!t current file when opened.

Per*anen, 1)!e Matters of continuing importance affecting the company or the audit should be kept in a separate file, suitably inde!ed and these should normally include)a* )b* )c* )d* )e* Memorandum and 'rticles of 'ssociation and other appropriate statutory or legal regulations. 4opies of other documents and minutes of continuing importance. ' short description of the type of business carried on the places of business. Cists of accounting records and responsible officials and plan of organi5ation. 7tatements showing a note of any accounting matters of importance such as a history of reserves and bases of accounting adopted, e.g for evaluation of stock and work in progress, depreciation and the carrying forward and writing off of e!penditure ultimately chargeable to revenue. The client/s internal accounting instructions and internal audit instructions, including when appropriate stocktaking instructions.

)f*

7teps should be taken to ensure that the permanent is brought up to date at the appropriate times. 1n the case of a non statutory audit the permanent should also contain the client/s instructions as to the scope of the work to be performed. 'part from the current file content listed above many firms also design and standardi5e supplementary audit aid such as)a* )b* )c* )d* 4ertificate of directors/ emoluments, including fees, commissions, bonuses, pensions, e!pense allowances and benefitsA &etailed report of attendance at stocktakingA 'udit completion checklistsA 4alling over sheetsA 11"

)e*

4hecklists for 4ompanies 'ct re,uirementsA 7tatements of 7tandard 'ccounting (ractice )particularly noting dates from when operative*A 7tock @!change re,uirements for listed companiesA 4ontent of the &irectors/ 2eportA 8ther statutes and regulations, e.g. building societies, friendly and provident societies, solicitorsA 7ecurities and @!change 4ommission )7@4* re,uirements for subsidiaries of J7 parent companiesA The audit report.

'lthough the subBect of the audit report is dealt with e!tensively in 4hapter F, in order to illustrate the checklist techni,ue, an audit report checklist and calling over sheet are reproduced belowA"&), re+or, C0e#$!)s, Te#0n)#a! Con,en, Yes No )a* Have all the e!planations and information necessary for the purposes of the audit been obtained L with particular reference to certificates confirmations from third parties, including subsidiary auditors0 Have proper accounting records been kept and proper returns received from any branches not visited0 're the accounts in agreement with the accounting records and returns0 &o the accounts give not only a true but also a fair view of the results and source and application of funds for the period and the state of affairs at the accounting date0 &o the accounts comply with the re,uirements of the 4ompanies 'ct 1GFD0 're we satisfied that any audit ,ualifications is not material in determining whether, under 7ec.6E1, 4' 1GFD, any dividends paid or proposed are permitted0 1f not, have we made the re,uired written statement to that effect0 NEA In),)a!s

)b* )c* )d*

)e* )f*

11E

)g*

're details of the following items included in the audit report to the e!tent that they are not properly disclosed in the accounts0 &irectors/ emoluments, pensions, and compensation for loss of office0 @moluments of highest paid director )other than chairman*0 &irectors/ emoluments waived0 The number of directors whose emoluments fall within specified statutory bands0 Coans and ,uasi loans to officers0 &etails of contracts and other transactions with directors/ covered by 4' 1GFD0

)h*

.here appropriate, do the group accounts show a true and fair view of the group position and comply with the re,uirement of the 4ompanies 'cts 1GFD and 1GFG0 .here appropriate, does the audit report include any ,ualifications contained in the reports or auditors of subsidiary and associated companies to the e!tent that the ,ualifications are material in the conte!t of the group accounts as a whole0 Have ,uestionnaires sent to subsidiary auditors been duty completed and returned to your satisfaction0 &oes the audit report refer, in appropriate terms, to all significant departures from accounting 7tandards0 Have the accounts been approved and signed by the directors before the audit report is signed0 Have all outstanding ,ueries been satisfactorily resolved0 &oes the report satisfy the re,uirements of the 'udit 2eport 7tandards0 &o the accounts include a fund statement which complies with 77'( 1#0 1f answer to )o* is ?no/ and turnover if greater than W6D,###, have we included a suitable ,ualification0 Have we e!amined the directors/ report as re,uired by the 4ompanies 'ct 1GFD, and if so are we satisfied 11F

)i*

)B* )k* )l* )m* )n* )o* )p* ),*

that it is consistent with financial statements0 1f not, have we disclosed lack of consistency in out report0 Poss) !e C!er)#a! Errors )a* )b* )c* &oes the audit report refer to the correct accounting date and period0 &oes the report state correctly whether the company has made a profit or a loss for the period0 're the references in the report to the page number in the accounts correct0 )1t is essential that the report covers only the information re,uired to be given by the 4ompanies 'ct and accounting 7tandards and not any additional non statutory information.* 1s the audit report correctly addressed0 Has a partner, not in any way involved with the audit in ,uestion, 1ndependently red the draft audit report and approved its technical content and the suitably of the wording relating to any departures form the clean ?short form/ report0 2eviewed this checklist0

)d* )e*

To avoid the danger of this error, many firms prefer to use the word ?results/, instead of referring to a profit or a loss, especially since the accounts may show an operating profit and a final lossA a pre ta! profit and a post ta! lossA a profit before e!traordinary items, and a loss after e!traordinary itemsA etc.

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16#

MANAGEMENT REPRESENTATIONS The auditors receive many representations during the course of the audit, both solicited and unsolicited. 7ome of these representations may be critical to obtaining s"11)#)en,( a++ro+r)a,e e/)&en#e. ISA *+0 ,anagement representations says ?the auditor should obtain appropriate representations from management. ?The auditor should obtain evidence that management acknowledges its responsibility for the fair presentation of the financial statements in accordance with the relevant financial reporting frameworks and has approved the financial statements. This will be done upon receipt of the signed copy of the financial statements, which incorporates relevant statement of management responsibilities. 'lternatively, the auditors may obtain such evidence from 2elevant minutes of meetings of the board of directors or similar body or by attendance of such a meeting ' written representation from management )management representation*

Re+resen,a,)on - *ana'e*en, as a"&), e/)&en#e 1n addition to representations relating to responsibility for the financial statements, the auditors may wish to rely on management representations as audit evidence. The 17' says ?the auditor should obtain written confirmation of representation from management on matters material to the financial statements when other sufficient appropriate audit evidence cannot be reasonably e!pected to e!ist./ .ritten confirmation of oral representation avoids confusion and disagreement. 7uch matters should be discussed with those responsible for giving the written confirmation to ensure that they understand what they are confirming. 8nly matters material to the financial statements will need confirmation. .hen auditors receive such representation they should 7eek corroborative audit evidence from sources inside and outside the entity 161

@valuate whether the representations made by management appear reasonable and are consistent with other audit evidence obtained, including other representations 4onsider whether the individuals making the representations can be e!pected to be well informed on the particular matters.

The 17' says ?representations by management cannot be a substitute for other audit evidence that the auditor could reasonably e!pect to be available. 1f the auditor is unable to obtain sufficient appropriate audit evidence regarding a matter which has, or may have, a material effect on the financial statements and such audit evidence is e!pected to be available, this will constitute a limitation in the scope of the audit, even if a representation from management has been received on the matter./ There are instances where management representations may be the only audit evidence available <nowledge of the fact is confined to management, e.g. the facts are a matter of management intention The matter is principally one of Budgement or opinion e.g. the trading position of a particular segment

There are instances when the representations received do not agree with other audit evidence obtained. The 17' says ?if a representation by management is contradicted by other audit evidence, the auditor should investigate the circumstances and, when necessary, consider whether it casts doubt on the reliability of other representations made by management/. 2as)# e!e*en,s o1 a *ana'e*en, !e,,er ' management representation letter should Be a&&resse& to the a"&),ors Con,a)n s+e#)1)e& )n1or*a,)on Be a++ro+r)a,e!- &a,e& and s)'ne& by those with specific relevant knowledge.

The letter will usually be &a,e& on ,0e &a- ,0e 1)nan#)a! s,a,e*en,s are a++ro/e&. A#,)on )1 *ana'e*en, re1"ses ,o +ro/)&e re+resen,a,)ons ?1f management refuses to provide written representation that the auditor considers necessary, this constitutes a limitation of scope for their report and the auditor should e!press a ,ualified opinion or a disclaimer of opinion./ 1n such circumstances the auditor should consider whether it is appropriate to rely on other representations made by management during the course of the audit.

166

E5a* Fo#"s Po)n, The most important points to remember about the letter of representation are)a* )b* The circumstances in which it can be used The auditor/s response if the client fails to agree to it

+ou should be able to draft appropriate representations if asked. THE AUDITOR3S REPORT ON FINANCIAL STATEMENTS The a"&), re+or, is the means by which the e!ternal auditors e!press their opinion on the ,r",0 and 1a)rness of the company/s financial statements. This is for the benefit principally of the shareholders, but also for other users as the audit report is usually kept on public record, with the filled financial statements. '(A /00 Auditors% reports on financial statements establishes standards and provides guidance on the form and content of the auditor/s report issued as a result of an audit carried out by an independent auditor of the financial statements of an entity. 1t sates that the auditor should review and assess the conclusions drawn from the audit evidence obtained as a basis for the e!pression of an opinion on the financial statements. This review assessment involves considering whether the financial statements have been prepared in accordance with acceptable financial reporting framework being either relevant 'A(s or relevant national standards or practices. 'uditors may also have to consider whether financial statements comply with statutory re,uirements. The 17' says ?the auditor/s report should contain a clear written e!pression of opinion on the financial statements taken as a whole./ 2ASIC ELEMENTS OF THE AUDITOR3S REPORT The auditor/s report includes the following basic elements, usually in the following layout)a* )b* )c* Title 'ddressee 8pening introductory paragraph 1* 1dentification of the financial statements being audited 6* ' statement of the responsibility of the entity/s management and the responsibility of the auditor 7cope paragraph including reference to 17's or other standards. &escription of the work the auditor performed 8pinion paragraph &ate of the report 'uditor/s address 'uditor/s signature 16>

)d* )e* )f* )g* )h* )i*

Un?"a!)1)e& a"&),or3s re+or, 'n ?un,ualified opinion/ should be e!pressed when the auditor concludes that the financial statements give a true and fair view )or are presented fairly, in all material respects* in accordance with the identified financial reporting framework. 'n un,ualified opinion also indicates implicitly that any changes in accounting principles or in the method of application, and the effects thereof, have been properly determined and disclosed in the financial statements. The following is an un,ualified audit report that has been signed by the auditors of <iln, a limited liability company. AUDITOR3S REPORT TO THE SHAREHOLDERS OF KILN COMPANY .e have audited the accompanying )reference can be made by page numbers* balance sheet of the <iln 4ompany as of &ecember >1, 6#P>, and the related statements of income, and cash flows for the year then ended. These financial statements are the responsibility of the 4ompany/s management. 8ur responsibility is to e!press an opinion on these financial statements based on our audit. .e conducted our audit in accordance with 1nternational 7tandards on 'uditing. Those standards re,uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. 'n audit includes e!amining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. 'n audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. .e believe that our audit provides a reasonable basis for our opinion. 1n our opinion, the financial statements give a true and fair view of )or present fairly, in all material respects* the financial position of the company as at &ecember >1, 6#P>, and of the results of its operations and of its cash flows for the year then ended in accordance with 1'7s and comply with company law. AUDITOR &ate 'ddress

16%

MODIFIED REPORTS Modified audit reports arise when auditors do not believe that they can state without reservation that accounts give a true and fair view. The audit report is considered to be modified in the following situations. )a* )b* matters that do not affect the auditor/s opinion- emphasis of a matter matters that do affect the auditor/s opinion )i* Mualified opinion )ii* &isclaimer of opinion )iii* 'dverse opinion Ma,,ers ,0a, &o no, a11e#, ,0e a"&),or3s o+)n)on 1n certain circumstances, an auditor/s report may be modified by adding e*+0as)s o1 *a,,er to highlight a matter affecting the financial statements which is included in a note to the financial statements that more e!tensively discusses the matter. The addition of such emphasis of matter paragraph &oes no, a11e#, ,0e a"&),or3s o+)n)on. The auditor may also modify the auditor/s report by using an emphasis of matter paragraph)s* to report matters other than those affecting the financial statements. T0e +ara'ra+0 %o"!& e +re1era !- )n#!"&e& a1,er ,0e o+)n)on +ara'ra+0 an& %o"!& or&)nar)!- re1er ,o ,0e 1a#, ,0a, ,0e a"&),or3s re+or, )s no, ?"a!)1)e& )n ,0)s res+e#,. ISA -00 Going concern distinguishes between going concern matters and other matters, saying ?the auditor should modify the auditor/s report by adding a paragraph to highlight material matter regarding a going concern problem. The auditor should consider modifying the auditor/s report by adding a paragraph if there is a significant uncertainty )other than a going concern problem*, the resolution of which is dependent upon future events which may affect the financial statement. KEY TERM 'n uncertainty is a matter whose outcome depends on future actions or events not under the direct control of the entity but that may affect the financial statements. The following is an e!ample given by the 17'.ithout ,ualifying our opinion we draw your attention to ;ote P to the financial statements. The 4ompany is a defendant in the lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The 4ompany has filed a counter action, and preliminary hearing and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot presently be determined, and no provision for any liability that may result has been made in the financial statements. 16D

'n illustration of an emphasis of matter paragraph relating to going concern is set out below.ithout ,ualifying our opinion we draw your attention to ;ote P in the financial statements. The 4ompany incurred a net loss of PPP during the year ended &ecember >1, 6#P1 and, as of that date, the 4ompany/s current liabilities e!ceeded its current assets by PPP. These factors, along with other matters as set in note P, raise substantial doubt that the company will be able to continue as a going concern. This type of paragraph will be ade,uate to meet the auditor/s reporting responsibilities. 1n e!treme cases, however, involving multiple uncertainties that are significant to the financial statements, a &)s#!a)*er o1 o+)n)on may be re,uired instead. Ma,,ers ,0a, &o a11e#, ,0e a"&),or3s o+)n)on 'n auditor may not be unable to e!press an un,ualified opinion when one of the following circumstances e!ist and, in the auditor/s Budgement, the effect of the matter is or maybe material to the financial statements There is !)*),a,)on on ,0e s#o+e of the auditor/s work There is &)sa'ree*en, with management regarding the acceptability of the accounting policies selected, the method of their application or the ade,uacy of the financial disclosures.

There are different types and degrees of modified reports ' limitation on scope may lead to a ?"a!)1)e& a"&), o+)n)on or &)s#!a)*er o1 o+)n)on ' disagreement may lead to a ?"a!)1)e& o+)n)on or an a&/erse o+)n)on

:UALIFIED AUDIT OPINION The 17' says that a ,ualified audit opinion should be e!pressed when the auditor concludes that an un,ualified opinion cannot be e!pressed but the effect of any disagreements with management or limitation on scope is not so material and pervasive to re,uire an adverse opinion or disclaimer of opinion. DISCLAIMER OF OPINION ' disclaimer of opinion should be e!pressed when the possible effect of limitation on scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate evidence and accordingly is unable to e!press an opinion on the financial statements. ADBERSE OPINION 16"

'n adverse opinion should be e!pressed when the effect of a disagreement is so material and so pervasive to the financial statements that the auditor concludes that a ,ualification of the report is not ade,uate to disclose the misleading or incomplete nature of the financial statements. LIMITATION ON SCOPE There are two circumstances identified by 17' E## where there might be a limitation on scope. Firstly, the limitation on scope may be imposed by the entity )for e!ample when the terms of engagement specify that the auditor will not carry out an audit procedure that the auditor believes is necessary*. 7econdly, a limitation on scope may be imposed by circumstances )when the timings of the auditor/s appointment is such that the auditor is unable to observe the counting of physical inventory*. 1t may also arise that the entity/s accounting records are inade,uate or the auditor is unable to carry out an audit procedure believed to be desirable. 1n these circumstances, the auditor would attempt to carry out reasonable alternative procedures to obtain sufficient appropriate evidence to support an un,ualified opinion. ?.here there is limitation on the scope of the auditor/s work that re,uires e!pression of a ,ualified opinion or a disclaimer of opinion, the auditor/s report should describe the limitation and indicate the possible adBustment to the financial statements that might have been determined to be necessary had the limitation not e!isted./ The following e!ample is one of the e!amples that are given in the standardLimitation of scope$ .ualified opinion .e have audited )as for un,ualified* @!cept as discussed in the following in the following paragraph, we conducted our audit in accordance withN .e did not observe the counting of the physical inventories as of &ecember >1, 6#P1, since that date was prior to our engagement by the company. 8wing to the nature of the records, we are unable to satisfy ourselves as to inventory ,uantities by other audit procedures. 1n our opinion, e!cept for the effect of such adBustments,NNNN the financial statements give a true and fair view of the N

E5a* Fo#"s Po)n, @!am ,uestions on audit reports are often about possible ,ualifications in specific situations. 16E

THE AUDIT REPORT AS A MEANS OF COMMUNICATION The audit report can convey a great deal of information to the reader of the financial statements. Jn,ualified reports may not appear to give a lot of information. The report says a lot, however, by implication. 2emember that the auditors report by exception so an un,ualified audit report tells the user that (roper accounting records have been kept The accounts agree with the records The auditors have received all the necessary information 'll director/s transactions have been disclosed The director/s report is consistent with the accounts

Jnfortunately the real problem is that, unfortunately, most users do not know that this is what an un,ualified report tells them. Most users do not understand the responsibilities of either the auditors or directors in relation to the financial statements. E5+e#,a,)ons 'a+ The difference between the apparent public perceptions of the responsibilities of the auditors on the one hand and the legal and professional reality on the other hand. 7ome of the misunderstandings are1. T0e a!an#e s0ee, +ro/)&es a 1a)r /a!"a,)on o1 ,0e re+or,)n' en,),-

2. T0e a*o"n,s )n ,0e 1)nan#)a! s,a,e*en,s are s,a,e& +re#)se!;. T0e a"&),e& 1)nan#)a! s,a,e*en,s %)!! '"aran,ee ,0a, ,0e en,),- #on#erne& %)!! #on,)n"e ,o e5)s, <. An "n?"a!)1)e& a"&),or3s re+or, *eans ,0a, no 1ra"&s 0a/e o##"rre& )n ,0e +er)o& =. T0e a"&),ors +ro/)&e a so!",e ass"ran#e ,0a, ,0e 1)'"res )n ,0e 1)nan#)a! s,a,e*en,s are #orre#, 8)'nor)n' ,0e #on#e+, o1 *a,er)a!),- an& ,0e +ro !e*s o1 es,)*a,)on*. &ifferent countries have tackled this problem in different ways. The role of the auditor has been included in the debate on 4orporate :overnance in many .estern countries, leading to further voluntary rules.

16F

CHAPTER =.0: INTERNAL CONTROL

REMEM2ER 'n )n,erna! #on,ro! s-s,e* comprises the #on,ro! en/)ron*en, and #on,ro! +ro#e&"res. 1ncludes all the policies and procedures )internal controls* adopted by the director and management of an entity to ensure, as far as practicable, the orderly and efficient conduct of its business, including adherence to internal policies, the safeguarding of asset, the prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. 1nternal controls may be incorporated within computeri5ed accounting systems. However, the internal control system e!tends beyond those matters, which relate directly to the accounting system. =.1 Co*+onen,s o1 Ma,er)a! Con,ro!s )a* 17' %## 2isk assessment and internal control covers the whole area of controls.

Con,ro! en/)ron*en, )b* 4ontrol environment is the framework within which controls operate. The control environment is very much determined by the management of a business.

DEFINITION Con,ro! en/)ron*en, is the overall attitude, awareness and actions of directors and managers regarding internal controls and their importance in the entity.

16G

)c* )d*

' strong control environment does not, itself, ensure the effectiveness of the overall internal control system. 'spects of the control environment )such as management attitudes towards control* will nevertheless be a significant factor in determining how controls operate. 4ontrols are more likely to operate well in an environment where they are treated as being important. 1n addition consideration of the control environment will mean considering whether certain controls )internal auditors, budgets* actually e!ist.

Se're'a,)on o1 &",)es )e* Se're'a,)on o1 &",)es is a vital aspect of the control environment. 7egregation of duties implies a n"* er o1 +eo+!e being involved in the accounting process. This makes it more difficult for fraudulent transactions to be possessed )since a number of people would have to collude in the fraud*, and it is also more difficult for accident errors to be processed )since the more people are involved, the more checking there can be*. 7egregation should take place in various waysSe're'a,)on o1 1"n#,)on. The key functions that should be suggested are the #arr-)n' out of a transaction, re#or&)n' that transaction in the accounting record and *a)n,a)n)n' #"s,o&- of assets that arise from the transaction. The various steps in carrying out the transaction should also be segregated. .e shall see how this works in practice when we look at the maBor control cycles in 4hapters 1# and 11. The #arr-)n' o", of various accounting operations should be suggested. For e!ample the same staff should not record transactions and carry out the reconciliations at the period end.

)f*

Con,ro! +ro#e&"res DEFINITION 4ontrol procedures are those policies and procedures in addition to the control environment, which are, established to achieve the entity/s specific obBectives. )g* 4ontrol procedures include those designed to prevent or to detect and correct errors. .e have already discussed the importance of segregation of dutiesA here are some other specific control procedures.

S+e#)1)# #on,ro! +ro#e&"res 1>#

'pproval and control of documents

Transactions should be approved by an appropriate person. For e!ample, overtime should be approved by departmental managers.

4ontrols over computeri5ed applications 4hecking the arithmetical accuracy of records Maintaining and reviewing control accounts and trial balances

These are discussed in 7ection 6 in greater detail, but common e!amples include passwords. For e!ample, checking to see if individual invoices have been added up correctly. 4ontrol accounts bring together transactions individual ledgers. Trial balances bring together unusual transactions for the organi5ation as a whole. (reparing these can highlight unusual transactions or accounts.

2econciliations

2econciliations involve comparison of a specific balance in the accounting of records with what another source says the balance should be. &ifferences between the two figures should only be reconciling items. For e!ample, bank reconciliation.

4omparing the results of cash, security and stock counts with accounting records 4omparing internal data with e!ternal sources of information Cimiting physical access to assets and records

For e!ample, physical count of petty cash. The balance shown in the cash book should be the same amount as is in the tin. For e!ample, dispatched comparing records of goods

8nly authori5ed personnel should have access to certain assets )particularly valuable or portable ones*. For e!ample, ensuring that the stock store is only open when the store personnel are there and is otherwise locked. This can be a particular problem in computeri5ed 1>1

systems. P!ease re1er ,o CHAPTER D.0 1or ,0e )n,erna! #on,ro!s ,0a, are a++!)#a !e ,o ,0e #o*+",er en/)ron*en, an& e!e#,ron)# &a,a )n,er#0an'e 8 EDI9 S*a!! #o*+an)es H ,0e +ro !e* o1 #on,ro! )h* Many of the controls which would be relevant to a large enterprise are neither practical nor appropriate for the small enterprise. For these the most important form of internal control is generally the close involvement of the directors or proprietors. However, that very involvement will enable them to override controls and, if they wish, to e!clude transactions from the records. The onus is on the proprietor by virtue of his day to day involvement, to compensate for this lack. This involvement should encompass physical, authori5ation, arithmetical and accounting checks as well as supervision. However, it is important to stress that in a well run small company there will be a system of internal control. 1n any case, all companies must comply with the provisions of the 4ompanies 'ct concerning the maintenance of a proper accounting system. .here the manager of a small business is not himself the owner, he may not possess the same degree of commitment to the running of it as an owner manager would. 1n such cases, the auditors will have to consider the ade,uacy of controls e!ercised by the shareholders over the manger in assessing internal control.

)i*

)B*

RISK ASSESSMENTS AND INTERNAL CONTROLS IN A CIS ENBIRONMENT )k* 17' %#1 'uditing in a computer information system environment deals with risk assessment in a computer environment. 1t contains the following provisions. ISA <01.< The auditors should have sufficient knowledge of the 417 to plan, direct, supervise and review the work performed. The auditor should consider whether speciali5ed 417 skills are needed in an audit. ISA <01.= 1n accordance with 17' %## 2isk 'ssessments and 1nternal 4ontrol the auditor should obtain an understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach. ISA <01.> 1>6

1n planning the portions of the audit which may be affected by the client/s 417 environment, the auditor should obtain an understanding of the significance and comple!ity of the 417 activities and the availability of data for use in the audit. ISA <01.@ .hen the 417 are significant, the auditor should also obtain an understanding of the 417 environment and whether it may influence the assessment of inherent and control risks. )l* The 17' points out that the risks and characteristics in 417 environment may include =.2 Cack of transaction trails. Jniform processing of transactions. Cack of segregation of functions. (otential for errors and irregularities. 1nitiation or e!ecution of transactions. &ependence of other controls over computer processing. (otential for increased management supervision. (otential for the use of computer assisted audit techni,ues. EBALUATION OF

UNDERSTANDING( DOCUMENTATION AND INTERNAL CONTROL AND CONTROL RISK Assess*en, o1 A##o"n,)n' An& Con,ro! S-s,e*s )a*

'uditors are only concerned with assessing policies and procedures, which are relevant to financial statement assertions. 'uditors try to 'ssess the ade,uacy of the accounting system as a basis for preparing the accounts. 1dentify the types of potential misstatements that could occur in the accounts. 4onsider factors that affect the risk of misstatements. &esign appropriate audit procedures.

A##o"n,)n' s-s,e* an& #on,ro! en/)ron*en, ISA <00.1A 'uditors must obtain understanding of the accounting system to enable them to identify and understand1. maBor classes of transactions in the entity operationsA 1>>

6. how such transactions are initiatedA >. significant accounting records, supporting documents and accounts in the financial statementsA and %. the accounting and financial reporting process, from the initiation of significant transactions and other events to their inclusion in the financial statements. )b* The factors affecting the nature, timing and e!tent of the procedures performed in order to understand the systems include )c* Materiality considerations. The si5e and comple!ity of the entity. Their assessment of inherent risk. The comple!ity of the entity/s computer systems The type of internal controls involved. The nature of the entity/s documentation of specific internal controls.

The auditors will normally update previous knowledge of the systems in the following ways. @n,uiries of appropriate supervisory and other personnel. 1nspection of relevant documents and records produced by the systems. 8bservation of the entity/s activities and operations.

Con,ro! en/)ron*en, an& #on,ro! +ro#e&"res ISA <00.1DE20 The auditor should obtain an understanding of the control environment sufficient to assess directors/ and management/s attitudes, awareness and actions regarding internal controls and half importance in the entity. The auditor should have an understanding of the control procedures sufficient to develop the audit plan.

)d*

1n obtaining this understanding, the auditors should consider knowledge about the presence or absence of control procedures obtained from the understanding of the control environment and accounting system. For e!ample, in obtaining an understanding of the accounting system pertaining to cash, the auditors will become aware of whether bank accounts are reconciled. &evelopment of the overall audit plan does not usually re,uire an understanding of every control procedure.

)e*

Pre!)*)nar- assess*en, o1 #on,ro! r)s$ 1>%

)f*

The preliminary assessment of control risk is the process of evaluating the effectiveness of an entity/s accounting and internal control systems in preventing or detecting and correcting material misstatements. There will always be some control risk because of the inherent limitations of any accounting and internal control system. ISA <00.22 'fter obtaining an understanding of the accounting and internal control systems, the auditor should make a preliminary assessment of control risk, at the assertion level, for each material account balance or class of transactions.

)g*

'uditors ordinarily assess control risk at a high level.

ISA <00.2< The preliminary assessment of control risk for a financial statement assertion should be high unless the auditor)a* )b* 1s able to identify controls relevant to the assertion which are likely to prevent or detect and correct a material misstatement, and (lans to perform tests of control to support the assessment.

)h*

1f)a* )b* The entity/s accounting and internal control systems are not effective, or @valuating the effectiveness of the entity/s accounting and internal control systems would not be efficient, auditors will not carry out tests of control.

Re!a,)ons0)+s e,%een ,0e assess*en,s o1 )n0eren, an& #on,ro! r)s$s )i* .here inherent risk is high, management may institute more rigorous accounting and control systems to prevent and detect material misstatements. This interrelationship means that inherent and control risks should often be assessed in combination.

Do#"*en,a,)on o1 "n&ers,an&)n' an& assess*en, o1 #on,ro! r)s$ ISA <00.2= 1>D

The auditor should document in the audit working papers)a* The understanding obtained of the entity/s accounting and internal control systemsA and )b* The assessment of control risk.

ACTING ON ASSESSMENT OF ACCOUNTING AND CONTROL SYSTEMS Tes,s o1 #on,ro! REMEM2ER Tests control are performed to obtain audit evidence about the effectiveness of the &esign of the accounting and internal control systems, i.e whether they are suitability designed to prevent or detect and correct material misstatementsA and 8peration of the internal controls throughout the period.

)a*

7ome procedures which were not designed or performed as tests of controls may ,ualify as such and many be used to support a control risk assessment as less than high. Tests of control may include the following1nspection of documents supporting controls or events to gain audit evidence that internal controls have operated properly, e.g. verifying that a transaction has been authori5ed. 1n,uiries about internal controls which leave no audit trail, e.g. determining who actually performs each function not merely who is supposed to perform it. 2eperformance of control procedures, e.g. reconciliation of bank accounts, to ensure they were correctly performed by the entity. @!amination of evidence of management views, e.g. minutes of management meetings. 1>"

)b*

Testing of internal controls operating on computeri5ed systems or over the overall information technology function, e.g. access controls. 8bservation of controls. 'uditors will consider the manner in which the control is being operated.

ISA <00.;1 The auditor should obtain audit evidence though tests of control to support any assessment of control risk which is less than high. The lower the assessment of control risk, the more support the auditor should obtain that accounting and internal control systems are suitability designed and operating effectively. )c* 'uditors should consider )d* How controls were applied. The consistency with which they were applied during the period. By whom they were applied.

&eviations in the operation of controls )caused by change of staff etc* may increase control risk and tests of control may need to be modified to confirm effective operation during and after any change.

ISA <00.;< Based on the results of the tests of control, the auditor should evaluate whether the internal controls are designed and operating as contemplated in the preliminary assessment of control risk. )e* )f* The use of 4''Ts )4omputer 'ssisted 'udit Techni,ues* may be appropriate. 1n a continuing engagement, the auditor will be aware of the accounting and internal control systems through work carried out previously but will need to update the knowledge gained and consider the need to obtain further audit evidence of any changes in control.

ISA <00.;> Before relying on procedures performed in prior audits, the auditor should obtain audit evidence, which supports this reliance.

1>E

)g*

The auditor would obtain audit evidence as to the nature, timing and e!tent of any changes in the entity/s accounting and internal control systems since such procedures were performed and assessed their impact on the auditor/s intended reliance. The longer the time elapsed since the performance of such procedures the less assurance that may result. 1n relation to tests before end, the 17' states the following-

)h*

ISA <00.;@ The auditor should consider whether the internal controls were in use throughout the period. )i* )B* Further evidence must be obtained to argument the results of tests carried out at an interim audit, i.e. before the period end. 2adical changes in controls, including a periodic breakdown in controls, should be considered as separate periods by the auditors.

F)na! assess*en, o1 #on,ro! r)s$ ISA <00.;D Before the conclusion of the audit, based on the results of substantive procedures and other audit evidence obtained by the auditor should consider whether the assessment of control risk is confirmed. )k* 1f deviations from controls mean that the level of control risk has to revised, the nature, timing and e!tent of the auditors planned substantive procedures should be modified. 7ignificant weaknesses on internal controls should be communicated in writing to management. 7ee 4hapter 6#*. The issues which might arise to be reported are discussed in 4hapters 1# and 11.

)l*

:"es,)on: In,erna! #on,ro! s-s,e*s 'n internal control system has been described as comprising ?the control environment and control procedures. 1t includes all the policies and procedures )internal controls* adopted by the directors and management of an entity to assist in achieving their obBective of ensuring, as far as practicable, the orderly and efficient conduct of its business, including adherence to internal policies, the safeguarding of assets, the prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information./

1>F

@!plain the meaning relevance to the auditors giving an opinion on financial statements of each of the management obBectives above0 Ans%er The auditors/ obBective in evaluating and testing internal controls is to determine the degree of reliance which they may place on the information contained in the accounting records. 1f they obtain reasonable assurance by means of tests of controls that the internal control system is effective in ensuring the completeness and accuracy of the accounting records and the validity of the entries therein, they may limit the e!tent of their substantive procedures. )a* ?The orderly and efficient conduct of its business/ 'n organi5ation which is efficient and conducts its affairs in an orderly manner is much more likely to be able to supply the auditors with sufficient appropriate audit evidence on which to base their audit opinion. More importantly, the level of inherent and control risk will be lower, giving e!tra assurance that the financial statements do not contain material errors. )b* ?'dherence to internal policies/ Management is responsible for setting up an effective system of internal control and management policy provides the broad framework within which internal controls have to operate. Jnless management does have a pre determined set of policies, then it is very difficult to imagine how the company could be e!pected to operate efficiently. Management policy will cover all aspects of the company/s activities and will range from broad corporate obBectives to specific areas such as determining selling prices and wage rates. :iven that the auditors must have a sound understanding of the company/s affairs generally and specific areas of control in particular, then the fact that management policies are followed will make the task of the auditors easier in that they will be able to rely more readily on the information produced by the systems established by management. )c* 7afeguarding of assets/ This obBective may relate to the physical protection of assets )for e!ample locking monies in a safe at night* or to less direct safeguarding )e!ample ensuring that there is ade,uate insurance cover for all assets*. 1t can also be seen as relating to the maintenance of proper records in respect of all assets.

1>G

The auditors will be concerned to ensure that the company ha properly safeguarded its assets so that they can form an opinion on the e!istence of specific assets and, more generally, on whether the company/s records can be taken as a reliable basis for the preparation of financial statements. 2eliance on the underlying records will be particularly significant where the figures in the financial statements are derived from such records rather than as the result of physical inspection. )d* ?(revention and detection of fraud and error/ The directors are responsible for taking reasonable steps to prevent and detect fraud. They are also responsible for preparing financial statements which give a true and fair view of the entity/s affairs. However, the auditors must plan and perform their audit procedures and evaluate and report the results thereof, recogni5ing that fraud or error may materially affect the financial statements. ' strong system of internal control will give the auditors some assurance that frauds and errors are not occurring, unless management are colluding to overcome that system. )e* 'ccuracy and completeness of the accounting records/3timely preparation of reliable financial information/ This obBective is most clearly related to statutory re,uirements to both management and auditors. The company has an obligation under the 4ompanies 'ct 1GFD to maintain proper accounting records. The auditors must form an opinion on whether the company has fulfilled this obligation and also conclude whether the financial statements are in agreement with the underlying records.

1%#

CHAPTER >.0: DOCUMENTATION

Having reviewed the internal controls applicable to an entity being audited, the auditor will identify means of recording the internal control system in their audit working papers. The auditor, however, will give particular attention to whether the client/s business system is computerised or manual and will in turn devise a system of documenting the system based on that. The documented system will then become part of the standard working papers, which evidences the work that the auditor has carried out in arriving at his opinion. Ke- Ter*: 'udit working papers are essential records of the work carried out by e!ternal auditors and provides a written evidence of the work undertaken and the basis upon which the auditor arrived at his opinion. The working papers may comprise a combination of techni,ues such as ratio analysis, benchmarking, narratives, flowcharts and testing. 2ecently, the formalisation of the audit work has led to standardisation of the working papers. The contents of the working papers will include 7cope of an audit and type of an audit ) e.g. compliance testing, value for money* 2eport from previous audit and recommendations outstanding .ork programmes including analytical methods used @vidence collected from ratio analysis, benchmarking, inspections in,uiries etc 1nterpretation of the evidence and significant findings 4onclusions 2ecommendations Final audit report 1%1

DOCUMENTING OF ACCOUNTING AND CONTROL SYSTEMS )a* 's mentioned above, there are several techni,ues for documenting the assessment of control risk, that is, the system. 8ne or more may be used depending on the comple!ity of the system. ;arrative notes. Muestionnaires )for e!ample, 14M*. 4hecklists. Flowcharts.

.hatever method of recording the system is used, the record will usually be retained on the permanent file and updated each year.

Narra,)/e no,es ;arrative notes have the advantage of being simple to record. However, they are awkward to change if written manually. @diting in future years will be easier if they are computeri5ed. The purpose of the motes is to describe and e!plain the system, at the same time making any comments or criticisms, which will help to demonstrate an intelligent understanding of the system. For each system notes to deal with the following ,uestions. .hat functions are performed and by whom0 .hat documents are used0 .here do the documents originate and what is their destination0 .hat se,uence are retained document filed in0 .hat books are kept and where0

;arratives notes can be used to support flowchart =.< FLO6CHARTS There are two methods of flowcharting in regular use &ocument flowcharts. 1nformation flowcharts.

DOCUMENT FLO6CHARTS &ocument flowcharts are more commonly used because they are relatively easy to prepare. 1%6

'll documents are followed through from ?cradle to grave/. 'll operations and controls are shown.

.e shall not concentrate on document flowcharts. INFORMATION FLO6CHARTS 1nformation flowcharts are prepared in the reverse direction from the flowthey start with the entry in the general3nominal ledger and work back to the actual transaction. Hey concentrate on significant information flows and key controls and ignore any unimportant documents or copies of documents.

A&/an,a'es o1 1!o%#0ar,s These are as follows. 'fter a little e!perience they can be +re+are& ?")#$!-. 's the information is presented in a standard form, they are fairly easy to follow and to review. They generally ensure that the system is recorded in its entirety, as all document flows have to be traced from beginning to end. 'ny ?loose ends/ will be apparent from a cursory e!amination. They eliminate the need for e!tensive narrative and can be of considerable help in highlighting the salient points of control and any weaknesses in the system.

D)sa&/an,a'es o1 1!o%#0ar,s These include the following)a* )b* They are only really suitable for describing standard systems. (rocedures for dealing with unusual transactions will normally have to be recorded using narrative notes. They are useful for recording flow of documents, but once the records or the assets to which they relate have become static they can no longer be used for describing the controls )for e!ample over non current assets*. MaBor amendment is difficult without redrawing. Time can be wasted by charting areas that are of no audit significance )a criticism of document not information flowcharts*.

)c* )d*

:"es,)onna)res 1%>

.e can look at two types of ,uestionnaire here, each with a different purpose. 1nternal 4ontrol Muestionnaires )14Ms* are used to ask whether controls e!ist which meet specific control obBectives. 1nternal 4ontrol @valuation Muestionnaires )14@Ms* are used to determine whether there are controls which prevent or detect specified errors or omissions.

In,erna! Con,ro! :"es,)onna)res 8IC:s9 The maBor ,uestion which internal control ,uestionnaires are designed to answer is ?How good is the system of controls0/ .here strengths are identified, the auditors will perform work in the relevant areas. 1f, however, weaknesses are discovered they should then ask .hat errors or irregularities could be made possible by these weaknesses0 4ould such errors or irregularities be materials to the accounts0 .hat substantive procedures will enable such errors or irregularities to be discovered and ,uantified0

'lthough there are many different forms of 14M in practice, they all conform to the following basic principles)a* )b* They comprise a list of ,uestions designed to determine whether desirable controls are present. They are formulated so that there is one cover to each of the maBor transaction cycles.

7ince it is the primary purpose of an 14M to evaluate the system rather than describe it, one of the most effective ways of designing the ,uestionnaire is to phrase the ,uestions so that all the answers can be given as ?+@7/ or ?;8/ and a ?;8/ answer indicates a weakness in the system. 'n e!ample would beAre +"r#0ase )n/o)#es #0e#$e& ,o 'oo&s re#e)/e& No,es e1ore e)n' +asse& 1or +a-*en,I YESENOECo**en,s ' ?;8/ answer to that ,uestion clearly indicates a weakness in the company/s payment procedures. 1%%

The 14M ,uestions below dealing with goods inward provide additional illustrations of the 14M approach. Goo&s )n%ar& )a* 're supplies e!amined on arrival as to ,uantity and ,uality0 )b* 1s such an e!amination in some way0 )c* 1s the receipt of supplies recorded, perhaps by means of goods inwards notes0 )d* 're receipt records prepared by a person independent of those responsible for)i* )ii* 8rdering functions. The processing and recording of invoice

)e* 're goods inwards controlled to ensure that invoices are obtained for all goods received and to enable the liability of goods to be determined )by pre numbering the records and accounting for all serial numbers*0 )i* 're goods inward records regularly reviewed for items for which no invoice have been received0 'r )ii* 're any such items investigated0 )f* 're these records reviewed by a person independent of those responsible for the receipt and control of goods0 In,erna! Con,ro! E/a!"a,)on :"es,)onna)res 8ICE:s9 1n recent years many auditing firms have developed and implemented an evaluation techni,ue more concerned with assessing whether specific errors )or frauds* are possible rather than establishing whether certain desirable controls are present. This is achieved by reducing the control criteria for each transaction stream down to a handful of key ,uestions )or control ,uestion*. The characteristic of these ,uestions is that they concentrate on the significant errors or omissions that occur at each phase of the appropriate cycle if controls are weak. The nature of the key ,uestions may best be understood by reference to the e!amples on the following pages. In,erna! #on,ro! e/a!"a,)on ?"es,)onna)re: #on,ro! ?"es,)ons 1%D

The sales )revenue* cycle 1s there reasonable assumable assurance that)a* )b* )c* )d* )e* )f* )g* )h* and deposited0 )i* )B* )k* )l* )m* 7low payers will be chased and that bad and doubtful debts will be provided against0 'll transactions are properly accounted for0 4ash sales are properly dealt with0 7undry sales are controlled0 't the period and the system will neither overstate nor understate trade accounts receivable0 7ales are properly authori5ed0 7ales are made to reliable payers0 'll goods dispatched are invoiced0 'll invoices are properly prepared0 'll invoices are recorded0 1nvoices are properly supported0 'll credits to customers/ accounts are valid0 4ash and che,ues received are properly recorded

The purchases )e!penditure* cycle is there reasonable assurance that)a* )b* )c* :oods or services could not be received without a liability being recorded0 2eceipt of goods or services is re,uired in order to establish a liability0 ' liability will be recorded)i* 8nly for authori5ed items )ii* 't the proper amount0 )d* 'll payments are properly authori5ed0 )e* 'll credits due from suppliers are received0 )f* 'll transactions are properly accounted for0 )g* 't the period end liabilities are neither overstated nor understated by the system0 )h* The balance at the bank is properly recorded at all times0 )i* Jnauthori5ed cash payments could not be made and that the balance of petty cash is correctly stated at all times0 .ages and salaries 1s there reasonable assurance that)a* )b* )c* )d* @mployees are only paid for work done0 @mployees are paid the correct amount )gross and net*0 The right employees actually receive the right amount0 'ccounting for payroll costs and deductions is accurate0 1%"

)e* )f* )g* )h*

The cut off is reliable0 The costing system is reliable0 The inventory sheets are accurately compiled0 The inventory valuation is fair0

;on current tangible assets 1s there reasonable assurance that)a* )b* )c* )d* )e* )f* 2ecorded assets actually e!ist and belong to the company0 4apital e!penditure is authorised and reported0 &isposals of non current assets are authorised and reported0 &epreciation is realistic0 ;on current assets are correctly accounted for0 1ncome derived from non current assets is accounted for0

1nvestments 1s there reasonable assurance that)a* 2ecorded investments belong to company and are safeguard from loss0 )b* 'll income, rights or bonus issues are properly received and accounted for0 )c* 1nvestment transactions are made only in accordance with company policy and are appropriately authorised and documented0 )d* The carrying values of investments are reasonably stated0 Management information and general controls 1s the normal ledger satisfactorily controlled0 're Bournal entries ade,uately controlled0 &oes the organi5ation structure provide a clear definition of the e!tent and limitation of authority0 're the systems operated by component employees, who are ade,uately supported0 1f there is an internal audit function, is it ade,uate0 're periodic internal reporting procedures ade,uate0 @ach key control ,uestion is supported by detailed control points to be considered. For e!ample, the detailed control points to be considered in relation to key control ,uestion )b* for the e!penditure cycle )1s there 1%E

reasonable assurance the receipt of goods or services is re,uired to establish a liability0* are as follows. 1. 1s segregation of duties satisfactory0 6. 're controls over relevant master files satisfactory0 >. 1s there a record that all goods received have been checked for .eight or number0 Muality and damage0

%. 're all goods received taken on charge in the detailed inventory ledgers By means of the goods received note0 8r by means of purchase invoices0 're thee, in a computeri5ed system, sensible control totals )has totals, money values and so on* to reconcile the inventory system input with the payables system0 D. 're all invoices initialled to shoe that ". 2eceipt of goods has been checked against the goods received records0 2eceipt of services has been verified by the person using it0 Muality of goods has been checked against the inspection0 1n a computeri5ed invoice approval system are there print outs )e!amined by a responsible person* of 4ases where order, :2; and invoice are present but they are not e,ual )?e,ual/ within predetermined tolerances of minor discrepancies*0 4ases where invoices have been input but there is no corresponding :2;0

)E* 1s there ade,uate control over direct purchases0 )F* 're receiving documents effectively cancelled )for e!ample cross referenced* to prevent their supporting two invoices0 'lternatively, 14@M ,uestions can be phrased so that the weakness, which should be prevented by a key control, is highlighted, such as the following. 4omments or e!planations of ?yes/ answer Muestion 1%F 'nswer

Can 'oo&s e sen, ,o Una",0or)se& s"++!)ers0 1n these cases a ?-es3 answer would re,uire an e!planation, rather than a Gno3 answer.

A&/an,a'es an& &)sa&/an,a'es o1 IC:s an& ICE:s 14Ms have various advantages)a* 1f drafted thoroughly, they can ensure all controls are considered. )b* They are ,uick to prepare. )c* They are easy to use and control. However they also have some disadvantages. )a* The client, may be able to overstate controls. )b* They may contain a large number of irrelevant controls. )c* They may not include unusual controls, which are nevertheless effective in particular circumstances. )d* They can give the impression that all controls are e,ual weight. 1n many systems one ;8 answer )for e!ample lack of segregation of duties* will cancel out a string of +@7 answers. 14@Ms have the following advantages)a* Because they are drafted in terms of obBectives rather than specific controls, they are easier to apply to a variety of systems than 14Ms. )b* 'nswering 14@Ms should enable auditors to identify the key controls which they are most likely to test during control testing. )c* 14@Ms can highlight areas of weakness where e!tensive substantive testing will be re,uired. The principal disadvantage is that they can be drafted vaguely, hence misunderstood and result in important controls not identified.

:"es,)on: Con,ro! +ro#e&"res @!plain the importance of the following control procedures. )a* 7egregation of duties. )b* Bank reconciliation. )c* 4omparing the results of inventory counts with accounting records. 1%G

Ans%er )a* 7egregation of duties is important because the more people that are involved in all the stages of processing a transaction, the more likely it is that fraud or error by a single person will be identified. 1n addition the more people that are involved, the less the chances of fraudulent collusion between them. )b* ' bank reconciliation is important because it reconciles the business/s records of cash held at bank with the bank/s records of cash held at bank. .ritten confirmation from the bank is strong evidence since it arises from an independent source and is in writing. :enerally the only differences on the reconciliation should be timing differences on unpresented che,ues or uncleared banking. For large unpresented che,ues and for all uncleared bankings the timing difference involved should be small. )c* 1nventory is an important figure in the accounts often affecting both the income statement and balance sheet. 1n addition the inventory of many businesses is highly portable, and it is thus subBect to a high risk of theft. )d* 1nventory is an important figure in the accounts often *a,er)a!!- a11e#,)n' both the )n#o*e s,a,e*en, and a!an#e s0ee,. 1n addition, the inventory of many businesses is highly portable, and it is thus subBect to high risk of theft. ' main #o*+ar)son of inventory as recorded in the accounting records with actual inventory held may identify difference which have to be )n/es,)'a,e&. The difference may be due to theft of inventory but may also be due to failure to record inventory movements properly. This may mean that purchases or sales have been recorded incorrectly. >.2 T0e 2"s)ness S-s,e* The business system ideally comprises all those areas that are involved in the generation of resources by the company. They include 7ales (urchases 1nvestments Financing

AUDITING FOR SALES There are specific aims of controls applicable to the sales system. The aims of controls in the sales system areA)*s o1 #on,ro!s 1D#

1rdering and granting of credit Goo&s an& ser/)#es are only s"++!)e& ,o #"s,o*ers with 'oo& #re&), ra,)n's C"s,o*ers are en#o"ra'e& ,o +a- +ro*+,! Or&ers are #orre#,!- re#or&e& Or&ers are 1"!1)!!e& Dispatch and 'nvoicing 'll despatches of goods are recorded 'll goods and services sold are correctly invoiced 'll invoices raised relate to goods and services supplied by the business 4redit notes are only given for valid reasons 2ecording$ accounting and credit control 'll sales that have been invoiced are recorded in the general and sales ledger 'll credit notes that have been issued are recorded in the general and sales ledgers 'll entries in the sales ledger are made to the correct sales ledger accounts 4ut off is applied to the sales ledger (otentially doubtful debts are identified and provided for Con,ro!s: or&er)n' an& #re&), a++ro/a! +ro#ess. 7egregation of dutiesA credit control, invoicing and inventory dispatch 'uthorisation of credit terms to customers o 2eferences and3or credit checks obtained o 'uthorisation by senior staff o 2egular review 'uthorisation of changes in other customer data o 4hange of address must be supported by letterhead o &eletion re,uests must be duly authorised and supported by evidence of balance cleared3 customer in li,uidation

8rders only accepted from customers who have no credit problems 7e,uential numbering of blank pre printed order documents 4orrect prices should be ,uoted to customers Matching of customer orders with production orders and despatch notes and ,uerying orders that are not matched &ealing with customer ,ueries

Con,ro!s: &)s+a,#0es an& )n/o)#e +re+ara,)on 1D1

'uthorisation of dispatch of goods &espatch only on sales order &espatch only to authorised customers 7pecial authorisation of despatches of goods free of charge or on special terms @!amination of goods outwards as to ,uantity, ,uality and condition 2ecording of goods outwards 'greement of goods outwards records to customer orders, despatch notes and invoices (re numbering of despatch notes and delivery notes and regular checks on se,uence 4onditions of returns checked 2ecording of goods returned notes 7ignature of delivery notes by the customers (reparation of invoices and credit notes 'uthorisation of selling prices3 use of price lists 'uthorisation of credit notes 4hecks on prices, ,uantity, e!tension and totals 1nventory records updated Matching of sales invoices with despatch and delivery notes and sales orders 2egular review for dispatch notes which is not matched by invoices

Con,ro!s: a##o"n,( re#or&)n' an& #re&), +ro !e*s 7egregation of duties- recording sales , maintaining customer accounts and preparing statements 2ecording of sales invoices se,uence and control over spoilt invoices Matching of cash receipts with invoices 2etention of customer remittance advices 7eparate recording of sales returns, price adBustments etc 4ut off procedures to ensure goods despatched and not invoiced ) or vice versa* are properly dealt with in the correct period 2egular preparation of trade accounts receivable statements 7afeguarding of trade accounts receivable statements so that they cannot be altered before despatch 2eview and follow up on overdue accounts 'uthorisation of writing off of bad debts 2econciliation of sales ledger control accounts 'nalytical review of sales ledger and profit margins Con,ro!s: or&er)n' an& 'ran,)n' o1 #re&), 4heck that references are being obtained for all new customers

1D6

4heck that all new accounts on the sales ledger have been authorised by senior staff 4heck that orders are only accepted from customers who are within their credit limits 4heck that customer orders are being matched with production orders and despatch notes

Con,ro!s: &es+a,#0es an& )n/o)#es Kerify details of trade sales or goods despatched notes with sales invoices checking o Muantities o (rices charged against price lists o Trade discounts have been properly dealt with o 4alculations and additions o @ntries in sales daybooks are correctly analysed o K'T, where chargeable, has been properly dealt with o (ostings to the general ledger o o o o o o o o o o o Kerify details of trade sales with entries in the inventory records Kerify non routine sales )scrap,non current assets* to 'ppropriate supporting documentation 'pproval by authorised officials @ntries in the plant register Kerify credit notes with 4orresponding or other supporting documentation 'pproval by authorised personnel @ntries in inventory records @ntries in goods returned records 4alculations and additions @ntries and additions @ntries in day book, checking these are correctly done (ostings to sales ledger Test numerical se,uence of dispatch notes and en,uire into missing numbers Test numerical se,uence of invoices and credit notes, en,uire into missing numbers Test numerical se,uence of order forms en,uire into missing numbers 4heck dispatches of goods free of charge or on special terms have been authorised by management 4heck recording and accounting entries in sales day book and the sales ledger, test a sample of entries therein

AUDITING FOR PURCHASES 1D>

A)*s o1 #on,ro!s 1rdering 'll orders for goods and services are properly authorised, and are for goods and services that are actually received and are for the company 8rders are made to authorised suppliers only 8rders are at competitive prices 2eceipt and invoicing 'll goods and services are used for the organisation/s purposes and not private purposes :oods and services are only accepted if they have been ordered, and the order has been authorised 'll goods and services are accurately recorded Ciabilities are recognised for all goods and services that have been received 2eceipt of goods and services is necessary to establish a liability to be recorded Accounting 'll e!penditure is for goods that have been received 'll e!penditure is authorised 'll e!penditure that is made is recorded correctly in the general ledger and purchase ledger 'll credit notes that are received are recorded correctly in the general and purchase ledgers 'll entries in the purchase ledger are made to the correct purchase ledger accounts 4ut off is applied correctly to the purchase ledger Con,ro!s: or&er)n' 7egregation of dutiesA re,uisition and ordering 4entral policy for choice of suppliers @vidence re,uired for purchase before purchase is authorised 8rder only prepared when a pre numbered purchase re,uisition has been received 'uthorisation of order forms (re numbered order forms 7afeguarding of blank order forms 2eview for orders not received or invoiced Monitoring of supplier terms and taking advantage of favourable conditions )bulk purchase discount* Con,ro!s: 'oo&s an& )n/o)#es re#e)/e& @!aminations of goods inwards o Muantity 1D%

o Muality o 4onditions 2ecording arrival and acceptance of goods 4omparisons of goods received with purchase orders 2eferencing of supplier invoices, numerical se,uence and supplier reference 2ecording of goods returned (rocedures for obtaining credit notes

Con,ro!s: a##o"n,)n' 1or +"r#0ases o o o o o o o 7egregation of duties- accounting and checking functions (rompt recording of purchases and purchase returns 2egular maintenance of purchase ledger 4omparison of supplier statement with purchase ledger balances 'uthorisation of payments 'uthority limits 4onfirmation that goods have been received, in accordance with purchase order, and are properly priced and invoiced 2eview of allocation of e!penditure 2econciliation of purchase ledger control account to total of purchase ledger balances 4ut off of accrual of goods received notes not matched by purchases at year end (urchase invoices are supported by purchase orders The officials are operating within laid down authority limits 8btain e!planations for items that have been outstanding for a long time 4heck numerical se,uence and en,uire into missing numbers of(urchase re,uisitions (urchase orders :oods received notes :oods returned notes 7uppliers invoices 4heck additions and casting of invoices and check entries in purchase day book if they are correctly analysed

AUDITING FOR PAYROLL A)*s o1 Con,ro!s (ettings of wages and salaries @mployees are only paid for what they have done :ross pay has been calculated correctly and authorised :ross pay and deductions are correctly recorded on the payroll .ages and salaries paid are correctly recorded in the bank and cash recorded 1DD

2ecording of wages and salaries

.ages and salaries are recorded correctly in the general ledger "he correct employees are paid All deductions have been calculated correctly and are authorised "he correct amounts are paid to the taxation authorities

)ayment of wages and salaries Deduction

Con,ro!s: 'enera! arran'e*en,s 2esponsibility for the preparation of pay sheets should be given to a responsible official and ade,uate staff appointed to assist him Con,ro!s : se,,)n' o1 sa!ar)es an& %a'es S,a11)n' and se're'a,)on o1 &",)es Maintenance of +ersonne! re#or&s and check of wages regularly to personnel records A",0or)sa,)on En'a'e*en, and &)s#0ar'e of employees C0an'es )n +a- ra,es 8vertime ;on statutory deductions 'dvances of pay 2ecording of changes in personnel and pay rates 2ecording of hours worked by timesheets, clocking in and out arrangements 2eview of hours worked 2ecording of advances of pay Holiday pay 'nswering ,ueries 2eview o1 %a'es against "&'e,

Con,ro!s: +a-*en, o1 #as0 %a'es 7egregation of duties o 4ash sheer preparation o Filling of pay packets o &istribution of wages 'uthorisation of wage che,ue cashed 4ustody of cash o @ncashment of che,ues o 7ecurity of pay packets o 7ecurity of transit o 7ecurity and prompt banking of unclaimed wages 1D"

Kerification of identity 2ecording of distribution (reparation and authorisation of che,ues and bank transfer lists 4omparison of che,ues with payroll Maintenance and reconciliation of wages and salaries account Basis for the compilation of wages payroll (reparation , checking and approval of the payroll &ealing with non routine matters 4orrect deductions from pay Maintenance of separate employees ? records with which pay lists may be compared if necessary 2econciliation of total pay and deductions between one pay and the ne!t 4omparison of actual pay totals with budget estimates or standards 'greement of gross earnings and total ta! deducted with ta!ation returns

'uditors may arrange to attend a pay out and confirm that the official procedures are being followed. For holiday pay, this will be compared with the underlying records and calculation of the amount paid will be checked. 'uditors should also check the calculation of ta!ation and non statutory deductions and also check that the payment to the ta! authorities are correct. For voluntary deductions, auditors will seek to see the authority completed by the relevant employees.

AUDITING FOR INBESTMENTS The aims of the controls in the audit of investments are authorisation and recording. Authorisation 'll e!penditure is authorised

2ecording That all e!penditure is classified correctly in the financial statements as capital or revenue e!penditure 1DE

The other types of audit procedures the auditor will employ are as belowINBESTMENTS 4heck board minutes resolutions relating to the ac,uisition of investments 4heck that management have authority to invest 4heck procedures on disposals of investments 4heck that accounting treatment is in accordance with the re,uired accounting standards @nsure that investments are reflected in the accounts at an appropriate carrying value. Con,ro! 8rders for capital items should be authorised 8rders should be re,uisitioned on appropriate documentation 1nvoices should be approved by the person who authorised the order They should be marked with the appropriate general ledger code 'll standard controls for recording of purchases are relevant 4apital items should be written up in the non current asset register The non current asset register should be reconciled regularly to the general ledger 'll necessary documents relating to investment income, and documentation will be reviewed by the auditor 2eview the level of capital purchases with relevant authorities 2eview board minutes for authorisation of capital purchases and investments AUDITING FOR FINANCING 'uditing for financing will centre around those medium and long term loans that the company has contracted for the purpose of financing their business. 1t will comprise &e en,"res, !oan s,o#$ and other !oans re+a-a !e within and after one year. 1mportant aspects are Co*+!e,eness of all interests payable Meas"re*en, of whether )n,eres, +a-a !e has been calculated correctly and included in the 1ncome 7tatement D)s#!os"re of whether !on' ,er* !oans and in,eres, have been correctly disclosed in the accounts 'ny res,r)#,)ons on the use of assets that have been pledged as #o!!a,era! for the loan

AUDIT PROGRAM: LONG4TERM DE2T

1DF

O ,a)n E+re+are s#0e&"!es of !on' ,er* &e , o",s,an&)n' at the balance sheet date showing for each loan- name of lender, date of loan, maturity date, interest date and rate balance at end of the period and security Co*+are opening balances to the 'enera! !e&'er 4heck name of lender to register of &e en,"re 0o!&ers Trace additions and repayment entries in the cash book 4onfirm re+a-*en,s with the lenders @!amine cancelled che,ues and memorandum of satisfaction for loans repaid Kerify that borrowing limits imposed by the articles of association or other agreements have not been e!ceeded @!amine signed Board minutes relating to ne% orro%)n'sEre+a-*en,s 8btain direct confirmation from lenders of amounts outstanding, a##r"e& )n,eres, and what security they hold Ber)1- )n,eres, #0ar'e& for the period and then ade,uacy of interest accrued 4onfirm assets charged have been entered in the register of charges and notified to the registrar 2eview res,r)#,)/e #o/enan,s and provisions relating to default2eview corresponding relating to the loan 2eview confirmation replies for non compliance 1f a default appears to e!ist, determine its effect, and schedule findings. 2eview minutes, cash books to check if all loans have been recorded

CHAPTER @.0: 2ALANCE SHEET AUDIT

(AS/ The use of cash in this conte!t includes bank balances and cash held at the company/s premises.

1DG

The audit of cash will particularly be concerned with #o*+!e,eness and a##"ra#- of balances. Bank reconciliations testing is in practice the most important of these tests and students will often be e!amined on bank reconciliations. 7ubstantive tests on bank balances will need to cover #o*+!e,eness, e5)s,en#e, r)'0,s an& o !)'a,)ons and /a!"a,)on. 'll of these elements can be audited directly through obtaining third party confirmations from the client/s banks and reconciling these with the accounting records, having regard for cut3off. The auditors will first update details of bank accounts ensuring the client holds accounts with bona fide banks. Use o1 Con1)r*a,)on Re?"es,s The auditors will decide from which banks they will re,uest confirmation and will have regard to such matters as s)Ce o1 a!an#e, /o!"*e o1 a#,)/),-, &e'ree o1 re!)an#e on internal controls, and *a,er)a!),- in the conte!t of the Financial 7tatements. The auditor will decide to use one of the following methods to get confirmation from the client/s banks: L)s,)n' a!an#es and other information and then asking the client/s banks to confirm their accuracy and completeness Re?"es,)n' &e,a)!s o1 a!an#es an& o,0er )n1or*a,)on from the client, and then comparing these with the banks/ records.

The procedure for a confirmation letter is simple and will depend on the purpose for which the confirmation is re,uired. The bank will re,uest its client whether they can disclose the information re,uested. C",4o11 4are will be taken to ensure that there is no window dressing by checking cut off carefully. .indow dressing is usually manifested by as an attempt to improve the li,uidity of the company by enhancing bank balances and reducing receivables by 2- $ee+)n' the cash book open to take credit for remittances actually received after year end Re#or&)n' #0e?"es paid in the period under review which are actually not dispatched until after the year end.

The above will enhance the li,uity ratio. 'J&1T (28:2'M- T';:1BC@ ;8; 4J22@;T LB';< ';& 4'7H 8btain standard bank confirmation from each bank with which the bank conducted its business during the audit period 4heck the arithmetic of bank reconciliation

1"#

Trace che,ues shown as outstanding from bank reconciliation to the cash book prior to and after the year end and obtain e!planations for any large or unusual items not cleared at the date of the audit 4ompare the bank statement and cash book entries in details for the last month of the year and check that all items are cleared in the last period or taken forward to the year end bank reconciliation 8btain satisfactory e!planations for all items in the cashbook for which they are no corresponding entries in the bank statements and vice versa Kerify contra items appearing in the cashbook or bank statements with original entry Kerify by checking pay in slips that uncleared bankings are paid in prior to the year end @!amine all lodgements in respect of which payment has been refused by the bank and ensure appropriate procedures are in place to deal with the issue 7crutinise the cash book and bank statements before and after the balance sheet date for e!ceptional entries or transfers which have a material effect on the balance shown to be on hand 1dentify whether any accounts have been secured on the assets of the company 4onsider whether any accounts are secured on the assets of the company &etermine whether the bank accounts are subBect to any restrictions

'J&1T (28:2'M- 4'7H 48J;T 4ount all cash balances held and agree to petty cash book or other records 4ount all balances simultaneously 'll counting to be done in the presence of the responsible individuals @n,uiries into any 18Js or cashed che,ues outstanding for unreasonable periods 8btain certificates of cash in hand from responsible officials 4onfirm that bank and cash balances as reconciled above are correctly stated in the accounts 4ash balances 3floats are often in themselves immaterial but may re,uire some audit emphasis because of opportunities for fraud that could e!ist where internal controls could be weak and because in aggregate they may be material. Hotels and retail organi5ations normally hold large amounts of cash and procedures are similar to the inventory count. RECEIBA2LES Much of the auditor/s detailed work will be based on the selected list of accounts receivables from the sales ledger listings provided by the client. The list should ideally be aged i.e. showing the period )s* the money has been owed. The following procedures will be normally be performed to check #o*+!e,eness and a##"ra#- of the client prepared list. 1"1

C0e#$ the a!an#es 1ro* )n&)/)&"a! sa!es !e&'er a##o"n,s to the !)s, o1 a!an#es and vice versa. C0e#$ the ,o,a! of the !)s, to the sales ledger control account Cas, )add up* the !)s, o1 a!an#es and the sa!es !e&'er #on,ro! a##o"n, Con1)r* whether !)s, o1 a!an#es re#on#)!es with the sa!es !e&'er #on,ro! a##o"n, Con1)r*a,)on o1 a##o"n,s re#e)/a !es '(A 40- Audit evidence3additional considerations for specific items covers the confirmation of accounts receivables. This states that when it is reasonable to e!pect customers to respond, the auditors will generally plan to obtain direct confirmation of accounts receivable to individual entries in an account balance. 4onfirmation of accounts receivable balances is an e!ample of e!ternal confirmations as given in '(A 404$ 5xternal ,onfirmations. Kerification of trade accounts receivable received by direct communication, is therefore, the normal means of providing audit evidence to satisfy the obBective that customers e!ist and owe bona fide amounts to the company 8e5)s,en#e an& r)'0,s an& o !)'a,)ons9 I&ea!!- the confirmation should take place ideally immediately after the month end and hence cover the year end balances to be included in the balance sheet. However, due to time constraints confirmation is normally prior to the year end but normally not more than three months before the year end. 17' D#D, @!ternal 4onfirmations outlines the auditor/s response should management refuse to give auditors permission to contact third parties for confirmation. ;ote that this applies to all such e!ternal confirmations. The 17' says / when the auditor seeks to confirm certain balances or other information, and management re,uest the auditor not to do so, the auditor should consider whether they are any valid grounds of such a re,uest and obtain evidence to support the validity of management/s re,uests. 1f the auditor agrees to management/s re,uest not to seek e!ternal confirmation regarding a particular matter, the auditor should apply alternative procedures to obtain sufficient appropriate audit evidence regarding that matter. 1f the auditor does not accept the validity of such re,uests, and is prevented from carrying out the confirmations, there has been a limitation on the scope of the auditor/s work and the auditor should consider the possible impact on the auditor/s report/ Pos),)/e Bs Ne'a,)/e Con1)r*a,)on .hen confirmation is undertaken the method of re,uesting information from the customer maybe either ?positive/ or ?negative/. Jnder the positive method the customer is re,uested to confirm the accuracy of the balance shown or state in what respect he is in disagreement. Jnder the negative method the customer is re,uested to reply if the amount stated is disputed. 1"6

The +os),)/e method is generally more preferable as it is designed to encourage definite replies from those contacted. The ne'a,)/e method may be used if the client has good internal control, with a small number of small accounts. 1n some circumstances, say where there is a small number of large accounts and a large number of small accounts, a combination of both methods as noted above may be used. 'uditors will normally only contact a sample of accounts receivable. 1f this sample is to produce a meaningful result it must be based upon a complete list of accounts receivable. 1n addition, when constructing the sample, a selection will be made of O!& "n+a)& a##o"n,s A##o"n,s %r),,en o11 &"r)n' ,0e +er)o& "n&er re/)e% A##o"n,s %),0 #re&), a!an#es A##o"n,s se,,!e& - ro"n& s"* +a-*en,s A##o"n,s %),0 n)! a!an#es A##o"n,s %0)#0 0a/e een +a)& - ,0e &a,e o1 e5a*)na,)on

Fo!!o%4 "+ 'uditors will follow up on and carry out further work in relation to those accounts receivable who D)sa'ree with ,0e a!an#e s,a,e& )(ositive and ;egative 4onfirmation* Do no, res+on& )(ositive 4onfirmation only*

REASONS FOR DISAGREEMENTS There is a &)s+",e between the client and the customer. The reasons for the disputes must be identified, and provision made if appropriate against the debt. C", o11 +ro !e*s e!ist, because the client records the following year/s sale in the current period or because goods returned by the customer in the current year are not recorded in the current year. 4ut off testing may be e!tended. The customers may have sent the *on)es e1ore the year Lend, but the monies were not re#or&e& by the client as receipts until a1,er the year end. &etailed cut off work may be re,uired on all receipts. Monies received may have been posted to the %ron' a##o"n, or cash in transit account. 'uditors should check if there is evidence of other misposting. 1f the monies have been

1">

posted to a cash in transit account, auditors should ensure that this account has been cleared promptly. 4ustomers who are also suppliers may ne, o11 a!an#es owed and owing. 'uditors should check that this is allowed. Tee*)n' an& !a&)n', s,ea!)n' monies and )n#orre#,!- +os,)n' to other receipts so that no particular customer is seriously in debt is a fraud that can arise in this area. 1f auditors suspect teeming and lading occurred, they may perform detailed testing on cash receipts, particularly on prompt posting of cash receipts. .hen positive confirmation is used, the auditors should follow up on those accounts receivable who 1a)! ,o res+on&. 7econd re,uests should be sent and if necessary followed by telephone calls with permission from the client. 1f it proves impossible to get confirmations from individual customers, alternative procedures may be carried out-

'J&1T (28:2'M- 2@4@1K'BC@7 'CT@2;'T1K@ (284@&J2@7

C0e#$ re#e)+, o1 #as0 after date Ber)1- /a!)& +"r#0ase orders if any E5a*)ne ,0e a##o"n, to see if the balance outstanding represents specific invoices and #on1)r* their /a!)&),O ,a)n e5+!ana,)ons for )n/o)#es re*a)n)n' "n+a)& after subse,uent ones have been paid C0e#$ if the a!an#e on the account is 'ro%)n', and if so, why Tes, #o*+an-3s #on,ro! over the issue of #re&), no,es and ,0e %r),e 4o11 o1 a& &e ,s

INBENTORY 1"%

T0ere are ,%o so"r#es o1 r"!es ,0a, &ea! %),0 )n/en,or-: )a* )b* 1'7 6 1nventories (art of 17' D#1 'udit evidence additional considerations for specific items which relates to attendance

IAS 2 In/en,or)es KEY TERMS Cos, is defined by 1'7 6 as comprising all costs of purchase and other costs incurred in bringing inventories to their present location and condition. Ne, rea!)sa !e /a!"e is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

Pro&"#,)on #os,s 8#os,s o1 #on/ers)on9 )n#!"&e: )a* )b* )c* 4osts directly attributable to units of production (roduction overheads 8ther overheads attributable to bring the product or service to its present location and condition

:"es,)on: D)11)#"!,)es o1 a"&),)n' s,o#$ :ive some of the main reasons why inventory is one of the most difficult areas of the audit E5a* Fo#"s Po)n, +ou must have a thorough knowledge of audit procedures before, during and after the physical inventory count. Res+ons) )!),- )n re!a,)on ,o )n/en,or- #o"n, Mana'e*en, @nsure that inventory figures in the accounts represents inventory that e!ists @nsure that inventory figures in the accounts represents inventory that is owned by the entity @nsure that accounting records includes statements of physical inventory count.

A"&),ors 1"D

O ,a)n s"11)#)en, a++ro+r)a,e e/)&en#e about figures from 1nventory records 1nventory control systems 2esults of physical inventory counts Test counts by the auditors

A,,en& +0-s)#a! )n/en,or- #o"n, if inventory is material and evidence of e!istence is provided by management inventory counts Me,0o&s o1 )n/en,or- #o"n,s )a* )b* )c* P0-s)#a! )n/en,or- #o"n,s a, ,0e -ear en& )preferred by auditors* P0-s)#a! )n/en,or- #o"n,s e1ore or a1,er the -ear en& Per+e,"a! )n/en,or- #o"n, where management has a programme of inventory counting throughout the year

1f perpetual inventory count is used, the auditors will check that management)a* )b* @nsures that all inventory lines are counted at least once in a year Maintains ade,uate inventory records that are kept up to date. 'uditors may compare sales and purchase transactions with inventory movements, and carry out other tests on the inventory records, e.g. checking casts and classification of inventory Has satisfactory procedures for inventory counts and test counting. 'uditors should confirm inventory count arrangements by reviewing inventory count instructions and observing counts. 4ut off will be particularly important. 1nvestigates and correct material differences. 2easons for differences should be recorded and any necessary corrective action should be taken

)c*

)d*

'J&1T (28:2'M- (@2(@TJ'C 1;K@;T82+ 48J;T 'ttend one of the inventory counts )to observe and confirm that instructions are being adhered to* Follow up the inventory counts attended to compare ,uantities counted by the auditors with the inventory records, obtaining and verifying e!planations for any differences, and checking that the client has reconciled count records with book inventory records. 2eview the year/s inventory counts to confirm that the e!tent of counting, the treatment of discrepancies, and the overall accuracy of records.

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'ssuming a full count is not necessary at the year end, compare the listing of inventory with the detailed inventory records, and carry out other procedures) cut off, analytical review* to gain further satisfaction.

'ttendance at the stock count gives evidence of e!istence and apparent ownership of inventory. 1t also gives evidence of completeness of inventory. PLANNING INBENTORY COUNT :ain knowledge Re/)e% previous year/s arran'e*en, D)s#"ss with *ana'e*en, )n/en,or#o"n, arran'e*en, and s)'n)1)#an, #0an'es Na,"re and /o!"*e of inventory R)s$s relating to inventory The )&en,)1)#a,)on o1 0)'0 /a!"e ),e*s Me,0o&s o1 a##o"n,)n' for )n/en,orLo#a,)on of inventory and how it affects inventory control and recording In,erna! #on,ro! and a##o"n,)n' s-s,e*s to identify potential areas of difficulty Ens"re re+resen,a,)/e se!e#,)on o1 !o#a,)ons, in/en,or- and +ro#e&"res are covered @nsure sufficient attention is given to 0)'0 /a!"e ),e*s Arran'e to obtain from ,0)r& +ar,)es #on1)r*a,)on o1 )n/en,or- they hold 4onsider the need for e5+er, help

'ssess key factors

(lan procedures

2@K1@. 8F 7T84< T'<@ 1;7T2J4T18;7 8rganisation of count S"+er/)s)on by senior staff including those not normally involved with inventory T)&-)n' an& *ar$)n' inventory to help counting Res,r)#,)on and #on,ro! of the production process and inventory movements during the count I&en,)1)#a,)on o1 &a*a'e& ,o so!e,e( s!o% *o/)n' ,0)r& +ar,- and re,"rna !e inventory 4ounting S-s,e* #o"n,)n' to ensure all inventory is counted Teams of ,%o #o"n,ers, one counting and the other checking or two )n&e+en&en, #o"n,s 1"E

2ecording

Ser)a! n"* er)n' , #on,ro! and return of inventory sheets 1nventory sheets e)n' #o*+!e,e& in )n$ and signed In1or*a,)on to be recorded on the count records )location, identity ,uantity counted etc* 2ecording of ?"an,),-( #on&),)on and s,a'e o1 +ro&"#,)on of .1( 2ecording of last numbers of 'oo&s inwards and o",%ar&s and internal transfers Re#on#)!)a,)on with )n/en,or- re#or&s and investigations and correction of any &)11eren#es

'J&1T (28:2'M- 'TT@;&';4@ 'T 1;K@;T82+ 48J;T 4heck the client/s staff are following instructions Make test counts to ensure that procedures and internal controls are working properly @nsure that the procedures for identifying damaged, obsolete and slow moving inventories operate properlyA the auditors must obtain information the inventory/s condition, age, usage and for .1( stage of condition 4onclude whether the count has been properly carried out and is sufficiently reliable as a basis for the determination of the e!istence of inventories 4onsider whether any amendments are necessary to subse,uent audit procedures 4onfirm that inventories held on behalf of third parties is separately identified and accounted for :ain an overall impression of the levels and values of inventories held so that the auditors may, in due course, Budge whether the figure for inventories appearing in the financial statements is reasonable CUT H OFF 4ut L off is the most critical to the accurate recording of transactions and auditors will carry out these procedures to ensure transactions have been recorded in the correct period.

1"F

'J&1T (28:2'M- 4JT 8FF 2ecord all movements relating to the period 8bserve whether correct cut off procedures are being followed in the dispatch and receiving areas &iscuss procedures with company staff performing the count to ensure they are understood @nsure no goods finished on the day of the count are transferred to the warehouse 6inal Audit 4onsider whether any amendments are necessary to subse,uent audit procedures Match goods received notes to the sales invoices and ensure the liability has been recorded in the correct period )only goods received before year end R purchases* Match goods dispatched notes to sales invoice to ensure the income has been recorded in the correct period Match the re,uisition notes to the .1( figures for the receiving department to ensure correctly recorded

Cos, Bers"s Ne, Rea!)sa !e Ba!"e 8NRB9 IAS 0 Inventories prescribes the accounting treatment relating to inventories. 'uditors should compare cost and net realisable value for each item of inventory. .here this is impractical to do, comparison may be done by group or category. ;et 2ealisable Kalue is likely to be less than cost when there has been 'n increase in costs or fall in selling prices (hysical deterioration 8bsolescence of products ' marketing decision to manufacture and sell products at a loss @rrors in production or purchasing

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'J&1T (28:2'M- 'TT@;&';4@ 'T 1;K@;T82+ 48J;T 2eview and test the client/s system for identifying slow moving, obsolete or damaged inventory Follow up on any such items that were identified at the inventory count, ensuring that the client has made ade,uate provision to write down the items to net realisable value @!amine inventory records to identify slow L moving items @!amine the prices at which finished goods have been sold after the year end and ascertain whether any finished goods items need to be reduced to below cost 2eview ,uantities of goods sold after the year end to determine that year end inventory has, or will be, realised 1f significant ,uantities of finished goods inventory remain unsold for an unusual time after the year end, consider the need to make appropriate provisions For .ork 1n (rogress ).1(*, the ultimate selling price should be compared with the carrying value at the year end plus costs to be incurred after the year end to bring the .1( to a finished state. PREPAYMENTS 'J&1T (28:2'M- (2@('+M@;T7 Ber)1- +re+a-*en,s by the reference to the cash book , e!pense invoices, correspondence and so on. C0e#$ #a!#"!a,)ons of prepayments 2eview the detailed profit and loss account to ensure that all likely prepayments have been provided for Re/)e% the &e,a)!e& +ro1), an& !oss a##o"n, to ensure that all likely prepayments have been provided for Re/)e% the +re+a-*en,s for reasona !eness by comparing with prior years and using analytical procedures where applicable

OTHER NON4CURRENT ASSETS The key assertion relating to intangible assets are e5)s,en#e and /a!"a,)on. They will therefore be audited with reference to criteria laid down in the financial reporting standards. 's only purchased goodwill or intangibles with a readily ascertainable market value can be capitali5ed, audit evidence should be available )purchase invoice or specialist valuations*. 'udit of amorti5ation will be similar to that of depreciation OTHER ASSETS The non current asset register is a very important aspect of internal control system. 1t enables assets to be identified, and comparisons between the :eneral Cedger, non current 1E#

asset register and the assets themselves provide evidence that the assets are #o*+!e,e!re#or&e& and thus provides further evidence of #o*+!e,eness. 'nother significant control is that of procedures over ac,uisitions and disposals, that the ac,uisitions themselves have been properly authori5ed, and precede and a##o"n,e& 1or. 8ther significant aspects are to ensure that 7ecurity arrangements over non current assets are sufficient. ;on current assets are maintained properly &epreciation is reviewed every year 'll income is collected from income yielding assets. COMPLETENESS AUDIT PROGRAM: TANGI2LE NON4CURRENT ASSETS4COMPLETENESS . 8btain or prepare a summary of tangible non current assets showing howA :ross book value 'ccumulated depreciation ;et book value 2econcile with the opening position. 4ompare non current assets in the general ledger with the non current register and obtain e!planations for differences 4heck whether assets which physically e!ist are recorded in the non current asset register 1f a non current asset register is not kept, obtain a schedule showing the original costs and present depreciated value of maBor non current assets 2econcile the schedule of non current asset register with the general ledger.

EFISTENCE: AUDIT PROGRAM: TANGI2LE NON4CURRENT ASSETS4EFISTENCE 4onfirm that the company physically inspects all items in the non current asset register each year 1nspect assets concentrating on high value items and additions each year 4onfirm items checked@!ist 're in use 're in good condition Have correct serial numbers 2eview records of income yielding assets 2econcile opening and closing vehicles by number as well as by amounts 1E1

BALUATION: AUDIT PROGRAM: TANGI2LE NON4CURRENT ASSETS4BALUATION Kerify additions to valuation certificate 4onsider reasonableness of valuation, reviewingA @!perience of the valuer 7cope of work Methods and assumptions used Kaluation bases are in line with accounting standards 4heck revaluations surplus has been correctly calculated 4heck valuations of all assets that have been revalued have been updated regularly )full valuation every five years and interim in year three generally* 4heck that client has recognised in the profit and loss account revaluation losses which relate to clear consumption of economic benefits or which the valuation below depreciated historical cost, and client has recognised all other gains and losses in statement of total recognised gains and losses

DEPRECIATION: 2eview depreciation rates applied in relation to1. asset lives 6. residual values >. replacement policy %. past e!perience of gains and losses on disposal D. consistency with prior year and accounting policy ". possible obsolescence 4heck depreciation has been charged on all assets with a limited useful life For revalued assets, ensure that the charge for depreciation is based on the revalued amount 4heck calculation of depreciation rates 4ompare ratios of depreciation to non current assets) by category with prior years and depreciation policy rates @nsure no further depreciation is provided on fully depreciated assets 4heck that depreciation policies and rates are disclosed in the accounts

INSURANCE: 2eview insurance rates in force for all categories of tangible non current assets and consider the ade,uacy of their insured values and check e!piry dates 1E6

RIGHTS AND O2LIGATIONS:

AUDIT PROGRAM: TANGI2LE NON4CURRENT ASSETS4RIGHTS AND O2LIGATIONS

Kerify title to land and buildings by inspection ofA 1. title deeds 6. land registry certificate >. leases 8btain a certificate from solicitors3bankers-

1. stating purpose for which deeds are being held 6. stating deeds are free from mortgage or loan 1nspect registration document for vehicles held, checking that they are in client/s name 4onfirm all vehicles used for the client/s business @!amine documents of title for other assets )including purchase invoices, architect/s certificate, contracts, hire purchase or lease agreements.

(/A%G"S AN1 (O,,I#,"N#S 1. review evidence of charges in statutory books and by company search 6. review leases of leasehold properties to ensure that the company has fulfilled the covenants contained therein >. e!amine invoices received after the yearLend , orders and minutes for evidence of capital commitments. 1nspection of the building/s title deeds does not give evidence about e!istence and if there is doubt that a building actually e!ists, the auditors should physically inspect it. ADDITIONS: AUDIT PROGRAM: TANGI2LE NON4CURRENT ASSETS4ADDITIONS Kerify additions by inspection of architect/s certificates, solicitor/s completion statements, supplier/s invoices etc 4heck capitali5ation of e!penditure is correct by considering for non current assets additions and items in relevant e!pense categories )repairs, motor vehicle e!penses, sundry etc* whether1E>

1. 4apital3revenue distribution is correctly drawn 6. 4apitali5ation is in line with consistently applied company policy 4heck purchases have been properly allocated to the correct non current assets 4heck purchases have been authori5ed by directors3 management @nsure that appropriate claims have been made for grants, and grants received and receivable have been received 4heck additions have been recorded in no current asset register and general ledger

SELF CONSTRUCTED ASSETS: 'J&1T (28:2'M- T';:1BC@ ;8; 4J22@;T L 7@CF 48;7T2J4T@& '77@T7 Kerify material and labour costs and overhead to invoices, wage rates, records etc @nsure e!penditure has been analysed correctly and properly charged to capital @!penditure should be capitali5ed if it1. enhances the economic benefit of the asset in e!cess of its previously assessed standard of performance 6. replaces or restores a component of the asset that has been treated separately for depreciation purposes, and depreciated over its useful economic life >. relates to a maBor inspection or overhaul that restores the economic benefits of the assets that have been consumed by the entity, and have already been reflected by depreciation

4heck that no profit element has been included in costs 4heck that finance costs capitali5ed in previous periods do not e!ceed total finance costs for the period

DISPOSALS: AUDIT PROGRAM: TANGI2LE NON4CURRENT H DISPOSALS Kerify proposals with supporting documentation, checking transfer of title, sales price and dates of completion and payment 4heck calculation of profit or loss 4heck that disposals have been authori5ed 4onsider whether proceeds are reasonable

1f the asset was used as security, ensure release from security has been correctly made. INTANGI2LES 1E%

 'gree purchased intangibles to purchase documentation 2eview specialist valuation of intangibles and ensure they are reasonable 2eview amorti5ation calculations to ensure corrections INBESTMENTS 4heck board minutes resolutions relating to the ac,uisition of investments 4heck that management have authority to invest 4heck procedures on disposals of investments 4heck that accounting treatment is in accordance with the re,uired accounting standards @nsure that investment is reflected in the accounts at an appropriate carrying value.

GOOD6ILL 'gree consideration to sales agreement 4heck that asset valuation is reasonable 'gree that the calculation is correct 2eview the impairment review @nsure valuation of goodwill is reasonable3 there has been no impairment which has not been adBusted

@.2.0 LIA2ILITIES @.2.1 TRADE ACCOUNTS PAYA2LE AND PURCHASES 's with accounts receivable, accounts payable are indeed likely to be a material figure in the balance sheet of most enterprises. The purchase cycle tests of controls will have provided the auditors with some assurance as to completeness of these liabilities. 'uditors should however be particularly aware, when conducting their balance sheet work, of the possibility of "n&ers,a,e*en, o1 !)a )!),)es to improve li,uidity and profits )by understating corresponding purchases*. The primary obBective of the balance sheet work will be to ascertain whether liabilities e!isting at the year end have been #o*+!e,e!- and a##"ra,e!y recorded. 's of trade accounts payable, this obBective can be subdivided as follows 1s there sa,)s1a#,or- #",4o11 between goods received and invoices received, so that purchases and trade discount payable are recognised in the correct year0 &o trade discounts payable present the ona 1)&e amounts due by the company0 Tra&e A##o"n,s Pa-a !e L)s,)n' 1ED

The list of balances will be one of the principal sources from which the auditors will select their samples for testing. The listing can be e!tracted from the purchase ledger by the client. The following is relevant to the auditor to ensure the purchase ledger has been properly e!tracted 4heck from the purchase ledger accounts to the list of balances and vice versa. 2econcile the total of the list with the purchase ledger control account 4ast the list of balances and the purchase ledger control.

The client should also prepare a detailed schedule showing all trade and sundry accrued e!penses 1n performing the substantive tests relating to Ciabilities, the auditor will be concerned with 4ompleteness2 rig!ts and o ligations and existence of trade accounts payable The other test is to compare supplier statements with purchase ledger balances. 'uditors must select a representative sample not Bust those with large year end balances. 2emember that it is errors of "n&ers,a,e*en, that auditors are looking. The auditor should select accounts with nil or negative balances, he should be wary of low balances with maBor suppliers. 2emember that the client has no incentive to record liabilities before they have been invoiced. 7upplier/s circulari5ation is not generally carried out in that third party information is generally more reliable and the supplier/s invoices will be part of the purchase cycle and the auditors will henceforth concentrate on these documents when designing and conducting their tests. 1n the following circumstances the auditor may consider circulari5ing creditors and he will be looking for ?positive/ responses. 7upplier statements are for whatever reason unavailable or incomplete .eaknesses in the internal controls or nature of the client/s business make possible a material misstatement of liabilities that would not be otherwise picked up 1t is thought that the client is deliberately trying to understate accounts payable That accounts appear to be irregular or if the nature or si5e of balances or transactions is normal

E5a* Fo#"s Po)n, Testing supplier/s statements is fre,uently tested in auditing e!amsT P"r#0ases an& E5+enses 'udit obBectives That purchases are for valid reasons That goods and services purchased were for the benefits of the company 'ccuracy of recording, so again cut off will be important 1E"

OCCURRENCE AND COMPLETENESS OF PURCHASE 's with sales analytical procedures will be important. 'uditors will consider The level of purchases and e!penses over the year, compared on a month by month basis with the previous period The effect on value of purchases of changes in ,uantities purchased The effect on value of purchases of changes in products purchased or prices of products How the ratio of trade accounts payable to inventory compares with previous year/s figures

AUDIT PROGRAM: PURCHASES4 COMPLETENESS AND OCCURRENCE 4heck purchases and other e!penses recorded in the purchase or general ledger or cash book to supporting documentation considering whetherA (urchases and e!penses are valid )invoice addressed to the client for goods ordered and received by the client (urchases and e!penses have been allocated to the correct purchase or general ledger account 4onsider reasonableness of deductions from purchase or e!penses by reference to subse,uent event. 4heck valid debts are recorded in purchase ledger to credit not In #ons)&er)n' +ro#e&"res a++!)e& - ,0e a"&),or( ,0e 1o!!o%)n' are re!e/an,: :oods received for which no invoice has not been received have been properly accrued :oods received which have been invoiced but not yet posted have been accrued :oods returned to suppliers prior to the yearLend are e!cluded from inventory and trade accounts payable

AUDIT PROGRAM: PURCHASES4 PURCHASE CUT OFF 4heck goods from goods received notes with serial numbers before the year end to ensure that they areA )osted to t!e purc!ase ledger prior to t!e 3ear end Included on t!e sc!edule of accruals 2eview the schedule of accruals to ensure that goods received after the year end are not accrued 4heck from goods returned notes prior to year end to ensure that credit notes have been posted to the purchase ledger prior to the year end or are accrued 2eview large invoices and credited notes included after the year end to ensure they refer to the following year 1EE

2eview outstanding purchase orders for indication of any purchase completed but not invoiced 2econcile daily batch totals around the year end to purchase ledger control ensuring that batches are posted in the correct year

LONG4TERM LIA2ILITIES: The auditors concern in respect of long term debts will be focus on those liabilities that are repayable after more than one year. 7ome e!amples of these areA debentures, loan stock etc. 'uditors will be more concerned with 4ompleteness whether all long term debt has been included in the Financial 7tatements Measurement .hether interest payable has been properly calculated and included in the correct accounting period &isclosure whether long term debt and interest have been properly disclosed in the F7 in accordance with applicable standards and legislation

AUDIT PROGRAM: LONG4TERM DE2T 8btain 3prepare schedules of long term debt outstanding at the balance sheet date showing for each loan- name of lender, date of loan, maturity date, interest date and rate balance at end of the period and security 4ompare opening balances to the general ledger 4heck name of lender to register of debenture holders Trace additions and repayment entries in the cash book 4onfirm repayments with the lenders @!amine cancelled che,ues and memoranda of satisfaction for loans repaid Kerify that borrowing limits imposed by the articles of association or other agreements have not been e!ceeded @!amine signed Board minutes relating to new borrowings3repayments 8btain direct confirmation from lenders of amounts outstanding, accrued interest and what security they hold Kerify interest charged for the period and then ade,uacy of interest accrued 4onfirm assets charged have been entered in the register of charges and notified to the registrar 2eview restrictive covenants and provisions relating to default2eview corresponding relating to the loan 2eview confirmation replies for non compliance 1f a default appears to e!ist , determine its effect, and schedule findings. 2eview minutes, cash books to check if all loans have been recorded 1EF

INCOME STATEMENT AUDIT The audit of the income statement will depend on the materiality of the items contained therein and the level of reliance the auditor has placed on the internal control systems. 1f the auditor assesses the internal controls as being weak, then he will increase his substantive tests on the (rofit and Coss 'ccount )1ncome 7tatement* and the Balance 7heet. 7ome of the tests that the auditor will carry out Trace material items in the 1ncome 7tatement and trace them back to the books of prime entry, checking what procedures were applied to the transaction)s* before it was posted to the 1ncome 7tatement 4arrying out other substantive tests like analytical procedures, arithmetic and accuracy of the material amounts reflected in the 1ncome 7tatement 1n,uiries from management about certain items in the 1ncome 7tatement which need satisfactory e!planations 'ny other audit tests that will help satisfy the auditor about the reasonableness, accuracy and completeness of the transactions in the 1ncome 7tatement 'pplicable Financial 2eporting 7tandards and whether their application in the 1ncome 7tatement is acceptable.

@.= PROBISIONS AND CONTINGENCIES KEY TERMS: ' +ro/)s)on is a liability of uncertain timing or amount ' !)a )!),- is a present obligation of the enterprise arising from past events, the settlement of which is e!pected to result in an outflow from the enterprise of resources embodying economic benefits 'n o !)'a,)n' e/en, is an event that creates a legal or constructive obligation that results in an enterprise having no realistic alternative to settling that obligation ' legal obligation is an obligation that derives from1EG

)a* ' contract )through its e!plicit or implicit terms* )b* Cegislation )c* 8ther operation of law A #ons,r"#,)/e o !)'a,)on is an obligation that derives from an enterprise/s action where)a* By an established pattern of past practice, publici5ed policies and sufficiently specific current statement, the enterprise has indicated to other parties that it will accept certain responsibilities, and )b* 's a result the enterprise has created a valid e!pectation on the part of those other parties that it will discharge those responsibilities A #on,)n'en, !)a )!),- is)a* a possible obligation that arises from past events and whose e!istence will be confirmed only on the occurrence or non occurrence of one or more uncertain future events not wholly within the control of the enterprise or )b* ' present obligation that arises from past events but is not recognised because1. 1t is not probable that an outflow of resources embodying economic benefits will be re,uired to settle the obligation, or 6. The amount of the obligation cannot be settled with sufficient reliability. A #on,)n'en, asse, is a possible asset that arises from past events and whose e!istence 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. Jnder 1'7 >E, an entity should not recognise a contingent asset or liability. @ntities should only recognise a contingent liability or asset should only be recognised unless 1t becomes probable that economic benefits will flow out3into the entity The asset or liability is capable of being measured reliably

@!amples of principal types of contingencies disclosed by companies-U '"aran,ees &)s#on,)n"e& )!!s o1 e5#0an'e "n#a!!e& !)a )!),)es on shares or loan stock !a%s"),s or claims pending o+,)ons to purchase assets

'(A 40- Audit evidence3additional considerations for specific items covers contingencies relating to litigation and legal claims, which represents the maBor part 1F#

of the audit work on contingencies. Citigation and claims involving the entity may have a material effect on the accounts and so will re,uire adBustments to3disclosure in those financial statements. AUDIT PROGRAM: PURCHASES4 PROBISIONS AND CONTINGENCIES Make appropriate in,uiries of management including obtaining its representation 2eview board minutes and correspondence with the entity/s lawyers. @!amine legal e!pense account Jse any other information available regarding the entity/s business information obtained from discussions with any in house legal department. The 17' discusses the form the letter to the entity/s lawyer should take. The letter which ideally should be prepared by management and sent by the auditor who should instruct the lawyer to communicate directly with the auditor The letter should have the following headings a list of litigations and claims management/s assessment of the outcome of litigation or claim and its estimate of financial implications including costs a re,uest that the lawyer confirm the reasonableness of management/s assessment and provide the auditor with further information if the list is considered by the lawyer to be incorrect or incomplete

' meeting between the auditor and lawyer should be set where a comple! matter arises and where there is disagreement between the lawyer and management. AUDIT PROGRAM: PROBISIONS AND CONTINGENCIES 8btain details of all provisions which have been included in the accounts all contingencies that have been disclosed 8btain a detailed analysis of all provisions showing opening balances , movements and closing balances &etermine for each material provision whether the company has a present obligation as a result of past events byA discussing &it! t!e directors 3 revie&ing correspondence relating to t!e item &etermine for each material item provision whether a transfer of economic benefits is probable 4heck whether any payments have been made in the post balance sheet period relating to the item 2eview correspondence with solicitors , insurers, bankers for both pre and post balance sheet periods 7end a letter to the solicitor to get their views &iscuss what happened to previous provisions with management 1F1

4heck contingent liability disclosed in the accounts 2ecalculate all provisions in the accounts 4onsider the likelihood of reimbursement 4ompare amounts provided with post balance sheet payments 4heck that the contingent liability is disclosed in the account 4onsider the nature of the client/s business, would you e!pect to see provisions, warranties etc 4onsider ade,uacy of the provisions, contingent assets and contingent liabilities.

E5a* Fo#"s Po)n, Yo" s0o"!& a++re#)a,e ,0a, ,0e +ro !e*s o1 a##o"n,)n' 1or #on,)n'en#)es *a$es a"&),)n' &)11)#"!,. @.< SHARE CAPITAL The issued share capital as stated in the Financial 7tatements must be a'ree& )n ,o,a! ,o ,0e s0are re')s,er. Transfers will be e!amined on a test basis should be done in cases where the company handles its registration work. .here this is not the case, the auditors will e!amine those reports reported by independent parties to the company. The auditor will also be concerned and will check carefully compliance by companies with the local legislation about share issues, purchase of own shares etc. The auditor will also be concerned as to whether any movements in reserves are /a!)&. AUDIT PROGRAM: CAPITAL AND RELATED ISSUES S!are e.uit3 capital A'ree ,0e a",0or)Ce& share capital with the statutory documents governing the company/s constitution A'ree #0an'es to a",0or)Ce& s0are #a+),a! with properly a",0or)Ce& board resolutions Issue of S!ares Ber)1- any issue of share capital or other changes during the year with general and board minutes Ens"re )ss"e or change is within the terms of the constitution, and the directors have a++ro+r)a,e a",0or), Con1)r* that cash and o,0er #ons)&era,)ons have been received or debtor)s* is included in called up share capital not paid. #ransfer of S!ares Ber)1- ,rans1er of shares by reference to correspondence, cancelled share certificate and minutes of directors/ meetings 1F6

C0e#$ balance of shareholder/s accounts in the register of members and the total list with the amount of issued share capital in the general ledger

1ividends A'ree &)/)&en&s +a)&E+ro+ose& to a",0or),- and check calculation was correct C0e#$ &)/)&en&s +a)& with &o#"*en,ar- e/)&en#e C0e#$ that dividends do not contravene the &)s,r) ",)on +ro/)s)ons of the legislation C0e#$ that imputed ta! has been accounted for to the revenue authority

%eserves C0e#$ *o/e*en,s on reserves to supporting documentation C0e#$ that *o/e*en,s do not contravene the legislation and the company/s constitution Con1)r* that the company can distinguish those reserves at the balance sheet date that are distributable from those that are un distributable Ens"re ,0a, a++ro+r)a,e disclosures of movements are made in the company/s books

@.> SU2SE:UENT EBENTS ?7ubse,uent events/ are Those events that occur between the period end and the date of the auditor/s report Facts discovered after the date of the auditor/s report

'(A 4*0 (ubsequent events begin by stating that- ?The auditor should consider the effect of subse,uent events on the financial statements and on the auditor/s report/ 'A( -0 5vents after the balance sheet date deals with the treatment in financial statements of events, both favourable and unfavourable, occurring after the year end. 1t identifies two types of events Those that provide further evidence of conditions that e!isted at the period end Those that are indicative of conditions that arose subse,uent to the period end

The auditor/s main concern in relation to subse,uent events is to ensure that they perform procedures designed to obtain s"11)#)en, a++ro+r)a,e e/)&en#e that all events up to the auditor/s report that may re,uire adBustment or disclosure in the financial statements have been identified. These procedures will be applicable to all the items that were e!amined during the audit but were susceptible to change after the year end. 1F>

17' D"# lists procedures to identify subse,uent events, which may re,uire adBustment or disclosure. They should be as near as possible to the date of the auditor/s report. PROCEDURES TESTING SU2SE:UENT EBENTS En?")r)es o1 Mana'e*en, status of items involving s" .e#,)/e ."&'e*en,s accounted for using preliminary data new #o**),*en,s, borrowings or guarantees sa!es or destruction of asse,s )ss"es of s0aresE&e en,"res or changes in business structure &e/e!o+*en,s involving r)s$ areas, +ro/)s)ons and #on,)n'en#)es "n"s"a! a##o"n,)n' a&."s,*en,s *a.or e/en,s ) e.g. going concern problems* affecting appropriateness of accounting policies for estimates

O,0er +ro#e&"res #ons)&er +ro#e&"res of management for identifying subse,uent events rea& *)n",es of general board 3 committee meetings re/)e% !a,es, a##o"n,)n' re#or&s and financial information 2eviews and updates of these procedures may be re,uired, depending on the length of time between the procedures and the signing of the auditor/s report and the susceptibility of the accounts to change over time./ .hen the auditor becomes aware of events, which materially affects the financial statements, the auditor should consider whether such events are properly accounted for and ade,uately disclosed in the accounts/. The financial statements are the responsibility of management and they should therefore inform management of any material subse,uent events between the date of the auditor/s report and the date the financial statements are issued. The auditors have no obligation to perform procedures, or make en,uiries regarding financial statements after the date of their report. ?.hen after the date of the auditor/s report but before the financial statements are issued the auditor becomes aware of a fact which may materially affect the accounts, the auditor should consider whether the financial statement need amendments, should discuss the matter with management and should take action appropriate in the circumstances/. ' situation may arise where the statements are not amended but the auditors feel they that they should be. The 17' says ?when management does not amend the financial statements in circumstances that they believe they need to be amended and the auditor/s report has not been released to the entity, the auditor should e!press a ,ualified opinion or an adverse opinion./ 1F%

?.hen after the financial statements have been issued, the auditor becomes aware of a fact which e!isted at the date of the audit report and which if known at that date, may have caused the auditor to modify the audit report, the auditor should consider whether the financial statements need revision, should discuss the matter with management, and should take the action as appropriate in the circumstances/

CHAPTER A.0: AUDIT EBIDENCE

KEY TERMS Ana!-,)#a! +ro#e&"res #ons)s, o1 ,0e ana!-s)s o1 s)'n)1)#an, ra,)os an& ,ren&s )n#!"&)n' ,0e res"!,)n' )n/es,)'a,)ons o1 1!"#,"a,)ons an& re!a,)ons0)+s ,0a, are )n#ons)s,en, %),0 o,0er re!e/an, )n1or*a,)on or %0)#0 &e/)a,e 1ro* +re&)#,a !e a*o"n,s. ISA *00 Anal3tical )rocedures s,a,es ?the auditor should apply analytical procedures at the planning and at the overall review stages of the audit/. 1n addition to the analytical procedures, the auditor will also perform other substantive tests to obtain audit evidence directly. Na,"re an& P"r+ose o1 Ana!-,)#a! Pro#e&"res T0e ISA s,a,es ,0a, ana!-,)#a! +ro#e&"res )n#!"&e: )a* The considerations of the comparisons with: S)*)!ar )n1or*a,)on for prior periods An,)#)+a,e& res"!,s of the entity, from budgets or forecasts Pre&)#,)ons prepared by auditors In&"s,r- )n1or*a,)on such as a comparison of the client/s ratio of sales to trade accounts receivables with industry averages, or with the ratios relating to other entities of comparable si5e in the same industry

)b* Those elements of financial information that are e!pected to conform to a predicted pattern based on the entity/s e!perience, such as the relationship of gross profit to sales. )c* Those between financial information and relevant non financial information, such as the relationship of payroll costs to number of employees . 1FD

' variety of methods can be used to carry out these analytical procedures above, ranging from s)*+!e #o*+ar)sons to #o*+!e5 ana!-s)s using statistics, on company, branch or individual account level. The 17' states that auditors must decide whether using available analytical procedures, as substantive procedures will be e11e#,)/e and e11)#)en, in re&"#)n' &e,e#,)on r)s$ for specific financial statement assertions. The 17' lists a number of factors that auditors should consider when using analytical procedures-

Fa#,ors ,o #ons)&er The obBectives of the analytical procedures and the e!tent to which their results are reasonable The degree to which information can be analysed

E5a*+!e 'nalytical procedures maybe a good indicator of whether a population is complete 'nalytical procedures may be more effective when applied to financial information on individual sections of an operation Financial- budgets or forecasts ;on financial e.g. the number of units produced or sold .hether budgets are prepared with sufficient care .hether budgets are established as results to be e!pected rather than as goals to be achieved Broad industry data may need to be supplemented with that of an entity that produces and sells specialised products The effectiveness of the accounting and internal control systems The types of problems giving rise to accounting adBustments in prior periods

The a/a)!a )!),- o1 )n1or*a,)on The re!)a )!),- of information available The re!e/an#e of the information available The comparability of the information available The knowledge gained during previous audits

'uditors will also consider the plausibility and predictability of the relationships being tested. 7ome relationships are strong for e!ample sales and selling e!penses where the sales people are paid by commission. The 17' identifies other factors, which should be considered when determining the reliance that the auditors must place on the results of analytical proceduresRe!)a )!),- Fa#,or E5a*+!e 1F"

Ma,er)a!),- of the items involved O,0er a"&), +ro#e&"res directed towards the same financial statement assertions

The a##"ra#- with which e!pected results of analytical procedures can be predicted

The 1re?"en#- with which a re!a,)ons0)+ is observed Assess*en, of )n0eren, and #on,ro! risks

.hen inventory balances are material, auditors do not solely rely on analytical procedures 8ther procedures auditors undertake in reviewing the collectibility of accounts receivable, such as review of subse,uent cash receipts, may confirm or dispel ,uestions arising from the application of analytical procedures to an aged profile of customer accounts 'uditors normally e!pect greater consistency in comparing the relationship of gross profit to sales from one period to another than in comparing discretionary e!penses such as research or advertising ' pattern repeated monthly as opposed to annually 1f internal controls over sales processing are weak, and control risk is high, auditors may rely more on tests of individual transactions or balances other than analytical procedures.

The auditor will identify and investigate significant fluctuations or relationships that are inconsistent with other relevant information or deviate from e!pected patterns and he will obtain ade,uate e!planations and appropriate corroborative evidence. 1nvestigations will start with en,uiries of management and then corroboration of management responses By comparing them with the auditor/s knowledge of the entity/s business and with other evidence obtained during the course of the audit. 1f the analytical procedures are being carried out as a substantive procedure, by undertaking additional audit procedures where appropriate to confirm the e!planations received.

1f the e!planations cannot be given by management, or if they are insufficient, the auditor must determine which further audit procedures to undertake to e!plain the fluctuation or relationship. .hen carrying out analytical procedures, the auditor should remember that every industry is different and that each company within an industry differs in certain respects. 7ome of the practical e!amples of analytical procedures are)c* )d* Ra,)o ana!-s)s E5a*)n)n' re!a,e& a##o"n,s in conBunction with each other. 8ften revenue and e!pense accounts are compared with the balance sheet 1FE

)e* )f*

accounts and comparisons are made to ensure that relationships are reasonable Tren& ana!-s)s L current year/s results are compared with previous period/s results. Reasona !eness ,es,s These involve calculating the e!pected value )e.g. cost X additions L disposals*S depreciation charge R charge in 1ncome 7tatement.

8ther main methods of analytical review include Benchmarking (hysical inspection 4orroboration 2ecalculation and reconciliation 7urveys and ,uestionnaires narratives testing

T0e %or$)n' +a+ers *"s, #on,a)n ,0e #o*+!e,e& res"!,s o1 ,0e ana!-,)#a! +ro#e&"res. They should include 8utline of the +ro'ra**e of work 7ummary of s)'n)1)#an, 1)'"res and relationships for the period 7ummary of #o*+ar)sons made with budgets and with previous years &etails of all s)'n)1)#an, 1!"#,"a,)ons or une!pected relationships considered &etails of res"!,s o1 )n/es,)'a,)ons into such fluctuations or une!pected relationships The a"&), #on#!"s)ons reached In1or*a,)on #ons)&ere& ne#essar- for assisting in the +!ann)n' o1 s" se?"en, a"&),s

TUTORIAL :UESTION4 ANALYTICAL PROCEDURES +ou are the auditor of <haya Toys, a limited liability company which manufactures and sells small toys by mail order. The company is managed by Mr. (hiri and two assistants. Mr.(hiri authorises important transactions such as wages and large orders, one assistant maintains the payables ledger and orders inventory and pays suppliers, and the other assistant receives customer orders and despatches the toys. &ue to other commitments Mr (hiri only visits the office once a week. 't any time, about 1## different types of toys are available for sale .'ll sales are made cash with order there are no receivables. 4ustomers pay using credit cards and occasionally by sending cash. Turnover is over <D.6 million.

1FF

+ou are planning the audit of <haya Toys and are considering using some of the procedures for gathering audit evidence recommended by 17' D## 'udit @vidence as follows)i* )ii* )iii* )iv* )v* RE:UIRED: )a* For each of the above procedures)i* )ii* )iii* @!plain its use in gathering audit evidence 8= *ar$s9 &escribe one e!ample for the audit of <haya Toys 8= *ar$s9 &iscuss the suitability of each procedure for <haya Toys , e!plaining the suitability of each 810 *ar$s9 'nalytical procedures 1n,uiry 1nspection 8bservation 2e calculation

SUGGESTED ANS6ER Ana!-,)#a! +ro#e&"res consist of evaluations of financial information made by a study of reasonable relationships among both financial and non financial data. In?")r- means to seek relevant information from sources, both financial and non financial, either from within the organisation or outside of it. @vidence gathered this way maybe done by writing or orally. Ins+e#,)on is the physical review of documents, records or even assets. 1t may include e!amination of records of evidence of controls in the operations of an entity. O ser/a,)on involves looking at the process or procedures being as they are being performed so that the auditor sees for himself what controls are applied to a given process and whether they are the same as the ones documented e.g. attendance at the entity/s stock take. Re#a!#"!a,)on means redoing calculations to check the arithmetic accuracy of records. Ana!-,)#a! Pro#e&"res 2eview the sales figure for the current year and compare it to the prior years and check whether income has been understated or overstated possibly cash being taken out by the owner of <haya Toys before it is banked. 4heck control over opening of cashA as cash could be misappropriated and the records falsified. In?")r1FG

8btain statements from suppliers of goods and services and whether all supplier invoices have been included in the current year/s liabilities. 1nvoices could be misplaced and the suppliers/ ledger could have been understated. O ser/a,)on The inventory of the company can be inspected to see whether they are in a saleable condition. O ser/a,)on 8bserve the procedures such as opening of cash and taking of customer orders to see whether the correct procedures are being applied there as documented in the system. Re#a!#"!a,)on 4hecking additions in the cash book to ensure accuracy. Ana!-,)#a! +ro#e&"res This method of collecting evidence will be useful in <haya Toys because it will help identify unusual changes in income. The techni,ue has limitations because it will not detect errors made during the year e.g. cash misappropriated on opening of mail will not be detected by analytical procedures. In?")r1n,uiries will be useful to get audit evidence from third parties. Third party evidence is generally more reliable than internal evidence. 7upplier statements can be checked to check the payables figures of <haya Toys. 4omplaint files and ,ueries will be reviewed to check on why certain orders have not been acted upon. 1n,uiries will not be helpful if obtained from Mr. (hiri or his assistants because lack of segregation of duties already entails that this information may be unreliable. 1nspection of documents within <haya Toys is necessary and helpful particularly to check whether the e!penses are genuine. 1nspection of documents will be time consuming but may be the only alternative way of obtaining evidence given the poor internal controls at <haya Toys. 8bservation of a process is useful at <haya Toys because it will give an insight as to what checks and controls are applicable to a particular process e.g. when opening mail. However, observation may be of little use because the assistants may act differently in the presence of the auditor. 2ecalculation of invoices to check castings, balancing of control accounts etc. The arithmetical accuracy, therefore, can be confirmed.

1G#

Cimitations of re calculations can only be carried out on figures that have actually been recorded. 1f sales are not recorded for instance, it means that no recalculations can be done on those sales. A.2 F.> AUDIT SAMPLING 'uditors do not normally e!amine all the information available to themA it would be impractical to do so and using audit sampling will produce valid conclusions. 17' D># 'udit sampling and other selective testing procedures states that ? when designing audit procedures, the auditor should determine appropriate means for selecting items for testing so as to gather audit evidence to meet the obBectives of audit tests/.

KEY TERMS: A"&), Sa*+!)n' involves the application of audit procedures to less than 1##$ the items within an account balance or class of transactions such that all sampling units have a chance of selection. This will enable the auditor to obtain and evaluate audit evidence about the characteristics of the items selected in order to form or assist in forming a conclusion concerning the population. Po+"!a,)on is the entire set of data from which a sample is selected and about which an auditor wishes to draw conclusions. F.% The 17' points out that some testing procedures do not involve sampling such as Tes,)n' 100J of items in a population Testing all items with a #er,a)n #0ara#,er)s,)# as selection is not representative. The 17' re,uires auditors to select appropriate methods of selecting the items for testing.

F.D

KEY TERMS: S,a,)s,)#a! sa*+!)n' is any approach to sampling that involves random selection of a sample, and use probability theory to evaluate sample results, including measurement of sampling risk Non4s,a,)s,)#a! sa*+!)n' is the approach to sampling where the auditor does not use statistical methods and draw a Budgement opinion about the population. 1G1

KEY TERMSError means either control deviations, when performing tests of control, or misstatements, when performing substantive procedures E5+e#,e& error is the error that the auditor e!pects to be present in the population Sa*+!)n' "n),s are the individual items constituting a population. F." There are a number of selection methods available for the units in the (opulation Ran&o* se!e#,)on S-s,e*a,)# se!e#,)on )constant interval between items* Ha+0aCar& se!e#,)on Se?"en#e or !o#$ se!e#,)on Mone,ar- "n), sa*+!)n' H This is a method which ensures that every Y1 in a population has an e,ual chance of being selected for testing. The advantages of this method are that they are easy when computers are used and every material item will be automatically be sampled. &isadvantages include the fact that if computers are not used, it can be time consuming to pick the sample.

E5a*+!e o1 MUS 4reditor ' B 4 & @ F : H 1 = < C M ; F.E Balance >#,### >D,### %D,### =2(000 1>,### =0(000 6>,### D## %6,### %E,### =<(000 1E,### A0(000 16,### 4umulative Total >#,### "D,### 11#,### 1"6,### 1ED,### 66D,### 6%F,### 6%F,D## 6G#,### >>E,### >G1,### %#F,### %FF,### D##,### 7elected +es +es Yes Yes +es +es Yes +es Yes +es

Material items are shown in bold and have all been picked. The cumulative total shows you when the ne!t D#,###th Y has been reached. 1G6

F.F

7tratification may be appropriate. 7tratification is the process of dividing the population into subpopulation, each of which is a group of sampling units, which have similar characteristics. @ach sampling unit can only belong to one specifically designed stratum, thus reducing the variability within each stratum. This enables the auditors to direct their attention towards items which contain the greatest potential monetary error. +ou divide items by age or by amount.

KEY TERMS: Sa*+!)n' r)s$ arises from the possibility that the auditor/s conclusions, based on a sample of a certain si5e, maybe different from the conclusion that would be reached if the entire population were subBected to the same audit procedure. Non4sa*+!)n' r)s$ arises from factors that cause the auditor to reach an erroneous conclusion for any reason not related to the si5e of the sample. For e!ample most audit evidence is persuasive rather than conclusive, the auditor might use appropriate procedures, or auditors might misinterpret evidence and fail to recognise an error. To!era !e error is the ma!imum error in the population that the auditor would be willing to accept. Ke- s,a'es )n ,0e sa*+!)n' +ro#ess are as 1o!!o%s: De,er*)ne o .e#,)/es an& +o+"!a,)on De,er*)n)n' sa*+!e s)Ce C0oos)n' *e,0o& o1 sa*+!e se!e#,)on Ana!-s)n' ,0e res"!,s an& +ro.e#,)n' errors on,o ,0e +o+"!a,)on F.G The use of statistical sampling results for the purpose of obtaining audit evidence will depend on the auditor/s assessment of such evidence as to reliability and the results and availability of the other audit evidence the audit has obtained. MATERIALITY

F.6.#

KEY TERMS Materiality is an e!pression of the relative significance or importance of a particular matter in the conte!t of the financial statements as a whole. 4onsideration of materiality at the planning stage is very important. The assessment of materiality at this stage should be based on recent information and will be helpful in determining the audit approach. Materiality assessment will help auditors to decide How many and what items to e!amine .hether to use sampling techni,ues 1G>

 .hat level of error is likely to lead to a ,ualified audit opinion. The auditor/s obBective is to reduce audit risk to an acceptable level. MATERIALITY CRITERIA 'n item might be material due to its Na,"re 7ome items by their nature affect the readers of the financial statements e.g. ,ransa#,)ons !)$e &)re#,ors3 re*"nera,)on or contracts with the company 7ome items will be significant in the financial statements - /)r,"e o1 ,0e)r s)Ce e.g. motor vehicles which comprise ED$ of the total non current assets 7ome items may by chance have greater impact on financial statements. @.g. a difference between a small profit and a small loss could be material to some readers

Ba!"e

I*+a#,

Materiality therefore is one of ."&'e*en, and auditors should be very much aware of such a fact in approaching their audit work. :eneral rules on materiality 1tems relating to directors are generally material (ercentage guidelines are often given for materiality e.g. $ of sales, turnover etc. Pro !e*s %),0 *a,er)a!),Materiality is a matter of ."&'e*en, and therefore +res#r)+,)/e r"!es will be of little help when assessing materiality. The problem with prescriptive rules is that an auditor can encounter a completely different situation which does not fall within the rules and he may overlook it leading to material misstatements in the financial statements . Therefore the percentage guidelines that are used for materiality calculations should be used with care. 1n some companies, post ta! profits are used which makes sense because the level of dividends is an important factor in the accounts KMa,er)a!),- )s an e5+ress)on o1 ,0e re!a,)/e s)'n)1)#an#e or )*+or,an#e o1 a +ar,)#"!ar *a,,er )n ,0e #on,e5, o1 ,0ese 1)nan#)a! s,a,e*en,s as a %0o!e. A *a,,er )s *a,er)a! )1 ), %o"!& reasona !- )n1!"en#e a rea&er. K A.< PROFESSIONAL LUDGEMENT

1G%

The auditor will use professional Budgement in assessing what level of reliance he should aim to obtain from the tests that he conducts. 1n particular materiality is one area where he will use his professional Budgement because what is material to one company is immaterial to another and the auditor must be able to relate 1n all other cases where estimates are used, the auditor will use his professional Budgement to decide on the reasonableness of those estimates and also the trends from prior periods. A.= FRAUD AND ERROR Many of the high risk factors listed are issues which could potentially result in a high risk of fraud and error arising. 7ignificant control weaknesses Muestionable integrity &oubtful accounting policies Cack of finance director Jne!plained transactions Fraud is an emotive issue. 1f news of a maBor fraud on a company hits the headlines, the ,uestion that is often asked is ?how did this happen0/ 1nvariably when ,uestions like that are asked, people raise ,uestions about the audit that has taken place on that company/s financial statements. ' maBor problem for the auditor can be that the public does not understand the auditors role with regard to fraud. This forms part of an ?e!pectations gap/ which e!ists between what auditors actually do and what people think that they do. .e are going to briefly consider here what the auditors/ role in relation to fraud and error, and consider when the risk of fraud and error arising is too great for the auditor to accept the engagement. IAS 2<0 1ra"& an& error ISA 2<0.20 1n planning the audit, the auditors should discuss with other member of the audit team the susceptibility of the entity to material misstatements in the financial statement resulting from fraud and error. FRAUDI

1GD

The sentence from 17' 6%# given above summarises the auditors/ professional re,uirements in relation to fraud and error- they must recogni5e that it may e!ist and materially affect the financial statements. The most important thing to understand with regard to fraud is that the auditor has no duty )specifically no statutory duty* to prevent or detect fraud. .ith regard to the statutory audit, the auditor must be aware that two potential causes of the financial statements being misstated are fraud or error e!isting. KEY TERMS Fraud comprises both the use of deception to obtain an unBust or illegal financial advantage, and intentional misrepresentation by management, employees or third parties. @rror is an unintentional mistake. 1.;.A EFAMPLES Fraud may involve Falsification or alteration of accounting records or other documents Misappropriation of assets or theft 7uppression or omission of the effects of transactions from records of documents 2ecording of transactions without substance 1nternational misapplication of accounting policies, or .ilful misrepresentations of transactions or the entity/s state of affairs

.hat this list of ?fraudulent behaviour/ might help you to see is that the detection of fraud committed by management is going to be e!tremely difficult because it is designed not to be found. (articularly where the fraud is fraud by omission, the auditor is unlikely to detect fraud as part of an audit. The standard does not e!pect the auditors to detect fraud as a matter of course. 2ather, it re,uires auditors to be aware, when planning and performing their audit, that fraud may e!ist, and more particularly, it highlights a number of factors which the auditor should be alert to, which could point to fraud being perpetrated. P!ann)n' 17' 6%#.66 .hen planning the audit, the auditor should make in,uiries of management)d* to obtain an understanding of1G"

)i*

)e* )c*

management/s assessment of the risk that the financial statements may be materially misstated as a result of fraudA and )ii* the accounting and internal control systems management has put in place to address such riskA to obtain knowledge of management/s understanding regarding the accounting and internal control systems in place to prevent and detect errorA to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigatingA and )d* to determine whether management has discovered material errors.

17' 6%#.>6 .hen assessing inherent risk and control risk in accordance with 17' %##, 2isk 'ssessments and 1nternal 4ontrol, the auditor should consider how the financial statements might be materially misstated as a result of fraud or error. 1n considering the risk of material misstatement resulting from fraud, the auditor should consider whether fraud risk factors are presented that indicate the possibility of either fraudulent financial reporting or misappropriation of assets. The factors, which may indicate fraud or error are given in an appendi! to the 17', which is reproduced hereFraud and 2isk 2elating to Misstatements 2esulting from Fraudulent Financial 2eporting 1 Fra"& R)s$ These fraud risk factors pertain to management/s abilities, Fa#,ors pressures, style, and attitude relating to internal control and Re!a,)n' ,o the financial reporting process. Mana'e*en,3s C0ara#,er)s,)#s There is motivation for management to engage in an& In1!"en#e fraudulent financial reporting. 7pecific indicators o/er ,0e might include the followingCon,ro! o ' significant portion of management/s En/)ron*en, compensation is represented by bonuses, stock options or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position or cash flow. o There is e!cessive interest by management in maintaining or increasing the entity/s stock price or earnings trend through the use of unusually aggressive accounting practices. o Management commits to analysts, creditors and other third parties to achieving what appear to 1GE

be unduly aggressive or clearly unrealistic forecasts. o Management has an interest in pursuing inappropriate means to minimi5e reported earnings for ta! motivated reasons. There is a failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. 7pecific indicators might include the followingo Management does not effectively communicate and support the entity/s values or ethics, or management communicates inappropriate values or ethics. o Management is dominated by a single person or a small group without compensating controls such as effective oversight by those charged with governance. o Management does not monitor significant controls ade,uately. o Management fails to correct known material weaknesses in internal control on a timely basis. o Management sets unduly aggressive financial targets and e!pectations for operating personnel. o Management continues to employ ineffective accounting, information technology or internal auditing staff. ;on financial management participates e!cessively in, or is preoccupied with, the selection of accounting principles or the determination of significant estimates. There is a high turnover of management, counsel or board members. There is a strained relationship between management and the current or predecessor auditor. 7pecific indicators might include the followingo Fre,uent disputes with the current or a predecessor auditor on accounting, auditing or reporting matters. o Jnreasonable demands on the auditor, including unreasonable time constraints regarding the completion of the audit or the issuance of the auditor/s report. o Formal or informal restrictions on the auditor that inappropriately limit the auditor/s access to 1GF

people or information, or limit the auditor/s ability to communicate effectively with those charged with governance. o &omineering management behaviour in dealing with the auditor, especially involving attempts to influence the scope of the auditor/s work. There is a history of securities law violations, or claims against the entity or its management alleging fraud or violations of securities laws. The corporate governance structure is weak or ineffective, which may be evidenced by, for e!ample-

o ' lack of members who are independent of management. o Cittle attention being paid to financial reporting matters and to the accounting and internal control systems by those charged with governance. 6 Fra"& R)s$ These fraud risk factors involve the economic and Fa#,ors regulatory environment in which the entity operates. Re!a,)n' ,o ;ew accounting, statutory or regulatory re,uirements In&"s,rthat could impair the financial stability or profitability Con&),)ons of the entity. ' high degree of competition or market saturation, accompanied by declining margins. .ith increasing business failures and significant declines in customer 2apid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence. Fra"& R)s$ Fa#,ors Re!a,)n' ,o O+era,)n' C0ara#,er)s,)#s an& F)nan#)a! S,a )!),These fraud risk factors pertain to the nature and comple!ity of the entity and its transactions, the entity/s financial condition, and its profitability. 1nability to generate cash flows from operations while reporting earnings and earnings growth. 7ignificant pressure to obtain additional capital necessary to stay competitive, considering the financial position of the entity )including a need for funds to finance maBor research and development or capital e!penditures*. 'ssets, liabilities, revenues or e!penses based on 1GG

>

significant estimates that involve unusually subBective Budgements or uncertainties, or that are subBect to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity )for e!ample, the ultimate collectibility of receivables, the timing of revenue recognition, the reliability of financial instruments based on highly subBective valuation of collateral or difficult to assess repayment sources, or a significant deferral of costs*. 7ignificant related party transactions which are not in the ordinary course of business. 7ignificant related party transactions which are not audited or are audited by another firm. 7ignificant, unusual or highly comple! transactions )especially those close to year end* that pose difficult ,uestions concerning substance over form. 7ignificant bank accounts or subsidiary or branch operations in ta! haven Burisdictions for which there appears to be no clear business Bustification. 'n overly comple! organi5ational structure involving numerous of unusual legal entities, managerial lines of authority or contractual arrangements without apparent business purpose. &ifficulty in determining the organisation or person )or persons* controlling the entity. Jnusually rapid growth or profitability especially compared with that of other companies in the same industry. @specially high vulnerability to changes in interest rates. Jnusually high dependence on debt, a marginal ability to meet debt repayment re,uirements, or debt covenants that are difficult to maintain. Jnrealistically aggressive sales or profitability incentive programs. ' threat of imminent bankruptcy, foreclosure or hostile takeover. 'dverse conse,uences on significant pending transactions )such as a business combinations or contract award* if poor financial results are reported. ' poor or deteriorating financial position when management has personally guaranteed significant debts of the entity.

6##

Fraud and 2isk Factors 2elating to Misstatements 2esulting from Misappropriation of 'ssets 1 Fra"& R)s$ These fraud risk factors pertain to the nature of an entity/s Fa#,ors assets ad the degree to which they are subBect to theft. Re!a,)n' ,o S"s#e+,) )!) Carge amounts of cash on hand or processed. ,- o1 Asse,s 1nventory characteristics, such as small si5e combined ,o with high value and high demand. M)sa++ro+ @asily convertible assets, such as bearer bonds, diamonds r)a,)on or computer chips. Fi!ed asset characteristics, such as small si5e combined with marketability and lack of ownership identification. 6 Fra"& R)s$ These fraud risk factors involve the lack of controls designed Fa#,ors to prevent or detect misappropriation of assets. Re!a,)n' ,o Con,ro!s Cack of appropriate management oversight )for e!ample, inade,uate supervision or inade,uate monitoring of remote locations*. Cack of procedures to screen Bob applicants for positions where employees have access to assets susceptible to misappropriation. 1nade,uate record keeping for assets susceptible to misappropriation. Cack of an appropriate segregation of duties or independent checks. Cack of an appropriate system of authori5ation and approval of transactions )for e!ample, in purchasing*. (oor physical safeguards over cash, investments, inventory or fi!ed assets. Cack of timely and appropriate documentation for transactions )for e!ample, credits for merchandise returns*. Cack of mandatory vacations for employees performing key control functionsA 'uditors are therefore ?put on en,uiry/ when such factors e!ist L in other words, they have a professional duty to satisfy themselves that any concerns raised have been answered to their satisfaction. .hen fraud or error are indicated 17' 6%#.>G Based on the auditor/s assessment on inherent and control risks )including the results of any tests of controls*, that misstatements resulting from fraud and error that are material to the financial statements taken as a whole will not be detected. 6#1

1n designing the substantive procedures, the auditor should address the fraud risk factors that the auditor has identified as being present. 17' 6%#.%6 .hen the auditor encounters circumstances that may indicate that there is a material misstatement in the financial statements resulting from fraud or error, the auditor should perform procedures to determine whether the financial statements are materially misstated. 17' 6%#.%" .hen the auditor identifies a misstatement, the auditor should consider whether such a misstatement may be indicative of fraud and if there is such an indication, the auditor should consider the implications of the misstatement in relation to other aspects of the audit, particularly the reliability of management representations. 17' 6%#.%F .hen the auditor confirms that, or is unable to conclude whether, the financial statements are materially misstated as a result of fraud or error, the auditor should consider the implications for the audit. 17' 6%#.D1 The auditor should obtain written representations from management that)e* )f* 1t acknowledges its responsibility for the implementation and operations of accounting and internal control systems that are designed to prevent and detect fraud and errorA 1t believes the effects of those uncorrected financial statement misstatements aggregated by the auditor during the audit are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. ' summary of such items should be included in or attached to the written representationA 1t has disclosed to the auditor all significant facts relating to its assessment of the risk that the financial statements may be materially misstated as a result of fraud. 1t has disclosed to the auditor the results of its assessment of the risk that the financial statements may be materially misstated as a result of fraud.

)g* )h*

Re+or,)n' Castly the 17' goes on to consider what the auditors should do, or rather, to whom they should report, in the event of them uncovering a fraud. 2emember that, as you learnt in 4hapter %, the auditors have a professional duty of confidentiality.

6#6

17' 6%#.D" .hen the auditor identifies a misstatement resulting from fraud, or a suspected fraud, or error the auditor should consider the auditor/s responsibility to communicate that information to management, those charged with governance and, in some circumstances, to regulatory and enforcement authorities. 7uch a discovery might also have an impact on the audit report (81;T T8 ;8T@ .e shall consider the audit report in chapter 1G. 1f auditors do detect a management fraud, they may consider it to be so serious that it is necessary to report it to the relevant authority in the public interest. 7uch a decision would not be taken lightly, and should only be taken once legal advice had been sought. The auditors have a duty of confidentiality, but in e!ceptional circumstances, where the matter is one of public interest, they may have to make such a disclosure. 17' 6%#.DG3"#3"6 1f the auditor has identified a material misstatement resulting from error, the auditor should communicate the misstatement to the appropriate level of management on a timely basis, and consider the need to report it to those charged with governance in accordance with 17' 6"#. ?4ommunication of audit Matters with Those 4harged with :overnance/.

The auditor should inform those charged with governance of those uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole. T0e a"&),ors 1dentified fraud, whether or not it results in a material misstatement in the financial statementsA or 8btained evidence that indicates that fraud may e!ist )even if the potential effect on the financial statements would not be material*.

The auditor should communicate these matters to the appropriate level of management on a timely basis and consider the need to report such mattes to those charged with governance in accordance with 17' 6"#, ?4ommunication of 'udit Matters with Those 4harged with :overnance/ 17' 6%#."G3E> 6#>

1f the auditor concludes that it is not possible to continue performing the audit as a result of a misstatement resulting from fraud or suspected fraud, the auditor should 4onsider the professional and legal responsibilities applicable in the circumstances, including whether there is a re,uirement for the auditor to report the person or persons who made the audit appointment 4onsider the possibility of withdrawing from the engagement and 1f the auditor withdrawsdiscuss with the appropriate level of management and those charged with governance the auditor/s withdrawal from the engagement and the reasons for the withdrawal, and consider whether there is a professional or legal re,uirement to report to the persons who made the audit appointment or in some cases, to regulatory authorities, the auditor/s withdrawal from the engagement and the reasons for the withdrawal.

)i* )ii*

's stated in the ?4ode of @thics for (rofessional 'ccountants/ issued by the international Federation of 'ccountants )the code*, on receipt of an in,uiry from a proposed successor auditor, the e!isting auditor should advise whether there are any professional reasons why the proposed successor auditor should not accept the appointment. 1f the client denies the e!isting auditor permission to discuss its affairs with the proposed successor auditor or limits what the e!isting auditor may say, the fact should be disclosed to the proposed successor auditor.

Fra"& an& a"&), a##e+,an#e 7everal issues have been raised here from the point of view of the audit firm 'uditors should plan and perform procedures whilst being aware that fraud may e!ist Fraud, however, may be e!tremely difficult to discover 'uditors must satisfy themselves if put on en,uiry 1f the auditors detect or suspect fraud, they must consider whether it is in the public interest to report it, having sought legal advice. Fraud is an emotive issue, which may bring bad publicity to the firm, deserved or not.

4ast your mind back to the high risk factors which were identified earlier on. 1t might be that an audit firm would choose not to accept a client which was identified as high risk at the outset, because the chances of conducting a cost 6#%

effective audit which fulfils professional re,uirements might be too low, even if the indicators were false, and there was no fraud being perpetrated at the company. KEY TERMS: Fraud is an intentional act by one or more individuals among management, those charged with governance )management fraud*, employees )employee fraud* or third parties involving the use of deception to obtain an unBust or illegal advantage. Fraud may be perpetrated by an individual, or colluded in, with people internal or e!ternal to the business. Fraud has a wide legal concept but the auditor is concerned with fraud which is likely to lead to material misstatements in the financial statements. 1t is distinct from error, which is a material misstatement caused by mistake, for e!ample in the application of computerised accounting system. There are two types of fraudFra"&"!en, 1)nan#)a! re+or,)n' )including falsification or alteration of accounting records and intentional misapplication of accounting policies9 M)sa++ro+r)a,)on o1 asse,s )including embe55ling receipts, stealing physical assets, causing the company to pay for goods not received etc* A"&),ors res+ons) )!),- %),0 re'ar& ,o 1ra"& an& error. Management and those charged with governance are responsible for preventing fraud and detecting fraud. 1t is up to them to put up strong internal controls and particular emphasis on detection and prevention of fraud. 'uditors are responsible for carrying out an audit in accordance with international auditing standard one of which is '(A 780 "he auditor%s responsibility to consider fraud in an audit of financial statements. ?1n planning and performing the audit to reduce audit risk to an acceptably low level, the audit should consider the risk of material misstatements due to fraud/ The Cetter of @ngagement )C8@* will even specify beforehand the respective responsibilities in relation to fraud and errors?The responsibility for the prevention and detection of irregularities and fraud rests with yourselves. However, we shall endeavour to plan our audit so that we have a reasonable e!pectations of detecting material misstatements in the financial statements or accounting records resulting from irregularities of fraud, but our e!amination should not be relied upon to disclose irregularities and frauds which may e!ist./ The auditor are re,uired to make en,uiries from management whether there have been any specific frauds. The auditors are also re,uired to obtain an understanding from internal audit or others of whether any suspected or actual frauds have taken place. The auditor will also seek an understanding of whether any fraud risk factors are present. 1n other words, the auditor6#D

1dentifies the risks of fraud 2elates this to what could go wrong at a financial statement level 4onsider the likely magnitude of the potential misstatements 4ome up with responses to the assessed risks 1f necessary, modify his audit approach

CHAPTER D.0: COMPUTER AIDED AUDIT TECHNI:UES

AUDITING IN A COMPUTER ENBIRONMENT RISK ASSESSMENTS AND INTERNAL CONTROLS IN A CIS ENBIRONMENT COMPUTER CONTROLS D.%.1 17' %#1 'uditing in a computer information system deals with risk assessment in a computer environment. 1t contains the following provisions. ISA <01.< 6#"

The auditors should have sufficient knowledge of the 417 to plan, direct, supervise and review the work performed. The auditor should consider whether speciali5ed 417 skills are needed in an audit. ISA <01.= 1n accordance with 17' %## 2isk 'ssessments and 1nternal 4ontrol the auditor should obtain an understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach. ISA <01.> 1n planning the portions of the audit which may be affected by the client/s 417 environment, the auditor should obtain an understanding of the significance and comple!ity of the 417 activities and the availability of data for use in the audit. ISA <01.@ .hen the 417 are significant, the auditor should also obtain an understanding of the 417 environment and whether it may influence the assessment of inherent and control risks. D.%.6 The 17' points out that the risks and characteristics in 417 environment may include Cack of transaction trails. Jniform processing of transactions. Cack of segregation of functions. (otential for errors and irregularities. 1nitiation or e!ecution of transactions &ependence of other controls over computer processing. (otential for increased management supervision.

Or'an)sa,)ona! s,r"#,"re 4haracteristics of a 417 organi5ation structure include the followingCon#en,ra,)on o1 1"n#,)ons an& $no%!e&'e Most systems using 417 methods include manual operations, but the number of personnel involved in processing financial information is greatly reduced. 7ome of the data processing personnel may be the only with a detailed knowledge of the use of the output. &ata processing staff may be aware of internal control weaknesses. They may take advantage of this by altering programs or data during storage or processing, having the opportunity to do so. 6#E

1n addition, many conventional controls, based on ade,uate segregation of incompatible functions, may not e!ist, or may be less effective in the absence of access and other controls. In,erna! #on,ro!s )n a CIS en/)ron*en, Transactions and master file data are often concentrate, usually in machine readable form, either in one central computer or on several installations distributed throughout the entity. 4omputer programs which provide the ability to obtain access to and alter such data are likely to be stored at the same location as the data. .ithout appropriate controls, there is an increased potential for unauthori5ed access to, and alteration of, programs and data. The internal controls in a 417 environment includes both manual procedures and procedures designed into computer programs. 7uch manual and computer control procedures comprise two types of control. KEY TERMS :eneral 417 controls aim to establish a framework control over the computer information system/s activities to provide a reasonable level of assurance that the overall obBectives of internal controls are achieved. 417 application controls are the specific controls over the relevant accounting applications maintained by the computer.3 The purpose of application controls is to establish specific control procedures over the accounting applications in order to provide reasonable assurance that all transactions are authorised and recorded, and are processed completely, accurately and on a timely basis.

Genera! CIS #on,ro!s These may include the followingGENERAL CONTROLS &evelopment applications of computer 7tandards over systems design, +ro'ra**)n' an& &o#"*en,a,)on. Full ,es,)n' +ro#e&"res using test data. 'pproval by #o*+",er "sers and *ana'e*en,. Se're'a,)on o1 &",)es so that those responsible for design are not responsible for testing. Ins,a!!a,)on +ro#e&"res so that data is not corrupted in transition. Tra)n)n' of staff in new procedures and 6#F

availability of ade,uate documentation. (revention or detection or Se're'a,)on o1 &",)es unauthorised changes to programs F"!! re#or&s of program #0an'es Pass%or& +ro,e#,)on of programs so that access is limited to computer operations staff. Res,r)#,e& a##ess to #en,ra! #o*+",er by locked doors, keypads. Ma)n,enan#e o1 +ro'ra*s !o's B)r"s #0e#$s on software- use of anti virus software and policy prohibiting use of non authorised programs or files. 2a#$4"+ #o+)es of programs being taken and stored in other locations. Con,ro!s #o+)es of programs being preserved and regularly compared with a#,"a! +ro'ra*s. S,r)#,er #on,ro!s over certain programs )utility programs* by use of rea& on!- *e*or-. Testing and documentation program changes of 4omplete ,es,)n' +ro#e&"res Do#"*en,a,)on s,an&ar&s A++ro/a! of changes by computer users and management. Tra)n)n' of staff using programs

4ontrols to prevent wrong programs O+era,)on #on,ro!s over programs or files being used L) rar)es of programs Pro+er .o s#0e&"!)n' 4ontrols to prevent unauthori5ed 7ee section below on real time systems amendments to data files. 4ontrols to ensure continuity of S,or)n' e5,ra #o+)es of programs and data files of operation site. Pro,e#,)on o1 e?")+*en, against fire and other ha5ards. 2a#$4"+ +o%er so"r#es E*er'en#- +ro#e&"res D)sas,er re#o/er- +ro#e&"res e.g availability of back up computer facilities. Ma)n,enan#e a'ree*en,s an& )ns"ran#e. Re/)e% o1 'enera! CIS #on,ro!s The auditors will wish to test some or all of the above general 417 controls, having considered how they affect the 417 applications significant to the audit. 6#G

:eneral 417 controls that relate to some or all applications are usually interdependent controls, i.e their operation is often essential to the effectiveness of 417 application controls. 's application controls may be useless when general controls are ineffective, it will be more efficient to review the design of 'enera! #on,ro!s 1)rs,, before reviewing the application controls. CIS a++!)#a,)on #on,ro!s The purpose of 417 application controls is to establish s+e#)1)# #on,ro!s +ro#e&"res over the accounting applications in order to provide reasonable assurance that all transactions are authorised and recorded, and are processed completely, accurately and on a timely basis 417 application controls include the followingA++!)#a,)on #on,ro!s 4ontrols over inputCo*+!e,eness Manual or programmed agreement of control totals &ocument counts. 8ne for one checking of processed output to source documents. (rogrammed matching of input to an e!pected input control file. (rocedures over resubmission of reBected controls. (rogrammes to check data fields )for e!ample value, reference number, date* on input transactions for plausibility&igit verification )eg reference numbers are as e!pected* 2easonableness test )e.g. K'T to total value* @!istence checks )e.g. customer name* 4haracter checks )no une!pected characters used in reference* ;ecessary information )no transaction processed over a certain value* Manual scrutiny of output and reconciliation to source. 'greement of control totals )manual3programmed* Manual checks to ensure information input was 'uthorised. 61#

4ontrols over inputa##"ra#-

4ontrols over )n+",: a",0or)sa,)on

1nput by authorised personnel 4ontrols over +ro#ess)n' 7imilar controls to input must be completed when input is completed, for e!ample, batch reconciliations. 7creen warnings can prevent people logging out before processing is complete. 4ontrols over master F)!es an& s,an&)n' &a,a 4yclical reviews of all master files and standing data 2ecord counts )number of documents processed* and has totals )for e!ample, the total of all the payroll numbers* used when master files are used to ensure no deletions. 4ontrols over the deletion of accounts that have no current balance. Re/)e% o1 CIS a++!)#a,)on #on,ro!s 4ontrol over input, processing, data files and output may be carried out by 417 personnel. Jsers of the system. ' separate control.

May be programmed into application software. The auditors may wish to test the following 417 application controls. Man"a! #on,ro!s e5er#)se& - ,0e "ser 1f manual controls e!ercised by the user of the application system are capable of providing reasonable assurance that the system/s output is complete, accurate and authorised, the auditors may decide to limit tests of controls to these manual controls. Con,ro!s o/er s-s,e* o",+", 1f, in addition to manual controls e!ercised by the user, the controls to be tested use information produced by the computer or are contained within computer programs, such controls may be tested by e!amining the system/s output using either manual procedures or 4''Ts. 7uch output may be in the form of magnetic media, microfilm or printouts. 'lternatively, the auditor may test the control be performing it with the use of 4''Ts. 611

Pro'ra**e& #on,ro! +ro#e&"res 1n the case of certain computer systems, the auditor may find that it is not possible or, in some cases, not practical to test controls by e!amining only user controls or the system/s output. The auditor may consider performing tests of control by using 4''Ts, such as test data or, in unusual situations, e!amining the coding on the application program. E/a!"a,)on 's we have already noted, general 417 controls may have a pervasive effect on the processing of transactions in the application system. 1f these general controls are not effective, there may be a risk that misstatements occur and go undetected in the application systems. 'lthough weaknesses in general 417 controls may preclude testing certain 417 application controls, it is possible that manual procedures e!ercised by users may provide effective control at the a++!)#a,)on !e/e!. STAND4ALONE MICROCOMPUTERS 1'(7 1##1 417 environments L stand alone microcomputers is the first of a series of statements designed to help auditors implement 17' %## 2isk assessment and internal control and 17' %#1 'uditing in a computer information systems environment. 'mong other things, it discusses the types of control in stand along computers. In,erna! #on,ro! )n *)#ro#o*+",er en/)ron*en,s ' centrally controlled 417 environment tends to be much more structured than a micro 417 environment. 1n a micro environment, application programs can be developed ,uite ,uickly by users with only basic processing skills. 1n a large computer environment, controls over s-s,e*s &e/e!o+*en, )e.g ade,uate documentation* and o+era,)ons )e.g. access control procedures* are essential for effective control. 1n a micro environment, however, such controls may be viewed by the developer, the user or management as either not important or not effective. 's micros oriented to individual end users, the accuracy and dependability of financial information produced will depend upon the internal controls re,uired by management and a&o+,e& by the "ser. 1f say a single micro is used by more than one person, without proper controls, programs and data stored on hard disk by one user may be vulnerable to unauthori5ed access by other users. 1n a micro environment it may be difficult to distinguish between general 417 controls and 417 application controls. The statement below therefore, lists some security and control procedures that can help to improve the o/era!! !e/e! of internal control. 1n particular management should lay down policies for the use of micros. Management policy statement on use of micros Management responsibilities. 1nstructions on microcomputer use. 616

Training re,uirements. 'uthorisation for access to programs and data 7ecurity, back up and storage re,uirement. 'pplication development and documentation standards. 7tandard of report format and report distribution controls. (ersonal usage policies. &ata integrity standards. 2esponsibility for programs, data error correction. 'ppropriate segregation of duties. P0-s)#a! se#"r),-: e?")+*en, Micros are obviously easy to steal, damage physically, gain access to and misuse due to their si5e, so financial information could easily be lost. 8ne physical security control is to restrict access of micros while during non business hours, by keeping the office locked. P0-s)#a! se#"r),-: re*o/a !e an& non4re*o/a !e *e&)a The standard is referring here to floppy )removable* and hard )non removable* disks used in micros. Jsers )particularly where there are several*, may be rather casual over storage of disks and conse,uently critical disks may be lost, altered with authori5ation, or destroyed. 4ontrol over removable storage media can be established by placing responsibility for such media under so1,%are #"s,o&)ans or !) rar)ans. &epending on the nature of the program and data files, #"rren, #o+)es of 0ar& &)s$s can be kept in fireproof container, either on site, off site or both. This applies e,ually to operating system and utility software and backup copies of 0ar& &)s$s.

Pro'ra* an& &a,a se#"r),.hen microcomputers are accessible to many users, there is a risk that programs and data may be altered without authori5ation. There are several internal control techni,ues which can be built into the application programs to help ensure that data is processed and read as authorise and that accidental destruction of data is prevented. )a* )b* )c* )d* Se're'a,e &a,a into files organi5ed under separate file directories. Jse 0)&&en 1)!es and secret file names. E*+!o- +ass%or&s )particularly when sending information down e!ternal telephone lines*. Back up information on floppy and then delete it from the hard disk )for confidential or sensitive information*. 61>

So1,%are an& &a,a )n,e'r),The primary purpose of micros is to allow end users to develop applications programs, to enter and process data and to generate reports. How accurate and dependable the resulting financial information is will depend on controls re,uired by management and those included in the application programs. So1,%are an& &a,a )n,e'r),- controls will ensure that processed information is free from error and also that software is protected from unauthori5ed Manipulation )i.e. authorised data is processed in the prescribed manner*. 1nternal control procedures such as 1or*a, and ran'e #0e#$s and cross checks of results can strengthen data integrity. (urchased software may contain error checking and error trappings facilities. 7oftware and data integrity controls will be further strengthened by ade,uate written documentation, including 7tep by step )ns,r"#,)ons. ' summary of re+or,s +re+are&. So"r#e o1 &a,a processed ' description of )n&)/)&"a! reports, files and other specifications, eg. 4alculations.

.here the same accounting application is used at various locations, such programs should be developed and maintained at one place, rather than by each user, and dispersed throughout the entity. This will improve application software integrity and consistency. In,erne, #on,ro!s. Jnauthorised users may be able to access business/ internal systems to obtain confidential information, or launch a virus that disrupts internal systems. 4ontrols include firewalls which disable part to the communication technology that normally allows two way communication, so that e!ternal contacts are denied access to part of the system. 8ther possibilities are en#r-+,)on of data, and #a!!4 a#$ to e!ternal customers who wish to access the system. Har&%are( so1,%are an& &a,a a#$4"+ Back up here means the entity/s access to comparable hardware, software and data in the event of their failure, loss or destruction. (rocedures should be implemented for back up by users on a regular basis )purchased software usually comes with a back up copy*. OTHER COMPUTER CONSIDERATIONS 1'(7 1##6 417 environments L on line computer systems provides guidance to the auditors on the implementation of 17's %## and %#1. 8n line computer systems are computer systems that enable users to access data and programs directly through terminal devices. They may be based on mainframe 61%

computers, minicomputers or microcomputers structured in a network environment. 8n line systems allow users to initiate various functions directly, including the following En,er ,ransa#,)ons, e.g. sales transactions in a retail store, cash withdrawals in the bank. Ma$e en?")r)es, e.g. current customer account or balance information. Re?"es, re+or,s, e.g. a list of inventory items with negative on hand ,uantities. U+&a,e *as,er 1)!es, e.g. set up new customer accounts. E!e#,ron)# #o**er#e a#,)/),)es )ordering and paying for goods by 1nternet*

C0ara#,er)s,)#s o1 on4!)ne #o*+",er s-s,e*s The significant characteristics apply to many of the types of on line systems. On4!)ne &a,a en,r- an& /a!"a,)on &ata entered on line is usually subBect to immediate validation. &ata which fails validation is reBectedA often users are offered on screen facilities for altering the data and re entering it. On4!)ne a##ess Jnlimited access from all functions )enter transactions, read change, delete program3data files etc* is undesirable, because the user may be able to make unauthori5ed changes. @!tent of access depends on application and access controls software designs. La#$ o1 ,ransa#,)on ,ra)! 7ystems which do not provide supporting documents may give details of transactions on re,uest or through the use of transaction logs.

Pro'ra**er a##ess 'gain, unrestricted access is not desirable because of the potential for unauthori5ed changes to programs. The e!tent of access depends on the re,uirements of the systemA in many systems programmers would only have access to programs maintained in a separate program development and maintenance library. In,erna! #on,ro! )n an on4!)ne #o*+",er s-s,e* Genera! CIS #on,ro!s These should include61D

)a*

A##ess #on,ro!s. These are procedures designed to restrict access to programs and data. These include the use of +ass%or&s and s+e#)a!)Ce& a##ess #on,ro! so1,%are )eg on line monitors that maintain control over menus, authori5ation tables, passwords, files and programs that users are permitted to access*. Con,ro!s o/er +ass%or&s. These are procedures for the assignment and maintenance of passwords. These should restrict access to authori5ed users. 7ystems development and maintenance controls. Pro'ra**)n' #on,ro!s. These are procedures designed to prevent or detect improper changes to computer programs which are accessed through on line terminal devices. 'ccess may be restricted by controls such as the use of separate operational and program development libraries. 1t is important for on line changed to programs to be ade,uately documented. Transa#,)on !o's. These are reports which are designed to create an audit trail for each on line transaction. F)re%a!!s. These are a combination of hardware and software that protects the server from unauthori5ed access through the 1nternet.

)b*

)c* )d*

)e* )f*

CIS a++!)#a,)on #on,ro!s %.> These should include)a* Pre4+ro#ess)n' a",0or)Ca,)on. This is permission to initiate a transaction, such as the use of a bank card together with a personal identification number before making a cash withdrawal through an automated teller machine. )b* Ter*)na! &e/)#e e&), reasona !eness an& o,0er /a!)&a,)on ,es,s. These are programmed routines that check the input data and processing results for completeness, accuracy and reasonableness. )c* C",4o11 +ro#e&"res. These ensure that transactions are processed in the proper accounting period. These are particularly necessary in systems which have continuous flow transactions. )d* F)!e #on,ro!s. These are procedures which ensure that the correct data fields are used for on line processing. )e* Mas,er 1)!e #on,ro!s. 7ince master file data may have a pervasive effect on processing results, more stringent enforcement of these control procedures may be necessary. 61"

)f* 2a!an#)n'. This is the process of establishing control totals over data being submitted for processing through the on line terminal devices and comparing the control totals during and after processing to ensure that compete and accurate data are transferred to each processing phase. E!e#,ron)# Da,a In,er#0an'e s-s,e*s @lectronic &ata 1nterchange )@&1* systems allow business to ,rans*), standard business documents such as sales invoices or purchase orders e!e#,ron)#a!!-. @&1 systems pose a number of problems for auditors. )b* Or)')na,)n' &o#"*en,s may be e!)*)na,e&( and there may be a !a#$ o1 e/)&en#e of the operation of controls. )c* The #onse?"en#es o1 +ro !e*s may be en0an#e&. :reater integration between the various aspects of an entity/s accounting system is likely, and problems with one business may have a serious impact upon its suppliers or competitors. 4omputer failures may rapidly lead to material losses. )d* The r)s$ o1 "na",0or)Ce& a##ess to data may be )n#rease&. ;ot only will a business have to have its own controls but it will have to rely as well on the controls operated by its business partners. 4ontrols over transmission including a#$no%!e&'e*en,s( a'ree*en,s by both parties of amounts transmitted, a",0en,)#a,)on #o&es and en#r-+,)on are particularly important. Transactions should be monitored continuously by #0e#$)n' the se?"en#e of transaction numbers and )n,e'ra,e& ,es, 1a#)!),)es within the computer. L)*),a,)on #on,ro!s, such as only allowing transactions with certain businesses could be built into the organi5ation/s computer system. There should also be virus protection and appropriate )ns"ran#e, and #on,)n'en#- +!ans and a#$4"+ arran'e*en,s. 'uditors are likely to have to place significant reliance on controls and may be able to ,es, #o*+!)an#e with agreed es, +ra#,)#e. 'uditors may be able to obtain assurance on the working of controls of business partners by obtaining a certificate from their auditors. Da,a ase s-s,e*s 1'(7 1##> 417 environments L data systems is designed to supplement 17's %## and %#1. &atabase systems consist of two components. The database. The database management system )&BM7*

61E

In,erna! #on,ro! )n a &a,a ase en/)ron*en, There must be effective control over the database, the &BM7 an& the application. The effectiveness of the controls depends on the nature of the database administration tasks )see above* and how they are performed. The characteristics of database systems mean that 'enera! CIS #on,ro!s have a greater influence than CIS a++!)#a,)on #on,ro!s. :eneral 417 controls have a +er/as)/e e11e#, on application processing in database systems and they can be classified into the four groups discussed below. )a* )b* 7tandard approach for development and maintenance of application programs. &ata ownership. The database administrator must clearly assign responsibility for the accuracy and integrity of each item of data. ' single data owner should be responsible for defining a##ess r"!es )who can use the data* and se#"r),- r"!es )what functions they can perform*. 2estriction of access to the database through the use of passwords etc. 7egregation of duties. 2esponsibilities for performing the various activities re,uired to design, implement and operate a database should be divided among technical, design, administrative and user personnel. These include system design, database design, administration and operation.

)c* )d*

LIMITATIONS OF ACCOUNTING AND CONTROL SYSTEMS Management of an entity will set up internal controls in the accounting system to assess the following Transa#,)ons are e!ecuted in accordance with +ro+er a",0or)Ca,)on. 'll transactions and other events are +ro*+,!- re#or&e& at the #orre#, a*o"n,, in the appropriate accounts and in the +ro+er a##o"n,)n' +er)o&. A##ess ,o asse,s is permitted only in accordance with proper authorisation. Re#or&e& asse,s are #o*+are& with the e5)s,)n' asse,s at reasonable intervals and appropriate action is taken with regard to any differences. However, any internal control system can only provide the directors with reasona !e ass"ran#e that their obBective are reached, because of )n0eren, !)*),a,)ons. These include T0e #os,s o1 #on,ro! no, o",%e)'0)n' ,0e)r ene1),s. T0e +o,en,)a! 1or 0"*an error. Co!!"s)on between employees The possibility of #on,ro!s e)n' -4+asse& or o/err)&&en by *ana'e*en,. 61F

4ontrols being &es)'ne& ,o #o+e with ro",)ne and no, non4ro",)ne ,ransa#,)ons.

These factors show why auditors cannot obtain all their evidence from tests of the systems of internal control. The key factors in the limitations of controls system are Human error. (otential for fraud.

.e have seen above that computer systems can detect and guard against logical errors. However, other simple errors such as incorrect amounts cannot be detected. The safeguard of segregation of duties can help deter fraud. However, if employees decide to perpetrate frauds in harness, or management commit fraud by overriding systems, the accounting system will not to be able to prevent such frauds. This is one of the reasons that auditors need to be alert to the possibility of fraud and error, the subBect of 17' 6%#, which was discussed 1 4hapter D. USE OF COMPUTER ASSISTED TECHNI:UES 8CAATs9 E5a* 1o#"s +o)n, Jse of computers on audits is now practice. The e!aminer e!pects you to consider the computer aspects of auditing as a matter of course. Therefore, in answering ,uestions on obtaining evidence, remember to include reference to 4''Ts if they seem relevant. 1. The overall obBective and scope of an audit do not change when an audit is conducted in a 417 environment. However, the application of auditing procedures may re,uire auditors to consider techni,ues that use the computer as an audit tool. These uses of the computer for audit work are known as 4omputer assisted audit techni,ues )4''Ts*. >. )a* 17' %#1 mentions some of the 4''Ts. The absence of input documents or the lack of a visible audit trail may re,uire the use of 4''Ts in the application of compliance and substantive procedures. The effectiveness and efficiency of auditing procedures may be improved through the use of 4''Ts. 61G

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1'(7 1##G 4omputer 'udit Techni,ues provides guidance in the use of 4''Ts. 1t applies to all uses of 4''Ts involving a computer of any type or si5e, but special considerations relating to small business computer environments are discussed at the end of the statements.

Des#r)+,)on o1 CAATs 'lthough the guidance in this statement applies to all types of 4''Ts, it discusses two of the more common types in detail. 'udit software Test data

A"&), so1,%are D. 'udit software consists of computer programs used by the auditors, as part of their auditing procedures, to process data of audit significance from the entity/s accounting system. 2egardless of the source of the programs, the auditor should substantiate their validity for audit purpose prior to use. 'udit software of the following)a* Pa#$a'e +ro'ra*s are generali5ed computer programs designed to perform data processing functions which include reading computer files, selecting information, performing calculations, creating data files and printing reports in a format specified by the auditors. P"r+ose4%r),,en +ro'ra*s are computer programs designed to perform audit tasks in specific circumstances. These programs may be prepared by the auditors, by the entity or by an outside programmer engaged by the auditors. 1n some cases, e!isting entity programs rams may be used by the auditors in their original or in a modified state because it may be more efficient than developing independent programs. U,)!),- +ro'ra*s are used by the entity to perform common data processing functions, such as sorting, creating and printing files. These programs are generally not designed for audit purposes and, therefore, may not contain such features as automatic record counts or control totals. @!amples of uses of audit software are Tes, &a,a 66# 1nterrogation software, which accesses the client/s data files. 4omparison programs which compare versions of a program 1nteractive software for interrogation of on line systems 2esident code software to review transactions as they are entered

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)c*

".

E.

test data techni,ues are used in conducting audit procedures by entering data)e.g. a sample of transactions* into an entity/s computer system, and comparing the results obtained with predetermined results. @!amples include)a* )b* Test data used to test specific controls in computer programs. @!amples include on line password and data access controls. Test transactions selected from previously processed transactions or created by the auditors to test specific processing characteristics of an entity/s computer system. 7uch transactions are generally processed separately from the entity/s normal processing. Test data can for e!ample be used to check the controls to prevent the processing of invalid data by entering with say a non e!istent customer code or worth an unreasonable amount, or a transaction which may if processed break customer credit limits. Test transactions used in an integrated test facility. This is where a ?dummy/ unit )e.g. a department or employee* is established, and to which transactions are posted during the normal processing cycle. ' significant problem with test data is that any resulting corruption of data files has to be corrected. This is difficult with modem real time systems, which often have built in )and highly desirable* controls to ensure that data entered cannot be easily removed without leaving a mark. 8ther problems with test data are that it only tests the operation of the system at a s)n'!e +o)n, o1 ,)*e, and auditors are only testing controls in the programs being run and controls which they know about. The problems involved mean that test is being used less as a 4''T.

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F.

G.

Uses o1 CAATs 4''Ts may be used in performing various auditing procedures, including the following Tes,s o1 &e,a)!s o1 Transa#,)ons an& a!an#es , for e!ample the use of audit software to test all )or a sample* of the transactions in a computer file. Ana!-,)#a! re/)e% +ro#e&"res, for e!ample the use of audit software to identify unusual fluctuations or items. Tes, o1 'enera! CIS #on,ro!s , for e!ample the use of test data to test access procedures to the program libraries.

661

Tes,s o1 CIS a++!)#a,)on #on,ro!s, for e!ample the use of test data to test the functioning of a programmed procedure.

Cons)&era,)ons )n ,0e "se o1 CAATs &uring audit planning, auditors should decide on an appropriate combination of manual audit techni,ues and 4''Ts. 1n determining whether to use 4''Ts, the factors listed below should be considered. 4omputer knowledge, e!pertise and e!perience re,uired. 'vailability of 4''Ts and suitable computer facilities. 1mpracticability of manual tests if no visible evidence is available.

ZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZ :"es,)on: In/)s) !e e/)&en#e Try to think of e!amples of where visible evidence may be lacking in the accounting process. Ans%er These e!amples come from the statement itself. )a* 1nput documents may be non e!istent where sales orders are entered on line. 1n addition, accounting transactions, such as discounts and interest calculations, any be generated by computer programs with no visible authori5ation of individual transactions. The system may not produce a visible audit trail of transactions processed through the computer. &elivery notes and suppliers/ invoices may be matched by a computer program. 1n addition, programmed control procedures, such as checking customer credit limits, may provide visible evidence only on an e!ception basis. 1n many cases, there may be no visible evidence that all transactions have been processed. 8utput reports may not be produced by the system. 1n addition, a printed report may only contain summary totals while supporting details are kept in computer files.

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ZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZ @ffectiveness and efficiency of using 4''Ts. Timing and availability of computer files.

1f the auditors are happy with the so1,%are being used )it is a standard package and has not been changed*, 4''Ts are unlikely to be necessary. 4''Ts are more likely 666

to be used in the first year of a new system, when auditors are concerned with how the system has developed. The maBor steps to be undertaken by the auditors in the application of a 4''T are as follows 7et the obBective of the 4''T application. &etermine the #on,en, and a##ess) )!),- of the entity/s 1)!es. &efine the ,ransa#,)ons types to be tested. &efine the +ro#e&"res to be performed on the data. &efine the o",+", re,uirements. 1dentify the audit and computer +ersonne! who may participate in the design and application of the 4''T. 2efine the estimates of costs and benefits. @nsure that the use of the CAAT )s +ro+er!- #on,ro!!e& and &o#"*en,e&. 'rrange the a&*)n)s,ra,)/e a#,)/),)es, including the necessary skills and computer facilities. @!ecute the use of the CAAT application. E/a!"a,e ,0e res"!,s.

Con,ro!!)n' ,0e CAAT a++!)#a,)on The use of a 4''T should be controlled by the auditors to provide reasonable assurance that the audit obBectives and the detailed specifications of the 4''T have been met, and that the 4''T is not improperly manipulated by the entity/s staff. The auditors should consider the need to perform the following)d* )e* 'pprove the technical specification, and carry out a technical review of the work involving the use of the 4''T. 2eview the entity/s general CIS #on,ro!s which may contribute to the integrity of the 4''T, e.g. controls over program changes and access to computer files )when such controls cannot be relied upon to ensure the integrity of the 4''T, the auditors may consider processing the 4''T application at another suitable computer facility*. @nsure a++ro+r)a,e integration o1 ,0e o",+", by the auditors into the audit process

)f*

Us)n' CAATs )n s*a!! "s)ness #o*+",er en/)ron*en, The general principles in the statement are applicable in small business computer environments. However, the following points should be given special consideration)g* The level of general 417 controls may be such that the auditors will place less reliance on the system of internal control. This will result in66>

)i*

Grea,er e*+0as)s on ,es,s o1 &e,a)!s of transactions and balances and analytical review procedures, which may increase the effectiveness of certain 4''Ts, particularly audit software. The a++!)#a,)on o1 a"&), +ro#e&"res to ensure the proper functioning of the 4''T and validity of the entity/s data

)ii* )h* )i* )B*

1n cases where smaller volumes of data are processed, manual methods may be more #os, e11e#,)/e. 'de,uate ,e#0n)#a! ass)s,an#e may not be available to the auditors from the entity, thus making the use of 4''Ts impracticable. 4ertain audit programs *a- no, o+era,e on small computers, thus restricting the auditors/ choice of the 4''Ts. However, the entity/s data files may be copied and processed on another suitable computer.

)k*

&etailed knowledge of computer o+era,)ons +ro'ra*s and files may be confined to a few people or even a single person. This may increase the opportunity to commit an undiscovered fraud by changing +ro'ra*s or &a,a. ZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZ :"es,)ons: CAATS .hen auditing a computer based accounting system, it is possible for most of the audit to be completed using conventional audit techni,ues. 1n some computer based systems, however, it is necessary for the auditors to employ computer assisted audit techni,ues )4''Ts*. Re?")re&: )a* )b* )c* )d* 8utline the maBor types of 4''Ts and describe the potential benefits that might be derived from using them. @!plain what is meant by a ?test pack/. Briefly e!plain the use that the auditors could make of such a test pack when e!amining a sales ledger system maintained on a computer system. Briefly outline the main practical problems encountered when using a test pack.

Ans%er )a* 'udit techni,ues that involve directly or indirectly, the use of a client/s computer are referred to as 4omputer 'ssisted 'udit Techni,ues )4''Ts*, of which the following are two principal categories. 66%

)i* )ii*

'udit software- computer program used for audit purposes to e!amine the contents of the client/s computer files. Test data- data used by the auditors for computer processing to test the operation of the enterprise/s computer programs.

The benefits of using 4''Ts are as follows)i* By using computer audit programs, the auditors can scrutini5e large volumes of data and concentrate skilled manual resources on the results, rather than on the e!traction of information. 8nce the programs have been written and tested, the costs of operation are relatively low, indeed the auditors do not necessarily have to be present during its use )thought there are fre,uently practical advantages in the auditors attending*.

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' ?test pack/ consists of input data submitted by the auditors for processing by the enterprise/s computer based accounting system. 1t may be processed during a normal production run )?live/* or during a special run at a point in time outside the normal cycle )?dead/*. The primary use of the test pack is in testing of application controls. The data used in the test pack will often contain items which should appear in e!ception reports produced by the system. The results of the processed test pack will be compared with the e!pected results.

)c*

The auditors could use a test pack to test the sales ledger system by including data in the pack which would normally be processed through the system, such as)i* )ii* )iii* )iv* 7ales 4redits allowed. 4ash receipts. &iscounts allowed.

The processing of the input world involve)i* )ii* )iii* )iv* (roduction (roduction of credit notes (osting of cash received, invoices and credit notes to individuals (osting all transactions to the sales ledger control and producing balances.

The result produced would be compare with those predicted in the test pack. @rrors should appear on e!ception reports produced by the computer, for e!ample, a customer credit limit being breached. 66D

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The practical problems involved in using a test pack are as follows)i* )ii* )iii* 1n using ?live/ processing there will be problems removing or reversing the test data, which might corrupt master file information. 1n using ?dead/ processing the auditors do not test the system actually used by the client. the system will be checked by the test pack, but not the year end balances, which will still re,uire sufficient audit work. 4osts may therefore be high. 'ny auditors who wish to design a test pack must have sufficient audit work. 4osts may therefore be high.

)iv* )v*

'ny changes in the client/s system will mean that the test pack will have to be rewritten which will be costly and time consuming. ZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZ A"&), ,ra)!s KEY TERM 'n audit trail auditors to investigate errors that they have been discovered in more detail. 1deally the audit trail should make it possible to trace all the reports and other information terms that have been effected by the error, and to trace the cause of the error. The original purpose of an audit trail was to preserve details of all stages of processing on paper. This meant that transactions could be followed stage by stage through a system to ensure that they had been processed correctly.

Aro"n& ,0e #o*+",er Traditionally, therefore, it was widely considered that auditors could fulfill their function without having any detailed knowledge of what was going on inside the computer. The auditors would commonly audit ?ro"n& ,0e #o*+",er3 ignoring the procedures which take place within the computer programs and concentrating on the input and corresponding output. 'udit procedures would include checking authori5ation, coding and control totals of input and checking the output with 66"

source documents and clerical control totals. significant testing on general controls.

They would also carry out

However, the traditional approach does not reflect the modern reality of computeri5ed accounting. 's the comple!ity of computer systems has increased there has been a corresponding loss of audit trail. Typical audit problems that arise as audit trails move further away from the hard copy hard trail include testing 4omputer generated totals when no detailed analysis is available. The completeness of output in the absence of control total. The completeness of output in the absence of input details.

1t is recogni5ed that one of the principal problems facing the auditors is that of ac,uiring an understanding of the workings of electronic data processing and of the computer itself.

T0ro"'0 ,0e #o*+",er 'uditors now customarily audit ?,0ro"'0 ,0e #o*+",er3. This involves an e!amination of the detailed processing routines and +ro'ra* #on,ro!s of the computer to determine whether the controls in the system are sufficient to ensure #o*+!e,e and #orre#, +ro#ess)n' of all data and also to ,es, the s,ren',0 of o,0er #on,ro!s +er1or*e& e!e#,ron)#a!!-, for e!ample authori5ation. 1n these situations auditors will often employ computer assisted audit techni,ues. 4''Ts will be a more e11)#)en, way of testing many routine operations, for e!ample pricing considerations. Modern computer methods have now cut out much of the laborious, time consuming work. There should still be some means of )&en,)1-)n' )n&)/)&"a! re#or& and the )n+", an& o",+", &o#"*en,s associated with the processing of any individual transactions. 'n audit trail should be provided so that every transaction on a file contains a "n)?"e re1eren#e back to the or)')na! so"r#e of the input )e.g. a sales system transaction record should hold a reference to the customer order, delivery note and invoice*. .hen file records are updated from se/era! so"r#es the provision of a satisfactory audit trail is difficult but some attempt should nevertheless be made to provide one. Typical contents, perhaps gathered from several sources, include the following items ' ,ransa#,)on n"* er and ,-+e. Full ,ransa#,)on &e,a)!s such as net and gross amount, customer 1& and so on. The identity of ,0e +erson %0o en,ere& ,0e ,ransa#,)on and3or the PC or ,er*)na! used to enter it. The date and perhaps the time of the entry. 66E

2eference to related transactions such as Bournal entries, reversals, notes and the like.

'll audit and review must be documented- the working papers are the evidence of the work done in support of the audit opinion. 17' 6># &ocumentation covers this area. ISA 2;0.2 'uditors should document matters which are important in providing evidence that the audit was carried out in accordance with 1nternational 7tandards on 'uditing.

CHAPTER 10. PU2LIC SECTOR AUDITING AND CONTROL

INTRODUCTION TO PU2LIC SECTOR AUDIT

66F

The public sector in most countries is a great variety of organisations. They all must have their accounts audited by an independent e!ternal auditor, in order to provide e!ternal accountability to the community at large. 1n the public sector, there is a tendency for an e!ternal audit to cover a much wider scope than in the private sector. The scope of public sector audit includes not only auditing of financial records and auditing to check compliance with rules and regulations but also auditing the achievement of economy, effectiveness and efficiency. The audit is an important part of public accountability and it provides an independent check on how public funds have been raised and spent. More specifically audit is needed to ensure P" !)# 1"n&s have been spent on proper, authorised purposes and legally within statutory powers. Or'an)sa,)ons )ns,a!! an& o+era,e #on,ro!s to limit the possibility of corrupt practices, fraud and poor administration 'rrangements are in place to secure e#ono*-( e11)#)en#- an& e11e#,)/eness in the use of resources

THE REGULATORY FRAME6ORK The public sector is often subBect to a high degree of regulation. For most public sector audits, the scope and obBectives of the audit are affected by the interests and re,uirements of certain third party organisations such as audit supervisory bodies and government sponsoring departments which have specific regulatory responsibilities. The manner in which the auditors conduct their work is affected by auditing standards and other regulatory influences including S+e#)1)# s,a,",or- re?")re*en,s 2e,uirements of an a"&), s"+er/)sor- o&- or sponsoring department Con,ra#,"a! re?")re*en,s contained in the terms of the engagement

The nature of the regulation affecting public sector bodies ranges from statutory to detailed administrative re,uirements. The auditors of a public body are e!pected to take reasonable steps to consider compliance by the audited body with regulations relevant to its activities and operations, and to ensure that the e!penditure made is not ultra vires. APPOINTMENT OF THE AUDITOR4GENERAL The 'uditor :eneral is appointed by His @!cellency, the (resident 2epublic of Hambia. He is constitution/s appointee.

66G

TERM OF OFFICE He can hold the office for a five year term, thereafter the appointment is subBect to renewal by the appointing authority )His @!cellency, The (resident*. FUNCTION AND PO6ERS The functions of the 'uditor :eneral are laid down in 'rticle 16F of the 4onstitution of the 2epublic of Hambia1. 6. >. Jnder the said 'rticle, He is to satisfy himself that all the public funds are used as laid down in the 4onstitutional and Finance Management 'ct )4ap "##*. He is empowered to audit the accounts and records of the :overnment Ministries, (arastatals and other statutory bodies as need arises. He is re,uired to produce 'nnual 2eports of the audited 8rganisations within twelve )16* months for the presentation to His @!cellency of the (resident of the 2epublic of Hambia, for tabling in the ;ational 'ssembly. For the 'uditor :eneral to carry out his 4onstitutional powers, he has the supporting staff who are civil servants PROCESSING OF RESULTS OF AUDIT 1f material observations are discovered they are communicated to the &epartment3Ministry concerned in writing. The Ministry concerned is usually given a month to reply to the observations, if the reply is received, it is evaluated by the section concerned to see if what has been agreed as being wrong corrective measures have been instituted. 1f corrective actions are not remedied this will feature as ,ualification to the appropriation account or the fund which is meeting the costs. 'lso at this stage the section will proceed to prepare Memorandum for the 4ommittee of (ublic 'ccounts of (arliament. This memorandum details facts and figures which surround the material errors which have affected the fund3appropriation account. .hen the Memorandum on the ,ualification is received by the 4ommittee of (ublic 'ccounts, a date is set for deliberations, and the officers concerned in the Ministry are re,uired to appear before this 4ommittee to answer ,uestions. The 4omptroller and 'uditor :eneral and his staff act as professional advisors to this committee and actually do the framing of the relevant ,uestions to be posed to the Ministry officers. 1f during the deliberations it is found that Ministry officials were responsible for the material errors, the committee is empowered to re,uest (ublic 7ervice 4ommission to transfer, sack, regrade and re training of the officials concerned.

%.

6>#

.here the 4omptroller and 'uditor :eneral feels the loss of the fund in the proBect was caused by the officer/s, he has the power to recover the money through raising of an audit surcharge in terms of section 1> of the audit and e!che,uer act 4hapter 1"F. The 4omptroller and 'uditor :eneral do not have to disclose the reason for the audit surcharge. 4onse,uently, any appeals against the surcharge by an officer would be made to His @!cellency the (resident of the country in terms of section 1% of the said act. 7ubmission of the audit report to (arliament. The 4omptroller and 'uditor :eneral is re,uired by law to submit his report to (arliament by >1st March every year, through the Ministry of Finance, @conomic (lanning and &evelopment. 'uditing of (arastatals This is done by professional firms of 4hartered 'ccountants and a full compliment of internal audit staff. The reports stemming out from these audits are copied to the 4omptroller and 'uditor :eneral for review. However, if it comes to the notice of the 4omptroller and 'uditor :eneral that certain actions and practices by the (arastatals are not in conformity with the regulations and are not able to be pointed out by both e!ternal and internal auditors, the 4omptroller and 'uditor :eneral is empowered to carry out his own audit of the (arastatals and produce special report to be tabled in (arliament under 7ection 1E of the audit and e!che,uer act 4hap. 1"F. This report is tabled through the Minister of Finance, @conomic (lanning and &evelopment and a copy to the relevant Minister responsible for the (arastatals. 1f this report which shall be tabled by the Minister of Finance within E days, is not tabled by the said Minister, the 4omptroller and 'uditor :eneral is empowered to by pass the Minister and table it himself to the (arliament through the speaker section 1F of the said act refers.

GOBERNMENT OF 7AM2IA Act No4 + of 56+0 6>1

&ate of 'ssent- %th 'pril 1GF# An Act to make certain provisions relating to the duties and powers of the Auditor3 9eneral$ and to provide for matters connected therewith or incidental thereto. [11th 'pril, 1GF#\ @nacted by the (arliament of Hambia. 1. This 'ct may be cited as the (ublic 'udit 'ct, 1GF#. 6. 1n this 'ct, unless the conte!t otherwise re,uires] V'uditor :eneralV means the 'uditor :eneral appointed, pursuant to article one hundred and twenty eight of the 4onstitutionA )4ap. 1* Vcontract auditV means the audit of transactions relating to contracts to which the :overnment, public company or statutory corporation is a partyA V&epartmentV means a department of the :overnment, and includes a MinistryA Vprivate institutionV means any unincorporated body in receipt of a :overnment grant, subsidy or subventionA Vpublic companyV means any company limited by shares and incorporated under the companies 'ct )4ap. "F"*, in which the :overnment is the sole shareholder, Vstatutory corporationV means any body corporate established by statute in which the 7tate has a maBority or controlling interest, and includes a statutory board. >. ;otwithstanding the provisions of section si!teen of the Finance )4ontrol and Management* 'ct )4ap. "##*, it shall be the duty of the 'uditor :eneral to audit, at such times as he deems fit, the accounts of] )a* every statutory corporation or public company. )b* every &epartment in which funds and working accounts are established under section eight of the Finance )4ontrol and Management* 'ct )4ap. "##*A and )c* every private institution which receives :overnment grant, subsidy or subvention in any financial year. %. )1* 1n the performance of his duty under section three, the 'uditor :eneral shall satisfy himself that the moneys e!pended by each statutory corporation, public company, &epartment or private institution have been applied to the purposes for which they were appropriated.

6>6

)6* the 'uditor :eneral shall determine the scope and e!tent of the e!amination or inspection of the accounts of each statutory corporation, public company, &epartment or private institution which he considers desirable to achieve the purposes specified in subsection )1*. )>* 1n the performance of his duties under subsections )1* and )6*, the 'uditor :eneral shall not be subBect to the direction or control of any other person or authority. D. )1* .henever the 'uditor :eneral has reason to believe that delay in reporting serious irregularities in the e!penditure of public funds through his annual report may occasion financial loss to the :overnment or preBudice effective financial control, he shall forthwith prepare such special, interim or other audit report relating to audit investigation into such serious irregularities as he considers necessary to prevent or reduce any financial loss to the :overnment. )6* The 'uditor :eneral shall, as soon as practicable, submit the special, interim or other audit report mentioned in sub section )1* to the (resident who shall, not later than seven days after the first sitting of the ;ational 'ssembly ne!t after the receipt of such report, cause it to be laid before the 'ssemblyA and if the (resident makes default in laying the report before the 'ssembly, the 'uditor :eneral shall submit the report to the 7peaker of the 'ssembly, or, if the office of 7peaker is vacant or if the 7peaker is for any reason unable to perform the functions of his office, to the &eputy 7peaker, who shall cause it to be laid before the 'ssembly . ". .henever the e!igencies of public audit services so re,uire, the Minister responsible for finance may, at the re,uest of the 'uditor :eneral, engage such agents or specialist consultants as are necessary to assist the 'uditor :eneral in the e!ecution of his duties. E. )1* 1n the performance of his duties under this 'ct, the 'uditor :eneral and any public officer, agent or specialist consultant authorised by him shall have] a. access to all books, records, returns, reports and other documents relating to the accounts of any statutory corporation, public company, &epartment or private institution under audit e!amination or inspectionA access at any reasonable time of the day to the premises of any statutory corporation, public company, &epartment or private institution under audit e!amination or inspectionA power to call for any relevant information from persons responsible for the financial administration of any statutory corporation, public company, &epartment or private institution under audit e!amination or inspection.

b.

c.

)6* ;otwithstanding anything contained in subsection )1*, the 'uditor :eneral shall not authorise any agent or specialist consultant]

6>>

a.

to have access to any books, records, returns, reports or other documents, or to enter upon any premises, of any component of the &efence Force or the Hambia 7ecurity 1ntelligence 7erviceA or to have access to any books, records, returns, reports or other documents, or to enter upon any premises other than those mentioned in paragraph )a*, if such access or entry is likely to] )i* preBudice the security, defence or international relations of the 2epublic or the investigation or detection of offencesA or )ii* involve the disclosure of any matters or deliberations of a secret or confidential nature of the 4abinet or any sub committee of the 4abinet.

b.

F. )1* ;otwithstanding anything to the contrary contained in any other written law, every contract for construction work or for the supply of e,uipment, machinery or materials involving the e!penditure of public funds to which the :overnment, a public company or statutory corporation is a party, shall contained a provision empowering the 'uditor :eneral or any public officer, agent or specialist consultant authorised by him to have access to, and e!amine all books, records, papers, reports and other documents relating to such contract. )6* ;o moneys appropriated for e!penditure on a contract for construction work or for the supply of e,uipment, machinery or materials valued at an amount in e!cess of fifty thousand kwacha shall be released to a contractor or supplier unless the 'uditor :eneral/s prior written certification that such contact contains the provision specified in subsection )1* has been obtained. )>* @very contractor or supplier under a contract for construction work or for the supply of e,uipment, machinery or materials involving the e!penditure of public funds in e!cess of fifty thousand kwacha to which the :overnment, public company or statutory corporation is a party, shall maintain separate books of account showing appropriate subsidiary accounts, together with relevant supporting documents relating to such contract. G. )1* .here under any written law establishing a statutory corporation or public company provision is made for the appointment of an auditor, it shall be the duty of the auditor appointed pursuant to such provision to furnish the 'uditor :eneral with copies of such certificates, reports, documents and other relevant information in respect of the accounts of such statutory corporation or public company as the 'uditor :eneral may re,uire. )6* Jpon receipt of the copies of certificates, reports, documents and other relevant information mentioned in subsection )1*, the 'uditor :eneral shall determine the nature and e!tent of any audit review he may consider necessary and, where desirable, he may prepare and submit to the (resident in the manner specified in subsection )6* of section five a report on such audit review. 6>%

1#. The 'uditor :eneral shall, at the re,uest of the (resident, conduct any specific audit investigation into the accounts of any statutory corporation, public company, &epartment or private institution, as the (resident may consider desirable in the public interest. 11. )1* @very public officer serving in the 8ffice of the 'uditor :eneral of or above the rank of (rincipal 'uditor, and every agent or specialist consultant engaged under the provisions of section si! shall, before entering upon the duties of his office, take and subscribe before the 4hief =ustice an oath in the form set out in the 7chedule. )6* The provisions of subsection )1* shall not apply to any public officer, agent or specialist consultant who entered upon the duties of his office before the commencement of this 'ct(rovided that any such public officer, agent or specialist consultant shall, as soon as may be after the commencement of this 'ct, take and subscribe an oath in accordance with the provisions of subsection )1*. )>* .here any person is re,uired to take an oath under the provisions of subsection )1*, and] )a* he has no religious beliefA or )b* the taking of an oath is contrary to his religious beliefA he may make a solemn affirmation in the form set out in the 7chedule by substituting the words Vsolemnly and sincerely declare and affirmV for the word VswearV and omitting the words V7o Help Me :odV. 16. ;o action or other proceeding shall lie against the 'uditor :eneral or any public officer, agent or specialist consultant authorised by him for or in respect of the findings of any audit e!amination or inspection carried out by him in the e!ercise or purported e!ercise of his functions under this 'ct. 1>. 'ny person who obstructs or resists the 'uditor :eneral or any public officer, agent or specialist consultant authorised by him in the e!ercise of his power of access, or power to call for relevant information, under this 'ct, shall be guilty of an offence and shall be liable, upon conviction, to a term of imprisonment not e!ceeding one year or to a fine not e!ceeding one thousand kwacha, or to both such imprisonment and fine.

6>D

SCHEDULE (ection --! 1, ................................................. having been appointed to e!ercise the functions of ................................. in the office of the 'uditor :eneral do swear that 1 will, without fear of favour, affection or ill will, discharge the functions of my office, and that 1 will not, directly or indirectly, reveal any matters relating to such functions other than in the course of duty. 7o help me :od 7worn3&eclared before me this ....................... day of ...................., 1G............. ............................ ........................... 4hief =ustice.

6>"

LEGISLATION ON PU2LIC SECTOR INTERNAL AUDIT FUNCTION( ROLE AND RESPONSI2ILITY OF INTERNAL AUDITOR UNDER PU2LIC SECTOR ENBIRONMENT 1n some countries government internal audit is regulated by its own 'ct. Thus, for e!ample, :hana has the 1nternal 'udit 'gency 'ct of 6##> and (akistan is in the process of developing a similar 'ct. The re,uirements for internal audit could also be included in legislation by including wording along the following lines in the relevant public financial management 'ct )or e,uivalent*IThe 'ccounting 8fficer of each ministry, department or agency shall ensure that

an internal audit function is maintained which is appropriate to the needs of the organisation concerned and conforms with internationally recognised standards in respect of its status and procedures the scope of internal audit includes the whole system of internal controls established by the organisation, including its financial, operational and compliance controls and risk management internal audit has unrestricted rights of access to all personnel, records )both electronic or otherwise*, assets, and to obtain such information and e!planations as it considers necessary for the proper fulfilment of its responsibilities the head of internal audit reports directly to a senior director, preferably the 'ccounting 8fficer, with direct access, as necessary, to the chair of the audit committee )or e,uivalent*.I

@!amples of similar approaches from other 'frican 4ountries Ma!a%) (ublic Finance Management 'ct 6##>, 7ection 1#)1* I@ach 4ontrolling 8fficer is responsible for ensuring that, in relation to his Ministry )p* an effective system of internal control is developed and maintained and, unless the 7ecretary to the Treasury approves otherwise in circumstances provided for in Treasury 1nstructions, an effective internal audit function is developed and maintainedI So",0 A1r)#a (ublic Finance Management 'ct 1GGG I:eneral responsibilities of accounting officers )1* the accounting officer for a department, trading entity or constitutional institution )a* must ensure that the department, trading entity or constitutional institution maintains )ii* a system of internal audit under the control and direction of an audit committee complying with and operating in accordance with regulations and instructions [financial regulations\ prescribed in terms of sections E" and EEI TanCan)a Jnder section 6G of the (ublic Finance 'ct 6##1, the 'ccountant :eneral shall have 6>E

power toI)a* 1ssue instructions regarding internationally known standards of internal audit to the accounting officersA )b* 1nspect the internal control and audit functions displayed by the accounting officers, to ensure that such instructions are being implemented and the appropriate standards are achieved. These instructions and inspections shall seek to ensure that the internal audit service is capable of operating independently of the management of a Ministry, &epartment or 'gency and that no limitation is placed on its access to information and it shall be incumbent on both the 'ccounting 8fficers and the Head of 1nternal 'udit in the Ministry, &epartment or 'gency, to ensure that all instructions are enforced and implemented in respect of the 'udit functions.I The (ublic Finance 2egulations )6##1* also re,uire accounting officers to Iestablish an effective internal audit service unit throughout the ministry, department or agency... for which he is responsibleI. Furthermore, Ito ensure that ade,uate and consistent standards of internal audit are applied throughout the :overnment, the 'ccountant :eneral shall be responsible under these regulations for ensuring the status and powers of the 1nternal 'udit function in each ministry, department or agency conforms to internationally accepted standardsI. The statutory duties of the Tan5ania 1nternal 'udit 7ervice are defined in paragraph >% of the 6##1 (ublic Financial 2egulations, as follows)a* 2eview and report on proper control over the receipt, custody and utilisation of all financial resources of the unitA )b* review and report on conformity with financial and operational procedures, and good practice as defined by the 'ccountant :eneral, in order to avoid incurring obligations and authorising payments to the e!tent which would ensure effective control over the e!penditure of the unitA )c* review and report on the correct classification and allocation of revenue and e!penditure accountsA )d* review and report on the reliability and integrity of financial and operational data, so that information provided allows for the preparation of accurate financial statements and other reports for the information of the unit and the general public as re,uired by legislation )e* review and report on the systems in place used to safeguard assets, and, as appropriate, the verification of the e!istence of such assetsA

6>F

)f* review and report on operations or programmes to ascertain whether results are consistent with established obBectives and goalsA )g* review and report on the ade,uacy of action by management in response to internal audit reports, and assisting management in the implementation of recommendations made by those reports and also, where appropriate, recommendations made by the 4ontroller and 'uditor :eneralA and )h* review and report on the ade,uacy of controls built into computerised systems in place within the unit.I U'an&a (ublic Finance and 'ccountability 'ct 6##> IThe 'ccountant :eneral shall )d* ensure that the internal audit function in each :overnment Ministry, department, fund, agency or other reporting unit re,uired to produce accounts under 7ection >1 is appropriate to the needs of the organisation concerned and conforms to internationally recognised standards in respect of its status and procedures.I 7a* )a The role of 1nternal 'udit is covered by 7ections %E D# of Financial 2egulations )4ap. >%E as proposed, originally 4ap. "## of the laws of the 2epublic of Hambia*. 7ection %F of the Financial 2egulations statesIThe e!istence of 1nternal 'udit teams will not relieve 4ontrolling 8fficers or any other 'ccounting 8fficers of their individual responsibilities, nor will it remove the need for normal checks within Ministries or &epartments.I 7ection %G of these regulations states thatI1nternal 'uditors will be directly responsible to the 4ontrolling 8fficers of the Ministries in which they are provided. The programme of checks to be carried out by 1nternal 'uditors will be laid down by the (ermanent 7ecretary [the 7ecretary to the Treasury in MoF@& as advised by the 4ontroller of 1nternal 'udit\ in consultation with 4ontrolling 8fficers and with the 'uditor :eneral, and will cover all accounting procedures and documentation. :enerally, 1nternal 'uditors will ensure

that the work entailed in the receipt and payment of public money has been properly carried out under proper supervisionA that the safeguards for the prevention or prompt detection of fraud or loss of stores, cash or other :overnment assets, are ade,uateA 6>G

that accounting forms are properly protected, recorded and regularly checkedA that the duties of members of accounting staff are changed from time to timeA that a satisfactory system e!ists for the checking of computer input and outputA that the system for the control of the receipt, issue and use of stores is ade,uateA that the recording of the assets is up to date and correctA that returns of revenue or e!penditure re,uired by 4ontrolling 8fficers are correctly prepared and promptly submitted.I

'44' would be happy to review and comment on proposed legislation for internal audit. 1f you are developing such legislation please contact 'ndy .ynne. 1f you would like a copy of :hanaIs 1nternal 'udit 'gency 'ct or the draft act for (akistan then please also contact 'ndy 8SOURCE ACCA 6E2SITE4 LEGISLATION ON PU2LIC SECTOR INTERNAL AUDIT9 RISK EBALUATION( PREBENTIBE AND CORRECTIBE ACTIONS The traditional view of risk management has been one of protecting the organisation from loss through conformance procedures, and hedging techni,ues. This is about avoiding the downside. The new approach to risk management is about ?seeking the upside while managing the downside/. 1n other words, its about taking a proactive approach to risk management. R)s$ Mana'e*en, )s &e1)ne& as: T0e +ro#ess o1 "n&ers,an&)n' an& *ana')n' ,0e r)s$s ,0a, ,0e or'an)sa,)on )s )ne/),a !- s" .e#, ,o )n a,,e*+,)n' ,o a#0)e/e #or+ora,e o .e#,)/es. 8 CIMA O11)#)a! Ter*)no!o'-9 T0e +ro#ess o1 r)s$ *ana'e*en, %)!! )n/o!/e: r)s$ )&en,)1)#a,)on r)s$ e/a!"a,)on %0ere ,0e r)s$ )s e/a!"a,e& an& ran$e& a##or&)n' ,o ),s re!a,)/e s)'n)1)#an#e r)s$ *ana'e*en, or *),)'a,)on

T0e r)s$ *ana'e*en, 1ra*e%or$ %)!! )n#!"&e ,0e 1o!!o%)n' e!e*en,s: risk management polic3- which defines the organisation/s approach to risk management and its attitude to and appetite for risk resourcing risk management- the resources re,uired to implement, monitor and coordinate the risk management process including risk management implementing of risk management- formalises the process involved in identifying and defining risks, the assessment of risk in terms of likelihood and impact and the key aspects of the business process that are used to respond to the risks 6%#

risk management and reporting- including the form and regularity of reporting and the risk reporting structure

1t is important to note that risk management re,uires commitment from the 2oar& o1 D)re#,ors, E5e#",)/e Mana'e*en, and E*+!o-ees. 2isks should be prevented and corrected as soon as possible to reduce their impact. Methods of assessing risks include (@7T37.8T analysis, interviews, surveys and statistical sampling. 'udit3 risk committees are increasing becoming important features of good corporate governance and will play a leading role in the risk management process. 2ene1),s o1 r)s$ *ana'e*en, L)n$)n' 'ro%,0( r)s$ an& re,"rn En0an#)n' r)s$ res+onse &e#)s)ons M)n)*)s)n' o+era,)ona! s"r+r)ses an& !osses Se)C)n' o++or,"n),)es Mer'ers an& a#?")s),)ons are *ana'e& +roa#,)/e!Goo&%)!! )s no, )*+a)re& Ha/)n' a 'oo& #re&), ra,)n'

AUDIT OF CENTRAL GOBERNMENT This chapter discusses the e!ternal audit of public sector bodies, its nature and its obBectives. 4omparisons will be made with the audit of companies and other organisations in the private sector. There will be discussion of recent developments in public sector audit and of the differing views which have emerged about its proper scope and organi5ation. There will be no attempt to give instruction in detailed audit techni,ues- for that a specialised professional training is necessary. In,ro&"#,)on 1t has already been shown that the public sector in many countries comprises a variety of organisations, but the main divisions of the sector into central government, local authorities and nationalised industries and other public corporations will be followed in e!amining the role of audit. Before e!amining the tree main areas, it is necessary to be clear about the essential nature of an e!ternal audit. .hat is it0 .hat is it for0 The clues to the answers to these ,uestions lie in the words ?e!ternal/ and ?independent/. 1n the Hambian public sector, an e!ternal audit is intended first to provide an assurance as to the reliability of the published accounts of the audited body. 7econd, it is intended to provide further assurance as to the regularity of the underlying transactions. 6%1

Third, in the central and local government sectors but not the nationalised industries it aims to provide an assessment of the efficiency and effectiveness with which the body performs its functions. The auditor provides these assurances and assessments from the standpoint of someone outside the body in ,uestion and independent of it. His e!aminations and reports are e!pected to be honest, impartial, dispassionate, indeed fearless, as well, it is to be hoped, as e!pert and thorough. The )n&e+en&en#e of the e!ternal auditor is crucial if his reports are to have credibility and authority. How such independence may be secured is discussed below. This brief definition of e5,erna! a"&), leads immediately to two further ,uestions. First, ,o %0o* are ,0ese ass"ran#es about financial or other matters, provided by ,0)s )n&e+en&en, #0ara#,er, to e a&&resse&I 7econd, what is the relationship between e!ternal and internal auditors0 'n answer to the second ,uestion can conveniently wait. The answer to the first depends on the #ons,),",)ona! +os),)on of the audited body- to whom is it answerable for its actions0 ' government department is answerable through its ministers and accounting officer )see below* directly to (arliament. ' nationalised industry is answerable to the responsible minister and through him to (arliament on its general performance, but not on its day to day operations. ' local authority is #ons,),",)ona!!- )n&e+en&en, of parliament acts on behalf of na,)ona! e!e#,ors an& ,a5+a-ers and its distinct from her E5e#",)/e L i.e. the #en,ra! 'o/ern*en, L local authorities act on behalf of local electors and ratepayers in both a representatives and an e!ecutive capacity. 1t follows that the e!ternal auditor of a government department reports to (arliament, the auditor of a nationalised industry reports to the 7ecretary of 7tate, and the auditor of local authorities to the authority itself. 1n doing so however, they always have in mind the interests of the 'enera! +" !)# services, and these entire audit reports are normally +" !)#!- a/a)!a !e. The public audit services of most advanced countries set out to provide, very broad terms, a financial audit of accounts and efficiency or /a!"e 1or *one- a"&), of activities. The first of these centres on the ade,uacy of the systems for controlling the re#e)+, an& +a-*en, o1 +" !)# 1"n&s, the second on the way resources purchased with those funds L manpower, capital e,uipment, buildings, supplies and so on L are allocated and utilised. The term audit is sometimes applied to a different type of e!ternal checkA for e!ample, a ?so#)a! a"&),3, advocated by some people, would attempt to establish how far public institutions, and indeed large private corporations, had contributed to social, community or similar goals. .e are not concerned here with these provider remits as such, though social considerations often play a part in public e!penditure decision and must be recognised and allowed for by the auditor. T0e #r),)#a! e5a*)na,)on o1 1)nan#)a! an& reso"r#e *ana'e*en, is a convenient general description of much of the auditor/s activity. (ublic audit is by no means confined to the financial audit of accounts and demands a close knowledge of the operations of (arliament and of the departments of state, it is clearly desirable that the person in charge should be familiar with +" !)# 1)nan#e and with the problems of managing large departments and securing the best use of /er- !ar'e s"*s o1 +" !)# *one-. The independence of the 'uditor :eneral is very important in public sector audit. 6%6

Thus within the broad statutory framework governing his audit he decides himself how to lay out the resources of his staff, how to conduct his audit work, and what reports to make. The audit of government departments can be divided into two sectors- the financial, more strictly the clarification, audit, and the value for money, the certification audit was laid down in the 1F"" 'ct, which established the arrangements by which the e!ecutive L the public funds they use. Much of the 'ct dealt with account procedures and responsibilities, but its main provisions, which still apply, can be simply summarised The way in which test audit should be carried out, to give a reasonable degree of assurance about the particular accounting systems to which they are applied, is an important aspect of audit techni,ues. 1t has led into the s-s,e*s4 ase& a"&), and the use of s,a,)s,)#a! sa*+!)n' where large numbers of transactions are involved, and its application has to be rethought with the rapid e!tension of #o*+",er)se& a##o"n,)n' s-s,e*s and a"&),)n' so1,%are. 1n this audit of the 2evenue &epartments, the auditor general is re,uired to satisfy himself only that the departments have established satisfactory procedures for the assessment and collection of all revenue due. He is not re,uired to certify that all revenue which should have been collected has been, still less that individual ta!payers have been correctly assessed for ta!. That would indeed have been an impossible ,as$. This approach appears to an early formulation of a ?s-s,e*4 ase& a"&),3, by several decades the general adoption of that techni,ue in both commercial and public audit work. THE O2LECTIBES OF THE FINANCIAL AUDIT The financial audit of government departments is intended to give an assurance that in all material respects)a* )b* Their accounts properly present the transactions to which they relateA They have spent the money voted to them only for the purposes intended by (arliament, as described in the @stimates and 7upplementary @stimates presented at the beginning of each financial year and subse,uentlyA and The e!penditure conforms to the authority governing it, i.e. has met the re,uirements of ?regularly/.

)c*

1n even plainer words, this means that the money provided by (arliament has been spent as intended, that no lawful, improper or irregular payments have been made, and that the figures are satisfactory. These simple sounding obBectives conceal some comple! problems for the 'uditor :eneral and his staff. The building of hospitals, the design and development of advanced military e,uipment, the installation of large computer systems are Bust a few of these highly diverse activities. 1t is therefore a maBor technical audit task to check that the accounting and financial control systems underlying the figures in the account are reliable and efficient. This 6%>

work is necessarily done on a se!e#,)/e as)s and increasingly utilises techni,ues, such as s,a,)s,)#a! sa*+!)n' and the e/a!"a,)on an& ,es,)n' of systems, similar to those applied by commercial auditors in the audit of large private sector concerns. 1t is also the case that an evaluation of financial control and information systems is likely to be of value not only for certification purposes but to Budge a department/s progress in the development of effective internal management systems. But other operational audit techni,ues, conveniently subsumed in the term G/a!"e 1or *one- a"&),3, need to be developed. Before discussing them, it is first necessary to make a brief digression into the field of commercial accounting and audit. COMMERCIAL AND GOBERNMENT ACCOUNTING :overnment spends money and uses large resources of manpower to provide a wide variety of services to the community- defence, health, support for industry and agriculture, social security, and many others 1t is true that a relatively small part of the activities of government departments closely related bodies is commercial in its nature and aims 4ommercial accounts are intended to show the results of trading operations over the year, and the financial state of the business L more specifically its net book value L at the end of each year. To do so, both income and e!penditure have to assess as accurately as possible, which is a more comple! task than simply logging up cash payments and receipts. 1ncome has to take account of sums due in respect of various activities and attributable to the year in ,uestionA e!penditure has to include amounts representing the proportion of the firm/s assets, stocks and work in progress used up in producing the year/s incomeA provisions against future loss or liabilities have to be assessed L and so on. .hen making calculations it is necessary to add an assessment of the effect of inflation on the firm/s profit and asset valuations, through the application of current cost accounting, the production and audit of the accounts of any si5eable commercial concern is a considerable e!ercise, involving acts of Budgement as well as of record and classification. This brief sketch of commercial accounting is intended only as background to two points. First, as mentioned above, there are some government activities which can and should be presented and accounted for in this way. They include not only the production and sale of a range of goods, from coins and medals to prints of medieval manuscripts, but also, for e!ample, the provision of offices and supplies to departments, where it is thought desirable to work out the ?full cost/ on some appropriate type of commercial accounting, to assist control and to promote the right decisions The second point is a wider and crucial one. The making of profit or loss and the increase or decrease each year in the value of a business, are critical tests of its success or failure. They measure the e!tent to which it achieves its essential obBectives. There may be others. ' firm which contributes to social progress or cultural achievement, which makes its staff happy in their work, or sponsors a tennis tournament, may earn applause for doing so. 1t also recognises that there are also likely to be financial benefits. But if it 6%%

consistently fails in the primary task of profit making, it is unlikely to survive, short of government rescue, for long.

BALUE FOR MONEY AUDIT ;one of this applies, clearly, to government departments providing or promoting the large communal services of defence, education, health law and order, and so on. Their efficiency, their performance, their success has to be Budged by ,uite different tests, and by ,uite different methods. This is the field in which the public audit services seek to apply the concepts now broadly known as /a!"e 1or *one- or e11)#)en#- a"&),)n'. They do not displace the audit of accuracy in accounting or of prosperity and regularity of transactions described earlier. They complement and e!tend it, and re,uire different techni,ues. :ood financial auditors have also produced useful /a!"e 1or *one- re+or,s on a wide range of financial management matters. 7uch work also be satisfactorily done by people without professional accountancy or audit training if they have right attitudes and approach. The prime responsibility for achieving value for money or efficiency is the management/s and not the public auditor/s. 7enior civil servants, and ultimately their ministers, are responsible and are held accountable for all their actions in running and managing their departments 1n this conte!t e#ono*- is taken to mean the achievement of a given result with the !eas, e5+en&),"re o1 *one-, *an+o%er or o,0er reso"r#es, while e11)#)en#- )*+or,s ,0e )&ea o1 #on/er,)n' reso"r#es )n,o a &es)re& +ro&"#, )n ,0e *os, a&/an,a'eo"s ra,)o . But this sometimes a rather subtle distinction, and the more important divide is between the pursuit and audit of economy and efficiency on the hand and of effectiveness on the other, because the latter brings into account goals or obBectives which the activity in ,uestion is intended to meet. The e!amination of effectiveness in government and other public sector programmes and policies raises issues, which are often intractable and sometimes controversial. The development or purchase of nuclear weapons is intended to contribute to the goal of national security. The e!tension of comprehensive education is intended to promote education and social aims. The introduction of the family income supplement was hoped do secure a minimum standard of living for the families/ low paid workers in employment. 7ubsidies for defined forms of industrial investment aimed to encourage the development of particular parts of the country, and reduce unemployment. The transformation of the old employment e!changes into Bob centres and their sitting in the high street has a similar aim. These cases and a great many more raise the ,uestions)a* 7hould the auditor be involved in effectiveness at all0 6%D

)b* )c*

1f so, does this not bring him to ,uestion policy decision0 Has he the necessary skills0

The ,uestion of the involvement of the e!ternal auditor in policy ,uestion is a sensitive one. 1t is for those running an organisation, and answerable for its results, to take and defend policy decisions, for e!ample to develop an new civil aircraft, to build a new comprehensive school, or to broadcast news in @nglish to various parts of the world. But the auditor may feel it necessary and Bustifiable)a* )b* )c* )d* )e* To ,uestion whether the goals which the policy decisions are meant to serve have been establishedA To e!amine whether managements have themselves established ade,uate procedures and criteria to assess the effectiveness of their policiesA To ,uantify the costs of the decisions takenA To report on whether the goals have in fact been achievedA To suggest alternative ways in which the goals might have been more effectively met.

In,erna! an& e5,erna! a"&), Most large organi5ations, in both public and private sectors have their internal audit arrangements. The essential difference between internal and e!ternal audit is that the former is part of the management, is organi5ed and directed and reports as senior management, decides, whereas the latter completely independent and, subBect to the law, decides these matters for itself. 1nternal audit is intended to contribute to the probity and efficiency of the enterprise from withinA e!ternal audit shares this obBective, operating from outside, but also serves the further obBective of e!ternal accountability.

6%"

CHAPTER 11: CORPORATE GOBERNANCE

KEY TERM (orporate Governance The system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders/ role is to appoint directors and auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the Board include setting the company/s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The Board/s actions are subBect to laws, regulations and the shareholders in general meetings 8CIMA O11)#)a! Ter*)no!o'-9 T0e Ca& "r- Re+or, defines #or+ora,e 'o/ernan#e as ?the system by which companies are &)re#,e& and #on,ro!!e&3. The roles of those concerned with the financial statements are described in the 4adbury 2eport. The directors are responsible for the corporate governance of the company. The shareholders are linked to the directors via the financial reporting system. The auditors provide the shareholders with an e!ternal obBective check on the directors/ financial statements. 8ther concerned users, particularly employees, are indirectly addressed by the financial statements.

Before looking at the codes that have been issued to support good corporate governance, it is important to understand why good corporate governance is considered to be important.

6%E

I*+or,an#e o1 Goo& Cor+ora,e Go/ernan#e The ideas which are central to the importance of good corporate governance are illustrated in the two diagrams below. 4 8 M ( ' ; + Manage &efraud0 2emunerate ':M 1nvest 7H'2@H8C&@27 2eceived 1ncome 8 ; @ 2emunerate .ork fees &efraud0 Cend (ay interest 'udit (ay fees 4 8 M ( ' ; + Manage &12@4T827 &efraud0 2emunerate 1nvest 2eceived 1ncome .H8 '2@ 'C78 ':M 7H'2@H8C&@27 )8.;@2 M';':@&* 8TH@2 7T'<@H8C&@27 &12@4T827

'J&1T827

6%F

T . 8

2emunerate .ork fees &efraud0 Cend (ay interest 'udit (ay fees 8TH@2 7T'<@H8C&@27

'J&1T827

The diagrams show two companies and their relationships with the key people associated with corporate governance. The key difference between the diagrams is that while in company two, the shareholders are fully informed about the management of the business, being directors themselves, in company one, the shareholders only have an opportunity to find out about the management of the company at the ':M. The day to day running of a company is the responsibility of the directors and other management staff to whom they delegate, and although the company/s results are submitted for shareholders/ approval at the annual general meeting )':M*, there is often apathy and ac,uiescence in director/s recommendations. ':Ms are often very poorly attended. For these reasons, there is the potential for conflicts of interest between management and shareholders. 'n audit is an e!ercise carried out on behalf of the shareholders but vitally, it does not report on two aspects of their investment which are of vital importance to them How their investment is being managed .hether their investment is subBect to fraud

'n audit provides an opinion on the veracity of the financial statements and leaves a member to draw his own conclusions concerning the above issues. This is not a problem for owner managed businesses, but many companies are not managed by their owners, and investors, particularly institutional investors, have been concerned at the knowledge gap that they are left with. The J< government took up their concerns in the wake of some high profile scandals and frauds in the 1GF#s and early 1GG#s.

6%G

Having established that it is important that companies are managed well )that there is good corporate governance*, the ,uestions that had to be addressed were How to enforce good practice by directors, and what that ?good practice/ should be0 How to communicate the adherence to good practice by management to the shareholders0

These issues, which include directors by virtue of them being the managers of the companies, and auditors by virtue of them already communicating information about the company to the shareholders, are addressed in the codes which we shall look at now. :"es,)on: 'oo& #or+ora,e 'o/ernan#e .hy is good corporate governance important0 Ans%er 7hareholders and managers are usually separate in a company and it is important that the management of a company deals fairly with the investment made by the owners. CODES OF 2EST PRACTICE #!e (ad ur3 %eport Financial aspects of corporate governance in the J< have been addressed in the report of the Ca& "r- Co**),,ee( which was formed in 1GG1. The terms of reference of the committee were to consider, along with any other relevant matters, the following issues. )a* The responsibilities of e!ecutive and non e!ecutive directors for reviewing and reporting on performance to shareholders and other financially interested parties, and the fre,uency, clarity and form in which information should be provided. The case for audit committees of the board, including their composition and role )this is discussed in its own right in 7ection >*. The principal responsibilities of auditors and the e!tent and value of the audit The links between shareholders, boards, and auditors.

)b* )c* )d*

The committee aimed to set out the responsibilities of each group involved in the reporting process and to make recommendations on good practice.

6D#

The 4ode of Best (ractice included in the 4adbury 2eport is aimed at the directors of all J< public companies, but the directors of all companies are encouraged to use the 4ode for guidance. &irectors should state in the annual report and accounts whether they comply with the 4ode and give reasons for any non compliance. This statement of compliance should only be published after a review by the auditors. Pro/)s)ons o1 ,0e Ca& "r- #o&e T0e oar& o1 &)re#,ors The board of directors must meet on a regular basis, retain full control over the company and monitor the e!ecutive management. ' clearly accepted division of responsibilities is necessary at the helm of the company, so no one person has complete power, answerable to no one. The report encourages the separation of the posts of 4hairman and 4hief @!ecutive. .here they are not separate, a strong independent group should be present on the board, with their own leader. There should be a formal schedule of matters which must be referred to board stating which decisions re,uire a single director/s signature and which re,uire several signatures. (rocedures should be in place to make sure the schedule is followed. The schedule should include ac,uisitions and disposals of assets of the company3subsidiaries that are material to the company and investments, capital proBects, bank borrowing facilities, loans and their repayment, foreign currency transactions, all above a predetermined si5e. Non4e5e#",)/e &)re#,or The following points are made about non e!ecutive directors, who are those directors not running the day to day operations of the company. They should bring independent Budgement to bear on important issues, including key appointments and standards of conduct. There should be no business, financial or other connection between the non e!ecutive directors and the company, apart from fees and shareholdings. Fees should reflect the time they spend on the business of the company, so e!tra duties should earn e!tra pay. 6D1

They should not take part in share option schemes and their service should not be pensionable, to maintain their independent status. 'ppointments should be for a specified term and re appointment should not be automatic. The board as a whole should decide on their nomination and selection. (rocedures should e!ist whereby non e!ecutive directors may take independent advice, at the company/s e!pense if necessary. E5e#",)/e &)re#,ors 1n relation to the e!ecutive directors, who run companies on a day to day basis, the main points in the 4ode relate to service contract. &irectors/ emoluments and those of the highest paid directors should be fully disclosed and analysed between salary and performance related pay. The basis of measuring performance should also be shown. ' remuneration committee of non e!ecutive directors should decide on the level of e!ecutive pay. A"&), The code states that audit is a cornerstone of corporate governance. 1t is an obBective and e!ternal check on the stewardship of management. There are design problems in the framework of auditing, however, including 4hoices in accounting treatments (oor links between shareholders and auditors (rice competition associated with auditing

'nother problem associated with the audit is the ?e!pectations gap/ between what an audit actually achieves and what people think it achieves. The threat to obBectivity of auditors offering other services to audit clients should be safeguarded against by disclosing fees for audit in the financial statements. The code also recommends that the auditing profession draw up formal guidelines concerning audit rotation. The advantages and disadvantages of audit rotation were discussed in earlier.

6D6

1t recommends the accountancy profession being involved in setting criteria for evaluation of internal control 1t recommended that auditors report on going concern. This has now been reflected in auditing standards and is common practice. 1t also recommended that auditors have guidelines about how to act in the event of suspicion of fraud. This is dealt with in 17' 6%#. S*a!!er #o*+an)es Many smaller companies have complained that the 4adbury 4ode is too burdensome for them raising fears that its re,uirements are not diluted then many small companies will simply fail to comply with them. 1n response to this, a special version of the code aimed at listed companies with market capitalisation below W6D# million was published in 1GG% by the 4ity :roup for 7maller 4ompanies )?4isco/*, with the endorsement of the 4adbury 4ommittee. &ifferences between the 4isco code and the 4adbury code include reduction of the number of non e!ecutives on a company board from three to two and not re,uiring smaller companies to split the roles of 4hief @!ecutive and 4hairman. T0e Co* )ne& Co&e The 4adbury report was issued in 1GG6, and the comments in the table above show that some of the points have been addressed subse,uently by the 'uditing (ractices Board )'(B*, particularly those in relation to fraud and going concern. 7ince the 4adbury report, there have been several other committees, which all produced recommendations about various issues such as directors/ remuneration. 1n 1GGF, the key guidance from all the reports was re issued in the form of the combined 4ode. The 4ombined 4ode is issued as part of the S,o#$ E5#0an'e guidance and so generally relates to !)s,e& #o*+an)es. However, this does not mean that following the guidance is not good practice for other companies also. Pr)n#)+!es o1 ,0e Co* )ne& Co&e T0e oar& @very company should be headed by an effective board, which is collectively responsible for the success of the company. There should be a clear division of responsibilities at the head of the company between the running of the board and the e!ecutive responsibility for the running of the company/s business. ;o one individual should have unfettered powers of decision. 6D>

The board should include a balance of e!ecutive and non e!ecutive directors )and in particular independent non e!ecutive directors* such that no individual or small group of individuals can dominate the board/s decision taking. There should be a formal, rigorous and transparent procedures for the appointment of new directors to the board. The board should be supplied in a timely manner with information in a form and of a ,uality appropriate to enable it to discharge its duties. 'll directors should receive induction on Boining the board and should regularly update and refresh their skills and knowledge. The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors. 'll directors should be submitted for re election at regular intervals, subBect to continued satisfactory performance. The board should ensure planned and progressive refreshing of the board. Re*"nera,)on Cevels of remuneration should be sufficient to attract, retain and motivate directors of the ,uality re,uired to run the company successfully, but a company should avoid paying more than is necessary for this purpose. ' significant proportion of e!ecutive directors/ remuneration should be structured so as to link rewards to corporate and individual performance. There should be formal and transparent procedure for developing policy on e!ecutive remuneration and for fi!ing the remuneration packages of individual directors. ;o director should be involved in deciding his or her own remuneration. The board should present a balance and understandable assessment of the company/s position and prospects. The board should maintain a sound system of internal control to safeguard shareholders/ investment and the company/s assets. The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company/s auditors. There should be a dialogue with shareholders based on the mutual understanding of obBectives. The board as whole has responsibility for ensuring that a satisfactory dialogue with 6D%

A##o"n,a )!),an& a"&), De+en&)n' on ,0e S)Ce o1 ,0e #o*+an-( ,0)s *a)n/o!/e se,,)n' "+ an )n,erna! a"&), &e+ar,*en, Re!a,)ons %),0 Ins,),",)ona! s0are0o!&ers

shareholders takes place. The board should use the AGM to communicate with investors and to encourage their participation.

Cor+ora,e Go/ernan#e S,a,e*en, The stock e!change rules re,uire that, as part of the annual report, a company must include a narrative statement of how it has applied the principles set out in the Co* )ne& Co&e. This statement must include an e!planation, which allows the shareholders to evaluate how the company have applied the principles. The statement must also provide e!planation of whether the company has complied with the principles of the 4ombined 4ode. They must also provide a statement showing how they have applied the principles relating to directors/ remuneration )not e!amined in detail here*. The auditors must review the corporate governance statement before it is published. Their duty to review it only e!tends to the following items 2oar& 0a/)n' a s#0e&"!e o1 *a,,ers 1or ,0e)r a,,en,)on Pro#e&"res 1or oar& *e* ers ,o see$ )n&e+en&en,( +ro1ess)ona! a&/)#e Non4e5e#",)/e &)re#,ors 0a/)n' s+e#)1)# ,er*s o1 o11)#e D)re#,ors e)n' s" .e#, ,o e!e#,)on an& re4e!e#,)on - ,0e s0are0o!&ers T0e &)re#,ors an& a"&),ors s,a,)n' ,0e)r res+e#,)/e res+ons) )!),)es T0e &)re#,ors #on&"#,)n' a re/)e% o1 )n,erna! #on,ro! e11e#,)/eness T0e oar& es,a !)s0)n' an a"&), #o**),,ee

2ene1),s o1 a /o!"n,ar- #o&e The Co* )ne& Co&e is a voluntary code. The S,o#$ E5#0an'e re,uires that disclosures be made as to whether it has been complied with, but there are no statutory re,uirements to comply with it. The main benefit in having a voluntary code is that the code can be applied fle!iblyA where management believe that it is relevant. The disclosure re,uirements ensure that shareholders are aware of the position and they can make any points they want to about compliance with the code at the 'nnual :eneral Meeting 8AGM9. 1t has been argued that making such a code obligatory would have punitive effects on some companies, due to their si5e or investor make up and that legislation would create a burden of re,uirement which could be e!cessive in many cases. 6DD

4ritics of the view would argue &isclosure of non compliance is insufficient as the ':M is still not sufficient protection for shareholders. Having a voluntary code allows some companies not to comply freely, to the detriment of their shareholders. The re,uirement to disclose is only a S,o#$ E5#0an'e re,uirement, and there are many unlisted companies who should be encouraged to apply the codes.

The government has shown concern for this area in the past and it is believed that it might take action in the future to regulate this area more heavily. However, at the moment, having a voluntary code is a compromise based on the points taken above. 2 AUDIT COMMITTEES >.1 ' maBor recommendation in the Ca& "r- Co&e is that all listed companies must establish effective audit committees if they have not already done so. The Co&e takes its e!ample from countries such as Cana&a where audit committees for listed companies are compulsory. 'udit committees were the subBect of the S*),0 Re+or, in ear!- 200;. The S*),0 Re+or, contained a summary of recommendations, which have been included in the revised Co* )ne& Co&e.

>.6 >.>

Co* )ne& Co&e Pro/)s)ons The board would establish an audit committee of at least three, or in the case of smaller companies, two members. The main role and responsibilities should be set out in written terms of reference and should include)a* To monitor the integrity of the financial statements of the company and any formal announcements relating to the company/s financial performance, reviewing significant financial reporting issues and Budgements contained in them. To review the company/s internal financial controls and, unless e!pressly addressed by a separate board or risk committee composed of independent directors by the board itself, the company/s control and risk management systems. To monitor and review the effectiveness of the company/s internal audit function. To make recommendations to the board for it to put to the shareholders for their approval in general meeting in relation to the appointment of the e!ternal auditor and to approve the remuneration and terms of engagement of the e!ternal auditors.

)b*

)c* )d*

6D"

)e*

To monitor and review the e!ternal auditor/s independence, obBectivity and effectiveness, taking into consideration relevant J< professional and regulatory re,uirements. To develop and implement policy on the engagement of the e!ternal auditor to supply non audit services, taking into account relevant ethical guidance regarding the provisions of non audit services by the e!ternal audit firm and to report to the board, identifying any matters in respect of which it considers that action or improvement is needed, and making recommendations as to the steps to be taken and to report to the board, identifying any matters in respect of which it considers that action or improvement is needed, and making recommendations as to the steps to be taken.

)f*

The audit committee should be provided with sufficient resources to undertake its duties. A&/an,a'es an& &)sa&/an,a'es o1 a"&), #o**),,ees >.% The key advantage to an auditor of having an audit committee is that a committee of independent non e!ecutive directors provides the auditor with an independent point of reference other than the e!ecutive directors of the company, in the event of disagreement arising. 8ther advantages that are claimed to arise from the e!istence of an audit committee include)a* )b* 1t will lead to increased confidence in the credibility and obBectivity of financial reports. By specialising in the problems of financial reporting and thus, to some e!tent, fulfilling the directors/ responsibility in this area, it will allow the e!ecutive directors to devote their attention to management. 1n cases where the interests of the company, the e!ecutive directors and the employees conflict, the audit committee might provide an impartial body for the auditors to consult. The internal auditors will be able to report to the audit committee.

>.D

)c*

)d* ;.>

O++onen,s o1 a"&), #o**),,ees ar'"e ,0a,: )b* There may be difficulty selecting sufficient non e!ecutive directors with the necessary competence in auditing matters for the committee to be really effective. The establishment of such a formali5ed reporting procedure may dissuade the auditors from raising matters of Budgment and limit them to reporting only on matters of fact. 6DE

)c*

)d*

4osts may be increased.

Ro!e an& 1"n#,)on o1 a"&), #o**),,ees >.E 1n an appendi! to the 4adbury 2eport, the 4ommittee e!pands on the role and function of the audit committee. ?1f they operate effectively, audit committees can bring significant benefits. 1n particular, they have the potential to)a* )b* )c* )d* 1mprove the ,uality of financial reporting, by reviewing the financial statements on behalf of the BoardA 4reate a climate of discipline and control which will reduce the opportunity for fraudA @nable the non e!ecutive directors to contribute an independent Budgement and play a positive roleA Help the finance director, by providing a forum in which he can raise issues of concern, and which he can use to get things done which might otherwise be difficultA 7trengthen the position of the e!ternal auditor, by providing a channel of communication and forum for issues of concernA (rovide a framework within which the e!ternal auditor can assert his independence in the event of a dispute with managementA 7trengthen the position of the internal audit function, by providing a greater degree of independence from managementA 1ncrease public confidence in the credibility and obBectivity of financial statements./

)e* )f* )g* )h*

2ene1),s o1 Goo& Cor+ora,e Go/ernan#e The benefits of applying good corporate governance are to 2educe risk 7timulate performance 1mprove access to capital markets @nhance the marketability of products3 services by creating confidence among stakeholders 1mprove leadership &emonstrate transparency and accountability 6DF

EFAM :UESTION 2ANK

1. PHIRI AND TEM2O Mr. (hiri and Mr. Tembo are in partnership. (reviously accounts have been prepared by their bookkeeper but as their business is growing they are considering asking your firm to act as auditors to the partnership. %e.uired )a* 7tate how a non statutory audit could assist the partnership. )b* 1dentify the maBor difficulty you could potentially face in a non statutory audit, and state how you would try to overcome it. 2. STANDARDS

+ou are required to discuss the advantages and disadvantages of accounting and auditing standards to auditors and the conse,uences of such standards being enforceable by statute. ;. ROLE OF INTERNAL AUDIT 820 *ar$s9

)a* +ou are a member of the internal audit team at Cumbeni Holdings, a listed company. The board of directors wants to raise the profile of the internal audit department in the company. They have asked the internal audit department to give as series of seminars on the corporate governance and the role of internal audit in achieving corporate obBectives to other members of staff The head of internal audit has asked you to prepare some notes on this subBect. %e.uired (repare the notes which the head of internal audit wants. +ou should cover the following matters8)9 The Board of &irectors 8))9 'ccountability )iii* The meaning of risk management )b* 'fter the seminars, the various departments of Cumbeni Holdings have been asked to carry out risk management brainstorming sessions to identify risks in each of their departments and to design internal control systems to reduce those risks The 7ales &irector, 4lifford, has asked you if you will attend the brainstorming session in the sales department and whether you sill assist them in the risk identification and 6DG

management process. %e.uired &raft a memorandum to the 7ales &irector, answering his ,uestions. +ou should cover the following matters8)9 8))9 .hether you will attend the meeting, and in what capacity. .hether you attend the meeting or not, what involvement you, as a member of the internal audit team, will have in the risk management e!ercise

<. )a*

O2LECTIBITY 820 *ar$s9 @!plain the concept of obBectivity, with reference to8)9 8))9 @!ternal auditors 1nternal auditors, who are members of H14', outlining any general threats to obBectivity that e!ist.

)b* S#enar)o 1 (lumbers Ctd is an audit client of 4M<, a firm of 4hartered 4ertified 'ccountants. The firm has audited (lumbers for 11 years and the fee represents E$ of the firm/s income. (lumbers is considering a maBor new proBect and has asked the firm if it would be happy to undertake some one off consultancy work for the firm. 1t is possible that the fee income for this contract would represent 1#$ of that year/s income for 4M<. The new business services partner, who heads up a new division of the firm, is keen to take on the work, as this would represent his best contract yet. Scenario 0 =ohn works in the purchasing department of Muntu Manufacturing 4o. He has been instrumental in setting up control systems in the purchasing department as part of a recent risk management e!ercise. He has a poor relationship with his immediate supervisor, the (urchasing &irector. Muntu Manufacturing has Bust advertised the post of trainee internal auditor. =ohn is interested in the work that internal audit do, having raised substantially with the department during the recent controls e!ercise. ;o formal accountancy ,ualifications are re,uired for the post, because the successful candidate will be put through accountancy training. =ohn has had a chat with the head of internal audit concerning the post and in seriously considering making an application. %e.uired &iscuss the threats and the safeguards to obBectivity that could be implemented in the two situations given above. 6"#

=.

AUDIT EBIDENCE 820 *ar$s9

For each of the following substantive tests you are re,uired to state, together with any limitations whether they provide strong or weak evidence of the completeness, e!istence, accuracy and valuation and )where applicable* ownership of the asset or liability at the financial year end. 1nspecting inventories and testing perpetual records by making test counts and noting damaged, obsolete and slow moving items Kouching non current assets additions to supporting documentation Kerification of bank balances by bank confirmation re,uest @!plain why it is important that audit evidence is fully documented and list the details relating to the audit tests which should be recorded in the working papers. >. GLO 820 *ar$s9

Caiti 4o, a limited liability company, manufactures various heating products which it sells to both High 7treet and catalogue retailers. The balance sheets for the years ended 6##> and 6##% are set out below. Cast year, materiality was set at Y1#,###. </### ;on current assets Tangible non current assets 1nvestments 4urrent 'ssets 1nventory 2eceivables 4ash at bank 4ash in hand Total assets 4urrent liabilities Trade payables Bank loan Cong term liabilities Bank loan (rovision 4apital and reserves 7hare capital (rofit and loss account Total liabilities 161 D 16" 6# 6# 6 )>* 1"D 6"1 D6 EF 16 1 1%> 1"D 1>> D 1>F 6D 6##% </### 6# 6 1EG 1>" >% 1 >D# >E> </### 6##> </### 61 6

6 6#F >E>

SThe provision of Y6#,### consists entirely of a warranty provision. %e.uired )a* .ithout carrying out any calculations, discuss whether the materiality level used in 6##> will be appropriate for this year/s audit, giving reasons for your answer. )b* @!plain audit risk. )c* 2eview the balance sheet given above and set out the areas on which audit work should be concentrated, giving reasons in each case. @. USING THE 6ORK OF AN EFPERT 820 *ar$s9

'n auditing standard has been issued, '(A *70 :sing the work of an expert. +ou are carrying out the audit of <anBani 4onstruction a ,uoted company The company/s business includes large civil engineering contractors )the construction of building s and roads*. 1t also owns investment properties which are let to third parties and these comprise offices and industrial buildings. &uring the year ended >1 8ctober 6#P" the company received a substantial claim for damages from ;endeni Manufacturing for faults in a building it had constructed. This claim includes the cost of repairs and damages, as the customer alleges that the building cannot be used because of the faults, so alternative accommodation has had to be found. The company has obtained advice on the likely outcome of this claim from a local solicitor. 1n the year end accounts the properties had been revalued by an independent valuer and the work in progress has been valued by an employee of the company who is a ,ualified valuer. %e.uired &escribe the matters you would consider and the other evidence you would obtain to enable you to assess the reliability of the work of e!perts in the following cases)a* )b* )c* A. )a* )b* )c* Cegal advice obtained from the local solicitor on the outcome of the claim by ;endeni Manufacturing Kaluation of the properties bye the independent valuer Kaluation of the work in progress by the internal valuer INTERNAL CONTROLS 820 *ar$s9 7tate your obBectives of an internal control system. 1nternal and e!ternal auditors may review internal control systems. @!plain the reason for their reviews, distinguishing between them. 7uggest the work an internal auditor could carry out to check procedures in a purchase system to minimise the risk of fraud. 6"6

)d*

1f the risk of fraud is assessed as higher than normal, how would that affect the work of an e!ternal auditor and an internal auditor0

D.

MUYE DISTRI2UTORS 820 *ar$s9

Muye &istributors is a small company which maintains its sales, purchase and nominal ledgers on a small (4, using a standard computerised accounting package. The company buys products from large manufacturers and sells them to shops which either sell or hire them to the general public. The products include draining clearing machines, portable generators, garden cultivators and wallpaper strippers. +ou have been asked to carry out an audit of the nominal ledger system to verify that items are accurately recorded in the year. 't the end of the year, the nominal ledger produces a trial balance, which is used to prepare the annual accounts. The company employs a bookkeeper, who is responsible for posting the sales and purchase ledgers, and maintaining the nominal ledger. &ata in posted to the nominal ledger as follows't the start of the financial year, all the balances on the nominal ledger accounts are set to 5ero )using the standard year end procedure of the computer package*. The following procedures relate to purchase transactions.hen invoices are posted to the purchase ledger, the purchase analysis code )for the nominal ledger*, the purchases value and the sales ta! value are entered. The total invoice value is posted to the purchase ledger. 't the end of the month, the computer posts the following items to the nominal ledger. The total of each category of invoice e!pense and sales ta! for purchase invoices and credit notes posted in the month )at the same time the computer prints details of the individual invoices making up the total of each invoice e!pense and sales ta! for the month*. The total of purchase ledger cash payments, discount received and adBustments posted to the purchase ledger in the month )the computer prints details of the individual items comprising the total cash discount and adBustments for the month*. .here there is no account in the nominal ledger relating to the items being posted, the computer posts the items to a accounts payable suspense account. 'lso, all adBustments are posted to the suspense account. 7ales ledger data is posted to the nominal ledger in a similar way to purchase ledger data. =ournals are posted manually to the nominal ledger forThe opening balances at the start of the year 6">

8ther cash book items )other than sales and purchase ledger cash* (etty cash payments .ages analysis )details are obtained from the computerised payroll system* 'dBustments, which include4orrection of errors &ealing with items in the sale and purchase ledger suspense accounts )adBustments posted to the ledger, and items where there is no account in the nominal ledger* 'll these Bournals are written manually in an accounts Bournal book, and they must be authorised by the managing director before posting. The opening balances are posted to the nominal ledger when the previous year/s accounts have been approved by the auditors. 'lthough the employee wages are calculated using another computer package, the total wages e!pense is posted to the nominal ledger manually. The wages e!pense is calculated from the payroll/s monthly summary, using a spreadsheet package, and the wages e!pense is analysed into directors, sales, warehouse and office wages )or salaries*. +ou are re,uired to list and describe the audit work you would perform on the computerised nominal ledger system, and in particularThe checks you would perform to verify the accuracy of purchases transactions, which are posted to the nominal ledger. The checks you would perform to verify the validity and accuracy of Bournals posted to the nominal ledger. 'lso, you should briefly describe any other checks you would perform to verify the accuracy of the year end balances on the nominal ledger. Note. ;ou should assume that sales transactions are accurately recorded and correctly posted to the nominal ledger. 10. CHE:UE PAYMENTS AND PETTY CASH 820 *ar$s9 Mr Mateyo has recently ac,uired the controlling interest in 7portec 4o, who are importers of sportswear. 1n his review of the organisational structure of the company Mr Mateyo became aware of weaknesses in the procedures for the signing of che,ues and the operation of the petty cash system. Mr Mateyo engages you as the company/s auditor and re,uests that you review the controls over che,ue payments and petty cash. He does not wish to be a che,ue signatory himself because he feels that such a procedure is an inefficient use of his time. 1n addition to Mr Mateyo, who is the managing director, the company employs 6# personnel including four other directors, and appro!imately three hundred che,ues are drawn each month. The petty cash account normally has a working balance of about Y>##, and Y"## is e!pended from the fund each month. Mr.Mateyo has again indicated that he is unwilling to participate in any internal control procedures, which would ensure the efficient operation of the petty cash fund. %e.uired

6"%

(repare a letter to Mr Mateyo containing your recommendations for good internal control procedures for4he,ue payments (etty cash )Marks will be awarded for the style and layout of the answer.* &iscuss the audit implications, if any, of the unwillingness of Mr Mateyo to participate in the che,ue signing procedures and petty cash function. 11. ANALYTICAL REBIE6 @!plain the purpose of analytical review and at what stages of the audit it should be carried out. @!plain the importance of analytical review in a review assignment. 12. MUKE MANUFACTURING 820 *ar$s9 +ou are the audit assistant assigned to the audit of Muke Manufacturing. The audit senior has asked you to plan the audit of non current assets. He has provisionally assessed materiality at <E6,###. Muke Manufacturing maintains a register of non current assets. The management accountant reconciles a sample of entries to physical assets and vice versa on a three monthly basis. 'uthorisation is re,uired for all capital purchases. 1tems valued less than <1#,### can be authorised by the production manager, item costing more than <1#,### must be authorised by the Managing &irector. The purchasing department will not place an order for capital goods unless it has been duly signed. The company has invested in a large amount of new plant this year in connection with an F year proBect for a government department. The management account has provided you with the following schedule of non current assetsLan& an& ")!&)n's K P!an, an& e?")+*en, K Co*+",ers K Mo,or /e0)#!es K To,a! K

4ost 't >1 March 6##1 'dditions 't >1 March 6##6 'ccumulated depreciation 't >1 March 6##1 4harge for year 's at >1 March 6##6 ;2K as at >1

M D##,###

ED,#>% 6D#,E6G

>#,6#E 1,1D% >1,>"1

D%,E6>

"DG,G"% 6D1,FF>

D##,###

>6D,E6G

D%E6>

G11,F%E

16F,### F,### 1>",### >"%,###

%D,>D% 6F,>%# E>,"G% 6D6,#"G

61,FG> 6,>"E 6%,6"# E,1#1

6D,G>E 1>,#F1 >G,#1F 1D,E#D

661,1F% D1,EFF 6E6,GE6 ">F,FED

6"D

March 6##6 ;2K as at >1 March 6##1

>E6,###

6G,"F#

F,>1%

6F,EF"

%>F,EF#

M 8f which <1#, ### relates to land %e.uired .ithout undertaking any calculations assess the risk of the tangible non current assets audit, drawing reasoned conclusions. 8utline the audit procedures you would undertake on non current assets in respect of the following assertions@!istence valuation )e!cluding depreciation* 4ompleteness &escribe how you would assess the appropriateness of the depreciation rates. 1;. SITTING PRETTY .ilongo 4o is a small, family run company that makes plastic chairs in a variety of shapes and colours for children and ?run at heart/ adults. 1t buys in sheets of plastic which can be cut and bent into the correct shape and a plastic leg that is custom made by another company to .ilongo/s re,uirements. 'll off cut plastic is sent back to the supplier who melts it down and re uses it, for which 7itting (retty receive a 1#$ discount off their purchase price. For the inventory count, the factory manager ensures that no work in progress is outstanding and closes down production for the day. The factory workers come in early on the day of the inventory count to count the inventory, and they are entitled to go home as soon as inventory is counted. :ood controls have always been maintained over the inventory count in previous years. There are no perpetual inventory records. 2aw materials are all kept in the stores and are only taken out when they are re,uired for production. Finished goods are kept in the factory, near the delivery e!it. +ou are the audit assistant assigned to attend the inventory count. +ou have Bust rung the factory manager and as mentioned that on the day of the inventory count a large consignment of plastic is going to be delivered. 1t is the only day that his supplier can make the delivery, and he needs the material to continue with production on the day after the inventory count. The audit engagement partner has told you that he is aware that .ilongo changed the specification of their customised leg recently, after a series of complaints over the stability of their chairs. Cast year/s inventory was valued at <6##, ### in the balance sheet, of which <>#, ### related to raw material inventory. 6""

Finished goods are all carried at the same valuation as each other as there is very little difference between the inventory ranges. (lanning materiality for this year has been set at <D, ### on the grounds, at this stage, that the figures are e!pected to be similar to last years. Re?")re& )a* @!plaining the importance of the inventory count in this situation. )b* (repare notes for your audit supervisor detailing the procedures you propose to undertake in relation to your inventory count attendance. )c* 8utline the procedures which should be taken in relation to cut off at the final audit. )d* Cist the audit procedures you would carry out on the valuation of inventory at the final audit. 1<. SPAKA 820 *ar$s9 7paka, a limited liability company, distributes domestic electrical e,uipment from one warehouse. 4ustomers are mainly installers of such e,uipment, but there is /cash and carry/ counter in the warehouse for retail customers. The warehousemen are responsible for raising invoices and credit notes relating to credit sales as well as handling cash sales. +ou have carried out your interim audit in respect of the year ending >1 &ecember 6#P# which included a circularisation of F# trade accounts receivable as at ># 7eptember 6#P# selected from a total credit customer list of 1,###. 2eplies were received from all customers circularised. The interim audit work disclosed the following)a* 8f the F# customers accounts circularised, F disagreed but could be reconciled by bringing into account payments stated by the customers concerned to have been made before ># 7eptember 6#P# but which in each case were recorded in 7paka/s books between 1% and 1F days after the dates stated by the customers as the date of payment. )b* +our tests suggested that some 6D$ of credit customers were allowed settlement discounts of 6136$ although payments were consistently received after the latest date eligible for discount. )c* ' large number of credit notes were raised representing appro!imately 16$ of the total number of invoices raised. ' review of the copy credit notes indicated that they usually arose from arithmetical and pricing errors on invoices raised. +ou are re,uired to set out the conclusions you would draw as a result of the interim audit and the work you would plan to carry out at the final audit on trade receivables at >1 &ecember 6#P# based upon those conclusions. 1=. FASHIONA 820 *ar$s9

6"E

+our firm is the auditor of Fashiona Te!tiles, a privately owned incorporated business, and you are auditing the financial statements for the year ended >1 8ctober 6#PE. The company has a turnover of <6.D million and a profit before ta! of <1D#.###. )a* The company has supplied you with the following bank reconciliation at the year end. +ou are entered the ?date cleared/ on the bank reconciliation, which in the date the che,ues and deposits appeared on the ;ovember/s bank statement. < 8D(A>=9

Balance as per bank statement as at >1 8ctober 6#PE 'dd deposits not credited.
4B &ate >1 8ct 6% 8ct 6E 8ct 6F 8ct 6G 8ct ># 8ct >1 8ct Cess Jncleared deposits 4B &ate ># 8ct >1 8ct >1 8ct >1 8ct >1 8ct >1 8ct >1 8ct >1 8ct >1 8ct Balance as per cashbook at >1 8ct 6#PE Type 7C 47 47 47 47 47 47 &ate cleared > ;ov > ;ov % ;ov D ;ov " ;ov E ;ov 1# ;ov < 11,>"% "D> 6>D >1D %6" E1% >"6 <

<

1<(0>D

4he,ue ;o. 61"> 61"% 61"D 61"" 61"E 61"F 61"G 61E# 61E1

Type 4( (C (C (C (C (C (C (C 4(

&ate cleared > ;ov 1F ;ov 1G ;ov 1F ;ov 6# ;ov 61 ;ov 1G ;ov 61 ;ov > ;ov

< 1,61" 1#,>16 11,6"% G,E>6 1D,>11 F,"E1 16,F"G G,>%6 G"%

8@D(>A19 8@=(<@@9

No,es ?4B date/ is the date the transaction was entered in the cash book Type of transactions 7C sales ledger receipt 47 receipt from cash sales (C purchase ledger payment 4( che,ue payment )for other e!penses* 6"F

'll che,ues for purchase ledger payments are written out at the end of the month.

Re?")re& )i* )ii* )iii* &escribe the matters which cause you concern from your scrutiny of the bank reconciliation. &escribe the investigations you will carry out on the items in the bank reconciliation which cause you concern. &escribe the adBustments you will probably re,uire to be made to the financial statements if your investigations confirm the problems you have highlighted in )i* above.

)b*

The manager in charge of the audit has asked you to consider the petty cash system and recommend what audit work may be necessary. +ou have found that petty cash is recorded in a hand written analysed petty cash book and it is not kept on an imprest system. From the petty cash book you have recorded the petty cash e!penditure for each month.
20F> ;ovember &ecember 6#PE =anuary February March 'pril May =une =uly 'ugust 7eptember 8ctober Total K FDD ",6%> GE6 EG" FG> ED1 GF" "GD E%G F,">% G%F F%G 2;(;@1

Re?")re& 'dvise the audit manager as to the desirability of performing further substantive procedures on petty cash. +ou should consider materiality and audit risk in relation to the petty cash system. 'ssuming the audit manager decides that further audit work is necessaryA describe the detailed substantive tests of transactions and balances you should carry out on the petty cash system. 6"G

1>. LIYILO ELECTRONICS 820 *ar$s9 +ou are the audit senior in charge of the audit of Truro @lectronics a limited company

Re?")re& 7tate the audit procedures you would carry out to verify the following items appearing in the balance sheet at >1 March 6#PF. Trade accounts payable Bank overdraft 1ncome ta! payable 'ccruals 1@. GOING CONCERN Muye =oinery, a private company, owned by its directors, manufactures wooden window frames, doors and staircases for domestic houses. 1t has prepared draft accounts for the year ended ># 7eptember 6#P" and you are concerned that they indicate serious going concern problems. The profit and loss accounts and balance sheets for the last five years )each ended ># 7eptember* are given below1;48M@ 7T'T@M@;T7 6#P6 </### 7ales "6D 4ost of sales )%EF* :ross profit 1%E 8ther e!penses )FF* 1nterest )"* ;et profit3)loss* D> B'C';4@ 7H@@T7 6#P6 </### 'ssets 4urrent assets 1nventory Trade accounts receivable ;et current assets Total assets Ciabilities and 6E# "E G1 1DF FG 6%E 6#P> </### 1>> 6%# >E> 1"1 D>% 6#P% </### 1F1 >#> %F% D%% 1,#6F 6#PD </### >#E >1> "6# "## 1,66# 6#P" </### %%G >"% F1> DFE 1,%## 6#P> </### EFE )E#1* F" )F"* )G* )G* 6#P% </### 1,161 )G"6* 1DG )1"1* )DF* )"#* 6#PD </### 1,""1 )1,>6"* >>D )6%#* )G#* D 6#P" </### 1,FF1 )1,D1#* >E1 )6FF* )11E* )>%* <>, 6##,### <6, 1##,### <D, 6##,### <6, >##,###

shareholders/ funds 4urrent liabilities Trade accounts payable Bank overdraft Cease creditor ;on current loan

G# 1# 1% 11% 11% 6#P6 </###

>1E "D 6F %1# %1# 6#P> </### 1E 1#E 16% D>%

>DD 611 GF ""% >## G"% 6#P% </### 1E %E "% 1,#6F

%G# 6"G G6 FD1 >## 1,1D1 6#PD </### 1E D6 "G 1,66#

"%1 >"D DG 1,#"D >## 1,>"D 6#P" </### 1E 1F >D 1,%##

7hareholders/ funds 7hare capital 2eserves Total liabilities and share holders/ funds

1E 11" 1>> 6%E

The company has been in business for about fifteen years. 1n =anuary 6#P> it decided to build a new factory on a site leased from the local authority which would allow a maBor increase in sales. This new factory with new machinery was completed a year later. The factory was financed by a non current loan of Y>##,### from a merchant bank and an increase in the bank overdraft. The loan from the merchant bank is secured by a fi!ed charge on the leasehold factory and the bank overdraft is secured by a second charge on the leasehold factory, a fi!ed charge on the other fi!ed assets and a floating charge on the current assets. The company purchases its main raw material, wood, from timber wholesalers. 1t sells about ED$ of its production to about twelve local and national builders of new domestic houses. The remaining sales are mainly to smaller builders with a very few sales to local builders merchants. Re?")re& )a* 1n relation to the accounts above, list and briefly describe the factors which indicate that the company may not be a going concern. +ou should also highlight certain figures and calculate relevant ratios in the accounts. ;ote. +ou will only be given credit for going concern problems which can be determined from the accounts above. )b* &escribe the investigations and checks you would carry out, in addition to those described in part above, to determine whether the company is a going concern.

1A. THE STANDARD EFTERNAL AUDIT REPORT 820 *ar$s9 )a* .hat are the main elements of the audit report prescribed by 17' E##0 6E1

)b*

+ou are an audit partner and are reviewing the audit files of four clients, on each of which there is a significant matter arising.

The audit team were not informed about the year end inventory count until after it had taken place. 1nventory is material in the financial statements. ;o provision has been made against a material amount owed by a customer who is now in li,uidation. The accounts of a client do not contain a cash flow statement. ' substantial claim has been lodged against the company by a maBor customer. The matter is fully e!plained in the notes to the accounts, but no provision has been made for legal costs or compensation payable as it is not possible to determine with reasonable accuracy the amounts, if any, which may become payable. The directors have received legal advice which appears to be reliable that the claim can be successfully defended. Re?")re& @!plain what impact each of these matters would have on the audit report. 1D. INTERNAL AUDIT REPORTING 820 *ar$s9 +ou have been appointed manager of internal audit in a large organisation and asked to set up an appropriate department. Re?")re& +ou are re,uired to produce a formal memorandum for the Board of &irectors, briefing them on the following matters)a* )b* )c* Brief comparison of the role of e!ternal audit with internal audit. @!plain the role of the internal audit function at the design state of a new accounting system. @!plain the format and nature of reporting that the internal audit department will carry out.

20. TUTEM6ANE 820 *ar$s9 +ou are an audit assistant in the firm .ilma 4hartered 'ccountants. +ou have been asked to plan the audit of ?TutemwaneT/ for the year ended ># =une 6#P6. 1t is the first time your audit firm has audited the charity, which has not been audited previously. The trustees have e!pressed interest in receiving a ?value added/ audit and are particularly interested in business advice, especially in the area of systems controls. Tutemwane is a registered charity that raises money for proBects building wells in 7outhern 'frica through musical entertainment. The group consists of volunteers who travel around the country, putting on variety shows of music and dance, the proceeds of 6E6

which are put towards building the wells. The main show is a tap dance production, acting out the difficulties many people face when they are no near a clean water supply. The administrative offices of Tutemwane are located in a large provincial town. 1t owns a house donated by legacy in the past, where the administration is carried out and where the volunteers stay during off periods. ' large proportion of Tutemwane/s income comes from bo! office receipts which are taken by the theatre at which they are performing. The theatres usually waive their standard terms for use of the premises and merely take a 1#$ commission on ticket receipts to cover light and heat and other such e!penses. 1ncome usually comes in after every booking in the form of a lump sum che,ue from the theatre, together with a break down of takings and commission. Tap also receives donations towards the work. These come from a variety of sources 4ash donations from buckets passed around at the interval of each performance 4ash donations on the )rare* occasion that the team do street performances 4ash donations made over the phone or by post by interested donors

The troupe consists largely of volunteers so they are only paid e!penses for their work. The cost of housing the group while they are on the road is borne by the charity. The charity employs an administrator who organises bookings, handles publicity and coordinates all the finances. Re?")re& )a* )b* )c* &iscuss the risks arising for the audit of the year ending ># =une 6#P6. 8utline the audit procedures you would undertake in respect of cash income in the financial statements. 8utline some controls over cash which the charity should implement.

EFAM ANS6ER 2ANK

1. PHIRI AND TEM2O )a* ' non statutory audit could assist the partnership of (hiri and Tembo in the following ways. )i* )ii* )iii* 1t would highlight any weaknesses in the partnership/s systems, and should provide constructive suggestions for improvements. 1t would help to substantiate the partnership accounts in case of any disagreement between the partners of any ,uery arising as to the results shown in the accounts. 'udited accounts carry more weight with interested third parties such as the ta!ation authorities and bankers or other potential sources of loan finance or credit.

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)b*

There is a risk that, in the absence of statutory guidance, auditors and clients has different e!pectations of the non statutory audit. For instance, as discussed in )b* above, the client may e!pect the audit to be aimed at detecting fraud. ' letter of engagement should be sent by the client to the auditors, having been discussed and agreed by both parties, setting out the areas to be covered by the audit. This should help to ensure that the client understands what degree of comfort the audit will give, and that the auditors are aware of the client/s re,uirements.

2. STANDARDS The maBor advantages of accounting standards and auditing standards can be summari5ed as follows)a* A##o"n,)n' s,an&ar&s )i* )ii* )iii* )iv* )v* )b* They reduce the areas of uncertainty and subBectivity in accounts. They narrow the areas where different accounting policies can be adopted. They increase the comparability of financial statements. They codify what is considered in most circumstances to be best accounting practice. They give an indication of the interpretation of the concept ?true and fair/ in many circumstances.

A"&),)n' s,an&ar&s )i* )ii* )iii* )iv* )v* They give a framework for all audits around which a particular audit can be developed. They help to standardi5e the approach of all auditors to the common obBective of producing an opinion. They assist the court in interpretation of the concept of ?due professional care/ and may assist auditors when defending their work. They increase public awareness of what an audit comprise and the work behind the production of an audit report. They provide support for auditors in a dispute with clients regarding the audit work necessary.

T0e +oss) !e &)sa&/an,a'es )n#!"&e ,0e 1o!!o%)n': 8a9 A##o"n,)n' s,an&ar&s )i* )ii* )iii* )iv* )v* )b* They are considered to be too rigid in some areas and too general in others, making their application difficult in some circumstance. They can be onerous for small companies to adopt. Their proliferation could be said to increase proportionately the number of ,ualified audit reports thereby reducing the impact of such ,ualifications. They can create divisions within the profession of those who agree and those who disagree with a particular standard. They would be difficult to change once they become statutory as alterations to company law can take years rather than months to enact.

A"&),)n' s,an&ar&s.

6E%

)i* )ii* )iii*

1t may appear that they impinge on rather than assist professional Budgement. They are considered by some to stifle initiative and developments of new auditing methods. They may create additional and unnecessary work and thus raise fees, particularly on the audit of small companies.

1f either type of standard were to be enforceable by statue it would mean that there would be government intervention in areas currently controlled solely by the profession itself. This might ultimately lead to a diminished role in self regulation. To be enforceable by statute the standards would have to be applicable to all circumstances and thus need to be very greatly and broad in their instructions. This might reduce their usefulness to the auditors. 'uditors might spend unnecessary time ensuring that they have compiled with the law rather than considering the ,uality of their service to their clients. Finally, it should be considered whether full statutory backing for standards would force auditors into narrow views and approaches which might gradually impair the ,uality of accounting and auditing practices. ;. ROLE OF INTERNAL AUDIT Tutorial note. This is an important area both in practice and in this syllabus. 1t is important that you get to grips with the all the issues relating to internal audit and risk management. (art )a* of this ,uestion re,uires you to state what you know about the background corporate governance issues and any re,uirements which companies must meet. (art )b* re,uires you to apply the role of internal audit in a practical situation. 1t demands that you draw some conclusions about what your role will be. +ou should provide reasoning for the conclusions you draw, so that the marker can credit you both for your conclusions and your thought processes. 's internal auditor you have been asked to educate the senior management about the role of internal audit, so in practice it would be appropriate for you to appraise the director of your reasoning.

)a*

No,es on ,0e ro!e o1 )n,erna! a"&), )i* 2e,uirements in relation to the Board of &irectors 's a listed company, Cumbeni Holdings should implement the following There should be a clearly accepted division of responsibilities (ositions of 4hief @!ecutive and 4hairman should be distinct ' formal schedule of matters for referral to the Board should e!ist There should be a balance of e!ecutive and non e!ecutive directors.

4ompanies should also set up remuneration committees comprised of non e!ecutive directors to determine e!ecutive remuneration. 4ommittee should report annually to the shareholders setting out the company/s policy to remuneration and making disclosures about director/s remuneration packages.

6ED

)ii*

2e,uirements in relation to accountability They should also consider the following matters in relation to accountability &irectors must e!plain responsibility for preparing accounts &irectors must report on the going concern status of the company The Board should establish an audit committee

1n addition, the financial statements are likely to be re,uired to be audited by an independent auditor who ,ualities for the position under legislation. )iii* 2isk management &irectors should review the effectiveness of internal control systems at least annually. 1nternal control systems are maintained to enable the business to operate efficiently, to ensure that assets are safeguarded and that reliable records are maintained. 'n internal control system reduces risk to a company. 's such, an internal control system is part of a company/s risk management. &irectors are re,uired to review the system as part of their management e!ercise, to ensure that the system is still reducing risks, and that all risks have been considered. The directors are also re,uired to appraise the need for an internal audit department annually. 1nternal audit have a role in monitoring the risk management of an entity. )b* 7ales department brainstorming session M@M82';&JM T8)i* 7ales director 1 should be able to come along to your brainstorming session in =uly. However, it is probably best that 1 attend in an advisory and interested capacity only. 's we shall be involved in monitoring the systems which the sales department put into place to mitigate risks in the business, it is inappropriate for me to get too involved in the initial systems design stage, as this will impair my future obBectivity when monitoring how the system is operating and achieving its obBectives. )ii* 1n terms of assessing risks, 1 am not best ,ualified to undertake this role. +ou are the specialists and should be able to identify the maBor risks arising in the department. =ust to give you a better idea if what my role can be, 1 can say that internal audit is able to provide three things-

6E"

8bBective assurance on the operation of systems once you have them up and running 'ssistance in setting up a process to help you identify risks 'ssistance in strengthening the control process once you have identified risks.

1n other words, if you are struggling to identify risks at the meeting, 1 can give you some pointers on how to go about it, but after that Bob will be looking at the systems you come up with, and helping you improve them continually. 7ee you at the meeting, if not before, 1nternal auditor <. O2LECTIBITY )a* O2LECTIBITY 8bBectivity is defined by H14' as being ?a state of mind which has regard to all considerations relevant to the task in hand but no other. 1t pre supposes intellectual honesty./ )i* @!ternal auditors. 8bBectivity is usually hallmarked by ?independence/ in the case of e!ternal auditors. The auditor must ?be, and be seen to be, independent/. H14' provides a number of guidelines as to how an auditor should maintain his independence. 1nternal auditors. 1nternal auditors are usually employees of the people they report to, so independence is a more difficult issue to understand here. However, it is vital that they maintain obBectivity towards their tasks within a company, so they must avoid conflicts of interest and maintain integrity in their relationships with other staff members. 1n particular, as a H14' member, an internal auditor is bound by H14'/s Fundamental (rinciples and 2ules of (rofessional 4onduct. 8bBectivity is a fundamental principle. T0rea,s ,o o .e#,)/),-: The following are all threats to obBectivity (ersonal interest )for e!ample, fear of losing fees or good relationship with a client3fellow staff member* 2eview of own work )for e!ample, if an auditor audits financial statements he has compiled, or an internal auditor monitors systems he has designed* &isputes )for e!ample, with a client, or where an audit firm advocates for its client, or where an internal auditor has a personal issue with a staff member* Cong association or undue sympathy )for e!ample, through close personal relationships* 1ntimidation )this is linked to self interest. For e!ample, fear of losing a client or an internal auditor losing his Bob*

)ii*

6EE

)b*

T%o s),"a,)ons S#enar)o 1 )i* T0rea,s The situation raises three potential threats to obBectivity. The first is the issue that the firm has a !on' asso#)a,)on with the audit client. 1t is unclear whether the same engagement staff have been associated with the entity in that time. The second is that the firm has been offered the opportunity to carry out work than for the firm. H14' guidance states that +ro/)s)on o1 o,0er ser/)#es can affect obBectivity. 4onnected to the previous point is the fact that a se!14)n,eres, threat arises through the s" s,an,)a! 1ee income that this client may generate in the current year. H14'/s guideline in respect to recurring income is that 1D$ of office income from one client is likely to adversely affect obBectivity )for a Ctd company*. The income in this year is likely to be 1E$, but much of that is not recurring. However, the form should consider that the result of the consultancy might be that the business e!pands and the audit fee might rise in the future. They should lay down contingency plans. )ii* Sa1e'"ar&s 1n relation to the other services, the key inherent safeguard is that it is a one o11 proBect, as stated above. 1t appears that it will also be carried out by a &e+ar,*en, o,0er ,0an ,0e a"&), &e+ar,*en, , which will help to maintain obBectivity. 1n terms of the audit, as the client has been associated with the audit firm for a number of years, the firm should consider laying out procedures for ro,a,)on o1 ,0e en'a'e*en, +ar,ner in relation to the client, so that the relationship cannot become too close over time. 1f this is considered inappropriate, it might consider instituting a se#on& +ar,ner re/)e% as another measure to maintain obBectivity. S#enar)o 2 )i* T0rea,s

6EF

1f =ohn was to get the Bob in the internal audit department, there would be considerable threat of self review, as he would have to monitor the systems which he has set up in the purchasing department. 's =ohn is a current employee of the company, there is also a risk that his obBectivity towards an internal audit role would be affected by his re!a,)ons0)+s %),0 1e!!o% e*+!o-ees. This is particularly the case with regard to his relationship with his current boss, the P"r#0as)n' D)re#,or( as he has a poor relationship with him. 's a member of the internal audit department, =ohn would in all likelihood have to report directly on matters relating to this director. )ii* Sa1e'"ar&s 1f =ohn gets the Bob, an important safeguard would be that he &)& no, %or$ on *a,,ers re!a,)n' ,o ,0e +"r#0as)n' &e+ar,*en, 1or a +er)o& o1 ,)*e , or perhaps until the systems have been reviewed again an3or the (urchasing &irector moves on. 1t would also be important to address the issue of obBectivity as part of the recruitment process. The issue of re!a,)ons0)+s %),0 s,a11 would have to be &)s#"sse& and "n&ers,oo&. Castly, it would be important to have o .e#,)/),- )n ,0e re#r"),*en, +ro#ess. 's =ohn has had an informal discussion with the head of 1nternal 'udit, the head of 1nternal 'udit should ensure that other staff members are included in the recruitment process. =. AUDIT EBIDENCE )a* )i* 1nspecting inventories and testing perpetual records by making test counts provides1. 7trong evidence of completeness with the limitation that items not physically in inventory or on the perpetual records will not be identified. This may apply to goods in the receiving area at the time of the inventory count. 6. 7trong evidence of e!istence. >. 7trong evidence of accuracy. %. .eak evidence of valuation, and D. .eak evidence of ownership as inventory items may be on consignment or help under 2omalpa conditions. )ii* Kouching non current asset additions to supporting documentation provides1. .eak evidence of completeness as such a test will not highlight omissions only overstatement. 6. .eak evidence of e!istence as, although the additions were purchased by the company, there is no evidence that they are physically held by the company at the year end. >. 7trong evidence of accuracy

6EG

%. 7trong evidence of valuation in respect of cost but not for any subse,uent fall in value, and D. 7trong evid>nce of ownership as the purchase will be invoiced in the company name. However,, this assumes no subse,uent sales of transfers. )iii* Kerification of bank balances by bank confirmation re,uest provides strong evidence for e!istence, accuracy, valuation and ownership for balances at the particular bank circulari5ed. However, only weak evidence if given of completeness, because undetectable balances may be held at other banks. The same applies to liens.

)c*

'udit evidence should be fully documented so that the auditor has a written record of the work and conclusions thereon on which he has based his audit opinion. &ocumentation also acts as a means of ,uality control on the work done providing evidence for the reviewer. )(er 1'7 66# work delegated should be reviewed in a matter which provided reasonable assurance that the work is performed competently*. 1t is particularly important in litigation situations. The details relating to the audit tests which should be regarded are as follows)i* )ii* )iii* &etailed audit tests carried out, the reasons for the timing and level of the tests and the obBectives of the tests. ;otes of errors or e!pectations found and action taken 4onclusions drawn by staff who performed the tests

LAITI Tutorial note. 1n part )a* you must discuss the issues raised by the ,uestion. 1t is not appropriate to answer a > marks ,uestion by saying ?no, it will not be appropriate/. The ,uestion asks you discuss, so you must e!plain your reasoning and come to a conclusion. (art )b* should represent easy marks. However, remember to e!plain %0a, you know swiftly to bank those marks and then move on to section )c* where a large number of marks are available for identifying risk areas in practice. 1n part )c* you need to identify what looks odd in the balance sheet because this will indicate that it is potentially a risk re,uiring a higher level of audit work. However, you should not Bust read through the balance sheet and compile an answer which lists the balance sheet areas in balance sheet order, e!plaining they are risky because ?inventory has fallen/ etc. +ou should e!plain %0- ,0)n's *a- e r)s$- for the audit, in other words, e5+!a)n %0a, ,0e a!an#e s0ee, *o/e*en, *a- )n&)#a,e, inventory may have fallen because a large amount of inventory held at a third parties wasn/t included in the inventory count, or because of a tremendous recent marketing push. The first e!planation shows the risk that the financial statements are materially misstated in terms of inventory completeness. +ou should structure your answer in terms of what you feel is the 'rea,es, r)s$. This may involve making links between the various !)nes o1 ,0e a!an#e s0ee, and pulling together an o/er/)e% o1 ,0e s),"a,)on. 1n our answer below, we highlight the issue of going concern. There is no point in auditing the Balance 7heet in its current form if the going concern basis is

6F#

inappropriate, therefore, going concern is a key risk in this audit. There are various indicators that the going concern assumption may be inappropriate- fall in value in the whole balance sheet, retained loss, fall in cash position, suggestion of fall inactivity.

)a*

Ma,er)a!),1t is ne/er a++ro+r)a,e to apply the prior year/s materiality figure to the current year figures. Materiality should be assessed in each year. 1f the financial position has not changed much, and the results are very comparable with the prior year it is possible that the materiality assessed year on year is very similar, but this does not mean that the auditors should not assess it for each audit. .hen assessing materiality the auditor must consider all known factors at the current date. 1n this case, the position has changed considerably, increasing the risk of the audit, which may lower materiality in itself. 's the balance sheet position has changed considerably, so when materiality is assessed, it is unlikely that it will be similar to the prior year. Jsing he information available, materiality is likely to be assessed e!tremely low in monetary terms, due to the overall decrease in assets and the loss that appears to have been made in the year. 1t is also possible that given the current balance sheet position, the sheet figures will not be used to assess materiality in this year.

)b*

A"&), r)s$ 'udit risk is the risk that the auditor will give an inappropriate opinion on financial statements. 1t is made up of three different elements of risk In0eren, r)s$- the risks arising naturally in the business and specific account3transactions Con,ro! r)s$- the risk that the accounting system will fail to detect and prevent errors De,e#,)on r)s$- the risk that the auditors will not detect material misstatements

&etection risk is comprised of sampling risk )the risk that the auditors/ conclusion drawn from a sample is different to what it would have been, had the whole population been tested* and non sampling risk )the risk that auditors may use the inappropriate procedures or misinterpret evidence*. 1nherent and control risk are assessed by the auditors. &etection risk is then set at a level which makes overall audit risk acceptable to them. )c* S+e#)1)# a"&), areas o1 r)s$ ' review of this balance sheet suggests that audit work should be directed in the following areasGo)n' #on#ern

6F1

The a!an#e s0ee, 0as re&"#e& #ons)&era !- )n /a!"e since the year. Total assets have fallen from <>E>, ### to <1"D, ###. 'lthough the income statement has not been reviewed, the balance sheet shows a retained loss for the year of <611,###. ;et assets show a re&"#,)on )n o,0 )n/en,or- an& re#e)/a !es , which s"''es, a &e#rease )n a#,)/),y, although trade payable does not seem to have fallen so considerably. However, this could be accounted for by Caiti not paying its suppliers in a similar fashion to the previous year. 1t will be ne#essar- ,o re/)e% ,0e )n#o*e s,a,e*en, to substantiate whether activity has reduced. The #as0 +os),)on 0as a!so %orsene&, with cash falling by <66, ###. The cash flow statement should reveal more detail about this fall. However, the company has paid of <D, ### of its bank loan, reducing all the debt. 1n summary, audit work should be directed at going concern as se/era! )n&)#a,ors o1 'o)n' #on#ern +ro !e*s e!ist in the balance sheet. This will be further amplified when the profit and loss account is available. In/en,or1nventory has been mentioned above in the conte!t of going concern. 'udit work should be directed at inventory specifically as this a!an#e 0as 1a!!en s)'n)1)#an,!- from the previous year, which seems o&& )n a *an"1a#,"r)n' #o*+an- . There is no suggestion on the balance sheet for why this should be so )for e!ample, receivables are not correspondingly high, suggesting high pre year end sales, and payables are not correspondingly low, and payables are not correspondingly low, suggested low pre year end purchases*. 1t may be that the inventory count did not include every item of inventory. 'lternatively it could simply point to a fall in activity )discussed above*. 6arran,- +ro/)s)on ' provision of <6#, ### has been included in 6##6 for warranties. The reasons for this must be investigated and the auditors must check that it has accounted for correctly. 1t seems o&& ,0a, a %arran,- +ro/)s)on s0o"!& s"&&en!- a++ear in a balance sheet. 1t suggests a change in the terms of contracts given to customers, or a change in the customers themselves )with different terms then applying*. 'lternatively it suggests that IAS ;@ has been %ron'!- a++!)e& )n ,0e #"rren, -ear( or s0o"!& 0a/e een a++!)e& )n ,0e +re/)o"s -ear( and was not. O,0er *a,er)a! ),e*s 's stated above, given to the indications of loss and the reduction in total asset value, it is likely that materiality will be assessed low in monetary terms. 1n this case, most balances on the balance sheet are likely to be material )e!cluding investments and cash in had which appear to be very low risk*. However, as the bank loan is likely to have good audit evidence available, the most risky of the other balances are ,ra&e re#e)/a !es an& ,ra&e +a-a !es, for reasons discussed above in going concern. More detail is re,uired to make a Budgement about the risk of tangible non current assets. @. USING THE 6ORK OF AN EFPERT

6F6

Tutorial note. ;ote that as well as considering the independence and ,ualifications of e!perts, auditors should consider the scope of the e!pert/s work and carry out some confirmation work on the e!pert/s opinion. +ou do not need )and would not e!pected to have* a detailed knowledge of valuation of long term contracts to be able to answer (art )c*

)a*

1n assessing the reliability of the legal advice obtained form a solicitor on the outcome of the claim by ;endeni Manufacturing, the auditors should consider the following)i* The materiality of the claim is important as the significance to the company of the amount involved would clearly affect the e!tent of the audit work re,uired. )ii* The ,ualification, e!perience, reputation and standing of the local solicitor would be relevant. (resumably the solicitor would be ,ualified, but it would also be necessary to consider his suitability to advise on this type of claim. The e!perience of the solicitor and his firm and their reputation in this field of litigation would be an important factor in determining the e!tent of reliance to be placed on the solicitor/s advice. 1n particular, consideration should be given as to whether the solicitor had advised the company in respect of similar litigation in the past and how reliable his advice had proved to be on those earlier occasions. The independence of the solicitor must be checked as any suggestion that the solicitor or his firm had any direct connection with the company or its management would tend to reduce somewhat the reliability of the evidence provided. The nature and e!tent of the evidence provided by the company to the solicitor, and on which he has based his opinion, should be carefully reviewed to ensure that the solicitor/s decision appears to have been based upon all relevant facts available to the company. The solicitor/s opinion should be e!amined and its reasonableness assessed, in the light of the auditor/s knowledge and e!perience of similar cases against both <anBani and other clients engaged in similar activities. 1f the auditors consider the amount of the claim to be material, and there is uncertainty in relation to the outcome of the claim and3or the solicitor/s evidence, the auditors should consider recommending to the client that a second opinion from an independent specialist in the filed be obtained. 1f the client was not agreeable to this action or if the auditors still considered there to be material uncertainty, then a ,ualification on the audit report would probably be re,uired.

)iii*

)iv*

)v*

)vi*

)b*

The factors to be considered by the auditors in assessing the reliability of the valuation of properties by an independent valuer would be as follows)i* )ii* The independence of the valuer should be considered in a similar way to that of the local solicitor, and for the same reasons. The ,ualification, reputation and e!perience of the valuer should be considered. The valuer should be a ,ualified member of a professional valuation body with e!perience of valuing similar properties within the same geographical area as the

6F>

properties owned by <anBani. 1f the valuer does not have e!perience of the type of properties held by the company or of the area in which they are located, then the value of his evidence is likely to be considerably reduced. The reputation of the valuer or his firm would also affect the reliability of his evidence so far as the auditors are concerned, with the likelihood that more reliance could be placed on a valuation made by a large firm with a good reputation, than one obtained from a little known small firm. )iii* The actual valuation of the properties by the valuer should be carefully e!amined. The auditors would need to satisfy themselves that a reasonable basis for the valuation had been adopted. Typically, an open market value based upon e!isting usage would be e!pected. 'ny change in the valuation of the properties since the time of the previous valuation should be assessed. The validity of any significant changes in the valuation of the properties should be considered in the light of any statistical or to other evidence available for similar properties. The reasonableness of the valuations should be considered against any profits or losses made on any properties disposed of in recent times, as this could be a good indication of any tendency to over or under value the properties to a material e!tent, either over or under valuation being likely to distort the truth and fairness of the financial statements. The reasonableness of the valuations could also be considered by the auditors comparing the valuations with those used by other clients holding similar properties in the same locations.

)iv*

)v*

)vi*

)c*

The matters to be considered when assessing the valuation of the work in progress by an internal valuer would be as follows)i* )ii* )iii* How material is this asset in the financial statements- as it is likely to be highly material, it needs to be valued accurately. The basis of the valuation should be carefully checked to consider the e!tent to which it appears to comply with the re,uirements of 1'7 6. 2ecognition of the fact that, as the valuer is an employer of <anBani, this will reduce the reliability of the evidence provided. However, this may be countered t a certain e!tent by the fact that the valuer should have a more detailed knowledge of the work in progress that it would perhaps ever be possible for an independent valuer to obtain. 4onfirmation should be sought that the valuer had actually visited all of the relevant sites or otherwise obtained satisfactory evidence as to the stage of completion of the inventory in order to provide himself with a reliable basis for their valuation. The valuer/s basis of determining costs should be ascertained and the auditor would need to be satisfied as to be reliability of the company/s records in this respect and, in particular, that a consistently applied satisfactory basis of overhead recognition had been employed.

)iv*

)v*

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A.INTERNAL CONTROLS Tutorial note. (arts )a* and )b* to this ,uestion should be reasonably straight forward. (art )c* re,uires you to set out the work that the internal audit department would routinely do to reduce the risk of fraud and error. 2emember that one of the risks facing the purchases department is that fraud may be perpetrated- internal controls have been put in place to ensure that this risk is reduced. Therefore, on a routine basis, this would fall within the role of the internal audit department checking that controls are operating effectively. 1n your answer to part )c* then, you should identify what controls would e!ist to mitigate against fraud and set out the procedures that internal audit carry out to test their effectiveness. 1n part )d*, you are asked how a risk assessment would affect the work of both internal and e!ternal auditors. +ou are not asked specifically for procedures that would be carried out. +ou should therefore not that as a higher than normal risk has been identified, more work would be carried out that usual. For the e!ternal auditor this would mean a higher number of the same procedures, for the internal auditor, it might mean a special investigation. However, you could also note that internal audit might disguise their special operations as normal operations so as not to alert the suspected party that they are investigating him. 1f fraud was e!pected to have a material impact on the financial statements, the e!ternal auditors would carry outcome procedures that they might not have otherwise carried out )for e!ample, a suppliers/ circularisation*. +ou should note those in your answer.

)a*

Fo"r o .e#,)/es o1 an )n,erna! #on,ro! s-s,e* 17' >1D outlines the obBectives of internal control systems To enable management to carry on the business that company in an orderly and efficient manner. To satisfy management that their policies are being adhered to To ensure that the assets of the company are safeguarded To ensure, as far as possible, that the enterprise maintains complete and accurate records.

)b*

Re/)e% o1 )n,erna! #on,ro! s-s,e*s 5xternal Auditor

6FD

's part of his audit, the e!ternal auditor is re,uired to ascertain the system and controls. 8nce the system has been ascertained, the e!ternal auditor will walkthrough the systems to ensure that they operate as he has been led to believe that they do. The auditor will then determine his audit approach. 1f he is planning to rely on the controls in the system, he has to evaluate the controls in the accounting system to assess whether they are reliable enough to produce financial records which are free of material misstatement. 1n other words, he is assessing whether the systems achieve the fourth obBective given above. He will conduct tests of controls to ensure that the controls have operated properly in the year. 1f these tests produce good results, the auditor can rely on the systems and undertake reduced substantive testing on the financial statements. The auditor will decide not to undertake tests of controls if the controls do not appear effective, or it is more cost effective to undertake high substantive procedures. 'nternal auditor 1nternal audit is an appraisal or monitoring activity established by the directors. 1t functions, amongst other things, by e!amining and evaluating the ade,uacy and effectiveness of components of the accounting and internal control systems. 1nternal audit therefore review and test internal control systems whether the systems are achieving the four obBectives stated above. ,onclusion The e!ternal auditor is interested in the internal control systems which help to produce the financial statements which he is auditing. 1nternal auditors are interested more generally in internal controls to ensure that they meet their obBectives of helping the business to operate effectively and reduce risks. )c* In,erna! a"&),or %or$ The sort of frauds which could be carried out in a (urchases system areA processing non businesses e!penses as business e!penses or paying fictional suppliers inflated prices. The work an internal auditor could carry out to check procedures in the purchase system and to lessen the risk of fraud and error is as follows)i* )ii* )iii* )iv* )v* 4heck individual purchases to the invoice, agreeing the details to the purchase order and delivery note. 1f these items are not available this should be noted. 2eview individual purchase to ensure that they are related to business e!penses. 1f an item appears ,uestionable, it should be investigated further. 2eview the prices paid for purchase and ensure that alternative supply options have been considered )either on an individual basis, or o a yearly basis*. Test che,ue payments to ensure that they related to approved invoices. (erform reconciliations to supplier statement to ensure that payments have been made to the correct suppliers for genuine invoices.

6F"

)vi*

4heck reconciliations made between the purchase ledger and the purchase control account to ensure that all differences have been investigated and reconciled. 4heck reconciliations made between the purchase ledger and the purchase control account to ensure that all differences have been investigated and reconciled. 2eview the purchase ledger on a regular basis to ensure that there are no unusual or une!plained balances or debits.

)vii*

)viii* )d*

2isk of fraud and error The auditors should consider the reasons that the risk of fraud and error has been assessed as high, as this will affect the work that they do. The factors that cause each set of auditor to assess risk as high may be different. 5xternal auditors% work 17' 6%# The auditor/s responsibility to consider fraud in an audit of financial settlements re,uires auditors to plan and perform their audit procedures and evaluate and report the results, recogni5ing that fraud or error may materially affect the financial statements. .hen planning the audit the auditors should assess the risk that fraud or error may cause the financial statements to contain material misstatements. 1n this case, the risk has been assessed and it appears to be higher than normal. This means that the e!ternal auditor will have to perform additional procedures to reduce the risk that the financial statements are materially misstated as a result of fraud. The additional risk would mean that materiality was assessed lower. This would result in a greater proportion of transactions and balances being subBect to evidence gathering. 1f a purchase ledger fraud was suspected, the e!ternal auditors would circulari5e suppliers, to obtain third party evidence as to the value of payables at the year end. 1f a sales ledger fraud was suspected, they would conduct a customers/ circulari5ation, or e!tend the sample from previous years. They would scrutini5e the ledgers for induction of suppliers or customers who may be connected to management. The e!ternal auditors might also carry out detailed transactions tests such as have been outlined above in part )c* to be carried out by internal audit. 'nternal auditors% work 1nternal auditors might assess the risk of fraud or error as high if they had specific suspicions about a particular member of staff. This would direct their additional work. 1nvestigating fraud would be a special proBect for the internal audit department, outside the scope of their normal work. However, 1t is possible that they would want the operation to be convert, so as to ensure that the person suspected would not be alerted to their suspicions. The special proBect would involve scrutini5ing past records, looking for evidence of controls is having been bypassed, particularly evidence of authori5ation not

6FE

being sought. This would be done by scrutini5ing documents for evidence of controls being kept, for e!ample, authori5ing initials, or ?paid/ stamps. They would interview staff to assess whether if controls are maintained as they should be. They would also observe the system operating at the current time. They might also run company searches on all the suppliers on their central suppliers/ register to ensure that they did not appear to be connected to members of staff. 1f the suspicions of fraud were strong, the company might hire specialist forensic practitioners to assist the internal audit department/s investigations. D. FENTON DISTRI2UTORS Tutorial note. 1n )b* significant emphasis is placed on testing unusual or suspicious items )particularly the adBustment Bournals*. ;ote also the importance of accounting controls at the year end. 4orrect categori5ation of e!penses is important from the viewpoint of the statutory accounts )directors/ emoluments*, and in ensuring the ,uality of management information, which the auditors may use for analytical procedures. )a* To verify the accuracy of the purchases transactions posted to the nominal ledger 1 would perform the following checks)i* )ii* 1 would check that the bookkeeper was up to date with the monthly posting of all purchase transactions to the nominal ledger. 7pecific checks on purchase transactions will include the following1. (urchase transactions will be traced from the invoice to the nominal ledger and the analysis and analysis code will be checked. 6. The total invoice value will be traced to the nominal ledger. >. The category of invoice e!pense and the e!pense amount will be checked to confirm that it appears correctly on the detailed computer list for the month concerned. %. The total of the items on the detailed list will be checked to the nominal ledger. D. Transactions will also be traced backwards form the entries in the nominal ledger making up the monthly total to the purchase ledger back to both the detailed analysis and the individual invoice. ". The amount of the invoice e!pense of the invoice e!pense will be agreed with the amount posted to the nominal ledger. The tests above check accounting entries forwards and backwards within the system and any errors would be fully investigated as to their type, cause, materiality and pattern. )iii* The test checks on the detailed list and total postings of cash payments, discounts received and adBustments will follow the same procedure as for invoices and credit notes. The monthly cash book total will be checked to the total posted from the purchase ledger to the nominal ledger.

6FF

)iv*

' check on the analysis and coding of purchase invoices will be carried out to establish the level of accuracy achieved. (articular care will be taken to see that the e!pense category ?purchases/ is correctly identified and coded from invoices and is not confused with other categories, for e!ample stationery, rates, gas and telephone. 1ncorrect analysis and3or coding may be indicated where the e!pense category is high or low in comparison with its budget to date. Carge variations between actual and budget on e!pense categories should be test checked to verify that they are not due to errors in analysis, coding or posting.

)b*

To verify the validity and accuracy of the Bournals posted to the nominal ledger 1 would carry out the following checks)i* Firstly, 1 would check the opening balances at the start of the financial year. To do this 1 would check the value of each trial balance item on the opening trial balance back to the closing entries on the previous year/s accounts. 'fter this, each item would be checked to the nominal ledger ensuring that both the value and analysis are correct. These opening postings should be the first entries in the new year as all nominal ledger balances should have been set to 5ero, and this should be confirmed. 8ther cash book items would be test checked to the nominal ledger to confirm that postings are correct as to value and e!pense category. Carge items would re,uire a larger sample si5e and large, unusual or suspicious items should be checked and evidenced by supporting documentation or Board approval. The year end balances of cash and bank on the nominal ledger should be agreed with the year end balances in the cash book. This would re,uire the last month to be checked as the closing balances at all previous month ends will have been checked already. The checks on petty cash payments transactions would include the following1. 4heck that transactions are supported by vouchers correctly posted to the right nominal ledger account. This would include checking that transactions are valid and coded to the correct e!pense category. 6. 4heck that petty cash transactions are within any limits, regarding the type of e!penditure of ma!imum value, established by management. >. 4heck that the petty cash balance in the nominal ledger at the end of each month and at the financial year end agrees with the balance in the petty cash book. )v* The wages e!pense is posted manually to the nominal ledger from the monthly payroll summaries by means of a Bournal. To verify that the Bournals are correctly posted 1 would select several Bournals and check the following matters. 1. The totals of the analysis columns on the monthly summary shown on the spreadsheet should be posted to the Bournal, and forward to the nominal ledger.

)ii*

)iii*

)iv*

6FG

6. The breakdown of wages e!pense into directors and the several departmental categories will be checked. The correct identification of directors/ pay is important as this re,uires statutory disclosure. 1 would obtain the current list of directors. 1 would add up the totals in the analysis columns to confirm the summary total, and consider its reasonableness. >. 'mounts owing at the year end for ta!, accrued pay, superannuation and other deductions will be verified and any reconciliation drawn up by the bookkeeper agreed. %. The analysis of wages e!pense for the year will be compared with the budget and an e!planation will be sought for any significant variances. )vi* 'dBustments Bournals are potentially a high risk area and any checks would include the following1. 4heck that all manually written adBustment Bournals were authorised by the managing director and supported by documentation and proper narratives. 6. 4heck Bournals are posted in numerical order and there should be missing numbers gaps in the postings. >. @!amine all large adBustments and the reasons given for the errors. These will be traced to the nominal ledger to ensure that posting do correct the errors. %. 1nvestigating closely recurring errors to establish their cause and whether these can be avoided in future by management action. D. @!amine the purchase ledger suspense account )accounts payable suspense* and trace all postings in and out. ". .here there was no account in the nominal ledger, check back to the purchase invoice, establish the account number and verify that the item has been posted from the suspense account to the correct account. E. .here the adBustment is due to the wrong account number being used, check that the Bournal correctly transfers the item to the right account. F. .here the bookkeeper has created entries between the purchase ledge and the sales ledger, check that the creditor3debtor company concerned is posted with a purchase ledger and sales ledger contra of the same value. G. 'll other adBustments will be checked for validity and supporting documentation. 2easons will be established for postings that increase or reduce purchase ledger balances. )vii* +ear end balances on the nominal ledger would be further checked as follows-

6G#

1. 'ny balances remaining on the purchase ledger and sales ledger suspense accounts should be itemi5ed on a supporting schedule and the e!istence of each item Bustified. 6. ;ominal ledger balances for the cash book, petty cash book, sales ledger and purchase ledger should agree to, or be reconciled to, the cash book, petty cash book, total sales ledger and total purchase ledger balances at the year end. 1 will check that any difference is reconciled and e!plained. 1t may be that further adBustments are re,uired to reduce or eliminate a difference. >. 'll non current asset movement should be checked, including purchases, sales, revaluations and depreciation. %. 'll outstanding liabilities should be verified and their si5e reviewed for reasonableness. D. The bank reconciliation should establish the correctness of balances on all types of bank account, i.e. loan, current, deposit, special transactions and son. ". ' review of the financial statements would be carried out to ensure that material changes in assets, e!penses, revenues, liabilities and share capital are Bustified and e!plained. =ustification would be sought in both relative and absolute terms. 10. CHE:UE PAYMENTS AND PETTY CASH Tutorial note. This ,uestion asks you to assess the controls over a particular area of a business. 's such, it could have been posed to either an internal or an e!ternal auditor L remember that either would be possible in the e!am. ;otice that the answer refers to the obBectives of the suggested controls as well as the controls themselves. Thinking through the control obBectives in any given area will help you to suggest relevant controls. 1n another situation, it might help you e!plain why controls are weak. )a* ' Mateyo Managing &irector 7portec 4o Cusaka &ear Mr Mateyo +ou recently re,uested that we should advise you ion good internal controls over che,ue payments and petty cash. .e should like to make the following recommendationsThe main obBectives of control over payments are to ensure that payments are made only in respect of valid transactions and that they are suitably authorised. The following control procedures will contribute toward attaining these obBectivesCHE:UE PAYMENTS )i* 4he,ues should be raised only on the basis of authori5ation, for e!ample a purchase invoice which has been suitably authorised. 4M< Q 4o Cusaka 1 &ate

6G1

)ii* )iii*

4he,ues should be signed by people other than those who approve invoices. There should be two independent signatories for each che,ue, for instance, two directors might act as signatories. 7ignatories should inspect the documents supporting the che,ue to ensure that the details agree. They should also mark the document so that it cannot be reused. 4he,ues should be restrictively crossed. Jnused che,ues should be kept in a secure place. 4he,ues should never be signed in blank. 4he,ues should be under se,uential control and all numbers should be accounted for. 7poilt che,ues should therefore, be retained. .hen che,ues have been signed, they should be dispatched immediately.

)iv* )v* )vi* )vii*

=

Pe,,- Cas0 )i* (etty cash payments should be made only on the basis of suitably authorised vouchers, which should be under se,uential control. Kouchers should be retained for subse,uent references. .here independent evidence is also available, for e!ample invoices and receipts, this should be retained. 'n imprest system should be used to control petty cash. This means that the petty cash float is maintained at a specific amount and is reimbursed at regular intervals on the basis of vouchers showing the payments, which have been made. 1t is suggested that the float should be kept at a level of <>## and be reimbursed on a weekly basis. The petty cash float should be subBect to a periodic surprise counts by a responsible person not involved with the petty cash system. The balance on hand should be reconciled to the imprest account by reference to the vouchers not yet reimbursed. The si5e of individual payments out of petty cash should be subBect to a ma!imum to be agreed by the directors. 7taff should not be allowed to cash personal che,ues or borrow from petty cash.

)ii*

)iii*

)iv* )v*

1 hope that the above information is useful to you in designing your systems on internal control. 1f you re,uire any more information, please let me know. +ours sincerely, =. 7imukonda )b* Mr Mateyo presumably feels that involvement in cash and che,ue controls will be time consuming, and that he is too busy to be involved in it. He may feel that he does not want play a direct part in the petty cash function. Because of the small amounts involved, he may wish to delegate this function to another director. He should appreciate, however, that involvement at least in the authori5ation of che,ue payments would help to ensure that he is aware of maBor transactions in his business.

6G6

He might consider the possibility of authori5ing che,ues in e!cess of a given amountA this would minimi5e the demands of his time, while e!ercising control and keeping him informed of significant outgoings from the business. 'uditors may wish to consider whether Mr Mateyo/s lack of involvement may be symptomatic of insufficient attention being given to financial matters by the board.

11. ANALYTICAL REBIE6

Tutorial note. This is not an e!am standard ,uestion, but it is a useful look at what analytical procedures are and when they should be used. 1t is easy to fall into a trap of thinking that analytical procedures are only relevant at the start and end of the audit. This is not the case. They are valid procedures to use in the use of every balance sheet area, and so might fall into an answer setting out procedures for the audit of any area. )a* 'nalytical review involves studying significant ratios, trends and other statistics and investigating any unusual or e!pected variations. The precise nature of these procedures and the manner in which they are documented will depend on the circumstances of each audit. 60a, &e,er*)nes #o*+ar)sons *a&eI The comparisons, which can be made, depend on the nature, accessibility and relevance of the data available. 8nce the auditors have decided on the comparisons which they intend to make in performing analytical procedures, they should determine what they e!pect to be disclosed by them. In/es,)'a,)on an& e/a!"a,)on o1 res"!,s Jnusual or une!pected variations, and e!pected variations which fail to occur, should be investigated. @!planations obtained should be verified and evaluated by the auditor to determine whether they are consistent with his understanding of the business and his general knowledge. @!planations may indicate a change in the business of which the auditors were previously unaware in which case they should reconsider the ade,uacy of their audit approach. 'lternatively, they may indicate the possibility of misstatements in the financial statementsA in these circumstance the auditors will need to e!tend their testing to determine whether he financial statementsA do contain material misstatements. Ana!-,)#a! re/)e% a, &)11eren, s,a'es o1 ,0e a"&), 'uditors use analytical review in audit planning to help them understand the client/s business and to identify areas of particular audit risk. 'nalytical procedures help auditors decide on the nature, timing and e!tent of audit procedures. 'uditors can use various sources of information at the planning stage, including budgets management accounts and bank and cash records. 'uditors may use analytical procedures as substantive tests. Karious factors determine how much they will do so. These include the level of detail available, the predictability of the data being studied, and the obBectives of the audit tests.

6G>

't the final stage of the audit auditors will use analytical procedures )such as ratio analysis and comparisons with previous years* to help them draw a conclusion about the accounts. 'uditors will carefully review the results of the procedures undertaken to see whether they are consistent with the results of other audit procedures and the auditors/ knowledge of the business. )b* 'nalytical procedures are likely to be used heavily as part of review e!ercise. ' review e!ercise will consist largely of observation and en,uiry. 'nalytical procedures will be the key substantive procedure used.

12. MUKE MANUFACTURING Tutorial note. 1n part )a*, where you are re,uired to assess the risk of the tangible non current assets section of the audit, you should assess each of the components of audit risk in relation to the information given to you and then draw a conclusion about overall audit risk. However, this does not mean you should give detailed definitions of each component of audit risk. That will not gain you any marks in this ,uestion. The re,uirement clearly asks you to assess audit risk in this situation. +ou need to understand what each component is in order to be able to assess the risk here, but this ,uestion re,uires application of your understanding, not e!planation. (art )b* is a very typical auditing ,uestion at this level. +ou should e!pect a ,uestion re,uiring you to set out appropriate procedures relating to any of the balance sheet areas you have studied. +ou should have a good knowledge of the sort of tests you are likely to carry out in respect of each balance sheet assertions, however, remember also to use information given to you in the ,uestion to direct you in the specific case. For e!ample, in this situation, there has been a heavy investment in plant in the year. ' high proportion of the total non current assets figure relates to this new plant. 1nformation given to you about these assets should affect your answer to part )c* when you consider how the depreciation rate should be set and assessed. However, it is also clearly relevant to part )b*. <nowing that depreciation on the new plant should in the region of <6D< should point you towards the fact that there may be plant, which is fully written down, in the financial statements. This may in fact be plant, which has been replaced by the new plant. 1f the plant is not in use, it should not be indicated in the balance sheet. )a* R)s$ )n ,an') !e non4#"rren, asse, a"&), Con,ro! r)s$ The controls over non current asset at Boston Manufacturing appear to be strong. The company maintains and reconciles a non current asset register and there are authori5ation procedures in operation. These controls should be tested, and if they prove effective, control risk could be assessed low. In0eren, r)s$ The tangible non current assets are material on the bases of the proposed materiality level. There has been a substantial movement on the plant and e,uipment account this year, but this appears to be supported by the information given by the management accountant. There appear to be no disposals in the year, which may indicate that they have been omitted, or that obsolete items are included in the register. 1t is also unclear whether land is being depreciated. 1t would be inappropriate if it was being depreciated. 8verall, the inherent risk seems to be medium.

6G%

De,e#,)on r)s$ :iven that inherent risk has been assessed as moderate and control risk has been assessed as low, detection risk will be assessed as higher. However, there is usually good evidence in relation to e!istence and valuation of non current assets and these are key assertions, which the auditors are interested in. There will also be scope to carry out good analytical procedures, such as proof in total of depreciation. Con#!"s)on The audit of non current assets appears to be medium to low risk. )b* 'udit procedures 8)9 E5)s,en#e 1n many cases it is self evident that land and buildings e!ist. However, it is important for the auditors to verify all components of land and buildings contained within the balance sheet, if they are on a site different to the one, which the auditors are primarily attending, for e!ample. Cand and buildings should also be verified to title deeds to ensure that they not only e!ist, but that they are owned by the client. The other classes of asset should be inspected. ' sample of assets from the register should be agreed to the physical asset. There may be scope to rely on the work that the management accountant has undertaken here. The auditor should check a reconciliation which the accountant has undertaken. The auditors should make use of any identification marks on assets recorded in the register, for e!ample, security stages or bar codes, which are kept on assets to distinguish them. The auditor should inspect the condition of the assets and ensure that they are in use. The motor vehicles should be reconciled in terms of number of vehicles e!isting at the opening and closing positions. 'gain, to ensure that they not only e!ist, but are owned by the company, the auditors should check the registration documents to ensure that the company is the registered owner. For all the above, the e!ternal auditor should also review the insurance provision for the assets. This gives party evidence of the e!istence of assets, as the insurer would not insure an asset, which did not e!ist. 8))9 Ba!"a,)on 8e5#!"&)n' &e+re#)a,)on9 Cand and buildings appear to be stated at historic cost, as the schedule does not contain the words ?or valuation/. The auditors should confirm that this is the case with the management accountant. The cost can then be agreed to brought forward figures as there have been no additions in the year. These figures will have been audited in the previous year. 1f the assets are held at valuation, the auditors must ensure that the re,uirements 1'7 1" in relation to revaluations are being compiled with.

6GD

7imilarly, as there have been no movements in the year, motor vehicles can be agreed to the opening position. To audit the valuation of plant and computers, the auditors should agree the opening position. They should then obtain a schedule of additions to non current assets, which can be agreed to purchase invoices to verify valuation. )iii* Co*+!e,eness The schedule of non current assets prepared should be reconciled to The opening position )that is, the previous balance sheet* The closing position )what is disclosed in the financial statements* The underlying records )the nominal ledger*

1f the non current asset register contains details of the cost and accumulated depreciation of each asset, the register should also be reconciled to the schedule. @!planations should be sought for any differences. The additions of the schedule should also be checked to ensure that the opening and closing positions reconcile within the schedule. The auditors should also carry out a test on some of the individual additions, tracing the transaction through the system, from purchase orders to delivery notes and invoices and through the ledgers to the financial statements to ensure that additions have been included completely. )c* De+re#)a,)on )i* A++ro+r)a,eness The appropriateness of the rates should be considered and discussed with management. 2elevant factors to consider are matters such as The replacement policy for the assets The pattern of usage in the business The purpose of the asset being owned

1n this instance, the auditors should establish the rationale behind the depreciation rates applied, particularly in the case of plant. 1n the case of the plant purchased this year, the depreciation rate applied is 1#$. However, the assets have been purchased in relation to an F year proBect, so 16.D$ might be a more appropriate rate.

)iii*

'udit procedures

6G"

&epreciation on buildings can be verified by agreeing the purchase date of the buildings to last year/s files or historic invoices3purchase documents and the valuation applied to the building portion. For the other classes of asset, depreciation should be agreed for individual assets, as it is not possible to agree them in total. The auditors should obtain a breakdown of the charges for the year. They should be able to recalculate the depreciation from details on the non current asset register and compare the results. 1; 6ILONGO Tutorial note. This ,uestion looks at the issue of control problems arising from an interim audit and then it asks you to draw conclusions for the final audit. The second part of this ,uestion is in effect of planning e!ercise. 1t re,uires you to look at specific procedures as a result of what has been done at the interim stageA however, you also need to include some more general procedures in yours answer. This ,uestion is lightly unusual in that an interim audit has already been done. 1n an e!am you are more likely to have to set out procedures from scratch. However, this ,uestion is also good practice in evaluating the results of procedures performed. This could also be e!aminedA perhaps in the conte!t of drawing conclusions forth audit report.

a*

I*+or,an#e o1 ,0e )n/en,or- #o"n, The inventory count provides important audit evidence as to the e!istence and completeness of inventory included in the financial statements. 1n this case, the inventory count is particularly important because the company does not maintain perpetual inventory records. 's no perpetual records are maintained, the only basis for the inventory entries in the financial statements is the results of this inventory count. 1nventory is generally material to the balance sheet of a manufacturing company and they are also one of the higher risk areas on the balance sheet. The inventory count provides important audit evidence reducing the risk of material misstatement in relation to inventory.

)c*

P!ann)n' 1or a,,en&an#e :ain knowledge- 1 must review the notes of last year/s inventory count and 1 must contact the factory manager to obtain details of this year/s. 1 must review this year/s details to ensure that the inventory count appears to be planned efficiently and effectively.

Tutorial note. 1t is possible you assumed that this part of planning was already completed as the ,uestion tells you that you have Bust rung the factory manager. 1f so, you should have

6GE

stated that assumption, or to cover yourself as we have, note that his is a re,uirement. However, you should not have spent long on this aspect of the ,uestion.

'ssess key factors- There are various key factors given in the scenario)i* ;ature and volume of the inventory. There should be no .1(, so 1 will count raw materials )appro!imately 1#$ of the inventory* and finished goods. However, raw material plastic should be low because a delivery is re,uired to continue with production. (ossible obsolescence. 1 must make a note of the number of old chair legs maintained in raw materials, as these are no obsolete, a new specification having been agreed. 4ut off issues. 1 need to ensure that the delivery on the day is isolated and that 1 obtain details of the delivery made during the inventory count. 1 need to determine whether this should be included as deliveries for the year, but most of all ensures that it does not get counted twice )as it arrives, and if it is put into stores*. 1 should also obtain copies of the relevant documents, for e!amples, the last invoices in the year and the last goods received and despatch notes. 8ff cuts. 1 need to consider whether any off cuts are maintained on site and whether these are being included in the inventory count. 's the company receives a discount relating to them, they are unlikely to legally be considered .ilongo/s and so should not be included. 7taff issues. 1t appears that the inventory count is undertaken by the people who work in the factory and handle the inventory on a daily basis. This is not best practice, although in practical terms it is difficult to avoid. However, 1 should discuss this with the factory manager to assess whether staff can be allocated to counting inventory they have not produced. 'lso as the staff is allowed to go home as soon as the inventory count is completed, there is a risk that the inventory count will be rushed and mistakes will be made. The manager should ensure that it is made clear that the inventory count should be thorough and that no one will leave before checks on the thoroughness of the counts have been made.

)ii*

)iii*

)iv*

)v*

(lan procedures- 1 need to determine my sample si5es and whether there is a need for e!pert assistance at this inventory count.

1= FASHIONA Tutorial note. The bank reconciliation is e!tremely important when auditing. 1t links the good, third party evidence of a bank letter to the client/s actual position after timing difference. 1f a ,uestion on auditing bank comes up, it is likely to involve procedures relating to auditing bank reconciliation, so this is practice. (art )b* looks at some audit considerations in relation to petty cash.

6GF

'lways remember to consider )and write down that you have* materiality with regard to pretty cash. 1t is often immaterialA this should affect the audit approach you take. )a* )i* The matters that are of concern in the bank reconciliation are as follows1. &elay in banking cash sales. 4ash received does not appear to have been banked until a week after the cash was received. ' team and lading fraud could have occurred, here an embe55lement receipts is covered up by an apparent delay in banking subse,uent receipts. 6. &elay in presentation of che,ues by suppliers. Most suppliers would bank che,ues within seven to ten days. However, payments to the maBority of suppliers entered on 8ctober >1 have not been cleared for over two weeks. 4he,ues, although entered prior to the year end, may not therefore have been sent to suppliers until some time after the year end. The reason for doing this would be to improve the appearance of the company/s li,uidity in its accounts, by decreasing cash and payables, and hence improving the company/s current and acid test ratios. )ii* Cas0 sa!es The following tests should be carried out1. 4ompare the date on the bank statement with the date stamped on the paying Lin slip. 1f the dates are the same or a day apart, then that is strong evidence of when the che,ues were actually banked. 6. 4ompare amounts banked with cash records for the day )invoices or the till roll*. >. 4ompare sales ledger cash received per cash book with daily listing of cash received. %. 4arry out further investigations if there does not appear to be a significant delay between collecting and banking cash. 1nvestigations should cover other periods of the year and the situation at the date of the audit. D. 1f there is unbanked cash at the date of the audit, insect this cash. Failure to produce this cash would be strong evidence of fraud. 7ncleared pa3ments The following tests should be carried out1. 6. 'sk cashiers and others involved in sending che,ues out when che,ues were actually sent. 8btain suppliers/ statements after the year end, and check the date the cash is shown as received. 1f this date is similar to the date shown on the bank statement, the che,ues would probably have been sent out after the year end.

)iii* 1. 1f the cash receipts represent monies that have been embe55led, these receipts should be e!cluded form the cash balances at the year end )<6, E#D*. 1f the

6GG

money is irrecoverable, it should be charged as an e!pense in the profit and loss accountA if it appears to be recoverable, it should be charged as an amount owing. 6. 4ash and payable should be increased as it appears that the true date of the che,ues, the date that the che,ues were sent to suppliers, was after the year end. Thus the bank balance and current liabilities should be increased by <EE, D#1, the total of che,ues 61"% to 61E#. Thus the true cash book balance will be <"F1 overdrawn. )b* )i* Ma,er)a!),Two commonly used measures of the materiality are 1$ of turnover and D$ of profit before ta!. For Fashiona these two measures would suggest materiality levels of <6D, ### and <E, D## respectively. Total petty cash e!penditure is well over the profit measure and slightly under the turnover measure, and this indicates that on balance it should be audited. However, about <1D, ### of total e!penditure occurred in two months. This suggests that testing should be concentrated on these months, with a briefer review taking place of other months, since material fraud and error is unlikely to occur during those months. A"&), r)s$ (etty cash is high risk audit area for the following reasons1. 4ash is a high most li,uid asset, and hence there is a high risk of defalcation. 6. 7upporting documentation for payments may be limited. >. The failure to keep petty cash on an imprest system means that it may not subBect to regular management review. %. 2isk would be increased by a large petty cash balance )say over Y1,###*, as this would offer greater opportunity for frauds. )iii* The audit tests that will be carried out are as followsIn),)a! +ro#e&"res 1. 6. >. %. 'gree opening balances to working papers for last year. 4heck additions in petty cash book 4heck that petty cash book totals have been posted to the general ledger 4heck that payments in the main cash book shown as payments to petty cash have been shown as receipts in the petty cash book.

Transactions )to test e!istence, completeness and rights and obligations* 1. Kerify individual payments in petty cash book )concentrating on the larger items* to supporting documentation and check that employee has acknowledged receipt of cash. 6. 4arry out analytical procedures on balances by comparing amounts with cash flow forecasts. Transactions )to test e!istence, completeness and rights and obligations*

>##

1.

Kerify individual payments in petty cash book )concentrating on the large items* to supporting documentation and check that employee has acknowledged receipt of cash. 4heck cash cut off procedures have been performed by reviewing reconciliation at the year end and checking that all reconciling items can be satisfactorily e!plained and have subse,uently been cleared.

6.

4ash counts )to verify e!istence, completeness, rights and obligations and valuation* 1. 6. 4ount all balances simultaneously and agree to petty cash book or other record. 'll counting should be done in the presence of the individuals responsible. They should sign at the end of the count to knowledge funds returned are complete. @n,uire into any 18Js or cashed che,ues outstanding for unreasonable periods of time. 8btain certificates of cash in hand from responsible officials confirm that bank and cash balances are reconciled above are correctly stated in the accounts.

>. %. D.

Follow up procedures should include the following tests1. 6. >. %. D. 8btain certificates of cash in hand as appropriate. 4heck unbanked che,ues3cash receipts have subse,uently been paid in and agree to the bank reconciliation. 4heck 18Js and che,ues cashed for employees have been reimbursed. 4heck 18Js or cashed che,ues outstanding for unreasonable periods of time have been provided for. 4heck the balances as counted are reflected in the accounts )subBect to any agreed amendments because of shortages and so on*.

(resentation and disclosure- 4heck this is correct. 1>. LIYILO ELECTRONICS Tutorial note. 'gain we have focused our answer round the financial statement assertions. This answer is longer than you would be e!pected to produce in an e!am. The ,uestion is not really e!am style L in the e!am you might be asked a similar re,uirement, but probably in the conte!t of a fuller audit scenario.

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The substantive procedures that might be performed to verify the specified balance sheet items are as follows)a* Trade accounts payable- Y>,6##,### .e should carry out the following general tests on trade accounts payable. )i* 'gree the opening balance on the purchase ledger control account with the previous year/s working papers to ensure all the necessary adBustments were put through last year. 8btain a list of purchase ledger balances in respect of the year end and 1. 6. >. )iv* Test check to and from purchase ledger accounts to list of balances. 4heck total of list with control account balance at year end )obtain e!planation if any reconciliation necessary*. 4ast lies of balance and control account.

)ii*

4arry out analytical review of statistic such as ratio of trade accounts payable to purchases and gross profit ratio- compare to previous periods and obtain e!planations for maBor variances. 7crutini5e ledger balances for unusual entries especially items that are large and occur around the year end.

)v*

2econciliation of suppliers/ statements with purchase ledger balances will be a key test of rights and obligations, valuation and e!istence. ' suppliers/ circulari5ation should be carried out if suppliers/ statements for significant trade accounts are not available. The following tests should be carried out to check payables are commonly recorded)i* 4heck purchases cut off. 1. 4heck from goods received notes with serial numbers before the year end to ensure that invoices are either 6. >. (osted to purchase ledger prior to the year endA or 1ncluded on the schedule of accruals.

2eview the schedule of accruals to ensure that goods received after the year end are not accrued. 4heck from goods returned notes prior to year end to ensure that credit notes have been posted to the purchase ledger prior to the year end or accrued. 2eview large invoices and credit notes included after the year end to ensue that they refer to the following year.

%.

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D. ". )ii*

2econcile daily batch invoice totals around the year end to purchase ledger control account ensuring batches are posted in the correct year. 2eview purchase ledger control account around the year end for any unusual items

4ompare current listing of trade accounts payable with that of the previous year and note any significant changes, for e!ample changes in maBor suppliers, proportion of debit balances.

.e should also check that trade accounts payable are disclosed separately in he notes to the accounts and other necessary disclosures )for e!ample amounts payable by instalments* made.

)b*

Bank overdraft- <6, 1##,### the bank letter will provide vital evidence concerning the financial statement assertions that relate to the bank overdraft. .e should carry out the following tests that relate to the bank letter and the year end bank reconciliation. )i* )ii* 4heck arithmetic of bank reconciliation Trace che,ues shown as outstanding from the bank reconciliation to the cash book prior to the year end and to the after bank statements and obtain e!planations for any large or unusual items not cleared at the time of the audit. Kerify by checking pay in slips that uncleared banking are paid in prior to the year end, and check uncleared banking are cleared ,uickly after the year end. Kerify balances per cash book according to the reconciliation with cash book and general ledger. Kerify the bank balances with reply to standard bank letter and with the bank statements. 7crutinise the cash book and bank statements before and after the balance sheet date for e!ceptional entries or transfers which have a material effect on that balance shown to be in hand. 8btain e!planations for all items in the cash book or which there are no corresponding entries in the bank statement and vice versa.

)iii* )iv* )v* )vi*

)vii*

The following tests relate specifically to rights and obligations. )i* )ii* @nsure that bank overdraft is within company/s agreed limit with the bank. 4onsider balance in terms of1. 2ight of set off with other balances

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6. >.

'ny security granted for the borrowing )if there is a charge over the assets it should be registered* The company/s borrowing limits per its articles and authori5ation in the directors/ minutes

.e should consider the classifications of the overdraft in the accounts as current or longer term, and check that it has been disclosed separately in the notes to the accounts. )c* 1ncome ta! payable- <D,6##,### The main emphasis will be checking the calculation and reasonableness of the provision. The auditors will carry out the following tests)i* 8btain and recomputed income ta! computation for the current year, check that current year/s provision has been computed at the correct rate, and reconcile the ta! charge in the profit and loss account with ta! at current rate applied to the profit before ta!. 4heck position regarding computations for previous yearsA note agreed computations and verify that provisions for computations for yet agreed reasonable. );ote. The provision of <D, 6##,### may be in respect of more than one accounting period.*. 4onfirm ta! paid to receipts from ta!ations authorities.

)ii*

)iii*

The following tests should be carried out to check the completeness of the provision and also rights and obligations)d* 'ccruals- <6, >##,### .e should obtain the list of accruals and check the list to the accounting records to confirm its accuracy. .e should check the valuation of accruals by carrying out the following tests)i* )ii* )iii* Kerify the amount of accruals by reference to subse,uent payments and supporting documentation )this also provides evidence of rights and obligations*. 4onsider basis for any round sum accruals and ensure it is consistent with prior years. 4arry out analytical review of accruals.

The main emphasis on testing accruals will be on testing that accruals have been completely provided. .e shall carry out the following tests)i* 7crutinise payments made and invoices received after year end to ascertain whether any further accruals are necessary.

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)ii* )iii* )iv*

4ompare prior year/s list of accruals. 1nvestigate any items brought forward and items normally paid in arrears not included on current year/s list. 'scertain why any payments on account are being made and ensure full liability has been provided. 4onsider whether there are any items, which might not be invoiced until a long time after the year end.

.e should also check that accruals are disclosed separately in the notes to the accounts. 1@. GOING CONCERN Tutorial note. (art )a* demonstrates what can be deduced from the calculations for e!amples short term funds to purchase non current assets and delayed payments to suppliers. 1t is vital when you approach ,uestions like this that you do not spend so long calculating ratios that you fail to make comments and draw conclusions from your. @,ually, having been asked in the ,uestion to undertake some calculations, it would be wrong not to do so. +ou must apply Budgement in the balance between calculations and analysis in your answer, remembering that you will score better marks for analysis. 8f course, to get marks, you must have something to analyseN

6or$)n's The following significant accounting ratios are based on the accounts provided in the ,uestion20F2 :ross profit )$* 8ther e!penses- sales )$* 1nterest- sales )$* ;et profit )$* 4urrent ratio Ci,uidity ratio Ceverage )$* 1nventory )months* 2eceivables )months* (ayables )months* 6>.D# 1%,1# #.G# F.D# 1.>G #.F# F%.E1 1."F 1.ED 6.6" 20F; 1#.G# 1#.G# 1,1# )1.1#* #.G1 #.DG DE.1% 6.6F >."" D.%> 20F< 1%.6# 1%.%# D.6# )D.%#* #.E> #.%" G.D6 6.6" >.6% %.%> 20F= 6#.6# 1%.%# D.D# #.># #.E> #.>E G.%D 6.EE 6.6" %.%> 20F> 1G.E# 1D.># ".6# )1.F#* #.E" #.>% %.F> >.DE 6.>6 D.#G

NOTES 1nventory age 2eceivables age (ayables age Ceverage R R R R +ear end inventory 4ost of sales +ear end receivables 7ales +ear end payables 7ales ! ! ! 16 16 16

7hareholders/ e,uity X Cong term loans R Bank overdraft X Cease 7hareholders/ e,uity

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)a*

The various factors in the accounts which may be indicative of going concern problems are as followsThe directors are also re,uired to appraise the need for an internal audit department annually. 1nternal audit have a role in monitoring the risk management of an entity.

)b*

7ales department brainstorming session

MEMORANDUM T8)vi* 7ales director 1 should be able to come along to your brainstorming session in =uly. However, it is probably best that 1 attend in an advisory and interested capacity only. 's we shall be involved in monitoring the systems which the sales department put into place to mitigate risks in the business, it is inappropriate for me to get too involved in the initial systems design stage, as this will impair my future obBectivity when monitoring how the system is operating and achieving its obBectives. )vii* 1n terms of assessing risks, 1 am not best ,ualified to undertake this role. +ou are the specialists and should be able to identify the a maBor risks arising in the department. =ust to give you a better idea if what my role can be, 1 can say that internal audit is able to provide three things 8bBective assurance on the operation of systems once you have them up and running 'ssistance in setting up a process to help you identify risks 'ssistance in strengthening the control process once you have identified risks.

1n other words, if you are struggling to identify risks at the meeting, 1 can give you some pointers on how to go about it, but after that Bob will be looking at the systems you come up with, and helping you improve them continually. 7ee you at the meeting, if not before, 1nternal auditor

1A THE STANDARD EFTERNAL AUDIT REPORT

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Tutorial note. The study guide states that you are re,uired to be able to describe the un,ualified audit report. (art )a* is a simple test of your knowledge in this area. (art )b* looks at some situations which have arisen in audits and asks you to assess the impact that each will have on the audit report. This is a higher skill. Think ?what impact will this have on my audit work0/ L if it causes a limitation and there is no good alternative evidence available, the audit report will be affected by that. Think ?what is the best accounting practice0/ L if it is not being followed and there is no good reason for non compliance, the report will be affected by that.

)a*

E!e*en,s o1 ,0e a"&), re+or, )i* )ii* )iii* )iv* )v* )vi* ' title identifying the addressee of the report 'n introductory paragraph identifying the financial statements audited ' scope paragraph 'n opinion paragraph The signature of the auditors and their address The date of the auditors/ report

)b*

S),"a,)ons )i* 1nventory count 1t is good practice for auditors to attend the inventory count where inventories are material in the company/s financial statements and the auditor is placing reliance on management/s inventory count in order to provide evidence of e!istence of inventory. There therefore, appears to have been a material limitation of the scope of this audit. The basis of opinion section of the report should state )1* )6* )>* The evidence available to us was limited because we could not attend the inventory count. .e were unable to carry out alternative procedures necessary to give sufficient assurance as to the e!istence of inventory )presumed* The amount of the inventories involved.

The opinion section of the report should be headed up as ?Modified opinion due to limitation of scope/. The section should state that the accounts give a true and fair view e!cept for any adBustments that may have been necessary had the

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auditors been able to gain sufficient evidence about inventory. 1t should also state that in respect of the limitation relating to inventory, we did not obtain all the information and e!planations that we considered necessary for the purpose of out audit and we were unable to determine whether proper accounting records had been kept. )ii* 'ccount receivable

1t appears in this instance that there is no prospect of the debt recovered. Best accounting practice would be to provide against that doubtful balance. The audit opinion should therefore be modified on the grounds of disagreement. The opinion section should be headed ?Modified opinion arising from disagreement about allowance section for trade account receivable/. 1t should state that the accounts give a true and fair view e!cept for the disagreement. 1n a paragraph above the opinion paragraph, the auditors should give details of the disagreement. )iii* 4ash flow statement The accounts should include cash flow statement. The audit opinion should therefore be modified on the grounds of disagreement. This disagreement is not pervasive to the accounts, it is limited to the cash flow statement, so this would be an e!cept for ,ualification. The opinion section should be headed ?Modified opinion arising from disagreement over the omission of the cash flow statement/. 1t should state that the accounts give a true and fair view and have been properly prepared e!cept for the omission of a cash flow statement. The omission should be detailed in a paragraph above the opinion section, which the auditors should give details of the net cash flows and state that in our opinion, information about the cash flows is necessary for a proper understanding of the company/s affairs. )iv* Cegal claim The auditors need to determine whether the legal claim is a material matter and even whether it is pervasive to the accounts as a whole, For e!ample, the customer involved is a maBor customer, it could be that an adverse outcome could affect the going concern basis of the company. 1t appears that the disclosure in the financial statements is ade,uate and there appears to be no basis on which to make a provision in the financial statements. Therefore there is no ,uestion that there is a disagreement in the audit. However, the audit report will be affected by the fact that there is an uncertainty affecting the business. The auditors will have to decide whether the inherent uncertainty is material or fundamental. 1f material, it does not need to mentioned in the audit report. However, if we decide that it is fundamental, the report

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should contain a paragraph giving the appropriate details. 1t should also state that the opinion is not ,ualified in relation to this matter. Thereafter, no reference should be made to the legal claim in the opinion section of the report.

1D INTERNAL AUDIT REPORTING Tutorial note. This is useful ,uestion to work through as it covers issues relating to the obBectives of internal audit as well as how internal audit will report on matters arising within the company. .hile there is no formal re,uirement for how internal audit reporting will be presented, it is important that the Board are familiar with the customs that will be set up so that they are best placed interact with the internal audit department and to facilitate the department/s suggestions.

MEMORANDUM ToFrom&ate7ubBect)a* Board of &irectors Head of 1nternal 'udit =une 6##> 1nternal audit obBectives and reporting

8bBectives of internal and e!ternal audit The main functions of internal and e!ternal audit are very different, although some of the means of fulfilling their obBectives are the same. The e!ternal auditors are appointed by the shareholders to report on the stewardship of the directors. The role of the e!ternal auditors is defined by statute and the report produced by the auditors states whether the financial statements give a true and fair view and have been properly prepared. 1n contrast, internal auditors are employed by the manager of the company. They are not independent of the management of the company, but work for it. Their work is likely to be more varied and wide ranging than the e!ternal auditors, and they report to the Board or to the 'udit 4ommittee on the results of that work. The internal auditors will be concerned with monitoring the effectiveness of all controls within a business and with the risk management policies of the business. The obBectives of the internal audit team are controlled by management.

)b*

&esign of a new accounting system The internal auditors should be involved in some degree at all stage of the design of a new accounting system.

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There are three main stages of development Feasibility studies 7ystem development 7ystem specification and construction

't each of these stages, the internal is in an ideal position to ensure 'll the proper controls that are re,uired have been built to the system design The system meets company standard along with the design process itself

1n effect, the internal auditors will be putting their customary skill of internal control evaluation into practice even before the system is devised and is running. The internal auditors will look for key attributes in the planned system 1s the benefit worth the cost of the system0 1s the planned system complete0 're the outputs )reports* relevant and will they be produced in a timely manner0 .ill the system be secure from internal and e!ternal tampering0 1s staff training on the new system necessary and has it been planned0

&uring the feasibility stage, the auditors should ensure that all user departments have been consulted and had input as to the key risks which the system is trying to answer. The internal auditors should assess any assumptions which have been made as part of the planning, for e!ample, estimates of future trading growth. 's the development stage commences, the internal auditors should ensure that the system development is properly documented. 8nce the system has been developed, the internal auditors will be re,uired to test the new system. The tests should also be properly recorded. )d* Re+or,)n' 's has been mentioned above, the internal audit department report to the Board of &irectors and3or the 'udit 4ommittee. 1t is up to the directors to determine whether they would prefer that the internal audit department report routinely to the 'udit 4ommittee, with any pressing matter being passed on to the full Board. 1n either case, there may be occasions and some matters where its appropriate for issues to be reported directly to the audit committee, only. 'n e!ample of such instances could include the suspicion of a senior management3director fraud. 1n contrast to the e!ternal auditors, internal auditors are not re,uired by law or other regulation to produce a particular format of report. Therefore, how the internal audit department report is also dependent to a degree on the re,uirements of the Board. However, there are some basic elements of internal audit that ere likely to be included in most reports. 1nternal audit will largely produce two types of report-

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2isk based reports (erformance enhancement reports

1n the scenario looked at in )b* above, where the auditors were reporting on the design and operation of a new system, this would be a risk based report. However, the new system might have been investigated because internal audit produced a performance enhancement report suggesting future action. Both types of report will probably conform to the accepted report which consists of an e!ecutive summary, followed by a detailed report and appendices. They are likely to include recommendations and action points, together with details of how such plans would be implemented, when, by whom, and at what cost. 1nternal audit reports will usually come with a distribution list to enable each reader of the report to know who is also reading it. They will also come with a date and a reference number. The report should also state whether it is final or draft. 1nternal audit reports may be produced so that they may be modified when feedback is obtained. Modified reports should state clearly that they have been modified and indicate the feedback that led to the modification.

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6 F@@ ;@:8T1'T18; ';& C8.B'CC1;: ...............................................................>G > C@TT@2 8F @;:':@M@;T.......................................................................................D6 % @P'M(C@ 8F 'J&1T @;:':@M@;T C@TT@2.....................................................D% 'nswer..............................................................................................................................DF B@F82@ '44@(T1;: ;8M1;'T18;........................................................................."D 8TH@2 M'TT@27.........................................................................................................."E @;:':@M@;T @48;8M147......................................................................................"G 2@C'T18;7H1(..............................................................................................................E# '((28K'C.....................................................................................................................E# (rincipal risk.....................................................................................................................E" 1mplications and uses of 1nformation Technology- .......................................................111 Cegislation on public sector internal audit......................................................................6>E D (etty 4ash.....................................................................................................................6G6

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