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Foundations in AuditFAUCAT

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Contents1. ......................................................Business Environment and audit framework! 3

2. .............................................................The ACCA code of ethics and conduct! 15

3. .................................................................................The regulatory framework! 23

4. ...........................................................................................................Audit risk! 27

5. ...............................................................Tests of control or substantive tests?! 39

6. ..........................................................................Assertions and audit evidence! 45

7. ...............................................................Obtaining audit evidence sampling! 51

8. ........................................................The use of experts and other third parties! 57

9. ......................Audit evidence: computer assisted auditing techniques (CAAT)! 61

10. ..................................................................................................Documentation! 65

11. ..................................................................................................Internal control! 75

12. ..............................................Examples of internal control and tests of control! 81

13. ...........................................................................................Substantive testing! 91

14. .................................................................................Final stages of the audit! 103

15. ..............................................................................................The audit report! 107

16. ............................................................................................Answers to Tests! 113

CAT FAU Foundations in Audit 1




Chapter 1BUSINESS ENVIRONMENT AND AUDIT FRAMEWORK1. The purpose and scope of an audit

Shareholders are the legal owners of companies. In very small businesses, such as family businesses, the shareholders will also take part in the day to day management of the company. However, once businesses grow, shareholders appoint directors and managers to run their company.

Shareholders (also known as members) are the principals, and directors are the agents of the shareholders. Agents should act in the best interests of the principals so, therefore, directors should act in the best interest of shareholders. However, this can introduce conflicts of interest between the two parties. Shareholders want large profits but the directors might want large salaries, generous pensions and bonuses, first class travel and expensive cars.

Companies are required to produce annual financial statements (accounts) for presentation to their shareholders. These should show how their company has got on during the year. The directors are responsible for producing the financial accounts and there is obviously a temptation for them not to report results accurately or fairly. For example, directors might try to overstate profits so as to keep their jobs or to qualify for bonuses.

Therefore, auditors are appointed by the members of the company to scrutinise independently the financial statements and to report to the members on whether the financial statements show a true and fair view of the companys affairs and its results. Auditors conclusions are published as part of the financial statements in the audit report.

In addition to the terms agent and principal, stewardship is sometimes used to describe the duty that directors have to look after the interests of the shareholders.

2. What auditors dont doAuditors do not: Prepare the financial statements: that is the job of the directors. Double check every transaction in the company: that would take too long and be very

expensive. Manage the company. Warn shareholders that the company has made a loss: that will be shown in the

financial statements. Undertake to discover every fraud or error that might have taken place in the

company: auditors look only for material misstatements (see later).



3. Advantages and disadvantages of an audit

3.1! Advantages Independent scrutiny and a report on the financial statements Greater credibility (believability) of the financial statements. This could help in raising

finance. Professional expertise applied to the financial statements. Especially important when

directors and shareholders might not have financial experience. Review of the companys internal control system (the accounting system used by the

company) and recommendations for its improvement.

3.2! Disadvantages Cost: auditors charge for their work Time and disruption. Auditors have to ask employees questions and have to find

documents. This distracts employees from their day-to-day tasks. A feeling of not being trusted. Auditors are always looking for independent evidence

and are reluctant to take employees word for anything. This can make staff feel that they are not trusted.

4. Accounting records Accounting records consist of:

Nominal or general ledger. This has accounts for assets (such as non-current assets, receivables), liabilities (such as amounts owed to suppliers and loans), income (such as sales) and expenses (such as rent, wages and electricity).

Cash book. This shows cash receipts and payments. Receivables ledger. This shows how much each credit customer owes. This ledger is

sometimes known as the debtors ledger or sales ledger. The total of these amounts should agree with the summary receivables account that is part of the nominal ledger.

Payables ledger. This shows how much is owed to each supplier. This is sometimes known as the creditors ledger or purchase ledger. The total of these amounts should agree with the summary payables account that is part of the nominal ledger.

Non-current asset register. This shows details of each non-current asset, such as purchase date, cost, depreciation rate, location, date last physically verified and depreciation to date. The total of the non-current asset register should agree to the summary accounts in the nominal ledger. The non-current asset register might sometimes still be referred to as the fixed asset register.

Inventory records. Lists inventory details such as cost, location number of items, deliveries and receipts.

The exact nature of the accounting records vary from business to business. For example, a small grocery shop will not have a receivables ledger because all sales are for cash. An architects practice will not have inventory records because they sell services, not goods. Some very small businesses keep little more than a cash book on a day-to-day basis and fuller accounting records are produced at year end.



5. Financial statementsAuditors report on a companys financial statements. These will have been produced from the financial records. Financial statements consist of:

A statement of financial position A statement of profit or loss A cash flow statements Notes to the financial statements Statement of movement in reserves

Together with the documents above, companies also produce directors reports, chairmans statements, graphs, forecasts and public relations material and combine the whole lot into their annual report. The annual report will also include the auditors report. For large companies this is often a glossy booklet designed to impress shareholders and potential investors.

However, the audit report covers only the financial statements, not the other documents that might be included.

6. The audit report

6.1 ! Prime purpose

The prime purpose of the audit report is to state whether or not the financial statements give a true and fair view of the financial position of the company at its year end and of its performance during the year.

True:! implies that the financial statements are factually correct, have been prepared according to an applicable reporting framework (such as the International Financial Reporting Standards) and that they do not contain any material misstatements that may mislead the users. Misstatements may result from material errors or omissions in the financial statements. True also implies that the financial statements are materially accurate.

Fair:! implies that the financial statements present the information faithfully without any element of bias and they reflect the economic substance of transactions rather than just their legal form. Presentation is an important element of fairness.



For example:

The statement of financial position should show current assets and current liabilities separately and in detail. Thus current assets and current liabilities might show:

Current assetsInventory 10,000Receivables 4,000Cash 2,000

16,000

Current liabilitiesTrade payables 12,000

This shows that the liquidity of the company is poor as suppliers expect $12,000 within the next few weeks but, although inventory is high, there is not much coming from customers or in cash with which to pay suppliers. Inventory can take a long time to be sold and to turn into cash.

If the presentation were as follows:

Current assets 16,000

Current liabilities 12,000

then users might have a very wrong impression. The amounts are true (correct), but concealing the large amount of inventory that contributes to the current assets is likely to mislead ie not a fair presentation.



6.2 ! Detail in the audit report

Reproduced below is the audit report for Marks and Spencer Plc, a large UK retail group:

1 Independent auditors' report2 We have audited the financial statements of Marks and Spencer Group plc for the 52 weeks ended 30 March 2013 which

comprise the Consolidated income statement, the Consolidated statement of comprehensive income, the Consolidated and Company statements of financial position, the Consolidated statement of changes in equity and Company statement of changes in shareholders equity, the Consolidated cash flow information and Company statement of cash flows and the related notes. The financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting Standards (IFRSs) as adopted by the European Union and, as regards the parent company financial statements, as applied in accordance with the provisions of the Companies Act 2006.

3 Respective responsibilities of directors and auditorsAs explained more fully in the Directors Responsibilities Statement set out within the other Disclosures page, the directors are responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view. Our responsibility is to audit and express an opinion on the financial statements in accordance with applicable law and International Standards on Auditing (UK and Ireland). Those standards require us to comply with the Auditing Practices Boards Ethical Standards for Auditors.

4 This report, including the opinions, has been prepared for and only for the Companys members as a body in accordance with Chapter 3 of Part 16 of the Companies Act 2006 and for no other purpose. We do not, in giving these opinions, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or into whose hands it may come save where expressly agreed by our prior consent in writing.

5 Scope of the audit of the financial statementsAn audit involves obtaining evidence about the amounts and disclosures in the financial statements sufficient to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error. This includes an assessment of: whether the accounting policies are appropriate to the Groups and the parent companys circumstances and have been consistently applied and adequately disclosed; the reasonableness of significant accounting estimates made by the directors; and the overall presentation of the financial statements. In addition, we read all the financial and non-financial information in the Annual report and financial statements 2013 to identify material inconsistencies with the audited financial statements. If we become aware of any apparent material misstatements or inconsistencies we consider the implications for our report.



6 Opinion on financial statementsIn our opinion: the financial statements give a true and fair view of the state of the Groups and of the parent companys affairs as at 30

March 2013 and of the Groups profit and Groups and parent companys cash flows for the 52 weeks then ended; the Group financial statements have been properly prepared in accordance with IFRSs as adopted by the European Union; the parent company financial statements have been properly prepared in accordance with IFRSs as adopted by the

European Union and as applied in accordance with the provisions of the Companies Act 2006; and the financial statements have been prepared in accordance with the requirements of the Companies Act 2006 and, as

regards the Group financial statements, Article 4 of the lAS Regulation.

7 Opinion on other matters prescribed by the Companies Act 2006In our opinion: the part of the Remuneration report to be audited has been properly prepared in accordance with the Companies Act 2006;

and the information given in the Directors Report for the financial year for which the financial statements are prepared is

consistent with the financial statements.

8 Matters on which we are required to report by exceptionWe have nothing to report in respect of the following:Under the Companies Act 2006 we are required to report to you if, in our opinion: adequate accounting records have not been kept by the parent company, or returns adequate for our audit have not been

received from branches not visited by us; or the parent company financial statements and the part of the Remuneration report to be audited are not in agreement with

the accounting records and returns; or certain disclosures of directors remuneration specified by law are not made; or we have not received all the information and explanations we require for our audit. Under the Listing Rules we are required to review: the directors statement, set out within the Other Disclosures page, in relation to going concern; the parts of the Corporate Governance Statement relating to the Companys compliance with the nine provisions of the UK

Corporate Governance Code specified for our review; and certain elements of the report to shareholders by the Board on directors remuneration.

9 Stuart Watson (Senior Statutory Auditor) for and on behalf of PricewaterhouseCoopers LLPChartered Accountants and Statutory Auditors London20 May 2013



The numbered paragraphs have the following significance:

(1) A clear title Independent auditors report.

(2) Defining what the audit covers the financial statements and the financial reporting framework.

(3) Pointing out what the directors are responsible for and what the auditors are responsible for. This reduces the expectations gap because many users of financial statements think that the auditors are responsible for their preparation. It also states that the audit was carried out in line with the International Standards of Auditing. This establishes the approaches and methods used during the audit.

(4) An attempt to limit the auditors responsibilities to the members of the company and not, for example, to lenders and suppliers.

(5) Again, reducing the expectations gap. Auditors give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error. There are no guarantees: reasonable assurance only and material misstatements only. Although the auditors do not routinely report on matters that are not in the financial statement they have a duty to report if other information in the companys report is inconsistent with the financial statements.

(6) The important part: the opinion paragraph, clearly headed so that it can be easily found. Here the auditors state whether in their opinion the financial statements give a true and fair view, comply with laws and financial reporting standards.This type of assurance is known as positive assurance or reasonable assurance because the auditors are definitive about their view on the financial statements

(7) Other matters on which the auditors report explicitly.

(8) Other matters on which the auditors report by exception: Proper accounting records kept Proper returns received from branches not visited Financial statements in agreement with the accounting records All explanations and information required have been obtained.

Matters requiring review: Going concern review Corporate governance compliance Directors remuneration

(9) Signed and dated. The date is important because the audit is still in progress until then.

7. Auditors rightsAuditors duties are to report on the matters as set out in the audit report above. They also have a legal duty to report certain matters to the authorities; this is covered in more detail later under auditors ethical duty to maintain client confidentiality.

! To fulfil their duties auditors are given certain rights by law: Access to the companys records. This includes not only he accounting records but

also documents such as contracts, correspondence and board minutes.



To be given all information and explanations they requires. Attendance at general meetings and notice thereof. A right to speak at general meetings. This is a very important right that auditors have:

the right to speak directly to those being reported to. A right to receive copies of written resolutions. A right to require that a general meeting is held at which the accounts can be laid

before (ie presented to) members.

8. Appointment of auditorsWith public companies the directors appoint the first auditor of the company and the auditor holds office until the end of the first meeting of the company at which the directors lay its accounts before the members. The members can then re-appoint the auditor, or appoint a different auditor to hold office until the end of the next meeting at which the accounts are laid. Therefore, auditors are reappointed annually by the members. If a public company fails to appoint an auditor the Secretary of State may appoint one or more persons to fill the vacancy.

In a private company, if the members do not pass a resolution appointing an auditor for a particular year the auditor in office is deemed to be re-appointed until the members pass a resolution to reappoint him/her or remove him/her from office. However this does not apply if the auditor was appointed by the directors or where the articles of association require reappointment.

9. Resignation and removal of auditors

9.1 ! Introduction

If an auditor resigns or is removed there is always the fear that they are going for some reason that members ought to know about. For example, the auditors might have concluded that the directors of the company are concealing important information or are committing a fraud on the company. In such cases the auditors are likely to resign because it will be impossible for them to carry out a thorough audit. Therefore, upon either resignation or removal the auditor must deposit a statement of circumstance at the companys registered office.

If the company is not quoted on a stock exchange the auditor may simply state that there are no circumstances that need to be brought to the attention of the companys members or creditors.If the auditor believes that there are matters that need to be brought to the attention of the companys members or creditors then the auditor must deposit a statement of the circumstances in connection with leaving office.

If the company is quoted on a stock exchange the auditor must deposit a statement setting out the circumstances of leaving of office irrespective of any matter that should be brought to the attention of its members or creditors

9.2! Resignation

The steps are:



(1) Deposit a written notice with the company informing them of the resignation together with the relevant statement of circumstance/no circumstance.

(2) Notify the Registrar of Companies and also provide the statement of circumstance(3) Notify everyone entitles to receive financial statements - principally the members of

the company.(4) Require the directors to hold an extraordinary general meeting. This enables the

resignation to be discussed with the member.

9.3! Removal

Auditors cannot be removed by the board. They can only be removed by the members (on whose behalf they act). This gives the auditors much greater strength should they disagree with the directors on some audit point: the directors cannot simply find more amenable auditors. However, directors can have great influence over the members and might recommend removal of the auditors even though the auditors are doing a good job. Therefore, the auditors are entitled to make representations to the members at a general meeting, arguing why they should not be removed.

If the resolution to remove them is passed, then:

(1) The auditors must deposit a statement of circumstance/no circumstance with the company.

(2) The company must notify the Registrar of Companies and also provide the statement of circumstance.

(3) Notify everyone entitled to receive financial statements - principally the members of the company.

10. Auditors liability

10.1! Introduction

Occasionally auditors get it wrong and they put their name to a set of financial statements which contain a material misstatement. Obviously, if users of the financial statements have relied on those statements to make investment decisions, they could suffer financial harm because they would have been misled.

When auditors are appointed they send an engagement letter to the company. Essentially, this is a contract setting out both the auditors and the companys responsibilities. It is possible for the auditors to breach this contract and so be liable for damages, but the main legal risk that auditors suffer is from the tort of negligence.

For a claimant to prove a negligence claim, it must be shown that:

A duty of care to the claimant existed The duty was breached Monetary loss was suffered.

10.2! Duty of care

The English courts have been very reluctant to extend an auditors duty of care beyond the members of the company as a whole. The key case is known as the Caparo case where a company was taken over by Caparo on the basis of financial statements Caparo claimed



were misleading. The House of Lords (the UKs highest court then) concluded that the auditors of the company taken over owed no duty of care to members of the public at large, such as potential investors.

In partial contrast, in the Bannerman case it was held that auditors could owe a duty of care to a bank if the auditors knew that the bank was relying on the audited financial statements and the auditors did not disclaim their liability to the bank.

Paragraph 4 in the audit report above is known as the Bannerman clause because it specifically warns users of the financial statements, other than the members as a whole, not to rely on the financial statements for any purpose except where specifically agreed.

10.3! Breach of the duty of care

If the auditors carried out their audit in accordance with the International Standards in Auditing it will be difficult to prove that they fell short of their duty of care.

10.4! Monetary loss

Negligence is a practical matter: monetary loss has to have occurred before the courts are interested.



Question 1 Auditors can be removed from office by the directors of the company Is this statement true or false?

Question 2 Which two of the following tasks do auditors undertake?A! Preparation of the financial statementsB! Provide independent scrutiny of the financial statementsC! Prepare an audit reportD! Warn shareholders that their company is loss-making

Question 3 Which (several) of the following are part of the financial statements?A! Directors reportB! Statement of financial positionC! Statement of profit or lossD! Chairmans statementE! Cash flow statement

Question 4 When discussing directors shareholders, who are the principals and who are the agents?

Question 5 How frequently must auditors of a public company be re-elected?

Question 6 Auditors have a right to speak at general meetingsIs this statement true or false?

Question 7 What is a statement of circumstance?



Question 8 Incoming auditors are not allowed to communicate with outgoing auditors.Is this statement true or false?

Question 9 Which of the following statements best describes auditors liability to users of financial statements?A! They are liable to all users of financial statementsB! They are liable only to the membersC! They are liable to members and can be liable to othersD! They are not liable to anyone because they only provide reasonable assurance that the

financial statements are free for material misstatement.



Chapter 2THE ACCA CODE OF ETHICS AND CONDUCT1. Introduction

All members and students of the ACCA must follow the provisions of this code. Note that it applies to:

Students ACCA members acting as auditors ACCA members acting in some other accounting roll.

Failure to comply with the code can lead to fines, to members being excluded from membership, or to students being removed from the student register.

Ethics are not just an add on: they are regarded as being fundamental to being an ACCA member or student. If poor ethical standards were allowed, then accountants lose much of their value. They might be technically able to prepare or audit financial statements, but it the financial statements lack credibility what is their point? Ethics give added value. Not only can the accountant prepare financial information, but that information is also more reliable (and so more valuable) because it has been prepared by someone adhering to ethical standards

2. The ethical frameworkThe ethical framework:

Establishes five fundamental principles Recognises that these come under threat, and categorises those threats Explains how many of the threats can be reduced or avoided altogether.

You might feel that some of the examples of threats described below are trivial, but it is important that the accountant is not only seen to be acting ethically, but that there is no danger of a suspicion of unethical conduct. In some situations, judgement is required as to the severity of the threat.



3. The fundamental principles and their threats

3.1! The five fundamental principles

Principle Meaning

1 Integrity Members should be straightforward and honest in business and professional relationships. Integrity is more than honesty. It also means sticking up for what you believe is right and following up areas of concern. For example, you would not be acting with integrity if, upon seeing what might be a fraudulent transaction you decide to not investigate it further ie you turn a blind eye.

2 Objectivity Members should not allow bias, conflicts of interest or undue influence to interfere with their professional or business judgement. For example, if you were producing a budget that will be used for a purchaser of the business, it will be difficult to be objective as there will be an understandable desire to draft an optimistic budget.

3 Professional conduct and due care

Members must keep up-to-date with legislation, accounting standards, auditing standards and so on. Members must ensure that enough time, resources and care are devoted to tasks so that they are carried out correctly.

4 Confidentiality Accountants frequently have access to confidential information. Auditors see financial results before shareholders; accountant in business might see everyones remuneration. Therefore, accountants must not disclose information unless:

> They have the clients permission to do so. For example, the audit firm might have been asked to carry out tax computations and to submit these to the revenue authorities.

> There is a legal or professional right or duty to disclose information. For example, many countries have anti-money laundering legislation which compels auditors to alert the authorities if they have even a suspicion of money laundering. A right to disclose information can arise if the audit firm had to defend itself in court against allegations of negligence.

> A public duty to disclose information. The concept of public interest is not defined by statute, and an auditor would be advised to seek legal advice on these matters. For example, is there a public duty to disclose that a client pays staff below minimum wages. You might think that morality is of disclosure, but the auditors prime duty is to report on the financial statements, not to be a watchdog for every breach of rules and regulations.



Principle Meaning

5 Professional behaviour Members must avoid any action that would bring the profession into disrepute. For example, being found guilty of theft (or even fare evasion) is likely land a member or student in trouble with the ACCA.

Although not listed as one of the fundamental ethical principles, the concept of independence is very important. It is more difficult to act with integrity and objectivity if you are not independent from a client. The ACCAs code of ethics and conduct requires members no only to be independent but also to be seen to be independent.

3.2! The threats

Title Meaning

1 Self-interest For example, financial self-interest

2 Self review For example, checking your own work and verifying your own judgements and decisions

3 Advocacy For example, promoting a client to others

4 Familiarity For example, personal relationships that can interfere with objectivity and professional scepticism

5 Intimidation For example, a physical threat (thankfully rare) or the threat of losing your job

3.3! The safeguards

These can be categorised as:

Safeguards created by the profession. For example, adhering to professional standards and following the ACCA S Code of Ethics and Conduct.

Safeguards created by the work environment. For example, a policy rotating members of an audit team to avoid familiarity with a client, and providing training and review procedures to ensure professional competence is not threatened.

Safeguards created by individual members. For example, staying up -to-date with new accounting and auditing standards.



4. Threats and how to avoid or reduce them to an acceptable level

4.1! Self-interest threats

Example of threat How it can be avoided or reduced to an acceptable level

Financial interest arising from holding shares in a client.

Shares in clients must not be owned by members of the audit team or their immediate family members.

Contingent fees, such as an audit fee of $50,000 for a clean audit report, but only $25,000 if the audit report is qualified.

Contingent fees for audit work are not permitted.

Gifts and hospitality, such the audit team being taken out to dinner by a client.

Gifts and hospitality should not be accepted unless clearly insignificant.

High fees from a single client. A very high fee from one client can mean that the auditor is very dependent on that client, is desperate to keep that client, and so will go easy on the client.

Fees from any one client should be kept under review. If the client is a public interest client (such as a listed company or a charity) the fees from that client should not exceed 15% of the firms total fees. If the fees are greater than this then the matter need to be reviewed independently.

Overdue fees. If an audit client still hasnt paid last years fees, then the audit firm will want the clients business to survive so that the fees are paid. This might lead to a clean audit report when really there are problems.

The auditor should not commence an audit if fees are outstanding

Loans from a client. Unless it is the clients normal business to make loans (for example, the client is a bank) and any loans are made on normal business terms, auditors should not accept loans from clients.

Accepting employment from a client. Simultaneous employment with a client and the audit firm is not permitted. Additionally, if a lead audit partner leaves the partnership he or she should not join a public interest client as an employee until at least a year has passed

A partner serving on the board of a client firm.

This is not permitted.



4.2! Self review threats


Preparing financial statements then auditing them.

In non-public interest companies this is permitted provided completely separate teams are used for each function. Except for emergencies, the preparation of financial statements by auditors is not permitted for listed or other public interest companies.

Designing and implementing internal control systems.

Evaluating internal control is often an important audit procedure, so if the auditors had designed the controls they might be blind to any deficiencies and they might be reluctant to subsequently criticise the system.

Valuation Even if the audit firm were professionally competent to do so, valuing, for example, property for the purposes of financial statements that the firm subsequently audited is not permitted.

Taking on management responsibility. For example, participating in board meetings, advising on which strategies to follow

The auditors should avoid this

4.3! Advocacy threats


Promoting the audit client to potential investors or siding with a client in a legal dispute.

Auditors should avoid assignments likely to cause an advocacy threat.



4.4! Familiarity threats


The audit partner is a close relative of the clients finance director

Another partner should run that audit. Close relative is not defined. Does it include brother and sisters, children, nephews and nieces, remote cousins? Judgement must be used and the auditor must be seen to be independent.

Friendships. Familiarity threats can arise even if there is no legal relationship.

Familiarity is a matter of judgement, but the auditor being the life-long best friend of the finance director would be hard to justify.

Familiarity can arise through long-association between audit and client staff. For public interest clients a partner cannot be in charge of the audit for more than seven consecutive years and there must be a gap of at least two years before further involvement.

4.5! Intimidation threats


Threat of litigation. For example, the client alleges that the auditor had been negligent over some matter in the past.

Resign as auditors.

Threat of reporting the auditor to regulatory authorities.

Resign as auditors.



Question 1 What are the five fundamental ethical principles of the ACCA?

Question 2

All students of ACCA are bound by its Code of Ethics and Conduct. Is this statement true or false?

Is this statement true or false?

Question 3 What is the ethical framework?

Question 4 What are the threats to an auditors independence?

Question 5 When may an auditor disclose confidential information about an audit client?

Question 6 For an auditor of a public interest company, what is the maximum fees that can regularly arise from any once client?A! 5%B! 10%C! 15%D! 20%





Chapter 3THE REGULATORY FRAMEWORK1. Sources of regulation

The auditing profession is regulated at three levels:

National International Professional bodies, such as the ACCA

These are not in a hierarchy. For example, some matters to do with auditing and its regulation are set out in national laws and auditors have to comply with the law in the country in which they are operating. No international law or professional rule will override national laws without the agreement of the national government. However, laws are often silent on matters of ethics and, as was seen in the previous chapter, the ACCAs Code of Ethics and Conduct have strict rules on ethical behaviour to which auditors and accountants must adhere.

2. National levelLaws and regulations vary greatly from country to country. For example, on matters of corporate governance, the Sarbanes Oxley Act in United States of America is very prescriptive and sets out in great detail how companies should be governed. By contrast, in Europe, corporate governance is much more principles-based than rules based.

National legislation, when it exists, is more powerful than international laws or professional rules. In particular national legislation determines who can be an auditor. This function can be carried out directly by government or delegated to a Recognised Supervisory Body. The ACCA is a Recognised Supervisory Body (RSB).

RSBs are required to ensure that:

Their members hold appropriate qualifications Are open only to fit and proper persons Have adequate rules and practices to ensure professional integrity and

independence. These include monitoring members and disciplinary procedures.

RSBs are also Recognised Qualifying Bodies and will:

Set out appropriate entry requirements Determine appropriate theoretical instruction and professional experience Set examinations



3. The international level

3.1! Introduction

As businesses and investment have become more and more international, there has been a need to make financial statements from companies operating in different countries more comparable. It is very difficult to compare companies if their financial statements are produced using different approaches. Similarly, standards of auditing could vary widely so that financial statements from some countries were much less reliable than those from others.

3.2! IFAC (the International Federations of Accountants)

IFAC is the international organisation of accountancy bodies, dedicated to serving the public interest by strengthening the profession and contributing to the development of international economies. IFAC is based in New York and its formal mission is to:

serve the public interest by: contributing to the development ofhigh-quality standards and guidance; facilitating the adoption and implementation of high-quality standards and guidance; contributing to the development of strong professionalaccountancy organisations and accounting firms and to high-quality practices by professional accountants, and promoting the value of professional accountants worldwide; and speaking out on public interest issues.

IFAC's view is that a fundamental way to protect and serve the public interest is to develop, promote, and enforce high-quality, internationally recognised standards for:

auditing and assurance education ethics, and public sector accounting.

These standards and related regulation are essential to ensuring the credibility of information upon which investors and other stakeholders depends and to achieving sustainable global economic development. As a result, IFAC supports the following independent standard-setting boards:

International Auditing and Assurance Standards Board International Accounting Education Standards Board International Ethics Standards Board for Accountants International Public Sector Accounting Standards Board

It promotes convergence to the standards issued by the boards as well as to the International Financial Reporting Standards (IFRSs) set by the International Accounting Standards Board. It also collaborates with member bodies and works with organisations throughout the world to support the growth and development of the accountancy profession in emerging economies.

More recently The Public Interest Oversight Board (PIOB) has been established. The PIOB ensures that these activities are properly responsive to the public interest; that due process is followed, including international exposure and consultation; and that the views of all those affected by new standards are thoroughly considered. Before the PIOB was established, there was a danger that IFAC and the standard setting bodies were too inward-looking. Now a much wider range of interested parties is represented.

The ACCA is a member of IFAC.



3.3 ! The International Auditing and Assurance Standards Board (IAASB).

The IAASB is a sub-committee of IFAC and is responsible for setting the International Standards on Auditing (ISAs). As of November 2011, over 75 jurisdictions are using or have signalled their intent to use the ISAs. The IAASB also sets assurance standards, including those for review engagements, as well as standards for related services.

The ISAs set out how various aspects of auditing should be carried out for material items in the financial statements. Auditors are expected to comply with the ISAs in all but the most exceptional circumstances or where national legislation prevents compliance.

The ISAs (and other examinable documents) covered by this syllabus are:

The accounting knowledge that is assumed for Paper FAU is the same as that examined in Paper FA1 and Paper FA2. Therefore, candidates studying for Paper FAU should refer to the Accounting Standards listed under Paper FA1 and Paper FA2. Candidates will also be expected to be familiar with Paper FFA.

International Standards on Auditing (ISAs)

Glossary of Terms

Preface to International Standards on Quality Control, Auditing, Review, Other Assurance and Related Services

ISA 200 ! Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISAs

ISA 220 ! Quality Control for an Audit of Financial Statements ISA 230 ! Audit Documentation ISA 260 ! Communication with Those Charged with Governance ISA 265 ! Communicating Deficiencies in Internal Control to Those Charged with

Governance and ManagementISA 300! Planning an Audit of Financial Statements ISA 315 ! Identifying and Assessing the Risks of Material Misstatement through

Understanding the Entity and Its EnvironmentISA 320 ! Materiality in Planning and Performing an Audit ISA 330 ! The Auditors Responses to Assessed Risks ISA 450 ! Evaluation of Misstatements Identified During the Audit ISA 500 ! Audit Evidence ISA 501 ! Audit Evidence Specific Considerations for Selected Items ISA 505 ! External Confirmations ISA 520 ! Analytical Procedures ISA 530 ! Audit Sampling ISA 540 ! Auditing Accounting Estimates, Including Fair Value Accounting Estimates

and Related DisclosuresISA 560 ! Subsequent Events ISA 570 ! Going Concern ISA 580 ! Written Representations ISA 700 ! Forming an Opinion and Reporting on Financial Statements ISA 705 ! Modifications to the Opinion in the Independent Auditors Report



Other Documents

ACCAs Code of Ethics and Conduct

Question 1 The international organisation of accountancy bodies, dedicated to serving the public interest by strengthening the profession and contributing to the development of international economies is known asA! IASSBB! IESBAC! IFACB! IAS

Question 2 What is the function of the Public Interest Oversight Board?

Question 3 Which sub-committee sets the international Standards on Auditing?

Question 4

The rules set out in the International Standards on Auditing always override national regulations governing the audit of the financial statements of companies




Chapter 4AUDIT RISK1. Introduction

Audit risk is the risk that the auditor gives an inappropriate opinion on the financial statements.

For example, the auditors state that the financial statements are true and fair but they actually contain a material misstatement.

There are no guarantees or absolute assurance in auditing: there is only reasonable assurance that there are no material misstatements. Therefore, the auditor is subject to the risk that the opinion might be wrong and the auditor must manage this risk and must weigh up:

the amount of audit work that has to be done the damage to reputation that will be done if the audit report is incorrect the type of business the audit fee the potential damages that might have to be paid whether or not it is worth having the client at all.



2. Client acceptance

2.1! Investigations

It is, of course, flattering to be asked to be a companys auditor. The assumption is that the company has heard good reports and a new audit means new fees. However, risk management starts with an investigation of whether or not the firm should take on the new company at all or not. There are ethical, practical and risk-related issues:

Is it ethical to take on the new work? For example, there might be close personal relationships to consider or the new fee income would make the auditor unduly reliant on that client.

Will the auditor be able to meet the professional competence and due care criteria? For example, the potential client might be an insurance company but the auditor has no experience of auditing such specialist businesses.

Is it practicable to take on the new work given the size of the job and the auditors current staffing levels and commitment to existing clients?

What is known about the type of business, its directors and its owners? Some types of business are more risky than others, some businesses might be in business sectors the auditor feels might cause reputational damage, and some directors can have shady pasts.

Is the fee acceptable?

The steps that an auditing firm should take before agreeing to become the auditors of a new client are therefore:

Ensure that it is professionally qualified to act on both ethical and legal grounds. Ensure that existing resources are adequate to cover both the required expertise and

the time that the new work will take Investigate the company, its owners and directors Communicate with the present /outgoing auditor.

The last step is obligatory: the outgoing auditor will be well-placed to tell the new auditor if there are professional or other reasons why the work should not be accepted. For example, the out-going auditor might simply say that they think that the client had become too big for them and that they were not able to continue. Alternatively, if they say something like there were serious disagreements over the financial statements and the directors were not willing to amend them, then the new auditors might think twice about becoming involved with what might be a difficult set of directors.



The full process when taking over from a previous auditor is as follows:

Ask the client for permission to contact the outgoing auditor. If the new client refuses, the appointment should be refused (what are they trying to hide?)

Contact the outgoing auditor and ask if there are any reasons why they should not accept appointment.

The outgoing auditor has to ask the clients permission to contact the new auditor (confidentiality rules require this). If the client refuses, the appointment should be refused (what are they trying to hide?)

Assess any information received in the reply, together with other evidence collected independently.

2.2! Engagement letter

Assuming that the auditor wants to accept the new client, then a letter of engagement will be sent out to the client. This forms the contract between auditor and client, so it is a very important document. Typical matters covered in the latter include:

Setting out the respective responsibilities of management and auditors The scope of the audit (reasonable assurance, financial statements, material

misstatements, not primarily trying to detect fraud) The financial reporting framework to be used. The form of any reports to be issued The auditors entitlement to see all documentation and receive all explanations

necessary for the audit. Practical arrangements, such as timing and the involvement of internal audit. The fee.

3. The audit process

3.1! Introduction

Once the audit has been accepted then the audit process can begin. There are essentially three stages to most audits:

Planning. This will often require a meeting with the client certainly in the first year of a new audit. Subsequently, a planning phone call might suffice for smaller clients. For new audits the auditor will want to meet senior staff and to see clients premises. They will want to discuss any problems that might have arisen in previous audits or any special reports needed by the client. In subsequent years, the auditor will be particularly interested in changes that the client has undertaken during the year such as a new accounting system, additional premises, changes in senior personnel and accounting or trading problems.

An interim audit. This takes place typically four or five months before the end of the accounting period. This is when the accounting system and internal controls are examined and tested.

A Final audit. This happens typically a few weeks after the accounting period end to allow the client to prepare the draft financial statements. It is on these statements that the auditor will be reporting.



A more detailed depiction of an audit is as shown below:

Planning the audit

Good internal control expected

Understand the entity and its environment

Test internal control

Responses to risk

Preliminary estimate of materiality

Assessment of risks

Poor internal control expected

Restricted substantive

testing

Good internal control

expected

Poor internal control

(letter to management)

Report

Final review

Full substantive

testing

3.2 ! Planning the audit

This is an essential stage in any audit. Indeed, in the audit report the auditor states that the audit was planned.

The first step is to understand the entity (client) and its environment. Information that will be collected includes:

Nature of the clients business Key customers, competitors and suppliers Location of operations, factories, shops and so on Organisational structure Recent sets of financial statements Industry comparatives Names of directors Organisational objectives



Changes to the IT system Industry regulation Industry growth/decline Accounting policies Initial assessment of internal control procedures

Based on this information preliminary estimates of materiality can be made. Risks arise from material misstatements so it is necessary to have an early idea of what sizes of errors are likely to be material.

This information will also give the auditor some insight into the higher risk areas of the audit. Risk would be increased, for example, if:

The business operates with cash sales Inventory consists of small high value items (such a jewellery) There are many dispersed locations A new IT system has been introduced.

The auditor will respond to the risk assessment by designing appropriate audit procedures aimed at supplying sufficient appropriate audit evidence that the financial statements are free from material misstatement.

For example, in the case of inventory consisting of small high value items it will be necessary to take great care over the audit of inventory. If a new IT system had been introduced during the year, the auditor will have to carry out additional work on accounting entries just after its implementation because the transition from old to new system might not have gone smoothly.

3.3! The purposes of audit planning

Planning an audit involves establishing the overall audit strategy for the engagement and developing an audit plan. Adequate planning benefits the audit of financial statements in several ways, including the following:

Helping the auditor to devote appropriate attention to important areas of the audit. Helping the auditor identify and resolve potential problems on a timely basis. Helping the auditor properly organise and manage the audit engagement so that it is

performed in an effective and efficient manner. Assisting in the selection of engagement team members with appropriate levels of

capabilities and competence to respond to anticipated risks, and the proper assignment of work to them.

Facilitating the direction and supervision of engagement team members and the review of their work.

Assisting, where applicable, in coordination of work done by auditors of components and experts.



3.4! Audit strategies and audit plans

Auditors are expected to produce and document both audit strategies and audit plans.

In establishing the overall audit strategy, the auditor shall:

(a) Identify the characteristics of the engagement that define its scope;

(b) Ascertain the reporting objectives of the engagement to plan the timing of the audit and the nature of the communications required. This will include the timing of any reports needed, the nature of the reports and for whom the reports are being prepared.

(c) Consider the factors that, in the auditors professional judgment, are significant in directing the engagement teams efforts. For example, ensuring that looking carefully a whether the company is likely to survive in the foreseeable future.

(d) Consider the results of preliminary engagement activities and, where applicable, whether knowledge gained on other engagements performed by the engagement partner for the entity is relevant; and

(e) Ascertain the nature, timing and extent of resources necessary to perform the engagement. This will includes deciding the number staff needed, their experience and seniority. It will also include deciding to what extend third parties might needed for some of the audit work, for example, surveyors might be needed to assess the stage of completion of a building.

The audit plan will include:

(a) The nature, timing and extent of planned risk assessment procedures. This can be in considerable detail as shown below.

(b) The nature, timing and extent of planned further audit procedures

(c) Other planned audit procedures that are required to be carried out so that the engagement complies with ISAs

An excerpt form an audit plan relating to receivables is:

Circularise a sample of customers asking them to confirm their amounts owing at year end.

Circularise:All customer with balances > $100,00050 with balances > $50,000 $100,00025 with balances


4. Materiality

4.1! Introduction

An item is material if its omission or misstatement could reasonably be expected to alter the economic decisions of users of the financial statements.

An item can be material through its size, incidence and nature. For example, directors remuneration has to be disclosed in the financial statements and no misstatement of these is likely to be considered immaterial. Similarly there is no excuse for failing to state the cash at bank figure accurately. However, with inventory, there can often be considerable judgement needed to arrive at a fair value, and materiality will be less strict.

Materiality is ultimately a matter for the judgement of the audit partner. Just how will shareholders be influenced by a figure? Are they all likely to be influenced the same way? Although it will be up to the partner to make the final decision, it is important for members of the audit team, many of whom are very junior and inexperienced, to be given some guidance. There is little point on an auditor spending a lot of time asking for a $5 error to be corrected in the financial statements of a multi-national company. Therefore, they work with preliminary indicators of materiality and if an error exceeds these then is should be brought to managements attention and, if not corrected, should be noted for the partners consideration.

4.2! Common benchmarks for materiality

Common materiality benchmarks (and you need to know these for your exam) are:

Profit before tax:! 5% 10% Revenue:! ! % - 1% Total assets! ! 1% - 2%

4.3! Performance materiality

Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures.

Consider this example: wages, electricity, depreciation, rent are all understated by 3%. Each item on its own might have an immaterial effect on profits, but taken together, because the errors add up the same way, the effect could be material. Therefore, the concept of performance materiality was developed so that materiality levels are reduced during testing so that more errors will be reported.



5. Analytical procedures

5.1! Introduction

Analytical procedures are extremely useful at the planning stage of an audit. The term analytical procedures means evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. For example, if sales rise you might also expect the packaging cost to rise. Analytical procedures includes investigation of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. So, if packaging costs do not rise in line with sales, the fear is that there has been an accounting error. Of course, the apparent discrepancy might be explained by the company having adopted cheaper packaging.

5.2! Type of analytical procedures

Analytical procedures include comparison of the entitys financial information with, for example:

Comparable information for prior periods. Anticipated results of the entity, such as budgets or forecasts, or expectations of the

auditor, such as an estimation of depreciation. Similar industry information, such as a comparison of the entitys ratio of sales to

accounts receivable with industry averages or with other entities of comparable size in the same industry.

Comparison of financial and related non-financial information. For example, number of hotel guests x average price per room should be approximately equal to room revenue.

Various methods may be used to perform analytical procedures. These methods range from performing simple comparisons to performing complex analyses using advanced statistical techniques.



6. The audit risk model

6.1! Introduction

At the start of this chapter, audit risk was defined as the risk that the auditor gives an inappropriate opinion on the financial statements. Proper planning is essential to reduce audit risk by, for example, giving appropriate attention to important of high risk areas of the audit.

However, this common sense approach to audit has an extremely important theoretical foundation that shows how risk can build up or be reduced.

6.2! The components of audit risk

Audit risk = Inherent risk x Control risk x Detection risk

Inherent risk:! the susceptibility of an assertion to misstatement that could be materialassuming that there were no related internal controls. In other words, the risk of an error occurring in the first place.

Control risk:! the risk that the misstatement will not be prevented, detected and corrected on a timely basis by the entitys internal control

Detection risk:! the risk that the auditors procedures will not detect the misstatement.

Therefore, for a material error to get into the published financial statements together with in inappropriate audit report, three things have to happen:

(1) The error has to have occurred (inherent risk)(2) It must not have been picked up by the clients internal control system (control risk)The error is now in the financial statements that are about to be audited, and together these two risks determine the risk of a material misstatement occurring.(3) The financial statements are audited, but the auditor does not detect the misstatementThe error will now be in the published financial statements that have an inappropriate audit report and which are sent to shareholders.

6.3! What causes the risks?

Inherent risk can be increased by factors such as:

Complex transactions Inexperienced staff Time pressure New IT systems Pressure to perform (leading to optimistic estimates) Cash businesses

Control risk can be increased by:

A poor internal control system



Poor supervision Poor compliance with internal control procedures In-experienced staff Shortcuts An unfavourable control environment (not supportive of internal controls).

Detection risk is decreased by:

Performing more audit work eg larger samples are tested. Performing different audit work eg by attending inventory locations in every branch or

by enlisting the help of experts. Assigning more experienced staff. Careful supervision and review of the audit work Peer reviews (one partner reviewing the work of another)

6.3! What can be done about the risks?

The auditor can do little about the inherent risk. Over time the auditor might be able to decrease the control risk by writing to the client and making recommendations about how the internal control system could be improved or more consistently implemented. However, that auditor can affect the detection risk as that is determined by the amount and nature of the audit work carried out.

Therefore, if inherent risk and/or control risks are high, the auditor can reduce audit risk to an acceptable level by performing more audit work.

If inherent risk and control risk are both low, the auditor will perform less work because there is only a low risk of an error having occurred and then only a low risk that the clients system will not detect the misstatement.

6.4! Professional scepticism

The amount of audit work that has to be carried out should be influenced by the concept of professional scepticism. If you are sceptical it means that you do not know whether or not something is true; you would have a questioning attitude and would not believe something in the absence of reasonable evidence.

Auditors must adopt this attitude. This does not mean that they suspect all directors and employees in the client company of telling lies and deliberately misleading them, but they are aware that everyone makes mistakes, everyone can be a victim of unrealistic optimism, and that everyone can give quick but incorrect replies if under time pressure. Of course, human nature being what it is, occasionally auditors will be deliberately given incorrect information.

Therefore, professional scepticism means walking a tight-rope between being completely disbelieving and completely accepting of all management statements.

Professional scepticism affects the amount of audit work that has to be carried out. It includes being alert to, for example:

Audit evidence that contradicts other audit evidence obtained. Information that brings into question the reliability of documents and responses to

inquiries to be used as audit evidence. Conditions that may indicate possible fraud.



Circumstances that suggest the need for audit procedures in addition to those required by the ISAs.

Maintaining professional scepticism throughout the audit is necessary if the auditor is, for example, to reduce the risks of:

Overlooking unusual circumstances. Over generalising when drawing conclusions from audit observations. Using inappropriate assumptions in determining the nature, timing and extent of the

audit procedures and evaluating the results thereof.

6.4! Fraud

It is not the auditors responsibility to detect fraud though if it gives rise to a material misstatement, an audit should give rise to reasonable assurance that the fraud is discovered. Fraud may involve sophisticated and carefully organised schemes designed to conceal it. Therefore, the procedures used to gather audit evidence may not be effective for detecting an intentional misstatement that involves, for example, collusion to falsify documentation which may cause the auditor to believe that audit evidence is valid when it is not.

Nevertheless, as part of planning the audit, the engagement team members and the engagement partner must discuss on how and where the entitys financial statements may be susceptible to material misstatement due to fraud, including how fraud might occur.

Question 1 What are the three components of audit risk and which can the auditor most easily affect?

Question 2

It is the auditors responsibility to detect fraud.


Question 3

Professional scepticism means not trusting anyone




Question 4 Which two of the following would increase the risk of a misstatement in the draft financial statements presented to an auditor to audit?A! Inexperienced accounting staffB ! Inexperienced auditorsC! Complex transactionD! A good system of internal control

Question 5 What are the commonly used preliminary estimates of materiality in terms of profit, turnover and total assets?

Question 6 What is the purpose of an engagement letter?

Question 7 What are the four things an auditor must consider before accepting a new appointment?



Chapter 5TESTS OF CONTROL OR SUBSTANTIVE TESTS?1. Introduction

The previous chapter introduced both the following diagram of the audit process and the components of audit risk:

Planning the audit

Good internal control expected

Understand the entity and its environment

Test internal control

Responses to risk

Preliminary estimate of materiality

Assessment of risks

Poor internal control expected

Restricted substantive

testing

Good internal control

expected

Poor internal control

(letter to management)

Report

Final review

Full substantive

testing

and the audit risk mode

Audit risk = Inherent risk x Control risk x Detection risk

We now bring these concepts together to determine how the audit will proceed.



2. Test internal controls or use full substantive testing?

2.1 ! Test internal controls

If the internal control system of the company is good, then the control risk is low and this will result in a low audit risk provided the controls are being carried out as they should be.

The audit will therefore proceed down the left hand side of the diagram and will substantially rely on testing the internal controls for their design and their operation. Testing controls means what it says: the auditor tests that the controls are operating rather than testing amounts in the financial statements.

For example, if an internal control is that all overtime claims have to be authorised by a supervisor, then the auditor would choose a sample of the claims to inspect them for the supervisors signature. As part of this test, the auditor is not really concerned with the amount of overtime: if the supervisor has been doing his or her job properly, the overtime payments will have been approved.

2.2! Substantive tests

If the internal control system is poor the auditor has few controls to test because the client has not implemented any. The control risk is high. Therefore, the only way that the auditor can get evidence that amounts are correct is to carry out more audit detection work by performing substantive tests, and the audit will proceed down the right hand side of the diagram. Substantive tests attempt to verify directly the items in the financial statements. There are two types of substantive tests:

Analytical procedures Tests of detail

So, using the overtime example, now the claims have not been authorised by the supervisor, so that auditor has do find evidence that the overtime cost is correct.

Analytical procedures:

Compare to the previous year Compare to budget Compare month by month and investigate very high or low amounts Try to tie in overtime payments to production volume Compare overtime payments amongst staff in the same department to see if anyone

appears to be consistently paid large amounts.

Tests of detail

Inspect and compare a large number of overtime claims to work records. Enquire of the supervisor and management about why any particularly large overtime

payments had been necessary.

2.3! Internal controls not operating effectively

Sometimes the auditor will start the audit on the assumption that there is a good internal control system, but then discover that the controls are not operating effectively.



In such a case the auditor will have to change approach and switch to the full substantive approach at least for the areas where internal control is not effective.

A management letter will be sent by the auditors to the companys management explaining:

The nature of the internal control weakness. The possible consequences How the internal control deficiency can be fixed.

2.4! Restricted substantive testing

Even where companies have very good systems of internal control, testing controls is never exclusively relied upon and there is always some substantive tests performed on material amounts in the financial statements.

Internal controls have some inherent limitations which mean that relying on them exclusively would be dangerous. The inherent limitations are:

Human error and judgement ! human error may lead to breakdowns in internal control. For example, in the design of computer processing controls.

Failure to understand or take action! there may be ineffective controls because individuals may not understand the purpose of a specific control. For example, the purpose of a payroll exception report.

Inappropriate management override of controls! management may purposefully override existing controls. For example, a sales director may choose to opt to extend credit to a long-standing customer in order to create customer goodwill, in contravention of laid down credit control procedures.

Collusion by two or more people! leading to circumnavigation of controls. For example, between a factory employee, factory manager and a wages data processing clerk to claim, authorise and process a fraudulent payment for overtime wages.

Management judgement ! with regard to the nature and extent of risk the company faces. For example, management might underestimate the risk of fraud.

Cost benefit consideration! For example, the cost of employing additional accounts staff to ensure adequate segregation of duties may outweigh the maximum benefit to be derived from improved internal control.



Ability to cope with non-routine transactions! the ability to predict the likelihood of non-routine transactions arising means that it is less likely that systems will be designed to cope with such transactions. For example, the purchase of a very expensive non-current asset.

2.5! Audit efficiency

If there is a good internal control system, and this is verified by testing the operation and effectiveness of the controls, then that can be substantially relied upon to prevent material errors occurring in the financial statements. This will result in a very efficient audit because relatively few instances of the control operating have to be tested: typically about 30. Therefore in a multi-million $ enterprise with thousands of invoices being processed, the auditor can collect sufficient appropriate audit evidence that, for example, an invoice cannot be paid twice by inspecting around 30 paid invoices to make sure that they have been marked Paid or cancelled in some other way. Marking the invoices Paid is part of the internal control system and if all invoices inspected have been properly cancelled the auditor will assume that the control is operating correctly. This is obviously a very efficient audit approach. Its not foolproof, of course, as there could be invoices that have slipped through the system and which were paid twice, but the audit test will provide reasonable assurance that there are no misstatements.

If 5 out of the 30 invoices inspected had not been cancelled, then the auditor will probably look at another 30 to see the extent of the internal control breakdown. If there is a high number in the additional invoices not cancelled, then the auditor might conclude that the control cannot be relied upon and will have to turn to substantive testing in which a very large number of payments might have to be inspected.

If the internal control system had originally been judged to be poor, then the substantive route would have been taken from the start and this usually means high volume testing of transactions. This is usually a much less efficient route to collect the sufficient appropriate audit evidence.

Occasionally, the substantive route might be taken even if controls do exist. For example, auditors may decide that 100% testing appropriate where there are a small number of high value items that make up a population, or when there is a significant risk of material misstatement and other audit procedures will not provide sufficient appropriate audit evidence. An example would be a property company that has have 20 purchase/sale transactions in the year. Each transaction is likely to be material and there is no gain in efficiency or audit effectiveness by not looking at all 20.



Question 1 What are the two classes of substantive test?

Question 2 Which approach to auditing will normally result in a more efficient audit? An audit relying primarily on:A ! Tests of controlB! Substantive tests

Question 3

If internal control is very good, auditors can rely on tests of control and do not need to carry out any substantive testing.


Question 4 What are the three elements of a management letter?





Chapter 6ASSERTIONS AND AUDIT EVIDENCE1. Introduction

When a figure appears in financial statements it is making a number of assertions. For example, if the receivables figure is $2,453,000, then figure is asserting:

The amount has been properly valued The receivables are owned by the company The receivables exist The receivables are complete The amount is indeed properly described as receivables.

It is not possible to simply audit $2,453,000 in one go: each assertion that figure is making requires audit evidence.

2. The assertions

2.1! Introduction

The full list of assertions is often remembered by the acronym ACCA COVER:

Accuracy Completeness Cut-off (that an event or transaction has been included in the correct period) Allocation (that correct labour and overhead costs are included in inventory) Classification and understandability Occurrence Valuation Existence Rights and obligations (for example, is the asset owned outright or leased).

However in ISA 315 the assertions are divided into three groups. The names of the assertions are as set out in ISA 315; in ACCA cover, above, they were slightly altered to allow the acronym.



2.2 ! Assertions relating to presentation and disclosure

(a) Occurrence and rights and obligationsdisclosed events, transactions, and other matters have occurred and pertain to the entity.

(b) Completenessall disclosures that should have been included in the financial statements have been included.

(c) Classification and understandabilityfinancial information is appropriately presented and described, and disclosures are clearly expressed.

(d) Accuracy and valuationfinancial and other information are disclosed fairly and at appropriate amounts.

2.3! Assertions relating to classes of transactions and events for the period under audit

(a) Occurrencetransactions and events that have been recorded have occurred and pertain to the entity.

(b) Completenessall transactions and events that should have been recorded have been recorded.

(c) Accuracyamounts and other data relating to recorded transactions and events have been recorded appropriately.

(d) Cutofftransactions and events have been recorded in the correct accounting period.

(e) Classificationtransactions and events have been recorded in the proper accounts.

2.4! Assertions relating to account balances at year end

(a) Existenceassets, liabilities, and equity interests exist.

(b) Rights and obligationsthe entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

(c) Completenessall assets, liabilities and equity interests that should have been recorded have been recorded.

(d) Valuation and allocationassets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.



3. Audit evidence

3.1! Audit procedures for obtaining audit evidence

These are the possible procedures:

Inspection Observation External confirmation Recalculation Reperformance Analytical procedures Enquiry

For the sake of easy learning they are sometimes written to (almost) form the vowels AEIOU:

Analytical procedures Enquiry and confirmation Inspection Observation RecalcUlation and reperformance

There are no methods to collect evidence that cannot be categorised under one of these headings.

All methods can be used for substantive testing; all except analytical procedures can be used for tests of control.



3.2! Examples of evidence collecting procedures

Procedure Example of use in tests of control

Example of use in substantive tests

Analytical procedures Comparison of receivables collection period from one year to the next to test the assertion of valuation.

Enquiry and confirmation Ask the sales order clerk if he/she performs a credit check before accepting an order.

Ask the directors if all liabilities have been included in the financial statements to test the assertion of completeness.

Confirm the amounts in receivables by obtaining written confirmation form debtors.

Inspection Inspect times sheets to ensure that they have been signed by the supervisor as authorisation

Inspect computers in the office to test the assertion of existence.

Observation Observe warehouse staff counting goods as they arrive to ensure the quantity is as ordered.

Observe the process of despatch and sales recording to test the assertion of completeness.

Recalculation and reperformance

Reperform the bank reconciliation to ensure that it is being carried out correctly

Recalculate the year-end receivables ageing analysis and subsequent provision for doubtful receivables to test the assertion of valuation

Note that for each substantive test, the assertion tackled by the procedure is described. Note that a test of control, tests the operation of a control. Tracing amounts from invoices to the nominal ledger is not a test of control: this is a test of detail (a substantive test). Inspecting the invoices to see that the nominal ledger account code had been indep