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Notes FIA Paper FAU Foundations in Audit For exams in 2013

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ExPress Notes

FIA Foundations in Audit

Contents

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About ExPress Notes

3

1.

Business environment and audit framework

7

2.

Audit planning and risk

14

3.

Internal control

20

4.

Audit evidence and procedures

25

5.

Audit completion

49

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ExPress Notes

FIA Foundations in Audit

START About ExPress Notes

We are very pleased that you have downloaded a copy of our ExPress notes for this paper. We expect that you are keen to get on with the job in hand, so we will keep the introduction brief. First, we would like to draw your attention to the terms and conditions of usage. It’s a condition of printing these notes that you agree to the terms and conditions of usage. These are available to view at www.theexpgroup.com. Essentially, we want to help people get through their exams. If you are a student for the ACCA exams and you are using these notes for yourself only, you will have no problems complying with our fair use policy. You will however need to get our written permission in advance if you want to use these notes as part of a training programme that you are delivering. WARNING! These notes are not designed to cover everything in the syllabus! They are designed to help you assimilate and understand the most important areas for the exam as quickly as possible. If you study from these notes only, you will not have covered everything that is in the ACCA syllabus and study guide for this paper. Components of an effective study system On ExP classroom courses, we provide people with the following learning materials: • • • •

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ExPress Notes

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ExPress Notes

FIA Foundations in Audit

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ExPress Notes

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ExPress Notes

FIA Foundations in Audit Chapter 1

Business environment and audit framework

START The Big Picture For the financial markets to be efficient they need trust. The investors must believe that the financial reports of companies are true and free from errors. This assurance is provided by external accountants that apply specialist procedures to the information presented by companies in their financial statements. These accountants are called auditors and are licensed by certain organizations of public trust or by governments directly. In order for their assurance to be meaningful there are some strict requirements on who they should be and how they should behave. These relate primarily to their independence – there can be no doubt that they work in the best interest of shareholders rather than the companies being audited. In the past, when such doubts arouse – this led to the collapse of both the company and its auditor (eg. Enron and Arthur Andersen) as investors stopped believing both the company’s financial reports and their auditors.

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FIA Foundations in Audit

KEY KNOWLEDGE The purpose and scope of an audit The need for the audit of the financial statements comes from the demand for trust in financial markets. Shareholders of companies hire managers to manage their businesses. Periodically those owners want to assess the effectiveness of the management actions. Thus they read the financial statements. Yet it is the managers that are responsible for the preparation of the financial statements. In order to remove the potential conflict of interest, the shareholders appoint auditors – professionals who will assert that the content of the financial statements shows a true and fair view of the company’s financial position and performance in accordance with an accepted reporting framework (eg. International Financial Reporting Standards). hire

Owners

own

Auditors for

The company Financial statements is managed by

to make sure that the financial statements are free from material misstatement.

The managers who prepare The scope of auditor’s work is to provide reasonable (rather than absolute) assurance that the financial statements are free of material misstatement. They provide reasonable assurance because their work is performed on a test basis – given the limited time they have to perform their procedures – auditors cannot verify every single transaction and event (which would effectively mean – reperform the accountant’s work over the period) – they will first analyse the internal control environment to check whether material misstatements could be made by lack of controls and then they will verify samples of transactions and balances to make sure that the ultimate financial statements are not materially misstated.

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FIA Foundations in Audit

KEY KNOWLEDGE Requirements for becoming an auditor Only a member of a Recognised Supervisory Body (eg. ACCA) may act as an auditor if that person is allowed to do it by the rules of that body. In some jurisdictions auditors are authorized directly by the state. Since his role is to provide assurance on the financial statements of the company the key requirement for becoming an auditor in a company is that they must be independent of that company. Independence is defined as freedom from situations and relationships where objectivity would be perceived to be impaired by a reasonable and informed third party. An auditor must be and must be seen to be independent. This means that despite his own feeling about his independence and objectivity, it must be absolutely clear to any informed external third party that there is no threat to the auditor’s objectivity. There are 5 threats to independence that the auditor must be aware of: 1. Self interest – eg. when the auditor is also an investor in the company (or a lender) – this poses a threat that his views on the financial statements will be impacted by his investment decisions. 2. Self review – eg. when financial statements contain information prepared by the auditor (through provision of some other services). 3. Advocacy – eg. when the auditor may be perceived as willing to unduly support company’s views without professional skepticism. 4. Familiarity – eg. when the auditor becomes too familiar with the company staff. 5. Intimidation – eg. when the auditor may be deterred from acting objectively by threats, actual or perceived. In order to reduce the threats above the audit profession requires auditors to introduce safeguards against those threats. Those safeguards will be implemented at the level of the profession (eg. through education and experience requirements), at the level of an audit firm (eg. through work practices, recruitment and oversight procedures) and at the level of an individual (eg. being in contact with professional bodies, complying with continuous professional development requirements of the professional body).

Professional ethics Auditors are required to adhere to the Code of Ethics issued by their professional body (eg. ACCA for ACCA members with practicing certificates).

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FIA Foundations in Audit A Code of Ethics was issued by IFAC (International Federation of Accountants) which contains key requirements that auditors should meet. Based on this code the professional bodies built their own Code of Ethics which may be more demanding than the one of IFAC. The professional bodies have the right to discipline their for non-compliance with their Code of Ethics. This discipline eventually ends with being removed from the register of members of the body which effectively means – being removed from the profession. The fundamental principles require the auditors to maintain 5 qualities in their behavior: 1. Integrity – auditors should be straightforward and honest in all professional and business relationships. 2. Objectivity – auditors should not allow bias, conflicts of interest or undue influence of others to override professional or business judgments. 3. Professional competence and due care – auditors have a continuing duty to maintain professional knowledge and skill at a level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques. 4. Confidentiality – auditors should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority or unless there is a legal or professional right or duty to disclose. 5. Professional behaviour – auditors should comply with relevant laws and regulations and should avoid any action that discredits the profession.

KEY KNOWLEDGE Legal duties of auditors In accordance with ISA 200 the auditor's duties are to:

• obtain reasonable assurance about whether the financial statements as a whole • •

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are free from material misstatement, whether due to fraud or error; express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable reporting framework; and report on the financial statements, and communicate as required by ISA's, in accordance with the auditor's findings.

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ExPress Notes

FIA Foundations in Audit

KEY KNOWLEDGE Auditor’s rights During his work the auditor has the right to:

• Access to the company’s books and records. • Receive information and explanations necessary for the audit. • Ro receive notice of and attend any general meeting of members of the •

company. Be heard at such meetings on matters of concern to the auditor.

KEY KNOWLEDGE Liabilities of auditors Auditors are liable for professional negligence which an auditor may incur because of an act or default by him/her or by one of his/her employees or associates which results in financial loss to a client or third party to whom a duty of care is owed. In recent years there have been a number of cases where substantial sums have been claimed as damages for negligence against accountants and auditors. In a number of cases it appears that the claims may have arisen as a result of some misunderstanding as to the degree of responsibility which the accountant was expected to assume in giving advice or expressing an opinion. It is therefore important to distinguish between: (a)

disputes arising from misunderstandings regarding the duties assumed (the expectation gap); and

(b)

negligence in carrying out agreed terms.

In order to limit the possibility of any liability to the clients, the auditors should:

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(a)

clearly agree the terms of each engagement in an engagement letter which details the responsibilities of the auditor and separates them from the responsibilities of the company; and

(b)

strictly adhere to the standards of auditing on which the engagement is based (eg. International Standards on Auditing ISA) in their work practices and evidence collection.

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ExPress Notes

FIA Foundations in Audit Other methods of reducing the impact of potential litigation and therefore restricting the liability include: (a)

obtaining a professional indemnity insurance (mandatory in certain jurisdictions);

(b)

acting through a limited liability company (not permitted in certain jurisdictions).

KEY KNOWLEDGE Audit regulation Auditors must follow a number of sets of regulatory guidance: 1.

The Code of Ethics

2.

The Auditing Standards (for this examination – the International Standards on Auditing are the standards to be followed)

3.

Any national legislation relating to the profession of auditors or in general the company law.

KEY KNOWLEDGE The impact of fraud ISA 240 the Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements recognises that misstatement in the financial statements can arise from either fraud or error. The difference is whether the misstatement was intentional or unintentional. Fraud can be of two types: (a)

Misappropriation of assets – the typical theft of company’s assets; or

(b)

Fraudulent financial reporting – leading to unjustified amounts (eg. bonuses) being paid out which effectively is the same as (a).

It is not the auditor’s responsibility to detect fraud. That is because fraud is a criminal activity that is usually well concealed. Auditor’s procedures should however allow to detect material misstatements in the financial statements, including those resulting from fraud. This means that the auditor must consider whether there is a possibility that the financial statements are misstatement as a result of fraud and should obtain sufficient and appropriate evidence on the likelihood of such a misstatement.

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ExPress Notes

FIA Foundations in Audit

KEY KNOWLEDGE External audit and internal audit The IIA (Institute of Internal Auditors) defines internal auditing as follows> “Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a systematic disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.” Fundamental differences between internal and external auditors Both internal auditors and external auditors will have a major interest in the effectiveness of a company’s internal control systems. Both are assurance providers and as such will make use of similar techniques and procedures. Due to these similarities the external auditors may find it useful sometimes to use the work or the products of the work of internal auditors. However, it is important for the external auditor to always be aware of certain fundamental differences as indicated below: SCOPE APPROACH RESPONSIBILITY

INTERNAL AUDITOR MANAGEMENT MANAGEMENT MANAGEMENT

EXTERNAL AUDITOR ISAs + REGULATIONS ISAs + REGULATIONS SHAREHOLDERS

The differences mentioned above lead to different requirements that one would have towards an internal auditor. Eg. the internal auditor cannot possibly by independent of the company (he/she is an employee of the company). Thus a lot of care should be taken by auditors when attempting to use the internal audit in their work.

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ExPress Notes

FIA Foundations in Audit

Chapter 2

Audit planning and risk

START The Big Picture The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement. 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:

• • •

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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 organize and manage the audit engagement so that it is performed in an effective and efficient manner.

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ExPress Notes

FIA Foundations in Audit

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.

KEY KNOWLEDGE Audit strategy, audit plan and audit programme (ISA 300) An overall audit strategy sets the scope, timing and direction of the audit, and guides the development of the audit plan. The process of establishing the overall audit strategy should assist the auditor to determine procedures, such matters as:

The resources to deploy for specific audit areas, such as the use of appropriately experienced team members for high risk areas or the involvement of experts on complex matters;

The amount of resources to allocate to specific audit areas, such as the number of team members assigned to observe the inventory count at material locations, the extent of review of other auditors’ work in the case of group audits, or the audit budget in hours to allocate to high risk areas;

When these resources are to be deployed, such as whether at an interim audit stage or at key cutoff dates; and

How such resources are managed, directed and supervised, such as when team briefing and debriefing meetings are expected to be held, how engagement partner and manager reviews are expected to take place (for example, on-site or off-site), and whether to complete engagement quality control reviews.

Based on this strategy the auditor should develop an audit plan that shall include a description of: (a)

The nature, timing and extent of planned risk assessment procedures

(b)

The nature, timing and extent of planned further audit procedures

The audit plan is more detailed than the overall audit strategy in that it includes the nature, timing and extent of audit procedures to be performed by engagement team members.

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FIA Foundations in Audit Planning for these audit procedures takes place over the course of the audit as the audit plan for the engagement develops. For example, planning of the auditor’s risk assessment procedures occurs early in the audit process. However, planning the nature, timing and extent of specific further audit procedures depends on the outcome of those risk assessment procedures. Audit programme is a list of specific procedures to be performed and documentation to be collected for each specific class of transactions of balances.

KEY KNOWLEDGE Risk assessment procedures (ISA 315) Before collecting audit evidence and performing audit procedures the auditor should perform risk assessment procedures. Those procedures aim at determining the risk of material misstatement in the financial statements. These procedures will include: (a)

(b)

(c)

Inquiries of management, and of others within the entity who in the auditor’s judgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. Analytical procedures (analysis of financial and not financial information in order to detect trends and expectations and investigate potential departures from those trends or expectations). Observation and inspection.

Based on this risk assessment the auditor will conclude on the likelihood of material misstatement at the financial statements level and at the assertion level (eg. whether there are issues with valuation, accuracy, completeness, rights and obligations, occurrence etc.) and designs his/her procedures to make sure that such potential material misstatements are detected.

KEY KNOWLEDGE Understanding the entity and its environment (ISA 315) The auditor must understand the key features of an entity including: (a)

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industry or regulatory factors and applicable reporting framework (eg. IFRS),

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ExPress Notes

FIA Foundations in Audit (b) (c) (d) (e) (f) (g) (h)

the nature of its operations, ownership and structure, entity’s accounting policies, entity’s objectives and strategies, its financial performance in the past, the internal control environment relating to the financial reporting and control activities relevant to audit, the entity’s business risk management process, entity’s IT infrastructure and systems

KEY KNOWLEDGE Audit planning documentation (ISA 300) The documentation of the overall audit strategy is a record of the key decisions considered necessary to properly plan the audit and to communicate significant matters to the engagement team. For example, the auditor may summarize the overall audit strategy in the form of a memorandum that contains key decisions regarding the overall scope, timing and conduct of the audit. The documentation of the audit plan is a record of the planned nature, timing and extent of risk assessment procedures and further audit procedures at the assertion level in response to the assessed risks. It also serves as a record of the proper planning of the audit procedures that can be reviewed and approved prior to their performance. The auditor may use standard audit programs or audit completion checklists, tailored as needed to reflect the particular engagement circumstances.

KEY KNOWLEDGE Audit materiality (ISA 320) Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of

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ExPress Notes

FIA Foundations in Audit uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. Determining materiality involves the exercise of professional judgment. A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole. Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include categories of reported income such as profit before tax (eg. errors in excess of 5-10% of profit are considered material), total revenue (eg. errors in excess of 0,5-1% of revenue are considered material), total assets (eg. errors in excess of 1-2% of total assets are considered material). However planning the audit solely to detect individually material misstatements overlooks the fact that the aggregate of individually immaterial misstatements may cause the financial statements to be materially misstated, and leaves no margin for possible undetected misstatements. Performance materiality (which can be one or more amounts) is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole. In other words performance materiality is a number which is lower than overall materiality and if the procedures are design to detect all errors in excess of performance materiality level – then the risk of a material misstatement resulting from aggregation of undetected errors is reduced to an acceptable low level (that level is determined by the auditor).

KEY KNOWLEDGE Audit risk AUDIT RISK is very simply the overall risk that the auditor gives an inappropriate audit opinion in his report. Eg. if an auditor gave an unqualified opinion, when in fact the company was not a going concern, then shareholders and others placing reliance on this report in making economic decisions relating to their dealings with the company might suffer financial loss. Audit risk is seen as being made up of 3 elements: AUDIT RISK = INHERENT RISK x CONTROL RISK x DETECTION RISK

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FIA Foundations in Audit The auditor must assess inherent risk and control risk but cannot influence them, they are what they are. The only element which the auditor can influence directly is detection risk, which he must do in order to have overall an acceptable level of audit risk. Inherent risk is the risk that there may be material errors or misstatements in the client’s financial statements, before giving consideration to any internal controls that may have been established. Eg. in a high tech company there is high risk of obsolescent inventory which if not recognised could result in a material overstatement of both profits and asset values. Control risk is the risk that the client’s internal control systems will fail to prevent or detect material errors or misstatements. Eg. if there is not effective segregation of duties then there is a much higher risk of employee fraud, without the need for collusion, going undetected. Detection risk is the risk that the auditor’s tests and enquiries will fail to detect material errors or misstatements in the transactions and balances reflected in the client’s financial statements. Eg the detection risk is always greater with a new client because the auditors have had less time to build up their knowledge and understanding of the client’s business and the risks to which it is exposed. Detection risk is seen to include the elements of: 1. Sampling risk – eg. if the auditor selects too small a sample size, it may not be representative of the population from which it is drawn, resulting in the auditor reaching an invalid conclusion about that population. 2. Non-sampling risk – is any other risk that might result in the auditor arriving at the wrong audit conclusion eg. if client management were to deliberately provide the auditor with misleading information and explanations.

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ExPress Notes

FIA Foundations in Audit

Chapter 3

Internal control

START The Big Picture The internal control is a fundamental issue in auditing. The auditor’s assessment of the control environment will impact on the nature, timing and extent of his/her procedures. Logically – the better controls exist in the organization over the accounting and financial reporting process – the lower the risk that misstatements appear in financial statement undetected by the organization itself. In the previous chapter the risk related to this was referred to as control risk. The auditor therefore will always perform an assessment of control environment based on which he/she will determine how much reliance can be placed on entity’s internal controls and thus how much procedure does the auditor need to do (how many procedures, how large sample sizes – the lower level of reliance on controls – the larger the sample to be tested by the auditor).

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ExPress Notes

FIA Foundations in Audit

KEY KNOWLEDGE General principles of internal control ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment states that there are 5 components of internal control: 1. 2. 3. 4. 5.

The control environment The entity’s risk assessment process The information system Control activities Monitoring of controls

The IIA have provided the following useful definition: “An internal control is any action taken by management to enhance the likelihood that established objectives and goals will be achieved. Management plans, organises and directs the performance of sufficient actions to provide reasonable assurance that objectives and goals will be achieved. Thus, control is the result of proper planning, organising and directing by management.” The UK Turnbull report gives us a useful summary of the main purposes of an internal control system, by stating that internal control consists of “the policies, processes, tasks, behaviour and other aspects of a company that taken together: •

• •

Facilitate its effective and efficient operation by enabling it to respond to significant business, operational, financial, compliance and other risks to achieving the company’s objectives. This includes safeguarding the assets from inappropriate use or from loss and fraud and ensuring that liabilities are identified and managed. Help to ensure the quality of internal and external reporting. Help ensure compliance with applicable laws and regulation, and also with internal policies with respect to conduct of business.

Control activities Control activities may be explained by the type or nature of activity. These include (but are not limited to):

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Segregation of duties - separating authorization, custody, and record keeping roles of fraud or error by one person.

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ExPress Notes

FIA Foundations in Audit

Authorization of transactions - review of particular transactions by an appropriate person.

• •

Retention of records - maintaining documentation to substantiate transactions.

Physical safeguards - usage of cameras, locks, physical barriers, etc. to protect property, such as merchandise inventory.

Top-level reviews-analysis of actual results versus organizational goals or plans, periodic and regular operational reviews, metrics, and other key performance indicators (KPIs).

IT Security - usage of passwords, access logs, etc. to ensure access restricted to authorized personnel.

Top level reviews-Management review of reports comparing actual performance versus plans, goals, and established objectives.

Controls over information processing-A variety of control activities are used in information processing. Examples include edit checks of data entered, accounting for transactions in numerical sequences, comparing file totals with control accounts, and controlling access to data, files and programs.

Supervision or monitoring of operations - observation or review of ongoing operational activity.

Recording and evaluating the controls Auditor must record and evaluate those controls. His/her work will have two objectives: (a)

to verify whether a relevant control activity exists Eg. to limit a possible fraud, an auditor would expect that the person making bank transfers is no the same as the person authorized to enter new counterparties into the system – segregation of duties.

(b)

to verify that the control activity is actually performed

Eg. continuing from previous example – if the duties in this area are segregated but the two persons shared their system passwords so that they can cover for each other in case of absence – the control (even though relevant) is not effective and cannot be relied on. The auditor identifies key controls that he/she would expect to see in order to rely on company’s internal control systems, documents their existence in the company and evaluates them through tests of controls. It may be possible that the auditor’s assessment of controls in negative or that the expectation is that they are not existent or not functioning properly (even before testing). In such circumstances the auditor may not place reliance on control (or even not test them)

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ExPress Notes

FIA Foundations in Audit and perform fully substantive procedures ie. extensive audit procedures with large sample sizes to accommodate for the fact that control risk is high.

Techniques to record and evaluate controls in accounting systems IT systems require some additional knowledge from the auditor. Specifically, internal control in a computer environment is normally considered under 2 main headings: 1.

General Controls These relate to the environment within which computer systems are developed, operated and maintained. They will therefore be relevant to all applications. They are often sub-divided into administration controls and systems development controls. They may be either manual or programmed. These will include: use of passwords, segregation of duties between IT and operational staff, back-ups etc.

2.

Application Controls These relate to those activities which have been computerised and are concerned with the completeness and accuracy of the processing of authorised data and the maintenance of computer files. As with general controls, they may be either manual or programmed. These will include: data verification on input (eg. no debit without a corresponding credit), data validation (eg. check digits), access control logs etc.

There are techniques of auditing the systems – the auditor must have an expectation of the controls he/she would see in the system and over the inputs and outputs from the system (have in mind that nowadays nearly all information in the financial statements is generated by the accounting system and thus the control over authorization and validation of inputs into this system becomes crucial). Auditor performs test of controls, often obtaining date from the system and transferring them into spreadsheets to test their accuracy or completeness. Sometimes the auditor is granted access to the system to perform procedures directly on it.

KEY KNOWLEDGE Tests of controls (ISA 330) Tests of controls are performed only on those controls that the auditor has determined are suitably designed to prevent, or detect and correct, a material misstatement Typical methods of controls testing include:

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ExPress Notes

FIA Foundations in Audit • • • • • •

inquiry inspection (verifying that documents or reports are physically authorized through a signature) reperformance observation of control activities walkthrough tests where a transaction is followed through the system computer assisted auditing techniques (CAAT)

The nature of the particular control influences the type of procedure required to obtain audit evidence about whether the control was operating effectively. For example, if operating effectiveness is evidenced by documentation, the auditor may decide to inspect it to obtain audit evidence about operating effectiveness. For other controls, however, documentation may not be available or relevant. In case of controls testing – the concept of materiality is not applied. In fact this is a blackor-white situation – the control either works or not – it cannot “work most of the time”.

KEY KNOWLEDGE Communicating control deficiencies (ISA 265) If the auditor detects deficiencies in internal controls (ie. missing internal controls or existing internal controls not operating effectively), the auditor will report those deficiencies to those charged with governance if those deficiencies are considered significant. Such deficiencies will be communicated in writing in the form of a Management Letter. The letter will include a description of the deficiency and the effect that the deficiency might have on the financial reporting process. Additionally the auditor may suggest how the deficiency should be removed.

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ExPress Notes

FIA Foundations in Audit

Chapter 4

Audit evidence and procedures

START The Big Picture This part of the syllabus is what people usually think the auditor does. It is about collecting the evidence in order to support conclusions that will take a form of auditor’s report and opinion. The auditor takes a huge risk – based on some limited procedures over a limited period of time he/she issues an opinion on the financial statements that are made up of thousands or millions of transactions – imagine consolidated financial statements of a multinational group! Thus the procedures must be very well designed to spot any potential misstatements and the evidence collected must be such that any other person would draw the same conclusions based on the information available from the company.

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ExPress Notes

FIA Foundations in Audit

KEY KNOWLEDGE Financial statements assertions An item in the financial statements may be misstated due to any of a number of events that might have resulted in an error. Thus the auditor, in his/her procedures should be able to verify that none of these events had a material impact on the item. The auditor therefore should use assertions for classes of transactions, account balances, and presentation and disclosures in sufficient detail to form a basis for the assessment of risks of material misstatement and the design and performance of further audit procedures. Take an example of inventory. It can be misstated due to: •

items being miscounted during the count (Accuracy);

items actually received after year end being included in the year-end balance (Cutoff);

items being incorrectly valued at cost while a net realisible value was appropriate (Valuation);

damaged items could have been counted as good ones (Valuation);

production cost may have been measured incorrectly (Valuation or Accuracy);

items might have been missed out of the inventory (Existence).

The auditor uses assertions in assessing risks by considering potential misstatements that may occur, and thereby designing audit procedures that are responsive to the particular risks. Assertions used by the auditor fall into the following categories: (a)

Assertions about classes of transactions and events for the period ended: • • • •

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Occurrence – did the transactions actually occur and pertain to the entity? Completeness – have all transactions, assets, liabilities and equity balances that related to the entity been recorded? Accuracy - have amounts, data and other information been recorded and disclosed appropriately? Cut-off - have transactions and events been recorded in the correct accounting period?

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ExPress Notes

FIA Foundations in Audit • (b)

Assertions about account balances at the period end: • • • •

(c)

Classification - have transactions and events been: recorded in the proper accounts?

Existence - do assets, liabilities and equity interests exist? Rights and obligations - does the entity hold or control the rights to assets and are liabilities the obligations of the entity? Completeness Valuation and allocation - are assets, liabilities and equity interests included in the financial statements at appropriate values?

Assertions about presentation and disclosure: • • • •

Occurrence Completeness Classification and understandability Accuracy and valuation

The assertions are not individually assessed but quite often at the same time. Eg. To ensure completeness of electricity expense, the auditor ensures the 12 months of payments were booked. Since the client may record the bills paid on a cash basis, electricity expense of a month of previous basis period might be entered in the current year. Electricity expense of last month of current year might be recorded next year. If the monthly fluctuation is immaterial, the auditor always ignore the cut-off issue. In case where electricity is a material expense, the auditor considers preparing adjustments for year ended cut-off purpose so that the profit or loss would not be materially misstated.

KEY KNOWLEDGE Audit evidence (ISA 500) The auditor is required to collect ‘sufficient’ and ‘appropriate’ evidence in order to justify the shape of his/her report and the conclusions formed in his/her audit opinion. The auditor considers reliability of audit evidence collected. For instance, audit evidence is more reliable when it exists in documentary form rather than subsequent oral representation of the matters. Auditors consider reliability of information but involve little authentication of evidence. Methods or techniques of audit evidence gathering are classified in 6 categories:

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ExPress Notes

FIA Foundations in Audit 1. 2. 3. 4. 5. 6.

Inspection Observation Inquiry Confirmation (audit) Re-performance Analytical procedures

For example, the auditor perform vouching to ensure such electricity expense occurred and whether correct amount was booked. The auditor compares electricity expense of current and last year to see whether there are fluctuations. If there are huge fluctuations, the auditor may examine electricity together with rental expense, water expense to find out reasons. The evidence collected must be sufficient. What is sufficient is a matter of auditor’s professional judgment. In exercising the judgment the auditor takes into account the following facts: • • • • •

the the the the the

risk of material misstatement; results of controls tests; size of a population being tested; size of the sample selected to test; and quality of the evidence obtained

In general the higher the risk – the more evidence should be collected. Similarly the poorer the results of tests of controls – the more evidence from substantive testing will be necessary etc. Evidence is appropriate when it is: relevant and reliable. Relevance is the feature of tests that determines whether the test is the right one to address the financial statement assertion. Eg. attendance at an inventory take is an excellent evidence of inventory’s existence. Reliability of evidence is a feature that depends on a number of factors. In general however: Evidence more reliable

Evidence less reliable

From independent external source Subject to effective control Obtained directly by the auditor

From within the company Not subject to effective control Obtained indirectly through the company Oral Copy

Written Original

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ExPress Notes

FIA Foundations in Audit The more reliable the evidence – the less of it needs to be collected to support the decision taken for the audit opinion. Substantive procedures Substantive procedures (or substantive tests) are those activities performed by the auditor during the substantive testing stage of the audit that gather evidence as to the completeness, validity and/or accuracy of account balances and underlying classes of transactions. Management implicitly assert that account balances and underlying classes of transaction do not contain any material misstatements: in other words, that they are materially complete, valid and accurate. Auditors gather evidence about these assertions by undertaking activities referred to as substantive procedures. Eg. An auditor may: physically examine inventory on the balance sheet date as evidence that inventory shown in the accounting records actually exists (validity assertion); arrange for suppliers to confirm in writing the details of the amount owing at balance date as evidence that accounts payable is complete (completeness assertion); and make inquires of management about the collectability of customers' accounts as evidence that trade debtors is accurate as to its valuation. There are two categories of substantive procedures - analytical procedures and tests of detail. Analytical procedures generally provide less reliable evidence than the tests of detail. Note also that analytical procedures are applied in several different audit stages, whereas tests of detail are only applied in the substantive testing stage. Substantive analytical procedures Comparisons of financial statement amounts with an auditor's expectation. Eg. A comparison of actual interest expense for the year (a financial statement amount) with an estimate of what that interest expense should be. The estimate can be found by multiplying a reasonable interest rate times the average balance of interest bearing debt outstanding during the year (the auditor's expectation). If actual interest expense differs significantly from the expectation, the auditor explains the difference in audit

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Tests of details Direct tests of financial statement balances (substantive audit procedures) that are not analytical procedures. Eg. • selecting a sample of items from the major account balances, and finding hard evidence (e.g. invoices, bank statements) for those items. • physically examining inventory on balance date as evidence that inventory shown in the accounting records actually exists (validity assertion); • arranging for suppliers to confirm in writing the details of the amount owing at

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ExPress Notes

FIA Foundations in Audit documentation.

balance date as evidence that accounts payable is complete (completeness assertion); and • making inquires of management about the collectability of customers' accounts as evidence that trade debtors is accurate as to its valuation.

KEY KNOWLEDGE Audit sampling (ISA 530) Audit sampling is the testing of less than 100% of the items within a population to obtain and evaluate evidence about some characteristic of that population, in order to form a conclusion concerning the population. The use of audit sampling, on all audit assignments, offers innumerable benefits to all auditors. These include: • • • • •

developing a consistent approach to audit areas; providing a framework within which sufficient audit evidence is obtained; forcing clarification of audit thinking in determining how the audit objectives will be met; minimising the risk of over-auditing; and facilitating more expeditious review of working papers.

It is crucial that the items selected should be representative, in order to be able to form a conclusion on the entire population. For if a test is applied only to those items which have a specific feature (e.g., all customer’s balances exceeding $20,000) this constitutes 100% examination of a sub-population (or selective testing of high-value items) and the results cannot be projected to the whole population. Samples can be selected statistically (by using random selection and then applying the probability theory to the analysis of the results) or non-statistically if the sample is selected using any other method. Example of methods are: • • • •

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random selection; systematic selection (eg. every 10th item is selected); monetary unit selection (eg. every item containing the multiple of 100 dollar is selected) haphazard selection – no structured technique applied by the auditor but without bias

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ExPress Notes

FIA Foundations in Audit The size of the sample will depend on the level of sampling risk the auditor is willing to accept. Sampling vs. non-sampling risk Sampling risk is the risk that the auditor’s conclusion based on the sample is different to that which

would be reached if the whole population was examined. This may result in: (a)

‘the risk of incorrect rejection’ which arises when the sample indicates a higher level of errors than is actually the case. This situation is usually resolved by additional audit work being performed;

(b)

‘the risk of incorrect acceptance’ when material error is not detected in a population because the sample failed to select sufficient items containing errors. Such errors should be detected by other complementary audit procedures.

Non-sampling risk is the component of detection risk that is not related to the fact that the auditor only tests a sample. Examples of sources of non-sampling risk include: • • •

failure to investigate significant fluctuations in relationships when placing reliance on analytical procedures; placing reliance on management representations as a substitute for other audit evidence that could reasonably be expected to be available; errors not detected due to allocating staff without appropriate skills or experience.

KEY KNOWLEDGE Computer assisted audit techniques (CAATs) CAATs is the practice of using computers to automate or simplify the audit process. In the broadest sense of the term, CAATs can refer to any use of a computer during the audit. CAATs is the practice of analyzing large volumes of data looking for anomalies. A well designed CAATs audit will not be a sample, but rather a complete review of all transactions. Using CAATs the auditor will extract every transaction the business unit performed during the period reviewed. The auditor will then test that data to determine if there are any problems in the data. Another advantage of CAATs is that it allows auditors to test for specific risks. For example, an insurance company may want to ensure that it doesn't pay any claims after a policy is terminated. Using traditional audit techniques this risk would be very difficult to test. The

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ExPress Notes

FIA Foundations in Audit auditor would "randomly select" a "statistically valid" sample of claims (usually 30-50.) They would then check to see if any of those claims were processed after a policy was terminated. Since the insurance company might process millions of claims the odds that any of those 30-50 "randomly selected" claims occurred after the policy was terminated is extremely unlikely. Even if one or two of those claims was for a date of service after the policy termination date, what does that tell the auditor? In practical terms the use of CAAT can take 2 major forms: (a)

Audit software – the auditor uses a specialised software to facilitate sampling, data analysis, trend spotting, preparing reports and letters;

(b)

Using test data – the auditor feeds the company’s system with test data containing errors. Subsequently the system is tested whether the errors were correctly addressed by the system and whether the data was rejected or treated in accordance with expectations.

KEY KNOWLEDGE Audit procedures Cash Risks •

Cash transactions may not be recorded accurately

Cash may not exist

Steps 1.

Confirm selected bank accounts and special arrangements Select bank accounts for confirmation in order to obtain a moderate to low level of assurance that the aforementioned audit objectives are achieved. Bank confirmations should be sent to all banking relationships to identify accounts not included in the general ledger. Confirmation requests should be sent under our control and, second requests and, where warranted, third requests should be mailed when responses to confirmation requests have not been received within a reasonable time. Consider sending a special inquiry letter to ascertain the existence of special arrangements or restrictions, for example, compensating balance arrangements, security arrangements, written guarantees.

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ExPress Notes

FIA Foundations in Audit 2.

Review confirmation replies For confirmations returned:

3.

(a)

agree account information and account balance to comparative summary;

(b)

investigate all discrepancies reported or questions raised in review and determine whether any adjustments are necessary; and

(c)

assess impact of special arrangements or restrictions identified and determine whether disclosure is appropriate.

Test accounts where there is no confirmation In the unusual situation where we do not receive a bank confirmation and are willing to forego the receipt of the bank confirmation, consider performing the following procedures to obtain a high level of assurance that the aforementioned audit objectives are achieved:

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(a)

obtain subsequent month bank statement, bank reconciliation and supporting documentation. Consider obtaining information directly from the bank;

(b)

test the mathematical accuracy of the bank reconciliation; (accuracy)

(c)

trace outstanding items listed on the bank reconciliation to the subsequent month's bank statement and for those not traced, trace to the cash disbursements records for the period prior to the balance sheet date; (accuracy and existence/occurrence)

(d)

trace deposits in transit listed on the bank reconciliation to the subsequent month's bank statement and for those not traced, trace to the cash receipts records for the period prior to the balance sheet date; (accuracy and existence/occurrence)

(e)

obtain explanation for large, unusual reconciling items and trace to supporting documentation and/or entries in the cash records, as appropriate; (accuracy and existence/occurrence)

(f)

review the date the above items cleared the bank or were recorded in the client's books to ensure appropriate recording period. Trace to supporting documentation as necessary; and (cut-off)

(g)

investigate items such as, long outstanding items, dishonoured checks and significant adjustments in the subsequent month, and record adjustments as necessary. (accuracy and existence/occurrence)

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ExPress Notes

FIA Foundations in Audit 4.

Test bank reconciliations Test bank reconciliation in order to obtain a moderate to low level of assurance that the aforementioned audit objectives are achieved by performing the following: (a)

test the mathematical accuracy of the reconciliation; (accuracy)

(b)

trace book balances on the client's bank reconciliation to the comparative summary; (accuracy)

(c)

trace bank balances on the client's bank reconciliation to the bank statement; (accuracy)

(d)

test reconciling items on the bank reconciliation by performing the following: i) ii)

iii)

iv)

v)

vi)

(e)

obtain subsequent month bank statement and supporting documentation. Consider obtaining information directly from the bank; trace outstanding items listed on the bank reconciliation to the subsequent month's bank statement and for those not traced, trace to the cash disbursements records for the period prior to the balance sheet date; (accuracy and existence/occurrence) trace deposits in transit listed on the bank reconciliation to the subsequent month's bank statement and for those not traced, trace to the cash receipts records for the period prior to the balance sheet date; (accuracy and existence/occurrence) obtain explanation for large, unusual reconciling items and trace to supporting documentation and/or entries in the cash records, as appropriate; (accuracy and existence/occurrence) review the date the above items cleared the bank or were recorded in the client's books to ensure appropriate recording period. Trace to supporting documentation as necessary; and (cut-off) investigate items such as, long outstanding items, dishonored checks and significant adjustments in the subsequent month, and record adjustments as necessary (accuracy and existence/occurrence).

review client's bank reconciliation for review and approval by appropriate management and timely completion of reconciliation.

Account receivable Risks

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•

The accounts receivable listing or individual balances may be inaccurate

•

Accounts receivable balances may not exist

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ExPress Notes

FIA Foundations in Audit •

Accounts receivable may not be collectible

Bad debts write-offs may not be valid

Sales transactions may be processed in the wrong period

Steps 1.

Agree a detailed listing of accounts receivable to the summary Obtain a detailed listing of accounts receivable balances (aged by customer, if possible) and: (a)

trace totals to the comparative summary of accounts receivable balances;

(b)

select reconciling items in order to obtain a moderate to low level of assurance that accuracy is achieved and i) ii)

2.

trace these items to supporting documentation; and determine whether the results of the client's investigations have been reviewed and approved by a responsible official;

(c)

test, to an extent to obtain a moderate to low level of assurance, the mathematical accuracy of the detailed listing; and

(d)

if appropriate, examine support for any significant adjustments made throughout the year in reconciling detailed accounts receivable records with the account(s) in the general ledger.

Positively confirm selected accounts receivable balances Select customers' account from the detail accounts receivable listing for positive confirmation in order to obtain a moderate to low level of assurance that the aforementioned audit objectives are achieved. Perform the following:

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(a)

send positive confirmation requests under our control. Where appropriate, send itemized statements to customers to facilitate responses. Second requests and, where warranted, third requests should be mailed when responses to positive confirmation requests have not been received within a reasonable time. When management requests us not to confirm certain accounts receivable balances, consider whether there are valid grounds for such a request. Before accepting a refusal as justified, examine any available evidence to support management's explanations.

(b)

summarize confirmation coverage.

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ExPress Notes

FIA Foundations in Audit 3.

Review confirmation replies For confirmations returned:

4.

(a)

agree account information and account balance to detail listing;

(b)

reconcile the account detail between the returned confirmation and the detail listing, where applicable; and

(c)

investigate all reconciling items and determine whether any adjustments are necessary.

Test accounts where there is no confirmation When confirmation is not carried out, or where it is not possible to confirm a selected amount (including where confirmation requests are unanswered), select customer accounts from the detail accounts receivable listing for verification and perform the steps outlined below in order to obtain a moderate to low level of assurance that the aforementioned audit objectives are achieved.

5.

(a)

compare subsequent remittances credited to accounts with remittance advices or other receipts (e.g. deposit slips and bank statement) and ascertain that payments relate to the account balances;

(b)

examine documentation such as shipping documents, copies of sales invoices, customer sales orders, and other relevant correspondence supporting the unpaid portion of the account balances. Coordinate this test with the review of the collectability of overdue accounts; and

(c)

consider whether it is necessary to verify further the existence of the customer.

Assess adequacy of allowance for doubtful accounts To an extent based upon materiality and inherent risk, assess the adequacy of allowance for doubtful accounts by performing the following procedures: (a)

obtain a list of accounts for which an allowance has been established. Review and test the process used by management to develop their estimate of collectability;

(b)

where provisions are made by the use of formulae based on the aged listing, determine by reference to the details in our notes of the client's procedures whether the basis is: i) ii) iii)

Page | 36

consistent with prior years; appropriate to the circumstances of the business; and in accordance with the accounting policy;

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ExPress Notes

FIA Foundations in Audit (c)

determine the effect, if any, of the client's policies and experiences regarding the timing of the passage of title, sales returns and allowances where right of return exists, and bill and hold situations; and

(d)

discuss collectability with management and review other documentation supporting collectability as necessary.

Review bad debt write-offs

6.

Review, in order to obtain a moderate to low level of assurance that valuation is achieved, bad debt write-offs by performing the following: (a)

consider the reasonableness of bad debt expense in light of the levels of bad debt write-offs compared with prior years; and

(b)

examine documentation relating to write-offs during the period and determine whether the write-offs were properly authorized.

Test sales/accounts receivable cutoff

7.

Accounts receivable cutoff testing is typically performed in conjunction with testing inventory cutoff and may be tested in the Inventory audit area. If cutoff is tested in the Accounts receivable audit area, perform the following: Select sales and credit memoranda to obtain a moderate to low level of assurance that cutoff is achieved by reviewing the cutoff at the time of inventory taking and at yearend (if different) and performing the following: (a)

for selected sales for periods before and after the cutoff date, examine the related records of goods shipped and services performed to determine that the sales invoices are recorded as sales in the proper period;

(b)

for selected credit (debit) memoranda for periods before and after the cutoff date, examine the related records of returns and claims from customers to determine that the credit (debit) memoranda are recorded in the proper period;

(c)

determine whether there are unusually high volumes of returned goods after year-end; and

(d)

consider unusual fluctuations in sales or return patterns before and after yearend and, if present, review for possible cutoff errors.

Inventory Risks •

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Inventory records may not be complete

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ExPress Notes

FIA Foundations in Audit •

Inventory transactions may be processed in the wrong period

Inventory items may not exist

Inventory carrying values may not be realizable

Steps 1.

Observe physical inventory To an extent based on materiality and inherent risk, perform the following: (a)

inspect the premises to determine whether: i) ii)

iii) iv) v) (b)

the arrangement of inventory is such that an accurate count is possible. the inventory is in good condition with adequate storage space, and whether items are properly packed or binned in a convenient manner for counting. scrap, obsolete, and damaged goods are adequately identified and segregated. inventory owned by third parties is adequately identified and segregated. inventories appear to be adequately safeguarded against access by unauthorized persons and protected against deterioration.

in observing physical inventory counts, determine whether: i)

the counts are carried out under proper supervision. Determine whether this official is independent of the custody and recording of inventory. Observe whether persons supervising the inventory make test counts in all areas and review all areas where inventory are kept to ensure that they have all been counted and the counts are recorded. ii) appropriate procedures are employed to control inventory movements (e.g., transfers, stock picking, etc.) during the count. iii) quantities and descriptions are properly entered on the inventory tags or sheets. iv) the methods used to determine quantities are reasonably accurate. v) there are adequate procedures for determining quantities of goods not susceptible to direct physical counting (e.g., screws, nails). vi) count totals are adequately checked by persons other than the original counters. vii) there are adequate procedures to ensure that all inventory (other than that on the company's premises owned by others) is counted and that no inventory is counted more than once. viii) inventory on the company's premises owned by others has been appropriately identified and counted.

Page | 38

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ExPress Notes

FIA Foundations in Audit ix)

2.

tags or count sheets are signed by individuals carrying out the count, or other suitable means of identifying individuals carrying out the count have been established, such as assigning tags or count sheets to count teams.

(c)

test the counting of inventory items by selecting items from the inventory tags or sheets and perform an independent count. Perform other counts of inventories and compare the results with those recorded on the inventory tags or sheets by company personnel. Follow up any differences noted in the counts. Record selected items counted for subsequent comparison with priced inventory listings. (Existence/Occurrence, Accuracy)

(d)

determine that procedures for accounting for all inventory tags and count sheets are followed and that all such tags and sheets have been accounted for, including used and unused tags and sheets, and that they are secured against alteration. Obtain details of records in order to test later for suppression, manipulation, addition or substitution of records after the physical inventory count (e.g., take copies of some or all of the count sheets) (Completeness)

(e)

determine whether slow-moving, obsolete, and damaged items are identified and recorded by the count teams.

(f)

consider the procedures established for determining cutoff , visit the receiving and shipping departments and note the last receiving and shipping document numbers before the count. If the client's procedures are not based on prenumbered documents, then prepare a list of shipping and receiving documents for a period immediately before and after the end of the period. Include documents for returns to suppliers and from customers, if different documents are used.

(g)

if appropriate, involve an expert to provide assistance in evaluating the appropriateness of the value assigned.

Examine receiving and issuing activity Test, to obtain a moderate to low level of assurance, the cutoff of inventory by using information obtained at the physical inventory observation and data from cutoff procedures and the search for unrecorded liabilities. Perform the following: (a)

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examine issues transactions and supporting documentation for a period before the balance sheet date and determine that goods issued before the balance sheet date have been excluded from raw materials inventory, and that goods included in raw materials inventory are not included in work in progress, finished goods, sales and cost of sales.

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ExPress Notes

FIA Foundations in Audit

3.

(b)

select receiving reports for goods received before the balance sheet date and determine that all goods received before the inventory have been included in inventory and liabilities.

(c)

review supporting documentation for goods not included in the physical count but included in the general ledger inventory control account (e.g., inventory in transit, duty and freight, returns) and determine that the goods are properly included in inventory and the related liability has been recorded.

(d)

examine purchase and issues transactions and detailed supporting documents for the period after the balance sheet date to determine that they have been reflected in the proper period. Where pre-numbered documents are used, ensure that documents have been used in sequence and earlier numbers are included in and later numbers excluded from transactions in the period.

(e)

review records of returned goods and claims against suppliers and related debit (credit) memoranda for periods before and after the cutoff date to determine that returns and claims against suppliers made after the cutoff date have been entered in the appropriate period

Test obsolete, slow-moving, scrapped or damaged listing Test, to an extent based upon materiality and inherent risk, the schedules of slowmoving, obsolete, scrapped or damaged items used to determine the net realizable value of inventory by performing the following: (a)

determine whether slow-moving, obsolete, scrapped or damaged items have been adequately identified by: i) ii)

iii) iv) v)

vi)

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obtaining and reviewing a schedule of items that have shown little or no recent movement; tracing information obtained during the observation of the physical inventory to management reports of slow-moving, obsolete, scrapped or damaged items; reviewing detailed inventory records, bin cards, etc.; reviewing periodic reports to management concerning such information; discussing with management quantities held in the light of current production requirements, sales orders received and future marketing forecasts; examine documentation, including, where appropriate, aged listings of inventory balances, substantiating the information obtained; and discussing with management whether any substantial inventory amounts may not be realizable because of major delays or disputes, defective work, marketing difficulties, etc.

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ExPress Notes

FIA Foundations in Audit (b)

review the pricing of such inventory and determine whether it is priced in excess of net realizable value.

Test client's costing of inventory detail

4.

Test the costing of the detailed priced raw materials inventory listings to obtain a moderate to low level of assurance that accuracy is achieved by performing the following: (a)

obtain and document an understanding of methods and procedures for costing inventory;

(b)

perform audit procedures to ensure that the inventory costs are appropriate, e.g., trace unit costs of inventory items to and from suppliers' invoices or standard costing information;

(c)

determine whether the method of inventory pricing is consistent with the prior year; and

(d)

if appropriate, involve an expert to provide assistance in evaluating the appropriateness of the value assigned.

Accounts payable Risks •

The accounts payable listing may not be accurate

There may be unrecorded accounts payable balances

Accounts payable transactions may be processed in the wrong period

Steps 1.

Agree detailed accounts payable listing to summary Obtain detailed accounts payable listing (aged by vendor, if possible) and perform the following:

Page | 41

(a)

trace totals from the detailed accounts payable listing to the totals of the summary;

(b)

select reconciling items in order to obtain a moderate to low level of assurance that accuracy is achieved. Trace the selected reconciling items to supporting documentation; and

(c)

where there are significant reconciling items, determine whether the results of the investigations have been reviewed and approved by a responsible official.

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ExPress Notes

FIA Foundations in Audit 2.

Test for unrecorded liabilities Obtain a moderate to low level of assurance that completeness and cutoff are achieved for accounts payable by selecting all invoices above $xx and a sample of other invoice amounts from all accounts payable sources (i.e. the disbursement records, invoices received and recorded records, goods received not yet invoiced records and credits for returns) for the period after the balance sheet date up to the date of the completion of fieldwork. By reference to supporting documentation, determine whether the item has been properly included as a liability or properly excluded.

Income statement Audit objectives •

Revenue is for valid transactions in the ordinary course of business that are recorded correctly as to account, amount, and period, and uncollectible amounts, returns, or allowances are adequately provided for (assertions E/O, R/O, V/A, and P/D).

Recorded revenue includes billings at the correct amount for products shipped or services provided (assertion C).

Costs of products or services are valid, complete, and recorded correctly as to account, amount, and period (assertions E/O, C, R/O, V/A, and P/D).

Expenses are valid, complete, and recorded correctly as to account, amount, and period (assertions E/O, C, R/O, V/A, and P/D).

Revenues, cost of products or services, expenses, and extraordinary, unusual, or infrequent items are properly described and disclosed in the income statement (assertion P/D).

Steps

Page | 42

1.

Inquire of management or review documentation obtained previously on the nature of the client’s business and industry and the factors that affect operations. Inquire about any major changes during the period. Obtain an understanding of the client’s revenue recognition policies and determine that they are in accordance with GAAP. Inquire of management about, and evaluate, changes in revenue recognition policies and significant, unusual, and complex transactions occurring at or near year end.

2.

Perform an analytical test of sales by obtaining for the workpapers a schedule summarizing sales by major product line and geographic location for the year compared to prior year amounts, budgets, or other expectations. Analyze this schedule

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ExPress Notes

FIA Foundations in Audit and critically evaluate and document explanations for significant differences that are unusual in amount or nature. 3.

4.

5.

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Obtain or prepare for the workpapers an analysis of sales, cost of sales, and gross profit summarized by product line, department, location, or other meaningful division, in total and by meaningful interim period (monthly, quarterly, etc.). Perform the following procedures: (a)

Test the analysis by selecting a few categories and compare the amounts shown with those recorded in the sales journal. Trace the sales journal balances to the general ledger.

(b)

Review the analysis and identify any unusual trends or variations within the period or compared to the prior period.

(c)

Determine the average or standard mark-up percentage for goods sold, if such percentage exists. Calculate the gross profit using the normal percentage (with an allowance for spoilage or waste) and compare it to the actual percentage realized during the period. Document the comparison.

(d)

Obtain and document sound business reasons for large or unusual differences in interim or total amounts included in the analysis. Relate sales by product line, if available, to inventory categories for possible overstock or obsolete inventory items.

For specific selected expense accounts that are sensitive or subject to unusual risk, select specific individual large disbursements and examine the documents supporting such transactions. This should be considered for repairs and maintenance, legal fees, consulting fees, and similar accounts, and any other expenses that should be vouched because the auditor, or his firm, has tax return preparation responsibility. (a)

Explain the nature and reason for any expense amounts that lack the proper support.

(b)

Determine that the amounts tested are properly classified and recorded in the correct general ledger account.

(c)

Document the items tested.

Review and document the large or unusual differences in specific expense accounts compared to the prior period actual amounts and, if available, the current period budget. From discussions with management and analysis of evidence from other audit areas, obtain and document explanations for the variations noted.

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ExPress Notes

FIA Foundations in Audit 6.

Review the payroll procedures with management and determine the key factors related to payroll (if it is significant). Determine the total employees by type or class from a review of the payroll records. Also identify the normal rate of pay for employees at various levels. Design and document a predictive test of the total compensation expense recorded and compare the results with the salary expense in the general ledger. Document explanations for significant or unusual differences.

7.

Scan the accounting records for large and unusual transactions and review evidence obtained in other audit areas to determine any matters that should be disclosed in the financial statements. Cross-reference work done in balance sheet areas to the related revenue and expense accounts. It is important to relate information from balance sheet audit areas to disclosure requirements for the income statement. Typical areas of concern are property and equipment, inventory, liabilities (leases), and income taxes.

8.

Consider the need to apply one or more additional procedures. The decision to apply additional procedures should be based on a consideration of whether information obtained or misstatements detected by performing substantive tests or from other sources during the audit alter your judgment about the need to obtain a further understanding of control activities, the assessed level of risk of material misstatements (whether caused by error or fraud), and on an evaluation of whether the basic procedures have been sufficient to achieve the audit objectives. Attach audit program sheets to document additional procedures.

9.

Consider whether procedures performed are adequate to respond to identified fraud risk factors. If fraud risk factors or other conditions are identified that require an additional audit response, consider those risk factors or conditions and the auditor’s response.

10.

Consider whether the results of audit procedures indicate reportable conditions in internal control and, if so, add to the management letter.

Property, plant and equipment Audit objectives •

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Property, plant, and equipment reflected in the accounts represent a complete listing of capitalizable cost of assets purchased, constructed or leased by the company, and such assets are physically on hand. Accordingly, noncapitalizable costs are properly expensed, and capitalizable costs are excluded from maintenance or other expense accounts (assertions E/O, C, and R/O).

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ExPress Notes

FIA Foundations in Audit •

Property, plant, and equipment is valued at cost in accordance with GAAP (assertion V/A).

The costs and related depreciation applicable to all sold, abandoned, damaged, or obsolete property have been properly removed from the accounts (assertions E/O, C, and V/A).

Depreciation charged to income during the period is adequate but not excessive and has been computed on an acceptable basis consistent with that used in prior years (assertion V/A).

The balances in the depreciation allowance accounts are reasonable, considering the expected useful lives of the property units and estimated salvage value. Accordingly, the net carrying values of property presented in the financial statements are expected to be recoverable in the ordinary course of business (assertion V/A).

Property is properly classified in the balance sheet, and liens, significant fully depreciated assets, idle property, and property held for investment purposes are properly disclosed. The financial statements also include disclosure of the major classes of depreciable assets, accumulated depreciation, depreciation methods and amounts, basis of valuation, amounts of capitalized interest, finance leases, impaired assets, assets held for sale, and asset retirement obligations (assertion P/D).

Basic procedures

Page | 45

1.

Determine the most efficient workpaper approach to audit property—(a) work directly from a copy of the company’s detailed property records or (b) use a lead schedule that summarizes the transactions in each account, then supplement with detailed schedules showing significant additions, retirements, or adjustments to each account. Test the clerical accuracy of these workpapers, cross reference amounts, and tie totals to the general ledger.

2.

For current year additions to property, perform the following procedures: (a)

Inquire of the managers if there are any major additions (purchased or constructed by the company or finance leases) that are omitted from the workpapers obtained in Step 1. Relate these facts to additions you observed during the inventory observations or plant tours.

(b)

If repairs and maintenance accounts have material balances, obtain an analysis of transactions in the account. Scan the analysis to determine if additional vouching of repairs and maintenance is necessary. If so:

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ExPress Notes

FIA Foundations in Audit

(c)

3.

4.

Page | 46

(1)

Examine significant invoices for repairs and maintenance expenses. Document the items tested.

(2)

Determine if the expenses contain significant components that should be capitalized as current year additions to property, plant, or equipment.

Scan the workpapers obtained in Step 1 to determine if additional procedures are warranted. Additional procedures normally are not warranted unless there are significant additions.

For current year retirements, perform the following procedures: (a)

Inquire of the owner/manager if there are any major retirements, sales of property, abandonments, or damages to property not reflected on the workpapers obtained in Step 1. Relate these facts to retirements, abandonments, etc., you noted during the inventory observation or plant tours.

(b)

Scan revenue accounts for significant proceeds from the sale of assets. Determine if the related cost and accumulated depreciation of the assets sold are reflected in the retirement workpapers obtained in Step 1.

(c)

Inquire if any major sales of fixed assets were sale/leaseback transactions. If so, determine the propriety of accounting for them.

(d)

Scan the workpapers obtained in Step 1 to determine if additional procedures are warranted. Additional procedures normally are not warranted unless there are significant retirements.

Test the adequacy of current year depreciation by performing the following procedures. (a)

Inquire of the owner/manager if there has been any change in depreciation lives or methods, and if there are significant amounts of fully depreciated assets.

(b)

Scan the workpapers obtained in Step 1 to determine if useful lives of assets are reasonable, if depreciation methods are in accordance with IFRS and consistent, and if depreciation expense for the year appears reasonable.

(c)

Perform analytical procedures, if practical, to test the reasonableness of the current year depreciation. (A predictive test based on prior year methods and ratios may be effective.)

(d)

If considered necessary, recompute depreciation expense on selected assets.

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ExPress Notes

FIA Foundations in Audit (e)

Page | 47

Cross-reference current year depreciation charged to the various allowance accounts to depreciation reflected in the expense accounts.

5.

Using information obtained in the above procedures, evaluate whether the remaining useful lives of assets are reasonable and if the net carrying values of property are recoverable in the ordinary course of business.

6.

Determine the following based on inquiry of the owner/manager and the results of procedures performed in other areas (i.e., review of minutes, items noted during inventory observations, confirmation procedures in liabilities and reading lease agreements): (a)

Whether idle property and property held for sale is appropriately identified and valued.

(b)

Whether encumbrances and liens related to property have been identified. Conversely, whether property currently pledged as collateral on a loan has not been sold or damaged.

(c)

Whether significant amounts of property held for investment purposes are properly identified.

(d)

Whether significant finance leases exist that are not reflected in the schedules obtained in Step 1. (If so, propose adjustments to record such finance leases.)

(e)

Whether the company has any legal obligations associated with the retirement of non-current assets that should be recognized in accordance with IFRIC 1.

7.

Obtain or prepare workpapers showing the proper classification of idle property, property held for sale, and finance leases.

8.

Summarize in the workpapers the information needed to prepare any required financial statement disclosures.

9.

Consider the need to apply one or more additional procedures. The decision to apply additional procedures should be based on a consideration of whether information obtained or misstatements detected by performing substantive tests or from other sources during the audit alter your judgment about the need to obtain a further understanding of control activities, the assessed level of risk of material misstatements (whether caused by error or fraud), and on an evaluation of whether the basic procedures have been sufficient to achieve the audit objectives. Attach audit program sheets to document additional procedures.

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ExPress Notes

FIA Foundations in Audit

Page | 48

10.

Consider whether procedures performed are adequate to respond to identified fraud risk factors. If fraud risk factors or other conditions are identified that require an additional audit response, consider those risk factors or conditions and the auditor’s response.

11.

Consider whether the results of audit procedures indicate reportable conditions in internal control and, if so, add to the management letter.

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ExPress Notes

FIA Foundations in Audit Chapter 5

Audit completion

START The Big Picture When all evidence has been collected and all fieldwork is done – it is time to conclude and review the work. Auditors apply a multi-level review process – seniors review the work of junior staff, managers review the work of seniors and partners discuss issues with managers. At the end management representations are obtained from the audited company, because even with the best evidence collected – the auditor can never be sure that he/she received a complete set of information and a true one – this needs to be separately confirmed by the managers. Having all this the auditor decides on the shape of the audit report (which can be unmodified or modifies) and opinion (which can be unqualified or qualifies). Any matter related to the misstatements identified during the audit should be promptly discussed with the managers.

Page | 49

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ExPress Notes

FIA Foundations in Audit

KEY KNOWLEDGE Events after the end of the reporting period (ISA 560) Such events are events that occurred after the end of the audited period. As you should be aware from your accounting studies – such events are split into adjusting events (those that provide additional information about conditions and balances that existed at the end of the reporting period and as such should adjust the reported figures) and non-adjusting events (those that provide information about new events, which if material should be disclosed in financial statements). Up to the date of signing the auditor’s report, auditor’s duty for the detection of material events after the reporting period is active – the auditor must plan and perform procedures to ensure such events are properly reported in the financial statements. Such procedures could entail: • • • • •

Discussions with management and subsequent review of company procedures for dealing with subsequent events Examining minutes of board and board committee meetings Review of management forecasts, budgets and management accounts Routine audit work which naturally takes auditor into subsequent period eg. tests relating to sales and purchases cut-off Obtaining management representations

After signing the report, the auditor only retains a reactive duty. That means that the auditor does not need to be actively look for the information however such information can come to his attention. And if it does – appropriate action needs to be taken which can be (depending on the situation): • • • •

Page | 50

Discussions with management on their proposed reaction Revision/withdrawal of earlier report Addressing company AGM/GM Seeking further advice

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ExPress Notes

FIA Foundations in Audit

KEY KNOWLEDGE Going concern (ISA 570) Going concern is a fundamental assumption in accounting. It means that the business will continue to exist as a viable commercial entity for the foreseeable future, without the need for any significant cut-back in its present level of activity. Foreseeable future is normally taken as being a minimum of 12 months from the current accounting date. If for any reason, management consider a shorter period, then there should be a note to the financial statements indicating what that shorter period is and management’s reasons for choosing it. Please have in mind that the going concern assumption is critical for enabling the use of many other accounting policies that are considered obvious. Take the example of depreciation – there is no possibility to justify depreciating cars over 5 years if the company will not exist for more than 12 months! Thus for the auditor the verification of the going concern assumption is a stepping stone for issuing any type of opinion. Surely the financial statements prepared under the going concern assumption will be materially misstated if the going concern assumption is not justified. In order to asses potential going concern problems the auditor will design procedures to analyse the business risks surrounding the entity and its risk management approach. The business risk is made of 3 types of risk: •

Operational risk – the risk that the entity’s operational processes are not suited to current market conditions or changes to them.

Financial risk – the risk that the entity may not be able to finance its operations.

Compliance risk – the risk that the entity will not be able to perform in accordance with the respective legal or regulatory regime.

Auditor’s work in respect of going concern might include: • • • • •

Page | 51

Assessment of current and projected economic environment in which company operates Assessment of state of industry sector in which company operates Review of correspondence files and board minutes for evidence of significant disputes Review of subsequent period cash flow and profit forecasts Discussion of management procedures and obtaining management representations

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ExPress Notes

FIA Foundations in Audit The auditor’s report consequences of going concern:

No issue with going concern assumption

Clean – no additional paragraphs

Going concern assumption used but significant uncertainty exist which was disclosed in FS

Going concern assumption used but significant uncertainty exist which was NOT disclosed in FS

Clean with emphasis of matter

Going concern assumption used but should not be used in auditor’s view

Qualified (usually adverse)

Going concern issue exists but FS prepared on appropriate basis (eg. liquidation basis)

KEY KNOWLEDGE Written representations (ISA 580) The auditor must obtain written representations from management and, where appropriate, those charged with governance that they believe that they have fulfilled their responsibility for the preparation of the financial statements and for the completeness of the information provided to the auditor Although written representations provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any of the matters with which they deal. Written representations are an important source of audit evidence. If management modifies or does not provide the requested written representations, it may alert the auditor to the possibility that one or more significant issues may exist.

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ExPress Notes

FIA Foundations in Audit Within the representations the management will confirm that: •

It has fulfilled its responsibility for the preparation of the financial statements in accordance with the applicable financial reporting framework.

It has provided the auditor with all relevant information and access as agreed in the terms of the audit engagement; and

All transactions have been recorded and are reflected in the financial statements.

The written representations should be in the form of a representation letter addressed to the auditor. If the auditor concludes that the written representations are not reliable, the auditor shall take appropriate actions, including determining the possible effect on the opinion in the auditor’s report. In such cases the auditor may also consider withdrawing from the engagement.

KEY KNOWLEDGE Recording the identified misstatements (ISA 450) Misstatement is a difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud. The auditor shall accumulate misstatements identified during the audit, other than those that are clearly trivial. When such misstatements are found by the auditor – the auditor will communicate this fact to management and request those misstatements to be adjusted. If management refuses to do so, the auditor should understand the reasons for the refusal and reassess the impact that the uncorrected misstatement might have on the overall financial statements. Ultimately the auditor will assess the impact on all of the uncorrected misstatements on the financial statements taking into account the materiality levels set (or reset now). All the uncorrected misstatements must be reported to those charged with governance and management representations should include management’s confirmation that in their view the misstatements are immaterial to the financial statements. The auditor’s documentation must include details of all corrected and uncorrected misstatements.

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© 2013 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.

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ExPress Notes

FIA Foundations in Audit

KEY TERMINOLOGY ISA 700 The Auditors Report on Financial Statements identifies the key elements of the auditor’s report (these must be learned and you should be prepared to give a brief explanation of the purpose of each element): 1. Title 2. Addressee 3. Introductory paragraph 4. Statement of responsibilities of management 5. Statement of responsibilities of the auditors 6. Scope paragraph 7. Opinion 8. Auditor’s signature 9. Date of report 10. Auditor’s address

KEY KNOWLEDGE Audit reports (ISA 700) Unmodified reports If the auditor concludes that the financial statements show a ‘true and fair’ view of company’s financial position and performance during the period and that they were prepared in accordance with the appropriate reporting framework, the auditor will issue and unmodified report. The ‘number 7’ paragraph from above will then say:

Opinion In our opinion, the financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. There may be cases however when the auditor concludes that the financial statements were prepared correctly, yet there is some issue which was properly disclosed in those financial

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© 2013 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.

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ExPress Notes

FIA Foundations in Audit statement but the auditor considers it so important that he/she decides to mention it in their report. It will then be an unmodified report with an emphasis of matter paragraph. An emphasis of matter paragraph follows the opinion paragraph and might take the following form:

Emphasis of Matter We draw attention to Note X to the financial statements which describes the uncertainty7 related to the outcome of the lawsuit filed against the company by XYZ Company. Our opinion is not qualified in respect of this matter. Examples of where the use of such paragraph would be appropriate include: •

where there the financial statements have been prepared on a going concern basis, but this is dependent upon some significant uncertainty which is fully and adequately disclosed in the notes to the financial statements

where there is a material inconsistency between the financial statements and the Directors’ Report and the adjustment required to remove the inconsistency would need to be made in the Director’s Report but the directors are not prepared to make such adjustment.

Modified reports with qualifications If the auditor comes to a conclusion that the financial statements do not show a true and fair view, he/she will come up with the qualified opinion. This may be due to a disagreement with the management over the application of accounting policies (eg. the management refuses to depreciate non-current assets for some reason). If such a disagreement is material, the auditor will issue an ‘except for’ opinion like the one below:

Basis for Qualified Opinion The company’s short-term marketable securities are carried in the statement of financial position at xxx. Management has not marked these securities to market but has instead stated them at cost, which constitutes a departure from International Financial Reporting Standards. The company’s records indicate that had management marked the marketable securities to market, the company would have recognized an unrealized loss of xxx in the statement of comprehensive income for the year. The carrying amount of the securities in the statement of financial position would have been reduced by the same amount at December 31, 20X1, and income tax, net income and shareholders’ equity would have been reduced by xxx, xxx and xxx, respectively.

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© 2013 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.

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ExPress Notes

FIA Foundations in Audit

Qualified Opinion In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly, in all material respects (or give a true and fair view of) the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. If the auditor concludes that the disagreement leads to misstatements in the financial statements that are ‘pervasive’ (ie. spread throughout the financial statements rather than being limited to two items in them), he/she issues an adverse opinion.

Basis for Adverse Opinion As explained in Note X, the company has not consolidated the financial statements of subsidiary XYZ Company it acquired during 20X1 because it has not yet been able to ascertain the fair values of certain of the subsidiary’s material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis. Under International Financial Reporting Standards, the subsidiary should have been consolidated because it is controlled by the company. Had XYZ been consolidated, many elements in the accompanying financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.

Adverse Opinion In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements do not present fairly (or do not give a true and fair view of) the financial position of ABC Company and its subsidiaries as at December 31, 20X1, and (of) their financial performance and their cash flows for the year then ended in accordance with International Financial Reporting Standards. Another reason for qualification may be a limitation on scope – this happens when the auditor could not collect sufficient and appropriate evidence to substantiate his/her conclusions. This may happen due to limitations imposed by the client (eg. the client did not provide evidence of impairment tests performed) or simply due to objective circumstances (eg. the auditor was appointed after the stock-take took place and due to this could not take part in it). If the limitation on scope was material, an ‘except for’ opinion will be issued:

Basis for Qualified Opinion ABC Company’s investment in XYZ Company, a foreign associate acquired during the year and accounted for by the equity method, is carried at xxx on the statement of financial position as at December 31, 20X1, and ABC’s share of XYZ’s net income of xxx is included in

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ExPress Notes

FIA Foundations in Audit ABC’s income for the year then ended. We were unable to obtain sufficient appropriate audit evidence about the carrying amount of ABC’s investment in XYZ as at December 31, 20X1 and ABC’s share of XYZ’s net income for the year because we were denied access to the financial information, management, and the auditors of XYZ. Consequently, we were unable to determine whether any adjustments to these amounts were necessary.

Qualified Opinion In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. If the limitation on scope was ‘pervasive’ the auditor issues a disclaimer of opinion meaning that due to the limitations he/she cannot issue and opinion:

Basis for Disclaimer of Opinion We were not appointed as auditors of the company until after December 31, 20X1 and thus did not observe the counting of physical inventories at the beginning and end of the year. We were unable to satisfy ourselves by alternative means concerning the inventory quantities held at December 31, 20X0 and 20X1 which are stated in the statement of financial position at xxx and xxx, respectively. In addition, the introduction of a new computerized accounts receivable system in September 20X1 resulted in numerous errors in accounts receivable. As of the date of our audit report, management was still in the process of rectifying the system deficiencies and correcting the errors. We were unable to confirm or verify by alternative means accounts receivable included in the statement of financial position at a total amount of xxx as at December 31, 20X1. As a result of these matters, we were unable to determine whether any adjustments might have been found necessary in respect of recorded or unrecorded inventories and accounts receivable, and the elements making up the statement of comprehensive income, statement of changes in equity and statement of cash flows.

Disclaimer of Opinion Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements. Overall, the decision tree for the auditor’s opinion can be summarized as follows:

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© 2013 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.

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ExPress Notes

FIA Foundations in Audit

Auditor’s opinion

Unmodified

Qualified

significant uncertainty disclosed in FS Standard

With emphasis of matter

Disagreement with management material ‘except for’

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pervasisve adverse

© 2013 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.

Limitation on scope material ‘except for’

pervasisve disclaimer

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FIA FAU 2013 notes  

FIA FAU 2013 notes