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Table of Contents- F8 Knowledge Summary (March/June 2018 ) Reasons for an unsuccessful attempt in F8 Very bad scripts
1. Very brief answers to most, if not all questions. In other words, some of the basic knowledge is known, but there is little or no application of that knowledge to thescenario 2. Significant lack of understanding of audit procedures and the audit process. For example, where a question asks for audit procedures to be listed and explained, a typical answer is ‘check the ledger’ providing no indication of which ledger will be ‘checked’ or what the ledger is being checked for 3. Lack of exam practice. In a significant minority of scripts, it appears that candidates have not attempted any mock exams prior to the ‘real’ exam. Poor exam technique isdentified i as: answering questions in a random sequence (for example, Question 1 Part (a), followed by Question 3 Part (b), followed by Question 2 Part (c), and so on) spending far too much time on one question, leaving little or no time for the other questions not writing in the required style (eg providing the answer in one long paragraph rather than splitting the answer up into individual points) focusing on theory only with no attempt to use the scenario. Marginal scripts 1. Answering questions correctly, but not including a sufficient number of relevant points to obtain a pass standard. 2. Having a good knowledge of auditing, but being unable to apply that knowledge to the scenarios provided in the question. 3. Not answering all the questions. Pass standard scripts
1. Are usually well presented, and make appropriate use of paragraphs, sentences and table formats where appropriate. 2.
Demonstrate that students are able to apply that knowledge to the question, clearly and succinctly. Audit procedures are listed as well as explained.
3. All questions are attempted, even though some sections may not be answered that well. A few marks could normally be obtained from a valid attempt; obviously, no marks are awarded if the question is not attempted at all.
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Assurance Engagements The practitioner examines the subject matter made available by the responsible party, matches it to the suitable criteria using evidence and reports to the intended users.
Elements of an assurance engagement
1. An assurance engagement will require a three-party relationship comprising of: a) The intended user who is the person who requires the assurance report. b) The responsible party, which is the organisation responsible for preparing the subject matter to be reviewed. c) The practitioner (i.e. an accountant) who is the professional who will review the subject matter and provide the assurance. 2. A second element whichis required for anassurance engagement is suitable subject matter.The subject matter is the data which the responsible party has prepared and which requires verification. 3. Thirdly this subject matter is then evaluated or assessed against suitable criteria in order for it to be assessed and an opinion provided. 4. Fourth, the practitioner must ensure that they have gathered sufficient appropriate evidence in order to give the required level of assurance.
5. Last, an assurance report provides the opinion which is given by the practitioner to the intended user
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Types of assurance assignments Reasonable assurance
Limited assurance
An Assurance engagement in which the Practioner reduces engagement risk to an acceptably low level in the circumstances of the engagement as the basis for the practitioner’s conclusion.
An assurance engagement in which the practitioner reduces engagement risk to a level that is acceptable in the circumstances of the engagement but wherethat risk is greater than for a reasonable assurance engagement Example: Review of financial statements
Example: External Audit High level of assurance but NOT absolute or 100%
Moderate level of assurance
A high but not absolute level of assurance is provided, this is known as reasonable assurance.
The practitioner gathers sufficient evidence to be satisfied that the subject matter is plausible; in this case negative assurance is given whereby the practitioner confirms that nothing has come to their attention which indicates that the subject matter contains material misstatements.
More testing (Analytical tests, test of controls and substantive testing)
Lesser testing-focus on obvious errors only (Analytical testing and Enquiry)
Going concern review carried out
No going concern review The procedures undertaken are not nearly as
Positive conclusion- Wording: ‘in our opinion the financial statements give (or do not give) a true and fair view of the state of the company’s affairs’.
comprehensive as those in an audit, with procedures such as analytical review and enquiry used extensively. In addition, the practitioner does not need to comply with ISAs as these only relate to external audits. Negative conclusion-Wording: “nothing has come to light to suggest errors or problems exist’'
The assurance is therefore given on the absence of any indication to the contrary. Review engagements are often undertaken as an alternative to an audit, and involve a practitioner reviewing financial data, such as six-monthly figures. This would involve the practitioner undertaking procedures to state whether anything has come to their attention which causes the practitioner to believe that the financial data is not in accordance with the financial reporting framework.
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Assignments were no assurance is given
1. Agreed-upon procedures : A report on factual findings is given but no assurance expressed. Users must judge for themselves and drawn their own conclusions 2. Compilation engagement: Users of the compiled information gain benefit fromthe accountant’s involvement but no assurance is expressed. It is used to collect, classify and summarise financial information. It means to present data in a manageable and understandable form.
External audit It is a review and assessment of the financial records to form an overall conclusion as to whether: - The financial statements have been prepared using acceptable accounting policies, which have been consistently applied. - The financial statements comply with all the relevant regulations and statutory requirements. - Adequate disclosure of all material matters relevant to the proper presentation of financial information has been made.
Objective of external audit engagements:“Opinion”: The auditor’s report contains a clear written expression of opinion on the financial statements.
General principles of external audit engagements
According to the International Standards on Auditing, the general principles of an audit are: 1. 2. 3. 4. 5.
Compliance with Code of Ethics (IFAC’s) Performance of an audit in accordance with ISAs Audit with professional skepticism Professional judgment Sufficient appropriate audit evidence
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Important Terms True and Fair presentation
Financial statements are produced by management which give a true and fair view of the entity’s results. The auditor in reviewing these financial statements gives an opinion on the truth and fairness of them. Although there is no definition in the International Standards on Auditing of true and fair it is generally considered to have the following meaning: True – Information is factual and conforms with reality in that there are no factual errors. In addition it is assumed that to be true it must comply with accounting standards and any relevant legislation. Lastly true includes data being correctly transferred from accounting records to the financial statements. Fair – Information is clear, impartial and unbiased, and also reflects plainly the commercial substance of the transactions of the entity. Those charged with governance – The person(s) with responsibility for overseeing the strategic direction of the
entity and obligations related to the accountability of the entity. This includes overseeing the financial reporting process. Management – The person(s) with executive responsibility for the conduct of the entity’s operations. In some cases, all of those charged with governance are involved in managing the entity, for example, a small business where a single owner manages the entity and no one else has a governance role
Engagement partner – The partner in the firm who is responsible for the audit engagement and its performance, and for the auditor’s report that is issued on behalf of the firm, and who has the appropriate
authority from a professional, legal or regulatory body. Professional judgment – The application of relevant training, knowledge and experience, within the context
provided by auditing, accounting and ethical standards, in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. Professional skepticism – An attitude that includes a questioning mind, being alert to conditions which may
indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence. Professional skepticism includes being alert to, for example: • •
Audit evidence that contradicts other audit evidence obtained. Information that brings into question the reliability of documents and responses to inquiries to be used as audit evidence.
• •
Conditions that may indicate possible fraud. Circumstances that suggest the need for audit procedures in addition to those required by the ISAs.
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Inherent Limitations of audit/ Reasons why absolute assurance cannot be given
1. Sampling – it is not practical for an auditor to test 100% of transactions and so they have to apply sampling methodologies in selecting balances/transactions to test. Therefore, there could be an error in an item not selected for testing by the auditor. 2. Subjectivity – financial statements include judgmental and subjective areas and therefore the auditor is required to use their judgment in assessing whether the financial statements are true and fair. 3. Inherent limitations of internal control systems – an internal control system is operated by people and hence is liable to human error. In addition, there is the possibility of controls override by management and of collusion and fraud. It is impossible to remove all of these inherent limitations and as the auditor relies on the internal control systems, this can reduce the usefulness of the audit. 4. Evidence is persuasive not conclusive – the opinion is based on audit evidence gathered; however, while this evidence can indicate possible issues affecting the audit opinion, evidence involves estimates and judgments and hence does not give a definite conclusion. 5. Even if everything reported on was examined and found to be satisfactory, there may be other items which should have been included– the completeness problem. 6. Auditors plan their work to detect material errors and frauds only – so small frauds (or large frauds split into many small amounts) may go unnoticed. An external audit has a number of other issues which reduce its usefulness
1. Audit report format – the format of the opinion is determined by International Standards on Auditing. However, the terminology used is not usually understood by non-accountants. This means that users may not actually understand the audit opinion given. 2. Historic information – the audit report is often issued some time after the year end, and so the financial information can be quite different to the current position. In the current marketplace where companies’ financial positions can change quite quickly, the audit opinion may no longer be relevant as it is out of date. 3. Auditors need to understand their clients in great depth if they are to understand how fraud could be carried out and hidden. However, auditors cannot become too close to their clients or their independence will be called into question. 4. Where auditors spot errors or fraud, their primary legal responsibility is to report this to management. Any external reporting is hampered by rules on confidentiality.
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The auditor’s duties
Fundamental duties are to: form an opinion on whether the financial statements give a true and fair view and are prepared in accordance with applicable reporting framework issue an audit report.
Duty to check and ensure: Adequate accounting records, Compliance with legislation, Truth and fairness, Adequacy of financial statements disclosures
The auditor’s rights
1. 2. 3. 4. 5. 6.
Right of access at all times to the company’s books, accounts and vouchers. Right to require from an officer of the company such information or explanations as they think necessary for the performance of their duties as auditors. Right to receive all communications relating to written resolutions. Right to receive all notices of, and other communications relating to, any general meeting which a member of the company is entitled to receive. Right to attend any general meeting of the company. Right to be heard at any general meeting which an auditor attends on any part of the business of the meeting which concerns them as auditor.
Appointment of auditors
Only a member of a recognised supervisory body is eligible to be a ppointed as an auditor. The person to be appointed as the auditor is required to hold a professional accountancy qualification. 1. Appointed by shareholders 2. Appointment runs from the end of the Annual General Meeting (AGM) until the end of the next AGM. 3. On appointment , need to get ‘clearance’ from outgoing auditor For entities in which a share is owned by the state, the auditor is appointed by the Secretary of State or Ministry of Finance (or a person authorised by the Ministry of Finance)
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Removal of auditors
1. RESIGNATION: Sometimes it is necessary for the auditors to resign. If an auditor resigns, they should do so in writing and they may wish to speak to the shareholders to explain their reasons 2. FORCED REMOVAL: Sometimes, the Board of Directors or some shareholders may wish to remove the auditors. A General Meeting must be called so that the shareholders can vote on the proposal (via an ordinary resolution). 3. AUDITORS DO NOT WISHTO SEEK REAPPOINTMENT: Sometimes the auditors finish the annual audit and decide they do not wish to audit the company in future years. As such,when the board asks them to accept nomination for the following year, the auditors should politely decline and issue a Statement of Circumstances.
Key points
Directors cannot remove the auditors themselves.
Auditors Can be removed by a simple majority at a general meeting.
The auditors should be given notice of such a meeting
They are allowed to speak at the general meeting
Deposit at the company’s registered office a statement of the circumstances connected with the removal/resignation or a statement that there are no such circumstances. They can request an Extraordinary General Meeting (EGM) of the company to explain the circumstances of the resignation.
Audit exemption for small companies
The main reasons for exempting small companies are: for owner-managed companies, those receiving the audit report are those running the company (and hence preparing the accounts!) the advice/value which accountants can add to a small company is more likely to concern other services, such as accounting and tax, rather than audit and which may also give rise to a conflict of interest under the ethics rules the impact of misstatements in the accounts of small companies is unlikely to be material to the wider economy it may also not be cost beneficial for the small entities.
Attempt questions to check your understanding: June 2015-Q5c
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Fundamental principles of ethics 1. Integrity: Members should be straightforward and honest in all professional and business relationships.
Auditors should not knowingly be associated with reports, returns, communications or other information where they believe that the information contains a materially false or misleading statement. 2. Objectivity: Members should not allow bias, conflicts of interest or undue influence of others to
override professional or business judgements.
3. Professional competence and due care : to maintain professional knowledge and skill at the level required to ensure that a client receives competent professional services, and to act diligently and in accordance with applicable technical and professional standards. 4. Confidentiality : Members 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 There are, however, circumstances where auditors may disclose information to third parties without first obtaining permission. These can be categorised as obligatory and voluntary disclosures. Obligatory: Auditors are obliged to make disclosure where, for example, there is a statutory right or duty to disclose, such asif the auditor suspects the client is involved inmoney laundering, terrorism or drug trafficking in which case they must immediately notify the relevant authorities. In addition, auditors must make disclosure if compelled by the process of law, for example under a court
order or summons, under which theyare obliged to disclose information. Voluntary In certain circumstances auditors are free, as opposed to obliged, to disclose information without obtaining the client’s permission first. These circumstances can be categorised into the four areas below:
Public interest – An auditor may disclose information which would otherwise be confidential if disclosure can be justified in the ‘public interest’. This would be perhaps if those charged with governance are involved in fraudulent activities; Protect a member’s interest –Members/auditors may disclose information to defend themselves against a negligence action, disciplinary proceedings or if suing for unpaid fees; Authorised by statute/laws– There are cases of express statutory provision where disclosure of information to a proper authority overrides the duty of confidentiality; Non-governmental bodies – Auditors may be approached by non-governmental bodies seeking information concerning suspected acts of misconduct not amounting to a crime or civil wrong. Disclosure should only be made to those bodies with statutory powers to compel disclosure.
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5.
Professional behaviour: Members should comply with relevant laws and regulations and should avoid any action that discredits the profession.
Threats
Once you have identified a threat from the scenario, you will need to name the threat, explain WHY it is a threat and tell the safeguard. QCR: Quality Review ( independent partner Having awork professional accountant who was not involved withControl the non-assurance service review thereview)non-assurance performed Chinese walls: The use of separate engagement teams, with different engagement partners and team members Public interest entities are: (a) All listed entities; and (b) Any entity: (i) Defined by regulation or legislation as a public interest entity; or (ii) For which the audit is required by regulation or legislation to be conducted in compliance with the same independence requirements that apply to the audit of listed entities. Such regulation may be circulated by any relevant regulator, including an audit regulator Self-interest : the threat that a financial or other interest will inappropriately influence the professional accountant’s judgment or behavior
Example
Safeguard
A member of the assurance team or the firm having a direct financial interest in the assurance client.
Remove the individual from the audit team-the self-interest threat created would be so significant that no safeguards could reduce the threat to an acceptable level. - Nature, value and intent of offer to be considered - Not allowed unless insignificant ( politely decline)
Gifts and hospitality
A firm having undue dependence on total fees from a client.
Listed clients:
If gross recurring fee from one client greater than 15% of the firm’s revenue for two consecutive years, -
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Tell client’s TCWG Independent QCR or external QCR before OR after issuing 2nd year’s opinion
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Other clients:
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Reducing the dependency on the client; External quality control reviews; or Consulting a third party, such as a professional regulatory body or a professional accountant, on key audit judgments.
Recent Service with an Audit Client
Remove from team if worked at the client in the
(if a member of the audit team has recently served
year being audited at a position to exert significant influence over the subject matter.
an employee of the audit client) A member of the assurance team(or the firm) having a significant close business relationship Commercial relationship - Common financial interest Examples: joint venture with the client or a
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If material, not allowed (The threat created would be so significant that no safeguards could reduce the threat to an acceptable level.)
controlling owner/ director, formal marketing of each other’s product, combine the services of the firm with those being offered by client and market the package A firm entering into acontingent fee arrangement relating to an assurance engagement. (relating to the outcome of a transaction or the result of the services
Politely decline the proposed contingent fee arrangement
to a loan to the client
Inform the client that the fees will be based on the level of work required to obtain sufficient and appropriate audit evidence. Discuss with those charged with governance the reasons why the payments have not been made.
(if fees due from an audit client remain unpaid for a long time, especially if a significant part is not paid before the issue of the audit report for the following
Should agree a revised payment schedule which will result in the fees being settled before much more work is performed for the current year audit.
performed by the firm) Overdue fee-might be regarded as being equivalent
year.) Loans and guarantee
If not under normal lending conditions, no safeguard acceptable If under normal lending conditions- review by network firm.
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Serving as a Director or Officer of an Audit Client
- No allowed. (Particular reference made by the code to the role of the Company Secretary. If allowed under local laws or professional rules, the duties and activities shall be limited to those of a routine and administrative nature, such as preparing minutes and maintaining statutory returns)
Recruitment services ( especially hiring of senior
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Listed clients: not allowed for directors or
management)
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senior positions toshould f/s preparation Otherwise, final related decision be by the client and DO NOT negotiate on the client’s behalf
Firm can undertake roles such as reviewing a shortlist of other candidates. However, they must ensure that they are not seen to undertake management decisions and so must not make the final decision on who is appointed A member of the audit team entering into employment negotiations with the audit client.
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Remove the individual from the audit team A review of any significant judgments made by that individual while on the team.
Compensation and Evaluation Policies (when a
A key audit partner shall not be evaluated on or
member of the audit team is evaluated on or compensated for selling non-assurance services to
compensated based on that partner’s success in selling non-assurance services to the partner’s
that audit client.)
audit client.
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Self-Review-the threat that the auditor will not appropriately evaluate the results of a previous judgment
made/or service performed by him Example
Safeguard
Provision of other services to an audit c lient
Listed Clients: Most non-assurance services
(Note: other threats due to this are self-interest because of the fee element and advocacy-see below)
related to financial reporting are not allowed. Other clients: Segregation of duties, Chinese walls,
QCR Temporary staff assignments-The lending of staff by
a firm to an audit client
Should ideally not be made a part of the audit team. Generally acceptable if no management responsibility taken up and the audit client shall be responsible for directing and supervising the activities of the loaned staff
Recent Service with an Audit Client- a member of
the audit team has recently served as a employee of the audit client- The threat is that the member of the audit team has to evaluate elements of the financial statements for which he had prepared the
Remove from team if worked at the client in the year being audited at a position to exert significant influence over the subject matter
accounting records while with the client.
Familiarity: the threat that due to a long or close relationship with a client , the auditor will be too
sympathetic to their interests or too accepting of their work Long Association of Senior Personnel with an Audit
Client
Listed clients: -
7 years plus 1 year of flexibility then a gap of two years for audit partner In the 2 years gap period, not participate in the audit or, provide quality control for the engagement, or consult with the engagement team or the client regarding technical or industry-specific issues
Other clients: rotate members, QCR
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Family and Personal Relationships
Remove from team if the relationship is with a senior person at the client with influence over the f/s.
Employment with an Audit Client
(the director or a senior member of the audit client has been a member of the audit team or partner of the firm in the past)
Listed client: for partners, ok if twelve months
have passed since the individual was Partner. Other safeguards
-Modifying the audit plan; -any work already undertaken by that individual should be independently reviewed. -Assigning individuals to the audit team who have sufficient experience in relation to the individual who has joined the client.
Advocacy: threat that the auditor will promote a client’s position to the point that the his objectivity is compromised Legal services to audit client ( for example contract
If they relate to resolving a dispute or litigation
support, litigation, mergers and acquisition legal advice and support to clients’ internal legal
when the amounts involved are material to the financial Statements: not allowed
departments) Auditor asked to promote client/shares in a client or
Not allowed ( politely decline)
asked to accompany the client to a meeting with the bank.
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Intimidation: the threat that the auditor will be deterred from acting objectively because of actual or perceived pressures, including attempts to exercise undue influence over the auditor Threat of dismissal or replacement of auditor/or his close family member over a disagreement about the application of an accounting principle. A dominant personality at the client attempting to influence the decision making process, for example
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Tell client’s TCWG
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ensure that all audit engagements are conducted in accordance with International Standards on Auditing Ensure you gather sufficient appropriate evidence
the application of an accounting principle. A firm being pressured to reduce inappropriately the extent of work performed in order to reduce fees. An auditor feeling pressured to agree with the judgment of a client employee because the employee has more expertise on the matter in question. Actual or Threatened Litigation (for example regarding a previous audit report)- When the firm
and the client’s management are placed in adversarial positions by actual or threatened litigation, affecting management’s willingness to
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QCR If a team member involved, remove from team Withdraw from engagement if very significant
make complete disclosures Fee dependence, close personal relationships, business relationships also cause intimidation
The safeguards for each will be the same as discussed earlier.
threats.
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Conflict of Interest (Firm competes with client or firm has a joint venture with a competitor of a client or the firm has competitors as clients)
Members should place their clients’ interests before their own and should not accept or continue engagements which threaten to give rise to conflicts of interest between the firm and the client. Any advice given should be in the best interests of the client. A conflict of interest arises where an auditor acts for both a client company and for a competitor company of the client. Where the acceptance/continuance of an engagement would, despite safeguards, materially prejudice the interests of any clients, the appointment should not be accepted/continued, or one of the appointments should be discontinued. Managing conflicts of interest 1.
2. 3. 4.
Full disclosure is important– both companies should be fully aware that the firm is acting for the other party. Regular review of situation by an independent senior partner Use of different partners and teams of staff for different engagements Internal procedures within the firm : o Procedures to prevent access to information, for example, strict physical separation of both teams, confidential and secure data filing. o Clear guidelines for members of each engagement team on issues of security and
o
5.
confidentiality. These guidelines could be included within the audit engagement letters. Potentially the use of confidentiality agreements signed by employees and partners of the firm
Advising at least one or all clients to seek additional advice
Attempt questions to check your understanding: Sept/Dec Hybrid 2015-Q1 June 2015-Q1 June 2014-Q3d Dec 2013-Q4c
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Client acceptance/continuance Steps before accepting an audit client Outgoing auditor- Professional etiquette letter
The auditor should communicate with the outgoing auditor the client to assess if there are any ethical or professional reasons why they should not accept appointment. They should obtain permission from the client’s management to contact the outgoing auditor; if this is not given, then the engagement should be refused. The previous auditor must obtain permission from the client’s management to respond; if not given, then the auditor should refuse the engagement.
Client- related issues
1.Formalities(of removal of outgoing auditor fulfilled) 2.Reputation and integrity of the client’s management assessed- If necessary, the firm may want to obtain references if they do not formally know the directors 3. Consider the level of risk attached to the audit whether this is acceptable to the firm. As part of this, they should consider whether the expected audit fee is adequate in relation to the risk auditing the client
Practitioner-related issues ( Audit firm)
1.Any issues which might arise which could threaten compliance with ACCA’sCode of Ethics and Conduct or any local legislation, including independence and conflict of interest with existing clients. If issues arise, then their significance must be considered.
2.Whether they are competent to perform the work and whether they Client screening would have appropriate The purpose of client screening procedures resources( especially human is to determine whether the prospective resource and time!) available, client is suitable for the firm. as well as any specialist skills or knowledge required for The firm should evaluate the potential risk the audit to the firm of acceptance. When a client is deemed to represent a high audit risk to the firm, the firm should carefully consider the implications arising should it fail in meeting its objective of giving an accurate audit opinion. If the firm is not confident that the benefit to be derived from accepting the appointment outweighs the potential risks (including financial and reputational risk of being sued), then the firm should decline the appointment. Factors to consider: The state of the economic sector in which the client operates (a depressed sector may indicate risk).
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The client’s previous audit history (frequent changes of auditors, and/or qualified reports, are obviously bad news). The experience and qualifications of the company’s management and their attitude towards controls. The current operating and financial position of the company. Directors’ understanding of External Auditor’s role and their own responsibilities The accounting policies used Evidence of client involvement in fraudulent or illegal activities. Management permission or refusal to allow auditors to examine significant documents, such as the minutes of directors’ meetings.
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Preconditions for an audit
ISA 210 Agreeing the Terms of Audit Engagements provides guidance to auditors on the steps they should take in accepting a new audit or continuing on an existing audit engagement. It sets out a number of processes that the auditor should perform including agreeing whether the preconditions are present, agreement of audit terms in an engagement letter, recurring audits and changes in engagement terms. Preconditions for an Audit
1. Determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable.
2. Obtain the agreement of management that it acknowledges and understands its responsibility: (i) For the preparation of the financial statements in accordance with the applicable financial reporting framework, including where relevant their fair presentation (ii) For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and (iii) To provide the auditor with: a. Access to all information of which management is aware that is relevant to the preparation of the financial statements such as records, documentation and other matters; b. Additional information that the auditor may request from management for the purpose of the c.
audit***; and Unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence
***Additional information: Additional information that the auditor may request from management for the purpose of the audit may include when applicable, matters related to other information in accordance with ISA 720 (Revised). When the auditor expects to obtain other information after the date of the auditor’s report, the terms of the audit engagement may also acknowledge the auditor’s responsibilities relating to such other information including, if applicable, the actions that may be appropriate or necessary if the auditor concludes that a material misstatement of the other information exists in other information obtained after the date of the auditor’s report
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Agreeing the terms of engagement Engagement letter ( compulsory for every new engagement; sent before the audit starts) Purpose of an engagement letter
An engagement letter provides a written agreement of the terms of the audit engagement between the auditor and management or those charged with governance. It confirms that there is a common understanding between the auditor and management, or those charged with governance, of the terms of the audit engagement helps to avoid misunderstandings with respect to the audit. Contents of an engagement letter
Generally, an audit engagement letter includes the following matters: 1. Objective of the audit: e.g. statutory audit or internal audit 2. Scope of the audit: Elaboration of the scope of the audit, including reference to applicable legislation,
regulations, ISAs, and ethical and other pronouncements of professional bodies to which the auditor adheres. 3. Identification of the applicable financial reporting framework: e.g. IFRS or US GAAP 4. Time schedule: estimated time required for completion of audit 5. The requirement for the auditor to communicate key audit matters in the auditor’s report in accordance
with ISA 701 6. Deliverables: The form of any other communication of results of the audit engagement.e.g. letters,
certificates or audit report. 7. The expectation that management will provide written representations 8. The basis on which fees are computed and any billing arrangements. 9. Permission to communicate with the previous accountant (by sending the etiquette letter) 10. Access to all the records, documentation and other information requested in connection with the audit, e.g.
customs documents to verify whether the goods are being held by customs 11. Management’s responsibility for establishing and maintaining effective internal controls, e.g. maintenance
of proper accounting records
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12. The fact that because of the inherent limitations of an audit, together with the inherent limitations of
internal control, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with ISAs. 13. Arrangements regarding the planning and performance of the audit, including the composition of the
engagement team. 14. The expectation that management will provide access to all information of which management is aware that
is relevant to the preparation of the financial statements, including an expectation that management will provide access to information relevant to disclosures. 15. The agreement of management to make available to the auditor draft financial statements including all
information relevant to their preparation, whether obtained from within or outside of the general and subsidiary ledgers (including all information relevant to the preparation of disclosures), and the other information,3 if any, in time to allow the auditor to complete the audit in accordance with the proposed timetable. 16. The agreement of management to inform the auditor of facts that may affect the financial statements, of
which management may become aware during the period from the date of the audito r’s report to the date the financial statements are issued. 17. A request for management to acknowledge receipt of the audit engagement letter and to agree to the terms
of the engagement outlined therein.
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Changes to engagement letters
Engagement letters for recurring/existing clients should be revised if any of the following factors are present: -
-
-
-
Any indication that the entity misunderstands the objective and scope of the audit, as this misunderstanding would need to be clarified. Any revised or special terms of the audit engagement, as these would require inclusion in the engagement letter. A recent change of senior management or significant change in ownership. The letter is signed by a director on behalf of those charged with governance; if there have been significant changes in management they need to be made aware of what the audit engagement letter includes. A significant change in nature or size of the entity’s business. The approach taken by the auditor may need to change to reflect the change in the entity and this should be clarified in the engagement letter. A change in legal or regulatory requirements. The engagement letter is a contract; hence if legal or regulatory changes occur, then the contract could be out of date. A change in the financial reporting framework adopted in the preparation of the financial statements. The engagement letter clarifies the role of auditors and those charged with governance, it identifies the reporting framework of the financial statements and if this changes, then the letter requires updating. A change in other reporting requirements. Other reporting requirements may be stipulated in the engagement letter; hence if these change, the letter should be updated.
What if management refuses to sign the engagement letter?
1. Identify the reason. Discuss the matter with the directors in an attempt to reach a suitable compromise. 2. Try to reach a suitable compromise keeping in mind your duties and responsibilities 3. Refuse the engagement if matter still not resolved
Attempt questions to check your understanding: Sept/Dec Hybrid 2015-Q2 a,b Dec 2013-Q4a,b
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Audit planning ( Audit Strategy and Audit Plan) Importance of audit planning
1. It helps the auditor to devote appropriate attention to important areas of the audit. 2. It helps the auditor to identify and resolve potential problems on a timely basis. 3.
It helps the auditor to properly organise and manage the audit engagement so that it is performed in an effective and efficient manner.
4.
It assists 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.
5.
It facilitates the direction and supervision of engagement team members and the review of their work.
6.
It assists, where applicable, in the coordination of work done by experts
Audit Strategy: An audit strategy sets the scope, timing and direction of the audit and guides the development
of the more detailed audit plan. Audit plan: Once the overall strategy has been planned, detailed consideration can be given to each individual . audit objective and how it can be best met A.UNDERSTANDING THE CLIENT/ KNOWLEDGE OF THE BUSINESS
The auditor obtains an understanding of the entity, its control environment and its detailed internal controls:
to identify and assess the risks of material misstatements in the financial statements and to provide a basis for designing and implementing responses to these risks
to determine the extent to which the auditor would rely on the internal control system.
to assess whether the team is competent to perform the audit
To understand relevant law and regulations impacting the entity
To consider the reliability of various evidence sources.
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Understanding to be gained about
-
Industry, regulatory and other external factors(
for example financial reporting framework, laws and regulations, stakeholders, economic conditions like volatility of exchange rates, competition, level of technology -
Nature of entity and accounting policies ( legal
structure, ownership and governance, main sources of finance) -
Objectives…strategies…related business risks!
-
Measurement and review of Financial performance ( measures important to the client,
KPIs, budgets, targets) -
Internal control (gain an understanding about the
design and implementation of internal controls) Miscellaneous
Understanding can be gained from Prior year financial statements: Provides information in relation to the size of the client as well as the key accounting policies, disclosure notes and whether the audit opinion was modified or not. Discussions with the previous auditors/access to their files: Provides information on key
issues identified during the prior year audit as well as the audit approach adopted.
Prior year report to management: If this can be obtained from the previous auditors or from management, it can provide information on the internal control deficiencies noted last year. If these have not been rectified by management, then they could arise in the current year audit as well and may impact the audit approach.
The client ‘s accounting systems Identification of issues that arose in the prior year audit and notes/procedural manuals : Provides how these were resolved. Also whether any points brought information on how each of the key forward was noted for consideration for this year’s audit. accounting systems operates and this will be used to identify areas of potential control risk Internal control deficiencies noted in the prior year; if these and help determine the audit approach. have not been rectified by management then they could arise Discussions with management: Provides in the current year audit as well information in relation to the business, any Significant changes in the entity as compared to prior years. important issues which have arisen or changes to accounting policies from the prior year.
Is the company using e-commerce?
Review of board minutes: Provides an overview of key issues which have arisen during the year and how those charged with
governance have addressed them. Current year budgets and management accounts: Provides relevant financial information for the year to date. It will help F8 KNOWLEDGE SUMMARY-SKANS SCHOOL OF ACCOUNTANCY
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the auditor during the planning stage for preliminary analytical review and risk identification. The client’s website: Recent press releases from the company may provide background on the business during the year as this will help in identifying the key audit risks.
Financial statements of competitors : This will provide information about the client ‘s competitors, in relation to their financial results and their accounting policies. This will be important in assessing the client’s performance in the year and also when undertaking the going concern review.
Important: Risks in companies using e-commerce
-loss of transaction integrity -security risk e.g. virus attacks -adoption of improper accounting policies e.g.improper revenue recognition -non- compliance with tax and legal requirements -failure to ensure that e-commerce contracts are binding in a court of law -over reliance on e-commerce -systems and infrastructure crashes
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B. AUDIT RISK and Auditor Response F8 Examiner’s comments
Audit risk questions typically require a number of audit risks to be identified (½ marks each), explained (½ marks each) and an auditor’s response to each risk (1 mark each). To explain audit risk, candidates need to state the area of the accounts impacted with an assertion (e.g. cut off, valuation etc.), or, a reference to under/over/misstated, or, a reference to inherent, control or detection risk. Misstated is only awarded if it was clear that the balance could be either over or understated.
Candidates are reminded that audit risk questions may also require a calculation of relevant ratios that will allow the auditor to identify the key areas of risk in the financial statements. If this is required, as it was in September 2015, it is noted that candidates should only provide one ratio per area of the financial statements (eg either “inventory days” or “inventory turnover”), not include calculations of movements year on year (eg “revenue has increased by x%), as while relevant in the discussion of risk, will not score the marks for calculating appropriate ratios, and also come equipped with a calculator for the F8 exam.
Importance of risk assessment
1. Assessing engagement risks at the planning stage, this will ensure that attention is focused early on the areas most likely to cause material misstatements. 2. It will help the auditor to fully understand the entity, which is vital for an effective audit. 3. Any unusual transactions or balances would also be identified early, so that these could be addressed in a timely manner. 4. Assessing risks early should also result in an efficient audit. The team will only focus their time and effort on key areas as opposed to balances or transactions that might be immaterial or unlikely to contain errors. 5. In addition assessing risk early should ensure that the most appropriate team is selected with more experienced staff allocated to higher risk audits and high risk balances. 6. A thorough risk analysis should ultimately reduce the risk of an inappropriate audit opinion being given. 7. It should enable the auditor to have a good understanding of the risks of fraud, money laundering, etc. 8. Assessing risk should enable the auditor to assess whether the client is a going concern.
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Audit Risk Auditors use the audit risk model to direct audit resources to the performance of additional substantive procedures in areas of the financial statement where audit risk is deemed to be high.
The formula for the audit risk model is: Audit Risk = Risk of material misstatement in the financial statements x Detection Risk
Audit Risk Explained
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of two main components being the risks of material misstatement and detection risk. Risk of material misstatement is made up of two components, inherent risk and control risk. Risk of material misstatement in the financial statements explained
Risk of material misstatement is made up of a further two components, inherent risk and control risk. Inherent risk Inherent risk:
Definition: The susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls. Inherent risk describes something about the nature of a business or its transactions that make it particularly susceptible to material misstatements.
Inherent risk is affected by the nature of an entity and factors which can result in an increase include: – Changes in the industry it operates in. – Operations that are subject to a high degree of regulation. – Going concern and liquidity issues including loss of significant customers. – Developing or offering new products or services, or moving into new lines of business. – Expanding into new locations. – Application of new accounting standards. – Accounting measurements that involve complex processes. – Events or transactions that involve significant accounting estimates. – Pending litigation and contingent liabilities.
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Control risk
Definition: The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detectedand corrected, on a timely basis by the entity’s internal control. It is the risk that an organisation’s internal control systems do not adequately protect the organization either because they have not been adequately designed and / or implemented.
The following factors can result in an increase in control risk: – Lack of personnel with appropriate accounting and financial reporting skills. – Changes in key personnel including departure of key management. – Deficiencies in internal control, especially those not addressed by management. – Changes in the information technology (IT) environment. – Installation of significant new IT systems related to financial reporting.
It is important to appreciate that the auditor has no control over the extent of either inherent or control risk; these are risks borne by the entity subject to audit. However, the auditor has to assess them in the process of determining the extent of the detailed substantive procedures to be carried out.
Detection risk Explained
Definition: The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements. Detection risk is affected by sampling and non-sampling risk. Detection risk is all down to the auditors and is the risk that the auditor’s procedures fail to detect a material misstatement.
Detection risk is affected by sampling and non-sampling risk and factors which can result in an increase include: – Inadequate planning. – Inappropriate assignment of personnel to the engagement team. – Failing to apply professional scepticism. – Inadequate supervision and review of the audit work performed. – Incorrect sampling techniques performed. – Incorrect sample sizes
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Detection risk include sampling risk and non-sampling risk ( these are explained in detail with the topic of sampling- below is an overview). Sampling risk= sample is not representative of the population Non-sampling risk = auditor’s procedures or the conclusion reached are incorrect.
Audit Risk
Needs to be at an acceptably low level
=
Inherent Risk
x
High
Control Risk
High
x
Detection risk
Must be low!
The audit risk model used by auditors, dictates that for a given level of audit risk, the acceptable level of detection risk bears an inverse relationship to the assessment of the risk of material misstatement. For example, on an audit assignment where the risk of material misstatement has been assessed as high, in order to achieve a low level of audit risk, detection risk must be set as low. In such circumstances the auditor would need to direct an appropriate level of resources to the testing of the assertion in question. This will comprise adequate planning, proper assignment of personnel, the application of professional scepticism and supervision and review of the audit work performed.
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Analytical procedures
Analytical procedure is anaudit procedure which seeks to provide evidence as to the completeness, accuracy and validity of the i nformation contained in the accounting records or in the financial statements. The procedure consists of the systematic study and comparison of relationships among elements of financial information and the investigation of significant fluctuations and variances from the expected relationship Steps involved in analytical procedures 1. Expectation:This step involves developing an expectation of what the financial information figures should be. This can be agreed through comparisons of financial information or considerations of relationships (ratio analysis). 2. Identification:This step involves identification of significant variations between the actual data with the expected data. 3. Investigation of unusual variances: Once the variation has been computed, and if significant variations are found, the auditor would consult the management in order to establish explanations for the variations revealed.
4. Performance of alternate procedures: If the auditor or the management does not find the variation reasonable, then they investigate further and perform analytical procedures to satisfy themselves.
analytical compares numbers, When performing anto , the auditor ratios or even information in order identify procedure unexpected trends or unexpected relationships,which maynon-financial indicate the existence of errors.
There are many different analytical procedures including the comparisons listed below year on year (e.g. revenue this year compared to revenue last year); to budget or forecast (e.g. actual purchases compared to budgeted purchases); to predictions made by the auditors-proof in total (e.g. auditors calculation of depreciation compared to client’s calculation); to industry information (e.g. client’s revenue compared to competitor’s revenue). Comparison/analysis of relationships between different elements of the financial statements ( for example gross profit compared to sales) Comparison of financial info with non-financial info ( for e.g. payroll expense matched to number of employees) Nonfinancial information. For example, sales revenue for a client from the hotel industry might be based on available data as to room occupancy rates.
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Analytical Procedures at the Planning stage
Analytical Procedures at substantive testing stage
Analytical Procedures at the Review stage
to assist the auditor in planning the nature, timing and extent of other audit procedures. Use at this stage should add to the firm’s understanding of the business and identify risk areas to which audit resources should be targeted. at the detailed testing stage– in most instances analytical procedures should be used in conjunction with tests of detail to achieve a particular audit objective in relation to specific financial statement assertions.. At the final review stage the auditor must design and perform analytical procedures that assist him when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity and that all of the audit objectives with regard to the financial statements have been met.
Using Ratios In the Paper F8 exam you may be asked to compute and interpret the key ratios used in analytical procedures at both the audit planning stage and when collecting audit evidence. Ratios a nd comparisons can be used to identify where the accounts might be wrong, and where additional auditing effort should be spent.
Calculating a ratio is easy, and usually is little more than dividing one number by another. Indeed, the calculations are so basic that they can be programmed into a spreadsheet. The real skill comes in interpreting the results and using that information to carry out a better audit. Saying that a ratio has increased because the top line in the calculation has increased (or the bottom line decreased) is rather pointless: this is simply translating the calculation into words.
Gross Profit Margin = Gross profit/Sales Revenue x 100 Operating profit margin =Operating profit/Sales Revenue x 100 Return on capital employed = Operating profit/ Capital employed x 100 Current Ratio= Current Assets/Current Liabilities Quick ( or asset test) ratios = Current assets minus inventory/ current liabilities
Inventory holding period or Inventory days = Inventory/Cost of sales x 365 Receivable days/ Receivables collection period =Trade receivables/Sales x 365 Trade payable Days/Payables payment period =Trade payables/Cost of sales x 365
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Gearing =Long-term loan finance/ equity finance x 100
The gearing ratio can also be defined in other ways, particularly by comparing long-term loan finance to total finance. As gearing increases so does the risk that the interest can’tbe paid. But it is difficult todefine a ‘safe’ level of gearing. For example, a property company with properties leased to tenants will have fairly predictable rental income. Such a company can probably safely sustain substantial borrowings (though it could be in trouble if interest rates increased significantly). A company with volatile streams of income would have to keep its gearing lower as it must ensure that interest can be paid during the lean times. Interest cover = profit before interest/ interest
Auditor’s Responses to Risk F8 Examiner’s comments An auditor’s response does not have to be a detailed audit procedure, rather an approach the audit team will take to address the identified risk.
Having identified the audit risk candidates are often required to identify the relevant response to these risks. A common mistake made by candidates is to provide a response that management would adopt rather than the auditor. In the past exams, in relation to the risk of valuation of receivables if a company has a number of receivables who were struggling to pay, many candidates suggested that management needed to chase these outstanding customers. This is not a response that the auditor would adopt, as they would be focused on testing valuation through after date cash receipts or reviewing the aged receivables ledger. Auditor’s responses should focus on how the team will obtain evidence to reduce the risks identified to an acceptable level. Their objective is confirming whether the financial statement assertions have been adhered to, and whether the financial statements are true and fair. Responses are not as detailed as audit procedures; instead they relate to the approach the auditor will adopt to confirm whether the transactions or balances are materially misstated.
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ISA 330 lists the following overall responses that may be used by auditors in order to address the assessed risks of material misstatement at the financial statement level:
Emphasizing to the audit team the need to maintain professional scepticism. Assigning more experienced staff, those with special skills, or using experts.
Providing more supervision. Incorporating additional elements of unpredictability in the selection of further audit procedures to be performed.
Making general changes to the nature, timing or extent of audit procedures
Examples from past exams Audit Risk
Audit Response
The finance director Abrahams is planning to capitalize the full A breakdown of the development expenditure $2.2 million of development expenditure incurred. However in should be reviewed and tested in detail to order to be capitalized it must meet all of the criteria under ensure that only projects which meet the IAS 38 intangible Assets
capitalization criteria are included as an intangible asset, with the balance being expensed.
In September Abrahams Co introduced a new accounting The new system will need to be documented in system. This is a critical system for the accounts preparation full and testing should be performed over the and if there were any errors that occurred during the transfer of data from the old to the new changeover process, these could impact on the final amounts system. in the trial balance.
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C.MATERIALITY
Definition: ‘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.’ In assessing the level of materiality there are a number of areas that should be considered. Firstly the auditor must consider both the amount (quantity) and the nature (quality) of any misstatements, or a combination of both. The quantity of the misstatement refers to the relative size of it and the quality refers to an amount that might be low in value but due to its prominence could infl uence the user’s decision, for example, directors’ transactions. In assessing materiality the auditor must consider that a number of errors each with a low value may when aggregated amount to a material misstatement. The assessment of what is material is ultimately a matter of the auditor’s professional judgement, and it is affected by the auditor’s perception of the financial information needs of users of the financial statements and the perceived level of risk; the higher the risk, the lower the level of overall materiality. Materiality is often calculated using benchmarks such as 5% of profit before tax or 2% of total assets. These values are useful as a starting point for assessing materiality.
Auditors need to establish the materiality level for the financial statements as a whole, as well as assess performance materiality levels, which are lower than the overall materiality. Performance materiality is normally set at a level lower than overall materiality. It is used for testing individual transactions, account balances and disclosures. The aim of performance materiality is to reduce the risk that the total of errors in balances, transactions and disclosures does not in total exceed overall materiality. Definition of performance materiality below: ‘Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures.’
Material by size (importance depends on value)-Quantitative factors
1% of revenue; 2% of total assets; 10% of PBT.
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Material by nature
Examples Bank balances Related party transactions ( including remuneration and personal expenses of directors) Fraud/ Unlawful transactions (e.g. illegal payments) -Violation of regulatory requirements Incorrect selection or application of an accounting policy that has an immaterial effect on the current period but is likely to have a material effect on future periods Failure to meet requirements of debt-covenants Key Performance Indicators of the company (e.g. converting loss into profit)
D.SCOPE.TIMING AND DIRECTION Scope Timing 1. Financial reporting framework for the financial
statements. 2. Are there industry specific or other special reporting requirements?
Deadlines for:
Final reporting
Any interim report
Meeting with Those charged with governance and
3. Are there other factors which influence the overall
approach to the audit?
Multiple locations Need of expert
Management to discuss important matters of audit
Reports to management
Reports to those charged with governance.
Whether the entity has an internal audit The normal timetable for an audit includes: function, and if so, in which areas and to what - An interim visit, usually at least threeextent work of the function can be used. quarters of the way through the
Nature of business (considering need of specialized knowledge).
Effect of information technology on the audit procedures
-
accounting year Attendance at inventory count Year end confirmation letters The final audit shortly after the accounting year-end
This pattern will often be modified to suit the needs of the particular business.
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Direction
The ‘direction’ of the audit covers the overall approach and concerns such issues as: 1. Reliance on controls or a fully substantive approach. 2.
Significant developments and changes in
Industry (e.g. regulations and reporting requirements) Business (impact of IT, changes in processes, mergers, acquisitions) Financial Reporting Framework
Others (e.g. legal environment)
3.
4. 5.
With respect to risk Identification of areas of financial statements where there is higher risk. Impact of risk at financial statements level on direction, supervision and review. With respect to materiality:; Setting materiality for planning purposes With respect to Internal Controls Internal control deficiencies identified in previous audits and actions to address them.
Appropriateness of design, implementation and operating effectiveness of internal control. Whether it is more efficient to rely on internal control.
Audit plan
An audit plan converts the audit strategy into a more detailed plan and includes the nature, timing and extent of audit procedures to be performed by engagement team members in order to obtain sufficientappropriate audit evidence to reduce audit risk to a low level . Audit planning is a detailed recording of each procedure and process required to perform an audit. Once the overall strategy has been determined, the auditor should prepare a detailed plan of the areas determined in the audit strategy. Once the audit strategy has been decided, the next stage is to decide how it is going to be carried out; an audit plan is necessary. The audit plan contains the nature, timing and extent of the procedures to be performed. The audit plan covers:
Allocation of work and duties to the assistants
Allocation of time and cost
Formation of various teams
Audit tests/procedures
Data gathering techniques
Types of audit evidence desired
The audit plan is developed in order to reduce audit risk to an acceptably low level.
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Interim vs Final Audit
Interim Audit
An interim audit refers to audit work that is conducted during the accounting year, at intervals, fixed or not. The audit of the remaining part of the year will be done at the end of the accounting year. The auditor uses the interim audit to carry out procedures which would be difficult to perform at the year end because of time pressure. There is no requirement to undertake an interim audit; factors to consider when deciding upon whether to have one include the size and complexity of the company along with the effectiveness of internal controls.
Typical work carried out at the interim audit includes: - consideration of inherent risks facing the company. ( Risk would be initially considered at the planning stage, but is, in fact, reassessed at all audit stages.) - documenting and testing of internal controls - testing of profit and loss transactions for the year to date - identification of potential problems that may affect the final audit work.
Final audit
The final audit will take place after the year end and concludes with the auditor forming and expressing an opinion on the financial statements for the whole year subject to audit. It is important to note that the final opinion takes account of conclusions formed at both the interim and final audit. Typical work carried out at the final examination includes: Follow up of items noted at the inventory count - Obtaining confirmations from third parties, such as bankers and lawyers - Analytical reviews of figures in the financial statements. - substantive procedures of account balances and transactions - Reviews of events after the reporting period - Consideration of the going concern status of the organisation.
Advantages of interim audit
a) The errors are discovered at early stage b) As the auditor visits the entity frequently, the chances of fraud being committed reduce. c) Fraud, if committed, will be discovered at an early stage, which results in minimising the loss due to the fraud. d) Most of the time, the audit staff is present at the client’s premises, which acts as a moral check and result in minimising the chances of errors or fraud. e) All the books and records of the client are always up-to-date. F8 KNOWLEDGE SUMMARY-SKANS SCHOOL OF ACCOUNTANCY
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f)
As the audit is started earlier, more time is available for a detailed checking of accounts and hence this allows for a comprehensive audit. g) An interim audit minimises the work and time involved in conducting the audit at the end of the year and therefore assures early completion of the audit reports. h) If the auditor plans to rely on the internal controls, some extensive testing may be done at the interim period only so that the workload at the end of the year will be reduced.
Disadvantages of interim audit a) There is always a danger that the audited figures may be altered either innocently or fraudulently. That is why ISA 330 states that when audit evidence (relating to the operating effectiveness of internal controls or the financial statement assertions), is obtained during the interim period, additional audit evidence (relating to the effectiveness of internal controls or the financial statement assertions) must also be obtained for the remaining period. b) It is just a waste of time in small entities. c) The cost would be high.
Attempt questions to check your understanding: Audit Risk
Sept. 2016-Q18 a,b March/June Hybrid 2016-Q6a,b Sept/Dec Hybrid 2015-Q4 June 2015-Q5b Dec 2014-Q2 June 2014-Q3a Dec 2013-Q1a,b,c June 2013-Q3 ( Ratios)
Planning-general
Sept/Dec Hybrid 2015-Q2c
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Internal control over financial reporting F8 Examiner’s comments Internal control questions typically require internal control deficiencies to be identified (½ marks each), explained (½ marks each), a relevant recommendation to address the control (1 mark), and, often a test of control the external auditor would perform to assess whether each of these controls, if implemented, is operating correctly (1 mark).
Internal control questions may also require a covering letter to management to accompany the list of deficiencies and recommendations.
Occasionally, as in September 2015, candidates may be asked to identify internal control strengths as well as deficiencies.
Internal controls: Internal control represents the system or policies and procedures implemented by an
organization.
Internal control over financial reporting: The process designedimplemented maintained by TCWG to
provide reasonable assurance about the reliability of financial reporting, effectiveness of operations and compliance with laws and regulations. Why does an auditor need t o understand internal controls?
Internal controls assure management of the accuracy of the financial statements, that the operations of the entity are conducted efficiently and that the entity has complied with all the laws and regulations which are applicable to the entity. The objectives of internal controls relevant to audit include:
1. Avoidance of fraud, errors, wastes and inefficiency 2. Maximum accuracy of all records, data and statements 3. Enables auditors to determine the degree of reliance they can place on the various systems. This will enable the auditors to assess the correctness, truth and fairness of the financial statements. 4. Informing management about weaknesses detected in internal controls so that corrective action can be taken. 5. Enabling planning of the audit 6. Understanding the components of internal control: While planning the audit, the auditor understands the various components of the internal control so as to: o
identify the types of potential misstatements. consider the factors that affect the risk of misstatement.
o
design effective substantive tests.
o
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Components of internal control over financial reporting
ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment considers the components of an entity’s internal control. It identifies the following components: 1. Control environment 2. Entity’s risk assessment process 3. Information system and communication 4. Control activities 5. Monitoring of controls Understand client’s Control Environment
The control environment sets the tone of an organisation, influencing the control consciousness of its people. It includes the attitudes, awareness, and actions of TCWG concerning the entity’s internal control and its importance in the entity. The control environment has many elements such as: a) Communication and enforcement of integrity and ethical values – essential elements which influence the effectiveness of the design, administration and monitoring of controls. b) Commitment to competence– management’s consideration of the competence levels for particular jobs and how those levels translate into requisite skills and knowledge. c) Management’s philosophy and operating style – management’s approach to taking and managing business risks, and management’s attitudes and actions towards financial reporting, information processing and accounting functions and personnel. d) Organisational structure– the framework within which an entity’s activities for achieving its objectives are planned, executed, controlled and reviewed. e) Assignment of authority and responsibility – how authority and responsibility for operating activities are assigned and how reporting relationships and authorisation hierarchies are established. f) Human resources policies and practices– recruitment, orientation, training, evaluating, counselling, promoting, compensating and remedial actions. g) Participation by TCWG ( their independence from the management, their experience, appropriateness of actions etc.)
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Understand client’s Risk
Auditor needs to understand the management’s process to identify and assess
Assessment Process
risks in financial reporting. Auditor also needs to understand actions taken by the management to address these risks. The auditor will then evaluate whether there are deficiencies in the client’s risk assessment process.
Understand client’s
Auditor will understand the process by which transactions and events are
Information systems relevant to financial
initiated, recorded, processed, corrected, transferred to general ledger and reported in the financial statements.
reporting Plus communication
Auditor will also understand how the clientcommunicates financial reporting roles and responsibilities as well as important matters relating to financial reporting.
Understand the Control
Control activities are the policies and procedures which help ensure that
Activities
management directives are carried out. Auditor has to understand control activities to assess risk of material misstatement in the financial statements and to design further procedures.
Examples of controls are: Segregation of duties :assignment of roles/responsibilities to different people, thereby reducing the risk of fraud and error occurring. The concept is that no individual person should be responsible for more than one of the following duties: (i) the authoristion of a transaction; (ii) the recording of the transaction in the accounting records; and (iii) the custody of the asset relating to the transaction. Information processing: computer controls including general IT controls, which cover a range of applications and support the overall IT environment and application controls which operate on a cycle/business process level ( details given separately) Authorisation: approval of transactions by a suitably responsible official to ensure transactions are genuine. Physical controls : restricting access to physical assets such as cash, inventory and plant and equipment, thereby reducing the risk of theft.
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Performance reviews : comparison or review of the performance of the business by looking at areas such as budget v actual results. Arithmetical controls: controls which checkthe arithmetical accuracy of accounting records. Account reconciliations : comparison of an account balance with another source; often this source is from a third party, such as the bank, with differences being investigated.
Understand client’s Monitoring process
Auditor will understand how internal controls over financial reporting monitored ( including whether there is an effective internal audit department)
Computer Controls GENERAL CONTROLS(Apply to the whole system)
Controls on the information system environment which ensure proper development of applications. Examples include
making regular back-ups of data and storing them off-site; having an IT help-desk and IT training for staff; keeping computers in locked rooms; having a disaster recovery plan; all computers have log in codes; anti-virus software and firewalls; segregation of duties between programmers and users. review of the data center or information processing facility should cover the adequacy of air conditioning (temperature, humidity), power supply (uninterruptible power supplies, generators) and smoke detectors
APPLICATION CONTROLS
Application controls are those controls that relate to the transaction and standing data relating to a computerbased accounting system. They are specific to a given application and their objectives are to ensure the completeness and accuracy of the accounting records and the validity of entries made in those records. An effective computer-based system will ensure that there are adequate controls existing at the point input, of processing and output stages of the computer processing cycle and over standing data contained in master files.
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Application controls need to be ascertained, recorded and evaluated by the auditor as part of the process of determining the risk of material misstatement in the audit client’s financial statements.
Input controls
Data input controls ensure the accuracy, completeness, and timeliness of data during its conversion from its srcinal source into computer data, or entry into a computer application. Examples are given below: -
Format checks: These ensure that information is input in the correct form. For example, the
requirement – not numeric and alphanumeric.that the date of a sales invoice be input in numeric format only -
Range /Reasonableness checks: These ensure that input data is rejected or highlighted if it is outside pre-set parameters.For example, where an entity rarely, if ever, makes bulk-buy purchases with a value in excess of $50,000, a purchase invoice with an input value in excess of $50,000 is rejected for review and follow-up.
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Compatibility/dependence checks: These ensure that data input from two or more fields is compatible. For example, a sales invoice value should be compatible with the amount of sales tax charged on the invoice.
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Exception checks: These ensure that an exception report is produced highlighting unusual situations that have arisen following the input of a specific item. For example, the carry forward of a negative value for inventory held.
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Sequence checks: ensure sequential input ofthat documentation/data is maintained. Theseare facilitate completeness of that processing by ensuring documents processed out of sequence rejected. For example, where pre-numbered goods received notes are issued to acknowledge the receipt of goods into physical inventory, any input of notes out of sequence should be rejected.
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Control totals: These also facilitate completeness of processing by ensure that pre-input, manually prepared control totals are compared to control totals input. For example, the total of all the invoices, such as the gross value, is manually calculated. The invoices are input, the system aggregates the total of the input invoices’ gross value and this is compared to the control total. This helps to ensure completeness and accuracy of input.
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Existence checks : the system is set up so that certain key data must be entered, such as supplier name, otherwise the invoice is rejected. This helps to ensure accuracy of input.
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Check digit verification: Check digits are used to protect against the transposition of data i.e. errors arising due to accidental reversal of digits. This process uses algorithms to ensure that data input is
accurate. -
Document counts :the number of invoices to be input are counted, the invoices are then entered one by one, at the end the number of invoices input is checked against the document count. This helps to ensure completeness of input.
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-
One for one checking: the invoices entered into the system are manually agreed back one by one to the srcinal purchase invoices. This helps to ensure completeness and accuracy of input.
Processing controls
Processing controls exist to ensure that all data input is processed correctly and that data files are appropriately updated accurately in a timely manner. For example, the balance carried forward on the bank account in a company’s general (nominal) ledger. Other processing controls should include the subsequent processing of data rejected at the point of input, for example: A computer produced print-out of rejected items. Formal written instructions notifying data processing personnel of the procedures to follow with regard to rejected items. Appropriate investigation/follow up with regard to rejected items. Evidence that rejected errors have been corrected and re-input. Output controls
Output controls exist to ensure that all data is processed and that output is distributed only to prescribed authorised users. While the degree of output controls will vary from one organisation to another (dependent on the confidentiality of the information and size of the organisation), common controls comprise: Appropriate review and follow up of exception report information to ensure that there are no permanently outstanding exception items. -
Careful scheduling of the processing of data to help facilitate the distribution of information to end users on a timely basis. Ongoing monitoring by a responsible official, of the distribution of output, to ensure it is distributed in accordance with authorised policy.
Term to remember: Standing Data
Standing data is the information that is held on computer files for long-term use. It is called standing data as it tends to change less frequently than other data. Examples of standing data would be: • the rate of sales tax to be applied to sales invoices; • the hourly pay rate for a factory worker to be used when calculating payroll; • employee bank account details.
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Master file controls The purpose of master file controls is to ensure the ongoing integrity of the standing data contained in the master files. It is vitally important that stringent ‘security’ controls should be exercised overl master al files. These include: -appropriate use of passwords, to restrict access to master file data -the establishment of adequate procedures over the amendment of data, comprising appropriate segregation of duties, and authority to amend being restricted to appropriate responsible individuals -regular checking of master file data to authorised data, by an independent responsible official
Limitations of internal c ontrol components
The internal control system, even if well-designed and well-implemented, does not completely eliminate the possibility of fraud or error. No internal control system can be perfect due to its inherent limitations. -
Controls are far more expensive compared to the benefits from the system. Overriding of controls by the management. Control systems are not geared up to cater to non-routine transactions. Possibility of human error. Possibility of fraud on account of collusion between employees. Possibility that, with a change in conditions, a control may not be modified and therefore may become inadequate. Obsolescence of controls.
Responsibilities of various parties regarding ICS
Management: design and implement and effective ICS. Check and ensure it is working effectively on a continuous basis BOD: ensure that an effective ICS is designed, implemented and monitored by the management. Ensure ICS are reviewed by internal and external auditors and their recommendations are implemented Auditors: review and report on ICS and recommend changes
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External auditor’s work regarding controls Document/Evaluate
Narratives
Narrative notes consist of a written description of the system; they would detail what occurs in the system at each stage and would include any controls which operate at each stage. Advantages of this method include: – They are simple to record; after discussion with staff members of Oregano, these
discussions are easily written up as notes. – They can facilitate understanding by all members of the internal audit team, especially more junior members who might find alternative methods too complex. Disadvantages of this method include: – Narrative notes may prove to be too cumbersome, especially if the sales and distribution system is complex.
– This method can make it more difficult to identify missing internal controls as the notes record the detail but do not identify control exceptions clearly. Flowcharts
Flowcharts are a graphic illustration of the internal control system for the sales and despatch system. Lines usually demonstrate the sequence of events and standard symbols are used to signify controls or documents. Advantages of this method include: – It is easy to view the sales system in its entirety as it is all presented together in one diagram. – Due to the use of standard symbols for controls, they are easy to spot as are any missing controls. Information is presented in a logical sequence. – They ensure that a system is recorded in its entirety as all documents have to be traced from beginning to end. – Facilitates easy understanding of a system. – Facilitates thehighlights of strengths andweaknesses of a system. – Serves as a permanent record of a system that can be subject to a minor amendment on a year-to-year basis. – They can be prepared quickly by staff with little experience. Disadvantages of this method include: – They can sometimes be difficult to amend, as any amendments may require the whole flowchart to be redrawn. – There is still the need for narrative notes to accompany the flowchart and hence it can be a time consuming method.
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– Not generally suitable for recording systems with numerous unusual transactions. – Only suitable for describing standard systems. – Major amendment is not normally possible without redrawing. – Time can be wasted by recording and checking areas that are of no audit significance. – They are not normally appropriate for recording systems where there are subsystems or subroutines. Questionnaires Internal control questionnaires are used to assess whether controls exist which meet specific objectives or prevent or detect errors and omissions. -
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ICQ( designed to ask if certain controls are present) ICEQ (designed to ask if certain errors can be prevented-i.e. test the effectiveness of controls)
An Internal Control Questionnaire (ICQ) normally comprises a checklist of standard controls that should exist in a specified functional area (for example sales and trade receivables or purchases and trade payables). Questions about the existence of specified controls are usually phrased to generate a ‘Yes’ or a ‘No’ answer, with an affirmative answer confirming the existence of the control and a negative answer indicating the absence of the control and a weakness in the system. A problem associated with ICQs is that whilst they do identify areas where controls appear to be weak, they do not provide evaluation of those weaknesses. For example, whilst a ‘No’ answer may indicate weakness in controls, it is possible that other controls in the system, of which the auditor is unaware, may compensate for the weakness. Internal Evaluation Questionnaires (ICEQs) provide an alternative and improved means of evaluating control systems, by asking key questions about those systems. Key questions are phrased such that answers in the positive should alert the auditor to the fact that there are deficiencies in the systems because systems objectives are not being met. ICEQs are usually designed to include a list of points that the auditor should consider before answering each key question. The auditor issues the questionnaires to the client, who in turn gets it filled by the appropriate employees. The feedback on the questionnaire enables the auditor to assess the inherent limitations in the design of the internal controls.
The ICEQs contain detailed questions relating to the functioning of internal controls. They are to be answered by the clients. The answers to the questions are generally in a narrative form. Information relating to the following matters is included the ICQs and ICEQs: _ segregation and rotation of duties _ maintenance of records and documents _ accountability for, and safeguarding of assets _ procedure for authorisations F8 KNOWLEDGE SUMMARY-SKANS SCHOOL OF ACCOUNTANCY
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The feedback received on the questionnaires will then be tested by the auditors and the weaknesses, if any, will be communicated in the form of a letter of weakness to the client. Advantages Questionnaires are quick to prepare, which means they are a cost effective method for recording the system.
They ensure that all controls present within the system are considered and recorded; hence missing controls or deficiencies are clearly highlighted. Questionnaires are simple to complete and therefore any members of the team can complete them and they are easy to use and understand. Disadvantages It can be easy for the company to overstate the level of the controls present as they are asked a series of questions relating to potential controls.
Without careful tailoring of the questionnaire to make it company specific, there is a risk that controls may be misunderstood and unusual controls missed. Test! Test of controls are performed to obtain audit evidence about 2 things: 1. Whether the ICS isdesigned suitably (to prevent, detect or correct material misstatements) 2. Whether the ICS areoperating properly ( test of controls) Test of controls- examples
inspection of documents (e.g. authorizations)
enquiries about internal controls which leave no audit trail ( e.g. is the person who is SUPPOSED to perform the function actually performing it or is someone else is doing so)
Re-performance of control procedures ( e.g. reconciliations)
examination of evidence of management views(e.g. minutes of meetings)
Observation of controls
Using TEST DATA(CAATs)
If controls appear strong, they are tested to ensure they operated as described throughout the year. If the results show they operated effectively, substantive testing may be reduced.
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Report control weaknesses to management
A letter on internal control (also referred to as a management letter or letter of weakness) is a letter usually forwarded by an auditor to the senior management of a company. The letter should normally be forwarded immediately following the completion of the tests of control and before the commencement of substantive procedures. The letter contains weaknesses identified in the entity’s system of internal control as identified by the auditor when performing tests of control and the purpose of the letter is to bring these weaknesses to the attention of management. The weaknesses identified in the main body of the letter should be those which could lead to fraud or material error in or omission from the company’s financial statements, and will be classified as those relating to: (i) the design of the systems of accounting and internal control. (ii) the operation of the systems of accounting and internal control. For both categories the implication(s) of the weakness(es) should be identified, however minor control issues which the auditor would wish to bring to the attention of the company’s senior management should be included in an appendix to the letter of weakness or in a supplementary report.
Examples of matters the external auditor should consider in determining whether a deficiency in internal controls is significant include: – The likelihood of the deficiencies leading to material misstatements in the financial statements in the future.
– – – –
The susceptibility to loss or fraud of the related asset or liability, the subjectivity and complexity of determining estimated amounts. The financial statement amounts exposed to the deficiencies. The volume of activity that has occurred or could occur in the account balance or class of transactions exposed to the deficiency or deficiencies. The cause and frequency of the exceptions detected as a result of the deficiencies in the controls.
Decide extent of substantive testing
Internal control over financial reporting strong- decrease substantive testing Internal control over financial reporting weak- inccrease substantive testing
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The Sales System Control objectives for sales and despatch system -
To ensure that orders are only accepted if goods are available to be processed for customers. To ensure that all orders are recorded completely and accurately. To ensure that goods are not supplied to poor credit risks. To ensure that goods are despatched for all orders on a timely basis. To ensure that goods are despatched correctly to customers and that they are of an adequate quality. To ensure that all goods despatched are correctly invoiced. To ensure completeness of income for goods despatched. To ensure that sales discounts are only provided to valid customers.
Sales order
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placed
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Goods dispatched
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to the customer
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All sales orders documented on a sequentially numbered multi-part SALES ORDER FORM. Confirm from the customer ( preferably in writing except on telephonic sales, a verbal reconfirmation/ call recording should be acceptable) Inventory check One copy of the GDN is sent with the goods, one copy stays in the warehouse, stapled to the relevant sales order, and one copy is sent to the invoicing department. New customer: credit checks, the obtaining of trade/bank references and the setting of appropriate credit limits for customers Existing customer: credit limit check, Customer credit limits should be regularly reviewed and updated based on the level of sales transactions and credit risk Any discounts committed to be authorized Follow up on unfulfilled orders- On a regular basis, a sequence check of orders should be undertaken to identify any missing orders. Automated environment: access to master file limited to authorized individuals only
Sequentially pre-numbered Goods Dispatched Note Matched to the sales order- Upon despatch, the GDN should be matched to the order; a regular review of unmatched orders should be undertaken to identify any unfulfilled orders. Signed by the warehouse manager after quantity and quality checks 3 copies( warehouse, customer, accounts/invoicing) Customer should sign the copies to acknowledge receipt of goods
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Sales invoice raised and entered in the accounting system
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Sequentially pre-numbered invoices Matched to GDN 3 copies ( accounts/invoicing, customer, sales day book clerk if applicable) Ensure the authorized price list is used to prepare the invoice Any discounts authorized Arithmetic checks on invoices Sequence check on GDNs to ensure all GDNs have been invoiced Sequence check onInvoices to ensure all invoices have been entered in the accounting system Customer statements should be sent monthly to ensure any errors and disputed invoices are quickly identified and resolved The sales ledger control account should be reconciled on a monthly basis to the individual ledger to identify any errors. The reconciliations should be reviewed by a responsible official and they should evidence their review.
Payment received from the customer
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Goods returned by the customer
Match payment to invoice Check validity of any settlement discounts availed by the customer Segregation of duties: receiving payment and recording Encourage bank transfers A Bank Reconciliation Statement should be prepared on a monthly basis
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Sequentially pre-numbered credit note Signed by the manager Matched to invoice Prepare a report for reasons for returns and actions taken by the management.
Other
Aged receivables report: prepare monthly and reviewed by a senior official
controls
Exceptions reports created and reviewed ( old receivables, credit limit exceeded etc.) Amendments to master file data should be restricted so that only senior officials can make changes.
Attempt questions to check your understanding: Sept. 2016- Q16a,b Dec 2014-Q5a Dec 2013-Q3
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The Purchase System The main objectives in purchase transactions are:
– – –
Procurement is made only when the requirements are genuine.
– –
Payments are made according to agreed terms.
Purchases are made at the most optimum prices and terms. Purchases meet the required quality standards and if substandard quality is accepted, must be at negotiated terms. They are procured on time and the payments are made according to agreed terms.
Purchase requisition
Purchase order
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Sequentially pre-numbered Authorized to ensure only those goods are ordered which are required Monitor inventory level or Re-order level set Inventory/ re-order level checked before raising the requisition to ensure only order when required.
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Sequentially pre-numbered and matched to requisition Authorized supplier list used and updated annually (this should take into account the price of goods, their quality and the speed of delivery.) Authorized 3 copies ( supplier, order department, warehouse) Follow up on order placed but not yet received ( exception reports can be created in a computerized environment) and sequence checkcan be performed for any unfulfilled orders
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Goods received
Invoice received
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Sequentially pre-numbered GRN Matched to purchase order Signed by the warehouse manager after quantity and quality checks 3 copies ( ordering department, warehouse for their records, account)
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Match to GRN File in an order ( CANNOT be Sequentially pre-numbered) but should be numbered manually. This way, a sequence check can then be carried out to ensure all invoices have been entered in the day book/ledger. Arithmetic checks Entered in the ledger /day book on a daily basis-application controls( such as control total) should be applied to ensure completeness and accuracy over the input of purchase invoices. Stamp ‘entered’ when recorded Segregation of duties ( order placement, goods received and recording) Monthly reconciliation: PL to PLCA
from supplier
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Payment made
Goods returned to the supplier
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Segregation of duties ( Purchase order, goods received, payment )
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Sequentially pre-numbered debit notes
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Before approving invoices for payment, a senior official should match them to the audit trail ( esp. the GRN)
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Authorized
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Bank transfer preferred
Vendor-wise analysis to identify consistent quality problems
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If payment by cheque: senior individuals only plus two signatories for high amounts
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Stamp invoice ‘paid’
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Try and avail settlement discounts and pay according to supplier’s terms to maintain supplier goodwill
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Payment against specific invoices only ( avoid ‘on account payment’)
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Supplier statement reconciliation with PL
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PL reconciliation with PLCA
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Monthly BRS
Examples of application controls to ensure the Completeness and
Document counts – the number of invoices to be input are counted, the invoices are then entered one by one, at the end the number of invoices input is checked against
the document count. This helps to ensure completeness of input.
accuracy of the input of
Control totals – here the total of all the invoices, such as the gross value, is manually
purchase invoices.
calculated. The invoices are input, the system aggregates the total of the input invoices’ gross value and this is compared to the control total. This helps to ensure completeness and accuracy of input. One for one checking – the invoices entered into the system are manually agreed
back one by one to the srcinal purchase invoices. This helps to ensure completeness and accuracy of input. Check digits – this control helps to reduce the risk of transposition errors.
Mathematical calculations are performed by the system on a particular data field, such as supplier number, a mathematical formula is run by the system, this checks that the data entered into the system is accurate. This helps to ensure accuracy of input.
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Range checks – a pre-determined maximum is input into the system for gross invoice
value, for example, $10,000; when invoices are input if the amount keyed in is incorrectly entered as being above $10,000, the system will reject the invoice. This helps to ensure accuracy of input. Existence checks – the system is set up so that certain key data must be entered,
such as supplier name, otherwise the invoice is rejected. This helps to ensure accuracy of input.
Attempt questions to check your understanding: June 2015-Q4 June 2013-Q1b,c
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The Payroll System The main objective of a payroll is to ensure that:
– – –
Wages and salaries are paid at the correct rates. Wages and salaries are paid to the right people. Wages and salaries are paid on time.
Key terms: 1. Clock cards/ timesheets2.Payroll sheet 3.Pay slips 4.Bank Transfer List/payment list (instructions
to the bank) Appointment/ leavers
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Appointments: All appointment of staff, whether temporary or permanent, should only be made by the human resources department, separate from the payroll department
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There should be formal procedures requiring the interviews manager to provide detailed written notification to a responsible official (for example the wages supervisor) of starters and leavers.
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Update ‘starters and leavers’ details on a timely basis. Procedures should ensure that ‘starters’ and ‘leavers’ details are added to or deleted from the master file immediately after starting or leaving the company’s employment.
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All increases of pay should be proposed by the HR department and then formally agreed by the board of directors.
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Standing data in the master file:
‘Read’ and ‘amend’ access to the master file should be available from specified terminals to responsible officials who have a need and authorised cause to access the information.
Maintain a log of access attempts (Controls should include a computer log which registers date and time access to the master file by the various users. This should regularly be reviewed by a senior responsible official of the company)
Match standing data to the personnel filed periodically
At random intervals a more senior responsible official of the company (for example the company accountant), should access the wages master file and check its contents to the manual records maintained, input documentation and notifications from the interviews manager as appropriate.
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Calculations
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Clock cards sequentially pre-numbered (which details the employee number and name)
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Clock card machine supervised or in open view (Staff attendance machine kept near the security gate (to ensure that there are no dummy attendances recorded).
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Head count by area supervisor ( attendance matched to actual employees present)
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Any overtime worked reviewed and then authorized. This should be evidenced by signature on the employees’ overtime sheets.
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Periodic verification of staff cards with personal files of employees (to ensure that there are no ghost employees).
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Data input: Use application and general IT controls ( for example range checks, passwords)
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Gross pay, deductions, net pay:
Preferably automatically calculated by the payroll system.
Calculations re checked on a sample basis- A senior member of the payroll team should recalculate the gross to net pay workings for a sample of employees and compare their results to the output from the payroll system.
Payments
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Pay slips to be sequentially pre-numbered
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Segregation of duties ( payroll sheet, recording, payment)
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Salaries:
Preferably through bank transfer
Bank transfer list/payment list matched to payroll sheet prior to authorising the bank payment.
When authorising the payments, the responsible official should on a sample basis perform checks from payroll records to payment list and vice versa to confirm that payments are complete and only made to bona fide employees.
Bank transfer list/payment list preferably authorized by someone other than the person who authorized payroll ( for example the Finance Director)
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-
Wages (cash)/Pay packets
All cash wages should only be paid upon sight of the employee’s clock card and photographic identification as this confirms proof of identity. Uncollected wage packets should be kept in a safe place/ deposited in the bank
Attempt questions to check your understanding: Sept. 2016- Q16c Sept/Dec Hybrid 2015-Q5 a,b June 2014-Q1a,b
Revenue and Capital Expenditure Capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value
of an existing fixed asset. Revenue expenditure is that expenditure which is incurred to maintain the existing capacity of an asset so that it
can do its daily work. Examples of revenue expenditure are cost of raw material and other stores, salaries and wages, repairs and maintenance, stationery and printing, advertisements, postage, telephone, travel expenses etc. The main control objectives over revenue and capital expenditure are to ensure that:
All expenditure is authorised. Proper segregation of capital and revenue expenses is made. Expenses are properly accounted for.
The transaction cycle for capital and revenue expenditure is quite similar for purchases. However, certain additional control points, which are to be ensured, are mentioned below: Am authorized budget is prepared for all expenditure.
Preparation of a report of capital budget versus actual expenditure. Preparation of a periodic variance report of those expenses that do not match the budget. Orders for capital items should be authorised by appropriate levels of management.
A document may be prepared for showing the distinction between capital and revenue expenditure and for
providing guidance on which expenses to be capitalised. All vouchers of revenue expenditure need to have approval of maintenance manager.
A senior person should check the accounting treatment for the expenses (especially repairs and maintenance).
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Non-Current Asset register The purpose of a tangible non-current assets register is to list details of all the non-current assets owned by an entity, in order to facilitate control over those assets. Typically, the register should record cost, depreciation and net book value information of each asset along with identifying details. For example in the case of plant and machinery – gross cost, annual depreciation rate, depreciation provision, net book value, date of acquisition, serial number and description and location of asset.
The register should be updated by individuals who are separated from the acquisition, custody and disposal of assets. Periodical reconciliation of non-current register with the general ledger to be done and any differences to be investigated. Preparation of an exception report if the non-current register does not match the non-current assets account maintained in accounts. Invoices should bear appropriate ledger code (distinguishing revenue items from capital expenditure) in order to facilitate correct recording. Depreciation rates should be reasonable and authorised. Depreciation calculations should be checked NCA register should be used to confirm physical existence on a periodic basis To ensure completeness of recording, periodic checks should be made to ensure that assets in existence are completely recorded in the register.
Bank and Cash
The main objectives of cash and bank transactions are to ensure that:
All money received is recorded. All money received is banked. Money is properly safeguarded. Payments are made to correct persons and properly recorded.
Main controls on bank and cash
Segregation of duties between the person receiving the money, the person depositing it in the bank and the
one making the payments. Match bank deposit slips with the cash and cheque receipt register.
Daily cash receipts immediately recorded in the customers’ accounts. Cash receipt register reconciled daily with the customer accounts. Periodical management review of the register is to be conducted to ensure that cheques are promptly
deposited into the bank. Bank reconciliation to be prepared periodically and differences to be investigated. Receivables’ ledger reconciled with control account. Cash kept under the custody of the cashier. And there should be restricted access to cashier’s room Security personnel to accompany the cashier while depositing or withdrawing cash from the bank Minimum cash balance to be maintained needs to be decided.
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Whenever cash balance exceeds minimum balance, excess balance deposited to be in the bank. Surprise cash counts by personnel other that the accounts department. Cash to be suitably insured for cash in hand, and cash in transit. Unused cheques to be kept under lock and key. Cheques books to be in the custody of a responsible person
Attempt questions to check your understanding: June 2015-Q2
Test of controls In the F8 exam, you might be asked to: -
Identify and explain deficiencies in the system Recommend a control to address each of these deficiencies Describe a TEST OF CONTROL the external auditors would perform to assess if each of these controls, if implemented, is operating effectively.
What is a Test of Control? An audit procedure designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level.
Examples of test of controls( also mentioned earlier):
inspection of documents (e.g. authorizations)
enquiries about internal controls which leave no audit trail ( e.g. is the person who is SUPPOSED to perform the function actually performing it or is someone else is doing so)
Reperformance of control procedures ( e.g. reconciliations)
examination of evidence of management views(e.g. minutes of meetings)
Observation of controls
Using TEST DATA(CAATs)
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If you are confused about how to word a TOC, start with “The auditor should….”
Example from a past exam
Deficiency
Customer credit limits are set by sales ledger clerks. Sales ledger clerks are not sufficiently senior and so may set limits too high, leading to irrecoverable debts, or too low, leading to a loss of sales.
Control
Test of Control
Credit limits should be set by a senior member of the sales ledger
The auditor should take a sample of new customers accepted in the
department and not by sales ledger clerks. These limits should be regularly reviewed by a responsible official.
year and review the authorisation of the credit limit, and ensure that this was performed by a responsible official. And/or The auditor should enquire of sales ledger clerks as to who can set credit limits.
Another example from a past exam
Deficiency
Control
Test of Control
Supplier statement reconciliations are no longer performed.
Supplier statement reconciliations should be performed on a monthly basis for all suppliers and these should be reviewed by a responsible official.
The auditor should review the file of reconciliations to ensure that they are being performed on a regular basis and that they have been reviewed by a responsible official.
This may result in errors in the recording of purchases and payables not being identified in a timely manner.
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Management assertions, Audit procedures and Audit evidence Management is responsible for the preparation of financial statements that give a true and fair view, but what does this really mean? For each item in the financial statements, management is making assertions. The auditors need evidence that these financial statements are valid! ‘In representing that the financial statements are in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding the recognition, measurement and presentation of classes of transactions and events, account balances and disclosures’.
Consequently auditors use these assertions when considering the potential types of misstatements that may occur and when designing and performing appropriate audit procedures.
Transactions include sales, purchases, and wages paid during the accounting period.
Account balances include all the asset, liabilities and equity interests included in the statement of financial position at the period end.
ISA 315, Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment identifies the following assertions: 1. 2.
Assertions about classes of transactions and events and related disclosures for the period under audit Assertions about account balances and related disclosures at the period end
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Assertions about classes of transactions and events and related disclosures for the period under audit
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This means that the transactions recorded or disclosed actually happened and relate to the entity. For example that a recorded sale represents goods which were ordered by valid customers and were despatched and invoiced in the period. An alternative way of putting this is that sales are genuine and are not overstated.
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Relevant test – select a sample of entries from the sales
1. Occurrence – the transactions and events that have been recorded or disclosed, have occurred, and such transactions and events pertain to the entity.
account in the nominal ledger and trace to the appropriate sales invoice and supporting goods despatched notes and customer orders. 2. Completeness – all transactions and events that should have been recorded have been recorded and all related disclosures that should have been included in the financial statements have been included.
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No omission
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Relevant test – select a sample of customer orders and check to despatch notes and sales invoices and the posting to the sales account in the nominal ledger.
Note the difference in the direction of the above test. In order to test completeness the procedure should start from the underlying documents and check to the entries in the relevant ledger to ensure none have been missed. To test for occurrence the procedures will go the other way and start with the entry in the ledger and check back to the supporting documentation to ensure the transaction actually happened.
3. Accuracy – amounts and other data relating to recorded transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described.
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This means that there have been no errors while preparing documents or in posting transactions to ledgers. The new reference to disclosures being appropriately measured and described means that the figures and explanations are not misstated.
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Relevant test – calculation checks on invoices, payroll, etc, and the review of control account reconciliations are designed to provide assurance about accuracy.
4. Cut–off – transactions and events have been recorded in the correct accounting period.
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That transactions are recorded in the correct accounting period.
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Relevant test – recording last goods received notes and despatch notes at the inventory count and tracing to purchase and sales invoices to ensure that goods received before the year–end are recorded in purchases at the year end and that goods despatched are recorded in sales.
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5. Classification – transactions and events have been recorded in the proper accounts.
6. Presentation – transactions and events are appropriately aggregated or disaggregated and
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Transactions recorded in the appropriate accounts – for example,the purchase of raw materials has not been posted to repairs and maintenance.
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Relevant test – check purchase invoices postings to nominal ledger accounts.
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This means that the descriptions and disclosures of transactions are relevant and easy to understand. There is a new reference to transactions being appropriately
clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.
aggregated or disaggregated. Aggregation is the adding together of individual items. Disaggregation is the separation of an item, or an aggregated group of items, into component parts. The notes to the accounts are often used to disaggregate totals shown in the profit or loss account. Materiality needs to be considered when judgements are made about the level of aggregation and disaggregation . -
Relevant test – check the total employee benefits expense is analysed in the notes to the financial statements under separate headings– ie wages and salaries, pension costs, social security contributions and taxes, etc.
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Assertions about account balances and related disclosures at the period end
1. Existence – assets, liabilities and equity interests exist.
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Means that assets and liabilities really do exist and there has been no overstatement – for example,by the inclusion of fictitious receivables or inventory. This assertion is very closely related to the occurrence assertion for transactions.
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Relevant tests – physical verification of non–current assets, circularisation of receivables, payables and the bank letter.
2. Rights and obligations – the entity holds or controls the rights to assets, and liabilities are the obligations of the entity
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Means that the entity has a legal title or controls the rights to an asset or has an obligation to repay a liability.
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Relevant tests – in the case of property, deeds of title can be checked. Current assets are often checked to purchase invoices although these are primarily used to confirm cost. Long term liabilities such as loans can be checked to the relevant loan agreement.
3. Completeness – all assets, liabilities and equity interests that should have been recorded have been recorded and all related disclosures that should
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That there are no omissions and assets and liabilities that should be recorded and disclosed have been. In other words there has been no understatement of assets or liabilities.
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Relevant tests – A review of the repairs and expenditure account can sometimes identify items that should have been capitalised and have been omitted from non–current assets. Reconciliation of payables ledger balances to suppliers’ statements is primarily designed to confirm completeness although it also gives assurance about existence.
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Means that amounts at which assets, liabilities and equity interests are valued, recorded and disclosed are all appropriate. The reference to allocation refers to matters such as the inclusion of appropriate overhead amounts into inventory valuation.
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Relevant tests – Vouching the cost of assets to purchase invoices and checking depreciation rates and calculations.
have been included in the financial statements have been included.
4. Accuracy, valuation and allocation – assets, liabilities and equity interests have been included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments have been appropriately recorded and related disclosures have been appropriately measured and described.
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5. Classification – assets, liabilities and equity interests have been recorded in the proper accounts.
6. Presentation – assets, liabilities and equity interests re appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.
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Means that assets, liabilities and equity interests are recorded in the proper accounts.
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Relevant tests – the test for transactions of checking purchase invoice postings to the appropriate accounts in the nominal ledger will be relevant again. Also that research expenditure is only classified as development expenditure if it meets the criteria specified in IAS 38.
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This means that the descriptions and disclosures of assets and liabilities are relevant and easy to understand. The points made above aggregation and disaggregation of transactions also apply to assets, liabilities and equity interests.
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Relevant tests – auditors often use disclosure checklists to ensure that financial statement presentation complies with accounting standards and relevant legislation. These cover all items (transactions, assets, liabilities and equity interests) and would include for example checking that disclosures relating to non–current assets include cost, additions, disposals, depreciation, etc.
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Methods for testing these assertions/Procedures to obtain evidence/sources of evidence
Audit evidence verifies the correctness of the assertions contained in the financial statements. Audit evidence can be obtained from different sources.
Inspection
Observation
Analytical procedures
Inspection involves examining records or documents, whether internal or external, in paper form, electronic form, or other media, or a physical examination of an asset. Observation consists of looking at a process or procedure being performed by others
Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount.
Example – the physical inspection of a freehold office building to verify existence of the building. Example – the examination of a purchase invoice to vouch the validity of an entry in the trade creditors ledger. Example – the observation of the counting of inventory by an entity’s personnel to ensure that they are counted in accordance with procedures authorised by the management of the entity. Example – the observation of the opening of the mail of an entity to ensure that at least two employees are present to receive and witness the receipt of monies received by the entity. Example – the calculation of the average remuneration (total wages and salaries divided by total employees) paid to the employees of an entity, to assess the reasonableness of the reported wages and salaries costs as compared to a previous equivalent period. Example – the calculation of an entity’s trade creditors ratio to help assess the reasonableness of bad debt provisions, the effectiveness of credit control and the possibility of under/over statement of reported sales.
Assertions normally tested by the analytical procedures are Completeness, Accuracy, Valuation and Classification
Inquiry
Inquiry consists of seeking information of knowledgeable persons, both financial and nonfinancial, within the entity or outside the entity.
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Example- inquire of the management whether they have opened/closed any bank accounts during the year.
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External confirmation
An external confirmation represents audit evidence obtained by the auditor as a direct written response to the auditor from a third party, in paper form, electronic form or by other medium.
Example – direct confirmation of a trade receivables balance – to verify the existence of a trade receivables balance. Example – letter from a loan company, confirming the balance outstanding on a loan – to verify the loan liability of the company. Example – a certificate from a specialist, confirming the value of specific inventories held – to verify the valuation of inventories.
Recalculation
Recalculation consists of checking the Example – checking the accuracy of inventory mathematical accuracy of documents calculations to verify the accuracy of the valuation of or records. Recalculation may be reported inventory. performed manually or electronically.
Reperformance
Re-performance involves the auditor’s independent execution of procedures or controls that were srcinally performed as part of the entity’s internal control.
Example – Using computer assisted audit techniques to re-perform the ageing of accounts receivable balances. Example – Re-performing the extraction of a trial balance from the company’s general ledger. Example-Re-perform the year end bank reconciliation to ensure the process was undertaken accurately.
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Sufficient Appropriate evidence
The term ‘audit evidence’ describes the information obtained by the auditors in arriving at the conclusions on which the audit opinion is based. Audit evidence comprises source documents and accounting records underlying the financial statements (subject to audit) and corroborating information from other sources. The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.
Sufficient (quantity of evidence)
Factors affecting sufficiency
1. Assessment of risk at the financial statement level and/or the individual transaction level. As risk increases then more evidence is required. 2. The materiality of the item. More evidence will normally be collected on material items whereas immaterial items may simply be reviewed to ensure they appear correct. 3. The nature of the accounting and internal control systems. The auditor will place more reliance on good accounting and internal control systems limiting the amount of audit evidence required. 4. The auditor’s knowledge and experience of the business. Where the auditor has good past knowledge of the business and trusts the integrity of staff then less evidence will be required. 5. The findings of audit procedures. Where findings from related audit procedures are satisfactory (e.g. tests of controls over receivables) then substantive evidence will be collected. 6. The source and reliability of the information. Where evidence is obtained from reliable sources (e.g. written evidence) then less evidence is required than if the source was unreliable (e.g. verbal evidence).
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Appropriate (quality of evidence)
Reliability of evidence
Following are the factors that influence the reliability of audit evidence: 1.
Audit evidence is more reliable when it is obtained from independent sources outside the entity.
2. Audit evidence that is generated internally is more reliable when the related controls imposed by the entity are effective. 3. Audit evidence obtained directly by the auditor (for example, observation of the application of a control) is more reliable than audit evidence obtained indirectly or by inference (for example, inquiry about the application of a control). 4. Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other medium. 5. Audit evidence provided by srcinal documents is more reliable than audit evidence provided by photocopies or facsimiles.
6. Evidence created in the normal course of business is better than evidence specially created to satisfy the auditor. 7.
The best-informed source of audit evidence will normally be management of the company (although management’s lack of independence may reduce its value as a source of such evidence).
8.
Evidence about the future is particularly diffi cult to obtain and is less reliable than evidence about past events.
Relevance of evidence: Audit evidence should be relevant to the area/ assertions
being tested.
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Substantive procedure Substantive procedure is an audit procedure which is designed to detect material misstatements at the assertion level.
Substantive procedures (or substantive tests) are those activities performed by the auditor that gather evidence as to the completeness, validity and / or accuracy of account balances and underlying classes of transactions and related disclosures.
Substantive procedures comprise the following a) Analytical procedures b) Tests of details (of classes of transactions, account balances, and related disclosures) a) Analytical procedures Analytical procedures mean the analysis of significant ratios and trends. It also involves the investigation of resulting fluctuations and inconsistent relationships. b) Test of detail Test of detail is carried out for transactions and balances. Details of transaction These are tests to obtain evidence of individual debits and credits that make up an account to reach a conclusion about the account. The tests can be made through tracing and vouching of transactions.
Tracing: Supporting documents traced to records/account books Vouching: Records/account books vouched/verified by matching to relevant supporting documents
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PROCEDURES on specific areas
Substantive on Receivables Key risk: overstatement
Receivables circularization (3rd party confirmation of receivables)
Types of receivable confirmation letters stated balance or write the 1. Positive confirmation: Receivable asked to agree or disagree with the balance owing.
2. Negative confirmation: Receivable asked to reply only if he disagrees with the balance. This type of confirmation should only be used when: The audit client has a strong internal control system over sales and trade receivables. Other good corroborative evidence with regard to the existence of trade receivables has already been obtained from other tests carried out. There are a large number of small balances. A substantial number of errors is not expected.
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Method of sending confirmation letter
1. 2. 3. 4.
Obtain the receivables ledger and reconcile it to the control account Select a sample of debtors to be circularized Inform the client of the intended list. Get the details of the debtors and prepare letters on client’s letterhead.
5. Get the letter signed by a senior person at the client. 6. Record names and amount circularized 7. Post/fax letters ensuring the replies are sent directly to the auditor. 8. Record replies received and test the ones not agreed. 9. For non-replies: -
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with the client’s permission, the team should arrange ot send a follow up circularisation. If the receivable does not respond to the follow up, then with the client’s permission, the senior should telephone the customer and ask whether they are able to respond in writing to the circularisation request. – If there are still non-responses, then the auditor should undertake alternative procedures to confirm receivables. These procedures include verifying post year end receipts from that customer, verifying order placement and dispatch documentation and carrying out bad debt procedures
10. – For responses with differences: i. the auditor should identify any disputed amounts, and identify whether these relate to timing differences or whether there are possible errors in the records of the client. ii. Any differences due to timing, such as cash in transit, should be matched with cash received after the year end iii. The receivables ledger should be reviewed to identify any possible mispostings as this could be a reason for a response with a difference. iv. If any balances have been flagged as disputed by the receivable, then these should be discussed with management to identify whether a write down is necessary
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Substantive testing Existence
1. Circularization of a sample of period end receivables (discussed above)
The receivable actually exists
2. Verify audit trail from records to source document: Select a sample of yearend receivable balances and agree back to valid supporting documentation of GDN and sales order to ensure existence
Accuracy, valuation, allocation Receivables are included in the financial statements at the correct amount
1. Circularization of a sample of period end receivables (discussed above) 2. Invoice: inspect and recalculate 3. Recoverability procedures ( bad debts):
Select a significant sample of receivables and review whether there are any after date cash receipts(ensure that a sample of slow moving/old receivable balances is also selected)
Review the aged receivable ledger to identify any slow moving or old receivable balances, discuss the status of these balances with the credit controller to assess whether they are likely to pay
Calculate average receivable days and compare this to prior year, investigate any significant differences
Review customer correspondence to identify any balances which are in dispute or unlikely to be paid.
Review board minutes to identify whether there are any significant concerns in relation to payments by customers.
4. Allowance for doubtful debts:
recalculate to ensure it is accurate
ensure rationale/basis reasonable and in line with your understanding of the client’s business
written representation from management that the basis/assumptions are reasonable and that the allowance is adequate.
-Inspect post year-end sales returns/credit notes and consider whether an additional allowance against receivables is required.
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Rights & obligation
1. Circularization of a sample of period end receivables (discussed above)
The receivable belongs to the client Completeness
2. Invoice: inspect to confirm right over the receivable
There has been no omission in recording of receivables
1. Verify audit trail from source document to record:
Select a sample of GDNs and agree to valid supporting documentation of invoice.
Ensure these invoices have been entered in the day books and individual ledgers.
Ensure the individual ledger is reconciled with the control account)
2. Compare ratios/balances of this period to prior periods and budgets, investigate any significant differences. 3. Ensure all disclosures relevant to receivables have been made.
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Substantive testing- Sales Revenue
1. Arithmetical accuracy of invoices checked 2. Recalculate discounts to ensure accuracy 3. Compare the overall level of revenue against prior years and budget and investigate any significant fluctuations. 4.
For a sample of invoices match rates to standard price list to confirm accuracy
5. Select a sample of credit notes raised, trace through to the srcinal invoice and ensure invoice correctly removed from sales. 6. Completeness as above: Select a sample of trade customer orders placed and agree these to the despatch notes and sales invoices through to inclusion in the sales ledger to ensure completeness of revenue. 7. Cut-off: Note down the last GDN for the year. Take a sample of GDNs immediately beforeAND after the year end and ensure they are recorded in the correct accounting period
Attempt questions to check your understanding: Sept. 2016- Q16d June 2015-Q6a and biii Dec 2014-Q5b
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Substantive testing: Inventory- Key risk: overstatement Inventory count Before Inventory Count
1. Review the prior year audit files to identify whether there were any particular warehouses/areas where significant inventory issues arose last year 2. Discuss with management whether any of the warehouses this year are new, or have experienced significant control issues. 3. Consider locations. Ensure all locations are covered OR decide locations the audit team members will attend, basing this on materiality and risk of each site. 4. Obtain a copy of the proposed inventory count instructions, review them to identify any control deficiencies and if any are noted, discuss them with management prior to the counts. 5. Arrange to verify any inventory held by 3rd party 6. Establish whether expert help is needed 7. If an internal audit department exists, discuss the procedures that they carried out and review their working papers. The following matters should be covered in the instructions for the physical inventory count: 1. There should be adequate supervisory controls, with one individual assuming overall responsibility for the inventory count. 2. Employees involved in the inventory count should be independent of those working in the stores and production areas 3. Counters should work in pairs with one counting inventory and the other recording and checking quantities counted. 4. Procedures should ensure that items are marked or tagged as ‘counted’ to avoid the possibility of double counting or omission. 5. There should be adequate control over the issue and returning of inventory control sheets, possibly involving the use of pre-numbered sheets with returned sheets being agreed to issued sequences for completeness. 6. Inventory sheets should be completed in ink and signed by the relevant individuals involved in the counting and recording process. 7. Movement of inventory during the count should be prohibited where possible and a special quarantine area should be created in which to store any goods received. 8. In order to minimise disruption to the production process, raw materials together with parts and finished goods inventories should be counted first with work-in-progress inventory being counted at the end of the working day. 9. There should be stringent controls over cut-off issues with careful note being made of the number of the last goods received, goods returned and goods despatched and raw materials/parts issued notes prior to the inventory count. 10. There should be adequate procedures to identify, count and record inventory that is slow moving or obsolete. F8 KNOWLEDGE SUMMARY-SKANS SCHOOL OF ACCOUNTANCY
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During Inventory Count The purpose of an auditor’s attendance at a client’s year -end inventory count is to assess the effectiveness of the client’s inventory counting procedures in order to determine whether reliance can be placed upon them to provide assurance about the existence and condition of inventory.
Auditor’s procedures during the count
1. Observe the counting teams to confirm whether the inventory count instructions mentioned above are being followed correctly. 2. Perform a test of controls (i.e. test the system used for recording, issuing inventory etc.) 3. Confirm the procedures for identifying and segregating damaged goods are operating correctly, and assess inventory for evidence of any damaged or slow moving items. 4. Test the counts that are being done by the client’s representative - Perform two-way testing: Match physical stock with stock records(completeness) and records with physical stock(existence 5. Check cut-off arrangements- Identify and make a note of the last goods received notes and goods despatched notes for the year end in order to perform cut-off procedures. 6. Note any inventory that is set aside or specially marked, providing possible indicators that inventory is not owned by the company 7. Enquire as to the possibility of consignment or third party inventories being held by the company and record appropriate notes for subsequent follow up 8. Obtain a photocopy of the completed sequentially numbered inventory sheets for follow up testing on the final audit.
After Inventory Count
1. Discuss any weaknesses discovered during count with the management 2. Match final inventory sheets with the photocopies that you did at the time of inventory count- Check to ensure that all sheets and records used at the inventory count are included in the final inventory count sheets and records. 3. Ensure that slow-moving and obsolete inventory lines recorded at the inventory count are properly highlighted in the sheets and records to be used in the valuation process. 4. Follow-up on any other matters recorded in working papers at time of count
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Substantive procedures Completeness
During the inventory count, take a sample of physical inventory and ensure it is
Existence
During the inventory count, select a sample of inventory from the ledger and verify its physical existence.
completed recorded in the records/inventory ledger
Rights and obligation
1. Inspect invoices/supporting documents to confirm right 2. IF there is any inventoryat the 3rd party, confirmed it is owned by the client by circularizing the 3rd party. 3. IF there is consignment stock, the agreement will need to be inspected to confirm when risks and rewards(control) are transferred.
Accuracy, Valuation. Allocation
1. Select a representative sample of goods in inventory at the year end, agree
the cost per the records to a recent purchase invoice and ensure that the cost is correctly stated. 2. For a sample of manufactured items obtain cost sheets and confirm:
raw material costs to recent purchase invoices labour costs to time sheets or wage records overheads allocated are of a production nature.
3. Net Realisable Value: a) For a sample of inventory, review post year end sales to see if
adjustments are required b) For unsold items, discuss with mngt to determine whether they are
slow moving and provision has been created c) Review aged inventory reports and identify any slow moving goods,
discuss with management why these items have not been written down d)
Perform a review of the average inventory days for the current year and compare to prior year inventory days .Discuss any significant variations with management.
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e)
Compare the gross margin for current year with prior year. Fluctuations in gross margin could be due to inventoryvaluation issues. Discuss significant variations in the margin with management.
f)
Follow up any damaged/obsolete items noted by the auditor at the inventory counts attended, to ensure that the inventory records have been updated correctly
g)
Determine estimated costs to completion. These costs represent another important element of net realisable value. Determine costs to be incurred in marketing, selling and distributing directly related to the items in question.
h) Get a written representation from the management that inventory
has been correctly valued. 4. WIP
a) Cast the schedule of total WIP and agree to the trial balance and financial statements. b) Obtain the costing records for a sampleof WIP and:
Agree labour costs to payroll; Agree labour hours to time sheets; Recalculate the overhead absorption rate
c) Obtain the breakdown of WIP and agree a sample of WIP assessed during the count to the WIP schedule, agreeing the percentage completion as recorded at the inventory count. d) Select a sample of items included in WIP at the year end and ascertain the final unit cost price, verifying to relevant supporting documentation, and compare to the unit sales price included in sales invoices post year end to assess NRV.
5. Procedures to confirm use of standard c osts for inventory valuation
a) Discuss with management the basis of the standard costs applied to the inventory valuation, and how often these are reviewed and updated. b) Review the level of variances between standard and actual costs and discuss with management how these are treated. c) Obtain a breakdown of the standard costs and agree a sample of these costs to actual invoices or wage records to assess their reasonableness
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Cut-off
Note down the last GDN and GRN for the year. Take a sample of GDNs and GRNs immediately beforeAND after the year end and ensure they are recorded in the correct accounting period
Inventory Held by Third Parties
Where the entity has inventory that is held by third parties and which is material to the financial statements, the auditor shall obtain sufficient appropriate audit evidence by performing one or both of the following:
Direct confirmation from the third party regarding quantities and condition (in accordance with ISA 505 External confirmations)
Inspection or other appropriate audit procedures (if third party's integrity and objectivity are doubtful, for
example) The other appropriate audit procedures referred to above could include the following: Procedures to confirm inventory held at third party locations
1. Send a letter requesting direct confirmation of inventory balances held at year end from the third party regarding quantities and condition. 2. Attend the inventory count (if one is to be performed) at the third party warehouses to review the controls in operation to ensure the completeness and existence of inventory. 3. Inspecting documentation in respect of third party inventory (eg warehouse receipts) 4. Requesting confirmation from other parties when inventory has been pledged as collateral
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Audit procedures for continuous (perpetual) inventory counts
In order that the company’s auditors may rely on the company’s revised continuous inventory checking system, the auditor should ensure that: I. II.
Inventory records are kept up to date. All inventory lines are counted at least once a year with higher value and desirable lines being counted more frequently.
III.
The counting of inventory is carried out by suitably experienced independent individuals in a systematic and orderly manner. All corrections to inventory records are authorised by a responsible official of the company. Any material discrepancies noted between inventory records and physical quantities are investigated immediately and reported to management for immediate further follow up as appropriate. There are satisfactory procedures with regard to cut-off and receipt/issue documentation at the time of inventory counts.
IV. V. VI.
Procedures
1. The audit team should attend at least one of the continuous (perpetual) inventory counts to review whether the controls over the inventory count are adequate. 2. The audit team should confirm that all of the inventory lines have been counted or are due to be 3. counted at least once a year by reviewing the schedules of counts undertaken/due to be undertaken. 4. Review the adjustments made to the inventory records on a monthly basis to gain an understanding of the level of differences arising on a month by month basis. 5. If significant differences consistently arise, this could indicate that the inventory records are not adequately maintained. Discuss with management how they will ensure that year-end inventory will not be under or overstated. 6. Consider attending the inventory count at the year end to undertake test counts of inventory from records to floor and from floor to records in order to confirm the existence and completeness of inventory.
Attempt questions to check your understanding:
March/June Hybrid 2016-Q5 Sept/Dec Hybrid 2015-Q6a, bi Dec 2014-Q6bii June 2014-Q3b
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Substantive testing: Property, Plant & Equipment Key risk: overstatement
Completeness
1. Take a sample of physical assets and ensure they are completely recorded in the NCA Register 2. Re-perform the NCA Register reconciliation to the General Ledger 3. Obtain a breakdown of additions, cast the list and agree included in the noncurrent assets register to confirm completeness of PPE. 4. Review the repairs and maintenance ledger to ensure capital expenditure has not been accidently expensed off
Existence
1. Select a sample of assets from the NCA Register and inspect them to verify their physical existence 2. Ensure disposed-off assets have been removed from the NCA Register as they no longer exist.
Rights & Obligation
1. Inspect the ownership documents (title deeds, registration documents etc) to ensure they are in client’s names. 2. Review insurance policies to confirm the asset is in client’s name.
Accuracy, valuation, allocation
Additions during the year
1. Select a sample of additions and agree cost to supplier invoice to confirm valuation. 2. Ensure all additions were authorized by inspecting the minutes of the board meetings 3. Review the list of additions and confirm that they relate to capital expenditure items rather than repairs and maintenance. Disposals during the year
1. Disposal proceeds matched to supporting documents such as invoices and to cash book and bank statement 2. Verify that the correct cost and depreciation has been removed from the records
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3. Recalculate profit/loss on disposal agree to the statement of profit or loss
4. Check authorising documentation to ensure that the disposal was appropriately authorised 5. Examine the sales documentation relating to the disposal and ensure that the sale details match those in the authorising documentation. Revaluation
1. Obtain a schedule of assets revalued this year and cast to confirm completeness and accuracy of the revaluation adjustment. 2. Ensure all similar assets have been revalued 3. Verify depreciation has been calculated on the revalued amount 4. Agree the valuation to the expert’s report 5. Inspect the valuer’s report to ensure the valuer was skilled and independent 6. Agree the revalued amounts for these assets are included correctly in the noncurrent assets register. 7. Review the financial statements disclosures of the revaluation to ensure they comply with IAS 16 Depreciation
1. Review the depreciation policy of the company to ensure that it is consistent and appropriate(this can be done by comparison with last year and with industry practice) 2. recalculate and re-perform depreciation charge to ensure its accuracy. 3. assess depreciation method is reasonable:
compare with last year
compare with industry practice
review NCA Register with Net Book Value of zero which are still in use
review NCA Register for excessive profit/loss on disposal.
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Enquire from the management the reason for this. 4. enquire from the management whether they consider the depreciation method
to be reasonable- obtain a ‘written representation’ 5. Review the disclosure of the depreciation charges and policies in the draft
financial statements. General
Review the disclosure of the additions and disposals in the draft financial statements and ensure it is in line with IAS 16Property, Plant and Equipment.
Repairs and Maintenance
1. Obtain a schedule of the expenditure and cast to ensure accuracy. 2. For those items treated as capital and included with property, plant and equipment, agree to purchase invoices and ascertain whether they are in fact of a capital nature. 3. For items treated as repairs, agree to invoices to ensure they are not of a capital nature and that they have been correctly expensed to the statement of profit or loss (income statement).
Attempt questions to check your understanding: Dec 2014-Q6bi June 2013-Q4a
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Intangible assets
1. Obtain and cast a schedule of intangible assets, detailing opening balances, amount capitalised in the current year, amortisation and closing balances. 2. Agree the opening balances to the prior year financial statements. 3. Agree the closing balances to the general ledger, trial balance and draft financial statements. 4. Recalculate the amortisation charge for a sample of intangible assets and confirm it is line with the amortisation policy.
Research and Development
1. For those expensed as research, agree the costs incurred to invoices and supporting documentation and to inclusion in profit or loss. 2. For those capitalised as development, agree costs incurred to invoices and confirm technically feasible by discussion with development managers or review of feasibility reports. 3. Review market research reports to confirm client has the ability to sell the product once complete and probable future economic benefits will arise. 4. Review the disclosures for intangible assets in the draft financial statements are in accordance with IAS 38 Intangible Assets.
An acquired brand/patents/license.
1. Review board minutes for evidence of discussion of the purchase of the acquired brand, and for its approval. 2. Agree the cost to the company’s cash book and bank statement. 3. Obtain the purchase agreement andconfirm the rights ofclient in respect of the brand. 4. Discuss with management the estimated useful life of the brand and obtain an understanding of how the useful life has been determined. 5. Recalculate the amortisation expense for the year and agree the charge to the financial statements 6. Confirm adequacy of disclosure in the notes to the financial statements.
Attempt questions to check your understanding: Sept/Dec Hybrid 2015-Q6bii
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Bank and cash General procedures
1. Agree the bank balance on the trial balance to the year end bank balance on the computer system, and the balance on the financial statements. -
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2. Review the cash book and bank statements for any unusual items or large transfers around the year end, as this could be evidence of window dressing. 3. Review the financial statements to ensure that the disclosure of cash and bank balances are complete and accurate. Bank confirmation
Procedure for obtaining a bank letter
letter
1. The auditor will produce a confirmation letter in accordance with local audit regulations and practices. 2. The letter will be sent to the client to sign and authorise disclosure and then it will be forwarded on to the client’s bank. (Alternatively, the client may already have provided a standard authority for the bank to respond to a bank letter each year. In this case separate authority would not be required.) Ideally the letter should be sent before the end of the accounting period to enable the bank to complete it on a timely basis e.g. at the year-end.
3. The bank will complete the letter and send it back directly to the auditor. Contents of a bank letter The following matters should be confirme d in the confirmation from the company’s bank:
1. Titles and account numbers of all bank accounts held in the name, joint name or trade name of client at the year end 2. Confirmation of balances held in those accounts at the year end 3. Full details of interest charged or received on accounts held during the year if not specified on bank statements. 4. Details of overdrafts and loans repayable on demand together with details of other loans and facilities. 5. Details of any assets of client which are held as security by the bank. 6. Details of any other assets held by the bank, for example share certificates, documents of title or deed boxes. 7. Accounts with nil balance 8. Details of accounts closed in the last 12 months 9. A list of branches of the bank, or other banks, or associated companies where it is known that a relationship has been established with the client.
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Audit procedures on the bank letter include:
1. Agree the balances for each bank account to the relevant bank reconciliation and the yearend balance in the financial statements. 2. Agree total interest charges on the letter to the interest expense account in the general ledger. 3. For any details of loans, ensure repayment terms are correctly disclosed in the financial statements between current and non-current liabilities. Period-end Bank
Obtain a copy of client’s bank reconciliation and perform the procedures below:
Reconciliation Statement (BRS)
1. 2. 3. 4.
Cast the reconciliation to check arithmetical accuracy Agree the bank balance to the trial balance. Agree the reconciliation’s balance per the cash book to the year-end cash book. Agree the balance per the bank statement to an srcinal year-end bank statement and also to the bank confirmation letter.
5. Trace all of the outstanding lodgments to the pre year-end cash book, post yearend bank statement and also to paying-in-book per year end. 6. Trace all un-presented cheques through to a pre year-end cash book and post yearend statement. For any unusual amounts or significant delays obtain explanations from management. 7. Examine any old un-presented cheques to assess if they need to be written back into the purchase ledger as they are no longer valid to be presented. Completeness
10. Agree all balances listed on the bank confirmation letter to client’s bank reconciliations or the trial balance to ensure completeness of bank balances. 11. Examine the bank confirmation letter for details of any security provided by client as this may require disclosure.
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Cash
Generally cash balance is immaterial to the financial statements. However, cash is an area which is prone to fraud, especially if the internal controls are not efficient. That is why cash verification is an important audit procedure for internal auditors. Physical verification of cash
Cash balances include the hard cash, unbanked cheques, credit card slips and IOUs. That is why all cash balances need to be counted at the same time. The audit working papers relating to the cash count will include the date of the count, time of the count, name and signature of staff conducting the countand the name of the client’s staff available at the count. Audit procedures for cash
The main audit work involved in verifying cash balances is a physical count. Audit procedures include the following:
The auditor should count cash at all locations simultaneously and in the presence of a company official. (Simultaneous counting is necessary, to prevent the client from moving cash that has been counted at one location to another location ready for the next count.)
After the count the auditor should obtain a signed receipt for the amount of cash returned to the official,
The auditor should check the cash balance obtained from the count against the client's cash records and cash balance in the draft financial statements.
Where appropriate, the auditor should also investigate the treatment of any money advances to employees (for example, against wages or salary).
Attempt questions to check your understanding: March/June Hybrid 2016-Q2 June 2015-Q6bii June 2013-Q1d
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Substantive testing: Trade Payables- Key risk: understatement
Completeness
1. Reconcile payables ledger to the general ledger. 2. Check reconciliation of supplier account statements to trade payable ledger balances, prepared by client. Enquire into any abnormalities and carry out further reconciliations as required. 3. Obtain year-end supplier statements: Agree the balance on the statement tothe individual account in client’s payables ledger. Where necessary, reconcile the balances taking into account cash and invoices in transit. 4. Compare trade payables individually and in total to prior, investigate any significant difference, in particular any decrease for this year. 5. Calculate the trade payable days and compare to prior years, investigate any significant difference. 6. Current supplier list matched to last year’s supplier list and explanations sought for suppliers missing this year 7. Select population purchase invoices received after theyear-end, year-end.ensure Trace invoice to evidence of goodsfrom receipt and where goods received prior amount included in purchase accrual 8. Post year end payments reviewed. If they relate to purchases made before the year end, ensure they were recorded as a liability at the year end!
9. Verify the Audit trail from source document to records (Take a sample of GRNs prior to the end of the year and trace to purchase invoice. Ensure a liability has been recorded)
Accuracy, Valuation, Allocation
1. Supplier circularization(rare in practice) 2. Verify supporting documentation ( Purchase order Goods Received Note, Invoice) 3. Supplier statements reconciled to individual supplier accounts ( as above)
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Cut-off (purchases)
1. Select a sample of GRNs before the year end and after the year end and follow through to inclusion in the correct period’s payables balance, to ensure correct cut off. 2. Review after date payments; if they relate to the year under audit, then follow through to the purchase ledger listing to ensure they are recorded in the correct period
Existence
1. Supplier circularization(rare in practice) 2. Verify the Audit trail from records to source documents ( individual ledger to purchase invoice and Goods Received Note)
Substantive procedures for supplier statement reconciliations
1.
Select a representative sample of year-end supplier statements and agree the balance to the purchase ledger. If the balance agrees, then no further work is required. 2. Where differences occur due to invoices in transit, confirm from goods received notes (GRN) whether the receipt of goods was pre year end, if so confirm that this receipt is included in year-end accruals. 3. Where differences occur due to cash in transit from client to the supplier, confirm from the cashbook and bank statements that the cash was sent pre year end. 4. Discuss any further adjusting items with the purchase ledger supervisor to understand the nature of the reconciling item, and whether it has been correctly accounted for.
Why supplier circularization is rare in practice
Third party evidence is a good source of audit evidence and a large proportion of the documentation available when auditing trade payables is produced by third parties, for example, suppliers’ invoices, statements and correspondence.
A trade payables circularisation may however be deemed appropriate where:
supplier statements are, for whatever reason, unavailable. only faxed or photocopied supplier statements are available and there is some doubt as to their authenticity. the auditor or the company, suspect that fraudulent manipulation with regard to supplier payments is taking place within the company.
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Substantive testing: Accruals
1. Obtain or prepare a listing of accruals as at the end of the reporting period. 2. If the list is prepared by the client company, check the calculations and additions far arithmetical accuracy. Check the amounts in the listing against the balances in the relevant main ledger expense accounts and ensure that the amounts are the same. 3. Sample check computations of accruals by comparing to earlier relevant invoices and payment records. 4. Review the bank statement for post year end payments that may relate to services used before the year end. Trace these items to the accruals listing. 5. Compare the list of accruals to those for the previous period to obtain assurance as to the completeness of the accruals. 6. Review the list of accruals for completeness, based on the auditor's knowledge of the business. The auditor will review expense categories included in the income statement to identify areas of possible accruals and check to list of accruals for inclusion. 7. Relate items on the list of accruals to other audit areas, such as the bank confirmation letter (which might provide details of unpaid/accrued bank charges). 8. Test transactions around the accounting period end to determine whether amounts have been recognised in the correct period.
Attempt questions to check your understanding: June 2015-Q6bi
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Substantive testing: Payroll
Substantive Analytical procedures
1. Compare the total payroll expense to the prior year and investigate any significant differences. 2.
Review monthly payroll charges, compare this to the prior year and budgets and discuss with management for any significant variances.
3.
Perform a proof in total of total wages and salaries, incorporating joiners and leavers and the annual pay increase. Compare this to the actual wages and salaries in the financial statements and investigate any significant differences.
Other procedures
1. Cast a sample of payroll records to confirm completeness and accuracy of the payroll expense. 2.
For a sample of employees, recalculate the gross and net pay and agree to the payroll records to confirm accuracy.
3. Re-perform the calculation of statutory deductions to confirm whether correct deductions for this year have been made in the payroll. 4. Select a sample of joiners and leavers, agree their start/leaving date to supporting documentation, recalculate that their first/last pay packet was accurately calculated and recorded. 5. Agree the total net pay per the payroll records to the bank transfer listing of payments and to the cashbook. 6. Agree the individual wages and salaries per the payroll to the personnel records for a sample to confirm bona fide employees.
7.
Select a sample of weekly overtime sheets and trace to overtime payment in payroll records to confirm completeness of overtime paid.
Substantive testing: Accrual for income tax payable on employment income
1. Agree the year-end income tax payable accrual to the payroll records to confirm accuracy. 2. Re-perform the calculation of the accrual to confirm accuracy. 3. Agree the subsequent payment to the post year-end cash book and bank statements to confirm completeness.
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Substantive testing: Corporation tax
1. Agree the year end tax liability back to the year end tax computation. 2. Agree the year end tax liability to the post year end payment to the tax authorities. 3. Agree the corporation tax liability to the amount owed as per correspondence from the tax authorities.
Attempt questions to check your understanding: Sept/Dec Hybrid 2015-Q5c Dec 2014-Q1 June 2014-Q1c,d
Substantive testing: Long term loans
1. If it’s an old loan with balance outstanding at the year end, agree the opening balance of the bank loan to the prior year audit file and financial statements. 2. For any loan payments made during the year, agree the cash outflow to the cash book and bank statements. 3. 4. Agree loan balances back to theloan statement from the bank. 5. Inspect the bank confirmation letter for details of loans and overdrafts and trace these amounts to the balance sheet to ensure they have been recorded. 6. Review Board minutes for evidence of new loans being taken out in the year and ensure they have been recorded. 7. Inspect the bank statements for the year for evidence of a significant deposit, which may be proceeds of a loan. 8. Recalculate expected interestcharges during the year and compare to the client’s figure. 9. Verify the amount of the loan outstanding at the balance sheet date and ensure that this is accurately stated and fully disclosed in the company’s balance sheet. The amount of the loan outstanding should be disclosed as repayable within 12 months and repayable after 12 months from the balance sheet date. 10. Examine the loan agreement to verify the amount of the loan, the rate of interest chargeable, the security provided and the repayment terms.
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11. Review the loan agreement for details of covenants and recalculate to identify any breaches in these.
12. Agree closing balance of the loan to the trial balance and draft financial statements.
13. Review that the F/S disclosures are adequate, including any security provided and that the disclosure is in accordance with accounting standards and local legislation.
Substantive testing: Accounting estimates
Accounting estimates are approximations. Approximations are often made in conditions of uncertainty regarding the outcome of events. When transactions involve precise amounts and are supported by specific documents, verification is relatively easier. However, this comfort is not available in the case of accounting estimates. There is greater risk of material misstatement. Therefore greater care is needed when auditing them.
The auditor should adopt one or a combination of the following approaches in the audit of an estimate: – review and test the process used by management to develop the estimate – use an independent estimate for comparison with that prepared by management – review subsequent events which confirm the estimate made.
F8 focus: Provision for fines/penalties, provision for legal claims, provision for restructuring(detailed formal plan, valid expectation raised in those affected, implementation of plan started/public announcement, DO NOT include retraining/relocation,marketing expenses etc),provision for warranties, provision for redundancies, Fair Value
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General procedures
1. Recalculate to ensure accuracy 2. Review process used by the management and controls over how the estimate was made. 3. Enquire of management how the accounting estimate is made and the data on which it is based-the data used should be accurate, complete and assumptions reasonable.
4. Review the method of measurement used and assess the reasonableness of assumptions made. Review the judgments and decisions made by management in the making of accounting estimates to identify whether there are indicators of possible management bias. 5. Test the operating effectiveness of the controls over how management made the accounting estimate. 6. Develop an expectation of the possible estimate or a range of amounts to evaluate management’s estimate. 7. – Obtain written representations from management and, where appropriate, those charged with governance whether they believe significant assumptions used in making accounting estimates are reasonable. 8. Review expert’s report if applicable 9. Determine whether events occurring up to the date of the auditor ’s report (after the reporting period) provide audit evidence regarding the accounting estimate. 10. To confirm the probability and amount of a provision(or the need of a contingent liability disclosure): -
Inspect pinutes of board meetings
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Inspect client’s Correspondence with any 3rd party Inspect Other documents (copy of claims, copy of laws etc) Enquire from a relevant 3rd party
11. Ensure disclosures relating to accounting estimates are adequate and complete 12. If applicable, compare with last year to evaluate reasonableness of the estimate. 13. If applicable, compare last year’s provision with actual result to evaluate reasonableness of the estimate. 14. Fair Value: Expert’s report
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Examples extracted from past exams- read through them rather than r ote learning them!
Scenario: Law suit filed by a former (ex) employee for unfair dismissal- decision pending Substantive procedures to confirm completeness of provisions or contingent liability: o
o
o
o
o
Discuss with management the nature of the dispute between the client and the former employee to ensure that a full understanding of the issue is obtained and to assess whether an obligation exists. Review any correspondence with the former employee to assess if a reliable estimate of any potential payments can be made. Write to the company’s lawyers to obtain their views as to the probability of the exemployeer’s claim being successful. Review board minutes and any company correspondence to assess whether there is any evidence to support the formeremployee’s claims of unfair dismissal. Obtain a written representation from the directors of client confirming their view of chances of a successful claim.
Scenario: sales ledger department is being made redundant and a redundancy provision has been included in the financial statements.
Substantive procedures to verify redundancy provision o
o
o
o
o
o
o
o
Discuss with the directors as to whether they have formally announced their intention to make the sales ledger department redundant, to confirm that a present obligation exists at the year end. If announced before the year end, review supporting documentation to verify that the decision has been formally announced. Review the board minutes to ascertain whether it is probable that the redundancy payments will be paid. Obtain a breakdown of the redundancy calculations by employee and cast it to ensure completeness. Recalculate the redundancy provision to confirm completeness and agree components of the calculation to supporting documentation. Review the post year-end period to identify whether any redundancy payments have been made, compare actual payments to the amounts provided to assess whether the provision is reasonable. Obtain a written representation from management to confirm the completeness of the provision. Review the disclosure of the redundancy provision to ensure compliance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
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Scenario: Customers of a hotel have filed a law suit claiming they got food poisoning- directors do not feel a provision is needed
1. Review the correspondence from the customers claiming food poisoning to assess whether client has a present obligation as a result of a past event. 2. Send an enquiry letter to the lawyers of client to obtain their view as to the probability of the claim being successful. 3. Review board minutes to understand whether the directors believe that the claim will be successful or not. 4. Review the post year-end period to assess whether any payments have been made to any of the claimants. Discuss with management as to whether they propose to include a contingent liability disclosure or not, consider the reasonableness of this. 6. Obtain a written management representation confirming management’s view that the lawsuit is unlikely to be successful and hence no provision is required. 7. Review the adequacy of any disclosures made in the financial statements. 5.
Scenario: Reorganisation provision has been made
1. Review the board minutes where the decision to reorganise the business was taken, ascertain if this decision was made pre year end. 2. Review the announcement to shareholders to confirm that this was announced before the year end. 3. Obtain a breakdown of the reorganisation provision and confirm that only direct expenditure from restructuring is included. 4. Review the expenditure to confirm that there are no retraining costs included. 5. Cast the breakdown of the reorganisation provision to ensure correctly calculated. 6. For the costs included within the provision, agree to supporting documentation to confirm validity of items included. 7. Obtain a written representation confirming management discussions in relation to the announcement of the reorganisation. 8. Review the adequacy of the disclosures of the reorganisation in the financial statements to ensure they are in accordance with IAS 37Provisions, Contingent Liabilities and Contingent Assets.
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Substantive testing: Capital and Other Issues
1. Review board minutes to confirm the issue of additional share capital during the year. 2.
Agree the issue of shares is permitted from a review of any statutory constitution agreements in place (Where local law requires that companies should have an authorised share capital, the auditor should check that the total authorised capital in the draft financial statements is consistent with the company's constitution)
3.
Inspect the cash book and bank statements for evidence of cash receipts from the share issue.
4. Recalculate the split of proceeds between the nominal value of shares and premium on issue and agree correctly recorded within share capital and share premium account.
5. Review the disclosure of the share issue in the draft financial statements and ensure it is in line with relevant accounting standards and local legislation. 6. Check that the amount reported as issued share capital agrees with the amount recorded in the register of members/shareholders, if the company has such a register. (In some countries there is a legal requirement to maintain a register of members.)
Substantive procedures: reserves
The auditor-will usually carry out tire following substantive procedures on reserves:
Obtain an analysis of movements on all reserves during the period.
Check the accuracy of these movements by checking supporting documentation.
Ensure that any specific legal requirements relating to reserves have been complied with. (For example, check that the entity has not breached legal restrictions on use of the share premium account.)
Confirm that dividends have been deducted only from those reserves that are legally distributable (usually the accumulated profits reserve/retained earnings).
Check the authorisation for the amount of dividends paid by reviewing board minutes.
Check the dividend calculations and check that the total dividends paid are consistent with the amount of issued share capital at the relevant date.
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Directors’ Emoluments
Emoluments include compensation paid for the services provided by the directors to the company and reward for entrepreneurial contribution. The various components of emoluments include:
Basic salary
Bonuses
Share options
Pension contributions
Other benefits (e.g. provision of a company car, rented accommodation, health insurance etc.)
Main procedures for directors’ bonus and remuneration
1. Obtain a schedule of the directors’ remuneration including anybonus paid and cast the addition of the schedule. 2. Agree the individual bonus payments to the payroll records. 3. Confirm the amount of each bonus paid by agreeing to the cash book and bank statements. 4.
Review the board minutes to confirm whether any additional bonus payments relating to this year have been agreed.
5. Obtain a written representation from management confirming the completeness of directors’ remuneration including the bonus. 6.
Review any disclosures made of the bonus and assess whether these are in compliance with local legislation
Other procedures:
Verify the accuracy of the emoluments recorded by recalculating the amount of emoluments applicable to the directors with the recommendations of the remuneration committee.
For all performance related bonus, verify the correctness of the bonus by comparing the bonus with the achievement of the performance related targets i.e. ensure that performance related bonus is supported with appropriate achievement of targets.
Loyalty bonuses are given when a person completes a certain number of years in a company. Verify the accuracy of the payments made along with adherence to the conditions of the loyalty bonus.
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Verify the directors’ rent accounts for the directors’ accommodation and trace entries therein with the approvals of the remuneration committee and also confirm the correctness of the values with the rent agreement.
Verify the directors’ health insurance accounts paid for the directors and trace entries therein with the approvals of the remuneration committee and also confirm the correctness of the values with the insurance policies.
Attempt questions to check your understanding: Sept. 2016-Q17a March/June Hybrid 2016-Q4 June 2014-Q3c Dec 2013-Q1d
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Relying on work of others
In certain cases, auditors may rely on the work ofthird parties when gathering their audit evidence. • Experts such as: lawyers; valuation experts; • The client’s internal auditors (who have reviewed the internal controls). • Service organization ( who work has been outsourced to by client) • Another firm of external auditors (who may for example be auditing an overseas subsidiary of our client). Why?
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Avoid duplication of work Improve efficiency and effectiveness Improve trust of shareholders Reduce cost
Reliance on the work of a management expert
ISA 500 Audit Evidence requires auditors to evaluate the competence, capabilities including expertise and objectivity of a management expert. 1. Are they suitably qualified? (member of a professional body or industry association) 2. Do they have the experience? 3. Are they independent of the client? 4. The auditor should meet with the expert and discuss with them their relevant expertise in order to understand their field of expertise. 5.
Evaluating the Adequacy of the Auditor’s Expert’s Work( the audit procedures carried out to evaluate the work done by the expert!) a) the relevance and reasonableness of that expert’s findings or conclusions, and their consistency with other audit evidence
b) If that expert’s work involves use of significant assumptions and methods, the relevance and reasonableness of those assumptions and methods in the circumstances c) Adequacy and appropriateness of source data
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Audit considerations relating to entities using service organisations
When any work is outsourced to the service organisation, the auditor should consider its impact on the internal control of the entity. If the auditor concludes that outsourcing to service organisation significantly affects the accounting and / or internal control system of the entity, they should obtain sufficient understanding of the entity and its environment, including the internal control. This will help him in assessing the risk of material misstatement and designing and performing further audit procedures
Factors auditors should consider in relation to client’s use of the service organisation include: 1. The audit team should gain an understanding of the services being provided by the service organisation , including the materiality of that area and the basis of the outsourcing contract. 2. They will need to assess the design and implementation of internal controls at the service organisation 3. The team may wish to visit the service organisation and undertake tests of controls to confirm the operating effectiveness of the controls. 4. If this is not possible, auditors should contact the service organisation’s auditors to request either a type 1 (report on description and design of controls) or type 2 report (on description, design and operating effectiveness of controls). 5. The auditor is responsible for obtaining sufficient and appropriate evidence, therefore no reference may be made in the audit report regarding the use of information from the service organisation’s auditors
Attempt questions to check your understanding: March/June Hybrid 2016-Q6c Dec 2014-Q6a
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Review
Subsequent events
Adjusting event: An event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period, including an event that indicates that the going concern assumption in relation to the whole or part of the enterprise is not appropriate. Non-adjusting event: An event after the reporting period that is indicative of a condition that arose after the end of the reporting period.
Events after the balance sheet date ADJUSTING
NON-ADJUSTING
Provide additional evidence of conditions existing at the balance sheet date
Concern conditions which did not exist at the balance sheet date
Adjust the financial statements to reflect the event
Impacts going concern
Does not impact going concern
Adjust the financial statements to present on an alternative basis( break-up basis)
Do not adjust the financial statements
If important to users understanding disclose in a note: nature of event estimate of financial effect
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Auditor’s responsibilities-ISA 560
For the purposes of ISA 560, subsequent events are those events that occur between the reporting date and the date of approval of the financial statements and the signing of the auditor’s report.
Period between the year-end date and the date the auditor’s report is signed
The auditor shall perform audit procedures designed to obtain sufficient appropriate audit evidence that all events occurring between the date of the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in, the financial statements have been identified.
A. Review procedures management has established to ensure that subsequent events are identified. B. Inspect: Read minutes of board meetings, shareholder meetings and audit committees that have taken place since the year-end. C. Obtain and review the latest available interim financial statements and/or management accounts, budgets and other related management reports. D. Perform normal post balance sheet work( e.g. checking receipts from trade receivables after the yearend) E. Enquire of the entity’s legal counsel concerning litigation and claims. F. Enquire of management as to whether any subsequent events have occurred which might affect the financial statements G. Checking whether any events have occurred that could call into question the validity of the going concern assumption
Facts discovered after the date of t he auditor’s report but before the date the financial statements are issued.
The auditor does not have any responsibility to perform audit procedures or make any enquiry regarding the financial statements or subsequent events after the date of the auditor ’s report. In this period, it is the responsibility of management to inform the auditor of facts which may affect the financial statements. When the auditor becomes aware of a fact which may materially affect the financial statements, the matter should be discussed with management.
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If the financial statements are appropriately amended then a new audit report should be issued, and procedures relating to subsequent events should be extended to the date of the new audit report. If management do not amend the financial statements to reflect the subsequent event, in circumstances where the auditor believes they should be amended, a qualified or adverse opinion of disagreement should be issued. Facts discovered after the financial statements have been issued. After the financial statements have been issued, the auditor has no obligation to perform any audit procedures regarding such financial statements. However, if, after the financial statements have been issued, a fact becomes known to the auditor that, had it been known to the auditor at the date of the auditor’s report, may have caused the auditor to amend the auditor’s report, the auditor shall: (a) Discuss the matter with management and, where appropriate, those charged with governance; (b) Determine whether the financial statements need amendment; and, if so, (c) Inquire how management intends to address the matter in the financial statements.
If management amends the financial statements, the auditor shall: (a) Carry out the audit procedures necessary in the circumstances on the amendment. (b) Review the steps taken by management to ensure that anyone in receipt of the previously issued financial
statements together with the auditor’s report thereon is informed of the situation.
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Event specific procedures
Confirm event( maybe through enquiry, inspection or observation) and calculate impact on financial statements(if any or the need for a disclosure
Discussion with the management ( any to be made, disclosure to be given, impact onadjustments going concern etc.)
Enquire: from any relevant 3rd party to get further evidence about the event( insurance company,lawyers, customer etc )
Review: minutes of the board meetings in which the event and its impact was discussed
Review: accounting records and any co rrespondence with
Attempt questions to check your understanding: March/June Hybrid 2016-Q3
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Going concern review
Under the ‘going concern assumption’, an entity is ordinarily viewed as continuing in business for the foreseeable future (being to a date of at least, but not limited to, 12 months from the end of the reporting period); with neither the intention nor the necessity of liquidation, cessation of trading or the seeking of protection from creditors pursuant to laws or regulations. Accordingly assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.
Management’s responsibility
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assess ability of the company to continue in the foreseeable future
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disclose uncertainties that might affect the going concern status
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adjust F/s and disclose if financial statement not prepared on a going concern basis
It is the responsibility of management to make an assessment of whether the going concern presumption is appropriate, or not, when they are preparing the financial statements.
Auditor’s responsibilities 1.
2.
They carry out appropriate audit procedures to determine whether the management’sassumption of going concern is appropriate and ensure that the organisation’s management have been realistic in their use of the going concern assumption Report if not appropriate. In forming the audit opinion, the auditor should consider two issues: have the financial statements been prepared using the appropriate going concern assumption, and is there adequate disclosure of any material uncertainty regarding the going concern status. Indicators of going concern problems
Financial Indicators – Net liability or net current liability position. – Fixed term borrowings approaching maturity without realistic prospects of renewal or repayment, or excessive reliance on short-term borrowings to finance long-term assets. – Adverse key financial ratios. – Substantial operating losses. – Arrears or discontinuance of dividends. – Inability to pay payables on due dates.
– Difficultyfrom in complying with the terms of loan agreements. – Change credit to cash-on-delivery transactions with suppliers. – Inability to obtain financing for essential new product development or other essential investments.
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Operating Indicators – Loss of key management without replacement. – Loss of major market, franchise, licence, or principal supplier. – Labour difficulties or shortages of important supplies. Other Indicators – Non-compliance with capital or other statutory requirements. – Pending legal proceedings against the entity that may, if successful result in judgements that could not be met. – Changes in legislation or government policy.
Audit Procedures
DONOT produce a list of generic audit procedures, but instead identify and highlight the factors from the scenario that may call into question the entity’s ability to continue as a going concern. 1. Evaluate the management’s assessment o
the process followed by management to make its assessment
o
the assumptions on which the assessment is based
o
management’s plans for future act ion
o
whether management has taken into consideration all the facts that the auditor is aware of due to their audit procedures
2. Reading minutes of shareholders’ meetings to identify any current, or potential, cash flow difficulties 3. Review post year end management accounts 4. Review cash flow forecast (sufficient cash to continue operations for next year?) In this evaluation the auditor should pay particular attention to the\ reliability of the company’s systems for generating the cash flow information, and whether the assumptions underlying the cash flow appear reasonable. 5. Confirming the existence, terms and adequacy ofborrowing facilities 6. Review events after the period end to identify those that affect the entity’s ability to continue as a going concern 7. Review the terms of loan agreements and determining whether they have been breached
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8. Requesting written representations from management and, where appropriate, those charged with governance, regarding their plans for future action and the feasibility of these plans. 9. View correspondence with major customers, suppliers and banks for evidence of dispute 10. Legal/solicitor letter- inspect correspondence to understand possible consequences of legal action being brought against the company. 11. Obtaining and reviewing reports of regulatory action 12. Other procedures relevant to question given should also be considered!
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Prepare this section AFTER revising Audit Opinion
Auditor’s conclusions Use of going concern basis of accounting is appropriate
Use of Going Concern Basis of Accounting Is Inappropriate
When the use of the going concern basis of accounting is not appropriate in the circumstances, management may be
but a material uncertainty exists relating to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern.
required, or may elect, to prepare the financial statements on another basis (e.g., liquidation basis). The auditor may be able to perform an audit of those financial statements provided that the auditor determines that the other basis of accounting is acceptable in the circumstances.
In auditor’s judgment, appropriate disclosure of the nature and implications of the uncertainty is necessary.
If adequate
If adequate
The financial
disclosure about the material uncertainty
disclosure about the material uncertainty
statements have been unmodified opinion on those financial prepared using the statements, provided there is
is made in the financial statements,
is not made in the financial statements,
going concern basis of accounting but, in the
adequate disclosure therein about the basis of accounting on which the
the auditor shall express an unmodified opinion
the auditor shall:
auditor’s judgment, management’s use of the going concern
financial statements are prepared, but may consider it appropriate or necessary to include an Emphasis of
basis of accounting in the preparation of the financial statements is inappropriate, the
Matter paragraph
and the auditor’s report shall include a separate section under the heading
Express a modified opinion ( Qualified or Adverse as appropriate)
“Material Uncertainty In the Basis for Related to Going Opinion section of Concern” the report, state that (a) Draw attention to a material the note in the uncertainty exists financial statements that may cast doubt that discloses the
The auditor may be able to express an
auditor shall express an adverse opinion
on entity’s ability to
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matters (b) State that these events or conditions indicate that a material uncertainty exists that may cast
continue as a going concern and that F/ S do NOT adequately disclose this matter
significant doubt on the entity’s ability to continue as a going concern and that the auditor’s opinion is not modified in respect of the matter.
Example Material Uncertainty Related to Going Concern
We draw attention to Note 6 in the financial statements, which indicates that the Company incurred a net loss of ZZZ during the year ended December 31, 20X1 and, as of that date, the Company’s current liabilities exceeded its total assets by YYY. As stated in Note 6, these events or conditions, along with other matters as set forth in Note 6,
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indicate that a material uncertainty exists that may cast significant doubt on the Company’s ability to continue as a going concern. Our opinion is not modified in respect of this matter.
REPORTING IN LINE WITH ISA 570, GOING CONCERN
Exam questions might ask the candidate to recognise indicators that an entity may not be a going concern, or require candidates to arrive at an appropriate audit opinion depending on the circumstances presented in the scenario. It may be the case that candidates are presented with a situation where the auditor has concluded that there are material uncertainties relating to going concern and the directors have made appropriate disclosures in relation to going concern and candidates must understand the new auditor reporting requirements in this respect. Under ISA 570 (Revised), if the use of the going concern basis of accounting is appropriate but a material uncertainty exists and management have included adequate disclosures relating to the material uncertainties the auditor will continue to express an unmodified opinion, but the auditor must include a separate section under the heading ‘Material Uncertainty Related to Going Concern’ and:
draw attention to the note in the financial statements that discloses the matters giving rise to the material uncertainty, and state that these events or conditions indicate that a material uncertainty exists which may cast significant doubt on the entity’s ability to continue as a going concern and that the auditor’s opinion is not modified in respect of the matter.
The section headed ‘Material Uncertainty Related to Going Concern’ is included immediately after the Basis for Opinion paragraph but before the KAM section. Over and above the new reporting requirements under ISA 570, candidates need to understand how issues identified regarding going concern interact with the requirements of ISA 701. By their very nature, issues identified relating to going concern are likely to be considered a key audit matter and hence need to be communicated in the auditor’s report. Where the auditor has identified conditions which cast doubt over oing g concern, but audit evidence confirms that no material uncertainty exists, this ‘close call’ can be disclosed in line with ISA 701. This is because while the auditor may conclude that no material uncertainty exists, they may determine that one, or more, matters relating to this conclusion are key audit matters. Examples include
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substantial operating losses, available borrowing facilities and possible debt refinancing, or non-compliance with loan agreements and related mitigating factors. In summary if a confirmed material uncertainty exists it must be disclosed in accordance with ISA 570 and where there is a ‘close call’ over going concern which has been determined by the auditor to be a KAM it will be disclosed in line with ISA 701. This is illustrated in the following example: Example – unmodified audit opinion but material uncertainty exists in relation to going concern and the disclosures are adequate Report on the Audit of the Financial Statements (extract) Opinion: In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of the Company as at 31 December 2015, and its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards (IFRSs). Basis for opinion: We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities under those standards are further described in theAuditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are independent of the Company in accordance with the ethical requirements that are relevant to our audit of the financial statements in Farland, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Material uncertainty related to going c oncern: We draw attention to Note 6 in the financial statements, which indicates that the Company incurred a net loss of $125,000 during the year ended 31 December 2015 and, as of that date, the Company’s current liabilities exceeded its total assets by $106,000. As stated in Note 6, these events or conditions, along with other matters as set forth in Note 6, indicate that a material uncertainty exists
that may cast significant doubt on the Company’s ability to continue as a going concern. Our opinion is not modified in respect of this matter. Key audit matters: Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the financial statements of the current period. These matters were addressed in the context of our audit of the financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. In addition to the matter described in the Material Uncertainty Related to Going Concern section, we have determined the matters described below to be the key audit matters to be communicated in our report. [Include a description of each key audit matter]
Attempt questions to check your understanding: Sept. 2016-Q17b Sept/Dec Hybrid 2015-Q3 June 2014-Q5a,b,c
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Written representations/Management representation letter
Written representations are necessary information that the auditor requires in connection with the audit of the entity’s financial statements. Accordingly, similar to responses to inquiries, written representations are audit evidence. The auditor needs to obtain written representations from management and, where appropriate, those charged with governance that they believe they have fulfilled their responsibility for the preparation of the financial statements and for the completeness of the information provided to the auditor. Written representations are needed to support other audit evidence relevant to the financial statements or specific assertions in the financial statements, if determined necessary by the auditor or required by other International Standards on Auditing. This may be necessary for judgemental areas where the auditor has to rely on management explanations. Written representations can be used to confirm that management have communicated to the auditor all deficiencies in internal controls of which management are aware. Written representations are normally in the form of a letter, written by th e company’s management and addressed to the auditor. The letter is usually requested from management but can also be requested from the chief operating officer or chief financial officer. Throughout the fieldwork, the audit team will note any areas where representations may be required During the final review stage, the auditors will produce a draft representation letter. The directors will review this and then produce it on their letterhead. It will be signed by the directors and dated as at the date the audit report is signed, but not after.
The ISAs require auditors to obtain written representations from management on matters material to the Financial Statements where other sufficient, appropriate, audit evidence cannot reasonably be expected to exist.
Purpose of written representation
1. Acknowledging responsibility for the financial statements by management(ISA 580 requires that “the auditor should obtain audit evidence that management acknowledges its responsibility for fair presentation of the financial statements and for the completeness of the information provided to the auditor) 2. Acknowledging responsibility for other matters (ICS, related party transactions etc) 3. Used as audit evidence there is no sufficient appropriate evidence in existence on a matter which is material to the financial statements. 4. Acknowledges representations previously made verbally by management 5. Minimises misunderstandings between management and auditor
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Reliability of written representations
– – – – – –
Representations from management are a source of assurance evidence. They cannot be used instead of other (better) evidence which the assurance providers expect to exist. HOWEVER, they may be the only available form of evidence in certain circumstances. They are relatively unreliable as evidence. Corroborative evidence will always be sought, but may not always be available. If a representation appears to be contradicted by other evidence:the circumstances should be investigated, andthe reliability of other representations made by managementshould be reconsidered.
Written representation letter contents No irregularities involving management or employees that could have a material effect on the financial statements All books of account and supporting documentation have been made available to the auditors Information and disclosures with reference to related parties is complete Financial statements are free from material misstatements including omissions No non-compliance with any statute or regulatory authority No plans that will materially alter the carrying value or classification of assets or liabilities in the financial statements No plans to abandon any product lines that will result in any excess or obsolete inventory No events, unless already disclosed, after the end of the reporting period that need disclosure in the financial statements. SPECIFIC MATTERS
Included here is anything else that the auditor would like a representation on for example: that a certain debt is recoverable; all bank accounts have been disclosed; any plans to reorganise the business or discontinue product lines have already been disclosed. Refusal to Provide Requested Written Representations
If management refuses to provide a written representation, then the auditor should again review the possibility of obtaining sufficient audit evidence from alternative sources in connection with the matter or issue under review. If the directors refuse to sign the representation letter, then the auditor has a number of options available to him: (i) (ii)
The auditor could discuss the matter with the directors and try to resolve their problems with the letter. The auditor could write a representation letter for the directors, then send this to the directors and ask them to sign it.
(iii)
If the auditor considers that he has not received all the information and explanations required for his audit, then the auditor’s report should be qualified.
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(iv)
Before taking these actions, the auditor should explain to the directors the consequences of not signing the representation letter, to try to avoid a confrontation.
An auditor should reconsider the reliability of other representations. If the representation is not consistent with other audit evidence, the auditor should perform audit procedures to attempt to resolve the matter. For this, the auditor should reassess the appropriateness of the risk of material misstatement on account of this inconsistency. If required, the auditor should revise the nature, timing and extent of further audit procedures.
Overall review of financial statements
Before the audit report is signed, the auditor needs to know that the work is finished and that all necessary issues have been dealt with. The easiest way to do this is to use a series of checklists:
The audit plan should be reviewed, to verify that all issues raised have been resolved.
An Accounting Standards Checklist will be completed, forcing the auditor to consider every possible accounting issue that could affect the client’s Financial Statements.
Additional checklists may be necessary (e.g. Company Law) to make sure that any other issues have been fully considered
Quality Control All audit work should be subject to review. This is a basic quality control requirement of ISA 220, for an Audit of Financial Statements, and serves to ensure that sufficient appropriate audit evidence has been
obtained in respect of transactions and balances included in the financial statements. In performing a file review, the reviewer should consider the sufficiency of evidence obtained and may need to propose further audit procedures if evidence is found to be insufficient or contradictory. ISA 230, Audit Documentation requires that documentation of the review process includes who reviewed the audit work completed and the date and extent of such review. Typically, the auditor will present the client with a list of misstatements (often referred to as the ‘audit error schedule’), quantifying the amount of each misstatement, and proposing the necessary adjustment to the financial statements. The proposed adjustment may be in the form of a journal entry, an amendment to the presentation of the financial statements, or a correction to a disclosure note. When management makes the necessary adjustments to the financial statements, the auditor should confirm that the adjustments have been made correctly.
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Procedures an auditor should perform include: 1.
Reviewing the financial statements to ensure compliance with accounting standards and local legislation disclosure. This is sometimes done via the use of a disclosure checklist.
2. Reviewing the disclosure of the accounting policies to ensure that they are in accordance with the accounting treatment adopted in the financial statements, and that they are sufficiently disclosed. 3. Reviewing the financial statements to ensure they are consisten t with the auditor’s knowledge of the business and the results of their audit work. 4. Reviewing the financial statements to assess whether they adequately reflect the information and explanations previously obtained and conclusions reached during the course of the audit. 5.
Analytical Procedures; this Performing analytical procedures of the financial statements, under ISA 520 helps the auditor to form an overall conclusion on the financial statements ( explained separately below)
6. Reviewing the aggregate of uncorrected misstatements to assess whether in aggregate a material misstatement arises; if so discuss with management with regards to a potential adjustment. 7. As part of the overall review, the auditor should assess whether the audit evidence gathered by the team is sufficient and appropriate to support the audit opinion.
Final analytical procedures
Before the audit report is signed, it is sensible to do some final analysis of the Financial Statements (e.g. ratio analysis) – just to make sure that the auditor is confident in the audit opinion. There are 2 main reasons for this final analysis: The Financial Statements may have been adjusted during the audit as mistakes were found, so the final figures may never have been analysed or been subject to ratio analysis. The auditor will have learned more about the company during the audit, so is in a better position at the end of the audit to analyse the figures and understand trends in ratios. The analytical procedures performed at this stage of the audit are not different to those performed at the planning stage – the auditor will perform ratio analysis, comparisons with prior period financial statements and other techniques to confirm that trends are as expected, and to highlight unusual transactions and balances that may indicate a risk of misstatement. The key issue is that, near the end of the audit, the auditor should have sufficient audit evidence to explain the issues highlighted by analytical procedures, and should therefore be able to conclude as to the overall reasonableness of the financial statements.
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When the analytical procedures performed near the end of the audit reveal further previously unrecognised risk of material misstatement, the auditor is required to revise the previously assessed risk of material misstatement and modify the planned audit procedures accordingly. This means potentially performing further audit procedures in relation to matters that are identified as high risk.
Attempt questions to check your understanding: June 2013-Q1a
Misstatements
Misstatements: 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. Uncorrected misstatements: Misstatements that the auditor has accumulated during the audit and that have not been corrected.
There are three categories of misstatements: i. Factual misstatements are misstatements about which there is no doubt. ii. Judgemental misstatements are differences arising from the judgements of management concerning accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate. iii. Projected misstatements are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements identified in audit samples to the entire populations from which the samples were drawn. The auditor has a responsibility to accumulate misstatements which arise over the course of the audit. Identified misstatements should be considered during the course of the audit to assess whether the audit strategy and plan should be revised.
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The auditor will communicate the uncorrected misstatements and their implication on the auditor’s report to those charged with governance. The auditor will also request a written representation (including a summary of uncorrected misstatements) from management and – where appropriate– those charged with governance as to whether they believe the effects of uncorrected misstatements are immaterial, individually and in aggregate to the financial statements as a whole. The auditor may find: 1. Individual material misstatements 2. Individual immaterial misstatements 3. Immaterial misstatements which become material when aggregated In all 3 cases, they have to be reported to the management.
Examples of circumstances when misstatement is considered material when it lower than quantitative (material by nature)
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Affects compliance with regulatory requirements; Affects compliance with debt covenants or other contractual requirements; Affects ratios used to evaluate the entity’s financial position, results of operations or cash flows;
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Has the effect of increasing management compensation, for example, by ensuring that the requirements for the award of bonuses or other incentives are satisfied;
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Audit Opinion F8 Examiner’s comments
Questions historically in this area of the syllabus have required a discussion of the accounting treatment, a materiality calculation, an assessment of the type of audit report modification and the impact on the auditor’s
report.
Candidates often find auditor’s reports a challenging part of the syllabus and in preparation for exams, it is imperative that candidates can: -
describe the different elements of the auditor’s report
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determine the most appropriate type of audit opinion in a given scenario, often through an explanation of why a certain opinion is appropriate which will test the application of the candidate’s knowledge
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understand the issues that may arise during the course of an audit that could require an Emphasis of Matter or Other Matter paragraph to be included in the audit report, and
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identify Key Audit Matters (KAM) that are required to be disclosed in an auditor’s report.
Candidates will not be expected to draft an auditor’s report but may be asked to present reasons for an unmodified or a modified opinion, or the inclusion of an Emphasis of Matter paragraph. Candidates attempting F8 may be required to identify and describe the elements of the auditor’s report and therefore candidates should ensure that they have a sound understanding of the revised ISA 700, Forming an Opinion and Reporting on Financial Statements . Candidates may also be presented with extracts from an auditor’s report and be asked to critically appraise the extracts, or challenge the proposed audit opinion.
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Form of opinion
Unmodified opinion
The auditor shall express an unmodified opinion when the auditor concludes that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.
Modified opinion
If the auditor:
-qualified
(a) concludes that, based on the audit evidence obtained, the financial statements as a whole are not free from material misstatement; or
-Adverse
(b) is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement, the auditor shall modify the opinion in the auditor’s report in accordance with ISA 705
-Disclaimer
(Revised).
To understand different types of opinions, the following terms need to be understood.
Misstatement: Discussed above Inability to obtain appropriate and sufficient evidence : The auditor was not able to get sufficient
appropriate audit evidence on which to base the opinion. The auditor’s inability to obtain sufficient appropriate audit evidence is also referred to as a limitation on the scope of the audit and could arise from: o o
o
Circumstances beyond the entity’s control (e.g. accounting records destroyed) Circumstances relating to the nature or timing of the auditor’s work (e.g. the timing of the auditor’s appointment prevents the observation of the physical inventory count). Limitations imposed by management (e.g. management prevents the auditor from requesting external confirmation of specific account balances).
Pervasive: This is a term used to describe the effects or possible effects on the financial statements of
misstatements or undetected misstatements (i.e. due to an inability to obtain sufficient appropriate audit evidence). There are three types of pervasive effect: o
o
o
Those that are not confined to specific elements, accounts or items in the financial statements. Those that are confined to specific elements, accounts or items in the financial statements and represent or could represent a substantial portion of the financial statements. Those that relate to disclosures which are fundamental to users understanding of the financial statements.
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Unmodified Opinion
Auditor concludes that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. Wording
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 of December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. Modified Opinion a) Qualified b) Adverse c) Disclaimer
a)Qualified Nature of matter: Material Reason: material misstatement or inability to obtain appropriate and sufficient evidence (regarding an accounting policy, transaction, balance or disclosure etc) Opinion: Qualified ‘Except for’ Wording: QUALIFIED OPINION In our opinion, except for the effects of the matter described in the Basis of 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.
BASIS FOR QUALIFIED OPINION (Nature, amount , impact to be explained) The company’s inventories are carried in the balance sheet at XXX. Management has not stated inventories at the lower of cost and net realizable value but has stated them solely at cost, which constitutes a departure from International Financial Reporting Standards. The company’s records indicate that had management stated the inventories at the lower of cost and net realizable value, an amount of XXX would have been required to write the inventories down to their net realizable value. Accordingly, cost of sales would have been increased by XXX, and income tax, net income and shareholders’ equity would have been reduced by XXX, XXX and XXX, respectively.
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b) Adverse Nature of matter: Material and pervasive Reason: Misstatement in the F/S Opinion: Adverse
Wording: ADVERSE OPINION In our opinion, because of the significance of the matter discussed in the Basis of Adverse Opinion paragraph, the consolidated financial statements do not present fairly (or do not give a nature 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.
BASIS FOR ADVERSE OPINION (Nature, amount , impact to be explained) c)Disclaimer Nature of matter: Material and pervasive Reason: Inability to obtain appropriate and sufficient evidence Opinion: Disclaimer Wording: 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
BASIS FOR DISCLAIMER OF OPINION (Nature, amount , impact to be explained)
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Emphasis of Matter paragraph Emphasis of Matter paragraph :A paragraph included in the auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements. Emphasis of Matter Paragraphs in the Auditor’s Report
If the auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor shall include an Emphasis of Matter paragraph in the auditor’s report provided: -
The auditor would not be required to modify the opinion in accordance with ISA 705 (Revised) as a result of the matter; and When ISA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the auditor’s report. (When ISA 701 applies, the use of Emphasis of Matter paragraphs is not a substitute for a description of individual key audit matters.)
When the auditor includes an Emphasis of Matter paragraph in the auditor’s report, the auditor shall: (a) Include the paragraph within a separate section of the auditor’s report with an appropriate heading that includes the term “Emphasis of Matter”; (b) Include in the paragraph a clear reference to the matter being emphasized and to where relevant disclosures that fully describe the matter can be found in the financial statements. The paragraph shall refer only to information presented or disclosed in the financial statements; and
(c) Indicate that the auditor’s opinion is not modified in respect of the matter emphasized. Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter paragraph are
1. An uncertainty relating to the future outcome of exceptional litigation or regulatory action. 2. A significant subsequent event that occurs between the date of the financial statements and the date of the auditor’s report. 3. Early application (where permitted) of a new accounting standard that has a material effect on the financial statements. 4. A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial 5. position. When a financial reporting framework prescribed by law or regulation would be unacceptable but for the fact that it is prescribed by law or regulation. 6. When facts become known to the auditor after the date of the auditor’s report and the auditor provides a new or amended auditor’s report (i.e., subsequ ent events).
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Other Matter paragraph Other Matter paragraph – A paragraph included in the auditor’s report that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities or the auditor’s report.
Other Matter Paragraphs in the Auditor’s Report
If the auditor considers it necessary to communicate a matter other than those that are presented or disclosed in the financial statements that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities or the auditor’s report, the auditor shall include an Other Matter paragraph in the auditor’s report, provided: (a) This is not prohibited by law or regulation; and (b) When ISA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the auditor’s report. When the auditor includes an Other Matter paragraph in the auditor’s report, the auditor shall include the paragraph within a separate section with the heading “Other Matter,” or other appropriate heading. Circumstances in Which an Other Matter Paragraph May Be Necessary
1. Relevant to Users’ Understanding of the Audit: In the rare circumstance where the auditor is unable to withdraw from an engagement even though the possible effect of an inability to obtain sufficient appropriate audit evidence due to a limitation on the scope of the audit imposed by management is pervasive,the auditor may consider it necessary to include an Other Matter paragraph in the auditor’s report to explain why it is not possible for the auditor to withdraw from the engagement.
2. Relevant to Users’ Understanding of the Auditor’s Responsibilities or the Auditor’s Report: Law, regulation or generally accepted practice in a jurisdiction may require or permit the auditor to elaborate on matters that provide further explanation of the auditor’s responsibilities in the audit of the financial statements or of the auditor’s report thereon.
3. Reporting on more than one set of financial statements: An entity may prepare one set of financial statements in accordance with a general purpose framework (e.g., the national framework) and another set of financial statements in accordance with another general purpose framework (e.g., International Financial Reporting Standards), and engage the auditor to report on both sets of financial statements. If the auditor has determined that the frameworks are acceptable in the respective circumstances, the auditor may include an Other Matter paragraph in the auditor’s report, referring to the fact that another F8 KNOWLEDGE SUMMARY-SKANS SCHOOL OF ACCOUNTANCY
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set of financial statements has been prepared by the same entity in accordance with another general purpose framework and that the auditor has issued a report on those financial statements.
4. Prior Period Financial Statements Audited by a Predecessor Auditor . If the financial statements of the prior period were audited by a predecessor auditor and the auditor is not prohibited by law or regulation from referring to the predecessor auditor’s report on the corresponding figures and decides to do so, the auditor shall state in an Other Matter paragraph in the auditor’s report: a. That the financial statements of the prior period were audited by the predecessor auditor; b. The type of opinion expressed by the predecessor auditor and, if the opinion was modified, the reasons
therefore; and c. The date of that report. 5. Prior Period Financial Statements Not Audited : If the prior period financial statements were not audited, the auditor shall state in an Other Matter paragraph in the auditor’s report that the corresponding figures are unaudited. Such a statement does not, however, relieve the auditor of the requirement to obtain sufficient appropriate audit evidence that the opening balances do not contain misstatements that materially affect the current period’s financial statements
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Matters to be communicated to TCWG (Those Charged with Governance)
1. The auditor’s responsibilities in relation to the financial statements
2. Planned scope and timing of audit
– A statement that the auditor is responsible for forming and expressing an opinion on the financial statements. – That the auditor’s work is carried out in accordance with ISAs and in accordance with local laws and regulations. This would include – The audit approach to assessing the risk of serious misstatement, whether arising from fraud or error. – The audit approach to the internal control system and whether reliance will be placed on it. – The timing of interim and final audits, including reporting deadlines.
3. Significant findings from the audit
4. A statement on independence issues affecting the audit ( for listed entities only)
This heading could include: – Significant difficulties encountered during the audit, including delays in obtaining information from management. – Material weaknesses in internal control and recommendations for improvement. – Audit adjustments, whether or not recorded by the entity, that have, or could have, a material effect on the entity’s financial statements. For example, the bankruptcy of a material receivable shortly after the year-end that should result in an adjusting entry. This would include: – That the audit firm has ensured that all members of the audit team have complied with the ethical standards of ACCA. – That appropriate safeguards are in place where a potential threat to independence has been identified.
The lists of examples listed under the above headings are not exhaustive and in practice many more specific matters would be communicated to those charged with governance such as: – Modifications to the audit r eport. – Any management representation points requested.
– Cases of suspected/actual fraud.)
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Key audit matters: Those mattersthat, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. Key audit matters are selected from matters communicated with those charged with governance. Objectives: The objectives of the auditor are to determine key audit matters and, having formed an opinion on the financial statements, communicate those matters by describing them in the auditor’s report.
Determining KAM The auditor shall determine, from the matters communicated with those charged with governance, those
matters that required significant auditor attention in performing the audit. In making this determination, the auditor shall take into account the following: 1. Areas of higher assessed risk of material misstatement, or significant risks identified in accordance with ISA 315 (Revised). 2. Significant auditor judgments relating to areas in the financial statements that involved significant management judgment, including accounting estimates that have been identified as having high estimation uncertainty. 3. The effect on the audit of significant events or transactions that occurred during the period. 4. Other considerations COMMUNICATING KAM
Once the auditor has determined which matters will be included as KAM, the auditor must ensure that each matter is appropriately described in the auditor’s report including a description of: 1. 2.
Why beaudit one of mostmay significance thereforeofa key audit matter, and How the the matter matter was was determined addressed into the (which include aand description the auditor’s approach, a brief overview of procedures performed with an indication of their outcome and any other key observations in respect of the matter).
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Audit Report-an exam focused summary
Column A and B will be in all reports. Column C explains the impact of various issues on the report-this will be in addition to Column B and C. Column A
Column B
Column C
Content
Explanation
Impact of various issues
1
Title
2
Addressee
3
Opinion
The auditor’s report shall have a title that clear ly indicates that it is the report of an independent auditor. The auditor’s report shall be addressed, as appropriate, based on the circumstances of the engagement. “we have audited..” - Name the client - Year end - Components of F/s + accounting policies “in our opinion”…..
4
Basis for Opinion
-
Conducted audit according to ISAs Our responsibilities described in a separate paragraph We are independent in accordance with IESBA code of ethics/local codes SAE gathered to provide a basis for the opinion
In modified opinion: - Heading changes to the name of the modified opinion - Wording of the opinion changes
Heading changes: Basis for Qualified/Adverse/Disclaimer Opinion Nature, amount, impact and reference to accounting standard given Material uncertainty relating to going concern” paragraph (if needed)
-
-
draw attention to the note in the financial statements that discloses the matters giving rise to the material uncertainty, and state that these events or conditions indicate that a material uncertainty exists which may cast significant doubt on the entity’s ability to continue as a
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going concern and that the auditor’s opinion is not modified in respect of the matter. Disclosure correctly given- ‘we draw your attention to notes to the account number 6 which relate to….”
5
Key Audit
-
Matters -
Provide further information about the process that led to the opinion so related to matters included in the F/S Selected from matters communicated to TCWG According to auditor’s judgment, the MOST significant matters relating to the audit
When the auditor expresses a disclaimer of opinion then the auditor’s report should not include a KAM section.
Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the financial statements of the current period. These matters were addressed in the context of our audit of the financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters.”
[Description of each key audit matter in accordance with ISA 701.]
EOMP ( can be placed here or before Key Audit Matters- auditor has to use his judgment) - Cannot be used for drawing attention to a going concern uncertainty disclosure as a separate paragraph is now
required for this - Should be headed as EOMP - Reference of the disclosure needs to be given ( Note # 7…)
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OMP - placed here ( always AFTER Key audit matters) - cannot be used for other information issues as there is now a separate paragraph for this. -none of the Key Audit Matters
can be mentioned here. 6
Other
-
information -
7
Responsibilities of management and TCWG
-
8
Auditor’s responsibility for audit of F/S
-
-
-
-
-
Management responsible for other information in the document containing financial statements Our opinion does not cover OI, no assurance give on it Our responsibility to read OI and find inconsistencies with F/s-
Any uncorrected inconsistencies in Other Information will be explained here. This paragraph will then be moved from here to underneath basis for opinion paragraph.
Preparation of F/S Internal control over financial reporting Assess ability of the company to continue as a going concern TCWG’s responsibility to oversee the financial reporting process Reasonable assurance that F/S free from material misstatements- not a guarantee that all misstatements will be detected Issue audit report Define material misstatement in this para Mention use of professional judgment and professional skepticism
Identify and assess risk of material misstatement due to fraud and error ( fraud could include collusion, forgery, intentional omissions, misrepresentation, override of internal control) Obtain understanding of internal control over financial reporting to design audit procedures- no opinion given Evaluate appropriateness of accounting policies Evaluate reasonableness of accounting estimated Conclude on appropriateness of
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-
9
management’s use of going concern basisalso mention that future events/conditions may still cause the company to cease as going concern Evaluate overall presentation, structure, content of F/S including disclosures Communicate with TCWG ‘ from matters communicated with TCWG, we determine the most significant ones (KEY AUDIT MATTERS)
Report on other legal and regulatory
In some jurisdictions, the auditor may have additional responsibilities to report on other matters that are
requirements
the ISAs
supplementary to the auditor’s responsibilities under
For example, the auditor may be asked to report certain matters if they come to the auditor’s attention during the course of the audit of the financial statements. . Auditing standards in the specific jurisdiction often provide guidance on the auditor’s responsibilities with respect to specific additional reporting responsibilities in that jurisdiction
10
Engagement partner’s name
11
Signatures
12
Auditor’s address
13
Date
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Audit report- Details Auditor’s report on F/S prepared in accordance with a fair presentation f ramework Content
Explanation
Title
The auditor’s report shall have a title that clearly indicates that it is the report of an independent auditor
Addressee
The auditor’s report shall be addressed, as appropriate, based on the circumstances of the engagement.
Opinion
“Heading “Opinion.”
The Opinion section of the auditor’s report shall also: (a) Identify the entity whose financial statements have been audited; (b) State that the financial statements have been audited; (c) Identify the title of each statement comprising the financial statements; (d) Refer to the notes, including the summary of significant accounting policies; and (e) Specify the date of, or period covered by, each financial statement comprising the financial statements.
Wording In our opinion, the accompanying financial statements present fairly, in all material respects, […] in accordance with [the applicable
financial reporting framework]
or In our opinion, the accompanying financial statements give a true and fair view of […] in accordance with [the applicable financial reporting framework]
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Basis of Opinion
The auditor’s report shall include a section, directly following the Opinion section, with the heading “Basis for Opinion”, that: -
-
Key Audit Matters
States that the audit was conducted in accordance with International Standards on Auditing; Refers to the section of the auditor’s report that describes the auditor’s responsibilities under the ISAs; Includes a statement that the auditor is independent of the entity in accordance with the relevant ethical requirements relating to the audit, and has fulfilled the auditor’s other ethical responsibilities in accordance with these requirements. The statement shall identify the jurisdiction of srcin of the relevant ethical requirements or refer to the International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code); and States whether the auditor believes that the audit evidence the auditor has obtained is sufficient and appropriate to provide a basis for the auditor’s opinion.
Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the financial statements of the current period. These matters were addressed in the context of our audit of the financial
For example:
statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters.”
-Highest risk areas -Areas with greater complexity, more subjectivity
[Description of each key audit matter in accordance with ISA 701. ]
-areas where more audit effort was needed for example consultations taken -significant events/transactions -separate issues interacted ( a long term contract which has an effect on revenue recognition as well as litigation aspects)
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5
Other information
(in the annual report)
6
“Responsibilities of Management/TCWG for the Financial
-
“Management responsible for other information in the document containing financial statements” - “Our opinion does not cover Other information, no assurance give on it” - “Our responsibility to read OI andfind inconsistencies with F/s” - If OI changes not made, they will be reported here. This section of the auditor’s report shall describe management’s responsibility for:
-
Statements.”
Preparing the financial statements in accordance with the applicable financial reporting framework, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error;
-
7
Assessing the entity’s ability to continue as a going concern and whether the use of the going concern basis of accounting is appropriate as well as disclosing, if applicable, matters relating to going concern. The explanation of management’s responsibility for this assessment shall include a description of when the use of the going concern basis of accounting is appropriate.
Auditor’s
The description of the auditor’s responsibilities for theaudit of the financial
responsibility for
statements shall be included:
audit of F/S
(a) Within the body of the auditor’s report; (b) Within an appendix to the auditor’s report, in which case the auditor’s report shall include a reference to the location of the appendix; or (c) By a specific reference within the auditor’s report to the location of such a description on a website of an appropriate authority, where law, regulation or national auditing standards expressly permit the auditor to do so Responsibilities
-
-
Reasonable assurance that F/S free from material misstatements- not a guarantee that all misstatements will be detected Issue audit report Define material misstatement in this para Mention use of professional judgment and professional skepticism Identify and assess risk of material misstatement due to fraud and error ( fraud could include collusion, forgery, intentional omissions, misrepresentation, override of internal control) Obtain understanding of internal control over financial reporting to design audit procedures- no opinion given Evaluate appropriateness of accounting policies Evaluate reasonableness of accounting estimated
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-
-
8
Conclude on appropriateness of management’s use of going concern basisalso mention that future events/conditions may still cause the company to cease as going concern Evaluate overall presentation, structure, content of F/S including disclosures Communicate with TCWG ‘ from matters communicated with TCWG, we determine the most significant ones (KAM)
Report on other
In some jurisdictions, the auditor may have additional responsibilities to report on
legal and regulatory requirements
other matters that are supplementary to the auditor’s responsibilities under the ISAs For example, the auditor may be asked to report certain matters if they come to the auditor’s attention during the course of the audit of the financial statements. . Auditing standards in the specific jurisdiction often provide guidance on the auditor’s responsibilities with respect to specific additional reporting responsibilities in that jurisdiction.
9
Engagement partner’s name
10
Signatures
11
Auditor’s address
12
Date
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APPLICATION OF ISA 701 WHEN A QUALIFIED OR ADVERSE OPINION IS ISSUED
ISA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report outlines the requirements when the auditor concludes that the audit opinion should be modified. ISA 705 (Revised) requires that the auditor includes a Basis for Qualified/Adverse Opinion section in the auditor’s report. When the auditor expresses a qualified or adverse opinion, the requirement to communicate other KAM is still relevant and hence will still apply. When the auditor issues an adverse opinion it means that the financial statements do not give a true and fair view (or present fairly) because the auditor has concluded that misstatements, individually and in aggregate, are both material and pervasive to the financial statements. Depending on the significance of the matter(s) which has resulted in the auditor expressing an adverse audit opinion, the auditor might determine that no other matters are KAM. In this situation, the auditor will deal with the matter(s) in accordance with applicable ISAs and include a reference to the Basis for Qualified/Adverse Opinion or the Material Uncertainty Related to Going Concern section(s) in the KAM section of the report as illustrated below.
Example – Qualified ‘except for’ opinion issued but no key audit matters The audit of Turquoise Industries Co has been completed and the auditor discovered a material amount of research expenditure which had been capitalised as an intangible asset in contravention of IAS 38 Intangible Assets. The finance director refused to derecognise the research expenditure as an intangible asset and include it in profit or loss and the auditor therefore issued a qualified ‘except for’ opinion on the basis of disagreement with the entity’s accounting treatment for research expenditure.
The auditor has concluded that there are no KAM which require to be communicated in the audit report. The KAM section of the report will therefore be as follows: Key audit matters Except for the matter described in the Basis for Qualified Opinion section, we have determined that there are no key audit matters to communicate in our report.
When the auditor has expressed an adverse opinion on the financial statements and communicates KAM, it is important that the descriptions of such KAM do not imply that the financial statements as a whole are more credible in light of the adverse opinion.
DISCLAIMER OF OPINION ISSUED A disclaimer of opinion is issued when the auditor is unable to form an opinion on the financial statements. ISA should not include 705 states that when the auditor expresses a disclaimer of opinion then the auditor’s report a KAM section.
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Attempt questions to check your understanding: Sept/Dec Hybrid 2015-Q6c June 2015-Q3 Dec 2014-Q4 Dec 2014-Q6c June 2014-Q5d June 2013-Q5c
A few important points- re-capped.
INTERIM AND FINAL AUDIT TESTS During the interim audit, the internal control system is documented and evaluated. This will determine the mix of tests of control and substantive tests but both will tend to focus on transactions that have occurred so far in the period.
During the final audit, the focus is on the financial statements and the assertions about assets, liabilities and equity interests. At this stage the auditor will design substantive procedures to ensure that assurance has been gained over all relevant assertions.
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Audit sampling Audit sampling is the application of audit procedures to less than 100% of items within a population of audit relevance, such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.
Audit sampling can be applied using either a statistical or a non-statistical approach. It involves testing a smaller number of items and using the results to draw a conclusion about the whole balance or class of transactions. It is necessary for auditors to sample as it is impossible to select all items for testing as this would take the audit team too long and it would cost too much. In addition, auditors do not provide 100% assurance in their audit report about the financial statements, they only provide reasonable assurance and hence it is not necessary to test every item within a population. Audit sampling is also widely known to reduce the risk of ‘over-auditing’ in certain areas, and enables a much more efficient review of the working papers at the review stage of the audit. In devising their samples, auditors must ensure that the sample selected is representative of the population. If the sample is not representative of the population, the auditor will be unable to form a conclusion on the entire population.
SAMPLING RISK Sampling risk is the risk that the auditor’s conclusions based on a sample may be different f rom the conclusion if the entire population were the subject of the same audit procedure.
ISA 530 recognises that sampling risk can lead to two types of erroneous conclusions: 1. The auditor concludes that controls are operating effectively, when in fact they are not. In substantive testing, the auditor may conclude that a material misstatement does not exist, when in fact it does. These erroneous conclusions will more than likely lead to an incorrect opinion being formed by the auditor. 2. The auditor concludes that controls are not operating effectively, when in fact they are. In terms of substantive testing, the auditor may conclude that a material misstatement exists when, in fact, it does not. NON SAMPLING RISK
Non-sampling risk is the risk that the auditor forms the wrong conclusion, which is unrelated to sampling risk. An example of such a situation would be where the auditor adopts inappropriate audit procedures, or does not recognise a control deviation.
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METHODS OF SAMPLING
Random selection: This method of sampling ensures that all items within a population stand an equal chance of selection by the use of random number tables or random number generators. The sampling units could be physical items, such as sales invoices or monetary units.
Systematic selection: This is a method of selection in which the auditor selects items using a constant interval between selections. The first item may be selected on a random or haphazard basis, and thereafter the sampling
interval is derived by the auditor, for example, by dividing the population by the sample size. Haphazard selection: The auditor selects the sample without following a structured technique – the auditor would avoid any conscious bias or predictability. Block selection: This involves selection of a block(s) of contiguous items from within the population. Block selection cannot ordinarily be used in audit sampling because most populations are structured such that items in a sequence can be expected to have similar characteristics to each other, but different characteristics from items elsewhere in the population. Monetary Unit Sampling: This is a type of value-weighted selection in which sample size, selection and evaluation results in a conclusion in monetary amounts. This selection method ensures that each individual $1 in the population has an equal chance of being selected.
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STATISTICAL VERSUS NON-STATISTICAL SAMPLING ‘Statistical’ sampling: ‘An approach to sampling that has the following characteristics:
i. Random selection of the sample items, and ii. The use of probability theory to evaluate sample results, including measurement of sampling risk.’ The ISA goes on to specify that a sampling approach that does not possess the characteristics in (i) and (ii) above is considered non-statistical sampling.
The advantages of using statistical sampling rather than judgemental sampling (non-statistical sampling) include: (1) The size of the sample is determined objectively having regard to the degree of risk associated with the area being tested. (2) Bias is eliminated. (3) Results of statistical sampling can be more easily justified as being representative of the population as a whole, thus increasing the level of confidence in the results of testing the sample. As a consequence of this, the conclusion drawn from the results of sample testing are more easily justified where an audit client disputes the audit conclusions. (4) In instances when there is a large population, the use of statistical sampling techniques may reduce the
sample size, and therefore the amount of audit work required, as compared to the sample size that would be selected using judgement sampling methodology.
When might sampling not be appropriate
A sampling approach to testing would not be appropriate in the following circumstances: i. ii. iii. iv. v. vi.
Where there is a statutory requirement to disclose specific items in the financial statements, for example directors’remuneration. Where the population is very small and the results from sampling could not be relied on, for example when conducting certain compliance tests. Where the population is small in number but comprises material individual balances or transactions, for example property additions. Where the population is not homogenous and requires subdivision before sampling can be attempted, for example purchase invoices and credit notes. When the auditor is put ‘on enquiry’ for example when testing for fraud. Where the costs of sampling outweigh the benefits as compared to 100% testing.
EXTRAPOLATION: Extrapolation takes the result of a sample and projects that result over the whole population. Imagine total sales are $10m. You select a sample of $1m (10% of the population) to test. If errors of $37k are found in the sample, it could be inferred by extrapolation that there are errors of $370k in the total population. Extrapolation can only be applied to statistical sampling.
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COMPUTER ASSISTED AUDIT TECHNIQUES (CAATs) Computer-assisted audit techniques (CAATs) are those featuring the ‘application of auditing procedures using the computer as an audit tool’ The extent to which an auditor may choose between using CAATs and manual techniques on a specific audit engagement depends on the following factors:
--the cost effectiveness of using CAATs --the availability of audit time --the availability of the audit client’s computer facility --the level of audit experience and expertise in using a specified CAAT --the level of CAATs carried out by the audit client’s internal audit function and the extent to which the extern al auditor can rely on this work
Test data
Audit test data is used to test the existence and effectiveness of controls built into an application program used by an audit client. As such, dummy transactions are processed through the cl ient’s computerised system. The results of processing are then compared to the auditor’s expected results to determine whether controls are operating efficiently and systems’objectiveness are being achieved. For example, two dummy bank payment transactions (one inside and one outside authorised parameters) may be processed with the expectation that only the transaction processed within theparameters is ‘accepted’ by the system.Clearly, if dummy transactions processed do not produce the expected results in output, the auditor will need to consider the need for increased substantive procedures in the area being reviewed. Test data should contain valid data ( to ensure the system processes it correctly) and invalid data (to ensure system rejects it). Live test data: data processed on the client’s system during a normal production run Dead test data: data processed at a time when the normal production run is not taking place Integrated test facility: the auditor may seek permission from the client to establish an integrated test facility within the accounting system. This entails the establishment of a dummy unit, for example, a dummy supplier account against which the auditor’s test data is processed during normal processing runs.
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Audit Software
The term ‘audit software’describes the computer software used by auditors to assist them in their work, when examining the operations of, and testing the output of a computer-based accounting system. Computer programs designed to carry out tests of control and/or substantive procedures This performs checks that auditors would otherwise need to do by hand. Such programs may be classified as: Packaged programs (off the shelf) These consist of pre-prepared generalised programs used by auditors and are not ‘client specific’. They may be used to carry out numerous audit tasks, for example, to select a sample, either statistically or judgementally, during arithmetic calculations and checking for gaps in the processing of sequences. Purpose written programs (bespoke) These programs are usually ‘client specific’ and may be used to carry out tests of control or substantive procedures. Audit software may be bought or developed, but in any event the audit firm’s audit plan should ensure that provision is made to ensure that specified programs are appropriate for a client’s system and the needs of the audit.Typically, they may be used to re-perform computerised control procedures (for example, cost of sales calculations) or perhaps to carry out an aged analysis of trade receivable (debtor) balances. Enquiry programs
These programs are integral to the client’saccounting system; however they may be adapted for audit purposes. For example, where a system provides for the routine reporting on a ‘monthly’ basis of employee starters and leavers, this facility may be utilised by the auditor when auditing salaries and wages in the client’s financial statements. Similarly, a facility to report trade payable (creditor) long outstanding balances could be used by an auditor when verifying the reported value of creditors Uses of audit software Highlighting of exceptions- For example, to identify exceptional wages payments outside of stated parameters Highlighting of trends- To highlight reported inventory movement both immediately before and after reporting dates to identify possible manipulation of inventory figures Performance of sequence checks - To verify completeness of sales reporting by ensuring that all invoices have been recorded. Calculation checks- To ensure that overhead costs are totalled correctly in the general ledger. F8 KNOWLEDGE SUMMARY-SKANS SCHOOL OF ACCOUNTANCY
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Stratification of data – To subdivide the population of inventory lines with a view to examining only material balances. Selection of items for testing – To select trade receivables accounts for circularisation, to verify the existence of trade receivables. Detecting violation of system rules – For example, where other people besides the accountant have been overriding overtime payments or employees amending their own gross wages.
The advantages of Computer-Assisted Audit Techniques (CAATs) are that they: 1. Enable the auditor to test program controls– if CAATs were not used then those controls would not be testable.
2. Enable the auditor to test a greater number of items quickly and accurately. This will also increase the overall confidence for the audit opinion. 3.
Allow the auditor to test the actual accounting system and records rather than printouts which are only a copy of those records and could be incorrect.
4. Are cost effective after they have been setup as long as the company does not change its systems. 5. Allow the results from using CAATs to be compared with ‘traditional’ testing if– the two sources of evidence agree then this will increase overall audit confidence
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Fraud Fraud: ISA 240 (Redrafted) defines fraud as: ‘An intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage.’
Error: is an unintentional misstatement in financial statements, including the omission of an amount or a
disclosure.
Two types of intentional misstatements are relevant to the auditor – misstatements resulting from fraudulent
financial reporting and misstatements resulting from misappropriation of assets. Fraudulent financial reporting
Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. Fraud can be committed by management overriding controls using such techniques as intentionally:
Recording fictitious journal entries, particularly close to the end of an accounting period, to manipulate operating results or achieve other objectives.
Inappropriately adjusting assumptions and changing judgments used to estimate account balances.
Omitting, advancing or delaying recognition in the financial statements of events and transactions that have occurred during the reporting period.
Omitting, obscuring or misstating disclosures required by the applicable financial reporting framework, or disclosures that are necessary to achieve fair presentation.
Concealing facts that could affect the amounts recorded in the financial statements.
Engaging in complex transactions that are structured to misrepresent the financial position or financial performance of the entity
Altering records and terms related to significant and unusual transactions
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Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by employees in
relatively small and immaterial amounts. However, it can also involve management who are usually more able to disguise or conceal misappropriations in ways that are difficult to detect. Misappropriation of assets can be accomplished in a variety of ways including: •
Embezzling receipts (for example, misappropriating collections on accounts receivable or diverting receipts in respect of written-off accounts to personal bank accounts).
•
Stealing physical assets or intellectual property (for example, stealing inventory for personal use or for sale, stealing scrap for resale, colluding with a competitor by disclosing technological data in return for payment).
•
Causing an entity to pay for goods and services not received (for example, payments to fictitious vendors, kickbacks paid by vendors to the entity’s purchasing agents in return for inflating prices, payments to fictitious employees).
•
Using an entity’s assets for personal use (for example, using the entity’s assets as collateral for a personal loan or a loan to a related party).
Misappropriation of assets is often accompanied by false or misleading records or documents in order to conceal the fact that the assets are missing or have been pledged without proper authorization. External auditor-responsibilities regarding fraud
The main focus of audit work is to ensure that the financial statements show a true and fair view. The detection of fraud is therefore not the main focus of the external auditor’s work.
Learn!
1. In accordance with ISA 240The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements, external auditors are responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. 2.In order to fulfil this responsibility, they are required to identify and assess the risks of material misstatement of the financial statements due to fraud. 3.They need to obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement due to fraud, through designing and implementing appropriate responses. In addition, auditors must respond appropriately to fraud or suspected fraud identified during the audit. 4.When obtaining reasonable assurance, auditors are responsible for maintaining professional scepticism throughout the audit, considering the potential for management override of controls and recognising the fact that audit procedures which are effective in detecting error may not be effective in detecting fraud.
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5. To ensure that the whole engagement team is aware of the risks and responsibilities for fraud and error, ISAs require that a discussion is held within the team, placing particular emphasis on how and where the entity’s financial statements may be susceptible to material misstatement due to faud, including how fraud might occur 6.In situations where the external auditor does detect fraud, then the auditor will need to consider the implications for the entire audit. In other words, the external auditor has a responsibility to extend testing into other areas because the risk of providing an incorrect audit opinion will have increased.
Groups to report fraud to
1. Report to audit committee: Disclose the situation to the audit committee as they are charged with maintaining a high standard of governance in the company. The committee should be able to discuss the situation with the directors and recommend that they take appropriate action 2. Report to members: If the financial statements do not show a true and fair view then the auditor needs to report this fact to the members through their audit report. 3. Report to professional body: If the auditor is uncertain as to the correct course of action, advice may be obtained from the auditor’s professional body.
Internal auditor’s responsibilities regarding fraud
Commenting on the process used by management to identify and classify the specific fraud and error risks to which the entity is subject (and in some cases helping management develop and implement that process) commenting on the appropriateness and effectiveness of actions taken by management to manage the risks identified (and in some cases helping management develop appropriate actions by making recommendations) periodically auditing or reviewing systems or operations to determine whether the risks of fraud and error are being effectively managed monitoring the incidence of fraud and error, investigating serious cases and making recommendations for appropriate management responses.
In practice, the work of internal audit often focuses on the adequacy and effectiveness of internal control procedures for the prevention, detection and reporting of fraud and error. It should be recognised, however, that many significant frauds bypass normal internal control systems and that, in the case of management fraud in particular, much higher level controls (those relating to the high level governance of the entity) need to be reviewed by internal audit in order to establish the nature of the risks and to manage them effectively.
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Laws and Regulations An important part of an external audit is the consideration by the auditor as to whether the client has complied with laws and regulations.
Key points Management’s responsibility: Management have a responsibility to ensure that the operations of The client are
conducted accordance with the provisions of laws in and regulations. This includes compliance withand lawscharges. and regulationsin that determine amounts and disclosures financial statements, including tax liabilities Auditor’s responsibility: Auditors are not responsible for preventing non-compliance with laws and regulations, and cannot be expected to detect non-compliance with all laws and regulations. They have a responsibility to obtain reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error.
Auditor’s responsibility differs in relation to the two different categories of laws and regulations identified below: 1. Laws and regulations which have a DIRECT effect on the determination of material amounts and disclosures in financial statements. Here the auditor is responsible for obtaining sufficient appropriate audit evidence regarding compliance. 2.
Laws and regulations which DO NOT HAVE A DIRECT EFFECT on the determination of material amounts and disclosures in financial statements, but may the entity’s tonon-compliance continue to trade. Here the auditor’s responsibility is limited to specified auditimpact procedures to helpability identify with those laws and regulations that may have a material effect on the financial statements. This includes inquiring with management whether the entity is in compliance with such laws and regulations, and inspecting correspondence with relevant licensing or regulatory authorities.
The auditor also has a responsibility to remain alert, by maintaining professional scepticism, to the possibility that other audit procedures may bring instances of identified or suspected non-compliance with laws and regulations. DIRECT AND INDIRECT LAWS AND REGULATIONS- IMPORTANT EXAPLANATION TO GO THROUGH There are many laws and regulations that a reporting entity may have to comply with in order to continue in business. For example, many entities (particularly in the UK) will have to comply with strict health and safety legislation; a food manufacturer may have strict food hygiene legislation to comply with, and an accountancy firm will have a code of ethics to follow from its professional body.
Such laws and regulations will have both a direct effect on the financial statements and an indirect effect.
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Laws and regulations that have a direct effect on the financial statements
Laws and regulations that have an indirect effect on the financial statements
Gather sufficient and appropriate audit evidence that the entity has complied with such laws and regulations. For example, when auditing the payroll the auditor will be concerned with gathering sufficient and appropriate audit evidence to ensure that tax legislation has been correctly applied by the entity because if it has not (there is risk that the entity could be fined for non-compliance and the fines could be material, either in isolation or when aggregated with other misstatements. In addition, amounts within the financial statements may also be misstated as a result of the non-compliance with laws and regulations.
The auditor will undertake procedures with the objective of identifying non-compliance with such laws and regulations. ISA 250 gives examples of: compliance with the terms of an operating license
compliance with regulatory solvency requirements, or
compliance with environmental regulations.
When designing procedures to help to identify non-compliance with laws and regulations, the auditor should obtain a general understanding of: the applicable legal and regulatory framework, and
how the entity complies with that framework.
the auditor must maintain a degree of professional scepticism and remain alert to the possibility that other audit procedures applied may bring instances of non-compliance or suspected non-compliance with laws and regulations to the auditor’s attention, and such procedures could include:
reading minutes of board meetings
enquiring of management and/or legal advisers concerning litigation or claims brought against the entity, and
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undertaking substantive tests on classes of transactions, account balances or disclosures.
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REPORTING IDENTIFIED OR SUSPECTED NON-COMPLIANCE WITH LAWS AND REGULATIONS
Where the auditor discovers non-compliance with laws and regulations, the auditor must notify those charged with governance. However, care must be taken by the auditor because if the auditor suspects that those charged with governance are involved, the auditor must then communicate with the next highest level of authority, which may include the audit committee. If a higher level of authority does not exist, the auditor will then consider the need to obtain legal advice. The auditor must also consider whether the non-compliance has a material effect on the financial statements and, in turn, the impact the non-compliance will have on their report. There may be occasions when the auditor’s duty of confidentiality may be overridden by law or statute. This can be the case when the auditor discovers non-compliance with legislation such as drug trafficking or money laundering.
Attempt questions to check your understanding: June 2015-Q5a =
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Audit Documentation Audit documentation’ means the record of audit procedures performed, relevant audit evidence obtained and the conclusions the auditor reached. Professional judgment is subjective. It needs to be supported by the facts and circumstances of the engagement or by sufficient appropriate audit evidence. Therefore, these matters need to be appropriately documented.
Need/ importance of documentation
1. Provides evidence of the auditor’s basis for a conclusion about the achievement of the overall objective of the audit. 2. Provides evidence that the audit was planned and performed in accordance with ISAs and applicable legal and regulatory requirements. 3. Assists the engagement team to plan and perform the audit. 4. Assists members of the engagement team responsible for supervision to direct, supervise and review the audit work. 5. Enables the engagement team to be accountable for its work. 6. Retains a record of matters of continuing significance to future audits. Contents of a working paper
1. Name of client – identifies the client being audited. 2. Year-end date – identifies the year end to which the audit working papers relate. 3. Subject – identifies the area of the financial statements that is being audited, the topic area of the working paper, such as receivables circularisation. 4. Working paper reference– provides a clear reference to identify the number of the working paper, for example, R12 being the 12th working paper in the audit of receivables. 5. Preparer – identifies the name of the audit team member who prepared the working paper, so any queries can be directed to the relevant person. 6. Date prepared – the date that the audit work was performed by the team member; this helps to identify what was known at the time and what issues may have occurred subsequently. 7. Reviewer – the name of the audit team member who reviewed the working paper; this provides evidence that the audit work was reviewed by an appropriate member of the team. 8. Date of review – the date the audit work was reviewed by the senior member of the team; this should be prior to the date that the audit report was signed. 9. Objective of work/test – the aim of the work being performed, could be the related financial statement assertion; this provides the context for why the audit procedure is being performed.
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10. Details of work performed – the audit tests performed along with sufficient detail of items selected for testing. 11. Results of work performed – whether any exceptions arose in the audit work and if any further work is required. 12. Conclusion – the overall conclusion on the audit work performed, whether the area is true and fair.
Audit documentation may be recorded on paper or on electronic or other media. The working papers should be so prepared so as to enable an experienced auditor, with no previous connection to the audit, to understand: -The nature, timing and extent of the audit procedures performed to comply with the International Standard on Auditing (ISA). -The results of the audit procedures and audit evidence obtained. -Significant matters resulting during the audit and the conclusions expressed thereon. Types of audit files
The files in which all the working papers are put are termed audit files. Permanent file papers The permanent file contains matters of continuing importance affecting the company or the audit. This generally has future or long term use.
Information concerning legal structure of entity (e.g., Memorandum and Articles of Association). Other documents of continuing importance: o terms of engagement; o minutes of important meetings; o debenture deeds; o title deeds and lease agreements; o royalty agreements. Descriptions of nature and history of client's business, locations and products. A list of client's investments (if any). Organisation charts, with extra details for finance department. Main accounting records, showing where kept and of what type (e.g., handwritten, computerised). Copies of previous financial statements and auditor's reports thereon. Previous reports to management (detailing weaknesses found in the accounting system. Client's other professional advisers. Client's insurance cover details. Significant ratios and trends. Accounting systems descriptions in flow chart and narrative form (see later). Internal controls evaluation data: questionnaires and checklists (see later). Principal accounting policies.
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2. Current audit file papers
The current file which is broadly concerned with the accounts being audited. This generally serves an immediate purpose. It generally contains the following papers: Examples of the working papers ordinarily contained in a typical current audit file include: -
Evidence of the planning process including audit programmes and any changes thereto. Evidence of the auditor’s consideration of the work of internal auditing and conclusions reached. Analyses of transactions and balances.
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Analyses of significant ratios and trends. The identified and assessed risks of material misstatements at the financial statement and assertion level. A record of the nature, timing and extent of audit procedures performed in response to risks at the assertion level and the results of such procedures. Evidence that the work performed by assistants was supervised and reviewed An indication as to who performed the audit procedures and when they were performed. Details of audit procedures applied regarding components whose financial statements are audited by another auditor. Copies of communications with other auditors, experts and other third parties. Copies of letters or notes concerning audit matters communicated to or discussed with management or those charged with governance, including the terms of the engagement and material weaknesses in internal control. Letters of representation received from the entity. Conclusions reached by the auditor concerning significant aspects of the audit, including how exceptions and unusual matters, if any, disclosed by the auditor’s procedures were resolved or treated.
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Copies of the financial statements and auditor’s report.
Controls required to ensure the safe custody of audit documentation
1. Maintain a log 2. Prevent unauthorised changes to the documentation 3. Protection from theft: passwords, access restrictions 4. Retention of working papers: minimum 5 years
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Quality control for an audit of financial statements 1
Leadership
Engagement Partner
responsibility for quality
2
Ethical requirements
Engagement Partner to ensure independence not compromised throughout the audit
3
Acceptance/
Matters to consider before accepting new clients/continuing with previous clients
continuance of client
4
HR policies
Engagement Partner should have skills, authority, time required for audit. He should also ensure the team has relevant skills
5
Engagement performance
a) Direction - Set by Engagement Partner - Set in the planning meeting - Responsibilities assigned to team - Objective of work to be done communicated - Risks
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Team told how to deal with problems as they arise
b) Supervision
Main responsibility: Engagement Partner The audit supervisor should keep track of the progress of the audit engagement to ensure that the audit timetable is met and should ensure that the audit manager and partner are kept updated of progress -
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Should be continuous Ensure work according to planned approach (The competence and capabilities of individual members of the engagement team should be considered, including whether they have sufficient time to carry out their work, whether they understand their instructions and whether the work is being carried out in accordance with the planned approach to the audit.) Ensure important matters told to seniors Ensure audit approach modified if needed ( based on any significant matters that may arise during the audit) See if consultation is needed.
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c) Consultation (use of experts) where needed - From outside the team or outside the firm d) Review - Hierarchical review (consider whether work has been performed in accordance with professional standards and other regulatory requirements and if the work performed supports the conclusions reached and has been properly documented.) - Check if objective of work has been achieved - Ensure conclusions are supported by sufficient appropriate evidence
e) Engagement Quality Control Review (if needed) - Reviewer will review significant judgments - Reviewer will evaluate conclusions reached in making the audit report - Reviewer will ensure consultations have been taken where needed - The review of the proposed auditor’s report includes consideration of the proposed wording to be included in the Key Audit Matters section(to be studied later)
f)
6
Monitoring
Documentation - Maintain and retain all documentation ( working papers) - Ensure confidentiality
-The firm should ensure quality control procedures are adequate and complied with.
Attempt questions to check your understanding: Sept. 2016- Q18c
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Corporate governance Corporate governance is the system by which companies are directed and controlled. According to the UK Corporate Governance Code the ‘purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company’. Corporate governance considers the responsibilities of directors, how the board of directors should be run and structured, the need for good internal controls and the relationship with external auditors. It is important for companies to consider good corporate governance principles as often it is management or those charged with governance who run the company, but the owners are the shareholders and they are not involved in the running of the business. For these shareholders their only opportunity to raise concerns is at the annual general meeting, which only occurs once a year and often attendance is low. Shareholders need to ensure that their needs are taken into account by management, and that there is a process in place for them to be informed as to how the business is operating. Corporate governance represents the set of policies and procedures that determine how an organisation is directed, administered and controlled. Although the contents of corporate governance will vary from organisation to organisation, almost all will have the following components: Accountability, compliance, transparency and integrity
TCWG: Those “charged with governance” are defined as the persons who are“accountable for ensuring that the entity achieves its objectives, with regard to reliability of financial reporting, effectiveness and efficiency of operations, compliance with applicable laws, and reporting to interested part ies.” Although there is no universal rule, in most instances these persons will either be the board of directors and/or the audit committee
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An Exam focused summary Can be principles based or rules based
1. Board of Directors
The ENTIRE board responsible for F/S, fraud prevention and detection, ICS, ethics, compliance etc.
Executive Directors: Remuneration package ( Basic Salary, Benefits in kind, Performance linked
elements in short term as well as long term, Retirement benefits)
Non-Executive Directors ( should be independent: No familiarity with the executive
management, no financial interest in company except a fixed fee for directors’ duties, not business relationship, not been an employee in the recent past, can serve for maximum 9 years)
Appoint NEDs to protect SH interest. They also bring external expertise.
2. CEO and Chairman roles should be segregated ( Chairman should be an NED)
3. Balance in the board: equal number of EDs and NEDs excluding the independent Chairman
4. Variety of skills, cultural and gender diversity in the board
5. There should be FOUR sub-committees of the board a) Audit Committee b) Remuneration Committee c) Risk Committee d) Nomination Committee
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6. For ALL directors: -
Induction
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CPD
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Annual performance appraisal
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Re-election ever 3 years ( retirement by rotation)
7. Regular board meetings ( with agenda and minutes). No single individual should dominate discussions.
8. The company should have a sound system of internal control.
9. There should be adequate risk management in the company.
10. There should be an internal audit department
11. Transparency in the annual report is important.
12. Institutional shareholders should intervene in the company when needed.
Provisions of international codes of corporate governance (such as OECD) that are most relevant to auditors.
The Principles cover six key areas of corporate governance: 1. Ensuring the basis for an effective corporate governance framework(should promote transparent and efficient markets, be consistent with the rule of law and have a clear division of responsibilities among different supervisory, regulatory and enforcement authorities) 2. The rights of shareholders and key ownership functions 3. The equitable treatment of shareholders 4. 5. 6.
The role ofand stakeholders in corporate governance Disclosure transparency The responsibilities of the board
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Important terms in corporate governance An executive director: an executive director is a director responsible for the administration of a company. They are primarily responsible for carrying out the strategic plans and policies as established by the board of directors. A non-executive director (NED): a non-executive director is a director without day-to-day operational responsibilities of the company.
Responsibilities of the board of directors in corporate governance establish a code of corporate ethics ensure that that the organisation establishes policies, procedures and controls to manage the potential risks it will face ensure compliance with laws and regulations ensuring that an effective system of internal controls is in place and functioning ensuring that a high quality and timely independent audit is conducted establish and oversee the work of audit and remuneration committee
The board of directors
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The board should meet regularly.
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The roles of chairman and CEO should not be performed by the same individual. The roles of chairman (NED) and chief executive(ED) are both very important and carry significant responsibilities; hence this prevents too much power residing in the hands of one individual.
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At least half of the board should be comprised of NEDs :There should be an appropriate balance of executives and non-executives (excluding the chairman), to ensure that the board makes the correct objective decisions, which are in the best interest of the stakeholders of the company, and no individual or group of individuals dominates the board’s decision-making
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Non-executives need to be independent of the executive management so that they can exercise judgment without bias or self interest
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All directors should receive induction training when they first join the board so that they are fully aware of their responsibilities.
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The shareholders should review on a regular basis that the composition of the board of directors is appropriate, and they do this by re-electing directors every three years ( retirement by rotation).
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The directors need to consider, on an annual basis, whether the company requires an internal audit department. Internal audit helps the director in monitoring the company.
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Director’s remuneration
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The performance of each board member should be appraised on an annual basis.
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There should be an on-going process of board development through continuous professional development (CPD) of all board members.
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Board sub-committees with appropriate composition should be made ( Audit and Remuneration committee should only have NEDs whereas Risk and Nomination should have a majority of NEDs)
No director should be involved in setting their own remuneration as this may result in excessive levels of pay being set. Levels of remuneration should be sufficient to attract and retain the directors needed to run the company successfully, but companies should avoid paying more than is necessary for this purpose. A proportion of executive directors’ remunerati on should be structured so as to link rewards to corporate and individual performance . Non-executive directors’ pay should not be based on meeting company targets as their pay should be independent of how the company performs.
Accountability and audit
The board should present a balanced and understandable assessment of the company’s position and prospects.
Internal control
The board should maintain a safe and registered system of internal control to safeguard the shareholders’ investment and the company’s assets.
Audit committee and auditors
i. The board should establish an audit committee of at least three directors, all nonexecutive, with written terms of reference which deal clearly with its authority and duties. ii. The audit committee should monitor and review the internal audit and the reports prepared by the internal audit team. iii. With regard to the external auditors, the audit committee should -Recommend their appointment. -Approve their remuneration and terms of engagement. -Monitor and review their independence, objectivity and effectiveness.
Relations with shareholders
All members of the board should be involved in ensuring that satisfactory dialogue occurs with shareholders (for example all should attend meetings with shareholders). Dialogue with i nstitutional shareholders: Companies should be ready, where practicable, to enter into a dialogue with institutional shareholders based on mutual understanding of objectives. Constructive use of the AGM: Boards should use the AGM to communicate with private investors and encourage their participation.
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Shareholder voting: Institutional shareholders have a responsibility to make careful use of their votes. Code provisions i. Institutional shareholders should, on request, make available to their clients the information on the proportion of resolutions on which votes were cast and nondiscretionary proxies lodged. ii. Institutional shareholders should take steps to ensure that their voting intentions are being translated into practice.
Institutional investors
Dialogue with companies: Institutional shareholders should be ready, where practicable, to enter into a dialogue with companies based on the mutual understanding of objectives.
Evaluation of governance disclosures:When evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional investors should give due weight to all relevant factors drawn to their attention.
Roles of the Audit Committee Composition: entirely NEDs-at least one of them should have recent and relevant financial experience. 1. With regards to Financial statements, the Audit committee: o o o
reviews integrity of financial statements (including reviewing significant judgments) checks the clarity and completeness of the disclosures in the financial statements. monitors formal announcement regarding financial performance
2. With regards to Internal audit, it o monitors effectiveness of IA, review their plan and ensure their recommendations are actioned o ensures IA is accountable to AC and preserve their independence + Chief Internal auditor has access to Chairman o approves appointment/termination of Chief Internal Auditor
3. With regards to External auditors, it o Is responsible for oversight of the company’s relationswith its external auditors. o Recommends appointment, re-appointment and removal of external auditor o o o o
Recommends remuneration and terms of engagement of EA Reviews and monitors independence of EA Develops and implements policy on EA providing non-audit services Reviews qualification and expertise of the EA
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4. It reviews control systems (internal controls, internal financial controls, risk management) 5. It monitors compliance with laws and regulations 6. The audit committee should also review the procedures in place for whistle-blowing within the company. Advantages of audit c ommittee
1. Improves Public confidence in the credibility and objectivity of the financial statements. (They can create a climate of discipline and control and reduce the opportunity for fraud) 2. It will help to improve the quality of the financial reportingguidance to BOD 3. An audit committee can help to improve the internal control environment of the company. The audit committee is able to devote more time and attention to areas such as internal controls. 4. Helps in risk management: The audit committee can also provide advice on risk management to the executive directors. 5. The audit committee will be responsible for appointing the external auditors and this will strengthen the auditors’ independence and contribute to a channel of communication and forum of issues. 6. The NEDs bring considerable external experience to the board as well as challenging the decisions of executive directors and contributing to independent judgements. 7. Senior management in the accounting and finance function can raise concerns and discuss accounting issues with the audit committee. 8. The independence of the internal audit department is improved The audit committee will assume responsibility for appointing and liaising with the external audit firm, thus ensuring the independence of the external auditor especially in cases of dispute with management.
Limitations of audit committee 1. Although audit committees do oversee the work of auditors (both internal and external) they do not have the authority to appoint or dismiss them. This limits the amount of power the committee has over the organisation’s auditors. 2. Audit committees generally do not have as much technical expertise and knowledge as the auditors they are overseeing. 3. Independent directors oftendo not have as thorough a knowledge of the organisation’s operations and functioning as executive directors. 4. Most of the members of the audit committee are non-executive directors. The board may feel that the audit committee has been formed to limit its powers and allow outsiders to run the company. 5. The non-executive directors have to be paid more for carrying out the responsibilities associated with the audit committee. Hence, it increases the cost of the organisation.
Attempt questions to check your understanding: March/June Hybrid 2016-Q1 Dec 2014-Q3
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Internal audit An independent appraisal activity established within an organization as a service to it. A control in itself which functions by examining and evaluating the adequacy and effectiveness of other controls ( Internal Audit is NOT a regulatory requirement BUT is a corporate governance best practice guideline) There is NO requirement for internal auditor to be professionally qualified.
INDEPENDENCE Internal auditors should: • monitor and review controls, not design and implement them; • report to the audit committee • be free to decide on the nature and scope of their work; • be free to communicate fully with the external auditors. Steps to conduct internal audit
1. Identify the risks in which 2. Identify controls placemay occur if there are no controls in place 3. Evaluate whether the controls in place reduce the risk to an acceptable level, i.e. they are adequate.
4. Evaluate whether the controls are working effectively. 5. Report
Functions of Internal Audit
1. Reviewing adequacy and effectiveness of financial and operational internal control systems 2. Helping management with risk assessment 3. Examining operating and financial information (is it reliable, adequate, timely? How is it identified and communicated?) 4. Review of compliance with laws, regulations and other external requirements and with management policies and directives and other internal requirements.
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5. Special assignments- some examples - Value for Money audit (VFM) - Mystery shopping - Financial audit - Financial statement audit - IT system audit - HR audit - Undertake inventory counts
6. Internal audit’s role in preventing and detecting fraud and error -
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Can help by assessing the main areas of fraud risk Can help by assessing the adequacy and effectiveness of control systems. Can undertake regular reviews of compliance of these controls. Where fraud is suspected, the internal audit department can undertake a detailed fraud investigation to identify who is involved, likely sums stolen and gather evidence for any subsequent police investigation. The presence of an internal audit department can itself act as a fraud deterrent, as the risk of being discovered means individuals are less likely to undertake fraudulent activities.
Factors determining need of internal audit
Before establishing an internal audit department, consider the following:
Will it be cost-beneficial?
Consider the size and complexity of operations as well as number of employees- is more monitoring needed due to increased chances of fraud and error?
Have key risks and processes changed? Internal audit can help in risk assessment and in reviewing controls.
Problems with existing controls- is there a history of control deficiencies?
Need of special assignments that normally internal audit carries out. The ability of current management to carry out these assignments will need to be considered. If they do not have the ability, an IA department may be needed.
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What does corporate governance say about Internal Audit?
IA should report to the Audit Committee. The AC will monitor if internal audit is effective. If there is no IA department, the AC should determine whether there is need for one. In case they believe the internal audit department is not required, it needs to explain the reason for this in the annual report.
Assistance to the board of directors: The IA department checks reports that are not audited by the external auditors. It can help the board with regards to accounting and auditing standards when required. IA can liaison with external auditors which can reduce the time and cost of external audit.
Differences between external and internal audit Internal Audit
External Audit
Appointment process
Determined by management; appointed by management.
Determined by statute; appointed by members. Formal auditing qualifications are required.
Objective
The main objective of internal audit is to improve a company’s operations, primarily in terms of validating the efficiency and effectiveness of the internal control systems of a company.
The main objective of the external auditor is to express an opinion on the truth and fairness of the financial statements, and other jurisdiction specific
Report to
Internal audit reports are normally addressed to the board of directors, or other people charged with governance such as the audit committee. Those reports are not publicly available, being confidential between the internal auditor and the recipient.
Scope
requirements. External audit reports are provided to the shareholders of a company. The report is attached to the annual financial statements of the company and is therefore publicly available to the shareholders and any reader of the financial statements. The work of the internal auditor normally relates The work of the external auditor to the operations of the organisation, including relates only to the financial the transaction processing systems and the statements of the organisation. systems to produce the annual financial statements. The internal auditor may also However, the internal control provide other reports to management, such as systems of the organisation will be value for money audits which external auditors tested as these provide evidence on rarely become involved with.
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the completeness and accuracy of the financial statements.
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Relationship with the organization
Planning and evidence collection
In most organisations, the internal auditor is an employee of the organisation, which may have an impact on the auditor’s independence. However, in some organisations the internal audit function is outsourced. No materiality
The external auditor is appointed by the shareholders of an organisation, providing some degree of independence from the company and management Materiality
Procedural or risk based
Risk based
Primarily internal sources of evidence
Internal and external sources of evidence
IA and risk management
IA ensures risk management systems are operating effectively and that the strategies implemented for business risks are operating effectively. Business risk (risk that the company’s objectives are not met or strategy not executed properly or inappropriate objectives and strategies were set).
Limitations of IA
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independence issues as employees so may be concerned about job security if it is not reporting to the AC, management can influence them (they will be checking the work of the people they are reporting to).
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Outsourcing Internal Audit
Advantages
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Greater expertise, specialist skills and access to better audit technology without extra cost available Cost: - The risk of staff turnover is passed on to the firm - Lesser cost of training staff and retaining permanent staff - Can budget better. May be more independent Lesser management consumed in administering the department IA will be immediatelytime available (also good for short term) The contract can be set for an appropriate time scale Flexibility in terms of that the staff can be called in according to workload
Disadvantages 1. 2. 3. 4. 5. 6.
May not be independent if the same firm is offering external audit and internal audit May be more expensive The firm will not have in-depth knowledge of the company Lesser control by the management over the standard of service May have confidentiality issues If the company has an existing IA department: - they may face opposition from the other staff - In-house skills will be lost - Redundancy costs if these staff members cannot be re-allocated other roles
Internal Audit assignments- examples to read through
1. VFM audit : A value for money audit focuses on whether the best combination of services has been obtained for the lowest level of resources. In performing a value for money audit there are three areas which an auditor will commonly focus on being economy, efficiency and effectiveness, and these are known as the three Es. Economy – Keeping the cost of resources used to a minimum. Efficiency – The relationship between the output from goods and services and the resources used to produce them. Effectiveness – How well the organisation’s objectives have been achieved. 2. IT audit
An informationThis technology auditif isthe aninformation examinationsystems of the controls within an information technology infrastructure. determines are: safeguarding assets, maintaining data integrity and operating effectively and efficiently to achieve the organisation’s goals or objectives. -
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3. Best value audit A best value review involves the following: Reviewing whether the products / services meet the requirements of the customers Determining whether there is balance between the cost and quality of the service or not Comparing product / service with competitors to find out the best and the worst features in the products of the entity so as to make improvements. -
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4. Financial audit
The scope of internal audit for financial functions may involve internal control topics such as the efficiency of operations, the reliability of financial reporting, deterring and investigating fraud, identifying errors, safeguarding assets and compliance with laws and regulations.
5. Operational audit (procurement, marketing, HR) 6. Mystery shopper reviews 7. Regulatory compliance review
INDEPENDENCE Internal auditors should: • monitor and review controls, not design and implement them; • report to the audit committee if possible, not the finance director; • be free to decide on the nature and scope of their work; • be free to communicate fully with ht e external auditors.
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EXTERNAL AUDIT RELIANCE ON INTERNAL AUDITWORK Reliance on internal audit
ISA 610 Using the Work of Internal Auditors details the factors the external auditors should consider in order to place reliance on the work of the internal audit (IA) department as follows: 1. Objectivity: They should consider the status of IA within the company and if they are independent of other departments, in particular thefinance department. In addition, consideration should be given as to who IA reports to, whether this is directly to thosecharged with governance or to a finance director. 2. Technical competence: The technical competence of IA staff should be considered. Consideration should be given to whether they are members of aprofessional body and have relevant qualifications and experience. 3. Due professional care: The external auditors should consider if the IA department have exercised due professional care, the work would need to have been properly planned including detailed work programmes, supervised, documented and reviewed. 4. Communication: In order to place reliance there needs to be effective communication between the internal auditors and the external auditor. This is most likely to occur when the IA department is free to communicate openly and regular meetings are held throughoutthe year.
Areas where external auditor can rely on/use internal auditor’s work: -
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External Auditors could look to rely on any internal control documentation produced by internal audit for changes in the control environment. If the IA department has performedtest of controls during the year, such as the payroll, sales and purchase systems, then external auditors could review and possibly place reliance on this work. This may result in the workload reducing and possibly a decrease in the external audit fee. IA department may have conducted arisk assessment which external auditors could use as part of their initial planning process. External auditors would need to consider therisk of fraud and error and non-compliance with law and regulations resulting in misstatements in the financial statements. This is also an area for IA to consider, hence there is scope for the external auditor to review the work and testing performed by IA to assist in this risk assessment. It is possible that the IA department mayassist with year-end inventory counting and controls and so external auditors can place some reliance on the work performed by them, however, they would still need to attend the count and perform their own reduced testing.
Attempt questions to check your understanding: June 2014-Q4 June 2013-Q4b,c,d June 2013-Q5a,b
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Not for profit organizations Examples: charities , housing associations, clubs. local authorities/councils, government bodies. Charities Unlike publicly traded companies, charities are not required by the Securities and Exchange Commission to undergo annual audits. Many not-for-profit organizations, however, are required to receive an audit if they accept certain types of funding or earn a large amount of revenue. A positive audit opinion can increase donor and board member confidence in the non-profit's operations. An audit may also be required by the regulators ( the charity commission for example). The auditor should clarify who the addresses of the report will be along with the scope of the engagement.
Important features to remember:
There are no external shareholders therefore no dividends Income likely to be from donations/grants. Likely additional reporting/accounting rules. Their activities may be restricted by regulators They are NOT forbidden from engaging in commercial activities 3Es very important for them. Normally managed by a council made up entirely of volunteers ( like NEDs)
Risks
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Inherent risk can be high in not-for-profit organizations that must report certain results to continue receiving grants.
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Non-profits that pay low wages may have trouble attracting qualified accountants Higher level of cash transactions. Income – completeness problem. Lack of predictability regarding future income/expenditure. (analytical procedures aren’t very useful
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here!) Potential restrictions regarding activities/use of income. Restricted number of employees so segregation of duties difficult Auditors should evaluate not only the number of people involved in the accounting process but the level of supervision. If no one is approving junior-level accounting staff entries, mistakes are less
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likely to be caught. Volunteer staff: Risks regarding their competence, training, lack of trust
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Informal environment Trustees (the time they give to the org, skills, qualifications, frequency of meetings, independence from each other)
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Auditors typically test a variety of accounts and transactions. They should pay special attention to revenue accounts when auditing a nonprofit. Nonprofit entities have different sources of revenue than their for-profit counterparts, and all employees may not be familiar with the revenue recognition rules for donations and grants. Auditors should check to see if the nonprofit has adequate supporting documentation and determine the correct timing of revenue recognition for grants that have strings attached Audit evidence
The auditors should give special attention to: - Completeness of income - Misuse of funds/ misappropriation of assets
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An overview External Audit Process-summary Engagement letter
Planning
1.Audit Strategy
a) Understanding the client (the environment, the accounting system, internal control systems, accounting policies etc.)
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b)Risk: The assessment of risk for the client and risk of fraud and error and the identification of significant audit areas. Analytical procedures are also performed.
c)Materiality: Financial statements will normally be useful provided they do not contain ‘material’ errors or misstatements.
The auditor therefore determines preliminary materiality at this stage
d) Scope, timing, direction Scope: characteristics of the audit client, such as its locations, whether the financialwith information be audited has been prepared in accordance IFRS– thetoextent to which audit evidence obtained in previous audits will be utilised, whether computer-assisted audit techniques will be used and the effect of IT on audit procedures etc , as these factors will help to establish the scale of the
Timing: Establishing deadlines for completion of work and key dates for expected communications Direction: The ‘direction’ of the audit covers the overall approach and concerns such issues as reliance on systems(controls) or a fully substantive approach.
2. Audit Plan
(detailed implementation of audit strategy)
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Internal control system over financial reporting
Deficiencies identified and reported
a)Document the ICS b)Test for deficiencies (in thedesign of the system and carry out test of controls to tests if the system is being implemented properly). CAATs(test data) can be used to test automated controls.
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c)Report deficiencies to the management d)Decide extent of substantive testing
Substantive testing-
Verifying the amounts and disclosures inthe financial statements primarily
includes: test of details and
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substantive analytical procedures. (testing assertions made by the management)
Analytical procedures Enquire: Management/TCWG, 3rd parties, Internal Auditor Inspection: documents, records, tangible assets Observation Recalculation/Reperformance
Review
-Going Concern -Subsequent events -Overall review
Opinion
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Modified opinion Unmodified opinion Additional paragraphs: EOPM and OMP
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Essential reading before sitting for the F8 exam
Attempting questions on audit evidence or audit procedure- Mini-case studies might be given in the exam Audit procedures are actions that auditors carry out during the audit. They are also known as ‘audit tests’ or ‘audit work’. Audit evidence is obtained by the auditor as a result of the audit procedure.
For example, ‘performing a circularisation of receivables/debtors’ is an audit procedure, whereas ‘replies from customers’ is audit evidence. Deciding on audit procedure
For each scenario: 1. Think about how the accountant would have: calculated the numbers in the financial statements, the source documents used and the systems followed, and then write about the documents etc, that one would expect to see. 2. Think about how to verify the other relevant facts in each case. 3. Consider the accounting/disclosure requirements of each scenario, and say how one can check if they are being met.
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About the F8 Exam
Section A
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Three 10 mark case-based questions. Each case has five objective test questions worth 2 marks each. Mix of knowledge and application based questions - Up to 10 minutes to read the pre-exam instructions. Section B
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One 30 mark question and Two 20 mark questions. Each question will have a number of requirements. Use word processing tools to construct the answer. A pre-formatted response template might also be given (mainly for audit risks, control deficiencies and IESBA’s ethical threats and safeguards)
Time: 3 hours, 20 minutes
Session CBEs will contain 110 marks of exam content: - 100 marks contributing to the student result, and - 10 marks of seeded questions which do not contribute towards the student's result. Tools available in the CBE
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Calculator- can bring own! Scratch pad Screen splitter- can be moved Highlight: visible for all requirements Strikethrough: dealt with this information Cut and paste within the CR area Re-set: ALL text removed. Be careful! Only if want to start again- warning message will come up. Can use undo function to restore!
Which formatting options should an F8 student use in CRs? - Bold - Underline - Marks for content NOT how you are presenting it. No marks for formatting! - Can insert table yourself if pre-formatted not given
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Audit Framework and Regulation
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Functions of an audit Distinguish between the scope of internal and external audit Corporate governance Professional ethics.
Examiner feedback
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Very brief answers with inadequate level of detail
Planning and Risk Assessment
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Obtaining and accepting audit engagements Obtaining an understanding of the entity and its environment, assesses the risk of material misstatement and plans an audit of the financial statements
Audit risk questions require a number of audit risks to be identified (½ marks each), explained (½ marks each) and an auditor’s response to each risk (1 mark each) Examiner’s feedback
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Knowledge questions not done well. To explain audit risk candidates need to state the area of the accounts impacted with an assertion (e.g. cut off, valuation etc.), or, a reference to under/over/misstated, or, a reference to inherent, control or detection risk. Misstated was only awarded if it was clear that the balance could be either over or understated. Auditor’s responses still continue to be weak and while an auditor’s response does not have to be a detailed audit procedure, rather an approach the audit team will take to address the identified risk. The responses given were sometimes too vague e.g. “discuss with the finance director” or they were impractical such as “recruit more audit staff” for the risk of the auditor not attendi ng all the company’s inventory counts. Additionally, candidates continue to concentrate their responses on what management should do rather than the auditor.
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Internal control
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Describe and evaluate internal controls techniques and audit tests, and, also an ability to make appropriate recommendations. Questions typically require internal control deficiencies to be identified (½ marks each), explained (½ marks each), a relevant recommendation to address the control (1 mark), and, often a test of control the external auditor would perform to assess whether each of these controls, if implemented, is operating correctly (1 mark).
These applied internal controls may be required to be presented in the form of a report to management, in which case a covering letter (2 marks) is required.
Examiner’s feedback
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Unclear explanation of the implication of the deficiency. Recommendations poorly described or do not clearly address the specific control weakness identified or were impractical suggestions. TOCs not well explained/ vague/ using the word ‘observe’ repeatedly.
Audit Evidence
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A description of the work and evidence obtained by the auditor required to meet the objectives of audit engagements and the application of International Standards on Auditing. Describe relevant audit procedures for a particular class of transactions or event
Examiner’s comments
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Students unable to tailor their knowledge of general substantive procedures to the specific issues in the question r equirements Often the requirement is to describe substantive procedures to address specific financial statement assertions, such as completeness, any tests provided which do not test this assertion would not score any marks Learning a generic list of tests will not translate to exam success – procedures must be tailored to t he specific requirements of the question.
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Review and Reporting
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An understanding of how consideration of subsequent events and the going concern principle can inform the conclusions from audit work and are reflected in different types of auditor’s report, written representations and the final review and report.
Examiner’s comments
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Candidates are often required to discuss the accounting issue, assess whether the error is material, consider the type of modification, if any, and lastly to discuss the impact on the auditor’s report.
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Candidates often omit the discussion of the issue and incorrectly assess the materiality of the issue. Weaker candidates continue to provide every possible report option available and include random words, such as modification, into their answer in a context which makes no sense.
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