Sources of knowledge

 

Following are important sources which provide background knowledg

External client:

Directors/senior personal

Internal audit financial

Visit to premises

Minutes of meetings

Documents sent to shareholders and authorities

Financial budgets

Management reports

Charts of accounts

Job organization ad descriptions

Auditor:

Predecessor auditors

Legal advisor

Industry regulations

Chamber of commerce

Govt. data

Customers

Bankers

Suppliers

Competitors

Trade journals

Financial press

 

 

Use of knowledge

To develop overall plan and audit programme

To assess component of risk

To determine materiality levels

To evaluate audit evidence

To identify related parties and transactions

To recognize conflicting and unusual circumstances

To appraise appropriateness and effectiveness to accounting policies

To provide better service to client

 

Nature of information

General economic factors

Recession / growth

Interest rates

Inflation

Fiscal policy

Monitory policies

Foreign currency

Devaluation / evaluation

The industry

Market

Technology

Key ratios

Specific accounting ratios

Environmental requirements

 

 

 

General economic factors

 

      Recession / growth

      Interest rates

      Inflation

      Fiscal policy

      Monitory policies

      Foreign currency

      Devaluation / evaluation

 

Management and ownership

 

        Corporate structure

        Owners and related parties

        Capital structure

        Organization structure

        Strategic plan

        Operating management

        Audit committee

 

Business

 

        Nature of business

        Locations

        Products / services / markets

        Suppliers

        Investors

        Information systems

Debt structure

Financial performance

 

        Key ratios

        Trends

        Accounting policies

        Leasing commitments

        Off balance sheet finance

 

Reporting environment

 

        Legislation

        Taxation

        Securities

Users of financial statements

 

DOCUMENTATION

 

Definition

The material (working papers) prepared by and for (or obtained and retained by) the auditor relating to the conduct of the audit.

 

      In the form of data stored on paper, film, electronic or other media matters, which are important in providing evidence, must be documented.

      To support the audit opinion

 

      To demonstrate that the audit was performed in accordance with ISAs.

 

 

Working Papers

      assist in the planning and performance of the audit (e.g. in providing information)

      facilitate the supervision and review of audit work (e.g. in giving instructors to assistants)

      Record the audit evidence generated by the audit procedures that are undertaken to support the auditor’s opinion.

 

 

Matters To Consider

      Nature of the engagement e.g.

• Private or public sector; and

• Other services undertaken (e.g. taxation, systems advice)

      From the auditor’s report (e.g. standardized, “short-form” report in which there is “modified” opinion)

      Nature and complexity of the organization and its accounting and internal control systems (e.g. the extent of computerization)

      Specific audit methodology (e.g. a risk-based approach) and technology (e.g. computer-assisted audit techniques) used in the course of the audit

      Standardization

      Extent of schedules, analyses and other documentation prepared by the entity

      Needs of direction, supervision and review of tasks assigned to assistants.

 

 

STANDARDIZATION

 

 

Used for

 

It is common practice for audit firms to use standard pre-printed documentation on audit engagement. For example:

 

      Audit completion, disclosure and other checklists

      Internal control questionnaires

      Audit programs

      Specimen letters – e.g. management representation letters

 

 

Documentation Techniques

 

Narrative notes  

 

 

Flowcharts 

 

 

Questionnaires

 

 

Checklist

 

 

 

 

 

 

 

              +/-                                      +/-                                     + /-

 

 

 

 

1. Narrative notes – written descriptions require little formal training and are best suited to small, simple systems descriptions or to explain peripheral aspects of larger systems not dealt with by other techniques (e.g. the issue of credit notes)

2. Flowcharts – visual descriptions highlight controls and are easy to understand by a trained use. However, different audit firms and their clients use different types (e.g. documentation flowcharts, information flowcharts and overview flowcharts).

 

1. questionnaires – internal control questionnaires (ICQs) are designed to indicate which parts of a system are strong or weak and so make a preliminary assessment  o the extent to which the auditor seeks to place reliance (if any) on internal controls.

 

 

Factors To Consider

The form and extent of this documentation is influenced by such factors as:

 

      Size and complexity of entity

      Nature of accounting and internal control systems (e.g. manual or electronic)

      Auditors intended reliance on internal controls

      Whether prepared by client (e.g. internal audit department) or external auditor

      Ease of preparation and / or updating

 

 

CONFIDENTIA LITY, SAFE CUSTODY, RETENTATION AND OWNERSHIP

 

 

 

Auditors should maintain the confidentiality and safe custody of working papers.

 

 

Confidentiality And Safe Custody

      Practical procedures include locked fireproof cabinets or rooms and the use of physical keys and logical passwords.

      Electronic documentation may be particularly susceptible to corruption or loss and should be backed up.

 

 

Considerations not in the ISA

      Legal requirements e.g. accounting records must be maintained for 3 years for private companies and 6 years for other companies in the UK.

      General position in law governing the period of time in which actions may be brought in a court of law e.g. 6 years for actions based on contract in the UK.

      Requirements for compiling tax returns e.g. assessments may be made 6 years after the period to which they relate.

      Likelihood of seeking quotation on a recognized stock exchange – previous 6 years are required to be reported on in UK.

 

 

Minimum Period

      Audit working papers – 7 years

 

 

Recommended by ACCA

      Tax files – 7 years and then returned to client (or former client)

 

 

Ownership

      Working papers are the property of the auditor and clients have no rights to demand access

 

 

General Principles

      Portions of or extracts from working papers may be made available to the entity at the discretion of the auditor

      All documents relating to clients are confidential

      A client may require auditor to disclose documents, which belong to the client (only) to a third party.

 

 

 

 

Standardization Of Documents

Advantages

Disadvantages

      Preparation and review is more efficient when audit files and sections and documents within them are presented in systematic manner

 

      A “mechanical” approach may lead to a lack of appreciation of test objectives and the implications of errors and deviations founds

      Helps to familiarize junior staff with standard procedure (e.g. attending physical inventory counting and requesting direct confirmations from customers).

 

      Adopting a “standard approach” may stifle initiative and discourage the exercise of professional judgement

      Similarly, it facilitates

      Standard programs may result in a “bare minimum” attitude.

 

      It provides a means of quality control by requiring a consistent approach to all audits and ensuring that essential procedures not overlooked.

 

      It may be inappropriate to follow set procedures for a particular client (e.g. one with subscription income rather that sales revenue)

 

CONTENTS FO WORKING PAPERS

 

Permanent Audit File

      Information concerning legal structure of entity (e.g. memorandum and articles of association)

      Other documents of continuing importance

 

§               Terms of engagement

§               Minutes of important meetings

§               Debenture deeds

§               Mortgage and charges

§               Title deeds and lease agreements

§               Agreements and labour contracts

§               Profit share and bonus agreements

§               Royal agreements

 

      Descriptions of nature and history of client’s business, locations and products

      A list of client’s investments (if any)

      Organization charts, with extra details for finance department

      Main accounting records, showing where kept and of what type (e.g. handwritten, computerized)

      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 adviser

      Client’s insurance covers details

      Significant ratios and trends

      Accounting systems descriptions in flow chart and narrative from

      Internal controls evaluation data: questionnaires and checklists

      Principals accounting policies.

 

 

Current Audit Files

      Financial statements being audited (evidenced as having been agreed to accounting records and cross-referenced to supporting schedules)

      Overall audit plan (including risk assessments and planning materiality) and audit program

      Schedule for each balance sheet item (including comparatives), cross-referenced to documents arising from external verification (e.g. of existence and valuation). For example, confirmation of accounts receivable and attendance at physical inventory counting).

      Copies of communications with other auditors, experts, and other third parties

      Schedule supporting each significant item in the income statement

      Checklist of compliance with statutory and IAS disclosure provision

      A record of queries raised during the audit and their clearance, with notes for next year

      Schedule of queries not cleared for the manager / partner reviewing the audit

      Extracts of minutes of meetings of directors and shareholders (cross-referenced where relevant)

      Report of management of material weaknesses in internal controls including client response

      Letter of representation received from management

      Job administration data

 

• Partner and staff employed

• Dates audit areas completed time summaries

• Time summaries

• Performance monitored against budget

 

      Working papers of results of tests, evaluation of systems, control weakness and action taken

      Schedule of results of audit tests on transactions and balances and conclusions reached (indexed and cross-referred to demonstrate sufficient and evidence)

      Completed audit program

      Accounts completion checklist.

 

 

 

Risk Assessment

Entity risk assessment is different from auditor’s risk assessment

 

 

Entity

The purpose of entity risk assessment is to identify, analysis (priorities) and manage risks that effect entity objectives

 

 

Auditor

The purpose of auditor’s risk assessment is to evaluate the likelihood that material misstatement could occur in financial statements

 

 

Inherent Risk Assessment

      Inherent risk is risk that items will be misstated due to characteristics of those items such as that they are estimates or complex accounts.

 

Auditor must use their professional judgement to assess inherent risk at two level

 

1. at the financial statements level

2. at the account balance and class of transaction level

 

 

At Financial Statement Level

In developing the overall audit plan the auditor should assess inherent risk at financial statement level. The relevant factors to be considered are

 

 

 

Factors Affecting Client as Whole

FACTORS

EXAMPLES

Directors attitude to risk

Domination of decisions by one person

 

Industry factors

Declining industry causing going concern problems, rapid changes in consumer demand

Management experience and knowledge

High management turnover, poor reputation of management

Unusual pressure on management

Tight reporting deadlines, undue emphasis on meeting earning projection

 

Nature of business

High sensitivity to economic factors (inflation, interest rate etc)

 

At Account Balance And Class Of Transaction Level

In developing audit programme auditor should assess inherent risk at account balance and class of transaction level.

 

 

Factors Affecting Individual Accounts Balance Or Transaction

FACTORS

EXAMPLES

 

Related party transactions

Transactions involving director’s interest

Unusual transaction

Year end transactions or transaction involving high accounts

Accounts prone to misstatement

 

Provisions and prior period

Complex items

Expert valuations

 

Competence personnel

Unqualified and untrained staff

 

Assets desirability

Moveable assets such as cash, laptops.

 

Control Risk Assessment

 

Control risk is the risk of material misstatement not being prevented or detected by internal controls control risk should be assessed in terms of financial statement assertions.

 

      Presentation and disclosure

      Existence or occurrence

      Rights and obligations

      Completeness

      Valuation

 

 

Detection Risk

      Detection risk is risk that material misstatements not being detected by auditor’s substantive procedures.

      The auditor’s inherent and controls risk assessment influences the nature timing and extent of substantive procedures required to reduce detection risk and thereby audit risk. In this regard auditor would consider modification in;

 

Nature -   Change from less effective to more effective t4ests (i.e. direct third  party confirmation rather then internal evidence)

Timing -    Less reliance on interim testing

Extent –    Larger sample size

 

 

Inter Relationship Of Components Of Audit Risk

There is an inverse relationship between combined levels of inherent and control risk and detection risk, following table shows how acceptable level of detection risk may vary based on combined assessment of inherent and control risk.

 

Control Risk Assessment

 

Inherent risk assessment

 

High

Medium

Low

High

Lowest

Lower

Medium

Medium

Lower

Medium

Higher

Low

Medium

Higher

Highest

 

Shaded area is relating acceptable level of detection risk

 

Analytical Procedures

 

Consist of analysis of significant ratios and trends including the resulting investigations of fluctuation and relationships that are inconsistent with often relevant information or which deviate from predictable amounts

 

 

Purpose

Analytical procedures used for 3 purposes

 

1.      Planning nature timing and extent of other auditing procedures

2.      substantive test about particular assertions

3.      overall view in the finance stage of audit

 

 

Nature

The ISA sates that analytical procedure include consideration of;

 

a)         Comparison with prior period comparable financial information and anticipated results such and budgets forecasts industry information

b)         Relation between

-         Elements of financial information such as gross profit to sales

-         Financial and relevant non-financial information such as payroll to no. of employees

 

 

Stage

Auditor should apply analytical procedures at

 

      Planning stage

      Substantive tests stage

      Overall review stages

 

 

Planning Purpose

To assist auditor to

 

      Understand the business and events since last audit.

      Identify areas of potential risk

      Determine timing nature and extent of other audit procedures.

 

Possible sources of information about client include

 

      Interim financial statements

      Management accounts

      Tax returns (sales, income)

      Board minutes

      Discussions with client at year end

 

 

Substantive Test Purpose

To assist auditor to

 

      Obtain corroborative evidence

      Test details of transactions

      Detect material misstatements in financial statements

      Reduce detections risk for financial statements assertions.

 

 

Factors

When intending to perform analytical procedures as substantive procedures auditor should consider following factors

 

FACTORS

EXAMPLE

Comparability

Financial information is comparable when accounting policies are consistent in comparable periods

Objective

Normally to obtain corroborative evidence

Desegregation of information

Breakup of administrative expenses appearing in P & L accounts to get more accurate picture for investigations of unusual fluctuations.

Source of information

 

Independent sources are more reliable than internal sources

Availability of information

Auditor should have unrestricted access to all relevant information

Relevance of information

Marketing expenses and sales, wages and laborers

Reliability of information

Whether budgets are prepared with due care and skill and are realistic

 

Knowledge gained during previous audit

      Adjustment in prior periods

      Significant changes in structure culture and resources.

 

Extent Of Reliances

 

The extent of reliance that the auditor place on the results of analytical procedures depends on following factors.

 

FACTORS

EXAMPLE

Materiality of items

When inventory balances are material does not rely only on analytical procedures

Assessment of inherent and control risk

If it is high, place more reliance on test of details of transactions than on analytical procedures

Other audit procedures

To confirm accounts receivable review subsequent cash receipts

Consistency and accuracy of results

Auditor expect greater consistency in comparing margins than from one period to another than in comparing discretionary expenses such as research and development.

 

Overall Review Purpose

 

Is to assist auditor to

 

      Assess the conclusions reached

      Highlight areas, which require further investigations

      Ensure that financial statements as a whole are consistent with auditors knowledge

      Consider in formations necessary for assisting in the planning of subsequent audit

 

 

Investigations

When analytical procedures identify

      Significant fluctuations

      Relationship that are inconsistent with often

      Deviation from predicted results.

Auditor should investigate and obtain adequate explanations and appropriate corroborative evidence by

      Inquiries of management

      Corroborations of management response by comparing them with auditor’s knowledge and other evidence obtained during audit. If explanations can not be given by management or if they are insufficient the auditor must determine which further audit procedures to undertake such as modification of report.

 

 

Practical Techniques

Analytical techniques may be

      Ratio analysis

      Examination of accounts

      Trend analysis

      Bar graph, Pi chart

      Time service analysis

      Visual presentations

      Reasonableness test e.g. Depreciation = (cost + additions – disposal) x ratio of depreciation

 

 

Working Papers

Working papers must contain the completed result of analytical procedures.

 

They should include:

 

      Summary of comparisons

      Summary of significant figures

      Details of significant fluctuations

      Details of results of investigations

      Audit conclusions reached

      Information considered necessary for planning subsequent audit

 

 

Important Ratio

GP margins

 

      In total

      By product

      By segments

      By months/quantity (if possible)

 

Expense ratio to sales

 

      Receivable ratios and collection periods

      Inventory turnover

      Current ratio

      Quick ratio 

      Gearing ratio

      Return on capital

 

 

Related Items

      Payable and purchases

      Goods and costs of sales

      Assets and depreciation and amortizations

      Investment and investment income

      Receivable and bad debts

 

 

Area Of Investigation

      Significant changes during the period

      Structure

      Culture

      Resources