Fau PDF

D
Ju ec
O
ne em
OpenTuition 20 be
20 r 2
Free resources for accountancy students Ex 01
am 9 -
s
CAT
Foundations in Audit
(FAU)
Please spread the word about

OpenTuition, so that all ACCA
students can benefit.
ONLY with your support can the site

exist and continue to provide free
study materials!
OpenTuition Lecture Notes can be downloaded FREE from http://opentuition.com

Copyright belongs to OpenTuition.com - please do not support piracy by downloading from other websites.
The best things
in life are free
IMPORTANT!!! PLEASE READ CAREFULLY
To benefit from these notes you must obtain a current edition of a

Revision / Exam Kit from one of the ACCA approved content providers
they contain a great number of exam standard questions (and
answers) to practice on.
Question practice is vital!!

FIA FAU December 2019 and June 2020 1
FAU Foundations in Audit
Syllabus 3
1. Business environment and audit framework 5
2. Professional ethics 15
3. Audit regulation and auditor engagement and liability 23
4. Audit planning and risk assessment 29
5. Tests of control and substantive procedures 39
6. Assertions and audit evidence 45
7. Audit sampling 51
8. Using the work of others 57
9. Computer assisted audit techniques 61
10. Audit documentation 65
11. Internal control 73
12. Examples of internal control and tests of control 79
13. Substantive procedures 89
14. Audit completion 101
15. The independent auditor's report 105
Answers to Tests 111
Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community
SYLLABUS
1. Overall aim
To develop knowledge and understanding of the principles of external audit and the audit process
and technical proficiency in the skills used for auditing financial statements.
2. Main capabilities
On successful completion of this exam, candidates should be able to:
A Explain the purpose and scope of an audit and its regulatory framework
B Explain how an auditor assesses risk and plans an audit
C Identify the principles of internal control and describe and evaluate the features of information
systems
D Identify and describe audit evidence and audit procedures required to meet the objectives of an
audit and apply International Standards on Auditing (ISAs)
E Explain how the audit is completed and reflected in the different types of auditor’s reports.
3. Approach to examining
The syllabus is assessed by a two hour computer-based examination (CBE). Questions will assess all
parts of the syllabus.
The examination will consist of two sections:
Marks
Section A – 15 two mark objective test questions 30
Section B – Eight questions:
Two 15 mark questions 30
Two 10 mark questions 20
Four 5 mark question 20
70
100
4. Accounting standards
The accounting knowledge that is assumed for FAU is the same as that examined in FA1 and FA2.
Therefore, candidates studying for FAU should refer to the IFRS® Standards listed under FA1 and FA2.
Candidates will also be expected to be familiar with FFA.
Chapter 1
BUSINESS ENVIRONMENT AND AUDIT
FRAMEWORK
1. The purpose and scope of an audit

Shareholders are the legal owners of companies. In very small businesses, such as family businesses,
the shareholders will also take part in the day to day management of the company. However, once
businesses grow, shareholders appoint directors and managers to run their company.
Shareholders (also known as members) are the principals, and directors are the agents of the
shareholders. Agents should act in the best interests of the principals so, therefore, directors should
act in the best interest of shareholders. However, this can introduce conflicts of interest between the
two parties. Shareholders want large profits but the directors might want large salaries, generous
pensions and bonuses, first class travel and expensive cars.
Companies are required to produce annual financial statements (accounts) for presentation to their
shareholders. These should show how their company has got on during the year. The directors are
responsible for producing the financial accounts and there is obviously a temptation for them not to
report results accurately or fairly. For example, directors might try to overstate profits so as to keep
their jobs or to qualify for bonuses.
Therefore, auditors are appointed by the members of the company to scrutinise independently the
financial statements and to report to the members on whether the financial statements show a ‘true
and fair’ view of the company’s affairs and its results. Auditors’ conclusions are published with the
financial statements in the auditor’s report.
In addition to the terms ‘agent’ and ‘principal’, ‘stewardship’ is sometimes used to describe the duty
that directors have to look after the interests of the shareholders.
2. What auditors don’t do

Auditors do not:
๏ Prepare the financial statements: that is the job of the directors.
๏ Double check every transaction in the company: that would take too long and be very
expensive.
๏ Manage the company.
๏ Warn shareholders that the company has made a loss: that will be shown in the financial
statements.
๏ Undertake to discover every fraud or error that might have taken place in the company: auditors
look only for material misstatements (see later).
3. Advantages and disadvantages of an audit

3.1 Advantages
๏ Independent scrutiny and a report on the financial statements.
๏ Greater credibility (believability) of the financial statements. This could help in raising finance.
๏ Professional expertise applied to the financial statements. Especially important when directors
and shareholders might not have financial experience.
๏ Review of the company’s internal control system (the accounting system used by the company)
and recommendations for its improvement.
3.2 Disadvantages
๏ Cost: auditors charge for their work.
๏ Time and disruption. Auditors have to ask employees questions and have to find documents.
This distracts employees from their day-to-day tasks.
๏ A feeling of not being trusted. Auditors are always looking for independent evidence and
cannot rely on employees' or management's word alone. This can make staff feel that they are
not trusted.
4. Accounting records
Accounting records consist of:
๏ General (also called nominal) ledger. This has accounts for assets (such as non-current assets,
receivables), liabilities (such as amounts owed to suppliers and loans), income (such as sales)
and expenses (such as rent, wages and electricity).
๏ Cash book. This shows cash receipts and payments.
๏ Receivables ledger. This shows how much each credit customer owes. This ledger is sometimes
known as the debtors’ ledger or sales ledger. The total of these amounts should agree with the
receivables control account that is part of the general ledger.
๏ Payables ledger. This shows how much is owed to each supplier. This is sometimes known as the
creditors’ ledger or purchase ledger. The total of these amounts should agree with the payables
control account that is part of the general ledger.
๏ Non-current asset register. This shows details of each non-current asset, such as purchase date,
cost, depreciation rate, location, date last physically verified and depreciation to date. The total
of the non-current asset register should agree to the relevant accounts in the general ledger.
The non-current asset register might sometimes still be referred to as the fixed asset register.
๏ Inventory records. Lists, schedules or cards with inventory details such as cost, location number
of items, deliveries and receipts.
The exact nature of the accounting records vary from business to business. For example, a small
grocery shop will not have a receivables ledger because all sales are for cash. An architect’s practice
will not have inventory records because they sell services, not goods. Some very small businesses
keep little more than a cash book on a day-to-day basis and fuller accounting records are produced at
year end.
5. Financial statements
Auditors report on a company’s financial statements. These will have been produced from the
financial records. Financial statements consist of:
๏ A statement of financial position

๏ A statement of profit or loss
๏ Statement of cash flows
๏ Statement of changes in equity
๏ Notes to the financial statements
Together with the documents above, companies also produce directors’ reports, chairman’s
statements, graphs, forecasts and public relations material and include it all in their annual report. The
annual report will also include the auditors’ report. For large companies the annual report is often a
'glossy' publication designed to impress shareholders and potential investors.
However, the auditor’s report covers only the financial statements, not the other documents that
might be included.
6. The auditor’s report

6.1 Expression of opinion
The objective of an audit is to issue an auditor's report that includes an expression of the auditor's
opinion. This may be expressed in terms of whether or not the financial statements give “a true and
fair view” of the financial position of the company at its year end and of its performance during the
year.
True: implies that the financial statements are factually correct, have been prepared
according to an applicable reporting framework (such as International Financial
Reporting Standards) and that they do not contain any material misstatements that
may mislead the users. Misstatements may result from material errors or omissions in
the financial statements. True also implies that the financial statements are
materially accurate.
Fair: implies that the financial statements present the information faithfully without any
element of bias and they reflect the economic substance of transactions rather than
just their legal form. Presentation is an important element of fairness.
For example:
The statement of financial position should show current assets and current liabilities separately and in
detail. Thus current assets and current liabilities might show:
Current assets
Inventory 10,000
Receivables 4,000
Cash 2,000
16,000
Current liabilities
Trade payables 12,000
This shows that the liquidity of the company is poor as suppliers expect $12,000 within the next few
weeks but, although inventory is high, there is not much coming from customers or in cash with
which to pay suppliers. Inventory can take a long time to be sold and to turn into cash.
If the presentation were as follows:
Current assets 16,000
Current liabilities 12,000
then users might have a very wrong impression. The amounts are true (correct), but concealing the
large amount of inventory that contributes to the current assets is likely to mislead ie not a fair
presentation.
6.2 Illustrative example
1 INDEPENDENT AUDITOR’S REPORT To the Shareholders of ABC company
2 Report on the Audit of the financial statements
3 Opinion
We have audited the financial statements of ABC Company (the Company), which comprise the statement of
financial position as at December 31, 20X1, and the statement of comprehensive income, statement of changes
in equity and statement of cash flows for the year then ended, and notes to the financial statements, including
a summary of significant accounting policies.
In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a true and
fair view of) the financial position of the 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
(IFRSs).
4 Basis for Opinion
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities
under those standards are further described in the Auditor’s Responsibilities for the Audit of the financial
statements section of our report.
We are independent of the Company in accordance with the International Ethics Standards Board for
Accountants’ Code of Ethics for Professional Accountants (IESBA Code) together with the ethical requirements
that are relevant to our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements and the IESBA Code. We believe that the audit evidence
we have obtained is sufficient and appropriate to provide a basis for our opinion.
5 Responsibilities of Management and Those Charged with Governance for the financial statements
Management is responsible for the preparation and fair presentation of the financial statements in accordance
with IFRSs 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.
In preparing the financial statements, management is responsible for assessing the Company’s ability to
continue as a going concern, disclosing, as applicable, matters related to going concern and using the going
concern basis of accounting unless management either intends to liquidate the Company or to cease
operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Company’s financial reporting process.
6 Auditor’s Responsibilities for the Audit of the financial statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our
opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement when it exists. Misstatements can arise from
fraud or error and are considered material if, individually or in the aggregate, they could reasonably be
expected to influence the economic decisions of users taken on the basis of these financial statements.
As part of an audit in accordance with ISAs, we exercise professional judgment and maintain professional
skepticism throughout the audit. We also:
• Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or
error...
• Obtain an understanding of internal control relevant to the audit...
• Evaluate the appropriateness of accounting policies used...
• Conclude on the appropriateness of management’s use of the going concern basis of accounting...
• Evaluate the overall presentation, structure and content of the financial statements, including the
disclosures...
We also provide those charged with governance with a statement that we have complied with relevant ethical
requirements regarding independence, and to communicate with them all relationships and other matters that
may reasonably be thought to bear on our independence, and where applicable, related safeguards.
The engagement partner on the audit resulting in this independent auditor’s report is [name].
7 [Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate for the
particular jurisdiction]
[Auditor Address]
[Date]
The numbered paragraphs have the following significance:
(1) A clear title “Independent auditors’ report”.
(2) Specifies what the audit covers – the financial statements.
(3) The first section of the report is the most important part: the opinion paragraph, clearly headed
so that it can be easily found. Here the auditors state whether in their opinion the financial
statements' present fairly, in all material respects' in accordance with IFRS.
This type of assurance is known as ‘positive assurance’ or ‘reasonable assurance’ because the
auditor's conclusion is an opinion - not an absolute guarantee.
(4) The basis for opinion section directly follows the opinion section. It states that:
‣ the audit was conducted in accordance with ISAs
‣ the auditor is independent
‣ the auditor's belief that the opinion is supported with audit evidence.
(5)/(6) Pointing out what the directors are responsible for (5) and what the auditors are responsible for
(6). This reduces the ‘expectations gap’ because many users of financial statements think that
the auditors are responsible for their preparation. Auditors “give reasonable assurance that
the financial statements are free from material misstatement, whether caused by fraud or
error.” There are no guarantees: reasonable assurance only and material misstatements only.
(7) Signed and dated. The date is important because the audit is still in progress until then.
7. Auditors’ rights
Auditor’s duties are to report on the matters as set out in the auditor’s report above. They also have a
legal duty to report certain matters to the authorities; this is covered in more detail later in Chapter 2.
To fulfil their duties auditors are given certain rights by law. For example
๏ Access to the company’s records. This includes not only he accounting records but also
documents such as contracts, correspondence and board minutes.
๏ To receive all information and explanations they require.
๏ The right to attend (and receive notice about) general meetings and the right to speak at
general meetings on relevant matters.
8. Appointment of auditors
Auditors have to be reappointed by an ordinary resolution of the members at every annual general
meeting (AGM). Reappointment is not automatic, so an auditor cannot simply stay in office. The
requirement for a resolution means that the members have to take positive action to get auditors
appointed.
Prior to the first AGM, the directors can appoint the first auditor. Or if an auditor resigns (eg due to
illness), the directors can appoint another auditor to fill a casual vacancy. These appointments will
only last till next AGM.
If all else fails, in the UK, the Secretary of State, in other words the government, will ensure that all
companies have an auditor.
9. Resignation and removal of auditors

9.1 Introduction
If an auditor resigns or is removed there is always the fear that they are going for some reason that
members ought to know about. For example, the auditors might have concluded that the directors
are concealing important information or are committing a fraud. In such cases the auditors are likely
to resign because it will be impossible for them to carry out a thorough audit. Therefore, upon either
resignation or removal, the auditor must give written notice accompanied by a 'statement of
circumstances' to the company’s registered office.
The 'statement of circumstances' will:
๏ give reasons why the auditor is ceasing to hold office that need to be brought to the attention
of members of creditors; or
๏ state that there are no such circumstances.
9.2 Resignation or failure to seek re-appointment

The steps are:
(1) Give written notice to the company together with the relevant statement of circumstances.
(2) Notify the relevant regulatory authority (eg Registrar of Companies) together with the
statement of circumstances.
(3) If there are 'circumstances', the auditor may request that the directors convene a general
meeting and circulate the statement to the members.
9.3 Removal
Auditors cannot be removed by the board. They can only be removed by the members. This gives the
auditors much greater strength should they disagree with the directors on some audit point: the
directors cannot simply find more amenable auditors. However, directors can have great influence
over the members and might recommend removal of the auditors even though the auditors are
doing a good job. Therefore, the auditors are entitled to make representations to the members at a
general meeting, arguing why they should not be removed.
If the resolution to remove them is passed the auditor has the right to attend, make representations
to and be heard at the general meeting at which:
๏ his term of office would otherwise have expired; or

๏ there is a proposal to fill the vacancy caused by his removal.
Question 1
Auditors can be removed from office by the directors of the company
Is this statement true or false?
Question 2
Which two of the following tasks do auditors undertake?
A Preparation of the financial statements
B Provide independent scrutiny of the financial statements
C Prepare an auditor’s report
D Warn shareholders that the company is loss-making
Question 3
Which (several) of the following are part of the financial statements?
A Directors’ report
B Statement of financial position
C Statement of profit or loss
D Chairman’s statement
E Statement of cash flows
Question 4
When discussing directors and shareholders, who are the principals and who are the agents?
Question 5
How frequently must auditors of a company be re-appointed?
Question 6
Auditors have a right to speak at general meetings
Question 7
What is a ‘statement of circumstance’?
Chapter 2
PROFESSIONAL ETHICS
1. Introduction
All members and students of the ACCA must follow the provisions of the Code of Ethics and Conduct
('the Code'). Note that it applies to:
๏ Students
๏ ACCA members acting as auditors
๏ ACCA members acting in some other accounting role.
Failure to comply with the Code can lead to fines, to members being excluded from membership, or
to students being removed from the student register.
Ethics are not just an ‘add on’: they are fundamental to being an ACCA member or student. If poor
ethical standards were allowed, then accountants lose much of their value. They might be technically
able to prepare or audit financial statements, but it the financial statements lack credibility what is
their point? Ethics give added value. Not only can the accountant prepare financial information, but
that information is also more reliable (and so more valuable) because it has been prepared by
someone adhering to ethical standards.
2. Conceptual framework
The Code includes a conceptual framework that:
๏ Establishes five fundamental principles

๏ Recognises that these come under threat, and categorises those threats
๏ Explains how, through safeguards, many of the threats can be reduced or avoided altogether.
You might feel that some of the examples of threats described below are trivial, but it is important
that the accountant is seen to be acting ethically and that there is no danger of a suspicion of
unethical conduct. In some situations, judgement is required as to the severity of the threat.
3. Fundamental principles, threats and safeguards

3.1 The five fundamental principles
Principle Meaning
1 Integrity Members should be straightforward and honest in business and
professional relationships. Integrity is more than honesty. It also means
sticking up for what you believe is right and following up areas of
concern. For example, you would not be acting with integrity if, upon
seeing what might be a fraudulent transaction you decide to not
investigate it further ie you ‘turn a blind eye’.
2 Objectivity Members should not allow bias, conflicts of interest or undue influence
to interfere with their professional or business judgement. For
example, if you were producing a budget that will be used for a
purchaser of the business, it will be difficult to be objective as there
will be an understandable desire to draft an optimistic budget.
3 Professional conduct Members must keep up-to-date with legislation, accounting standards,
and due care auditing standards and so on. Members must ensure that enough time,
resources and care are devoted to tasks so that they are carried out
correctly.
4 Confidentiality Accountants frequently have access to confidential information.
Auditors see financial results before shareholders; accountant in
business might see everyone’s remuneration. Therefore, accountants
must not disclose information unless:
๏ They have the client’s permission to do so. For example, the audit
firm might have been asked to carry out tax computations and to
submit these to the tax authorities.
๏ There is a legal or professional right or duty to disclose
information. For example, many countries have anti-money
laundering legislation which compels auditors to alert the
authorities if they have even a suspicion of money laundering. A
right to disclose information can arise if the audit firm had to
defend itself in court against allegations of negligence.
๏ A public duty to disclose information. The concept of public
interest is not defined by statute, and an auditor would be
advised to seek legal advice on these matters. For example, is
there a public duty to disclose that a client pays staff below
minimum wages. You might think that morality is of disclosure,
but the auditor’s prime duty is to report on the financial
statements, not to be a watchdog for every breach of rules and
regulations.
5 Professional behaviour Members must avoid any action that would bring the profession into
disrepute. For example, being found guilty of theft (or even fare
evasion) could land a member or student in trouble with the ACCA.
Although not listed as one of the fundamental ethical principles, the concept of independence is
very important. It is more difficult to act with integrity and objectivity if you are not independent from
a client. The ACCA’s code of ethics and conduct requires members not only to be independent but
also to be seen to be independent.
3.2 The threats
Category Meaning
1 Self-interest For example, financial self-interest
2 Self review For example, checking your own work and verifying your own
judgements and decisions
3 Advocacy For example, promoting a client to others
4 Familiarity For example, personal relationships that can interfere with objectivity
and professional scepticism
5 Intimidation For example, a physical threat (thankfully rare) or the threat of losing
your job
3.3 The safeguards
These can be categorised as:
๏ Safeguards created by the profession. For example, adhering to professional standards and
following the ACCA’s Code of Ethics and Conduct.
๏ Safeguards created by the work environment. For example, a policy rotating members of an
audit team to avoid familiarity with a client, and providing training and review procedures to
ensure professional competence is not threatened.
๏ Safeguards created by individual members. For example, staying up -to-date with new
accounting and auditing standards.
4. Threats and safeguards

4.1 Self-interest threats
How it can be avoided or reduced to an

Example of threat
acceptable level
Financial interest arising from holding shares in Shares in clients must not be owned by
a client. members of the audit team or their immediate
family members.
Contingent fees, such as an audit fee based on a Contingent fees for audit work are not
percentage of revenue or profit reported in the permitted.
financial statements.
Gifts and hospitality, such the audit team being Gifts and hospitality should not be accepted
taken out to dinner by a client. unless clearly insignificant.
High fees from a single client. A very high fee Fees from any one client should be kept under
from one client can mean that the auditor is very review. If the client is a public interest client
dependent on that client, is desperate to keep (such as a listed company) the fees from that
that client, and so will ‘go easy’ on the client. client should not exceed 15% of the firm’s total
(Note also the intimidation threat later.) fees. If the fees are greater than this, for two
consecutive years, the audit should should
undergo an independent quality control review.
Overdue fees. If an audit client still hasn’t paid The auditor should not commence an audit if
last year’s fees, then the audit firm will want the fees are outstanding.
client’s business to survive so that the fees are
paid. This might lead to a 'clean' auditor's report
when really there are problems.
Loans from a client. Unless it is the client’s normal business to make
loans (for example, the client is a bank) and any
loans are made on normal business terms,
auditors should not accept loans from clients.
Accepting employment from a client. Simultaneous employment with a client and the
audit firm is not permitted. Additionally, if a lead
audit partner leaves the partnership he or she
should not join a public interest client as an
employee until at least a year has passed.
A partner serving on the board of a client firm. This is not permitted.
4.2 Self review threats

Example of threat
acceptable level
Preparing financial statements then auditing For non-public interest companies this is
them. permitted provided completely separate teams
are used for each function. In general, the
auditor cannot provide accounting or
bookkeeping services to or prepare financial
statements for a public interest client. An
exception to this is if the service is not material
to the financial statements and a separate team
provides the service.
Designing and implementing internal control An auditor cannot provide services that assume
systems. management responsibilities. Evaluating
internal control is often an important audit
procedure, so if the auditors had designed the
controls they might be blind to any deficiencies
– and they might be reluctant to subsequently
criticise the system.
Valuation services. Even if the audit firm were professionally

competent to do so, valuing, for example,
property for the purposes of financial
statements that the firm subsequently audited is
not permitted unless the valuation is not
material to the financial statements
Temporary staff assignments to audit clients. An audit firm may 'lend' staff to an audit client as
long as they will not assume management
responsibilities (however short the period of
time) and the loaned staff is not a member of the
audit team.
4.3 Advocacy threats

Example of threat
acceptable level
Promoting the audit client to potential investors Auditors should avoid assignments likely to
or supporting a client in a dispute (eg with a tax cause an advocacy threat.
authority).
4.4 Familiarity threats

Example of threat
acceptable level
The audit partner is a close relative of the client’s Another partner should be the engagement
finance director partner (ie responsible for the audit). ‘Close
relative’ is not defined. Does it include brother
and sisters, children, nephews and nieces,
remote cousins? Judgement must be used and
the auditor must be seen to be independent.
Friendships. Familiarity threats can arise even if Familiarity is a matter of judgement, but the
there is no legal relationship. auditor being the life-long best friend of the
finance director would be hard to justify.
Familiarity can arise through long-association

between audit and client staff. For public
interest clients a partner cannot be in charge of
the audit for more than seven consecutive years
and there must be a gap of at least two years
before further involvement.
4.5 Intimidation threats

Example of threat
acceptable level
Actual or threatened litigation. For example, the The only appropriate action may be to withdraw
client alleges that the auditor had been from the engagement and resign or not seek
negligent over some matter in the past. reappointment.
Threat to remove or not reappoint the auditor if The firm should not be so financially dependent
the auditor's report is not 'clean'. on the client that it cannot stand up to such a
threat.
Question 1
What are the five fundamental principles of the ACCA's Code of Ethics and Conduct?
Question 2
‘All students of ACCA are bound by its Code of Ethics and Conduct.’
Question 3
What is the conceptual framework?
Question 4
What are the categories of threat to an auditor’s independence?
Question 5
When may an auditor disclose confidential information about an audit client?
Question 6
Fees from a public interest entity should generally not exceed which of the following
percentages of total fees?
A 5%
B 10%
C 15%
D 20%
Chapter 3
AUDIT REGULATION AND AUDITOR
ENGAGEMENT AND LIABILITY
1. Regulation
Auditors are regulated by:
๏ Professional bodies (eg ACCA)
๏ International bodies (eg IFAC, the International Federation of Accountants)
๏ National bodies (in the UK the FRC, Financial Reporting Council)
The purpose of IFAC is to serve the public interest by establishing and promoting adherence to high-
quality professional standards. It has a number of boards including:
๏ IAASB (International Auditing and Assurance Standards Board): Sets International Standards on
Auditing (ISAs) and other assurance standards
๏ IESBA (International Ethics Standards Board for Accountants): Issues the International Code of
Ethics for Professional Accountants.
The IAASB's ISAs are adopted by the FRC in the UK which has local regulatory power. The IESBA's Code
has been adopted by ACCA in its Code of Ethics and Conduct.
2. International Standards on Auditing (ISAs)

2.1 Authority
The IAASB’s International Standards do not override local (national) laws or regulations that govern
the audit of financial statements. Therefore, if an audit is conducted in accordance with national
requirements that differ from or conflict with ISAs, it may not comply with International Standards.
2.2 Purpose
ISAs are high-quality standards which promote consistency of practice throughout the world and
thereby strengthen public confidence in the global auditing professions. Nearly 80% of jurisdictions
worldwide have adopted ISAs for mandatory (statutory) audits.
2.3 Scope
ISAs apply to and are written in the context of an audit of financial statements by an independent
auditor. An audit will comply with the IAASB’s Standards only if the auditor has complied full with all
standards relevant to the audit.
The vast majority of the standards listed in the next section will be relevant to all audits. Clearly
though, ISAs 610 and 620 would only be relevant if the auditor uses the work of internal audit or an
expert.
2.4 Examinable documents
Glossary of Terms
Preface to International Standards on Quality Control, Auditing, Review, Other Assurance and Related
Services
ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance
with ISAs
ISA 220 Quality Control for an Audit of Financial Statements
ISA 230 Audit Documentation
ISA 260 Communication with Those Charged with Governance
ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and
Management
ISA 300 Planning an Audit of Financial Statements
ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and Its Environment
ISA 320 Materiality in Planning and Performing an Audit
ISA 330 The Auditor’s Responses to Assessed Risks
ISA 450 Evaluation of Misstatements Identified During the Audit
ISA 500 Audit Evidence
ISA 501 Audit Evidence – Specific Considerations for Selected Items
ISA 505 External Confirmations
ISA 520 Analytical Procedures
ISA 530 Audit Sampling
ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related
Disclosures
ISA 560 Subsequent Events
ISA 570 Going Concern
ISA 580 Written Representations
ISA 610 Using the Work of Internal Auditors
ISA 620 Using the Work of an Auditor’s Expert
ISA 700 Forming an Opinion and Reporting on Financial Statements
ISA 705 Modifications to the Opinion in the Independent Auditor’s Report
3. Engagement acceptance
3.1 Factors to be considered
It is, of course, flattering to be asked to be a company’s auditor. The assumption is that the company
has heard good reports and a new audit means new fees. However, there are many factors to be
considered before accepting an audit engagement:
๏ Is it ethical to take on the new work? For example, there might be close personal relationships to
consider or the new fee income would make the auditor unduly reliant on that client.
๏ Will the auditor be able to meet the professional competence and due care criteria? For
example, the potential client might be an insurance company but the auditor has no experience
of auditing such specialist businesses.
๏ Is it practical to take on the new work given the size of the job and the auditor’s current staffing
levels and commitment to existing clients?
๏ What is known about the type of business, its directors and its owners? Some types of business
are more risky than others, some businesses might be in business sectors the auditor feels might
cause reputational damage, and some directors can have shady pasts.
๏ Is the fee acceptable?
The steps that an audit firm should take before agreeing to become the auditor of a new client are
therefore:
๏ Ensure that it is professionally qualified to act on both ethical and legal grounds.
๏ Ensure that existing resources are adequate to cover both the required expertise and the time
that the new work will take
๏ Investigate the company, its owners and directors
๏ Communicate with the present /outgoing auditor.
3.2 Communication with existing auditor

This is obligatory: the outgoing auditor will be well-placed to tell the prospective auditor if there are
professional or other reasons why the work should not be accepted.
If, for example, there had been serious disagreements about an accounting treatment and the
directors were not willing to amend the financial statements, the new auditor might think twice about
becoming involved with what might be a difficult client.
If, however, the outgoing auditor declined to be reappointed because the client had become too big
for them, that would not be a reason why the prospective auditor could not accept the engagement.
The full process when taking over from a previous auditor is as follows:
๏ Ask the client for permission to contact the outgoing auditor. If the new client refuses, the
appointment should be refused (what are they trying to hide?)
๏ Contact the outgoing auditor and ask if there are any reasons why they should not accept
appointment.
๏ The outgoing auditor has to ask the client’s permission to reply to the new auditor
(confidentiality rules require this). If the client refuses, the appointment should be refused (what
are they trying to hide?)
๏ Assess any information received in the reply, together with other evidence collected
independently.
3.3 Engagement letter

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

๏ The scope of the audit (reasonable assurance, financial statements, material misstatements, not
primarily trying to detect fraud)
๏ The financial reporting framework to be used.
๏ The form of any reports to be issued
๏ The auditor’s entitlement to see all documentation and receive all explanations necessary for
the audit.
๏ Practical arrangements, such as timing and the involvement of internal audit.
๏ The fee.
4. Auditor liability
4.1 Introduction
Occasionally auditors get it wrong and they put their name to a set of financial statements which
contain a material misstatement. Obviously, if users of the financial statements have relied on those
statements (eg to make investment decisions), they could suffer financial harm because they would
have been misled.
When auditors are appointed they send an engagement letter to the company. Essentially, this is a
contract setting out both the auditors’ and the company’s responsibilities. It is possible for the
auditors to breach this contract and so be liable for damages, but the main legal risk that auditors
suffer is from the tort of negligence.
For a claimant to prove a negligence claim, it must be shown that:
๏ A duty of care to the claimant existed

๏ The duty was breached
๏ Monetary loss was suffered.
4.2 Duty of care

The English courts have been very reluctant to extend an auditor’s duty of care beyond the members
of the company as a whole. The key case is known as the Caparo case where a company was taken
over by Caparo on the basis of financial statements Caparo claimed were misleading. The House of
Lords (the UK’s highest court then) concluded that the auditors of the company taken over owed no
duty of care to members of the public at large, such as potential investors.
In partial contrast, in the Bannerman case it was held that auditors could owe a duty of care to a bank
if the auditors knew that the bank was relying on the audited financial statements and the auditors
did not disclaim their liability to the bank.
4.3 Breach of the duty of care

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

Negligence is a practical matter: monetary loss has to have occurred before the courts are interested.
Question 1
Who sets international Standards on Auditing?
Question 2
The rules set out in the International Standards on Auditing always override national laws and
regulations governing the audit of the financial statements of companies.
Question 3
An audit of financial statements will comply with International Standards if the auditor complies fully
with all standards relevant to the engagement.
Question 4
Which of the following ISAs would not be relevant to all audits of financial statements?
A Audit Documentation
B Materiality in Planning and Performing an Audit
C Forming an Opinion and Reporting on Financial Statements
D Using the Work of Internal Audit
Question 5
Incoming auditors are not allowed to communicate with outgoing auditors.
Question 6
State four factors an auditor must consider before accepting a new appointment.
Question 7
What is the purpose of an engagement letter?
Question 8
Which of the following statements best describes auditors’ liability to users of financial
statements?
A They are liable to all users of financial statements
B They are liable only to the members
C They are liable to members and can be liable to others
D They are not liable to anyone because they only provide reasonable assurance that the
financial statements are free for material misstatement
Chapter 4
AUDIT PLANNING AND RISK
ASSESSMENT
1. Introduction
Audit risk is a technical term related to the process of auditing. The first thing to appreciate is that
audit risk cannot be reduced to zero as an audit cannot provide absolute assurance – only reasonable
assurance. This is because an audit has ‘inherent limitations’, for example:
๏ Part of the nature of financial reporting is that financial statements should include accounting
estimates which necessarily involve judgement.
๏ Audit procedures are designed to gather audit evidence, not to detect intentional misstatement
that has been deliberately concealed.
๏ As an audit needs to be conducted within a reasonable period of time and at a reasonable cost,
it is not possible to examine everything exhaustively.
Audit risk is considered throughout the audit, in particular:
๏ In understanding the entity – what are the risks?

๏ In planning the audit – how are risks to be reduced to an acceptably low level?
2. The audit process

2.1 Introduction
Once the audit has been accepted then the audit process can begin. There are essentially three
stages:
๏ Planning. This will often require a meeting with the client – certainly in the first year of a new
audit. Subsequently, a planning phone call might suffice for smaller clients. For new audits the
auditor will want to meet senior staff and to visit the client’s premises. They will want to discuss
any problems that might have arisen in previous audits. In subsequent years, the auditor will be
particularly interested in changes during the year such as a new accounting system, additional
premises, changes in senior personnel and accounting or trading problems.
๏ An interim audit. This takes place typically four or five months before the end of the accounting
period. This is when the accounting system and internal controls are examined and tested.
๏ A final audit. This happens typically a few weeks after the accounting period end to allow the
client to prepare the draft financial statements. It is on these statements that the auditor will be
reporting.
A more detailed depiction of an audit is as shown below:
Planning the audit
Understand the
entity and its
environment
Preliminary
materiality
Assessment of risks
Responses to risk
Good internal Poor internal

control expected control expected
Test internal
control
In
(let effec
ter ti
to m ve co
Effective ana ntrol
controls gem s
ent
)
Full
Reduced substantive
substantive procedures
procedures
Final review
Report
2.2 Planning the audit
This is an essential stage in any audit. Indeed, in the auditor’s report the auditor states that the audit
was planned.
The first step is to understand the entity (client) and its environment. Information that will be
collected includes:
๏ Nature of the client’s business

๏ Key customers, competitors and suppliers
๏ Location of operations, factories, shops and so on
๏ Organisational structure
๏ Recent sets of financial statements
๏ Industry comparatives
๏ Names of directors
๏ Organisational objectives
๏ Changes to the IT system

๏ Industry regulation
๏ Industry growth/decline
๏ Accounting policies
๏ Initial assessment of internal control procedures
Based on this information, preliminary materiality can be calculated. Risks arise from material
misstatements so it is necessary to have an early idea of what sizes of errors are likely to be material.
This information will also give the auditor some insight into the higher risk areas of the audit. Risk
would be increased if, for example:
๏ The business operates with cash sales

๏ Inventory consists of small, high-value items (such a jewellery)
๏ There are many dispersed locations
๏ A new IT system has been introduced.
The auditor will respond to the risk assessment by designing appropriate audit procedures to obtain
sufficient appropriate audit evidence that the financial statements are free from material
misstatement.
For example, in the case of inventory consisting of small, high-value items it will be necessary to take
great care over the audit of inventory. If a new IT system had been introduced during the year, the
auditor will have to carry out additional work on accounting entries just after its implementation
because the transition from old to new system might not have gone smoothly.
2.3 Objectives of audit planning
Planning an audit involves establishing the overall audit strategy for the engagement and developing
an audit plan. Adequate planning benefits the audit of financial statements in several ways, including
the following:
๏ To give appropriate attention to important areas of the audit.

๏ To identify and resolve potential problems on a timely basis.
๏ To properly organise and manage the audit engagement so that it is performed in an effective
and efficient manner.
๏ To select engagement team members with appropriate levels of capabilities and competence to
respond to anticipated risks, and the proper assignment of work to them.
๏ To facilitate the direction and supervision of engagement team members and the review of their
work.
๏ To assist where applicable, in coordination of work done by internal audit and experts.
2.4 Overall audit strategy and audit plan
Auditors are expected to produce and document both the audit strategy and the audit plan.
In establishing the overall audit strategy, the auditor will:
(1) Identify the characteristics of the engagement that define its scope;
(2) Plan the timing of the audit and the nature of the communications required. This will include
the timing of any reports needed, the nature of the reports and for whom the reports are being
prepared.
(3) Consider the factors that, in the auditor’s professional judgment, are significant in directing the
audit team’s efforts. For example, looking carefully at whether the going concern basis of
accounting is appropriate.
(4) Ascertain the nature, timing and extent of resources necessary to perform the engagement. This
will includes deciding the number staff needed, their experience and seniority. It will also
include deciding to what extend third parties might needed for some of the audit work, for
example, surveyors might be needed to assess the stage of completion of a building.
The audit plan will include:
(1) The nature, timing and extent of risk assessment procedures.
(2) The nature, timing and extent of further audit procedures to respond to the assessed risks.
An extract from an audit plan relating to receivables is:
External confirmation of a sample of customers asking Request confirmation from:

them to confirm their amounts owing at year end. All customer with balances > $100,000
50 with balances > $50,000 – $100,000
25 with balances <= $50,000
Assess the recoverability of a sample of invoices that All invoices over $20,000
have been outstanding for more than three months 20 invoices <= $20,000
For a sample of invoices trace to cash received after All invoices >$50,000
year end. 10 invoices <=$50,000
This part of the plan is a detailed audit program which sets out exactly the work that has to be done.
3. Materiality
3.1 Introduction
Information is material if its omission or misstatement could influence the decisions of users of the
Information can be material through its size, incidence and/or nature. For example, if there is a
requirement to disclose directors' remuneration, this must be accurate so any misstatements should
be regarded as material. Similarly there is no excuse for failing to state the cash at bank figure
accurately. However, with inventory, there can often be considerable judgement needed to arrive at
net realisable value, so there will be a range of acceptable amounts.
Materiality is ultimately a matter for the judgement of the audit partner. How may shareholders be
influenced by a figure? Although it will be up to the partner to make the final decision, it is important
for members of the audit team, to be given some guidance. There is no point asking for a $5,000 error
to be corrected in the financial statements of a multi-national company that is reporting in $ millions..
3.2 Common benchmarks for materiality
Common materiality benchmarks (and you need to know these for your exam) are:
๏ Profit before tax: 5% – 10%

๏ Revenue: ½% - 1%
๏ Total assets: 1% - 2%
3.3 Performance materiality

Performance materiality is the amount(s) set by the auditor at less than materiality for the financial
statements as a whole. Being less means that it reduces the probability that the aggregate of
uncorrected and undetected misstatements exceeds materiality for the financial statements as a
whole.
Consider this example: wages, electricity, depreciation, rent are all understated by 3%. Each item on
its own is immaterial to profit, but taken together, because the errors add up the same way, the effect
is material. Therefore, the concept of performance materiality means that smaller errors may be
identified by audit procedures..
4. Analytical procedures
4.1 Introduction
The term “analytical procedures” means evaluations of financial information through analysis of
plausible relationships among both financial and non-financial data. For example, if sales rise you
might also expect the packaging cost to rise. Analytical procedures includes investigation of identified
fluctuations or relationships that are inconsistent with other relevant information or that differ from
expected values by a significant amount. So, if packaging costs do not rise in line with sales, the fear is
that there has been an accounting error. Of course, the apparent discrepancy might be explained by
the company having adopted cheaper packaging.
Analytical procedures must be used at the planning stage to assess whether or not the financial
statements are consistent with the auditor's understanding of the entity.
4.2 Examples
Analytical procedures include comparison of the entity’s financial information with, for example:
๏ Comparable information for prior periods.

๏ Anticipated results of the entity, such as budgets or forecasts, or expectations of the auditor,
such as an estimation of depreciation.
๏ Similar industry information, such as a comparison of the entity’s ratio of sales to accounts
receivable with industry averages or with other entities of comparable size in the same industry.
๏ Comparison of financial and related non-financial information. For example, number of hotel
guests x average price per room should be approximately equal to room revenue.
Various methods may be used to perform analytical procedures. These methods range from
performing simple comparisons to performing complex analyses using advanced statistical
techniques.
5. The audit risk model

5.1 Introduction
At the start of this chapter, audit risk was defined as the risk that the auditor gives an inappropriate
opinion on the financial statements. Proper planning is essential to reduce audit risk by, for example,
giving appropriate attention to high risk areas of the audit.
However, this ‘common sense’ approach to audit has an extremely important theoretical foundation
that shows how risk can build up or be reduced.
5.2 The components of audit risk
Audit risk = Inherent risk x Control risk x Detection risk
Inherent risk: the susceptibility of an assertion to misstatement that could be

material…assuming that there were no related internal controls. In
other words, the risk of an error occurring in the first place.
Control risk: the risk that the misstatement will not be prevented, detected and
corrected on a timely basis by the entity’s internal control
Detection risk: the risk that the auditor’s procedures will not detect the
misstatement.
Therefore, for a material error to get into the published financial statements together with in
inappropriate auditor’s report, three things have to happen:
(1) The error has to have occurred (inherent risk)
(2) It must not have been picked up by the client’s internal control system (control risk)
The error is now in the financial statements that are about to be audited, and together these two
risks determine the risk of a material misstatement ('ROMM').
(3) The financial statements are audited, but the auditor does not detect the misstatement
The error will now be in the published financial statements that will be sent to shareholders with
an inappropriate audit opinion - that they show a true and fair view (or present fairly), when they
do not.
5.3 What causes the risks?
Inherent risk can be increased by factors such as:
๏ Complex transactions
๏ Inexperienced staff
๏ Time pressure
๏ New IT systems
๏ Pressure to perform (leading to optimistic estimates)
๏ Cash businesses
Control risk can be increased by:
๏ A poor internal control system

๏ Poor supervision
๏ Poor compliance with internal control procedures
๏ In-experienced staff
๏ Shortcuts
๏ An unfavourable control environment (not supportive of internal controls).
Detection risk is decreased by:
๏ Performing more audit work eg larger samples are tested.

๏ Performing different audit work eg by attending inventory locations in every branch or by
enlisting the help of experts.
๏ Assigning more experienced audit staff.
๏ Greater supervision and review of the audit work.
๏ A quality control review before the auditor's report is issued (one partner reviewing the work of
another).
5.4 What can be done about the risks?

The auditor can do little about the inherent risk. Over time the auditor might be able to decrease the
control risk by writing to the client and making recommendations about how the internal control
system could be improved or more consistently implemented. However, that auditor can affect the
detection risk as that is determined by the amount and nature of the audit work carried out.
Therefore, if inherent risk and/or control risks are high, the auditor can reduce audit risk to an
acceptable level by performing more audit work.
If inherent risk and control risk are both low, the auditor will be able to perform less work because
there is only a low risk of an error having occurred and then only a low risk that the client’s system will
not detect the misstatement.
5.5 Professional scepticism
The amount of audit work that has to be carried out should be influenced by the concept of
professional scepticism. If you are sceptical it means that you do not know whether or not something
is true; you would have a questioning attitude and would not believe something in the absence of
reasonable evidence.
Auditors must adopt this attitude. This does not mean that they suspect all directors and employees
in the client company of telling lies and deliberately misleading them, but they are aware that
everyone makes mistakes, everyone can be unrealistically optimistic, and that everyone can give
quick but incorrect replies if under time pressure. Of course, human nature being what it is,
occasionally auditors will be deliberately given incorrect information.
Professional scepticism affects the amount of audit work that has to be carried out. It includes being
alert to, for example:
๏ Audit evidence that contradicts other audit evidence obtained.

๏ Information that brings into question the reliability of documents and responses to inquiries to
be used as audit evidence.
๏ Conditions that may indicate possible fraud.
Maintaining professional scepticism throughout the audit is necessary if the auditor is, for example, to
reduce the risks of:
๏ Overlooking unusual circumstances.

๏ Over generalising when drawing conclusions from audit observations.
๏ Using inappropriate assumptions in determining the nature, timing and extent of the audit
procedures and evaluating the results thereof.
5.6 Fraud
It is not the auditor’s responsibility to detect fraud – though if it gives rise to a material misstatement,
an audit should provide reasonable assurance that the fraud is discovered. Fraud may involve
sophisticated and carefully organised schemes designed to conceal it. Therefore, the procedures used
to gather audit evidence may not be effective for detecting an intentional misstatement that involves,
for example, collusion to falsify documentation which may cause the auditor to believe that audit
evidence is valid when it is not.
Nevertheless, as part of planning the audit, the engagement team members and the engagement
partner must discuss on how and where the entity’s financial statements may be susceptible to
material misstatement due to fraud, including how fraud might occur.
Question 1
What are the three components of audit risk and which can the auditor most easily affect?
Question 2
It is the auditor’s responsibility to detect fraud.
Question 3
Professional scepticism means not trusting anyone.
Question 4
Which two of the following would increase the risk of a misstatement in the draft financial
statements presented to an auditor to audit?
A Inexperienced accounting staff
B Inexperienced auditors
C Complex transaction
D A good system of internal control
Question 5
What are the commonly used benchmarks for materiality in terms of profit, revenue and total
assets?
Chapter 5
TESTS OF CONTROL AND SUBSTANTIVE
PROCEDURES
1. Introduction
The previous chapter introduced both the following diagram of the audit process and the
components of audit risk:
Planning the audit
Understand the
entity and its
environment
Preliminary
materiality
Assessment of risks
Responses to risk
Good internal Poor internal

control expected control expected
Test internal
control
In
(let effec
ter ti
to m ve co
Effective ana ntrol
controls gem s
ent
)
Full
Reduced substantive
substantive procedures
procedures
Final review
Report
and the audit risk model:
Audit risk = Inherent risk x Control risk x Detection risk
We now bring these concepts together to determine how the audit approach.
2. General audit approaches

As shown by the diagram, there are only two general approaches to the auditor’s response to
assessed risks:
๏ Either to use substantive procedures only (‘substantive approach’) – right side of diagram
๏ Or use tests of controls and substantive procedures (‘combined approach’) – left side of
diagram
As explained in the next section, using tests of controls alone is not an audit approach.
Where it is possible to use tests of controls (ie controls are effective), the combined approach will
usually be more efficient than the substantive approach. This is because, in the combined approach,
substantive procedures will be reduced.
Tests of controls and substantive procedures are collectively referred to as ‘further audit
procedures’ (i.e. the procedures to obtain audit evidence after performing the risk assessment
procedures).
Test of controls – these provide indirect evidence about the accuracy/completeness, etc of
transactions (and hence balances) because they are just that – a test of control – was the control
applied – yes or no? Substantive procedures (which include substantive analytical procedures and
tests of details) provide direct evidence about the accuracy/completeness etc of transactions and
balances because they are concerned with monetary amounts
3. Further audit procedures

3.1 Tests of controls
If the internal control system of the company is good, then the control risk is low and this will result in
a low audit risk – provided the controls are effective.
Consider for example the control that all purchases are authorised before an order is placed with a
supplier. This should apply to all purchases regardless of the monetary amounts involved. The test of
the control will not distinguish between a purchase order for $500 of goods and a purchased order for
$50,000 of goods.
This is why it is not possible to use tests of controls alone - some substantive procedures must always
be performed to obtain audit evidence about monetary amounts.
As another example, if an internal control is that all overtime claims have to be authorised by a
supervisor, then the auditor would choose a sample of the claims to inspect them for the supervisor’s
signature. As part of this test, the auditor is not really concerned with the amount of overtime: if the
supervisor has been doing his job properly, the overtime payments will have been approved.
3.2 Substantive procedures
Substantive procedures are designed to detect material misstatements in the financial statements.
They are therefore concerned with the monetary amounts of transactions (in the statement of profit
and loss) and balances (in the statement of financial position).
There are two types of substantive procedure:
๏ Substantive analytical procedures

๏ Tests of details
So, using the overtime example, what procedures may be used to determine whether the overtime
cost is correct?
Analytical procedures were introduced in the previous chapter as an essential risk assessment
procedure carried out at the planning stage. In contrast, substantive analytical procedures will only
be carried out when it is more effective than using tests of details alone. This will usually be the case
for large volumes of transactions that tend to be predictable over time. So, for example:
๏ Comparing the total cost of overtime to the previous year and/or budgeted cost
๏ A month-by-month comparison of the cost of overtime and investigation of very high or low
amounts
๏ Comparing actual overtime payments against predictions based on production volume
๏ Analysing overtime payments amongst staff in the same department to see if anyone appears to
be consistently paid large amounts.
Tests of details
๏ Agree a sample of overtime hours claimed to work records.

๏ Recalculate a sample of overtime payments (number of hours x hourly overtime rate).
3.3 Internal controls not operating effectively

Sometimes the auditor will start the audit on the assumption that there is a good internal control
system, but then discover that the controls are not operating effectively.
In such a case the auditor will have to change from the combined approach to the substantive
approach – in the areas where internal control is not effective.
A management letter (see Chapter 11) will be sent by the auditors to management explaining:
๏ The internal control deficiencies.

๏ The possible consequences
๏ How the deficiencies can be fixed.
3.4 Reduced substantive procedures
Even where companies have very good systems of internal control, the auditor cannot obtain
sufficient evidence to form an audit opinion through tests of internal controls alone. Even though the
extent of substantive procedures necessary will be reduced - the need for substantive procedures
cannot be eliminated altogether.
However 'good' or 'sound' a system of controls appears to be - it cannot be infallible. Controls can
only reduce, but not eliminate, risks of material misstatement due to inherent limitations:
Human error human error may lead to breakdowns in internal

control. For example, in the design of computer
processing controls.
Failure to understand or take action there may be ineffective controls because individuals
may not understand the purpose of a specific control.
For example, the purpose of a payroll exception report.
Inappropriate management override management may purposefully override existing

controls. For example, a sales director may choose to
opt to extend credit to a long-standing customer in
order to create customer goodwill, in contravention of
laid down credit control procedures.
Collusion by two or more people cooperation to circumvent controls. For example,

between a factory employee, factory manager and a
wages data processing clerk to claim, authorise and
process a fraudulent payment for overtime wages.
Cost benefit consideration For example, the cost of employing additional accounts
staff to ensure adequate segregation of duties may
outweigh the maximum benefit to be derived from
improved internal control.
Non-routine transactions relatively rare transactions may fall outside routine

control procedures (which may be highly automated).
For example, the disposal of factory plant and
equipment.
3.5 Audit efficiency
If there is a good internal control system, and this is verified by testing the operation and effectiveness
of the controls, the auditor will assess control risk as low. This will result in a very efficient audit
because relatively few instances of the control operating have to be tested: maybe 30, 60 or 100 (but
typically not more than 100).
Therefore in a multi-million $ enterprise with thousands of invoices being processed daily, the auditor
can collect sufficient appropriate audit evidence that, for example, an invoice cannot be paid twice, by
inspecting relatively few paid invoices to make sure that they have been marked as paid in some way
(eg stamped 'Paid'). Marking the invoices ‘Paid’ is part of the internal control system and if all invoices
inspected have been properly stamped 'Paid' the auditor will have evidence that the control is
operating correctly. This is obviously a very efficient audit approach. It’s not foolproof, of course, as
there could be invoices that were not marked 'paid' but not in the sample selected. This 'sampling
risk' is considered later in Chapter 7.
If the internal control system had originally been judged to be poor, the substantive approach will be
the most efficient, even though this may require more audit effort than if the controls had been
effective. What would be inefficient, would be start taking the combined approach and the having to
switch to the substantive approach (eg due to insufficient understanding in planning the audit).
Even if there appear to be good controls, the auditor make take the substantive rather than combined
approach because it is the more efficient. For example, auditors may decide that 100% testing is
appropriate where there are a small number of high value items that make up a population. An
example would be a property development company that has only 20 purchase/sale transactions in
the year. Each transaction is likely to be material and there is no gain in efficiency or audit
effectiveness by not looking at all 20.
Question 1
What are the two types of substantive procedure?
Question 2
Which of the following is a test of control?
A Inspect a sample of timesheets for authorisation of hours worked
B Make enquires of management about changes in the payroll during the year
C Agree a sample of wages and salaries payments to the payroll
D Compare the monthly payroll with budgeted employee costs
Question 3
If internal control is very good, auditors can rely on tests of control and do not need to carry out any
substantive procedures.
Question 4
What are the three elements of a management letter?
Chapter 6
ASSERTIONS AND AUDIT EVIDENCE
1. Introduction
When a figure appears in financial statements it is making a number of assertions. For example, if the
receivables figure is $2,453,000, the figure is asserting:
๏ The amount has been properly valued

๏ The receivables are owned by the company
๏ The receivables exist
๏ The receivables are complete
๏ The amount is indeed properly described as receivables.
It is not possible to simply audit $2,453,000 ‘in one go’: each financial statement assertion requires
audit evidence.
2. Assertions about classes of transactions and events and

related disclosures
These assertions relate to the period under audit:
๏ Occurrence – transactions and events that have been recorded or disclosed have
occurred and pertain to the entity.
๏ Completeness – all transactions and events that should have been recorded/
disclosed have been recorded/disclosed.
๏ Accuracy – amounts have been recorded appropriately and related disclosures
have been properly measured and described.
๏ Cut-off – transactions and events have been recorded in the correct
accounting period.
๏ Classification – transactions and events have been recorded in the proper
accounts.
๏ Presentation – transactions and events are appropriately aggregated (or
disaggregated) and clearly described. Related disclosures are
relevant and understandable.
3. Assertions about account balances and related disclosures

These assertions relate to the period end:
๏ Existence – assets, liabilities and equity interests exist.

๏ Rights and obligations – the entity holds or controls the rights to assets,
and liabilities are the obligations of the entity.
๏ Completeness – all assets, liabilities and equity interests that
should have been recorded have been recorded
and all related disclosures included.
๏ Accuracy, valuation and allocation – assets, liabilities and equity interests are included
at appropriate amounts and any resulting
valuation or allocation adjustments are
appropriately recorded Related disclosures are
appropriately measured and described.
๏ Classification – assets, liabilities and equity interests have been
recorded in the proper accounts.
๏ Presentation – assets, liabilities and equity interests are
appropriately aggregated (or disaggregated) and
clearly described. Related disclosures are relevant
and understandable.
Learn the assertions:
๏ Note that completeness, accuracy, classification and presentation are relevant to both
'transactions and events' and 'account balances' and their related disclosures.
๏ Understand that occurrence and cut-off relate only to transactions and events.
๏ Understand that existence, rights and obligations and valuation and allocation relate only to
account balances.
4. Audit evidence
4.1 Audit procedures for obtaining audit evidence
These are the possible procedures:
๏ Inspection
๏ Observation
๏ External confirmation
๏ Recalculation
๏ Reperformance
๏ Analytical procedures
๏ Enquiry
For the sake of easy learning they are sometimes written to (almost) form the vowels AEIOU:
๏ Enquiry and confirmation
๏ Inspection
๏ Observation
๏ RecalcUlation and reperformance
There are no methods to collect evidence that cannot be categorised under one of these headings.
Note from the following examples that:
๏ Analytical procedures, which concern monetary amounts, do not apply to controls.

๏ Observation, which means looking at a process or procedure, is used in tests of controls.
4.2 Examples of evidence collecting procedures
Procedure Example of use in tests of Example of use in substantive

control procedures
Analytical procedures – Comparison of receivables
collection period from one year to
the next to test the assertion of
valuation.
Enquiry and confirmation Ask the sales order clerk if he/she Ask the directors if all liabilities
performs a credit check before have been included in the
accepting an order. financial statements to test the
assertion of completeness.
(Then observe this check being
carried out and/or inspect sales Confirm the existence of
orders for a signature or other receivables by obtaining written
evidence of the check having confirmation from customers.
been performed.)
Inspection Inspect times sheets to ensure Inspect computers in the office to
that they have been signed by the test the assertion of existence.
supervisor as authorisation.
Observation Observe warehouse staff counting Not applicable
goods as they arrive to ensure the
quantity is as ordered.
Recalculation and Reperform the bank reconciliation Recalculate the year-end
reperformance to ensure that it was carried out allowance for irrecoverable debts
correctly. based on the aged analysis of
receivables to test the assertion of
valuation
Note that:
๏ For a test of control, enquiry alone would never be sufficient to conclude that a control is
operating effectively.
๏ Substantive procedures are directed to specific assertions.
4.3 Sufficient, appropriate audit evidence
So now we know the various procedures to obtain audit evidence, but how much audit evidence is
needed? The sufficiency and appropriateness of audit evidence are interrelated.
Sufficiency relates to the quantity of audit evidence. The quantity of audit evidence needed is
affected by the auditor’s assessment of the risks of misstatement (the higher the assessed risks, the
more audit evidence is likely to be required) and also by the quality of such audit evidence (the higher
the quality, the less may be required). Obtaining more audit evidence, however, may not compensate
for its poor quality.
Appropriateness relates to the quality of audit evidence - its relevance (ie to the financial statement
assertions) and reliability. With respect to the reliability of audit evidence we can say that, in
general:
๏ External evidence is stronger than internal evidence.

๏ Written is stronger than oral.
๏ Evidence is better if the internal control system is strong.
๏ Evidence obtained directly by the auditor is better than evidence obtained via the client.
๏ Originals are better than photocopies.
Therefore, a director simply telling the auditor something is very weak evidence (internal, oral). A bank
writing to the auditor to confirm the bank balance is very strong evidence (written, external, obtained
directly by the auditor).
Question 1
What are the financial statement assertions about classes of transaction and events?
Question 2
Which financial statement assertions relate to balances at the period end?
Question 3
What are the ways in which audit evidence can be collected (AEIOU)?
Question 4
An auditor requires __________ audit evidence that the financial statements are free from material
misstatement.
Complete this statement.
Question 5
Select from each of the following pairs of terms, the word(s) that describe the more reliable
audit evidence.
Written Oral
Obtained via the client Auditor direct obtained
Internal External
Photocopies Originals
Chapter 7
AUDIT SAMPLING
1. Introduction
Unless an audit client is very small almost all audit 'testing' relies on sampling. This is because there
simply isn’t time to examine all documents, transactions and balances and it wouldn’t be
economically viable to do so. If, however, valid statistical conclusions are to be drawn about a
population based on a sample, then the sample must be free from bias. In other words every
document, transaction or balance in the population has an equal chance of being included in the
sample. This is known as audit sampling.
2. Audit sampling
The process involves:
๏ Sample design – includes specify the population (is it complete?)

๏ Sample size – must be sufficient to reduce sampling risk (as explained in Chapter 9)
๏ Sample selection – choose a selection method (see below)
๏ Performing audit procedures – test the selected items. This will be either a test of controls or a
test of details (a substantive procedure).
๏ Evaluate sample results – investigate all ‘errors’ (see later) and conclude on the population.
In statistical sampling:
๏ Sample selection must be regarded as random, and

๏ Probability theory must be used to evaluate sample results including measurement of
sampling risk (which will determine the sample size).
If either of these conditions is not met, sampling is non-statistical.
3. Selection methods
๏ Random selection. The best way to remove bias and to obtain a representative sample is to
adopt what’s called random selection. Let’s say we wanted to look at purchase invoices
throughout the year. There might be 20,000 purchase invoices and we want to inspect 20 of
them. What you would do is to number the 20,000 invoices consecutively and then use a
random number generator to produce 20 numbers and you would then go and look at the
corresponding invoices. The difficulty with this approach is that very often the population is not
pre-numbered and to set out initially numbering all 20,000 invoices would be very time-
consuming.
๏ Systematic ('interval') selection. This is an approximation to pure random selection. Again, if
with 20,000 invoices you wanted to look at about 20 invoices you could do that by looking at
every 1,000th invoice. So what you would do is that near the beginning of the population you
would choose an invoice at random and then count through selecting every 1,000th one.
Provided there isn’t some weird correspondence of every 1,000 invoice being from exactly the
same supplier, you are going to get pretty close to random selection.
๏ Haphazard selection. This is frequently used because it is convenient. For example, the auditor
opening a file at random and picking the invoice at which the file is opened. There can be
obvious problems with this. The file might always open at a slightly thicker invoice or a slightly
larger invoice and that invoice could be from the same small group of suppliers. There might be
a relatively small chance of the physically small invoice being chosen. There is also a risk of bias.
The auditor may, consciously or unconsciously pick out invoices which appear to be correct (so
quickly dealt with) or 'more interesting' (perhaps more likely to have an error). The sample is
therefore unlikely to be representative, so cannot be used in statistical sampling.
๏ Block selection. For example choosing 20 invoices all in a sequence. Depending on how they
are filed, they could all from the same supplier or may be from different suppliers, but all with
the same date. This is not a representative sample. (Clearly it would not be possible in a test of
control to conclude on the effectiveness of controls throughout the period.)
๏ Stratification. If we know that there are 20,000 invoices, 10 of those are above 100,000 then it
might make sense to make sure we choose at least all of those 10 invoices plus another 10
chosen randomly. Stratification means dividing your population into different sub-populations
('layers') with similar characteristics (usually monetary amount). The results of testing each layer
must be separately evaluated.
๏ Value-weighted selection. This is used in monetary unit sampling and is rather more complex
as described on the next page.
4. Monetary unit sampling

Monetary unit sampling uses a form of interval selection but based on monetary amounts (hence
'value-weighted selection'). Here is an illustration, but note that you will not be expected to apply this
(or indeed any selection method) in the exam.
Invoice Cumulative
value invoice value
($) ($)
80 80
70 150 5,000/4 = 1,250
400 550
90 640 Choose first at random – say, 605
1,600 2,240 Then: 1,855 ( = 605 + 1,250)
20 2,260
700 2,960
50 3,100
1,010 4,020 Then: 3,105 ( = 1,855 + 1,250)
80 4,100
30 4,130
600 4,730 Then: 4,355 ( = 3,105 + 1,250)
380 5,110
What we have is a list of say customer invoices 80, 70, 400, 90, all the way down to 380.
The right hand column of the table is a cumulative total, so the first one is 80, then 80 plus 70 is 150,
150 plus 400 is 550, 550 plus 90 is 640, so our total receivables is 5110.
We want to look at four invoices out of these receivables. So you take the total, and if we round it to
5,000 and divide by 4 that give 1,250. Choose the first interval at random, here is say 605, and then go
up 1,250 at a time. So after 605 plus 1,250 will be 1,855, plus 1,250 will be 3,105, plus 1,250 will be
4,355 and you see where a cumulative total of those values lie. So 1,855 falls within the cumulative
total of 2,240 and that corresponds to the invoice value 1,600. The next one 3,105 falls within the
cumulative 4,020 and that corresponds to the invoice with value 1,010.
What this process does is increase the chance of selecting higher value transactions. This will direct
testing to where there is the greatest potential for misstatement. Note that any invoice value which
exceeds the interval (here only 1,600) is guaranteed to be selected. This also has the effect of
stratifying the population.
5. Audit risk revisited

5.1 Introduction
You should remember from a previous chapter that audit risk is the risk that the auditor comes to the
wrong conclusion about the financial statements and gives an inappropriate opinion. One of the
contributors to audit risk was detection risk – the auditor failing to spot a misstatement.
Detection risk has two causes: sampling risk and non-sampling risk.
5.2 Sampling risk
This can be described as ‘bad luck’. For example, a population contains 10% of documents that have
not been properly approved. If a sample of 10 items were randomly chosen there is approximately a
35% chance (0.910) that no non-approved items have been chosen. If the auditor only happens to pick
10 good invoices the auditor will conclude that the internal control is working well when, in fact, 10%
of invoices are not approved.
Sampling risk is reduced by increasing the sample size. If 30 were chosen then the chance of not
finding a bad invoice is reduced to 4%.
Sample size should be large enough to reduce sampling risk to an acceptably low level.
For tests of controls sample size is affected by:
๏ The extent to which the auditor relies on the control

๏ The desired level of assurance
๏ The expected rate of deviation. The higher the rate of deviation the greater the sample size
needs to be to draw conclusions.
For tests of details sample size is affected by:
๏ The risk of material misstatement (the greater the risk, the larger the sample)
๏ What other audit work can be done to address the same assertion
๏ The desired level of assurance
๏ Stratification (generally reduces total sample size for the population).
5.3 Non-sampling risk

Non-sampling detection risk is defined as any risk not arising from sampling. For example, if
transactions were very complex and the auditor lacked the right knowledge to examine the
documents properly, it wouldn’t matter if 100% were selected as the auditor would not be capable of
finding any errors. The auditor simply doesn’t know what to look for.
Non-sampling risk is reduced by:
๏ Assigning more experienced staff to the audit

๏ Proper direction and supervision
๏ Careful review
๏ Training
Question 1
Explain what is meant by the term ‘statistical sampling’.
Question 2
Explain what is meant by the term ‘'stratification'.
Question 3
Identify which of the following selection methods may be used in statistical sampling (S) and
which can only be used in non-statistical sampling (N).
N or S
Haphazard
Monetary unit
Systematic
Block
Question 4
How can sampling risk be reduced?
Question 5
How can non-sampling risk be reduced?
Chapter 8
USING THE WORK OF OTHERS
1. Introduction to internal audit

The internal audit function is an appraisal and monitoring activity established by management and
directors for the review of internal control as a service to the entity.
Remember that the directors are required under corporate governance codes to review the need for
internal audit. Normally to achieve an element of independence from the executive directors, you
would expect internal audit to report to the audit committee, which is responsible for monitoring and
reviewing the effectiveness of internal audit.
The main function of the internal audit department is to examine, evaluate and report to
management and directors on the adequacy and effectiveness of internal control. They will play a
major part in designing internal control system and will report on departures from that system and
give suggestions about where it can be improved.
2. Internal audit functions

Here is the list of the typical functions of an internal audit department:
๏ Helps achievement of corporate objectives (how could a company make profits if it doesn’t
safeguard its assets or properly record transactions?)
๏ Aids risk assessment and management.
๏ Improves efficiency, effectiveness and economy.
๏ Designs internal control system.
๏ Checks operation of internal controls system.
๏ Value for money audits.
๏ Tests IT controls.
๏ Liaises with external auditors/shares work.
And finally internal audit often plays a major part in liaising with external auditors and sharing work.
Typically in very large organisations the external auditors do not visit every department or every
branch, every factory or every outlet. Quite a lot of that audit work is carried out by the internal audit
department and the external auditors will review the working papers and findings of internal audit.
Generally the external auditors will move around to different departments and branches so that over
a period of few years, external auditors have visited every part of the client.
3. Using the work of internal audit

The external auditor may decide to use the work of internal audit provided that internal audit:
๏ Is objective and supported by organisational status (eg has direct access to those charged with
governance); and
๏ Is competent – not only in terms of professional qualifications and experience but whether it
has adequate resources; and
๏ Applies a systematic and disciplined approach to planning, performing and documenting its
activities, including quality control.
All three criteria must be met (ie a high level of objectivity cannot compensate for a lack of
competence, or vice versa). If the auditor decides to use the work of internal audit, the auditor must
evaluate whether the work of internal audit is adequate for audit purposes.
4. Using the work of experts

Using the work done by internal audit is one example of where auditors rely on the work of 3rd
parties. Other examples include:
๏ Relying on experts such as estate agents, actuaries, lawyers.

๏ Relying on the work of other external auditors (e.g. if some companies in a group have different
auditors). This is not examinable in FAU.
There are two classes of expert (ie expertise in a field other than accounting or auditing):
๏ Management’s expert – assists management in preparing the financial statements.

๏ Auditor’s expert – assists the auditor in obtaining sufficient appropriate audit evidence. May
be internal or external to the audit firm.
If the work of management’s expert is to be used as audit evidence (ISA 500), the auditor must
evaluate:
๏ The expert’s competence, capabilities and objectivity

๏ The appropriateness of their work to the relevant assertion(s)
๏ Whether it is sufficiently reliable for audit purposes (i.e. accurate and complete and sufficiently
precise and detailed).
An auditor’s expert (ISA 620) may be needed:
๏ To evaluate the work of management’s expert

๏ If management does not have necessary expertise/a management expert.
This should be determined at the planning stage of the audit. The auditor must evaluate the
competence, capabilities and objectivity of the auditor’s expert (as for management’s expert).
The following matters must be agreed, in writing, with the auditor's expert:
๏ Nature, scope and objectives of work

๏ Respective responsibilities
๏ Nature, scope and timing of communications
๏ That the expert observes confidentiality
The auditor must evaluate the adequacy of the expert's work including:
๏ Consistency with other evidence. For example, if a property valuer reported a decrease in the
value of a client’s property portfolio, yet the newspapers were full of news about a property
boom, the auditor should challenge the valuer’s results.
๏ Assumptions made. For example about the rate of returns that might be earned on pension
funds.
๏ Use and accuracy of source data. To value property the valuer must start with an up-to-date list
of the properties the company owns.
Question 1
What is the main function of internal audit?
Question 2
What three criteria must be met for the auditor to use the work of internal audit?
Question 3
What is the difference between management’s expert and an auditor’s expert?
Question 4
When may an auditor’s expert be needed?
Chapter 9
COMPUTER ASSISTED AUDIT
TECHNIQUES
1. Introduction
Even very small businesses will usually maintain their computer records on computer. There are many
advantages to this, not least that trial balances will usually balance and control accounts will reconcile
to the underlying detailed records. However, the absence of as many hand-written data and
documents data can make auditing more difficult. For example, it can be difficult to test whether a
computer is carrying out a procedure correctly and it can be more difficult to ‘see’ and examine the
information and records than in a manual system.
Computer Assisted Audit Techniques (CAATs) have been developed to assist the auditor when the
client maintains computerised records.
2. Types of CAAT
2.1 Audit software
Audit software (or audit programs) is software developed and used by auditors. Audit software allows
clients’ accounting data files to be read and examined.
Auditor’s Reads Client’s accounting

audit software data
The processes carried out by the auditor’s software commonly include:
๏ Adding up the records. For example, inventory values and receivables balances. The totals are
the amounts that should appear in the statement of financial position.
๏ Performing calculations for analytical procedures.
๏ Identifying and printing details of unusual items for further investigation, such as credit
balances on a receivables ledger or negative inventory balances.
๏ Picking samples. For example, that audit software can be programmed to create a stratified
sample or a pure random sample.
๏ Picking all items with particular characteristics, such as all sales orders approved by a certain
employee.
Once it is set up, audit software can quickly, efficiently and economically examine every item on a
data file. This which would often be difficult or impossible if attempted manually. It can greatly speed
up audit procedures and reduce costs.
2.2 Test data
Test data is auditor’s data that is operated on by client’s program. It is used to test the workings and
resilience of programs.
Auditor’s Is processed by Client’s accounting

test data software
The results produced by client programs are compared with predictions of what should happen and
any discrepancies are investigated.
Test data is designed to:
๏ Test that calculations are carried out correctly by client software. For example, enter time sheet
data of 50 hours worked and ensure that the correct wages and tax are calculated.
๏ Test that programmed controls and procedures are carried out correctly. For example, if a
client’s system should reject orders from customer over their credit limit, test that such orders
are indeed rejected by entering an order that should be rejected.
๏ Test how resilient software is against input errors. For example, test what happens if an account
number is entered incorrectly, or a negative amount of goods is ordered, or an impossible date
is entered.
Test data will therefore include normal error-free items, some unusual items and some extreme or
unexpected items. Test data will therefore usually be 'dummy' data rather than actual data. Also,
because of the risk of corrupting the client's records with such data, it will usually be processed
'dead' (ie using copies of files) rather than live.
Question 1
What is ‘test data’?
Question 2
Which of audit test data (TD) or audit software (AS) would be more useful for the following?
To determine what would happen if a negative amount of goods were ordered

To find and print out negative inventory amounts
To select receivables balances for verification
To re-perform an aged receivables analysis
To determine whether a customer can exceed their credit limit
Question 3
Which two of the following statements are correct?
A Audit software belongs to the client and is applied to the auditor’s data.
B Audit software belongs to the auditor and is applied to the client's data.
C Test data is the client’s and is processed by audit software.
D Test data is the auditors and is processed by the client’s programs.
Question 4
Which of the following is a use of test data?
A Extracting data from the client’s system for review
B Performing calculations for analytical procedures
C Processing data to confirm that controls are operating as expected
D Selecting a sample for tests of details
Chapter 10
AUDIT DOCUMENTATION
1. Introduction
Before the auditor can assess and test a client’s system of internal control, the accounting system
must be documented and understood. These processes are usually carried at the interim audit stage.
The accounting system documentation will be filed in the auditor’s permanent audit file for the client.
Each year, before starting the audit process the documentation has to be reviewed and updated for
any changes in the client’s system.
2. Control objectives, control activities and tests of control

2.1 Control objectives
The objective of controls is to prevent loss or damage to the client. For example, a company does not
want:
๏ Purchase invoices to be paid twice

๏ Goods to be despatched to non-credit worthy customers
๏ Overtime to be paid if not worked
๏ Inventory or cash to be stolen
๏ Non-current asset to be bought without proper authorisation
2.2 Control activities
Control activities are the policies and procedures that help ensure that control objectives are met. For
example, the above objectives could be met by:
Objective: to prevent Possible procedures (controls)

Purchase invoices to be paid twice Cancel invoices (e.g. stamp 'paid') when paid
Goods to be despatched to non-credit worthy Credit check before processing sales order
customers
Overtime to be paid if not worked Timesheets or clock cards are authorised by
supervisor
Inventory or cash to be stolen Physically safeguarding these assets
Non-current asset to be bought without proper Requisition for capital expenditure signed by a
authorisation. director before an order is placed
2.3 Tests of control
Once control procedures have been identified then they can be tested to see if they are operating
properly.
Possible procedures
Objective: to prevent Test of control
(controls)
Purchase invoices to be paid Cancel invoices when paid Select 20 paid invoices and
twice inspect them to ensure that
they have been cancelled.
Goods to be despatched to Credit check before processing Select 20 sales orders and
non-credit worthy customers sales orders inspect them to see if they are
marked as having been
approved for credit.
Overtime to be paid if not Timesheets or clock cards are Select 15 timesheets and
worked authorised by supervisor inspect them to ensure that all
have been signed by the
supervisor as authorisation.
Inventory or cash to be stolen Physically safeguarding these Observe how inventory and
assets cash is safeguarded.
Non-current asset to be bought Requisition for capital Select 10 purchase orders for
without proper authorisation. expenditure signed by a non-current assets and inspect
director before an order is them to ensure that they are
placed supported by an authorised
requisition.
3. Methods of documenting the internal control system

3.1 Narrative
Short descriptive passages are written setting out the various stages in the accounting system. For
example:
“When inventory falls below the reorder level, a pre-numbered purchase requisition is raised and
signed by the stores supervisor. This is passed to the purchasing department where three suppliers
are asked for prices. A three-part order is raised for the cheapest supplier and the order sign by the
purchasing manager”.
Narrative is quick to produce but lacks rigour and uniformity. For example, in the above system no
information has been given about where the purchase requisitions are stored or what happens each
of the three parts of the order.
Narrative notes tend to be used for smaller, simpler accounting systems.
3.2 Flowcharts
A flowchart is drawn showing documents, files processes and controls. Standard symbols are used
and the process is much more formal. For example, every document introduced to the flowchart
should be accounted for eg by filing, sending to the next department, or sending outside the
organisation. A special symbol is used to identify controls as these are important for the audit.
Flowcharts can be time-consuming to draw and amend, but they produce very structured and well-
disciplined descriptions of the client’s system. Each symbol can be numbered and cross-referenced to
the internal control procedures and test procedures that have to be carried out.
Flowcharts would normally be reserved for larger more complex accounting systems.
3.3 Questionnaires
An internal control evaluation questionnaire (ICEQ) asks about control objectives. For example:
Flowchart
Question Answer Justification for answer
reference
Can purchase invoices be paid No Invoices are cancelled by the P10
twice? purchase ledger clerk when they
are paid.
Can despatches be made to No Copy despatch notes are S12
customers but not invoiced? maintained in numerical sequence
with copy invoice attached. This
file is periodically reviewed to
ensure invoicing is complete.
In ICEQs if questions are answered ‘No’ then that is good news for the auditor.
An internal control questionnaire (ICQ) asks if specific controls are present. For example:
Flowchart
Question Answer Justification for answer
reference
Are suppliers' invoices cancelled Yes Invoices are cancelled by the P10
after payment? purchase ledger clerk when they
are paid.
Are despatch notes matched to Yes Copy despatch notes are S12
invoices to ensure all despatches maintained in numerical sequence
are invoiced? with copy invoice attached. This
file is periodically reviewed to
ensure invoicing is complete.
ICEQs require a greater degree of skill to complete as they leave it up to the auditor to decide if a
control objective has been met in some way or other.
ICQs are simpler to answer, but can be inflexible as control objectives might be met by another
control procedure.
4. Walk-though tests
Whenever documentation of a system has been completed for the first time, a walk-through test is
performed. This means that a particular transaction is followed through from start to finish to check
that the documentation is accurate. So a sales system would be verified by tracing from sales order,
despatch notes, invoice, receivables ledger, receipt of payment into the bank.
In subsequent years walk-through tests will be performed again to verify that the documentation still
accurately describes the accounting system.
5. Audit files
5.1 Introduction
It is essential that auditors carefully document all parts of their audit, including:
๏ Planning
๏ Information about the client
๏ The accounting system/internal control system
๏ Tests of controls
๏ Substantive procedures.
Careful documentation is needed to:
๏ Provide evidence of planning and risk assessment

๏ Provide evidence of the audit work performed.
๏ To facilitate review of the work, by supervisors, then managers, then the partner.
๏ To ensure that the work is carried out completely and in an orderly manner.
It is normal to divide the documentation over two files, the permanent audit file and the current audit
file.
5.2 Permanent audit file
As its name might suggest, the permanent audit file holds information which is relatively permanent
and which can be carried forward from year to year.
Typical contents are:
๏ Nature of the business

๏ Addresses of offices, factories etc
๏ Names of directors and senior accounting personnel
๏ An organisation chart
๏ Documentation of the accounting system eg flowcharts
๏ Previous sets of financial statements
๏ A schedule setting out a history of important ratios (for analytical procedures)
๏ The letter of engagement
5.3 Current audit file

This file contains details of the audit work done for the current audit and will have two main parts:
๏ Work carried out to test the system of internal control

๏ Work carried out to verify the amounts in the financial statements – substantive procedures.
As they progress through their work the audit team creates ‘working papers’ (now usually on
computer). Each working paper should show:
๏ The name of the client and the date of the financial statements being audited.
๏ The date of the test/procedure
๏ The aim of the test/procedure
๏ Cross referencing to ICQs or amounts in the financial statements
๏ The evidence obtained
๏ How exceptions, if any, were followed up
๏ The conclusions drawn
๏ The identity of the audit team member carrying out the test
๏ The identity of those who review the work and the dates of their reviews.
When the final audit is carried out, the draft financial statements will usually be placed at the
beginning of the file, and each figure will be referenced to files sections where details of the audit
work are set out.
For example
Egremont Co
Statement of financial position 31/12/20X4
$000
Non-current assets F1 23,000
Current assets
Inventory S1 5,000
Receivables R1 3,000
Cash C1 2,500
Egremont Co y/e 31/12/20X4 F1

$000
Non-current assets
Premises F2 20,000
Machinery F3 2,000
Motor vehicles F4 1,000
SOFP 23,000
Egremont Co y/e 31/12/20X4 F2

$000
Non-current assets
Premises
Cost F7 23,000
Depreciation (buildings) F7 (3,000)
F1 20,000
Ownership rights assertion tested by inspecting the land registry

Existence assertion tested by inspecting all premises.
Conclusion: rights and existence assertions satisfactorily tested.
Therefore, as the working papers are created, the cross-referencing system allows reviewers to easily
see the audit work carried out to test every relevant assertion.
5.4 Delegation, supervision and review
The staff who go to a client to perform the audit consist of an auditor in charge (sometimes called an
audit senior of supervisor) and usually one or more junior assistants.
The auditor senior delegates work to the assistants and then reviews the work that they have done by
examining the working papers. Sometimes it is decided to perform additional work if the initial results
are unsatisfactory. The reviewer will sign off each page reviewed, together with the date of the review.
When work at the client is completed, back at the auditor’s office the audit manager in charge of the
job will review the whole file again. More work or clarification might be requested at this stage also.
The audit manager signs off each page of working paper.
Finally, when all outstanding points have been completed, the audit file is reviewed by the partner in
charge. Usually it is the audit senior who takes the file to the partner because the partner will often
want to ask questions that only someone directly involved in examining client’s records can answer.
Sometimes, even at this late stage, the partner will request additional work to be performed.
The file has now been reviewed at least three times. If all is well with the file and the financial
statements, the partner will be prepared to sign the auditor’s report.
5.5 Quality control review
As part of auditors’ efforts to produce high quality work, most firms will engage in quality control
reviews. These are reviews of audits but they are carried out by a partner, or team of partners,
independent from the original audit. Often a partner from another office carries out the review.
There are two types of quality control review;
๏ Cold review: this is carried out after the audit has been completed and the auditor’s report
signed. It will examine all aspects of the audit: risk assessment, planning, audit evidence,
conclusions, completion of all documentation and the auditor’s report. Any shortcomings in the
audit process will be documented and reported to the partner, manager and perhaps more
junior staff.
๏ Hot review: this is carried out before the auditor's report is signed and is therefore potentially
disruptive as all audit files have to be made available to the reviewers. It is usually performed if
risk assessment has shown that the audit, or some part of it, is high risk. This 'pre-issuance'
review therefore provides some additional safeguards that will be effective before the auditor’s
report is signed.
Question 1
When are tests of control usually carried out?
A Interim audits
B Final audits
Question 2
What are the three ways of documenting an accounting system?
Question 3
What is a “walk though” test and what is it used for?
Question 4
In which document would each of the following questions typically appear?
1 Are goods checked against orders when received?
2 Can inventory be misappropriated?
Question 5
Is the following a control objective, a control activity or a test of control?
“All purchases of non-current assets exceeding $1,000 are authorised by the finance director”
Chapter 11
INTERNAL CONTROL
1. Introduction
The function of internal controls is to prevent or detect and correct errors in the accounting system.
The main control objectives aim to ensure that:
๏ All assets are safeguarded.

๏ All revenue is recorded.
๏ Only legitimate expenses are incurred
๏ All costs are properly recorded
๏ All liabilities are recognised
This chapter looks at the components of internal control.
2. Components of internal control

2.1 The five components
๏ The control environment
๏ Risk assessment process
๏ Information systems
๏ Control activities
๏ Monitoring of controls
2.2 The control environment
The control environment refers to the culture of the organisation:
๏ Are internal controls regarded as being important?

๏ Does management like a well-disciplined office and careful records?
๏ Does management appreciate good accounting information?
๏ Does management require careful recording of events and transactions?
All of these give a favourable control environment.
Contrast this with an organisation which:
๏ Is careless with its records

๏ Is lax about recording transactions
๏ Has an untidy office
๏ An attitude which thinks that internal controls are unnecessary, a nuisance and actually interfere
with the business’s operations.
All of these give an unfavourable control environment.
2.3 Risk assessment process
The purposes of internal control are to prevent errors, detect errors and fix errors. To accomplish this
effectively, management must be aware about where errors could occur and, in particular, where they
are likely to occur. High risk of errors implies that controls are necessary to counter that risk.
Furthermore, businesses do not stand still. They change and evolve as they try to remain successful or
to increase profits. As businesses change new risks will emerge and management has to devise new
controls.
For example:
(1) A business starts to export. Therefore there will be additional risks arising from exchange rate
fluctuations and that goods are damaged in transit.
(2) A business starts to trade over the internet. Therefore there are additional risks posed by hackers
and credit card fraud.
New risks imply new controls.
2.4 Information systems
Examples of records in an information system which are relevant to financial reporting include
(1) Monthly management accounts
(2) Aged receivables listings
(3) Aged inventory listings
These records and related procedures contribute to internal control as follows:
๏ Monthly management account allow comparisons to be made between actual and budget. If
actual expenses are running much higher, this might indicate an accounting error, or even
fraud.
๏ Aged receivables listings help with credit control and might prevent more goods being sent to
customers who are credit risks.
๏ Aged inventory listings will indicate which goods should be marked down for a quick sale and
which should not be ordered again.
2.5 Control activities
Generally, control activities relevant to an audit include the policies and procedures that relate to:
๏ Segregation of duties
๏ Authorisation
๏ Information processing
๏ Performance reviews
๏ Physical controls
Segregation of duties
‘Segregation of duties’ means that the authorisation of transactions, the recording of transactions and
the custody of assets should be assigned to different people. Therefore, for a purchase transaction,
each of the following should be done by a separate person:
๏ Authorising the purchase order

๏ Receiving the goods
๏ Posting the invoice
๏ Paying suppliers
Similarly, the following should be carried out by different people:
๏ Authorising salary levels

๏ Authorising overtime
๏ Paying salaries
Segregation of duties has two advantages:
๏ More than one person is involved so the errors of one are more likely to be identified by another.
๏ Fraud is more difficult because it would require cooperation (collusion) between several people.
Segregation of duties can be difficult for small businesses to achieve because they simply do not have
enough staff to allow transactions to be divided up. In small businesses more emphasis is placed on
the close supervision of owners and/or management.
Authorisation
For example, the following should all be authorised:
๏ Purchases of non-current assets

๏ Changes to wages and salaries
๏ Writing-off a bad debt
๏ Setting a credit limit
๏ Paying invoices
Authorisation is usually carried out by someone in authority signing or stamping a document. In a

computer system, a person’s log-on details can give them authority to approve transactions.
Information processing
General IT controls include, for example:
๏ Taking regular backups

๏ Keeping passwords secure
๏ Physical security of the server
๏ Controls over the implementation of software upgrades
Application controls (ie controls over a specific application such as sales, purchases or payroll
processing) include:
๏ Sequence checks (ie ensuring completeness of input documents)

๏ Edit checks (eg checking that input is in the required format or range of values)
๏ One-for-one matching (eg checking that there is a clockcard for every employee on the payroll)
๏ Control or batch totals (ie to agree an output total to a pre-determined input total)
Performance reviews
๏ Comparing actual performance against budgets, forecasts and prior periods

๏ Relating different sets of data (eg production volume against costs)
๏ Investigative and corrective actions (eg through variance analysis)
Physical controls
๏ Ensuring that inventory is kept securely

๏ Banking cash regularly
๏ Locking laptops away in the evenings
๏ Periodic inspection of assets and comparison with related records (eg inventory records and
non-current asset register)
๏ Also safeguarding of records of assets
2.6 Monitoring of controls

These controls assess the effective operation of internal control over time. They include regular
management and supervisory activities. For example:
๏ Management should review whether bank reconciliations are properly prepared on a timely
basis. (If not monitored, staff are more likely to stop preparing them.)
๏ Internal audit will typically evaluate the effectiveness of internal control, report deficiencies and
make recommendations for improvements.
4. Control deficiencies
3.1 Introduction
A control deficiency (weakness) can arise because a control has not been properly designed or not
properly carried out or is missing.
The auditor shall communicate in writing on a timely basis significant deficiencies in internal control
identified during the audit to those charged with governance and, unless inappropriate, to
management.
The auditor shall also communicate to management at an appropriate level of responsibility on a

timely basis other deficiencies in internal control that, in the auditor’s professional judgment, are of
sufficient importance to merit management’s attention.
Examples of matters that the auditor may consider in determining whether a deficiency or
combination of deficiencies in internal control constitutes a significant deficiency 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.
3.2 Management letters

The written communication of deficiencies in internal control are often by way of what is called a
management letter. This is a letter from the auditor to management and it is often set out with a
covering letter and an appendix in the following format:
Internal control deficiency Potential consequences Recommendation
Example: All stores should be fitted with

Stores are not locked at Goods could be stolen a secure lock and locked when
lunchtimes or in the evenings the stores are unmanned.
Question 1
What are the elements of an internal control system?
Question 2
What are the three sections of a management letter?
Question 3
What is meant by the term ‘segregation of duties?”
Question 4
Which one of the following is NOT a control activity?
A Authorisation
B Posting expense invoices to the Dr side of expense accounts
C Carrying out a bank reconciliation
D Ensuring anti-virus and anti-hacking programs always run on the IT system
Question 5
To whom should significant deficiencies in internal control be notified?
Chapter 12
EXAMPLES OF INTERNAL CONTROL AND
TESTS OF CONTROL
1. Introduction
This chapter looks at internal control procedures commonly found in accounting systems relating to:
๏ Sales
๏ Purchases
๏ Wages and salaries
๏ Non-current assets
The aims of all systems should be to ensure that:
๏ Only genuine business transactions are processed (i.e. are valid)

๏ Transactions are complete. It must be possible to trace a transaction through from beginning to
end – and in reverse order. This audit trail should be ‘watertight’
๏ Recording is accurate.
Think: “What could go wrong?” and try to devise a control that will prevent or detect errors.
The systems below are not universal, but they illustrate very typical approaches to internal controls.
2. Sales
2.1 Overview
The sales system can be represented as:
Granting credit and establishing a credit limit
Order processing
Despatch
Invoice and receivables
Receipt of payment
2.2 Granting credit and establishing a credit limit

Before any credit sales are made there should be control procedures in place to try to ensure that only
credit-worthy customers are accepted. A suitable initial credit limit and payment terms should be
established.
Controls therefore involve: examining the customer's most recent financial statements, enquiries to
credit reference agencies and the customer’s bank.
2.3 Order processing

As soon as an order is received it should be recorded, for example, by entering details in a register.
Later it should be possible to ensure that all approved orders have resulted in a sale.
Orders should be compared to the customer’s balance and credit limit to ensure the credit limit is not
breached.
Order quantities should be compared to inventory levels to ensure that goods are available.
The customer should be informed if there is going to be a delay either because of credit or inventory
problems.
If these checks are passed, then a multi-part pre-numbered despatch note should be raised. One copy
will remain in number order in the order processing department. Other copies of the despatch notes
are passed to the warehouse.
2.4 Despatch
The despatch notes are used to pick and pack the goods ordered. An independent check should be
performed in the warehouse to ensure that the goods conform to what was ordered.
One copy of the despatch can be packed with the goods (it will bear the customer’s order number so
that this can be checked when received by the customer).
One copy will go with the despatch as a gate release copy. As goods leave the company, there is often
a security gate where despatches are compared to despatch notes to ensure only authorised sales
leave the premises.
One copy can be sent to the accounting department for an invoice to be raised. One copy can go back
to the order processing department where it can be attached to the order to show that ordered goods
have been despatched.
The file of orders should be reviewed regularly for long-outstanding orders awaiting despatch; these
should be investigated.
The despatch note that accompanies the goods should be signed by the customer as proof of receipt
and returned to the company where it can be files in numerical order.
2.5 Invoicing
Invoices will be raised from the despatch notes and price lists. If manually raised, these should be
independently arithmetically checked.
One copy of each invoice will be sent to the customer.
One copy attached to the despatch note to ensure that all despatches are invoiced. This copy can also
be used to post the receivables ledger.
Invoices should be listed in a sales day book, then individual invoices posted to each customer’s
account. The sum of the sales day book can be posted to the receivables controls account. Regular
reconciliations should be performed between the controls account and the sum of the individual
ledger accounts.
Copy invoices should be marked “Posted” and a regular review should be carried out to ensure that all
invoices are accounted for and have been posted to the receivables ledger.
2.6 Receipt of payment
Receipts should be posted to each customer’s account and the cash book, and the sum of receipts
posted to the control account. Postings to the cash book should show the invoice number of the
invoice being paid
Aged receivables reports should be prepared regularly and slow payers followed up. A ‘Stop’ should
be placed on the accounts of very slow payers to prevent the situation deteriorating.
Statements should be sent each month to customers both to remind them of what they owe and also
to allow them to check the seller’s version of the account.
3. Purchases
3.1 Overview
The purchases system can be represented as:
Finding suitable suppliers and negotiating credit

terms
Order processing
Receipt of goods
Invoice and payables
Payment
3.2 Finding suitable suppliers and negotiating credit terms

Before any purchases are made there should be control procedures in place to try to ensure that
suitable suppliers are used. A suitable supplier might be one where a good discount has been
negotiated or where quality is very high. Sometimes companies have a policy to ensure that they
have several suppliers for each type of purchase and that quotes are always received from each before
an order is placed. A credit limit and payment terms should be agreed with each supplier.
3.3 Order processing

The store-keeper should regularly review inventory and raise a sequentially pre-numbered 2-part
purchase requisition when an item of inventory is below or close to its reorder level. Inventory records
should record the requisition number to ensure that the goods are not inadvertently ordered again. A
copy of each requisition should be filed in stores in numerical sequence.
A copy of the requisition note is passed to the purchasing department which will raise a sequentially
pre-numbered multi-part purchase order from a suitable supplier. The purchase price should be
stated on the order. One copy will stay in the purchasing department, one will go to the goods
received area of the warehouse and one copy will be sent to the supplier.
Long-outstanding orders and requisitions should be followed up: goods not received will hold up
production and jeopardise sales.
3.4 Receipt of goods
When goods are received they should be checked to the order to ensure that they are what was
ordered, counted and inspected for damage. A multi-part good received note (GRN) will be raised
when goods are received. This can be attached to the order and the two documents passed to
accounts.
Stores records and purchase department records should be updated from the copy goods received
notes.
Inventory should passed to stores where it should be correctly placed in the correct location.
3.5 Receipt of invoices
The GRN/order pair are in the accounting department, awaiting an invoice being received. When an
invoice is received it should be checked to these documents to ensure that only invoices for properly
ordered and received goods are processed. The invoice can be attached to the matched order/GRN.
Invoices should be analysed for expense category, input VAT etc. The analyses should be
independently checked.
Invoices will be listed in a purchases day book. Individual invoices will be credited to the appropriate
account in the purchase ledger, and the total of the purchases day book posted to the credit of the
payables ledger control account. Appropriate expenses accounts should be debited.
Invoices should be marked ‘Posted’.
If Order/GRN pair are outstanding for a long period, the company should investigate why this is the
case and, if so, alert the supplier that an invoice seems to be missing.
Monthly statements received from suppliers should be reconciled to the payables balances.
3.6 Payment
Payments might be made to every supplier after a set period of time, or a list of invoices outstanding
might be printed out for manual approval and cash flow management.
Once payments have been made, the invoices should be stamped 'paid' or otherwise cancelled.
Payments should be debited to individual supplier accounts and the total payments debited to the
receivables control account.
4. Wages and salaries

4.1 Overview
The wages and salaries system can be represented as:
Authorised recruitment
Authorised rates of pay
Weekly/monthly pay calculations
Payments to employees, tax authorities etc
Departure of employee
4.2 Authorised recruitment

Recruitment of additional or replacement employees should be authorised at an appropriate level in
the organisation. There should be a written record of the recruitment decision.
The employees bank details must be recorded.
4.3 Authorised rates of pay

The wage and salary rates should also be authorised at a senior level for new employees and for salary
amendments. There should be authorised rate of pay forms for each employee and only authorised
personnel should be able to alter rates.
4.4 Weekly/monthly pay calculations

Some pay calculations will be very simple. For example, many salaried employees will receive the
same amount each month. There might occasionally be bonus payments to make and these require
separate authorisation.
Some calculations are more complex. Hourly paid employees will be paid on the basis of time spent
working and there might be overtime and shift allowances. In this case, there should be controls to
ensure that staff are only paid for time or output. Typically, clock cards are used to allow the employee
to record arrival time and leaving time on a time recording system. This has to be monitored to ensure
that employees don’t clock each other out and in to inflate their hours.
Based on salaries or hourly rates/time, gross pay, tax and other deductions can be calculated. If this is
done manually, it will have to be independently checked. Normally it will be done by computer.
4.5 Payments to employees, tax authorities etc
The payroll amounts should be scrutinised by a senior member of management who will be looking
for consistencies with previous periods.
If wages are paid by cash, the payroll cash should be held securely until paid out. Employees need to
present identification and must sign when they receive their wages. Special arrangements should be
in place to allow substitute employees to pick up wages on behalf of absent colleagues.
Credit transfer payments are much easier and safer.
Every month, a senior member of management should ensure that deductions are paid over to the
tax authorities etc.
4.6 Departure of employees
There should be standard systems and documentation in place to ensure that details of all leaving
employees are sent to the payroll department.
Every year, all managers should be circulated with a list of their employees who are on the wages
system and they should verify that the employee is still actually employed and that the rate of pay is
correct.
5. Non-current assets
5.1 Overview
The purchases system can be represented as:
Finding suitable suppliers and negotiating credit

terms
Order processing
Receipt of goods
Invoice and payables
Payment
The controls needed here are very similar to those for other purchases, but there will be differences.
(1) Capital expenditure is usually carefully budgeted because it is a long-term investment (whereas
purchases of goods for resale should produce revenue reasonably quickly). Therefore,
expenditure needs to be authorised by senior management or the board.
(2) Once a non-current asset is bought, the company is ‘stuck with it’ for some years, so it important
to choose carefully.
(3) A single purchase can be for a significant amount, so it is important to get competitive quotes.
(4) The assets should be inspected every year to ensure that they are still there and are still being
used.
As for the sales system, there must be controls to ensure that disposals of non-current assets are
approved and completely and accurately recorded.
6. Tests of control
The precise internal control systems used by the client will be documented by the auditor. As
previously described the auditor can use narrative, flowcharts ICQs or ICEQs (or a combination of
methods).
The consistent and effective operation of the controls then needs to be tested: the auditor has to
collect evidence that the control is operating properly.
Evidence about the operation of controls can be collected by:

๏ Inspection
๏ Observation
๏ Re-performance.
Some examples of evidence of controls operating were given in chapter 6. Here are some more
examples of audit tests that tie in to some of the systems described above:
Control procedure Evidence

Sales All goods despatched notes should Inspect the file of copy despatch
have a copy of the invoice attached notes in the accounting department
to them. to ensure that each of 20 despatch
notes chosen at random has a copy
[A control procedure to meet the invoice attached
control objective that no dispatches
can be made without invoicing]
Purchases All purchases of >$1,000 should have Inspect 15 orders in copy order files
three supplier prices quoted and be for evidence of competitive
awarded to the lowest price supplier. tendering.
[A control procedure to meet the

control objective that goods are not
bought at inflated prices]
Wages and salaries All clocking-in and clocking-out by Observe staff arriving and leaving on
staff is supervised by the factory 3 separate days to ensure the
manager. processes are supervised by the
factory manager.
control objective that unworked
hours are not paid for.]
Non-current assets All non-current assets of with a Inspect 10 records in the asset
carrying amount >$1,000 should are register with carrying amount
physically verified each year for >$1,000 to ensure that the physical
existence and continued use. inspection date noted is within the
previous12 months
control objective that assets are
safeguarded]
Question 1
What are the four ways in which internal control can be tested?
Question 2
What is meant by the term ‘audit trail’
Question 3
A manufacturing company is evaluating its internal control system for purchases.
State FOUR objectives of the internal control that should be exercised over the purchases and
trade payables system.
Question 4
Describe three internal control objectives of a wages and salaries system.
Chapter 13
SUBSTANTIVE PROCEDURES
1. Introduction
Substantive procedures are generally carried out during the final audit when the draft financial
statements have been produced. Each material amount on the statements has to be audited for all
relevant assertions.
To recap, methods of gathering evidence are:
๏ Inspection
๏ Observation
๏ RecalcUlation and reperformance.
And the assertions are:
Relevant to transactions Relevant to period end

and events balances
Accuracy X X
Completeness X X
Cut-off X
Classification X X
Presentation X X
Occurrence X
Valuation and allocation X
Existence X
Rights and obligations X
This chapter looks at typical substantive procedures for:
๏ Inventory
๏ Receivables
๏ Cash
๏ Trade payables
๏ Accruals and prepayments
๏ Non-current assets
๏ Contingent liabilities and assets
2. Inventory
2.1 Introduction
Inventory is one of the most challenging items to audit. There are difficulties ensuring that the
physical quantities are correct and then ensuring that inventory is properly valued at the lower of cost
and net realisable value. Valuation is more involved than looking at purchase invoices for
manufactured goods and work-in-progress.
2.2 Inventory counts (stock takes)
If inventory is material to the financial statements, it is normal to have a year-end stock take and the
auditor will normally attend this. It is not the auditor’s responsibility to count the stock (that is the
responsibility of client’s staff) but the auditor has to observe the stocktake and to ensure that it is
begin carried out correctly so that the results can be relied upon. The auditor will perform a few test
counts only.
The normal sequence of a stock take and the auditor’s involvement is as follows:
๏ Instructions should be issued to client staff and they should be briefed about how the count
should proceed. This is important because counts might be done only once per year so it is not a
process with which staff are familiar. Many staff might not have been involved previously. The
auditor must review the instructions and make recommendations to the client as necessary.
๏ The count should be planned for a date and time when stock movements are not taking place.
New Year’s Day is often chosen (popular with both client staff and auditors!)
๏ Inventory has to be sorted, tidied and arranged in an orderly fashion. This might be relatively
easy in a retail environment, but think how difficult it can be in an engineering company, a
builder’s premises or a wood yard.
๏ Damaged inventory should be identified and labelled.
๏ Each inventory location should be labelled and the labels should have space for:
‣ Location reference/description
‣ Product code
‣ Product description
‣ Quantity counted
‣ Count sheet number
‣ Initials/signature of 1st counter
‣ Initials/signature of 2nd counter
๏ Counters should be in teams of two. Both counters should not be from stores because they can
have incentive to cover-up stock shortfalls. If both counters are from the accounting
department, they are less likely to be able to identify properly what they are counting. A mixed
pair is good: one from stores, one from accounts.
๏ Sequentially pre-numbered count sheets are issued to each counting team and the count
progresses. The label in each inventory location is filled in as are the stock sheets with produce
description and quantities. The stock sheets and location labels are cross-referenced.
๏ The auditor should perform some test counts: from stock locations, recount and trace details to
the count sheets (completeness assertion), and from stock sheets trace to stock locations and
recount (existence assertion). Discrepancies should be noted.
๏ The auditor should make a note of the few goods received notes and despatch notes issued in
the year. These will be used later for cut-off tests (see below).
๏ The auditor should be alert to any inventory that seems to be damaged and should make a note
of this and raise the matter at the time with the manager in charge of the count.
๏ All count sheets should be collected in and the numerical sequence verified as being complete.
2.3 After the stocktake

When the stocktake is complete the company should have records of the physical quantities of
inventory; this can be compared to book records (if any) and discrepancies investigated. Occasionally
a recount of certain items might be needed.
The inventory now needs to be valued at the lower of cost and net realisable value.
The cost of purchased goods can be established by inspecting recent purchase invoices.
The cost of manufactured goods and work-in-progress should include material, labour and
production overheads. The auditor will have to examine the cost accounting records to check on
production times, wage rates and overhead absorption rates. Although the auditor can inspect WIP it
will be difficult to ascertain its degree of completion. If material, the auditor may ask management for
written representation about its completion stage (see Chapter 14).
Net realisable value is only relevant if this is lower than cost.
๏ The auditor should identify slow-moving lines of inventory by examining stock records and also
by calculating days of inventory as at year end. An increase in this ratio might indicate that
inventory will not sell easily and might have to be written down in value.
๏ The auditor will review records relating to damaged stock identified during the stock-take.
๏ The auditor can use analytical procedures to determine if the days of inventory seem to be high.
๏ The auditor can look at post year-end sales to ensure that the selling prices of inventory are
above cost.
Once all costs/NRVs have been determined and entered on the count sheets, the value of each line of
inventory can be worked out (eg quantity x cost) and the values added up. It is essential that the
auditor reperforms these calculations. Remember, every extra $1 in inventory value is an extra $1 on
profit.
2.4 Cut-off
Cut-off is one of the assertions: it means that that transactions should be recorded in the correct
period. For example, sales made in January 20X4 should not be included as revenue in the 12 months
ended 31/12/20X3.
Correct cut-off on sales ensures consistency with receivables and inventory. Correct cut-off on
purchases ensures consistency with payables and inventory.
For example, goods might have been despatched around 28/12/20X4, but not invoiced until January
20X5. Generally, the sale is to be recognised when goods are despatched. The goods will not have
been counted in closing inventory at 31/12/20X4, yet the sale might not have been recognised until
the invoice was issued in the following year (Dr Receivables Cr Sales).
Similarly, goods might have been received 27/12/20X4, but the invoice not received until January
20X5. The goods will be in closing inventory (they are physically present), but the purchase will not
have been put through the accounts (Dr Purchases Cr Supplier) until the invoice is received.
For goods received just before year end:
๏ Goods will be in closing inventory

๏ Cost should be included in purchases
๏ Liability should be recognised.
If the invoice was received before year end, the liability (payable) will have been be accounted for
provided all invoices are posted. If the invoice is not received until after year end, an accrual should be
established (ie Dr Purchases, Cr 'Goods received - not invoiced' accrual).
For goods received just after year end:
๏ Goods will not be in closing inventory

๏ If the invoice has been received before year end, this should not be recorded (as goods not yet
received)
๏ There should be no asset in respect of these goods in closing inventory, no expense and no
liability.
For goods despatched just before year end:
๏ Goods will not be in closing inventory

๏ Sale should be recognised in revenue
๏ A receivable should be recognised even if not invoiced until after year end
For goods despatched just after year end:
๏ Goods will be in inventory

๏ There is no sale in the current year
๏ Even if invoiced in advance, the amount should not be included in revenue or receivables.
(Advance payments received for goods not despatched at the year end are a liability.)
3. Cash in hand and at bank

Cash is one of the easiest assets to audit. Most businesses will have a relatively immaterial amount of
cash in hand (in the petty cash box), and that can be counted if necessary.
Some businesses, like retail businesses which keep cash for sales registers, will have more material
amounts and some of these should be counted by the auditor on a test basis.
For most businesses, their material amounts of cash will be on deposit or in current accounts at their
bank(s). The standard procedure is to obtain a 'bank report for audit purposes' ('bank certificate') from
clients’ banks setting out the balances and any security that the bank has for loans. A bank certificate
is very reliable audit evidence.
The amount certified by the bank is not necessarily the amount that will appear in the statement of
financial position and a bank reconciliation will have to be performed by the client and re-performed
by the auditor to ensure that the cash book balance (ie the amount in the financial statements) can be
reconciled to the bank certificate.
4. Trade Receivables
4.1 Introduction
Receivables are likely to be material when businesses make sales on credit. A particular difficulty is to
test the valuation assertion as sometimes receivables ‘go bad’ and will never be paid.
4.2 External confirmation

Assuming trade receivables are material, external confirmation procedures (a 'receivables
circularisation') is used to obtain evidence about the existence and ownership of receivables.
First, the auditor must ensure that the receivables figure in the financial statements is based on the
sum of individual customer balances. The assets being audited are the individual receivables balances
– not the total balance. If the control account and the sum of the individual balances do not reconcile,
there is no basis for the receivables figure in the financial statements.
Then a sample of receivables balances is chosen. Typically this will be a stratified sample. Say that the
receivables balances were as follows:
Balances
Number of customers
$
20 >100,000
50 20,000 – 100,000
200 <20,000
A typical sample might be:
๏ All the customers owing >$100,000

๏ 50% of those owing $20,000 – $100,000
๏ 50 balances from those owing <$20,000
In addition, customers with credit balances and very old balances would be circularised, as would a
selection of customers with Nil balances.
A request for confirmation will usually include management's authorisation or encouragement for the
customer to disclose confidential information to the auditor. The auditor must have control over
sending the requests and receive responses directly.
There are two types of confirmation request:
๏ Positive – requests a reply from everyone who has been written to, whether or not they
agree with the balance. This is most suitable where the risk of misstatement is
high (e.g. weak internal controls, errors expected or suspicion of irregularity or
disputed amounts).
๏ Negative – requests a reply only if the customer disagrees with the balance. This type is
appropriate when control risk is low (i.e. errors are not expected), there is a
large proportion of smaller balances and customers are not expected to ignore
the request.
A positive request provides more conclusive evidence. For a negative request, the auditor can never
be sure that no reply means agreement rather than that the customer has simply not bothered to
reply.
A schedule is maintained of replies, showing agreements and disagreements. Disagreements can

often be explained by timing differences. For example, the client issues an invoice 29/12 but that
wasn’t processed by their customer until 2/1.
If sending positive requests (only), after a couple of weeks, with the client’s permission, customers
who have not replied will be sent a reminder letter by the auditor. If there is still no reply then, for very
material receivable balances, and again with client’s permission, the auditor might attempt to get
telephone confirmation.
4.3 Valuation of receivables
Even if a positive reply confirms agreement of amounts owing (which is important) it does not give
any assurance that the debt will be paid.
The valuation assertion can be addressed by:
๏ Examining aged receivables reports. Allowances may need to be made for overdue debts and
very old debts should be written off if expected to be irrecoverable.
๏ Performing analytical procedures on receivables balances. For example, average collection
period (days).
๏ Reviewing cash receipts after year end. If the full amount is received after year end there is
obviously no valuation problem at year end.
๏ Reviewing correspondence with customers and lawyers for evidence of disputed amounts that
may not be paid.
๏ Reviewing board minutes (large debts that might go bad are probably discussed at board
meetings).
4.4 After year end credit notes

Credit notes issued in the first month or so after year end should be scrutinised to ensure that any
sales and receivables balances as at year end are reduced appropriately. Occasionally, it is found that
an invoice has been deliberately raised and posted before year end then a credit note issued against is
after year end as a mechanism for fraudulently boosting sales.
5. Trade payables
5.1 Introduction
Many of the audit procedures that are carried out on trade payables balance are similar in principle to
those that are carried out on receivables balances. However, the auditor will be most concerned
about the completeness assertion - how to detect a liability (and corresponding expense) that is
missing? The first essential step is to ensure that the trade payables figure in the financial statements
reconciles to the sum of the individual payables balances.
5.2 Supplier statements
In many countries it is common for suppliers to send monthly statements of account to their
customers. An important internal control is that the client should reconcile these statements to the
individual payables balances. Reconciling items might include:
๏ Cash-in-transit (ie payments by client not received by supplier)

๏ Goods-in-transit (ie goods invoiced by supplier not received by the client)
๏ Disputed invoices - if the dispute is valid, the invoice should be subsequently cancelled with a
credit note from the supplier.
The auditor will generally reperform a sample of reconciliations.
If monthly statements are not available, the auditor may send a request to suppliers asking for a
statement and then reconcile the balances.
5.3 Post year end payments
Payments made in the first month or so after year end should examined. Payments will be traced to
purchase invoices and, if they relate to an expense in the year being audited, they must be included in
either the payables ledger or accrued expenses.
5.4 Analytical procedures
Analytical procedures such as the calculation of payables days and comparison with previous ratios
might indicate that payables are incorrect.
5.5 Written representation
Because of the difficulty in ensuring that all liabilities have been included, in addition to the work
described above, it is normal to ask management to give a written representation to the effect that all
liabilities have been included in the financial statements. (see Chapter 14)
6. Accruals and prepayments

6.1 Introduction
These are often, but not always relatively small amounts. If so audit work can be kept to a minimum.
Very often they will be similar to previous year’s figures.
6.2 Prepayments
๏ Look at the previous year’s audit file. Many payments are standard (eg car insurance always paid
1 June for the next 12 months) so there is an expectation for last year’s prepayments to be
similar to last periods (adjusted for inflation).
๏ Inspect invoices paid in the last few months of the period (where more months likely to be
prepaid).
6.3 Accruals
๏ Look at the previous year’s audit file. Many payments are standard (eg electricity always paid
28/2 for the previous three months, so there is an expectation for last year’s accruals to be
similar to last periods (adjusted for inflation).
๏ Inspect invoices and payments in the first few months after the year end. If they relate to
expenses in the current year and are not included in the payables ledger at the year end, they
must be accrued.
๏ Include a representation about the completeness of liabilities in the letter of representation.
7. Non-current assets
7.1 Acquisitions and disposals
Verify amounts by inspecting sale and purchase agreements and invoices.
Large movements should be referred to in board minutes.
7.2 Ownership
Verify ownership by inspecting documents of title, such as land registry entries for land and buildings.
7.3 Existence and completeness.
Verify existence by inspecting assets. Verify completeness by reconciling the figures in the financial
statements to the sum of the items in the non-current ('fixed') asset register.
7.5 Valuation
Verify valuation by inspecting depreciation rates and ensuring these are with industry norms and are
consistent with previous years. Recalculate depreciation for a sample of assets.
Perform a 'test in total' (an example of an analytical procedure) to verify that the total depreciation
expense for each type of asset is reasonable.
Inspect assets to ensure that they appear to be in working order and that they are still used by the
company.
Obtain management's written representations that they do not intend to dispose of major assets in
the near future (eg by closing down part of the business). That might require the assets to be carried
at a disposal value rather than cost less depreciation.
8. Contingent liabilities and contingent assets

8.1 Contingent liabilities
A contingent liability is a possible liability arising from past events but the existence of that liability
will only be confirmed by future events.
An example is a damages claim against the company.
๏ Date of incident that might give rise to damages: 12/07/20X4

๏ Year end date: 31/12/20X4.
๏ Court case to be heard on 30/9/20X4
So, for the financial statements to 31/12/20X4, the event has happened. However, the outcome of the
court case will not be known until long after the year end and after the audit will be complete.
Accounting for contingent liabilities depends on the likelihood (probability) of having to make a
payment to settle it:
๏ If probable (ie >50%) - make a provision in the financial statements

(ie Dr Expense Cr Liabilities).
๏ If possible (i.e. < 50% but not unlikely) - disclose in the notes to the financial statements
(ie no provision).
๏ If remote (ie very unlikely) - make no reference to the matter at all.
The auditor has to collect evidence about the likelihood that an amount will have to be paid and the
best estimate of that amount (unless the likelihood is remote).
Evidence can be obtained from:
๏ Board minutes
๏ Correspondence with the claimant and his/her lawyers
๏ Correspondence with the client’s own lawyers
๏ Written representations.
Occasionally, the auditor might seek expert evidence directly by asking a suitably experienced lawyer
for an opinion.
8.2 Contingent assets
A contingent asset is a possible asset arising from past events but whose existence will only be
confirmed by future events.
An example is a damages claim by the company against a supplier.
Accounting for contingent assets similarly depends on the likelihood of the asset materialising - but is
more cautious ('prudent'):
๏ If virtually certain the asset is not contingent so should be recognised.

๏ If probable - disclose in the notes to the financial statements (ie no asset).
๏ If only possible (less than probable) - make no reference to the matter.
Question 1
Why is it important to ensure that the receivables and payables control accounts (total
receivables and total payables accounts) reconcile to the sum of the balances in the receivables
and payables ledger?
Question 2
At a stock take it is the auditor’s responsibility to count the inventory.
True/False
Question 3
Why do auditors take an interest in cash received from customers after year end?
Question 4
Why do auditors take an interest in payments made in the first month of the next financial
period?
Question 5
What evidence would you look for to verify the valuation of a non-current asset bought in the
period?
Question 6
A goods received not is dated 24/12/20X4. An invoice for the goods is received 15/1/20X5.
What is the correct treatment of this transaction in the financial statements to 31/12/20X4?
A Goods not included in inventory; no expense; no purchase.
B Goods included in inventory; no expense; no purchase.
C Goods included in inventory; expense in purchases; purchase reserve established.
D Goods included in inventory; expense in purchases; supplier’s account credited.
Question 7
A customer of a client slipped on a wet floor on 1/9/20X4 and is suing your client. Legal advice
suggests that your client will possibly have to pay compensation of $25,000.
How should this be treated in the financial statements?
Chapter 14
AUDIT COMPLETION
1. Introduction
Until the auditor’s report is signed, the auditors have an active duty to look for evidence or events that
might alter their opinion on the financial statements
This chapter deals with:
๏ Subsequent events
๏ Going concern
๏ Written representations
2. Subsequent events
2.1 Introduction
Imagine that a set of financial statements has been produced for the year to 31/12/20X4 and then on
15/1/20X5, the company has a really bad day:
๏ A customer who owed $250,000 as at 31/12/20X4, and who has paid nothing subsequently,
goes into liquidation with little chance of creditors receiving anything;
๏ The company’s factory burns down.
How should these events be treated in the financial statements?
2.1 Adjusting and non-adjusting events

The rule is that if the event provides evidence about the state of affairs that existed at the period end
date, then the event is an adjusting event: the amounts in the profit and loss account and statement
of financial position must be changed to take account of the event.
Otherwise the event is a non-adjusting event. No adjustments are made to the profit and loss
account and statement of financial position, but if material the matter should be disclosed in notes to
the financial statements.
Therefore the treatment of the two incidents outlined above will be:
๏ The customer who went into liquidation must have been in a poor state at the year end and the
debt was to all intents and purposes irrecoverable then. Going into liquidation gives evidence
about the debt’s valuation as at 31/12/20X4. Therefore, write down the debt as at 31/12/20X4.
๏ The factory destruction happened 15/12/20X5, but the factory was perfectly ‘fine’ and existed
on 31/12/20X4. This is a non-adjusting event. Because it is so serious, a note would be added to
the financial statements disclosing the fire and its financial impact.
2.2 Auditor’s responsibility
Until the auditor’s report is signed (ie the auditor has fulfilled his duty to report) the auditor has an
‘active’ duty to consider subsequent events. The auditor must obtain sufficient appropriate audit
evidence to ensure that events after the reporting date have been:
๏ Identified (both adjusting and non-adjusting)

๏ Appropriately reflected in the financial (adjusted or disclosed).
Audit procedures must include:
๏ Inquiring of management whether any such events have occurred

๏ Reading minutes of board meetings
๏ Obtaining written representation that all such events have been adjusted or disclosed.
Additional procedures may be considered necessary. For example, making specific inquiry of the
client’s lawyer about developments in a legal case since the year end.
3. Going concern
Financial statements are normally drawn up on a going concern basis which is the assumption that
the organisation will continue trading in the foreseeable future (usually taken to be 12 months).
If there is doubt about whether the going concern assumption is valid, then this should be disclosed
in a note in the financial statements.
If it looks inevitable that the organisation will soon fail, then the financial statements should be drawn
up on a break-up basis.
Indicators of going concern problems include:
๏ Negative operating cash flows

๏ Operating losses
๏ Borrowing facilities not renewed or extended
๏ Poor liquidity ratios (such as a low current ratio)
๏ High gearing
๏ Taking longer to pay suppliers
๏ Loss of key personnel
๏ Loss of key customers
๏ Technological advances
๏ Legal and regulatory changes
๏ Bad publicity
It is management’s responsibility when preparing the financial statements to review the company’s
going concern position and the auditor must audit management’s conclusions.
Audit work will include:
๏ Review the work that management has carried out on going concern
๏ Obtain cash flow forecasts and budgets for the forthcoming 12 months and review the
assumptions on which these are based.
๏ Examine the trading pattern of the first weeks (or months) after the period end to ensure that
this appears adequate to support a going concern assumption.
๏ Calculation of liquidity interest cover and gearing ratios
๏ Review correspondence with the company’s bankers.
๏ Obtain written representation of management's plans for future actions that support the going
concern assumption.
4. Written representation
This is a letter sent by management to the auditor, just before the auditor signs the auditor’s report. It
is an essential piece of audit evidence.
The auditor must obtain written representations to confirm the responsibilities of management (and
those charged with governance):
๏ That they have properly prepared and presented the financial statements
๏ That they have provided complete information to the auditor.
๏ That all transactions have been recorded.
Other representations may be required to support other audit evidence. But they cannot substitute
for other audit evidence. For example:
๏ All knowledge or suspicion of fraud has been disclosed to the auditor.

๏ All known actual or possible litigation and claims has been disclosed to the auditor and properly
accounted for.
๏ All subsequent events have been adjusted or disclosed as required.
๏ Plans for future actions relevant to management’s assessment that the entity is a going concern.
These examples illustrate how written representations support the assertion of completeness.
Question 1
How long is ‘foreseeable future’ for going concern purposes?
Question 2
Sales revenue has fallen rapidly in the first few months after the year end.
Could this be an adjusting event?
Question 3
A written representation is no substitute for other audit evidence, so auditors will be prepared to sign
an auditor’s report without receiving written representations.
Question 4
A flood of the client’s warehouse occurs on 23/1/20X5 ruining most of the inventory, which is material
to the financial statements.
Is it an adjusting event?
Chapter 15
THE INDEPENDENT AUDITOR'S REPORT
1. Introduction
Chapter 1 introduced the sections that you would expect to see in any auditor's report. This chapter
looks at:
๏ Additional paragraphs that would only be included in specific circumstance

๏ Modified audit opinions.
Note that the terms 'auditor's report' and 'audit opinion' are not the same thing. The audit opinion is
only the first section of an auditor's report. It is followed by a 'basis for opinion' section and sections
detailing the respective responsibilities of management and the auditor (see Illustrative example in
Chapter 1).
2. Additional paragraphs
2.1 Emphasis of matter
An emphasis of matter is a paragraph in the auditor’s report which draws attention to some matter
already properly disclosed within the financial statements. Such a paragraph does not affect the
audit opinion: it is simply drawing attention to an important note in the financial statements that
shareholders ought to be aware of to properly appreciate the financial statements.
Here is an example:
We draw attention to Note 27 to the financial statements, which describes the effects of a fire in
the Company's warehouse. Our opinion is not modified in respect of this matter.
If the matter had not been disclosed properly then the opinion paragraph would have to be modified
(see later).
2.2 Material Uncertainty Relating to Going Concern
One of the auditor's responsibilities is to conclude on the appropriateness of management’s use of

the going concern basis of accounting and, based on the audit evidence obtained, whether a
material uncertainty exists related to events or conditions that may cast significant doubt on the
company’s ability to continue as a going concern.
If a material uncertainty exists which is adequately disclosed in the financial statements, the auditor
is required to draw attention to the related disclosure in a separate section of the auditor's report
headed “Material Uncertainty Related to Going Concern”.
For example:
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, 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.
Although similar to an emphasis of matter, its use is very specific.
3. Modified audit opinions

3.1 Modified opinions
Auditors will modify their opinion if:
๏ The financial statements contain one or more material misstatements, or

๏ The auditor has been unable to obtain sufficient appropriate audit evidence.
Each of these problems may result in an ‘extreme’ expression of opinion:
๏ If material misstatements are so many and so severe that in the auditor’s opinion the financial
statements, as a whole, do not show a true and fair view, the auditor will state this in an
adverse opinion.
๏ If a lack of sufficient appropriate audit evidence is so extensive that the auditor cannot form an
opinion on whether the financial statement, as a whole, show a true and fair view, the auditor
will state this in a disclaimer of opinion.
Note that these expressions of opinion relate to matters that affect the financial statements ‘as a
whole’ – the term to describe such matters is that they are pervasive.
If matters are material but not pervasive, the auditor will be able to conclude ‘except for … [problem]
… the financial statements show a true and fair view …’. This is a qualified opinion.
The different forms of modified opinion can be summarised as follows:
Nature of circumstance Material but not pervasive Pervasive
Financial statements are A qualified opinion:

Adverse opinion
materially misstated Except for ...
Unable to obtain sufficient, A qualified opinion:

Disclaimer of opinion
appropriate evidence Except for ...
If the opinion is unmodified, the opinion paragraph is headed up ‘Opinion’. However, to warn users
that something is amiss, this paragraph’s title changes when the opinion is modified:
๏ ‘Qualified opinion’,
๏ ‘Adverse opinion’ or
๏ ‘Disclaimer of opinion’
3.2 Basis for opinion paragraphs

When an opinion is modified, the title of the ‘basis’ is changed to match the ‘opinion’ paragraph. For
example ‘Basis for qualified opinion’.
3.3 Examples of modified opinions
Qualified opinion [because of material misstatement]

Qualified opinion In our opinion, except for the matter referred to in the Basis for
Qualified Opinion section, the financial statements give a true and
fair view…
Basis for qualified opinion The Company's property, plant and equipment is carried in the
statement of financial position at $x. Management has not
depreciated ... which constitutes a departure from IFRSs. The
Company's records indicate that had management
depreciated ..., the company would have recognised depreciation
of $x in the statement of profit or loss ... The carrying amount... in
the statement of financial position would have been reduced by
the same amount ....
Qualified opinion [because of lack of sufficient appropriate audit evidence]
Qualified opinion In our opinion, except for the possible effects of the matter
described in the Basis for Qualified Opinion section of our report,
the financial statements give a true and fair view…
Basis for qualified opinion We were unable to obtain sufficient appropriate evidence about
the carrying amount of inventories because we were unable to
attend the count of physical inventories at 31 December 20X1.
Therefore, we were unable to determine whether any
adjustments to this amount was necessary.
Adverse opinion
Adverse opinion In our opinion, because of the significance of the matter
described in the Basis for Adverse Opinion section of our report,
the accompanying financial statements do not present fairly...
Basis for adverse opinion The Company's financing arrangements expired ... and is
considering filing for bankruptcy ... a material uncertainty exists...
The financial statements do not adequately disclose this fact ...
Disclaimer of opinion
Disclaimer of opinion We do not express an opinion on the accompany financial
statements. Because of the significance of the matters described
in the Basis for Qualified Opinion section of our report, we have
not be able to obtain sufficient appropriate audit evidence to
provide a basis for an audit opinion on these financial
statements.
Basis for disclaimer of opinion We were not appointed as auditors of the Company until [date]
and thus did not observe the physical inventory counts at the
beginning and end of the year...
In addition, the introduction of a new computerised system in
[date] resulted in numerous errors in accounts receivable this
report ...
Note that, wherever possible, the auditor will quantify and state the effects on the financial
statements of the matter(s).
Question 1
What are the three types of modified audit opinion?
Question 2
What additional paragraphs may included in an auditor's report that do not affect the audit
opinion?
Question 3
What term describes a matter that results in an adverse opinion or a disclaimer of opinion?
Question 4
The ‘opinion’ paragraph in an auditor’s report contains the phrase ‘Except for…… the financial
statements show a true and fair view….”.
What should be the title of the 'opinion' paragraph?

A Opinion
B Qualified opinion
C Adverse opinion
D Disclaimer of opinion
Question 5
There are going concern doubts about a company’s future. These are adequately disclosed in a note
to the financial statements.
What should the auditor's report include?
A Qualified opinion
B Adverse opinion
C Emphasis of matter
D Material uncertainty relating to going concern
Question 6
There are going concern doubts about a company’s future. These are not disclosed in the financial
statements.
What should the auditor's report include?
A Qualified opinion
B Adverse opinion
C Emphasis of matter
D Material uncertainty relating to going concern
ANSWERS TO TESTS
Chapter 1
Question 1
False. Auditors can be removed only by the members of the company.
Question 2
B, C
Question 3
B, C, E
Question 4
Directors = agents; shareholders = principals
Question 5
Annually
Question 6
True. Auditors can speak on matters relevant to the financial statements and their audit.
Question 7
A statement of circumstances is provided by an auditor upon resignation of removal explaining why
the resignation/removal has taken place.
Chapter 2
Question 1
Integrity, objectivity, confidentiality, professional conduct and due care, professional behaviour.
Question 2
True
Question 3
There are fundamental ethical principles. These are subject to threats. The threats can be reduced or
avoided by appropriate safeguards.
Question 4
Self-interest, self-review, advocacy, familiarity, intimidation.
Question 5
With the client’s permission, legal duty, legal or professional right, a public duty.
Question 6
C
Chapter 3
Question 1
The International Auditing and Assurance Standards Board (IAASB).
Question 2
False. ISAs do not override national laws or regulations.
Question 3
True
Question 4
D
Question 5
False. In fact they must communicate with the outgoing auditors.
Question 6
(1) Ensure that it the firm is professionally qualified to act on both ethical and legal grounds.
(2) Ensure that existing resources are adequate to cover both the required expertise and the time
that the new work will take.
(3) Investigate the company, its owners and directors.
(4) Communicate with the present /outgoing auditor.
Question 7
It is the contract between the auditor and client. It sets out requirements, responsibilities, duties, fees
and timings.
Question 8
C
Chapter 4
Question 1
Inherent risk, control risk and detection risk. The auditor can most easily alter the detection risk by
altering the amount of audit work to be carried out.
Question 2
No, it is management’s responsibility. However, the auditor should detect material misstatements
whether caused by error or fraud.
Question 3
Profession scepticism means not knowing. Evidence is needed before the auditor can make a decision
about an item in the financial statements. It does not mean distrusting everyone, but means that
auditors are aware that honest errors are made.
Question 4
B, D
Inexperienced auditors would not affect error rates in the draft statements prepared by the client’s
accounting staff.)
Question 5
½ - 1% of revenue; 1 – 2% of total assets; 5 -10% of profit before tax.
Chapter 5
Question 1
Analytical procedures; tests of detail.
Question 2
A Tests of control. (B is a risk assessment procedure. C is a test of details. D is a substantive
analytical procedure.)
Question 3
False. Some substantive procedures must always be carried out.
Question 4
A management letter will be sent by the auditors to the company’s management explaining:
๏ The nature of the internal control weakness.
๏ The possible consequences
๏ How the internal control deficiency can be fixed.
Chapter 6
Question 1
๏ Occurrence
๏ Completeness
๏ Accuracy
๏ Cut-off
๏ Classification
๏ Presentation
Question 2
๏ Existence
๏ Rights and obligations
๏ Completeness
๏ Accuracy, valuation and allocation
๏ Classification
๏ Presentation
Question 3
Analytical procedures
Enquiry and confirmation
Inspection
Observation
Recalculation and reperformance
Question 4
An auditor requires sufficient appropriate audit evidence that the financial statements are free from
material misstatement.
Question 5
Written
Auditor direct obtained
External
Originals
Chapter 7
Question 1
Each item in the population must have an equal chance of selection (ie sample selection must be
random) and probability theory must be used to evaluate the sample results.
Question 2
The population is divided into strata and separate rules are established for drawing samples from
each stratum. For example, 50% of the population sampled where balances >$20,000, 20% for
balances 10,000 – 20,000, 50 items for balances < 10,000.
Question 3
N or S
Haphazard N
Monetary unit S
Systematic S
Block N
Question 4
Increase sample size.
Question 5
Increase the standard of training, assignment of work to more experienced staff, better direction,
supervision and review.
Chapter 8
Question 1
The main function of internal audit is to evaluate and improve the effectiveness of internal control.
Question 2
The internal audit function must be objective, competent and apply a systematic and disciplined
approach.
Question 3
Both types of expert have expertise in a field other than accounting or auditing. Management’s expert
assists management in preparing the financial statements. An auditor’s expert assists the auditor
in obtaining sufficient appropriate audit evidence.
Question 4
๏ To evaluate the work of management’s expert.
๏ If management does not have necessary expertise/a management expert.
Chapter 9
Question 1
Test data is data designed by the auditor to test the operation of a client's accounting program.
Question 2
Test data (TD) or audit software (AS):
To determine what would happen if a negative amount of goods were ordered TD

To find and print out negative inventory amounts AS
To select receivables balances for verification AS
To re-perform an aged receivables analysis AS
To determine whether a customer can exceed their credit limit TD
Question 3
B, D
Question 4
C
Chapter 10
Question 1
Tests of control are usually carried out at the interim audit stage.
Question 2
Narrative, flowcharts and questionnaires (ICQs and ICEQs)
Question 3
A walk through test is when a transaction is ‘walked though’ the system. These tests are used to verify
the accuracy of the recording and understanding of the system
Question 4
1 Are goods checked against orders when received? ICQ
2 Can inventory be misappropriated? ICEQ
Question 5
Control activity - a component of internal control.
Chapter 11
Question 1
๏ The control environment
๏ Risk assessment process
๏ Information systems
๏ Control activities
๏ Monitoring of controls
Question 2
Internal control deficiency Potential consequences Recommendation
Question 3
Segregation of duties means that the authorisation of transactions, the recording of transactions and
the custody of assets should be assigned to different people.
Question 4
B (this is just transaction processing).
Question 5
Significant control weaknesses should be notified to those charged with governance.
Chapter 12
Question 1
๏ Inspection
๏ Observation
๏ Re-performance
Question 2
The ability to trace a transaction forwards and backwards through the accounting system.
Question 3
The objectives of the internal control system in purchases and trade payables are (only four required):
(1) To ensure that only necessary goods and services are purchased
(2) To ensure that all goods and services bought are received by the company
(3) To ensure that goods and services are bought from approved suppliers or are bought on the
basis of competitive tendering.
(4) To ensure that goods and services bought are of sufficient quality.
(5) To ensure that goods are bought at the correct time to prevent stock-outs and over-stocking.
(6) To ensure that goods and services are bought at competitive trading terms taking into account
price, quality, and payment terms.
(7) To ensure that all purchase transactions are accurately and completely recorded in the
company’s accounting records.
(8) To ensure that payments are made only in respect of goods or services properly ordered and
received.
Question 4
(Only three required)
(1) To ensure that employees are properly paid for work performed.
(2) To ensure that any employment decision is authorised
(3) To ensure that wage and salary rates are authorised
(4) To ensure wage and salary calculations are carried out correctly.
(5) To ensure that overtime and bonuses etc cannot be paid without authorisation.
(6) To ensure cash or credit transfers are paid to the correct employees
(7) To ensure that deductions (such as income tax) are paid on time to the authorities.
(8) To ensure that payments do not continue to employees who have left.
Chapter 13
Question 1
The receivables and payables figures in the statement of financial position are made up of many
individual balances. Only the individual amounts owing from customers or owing to suppliers can be
audited. Therefore it is important to know that what’s being audited agrees with the figures in the
Question 2
It is the client’s responsibility to count inventory. The auditor observes the process.
Question 3
Cash received after year end provides evidence concerning the valuation of receivables.
Question 4
This will provide evidence about the completeness of accruals and other liabilities.
Question 5
Purchase price – inspect invoice
Depreciation – inspect company accounting policy for that class of asset
Depreciation – reperform the calculations
Depreciation – ensure machine is being used and the impairment (write-down) is not needed
(unlikely for a new machine)
Question 6
C
Question 2
This is a possible outflow of resources so should be disclosed in the notes to the financial statements.
No expense/liability should be set up
Chapter 14
Question 1
12 months from the date of the statement of financial position.
Question 2
Yes. For example, it calls into question the valuation of year-end inventory.
Question 3
False. The auditor must obtain written representations to confirm the responsibilities of management
(even if no other representations were required). Think: why won’t the directors provide these
representations? Are they hiding something?
Question 4
It is a non-adjusting event. Warehouse and inventory were all fine at 31/12/20X4.
Chapter 15
Question 1
Qualified; adverse; disclaimer.
Question 2
Emphasis of matter; Material uncertainty relating to going concern
Question 3
Pervasive
Question 4
B
Question 5
D
A 'Material uncertainty relating to going concern' section will be added to drawn attention to the
disclosure.
Question 6
A
'Except for ... [description of what should have been disclosed] ...'
An adverse opinion would only be appropriate when there is more that 'doubt' (ie the auditor
concludes that the going concern basis of preparation is not appropriate).

Fau PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fau PDF

Uploaded by

Copyright:

Available Formats

D

Please spread the word about

ONLY with your support can the site

OpenTuition Lecture Notes can be downloaded FREE from http://opentuition.com

IMPORTANT!!! PLEASE READ CAREFULLY

To benefit from these notes you must obtain a current edition of a

Question practice is vital!!

FAU Foundations in Audit

1. Business environment and audit framework 5

3. Audit regulation and auditor engagement and liability 23

4. Audit planning and risk assessment 29

5. Tests of control and substantive procedures 39

6. Assertions and audit evidence 45

8. Using the work of others 57

9. Computer assisted audit techniques 61

10. Audit documentation 65

11. Internal control 73

12. Examples of internal control and tests of control 79

13. Substantive procedures 89

14. Audit completion 101

15. The independent auditor's report 105

Answers to Tests 111

B Explain how an auditor assesses risk and plans an audit

The examination will consist of two sections:

1. The purpose and scope of an audit

2. What auditors don’t do

3. Advantages and disadvantages of an audit

๏ A statement of financial position

6. The auditor’s report

If the presentation were as follows:

Current assets 16,000

Current liabilities 12,000

6.2 Illustrative example

1 INDEPENDENT AUDITOR’S REPORT To the Shareholders of ABC company

2 Report on the Audit of the financial statements

4 Basis for Opinion

6 Auditor’s Responsibilities for the Audit of the financial statements

The numbered paragraphs have the following significance:

(1) A clear title “Independent auditors’ report”.

(2) Specifies what the audit covers – the financial statements.

9. Resignation and removal of auditors

The 'statement of circumstances' will:

9.2 Resignation or failure to seek re-appointment

๏ his term of office would otherwise have expired; or

๏ Establishes five fundamental principles

3. Fundamental principles, threats and safeguards

3.2 The threats

3.3 The safeguards

These can be categorised as:

4. Threats and safeguards

How it can be avoided or reduced to an

4.2 Self review threats

How it can be avoided or reduced to an

Valuation services. Even if the audit firm were professionally

4.3 Advocacy threats

How it can be avoided or reduced to an

4.4 Familiarity threats

How it can be avoided or reduced to an

Familiarity can arise through long-association

4.5 Intimidation threats

How it can be avoided or reduced to an

Is this statement true or false?

2. International Standards on Auditing (ISAs)