F8 Innn

Chapter 9 • Internal control systems
Internal control • The use of internal control

systems by auditors
• The evaluation of internal
control components
• Internal controls in a
computerised environment
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Syllabus learning outcomes 1
• Explain why an auditor needs to obtain an understanding of internal

control activities relevant to the audit.
• Describe and explain the five components of an internal control
system: the control environment, the entity's risk assessment process,
the information system, including related business processes relevant
to financial reporting and communication, control activities relevant to
the audit, and monitoring of controls.
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• Explain how auditors record internal control systems including the use
of narrative notes, flowcharts, internal control questionnaires and
internal control evaluation questionnaires.
• Evaluate internal control components, including deficiencies and
significant deficiencies in internal control.
• Discuss the limitations of internal control components.
• Discuss computer system controls, including general IT controls and
application controls.
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• Discuss the requirements and methods of how reporting significant

deficiencies in internal control are provided to management and those
charged with governance.
• Explain, in a format suitable for inclusion in a report to management,
significant deficiencies within an internal control system and provide
recommendations for overcoming these deficiencies to management.
• Describe why smaller entities may have different control environments
and describe the type of evidence likely to be available in smaller
entities.
• Discuss the difference between tests of controls and substantive
procedures.
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Overview
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Overview (cont'd)
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Chronology of an audit
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Internal control 1
Internal control is the process designed and effected by those charged

with governance, management, and other personnel to provide
reasonable assurance about the achievement of the entity's objectives
with regard to reliability of financial reporting, effectiveness and efficiency
of operations and compliance with applicable laws and regulations.
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Question: Internal controls
You are the audit senior responsible for the audit of Supreme Food
Limited, a company which runs a chain of fast food stores.
The major risk in this industry is always related to food quality which
might result in damage claims by customers.
What controls should the company have in place to reduce the risk
associated with purchases of food and its preparation in the kitchen?
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Answer: Internal controls
Possible controls which could be used to reduce the risk associated

with purchases of food and its preparation in the kitchen:
• Overall authority for food purchasing should be in the hands of a
designated person to ensure that the food purchased is of the
desired quality.
• There should be a list of approved suppliers to ensure that the
food comes from sources known to meet the required quality
standards.
• When food is received (whether meat, fish, or vegetables and fruit)
it should be carefully inspected by informed people, including
those responsible for food preparation to ensure that food
received is of the desired quality as well as quantity. A goods
received note should be signed to provide evidence of receipt and
inspection.
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Answer: Internal controls (cont'd)
• Food purchased should be kept in a clear place and refrigerated, if

necessary. This is to ensure that it retains its quality.
• There should be strict adherence to use-by dates, to ensure that
food of the highest quality food is prepared.
• There should be a person in the company who has overall
responsibility for health and safety and who has relevant training
to ensure health and safety standards are adhered to.
This list is not exhaustive though. You may have thought of other
controls the company could have in place.
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Internal control 2
Why do auditors need to understand internal control?

Because it helps them to:
• Identify types of potential misstatements and factors affecting the risks
of material misstatements
• Design the nature, timing and extent of their audit procedures
ISA 315 (Revised) Identifying and assessing the risks of material

misstatement through understanding the entity and its environment
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Internal control 3
If internal controls are strong, the auditor can rely on them and base
their audit work on tests of controls, and therefore reduce the amount
of substantive procedures required.
If internal controls are weak, the auditor cannot rely on them and will
have to carry out a fully substantive audit.
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Internal control 4
There are five components of internal control:
• CONTROL ENVIRONMENT
• ENTITY'S RISK ASSESSMENT PROCESS
• INFORMATION SYSTEM RELEVANT TO FINANCIAL REPORTING
• CONTROL ACTIVITIES
• MONITORING OF CONTROLS
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Internal control 5
CONTROL ENVIRONMENT
• The framework within which controls operate
• Includes the governance and management functions and the
attitudes, awareness and actions of those charged with governance
and management concerning the entity's internal control and the
importance of internal controls in the entity
• Auditors must understand the control environment because the
control environment can affect the risk of material misstatement in the
entity's financial statements
• Have a look at this article in Student Accountant from March 2013:
http://www.accaglobal.com/content/dam/acca/global/PDF-
students/2012s/sa_mar13_fauf8p7_controlenv.pdf
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Internal control 6
CONTROL ENVIRONMENT
Communication and Essential elements which influence the effectiveness of the design,
enforcement of integrity administration and monitoring of controls
and ethical values
Commitment to Management's consideration of the competence levels for particular jobs
competence and how those levels translate into requisite skills and knowledge
Participation by those • Independence from management
charged with governance • Experience and stature
• Extent of involvement and scrutiny of activities
• Appropriateness of actions and interaction with internal and external
auditors
Management's philosophy • Approach to taking and managing business risks
and operating style • Attitudes and actions towards financial reporting
• Attitudes towards information processing and accounting functions and
personnel
Organisational structure The framework within which an entity's activities for achieving its objectives
are planned, executed, controlled and reviewed
Assignment of authority How authority and responsibility for operating activities are assigned and
and responsibility how reporting relationships and authorisation hierarchies are established
Human resource policies Recruitment, orientation, training, evaluating, counselling, promoting,
and practices compensation and remedial actions
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Internal control 7
ENTITY'S RISK ASSESSMENT PROCESS

The auditor needs to obtain an understanding of whether processes are
in place for the following:
• Identifying business risks relevant to financial reporting objectives
• Estimating the significance of the risks
• Assessing the likelihood of their occurrence
• Deciding upon actions to address those risks
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Internal control 8
INFORMATION SYSTEM RELEVANT TO FINANCIAL REPORTING

A component of internal control that includes the financial reporting
system, and consists of the procedures and records established to
initiate, record, process and report entity transactions (as well as events
and conditions) and to maintain accountability for the related assets,
liabilities and equity.
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Internal control 9

The auditor must understand the system, including the following:
• The classes of transactions in the entity's operations that are
significant to the financial statements
• The procedures, within both IT and manual systems, by which those
transactions are initiated, recorded, processed, corrected, transferred
to the general ledger and reported in the financial statements
• The related accounting records, supporting information, and specific
accounts in the financial statements, in respect of initiating, recording,
processing and reporting transactions
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Internal control 10

The auditor must understand the system, including the following:
• How the information system captures events and conditions, other
than transactions, that are significant to the financial statements
• The financial reporting process used to prepare the entity's financial
statements, including significant accounting estimates and disclosures
• Controls surrounding journal entries, including non-standard journal
entries used to record non-recurring, unusual transactions or
adjustments
• As well as understanding how information is obtained from within the
general and subsidiary ledgers, auditors must gain an understanding
of the system relating to information obtained outside of the
ledgers (ie contracts and agreements, risk management system files,
reports from management’s experts)
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Internal control 11
CONTROL ACTIVITIES
Those policies and procedures that help ensure that management
directives are carried out.
Control activities include those activities designed to prevent, or detect
and correct, errors.
Examples
• Authorisation controls
• Performance reviews
• Information processing
• Physical controls
• Segregation of duties
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Question: Control activities
Can you think of examples of control activities that you would expect
to find in a small independent bakery store?
Contrast this to the control activities that you would expect to find in a
large national supermarket chain, such as Wumart.
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Answer: Control activities
Control activities in a small independent bakery store

• Daily banking of cash (if possible)
• CCTV camera (possibly)
• Alarm system when shop is closed
• Agreement of takings to till roll
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Answer: Control activities (cont'd)
Control activities in a national supermarket like Wumart

• Daily bankings of cash by security firm
• CCTV cameras and security guards in all stores
• Weekly bank reconciliations
• Computerised inventory system
• Periodic inventory checks (floor to sheet and sheet to floor)
• Controls over self-service checkouts
• Full vetting of prospective employees
• Price checks of all goods on sale against competitors
• Analysis of electronic point of sale (EPOS) data
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Answer: Control activities (cont'd)
• Health and safety audits

• Full recording of all health and safety incidents
• Checks of staff leaving premises
• Clocking in and out by staff
• Mystery shoppers
This list is not exhaustive though. You may have thought of additional
control activities!
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Tackling the exam
• You will appreciate from the previous question that control

activities vary greatly depending on the nature and size of the
entity. A national supermarket chain is likely to have far more
sophisticated controls in place than a small bakery store. A small
entity employing few people has less scope to use segregation of
duties because of its very nature.
• You must take into account the type of entity you are auditing
when it comes to the exam. Internal control is a key syllabus area
and you are highly likely to get a question based on a scenario
that tests it.
• You might be asked for internal controls so it is important that you
appreciate the type of business you are auditing. Irrelevant
controls will not gain many marks.
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Internal control 12
MONITORING OF CONTROLS
A process to assess the effectiveness of internal control performance
over time.
It includes assessment of the design and operation of controls on a
timely basis and taking necessary corrective actions modified for
changes in condition.
Who could monitor the controls within an entity?
INTERNAL AUDITORS (…provided the entity has an internal audit
function)
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Question: 2014 Specimen Paper (Sec A, Q12)
ISA 315 Identifying and Assessing the Risks of Material Misstatement

through Understanding the Entity and its Environment sets out the
five components of internal control.
Which of the following is NOT set out as a component of internal
control within ISA 315?
A Control environment
B The information system relevant to financial reporting
C Human resource policies and practices
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Answer: 2014 Specimen Paper (Sec A, Q12)
C Human resource policies and practices
Human resource policies and practices form part of the control

environment of an entity but are not themselves a component of
internal control as set out in ISA 315.
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Internal control 13
The limitations of accounting and control systems

Internal control systems can only provide reasonable assurance that
their objectives are reached, because of inherent limitations:
• Costs of control not outweighing the benefits
• Potential for human error
• Collusion between employees
• Possibility of controls being overridden or by-passed by management
• Non-routine transactions being difficult for the system to cope with
This is why auditors cannot rely on internal controls alone – they

always have to carry out some substantive procedures as well.
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The use of internal control systems by auditors 1
• Auditors are only interested in the control activities which are relevant
to the financial statements.
• Auditors must do the following:
— Assess the adequacy of the accounting system as a basis for
preparing the accounts
— Identify the types of potential misstatements that could occur
in the accounts
— Consider factors that affect the risk of misstatements
— Design appropriate audit procedures
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Auditors will record the accounting and control systems in place.

There are a number of methods for doing this:
• Narrative notes
• Flowcharts
• Questionnaires (Internal Control Questionnaires (ICQs) and Internal
Control Evaluation Questionnaires (ICEQs))
• Checklists
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Narrative notes
Advantages Disadvantages
Relatively simple to record More time consuming than a simple
Can facilitate understanding by flowchart
all audit team members Particularly where the system follows
a logical flow
Flexible They are awkward to update if
Can be used for any system written manually
Editing in future years can be Can be difficult to identify missing
relatively easy if computerised internal controls – may not identify
exceptions clearly
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Flowcharts
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Flowcharts
Advantages
• Can be prepared quickly
• Standard format so easy to follow and review
• Ensure system is recorded in its entirety
• Eliminate need for extensive narrative
Disadvantages
• Generally only suitable for describing standard systems
• Major changes difficult without redrafting
• Time wasted in charting areas of no audit significance
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Questionnaires: Internal Control Questionnaires (ICQs)

• How good is the system of controls?
• List of questions to determine whether desirable controls are present
• One list of questions for each major transaction cycle
Questionnaires: Internal Control Evaluation Questionnaires (ICEQs)

• Focus on whether specific errors/frauds are possible, rather than
establishing whether certain desirable controls are present
• Key questions or control questions for each transaction stream
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Questionnaires
Advantages Disadvantages
If drafted thoroughly, they can ensure all If drafted vaguely, may be misunderstood
controls are considered and important controls may be missed
They are quick to prepare May contain irrelevant controls
They are easy to use and control They may not include unusual controls, which
are nevertheless effective in particular
circumstances
Because they are drafted in terms of They can give the false impression that all
objectives rather than specific controls, controls are of equal weight
ICEQs are easier to apply to a variety of
systems than ICQs
They should enable auditors to identify The client may be able to overstate controls
the key controls which they are most
likely to test during control testing
ICEQs can highlight deficiencies where
extensive substantive testing will be
required
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Checklists
• Statements are made
• Tick boxes used to indicate where the statement holds true
• Share many advantages and disadvantages with questionnaires
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Tackling the exam
• You could be tested on the documentation of internal control

systems, either in Section A or in a knowledge-based question in
Section B.
• The June 2011 paper had a six-mark part on the advantages and
disadvantages of narrative notes and internal control
questionnaires.
• The December 2014 paper had a multiple choice question about
the disadvantages of using internal control questionnaires.
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The evaluation of internal control components 1
• Once the auditors have documented the internal control system, they
need to test the controls to see whether they can rely on them for the
audit of the financial statements.
• They will initially do a walk-through test – that is, they will follow a
transaction through the system to see if all the controls they think
should be in existence operated for that transaction.
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Tests of controls (recap)

Tests performed to obtain audit evidence about the effectiveness of the:
• Design of the accounting and internal control systems, ie whether
they are suitably designed to prevent, or detect and correct, material
misstatement at the assertion level
• Operation of the internal controls throughout the period
Remember: Tests of control are not designed to detect material

misstatements in the financial statements. The purpose of substantive
tests is to detect these misstatements.
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What audit procedures can the auditor use to get evidence about
controls?
• INSPECTION OF DOCUMENTS
• INQUIRIES about internal controls
• REPERFORMANCE of control procedures
• OBSERVATION of controls
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Document internal controls
Test the controls
Reliable Not reliable
Audit approach: Audit approach:

Tests of controls Fully substantive
+ reduced substantive approach
procedures
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• Once auditors have documented and tested the system, they might
find that there are weaknesses in the system.
• These weaknesses are known as deficiencies.
• Auditors have responsibilities regarding deficiencies in internal
control, as set out in ISAs.
• ISA 265 Communicating deficiencies in internal control to those
charged with governance and management
• Auditors must communicate significant deficiencies in internal
control to those charged with governance and management.
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• A deficiency in internal control exists when a control is designed,

implemented or operated in such a way that it is unable to prevent, or
detect and correct, misstatements in the financial statements on a
timely basis, or a control necessary to prevent, or detect and correct,
misstatements in the financial statements on a timely basis is missing.
• A significant deficiency in internal control is a deficiency or
combination of deficiencies in internal control that, in the auditor's
professional judgement, is of sufficient importance to merit the
attention of those charged with governance.
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So how does an auditor judge whether a deficiency is significant enough to

warrant it being reported to those charged with governance and management?
Here are some factors the auditor must consider:
• The likelihood of the deficiencies resulting in material misstatements in the
financial statements in the future
• The susceptibility to loss or fraud of the related asset or liability
• The subjectivity and complexity of determining estimated amounts
• The amounts exposed to the deficiencies
• The volume of activity that has occurred or could occur
• The importance of the controls to the financial reporting process
• The cause and frequency of the exceptions identified as a result of the
deficiencies
• The interaction of the deficiency with other deficiencies in internal control
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• Auditors must communicate significant deficiencies in internal control

on a timely basis in writing
• Include a description of the deficiencies and an explanation of their
potential effect
• Include sufficient information to enable those charged with
governance and management to understand the context of the
communication
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• Auditors can include recommendations

• They can state that more deficiencies may have been identified had
the auditor undertaken more extensive procedures on internal control
or that some of the reported deficiencies need not have been reported
• They can include a statement that the written communication is for the
purpose of those charged with governance and may not be suitable
for other purposes
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Tackling the exam
• A very common requirement from the F8 examiner is to ask you to

explain the deficiencies and the implications of those deficiencies
of a given system in a scenario question, together with suggested
recommendations.
• This type of requirement is generally worth a lot of marks and has
been tested in all sittings except June 2011.
• We will look at this in more detail in Chapter 10 where we will go
through some such questions.
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Internal controls in a computerised environment 1
• IT controls can be general controls or application controls.

• General IT controls are policies and procedures that relate to many
applications and support the effective functioning of application
controls by helping to ensure the continued proper operation of
information systems. They commonly include controls over data
centre and network operations, system software acquisition, change
and maintenance, access security, and application system acquisition,
development and maintenance.
• Application controls are manual or automated procedures that
typically operate at a business process level. They can be
preventative or detective in nature and are designed to ensure the
integrity of the accounting records. Accordingly, they relate to
procedures used to initiate, record, process and report transactions or
other financial data.
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General controls
GENERAL EXAMPLES
CONTROLS
Development of Standards over systems design, programming and
computer documentation
applications Full testing procedures using test data
Approval by computer users and management
Segregation of duties so that those responsible for design
are not responsible for testing
Installation procedures so that data is not corrupted in
transition
Training of staff in new procedures and availability of
adequate documentation
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General controls
GENERAL EXAMPLES
CONTROLS
Prevention or Segregation of duties
detection of Full records of program changes
unauthorised Password protection of programs so that access is limited to
changes to computer operations staff.
programs
Restricted access to central computer by locked doors, keypads
Maintenance of programme logs
Virus checks on software: use of anti-virus software and policy
prohibiting use of non-authorised programs or files
Back-up copies of programs being taken and stored in other
locations
Control copies of programs being preserved and regularly
compared with actual programs
Stricter controls over certain programs (utility programs) by use of
read-only memory
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General controls
GENERAL EXAMPLES
CONTROLS
Testing and Complete testing procedures
documentation of Documentation standards
program changes Approval of changes by computer users and management
Training of staff using programs
Controls to prevent Operation controls over programs
wrong programs or Libraries of programs
files being used Proper job scheduling
Controls to prevent Password protection
unauthorised Restricted access to authorised users only
amendments to data
files
Controls to ensure Storing extra copies of programs and data files off-site
continuity of Protection of equipment against fire and other hazards
operation Back-up power sources
Disaster recovery procedures eg availability of back-up computer
facilities.
Maintenance agreements and insurance
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Application controls
Application controls include the following:
• Controls over input
• Controls over processing
• Controls over master files and standing data
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Controls over input

Completeness
• Manual or programmed agreement of control totals
• Document counts
• One-for-one checking of processed output to source documents
• Programmed matching of input to an expected input control file
• Procedures over re-submission of rejected controls
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Controls over input

Accuracy
• Programmes to check data fields on input transactions for plausibility
• Manual scrutiny of output and reconciliation to source
• Agreement of control totals
Authorisation
• Manual checks to ensure information input was authorised and input
by authorised personnel
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Controls over processing

Accuracy
• Batch reconciliations
• Screen warnings (eg to prevent people logging out before processing
is complete)
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Controls over master files and standing data

• One-to-one checking
• Cyclical reviews of all master files and standing data
• Record counts and batch totals
• Controls over deletion of accounts with no current balance
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Application controls are manual or automated procedures that
operate over accounting applications to ensure that all transactions
are complete and accurate.
Which TWO of the following are application controls?
1 Password protection of programs
2 Batch controls
3 One for one checking
4 Regular back up of programs
A 1 and 4
B 3 and 4
C 1 and 2
D 2 and 3
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D 2 and 3
Password protection of programs and regular back up of programs

are examples of general IT controls, not application controls.
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Tackling the exam 1
• The vast majority of businesses use computerised systems so it is

essential that you are familiar with IT controls as they may come
up in scenario-based questions in the exam.
• For example, the June 2013 paper contained the following
requirement (Question 1, part c):
'Identify and explain FOUR application controls that should
be adopted by Fox Industries Co to ensure the completeness
and accuracy of the input of purchase invoices.' (4 marks)
• Students notoriously find computer audit difficult but it is an area
that could be tested regularly by the examiner.
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Tackling the exam 2
• This article from the January 2011 edition of Student Accountant

may prove useful:
students/2012s/sa_jan11_CAATs.pdf
• This article from August 2009 is also worth reading:
students/2012s/sa_aug09_byrne.pdf
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Tackling the exam 3
• The current F8 examining team have tested internal control in

every sitting so this is a key syllabus area.
• You could be tested on the components of internal control as we
saw earlier.
• You might also be asked to explain one element of internal control
in more detail.
• You could be asked to distinguish between tests of controls and
substantive procedures.
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Tackling the exam 4
• Scenario-based internal controls questions have also been asked

in every sitting so far. A common requirement is to ask you to
describe the deficiencies and implications of those from the
scenario and then to make recommendations to overcome those
deficiencies.
• This kind of requirement also features in the 2016 Specimen
Paper, for 18 marks.
• These kind of questions are best answered in a tabular format,
and we will be looking at them in more detail in Chapter 10.
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• The sales system
Chapter 10
• The purchases system
Tests of controls
• The inventory system
• The bank and cash system
• The payroll system
• Revenue and capital
expenditure
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Syllabus learning outcomes
• Describe control objectives, control procedures, activities and tests of

control in relation to: the sales system, the purchases system, the
payroll system, the inventory system, the cash system, non-current
assets.
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Overview
Audit evidence Internal audit reports
Tests of controls
Sales Purchases Payroll
Revenue and
Bank and cash Inventory
capital expenditure
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The sales system 1
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The sales system 2
Assertions: Occurrence and existence

Control objectives
To ensure that one person is not responsible for taking orders,
recording sales and receiving payment
Controls
Segregation of duties
Tests of controls
Observe and evaluate whether proper segregation of duties is operating
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The sales system 3

Control objectives
To ensure that recorded sales transactions represent goods or services
provided
Controls
• Sales are only recorded if there is an approved sales order form and
shipping/dispatch documentation
• Accounting for numerical sequences of invoices
• Monthly customer statements sent out and customer queries and
complaints handled independently
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The sales system 4
Tests of controls
• For a sample of sales invoices ensure there is a related sales order
form that has been authorised and shipping documentation
• Examine application controls for authorisation
• Review and test entity's procedures for accounting for
numerical sequences of invoices
• Review entity's procedures for sending out monthly statements
and dealing with customer queries and complaints
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The sales system 5

Control objectives
To ensure that goods and services are only supplied to customers with
good credit ratings.
Controls
• Authorisation of credit terms to customers (senior staff authorisation,
references/credit checks for new customers, regular review of credit
limits)
• Authorisation by senior staff required for changes in other customer
data such as address
• Orders not accepted unless credit limits reviewed first
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The sales system 6

Tests of controls
• Review entity's procedures for granting credit to customers.
• Examine a sample of sales orders for evidence of proper credit
approval by the appropriate senior staff member.
• Examine application controls for credit limits.
• Review all new customer files to ensure satisfactory credit references
have been obtained.
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The sales system 7

Control objectives
To ensure that goods and services are provided at authorised prices and
on authorised terms.
Controls
Authorised price lists and specified terms of trade in place.
Tests of controls
Verify that price lists and terms of trade are properly documented,
authorised and communicated.
Examine application controls for authorised prices and terms.
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The sales system 8
Assertion: Completeness
Control objectives
To ensure that all revenue relating to goods dispatched is recorded.
Controls
Accounting for numerical sequences of invoices.
Tests of controls
Review and test entity's procedures for accounting for
numerical sequences of invoices.
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The sales system 9
Control objectives
To ensure that all goods and services sold are correctly invoiced.
Controls
(i) Shipping/dispatch documentation is matched to sales invoices.
(ii) Sales invoices are reconciled to the daily sales report.
(iii) An open-order file is maintained and reviewed regularly.
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The sales system 10
Tests of Controls
(i) For a sample of shipping/dispatch documents, inspect to ensure
each has been matched to a related sales invoice that was
subsequently recorded.
(ii) Review a sample of reconciliations performed.
(iii) Inspect the open-order file for unfilled orders.
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The sales system 11
Assertion: Accuracy
Control objectives
To ensure that all sales and adjustments are correctly journalised,
summarised and posted to the correct accounts.
Controls
Sales invoices and matching documents required for all entries and the
date and reference of the entry are written on each document.
Tests of controls
Review supporting documents for a sample of sales entries to ensure
they contain the written details that indicate they were referred to when
entered.
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The sales system 12
Assertion: Cut-off
Control objectives
To ensure that transactions have been recorded in the correct period.
Controls
(i) All shipping documentation is forwarded to the invoicing section on a
daily basis.
(ii) Daily invoicing of goods shipped.
Tests of controls
(i) Compare dates on sales invoices with dates of corresponding
shipping documentation.
(ii) Compare dates on sales invoices with dates recorded in the sales
ledger.
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The sales system 13
Assertion: Classification assertions

Control objectives
To ensure that all transactions are properly classified in accounts
Controls
(i) Chart of accounts in place which is regularly reviewed and updated
(ii) Codes in place for different types of products or services
Tests of controls
(i) Inspect any documentary evidence of review (such as emails
requesting update to chart of accounts as a result of review)
(ii) Test application controls for proper codes
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Tackling the exam: the sales system
• Deficiencies in the sales system were examined in the 2016

Specimen Paper (Section B, Question 17).
• The most typical requirement you will get is to explain the
deficiencies and the consequences of them, followed by
recommendations to overcome them. Sometimes you are also
required to suggested associated tests of controls.
• The best way to present your answer is in a table format – this
allows you to link the deficiencies with the consequences and
recommendations, and also gives your answer structure. But
make sure you present your answer neatly.
• Don't forget to use a ruler for tables and headings!
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Tackling the exam
• Tests of controls are very likely to be examined as the examiner

will want to see that students understand the difference between
tests of controls and substantive tests.
• Another area of confusion is the difference between control
objectives, controls and tests of controls.
• Control objectives tell you what the control is trying to achieve and
will always start 'To ensure that….'.
• Controls are the processes in place to achieve the control
objectives eg monthly bank reconciliations.
• Tests of controls are carried out by the auditor and are procedures
to gain evidence about whether controls are working, so to test the
control of monthly bank reconciliations, the auditor would inspect
all the bank reconciliations for the year to see if they had been
done every month.
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The purchases system 1
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Control objective
To ensure that recorded purchases represent goods and services
received.
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Controls
(i) Authorisation procedures and policies in place for ordering goods
and services
(ii) Segregation of duties
(iii) Purchase orders raised for each purchase and authorised by
appropriate senior personnel
(iv) Approved purchase order for each receipt of goods
(v) Staff receiving goods check them to the purchase order
(vi) Stores clerks sign for goods received
(vii) Purchase orders and GRNs are matched with the suppliers' invoices
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Tests of controls
(i) Inspect policies and procedures in place.
(ii) Observe and evaluate segregation of duties.
(iii) Examine a sample of purchase orders to ensure they have been
appropriately authorised.
Review the delegated list of authority for purchases.
(iv) For a sample of GRNs, ensure there is a related purchase order that has
been properly approved.
(v) Observe receipts of goods by staff to confirm whether the check is done.
(vi) Inspect a sample to confirm whether stores staff undertake this check.
(vii) Examine supporting documentation to ensure it has been matched for a
sample of invoices.
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Assertions: Completeness
Control objectives
To ensure that all purchase transactions that occurred have been
recorded
Controls
(i) Purchase orders and GRNs are matched with the suppliers' invoices
(ii) Periodic accounting for pre-numbered GRNs and purchase orders
(iii) Independent check of amount recorded in the purchase journal
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Assertions: Completeness
Tests of controls
(i) For a sample of purchase orders in the year ensure each has been
matched to a related invoice that was subsequently recorded.
(ii) Review entity's procedures for accounting for pre-numbered
documents.
(iii) Examine application controls.
Examine documentation for evidence of this check.
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Assertions: Rights and obligations
Control objectives
To ensure that recorded purchases represent the liabilities of the entity
Controls
Purchase orders and GRNs are matched with the suppliers' invoices
Tests of controls
Examine supporting documentation to ensure it has been matched for a
sample of invoices
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Assertions: Accuracy, classification and valuation
Control objectives
To ensure that purchase transactions are correctly recorded in the
accounting system
Controls
(i) Purchase orders and GRNs are matched with the suppliers' invoices
(ii) Mathematical accuracy of the supplier's invoice is verified
(iii) Amount posted to general ledger is reconciled to the purchases
ledger
(iv) Chart of accounts in place
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Assertions: Accuracy, classification and valuation

Tests of controls
(i) Examine supporting documentation for a sample of invoices.
(ii) Review a sample of invoices for evidence the accuracy has been
verified (eg signature or initials) and reperform the check.
(iii) Review reconciliations for evidence of this check.
(iv) Review purchases journal and general ledger for reasonableness.
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Assertion: Cut-off
Control objectives
To ensure that purchase transactions are recorded in the correct
accounting period
Controls
(i) All goods received reports forwarded to accounts payable department
daily
(ii) Procedures in place that require recording of purchases as soon as
possible after goods/services received
Tests of controls
(i) Compare dates on reports to dates on relevant vouchers
(ii) Compare dates on vouchers with dates they were recorded in the
purchases journal
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Tackling the exam: The purchases system
• Deficiencies in the purchases system were examined in the June

2015 paper.
• The requirement was to explain the deficiencies and the
consequences of them, followed by recommendations to
overcome them.
• Do not produce a covering letter unless it is specifically asked for
as you won't get any credit for doing so.
• We will work through the June 2015 question in the next few
slides.
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Question: June 2015 Sec B Question 4
Cherry Blossom Co (Cherry) manufactures custom made furniture

and its year end is 30 April. The company purchases its raw materials
from a wide range of suppliers. Below is a description of Cherry’s
purchasing system.
When production supervisors require raw materials, they complete a
requisition form and this is submitted to the purchase ordering
department. Requisition forms do not require authorisation and no
reference is made to the current inventory levels of the materials
being requested. Staff in the purchase ordering department use the
requisitions to raise sequentially numbered purchase orders based
on the approved suppliers list, which was last updated 24 months
ago. The purchasing director authorises the orders prior to these
being sent to the suppliers.
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When the goods are received, the warehouse department verifies the
quantity to the suppliers despatch note and checks that the quality of
the goods received are satisfactory. They complete a sequentially
numbered goods received note (GRN) and send a copy of the GRN
to the finance department.
Purchase invoices are sent directly to the purchase ledger clerk, who
stores them in a manual file until the end of each week. He then
inputs them into the purchase ledger using batch controls and gives
each invoice a unique number based on the supplier code. The
invoices are reviewed and authorised for payment by the finance
director, but the actual payment is only made 60 days after the
invoice is input into the system.
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Required:
In respect of the purchasing system of Cherry Blossom Co:
(i) Identify and explain FIVE deficiencies; and
(ii) Recommend a control to address each of these deficiencies.
Note: The total marks will be split equally between each part.
(10 marks)
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Approach: June 2015 Sec B Question 4
Firstly, look at the requirement carefully: there are 10 marks

available, split between the requirements equally so four marks each
for deficiencies and recommended controls.
Note the requirement for five deficiencies so make sure you have five
but no more as you won't get credit for more than five.
The deficiencies and recommendations should be in a separate
Appendix and presented in a tabular format.
You will see from the model answer that follows that there are more
than four deficiencies that you can choose to include in your answer.
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Answer: June 2015 Sec B Question 4
Deficiencies Controls
Requisition forms are completed by Requisition forms should be authorised by the
production supervisors but are not production manager or director prior to being
authorised. This increases the risk of sent to the purchase ordering department.
fraudulent purchases, or of goods being This department should not process any
ordered which are not required, leading to unauthorised requisitions.
unnecessary cash outflows.
Orders are being placed for goods without The inventory system should be updated to
the inventory levels being checked first. This record minimum/maximum required levels of
could result in goods being ordered which raw materials. When completing the purchase
are not required, leading to unnecessary order, the ordering clerk should check the
cash outflows. current level of inventory on the system and
only order if the quantity is within the set
parameters.
In addition, as the company does not The company should set minimum authorised
currently monitor inventory levels, it could reorder levels for inventory items.
experience stock-outs resulting in the
company being unable to meet customer
orders.
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Answer: June 2015 Sec B Question 4 (cont’d)
The purchase ordering department maintains an The approved supplier list should be reviewed
approved supplier list; however, this has not and updated as necessary. Going forward, it
been updated for 24 months. should be updated regularly, at least on an
As this list has not been recently updated, the annual basis.
suppliers being used may not be ideal with
regards to price, quality and delivery times. This
could result in Cherry paying increased costs for
raw materials or receiving poorer quality goods.
Goods are being received without any checks A copy of the authorised order form should be
being made against purchase orders. This could sent to the warehouse department. This should
result in Cherry receiving and subsequently then be checked to the goods when received.
paying for goods it did not order.
In addition, if no check is made against the Once checked, the order should be sent to the
purchase order, then the company may have purchase ordering department and logged as
significant purchase orders which are completed. On a regular basis, an ordering clerk
outstanding, leading to loss of sales. should review the order file for any outstanding
items.
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Purchase invoices are manually filed by the The purchase ledger clerk should record the
purchase ledger clerk and only updated to invoices in the ledger on a daily rather than
the ledger on a weekly basis. Until the weekly basis.
invoices are input into the system, there is a If this is not practical, then upon receipt of the
risk that they may be misplaced and not invoices, each should be attributed a
entered. This would result in an sequential number and filed. When these are
understatement of trade payables and logged into the ledger, the clerk should check
Cherry failing to make payment to the that there are no breaks in the sequence.
suppliers on time.
Purchase invoices are not being agreed to All purchase invoices should be matched to
the relevant goods received notes (GRNs) the related GRN; the details should be agreed
prior to authorisation and payment by the prior to the invoice being logged in the
finance director. This could result in invoices purchase ledger.
being paid for goods which were not
received.
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Purchase invoices are not sequentially All purchase invoices should be sequentially
numbered. Failing to sequentially number them numbered and on a regular basis a sequence
means that Cherry’s finance department are check of unrecorded invoices should be
unable to monitor if all invoices have been performed.
completely recorded; this could result in a
failure to make payment to a supplier on time.
If the invoices are sequentially numbered, then
a sequence check can be performed for any
unrecorded invoices.
Invoices are authorised by the finance director, The policy of making payment after 60 days
but payment is only made 60 days after the should be reviewed. Consideration should be
invoice is input. There is the risk that Cherry is given to earlier payment if the settlement
missing out on early settlement discounts. discounts are sufficient. If not, invoices should
Also, failing to pay in accordance with the be paid in accordance with the supplier’s
supplier’s payment terms can lead to a loss of payment terms.
supplier goodwill as well as the risk that
suppliers may refuse to supply goods to
Cherry.
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The inventory system 1
There are three approaches to the audit of inventory, and the approach
taken depends on whether controls around inventory are assessed as
strong or weak.
Approach 1
Perpetual inventory can be relied on if controls are strong.
Approach 2
Inventory count near year-end and adjusted by perpetual inventory, only
if controls are strong.
Approach 3
Year-end count: use a substantive approach (see Chapter 13).
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Control objective 1
To ensure that all inventory movements are authorised and recorded
Controls
(i) Pre-numbered documentation (GDNs and GRNs) in use
(ii) Reconciliations of inventory records with general ledger
(iii) Segregation of duties
Tests of controls
(i) Review documentation in use
(ii) Review a sample of reconciliations to confirm they are performed
and then reviewed by a more senior individual
(iii) Observe and evaluate proper segregation of duties
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Control objective 2
To ensure that inventory included on the statement of financial position
physically exists
Controls
(i) Physical safeguards to ensure inventory is not stolen
(ii) Separate responsibilities for maintenance of records and custodianship
(iii) Inventory counted regularly
Tests of controls
(i) Review security systems in place
(ii) Review policies and procedures in place and discuss them with relevant
staff
(iii) Review procedures for counting inventory and attend inventory count
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Control objective
To ensure that all purchases and sales of inventory have been recorded
in the accounting system
Controls
(i) Procedures in place to include inventory held at third parties and
exclude inventory held on consignment for third parties
(ii) Reconciliations of accounting records with physical inventory
Tests of controls
(i) Review entity's procedures relating to consignment inventory
(ii) Review reconciliations performed and whether reviewed by an
independent person
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Assertion: Rights and obligations

Control objective
To ensure that inventory records only include items that belong to the
entity
Controls
Procedures in place to include inventory held at third parties and exclude
inventory held on consignment for third parties
Tests of controls
Review entity's procedures relating to consignment inventory
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Assertions: Accuracy, valuation and allocation
Control objective 1
To ensure that inventory quantities have been accurately determined
Controls
Periodic or annual comparison of inventory with amounts shown in
perpetual inventory records
Tests of controls
Review and test entity's procedures for taking physical inventory
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Control objective
To ensure that inventory is properly stated at the lower of cost and net
realisable value
Controls
(i) Standard costs reviewed by management
(ii) Review of cost accumulation and variance reports
(iii) Inventory managers review inventory regularly to identify slow-moving,
obsolete and excess inventory
Tests of controls
(i) Review and test entity's procedures for developing standard costs
(ii) Inspect variance reports produced
(iii) Discuss with managers how this is done and observe procedure
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Assertion: Cut-off
Control objective
To ensure that all purchases and sales of inventory are recorded in the
correct accounting period
Controls
(i) All dispatch documents processed daily to record the dispatch of
finished goods
(ii) All goods inwards reports processed daily to record the receipt of
inventory
(iii) Reconciliations of inventory records with general ledger
Tests of controls
(i) and (ii) Inspect documentation to confirm daily processing
(iii) Review reconciliations performed
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Assertions: Presentation
Control objective 1
To ensure that inventory transactions and balances are properly
identified and classified in the financial statements
Controls
Orders for materials and production data forms used to process goods
through manufacturing
Tests of controls
Review entity's procedures and documentation used to classify inventory
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Control objective 2
To ensure that disclosures relating to classification and valuation are
sufficient
Controls
Approval by Finance Director
Tests of controls
Review entity's working papers for evidence of review
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Exam link: The inventory system
• Deficiencies in the inventory system were examined in June 2010,

December 2010 and June 2012.
• The requirement was to explain the deficiencies and the
consequences of them, followed by recommendations to
overcome them.
• Spend time planning your answer – go through the scenario line-
by-line, noting down the potential deficiencies in the system.
• Again, present your answers in a table, using a ruler for the table
and headings.
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The bank and cash system 1
• The following slides look at the controls around cash.

• Controls around cash payments and receipts are designed to help
prevent theft and fraud.
• First we will look at the controls around cash payments, followed by
controls around cash receipts.
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Cash payments
Assertion: Occurrence
Control objective
To ensure that only valid cash payments are made
Controls
(i) Segregation of duties
(ii) Supplier statements independently reviewed and reconciled to trade
payables records
(iii) Monthly bank reconciliations prepared and reviewed
(iv) Only authorised staff able to make electronic cash payments and
issue cheques
(v) Electronic cash payments and cheques prepared only after all source
documents have been independently approved
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Tests of controls
(i) Observe and evaluate proper segregation of duties
(ii) Review procedures for reconciling supplier statements
(iii) Review reconciliations to confirm whether undertaken and reviewed
(iv) Review delegated list of authority for cash payments
(v) Inspect relevant documentation for evidence of approval by senior
personnel
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Cash payments
Control objective
To ensure that all cash payments that occurred are recorded
Controls
(ii) Supplier statements independently reviewed and reconciled to trade
payables records
(iii) Monthly bank reconciliations prepared and reviewed
(iv) Review of cash payments by manager before release
(v) Daily cash payments reconciled to posting to payables accounts
(vi) Use of pre-numbered cheques
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Tests of controls
(ii) Review procedures for reconciling supplier statements
(iii) Review reconciliations to confirm whether undertaken and reviewed
(iv) Inspect sample of listings for evidence of senior review
(v) Review a sample of reconciliations for evidence that they have been
done
(vi) Examine evidence to verify use of pre-numbered cheques
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Cash payments
Control objective 1
To ensure that cash payments are recorded correctly in the ledger
Controls
(i) Reconciliation of daily payments report to electronic cash payment
transfers and cheques issued
(ii) Supplier statements reconciled to payables accounts regularly
(iii) Monthly bank reconciliations of bank statements to ledger account
Tests of controls
(i) Review reconciliations to ensure performed and reviewed
(ii) Review reconciliations for a sample of accounts
(iii) Review bank reconciliations for evidence performed and reviewed
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Cash payments
Assertions: Classification
Control objective 2
To ensure that cash payments are posted to the correct payable accounts
and to the general ledger
Controls
(i) Supplier statements reconciled to payables accounts regularly
(ii) Agreement of monthly cash payments journal to general ledger posting
(iii) Payable accounts reconciled to general ledger control account
Tests of controls
(i) Review reconciliations for a sample of accounts
(ii) Review postings from journal to general ledger
(iii) Review reconciliations for evidence performed and reviewed
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Cash payments
Assertion: Cut-off
Control objective
To ensure that cash payments are recorded in the correct accounting
period
Controls
Reconciliation of electronic funds transfers and cheques issued with
postings to cash payments journal and payable accounts
Tests of controls
Review reconciliation to confirm it is done regularly
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Cash payments
Control objective
To ensure that cash payments are charged to the correct accounts
Controls
(i) Chart of accounts
(ii) Independent approval and review of general ledger assignment
Tests of controls
(i) Review cash payments journal to assess reasonableness of charging
of accounts
(ii) Review assignment of general ledger account
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Cash receipts
Assertions: Occurrence
Control objective
To ensure that all valid cash receipts are received and deposited
Controls
(ii) Use of electronic cash receipts transfer not received or deposited
(iii) Monthly bank reconciliations performed and independently reviewed
(iv) Use of cash registers or point-of-sale devices
(v) Periodic inspections of cash sales procedures
(vi) Restrictive endorsement of cheques immediately on receipt
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Cash receipts
Controls continued
(vii) Mail opened by two staff members
(viii) Immediate preparation of cash book or list of mail receipts
(ix) Independent check of agreement of cash/cheques to be deposited
at bank with register totals and receipts listing
(x) Independent check of agreement of bank deposit slip with daily
cash summary
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Cash receipts
Tests of controls
(ii) Examine application controls for electronic cash receipts transfer
(iii) Review monthly bank reconciliations to ensure performed and reviewed
(iv) Observe cash sales procedures
(v) Inquire with managers about results of inspections
(vi) Observe mail opening, including endorsement of cheques
(vii) Observe mail opening procedures
(viii) Observe preparation of cash receipts' records
(ix) Review documentation for evidence of independent check
(x) Review documentation for evidence of independent check
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Cash receipts
Control objective
To ensure that all cash receipts are recorded
Controls
(ii) Use of electronic cash receipts transfer not received or deposited
(iii) Monthly bank reconciliations performed and independently reviewed
(iv) Daily cash receipts listing reconciled with posting to customer
accounts
(v) Customer statements prepared and sent out on a regular basis
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Cash receipts
Tests of controls
(ii) Observe application controls for electronic cash receipts transfer
(iii) Review monthly bank reconciliations to confirm performed and
independently reviewed
(iv) Review reconciliation
(v) Inquire of management about handling of customer statements
Examine a sample of customers and note frequency of statements
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Cash receipts
Control objective 1
To ensure that cash receipts are recorded at correct amounts
Controls
(i) Daily remittance report reconciled to control listing of remittance
advices
(ii) Monthly bank reconciliation performed and reviewed independently
Tests of controls
(i) Review reconciliations
(ii) Review reconciliations for evidence performed and reviewed
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Cash receipts
Control objective 2
To ensure that cash receipts are posted to correct receivables accounts
and to the general ledger
Controls
(i) Daily remittance report reconciled daily with postings to cash receipts
journal and customer accounts
(ii) Monthly customer statements sent out
(iii) Monthly cash receipts journal agreed to general ledger posting
(iv) Receivables' ledger reconciled to control account
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Cash receipts
Tests of controls
(i) Review reconciliations
(ii) Review entity's procedures for sending out statements
(iii) Review journal and posting to general ledger
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Cash receipts
Assertion: Cut-off
Control objective
To ensure that cash receipts are recorded in the correct accounting
period
Controls
Bank reconciliation at period-end
Tests of controls
Review reconciliation to confirm it has been done and reviewed
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Cash receipts
Assertions: Presentation and disclosure
Control objective
To ensure that cash receipts are charged to the correct accounts
Controls
(i) Chart of accounts in place and regularly reviewed
(ii) Codes in place for different types of receipts
Tests of controls
(i) Inspect any documentary evidence (eg emails requesting update to
chart of accounts as a result of review)
(ii) Test application controls for proper codes
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Exam link: Cash controls
• Cash controls around cash payments and receipts will also be

relevant to controls in the purchasing and sales systems
respectively, so could be examined on a question on deficiencies
in a purchases or sales system.
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The payroll system 1
Control objectives
To ensure that payment is made only to bona fide employees of the entity
Controls
(i) Segregation of duties between HR and payroll functions
(ii) Personnel files held for all employees
(iii) Authorisation procedures for hiring, termination, time worked, wage
rates, overtime, benefits etc
(iv) Any change in employment status informed to HR department
(v) Use of time clocks to record time worked
(vi) Clock cards approved by supervisor
(vii) Only employees with valid employee numbers are paid
(viii) Payroll budgets in place, reviewed by management
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Tests of controls
(i) Observe and evaluate proper segregation of duties.
(ii) Review a sample of starters and leavers in the year to ensure
correct documentation in place.
(iii) Review and test authorisation procedures in place.
(iv) Review policies and procedures in place for changing status and
consider if adequate. Review personnel files for a sample of
employees whose status changed in year.
(v) Observe employees' use of time clocks.
(vi) Inspect a sample of clock cards for evidence of approval by
appropriate level of management.
(vii) Review and test procedures for entering and removing employee
numbers from the payroll master file.
(viii) Review budgeting procedures.
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Control objective
To ensure that all payroll costs are recorded for work done by employees
Controls
(i) Pre-numbered clock cards in use
(ii) Segregation of duties
(iii) Regular reconciliations of payroll records and employee costs
recorded in the general ledger
(iv) Comparison of cheques and bank transfer list with payroll
(v) Preparation and authorisation of cheques and bank transfer list
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Tests of controls
(i) Review numerical sequence of clock cards.
(ii) Observe and evaluate proper segregation of duties.
(iii) Review a sample of reconciliations to ensure they are properly
carried out and reviewed by an independent person.
(iv) Inquire whether comparisons are made between payment records
and payroll and inspect any documentary evidence of the review.
(v) Examine paid cheques or a certified copy of the bank list for
employees paid by cheque or bank transfer to ensure proper
authorisation.
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Control objective 1
To ensure that all benefits and deductions are computed correctly
Controls
Reperformance of a sample of payroll benefit and deduction calculations
Payroll budgets in place and reviewed by management
Agreement of gross earnings and total tax deducted with taxation returns
Tests of controls
Review documentary evidence that recalculation occurred
Review budgeting procedures
Inspect documentation for evidence of management's review
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Control objective 2
To ensure that payroll transactions are correctly recorded in the
accounting system
Controls
(i) Changes to master file verified through 'before and after' reports
(ii) Payroll master file reconciled to general ledger
Tests of controls
(i) Review reconciliations of 'before and after' reports to payroll master
file
(ii) Review reconciliations of payroll master file to general ledger and
confirm whether discrepancies are followed up promptly and
resolved
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Assertion: Cut-off
Control objective
To ensure that payroll transactions are recorded in the correct accounting
period
Controls
All starters, leavers, changes to salary and deductions are reported
promptly to payroll department and changes are updated to the payroll
master file promptly
Tests of controls
• Review entity's procedures for reporting changes to the payroll
department
• Verify sample of starters and leavers
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Assertion: Presentation
Control objective
To ensure that payroll transactions are properly classified in the financial
statements
Controls
• Chart of accounts
• Independent approval and review of accounts charged to payroll
• Payroll budgets in place and reviewed by management
Tests of controls
• Review chart of accounts
• Review procedures for classifying payroll costs
• Review budgeting procedures
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Exam link: The payroll system 1
• Deficiencies in the payroll system have been examined in the

December 2013 and June 2014 papers.
• There is a good chance then that this might be tested again soon.
• Again, with this type of answer, present your answers in a table,
using a ruler for the table and headings.
• When suggesting recommendations, make sure they are sensible
and relevant to the scenario you are presented with in the
question.
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Exam link: The payroll system 2
The September 2013 edition of Student Accountant contains an

excellent article on the audit of wages:
http://www.accaglobal.com/en/student/acca-qual-student-
journey/qual-resource/acca-qualification/f8/technical-articles/the-
audit-of-wages.html
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Revenue and capital expenditure 1
• It is important that an entity has controls in place to ensure that capital

and revenue expenditure are accounted for correctly as errors will
result in the misstatement of profit and net assets.
• Management may have an incentive to misclassify expenditure in
order to manipulate profit or for tax purposes.
• Costs which are susceptible to incorrect accounting treatment are
repairs and maintenance, research and development, and
website/software costs.
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Real World Example: WorldCom
In 2001, WorldCom recognised over $3 billion of operating costs as

capital expenditure on its statement of financial position. These costs
related to 'line costs' – fees that the company had to pay other
telecom companies for the right to access their networks.
If the company had recognised this as revenue expenditure that year,
it would have made a loss, but by capitalising the costs, it managed
to smooth its earnings.
The fraud was uncovered by WorldCom's internal auditors and its
new external auditors, KPMG.
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Assertion: Authorisation
Control objectives
To ensure that expenditure is properly authorised
Controls
(i) Orders for capital items should be authorised by appropriate levels of
management.
(ii) Order should be requisitioned on appropriate (different to revenue)
documentation.
(iii) Invoices should be approved by the person who authorised the order.
(iv) Invoices should be marked with the appropriate general ledger code.
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Tests of controls
(i) Review policies and procedures in place.
(ii) Examine a sample of orders for appropriate authorisation.
(iii) Inspect invoices to verify the invoice has been appropriately
approved.
(iv) Inspect invoices to verify the invoice has the correct general ledger
code marked on it.
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Control objectives
To ensure that all non-current assets are correctly recorded in the
accounting system
Controls
(i) Capital items should be written up in the non-current asset register.
(ii) The non-current asset register should be reconciled regularly to the
general ledger and any differences should be investigated and
resolved promptly.
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Tests of controls
Review reconciliations to ensure they are regularly carried out, reviewed
by a more senior person, and that all discrepancies are followed up and
resolved on a timely basis.
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Assertion: Classification
Control objectives
To ensure that all expenditure is classified correctly in the financial
statements as capital or revenue expenditure
Controls
As for purchases system
Tests of controls
As for purchases system
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Question: Specimen Paper (Sec B, Question 6a)
Baggio International Co (Baggio) is a manufacturer of electrical

equipment. It has factories across the country and its customer base
includes retailers as well as individuals, to whom direct sales are
made through their website. The company's year end is 30
September 20X5. You are an audit supervisor of Suarez & Co and
are currently reviewing documentation of Baggio's internal control in
preparation for the interim audit.
Baggio's website allows individuals to order goods directly, and full
payment is taken in advance. Currently the website is not integrated
into the inventory system and inventory levels are not checked at the
time when orders are placed. Inventory is valued at the lower of cost
and net realisable value.
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Question: Specimen Paper (Sec B, Question 6a) cont'd
Goods are despatched via local couriers; however, they do not

always record customer signatures as proof that the customer has
received the goods. Over the past 12 months there have been
customer complaints about the delay between sales orders and
receipt of goods. Baggio has investigated these and found that, in
each case, the sales order had been entered into the sales system
correctly but was not forwarded to the despatch department for
fulfilling.
Baggio’s retail customers undergo credit checks prior to being
accepted and credit limits are set accordingly by sales ledger clerks.
These customers place their orders through one of the sales team,
who decides on sales discount levels.
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Raw materials used in the manufacturing process are purchased

from a wide range of suppliers. As a result of staff changes in the
purchase ledger department, supplier statement reconciliations are
no longer performed. Additionally, changes to supplier details in the
purchase ledger master file can be undertaken by purchase ledger
clerks as well as supervisors.
In the past six months, Baggio has changed part of its manufacturing
process and as a result some new equipment has been purchased,
however, there are considerable levels of plant and equipment which
are now surplus to requirement. Purchase requisitions for all new
equipment have been authorised by production supervisors and little
has been done to reduce the surplus of old equipment.
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Required:
(a) In respect of the internal control of Baggio International Co:
(i) Identify and explain SIX deficiencies;
(ii) Recommend a control to address each of these deficiencies;
and
(iii) Describe a test of control Suarez & Co would perform to
assess if each of these controls is operating effectively.
Note. The total marks will be split equally between each part.
(18 marks)
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Answer: Specimen Paper (Sec B, Question 6a)
Deficiency and Recommended control Test of control

explanation
The website and inventory The website should be fully Use test data to order items not
system are not integrated. integrated with the inventory currently in stock to ensure that
This could result in orders made system so that orders are the customer is informed and an
via the website not being processed only when the item is approximate time is given for
fulfilled and consequent loss of in stock. Where an item is out of when the item is next expected
revenue and customer goodwill. stock, the website should be to be in stock.
able to inform customers when
stock would be replenished.
Couriers do not always take a Couriers must take a signature Inspect a sample of goods
signature from the customer from the customer on delivery of despatched notes to confirm
on delivery. This gives rise to the goods as proof of delivery. that customer signatures have
the risk of theft by couriers and been taken.
the risk that customers who
have had their item delivered
claim not to have received it,
leading to goods being
despatched twice.
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Answer: Specimen Paper (Sec B, Question 6a) cont'd

explanation
There is a long delay As soon as an order has For a sample of sales orders,
between the placing of the been made, it should be compare the time of the
order and the despatch of entered into the sales system order to the time the order
the products. This will result and sent to the despatch was despatched to ensure
in a loss of customer goodwill department straightaway with that despatch of orders is
and damage and reputation a copy of the sales order being carried out on a timely
of the company. form. The system should basis.
flag any outstanding sales Review the report of
orders past a certain period. outstanding sales orders.
Sales ledger clerks set credit For any new retail customers, For a sample of new
limits for retail customers limits should be authorised by customers, review the credit
without any monitoring. a senior manager and limits set to ensure they are
Inappropriate limits could be reviewed on a regular basis. reasonable and were
set, resulting in goods not authorised by an appropriate
being paid for and senior staff member.
irrecoverable debts.
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explanation
The sales team decide on Discount levels should be set Review the discount levels
the level of discounts for by an authorised manager. for a sample of customers to
retail customers. This could Any changes to the discount ensure they were set by
lead to levels of discount level should be discussed appropriate personnel and
being offered at too high an and authorised by a senior any changes were
amount, resulting in loss of manager. authorised.
revenue.
The company uses a wide A preferred supplier list Review the raw material
range of suppliers. As a should be set up and used purchase orders against the
result, it may be missing out when purchasing raw supplier list to confirm that
on bulk discounts. There is materials. only preferred suppliers are
also a risk of raw materials used.
not being of the required
quality, affecting customer
goodwill.
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explanation
Supplier statement Monthly supplier Inspect supplier statement

reconciliations are not reconciliations must be reconciliations to ensure
performed. This could result undertaken by purchase they have been prepared
in errors in the recording of ledger clerks and reviewed by each month and then
purchases and disputes with the finance director, with any reviewed by a more senior
suppliers. discrepancies being staff member.
investigated on a timely
basis.
Purchase ledger clerks can Only authorised personnel Review the register of
make changes to supplier should have the ability to amendments made to the
details in the purchase amend details in the purchase ledger master file
ledger master file. This purchase ledger master file. to confirm that only
could result in fraud through authorised staff have made
the set up of fictitious changes.
suppliers.
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Chapter 11 • Substantive procedures
Audit procedures • Accounting estimates
and sampling • Audit sampling

• Computer-assisted audit
techniques
• Using the work of others
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• Discuss the substantive procedures for obtaining audit evidence.

• Discuss and provide examples of how analytical procedures are used
as substantive procedures.
• Discuss the problems associated with the audit and review of
accounting estimates.
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• Define audit sampling and explain the need for sampling.

• Identify and discuss the differences between statistical and non-
statistical sampling.
• Discuss and provide relevant examples of the application of the basic
principles of statistical sampling and other selective testing
procedures.
• Discuss the results of statistical sampling, including consideration of
whether additional testing is required.
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• Explain the use of computer-assisted audit techniques in the context

of an audit.
• Discuss and provide relevant examples of the use of test data and
audit software.
• Discuss why auditors rely on the work of others.
• Discuss the extent to which external auditors are able to rely on the
work of experts, including the work of internal audit.
• Discuss the audit considerations relating to entities using service
organisations.
• Explain the extent to which reference to the work of others can be
made in audit reports.
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Overview
Audit procedures and
sampling
Computer-assisted Using the work

Sampling
audit techniques of others
Service Internal
Experts
organisations audit
Audit
Test data
software
Audit of accounting Auditing smaller

estimates entities
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Substantive procedures 1
What are substantive procedures?

Substantive procedures are audit tests to obtain audit evidence to detect
material misstatements in the financial statements.
Two types of substantive procedures:
1. Tests of details
2. Substantive analytical procedures
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Remember!
Analytical procedures must be used during audit planning and audit
completion.
They can also be used as substantive audit procedures during audit
fieldwork.
This article on analytical procedures from the September 2010 edition of

Student Accountant will help clarify when and why analytical procedures
are used in an audit:
http://www.accaglobal.com/content/dam/acca/global/pdf/sa_sept10_audit
.pdf
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This is a useful model for preparing an audit plan:
• Agree opening balances with previous year's working papers

• Review general ledger for unusual records
• Agree client schedules to/from accounting records to ensure
completeness
• Carry out analytical review
• Test transactions in detail
• Test balances in detail
• Review presentation and disclosure in financial statements
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Exam link
• The F8 exam will almost invariably have a question on substantive

audit procedures. Here is a typical requirement:
Describe substantive procedures you would perform to obtain

sufficient appropriate audit evidence in relation to Torres's trade
receivables. (6 marks)
• When designing audit tests, make sure you distinguish between

substantive audit tests and tests of controls.
• Another issue to consider, which is very important, is the financial
statement assertions you are testing. The examiner will test
whether you understand the assertions and how different audit
tests are used to provide evidence to support them.
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Question: Substantive audit procedures
You are the audit junior who has been assigned the task of audit
fieldwork on the non-current assets balance on a client's statement of
financial position.
Can you think of some suitable substantive procedures, which

include a mixture of tests of details and substantive analytical
procedures, which you might use?
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Answer: Substantive audit procedures
The table sets out various substantive audit procedures you might
use in the audit of non-current assets. It is not an exhaustive list.
Tests of details Substantive analytical procedures
Selecting a sample of assets from the Performing a proof-in-total test on the
asset register and physically inspecting depreciation charge for the year to confirm
them. its accuracy and reasonableness.
Selecting a sample of physically inspected Comparing additions in the year to the prior
assets and tracing them back to the non- year and investigating the reasons for any
current asset register and ledger to test big differences.
completeness.
Taking a sample of additions in the year Comparing ratios of depreciation to non-
and tracing them back to the purchase current assets (by category) with previous
invoices. years, depreciation policy rates.
Reconciling the non-current asset register

with the general ledger.
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Accounting estimates 1
We now go on to look at accounting estimates. You need to understand
these key terms:
An accounting estimate is an approximation of a monetary amount in
the absence of a precise means of measurement.
Estimation uncertainty is the susceptibility of an accounting estimate
and related disclosures to an inherent lack of precision in its
measurement.
Management's point estimate is the amount selected by management
for recognition or disclosure in the financial statements as an accounting
estimate.
Auditor's point estimate or auditor's range is the amount, or range of
amounts, respectively, derived from audit evidence for use in evaluating
management's point estimate.
ISA 540 Auditing accounting estimates, including fair value accounting
estimates, and related disclosures
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Examples of accounting estimates

• Allowance for doubtful accounts
• Inventory obsolescence
• Warranty obligations
• Depreciation method or asset useful life
• Outcome of long-term contracts
• Costs arising from litigation settlements and judgements
• Provision against the carrying amount of an investment where there is
uncertainty regarding its recoverability
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Nature and reliability of information
affects
Degree of uncertainty
affects
Risk of material misstatement
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Audit procedures
• Inquiries of management about alternative assumptions
• Assessment of whether assumptions used are reasonable
• Evaluation of whether accounting estimate is either reasonable or
misstated
• Obtain sufficient appropriate audit evidence about whether
disclosures are correct
• For accounting estimates that give rise to significant risks, evaluate
adequacy of disclosure of their estimation uncertainty
• Review judgements and decisions of management in making the
accounting estimates to identify if there are indications of possible
management bias
• Obtain written representations from management whether
they believe significant assumptions used are reasonable
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Exam link: Accounting estimates
• Accounting estimates could be tested in a knowledge requirement

in Section A of the exam.
• However, they could also come up in a scenario context. For
example, you could be presented with a scenario where there is a
warranty provision and be asked for substantive audit procedures
to test it.
• You could also be asked to define some of the terms relating to
accounting estimates from ISA 540 as part of a Section B
question.
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Question: December 2010 Question 5a
Required:
Describe the audit procedures required in respect of accounting
estimates. (5 marks)
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Approach: December 2010 Question 5a
This is a general question on accounting estimates, worth five marks

which gives you nine minutes to answer it.
Assume that you can score one mark for each well-explained audit
procedure.
Ensure that your audit procedures make sense and have enough
detail in them to enable an auditor to carry them out independently.
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Answer: December 2010 Question 5a
• Inquire from management how the accounting estimate is made
and the data and assumptions on which it is based.
• Make an assessment as to the reasonableness of the assumptions
used by management in deriving the accounting estimate.
• Review draft disclosure notes to ensure disclosures relating to the
accounting estimate are correct.
• Develop an expectation of the possible estimate (point estimate) or
a range of amounts to evaluate the reasonableness of
management's estimate.
• Review the judgements and decisions made by management in
the making of accounting estimates to identify if there are
indicators of possible management bias.
• Obtain written representations from management whether they
believe significant assumptions used in making accounting
estimates are reasonable.
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Audit sampling 1
What is audit sampling?

Audit sampling is the application of audit procedures to less than 100%
of items within a population of audit relevance such that all sampling
units have a chance of selection. This will enable the auditor to obtain
and evaluate audit evidence about some characteristic of the items
selected in order to provide the auditor with a reasonable basis on which
to draw conclusions about the entire population. Audit sampling can use
either statistical or non-statistical approaches.
ISA 530 Audit sampling
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Audit sampling 2
Why do auditors need to use audit sampling?

Imagine you are the auditor responsible for audit work on year-end
receivables. This balance is the largest balance on the statement of
financial position for your client and the draft year-end figure is made up
of 355 different amounts, ranging in value from $45 to $63,250.
You are one person in a total team of four. It just wouldn't be practical in
terms of time and cost to audit every single balance making up the total
receivables figure. After auditing receivables, you have to do audit work
on payables, accruals and non-current assets too!
That's why auditors use sampling.
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Audit sampling 3
Selecting items to test
100% of items Items with a certain Sampling

characteristic
Not sampling
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Audit sampling 4
Non-sampling methods
1. Testing 100% of a population

This can be used where a population consists of only a few items.
2. Testing items with a certain characteristic

• High value or key items
• All items over a certain amount
• Items to obtain information
• Items to test procedures
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Audit sampling 5
Let's recap from Chapter 6:

• Sampling risk arises from the possibility that the auditor's conclusion,
based on a sample of a certain size, may be different from the
conclusion that would be reached if the entire population were
subjected to the same audit procedure.
• Non-sampling risk arises from factors that cause the auditor to reach
an erroneous conclusion for any reason not related to the size of the
sample. For example, the use of inappropriate audit procedures, or
misinterpretation of audit evidence and failure to recognise a
misstatement or deviation.
Remember!
Detection risk = Sampling risk + Non-sampling risk
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Audit sampling 6
Types of sampling
Statistical
• Uses mathematical number tables to choose a sample free from
bias
• Probability theory used to evaluate results
Non-statistical
• No mathematical basis for selecting a sample or evaluating results
So if each item in the population does not have an equal chance of

being selected, the sampling technique is non-statistical.
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Audit sampling 7
Selection Methods
• Random (statistical)
• Systematic (statistical)
• Haphazard (non-statistical)
• Block (non-statistical)
• Value weighted selection/monetary unit sampling (statistical)
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Audit sampling 8
Random selection
Ensures that all items in the population have an equal chance of
selection, eg by the use of random number tables or random number
generators.
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Audit sampling 9
Systematic selection
Involves selecting items using a constant interval between selections, the
first interval having a random start.
When using systematic selection, auditors must ensure that the
population is not structured in such a manner that the sampling interval
corresponds with a particular pattern in the population.
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Audit sampling 10
Haphazard selection
May be an alternative to random selection provided auditors are satisfied
that the sample is representative of the entire population.
This method requires care to guard against making a selection which is
biased, for example, towards items which are easily located, as they may
not be representative. It should not be used if auditors are carrying out
statistical sampling.
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Audit sampling 11
Block selection
May be used to check whether certain items have particular
characteristics.
For example, an auditor may use a sample of 50 consecutive cheques to
test whether cheques are signed by authorised signatories rather than
picking 50 single cheques throughout the year.
However, block sampling may produce samples that are not
representative of the population as a whole, particularly if errors only
occurred during a certain part of the period and hence the errors found
cannot be projected onto the rest of the population.
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Audit sampling 12
Monetary unit sampling

This is a type of value weighted selection in which sample size, selection
and evaluation results in a conclusion in monetary amounts.
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Which of the following sampling methods correctly describes

systematic sampling?
A A sampling method which is a type of value-weighted
selection in which sample size, selection and evaluation
results in a conclusion in monetary amounts
B A sampling method which involves having a constant
sampling interval, the starting point for testing is determined
randomly
C A sampling method in which the auditor selects a block(s) of
contiguous items from within the population
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B A sampling method which involves having a constant

sampling interval, the starting point for testing is determined
randomly
Choice A refers to monetary unit sampling and choice C refers to

block selection.
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Question: June 2014 exam (Sec B, Q2)
ISA 530 Audit Sampling applies when the auditor has decided to use
sampling to obtain sufficient and appropriate audit evidence.
Required
Define what is meant by ‘audit sampling’ and explain the need for
this. (3 marks)
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Answer: June 2014 exam (Sec B, Q2)
Audit sampling is the application of audit procedures to less than
100% of items within a population of audit relevance, such that all
sampling units have a chance of selection in order to provide the
auditor with a reasonable basis on which to draw conclusions about
the entire population.
Audit sampling can be applied using either a statistical or a non-
statistical approach. It involves testing a smaller number of items and
using the results to draw a conclusion about the whole balance or
class of transactions.
It is necessary for auditors to sample as it is impossible to select all
items for testing as this would take the audit team too long and it
would cost too much.
In addition, auditors do not provide 100% assurance in their audit
report about the financial statements, they only provide reasonable
assurance and hence it is not necessary to test every item within a
population.
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Question: Audit sampling
You are the auditor of XYZ Co and are intending to audit receivables
by external confirmation of a sample of the year-end balances. The
trade receivables on the next slide have been randomly tabulated. At
the year-end, trade receivables amount to $1 million and materiality is
$100,000.
State which receivables balances will be selected for sampling using

valued weighted selection (monetary unit sampling).
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Question: Audit sampling (cont'd)
Customer Balance ($) Cumulative total Selected (Y/N)

($)
1 60,000
2 70,000
3 90,000
4 105,000
5 28,000
6 100,000
7 46,000
8 1,000
9 84,000
10 94,000
11 108,000
12 34,000
13 160,000
14 20,000
1,000,000
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Answer: Audit sampling
Customer Balance ($) Cumulative total Selected (Y/N)

($)
1 60,000 60,000 N
2 70,000 130,000 Y
3 90,000 220,000 Y
4 105,000 325,000 Y
5 28,000 353,000 N
6 100,000 453,000 Y
7 46,000 499,000 N
8 1,000 500,000 Y
9 84,000 584,000 N
10 94,000 678,000 Y
11 108,000 786,000 Y
12 34,000 820,000 Y
13 160,000 980,000 Y
14 20,000 1,000,000 Y
1,000,000
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Audit sampling 13
Evaluation of sample results

• Once the audit procedures have been carried out on the sample, the
auditor should evaluate the sample results to determine whether they
are satisfactory or whether further work is required.
• Where there are errors, the auditor should consider:
— The nature and cause
— Whether it is a 'one-off' (anomalous) error
— Whether the error affects other audit areas
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Audit sampling 14

• An anomaly is a misstatement or deviation that is demonstrably not
representative of misstatements or deviations in a population.
• Deviations: tests of controls
• Misstatements: tests of details
• Tolerable misstatement is a monetary amount set by the auditor in
respect of which the auditor seeks to obtain an appropriate level of
assurance that the monetary amount set by the auditor is not
exceeded by the actual misstatement in the population.
• Tolerable rate of deviation is a rate of deviation from prescribed
internal control procedures set by the auditor in respect of which the
auditor seeks to obtain an appropriate level of assurance that the rate
of deviation set by the auditor is not exceeded by the actual rate of
deviation in the population.
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Audit sampling 15
Tests of details Tests of controls
Project monetary No projection necessary

errors and compare
Decide if error rate
to tolerable
acceptable
misstatement
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Audit sampling 16
Tests of details
• For tests of details, the auditor should project monetary errors found
in the sample to the population and compare this to the tolerable
misstatement.
• Where an error has been established as an anomaly, it may be
excluded when projecting sample errors to the population (but still
needs to be considered overall in addition to the projection of the non-
anomalous errors).
• Where a class of transactions or account balance has been divided
into strata, the error is projected for each stratum separately.
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Question: Evaluation of results 1
You are auditing trade receivables and have obtained the following
results based on your sample:
Total value of population $1,000,000
Number of items in the population 400
Number of items tested 20
Sample value $200,000
Error in sample $9,000
(a) Assuming the errors are not anomalous ones, calculate the
expected error in the population.
(b) Assuming that tolerable misstatement was set at $40,000,
explain what action should be taken.
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Answer: Evaluation of results 1
(a) Error rate in sample x total value of population

$9,000
×$1,000,000= $45,000
$200,000
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Answer: Evaluation of results 1 (cont'd)
(b) The projected error is above the tolerable misstatement limit.

This means that further evidence is needed. This could be done
by:
• Extending the sample tested in the procedure and then re-
performing the extrapolation, or
• Designing and performing additional substantive procedures.
If the further evidence allows the auditor to conclude that the
actual error in the population does not exceed tolerable
misstatement, then the auditor will conclude that no adjustment is
necessary, although the error of $9,000 will be noted on a
schedule of uncorrected misstatements.
If the further evidence indicates that there is a misstatement that
exceeds tolerable misstatement then the auditor will ask the
client to make an adjustment to the financial statements.
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Audit sampling 17
Tests of controls
• For tests of controls, no explicit projection of errors is necessary since
the sample error rate is also the projected rate of error for the
population as a whole.
• For example, if the auditor has performed tests of controls on a
sample of 20 items and has found 2 deviations, this represents an
error rate of 10% (2/20 × 100). The auditor must then decide if this
error rate is acceptable.
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Question: Evaluation of results 2
You are auditing the internal controls relating to the authorisation of

adjustments made to a client's inventory system in order to determine
the accuracy and validity of the adjustments. You have obtained the
following results based on your sample:
Total number of adjustments made to inventory records during 1,500

the year
Number of adjustments tested in the sample 225
Number of occasions when adjustments tested were not 18
authorised
(a) Assuming the errors are not anomalous ones, calculate the error
rate in the population.
(b) Assuming that the tolerable rate of deviation was set at an error
rate of 13%, explain what action should be taken.
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Answer: Evaluation of results 2
(a) Error rate in sample:

18
= 18%
225
(b) The projected error rate is below the tolerable rate of deviation
limit of 13%.
This means that the internal control is believed to have operated
effectively throughout the period and the auditor can rely on it
when assessing the accuracy and validity of adjustments made to
the inventory system.
No further testing is required, however any monetary errors
resulting from the 18 failures of the internal control should be
noted on the schedule of uncorrected misstatements.
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Audit sampling 18
Key stages in the sampling process

• Determining objectives and characteristics of the population
• Determining sample size
• Choosing method of sample selection
• Projecting errors and evaluating the results
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Exam link: Audit sampling
• Students historically find audit sampling a tricky part of the F8

syllabus and it is an area where your knowledge could easily be
tested by the examiner.
• This article from the August 2011 edition of Student Accountant
will prove very useful:
students/2012s/SA_Aug11_auditsampling_F8v2.pdf
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Computer-assisted audit techniques 1
• Computer-assisted audit techniques (CAATs) involve using a

computer to perform audit work.
• Computers can be used to perform either substantive tests (tests of
details or substantive analytical procedures) or tests of controls.
• Two main types of CAATs:
— Audit software
— Test data
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Audit software
• Consists of computer programs used by the auditor, as part of his
auditing procedures, to process data of audit significance from the
entity's accounting system.
• Can be used to:
— Read and extract data from a client's system and produce a
report in a specified format
— Select information (eg a sample)
— Perform calculations (eg casting)
— Print reports in specified formats
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Test data
• Test data techniques are audit procedures which enter data into an
entity's computer system, and compare the results obtained with pre-
determined results.
• Test data is a fictitious set of test transactions which are input to the
client's system in order to determine whether the internal controls
within the entity's computer systems have operated effectively
throughout the period.
• This will require significant co-operation from the client, especially in
terms of computer access time.
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Typical uses of test data

• To test specific controls in computer programs
• To test transactions
— Conducted 'live' or 'dead'
— Sometimes using an integrated (embedded) test facility
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Advantages of CAATs
• Auditors can test programme controls as well as general internal
controls associated with computers.
• Auditors can test a greater number of items more quickly and
accurately than would be the case otherwise.
• Auditors can test transactions rather than paper records of
transactions that could be incorrect.
• CAATs are cost-effective in the long-term if the client does not
change its systems.
• Results from CAATs can be compared with results from traditional
testing – if the results correlate, overall confidence is increased.
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Disadvantages of CAATs
• Setting up the software needed for CAATs can be time consuming
and expensive.
• Audit staff will need to be trained so they have a sufficient level of IT
knowledge to apply CAATs.
• Not all client systems will be compatible with the software used with
CAATs.
• There is a risk that live client data is corrupted and lost during the use
of CAATs.
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Exam link: CAATs
• CAATs are a common area of confusion for students.

• Specific questions on this area could be both knowledge-based
and applied, and could come up in either Section A or Section B.
• Remember, you can also suggest CAATs when asked for tests of
controls or substantive procedures, but simply stating 'Perform
CAATs' wont get you many marks!
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Exam link: CAATs
• This article from the January 2011 edition of Student Accountant

may prove useful:
students/2012s/sa_jan11_CAATs.pdf
• This article from August 2009 is also worth reading:
students/2012s/sa_aug09_byrne.pdf
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Using the work of others 1
• An auditor's expert is an individual or organisation possessing

expertise in a field other than auditing or accounting, whose work in
that field is used by the auditor to assist the auditor in obtaining
sufficient appropriate audit evidence. An auditor's expert may be
either an auditor's internal expert (partner or staff, including temporary
staff, of the auditor's firm or network firm) or an auditor's external
expert.
• A management's expert is an individual or organisation possessing
expertise in a field other than accounting or auditing, whose work in
that field is used by the entity to assist the entity in preparing the
financial statements.
• ISA 620 Using the work of an auditor's expert
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Examples when an auditor's expert may be needed:

• Valuations of land and buildings
• Determination of inventory quantities or physical condition
• Legal opinions concerning interpretations of agreements, statutes and
regulations, or on the outcome of litigation or disputes
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• Competence, capabilities and objectivity of the auditor's expert must

be considered by the auditor.
• Agree in writing:
— Nature, scope and objectives of the work
— Respective roles and responsibilities of the auditor and the
auditor's expert
— Nature, timing and extent of communication between auditor and
auditor's expert, including the form of any report
— Confidentiality requirements
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Evaluating the work of the auditor's expert

• The relevance and reasonableness of the expert's work and
consistency with other audit evidence
• The relevance and reasonableness of any assumptions and methods
used
• The relevance, completeness and accuracy of any source data used
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• Auditors can sometimes rely on the work done by internal auditors.

• ISA 610 (Revised) Using the work of internal auditors
• Must consider objectivity, competence, and whether a systematic and
disciplined approach is used.
• If internal audit is lacking in any of these areas, the external auditor
must not use their work!
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Evaluation of internal audit work – objectivity

• Status of internal audit function
• Who it reports to
• Restraints or constrictions
• Whether those charged with governance oversee employment
decisions
• Whether management acts on recommendations
• Members of professional bodies
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Evaluation of internal audit work – competence

• Adequacy of resources
• Members of relevant professional bodies
• Adequate technical training and proficiency
• Established policies for hiring and training
• Required knowledge of financial reporting
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Evaluation of internal audit work – systematic and disciplined

approach
• Planning, supervision, reviewing and documenting assignments
• Appropriate quality control procedures
• Existence of audit manuals, work programmes and internal audit
documentation
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• A service organisation is a third party organisation that provides

services to user entities that are part of those entities' information
systems relevant to financial reporting.
• A user entity is an entity that uses a service organisation and whose
financial statements are being audited.
• A user auditor is an auditor who audits and reports on the financial
statements of a user entity.
• A service auditor is an auditor who, at the request of the service
organisation, provides an assurance report on the controls of a
service organisation.
• ISA 402 Audit considerations relating to an entity using a service
organisation
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Service organisations provide a wide variety of services to businesses:

• Maintenance of accounting records
• Payroll
• Credit control
• Data entry/information processing
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• Where service organisations are relevant to the financial statements,

the auditors (user auditors) are required to gain an understanding of:
• The nature of services provided and the significance of these to the
user entity, including effect on user entity's internal control
• The nature and materiality of transactions processed or financial
reporting processes affected
• The degree of interaction
• The nature of the relationship, including contractual terms
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Using the work of others and the auditor's report

The external auditor cannot make reference to work done by an auditor's
expert, internal auditor or service auditor in the auditor's report.
The auditor's report is the sole responsibility of the external auditor.
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Procedures
• Risk assessment procedures and related activities
• Auditor must understand how management identifies the need for
accounting estimates and how these accounting estimates are
calculated, including the underlying accounting assumptions
• Identify and assess the risks of material misstatement
• Evaluate the degree of uncertainty associated with an accounting
estimate
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Exam link: Using the work of others
The following article from the May 2011 edition of Student Accountant
discusses the use of an auditor's expert:
students/2012s/sa_may11_cat8_fau_expert.pdf
Although it is aimed at FAU students, the content of the article is
equally relevant to F8 students.
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Chapter 12 • Tangible non-current assets
Non-current assets • Intangible non-current assets
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Explain the audit objectives and the audit procedures to obtain sufficient
appropriate evidence in relation to:
Tangible and intangible non-current assets
(i) Evidence in relation to non-current assets, and
(ii) Depreciation
(iii) Profit/loss on disposal
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Overview
Non-current assets
Evidence on statement
of profit or loss entries
• Depreciation
• Gains/losses on
Tangible Intangible disposals
non-current assets non-current assets • Impairments
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Tangible non-current assets 1
Audit objectives for tangible non-current assets

Financial statement assertion Audit objective
Existence and occurrence – Additions represent assets acquired in the year and
disposal represent assets sold or scrapped in the year
– Recorded assets represent those in use at the year-end
Completeness – All additions and disposals that occurred in the year have
been recorded
– Balances represent assets in use at the year-end
Rights and obligations – The entity has rights to the assets purchased and those
recorded at the year-end
Accuracy, valuation and allocation – Non-current assets are correctly stated at cost less
accumulated depreciation
– Additions and disposals are correctly recorded
Classification – Tangible assets have been recorded in the correct
accounts, and expenses which are not of a capital nature
are taken to profit or loss‘
Presentation – Disclosures relating to cost, additions and disposals,
depreciation policies, useful lives and assets held under
finance leases are adequate and in accordance with
accounting standards
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• The following slides set out audit procedures for tangible non-current
assets.
• Remember, these are substantive audit procedures.
• DO NOT confuse these with tests of controls, which were covered in
Chapter 10!
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Substantive audit procedures to test COMPLETENESS

• Obtain or prepare a summary of tangible non-current assets showing
how gross book value, accumulated depreciation and net book value
reconcile with the opening position.
• Compare non-current assets in the general ledger with the non-
current assets register and obtain explanations for differences.
• For a sample of assets which physically exist agree that they are
recorded in the non-current asset register.
• If a non-current asset register is not kept, obtain a schedule showing
the original costs and present depreciated value of non-current
assets.
• Reconcile the schedule of non-current assets with the general ledger.
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Substantive audit procedures to test EXISTENCE

• Confirm that the company physically inspects all items in the non-
current asset register each year.
• Inspect assets, concentrating on high value items and additions in-
year. Confirm that items inspected exist, are in use, are in good
condition, have correct serial numbers.
• Review records of income-yielding assets.
• Reconcile opening and closing vehicles by numbers as well as
amount.
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Substantive audit procedures to test RIGHTS AND OBLIGATIONS

• Verify title to land and buildings by inspection of title deeds, Land
Registry certificates, lease agreements.
• Obtain a certificate from solicitors/bankers stating purpose for which
the deeds are being held (custody only), stating deeds are free from
mortgage or lien.
• Inspect registration documents for vehicles held, confirming that they
are in client's name.
• Confirm all vehicles are used for the client's business.
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• Examine documents of title for other assets (including purchase
invoices, architects' certificates, contracts, hire purchase or lease
agreements).
• Review for evidence of charges in statutory books and by company
search.
• Review leases of leasehold properties to ensure that company has
fulfilled covenants therein.
• Examine invoices received after year-end, orders and board minutes
for evidence of capital commitments.
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Substantive audit procedures to test VALUATION

• Verify valuation to valuation certificate.
• Consider reasonableness of valuation, reviewing experience of
valuer, scope of work done, methods and assumptions used, whether
valuation bases are in line with accounting standards.
• Reperform calculation of revaluation surplus.
• Confirm whether valuations of all assets that have been revalued
have been updated regularly (full valuation every five years and an
interim valuation in year 3 generally) by asking the Finance Director
and inspecting the previous financial statements.
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Substantive audit procedures to test VALUATION continued

• Inspect draft financial statements to check that client has recognised
in the statement of profit or loss revaluation losses unless there is a
credit balance in respect of that asset in equity, in which case it
should be debited to equity to cancel the credit. All revaluation gains
should be credited to equity.
• Review insurance policies in force for all categories of tangible non-
current assets and consider the adequacy of their insured values and
verify expiry dates.
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Substantive audit procedures to test DEPRECIATION (part of

accuracy, valuation and allocation)
• Review depreciation rates applied in relation to asset lives, residual
values, replacement policy, past experience of gains and losses on
disposal, consistency with prior year's accounting policy, possible
obsolescence.
• Review non-current assets register to ensure that depreciation has
been charged on all assets with a limited useful life.
• For revalued assets, ensure that the charge for depreciation is based
on the revalued amount by recalculating it for a sample of revalued
assets.
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Substantive audit procedures to test DEPRECIATION continued

• Re-perform calculation of depreciation (proof in total test) to ensure it
is correct and appears reasonable.
• Compare ratios of depreciation to non-current assets (by category)
with previous years, depreciation policy rates.
• Scrutinise draft accounts to ensure that depreciation policies and
rates are disclosed adequately.
• For a sample of fully depreciated assets, inspect the non-current
assets register to ensure no further depreciation has been charged.
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Substantive audit procedures to test ADDITIONS (part of accuracy,

valuation and allocation)
• Verify additions by inspection of architects' certificates, solicitors'
completion statements, suppliers' invoices and other relevant
documentation.
• Review capitalisation of expenditure by examining for non-current
assets additions and items in relevant expense categories (repairs,
motor expenses, sundry expenses) to ensure that capital/revenue
distinction is correctly drawn and capitalisation is in line with
consistently applied company policy.
• Inspect non-current asset accounts for a sample of purchases to
ensure they have been properly allocated.
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Substantive audit procedures to test ADDITIONS continued

• Ensure that appropriate claims have been made for grants, and
grants received and receivable have been received, by inspecting
claims documentation and bank statements.
• Verify that additions have been recorded by scrutinising the non-
current asset register and general ledger.
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Substantive audit procedures to test SELF-CONSTRUCTED

ASSETS (part of accuracy, valuation and allocation)
• Verify material and labour costs and overheads to invoices, wage
records etc.
• Ensure expenditure has been analysed correctly and properly
charged to capital by inspecting a sample of invoices and other
relevant documentation relating to self-constructed assets.
• Review costs to ensure that no profit element has been included.
• Review accounts to ensure that finance costs have been capitalised
or not capitalised on a consistent basis, and costs capitalised in
period do not exceed total finance costs for period.
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Substantive audit procedures to test DISPOSALS (part of accuracy,

valuation and allocation)
• Verify disposals with supporting documentation, checking transfer of
title, sales price and dates of completion and payment.
• Recalculate profit or loss on disposal to ensure it is correct and has
been correctly reflected in the financial statements.
• Consider whether proceeds are reasonable.
• If the asset was used as security, ensure release from security has
been correctly made by inspection of documentation.
• Review board meeting minutes to confirm that disposals made during
the period were authorised and bona fide.
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Intangible non-current assets 1
Key financial statement assertions

• Existence
• Accuracy, valuation and allocation
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REMEMBER!
1. Only purchased goodwill or intangibles with a readily
ascertainable market value can be capitalised.
2. For research and development costs, research costs should be

expensed.
3. PIRATE criteria for development costs to be capitalised.
4. The audit of amortisation will be similar to the audit of

depreciation.
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Development expenditure
• Probable future economic benefits
• Intention to complete and use/sell asset
• Resources adequate and available to complete and use/sell asset
• Ability to use/sell the asset
• Technical feasibility of completing asset for use/sale
• Expenditure can be measured reliably
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Substantive audit procedures for goodwill

• Agree sales consideration to sales agreement by inspection.
• Consider whether asset valuation is reasonable.
• Review impairment review and discuss with management.
• Assess whether valuation of goodwill is reasonable/impaired or not
by discussion with management.
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Substantive audit procedures for research and development

• Confirm that capitalised development costs conform to IAS 38 criteria
by inspecting details of projects and discussions with technical
managers.
• Confirm feasibility and viability of projects by inspection of budgets
and discussions with project managers and technical staff.
• Recalculate amortisation for capitalised costs to ensure it commences
with production and is reasonable.
• Inspect invoices to verify material expenditure incurred on research
and development projects.
• Verify wages costs to supporting documentation such as time sheets.
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Substantive audit procedures for research and development

continued
• Review the accounting records to ensure that the expenditure can be
readily measured, eg separate cost centre or nominal ledger code.
• Consider probability of future economic benefits (ie commercial
viability) and ability to sell or use the asset in relation to market
research results, advance orders, budgets and forecasts.
• Review budgeted costs and revenues for reasonableness.
• Review cash flow forecasts to ensure that adequate resources exist to
complete the project.
• Obtain written representations from management of their intention to
complete and use the asset.
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Substantive audit procedures for other intangibles

• Agree purchased intangibles to purchase documentation agreement
by inspection.
• Inspect specialist valuations of intangibles for reasonableness.
• Review amortisation calculations and recalculate to verify accuracy
and reasonableness.
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Exam link 1
• Questions on non-current assets are likely to come up in a

scenario context and ask you to provide audit procedures to test
certain financial statement assertions.
• The June 2012 exam tested the audit of additions and disposals of
plant and equipment using substantive procedures.
• In the June 2013 exam, the requirement asked for procedures
used to get audit evidence and then for examples relevant to
property, plant and equipment.
• Part B of the 2015 Specimen Paper included a 10-mark
requirement for substantive procedures in relation to a revaluation
of land and buildings and the valuation of work-in-progress.
• There was also a scenario-linked objective test question on non-
current assets in Part A of the 2015 Specimen Paper.
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Exam link 2
• Audit evidence in the form of substantive procedures has been

tested in every sitting under the current F8 examiner and therefore
it is most important that you firstly understand the difference
between substantive procedures and tests of controls, and
secondly the financial statement assertions and how these can be
tested.
• When you suggest audit procedures (be they substantive tests or
tests of controls) it is VITAL that they are sufficiently detailed
otherwise you will not score full marks.
• For example, stating 'Discuss with management' or 'Check for
existence' are too vague. Would a real auditor be able to go away
and complete the audit of an account area with tests such as
these?
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Exam link 3
• As a general rule, when asked for audit procedures, do not use

'Check …' or 'Ensure …'.
• You must use action verbs such as 'Inspect …', 'Discuss …',
'Observe …' , 'Recalculate …' – remember the methods which
auditors use to get audit evidence, which were discussed in
Chapter 8.
• Generally, you should assume one mark for each well explained
audit procedure.
• Questions on audit risk and responses may require you to apply
the knowledge you have gained from this chapter.
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Question: 2015 Specimen Paper (Sec A, Question 7)
Balotelli Beach Hotel Co (Balotelli) operates a hotel providing

accommodation, leisure facilities and restaurants. You are an audit
senior of Mario & Co and are currently conducting the audit of
Balotelli for the year ended 31 December 20X4. During the course of
the audit a number of events and issues have been brought to your
attention:
Non-current assets and depreciation
Balotelli incurred significant capital expenditure during the year
updating the leisure facilities at several of the company’s hotels.
Depreciation is charged monthly on all assets on a straight line basis
(SL) and it is company policy to charge a full month’s depreciation in
the month of acquisition and none in the month of disposal.
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Question: 2015 Specimen Paper (Sec A, Q7) cont'd
Which of the following audit procedures are appropriate to test the
VALUATION assertion for non-current assets?
(1) Ensure disposals are correctly accounted for and recalculate gain/loss on
disposal
(2) Recalculate the depreciation charge for a sample of assets ensuring that it
is being applied consistently and in accordance with IAS 16 Property, Plant
and Equipment
(3) Review the repairs and maintenance expense accounts for evidence of
items of a capital nature
(4) Review board minutes for evidence of disposals during the year and verify
that these are appropriately reflected in the non-current assets register
A 1 and 2
B 1, 3 and 4
C 2, 3 and 4
D 2 and 3 only
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• Test 4 is a test for existence and test 3 is for completeness. All

other tests are relevant for valuation. Option A is correct.
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Question: 2015 Specimen Paper (Sec B, Q6b)
[See slides 631 to 633 for the question scenario.]
Required:
(b) Describe substantive procedures Suarez & Co should perform at
the year end to confirm plant and equipment additions. (2 marks)
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Approach: 2015 Specimen Paper (Sec B, Q6b)
• Note that the question states 'plant and equipment' so make sure
you do not include tests relating to property.
• You are asked for substantive procedures so do not include any
tests of controls.
• There are two marks available in total. This suggests you will be
able to score one mark per each well-explained audit procedure.
• Make sure your tests are sufficiently precise and detailed as
vague answers will not score very well.
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Answer: 2015 Specimen Paper (Sec B, Q6b)
• Inspect a sample of additions to ensure that they physically exist.

• Cast the list of additions of plant and equipment and match the
total back to the total in the non-current assets register and the
draft financial statements to ensure it is correctly stated.
• Recalculate the depreciation charge for the year for a sample of
additions to ensure it is correct and in line with the depreciation
policy for plant and equipment.
• Inspect purchase documentation for a sample of additions to verify
whether it is in the name of Baggio to confirm rights and
obligations.
• Inspect board meeting minutes during the year to ensure that
capital expenditure on new plant and equipment was authorised
appropriately by the board of Baggio.
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Question: December 2010 Question 4c
Required:
(c) Describe two substantive procedures the external auditor of
Bluesberry should adopt to verify each of the following assertions
in relation to an entity's property, plant and equipment:
(i) Accuracy, valuation and allocation
(ii) Completeness
(iii) Rights and obligations (6 marks)
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Approach: December 2010 Question 4c
• This question is testing your understanding of the financial

statement assertions so it is really important that you understand
these and how to test for them.
• There are six marks available in total so assume that there are
two marks for each assertion. This suggests you will be able to
score one mark per each well-explained audit procedure.
• Make sure you only provide audit procedures for the assertions
specifically asked for – don't include tests for existence, for
example.
• You are specifically asked for two procedures for each assertion
so don't do more than this as you won't get any credit for doing so.
• Note: The answer has more than two procedures for each
assertion as it is for illustrative purposes only.
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Answer: December 2010 Question 4c
Accuracy, valuation and allocation

• Obtain a schedule of property, plant and equipment and for a
sample of these, confirm the amount capitalised to the purchase
invoices to confirm valuation.
• For any properties revalued during the year, confirm the revalued
amount to the valuation report and assess the valuer in terms of
scope, objectivity, assumptions, qualifications etc.
• Perform a proof in total test for depreciation, using the
depreciation policy and rates for property, plant and equipment,
and compare this to the actual charge for the year to confirm
whether the charge appears reasonable.
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Answer: December 2010 Question 4c (cont'd)
Completeness
• For a sample of property, plant and equipment selected by
physical inspection, trace these back to the non-current assets
register to confirm that they have been included on the register.
• Perform a review of expenditure accounts (repairs, maintenance
etc) and select sample for further testing. Obtain invoices relating
to these to ensure the costs have been correctly expensed rather
than capitalised.
• Re-perform the reconciliation of the non-current assets register to
the general ledger, investigating fully any differences.
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Answer: December 2010 Question 4c (cont'd)
Rights and obligations

• Obtain a schedule of property, plant and equipment and for a
sample of these, confirm the amount capitalised to the purchase
invoices to confirm they were purchased by Bluesberry.
• Inspect title deeds of property to ensure that it belongs to
Bluesberry.
• For leased assets, review lease agreements to verify whether they
should be treated as finance leases or operating leases.
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• Introduction to auditing
Chapter 13 inventory
Inventory • Accounting for inventory
• Audit procedures for inventory
• The physical inventory count
• Cut-off
• Valuation
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Inventory
(i) Inventory counting procedures in relation to year-end and continuous
inventory systems
(ii) Cut-off
(iii) Auditor's attendance at inventory counting
(iv) Direct confirmation of inventory held by third parties
(v) Valuation
(vi) Other evidence in relation to inventory
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Overview
Inventory
Inventory counting Other evidence

Cut-off
procedures • Valuation
• Year end
• Continuous
inventory
Auditor's attendance 3rd party

at inventory count confirmations
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Introduction to auditing inventory
Audit objectives for tangible non-current assets
Financial statement assertion Audit objective
Existence and occurrence – Recorded purchases and sales represent inventories bought
and sold
– Inventory on the statement of financial position physically exists
Completeness – All purchases and sales are recorded
– All inventory at year-end is included on the statement of financial
position
Rights and obligations – The entity has rights to inventory recorded in the period and at
the year-end
Accuracy, valuation and – Costs are accurately determined in accordance with accounting
allocation standards
– Inventory is recorded at year-end at the lower of cost and net
realisable value
Classification – Inventory is recorded in the proper accounts
Cut-off – All purchases and sales of inventories are recorded in the
correct period
Presentation – Inventory is properly classified in the accounts
(classification and – Disclosures relating to classification and valuation are adequate
understandability, and in accordance with accounting standards
completeness, accuracy and
valuation)
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Accounting for inventory
• IAS 2 Inventories
• Inventory should be valued at the lower of cost and net realisable
value.
• Cost: all costs of purchase and other costs incurred in bringing
inventory to its present location and condition.
• Net realisable value: the estimated selling price in the ordinary
course of business, less the estimated costs of completion and the
estimated costs necessary to make the sale.
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Audit procedures for inventory 1
Substantive audit procedures to test COMPLETENESS

• Complete the disclosure checklist to ensure that all the disclosures
relevant to inventory have been made.
• Trace test counts to the detailed inventory listing.
• Where inventory is held in third party locations, physically inspect this
inventory or review confirmations received from the third party and
match to the general ledger.
• Compare the gross profit % to the previous year or industry data.
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Substantive audit procedures to test EXISTENCE

• Observe the physical inventory count.
The inventory count is covered in detail in later slides.
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• Verify that any inventory held for third parties is not included in the
year-end inventory figure by observing whether it is being
appropriately segregated during the inventory count.
• For any 'bill-and-hold' inventory (ie where the inventory has been sold
but is being held by the entity until the customer requires it), identify
such inventory and ensure that it is segregated during the inventory
count so that it is not included in the year-end inventory figure.
• Confirm that any inventory held at third party locations is included in
the year-end inventory figure by reviewing the inventory listing.
• Review loan agreements and board meeting minutes for evidence
that inventory has been pledged or assigned.
• Inquire of management about any warranty obligations.
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Substantive audit procedures to test ACCURACY, VALUATION AND

ALLOCATION
• Obtain a copy of the inventory listing and agree the totals to the
general ledger.
• Cast the inventory listing to ensure it is mathematically correct.
• Vouch a sample of inventory items to suppliers' invoices to ensure it is
correctly valued.
• Where standard costing is used, test a sample of inventory to ensure
it is correctly valued.
• For materials, agree the valuation of raw materials to invoices and
price lists.
• Confirm that an appropriate basis of valuation (eg FIFO) is being used
by discussing with management.
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ALLOCATION continued
• For labour costs, agree costs to wage records.
• Review standard labour costs in the light of actual costs and
production.
• Reconcile labour hours to time summaries.
• Make inquiries of management to ascertain any slow-moving or
obsolete inventory that should be written down.
• Examine prices at which finished goods have been sold after the
year-end to ascertain whether any finished goods need to be written
down.
• If significant levels of finished goods remain unsold for an unusual
period of time, discuss with management and consider the need to
make allowance.
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• Compare the gross profit % to the previous year or industry data.
• Compare raw material, finished goods and total inventory turnover to
the previous year and industry averages.
• Compare inventory days to the previous year and industry average.
• Compare the current year standard costs to the previous year after
considering current conditions.
• Compare actual manufacturing overhead costs with budgeted or
standard manufacturing overhead costs.
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• Obtain a copy of the inventory listing and cast it, and test the
mathematical extensions of quantity multiplied by price.
• Trace test counts back to the inventory listing.
• If the entity has adjusted the general ledger to agree with the physical
inventory count amounts, agree the two amounts.
• Where a continuous (perpetual) inventory system is maintained,
agree the total on the inventory listing to the continuous
inventory records, using CAATs.
• Read the notes to the financial statements to ensure that the
information is accurate and properly presented at the appropriate
amounts.
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Substantive audit procedures to test CUT-OFF

• Note the numbers of the last GDNs and GRNs before the year-
end and the first GDNs and GRNs after the year-end and check that
these have been included in the correct financial year by reviewing
the ledger.
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Substantive audit procedures to test CLASSIFICATION

• Review the inventory listing to ensure that inventory has been
properly classified between raw materials, work-in-progress and
finished goods.
• Read the notes to the accounts relating to inventory to ensure they
are understandable.
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The physical inventory count 1
• ISA 501 Audit evidence – specific considerations for selected items

• Inventory count provides evidence of existence and condition of
inventory.
• If inventory is material:
— Evaluate management's instructions
— Observe performance of count procedures
— Inspect inventory
— Perform test counts
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Inventory counting methods

1. Physical counts at year-end
2. Physical counts before or after the year-end
3. Perpetual (continuous) inventory counting
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Perpetual (continuous) inventory

Auditors need to verify that management:
• Ensures that all inventory lines are counted at least once a year
• Maintains adequate inventory records that are kept up-to-date
• Has satisfactory procedures for inventory counts and test-counting
• Investigates and corrects all material differences
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Before the count

• Review prior year's arrangements.
• Discuss arrangements with management.
• Assess key factors (risk, material items, location etc).
• Review inventory count instructions (organisation, counting,
recording).
• Plan procedures (representative selection, high value items, inventory
held by third parties, need for an expert).
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During the count

• Observe whether the client's staff are following instructions as this
will help to ensure the count is complete and accurate.
• Perform test counts to ensure procedures and internal controls are
working properly, and to gain evidence over existence and
completeness of inventory.
• Ensure that the procedures for identifying damaged, obsolete and
slow-moving inventory operate properly by observation.
• Confirm that inventory held on behalf of third parties is separately
identified and accounted for so that inventory is not overstated.
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During the count continued

• Conclude whether the count has been properly carried out and is
sufficiently reliable as a basis for determining the existence of
inventories.
• Consider whether any amendment is necessary to subsequent audit
procedures.
• Gain an overall impression of the levels and values of inventories held
so that the auditors may, in due course, judge whether the figure for
inventory appearing in the financial statements is reasonable.
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After the count

• Trace items that were test counted to final inventory sheets.
• Observe whether all count records have been included in final
inventory sheets.
• Inspect final inventory sheets to ensure they are supported by count
records.
• Ensure that continuous inventory records have been adjusted to the
amounts physically counted or measured, and that differences have
been investigated.
• Confirm cut-off by using details of the last serial number of goods
inwards and outwards notes and details of movements during the
count.
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After the count continued

• Review replies from third parties about inventory held by or for them.
• Confirm the client's final valuation of inventory has been calculated
correctly.
• Follow up queries and notify problems to management.
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Inventory held by third parties

If inventory held by third parties is material:
• Direct confirmation per ISA 505 External confirmations
• Inspection or other appropriate audit procedures
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Inventory held by third parties continued

Other appropriate audit procedures:
• Attending, or arranging for another auditor to attend, the third party's
inventory count
• Obtaining another auditor's report on the adequacy of the third party's
internal control for ensuring that inventory is properly counted and
adequately safeguarded
• Inspecting documentation in respect of third party inventory
• Requesting confirmation from other parties when inventory has been
pledged as collateral
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Cut-off 1
• There should ideally be no movements during the inventory count

• Receipts and dispatched should be suspended during the count
• If it is not possible to suspend all deliveries, these should be kept
separate from other inventory and carefully documented
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Cut-off 2
Year-end
Before After
GRN GRN
Purchase
Purchase
Included in? Included in?
— Purchases — Purchases X
— Payables — Payables X
— Inventories — Inventories X
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Cut-off 3
Year-end
Before After
GDN GDN
Included in? Included in?

Sales
Sales
— Sales — Sales X
— Receivables — Receivables X
— Inventories X — Inventories
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Valuation 1
• Inventory must be valued at the lower of cost and net realisable value.
• Auditors need to understand how cost is determined.
• Cost should include an appropriate proportion of overheads.
• As there are many ways to determine cost, management should be
using a method consistently and a method that gives a fair
approximation to cost.
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Valuation 2
Valuation of raw materials and brought-in components

• Use suppliers' invoices
• If standard costs used, check the basis of standards, compare with
actual costs and confirm that variances are being treated
appropriately
Valuation of work-in-progress and finished goods

• Use analytical procedures
• Reasonableness check
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Valuation 3
Cost versus net realisable value

NRV < cost when:
• An increase in costs or a fall in selling price
• Physical deterioration
• Obsolescence of products
• A marketing decision to manufacture and sell products at a loss
• Errors in production or purchasing
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Exam link 1
• Questions on inventory are likely to come up in a scenario context

and ask you to provide audit procedures to test certain financial
statement assertions.
• Requirements may tend to focus on a particular financial
statement assertion and the substantive audit procedures to test
that assertion.
• The examining team has commented time after time that
candidates do not provide enough detail in audit procedures or fail
to provide tests for the specific assertion in the question or just
provide a list of generic tests without regard to the scenario they
are presented with.
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Exam link 2
• Audit evidence in the form of substantive procedures has been

tested in every sitting under the current F8 examining team and
therefore it is most important that you firstly understand the
difference between substantive procedures and tests of controls,
and secondly the financial statement assertions and how these
can be tested.
• When you suggest audit procedures (be they substantive tests or
tests of controls) it is VITAL that they are sufficiently detailed
otherwise you will not score full marks.
• For example, stating 'Discuss with management' or 'Check for
existence' are too vague. Would a real auditor be able to go away
and complete the audit of an account area with tests such as
these?
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Exam link 3
• As a general rule, when asked for audit procedures, do not use

'Check …' or 'Ensure …'.
• You must use action verbs such as 'Inspect …', 'Discuss …',
'Observe …' , 'Recalculate …' – remember the methods which
auditors use to get audit evidence, which were discussed in
Chapter 8.
• Try to use the approach VERB-DOCUMENT-REASON in your
audit procedures, for example “Vouch the cost of inventory to the
original invoice to determine whether cost is accurately stated.”
• Questions on audit risk and responses may require you to apply
the knowledge you have gained from this chapter.
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Chapter 14 • Introduction
Receivables • Audit procedures for

receivables
• The receivables' confirmation
• Sales
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Explain the audit objectives and the audit procedures to obtain

sufficient appropriate evidence in relation to:
Receivables
(i) Direct confirmation of accounts receivable
(ii) Other evidence in relation to receivables and prepayments
(iii) Completeness and occurrence of sales
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Overview
Receivables
Statement of financial position: receivables and prepayments

Statement of profit or loss: revenue, irrecoverable debts expense
Direct
Other evidence
confirmation
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Introduction 1
• Receivables may be a material balance on a company's statement of

financial position.
• They are usually audited using tests of details and analytical
procedures.
• Sales can be tested at the same time as receivables.
• Existence, completeness and accuracy, valuation and allocation are
key financial statement assertions for receivables.
• Occurrence, completeness and accuracy are key financial statement
assertions for sales.
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Introduction 2
Audit objectives for receivables
Assertions about – All sales transactions recorded have occurred and relate to
classes of the entity (occurrence)
transactions and – All sales transactions that should have been recorded have
related disclosures been recorded (completeness)
– Amounts relating to transactions have been recorded
appropriately (accuracy)
– All transactions have been recorded in the correct period
(cut-off)
– All transactions are recorded properly (classification)
– All disclosed events and transactions relating to receivables
have occurred and pertain to the entity (occurrence, rights
and obligations)
– All disclosures required have been included (completeness)
– Financial information is appropriately presented and
described and disclosures clearly expressed (presentation)
– Financial and other information is disclosed fairly and at
appropriate amounts (presentation)
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Introduction 3
Audit objectives for receivables

Assertions about – Recorded receivables exist (existence)
account balances at – The entity controls the rights to receivables and related
the period-end and accounts (rights and obligations)
related disclosures – All receivables that should have been recorded have been
recorded (completeness)
– Receivables are included in the accounts at the correct
amounts (accuracy, valuation and allocation)
– All disclosures required have been included (presentation)
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Audit procedures for receivables 1
• The following slides set out audit procedures for receivables.

Chapter 10!
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Substantive procedures to test the COMPLETENESS of receivables

• Agree the balance from the individual sales ledger accounts to the
aged receivables' listing and vice versa.
• Match the total of the aged receivables' listing to the sales ledger
control account.
• Cast and cross-cast the aged trial balance before selecting any
samples to test.
• Trace a sample of shipping documentation to sales invoices and into
the sales and receivables' ledger.
relevant to receivables have been made.
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Substantive procedures to test the COMPLETENESS of receivables

continued
• Compare the gross profit % by product line with the previous year and
industry data.
• Compare the level of prepayments to the previous year to ensure the
figure is materially correct and complete.
• Review detailed statement of financial position to ensure all likely
prepayments have been included.
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Substantive procedures to test the EXISTENCE of receivables

• Perform a receivables' confirmation on a sample of year-end trade
receivables.
• Follow up all balance disagreements and non-replies to the
receivables' confirmation.
• Perform alternative procedures for any exceptions and non-
replies to the receivables' confirmation such as:
— Reviewing after-date cash receipts by inspecting bank statements
and cash receipts' documentation.
— Examining the customer's account and customer correspondence
to assess whether the balance outstanding represents specific
invoices and confirm their validity.
— Examining the underlying documentation (purchase order, dispatch
documentation, duplicate sales invoice etc).
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Substantive procedures to test the EXISTENCE of receivables

continued
— Inquiring from management explanations for invoices remaining
unpaid after subsequent ones have been paid.
— Observing whether the balance on the account is growing and if so,
finding out why by discussions with management.
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Substantive procedures to test the RIGHTS AND OBLIGATIONS of

receivables
• Inspect the bank confirmation letter for any liens on receivables.
• Inquire with management to ascertain whether any receivables have
been sold (eg to factors).
• Inspect loan agreements and board meeting minutes for any evidence
of receivables being sold (eg to factors).
• Determine, through discussion with management, whether any
receivables have been pledged, assigned or discounted and whether
such items require disclosure in the financial statements.
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Substantive procedures to test the ACCURACY, VALUATION AND

ALLOCATION of receivables
• Compare receivables' turnover and receivables' days to the previous
year and/or to industry data.
• Compare the aged analysis of receivables from the aged trial balance
to the previous year.
• Review the adequacy of the allowance for uncollectable accounts
through discussion with management.
• Compare the irrecoverable receivable expense as a % of sales to the
previous year and/or to industry data.
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ALLOCATION of receivables continued
• Compare the allowance for uncollectable accounts as a % of
receivables or credit sales to the previous year and/or to industry
data.
• Confirm adequacy of allowance by reviewing correspondence with
customers and solicitors.
• Examine credit notes issued after year-end for allowances that should
be made against current period balances.
• Examine large customer accounts individually and compare to the
previous year's balances.
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ALLOCATION of receivables continued
• For a sample of old debts on the aged trial balance, obtain further
information regarding their recoverability by discussions with
management and inspection of customer correspondence.
• For a sample of prepayments from the prepayments' listing,
recalculate the amount prepaid to ensure that it has been accurately
calculated.
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Substantive procedures to test the CLASSIFICATION of receivables

• Review the aged analysis of receivables for any large credits, non-
trade receivables and long-term receivables and consider whether
such items require separate disclosure.
• Read the disclosure notes relevant to receivables in the draft financial
statements and review of understandability.
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Substantive procedures to test the ACCURACY of sales

• For a sample of sales invoices, compare the prices and terms to the
authorised price list and terms of trade documentation.
• Test whether discounts have been properly applied by recalculating
them for a sample of invoices.
• Test the correct calculation of tax on a sample of invoices.
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Substantive procedures to test the CUT-OFF of sales

• For a sample of sales invoices around the year-end, inspect the dates
and compare with the dates of dispatch and the dates recorded in the
ledger for application of correct cut-off.
• For sales returns, select a sample of returns documentation around
the year-end and trace to the related credit entries.
• Perform analytical procedures on sales returns, comparing the ratio of
sales returns to sales.
• Review material after-date invoices, credit notes and adjustments and
ensure they are recorded correctly in the relevant financial period.
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Substantive procedures to test the OCCURRENCE of sales

• For a sample of sales transactions recorded in the ledger, vouch the
sales invoice back to customer orders and dispatch documentation.
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The receivables' confirmation 1
• The receivables' confirmation provides third party audit evidence

about amounts outstanding at the year-end.
• It is therefore an excellent source of audit evidence in terms of
sufficiency and appropriateness.
• It provides audit evidence about existence and rights and obligations.
• It does not provide audit evidence about valuation!
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• External confirmations are audit evidence obtained as a direct written

response to the auditor from a third party in paper form or by
electronic or other medium.
• ISA 505 External confirmations
• Confirmation is essentially an act of the client, who alone can
authorise third parties to divulge information to the auditors.
• There are two methods: positive and negative.
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What should the auditor do if the client does not give permission for
receivables' confirmations?
• Inquire about management's refusal to give permission.
• Seek audit evidence about the validity and reasonableness of the
reasons for refusal.
• Evaluate the implications of the refusal on the audit.
• Perform alternative substantive procedures to get audit evidence.
• Communicate with those charged with governance and consider
implications for the auditor's report if the reasons seem unreasonable
or cannot get sufficient, appropriate audit evidence from other
sources.
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Positive confirmation
• A positive confirmation request is one in which the confirming party
responds directly to the auditor indicating whether they agree or
disagree with the information in the request or provides the requested
information.
Negative confirmation
• A negative confirmation request is one in which the confirming
party responds directly to the auditor only if they disagree with the
information in the request.
The positive method is generally preferable.
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The negative method is only used if all of the following apply:

• The risk of material misstatement has been assessed as low.
• The auditor has obtained sufficient appropriate audit evidence on the
operating effectiveness of relevant controls.
• The population consists of a large number of small, homogeneous
account balances.
• A very low exception rate is expected.
• The auditor is not aware of circumstances or conditions that would
cause customers to disregard the requests.
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Points to note about the receivables' confirmation

• The letters are normally prepared by the client's staff on the client's
paper and signed by the client.
• Therefore the auditor must maintain strict control over this process to
mitigate the risk of fraudulent manipulation.
• A copy of the statement is included with the letter.
• Customers must send replies direct to the auditor in a pre-paid
envelope.
• Undelivered items should be returned to the auditor's office, not the
client's office, for follow-up.
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Specimen positive confirmation request letter
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How does the auditor select a sample of receivables for

confirmation?
The following should be included in the sample:
• Old, unpaid accounts

• Accounts written-off during the period under review
• Accounts with credit balances
• Accounts settled by round sum payments
• Accounts with nil balances
• Accounts which have been paid by the date of the examination
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What should the auditor do if a reply is not received?

A non-response is a failure of the confirming party to respond, or fully
respond, to a positive confirmation request, or a confirmation request
returned undelivered.
The auditor can:
• Send an additional confirmation request if a reply has not been
received within a reasonable time.
• Phone the customer (with the client's permission) to request a reply.
The auditor may have to do alternative audit work to gain evidence about
these balances such as reviewing after-date cash, shipping
documentation and sales.
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What happens if the response shows a different amount to that in

the client's records?
An exception is a response that shows a difference between the
information requested to be confirmed, or contained in the entity's
records, and information provided by the confirming party.
The auditor will need to do further work where responses give rise to
exceptions.
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Reasons for exceptions

• Disagreement of balances
• Cut-off issues
• Monies received posted to the wrong account or a cash-in-transit
account
• Netting off balances by customers who are also suppliers
• Fraud (teeming and lading, stealing monies, incorrect postings)
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Question: ABC Co
You have obtained the following results from three receivables

balances selected for external confirmation during the audit of ABC
Co.
Detail the tests you would perform on each of these responses.
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Answer: ABC Co
Customer 1
• The cash in transit should be traced to the cash receipts book post
year-end. I would expect it to be received within a few days of the
year-end.
• I would also trace the cash to the bank paying-in slip. Again, this
should be stamped by the bank post year-end.
Customer 2
• The goods in transit should be traced to a GDN dated prior to the
year-end.
• If inventory records exist the dispatch could be traced to the
records to confirm that it was sent prior to the year-end.
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Answer: ABC Co (cont'd)
Customer 3
• The reason for the dispute and my client's views on it should be
obtained from the correspondence file between Customer 3 and
my client.
• Credit notes post year-end should be scrutinised to determine
whether a credit was given for the disputed goods.
• Cash receipts should be reviewed post year-end to determine
whether Customer 3 paid the full balance.
• If the amount is outstanding at the audit date, discuss
recoverability with the credit controller.
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Sales 1
• Sales and receivables are often tested together.

• Sales are likely to be a material figure in the statement of profit or
loss.
• Completeness and occurrence are key financial statement assertions
for sales.
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Sales 2
• Analytical review is a key substantive procedure when testing the

completeness of sales.
• Compare level of sales, month by month, to previous year.
• Review effect on sales value of changes in quantity sold, prices and
products.
• Review level of goods returned, sales allowances and discounts.
• Efficiency of labour expressed in sales or profit per employee.
• Analyse changes in gross profit margin.
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Exam link
• When asked for substantive procedures to test receivables, make

sure your answer doesn't just talk about the receivables'
confirmation! Other tests also need to be done, such as a review
of after-date cash and analytical procedures.
• Remember, the receivables' confirmation does not provide audit
evidence about the valuation assertion!
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Question: 2014 Specimen Paper (Sec B, Q4b)
Torres Leisure Club Co (Torres) operates a chain of health and
fitness clubs. Its year end was 31 October 20X4. You are the audit
manager and the year-end audit is due to commence shortly. The
following matter has been brought to your attention. Torres's trade
receivables have historically been low, as most members pay
monthly in advance. However, during the year, a number of
companies have taken up group memberships at Torres and hence
the receivables balance is now material. The audit senior has
undertaken a receivables circularisation for the balances at the year
end; however, there are a number who have not responded and a
number of responses with differences.
Required:
sufficient and appropriate audit evidence in relation to Torres's trade
receivables. (6 marks)
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• Send an additional confirmation request if a reply for the non
responses has not been received within a reasonable time.
• Where the customer does not respond to this follow-up, phone the
customer with the client's permission to request a written
response.
• If a reply is still not received, review after date cash receipts to
assess the recoverability of year end balances.
• For exceptions, review the receivables ledger to identify possible
mispostings.
• For balances that are disputed, determine whether they relate to
timing differences or possible errors in Torres' records.
• Agree timing differences (ie cash in transit) to post year-end cash
receipts in the cash book.
• Discuss disputed balances with the finance director to assess
whether any write downs are required.
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Question: June 2015 (Section B, Question 6b)
Hawthorn Enterprises Co (Hawthorn) manufactures and distributes

fashion clothing to retail stores. Its year end was 31 March 2015. You
are the audit manager and the year-end audit is due to commence
shortly. The following matter has been brought to your attention.
Receivables
Hawthorn’s receivables ledger has increased considerably during the
year, and the year-end balance is $2.3 million compared to $1.4
million last year. The finance director of Hawthorn has requested that
a receivables circularisation is not carried out as a number of their
customers complained last year about the inconvenience involved in
responding. The engagement partner has agreed to this request, and
tasked you with identifying alternative procedures to confirm the
existence and valuation of receivables.
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Question: June 2015 (Section B, Q6b) cont'd
Required:
sufficient and appropriate audit evidence in relation to the above.
(5 marks)
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Approach: June 2015 (Section B, Question 6b)
• This question is about what audit work to do if your receivables'

confirmation cannot be carried out.
• We are not looking to perform a receivables’ confirmation, so do
not write down the process for carrying out a receivables'
confirmation in your answer!
• There are five marks available so assume there is one mark for
each well-explained audit procedure.
• You need to both read the requirement carefully AND ensure your
answers apply to the scenario described.
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Answer: December 2012 Question 4b(ii)
Substantive procedures for receivables

• Review the aged receivable ledger to identify any slow moving or
old receivable balances, discuss the status of these balances with
the credit controller to assess whether they are likely to pay.
• Select a significant sample of receivables and review whether
there are any after date cash receipts, ensure that a sample of
slow moving/old receivable balances is also selected.
• Review customer correspondence to identify any balances which
are in dispute or unlikely to be paid.
• Review board minutes to identify whether there are any significant
concerns in relation to payments by customers.
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Answer: December 2012 Question 4b(ii)
Substantive procedures for receivables (cont.)

• Calculate average receivable days and compare this to prior year,
investigate any significant differences.
• Inspect post year-end sales returns/credit notes and consider
whether an additional allowance against receivables is required.
• Select a sample of goods despatched notes (GDN) before and
just after the year end and follow through to the sales ledger to
ensure they are recorded in the correct accounting period.
• Select a sample of year-end receivable balances and agree back
to valid supporting documentation of GDN and sales order to
ensure existence.
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Chapter 15 • Introduction
Cash and bank • Bank

• Cash
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Bank and cash
(i) Bank confirmation reports used in obtaining evidence in relation to
bank and cash
(ii) Other evidence in relation to bank
(iii) Other evidence in relation to cash
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Overview
Bank and cash
Bank confirmation Other evidence

letters • Bank reconciliations
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Introduction 1
What is 'cash' in the financial statements?

Cash-in-hand and cash on deposit in bank accounts.
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Introduction 2
Audit objectives for cash

Financial statement Audit objective
assertion
Existence Recorded cash balances exist at the period-end
Completeness Recorded cash balances include the effects of all
transactions that have occurred
Rights and obligations The entity has legal title to all cash balances shown
at the period-end
Accuracy, valuation and Recorded cash balances are realisable at the
allocation amounts stated
Presentation (classification Disclosures relating to cash are adequate and in
and understandability, accordance with accounting standards and
occurrence and rights and legislation
obligations, accuracy and
valuation, completeness)
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Bank 1
• The year-end bank balance figure is usually confirmed by a direct

confirmation with the bank holding the account.
• This is a third party source of evidence and so provides the auditor
with excellent audit evidence in terms of sufficiency and
appropriateness.
• The bank confirmation covers the assertions of completeness,
existence, rights and obligations and valuation.
• ISA 505 External confirmations
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Bank 2
Approaches to the bank confirmation request

1. Listing balances and other information, and requesting confirmation
of their accuracy and completeness
2. Requesting details of balances and other information, which can
then be compared with the requesting client's records
Auditors need to decide which of these approaches is the most

appropriate. However, responses need to be sought for all confirmation
requests.
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Bank 3
• Control over content and dispatch of confirmation requests is the

auditor's responsibility but…
• The request must be authorised by the client.
• Replies must be sent directly to the auditor so a pre-addressed
envelope should be enclosed.
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Bank 4
Items included in the confirmation request

• Balances due to or from the client on current, deposit, loan and other
accounts
• Nil balances on accounts
• Accounts closed in the 12 months prior to confirmation date
• Maturity and interest terms on loans and overdrafts
• Unused facilities
• Lines of credit/standby facilities
• Any offset or other rights and encumbrances
• Details of any collateral given or received
• Contingent liabilities
• Securities held by the bank
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Bank 5
Bank confirmation procedure

• The banks will require explicit written authority from their client to
disclose the information requested.
• The auditors' request must refer to the client's letter of authority
and the date thereof.
• Alternatively it may be countersigned by the client or it may be
accompanied by a specific letter of authority.
• In the case of joint accounts, letters of authority signed by all
parties will be necessary.
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Bank 6
Bank confirmation procedure continued

• Such letters of authority may either give permission to the bank to
disclose information for a specific request or grant permission for an
indeterminate length of time.
• The request should reach the branch manager at least one month
in advance of the client's year-end and should state both that year-
end and the previous year-end date.
• The auditors should themselves check that the bank response
covers all the information in the standard and other responses.
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Bank 7
Window-dressing
• The bank balance is open to the risk of window-dressing so cut-off
must be audited carefully.
• Management may try to overstate liquidity by keeping the cash book
open to take credit for remittances actually received after the year-end
(overstate cash and understate receivables), or recording cheques
paid in the period which are not actually dispatched until after the
period-end (understate cash and overstate liabilities).
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Bank 8
• The following slides set out audit procedures for bank.

Chapter 10!
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Bank 9
Substantive procedures to test bank

• Obtain standard bank confirmations from each bank with which the
client conducted business during the audit period.
• Re-perform arithmetic of bank reconciliation.
• Trace cheques shown as outstanding from the bank reconciliation
to the cash book prior to the year-end and to the after-date bank
statements and obtain explanations for any large or unusual items not
cleared at the time of the audit.
• Compare cash book(s) and bank statements in detail for the last
month of the year, and match items outstanding at the reconciliation
date to bank statements.
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Bank 10
Substantive procedures to test bank continued

• Review bank reconciliation previous to the year-end bank
reconciliation and test whether all items are cleared in the last period
or taken forward to the year-end bank reconciliation.
• Obtain satisfactory explanations for all items in the cash book for
which there are no corresponding entries in the bank statement and
vice versa by discussion with finance staff.
• Verify contra items appearing in the cash books or bank statements
with original entry.
• Verify by inspecting paying-in slips that uncleared bankings are paid
in prior to the year-end.
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Bank 11

• Examine all lodgements in respect of which payment has been
refused by the bank; ensure that they are cleared on representation or
that other appropriate steps have to be taken to effect recovery of the
amount due.
• Verify balances per the cash book according to the bank reconciliation
by inspecting cash book, bank statements and general ledger.
• Verify the bank balances with reply to standard bank letter and with
the bank statements.
• Inspect the cash book and bank statements before and after the year-
end for exceptional entries or transfers which have a material effect
on the balance shown to be in-hand.
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Bank 12

• Identify whether any accounts are secured on the assets of the
company by discussion with management.
• Consider whether there is a legal right of set-off of overdrafts against
positive bank balances.
• Determine whether the bank accounts are subject to any
restrictions by inquiries with management.
• Review draft accounts to ensure that disclosures for bank are
complete and accurate and in accordance with accounting standards.
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Tackling the exam
• If the exam asks for audit procedures to verify bank balances,

remember that although the bank confirmation letter is important,
there are other procedures that need to be carried out.
• The F8 examining team has previously commented that
candidates lose out on marks for not focusing enough on
procedures other than obtaining the bank confirmation.
• Remember that the bank confirmation letter shows the balance
held by the client at the bank per the bank's records. So this must
be reconciled to the balance on the client's records.
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Cash 1
• Most businesses hold cash. This presents a fraud risk as cash is

easily misappropriated.
• In some types of industry, such as retail, cash held may be a
considerable amount.
• In other businesses, it may be a small amount such as petty cash
floats.
• The best way for the external auditor to audit cash in hand is to carry
out a cash count.
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Cash 2
Cash balances comprise:

• Notes and coins
• Unbanked cheques received
• IOUs
• Credit card slips
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Cash 3
The cash count has three phases:

• Planning
• Count
• Follow-up procedures
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Cash 4
Planning the cash count

• All cash balances should be counted at the same time.
• Need to establish locations where cash is held.
• Need to establish time of count.
• Need to know names of audit staff and client staff attending the
counts.
• Where a location is not visited, it may be appropriate to get a letter
confirming the balance from the client.
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Cash 5
Cash count
• All cash/petty cash books should be written up to date in ink (or
other permanent form) at the time of the count.
• All balances must be counted at the same time.
• All negotiable securities must be available and counted at the time the
cash balances are counted.
• At no time should the auditors be left alone with the cash and
negotiable securities.
• All cash and securities counted must be recorded on working
papers subsequently filed on the current audit file.
• Reconciliations should be prepared where applicable (for example,
imprest petty cash float).
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Cash 6
Substantive procedures to test cash

Cash count
• Count cash balances held and agree to petty cash book or other
record. Count all balances simultaneously and all counting to be done
in the presence of the individuals responsible.
• Enquire into any IOUs or cashed cheques outstanding for a long
period of time.
• Obtain certificates of cash-in-hand from responsible officials.
• Confirm that bank and cash balances as reconciled above are
correctly stated in the financial statements.
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Cash 7
Substantive procedures to test cash continued

Follow-up procedures
• Obtain certificates of cash-in-hand as appropriate.
• Verify unbanked cheques/cash receipts have subsequently been paid
in and agree to the bank reconciliation by inspection of the relevant
documentation.
• Ensure IOUs and cheques cashed for employees have been
reimbursed.
• Review whether IOUs or cashed cheques outstanding for
unreasonable periods of time have been provided for.
• Verify the balances as counted are reflected in the accounts (subject
to any agreed amendments because of shortages and so on) by
inspection of draft financial statements.
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Question: June 2013 Question 1d
Required:
Describe substantive procedures the auditor should perform to
confirm the bank and cash balance of Fox Industries Co at the year
end. (7 marks)
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Approach: June 2013 Question 1d
• There are seven marks available here so assume that there is one
mark awarded per well-explained audit procedure.
• Note that substantive procedures are required so do not mention
tests of controls in your answer!
• You are asked for audit procedures on bank and cash so do not
just focus on the bank balance.
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Answer: June 2013 Question 1d
Bank balance
• Send a bank confirmation request to the bank(s) holding the
current and savings accounts of Fox Industries Co so that the
year-end bank balance can be verified.
• Review the year-end reconciliation of the bank balance per the
general ledger against the bank balance per the bank letter.
• Re-perform the year-end bank reconciliation for each account and
investigate any differences fully.
• Agree the balance per the draft financial statements to the general
ledger and the bank reconciliations.
• Review draft financial statements to confirm that all amounts and
relevant disclosures relating to cash have been correctly stated.
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Answer: June 2013 Question 1d (cont'd)
Bank balance continued

• Trace cheques shown as outstanding from the bank reconciliation
to the cash book prior to the year-end and to the after-date bank
statements and obtain explanations for any large or unusual items
not cleared at the time of the audit.
• Compare cash book(s) and bank statements in detail for the last
month of the year, and match items outstanding at the
reconciliation date to bank statements.
• Obtain satisfactory explanations for all items in the cash book for
which there are no corresponding entries in the bank statement
and vice versa by discussion with finance staff.
• Verify contra items appearing in the cash books or bank
statements with original entry.
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Bank balance continued

• Verify by inspecting paying-in slips that uncleared bankings are
paid in prior to the year-end.
• Verify balances per the cash book according to the bank
reconciliation by inspecting cash book, bank statements and
general ledger.
• Verify the bank balances with the reply to standard bank letter and
with the bank statements.
• Inspect the cash book and bank statements before and after the
year-end for exceptional entries or transfers which have a material
effect on the balance shown to be in-hand.
• Identify whether any accounts are secured on the assets of the
company by discussion with management.
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Cash balance
• Count year-end cash balances and match to cash records such as
the petty cash book.
• Obtain certificates of cash-in-hand from responsible officers.
• Review draft financial statements to confirm that all amounts and
relevant disclosures relating to cash have been correctly stated.
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• Introduction
Chapter 16
• Procedures for trade payables,
Liabilities, capital accruals and expenses
and directors' • Non-current liabilities
emoluments • Provisions and contingencies
• Capital and other issues
• Directors' emoluments
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Payables and accruals
(i) Supplier statement reconciliations and direct confirmation of
accounts payable
(ii) Obtain evidence in relation to payables and accruals, and
(iii) Purchases and other expenses
Non-current liabilities, provisions and contingencies

(i) Evidence in relation to non-current liabilities
(ii) Provisions and contingencies
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Share capital, reserves and directors' emoluments
(i) Evidence in relation to share capital, reserves and directors'
emoluments
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Overview
Liabilities, capital and

directors' emoluments
• Payables and • Non-current liabilities • Share capital

accruals • Provisions and • Reserves
• Purchases and contingencies • Directors'
expenses • Finance costs emoluments
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Introduction 1
Audit objectives for liabilities, capital and directors' emoluments
Assertions – All purchase transactions recorded have occurred and relate to the
about classes entity (occurrence)
of – All purchase transactions that should have been recorded have been
transactions recorded (completeness)
and related
– Amounts relating to transactions have been recorded appropriately
disclosures (accuracy, valuation and allocation)
– Purchase transactions have been recorded in the correct period
(cut-off)
– Purchase transactions are recorded properly in the accounts
(classification)
– All disclosed events and transactions relating to liabilities have
occurred and relate to the entity (presentation)
– Financial information is appropriately presented and described and
disclosures clearly expressed (presentation)
– Financial information is disclosed fairly and at appropriate amounts
(presentation)
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Introduction 1 (continued)
Audit objectives for liabilities, capital and directors' emoluments
Assertions – Trade payables and accrued expenses are valid liabilities
about period- (existence)
end account – Trade payables and accrued expenses are the obligations of the
balances and entity (rights and obligations)
related
– All liabilities have been recorded (completeness)
disclosures
– All liabilities are included in the accounts at appropriate amounts
(accuracy, valuation and allocation)
– Financial information is appropriately presented and described and
disclosures clearly expressed (presentation)
– Financial information is disclosed fairly and at appropriate amounts
(presentation)
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Procedures for trade payables, accruals and expenses 1
• Accounts payables are likely to be a material figure in the statement

of financial position.
• When auditing trade payables, accruals and expenses, the auditor
must focus on understatement ie completeness.
• Cut-off testing is therefore a key audit test.
• Purchases are often tested in conjunction with trade payables.
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Substantive procedures to test COMPLETENESS

• Obtain a listing of trade accounts payables and agree the total to the
general ledger by casting and cross-casting.
• Test for unrecorded liabilities by inquiries of management on how
unrecorded liabilities and accruals are identified and examining post
year-end transactions.
• Obtain selected suppliers' statements and reconcile these to the
relevant suppliers' accounts.
• Examine files of unmatched purchase orders and supplier invoices for
any unrecorded liabilities.
• Perform a confirmation of accounts payables for a sample.
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Substantive procedures to test COMPLETENESS continued

relevant to liabilities have been made.
• Compare the current year balances for trade accounts payables and
accruals to the previous year.
• Compare the amounts owed to a sample of individual suppliers in the
trade accounts payable listing to amounts owed to these suppliers in
the previous year.
• Compare the payables' turnover and payables' days to the previous
year and industry data.
• Reperform casts of payroll records to confirm completeness and
accuracy.
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Substantive procedures to test COMPLETENESS continued

• Confirm payment of net pay per payroll records to cheque or bank
transfer summary.
• Agree net pay per cashbook to payroll.
• Inspect payroll for unusual items and investigate them further by
discussion with management.
• Perform proof-in-total (analytical procedures) on payroll and compare
to figure in draft financial statements to assess reasonableness.
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Substantive procedures to test EXISTENCE

• Vouch selected amounts from the trade accounts payables listing and
accruals listing to supporting documentation such as purchase orders
and suppliers' invoices.
• Obtain selected suppliers' statements and reconcile these to the
relevant suppliers' accounts.
• Perform a confirmation of accounts payables for a sample.
• Perform analytical procedures comparing current year balances to the
previous year to confirm reasonableness, and also calculating
payables' turnover and comparing to the previous year.
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Substantive procedures to test RIGHTS AND OBLIGATIONS

• Vouch a sample of balances to supporting documentation such as
purchase orders and suppliers' invoices to obtain audit evidence
regarding rights and obligations.
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Substantive procedures to test ACCURACY, VALUATION AND ALLOCATION

• Trace selected samples from the trade accounts payables' listing and
accruals listing to the supporting documentation (purchase orders, minutes
authorising expenditure, suppliers' invoices etc).
• Obtain selected suppliers' statements and reconcile these to the relevant
suppliers' accounts.
• For a sample of accruals, recalculate the amount of the accrual to ensure
the amount accrued is correct.
• Compare the current year balances for trade accounts payables and accruals
to the previous year.
• Compare the amounts owed to a sample of individual suppliers in the trade
accounts payables' listing to amounts owed to these suppliers in the previous
year.
• Compare the payables' turnover and payables' days to the previous year
and industry data.
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Substantive procedures to test ACCURACY, VALUATION AND

• Recalculate the mathematical accuracy of a sample of suppliers'
invoices to confirm the amounts are correct.
• Recast calculation of remuneration.
• Re-perform calculation of statutory deductions to confirm whether
correct.
• Confirm validity of other deductions by agreeing to supporting
documentation.
• Recast calculation of other deductions.
• Read disclosure notes to ensure information is accurate and properly
presented at the appropriate amounts.
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Substantive procedures to test CUT-OFF

• For a sample of vouchers, compare the dates with the dates they
were recorded in the ledger for application of correct cut-off.
• Test transactions around the year-end to determine whether amounts
have been recognised in the correct financial period.
• Perform analytical procedures on purchase returns, comparing the
purchase returns as a % of sales or cost of sales to the previous year.
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Substantive procedures to test OCCURRENCE

• For a sample of vouchers, inspect supporting documentation such as
authorised purchase orders.
• Agree individual remuneration per payroll to personnel records,
records of hours worked, salary agreements etc.
• Confirm existence of employees on payroll by meeting them,
attending wages payout, inspecting personnel and tax records, and
confirmation from managers.
• Agree benefits on payroll to supporting correspondence.
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Substantive procedures to test CLASSIFICATION AND

UNDERSTANDABILITY
• Review the trade accounts payables listing to identify any large debits
(which should be reclassified as receivables or deposits) or long-term
liabilities which should be disclosed separately.
• Read the disclosure notes relevant to liabilities in the draft financial
statements and review for understandability.
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Substantive procedures to test PURCHASES AND OTHER

EXPENSES
• Inspect a sample of purchase invoices to ensure they agree to the
amount posted to the general ledger.
• Compare expenses making up administrative expenses to the prior
year charge and to expectations on a line-by-line basis. Investigate
any differences from expectations.
• Inquire of management whether there are any unsettled claims or
obligations arising before the year-end and ensure these are provided
for.
• Recalculate accruals and prepayments to gain evidence that other
expenses are not over or understated.
• Compare gross profit margin with the previous year, the gross margin
per the budget and expectations. Investigate any unexpected
fluctuations.
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Substantive procedures to test WAGES COST

• Reconcile the gross costs on the payroll to the wages cost in the
• Re-perform casts of payroll records to confirm completeness and
accuracy of costs used as a basis for the journals to the accounts.
• Confirm payment of net pay per payroll records to cheque or bank
transfer summary.
• Inspect payroll for unusual items and investigate them further by
discussion with management.
• Perform proof-in-total (analytical procedures) on payroll by multiplying
estimated average wage (last year's figures x expected increases) by
average number of employees.
• Re-perform calculations of statutory deductions to establish whether
valid deductions have been included in the payroll expense.
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The suppliers' confirmation

• If the client's internal controls are weak, suppliers' statements may not
be available so a suppliers' confirmation may be undertaken
• This provides evidence of completeness
• Where internal controls are good, the confirmation will focus on large
balances
• Where internal controls are weak, the confirmation will focus on
regular suppliers with small/zero balances, other accounts, and large
balances
• Positive confirmation (blank or zero-balance confirmation)
• Does not state balance owed – the supplier has to fill the amount in
and return it, with a detailed statement of the account
• Amount must be reconciled with entity's records
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Exam link
• Trade payables and accruals are likely to be tested in a question

on audit evidence, asking for substantive audit procedures to
cover specific assertions
• This area has been tested on a regular basis, including in June
2014
• Remember the key point about audit procedures – they need to
be precise and test for the financial statement assertion asked for
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Non-current liabilities 1
Examples of non-current liabilities

• Debentures
• Loan inventory
• Loans repayable > 1 year after year-end
Key financial statement assertions

• Completeness
• Accuracy
• Classification and understandability
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Substantive procedures
• Obtain/prepare schedule of loans outstanding at the year-end date
showing, for each loan: name of lender, date of loan, maturity
date, interest date, interest rate, balance at the end of the period and
security.
• Compare opening balances to previous year's papers.
• Test the clerical accuracy of the analysis.
• Compare balances to the general ledger.
• Agree name of lender etc to register of debenture holders or
equivalent (if kept).
• Trace additions and repayments to entries in the cash book.
• Confirm repayments are in accordance with loan agreement.
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Substantive procedures continued

• Examine cancelled cheques and memoranda of satisfaction for loans
repaid.
• Verify that borrowing limits imposed by agreements are not exceeded.
• Examine signed Board minutes relating to new borrowings and
repayments.
• Obtain direct confirmation from lenders of the amounts outstanding,
accrued interest and what security they hold.
• Verify interest charged for the period is in accordance with statements
and supporting agreements, and consistent with known interest rates.
Consider the adequacy of accrued interest.
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Substantive procedures continued

• Confirm assets charged have been entered in the register of charges
and notified to the Registrar.
• Review restrictive covenants and provisions relating to default: review
any correspondence relating to the loan, review confirmation replies
for non-compliance, if a default appears to exist determine its effect
and schedule findings.
• Review minutes, cash book to confirm that all loans have been
recorded.
• Review draft accounts to ensure that disclosures for non-current
liabilities are correct and in accordance with accounting standards.
Any elements repayable within one year should be classified under
current liabilities.
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Provisions and contingencies 1
• Provisions and contingencies involve the judgement of management,

which makes them difficult to audit.
• You need to use your financial reporting knowledge from Paper F3
regarding IAS 37 Provisions, contingent liabilities and contingent
assets.
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• Examples of contingencies
— Guarantees
— Discounted bills of exchange
— Uncalled liabilities on shares or loan inventory
— Lawsuits or claims pending
— Options to purchase assets
• ISA 501 Audit evidence – specific considerations for selected items
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Audit procedures to identify possible litigations and claims

• Make appropriate inquiries of management and others including in-
house legal advisers.
• Review minutes of meetings of those charged with governance and
correspondence between the entity and its external legal advisers.
• Review legal expense accounts.
• Use any information obtained regarding the entity's business including
information obtained from discussions with any in-house legal
department.
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Audit procedures when litigations and claims have been identified

• Seek direct confirmation with lawyers through a letter of inquiry
• Letter of inquiry: general inquiry or specific inquiry
• Prepared by management and sent by auditor
• Lawyer to communicate directly with the auditor
• Written representations also required from management regarding
litigations and claims
• In certain circumstances, auditors may have to meet with lawyers
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For each material provision:

• Determine whether the company has a present obligation as a result
of a past event at the year end date.
• Determine whether it is probable that an outflow of resources will be
required to settle the obligation.
• Determine whether provisions represent the best estimate of liability.
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Audit procedures to test provisions

• Obtain details of all provisions which have been included in the
accounts and all contingencies that have been disclosed.
• Obtain a detailed analysis of all provisions showing opening balances,
movements and closing balances.
• Determine for each material provision whether the company has a
present obligation as a result of past events by review of
correspondence relating to the item and discussion with directors.
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Audit procedures to test provisions continued

• Determine for each material provision whether it is probable that a
transfer of economic benefits will be required to settle the obligation
by:
— Checking whether any payments have been made in the post
year-end period by reviewing after-date cash
— Review of correspondence with solicitors, banks, customers,
insurance company and suppliers both pre and post year-end
— Sending a letter to the solicitor to obtain his views (where
relevant)
— Discussing the position of similar past provisions with the directors
— Considering the likelihood of reimbursement
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Audit procedures to test provisions continued

• Recalculate all provisions made.
• Compare the amount provided with any post year-
end payments and with any amount paid in the past for similar items.
• In the event that it is not possible to estimate the amount of the
provision, check that a contingent liability is disclosed in the accounts.
• Consider the nature of the client's business. Would you expect to see
any other provisions eg warranties?
• Consider the adequacy of disclosure of provisions, contingent assets
and contingent liabilities in accordance with IAS 37.
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Exam link: Provisions and contingencies
• F8 students are often confused between contingent liabilities and
provisions so it is best to revisit your F3 notes in this area to clarify
the difference between the two.
• The best way to prepare is to first make sure you are comfortable
with the accounting side and then to practise past exam/exam-
standard questions where this topic is tested.
• Past exam questions on this area can be found in recent exam
sittings: December 2011 (Q1d, Q5b), June 2012 (Q4b), December
2012 (Q4b) and the 2014 and 2016 Specimen Exams.
• The 2014 Specimen Exam used the same scenario as the 2016
Specimen Exam. It is the 2014 version of the question – a Section
B written requirement – that we will look at now.
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Question: 2014 Specimen Paper (Sec B, Question 2b)
Balotelli Beach Hotel Co (Balotelli) operates a hotel providing

accommodation, leisure facilities and restaurants. Its year end was
31 October 20X4. You are the audit senior of Mario & Co and are
currently preparing the audit programmes for the year end audit of
Balotelli. You are reviewing the notes of last week's meeting between
the audit manager and finance director where two material issues
were discussed.
Food poisoning
Balotelli's directors received correspondence in September from a
group of customers who attended a wedding at the hotel. They have
alleged that they suffered severe food poisoning from food eaten at
the hotel and are claiming substantial damages. Balotelli's lawyers
have received the claim and believe that the lawsuit against the
company is unlikely to be successful.
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Question: 2014 Specimen Paper (Sec B, Q2b) cont'd
Required:
Describe substantive procedures to obtain sufficient and appropriate
audit evidence in relation to the above issue. (4 marks)
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Answer: 2014 Specimen Paper (Sec B, Question 2b)
• Review correspondence regarding the claim for damages to

assess whether the view of the claim being unsuccessful is
reasonable.
• Review the post year end period to confirm whether any payments
regarding the claim have been made.
• Contact Balotelli's lawyers, with the client's permission, to obtain
their view as to the success of the claim.
• Review the board minutes for evidence of the directors'
expectations of the claim's outcome.
• Obtain a written representation from Balotelli's directors confirming
management's view that the claim is unlikely to be successful.
• Review the financial statements to ensure that adequate
disclosure has been made of the issue as a contingent liability if
provision is not required.
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Capital and other issues
• The main area of concern with share capital and reserves is

compliance with law.
• Audit work will focus on share equity capital, the issue of shares, the
transfer of shares, dividends and reserves.
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Directors' emoluments 1
What are directors' emoluments?

• Salaries
• Fees
• Bonuses
• Pension contributions and retirement benefits
• Non-cash benefits
• Compensation for loss of office
Directors' emoluments are material by nature!
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Why are directors' emoluments important?

IAS 24 Related party disclosures is not in this syllabus, but it is useful to
look at its requirements here.
• IAS 24 requires that compensation payments to key management
personnel be disclosed
• Key management will include the board of directors
• Compensation includes items such as wages, paid annual leave,
profit-sharing, bonuses plus post-employment and long-term benefits
such as pensions and termination benefits
The auditor must ensure that the requirements of International
Accounting Standards and local legislation are met.
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Audit plan to test directors' emoluments

• For each director, obtain a schedule of emoluments for the year, split
between wages, bonuses, benefits, pension contributions and other
emoluments.
• Recast the addition of the schedule and ensure the totals are in
agreement with the disclosure in the financial statements.
• Ask each individual director to confirm the emoluments listed are
complete and in line with their expectations.
• Compare the emoluments with both the previous year's emoluments
and with expectations, taking into account the knowledge obtained
during the audit (for example if you know a director has left during
the year, is there any compensation for loss of office expected?).
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Audit plan to test directors' emoluments continued

• Agree salaries, fees, bonuses and pension contributions to payroll
records for the individual directors and check the amounts paid on the
bank statements agree with the payroll records.
• Review the directors' contracts and ensure emoluments are
consistent with the terms of these contracts.
• Review board meeting minutes and meetings of any remuneration
committee for evidence of any bonuses, fees or other emoluments not
disclosed.
• Review the cash book for any unusual transactions which suggest
undisclosed directors emoluments.
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Audit plan to test directors' emoluments continued

• Obtain and review returns to tax authorities made on behalf of the
directors by the company which detail non-cash benefits. Ensure
these are consistent with the benefits disclosed in the financial
statements.
• Consider the adequacy of disclosure of directors' emoluments in
accordance with applicable accounting standards and local
legislation, including the separate disclosure of amounts due to or
from directors in respect of directors' emoluments.
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Question: Directors' emoluments
You are responsible for auditing the directors' emoluments of ABC Co

and have been provided with the information below.
Termination Incentive
Salary Bonuses payments payments Total
$ $ $ $ $
Director A 120,000 90,000 – – 210,000
Director B 80,000 50,000 – – 130,000
Director C 50,000 5,000 15,000 – 70,000
Director D 20,000 5,000 – 10,000 35,000
270,000 150,000 15,000 10,000 445,000
State what audit tests you would perform.
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Answer: Directors' emoluments
Salary:
• Vouch salary amounts to monthly payroll records and bank statements to
ensure the amounts are accurate.
• For Directors C and D, obtain their leaving/start dates from the HR
department and vouch this to board meeting minutes. Recalculate their
salaries on a pro-rata basis to ensure they are accurately recorded.
Bonuses:
• Vouch the level of bonuses awarded to board meeting minutes, payroll
records and bank statements to ensure they have been authorised and
are accurately recorded.
• Discuss with management the reasons why Director C was awarded a
bonus despite leaving the company during the year. Support any
explanations with written documentation where possible (for example
Director C's contract).
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Answer: Directors' emoluments (cont'd)
Termination payments/incentive payments:

• Review the employment contracts for Directors C and D to verify
that there is a clause outlining that these payments are applicable.
• Vouch the level of these payments to board meeting minutes,
payroll records and bank statements.
General:
• Re-cast the schedule to ensure the note is accurate.
• Review the disclosure to ensure that it is in accordance with
applicable law and accounting standards.
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Chapter 17 • Objectives of not-for-profit
organisations
Not-for-profit
• Audit planning
organisations
• Audit evidence
• Audit reporting
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• Apply audit techniques to not-for-profit organisations.
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Overview
Not-for-profit organisations
Types of not-for-profit
organisations
Comparison with audit of Application of audit

for-profit organisations techniques
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Objectives of not-for-profit organisations 1
• Firstly, what are not-for-profit organisations?

• The first thing that springs to mind is charities
• However, there are many other kinds of not-for-profit organisations
• Charities, clubs, schools, hospitals etc
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Let's look now at the objectives of some key not-for-profit organisations.
Charities
To carry out the charitable purpose
Schools
To provide education
Hospitals
To provide healthcare
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Real World Example: Oxfam
Oxfam is an international confederation of 17 organisations that are

networked together in more than 90 countries.
Its objective is to build a future free from the injustice of poverty.
www.oxfam.org
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Real World Example: Cedars-Sinai hospital 1
Cedars-Sinai hospital in Los Angeles, USA, is one of the most

famous hospitals in the world.
It is the largest non-profit academic medical centre in the western
USA.
Let's look at its mission statement in the next two slides.
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'Cedars-Sinai Health System, a non-profit, independent healthcare

organisation, is committed to:
• Leadership and excellence in delivering quality healthcare
services
• Expanding the horizons of medical knowledge through biomedical
research
• Educating and training physicians and other healthcare
professionals
• Striving to improve the health status of our community'
from www.cedars-sinai.edu
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'Quality patient care is our priority. Providing excellent clinical and

service quality, offering compassionate care, and supporting research
and medical education are essential to our mission. This mission is
founded in the ethical and cultural precepts of the Judaic tradition,
which inspires devotion to the art and science of healing, and to the
care we give to our patients and staff.'
from www.cedars-sinai.edu
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Exam link
Question 4 of the December 2010 exam was a scenario question

based around a hospital.
Students were asked to identify strengths in the hospital's operating
environment, before making recommendations about how further
improvements might be made to provide value for money.
In questions like these it is vital that you spot clues given in the
scenario about what is important to the organisation.
This question also shows that you need to be able to link different
areas of the syllabus – in this instance applying your knowledge of
value for money and internal control in the context of a not-for-profit
organisation that is funded by taxpayers.
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• Many not-for-profit organisations are legislated for

• The acts which relate to them may specify how they report their
results
• Not-for-profit organisations may be:
— Companies
— Co-operatives
— Industrial or provident societies
— Trusts
— Clubs
— Associations
— Government departments
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• In the UK, there are SORPs (Statements of Recommended Practice)

in place for some entities such as charities and local authorities
• These supplement accounting standards and other legal requirements
• Different countries may have similar guidance in place for not-for-
profit organisations
• Let's look at the UK charities SORP in more detail…
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UK SORP Accounting and Reporting by Charities

• A statement of financial activities (SOFA) that shows all resources
made available to the charity and all expenditure incurred, and
reconciles all changes in its funds
• Where the charity is required to prepare accounts in accordance with
the Companies Act, or similar legislation, or where the governing
instrument so requires, a summary income and expenditure account
(in addition to the SOFA) in certain circumstances
• A balance sheet (the equivalent of a statement of financial position)
that shows the assets, liabilities and funds of the charity
• A cash flow statement, where required by accounting standards
• Notes
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An audit of a not-for-profit organisation may differ from a for-profit audit

due to:
• Its objectives and the impact on operations and reporting
• The purpose for which an audit is required
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When carrying out an audit of a not-for-profit organisation, the auditor

must establish:
• Whether a statutory audit is required
• If a statutory audit it not required, what the objectives of the
engagement are
• What the engagement is to report on
• To whom the report should be addressed
• What form the report should take
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Audit planning 1
When planning the audit of a not-for-profit organisation, the auditor

should consider the following factors:
• The scope of the audit
• Recent recommendations of the regulatory bodies
• The acceptability of accounting policies adopted
• Changes in circumstances in the sector in which the organisation
operates
• Past experience of the effectiveness of the organisation's accounting
system
• Key audit areas
• The amount of detail included in the financial statements on which
the auditors are required to report
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Audit planning 2
Audit risk
Let's look at some of the audit risks that might be relevant to the audit of
a not-for-profit organisation.
We will consider inherent risk and control risk.
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Audit planning 3
Inherent risk
• Complexity and extent of regulation
• Significance of donations and cash receipts
• Difficulties in establishing ownership and timing of voluntary income
where funds are raised by non-controlled bodies
• Lack of predictable income or precisely identifiable relationship
between expenditure and income
• Uncertainty of future income
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Audit planning 4
Inherent risks that may be relevant to charities

• Restrictions imposed by the objectives and powers given by charities'
governing documents
• Importance of restricted funds
• Extent and nature of trading activities must be compatible with
charitable status
• Complexity of tax rules
• Sensitivity of certain key statistics, eg proportion of resources used in
administration
• Need to maintain adequate resources for future expenditure while
avoiding the build up of reserves which could appear excessive
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Audit planning 5
Control risk
• Amount of time committed by directors/trustees to the organisation's
affairs
• Skills and qualifications of directors/trustees
• Frequency and regularity of board/trustee meetings
• Form and content of board/trustee meetings
• Independence of trustees from each other
• Division of duties between management/trustees
• Degree of involvement in the organisation's transactions by individual
directors/trustees
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Audit planning 6
Control risk continued

• Segregation of duties
• Supervision by management/trustees of activities of staff where
segregation of duties is not practical
• Competence, training and qualifications of paid staff and volunteers
• Board/trustee involvement in recruitment, appointment and
supervision of senior executives
• Access of trustees to independent professional advice where
necessary
• Budgetary controls
• Communication of results to board/trustees on a regular basis
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Audit planning 7
Internal controls over cash – collection boxes and tins

• Numerical control over collection boxes and tins
• Sealing of boxes and tins so that any opening prior to counting is
apparent
• Regular collection and recording of proceeds from collection boxes
and tins
• Dual control over counting and recording of proceeds
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Audit planning 8
Internal controls over cash – postal receipts

• Unopened mail kept securely
• Dual control over mail opening
• Immediate recording of donations on opening of mail or receipt
• Agreement of bank paying-in slips to record of receipts by an
independent person
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Audit planning 9
Internal controls over cash – deeds of covenant

• Regular checks and follow-up procedures to ensure due amounts are
received
• Regular checks to ensure all tax repayments have been obtained
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Audit planning 10
Internal controls over cash – legacies

• Comprehensive correspondence files maintained for each legacy
• Regular reports and follow-up procedures for outstanding legacies
Internal controls over cash – donations-in-kind

Separation of recording, storage and sale of inventory (charity shops)
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Audit planning 11
Internal controls over other income – fundraising activities

• Records maintained for each fundraising event
• Other appropriate controls over receipts
• Controls maintained over expenses as for administrative expenses
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Audit planning 12
Internal controls over other income – central and local government

grants and loans
• Regular checks that all sources of income or funds are fully utilised
and appropriate claims made
• Ensuring income or funds are correctly applied by adequate
monitoring
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Audit planning 13
Internal controls over use of resources – restricted funds

• Separate records maintained of relevant income, expenditure and
assets
• Terms controlling application of funds
• Oversight of application of fund monies by independent personnel or
trustees
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Audit planning 14
Internal controls over use of resources – grants to beneficiaries

• Records maintained of requests for material grants received and their
treatment
• Appropriate checks made on applications and applicants for grants,
and that amounts paid are in accordance with legislation
• Records maintained of all grant decisions, checking that proper
authority exists, that adequate documentation is presented to
decision-making meetings, and that any conflicts of interest are
recorded
• Controls to ensure grants made are properly spent by the recipient for
the specified purpose
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Question: Paws for Thought
Paws for Thought is a local charity whose objectives are to provide

care for lost and stray dogs and to eventually find them good homes.
The charity houses the dogs in a purpose-built kennel building which
also includes the administrative office and a vet.
The charity relies on donations from the public and runs three charity
shops in the area, which are overseen by one manager (who divides
her time between the three shops and the administrative offices). The
shop staff consist entirely of volunteers.
Each shop contains a collection box by the till. These are usually left
in the shop overnight but occasionally the manager takes them home
where she counts the cash collected in them.
The manager often does not have time to bank the cash takings from
the shops on a daily basis so she takes these home too as the shops
do not have safes.
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Question: Paws for Thought (cont'd)
The director of the charity is the vet who looks after the dogs. As she
is very busy tending to the dogs, she has little time to spend on
administrative activities and tends to delegate this to the one
administrative assistant employed and the shop manager.
Recently, the vet has been talking to an accountant friend of her's
who suggested that she ought to take a greater interest in the
financial side of the charity as there may be scope to improve how
the charity is run.
Imagine that you are the external auditor of Paws for Thought. What
audit risks can you identify from this scenario?
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Approach: Paws for Thought
If this were an exam question, the best approach would be to go

through the scenario line-by-line to identify the risk factors and then
explain how these would affect the financial statements.
Here are some ideas:
• Lack of segregation of duties
• Lack of supervision and monitoring of activities by director
• Poor controls over collection boxes
• Poor controls over cash takings in shops
• Shops have predominantly volunteer staff
• Too much control given to one member of staff (manager)
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Audit evidence 1
• There are special considerations for the audit of not-for-profit

organisations, especially where there are informal arrangements in
place.
• Obtaining sufficient, appropriate audit evidence may be an issue for
auditors.
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Audit evidence 2
The auditor must be alert to the following:

• Understatement or incompleteness of the recording of all income
including gifts in kind, cash donations and legacies
• Overstatement of cash grants or expenses
• Misanalysis or misuse in the application of funds, including the misuse
of taxpayers funds if the entity is government funded
• Misstatement or omission of assets including donated properties and
investments
• The existence of restricted or uncontrollable funds in foreign or
independent branches
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Audit evidence 3
Completeness of income issues

• Loss of income through fraud
• Recognition of government funding
• Recognition of income from professional fund raisers
• Recognition of income from branches, associates or subsidiaries
• Income from informal fundraising groups
• Income from grants
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Audit evidence 4
Issues to consider during overall review

• Appropriateness of accounting policies
• Consistent application of accounting policies
• Disclosure of accounting policies
• Do the financial statements present fairly the state of affairs and
results for the period under review?
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Audit evidence 5
Particular issues to consider during overall review

• Disclosure of income from fundraising activities (net or gross)
• Accounting for income and expenses (cash or accruals)
• Capitalisation of expenditure on non-current assets
• Apportionment of administrative expenses
• Recognition of income from donations and legacies
• Whether the going concern basis is appropriate
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Audit reporting 1
• For not-for profit organisations that require a statutory auditor's report,

auditors should issue an auditor's report in accordance with ISA 700
Forming an opinion and reporting on financial statements.
• We look at standard auditor's reports in detail in Chapter 19.
• There may be additional statutory reporting requirements for not-for-
profit organisations.
• If a not-for-profit organisation is having an audit for the benefit of its
members or trustees, or the organisation is government-funded or
heavily regulated, the standard auditor's report may not be applicable.
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Audit reporting 2
The following issues need to be included:

• The addressees of the report
• What the report relates to
• The scope of the engagement
• The respective responsibilities of auditors and management/trustees/
directors
• The work done
• The opinion drawn
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Tackling the exam 1
• The audit of not-for-profit organisations can be tested in both

Section A and Section B.
• Do not panic if presented with a client that is a charity or a hospital
or other not-for-profit organisation.
• Use the clues in the scenario to help you plan your answer.
• Remember that not-for-profit organisations will have their own
particular issues in relation to auditing.
• Remember also that the issues relating to the audit of small
entities might also apply to the audit of not-for-profit organisations.
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Tackling the exam 2
• The following articles from Student Accountant on not-for-profit

organisations may be useful and can be accessed via the ACCA's
website:
students/2012s/3244839_09.pdf
http://www.accaglobal.com/content/dam/acca/global/pdf/sa_oct09
_souster.pdf
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Chapter 18 • Subsequent events
Audit review and • Going concern
finalisation • Written representations

• Overall review of financial
statements
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• Explain the purpose of a subsequent events review.

• Explain the responsibilities of auditors regarding subsequent events.
• Discuss the procedures to be undertaken in performing a subsequent
events review.
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• Define and discuss the significance of the concept of going concern.

• Explain the importance of and the need for going concern reviews.
• Explain the respective responsibilities of auditors and management
regarding going concern.
• Identify and explain potential indicators that an entity is not a going
concern.
• Discuss the procedures to be applied in performing going concern
reviews.
• Discuss the disclosure requirements in relation to going concern
issues.
• Discuss the reporting implications of the findings of going concern
reviews.
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• Explain the purpose of and procedure for obtaining written

representations.
• Discuss the quality and reliability of written representations as audit
evidence.
• Discuss the circumstances where written representations are
necessary and the matters on which representations are commonly
obtained.
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• Discuss the importance of the overall review of evidence obtained.

• Describe the procedures an auditor should perform in conducting their
overall review of financial statements.
• Explain the significance of uncorrected misstatements.
• Evaluate the effect of dealing with uncorrected misstatements.
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Overview
Overall review of evidence
Audit review and

finalisation
Uncorrected misstatements
Written
Subsequent events Going concern
representations
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Subsequent events 1
Subsequent events are events occurring between the date of the

financial statements and the date of the auditor's report, and facts that
become known to the auditor after the date of the auditor's report.
Two types
• Adjusting events: events that provide evidence of conditions that
existed at the year-end date
• Non-adjusting events: events that are indicative of conditions that
arose after the year-end date
ISA 560 Subsequent events

IAS 10 Events after the reporting period
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Subsequent events 2
Examples of adjusting and non-adjusting events
Adjusting events Non-adjusting events

Settlement of a court case Dividends declared after the year-end
Sales of inventory after year-end Fire causing destruction of major
providing evidence of its NRV at year- plant
end
Fraud or error showing the financial Announcement of a major
statements are incorrect restructuring
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Subsequent events 3
Between the year-end and the date of the auditor's report

The auditor must obtain sufficient appropriate audit evidence that all
events up to the date of the auditor's report that require adjustment or
disclosure have been identified.
Audit evidence
• Inquiries of management
• Inspection of board meeting minutes and latest interim financial
statements
• Review of procedures to identify subsequent events
• Inquiries with client's lawyers re litigation claims
• Written representations
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Subsequent events 4
Between the date of the auditor's report and issue of financial

statements
No obligation to perform procedures BUT if become aware of a fact that
would have caused an amendment to the auditor's report if it had been
known at the date of the auditor's report:
• Discuss matter with management and those charged with governance
• Determine whether financial statements need amending
• If amendment required, discuss with management how they intend to
address the matter in the financial statements
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Subsequent events 5
If amendment is required:
Management make the amendment Management do not make the

amendment
• Perform necessary audit • Modify the opinion (if auditor's
procedures on the changes. report not yet provided) and then
• Extend audit procedures for provide the auditor's report.
identifying subsequent events to • Notify management and those
the date of new auditor's report. charged with governance not to
• Provide a new auditor's report. issue the financial statements (if
auditor's report already provided).
• If financial statements issued, take
action to seek to prevent reliance
on the auditor's report.
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Subsequent events 6
Facts discovered after the financial statements have been issued

No obligations to perform procedures BUT if become aware of a fact that
would have caused an amendment to the auditor's report if it had been
known at the date of the auditor's report:
• Discuss matter with management and those charged with governance
• Determine whether financial statements need amending
• If amendment required, discuss with management how they intend to
address the matter in the financial statements
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Subsequent events 7
If amendment is required:
Management make the amendment Management do not make the

amendment
• Perform necessary audit • Notify management and those
procedures on the changes. charged with governance that the
• Review procedures to ensure that auditor will seek to prevent future
anyone in receipt of previously reliance on the auditor's report.
issued financial statements is • If still no progress, take action to
informed. seek to prevent reliance on the
• Issue a new auditor's report with auditor's report.
an explanatory paragraph.
• Extend audit procedures to date of
new auditor's report.
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Subsequent events 8
Summary
Audit field work
Year Auditor's F/S AGM

end report issued
date issued
Active duty Passive duty
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Exam link
• Subsequent events are likely to be tested in a question on the

auditor's report in the context of two or three mini scenarios.
• However, you could also be tested on your knowledge skills with a
question in section A.
• The following article from Student Accountant (April 2011) is
recommended reading on subsequent events:
students/2012s/sa_apr11_f8_subs_events.pdf
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Question: 2016 Specimen Paper (Sec A, Question 12)
Cannavaro.com is a website design company whose year end was

31 December 20X4. The audit is almost complete and the financial
statements are due to be signed shortly. Profit before tax for the year
is $3.8 million and revenue is $11.2 million.
The company has only required an audit for the last two years and
the board of directors has asked your firm to provide more detail in
relation to the form and content of the auditor’s report.
During the audit it has come to light that a key customer, Pirlo Co,
with a receivables balance at the year end of $285,000, has just
notified Cannavaro.com that they are experiencing cash flow
difficulties and so are unable to make any payments for the
foreseeable future. The finance director has notified the audit team
that he will write this balance off as an irrecoverable debt in the 20X5
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The audit assistant assigned to the audit of Cannavaro.com wants a

better understanding of the effect subsequent events have on the
audit and has made the following statements:
(1)All material subsequent events require the numbers in the
financial statements to be adjusted
(2)A non-adjusting event is a subsequent event for which NO
amendments to the current year financial statements are required
(3)The auditor’s responsibilities for subsequent events which occur
prior to the audit report being signed are different from their
responsibilities after the audit report has been issued
(4)The auditor should request a written representation confirming that
all relevant subsequent events have been disclosed
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Which of the statements above in relation to subsequent events

are true?
A 1 and 3
B 2, 3 and 4
C 1, 2 and 4
D 3 and 4
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Statement 1 is false as not all subsequent events will require an

adjustment to the numbers within the financial statements.
IAS 10 Events after the Reporting Period makes a distinction
between an adjusting and non-adjusting event. Only material
adjusting events would require an amendment to the figures within
the financial statements.
Statement 2 is false as while a non-adjusting event would not require
a change to the numbers within the financial statements, IAS 10 may
require a disclosure to be made. If the non-adjusting event is
material, non-disclosure could still result in a modification to the audit
report.
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Statement 3 is true as the auditor is required to carry out procedures

up to the date of the audit report to gain sufficient appropriate audit
evidence that all relevant subsequent events have been identified
and dealt with appropriately. After the audit report is issued, the
auditor does not need to actively look for subsequent events but is
only required to respond to subsequent events which they become
aware of.
Statement 4 is true as ISA 560 Subsequent Events requires the
auditor to obtain written confirmation from management/those
charged with governance that all subsequent events have been
identified and dealt with in accordance with the appropriate reporting
framework.
D is therefore correct.
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Question: June 2013 Question 5b
Panda Co manufactures chemicals and has a factory and four offsite

storage locations for finished goods. Panda Co's year end was 30
April 20X3. The final audit is almost complete and the financial
statements and audit report are due to be signed next week.
Revenue for the year is $55 million and profit before taxation is $5.6
million.
The following two events have occurred subsequent to the year end.
No amendments or disclosures have been made in the financial
statements.
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Question: June 2013 Question 5b (cont'd)
Event 1 – Defective chemicals

Panda Co undertakes extensive quality control checks prior to
despatch of any chemicals. Testing on 3 May 20X3 found that a batch
of chemicals produced in April was defective. The cost of this batch
was $0.85 million. In its current condition it can be sold at a scrap
value of $0.1 million. The costs of correcting the defect are too
significant for Panda Co's management to consider this an alternative
option.
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Event 2 – Explosion
An explosion occurred at the smallest of the four offsite storage
locations on 20 May 20X3. This resulted in some damage to
inventory and property, plant and equipment. Panda Co's
management have investigated the cause of the explosion and
believe that they are unlikely to be able to claim on their insurance.
Management of Panda Co has estimated that the value of damaged
inventory and property, plant and equipment was $0.9 million and it
now has no scrap value.
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Required:
For each of the two events above:
(i) Explain whether the financial statements require amendment.
(ii) Describe audit procedures that should be performed in order to
form a conclusion on any required amendment.
(12 marks)
Note. The total marks will be split equally between each event.
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Approach: June 2013 Question 5b
• There are 12 marks available in total, so six for each event.

Assuming that parts (i) and (ii) are also equally weighted, there will
be three marks for a discussion on whether the financial
statements need amending and three marks on audit procedures.
• You are provided with figures for revenue and profit before tax –
you MUST use them in assessing whether the events are material
or not!
• The first thing to do is consider whether the event is an adjusting
event or a non-adjusting event, so you need to use your financial
reporting knowledge from F3 here.
• Then look at whether it is material or not.
• In part (ii), remember that where you are asked for audit
procedures, they must be sufficiently detailed and avoid
vagueness, otherwise you will not be awarded any/full marks.
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Answer: June 2013 Question 5b
Event 1 – Defective Chemicals

A batch of chemicals produced before the year-end, costing $0.85m
to produce, has been found to be defective after the year-end. Its
scrap value is $0.1m. Inventory should be valued at the lower of cost
and net realisable value in accordance with IAS 2 Inventories. This is
an adjusting event in accordance with IAS 10 Events after the
reporting period. As it stands, the inventory is overstated by $0.75m.
This represents 13.4% of profit before tax and 1.4% of revenue and is
therefore material to the financial statements.
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Answer: June 2013 Question 5b (cont'd)
Audit procedures to be performed:

• Obtain a schedule to confirm the cost value of the defective batch
of $0.85m and documentary proof of the scrap value of $0.1m.
• Discuss with management whether this is the only defective batch
or whether there are likely to be other batches affected.
• Review quality control reports to assess the likelihood of other
batches being affected and discuss results of testing with technical
team members at Panda.
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Event 2 – Explosion
The amount of inventory and property, plant and equipment damaged
is estimated to be $0.9m. It has no scrap value. Inventory and
property, plant and equipment are therefore overstated by $0.9m.
This represents 16.1% of profit before tax and 1.6% of revenue, and
is therefore material. The explosion represents a non-adjusting event
in accordance with IAS 10 Events after the reporting period. It
therefore does not require adjustment in the financial statements but
should be disclosed as it is material.
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Audit procedures to be performed:

• Obtain a schedule of the inventory and property, plant and
equipment damaged in the explosion to verify the value of $0.9m.
• Visit the site where the explosion took place to assess damage.
• Discuss with directors the need to make disclosure in the financial
statements and review any draft disclosure note drafted.
• Inspect insurance agreement to assess whether any claim can be
made on the insurance.
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Going concern 1
• Financial statements should be prepared on a going concern basis

unless management either intends to liquidate the entity or has no
realistic alternative but to do so.
• Going concern means the entity is viewed as continuing in business
for the foreseeable future.
• If the going concern basis is not appropriate the financial statements
must be prepared on a break-up basis.
• ISA 570 Going concern
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Going concern 2
Financial indicators of going concern problems
Negative operating Substantial sales of

cash flows non-current assets
Net liabilities
Borrowing facilities not Financial Inability to pay

agreed creditors when due
Arrears or
Adverse key financial Operating losses discontinuance of
ratios Change from credit to dividends
cash-on-delivery with
suppliers
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Going concern 3
Operating indicators of going concern problems

Management
intentions to liquidate
or cease operating
Loss of key Labour difficulties
staff without
replacement Highly successful
Operating
competitor
Loss of major market,

key customers, licence Shortages of important
or suppliers Excessive supplies
dependence on a few
product lines
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Going concern 4
Other indicators of going concern problems
Uninsured or underinsured catastrophes
Other
Non-compliance with Changes in legislation

regulations
Pending legal proceedings
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Going concern 5
Management's responsibility re going concern

• To make an assessment of the entity's ability to continue as a going
concern, which should cover 12 months from the reporting date
Auditor's responsibility re going concern

• To obtain sufficient appropriate audit evidence regarding the
appropriateness of management's use of the going concern
assumption
• To conclude whether a material uncertainty exists related to events or
conditions that may cast significant doubt on the entity's ability to
continue as a going concern
• To determine the implications for the auditor's report
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Going concern 6
Audit procedures relating to going concern

• Analyse and discuss cash flow, profit and other relevant forecasts with
management.
• Analyse and discuss the entity's latest available interim financial
statements (or management accounts).
• Review the terms of debentures and loan agreements and determine
whether they have been breached.
• Read minutes of the meetings of shareholders, the board of directors
and important committees for reference to financing difficulties.
• Inquire of the entity's lawyer regarding litigation and claims.
• Confirm the existence, legality and enforceability of arrangements to
provide or maintain financial support with related third parties.
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Going concern 7
Audit procedures relating to going concern continued

• Assess the financial ability of such parties to provide additional funds.
• Consider the entity's position concerning unfulfilled customer orders.
• Review events after the period-end for items affecting the entity's
ability to continue as a going concern.
• Confirm the existence, terms and adequacy of borrowing facilities.
• Obtain and review reports of regulatory actions.
• Determine the adequacy of support for any planned disposals of
assets.
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Going concern 8
Impact on the auditor's report

• The auditor's work on going concern is very important as there can be
a significant impact on the auditor's report.
• We will look at audit reporting in more detail in Chapter 19.
• The next slide provides a summary table of how the auditor's report
can be affected by issues relating to going concern.
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Going concern 9
Summary of impact on auditor's report

Scenario Impact on auditor's report
Going concern assumption Unmodified opinion with Material

appropriate but material uncertainty Uncertainty Related to Going Concern
which is adequately disclosed paragraph
Going concern assumption Modified opinion (qualified opinion or
appropriate but material uncertainty adverse opinion)
which is not adequately disclosed
Use of going concern assumption Modified opinion (adverse opinion)
inappropriate
Management unwilling to make or Modified opinion (qualified opinion or

extend its assessment disclaimer of opinion)
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Tackling the exam
Students often find the reporting aspect of going concern a confusing

area. The September 2012 edition of Student Accountant has an
excellent article on going concern and how this can be examined in
paper F8:
students/2012s/sa_sept12_f8_goingconcern.pdf
However, note that ISA 570 has been revised recently, changing the
audit reporting requirements. The article stated that where the going
concern assumption is appropriate but there is a material uncertainty
which is adequately disclosed, the matter should be described in an
emphasis of matter paragraph. This should now be described in a
separate section of the auditor’s report, headed material uncertainty
related to going concern.
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Question: Going concern
The following issues have arisen during two of your firm's audits:
(i) The directors of Difficult Times Co have prepared the financial
statements on the going concern basis but the auditor does not
believe that the company is a going concern. The directors refuse
to amend the financial statements.
(ii) The directors of Trading's Hard Co have made the appropriate
disclosures relating to material uncertainties related to going
concern in the financial statements. The auditor has a significant
level of concern regarding the going concern basis but is happy
with the disclosure and does not disagree with the use of the
going concern basis.
Describe the impact on the auditor's report for each company.
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Answer: Going concern
(i) The directors of Difficult Times Co have prepared the financial

statements on the going concern basis but the auditors do not
feel that this is appropriate.
This is certainly material and likely to be material and pervasive
as going concern is fundamental to the basis on which the
financial statements are prepared.
An adverse opinion would therefore be required.
A basis for adverse opinion paragraph would need to be included
explaining the material misstatement in relation to the
inappropriate use of the going concern basis and the effect on
the financial statements.
The opinion paragraph would show an adverse opinion stating
that the financial statements do not present fairly – due to
material misstatement.
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Answer: Going concern (cont'd)
(ii) The directors of Trading's Hard Co have made appropriate

disclosures of material uncertainties related to going concern in
the financial statements and the auditor is happy with this
disclosure.
The audit opinion will therefore be unmodified.
Significant concern still exists however and so, due to the
importance of the issue, the auditor will include a material
uncertainty related to going concern.
This section must contain a clear reference to the disclosures in
the financial statements and state that the auditor's opinion is not
modified in respect of this matter.
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Exam link
• Going concern is likely to be tested as part of a mini-scenario

question in Section A.
• You might also be presented with a Section B question on audit
risk where the information in the scenario suggests that the
company may not be able to continue as a going concern (for
example, because of high operating costs, increased borrowing
sought etc).
• Question 5 of the June 2010 exam and the June 2012 exam are
excellent questions to practise as they cover knowledge,
indicators of going concern problems, audit procedures and the
auditor's report.
• The following question from the 2014 Specimen Exam does not
conform to the current exam style, but it is still good practice.
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You are the audit senior of Holtby & Co and are planning the audit of
Walters Co (Walters) for the year ended 31 December 20X4. The
company produces printers and has been a client of your firm for two
years; your audit manager has already had a planning meeting with
the finance director. He has provided you with the following notes of
his meeting and financial statement extracts.
Walter's management were disappointed with the 20X3 results and
so in 20X4 undertook a number of strategies to improve the trading
results. This included the introduction of a generous sales-related
bonus scheme for their salesmen and a high profile advertising
campaign. In addition, as market conditions are difficult for their
customers, they have extended the credit period given to them.
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The finance director of Walters has reviewed the inventory valuation

policy and has included additional overheads incurred this year as he
considers them to be production related.
The finance director has calculated a few key ratios for Walters; the
gross profit margin has increased from 44.4% to 52.2% and
receivables days have increased from 61 days to 71 days. He is
happy with the 20X4 results and feels that they are a good reflection
of the improved trading levels.
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Financial statement extracts for the year ended 31 December

DRAFT ACTUAL
20X4 20X3
$m $m
Revenue 23.0 18.0
Cost of sales (11.0) (10.0)
Gross profit 12.0 8.0
Operating expenses (7.5) (4.0)
Profit before interest and taxation 4.5 4.0
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Financial statement extracts for the year ended 31 December

DRAFT ACTUAL
20X4 20X3
$m $m
Inventory 2.1 1.6
Receivables 4.5 3.0
Cash - 2.3
Trade payables 1.6 1.2
Overdraft 0.9 -
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Required:
Describe the procedures that the auditor of Walters Co should
perform in assessing whether or not the company is a going concern.
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• Analyse cash flow forecasts prepared by Walters Co and assess whether

assumptions used in their preparation appear reasonable.
• Analyse post-year end sales and order book to assess the
reasonableness of the revenue figures in the cash flow forecast.
• Compare post year end management accounts to the cash flow forecast.
• Review current overdraft agreements to ensure covenants have not been
breached.
• Perform audit procedures in respect of subsequent events to identify
matters that might affect the going concern assumption.
• Make inquiries with Walters Co's lawyers regarding any on-going or
potential litigation claims against the company.
• Inspect board minutes to identify potential issues that may impact on the
company's ability to continue as a going concern.
• Obtain a written representation from management regarding the
company's ability to continue as a going concern.
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Written representations 1
Written representations are written statements by management

provided to the auditor to confirm certain matters or to support other audit
evidence.
ISA 580 Written representations
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Written representations about management's responsibilities

• Management has fulfilled its responsibility for the preparation and
presentation of the financial statements as set out in the terms of the
audit engagement and whether the financial statements are prepared
and presented in accordance with the applicable financial reporting
framework.
• Management has provided the auditor with all relevant information
agreed in the terms of the audit engagement and that all transactions
have been recorded and are reflected in the financial statements.
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Other written representations

• Whether the selection and application of accounting policies are
appropriate
• Plans or intentions that may affect the carrying value or classification
of assets and liabilities
• Liabilities, both actual and contingent
• Title to, or control over, assets, liens or encumbrances on assets and
assets pledged as collateral
• Aspects of laws, regulations and contractual agreements that may
affect the financial statements, including non-compliance
• All deficiencies in internal control that management is aware of have
been communicated to the auditor
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Other representations continued

• Written representations about specific assertions in the financial
statements
• Significant assumptions used in making accounting estimates are
reasonable
• All subsequent events requiring adjustment or disclosure have been
adjusted or disclosed
• The effects of uncorrected misstatements are immaterial, both
individually and in aggregate
• Management has disclosed the results of management's assessment
of the risk that the financial statements may be materially misstated
as a result of fraud
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Other representations continued

• Management has disclosed all information in relation to fraud or
suspected fraud involving management, employees with significant
roles in internal control, and others where fraud could have a material
effect on the financial statements
• Management has disclosed all information in relation to allegations of
fraud or suspected fraud communicated by employees, former
employees, analysts, regulators or others
• Management has disclosed all instances of non-compliance or
suspected non-compliance with laws or regulations
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Remember!
• Written representations on their own do not provide sufficient
appropriate audit evidence
• Written representations support other audit evidence
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Main elements of a representation letter from management

• Addressed to the auditors
• Contains specified information
• Appropriately dated
• Approved by those with specific knowledge
• Signed by senior financial officer
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Exam link
• Written representations could be tested as part of a mini-scenario

question in Section A
• Don't forget also that in evidence and risk questions, you might
suggest obtaining written representations from management
regarding specific issues
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Overall review of financial statements 1
• Auditors must carry out an overall review of the draft financial

statements using analytical procedures.
• ISA 520 Analytical procedures
• A senior member of the audit team must do this.
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Analytical review should cover:

• Important accounting ratios
• Related items
• Changes in products/customers
• Price and mix changes
• Wages changes
• Variances
• Trends in production and sales
• Changes in material and labour content of production
• Other expenditure in the statement of profit or loss
• Variations caused by industry or economy factors
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Treatment of misstatements
A misstatement is a difference between the amount, classification,
presentation, or disclosure of a reported financial statement item and the
amount, classification, presentation, or disclosure that is required for the
item to be in accordance with the applicable financial reporting
framework. It can arise from error or fraud.
An uncorrected misstatement is a misstatement accumulated during
the audit by the auditor which has not been corrected.
ISA 450 Evaluation of misstatements identified during the audit
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Misstatements
• Factual misstatements
• Judgemental misstatements
• Projected misstatements
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• All misstatements accumulated during the audit (unless clearly trivial)

must be communicated to management on a timely basis with a
request to correct them.
• The auditor must consider whether the aggregate of uncorrected
misstatements is material.
• Uncorrected misstatements and their effect must be communicated to
those charged with governance, with material uncorrected
misstatements being identified individually. A request must be made
for correction.
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Exam link
• Overall review is likely to be tested in the context of an auditor's

report question in Section A.
• The 2016 Specimen Exam tested the overall review of financial
statements in two objective test questions linked to a mini-
scenario, for a total of 4 marks.
• Remember, if a misstatement is immaterial, you must state that it
should be added to the schedule of uncorrected misstatements as
per the requirements of ISA 450.
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Question: 2016 Specimen Paper (Sec A, Q13 and 14)
Cannavaro.com is a website design company whose year end was

31 December 20X4. The audit is almost complete and the financial
statements are due to be signed shortly. Profit before tax for the year
is $3·8 million and revenue is $11·2 million.
The company has only required an audit for the last two years and
the board of directors has asked your firm to provide more detail in
relation to the form and content of the auditor’s report.
During the audit it has come to light that a key customer, Pirlo Co,
with a receivables balance at the year end of $285,000, has just
notified Cannavaro.com that they are experiencing cash flow
difficulties and so are unable to make any payments for the
foreseeable future. The finance director has notified the audit team
that he will write this balance off as an irrecoverable debt in the 20X5
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13 The audit engagement partner has asked you to make an initial

assessment of the materiality of the issue with the outstanding
receivables balance with Pirlo Co and to consider the overall impact
on the financial statements.
Which of the following correctly summarises the effect of the
outstanding balance with Pirlo Co?
Material Financial statement impact
A No Revenue is overstated
B No Gross profit is understated
C Yes Profit is overstated
D Yes Going concern principle is in doubt
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C
The outstanding balance with Pirlo Co is likely to be irrecoverable as
the customer is experiencing financial difficulties.
The balance is material at 7·4% of profit before tax and 2·5% of
revenue.
Currently profit and assets are overstated by $285,000. Therefore the
correct option is C.
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The audit engagement partner requires you to perform additional procedures

in order to conclude on the level of any adjustment needed in relation to the
outstanding balance with Pirlo Co.
Which TWO of the following audit procedures should be performed to
form a conclusion as to whether the financial statements require
amendment?
(1) Discuss with management the reasons for not amending the financial
statements
(2) Review the cash book post year end for receipts from Pirlo Co
(3) Send a request to Pirlo Co to confirm the outstanding balance
(4) Agree the outstanding balance to invoices and sales orders
A 1 and 2
B 1 and 4
C 2 and 3
D 2 and 4
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A
Writing to the customer/agreeing to invoices, while valid procedures
during the audit to verify the existence of an outstanding balance,
would not allow the auditor to assess the recoverability of the balance
which is the key issue in determining whether an adjustment is
required. Therefore options 3 and 4 are incorrect.
Post year-end cash testing is the best way for the auditor to assess if
the balance is recoverable wholly or in part and therefore the cash
book should be reviewed for any receipts which will change the
assessment of the debt after the year end. The issue should also be
discussed with management to understand their reasons for not
wanting to amend the financial statements as this may be due to a
change in circumstances.
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Chapter 19 • The auditor's report on financial
statements
Reports
• Reports to management
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• Identify and describe the basic elements contained in the auditor's

report.
• Explain unmodified audit opinions in the auditor's report.
• Explain modified audit opinions in the auditor's report.
• Describe the format and content of emphasis of matter and other
matter paragraphs.
• Discuss the requirements and methods of reporting significant
deficiencies in internal control to management and those charged with
governance.
• Explain, in a format suitable for inclusion in a report to management,
significant deficiencies within an internal control system and provide
recommendations for overcoming these deficiencies to management.
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Overview
Opening balances and

Reports
comparatives
Auditor's reports
Standard report Changes to the

'unmodified opinion' audit reports
Unmodified opinions with Modified on matters that do

additional communication affect the auditor's opinion
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Overview continued
Unmodified opinions with Modified on matters that do

additional communication affect the auditor's opinion
Emphasis of Key Other

Material
matter Audit Matters matter
uncertainty
paragraph paragraph
related to
'Without
going concern
qualifying
paragraph
our opinion
…' Insufficient or inappropriate Material
(Eg 6) audit evidence misstatement
Material but Material and Material but Material and

not pervasive pervasive not pervasive pervasive
Qualified Disclaimer Qualified Adverse
'except for' of opinion 'except for' '…do not give
(Eg 4) 'do not express (Eg 2) a true and fair
an opinion' view'
(Eg 5) (Eg 3)
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The auditor's report on financial statements 1
• At the end of the external audit, the auditor produces a report which
sets out the opinion on the truth and fairness of the financial
statements.
• Are the financial statements prepared, in all material respects, in
accordance with the applicable financial reporting framework?
• ISA 700 Forming an opinion and reporting on financial statements
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Unmodified opinions
An unmodified opinion is the opinion expressed by the auditor when the
auditor concludes that the financial statements are prepared, in all
material respects, in accordance with the applicable financial reporting
framework.
This is good!
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Unmodified opinions
In our opinion, the financial statements present fairly, in all material

respects, (or give a true and fair view of) the financial position of ABC
Company as of December 31, 20X1, and (of) its financial performance
and its cash flows for the year ended in accordance with International
Financial Reporting Standards.
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Basic elements of the auditor's report

• Title
• Addressee
• Opinion paragraph
• Basis for opinion
• Key audit matters paragraph (where relevant)
• Material uncertainty related to going concern paragraph (where
relevant)
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Basic elements of the auditor's report continued

• Other information paragraph
• Responsibilities for the financial statements
• Auditor's responsibility
• Other reporting responsibilities
• Auditor's signature
• Date of the auditor's report
• Auditor's address
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New elements of the auditor’s report

• Material uncertainty related to going concern (see Chapter 18)
• Key audit matters
− For listed entity audits and other audits where ISA 701 applies
− Describes matters of most significance in the audit of the financial
statements of the current period
− The aim is to enhance users’ understanding of the audit process
• Other information
− Describes other information obtained during the audit
− Clarifies that the audit opinion does not cover other information
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New elements of the auditor’s report continued

• Emphasis of matter paragraph
− Draws users’ attention to matters which are fundamental to
understanding the financial statements
− Must not be a matter that is covered in the Going concern or Key
audit matters paragraphs
New structure for reporting the audit opinion: the Opinion

paragraph comes before the Basis for Opinion!
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• The next few slides are going to discuss situations where the opinion
is not modified (ie the financial statements show a true and fair view)
BUT the report itself is modified.
• This can be because the report includes an emphasis of matter
paragraph or an other matter paragraph.
• ISA 706 Emphasis of matter paragraphs and other matter paragraphs
in the independent auditor's report
• It is important that you understand that although an opinion may be
unmodified, the report will be modified by the inclusion of an
emphasis of matter paragraph or other matter paragraph.
• So you can have a modified report with a modified opinion or you can
have a modified report but an unmodified opinion (due to an emphasis
of matter paragraph or an other matter paragraph).
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Emphasis of matter paragraphs

Refers to a matter appropriately presented or disclosed in the financial
statements that, in the auditor's judgement, is of such importance that it
is fundamental to users' understanding of the financial statements.
Examples
• Uncertainty relating to future outcome of exceptional litigation or
regulatory action
• Early application of a new accounting standard that has a pervasive
effect on the financial statements
• Major catastrophe that has had/continues to have a significant effect
on the entity's financial position
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What is the content of an emphasis of matter paragraph?

• Comes either before or after Key Audit Matters
• Clear reference to matter being emphasised
• Location of relevant disclosures in the financial statements
• Must state that the auditor's opinion is not modified in respect of the
matter being emphasised
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Example emphasis of matter paragraph
Emphasis of Matter
We draw attention to Note X to the financial statements which describes
the uncertainty related to the outcome of the lawsuit filed against the
company by XYZ Company. Our opinion is not qualified in respect of this
matter.
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Other matter paragraphs

Refers to a matter other than those presented or disclosed in the
financial statements that, in the auditor's judgement, is relevant to users'
understanding of the audit, the auditor's responsibilities or the auditor's
report.
Example
• Prior period financial statements not audited
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What is the content of an other matter paragraph?

• Describes other matter not presented and disclosed in the financial
statements that is relevant to users' understanding of the audit, the
auditor's responsibilities or the auditor's report
• Does not include information that the auditor is prohibited from
providing by law and regulations or other standards, or information
required to be provided by management
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Certain ISAs contain requirements for emphasis of matter or other matter

paragraphs in specific circumstances.
Emphasis of matter paragraph Other matter paragraph

ISA 210 Agreeing the terms of audit ISA 560 Subsequent events
engagements
ISA 560 Subsequent events ISA 710 Comparative information –
corresponding figures and comparative
financial statements
ISA 800 (outside the scope of F8)
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Exam link 1
• Emphasis of matter paragraphs and other matter paragraphs

seem to be a difficult area for students.
• Remember that there are specific circumstances when these
paragraphs are used.
• Students tend to suggest they need to be used when they are not
appropriate at all!
• Emphasis of matter paragraphs and other matter paragraphs
could be examined in section A as an objective test question
linked to a mini-scenario, as seen in the 2016 specimen paper.
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Modified audit opinions 1
• But what happens if the auditor cannot issue an unmodified opinion

on the financial statements?
• That is, the auditor cannot say that the financial statements, present
fairly, in all material respects …?
• In this case, the auditor has to issue a modified opinion on the
• This is not good!
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Types of modified opinions

• ISA 705 Modifications to the opinion in the independent auditor's
report
• Three possible types of modified opinion:
— Qualified opinion
— Adverse opinion
— Disclaimer of opinion
• How does the auditor know which type of modified opinion to use?
Let's find out…
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The type of modified opinion depends on:

• The nature of the matter giving rise to the modification (material
misstatement or lack of sufficient, appropriate audit evidence)
• The auditor's judgement about the pervasiveness of the
effects/possible effects of the matter on the financial statements
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But first we need to understand what pervasiveness is.

Pervasiveness describes the effects/possible effects on the financial
statements of misstatements or undetected misstatements (due to an
inability to obtain sufficient appropriate audit evidence).
Three types:
1. Those that are not confined to specific elements, accounts or items
in the financial statements
2. Those that are confined to specific elements, accounts or items in
the financial statements and represent or could represent a
substantial portion of the financial statements
3. Those that relate to disclosures which are fundamental to users'
understanding of the financial statements
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A modified opinion is required when:

• The auditor concludes that the financial statements as a whole are
not free from material misstatements or
• The auditor cannot obtain sufficient appropriate audit evidence to
conclude that the financial statements as a whole are free from
material misstatement.
It is very important that you understand this. The following slides

show examples of the different types of modified opinion.
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Qualified opinion due to material misstatement
Qualified Opinion
In our opinion, except for the effects of the matter described in the Basis
for Qualified Opinion paragraph, the financial statements present fairly, in
all material respects, (or give a true and fair view of) the financial position
of ABC Company as at December 31, 20X1, and (of) its financial
performance and its cash flows for the year then ended in accordance
with International Financial Reporting Standards.
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Qualified opinion due to material misstatement continued

Basis for qualified opinion
The company's inventories are carried in the statement of financial
position at xxx. Management has not stated inventories at the lower of
cost and net realisable value but has stated them solely at cost, which
constitutes a departure from International Financial Reporting Standards.
The company's records indicate that had management stated the
inventories at the lower of cost and net realisable value, an amount of
xxx would have been required to write the inventories down to their net
realisable value. Accordingly, cost of sales would have been increased
by xxx, and income tax, net income and shareholders' equity would have
been reduced by xxx, xxx and xxx, respectively.
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Adverse opinion due to material misstatement with a pervasive

effect
Adverse Opinion
In our opinion, because of the significance of the matter discussed in the
Basis for Adverse Opinion paragraph, the financial statements do not
present fairly (or do not give a true and fair view of) the financial position
of ABC Company as at December 31, 20X1, and (of) its financial
performance and its cash flows for the year then ended in accordance
with International Financial Reporting Standards.
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Adverse opinion due to material misstatement with a pervasive

effect continued
Basis for adverse opinion
The company has included houses built for re-sale (including related
land) at a cost of $X as non-current assets and depreciated them at a
rate of X%, resulting in depreciation of $X. Under International Financial
Reporting Standards, these should have been included as inventory in
the financial statements and no depreciation should have been provided
in respect of these. The carrying value of the houses represent 90% of
the company's total assets and the company's records indicate that
…[explanation of the effect on amounts presented in the financial
statements].
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Qualified opinion due to inability to obtain sufficient appropriate

audit evidence
Qualified Opinion
In our opinion, except for the possible effects of the matter described in
the Basis for Qualified Opinion paragraph, the financial statements
present fairly, in all material respects, (or give a true and fair view of) the
financial position of ABC Company as at December 31, 20X1, and (of) its
financial performance and its cash flows for the year then ended in
accordance with International Financial Reporting Standards.
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Qualified opinion due to inability to obtain sufficient appropriate

audit evidence continued
Basis for Qualified Opinion
With respect to inventory having a carrying amount of $X the audit
evidence available to us was limited because we did not observe
physical inventory as at 31 December 20X1, since that date was prior to
our appointment as auditor of the company. Owing to the nature of the
company's records, we were unable to obtain sufficient appropriate audit
evidence regarding the inventory quantities by using other audit
procedures.
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Disclaimer of opinion due to inability to obtain sufficient

appropriate audit evidence about multiple elements of the financial
statements continued
Disclaimer of Opinion
Because of the significance of the matters described in the Basis for
Disclaimer of Opinion paragraph, we have not been able to obtain
sufficient appropriate audit evidence to provide a basis for an audit
opinion. Accordingly, we do not express an opinion on the financial
statements.
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Disclaimer of opinion due to inability to obtain sufficient

appropriate audit evidence about multiple elements of the financial
statements continued
Basis for Disclaimer of Opinion
We were not appointed as auditors of the company until after December
31, 20X1 and thus did not observe the counting of physical inventories at
the beginning and end of the year. We were unable to satisfy ourselves
by alternative means concerning the inventory quantities held at
December 31, 20X0 and 20X1 which are stated in the statement of
financial position at xxx and xxx, respectively. In addition, the introduction
of a new computerised accounts receivable system in September 20X1
resulted in numerous errors in accounts receivable.
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Summary table
Nature of circumstances Material but not pervasive Material and pervasive
Financial statement QUALIFIED ADVERSE OPINION

are materially OPINION
misstated
Auditor unable to QUALIFIED DISCLAIMER
obtain sufficient OPINION OPINION
appropriate audit
evidence
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Question: Modified opinions
Consider the following three situations and decide whether a

modified opinion is required or not. If you decide a modified opinion is
necessary, explain what sort of modified opinion would be most
appropriate.
Additional information
Net assets: $250,000
Revenue: $455,000
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Question: Modified opinions (cont'd)
Situation 1
A major customer has gone bankrupt shortly after the year-end. At
the year-end, $25,500 was owing from this customer but the directors
will not amend the financial statements as a result of the customer
becoming bankrupt.
Situation 2
An accrual worth $1,560, representing an amount due to a new
supplier, has been omitted from the year-end statement of financial
position in error. No other errors on accruals or trade payables have
been found.
Situation 3
A small fire at head office has resulted in the loss of some records,
most of which relate to inventory. Inventory is one of the biggest
figures in the statement of financial position at year-end.
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Approach: Modified opinions
You have been provided with some information about net assets and
revenue in this question. You must use it to assess whether the
issues in the question are material or not as this will directly impact
the effect on the auditor's opinion.
In an exam question, if you are provided with figures for net
assets/revenue/profit before tax etc, you must ensure you use them –
it is not enough to say that something is material without comparing it
to the information you have been given in the question.
The first thing to do, therefore, is a quick calculation to see whether
the issue is material or not.
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Answer: Modified opinions
Situation 1: Major customer going bankrupt

1. A major customer going bankrupt after the year-end is indicative
of an adjusting event. In this case, it would seem unlikely that the
balance owing will be recovered.
2. $25,500 represents 10.2% of net assets and 5.6% of revenue so
it is a material amount.
3. As the directors are refusing to amend the financial statements,
this would constitute a material misstatement as they should
write the balance off.
4. The impact on the auditor's opinion would therefore be a
qualified opinion ('except for') due to material misstatement.
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Answer: Modified opinions (cont'd)
Situation 2: Accrual omitted

1. An accrual worth $1,560 has been omitted from the accruals
balance on the statement of financial position but no other errors
have been found by the auditor, suggesting this is a one-off.
2. $1,560 represents 0.62% of net assets and 0.34% of revenue so
it is clearly not material.
3. Although the amount is not material, it should be added to the
schedule of uncorrected misstatements which in total, may
represent a material amount which may lead to the financial
statements requiring amendment.
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Answer: Modified opinions (cont'd)
Situation 3: Fire destroying inventory records

1. A fire has destroyed inventory records and inventory is a material
balance.
2. Unless the auditors can obtain the evidence relating to the
destroyed records from elsewhere, it is likely that this will have an
impact on the auditor's opinion.
3. The auditor's opinion will probably be modified due to the inability
to obtain sufficient appropriate audit evidence. Without further
information, we cannot say whether the opinion will be qualified
('except for') or a disclaimer of opinion.
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Exam link 1
• Auditor's reports are a common source of confusion for students.

• However, they are highly likely to be tested as this is a key
syllabus area.
• The current F8 examining team has examined auditor's reports in
every sitting so far.
• The best way to improve your confidence in this area is to practise
as many past exam questions or exam-standard questions as you
can.
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[Please refer to slide 968 for the full question scenario]
The finance director has asked you to outline the appropriate audit opinions which
will be provided depending on whether the company decides to amend or not
amend the 20X4 financial statements for the issue identified regarding the
recoverability of the balance with Pirlo Co.
Which of the following options correctly summarises the audit opinions
which will be issued depending on whether or not the 20X4 financial
statements are amended?
Financial statements amended Financial statements not amended
A Unmodified Unmodified with emphasis of matter
B Unmodified with emphasis of matter Qualified ‘except for’
C Unmodified Adverse
D Unmodified Qualified ‘except for’
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The debt with Pirlo Co should be provided for and is material to the
financial statements at 7·4% of profit before tax and 2·5% of revenue.
This represents a material misstatement which is material but not
pervasive. As such, if no adjustment is made the auditor will be
required to provide a qualified ‘except for’ opinion. If the required
change is made, then no material misstatement exists and therefore
the auditor will be able to issue an unmodified opinion.
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Other information 1
We now look at other information in documents containing audited

ISA 720 The auditor's responsibilities relating to other information in
documents containing audited financial statements
Other information is financial and non-financial information, other than
the financial statements and the auditor's report, which is included, either
by law, regulation or custom, in a document containing audited financial
statements.
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Other information 2
Examples of other information

• A report by management or those charged with governance on
operations
• Financial summaries or highlights
• Employment data
• Planned capital expenditures
• Financial ratios
• Names of officers and directors
• Selected quarterly data
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Other information 3
So what are the auditor's responsibilities for other information?

They must read the other information to identify any material
misstatements.
A misstatement of the other information exists when the other
information is incorrectly stated or otherwise misleading (including
because it omits or obscures information necessary for a proper
understanding of a matter disclosed in the other information).
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Other information 4
Material inconsistency found
Amendment required in Action to take if management refuses

Financial statements • Modified opinion
Other information • Communicate to those charged with
governance and
• Include an Other information paragraph
in the auditor’s report OR
• Withhold auditor's report OR
• Withdraw from engagement
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Other information 5
Material misstatement found in other information
Initial actions to take Action to take if management refuses

to amend other information
• Discuss with management • Inform those charged with
• If still relevant, ask governance
management to consult an • Appropriate further action eg
independent third party (eg consulting auditor's lawyer
lawyer) and consider advice
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The auditor's report on financial statements
Implied information
• Adequate accounting records have been kept.
• The accounts agree with the records.
• The auditors have received all necessary information.
• All directors' transactions have been disclosed.
• The directors' report is consistent with the accounts.
The expectations gap

The difference between the apparent public perceptions of the
responsibilities of auditors on the one hand and the legal and
professional reality on the other
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You are the audit manager of Villa & Co and you are currently
reviewing the audit files for several of your clients for which the audit
fieldwork is complete. The audit seniors have raised the following
issues:
Czech Co
Czech Co is a pharmaceutical company and has incurred research
expenditure of $2.1m and development expenditure of $3.2m during
the year, this has all been capitalised as an intangible asset. Profit
before tax is $26.3m.
Dawson Co
Dawson Co's computerised wages program is backed up daily,
however for a period of two months the wages records and the back-
ups have been corrupted, and therefore cannot be accessed. Wages
and salaries for these two months are $1.1m. Profit before tax is
$10m.
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Required:
For each of the clients above:
(i) Discuss the issue, including an assessment of whether it is
material; and (4 marks)
(ii) Describe the impact on the audit report if the issue remains
unresolved. (4 marks)
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Approach: 2014 Specimen Paper (Sec B, Q3b)
This style of written question will no longer come up in your F8

exams. However, it offers good applied knowledge practice.
When asked about the impact of an issue on the auditor’s report,
make sure you always calculate and discuss materiality.
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Czech Co
IAS 38 Intangible Assets states that research expenditure must
always be expensed. Development expenditure can only be
capitalised if it meets certain criteria.
Czech has incorrectly capitalised $2.1m of research expenditure.
This represents 7.9% of profit before tax and is therefore material.
The development costs capitalised of $3.2m represent 12.2% of profit
before tax and are also material. If these do not meet the criteria for
capitalisation, they should be expensed.
If the directors refuse to expense the research costs, the auditor's
opinion will be modified with a qualified opinion as the issue is
material but not pervasive. This will also apply if the development
costs have been incorrectly capitalised.
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Answer: 2014 Specimen Exam (Sec B, Q3b) cont'd
Dawson Co
The wages costs of $1.1m for the two months in question represent
11% of profit before tax and are therefore material.
The auditors should seek alternative audit procedures to verify the
wage costs for the two months.
If the auditors cannot obtain sufficient appropriate audit evidence for
the wages cost then the audit opinion will be qualified 'except for' as
this is a material but not pervasive issue.
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Reports to management 1
• The report to management is a by-product of the external audit.

• It may also be known as a management letter or letter on internal
control.
• The purpose of a report to management is to set out significant
deficiencies in internal control, the implications of those deficiencies,
and possible recommendations to mitigate the deficiencies.
• A report to management may be sent after both the interim audit and
the final audit visits.
• Such reports are for internal use and are not in the public domain.
• ISA 265 Communicating deficiencies in internal control to those
charged with governance and management
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Reports to management 2
Drafting the report to management

• Do not include language which conflicts with the opinion in the
auditor's report.
• State the accounting and internal control system were considered
only to the extent necessary to determine auditing procedures to
report on the financial statements, and not to determine the adequacy
of internal control for management purposes or to provide assurances
on the accounting and internal control system.
• State it discusses only deficiencies in internal control which have
come to the auditor's attention as a result of the audit and that other
deficiencies in internal control may exist.
• Include a statement that the report is provided for use only by
management (or another specific named party).
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Exam link 1
• Questions on the report to management are highly likely to come

up in a scenario context and we looked at these in detail in
Chapter 10.
• In such questions, do not include a covering letter unless you are
specifically asked for one.
• Always set your answer out in a tabular format so that you can link
the deficiencies with the implications and suggested
recommendations.
• Reports to management could also be tested in a knowledge-
based requirement on reporting to those charged with
governance, focussing on ISAs 260 and 265.
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Exam link 2
If you are asked for a covering letter, make sure it includes:

• An address and date
• A short introduction explaining the purpose and content of the
report to management
• A closing paragraph that states the report only sets out those
significant deficiencies identified during the audit and that more
extensive procedures on internal control may have resulted in
more deficiencies being identified
• A statement that the report is solely for management's use
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Copyright notice
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd.
The contents of these slides are intended as a guide and not professional advice. Although every effort has been made to ensure that the contents
of this book are correct at the time of going to press, BPP Learning Media makes no warranty that the information in this book is accurate or
complete and accept no liability for any loss or damage suffered by any person acting or refraining from acting as a result of the material in this
book.
The publishers are grateful to the IASB for permission to reproduce extracts from the International Financial Reporting Standards including all
International Accounting Standards, SIC and IFRIC Interpretations (the Standards). The Standards together with their accompanying documents
are issued by:
The International Accounting Standards Board (IASB)
30 Cannon Street, London, EC4M 6XH, United Kingdom.
Email: info@ifrs.org Web: www.ifrs.org
Disclaimer: The IASB, the International Financial Reporting Standards (IFRS) Foundation, the authors and the publishers do not accept
responsibility for any loss caused by acting or refraining from acting in reliance on the material in this publication, whether such loss is caused by
negligence or otherwise to the maximum extent permitted by law.
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utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including
photocopying and recording, or in any information storage and retrieval system, without prior permission in writing from the IFRS Foundation.
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Chapter 9 • Internal control systems

Internal control • The use of internal control

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• Explain why an auditor needs to obtain an understanding of internal

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• Discuss the requirements and methods of how reporting significant

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Internal control is the process designed and effected by those charged

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Possible controls which could be used to reduce the risk associated

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• Food purchased should be kept in a clear place and refrigerated, if

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Why do auditors need to understand internal control?

ISA 315 (Revised) Identifying and assessing the risks of material

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There are five components of internal control:

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ENTITY'S RISK ASSESSMENT PROCESS

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INFORMATION SYSTEM RELEVANT TO FINANCIAL REPORTING

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INFORMATION SYSTEM RELEVANT TO FINANCIAL REPORTING

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INFORMATION SYSTEM RELEVANT TO FINANCIAL REPORTING

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Control activities in a small independent bakery store

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Control activities in a national supermarket like Wumart

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• Health and safety audits

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• You will appreciate from the previous question that control

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ISA 315 Identifying and Assessing the Risks of Material Misstatement

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C Human resource policies and practices

Human resource policies and practices form part of the control

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The limitations of accounting and control systems

This is why auditors cannot rely on internal controls alone – they

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Auditors will record the accounting and control systems in place.

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Questionnaires: Internal Control Questionnaires (ICQs)

Questionnaires: Internal Control Evaluation Questionnaires (ICEQs)

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