Admas University College

Bishoftu Campus
TVET Program
Qualification: Accounting - Level IV

Perform Audit & Report

Unit of Competence:
on Financial System and Record

Competence Based Learning Materials (CBLM)

 Information Sheet
 Operation Sheet
 Job Sheet

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 Information Sheet

1. Occupation: Accounting Level IV

2. Unit of Competence: Perform Audit Report
3. Module title: Perform Audit Report
4. Contents (Elements of Competence):

UNIT ONE

1. Identifying Fundamentals of Auditing

Introduction

Dear learner! This is the first duty in the this module which contains eight tasks .The theme of the
section is to enable you comprehend issues in the definition of Auditing, differentiate types of audits
and auditors, Distinguishing between accounting & audits, identifying generally accepted auditing
standard, identifying auditors standard report.

Dear learner you can successfully achieve the study objectives through your actives
participation .In this regard what you need to do is reading thoroughly the study materials as well as
practicing steadily the self test exercise you will find in the duty. Relevant in text questions and
exercises given in terms of activities and self –check exercises. You can counter your responses
against answer keys provided at the end of the module. I hope you will find the study inspiring and
beneficial.

General Objectives

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After completing studying of this duty, you will be able to:

- define auditing & identify the important parts of the auditing definition.
- practice code of ethics for auditors
- differentiate the different types of audits & auditors
- understand the need for financial statement of auditing
- understand the difference b/n auditing & accounting
- know GAAS and their relationship to statement on auditing

Section 1.1 Definition of Auditing

Specific objectives

At the end of this lesson you will be able to define auditing and discuss the defining element
of auditing.

Check your progress

?Describe what is means by auditing and parts of the definition of auditing

(write your answer on the space provided)

_____________________________________________________________________

Definitions of Auditing

It is quite difficult to give a single and precise definition of the term “Audit ”. The word “audit ” has
been defined by many distinguished authors and other bodies, and every one of them has
attempted to highlight one aspect or the other, but the central idea is more or less the same.

I. Definition

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Auditing is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of correspondence between
those assertions and established criteria and communicating the results to interested users.

Discussion of key words in the definition

 Accumulation – suggests that the evidence is not considered by itself. It is looked at as part
of a whole.
 Systematic – done according to a plan.

 Objective – any two persons would come to the same conclusion. This suggests that the
auditor should be without bias to either side.
 Assertion – declaration, clear statement

 Evidence – something we look at to draw a conclusion.

 Degree of Correspondence – step or stage reached in answering “how close?” the
agreement or similarity of the documents to the criteria is, defined below.
 Established Criteria – In the case of financial statements, the criteria is Generally Accepted
Accounting Principles (GAAP). The auditor is trying to determine if the statements are
prepared in accordance with those principles, e.g. prepared on the accrual basis, in
accordance with the matching principles.

For other types of audits, the criterion needs to be agreed on before beginning the audit. For
tax audits of businesses, for example, the “established criteria ” will be the tax rates and rules
written in the various Negarit Gazettas that deal with tax.

 Communicating the Results – When doing the audit, always ask the question, “How is this
action going to contribute to my report. If it will not contribute anything, it will be wasted effort.
The users of audit reports are further discussed below.

II. Definition

Auditing is the process by which a competent, independent person accumulates, and evaluates
evidences about quantifiable information (Financial Statement, etc) to define and report on the

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degree of correspondence between the information, and established criteria (e.g. GAAP, etc) From
this definition, you should observe:

* economic information, and established criteria

* accumulating, and evaluating evidences

* competent, independent person

* audit report

 To do an audit: there must be economic information in a verifiable form, and some

Standards (criteria) by which the auditor can evaluate the information. Criteria for example,
GAAP, i.e. whether Financial Statement have been prepared in accordance with Generally
Acceptable Accounting Principle (GAAP).

 Accumulating, and evaluating evidence:- Evidence is any information used by the

auditor to determine weather the information being audited is stated in accordance with the
established criteria. Evidence takes many different forms, including oral testimony of the
Audi tee (clienteles), written communication with outsiders, and observation by the auditor.
 Competent, independent person:- Auditor must be qualified to understand the criteria used &
competent to know the types and amount of evidence to accumulate to reach the proper
conclusion after the evidence has been examined. The auditor must have an independent mental
attitude.
 The final stage in the audit process is the audit report, which is the communication of the
findings to the users.

 Activity 1

Define auditing using your own words or phrases.

_______________________________________________________

Section 1.2 Identifying Codes of Ethics for Auditors

1.2.1 The Nature of Ethics

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Ethics has been defined as the study of moral judgment and standards of conduct. While personal
ethics vary from individual to individual, at a point in time, most within the society are able to agree
as to what is considered ethical and unethical behavior. In fact a society posses laws that define
what its citizens consider to be the more extreme forms of unethical behavior.

However, much of what is considered unethical in a particular society is not specifically prohibited.
Thus, a good starting point to considering whether a given behavior is ethical or not is to examine
the context in which most ethical questions arise relationships among people. Any relationship
between two or more individuals such as a CPA and client carries with it sets of expectation by each
of the individuals involved.

1.2.2 The Need for Professional Ethics

Professional ethics is necessary for society to function in an orderly manner. It can be argued that
ethics is the glue that holds a society together. To understand the importance of a code of ethics to
public accountants and other professionals, one must understand the nature of a profession as
opposed to other vocations. There is no universally accepted definition of what constitutes a
profession; yet, for generations, certain types of activities have been recognized as professions while
others have not.

Significance of professional ethics in accounting: - Careless work or lack of integrity on the part of
any public auditor is a reflection upon the entire profession. Consequently, the members of the
public accounting profession / auditing profession/ have acted in union through the certain
appropriate code of conduct such as the AICPA code of conduct. This code provides practical
guidance to the individual members in maintaining a professional attitude. In addition, this code
gives assurance to clients and to the public that the profession intends to maintain high standards
and to enforce compliance by individual members.

Section 1.2.3 Ethical Dilemmas

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 Check your progress

? Explain the situations that affect the Ethical dilemma

(write your answer on the space provided below)

______________________________________________________________

Ethical dilemma is a situation that an individual faces involving a decision about appropriate
behavior. A simple example of an ethical dilemma is presented below

Assume that a student at your University finds an expensive watch in the University compound.
What action, if any, does the student take to find the original owner?

Ethical dilemmas generally involve situations in which the welfare of one or more other individuals is
affected by the results of the decision. In the dilemma presented above, the welfare of the original
owner of the watch is affected by the student ’s decision. Ethical dilemmas faced by auditors often
have an effect on the welfare of a large member of individuals or groups.

For example, if an auditor made an unethical decision about the content of an audit report, the
welfare of thousands of investors, creditors and other members of the society would be affected. It
is therefore essential for professions to have ethical and moral standards in addition to other
professional and technical standards so that the profession can provide quality services that can
properly address the interest and welfare of its users.

1.2.4 Special Need for Ethical Conduct in Professions

The underline reason for code of ethics for any profession is the need for public confidence in the
quality of services they provide by the profession regardless of the individual providing it. If users of
service do note have confidence in physicians, judges, or Certified Public Accountants (CPAs), the
abilities of those professionals to serve clients and the public effectively is diminished. For an

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auditor, it is essential that the clients and external financial statements users have confidence in the
quality of audits.

All of the generally recognized professions such as auditing, medicine, engineering, theology,
architecture and the like are characterized by the following elements/ features/.

1. Specialized and dynamic body of knowledge: - Every profession will have its own
specialization and this written body of knowledge will be upgraded for changes. The more
the profession is highly developed, the more specialize the body of knowledge and
voluminous requiring longer period to observe that knowledge.
2. Standard of qualification for admission: - a profession to be a profession must have well
recognized and accepted predetermined criteria for qualification for admission in to the
profession. (Educational, moral and legal criteria).
3. Standard of conduct of behavior: - a profession has a standard of conduct of behavior to
be observed by the professional through prescribed code of Ethics that attempt to enforce
general rules of conducts, and maximum and minimum rules on competence and
responsibility to client and colleagues (Friends or a pair).
4. Level of status recognition: - the quality and level of professional service demanded by the
society determines the level of status and recognition to the profession and this status
recognition is the out-come of the quality of professional service rendered which is
dependent on the professional qualification and degree of social, moral and legal
responsibility assumed.
5. Acceptance of social responsibility: - a profession to be a professional must accept
responsibility for the consequences of its action.
As a summary, the role of professional associations in the development of these (characterizes) is
crucial and it places important role in prescribing the professional standards and policing their
implement ability.

1.2.5 Professional Qualifications Requirements for Auditors

In various countries, Professional Qualifications Requirements for Auditors the most common
element in all is:

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 * minimum educational background which now a day is being pushed higher and higher.

* completion of required specialized body of knowledge as prescribed by the professional and

proved through passing of qualifying examinations.

* fulfillment of prescribed practical experiences.

* moral and ethical requirements as invoked through character reference.

* age limit for determining legal personality and responsibility.

1.2.6 Principles of Professional Conduct

Check Your Progress

? Describe the six principles of professional conduct

(You can use the space left to below write your response)

___________________________________________________________________________

These principles of AICPA express the profession ’s recognition of its responsibilities to the public to
clients, and to colleges. They guide members in the performance of their professional
responsibilities and express the basic tents of the ethical and professional conduct. The principles
call for an unlimited commitment to honorable behavior, even at the sacrifice of personal
advantages. These principles are explained below article by article:

I. Responsibilities

In carrying out their responsibilities as professionals, members should exercise sensitive professional
and moral judgments in all their activities.

II. The public interest

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Members should accept the obligation to act in a way that will serve the public interest, honor the
public trust and demonstrate commitment to professionalism

A distinguishing mark of a profession is acceptance of its responsibilities to the public. The

accounting profession’s public consists of clients, credit grantors, governments, employers,
investors, the business and financial community and others who rely on the objectivity and integrity
of certified public accountants to maintain the orderly functioning of their business.

The public interest is thus defined as the collective well being of the community of peoples and
institutions the profession serves. Those who rely on certified public accountants expect them to
discharge their responsibilities with integrity, objectivity, due professional, and a genuine interest in
serving the public i.e. they are expected to provide quality services, enter into fee arrangements,
and offer a range of services- all in a manner that demonstrates a level of professionalism consistent
with these principles of the code of professional conduct.

III. Integrity

To maintain and broaden public confidence, members should perform all professional
responsibilities with the highest sense of integrity, i.e. a member shall be free of conflict of interest,
and /or not deliberately misrepresent facts or subordinate his/ her judgments to others.

IV. Objectivity and independence

A member should maintain objectivity and be free of conflicts of interest in discharging professional
responsibilities. A member in public practice should be independent in fact and appearance when
providing auditing and other attestation services

V. Due professional care

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A member should observe the professions technical and ethical standards, strive continually to
improve competence and the quality of services, and discharge professional responsibilities to the
best of the member’s ability.

VI. Scope and Nature of services

A member in public practice should observe the scope and nature of services to be provided.

Members in determining whether to provide specific services in individual circumstances should

consider each of these principles. As there is no hard- and-fast rules that can be developed to help
members reach these judgments, they must be sure whether they are satisfied that they are
meeting the spirit of the principles in this regards.

1.2.7 Rules of Conduct

Check your progress

? Discuss some of the AICPA rules of conduct

(you can use the space left to below write your response)

____________________________________________________________________________

Applicability-the bylaws of AICPA require that members adhere to the rules of the code of
professional conduct.

i. Independence

A member in public practice shall be independent in the performance of professional services as

required by standards promulgated by bodies designated by council.

Lack of independency may also arise from financial interests that may result from past employment
relationship with the client, interest of a close relatives of an auditor such as her or his spouse and
dependents. Other situations that may impair independency of auditor are past due fees, gifts from
client, and client auditor or CPA litigation if any
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Two distinct ideas are involved in the concept of independency. These are:

1) Independence in fact- A CPA (auditor) must in fact be independent of any enterprise for
which they provide attestation services i.e. an auditor must be able to maintain an objective
and impartial mental attitude throughout the engagement.
2) Independent in appearance- The relationship between the CPAs and their client must be
such that the auditor will appear independent to third party i.e. an auditor must be able to
maintain an objective and impartial mental attitude throughout the engagement.

! Remarks - The independency rule does not apply to all services performed by public auditor(s).
Services in which the client is a major beneficiary such as management consultancy service, tax
services, accounting/compilation/ service and the like do not require independency.

The independency rule applies to auditing, and other attestation services such as review of financial
statements, examination of financial forecasts, performance of agreed up on procedures and the
like.

Independency - a matter of degree i.e. the concept of independency is not absolute; no

CPA/auditor/ can claim complete independence of a client. Rather, independence is relative i.e. a
matter of degree. Thus, CPAs must strive for the greatest degree of independence consistent with
this business environment.

ii. Integrity and Objectivity

In the performance of any professional service, a member shall maintain objectivity and integrity,
shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate
his/her professional judgments to others.

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iii. General Standards

A member shall comply with the following standards and with any interpretations thereof by bodies
designated by council.

a) Professional competence- undertakes only those professional services that the member or
member’s firm can reasonably expect to be completed with professional competence.
b) Due professional care- Exercise due professional care in the performance of professional
services.
c) Planning and supervision- adequately plan and supervise the performance of professional
services.
d) Sufficient relevant data- Obtain sufficient relevant data to afford a reasonable basis for
conclusions or recommendations in relation to any professional services performed.

iv. Compliance with Standards

A member who performs auditing, review, compilation, management consultancy, tax return
preparation, or other professional services shall comply with standards promulgated by bodies
designated by council.

v. Accounting principles

A member shall not (1) express an opinion or state affirmatively that the financial statements or
other financial data of any entity are presented in conformity with GAAP or (2) state that he/she is
not aware of any material modification that should be made to such statements or data in order for
them be in conformity with GAAP, if such statements or data contain any departure from accounting
principles promulgated by bodies designated by council.

If however, the statements or data contain such departure and the members can demonstrate that
due to unusual circumstance, the financial statements or data would otherwise have been
misleading, the members can comply with the rule by describing the departure, its approximate
effects, if practicable; and the reasons why compliances with the principle would result in misleading
statements.

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vi. Confidential Client Information

A member in public practice shall not disclose any confidential client information without the
specific consent of the client.

vii. Contingent Fees

A contingent fee is a fee established for the performance of any service pursuant, or an
arrangement in which no fee will be charged unless a specified finding or result is attained, or in
which the amount of the fee is otherwise dependent upon the finding or result of such services.

A member in public practice shall not perform for a contingent fee any professional services for, or
receive such a fee from a client for whom the member or member’s firm performs services such as:

(a) An audit or review of financial statements

(b) Compilation of financial information expected to be used by third party,

(c) An examination of prospective financial information or

(d) Prepare an original or amended tax return or claim for a tax refund.

viii. Acts Discreditable

A member shall not commit an act discreditable to the profession.

Activity 2
What is meant by principles of the code in related with code of Ethics?

______________________________________________________________________

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Section-1.3 Identifying Management and Auditors Responsibility

1.3.1 Management and Auditors Responsibility

Management of the client and independent auditors has different responsibilities. The primary
responsibility of management is preparing financial statements in according to GAAP. On the other
hand, auditors are responsibility for auditing financial statements and issuing financial audit report.

Financial statements prepared by management and transmitted to outsiders with out first being
audited by independent auditors leave a credibility gap.

Dear learner you must have understood that management of the client and independent auditors
have different responsibility and criteria for discharging their responsibility. The major areas of
difference in this regard are summarized below:

Basis of comparison Management Independent auditors

Primary responsibility Prepare financial statements Audit financial

statements

End product Financial statement Audit report

Criteria in discharging Generally accepting Generally accepted

responsibilities accounting principles(GAAP) auditing Standards(GAAS)

Section 1.3.2 Primary Responsibility of Auditors

Auditors have a primary serve to society. To this end auditors should be able to have a better
communication skill, to detection of errors and irregularity, to detect illegal acts of clients and to
report doubts as to an entity’s ability continue as a going concern.

Section -1.4 Identifying Types of Audits and Auditors

Check your progress

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 ? List and explain the type of Audits and Auditors
(write your answer on the space provided below)

1.4.1 Types of Audit

The various types of audit that might be undertaken by the auditor can be categorized as:

i) audit of financial statements

Ii) compliance audits

Iii) operational audits

i. Financial Statement Audit - an audit of financial statements ordinarily covers the balance
sheet and the related income statements, retained earnings /owner ’s equity/, statements of
cash flows. The goal is to determine whether these statements have been prepared in
conformity with generally accepted accounting principles.
ii. Compliance Audits- Society has always concerned about compliance with laws and
regulations by all types of organizations. As a result, compliance auditing has involved
becoming an important part of the work of both external and internal auditors. Compliance
auditing is, therefore, the testing and reporting on whether an organization has complied
with the requirements of various laws, regulations, polices, procedures, and agreements.

Example Include foreign governments that make grants (gifts, donations) to organizations working
in Ethiopia, like Oxfam. Grants almost always have rules and regulations for the administration of
the grant. Take, for example, a particular grant which must be used to distribute food to mothers
and children in Region Five. Auditors examine the actual work of the program and compare it to the
agreed rules and regulations.

iii. Operational Audits-the term operational audit refers to a comprehensive examination of

an operating unit or a complete organization to evaluate its systems, controls, and
performance, as measured by management objectives. An operational audit focuses on the

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 efficiency and effectiveness of operations. Efficiency is success in using the available
resources to the best advantage of the organization. Effectiveness is success in meeting
one’s stated goal and responsibility. Operational audit is usually performed by internal
auditors of the organizations.

1.4.2 Types of Auditors

There are three types of auditors. Among these well known types of auditors are:

i) certified public accountants (Independent) auditors

ii) internal auditors

iii) government auditors

(i) Certified public accountants (Independent) auditors-These are a group of auditors who
examine the records supporting the financial reports of an enterprise and give an opinion regarding
their fairness and reliability. They are independent professionals who perform or render
professional service on a fee base, but not the employee of the company being audited. They report
their findings to stockholders.

(ii) Internal auditors- The principal goal of the internal auditors is to investigate and appraise the
efficiency and effectiveness with which the various organization units of the company are
carrying out their assigned functions. Even though internal auditors are not independent as in
the same sense as the independent public auditors,

- They should be independent of the department heads and other line executives whose work
they review.
- Internal auditors report to the audit committee of the board of directors, to the president or
to other high executives.
- Internal auditors are employee (is a salaried employee) of the business organization in
which they work and, thus, subject to rules and regulations inherent in the employer-
employee relation ships.

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 - Large part of the work of internal auditors consists of operational audit, they also
conduct compliance audit.
The Internal auditor is responsible to:
a) establish rules and procedures of the internal accounting system.
b) review the day-to-day financial operating procedures, and to check of there is adequate
supervision with a clear and up to date supply of information to the management.
c) evaluate the system of internal control.
d) give periodic report to the management about the financial condition of the
organization.
e) give recommendations about the improvement of procedures.
f) appraising the quality of performance in carrying out assigned responsibilities.
g) ascertain whether assets of the businesses are accounted for & safeguarded form losses
of all kinds.
(iii) Government Auditors - Congress or federal government have long had its own auditing staff,
headed by the controller general and known as general accounting office, GAO auditor. The
work of GAO auditors includes audits of government agencies to determine the spending
programs, evaluate the efficiency and effectiveness of selected government programs; audit of
financial statements of a number of federal agencies and others.

Activity 3
Three types of auditors are listed below. Indicate the category to which each statement belongs by
placing the appropriate letter in the space provided:

a. independent auditors

b . internal auditors

c. governmental auditor

1. The perform audit has employee of various local, state and federal agency.

2. The perform audit has employed of the companies the audit.

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 3. The renders professional auditing serves to their clients.

4. They perform independent financial statement audit.

Activity 4
Three types of audits are listed below. Indicate the category to which each statement belongs by
placing the appropriate letter in the space provided:

a. financial audit

b. compliance audit

c. operational audit

1. The results of such an audit are distributed to a wide spectrum of users such as creditors,

stockholders, regulatory agencies, and the general public.

2. This type of audit is called a performance audit or management audit.

3. This type of audit may be performed by Inland Revenue Authority auditor.

4. The scope of this type of audit may encompass all the activity of a department.

5. This audit relates to fair presentation of statements in accordance with GAAP.

Section -1.5 Describing the Need for Financial Audits

True auditing, according to some definitions, must be done by an independent person. It is

often appropriate to have work examined by an independent, unbiased party, regardless of
the type of endeavor.

In business generally, reports generated from audit work have many users and uses. The need for
dependable financial information by different groups of society is related to the decisions they
make.

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  Investor- for making a decision to buy, or sell securities.
 Government-obtaining revenue based on income taxes.
 Lenders-bankers etc, to decide whether to approve a loan.

Here are some examples of users

Shareholders: The owners (shareholders) of a share company (corporation) often are passive
investors who invest money, and then hire professional managers to run the business. The
shareholders need assurance, therefore, that the managers are using the resources that belong to
the shareholders in a way that benefits the shareholders. Auditors are hired by the shareholders to
check the financial records produced by the managers to see if this is so. (NB: Banks and insurance
companies are required by Ethiopian law to be set up as share companies.)

Bankers and other Lenders:-Financial information is used extensively by lenders to evaluate loan
requests from customers. The profits of the business and the costs of assets are two areas looked at
in detail by bankers. Auditors help prevent customers from overstating these values in order to
deceive the bank into granting a loan to unworthy customer.

Since banks deal with large amounts of cash, internal auditors are hired to examine the work of
cashiers and others to ensure that money is not being stolen through, for example, creation of false
transactions.

Government: Government agencies use audit reports in many ways. For example, the Disaster
Prevention and Preparedness Commission (DPPC) uses audit reports to ensure that resources given
to Relief and Development; NGOs are used "for the good of the people of Ethiopia." The Inland
Revenue Department uses audit reports to verify that taxes have been paid. Most, if not all,
government departments have internal auditors to ensure that resources are used according to the
rules and regulations of the government.

! Here all are depending on information provided by others but there is a conflict of interest
between providers & Users of financial information. Hence, the need for independent

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auditors, individuals of professional competence, & integrity who can tell whether the
financial information provided constitutes a fair picture of what is really going on.
There are various conditions or reasons for the need of financial statement audit .These are:

1. Consequence: This is to say that decisions made based up on Financial Statement are so costly, and
the consequence; in case misstated figures are reported, is so destructive thus to avoid this
irreversible costly consequences having audited Financial Statement is of no choice.

2. Complexity: The complexity of modern business by itself leave a ground for those people
reporting about financial position of companies to present in some distorted manner; however,
with the existence of Auditing , it is possible to minimize, or avoid this distortion.

3 Remoteness: The remoteness of owners from the company and companies they own require for
third party verification on what is reported, and done. This third party verification is more or less
satisfied by independent auditors.

4. Rules and Regulations: There are laws, and regulations in different nations that require
organization to get their Financial Statement audited every fiscal or reporting period.

5. Control Mechanism: Auditing made internally and /or externally by serving as a control
mechanism by assuring that, these bodies have obeyed the rule or not.

Activity 5
Bankers who are processing a loan application from companies seeking large loans will probably
ask for financial statements audited by an independent auditor. Explain why audited financial
statements are required in such situation

Section-1.6 Distinguishing between Accounting and Auditing

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Dear learner, do you think that accounting and auditing are the same? Or do you think that they are
the different? Read the following terms and you will be clear about the difference and similarities
between accounting and auditing.

Difference between accounting and auditing

a. Meaning:-accountancy means maintaining the book of account where as auditing means

examining the accounts and reporting on there accuracy.

b. Hierarchy: - the spadework is done by the accountant to enable the auditor to give the finishing
touch. In other words accounting begins where bookkeeping ends and where accounting ends
auditing begins. There can not be auditing without prior existence of accountants

c. Subject matter: - the accountant prepares the financial statements that are accountancy is mainly
concerned with preparation and interpretation of financial statements with the help of
transactions recorded by bookkeeper. Where as audit entails preparation and submission of
report based on the checking and examination of the accountants

d. Purpose:-The main purpose of accountancy is to know the trading results or state of affaires of a
business during a financial year, while the object of audit is to certify the correctness of financial
segments prepared by the accountant

e. Qualification of the performer: - Now prescribed qualifications are legally required to be

possessed before appointment of an accountant is made but it is mandatory that an auditor of
Joint Stock Company must be a chartered accountant.

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f. Replacement by auditor: - an accountant is not expected to posses the knowledge of auditing but
for an auditor it is quite necessary to have an in-depth knowledge of accountancy. In other
words an accountant can not replace an auditor but can be replaced by an auditor

g. Status: - an accountant is an employee of the firm whereas an auditor is an outsider who enjoys
full autonomy.

h. Nature: - accountancy is constructive and theoretical in nature whereas auditing is referred as

critical aspect of accountancy and is analytical in nature.

Section-1.7 Identify Generally Accepted Auditing Standard (GAAS)

1.7.1 Generally Accepted Auditing Standards (GAAS)

Check your progress

? What are the general category of Generally Accepted Auditing Standards

(use the following space provided below)

____________________________________________________________________

Auditing standards are generally guidelines to aid auditors in fulfilling their professional
responsibilities in the audit of financial statement. It serves as a benchmark against which work
performed is compared, and thus principles are translated into more practical and ad hearable
terms. The existence of generally accepted auditing standards is evidence that the accounting

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profession is very concerned with maintaining a uniformity and high quality of audit work by all
independent public accountants.

According, the AICPA has set forth the basic frame work in the following 10- generally accepted
auditing standards which are grouped under three major categories.

A. General standards

(1) The audit is to be performed by a person or persons having adequate technical training and
proficiency as an auditor.
(2) In all matters relating to the assignment, independence in mantel attitude is to be
maintained by the auditor or auditors.
(3) Due professional care is to be exercised in the planning and performance of the audit and
the preparation of the report.
B. Standards of field work

(1) The work is to be adequately planned and assistants if any are to be properly supervised.
(2) Sufficient understanding of internal-control is to be obtained to plan the audit and to
determent the nature, timing, and extent of tests to be performed.
(3) Sufficient competent evidential matter is to be obtained through inspection, observation,
inquiries, and confirmation to afford reasonable bases for an opinion regarding the
financial statements under audits.

C. Standards of reporting

(1) The report shall state whether the financial statements are presented in accordance with
generally accepted accounting principles.
(2) The report shall identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period.
(3) Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless other wise stated in the report.

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 (4) The report shall either contain an expression of opinions regarding the financial statements
taken as a whole, or an assertion to the effect that an opinion can not be expressed. When
an overall opinion can not be expressed, the reason therefore should be stated.

Activity 6
The ten generally accepted auditing standards are listed below in a paraphrased form. Indicate the
category to which each statement belongs by placing the following letters in the space provided.

A. General standards

B. Field work standards

C. Reporting standard

1. An understanding of the internal control structure is to be obtained.

2. The auditor should be unbiased during examination.

3. The financial statements should be in conformity with GAAP.

4. The financial statement contains adequate disclosure.

5. The auditor should have adequate technical training and proficiency as an auditor.

6. Sufficient competent evidential matter is to be obtained.

7. Due professional care is to be exercised.

8. The work to be adequately planned and assistants to be properly supervised.

9. The report shall contain an expression opinion.

10.Circumstances in which GAAP have not be consistently observed should not be identified.

Section-1.8 Identifying Auditor Standard Report

1.8.1 Auditors Report

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The auditors report is, therefore, the means by which the auditors formally communicates the
results of his /her/audit to the members of the company as well as to the readers of financial
statements, such as creditors, financial institutions, and all others who have a stack in the company
or wish to acquire a stake or transact with the company. The messages that are communicated
through the audit report are based on various conclusions reached by the auditors in the course of
his/her examination.

The auditors report does not guarantee the truth or otherwise of the matter reported upon; it is
expression of auditors’ opinion on the financial statements. That is, an auditors opinion on the
financial statements. That is, an auditor’s /auditors/ cannot ascertain and state or certify the exact
figure of various assets and liabilities. All they can do is to report whether or not, in his opinion, the
financial statements are true and fair. Different auditors may form different opinion based on their
exercises of judgment on the same set of financial accounts. Thus, an auditor is not a guarantor or
an insurer.

The auditors report thus, serves the under mentioned purposes.

(i) It substantiates that the financial information of the company reflects a true and fair
picture of the state of affair of clients business.
(ii) It summarizes the result of the audit work carried out by the auditors
(iii) A report from acquainting the shareholders with material facts about the affairs of
company’s business, it offers an opportunity to the readers of financial statements such
as creditors, bankers, financial institutions, and potential investors and others to get
reliable insight into the financial position of the company as reflected by its profit and
loss accounts and the balances sheet.
(iv) Auditors’ report is the indicator of credibility of financial statements.
Thus, an auditor’s report is a valuable document in which the auditors sets forth the scope and
nature of the audit and gives his impartial opinion as regards the financial statements of client ’s
business.

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1.8.2 Form of Audit Report

International Auditing Guidline-13 on the auditors ’ report on financial statements; provide guidance
on the form and content of the auditors ’ report issued after an examination of financial statements.
According to the guidelines, the basic elements of the auditors ’ report are as follows:

(i) Title: An appropriate title as ‘Auditors Report, ’ helps the users / readers / to identify the
report and to distinguish it from reports issued by others.
(ii) Address: The report should be appropriately addressed. For example, in the case of a
statutory audit of a company, the report is addressed to the shareholders.
(iii) Identification of financial statements: The financial statements can be identified by
including the name of the entity and the date period covered by the financial statements.
(iv) Reference to auditing standards or practices: Such references in the report assure the
reader that the audit has been carried out in accordance with established standards or
practices.
(v) Opinion on the financial statements: The report should clearly set forth the auditors
opinion on the entity’s financial positions and operational results e.g. the financial
statements give a true and fair view. The guideline also suggests that a reference to
accounting standards should be made in order to advise the reader of the framework within
which the auditor has reached his professional opinion
(vi) Signature: The report should be signed in the name of the audit firm or the personnel name
of the firm sings on behalf of the firm in case of statutory audit of companies.
(vii) Auditors’ or Audit firm’s Address: The report should also mention the specific location in
the city where the auditor(s), or audit firm maintain his office

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 To differentiate between the various sections of audit reports, look at the following auditor’
standard report.

Title INDEPENDENT AUDITORS’ REPORT

To the board of Directors and stockholders

addre
XYZ –Company:

We have audited the accompanying balance sheet of XYZ Company as of December-31,

20x1, and the related statements of income, retained earnings, and cash flows for the year
Introductory
then ended. These financial statements are the responsibility of the company ’s
paragraph management. Our responsibility is to express an opinion on these financial statements
based on our audit.

We conducted our audit in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatements. An audit includes
Scope
examining, on a test basis, evidences supporting the amounts and disclosures in the
paragraph
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by managements, as well as evaluating the overall financial
statements presentation. We believe that our audit provides a reasonable basis for our
opinion.

Opinion In our opinion, the financial statements referred to above present fairly, in all material
paragraph respects, the financial positions of XYZ company as of December-31,20x1, and the results
of its operations and its cash flows for the year then ended in conformity with generally
accepted accounting principles.

Addis Ababa
Auditor’s
signature Blue, Grey and Company

Certified Public Accountants

Date of
the report
February-26, 20x2.

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1.8.3 Types of Auditors’ Reports (opinions)

Expressing an independent and expert opinion on the fairness of financial statements is the most
important and valuable service rendered by auditors. Thus, the auditors ’ reports may be classified as
follows:

(1) unqualified ( clean ) report

(2) qualified report( negative) report
(3) adverse report
(4) disclaimer of opinion ( no-opinion)
(1) Unqualified (clean) report- An auditors’ report with an unqualified opinion may be issued only
when the following two conditions have been meet.
(i) The financial statements are presented in conformity with generally accepted
accounting principles, including disclosure.
(ii) The audit was performed in accordance with generally accepted auditing
standards, with no significant scope limitations preventing the auditors from
gathering the evidence necessary to support their opinion.
The unqualified auditors report could take either of the following two forms.

(A). An unqualified opinion- standards report- The standard report express a “ clean opinion”
and may be issued only when the two conditions listed in the preceding sections have been met
and when no conditions requiring explanatory language exists.

(B) An unqualified opinion –with explanatory language- under certain circumstances, auditors
add explanatory languages to their report, even when issuing an unqualified opinion. Adding
the additions languages is not regarded as a qualified; rather, the language merely draws
attention to a significant situation.

(2) Qualified opinions- a qualified opinion expresses the auditor’s reservations or uncertainty about
fair presentation in some areas of the financial statements. The opinion states that except for

29
 the effects of some deficiency in the financial statements, or some limitations in the scope of
the auditors’ examination, the financial statements are presented fairly.

Qualified audit reports should be carefully worded to auditors are qualifying their opinion.

Following is an example of the explanatory and opinion paragraphs of an audit reports qualified for
a departure from generally accepted accounting principles.

Explanatory Sony Corporation has not presented segments information for

Paragraph of each of the three years in the period ended March-3, 1992.The

qualified presentation of segment information concerning operations in

report different industries, and foreign operations and export sales is

required by a accounting principles generally accepted in the

in the United States of America for a complete presentation of

the consolidated financial statements

Opinion paragraph In our opinion, except for the omission of segments

of qualified report information as discussed in the third paragraph of this

report, the Financial statements are audited by us presents

30
 fairly, in all material respects, the financial position of Sony

Corporation and its consolidated subsidiaries at March-31,

1991 and 1992, and the results of its operations and their

cash flows for each of the three years in the period ended

March-31, 1992, inconformity with accounting principles

Generally accepted in the United States of America

Auditors may issue qualified audit opinion when

(i) There is a departure from generally accepted accounting principles by client and auditors
do not agree with the accounting principles used in preparing financial statements. When
the departure is immaterial, on unqualified opinion may be issued. But, when it is material
but not material enough to make the financial statements misleading, a qualified opinion
is appropriate.
The term ‘material’ is used to describe problems sufficient to require qualification of auditors ’
report but which do not overshadow the fairness of the statements in this case

(ii) Scope limitations- limitation on the scope of an audit arise when the auditors are un able
to perform an essential audit procedure. Limitation may be imposed either by
circumstances surrounding the audit (for example, the auditors were engaged too late in
the year to observe the client’s beginning inventory or by the client (for example, the
client refuses to allow the auditor to send confirmation to customers.
When the circumstance imposed scope limitation is involved, the auditor will attempt to perform
alternative procedures to gather sufficient competent evidential matter, and may issue an
unqualified opinion if the collected evidential matters are believed by the auditors to be sufficient.
Otherwise, unqualified opinion may be issued or an auditor may disclaim an opinion

(iii) When the account do not disclose a true and fair view of the companies affair, and when books
of accounts have not been kept in accordance with the law and profit and loss accounts are not
in agreements with the books of account and other related issues.

31
(3) Adverse Opinions- An adverse opinion is the opposite of an unqualified opinion; it is an opinion
that is issued when;

(i) The financial statements do not present fairly the financial position, results of operation,
and cash flows of the client in conformity with generally accepted accounting principles.
(ii) When the deficiencies (departure) in the financial statements are so significant, that the
financial statements taken as a whole are misleading.
When the auditors express an adverse opinion, they must have set forth in an explanatory
paragraph, all significant evidences to support this unfavorable opinion i.e. they should disclose in a
separate paragraph of their report the reasons for the adverse opinion and the principal effect on
the financial statements, if the effects can be determined.

An audit report that express an adverse opinion generally includes standard introductory and scope
paragraphs, one or more explanatory paragraphs preceding the opinion paragraph and describing
the reasons for the adverse opinion, and an opinion paragraphs.

Because the reasons for an adverse opinion are usually lengthy and complex, we illustrate only, the
opinion paragraph below.

Opinion In our opinion, because of the effects of the matters discussed in the Paragraph
explanatory paragraph, the financial statements referred to above do

Of adverse not present fairly, in conformity with generally accepted report

accounting principles, the financial position of XYZ- Company

As of December-31, 20x9, or the results of its operations or its

Cash flows for the year then ended.

Adverse opinions are rare because most clients follow the recommendation of the independent
auditors with respect to fair presentation of financial statements

(4) Disclaimer of opinion- A disclaimer of opinion means giving no opinion as to the status of
the financial statements under audit. Auditors issue a disclaimer whenever:

(i) Auditors are un able to form an opinion or have not formed an opinion as to the fairness
of presentation of the financial statements due to significant scope limitations either by

32
 substantial circumstances and/ or by client and this limitations of scope precludes the
auditors’ compliance with generally accepted auditing standards and
(ii) When a material uncertainty affects the financial statements.
E.g. The probable outcome of a very significant lawsuit against the client
Disclaimers are not alternatives to adverse opinion. A disclaimer can only be issued when the
auditors do not have sufficient information to form an opinion on the financial statements. If the
auditors have already formed an opinion that the financial statements are not a fair presentation,
the disclaimer can not be used as a way to avoid expressing an adverse opinion.

Independent auditors report the phrase ‘Financial statements present fairly, in all material respects ’
may be used since many of items in the financial statements cannot be measured exactly, the
auditors cannot say that the statements present exactly or correctly the financial position or
operating results.

The meaning of “present fairly” in dependent auditors report is to state the fairly stated financial
statements are (SAS-69)

(i) Prepared in accordance with accounting principles that have general acceptance and are
appropriate in the circumstance
(ii) Information of matters that may affect their use, understanding and interpretation
(iii) Presented in a manner that is classified and summarized in a reasonable manner,
neither to detailed nor to condense.
(iv) Prepared to reflect transactions and events within a range of reasonable limits.

33
Check-List
Important concepts of the unit are listed below. Evaluate yourself by
indicating a check mark ( ) in the ''Yes'' column if the check list item is clear
to you or in the ''No'' column if the check list item is not clear. Thus, if there
is any item that is not clear to you to understand please reread the material
and evaluate yourself again and again until items are clear to you.

Confirmation Ideas Yes No.

Can you define auditing

Can you understand codes of Ethics for auditors

Can you differentiate management with auditors responsibility

Can you identify types of auditors and audits

Can you describe the need for financial statements audit

can you distinguish accounting with auditing

can you understand GAAS

Can you understand auditors standard

34
 Summary

This duty explained the need for professional ethics to adhere to high standards of professional
conduct and described the details of the codes of ethics that apply to both external and internal
auditors.

To summarize:-

▪ Ethics are the moral principles that over the behavior of individuals. An ethical dilemma is a
situation that involves a decision about appropriate behavior. A key aspect for ethical dilemma is
that it generally affects parties that are note involved in the decision

▪ Among the characteristics common to recognized professions are:-

(a) Acknowledgement of a responsibility to serve the public.

(b) Existence of a complex body of knowledge.
(c) Standards of admission to the profession and
(d) A need for public confidence.

35
▪ The code of ethics of the institute of internal auditor primarily addresses internal auditors
obligations to their employers but, it also include provision requiring integrity, objectivity and
competency in the practice of internal auditing

 Self Check Exercise-1

Part-I: Choose the Best Answer from the Given Choices

______1. Which of the following is a not characteristic of auditing

A. Detection of errors & frauds

B. Audit is an independent & critical examination of books

36
 C. Examination of the books accounts enable the auditors to satisfy him self that the
financials statements rare down up correctly.
D. None of the above.
______2. The end product of the audit process is

A. Examination of books accounts and errors record

B. Ascertaining the compliance of the person’s responsibility to keep the account.

C. Prepare a report to the proprietor
D. Prepare the book of accounts
______3. ____ involves systematic review of the organizations activities and helps to

asserts performance of the organizations:

37
 A. Performance audit B. Management audit

C. Operation audit D. All of the above

______4. The primary objectives of internal auditor is

A. To conduct compliance and operational audit

B. To audit the financial statement of an organization

C. To examine and detect variety of fraudulent activates

D. To assist the external auditors with that annual financial statement

______5. One of the following is not related to actual conduct of the audit (standard of
fieldwork).

A. Informative disclosures have been made

B. The work is to be adequately planned and properly supervised

C. Sufficient evidential matter is to be obtained

D. Systematic control of design is to be obtained

_____6. Guide line to aid auditors in fulfilling their professional responsibilities is called

A. General standard

B. Auditing standard

C. Standard of reporting

D. Standard of field work

38
 UNIT TWO

2. Overview of the Audit Process

Introduction

Every person plans as does every organization. Planning is required to perform any economic activity.
Planning is begins especially with an intended goal, an end result or targeted out come. The concept of ad
equating planning includes investigating a prospective clients before whether to accept the engagement,
obtaining an understanding the clients business operation and developing an over all stratagem to organize,
coordinate and schedule the activity of the audit staff. Although much planning is done before beginning the
actual field work, the planning process continues through the engagement. This duty describes the dynamic
process of planning the audit, beginning with obtaining a client and proceeding through the designee of the
audit program. It also provides an over view of the entire audit

General Objective

Dear learners after studying these duties, you should be able to:

● understand the audit process

● practice the field work of auditing.

● understand the roles of sampling

● report the audit finding

Section 2.1 Planning the Audit

2.1.1 Audit Planning

Audit planning is a vital area of the audit. Audit is planned at the beginning of the audit process. The plan
will be revised as necessary during the course of the audit. In undertaking effective planning the auditor
needs to understand the different steps of the audit and make judgments on the level and detail of work to
be undertaken. The objective of planning is to enable the audit to be performed in an effective manner.
Planning also helps the auditor to:

 ensure that appropriate attention is paid to the different areas of the audit;
 ensure that potential problem areas are identified, such as weaknesses in the control over creditors,
which might lead to a material understatement; and
 facilitate reviewing the audit process.
To obtain the benefits mentioned above, the auditor should plan the audit adequately. The concept of
adequate planning includes investigating a prospective client before deciding whether to accept the
engagement, obtaining an understanding of the clients ’ business operations, and developing an overall
strategy to organza, coordinate the audit activity.

2.1.2 Purpose of Planning

Check your progress

? What do you think about the purpose of planning the audit

(you can use the space left to below write your responses)

_____________________________________________________________________________________

Audit planning is a vital area of the audit. A major purpose is to provide information to aid the auditor in
assessing acceptable audit risk and inherent risk. These assessments will affect the auditor ’s client
acceptance or continuation decision, the proposed audit fee, and the auditor ’s evidence. A second purpose
is to obtain information that requires follow-up during the audit. Doing so is one step in obtaining sufficient
competent evidences. Examples include identifying approvals in the minutes such items as dividends and
officer’s salaries, and searching for the names of related parties to help the auditor determine whether
related party transactions exists. Others, purposes include staffing the engagement and engagement letter

Generally, planning is very important to:

a) enable the auditors to obtain sufficient competent evidence for the circumstances
b) keep audit costs reasonable
c) avoided misunderstandings with the client.

The audit planning processes begins when the auditor accepts an audit engagement and continues until the
completion of the audit. Thus, you will see the steps in accepting a new audit client in the next section.

2.1.3 Phases of Audit Process

The audit process includes the following phases: Accepting the audit engagement, planning the audit,
performing the fieldwork, and reporting findings.

Phase I: Accepting the Audit Engagement

An audit is planned after an engagement is accepted. Accepting an engagement involves three steps. These
are:-

1. Evaluate integument;
2. Assess ability to conduct the audit according to GAAS, and
3. Prepare an engagement letter.

(1) Evaluate integrity

The auditor should evaluate integrity of management before accepting a new engagement. If management
lacks integrity, it is highly likely that financial statements be internationally misstated. This in turn increases
the risk of issuing inappropriate opinion. For a new client, the auditor obtains information about the
integrity of management by communication with predecessor auditor, and making inquiries of other third
parties. For an existing client, you can get information by reviewing prior year working papers.
Communicating with predecessor audit helps the successor audit to evaluate integrity of management,
disagreements with management concerning accounting principles, the predecessor auditors understanding
as to why there is a need for assigning another auditor. This helps you to decide to accept or reject the
engagement.

The predecessor auditor gives the business form industry statistics, press reports, bankers and legal
advisors, prior year financial statements, and other written materials.

(2) Assess ability to perform the audit in accordance with GAAS

You should evaluate whether the engagement could be completed in accordance with GAAS before deciding
to accept and engagement with a new client or to continue with an existing client. That is, auditors should
make sure that the audit assignment can be performed competently and with due professional care.
Moreover they have to make sure that there are no factors that affect their independence. GAAS are
discussed thoroughly task 7 of this course material.

After evaluation integrity of management and after assessing your ability to conduct that audit in
accordance with GAAS, you may decide to accept or reject the engagement. If you decide to accept the
engagement, you will prepare and engagement letter.

(3) Prepare Engagement Letter

If you decide to accept the engagement, you have to prepare and send an engagement letter to the client.
An engagement letter is prepared to avoid misunderstanding with the client and as a means of avoiding
litigation as to the scope and quality of the work performed by the auditor. This is because the engagement
letter sets forth the terms of the engagement. A copy of this letter, signed and confirmed by the client,
remains in the auditor’s file for contracts.
An engagement letter is prepared in two copies (one to the client and the other to the auditor) and must be
signed by the responsible official of the client. After it is signed, the engagement letter becomes a contract
between the auditor and the client.

An engagement letter contains the following information:-

 Nature and scope of the audit;

 A statement that the audit is primarily designed to enable the auditor to express her/his opinion on
the fairness of the financial statement presentation and statement;
 A statement that the records should be update in preparation for the audit;
 Auditors assistance in the preparation of income tax return; and
 Fees and billing arrangements.

Phase II: Planning the Audit Engagement

An audit plan is drafted before starting the audit work but it may be modified throughout the audit
engagement. The components of audit planning and the sequence in which they are performed are shown
below:-

 Obtain understanding of the client’s business and industry:

 Obtain understanding of client’s internal control structure:
 Asses materiality:
 Asses audit risk
 Design audit programs:
 Schedule the work; and
 Assign professional staff to engagement
 Obtain understanding of the clients business and industry
You have to plan the audit after gaining knowledge of the client ’s business and industry. This helps you to
understand events, transactions, and practices that may have significant effect on the financial statements.
As and auditor, you need to know the following to understand the client’s business:

 type of business, types of products and services, company location,. and operating characteristics of
the client’s organization such as its production and marketing methods;
  the type of industry, vulnerability of industry to changing economic conditions, and major industry
policies and practices;
 government regulations that affect the entity and its industry; and
 entity’s internal control.

Auditors gain understanding of the client’s business and industry by reviewing prior year ’s working papers,
reviewing industry and business data, touring client operations, making inquiries in to management, and
performing analytical procedures.

 Obtain understanding of client’s internal control structure

The second standard of fieldwork includes a requirement that the auditor obtain a sufficient understanding
of the internal control structure to plan the audit. To meet this requirement, you will beer interested in the
control policies and procedures that are designed to assure the reliability of the financial records and to
safeguard assets.

You may gain understanding of the client’s internal control structure by reviewing documents, inquiring
management, observing control procedures (These and other procedures are fully discussed in task 9 of this
course material)

 Assess materiality
In planning an audit, auditors should consider carefully the appropriate levels of materiality and risk. The
main purpose of an audit is to express and opinion on the reasonableness and fairness of the financial
statements. Thus, the auditor designs audit procedures to verify if financial statement items are free of
material error and fraud. In financial statement audit, due to cost and time, the auditor examines only
selected transactions. This implies accepting errors in the financial statements of remain undetected.
However, you may to attain 100% guarantee of the accuracy even if you examine 100% hence, your main
concern in financial statement audit is to minimize risk and to ensure that no material error remains
undetected.
Materiality and audit risk are related. For planning purposes, materiality is the magnitude of an omission or
misstatement of accounting information that, in the light of surrounding circumstances, makes it probable
that the judgment of a reasonable person relying on the information world have been changed or influenced
by the omission or misstatement 2.

Assessing the level of materiality of misstatement helps auditors to appropriately modify their opinions
whenever there are material deficiencies in the client ’s financial statements. However, they may issue
unqualified report if the deficiencies are immaterial.

Materiality involves both quantitative and qualitative considerations. In assessing the quantitative
importance of misstatements, you have to relate the Birr /dollar amount of the error to the financial
statements. Qualitative considerations rate to the causes of misstatement. You are required to asses’
materiality at two levels: the financial statement level since your opinion will be about the overall fairness of
the financial statements, and the account balance level because you verify account balances in reaching and
overall conclusion on the fairness of the financial statements.

Financial statement materiality: Financial statements are materially misstated when they contain errors or
irregularities whose effect, individually or in aggregate, is important enough to prevent the statements form
being presented fairly in conformity with GAAP. In this context, error or irregularities may result from
misapplication of GAAP or omission of necessary information.

For income statement, materiality may be related to total revenues, operating income, before taxes, or net
income. For the balance sheet, materiality could be based on total assets, current assets, working capital, or
shareholders’ equity. What is material is determined based on the auditor ’s professional judgment. For
instance, you may say, errors totaling Birr 50,000 is material for income statement, and Birr 100,000 for
balance sheet. What is material for one organization may not be material for another organization; it all
depends on the size of the organization and professional judgment of the auditor.
Account balance materiality: The materiality level for an account balance is the maximum error that can
exist in the account before it is considered to be materially misstated. When making judgment about
materiality levels for account balance, you should consider the relationship between the account balance
materiality and financial statement materially.

 Assess audit risk

In planning the audit, the auditor should also consider audit risk. Audit risk is the risk that the auditor may
unknowingly fail to appropriately modify her/his opinion on the financial statements that are materially
misstated. For example, if 95% certainty is desired, audit risk is 5% or in other words, he/she is ensuring
that he/she is 95% certain that her/his opinion on the financial statements is correct. the percentage used
(95%) in one of convention only. It implies that you can never be100% sure of any conclusion. This is known
as audit risk and means that auditors accept hat 5 every 100 reports issues issued may be incorrect. Audit
risk can be set at any level. It the auditors set it at 100% there is no need to do any work at all, but there is a
high risk of being found negligent. Auditors in practice set audit risk at 4-6% and tailor their audit procedures
accordingly. Our objective in financial statement audit is to restrict audit risk to a level tolerable Audit risk
has three components. These are inherent risk, control risk, and detection risk.

Inherent risk: refers to the susceptibility of an account balance to material error assuming the client does
not have any related internal controls. Inherent risk is greater for some accounts than for others. For
example, cash is more likely to be stolen than plant assets, and inventories are more vulnerable to decline in
value than other assets.

Control risk: is the risk that a material misstatement in an account balance will not be prevented or detected
on a timely basis by the company’s internal control.

Detection risk: is the risk that auditor’s procedures for verifying account balances will not detect a material
error when in fact such error exists. It is the risk that the auditor ’s procedures will lead them to conclude
that a material misstatement does not exist in an assertion when in fact such misstatement does exist. There
fore, detection risk is directly related to the effectiveness of the auditor ’s procedures, while inherent and
control risks are functions of the client and its environment. Total (TR) is the function of inherent risk (IR (,
control risk (CR) and detection risk (DR). Thus, TR = IR x CR x DR.

In planning the audit you have to assess the extent of inherent and control risk, and then plan relevant audit
procedures to reduce detection risk to the level tolerable. This in turn helps you to reduce the overall audit
risk so as to issue an appropriate opinion.

 Design audit programs.

An audit program is list of the audit procedures to be applied in an audit in the given circumstances along
with proper instructions. Thus , and audit program contains the description of the specific and it procedures
to be performed in respect of different aspects to be covered, the extent to which those tests will be
performed, and the timing of such tests.

To complete the audit efficiently and effectively, an audit program is divided into two sections: the systems
section and the substantive test section.

The systems section of the audit program focuses on the procedures used to evaluate the effectiveness of
the internal control structure, and it is organized major transaction cycles of the internal control structure.
On the other hand, the substantive test section deals with the procedures for substantive testing of financial
statement amounts and the adequacy of financial statements items.

 Schedule the work

After developing the audit program, auditors should schedule the work. Scheduling the audit work means
determining when audit programs are to be executed on the client’s premises.

 Assign professional staff to the audit engagement

The final component of audit planning is the assigning of professional staff to the engagement. In making
staff assignments, the composition of the audit staff in terms of overall experience. Responsibility,
supervision, and technical expertise should be considered.
Phase III. Performing the Field Work

The objective of this is to obtain sufficient evidence to determine whether the financial statements are fairly
stated. The nature and extent of the work depends on the findings on the audit- planning phase.

There are two general categories of tests in phase III: Analytical review and direct test of balances, which are
also refereed to as test of details. Analytical reviews procedures are those that assess the overall
reasonableness of transactions and balances. Direct tests are specific procedures intended to test for
monetary errors in the balances in the financial stamens. Certain key transactions and amount are so
important that each one must be audited. Other items can be tested on sample basis.

Phase IV. Reporting Findings

After the first three phases are completed, it is necessary to summarize the results and issue the audit
report. This phase has four main parts: Review for contingent liabilities, review of subsequent events. And
evaluation of results and issuing audit report. These parts are discussed in the following sections.

Review for contingent liabilities: Contingent liabilities are potential liabilities that must be disclosed in the
client’s footnotes. Auditors must make sure the disclosure for such liabilities is adequate. The auditor will
perform a considerable portion of the search for contingent liabilities in the first three phases, but additional
test is done during phase IV.

Review for contingent Liabilities: Contingent liabilities are potential liabilities that must be disclosed in the
client’s footnotes. Auditors must make sure the disclosure for such liabilities is adequate. The auditor will
perform a considerable portion of the search for contingent liabilities in the first three phases, but additional
test is done during phase IV.

Review of subsequent events: Occasionally events occurring subsequent to the balance sheet date but
before the issuance of the financial statements and auditors report will have an effect on the information
presented in the financial statements. Specific review procedures are designed to bring to the auditor ’s
attention any subsequent events that may require recognition in the financial statements.

Evaluation of results: the auditor should evaluate the results of the audit and decide whether sufficient
evidence has been accumulated. Audit supervisors also review audit working papers to uncover and
mistakes and to evaluate the judgments and conclusions reached. Issue audit report: the final task in phase
IV is issuing the appropriate audit report based on the findings.

Activity 7
List the four phases of audit process.

________________________________________________________________________________________
______________________________________________________________

Section 2.2 Performing the Field Works of Auditing

You will recall that there are four phases in the audit process. The first phase involves accepting an audit
engagement, while the second phase focuses on planning the audit engagement. The third phase related to
conduction the fieldwork followed by the fourth phase which deals with reporting finding.

In the discussion on phases of audit process, you have seen that performing the fieldwork involves gathering
sufficient evidence with a view to evaluate whether the facial statements are fairly stated. The major tasks in
performing the fieldwork of auditing are making a study and evaluation of the client ’s system of control,
verifying financial statements balances, and evaluating evidence obtained.

2.2.1 Making a Study and Evaluation of The Client’s System of Control

The system of internal control is the plan of the organization and all the methods and procedures adopted
by the management of an entity to assist in achieving management ’s objectives of ensuring that orderly and
efficient conduct of its business. The accounting system represents the major part of he internal control
system of an entity.

Three steps are involved in studying and evaluation the internal control of the audit client: Study the system,
test compliance of the system. And evaluate adequacy of the system.

1. Study the system: The accounting system is the most significant part of the accounting controls. Thus,
your focus will be on this part. In order to understand the accounting system and the related internal
controls of a client, you may use different techniques such as inquiry and inspection of documents. To gain
understanding of the accounting system, you have to concentrate on the following areas the:

 major classes of transactions of the organization,

 manner in which transactions are initiated and executed.
 accounting records and supporting documents related to the information included in the finical
statements.
 accounting process (from initiation of a transaction of the preparation of financial statements )

Auditors document their understanding of the internal control system using various methods. The most
commonly used methods are narrative description. Flow charts and internal control questionnaires. You may
use these methods separately or in combination.

A. Narrative description: A narrative is a written description of a client’s internal control structure. This
method is usually used for internal control structures that are simple and easy to describe. A proper
narrative of accounting system and related control procedures the takes place, the disposition of every
document and record in the system, an indication of the control procedures relevant to the assessment of
control risk. Flowchart: An internal control flow chart is a symbolic representation of the client ’s documents
and their sequential flow in the organization. An adequate flow chart includes the same four characteristics
identified above in relation with narrative descriptions.
B. Internal control questionnaire: An internal control questionnaire about the control in each audit area as a
means of indicating to the auditors aspects of the internal control structure that may be inadequate. The
use of both questionnaire and flowcharts is highly desirable for understanding the client ’s system.

C. Flowcharts provide an overview of the system and questionnaires are useful checklists to remind the
auditor of many different types of controls that should exist. If properly used, a combination of these two
methods provides you with an excellent description of the system.

2. Test compliance of the system: The second step in understanding the internal control system is testing
compliance with prescribed controls. You may use compliance procedures to evaluate whether or not the
internal controls on which you internal controls on which you intend to rely were actually in operation.
Compliance test is performed through inspection to documents and reports, observation and inquiry.

For internal control procedures that leave documentary evidence of performance in the form of signatures,
initials, stamps, etc, you may examine the related documents. But, you rely on observation and inquiry to
obtain evidence about the actual operation of internal controls if control procedures leave no documentary
evidence of performance.

3. Evaluate adequacy of the system: After completing the above two steps, you would gain adequate
understanding of the system. Thus, the third step shows your conclusion about the weaknesses and
strengths of the system. This determines the degree of reliance and the extent of the substantive test that
you would apply in the actual audit. Understanding and evaluation the internal control also helps you to
assess control risk.

Control risk is the risk that material misstatements will not be prevented or detected by the client ’s internal
control structure. If structure. If client ’s internal control is weak. Therefore, your understanding of the
internal control is important in determining the nature, timing and extent of substantive testing to verify
information included in the financial statements.

The auditor evaluates adequacy of the internal control system by applying procedures such as inquires of
appropriate personnel, Inspection of documents, observation.

 Inquires of appropriate personnel: although inquiry is not generally a strong source of evidence about
the effective operation of controls, it is an appropriate form of evidence. For example, you may
determine that unauthorized personnel and not allowed access to computer files by making inquires of
the person who controls the computer library.

 Inspection of documents, Records and reports: Many control–related activities and procedures leave a
clear trail of documentary evidence. For example, when a customer order is received, it is used to create
a customer sales order which is approved for credit. The customer order is attached to the sales order as
authorization for further processing. Thus, you may examine these documents to make sure they are
complete and properly matched, and that required signatures or initials are present
 Observation: some control related activities may not leave an evidential trial. For example separation of
duties riles o specific parsons performing specific tasks ad there is documented of the separate
performance. There fore for controls that leave no documentary evidence, you generally observe them
being applied

 Re-performance: there are also control related activities for which there are related documents ad
records, but their content is insufficient for auditor’.
purpose of assessing whether controls are operating effectively for example assume prices on sales
invoices are to be verified to a standard price list by client ’s personnel as a internal control verification
procedure but no indication of perm is entered o the sales invoice I this case you may freeform the control
activity to see whether the proper result were obtained for example you can re perform the procedure by
tracing the sales prices to the authorized price list in effect at the date of the transaction if no errors are
found you ca conclude that the procedure is operation as intended.
There are three types of tests in determining whether financial statements are fairly stated: test of
transaction. Analytical procedures and direct test of balances.

 Test of transaction : the purpose the test of transaction is to determine whether the client
accounting system is function as intended if the accouter system is function will tractate will have bee
properly authorized correctly recorded ad summarized in the journal and correctly posted to subsidiary
ledges

Test of taxation determine whether amounts are correct because control were preset ad properly function
(compliance testing) because accounting procedures have bee correctly applied (Substantive testing) or both
as discussed below

 Analytical procedures: the term analytical procedures refer to a collocation of activities performed
by auditors to gather evidence I four of the five audit stages (I.e. all except the control testing stage

Analytical procedures involve a comparison of the value of an actual ration trend account balances
transaction etc (based o amount recorded in the accounting system) with the value of the expected ratio
(tried account balance transaction etc. The objective of this comparison is to identify ad investigate the
reason for ay unusual or unexpected relationship between the actual and expected value. Auditors estimate
the expected value (of the ratio tried account balance transaction etc before calculation the actual value in
order to avoid the actual value biasing the auditor’s estimate of the expected value

 Direct test of balance: direct test balances focus on he ending general ledge balances for boot balance
sheet and income statement accounts. Examples of such tests include a direct communication in writing
with customers for accost receivable physical examination of inventory and examinant f vendors
statement for account payable. These tests of ending balance are essential to be audit because the
evidence is obtained from a source independent of the client and is considered to be of high quality.

Section 2.3 Identifying the Role of Sampling

2.3.1 Audit Sampling

? Check your progress

Described the samples selections method

(you can use the spaces left to below write your responses)

________________________________________________________

Sampling whether statistical or non statistical, is the process of selecting a group of items (called the sample)
or representatives from large characteristics of the sample to draw inference about the characteristics of the
entire population of items.

Audit sampling methods can be divided in to two major categories: statistical and non-statistical sampling.
These categories have similar and differences. They are similar in that they both apply the following four
steps.

1. Planning the sample

2. Selecting the sample

3. Performing the test

4. Evaluating the results and drawing the conclusion

Statistical sampling differ from non-statistical sampling in that, the auditor can quantify sampling risk and
evaluate the sampling result by applying mathematical mode. In non-statistical sampling, the auditors
doesn’t quantity sampling risk rather, the auditor selects sampling items and conclusion are reached about
population on judgmental base.
a. Statistical sampling-is a sampling technique that are based upon the laws of probability (statistical
techniques), which enables auditors in planning, selection, and evaluation of the sample. Generally,
statistical sampling may assist auditors in:

i) designing efficient samples

ii) measure the proficiency of the evidence obtained, and
iii) objectively evaluate sample results.
This is because of the possibility that auditors may specify in advance the sampling risk that they can
tolerate, the auditor can select on of the following probability sampling method.

1.Simple random sampling:- this method uses sampling with out replacement i.e., once an item has been
selected for testing it is removed from the population and is not subject to reselection.

2. Stratified sampling: - This method of sampling provides selection of the sample items by breaking the
population down in to strata or cluster.

3. Systematic sampling:- This sampling method provides for the selection of sample items in such away that
there is a uniform interval between each item.

b. Non-statistical sampling- A sample is said to non-statistical (or judgmental) when the auditors estimate
sampling risk by using professional judgments rather than by using statistical technique.

Non-statistical sampling provides no means of quantifying sampling risk. Thus, the auditors may find
themselves taking larger and more costly samples than are necessary or unknowingly accepting a higher
than acceptable degree of sampling risk.

Non-statistical sampling includes haphazard, Block selection, and Judgment selection sampling.

2.3.2 Statistical Sampling in Test of Controls

? Check your progress

So far you have seen the nature and the meaning of sampling. You have also seen the method of
sampling. What steps do you think auditors follow in statistical sampling?
(you can use the space left to below to write your response)

_______________________________________________________________

Test of controls are used to determine whether the client ’s internal control is operating in a way that could
prevent or detect material misstatements in the financial statements. As discussed earlier, audit sampling
can not be used to test the operating effectiveness of all controls , rather it allow the auditors to determine
whether the controls are being applied to each items included in the sample.

When performing test of controls, the auditors are concerned with two aspects of sampling risk. These are
the:

(1) risk of assessing control risk too high. The risk is the possibility that the sample results will cause the
auditors to assess control risk at a higher level than is warranted bases on the actual operating
effectiveness of the control
(2) risk of assessing control risk too low- is the possibility that the sample result will cause the auditors
to assess control risk at a lower level than is warranted based on the actual operating effectiveness
of the control.
The risk of assessing control risk too-high relates to the efficiency of the audit process as this leads auditors
to perform more substantive testing than is necessary in the circumstance which reduce the efficiency of the
audit but does not lesson the effectiveness of the audit.

On the other hand, the risk of assessing control risk too-low is of utmost concern which leads the auditors to
inappropriately reduce the extent of their substantive tests. This unwarranted reduction in substantive
testing lessens the overall effectiveness of the audit as a means of detecting a material misstatement in the
client’s financial statements.

2.3.3 Statistical Sampling for Substantive Tests

Substantive tests used /designed/ to detect misstatements, both due to errors and fraud that may exist in
the financial statements. Accordingly, the sampling plans that are used for substantive tests are designed to
estimate the dollar amount of misstatement in a particular account balance. Based on the sample results,
the auditors then conclude whether there is an unacceptably high risk of material misstatement in the
balance. The actual steps involved may be summarized as:

1. determine the objective of the test

2. define the population and sampling unit
3. choose an audit sampling technique
4. determine the sample size
5. select the sample
6. test the sample items
7. evaluate the sample results
8. document the sampling procedures
Similar to sampling risk of tests of controls, there are two aspects of sampling risk for substantive tests.
These are:

(1) The risk of incorrect rejection “ Alpha- risk” of an account –This is the possibility that sample
results will indicate that an account balance is materially misstated when in fact, it is not
materially misstated ( affect the efficiency of the audit)
(2) The risk of incorrect acceptance “Beta-risk” of an account –is the possibility that sample results
will indicate that an account balance is not materially misstated when in fact, it is materially
misstated. (This affects the effectiveness of the audit of the client’s financial statements.)

Activity 8
Explain briefly for what purpose auditor use statistical sampling?

_______________________________________________________________________

Section2.4 Reporting audit Finding

An auditors report is the independent examination of, and expression of opinion on the financial statements
of the company by appointed auditors in pursuance of that appointment and incompliance with any
statutory obligations. The responsibility for the preparation of the financial statements and the presentation
of the information included therein rests with management of the company. The auditors ’ responsibility
under the companies Act is to make a report to the members of the company on the books of accounts and
financial statements besides others necessary and relevant documents examined by him/her/them.

The auditors report is, therefore, the means by which the auditors formally communicates the results of
his /her/audit to the members of the company as well as to the readers of financial statements, such as
creditors, financial institutions, and all others who have a stack in the company or wish to acquire a stake or
transact with the company. The messages that are communicated through the audit report are based on
various conclusions reached by the auditors in the course of his/her examination.

The auditors report does not guarantee the truth or otherwise of the matter reported upon; it is expression
of auditors’ opinion on the financial statements. That is, an auditors opinion on the financial statements.
That is, an auditor’s /auditors/ can not ascertain and state or certify the exact figure of various assets and
liabilities. All they can do is to report whether or not, in his opinion, the financial statements are true and
fair. Different auditors may form different opinion based on their exercises of judgment on the same set of
financial accounts. Thus, an auditor is not a guarantor or an insurer.

Confirmation Ideas Yes No

Ch eck-
list Can you plan the audit?

Can you perform the field works of auditing?

Can you apply sampling procedure?

Can you report the findings of the audit?

Important concepts of the unit are listed below. Evaluate your self by indicating a check mark ( ) in the
''Yes'' column if the check list item is clear to you or in the ''No'' column if the check list item is not clear.
Thus, if there is any item that is not clear to you to understand please reread the material and evaluate
yourself again and again until items are clear.
Summary

This duty explains the manner in which auditors plan an audit and design audit programs .To summarizes:

● Investigate a potential audit clients is essentials because auditors want to avoid accepting clients that have
unscrupulous management.

● When planning an audit the auditors are required to perform preliminary analytical procedures which
helps them to obtain a better understanding of the nature of clients business and identify accounts that
have higher risk of material misstatement
● The planning process is documented with audit planes, time budget and audit program. Audit program
generally include both a systems portions that focus on the clients internal control and a substantive
testing portion

Self Check Exercise 2

Part-I: Choose the Best Answer from the Given Choices

____1. Which of the following is not a part of the auditing process?

A- Preparation of the balance sheet and profit and loss account

B- Examination of vouchers accounts and records

C. Preparation of audit report

D. Discussion with offices ad staff of the enterprise to seek certain explanation

____2. The end product of Audit process is

A- Examination of books, accounts and errors of records

B- Ascertaining the compliance of the persons responsibility to keep the account

C- Prepare a report to the proprietor

D- Prepare the book of accounts

____3. Provides means of quantifying sample size

A-Statistical sampling B-Non – statistical sampling

C-Sampling risk D-Non-sampling risk

____4. Planning an audit is useful

A- To keep the audit cost fair B- To avoid understanding with the client

C-Both A and B D-None

____5. The sampling plan that enables the auditor to estimate the rate of occurrence of

certain characteristics in the population

 A- Variable sampling B-Attribute sampling

C-Statistical sampling D-Non- statistical sampling

____6. The audit plan is normally drafted

A-After starting audit engagement B- After the field work

C-Before stating field work D-All of the above

UNIT THREE

3. Obtaining Evaluating and Documentation Audit Data

Introduction

This duty covers the third important concept underlying the entire audit process. Evidential matter consists
of accounting data and all corroborative information that support the amounts included in the financial
statements. The third standard of field work states: sufficient, competent evidential matter is to be obtained
through inspection, observation, inquires, and confirmations to afford a reasonable basis for an opinion
regarding the financial statements under examination.

This standard indicates that on a typical financial statement audit most of the auditor ’s work involves
obtaining and evaluating evidence using procedures such as inspection and confirmations to test fair
presentation of the financial statements. To perform this task efficiently and effectively, an auditor must
thoroughly understand the important aspect of evidential matter. This includes understand how audit
evidence relates to financial statement assertion and the auditor ’s report, basic concepts of evidential
matter, types of audit evidence in the working papers. Each of this topic is covered in this duty.

General Objectives

Dear students after studying this chapter you should be able to:
 ● know the relationship between evidences and audit risk

● identify and explain the components of audit risk

● list and describe types of evidential matter

● understand the functions of audit work papers

● learn the types of working papers and the way they are organized.

Section 3.1 Over Viewing Nature of Evidential Matter in Auditing

3.1.1 Nature of Audit Evidence

Evidence is the information obtained by the auditor in arriving at conclusions on which their reports are
based. During financial statement audits, the auditors gather and evaluate evidence to form an opinion
about whether the financial statements follows the appropriate criteria, usually, generally accepted
accounting principles. The auditors must gather sufficient competent evidence to provide an adequate basis
for their opinion on the financial statements. The audit evidence is intended to assure the users of
accounting information that the financial statements are a credible source of information about the
organization. The users may not accept the auditor ’s opinion on the truth and fairness of financial
statements unless the auditor has collected sufficient competent evidence about the material
misstatements. Hence, the collection of evidence lies in the heart of the audit.

Hence, the requirement to obtain sufficient competent evidence is reflected in the third standard of field
work that states:

Audit risk which refers to the possibility that the auditors may unknowingly fail to appropriately modify their
opinion on financial statements that are materially misstated, can be greatly reduced by gathering evidence.
One way to gather additional evidence is to increase the extent of the audit procedures. However, additional
evidence may also be obtained by selecting a more effective audit procedure or by performing the
procedures closer to the balance sheet date.
The auditor must gather sufficient evidence to reduce audit risk to a low level in every audit and this concept
is reflected in the third standard of fieldwork. The evidence collected by the auditor must be sufficient and
appropriate.

3.1.2 The nature of assertions for financial statements

The nature of assertions for which the auditor collects evidences for an independent financial audit is
the following
1. Existence: the inclusion of an item of asset or liability in the balance sheet implies an assertion by the
preparer that the asset or the liability exists at the date of the balance sheet.
2. Rights and obligations: it is asserted that the assets shown in the balance sheet are the rights of the
organization and liabilities are the obligations on the date of the balance sheet
3. Occurrence: there is an assertion that the transactions reflected in the financial statements are occurred
during the relevant accounting period and that they pertain to the organization.
4. Completeness: this assertion implies that there are no unrecorded assets, liabilities or transactions.
5. Valuation: this assertion implies that the assets and liabilities are included in the balance sheet are at an
appropriate value i.e. as per the normally accepted bases of valuation.
6. Measurement: this assertion implies that transactions have been recorded at proper amounts and that
revenues and expenses have been allocated to the proper accounting periods
7. Presentation and disclosure: this assertion implies that the disclosure, classification and description of
various items in the balance sheet and in the income statements are in accordance with the generally
accepted accounting standards and relevant statutory requirements.
General audit objectives in financial statement audit are presented below:

Validity: deals with whether the amounts included in the financial statements should actually been
included.

Completeness: These objectives deals with whether all amounts that should be included have been include

Valuations: the correct valuation of the individual balances making up the totals account balances, including
the arithmetic accuracy of all calculations and recognition of declines in net realizable
values, the concern in this objective.
Classifications: involves determining whether items are included in the correct amounts and accounts are
properly displayed on the financial statements.

Disclosure: the auditor tests to make certain that balances sheet, income statement and related information
are correctly set forth in financial statement and properly described in the body and
footnotes to the financial statement

Activity 9
What does competences refers to in an audit evidences context?

---------------------------------------------------------------------------------------------------

3.1.3 Considerations that May affect the Auditor’s Judgment as to Sufficiency

The evidential matter supporting the assertions in a company ’s financial statements consists of the
underlying accounting data and all corroborating information available to the auditors. The third
fieldwork standard states that sufficient competent evidential matter should be obtained to afford a
reasonable basis for an opinion regarding the financial statements under audit. So the evidence
obtained by the auditor should be:
a. sufficient
b. competent

a. Sufficiency-the term sufficient relates to the quantity of evidence the auditor should obtain. The
amount of evidential matter that is considered sufficient to support the auditors ’ opinion is a
matter of professional judgment. The considerations that should be followed in evaluating the
sufficiency of audit evidence are
1. The amount of evidence that is sufficient in a specific situation varies inversely with the
competence of the evidences that are available. The more competent the evidence matter is, the
less the amount of evidence needed to support the auditor’s opinion
2. The need for the evidential matter is closely related to the concept of materiality. The more the
need for the materiality the more the evidence is required
3. The risk that the material misstatements in the financial statements may vary from engagement to
engagement and it depends on the factors such as the financial condition of the client, the line of
business, the internal control structure, the integrity of the management etc.
b. Competency -the competency of the evidential matter refers the quality of the evidence which
depends on its relevance and its validity. For the evidence to be relevant, it must apply/related/ to
the audit objective being tested. The validity of the evidence refers to its credibility or
believability which depends on the circumstances in which it is obtained.

The factors that generally affect the validity of the evidential matter are the:
 source from where the evidence is obtained i.e. whether external or internal
 effectiveness of the internal control system of the client company
 collection procedure of the evidence i.e. whether the evidence is obtained directly or
indirectly
 types of evidence i.e. whether they are documents or written representations or oral evidence
The competence of the evidential matter is increased when the auditors are able to obtain additional
information to support the original evidence. Thus, several pieces of related evidence may form a
package of evidence that has greater competence than do any of the pieces viewed individually.

Section 3.2 identifying the types of corroborating information available to the auditor

3.2.1 Types of Audit Evidence

The major types of audit evidences gathered by the auditor during audit are the following:
1. Physical evidence:
Actual physical examination or observation provides the best evidence of the existence of certain
assets. The existence of the property may be established through physical examination. For
example, the existence of plant assets, inventory, cash etc can be verified by the physical
examination. It might seem that physical examination of an asset would be conclusive
verification of all assertions relating to that asset. It may not be always true. Physical verification
gives evidence of the existence of the asset to the auditor.

2. Documentary evidence
Another types of evidence relied upon by the auditor is the documents. The worth of the
documentary evidence depends on whether the documents are created within the company (sales
invoices) or it came from outside the company (vendors invoice). Some times the documents
created within the organization are sent outside for endorsement and processing and these
documents are regarded as very reliable evidence. In accepting the reliability of the documentary
 evidence, the auditor should consider whether the document is of a type that could easily be
forged or created in its entirety by a dishonest employee. The documentary evidence is classified
into three categories and they are
a. Documents created outside the organization and transmitted directly to the auditor- the
most reliable documentary evidence consists of documents created by independent parties
outside the organization and transmitted directly to the auditors without passing through
the client’s hands. For example, the verification of accounts receivable
b. Documents created outside the organization and held by the organization-many of the
externally created documents referred to by the auditors will be in the possession of
organization. For example, bank statements, vendor’s invoices and statements, property
tax bills notes receivables etc.
c. Documents created and held within the organization- most documents created within the
organization represent a lower quality of evidence because they circulate only within the
company and do not receive critical review by an outsider. For example, the sales
invoices, shipping notices, purchase orders etc. The degree of reliance to be placed on
documents created and used only within the organization depends on the effectiveness of
the internal control. If the accounting procedures are so designed that another person
must critically review a document prepared by one person and if all documents are
serially numbered and all numbers in the series accounted for, these documents may
represent reasonably good evidence. Adequate internal control will also provide for
extensive segregation of duties so that no one handles a transaction from beginning to
end.

3. Accounting records as evidence

The dependability of ledgers and journals as evidence is indicated by the extent of internal control
covering their preparation. An auditor will attempt to verify an amount in the financial statements by
tracing it back through the accounting records. They will ordinarily carry this process through the
ledgers to the journals and vouch the item to such basic documentary evidence. To some extent, the
ledger and journals constitute worthwhile evidence in themselves to the auditors

4. Evidence from the analytical procedures

 Analytical procedures involve evaluations of the financial statements by a study of relationships
among financial and no financial data. The process of analytical procedures consists of four
steps:-
a. Develop an expectation of an account balance
b. Determine the amount of difference from the expectation that can be accepted without
investigation
c. Compare the account balances with the expected account balance
d. Investigate the significant deviations from the expected account balance
Techniques used in performing analytical procedures range from complex models involving
many relationships and data from many years. For example, comparison of revenue and
expense amounts for the current year to those of the previous years and to the industries
average.

5. Evidence from computations

To prove the arithmetical accuracy of the client ’s records, the auditor make computations
independently as another form of audit evidence. Computations verify the mathematical
processes and used to prove the calculation of the client.

6. Evidence provided by the specialists

Since the auditors may not be experts in all the fields of business of the client, he may get the
services of the experts in performing highly technical tasks such as valuation of inventory, or
making the actuarial computations to verify liabilities for postretirement benefits. The expert
should be independent person. If the auditor feels that the expert is not an independent person, he
may perform additional procedures or engage another specialist.
7. Oral evidence
During the examination of records, the auditor may ask many questions to the officers and the
employees of the organization on the endless topics ranging from the location of records and
documents, the reasons underlying an unusual accounting procedures, the probabilities of
collecting a long past due accounting receivables etc. The answers the auditor receives to the
questions constitute another type of evidence.
8. Evidence from client representation letters
 The auditor should get a representation letter from the client summarizing the most important oral
representations made during the engagement. These letters are dated as the last day of the
fieldwork and usually signed by the chief executive officer and chief finance officer. Most of the
representations fall into the following categories
1. All accounting records, financial data and minutes of the directors meetings have been
made available to the auditors
2. The financial statements are complete and prepared in conformity with the generally
accepted accounting principles
3. All items requiring disclosure have been properly disclosed

Section 3.3 Identifying Auditing Procedures for Tests of Transactions and Balances

3.3.1 Meaning of Auditing Procedure

Are steps of actions taken in the process of gathering audit evidence to verify or accomplish specific task or
audit objective. Auditors’ uses a variety of audit techniques to obtain corroborating information. Some of
the common types of audit procedures are as follows:

 Physical examination: it means to view physical evidence of asset. For example, the auditors might
physically examine plant, equipment, or inventory items to obtain evidence as to their existence or
condition.
 Confirmation: it is the process of obtaining and evaluating a response from a debtor, creditor or
other parties in reply to a request for information about a particular item affecting the financial
statements.
 Comparison: it is the process of agreeing or contrasting two different sources of information.
Auditors often use comparison to test information at various stages of processing within the
accounting system.
 Tracing: it is the process of establishing the completeness of transaction processing by following a
transaction forward through the accounting records i.e. from the source document to the recorded
transaction.
 Vouching: it is the process of establishing the occurrence or valuation of recorded
transactions by following transaction back to supporting document from a subsequent
processing step
 Re-performance: is the process of repeating a client activity. For example the auditors may
recalculate the depreciation or re-perform the bank reconciliation statement. Re performance
may include:-
1. Footing is the process of proving the totals of a vertical column of figures
2. Cross-footing is the proves of proving the totals of horizontal row
3. Extending is the process of re-computing by multiplication.
 Observation: it is the process of viewing a client activity. For example, the auditors may
observe the application of internal control procedures such as the client ’s inventory taking
procedures.
 Inspection: it involves a reading or point-by-point review of a document or record. For
example the auditor may inspect the loan agreement document.
 Reconciliations: it is used to establish agreement between two sets of independently
maintained by related records. For example, the cash in bank in the ledger account is
reconciled with the bank statement.
 Inquiries: these are the questions directed towards the appropriate client personnel. The
response to the questions may be written or oral. The term inquiry is also sometimes used to
refer to the technique of questioning parties outside the organization.
 Analytical procedures: they are the evaluations of financial information made by a study of
expected relationships among financial and non financial data. For example, the auditor may
analyze the financial ratios of the current year with the ratios of the previous years.

Activity 10
When gathering audit evidences ,auditors use various types of audit techniques at
least five of these procedures
___________________________________________________
Section 3.4 Identifying the Purpose of Auditor’s Working Paper
3.4.1 Nature of Working Papers

Working papers are the connecting link between the client ’s accounting records and the auditors ’ report.
They document all of the work performed by the auditors and provide the justification for the auditors’
report. Information such as audit contact entered to, audit plans, audit programmers and data gathered ,
description of work performed , documents received, peoples interviewed, items traced and reconciled ,
events and incidents encountered , evidences gathered , schedules, experts and photocopies of financial
statements and accounts, references comments and observations noted --- etc, are documented in auditors
work papers. The sufficient, competent evidential matter required by the third standard of field work must
be clearly documented in the auditors work papers.

3.4.2 Functions of Audit Work Papers

Audit working papers assist auditors in several major ways such as the following.

Assigning and coordination the audit work: The audit work may be conveniently delegated by assigning
different auditors responsibility for completing different working papers. In case of joint audit, the work
done by different auditors can be coordinated through the working papers

Supervising and reviewing the work of the assistants: The audit assistants complete audit working papers
and the seniors, supervising the audit work, can review it. If the senior finds any shortcoming, the senior can
write review notes to the assistants describing additional procedures to be performed or how the working
papers should be revised. The review of working papers by seniors will help to ensure that the work of audit
staff is carefully reviewed and supervised.

Support for the report: the working papers must contain adequate evidence and documentation to convince
the auditors’ engagement. This will help the auditors to arrive at appropriate opinion on the client ’s financial
statements. The auditors want some evidence to support their reports and audit working papers can rely on
the evidence contained in the working papers

3.4.3 Types of Audit Work Papers

There are numerous types of working papers as the audit working papers document a variety of information
gathered by the auditors. The general categories into which most working papers may be grouped are

1. Working Trial Balance: It is the schedule listing the balances of the accounts in the general ledger for the
current and previous year and also providing columns for the auditors ’ proposed adjustments and
reclassifications and for the final amounts that will appear in the financial statements

2. Lead Schedules: these are also called as the grouping sheets or summary schedules and are set up to
combine similar general ledger accounts. The totals will be appearing on the working trial balance as a
single amount.

3. Adjusting Journal Entries and Reclassification Entries: To correct material errors or irregularities
discovered in the financial statements and accounting records, the auditors draft adjusting journal entries

4. Corroborating Documents: Auditing is not limited to the examination of financial records, and working
papers are not confined to schedules and analyses. During the course of an audit, the auditor gathers
much purely expository material to substantiate their report.

5. Analysis of Ledger Accounts: An analysis of a ledger account is another common type of audit working
paper. The purpose of an analysis is to show on one paper all changes in an asset, liability, equity,
revenue, or expense account during the period covered by the audit.

Section 3.5 Working Paper Files

The auditors usually maintain two files of working papers for each client:

1. Current files for every completed audit and

2. A permanent file of relatively unchanging data.
The Current files: - The auditor’s report for a particular year is supported by the working papers contained in
the current files. Many CPA firms have found it useful to organize the current files around the arrangement
of the accounts in the client’s financial statement. Each working paper in a file is assigned an index number,
and information is tied together through a system of cross-referencing.

The Permanent File: - The permanent file serves three purposes to:

a) refresh the auditor’s memories on items applicable over a period of many years
b) provide for new staff members a quick summery of the policies and organization of the client and
c) preserve working papers on items that show relatively few or no changes, thus eliminating the
necessity for their preparation year after year.

3.5.1 Ownership of the Audit Work Papers

Audit working papers are the property of the auditors and not of the client. At no time does the client have
the right to demand access to the auditor ’s working papers. After the audit, the auditors retain the working
papers. Clients may sometimes find it helpful to refer to information from the auditor ’s working papers from
prior years. Auditors usually are willing to provide this information, but their working papers should not be
regarded as a substitute for the clients own accounting records.

3.5.2 Confidential Nature of Working Papers

To conduct a satisfactory audit, the auditors must be given unrestricted access to all information about the
client’s business. Much of this information is confidential, such as the profit margin on individual products,
tentative plans for business combinations with other companies, and the salaries of officers and key
employees and other similar issues.

Much of the information gained in confidential way by the auditors is recorded in their working papers’
consequently; the working papers are confidential in nature. Thus, they must be safeguarded at all times.
Safeguarding working papers usually means keeping them locked in a file cabinet or an audit case during
lunch and after working hours.
 Confirmation Ideas Yes No

Can you describe the natures of evidential matters in auditing

C heck
Can you understand the competency of evidential matter
-list
Can you list the corroborating information available to the auditor

Can you explain substantive & compliance test

Can you explain the purpose of working paper

Important concepts of the unit are listed below. Evaluate your self by indicating a check mark ( ) in the
''Yes'' column if the check list item is clear to you or in the ''No'' column if the check list item is not clear.
Thus, if there is any item that is not clear to you to understand please reread the material and evaluate
yourself again and again until items are clear.
Summary

This chapter focuses on the concept of sufficient competent evidential matter and the manner in which this
evidence is documented in the audit working paper to summarize:-

▪ The third standard of field work requires the auditors to obtain sufficient competent evidential matter to
support to their audit opinion. To be competent, evidence must be both relevant and valid.

▪ Evidence is gathered by the auditors to reduce audit risk the risk of failing to modify their opinion on
financial statements that are materially misstated.

▪ Auditors must be especially careful in considerably financial statement accounts that are affected by
estimates made by management such as the allowance for allowance doubt full accounts.

 Self Check Exercise

Part-I: Choose the Answer from the Given Choices

_____1. The information obtained by the auditor in arriving at conclusion on which their reports are based

A. Audit data B. Audit evidence C. Audit Sample D. None of the above

_____2. In order to reduce the audit risk at the lower level

A. Auditor must gather information daily B. Auditor must gather sufficient evidence
C. Auditor must prepare statement D. None of the above

_____3. An assertion that implies an asset and liability are included in the balance sheet at

appropriate value
 A. Completeness B. Occurrence C. Rights obligation D. Valuation

_____4. An assertion that implies an asset or liability exists at the date of the balance sheet

A. Rights and obligation B. Occurrence C. Existence D. Valuation

_____5. The evidence obtained by the auditor should be

A. Complete B. Competent Sufficient

C. Complete efficient D. All of the above

_____6. The term Competency refers to

A. The quality of information B. The close relatedness of information

C. The quantity of information D. None

_____7. The worth of the documentary evidence depends on

A. The source from share it is created B. Physical examination or observation

C. Expectation of an account balance D. Evidence from computation

_____8. The process of analytical procedure consists of

A. Develop an explanation of an account balance

B. Compare the account balances with the expected account balance

C. Determine the amount if deferens from the exception that can be accepted without
investigation D. All

_____9. Of the following which one is not correct about functions of audit working papers

A. Assigning and coordination the audit work

B. Compliance with the three standards of field work

C. Support for the report D. None

_____10. Is the schedule listing the balance of the accounts in the general ledger for the current and
previous year

A. Working trial balance B. Audit administrative working paper

 C. Supporting schedules D. Analysis of ledger accounts

UNIT FOUR

4. Study and Evaluation Internal Control

Introductions

Dear learner our consideration of internal control in this duty has three major objectives: first, to explain
the meaning and significance of internal control; second, to discuss the major components of a client ’s
internal control structure; and third, to show how auditors go about obtaining and understanding of
internal control to meet the requirements of the second standard of field work.

General Objective

Dear learner after studying this chapter, you should be able to:

- Define what is meant by internal control

- Distinguish among the components of a client ’s internal control, the control environment, risk
assessment, the (accounts) in formation and communication system, control activates and monitory.
- Learn the technique used by auditors to obtain an understanding internal control

Section 4.1 Describing Importance of Internal Control

Definition of Internal control

? Check your progress

In your words can you try to define the meanings o f internal control

(you can use the space left below to write your responses)

_______________________________________________________________
Internal control is the plan of the organization and all the methods and procedures adopted by the
management of an entity to assist in achieving management’s objective of ensuring, as far as practicable, the
orderly and efficient conduct of its business.

In other words, internal control is defined as a process, effected by the entity ’s board of directors,
management, and other personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories:

 effectiveness and efficiency of operations

 reliability of financial reporting
 compliance with applicable laws and regulations
It includes the methods by which top management delegates authority and assigns responsibility from such
functions as selling, purchasing, accounting, and production. Internal control also includes the program for
preparing, verifying and distributing to various levels of management those current reports and analyses
that enable executives to maintain control over the variety of activities and functions that are used by a
large organization.

Although internal control is broadly defined, not all of the internal control structure polices and procedures
are relevant to a given engagement at hand i.e. they may vary depending on the type, nature and scope of
engagement, areas of concern and so on. Generally the internal control structure policies and procedures
that are relevant to an audit are those that pertain to the reliability of financial reporting. That is, those that
affects the preparation of financial information for external reporting purpose. However, other policies and
procedures may be relevant if they affect the reliability of data that the auditors use to apply auditing
procedures.
For example, controls applicable to non financial data that the auditors use in performing analytical
procedures (e.g. production statistics) may be relevant to an audit. The internal control structure policies
and procedures designed to safeguard assets against loss from errors and irregularities are ordinarily
relevant to audit

4.1.1Importance of Internal Control

? Check your progress

Write at least five points about the purpose of internal control

________________________________________________________

The importance of establishing and maintaining effective internal control are to:

 aid management in information, protection and control.

 protect assets from theft, loss, damage, spoilage wastage etc
 prevent errors and frauds in advance before they occur
 assure accuracy and dependability of personnel and financial operation
 monitor operating efficiency
 monitor adherence to prescribed policy and procedure
Activity 11
What are some the primary purpose of internal control?

___________________________________________________

Section 4.2 Identifying the Four Components of Internal Control Structure

? Check your progress

Can you discuss about the two categories of internal control system

(You can use the left below to write your responses.)

__________________________________________________________
An internal control system has a wide coverage that extends beyond those matters, which relate directly to
the functions of the accounting system and from this angle, the internal control system can be divided into
two categories:-

 Accounting controls
 Administrative controls
1. Accounting controls:-Those controls which are related to the accounting system is known

as the accounting controls and has the following objectives:

a. Transactions are executed in accordance with the management ’s authorization, i.e. in accordance
with the laid down policies and procedures
b. Transactions are promptly recorded in a proper manner and the purpose is to facilitate the timely
preparation and communication of reliable financial information.
c. Accountability for assets is maintained and assets are safeguarded from unauthorized access, use or
disposal.
To achieve the objectives of internal control system, it is necessary to establish adequate policies and
procedures. While the specific control policies and procedures depend on the nature of the transactions,
manner of information processing and similar factors, most of these policies and procedures generally fall
into the following categories

1. Segregation and rotation of duties

2. Authorization of transactions
3. Maintenance of adequate records and documents
4. Accountability for and safeguarding of assets
5. Independent checks on perform

Activity 12

?What are the objectives of internal control so far as financial and accounting aspects are
concerned?

_______________________________________________________________
2. Administrative controls-It comprises of internal controls other than accounting controls. The
maintenance of records giving details of customers contacted by the salesmen is the example of
administrative control. Another example of an administrative control is the system of a periodic review,
by specially designated authorities, of the adequacy of the action taken on the customer ’s complaints.
Means of achieving Internal Control- For purposes of financial audits, the policies and procedures used
by an entity to achieve internal control are referred to as the entity ’s internal control structure. Internal
control structure vary significantly from one organization to the next, depending on such factors as the
size, nature of operations, and objectives of the organization for which the structure was designed. Yet
certain features are essential to satisfactory internal control in almost any large organization.

Section 4.2.1 Elements of Internal Control Structure

? Check your progress

Can you identify the elements of internal control

_______________________________________________________________

The elements of internal control structures of all organizations include five components. These are:

1. the control environment

2. risk assessment
3. the accounting information and communication system
4. control activities; and
5. monitoring

1. Control Environment
The control environment sets the tone of an organization by influencing the control consciousness of the
people. It is viewed as the foundation for the other components of internal control. The following are the
major control environment factors:

a. Integrity and Ethical values-the effectiveness and efficiency of the internal control structure depends
directly upon the integrity and ethical values of the personnel who are responsible for creating,
administrating, and monitoring that structure. Management should establish behavioral and ethical
standards that discourage employees from engaging in activities that would be considered dishonest,
unethical or illegal. The standards must be communicated by appropriate means and also remove and
reduce the temptations and incentives to engage in such behavior.

b. Commitment to competence-the employees employed must be competent enough to perform the

assigned tasks. They must posses the skills and knowledge essential for the performing the jobs and
also in applying the internal control policies and procedures. The employees appointed should have
adequate education and experience and should provide adequate training and supervision.

c. Board of Directors or Audit Committee-the effectiveness of the Board of Directors or Audit

Committee will significantly influence the control environment. The extent of its independence from
the management, the experience and stature of its members, the extent to which it raises and pursue
the difficult questions with the management and its interaction with the internal and external auditors
will improve the effectiveness of the internal control system. The independence of the Board of
Directors or the Audit Committee enables it to be effective at overseeing the quality of the
organization’s financial reports, and act as a deterrent to management override of internal controls
and to management fraud.
d. Management’s philosophy-management philosophies will differ towards financial reporting and
towards taking business risks. Some may be very aggressive in financial reporting and may be
willing to take great risks, while others may be conservative and risk adverse. The differing attitudes
and styles may have an impact on the overall reliability of the financial statements. The internal
control in an informal organization will be implemented by face to face contact with employees and
in formal organization, it will establish written policies, performance reports, and exception reports
to control its various activities.
e. Organizational structure-another factor affecting the control environment is the organizational
structure. A well-designed organizational structure provides a basis for planning, directing, and
controlling operations. It divides authority, responsibilities and duties among members of the
organization by dealing with such issues as centralized versus decentralized decision-making and
appropriate segregation of duties among the various departments. When the management decision-
making is centralized and dominated by one individual, that the individual ’s moral character is
extremely important to the auditors. When decentralized style is used, procedures to monitor the
decision making of the many managers involved become equally important.

f. Human resource polices and procedures-the effectiveness of the internal control is affected by
the nature and characteristics of the people working in the organization. The management ’s policies
and practice pf hiring, training, evaluating, promoting and compensating employees have a
significant effect on the effectiveness of the control environment. Effective human resource policies
often can reduce or sometimes remove other weaknesses in the control environment.

g. Assignment of Authority and responsibility

The employees in the organization should have a clear understanding of their responsibilities and rules and
regulations that govern their actions. To enhance the control environment, the management should develop
employee job descriptions and should define clearly the authority and responsibility within the organization.
Policies should be established describing appropriate business practices, knowledge and experience of the
key personnel and the use of resources.

2. Risk Assessment
The second component of internal control is the risk assessment. The management should carefully consider
the factors that affect the risk of an organization. The risks affecting the preparation of financial statements
in accordance with the generally accepted accounting principles (GAAP) should be considered in the
financial reporting objective. The factors that affect the increased financial reporting risks are the following:

 Changes in the organization’s regulatory or operating environment

 Changes in personnel
 Implementation of a new or modified information system
 Rapid growth of the organization
 Changes in technology affecting production process or information system
 Introduction of new lines of business, products or process
The scope of management’s risk assessment is more comprehensive and it considers all factors affect
the organization. But the auditors are concerned with the levels of inherent risk and control risk that
affect the organization’s ability to produce financial statements that are in accordance with the
generally accepted accounting principles.
3. The Accounting Information System

Accounting information and communication systems capture, process, and report information to be used by
parties both within and outside the organization. An organization ’s accounting information system consists
of the methods and records established to identify, assemble, analyze, classify, record, and report an entity ’s
transactions and to maintain accountability for the related assets. Accordingly, an accounting information
system should:

1. identify and record all valid transactions.

2. describe on a timely basis the transactions in sufficient detail to permit proper classification of
transactions for financial reporting.
3. measure the value of transactions in a manner that permits recording their proper monetary
value in the financial statements.
4. determine the time period in which transactions occurred to permit recording of transactions in
the proper accounting period.
5. present properly the transactions and related disclosures in the financial statements.
In addition to the typical system of journals, ledger, and other recordkeeping devices, an accounting
information system should include a chart of accounts and a manual of accounting policies and procedures
as aids for communication of policies.

Chart of accounts is a classified listing of all accounts in use, accompanied by a detailed description of the
purposes and content of each.

A manual of accounting policies and procedures states clearly in writing the methods of treating
transactions. In combination, the chart of accounts and manuals of accounting policies and procedures
should provide clear guidance that will allow proper and uniform handling of transactions.

4. Control Activities
The policies and procedures that help the management to carry out the directives are known as the control
activities. These policies and procedures will help the management to ensure that the actions are taken to
address the risks that affect the organization. The following are the control activities that are relevant to an
audit of the organizations financial statements:

 performance reviews
  information processing
 physical controls
 segregation of duties

5. Monitoring

Monitoring is a process that assesses the quality of the internal control structure over time and it is the last
component of internal control. The monitoring of the internal control structure is important to determine
whether it is operating as intended and whether any modifications are necessary. Monitoring can be
achieved by

a. Ongoing monitoring activities include regularly performed supervisory and management activities
such as continuous monitoring of customer complaints or reviewing the reasonableness of the
management reports.
b. Separate evaluations are monitoring activities that are performed on a non-routing basis, such as
periodic audits by the internal auditors. Internal auditors investigate and appraise the internal
control structure and the efficiency with which the various units of the organization are performing
their assigned functions, and report their findings and recommendations to the top management.

Section 4.3 Identifying the Elements of Control Procedures

4.3.1 Limitations of Internal Control

Internal control can do much to protect against both errors and irregularities and ensure the reliability of
accounting data. Still, it is important to recognize the existence of inherent limitations in any internal control
structure.

 Internal control is not simple; it could be complex as it involves divisions of functions and allocation
of responsibilities into many different people and units involving greater paper work leading to
excessive control. This way, many people in fact think of more control but not better control. More
 control brings bottle neck, therefore, inefficiency not efficiency, and delays and loss in productivity.
Thus there is control risk that must be assumed to balance between risk and safeguards to be
implemented. Internal control can only provide reasonable assurance not complete reliance to be
placed.
 Mistakes may be made in the performance of internal control policies and procedures as a result of
misunderstanding of instructions, mistakes of judgment, carelessness, distraction, or fatigue.
 The internal control adopted by a business also is limited by cost considerations. It entails
increased personnel and /or sophisticated techniques of control. Thus, cost- benefit analysis must
be made to see if the costs of control can justify the benefits to be derived. In this regard, internal
controls may be more viable to implement in large organizations rather than in small organizations.

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a check mark ( ) in the
''Yes'' column if the check list item is clear to you or in the ''No'' column if the check list item is not clear.
Thus, if there is any item that is not clear to you to understand please reread the material and evaluate
yourself again and again until items are clear.

Confirmation ideas Yes No

Can you define internal control?

Can you describe the importance of internal control?

Can you distinguish the components of internal controls structure?

Can you list the factors of control environment?

Summary
This duty explained the meanly and significance internal control, the major components of the clients’
internal control and the manner in which auditors consider internal control-to summarizes:

1. Internal control is a process affected by the entity’s board of director ’s management and other
personnel. Designed to provide. Reasonable assurance regarding the achievement of objectives in
the categories of:
a. effectiveness and efficient of operations

b. reliability of financial reentry and

c. compliance with applicable lows and regulations.

2. The five components of internal control include the control environments risk assessment, the
accounting information and communication system control activities and monitoring. The portion of
internal control relevant to auditors is that which pertains to the entity ’s ability to prepare reliable
financial statements.

3. The auditor’s considerations of internal control are performed to obtain information

necessary to plan the audit and assess control risk.

 Self Check Exercise
Choose the Best Answer from the Given Choices

_____1. Which of the following factors influence (s) the internal control environment of an enterprise

A. Managements philosophy and operating style

B. The organizational structure of the enterprise

C. A and B D. All of the above

_____2. The general control procedure which applies to all organizations through out

account system includes.

A. Competent truth worthy personnel and rotation of duties

B. Assignment of responsibility C. Segregation of duties D. All of the above

_____3. Which of the following statements best described the relationship between internal

control and internal audit?

A .internal audit is a part of the internal control system

B .Internal control is apart of internal audit

C .internal control and internal audit are different techniques of exercising control
 over the functions an enterprise which can be operated simultaneously

D. All except B

_____4. Which of the following is not true about internal control?

A .internal control is means to an end

B. internal control is an end in and of itself

C. internal control addresses the achievement of objectives

in the area of financial reporting operations and compliance.

D. none of the above

_____5. Proper segregations of function responsibilities calls for separations of the.

A. Authorization, record keeping and custodial function.

B. authorization, execution and payment function

C .receiving, shipping, and custodial function

D authorization, approval and execution function

UNIT FIVE

5. Auditing Cash

5.1 Evaluating Internal Control over Cash

 Definition and Nature of Cash

Cash: - Cash normally includes general, payroll accounts, petty cash fund, saving accounts, marketable
securities and other cash equivalents such as money market funds, certificate deposit, saving certificates
and other similar types of adiposities. On other hand, the liquid nature of cash increases the risk of
undetected fraud. Cash sale, collection of receivables and investment of additional capital typically increase
the cash account; business expenditure decreases it. Under a term of a bank loan agreement, cash in a
company’s general account some times must be maintained at a specified minimum balance, referred to us
compensating balance

Section 5.2 Auditing Cash Receipts

Audit of receipt of cash is a significant aspect of financial statement audit. This is because cash receipts
affect almost all accounts relating to balance sheet and income statement. Moreover this area is prone to
error and fraud

The most difficult type of defalcation to detect by the auditor is when cash is taken before it is recorded. For
example, a cashier may take the money with out recording the transactions unless the customer requests
written receipts. This is very difficult for auditors to detect. But such deflections can be prevented if the
client establishes strong internal control.

5.2.1 Auditing cash sales

Cash sales often constitute a substantial part of collection of a business organization. Most of the functions
relating to cash handling are the responsibility of finance department, under the direction of
treasurer .These functions include handling and depositing of cash receipts of cash ;signing checks; investing
idle cash; and maintain custody of cash, marketable security and other negotiable asset.

The functions of finance department and accounting department should be integrated in a manner that
provides assurance that

1. All cash should have been received was in fact received, recorded accurately, and deposited promptly.

2. Cash disbursements have been made only for authorized purpose and have been properly recorded

3. Cash balances are maintained are adequate, but not excessive.

5.2.2 The Auditor’s Objectives in the Audit of Cash

The auditor’s objectives in the audit of cash are to:

(1) consider internal control over cash transactions

(2) substantiate the existence of recorded cash
(3) establish the completeness of recorded cash
(4) determine that the client has rights to recorded cash
(5) establish the clerical accuracy of cash schedules
(6) determine that the presentation and disclosure of cash, including restricted funds (such as
compensating balances and bank sinking funds) are appropriate.
As in the case with other assets, auditors are especially concerned with the possibilities of overstatements of
the cash accounts; therefore, objective two i.e. the existence of recorded cash, is of utmost importance.

Study and evaluation of accounting and internal controls include:

 examining whether the authority to execute sales. receive the payment, and deliver the goods in
assigned to different persons;
 examining whether there is a system of maintaining up to date price lists and of verifying the
prices to be charged with such price lists;
 examining whether there is a system of proper authorization of discounts and refunds to be
given to customers; and
 examining whether cash receipt vouchers are pre – numbered, and whether the unused cash
receipt vouchers are kept under the custody of a responsible official.

5.2.3 Substantive Procedures

You have to apply the following substantive procedures in auditing cash sales:
  check the prices charged, docents allowed, and rates of sales tax charged, as shown in the cash
receipt vouchers to ensure that they are proper and duly authorized;
 check the arithmetical accuracy of cash receipt vouchers
 compare the copies of the cash receipt vouchers with the daily cash sales summary sheet;
 check the arithmetical accuracy of the daily cash sales summary sheets and the entries in the
cash receipt journal;
 if the cash sales are recorded through mechanical cash registers, compare the licked-in totals
provided by the cash register with the recorded receipts in the cash receipt journal; and
 examine the classification of cash sales to ensure that the credit is recorded to correct accounts.

5.2.4 Auditing credit sales and cash collections from Credit Sales.

An essential part of the auditor’s task is identifying weaknesses in controls that increase risk of fraud. In
auditing cash receipts, the auditor has to collect sufficient audit evidence to obtain reasonable assurances
on the following assertions:

(1) occurrence: the receipts recorded in the accounts represent amounts actually received by the
organization during the period under audit.
(2) completeness: the receipts that took place during the period under audit have been recorded in
the books of accounts.
(3) measurement: this includes:
(a) cash receipts have been recorded at appropriate amounts.
(b) receipts have been properly classified between revenue and capital and further under
appropriate account heads. for example, if certain receipts represent income of future
periods, they have to be classified as income received in advance.
(c) cash receipts have been arithmetically accurate.

(4) presentation and disclosure: this includes the following essential points:
(a) cash Receipts have been properly classified and disclosed under appropriate account
heads in the financial statements.
(b) the disclosure of cash receipts in the financial statements is in accordance with
recognized accounting principles and relevant statutory requirements.
The audit procedures you apply should be designed to help you collected sufficient relevant audit evidence
about the reliability of cash receipts. You will be able to achieve this by applying the following steps:

 studying the accounting system and internal controls in relation to receipts and evaluation them
through compliance testing procedures.
 testing transactions relating to cash receipts and applying analytical procedures.

5.2.5 Study and Evaluation of Accounting System and Internal Controls

The study and evaluation of internal controls assumes special importance in the case of audit of receipts
since much of the evidence in support of receipts is internal. Its reliability, therefore, depends on the
existence of an effective internal control system.

The auditor examines the internal controls over receipts with reference to the following:

 segregation and rotation of duties:

 procedures for authorization
 maintenance of records and documents:
 accountability for and safeguarding of, assets; and
 independent checks.
Segregation and rotation of duties: to evaluate whether there is segregation of duties, the auditor raises
the following questions are:

 a the duties relating to cash receipts so allocated than no single person has exclusive control
over and entire transaction: The duties should be so allocated that no individual can override
the control system? For this purpose, there should be a proper segregation of those duties
whose combination may permit the commitment or concealment of fraud or error. As far as
possible, there should be segregation of duties relating to (a) receipts or cash, checks, drafts,
etc... (b) Deposit of cash, checks, drafts, etc, into the bank,(C) accounting of cash receipts, and
(d) reparation of bank reconciliation statements. Wherever possible, there should be a further
segregation of duties of recording the receipts in the cashbook and posting of receipts in the
relevant ledger accounts.
 a the duties of the various relating to receipts rotated periodically?
Procedures for authorization: to ensure whether there is proper procedure for authorization, the
auditor has to raise the following questions:
 are cash, check received only by persons authorized to do so?
 is there a clear-cut policy regarding of cash discounts and rebates, issue of credit notes, etc? are
the authorities which are entitled to grant cash discounts/rebates clearly specified in the policy
along with the broad limits within which they can operate?
 what are the controls over miscellaneous receipts like sale of scrap/waste, etc.? Are these
transactions executed under the supervision of a responsible officer?

Maintenance of records and documents: one of the qualities of strong internal control system is the
existence of adequate system of records and documents. To ensure that your client has an adequate
system of records and documents, you have to ask the following questions:
 is there a system of issuing receipts in all cases, or receipts issued only if so required by the parts
making the payment? What are the controls in the latte date?
 what are the controls to ensure that the details on counterfoils/copies of receipts are the same
as those on the original receipts? for example, one method of ensuring this is the use of receipts
having automatic carbons where by anything written on the original gets automatically
transcribed on the copy . Alternatively, cash receipt can be issued through the automatic cash
register.
 Accountability for safeguarding of assets: to ensure that the client has established accountability for
assets and has designed prior safeguarding for assets, the auditor should raise the following questions:
 is the person responsible for opening the mail containing remittances required to prepare
immediately a list of all check, draft, etc, and mark them “for deposit only”?
 are all check drafts, cash which are received deposited on the same day this control procedure is
particularly important

Independent checks: to ascertain that cash receipts are free of material error or fraud, the client has
to establish a system of independent check. To this end, you have to ask if receipts are regularly audited by
an internal auditor. Moreover, cash should be counted on surprise basis periodically by an internal auditor
or another independent official who does not have any duties relating to handling of cash or related
activities.

Testing transactions relating to cash receipts (substantive procedures)

After evaluation the internal controls, the auditor carries out substantive procedures. These procedures
involve:

(1) tests of individual transactions; and

(2) analytical procedures. The following are the audit procedures auditors apply insetting transactions
relating to cash recipients:

(3) examine the entries in the cash book/cash receipt summary with reference to the copies of cash receipts
or cash memos. In examining the copies of receipts, you have to pay special attention to the following:-

 Date: the date on the receipt agrees with the cashbook

 Account credited: the proper account correctly.
 Amount: the amount has been recorded correctly
 Cutting/overwriting: there is no overrating and all corrections are properly made under the
signature of tan authorized officer.
(4) Compare the copies of pay-in –slips relating to deposits of check drafts into the bank

Automatic cash register is a machine which locks in the totals of the transactions recorded in the
machine. When ever a transaction is recorded in the machine and the cash drawer is opened, a bell
 rings, confirming that the transaction has been recorded. The machine also shows the amount of the
transaction on a panel facing the customer. Simultaneously, the machine prints a receipt which is
handed over to the customer. The amount of the receipt is then recorded on a locked-in tape. After the
business hours, the physical cash is counted and compared with the locked in total by the supervisor.
Use of automatic cash registers is common in supermarkets, restaurants, etc

(5) Examine the bank reconciliation statements.

(6) Check the arithmetical accuracy of the cash receipt sheets and their recording in the cash book.

(7) Check the posting of the entries relating to receipts in the relevant ledger accounts.

(8) check the transfer of money from one bank to another, especially which have taken place around the
date of closing of accounts. This procedure may uncover kiting. Kiting will be discussed in task 4 of this
duty.

(9) Review the cash book or cash receipt summary sheets to identify any unusual items.

(10) Apply appropriate analytical procedures to judge the overall reasonableness of recorded receipts.

(11) Examine whether the receipts have been properly classified and disclosed under appropriate accounts
in the financial statements in accordance with GAAP.

Activity 13
While evaluating the income statement over cash receipts in an enterprise, you observe the
financial weakness in the design and operation of the system. State for each weakness the resulting
error(s) or fraud (s) that could arise or remain undetected. Also state and audit procedure that you
would employ in view of each weakness.

a) There is no regular system of preparing bank reconciliation statements. The employee who
performs this task is in your assessment, incompetent and reckless.
b) Miscellaneous receipts are handled and recorded by the same person.
c) There is no system of obtaining periodic confirmation of balances form customers.
Section 5.3 Auditing Cash Payments

5.3.1 Check Payments

Organization should make payments using checks and use petty cash for small payments in order to exercise
control over cash payments. The principal reason for using checks is to obtain evidence of receipt form the
payee in the form of an endorsement on the check. Other advantages of using checks include (1) the
centralization of disbursement authority in the hands of a few designated officials –only officials authorized
to sign checks: (2) a permanent record of disbursements; and (3) a reduction in the amount of cash kept in
hand.

To maximize the benefits from using checks the following should be applied:

 all checks should be pre-numbered

 un issued checks should be adequately against theft or misuse:
 voided checks should be defaced to eliminate any possibility of further use filed in the regular
sequence of paid checks; and
 officials authorized to sign checks should review the documents supporting the payment and
deface these documents at the time checks to prevent them form being submitted a second
time.

5.3.2 Standard Audit Procedures |for Wages and Salaries.

Wages and salaries constitute major items of expenses in the case most enterprises. As wages and salaries
involve payments to a large number of persons and the supporting document is generally internal, this area
is stable to fraud and error. Audit of wages and salaries, therefore, audit of wages and salaries is carryout by
the auditor in the following tow stages:
Audit of wages and salaries is carried out by the auditor in the following tow stages:

 study of the accounting system and internal controls relating to wages and salaries and their
evaluation through compliance procedure : and
 application of standard audit procedures for wages and salaries.

A. Study and Evaluation of Accounting System and Internal Controls

You have to study and evaluate the accountings system and internal controls relating to wages and salaries
to determine the nature, timing and extent of the procedures to be applied in this area. In evaluating the
effectiveness of internal controls, you have to examine the adequacy of segregation and rotation of duties,
procedures for authorization of transactions, adequacy of records and documents maintained in support of
transactions, procedures for securing accountability and safeguarding of related assets, and independent
checks on performance.

B. Standard Audit Procedures for Wages and Salaries.

On the basis of your evaluation of the internal controls relating to wages and salaries. You have to decide
the nature and timing of timing of the audit procedures to be used in this area. The standard audit
procedure for wages and salaries consists of the following:-

i. Detailed examination of the payroll:

ii. Detailed examination of the wages and

iii. Application of analytical procedures.

i. Detailed examination of the payroll

Payroll of selected month is checked as below:

 examine the primary employee data. this includes name, wage rate, record of attendance, etc with
reference to the records kept by the personnel department;
  check the computation of wages and salaries parable on the basis of the verified primary data and
other relevant factors such as contribution to saving and credit associations and contributions to
pension funds.
 check the arithmetical accuracy of the payroll, i.e. additions, subtractions.
 examine the receipts/acknowledgements by employees. (see whether the employees have signed
on receipt of their salary and wages.)
 examine the deductions made in respect of income tax, contributions to pension funds, and others
with reference to the returns submitted to the authorizes concerned.
 examine whether the amounts remaining undisturbed (unclaimed wages and salaries) have been
deposited. examine the vouchers relating to subsequent disbursement of unclaimed wages and
salaries.
 examine the statement of unclaimed wages as well as the list of persons to whom wages were paid
on the basis and authority letter. if certain names are repeated this may be an indication that they
are fictitious, dummy or retired workers. in such a case, the auditor may decide to carry out further
audit procedures; for example, the auditor may examine the detailed attendance records in respect
of such workers.

ii. Detailed examination of wages and salaries of selected employees

 Select a few employees using sampling techniques (it could be random or based on the auditors
judgment)
 Examine the wages and salaries paid to the selected employees during the year in depth with
reference to their personnel records detailed attendance records, and other supporting data .
This procedure helps you to evaluate whether wages and properly disbursed.
Iii. Application of analytical procedures

Salaries and wages usually have consistent pattern over several years applying analytical procedures helps
an auditor to identify unusual fluctuation f wages ad salaries. The most common analytical procedures I
auditing wages ad salaries are presented below.

1- compare the ration of total wage bill for the year to the wage bill of the previous year
 2- compare the ratio of the total wages and salaries to total sales and cost of goods sold for the current
year with the corresponding figures for the previous year
3- compare the ratio of contribution to pension fund to total wages and salaries for the current year
with the corresponding figures for previous years as well as with the rates of contribution specified in
the revenant law

5.3.3 Standard Audit Procedures for Petty Cash Payments

Business organization established a petty cash fund to effect small payments such as payments for postage,
entertainment, cartage, local transpiration. A petty cash is established as per the decision of the
management. Under this system, the petty cashier is given a certain amount known as “petty cash ” The
petty cashier makes payments from the petty cash fund. The amount disbursed by the petty cashier is
periodically reimbursed so that he\she again has fixed amount. The petty cashier maintains a petty cash
book he\she records all transactions relating to petty cash.

You, as an auditor, perform the following procedures to examine petty cash transaction:

Evaluate the internal over petty cash. The is particular important in view of the fact that petty cash is
normally under the charge of only one individual and is, therefore, prone to defalcation. In evaluating the
relevant internal controls, you have to examine the following aspects:

- is the amount of petty cash fund fixed? is this amount reasonable considering the total amount of
petty cash payments made a month or so?
- are items or expenditure which can be reimbursed from the petty cash well defined?
- is there a limit on the on the amount that can be reimbursed from the petty cash in respect of a
single transaction?
- is the petty cash kept separate from other receipts?
- is the disbursements form the petty cash fund made only against the petty cash expense vouchers
duly approved by a responsible official?
- is the petty cash in hand periodically examined by the internal auditor or another responsible
official? is the petty cash reconciled with book records periodically?
- is the reimbursement of petty cash only for the exact amount of petty cash expense during the
period as supported by petty cash vouchers?
 - are petty cash vouchers marked as” paid after payments to prevent duplicate payments the same?

NB. -Since cash generally has a high degree of inherent risk, more audit time is devoted to the audit of the
account than is indicated by its dollar amounts.

Internal control over cash receipts should provide assurance that all cash received is recorded promptly and
accurately. Control over sales is strongest when two or more employees participate in each transaction, or
when a cash register or an electronic point of sale system controls collections. When a cash receipt consists
of checks received through the mail, the receipts should be listed and controlled by personnel who do not
maintain cash or accounts receivables records. The control listing should be reconciled to the entries in the
cash receipts journal and deposit records from the financial institutions.

Internal control over cash disbursements is best achieved when all payments are made by check or well-
controlled electronic fund transfers, except for payments of minor items from petty cash funds.

Separation of the functions of presentation of the payments from that of signing checks tends to prevent
errors and fraud in cash disbursements.

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a check mark ( ) in the
''Yes'' column if the check list item is clear to you or in the ''No'' column if the check list item is not clear.
Thus, if there is any item that is not clear to you to understand please reread the material and evaluate
yourself again and again until items are clear.

Confirmation Ideas Yes No

Can you list the specific feature of control over cash

Can you list the possible questions raised by auditors to control cash receipts

Can you identify standard audit procedure for cash payment

Summary

This duty described the fundamental controls over cash receipts and payments. It also explained the
auditors design test of controls for cash, and substantive tests for cash accounts. To summarize:-

Since cash generally has a high degree of inherent risk, more audit time is devoted to the audit of the
account than is indicated by its dollar amount.

Internal control over cash receipts should provide assurance that all cash received is recorded promptly and
accurately. Control over cash sale is strongest when two or more employees participate in each transaction,
or install a cash register control system.

Internal control over cash payment is best achieved when all payments are made by check except for
payment of minor items from petty cash funds separation of functions.

The principal objectives for the substantive tests of cash are to (a) substantiate the existence of the recorded
cash, (b) establish the completeness of recorded cash, (c) determine that the client has rights to recorded
cash, and (d) evaluate the adequacy of the presentation and disclosure of the cash accounts. A primary
substantive test of cash is confirmation of the balances of the company's accounts with financial institution.
 UNIT SIX

6. Auditing of Receivable

Introduction

This duty describes the audit of receivables, both products of the receivable cycle. In broad terms this
cycle includes the receives of orders from customers. Receivable form customers include both accounts
receivable, and various types of notes receivables

Sources and natures of accounts receivables

Account receivables include not only claims against customers arising from the sale of goods or service,
but also variety of miscellaneous claims such as loans to officers or employees, loans to subsidiaries
claims against various other firms, claims for tax refund and advances to suppliers.

Trade notes and accounts receivable usually are relatively large in amount and should appear as
separate items in the current asset sections of the balance sheet in their net realizable value.

General Objective

At the end of this lesson, you will be able to audit receivables. Auditors are especially concerned with the
presentation and disclosure of loans to officers, directors and officiated companies.

Section 6.1 Evaluating Internal Control over Receivables For many companies the primary source of
receivables is from the sales of goods or services to customers on credit. Ineffective controls over credit
sales and receivables can be costly to a business. When control activities over sales on account are
inadequate, large credit losses are almost inevitable. For example, merchandise may be shipped to
customers whose credit standing has not been approved. Shipments may be made to customers without
notice being given to the billing department; consequently, no sales invoice is prepared. Sales invoices
 may contain errors in prices and quantities and if sales invoices are not controlled by serial numbers,
some may be lost and never recorded as accounts receivable. To avoid such difficulties, strong controls
over credit sales are necessary. Usually, internal control over credit sales is strengthened by a division of
duties so that different department or individuals are responsible for

1. Controlling customers’ orders- The controlling and processing of orders received from customers
require carefully designed operating procedure and numerous controls if costly errors are to be avoided.
Important initial steps include registering the customer ’s purchase order reviewing items and quantities to
determine whether the order can be filled within a reasonable time and preparing a sales order. The
sales order is a translation of the terms of the customer ’s order into a set of specific instruction for the
guidance of various divisions including the credit finished goods stores, shipping billing and accounts
receivable units. The action to be taken by the factory up on receipt of a sales order will depend upon
whether the goods are standard products carried in stock or are to be produced to specifications set by
the customer.

2. Credit approval- Before sales orders are processed the credit department must determine whether
goods may be shipped to the customer on open account. This department is supervised by a credit
manager who reports to the treasurer or the vice president of finance.

3. Loading the goods into cars or trucks. The shipping should be numerically controlled and entered in a
shipping register before being forwarded to the billing department when shipments are made by truck; a
gate control is needed to ensure that all good leaving the company have been recorded as shipments. This
may require giving special copies of shipping documents to the gatekeeper.

4. The billing function: the term billing means notifying the customer of the amount due for goods or
services delivered. This notification is made by preparing and mailing a sales invoice. Billing should be
performed by the accounting department other than sales. The function is generally assigned to a
separate section within the accounting data processing, or finance departments. The billing section has
the following responsibilities:
  accounting for the serially numbered shipping documents:
 comparing shipping documents with sales orders and customers' purchase orders and change
notices:
 entering relevant data from these documents on the sales invoice:
 applying prices and discounts from price lists to the invoice;
 making the necessary extensions and footings; and
 accumulating the total amounts billed.
5. Collection of receivables: most receivables are collected by receipt of customers' checks and remittance
advices through the mails. The cashier has to control and deposit checks. The remittance advices or a listing
of the receipts should be forwarded to the accounts receivable section or the data processing department,
which records them in the appropriate accounts in the customers' ledger. The total reduction in accounts
receivable should be posted periodically to the general ledger control account from the total of the accounts
receivable column in the cash receipts journal.

6. Write-off of receivables: receivables judged by management to be uncollectible should be written off

(after review by the credit department) and transferred to a separate ledger and control account. Also,
statements should continue to be mailed to the debtors requesting payment. Otherwise, and subsequent
collections my be abstracted by employees without the necessity of any falsification of the records to
conceal the theft.

7. Internal audit of receivables: internal auditors should review shipping reports, invoices, and credit
memoranda to determine whether authorized procedures are being carried out consistently.

Activity 14
For a strong internal control over credits sales to existence, which functions should be
segregated and assigned to different individuals / departments?

---------------------------------------------------------------------------------------------------------
Section 6.2 Performing Audit for Receivables

6.2.1 Audit Objectives of Receivables

The following are the audit objectives of receivables:-

 The recorded receivables are valid (existence and rights)

 All receivables are recorded (completeness)
 Receivable records and supporting schedules are mathematically correct and agree with
general ledger accounts (clerical accuracy)
 The valuation of receivables approximates their realizable values. (Valuation)
 The presentation and disclosure of receivable is adequate, including the separation of
receivables into appropriate categories, and adequate reporting of any receivables pledged
as collateral and related party receivables. (Presentation and disclosure)

As an auditor, your objective is to determine the validity of the recorded receivables involves (1)
determining the genuineness of customers' accounts and (2) determining whether generally accepted
accounting principles have been followed in the establishment of the receivables. You can evaluate the
genuineness of receivables by examining client controls over issuance of sales invoices, shipping documents,
and other evidence of claims against customers. To examine whether the client follows generally accepted
accounting principles, you should analyze estimates made by management in areas such as the capitalization
of leases and the sale of franchises.
Completeness addresses the question of whether other receivables have been omitted. Improper cutoffs of
either sales or collections may result in errors affecting both validity and completeness. For example, cash
received after year-end may be treated as having been received prior to year-end (resulting in a validity
problem), or credit sales made toward the end of the year may have been included in the subsequent year's
first month (resulting in a completeness problem).

In evaluating whether receivables are properly valued, your focus would be on testing if the receivables are
recoded at their expected net realizable value. To meet this objective, you have to analyze the allowance for
doubtful accounts and bad debt expense. The balances of these accounts are based almost entirely on
management's estimates (aided by past results) and are, therefore, considered to have a high degree of
inherent risk.

To meet the objective of determining adequacy of presentation and disclosure, you may evaluate the
classification of receivables into appropriate categories, reporting of receivables pledged as collateral. This is
achieved by understanding and evaluating the internal control over sales transactions and receivables.

6.2.2 Audit Procedures for Receivables

Below are the audit procedures applied by auditors to achieve the audit objectives of receivables and sales.

 Verify Accuracy of Accounts Receivable Trail Balance and Agreement with General Ledger Control.
 Apply analytical procedures.
 Confirm accounts receivable.
 Vouch recorded receivables to supporting documentation.
 Perform sales cutoff test
 Examine subsequent collections
 Vouch aged trial balance to supporting documentation.
 Compare statement presentation with GAAP.
Each audit procedure is discussed in the following paragraphs.

 Verify Accuracy of Accounts Receivable Trial Balance And Agreement with General Ledger Control
Accounts receivable trial balance is a manual listing or computerized printout of individual customer
balances in the accounts receivable ledger. You have to check if the trial balance agrees with the accounts
receivable control in the general ledger. An accounts receivable aging analysis is useful in evaluating the
adequacy of the allowance for doubtful accounts. Subsequent remittance by the customer is the best
evidence of collectibles at the balance sheet date.

 Apply Analytical Procedures

Analytical procedures reveal areas that require further investigation. In auditing receivables, you may apply
analytical procedures in the following financial relationships.

 Accounts receivable turnover: net sales / average accounts receivable.

 Accounts receivable to total current assets: accounts receivable / total current assets.
 Rate of return on net assets: net income / net assets.
 Uncollectible accounts expense to net credit sales: uncollectible accounts expense / net credit sales.
 Uncollectible accounts expense to actual uncollectible: uncollectible accounts expense / actual
uncollectible.
You have to compare each financial relationship with prior periods, expected results, and industry data. If
there is no significance fluctuation, the related account balances are stated fairly. If there is significant
fluctuation, you have to conduct further investigation.

Analytical procedures are related to the existence, completeness and valuation of receivables.

 Confirm Accounts Receivable

Confirmation of accounts receivable involves direct written communication between individual customers
and the auditor. Confirmation of accounts receivable on a test basis helps you to substantiate the
genuineness of receivables and to evaluate correctness of valuation of the year-end balances. Confirmation
consists of customers replying directly to the auditor concerning the accuracy of the receivable balances, as
reflected by the client. Two types of confirmation are used in practice- positive form and negative form. The
positive from requests the customer to respond his/ her agreement or disagreement with the reported
balance. The negative from requests the customer to reply only in the event of disagreement. A
disadvantage of the negative confirmation is that non-replies may signify either agreement or simply failure
to respond. For this reason, auditors frequently stratify the population of customer accounts based on size
requesting positive confirmation for most of the large balances, and relying on negative confirmation for a
sample of smaller accounts.

The confirmation letter is prepared by the client staff. But you must control the mailing of the confirmation
requests. To maintain control, you may either mail the forms directly or carefully supervise the client's
mailing of the confirmations. For positive confirmation requests, a self-addressed envelope is included with
the customer statement and confirmation requests to assure that customer replies are received directly by
the auditor. Sample confirmation of both positive and negative are presented below.

As you receive the replies, you have to analyze them to clear all exceptions. Many exceptions consist of
goods or remittances in transit, and assuming proper cutoff, do not require audit adjustment. You have to
explore in depth those exceptions that are indicative of genuine disputes concerning prices, discounts,
allowances, or returns.

For customers not responding to the initial requests for positive confirmations, you should mail second and
possible third requests. In the absence of replies to second and third requests, you have to apply alternative
procedures. Such procedures may be in the form of examining billing and shipping documents, or remittance
advice in support of subsequent collections. If customers cannot confirm balance because the sales and
accounts receivable systems restrict information to transactions, you have to consider confirming selected
transactions with these customers.
In addition to completeness, existence, and valuation, you must gather evidence in support of proper
presentation and adequacy of disclosure relative to sales revenue and trade accounts receivable. Credit
balances in customers' accounts and non-trade receivables are best detected through inquiry of
management. To support your inquiry, you have to analyze the accounts receivable subsidiary ledger as part
of the confirmation process. Substantive testing of trade accounts receivable provides evidence in support
of operating revenue transactions. You are also expected to apply substantive procedures to miscellaneous
revenues. The first step in auditing miscellaneous revenues is to perform analytical review procedures.
These consist of comparing balances in the accounts with the prior year, for both amount and source of
revenue.

 Vouch Recorded Receivables

The supporting documents of receivables include customer orders, shipping documents, sales invoice, credit
memoranda, and correspondence. These documents provide evidence on the existence of the receivable.
You may vouch the recorded receivable to supplement confirmation procedures when no response is
obtained from a positive confirmation or when the negative form of confirmation is used.

This test provides evidence primarily about the existence of receivables. Besides, the supporting
documentation also provided evidence concerning the gross claim on the customer (valuation assertion),
and that the client bolds a legal claim on the customer for payment (rights assertion), and that the client
holds a legal claim on the customer for payment (rights assertion)

 Perform Sales Cutoff Test

The sales cutoff test is designed to obtain reasonable assurance those sales and accounts receivables are
recorded in the accounting period in which the goods are shipped and the corresponding entries for
inventories and cost of goods sold are made in the same period.
The basis for recognizing sales normally is the date of shipment, but when goods are shipped F.O.B (fee on
board) destination, the seller may arbitrarily add several days to the shipping date,

Since legal title does not pass in such case until the buyer receives the goods. The sales cutoff test usually in
made as of the balance sheet date. The test involves the following:

 examining shipping documents for several days before and after the cutoff date to determine the
date and terms of shipment.
 tracing shipping documents to the sales and inventory records to establish that the entries are made
in the correct accounting period.
 inspecting invoices for a period of time before and after the cutoff date to ascertain the validity and
propriety of the shipments and corresponding entries.
 inquiring of management about any direct shipment by outside suppliers to customers and
determining the propriety of related entries.

If you have assessed control risk as high, there is a possibility of fictitious sales. For example, unordered
goods may be shipped to a regular customer shortly before the statement date, with the subsequent return
not made and booked until the following period. If the cut off test shows you material errors in recording
year-end sales, you should request the client to make the necessary adjustments.

This test provides evidence concerning the completeness and existence assertions for the accounts
receivable.

 Examine Subsequent Collection

The best evidence of collectibles is the receipt of payment from customer, prior to actual receipt; the
collectibles of an account can only be estimated. The client may receive collections on prior year's
receivables between the balance sheet date and the conclusion of your examination. Thus, you have to
compare such collections back to balances outstanding at the statement date to establish the collectibles of
receivables.
This test provides evidence as to the existence and valuation of accounts receivable assertions. This test also
provides evidence about the completeness of accounts receivable.

 Vouch Aged Trial Balance to Supporting Documentation

An aged trial balance is a trial balance that shows the amount due from a customer by length of time the
balance has been unpaid. The vouching of the aged trial balance to supporting documentation provides
strong evidence about the valuation of accounts receivable. Here, your focus is on the adequacy of the
balance reported by the client for the allowance for doubtful accounts.

The provision for bad debts is an accounting estimate made by management that involves both objective
and subjective considerations. Your responsibility is to judge the reasonableness of the provision and the
resulting fairness of the allowance account. In making this assessment, you should evaluate the controls
over the granting of credit and the control over the write-off of bad debt accounts. If the internal control
over these areas is strong, the related control risk is low. Thus, you would need less evidence. However, if
control risk is high, you need to gather more evidence to substantiate your test.

 Compare Statement Presentation with GAAP

You have to evaluate if the presentation and disclosure of accounts receivable and sales is in accordance
with GAAP. To this end, you have to examine if receivables and sales are properly classified and presented in
the financial statements. To determine the receivables from employees, officers and affiliated companies,
you can review the accounts receivable trial balance. Under GAAP, there should be disclosure of the
pledging, assigning, or factoring of accounts receivable, you have to obtain evidence from a review of the
minutes of board of directors' meeting and inquiry of management. (You will recall your discussion in
financial accounting about pledging, assigning, and factoring of accounts receivable).

Activity 15
(1) What audit objective is met when an auditor selects a sample from the file of shipping documents to
determine whether invoices were prepared?

(2) Suggests an internal control procedure that may prevent the failure to bill customers for some
shipments.

__________________________________________________________________

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a
check mark ( ) in the ''Yes'' column if the check list item is clear to you or in the
''No'' column if the check list item is not clear. Thus, if there is any item that is not
clear to you to understand please reread the material and evaluate yourself again
and again until items are clear.

Confirmation Ideas Yes No

Can you identify the internal control principles for receivables

Can you list audit objectives of receivable

Can you list procedures for receivables

Summary

In the duty we described the controls over receivable, the auditors' consideration of these controls, and
substantive tests of the receivables. To summarize:

 The audit of receivables represents significant audit risk because

Many incidences of financial statement fraud have involved the overstatement of receivables. As a result
companies should establish effective high-level controls over financial reporting of the receivable account.

Effective internal control over sales transaction is best achieved by having separate departments responsible
for preparing sales order, approving credit, shipping merchandise, billing customers, maintaining the
accounts receivable subsidiary ledger & proper authorization.

To assess control risk, at less than the maximum for a particular assertion, the auditors must perform tests
of the operating effectiveness of the controls. This assessment is used to determine the nature, timing, and
extent of the substantive tests of receivables.

The primary objectives for the auditors substantive tests of receivable are to (a) substantiate the existence
of receivable (b) establish the completeness of receivable (c) determine that the clients has rights to the
record receivables.(d) determine that the valuation of receivable is appropriate (e) establish that the
presentation and disclosure of receivables are appropriate.

The most time-consuming and critical audit procedures for receivables is those designed to test the
assertions of existence, occurrence, and valuation.
 Self Check Exercise
Part-I: Choose the Best Answer from the Given Choices

____1. To determine that all sales have been recorded, the auditors would select sample transactions from
the:

A. Shipping documents file B. Sales journal.

C. Accounts receivable subsidiary ledger D. Remittance advices.

____2. Which of the following might be detected by an auditors' review of the client's sales cutoff?

A. Excessive goods returned for credit. B. Unrecorded sales discounts.

C. Lapping of year-end accounts receivable. D. Inflated sales for the year.

____3. To test the existence assertion for recorded receivables, the auditors would select s sample from the:

A. Sales orders file.

B. Customer purchase orders.

C. Accounts receivable subsidiary ledger.

D. Shipping documents (bills of lading) file.

____4. Which assertion relating to sales is most directly addressed when the auditors compare sample of
shipping documents to related sales invoices?

A. Existence or occurrence. B. Completeness.

 C. Rights and obligations. D. Presentation and disclosure.

____5. Cooper, CPA is auditing the financial statements of a small rural municipality. The receivable balances
represent residents' delinquent real estate taxes. The internal control structure at the municipality is
weak. To determine the existence of the accounts receivable balances at the balance sheet date,
cooper would most likely:

A. Send positive confirmation requests.

B. Send negative confirmation requests.

C. Examine evidence of subsequent cash receipts.

D. Inspect the internal records such as copies of the tax invoices that were mailed to

the residents.

____6. Which one of the following controls most likely prevents the concealment of a cash

shortage resulting from the improper write-off of a trade account receivable?

A. Writ-offs must be approved by a responsible official after review of credit

department recommendations and supporting evidence.

B. Write-offs must be approved by the accounts receivable department.

C. Write-offs must be authorized by the shipping department.

D. Write-offs must be supported by an aging schedule showing that only receivables.

____7. How can you determine the validity of the recorded receivables?

A. By analyzing estimates made by management.

B. By examining client controls over issuance of sales invoices.

C. By obtaining confirmation from customers.

 D. None

____8. What is the purpose of confirmation of accounts receivable?

A. To substantiate the genuineness of receivables.

B. To evaluate correctness of valuation of the year-end balances.

C. To determine the accuracy of receivables.

D. A and B

____9. What do you test the existence and valuation of accounts receivable?

A. By performing cash cutoff test B. By examining subsequent collection.

C. By performing cash proof. D. None

UNIT SEVEN
 7. Auditing Revenue and Expense

General Objective: At the end of this session, you will be able to audit revenue and expense.

Section 7.1 Evaluating Internal Control over Revenue

7.1.1 The Revenue Cycle

Sales may be either credit sales or cash sales. In the case of cash sales, goods are delivered only against
receipt of immediate payment and therefore the point of control and recording is the receipt of cash. The
audit procedures cash sales transactions are therefore incorporated with the audit procurers for cash
received under. This section therefore focuses on only sales on credit.

7.1.2 Functions and Control Objectives Relating to Credit Sales

The following functions are important in the processing of credit sales transactions:

 accepting the customer's order;

 approving credit:
 filling the sales order;
 billing the customer;
 journalizing and posting sales transactions;
 updating the accounts receivable ledger ( and the inventory records in a perpetual system);
 protecting the accounts receivable ledger and unused sales documents; and
 maintaining the correctness of customer balances.

The performance of these functions involves individuals in several of the department's in the organization,
the accounting system for sales transaction, and a variety of control procedures. In the aggregate, the
control structure should result in attaining the following control objectives for credit sales transactions.
  Validity. All recorded sales transactions represent events that have occurred (i.e. there are no
fictitious sales transactions).
 Completeness. All valid sales transactions are recorded.
 Recording propriety. The details of sales transactions are accurately captured on source documents,
and the sales are correctly journalized and posted as to amounts, time period, and classification.
 Safeguarding. Access to the accounts receivable ledger and preprinted sales documents is restricted
to authorized personnel.
 Subsequent Accountability. The accounts receivable ledger agrees with accounts receivable control
and individual customer balances are correct.
 Validity
Proper documentation is essential in establishing the validity of recorded sales. each sale should be
supported by a customer order a sales order, a shipping document, and a sales invoice.

Validity is further enhanced when transactions are processed in accordance with authorization procedures
established by management.

 Completeness
The use of pre numbered sales orders, shipping documents, and sales invoices, and accounting for all used
documents, are important controls in meeting the completeness objective for sales transactions. To ensure
that all sales transactions are recorded, it is customary for the billing department to prepare a daily sales
summary of the sales invoices that have been issued. The completeness of the summary is independently
verified by a billing department supervisor.

 Recording Propriety
The starting point in meeting the control objective of recording propriety is to have independent internal
verification of the accuracy of the sales invoices. This is done by having a second employee in the billing
department verify the selling prices used and the mathematical computations made in preparing the
invoice. Segregation of duties between (1) journalizing and posting sales transactions to the general ledger
and (2) posting to the accounts receivable ledger directly from the sales invoices contributes to the accuracy
of recorded amounts. When these duties are segregated, periodic comparisons of the agreement of the
control account with the subsidiary ledger by an accounting supervisor will reveal errors in amounts
journalized and posted, as explained below under subsequent accountability.

 Safeguarding
Appropriate access controls are necessary in meeting the safeguarding control objective. These controls
include keeping the accounts receivable subsidiary ledger in a secure area such as a locked file, safe, or
vault, when not in use. Unused preprinted sales documents should also be stored in a secure area. Access to
the storage areas should be restricted to authorized personnel.

 Subsequent accountability
The control procedure of independent internal verification is important in meeting this control objective.
First, an accounting department supervisor should independently verify the agreement of the accounts
receivable subsidiary ledger with accounts receivable control on a monthly basis. Second, there should be
independent mailings of monthly statements to customers and follow-up of any differences reported by
customers.

Activity 16
Write about the functions relating to credit sales.

____________________________________________________________________

Section 7.2 Performing Audit for Revenue

7.2.1 Audit Objectives Relating to Sales

In carrying out an audit of sales, your aim, as an auditor, is collecting sufficient appropriate audit evidence to
reasonable assuring yourself about the following assertions:-
 1. Occurrence: The sales recorded in the books of account represent the exchange of goods for
cash, receivables or other consideration during the period under audit. In this context, it is
important to understand at what point of time sales should be recognized in accounts.
2. Completeness: The sales made during the period under audit have been recoded in the books
of account
3. Measurement: Sales have been recorded at appropriate amounts. To satisfy this audit
objective sale should be properly classified in to different categories and arithmetical accuracy
has been maintained while recording the books of account.
4. Presentation and disclosure: Sales have been properly classified and disclosed under
appropriate account heads in the financial statements in accordance with recognized
accounting principles and relevant statutory requirements.

7.2.2 Audit Procedures for Revenue

In designing the audit procedures for auditing sales, you should collect sufficient appropriate audit evidence
to obtain reasonably assurance that the above objectives are achieved. As in the case of other transactions,
the auditor achieves the objective through the following two stages.

 Study the accounting system and internal control relating to sales and evaluating them through
compliance procedures.
 Perform substantive procedures through tests of transactions relating to sales and analytical
procedures. The auditor also examines the presentation and disclosure of sales in the financial
statements.

7.2.3 Tests of Control / Compliance Tests/

You should design tests of control to check that the control procedures are being applied and that objectives
are being achieved. Tests may be appropriates under the following broad headings:

a) carry out sequence test sequence on invoices, credit notes, dispatch notes and orders. ensure that
all items are included and that there are no omissions or duplications.
b) check the authorization for the acceptance of the order, dispatch of goods, rising of the invoices or
credit note, pricing and discounts, and write-off of bad debts. you should also check that the
 relevant signature exists and that the control has been applied. for example, you may check pricing
for accuracy and credit limits to ensure that they have not been exceeded.
c) examine the arithmetic accuracy of Invoices, Credit notes, Sales tax.
d) check dispatch notes and goods returned to ensure they are referenced to invoices and credit notes
and vice versa.
e) check that control account reconciliation have been performed and reviewed.
In all cases, these should be performed on a sample basis; you should investigate errors and consider the
need for further testing to satisfy yourself on the proper application of the control procedure.

7.2.4 Substantive Procedures

You will recall that substantive procedures are procedures you apply to examine the completeness, validity,
and accuracy of an account balance. In auditing sales, the following are the most common substantive
procedures applied in auditing sales:.

a) Accounting records check:

 check additions of the sales day book and sales returns day book.
 check the posting of individual invoices to the nominal ledger and the control account.
 check entries in the sales day book and sales returns day book to original invoices, credit
notes, dispatch notes, and vice versa.
b) Invoices and credit notes:

 check numerical sequence of invoices enquiring into missing numbers and

inspecting all copies of cancelled invoices.

 check copy sales invoices and credit notes with the sales day books and sales
ledger accounts. Check analysis of sales day books where appropriate and

authorization of credit notes.

 Compare invoiced prices with authorized, up to date lists, quotations and

correspondence.

 Check calculations of invoices and credit notes.

 Examine credit notes for large of unusual items.
c) Inventory records

 check goods dispatched notes or goods outwards records to the copy sales
invoices.

 trace goods outwards from invoices to dispatched notes to inventory records.

 trace goods returned from returns documentation to inventory records and
credit note.

d) General

 where returns of allowances affect the calculations of commission ensure that adjustments
have been made properly.
e) Control accounts

 test the year end control account reconciliation, checking back to source documentation
such as sales invoices, cash and returns records. Ensure that any reconciling items are dealt
with properly.
f) Analytical procedure: You should apply analytical procedures focusing on the following:

 fluctuations in sales levels: fluctuations, particularly around the year end can be identified
by comparing levels of sales throughout the year on a month by month basis, or comparing
the sales in the last month of the year to sales in the first month of the next year.
 cut off problems: an increase just before the year end with low sales after year end may
indicate to maximize reported profits. thus, you should checking large items in the last
month and first month of the next period to ensure that goods reported as sold are
delivered to the buyer before the year end.
g) Disclosure: Sales revenue must be disclosed by class of business and geographical market.

You may have noted that the test of control and substantive procedures noted above sometimes appear
to be very similar. Remember that we have said that one test can serve both as a test of control and as a
substantive procedure where, for example, an invoice is checked for authorization (test of control), it
can also be checked for the accuracy of pricing (sustentative procedure). This does not mean that tests
of controls and substantive procedure are interchangeable! It is vital that you understand the
conceptual difference between the two types of test.
Section 7.3 Evaluating Internal Controls over Expenses

7.3.1 Expenditures Cycle

The expenditure cycle involves the activities associated with the acquisition of and payment for plant assets,
goods and services, and labor. There are three major classes of transactions in this cycle: Purchases, cash
disbursements, and payroll.

Purchasing (acquisition) and cash disbursements (payments) transaction involve the acquisition of goods
and services from outsiders and the subsequent payment of the liabilities that have been incurred. The
acquisition part of this cycle extends beyond the buying of merchandise for resale or raw materials for use in
production. Purchasing also includes the methods and procedures that culminate in the acquisition of other
assets (property, plant, equipment, intangibles, and prepayments) and myriad day-to-day operating
expenses such as advertising, repairs, utilities, and insurance. Cash disbursement transactions, in turn,
consist of preparing, signing, and mailing checks to vendors and providers of services for the benefits that
have been received. A complete listing of the functions for purchases and cash disbursements in as follows:

 requisitioning goods, other assets, and services;

 ordering the items requisitioned;
 receiving the items;
 storing goods received for inventory;
 preparing the payment voucher;
 paying the liability;
 journalizing and posting the transactions;
 updating the unpaid voucher file and inventory records;
 protecting the accounting records, unused documents, and inventory on hand; and
 maintaining correctness of accounts payable, inventory, and cash balances.

7.3.2 Internal Control Principle for Expenditures

The performance of the above functions involves several departments and numerous control procedures.
The control objectives for purchases and cash disbursements transactions are.
  Validity. Recorded purchases and cash disbursements transactions represent events that occurred;
 Completeness. All valid purchases and cash disbursements transactions are recorded;
 Recording propriety. Details of purchases and cash disbursements source documents are correct and
properly journalized and posted as to amount, time period, and classification;
 Safeguarding. Secure areas and storage devices accessible only to authorized personnel are
maintained to the accounting records, unused documents, check writing equipments, and inventory
on hand; and
 Subsequent Accountability. The accounts payable balance agrees with the unpaid voucher file, and
the inventory records agree with inventory on hand.
The applicability of control procedures to each of these objectives is explained in the following sections.

 Validity
Proper documentation is necessary to establish the validity of purchases and cash disbursements
transactions. The key documents in ordering goods and services are the purchase requisition and the
purchase order. For recording and paying the liability, the key documents are the voucher and check.

 Completeness
The use of pre numbered purchase order, receiving reports, vouchers and checks, and accounting for all
documents, are important controls in meeting the completeness objective for purchases and cash
disbursement transactions.

Activity 17
What meant by the expenditure cycle and list the three major classes of the expenditure cycle.

___________________________________________________________________________
Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a
check mark ( ) in the ''Yes'' column if the check list item is clear to you or in the
''No'' column if the check list item is not clear. Thus, if there is any item that is not
clear to you to understand please reread the material and evaluate yourself again
and again until items are clear.

Confirmation Ideas Yes No

Can you identify the internal control principles over revenue

Can you perform audit for revenue

Can you identify internal control over expense

Can you perform audit for expense

Summary

This explain auditing revenue and expenses and procedure involved in completing the audit. To summarize
The analysis throughout the duty has emphasized the need to consider revenue and expense account in
conjunction with the audit of assets and liability account.

Substantive test for payroll account address the overall reasonableness of the payroll cost.

Self Test Exercise

Part- I: Choose the Best Answer from the Given Choices

_____1. Of the following functions which one is not important in the processing of credit sales transactions?

A. Billing the customer

B. Receiving and deposit of cash

 C. Approving credit

D. Filling the sales order

_____2. Is further enhanced when transactions are processed in accordance with authorization procedures
established by management

A. Completeness

B. Validity

C. Recording propriety

D. Safeguarding

_____3. An assertion that represent that sales have been recorded at appropriate amounts

A. Presentation and disclosure

B. Measurement

C. Completeness

D. Occurrence

_____4. The expenditure cycle involves

A. The acquisition and payment for plant asset

B. Acquisition and payment for goods and services

C. Acquisition and payment for labor

D. All of the above

_____5. A complete listing of the function for purchases and cash disbursement include

A. ordering the items requisitioned

B. Receiving the item

C. Both and B
 D. None of the above

UNIT EIGHT

8. Auditing Inventory

General Objective: At the end of this session, you will be able to audit inventories properly

Section 8.1 Evaluation of Internal Control over Inventory

Inventories as tangible property held for sale in the ordinary course of business (i.e. finished goods), or in
the process of production for such sale (i.e., work-in process), or for consumption in the production of goods
or services for sale (i.e., raw materials and components, maintenance supplies, and consumable stores and
spare parts mean for replacement in the normal course).

In both the case of manufacturing and trading enterprises, inventories generally constitute a significant
proportion of the total assets. Audit of inventories is, therefore, an important part of an independent
financial audit.

8.1.1 Special Features of Inventories

The following features of inventories affect the related audit procedures and are, therefore, of special
significance to the auditor.

1) Inventories of major raw materials, components, work-in process and finished goods normally turn
over quickly. Many items may, however, be slow moving, e.g., stocks of woolen garments may move
only in winter. If the rate of turnover of certain inventories is below normal, it may indicate that
those inventories are obsolete or excessive. This may affect their valuation.
 2) Many items of inventories are liable to become obsolete due to market changes (e.g., inventories of
fashion garments). Similarly, many items may deteriorate with the passage of theme (e.g.,
perishable goods) or may have a limited shelf-life (e.g., most medicines). These factors affect the
valuation of the inventories.
3) Inventories are normally movable (though some inventories may be immovable, e.g., flats being sold
by a construction company). This makes inventories prone to misappropriation, theft, etc. The
auditor, therefore, needs to carefully examine the adequacy of internal controls relating to
safeguarding of inventories.
4) The items of inventories may be located at different places, or may be with third parties such as
consignment agents. This may require the auditor to carry out appropriate audit procedures
(including obtaining suitable certificates from the third parties) to reasonable assure him about the
existence, ownership, quantity and condition of such inventories. Similarly, inventories belonging to
third parties may be in the possession of the enterprise under audit, e.g., for performing certain job
work. In such cases, the auditor needs to carry out appropriate procedures to reasonably assure
himself that such items are not included in the inventories of the enterprise.
5) Valuation of certain specialized inventories may involve varying degrees of estimation; in some
cases, this may require expert valuations, e.g., in the case of jeweler. Thus, in the case of specialized
items of inventories, the auditor may have to use the work of experts to satisfy himself about their
valuation.

8.1.2 Internal Control Principles for Inventories (Stock Records)

The auditor carries out a study and evaluation of the accounting system and internal controls relating to
inventories. This helps him/her in determining the nature, timing and extent of the substantive procedures
to be carried out by him.

Generally, the auditor reviews the following aspects of internal controls relating to inventories, among
others:

 Segregation and Rotation of Duties

The persons responsible for handling physical inventories should not be assigned in duties relating to
purchasing, billing or accounting. To ascertain this, the duties relating to inventories properly segregated
and the duties of various persons relating to inventories rotated periodically.
 Authorization of Purchases, Receipts and Issues
To ensure that transactions relating to purchases, receipts and issuance of inventories are properly
authorized, the authorities for purchases, receipt of goods and their issuance from stores must be clearly
laid down.

Inventories must be issued from the stores only against proper requisition notes approved by authorized
managers. Transfers of inventory items from one department to another should also be made only after
obtaining the approval of authorized managers.

 Maintenance of Records and Documents

One of the means of ensuring strong control over inventories is by maintaining records and documents. To
this end, there has to be proper documentation for receipt of goods from suppliers as well from the factory
and for transfer of inventory items from one department to another.

There should also be a perpetual inventory system whereby receipts and issues are recorded in the
inventory records as soon as they take place. The perpetual inventory records should be reconciled
periodically with financial records / cost accounting records.

Records maintained in respect of waste, scrap, returnable containers and by-products should be properly
maintained. A separate record should be maintained for of inventories kept with third parties such as public
warehouses, consignees, sub-contractors, goods sent to customers on approval, etc. like wise, records of
inventories received on consignment basis should be properly maintained.

 Accountability for and Safeguarding of, Inventories

In order to prevent theft and loss of inventories, there has to be proper protection of inventories against
damage, deterioration, etc. Access to area where inventories are stored should be restricted and the
safeguards should be suitable to ensure that inventory items cannot be taken out of the stores without
proper authorization.
Activity 18
State how, as an auditor you satisfy yourself about each of the following aspects of internal control
relation to inventories.

Goods received to stores represent authorized purchases.

Section 8.2 Performing Audit for Inventory

8.2.1 Audit Objectives Relating to Inventories

In carrying out an audit of inventories, the auditor aims at obtaining sufficient appropriate audit evidence to
reasonably assure himself regarding the following assertions:

(1) Existence

Inventories included in the financial statements exist on the date of the balance sheet.

(2) Rights and Obligations

a) The entity has right of ownership to the inventories.

b) Inventories exclude items billed to customers or those owned by others.

(3) Completeness

Inventories include all raw materials and components, work-in-process, finished goods, maintenance
supplies, and stores and spares on hand as well as those, which are in transit or stored at third party
locations (e.g., in public warehouses).

(4) Valuation

Inventories are stated in the financial statements at appropriate amounts in accordance with the
recognized accounting principles. This implies, inter alias, that slow-moving, excess, defective, damaged
and obsolete items included in inventories are properly identified and valued.
(5) Presentations and Disclosure

Inventories are properly classified and disclosed in the financial statements in accordance

with recognized accounting principles and relevant statutory requirements.

8.2.2 Audit Procedures for Inventories

On the basis of his evaluation of the effectiveness of the internal controls, the auditor carries out
substantive procedures in relation to inventories. These substantive procedures include the following:

a) examination of records and documentation;

b) review / observation of physical verification carried out by management;

c) examination of valuation and disclosure of inventories;

d) carrying out analytical procedures; and

e) obtaining confirmation from third parties and representations form management.
a) Examination of Records and Documents

There is a considerable diversity regarding the records maintained by different enterprises in respect of
inventories. Some enterprises maintain detailed records in the form of stores / /stock ledgers. Some other
enterprises maintain only the quantitative record of receipts, issues and balances on a perpetual basis in
respect of each major item. Many enterprises, especially the smaller ones, do not maintain perpetual
inventory records; they just maintain the basic records relating to purchases and sales as also statements of
periodic stocktaking.

The auditor's examination of records relating to inventories depends upon the nature of records maintained
by the enterprise under audit. Where the enterprise maintains inventory records showing quantities and
values of inventories on a perpetual basis, the auditor examines such records (on a sampling basis). Where
such records are not maintained, the auditor suitably extends his other procedures, i.e., review /
observation of physical verification and analytical procedures.

b) Review/ Observation of physical Verification carried out by Management

Physical verification (or physical stock-taking) of inventories is the responsibility of the management of the
enterprise. However, since the closing stocks are usually determined on the basis of physical verification to
satisfy himself that the physical verification was carried out properly. In any case, the auditor needs to
review the procedures, work sheets and the follow-up action on the physical verification of inventories
carried out by the management.

c) Observation of Physical Verification

It is the responsibility of the management of the enterprise to carry out physical verification of inventories.
It is for the auditor to decide whether he would observe the physical verification and, is so, to what extent.
However, where the inventories are materials and the auditor is placing reliance upon the physical
verification by the management, it may be appropriate for him attend the stock-taking. The extent of the
auditor's attendance at stock-taking depends on his assessment of the effectiveness of internal controls,
examination of the records maintained by the enterprise, and the results of analytical procedures.

The auditor evaluates the effectiveness of stock-taking procedures by conducting test counts of inventories.
For this purpose, the auditor selects a sample of inventory items and accounts them to test the accuracy of
the counts performed by the stock-taking personnel.

d) Review of Work Sheets and Follow-up Relating to Physical Verification

Though the auditor may or may not observe the physical verification of inventories carried out by the
management depending upon the results of his other audit procedures, he, in any case, the auditor must
review the work sheet and should follow-up the fiscal verification.

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a
check mark ( ) in the ''Yes'' column if the check list item is clear to you or in the
''No'' column if the check list item is not clear. Thus, if there is any item that is not
clear to you to understand please reread the material and evaluate yourself again
and again until items are clear.

Confirmation Ideas Yes No

Can you identify internal control over inventories

Can you perform audit for inventory

Summary

This duty described details of the controls over inventories and cost of goods sold the auditors’
consideration of these controls and substantives tests of inventories and costs of goods sold. To summarize:

1. The audit of inventories presents the auditors with significant risk because:
1.1 they often represent a very substantial portion of currents assets.
1.2 numerous valuation method are used for inventories
1.3 the valuation inventories directly affects the cost of goods sold account and the determination
inventory quality, conditions and value is inherently complex.
2. Effective internal control over inventories requires appropriate controls over purchasing, receiving and
issuing supplies and producing and shipping products, and cost accounting. A perpetual inventory
system is also important.
3. The auditors under standing of the controls over inventories, purchase and production will allow them
to design appropriate substantive tests of inventory and cost of goods sold accounts
4. The auditors objective in the audit inventories and cost of goods sold are to:
4.1 consider relevant controls
4.2 establish the existence of and the client’s right to inventories
4.3 establish the completeness of inventories
4.4 establish the clerical accuracy of records and supporting schedules
4.5 determine that presentation and disclosures inventory account are appropriate
In the audit of inventories, auditors are primarily concerned about the existence assertion that is the
possibility of over statements of year end balances
Self Check Exercise
Part –I: Choose the Best Answer from the Given Choices

.
_____1 Which of the following statements best describes the duties of an independent

financial auditor in relation to physical verification of inventories?

A. The auditor should physically verify the inventories by counting, weighing or measuring them
B. The auditor should supervise the physical stock taking carried out by the management and
perform test counts
C. The auditor should observe the physical stock taking carried out by the management and
perform test counts
D. The auditor should satisfy himself about the effectiveness of the methods and procedures of
physical stock taking adopted by the management. He may also observe physical stock taking
if the considers it necessary to do so.

_____2. The auditor’s attendance at physical stock taking is one of the audit procedures often employed in
an audit of inventories. What in your view is the role of the auditor in stock taking where the audit
of decides to attend the stock taking?

A. he conducts physical stock taking him self

B. he supervises the stock taking while it is conducted by personnel who are specially assigned by
the management for this task
C. He observes the stock taking conducted by personnel who are specially as signed by the
management for his purpose
D. He observes the stock taking as at © above and also performs test counts himself in
appropriate cases.
_____3 An auditor wishes to determine whether the inventories include any damaged items.

Which of the following procedures would provide him the most persuasive evidence

in this behalf?

A. Observe physical stock taking

B. Examine management representations concerning inventories
 C. Compare stock turnover ratios of individual items for the current year with the corresponding
figure for previous years and enquire into any abnormal variations.
D. Compare physical quantities of items shown as damaged in inventory listing with the
corresponding figure for previous years
_____4. Which of the following procedures would, in your view provide an auditor with the most persuasive
evidence that the methods and procedures of stock taking adopted by the management are
effective?

A. Examine the appropriateness and adequacy of instructions issued by the management to stock
taking personnel
B. Insist that the instructions issued to the stock taking personnel be framed in consultation with
him
C. Observe stock taking conducted by the management
D. Apply analytical procedures to judge the fairness of inventory valuation
_____5. In determining whether the receipts of materials have been properly record in the perpetual
inventory records maintained by an enterprise, a sample of which of the following documents will
be most useful to the auditor

A. purchase requisition
B. Purchase order
C. Purchase invoice
D. Goods received note.
 UNIT NINE

9. Auditing Fixed Asset

Introduction

This part of the Manual includes procedural guidance for financial and compliance audits. Each section of
this part contains an introduction definition, audit objectives, internal control system and the audit
procedures to be carried out by the internal auditors to discharge their responsibilities. Internal auditors
should carry out these activities by taking into account the basic concepts and principles explained in Part
Three. The audit procedures provided in this part should only be used as guidance for the internal auditor
to design an audit program, which specifically meets the requirement of the public body under audit. The
internal auditor should select audit procedures, which are materially related to risk, feasible to the audit and
likely to generate useful findings.

General Objective

At the end of this session, you will be able to audit fixed assets properly.
Section 9.1 Evaluating Internal Control over Fixed Assets

9.1.1 Fixed Asset

The term fixed assets includes all tangible assets with a service life of more than one year that are used in
the operation of the business and are not acquired for the purpose of resale. Before starting the audit
activity, you should obtain understanding of all accounting policies, adopted by the clients, which are
relevant to fixed asset.

1). Land, such as property used in the operation of the business, has the significant characteristics of
not being subject to depreciation.

2). Building machinery, equipment and land improvements, such as fences and parking lots, have
limited service lives and are subject to depreciation.

3). Natural resources(wasting assets), such as oil wells, coal mines, and tracts of timber, are subject to
depletion as the natural resources are extracted or removed.

9.1.2 Internal Control Principles for Fixed Assets

The important controls applicable to plant and equipment are as follows:-

 A subsidiary ledger consisting of a separate record for each unit of property. An adequate plant and
equipment ledger facilitates your work in analyzing additions and retirements; in verifying the
depreciation provision and maintenance expenses; and in comparing authorizations with actual
expenditures.
 A system of authorizations requiring advance executive approval of all plant and equipment
acquisitions, whether by purchase, lease, or construction. Serially numbered capital work orders are a
convenient means of recording authorizations.
 A reporting procedure assuring prompt disclosure and analysis of variances between authorized
expenditures and actual costs.
 A policy requiring all purchases of plant and equipment to be handled through the purchasing
department and subjected to standard routines for receiving, inspection and payment.
  Periodic physical inventories designed to verify the existence, location, and condition of all property
listed in the accounts and to disclose the existence of any unrecorded units.
 The reconciliation of detailed records with control accounts
 Physical security over fixed assets and, if appropriate, the title to fixed assets recorded in the
accounts.

Internal control questionnaires for fixed assets

1. Are fixed assets registers or similar records maintained detailing the cost and accumulated depreciation of
each individual asset and identifying each asset by number which also appears on the asset itself?
2. Are these records maintained by persons other than those responsible for the custody of the physical
properties?
3. Are the detailed records agreed at least annually for each class of asset with cost and accumulated
depreciation according to the general ledger accounts?
4. Is a nominal book value in respect of fully depreciated assets retained in the records until the assets are
disposed of?
5. Is the original cost and accumulated depreciation (or if not known an estimate of the cost and
depreciation) eliminated from the accounting records and fixed asset records whenever an asset is sold or
 scrapped?
6. Are adequate records maintained of capital works in progress to identify expenditure incurred on each
separate project and provide proper control over costs?
7. Are adequate records maintained to control small tolls; cutlery; linen and other miscellaneous items?
8. Are fixed assets adequate physical safeguard?
9. Are fixed assets adequately covered by insurance?
10. Are physical inventories of fixed assets taken periodically, by or under the supervision of employees not
responsible for physical custody or record keeping of such properties?
11. Is adequate follow-up action taken by management in respect of assets reported as missing or damaged?
12. Are document of title kept in safe custody and controlled by register?

Activity 19
What are some of the key controls over fixed assets?

____________________________________________________________________

Section 9.2 Performing Audit for Fixed Assets

9.2.1 Audit Objectives of Fixed Assets

The auditors' objectives in fixed assets audit are to determine that:

 the recorded property, plant, and equipment is valid (existence and rights).
 all property, plant, and equipment is recorded (completeness)
 property, plant, and equipment records and supporting schedules are mathematically correct and
agree with general ledger accounts) clerical accuracy).
 the valuation of property, plant, and equipment is proper (valuation).
 the presentation and disclosure of property, plant, and equipment, including disclosure of
depreciation methods, is adequate. ( Disclosure)
In conjunction with the audit of fixed assets, you should also obtain evidence about the related accounts of
depreciation expense, accumulated depreciation, and repairs and maintenance expense.

9.2.2 Audit Procedures for Fixed Assets

 To ascertain that validity of the records of fixed assets,

 examine the fixed asset register, and trace the balances to the ledger accounts and the balance
sheet.
 trace the purchase invoices during the year to the fixed asset register, the ledger accounts and the
balance sheet.
 examine purchase invoices to verify that all the fixed assets acquisitions recorded in the books are
for transactions that have occurred.
 review minutes of the executive committee for approval of acquisitions.
 physical observation of assets to ascertain existence of fixed assets.
 To verify the completeness of fixed asset records, apply the following audit procedures:
 examine the fixed asset register, and trace the balances to the ledger accounts and the balance
sheet.
 trace the purchase invoices during the year to the fixed asset register, the ledger accounts and the
balance sheet.
 examine plant asset acquisitions and disposals to make sure that these transactions are in the right
period.
 To verify the clerical accuracy of records reconcile the figures of cost, accumulated depreciation and
book value with the corresponding figure in the previous year end:
 verify calculation of depreciation.
 examine the valuation of assets at acquisition
 verify arithmetic accuracy of addition.
 examine sales invoices and accounting records for disposals and check that depreciation is
calculated to date of disposal.
 For proper disclosure and presentation in the financial statements, you have to examine the chart
of accounts and the balance sheet for proper presentation of fixed assets, separate current assets
and notes to the financial statements regarding depreciation.

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a check mark ( ) in the
''Yes'' column if the check list item is clear to you or in the ''No'' column if the check list item is not clear.
Thus, if there is any item that is not clear to you to understand please reread the material and evaluate
yourself again and again until items are clear.

Confirmation Ideas Yes No

Can you identify internal control over fixed assets

Can you perform audit for fixed assets

Summary

Dear learner in this duty we presented the appropriate controls for fixed asset accounts the auditor ’s
consideration of these accounts, and the substantive procedures for fixed asset. To summarize

The financial statement" Fixed asset" includes tangible assets with a useful life of more than one year that
are used in operations. In the audit of fixed asset the auditors primary objectives are to (1) consider controls
over these assets, (2) determine the existence of fixed asset (3) determine the completeness of records (4)
evaluate the adequacy of presentation & disclosure.

Key controls over fixed asset should include proper authorization of acquisitions, adequate records & use of
serially numbered retirement work order.

In the audit of fixed asset for a continuing client, the emphasis of the testing is one transaction that occurred
during the year, as contrasted to an emphasis on ending balances.
Self Check Exercise
Part-I: choose the Best Answer from the Given Choices

____1. ABC Ltd. Has spent a substantial amount on white-washing and painting of its premises. Considering
that the amount involved in substantial, the accountant debits it to building account. Which of the
following audit procedures is most likely to result in the detection of this error by the auditor?

(A) Review of the list of construction work orders issued during the year.

(B) Discussions on accounting policies with the accountant.

(C) Observing, during his visit to the premises to attend physical stock-taking, that the premises have
been recently painted.

(D) Examining in detail a sample of construction work orders.

____2. Which of the following is the most common audit procedure for verification of ownership of land
held by an enterprise?

(A) Examination of correspondence with the solicitors of the company concerning acquisition of land.

(B) Examination of title deeds.

(C) Examination of minutes of the meeting of the board of directors concerning acquisition of the
land.

(D) Physical verification of the land

____3. Which of the following audit procedures is most likely to enable an auditor to discover unrecorded
additions to fixed assets?

(a) Examination of insurance policies.

 (B) Review of repairs and maintenance expenses

(C) Examination of invoices relating to additions to fixed assets.

____3. Which of the following procedures is most likely to enable an auditor to discover unrecorded
addition to fixed assets?

(A) Examination of capital budget.

(B) Review of repairs and maintenance expenses.

(C) Examination of invoices relating to additions to fixed assets.

____4. Which of the following statements best describes the duties of an independent financial auditor with
regard to physical verification of fixed assets?

(A) It is the responsibility of the management to carry out physical verification of fixed

assets. The auditor has no duty in this regard.

(B) It is the responsibility of the management to carry out physical verification of fixed assets. However,
the auditor should satisfy himself that the method and frequency of verification are reasonable in
the circumstances of the case. It is no part of an auditor's duty to attend the verification being
conducted by the management.

(C) It is the responsibility of the management to carry out physical verification of fixed assets. However,
the auditor should satisfy himself that the physical verification was carried out properly by observing
the verification being conducted by the management, wherever possible, and by examining the
written instructions issued by the management to the staff responsible for verification and the
relevant working papers.
 UNIT TEN

10. Auditing Liabilities

General Objective: At the end of this session, you will be able to audit liabilities properly.

Section 10.1 Performing Audit for Current Liabilities

Current liabilities include trade liabilities (accounts payable and notes payable) and accrued charges, and
short term borrowings. Trade liabilities constitute the major part of current liabilities.

Of all the types of payable, the item requiring most work under the general heading of current liabilities will
be trade payable which will be tested by extracting appropriate sample. To ensure that trade liabilities
reported in the balance sheet are valid, complete and accurate, the client should establish strong internal
control.
10.1.1 Internal Controls over Trade Payables

The client should establish strong internal control over trade payable to ensure that:

a) purchased goods /services are ordered under proper authorities and procedures;
b) purchased goods /services are only ordered as necessary for the proper conduct of business
operations and are ordered from suitable suppliers;
c) good / services received are effectively inspected for quality, quantity and conditions;
d) invoices and related documentation are properly checked and approved as being valid before being
entered as trade payables;
e) all valid transactions relating to trade payable (suppliers' invoices, credit notes and adjustments),
and only those transactions), and only those transactions, should be accurately recorded in the
accounting records.

10.1.2 Audit Objectives of Current Liabilities

The creditor's ledger contains individual accounts of suppliers from whom materials or goods have been
purchased or services received. In carrying out an audit of trade liabilities, the auditor aims at collecting
sufficient appropriate audit evidence to reasonably assure him/her self regarding the following assertions:

1) existence: the amounts recorded in respect of creditors are actually outstanding

2) rights and obligations: creditors represent obligations of the enterprise;
3) completeness; the creditors as shown by ledger accounts are complete;
4) valuation: the creditors' balances are stated at appropriate amounts; and
 5) presentation and disclosure: creditors' accounts are properly classified and disclosed in the financial
statement in accordance with generally accepted accounting principles.

10.1.3 Audit Procedures for Trade payables

The main procedures are as follows.

a) Obtain a schedule of the trade payable with appropriate age analysis and check this with the control
account and the purchase ledger.
b) Debit and credit balances should be separated, debit balances being included the receivables ( this is
known as grossing up)
c) Review the individual accounts with the largest throughput of transactions during the period ( not
necessarily the largest balances at the year end)
d) Review the year-end cut-off procedures for purchases.
e) Review the internal control over the purchases systems which ensures that all goods received are
properly recognized as liabilities of the company.
f) The following should be considered during the tests of individual balances:
I. Is the balance made up of specific items outstanding within a reasonable period?
II. Have all the items been authorized for payment?
III. Does the amount agree or can it be reconciled with supplier's statements?
IV. Consider the need to perform a confirmation of accounts payable.
V. Review payments to payables just after the year end.
g) Perform analytical procedures on payables, comparing age analysis with pervious periods and payable
days.

10.1.4 Accrued Charges

Accrued charges are also classified as current liability. Accrued charges are accruals, like prepayments which
are commonly made for rent, gas, electricity, telephone and other items where the expenditure has been
incurred in the current period but where no invoice has yet been paid. Accruals are often immaterial and
reliance's often placed on analytical procedures. Nevertheless, as year end adjustments, there are rarely any
controls over accruals and any errors are likely to be those of understatement.

Evidence will include:

 i. considering the client's own system (if any) for capturing accruals.
ii. obtaining a schedule of accruals, ensuring that it is cast correctly and comparing it with prior year
accruals and performing other analytical procedures.
iii. testing checking a sample of accruals for correct calculation, referring to supporting invoices received
in the next period.
iv. include confirmation for the completeness of accruals in the management representation letter.

10.1.5 Short Term Borrowing

Bank overdraft are shown as liabilities even though there may be other bank balances shown as an asset,
the only exception being if there is a legal rights of set-off. Verification of bank overdraft is in other respects
identical to the verification of cash balances

Section 10.2 Performing Audit for Long-term Liabilities

10.2.1 Internal Control Principles for Long Term Liabilities

The auditor evaluates the accounting system and internal controls relating to loans borrowings aspects
focusing on the following:

(1) The terms relating to loans and borrowings to ensure if it covers the following aspects

a) interest , securely , repayment , etc.

b) maximum amount up to which a loan or a borrowing can authorize the acceptance of a loan or a
borrowing along with the limit on the amount of all loans ad borrowings
c) procedure for negotiating the terms; the persons who can be authorize the acceptance f a loan or a
borrowing along with t limits on the amount
d) documentation i.e. agreements and there documents to be executed for different kinds of loads a
borrowing
e) procedure of ensuring compliance with the relevant legal requiems
2- The availability of proper system for safe custody of documents relating to loans and borrowings.

3- The availability of a system of periodic review of the condition and value of securities offered.
4- The availability of a system of obtaining periodic confirmation of balance relating to each loan or
borrowing. The auditor should also check if the discrepancies revealed by such confirmation investigated
is appropriate and follow up act is taken.

5- The auditor should also ascertain if there is a periodic review of all loans ad borrowing to identify cases
where the enterprise has failed to comply with the terms coeditors, particularly those where the
amount of principal and or interest have become overdue.

10.2.2 Audit Objectives Relating to Long Term Liabilities

In carrying out an audit of liabilities, the auditor seeks to obtain sufficient appropriate audit evidence to
reasonable assure himself in respect of the following assertions:

 existence : the obligation in respect of liabilities shown on the balance sheet outstanding at the
balance sheet date
 rights and obligations : liabilities represent obligations of the enterprise to the third parties
 completeness : the outstanding obligations to third parties are included in liabilities show in the
balance sheet
 valuation: liabilities are stated in the financial statements at appropriate amounts.
 presentation and disclosure: Liabilities are classified and disclosed in the financial statements in
accordance with recognized accounting principles and relevant statutory requirements.

10.2.3 Audit Procedures for Long – Term Liabilities

The auditor decides the nature of timing and extent of the examination of the basis of his/ her evaluation of
the internal controls relating to loans and borrowings. The following specific procedures are generally
employed in auditing liabilities:

1. examine Whether the total amount of loans and borrowings is within the statutory or other limits
on the borrowing powers
2. examine the relevant agreements and other documents supporting the transactions relating to
loans , borrowings etc in particular , the auditor has to examine the following:
 A. are important terms of loan agreements being completed with the terms? the auditor pays
particular attention to those terms which affect to financial statement and examines weather
these requirement or restriction have bee complied with the terms.
B. in the case of a loan classified as secured, is the market value of the security at the balance
sheet date is at least equal to the amount of the lone outstanding?
C. in the case of loans advances from banks and financial intuitions, do the amounts show as
outstanding agree with the statements of account / confirmation received from the lenders? In
case of the discrepancy, has reconciliation been carried out between the amount in the book of
the company and that shown in the statement of the lender?
3. examine any specific aspects relating to loans and borrowings which are required to the examined
or reported up on under the statue governing the company.
4. in the case of bonds issued by a company, you have to carry out the following procedures
a- verify the opening balance of bonds with the amount show in the audited balance sheet of the
previous year
b- in respect of bonds issued during the year, examine the memorandum and the articles of association
of the company as well as the relevant resolution of the board of directors and where relevant of
the general meeting, authorizing the issue of bonds.
5- examine whether the loans ad borrowings have bee properly classified and disclosed in the financial
statements in accordance with recognized amount principals.

Activity 20
Write about the audit objectives relating to long term liabilities

______________________________________________________________________

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a
check mark ( ) in the ''Yes'' column if the check list item is clear to you or in the
''No'' column if the check list item is not clear. Thus, if there is any item that is not
clear to you to understand please reread the material and evaluate yourself again
and again until items are clear.

Confirmation Idea Yes No

Can you describe principles of internal control

Over current liability & long term liability

Can you perform auditing for currents & long term liability

Summary

This duty explained the fundamental controls over account payables and purchase transactions. It also
discussed the auditors consideration of thee controls and the substantive procedures foe accounts payable
and purchase. To summarize

1. Account payables are short-term obligations arising from the purchase of goods and services in the
ordinary course of the business
2. the purchase cycle includes initiate and authorized purchases ordering goods and services and
recording and paying accounts payables effective internal control over purchase transaction is best
achieved by having separate department responsibility for purchasing receiving and accounting for
transaction
3. The auditor principal objectives in the examination of account payable and purchases are to:
(a) substantiate the existence of recorded account payable and the accounting of purchase
transaction
(b) establish the completeness of account payables and purchase transactions
(c) determine that the clients has obligation to pay the recorded account payable.
(d) determine that the presentation and disclosure of account payable and purchase are
appraise
4. Accrued liabilities represent obligations payable for service receives before the balance sheet date
that will be paid in the subsequent periods. The substantive procedures to audit these liabilities
generally include inspection of documents, recompilation and analytical procedures.

 Self _Check Exercise

 Part-I: choose the Best Answer from the Given Choices

____1. Which of the following procedures is least likely to be completed before the balance sheet date?

A. Confirmation of receivables
B. Search for unrecorded liabilities
C. Observation of inventory
D. Review of internal control over cash disbursements
____2. An audit of the balance of the accounts payable account is ordinarily not designed to

A. Detect accounts payable that are substantially past due

B. Verify that accounts payable were properly authorized

C. Ascertain the reasonableness of recorded liabilities

D. Ascertain that all existing liabilities at the balance sheet date have been recorded

____3. Which of the follow is the best audit procedure for determine the existence of

unrecorded liabilities?

A. examine confirmation requests returned by creditors whose accounts appear on a subsidiary

trial balance of accounts payable
B. examine unusual relationships between monthly accounts payable balances and recorded
purchases
C. examine a sample o invoices a few days prior to and subsequent to year end to ascertain
whether they have bee properly recorded
D. examine selected cash disbursements in the period subsequent to year end
____4. Auditor confirmation of accounts payable balances at a the balance sheet date may be

unnecessary because

A. This is a duplication of cutoff tests

B. Accounts payable balances at a the balances sheet date may not be paid before the audit is
completed
C. Correspondence with the audit client ’s attorney will reveal all legal action by vendors for
nonpayment
D. There is likely to be other reliable external evidence available to support the balance
____5. A client erroneously recorded a large purchase twice. Which of the following internal control
measures would be most likely to detect this error in a timely ad efficient manner?

A. Footing the purchases journal

B. Reconciling vendor’s monthly statements with subsidiary payable ledger accounts

C. Tracing total from the purchases journal to the ledger accounts

 D. Sending write quarterly confirmation to all vendors

UNIT ELEVEN

7. Auditing Owners' Equity

General Objective: At the end of this session, you will be able to audit liabilities properly.

Section 11.1 Performing Audit for Owners' Equity of Sole Proprietorship or

Partnerships

Perhaps the most common reason for a small business to arrange for an independent audit is the need for
audited financial statement in order to obtain a bank loan. Often, a banker, when approached by the owner
of a small business applying for a loan, will request audited financial statements as an aid to reaching a
decision a loan application.

It is natural for the owner of a business being audited for the first time to be concerned about the auditors'
fee and to question whether all the procedures performed by the auditors are really necessary. If you are
informed that the reason for the audit is to obtain a bank loan, you have to arrange a joint meeting in which
the owner, the bankers, and you (the auditor) will discuss the objectives and scope of the examination. Such
a meeting is helpful in making the small-business owner aware that the auditor must have unlimited access
to all information about the business. The owner then is more likely to cooperate fully with respect to such
audit procedures as confirmation of receivables and observation of inventories.
11.1.1 Procedure for Audit Partners' Accounts

A most significant document underlying the partnership from of organization is the partnership contract.
You will be particularly interested in determining that the distribution of net income has been carried out in
accordance with the profit-sharing provisions of the partnership contract. You have to verify whether
partners' capital accounts are maintained at prescribed levels and restriction of drawings by partners to
specify amounts are according to the partnership contract. You should also compare the partners' loan
accounts with the partnership contract to determine the treatment by the partners.

11.1.2 The Auditors Approach to the Audit Owners’ Equity

The auditors’ objectives in the audit of owners’ equity are to:

1. internal control Consider over owners’ equity

2. Determine the existence of recorded owners’ equity
3. Establish the completeness of recorded owners ‘equity.
4. Determine that the valuation of owners’ equity is in accordance with generally accepted accounting
principles.
5. Establish the clerical accuracy of schedules of owners’ equity
6. Determine that the presentation and disclosure of owners’ equity are appropriate.

In conjunction with the audit of owners’ equity accounts, the auditor will also obtain evidence about the
related accounts of dividends payables and capital stock discounts and premiums. Evidence is also gathered
regarding the proper cutoff of cash receipts and disbursements relating to the equity accounts.

Activity 21
Write about auditors objectives in the audit of owner equity

_________________________________________________________________
10.1.3 Audit Program for Capital Stock

The following procedures are typical of the work required in many engagements for the verification of
capital stock.

1. obtain an understanding of internal control over capital stock transactions

2. examine articles of incorporation, bylaws, and minutes for provisions relation to capital stock.
3. obtain or prepare analyses of the capital stock accounts.
4. accounts for all proceeds from stock issues.
5. confirm shares outstanding with the independent register and stock transfer agent.
6. for a corporation acting as its own stock register and transfer agent, reconcile the stockholders
records with the general ledger.
7. determine compliance with stock option plans and with other restrictions and preferences
pertaining to capital stock.
Capital stock transactions are usually few in number; consequently, the auditors usually, substantiate all
transactions rather than obtaining evidences to reduce their assessment of control risk. In additions to the
proceeding steps, the auditors must, determine the appropriate financial statements presentation of capital
stock.

Check-list
Important concepts of the unit are listed below. Evaluate your self by indicating a
check mark ( ) in the ‘’Yes’’ column if the check list item is clear to you or in
the ‘’No’’ column if the check list item is not clear. Thus, if there is any item that
is not clear to you to understand please reread the material and evaluate yourself
again and again until items are clear.

Confirmation Ideas Yes No

 Can you describe the internal control principles for owner's equity

Can you identify audit objectives of owner's equity of corporation

Describe audit procedures of corporation

Summary

Describe the auditors approach to auditing interest bearing debt. The details of the audit of long term debt
and equity accounts were discussed in this chapter. The chapter includes a description of the controls for
these types of accounting and the audit procedure that the auditors use to substantiate long-term debt and
equity accounts

1. The financing cycle involves the activities of the company that are designed to obtain capital fund. It
typically involves the issuance and repayment of debt and equity as well as payment interest and
dividends.
2. In the audit interest bearing debt the auditors’ primary substantive procedures will include vouching
selected transaction acuity during the provide examined debt agreements, confining balance and
terms and evaluating compliance with restrictive covenants
3. The auditors’ primary substantive procedure. For equities transaction will typically include vouching
the major equity transaction accounting during the period confirming the number of shares
outstanding with the registrar and evaluating the company ’s compliance with stock option plan
requirements and other restricting agreements

Operation Sheet (BIS ACC S13 1008)

Operation Title: Perform Audit Report
Purpose: To perform audit report

Operational Procedures:

Range of Variables Range Statements

 Unit scope
The scope Statement provides advice to interpret the scope and
context of this unit of competency, allowing for differences
between enterprises and workplaces. It relates to the unit as a
whole and facilitates holistic assessment. The following
variables express the scope of the unit i.e.:, Data sources:,
Audit lines of inquiry:, Internal control procedures:,
Established professional standards etc

 Company accounting policy, rules and regulation and

 Tools and Equipment
 Types and Sources of
Information
 Required knowledge
related government requirement.
 Printers
 Adding Machine
 Box files and cabinets
 Correcting fluid
 Models for audit report
 Models for audit working
 Company accounting policy, rules and regulation,
organization structure and related government
requirement.
 Financial statements, ledger, Journals
 Evidential materials
 employee records/history
 Annual budget, management report, previous Audit
report
 Memorandum and article of Association of the
company
 Financial manuals, commercial code of Ethiopia
 principles of internal control (including statutory
requirements)
 wide knowledge of recording and information
management systems and software applicable to
financial recording
 ethical considerations for records and file
management (eg confidentiality)
 testing procedures and methods of inquiry
 financial legislation (eg taxable transactions, reporting
requirements)
 duties and responsibilities of auditors
 principles of auditing
  knowledge of relevant professional accounting
standards
 Definition of other variables
Data sources may include:
(Bold italic written terms or
 budgets and forecasts
phrases)
 financial statements and reports
 market valuations
 financial markets monitoring services (eg Reuters)
Audit lines of inquiry may include:
 evaluation of achievement of accounting system
objectives
 assessment of objectives of internal control
 accounting staff
 management
 specialist and expert advice
 company officers
 operation and strategic plans
Internal control procedures may include:
 identification, measurement and recording of income,
assets, expenditure, liabilities and equity
 safeguarding and insurance of assets
 decision making authorities
 accuracy in valuations
 transparency in financial reporting
 risk management strategies
Established professional standards may include:
 Accounting Standards Board
 Auditing Standards
 Auditing Guidance Statements
 ethical requirements
Testing procedures may include:
 interviews with personnel concerning the
performance of duties
 observation of personnel
 inspection of documentation for evidence of control
procedures
 reconstruction of accounting routines
 achievement of debt repayment schedules
 submission of statutory returns
Systems may include:
 financial information systems
 personal information systems
 recording and filing systems
 communication and distribution systems
 data bases
  decision making authorities
System specifications may include:
 logical data models (eg data base design)
 software (upgrades and legacies)
 changing needs
 client compatibilities
 financial analysis functions
 processing capacities (eg system size, speed)
 networking capacities
Security requirements may include:
 limited personnel access
 passwords
 encrypted data
 read only files requirements
 virus scanning
 data storage requirements
Risk management strategies may include:
 quantification of risks
 periodic reporting
 decision making authorities
 policy statements
 forecasting
 comparative analysis
Strengths and weakness of organisational processes may
include:
 computer literacy (eg skills profiles)
 compliance with internal procedures
 documented procedures
 recording systems
 work practices
 attitudes to change
 decision making authorities
Implementation may include:
 testing
 feedback
 consultation
 staged introduction
 evaluation
 documentation and guidelines
 budgeting
Short and long term objectives may include:
 budgetary targets (eg quarterly, half yearly, annual)
 sales and revenues targets
 monthly cash flows
  investment realisations
 client development
 profit growth
Sources of input data and documentation may include:
 invoices
 purchase orders
 requisitions
 receipts
 system reports
Evidence Guide Description
 knowledge of internal control systems
 Critical Aspects of
 knowledge of organisational policies and procedures
Competency
 knowledge of professional accounting standards
 ability to identify strengths and weakness within
organisational policies and procedures
 ability to evaluate information systems
 ability to develop implementation plans
 ability to review resources
 ability to monitor plans
The learner and trainer should have access to appropriate
 Resource Implications
documentation and resources normally used in the
workplace which may include:

 workplace reference materials such procedural

manuals and company policy
 calculator
 computer equipment and relevant software
 financial data from preceding pay periods

Job Sheet (BIS ACC S13 1008)

Job Title: Perform Audit Report

Unit: Performing Audit Report

let’s do the following self test exercises:

 Activity 1

Define auditing using your own words or phrases.

 Answer key for Activities and Self Check Exercises

UNIT ONE

Activity 1

Auditing is a systematic process of objectively obtain and evaluating evidence regarding assertions about
economic actions and events to ascertain the degree of correspondence b/n those assertion establish
criteria and communicating the results to interest users.

Activity 2

The part of the AICPA code of professional conduct that expresses the profession ’s responsibilities to the
public clients and colleagues, and provides a framework for the rules.

Activity 3

1. Governmental auditor
2. Internal auditor
3. Internal auditors
4. Independent auditor

Activity 4

1. Financial audit
2. Operational audit
 3. Compliance audit
4. Operational audit
5. Financial audit

Activity 5

Because auditors help percent customers from over stating the profit of the business and costs of assets in
order to decisive the bank in to granting a loan to un worthily customer

Activity 6

1. B 6. B
2. A 7. A
3. C 8. B
4. C 9. C
5. A 10. C

Self-Check Exercise 1

1. D 6. B
2. C 7. A
3. C 8. D
4. A 9. C
5. A 10. A

UNIT TWO

Activity 7

Phase I accepting the audit engagement

Phase II planning the audit engagement

Phase III performing the field work

Phase IV reporting findings

Activity 8

Statistical sampling is a sampling technique that is based up on the cause of probability which enables
auditors in planning selection and evaluation self test.

Self-Check exercise 1

1. A 4. C
2. C 5. B
3. A 6. B

UNIT THREE

Activity 9

The competency of the evidential matter refers to the quality of the evidence which depends on its
relevance of its validity

Activity 10

Some of the common types of audit procedures are

- Physical examination
- Confirmation
- Comparison
- Tracing
- Vouching
Self- Check Exercise 2
1. B 6. A
2. B 7. A
3. D 8. B
4. C 9. D
5. B 10.A
UNIT FOUR

Activity 11

The purpose of internal control

- To monitor operating efficiency

- To monitor adherence to prescribed policy
Activity 12

The objective of internal control for financial of accounting aspects are

- Transaction are

Self-Check Exercise 3

1. D 4. A
2. D 5. B
3. D
Activity 13

A) Lack of maintenance of records and documents

B) Lack of segregation of duties.

C) Lack of testing transaction related to cash receipt.

Activity 14

The billings function.

Activity 16

Some of the functions related to credit sales are:

Accepting the customer's order; Approving credit; Filling the sales order; Billing the customer etc
Activity 17

Expenditure cycle is the activities associated with the acquisition of and payment for plant assets, goods and
services, and labor. There are three major classes of transactions in this cycle these are: Purchases, cash
disbursements, and payroll.

Activity 18

A) Inventories must be received to the stores only against proper requisition notes approved by authorized
managers..

Self-Check Exercise 4

1. D 2. D 3. A 4. C 5. D

Activity 19

Some of the key internal controls of fixed asset are:

 A subsidiary ledger consisting of a separate record for each unit of property. An adequate plant and
equipment ledger facilitates your work in analyzing additions and retirements; in verifying the
depreciation provision and maintenance expenses; and in comparing authorizations with actual
expenditures.
 A system of authorizations requiring advance executive approval of all plant and equipment
acquisitions, whether by purchase, lease, or construction. Serially numbered capital work orders are a
convenient means of recording authorizations.
 A reporting procedure assuring prompt disclosure and analysis of variances between authorized
expenditures and actual costs.

Activity 20

 Existence : the obligation in respect of liabilities shown on the balance sheet outstanding at the
balance sheet date
 Rights and obligations : liabilities represent obligations of the enterprise to the third parties
  Completeness : the outstanding obligations to third parties are included in liabilities show in the
balance sheet
 Valuation: liabilities are stated in the financial statements at appropriate amounts.
 Presentation and disclosure: Liabilities are classified and disclosed in the financial statements in
accordance with recognized accounting principles and relevant statutory requirements.
Activity 21

The auditors’ objectives for owner’s equity are:

examine the internal control over owners’ equity

determine the existence of recorded owners’ equity

establish the completeness of recorded owners ‘equity.

determine that the valuation of owners’ equity is in accordance with generally accepted accounting
principles.

establish the clerical accuracy of schedules of owners’ equity

determine that the presentation and disclosure of owners’ equity are appropriate.

Self –test 5.

1. B 4. D

2. B 5. D

3. B