Auditing 3e (Volume I)

AUDITING
An ISA Perspective
3rd (updated and revised) Edition
Study Notes and Case Studies
By: Muhammad Asif, ACA

ALL RIGHTS RESERVED.
3rd (updated and revised)

Edition: April 2017
AUDITING, 3/e (updated and revised)
AUTHOR
Muhammad Asif, ACA
DEDICATED
TO
PAKISTAN
PREFACE
Why this Book:

While teaching Auditing, I have seen a lot of students having problem in preparing the subject.
This problem arises for a number of reasons, i.e.
1) Books available in the market on this subject are not student-friendly, key concepts from
examination point of view are not spotlighted, students encounter many irrelevant
paragraphs, and sometimes requirements are not arranged in logical and practical
sequence.
2) Students adopt wrong approach towards the subject i.e. “Simply memorize paragraphs
and reproduce them in exam!”.
This is not going to work in auditing. If you analyze the recent trend of ICAP’s past
papers, you will see that emphasis of examiner has shifted from “reproduction of
concepts” towards “application of concepts”. Even if you memorize 100% of
recommended text, you will not get passing marks unless you are able to apply them in
real world scenarios. Unfortunately, there is little practice material available in the
market for concept application questions and case-studies.
I have created a separate section in the book specifically to learn and practice case
studies.
This book is an effort to make students’ life easy. I have tried to make this subject easy and
interesting. I hope you will find it so.
What is NEW in the 3rd Edition:

In 3rd edition, the book has been divided into two separate volumes i.e.
 Volume I, which consists of
o Part A: study notes, and
o Part B: how to attempt case studies for each topic
 Volume II, which consists of
o Part A: multiple choice questions, concept review questions and case studies, and
o Part B: suggested solution to the questions of Part A
Volume – I:
 Virtually all learning objectives have been revised in accordance with ISA 2016 edition
and ICAP's latest syllabus.
 Every learning objective has been marked with one, two or three stars to show their
relative exam importance.
 Every learning objective has been linked with ICAP's Study Text to ensure that students
automatically cover ICAP's study text through this book.
 Chapter-wise list of questions in ICAP's question bank has been given with each chapter
of the book so that students can practice relevant questions from ICAP's question bank.
 Carefully selected questions from past exam papers of various national and
international professional bodies e.g. ICAP, ICMA Pakistan, PIPFA, ICAEW (England and
Wales), AICPA (USA), ACCA (UK),CGA (Canada), have been included at the end of almost
every learning objective. This will help students in evaluating how the concept may be
tested in exam, and whether their preparation is upto the mark.
Volume – II:
Please see Volume – II of the book.
i
ACKNOWLEDGEMENT
This book is not an individual’s effort. I am thankful to all of my students, colleagues,

friends and assistants who encouraged me and helped me during completion of this
project. Especially, I am thankful to my students Mr.Tauseef Ullah Usmani and
Mr.Humaer Jahangir who did a lot of work in compilation of examination questions and
proof-reading of previous edition of the book.
I am also thankful to my students Umer Shafiq, Muhammad Jahanzeb Hashim and

Syed Muhammad Asif who have helped me during various stages of the preparation of
the 3rd edition of the book.
iii
ANY SUGGESTIONS/COMMENTS?
This book is not the best book of auditing. However, I am committed to make it the best book for
students. This aim cannot be achieved by a single person. Therefore, your help is needed.
If you find any errors in the book, any concept which needs to be improved (keeping in mind
students’ perspective), or any other suggestion, I will highly appreciate if you share it with me
so that in future this book may further be improved.
For any comments/ suggestions/additional support, you can contact me through:
Address: RISE School of Accountancy
06 Aurangzaib Block, New Garden Town, Lahore
Cell # : 0331-4585358 (sms only)
e-mail address: asif@riseschool.edu.pk
facebook page: https://web.facebook.com/groups/CAF09
Muhammad Asif
April 24, 2017
Lahore
iv
Explanation of Symbols given at start of each chapter
Explanation of Symbol:
Symbol ✯ indicates importance of the concept from exam point of view.
 If a concept is tagged with three stars i.e. ✯✯✯, it is very very important concept. Such
concepts should be focused most during preparation, should be revised atleast 10 times in
the last month before exam, and should be revised first on last day before exam.
 If a concept is tagged with two stars i.e. ✯✯, it is very important concept. Such concepts
should be focused highly during preparation, should be revised atleast 6 times in the last
month before exam, and should be revised after three-star concepts on last day before
exam.
 If a concept is tagged with single star i.e. ✯, it is important concept. Such concepts should
be focused moderately during preparation, should be revised atleast 3 times in the last
month before exam, and should be revised after two-star concepts on last day before exam.
(Note that none of the concept is unimportant, therefore none should be skipped)
v
Reasons of Failure and Suggestions for Successful Performance in Auditing (CAF – 09)
General Reasons:
 Time Management Problems.
 Poor Planning and Presentation skills.
Specific Reasons:
Reason What examiners said
“Primary reasons contributing to marginal performances appeared to be
lack of preparation and presentation skills combined with cursory
reading of auditing standards.”
Examiners’ Comments (Autumn 2011)
“The candidates are reminded that questions set in this paper require
answers specific to set scenarios rather than those consisting of general
comments.”
Giving answers in
Examiners’ Comments (Spring 2009)
general way (and not
standardized text)
“Candidates did not submit specific replies rather tried to answer by
making general comments without making the use of appropriate
terminologies which resulted in a poor expression.”
“Students could have performed well had they read the Auditing
standards in a reasonable depth”
“The paper was set in such a way as to cover a large area of the syllabus.
Hence, the students with lack of adequate coverage of the syllabus could
Selective Studies
not do well.”
“It was quite obvious from a large number of scripts that candidates
scored good marks in theoretical components but failed to handle
questions involving practical approach.”
Insufficient practice Examiners’ Comments (Autumn 2011)
on application of
concepts “As expected, candidates did well on the theoretical part but seemed to
be confused while applying their knowledge on scenario based
questions.”
“Answers submitted by some of them were extremely brief and lacked
any profundity of knowledge of the relevant areas of the syllabus.”
“Most candidates started to write whatever they knew about the topic
without comprehending the requirement of the question”
Omitting relevant
details, and Giving
irrelevant details
“As in the past, even good answers contained irrelevant portions which
were not required. There is a general tendency in many students to
produce as much information as they know even if only a part of it has
been asked for. The students are advised to cut this tendency, if they
really want to succeed in the examinations.”
vi
“Successful candidates (....) attempted their strongest question first to get them off to a
triumphant start.”
Candidates must note the total number of available marks and provide an answer in line with
this.
Examiners’ Comments
Author’s Suggestions:
 Never use outdated and/or sub-standard study material.
 Have enough practice for case studies and questions requiring analytical skills.
 Develop “Either right or wrong” approach towards the subject.
And the most important thing to remember is “Key to Success is PRAYER”.
vii
CROSS REFERENCE FOR TRANSITION FROM ICAP’S STUDY TEXT (2017) TO THIS BOOK
Chapter 1: Concept and need for assurance Chapter 3: Planning and risk assessment
ICAP’s Study Text
Coverage in this Book ICAP’s Study Text
(2017) Reference Coverage in this Book
(2017) Reference
1.1 LO 1 & LO 2 of Chapter 2
1.1 Not Covered
1.2, 1.3, 1.4 LO 1 of Chapter 1
1.2 LO 8 of Chapter 2
LO 1 of Chapter 5, LO 1 of
2.1, 2.2 LO 3 of Chapter 1 1.3
Chapter 9
2.3 LO 2 of Chapter 1 1.4 LO 2 of Chapter 9
3.1, 3.2, 3.3 LO 1 & LO 2 of Chapter 6 1.5 LO 4 of Chapter 9
4.1, 4.3, 4.5 Not Covered 2.2 Not Covered
4.2, 4.4 LO 9 of Chapter 2 2.3 LO 1 of Chapter 10
4.6 LO 5 & LO 8 of Chapter 2 2.4 LO 5 - 8 of Chapter 9
5.2 LO 1 & LO 3 of Chapter 1 3.3 LO 2 of Chapter 10
3.4 Appendix 1 of Chapter 10
Chapter 2: Obtaining an engagement 4.1 LO 1 of Chapter 19
LO 1 - 3 & LO 6 of Chapter
ICAP’s Study Text 4.2
Coverage in this Book 19
(2017) Reference
4.4 (mistyped as 4.5) LO 4 of Chapter 19
1.1 Not Covered
Case 16 (Appendix 1) of
1.2 5.1 & 5.2 LO 9 of Chapter 10
Chapter 7
1.2 (Fee &
Not Covered
tendering)
LO 2 & LO 3 of Chapter 5,
1.3
LO 2 of Chapter 6
2.2 LO 1 - 4 of Chapter 8
viii
Chapter 4: Evidence and sampling Chapter 6: Flowcharts and IT concepts
ICAP’s Study Text (2017) ICAP’s Study Text

Coverage in this Book Coverage in this Book
Reference (2017) Reference
1.1 Not covered
1.2 LO 2 of Chapter 3 1.1 - 1.3 LO 8 of Chapter 11
1.3 LO 2 of Chapter 3 LO 8, LO 9 & LO 10 of
1.4
1.4 LO 3 of Chapter 3 Chapter 11
1.5 Not covered 2.1 Not covered
1.7 LO 4 of Chapter 3 LO 11 & LO 12 of
2.1 LO 6 & LO 8 of Chapter 3 2.4
Chapter 13
2.3 LO 7 - 9 of Chapter 3
3.3 - 3.4 Not covered
3.5 LO 6 of Chapter 17 Chapter 7: Tests of controls
ICAP’s Study Text
Chapter 5: Internal control Coverage in this Book
(2017) Reference
ICAP’s Study Text (2017)

Coverage in this Book 1.1 Not covered
Reference
LO 8 & LO 9 of Chapter
1.2
1.1 Not covered 13
1.2 LO 1 of Chapter 11 1.3 Not covered
1.3 Not covered Appendix 1 of Chapter
1.4 LO 1 of Chapter 10 1.4
11
2.1 Not covered 2.1 - 2.4 LO 3 of Chapter 11
2.2 - 2.6 LO 2 of Chapter 11 3.1 - 3.4 LO 4 of Chapter 11
4.1 - 4.6 LO 5 of Chapter 11
2.8 Appendix 1 of Chapter 11
5.1 - 5.3 LO 6 of Chapter 11
3.1 LO 1 of Chapter 11 Appendix 1 of Chapter
7.2
3.2 LO 9 of Chapter 10 11
4.1 Not covered
5.1 - 5.2 LO 3 of Chapter 13
ix
Chapter 8: Introduction to substantive procedures Chapter 10: Substantive procedures: current assets
ICAP’s Study Text (2017) ICAP’s Study Text (2017)

Coverage in this Book Coverage in this Book
Reference Reference
LO 4 of Chapter 3, Intro of 1.1 Not covered

1.1
Chapter 12 1.2 LO 5 of Chapter 3
1.2 LO 5 of Chapter 3 1.3, 2.1 - 2.3, 3.1 - 3.2 LO 3 of Chapter 12
1.3 Not covered 3.3 LO 7 of Chapter 11
1.4 LO 9 of Chapter 13 LO 5 of Chapter 3, LO 1
4.1
1.5 LO 7 of Chapter 13 of Chapter 14
1.6 LO 3 of Chapter 3 LO 2 & LO 5 of Chapter
4.2
LO 1 of Chapter 15, 4.4 LO 3 of Chapter 14
2.1 - 2.2 Appendix 1 of Chapter
Appendix 2 of Chapter 10 4.5
2.5 Appendix 2 of Chapter 10 4.7 Not covered
Chapter 9: Substantive procedures: non-current assets 4.9 LO 5 of Chapter 12
ICAP’s Study Text (2017) LO 3 & LO 6 of Chapter
Coverage in this Book 5.2
Reference 14
1.3 - 1.4 LO 1 of Chapter 12
2.1 - 2.4 LO 2 of Chapter 12
Note for Students
These transitional pages are prepared to ensure that all concepts of ICAP’s study text
have been covered in this book. This list will also be helpful for students who want
transition from ICAP’s study text to this book.
However, there are certain paragraphs which are not important from exam point of
view and therefore, are not covered in this book. Once, you cover all concepts from
this book, you may read these paragraphs too from ICAP’s study text if you have time.
x
Chapter 11: Substantive procedures: other areas Chapter 14: Professional ethics and codes of
conduct
ICAP’s Study Text
Coverage in this Book
(2017) Reference ICAP’s Study Text (2017)
1.1 LO 5 of Chapter 3 Reference
1.2 - 1.3 LO 9 of Chapter 12
2.3 - 2.4 LO 10 of Chapter 12 2.2 LO 2 of Chapter 7
4.1 Not covered
4.2 - 4.3 LO 12 of Chapter 12 2.5 Not covered
4.4 Not covered
5.1 Not covered
Chapter 12: Related party transactions
ICAP’s Study Text

(2017) Reference
LO 3, LO 4, LO 5 of
1.3
Chapter 16
Chapter 13: Reliance on others

ICAP’s Study Text
(2017) Reference
LO 1, LO 2 & LO 3 of
1.1
Chapter 18
1.2 Not covered
1.4
18
2.2 Not covered
2.3
18
xi
Chapter 15: Audit finalisation and reporting Chapter 16: International standards on review
engagements
ICAP’s Study Text
(2017) Reference ICAP’s Study Text (2017)
Reference
1.1 - 1.2 LO 5 of Chapter 20
2.2 1.4 LO 4 & LO 5 of Chapter 22
20
2.4
20
3.1 - 3.2 Not covered
4.1 Not covered
5.1 Not covered
5.4 Not covered
Appendix 3 (Category
5.5
8) of Chapter 4
6.1 - 6.2 LO 4 of Chapter 21 Note for Students
6.3 - 6.5 LO 5 of Chapter 21 Below is the list of questions/subparts from ICAP’s
7.1 LO 2 of Chapter 4 question bank, which (in author’s opinion) are not
LO 3 & LO 6 of Chapter suitable for preparation or revision of CAF 09
7.2 exam, therefore these questions may be skipped:
6
 9 (Regulatory and professional requirements)
7.3 LO 6 of Chapter 6  12 (Independence of external auditors)
7.4 Not covered  47 (Educational University)
8.1 LO 7 of Chapter 4  55d (IT Department)
8.2 LO 4 of Chapter 4  92 (Wings)
8.3 LO 5 of Chapter 4  101a (Bubbles)
 102b (ISA 500)
 111d (Multiple Situations)
8.5 LO 5 of Chapter 4  133a (Situations have arisen on)
LO 1 & LO 2 of Chapter  144bii (Kazmi-Wassan)
8.6
21
8.8
21
9.1 - 9.3 LO 8 of Chapter 4
10.1 Not covered
10.2 - 10.4 LO 3 of Chapter 21
xii
TABLE OF CONTENTS
Page Number
Chapter
Chapter Title Study Case
No.
Notes Studies
PHASE I: BASICS OF AUDITING

1 Introduction To Assurance Services 1 199
2 Basic Concepts of Auditing 6 200
3 Audit Evidence 15 203
4 Auditor’s Report & Types of Opinions 28 206
PHASE II: PRELIMINARY ENGAGEMENT ACTIVITIES

5 Acceptance and Continuance Procedures 42 215
6 Compliance With Legal Requirements 48 217
7 Compliance With Ethical Requirements 55 220
8 Engagement Letter 60 227
PHASE III: PLANNING OF AUDIT

9 Planning an Audit 64 229
10 Understanding of Entity and Inherent Risk Assessment 71 232
Understanding of Internal Control and Control Risk
11 80 246
Assessment
12 Substantive Procedures 100 251
13 IT Systems, Controls, CAATs and Flowcharts 120 255
PHASE IV PERFORMANCE OF AUDIT

14 External Confirmation 135 259
15 Analytical Procedures 142 263
16 Related Parties 146 264
17 Audit Sampling 152 265
18 Reliance on Work of Others 160 269
19 Fraud Considerations in Audit 169 270
PHASE V: REPORTING AND POST-REPORTING ISSUES

20 Final Matters 177 274
21 Auditor’s Report II 184 279
PHASE VI: REVIEW AND RELATED SERVICES

22 Review Engagement 193 282
xiii
PART A
STUDY NOTES
Auditing – Study Notes Chapter 1 Introduction to Assurance Services
CHAPTER ONE
INTRODUCTION TO ASSURANCE SERVICES
LO # LEARNING OBJCTIVE
LO 1
ORIGIN, ADVANTAGES AND DISADVANTAGES OF ASSURANCE SERVICE
✯
LO 2
DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT
✯✯
LO 3
TYPES OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE PROVIDED
✯✯✯
For explanation of star symbol, refer to page # v at start of the book.
Coverage from ICAP’s Question Bank (2017 Edition)
After completion of this chapter, you will be able to attempt following concept review questions
in ICAP's Question Bank:
Q. # 2 (Levels of assurance) Q. # 147a (ISRE 2400)

Q. # 111g (Multiple Situations)
After completion of this chapter, you will be able to attempt following case studies in ICAP's
Question Bank:
None. There is no case study in ICAP’s question bank relating to this chapter.
Tick the box of each question, if you have completed the question from ICAP’s
Question Bank (2017 edition).
Alternatively, you can attempt practice questions from Volume – II of this book
which substantially covers these questions as well as further questions to have
sufficient practice.
1
LO 1: ORIGIN, ADVANTAGES AND DISADVANTAGES OF ASSURANCE SERVICES: ✯

Origin of Assurance Services:
Since the Industrial Revolution in 18th century, businessmen started forming Joint Stock Companies
to do business. In most situations, people who managed the company (called management or
directors) were separate from those who owned the company (called shareholders). Following
concepts explain the nature of relationship between management/directors and shareholders:
 Stewardship:
Management and Directors have role of stewardship i.e. management wisely look after the
assets of the company on behalf of shareholders
 Agent:
Management and Directors act as agent in accordance with instructions of shareholders
(the principal).
 Accountability:
Management and Directors are accountable to the shareholders.
To judge the performance of management and directors, shareholders asked them to prepare and
present them financial statements. Soon after, it was recognized that financial statements prepared
by management/directors presented “best-view” of business instead of “true-and-fair-view” due
to some Incentive (e.g. bonus) or Pressure (e.g. fear of removal) faced by management. Thus
credibility of financial statements was questioned. To enhance the credibility/ confidence/
assurance on these financial statements, an expert person (called assurance provider or auditor)
was hired by shareholders to verify financial statements. This person is independent of both
management and shareholders.
Advantages of Assurance Services:

An assurance engagement may be performed not only to meet statutory requirements, but there
are also some other value-added advantages.
For Shareholders:
1. Financial statements are more reliable for decision making because most of the
misstatements will be detected during audit.
2. Minority shareholders (or sleeping partners) will have assurance that their interest is
protected.
For Directors/Management:
An audit improves a company’s governance i.e.
1. Audit identifies deficiencies in entity’s internal control system and assurance providers
suggest recommendations for improvement through Management Letter.
2. Audit acts as a check on employees; thereby positive behavior increases and risk of fraud is
reduced.
3. Audit assures that management is performing its statutory duties.
For Third Parties:

An audit also provides facilities to third parties in their dealings with company e.g.
1. To prospective investors in purchase of Business or Shares.
2. To banks in granting loan.
3. To tax authorities in ascertaining tax liability.
4. To insurance companies in settlement of insurance claims
2
Disadvantages of Assurance Services:

1) Audit takes cost and time of client.
2) Entity has to share its confidential information with auditor.
3) Management/Directors often think audit as a “disturbing activity” instead of a “value added
activity”.
4) Audit does not provide 100% (i.e. absolute) assurance, therefore, there is still some risk that
errors or fraud may exist.
5) Terminology used in audit report is not usually understood by non-accountants which
causes misunderstanding among stakeholders (e.g. terms of “reasonable assurance”,
“material”, “misstatement”, “true and fair”, “test basis”, “accounting principles”)
6) Audit is of little value if shareholders are actively involved in management.
Services of auditors were appreciated greatly. Now a days, assurance engagements are performed
either because:
 they are required by law (called statutory assurance engagements e.g. all companies in
Pakistan are required by law to get their annual financial statements audited before they
are given to shareholders), or
 they are not required by law but are voluntarily performed (called non-statutory
assurance engagements e.g. sole-proprietorships, partnerships and NGOs etc. conducting
an audit).
CONCEPT REVIEW QUESTION

What are the advantages of an audit to an organization? (05 marks)
(ICAP, CAF 09 Level – Spring 2004)
LO 2: DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT: ✯✯

Assurance Engagement:
“Assurance engagement” means an engagement in which a practitioner obtains evidence about
evaluation of a subject matter against suitable criteria, and expresses his conclusion to enhance the
confidence of the intended users (other than the responsible party).
Elements of Assurance Engagement:

Every assurance engagement consists of following 5 elements:
Element Explanation (with respect to assurance on financial statements)

1. Intended users (the parties who require subject matter and assurance
report e.g. shareholders, bankers)
A three party 2. A responsible party (the party which is responsible for preparation of
relationship subject matter i.e. management) and
3. A practitioner (the professional who verifies subject matter and provides
assurance on it i.e. auditor)
Subject matter is the data which responsible party prepares and is to be
A subject matter
verified e.g. Financial Statements
Criteria means Framework (i.e. standard rules and regulations) which is used
A Suitable Criteria to prepare and evaluate financial statements e.g. IFRS or Tax Laws.
Suitable means it should be selected appropriately.
Evidence means information on which practitioner’s conclusion is based.
Evidence
Evidence should be sufficient and appropriate.
3
It is a page written in standard format which includes conclusion of

Written Assurance
practitioner. It is provided by practitioner to intended users e.g. Report on
Report
audit of financial statements, or Report on review of financial statements.

Explain the five elements of an assurance engagement. (05 marks)
(ACCA, Fundamentals Level F8 – June 2013)
LO 3: TYPES OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE PROVIDED:

✯✯✯
“Assurance” means confidence with which a practitioner expresses his conclusion. Assurance adds
credibility in financial statements, however level of credibility depends on type of assurance
provided.
Types /Levels of Assurance:

There are two levels of assurance that can be provided to assurance client i.e. Reasonable
Assurance and Limited Assurance.
Reasonable Assurance (also called High Level or Positive Assurance)

It is a high, but not absolute, level of assurance which is expressed in positive form of conclusion i.e.
“in our opinion, financial statements give true and fair view”.
Concept of reasonable assurance states that it is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement whenever it exists; and
misstatements can arise from fraud or error which could be material.
This is usually given in an audit of financial statements.
Limited Assurance (also called Moderate Level or Negative Assurance)

It is a moderate level of assurance which is expressed in negative form of conclusion i.e. “Based on
our review, nothing has come to our attention that causes us to believe that financial statements do
not give true and fair view”.
This is usually given in a review of financial statements.
Why absolute assurance cannot be provided to an assurance client:

Auditor cannot provide absolute assurance because of inherent limitations of assurance/audit.
These limitations are discussed below:
1. Some accounts in financial statements involve estimates / judgments/ uncertainties which
are difficult to calculate and verify (e.g. Provision for bad debts, Depreciation, Outcomes of
legal cases, Warranty expenses, Intangible assets.)
2. There are always some limitations/weaknesses in internal control system of client.
3. Many of the audit procedures based on auditor’s judgment which can be faulty.
4. Because of time and cost limitation, auditor checks only a sample of transactions.
5. Fraud involving collusion and complex techniques are harder to detect.
6. Management may not provide complete information to auditor.
7. Auditor does not have specific legal powers e.g. power to search.
8. Most of the evidence is persuasive rather than conclusive.
4

(a) What is meant by reasonable assurance? (02 marks)
(b) Why an auditor cannot provide an absolute assurance as a result of audit? Explain. (03 marks)
(ICAP, CAF 09 Level – Autumn 2004)
5
Auditing – Study Notes Chapter 2 Basic Concepts of Auditing
CHAPTER TWO
BASIC CONCEPTS OF AUDITING
PART A – FINANCIAL STATEMENTS

LO 1
WHAT IS INCLUDED IN COMPLETE SET OF FINANCIAL STATEMENTS
✯
PART B – FINANCIAL REPORTING FRAMEWORK
LO 2
FINANCIAL REPORTING FRAMEWORK AND ITS TYPES
✯
LO 3
WHAT IS MEANT BY TRUE AND FAIR VIEW
✯
PART C – RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT
LO 4
OVERALL RESPONSIBILITIES OF MANAGEMENT
✯✯
LO 5
OVERALL RESPONSIBILITIES OF AUDITOR
✯
LO 6
RESPONSIBILITIES OF STAKEHOLDERS / EXPECTATION GAP
✯✯
PART D – SCOPE OF AUDIT
LO 7
SCOPE OF AUDIT
✯
LO 8
ESSENTIALS OF PROPER CONDUCT OF AUDIT
✯✯✯
PART E – REGULATORY ENVIRONMENT OF AUDITING
LO9
INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)
✯✯
LO 1 0
INTERNATIONAL STANDARDS ON AUDITING (ISAs)
✯
6
4 (Core concepts) 96e (Auditors)

8a (Audit process) 111a (Multiple Situations)
88i (Framework) 146a (Rake Enterprises)
Question Bank:
7
PART A – FINANCIAL STATEMENTS
LO 1: WHAT IS INCLUDED IN COMPLETE SET OF FINANCIAL STATEMENTS: ✯

Requirements of AFRF determine what is a complete set of financial statements. Generally, a
complete set of financial statements includes following elements:
 Balance-sheet
 Profit and loss account/Income Statement
 Cash flow statement
 Statement of changes in equity
 Notes to the accounts

What parts of a company’s annual report are covered by an audit report? (02 marks)
(ICAEW Professional Stage – September 2006)
PART B – FINANCIAL REPORTING FRAMEWORK
LO 2: FINANCIAL REPORTING FRAMEWORK AND ITS TYPES: ✯

A financial reporting framework is a set of criteria used to prepare financial statements.
There are two main types of financial reporting frameworks i.e. Compliance Framework and Fair
Presentation Framework.
Compliance Framework:
Compliance framework is a financial reporting framework that requires compliance with
requirements of the framework, and does not contain acknowledgements which are contained in
fair presentation framework (regarding additional disclosures or departure from requirements of
framework to achieve fair presentation).
An example is Tax-basis Framework.
Fair Presentation Framework:

Fair presentation framework is a financial reporting framework that requires compliance with
requirements of the framework, and contains acknowledgment that, to achieve fair presentation, it
may be necessary for management:
 To provide disclosures in addition to specific requirements of framework or
 To depart from a requirement of framework
An example is International Financial Reporting Standards.
Study Tip: Applicable Financial Reporting Framework/AFRF

AFRF is the financial reporting framework which management adopts in preparation of financial
statements considering legal requirements, nature of entity, nature of financial statements, and purpose of
financial statements.
Auditor shall not accept proposed audit engagement, if AFRF is not acceptable.
8

Differentiate between the following:
(i) Fair presentation framework and compliance framework (04 marks)
LO 3: WHAT IS MEANT BY TRUE AND FAIR VIEW: ✯

In a fair presentation framework, financial statements should present true and fair view.
The term “True and Fair View” has not been defined in the Companies Ordinance 1984 or in ISAs or
in IFRSs. Therefore, it is the most judgmental and difficult aspect of audit. Generally,
 Financial statements are True when:
o data is correctly transferred from accounting records to financial statements, and
o financial statements are free from factual errors, and
o financial statements comply with accounting standards and local regulations.
 Financial statements are Fair when:
o financial statements are free from undue bias, and
o financial statements show “substance over form” and “consistency”.
Study Tip
Terms “give true and fair view” and “present fairly, in all material respects” are equivalent. However,
first term is more common in practice.

Discuss the concepts of stewardship and accountability in the context of a limited company and fair presentation (true
and fair view) in relation to the financial statements. (06 marks)
PART C – RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT
LO 4: OVERALL RESPONSIBILITIES OF MANAGEMENT: ✯✯

In an audit of financial statements, management (and where applicable TCWG) is responsible:
1. For preparation and presentation of financial statements in accordance with AFRF. This
responsibility includes:
 Selecting financial reporting framework to be used.
 Applying financial reporting framework in preparation and presentation of financial
statements.
 Selecting appropriate accounting policies and applying them consistently.
 Making judgments and estimates that are reasonable and prudent.
2. For such internal control which management and TCWG determine necessary for
preparation of financial statements that are free from material misstatement (whether due
to error or fraud); and
3. To provide the auditor all:
i. relevant information (relevant to the preparation of the financial statements);
ii. additional information (requested by auditor for the purpose of audit); and
iii. unrestricted access to persons within the entity (to obtain audit evidence).
9
Study Tip
“Premise of an audit” means management (and where applicable TCWG) has acknowledged and
understands that it has responsibilities as described above.
Auditor shall not accept proposed audit engagement, if premise of audit is not present.

Briefly highlight the management’s responsibilities relating to the financial statements? (07 marks)
LO 5: OVERALL RESPONSIBILITIES OF AUDITOR: ✯

Overall responsibilities/objectives of the auditor are to obtain reasonable assurance about whether
the financial statements are free from material misstatement (whether due to fraud or error), and
to issue report that includes the auditor’s opinion on financial statements.
Auditor is also responsible to communicate with other parties in accordance with his findings if
ISAs require. For example, auditor is required to communicate certain matters to TCWG in writing
(list of such matters is given in LO 9 of Chapter # 4).
Exam Tip
Responsibilities described above are overall responsibilities of management and auditor (i.e. with respect
to whole financial statements and audit). However, there are also some area-specific responsibilities of
management and auditor e.g. with respect to Internal Controls, Accounting Policies, Related Parties, Going
Concern, and Subsequent Events.

What is the primary/overall objective of an audit? (04 marks)
LO 6: RESPONSIBILITIES OF STAKEHOLDERS / EXPECTATION GAP: ✯✯

It is the responsibility of general public (i.e. stakeholders) to understand and eliminate expectation
gap so that scope of audit is not misunderstood.
Expectation Gap:
Expectation Gap is the difference between ‘what general public perceives about role and
responsibilities of auditor’ and ‘what statutory role and responsibilities of auditor are’.
Public expectations are usually higher than auditor’s statutory responsibilities.
Some Common Misunderstandings (i.e. Expectation Gap) about Audit:

1. Auditor prepares financial statements.
2. Auditor checks 100% transactions of entity during the accounting period.
3. Auditor provides absolute assurance (i.e. he certifies or guarantees that financial statements
are correct).
4. Auditor is responsible to detect all misstatements.
5. Auditor has a responsibility to prevent and detect all frauds.
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6. Auditor provides assurance/opinion on internal control.

7. Unmodified report assures efficiency and effectiveness of management.
Consequences of Expectation Gap:

There is increasing tendency to file legal actions against auditors without any valid basis.
How to Reduce Expectation Gap:

Expectation gap can be reduced by:
 Mentioning management’s responsibilities, auditor’s responsibilities and inherent
limitations of audit in Engagement Letter.
 Mentioning management’s responsibilities, auditor’s responsibilities and brief description
of audit in Auditor’s Report.
 Expanding and improving the format of auditor’s report.
 Steps taken by SECP and ICAP e.g. through implementation of Code of Corporate
Governance.
 Public awareness on scope of audit and responsibilities of auditor.

What are the principal misunderstandings made by lay users of audited financial statements that are commonly referred
to as “The Expectation Gap”? (02 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – September 2007)
Outline the measures adopted in the country to address the expectations gap. (02 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – March 2011)
PART D – SCOPE OF AUDIT
LO 7: SCOPE OF AUDIT: ✯
Scope of audit means nature, timing and extent of audit procedures which are necessary to achieve
the overall objective of audit. Scope of an audit is determined considering requirements of ISAs,
local laws and regulations, and auditor’s Professional Judgment.
Scope of audit includes performing procedures as per ISAs to obtain reasonable assurance about
financial statements. It also includes:
1. To evaluate whether financial statements present true and fair view.
2. To identify and assess risk of material misstatement (whether due to fraud or error), to
design and perform audit procedures responsive to those risks, and to obtain sufficient
appropriate audit evidence on which to base opinion.
3. To obtain an understanding of internal control to assess risk of material misstatement, but
not to express an opinion on the effectiveness of the entity’s internal control.
4. To evaluate the appropriateness of accounting policies and the reasonableness of
accounting estimates and related disclosures made by management.
Scope of audit does not assure efficiency and effectiveness of management, future viability of entity,
or other parts of the annual report.
Study Tip
If auditor is unable to perform a procedure and obtain evidence, it is called “limitation on scope of
audit” or precisely “scope limitation”.
11

What is your understanding of the term “scope of an audit”? (03 marks)
(ICAP, CFAP 06 Level – Winter 1998)
LO 8: ESSENTIALS OF PROPER CONDUCT OF AUDIT: ✯✯✯

For the successful completion of a good audit, it is necessary that auditor exercises following
attributes throughout the audit engagement:
Professional Judgment:
Definition:
Professional Judgment is the application of Cumulative Audit Knowledge, Experience and Training,
within the context of accounting, auditing, and ethical standards, in different circumstances of audit
to reach an appropriate course of action or conclusion.
Areas where professional judgment is applied:

 in assessing risk of material misstatement.
 in determining whether an item is material.
 in planning and performing nature, timing and extent of audit procedures.
 in evaluating sufficiency and appropriateness of audit evidence.
 in evaluation of management’s judgments and estimates.
Professional Skepticism:
Definition:
Professional skepticism is an attitude that includes:
 a questioning mind
 being alert to conditions which may indicate possible misstatement (due to error or fraud),
and
 critical assessment of audit evidence.
It means auditor should not accept anything without corroborative evidence (even if management
showed honesty and integrity in past).
Professional skepticism includes being alert:

1. if there is any contradictory evidence.
2. if there is any indication of fraud.
3. if there is any doubt over reliability of evidence.
Importance of Professional Skepticism in planning and performing an audit:

ISAs require auditor to maintain professional skepticism throughout the audit (especially in
complex and highly judgmental areas). Professional skepticism increases audit quality and reduces
risk of:
 overlooking unusual circumstances,
 over-generalizing conclusions.
 using inappropriate assumptions in determining audit procedures and
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Independence:
Independence means auditor should be free to perform audit procedures without any bias or
influence. Auditor should be Independent of financial, personal and employment relations with
client.
(This concept will be discussed in detail in later chapters.)

The International Standards of Auditing require an auditor to exercise professional judgment in planning and performing
an audit of financial statements.
Define professional judgment. Identify the areas regarding which an auditor should exercise professional judgment
during an audit. (07 marks)
(ICMA Pakistan, Professional Level P2 – Summer 2013)
Explain the meaning of the term professional skepticism, and discuss its importance in planning and performing an audit.
(05 marks)
(ACCA, Professional Level P7 – June 2015)
PART E – REGULATORY ENVIRONMENT OF AUDITING
LO 9: INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC): ✯✯

International Federation of Accountants:
IFAC is the worldwide leader of audit profession. It is the global organization of professional
accountants dedicated to serving the public interest.
IFAC supports the development of profession in the area of auditing, ethics, professional education
and public sector by following activities:
 development of high-quality standards and guidance
 facilitating the adoption and implementation of standards and guidance
 promoting the value of professional accountants worldwide
 speaking out on public interest issues
IFAC includes following four boards:

 International Auditing and Assurance Standards Board (IAASB);
 International Ethics Standards Board for Accountants (IESBA); and
 International Public Sector Accounting Standards Board (IPSASB).
 International Accounting Education Standards Board (IAESB);
International Auditing and Assurance Standards Board (IAASB):

IAASB is one of the boards within IFAC. It is a standard-setting body which enhances quality and
consistency of assurance practice throughout the world by following activities:
1. It develops and promotes standards to be applied in providing the audit, review and related
services.
2. It also provides facilitation in adoption and implementation of international standards.
3. IAASB also issues International Auditing Practice Statements (IAPS) to help auditors in
implementing ISAs and to promote good auditing practice in general.
13

International Federation of Accountants (IFAC) provides leadership to the worldwide accountancy profession in serving
the public interest. What activities are undertaken by IFAC to achieve this aim? (04 marks)
Explain briefly the role of International Auditing and Assurance Standards Board (IAASB). (04 marks)
LO 10: INTERNATIONAL STANDARDS ON AUDITING (ISAs): ✯

Authority/Status of an ISA:
In Pakistan, audit is conducted in accordance ISAs; and to obtain reasonable assurance, it is
compulsory for auditors to comply will all required procedures of all ISAs.
Exception to application of ISA:

A required procedure will not be performed if it is not relevant or is not practicable. However, if a
procedure is not practicable, auditor shall document:
 reason of departure from required procedure, and
 alternative procedures performed to obtain evidence/assurance.

Explain the status of International Standards on Auditing. (02 marks)
(ACCA, Fundamentals Level F8 – December 2010)
14
Auditing – Study Notes Chapter 3 Audit Evidence
CHAPTER THREE
AUDIT EVIDENCE
PART A – AUDIT EVIDENCE

LO 1
WHAT IS MEANT BY AUDIT EVIDENCE
✯
LO 2
WHAT IS MEANT BY SUFFICIENT AND APPROPRIATE AUDIT EVIDNENCE
✯✯✯
PART B – AUDIT PROCEDURES
LO 3 PROCEDURES (OR METHODS OR TECHNIQUES) TO OBTAIN AUDIT
✯✯ EVIDENCE
LO 4
PHASES OF OBTAINING AUDIT EVIDENCE
✯✯
LO 5
ASSERTIONS TESTING APPROACH TO OBTAIN EVIDENCE
✯✯
PART C – AUDIT DOCUMENTATION
LO 6
AUDIT DOCUMENTATION, ITS PURPOSES AND RETENTION
✯
LO 7
AUDIT FILE AND ITS TYPES
✯
LO 8
FORM, CONTENT AND EXTENT OF AUDIT DOCUMENTATION
✯✯
LO 9
CHANGES IN DOCUMENTATION AFTER AUDITOR’S REPORT
✯✯✯
15
20b (Engagement letter and documentation) 96b (Auditors)

22c (Assertions) 108c (Zeedin Co)
43 (Calm Co) 110d (Bashir Co)
81 (Working papers) 112 (Final audit file)
85 (Guava & Co) 115 (XYZ Limited)
93a, b (Glasses2Go) 126j (Multiple Questions)
95 (Cuddly World)
Question Bank:
93c (Glasses2Go)
16
To obtain reasonable assurance, auditor shall:

 obtain “Audit Evidence”
 by performing “Audit Procedures” (also called “Audit Tests”) and
 shall retain “Audit Documentation”.
PART A – AUDIT EVIDENCE
LO 1: WHAT IS MEANT BY AUDIT EVIDENCE:✯

Audit evidence is the information used by auditor in arriving at the conclusions on which the
auditor’s opinion is based.
Audit Evidence = Information contained in Accounting Records + Other Corroborative Information
Evidence may be obtained from different sources e.g. internal or, external, or by auditor himself.

Explain what is meant by the term ‘audit evidence’ and state what it comprises. (03 marks)
(Certified Accounting Technician UK – December 2004)
LO 2: WHAT IS MEANT BY SUFFICIENT AND APPROPRIATE AUDIT EVIDNENCE:✯✯✯

What is meant by Sufficient Evidence:
Sufficiency is the measure of the quantity of audit evidence. Sufficiency of the audit evidence is
affected by:
 Assessed risk at financial statement level and assertion level (if risk is high, more evidence
is required)
 Materiality and complexity of item (if item is highly material or complex, more evidence is
required)
 Auditor’s knowledge and experience of business (the more knowledge and experience, the
less evidence will be required)
 Quality of audit evidence (if quality is high, less evidence is required).
 Nature of internal control (if internal control is strong, auditor may place reliance on it and
less evidence is required)
What is meant by Appropriate Evidence:

Appropriateness is the measure of the quality of audit evidence i.e. its relevance and its reliability in
providing support for the conclusion on which auditor’s opinion is based.
Relevance:
Relevance of evidence deals with logical connection with the purpose of the audit procedures and,
where appropriate, the assertion under consideration. A procedure relevant for one assertion may
not be relevant for other assertions e.g. if your purpose is to verify existence of vehicles, relevant
evidence will be obtained by inspecting vehicle physically. However, if your purpose is to verify
rights and obligation of vehicle, relevant evidence will be obtained by inspecting title documents of
vehicle.
17
Reliability:
Reliability of evidence depends on its source, nature, and circumstances under which it is obtained
e.g.
 Evidence from independent external source is more reliable than internal evidence (e.g.
confirmation from customer is more reliable than a sales invoice)
 Evidence in documentary form (whether paper, electronic or other medium) is more
reliable than evidence in oral form (e.g. a written confirmation from a debtor is more
reliable than a telephonic reply).
 Evidence in the form of original document is more reliable than photocopy or fax.
 Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly
or by inference (e.g. observation of application of a control is more reliable than inquiry
about application of a control)
 Evidence generated internally is more reliable when related controls over its preparation
and maintenance are effective (e.g. pre-numbered documents are more reliable than
unnumbered documents because their numerical sequence can be checked).
Exam Tip
A mnemonic to remember the reliability criteria of evidence is that evidence should be “CODED” i.e.
Controlled, Original, Documentary, External and Direct.

Explain the term “Sufficient and Appropriate Audit Evidence”. (04 marks)
List and explain FOUR factors that will influence the auditor’s judgement regarding the sufficiency of the evidence
obtained. (04 marks)
State any two factors which the auditor should consider to ensure reliability of audit evidence. (02 marks)
PART B – AUDIT PROCEDURES
LO 3: PROCEDURES (OR METHODS/TECHNIQUES) TO OBTAIN AUDIT EVIDENCE:✯✯

Audit procedures are methods and techniques used by the auditor to gather audit evidence.
1. Inquiry:
Inquiry consists of seeking information from knowledgeable persons, both financial and non-
financial, within the entity or outside the entity.
Examples:
1. Inquiring management about any change in accounting policy or change in requirements of
financial reporting framework.
2. Inquiry of management about legal cases against company and assessment about their
outcomes.
18
2. Observation:
Observation consists of looking at a process or procedure (e.g. controls) being performed by others.
Examples:
1. Observing inventory counting by the entity’s personnel to ensure that proper control and
counting procedures are being followed.
2. Observing cash receiving process to ensure segregation of duties between receiving and
recording of cash.
3. Inspection:
Inspection involves examining records or documents (whether internal or external), or a physical
examination of an asset.
Examples:
1. Inspection of purchase invoices for evidence of authorization.
2. Physical examination of individual inventory items to verify existence of inventory.
4. External Confirmation:
External confirmation is a process of obtaining evidence by auditor directly from a third party in
written (on paper, electronic or other medium).
Examples:
1. Circularization of sample of customers to confirm the existence of trade receivable balances
2. Send confirmation letter to banks to confirm the balances and other information.
5. Recalculation:
Recalculation consists of checking the mathematical accuracy of documents or records.
Recalculation may be performed manually or electronically.
Examples:
1. Recalculation of sales invoices or purchase invoices.
2. Recalculate the profit or loss on disposal for a sample of fixed assets disposed during the
year to ensure accuracy.
3. Recalculate valuation for a sample of inventory items to ensure correct calculation of cost.
6. Reperformance:
Reperformance means auditor independently performing procedures or controls that were
originally performed by entity as part of its internal control.
Examples:
1. Reperforming ageing of accounts receivable balances.
2. Reperforming the extraction of a trial balance from company’s general ledger.
7. Analytical Procedures:
Analytical Procedures means evaluation of financial information through comparisons and analysis
of plausible relationships with other financial and non-financial information. Analytical procedures
also include investigation if actual values are significantly different from expected values.
Examples:
1. Calculate gross profit ratio and compare with last year to assess its reasonableness.
19
2. Develop expectation of salaries expense, taking into account joiners and leavers to assess its
reasonableness. Compare it with actual expense and investigating unusual difference.
Study Tip
Above procedures can be performed for different purposes e.g. as Risk Assessment Procedures, as
Test of Control or as Substantive Procedures.

Briefly explain any six methods for collecting audit evidence. (12 marks)
(i) Describe FIVE types of procedures for obtaining audit evidence; and
(ii) For each type of procedure, describe an example relevant to the audit of BANK balances. (10 marks)
(ACCA, Fundamentals Level F8 – March/June 2016)
LO 4: PHASES OF OBTAINING AUDIT EVIDENCE:✯✯

Risk Assessment Procedures (RAPs):
Definition/Objective:
Risk Assessment Procedures are auditor’s procedures to obtain understanding of the entity and its
internal control to assess the risk of material misstatement (whether due to error or fraud) at
financial statement level and at assertion level.
Examples:
1. Inquiries of:
a. management (e.g. about any change in accounting policy or change in financial
reporting framework or legal requirements),
b. internal audit function (e.g. about issues which have been raised with BOD), and
c. others within the entity (e.g. to in-house legal counsel about any litigation, to sales
personnel about trend of sales).
2. Observation and inspection
For example, observation of entity’s operations, inspection of internal control manuals,
inspection of entity’s plant and premises, inspection of reports prepared by management
and TCWG.
3. Analytical procedures.
Analytical procedures may identify unusual ratios and relationships in financial statements
and may help in assessing the risk of material misstatement e.g. calculation and comparison
of debtors’ turnover ratio.
Additionally, ISAs also require that engagement partner and other key engagement team members
to have Discussion among engagement team about susceptibility of the entity’s financial
statements to material misstatement.
Objectives/Benefits of discussion among engagement team:

1. More experienced members share their insights based on their knowledge of the entity.
2. Team members exchange information about the business risks of entity and how
financial statements may be misstated.
3. Team members gain a better understanding of audit risk in specific areas assigned to
them, and how the results of their work can affect other aspects of audit.
4. Team members communicate and share new information obtained throughout the audit
that may affect the audit risk or audit procedures
20
Applicability/When are these procedures performed:

ISAs require auditor to perform risk assessment procedures in every audit.
Tests of Controls (TOC): (also called Compliance Tests)

Objective of TOC is to confirm the operating effectiveness of internal control in preventing,
detecting and correcting misstatements at assertion level.
Examples:
1. Inspect signature of appropriate authority as evidence of approval of sales invoices or
purchase invoices.
2. Observing cash receiving process to ensure segregation of duties between receiving and
recording of money.

ISAs require auditor to perform Tests of Controls if:
 auditor assesses control risk less than maximum (i.e. controls are operating effectively and
he plans to rely on internal control in his risk assessment), or
 substantive procedures alone do not provide sufficient appropriate audit evidence.
Substantive Procedures:
Objective of Substantive Procedures is to detect material misstatements in financial statements at
assertion level. These include Analytical Procedures and Tests of Details (of classes of transactions,
account balances, and disclosures).
Examples:
1. Analytical Procedures:
Develop expectation of salaries expense, taking into account joiners and leavers. Compare it
with actual expense and investigate unusual difference.
2. Tests of Details:
Recalculate the profit or loss on disposal for a sample of fixed assets disposed during the
year to ensure accuracy.

ISAs require auditor to perform substantive procedures for all material areas.
Study Tips
ICAP’s syllabus requires that you should have skills:
1. To identify inherent risks from a given set of financial and non-financial information about
entity (to be learnt in Chapter # 10).
2. To assess whether controls in an area are strong or weak. If controls are assessed strong,
you should be able to suggest tests of controls to confirm their operating effectiveness. If
controls are weak, you should be able to make recommendations to improve it (to be
learnt in Chapter # 11).
3. To recommend Substantive Procedures for important areas of financial statements to
detect misstatements (to be learnt in Chapter # 12).
21

Describe the following methods used to obtain audit evidence by providing at least two examples of each:
(i) Tests of controls (05 marks)
(ii) Substantive procedures (05 marks)
(ICMA Pakistan, Professional Level P2 – 2014 August )
The auditor performs risk assessment procedures to obtain an understanding of the entity and its environment, including
its internal controls. Briefly discuss all such procedures. (09 marks)
List the benefits associated with holding timely discussion among the team members in respect of matters susceptible to
material misstatements. (05 marks)
LO 5: ASSERTIONS TESTING APPROACH TO OBTAIN EVIDENCE:✯✯

While preparing financial statements, management has specific objectives regarding ear area of
financial statements e.g. sales must be accurate and complete, or inventory must exist and properly
valued). These specific objectives are called assertions. ISAs require auditor to obtain evidence for
every assertion of every area of financial statements.
Assertions/Management Assertions/Financial Statement Assertions:

Assertions are representations by management, explicit or otherwise, that are embodied in the
financial statements. These are:
 used by the auditor to consider different types of misstatements that may occur and
 tested by the auditor to obtain evidence which supports these assertions.
Types/Categories of assertions:
There are three types/categories of assertions i.e.
Assertions about classes of transactions and events for the period:
1. Occurrence i.e. all transactions and events, that have been recorded, have actually occurred
and pertain to the entity.
2. Completeness i.e. all transactions and events, that should have been recorded, have been
recorded.
3. Accuracy i.e. amounts and other data relating to transactions and events have been
recorded appropriately.
4. Classification i.e. transactions and events have been recorded in the proper accounts.
5. Cutoff i.e. transactions and events have been recorded in correct accounting period.
Assertions about account balances at the period end:

1. Existence i.e. recorded assets, liabilities, and equity actually exist.
2. Completeness i.e. all assets, liabilities and equity interests, that should have been recorded,
have been recorded.
3. Valuation and allocation i.e. assets, liabilities, and equity are included in the financial
statements at appropriate amounts; and adjustments relating to valuation/allocation have
been recorded.
4. Rights and obligations i.e. entity holds or controls the rights to assets, and liabilities are
obligations of entity.
22
Assertions about Presentation and Disclosures:

1. Occurrence and rights and obligations i.e. disclosed events, transactions, and other
matters have occurred and relate to the entity.
2. Completeness i.e. all necessary disclosures have been included in financial statements.
3. Accuracy and valuation i.e. disclosures are made at appropriate amounts.
4. Classification and understandability i.e. financial information is correctly categorized,
and disclosures are clearly expressed.
Directional Testing : (an old approach to obtain evidence)

Directional testing means directly testing debit items (assets and expenses) for
overstatement and credit items (liabilities and income) for understatement; thereby opposite
accounts are automatically tested indirectly because of double-entry system e.g. direct testing
of liabilities for understatements also tests indirectly expenses for understatement.
Exam Tip
In exam, if you are asked to state types of misstatement that could occur in an area of financial
statements, write with reference to assertions of that area.

Briefly describe the assertions used by the auditors in respect of the following:
(i) account balances
(ii) classes of transactions; and
(iii) presentation and disclosures (07 marks)
Identify and explain FOUR assertions relevant to accounts payable at the year-end date. (06 marks)
Use of the audit method called directional testing means that certain items are tested primarily for understatement and
others for overstatement. When this method is adopted, state whether the following are tested for understatement or
overstatement:
• assets; • liabilities; • income; and • expenditure (02 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2007 December)
23
PART C – AUDIT DOCUMENTATION
LO 6: AUDIT DOCUMENTATION, ITS PURPOSES AND RETENTION:✯
Audit Documentation/Working Papers:

Audit Documentation is the written record of audit procedures performed, evidence
obtained and conclusions reached by auditor.
Purposes/Objectives/Benefits of Preparation of Audit Documentation:

Primary Purposes:
Audit documentation provides evidence that:
 audit is planned and performed in accordance with ISAs and regulatory requirements, and
 auditor has appropriate basis for opinion in audit report and achievement of overall
objectives.
Additional Purposes:
Audit documentation also helps to:
a) assist engagement team in planning and performance of audit.
b) assist engagement team in direction, supervision and review of audit to discharge their
review responsibilities.
c) enable quality control reviews.
d) enable accountability of engagement team for its work.
e) retain a record of matters of continuing significance to future audits.
Timely prepared documentations (prepared at time when work is performed) enhance audit
quality and are more accurate.
Advantages of using computer-based audit working papers:

Advantages of using automated/computerized working papers include:
 Standardized and easy to use formats.
 Preparation of working papers becomes speedy, neater and less costly.
 Analytical procedures are easy to perform.
 Automated processing reduces risk of errors e.g. in casting numeric schedule.
 “Online review” is possible from distant locations.
 Working papers can be integrated with other areas.
Ownership, Confidentiality and Retention of Audit Documentation:

 Audit documentation is not part of accounting record. It is the property/ownership of
auditor. However, auditor is also required to keep them in safe custody to ensure
confidentiality of these documents.
 Each firm should establish its own policies and procedures for retention of documentation.
However, minimum period for retention is atleast 5 years from date of auditor’s report or
group auditor’s report, whichever is later.
24

ISA 230 Audit Documentation deals with the auditor’s responsibility to prepare audit documentation for an audit of
Required: State FOUR benefits of documenting audit work. (04 marks)
Explain the reasons for preparing and keeping audit working papers. (06 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – June 2001)
LO 7: AUDIT FILE AND ITS TYPES:✯

Audit Files:
“Audit Files” are folders or other storage media (in physical or electronic form) containing audit
documentation for an engagement.
There are two types of audit files i.e. Current File and Permanent File.
Current File:
Definition:
This file contains documents relevant to current audit only. Primarily, it contains the evidence on
which the conclusion of the current audit is based.
Examples of documentation in Current File:

 Identified risk of material misstatement at financial statement level and at assertion level
 Evidence of auditor’s communication with different parties e.g. Professional Clearance Letter,
Confirmation Letter, Representation letter, Audit Report, Letter of Weakness/Management
Letter.
 Abstracts or copies of client’s documents e.g. Copy of trial balance and current year’s financial
statements, Agreements (e.g. sales agreement, purchase agreements).
 Summary of corrected and uncorrected misstatements.
 For each area of financial statements:
o Audit Plan/Program
o Working papers showing items selected, and procedures performed on items.
o Lead Schedule (it is a document which shows final figures to be included in financial
statements, conclusion of auditor on area and cross-reference to relevant working papers.)
Permanent File
Definition:
This file contains documents of continuance relevance i.e. relevant to current as well as future
audits.
Examples of documentation in Permanent File:

 Engagement Letter
 Long term loan agreements.
 Documentation of accounting and internal control systems (narrative notes, questionnaire,
flowcharts etc.)
 Minutes of meetings of shareholders and directors.
 Previous years’ financial statements
 Constitutional documents (e.g. memorandum and articles)
 Copies of Legal and Tax Status of client.
 Organizational hierarchy chart
25

Briefly describe various types of audit files and state at least five contents of each type of audit file maintained by an audit
firm. (08 marks)
What are the contents of:

a) Permanent file (05 marks)
b) Current audit working paper files (05 marks)
LO 8: FORM, CONTENT AND EXTENT OF AUDIT DOCUMENTATION:✯✯

Experienced Auditor Principle:
Audit documentation should be self-explanatory i.e. audit documentation shall be sufficient to
enable an Experienced Auditor (having no previous connection with the ongoing audit) to
understand:
 Nature, timing and extent of audit procedures performed
 Evidence obtained and conclusion reached.
 Significant matters and significant judgments in reaching conclusions.
Information that should be included on the header of every working paper

a. Name of audit client.
b. Period under audit
c. Page reference
d. Who prepared the working paper and when
e. Who reviewed the working paper and when
f. Area for which working paper is prepared.
g. A key to “audit ticks” and other symbols used in the working papers.
h. Objective of the auditor, Basis of selection of items, Procedures performed and
conclusion drawn by auditor
Factors affecting Form, Content and Extent of Audit Documentation:

Form, content and extent of audit documentation to be prepared is a matter of professional
judgment of auditor, and will depend on following factors:
i. Assessed risk of material misstatement.
ii. Size and complexity of entity.
iii. Audit methodology and tools used.
iv. Nature and significance of audit procedures performed.
v. Nature and significance of evidence obtained.
vi. Nature and significance of exceptions identified.

The preparation of working papers is an integral part of the auditor’s responsibilities. Identify the factors that the auditor
should consider while determining the form, content and extent of audit working papers. (07 marks)
26
LO 9: CHANGE IN DOCUMENTATION AFTER AUDITOR’S REPORT:✯✯✯

Changes during file assembly period:
Time period for assembly of final audit file:
ISAs require firms to establish their own policies and procedures for timely completion of assembly
of audit files. However, an appropriate time limit is within 60 days from the date of auditor’s report.
Type of changes during file assembly period:

Following types of changes can be made during file assembly period:
1. Deleting or discarding superseded documentation.
2. Sorting and cross-referencing working papers.
3. Signing off on completion checklists relating to the file assembly process.
4. Documenting audit evidence that the auditor has obtained before the date of the auditor’s
report.
If changes are necessary after file assembly period:

After the assembly of the final audit file has been completed, the auditor shall not delete or discard
audit documentation of any nature before the end of its retention period. However, auditor may
modify the existing document or add new documents after file assembly period if it is necessary
(e.g. as a result of quality control review).
In this case, auditor shall document following:

 The specific reasons for making change.
 Who made the changes, and when.
 Who reviewed the changes, and when.
If exceptional circumstances arise after the date of auditor’s report:

Auditor may perform new audit procedures or draws new conclusions after the date of auditor’s
report if there are exceptional circumstances (e.g. subsequent discovery of misstatement in
financial statements).
In this case, auditor shall document following:

 The specific reasons for making change.
 The new or additional audit procedures performed, audit evidence obtained, and
conclusions reached, and their effect on the auditor’s report.
 Who made the changes, and when.
 Who reviewed the changes, and when.

You are the training manager at Guava & Co., Chartered Accountants. Some trainees in the firm have requested you to
clarify the following issues:
(a) Can the auditor discard any audit document, forming part of his opinion, after the issuance of the auditor’s report?
(b) The changes that can be incorporated during the final file assembly process citing three such examples.
(c) The circumstances under which it becomes necessary to modify the existing audit documents or add new audit
documents after the issuance of the auditor’s report and the matters that should be documented in such a situation.
Required:
Offer appropriate explanations for each of the above issues. (11 marks)
In how many days after the date of auditor’s report, the auditor is required to complete the assembly of his final audit file.
27
Auditing – Study Notes Chapter 4 Auditor’s Report & Types of Opinions
CHAPTER FOUR
AUDITOR’S REPORT & TYPES OF
OPINIONS
PART A – AUDITOR’S REPORT

LO 1
ELEMENTS OF AUDITOR’S REPORT
✯✯
LO 2
FORMAT OF AUDITOR’S REPORT (FORM 35A OF COMPANIES RULES 1985)
✯✯✯
PART B – AUDITOR’S OPINIONS ON FINANCIAL STATEMENTS
LO 3
MATTERS TO BE EVALUATED BEFORE EXPRESSING OPINION
✯
LO 4
WHAT IS MEANT BY MISSTATEMENTS AND AUDITOR’S COURSE OF ACTION
✯✯
LO 5 WHAT IS MEANT BY SCOPE LIMITATION AND AUDITOR’S COURSE OF
✯✯ ACTION
LO 6
WHAT IS MEANT BY IMMATERIAL, MATERIAL AND PERVASIVE
✯
LO 7
DECIDING TYPE OF OPINION ON FINANCIAL STATEMENTS
✯✯✯
PART C – EMPHASIS OF MATTER AND OTHER MATTER PARAGRAPHS
LO 8DECIDING ABOUT “EMPHASIS OF MATTER” AND “OTHER MATTER” PARAGRAPHS
✯✯✯ IN AUDIT REPORT
LO 9
COMMUNICATION WITH TCWG
✯
28
128 (Auditor responsibility) 139 (Audit report at the end of the audit)
135 (An ‘emphasis of matter’ paragraph 142 (Form 35A in the Companies)
and an ‘other matter’ paragraph)
138a (Pervasive effects)
Question Bank:
13 (Tahira and Parvez) 134 (Hafiz Limited)

118 (Nadeem Limited) 136 (MM Electronics (Private) Limited)
129 (Al-Badr) 137 (Ranjha Limited)
130 (Shahrukh and Company) 138b (Pervasive effects)
131 (The engagement partner) 140 (Iqra Industries Limited)
132 (Different audit clients) 146b (Rake Enterprises)
133b&c (Situations have arisen on
different clients)
29
PART A – AUDITOR’S REPORT
LO 1: ELEMENTS OF AUDITOR’S REPORT: ✯✯

Auditor’s Report is always in written form with following elements/contents:
Title:
The auditor’s report shall have a title that clearly indicates that it is the report of an independent
auditor. Title is necessary to differentiate auditor’s report from other reports issued by others.
Addressee
The auditor’s report shall be addressed, as appropriate, based on the circumstances of the
engagement. Law, regulation or the terms of the engagement may specify to whom the auditor’s
report is to be addressed. Normally report is addressed to shareholders or those charged with
governance.
Opinion:
This section shall state that “auditor has audited the financial statements of ABC Company which
comprise statement of financial position as at June 30, 2015 and statement of comprehensive
income, statement of changes in equity and statement of cash flows for the year then ended and
notes to the financial statements, including a summary of significant accounting policies”.
This section of the report shall further include the auditor’s opinion (whether financial statements
give true and fair view in accordance with AFRF).
Study Tip – Other Reporting Responsibilities

If local laws or regulations require auditor to express opinion on certain other matters (i.e. other than
financial statements), auditor shall express opinion on those matters in a separate section in his report.
Basis for Opinion:

This section shall be included immediately after the opinion section. If auditor’s opinion is modified,
auditor shall also describe nature of misstatement or scope limitation in this paragraph.
Following further matters shall also be described in auditor’s report:

 Auditor conducted audit in accordance with ISAs.
 Auditor’s responsibilities under ISAs are described in the auditor’s responsibilities section
of this report.
 Auditor is independent of the company in accordance with ethical requirements and he has
fulfilled his ethical responsibilities.
 Auditor believes that he has obtained sufficient and appropriate audit evidence to provide a
basis for his opinion.
“Emphasis of Matter Paragraph” or “Other Matter Paragraph”: (if applicable)

This concept will be discussed in detail in LO 8 of this chapter.
Material uncertainty related to Going Concern: (if applicable)

This concept will be discussed in detail in LO 3 of Chapter # 21.
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Key Audit Matters: (if applicable)

This concept will be discussed in detail in LO 4 of Chapter # 21.
Responsibilities of Management and TCWG for the Financial Statements:

1. This section shall describe management’s responsibility for:
a. Preparing the financial statements in accordance with the AFRF, and for such
internal control as management determines is necessary to enable the preparation
of financial statements that are free from material misstatement, whether due to
fraud or error; and
b. Assessment of the company’s ability to continue as a going concern and to make
appropriate accounting/disclosures according to circumstances.
2. This section shall also identify those responsible for the oversight of the financial reporting
process.
Auditor’s Responsibilities for the Audit of the Financial Statements:

This section of the auditor’s report shall state that overall responsibilities/objectives of the auditor
are to obtain reasonable assurance about whether the financial statements are free from material
misstatement (whether due to fraud or error), and to issue report that includes the auditor’s
opinion on financial statements.
This section also states:

1. that auditor communicates to TCWG matters required by ISAs (list of such matters is given
at end of this chapter).
2. scope of audit (covered in LO 7 of Chapter # 2).
3. explanation of reasonable assurance (covered in LO 3 of Chapter # 1),
4. that auditor exercises professional judgment and maintains professional skepticism
throughout the audit
Location of the description of the auditor’s responsibilities

The description of the auditor’s responsibilities shall be included:
(a) Within the body of the auditor’s report; or
(b) Within an appendix to the auditor’s report, in which case the auditor’s report shall include a
reference to the location of the appendix; or
(c) on a website of an appropriate authority, where law, regulation or national auditing standards
expressly permit to do so, in which case the auditor’s report shall include a specific reference to the
location of such a description.
Signature of the Auditor:

The auditor’s signature can be in firm’s name, or in personal name of the auditor or both, as
appropriate. Law or regulation may allow for the use of electronic signatures in the auditor’s report.
Name of the Engagement Partner:

If auditors’ report is signed in the firm’s name, the name of the engagement partner shall be
included in the report.
Date of the Auditor’s Report:

The date of audit report should not be earlier than the date on which auditor obtains sufficient
appropriate evidence on which his report is based (including evidence that financial statement
have been prepared and approved by appropriate authority).
31
Date also indicates that auditor has considered the effect of events and transactions upto that date.
Auditor’s Address:
The auditor’s report shall state the location (usually city name) where the auditor practices.
Exam Tips
In Pakistan, format of Companies Ordinance 1984 (Form 35A) is used to issue reports, which is a bit
different from format of ISAs (ISA 700). There are two types of differences between two formats:
1. Though number of elements is same, however, arrangement and wording of elements is
different. (this difference is not important from exam point of view).
2. Some matters are included in report under Form 35A but NOT in ISA 700. Similarly, some
matters are included in report under ISA 700 but NOT in Form 35A. (this difference is
important from exam point of view).

List down the basic elements of an audit report. (05 marks)
The auditor is required to issue an audit report at the end of the audit, which sets out his opinion on the financial
statements. An important element of the audit report is the statement of auditor’s responsibility.
Required:
Narrate the matters that should be contained in the statement of auditor’s responsibility as included in an audit report
issued under ISA-700 ‘The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements’.
(08 marks)
LO 2: FORMAT OF UNMODIFIED AUDITOR’S REPORT (FORM 35A OF COMPANIES

RULES 1985): ✯✯✯
Auditor’s Report to the Members
We have audited the annexed balance sheet of Star Chemicals Limited (the Company) as at June
30, 2015 and the related profit and loss account, cash flow statement and statement of changes
in equity together with the notes forming part thereof, for the year then ended and we state that
we have obtained all the information and explanations which, to the best of our knowledge and
belief, were necessary for the purposes of our audit.
It is the responsibility of the company’s management to establish and maintain a system of internal
control, and prepare and present the above said statements in conformity with the approved
accounting standards and the requirements of the Companies Ordinance, 1984. Our
responsibility is to express an opinion on these statements based on our audit.
We conducted our audit in accordance with the auditing standards as applicable in Pakistan.
These standards require that we plan and perform the audit to obtain reasonable assurance about
whether the above said statements are free of any material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the above said
statements. An audit also includes assessing the accounting policies and significant estimates
made by management, as well as, evaluating the overall presentation of the above said statements.
We believe that our audit provides a reasonable basis for our opinion and, after due verification, we
report that:
(a) in our opinion, proper books of accounts have been kept by the company as required by the
Companies Ordinance, 1984;
32
(b) in our opinion:

(i) the balance sheet and profit and loss account together with the notes thereon have
been drawn up in conformity with the Companies Ordinance, 1984, and are in
agreement with the books of accounts and are further in accordance with accounting
policies consistently applied, except for the changes as stated in note # xxx with
which we concur;
(ii) the expenditure incurred during the year was for the purpose of the company’s
business; and
(iii) the business conducted, investments made and the expenditure incurred during the
year were in accordance with the objects of the company;
(c) in our opinion and to the best of our information and according to the explanations given to
us, the balance sheet, profit and loss account, cash flow statement and statement of
changes in equity together with the notes forming part thereof conform with approved
accounting standards as applicable in Pakistan, and, give the information required by
the Companies Ordinance, 1984, in the manner so required and respectively give a true
and fair view of the state of the company’s affairs as at June 30, 2015 and of the profit (or
loss), its cash flows and changes in equity for the year then ended; and
(d) in our opinion, Zakat deductible at source under the Zakat and Ushr Ordinance, 1980 (XVIII
of 1980), was deducted by the company and deposited in the Central Zakat Fund
established under section 7 of that Ordinance(N–1).
ABC & Co.
August 13, 2015
Lahore
Engagement partner: XYZ
N – 1: Where no Zakat is deductible, substitute “in our opinion, no Zakat was deductible at source
under the Zakat and Ushr Ordinance, 1980”.
Study Tips
You are advised to learn (by reading the audit report many times) how the key words/phrases (in
bold) are presented in report. In exam, you may be required to identify errors in a given report either
omitting or wrongly including these words/phrases.

Under the Companies Ordinance 1984, while reporting on the financial statements the auditor has to express an opinion
whether the financial statements give a true and fair view in all material respect.
Briefly state the matters other than the above, on which the auditor is required to express his opinion as per the
requirements of Section 255 of the Companies Ordinance, 1984. (08 marks)
33
PART B – AUDITOR’S OPINIONS ON FINANCIAL STATEMETNS
LO 3: MATTERS TO BE EVALUATED BEFORE EXPRESSING OPINION: ✯

Before reaching an opinion, auditor shall conclude whether auditor has obtained sufficient
appropriate audit evidence about whether financial statements are free from material
misstatements i.e.
1) Whether there is a misstatement or scope limitation.
2) Whether effect of misstatements or scope limitation is immaterial, material or pervasive.
Auditor shall also evaluate following whether financial statements have been prepared in
accordance with AFRF and, particularly, whether:
 The financial statements adequately disclose the significant accounting policies;
 The accounting policies are consistently applied in accordance with AFRF.
 The accounting estimates are reasonable.
 The information presented in the financial statements is relevant, reliable, comparable, and
understandable.
 The terminology used in the financial statements, including the title of each financial
statement, is appropriate.
 Whether financial statements adequately describe AFRF.
 Whether financial statements present true and fair view (if fair presentation framework is
used).
Auditor’s responsibilities if accounting policy is changed during the year:

Auditor shall:
a) mention the exception to consistent application of accounting policies in his report.
b) refer to the note in financial statements where full disclosure is available.
c) also state in his report whether he concurs with the change or not.

What steps should auditors take before forming an opinion on the financial statements of a company. (08 marks)
What is the responsibility of the external auditor regarding assessment and disclosure of a change in accounting policy
made by his client. (05 marks)
(ICAP, CFAP 06 Level – Summer 2003)
LO 4: WHAT IS MEANT BY MISSTATEMENTS AND AUDITOR’S COURSE OF ACTION IF

HE IDENTIFIES A MISSTATEMENT DURING AUDIT: ✯✯
Definition and Examples of Misstatements:
Misstatement:
Misstatement means difference between:
 amount, presentation and disclosure reported in financial statements, and
 amount, presentation and disclosure required to be reported in accordance
with AFRF.
34
A misstatement in financial statements may arise in relation to following:

(a) The appropriateness of the selected accounting policies: e.g.
 The selected accounting policies are not consistent with the AFRF.
(b) The application of the selected accounting policies: e.g.

 Selected accounting policies are not applied correctly (i.e. errors in application of
accounting policies)
 Selected accounting policies are not applied consistently (i.e. not consistent with prior year
or with other similar items) and auditor does not concur with change.
(c) The appropriateness or adequacy of disclosures in the financial statements: e.g.

 Financial statements do not provide disclosures required by AFRF or disclosure is not
appropriate.
 A disclosure is necessary to achieve fair presentation, but not included in F/S.
Study Tips
1. Disclosure of misstatement in financial statements is not a substitute for correct accounting
treatment.
2. There will be no misstatement in financial statements if management corrects it before signing of
auditor’s report.
3. A misstatement of any type affects the report in the same way.
Auditor’s course of action/responsibilities if there is a misstatement:

Auditor accumulates all misstatements identified during audit, communicates them to management
on timely basis, and requests to correct them.
Implications on auditor’s report:

If management does not correct a misstatement, auditor shall express Qualified opinion (if effect is
material) or Adverse opinion (if effect is pervasive).
If misstatements are immaterial (individually as well as aggregate), auditor shall express

unmodified opinion, however, auditor shall obtain written representation from management that
uncorrected misstatements are immaterial.
Other implications on audit:

In the light of identified misstatements, auditor considers their impact on audit strategy and audit
plan (i.e. risk and audit procedures may be revised).
Study Tips
A misstatement can also be identified after end of the audit (i.e. after auditor’s report). Appropriate
course of action in this case will be discussed in a later chapter.

Explain the term ‘misstatement’ and describe the auditor’s responsibility in relation to misstatements. (04 marks)
35
LO 5: WHAT IS MEANT BY SCOPE LIMITATION AND AUDITOR’S COURSE OF ACTION IF

HE FACES A SCOPE LIMITATION DURING AUDIT: ✯✯
Definition and Examples of Scope Limitation:
Scope Limitation:
Scope Limitation arises when auditor is unable to obtain sufficient appropriate
audit evidence on which to base his opinion.
A scope limitation on audit may arise in relation to following:

(a) Circumstances beyond the control of entity:
 Accounting records of entity have been destroyed (e.g. by fire, computer virus or other
natural disaster).
 Accounting records of entity have been seized by govt. authorities.
(b) Circumstances relating to the timing or nature of auditor’s work:

 The timing of the auditor’s appointment is such that the auditor is unable to observe the
counting of the physical inventories.
 Entity is required to use “equity method” of accounting for an associated entity, but auditor
is unable to obtain evidence about financial information of associated entity.
 Substantive procedures alone do not provide sufficient evidence and entity’s internal
controls are also weak.
(c) Limitations imposed by management/ entity:

 Management prevents the auditor from observing the counting of the physical inventory.
 Management prevents the auditor from requesting external confirmation of specific account
balances.
 Management does not provide written representations to auditor.
Study Tips
1. There will be no scope limitation if auditor is able to obtain evidence from alternative audit
procedures in above cases.
2. A scope limitation of any type affects the report in the same way. However, if there is a scope
limitation by management which is unreasonable, it also affects other aspects of audit (e.g. risk
and audit procedures).
Auditor’s course of action/responsibilities if there is a scope limitation during audit:

If auditor is unable to perform a required procedure, auditor shall try to perform alternative audit
procedures to obtain evidence. If auditor is unable to obtain evidence from alternative procedures
too, it will be a scope limitation, and:
 If effect is material, auditor shall express qualified opinion.
 If effect is pervasive, auditor shall withdraw from engagement if possible and practicable. If
withdrawal is not possible or practicable, auditor shall express Disclaimer of opinion.

If there is an inappropriate scope limitation by management:
 Auditor shall re-evaluate integrity of management and shall consequently revise risk of
material misstatement (including risk of fraud) and shall also modify nature, timing and
extent of audit procedures.
36
 If auditor has serious concerns about integrity of management, he may also consider
withdrawal from engagement.
Study Tip
A scope limitation can also be faced before acceptance of audit. When scope limitation is imposed
before acceptance:
 If possible effect of limitation is material, auditor may accept the engagement but he will
communicate possible modification in auditor’s opinion in the engagement letter.
 If possible effect of limitation is pervasive, the auditor shall not accept such proposed audit
engagement.

List down the situations that may result in limitation on scope of auditor’s work. (04 marks)
In peculiar circumstances the client restricts the auditors from performing certain audit procedures. Discuss how the
auditor should deal with such restrictions if the same are imposed:
(i) at the time of appointment
(ii) during the audit. (08 marks)
LO 6: WHAT IS MEANT BY IMMATERIAL, MATERIAL AND PERVASIVE: ✯
Immaterial:
An item which is not material, is called immaterial.
Material:
Items (misstatement or scope limitation) are considered material if they, individually
or in aggregate, could reasonably be expected to influence the economic decisions of
users taken on the basis of the financial statements.
Materiality depends on size as well as nature of misstatement.
Pervasive:
Pervasive effects on the financial statements are those that, in the auditor’s
judgments:
i. Are not confined to specific accounts/elements of the financial statements;
ii. If so confined, represent substantial proportion of the financial statements; or
iii. In relation to disclosures, are fundamental to users’ understanding of the
CONCEPT REVIEW QUESTIONS

What are the factors which make an item material? (04 marks)
Briefly explain the term ‘pervasive effects on the financial statements’. (04 marks)
37
LO 7: DECIDING TYPE OF OPINION ON FINANCIAL STATEMENTS: ✯✯✯

Which opinion to express in what Circumstances:
There are four types of audit opinions, expressed by an auditor.
Immaterial effect Material effect Pervasive effect
Misstatement Adverse Opinion

Unmodified Opinion Qualified Opinion
Scope Limitation Disclaimer of Opinion
When to express Unmodified Opinion:

Auditor shall express unmodified opinion when auditor has obtained sufficient appropriate audit
evidence and concludes that financial statements are free from material misstatements.
This opinion is expressed as “the financial statements give a true and fair view… in accordance with
AFRF”.
When to express Adverse Opinion:

Auditor shall express adverse opinion when auditor has obtained sufficient appropriate evidence
and concludes that there are misstatements in financial statements whose effect is pervasive.
This opinion is expressed as “the financial statements do not give a true and fair view….. in accordance
with AFRF”.
When to express Disclaimer of Opinion:

Auditor shall express disclaimer of opinion when:
1. auditor is unable to obtain sufficient appropriate evidence on which to base the opinion and
concludes that possible effect of undetected misstatements in financial statements is pervasive,
or
2. there are multiple uncertainties and auditor concludes that it is not possible to form an opinion
due to these uncertainties.
This opinion is expressed as “we do not express an opinion on the financial statements”.
When to express Qualified Opinion:

Auditor shall express qualified opinion when:
1. auditor has obtained sufficient appropriate evidence and concludes that there are
misstatements in financial statements whose effect is material (but not pervasive), or
2. auditor is unable to obtain sufficient appropriate evidence on which to base the opinion and
concludes that possible effect of undetected misstatements in financial statements is material
(but not pervasive).
This opinion is expressed as “except for …….., the financial statements give a true and fair view… in
accordance with AFRF”.
Study Tips
1. Qualified Opinion, Adverse Opinion and Disclaimer of Opinion are collectively called “Modified
Opinions”. Students are advised NOT to use the term “Modified Opinion” in exam; rather they
should state specific type of opinion i.e. qualified opinion, adverse opinion or disclaimer of
opinion.
2. Whenever a Qualified/Adverse/Disclaimer of opinion is expressed, nature of misstatement or
scope limitation is explained in Basis for Qualified/Adverse/Disclaimer of opinion.
38

(i) Explain the circumstances when a modification to the auditor's opinion is required. (02 marks)
(ii) Describe the circumstances when an auditor will form a qualified opinion, an adverse opinion and a disclaimer
of opinion. (05 marks)
(ICMA Pakistan, Professional Level P2 – 2016 February)
PART C – EMPHASIS OF MATTER AND OTHER MATTER PARAGRAPHS
LO 8: DECIDING ABOUT “EMPHASIS OF MATTER” AND “OTHER MATTER”

PARAGRAPHS IN AUDIT REPORT: ✯✯✯
Emphasis of Matter Paragraph:
When to add paragraph in auditor’s report (Definition)
Emphasis of Matter Paragraph is included in audit report if auditor considers it necessary to draw
users’ attention to a matter which is disclosed in financial statement and is fundamental to users’
understanding of the financial statements, provided:
 The auditor is NOT required to modify his opinion because of the matter, and
 Matter is not a key audit matter to be communicated in the auditor’s report.
Examples of Situations/ Circumstance:

1. If there is uncertainty relating to the future outcome of an exceptional litigation or
regulatory action pending against company.
2. A significant subsequent event that occurs between the date of the financial statements and
the date of the auditor’s report
3. When a major catastrophe has significantly affected or continues to affect entity’s financial
position.
4. Early application of a new accounting standard that has a material effect on financial
statements.
Presentation in Auditor’s Report:

 Use a separate section in audit report.
 Include in the paragraph a clear reference to the matter being emphasized.
 State the reference to the notes in financial statements which fully describe the matter.
 State that auditor’s opinion is not modified in respect of this matter.
Placement in Auditor’s Report:

Placement of Emphasis of Matter Paragraph depends on nature of information to be communicated.
Usually, it is placed immediately after the Basis of Opinion section.
When a Key Audit Matters section is presented in the auditor’s report, EOM paragraph may be
presented either immediately before or immediately after the Key Audit Matters section
(depending on significance of matter).
Example of Draft:
“We draw your attention to Note X to the financial statements which describe the uncertainty
related to the outcome of the lawsuit filed against the company by XYZ Company. Our opinion is
not modified in respect of this matter.”
39
Other Matter Paragraph:

When to add paragraph in auditor’s report (Definition):
Other Matter Paragraph is included if auditor considers it necessary to communicate a matter
which is not required to be disclosed in financial statements but is relevant to users’ understanding
of the audit, auditor’s report or auditor’s responsibilities, provided:
 Communication is not prohibited by law, and
 Matter is not a key audit matter to be communicated in the auditor’s report.
Examples of Situations/ Circumstance:

1. When financial statements of prior period were not audited or were audited by another
auditor.
2. When auditor reports on more than one sets of financial statements for same entity and for
same period (but with different frameworks).
3. When auditor restricts distribution of auditor’s report.
4. When “Other Information” is materially inconsistent with audited Financial Statements.
Presentation in Auditor’s Report:

Use a separate section in audit report.
Placement in Auditor’s Report:

Placement depends on nature of information to be communicated. Usually, it is placed immediately
after key audit matter section.
Example of Draft:
“The financial statements of ABC Company for the year ended December 31, 20X0 were audited by
another auditor who expressed an unmodified opinion on those statements on March 31, 20X1.”
Exam Tips
1. Emphasis of Matter paragraph, Other Matter Paragraph or Key Audit Matter is not a substitute
of “Modified Opinion”, or “Disclosure required in financial statements”.
2. Auditor should avoid excessive use and excessive elaboration of Emphasis of Matter
paragraph.

(i) Define an ‘Emphasis of Matter paragraph’ and explain, providing examples, the use of such a paragraph; (06 marks)
(ii) Define an ‘Other Matter paragraph’ and explain, providing examples, the use of such a paragraph. (04 marks)
Note: You are not required to produce draft paragraphs.
Identify the situations in which an auditor may modify his report without affecting his opinion. Also explain how such a
modification should be presented in the audit report. (07 marks)
Specify the requirements of International Standards on Auditing while including an emphasis of matter paragraph in the
auditor’s report. (04 marks)
(ICMA Pakistan, Professional Level P2 – 2013 September )
40
LO 9: COMMUNICATION WITH TCWG: ✯

In an audit, auditor is required to communicate with TCWG following matters:
1. The Auditor’s Responsibilities in Relation to the Financial Statement Audit.
2. Overview of Planned Scope and Timing of the Audit.
3. Significant Findings from the Audit (e.g. significant deficiencies in internal control)
4. Key Audit matters (in case of listed entities)
5. Auditor Independence (in case of listed entities). Auditor communicates with TCWG:
 a Statement that auditor has complied with ethical requirements regarding
independence, and
 all relationships and other matters that may impair independence along with
related safeguards.
6. If there is any event or condition casting doubt on Going Concern, auditor shall
communicate:
a. Whether event or condition constitute material uncertainty.
b. Whether use of going concern assumption is appropriate
c. Whether related disclosures in financial statements are adequate.
d. Implication on auditor’s report
7. If the auditor expects to modify his report by including “Modified Opinion” or “Emphasis of
Matter” or an “Other Matter” paragraph in his report, the auditor shall communicate with
those charged with governance the circumstances that led to modification and the proposed
wording of modification.
This communication:
 Enables auditor to communicate the intended modification and its reasons to TCWG
on timely basis
 Enables auditor to obtain concurrence of TCWG regarding facts of the matter.
 Gives TCWG an opportunity to provide further information and explanation
regarding the matter causing modification.
41
Auditing – Study Notes Chapter 5 Acceptance and Continuance Procedures
CHAPTER FIVE
ACCEPTANCE AND CONTINUANCE
PROCEDURES
LO 1
PHASES OF AUDIT – FROM INCEPTION TO CONCLUSION
✯
LO 2 MATTERS TO BE COSNIDERED AND PROCEDURES TO BE PERFORMED BEFORE
✯✯✯ ACCEPTING AN AUDIT CLIENT
LO 3
COMMUNICATION WITH PREDECESSOR AUDITOR
✯✯
LO 4
PRECONDITIONS FOR AUDIT
✯✯✯
LO 5 CIRCUMSTANCES AND COURSE OF ACTION WHEN AUDITOR WITHDRAWS
✯ FROM ENGAGEMENT
21a (Shahid Corporation) 121 (Khanewal Limited)

37 (SPL)
Question Bank:
42
LO 1: PHASES OF AUDIT – FROM INCEPTION TO CONCLUSION: ✯

Stage – 1: Preliminary Engagement Activities:
Preliminary engagement activities are those activities which are performed by an auditor at the
start of each audit engagement. These include:
(a) Performing acceptance and continuance procedures. (discussed in chapter # 5)
(b) Evaluating compliance with independence requirements (including legal and ethical
requirements). (discussed in chapter # 6 & 7)
(c) Establishing an understanding of the terms of engagement. (discussed in chapter # 8)
Stage – 2: Planning Activities: (discussed in chapter # 9)

Planning an audit involves:
 establishing the overall audit strategy (that sets scope, timing and direction for
engagement) and
 developing audit plan (which includes nature, timing and extent of audit procedures to be
performed by engagement team).
Stage – 3: Performance Activities:

Performance activities include:
1. Risk Assessment Procedures (discussed in chapter # 10)
2. Tests of Controls (discussed in chapter # 11)
3. Substantive Procedures (discussed in chapter # 12)
Following specialized techniques are used during performance phase:

 Using information technology to obtain audit evidence (discussed in chapter # 13)
 Using External Confirmation (discussed in chapter # 14)
 Using Analytical Procedures (discussed in chapter # 15)
 Verifying Related Parties (discussed in chapter # 16)
 Using Sampling technique (discussed in chapter # 17)
 Using work of others (i.e. internal auditor, expert) (discussed in chapter # 18)
 Fraud (discussed in chapter # 19)
 Verifying Subsequent events & Obtaining Written Representation Letter (discussed in
chapter # 20)
Stage – 4: Reporting: (discussed in chapter # 4 & 21)

It includes issuing audit report in accordance with results of performance activities.

Briefly describe ‘Preliminary Engagement Activities’ and ‘Planning Activities’. (05 marks)
43
LO 2: MATTERS TO BE COSNIDERED AND PROCEDURES TO BE PERFORMED BEFORE

ACCEPTING AN AUDIT CLIENT: ✯✯✯
Matters to be considered before accepting an audit client:
Auditor should consider following matters before accepting an audit client:
1. Whether engagement team is competent to perform the audit engagement and has the
necessary capabilities, including time, resources and specialized knowledge
2. Whether the firm and the engagement team can comply with relevant ethical requirements.
3. Significant matters which arose during previous audits, and other non-assurance
engagements (if any).
4. Integrity of owners, TCWG and key management of entity. To evaluate integrity, following
matters are considered:
a. Reason for change in auditors.
b. Reputation of client’s Owners / Key management / TCWG / Related parties.
c. Attitude of owners, key management and TCWG towards accounting standards and
internal control.
d. Indications that client may be involved in money laundering or other illegal
activities.
e. Indication of disagreement or inappropriate scope limitation by management
5. Whether preconditions of audit are present.
Procedures to be performed before accepting an audit client:

Auditor should perform following Acceptance and Continuance procedures before accepting an
audit client:
1. Whether engagement team is competent to perform the audit engagement and has the
necessary capabilities, including time, resources and specialized knowledge
2. Whether the firm and the engagement team can comply with relevant ethical requirements.
3. Significant matters which arose during previous audits, and other non-assurance
engagements (if any).
4. Auditor shall also perform following client screening procedures (i.e. procedures to
evaluate integrity of management):
 Hold discussion with directors (regarding reason of change of auditor, permission to
communicate with predecessor auditor).
 Communicate with predecessor auditor through “Professional Clearance/Etiquette
Letter”.
 Obtain references from third parties (e.g. from professional advisors, Credit rating
agencies)
 Undertake client identification procedures
 Inspect financial statements and auditor’s report of prior periods
 Undertake search of relevant database (e.g. internet, press releases, business journals
and other relevant data bases)

With reference to the Acceptance procedures in respect of prospective clients, discuss the procedures, which you would
include in your evaluation. (05 marks)
A prestigious company has approached your firm to accept appointment as its external auditor. State the matters that
your firm should consider before accepting the engagement. (04 marks)
44
LO 3: COMMUNICATION WITH PREDECESSOR AUDITOR: ✯✯

Requirement of Communication between predecessor and successor auditor:
Before acceptance of an audit engagement, it is ethical responsibility of every incoming auditor to
write a letter (called Professional Clearance Letter) to outgoing auditor. It is also ethical
responsibility of predecessor auditor to respond to such letter.
Purpose of such Communication:

Purpose of this letter is to ensure that proposed auditor knows and considers all relevant facts of
client before making decision to accept it e.g.
 Reason of change of auditor
 Issues with integrity of management
 Indication of unreasonable scope limitation or disagreement by management
 Outstanding fee of predecessor auditor
Procedures by incoming auditor:

1. Obtain written permission from client to communicate with predecessor auditor to comply
with confidentiality principle.
2. If permission is not given, refuse the engagement because it will be a scope limitation.
3. If permission is given, write professional clearance letter to inquire facts relevant to
acceptance decision.
4. If response is received from predecessor auditor, firm should review the response to
consider how to resolve relevant issues before acceptance of audit.
5. If response is not received, proposed auditor should try to obtain information about any
possible threats by other means (e.g through inquiries of third parties or background
investigations of senior management/TCWG).
Procedures by outgoing auditor:

1. Obtain written permission from client to communicate with proposed auditor to comply
with confidentiality principle.
2. If permission is not given, inform proposed auditor about non-permission.
3. If permission is given, write as quickly as possible to proposed auditor honestly stating
facts.

What is the purpose of the professional etiquette letter sent by an incoming auditor to the outgoing auditor. (02 marks)
Your firm has received a request for information from Blonde LLP, a firm of auditors, in respect of its prospective external
audit client Auburn Ltd (Auburn). Auburn is currently audited by your firm but, after discovering that Auburn’s
manufacturing process includes unethical labour practices in its overseas supply chain, your firm decided not to seek
reappointment.
State the actions that your firm should take with respect to the request for information from Blonde LLP. (04 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2012 September)
45
LO 4: PRECONDITIONS FOR AUDIT: ✯✯✯

What are Preconditions for audit:
Preconditions for an audit means:
1. AFRF used by management in preparation of financial statements is acceptable.
2. Management (and TCWG where applicable) agrees to the premise on which an audit is
conducted.
How auditor establishes whether Preconditions for Audit are present/exist:

1. Auditor shall determine whether financial reporting framework adopted by management in
preparation of financial statements is acceptable (considering, nature of financial statements,
purpose of financial statements, nature of entity, legal requirements).
2. Auditor shall obtain agreement from management (via engagement letter) that it understands
and acknowledges its responsibilities:
a. for preparation and presentation of financial statements in accordance with AFRF.
b. for such internal control which management and TCWG determine necessary for
preparation of financial statements that are free from material misstatement (whether
due to error or fraud); and
c. to provide the auditor all relevant information (i.e. relevant to the preparation of the
financial statements); additional information (i.e. requested by auditor for the purpose of
audit); and unrestricted access to personnel (i.e. to obtain audit evidence).
Course of Action of Preconditions for audit are NOT present:

If management does not agree to premise on which audit is conducted:
Auditor shall not accept the proposed audit engagement.
If AFRF is not acceptable:

Auditor shall refuse the engagement unless AFRF is required by law.
If unacceptable AFRF is required by law, auditor shall accept engagement under ISAs only if
following conditions are met:
1. Management agrees to provide additional disclosure in financial statements (to avoid F/S
being misleading), and
2. It is included in Engagement Letter that:
 auditor’s opinion will not include phrases “give a true and fair view” or “present
fairly, in all material respects”.
 auditor’s report will include Emphasis of Matter Paragraph (to draw users’ attention
towards additional disclosure)
If unacceptable AFRF is required by law, and above conditions are also NOT met:
1. Auditor shall evaluate the effect of misleading F/S on auditor’s report.
2. Auditor shall refer to this effect in engagement letter.

Discuss the course of action which may be adopted by the auditor if pre-conditions of audit are not present. (04 marks)
Khanewal Limited (KL) has requested your firm to submit engagement letter for KL’s statutory audit. The engagement
partner has asked you to establish whether preconditions for the audit of KL are present.
46
Required:
What matters would you consider in order to ensure that preconditions for the audit exist? (05 marks)
LO 5: CIRCUMSTANCES AND COURSE OF ACTION WHEN AUDITOR WITHDRAWS FROM

ENGAGEMENT DRUING AUDIT: ✯
Circumstances when auditor is unable to continue the engagement:
Once an engagement letter is signed, it is auditor’s duty to complete audit and issue his report to
members. However, following are exceptions when auditor can withdraw from audit engagement
(if withdrawal is possible and practicable):
1. When there is scope limitation whose effect is pervasive.
2. If there is a threat to independence and it is not possible for firm to reduce the threat to
acceptable level.
3. When integrity of management or TCWG is in doubt (e.g. when there is risk of fraud or
violation of law involving management and TCWG.)
Auditor’s course of action, if auditor decides to withdraw from engagement:

1. Auditor shall discuss with appropriate level of management and TCWG, and shall inform
them in writing about auditor’s withdrawal and reasons of withdrawal.
2. Auditor should also prepare a “Statement of Facts/Circumstances” explaining auditor’s
withdrawal and reasons of withdrawal. Depending on legal, professional or contractual
requirements, this statement may be sent to shareholders and regulatory authorities (e.g.
SECP and ICAP).
3. Auditor shall also document the withdrawal and reasons of withdrawal in significant
matters.

Identify the situations under which you would recommend declining an assurance engagement or consider resigning
from the current engagement. (03 marks)
47
Auditing – Study Notes Chapter 6 Compliance with Legal Requirements
CHAPTER SIX
COMPLIANCE WITH LEGAL
REQUIREMENTS
LO 1
AUTHORITY FOR APPOINTMENT AND REMOVAL OF STATUTORY AUDITOR
✯✯✯
LO 2 PROCEDURES FOR APPOINTMENT AND REMOVAL OF STATUTORY
✯✯ AUDITOR BY MEMBERS
LO 3
POWERS (RIGHTS) AND DUTIES OF STATUTORY AUDITOR
✯
LO 4
QUALIFICATION AND DISQUALIFICATION OF STATUTORY AUDITOR
✯✯✯
LO 5
AUDIT OF COST ACCOUNTS
✯
LO 6
✯
PENALTY FOR NON-COMPLIANCE WITH COMPANIES ORDINANCE 1984
106b (ISA 620: Using the Work of an 122 (ABD Limited)
Auditor’s Expert)
Question Bank:
7 (Zaman and Bilal) 28 (Kashif and Company)
14 (ABC Limited) 30 (Daud and Company)
19 (Alpha) 38 (Fruit and nuts)
23 (Companies Ordinance 1984)
48
LO 1: AUTHORITY FOR APPOINTMENT AND REMOVAL OF STATUTORY AUDITOR: ✯✯✯

Appointment of Auditor:
Appointment of first auditor:
1. First auditor is appointed by Directors within 60 days of incorporation.
2. If directors fail to appoint first auditor, Company (i.e. Members) will appoint the auditor within
120 days of incorporation.
3. If first auditor is not appointed by directors and members, SECP will appoint the first auditor
after 120 days of incorporation.
Appointment of subsequent auditor:

1. Subsequent Auditor is appointed by Company (i.e. by members) at each AGM.
2. If members do not appoint auditor at an Annual General Meeting, Commission (i.e. SECP)
will appoint the subsequent auditor.
Appointment in case of casual vacancy:

1. If casual vacancy (i.e. death or disqualification or resignation of auditor during audit) arises,
directors have authority to appoint auditor to fill casual vacancy within 30 days of its
occurrence.
2. If directors do not fill casual vacancy within 30 days (and there are no surviving or
continuing auditors), SECP has authority to appoint auditor to fill casual vacancy.
Appointment in case of mid-term removal of auditor:

If subsequent auditor is removed by members before expiry of his term, vacancy is filled by SECP
(and not by members).
If a disqualified person is appointed by company:

If a company appoints disqualified person as auditor, this appointment shall be void, and SECP will
appoint qualified auditor in his place.
Tenure/Term of Auditor:
Tenure of auditor appointed in each case is from date of appointment till the conclusion of next
AGM. At each AGM, existing auditor is retired/removed and fresh appointment is made for next
term (either for same auditor or for another auditor).
Mid-Term Removal of Auditor: (i.e. removal before expiry of tenure)

Removal of First Auditor:
First auditor (which is appointed by directors) may be removed by members in a general meeting
provided:
 a member has nominated another auditor, and
 notice of nomination has been sent to company atleast 14 days before general meeting.
Removal of Subsequent Auditor:

An auditor appointed at AGM can be removed before expiry of his term by members only through
Special Resolution. If removed, company shall inform SECP within one week of removal, because
authority to fill vacancy in such case rests with SECP and not with company.
49
Remuneration of Auditor:
Remuneration of auditor shall be fixed by appointing authority i.e.
 by SECP (if appointment is made by SECP), or
 by Directors (if appointment is made by directors) or
 by Company (in all other cases) in general meeting or in such manner as the general
meeting may determine.

State the circumstances in which the auditors may be appointed by the directors and by the members of a company.
(03 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – December 2001, Amended)
Can auditor of a listed company be removed during the term of his office? (02 marks)
LO 2: PROCEDURES FOR APPOINTMENT AND REMOVAL OF STATUTORY AUDITOR:

✯✯
Legal Procedure for Removal/Appointment/Change of Statutory Auditor at AGM:
1. A member shall send a notice to company to appoint another auditor at AGM for the next
period. Such notices shall be sent atleast 14 days before AGM.
2. Company shall send copy of notice:
a. to retiring and nominated auditor immediately
b. to members atleast 7 days before AGM.
c. to publish in 1 English and 1 Urdu news paper having circulation in province where
relevant stock exchange is situated (in case of listed company only).
3. Retiring auditor has a right to make a representation in writing to company.
If a representation in writing is made by retiring auditor:
a. Company shall send a copy of such representation to every member whom notice of
meeting is sent.
b. If representation is not sent as aforesaid (e.g. because it was too late or because of
default of company), retiring auditor may require that representation shall be read-
out in meeting. ***
4. Nominated auditors perform their acceptance and continuance procedures before AGM, and
if willing, communicate their willingness to company.
5. At AGM, members will pass a resolution to appoint an auditor from willing auditors.
6. Company shall also inform Registrar within 14 days of appointment/removal of auditor
alongwith consent of appointed auditor.
*** However, it is not necessary for company to circularize or read-out representation given by auditor
if Registrar is satisfied, on application of company or other aggrieved person, that this right is being
misused to obtain needless publicity or for defamatory purpose.
Ethical Responsibilities when there is change of auditor:

Responsibilities of Incoming (Proposed/Successor) Auditor:
1. Incoming auditor shall send professional clearance letter to outgoing auditor to ensure that
incoming auditor knows and considers all relevant facts of client before making decision to
accept.
2. Incoming auditor shall obtain a copy of the Representation before acceptance (if made by
retiring auditor).
50
3. Additional responsibility if predecessor auditor is removed during audit,

 Incoming auditor should also inform ICAP about the offer of appointment.
 Incoming auditor should not accept offer of appointment without prior clearance from ICAP.
ICAP usually gives clearance within 15 days
Responsibilities of Outgoing (Existing/Predecessor) Auditor:

1. To maintain confidentiality (even after change of appointment).
2. To transfer all books and papers of client (to client or to incoming auditor if advised so by
client).
3. To reply promptly to incoming auditor’s Professional Clearance Letter.
4. Outgoing auditor will file with ICAP a copy of Representation (if made to members).
5. Additional responsibility if predecessor auditor is removed during audit, he must immediately
file with ICAP a “Statement of Facts/Circumstances”.

Describe the procedure prescribed in the Companies Ordinance, 1984 for removal of auditor of a listed company.
(06 marks)
Set out the responsibilities of the outgoing firm of auditors relating to the change of appointment in order to comply with
the ICAEW Code of Ethics. (06 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2007 June)
LO 3: POWERS (RIGHTS) AND DUTIES OF STATUTORY AUDITOR: ✯

Statutory Powers/Rights of Auditor:
Rights during audit
1. Right of access to books of accounts and supporting documents/papers (whether kept at
registered office or elsewhere). If a company has branch office outside Pakistan, it will be
sufficient if auditor is allowed access to copies or extracts of books and papers transmitted
to principal office in Pakistan.
2. Right to require information and explanation from directors and company (which is
necessary to perform auditor’s duties).
3. Right to receive notices of general meetings.
4. Right to attend general meetings. However, in case of listed company, auditor or a person
authorized by him in writing is required to attend general meeting in which accounts and
auditor’s report are considered.
5. Right to speak at general meetings on audit related matters.
Rights on removal:
1. Right to receive notice of removal.
2. Right to make a representation in writing to company.
3. Right to have representation circulated to all members of the company or to be read-out at general
meeting.
4. Right to receive notices of general meetings, attend general meetings and speak at general
meetings at which he is being removed.
51
Statutory Duties of Auditor:

Duties regarding audit:
The auditor shall make a report to the members of the company which shall state:
1. whether or not they have obtained all the information and explanations which to the best of
their knowledge and belief were necessary for the purposes of the audit;
2. whether or not in their opinion, proper books of accounts have been kept by the company
as required by the Companies Ordinance, 1984
3. whether or not in their opinion,
(i) the balance sheet and profit and loss account together with the notes thereon have
been drawn up in conformity with the Companies Ordinance, 1984, and are in agreement
with the books of accounts and are further in accordance with accounting policies
consistently applied;
(ii) the expenditure incurred during the year was for the purpose of the company’s
business; and
(iii) the business conducted, investments made and the expenditure incurred during the
year were in accordance with the objects of the company;
4. whether or not in their opinion and to the best of their information and according to the
explanations given to them, the balance sheet, profit and loss account, cash flow statement
and statement of changes in equity together with the notes forming part thereof conform
with approved accounting standards as applicable in Pakistan, and, give the information
required by the Companies Ordinance, 1984, in the manner so required and respectively
give a true and fair view of the state of the company’s affairs as at June 30, 2015 and of the
profit (or loss), its cash flows and changes in equity for the year then ended.
5. whether or not in their opinion, Zakat deductible at source under the Zakat and Ushr
Ordinance, 1980, was deducted by the company and deposited in the Central Zakat Fund
established under that Ordinance.
If any of the above matters is answered in “negative” or in “qualification”; auditor shall state its reason
with factual position in auditor’s report.
Duties of statutory auditor regarding other engagements:

1. If company is issuing Statutory Report, duty to certify receipts and payments contained in
Statutory Report.
2. If company is winding up voluntarily, duty to make report on declaration of solvency of
company.
3. If company is issuing shares or debentures, duty to issue a report to be included in
prospectus on profits and losses of last 5 years, and rates of Dividend of last 5 years.
Signing of Audit Report:

The person appointed as auditor shall sign the auditors’ report and all other documents required to
be signed or authenticated by the auditor. However, if a firm is appointed as auditor, any of the
partners practicing in Pakistan may sign the above said documents.
Reading and inspection of auditor’s report:

The auditor’s report shall be read before the company in general meeting and shall be open to
inspection by any member of the company.

What are the rights and duties of an auditor under the Companies Ordinance, 1984? (10 marks)
52
Your firm has received notice from Ash plc (Ash), a listed company, that your firm will not be re-appointed as external
auditor when its term of office expires as the audit committee of Ash has recommended the appointment of another firm.
Set out the rights and responsibilities of your firm, including those under the Companies Ordinance 1984, relating to the
change in appointment. (03 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2016 June, amended)
LO 4: QUALIFICATION AND DISQUALIFICATION OF STATUTORY AUDITOR: ✯✯✯

Annual audit is required for all types of companies. There is no exemption in Pakistan for any
company whether public or private and whether small or large.
Qualification Criteria:
Audit of:
 a Public Company, or
 a Private company which is subsidiary of a public company, or
 a private company with paid up capital of Rs. 3 million or more
, shall be conducted by:
 A Chartered Accountant (as per Chartered Accountants Ordinance, 1961)or
 A firm of Chartered Accountants (provided all partners of firm are chartered accountants)
For other companies, audit is required but qualification is not prescribed by law. However, such
auditor shall still comply disqualification criteria.
Disqualification Criteria:
Following persons are disqualified for appointment as auditor in a company:
1. If a person (i.e. sole-practitioner or any partner in a firm) or his spouse or minor child holds
shares in the company or any of its associated company. However, if such a person holds
shares at time of appointment, he can be appointed if he discloses the fact at time of
appointment and disposes shares within 90 days of appointment.
2. If a person is indebted to the company.
However following are not considered debt in this regard:
a. sum payable to a credit card issuer not exceeding Rs. 500,000.
b. sum payable to a utility company not exceeding period of 90 days.
3. If a person is or was an employee (or officer or director) of the company in last 3 years.
4. If a person is a partner or employee of an employee (or officer or director) of the company.
5. If a person is Spouse of a director.
6. If a person is a Body corporate.
If a person is disqualified for a company, he is also disqualified for its subsidiaries, its holding, and
holding’s other subsidiaries.
Exam Tips
1. All conditions of disqualification apply at time of appointment as well as during
term of appointment.
2. Appointment by firm’s name shall be appointment of all partners. Therefore, ALL
partners must comply qualification and disqualification criteria.
53

Under the Companies Ordinance, 1984 which persons are not qualified for appointment as auditors of companies?
(05 marks)
LO 5: AUDIT OF COST ACCOUNTS: ✯

Cost Accounting Records:
A company engaged in production, processing, manufacturing or mining activities is required to
keep prescribed particulars relating to following cost accounting records:
1. Utilisation of Material,
2. Utilisation of Labour,
3. Utilisation of Other inputs or items of cost.
Audit of Cost Accounting Records:

Where a company is required to keep Cost Accounting records, Federal Govt. may direct that an audit
of cost accounts of the company shall be conducted in the manner as may be specified in the order.
Audit of cost accounts shall be conducted by an auditor who is a:

 Chartered accountant within the meaning of the Chartered Accountant Ordinance, 1961, or
 Cost and management accountant within the meaning of the Cost and Management
Accountants Act, 1966.
Such auditor shall have the same powers and duties as a statutory auditor of the company and such
other powers and duties as may be prescribed.
LO 6: PENALTY FOR NON-COMPLIANCE WITH COMPANIES ORDINANCE 1984: ✯

Non-compliance by Company or Officer of the Company:
If company or an officer of company refuses or fails (without lawful justification):
 to allow auditor access to books and papers of the company or
 to provide auditor information and explanation required by him or
 obstructs or delays an auditor in performance of his duties or
 fails to give notice of a general meeting to auditor
, he shall be liable to a fine upto Rs. 5,000 + Rs. 100 per day (if default is continuing).
Non-compliance by Auditor:
If a person is not a qualified auditor but acts as a qualified auditor, he shall be liable to a fine upto
Rs. 25,000.
54
Auditing – Study Notes Chapter 7 Compliance with Ethical Requirements
CHAPTER SEVEN
COMPLIANCE WITH ETHICAL
REQUIREMENTS
LO 1
FUNDAMENTAL PRINCIPLES OF ETHICS
✯✯✯
LO 2
THREATS TO FUNDAMENTAL PRINCIPLES
✯✯✯
LO 3
SAFEGUARDS TO FUNDAMENTAL ETHICAL PRINCIPLES
✯
LO 4
✯
ETHICAL CONFLICT RESOLUTION
1a (ICAP Code of Ethics) 11 (Confidential information)
5 (Threats) 126a–d (Multiple Questions)
10 (Fundamental principles)
Question Bank:
1 b (ICAP Code of Ethics) 16 (Prime Super Markets Limited)
3 (Shamsuddin) 18 (Saad Co)
6 (Burewala and Kamal) 29 (Delicious Biscuits Limited)
15 (Masoom, Chalak and Hoshiyar 31 (ABC Private Limited)
Limited)
55
LO 1: FUNDAMENTAL PRINCIPLES OF ETHICS: ✯✯✯

Integrity:
A chartered accountant should be straight forward, honest, fair and truthful in his professional
dealings and business relationships.
A chartered accountant should not be associated with reports, returns or communications which
(in his belief) are false, or furnished recklessly or omit information where such omission would be
misleading.
Objectivity:
A chartered accountant should not allow bias, undue influence or conflict of interest in his
professional judgments. A way to achieve objectivity is to be Independent.
Independence has two aspects:

 Independence of Mind/ Independence of Fact
Actual independence means auditor should make his professional judgment and opinions
with freedom of mind, and without any bias or influence.
 Independence in Appearance
The auditor must be seen to be independent, i.e. the auditor should avoid actions and
circumstances due to which a third party may conclude that his independence has been
compromised.
Confidentiality:
Confidentiality Principle:
A chartered accountant, acquiring confidential information in the course of professional
relationship:
 should not disclose such information to any third party except when permitted by client or
required by law or where there is professional right or duty to disclose.
 should not use such information for personal advantage or for advantage of third parties.
Confidentiality principle applies even within the firm, in social environment, and after termination
of relationship.
Exceptions of Confidentiality Principle:

Confidential information may be disclosed in following circumstances:
− If disclosure is permitted by client or
− If disclosure is required by law or court e.g.
o There is non-compliance of law (e.g. money laundering) which is required to be
disclosed, or
o Court orders chartered accountant to produce documents in a legal proceedings.
− When there is professional duty or right to disclose:
o To comply with Quality Control Review Program of the ICAP.
o To respond to an inquiry/investigation by the ICAP/SECP.
o To comply with requirements of international standards of auditing or ethics (e.g.
when required to communicate with lawyer, professional or regulatory authorities)
o To protect the professional interest of a chartered accountant in legal proceedings
(e.g. in case of unpaid fee or defending case of negligence).
56
Professional competence and due care:

Professional competence and due care means attaining and subsequently maintaining (through
continuing professional development) professional knowledge and skill at the level required to
ensure that clients receive a quality service, based on latest developments in profession, legislation
and techniques.
Consequences of not exercising professional competence and due care:

 Legal claims against the auditor in the law of contract or the law of tort.
 Disciplinary proceedings against the auditor by ICAP
 Firm may lose clients due to bad reputation
Professional behavior:
A chartered accountant should comply with relevant laws and regulations. He should always
behave with courtesy in professional dealings and should avoid misconduct and actions that
discredit profession.

A professional accountant is required to comply with the five fundamental principles described in “Code of Ethics
for Professional Accountants”. What are these principles? Explain. (10 marks)
LO 2: THREATS TO FUNDAMENTAL PRINCIPLES: ✯✯✯

In many circumstances, there arises possibility that a Chartered Accountant may not comply with
above fundamental principles. These circumstances are called Threat (given below).
Self-interest threat:
Definition:
Threat that judgment or behavior of a team member will be inappropriately influenced because of a
financial interest held by an assurance team member (or his relatives).
Examples:
1. Holding of shares in assurance client by team member or his relatives
2. Loan or Guarantee from an assurance client by team member or his relatives.
3. Business relationship between firm (or assurance team member) and client (or
management)
4. Contingent fee arrangements (also called incentive based fee).
5. Overdue fee.
6. Undue dependence on total fee from a client
7. An assurance member entering into employment negotiations with client.
8. An audit team member is evaluated or compensated on the basis of selling non-assurance
services to assurance client.
Familiarity threat:
Definition:
Threat that an assurance team member will be too sympathetic to the interest of client or too
accepting work of client because of long or close relationship with client.
57
Examples:
1. Immediate or close family member of an assurance team member is a director or officer of
client, or an employee in a position to significantly influence financial statements.
2. Long association of a senior team member with assurance client.
3. Acceptance of significant gifts or preferential treatment.
4. An assurance team member has been a director officer, or employee of client in a position to
significantly influence financial statements (and vice-versa).
Self review threat:

Definition:
Threat that an assurance team member will not appropriately evaluate results of previous service
performed by himself or by another individual of his firm.
Examples:
1. Performing non-assurance services that directly affect subject matter of assurance services
(e.g. preparation of accounting records and financial statements, or valuation of assets and
liabilities).
2. A member of assurance team has been a director, officer or employee of client.
3. A member of the audit team has provided temporary staff services (i.e. secondment) to
client during engagement period.
4. A firm reviewing the operations of financial system after designing and implementation of
the system.
Intimidation threat:
Definition:
Threat that an assurance team member is deterred from acting objectively because of threats,
undue influence or pressure.
Examples:
1. Threat of dismissal of auditor from client.
2. Threat of dismissal of auditor (or his relative) by client from proposed engagement (e.g. in
case of disagreement).
3. Threat of litigation by client
4. A pressure by client to inappropriately reduce the extent of work (to reduce fee).
5. An engagement partner threats team member not to promote unless he agrees with client’s
inappropriate accounting treatment.
Advocacy threat:
Definition:
Threat that an assurance team member will promote client’s position on a matter (to third parties)
and compromises his own objectivity.
Examples:
1. Firm promoting shares of an assurance client.
2. Acting as an advocate of assurance client in litigations or disputes (e.g. tax disputes) with
third parties.
State the FIVE threats contained within ACCA’s Code of Ethics and Conduct and for each threat list ONE example of a
circumstance that may create the threat. (05 marks)
58
LO 3: SAFEGUARDS TO FUNDAMENTAL ETHICAL PRINCIPLES: ✯

Safeguards are actions or other measures that may eliminate threats or reduce them to an
acceptable level.
They fall into two broad categories:

1. Safeguards created by the profession, legislation or regulation; and
2. Safeguards in the work environment.
Safeguards created by the profession, legislation or regulation: (i.e. by regulators)

 Education, training and experience requirements for entry into profession
 Continuing Professional Development (CPD)Requirements
 Professional standards e.g. Code of Ethics, Code of Corporate Governance
 External Quality Control Review Programs by professional/regulatory organizations.
 Disciplinary mechanism by professional and regulatory bodies.
Safeguards in the work environment: (i.e. by firm)

 Internal Quality Control Review of engagements
 Use of separate teams to provide assurance and non-assurance services.
 Use of information barriers between teams providing services to clients having conflict of
interest (e.g. competitors).
 Appointment of ethics partner.
 Rotation of senior team members.
 Terminating financial interest with clients.
 Declaration of independence to be signed by all team members at start of audit.
 Policies and procedures to identify and communicate interests or relationships between
engagement team and client identified during audit.
 A disciplinary mechanism by firm.

How do the audit firm's own systems and procedures provide safeguards against threats to its independence?(05 marks)
(ICMA Pakistan, Professional Level P2 – Winter 2006)
LO 4: ETHICAL CONFLICT RESOLUTION: ✯

When faced with an ethical conflict, a chartered accountant should consider relevant facts of the
situation and should:
1. Identify threat(s) involved in the situation.
2. Evaluate threat (i.e. whether significant or insignificant).
3. Apply relevant safeguards (or course of actions) to reduce threat to acceptable level.
4. All ethical issues and relevant considerations should be documented.
If a significant ethical conflict/threat cannot be resolved, chartered accountant should consider

withdrawal from engagement, if possible and practicable.
59
Auditing – Study Notes Chapter 8 Engagement Letter
CHAPTER EIGHT
ENGAGEMENT LETTER
LO 1
PURPOSES/OBJECTIVES OF AUDIT ENGAGEMENT LETTER
✯
LO 2
FORM AND CONTENTS OF ENGAGEMENT LETTER
✯✯
LO 3
ACCEPTANCE OF CHANGE IN THE TERMS OF AUDIT ENGAGEMENT
✯✯✯
LO 4
ENGAGEMENT LETTER ON RECURRING AUDITS
✯✯
20a (Engagement letter and documentation) 42 (EL)
21b (Shahid Corporation) 50 (Elegant Limited)
41 (Changing terms)
Question Bank:
60
LO 1: PURPOSES/OBJECTIVES OF AUDIT ENGAGEMENT LETTER: ✯

Audit Engagement Letter:
Engagement letter is a written agreement between auditor and authorized representative of client
(e.g. CFO, CEO) on terms and conditions of audit engagement.
Purposes of Engagement Letter:

 It confirms appointment by client and acceptance by auditor and constitutes a contract
between them.
 It removes misunderstanding between auditor and client on scope of audit and their
respective responsibilities.

List the objects of the engagement letter. Indicate who writes the letter to whom it is written and the time when it is
written.
LO 2: FORM AND CONTENTS OF ENGAGEMENT LETTER: ✯✯

Audit Engagement Letter shall include:
a) The objective and scope of the audit;
b) Identification of the applicable financial reporting framework;
c) The responsibilities of the auditor;
d) The responsibilities of management (also called Premise);
e) Expected form and content of report to be issued by the auditor and
f) A statement that there may be circumstances in which a report may be different from its
expected form and content.
An audit engagement letter may also include following:

a) Elaboration of the scope of the audit.
b) Inherent limitations of an audit
c) Inherent limitations of internal control.
d) Arrangements regarding the planning and performance of the audit, including composition
of the audit team and timing.
e) Fee or Basis of fee.
f) Agreement of management to inform the auditor of subsequent events affecting financial
statements (after date of auditor’s report till issuance of financial statements).
g) The expectation that management will provide written representation letter.
h) Reference to any other communication as a result of the audit engagement (e.g. Letter of
Weakness).
i) Arrangements concerning involvement of predecessor auditor, component auditor, expert,
internal auditor, quality control reviewer.

List the important matters that are required to be included in an audit engagement letter. (06 marks)
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LO 3: ACCEPTANCE OF CHANGE IN THE TERMS OF AUDIT ENGAGEMENT: ✯✯✯

Circumstances leading to change in terms of audit engagement:
Client may request auditor to change terms of the audit engagement as a result of:
 a change in circumstances affecting the need for the service,
 a misunderstanding as to the nature of service originally requested, or
 a restriction on the scope of the audit engagement.
Factors to be considered by auditor before accepting change:

If, prior to completing the audit engagement, auditor is requested to change the terms of
engagement, auditor shall consider:
1. whether there is a reasonable justification to do so, and
2. legal or contractual implications of the change.
A change in circumstances that affects the need for the service or a misunderstanding as to nature
of the service originally requested may be a reasonable justification. In contrast, a change may not
be reasonable if it relates to information that is incorrect, incomplete or otherwise unsatisfactory.
Acceptance of Change by Auditor:

If auditor accepts the change:
1. Revised terms of engagement shall be agreed.
2. Procedures to be performed and Report to be issued shall be according to revised engagement.
3. Report shall NOT refer to:
 Original audit engagement or
 Any procedures performed in original audit engagement
If auditor does not accept the change:

Auditor shall continue to perform the audit engagement as per original terms of engagement.
If management does not permit auditor to continue original engagement, it will be scope limitation
whose effect is pervasive. Auditor shall withdraw from engagement (if withdrawal is possible and
practicable). If withdrawal is not possible and practicable, auditor shall express disclaimer of
opinion on financial statements.

Your firm has been the auditor of Mujahid Limited (ML) for many years. Before the commencement of the current year’s
audit ML has requested that some changes be made in the terms of engagement.
Required:
(i) What are the circumstances which may lead to changes in the terms of engagement? (03 marks)
(ii) Discuss the important points which should be considered before accepting the changes in the terms of engagement.
(05 marks)
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LO 4: ENGAGEMENT LETTER ON RECURRING AUDITS: ✯✯

On recurring audit, auditor shall assess whether there is need to send fresh engagement letter to
remind management of the existing terms of the engagement or due to changes in circumstances.
Following factors may indicate that fresh engagement letter should be sent on recurring audit:
1) Any indication that client misunderstands the objective and scope of the audit.
2) A recent change in senior management or ownership of entity.
3) A change in legal or regulatory requirements.
4) A significant change in nature or size of entity’s business.
5) A change in applicable financial reporting framework of entity.
6) A change in other reporting requirements
7) Any revised or special terms of the audit engagement.

Is it necessary for an audit firm to issue an engagement letter every year in case of a recurring audit? What are the factors
to be considered in this regard? (04 marks)
63
Auditing – Study Notes Chapter 9 Planning an Audit
CHAPTER NINE
PLANNING AN AUDIT
PART A – PLANNING OF AN AUDIT

LO 1
PLANNING ACTIVITIES
✯
LO 2
DIFFERENCE BETWEEN OVERALL AUDIT STRATEGY AND AUDIT PLAN
✯✯
LO 3
ADDITIONAL PLANNING CONSIDERATIONS FOR INITIAL AUDIT ENGAGEMENT
✯✯
LO 4
DIFFERENCE BETWEEN INTERIM AUDIT AND FINAL AUDIT
✯
PART B – AUDIT MATERIALITY
LO 5
MATERIALITY
✯✯
LO 6
PERFORMANCE MATERIALITY
✯✯
LO 7
QUALITATIVE MATERIALITY
✯✯
LO 8
REVISION IN MATERIALITY
✯✯
8b (Audit process) 91c (Taskeen Co)
32 (Materiality) 97b (Analytical procedures and
36 (Acceptance and planning) materiality)
Question Bank:
45a (Hurricane)
64
PART A – PLANNING OF AN AUDIT
LO 1: PLANNING ACTIVITIES:✯
Planning Activities:
Planning an audit involves:
 establishing the overall audit strategy (that sets scope, timing and direction for
engagement) and
 developing audit plan (which includes nature, timing and extent of audit procedures to be
performed by engagement team for each area of financial statements).
Who is involved in Planning of audit:

The engagement partner and other key members of the engagement team shall be involved in
planning the audit.
Importance/Benefits/Objectives of Planning:
Planning helps to:
1. Identify potential problems (e.g. risks) on timely basis.
2. Pay attention to important areas of audit.
3. Assist in selection of appropriate team and proper assignment of work to them.
4. Perform direction, supervision and review of engagement team.
5. Coordinate with component auditor and experts, if any.
6. Organize and manage engagement so that it is completed efficiently and effectively.
Documentation of Planning:
Auditor shall include following planning matters in his documentation:
 Overall Audit Strategy
 Audit Plan
 Significant changes in audit strategy or audit plan alonwith reasons of change.

ISA 300 Planning an Audit of Financial Statements provides guidance to auditors. Planning an audit involves establishing
the overall audit strategy for the engagement and developing an audit plan. Adequate planning benefits the audit of
financial statements in several ways.
Required:
Explain the importance of audit planning.
65
LO 2: DIFFERENCE BETWEEN OVERALL AUDIT STRATEGY AND AUDIT PLAN:✯✯

Audit Strategy and its Contents:
Definition:
Audit strategy sets the scope, timing and direction of audit, and guides the development of the audit
plan.
Matters documented in audit strategy:

1. Characteristics of the engagement that determine its scope:
This includes consideration of Applicable Financial Reporting Framework, industry specific
requirements, expected audit coverage, including the number and locations of components
to be covered.
2. Reporting objectives of the engagement
It relates to establishing deadlines for completion of work and key dates for expected
communication.
3. Factors that are significant in directing the engagement team’s efforts:
This includes determination of materiality threshold, areas of high risks, audit approach to
address risks (e.g. whether to rely on internal controls).
4. Resources necessary to perform the engagement:
 When resources are needed (e.g. whether resources are to be used at interim audit).
 How much resources are to be used and where (e.g. high number and experience of staff
needed on high risk areas)
 How to direct, supervise and review resources during audit.
5. Results of preliminary engagement activities and knowledge gained on other
engagements performed for the entity.
Audit Plan and its Contents:

Definition:
The audit plan is more detailed than the overall audit strategy and includes the nature, timing and
extent of audit procedures to be performed by engagement team members to obtain sufficient
appropriate audit evidence to reduce audit risk to appropriate level.
Matters documented in audit plan:

 Nature, timing and extent of planned risk assessment procedures. This includes assessment of
both inherent risk and control risk at financial statement level and at assertion level.
 Nature, timing and extent of further audit procedures at assertion level for each class of
transactions, balance and disclosure of financial statements. This includes:
o Tests of Controls (if auditor wants to rely on controls), and
o Substantive Procedures (depending on risk assessment)

(a) Explain the difference between “The Overall Audit Strategy” and the “Audit Plan”. (04 marks)
(b) Identify the matters which are usually discussed / explained in each of the above documents. (12 marks)
66
LO 3: ADDITIONAL PLANNING CONSIDERATIONS FOR INITIAL AUDIT ENGAGEMENT:✯✯

Why risk of audit failure is higher in first year of audit:
There is an increased risk of audit failure in the first year of audit client relationship because of:
 Limited understanding of entity and its environment.
 Possibility of misstatement in opening balances which affect current year’s financial
statements.
Additional planning considerations to reduce risk in initial audit engagement:

To mitigate the audit risk, auditor performs following additional activities prior to starting an initial
audit:
1. Perform procedures regarding accepting of client relationship and audit engagement
(specially considering integrity of management).
2. Discuss with management major issues regarding initial selection as auditor (e.g. any
disagreement on accounting treatment or any indication of scope limitation), and
communicate to TCWG these matters and their effect on audit strategy and audit Plan.
3. Communicate with predecessor auditor and make arrangements e.g. arrangement to review
the working papers.
4. Procedures to obtain sufficient appropriate audit evidence regarding opening balance
5. Other procedures in accordance with firm’s quality control system (e.g. assignment of
quality control review for initial audit engagement)

You have been appointed as the auditor of a company which was previously audited by another auditor. Being a new
client, what additional considerations would you take into account while performing the preliminary engagement
activities prior to commencement of the audit? (05 marks)
LO 4: DIFFERENCE BETWEEN INTERIM AUDIT AND FINAL AUDIT:✯

Interim Audit:
Definition:
Interim audit is that part of the audit which takes place before the year end. Interim audit is not
required by ISAs. Auditor decides to conduct interim considering time pressure, size and
complexity of entity, and effectiveness of controls.
Typical Interim Audit Procedures:

 Obtaining understanding of entity and assessing inherent risk.
 Obtaining understanding of internal control and assessing control risk.
 Documentation and testing of internal controls.
 Preliminary analytical procedures.
 Testing of profit and loss transactions for the year to date.
 Identification of potential problems which may affect the final audit work.
Advantages of Interim audit:

Interim Audit gives following benefits:
a) Earlier identification of significant matters.
b) Flexible planning of human resources.
c) Stakeholders receive audit report quickly.
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d) Burden of audit team is spread, therefore, efficiency and effectiveness of audit team is
increased.
Study Tip
Do NOT mix/confuse between concepts of “Interim Audit”, “Review Engagement” and Internal Audit”.
Final Audit:
Definition:
Final audit will take place after the year end and concludes with the auditor forming and expressing
an opinion on the financial statements for the whole year.
Typical Procedures performed at Final Audit:

 Agreeing financial statements to accounting records
 Examining adjustments made during preparation of financial statements
 Ensure proper cut-off on sales and purchases.
 Substantive Procedures for transactions between interim date and B/S date.
 Obtaining Confirmation Letters (e.g. from banks, debtors and creditors)
 Obtaining Representation Letter from Management.
 Inventory count and follow-up of items noted during inventory count.
 Review of subsequent events.
 Final analytical procedures.
 Going Concern Review

Explain the difference between an interim and a final audit. (05 marks)
PART B – AUDIT MATERIALITY
LO 5: MATERIALITY:✯✯
What is Materiality:
Misstatements (and scope limitations) are considered material if they, individually or in aggregate,
could reasonably be expected to influence the economic decisions of users taken on the basis of the
Materiality depends on size as well as nature of misstatement.
Use/Purpose of Materiality:
Materiality is determined at the start of the audit but is used at:
 Planning stage, to determine nature, timing and extent of audit procedures to be performed.
 Performance stage, to reduce the risk that the aggregate of uncorrected and undetected
misstatements exceeds materiality for the financial statements as a whole..
 Reporting stage, to evaluate the effect of uncorrected misstatements on financial
statements, and in forming opinion on financial statements (i.e. whether financial
statements give true and fair view in all material respects).
How is Materiality determined:

On the basis of size, materiality is determined as follows:
Materiality = Chosen Benchmark * Chosen Percentage
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 Benchmark depends on whether entity is profit oriented or not-for-profit.

 Percentage depends on Benchmark and Risk (i.e. risk and materiality have inverse
relationship).
Exam Tip
Following “rule of thumb” has been established to determine materiality:
1. For profit oriented entity, materiality= Profit before tax * 5%
2. For not-for-profit entity, materiality = Total Revenue or Total Expenses or Total Assets* 0.5% (or 1%)
Documentation of Materiality:
The auditor shall document the following aspects of materiality:
(i) Materiality for the financial statements as a whole
(ii) Performance materiality
(iii) Basis of computing materiality
(iv) Any revision in (i) or (ii) above.

ISA 320 Materiality in Planning and Performing an Audit provides guidance on the concept of materiality in planning and
performing an audit.
Required: Define materiality and determine how the level of materiality is assessed. (05 marks)
Determination of materiality level requires professional judgement on the part of the auditor.
(a) Briefly describe the importance of materiality in the following stages of audit:
(i) Planning stage (01 marks)
(ii) Reporting stage (02 marks)
(b) What aspects of materiality should be documented by an auditor in the working papers? (04 marks)
LO 6: PERFORMANCE MATERIALITY:✯✯
What is Performance Materiality:
Performance Materiality is the amount set by the auditor, less than materiality for the financial
statements as a whole, to reduce the risk that the aggregate of uncorrected and undetected
misstatements exceeds materiality for the financial statements as a whole.
If applicable, performance materiality also refers to the amount or amounts set by the auditor at
less than the materiality levels for particular classes of transactions, account balances or
disclosures.
How is Performance Materiality determined:

Determination of performance materiality is not a mathematical calculation. It involves the exercise
of professional judgment and is affected by:
 misstatements identified in previous periods; and
 expected misstatements in current periods (based on auditor’s risk assessment procedures)

You are the training manager in a firm of chartered accountants. Prepare brief presentation for newly inducted trainees,
on Materiality and Performance Materiality. (05 marks)
69
LO 7: QUALITATIVE MATERIALITY:✯✯
What is Qualitative Materiality:
Qualitative materiality means ignoring the amounts of misstatements and considering its
“qualitative characteristics” to determine whether it is material or not.
Examples Areas where Materiality is determined on Qualitative basis:

1. Inadequate or improper description of an accounting policy and related party transactions
2. Non-compliance of legal requirements (e.g illegal payments, money laundering)
3. Fraud
4. A misstatement which is small in size but:
o Converts a loss into profit (and vice-versa).
o Takes financial figures below a certain threshold
o Affects a key ratio (e.g. debt-covenant requirements)
o Affects Directors’ remuneration
o Affects Share capital

During the course of an audit, both quantitative as well as qualitative misstatements need to be considered. Give four
examples of qualitative misstatements. (04 marks)
LO 8: REVISION IN MATERIALITY:✯✯
When is Materiality Revised:
Materiality is revised if auditor obtains new information/evidence which is different from
information/evidence on which original assessment was based e.g.
1. Revision in risk
2. Change in the auditor’s understanding of the entity and its operations
3. Occurrence of events substantially affecting draft financial statements
4. Change in circumstances during audit (e.g. decision to dispose a major part of the business)
Effect of Revision of Materiality on Audit:

If materiality is revised, it may have impact on following aspects of audit:
 Performance materiality
 Risk of material misstatement
 Nature, timing and extent of audit procedures

Sajjad is the audit senior on the audit of Hameed Limited (HL). Upon his manager’s instruction Sajjad had determined the
acceptable materiality level to be Rs. 10 million at the initial planning stage. However, at the time of evaluating the results
of audit procedures carried out at the interim stage, he has reduced the materiality level to Rs. 7.5 million.
Required:
(i) Identify the possible causes which motivated Sajjad to reduce the materiality level. (02 marks)
(ii) Discuss the impact of reduction in the materiality level on audit risk and the audit procedures to be performed.
(05 marks)
70
Auditing – Study Notes Chapter 10 Understanding of Entity and Inherent Risk Assessment
CHAPTER TEN
UNDERSTANDING OF ENTITY AND
INHERENT RISK ASSESSMENT
PART A – RISK BASED APPROACH TO AUDITING

LO 1
APPROACHES TO AUDITING
✯
LO 2
AUDIT RISK MODEL
✯✯✯
PART B – INHERENT RISK ASSESSMENT, CLASSIFICATION AND RESPONSE
LO 3
OBTAINING UNDERSTANDING OF ENTITY
✯✯
LO 4
LEVELS OF RISKS
✯✯✯
LO 5
RESPONSE TO RISKS
✯
LO 6
REVISION OF RISK ASSESSMENT
✯
LO 7
DOCUMENTATION OF RISK ASSESSMENT
✯
PART C – RISK ASSESSMENT IN SPECIALIZED ENTITIES
LO 8
RISK ASSESSMENT IN SMALL ENTITIES AND EFFECT ON AUDIT
✯
LO 9
RISK ASSESSMENT IN NOT-FOR-PROFIT ORGANIZATIONS
✯✯
71
22a,b (Assertions) 48a (Hajira)

39 (Discussions and judgment) 51 (Training Manager)
Question Bank:
17 (Durable Cement Limited) 45b (Hurricane)

35 (AMF) 46b (Zakir Co)
40 (Dynamic) 48b & c (Hajira)
44 (Azam)
72
PART A – RISK BASED APPROACH TO AUDITING
LO 1: APPROACHES TO AUDITING: ✯
Transaction-based/ Vouching-based/ Direct verification / Substantive Approach:
Under this approach no reliance is placed on entity’s system of internal control to determine level
of detailed testing of transactions. This approach is used by auditor when entity’s internal controls
are absent/weak, or number of transactions is low. Auditor may set testing level between 50% to
100% of the population.
This approach is often used when auditing financial statements of a small entity.
The system-based approach

System based approach means auditor places reliance on entity’s system of internal control to
determine level of detailed testing of transactions. This approach is used by auditor when entity’s
internal controls are strong and auditor decides to rely on internal control.
Following are stages of system-based approach:

1. Make preliminary assessment of strength of internal control.
2. Perform test of control to confirm whether preliminary assessment is correct.
3. Determine level of detailed testing of transactions based on results of tests of controls (i.e. if
internal controls are strong, reduce level of testing and vice-versa).
Risk-Based Approach:
Under risk-based auditing, objective of auditor is to reduce audit risk to an acceptable level. This is
achieved by performing detailed testing on areas where there is high risk of material misstatement.
Following are stages of risk-based approach:

1. Auditor sets appropriate level of audit risk in accordance with nature of engagement and
firm’s quality control policies and procedures.
2. Auditor performs risk assessment procedures to obtain understanding of entity and
internal control to assess inherent risk and control risk.
3. Auditor uses “audit risk model” to calculate acceptable level of detection risk i.e.
DR = AR/(IR * CR)
4. Based on level of acceptable level of detection risk, auditor determines nature, timing and

“The auditing techniques for audit testing now takes cognizance of risk element in the modern audit”. In the light
of this statement, explain risk based audit approach and vouching based audit approach. (04 marks)
LO 2: AUDIT RISK MODEL: ✯✯✯

Below is a presentation of audit risk model which elaborates how risk is assessed and used by
auditor in determining further audit procedures. This model is used by auditors in audit of all areas
of financial statements.
73
Numeric example of application of Audit Risk Model:
Risk Assessment Procedures

Understanding Understanding of Internal
of entity Control
Weakness i.e. RMM Detection Risk Audit Risk
Inherent Risk Strength Audit Procedures
Control Risk (IR * CR) (AR/RMM) (set by firm)
 Extensive TOC (because auditor
relies more on internal control)
Area
60% 80% 20% 12% 40% 4.8%  Reduced Substantive
A
Procedures (because desired
level of detection risk is high)
 Reduced TOC (because auditor
relies less on internal control)
Area
60% 20% 80% 48% 10% 4.8%  Extensive Substantive
B
Procedures (because desired
level of detection risk is low)
Explanation of Components/Elements of Audit Risk:

Inherent Risk:
The susceptibility of an assertion about a class of transaction, account balance or disclosure to a
misstatement that could be material (either individually or when aggregated with other
misstatements), before consideration of any related controls.
Inherent risk cannot be controlled/minimized.
Control Risk:
The risk that a misstatement that could occur in an assertion about a class of transaction, account
balance or disclosure and that could be material (either individually or when aggregated with other
misstatements) will not be prevented, or detected and corrected, on a timely basis by the entity’s
internal control.
Control risk (and consequently risk of material misstatement) can be controlled/reduced by client
through internal control.
Study Tip – Risk of Material Misstatement

The risk that the financial statements contain material misstatements (individually or in aggregate) prior
to audit. This consists of two components at assertion level i.e. Inherent Risk (IR) and Control Risk (CR).
Detection Risk:
The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low
level will not detect a misstatement that exists and that could be material (either individually or
when aggregated with other misstatements).
Detection risk (and consequently audit risk) can be controlled/reduced by auditor through audit
procedures.
Study Tip – Audit Risk
The risk that the auditor expresses an inappropriate opinion when financial statements are materially
misstated. Audit risk is a function of Risk of Material Misstatement and Detection Risk.
Audit Risk = Inherent Risk * Control Risk * Detection Risk.

Define audit risk and the components of audit risk. (05 marks)
(ACCA, Fundamentals Level F8 – March/June 2016)
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PART B – INHERENT RISK ASSESSMENT, CLASSIFICATION AND RESPONSE
LO 3: OBTAINING UNDERSTANDING OF ENTITY: ✯✯

Auditor is required to obtain understanding of entity and its environment. This understanding shall
cover following:
1. Relevant industry, regulatory and other external factors, including relevant accounting
requirements.
2. The nature of the entity and its operations, ownership and management structures.
3. The entity’s selection and application of accounting policies, including whether they are
consistent with applicable financial reporting framework, consistent with industry, and any
change in accounting policies is appropriate.
4. The entity’s objectives and strategies and those related business risks that may result in risks
of material misstatement in financial statements.
5. The measurement and review of the entity’s financial performance (through analytical
procedures).
Business Risk:
Business risk is a risk resulting from significant conditions, events, circumstances, actions
or inactions that could adversely affect an entity’s ability to achieve its objectives. Business
risks can also occur as a result of setting of inappropriate objectives, strategies or goals.
Understanding of business risks helps auditor in his risk assessment because most of the
business risks ultimately affect financial statements hence they also become risks of
material misstatement.

List FOUR examples of matters the auditor may consider when obtaining an understanding of the entity. (02 marks)
Define and explain the term ‘business risk’. (05 marks)
LO 4: LEVELS OF RISKS: ✯✯✯

There are two levels of risk i.e. risks at Financial Statement Level and risks at Assertion Level.
Risk at Financial Statement Level:

Risks at the financial statement level refer to risks that affect financial statements pervasively and
potentially affect many assertions. They are not necessarily identifiable with specific assertions.
Rather, they represent circumstances that may increase the risks of material misstatement at the
assertion level.
Examples of (Inherent) risks at financial statement level:

1. Risk of management override of control.
2. Declining economic conditions causing going concern problems (e.g. Poor liquidity/credit
position, Decreasing sales and profits, loss of key customers, increased competition).
3. Competence and Integrity of management.
4. Risk of fraud (e.g. due to unusual pressure on management to meet targets).
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5. Nature of the entity’s business and operations (e.g. high-tech or fashion based products,
expansion through new products or new locations, intended sale of business, significant
transactions with related parties, significant transactions outside the normal course of
business).
Risk at Assertion Level:

Risk at assertion level refers to risks that do not affect financial statements pervasively and affect
only specific identifiable assertions.
Examples of (Inherent) risks at assertion level:

1. Complex transactions
2. Non-routine transactions (e.g. purchase or disposal of fixed assets)
3. Subjectivity and judgments involved in measurement of transactions (e.g. pending
litigations and contingent liabilities)
4. Accounts with history of errors
5. Large transactions/adjustments at period end.
6. Assets with high risk of misappropriation (e.g. cash or other movable/marketable assets)

The auditor is required to identify and assess the risk of material misstatement at both the financial statement and
assertion levels.
State what is meant by risk at financial statement level and assertion level. Give one example of risk at each level.
(03 marks)
LO 5: RESPONSE TO RISKS: ✯
Response to Risk at Financial Statement Level:
To address risk at financial statement level, auditor shall design and implement overall responses
e.g.:
 Increase level of professional skepticism specially during audit of judgmental areas.
 Adequate planning, and reduced materiality level.
 Assigning more experienced and specialized staff e.g. use of experts if necessary.
 Adequate supervision and review of the audit work performed (e.g. quality control
review of the engagement).
 Incorporating unpredictability in nature, timing and extent of audit procedures
o Performing procedures on account balances not usually tested.
o Using different sampling methods.
o Performing audit procedures at different locations on unannounced basis.
 Making changes to audit procedures.
 More audit procedures at period end rather than at interim date.
 Obtaining more reliable audit evidence (e.g. from external sources).
Response to Risk at Assertion Level:

To address risk at assertion level, auditor shall perform following audit procedures:
 Tests of Controls (to be discussed in chapter # 11) and
 Substantive Procedures (to be discussed in chapter # 12).
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Suppose, you are an Audit Manager in a medium sized audit firm and M/s. Alpha Designers Limited is one of your key
audit clients. You are in the process of audit planning of the client for the year ended December 31, 2014 and the initial
meeting for briefing the engagement team has been scheduled next week. You have been requested by the team in-charge
to brief the team on key aspects of the audit risk to be applied while carrying out the audit under the International
Standards on Auditing.
Required:
(a)Discuss audit risk and its components in the meeting with the team. (08 marks)
(b)Enumerate the possible overall responses to address the assessed risks of material misstatement at the financial
statement level. (08 marks)
(ICMA Pakistan, Professional Level P2 – March 2015)
LO 6: REVISION OF RISK ASSESSMENT: ✯

If during the course of audit, additional evidence is obtained by auditor from performing further
audit procedures which is inconsistent with information/evidence on which original risk
assessment was based, auditor shall revise risk assessment. For example:
 In performing tests of controls, the auditor detects deviations greater than original
assessment.
 In performing substantive procedures, the auditor detects misstatements greater than
original assessment.

“The auditor’s assessment of materiality and audit risk may be different at the time of initially planning the engagement
from at the time of evaluating the results of audit procedures.”
Briefly describe the reasons which may lead to such a change in the auditor’s assessment. (03 marks)
LO 7: DOCUMENTATION OF RISK ASSESSMENT: ✯

Auditor is required to document following regarding risk assessment:
1. Risk assessment procedures performed, including discussion among the engagement team
about the susceptibility of the entity’s financial statements to material misstatement and
decisions reached.
2. Understanding obtained regarding each aspect of entity.
3. Risk of material misstatement identified at financial statements level and at assertion level.
4. Significant risks identified and controls related to significant risks.

An auditor is required to identify and assess the risks of material misstatements to provide a basis for designing and
performing further audit procedures.
Required:
State the matters which you would include while documenting the risk identification and risk assessment procedures.
(06 marks)
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PART C – RISK ASSESSMENT IN SPECIALIZED ENTITIES
LO 8: RISK ASSESSMENT IN SMALL ENTITIES AND EFFECT ON AUDIT: ✯

What is a Small Entity:
Small entity means a sole-proprietorship or a partnership.
Features, Risks and Effect on Audit of Small Entity:
Features/Characteristics of
Risks and Effect on Audit
Small Entity
This can increase audit risk (as owner-manager is easily able to override any internal
Common ownership and controls) or decrease audit risk (as owner is actively involved in day to day operations).
management Risk assessment will depend on auditor’s knowledge of the integrity and competencies
of management.
There will be lack of internal control e.g. no segregation of duties or no authorization
Few Employees controls. Control risk will be increased. Auditor shall place less reliance on controls and
large amount of substantive procedures will be performed.
Use of standardized or less sophisticated accounting system may fail to provide
Less sophisticated accounting adequate audit trail as they are not specific to needs of entity. Further, system errors
system may occur due to inadequate programming or training of staff on use of package.
Auditor is unlikely to use CAATs.
Auditor is likely to himself prepare financial statements which may create self-review
No full time well-qualified
threat. Therefore, safeguards should be applied to reduce threats (e.g. use of different
accountant
teams).

Describe the specific risks involved in the audit of a small business. (05 marks)
LO 9: RISK ASSESSMENT IN NOT-FOR-PROFIT ORGANIZATIONS (NFPO): ✯✯

What is a Charity or NFPO:
A not for profit organization raises funds from general public and spends its funds on defined
beneficiaries in accordance with its objects.
Inherent Risks in NFPO and their effect on Audit Approach:

Risks associated with Income:
Risk and explanation of risk Effect on Audit Approach
Risk Factor: If income of charity is derived wholly
from donations.
Donation income is likely to be unpredictable, Auditor Audit report may need to be modified because going concern
cannot obtain evidence on income through analytical assumption is affected by uncertainty of future income.
procedures. Also, it may fall in poor economic conditions.
Risk Factor: If cash is collected by volunteers from
various places.
It is difficult to ensure completeness of income because Audit report may need to be modified because lack of
volunteers may be inexperienced or untrained. Further, evidence to ensure completeness of income.
donation may be stolen by volunteers (as no sales
invoices are raised).
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Risks associated with Expenses:

Risk Factor: If constitution of charity specifies how
the income is to be spent/expended:
There is a risk that expenditures can be incurred for Expenditures will have to be carefully reviewed to ensure
objects outside of constitution of Charity. that expenditures are not ‘ultra vires’ the objectives of
Charity.
Risk Factor: If there are specific instructions about
utilization of donation.
There is a risk that donation may be recorded Auditor will carefully check whether:
inappropriately (e.g. misclassification between recording  Specific donations is recorded as liability.
as liability or income) or may be spent inappropriately  Specific donation is expended in accordance with
(e.g. it may not be spent in accordance with instructions instructions of donor.
of the donor).
Risk Factor: If constitution of charity requires that
administration expenditure cannot exceed a certain
percentage of income. Auditor will check whether this limit has exceeded. Auditor
There is a risk that administration expenditure can will also check other areas if there are unusual increase in
exceed this limit and may be misclassified by expense for possibility of misclassification of admin expenses.
management.
Risk Factor: If there are complex regulations and tax
rules applicable on charity.
There is a risk that rules will be broken due to lack of Auditor will ensure that staff is familiar and complying with
knowledge and expertise. relevant regulations and tax rules.
Risk of Weak Control Environment:

Control Environment of a NFPO is likely to be weak due Control risk will be increased. Auditor shall place less reliance
to: on controls and large amount of substantive procedures will
 Lack of segregation of duties as staff is limited. be performed.
 Volunteer staff which may not well qualified or
experienced to have good control system.
 No internal audit department working in NFPO.
 Lack of involvement of trustees.

Al-Madad Foundation (AMF) is a charitable organization. It receives donations which are utilized to help the destitute
persons in accordance with the rules and regulations prescribed by the AMF’s Trust Deed.
The donations are received from the following sources:
(i) Cash collected from the general public through charity boxes placed at key points in hospitals, airports, superstores
etc.,
(ii) cash and cheques received from individuals and institutions at AMF’s office; and
(iii) cash from generous individuals who prefer to remain anonymous.
Donations received in case of (ii) and (iii) above, often contain specific instructions for utilisation of the donated amount
for specific purposes e.g. for education of orphan children.
Required:
(a) Identify the inherent risks in the operations of AMF. (03 marks)
(b) Briefly discuss the effect of each of these risks on the audit of AMF. (03 marks)
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Auditing – Study Notes Chapter 11 Understanding of Controls and Control Risk Assessment
CHAPTER ELEVEN
UNDERSTANDING OF INTERNAL CONTORL
AND CONTROL RISK ASSESSMENT
PART A – UNDERSTANDING AND TESTING OF INTERNAL CONTROLS

LO 1
DEFINITION AND LIMITATIONS OF INTERNAL CONTROL
✯
LO 2
OBTAINING UNDERSTANDING OF INTERNAL CONTROL
✯✯
LO 3
THE SALES SYSTEM
✯✯✯
LO 4
THE PURCHASES SYSTEM
✯✯✯
LO 5
THE PAYROLL SYSTEM
✯✯✯
LO 6
THE BANK AND CASH SYSTEM
✯✯✯
LO 7
THE INVENTORY AND NON-CURRENT ASSETS SYSTEM
✯✯✯
PART B – DOCUMENTATION OF UNDERSTANDING OF ENTITY AND INTERNAL CONTROL
LO 8
METHODS OF DOCUMENTATION OF A SYSTEM
✯
LO 9
DIFFERENCE BETWEEN ICQ AND ICEQ
✯
LO 1 0
CHECKING THE ACCURACY OF PREVIOUS YEAR’S ICQ
✯
PART C – ADDITIONAL CONCEPTS
LO 1 1 AUDITOR’S COURSE OF ACTION IF HE IDENTIFIES A WEAKNESS IN
✯ INTERNAL CONTROL
LO 1 2
AUDIT LETTERS AND REPORT
✯
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55c (IT Department) 65 (Trade Receivables)

57 (Bhurbhan Limited) 108a (Zeedin Co)
59 (Supermarkets) 109a (Sahito Co)
60 (Controls) 110a (Bashir Co)
61a (Shahzad Limited) 111b (Multiple Situations)
64a (Roses Anytime) 120 (Overtime payments)
Question Bank:
61b (Shahzad Limited) 66a (Granger)

62a & b (Waheed Engineering) 108d (Zeedin Co)
63 (Danish) 109b (Sahito Co)
64b (Roses Anytime) 110b (Bashir Co)
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A – UNDERSTANDING OF INTERNAL CONTROL
LO 1: DEFINITION AND LIMITATIONS OF INTERNAL CONTROL: ✯

Definition of Internal Control:
Internal Control means policies and procedures designed, implemented and operated by
management and TCWG to provide reasonable assurance about achievement of entity’s objectives
with regard to:
 Effectiveness and efficiency of its operations
 Compliance with applicable laws and regulations
 Reliability of the entity’s financial reporting
Limitations of Internal Control:

Internal Control system is never perfect. It cannot provide absolute assurance about achievement of
objectives because of Inherent Limitations of Internal Control i.e.
i. Breakdowns caused by human errors
ii. Management override of controls.
iii. Segregation of duties in smaller entities not possible.
iv. Collusion i.e. internal control is circumvented intentionally through collusion among more
than one person.
v. Cost-benefit trade off may not justify a control
vi. Often non-routine transactions are not subject to internal control.
vii. Often Judgments are involved in risk assessment, and implementation of control which can
be faulty

Describe some inherent limitations of Internal Controls. (04 marks)
LO 2: OBTAINING UNDERSTANDING OF INTERNAL CONTROL: ✯✯

Auditor is required to obtain understanding of internal control of entity to assess control risk. This
understanding shall cover following elements:
Control Environment:
Control environment includes the governance and management functions, and attitude, awareness
and actions of TCWG and management regarding entity’s internal control and its importance in the
entity. The control environment sets the tone of an organization, influencing the control
consciousness of its people.
Auditor shall evaluate whether entity has a strong control environment. In evaluating the control
environment, auditor considers the following elements:
 Audit committee and board of directors have significant influence in the organization and
actively participate in business.
 Management actions and attitudes show character, integrity, and ethics.
 Management is committed towards Competence.
 No tolerance over code of conduct (e.g. petty theft).
 Management's operating style and philosophy is not aggressive towards financial reporting.
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 Organizational structure is appropriate according to business.

 Management assigns authority and responsibility appropriately.
 Human resource policies emphasize on strong control environment.
Information System Relevant to Financial Statements:

Relevant Information system means processes by which entity obtains, process and records
transactions to prepare financial statements.
Auditor should understand following aspects of information system:

 Classes of transactions that are significant to financial statements.
 The procedures, within both information technology (IT) and manual systems, by which
those transactions are initiated, recorded, processed, transferred to the general ledger.
 Related accounting records (either manual or electronic) in support of transactions.
 Controls over standard and non-standard journal entries.
 The process used to prepare the entity’s financial statements.
Entity’s Risk Assessment Process:

Risk Assessment Process means process to identify, assess and manage business risks. Identifying
risk means recognizing existence of risk. Assessing risk means deciding whether risk is significant
or not. Managing risk means designing and operating internal controls to minimize the risk.
Risk can arise or change due to following circumstances:

 changes in the entity’s operating environment.
 new personnel.
 new or revamped information systems.
 rapid growth.
 new technology.
 new business models, products or activities.
 corporate restructurings.
 expanded foreign operations.
 new accounting pronouncements.
Auditor shall evaluate whether entity has a good Risk Assessment Process.
Control Activities Relevant to Audit:

Control activities are the policies and procedures (other than control environment) to ensure that
management directives are carried out. Control activities, whether within IT or manual systems,
have various objectives and are applied at various organizational and functional levels.
In evaluating the control activates in an area, auditor considers the following categories:
1. Authorization.
All significant transactions should be authorised/approved by an appropriate level of
management e.g.
 Authorization of capital expenditure before they are incurred.
 Authorization of payroll sheet before payment.
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2. Performance reviews.
These control activities include reviews and analyses of actual performance versus budgets,
forecasts, and prior period performance, together with investigative and corrective actions.
It also includes comparing internal data with external sources of information. These are
usually performed by management to supervise work of subordinates, and are also called
Management Controls.
3. Information processing Controls.

These are used to check accuracy and completeness of transactions. These controls are
classified between two broad groups i.e. General Controls, and Application Controls.
4. Physical controls.
These are controls to prevent unauthorized access to tangible assets and computer
programs/data files e.g.
 Physical security of assets (e.g. secured facilities)
 Authorization for access to computer programs and data files
 Periodic counting and comparison of physical balances with book balances (e.g.
comparing results of inventory counts, cash counts)
5. Segregation of duties.
Segregation of duties means assigning different people the responsibilities of authorizing
transactions, recording transactions, and maintaining custody of assets. It ensures that one
person who makes the error or fraud, is not able to conceal it.
Monitoring of Controls:
Monitoring of control is a process to evaluate whether internal controls are operating as intended,
and effectively. It also includes taking remedial actions, if necessary. It includes activities e.g.
 review of whether bank reconciliations are being prepared on a timely basis, or
 internal auditors’ evaluation of sales personnel’s compliance with the entity’s policies on
terms of sales contracts
Auditor shall obtain understanding of major activities that entity uses to monitor internal control. If
entity has an internal audit function, auditor shall obtain understanding of activities performed by
internal audit function.

International Standards on Auditing require an auditor to evaluate the control environment and assess its effectiveness.
State the factors that the auditor should consider in evaluating the control environment. (04 marks)
Briefly explain the components of internal control as referred to in the International Standards on Auditing. (09 marks)
In the context of control activities explain what is included in ‘Performance reviews’. (03 marks)
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LO 3: THE SALES SYSTEM: ✯✯✯

There should be segregation of duties between Sales Order (to prepare sales order), Despatch
Department (to despatch goods and prepare GDN), Invoicing Department (to prepare invoice) and
Accounts Department (to post invoices into Sales Journal & Ledgers).
Order Department
Control Objectives Control Activities Tests of Controls
There should be segregation of duties Auditor should observe whether segregation of

between person who processes the sale duties exist between person who processes the
order and person who approves credit sales order and person who approves credit
Orders are approved limit. limit.
only when customer A separate credit department should set Select a sample of customers and inspect
has authorized credit authorized credit limit for every customer, signature/initial of appropriate authority as
limit and order is after investigation. evidence of approval of credit limits.
within credit limit -Select a sample of customers and compare their
Order department should check credit limit
outstanding balance with their credit limits.
before approving order and order should
-Use "Test Data" to check that an order over
be rejected if it exceeds credit limit.
authorized limit is rejected (if IT system is used).
Order department should check inventory

Orders are approved
balance before approving order and order Auditor should observe whether inventory
only when inventory is
should be rejected if inventory is not balance is checked before approving sales order.
available
available.
A separate authority (e.g. CFO/BOD) should Select a sample of products and inspect their
set rate list and discount policy for every authorized rate list approved by appropriate
Orders are approved product. authority (e.g. CFO/BOD).
on the basis of -Select a sample of sales orders and compare
authorized Rates and Order department should approve sales with authorized rate list and discounts.
Discounts. order only at authorized rates and -Use "Test Data" to check that an order at
discounts. unauthorized rate or discount is rejected (if IT
system is used).
Orders are correctly

recorded (regarding Auditor should observe whether oral sales
Sales orders should be in writing.
quantity, item and orders are accepted.
customer details)
All orders from -Auditor should inspect numerical sequence of

customers are Sales orders should be sequentially pre- sales orders.
processed. No order is numbered. -Use test data to check that a sales order is
processed twice. allocated next number in the sequence.
Despatch Department
-Goods are despatched

Auditor should inspect numerical sequence of
for all sales orders. Sequentially prenumbered GDNs are
GDNs. If there is any non-sequential numbering
-Goods are not prepared and are matched with
of GDN, it should be investigated to explain
despatched twice, for sequentially prenumbered Sales Orders.
reason.
the same sales order.
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Goods should be cross-checked with sales

Goods are despatched orders before despatch. A GDN should be -Observe the despatch process to assess whether
with right specification accordingly prepared and signed by goods are despatched as per sales order and
to right customer authorized member of despatch GDN is prepared as per goods despatched.
department.
Customer should Customer should sign a copy of GDN and -Select a sample of GDN and inspect for
acknowledge receipt of should return it as acknowledgement of signature of customer as acknowledgement of
goods. receipt. receipt.
Invoicing/Billing Department
Sequentially prenumbered sales invoices -Inspect numerical sequence of sales invoices.

are prepared and are matched with -Select a sample of GDN and inspect related
Invoice is prepared for sequentially prenumbered GDN. invoice.
all goods despatched There should be segregation of duties Observe whether segregation of duties exist
between person who despatches goods and between person despatching goods and person
person who prepares sales invoices. preparing sales invoices.
Each sales invoice should be linked to GDN -Select a sample of sales invoices and check
and authorized Sales Order (to be used in whether it includes reference to relevant GDN
Invoices are correctly preparing sales invoices) and authorized Sales Order.
prepared (using -Sales invoices should be rechecked by an
-Auditor should select a sample of sales invoices
correct quantity, price independent person.
and inspect evidence for rechecking of accuracy.
and discount) -Alternatively, there should be strong IT
-Auditor should test controls over IT system to
controls over accuracy of invoices, if IT
ensure accuracy of invoices, if IT system is used.
system is used.
-A Credit Note should be issued only by

For goods returned by
authorized staff member. Select a sample of credit notes and inspect for
customers, there must
-Credit note should be sequentially numerical sequence, authorization and cross
be an authorized credit
prenumbered and should contain reference reference to relevant sales invoice.
note.
of relevant sales invoice.
Accounting Department
Select documentary evidence on sample basis

-Sales invoices (and "Transaction Counts" and "Control Totals"
and inspect whether Transaction Counts and
credit notes) are of source documents should be compared
Control Totals of sales invoices have been
correctly and with recorded transactions.
performed on recorded transactions.
completely recorded in
Select a sample of Account statements sent to
Sales Journal. -Accounts statements are sent to customers
customers and inspect evidence of its
-Sales invoices (and monthly and exceptions are followed up.
preparation, review and follow-up of exceptions.
credit notes) are
Select a sample of Reconciliation statements
correctly posted in
-Debtors' Control Account and Sales Ledger between Debtors' Control Account and Sales
relevant customers'
are reconciled monthly. Ledger; and inspect evidence of its preparation,
account.
review and follow-up of exceptions.
-Select reports of overdue debts, and inspect

A list of overdue debts should be prepared
evidence of its preparation, review and follow-
Bad debts are written and followed up.
up.
off only when
-Select a sample of write-offs during the year and
authorized. An appropriate authority should give
inspect approval for write-off by appropriate
approval for write-off of receivables.
authority.
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Sales are recorded Select a sample of sales recorded in Sales

All GDNs and Sales invoices are processed
promptly in books of Daybook and compare date of recording with
and posted in accounts daily.
accounts. date of GDN.

State FOUR objectives of the internal control which should be exercised over a sales and trade receivables system.
(04 marks)
(Certified Accounting Technician, UK – December 2005)
State internal control procedures in respect of the following functions:
- Dispatches and invoice preparation for sales (05 marks)
LO 4: THE PURCHASES SYSTEM: ✯✯✯

There should be segregation of duties between Purchase Order Department, Despatch Department,
Invoicing Department and Accounts Department.
Order Department
-Inspect numerical sequence of purchase orders.

Purchase Orders should be sequentially
-Use test data to check that a purchase order is
prenumbered.
allocated next number in the sequence.
All Purchase Orders There should be segregation of duties
Auditor should observe whether segregation of
must be properly between individuals who make
duties exist between the person who made
authorized requisition and individuals who place
requisition and person placing the order.
order with supplier.
All purchase orders must be authorized -select a sample of large purchase orders and
by head of purchase department. inspect for approval by appropriate authority.
-Select a sample of approved suppliers and

-Company should have standard inspect documentation to ensure that standard
operating procedures to approve a operating procedures to approve a supplier
supplier and should maintain a list of operate as intended.
Orders are given to approved suppliers. Access rights to this -Test controls over master file of approved
approved suppliers list should be restricted (in IT system). suppliers.
only. -Purchase Orders should include -Select a sample of purchase orders, inspect
"approved supplier reference number" to approved reference number and compare with
ensure that orders are given only to list of approved suppliers.
suppliers on approved list. -Use test data to check orders to unauthorized
suppliers are rejected (in IT system)
Select a sample of purchase orders and inspect

Orders are made at -Quotations/Bids should be obtained for
documentary evidence to ensure quotations were
competitive rates. all purchase orders.
called and order is given to lowest quotation.
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Receiving Department
Sequentially prenumbered GRNs are Auditor should inspect numerical sequence of

Goods are received
prepared for every receipt of goods; and GRNs. Any break (identified by auditor or
against all purchase
are matched with sequentially produced by system) should be investigated to
orders
prenumbered Purchase Orders. explain reason.
-Quantity and specification of goods

-Observe the receiving process to assess whether
received should be physically inspected
goods are cross-checked with purchase order
Goods are received in and checked with purchase order before
before acceptance.
accordance with valid acceptance.
purchase orders -A GRN is signed for every receipt of
-Select a sample of GRN and inspect signature of
goods by an authorized officer of
receiving staff. Also compare it with PO.
receiving department.
Invoicing/Billing Department
Suppliers' invoices are Suppliers' invoices should be compared -Select a sample of suppliers' invoices and inspect
processed only if goods with sequentially prenumbered GRN and for evidence that they are matched with relevant
are received from them. purchase orders. GRN and Purchase Orders.
Suppliers' Invoices are -Suppliers' invoices should be compared

-Auditor should select A sample of suppliers'
checked for accuracy (of by invoicing department to ensure
invoices and inspect evidence for rechecking of
quantity, price and correct quantity, rate and applicable
invoice for accuracy.
discount) discounts are used by supplier.
A Debit Note should be issued for all

For goods returned to purchases returns, which should be Select a sample of debit notes and inspect for
suppliers, debit note sequentially prenumbered and matched numerical sequence, and cross reference to
must be taken. with suppliers' credit note when it is suppliers' credit note.
received.
Accounts Department
Before recording in accounts, purchase Select a sample of purchase invoices and inspect
invoices must be checked against for relevant purchase order # on invoice, and
purchase order, and purchase order # signature of individual who checked with
-Purchase invoices (and should be printed on purchase invoice . purchase order.
debit notes) are
Select documentary evidence on sample basis and
correctly and "Transaction Counts" and "Control
inspect whether Transaction Counts and Control
completely recorded in Totals" of source documents should be
Totals of source documents have been performed
Purchase Journal. compared with recorded transactions.
on recorded transactions.
-Purchase invoices (and
-Accounts statements are sent to Select a sample of Account statements sent to
debit notes) are
suppliers monthly and exceptions are suppliers and inspect evidence of its preparation,
correctly posted in
followed up. review and follow-up of exceptions.
relevant suppliers'
Select a sample of Reconciliation statements
account.
-Creditors' Control Account and Purchase between Creditors' Control Account and Purchase
Ledger are reconciled monthly. Ledger; and inspect evidence of its preparation,
review and follow-up of exceptions.
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Purchases are recorded Select a sample of purchases recorded in

All GRNs and Purchase invoices are
promptly in books of Purchases Daybook and compare date of
processed and posted in accounts daily.
accounts. recording with date of GRN.
Supplier’s Statement:
A supplier’s statement is a printed statement, received at regular intervals from a supplier (usually
each month), showing details of transactions between the supplier and its customer (purchases,
purchase returns and payments) since the previous statement, and the amount owing as at the date
of the statement.

You have been assigned to plan the test of controls in respect of receiving of goods and invoices from suppliers of
Bhurban Limited.
In this regard, you are required to identify the following:
(a) The related risks
(b) Controls that you expect to see to address the above risks
(c) Audit procedures that you need to perform to test the controls (10 marks)
State FOUR objectives of the internal controls that should be exercised over the purchases and trade payables system of
Country Co. (04 marks)
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LO 5: THE PAYROLL SYSTEM: ✯✯✯
Calculation of Gross Wages and Salaries
-Select a sample of joiners during the year and

check documentation for authorization of new
Payroll is calculated -New employees in payroll should be
employees.
only for real authorized by HRD.
-Select a sample of leavers during the year and
employees. (i.e. no -Employees who resigned should be
check that they do not exist on payroll after the
payment to former or promptly communicated to Payroll
month they left.
phantom employee) Department.
-Select a sample of workers from payroll sheet
and check whether they are physically present.
Supervisor should maintain sequentially

Select a sample of time sheets, and inspect for
prenumbered "Time Sheets" for each
signature/initial of supervisor as evidence of
employee working on hourly based; and
Wages are calculated approval of hours worked.
should authorize all time sheets.
only for work done by
-Observe whether clocking-in process is being
employees. (i.e. no Alternatively, Clock-card system should be
monitored so that a worker cannot clock-in for
overtime if employees maintained and monitored.
multiple workers.
did not work)
Select a sample of overtime/bonus payments,
All overtimes and bonuses should be
and inspect that they are properly calculated and
approved by appropriate authority.
authorized.
-Payroll Preparation department should Select a sample of employees from payroll and
use Authorized Time Sheet and Approved inspect that hours worked and rates of pay are in
Rates of Pay. accordance with Time-sheet and approved rates.
A senior member should ensure that Select a sample of payroll sheets and inspect
Payroll should be payroll expense is not excessive, and should signature/initial of appropriate authority as
calculated correctly. approve payroll sheet. evidence of approval of payroll.
-Use Test data to check that exception report is
If an IT system is used, an exception report
generated for wages beyond pre-set limits.
should be produced for wages beyond pre-
-Inspect exception reports (of salaries & wages
set limits, and it should be followed up by
beyond pre-set limits) as evidence of
an independent person.
preparation and follow-up.
Calculation of tax and other deductions
-Auditor should review manual procedures to

-Statutory deductions -Payroll procedures should provide ensure that tax deduction is correctly made.
from pay (e.g. Tax) deduction of tax using up-to-date rates of -Use Test-data for calculation of tax and compare
should be calculated tax. results with independently calculated amount (if
correctly. IT system is used).
-Voluntary deductions All voluntary deductions must be -Select a sample of employees and inspect
from pay (e.g. pension authorized by employee in writing; and this written consent of employee regarding
contributions) should consent should be kept in file of employee. voluntary deductions and their amounts.
be authorized by A senior member should check that amount Select a sample of payroll sheet and inspect
employee. of total deductions is reasonable, and signature/initial of appropriate authority as
should approve it. evidence of approval of deductions.
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Payment of wages and salaries
-Cheques and bank transfer list should be

prepared and authorized by appropriate
The correct amounts of
authority. -Inspect cheque and bank transfer list for
net pay should be paid
-Cheque and bank transfer list should be evidence of authorization.
to employees.
compared with payroll to ensure correct
amount is paid.
The correct amount of

deductions is paid to Auditor should inspect whether formal
There should be formal procedures and
the appropriate procedures and timetable for payment of
timetable for payment of deductions.
authority (for example, deductions are being followed.
the tax authority).
-There should be segregation of duties Auditor should observe whether segregation of

between person who prepares payroll and duties exist between the person who prepares
Wages are paid only to person who distributes payroll. payroll and person who distributes payroll.
genuine employee. Observe payroll distribution process to ensure
Payroll distributor should confirm identity
whether identification of employee if confirmed
of employee before making payment.
before making payment.
Recording wages and salaries payable in the accounts
Review reconciliation of payroll file to general

Payroll file should be reconciled with
ledger. Confirm whether discrepancies are
Gross pay, deductions accounts in general ledger.
followed-up and resolved.
and net pay should be
properly and Payroll should be accounted for within a Review whether payroll is being recorded within
accurately recorded in strict deadline. timescale.
the accounts. Auditor should inspect whether authorized
Authorized payroll should be used to
payroll has been used to record wages in
record wages in accounts.
accounts.

State FIVE objectives of the internal controls that should be exercised over a wages system. (05 marks)
(Certified Accounting Technician, UK – June 2008)
Discuss any four (04) audit procedures for M/s. Farooq Enterprise for the test of control of Payroll. (04 marks)
(ICMA Pakistan, Professional Level P2 – 2014 May )
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LO 6: THE BANK AND CASH SYSTEM: ✯✯✯
Cash Receiving
Controls over cash received through

Post: -Observe whether mail-opening process is being
-Process of opening the mail should be monitored.
monitored. -Check amount received from customers (as
-A listing should be prepared by appearing in list) with remittance advices sent
independent person for all cash and by customers (confirming amount paid).
cheques received through mail.
Controls over Cash received at counter:
-There should be segregation of duties
between Receiving, Recording and
Reconciliation functions.
-For cash received at counters, the cashier
counts the cash and prepares a receipt -Observe whether segregation of duties exist
voucher between receiving, recording and reconciliation.
-Only a restricted number of employees -Observe whether authority to receive cash is
should be authorised to receive cash. limited.
-Cash should be kept in locked-boxes and in -Check whether cash is kept in locked boxes in
All money received is
secured area until it is deposited. secured area.
recorded.
-Till-Roll (or sequentially prenumbered -Check for evidence that till roll totals (or cash-
cash-receipts) should be used to record receipts totals) are checked against cash
cash sales; and a copy should be retained. received by an independent person.
-At day end, till roll totals (or cash-receipts
totals) should be balanced with cash
received, by an independent person.
-Surprise cash counts are conducted by
persons independent of custodian of cash.
Controls over Cash received through
Boxes (e.g. in donation):
-Boxes should be numerically sequenced.
-Inspect a sample of boxes for numerical
-Boxes should be appropriately sealed so
sequence and appropriate sealing.
that opening prior to recording is apparent.
-Observe the process of collection, opening box
-There should be process for regular
and recording.
collection and recording of cash boxes.
-Process of opening boxes should be
monitored.
-Inquire frequency of deposit into bank.

-Cash should be immediately recorded and
-Compare amounts and dates of cash received
promptly banked.
All money received is and cash deposited into bank.
banked. Check whether total of till-roll matches with
Total of listing of cash should be matched
deposit slip, entry in cash book and in bank
with cash book and deposit slip.
statement.
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Cash Payments
All payments (except petty expenses)

should be made through cross cheque and
should be backed by supporting
documents. -Select a sample of paid cheques and inspect:
All payments should Supporting documents should be cancelled (a)supporting documents are available and
be properly once cheque is prepared (to avoid duplicate (b)supporting documents are duly cancelled.
authorised, made to payment). (c) signatories are authorized.
the correct person and There should be established authority (d)entry into accounting record, bank
are properly recorded levels for cheque signing (usually two statements and creditors' account.
signatures required for cheques above a
certain amount)
Payments must be recorded promptly.
Cash Balance
Controls over Bank Balance:

-New bank accounts should be opened only
in accordance with established procedures.
-Confirm that new bank accounts have only been
-Responsibility for holding of cheque book
opened under established procedures.
and preparation of cheques should be given
-Observe which people are involved in holding of
to restricted person.
cheque book and preparation of cheques.
-There should be safe custody of cheque
All money held as -Inquire as to custody of cheque book and
book and cheques should not be pre-signed.
cheques, notes and inspect whether any cheque is pre-signed (i.e.
-Bank reconciliation statements are
coins is properly blank cheque).
prepared and reviewed on a regular basis
safeguarded
and unadjusted / reconciling items are
investigated and recorded on timely basis.
Controls over Cash in hand:
Cash and coins should be kept in a heavy
locked box in secured place. -Observe cash custody procedures.
Access to cash should be restricted to
authorized employee.
Petty Cash
Control Objectives Control Activities
Maximum Limit for petty cash should be one month's petty cash spending.
To avoid or reduce the risk of Petty cash should be kept in a locked cash box or drawer.
petty cash being stolen.
There should be 'occasional/surprise cash counts' of petty cash by an independent
person.
All Petty cash expenses should be authorized in advance by a properly authorized
person.
To ensure that all spending out
of petty cash is properly Pre-numbered petty cash vouchers should be maintained. Supporting documents
authorized should be attached with vouchers for every withdrawal from petty cash. All
withdrawals of petty cash should be recorded on a sequentially prenumbered Petty
Cash Voucher.
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To ensure that only correct

When petty cash is 'topped up', the amount of withdrawal from bank should be equal
amount of cash are withdrawn
to total of petty cash vouchers.
from bank to go into Petty Cash.
Each entry in petty cash book should include voucher number, to ensure all expenses
To ensure that all spending out are recorded.
of petty cash is accounted for. Petty cash expenses should be periodically recorded in general ledgers after the
details are reviewed by the Finance Manager.

Describe, and explain the purpose of, the internal controls you might expect to see in the sales system at audit client over
the collection of cash. (10 marks)
Discuss any four (04) audit procedures for M/s. Farooq Enterprise for the test of control of Cash payment. (04 marks)
(ICMA Pakistan, Professional Level P2 – 2014 May)
LO 7: THE INVENTORY AND NON-CURRENT ASSETS SYSTEM: ✯✯✯
INVENTORY
There should be segregation of duties Auditor should observe whether segregation of

between Ordering, Recording and Custody duties exists between ordering, recording and
-Inventory records of inventory. custody of inventory.
should be accurate and Appropriate inventory records should be
complete. properly maintained alongwith physical Auditor should inspect inventory records to
stocktaking and reconciliation with book ensure they are accurate and complete.
balance.
-Every receipt of inventory should be -Auditor should select a sample of GRN and
timely and correctly recorded in Inventory should compare quantity and date with
All inventory
ledger Card and should be supported by Inventory Ledger Card to ensure correct and
movements should be
approved GRN. timely recording.
timely and correctly
-Every issue of inventory should be timely -Auditor should select a sample of GDN or other
recorded; and should
and correctly recorded in Inventory ledger supporting evidence, and should compare
be authorized.
Card and should be supported by approved quantity and date with Inventory Ledger Card to
GDN or Inventory Requisition. ensure correct and timely recording.
-Access to secure storage areas should be

-Auditor should check compliance with access
restricted (e.g. through locked ware-house,
restrictions.
CCTV Camera).
Inventory is protected
-Regular inventory counts (i.e. Stock-take)
against theft and -Auditor should check for evidence that periodic
should be performed using appropriate
damage. inventory counts are performed, and any
procedures; and physical balance should be
difference between physical balance and book
reconciled with book balance, differences
balance is identified.
should be followed up.
-Standard Costs should be used by

management which should be compared Review and test entity's procedures for
Inventory should be with actual cost and variances should be determination of standard cost and adjustment
correctly valued at appropriately adjusted. of variance.
lower of Cost and NRV -Standard Costs should be updated yearly.
in accordance with IAS -There should be procedures for
-Auditor should check that procedures are in
- 2. identification of obsolete items e.g. aging
place for identification of obsolete items. Auditor
report of inventory items, or separation of
should monitor these procedures.
damaged inventory during stock count.
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-Auditor should check whether inventory

balances are below minimum level or above
maximum level.
Appropriate levels of
There should be maximum and minimum -Use test data to check whether exception report
inventory should be
inventory levels for all inventory items. is generated if inventory balance is above
held at all times.
maximum level or below minimum level.
-Auditor should inquire frequency of out of stock
situations.
CONTROLS OVER INVENTORY COUNT
Control Objectives Control Activities
1. Movements of inventory should be stopped during inventory counts.

2. Inventory counting sheets should be pre-printed with a description of the goods, but
the quantities as per the records should not be pre-recorded.
3. Count-teams should be independent of warehouse department and should be
sufficiently experienced and permanent employees of company.
4. Each count-team should consist of two members. One should count items, other
Closing balance of inventory should record item quantity.
must be counted correctly. 5. Clear instructions should be given to all teams as to which area of warehouse is to be
counted by which team to avoid omission or duplication of counting of items.
6. Count-sheets are signed by each member of counting team to determine
accountability.
7. Counted inventory should be marked/tagged to indicate that it has been counted.
8. All inventory sheets should be prenumbered.
9. Damaged inventory should be separately identified.
NON-CURRENT ASSETS
Select a sample of fixed assets

There should be proper authorization for
purchased/disposed during the year and inspect
purchase and disposal of fixed asset.
for evidence of authorization.
Suppliers' Invoice should be approved by
the person who authorized the purchase Select a sample of suppliers' invoices and inspect
All purchases and
and should be marked with appropriate for approval and correct account code.
disposal of non-
Account Heads.
current assets are
Select a sample of fixed assets
properly authorized Purchases of fixed assets are included in
purchased/disposed during the year and trace
and correctly recorded and disposal of fixed assets are excluded
their inclusion in /exclusion from Fixed Assets'
in accounting system. from Fixed Assets' Register.
Register.
Inspect reconciliation between Fixed Assets'
Fixed Assets' Register is periodically Register and General Ledger as an evidence of its
reconciled to General Ledger. preparation, review and follow-up of
discrepancies.
Invoices must be bifurcated between

All expenditures are Select a sample of invoices and inspect for
capital expenditure and revenue
properly analyzed as capital/revenue analysis of invoice and correct
expenditures and should be marked with
capital or revenue. account code.
appropriate Account Heads.
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Management should review the

All capital Auditor should check that entries for capital
classification between capital and revenue
expenditures should expenditures are made in non-current asset
item to ensure compliance with standard
be properly recorded. register.
accounting practice.

State FOUR objectives of the internal controls that should be exercised over non-current assets. (04 marks)
List the internal controls that a small printing company with office equipment, motor vehicles and plant and machinery
should have in place. (10 marks)
Exam Tips
In exam if a concept review question is set from “Controls”, you may be required to:
1. State control objectives for whole system or for a specific department.
2. State control activities for a specific department (sometimes, you may also be required to state reason of
each control activity. If so, control objective is reason).
3. State tests of controls for a specific department (sometimes, you may also be required to state reason of
each test of control. If so, control objective is reason).
4. State risks in each department. If so, not meeting objective is risk.
Remember that Control Activities are performed by management; and Tests of Controls are performed by auditor. State
them accordingly.
PART B – DOCUMENTATION OF UNDERSTANDING OF ENTITY AND

INTERNAL CONTROL
LO 8: METHODS OF DOCUMENTATION OF A SYSTEM: ✯

There are three methods of documentation of accounting and internal control system of client i.e.
1. Narrative Notes
2. Questionnaires
3. Flowcharts
Narrative Notes Questionnaires Flowcharts

Narrative notes consist of a Questionnaires contain a Flowcharts are a graphic illustration of
written description of the system; list of questions used to showing how a system (e.g. sales system)
they would detail what occurs in assess about existence is processed in different steps. Lines
Definition
the system at each stage and and effectiveness of usually demonstrate the sequence of
would include any controls which controls. events and standard symbols are used to
operate at each stage. signify controls or documents.
– They are simple to record; –Questionnaires are quick – It is easy to view entire system as all is
discussions with client are easily to prepare. presented together in one diagram.
written up as notes. –As they emphasize on – It presents systems information in a
– Easily understandable for all controls; hence missing logical sequence
Advantages/
team members specially for junior controls or deficiencies –highlight relationships between
Benefits
team members who find other are easily highlighted by different parts of a system
methods too complex. the team. – Due to the use of standard symbols for
controls, they are easy to spot any
missing controls.
96
– Narrative notes may prove to be –It can be easy for client – They can sometimes be difficult to
too lengthy and time consuming. to overstate the level of amend, as any amendments may require
– This method can make it more the controls. the whole flowchart to be redrawn.
difficult to identify missing –A standard list of – There is still the need for narrative
Disadvantages/
internal controls as the notes questions may miss out notes to accompany the flowchart and
Limitations
record the detail but do not unusual controls of client. hence it can be a time consuming
identify control weaknesses method.
clearly. –It can be complex for junior team
members.

Auditors are required to document their understanding of the client’s internal controls. There are various options
available for recording the internal control system. Two of these options are narrative notes and internal control
questionnaires.
Required:
Describe the advantages and disadvantages to the auditor of narrative notes and internal control questionnaires as
methods for documenting the system. (06 marks)
Identify FOUR benefits of using document flowcharts to record a company’s accounting and internal control systems.
(04 marks)
LO 9: DIFFERENCE BETWEEN ICQ AND ICEQ: ✯
Internal Control Evaluation Questionnaires

Internal Control Questionnaires (ICQs)
(ICEQs)
ICQs are used to check whether a particular ICEQs are used to check whether a certain
control exists or not. existing control is operating effectively or not.
ICQs are used to evaluate design of controls. ICEQs are used to evaluate operating
effectiveness of controls.
ICQs are developed by auditor as part of risk ICEQs are developed by auditor as part of tests
assessment procedures (after obtaining of controls (after obtaining understanding of
understanding of entity). entity and its Internal Control)

(a) State THREE methods by which your firm may record the internal control system of Palm Co. (03 marks)
(b) Explain how an Internal Control Questionnaire (ICQ) differs in nature and design from an Internal Control Evaluation
Questionnaire (ICEQ). (06 marks)
97
LO 10: CHECKING THE ACCURACY OF PREVIOUS YEAR’S ICQ: ✯

Following are the necessary steps to check the accuracy of the previous year’s internal control
questionnaires.
1. Inspect last year’s audit working papers:
Review the last year’s audit file for indications of weaknesses in the system (e.g. sales
system) and note these for investigation this year.
2. Inquire client:
Interview client staff to ascertain whether systems have changed this year and to ensure
that the internal control questionnaires produced last year are correct and relevant.
3. Inspect current year’s system documentation of client:
Obtain system documentation from the client. Review this to identify any changes since last
year.
4. Perform walk-through tests.
Walk-through Test is a procedure in which the auditor selects a transaction and literally
walks through the various stages of processing in accounting system to establish whether
his understanding of system and its control is correct.

Explain the steps necessary to check the accuracy of the previous year’s internal control questionnaires. (04 marks)
PART C – ADDITIONAL CONCEPTS
LO 11: AUDITOR’S COURSE OF ACTION IF HE IDENTIFIES A WEAKNESS IN INTERNAL

CONTROL: ✯
Auditor’s course of Action if he identifies a weakness/deficiency in internal control:
1. Auditor shall increase risk of material misstatement.
2. Auditor may decide not to rely on internal controls, if weaknesses in internal control are
unacceptably high.
3. Auditor should communicate deficiency in internal control to management on timely basis.
4. If deficiency is significant, auditor shall also communicate it to those charged with
governance in writing.
Management Letter and its Contents:

Management Letter is a document prepared by auditor to communicate deficiencies in internal
control to management and those charged with governance.
Management Letter contains following elements:

 Description of internal control weakness
 Explanation of potential affect of control weakness
 Suggestions by auditor on how to remove control weaknesses

After performing tests of controls, the auditor is of the opinion that audit evidence is not sufficient to support the audit
opinion; in other words many control errors were found.
Required: Explain THREE actions that the auditor may now take in response to this problem. (03 marks)
98
What is a Management Letter? What is the most appropriate time for issuing a Management Letter? (05 marks)
During the external audit of Bushat Ltd it was discovered that, on a number of occasions, adjustments were made, by the
payroll clerk, to standing data relating to employees on the payroll system on the oral authority of the human resources
manager.
Outline the possible consequences of this internal control deficiency and provide recommendations to remedy the
deficiency. (03 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2016 March)
LO 12: AUDIT LETTERS AND REPORT: ✯
Type of Letter By To Timing Brief Description

Professional Before To discuss whether there is any professional
Predecessor
Clearance Auditor Acceptance of reason because of which engagement should
Auditor
Letter audit client not be accepted.
Engagement At start of the Engagement Letter confirms acceptance and
Auditor Management
Letter engagement appointment of auditor
Confirmation External To obtain information about entity from
Auditor During Audit
Letter Parties outside parties.
It reminds management about their
Representation Near the end responsibility for preparation of financial
Management Auditor
Letter of the audit statements and for completeness of
information provided to auditor.
Members At the end of The audit report expresses opinion on
Audit Report Auditor
(or TCWG) the audit financial statements.
It includes:
–identified weaknesses in internal control,
Management
After the –risks because of weakness in internal
Letter/ Letter Auditor Management
Audit Report control, and
of weakness
–recommendations to improve internal
control.

State the difference between an “Engagement Letter” and a “Professional Clearance Letter”. (03 marks)
99
Auditing – Study Notes Chapter 12 Substantive Procedures
CHAPTER TWELVE
SUBSTANTIVE PROCEDURES
LO 1
TANGIBLE NON-CURRENT ASSETS
✯✯✯
LO 2
INTANGIBLE NON-CURRENT ASSETS
✯✯
LO 3
INVENTORY
✯✯✯
LO 4
TRADE RECEIVABLES
✯✯
LO 5
PREPAYMENTS FOR EXPENSES
✯
LO 6
ACCRUALS FOR EXPENSES
✯
LO 7
BANK
✯✯
LO 8
CASH
✯
LO 9
TRADE PAYABLES
✯✯
LO 1 0
CONTINGENCIES & PROVISIONS
✯✯
LO 1 1
NON-CURRENT LIABILITIES/LONG TERM BORROWINGS
✯✯
LO 1 2
EQUITY
✯
LO 1 3
DIRECTORS’ EMOLUMENTS
✯
LO 1 4
REVENUE
✯
LO 1 5
PURCHASES
✯
LO 1 6
PAYROLL
✯✯
LO 1 7
EXPENSES
✯
LO 1 8
INTEREST EXPENSE AND INTEREST INCOME
✯
100
77 (Hard Stone Limited) 106c (ISA 620: Using the Work of an

87 (Manufacturing inventories) Auditor’s Expert)
90 (BPR) 108b (Zeedin Co)
96a (Auditors) 110c (Bashir Co)
98 (Tahira Transporters) 111f (Multiple Situations)
99 (Willow) 116 (Noncurrent assets)
101b (Bubbles) 124 (Substantive procedures)
103 (Javeria Co)
Question Bank:
49a (Tahir Co) 100a, c (Sparkle Forever)

62c & d & e (Waheed Engineering) 104 (Porridge)
66b (Granger) 105 (Trembridge Engineering)
70 (Nobel)
101
ISAs require auditor to perform substantive procedures for each material area of financial
statements. Extent of these substantive procedures depends on risk assessment. Despite from
procedures on individual areas (described below), auditor is also required to perform following
substantive procedures related to the financial statement closing process:
 Agreeing or reconciling the financial statements with the underlying accounting records;
and
 Examining material journal entries and other adjustments made during the course of
preparing the financial statements.
LO 1: TANGIBLE NON-CURRENT ASSETS: ✯✯✯

Completeness
Obtain Fixed Assets’ Schedule showing Cost, Depreciation and Book Value:
 agree the total to the general ledger and the financial statements.
 Reconcile the schedule with Fixed Assets’ Register.
 during stock-taking, select a sample of fixed assets from floor, and check that they are
recorded in Fixed Assets' Register.
Existence:
Select a sample of high value fixed assets from Fixed Assets’ Register and physically inspect them
to confirm they:
 exist,
 are in good condition and are in use,
 have correct identification number (e.g. vehicle #, or fixed asset coding #)
Valuation and Allocation:

Cost:
1. Select sample of additions and agree cost to supplier’s invoice. Also inspect invoice to
verify cost does not include revenue expenses.
2. Review repair and maintenance account to verify repairs do not include capital
expenditures.
Depreciation:
1. Review Fixed Assets' Register to ensure:
 depreciation has been charged on all fixed assets (excluding land and fully
depreciated assets) correctly.
 depreciation on addition starts when asset is available for use.
 fully depreciated assets are separately identifiable and no depreciation is charged
on such assets.
2. Check whether residual value, useful life/depreciation rate, depreciation method are:
 reasonable (considering industry average, replacement policy, nature of asset), and
 consistent with last year and industry practice and AFRF.
3. Use following analytical procedures:
a. Recalculate depreciation expense taking into account additions and disposal.
Compare it with actual expense and investigate unusual difference.
b. Compare ratios of depreciation to non-current assets (for each category) with
previous years, and depreciation policy rates.
4. Check whether allocation of depreciation expense between manufacturing and operating
expenses is on reasonable basis.
102
5. Review gain or losses on disposals as indication of possible understatement or

overstatement of depreciation expense.
Rights and obligations

1. For land and building, inspect sale deed, purchase invoices, and legal documents as
evidence of transfer of ownership in the name of company.
2. For Vehicles, inspect registration documents to check title in name of client.
3. For shares and other securities held by bankers or lawyers, obtain confirmation from
bankers or lawyers stating purpose of holding securities and charge (if any) on them.
4. Inspect ‘search reports’ from statutory records for evidence of charge on company’s assets.
Presentation and disclosure:

1. Review non-current asset disclosures in the financial statements to ensure they meet IAS
16 criteria (e.g. depreciation rates).
2. Obtain confirmation from bank and lawyer of the company whether any non-current
assets are held for security, to ensure completeness of disclosures in financial statements.
Substantive Procedures If there are Additions:

1. Obtain list of all fixed asset purchased during the period and agree with fixed assets’
schedule and fixed assets register.
2. Review repair and maintenance account to verify repairs do not include capital
expenditures.
3. Select a sample of additions and:
a. agree cost to supplier’s invoice. Also inspect invoice to verify cost does not include
revenue expenses.
b. Inspect sale deed, purchase invoices, and legal documents as evidence of
transfer of ownership in the name of company.
c. Physically inspect sample of fixed assets acquired during the year to verify
existence.
Substantive Procedures If there are Disposals:

1. Obtain list of all fixed asset disposed during the period and agree with fixed assets’
2. Check that cost and accumulated depreciation has been removed from books of accounts,
and fixed assets’ register.
3. Select a sample of disposals and:
 agree Cost and Accumulated Depreciation with Fixed Assets’ Register
 agree Sale Price with Invoice.
 Recalculate profit or loss recognized on disposal of assets.
Substantive Procedures if PPE is Revalued:

Where a valuer has been engaged to revalue PPE:
1. Ensure Competence, Capabilities and Objectivity of Valuer:
2. Ensure adequacy of valuation report:
(Considering marks of question, above procedures can be discussed in detail as per LO 7 of Chapter #
18).
Ensure revaluation has been properly accounted for and disclosed in financial statements:
1. Ensure that valuation is up-to-date.
2. Ensure that entire class of asset has been revalued.
103
3. Evaluate the method used to measure fair value to ensure consistency.

4. Ensure that valuation is appropriately accounted for in accounts.
5. Ensure that appropriate disclosures have been made in accordance with IAS – 16.
6. Recalculate “revaluation surplus (or loss)”, and “depreciation expenses” and ensure these
have been correctly recorded in books of accounts.
7. Inspect the buildings physically to ensure their condition is the same as described in
valuation report.
8. Obtain written representations from management regarding reasonableness of any
assumptions used in determining the fair value.
Substantive Procedures If there is Self-constructed Fixed Asset:

1. Obtain list of all fixed asset constructed during the period and agree with fixed assets’
2. Select a sample of costs capitalized and agree with supporting documentation i.e.:
 Site acquisition costs to purchase invoice, Transfer deed and Paid cheque.
 Materials (such as cement, bricks, and fittings) to suppliers’ invoice.
 Labour costs to approved payroll records, time sheets, etc,
 Overheads to relevant evidence.
3. Review the list of amounts capitalised to ensure that revenue items have not been
capitalized.
4. Review expert’s assessment of stage of completion, or completion certificate.
5. Physically inspect of the construction at the year end to confirm work to date and assess
the reasonableness of stage of completion.
6. Compare budgeted cost with actual cost and investigate significant differences.
7. Recalculate borrowing cost associated with project to ensure its accuracy.
8. Ensure that depreciation starts when asset become ‘available for use’.

Briefly state test of details for verifying the valuation assertion of tangible non current assets where the company follows
revaluation policy for valuation of such assets. (08 marks)
List the audit procedures for the verification of fixed assets as appearing in the financial statements. Also give the related
‘audit assertion’ against each step. (12 marks)
Describe TWO substantive procedures the external auditor should adopt to verify EACH of the following assertions in
relation to an entity’s property, plant and equipment;
(i) Valuation;
(ii) Completeness; and
(iii) Rights and obligations. (06 marks)
Describe substantive procedures you should perform at the year end to confirm each of the following for plant and
equipment: (i) Additions; and (ii) Disposals (04 marks)
Your audit client, Constantine plc (“Constantine”), is a manufacturer of chocolate bars. During the year ended 31 July 2007
the company constructed a new packing line. The packing line consists of pieces of equipment bought in from third
parties, adapted by the company using both subcontract labour and its own in-house labour. Constantine has capitalised
all these costs as part of non-current tangible assets.
State the audit work required to ensure the packing line is fairly presented in the financial statements of Constantine.
(03 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2007 September)
104
LO 2: INTANGIBLE NON-CURRENT ASSETS: ✯✯

Goodwill:
1. Review board minutes for approval of purchase.
2. Inspect the sale agreement and confirm:
a. cost of acquisition (deferred or contingent consideration) and
b. reasonableness of fair value of assets acquired.
3. Agree cash payment to cash book and bank statement.
4. Inspect due-diligence report for the acquisition, and ensure that all identifiable assets
have been recognized by company alongwith their estimated fair values.
5. Recalculate the amount of Goodwill as the difference between the cost of acquisition and
fair value of net assets.
6. Discuss with management and review for possibility of impairment subsequent to
recognition.
Development Cost:
1. Inspect details of projects and discuss with management to ensure that following criteria
required by IAS - 38 to recognize development cost as intangible asset has been met e.g.
future economic benefits are probable, project is feasible.
2. Discuss the feasibility of the project with management i.e.
a. Review projects and forecasts.
b. Production and marketing plans actually exist.
c. Obtain representation from management regarding intention to complete the
project.
3. For a sample of costs, inspect supporting documents e.g. development contracts, billing
and timesheets.
4. Test controls over documentation and safekeeping of scientists’ notes, discoveries and
conclusions.
recognition.
Other Intangibles (e.g. purchase of Brand):

1. Review board minutes for approval of purchase.
2. Inspect legal and purchase documents to ensure existence, valuation and right of entity
over intangible asset.
3. Discuss the determination of useful life with management (e.g. life expectancy or period
mentioned in purchase agreement) and check amortization calculation is accurate using
client’s policy.
4. Obtain market research reports or customer satisfaction surveys or sales statistics to
confirm revenue stream is not decreasing.
5. Review planned expenditures on marketing and advertisement to maintain image of
brand name.
recognition.
If there is Impairment loss on Intangible Assets:

1. Confirm whether management has itself calculated impairment loss or has used an expert.
2. Obtain understanding of management’s controls over impairment testing (e.g. review and
approval of assumptions)
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3. Check for accuracy of calculations used in impairment loss.

4. Assess reasonableness of assumptions (e.g. cash flow projections, growth rates, discount
rates) based on auditor’s understanding of entity
5. Develop an independent estimation of impairment loss and compare with management’s
calculation.

Recommend the principal audit procedures to be performed in respect of the goodwill initially recognized on the
acquisition of a company by audit client. (05 marks)
Explain the principal audit procedures to be performed on the impairment of goodwill. (05 marks)
You are the audit manager of Ravi Pharmaceuticals Limited (RPL) for the year ended 30 September 2013. The draft
financial statements disclose a profit before tax of Rs. 200 million (2012: Rs. 150 million) and total assets of Rs. 5 billion
(2012: Rs. 4.8 billion).
RPL has been awarded a 20 year patent right for a new drug with a brand name of Dengcol. The drug has been developed
at a cost of Rs. 400 million.
Required:
Identify the matters that you should consider in the above situation, and state the audit evidence you would expect to find
in your review of the audit working papers for the year ended 30 September 2013. (10 marks)
Jolie Co sells clothing, with a strategy of selling high fashion items under the JLC brand name. The JLC brand name was
purchased a number of years ago and is recognised at cost as an intangible asset, which is not amortised. The brand
represents 12% of the total assets recognised on the statement of financial position.
Recommend the principal audit procedures to be performed in respect of the valuation of the JLC brand name.(05 marks)
(ACCA, Professional Level P7 – December 2010)
LO 3: INVENTORY: ✯✯✯
Completeness:
Obtain Inventory listing showing quantity and cost, and:
 agree the total to the general ledger and the financial statements.
 during stock-taking, select a sample of goods physically present in the warehouse and
confirm they are recorded in the inventory records.
Existence:
Select a sample of items from inventory lists and physically inspect them in warehouse.

Inventory is valued at lower of Cost and NRV.
Confirming Cost:
1. Confirming cost of purchased inventory (e.g. raw material, retail inventory):
 Select a sample of inventory; agree cost as per the records with purchase invoice.
 Recalculate the cost using approach adopted by management (e.g. FIFO or
Weighted Average).
2. Confirming cost of manufactured inventory (e.g. work in process, finished goods):

 Obtain a breakup of cost of each item agree the total to the general ledger.
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 Confirm material cost with purchase invoices.

 Check Labor cost to approved payroll records, time sheets etc.
 Review the basis for absorption of overhead rates and assess its reasonableness
(to ensure only production overheads are included).
 Review expert’s assessment of stage of completion.
Confirming NRV:
1. Review client’s procedures for comparing NRV with cost of each item of inventory.
2. During stock-taking, check for conditions of obsolescence, damage indicating that NRV
may be lower than Cost.
3. Select a sample of year end stock-items and review sales invoices after year-end to
ascertain if NRV is above cost or if an adjustment is required. (for finished goods)
4. Inquire management about estimated selling price of inventory, cost of completion and
cost to make sale. (for work in process)
5. Review aging reporting of inventory and identify any damaged, slow moving or obsolete
goods, and ensure they have been recorded at lower of Cost and NRV.
6. Compare inventory turnover ratio (days) with prior years and investigate unusual
difference.
7. Review expert’s report regarding valuation of inventory (if inventory is of specialized
nature).
Rights and Obligation:

1. Confirm during the inventory count that any goods belonging to third parties (e.g. on
"consignment basis" or "approval basis") is separately identifiable, and not included in
closing inventory.
2. For year-end raw materials and finished goods, confirm title belongs to the company by
agreeing goods to a recent purchase invoice in the company name.
Presentation and Disclosure:

1. Ensure that all disclosures as required by IAS – 2 have been included in the financial
statements.
2. Review that disclosures in the financial statements are correct and clear.
Procedures if auditor attends inventory count:
 Review client’s instruction for inventory (discussed in previous chapter)

count to assess effectiveness of count.
Before Inventory  Determine if any inventory is held by third parties to assess need to
count (i.e. Planning) send confirmation letter.
 Determine whether there is need of an expert or component auditor.
 Decide which counts locations will be observed by audit team.
 Observe the count to ensure that management’s instructions are being
followed.
 Perform test count by checking items from inventory sheet to
During inventory warehouse and vice-versa.
count (i.e. Observing  Observe conditions of inventory for possible NRV adjustment.
and Recording)  Ensure that inventory belonging to third parties but held by client is
segregated.
 Perform cutoff test on sales and purchases.
 Obtain signed copies of count sheets from client.
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 Ensure quantity of final valuation match with inventory list.

 Inspect aging of inventory to identify slow moving and obsolete stock
After inventory and discuss provisioning with management.
count (i.e. Follow up)  Ensure that inventory is valued at lower of cost and NRV.
 Ensure that Cutoff procedures have been appropriately applied while
recording sales and purchases.
If inventory is held by third parties:

1. Send a letter requesting direct confirmation of inventory balances held at year end from
the third party regarding quantities and condition.
2. Attend the inventory count (if required and possible) at the third party warehouses to
ensure the completeness and existence of inventory.
3. Inspect any reports produced by the auditors of the third party warehouses in relation
to the adequacy of controls over inventory.
4. Inspect any documentation in respect of third party inventory.
5. Review subsequent transfer of inventory from third party to client.

During the audit of Shahbaz Chemicals Limited (SCL) for the year ended 31 December 2016, the audit team had noticed
that sales of SCL has declined due to various reasons and SCL is facing difficulties in selling the existing stock of inventory
at current price levels.
Required:
Explain the steps which the auditor should perform to ensure that carrying value of inventories is based on lower of cost
and net realisable value. (04 marks)
You are the audit senior on the audit engagement of Farhan Foods Limited and assigned to attend the inventory count.
Required:
State what matters you would consider while observing the inventory count. (05 marks)
List the substantive procedures that may be performed by the auditor to verify the amount of inventories as appearing in
the financial statements of a manufacturing concern. (15 marks)
How does the auditor deal with the situation when inventory is found under the custody and control of a third party?
(05 marks)
Describe audit procedures you would perform during the audit of your client BEFORE and DURING the inventory counts.
(08 marks)
(ACCA, Fundamentals Level F8 – October/December 2015)
(i) Identify and explain FOUR financial statement assertions relevant to account balances at the year end; and
(ii) For each identified assertion, describe a substantive procedure relevant to the audit of year-end inventory.
(08 marks)
Explain the principal audit procedures to be performed in respect of the valuation of work in progress. (04 marks)
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LO 4: TRADE RECEIVABLES: ✯✯
Existence, Completeness, and Rights and Obligation:
1. Obtain a listing of trade receivables from the sales ledger:
 Cast it and agree to the control account and financial statements.
 Review reconciliation between control account and sales ledger if difference exists.
2. Calculate debtors’ turnover ratio and compare with prior years. Investigate any significant
differences.
3. Compare with previous years to identify any significant variations/omissions in balances
of trade receivables.
4. Select a sample of debtors from sales ledger at year end and perform a trade receivables’
circularization (i.e. direct confirmation). Perform alternative audit procedures in case of
non-response and perform additional audit procedures in case of exceptions identified.
5. Select a sample of debtors from sales ledger at year end and vouch back to sale invoices,
GDN and Sales orders.
6. Review whether effect of cut-off on sales have been appropriately accounted for in debtors.
7. Review the control account entries shortly before and after the year end for unusual
items and investigate them.
8. Review cash receipts after year end and trace to debtors at year end.
9. Review credit notes after year end to identify any sales transactions before year end
which should be reversed.
Evaluate adequacy of Provision for bad debts:

a) Inquire management regarding estimates used in calculation of provision for bad debts.
b) Obtain aging report of receivables:
o Compare it with control account,
o Test the aging.
o Review the aged receivable ledger to identify old receivable balances. Discuss the status
with the management to assess whether they are likely to pay.
c) Examine whether there are any cash recovery of doubtful debts or bankruptcy after the year-
end.
d) For large overdue balances, review financial statements of debtors and discuss with
management likelihood of their collection.
e) Recalculate provision for bad-debts using sales, write-offs and current economic conditions of
customers.
f) Inquire management about any disputes with customers and review board minutes for
disputed receivables.
g) Review communication of client with customers, lawyers and collection agencies regarding
debts which are in dispute or unlikely to be paid.
For Presentation & Disclosures:

 Determine if any receivables have been discounted.
 Inquire about receivables from officers, directors or other related parties.
 Ensure that receivables are correctly disclosed and classified in financial statements.

You are the senior member of the audit engagement team, auditing the financial statements of a manufacturing company,
Hard Stone Limited. List down the primary substantive procedures, which you would carry out in the verification of trade
debts (excluding receipts from customers). (06 marks)
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List down any five (05) key audit procedures for verification of provisions against doubtful receivables. (05 marks)
(ICMA Pakistan, Professional Level P2 – 2014 May )
LO 5: PREPAYMENTS FOR EXPENSES: ✯

1. Obtain a schedule/list of all prepayments. Cast list to ensure mathematical accuracy and
agree balances with financial statements.
2. Nature and amount of all prepayments should be compared with prior periods to ensure
all likely prepayments have been included.
3. For a sample of prepayments from the prepayments' listing:
a. Recalculate the amount prepaid to ensure that it has been accurately calculated.
b. Verify prepayment with reference to invoice, cash book and bank statement.
4. Agree prepayments to the adjustments after the end of the year.

Draft audit programmes for the following:
(a) Accrued expenses
(b) prepayments (06 marks)
LO 6: ACCRUALS FOR EXPENSES: ✯

1. Obtain a schedule of all accruals. Cast list to ensure mathematical accuracy and agree
balances with financial statements.
2. Nature and amount of all accruals should be compared with prior periods to ensure all
likely accruals have been included.
3. Select sample of:
a. Accruals and vouch with payments after the year-end.
b. Payments after the year-end and check supporting of payment to identify if any
payment requires accrual.
4. Ensure that period end accruals of expenses includes necessary items (e.g. Salaries
accrual, Accruals for Utility bills, Withholding tax payable etc.)
5. Check calculations of individual accruals to supporting documentation e.g. withholding tax
payable, or bonus/commission payable.
6. Ensure that appropriate split of accruals is made between current and non-current
liabilities.
Procedures for accruals of wages & salaries:

 Check whether accrual is based on last month’s payroll using correct records of time
sheets, records of wage rates and salaries.
 Confirm that additional costs (e.g. employer’s contributions) have been accounted for.
 Test reasonableness of accrual balance by performing analytical procedures.

List any five substantive procedures for the verification of Accrued expenses. (05 marks)
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LO 7: BANK: ✯✯
1. Obtain a list of all bank accounts (including accounts closed during the year) along with
closing balances. Cast list to ensure mathematical accuracy and agree balances with
2. Obtain bank confirmation letter for all bank accounts (including accounts closed during
the year) and perform following procedures:
 Agree balances as per bank confirmation letter with bank reconciliation statements
(to ensure accuracy) and with list of bank accounts (to ensure completeness).
 Confirmation should be reviewed for evidence of loans, security or restriction on
balance.
 check that the bank has answered all the questions in the letter
3. Obtain Bank Reconciliation Statements (BRS) for each bank account and perform
following procedures:
 cast BRS to ensure mathematical accuracy and agree balances as per cash book with
GL and balance as per bank statement with bank statement/confirmation letter.
 trace deposits in-transit into deposit slips and cash book of current month; and in
bank statement of subsequent month. For significant delays inquire explanation
from management.
 trace unpresented cheques into cash book of current month; and in bank statement
of subsequent month for clearance. For significant delays inquire explanation from
management. Examine long-outstanding cheques for reversal.
 for untraced items, examine supporting documentation.
 check whether deposits in-transit and unpresented cheques in previous bank
reconciliation statement are appearing in current month’s bank statement or
current bank reconciliation statement.
4. Perform cutoff test on cheque receipts and cheque payments.
5. Review cash book and bank statement for large transfers near year-end as indication of
window-dressing.

You are the Audit Senior on the audit of Al-Haq Limited. The company is a trading concern and 70% of its business relates
to imported goods. The chief accountant has provided you the bank reconciliation statements of all the bank accounts
alongwith the bank statements.
Required: State the substantive procedures that you would carry out for the verification of bank balances. (06 marks)
List down at least five audit procedures undertaken by the auditor in respect of the following:
(i) Bank reconciliation statements (05 marks)
(ii) Bank confirmations (05 marks)
(ICMA Pakistan, Professional Level P2 – 2015 March )
LO 8: CASH: ✯
Existence:
Perform cash count simultaneously at all locations at year end (including petty cash) and agree the
total to the balance includes in financial statements.
Completeness:
 Perform cut-off test on cash receipts and cash payments to ensure that there is no
unrecorded or in-transit cash.
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 Review reconciliation for difference between book balance and physical balance.
Rights and Obligation:

 Ensure cash is under proper lock and key, and in safe custody.
 Ensure that company owns cash in hand and none of the cash is held on behalf of any third
party.

Ensure that currency notes of high denomination are real one.

You are a part of the team on the audit of Fresh Meat (Private) Limited which sells fresh meat products through 25 retail
outlets. Each outlet holds cash at the year end. Sales are made on cash as well as against credit cards. All the accounting
records are maintained at the outlets and balances with the Head Office are reconciled on a monthly basis.
Required:
List the audit assertions relevant to the audit of cash in hand and state how you would obtain audit evidence to support
those assertions. (06 marks)
LO 9: TRADE PAYABLES: ✯✯
Existence, Valuation & Allocation, and Rights and Obligations:
1. Obtain a listing of trade payables from the purchase ledger:
 Cast it and agree to the control account and financial statements.
 Review reconciliation between control account and purchase ledger if difference
exists.
2. Calculate creditors’ turnover ratio and compare with prior years. Investigate any
significant differences.
3. Compare balances of trade payables with previous years to identify any significant
variations/omissions.
4. Select a sample of creditors from purchase ledger at year end and perform a trade payables’
circularization (i.e. direct confirmation). Perform alternative audit procedures in case of
non-response and perform additional audit procedures in case of exceptions identified.
5. Select a sample of creditors from purchase ledger at year end and agree back to valid
supporting documentations of GRN and Purchase Orders.
6. Review whether effect of cut-off on sales have been appropriately accounted for in debtors.
7. Review the control account entries shortly before and after the year end for unusual
items and investigate them.
8. Examine cash paid to supplier after the balance sheet date.
9. Examine debit notes after year end to identify any purchases transactions which should
be reversed.
10. If cash is not paid or partly paid to supplier, auditor shall:
 inspect valid supporting documents e.g. supplier signed purchase orders, suppliers’
invoices, Goods Received Notes and other documents.
 obtain explanation for cash not paid within credit period.
Completeness: (i.e. ensuring accrual for purchases)

1. Examine cash paid to supplier after the balance sheet date and ensure liabilities were
recorded at balance sheet date.
2. Inspect pending GRNs (i.e. goods received but suppliers’ invoices not received) and ensure
they are recorded at balance sheet date.
3. Perform cut-off test by examining purchases near balance sheet date.
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Develop a brief work program for verification of Trade Creditors. (05 marks)
LO 10: CONTINGENCIES & PROVISIONS: ✯✯

Contingencies: (e.g. litigations and claims)
Auditor shall perform following procedures to identify any litigations and claims against company.
1. Follow up contingencies reported in last year.
2. Make appropriate inquiries of management and others including in-house legal advisers
3. Inspect minutes of meetings of those charged with governance and correspondence
between the entity and its external legal advisers
4. Review legal expense accounts.
5. Send letter of inquiry (general or specific) to external legal advisors.
6. Obtain written representation from management about completeness of contingencies
and provisions.
7. Check status of contingencies and provisions subsequent to reporting period.
Provisions:
1. Obtain a schedule of provisions. Check for arithmetical accuracy and agree to the financial
statements.
2. Compare provisions for the current financial year with provisions in previous years to
ensure provisions includes necessary items considering nature of business (e.g. Provisions
for warranty, Provision for redundancy, Provision for Legal cases, Provision for site
restoration, etc.). Investigate any major differences or omissions.
3. Obtain a detailed analysis of all provisions showing opening balances, movements and
closing balances.
4. Determine for each material provision whether the company has a present obligation as a
result of past events by:
 Review of correspondence relating to the item
 Discussion with the directors.
5. Determine for each material provision whether transfer of economic benefits is
probable to settle the obligation by:
 Checking whether any payments have been made after year-end in respect of the
item by reviewing after-date cash
 Review of correspondence with lawyers, banks, customers, insurance company
 Sending a letter to the lawyers to obtain their views (where relevant)
6. Review whether provisions have been adjusted in accordance with events occurring after
the balance sheet date.
7. Recalculate all provisions made.
8. Compare the amount provided with any post year end payments and with any amount
paid in the past for similar items.

State five key substantive audit procedures for verification of Provisions. (05 marks)
Explain the principal audit procedures to be performed during the final audit in respect of the estimated warranty
provision in the balance sheet of audit client as at 30 November 2007. (05 marks)
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Discuss briefly some of the procedures that are normally employed by an auditor to ensure that all the contingent
liabilities have been identified. (06 marks)
List any five substantive procedures for the verification of each of the following:
(i) Accrued expenses
(ii) Contingencies (10 marks)
The company is facing a potential legal claim from Mehran Motors Limited (MML) in respect of defective air conditioners
supplied to them. A claim for Rs. 25 million being the cost of replacement of air conditioners and lost production time has
been lodged with the Company by MML. The management is of the view that the claim is not justified, as the air
conditioners were properly functioning and had been tested for quality and that the defects have arisen because of the
negligence of MML and its technicians. However, a provision of Rs. 2 million has been made in the financial statements in
this respect.
Required:
What audit evidence will you gather to address the above issues? (05 marks)
LO 11: NON-CURRENT LIABILITIES/LONG TERM BORROWINGS: ✯✯

1. Obtain a list of all borrowings from client (with opening balance, new borrowings,
repayments and closing balance) including debentures, bank loans, and finance lease
obligations. Cast list to ensure mathematical accuracy and agree balances with financial
statements. Agree the opening balances on the listing with the amount for non-current
liabilities in last year’s statement of financial position.
2. For new borrowings check authorization of borrowing from minutes of BOD meeting or
other relevant meeting.
3. Inspect loan agreements (for securities, repayment schedule, interest rate and restrictive
conditions etc.).
4. Check that interest payments have been accurately calculated in accordance with terms
of loan and are presented separately from long-term loans in accounts.
5. Confirm loan repayments during the year with payments recorded in the cash book, entries in
bank statements and also with any correspondence from lenders.
6. Obtain confirmation letter from lenders for outstanding amounts, alongwith interests and
details for securities.
For Presentation and Disclosure:

1. Review disclosure of interest rates, security and split between current and non-current
portion.
2. Check whether loan-agreement gives lender right to impose penalty or withdraw facility in
case of breach of conditions of loan. Also check that client is not in breach of any
conditions.

List the substantive procedures which may be performed by the auditor to verify the Long Term Bank Loan. (07 marks)
List down any five (05) key audit procedures for the following:
(i) Verification of loans obtained during the year. (05 marks)
(ii) Verification of provisions against doubtful receivables. (05 marks)
(ICMA Pakistan, Professional Level P2 – 2014 May)
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LO 12: EQUITY: ✯
Share Capital:
1. Agree authorised share capital with memorandum and articles of association of
company.
2. Agree opening balance of share capital with last year’s financial statements and working
papers.
3. For share capital issued during the year, auditor should check:
 Review minutes of board of directors’ meeting to confirm authorization of the issue
of additional share capital.
 Inspect the cash book and bank statements for evidence of cash receipts from the
share issue.
 Recalculate the split of proceeds between the nominal value of shares and
premium/discount on issue and agree that they are correctly recorded in relevant
accounts.
 Review the disclosure of the share issue in the draft financial statements and
ensure it is in line with relevant accounting standards and local legislation.
 Inspect supporting documents to ensure that all legal requirements have been
complied with.
4. Agree amount of issued share capital in balance sheet with register of shareholders.
Dividend:
1. Check approval of dividend by Board meeting and/or General Meeting.
2. Recalculate amount of dividend with reference to issued capital at relevant date.
3. Ensure that dividend is paid out of distributable profits only (dividend is not paid out of
capital profits).
4. Ensure that dividend is paid within prescribed time.
5. Check that Zakat and Witholding tax has been deducted from cash dividend.
6. Ensure that unpaid/unclaimed dividend is adequately disclosed.
Reserves:
1. Obtain a list of movement in all reserves from client (with opening balance, additions,
deletions and closing balance). Agree movement with supporting documents and check
authorization of all movements during the year. Check accuracy of listing of client with
supporting documents.
2. Ensure that Revenue Reserves and Capital Reserves are separately identified by
company.
3. Ensure that legal requirements relating to reserves have been complied (e.g. regarding use
of share premium).
4. Ensure that appropriate disclosures of movements on reserves are made in the
company's accounts by inspection of the financial statements.

Identify the substantive procedures for verifying share capital. (08 marks)
(Malaysian Institute of Accountants – March 2012)
State four substantive procedures for verification of share premium account appearing in the statement of financial
position. (02 marks)
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Develop an audit work program in respect of dividend to shareholders.

Identify ten (10) substantive audit procedures that should be applied by auditor in auditing the shareholders’ equity
account of audit client. (10 marks)
(Malaysian Institute of Accountants – September 2012)
LO 13: DIRECTORS’ EMOLUMENTS: (e.g. BONUS) ✯

1. Obtain a schedule of the directors’ remuneration (including the bonus, benefits, pension
contribution) paid and agree with financial statements’ disclosure.
2. Review the directors' contracts and ensure emoluments are consistent with the terms of
these contracts.
3. Agree the individual emoluments payments to the payroll records.
4. Inspect bank statements to verify actual amounts paid to directors.
5. Review the tax returns of directors to ensure these agree with emoluments as per listing.
6. Compare the emoluments with previous year's emoluments to ensure emoluments in
accounts is complete.
7. Obtain written representation from directors that they have disclosed all directors’
remuneration and related party transactions to the auditor.
8. Inspect minutes of BOD to ensure there are no undisclosed bonuses or other
remuneration.
9. Consider the adequacy of disclosure of emoluments paid to directors in accordance with
AFRF.

Describe substantive procedures you should perform to confirm the directors’ bonus payments included in the financial
statements. (03 marks)
LO 14: REVENUE: ✯
Completeness:
Select a sample of goods despatch notes and agree to the sales invoices and sales/subsidiary
ledger to ensure completeness of revenue.
Occurrence:
Select a sample of sales recorded in Sales Journal and vouch back to sales invoices, shipping
documents and customer orders.
Accuracy:
Select a sample of sales invoices and perform following procedures to ensure these are accurate:
(a) compare prices, discounts and terms and conditions with authorized price list and authorized
terms and conditions.
(b) recalculate sales tax on invoice.
Cut-off on Sales:
At year-end, auditors should select the last goods despatch note (GDN) made on that day. He
should then select further a sample of GDN for despatches immediately before and after the last
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GDN. The sample of GDNs should be traced to the associated sales invoices to ensure that
despatches have been posted as sales in the correct accounting period.
Presentation & Disclosures:

-Review accounting policies for revenue recognition and ensure they comply with AFRF and are
properly disclosed.
-Read notes to the accounts to ensure they are accurate, complete, and easy to understand.

(i) Identify and explain FOUR financial statement assertions relevant to classes of transactions and events for the year
under audit; and
(ii) For each identified assertion, describe a substantive procedure relevant to the audit of REVENUE. (08 marks)
Describe the audit work you would undertake in order to determine that revenue is fairly stated in the financial
statements of Hermes for the year ending 31 December 2007. (04 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2007 December)
LO 15: PURCHASES: ✯
Completeness:
Select a sample of goods receipt notes and agree them to the purchase invoices and
purchase/subsidiary ledger to ensure completeness of purchases.
Occurrence:
Select a sample of purchases recorded in Purchase Journal and vouch back to purchase invoices,
receiving documents, and purchase orders.
Accuracy:
Select a sample of purchase invoices and perform following procedures to ensure these are
accurate:
(a) compare prices, discounts and terms and conditions with authorized terms and conditions.
(b) recalculate tax on invoice.
Cut-off on Purchases:
At year-end, auditors should select the last goods receipt note (GRN) made on that day. He should
then select further a sample of GRN for receipts immediately before and after the last GRN. The
sample of GRNs should be traced to the associated purchases invoices to ensure that receipts have
been posted as purchases in the correct accounting period.

State the procedures to be performed during the final audit in relation to the cut-off assertions for sales and purchases.
(03 marks)
What do you understand by a cut off test? How an auditor normally performs it in case of local purchases? (05 marks)
State the significant procedures auditors generally include in the audit programme for Purchases. (06 marks)
List the substantive procedures that may be performed by an auditor to verify the Raw material purchases (06 marks)
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LO 16: PAYROLL: ✯✯
1. Compare the total payroll expense to the prior year and investigate any significant
differences.
2. Compare payroll expense of month-wise to ensure payroll expense in one month does
not unusually change in next month.
3. Obtain all payroll sheets processed during the year. Agree total of payroll sheets with
4. Cast a sample of payroll sheets to confirm completeness and accuracy of the payroll
expense.
5. Perform analytical procedures on total salaries expense, incorporating joiners and
leavers and the pay increase. Compare this to the actual wages and salaries in the financial
statements and investigate any significant differences.
6. For a sample of employees, recalculate the gross and net pay and agree to the payroll
records to verify accuracy.
7. Select a sample of employees from payroll and check whether employees exist.
8. Select a sample of newly appointed staff and check their salaries with appointment letter.
9. Ensure that payroll costs have been properly disclosed in the financial statements.

List the substantive procedures that may be performed by an auditor to verify the Payroll. (08 marks)
Describe substantive procedures you should perform at the final audit to confirm the completeness and accuracy of audit
client’s payroll expense. (06 marks)
LO 17: EXPENSES: ✯
Occurrence:
Select a sample of transactions, and vouch as follows:
 Check supporting documents.
 Check mathematical accuracy.
 Check acknowledgement of receipt of goods/services.
 Check calculation and deduction of tax.
 Check evidence of payment (e.g. signature of person receiving payment, copy of cheque,
tracing the payment into bank statement).
 Ensure that expense is incurred for the purpose of business and is in accordance with
objects of the company.
Completeness:
 Compare the expense with prior year.
 Check that all expenses requiring accruals have been accounted for.
 Search for unrecorded liabilities.
Accuracy:
Select a sample of invoices and perform following procedures to ensure these are accurate:
(a) check rates used in expense are based on market rates.
(b) recalculate invoice to ensure transaction is correctly recorded based on invoice.
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Cut-off on Sales:
Select a sample of transaction immediately before and after year end, and check date of
acknowledgement of receipt of goods/services.
Presentation & Disclosures:

 Check allocation of payment between expenses and prepayments.
 Scan GL for unusual entries in the account.
LO 18: INTEREST EXPENSE AND INTEREST INCOME: ✯

1. Inspect legal documents (e.g. loan agreements) creating right of entity to receive/pay
interest.
2. Perform analytical procedures to confirm reasonableness of interest by following formula
Interest = Principal x Applicable Interest Rate x Period
3. Vouch the payment from recording into G.L. and tracing into bank statement.
4. Confirm interest payments/receipts during the year with payments recorded in the cash
book, entries in bank statements and also with any correspondence from lenders/borrower.
Exam Tips
In exam if a concept review question is set from “substantive procedures”, you may be required to:
1. State substantive procedures to verify whole area e.g. Long term bank loan, Inventory, Provisions,
Contingencies, Payroll, Purchases, Trade debts and Prepayments.
2. State substantive procedures to verify a critical part of the area e.g. Bank Reconciliation Statement,
Provision for bad debts, fixed assets carried at revalued amount.
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Auditing – Study Notes Chapter 13 IT Systems, Controls, CAATs and Flowcharts
CHAPTER THIRTEEN
IT SYSTEMS, CONTROLS, CAATS AND
FLOWCHARTS
PART A –TYPES OF IT SYSTEMS USED BY CLIENT

LO 1
ELECTRONIC DATA INTERCHANGE (EDI) SYSTEM, BENEFITS AND RISKS
✯
LO 2
CONTROLS IN EDI SYSTEM
✯✯
LO 3
MICRO COMPUTER SYSTEM, AND ONLINE SYSTEM
✯
PART B – TYPES OF CONTROLS USED BY CLIENT IN AN IT SYSTEM
LO 4
IT CONTROLS
✯✯✯
LO 5
CATEGORIES OF IT GENERAL CONTROLS
✯✯✯
LO 6
CATEGORIES OF IT APPLICATION CONTROLS
✯✯✯
PART C – USE OF COMPUTERS IN AUDITING
LO 7
AUDITING AROUND COMPUTERS VS. AUDITING THROUGH COMPUTERS
✯
LO 8
COMPUTER ASSISTED AUDIT TECHNIQUES (CAATs)
✯✯
LO 9
TEST DATA AND AUDIT SOFTWARES
✯✯
PART D – FLOWCHARTS
LO 10
TYPES AND LEVELS OF FLOWCHARTS
✯✯
LO 11
APPROACH TO DRAWING A SUCCESSFUL FLOWCHART
✯
LO 12
SYMBOLS USED IN FLOWCHARTS AND THEIR MEANINGS
✯
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55a & e (IT Department) 96d (Auditors)

56 (Controls) 119 (System logs)
58 (Audit trail)
Question Bank:
52 (Vision Limited) 54 (Deehan Super Stores)

53 (Types of Controls) 107a (Heidi Co)
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PART A – DIFFERENT TYPES OF IT SYSTEMS USED BY CLIENT
LO 1: ELECTRONIC DATA INTERCHANGE (EDI) SYSTEM, BENEFITS AND RISKS: ✯

Definition:
Electronic data interchange (EDI) is the electronic transmission of business documents (e.g.
purchase orders, invoices or payroll information). EDI system can work:
 Internally (e.g. sales order department transmitting sales order data to accounts
departments), or
 Externally (e.g. purchase order department transmitting purchase order data to suppliers)
Benefits of EDI System:

 Error reduction and improved efficiency
 Reduction of paper.
 Postage-free
Risks in EDI System:

1. Security risks in transmission of data (e.g. hacking)
2. Lack of paper ‘audit trail’. (Audit Trail is the ability of users to trace a transaction through
all of its processing stages.)
3. Increased dependency on computer system may adversely affect organization in case of
computer failure.
4. Risk of possible loss or corruption of data in the process of transmission.
LO 2: CONTROLS IN EDI SYSTEM: ✯✯

Typical controls in an EDI System includes following:
1. Controls over transmission of data.
2. Electronic audit trail
3. Virus protection systems.
4. Contingency plans and back-up arrangements.
Controls over transmission of data:

Controls over data transmission ensure that data is transmitted accurately, completely and with
confidentiality.
Controls over data transmission include:

 Authentication codes
 Data Encryption
 Acknowledgement systems
 Using secured Wi-Fi with password protection
 Firewalls and Virus Protection Systems to prevent intrusion.
 Using check sums and check digits to ensure that data received is accurate and complete.
 Programmed Control that ensure data is transmitted in the correct format.
 Restricting access to source data that is transmitted.
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Authentication Codes:
Authentication codes are used so that senders and receivers of transmitted data have to
authenticate their identity before data is transmitted and received.
Data Encryption:
Encryption is the process of transforming information (called plain text) using an algorithm (called
cipher) to make it unreadable for everyone except recipient possessing a special knowledge (called
key).
Data to be encrypted can be ‘at rest’ (i.e. in a database or storage media) or ‘in-transit’ (i.e.
travelling on network via web-application or smart-phones).
There are two methods of encryption:

1. Symmetric (in which same keys are used to encrypt and decrypt data; this is sometimes
called shared-secret key)
2. Asymmetric (in which different keys are used to encrypt and decrypt data; this is
sometimes called public-private key).
There are two types of symmetric encryption i.e.

 Block Ciphers (in which a fixed length block is encrypted)
 Stream Ciphers (in which the data is encrypted one 'data unit', typically 1 byte, at a time in
the same order it was transmitted.)
Firewalls:
These are software or hardware devices that protect the computer (i.e. server) in network from
unauthorized access via internet.
Electronic audit trail:

Electronic Audit Trail means there are no paper documents rather computer program is written to
generate the audit trail for any transaction on request.
Paper Audit Trail (opposite to electronic audit trail) means processing of transactions can
be traced by going from one paper document to another paper document.

Most of the advanced and sensitive systems place significant reliance on automated controls. Audit trail is one such
automated control.
Explain the concept of audit trail in a computerized environment. (02 marks)
Controls over data transmission help to ensure that transmitted data is complete, secure and unaltered.
Required:
State any five controls over data transmission which help to ensure that the data is secure and unaltered. (04 marks)
Differentiate between Symmetric key ciphers and Asymmetric key ciphers in relation to data encryption techniques.
(02 marks)
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LO 3: MICRO COMPUTER SYSTEM, AND ONLINE SYSTEM: ✯
MICRO-COMUPTER SYSTEM (or PC System)

Definition:
A microcomputer system is a system where the client uses a number of ‘desktop’ computers located
throughout the organisation, rather than a large ‘centralised’ computer-based information system.
Benefits of micro-computer system:

 This system is more efficient than centralized system.
 This system can be operated by user’s operating staff without much technical training.
Audit risks in micro-computer system:

1. Inadequate segregation of duties as single employee may have access to many applications.
2. Weak access controls (e.g. log-on procedures may be bypassed by forcing the computer to
boot from a CD-ROM.
3. There is a risk of theft of IT equipment because of portability of equipment
4. The data stored on microcomputers that are shared by multiple users are exposed to
unauthorized access, manipulation, and destruction.
5. There may be several processing and software problems because different types of
programs may be written or modified by users.
6. Weak Backup Procedures
7. Risk of Virus Infection
ONLINE SYSTEM (or Mainframe/Network System)

Definition:
These are computer-based information systems that allow users direct access to centrally-held data
and programs through remote terminals linked together in a network.
Benefits of Online-system:
 Immediate entry of transactions into the system (e.g. a sale transaction in retail outlet is
entered in electronic point of sale terminal which is linked to central computer in network).
 Immediate updating of master file (e.g. immediate updating of inventory records as soon as
inventory is requisitioned).
 Immediate response to Enquiry system (e.g. immediate answers to price/balance enquiries
from customers)
Controls in Online-System:
General Controls:
 Logical Access Controls i.e. to prevent unauthorized access to programs and data files.
 Programming Controls i.e. to prevent unauthorized changes to programs or data files.
 System-logs should be used.
 Firewalls should be used.
Application Controls:
 ‘Input-Authorization Controls’. (to be discussed later in chapter)
 ‘Input Validation Controls’. (to be discussed later in chapter)
 ‘Balancing’. This is the checking of control totals of data submitted from a remote terminal,
before and after processing.
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System Log (or Log-file)

A system log is a record of events that take place in the execution of a system. System log
produces audit trail and can be used to analyze and improve a system’s performance.
Examples of system logs include:
 Failed log-in attempts
 Which users logged-in, when and from where
 Who accessed and amended data file.
 Which web pages a user accessed
 Changes made to a program – what when and by whom
 Attempted cyber intrusions.
 CPU speed
 Broadband speed

Identify any four types of information that can be extracted from system logs. (02 marks)
PART B – TYPES OF CONTROLS ESTABLISHED BY CLIENT IN AN IT

SYSTEM
LO 4: IT CONTROLS: ✯✯✯
Types of Controls:
If an organization uses IT system, its control activities may be either Manual or IT based.
 A manual control is a control which is performed by people e.g. Authorization, Review,
Reconciliations.
 An IT (or Automated or Programmed) control is a control which is performed by computer
software e.g. input validation checks.
These controls can be either Preventive, Detective or Corrective.
Type of Control Definition and Examples

These are designed to stop errors or irregularities from occurring in first place e.g.
Preventive 1. Restricting access through passwords, firewalls, doorlocks
Controls 2. Training of employees
3. Segregation of duties
These are designed to identify errors or irregularities that may have occurred e.g.
1. Review of system logs, or exception report.
Detective
2. Comparing actual expense with budgeted expenses.
Controls
3. Reviewing manually calculated batch total with output of system.
4. On-screen prompts.
These are designed to correct errors or irregularities that have been detected e.g.
Corrective 1. Backup and recovery procedures.
Controls 2. Contingency Planning.
3. Disciplinary Mechanism.
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Types of IT Controls:
IT Controls are further classified between two types i.e. IT General Controls (ITGC) and IT
Application controls (ITAC).
 IT General Controls (ITGC)
IT General Controls are those controls that relate to all or many applications. They help
effective functioning of application controls by ensuring continued proper operation of IT
system.
 IT Application controls (ITAC):
IT applications (e.g. sales application or payroll application in accounting) accept input data,
perform calculations, and produce output data. ITACs ensure that entry of transactions is
authorized, transactions are accurately processed, and output is timely and confidentially
distributed.

Explain each of the following types of controls. Also give two suitable examples in each case.
(a) Preventive Controls (03 marks)
(b) Detective Controls (03 marks)
(c) Corrective Controls (03 marks)
LO 5: CATEGORIES OF IT GENERAL CONTROLS: ✯✯✯
ITGC 1 Controls over System Acquisition and Development.

Objective:
To ensure Computer based information system and application are developed/acquired in
consistency with entity’s objectives.
Examples:
 Use of appropriate IT standards (e.g. System Development Life Cycle Approach) for design,
development, programming of new computer system.
 Acquuisition of new system should be approved by approrpirate level of management.
 There should be full documentation of new systems.
 All new systems should be tested before implementation.
 Training should be provided to staff before “live” operation of new system.
 New system should be formally approved by system-user.
ITGC 2 Controls over Program Changes

Objective:
To prevent/detect unauthorized program changes.
Examples:
Controls to prevent unauthorized changes:
 There should be virus-protection and backup copies of all programs.
 Access to prgoram files should be restrictred.
 Program logs should be maintained and periodically reviewed to identify which program or
versions are used.
 There should be segregation of duties between tasks of prgorammer (who writes the
program) and operator (who uses the program).
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Controls to implement authorized changes:

 Changes in programs should be tested before live operations.
 Changes in programs should be approved by appropriate level of mangement.
 Changes in programs should be fully documented.
ITGC 3 Controls over use of Programs and Data

Objective:
To prevent use of incorrect program or data files.
Examples:
 Training:
Computer operating staff should be suitably trained
 Job scheduling
There should be Job scheduling in large scale operations to specify which version of program to
use.
 Supervision
Supervisors should monitor the activities of operating staff
 Reviews by management
Management should carry out periodic reviews to ensure that correct versions program and
correct data files are being used.
ITGC 4 Access Controls

Objective:
To prevent unauthorized access to IT equipment and program and data files.
Examples of Physical Access Controls: (to safeguard IT equipment)

 Fences, and door-locks with log-in function (e.g. passwords, access cards, biometric)
 Controlled single entry point with visitors’ logs.
 Identification badges
 Alarm
 Surveillance videos (CCTV System).
 Lockable briefcase
Examples of Logical Access Controls: (to safeguard program and data)

 Each user has a unique Log-in ID and password (which is difficult to guess and is changed
periodically).
 There are access rights for every user which are peridoically reviewed (to ensure segregation of
duties)
 Inactive accounts are disabled after a pre-defined period of non-usage (e.g. of terminated
employees).
 Audit-Trail and System-Logs are available for all important activities.
 Use of antivirus and firewalls to prevent unauthorized acces via internet.
ITGC 5 Controls over Data Center and Continuity in Operations

Objective:
To ensure continuity of operations in the event of disaster.
Examples:
a) Security measures for protection of equipment against fire, flood, power-failure, theft or other
diasters.
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b) Disaster Recovery Plan/Contingency Plan e.g.

 Insurance coverage for IT infrastructure.
 Maintenance and service agreements with software companies, to provide ‘technical support’
in the event of operating difficulties with the system
 Agreement with another entity to make use of its computer centre in the event of a disaster
such as a fire or flood.
 Offsite storage of backup data.

Specify any four main categories of general controls that an auditor would expect to find in a computer based information
system. (04 marks)
List six physical access controls over an IT system. (03 marks)

While reviewing the system documentation of EWC Limited you have noticed that appropriate program maintenance
controls do not exist.
Prepare a note for the guidance of the information systems development team, covering the importance of controlling the
changes to the programs. Also list any four controls that should be implemented in this regard. (05 marks)
(ICAP, CAF 09 Level – Spring 2013, amended)
LO 6: CATEGORIES OF IT APPLICATION CONTROLS: ✯✯✯
ITAC 1 Input Controls (also called Input Validation or Data Validation Controls)
Objective:
To ensure that input data is Authorized, Accurate and Complete.
Examples of Input Controls:

 Limit Test/Check: A check to ensure that a financial value does not exceed some
predetermined value.
 Range/Reasonableness Test: A check to ensure that a numerical value does not fall outside
the predetermined range of values e.g. wages of employees fall within 10,000 to 25,000.
 Sequence Test: A check to ensure that all entries in system are in numerical sequence e.g.
there is no missing purchase invoice.
 Existence Test: A check to ensure that a code/number exists by looking up the code in the
valid record e.g. whether a supplier exists.
 Check-digit: A check-digit is a digit that is calculated in a mathematical way from the
original code and then is added to the end of the code as extra-digit e.g. to detect
transposition errors.
 Batch Total: A Batch total is the sum of number of transactions (called Transaction Count) or
sum of value of transactions (called Control Total) which are entered into the system in
batch. A manually calculated sum from source documents is compared with electronically
calculated sum from recorded transactions to ensure transactions are accurately and
completely recorded.
ITAC 2 Controls over Processing

Objective:
To ensure that all data input is processed correctly (i.e. there is no duplication or loss of data during
processing).
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Examples:
 Batch Total, Range and Limit tests
 Transactions log for successful transactions.
 Error listing for rejected transactions with follow up actions.
 On-Screen Prompts (prevent people logging out before processing is complete).
 Marking a file as read only.
 Checkpoint and recovery procedures.
 Review of output against expected value.
ITAC 3 Controls over Output

Objective:
To ensure that output reports (electronic or paper) are distributed to authorized personnel, output
is not lost and privacy is not violated.
Examples:
 Restriction on printing of confidential reports, and controls to ensure sensitive data is not
left on printers for others to view (specially when transmitting over public networks).
 Print-out reports should be placed in tamper-proof envelope.
 Electronic Reports should be encrypted and password-protected.
 A distribution-log and acknowledgement of recipients should be kept for all reports
distributed
 Audit Trails and Exception Reports
ITAC 4 Controls over Master File and Standing Data.

Objective:
To ensure that data held on master files and standing files is accurate and complete.
Examples:
 Regular update of master files from transaction files (e.g. when new product is introduced).
 Access rights to update and amend data in master files should be restricted.
 Record-counts in master file and comparison with previous records.
 Review of fields of master file by management.

Differentiate between General IT controls and Application controls. Also give two examples of each type of control.
(06 marks)
(i) List and describe THREE categories of application controls over data, which should be incorporated in the new
computer-based accounting system; and (06 marks)
(ii) For each application control listed provide an example of its use. (03 marks)
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PART C – USE OF COMPUTERS IN AUDITING
LO 7: AUDITING AROUND COMPUTERS VS. AUDITING THROUGH COMPUTERS: ✯

Auditing Around Computers:
“Auditing Around Computers” means that client’s ‘internal’ software is not audited. Auditor agrees
inputs of the system with output and compares actual output with expected output.
This method of auditing increases audit risk because:

 Auditor has no direct evidence that the programs are working correctly because actual
program files of system are not tested.
 Where errors are found in reconciling inputs to outputs, it may be difficult or even
impossible to determine how those errors occurred.
Auditing Through Computers:

“Auditing Through Computers” means that the auditor uses various techniques (e.g. CAATs) to
evaluate client’s computerized information system to determine reliability of its operations
(alongwith its output).

As data is stored electronically it may be difficult to trace transactions from the detail to the summary. For example a
report may claim to show TOTAL SALES for the month but there is no way to check manually that every single invoice has
been included unless each transaction is logged. This ability to track transactions through various reports is known as
audit trail.
Required:
Discuss ‘Round the Computer Audit’ and ‘Through the Computer Audit’. (08 marks)
(ICAP, CAF 09 Level – 2005 Autumn)
LO 8: COMPUTER ASSISTED AUDIT TECHNIQUES (CAATs): ✯✯

Computer Assisted Audit Techniques (CAATs):
CAATs are the use of computer techniques by auditor to perform procedures and obtain audit
evidence.
There are two types of CAATs which are commonly used by auditors:
1. Test Data (used in Tests of Control)
2. Audit Softwares (used in Substantive Procedures)
Advantages of CAAT:
1. Enables auditor to test program controls (i.e. “auditing through computers”) and not just
copies or printouts.
2. Enable auditors to test a large volume of data accurately and completely.
3. Reduce level of human errors in performing audit procedures.
4. Reduces efforts on routine work and gives opportunity to concentrate on judgmental areas.
Disadvantages of CAAT:
1. Expensive to set up (Cost of CAAT includes purchase cost of infrastructure, cost of programs
and cost of training of staff).
2. Require co-operation of the client.
3. Client’s system may not be compatible with audit softwares.
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4. Checking client’s original files ‘lively’ may increase risk of files being corrupted. If client
gives a copy of files, these may not be genuine.

(i) Explain the potential advantages of using CAATs; and (04 marks)
(ii) Explain the potential disadvantages of using CAATs. (04 marks)
LO 9: TEST DATA AND AUDIT SOFTWARES: ✯✯

Test Data:
Definition:
Test data is a set of dummy transactions developed by auditor and processed by client’s IT system.
After processing, auditor compares actual results with expected results to determine whether
controls are operating effectively.
Examples of Use:
Test Data can be used in any area of financial statements for following purposes:
 In performing tests of controls e.g. to ensure credit limit is observed by client.
Problem with Test data:

A problem with test data is that it provides evidence about operation of controls only at the time
when test data is processed. (its solution is use of Embedded Audit Facilities).
Audit Softwares:
Definition:
Audit Softwares are computer programs used by the auditor to interrogate (i.e. to verify)
information in client’s IT system for use in audit work. Their principle objective is substantive
testing.
Examples of Use:
Audit Softwares can be used in any area of financial statements for following purposes:
 In Analytical Procedures (e.g. in variance analysis, turnover ratios, trend analysis).
 In Sampling (e.g. stratification, sample selection).
 In determination of Materiality.
 In detection of unusual items.
 In drafting report
Types of Audit Softwares:

Following are main types of Audit Softwares:
 Interrogation programs: These are used to access the client’s files and records and to
extract data for auditing. These could be:
o Package programs (or generalised audit software): These are pre-prepared programs.
o Purpose-written programs: These are used to perform specific functions of the auditor’s
choice.
 Interactive software: These are used in interrogation of on-line IT systems.
 Embedded Audit Facilities
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Embedded audit facilities

(also called “integrated audit facility” or “resident audit software”)
It is auditor’s computer programs that is built into the client’s IT system to allow the audit to carry out
tests at the time transactions are processed in ‘real time’. In this approach, a dummy department is built
into client’s accounting system that operates every time the ‘live’ process is run and stores information in
a secured file.
Embedded Audit Facilities are suitable when:

 Database is continually processed and master file is continually updated in real time by client.
 Paper Audit Trail is not available after the processing of transactions.
Exam Tip
Benefits and Problems of using “Audit Software” are the same as advantages and disadvantages of CAAT.

Explain the term ‘audit software’. (02 marks)
Explain the benefits of using audit software in the audit. (04 marks)
You are also considering using audit software as part of your substantive testing of the data files in the sales and
inventory systems of Porthos.
(i) List and briefly explain some of the difficulties of using audit software; (04 marks)
(ii) List the audit tests that you can program into your audit software for the sales and inventory system in Porthos,
explaining the reason for each test. (06 marks)
Briefly describe the following concepts:

(a) Audit trail in a computerized environment (03 marks)
(b) Embedded audit facilities and its significance (04 marks)
PART D – FLOWCHARTS
LO 10: TYPES AND LEVELS OF FLOWCHARTS: ✯✯

Types of Flowchart:
Linear Flowchart.
 A Linear Flowchart is a diagram that displays the sequence of activities that make up a
process.
 This tool can help to identify redundant or unnecessary steps within a process
Opportunity Flowchart
 An Opportunity Flowchart differentiates process activities that add value from those that
add cost only.
 Activities that add value: These are essential for producing the required product or service.
Without them, output cannot be produced.
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 Activities that add cost only: These are not essential for producing the required product or
service. They are added to a process to avoid something wrong e.g. end-of-process review,
or waiting for approval.
Deployment Flowchart.
 A Deployment Flowchart shows the actual process flow and identifies the people or groups
involved at each step.
 This type of chart shows where the people or groups fit into the process sequence, and how
they relate to one another throughout the process.
Levels of Flowchart:
Macro level:
 This is a “big picture” of flowchart for top level management who broadly need to know
what the system does.
 Generally, a macro-level Flowchart has six or fewer steps.
Mini/Midi Level:
 This is a flowchart between Macro and Micro.
 It focuses only on one part of the Macro level flow chart.
Micro/Ground Level:
 This provides detailed presentation of a specific portion of the process by documenting
every action and decision.
 This is used to chart how a particular task is performed.

Describe deployment and opportunity flowcharts. (04 marks)
LO 11: APPROACH TO DRAWING A SUCCESSFUL FLOWCHART: ✯

1. Observe the process to be documented (specially where to start and where to end)
2. Record steps in the process (in narrative form e.g. step 1, step 2 etc.)
3. Arrange the sequence of steps (steps may be different for different people but it should be
logical)
4. Draw flowchart using standardized Symbols.
5. Check accuracy and completeness of flowchart using a “test data”.

In order to take full advantage of a Flowchart one should be aware of the mistakes made when drawing/designing
flowchart.
Required:
List at least five points to be considered for producing correct and meaningful flowchart. (05 marks)
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LO 12: SYMBOLS USED IN FLOWCHARTS AND THEIR MEANINGS: ✯
Shape Symbol Function/When to use
Oval This shows Start Point, and End Point of flowchart.
Rectangular This shows individual activity/process/instruction in the process

Box i.e. what to do.
This shows decision point. Decision is in Yes/No Form (like ‘if’

Diamond
command in excel).
Arrow / Flow-
This shows directional flow of the process.
line
Circle is a connector symbol used to show connection between
Circle two parts of a flow charts without drawing a connection line.
A letter/number inside circle clarifies continuation.
Pentagon is a connector symbol like circle to show connection
between two parts of a flow charts without drawing a connection
Pentagon
line. However, it connects different steps on different pages.
A letter/number inside circle clarifies continuation.

The flowchart is a mean of visually presenting the flow of data through an information processing system, the operations
performed within the system and the sequence in which they are performed.
Required:
(a) Draw and briefly explain five symbols commonly used in a flowchart. (05 marks)
(b) Identify the advantages of using flowcharts. (05 marks)
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Auditing – Study Notes Chapter 14 External Confirmation
CHAPTER FOURTEEN
EXTERNAL CONFIRMATION
LO 1
DEFINITION AND USE OF EXTERNAL CONFIRMATION
✯
LO 2
MATTERS TO BE CONSIDERED WHEN USING CONFIRMATION REQUEST
✯
LO 3
DECIDING TYPE OF CONFIRMATION
✯✯
LO 4
AUDIT PROCEDURES FOLLOWING THE RECEIPT OF REPLIES
✯✯✯
LO 5 AUDITOR’S PROCEDURES IF MANAGEMENT REFUSES TO ALLOW AUDITOR TO
✯✯ SEND CONFIRMATION REQUEST
LO 6
BANK CONFIRMATION LETTER
✯
46c (Zakir Co) 102a (ISA 500)

55b (IT Department) 109c & di (Sahito Co)
73 (Direct confirmations 1) 111h (Multiple Situations)
80 (Direct confirmations 2) 126f (Multiple Questions)
Question Bank:
69 (Sehat Pharmaceutical Limited) 109dii (Sahito Co)

89 (MWL)
135
LO 1: DEFINITION AND USE OF EXTERNAL CONFIRMATION: ✯

Definition:
External confirmation is a process of obtaining evidence by auditor directly from a third party in
written (on paper, electronic or other medium).
Examples of situations where external confirmation is used:

Usually, confirmation procedure is used to confirm information from Debtors, Creditors, Banks,
Lawyers, Inventories held by third parties, and investments held by brokers.
Objective of using External Confirmation:

External confirmation is used in most of audit because it provides highly reliable evidence (being
written, external and direct evidence) about:
 certain information (e.g. account balances, specific transactions, and other terms and
conditions of transactions)and
 certain assertions (e.g. it provides strongest evidence about Existence. It may also provide
evidence about Completeness if major parties with small balances are selected).
However, confirmation provides weak evidence about ‘Rights and Obligation’, and ‘Valuation
and Allocation’.
Whether or not to use Confirmation in obtaining Audit Evidence:

External confirmation is a frequently used audit procedure. However, it is not a required procedure
and auditor may omit it in following situations:
i. When Inherent Risk and Control Risk both are assessed as low, or
ii. When balance is not material, or
iii. When response is not expected to be adequate or reliable (e.g. if confirming party does
not have ability, objectivity or willingness to respond) , or
iv. When sufficient appropriate evidence can be obtained from other substantive
procedures, or
v. When management requests auditor not to send confirmation request and there is a
reasonable justification for this.
Exam Tip
Be careful for difference between following situations:
 Auditor decides not to use confirmation in obtaining evidence.
 Client insists auditor not to send confirmation.
 Confirming party does not reply to a confirmation request.
Procedures to be performed at year end, if confirmation is used at interim date:

Confirmation is usually sent at year end. However, it may also be used at interim date. If
confirmation is used at interim-date, following further procedures are performed at year end to
ensure that intervening transactions are not materially misstated:
1. Obtain break-up of balances (i.e. party wise detail) at year end along with summary of
transactions with each party between interim date and final date.
2. Agree sum of individual transactions with control account.
3. Compare individual balances as on year end with balances as on interim date, and
investigate unusual variations.
4. Select a sample of transactions (e.g. sales and receipts) and perform tests of controls to
ensure operating effectiveness of control after interim period.
136
5. Select a sample of material transactions (e.g. sales and receipts) and vouch them with
supporting documents.
6. Perform cut-off test at year end.
7. Check subsequent recovery of year-end balances.

Define external confirmations. Explain the purpose of using external confirmations by the auditors during an audit of
financial statements and also identify any four (04) situations where auditor can use direct confirmations. (06 marks)
(ICMA Pakistan, Professional Level P2 – February 2014)
You are the Manager on the audit of Ghazi Power Limited (GPL), a gas transmission and distribution company, for the
year ending 31 October 2011. On the company’s request, your firm has agreed to complete the audit by 20 November
2011.
What audit procedures should be performed at the year end, if requests for confirmation of balances are sent on 31
August 2011? (07 marks)
LO 2: MATTERS TO BE CONSIDERED WHEN USING CONFIRMATION REQUEST: ✯

If auditor decides to use external confirmation to obtain evidence, auditor shall consider following
matters:
1. Decide timing of confirmation (i.e. whether to be used at interim date or at final date).
2. Select appropriate confirming parties (for this purpose population should be stratified, and
a suitable sample should be selected considering each category).
3. Design confirmation request to be sent i.e.
 Decide the information and assertion to be confirmed.
 Decide method of confirmation (i.e. whether positive or negative)
 Obtain Authorized signature of CFO (or other responsible official).
 Request confirming party to send reply directly to auditor.
4. Appropriate procedures should be performed (depending on reply) on replies received.

Direct confirmations of balances due from customers are obtained to satisfy the objective of ensuring that the customer
exists and owes the specified amount to the company at a certain date.
Required:
(a) State the circumstances in which an auditor may decide not to circulate the requests for direct confirmation.
(05 marks)
(b) What are the factors that an auditor considers while designing the requests for direct confirmation? (05 marks)
(c) Describe the alternative audit procedures which may be conducted if the customer does not reply to a request for
confirmation. (06 marks)
LO 3: DECIDING TYPE OF CONFIRMATION: ✯✯

Broadly, there are two types of confirmation requests which are used by auditors i.e.
1. Positive Confirmation Request and
2. Negative Confirmation Request
Positive Confirmation Request:

Definition:
A positive confirmation request asks confirming party to reply auditor in all cases whether he
agrees or disagrees with the information provided in the request.
137
Risk in positive confirmation:

There is a risk in positive confirmation that confirming party may reply without due verification.
This risk can be reduced by sending a blank confirmation (i.e. a confirmation without amount or
information; confirming party is asked to fill it himself).
Negative Confirmation Request:

Definition:
A negative confirmation request asks confirming party to reply auditor only if he disagrees with the
information provided in the request.
Risk in negative confirmation:

Negative confirmation is less reliable because there is no explicit evidence that confirming party
received and verified confirmation. Confirmation may be lost or disregarded by party.
Therefore, negative confirmation is used in combination with positive confirmation. However, it can
be used as sole substantive procedure only when all of following conditions are met:
1. Relevant population consists of large number of small account balances.
2. Inherent risk and control risk are low, and auditor has obtained evidence about operating
effectiveness of controls.
3. A very low exception rate is expected, and
4. Auditor is not aware of any circumstances that confirming party will disregard such
requests.

Direct confirmations from third parties provide independent audit evidence that certain account balances and items in
the financial statements are properly recorded and disclosed.
Required:
(a) Distinguish between positive and negative confirmations. (02 marks)
(b) Briefly describe the risks associated with each of the above type of confirmation and the steps that an auditor usually
takes to avert such risks. (05 marks)
(c) Explain why and under what circumstances an auditor may decide to use negative confirmation requests. Also,
identify the circumstances where the auditor may use a combination of positive and negative confirmations. (06 marks)
LO 4: AUDIT PROCEDURES FOLLOWING THE RECEIPT OF REPLIES: ✯✯✯

When evaluating the results of external confirmation requests, the auditor may categorize such
results as follows:
a) A response indicating agreement
b) A response indicating exception
c) A non-response of positive confirmation.
A response indicating agreement:

If response indicates agreement, it forms sufficient appropriate audit evidence. No further work is
required.
138
A response indicating exception/disagreement:

If there is an exception (i.e. difference between information requested to be confirmed and
information provided by the confirming party), auditor shall ask client to reconcile the balances in
its records with the balances confirmed by the parties.
Reconciliation prepared by client should be checked to determine whether this exception is

because of:
− timing difference (i.e. cash in transit or goods are in transit), or
− misstatements in record of third party, or
− misstatement in accounts of client
Auditor shall also consider:

 whether it is indicative of fraud or deficiencies in internal control, and
 if so, whether there is need to revise his risk assessment.
A non-response of positive confirmation:

In cases of non-response of positive confirmation within a reasonable time, follow-up procedures
should be initiated (e.g. sending 2nd request letter, or asking client to contact party and ask for
reply). If response is still not received, auditor shall perform following alternative audit procedures
to obtain evidence e.g.
Alternative procedures if positive confirmation from accounts receivable is not received:

1. Examine cash received from customer after the balance sheet date. Obtain explanation for
cash not received within credit period.
2. If cash is not received or partly received from customer, auditor shall inspect customer
signed sales orders, sales invoices, Goods Dispatch Notes and other documents
acknowledged by customer.
3. Perform cut-off test by examining sales near balance sheet date.
4. If any amount is disputed, examine correspondence with receivable, lawyer opinion,
appropriateness of provision.
Alternative procedures if positive confirmation from accounts payable is not received:

1. Examine cash paid to supplier after the balance sheet date. Obtain explanation for cash not
paid within credit period
2. If cash is not paid or partly paid to supplier, auditor shall inspect valid supporting
documents e.g. supplier signed purchase orders, suppliers’ invoices, Goods Received Notes
and other documents.

In the course of verification of ‘trade creditors’ of Mirpur Limited, you sent fifteen positive confirmations to the suppliers.
The results have been summarized as under:
(i) Three suppliers confirmed the balance. You came to know that bulk of the sales of these suppliers is made to Mirpur
Limited.
(ii) Five suppliers confirmed the balances over telephone.
(iii) No replies have been received from the remaining suppliers.
Briefly discuss how you would deal with each of the above situations. (09 marks)
139
LO 5: AUDITOR’S PROCEDURES IF MANAGEMENT REFUSES TO ALLOW AUDITOR TO SEND

CONFIRMATION REQUEST TO A PARTY: ✯✯
If management refuses to allow the auditor to send a confirmation request, the auditor shall inquire
reason for refusal from management (e.g. it may be a legal dispute or ongoing negotiation) and shall
seek evidence for validity and reasonableness of reason.
If refusal is reasonable:
Auditor shall try to perform alternative audit procedures (discussed above) to obtain evidence. If
auditor is unable to obtain evidence from alternative procedures, it will be a scope limitation.
Auditor shall express Qualified opinion (if effect is material) or Disclaimer of opinion (if effect is
pervasive).
If refusal is not reasonable:

If auditor is unable to obtain evidence from alternative procedures, it will be a scope limitation.
Auditor shall express Qualified opinion (if effect is material) or Disclaimer of opinion (if effect is
pervasive).


Discuss the auditor’s course of action if management refuses to allow auditor to send confirmation request. (Impact on
audit report is not required). (05 marks)
LO 6: BANK CONFIRMATION LETTER: ✯

Following information is normally requested by the auditor in a bank confirmation request:
Information regarding bank accounts:

1. Full Title and account number of all bank accounts held in the name or joint name of client,
along with balances therein, as on year end.
2. For all accounts closed during the period, full titles and dates of closure.
3. The separate amounts of interest credited/charged during the period
4. Details of unpaid bank charges.
5. If there is any restriction on bank accounts, information regarding nature and extent of
restriction.
Information regarding overdrafts/loans:

1. Details of overdrafts and loans.
2. Details of any assets held as security by bank including type of charge, (e.g. pledge,
hypothecation, mortgage)
3. Terms of Interest/Markup.
4. Repayment Schedule.
140
Information regarding contingent liabilities:

1. Details of contingent liabilities (e.g. bills discounted)
2. Total of Letter of Guarantees.
3. Total of letters of credits.
Additional Information:
A list of other banks, or branches of your bank, where you are aware that a relationship has been
established during the period.

Identify any eight types of information which you would verify from the confirmations received directly from the bank.
(08 marks)
141
Auditing – Study Notes Chapter 15 Analytical Procedures
CHAPTER FIFTEEN
ANALYTICAL PROCEDURES
LO 1
DEFINITION, EXAMPLES, AND USES OF ANALYTICAL PROCEDURES
✯✯
LO 2
USE OF ANALYTICAL PROCEDURE – EXPLANATION
✯✯✯
LO 3
INCONSISTENCIES OR FLUCTUATIONS IN ANALYTICAL PROCEDURES
✯✯
46a (Zakir Co) 127a (Analytical procedures)

72 (Sky blue)
Question Bank:
97a (Analytical procedures and materiality)
142
LO 1: DEFINITION, EXAMPLES, AND USES OF ANALYTICAL PROCEDURES: ✯✯

Definition of Analytical Procedures:
Analytical Procedures means evaluation of financial information through comparisons and analysis
of plausible relationships with other financial and non-financial information. Analytical procedures
also include investigation if actual values are significantly different from expected values.
Examples/Types of Analytical Procedures:

Analytical procedures include the consideration of comparisons, for example comparison of entity’s
financial information with:
 Comparable information of prior periods (to identify unusual fluctuations).
 Comparable industry information (e.g. comparison of debtors’ turnover ratio with industry
or competitors).
 Comparable parts of the same entity (e.g. comparing results of different branches/divisions
within the same entity).
 Budgets of the entity.
 Expectations of the auditor (e.g. estimate of depreciation).
Analytical procedures also include consideration of relationships, for example:

 Among elements of financial information that have predictable pattern, e.g. GP Ratio.
 Between financial information and relevant non-financial information, such as payroll costs
to number of employees.
Use/Purposes of Analytical Procedures:

At Planning stage as risk assessment procedures: (also called Preliminary Analytical Procedures)
Analytical procedures are used at the beginning of the audit to help the auditor obtain an
understanding of the entity and assess the risk of material misstatement.
As substantive procedures: (also called Substantive Analytical Procedures)

Analytical procedures can be used as substantive procedures (in combination with tests of details)
to obtain evidence that assertions of account balances or classes of transactions are free from
material misstatements.
At end of audit in forming overall conclusion: (also called Final Analytical Procedures)
Analytical procedures help the auditor at the end of the audit in forming an overall conclusion as to
whether the financial statements as a whole are consistent with the auditor’s understanding of the
entity.
Limitations of Analytical Procedures:

1. A good knowledge of client business is required to understand results.
2. Figures used to perform analytical procedures must be logically related to each other.
3. Consistency of results may conceal an error in both periods.
4. Requires an experienced member of staff to be done properly.
5. Reliable data may not be available.
6. Lack of comparability if business is growing or changing.
7. Its usefulness depends on quality of underlying financial information.
143

With reference to ISA 520 Analytical Procedures explain
(i) what is meant by the term ‘analytical procedures’; (02 marks)
(ii) the different types of analytical procedures available to the auditor; and (03 marks)
(iii) the situations in the audit when analytical procedures can be used. (03 marks)
Set out the benefits and limitations of using analytical procedures at the planning stage of an external audit. (05 marks)
LO 2: USE OF ANALYTICAL PROCEDURE – EXPLANATION: ✯✯✯

Use of Analytical Procedures at Planning stage as risk assessment procedures:
Analytical procedures are used at the beginning/planning stage of the audit:
 To obtain an understanding of the entity.
 To identify areas of high risk.
 To help auditor to determine audit approach.
 To identify any aspect of entity of which auditor is unaware.
 To identify unexpected changes from the prior period.
Use of Analytical Procedures as substantive procedures:

There are two types of substantive procedures i.e. analytical procedures and tests of details. If
auditor decides to use analytical procedures as substantive procedures, auditor shall perform
following steps:
1. Determine the suitability of analytical procedures for given assertion:
It means how effective they will be in detecting a particular type of misstatement in that
assertion. Analytical procedures are effective when relationships are predictable and plausible
e.g. relationship between selling commission and sales revenue (however there is no
predictable relationship between admin expense and sales revenue).
2. Evaluate the reliability of data from which auditor’s expectation is developed:

Reliability of data for analytical procedures is influenced by following factors:
 Source of information available (e.g. information from independent source is more reliable)
 Nature and Relevance of information available (e.g. budget can be used if they are prepared
as results to be expected and not as challenging goals to be achieved).
 Controls over preparation of information (to ensure its accuracy and completeness)
 Comparability of financial information (e.g. broad industry data may need to be
supplemented to be comparable for company selling single product)
3. Develop an expectation of recorded amount which is sufficiently precise to identify

misstatement:
Precise expectation depends on:
 Availability of the information, both financial and non-financial
 Degree to which information can be disaggregated
 Accuracy with which expected results can be predicted
4. Determine the amount of difference which is acceptable without further investigation

Acceptable difference is influenced by Materiality, Risk Assessment and Desired Level of
Assurance.
144
Use of Analytical Procedures at end of audit in forming overall conclusion:

Auditor performs analytical procedures at the end of audit:
 To form an overall conclusion whether financial statements as a whole are consistent with
auditor’s understanding of entity.
 To corroborate conclusions formed through other procedures performed during the audit of
individual components.
 To identify previously unrecognized risk of material misstatement. If a previously
unrecognized risk is identified, auditor shall revise its risk assessment and shall modify further
audit procedures accordingly.

State the factors which determine the extent to which an auditor may use Analytical procedures as a form of substantive
audit evidence. (04 marks)
An auditor has to rely on various kinds of data while performing analytical procedures. The reliability of data is influenced
by a number of factors. List out the main factors with examples. (04 marks)
The analytical procedures which are carried out near the end of the audit usually assist the auditor in forming an overall
conclusion on the financial statements.
Required:
State the objectives which an auditor expects to achieve while applying analytical procedures at the end of an audit.
(04 marks)
LO 3: INCONSISTENCIES OR FLUCTUATIONS IN ANALYTICAL PROCEDURES: ✯✯

If relationships are inconsistent with other information or difference between expected value and
actual value is significant, auditor shall investigate the difference by:
1. Inquiring of management,
2. Obtaining evidence to corroborate management’s response. This evidence is obtained by
taking into account:
 auditor’s understanding of entity and its environment and
 other audit evidence obtained during audit
3. Perform other audit procedures (e.g. tests of details) if:
 management is unable to provide an explanation, or
 explanation together with the audit evidence obtained is not considered adequate.

The analytical procedures which are carried out near the end of the audit usually assist the auditor in forming an overall
conclusion on the financial statements.
Required:
Discuss the course of action an auditor should adopt when results of analytical procedures identify inconsistent
relationships or differ from expected values by significant amounts. (04 marks)
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Auditing – Study Notes Chapter 16 Related Parties
CHAPTER SIXTEEN
RELATED PARTIES
LO 1
DEFINITION OF RELATED PARTY AND RELATED PARTY TRANSACTIONS
✯
LO 2
RESPONSIBILITIES OF MANAGEMENT AND AUDITOR REGARDING RELATED PARTY
✯
LO 3 PROCEDURES TO ENSURE ALL RELATED PARTY RELATIONSHIPS AND
✯✯✯ TRANSACTIONS ARE IDENTIFIED AND DISCLOSED IN FINANCIAL STATEMENTS
LO 4
RISKS IDENTIFIED AND AUDITOR’S COURSE OF ACTION
✯✯✯
LO 5 MATERIALITY, WRITTEN REPRESENTATION, COMMUNICATION WITH TCWG AND
✯ D OCUMENTATION
78 (Related parties) 111c (Multiple Situations)

79 (Kamil Limited) 113a (Energy Limited)
82 (Al-Shams) 126i (Multiple Questions)
86 (RP planning)
Question Bank:
146
LO 1: DEFINITION OF RELATED PARTY AND RELATED PARTY TRANSACTIONS: ✯

Related Parties:
A related party is either a party as defined in AFRF. If AFRF establishes no or minimum
requirements, related party is:
 A person or entity which has control or significant influence over audit client.
 An entity over which audit client has control or significant influence.
 An entity which is under common control with audit client through common key
management, common controlling ownership, and owners who are close family members
(however, entities under common control by a state are not considered related in this
regard).
Examples of related parties include directors, majority shareholders, holding company, subsidiary,
associated company.
Related Party Transactions:

Related party transactions are transactions between the client company and a related party of the
company.

What is a related party and a related party transactions? (04 marks)
LO 2: RESPONSIBILITIES OF MANAGEMENT AND AUDITOR REGARDING RELATED PARTY: ✯

Responsibilities of Management:
If AFRF establishes related party requirements, responsibility of management will be to identify,
account for and disclose related party relationships and transactions in accordance with AFRF.
Responsibilities of Auditor:
Auditor is not responsible to identify all related party relationships and transactions as these
provide higher risk of material misstatement because:
1. Management may not be aware of all related party relationships/transactions (particularly
if AFRF does not require management to identify/disclose).
2. Management may intentionally conceal related party relationships/transactions for fraud.
3. Information systems may not be able to separately identify transactions of related parties.
4. Related party transactions may be conducted at immaterial amounts or even without
consideration.
Auditor is responsible to evaluate:

1. whether related party relationships/transactions have been appropriately identified,
accounted for and disclosed in accordance with AFRF.
2. whether fraud risk factors arising from related party relationships exist, and
3. whether financial statements present true and fair view in respect of related party
relationships.

Explain the inherent limitations which mean that auditors may not identify related parties and related party transactions.
(04 marks)
147
LO 3: PROCEDURES TO ENSURE ALL RELATED PARTY RELATIONSHIPS AND TRANSACTIONS

ARE IDENTIFIED AND DISCLOSED IN FINANCIAL STATEMENTS: ✯✯✯
1. Auditor shall inquire of management regarding:
 Identification of related parties, including changes from the prior period
 Relationships with related parties; and
 Transactions with related parties
2. Auditor shall inquire management and shall perform other risk assessment procedures to
obtain understanding of client’s controls over:
 Identification, accounting for and disclosure of related party relationships and
transactions.
 Approval of significant transactions with related parties.
 Approval of significant transactions outside normal course of business.
3. Auditor shall inquire about affiliation of TCWG, directors and other officers with other
entities.
4. Auditor shall review working papers for previous years for known related parties.
5. Auditor shall inquire component auditor or predecessor auditor about their knowledge of
additional related parties (if applicable).
6. Auditor shall remain alert when inspecting records or documents, including:
 Bank and legal confirmations obtained as part of the auditor’s procedures;
 Minutes of meetings of shareholders and of those charged with governance; and
 Such other records or documents as the auditor considers necessary in the
circumstances e.g.
o Third-party confirmations (in addition to bank and legal confirmations).
o Register of shareholders to identify principal shareholders.
o Entity’s income tax return and other information supplied to regulatory bodies.
o Records of the entity’s investments and those of its pension plans.
o Significant contracts and agreements not in the entity’s ordinary course of
business.
o Register of directors/officers.
o Significant contracts re-negotiated by the entity during the period.
o Published documents by company (e.g. financial statements of prior period,
prospectuses).

Specify the procedures that an auditor should perform to ensure completeness of the list of related parties provided by
the directors. (06 marks)
148
LO 4: RISKS IDENTIFIED AND AUDITOR’S COURSE OF ACTION: ✯✯✯

Risk Identified Auditor’s course of action/procedures to address risk
Auditor shall perform following procedures when he identifies a previously
unidentified related party relationship/transaction:
 Promptly communicate the relevant information to other members of
engagement.
 If AFRF establishes related party requirements:
If auditor identifies
 Request management to identify all transactions with newly identified
related party
related party, and disclose them accordingly.
relationships or
 Inquire as to why entity’s process and controls failed to identify or disclose
transactions not
such related party relationship/transaction.
identified by
 Perform appropriate substantive procedures on newly identified related party,
management:
and/or significant related party transactions.
 Reconsider risk of completeness of related party information because other
unidentified related parties may also exist.
 If non-disclosure appears intentional, reconsider risk of fraud and other
implications on audit.
For significant transactions that are outside the normal course of business or that
appear unusual, auditor shall evaluate whether a related party is involved and
whether they have appropriate business rationale or have been entered to engage
in fraudulent financial reporting or conceal misappropriation of asset.
For such transactions, auditor shall:

If auditor identifies
(a) inspect underlying contracts or agreements and shall evaluate whether:
significant transactions
i. Transaction is entered to engage in fraudulent financial reporting or
outside the normal
misappropriation of assets (lack of business rationale may indicate this).
course of business.
ii. Terms of the transactions are consistent with management’s
explanations.
iii. Transactions have been appropriately accounted for and disclosed in
accordance with the AFRF.
(b) Obtain audit evidence that transactions have been appropriately
authorized (e.g. by TCWG).
1. Auditor shall inquire about management’s process to support assertion, and
shall evaluate appropriateness of process, and reasonableness of significant
assumptions on which assertion is based.
If management states
2. Auditor shall obtain internal and external data used in support of assertion and
that transactions with
shall test data to determine its accuracy, completeness and relevance.
related party are on
3. Auditor shall obtain terms of transactions with related party, and shall
arm’s length.
compare them with market terms and conditions (if market exists), or terms of
transactions with unrelated parties (if no market exists).
4. Auditor may also engage an expert to evaluate assertion.
Any such party may override the views of entity’s management and force entity to
If there is a related party
enter into a transaction in which dominant party has an interest. If there is a
with dominant
related party with dominant influence, auditor shall inspect significant contracts of
influence***
entity with such related party.
149
***Indicators of dominant influence exerted by a related party include:

 If the related party has played a leading role in founding the entity and continues to play a
leading role in managing the entity.
 Significant transactions are referred to the related party for final approval.
 The related party has vetoed significant business decisions taken by management or those
charged with governance.
 There is little or no debate among management and those charged with governance
regarding business proposals initiated by the related party.
 Transactions involving the related party are rarely independently reviewed and approved.

Give four examples of situations that may be indicative of dominant influence exerted by a related party. (04 marks)
A schedule of related party transactions provided by the client includes two significant transactions which are outside the
normal course of business. State the substantive procedures that an auditor should undertake, in respect of these
transactions. (04 marks)
You are the audit manager on the audit of a listed company, Kamil Limited (KL). Prior to completion of audit, you came
across a prospectus issued by Neelum Limited (NL) according to which a director of KL is the chief executive of NL.
However, the name of NL was not included in the list of related parties provided by KL. On being confronted the
management has advised that the name was omitted inadvertently as the appointment took place just two months prior
to the year end.
Required:
Discuss your course of action in the above situation. (07 marks)
LO 5: MATERIALITY, WRITTEN REPRESENTATION, COMMUNICATION WITH TCWG AND

DOCUMENTATION: ✯
Materiality:
Transactions with related parties are usually considered material irrespective of size of transaction
(e.g. sale of company’s assets to related party at nominal amount).
Written Representation:
If AFRF establishes related party requirements, auditor shall obtain written representations from
management (and TCWG where appropriate) that:
1. They have disclosed to the auditor the identity of the entity’s related parties and all the
related party relationships and transactions of which they are aware
2. They have appropriately accounted for and disclosed such relationships and transactions in
financial statements in accordance with the requirements of the framework.
Communication with TCWG:

Auditor shall communicate TCWG significant matters regarding Related Parties e.g.:
 Non-disclosure (whether intentional or not) by management to the auditor of significant
related party relationships or transactions.
 Significant related party transactions that have not been appropriately authorized and
approved.
 Disagreement with management regarding the accounting for and disclosure of significant
related party transactions in accordance with AFRF.
150
 Non-compliance with laws and regulations (e.g. entering in prohibited transactions with
related parties).
Documentation:
The auditor shall include in the audit documentation:
 Names of identified related parties
 Nature of relationships with related parties
151
Auditing – Study Notes Chapter 17 Audit Sampling
CHAPTER SEVENTEEN
AUDIT SAMPLING
LO 1
SELECTING ITEMS FOR TESTING
✯✯
LO 2
RELATIONSHIP BETWEEN SAMPLING AND AUDIT RISK MODEL
✯✯
LO 3
STEPS IN SAMPLING
✯
LO 4
SAMPLE DESIGN
✯✯✯
LO 5
SAMPLE SIZE
✯✯✯
LO 6
PERFORMING AUDIT PROCEDURES ON SAMPLE
✯
LO 7
PROEJCTING, AND EVALUATING RESULTS OF SAMPLING
✯
67a (Verification of Evidences) 88ii (Framework)
75b (Sales sampling) 91a (Taskeen Co)
84a (ADL) 126e (Multiple Questions)
Question Bank:
67b (Verification of Evidences) 84b (ADL)
68 (Rehan Limited) 91b (Taskeen Co)
75a (Sales sampling)
152
LO 1: SELECTING ITEMS FOR TESTING: ✯✯

Following are different means of selecting items for testing:
1) 100% Selection (i.e. selecting all items for examination)
2) Specific item selection (or Judgmental selection)
3) Audit sampling
100% Selection:
100% examination of population may be done in Tests of Details but not in Tests of Controls. It may
be appropriate when:
o Population consists of small number of large values items or
o There is a significant risk which cannot be reduced by other means or
o 100% examination becomes cost effective due to repetitive nature of calculation or
automatic performance by an information system.
Specific item selection (or Judgmental selection):

The auditor may decide to select specific items for examination in the following circumstances:
All items over a certain amount:

The auditor may decide to examine items whose recorded values exceed a certain amount so as to
verify a large proportion of the total amount of a class of transactions or account balance.
Key items showing certain characteristics:

Auditor may selects items which exhibit some characteristic, for example, items that are suspicious,
unusual, particularly risk-prone or that have a history of error.
Items to obtain information about entity:

It is used when auditor intends to obtain information about matters such as the nature of the entity
or the nature of transactions.
Audit Sampling:
Audit sampling:
Audit Sampling is the application of audit procedures to less than 100% of
items within a population in such a way that all sampling units have a chance
of selection. Objective of sampling is to provide auditor a reasonable basis to
draw conclusions about entire population.
Auditor uses audit sampling in Tests of Controls and Tests of Details.

Narrate the circumstances under which the auditor would resort to the following techniques while selecting items
for tests of details and controls:
(i) Selecting all items of a population. (03 marks)
(ii) Selecting specific items from a population. (05 marks)
153
LO 2: RELATIONSHIP BETWEEN SAMPLING AND AUDIT RISK MODEL: ✯✯

Detection risk arises because of two components/reasons:
 Sampling risk
 Non-Sampling risk
Therefore, to reduce detection risk, it is necessary to understand and reduce sampling risk and non-
sampling risk.
Sampling Risk:
Definition:
“Sampling risk is the risk that auditor’s conclusion based on sampling might be different from the
conclusion if entire population would have been tested.”
Two Types of Erroneous Conclusions in Sampling Risk:

1. Incorrect conclusions which may lead to increased audit procedures:
 In Tests of Controls, auditor erroneously concludes that controls are not operating
effectively (but actually they are).
 In Tests of Details, auditor erroneously concludes that population is not free from
material misstatement (but actually it is).
2. Incorrect conclusions which may lead to incorrect audit opinion:
 In Tests of Controls, auditor erroneously concludes that controls are operating
effectively (but actually they are not).
 In Tests of Details, auditor erroneously concludes that population is free from
material misstatement (but actually it is not).
How to reduce Sampling Risks:

Sampling risk can be reduced through:
 Increase in Sample Size.
 Stratification. (It is the process of dividing a population into subpopulations, each of which
is a group of sampling units which have similar characteristics, often monetary value.)
Non-Sampling Risk:
Definition:
“Non-sampling risk is the risk that auditor’s conclusion may be wrong for any reasons/errors other
than sampling risk e.g. due to errors by auditors or incompetence of audit team or meeting tight
deadline. “
Examples:
 Inappropriate selection of audit procedure.
 Inappropriate application of audit procedures.
 Inappropriate interpretation of results of audit procedures (i.e. failure to recognize a
misstatement/deviation).
How to reduce Non-Sampling Risk:

Non-sampling risk can be reduced through:
 Adequate planning
 Adequate application of professional skepticism
 Assigning more experienced and specialized staff e.g. use of experts if necessary.
 Adequate supervision and review of the audit work performed
154

Discuss the differences between sampling risk and non-sampling risk (02 marks)
What do you understand by the term “sampling risk”? Briefly describe the two types of sampling risks and the effect
thereof on the audit as a whole. (05 marks)
How can an auditor reduce sampling and non-sampling risks in case of tests of control and substantive tests? (05 marks)
LO 3: STEPS IN SAMPLING: ✯
1) Sample Design
2) Performing Audit Procedures on Sample
3) Projecting Misstatements/Rate of Deviation
4) Evaluating results of Sampling
LO 4: SAMPLE DESIGN: ✯✯✯

Designing of audit sample includes making following decisions:
i. Determine Purpose and Population for Sampling.
ii. Define what constitutes a Deviation or Misstatement.
iii. Determine Tolerable Rate of Deviation and Expected Rate of Deviation (For Tests of
Controls)
iv. Determine Tolerable Misstatement and Expected Misstatement (For Tests of Details)
v. Determine Sampling Approach (i.e. whether Statistical or Non-Statistical)
vi. Determine Method of Selection (i.e. whether Systematic, Random or Haphazard)
vii. Determine sample size.
Determine Purpose and Population for Sampling:

Determining Purpose means deciding whether to perform sampling for tests of controls or tests of
details. Purpose then determines what would be relevant population.
Population is the entire set of data from which a sample is selected and about which
the auditor wishes to draw conclusions.
Sampling Unit is the individual items constituting a population.
Define what constitutes a Misstatement or Deviation:

In using sampling, misstatement or deviation may have different meanings depending on the
purpose of sampling.
Determine Tolerable Rate of Deviation and Expected Rate of Deviation:

Tolerable Rate of Deviation:
A rate of deviation from prescribed internal control procedures set by the auditor in respect of
which the auditor seeks to obtain an appropriate level of assurance that the actual rate of deviation
in the population does not exceed rate of deviation set by the auditor.
155
Expected Rate of Deviation:

Determination of Expected Rate of Deviation is based on following factors:
 the results of audit procedures applied in prior periods
 auditor’s understanding of the business (in particular, risk assessment procedures
undertaken to obtain an understanding of internal control).
 changes in personnel or in internal control.
 the results of other audit procedures.
Determine Tolerable Misstatement and Expected Misstatement:

Tolerable Misstatement:
It is the amount of misstatement (in financial statements) set by auditor for which auditor obtains
assurance that actual amount of misstatements in population does not exceed from this set-amount.
Expected Misstatement:
Determination of Expected Misstatement is based on following factors:
 results of audit procedures applied in prior periods.
 extent to which value of item is determined subjectively.
 results of risk assessment procedures.
 results of tests of control.
 results of other substantive procedures.
If the expected misstatement is high, 100% examination or use of a large sample size may be
appropriate when performing tests of details.
Determine Sampling Approach:

Auditor shall determine whether to use Statistical Sampling or Non-Statistical Sampling.
Statistical Sampling:
An approach of sampling is called Statistical Sampling, if it has following
characteristics:
i. Use of Random selection to select items, and
ii. Use of Probability theory to measure sampling risk and evaluate
results of sampling.
e.g. Random Selection, Systematic Selection
Non-Statistical Sampling: (or Judgmental Sampling)

A sampling approach that does not have characteristics of Statistical Sampling.
Instead of probability theory, it is based on judgmental opinion of auditor
about results of the sample e.g. Haphazard Selection.
Advantages Disadvantages
1. It is based on scientific techniques 1. Lacks human judgement and over-emphasize
2. Sample size can be calculated accurately and statistical conclusion. Therefore, some auditors
objectively (using statistical techniques) prefer to rely on their skills, experience and
3. Special softwares are available to help efficient judgments instead of statistical models.
Statistical execution. Therefore, it can be used by staff at 2. Investment, training and technical expertise are
Sampling all levels. required for statistical sampling.
4. The method is free from bias and can be 3. As the technique is not always understood, false
defended easily. conclusions may also be drawn.
5. It is a mean of efficient auditing in case of large
population.
156
1. As the approach is being used for many years 1. It is not based on any scientific technique. No
so it is well understood and refined by quantitative results are obtained.
Non- experience. 2. Personal bias in the selection of sample is
Statistical 2. No special knowledge of statistics is required. unavoidable.
Sampling 3. Saving of extra resources such as investment 3. There is no real logic behind the selection of the
on computer infrastructure. sample or its size. Therefore, it is difficult to defend
in some cases.
Determining Methods of Sample Selection:

In sampling, items should be selected in such a way that each sampling unit in population has an
equal chance of selection. Sample selection includes three methods:
Systematic Selection:
In this method, the number of sampling units in the population are divided by the sample size. This
gives a sampling interval (e.g. 50). Having determined a starting point within the first 50 items,
every 50th sampling unit thereafter is selected.
Random Selection:
In this method, items are selected using random numbers (e.g. using random number tables).
Haphazard Selection:
In this method, auditor selects the sample without following a structured technique. However,
auditor avoids any conscious bias or predictability to ensure all items have chance of selection.
Haphazard selection is not appropriate when using statistical sampling.
Block Sampling:
Block selection involves selection of a block of contiguous items from the population e.g. selecting
all sales invoices of a particular week.

What do you understand by:
(i) Statistical sampling; and (02 marks)
(ii) Stratification? (02 marks)
The purpose of audit sampling is to draw conclusions about the entire population. The auditor adopts different methods
to select a representative sample i.e. which has characteristics typical of the population. Briefly describe the principal
methods of selecting the samples. (09 marks)
While determining the sample size for tests of controls, the auditor takes into account the expected rate of deviation. State
the factors that are relevant to the auditor’s consideration of the expected rate of deviation. (04 marks)
157
LO 5: SAMPLE SIZE: ✯✯✯

Following factors influence determination of sample size:
Factors Effect on Sample Size

(Increase in) for Tests of Control
Tolerable rate of deviation Decrease
Expected Rate of deviation* Increase
Desired Level of Assurance Increase
Extent to which auditor plans to rely on controls Increase
Population Size Negligible
* If the expected rate of deviation is unacceptably high, the auditor will normally decide not to perform tests of controls.
Factors Effect on Sample Size

(Increase in) for Tests of Details
Tolerable misstatement Decrease
Expected Misstatement Increase
Risk of Material Misstatement Increase
Desired Level of Assurance Increase
Stratification of Population Decrease
Other Substantive Procedures (e.g. analytical procedures) Decrease
Population Size Negligible

Identify the factors which influence the sample size for:
(i) Tests of controls
(ii) Tests of details. (05 marks)
Describe some factors and their effect on auditor’s judgment of sample size for a substantive procedure. (06 marks)
LO 6: PERFORMING AUDIT PROCEDURES ON SAMPLE: ✯

Performing Procedures:
Auditor shall perform audit procedures on EACH item selected.
 If audit procedures are not applicable to a selected item (e.g. cancelled cheque), auditor shall
perform procedures on a replacement item (e.g. by selecting very next cheque).
 If auditor is unable to apply audit procedures on a selected item (e.g. when a cheque is
missing), auditor shall treat that item as a deviation (in case of tests of controls) or a
misstatement (in case of tests of details).
Audit Procedures if a deviation or misstatement is identified:

If auditor identifies a deviation or misstatement, he shall consider the nature and cause of deviation
or misstatement. If a deviation or misstatement is anomalous, auditor shall not consider it for
projection. However, in such case, auditor is required to obtain strong evidence that deviation or
misstatement does not affect the rest of population.
158
Anomaly:
Anomaly is a deviation or misstatement that occurs because of a one-off event and is not
representative of misstatements or deviations in a population e.g. error by a temporary employee.

Define ‘anomalous error’. How should it be treated at the time of projecting sample errors to the population? (02 marks)
LO 7: PROEJCTING, AND EVALUATING RESULTS OF SAMPLING: ✯

Projection:
Projecting Deviation Rate (for T.O.C.):
No explicit projection is made for tests of controls because Sample Deviation Rate is always the
Projected Deviation Rate for population.
Projecting Misstatements (for T.O.D.):

Projected misstatement means “Auditor’s best estimate of misstatements in population on the basis
of sample”.
Evaluating results of Tests of Controls:

If Projected Deviation Rate is below Tolerable Rate of Deviation:
Controls are operating effectively. Auditor can rely on internal control, and can decrease
substantive testing.
If Projected Deviation Rate is above Tolerable Rate of Deviation:

Auditor may increase his assessment of control risk, and places no reliance on internal control.
Consequently, extent of tests of details is increased.
Evaluating results of Tests of Details:

If Projected Misstatement is below Tolerable Misstatement:
Population is not materially misstated. No further work necessary.
If Projected Misstatement is above Tolerable Misstatement:

Sample has not provided a reasonable basis for conclusion about population that has been tested. In
this situation, auditor shall:
 Request management to investigate identified misstatement, and search for further
misstatements to make necessary adjustments, or
 Revise nature, timing and extent of further audit procedures.

Explain the steps to be followed if the audit sampling has not provided a reasonable basis for conclusion about the
population that has been tested. (02 marks)
(Malaysian Institute of Accountants, March 2013)
159
Auditing – Study Notes Chapter 18 Reliance on Work of Others
CHAPTER EIGHTEEN
RELIANCE ON WORK OF OTHERS
PART A – USING THE WORK OF INTERNAL AUDITORS

LO 1
DEFINITION AND OBJECTIVES OF INTENRAL AUDIT FUNCTION
✯✯
LO 2
COMPARISON OF INTERNAL AUDITOR WITH EXTERNAL AUDITOR
✯✯
LO 3 FACTORS TO BE CONSIDERED BEFORE PLACING RELIANCE ON WORK OF
✯✯✯ INTERNAL AUDITOR
LO 4
DISCUSSION WITH INTERNAL AUDITORS, AND DOCUMENTATION
✯
LO 5
DIRECT ASSISTANCE OF INTERNAL AUDITOR
✯
PART B – USING THE WORK OF AUDITOR’S EXPERT
LO 6
DEFINITION OF AUDITOR’S EXPERT
✯✯
LO 7 FACTORS TO BE CONSIDERED BEFORE PLACING RELIANCE ON WORK OF
✯✯✯ EXPERT
LO 8
REFERENCE OF EXPERT’S WORK IN AUDITOR’S REPORT
✯
160
33 (Auditor’s Expert) 96c (Auditors)

34 (Mineral Limited) 100b (Sparkle Forever)
71 (Masoom Limited) 106a (ISA 620: Using the Work of an
74 (Chill) Auditor’s Expert)
76 (PQR) 107b (Heidi Co)
83 (Auditor’s expert) 111e (Multiple Situations)
94 (ISA 620)
Question Bank:
123b (Cell Phones Private Limited)
161
PART A – USING WORK OF INTERNAL AUDITOR
LO 1: DEFINITION AND OBJECTIVES OF INTENRAL AUDIT FUNCTION: ✯✯

Definition:
Internal Audit Function is a function of entity that performs activities to evaluate and improve
entity’s Governance, Risk Management and Internal Control.
Internal audit is not required by law, therefore it is conducted by an entity only if its benefits are
greater than its cost. Internal audit may be conducted by entity’s own employees or by outsourced
to external firms.
Scope/Objectives/Functions/Activities/Benefits of Internal Audit Function:

Governance Activities:
 The internal audit function may assess the governance process to ensure entity is
complying best practices in corporate governance.
 Internal audit function may also assess effectiveness of communication among those
charged with governance, external and internal auditors, and management.
Activities Relating to Risk Management:

 The internal audit function may assist the entity by identifying and evaluating significant
exposures to risk and contributing to the improvement of risk management.
 The internal audit function may perform procedures to assist the entity in the detection of
fraud.
Activities Relating to Internal Control:

 Evaluation of internal control:
The internal audit function may be assigned specific responsibility for reviewing controls,
evaluating their operation and recommending improvements. For this purpose, internal
audit function may perform tests of controls.
 Examination of financial and operating information:

For this purpose, internal audit function may perform tests of details.
 Review of operating activities:

The internal audit function may be assigned to review the economy, efficiency and
effectiveness of operating activities, including non-financial activities of an entity.
(this is also called Operational Audit, or Value for Money Audit or 3E’s Audit)
 Review of compliance with laws and regulations.
Examples of work of the internal audit function that can be used by the external auditor:
 Accounting and internal control documentation produced by internal audit function.
 Risk assessment performed by internal audit department.
 Testing of the operating effectiveness of controls.
 Tests of details involving limited judgment.
 Observations of inventory counts.
 Testing of compliance with regulatory requirements.
162
Disadvantages of Internal Audit Department:

Disadvantages of internal audit department include:
 Internal auditors are not as independent of entity as external auditors.
 Higher cost is involved in establishing internal audit department.
 There may be lack of qualification and experience in internal audit department.

Define the ‘three Es’ of a value for money audit. (03 marks)
Describe additional functions, other than fraud investigations, the directors of a company could ask the internal audit
department to undertake. (05 marks)
`
LO 2: COMPARISON OF INTERNAL AUDITOR WITH EXTERNAL AUDITOR: ✯✯
Internal Auditor External Auditor

Relationship/Independence Employee of entity Independent of entity
Appointment By BOD/Audit Committee By Shareholders
Qualification Determined by BOD/Audit Committee Determined by Law
Objective is to evaluate and improve Objective is to express an opinion on
Scope / Objectives /
entity’s Governance, Risk Management and financial statements and on additional
Activities
Internal Control. matters required by law.
Scope/Objectives/ Activities
BOD/Audit Committee Determined by ISAs, Laws and Regulations
determined by
Reports To BOD/Audit Committee and his Reports to Members and his report is
Reporting
reports are restricted to them. publically available.
Format of Report Any (depending on circumstances) Determined by Law

Differentiate between external and internal auditors with respect to scope of work and reporting responsibilities.
(06 marks)
LO 3: FACTORS TO BE CONSIDERED BEFORE PLACING RELIANCE ON WORK OF

INTERNAL AUDITOR: ✯✯✯
Evaluating the Internal Audit Function:
External auditor shall evaluate internal audit function by considering following factors:
1. Level of competence of the internal audit function, i.e.

 Level of education, professional qualification and experience.
 whether there are established practices for training of internal auditors
 Specific knowledge and skills relating to entity’s financial statements.
 Whether internal audit function is adequately resourced.
2. Organizational status and relevant policies and procedures supporting objectivity of

internal auditor, i.e.
 Employment decisions like hiring, firing or promotion of internal audit functions should be
made by TCWG, and not by management.
 Internal auditors should be reportable to TCWG and not to management.
163
 Scope of work of internal auditor should be decided by audit committee; and not by
management.
 Internal audit function should be free from conflicting responsibilities. They should not
perform any managerial work.
 Internal auditors should be rotated periodically to avoid familiarity threat e.g. after every 3
to 5 years.
3. Whether the internal audit function applies a systematic and disciplined approach,
including quality control i.e.
 Whether internal auditors apply a systematic and disciplined approach i.e. work is properly
planned, performed, documented and reviewed.
 Quality of internal auditor’s working papers.
 Consistency of Conclusions with work performed.
 Quality Control Program for internal auditor.
Evaluating the adequacy of work of Internal Audit Function:

Auditor shall perform sufficient audit procedures on the body of work of the internal audit function
to determine adequacy of work for external audit, including evaluating whether:
 The work of the function has been properly planned, performed, reviewed and documented.
 Sufficient appropriate evidence has been obtained to draw reasonable conclusions, and
 Conclusions reached are appropriate in the circumstances and reports prepared are
consistent with results of the work performed.
Depending on risk assessment, judgments involved, and evaluation of internal audit function;
auditor’s procedures:
 shall include Reperformance of some of the work; and
 may include inquiry of internal auditors, observation of procedures of internal auditors, or
inspection of working papers of internal auditors.
If work is not adequate for auditor’s purposes:

If auditor determines that the work of internal auditor is not adequate for auditor’s purposes,
auditor may:
− Perform additional audit procedures appropriate to the circumstances, or
− Agree with internal auditor on further work to be performed by internal auditor (i.e. Direct
Assistance).

Suppose you have been working as a Manager of external audit team of M/s. Frame Limited. The company has internal
audit department lead by a certified internal auditor.
What factors would enable you to place reliance on the work done by the internal audit department? (10 marks)
Identify the factors that are considered in determining the independence of internal auditors. (02 marks)
Briefly explain how an external auditor would evaluate the adequacy of the work performed by the internal audit
function. (04 marks)
164
LO 4: DISCUSSION WITH INTERNAL AUDITORS, AND DOCUMENTATION: ✯

Discussion and Coordination with the Internal Audit Function:
If the external auditor plans to use the work of the internal audit function, it will be useful to discuss
and coordinate following matters with internal auditor in advance:
 the timing of such work.
 the nature of the work performed.
 the extent of audit coverage.
 materiality and performance materiality.
 methods of item selection and sample sizes.
 documentation of work performed.
 review and reporting procedures.
Documentation:
If the external auditor uses the work of the internal audit function, the external auditor shall include
in the audit documentation:
(a) The nature and extent of the work used and the basis for that decision; and
(b) The evaluation of competence, objectivity and systematic and disciplined approach of
internal audit function.
(c) The audit procedures performed by the external auditor to evaluate the adequacy of the work
used.
LO 5: DIRECT ASSISTANCE OF INTERNAL AUDITOR: ✯

Direct Assistance:
Direct assistance is the use of internal auditors to perform audit procedures under the direction,
supervision and review of the external auditor.
Determining Whether Internal Auditors Can Be Used to Provide Direct Assistance:

The external auditor shall not use direct assistance of internal auditors if:
(a) Law or regulations prohibit to use such assistance, or
(b) There are significant threats to the objectivity of the internal auditor; or
(c) The internal auditor lacks sufficient competence to perform the proposed work, or
(d) The work:
 involves making significant judgements;
 involves higher assessed risks of material misstatement;
 relate to work with which the internal auditors have been involved and which has
already been, or will be, reported to TCWG by the internal audit function; or
Using Internal Auditors to Provide Direct Assistance:

If direct assistance of internal auditor is to be used, external auditor shall obtain prior written
agreement:
 from an authorized representative of the entity that the internal auditors is allowed to
follow the external auditor’s instructions, and that the entity will not intervene in the work;
and
 from internal auditors that they will keep confidential specific matters as instructed by the
external auditor and inform the external auditor of any threat to their objectivity.
165
Documentation if direct assistance of internal audit is obtained:

If the external auditor uses internal auditors to provide direct assistance on the audit, the external
auditor shall include in the audit documentation:
(a) The evaluation of competence, and objectivity of internal audit function.
(b) The written agreements obtained from an authorized representative of the entity and the
internal auditors
(c) The working papers prepared by the internal auditors who provided direct assistance on
the audit engagement
(d) Who reviewed the work performed and the date and extent of that review.
PART B – USING WORK OF EXPERT
LO 6: DEFINITION OF AUDITOR’S EXPERT: ✯✯

Definition:
An individual or organization possessing expertise in a field (other than accounting or auditing),
whose work in that field is used by the auditor to assist the auditor in obtaining sufficient
appropriate audit evidence.
Examples of areas where work of expert can be used by the external auditor:
Expert may be required by auditor when financial statements involve:
 Estimation of life and valuation of fixed assets.
 Valuation of specialized inventory.
 Analysis of complex or unusual tax compliance issues
 IT Expertise
 Legal Opinions

Define the term “Auditor’s Expert”. (02 marks)
(ICMA Pakistan, Professional Level P2 – September 2013)
As the manger on the audit of Masoom Limited you want the management to appoint experts to assist you on certain
matters.
Explain the circumstances where auditor may use the work of an expert and the auditor’s responsibilities in this regard.
(07 marks)
LO 7: FACTORS TO BE CONSIDERED BEFORE PLACING RELIANCE ON WORK OF

EXPERT: ✯✯✯
If auditor uses work of an expert, it is auditor’s responsibility to:
 Evaluate Competence, Capabilities and Objectivity of the Auditor’s Expert.
 Obtaining an Understanding of the Field of Expertise.
 Agree terms with Auditor’s Expert.
 Evaluate the Adequacy of the Expert’s Work.
166
Evaluate Competence, Capabilities and Objectivity of the Auditor’s Expert.

Auditor shall obtain knowledge of expert’s qualification, experience, expertise, reputation and
independence. In case of auditor’s expert, the evaluation of objectivity shall include inquiry
regarding interests and relationships that may create a threat to that expert’s objectivity.
This knowledge can be obtained through different sources e.g.

 Personal experience with previous work of that expert.
 Discussions with that expert.
 Discussions with other auditors or others who are familiar with that expert’s work.
 Knowledge of that expert’s qualifications, membership of a professional body or industry
association, license to practice, or other forms of external recognition.
 Published papers or books written by that expert.
 The auditor’s firm’s quality control policies and procedures
Obtaining an Understanding of the Field of Expertise:

The auditor shall obtain a sufficient understanding of the field of expertise of the auditor’s expert to
enable the auditor to:
(a) Determine the nature, scope and objectives of expert’s work for the audit purposes; and
(b) Evaluate the adequacy of expert’s work.
Agreement between Auditor and his Expert:

The auditor shall agree, in writing when appropriate, on the following matters with the auditor’s
expert:
(a) The nature, scope and objectives of that expert’s work;
(b) The respective roles and responsibilities of the auditor and that expert;
(c) The nature, timing and extent of communication between the auditor and that expert,
including the form of any report to be provided by that expert; and
(d) The need for the auditor’s expert to observe confidentiality requirements.
Ensure adequacy of work of expert:

Before using specific work of expert, auditor shall determine adequacy of work by evaluating:
1. Accuracy, Completeness, and Relevance of significant source data (if expert’s work involves
use of significant source data)
2. Relevance and reasonableness of significant assumptions and methods (if expert’s work
involves use of significant assumptions and methods)
3. Reasonableness of expert’s findings and conclusions (e.g. compare the value with similar
properties in the locality).
4. Consistency of these conclusions with other audit evidence.
If work is not adequate for auditor’s purposes:

If auditor determines that the work of auditor’s expert is not adequate, auditor shall:
− Agree with that expert on the nature and extent of further work to be performed by that
expert; or
− Perform additional audit procedures appropriate to the circumstances or
− Hire another expert, if work of management’s expert was used.
167

Mineral Limited (ML) has incorporated a liability for gratuity payable to its employees on the basis of actuarial valuation
carried out by Professionals Limited (PL). As the audit partner of ML you are not satisfied with the valuation report
prepared by PL, and have decided to appoint Experts Limited (EL) to carry out the valuation exercise again.
Required:
(a) State the matters that you would consider regarding:
(i) The competence, capabilities and objectivity of EL. (03 marks)
(ii) Evaluation of the adequacy of EL’s work. (03 marks)
(b) Briefly discuss the course of action in case you are not satisfied with the work performed by EL. (03 marks)
List four key terms of engagement which should be agreed with the expert. (02 marks)
When expertise in a field other than accounting or auditing is necessary to obtain sufficient appropriate audit evidence,
the auditor has to determine whether to use the work of an auditor’s expert.
Required:
List down the sources from where the auditor may get the information regarding the expert’s competence, capabilities
and objectivity. (06 marks)
LO 8: REFERENCE OF EXPERT’S WORK IN AUDITOR’S REPORT: ✯

Auditor shall not refer to the work of expert in auditor’s report unless:
1. it is required by Law or Regulation, or
2. such reference is relevant to understand nature of modification to the auditor’s opinion. In
such circumstances, the auditor may need the permission of the auditor’s expert before
making such a reference.
If such reference is required by law or regulation, the auditor’s report shall indicate that the
reference does not reduce the auditor’s responsibility for audit opinion.

Under what circumstances would an auditor refer to the result of the work of an expert in the audit report? (04 marks)
168
Auditing – Study Notes Chapter 19 Fraud Considerations in Audit
CHAPTER NINTEEN
FRAUD CONSIDERATIONS IN AUDIT
LO 1
FRAUD AND ITS TYPES
✯
LO 2
RESPONSIBILITY OF MANAGEMENT AND AUDITOR REGARDING FRAUD
✯✯
LO 3
ASSESSING RISK OF FRAUD, AND AUDITOR’S COURSE OF ACTION
✯✯✯
LO 4
CIRCUMSTANCES INDICATING FRAUD, AND AUDITOR’S COURSE OF ACTION
✯
LO 5
WRITTEN REPRESENTATION, AND COMMUNICATIONS
✯
LO 6
MANAGEMENT OVERRIDE OF CONTROL AND AUDITOR’S COURSE OF ACTION
✯✯✯
25a & b (Information Limited) 27 (Fraudulent Financial Statements)
Question Bank:
24 (ASPL) 49b (Tahir Co)

25c (Information Limited) 123a (Cell Phones Private Limited)
26 (Distributor)
169
LO 1: FRAUD AND ITS TYPES: ✯

Distinction between Error and Fraud:
Misstatements in the financial statements can arise from either fraud or error.
Error: an unintentional misstatement in financial statements.
Fraud: An intentional act by one or more individuals (among management, those charged with
governance, employees, or third parties) involving the use of deception to obtain an unjust or illegal
advantage.
There are two types of fraud i.e. Misappropriation of Assets and Fraudulent Financial Reporting.
Misappropriation of Assets:
Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by
employees.
Misappropriation of assets can be accomplished in a variety of ways including:

 Embezzling receipts (for example, misappropriating collections on accounts receivable or
diverting receipts in respect of written-off accounts to personal bank accounts).
 Stealing physical assets or intellectual property (for example, stealing inventory for
personal use or for sale, stealing scrap for resale, colluding with a competitor by disclosing
technological data in return for payment).
 Causing an entity to pay for goods and services not received (for example, payments to
fictitious vendors, kickbacks paid by vendors to the entity’s purchasing agents in return for
inflating prices, payments to fictitious employees).
 Using an entity’s assets for personal use (for example, using the entity’s assets as collateral
for a personal loan or a loan to a related party).
Fraudulent Financial Reporting:

Fraudulent financial reporting involves intentional misstatements in financial statements to deceive
financial statement users. It is usually committed by management:
Fraudulent financial reporting may be accomplished by the following:

 Recording fictitious journal entries, particularly close to the end of an accounting period, to
manipulate operating results.
 Inappropriately changing assumptions and judgments used to estimate account balances.
 Omitting, advancing or delaying recognition in the financial statements of events and
transactions that have occurred during the reporting period.
 Concealing, or not disclosing, facts that could affect the amounts recorded in the financial
statements.
 Engaging in complex transactions that are structured to misrepresent the financial position or
financial performance of the entity.
 Altering records and terms related to significant and unusual transactions.

Recent worldwide events of fraud have raised several questions over the role of external auditors in relation to
identification of fraud.
Required:
Define the term ‘fraud’ and describe any two major categories of fraud. (08 marks)
170
Explain the term ‘fraudulent financial reporting’, illustrating your explanation with examples. (04 marks)
LO 2: RESPONSIBILITY OF MANAGEMENT AND AUDITOR REGARDING FRAUD: ✯✯

Responsibility of Management (& TCWG) regarding Fraud:
The primary responsibility for the prevention and detection of fraud rests with both TCWG and
management. Management should create a culture of honesty and ethical behaviour with oversight
of TCWG to prevent fraud. Oversight by TCWG should also include consideration for potential for
management override of control.
Responsibility of Auditor regarding Fraud:

Auditor is not responsible to detect all frauds, because:
 fraud may involve sophisticated and carefully organized schemes.
 there may be collusion.
 management fraud is more difficult to detect than other frauds because of management
override of control
Regarding fraud, It is auditor’s responsibility to:

 Perform risk assessment procedures.
 Assess risk of material misstatement due to fraud.
 Maintain professional skepticism throughout the audit recognizing the possibility that a
material misstatement due to fraud may exist.

What are the responsibilities of an auditor and those charged with governance with respect to fraudulent financial
reporting? (06 marks)
State external auditor’s responsibilities in relation to the prevention and detection of fraud and error. (04 marks)
LO 3: ASSESSING RISK OF FRAUD, AND AUDITOR’S COURSE OF ACTION: ✯✯✯

Risk Assessment Procedures to identify risk of fraud:
ISAs require the auditor to perform the following procedures to identify the risks of material
misstatement due to fraud:
1. Make enquiries of management in respect of:
a) their assessment of the risk of fraud.
b) their process in place for identifying and responding to the risks of fraud.
c) any specific risks of fraud identified or likely to exist.
d) any communications within the entity in respect of fraud (e.g. code of conduct).
2. Make inquiries of management and others within the entity as to whether they have
knowledge of any actual, suspected or alleged frauds.
3. Evaluate any unusual or unexpected relationships identified in performing analytical
procedures which may indicate a risk of material fraud.
4. Evaluate whether any fraud risk factors are present.
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Fraud Risk Factors:

Misappropriation of Assets Fraudulent Financial Reporting
1. Personal Financial Obligations. 1. Intended sale of shares/ business, or acquiring loan.
2. Adverse Relationships between entity 2. Management holds majority shareholding.
and employee. 3. Bonuses based on financial performance.
Incentives or 4. Pressure on management to meet financial targets e.g.
Pressures debt-covenant or investor’s expectations.
(i.e. Motives) 5. Personal guarantee of management for repayments of
loans.
6. Going Concern Issues e.g. increased competition,
product failures, operating losses
1. Excessive cash in hand. 1. Domination of management by a single person or
2. Portable and precious inventory or small group without audit committee or internal audit
fixed assets. function.
3. Deficiencies in internal control over 2. Ineffective oversight by audit committee or internal
assets e.g. audit function (due to lack of independence from
a. Inadequate segregation of duties management).
for assets (e.g. cash, inventory). 3. Significant transactions outside the normal course of
Opportunity
b. Inadequate record keeping and business with related parties.
reconciliations for assets. 4. Deficiencies in internal control over financial
c. Inadequatephysical safeguards over reporting.
tangible assets. 5. High turnover of senior management.
6. Nature of entity’s operations e.g. operations in
diversified jurisdictions and use of business
intermediaries.
1. Disregard for monitoring of control. 1. Lack of integrity in management.
2. Tolerance on petty theft. 2. Ineffective communication of code of conduct.
Attitudes/ 3. Disregard for internal control by 3. Non-financial management’s excessive participation in
Rationalizations overriding. accounting policies and estimates.
4. Dissatisfied or unhappy employees 4. Management failing to correct material weakness in
5. Change in lifestyle. internal controls.
Auditor’s course of action if there is fraud risk factor:

Overall response to risk at financial statement level has been covered in chapter 10.

Briefly state the audit procedures which may be performed to identify the risks of material misstatement due to fraud.
(05 marks)
(a) Identify the two categories in which fraud risk factors relating to misstatements resulting from misappropriation of
assets may be grouped. (02 marks)
(b) For each of the above two categories, identified in (a) above, list examples of fraud risk factors which relate to
misstatements that results from misappropriation of assets. (08 marks)
Describe what actions are to be taken by an auditor on identifying a fraud risk factor. (04 marks)
LO 4: CIRCUMSTANCES INDICATING FRAUD, AND AUDITOR’S COURSE OF ACTION: ✯

Circumstances that indicate the possibility of fraud:
Discrepancies in accounting records, including
− Transactions not recorded/completed in timely manner or improperly recorded as to
amount, period, or classification.
− Supporting documents are not available for transactions/balances.
− Last minute adjustments that significantly affect financial statements.
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− Tips or complaints to the auditor about the alleged fraud.

− Employees’ access to systems and records is more than necessary to do job.
Conflicting or missing evidence, including

− Missing accounting records.
− Documents that appear to have been altered.
− Unavailability of original documents when they are expected to exist.
− Significant unexplained items on reconciliations.
− Unusual discrepancies between the entity’s record and confirmation replies.
− Large amount of credit entries and other adjustments at year end.
− Unusual changes in trends or important financial statement ratios or relationships.
− Missing inventory or physical assets of significant magnitude.
Problematic or unusual relationships between the auditor and management, including

− Denial of access to records, facilities, certain employees, customers, vendors, or others from
whom audit evidence might be sought.
− Undue time pressure by management to resolve complex or contentious issues.
− Complaints by management about the conduct of the audit or management intimidation.
− Unusual delays by entity in providing requested information.
− Denial of access to key IT operations staff, facilities, and electronic files for testing through
CAAT.
− An unwillingness to address identified deficiencies in internal control on a timely basis.
Others
− Accounting policies at variance with industry norms.
− Frequent changes in accounting estimates that do not appear to result from changed
circumstances.
− Unwillingness by management to permit the auditor to meet privately with those charged with
governance.
− Tolerance of violations of the entity’s code of conduct.
Auditor’s course of action if a misstatement is identified which indicates fraud:

Effect on audit report:
Auditor shall also consider impact of fraud on auditor’s report.
Effect on other aspects of audit:

If a misstatement is indicative of fraud and involves management (whether material or not), it will
affect different aspects of audit as follows:
1. There may also be a possibility of other frauds, and collusions.
2. Auditor shall reassess integrity of management, and the risk of fraud.
3. Reliability of evidence previously obtained (management representations and other
records/documents) may be called into question, since there may be doubts about their
accuracy and completeness.
4. In exceptional circumstances, auditor may be unable to continue the engagement. If auditor
withdraws:
a. Auditor shall discuss with management and TCWG withdrawal and reason of
withdraw.
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b. Auditor shall consider whether there is a professional or legal requirement to report

to appointing authority or regularity authorities about withdrawal and reason of
withdrawal.

Is an auditor responsible for detection of frauds in the financial statements? What an auditor should do when he becomes
aware about existence of fraud in the financial statements? (06 marks)
LO 5: WRITTEN REPRESENTATION, AND COMMUNICATIONS: ✯

Written Representation:
The auditor shall obtain written representations from management and, where appropriate, those
charged with governance that:
1. They acknowledge their responsibility for the design, implementation and maintenance of
internal control to prevent and detect fraud;
2. They have disclosed to the auditor the results of management’s assessment of the risk that
the financial statements may be materially misstated as a result of fraud;
3. They have disclosed to the auditor their knowledge of fraud, or suspected fraud, affecting
the entity involving Management, Employees or Others; and
4. They have disclosed to the auditor their knowledge of any allegations of fraud, or suspected
fraud, affecting the entity’s financial statements communicated by employees, former
employees, analysts, regulators or others.
Communications:
To Management:
If the auditor has identified or suspects fraud, the auditor shall communicate these matters on a
timely basis to the appropriate level of management (regardless of size of fraud). Ordinarily, the
appropriate level of management is at least one level above the persons who appear to be involved
with the suspected fraud.
To TCWG:
1. Auditor shall communicate identified/suspected fraud to TCWG if fraud involves
management, employees in significant role or material fraud by others.
2. The auditor shall also communicate with those charged with governance any other matters
related to fraud that are, in the auditor’s judgment, relevant to their responsibilities
To Regulatory and Enforcement Authorities:

Ordinarily auditor does not communicate to outside parties if he has identified or suspects fraud
because of professional duty to maintain confidentiality of client information. However, in some
circumstances, legal responsibility may override duty of confidentiality. Therefore, auditor may
consider it appropriate to obtain legal advice to determine the appropriate course of action

Because of the nature of fraud and the difficulties encountered by the auditors in detecting material misstatements in the
financial statements on account of fraud, the management has to play a significant role in assisting the auditors in the
performance of appropriate audit procedures. Make a list of representations that the auditor should obtain from the
management in this regard. (07 marks)
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LO 6: MANAGEMENT OVERRIDE OF CONTROL AND AUDITOR’S COURSE OF ACTION: ✯✯✯

Definition:
The term ‘management override of control’ means ability of management to overrule prescribed
policies and procedures to prepare fraudulent financial statements, even where the controls might
otherwise appear to be operating effectively.
Risk of management override of control exists in every entity.
Techniques:
Fraudulent financial reporting can be committed by management overriding controls using such
techniques as:
 Recording fictitious journal entries, particularly close to the end of an accounting period, to
manipulate operating results.
 Inappropriately changing assumptions and judgments used to estimate account balances.
 Omitting, advancing or delaying recognition in the financial statements of events and
transactions that have occurred during the reporting period.
 Concealing, or not disclosing, facts that could affect the amounts recorded in the F/S.
 Engaging in complex transactions that are structured to misrepresent the financial position or
financial performance of the entity.
 Altering records and terms related to significant and unusual transactions.
Audit Procedures to address risk of Management override of control:

Irrespective of the auditor’s assessment of the risks of management override of controls, the
auditor shall design and perform following audit procedures:
1. Test the appropriateness of journal entries recorded in the general ledger and other
adjustments made in the preparation of the financial statements.
In designing and performing audit procedures for such tests, the auditor shall:
 Make inquiries of individuals involved in the financial reporting process about
inappropriate or unusual activity relating to the processing of journal entries and other
adjustments;
 Select journal entries and other adjustments made at the end of a reporting period; and
 Consider the need to test journal entries and other adjustments throughout the period.
When selecting journal entries for testing, following matters are relevant:
 Assessment of risk of material misstatement due to fraud
 Controls that have been implemented over journal entries and other adjustments
 The characteristics of fraudulent journal entries or other adjustments i.e. entries
o made to unrelated, unusual, or seldom-used accounts,
o made by individuals who typically do not make journal entries,
o recorded at the end of the period or as post-closing entries that have little or no
explanation or description,
o made either before or during the preparation of the financial statements that do not
have account numbers, or
o containing round numbers or consistent ending numbers.
 The nature and complexity of the accounts i.e. accounts that
o contain transactions that are complex or unusual in nature,
o contain significant estimates and period end adjustments,
o have been prone to misstatements in the past,
o have not been reconciled on a timely basis or contain unreconciled differences,
o contain inter-company transactions, or
o are otherwise associated with an identified risk of material misstatement due to fraud.
 Journal entries or other adjustments processed outside the normal course of business
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2. Review accounting estimates for biases, and evaluate whether circumstances represent a
risk of fraud
In performing this review, the auditor shall:
 Evaluate whether judgments and assumptions by management in making estimates,
indicate a possible bias (even if they are individually reasonable) that represent risk of
fraud. If so, the auditor shall re-evaluate the accounting estimates taken as a whole; and
 Perform a retrospective review of management judgments and assumptions related to
significant accounting estimates reflected in the financial statements of the prior year.
3. For significant transactions that are outside the normal course of business or that appear
unusual, evaluate whether they have appropriate business rationale or have been entered
to engage in fraudulent financial reporting or conceal misappropriation of asset.
Indicators that suggest that such transactions are entered to engage in fraud include:
 The form of such transactions appears overly complex (for example, the transaction
involves multiple entities).
 Management has not discussed the nature and accounting for such transactions with TCWG,
and there is inadequate documentation.
 Management is placing more emphasis on the need for a particular accounting treatment
than on the underlying economics of the transaction.
 Transactions that involve non-consolidated related parties have not been properly
reviewed or approved by those charged with governance of the entity.
 The transactions involve previously unidentified related parties or parties that do not have
the substance or the financial strength to support the transaction without assistance from
the entity.

Management is in a unique position to perpetrate fraud because of its ability to manipulate accounting records and
prepare fraudulent financial statements by overriding controls that otherwise appears to be operating effectively.
Required:
Determine the audit procedures that may be performed by the auditor to address the risks related to override of controls.
(08 marks)
Fraudulent activities can be carried out through the use of journal entries. State the characteristics of journal entries that
external auditors should select for testing to identify fraudulent activities. (03 marks)
Because of its ability to exert influence, management is in a position to perpetrate fraud and prepare fraudulent financial
statements.
Identify six different ways in which fraud may be committed by management through overriding of controls. (06 marks)
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Auditing – Study Notes Chapter 20 Final Matters
CHAPTER TWENTY
FINAL MATTERS
PART A: WRITTEN REPRESENTATION

LO 1
DEFINITION OF WRITTEN REPRESENTATION
✯✯
LO 2 WRITTEN REPRESENTATIONS (OR ELEMENTS OF REPRESENTATION
✯✯ LETTER) REQUIRED BY ISAs
LO 3
DOUBT AS TO THE RELIABILITY OF WRITTEN REPRESENTATIONS
✯✯
LO 4
AUDITOR’S COURSE OF ACTION IF WRITTEN REPRESENTATION IS NOT
✯✯✯ PROVIDED
PART B: SUBSEQUENT EVENTS
LO 5 EVENTS OCCURRING BETWEEN DATE OF FINANCIAL STATEMENTS AND DATE OF
✯✯✯ AUDITOR’S REPORT
LO 6 AUDITOR’S PROCEDURES IF A MISSTATEMENT IS IDENTIFIED AFTER THE
✯✯✯ DATE OF AUDITOR’S REPORT
113b (Energy Limited) 143 (Written representations)
126h (Multiple Questions) 144a&c (Kazmi-Wassan)
127b (Analytical procedures) 145a (RK Resourcing)
Question Bank:
114 (XYZ & Company) 144bi (Kazmi-Wassan)
117 (Customized Machinery Limited) 145b (RK Resourcing)
125 (Pioneer Textile Limited)
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PART A – WRITTEN REPRESENTATION
LO 1: DEFINITION OF WRITTEN REPRESENTATION:

Definition of written representations:
“A written statement by management provided to the auditor to confirm certain matters or to
support other audit evidence. Written representations in this context do not include financial
statements, the assertions therein, or supporting books and records”
Purposes/Uses of Written Representation:

1. The purpose of obtaining written representations is to confirm that management has
fulfilled its responsibility for the preparation of the financial statements and for the
completeness of the information provided to the auditor.
2. Written representations are also used to support other audit evidence if required by other
International Standards on Auditing or determined necessary by the auditor. However, it is
only a supporting evidence (NOT sufficient and appropriate on its own) and does not
reduce the need to obtain other evidence.
Exam Tip
Sufficient Appropriate Evidence = Written Representation + Other evidence which is expected to exist
If either is missing (whether representation or evidence), it will be scope limitation.
Form and Date of written representations:

Written representations shall be:
 in the form of a letter signed by persons responsible for preparation of financial statements
e.g. CEO and CFO.
 addressed to auditor.
 dated as near as possible, but not after, the date of auditor’s report.

The audit of Three Stars Limited (TSL) for the year ended December 31, 2014 was completed and initial report was issued
on February 15, 2015. The meeting of the board of director was held on February 22, 2015 to approve the accounts and
thereafter, being an auditor, you have been required to issue signed auditor’s report for the purposes of issuing financial
statements to shareholders. As per the provisions of International Standards on Auditing, you also need to obtain a
written representation from your client (TSL) before issuing the signed auditor’s report.
Required:
In the light of the given situation, answer the following:
(i) Briefly explain the term “written representation”. Why does an auditor need to obtain a written representation from
management and those charged with governance. (04 marks)
(ii) What is the most commonly used form of a written representation and what should be the date of written
representation in the above scenario? Discuss in the light of ISA – 580. (04 marks)
(iii) Who is responsible to provide the written representation on behalf of the company. (02 marks)
(ICMA Pakistan, Professional Level P2 – August 2015)
178
LO 2: WRITTEN REPRESENTATIONS (OR ELEMENTS OF REPRESENTATION LETTER)

REQUIRED BY ISAs:
Written Representation about Management’s Responsibilities:
Representations about Preparation of the Financial Statements:
Management has fulfilled its responsibility for the preparation of financial statements in accordance
with the AFRF, as agreed in the terms of the audit engagement.
Representations about Information Provided and Completeness of Transactions:

a) Management has provided the auditor with all relevant information and access, as agreed in the
terms of the audit engagement, and
b) All transactions have been recorded in financial statements.
Written Representation about Specific Assertions:

Representations about Financial Statements:
1. Significant assumptions and accounting estimates are reasonable. (ISA 540)
2. Related party relationships and transactions have been appropriately accounted for and
disclosed in accordance with the requirements of AFRF. (ISA 550)
3. All events subsequent to the date of financial statements for which AFRF requires
adjustment or disclosure, have been adjusted or disclosed. (ISA 560)
4. The effects of uncorrected misstatements are immaterial, both individually and in the
aggregate, to the financial statements as a whole. (ISA 450)
Representations about Information Provided to Auditor:

1. We have disclosed to you the results of our assessment of the risk that the financial
statements may be materially misstated as a result of fraud. (ISA 240)
2. We have disclosed to you all information in relation to fraud or suspected fraud that we are
aware of and that affects the entity involving management, employees or others. (ISA 240)
3. We have disclosed to you the identity of the entity’s related parties and all the related-party
relationships and transactions of which we are aware. (ISA 550)
4. We have disclosed to you all known instances of non-compliance or suspected non-
compliance with laws and regulations affecting financial statements. (ISA 250)
Auditor may also obtain additional representations if he considers necessary.

What are the situations in which written representation from the management is mandatory? (07 marks)
179
LO 3: DOUBT AS TO THE RELIABILITY OF WRITTEN REPRESENTATIONS:
Factor creating doubt Auditor’s Course of Action

The auditor shall perform audit procedures to attempt to resolve the
matter.
If the matter remains unresolved, the auditor:
 Shall reconsider the assessment of the competence, integrity,
ethical values or diligence of management, and
if written representations
 Shall determine the effect that this may have on the reliability
are inconsistent with
of representations (oral or written) and audit evidence in
other audit evidence
general.
Auditor may revise the risk assessment and determine the nature,
timing and extent of further audit procedures to respond to the
assessed risks.
Auditor shall determine the effect that such concerns may have on the
reliability of representations (oral or written) and audit evidence in
If the auditor has general.
concerns about the
competence, integrity, If auditor concludes that risk of management misrepresentation is
ethical values or such that an audit cannot be conducted, the auditor may consider
diligence of management withdrawing from the engagement, where withdrawal is possible
under applicable law or regulation, unless those charged with
governance put in place appropriate corrective measures.

One of the objectives of obtaining a written representation from management is to ensure that the management knows
and acknowledges its responsibility for the preparation of the financial statements and for the completeness of the
information provided to the auditor.
Required:
Specify the situations which may create doubts as to the reliability of written representations. What course of action
would the auditor take in such a situation? (07 marks)
State the matters that auditor needs to consider where the written representation provided by the management is
inconsistent with other audit evidence. (03 marks)
LO 4: AUDITOR’S COURSE OF ACTION IF WRITTEN REPRESENTATION IS NOT

PROVIDED:
If management refuses to provide written representation to auditor, auditor shall discuss the
matter with management to convince them to provide written representation.

If auditor is unable to obtain written representation, it will be a scope limitation. Auditor shall
express Qualified opinion (if effect is material) or Disclaimer of opinion (if effect is pervasive).
180

extent of audit procedures. This will also affect reliability of representations (oral or
written) and audit evidence in general.

Briefly state the course of action which should be adopted by a firm if the requested written representations are not
provided by the client. (02 marks)
As part of the audit process, the management provides written representations to confirm certain matters in connection
with the audit.
Required:
(a) State the matters that you will consider as an auditor while assessing the reliability of representations made by the
management. (05 marks)
(b) Describe the course of action available to an auditor if the management refuses to provide representation on a
particular issue. (05 marks)
PART B – SUBSEQUENT EVENTS
LO 5: EVENTS OCCURRING BETWEEN DATE OF FINANCIAL STATEMENTS AND DATE OF

AUDITOR’S REPORT:
Events occurring between date of F/S and date of audit report:
Auditor’s Responsibility:
Auditor’s responsibility is to perform audit procedures to obtain sufficient appropriate audit
evidence that all events occurring between the date of the financial statements and the date of the
auditor’s report have been identified by management and have been adjusted or disclosed in
financial statements, as appropriate.
To meet this responsibility, auditor performs Active Review of subsequent events (i.e. auditor
actively searches for significant subsequent events).
Auditor’s Procedures to identify subsequent events affecting financial statements:

1) Inquiring of management and TCWG as to whether any subsequent events have occurred
which might affect the financial statements (auditor may make specific inquiries relating to
following matters) e.g.
a. New borrowings
b. Significant sales of assets
c. New shares or debentures issued
d. Assets destroyed by fire, flood etc or appropriated by government.
2) Obtaining an understanding of procedures established by management to identify
subsequent events.
3) Reading minutes of subsequent meetings of the entity’s owners, management and TCWG
and inquiring about matters discussed at any such meetings for which minutes are not yet
available.
4) Reading the entity’s subsequent interim financial statements, if any.
181
5) Requesting management to provide written representation that “all events subsequent to

the date of the financial statements requiring adjustment or disclosure have been adjusted
or disclosed”.
Events occurring after date of audit report:

Auditor’s Responsibility:
Auditor has no responsibility to perform any audit procedures regarding financial statements after
the date of auditor’s report. However, auditor is responsible to respond appropriately to facts
which affect financial statements and auditor’s report but that become known to the auditor after
the date of the auditor’s report.
To meet this responsibility, auditor performs Passive Review of subsequent events (i.e. auditor
does not search subsequent events actively; rather he relies on information from management)

(a) Briefly describe the extent of auditor’s responsibility relating to subsequent events occurring between the date of the
financial statements and the auditor’s report. (03 marks)
(b) Identify any five procedures that the auditor may undertake to fulfill the responsibility as discussed in (a) above.
(05 marks)
LO 6: AUDITOR’S PROCEDURES IF A MISSTATEMENT IS IDENTIFIED AFTER THE DATE

OF AUDITOR’S REPORT:
If financial statements have not been issued:
Auditor shall discuss the matter with management and TCWG, and determine whether financial
statements need amendment. Thereafter, auditor shall inquire how management intends to address
the matter in the financial statements.
If management amends financial statements:

1. Auditor shall carry out necessary audit procedures for verification of amendment in
2. Auditor shall extend his review of subsequent events up to the date of new audit report.
3. Provide a new audit report (on amended financial statements).
4. New audit report should be dated on or after the date of adjustment and approval of revised
If management does not amend financial statements:

1. Auditor shall consider other methods to inform members e.g. auditor can speak at AGM to
inform members, or can resign and send representation to shareholders.
2. Auditor shall notify management and TCWG not to issue audit report to third parties.
3. If despite such notification, management or TCWG issue audit report with financial
statements, the auditor shall obtain legal advice and shall take appropriate action to prevent
users from relying on auditor’s report.
182
If financial statements have been issued:

Auditor shall discuss the matter with management and TCWG, and determine whether financial
statements need amendment. Thereafter, auditor shall inquire how management intends to address
the matter in the financial statements and how to take steps to inform users about this event.

1. Auditor shall review the steps taken by management to ensure that users do not rely on
previously issued financial statements.
2. Auditor shall carry out necessary audit procedures for verification of amendment in
4. Provide a new audit report (on amended financial statements) that shall include an
Emphasis of Matter Paragraph or Other Matter Paragraph, referring to the
 note in financial statements that explains reason for the amendment in financial
statements, or
 earlier report provided by the auditor.
5. New audit report should be dated on or after the date adjustment and approval of revised
If management does not amend financial statements:

1. Auditor shall notify management and TCWG that the auditor will seek to prevent reliance on
auditor’s report.
2. If despite such notification, management or TCWG do not take necessary steps, the auditor
shall obtain legal advice and shall take appropriate action to prevent users from relying on
auditor’s report.

Describe the auditor’s responsibility for subsequent events occurring between:
(i) The year-end date and the date the auditor’s report is signed; and
(ii) The date the auditor’s report is signed and the date the financial statements are issued. (05 marks)
Masoom & Co. Chartered Accountants have audited the financial statements of Cunning Limited. The financial statements
have been issued after getting proper approval of the Board of Directors and audit report signed by the auditors. After
some time, the auditors came to know that a major lawsuit was decided against the company subsequent to the year-end
but before the audit report was signed by the auditors. The issue existed at the balance sheet date.
The outcome of the lawsuit was not brought to the knowledge of the auditors. Had it been known to the auditors, the
financial statements would have required proper adjustments in this respect. State auditors’ responsibilities in this
situation. (06 marks)
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Auditing – Study Notes Chapter 21 Auditor’s Report II
CHAPTER TWENTY ONE

AUDITOR’S REPORT II
PART A – DRAFTING MODIFIED OPINIONS

LO 1
EFFECT ON REPORT WHEN OPINION IS MODIFIED
✯✯
LO 2 EXAMPLES OF MODIFIED OPINION AND BASIS FOR MODIFIED OPINION
✯ PARAGRAPHS
PART B – GOING CONCERN
LO 3 EVENTS/CONDITIONS, AUDIT PROCEDURES AND AUDIT REPORTING REGARDING
✯ GOING CONCERN STATUS
PART C – KEY AUDIT MATTERS
LO 4
DETERMINATION OF KEY AUDIT MATTERS (KAMs)
✯✯✯
LO 5
COMMUNICATION OF KEY AUDIT MATTERS
✯✯✯
None. There is no concept review question in ICAP’s question bank relating to this chapter.
Question Bank:
141 (Blue Sky Limited)
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PART A – DRAFTING MODIFIED OPINIONS
LO 1: EFFECT ON REPORT WHEN OPINION IS MODIFIED: ✯✯

Effect on Opinion Paragraph:
Auditor shall use the heading “Qualified Opinion,” “Adverse Opinion,” or “Disclaimer of Opinion,” as
appropriate.
Case Effect on Opinion Paragraph

Auditor shall state “except for the effects/possible effects of the matter described in
Qualified
the Basis for Qualified Opinion section, financial statements give a true and fair
opinion
view of ………..”
Auditor shall state “because of the significance of the matter(s) described in the
Adverse
Basis for Adverse Opinion section, financial statements do not give a true and fair
opinion
view of ………..”
Auditor shall state that:
1. because of the significance of the matter(s) described in the Basis for
Disclaimer of Opinion section, the auditor has not been able to obtain sufficient
Disclaimer of
appropriate audit evidence to provide a basis for an audit opinion on the
opinion
financial statements, and
2. the auditor does not express an opinion on the accompanying financial
statements.
Effect on Basis for Opinion Paragraph:

Auditor shall use the heading “Basis for Qualified Opinion,” “Basis for Adverse Opinion,” or “Basis
for Disclaimer of Opinion,” as appropriate.
If modification is
Effect on Basis for Opinion Paragraph
because of…
 If misstatement relates to amounts in financial statements (including
quantitative disclosures in the notes), auditor shall describe the nature of
misstatement; and shall include quantification* of financial effects of
misstatement, unless it is impracticable to do so**.
Misstatement  If misstatement relates to wrong disclosures, auditor shall describe the
nature of wrong disclosure.
 If misstatement relates to non-disclosure, auditor shall describe nature of
omitted disclosure; and shall include the omitted disclosures, unless it is
impracticable to do so*** or it is prohibited by law.
Auditor shall include reason for inability to obtain sufficient appropriate audit
Scope limitation evidence (by stating area affected, procedure not performed, reason of not
performing procedure, alternative procedures not performed).
* An example of quantification of financial effects if effect on income tax, income before taxes, net
income and equity if inventory is overstated.
** If it is not practicable to quantify the financial effects, the auditor shall so state in this section.
***Including the omitted disclosure would be impracticable if:

i. Disclosure is not prepared by management, or
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ii. Disclosure is not readily available to auditor, or

iii. Disclosure is unduly lengthy in relation to audit report.
Other Effects on Report:

If auditor expresses disclaimer of opinion, auditor shall not include Key Audit Matter section in
audit report, unless required by law or regulation to include it.
If auditor expresses disclaimer of opinion or adverse opinion and there is other matter requiring
modification in opinion (i.e. material misstatement in case of disclaimer of opinion, or material
scope limitation in case of adverse opinion), auditor shall describe that matter in Basis for Opinion
section.

List down the information which should be included in the qualification paragraph. Where such paragraph should be
placed, in the audit report? (05 marks)
LO 2: EXAMPLES OF MODIFIED OPINION AND BASIS FOR MODIFIED OPINION PARAGRAPHS:

✯
Example 1: Report with Qualified Opinion (due to misstatement)

Inventory is not stated at lower of cost & NRV, and effect is Material
Qualified Opinion:
We have audited …..
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the
balance sheet, profit and loss account, ……….. give a true and fair view of ………..
Basis for Qualified Opinion:

The Company’s inventories are carried in the statement of financial position at xxx. Management has not stated the
inventories at the lower of cost and net realizable value but has stated them solely at cost, which is a departure from
IFRS. The Company’s records indicate that, had management stated the inventories at the lower of cost and net realizable
value, an amount of xxx would have been required to write the inventories down to their net realizable value.
Accordingly, cost of sales would have been increased by xxx, and income tax, net income and shareholders’ equity would
have been reduced by xxx, xxx and xxx, respectively.
Example 2: Report with Qualified Opinion (due to scope limitation)

Auditor is unable to physically count the inventory, and effect is Material
Qualified Opinion:
In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion section of our
report, the balance sheet, profit and loss account, ……….. give a true and fair view of ………..
Basis for Qualified Opinion:

We were unable to obtain sufficient appropriate audit evidence about the carrying amount of ABC’s inventory as at
December 31, 20X1 because we did not observe the counting of the physical stock as of December 31, 20X1 since that
date was prior to our appointment as auditor of the company. We were unable to obtain sufficient appropriate audit
evidence by performing alternative audit procedures. As a result of aforementioned situation, we were unable to verify
whether these amounts are stated fairly in financial statements.
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Example 3: Report with Adverse Opinion

A subsidiary is not consolidated, and effect is Pervasive
Adverse Opinion
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion section of our report,
the balance sheet, profit and loss account, ……….. do not give a true and fair view of………..
Basis for Adverse Opinion

As explained in Note X, the company has not consolidated the financial statements of subsidiary XYZ Company which it
acquired during 20X1, because it has not yet been able to ascertain the fair values of certain of the subsidiary’s assets and
liabilities at the acquisition date. This investment is therefore accounted for on a cost basis. Under IFRS, the subsidiary
should have been consolidated because it is controlled by the company.
Example 4: Report with Disclaimer of Opinion

Auditor is unable to physically count the inventory, and to confirm accounts receivable, and effect is Pervasive
Disclaimer of Opinion
We were engaged to audit …..
We do not express an opinion on the accompanying financial statements of the company. Because of the significance of
the matter described in the Basis for Disclaimer of Opinion section of our report, we have not been able to obtain
sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements.
Basis for Disclaimer of Opinion

We were unable to obtain sufficient appropriate audit evidence about the carrying amount of ABC’s inventory as at
December 31, 20X1 because we did not observe the counting of the physical stock as of December 31, 20X1 since that
date was prior to our appointment as auditor of the company. We were also unable to obtain sufficient appropriate
audit evidence about the carrying amount of company’s accounts receivables amounting Rs. XXX million because we
were prohibited to obtain confirmation of certain accounts receivables due to introduction of a new computerized
accounts receivable system during the year which resulted in numerous errors in accounts receivable. We were unable
to obtain sufficient appropriate audit evidence by using other alternative procedures. As a result of aforementioned
situation, we were unable to verify whether these amounts are stated fairly in financial statements.
Exam Tip
Wording of opinion is given by ISAs and is standardized. However, wording of basis for opinion is
not standardized and may vary from situation to situation.

Rentals Limited (RL) is a real estate company engaged in the business of renting of office buildings and shopping centres
across the country. The investment properties are carried at fair value. The fair values are determined by an internal
valuer at the end of each reporting period. Assume that after performing the audit procedures, the auditor is not satisfied
with the valuation and has finally decided to modify the audit report.
Required:
Draft an appropriate basis of modification paragraph in the above situation, for inclusion in the audit report. (Assume
necessary details) (06 marks)
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PART B– GOING CONCERN
LO 3: EVENTS/CONDITIONS, AUDIT PROCEDURES AND AUDIT REPORTING REGARDING

GOING CONCERN STATUS: ✯✯
Responsibilities of Management and Auditor regarding Going Concern:
Responsibilities of Management:
Management has a responsibility to make assessment of the company’s ability to continue as a
going concern and to make appropriate accounting/disclosures if:
 Going concern assumption is inappropriate, or
 Going concern assumption is appropriate but a material uncertainty exists.
Responsibilities of Auditor:
Auditor is not responsible to express opinion on going concern. However, he is required to perform
appropriate procedures to obtain evidence whether:
 use of the going concern assumption by management is appropriate.
 there is a material uncertainty about the entity’s ability to continue as a going concern.
Procedures to be performed when assessing whether or not entity is a going concern (or
whether or not material uncertainty exists):
During risk assessment procedures, auditor shall consider whether events or conditions exist that
may cast significant doubt on the entity’s ability to continue as a going concern.
If such events or conditions are identified, auditor shall perform following additional procedures:
1. Requesting management to make assessment of entity’s ability to continue as a going
concern, if management has not yet performed an assessment.
2. Evaluating management’s plans for future actions to improve the situation
3. If entity has prepared a cash flow forecast:
a. Evaluating the reliability of the underlying data generated to prepare cash flow
forecast
b. Determining whether there is adequate support for the assumptions underlying the
forecast.
4. Considering whether any additional facts or information have become available since the
date on which management made its assessment
5. Requesting written representations from management and, where appropriate, those
charged with governance, regarding their plans for future actions and the feasibility of these
plans
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Examples of events or conditions that may cast significant doubt on the entity’s ability to
continue as a going concern:
Financial
 Substantial losses or eroded equity.
 Net liability position (i.e. liabilities exceeding assets).
 Negative operating cash flows (i.e. inability to pay debts, dividends).
 Inability to obtain financing (lenders withdrawing financial supports, suppliers changing
terms to cash).
Operating
 Loss of key management without replacement.
 Loss of a major market, key customer(s), franchise, license, or principal supplier(s).
 Labor difficulties.
 Shortages of important supplies.
 Entry of a highly successful competitor.
Other
 Non-compliance with legal requirements.
 Changes in law or regulation or government policy expected to adversely affect the
entity.
 Pending legal or regulatory proceedings against the entity that may, if successful, result
in claims that the entity is unlikely to be able to satisfy.
 Uninsured or underinsured catastrophes when they occur.
Study Tip
Events/Conditions casting doubt on going concern + Management's Plan to overcome = No Material uncertainty
Events/Conditions casting doubt on going concern – Management's Plan to overcome = Material uncertainty
Auditor’s Conclusions:
Conclusion of Auditor How to Report

1. If financial statements have been prepared on going concern basis, auditor shall
Use of Going Concern express adverse opinion.
Basis of Accounting Is 2. if financial statements have been prepared on another basis (e.g., liquidation basis),
Not appropriate auditor shall express unmodified opinion and shall include Emphasis of Matter
paragraph in his report to draw users’ attention.
If adequate disclosure of material uncertainty is made in financial statements:
Auditor shall express an unmodified opinion, and shall include in report a separate section
under the heading “Material Uncertainty Related to Going Concern” to:
 Draw attention to the note in the financial statements that discloses the matters;
and
Use of Going Concern
 State that these events or conditions indicate that a material uncertainty exists that
Basis of Accounting
may cast significant doubt on the entity’s ability to continue as a going concern and
appropriate but a
 State that auditor’s opinion is not modified in respect of the matter.
material uncertainty
exists
If adequate disclosure of material uncertainty is not made in financial statements:
Auditor shall express a qualified opinion (if effect is material) or adverse opinion (if effect is
pervasive). Auditor shall also state in “Basis for Qualified/Adverse) Opinion paragraph that
material uncertainty exists and that the financial statements do not adequately disclose this
matter.
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In accordance with ISA 570 Going Concern, explain the responsibilities of auditors and management regarding going
concern. (03 marks)
(a) Explain FIVE potential indicators that audit client is NOT a going concern. (05 marks)
(b) Describe the audit procedures which you should perform in assessing whether or not audit client is a going concern.
(05 marks)
(ACCA, Fundamentals Level F8 – amended)
What are the reporting responsibilities of the auditor in the following situations:
a) There is uncertainty regarding going concern assumption which is properly disclosed in the financial statements.
(05 marks)
b) Auditor is of the opinion that the company is not a going concern (05 marks)
PART C– KEY AUDIT MATTERS

ISAs require auditor to communicate Key audit matters (KAM) in his audit report when:
 audit client is a listed entity, or
 communication of KAM is required by law, or
 auditor otherwise decides (using his judgment) to communicate KAM in his report.
LO 4: DETERMINATION OF KEY AUDIT MATTERS (KAMs): ✯✯✯

What are “Key audit matters”:
Those matters that, in the auditor’s professional judgment, are of most significance in the audit of
the financial statements of the current period. Key audit matters are selected from matters
communicated with those charged with governance.
Determining the key audit matters:

The auditor shall determine, from the matters communicated with TCWG, those matters that
required significant auditor attention in performing the audit considering:
 Areas of higher assessed risk of material misstatement, or significant risks identified in
accordance with ISA 315, or
 Significant auditor judgments relating to areas in the financial statements that involved
significant management judgment (e.g. accounting estimates that have high estimation
uncertainty), or
 The effect on the audit of significant events or transactions that occurred during the
period. (e.g. significant transactions with related parties, or significant transactions outside
the normal course of business).
The auditor shall determine which of the matters determined in accordance with above paragraph
were of most significance in the audit of the financial statements of the current period and
therefore are the key audit matters.
Other considerations that may be relevant in determining a key audit matter include:
1. The importance of the matter to intended users’ understanding.
2. The complexity or subjectivity involved in management’s selection of an appropriate policy
compared to other entities within its industry.
3. The nature and extent of audit effort needed to address the matter, including:
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a. The extent of specialized skill or knowledge needed to apply audit procedures to

address the matter or evaluate the results of those procedures, if any.
b. The nature of consultations outside the engagement team regarding the matter.
4. The severity of any control deficiencies identified relevant to the matter.
Study Tip - Circumstances when a Key Audit Matter Is Not Communicated in the Auditor’s Report
In following circumstances, a matter determined to be a key audit matter is not communicated in Auditor’s Report:
1. If law or regulation precludes public disclosure about the matter.
2. If, in extremely rare circumstances, the auditor determines that adverse consequences of such
communication are more than public interest benefits of such communication.
Further, if auditor expresses disclaimer of opinion on the financial statements, the auditor’s report shall not include
a Key Audit Matters section.

(a) In relation to the audit report on financial statements and the contents thereof (under revised/new ISAs), discuss the
appropriateness or otherwise of the following statements:
Key audit matters are determined from the matters communicated with the management of the entity that required
significant auditor’s attention in performing the audit. In making that determination, the auditor shall take into account
the effects on the audit or significant events or transactions that occurred during the current year and prior period
presented. (03 marks)
(b) What is meant by Key Audit Matter? How auditor decides whether a matter is key audit matter or not?
(c) Does requirement to communicate Key Audit Matters apply to all audit clients?
(d) ABC Limited, is a listed audit client. Auditor has determined a matter to be Key Audit Matter. What could be the
situations when auditor will not include this Key Audit Matter in his audit report?
LO 5: COMMUNICATION OF KEY AUDIT MATTERS: ✯✯✯

Communication/Description/Presentation of Key Audit Matters in Audit Report:
Placement of Key Audit Matter Paragraph:
Key Audit Matters are described in audit report (using appropriate subheadings) under the heading
“Key Audit Matters”. KAM Section will be placed immediately after basis for opinion paragraph.
Descriptions of Introductory Language of Key Audit Matter Section:

The introductory language of this section shall state that key audit matters are those matters that,
in the auditor’s professional judgment, were of most significance in the audit of the financial
statements of the current period; and these matters were addressed in the context of the audit of
the financial statements as a whole, and the auditor does not provide a separate opinion on these
matters.
Descriptions of Individual Key Audit Matters:

Thereafter, auditor shall describe each key audit matter one by one (using appropriate
subheadings). For each key audit matter auditor is required to describe:
1. Why the matter was considered to be one of most significance in the audit
2. How the matter was addressed in the audit, including
(a) a brief overview of procedures performed; or
(b) key observations with respect to the matter, or
(c) an indication of the outcome of the auditor’s procedures; or
(d) some combination of these elements.
3. Reference to the related disclosure(s) in financial statements
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Study Tips
If the auditor determines that there are no key audit matters to communicate, the auditor shall include
a statement to this effect in auditor’s report under the heading “Key Audit Matters.”
Communication of Key Audit Matters to TCWG:

The auditor shall communicate with those charged with governance:
(a) Those matters the auditor has determined to be the key audit matters; or
(b) If applicable, the auditor’s determination that there are no key audit matters to
communicate in the auditor’s report.
Exam Tip – Key Audit Matters (KAM) are Not a Substitute for other modifications in report
If a matter is a misstatement/scope limitation, or Emphasis of matter/Other matter, or Going concern
uncertainty, it will NOT be discussed in KAM (rather these will be discussed in their relevant place).

(a) Where is KAM presented in audit report?
(b) What information is included in a Key Audit Matter section of an audit report?
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Auditing – Study Notes Chapter 22 Review Engagement
CHAPTER TWENTY TWO

REVIEW ENGAGEMENT
PART A – INTRODUCTION TO AUDIT AND RELATED SERVICES

LO 1
AUDIT AND AUDIT RELATED SERVICES
✯✯
PART B – ENGAGEMENT TO REVIEW FINANCIAL INFORMATION
LO 2
PRINCIPLES TO APPLY TO REVIEW ENGAGEMENTS
✯
LO 3
PROCEDURES FOR A REVIEW ENGAGEMENT
✯✯✯
LO 4 MATTERS TO BE EVALUATED BEFORE EXPRESSING CONCLUSION AND
✯ TYPES OF CONCLUSIONS
LO 5
REPORT OF A REVIEW ENGAGEMENT
✯✯
111d (Multiple Situations) 147b (ISRE 2400)

126g (Multiple Questions)
Question Bank:
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PART A – INTRODUCTION TO AUDIT AND RELATED SERVICES
LO 1: AUDIT AND AUDIT RELATED SERVICES: ✯✯

Audit: (or reasonable assurance engagement)
Objective of a reasonable assurance engagement (e.g. audit of financial statements) is to obtain high
but not absolute level of assurance to provide positive form of conclusion about subject matter (e.g.
In our opinion, financial statements give true and fair view).
Review: (or limited assurance engagement)

Objective of a limited assurance engagement (e.g. review of financial statements) is to obtain
moderate level of assurance to provide negative form of conclusion about subject matter (e.g. Based
on our review, nothing has come to our attention that causes us to believe that financial statements
do not give true and fair view).
Agreed-upon Procedures:
The objective is to carry out procedures of audit nature to which the auditor and the entity have
agreed and to report on factual findings. Report is restricted to interested parties only.
Compilations:
The objective is to carry out procedures of accounting nature to collect, classify and summarize
financial information e.g. preparing a tax computation for client.
Difference between Audit and Review:
Audit Review
Procedures performed in audit are The practitioner performs primarily inquiry and analytical
more than performed in review. procedures to obtain sufficient appropriate evidence in a
review engagement. A review ordinarily does not require
Procedures
tests of controls, or tests of details (e.g. inspection of
documentation, observation or confirmation) which are
performed in an audit.
Level of In an audit, reasonable/high/positive In a review, limited/moderate/negative assurance is
assurance assurance is provided. provided.
How In an audit, assurance is expressed in In a review, assurance is expressed in negative form of
assurance is positive form of conclusion i.e. “in our conclusion i.e. “Based on our review, nothing has come to our
presented in opinion, financial statements give true attention that causes us to believe that financial statements
report and fair view” do not give true and fair view”.

(i) Explain the purpose of review engagements and how these differ from external audits; and (02 marks)
(ii) Describe the level of assurance provided by external audits and review engagements. (02 marks)
Explain how and why the levels of assurance provided by an audit and assurance firm might differ for different types of
assurance engagement. (03 marks)
Briefly discuss the level of assurance given in the following types of engagements:
i. Audit
ii. Review
iii. Agreed upon procedures
iv. Compilation (06 marks)
194
Explain how and why the planned procedures for an engagement to review financial statements would differ from the
planned procedures for an audit required under the Companies Act 2006. (04 marks)
What is agreed-upon procedures engagement?
PART B – ENGAGEMENT TO REVIEW FINANCIAL INFORMATION
LO 2: PRINCIPLES TO APPLY TO REVIEW ENGAGEMENTS: ✯

A professional engaged in a review engagement shall:
 Comply with ethical requirements.
 Agree terms of engagement in engagement letter.
Engagement letter for a review shall include all required elements of an engagement letter
for audit. Further, engagement letter for a review shall also include a statement that the
engagement is not an audit, and the practitioner will not express an audit opinion on the
 Determine and apply materiality for the financial statements.
 Obtain sufficient and appropriate evidence by performing “Review Procedures”.
 Express his conclusion in negative form in a written report.
LO 3: PROCEDURES FOR A REVIEW ENGAGEMENT: ✯✯✯

The practitioner performs primarily inquiry and analytical procedures to obtain sufficient
appropriate evidence in a review engagement. However, additional procedures may also be
performed if practitioner becomes aware of an indication of misstatement.
Examples of Inquiries:
Practitioner’s inquiries of management and others within the entity shall include following:
1. How management makes the significant accounting estimates
2. identification of related parties and related party transactions
3. Whether there are significant, unusual or complex transactions, events or matters affecting
financial statements
4. The existence of any actual, suspected or alleged fraud or non-compliance with laws
5. Whether management has identified and addressed events occurring between the date of
the financial statements and the date of the practitioner’s report that require adjustment of,
or disclosure in, the financial statements
6. The basis for management’s assessment of the entity’s ability to continue as a going
concern, and any conditions casting doubt.
Evaluating the responses provided by management is integral to the inquiry process.
Examples of Analytical Procedures:

1. Comparison of entity’s financial information with comparable prior period, industry
information, or budgets.
2. Consideration of relationships among financial and non-financial information e.g. analysis of
GP Ratio, debtors’ turnover ratio.
195
Other Procedures:
Practitioner shall:
1. Reconciling the financial statements to the underlying accounting records
2. Review going concern status of entity, and subsequent events.
3. Obtain written representation letter from management.

State any eight key procedures which are performed during a review engagement of historical financial statements.
(08 marks)
The auditor of a listed company is required to review the half yearly financial statements. You are required to explain:
(a) the objectives of such review and how does it differ from audit; and
(b) the procedures that are performed while carrying out such review. (07 marks)
LO 4: MATTERS TO BE EVALUATED BEFORE EXPRESSING CONCLUSION AND TYPES OF

CONCLUSIONS: ✯
Matters to be evaluated before expressing conclusion:
Before reaching a conclusion, practitioner shall consider the same factors as are considered in an
audit. (Refer LO 3 of Chapter # 4).
Which type of conclusion to express in which circumstances:

There are four types of audit opinions, expressed by an auditor.
Immaterial effect Material effect Pervasive effect
Misstatement Adverse Conclusion

Unmodified Conclusion Qualified Conclusion
Scope Limitation Disclaimer of Conclusion
If a modified conclusion is expressed in review report, auditor shall describe nature of

misstatement or scope limitation in basis for conclusion paragraph (as explained in case of
modified audit opinion, refer LO 1 of Chapter # 21).
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LO 5: REPORT OF A REVIEW ENGAGEMENT: ✯✯

A review report consists of following elements:
Sr. # Content Brief Explanation

Title shall clearly indicate that it is the report of an independent
1. Title
practitioner for a review engagement.
2. Addressee As required by the circumstances of the engagement
Introductory Almost similar information as is included in audit report.
3.
Paragraph
Description of Responsibilities of management for preparation of financial statements in
4. Management’s accordance with AFRF.
Responsibility
Description of Practitioner’s responsibility to express a conclusion on financial
5. Practitioner’s statements including reference to the ISRE and applicable laws and
Responsibility regulation.
This paragraph shall state description of a review of financial statements
and its limitations, and the following statements:
 A review engagement under this ISRE is a limited assurance
engagement.
Scope of Review
6.  The practitioner performs procedures, primarily consisting of
Paragraph
making inquiries ................... (to be produced as stated in format
below)
 The procedures performed in a review are substantially less than
........ (to be produced as stated in format below)
A paragraph under the heading “Conclusion” that contains:
 The practitioner’s conclusion on the financial statements
Conclusion  A reference to the applicable financial reporting framework used
7.
Paragraph to prepare the financial statements
If conclusion is modified, a paragraph is to be included to explain the
nature of misstatement or scope limitation causing modification.
8. Signature Same as in audit report.
9. Date Same as in audit report.
10. Address Same as in audit report.
Study Tip
Practitioner can also include in his report “Emphasis of matter” and/or “Other matter” paragraphs.
197
Example of Review Report (Unqualified Conclusion)

INDEPENDENT PRACTITIONER’S REVIEW REPORT
[Appropriate Addressee]
We have reviewed the accompanying financial statements of ABC Company, which comprise the statement of financial
position as at December 31, 20X1, and the statement of comprehensive income, statement of changes in equity and
statement of cash flows for the year then ended, and a summary of significant accounting policies and other
explanatory information.
Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these financial statements in accordance with
the International Financial Reporting Standard for Small and Medium-sized Entities, and for such internal control as
management determines is necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error.
Practitioner’s Responsibility
Our responsibility is to express a conclusion on the accompanying financial statements. We conducted our review in
accordance with International Standard on Review Engagements (ISRE) 2400, Engagements to Review Historical
Financial Statements. ISRE 2400 requires us to conclude whether anything has come to our attention that causes us to
believe that the financial statements, taken as a whole, are not prepared in all material respects in accordance with the
applicable financial reporting framework. This Standard also requires us to comply with relevant ethical requirements.
Scope of Review
A review of financial statements in accordance with ISRE 2400 is a limited assurance engagement. The practitioner
performs procedures, primarily consisting of making inquiries of management and others within the entity, as
appropriate, and applying analytical procedures, and evaluates the evidence obtained.
The procedures performed in a review are substantially less than those performed in an audit conducted in accordance
with International Standards on Auditing. Accordingly, we do not express an audit opinion on these financial
statements.
Conclusion
Based on our review, nothing has come to our attention that causes us to believe that these financial statements do not
present fairly, in all material respects, (or do not give a true and fair view of) the financial position of ABC Company as
at December 31, 20X1, and (of) its financial performance and cash flows for the year then ended, in accordance with the
International Financial Reporting Standard for Small and Medium-sized Entities.
Signature
Date
Address

Describe the main contents of the limited assurance report to be issued following your firm’s review of the financial
information. (07 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – December 2009)
You, the Audit Manager, have been asked by the Engagement Partner to draft “Negative Assurance” in your report on the
accounts of WWF Manufacturing Company Limited for the year ended June 30, 2000, based on your Review which you
carried out as result of your firm’s engagement to review financial statements.
Required:
Draft the requested Negative Assurance. (05 marks)
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PART B
CASE STUDIES
Auditing – Case Studies Chapter 1 Introduction to Assurance Services
CHAPTER ONE (CASE STUDIES)

INTRODUCTION TO ASSURANCE SERVICES
APPENDIX 1: CASE STUDY RELATING TO NECESSAITY, ADVANTAGES AND DISADVANTAGES

OF ASSURANCE SERVICE: ✯
Structure of the Case:
In exam, you may be required to comment on necessity, advantages or disadvantages of performing
assurance service in a given situation.
Suggested Approach to Answer:

Before attempting question, carefully note:
 From whose perspective you are required to comment (whether shareholders, directors or
bankers etc.)
 What you are required to comment (whether necessity, advantages or disadvantages).
Model Case Study From Examination Questions:
Case Study:
You are the auditor of Royale Limited, a manufacturer of fireworks. Following a disappointing last three months of
trading, the company has requested an extension to its overdraft facility from its bankers. The bank has in turn asked
your firm to carry out an assurance engagement on financial statements of company.
Explain the benefits and disadvantages to both the bank and Royale Limited of obtaining the assurance report.
(04 marks)
Suggested Solution:
Benefits to Bank:
 Independent assurance report increases credibility of financial statements. Bank can better analyze liquidity and
solvency position of company as well as appropriateness of value of securities.
Limitation for Bank:

 Assurance is not absolute. There is still some risk of misstatement in financial statements.
Benefits to Royale Limited:

 Help in approval and quick processing of loan.
Limitation for Royale Limited:

 Assurance will take cost and time of Royal Limited.
199
Auditing – Case Studies Chapter 2 Basic Concepts of Auditing
CHAPTER TWO (CASE STUDIES)

BASIC CONCEPTS OF AUDITING
APPENDIX 1:
CASE STUDY RELATING TO AUDITOR’S RESPONSIBILITIES/
EXPECTATION GAP: ✯✯
In exam, a situation may be given in which a misstatement or deviation in internal control has
occurred, and auditor could not identify it even if an audit was conducted. You will be required to
comment whether auditor is responsible in the case or not.
Suggested Approach to Solve:

Keep in mind the responsibilities of auditor, and check in the case whether auditor has met them or
not.
Case Study 1:
The following issues were highlighted in a meeting of the audit committee of XYZ Limited with regard to financial
statements of one of its subsidiaries on which auditors had issued an unmodified audit report:
(i) The audit procedures were unable to detect a material error in inventory valuation, because it occurred under
exceptional circumstances and the internal controls established by the management could not prevent and detect the
same.
(ii) The provision for bad debt was insufficient and the impact was material. It was also evident from the subsequent
events, which came into the knowledge of the auditors before they issued their report.
You are one of the independent members of the audit committee and are considered an expert on financial reporting
issues. The chairman of the audit committee has asked your comments with regard to the responsibilities of management
and auditors of the above mentioned subsidiary. Give your comments on each of the above matters. (06 marks)
Solution:
(i)
In this case, although financial statements contained a material misstatement but auditor was justified in issuing
unmodified audit report because error occurred in exceptional circumstances. It is the duty of management to design and
operate internal controls which are necessary to prepare financial statements that are free from error or fraud.
However as the matter has come to attention now, auditor should take necessary steps to ensure that financial statements
are revised and should issue new audit report on them because subsequent discovery of errors or frauds is an adjusting
event.
(ii)
In this case, auditor can be held responsible for this because matter had come into his knowledge before issuance of
auditor’s report. He should have proposed adjustment for the misstatement and if uncorrected, he should have issued
Qualified Opinion or Adverse Opinion.
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Case Study 2:
You were the engagement partner on the audit of a commercial bank which has a network of more than 200 branches,
across the country. During a recent meeting, a member of the audit committee referred to an instance of irregularity in a
branch, whereby the Branch Manager had extended credit to a close relative without following the bank’s credit
disbursement procedures. The member criticized the auditors for their failure to highlight such instances.
Required:
As an engagement partner, write a letter to the audit committee explaining your point of view in detail with specific
references to the International Standards on Auditing, wherever applicable. (09 marks)
Solution:
View point expressed by member of audit committee is incorrect.
Auditor’s Primary responsibility/Overall objective is:

 To obtain reasonable assurance whether financial statements are free from material misstatement (due to error
or fraud) to enable auditor to express opinion on financial statements, and to report on financial statements and
 To communicate in accordance with the auditor’s findings as required by ISAs. (e.g. to communicate TCWG
significant deficiencies in internal control if identified during the audit).
Granting a credit without following bank’s procedures is a weakness in Internal Control, not a misstatement in financial
statements. Therefore, responsibility regarding financial statements has been fulfilled.
Although auditor is required to communicate TCWG significant deficiencies in internal control if identified during the
audit; however:
(a) This deficiency may not have been identified during the auditor because auditor’s work is based on sample basis
or branch manager may have intentionally concealed this fact from auditor which makes it difficult to detect
such irregularities.
(b) Even if identified, this deficiency in internal control may not be significant in auditor’s judgment.
Last but not least, primary responsibility to design, implement and operate internal control is of management/TCWG (and
not of auditor).
Author’s Comments:
This was a case of weakness in internal control. Had it been a case of misstatement not identified by auditor, arguments of
auditor would have been on the basis of “Materiality”, and “Inherent Limitations of Audit”.
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APPENDIX 2: CASE STUDY RELATING TO APPLICATION OF PROFESSIONAL

SKEPTICISM: ✯
In exam, you may be given a situation in which there will be:
 inconsistency/contradiction between two sources of evidence, or
 client may ask you to rely on his working without detailed investigation.
You will be required to identify appropriate course of action in the situation.

You will state that:
 auditor shall investigate the matter, by applying professional skepticism.
 auditor shall determine what further audit procedures are necessary to resolve the matter
(depending on specific situation).
 auditor shall also consider the effect of the matter on other aspects of the audit (e.g. on risk
assessment).
Case Study:
During the course of the audit of Smart Services Limited for the year ended March 31, 2010, the auditor noted
certain contradictions between the results of inquiries from company’s legal advisor and the representation provided
by the management in respect of certain contingencies.
Considering the above scenario, explain how the attitude of “Professional Skepticism” would help the auditor to
deal with such matters? (03 marks)
Solution:
Auditor shall not ignore this inconsistency between inquiries from legal advisor and management’s representation as it
indicates possibility of misstatement.
Auditor should perform further specific procedures to determine which source of evidence is reliable e.g.:
1. further inquiry of management and legal advisor about reasons of difference.
2. inspect documents relating to litigations/contingencies.
3. obtain opinion from third parties e.g. other lawyers.
4. consider subsequent decision of the legal case/contingencies.
In the light of results of procedures performed, auditor shall also revise it risk assessment.
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Auditing – Case Studies Chapter 3 Audit Evidence
CHAPTER THREE (CASE STUDIES)

AUDIT EVIDENCE
APPENDIX 1: CASE STUDY RELATING TO RELEVANCE AND RELIABILITY OF EVIDENCE:
✯
Structure of the Case Suggested Approach

In exam, you may be required to conclude Check whether all assertions of the relevant area
Case study on
whether sufficient evidence has been obtained in have been verified. If any of the assertion is not
Sufficiency of
a given situation or not. addressed, sufficient evidence has not been
Evidence
obtained.
In exam you may be given: This is quite easy question because an audit
 An audit procedure, and may be required to procedure may address many assertions; an
Case study on
identify relevant assertion being addressed by assertion may be addressed by many procedures.
Relevance of
that procedure, or State any one (or two if you can).
Evidence
 An assertion, and may be required to identify
relevant audit procedure.
In exam, you may be given some evidences (e.g. Apply the rules of reliability learnt in the chapter
confirmation letter, representation letter, bank and conclude whether reliability of evidence is
Case study on statement), and you will be required to comment high, moderate or low.
Reliability of on their reliability.
Evidence However, you will be given marks for your basis of
conclusion (e.g. for stating whether evidence is
external or written)
Case Study 1:
Comment on the Relevance and Reliability of following evidences:
1. A letter from bank, confirming bank balance at year end, directly received by auditor.
2. Creditors' monthly statements of accounts prepared by Accounts Payable Department of the company.
3. Shipping documents sent by company and received back after acknowledgment of customer.
4. Title documents about company's properties held by client.
5. A bank statement from client's file.
Solution:
Sr. Relevance
Reliability Reason
# (i.e. provides evidence about)
Existence and Rights and External documentary evidence,
1. High
Obligation of Bank Balance directly obtained by auditor
Moderate (if internal Internal documentary evidence, created

2. Completeness of Creditors
controls are strong) and held by client
Internal documentary evidence, created
3. Occurrence of Sales Transactions Moderate and held by client. However also
circulated externally.
External documentary evidence, but not
4. Rights & Obligations of Properties Moderate
direct
External documentary evidence, but not
5. Existence of Bank Balance Moderate
direct
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Case Study 2:
You are the audit senior on the audit of Orio (Private) Limited, a large manufacturing company, for the year ended 30 June
2015. You are reviewing the audit working papers prepared by the audit assistant, Bisma.
(a) You notice that on 30 June Bisma attended the stocktake and observed that the client followed the stocktake
instructions. She selected numerous items for test counting from the client’s inventory sheets and all were found to be
correct. Bisma concluded that the inventory was fairly stated.
(b) You also noticed that advertising expenses are material, although only 50 per cent of last year’s balance. Bisma
selected a large sample of entries and agreed them to supporting documents. No errors were found. Bisma concluded that
advertising expenses were reasonable.
Required:
Indicate whether sufficient appropriate audit evidence was obtained to support the conclusions reached. Give reasons.
Solution:
(a) Sufficient appropriate evidence has not been obtained as only two assertions relating to Inventory have been verified
(i.e. Existence, and Rights & Obligation). No work has been performed to test “Completeness” and “Valuation and
Allocation” assertions.
(b) Sufficient appropriate evidence has not been obtained as Bisma has tested assertion of “Occurrence” only. Whereas,
primary risk in advertisement was of “Completeness” (considering 50% reduction is compared to last year). , Therefore,
Bisma should also have tested unrecorded amounts in advertising expense.
APPENDIX 2: CASE STUDY RELATING TO AUDIT PROCEDURES: ✯

In exam, you may be given a list of procedures, and may be required to identify whether:
1. Technique to which it relates (i.e. whether inquiry, observation etc)
2. Each procedure is a Test of Control or Substantive Procedure. (requires advanced
understanding of the topic to be covered in later chapters of Tests of Controls and
Substantive Procedures.)
3. Assertion which it verifies.

To attempt these types of questions, you should be familiar with audit procedures performed in
major areas of financial statements alongwith relevant assertions verified by each procedure.
Study Tips
 Most of the inquiries are Risk Assessment Procedures, and most of the observations are Test of
Control.
 If analytical procedures involve use of Ratios/Percentages, these are Risk Assessment
Procedures. If analytical procedures involve development of expected amounts, these are
Substantive Procedures.
 If you are verifying information included in financial statements, it is substantive procedure,
otherwise it is Test of Control.
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CASE STUDY OF AUDIT PROCEDURES – AN EXAMPLE

Case Study:
You are working on the audit of Butter Cookies Limited, for the year ending 30 June 2015. You are reviewing the audit
plan of “Sales” which includes relevant assertions and the detailed procedure you are about to perform.
An extract from the Audit Plan is reproduced below:

Item Assertion Detailed Audit Procedure
Select a sample of sales invoices from the sales journal and ensure each sales invoice has been
1. Completeness
matched by the sales staff to an authorized delivery note and approved customer order.
2. Accuracy Select a sample of sales invoices from the sales journal and check its computation.
Required:
For each of the items 1 to 2 above:
(a) Indicate whether the audit procedure is a test of control or substantive procedure.
(b) Indicate whether the audit procedure addresses the given assertion and if the audit procedure does not address the
given assertion, state the assertion that is addressed.
Solution:
Item # Type of Procedure Is stated assertion correct?

1. Test of control No, correct assertion is Occurrence.
2. Substantive Procedure Yes.
APPENDIX 3: CASE STUDY RELATING TO AUDIT DOCUMENTATION: ✯

In exam, you may be given a statement or situation dealing with Preparation, Ownership, Retention,
Confidentiality, Change after auditor’s report of audit documentation.
You will be required to comment whether the statement/situation violates any requirement of ISAs.

Keep in mind relevant requirements which you have studies and apply relevant requirements to
case.
CASE STUDY OF AUDIT DOUCMENTATION – AN EXAMPLE

Case Study:
The partnership of Smith, Frank & Clark, a CPA firm, has been the auditor of Greenleaf, Inc., for many years. During the
annual audit of the financial statements for the year ended December 31, 20X2, a dispute developed over whether certain
disclosures should be made in the financial statements. The dispute resulted in Smith, Frank & Clark’s being dismissed
and Greenleaf’s engaging another CPA firm. Greenleaf demanded that Smith, Frank & Clark turn over all working papers
applicable to the Greenleaf audits or face a lawsuit. Smith, Frank & Clark refused. Greenleaf has instituted a suit against
Smith, Frank & Clark to obtain the working papers.
Will Greenleaf succeed in its suit? Explain.
(American Institute of Certified Public Accountants – adapted)
Solution:
No, because auditor is the owner of working papers prepared by him and it is not obligatory on him to give them to any
other person unless this is mutually agreed between client and auditor.
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Auditing – Case Studies Chapter 4 Auditor’s Report & Types of Opinions
CHAPTER FOUR (CASE STUDIES)

AUDITOR’S REPORT & TYPES OF
OPINIONS
APPENDIX 1: CASE STUDY RELATING TO IDENTIFYING ERRORS IN AUDITOR’S
REPORT: ✯✯
An audit report with numerous errors will be given in question; and you will be required to identify
errors from given auditor’s report.

1. Learn the key terms used in the audit report; also keep in mind circumstances when an
opinion is modified, or emphasis of matter paragraph other matter paragraph is included.
2. Use element-wise format to comment on report.
3. If something is omitted, state the words/phrase/name of para which is omitted.
4. If something is wrong, write error alongwith explanation (i.e. correct treatment).
5. DO NOT redraft report; otherwise you will get zero marks.
If there is modification in report:

1. Evaluate whether type of modification is correctly chosen (between modified opinion,
emphasis of matter or other matter).
2. Basis for modified opinion paragraph and modified opinion paragraph should be separate.
3. Management’s point of view is not given in Basis for Modified Opinion Paragraph.
In the absence of information, assume that Auditor’s Report is to be drafted/corrected in accordance

with “Form 35A of Companies Rules 1985”.
Case Study 1:
Al-Badr & Company, Chartered Accountants, have conducted the statutory audit of the financial statements of Al-Qasim
Limited, a listed company, for the year ended June 30, 2010 under the requirements of the Companies Ordinance, 1984.
The job in charge has drafted the following audit report:
Auditors’ Report to the Directors

We have audited the annexed balance sheet of Al-Qasim Limited as at June 30, 2010 and the related profit and loss
account and statement of changes in equity together with the notes forming part thereof, for the year then ended and we
state that we have obtained all the information and explanations which, to the best of our knowledge and belief, were
necessary for the purposes of our audit.
We conducted our audit in accordance with the auditing standards. These standards require that we plan and perform the
audit to obtain reasonable assurance about whether the above said statements are free of any material misstatement. An
audit includes examining evidence supporting the amounts and disclosures in the above said statements. An audit also
includes assessing the accounting policies and all estimates made by management, as well as, evaluating the overall
presentation of the above said statements. We believe that our audit provides a reasonable basis for our opinion and, after
due verification, we report that:
(a) in our opinion:
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(i) the balance sheet and profit and loss account together with the notes thereon have been drawn up in
conformity with the Companies Ordinance, 1984, and are in agreement with the books of account and further in
agreement with accounting policies consistently applied;
(ii) the expenditure incurred during the year was for the purpose of the company’s business; and
(iii) the business conducted, investments made and the expenditure incurred during the year were in
accordance with the objects of the company;
(b) in our opinion and to the best of our information and according to the explanations given to us, the balance sheet,
profit and loss account and statement of changes in equity together with the notes forming part thereof conform with
International Financial Reporting Standards, and give the information required by the Companies Ordinance, 1984, in the
manner so required and respectively give a true and fair view of the state of the company’s affairs as at June 30, 2010 and
of the profit and changes in equity for the year then ended; and
(c) in our opinion, no zakat was deductible at source under the Zakat and Ushr Ordinance, 1980 (XVIII of 1980).
Al-Badr & Company
Chartered Accountants
Karachi
Dated: September xx, 2010
Required:
Identify and explain (where necessary) the errors in the above audit report.
(Note: You are not required to redraft the report.) (12 marks)
Solution:
Element Error/Omission
Addressee  Word “Directors” should be replaced by word “Members”.
Introductory  “Cash flow statement” is omitted from complete set of financial statements.
Paragraph
Management’s  This paragraph is omitted from report.
Responsibility
Paragraph
 Sentence “Our responsibility is to express an opinion on these statements based on our
audit” is omitted.
Auditor’s
 Words “as applicable in Pakistan” are omitted after the words “We conducted our audit
Responsibility
in accordance with the auditing standards”.
Paragraph
 Phrase “on a test basis” is omitted from description of audit.
 Words “all estimates” should be replaced by words “significant estimates”.
 Sentence “in our opinion, proper books of accounts have been kept by the company as
required by the Companies Ordinance, 1984;”, is omitted.
 “cash flow statement” is omitted from complete set of financial statements.
Opinion Paragraph
 Words “conform with International Financial Reporting Standards” should be replaced
by words “conform with approved accounting standards as applicable in Pakistan”.
 True and fair view of “cash flows” is omitted
Date  “xx” should be replaced by a real date of the month of September.
Name  Name of engagement partner is omitted.
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APPENDIX 2: CASE STUDY RELATING TO IDENTIFYING IMPACT ON AUDITOR’S

OPINION/REPORT: ✯✯✯
You will be given many short situations, and requirement will be to explain implication of each
situation on auditor’s opinion/report. Every situation is to be solved separately, whether all
situations relate to different clients or same client.

Step # 1:
Explain whether the given situation is a Misstatement, Scope Limitation or some other matter (e.g.
5 additional opinion or EOM/OM paragraphs). Any wrong concept (of accounting or auditing)
mentioned in the question is to be corrected.
(A list of frequently examined situations is given in Appendix – 3 alongwith explanation).
Step # 2: (only if there is a misstatement or scope limitation)

Determine effect of misstatement or scope limitation i.e. whether immaterial, material or pervasive.
Two situations are possible in exam in this regard:
 It will be mentioned in question (i.e. question clearly states that effect is
material/pervasive, or profit is given. If profit is given, we can calculate materiality using
Rule of Thumb i.e Materiality = 5% of Profit)
 If it is not mentioned in question, cover both situations. (words “significant” or “major” in
question indicate to cover both situations).
Step # 3:
State effect on opinion/report in 3 stages:
1. State type of opinion on financial statements.
2. If any of 5 additional opinions (e.g. proper books of accounts, deduction and deposit of
Zakat, change in accounting policy) is to be modified, state this.
3. If the situation requires inclusion of emphasis of matter paragraph or other matter
paragraph or key audit matter or material uncertainty related to going concern, state this.
Exam Tip – Effect on Opinion/Report Vs. Effect on Audit/Course of Action

If it is an open-end question (e.g. requirement is ' what should auditor do in this situation' or 'what
shall be effect on audit') , you should discuss all possibilities i.e. effect on audit report as well as effect
on other aspects e.g. risk assessment, procedures, communication with other stakeholders.
CASE STUDY ON DECIDING TYPE OF OPINION– FIRST EXAMPLE

Case Study 1:
Identify with justification how the following items would effect the auditors opinion
(a) The auditors have not been able to physically verify the inventory and have to rely on management
representation letter. The inventory constitutes a material portion of the current assets of the company.
(b) The company has determined the useful life of vehicles to be 10 years over which they are depreciated. The
auditors believe that this useful life is not justified.
(c) 3% of the total purchases are authorized by the purchase officer rather than the purchase manager.
(d) The Company is not complying with the provisions of IAS-2 Inventories for valuation of inventory. The company
has misclassified capital expenditure on account of machinery as revenue expenditure. The company has not
disclosed one of its long term loans in the financial statements. (08 marks)
(PIPFA, Corporate Sector – Winter 2008)
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Solution:
(a)
 Management representation letter is not a sufficient appropriate audit evidence, therefore, this is a scope limitation
if auditor is unable to obtain evidence from alternative procedures too.
 Auditor shall express Qualified Opinion on financial statements (as effect is material).
(b)
 As depreciation estimate is not reasonable, this is a misstatement in financial statements.
 Auditor shall express qualified opinion (if effect is material) or adverse opinion (if effect is pervasive) on financial
statements.
(c)
 Authorization of purchasers by other than appropriate authority is a weakness in internal control (not a
misstatement or scope limitation). This does not affect audit report as no opinion is required in Pakistan regarding
operating effectiveness of internal controls.
 Auditor shall express unmodified opinion on financial statements.
(d)
 These are misstatement in financial statements as company is not complying with various requirements of IFRS.
 Auditor shall express adverse opinion on financial statements, because effect is pervasive as it is not confined to
single element of financial statements..
CASE STUDY ON DECIDING TYPE OF OPINION– SECOND EXAMPLE

Case Study 2:
The following situations have arisen on different clients being audited by your firm. The year-end in each instance is 31
December 2013.
(i) During the year Iron Limited has changed its policy for valuation of intangible assets from Cost Model to
Revaluation Model. (03 marks)
(ii) Due to fire in the record room of Titanium Limited, all the records and backup related to the fixed assets, trade
debtors and stocks were destroyed and you are unable to perform audit procedures for verification of the balances.
(03 marks)
(iii) During the planning stage of Coal Limited it was noted that the system of internal controls of the company is weak.
This aspect was taken into consideration in determining the nature, timing and extent of the audit procedures.
(02 marks)
(iv) One of the plants of Uranium Limited was destroyed subsequent to year-end. Appropriate disclosure thereof has
been made in the financial statements. (02 marks)
Required:
Discuss the impact of each of the above matters on the audit report.
Solution:
(i)
This is a change in accounting policy. Auditor shall express unmodified opinion on financial statements. However, auditor
shall:
a) Mention the exception to consistent application of accounting policies in his report.
b) Refer to the note in financial statements where full disclosure is available.
c) State in his report whether he concurs with the change or not.
(ii)
1. This is a scope limitation.
2. Auditor shall express Disclaimer of opinion on financial statements, because effect is pervasive as it is not confined to
single element of financial statements.
3. Auditor shall also modify his opinion, as required by Form 35A, by stating that “proper books of accounts have not
been kept in respect of this matter”.
(iii)
 This is a weakness in internal control. This does not affect audit report as no opinion is required in Pakistan
regarding operating effectiveness of internal controls.
 Auditor shall express unmodified opinion on financial statements.
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(iv)
1. As per IAS – 10, it is a non-adjusting event requiring disclosure in financial statements.
2. Auditor shall express unmodified opinion on financial statements.
3. However, as this is a significant subsequent event, auditor shall include Emphasis of Matter Paragraph in his
report which shall:
o State a clear reference to the matter being emphasized.
o Refer to the note in financial statements which fully describe the matter.
o State that auditor’s opinion is not modified in respect of this matter.
Examiners’ Comments:
(i) Very few candidates identified the need to mention the exception to the consistent application of accounting policies and
whether or not the auditor concurred to the exception. Instead, they stated that an emphasis of matter paragraph would be
required. Some candidates wrote about the accounting treatment of intangible assets under the Cost and Revaluation model
which was not required.
(ii) Most candidates correctly mentioned that a disclaimer of opinion would be required under the circumstances; however,
many among them could not identify that the auditor would also be required to report that proper books of accounts as
required by the Companies Ordinance, 1984 have not been maintained.
(iii) Most of the candidates did not appreciate the fact that weaknesses in controls are not reported in the audit report. Most
of them advised some sort of modification.
(iv) About half the candidates correctly identified the need of an emphasis of matter paragraph which should give reference
to the note in the financial statements where the matter was disclosed. The others had little idea and resorted to guesswork
which mostly resulted in irrelevant answers. Some candidates went into details regarding the going concern assumption.
Such a discussion was not required.
CASE STUDY ON DECIDING TYPE OF OPINION– THIRD EXAMPLE

Case Study 3:
Described below are situations which have arisen in four audits. The year end in each case is 31 March 2002.
Mercury Ltd
On 21 March 2002, the Inland Revenue commenced a major enquiry into all aspects of the tax affairs of the company. Until
the enquiry is completed, it is not possible to estimate, with any reasonable degree of certainty, any ultimate liability
which may fall upon the company. Consequently, no liability in respect of this matter has been included in the financial
statements. The directors have included a note to the accounts explaining the situation.
Pluto Ltd
Included in the balance sheet at 31 March 2002 are fixed assets at cost of £2.5 million which have been constructed by the
company during the year. The costs include own labour capitalised of £180,000. The labour costs are based on the
directors’ estimates of time spent by employees on the construction work, which are unsupported by time records. There
are no satisfactory audit procedures to confirm that labour costs have been appropriately capitalised.
The pre-tax profit of Pluto Ltd for the year ended 31 March 2002 is £650,000.
Jupiter Ltd
On 16 May 2002 a liquidator was appointed at Saturn Ltd, a major customer of Jupiter Ltd. The balance due from Saturn
Ltd on 31 March 2002 was £242,000. In addition, work in progress included £520,000, the cost of customised work
relating to Saturn Ltd. The directors refuse to make a provision for the debt on the grounds that the liquidator was
appointed after the balance sheet date. They also refuse to make any provision in respect of the work in progress because
they are planning to convert it to finished goods at an estimated cost of completion of £260,000 as another customer has
agreed to buy it for £700,000.
Final audit materiality has been set at £250,000 for Jupiter Ltd for the year ended 31 March 2002.
Requirement
In respect of each of the situations outlined above, reach a conclusion on whether or not you would qualify your audit
report. Give reasons for your conclusion and describe the effect on your audit report. (12 marks)
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Solution:
Mercury Ltd:
As per IAS – 37, if a regulatory action is pending against company at year end, and amount of obligation is uncertain, it
should be disclosed as contingency.
If disclosure in financial statements is adequate, there is no misstatement. Auditor shall express unmodified opinion on
financial statements. However, auditor shall include Emphasis of Matter Paragraph in his report which shall:
o Briefly state this matter.
o Refer to the note in financial statements where full disclosure is available.
If disclosure in financial statements is not adequate, there is misstatement. Auditor shall express qualified opinion on
financial statements (if effect is material) or adverse opinion (if effect is pervasive).
Pluto Ltd:
 This is a scope limitation on audit.
 Effect is material as amount of scope limitation 180,000 is greater than materiality level determined using rule
of thumb 32,500 (650,000 * 5%).
 Auditor shall express Qualified Opinion on financial statements.
 Auditor shall also describe the nature of scope limitation in "Basis for Qualified Opinion ".
 Auditor shall also qualify his opinion, as required by Form 35A, by stating that proper books of accounts have
not been kept in respect of this matter.
Jupiter Ltd:
As per IAS – 10, subsequent bankruptcy of debtor and reduction of NRV below cost after the year-end are adjusting
events. If provision is not recorded for unrecoverable debt, or write-down of inventory below cost is not recorded, these
will be misstatements in financial statements.
Amount of misstatement of debtor 242,000 is less than materiality level 250,000, therefore it is individually immaterial.
Amount of misstatement of inventory 80,000 (Cost 520,000 – NRV 440,000 i.e. 700,000 – 260,000) is less than materiality
level 250,000, therefore it is also individually immaterial. However, when aggregated, these amounts become material
(322,000 = 242,000 + 80,000).
Auditor shall express Qualified Opinion on financial statements. Auditor shall also describe nature of misstatements in
Basis for Qualified Opinion.
Weaker candidates were unable to distinguish between the two grounds for qualification ie disagreement and limitation in
scope. The most common omission was the failure to appreciate that, in the case of Pluto Ltd, there would be a requirement
to consider whether proper accounting records had been maintained. The most common misunderstanding was that, in the
case of Jupiter Ltd, although the amount owed by the customer in liquidator ship and the amount needed to reduce stock to
its NRV were individually immaterial when aggregated they were material.
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APPENDIX 3: EXPLANATION OF FREQUENTLY ASKED CASES: ✯✯✯

Category 1 There is misstatement in financial statements.
Inventory becomes physically damage or technically obsolete:
IAS – 2 requires that inventories are measured at lower of cost and net realizable value.
Appropriate depreciation or impairment loss on fixed assets is not recorded:

IAS – 16 requires that depreciation should be recorded on fixed assets when they are available for use.
Selective revaluation of fixed assets:

IAS – 16 requires policy of revaluation to be applied to entire class of non-current assets. If revaluation exercise cannot be
completed before auditor’s report, revaluations recorded so far should be reversed and should be stated at cost.
Research Cost is recognized as Intangible Asset:

IAS – 38 requires to capitalize development cost only if strict criteria is met.
Related party transactions are not disclosed in financial statements:

IAS – 24 requires management to disclose adequately all related party relationships and transactions in financial
statements.
Litigations/Regulatory Action started against entity before year end:

IAS – 37 required that:
 If it is probable that company will lose a litigation against it, a provision should be recorded.
 If it is probable that company will win a litigation against it, disclose it as a contingency.
 If outcomes are uncertain (i.e. cannot be measured reliably), disclose it as a contingency.
However, auditor shall also include Emphasis of Matter Paragraph, if there is uncertainty related to exceptional litigation
or regulatory action.
A material uncertainty related to going concern (whether created before or after year end):
As per IAS – 1, if there is a material uncertainty which cast significant doubt on entity’s ability to continue as a going
concern (e.g. cash flow difficulties, major product failure, loss of major franchise/license/customer/supplier), it should be
disclosed in the financial statements.
Auditor shall include a separate section in audit report with heading "Material uncertainty related to Going Concern".
However, if there are multiple uncertainties, auditor shall express disclaimer of opinion.
Category 2 There are Subsequent events requiring adjustment.

Bankruptcy of debtor after year end:
As per IAS – 10, subsequent bankruptcy of debtor after the year-end is an adjusting event. Provision should be recorded
for unrecoverable debt.
Notes:
 If some customized inventory is held on behalf of bankrupt customer, it will also be written-down to NRV.
 Similarly, if some specialized equipment is held on behalf of bankrupt customer, impairment loss will also be
recorded on such equipment.
Sale of inventory below cost after year end:

As per IAS – 10, sale of inventory below cost after the year-end is an adjusting event. Inventory should be written down to
NRV.
Decision of Litigations after year-end:

As per IAS – 10, settlement of a court case after the year-end is an adjusting event.
Category 3 There are Subsequent events requiring disclosure.

Major fixed assets have been destroyed/impaired (e.g. due to fire, natural disaster):
As per IAS – 10, if major fixed assets have been destroyed/impaired because of events after the year, it is a non-adjusting
event requiring disclosure in financial statements.
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Litigations/regulatory action started after year end:

If a litigation is initiated against company after the year (because of events after the year), IAS – 10 states that it is a non-
adjusting event and requires to disclose it in financial statements.
Restructuring (due to closure of factory and redundancies):

IAS – 10 states that a restructuring announced after year end is a non-adjusting event requiring disclosure in financial
statements.
Bank Guarantee issued:

If significant guarantee has been issued after the year, IAS – 10 states that it is a non-adjusting event requiring disclosure
in financial statements.
Exam Tips
 If disclosure is given in financial statements, check whether disclosure is adequate/ appropriate.
 If there is a significant subsequent event, auditor shall include "Emphasis of Matter" paragraph in
his report.
Category 4 There is scope limitation on audit.

If auditor is unable to physically verify the inventory:
This will be a scope limitation if auditor is unable to obtain evidence from alternative procedures too.
If books of accounts are destroyed by fire (or evidence supporting expenses/assets is not available):
This is a scope limitation if auditor is unable to obtain evidence from alternative procedures too.
Auditor shall also modify his opinion, as required by Form 35A, by stating that proper books of accounts have not been
kept in respect of this matter.
If management does not provide written representation required by auditor.

If management does not provide written representation, it will be scope limitation on audit.
Auditor shall also qualify his opinion, as required by Form 35A, by stating that he has not obtained all the information and
explanation which were necessary for the purpose of audit.
Exam Tips
1. If fire burns accounting records, it may cause scope limitation and modification regarding proper
books of accounts. However, if fire burns assets, it may cause emphasis of matter paragraph.
2. If there is scope limitation, check whether to discuss if evidence can be obtained from alternative
procedures.
Category 5 There is a change in accounting policy

If an accounting policy is changed, auditor shall:
a) Mention the exception to consistent application of accounting policies in his report.
b) Refer to the note in financial statements where full disclosure is available.
c) State in his report whether he concurs with the change or not.
Examples of changes in Accounting Policy

 Valuation method of PPE changed from Cost to Revaluation Model (or vice-versa)
 Valuation method Intangible Assets changed from Cost to Revaluation Model (or vice-versa)
 Valuation of Inventory changed from FIFO to Average Cost (or vice-versa)
 Valuation of Investments changed from fair value to cost (or vice-versa).
(remember change in depreciation method is a change in estimate, not a change in policy)
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Category 6 There is a matter affecting additional opinions required by Law

Expenditure incurred during the year was not for the purpose of the company’s business
Auditor shall state in his report that expenditure was not for the purpose of the company’s business.
Investments/Expenditures were not in accordance with the objects of the company.

Auditor shall state in his report that investment/expenditure was not in accordance with the objects of the company.
Zakat deductible was not deducted or not deposited by the company.

Auditor shall also state in his report that Zakat deductible at source has not been deducted by company, or has not been
deposited by the company in central zakat fund.
Category 7 Matters requiring “Emphasis of Matter Paragraph”

When auditor includes an Emphasis of Matter paragraph in his report, auditor shall:
o State a clear reference to the matter being emphasized.
o Refer to the note in financial statements which fully describe the matter.
Category 8 Matters requiring “Other Matter Paragraph”

When financial statements of prior period were audited by another auditor.
Auditor shall add “Other Matter Paragraph” in the audit report in which auditor shall state:
1. That financial statements of company for last year were audited by another auditor
2. Type of opinion expressed by predecessor auditor. (If opinion of predecessor auditor is modified, auditor should
also explain reason for modification in this paragraph)
3. Date when opinion was expressed by predecessor auditor.
If other information (e.g. Directors’ Report, or Supplementary information) is materially inconsistent with
financial statements:
Auditor shall:
 Discuss the matter with management to determine whether the audited financial statements or the other
information needs to be corrected.
 If financial statements need correction, and management refuses to correct financial statements, auditor shall
modify his opinion.
 If other information needs correction, and management refuses to correct other information, there is no ground
for qualification of opinion on financial statements. However, auditor should:
o communicate the matter to TCWG, and
o include Other Matter Paragraph in audit report describing material inconsistency or withhold report
or withdraw from engagement.
Category 9 Matters NOT affecting audit report.

Following matters do not affect audit report in any manner:
 Weakness in Internal Control.
 Immaterial misstatements or scope limitations.
 Change in accounting estimates (unless change is unreasonable).
 Use of internal auditor
 Use of expert (unless work of expert requires modification in report)
 Use of component auditor (unless work of component auditor requires modification in report)
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Auditing – Case Studies Chapter 5 Acceptance and Continuance Procedures
CHAPTER FIVE (CASE STUDIES)

ACCEPTANCE AND CONTINUANCE
PROCEDURES
APX 1: CASE STUDY RELATING TO ACCEPTANCE OF AN AUDIT CLIENT: ✯
In exam, you may be given a brief description of a prospective audit client. Included in description,
there will be matters affecting your acceptance decision e.g. lack of integrity of management.
You will be expected to identify and explain relevant issues to be considered by auditor before
accepting audit engagement.

Remember the “matters to be considered before accepting an engagement”, identify them in the
description of the case one by one, and explain.
Case Study:
Giza Science Group plc (Giza), a listed scientific research company, has requested your audit firm to provide following
services:
 external audit of Giza’s financial statements for the year ending 30 September 2014
 valuation of the shares in a company.
You have been provided following additional information relating to Giza:

 Giza provides scientific research services to the pharmaceutical, veterinary and food industries and is subject to
a number of laws and regulations.
 In 2012, three employees were suspended after serious breaches of animal protection laws were identified by a
TV programme.
 Giza controls subsidiaries operating in Europe, the US and Japan.
 Your firm also provides assurance services to a number of companies operating in scientific research sector.
 Giza’s existing external auditors resigned from office after completing the external audit for the year ended 30
September 2013.
 If accepted, Giza will become one of your firm’s largest external audit clients.
Requirements
Identify and explain the matters your firm should consider before deciding to accept for the services required by Giza.
(09 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – March 2014) – Amended
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Auditing – Case Studies Chapter 5 Acceptance and Continuance Procedures
Solution:
Matter to be considered
Explanation
before acceptance
Reason for change of auditor may indicate disagreement with management, unpaid
Reason for change of auditor
fee, illegal acts or inappropriate scope limitation.
Firm may lack cumulative audit knowledge and experiences about entity which may
New Audit Client
increase audit risk. Opening balances will be difficult to verify.
Non-assurance engagement Providing valuation services to audit client may create self-review threat.
Specialized nature of Firm will require specialized and complex knowledge to audit client in scientific
business research sector.
Number of laws and Large number of legal requirements increases risk of non-compliance and may
regulations applicable on adversely affect financial statements. Consequently, it increases risk of
client inappropriate audit opinion.
Breach of laws may indicate doubt over integrity of management which increases
Breach of laws
audit risk and reputation risk.
Subsidiaries in other Firm may not have sufficient resources or arrangements to audit subsidiaries
countries located in other countries.
Other clients in the same Having clients in the same industry may create conflict of interest (as confidential
industry information may pass to competitors).
Audit Fee Large size of fee income may give rise to self-interest threat.
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Auditing – Case Studies Chapter 6 Compliance with Legal Requirements
CHAPTER SIX (CASE STUDIES)

COMPLIANCE WITH LEGAL
REQUIREMENTS
APX 1: STEP-WISE APPROACH TO SOLVE CASE STUDY FOR APPOINTMENT OF
AUDITOR (LEGAL + ETHICAL): ✯✯✯
You may be given different short situations and requirement will be to comment on
appointment/qualification/independence of statutory auditor in each situation.

Decide whether it is a situation of legal requirements or ethical requirements:
 If words like “Companies Ordinance”, “Legal”, “Statutory” are used, apply legal provisions.
 If words like “Code of Ethics”, “Ethical”, “Threats, Safeguards” are used apply ethical provisions.
 If words “applicable rules and regulation” are used, apply legal provision if situation is
discussed in law. Otherwise, apply ethical provisions.
Remember: In exam, both (legal and ethical) regulations are not discussed in a single situation.
If question relates to legal requirements:

1. There may be THREE issues involved in the case:
a. Whether appointment is made by appropriate authority.
b. Whether qualification criteria is complied.
c. Whether disqualification criteria is complied.
2. If appointment is not appropriate on more than one grounds, you will cover BOTH one by one.
3. Whatever is the case, do not reproduce provision of law; rather state your decision by directly
applying legal provisions to the facts of case. (this is because usually 2 or 3 marks only are
allocated to each case of legal provisions in exam question)
If question relates to ethical requirements:

When faced with an ethical conflict, a chartered accountant should consider relevant facts of the
situation and should:
1. Identify threat(s) involved in the situation.
2. Evaluate threat (i.e. whether significant or insignificant).
3. Apply relevant safeguards (or course of actions) to reduce threat to acceptable level.
4. All ethical issues and relevant considerations should be documented.
If a significant ethical conflict/threat cannot be resolved, chartered accountant should consider

withdrawal from engagement, if possible and practicable.
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Case Study – First Example

Comment on each of the following situations with reference to the appointment of external auditors in accordance with
the requirements of the Companies Ordinance, 1984:
(a) Farrukh & Co., Chartered Accountants, has received an offer to be appointed as the external auditor of Ebrahim Gas
Company. The firm is indebted to the company as it has not paid the last two months’ bills amounting to Rs. 4,860.
(b) After seventy days of incorporation, the directors of Rahman Limited (RL) decided to appoint Mr. Shahid as the
company’s statutory auditor. Mr. Shahid was employed by RL before he started his own practice.
(c) The directors of Fazal Limited (FL) have decided to appoint Syed & Company, Chartered Accountants, as external
auditor of the company. One of the partner’s spouse holds 1,000 shares in the subsidiary of FL.
(d) The directors of Najam (Pvt.) Limited having paid-up capital of Rs. 4.5 million have appointed Mr. Dawood to act as the
external auditor of the company. Mr. Dawood has been awarded a diploma in International Financial Reporting Standards
by the Institute of Chartered Accountants of Pakistan and has completed the mandatory period of training from a leading
firm of chartered accountants.
(e) All directors of Hussain Associates (Pvt.) Limited are chartered accountants. The company has recently received an
offer for appointment as the external auditor of Masood (Pvt.) Limited which has a paid-up share capital of Rs. 1,000,000.
(10 marks)
Suggested Solution:
(a)
Farrukh & Co. can be appointed as statutory auditor of Ebrahim Gas Company because the firm is not indebted to the
company as the sum payable to utility company does not exceed period of 90 days.
(b)
As directors have not appointed first auditor within 60 days of incorporation, authority to appoint auditor rests with
members, and not with directors.
Mr. Shahid cannot be appointed as statutory auditor of RL because he has been an employee of the company in last three
years.
(c)
Subsequent auditor is appointed by Company (i.e. by members) and NOT by directors.
Syed & Company can be appointed as statutory auditor of FL only if:

 Shareholding by spouse of partner in associated company of FL is disclosed at time of appointment, and
 Shares are disposed within 90 days of appointment.
(d)
Subsequent auditor is appointed by Company (i.e. by members) and NOT by directors.
Mr. Dawood cannot be appointed as statutory auditor of Najam (Pvt.) Limited because audit of a company having paid up
capital of three million or more can be conducted only by a chartered accountant (within the meanings of CA Ordinance
1961).
(e)
Hussain Associates (Pvt) Limited cannot be appointed as statutory auditor of any company because it (auditor) is a body
corporate and, therefore, is disqualified.
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Case Study – Second Example

Analyze the following independent situations with reference to qualification of statutory auditor:
(i) Mr. Zakir Ali, a practicing chartered accountant, has been offered appointment in Heera Limited as external auditor. He
was an employee of the company before he started his own practice.
(ii) Diamond Associates (Pvt) Limited, a consultancy company, the majority of whose directors are chartered accountants,
have been offered appointment as external auditor in Lal (Pvt) Limited whose share capital is less than Rs. 1.5 million.
(iii) Miss Fatima Khan, a practicing chartered accountant, has been offered appointment in Neelam Limited as external
auditor. She was an employee of the company’s director two months before the offer.
(iv) Mr. Farid Hussain is a partner of Farid & Company, Chartered Accountants. The firm has been offered appointment in
Feroza Limited as external auditor. Son of Mr. Farid holds shares of Feroza Limited. (08 marks)
Suggested Solution:
(i)
If Zakir was an employee of Heera Limited in last 3 years:
Zakir Ali cannot be appointed as statutory auditor of Heera Limited.
If Zakir was not an employee of Heera Limited in last 3 years:

Zakir Ali can be appointed as statutory auditor of Heera Limited.
(ii) Diamond Associates (Pvt) Limited cannot be appointed as statutory auditor of any company because it (auditor) is a
body corporate and, therefore, is disqualified.
(iii) Miss Fatima Khan can be appointed as statutory auditor of Neelam Limited because she is no more an employee of
director of Neelam Limited.
(iv) If son of partner is major:

Farid & Company can be appointed as statutory auditor of Feroza Limited because there is no violation of law if major son
of auditor holds shares in audit client.
If son of partner is minor:

Firm can be appointed as statutory auditor of Feroza Limited only if:
 Shareholding of a minor son of partner in audit client is disclosed at the time of appointment, and
 Share are disposed within 90 days of appointment.
Legal provisions regarding appointment of statutory auditor is a topic regularly asked and was attempted fairly by most
students. The general deficiencies noted in the answers were as follows:
• The time lapse after which an ex-employee can become an external auditor was not mentioned.
• There were many examinees who said that a private limited company having paid up capital less than rupees three million
can appoint, even a body corporate, as its auditors.
• There was a general misconception that an ex-employee of a director also needs a time lapse of three years for appointment
as an external auditor.
• Very few students knew that if shares are held by the minor son of a person, he cannot accept appointment as an external
auditor. There is no such restriction if the son has attained the age of majority.
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Auditing – Case Studies Chapter 7 Compliance with Ethical Requirements
CHAPTER SEVEN (CASE STUDIES)

COMPLIANCE WITH ETHICAL
REQUIREMENTS
APENDIX 1: CASE STUDIES INVOLVING ETHICAL VIOLATIONS: ✯✯✯
Can an assurance team member or his relative hold shares (i.e. financial interest) in assurance
Case 1
client?
Threat:
Holding of shares in an audit client (or any of its associated companies) by assurance team members or by their family
members (or by other partners practicing in the same office or by other partners providing non-assurance services to
same client) creates Self-Interest Threat.
Safeguards/Course of Action:
1. Firm’s quality control policies and procedures should require team members to immediately communicate to
audit firm any financial interest in assurance client.
2. Team member (or his relative) should be convinced to dispose-off shares as soon as practicable.
3. If interest is not disposed, firm should remove concerned member from assurance team.
4. If any work is performed by concerned individual prior to disposal or removal, firm should involve an
independent chartered accountant to review the work performed by team member.
Can an assurance team member be associated to a client for long period of time (e.g. for more than
Case 2
3 years)?
Threat:
Using the same senior personnel on an assurance engagement over a long period of time creates Familiarity Threat and
Self-Interest Threat.
1. Firm should remove the concerned team member from assurance engagement.
2. Firm should involve an independent chartered accountant to review the work performed by relevant team
member, or
3. Regular independent internal or external quality control reviews of engagement.
Case 3 Can a relative of a director or officer of client be appointed as assurance team member?
Threat:
If a director, officer or certain employee of client is Immediate family member, or Close family member, or Close relative
of an assurance team member or a partner of firm, it creates Familiarity Threat, Intimidation Threat, and Self-interest
Threat.
1. Firm’s quality control policies and procedures should require team members to immediately communicate to
audit firm close relationships with employees of assurance client.
2. Firm should remove concerned member from assurance team or, if possible, firm should restructure
responsibilities of team member so that the team member does not work on matters under the responsibility of
his relative.
Case 4 Can an assurance team member of firm obtain loan from an assurance client?
Threat:
Obtaining a material loan from an audit client by Firm, Team member or their immediately family members creates Self-
Interest Threat.
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If loan is accepted from client:
Loan from a client which is NOT a
Loan from a client which is a Bank or similar
Bank or similar financial
financial institution
institution
If a loan of material amount is If loan is made under normal lending procedures and
accepted from a client which is NOT a terms and conditions, it does not create threat to
Loan by an bank or similar financial institution, it independence (e.g. Home Mortgage, Bank Overdraft, Car
assurance team creates Self-interest threat which loans and Credit card balances).
member or his cannot be reduced to acceptable
immediate family level. If loan is NOT under normal lending procedures and
member terms and conditions, Self-interest threat would be so
Consequently, firm should either significant that no safeguard could reduce the threat to
remove relevant individual from acceptable level.
assurance engagement or should If loan is made under normal lending procedures and
withdraw from engagement. terms and conditions, but loan is material either to the
audit client or firm receiving the loan, firm should apply
safeguards to reduce the threat to acceptable level e.g.
firm should involve an independent chartered accountant
Loan by Firm to review the work done by firm.
If loan is not under normal lending procedures and terms

and conditions, Self-interest threat would be so
significant that no safeguard could reduce the threat to
acceptable level.
Case 5 Can an employee (director or officer) of client join audit firm as assurance team member?
Threat:
If a director, officer or employee (in a position to significantly influence preparation of financial statements) of client
leaves the client and joins firm as an assurance team member, it creates Self-Review Threat, Familiarity Threat and Self-
Interest Threat.
If the concerned assurance team member has served the client during the period covered by audit report, threat would be
so significant that no safeguard can reduce it to acceptable level. Consequently, such individual shall not be assigned to
assurance team.
If the concerned assurance team member has served the client before the period covered by audit report, significance of
threat should be evaluated and necessary safeguard should be applied e.g. review of the work performed by individual as
a member of the audit team.
Case 6 Can an assurance team member joint client as employee (director or officer)?
Threat:
If an assurance team member or a partner of the firm leaves the firm and joins client as a director, officer or employee (in
a position to significantly influence preparation of financial statements), it creates Familiarity Threat, and Intimidation
Threat.
1. Ensure that there is no significant connection remaining between firm and individual i.e.:
 Individual is not entitled to any benefits or payments from firm unless these are made in accordance with
fixed pre-determined arrangements; and any amount owed to individual is not material to firm, and
 Individual does not continue to participate in firm’s business or professional activities.
2. Firm should modify the audit plan.
3. Firm should assign staff to audit team who has sufficient experience in relation to individual who joined client.
4. Having a chartered accountant review the work of the former member of the audit team.
221
Can an assurance team member negotiate client to join it as employee (director or officer) in
Case 7
future?
Threat:
If an engagement team member is willing to join client in future, it creates Self-Interest threat.
Firm’s quality control policies and procedures should require team members to immediately notify audit firm when
entering employment negotiations with client. (team member lacks integrity if he does not notify firm)
On receiving such notification, firm should evaluate significance of threat and should apply safeguards to reduce threat to
acceptable level e.g.
1. Firm may remove the individual from audit team, or
2. A review of any significant judgments made by that individual while on the team.
Case 8 Can firm or an assurance team member purchase goods or services from assurance client?
Threat:
Purchases of goods and services from client (by firm, assurance team members or their immediate members) creates Self-
interest threat if magnitude of transaction is material or transaction is not on arm’s length basis.
Significance of threat should be evaluated. Based on significance of threat, safeguards given below may be applied to
eliminate or reduce the threat to acceptable level.
 Removing the individual from assurance engagement.
 Eliminating or reducing the magnitude of transactions
 Changing the terms of transactions to make it on arm’s length basis.
Case 9 How to respond to a threat from client?

Threat:
Threat by client to remove the existing auditor over disagreement creates Intimidation Threat, and Self-Interest Threat.
Course of Action/Safeguards to reduce significant threat to acceptable level:

 Discuss the issue with other partners (e.g. ethics partner), and also disclose to TCWG.
 Consider withdrawal from engagement (as threat by management indicates lack of trust and management
integrity)
 Conduct engagement quality control review, if not withdrawn from engagement.
Case 10 Can an assurance team member accept gifts from assurance client?
Threat:
Accepting gifts or hospitality from an assurance client creates Self-Interest threat and Familiarity threats, unless value is
trivial and inconsequential.
Firm or member of assurance team shall not accept significant gifts or hospitality from client because threat would be so
significant that no safeguard could reduce threat to acceptable level.
Case 11 Is there any threat if large proportion of revenue coming from a single client?
Threat:
If a firm (or an office or a partner) is generating large portion of its revenue (e.g. more than 15% revenue by providing
assurance as well as non-assurance services of recurring nature) from a single assurance client, it creates Self-Interest
Threat and Intimidation Threat.

1. Firm should take necessary steps to reduce this dependency e.g. increase client–base or withdraw from some of
services.
2. Regular internal or external quality control reviews.
3. Consulting a third party (e.g. an independent chartered accountant or a professional regulatory body) on key
audit judgments.
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Case 12 Overdue Fee.

Threat:
If fee (or significant part of fee) due from an assurance client remains unpaid for a long period, it creates Self-Interest
Threat.
Firm should discuss the matter with audit committee and TCWG and should require that:
 Predecessor auditor’s fee should be paid before acceptance of engagement (in case of initial engagement).
 Fee of previous year’s professional services (assurance as well as non-assurance) should be paid before issuance
of current year’s assurance report. (in case of recurring engagement).
If previous year’s fee is not paid before issuance of audit report, significance of threat shall be evaluated and following
safeguards may be applied:
1. Firm should involve an independent chartered accountant to review the work done or otherwise advice as
necessary.
2. Firm should consider whether overdue fee may be equivalent to loan.
3. Firm should also consider whether it is appropriate to continue the engagement or to be reappointed for next
period.
Case 13 Contingent Fee.

Definition:
Contingent fees are fees calculated on the basis of outcome of a transaction or results of service performed by firm.
However, a fee is not regarded as being contingent if established by a court or other public authority.
Threat:
Accepting a contingent fee from an assurance client (for assurance or non-assurance service) creates Self-Interest Threat.

Threat for contingent fee is so significant that no safeguard could reduce the threat to acceptable level. Consequently, a
firm shall not enter into any such fee arrangement. Fee should be based on time and experience required to complete job
(e.g. lump-sum fee, or fee based on hourly rates).
Case 14 Accepting a fee lower than predecessor auditor or market rates

Threat:
Accepting a fee lower than that charged by predecessor auditor is regarded as undercutting.

An auditor should not quote fee lower than that charged by predecessor auditor unless the scope and quantum of work
materially differs from the scope and quantum of work carried out by the previous auditor, and following safeguards are
also applied:
 Appropriate time and qualified staff is assigned to engagement.
 Client should be made aware of scope of work and basis of fee.
Note: a slightly different concept is Lowballing which means accepting a fee lower than market rates (in hope of getting
lucrative non-assurance services in future). Above safeguards are also applied in case of Lowballing.
Case 15 Audit firm having conflict of interest with audit client.

Threat:
A conflict of interest is created if a chartered accountant provides professional services to a client related to a matter for
which interest of that client is in conflict with interest of other client or interest of chartered account.
A conflict of interest creates threat to:

 Objectivity (because auditor may not act in the best interest of both parties) and
 Threat to other fundamental ethical principles (e.g. Confidentiality as information from one client may be used
for benefit/loss of other).
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̶ Both clients should be notified about the fact and their consent should be obtained to act as auditor of other company.
̶ Separate teams and engagement partners should be engaged to perform audit.
̶ Chinese Walls (i.e. Information barriers) should be implemented between teams to ensure confidentiality. These are
implemented by:
 giving clear guidelines to members of the engagement team on issues of security and confidentiality of
information.
 strict physical separation of such teams
 confidential and secure data filing.
 Use of confidentiality agreement, signed by team members.
̶ An independent senior should regularly review safeguards applied.
If above safeguards cannot be applied, auditor should not act for one of the parties.
Examples of Situations creating Conflict of Interest

 Providing assurance services to two competitors.
 Providing assurance services to two companies which are in dispute with each other.
Case 16 Advertisement and Publicity.

Threat:
Advertisement for solicitation and undue publicity by a chartered accountant in practice create Self-interest threat and
Threat to Professional Behavior.
Course of Action/Safeguards:
Purposes for which advertisement/publicity cannot be done:
Advertisement for solicitation should be avoided. Similarly, undue publicity should be avoided.
Purposes for which advertisement/publicity can be done:

However, a chartered accountant can use appropriate newspaper/magazine only to inform public (e.g. about
establishment of new practice, changes in partnership or address etc) provided such announcements are limited to bare
statement of fact.
Rules if advertisement/publicity is done:

An announcement, communication and notices should be aimed at informing public in objective manner and should
conform to the basic principles of legality, truthfulness and decency.
Following activities are prohibited in this regard:

(a) use means which bring the profession into disrepute.
(b) exaggerate work of himself
(c) contain testimonials or endorsements;
(d) make comparisons with other chartered accountants in practice or degrade work of other accountants.
(e) create false expectations of favorable results
Case 17 Referral Fee.
Threat:
Accepting a referral fee or commission creates self-interest threat to objectivity and professional competence and due
care.
Course of Action/Safeguards:
Before referring to another chartered accountant, disclose to client and obtain agreement from client about arrangements
to receive/pay referral fee or commission.
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APENDIX 2: CASE STUDIES INVOLVING NON ASSURANCE SERVICES TO ASSURANCE

CLIENTS: ✯✯✯
Case 1 Preparing Accounting Records or Financial Statements
Threat:
Preparing accounting records or financial statements for audit client creates Self-Review Threat when financial
statements are subsequently audited by firm.
A firm can provide bookkeeping and accounting services to an unlisted audit client if services are of a routine or
mechanical nature e.g.:
 Recording transactions approved by client.
 Posting transactions to general ledger and to trial balance.
 Preparing financial statements based on information in the trail balance.
 Providing payroll services based on client-originated data.
Safeguards for assurance service:

1. Individual performing non-assurance engagement should not be part of audit engagement team.
2. Firm should involve an independent chartered accountant to review the work.
Safeguards for non-assurance service:

3. Managerial functions/decisions should not be taken by firm/individuals (e.g. approval of transactions, preparing
or changing source data for transactions, determining or changing journal entries).
4. Obtaining the client’s acknowledgement of responsibility for the results of the work performed by the
firm/individual.
Case 2 Valuation Service:

Threat:
Performing valuation services for an audit client creates Self-Review Threat if results of valuation are incorporated in
client’s financial statements.
A firm can provide valuation services to unlisted audit clients if these services are not material and do not involve
significant degree of subjectivity. However, following safeguards should be applied in this case:
1. Individuals performing non-assurance engagement should not be part of assurance engagement team, or
2. Firm should involve an independent chartered accountant to review the audit or valuation work performed.
Case 3 Taxation Services.

Service: Tax Return Preparation:
Preparing tax return of audit client does not create a threat to independence if management takes responsibility for the
returns including any significant judgments made.
Case 4 Temporary Staff Assignments/ Secondment.

Threat:
The lending of staff by a firm to an assurance client will create Self-review threat.
Temporary staff services can be provided to audit clients for short period of time.
Safeguards for non-assurance engagement:

 Management decisions will not be made on behalf of audit client., and
 Audit client shall be responsible for directing and supervising the activities of the loaned staff.
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Safeguards for assurance engagement:

Significance of threat shall be evaluated and following safeguards should be applied to reduce the threat to acceptable
level:
 Firm should not include the loaned-staff in assurance team.
 If loaned-staff is included in assurance team, he should not be given responsibility for any function or activity
that he performed during temporary staff assignment.
 Firm should involve an independent chartered accountant to review the work performed by loaned staff.
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Auditing – Case Studies Chapter 8 Engagement Letter
CHAPTER EIGHT (CASE STUDIES)

ENGAGEMENT LETTER
APX 1: CASE STUDY RELATING TO ENGAGEMENT LETTER: ✯
In exam, you may be given a situation in which, you will be required to assess whether:
 it is necessary to issue a fresh letter on recurring audit, considering facts of the case.
 to accept changes in terms of audit engagement during audit.

Remember to differentiate between change in terms of engagement on “recurring audit” and
“during the audit”.
Case Study 1:
Guilin & Partners is a CGA firm that has audited ZFL for the past 5 years. During the past year, ZFL has grown to include
exports to Asia. The president and the controller both retired last year. The new management met with Guilin this year to
discuss this year’s audit and hope to reduce the audit fees. ZFL’s new management suggested that since the company had
received an unqualified audit opinion every year from Guilin, less audit work would be needed this year. They suggested
that there was no need for an engagement letter this year since Guilin’s staff were very familiar with the company. The
managing partner at Guilin, Tim, explained to the controller that there were new accounting principles being applied this
year because differential reporting rules no longer applied to the company. Tim also explained the audit process in more
detail to the controller and president, who then agreed that the audit fees requested by Guilin were reasonable.
Required
Explain why you would or would not require an engagement letter this year. Support your answer with three points.
(08 marks)
(CGA – Canada, External Auditing 1, September 2011)
Suggested Solution:
A fresh engagement letter should be sent to ZFL (even if it is our recurring audit) this year because:
1. Size of business has grown (now goods are also exported to Asia) which will bring new accounting and audit
implications to engagement.
2. There has been a significant change in senior management (president and controller have retired).
3. New management has some misunderstanding about objective and scope of audit (as it is expecting auditor to
reduce fee and work less).
4. There has been major changes in requirements of Applicable Financial reporting framework.
Question was answered satisfactorily by most students; however, some students simply discussed engagement letters in
general, without any reference to the situation given in the question. To succeed on the examination, it is necessary to identify
the concept, and then explain how it relates to the facts given in the question. If students simply state a general answer
without referring to the question facts, this only shows that they can recite a definition or memorize points, whereas a
professional accountant must be able to apply the knowledge in the course material to everyday facts.
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Auditing – Case Studies Chapter 8 Engagement Letter
Case Study 2:
Your audit firm has been appointed to conduct a full scope audit of the financial statements covering a period of three
months of Clever Limited. Clever Limited needs the audit report for obtaining a bank loan. While verifying certain account
heads you identify certain problems for which you are not provided satisfactory replies by the client. At the same time
Clever Limited approaches you and asks you to change the scope of assignment from a full scope audit to a review
assignment. They give you the reason that they have misunderstood the scope of assignment earlier. What course of
action you would adopt in this situation? (06 marks)
Solution:
Whenever auditor is asked by client to revise terms of engagement during audit, auditor shall consider following factors
before accepting change:
1. Whether there is a reasonable justification for the change.
2. Legal or Contractual implications of the change.
As certain problems have been identified for which no satisfactory replies have been given by the client, it seems that this
change in engagement is due to incorrect or incomplete information and client wants to avoid qualified opinion by
changing terms of engagement. Hence, there is no reasonable justification to the change. So, we will not agree to change
the terms of engagement.
In this situation, auditor should continue to perform the audit engagement as per original terms of engagement. If
management of Clever Limited does not permit auditor to perform original engagement, it will be similar to scope
limitation and auditor shall:
 Withdraw from engagement if possible and practicable.
 Express disclaimer of opinion if withdrawal is not possible and practicable..
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Auditing – Case Studies Chapter 9 Planning an Audit
CHAPTER NINE (CASE STUDIES)

PLANNING AN AUDIT
APPENDIX 1: CASE STUDY RELATING TO CALCULATION AND USE OF MATERIALITY:
✯
You may be given financial information of an audit client and misstatement(s) in the question. You
will be required to calculate materiality from the financial information, and to comment whether
given information is material or not.

While evaluating whether effect is material or not, consider aggregate effect of misstatement as well
as qualitative aspect of materiality.
Model Case Study:
Case Study 1:
For each of the following scenarios determine:
a) Planning materiality,
b) Performance materiality and
c) Evaluate audit findings.
Scenario 1:
HMK & Co. operates in retail business. The components of its financial statements are:
1. Net Profit 3,200,000
2. Total Revenue 350,000,000
3. Total Assets 240,000,000
Auditor of HMK & Co. allocates 40% of financial statement materiality to inventories. During the audit of inventories, HMK
& Co.’s audit firm detected two misstatements amounting Rs. 60,000 and Rs. 50,000 respectively.
Scenario 2:
Welfare Hospital treats poor patients and runs on donations received from general public. The components of its financial
statements are:
1. Net Profit 15,000
2. Total Revenue 30,000,000
3. Total Assets 22,000,000
Welfare Hospital’s auditor uses 50% of financial statements materiality as performance materiality. During the course of
the audit, audit firm detected one misstatement that resulted in understatement of expenses by Rs. 20,000.
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Solution:
Scenario 1:
Planning Materiality:
Auditor shall determine materiality using rule of thumb. As this audit client is a profit oriented entity hence benchmark
will be Profit (total revenue and total assets will be ignored for this purpose). Hence materiality = Net Profit * 5% i.e.
3,200,000 * 5% = Rs. 160,000
Performance Materiality:
Performance Materiality = Overall Materiality * 40% = 64,000.
Evaluation of Result:
Although the amount of both misstatements are individually immaterial, however aggregate exceeds performance
materiality, hence it is material and is required to be corrected.
(Note: Misstatements in classes of transactions or account balances are compared with performance materiality and not with
overall materiality).
Scenario 2:
Planning Materiality:
Auditor shall determine materiality using rule of thumb. As this audit client is a not-for-profit entity hence benchmark will
be Total Revenue or Total Assets (net profit will be ignored for this purpose). Hence materiality = Total Revenue * 1% i.e.
30,000,000 * 0.5% = Rs. 150,000 (Note: Alternatively total assets may also be used to determine materiality)
Performance Materiality:
Performance Materiality = Overall Materiality * 50% = 75,000.
Evaluation of Result:
As the amount of misstatement does not exceed performance materiality, hence it is immaterial on quantitative basis.
However, if corrected, this misstatement will affect key performance indicator i.e. it will convert its profit into loss, hence
it is considered material on the basis of qualitative criteria and is required to be corrected.
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APPENDIX 2: CASE STUDY RELATING TO IMPACT OF CERTAIN EVENTS ON AUDIT

STRATEGY: ✯
You may be given information about nature and business of an audit client. You will be required to
identify different factors which may be important for an auditor and you will have to explain their
impact on audit strategy.

Keep in mind the factors affecting audit strategy, and check if such factors are present in the case.
Model Case Study:

Case Study 1:
Suppose you are the auditor of Adamjee Insurance Company Limited (listed on all three Stock Exchanges of Pakistan) and
are planning the audit for the year ended December 31, 2012.
The head office is located in Karachi and it operates a network of 34 branches in Pakistan and one in UAE (Dubai).
Company also has an Internal Audit Department and you are convinced that internal auditors are competent, objective,
work with due care and are available for any kind of communication.
During initial meeting with CFO of the company, he told you that in April 2012, company has installed computerized
accounting system on its branches to replace manual accounting system. Although, in the first two months of installation,
employees faced some problems but now they have sufficient experience to operate it and this shift has saved time and
money of company.
Required
From the situation given above, identify the matters which will affect audit strategy (using Appendix of ISA 300 as guide)
and briefly describe implication of each matter on audit.
Solution:
Matter affecting scope of the audit Implications of the Matter
Audit client is a listed company so it has to comply with following
framework and regulations:
-IFRS
Financial Reporting Framework -Companies Ordinance 1984
- Insurance Ordinance 2000
-Listed Regulations of Stock Exchange
Company is in Insurance sector, hence it will also have to comply with
Industry-specific reporting Insurance Ordinance 2000. (similarly banks comply with Banking
requirements Companies Ordinance 1962)
Branches are in remote areas so auditor will have to select extent of
Expected audit coverage
branches to be covered.
Extent to which components are to be Auditor has to decide whether he himself will perform audit of foreign
audited by other auditors branch or a component auditor will be used.
Availability of the work of internal Work of the internal auditors is likely to be adequate for purposes of the
auditors and extent of reliance on it. audit, hence, auditor can rely on it.
Nature of business requires specialized knowledge to audit it (i.e. the
Nature of business actuarial calculation of liabilities associated with insurance contracts)
hence, auditor may need involvement of an expert.
Expected use of audit evidence Accounting system has changed so evidence obtained in prior year may not
obtained in previous audits be relevant this year.
Effect of information technology on the On implementation of new accounting system, inexperienced staff may have
audit procedures caused errors in financial statements.
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Auditing – Case Studies Chapter 10 Understanding of Entity and Inherent Risk Assessment
CHAPTER TEN (CASE STUDIES)

INHERENT RISK ASSESSMENT
APPENDIX 1: INHERENT RISK ASSESSMENT THROUGH FACTS: ✯✯✯
Inherent risk assessment through facts means performing inquiry, observation and inspection of
entity and identifying areas where there is potential of misstatement. In exam, you may be given
non-financial (i.e. descriptive) information about audit client and you will be required to identify
and describe/explain/evaluate audit risks i.e. areas where there is high risk and give explanation
of risks.
(Note for students: In advanced questions, you may also be required to describe how you would
address these audit risks.)

Read the paragraphs carefully and identify risk-factors (i.e. information which increases risk) one
by one. Also explain risk-factor. However, there is no need to explain whether identified risk is
inherent risk, control risk or detection risk.
(Note for students: In this chapter, you are expected to learn only to identify and explain audit risks.
Therefore, your will be able to attempt requirement relating to auditor’s response to each risk after
covering chapter # 12 Substantive Procedures.)
Examples of Frequently Asked Risks and Their Explanation
Risk Factor: Long-standing Inventory OR Technology/Fashion based Inventory OR Launch of new product by
competitor OR Decrease in selling price/sales OR Damaged Inventory:
Inventory may have become obsolete requiring write-down of inventory from cost to NRV.
Risk Factor: Client deals in significant imports and/or exports:

Some items may be in-transit at year end which may be wrongly included in or excluded from inventory. Further,
incorrect exchange rates may be used to translate into transactions into local currency.
Risk Factor: Existence of precious and portable Inventory or Cash:

Inventory or Cash may be misappropriated by dishonest individuals.
Risk Factor: “Standard costing” or “Sale Price less profit margin” method is used for Inventory valuation:
At year end, actual Cost may be different from standard cost/S.P less profit margin method.
Risk Factor: Inventory is held at various locations OR Inventory is held with third party OR Physical count was
not done at balance sheet date:
It is difficult to determine correct amount of inventory at balance sheet date.
Risk Factor: Client has work-in-process inventory

It is difficult to determine correct cost of work-in-process because it involves estimation of stage of completion (which is
subjective); and absorption of overhead (which is complex).
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Risk Factor: Dispute with debtors

It may be difficult to recover full amount from disputed debtor.
Further, if dispute arises with a major customer, there is also a risk that going concern assumption may not be
appropriate because future income stream is lost.
Further, if dispute arises because of malfunctioning of goods, inventory may also require provisioning.
Risk Factor: Long-standing Debtors OR Debtor experiencing financial difficulty OR Extension in Credit Period:
Slow-moving/doubtful debtors may exist from whom full recovery is not expected, and may require provisioning.
Risk Factor: Specialized/Customized inventory:

If customer cancels order or goes bankrupt, specialized/customized inventory manufactured for such client may also
require provisioning.
Risk Factor: Sales-based remuneration being paid to staff:

There is a risk that fake sales (particularly at year-end) or next-period’s sales may be recorded to earn sales-commission.
Further, Goods may be sold to debtors with poor financial position, from whom full recovery is not expected.
Risk Factor: Cash is received from sales at different phases (i.e. before despatch or after despatch):
Revenue may be recognized pre-mature (if cash received before delivery) or delayed (if cash received after delivery) at
time of receipt of cash.
Risk Factor: Significance Purchases of Fixed Assets during the year:

Directly attributable costs on acquisition may be incorrectly calculated.
Risk Factor: Significance Disposals of Fixed Assets during the year:

Profit or loss on disposal may be incorrectly calculated.
Risk Factor: Heavy Repair and Maintenance or Construction of fixed assets during the year:
There may be incorrect categorization of cost between Revenue and Capital Expenditure.
Risk Factor: Destroyed OR Unused OR Under-utilized Fixed Assets:

Fixed assets may have been impaired.
Risk Factor: Revaluation of Fixed Assets:

Revaluation may be incorrectly calculated and recorded because it involves Subjectivity (e.g. determination of useful life)
and Complexity (e.g. deferred tax implication).
Risk Factor: Change in estimates of depreciation:

Change in useful life or residual value or method of depreciation may be unreasonable, to increase profit.
Risk Factor: Goods sold over internet:

Internet sales may be recorded before risk and rewards are transferred because high level of sales return is expected on
such sales because of wrong specification, late delivery or dissatisfaction of customer.
Risk Factor: Warranty on Sales:

Warranty may be incorrectly calculated because it involves estimation and complexity.
Risk Factor: Pending litigations and contingent liabilities (e.g. unfair dismissal of staff, or physical injury to staff
due to poor working conditions, physical injury to customers because of defective good):
There is a risk that disclosure or provision relating to litigation may not be appropriately recorded in financial
statements.
If litigation relates to customer, there is also risk that amount receivable may not be fully recovered. If customer is major,
there is also a risk that going concern assumption may not be appropriate.
If dispute arises because of malfunctioning of goods, inventory may also require provisioning. If product is major, there is
also a risk that going concern assumption may not be appropriate.
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Risk Factor: High turnover of workers:

There is a risk that payments may be made to ghost employees, or salaries expense may not be accurately or completely
calculated.
Risk Factor: Intangible asset recognized by client (e.g. Capitalization of Development cost, brand name, web-site
development):
Intangible assets may not have met recognition criteria, or may be incorrectly valued because of subjectivity and
complexity in valuation (e.g. issue of useful life, issue of internal expenses).
Risk Factor: Deferred tax asset is recognized by client:

Deferred tax asset may not have met recognition criteria (e.g. when future profit/sales are declining) or may be
incorrectly calculated because of complexity involved in calculation.
Risk Factor: Investigation by tax authorities:

Tax expense may be understated.
Risk Factor: Redundant workforce:

Compensation payable to redundant workforce may not be completely recorded.
Risk Factor: Loan from Bank:

Split of loan between current and non-current portion, and disclosures (e.g. charges on assets) may be inappropriately
included in financial statements.
Further, if default is made in debt-covenant requirements, , there is also a risk that bank may call-back entire loan and if
company does not have alternate source of financing, going concern assumption may not be appropriate.
Risk Factor: Reconciliations not being prepared (in bank, debtors, creditors, inventory):
There is an increased risk that errors may not be identified timely.
Other/General Risks:
New/inexperienced staff in accounting and finance department:
Errors may occur in financial statements because of lack of experience.
Few/overburdened staff in accounting and finance department:

Errors may occur in financial statements because of lack of segregation of duties.
Finance department is working without financial controller (or IT department working without IT manager):
Staff may have some problems and without support from departmental head, errors may occur in financial statements
due to lack of knowledge and experience.
Introduction of new IT system:

Errors may occur during changeover process which may impact financial statements.
Sales/Operations being made at various distant locations:

Accuracy and Completeness of transaction in financial statements may be incorrect.
This is first year of audit of client (i.e. initial audit):

Audit risk is increased in first year of audit because it may be difficult to verify opening balances and auditor has limited
knowledge about entity.
Reduced reporting timetable:

Audit risk is increased as audit team will have less time which will restrict team’s ability be obtain sufficient appropriate
audit evidence.
Prospective sale of business, OR Contingent remuneration of management or CEO/Director with majority

shareholding:
There is a risk of management bias to manipulate financial statements, to increase personal wealth of
management/shareholders.
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Case Study – First Example:

You are the audit supervisor of Seagull & Co and are currently planning the audit of your existing client, Eagle Heating Co
(Eagle), for the year ending 31 December 2014. Eagle manufactures and sells heating and plumbing equipment to a
number of home improvement stores across the country.
Eagle has experienced increased competition and as a result, in order to maintain its current levels of sales, it has
decreased the selling price of its products significantly since September 2014. The finance director has informed your
audit manager that he expects increased inventory levels at the year end. He also notified your manager that one of
Eagle’s key customers has been experiencing financial difficulties. Therefore, Eagle has agreed that the customer can take
a six-month payment break, after which payments will continue as normal. The finance director does not believe that any
allowance is required against this receivable.
In October 2014 the financial controller of Eagle was dismissed. He had been employed by the company for over20 years,
and he has threatened to sue the company for unfair dismissal. The role of financial controller has not yet been filled and
so his tasks have been shared between the existing finance department team. In addition, the purchase ledger supervisor
left in August and a replacement has been appointed in the last week. However, for this period no supplier statement
reconciliations or purchase ledger control account reconciliations were performed.
You have undertaken a preliminary analytical review of the draft year to date statement of profit or loss, and you are
surprised to see a significant fall in administration expenses.
Required:
Explain FIVE audit risks, and the auditor’s response to each risk, in planning the audit of Eagle Heating Co. (10 marks)
Suggested Solution:
Risk Response
Risk Factor: Decrease in selling price and Increase

in inventory level at year end:
Inventory may have become obsolete requiring write- Auditor should under undertake detailed testing of
down of inventory from cost to NRV. Cost and NRV to assess whether inventory requires
NRV.
Risk Factor: Debtor experiencing financial difficulty
and Extension in Credit Period: Discuss with finance director why allowance is not
Debtor facing financial difficulty may not pay full required. Review whether any cash has been received
amount of debt, and may require provisioning. after expiry of six months’ break. Evaluate whether a
provision is requiring considering financial position of
customer.
Risk Factor: Threat by ex financial controller to sue
company for unfair dismissal:
There is a risk that disclosure or provision relating to Audit team should write a letter of inquiry to legal
threatened litigation may be inappropriately recorded advisor to inquire about existence and possible
in financial statements. outcome of any claim from former finance controller.
Finance department is working without financial
controller:
Staff may have some problems and without support The team should remain alert throughout the audit for
from departmental head, errors may occur in financial additional errors within the finance department due to
statements due to lack of knowledge and experience. lack of supervision and increase in workload.
Risk Factor: Purchase ledger reconciliation not The audit team should increase their testing on trade
being performed: payables at the year end. A detailed review of the year-
There is an increased risk that errors in purchases and end purchase ledger control account reconciliation
creditors may not be identified timely. should be performed with a focus on any unusual
reconciling items.
Risk Factor: Significant fall in admin expenses Discuss the reason of fall with management, and obtain
Admin expenses are fixed in nature and do not change corroborative evidence to verify management
with sales. Significant decrease in admin expenses explanation. Also, remain alert for misclassification of
indicates understatement or misclassification of admin admin expenses with other areas or omission of admin
expenses. expenses.
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Case Study – Second Example:

Abrahams Co develops, manufactures and sells a range of pharmaceuticals and has a wide customer base across Europe
and Asia. You are the audit manager of Nate & Co and you are planning the audit of Abrahams Co whose financial year end
is 31 January. You attended a planning meeting with the finance director and engagement partner and are now reviewing
the meeting notes in order to produce the audit strategy and plan. Revenue for the year is forecast at $25 million.
During the year the company has spent $2·2 million on developing several new products. Some of these are in the early
stages of development whilst others are nearing completion. The finance director has confirmed that all projects are likely
to be successful and so he is intending to capitalise the full $2·2 million.
Once products have completed the development stage, Abrahams begins manufacturing them. At the year end it is
anticipated that there will be significant levels of work in progress. In addition the company uses a standard costing
method to value inventory; the standard costs are set when a product is first manufactured and are not usually updated.
In order to fulfill customer orders promptly, Abrahams Co has warehouses for finished goods located across Europe and
Asia; approximately one third of these are third party warehouses where Abrahams just rents space.
In September a new accounting package was introduced. This is a bespoke system developed by the information
technology (IT) manager. The old and new packages were not run in parallel as it was felt that this would be too onerous
for the accounting team. Two months after the system changeover the IT manager left the company; a new manager has
been recruited but is not due to start work until January.
In order to fund the development of new products, Abrahams has restructured its finance and raised $1 million through
issuing shares at a premium and $2·5 million through a long-term loan. There are bank covenants attached to the loan, the
main one relating to a minimum level of total assets. If these covenants are breached then the loan becomes immediately
repayable. The company has a policy of revaluing land and buildings, and the finance director has announced that all land
and buildings will be revalued as at the year end.
The reporting timetable for audit completion of Abrahams Co is quite short, and the finance director would like to report
results even earlier this year.
Required:
Using the information provided, identify and describe FIVE audit risks and explain the auditor’s response to each risk in
planning the audit of Abrahams Co. (10 marks)
Suggested Solution:
Risk Response
Risk Factor: All development cost have been

capitalized:
Some of the development cost may not have met A breakdown of the development expenditure should be
recognition criteria. reviewed and tested in detail to ensure that only
projects which meet the capitalisation criteria are
included as an intangible asset, with the balance being
expensed.
Risk Factor: Significant level of work-in-process
inventory
It is difficult to determine correct cost of work-in- Consideration should be given as to whether an
process because it involves estimation of stage of independent expert is required to value the work in
completion (which is subjective); and absorption of progress. If so this will need to be arranged with consent
overhead (which is complex). from management and in time for the year-end count.
Risk Factor: “Standard costing” method is used for
Inventory valuation:
At year end, actual Cost may be different from standard Standard costs should be compared with actual cost. If
cost, specially as it is not updated periodically. there are significant variations this should be discussed
with management, and should be adjusted.
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Risk Factor: Inventory is held at various locations: Auditor will have to attend inventory count at some of
It is difficult to determine correct amount of inventory other locations too. Further, inventory held by third
at balance sheet date. parties need to be confirmed in writing by auditor.
Risk Factor: Introduction of new IT system: The new system will need to be documented in full and
Errors may occur during changeover process which testing should be performed over the transfer of data
may impact financial statements. from the old to the new system.
Risk Factor: IT department working without IT
manager: The team should remain alert throughout the audit for
Staff may have some problems and without support additional errors within the IT department due to lack of
from departmental head, errors may occur in financial supervision and increase in workload.
statements due to lack of knowledge and experience.
Split of loan between current and non-current portion, Review whether Abrahams Co has complied with debt-
and disclosures (e.g. charges on assets) may be covenants. If there has been any default, then determine
inappropriately included in financial statements. the effect on financial statements of company.
Further, if default is made in debt-covenant The team should also maintain their professional
requirements, , there is also a risk that bank may call- scepticism to verify assets have not been overstated to
back entire loan and if company does not have alternate ensure compliance with covenants.
source of financing, going concern assumption may not
be appropriate.
Risk Factor: Revaluation of Fixed Assets:
Revaluation may be incorrectly calculated and recorded Review the reasonableness of the valuation and
because it involves Subjectivity (e.g. determination of recalculate the revaluation surplus/deficit to ensure
useful life) and Complexity (e.g. deferred tax that land and buildings are correctly valued.
implication).
Risk Factor: Reduced reporting timetable:
Audit risk is increased as audit team will have less time Audit team should consider to perform interim audit or
and will be under-pressure in obtaining sufficient should request to extent reporting timetable.
appropriate audit evidence.
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APPENDIX 2: INHERENT RISK ASSESSMENT THROUGH FIGURES: ✯✯

Inherent risk assessment through figures means performing analytical procedures and identifying
areas where there is potential of misstatement. Two types of cases are possible in exam:
1. You are given Ratios/Percentages and are required to identify risks, or
2. You are given Extracts of Financial Statements and are required to identify risks.
In advanced questions, you may also be required to describe how you would address these audit risks.

1. If you are given ratios/percentages, then you have to directly identify risks.
2. If you are given extracts of financial statements, then first you have to calculate
ratios/percentages, and then you have to identify risks.
Examples of Frequently Asked Risks and Their Explanation

Risk Factor: Significant increase/decrease in Sales compared to last year:
(Formula to be used: current year’s sales/last year’s sales * 100)
Significant increase in sales indicates overstatement of sales. Therefore, Occurrence and Cut-off assertions of Sales are at
risk.
Significant decrease in sales indicates understatement of sales. Therefore, Completeness and Cut-off assertions of sales
are at risk.
Further, a decrease in sales due to decrease in demand or sale price of products also indicates inventory may have
become obsolete requiring write-down of inventory from cost to NRV. Therefore, Valuation and Allocation assertion of
Inventory is also at risk.
However, there will be no risk in sales if increase/decrease is due to launch of new

products or discontinuance of existing products, or change in marketing strategies.
Risk Factor: Significant increase/decrease in Cost of Sales (as %age of sales) as compared to last year:
(Formula to be used: Cost of Sales/Sales * 100 for both year)
Significant increase in %age of cost of sales indicates overstatement of Purchases. Therefore, Occurrence and Cut-off
assertions of Purchases are at risk. Further, it may also indicate overstatement of Overheads and understatement of
Closing stock.
Significant decrease in %age of cost of sales indicates understatement of Purchases. Therefore, Completeness assertion of
Purchases is at risk. Further, it may also indicate understatement of Overheads and overstatement of Closing stock.
However, there will be no risk in cost of sales if increase/decrease is due to change in

cost of inputs or change in production technology.
Exam Tip
If you are given GP ratio in exam, remember that it includes effect of both Sales and Cost of Sales.
Therefore, your risk assessment through GP ratio should cover both.
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Risk Factor: Significant increase/decrease in Selling/Operating Expenses (as %age of sales) as compared to last
year:
(Formula to be used: Selling Expenses/Sales * 100 for both year)
Significant increase in selling/operating expenses indicates overstatement or misclassification of selling/operating
expenses. Therefore, Occurrence and Classification assertion of selling/operating expenses are at risk.
Significant decrease in selling/operating expenses indicates understatement or misclassification of selling/operating

expenses. Therefore, Completeness and Classification assertion of selling/operating expenses are at risk.
However, there will be no risk in selling/operating expenses if increase/decrease is

due to change in number of employees, advertisement and promotional schemes.
Risk Factor: Significant increase/decrease in Admin expenses as compared to last year:

(Formula to be used: current year’s admin expense/last year’s admin expense * 100)
Admin expenses are fixed in nature and do not change with sales.
Significant increase in admin expenses indicates overstatement or misclassification of admin expenses. Therefore,
Occurrence and Classification assertion of admin expenses are at risk.
Significant decrease in admin expenses indicates understatement or misclassification of admin expenses. Therefore,
Completeness and Classification assertion of admin expenses are at risk.
Risk Factor: Significant increase/decrease in Depreciation Expenses (as %age of tangible fixed assets) as
compared to last year:
(Formula to be used: Depreciation Expense/Tangible Fixed Assets * 100 for both year)
Significant increase in depreciation expenses indicates overstatement of depreciation expenses. Therefore, Accuracy
assertion of depreciation expenses is at risk.
Significant decrease in depreciation expenses indicates understatement of depreciation expenses.. Therefore,

Completeness assertion of depreciation expenses is at risk.
Risk Factor: Significant increase/decrease in Interest/Finance charges (as %age of Borrowings/Loans) as

compared to last year:
(Formula to be used: Interest/Loans * 100 for both year)
Significant increase in finance charges indicates overstatement of finance charges. Therefore, Occurrence and Accuracy
assertions of finance charges are at risk. It may also indicate understatement of borrowings.
Significant decrease in finance charges indicates understatement of finance charges. Therefore, Completeness and
Accuracy assertions of finance charges are at risk. It may also indicate overstatement of borrowings.
However, there will be no risk in finance charges if increase/decrease is due to change

in interest rates during the year.
Risk Factor: Significant increase/decrease in Debtors’ Turnover Ratio in days compared to last year:
(Formula to be used: Debtors/Sales * 360 for both year)
Significant increase in debtors’ turnover days indicates that debtors may be overstated e.g. fake debtors may exist or
Slow-moving/doubtful debtors may exist from whom full recovery is not expected. Therefore, Existence and Valuation
and Allocation assertions of Debtors are at risk.
Significant decrease in debtors’ turnover days indicates that debtors may be understated. Therefore, Completeness
assertion of debtors is at risk.
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Risk Factor: Significant increase/decrease in Inventory Turnover Ratio in days compared to last year:
(Formula to be used: Inventory/ Cost of Sales* 360 for both year)
Significant increase in inventory turnover days indicates that Inventory may be overstated e.g. fake inventory may exist,
or there may be incorrect valuation of inventory, or inventory may have become obsolete requiring write-down of
inventory from cost to NRV. Therefore, Existence and Valuation and Allocation assertions of Inventory are at risk.
Significant decrease in inventory turnover days indicates that inventory may be understated e.g. some inventory may be
omitted, or there may be incorrect valuation. Therefore, Completeness and Valuation and Allocation assertions of
Inventory are at risk
However, there will be no risk in inventory if increase/decrease in days is due to change

in methods of production and change in inventory levels to support future sales.
Risk Factor: Significant increase/decrease in Creditors’ Turnover Ratio in days compared to last year:
(Formula to be used: Creditors/Purchases * 360 for both year)
Significant increase in creditors’ turnover days indicates that creditors are overstated. Therefore, Existence assertion of
Creditors is at risk. It also indicates that company is having financial problems and is unable to pay creditors timely.
Significant decrease in creditors’ turnover days indicates that creditors may be understated. Therefore, Completeness
assertion of Creditors is at risk.
However, there will be no risk in creditors if increase/decrease in days is due to change

in credit period by suppliers.
Exam Tip
Turnover ratios (e.g. debtors /inventory/creditors turnover ratios) can be calculated in two ways i.e. in
times or in days. You are advised to always calculate and interpret these ratios in days.
Risk Factor: Significant increase/decrease in current ratio compared to last year:

(Formula to be used: Current Assets/Current Liabilities for both year)
Significant increase in current ratio indicates overstatement of current assets or understatement of current liabilities.
Therefore, Existence assertion of current assets and Completeness assertion of current liabilities are at risk.
Significant decrease in current ratio indicates understatement of current assets or overstatement of current liabilities.
Therefore, Completeness assertion of current assets and Existence assertion of current liabilities are at risk.
Risk Factor: Ratios indicating liquidity or going concern problems of entity:

1. Decrease in Current Ratios
2. Decrease in NP ratio.
3. Decrease in interest coverage ratio (also called Times Interest Earned).
4. Increase in borrowings.
Exam Tip
Risk Assessment through figures is to be done in the same order as given above i.e. first I/S ratios and
then B/S ratios.
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Case Study – First Example

In the planning phase of the audit of Dynamic Limited for the year ending 30 June 2012, you have calculated the following
ratios from the management accounts of the company for the eight months ended 29 February 2012:
Eight months period

Year ended Year ended
ended
30 June 2011 30 June 2010
29 February 2012
Gross profit percentage 35% 40% 40%
Inventory turnover days 120 105 78
Current ratio 1.5 2.3 2.6
Quick asset ratio 0.78 1.6 1.7
Times interest earned 0.91 1.67 2.1
Debtors turnover days 132 86 68
Required:
Identify the prospective audit risks which the auditor should consider while planning the audit. (09 marks)
Suggested Solution:
Risk Factor: Decrease in Gross Profit Percentage:
Analysis of GP ratio can be subdivided into two aspects i.e. Sales and Cost of Sales.
1. Decrease in GP ratio indicates understatement of sales. Therefore, Completeness assertion of sales is at risk.
2. Decrease in GP ratio also indicates overstatement of Purchases. Therefore, Occurrence and Cut-off assertions of
Purchases are at risk. Further, it may also indicate overstatement of Overheads and understatement of Closing
stock.
Risk Factor: Increase in Inventory turnover days:

Significant increase in inventory turnover days indicates that Inventory may be overstated e.g. fake inventory may exist,
or there may be incorrect valuation of inventory, or inventory may have become obsolete requiring write-down of
inventory from cost to NRV. Therefore, Existence and Valuation and Allocation assertions of Inventory are at risk.
Risk Factor: Increase in Debtors turnover days:

Significant increase in debtors’ turnover days indicates that debtors may be overstated e.g. fake debtors may exist or
Slow-moving/doubtful debtors may exist from whom full recovery is not expected. Therefore, Existence and Valuation
and Allocation assertions of Debtors are at risk.
Risk Factor: Decrease in Current ratio:

Significant decrease in current ratio indicates overstatement of current liabilities. Therefore, Existence assertion of
current liabilities is at risk. Further, this also indicates that entity is facing liquidity or going concern problems.
Risk Factor: Liquidity problems of entity:

Current ratio, quick asset ratio, times interest ratio and GP ratios are decreasing, which indicates company’s liquidity
position is worsening. There are also doubt on going concern assumption as quick ratio and times interest earned ratio
are below 1. Therefore, there is a risk of management bias in financial statements (of next four months) to present best-
view of financial statements, to increase personal wealth of management/shareholders.
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Case Study – Second Example

You are the Audit Manager of Mustafa and Company, Chartered Accountants, responsible for the audit of Standard
Home Appliances Limited, a listed company.
Extracts from the company’s financial statements are presented below:
30-Sep-2012 30-Sep-2011
Income statement ----------Rs. in million---------
Revenue 1,190 1,174
Gross profit 509 537
Operating profit 242 227
Finance charges (77) (69)
Profit before tax 165 158
Statement of financial position

Property, plant and equipment 1,054 833
Intangible assets 140 100
Inventory 423 260
Trade receivables 417 250
Cash and bank balances 29 54
Total assets 2,063 1,497
Equity and liabilities

Share capital 1,000 1,000
Retained earnings 218 233
Long-term borrowings 277 50
Liabilities against assets subject to finance lease 180 -
Bank overdraft 185 52
Trade and other payables 203 162
Total equity and liabilities 2,063 1,497
During the year, the company has introduced various products based on latest technologies. These new products
are being manufactured on a new plant which has been acquired under a lease agreement for a period of four years.
The plant commenced operations on 01 January 2012. The useful life of the plant is 5 years.
Intangible assets represent cost of software installed and designs which have been acquired from a renowned
multinational company.
Required:
Identify and evaluate the audit risks in the above situation. (12 marks)
Suggested Solution:
Risk Factor: Stagnant Revenue despite launch of various new products
There has been only 1% increase in sales (1,190/1,174) despite launch of various new products this year based on latest
technologies. It indicates sales may be understated. Therefore, Completeness assertion of sales is at risk.
Further, it also indicates that new products have not been successful or demand for existing products have decreased, and
indicates inventory may have become obsolete requiring write-down of inventory from cost to NRV. Therefore, Valuation
and Allocation assertion of Inventory is also at risk.
Further, new plant purchased for new products may also have become impaired as its value in use has decreased if new
products are not successful.
Risk Factor: Increase in Cost of Sales (as %age of Sales)

Increase in cost of sales (681/1,190= 57.23% as compared to last year 637/1,174= 54.23%) may be because of
depreciation of new plant, but it also indicates overstatement of purchases or overheads. Further, it may indicate
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understatement of closing stock.
Risk Factor: Decrease in operating expenses(as %age of Sales)

Decrease in operating expenses (267/1,190 = 22.4% as compared to last year 310/1,174 = 26.4%) indicates
understatement of operating expenses (specially advertisement and sales related cost should increase when new
products are launched). It also indicates misclassification between operating expenses and cost of sales.
Risk Factor: Decrease in finance charge (as %age of borrowings)

Decrease in finance charge (77/642=11.99% as compared to last year 69/102=67.65%) indicates understatement of
finance charges. Therefore, Completeness and Accuracy assertions of finance charges are at risk. It may also indicate
overstatement of borrowings.
Risk Factor: Increase in Inventory Turnover Days:

Increase in inventory turnover days (423/681*360 = 224 days as compared to last year 260/637*360 = 147 days)
indicates that Inventory may be overstated e.g. fake inventory may exist, or there may be incorrect valuation of inventory,
or inventory may have become obsolete requiring write-down of inventory from cost to NRV. Therefore, Existence and
Valuation and Allocation assertions of Inventory are at risk.
Risk Factor: Increase in Debtors Turnover Days:

Increase in debtors turnover days (417/1,190*360 = 126 days as compared to last year 250/1,174*360 = 77 days)
indicates that debtors may be overstated e.g. fake debtors may exist or slow-moving/doubtful debtors may exist from
whom full recovery is not expected. Therefore, Existence and Valuation and Allocation assertions of Debtors are at risk.
Risk Factor: Intangible assets recognized and purchased by company:

Intangible assets may not have met recognition criteria, or may be incorrectly valued because of subjectivity and
complexity in valuation (e.g. issue of useful life, issue of internal expenses). Therefore, Valuation and Allocation assertion
of Intangible Assets is at risk.
Risk Factor: Increased level of borrowing:

Deteriorating current ratio and increased level of borrowing which indicates company’s liquidity position is worsening.
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Case Study – Third Example

You are the audit senior of Rhino & Co and you are planning the audit of Kangaroo Construction Co (Kangaroo) for the
year ended 31 March 2013. Kangaroo specialises in building houses and provides a five-year building warranty to its
customers. Your audit manager has held a planning meeting with the finance director. He has provided you with the
following notes of his meeting and financial statement extracts:
Kangaroo has had a difficult year; house prices have fallen and, as a result, revenue has dropped. In order to address this,
management has offered significantly extended credit terms to their customers. However, demand has fallen such that
there are still some completed houses in inventory where the selling price may be below cost. During the year, whilst
calculating depreciation, the directors extended the useful lives of plant and machinery from three years to five years.
This reduced the annual depreciation charge.
The directors need to meet a target profit before interest and taxation of $0·5 million in order to be paid their annual
bonus. In addition, to try and improve profits, Kangaroo changed their main material supplier to a cheaper alternative.
This has resulted in some customers claiming on their building warranties for extensive repairs. To help with operating
cash flow, the directors borrowed $1 million from the bank during the year. This is due for repayment at the end of 2013.
Financial statement extracts for year ended 31 March

DRAFT ACTUAL
2013 2012
$m $m
Revenue 12.5 15.0
Cost of sales (7.0) (8.0)
Gross profit 5.5 7.0
Operating expenses (5.0) (5.1)
Profit before interest and taxation 0.5 1.9
Inventory 1·9 1·4

Receivables 3·1 2·0
Cash 0.8 1·9
Trade payables 1·6 1·2
Loan 1·0 –
Required:
Using the information above:
(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit; and (05 marks)
(ii) Using the information provided and the ratios calculated, identify and describe FIVE audit risks and explain the
auditor’s response to each risk in planning the audit of Kangaroo Construction Co. (10 marks)
Suggested Solution:
(i)
Ratio Formula Calculation
2013 2012
Gross Profit Ratio G.P. / Sales 44.0% 46.7%
Net Profit Ratio N.P./Sales 4.0% 12.7%
Inventory Turnover Ratio (days) Inventory/Cost of Sales * 360 97.7 63.0
Debtors Turnover Ratio (days) Debtors/Sales * 360 89.3 48.0
Current Ratio Current Assets/Current Liabilities 2.2 4.4
Quick Asset Ratio Current Assets - Inventory /Current Liabilities 1.5 3.3
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(ii)
Risk Response
Risk Factor: Fall in demand of houses, Fall in price

of houses, Increase in Inventory turnover days:
Inventory may have become obsolete requiring write- Detailed cost and net realisable value (NVR) testing to
down of inventory from cost to NRV. Therefore, be performed and the aged inventory report to be
Valuation and Allocation assertion of Inventory is at review
risk.
Risk Factor: Extension in credit terms to customers
and Increase in debtors’ turnover days
Slow-moving/doubtful debtors may exist from whom Extended post year-end cash receipts testing and a
full recovery is not expected. Therefore, Valuation and review of the aged receivables ledger to be performed to
Allocation assertion of Debtors is at risk. assess valuation.
Risk Factor: Change in useful life of fixed assets: Discuss with the directors the rationale for extending
Increase in useful life from 3 to 5 years may be the useful lives. Also, the five year life should be
unreasonable, to increase profit. Therefore, Valuation compared to industry average and replacement policy.
and Allocation assertion of fixed assets is at risk. Written representation may also be obtained for
significant estimates.
Risk Factor: Management’s annual bonus based on
target profit:
There is a risk of management bias to manipulate Throughout the audit, the team will need to be alert to
financial statements, to increase personal wealth of this risk and maintain professional skepticism. They will
management. need to carefully review judgemental decisions.
Risk Factor: Shift to cheap supplier and increase in
claims for warranty: Review the level of the warranty provision in light of the
Warranty may be incorrectly calculated because it increased level of claims to confirm completeness of the
involves estimation and complexity. Therefore, provision.
Accuracy assertion of Warranty is at risk.
Split of loan between current and non-current portion, Send confirmation letter to bank to confirm terms and
and disclosures (e.g. charges on assets) may be conditions (including security and debt-covenants).
inappropriately included in financial statements. Check whether presentation and disclosure
Therefore, Presentation and Disclosure assertions of requirements of AFRF have been complied in financial
loan are at risk. statements.
Review whether client has complied with debt-
covenants. If there has been any default, then determine
the effect on financial statements of company.
Risk Factor: Liquidity problems of entity:

Current ratio, and quick asset ratio are decreasing, Detailed going concern testing to be performed during
which indicates company’s liquidity position is the audit and discussed with the directors to ensure that
worsening. the going concern basis is reasonable.
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Auditing – Case Studies Chapter 11 Understanding of Internal Control & Control Risk Assessment
CHAPTER ELEVEN (CASE STUDIES)

UNDERSTANDING OF INTERNAL CONTORL
AND CONTROL RISK ASSESSMENT
APPENDIX 1:ATTEMPING CASE STUDY ON INTERNAL CONTROLS: ✯✯
Structure of the Case and Suggested Approach:
In exam if a case study is set from “Controls”, you may be given a typical system and you may be required to:
1. Identify strengths or weakness/deficiencies in the system. (Weakness = Lack of Control Activity with specific
reference to case)
2. Explain the effect/implication of each weakness/deficiency (Effect of Weakness = Objective of Absent Control
Activity will not fulfilled).
3. Provide a recommendation to address/improve each weakness/deficiency (State control activity with specific
reference to case).
4. State tests of controls which you will perform on system. (state tests of controls with specific reference to case).
Use “Table-format” to list weakness, effect, recommendation, and test of control.

Pear International Co (Pear) is a manufacturer of electrical equipment. It has factories across the country and its customer
base includes retailers as well as individuals, to whom direct sales are made through their website. The company’s year
end is 30 September 2012. You are an audit supervisor of Apple & Co and are currently reviewing documentation of
Pear’s internal control in preparation for the interim audit.
Pear’s website allows individuals to order goods directly, and full payment is taken in advance. Currently the website is
not integrated into the inventory system and inventory levels are not checked at the time when orders are placed.
Goods are despatched via local couriers; however, they do not always record customer signatures as proof that the
customer has received the goods. Over the past 12 months there have been customer complaints about the delay between
sales orders and receipt of goods. Pear has investigated these and found that, in each case, the sales order had been
entered into the sales system correctly but was not forwarded to the despatch department for fulfilling.
Pear’s retail customers undergo credit checks prior to being accepted and credit limits are set accordingly by sales ledger
clerks. These customers place their orders through one of the sales team, who decides on sales discount levels.
Raw materials used in the manufacturing process are purchased from a wide range of suppliers. As a result of staff
changes in the purchase ledger department, supplier statement reconciliations are no longer performed.
Required:
In respect of the internal control of Pear International Co:
(i) Identify and explain FIVE deficiencies;
(ii) Recommend a control to address each of these deficiencies; and
(iii) Describe a test of control Apple & Co would perform to assess if each of these controls is operating effectively.
(15 marks)
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Suggested Solution:
Deficiency Recommended Control Test of Control
Inventory levels are not Website should be integrated with Use test data to check whether
checked at time of order inventory system so that every order is orders for out-of-stock inventory
from customer. checked for inventory before approval. are rejected.
Customer signatures are Courier-persons should be required to Check a sample of goods despatch
not always received as obtain signature of customer at time of notes, and inspect for signature of
proof of receipt of goods. receipt of goods. receipt by customer.
There are significant delays Select a sample of sales orders and
Sales orders should be immediately sent
between sales order and compare the date of order to the
to despatch department.
despatch of goods. goods despatch date
Select a sample of new credit
Credit limits should be set by a
Credit limits are set by customers approved and inspect
responsible independent person outside
sales ledger CLERKS. whether it was authorized by
the sales department.
appropriate authority.
Discount levels should be set by a Select a sample of sales orders and
Discount levels are decided
responsible independent person outside inspect whether it was authorized
by sales team.
the sales department. by appropriate authority.
Supplier statement reconciliations should Select a sample of supplier
supplier statement
be performed on monthly basis for all reconciliation statements and
reconciliations are no
suppliers and these should be reviewed inspect signature of person
longer performed
by a responsible official. reviewing the reconciliation.

Greystone Co is a retailer of ladies clothing and accessories. It operates in many countries around the world and has
expanded steadily from its base in Europe. Its main market is aimed at 15 to 35 year olds and its prices are mid to low
range. The company’s year end was 30 September 2010.
Greystone Co has an internal audit department but at present their only role is to perform regular inventory counts at the
stores.
Ordering process
Each country has a purchasing manager who decides on the initial inventory levels for each store, this is not done in
conjunction with store or sales managers.
Goods received and Invoicing

To speed up the ordering to receipt of goods cycle, the goods are delivered directly from the suppliers to the individual
stores. On receipt of goods the quantities received are checked by a sales assistant against the supplier’s delivery note,
and then the assistant produces a goods received note (GRN). The checked GRNs are sent to head office for matching with
purchase invoices.
As purchase invoices are received they are manually matched to GRNs from the stores, this can be a very time consuming
process as some suppliers may have delivered to over 500 stores. Once the invoice has been agreed then it is sent to the
purchasing director for authorisation. It is at this stage that the invoice is entered onto the purchase ledger.
Required:
As the external auditors of Greystone Co, write a report to management in respect of the purchasing system which:
(i) Identifies and explains FOUR deficiencies in that system;
(ii) Explains the possible implication of each deficiency;
(iii) Provides a recommendation to address each deficiency.
Note: Up to two marks will be awarded within this requirement for presentation. (14 marks)
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Suggested Solution:
Deficiency Implication Recommendation
Purchase manager decides Goods may pile-up and company may

Purchase manager should discuss the
inventory levels without not be able to sell that at regular price.
expected sales in next period with
consultation with stores or If fashion changes, these goods may
sales managers.
sales manager. become obsolete.
Technical specification and Goods should then be checked on
Faulty goods may be accepted by sales
quality of goods is not arrival for quantity and quality prior to
assistant.
checked. acceptance from the supplier.
A copy of the authorised order form
Goods received are not
Company may have to pay for goods should be sent to the store. Staff
matched with purchase
which it did not order. should match goods received with
orders.
purchase order.
Invoice may be misplaced, and there
Purchase invoice is entered Invoices should be entered into system
may be disputes with suppliers.
into the system only after at time of receipt of invoices. Further,
Further, purchases will be understated
authorization of purchase unapproved invoices at year end
at year end becaue of lots of pending
director. should be accrued.
purchase invoices.
Case Study – Third Example:

Trombone Co (Trombone) operates a chain of hotels across the country. Trombone employs in excess of 250 permanent
employees and its year end is 31 August 2014. You are the audit supervisor of Viola & Co and are currently reviewing the
documentation of Trombone’s payroll system, detailed below, in preparation for the interim audit.
Trombone’s payroll system

Permanent employees work a standard number of hours per week as specified in their employment contract. However,
when the hotels are busy, staff can be requested by management to work additional shifts as overtime. This can either be
paid on a monthly basis or taken as days off.
Employees record any overtime worked and days taken off on weekly overtime sheets which are sent to the payroll
department. The standard hours per employee are automatically set up in the system and the overtime sheets are entered
by clerks into the payroll package, which automatically calculates the gross and net pay along with relevant deductions.
These calculations are not checked at all. Wages are increased by the rate of inflation each year and the clerks are
responsible for updating the standing data in the payroll system.
Employees are paid on a monthly basis by bank transfer for their contracted weekly hours and for any overtime worked
in the previous month. If employees choose to be paid for overtime, authorisation is required by department heads of any
overtime in excess of 30% of standard hours. If employees choose instead to take days off, the payroll clerks should check
back to the ‘overtime worked’ report; however, this report is not always checked.
The ‘overtime worked’ report, which details any overtime recorded by employees, is run by the payroll department
weekly and emailed to department heads for authorisation. The payroll department asks department heads to only report
if there are any errors recorded.
Required:
In respect of the payroll system of Trombone Co:
(i) Identify and explain FIVE deficiencies;
(ii) Recommend a control to address each of these deficiencies; and
(iii) Describe a test of control Viola & Co should perform to assess if each of these controls is operating effectively.
Note: The total marks will be split equally between each part. (15 marks)
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Suggested Solution:
Wages calculations performed A responsible official should manually Select a sample of wages sheet and
by system are not checked recalculate and approve wages to check whether they are approved
manually. ensure there are no system errors. by an official.
Standing data in payroll file is Payroll clerks should not have access Ask a clerk to change standing data
changed by CLERKS. to amend standing data. and check whether system rejects
the change.
Overtime upto 30% are not All overtime hours worked should be Select a sample of overtime sheet
authorized. authorised by the relevant and inspect for evidence of
department head. authorization (e.g. signature by
appropriate authority).
Payroll clerk does not always Payroll clerk should always check Select a sample of overtime sheets
check back "overtime worked" back "overtime worked" report before with time taken off and confirm
report before allowing time-off. allowing time-off. that there is evidence of a check by
the payroll clerk
Department heads are asked to Departmental heads should be asked For a sample of overtime reports
reply only if there is any to report in all cases i.e. whether they emailed to department heads
exception. approve or not approve overtime, so confirm that a response has been
that overlooked reports are not paid. received from each head
Case Study – Fourth Example:

Your audit team members have attended the physical inventory count of Sutlaj Limited. Their observations are as follows:
(i) Stock count was supervised by the warehouse incharge who reports to the production manager.
(ii) In view of the various ongoing projects, temporary staff had to be hired to conduct the stock count.
(iii) Pre-numbered count sheets were used by the staff which contained columns for inventory ledger balances,
physical balances and excess/shortages.
(iv) The staff was instructed to ensure that no item of inventory was counted twice and for this purpose they were
asked to remain in constant contact with other staff.
(v) On completion, all the count sheets were signed by the store incharge and the head of the administration
department
Required:
Identify the weaknesses in the inventory count procedures and state the implications on the physical count. (08 marks)
Suggested Solution:
Weakness Implication on physical count
He has overall responsibility for the inventory and so he is not

The warehouse incharge supervised
suitable for this control. There could be a temptation to hide errors or
the inventory count.
missing inventory that they have removed from the store fraudulently.
Temporary staff is assigned to conduct Temporary staff may not be experienced enough to follow instructions
stock count. for inventory count.
Inventory sheets stated the quantity of Count teams may try to confirm the inventory ledger balance without
items expected to be found in the store. performing actual physical count.
There is no clear division of There is the risk that some areas of the warehouse could be double
responsibilities among the staff. counted or missed out.
Count sheets do not have signatures of Absence of signature of persons who counted the stock, may cause
persons who counted the stock. accountability problems.
There have been no procedures to look
for conditions of stock to identify slow- This may result in overstatement of inventory.
moving and obsolete stock.
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Case Study – Fifth Example:

Shiny Happy Windows Co (SHW) is a window cleaning company. Customers’ windows are cleaned monthly, the window
cleaner then posts a stamped addressed envelope for payment through the customer’s front door.
SHW has a large number of receivable balances and these customers pay by cheque or cash, which is received in the
stamped addressed envelopes in the post. The following procedures are applied to the cash received cycle:
1. A junior clerk from the accounts department opens the post and if any cheques or cash have been sent, she
records the receipts in the cash received log and then places all the monies into the locked small cash box.
2. The contents of the cash box are counted each day and every few days these sums are banked by which every
member of the finance team is available.
3. Usually on a monthly basis the cashier performs a bank reconciliation, which he then files, if he misses a month
then he catches this up in the following month’s reconciliation.
Required:
For the cash cycle of SHW:
(i) Identify and explain THREE deficiencies in the system; (03 marks)
(ii) Suggest controls to address each of these deficiencies; and (03 marks)
(iii) List tests of controls the auditor of SHW would perform to assess if the controls are operating effectively.
(03 marks)
Suggested Solution:
A junior clerk opens mail without A second person should observe and Observe the mail opening process.
supervision. record cash received through post.
Cash and cheques are secured in a Cash and cheques should be banked Inquire about banking routine of
small locked box and only banked daily, and kept in a secured heavy cash, and inspect location of safe.
every few days. safe.
Bank reconciliation statements are Bank reconciliation statements Select a sample of reconciliations,
not performed every month, and should be performed every month. An and inspect for evidence of review
are not being reviewed by independent person should review by an independent senior person.
independent person. the reconciliation.
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Auditing – Case Studies Chapter 12 Substantive Procedures
CHAPTER TWELVE (CASE STUDIES)

SUBSTANTIVE PROCEDURES
APPENDIX 1: RECOMMENDING SUBSTANTIVE PROCEDURES IN A SPECIFIC
SITUATION: ✯✯
In exam, you may be given a situation regarding a particular assertion/aspect/part of an area of
financial statements. You will be required to list the substantive procedures you will perform to
verify the related assertion/aspect/part.

Keep in mind the substantive procedures of that area and list relevant procedures specific to the
situation
Case Study 1:
You are the manager on the audit of Nobel Limited, a listed company, which manufactures automotive parts and air-
conditioners for motor vehicle assemblers. Annual sale of the Company is Rs. 850 million and profit before tax is Rs. 60
million.
Your review of the audit working paper file has disclosed the following outstanding issues:
(i) The company is facing a potential legal claim from Mehran Motors Limited (MML) in respect of defective air
conditioners supplied to them. A claim for Rs. 25 million being the cost of replacement of air conditioners and
lost production time has been lodged with the Company by MML. The management is of the view that the claim
is not justified, as the air conditioners were properly functioning and had been tested for quality and that the
defects have arisen because of the negligence of MML and its technicians. However, a provision of Rs. 2 million
has been made in the financial statements in this respect.
(ii) Depreciation on certain equipment has been charged at 10% per annum on reducing balance method. This rate
is consistent with prior years and the same rate is being used by most other companies, in the automobile
industry. However, significant losses have recently been recorded on the disposal of similar equipment.
Management has provided written representations in respect of the above matters.
Required:
What audit evidence will you gather to address the above issues? (10 marks)
Suggested Solution:
(i)
Management representation is not a sufficient appropriate audit evidence in this regard, as other better evidence is
expected to exist.
Audit procedures to obtain evidence in this regard:

 Discuss with management (also obtain written representation if necessary)
 Communicate with external legal counsel (detail below)
 Check correspondence with specific customers
 For warranty claims, review:
o Terms and conditions of Sales contract
o Past records of returns and claims
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o Industry practice
o Evaluation of basis of provision
 Check status subsequent to reporting period
(ii)
Management representation is not a sufficient appropriate audit evidence in this regard, as other better evidence is
expected to exist.
Audit procedures to obtain evidence in this regard:

Losses on disposal indicates that fixed assets’ book values is significantly higher from its market values at time of
disposal; which may be because depreciation rate is not appropriate. Auditor may perform following procedures:
 Compare depreciation rate with industry.
 Engage expert to review useful life of fixed assets.
 Test fixed assets for impairment.
 Inquire reason for sale of fixed assets.
 Review if any related party is involved in the transaction (to ensure transactions are at arm’s length basis).
Although the situations were simple yet most students were unable to mention the related audit evidence.
Case Study 2:
You have been assigned the task of checking the cash at bank figure in respect of the audit of Portland Ltd for the year
ended 31 March 2006. The accountant routinely prepares bank reconciliations at the end of each month and has provided
you with the following bank reconciliation as at 31 March 2006.
£
Balance per bank statement 113,340
Outstanding lodgements 25,675
Unpresented cheques (97,222)
Balance per cash book 41,793
Set out the audit procedures that you would undertake in respect of the reconciliation prepared by the accountant.
(03 marks)
Suggested Solution:
Check recalculation of reconciliation statement by casting.
Procedures to be performed on balance as per bank statement:
 Agree the balance with bank statement held by client and with external confirmation letter.
Procedures to be performed on outstanding lodgements:

 Trace the transactions into cash book prior to the year.
 Trace the clearance of lodgements into bank statement after the year.
 Inquire if there is any unusual delay in clearance of deposits.
Procedures to be performed on outstanding cheques:

 Trace the transactions into cash book prior to the year.
 Trace the payments from bank statement after the year.
Procedures to be performed on Balance as per cash book:

 Agree the balance with cash book and financial statements.
Those candidates who systematically worked through each figure in the reconciliation and performed a procedure in respect
of that figure tended to score high marks. The point most commonly overlooked was that relating to checking the balance per
cash book to the financial statements. Some candidates strayed beyond the requirement and cited vouching the unpresented
items to invoices/supplier statements.
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Case Study 3:
Bullfinch.com is a website design company whose year end was 31 October 2014. The audit is almost complete and the
financial statements are due to be signed shortly. Revenue for the year is $11·2 million and profit before tax is $3·8
million. A key customer, with a receivables balance at the year end of $283,000, has just notified Bullfinch.com that they
are experiencing cash flow difficulties and so are unable to make any payments for the foreseeable future. The finance
director has notified the auditor that he will write this balance off as an irrecoverable debt in the 2015 financial
statements.
Required:
(i) Explain whether or not the 2014 financial statements require amendment; and
(ii) Describe audit procedures which should be performed in order to form a conclusion on any required amendment.
Note: The total marks will be split equally between each part. (06 marks)
Suggested Solution:
(i) This is an adjusting event because subsequent inability of customer to make payment usually provides evidence that
condition existed at balance sheet date. As the amount involved $283,000 is greater than materiality level determined
using rule of thumb 190,000 (=3,800,000 * 5%), this amount is required to be adjusted.
(ii)
 Inquire from management reason for insisting on writing off the debt in 2015 instead of in 2014.
 Review correspondence with customer to likelihood of recovery.
 Review the receipts after the year to check if any recovery has been made from customer.
Candidates were generally able to identify that the financial statements required amendment, as the error was material
and constituted an adjusting event in line with IAS 10 Events after the Reporting Period. Fewer candidates were able to
fully explain why the amendment was required, with many just stating this was an adjusting event, rather than why it was
adjusting.
Unfortunately, the requirement for audit procedures was overlooked by many candidates, as rather than listing tests they
instead focused on audit report implications if the amendment was not made. This was not what the question required
and hence did not score any marks. Candidates must answer the question that has been set.
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Case Study 4:
You are the manager responsible for the audit of Park Hotels Limited (PHL), which operates three hotels in Pakistan. PHL
has adopted the revaluation model for the valuation of buildings. In the current year, revaluation has been carried out by
a new firm, Farhan Associates (FA). PHL has incorporated the effects of revaluation in the financial statements
accordingly.
Required:
Identify and explain the principal audit procedures to be performed on the valuation of the hotel’s buildings.
(06 marks)
Suggested Solution:
Procedures to be performed on revaluation by valuer:
1. Ensure Competence, Capabilities and Objectivity of Valuer
2. Ensure adequacy of valuation report
Procedures to ensure revaluation has been properly accounted for and disclosed in financial statements:
1. Ensure that valuation is up-to-date.
2. Ensure that entire class of asset has been revalued.
3. Evaluate the method used to measure fair value to ensure consistency.
4. Ensure that valuation is appropriately accounted for in accounts.
5. Ensure that appropriate disclosures have been made in accordance with IAS – 16.
6. Recalculate “revaluation surplus (or loss)”, and “depreciation expenses” and ensure these have been correctly
recorded in books of accounts.
7. Inspect the buildings physically to ensure their condition is the same as described in valuation report.
8. Obtain written representations from management regarding reasonableness of any assumptions used in
determining the fair value.
It was stated in the question that a valuation had already been carried out by the expert, hence, what was required was an
explanation of the procedures required to ensure that such valuation was appropriate. However, candidates went into details
regarding the accounting techniques, policies, presentation and disclosure requirements instead of explaining the principal
auditing procedures to be carried out.
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Auditing – Case Studies Chapter 13 IT Systems, Controls, CAATs and Flowcharts
CHAPTER THIRTEEN (CASE STUDIES)

IT SYSTEMS, CONTROLS, CAATS AND
FLOWCHARTS
APPENDIX 1: DECIDING ABOUT TYPE OF CONTROL: ✯✯✯
You will be given a list of controls, and will be required to identify type of control i.e. whether each control is:
1. Manual Control or IT Control.
2. Preventive, Detective or Corrective Control.
3. Input, Processing or Output Control.
4. General Control or Application Control.

Prepare a table of two (or three) columns. Write for serial number in first column and type of control in second column.

Following IT related controls are being employed at Vision Limited:
(i) The general ledger system is automatically updated with sub-ledger transactions (e.g. Accounts Receivable) every
night through batch processing.
(ii) The system automatically maintains second copies of all programs and data files.
(iii) Access to programs and data files is restricted using passwords.
(iv) Invoices that are entered into the system are physically counted.
(v) Firewalls (software and hardware) are installed to restrict unauthorized access.
(vi) Screen warnings are displayed as regards incomplete processing.
(vii) Vision Limited has service level agreements with reliable software companies, for technical support.
(viii) Review of output against expected values.
Required:
(a) In respect of each control, determine whether it is a preventive, detective or corrective control. (04 marks)
(b) Also classify each of the above between general IT controls and application controls. (04 marks)
Suggested Solution:
Sr. # of Controls Preventive, Detective or Corrective? IT General or IT Application?

(i) Detective IT Application Control
(ii) Corrective IT General
(iii) Preventive IT General
(iv) Detective IT Application
(v) Preventive IT General
(vi) Detective IT Application
(vii) Corrective IT General
(viii) Detective IT Application
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APPENDIX 2: DRAWING FLOWCHART: ✯✯

You will be given some description about a system in the exam e.g. billing system of a departmental store, or ATM-
withdrawal System. You will be required to document the system in the form of a flowchart.

1. Key to success is deciding how many decisions/conditions are involved and then arranging decisions/conditions
in sequence.
2. Start from the left section of the page (not from middle).
3. Use*** only four symbols i.e. Oval, Box, Diamond, Flow-line (as described below).
4. Every symbol is to be filled with some words (you may also use signs like “>”, “=”, “<”).
5. The flow of sequence is generally from top to bottom and from left to right (however, this can vary in some
cases).
6. A flow chart should be presented and completed on one page. It should not have more than 15 symbols
(including START and STOP).
*** How to Use Symbols:

Shape Tips
1. Every flowchart will have 2 Oval Shapes; one at starts and other at end..
Oval 2. At start only one arrow comes out.
3. At end, only one arrow comes in (however other arrows may merge with last arrow).
1. It is always in ‘verb’ form (as it shows an activity).
2. Only one arrow should come in Box.
Rectangular Box
3. Only one arrow comes out from Box which leads to next activity or a decision table (except
when End).
1. Two arrows come out from Diamond one for “yes” and one for “no”. These arrows can lead
Diamond
to a Box or another Diamond.
1. Usual direction is “Top to Down” or “Left to Right”. However, sometimes it may also be from
down to up.
2. Only one arrow enters/comes out of a shape (except diamond from which 2 arrows will
Arrow / Flow-line
come out).
3. Give arrow a head at each turn.
4. An arrow may join another arrow, or may cross over another arrow.
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One Place Departmental Store is offering 10% discount to all its customers who make purchases of more than Rs. 10,000
during a single visit. On each counter, the item code and the quantity is fed into a computer for generating the cash memo.
You are required to prepare a program flowchart showing the above steps. (06 marks)
Suggested Solution:
Very few students could draw a complete flow chart correctly. Most of them got stuck up at one stage or the other. Numerous
mistakes were witnessed of which the common ones are discussed below:
• Some candidates used incorrect symbols to signify start/end, processing and decision.
• Some candidates incorrectly ended up showing two different ‘end’ symbols.
257

Mr X approached an ATM machine to draw an amount of Rs.5000/-. He inserted his ATM Card into the machine and
entered his pin code on prompt. He also entered his choice of getting only 1000 currency notes. The machine served his
request. Draw a program flow chart of the ATM machine for completing this task. (05 marks)
Suggested Solution:
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Auditing – Case Studies Chapter 14 External Confirmation
CHAPTER FOURTEEN (CASE STUDIES)

EXTERNAL CONFIRMATION
APPENDIX 1: WHAT SAMPLE TO SELECT FROM POPULATION FOR CONFIRMATION:
✯✯✯
In exam question, you may be given a population (e.g. of debtors) stratified in different categories (e.g. by value, by aging,
by product, by type of customer, by geography, or by terms of trade), and you will be required to select parties for
external confirmation request.

Remember that you have to select confirming parties from each category of stratification (so that you can cover entire
population).
Basis of selection will be:

1. All high-value items over a certain amount (to ensure evidence is obtained about large portion of population).
2. Specific item selection e.g. in case of debtors
a. select overdue debts which are significant (because these may not be collectible and may require
provision)
b. select debtors with negative/credit balance (to ensure that there are no omitted or misclassified
transactions)
c. select major customers with small or zero balance. (to ensure that any transaction with major
customers is not omitted and balances are complete)
3. select a sample from remaining population (to provide an overall view of the accuracy of receivable balance.)
Case Study 1:
The aged receivables report produced by the computer is shown below:
Number of 1 to 2 More than 2

Range of debt Total debt $ Current $
receivables months old $ months old $
15 Less than $0 (87,253) (87,253)
197 $0 to $20,000 2,167,762 548,894 643,523 975,345
153 $20,001 to 50,000 5,508,077 2,044,253 2,735,073 728,751
23 $50,001 or more 1,495,498 750,235 672,750 72,513
388 9,084,084 3,256,129 4,051,346 1,776,609
In view of the deteriorating receivables situation, a direct confirmation of receivables will be performed this year.
Required:
Discuss which particular categories of receivables might be chosen for the sample. (05 marks)
259
Solution:
Selection on the basis of materiality:
Select all receivables ranging $50,001 or more, to ensure that no material misstatement exists in significant part of
population.
Selection on the basis of risk:

1. Select all receivables less than 0, to ensure that there are no omitted or misclassified transactions e.g. advance
cash recorded in debtors or cash recorded but relevant sales not recorded.
2. Select material receivables which are “1 to 2 months old” or “more than 2 months old”, because these may not be
collectible and may require provision
Remaining receivables:
Random sample will be selected from remaining population of categories, to provide an overall view of the accuracy of
receivable balance.
Case Study 2:
You are the Audit Incharge of Rehan Limited for the year ended 31 December 2015. While reviewing the working papers
and discussion with audit team, you have noted the following:
(i) The audit team did not send balance confirmation requests for amounts below Rs. 100,000 because according to the
client, lot of efforts were required to follow up the customers and the balances were also not material.
(ii) One of the conclusions drawn as per the working papers is “there are no unrecorded liabilities, as confirmations have
been received from all selected parties and no differences were noted. Hence, no further test is required.”
Required:
(a) Discuss with reasons whether you agree with the approach adopted/conclusion drawn by the audit team. (03 marks)
(b) Provide brief guidance to the audit team in respect of each of the above situations. (05 marks)
Solution:
(a)
(i) Approach of not sending confirmation requests to amounts below Rs. 100,000 is incorrect because small
misstatements may also become material when aggregated. Further, there may be risk of omitted transactions in small
balances with major parties.
(ii)This conclusion is correct, if major suppliers with small, zero or negative balances were also selected for confirmation.
If such suppliers were not selected, then this conclusion is incorrect.
(b)
(i) Audit team should not accept client’s suggestion of not sending confirmation, because it is auditor’s decision whether
to use confirmation which cannot be omitted simply because it requires lot of efforts. If client refuses to send
confirmation requests, it will be considered inappropriate scope limitation. Auditor shall communicate this to TCWG and
shall determine its effect on audit and auditor’s report.
(ii)Following other procedures should also be performed to ensure completeness of creditors:

1. Examine cash paid to supplier after the balance sheet date and ensure liabilities were recorded at balance sheet
date.
2. Inspect pending GRNs (i.e. goods received but suppliers’ invoices not received) and ensure they are recorded at
balance sheet date.
260
APPENDIX 2: WHETHER TO USE NEGATIVE CONFIRMATION (OR POSITIVE

CONFIRMATION) IN A GIVEN SITUATION: ✯✯
In exam question, you may be required to comment whether sending a negative confirmation is appropriate in a given
situation.

First state that negative confirmation can only be used if all of following conditions are met:
1. Relevant population consists of large number of small transactions or balances.
2. Risk of material misstatement is low, and auditor has obtained evidence about operating effectiveness of
controls.
4. Auditor is not aware of any circumstances that confirming party will disregard such requests.
Then, link conditions with information given in the question. If question contains information that any condition is not
being met, you will state negative confirmation will not be used. If question contains information that some of conditions
are being met but question is silent about other conditions, you will state that negative confirmation can be used
assuming other conditions are also met.
Case Study 1:
You are the Manager on the audit of Ghazi Power Limited (GPL), a gas transmission and distribution company, for the
year ending 31 October 2011. On the company’s request, your firm has agreed to complete the audit by 20 November
2011.
In order to meet the audit deadline, you are considering various measures which include sending requests for negative
confirmations related to balances due on 31 August 2011. On 31 August 2011, total debtors aggregated Rs. 45 Million.
50% of the amount is due from 15 major debtors, whereas the total number of debtors is 2,450.
Your previous experience with the client and the results of initial risk assessment procedures suggest that the risk of
material misstatement is low.
Required:
Discuss whether it would be appropriate to use the negative confirmations procedure in the above situation. (06 marks)
Solution:
Population of debtors has been stratified between two categories i.e. 15 major debtors covering 50% of the amount and
remaining 2,435 debtors covering remaining 50% of amount.
Category 1: 2,435 debtors covering 50% of amount:

Negative confirmation is appropriate for this category because conditions for sending negative confirmation are being
met i.e.
1. Population consists of large number of small balances.
2. Risk of material misstatement is low.
In the absence of information it is assumed that following conditions are also met:
4. Auditor is not aware of any circumstances that confirming party will disregard such requests.
Category 2: 15 debtors covering remaining 50% of amount:

Positive confirmation is appropriate for this category because population consists of small number of large balances.
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APPENDIX 3: COURSE OF ACTION IF THERE IS A DIFFERENCE IN REPLY (AND REASON

IS ALSO GIVEN): ✯✯
In exam question, you may be given different replies from confirming party and instead of general statement that “balance
does not agree”, there may be additional specific reason of disagreement of balance.

You have to mention audit procedures depending on to specific reason. Suppose, audit client has receivable of Rs. 5
million from Mr. A as on December 31, 2013. Auditor selects Mr. A to send him positive confirmation request. Below are
different possible situations and auditor’s course of action in each situation.
Reply Auditor’s Response

Auditor should verify date of receipt of cash/cheque.
 If date of receipt is before year end, this will be a misstatement (because this
This amount was paid on year’s receipt is not recorded). This also shows weak internal control over cash
December 28, 2013 receipts.
 If date of receipt is after year end, this shows that account is valid and
exception was because of timing difference (i.e. cash in transit).
Auditor should verify date of shipment.
 If date of shipment is before year end, this shows that account is valid and
We received these goods on exception was because of timing difference (i.e. goods in transit).
January 3, 2014  If date of shipment is after year end, this will be a misstatement (because next
year's sale is recorded this year). This also shows weak internal control over
sales.
Auditor should investigate the matter by discussing it with client and confirming party.
 This is a misstatement (because amount received has not been recorded) in
We have paid this amount financial statements. This also shows weak internal control over cash receipt.
since long.  This also indicates fraud if bank/cash reconciliation has also been prepared
fraudulently. Consequently, auditor shall re-assess risk of misstatement
including risk of fraud.
 This is a misstatement (because returned goods have not been recorded). This
We have returned these also shows weak internal control over sales return.
goods since long.  This also indicates fraud if inventory reconciliation has also been prepared
fraudulently. Consequently, auditor shall re-assess risk of misstatement
including risk of fraud.
 This is a misstatement (because sales have been recorded without order and
We never ordered/received
delivery). This also shows weak internal control over sales.
these goods.
 This also indicates fraud, if intentional. Consequently auditor shall re-assess
risk of misstatement including risk of fraud.
We are unable to confirm this This should be treated same as non-response. Auditor should perform alternative audit
amount (for certain reasons) procedures to obtain evidence.
Auditor should discuss with management and check whether address is correct.
Confirmation returned  If address is wrong, auditor should send confirmation again.
undelivered  If address is correct, this may be because of non-existent/fake customer.
Consequently auditor shall re-assess risk of misstatement including risk of fraud.
 Auditor shall request confirming party to confirm balance in writing because oral
When a response is oral (e.g. response does not meet definition of Confirmation Letter.
through telephone)  If written response is not received, this is same as non-response and auditor shall
perform alternative audit procedures (discussed above)
When a response is received Auditor shall request confirming party to confirm balance directly because indirect
indirectly (via management) response does not meet definition of Confirmation Letter.
When a response is received Auditor shall obtain evidence whether communication process is secured and controlled
electronically (e.g. through (e.g. by use of encryption, digital signature, web-trust authenticity).
email or fax)
262
Auditing – Case Studies Chapter 15 Analytical Procedures
CHAPTER FIFTEEN (CASE STUDIES)

ANALYTICAL PROCEDURES
APPENDIX 1: USE OF ANALYTICAL PROCEDURES AS RISK ASSESSMENT PROCEDURES:
✯✯
In exam, you may be required to assess risks through analysis of financial statements of an entity. Concept of using
analytical procedures to identify risks has been discussed in detailed in appendix 2 of chapter # 10 (you can refer that
section to revise the concept).
APPENDIX 2: USE OF ANALYTICAL PROCEDURES AS SUBSTANTIVE PROCEDURES: ✯

You may be given some financial and non-financial information about an area of financial statements and may be required
to calculated expected figure of that area on the basis of plausible relationship between different types of information.

Think logically what items can have an effect on the given area and appropriately calculate amounts of that effect to be
included in expected calculation.
Case Study 1:
You are responsible for planning the audit of payroll as part of the external audit of Geese Ltd (Geese) for the year ended
31 December 2012. You have been provided with the following information:
Year ended 31 December
2012 2011
(draft) (audited)
Employees’ total gross pay (£’000) 2,189 2,175

Average number of employees in year 85 91
Company-wide pay rise (effective 1 January) 2% 3.50%
Amounts deducted from gross pay in respect of payroll taxes (£’000) 548 652
Profit before tax (£’000) 1,088 1,081
Using analytical procedures, identify factors which may indicate a risk of misstatement in the payroll of Geese for the year
ended 31 December 2012. (04 marks)
(Institute of Chartered Accountants in England and Wales, Professional Level – 2013 March)
Solution:
Audited total pay of prior year (A) 2,175
Add: Effect of increase in pay rise (A * 2%) 44
Add: Effect of joiners –
Less: Effect of leavers (6 * 23.9 * 1.02) N-1 (146.27)
Expected Payroll expense for the current year 2,072.23
Recorded Payroll expense for the current year 2,189.00
Difference 116.77
N-1: Employees left are 6 (91 - 85). Average salary of employee is 23.9 = (2,175/91).
As difference between expected and recorded expense (116.77) is greater than materiality level determined using rule of
thumb 54.4 (1,088 * 5%), there is a risk that recorded payroll expenses is materially overstated.
Moreover, rate of deduction of taxes from payroll was 30% (652/2175) last year which is 25% (548/2189) this year
which also increases risk that withholding tax is understated.
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Auditing – Case Studies Chapter 16 Related Parties
CHAPTER SIXTEEN (CASE STUDIES)

RELATED PARTIES
APPENDIX 1: AUDITOR’S COURSE OF ACTION ON SPECIFIC RISKS REGARDING
RELATED PARTIES: ✯✯
You may be given any of following situations in exam, and may be required to discuss appropriate audit procedures in
response to these:
1. If auditor identifies related party relationships or transactions not identified by management
2. If auditor identifies significant transactions outside the normal course of business.
3. If there is a related party with dominant influence
4. If management states that transactions with related party are on arm’s length.

Identify the situation and write the relevant procedures keeping in mind LO # 4 of the chapter 16.
Case Study 1:
While reviewing the audit working papers of Apple Limited (AL), the following matters have come to your attention:
(i) The audit team was able to ascertain that AL has entered into a number of transactions near the year-end with a new
distributor Fruits Limited (FL), which is a related party. On being confronted, the management has informed that since
there were no transactions with FL in the past, its inclusion in the schedule of related party transactions was
inadvertently omitted. (05 marks)
(ii) The details of related party transactions provided by the management includes a payment of Rs. 300 million to Mango
Limited. The job incharge is of the view that this transaction is not in normal course of business of the company.
(04 marks)
Required:
Analyse each of the above situations and briefly describe your course of action.
Solution:
(i) Auditor shall perform following procedures when he identifies a previously unidentified related party
relationship/transaction:
1. Promptly communicate the relevant information to other members of engagement.
2. If AFRF establishes related party requirements:
 Request management to identify all transactions with newly identified related party, and disclose them
accordingly.
 Inquire as to why entity’s process and controls failed to identify or disclose such related party
relationship/transaction.
3. Perform appropriate substantive procedures on newly identified related party, and/or significant related party
transactions.
4. Reconsider risk of completeness of related party information because other unidentified related parties may also
exist.
5. If non-disclosure appears intentional, reconsider risk of fraud and other implications on audit.
(ii) For identified significant related party transactions, outside the normal course of business, auditor shall:
(a) Inspect underlying contracts or agreements and shall evaluate whether:
i. Transaction is entered to engage in fraudulent financial reporting or misappropriation of assets (lack of
business rationale may indicate this).
ii. Terms of the transactions are consistent with management’s explanations.
iii. Transactions have been appropriately accounted for and disclosed in accordance with the AFRF.
(b) Obtain audit evidence that transactions have been appropriately authorized (e.g. by TCWG).
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Auditing – Case Studies Chapter 17 Audit Sampling
CHAPTER SEVENTEEN (CASE STUDIES)

AUDIT SAMPLING
APPENDIX 1: COMMENTING ON SAMPLING APPROACH ADOPTED BY AUDIT TEAM:
✯✯✯
In exam question, you may be given a population (which may be stratified), and also how audit team selected sample from
that population. You will be required to comment on sampling approach adopted by audit team.

In commenting on sampling approach, state what is wrong with the approach, and what should have been correct
approach. If stratification is given, comment on each stratum.
Case Study 1:
You are the audit manager on a client where an annual sale is Rs. 640 million. During the course of annual audit the
following table was developed by an audit team member, to categorize the annual sales:
Rs.
Category A 50 sales transactions to different customers 300 million
Category B 100 transactions to different customers 200 million
Category C 500 transactions to different customers 140 million
Total 640 million
Sohail, a team member, is of the view that if verification of all the transactions in category A is carried out, there is no need
to perform further procedures. However, other team members do not agree and consider that proper sampling should be
carried out from the total population and categorization should be ignored.
Required:
As an audit manager of the job, you are required to:
i. Explain how audit efficiency is improved by using the above table.
ii. List other ways in which the sales population may be categorized and what precaution should be taken while
carrying out such categorization.
iii. Give your opinion on the views expressed by:
 Sohail
 Other audit team members. (11 marks)
Solution:
(i)
Audit efficiency is improved as population has been stratified. Stratification reduces sampling risk, and results in decrease
in sample size to be selected. Therefore, efficiency is increased.
(ii)
Other ways in which population may be categorized:
 Product-wise
 Month-wise
 Customer-wise (e.g. related or unrelated parties)
 By geographically (e.g. local or exports)
 By terms of trade (e.g. cash or credit)
Precaution:
An item should not be included in more than one categories.
265
(iii)
Opinion on views of Sohail:
Views expressed by Sohail are not correct. If items are selected only from Category A, opinion cannot be expressed on
items not tested by auditor. Therefore, auditor should also select sample from categories B and C to express opinion on
entire population.
Opinion on views of other audit team members:

Views expressed by other audit team members are also incorrect. Stratification increases audit efficiency by reducing
sampling risk and reducing sample size.
Case Study 2:
You are the audit manager on Apple Distribution Limited (ADL). While reviewing the audit planning documentation, you
found that the audit team has selected 100 out of a total of 2,550 debtors for balance confirmation. The details are as
follows:
 50 largest debtors constitute approximately 40% of total debtors. Out of these, 10 have been selected.
 90 other debtors were selected through haphazard sampling.
 All debtors below Rs. 5,000 were ignored as immaterial.
 Balances due from government and some of the related parties were ignored as prior years working papers
showed that they never responded to requests for confirmation.
Required:
Comment on the sampling approach adopted by the audit team. (04 marks)
Solution:
50 largest debtors:
All debtors should have been selected to focus audit efforts on major portion of debtors.
90 other debtors
There is no issue in this selection as ISAs allow use of haphazard sampling.
Debtors below Rs. 5,000:

Sample should also have been selected from this stratum because immaterial misstatements may also become material
when aggregated.
Balance due from related parties:

Auditor may decide not to use confirmation from related parties as response rate is not adequate in past. However, they
should not be completely ignored. Auditor should obtain evidence from alternative sources as transactions with related
party have high risk of material misstatement.
Balance due from Government:

Auditor may decide not to use confirmation from Government as response rate is not adequate in past. However, it should
not be completely ignored. Auditor should obtain evidence from alternative sources as opinion on entire population
cannot be expressed without testing balance due from government.
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APPENDIX 2: EFFECT OF CHANGE IN FACTORS ON SAMPLE SIZE FOR TESTS OF

CONTROLS AND TESTS OF DETAILS: ✯✯
In exam question, you may be given different factors affecting sample size for tests of controls or tests of details. You will
be required to identify the effect of change in given factor on sample size.

First identify whether factor is increasing or decreasing, and then write appropriate effect on sample size. Also remember,
the difference between factors affecting tests of controls and tests of details. Examiner may mix them to create confusion,
so be careful.
Case Study 1:
You are the audit manager in a firm of Chartered Accountants. The audit seniors on various jobs have sought your advice
in respect of the following independent situations:
(i) The expected rate of deviation based on the auditor’s understanding of controls has increased to an extent which is
unacceptably high.
(ii) Number of debtors has increased from 4,500 to 5,000 and the amount of debtors as a percentage of total assets has
also increased.
(iii) The expected amount of misstatement has decreased from Rs. 300,000 to Rs. 200,000.
Required:
State with reasons, the effect of each of the above issues on the sample size of:
(i) Tests of controls; and
(ii) substantive procedures. (07 marks)
Solution:
(i) Effect on Sample Size for Tests of Controls:
(i) If expected rate of deviation is unacceptably high (i.e. greater than acceptable rate of deviation), auditor shall not
perform tests of controls.
(ii)Increase in population has negligible effect on sample size for tests of controls.
(iii) It shall not affect sample size for tests of controls because expected amount of misstatements is not a relevant factor
for determining sample size for tests of controls.
(ii) Effect on Sample Size for Tests of Details:

(i) If expected rate of deviation is unacceptably high, it shall not affect sample size for tests of details because expected
rate of deviation is not a relevant factor for determining sample size for tests of details.
(ii) Increase in amount of debtors has negligible effect on sample size for tests of details.
(iii) If expected amount of misstatement has decreased, sample size for tests of details will decrease.
Case Study 2:
Discuss with reasons, the appropriateness or otherwise of the following decisions taken by the audit seniors, on different
assignments.
(a) Sample size of tests of controls was decreased due to increase in the expected rate of deviation. (02 marks)
(b) In view of the increase in the auditor’s desired level of assurance that tolerable misstatement is not exceeded by
actual misstatement in the population, the audit senior increased the sample size of test of details. (02 marks)
(c) Sample size of tests of controls was decreased because the sampling was done after stratification of data.
(02 marks)
(d) Sample size of tests of details was increased due to increase in the tolerable rate of deviation. (02 marks)
(e) As the expected rate of deviation was unacceptably high, the audit senior decided not to perform tests of
controls and carried out tests of details on 100% items. (03 marks)
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Solution:
Decision Appropriate or Reasons
reference not?
If there is increase in expected rate of deviation, sample size for tests of controls
(a) Not appropriate.
should be increased.
(b) Appropriate. If there is increase in desired level of assurance, sample size should be increased.
(c) Not appropriate. Stratification is a relevant factor for tests of details, but NOT for tests of controls.
Tolerable rate of deviation is a relevant factor for tests of controls, but NOT for
(d) Not appropriate.
tests of details.
Decision of not performing tests of control due to unacceptably high expected
(e) Not appropriate. rate of deviation is correct. However, this is not a relevant factor in deciding to
test 100% items.
This question had a varied response as some candidates managed to score their highest marks from this question, whereas
some were not able to answer correctly. Candidates should remember that in such questions, they must state whether they
agree or not with the decisions of the audit team member, before explaining their reasons. Quite a few candidates wrote
details regarding the correct procedure but did not specify whether the audit senior’s actions were approprite or not.
Most candidates managed to answer parts (a) and (b) correctly, stating that the sample size needed to be increased and
displayed understanding of the underlying reasons. In parts (c) and (d) most candidates were unable to produce an
appropriate response. For example, they could not identify that stratification relates to test of details and not test of controls,
whereas tolerable rate of deviation relates to test of controls and not test of details.
In part (e) most students correctly identified that not performing test of controls is appropriate when the expected rate of
deviation is unacceptably high. However, instead of stating that the decision to test 100 % items in test of details cannot be
taken on the basis of expected rate of deviation, candidates went into details about which scenarios support 100% testing.
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Auditing – Case Studies Chapter 18 Reliance on Work of Others
CHAPTER EIGHTEEN (CASE STUDIES)

RELIANCE ON WORK OF OTHERS
APPENDIX 1: EVALUATION OF INTERNAL AUDIT FUNCTION: ✯✯
In exam question, you may be given a brief description about internal audit department of a company, and you will be
required to evaluate the department.

Keep in mind the factors of competence, objectivity and approach of internal auditor and look which factors are being met
or violated in the given case. List the relevant points from case. Don’t write general points which are not discussed in case.

Case Study 1:
You are a member of the audit team engaged in the audit of a listed company. At the planning stage the audit in-charge
paid little attention to the internal auditing activity on the pretext that internal auditor generally lacks independence in
performing its duties.
The department is headed by a professional and experienced individual who is a close friend of the Chief Executive Officer
and the General Manager of the company. He utilizes such relations very effectively and applies surprise physical checks,
unplanned investigations and takes on-the-spot corrective measures on detection of errors or flaws in controls. This
approach has reduced the lengthy paper work that is normally seen in internal auditing departments of other companies.
Required:
(a) Assess the internal audit function of the company and its relevance for the external auditors; (07 marks)
(b) Comment on the present approach of the audit in-charge and how it would affect the overall audit performance.
(03 marks)
Solution:
(a)Evaluation – Strengths
1. Head of Internal audit is professional and experienced (i.e. Competent)
2. His recommendations are given due consideration.
3. His scope of work is wide
Evaluation – Weaknesses
1. Independence of Internal Audit Function is impaired as head is a close friend of Chief Executive Officer and
General Manager. (i.e. Objectivity may be in doubt)
2. Proper Planning and Work Programs are not prepared (i.e. no systematic and disciplined approach)
3. Competence of staff need to be evaluated.
(b)
Auditor incharge’s view is not justified. Although, this is auditor’s judgment whether to use the work of internal auditor or
not, however, if internal audit function of an entity is ignored without evaluation, this may affect efficiency of audit.
Auditor may have to do a lot of work himself which already have been done by internal auditor e.g. system
documentation.
(a) A large number of students answered this question in a general manner i.e. without giving due consideration to the
situation which was presented in the question. Consequently, they simply listed the various factors that are considered by the
auditor while assessing the internal audit function and secured very few marks.
(b) Surprisingly at this level also many students fully agreed with the approach of the audit incharge and declared that since
internal audit function lacks independence it cannot be relied upon altogether. Making such a decision even before making
any assessment of the relevance thereof is not justified. It is generally true that internal audit lacks independence yet some of
its objectives are similar to those of external audit and hence it may be useful.
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Auditing – Case Studies Chapter 19 Fraud Considerations in Audit
CHAPTER NINTEEN (CASE STUDIES)

FRAUD CONSIDERATIONS IN AUDIT
APPENDIX 1: CASE STUDIES ON IDENTIFYING WHICH OF THE SITUATIONS
REPRESENTS RISK OF FRAUD: ✯✯✯
You may be given a long situation or different short situations in exam, and you will be required to identify factors which
increase risk of fraud.

Keep in mind list of ‘fraud risk factors’ and ‘circumstances indicating existence of fraud’, and search presence of any such
item in the case.
Case Study 1:
Standard Commercial Bank (SCB) is an audit client of your firm. Given below are some factors which you came to know
during risk assessment procedures. For each of the factor mentioned below Indicate whether it increases, or decreases
risk of material misstatement, and whether it affects risk of fraud.
1. SCB is a continuing audit client.
2. SCB has remained profitable over many years.
3. SCB's board of directors is controlled by Saqib, the majority stockholder, who also acts as the chief executive officer.
4. Management at the bank's branch offices is compensated based on branch profitability.
5. The internal auditor reports directly to Haris, a minority shareholder, who also acts as chairman of the board's audit
committee.
6. During 20X1, SCB increased the efficiency of its accounting operations by installing a new, sophisticated computer
system.
7. SCB’s formula has consistently underestimated the allowance for loan losses in current years.
8. Management has been receptive to auditor’s suggestions relating to internal control.
Solution:
1. It decreases audit risk. No effect on risk of fraud.
3. It increases audit risk. It also increases fraud risk factor relating to fraudulent financial reporting.
6. It increasers audit risk. No effect on risk of fraud.
Case Study 2:
During the planning of an audit, auditor has come to know about following situations. Indicate whether each of the
situations given below indicates risk of fraud. If so, also identify type of fraud involved.
1. Management wants to minimize profit to save tax.
2. Company' board of directors include non-executive, independent directors.
3. Significant judgments, estimates and uncertainties are involved in financial statements.
4. Manager accounts has applied for a loan. Application was rejected by CFO.
5. The company has to meet stock exchange listing requirements and debt-covenant requirements regarding financial
statemetns.
6. The company has experienced low turnover in management and its internal audit function.
7. Purchase Manager was found involved in a petty theft. Although amount involved was immaterial, he was issued a
warning.
8. Significant operations of business in different jurisdictions with different environments.
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9. Company deals in imported watches, which have high demand in market.

10. There is high competition and market saturation.
Solution:
1. Risk of fraud is increased. Type of fraud is fraudulent financial reporting.
2. There is no risk involved in this situation.
3. There is risk of material misstatement, but no risk of fraud (as no information of bias is given in question).
4. Risk of fraud is increased. Type of fraud is misappropriation of asset.
6. There is no risk involved in this situation.
Case Study 3:
While reviewing the audit files of four different clients you confronted the following situations:
(i) Due to tough competition in the market, the company has been unable to increase the prices of its products since last 5
years.
(ii) Addition to intangible assets, amounting to Rs. 500 million include research cost of Rs. 10 million which is duly
supported by invoices from suppliers.
(iii) During the last three years, the Chief Executive and higher management has been earning handsome bonuses, based
on the profitability of the company.
(iv) Physical stock take on 31 December 2014 included goods sold but not despatched amounting to Rs. 52 million. The
delivering of goods was stopped on the request of a distributor. Upto 20 January 2015, the distributor has taken delivery
of goods amounting to Rs. 2 million.
Required:
In each of the above situations, identify with justification whether it represents a risk of fraud. (06 marks)
Solution:
(i) This situation represents risk of fraud relating to fraudulent financial reporting, because there is increased competition
in the market and company is unable to increases its price of product since last 5 years. Due to decreasing profitability,
company may face going concerns problems and may attempt to hide it in financial statements.
(ii) This appears to be an error as there is inherent risk in research and development costs for misclassification. Further,
supporting evidence is also available.
(iii) This represents risk of fraud relating to fraudulent financial reporting, because chief executive and higher
management may attempt to overstate profits to earn high bonuses.
(iv) This appears to be a risk of fraud relating to fraudulent financial reporting, because significant sales has been made
on the last days of the accounting year which have not been dispatched within reasonable time.
Case Study 4:
You are the Audit Manager on the audit of Al-Salam Pakistan Limited (ASPL) for the year ended June 30, 2010. ASPL is
engaged in the manufacture of a wide range of plastic products. While reviewing the initial work performed by the audit
team, the following matters have come to your notice:
(i) The quantity of material scrapped during the year is materially different from the quantity of scrap sold. The
company’s records show nil balance both at the beginning and at the close of the year. No reconciliation for the difference
has been provided by the company.
(ii) Sales for the year have increased by 7% over the previous year. However, it has been noted that sales in the last two
weeks of June 2010 have been exceptionally high and represent 15% of the annual sales.
The audit working papers carry the following observations in respect of the above:
 70% of the sales in the last two weeks of June were made to two new customers whose credit assessment has
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not been formally documented;

 a significant portion of the goods sold to the above referred customers were returned in the first week of July
2010; and
 management bonuses are linked to the operating performance of the company.
(iii) During the year, ASPL purchased a machine for Rs. 25 million. The payment voucher is duly supported by the invoice
from the supplier. However, the fixed assets schedule provided by the client shows the amount capitalized as Rs. 2.5
million. Depreciation has been charged on this amount. The difference of Rs. 22.5 million is appearing in the Bank
Reconciliation Statement.
Required:
Analyze each of the above situations and assess whether it represents a fraud or an error. (06 marks)
Solution:
(i) This situation represents risk of fraud relating to misappropriation of assets as scrap inventory of company is missing,
and no reconciliation has been performed which shows deficiencies in internal control over assets.
(ii) This situation represents risk of fraud relating to fraudulent financial reporting on following grounds:
 there have been unusually high sales in the last two weeks of the year.
 there have been week internal controls over financial reporting i.e. credit assessment is not made for new
customers.
 Significant portion of sales has been returned soon after the year.
 Management may intentionally overstate profits to get its bonuses based on profits of the company.
(iii) This appears to be an error of transposition as supporting documents are available (neither missing nor altered).
Although there is a difference in bank reconciliation but it has been duly explained by management.
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APPENDIX 2: CASE STUDIES ON IDENTIFY WHETHER AUDITOR IS LIABLE IN A GIVEN

SITUATION OF FRAUD: ✯
In exam, a situation may be given in which a fraud has occurred even if an audit was conducted. You
will be required to comment whether auditor is responsible in the case or not.

Keep in mind the responsibilities of auditor regarding fraud, and check in the case whether auditor
has met them or not.
Case Study:
You have received a letter from the managing director of one of your audit clients, informing you that he has recently
dismissed his payables ledger clerk. It was discovered that the clerk had set up a number of fictitious supplier accounts as
a means of paying company funds into his own bank account. The total amounts defrauded have been estimated at
£50,000 over the last two years. The managing director is unhappy that the fraud was not detected earlier by your firm,
and has requested an immediate explanation. The company’s revenue last year was £5,000,000 and its profit was
£750,000.
Briefly set out the points to include in your response to the managing director. (02 marks)
Solution:
Primary responsibility to prevent and detect fraud rests with management and those charged with governance. Auditor is
required to obtain reasonable assurance. In this case auditor has not detected this fraud because it may have involve
sophisticated techniques. Further, amounts involved are immaterial (if divided in two years) for which auditor does not
provide reasonable assurance.
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Auditing – Case Studies Chapter 20 Final Matters
CHAPTER TWENTY (CASE STUDIES)

FINAL MATTERS
APPENDIX 1: CASE STUDIES RELATING TO SUBSEQUENT EVENTS: ✯✯✯
In the exam, you will be given one or more events occurring after the balance sheet date, but affecting financial
statements. You will be required:
1. To describe whether financial statements need amendment, or
2. To describe auditor’s course of action if event identified after the signing of audit report

To conclude whether financial statements need amendment, you need to apply your knowledge of accounting (IAS – 10).
To describe auditor’s course of action if event identified after the date of auditor’s report, you need to carefully check the
date of event and see whether financial statements have been issued or not. After that, rest of the question will be
reproduction of procedures mentioned in the chapter under heading “Auditor’s Procedures if a misstatement is identified
after the date of auditor’s report”
List of frequently examined adjusting events in exams:

1. Settlement of a court case after the reporting period.
2. Bankruptcy of a customer that occurs after the reporting period usually confirms that a loss existed at
balance sheet date.
3. Sale of inventories below cost after the reporting period.
List of frequently examined non-adjusting events (requiring disclosures):

1. Announcing or commencing of a major restructuring, discontinuance of operations, business
combination or disposition of subsidiary (after the balance sheet date).
2. Major ordinary share transactions (after the balance sheet date).
3. Significant purchase and disposal of assets, or expropriation of major assets by government
4. destruction of a major production plant by a fire after the reporting period;
5. Entering into significant contingencies or commitments (e.g. significant bank guarantees).
6. Commencement of major litigation arising solely out of events that occurred after the reporting period.
Case Study 1:
The audit field work of STU Limited has been completed and financial statements for the year ended June 30, 2008 have
been initialed for the purpose of identification. Two days before the board meeting, following matters have come to the
knowledge of the audit manager.
(i) In a pending case, a lower court has delivered its judgment according to which the company was found guilty and liable
for damages of Rs. 10 million.
(ii) The company has received a dividend warrant issued by an investee company. The dividend was declared by the
Board of Directors on June 30, 2008. This amount has not been recognized in the financial statements.
(iii) The company has received a notice that one of its major customers has gone into liquidation. The amount due from
the customer at the balance sheet date has been treated as good.
(iv) A long term loan has been classified as current liability as loan conditions have been breached during the period. As
per agreement, breach of conditions makes the liability payable on demand. However, subsequent to balance sheet date,
the lender has agreed not to demand the loan during the next 12 months.
Required:
Evaluate each subsequent event and discuss whether financial statements need to be adjusted or not. (08 marks)
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Solution:
(i)This is an adjusting event because condition existed at balance sheet date. Financial statements should be adjusted and
a provision of Rs. 10 million should be recognized.
(ii)Dividends are recorded in the financial statements when right to receive is established. Here, right to receive (i.e.
dividend warrant) is established after the year end so this is a non-adjusting event.
(iii)The bankruptcy of a customer that occurs after the reporting period usually confirms that a loss existed at balance
sheet date. This is an adjusting event. Debtor should be provided for in financial statements.
(iv)When an entity breaches a provision of long term loan, on or before the end of the reporting period, with the effect
that the liability becomes payable on demand, it classifies the liability as current even if subsequent to balance sheet date,
the lender agrees to recover payment after 12 months of the end of reporting period.
Case Study 2:
You are the auditor of OilRakers, a limited liability company which extracts, refines and sells oil and petroleum related
products.
The audit of OilRakers for the year ended 30 June 2005 had the following events:
Date Event
Bankruptcy of major customer representing 11% of the trade receivables on the balance
15 August 2005
sheet.
21 September 2005 Financial statements approved by directors.
22 September 2005 Audit work completed and auditor’s report signed.
Accidental release of toxic chemicals into the sea from the company’s oil refinery resulting
1 November 2005 in severe damage to the environment. Management had amended and made adequate
disclosure of the event in the financial statements.
23 November 2005 Financial statements issued to members of OilRakers.
A fire at one of the company’s oil wells completely destroys the well. Drilling a new well
30 November 2005
will take ten months with a consequent loss in oil production during this time.
Required:
For each of the following three dates:
– 15 August 2005;
– 1 November 2005; and
– 30 November 2005
(i) State whether the events occurring on those dates are adjusting or non-adjusting according to IAS 10 Events After the
Balance Sheet Date, giving reasons for your decision; (06 marks)
(ii) Explain the auditor’s responsibility and the audit procedures that should be carried out. (09 marks)
Solution:
Event of 15 August 2005:
(i)
This is an adjusting even as bankruptcy of customer after balance sheet date usually confirms that condition existed at
balance sheet date.
(ii)
Event occurred between date of financial statements and date of auditor’s report. It is auditor’s responsibility to perform
procedures to identify such events.
Audit procedures include:

 Confirming amount due from customer through confirmation (if possible) or sales invoices etc.
 Confirming amount recoverable by sending letter to liquidator or other authorized person.
 Verifying that different between amount originally receivable and amount recoverable after bankruptcy is
provided for in accounts.
 Auditor may modify his opinion if appropriate adjustment is not made in financial statements.
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Event of 1 November 2005

(i)
This is a non-adjusting event as no condition of accident existed at balance sheet date. As it is a significant event,
therefore, this should be disclosed in financial statements.
(ii)
Event occurred after the date of auditor’s report; therefore, auditor has no responsibility to perform procedures to
identify such event. However, if such event comes into auditor’s attention, auditor should ensure that financial statements
are amended.
Auditor shall inquire how management intends to address the matter in the financial statements.
1. Auditor shall carry out necessary audit procedures for verification of amendment in financial statements e.g.
obtain information from local press or entity’s lawyer and ensure disclosure in financial statements is
appropriate.
3. Provide a new audit report (on amended financial statements)
4. New audit report should be dated on or after the date of approval of revised financial statements.
Event of 30 November 2005

(i)
This is a non-adjusting event as no condition of accident existed at balance sheet date, and it occurred after issuance of
(ii)
Event occurred after the date of auditor’s report; therefore, auditor has no responsibility to perform procedures to
identify such event.
Auditor is not required to perform any procedures in this case, as there is no requirement to adjust or disclose events in
financial statements which occur after issuance of financial statements. This event will be recorded in next year’s financial
statements.
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APPENDIX 2: CASE STUDIES RELATING TO WRITTEN REPRESENTATION: ✯✯

There may be four types of case studies from written representation:
1. Evidence will not be available, but Management is willing to provide written representation.
2. Management is not willing to provide written representation, but other evidence will be available.
3. Management’s representation is inconsistent with other evidence.
4. You have to decide whether, as per ISAs, representation is appropriate/required in a given case or not.

Remember that Representation and Evidence, are not substitute of each other. Both should be obtained. If any one is
missing, it will be a scope limitation.
If there is inconsistency between representation and other evidence, this creates doubt about reliability of evidence.
While deciding whether representation is appropriate or not:

 first check whether it is required by ISAs (a representation is appropriate, if required by ISAs).
 second, check whether auditor has obtained sufficient appropriate audit evidence (if evidence obtained, there is
no need to obtain representation) .
Case Study 1:
During the verification of ‘repair and maintenance account’, the auditor noted that a repair expenditure of material
amount was not supported by proper documentary evidence. According to the management, it was done in haste to avoid
an abnormal shut down of plant. The management has offered to give specific representation in this regard.
Discuss the appropriateness of management’s representation as audit evidence in this case. (03 marks)
Solution:
Written representation is a form of evidence, however being internal it is a weak evidence. Further, its reliability is also
affected by competence and integrity of management. Therefore, ISAs do not allow to solely rely on representation when
other strong evidence is expected to exist. Therefore, in this situation, it is not appropriate to obtain and rely on written
representation as other documentary evidence of repair (e.g. invoices, approval, acknowledgements etc) is expected to
exist. Auditor should obtain other sufficient appropriate audit evidence.
Case Study 2:
As part of audit procedure you have requested the management of Energy Limited to provide specific representation
relating to completeness of related parties and related party transactions.
The management is of the view that since the auditor has carried out a detailed review in which no undisclosed
transactions were identified, a written representation is not necessary.
Required:
Evaluate the above situation, comment on the management’s stance and suggest the appropriate course of action
available to the auditor. (06 marks)
Solution:
Evaluation and Comment on management’s stance:
Written representation in this case is appropriate, because ISAs require auditor to obtain written representation from
management that about completeness of related parties and related party transactions.
Management’s view is incorrect because obtaining written representation is a required evidence to be obtained from
management. Further, management also agrees (through engagement letter) to provide written representations to
auditor.
Appropriate course of action:

If management refuses to provide written representation to auditor, auditor shall discuss the matter with management
and shall inquire reason for refusal. Auditor shall try to convince management to provide representation.
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If representation is still not provided:

1. Auditor shall:
 Re-evaluate integrity of management and consequently revise risk of material misstatement, including risk
of fraud.
 Take appropriate actions, including considering effect on other audit procedures (including other
representations and evidence provided by management).
 If auditor has serious concerns about integrity of management, consider withdrawing from the audit.
2. Not providing representation is a scope limitation. Auditor may express qualified opinion (if possible effect is
material) or disclaimer of opinion (if possible effect is pervasive).
Case Study 3:
You are the audit partner of XYZ & Company, Chartered Accountants. The following matter is under your consideration:
Asif Limited has made certain investments and has classified them as long term investments. The management has also
provided written representation in this regard. However, before the finalization of financial statements the company
disposed of some of the said investments.
Required:
Analyse the above situation and explain how you would proceed in the above matter. (04 marks)
There is an inconsistency between written representation of client and other evidence. Auditor shall perform further
procedures to investigate and resolve the matter e.g. by discussing the matter with management.
If the matter remains unresolved, the auditor:

 Shall reconsider the assessment of the competence, integrity, ethical values or diligence of management, and
 Shall determine the effect that this may have on the reliability of representations (oral or written) and audit
evidence in general.
Auditor may revise the risk assessment and modify the nature, timing and extent of further audit procedures to respond
to the assessed risks.
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Auditing – Case Studies Chapter 21 Auditor’s Report II
CHAPTER TWENTY ONE

AUDITOR’S REPORT II
APPENDIX 1: CASE STUDIES RELATING TO DRAFTING MODIFICATION IN AUDIT
REPORT: ✯✯
In exam, you may be given a situation causing modification in audit report and you will be required to draft relevant
paragraphs of audit report. Remember that this type of case study is different from case study of chapter # 4 in which you
were required to identify the impact on audit report, but you were NOT required to draft the relevant part of report.

Important thing is to identify correct impact on report. Then, it will be like a question of reproducing the extracts of
report, which you have learnt in LO # 2 of this chapter.
Case Study 1:
You are the senior in-charge on the audit of financial statements of Fine Tractors Limited, for the year ended June 30,
2008. The audit field work has revealed the following issues which are still unresolved:
(a) The company is not charging depreciation on a building which was constructed during the year on freehold land
belonging to the company, at a cost of Rs. 128 million. The management is of the view that land and building are
part of the same class of assets and no depreciation is required to be charged thereon because the value of such
assets is expected to increase considerably in future.
(b) A customer of the company has filed a suit claiming damages of Rs. 4.6 million, on account of company’s failure to
meet a deadline for supply of certain goods. The company has filed a counter claim of Rs. 5.5 million, against the
same customer on account of the customer’s failure to fulfil certain conditions regarding payment of advance. No
provision has been made in the books of the company as the company’s lawyers are not very sure about the
outcome of the lawsuit.
You have discussed these matters with your manager who believes that the amounts involved are material.
Required:
Draft qualification paragraph(s) that may have to be included in the Audit Report. You may assume necessary details.
(10 marks)
Suggested Solution:
(a)
This is a case of material misstatement, hence qualified opinion will be given with following qualification paragraphs:
Basis for Qualified Opinion

As more fully explained in note x to the financial statements, the company’s fixed assets include building which was
constructed during the year at a cost of Rs. 128 million. Management has not charged any depreciation on this building,
which constitutes a departure from International Financial Reporting Standards. The company’s records indicate that had
management recorded the depreciation on this building, an amount of Rs. xxx would have been required to charge to
depreciation. Accordingly, operating expenses would have been increased by Rs. xxx, and income tax, net income and
shareholders’ equity would have been reduced by Rs. xxx, xxx and xxx, respectively.
Qualified Opinion
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial
statements give a true and fair view of the financial position of ABC Company as at December 31, 20X1, and of its financial
performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards.
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(b)
No provision is required in this situation as the amounts likely to be settled are not probable and measureable. However,
a disclosure is required to be made in financial statements (as material uncertainty exists at balance sheet date) and if, in
auditor’s opinion, this fact is fundamental to user’s understanding, an Emphasis of Matter paragraph may be given in
auditor’s report as follows.
Emphasis of Matter
We draw attention to Note X to the financial statements which describes the uncertainty related to the outcome of the
lawsuit filed against the company by XYZ claiming damages of Rs. 4.6 million. The company has filed a counter claim of Rs.
5.5 million, against the same customer. Our opinion is not qualified in respect of this matter.
This question examined the ability of the candidates to draft appropriate qualification paragraphs for inclusion in the
auditors’ report based on the given issues. It was noticeable that many candidates either did not attempt this question or
simply stated irrelevant matters while many others produced the entire auditor’s report and wasted precious time. There
were very few replies that could be considered complete and relevant. Most of the answers suffered from one or more of the
following discrepancies.
• Whereas the first situation justified a qualified opinion due to disagreement with the management, the second situation
should have been dealt with by including an emphasis of the matter paragraph. In many cases, a qualification paragraph was
drafted in the second situation also.
• A reference to the concerned note was missing in either case. Since the question had given clear directions that the
candidates may assume necessary detail, it would have been appropriate to refer to the notes contained in the financial
statements in respect of both the issues. For example the modification paragraph relating to depreciation could have
commenced with the words “As more fully explained in Note ABC of the financial statements”.
• While referring to the first situation, most of the replies were restricted to stating that depreciation has been short
provided. References to the facts that accounting policy being followed was not in accordance with the IFRSs was missing
whereas the impact on fixed assets, loss for the year and accumulated loss was not mentioned either.
• In the emphasis of the matter paragraph, only the suit filed by the customer amounting to Rs. 4.6 million was mentioned but
quite often the reference to the counter claim filed by the Company was missing.
APPENDIX 2: CASE STUDIES RELATING TO GOING CONCERN: ✯✯

In exam, you may be given a situation of a client and you will be required to identify events and conditions which cast
doubt on entity’s ability to continue as a going concern.

Keep in mind the list of events/conditions casting doubt on going concern (learnt in the chapter) and look for relevant
points in the case.
Case Study 1:
planning the external audit of Steady Eddy Ltd (Steady Eddy) whose principal activity is the provision of road haulage
services. You have been provided with the following information in respect of the year ended 31 May 2007.
The company made a loss for the year to 31 May 2007. This is mainly due to the loss of a major customer to a competitor
and exceptional costs incurred in relocating to new premises. In previous years the company has been profitable but has
recently experienced reduced margins due to the high cost of fuel.
Despite its poor trading results, the company has managed to stay within its overdraft limit of £500,000. This was
achieved by the managing director temporarily lending the company £200,000 and delaying payments to creditors. The
overdraft facility is to be reviewed by the bank in September 2007 after the audited financial statements are available.
The company has a loan installment falling due in October 2007 which it plans to repay with the proceeds from the
recently vacated premises which are currently for sale.
The company has fallen behind with its payments to HM Revenue & Customs, but the directors have successfully
negotiated a scheme for settling the arrears over a period of four months. A condition of this concession granted by HM
Revenue & Customs is that the company pays all its future monthly tax liabilities on the due dates.
280
Requirements
Explain the circumstances particular to Steady Eddy which may indicate that it is not a going concern. (08 marks)
Suggested Solution:
Loss of major customer causing loss for the year:
Future revenue stream has been lost. This will have adverse impact on company’s ability to generate cash in future.
Increased competition:
Company is losing its revenue to competitors. A tough competition may further cause company to lose its customers and
revenue.
Reducing profit margins due to high cost of fuels:

Company’s profitability will further reduce in future.
Delaying payments to creditors:

Creditors may withdraw credit facilities and may change terms of transactions (e.g. from credit to cash).
Overdraft facility is subject to review in September 2007:

Bank may not approve overdraft facility for next term, and company may not have sufficient cash to pay it.
Loan installment falling due in October:
Lender may file petition to court to wind-up company.
Default in payment to HM Revenue & Customs:

HM Revenue & Customs may file petition to court to wind-up company if obligations not met as agreed.
(a)Almost all candidates were able to explain what is meant by the going concern concept. Although the majority of
candidates appreciated that the auditor had to consider the going concern because of the potential impact on the financial
statements, many failed to develop the point and did not describe what the impact would be i.e. the classification of items and
the amounts at which they would be stated. Furthermore, many failed to consider the disclosure implications for the financial
statements and the implications for the audit report.
(b)This part of the question was generally well answered with a number of candidates attaining maximum marks.
Candidates tended to be better at identifying the circumstances but not so good at explanations.
281
Auditing – Case Studies Chapter 22 Review Engagement
CHAPTER TWENTY TWO(CASE STUDIES)

REVIEW ENGAGEMENT
APPENDIX 1: CASE STUDY RELATING TO IDENTIFYING ERRORS IN REVIEW REPORT:
✯✯
An audit report with numerous errors will be given in question; and you will be required to identify
errors from given auditor’s report.

1. Learn the key terms used in the REVIEW report; also keep in mind circumstances when an
emphasis of matter paragraph other matter paragraph is included.
2. Use element-wise format to comment on report.
3. If something is omitted, state the words/phrase/name of para which is omitted.
4. If something is wrong, write error alongwith explanation (i.e. correct treatment).
5. DO NOT redraft report; otherwise you will get zero marks.
Case Study:
Sigma & Company, Chartered Accountants has carried out a review of the financial statements of Bilal Limited, a listed
company, for the half year ended June 30, 2009. The job in charge has drafted the following review report:
Independent Practitioner’s Review Report
We have reviewed the accompanying financial statements of Bilal Limited (“the company”), which comprise the statement
of financial position as at as at June 30, 2009 and 2008, and the statement of comprehensive income, statement of cash
flows for the year then ended, and a summary of significant accounting policies and other explanatory information in
accordance with International Standards on Auditing.
Management is responsible for the preparation and fair presentation of these financial statements in accordance with the
International Financial Reporting Standard for Small and Medium-sized Entities.
Scope of Review
A review of financial statements in accordance with international standard is a limited assurance engagement. The
practitioner performs procedures, primarily consisting of making inquiries of management and others within the entity,
as appropriate, and applying analytical procedures, and evaluates the evidence obtained. The procedures performed in a
review are substantially less than those performed in an audit conducted in accordance with International Standards on
Auditing.
Conclusion
Based on our review, nothing has come to our attention that causes us to believe that these financial statements do not
present fairly, in material respects, (or do not give a true and fair view of) the financial position of ABC Company as at
December 31, 20X1, and (of) its financial performance and cash flows for the year then ended. Because of the inherent
limitations of our review engagement, this report is intended for the information of management and should not be used
for any other purposes.
Emphasis of matter
Without qualifying our conclusion, we draw attention to note X to the financial statements. Management has informed us
that inventory has been stated at cost which is in excess of its net realizable value. Management’s computation, which we
have reviewed, shows that inventory, if valued at the lower of cost and net realizable value as required by International
Financial Reporting Standards, would have been lower by Rs. 20,000,000/-, and the reported net income and
282
Auditing – Case Studies Chapter 22 Review Engagement
shareholders’ equity would have decreased by Rs. 18,900,000/-.
Sigma & Company

Chartered Accountants
Required:
Highlight the deficiencies, if any, in the draft review report. (14 marks)
(ICAP, CAF 09 Level – Autumn 2009, amended)
Suggested Solution:
Content Error/Omission
Addressee  Appropriate Addressee is not mentioned
 Conclusion is only on current period’s interim financial information, hence, reference
to the last year’s period should not be mentioned in Introduction.
 In Introductory Paragraph, “Statement of changes in equity” is not mentioned in as
Introductory
component of financial statements.
Paragraph
 Review of financial statements is conducted in accordance with International
Standards on Review Engagement (ISRE) and NOT in accordance with International
Standards on Auditing.
Practitioner’s  Practitioner’s responsibility is omitted from the report.
Responsibility
Scope of Review  Phrase “we do not express an audit opinion” is omitted from scope paragraph
Paragraph
 Conclusion paragraph does not state words ““in accordance with the International
Financial Reporting Standard for Small and Medium-sized Entities”.
 Conclusion paragraph does not contain word “material” i.e. phrase “in all respects”
Conclusion
should be replaced by “in all material respects” .
Paragraph
 Restriction on use should not be mentioned in conclusion paragraph.
 Auditor should qualify its review report on the basis of misstatement in financial
statements. Emphasis of Matter paragraph is not a substitute of Qualified Conclusion.
Date  Date is not mentioned in review report.
Address  Address of auditor is not mentioned in review report.
283

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AUDITING

Study Notes and Case Studies

By: Muhammad Asif, ACA

3rd (updated and revised)

AUDITING, 3/e (updated and revised)

Why this Book:

What is NEW in the 3rd Edition:

This book is not an individual’s effort. I am thankful to all of my students, colleagues,

I am also thankful to my students Umer Shafiq, Muhammad Jahanzeb Hashim and

For any comments/ suggestions/additional support, you can contact me through:

Address: RISE School of Accountancy

06 Aurangzaib Block, New Garden Town, Lahore

Cell # : 0331-4585358 (sms only)

e-mail address: asif@riseschool.edu.pk

facebook page: https://web.facebook.com/groups/CAF09

And the most important thing to remember is “Key to Success is PRAYER”.

ICAP’s Study Text (2017) ICAP’s Study Text

ICAP’s Study Text (2017)

ICAP’s Study Text (2017) ICAP’s Study Text (2017)

LO 4 of Chapter 3, Intro of 1.1 Not covered

Note for Students

Chapter 12: Related party transactions

ICAP’s Study Text

Chapter 13: Reliance on others

PHASE I: BASICS OF AUDITING

PHASE II: PRELIMINARY ENGAGEMENT ACTIVITIES

PHASE III: PLANNING OF AUDIT

PHASE IV PERFORMANCE OF AUDIT

PHASE V: REPORTING AND POST-REPORTING ISSUES

PHASE VI: REVIEW AND RELATED SERVICES

Coverage from ICAP’s Question Bank (2017 Edition)

Q. # 2 (Levels of assurance) Q. # 147a (ISRE 2400)

LO 1: ORIGIN, ADVANTAGES AND DISADVANTAGES OF ASSURANCE SERVICES: ✯

Advantages of Assurance Services:

For Third Parties:

Disadvantages of Assurance Services:

CONCEPT REVIEW QUESTION

LO 2: DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT: ✯✯

Elements of Assurance Engagement:

Element Explanation (with respect to assurance on financial statements)

It is a page written in standard format which includes conclusion of

CONCEPT REVIEW QUESTION

LO 3: TYPES OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE PROVIDED:

Types /Levels of Assurance:

Reasonable Assurance (also called High Level or Positive Assurance)

This is usually given in an audit of financial statements.

Limited Assurance (also called Moderate Level or Negative Assurance)

This is usually given in a review of financial statements.

Why absolute assurance cannot be provided to an assurance client:

CONCEPT REVIEW QUESTION

PART A – FINANCIAL STATEMENTS

Coverage from ICAP’s Question Bank (2017 Edition)

4 (Core concepts) 96e (Auditors)

PART A – FINANCIAL STATEMENTS

LO 1: WHAT IS INCLUDED IN COMPLETE SET OF FINANCIAL STATEMENTS: ✯

CONCEPT REVIEW QUESTION

PART B – FINANCIAL REPORTING FRAMEWORK

LO 2: FINANCIAL REPORTING FRAMEWORK AND ITS TYPES: ✯

An example is Tax-basis Framework.

Fair Presentation Framework:

An example is International Financial Reporting Standards.

Study Tip: Applicable Financial Reporting Framework/AFRF

CONCEPT REVIEW QUESTION

LO 3: WHAT IS MEANT BY TRUE AND FAIR VIEW: ✯