Audit processes to gather evidence on the assertions in account balances are called
Show Chapter learning objectives When you have completed this chapter you will be able to:
1 General principles We dealt with the principles of audit evidence in an earlier chapter. This chapter deals with the application of those principles. It is a starting point to help you familiarise yourself with the basic auditing techniques to allow you to apply them to questions. It is not an exhaustive summary of all audit tests, this would simply not be possible in one volume. 2 Financial statements assertions The objective of audit testing is to assist the auditor in coming to a conclusion as to whether the financial statements are free from material misstatement. However, the auditor does not simply design tests with the broad objective to identify material misstatement. This is a difficult conclusion to reach and can only be based upon a series of detailed tests, each designed with a specific testing objective relating to certain areas of the financial statements. For example: auditors have to assess whether inventory balances are free from material misstatement. Unfortunately, there are many ways inventory could be misstated:
Each of these concerns could result in misstatement, which ultimately could (alone or in aggregate) be material. For this reason auditors have to perform a range of tests on the significant classes of transaction, account balances and disclosures to be reasonably sure that they are not misstated. These tests focus on what are known as financial statements assertions: Occurrence – did the transactions and events recorded actual occur and pertain to the entity? Completeness – have all transactions, assets, liabilities and equity interests been recorded that should have been recorded? Accuracy – have amounts, data and other information been recorded and disclosed appropriately? Cut-off – have transactions and events been recorded in the correct accounting period? Classification and understandability – have transactions and events been: recorded in the proper accounts; and described and disclosed clearly? Existence – do assets, liabilities and equity interests exist? Rights and obligations – does the entity hold or control the rights to assets and are liabilities the obligations of the entity? Valuation and allocation – are assets, liabilities and equity interests included in the financial statements at appropriate values? Linking assertions to testsWhen the auditor designs further audit procedures they must ensure that they test a range of the assertions listed. For transactions (i.e. incomes and expenses recorded in the income statement) the auditor should test:
For accounts balances (i.e. those balances recorded on the statement of financial position) the auditor should test:
Whilst the testing of accounts balances and transactions will probably be the focus of the audit, the auditor must also design tests to ensure that transactions, balances and other relevant information/matters are appropriately disclosed in the financial statements. Assertions relevant to the disclosures are:
To assist your studies and simplify this process consider the following four questions that an auditor needs to answer when approaching testing: (1)Should items be in the accounts at all? (occurrence, existence, rights and obligations, cut-off). (2)Are they included at the right value? (accuracy, valuation). (3)Are there any more? (completeness). (4)Are they disclosed properly? (classification, allocation, understandability). A further warningIn the sections that follow, we will consider specific audit areas and suggest how these are usually tested. You may be tempted to learn these tests and repeat them 'parrot fashion' in the exam. This would be unwise. Audit procedures are designed to reflect the unique risks of an audit and the nature of items and assertions under scrutiny. You must always try and make your answers specific to any scenarios presented in the exam. This requires both knowledge and application skills. 3 The audit of receivables Key assertions
Audit procedures Existence
Rights and obligations
Valuation and allocation
Completeness
Classification and understandability
Receivables circularisations If successful, circularisations provide evidence directly from the receivables themselves. These are considered to be reliable because they are external, third party confirmations. Circularisations are also written and original. Procedure
Considerations Whilst circularisations are undoubtedly a useful and efficient tool for providing good quality evidence, their success does depend on response rates. It must be remembered that the audit client's customers are under no obligation to reply and, for this reason, responses may be limited. If the response rate is poor then other forms of evidence must be sought. To maximise the response rate auditors should ensure:
Customer Ltd Customer’s address Date of circularisation Dear Sirs As part of their normal audit procedures we have been requested by our auditors, Auditor & Co, to ask you to confirm the balance on your account with us at 31 December 2009, our year-end. The balance on your account, as shown by our records, is shown below. After comparing this with your records will you please be kind enough to sign the confirmation and return a copy to the auditor in the prepaid envelope enclosed. If the balance is not in agreement with your records, will you please note the items making up the difference in the space provided. Please note that this request is made for audit purposes only and has no further significance. Your kind co-operation in this matter will be greatly appreciated. Yours faithfully Auditor & Co Auditor’s address Dear Sirs We confirm that, except as noted below×, a balance of $10,000 was owing by us to Client Limited at 31 December 2009. (space for customer's signature) ×Details of differences: 4 The audit of inventories Key assertions
The inventory count Principles
Inventory counting procedures Before the count
During the count
Continuous inventory systems The procedures suggested above apply to all inventory counts, whether as a one-off, year-end exercise or where inventory is counted on a rolling basis throughout the year. The objective is the same:
Where the client uses a continuous counting system lines of inventory are counted periodically (say monthly) throughout the year so that by the end of the year all lines have been reviewed. There are both advantages and disadvantages of this for the auditor. Advantages
Disadvantages
Inventory held at third parties
Final audit procedures Completeness
Cut-off
Presentation and disclosure
Valuation
5 The audit of payables, accruals, provisions and contingent liabilities Key assertions
Completeness is usually the key consideration when testing payables due to the timing and nature of the items included. Provisions and accruals accounting do offer an opportunity for creative accounting to manipulate reported profits. Auditors therefore have to consider indicators that additional liabilities may exist, such as:
Classification and understandability
Existence
Completeness
Cut-off
Companies may send out monthly statements of account as part of their credit control procedures. Therefore it is likely that audit clients will receive a number of these statements from suppliers at the year-end. These can be reconciled to their own payables control account to ensure that their records are correct. This is known as a supplier statement reconciliation and is an important source of audit evidence. Like most statements sent through the post there are a number of reasons why there may be variances: (1)Timing differences:
(2)Errors
Auditors can inspect or reperform the supplier statement reconciliations to ensure the completeness, existence and valuation of payable balances. They are a reliable source of evidence because they are produced by the suppliers, who are (usually) independent, external sources (but note suppliers may be related parties/intergroup companies, and therefore not independent). Accruals
Tax balances
Overdrafts, loans, etc.
Leases, hire purchase
Loan payables
Provisions and contingencies Provisions are a form of payable where the amount or timing of payment is uncertain. As such they are harder to audit. Where the likelihood of payment is only possible, rather than probable, no amounts will be entered in the accounts. However, the matter (contingent liability) must be adequately disclosed.
6 The audit of bank and cash Key assertions
The bank letter
Whites & Harper Inc. Manager (Audit Confirmations) 1 January 20X1 Dear Sir, Re: Blakes Co. In accordance with the agreed practice for provision of information to auditors, please forward information on our mutual client as detailed below on behalf of the bank, its branches and subsidiaries. This request and your response will not create any contractual or other duty with us. Company name: Blakes Co. Main account number: 01789311 Sort code: 4-83-12 Information required
Audit confirmation date: 31/12/X0 The Authority to Disclose Information signed by your customer is already held by you. This is dated 30/08/X0. Please advise us if this Authority is insufficient for you to provide full disclosure of the information requested. The contact name is: James Hodges (Audit Partner) Yours Faithfully, Whites & Harper Inc. Bank and cash – other evidence
Bank reconciliation as at 31 December 20X0
Presentation and disclosure
7 The audit of tangible non-current assets Key assertions
Existence
Completeness
Valuation
Rights and obligations
Disclosure
8 The audit of share capital, reserves and directors' remuneration Directors' remuneration is a key audit area as it is invariably material by nature.Key assertions
Share capital
Directors' remuneration
Reserves
9 Accounting estimates Accounting estimates are of particular concern to the auditor as, by their nature, there may not be any physical evidence to support them and they are prone to inaccuracy. They are also subjective and therefore prone to management bias. If the directors wished to manipulate the accounts in any way, accounting estimates are an easy way for them to do this. The auditor must take care when auditing estimates to ensure this has not been the case. In accordance with ISA 540 Auditing Accounting Estimates auditors need to obtain an understanding of:
ISA 540 also requires the auditor to:
In response to this assessment auditors should perform the following further procedures:
Smaller commercial entities will usually have the above attributes. This can lead to both advantages and disadvantages:
Evidence implications
Problems
Not for profit (NFP) organisations include charities and public sector entities. The most important differences from privately owned companies are that NFP entities:
Potential problems auditing a NFP entity Some NFP entities, particularly small charities, may have weaker systems due to:
Significantly, with many charities, much of the income received is by way of donation. These transactions will not be accompanied by invoices, orders or despatch notes. Assessing the going concern of a NFP entity may also be more difficult, particularly for charities who are reliant on voluntary donations. Many issues, such as the state of the economy, could impact on their ability to generate revenue in the short term. Audit implications Auditors of not for profit organisations will be required to assess whether the aims of the organisation are being met in an economic, efficient and effective manner. For this reason "value for money" audits are much more appropriate. These are discussed in more detail in the internal audit chapter. Testing tends to concentrate on substantive procedures where control systems are lacking. In the absence of documentary evidence procedures rely heavily on analytical review, enquiry and management representation. The volumes of transactions in not for profit organisations may be lower than a private one, therefore auditors may be able to test a larger % of transactions. Ultimately, if sufficient appropriate evidence is not available the auditor will have to modify their audit report. Test your understanding 1List and explain FOUR assertions from ISA 315 Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and its Environment that relate to the recording of classes of transactions.
List FOUR assertions relevant to the audit of tangible non-current assets and state one audit procedure which provides appropriate evidence for each assertion.
(a)Define 'tests of control' and explain why they are an important procedure in the statutory audit of any company. (4 marks) You are an audit senior working at a medium sized firm of auditors. One of your clients is an exclusive hotel called ‘Numero Uno’ situated in the centre of Big City. As part of your audit procedures you are assessing the controls surrounding payroll. You have read last year’s audit file and have obtained the following information: The hotel employs both full and part time staff. Due to the nature of the business most of the work is done in shifts. All staff are paid on a monthly basis. New members of staff are given an electronic photo identification card on the day they join by the personnel department. This card is used to ‘clock in’ and ‘clock out’ at the start and end of the shift to record the hours worked. At the end of each week the information recorded on the system is sent automatically to the payroll department and also to the head of each of the three main operating divisions: Rooms, Food & Beverage and Corporate Events. Each division head must reply back to the payroll department by email to authorise the hours worked by their staff. The payroll clerk collates all the authorised information and then inputs the hours worked into a standardised computerised payroll package. This system is password protected using an alphanumerical password that only the payroll clerk and the finance manager know. Once the hours have been inputted, the calculations of gross pay and taxation are calculated automatically along with any other statutory deductions. At the end of the calculations a payroll report is produced and printed. The finance manager reviews the report and compares the data to last month to identify and follow up any unusual variances. When he is satisfied with the information he authorises the payroll run by signing the payroll report and the payroll clerk submits the data. Payslips are sent to the home address of each employee and payment is made by bank transfer. ‘Numero Uno’ prides itself on delivering a first class dining experience and is renowned for its standards of service and cooking that few restaurants in the country come close to. Its inventory therefore consists of the very best foods and beverages from across the globe. Food products held in inventory are mostly fresh as the head chef will only work with the very best ingredients. ‘Food’ inventory is stored in the kitchens and managed by the head chef himself. The majority of beverages held at the hotel are expensive wines that have been sourced from exclusive vineyards. The hotel also stocks a wide range of spirits and mixers. All beverages are stored either in the hotel cellar or behind the bar. The cellar can only be accessed by the duty manager who holds the key. As part of your audit procedures you will attend the year end inventory count of the hotel’s beverages. Required: (b)With reference to the scenario: (i)Identify and explain FOUR STRENGTHS within the hotel’s internal control system in respect of payroll. (6 marks) (ii) For each of the identified strengths, state a test of control the auditor could perform to assess if the controls are operating effectively. (4 marks) (c)Describe the audit procedures an auditor would conduct before and whilst attending the inventory count of the beverages in the hotel. (8 marks) (d)Identify and explain THREE financial statement assertions that are most relevant to inventory. (3 marks) (e)Apart from attending the inventory count, describe the substantive procedures an auditor would carry out to confirm the valuation of the wine and spirits held in inventory at the year end. (5 marks) (Total: 30 marks) Test your understanding 4(a)Describe the steps an auditor should take when conducting a trade receivables confirmation (circularisation) test. (4 marks) (b)Explain why a direct confirmation test may not provide sufficient appropriate audit evidence on its own. (3 marks) You are the audit manager in charge of the audit of Builders Mate, a limited liability company. The company’s year end is 31 March, and Builders Mate has been an audit client for three years. Builders Mate sells small tools, plant and equipment exclusively to the building trade. They have 12 warehouse style shops located throughout the country. Builders Mate does not manufacture any products themselves. The audit fieldwork is due to commence in 3 weeks time and you are preparing the audit work programme for the trade receivables section of the audit. Extracts from the clients trial balance show the following information. From your review of last year’s audit file you have determined that last year there were 2 specific provisions of $5k and $2k as well as a 3% general provision. Initial conversations with the client indicate that there are no specific provisions that are to be made this year however they intend to reduce the general provision from 3% to 2%. You are aware that two of Builders Mate’s major customers went into administration during the year and they are likely to be liquidated in the near future. Both of these customers owed material amounts at the year-end. Required: (c)Describe substantive procedures the auditor should perform on the year-end trade receivables of Builders Mate. (9 marks) (d)Describe how audit software could facilitate the audit of trade receivables. (Total: 20 marks) 10 Chapter summary Test your understanding answers Test your understanding 1Assertions: classes of transactions
Tangible non-current assets: assertions
Note: Only four assertions were required. Test your understanding 3(a)Tests of control A test of control tests the operating effectiveness of controls in preventing, detecting or correcting material misstatements. It is important for the external auditor to test controls to ensure their initial understanding obtained when assessing the control environment and internal controls is appropriate. This will allow the auditor to identify and assess the risks of material misstatements in the financial statements and to determine to what extent to rely on the internal control system during the audit. The auditor will then be able to design sufficient and appropriate substantive audit procedures to reduce detection risk, and therefore audit risk, to an acceptable level. (b)Payroll system strengths and tests of control Strengths in the control environment at the hotel in respect of payroll are set out below including the test of control to be performed by the auditor. (c)Procedures before the count
During the count
(d)Inventory assertions (e)Substantive procedures Quantity
The beverages should be valued at the lower of cost and net realisable value.
(a)Trade receivables circularisation Several steps should be performed by an auditor when performing a trade receivables circularisation audit test:
(b)Sufficiency of the evidence from a direct confirmation test. Several factors influence the sufficiency of evidence gathered during a direct confirmation of trade receivables and other evidence may be required by an auditor to form an opinion in this area:
(c)Substantive procedures for trade receivables.
(d)Audit software Audit software can be used to improve the effectiveness and efficiency of the audit process of trade receivables.
What procedure is used to audit assertions?Physical Inspection. Physical examinations are useful procedures for auditing assertions because they provide highly reliable audit evidence regarding the existence of assets. Inspections go beyond merely scrutinizing the supporting documents.
What are the account balance assertions?Account balance assertions
Existence – means that assets and liabilities really do exist and there has been no overstatement – for example, by the inclusion of fictitious receivables or inventory. This assertion is very closely related to the occurrence assertion for transactions.
What are the audit assertions for balance sheet?There are five assertions, including accuracy and valuation, existence, completeness, rights and obligations, and presentation and disclosure.
What are the 4 types of audit evidence?Audit evidence is collected through audit procedures.. Physical examination. ... . Confirmations. ... . Documentary evidence. ... . Analytical procedures. ... . Oral evidence. ... . Accounting system. ... . Re-performance.. |