Chapter 1

Chapter 1

AUDIT amp ASSURANCE

INTRODUCTION -AN OVERVIEW OF AUDITING

bull Economic decisions in every society must be based upon the information available at the time the decision is made For example the decision of a bank to make a loan to a business is based upon previous financial relationships with that business the financial condition of the company as reflected by its financial statements and other factors

bull As a means of overcoming the problem of unreliable information the decision-maker must develop a method of assuring him that the information is sufficiently reliable for these decisions In doing this he must weigh the cost of obtaining more reliable information against the expected benefits

bull A common way to obtain such reliable information is to have some type of verification (audit) performed by independent persons The audited information is then used in the decision making process on the assumption that it is reasonably complete accurate and unbiased

What is an Auditbull Audit is an independent examination of financial statements of an entity that

enables an auditor to express an opinion whether the financial statements are prepared (in all material respects) in accordance with an identified and acceptable financial reporting framework (eg international or local accounting standards and national legislations)

bull Auditing is such an examination of books of accounts and vouchers of business as will enable the auditors to satisfy himself that the balance sheet is properly drawn up so as to give a true and fair view of the state of affairs of the business and that the profit and loss account gives true and fair view of the profitloss for the financial period according to the best of information and explanation given to him and as shown by the books and if not in what respect he is not satisfied

bull This view of audit is presented by ISA 200 Objective and General Principles Governing an Audit of Financial Statements

bull The phrases used ldquoto express the auditorrsquos opinionrdquo means that the financial statements give a true and fair view or have been presented fairly in all material respects

bull True and fair presentation means that the financial statement are prepared and presented in accordance with the requirements of the applicable International Financial Reporting Standards (IFRS) and local pronouncementslegislations

2

bull What we can understand as the essential features of an audit from the above definition and explanation are as underbull An auditor involves in examination of financial statements the auditor is not responsible for the Preparation of the financial statementsbull The end result of an audit is an opinion to assist the user of the financial statements Auditing therefore relies heavily on professional judgment not merely on the factsbull The auditorrsquos opinion makes reference to ldquotrue and fairrdquo or ldquofair presentationsrdquo but ldquotrue and fairrdquo is again a matter of judgment It is not precisely defined for the auditorbull In order to make the user of the auditorrsquos report able to feel confident in relying on such report the auditor should be independent of the entity Independent essentially means that the auditor has no significant personal interest in the entity This allows an objective professional view to be taken

FEATURES OF AUDITINGbull a Audit is a systematic and scientific examination of the books of accounts of a

businessbull b Audit is undertaken by an independent person or body of persons who are

duly qualified for the jobbull c Audit is a verification of the results shown by the profit and loss account and

the state of affairs as shown by the balance sheetbull d Audit is a critical review of the system of accounting and internal controlbull e Audit is done with the help of vouchers documents information and

explanations received from the authoritiesbull f The auditor has to satisfy himself with the authenticity of the financial

statements and report that they exhibit a true and fair view of the state of affairs of the concern

bull G The auditor has to inspect compare check review scrutinize the vouchers supporting the transactions and examine correspondence minute books of share holders directors Memorandum of Association and Articles of association etc in order to establish correctness of the books of accounts

OBJECTIVES OF AUDITINGbull There are two main objectives of auditing The primary objective and the

secondary or incidental objectivea) Primary objective ndashthe primary duty (objective) of the auditor is to report to the

owners whether the balance sheet gives a true and fair view of the Companyrsquos state of affairs and the profit and loss Ac gives a correct figure of profit of loss for the financial year

b) Secondary objective ndash it is also called the incidental objective as it is incidental to the satisfaction of the main objective The incidental objective of auditing arebull i Detection and prevention of Frauds andbull ii Detection and prevention of Errors

bull Fraud refers to intentional misrepresentation of financial information with the intention to deceive Frauds can take place in the form of manipulation of accounts misappropriation of cash and misappropriation of goods It is of great importance for the auditor to detect any frauds and prevent their recurrence

bull Errors refer to unintentional mistake in the financial information arising on account of ignorance of accounting principles ie principle errors or error arising out of negligence of accounting staff ie Clerical errors

2

bull Benefit of opinionbull It improves credibility of financial statements

bullAssurance statement made to give confidence It can also be evidence

2bullAll Assurance Engagements require-

bull Userbull Subject matterbull Practitioner (provides professional services with competence objectivity independence and to

expected standards)for example the AUDITOR The practitioner is responsible for determining the timing the nature and extend of procedures and is required to pursue anything that leads the practitioner to question whether a material modification should be made to the subject matter information

bull Responsible party (the person supplying goods services) the person responsible for the information and assertions

bull Intended user are the person(s) for whom the practitioner prepares the assurance report The responsible party can be one of the intended user

bull Subject matter information (agents details FS)bull Criteria (your expectation against which youll decide your purchase is worthwhile) are benchmarks

used to evaluate or measure subject matter Criteria need to be available to the intended users to allow them to understand how subject matter has been evaluated or measured

Engagement process involves-bull Agree terms of engagement (engagement letter)bull Decide methodology for evidence gathering evaluation measurement to support a conclusion bull Type of report(unqualified report or qualified report)

What are the different stages of auditbull Auditing is essentially a practical task The auditor always needs to reflect the nature of the

circumstances of the entity under audit It is unlikely that any two audit assignments will ever identical It is however possible to identify a number of standard stages in a typical external audit These are as follows

bull - Audit appointmentbull - Engagement letterbull - Initial planning

1048707 Knowledge of the business1048707 Risk Assessment1048707 Internal control review (procedures)1048707 Control procedures (authoritiesapprovalssegregation of duties)

bull - Preparation of the audit planbull - Accounting system reviewbull - Analytical review techniques (Compliance procedures-Application of control test procedures) like

purchasing are according to the controls establishedbull - Considering the ways in which audit evidence can be soughtbull - Substantive testing (transaction level procedures)bull - Reasonable assurancebull - Review of the financial statements (compliance with the standardsmaterial misstatement etc) bull - Preparation and signing of report

Managementrsquos Responsibility for the Financial Statements

bull Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards This responsibility includes designing implementing and maintaining internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement whether due to fraud or error selecting and applying appropriate accounting policies and making accounting estimates that are reasonable in the circumstances

Auditorrsquos Responsibility

bull Our responsibility is to express an opinion on these financial statements based on our audit We conducted our audit in accordance with International Standards on Auditing Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance whether the financial statements are free from material misstatement

Responsibility for the Financial Statements

bull Responsibilities for preparing and presenting the financial statements are that of management

bull Auditorrsquos responsibility is to express an opinion thereon

Positive Assurance

bull Companies prepare annual Financial Statementsbull Shareholders need to be assured that they are accuratebull A team of auditors (qualified accountants) from outside the

company will come in to check whether the FS are ldquotrue and fairrdquo - a term meaning that the FS have no ldquomaterialrdquo (important) errors

bull The criteria that the auditors will use to check the FS are the accounting standards

bull An audit report will be written to the shareholders stating whether in the auditorslsquo opinion the FS do or do not present a true and fair view (ie positive assurance)

Internal audit

bull Companies have many internal systems ndash risk management internal controls accounting systems

bull The Directors need to be assured that the systems are workingbull A team of auditors who may be from inside or outside the

company will check whether these systems are working properly

bull The criteria that the auditors will use are likely to be their own experience of what makes a good system combined with legal requirements and corporate governance

bull An audit report will be written to the Directors stating whether the systems are working and making recommendations for future improvement

The importance of independence in assurance

bull Assurance reports are written for the benefit of the people reading them The readers need to be able to trust that the reports are reliable and correct If they sense any links between the auditors and the things being audited they may not trust the opinions given

bull If there are any links between the auditors and the things being audited the report loses credibility and the assurance is undermined

bull It is therefore a requirement if the auditors are independent of those they are auditing

THE EXTERNAL AUDIT TIMELINEbull Interim audit The detailed audit planning and assessment of internal

controls are often carried out on an interim audit which can be done without waiting for the accounting year to end On very large audits more than one interim audit visit may be necessary

bull Year end At the client year end a number of audit procedures are likely to occur= Attend clients year end stock-take= Perform a debtor circularization= Perform a creditor circularization= Request Bank Letter

bull Final audit The Draft (unaudited) Financial Statements are now available The main focus is substantive testing ndash results of control tests determine how much substantive testing is required

Reasonable assurance true and fair view materiality

bull REASONABLE ASSURANCEbull What is reasonable assurance A conclusion that the financial statements are not materially

misstated An auditor cannot obtain absolute assurance because of limitations described in Para below

bull How reasonable assurance is achieved It is achieved by obtaining audit evidencebull Factors affecting reasonable assurance

i) Inherent limitation of an audit ie failure of audit procedures to detect material misstatements in financial statements because of

a) The use of testing (application of procedures on samples)b) The inherent limitations of accounting and internal control systemc) Persuasive nature of audit evidence rather than conclusive (Persuasive one leading to

an opinion one which causes to believe Conclusive final convincing)ii) Exercise of judgment by the auditor in gathering of evidence and drawing of conclusioniii) Existence of other limitations like related parties etc

bull Auditors cannot test every single transaction and even if they did it is usually impossible to know for sure that things have been correctly recorded As a result auditors carry out their work until they are reasonably assured (not 100 certain) that the Financial Statements are true and fair (no clear errors and presented with no bias) Since not all transactions have been tested the auditors can only be assured that the Financial Statements are free from material errors or misstatements

bull In other words there are no mistakes that anyone reading the Financial Statements would want to know about

2

bull Reasonable Assurance(positive assurance)-bull Gathers sufficient appropriate evidence bull Concludes subject matter conforms in all material

respects with identified suitable criteria (information given is reliable)

bull His opinion- positive assurance bull Reasonable Assurance(negative assurance)-bull Gathers sufficient appropriate evidence to be satisfied

that subject matter is plausible in the circumstancesbull Gives his report- negative assurance

Assurance report opinion is not an absolute opinion why

1 Because of lack of precision often associated with subject matter (FS subject to estimation and judgment)2 Nature timing and extent of procedures3 Evidence is persuasive rather than conclusive4 Evidence is gathered on test basis

Reporting the outcome of assurance engagement

bull Practitioner gt reports gt user bull Two types of reports a) positive assurance b) negative assurance

bull Audit of Cos (annual statutory FS these are collectively called General Purpose FS by IASB) are the most common assurance engagement

bull Reports are directed to different STAKEHOLDERS who have different reporting needs these are Mgt + those in charge of governance how effective the Cos systems are as a mechanism for producing FS showing fair amp true view and safeguarding of COs assets

bull Lenders (Banks Financial Institutions) often on a limited assurance basis require reports on financial viability of a Co Management employment and environmental practices to satisfy demands of employees+ local community groups

Review Engagement(limited assurance)

bull The objectives of a review engagement is to enable to practitioner to state whether on the basis of procedures which dont provide all the evidence that would be required in an audit anything that has come to the practitioner attention that causes the practitioner to believe that the financial statements are not prepared in all material respects in accordance with an applicable financial reporting framework

bull Characteristics of review engagementbull A review engagement has all the attributes of assurance engagement1 The practitioner who conducts the work2 The user who commissioned (means specially-made)the work3 A responsible party4 The subject matter5 The subject matter information6 Criteria7 Sufficient appropriate evidence which needs to be documented8 A report

Knowing the audit profession and other services

bull Auditing firms do not describe themselves as auditors They describe themselves as Chartered Accountants Auditing firms are composed of accountants who perform audits for their clients They also perform other services The small chartered accountant firms especially may spend more time on other services than on auditing

bull The other services may includea Writing up books of accounts (Book keeping)b Balancing books of accounts (Extracting trial balance)c Preparing final accountsd Tax managemente Statutory form fillingf Financial consultancyg Management and system consultancyh Liquidation and receivership worki Investigations (Fraud audit)

We have two issues on reporting area-bull There is a legal requirement for accounts to be produced by Mgt on a regular basis

to account to shareholders for their STEWARDSHIP of the businessbull The recognition of the need for these accounts to be checked in some way by

someone INDEPENDENT of the managers (the AUDITOR) bull STEWARDSHIP-the responsibility to take good care of resources and STEWARD

person entrusted with mgt of another persons property he is accountable for the way he carries out his role

bull FIDUCIARY RELATIONSHIP the relationship where one person has a duty of care towards someone else it is a relationship of good faith between shareholders and directors of CO Separation of ownership (shareholders) and control (directors) Therefore directors must take decisions in the interests of the shareholders rather than their own selfish personal interests

bull ACCOUNTABILITY people in positions of power can be held to account for their

actions therefore compelled to explain their decisions criticized punished if they have abused their position accountable for using Cos assets efficiently and effectively

2bull AGENCY RELATIONSHIP 1 Occur when one party (principal) employs another party (agent) to perform a task on their

behalf2 It is a relationship between various stakeholders in a Co are described in term of agency

theoryDirectors are agent for shareholder

Employees directorsAuditors shareholders

3 Cos mgt account for their stewardship of Co at regular intervals by producing FS4 What if FS contains errors or even worse are fraudulent There was a need for independent

audit 5 A need for 100 verification of FS and that they are correct there is a problem

1 Too expensive due to amount of work2 May prove to duly disruptive of Cos operations

Therefore auditors are established as forming an independent opinion about-3 Truth and fairness of FS4 FS comply with legal and regulatory requirements

3 And this is a typical assurance engagement (and NOT an absolute assurance) that 1 gives confidence to SH that FS are true amp fair view

2 Reduce risk of misstatement

3

bull EXTERNAL AUDITbull It is a requirement by Law in most developed countries that its objective is to

enable auditors to express an opinion on whether FS bull presented fairly in all material respects (true amp fair view)bull prepared in accordance with an applicable financial reporting framework (which

vary from country to another)bull bull bull GENERAL PRINCIPLESbull 1 Compliance with applicable ethical principles (IFAC code of ethics for

professional accountants) and ethical pronouncements of auditors professional body (eg ACCA rules of professional conduct)

bull 2 Compliance with applicable auditing standards (IAASB ISA)bull 3 Planning and performing the audit with the attitude of professional skepticism

recognizes that FS may be materially misstated

APPOINTMENT OF EXTERNAL AUDITORS

bull In most countries the auditors are reporting to the shareholders so are appointed by the shareholders

bull The Board of Directors will propose a Firm and this will then be voted on by the shareholders

bull Usually they are appointed on an annual basis at the AGMbull If auditors are needed mid-year (eg because the previous

Firm resigned) then it is often possible for the Board of Directors to appoint a Firm up till the next AGM

bull In most large companies there will be a specialist Board Committee that will recommend a Firm to the main Board ndash this committee is called the Audit Committee

WHO IS ALLOWED TO BE AN EXTERNAL AUDITOR

bull To be allowed to do external audits someone must go through an approval process This helps to ensure quality The process includes= Must pass an approved set of professional examinations set by a Recognised Qualifying Body (RQB) Examples of RQBs include the ACCA and ICAEW= Must become a member (and stay a member) of a Recognised Supervisory Body (RSB) The ACCA and ICAEW are also examples of RSBs

bull To be allowed to do the external audit of a particular company there are additional rules= the auditor must not be a Director or Employee of the company or of any associated companies= the auditor must not be an Employee or Business Partner of a Director or Employee of the company or of any associated companies

bull Beyond these rules governments typically leave further detailed guidance to the RSB to decide