Auditng notes

Makerere University MBA Auditing
College of Business Studies
CHAPTER ONE THE NATURE, PURPOSE AND SCOPE OF AUDITING
After completion of this lecture, you should be able to:
 Describe the nature and function of auditing.
 Identify the place of auditing within the profession of accounting.
 Distinguish between different types of audits.
 Describe the professional standards required of auditors.
 Describe the statutory requirements for the audit of the financial statements of
companies.
What Is Auditing?
"a systematic process of objectively obtaining and evaluating evidence regarding assertions
about economic actions and events to ascertain the degree of correspondence between
those assertions and established criteria and communicating the results to interested users
The most common application of auditing is a financial report audit, although other types of
audit are explained.
The Place of Auditing in the Accounting Profession
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Auditors are members of the accounting profession, which in most countries is organised
into professional bodies. It is usual that official registration as an auditor is only available to
members of professional accounting bodies.
It is also useful to compare the accounting and auditing process. Whereas accounting
creates new information, which is usually presented in the form of financial reports, auditing
evaluates these financial reports and provides the results of the evaluation in the form of an
audit report.
Key Terms
1. Accountability: Is the quality or state of being accountable that is being required
or expected to justify actions and decisions. It suggests an obligation or willingness to
accept responsibility for one’s actions.
2. Stewardship: Is the practice of being a steward, i.e. being employed to manage
another’s property;
3. Agents: Agents are people employed or used to provide a particular service. In
case of a company, the people being used to provide the service, managing the
business also have the second role of being people in their own right trying to
maximise their personal wealth.
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The auditor can give assurance to the owner that their agents have accounted properly for
their actions, so that owners can assess how well management have discharged their
stewardship.
DIFFERENT TYPES OF AUDITS
Six different types of audits are;
1. Financial report audit is the most common type of audit and will be discussed in
detail throughout the study.
2. Compliance audit involves obtaining and evaluating evidence to determine
whether certain financial or operating activities of an entity conform to specified
conditions, rules or regulation. It is most relevant to the public sector.
3. Performance audit involves obtaining and evaluating evidence about the economy
and effectiveness of an entity's operating activities in relation to specified objectives.
It is closely related to internal auditing.
4. Comprehensive audit is more common in the public sector and includes financial,
compliance and performance audits. It usually occurs when an auditor undertakes a
range of audit and audit-related services.
5. Environmental audit covers environmental matters, which may have an impact on
the financial statements. The activities of a business may impact on reported assets
and profits due to their effects on the environment and environmental regulations.
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6. Internal audit refers to any of the activities listed above, but conducted by auditors
employed by the organisation. Internal audit is a management tool used by the
organisation to enhance internal control
In order to give an objective opinion, auditors must be independent from both owners and
managers.
The nature of an audit
Key term – Audit objective
The objective of an audit of financial statements is to enable the auditor to express an
opinion whether the financial statements are prepared in all material respects in accordance
with an identified financial reporting framework.
The phrases used to express the auditor’s opinion are to give a “True and Fair” view or
present fairly in all material respects, which are equivalent terms.
To express an opinion
The purpose of an audit is to enable auditors to give an opinion on the financial statements.
While an audit might produce by-products such as advise to the directors on how to run the
business, the point of an audit is to report solely to shareholders.
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Truth and Fairness (Not defined in law or audit)
True: Information is factual and conforms to reality, not false. In addition, the information
conforms to required standards and law. The accounts have been correctly extracted from
the books and records.
Fair: Information is free from discrimination and bias and is compliant with expected
standards and rules. The accounts should reflect the commercial substance of the
company’s underlying transactions.
Legal Opinion: On the status of true and fair in relation to accounting standards
An International Accounting Standard (IAS) is a declaration by the IASC on behalf of its
constituent professional bodies that save in exceptional circumstances, accounts that do not
give a true and fair view.
The rest of the opinion is relevant:
 Accounts will not be true and fair unless the information they contain is sufficient to
quantity and quality to satisfy reasonable expectations of readers to whom they are
addressed.
 The expectation of readers will have been influenced by normal practices of
accountants
 International Accounting Standards serve the following purposes.
- They crystallise professional opinion about what may be expected in accounts
that are true and fair
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- Because accounts are obliged to comply with IASs, readers will thus expect
the accounts to conform to IASs
 IASs therefore have an indirect but important effect on truth and fairness. The courts
will treat compliance with accepted accounting principles as prima-facie evidence
that accounts are true and fair. Equally, the deviation from accounting principles will
be prima-facie evidence that they are not. Truth and fairness is a dynamic (constantly
changing) subject.
GUIDANCE ON AUDITING
Auditing Standards
The auditing standards contain:
. the basic principles and essential procedures with which the auditor is required to
comply in the planning, conduct and reporting of an audit; and
. explanatory and other material to assist the auditor in interpreting and applying the
basic principles and essential procedures.
Professional accounting bodies throughout the world generally publish guidelines for the
practice of auditing by their members. These guidelines are known as statements of auditing
standards and are often backed by statements of auditing practice covering the procedures
to be used in carrying out audits.
It is useful to classify auditing standards under the following headings:
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General Standards - these relate to the qualifications and personal qualities required of
auditors in carrying out their work.
Performance Standards - cover the conduct of the audit and outline the responsibilities
placed upon auditors in their work.
Reporting Standards - relate to the provision of an audit opinion and are often related to
legal requirements for audit e.g., in relation to companies.
IFAC – International Standards on Auditing
ISA 200 Objectives and general principles governing an audit of financial
statements
The auditors should comply with the code of ethics for professional accountants issued by
the International Federation of Accountants – ISA 200.4
The auditor should conduct an audit in accordance with International Standards on Auditing
(ISAs)
The Audit Report: An Introduction
We will discuss audit reports in more detail in another chapter. As an introduction to the
types of reports, which may be given, the following provides a guide:
- An unqualified report: this is the most common type of report issued. It is usually in
prescribed language and consists of a scope and opinion sections.
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- A modified audit report: is issued when the auditor expresses a qualified opinion, or
adds explanatory language to draw attention to or emphasise a matter that is relevant to
users.
A qualified opinion is issued when:
1. there is a disagreement with management;
2. there is a conflict between financial reporting frameworks; or
3. there is a limitation on the scope of the audit.
Three types of qualified opinions may result:
1. an "except for" opinion;
2. an adverse opinion; or
3. an inability to form an opinion.
Further, an emphasis of matter paragraph may be added to an unqualified audit report in
circumstances such as when additional disclosures contrary to accounting standards are
made; or there are inherent uncertainties (including those in relation to going concern) which
are adequately disclosed; or there is inconsistent other information; or subsequent events
have occurred
Auditors’ general approach to audit work
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The auditor should plan and perform the audit with an attitude of professional scepticism
recognising; the auditor would not simply accept what managers say during an audit of the
entity but would look for supporting evidence.
The procedures required to conduct an audit in accordance with ISAs should be determined
by the auditor having regard to the requirements of ISAs, relevant professional bodies,
legislation, regulation and where appropriate, the terms of the audit engagement and
reporting requirements.
There are provisions. The auditors’ opinion is not:
 A guarantee of the future viability of the entity
 An assurance of management’s effectiveness and efficiency.
Responsibility of directors
While the auditor is responsible for forming and expressing an opinion on financial
statements, the responsibility for preparing and presenting the financial statements is that of
the management of the entity. The auditor of financial statements does not relieve
management of its responsibilities
Scope of External Audit
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Statutory and Non Statutory Audits
Statutory Audit
This is required under national standards or laws/statutes. It applies for limited liability
companies.
Non-statutory Audit
Performed by independent auditors because the owners, proprietors, trustees, professional
and governing bodies or interested parties want them rather than because law requires
them.
The auditor must take into account the regulation contained in the internal rules or
constitution of the undertaking.
Advantages of audits
 Verification of accounts
 Recommendations of accounting and control systems
 Possible detection of errors and fraud
 Provide a means of setting accounts between partners
 Audited accounts make the accounts more acceptable to taxation authorities.
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 The sale of the business or the reorganisation of a loan or overdraft facilities may be
facilitated if the firm is able to produce audited accounts.
The expectations gap
This is the difference between what auditors do and what people in general think that they
do. It is misconception in relation to the role of the auditor. For example
-Auditors report to the directors of the company and not to the members.
-A favourable audit report is more favourable than an unqualified audit report and the
reverse is true
-Perception that it is the auditor’s duty to detect fraud when in fact directors should be the
detectors of fraud.
The auditor and fraud
External auditor does not have a statutory duty to prevent and detect fraud. The risk of fraud
is the material misstatement of financial statements.
Reviews:
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The objective of a review engagement is to enable an auditor to state whether on the basis
of procedures which do not provide all the evidence that would be required in an audit,
anything has come to his/her attention that causes the auditor to believe that the financial
statements are not prepared in all material respects in accordance with an identified financial
reporting framework.
The level of assurance recipients’ get from a review is not as high as that from an audit. The
procedures carried out in a review engagement are similar to an audit.
Assurance – Auditors’ satisfaction as to the reliability on assertions made by one party for
use by another party (i.e. by management for use by the readers of the accounts). Auditors
assess evidence collected as a result of procedures conducted and then express a
conclusion.
Audit and other engagements.
Audit engagement – Auditor provides a high but not absolute level of assurance that
information audited is free from material misstatements. (Reasonable assurance)
Review engagement – Auditor provides moderate level of assurance that information
subject to review is free from material misstatements (Negative assurance)
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Agreed-upon procedures – The auditor simply provides a report of the actual findings so
no assurance is expressed. Users of the report must instead judge for themselves the
auditors’ procedures and findings and draw their own conclusions from the auditors’ work.
Compilation engagement – Users of compiled information gain some benefit from the
accountants (as opposed to auditors’) involvement, but no assurance is expressed in the
report.
Negative assurance – When the auditor gives an assurance that nothing has come to his
attention, which indicates that financial statements have not been prepared according to the
framework. In other wards, he gives his assurance in the absence of any evidence to the
contrary.
Limitations of an audit.
Auditors use judgement in deciding what audit procedures to use and what conclusions to
draw.
Limitations of every audit
1. Auditing is not a purely objective exercise. Auditors have to make judgement in areas
such as risk assessment, what constitutes a significant error, what tests to perform and
what opinion to give
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2. Auditors do not check every item in the accounting records i.e. they check a sample of
items.
3. Limitations of accounting and internal control systems; these may not be able to deal
with unusual transactions and may not be flexible to deal with changing circumstances.
4. Client management or staff may not tell the truth or may collude in fraud – segregation of
duties fails.
5. Audit evidence indicates what is probable rather than what is certain. Some figures are
estimates; others require significant degree of judgement.
6. Auditors are reporting some months after the balance sheet date. There is a change in
the financial position/situation of client from balance sheet date to date. However, if
auditors report soon after balance sheet date, evidence about certain figures in the
balance sheet may be insufficient.
7. Limitations of an audit report – The standard format of the audit report is not likely to
reflect all aspects of the audit. Therefore, auditors can not certify that the accounts are
correct, they can only express an opinion
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The concept of materiality
Auditors are not responsible to establish whether the accounts are correct because:
 It takes a great deal of time and trouble to check the correctness of even a very small
transaction and the resulting benefit may not justify the effort.
 Financial accounting involves a degree of estimation, which means that financial
statements can never be precise.
Definition:
Materiality is an expression of relevant significance or importance of a particular matter in
the context of financial statements as a whole. A matter is material if its omission or
misstatement would reasonably influence the decisions of an addressee of the auditor’s
report.
Materiality may also be considered in the context of any individual primary statement within
the financial statement or of individual items included in them.
Materiality is not capable of general mathematical definition as it has both qualitative and
quantitative aspects.
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Duties of auditors of limited companies
They must satisfy themselves that:
 Proper accounting records have been kept
 The accounts are in agreement with the accounting records
 Accounts have been prepared in accordance with the companies Act, and relevant
accounting standards
 The balance sheet shows a true and fair view if the company’s affairs and the profit and
loss account show a true and fair view of the results for the period.
Auditors’ work for any client
 Making such tests and inquiries, as they consider necessary to form an opinion as to
reliability of the accounting records as basis for the preparation of accounts.
 Checking the accounts against the underlying records.
 Reviewing the accounts for compliance with the Company’s Act and accounting
standards.
Stages of an audit
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The systems audit- Refer to appendix
Stage 1 to 3 Self explanatory
Stage 4 Confirm that the system recorded is the same as that in operation. This is
achieved by performing walkthrough tests. These involve tracing a handful of transactions
through the system and observing the operation of controls over them
Auditors need to determine what is actually done, than believe what staff say should be
done.
Assess the system and internal controls
Stage 5. Evaluate the systems to gauge their reliability and formulate a basis for testing
their effectiveness in practice.
Test the system and internal controls
Stage 6. If controls from stage 5 are effective, tests should be designed to establish
compliance with the system should be selected and performed.
Tests of controls should be carried out. If controls are strong, the records should be reliable
and the amount of detailed testing can be reduced. If controls are ineffective, in practice,
more extensive substantive procedures should be required.
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Stage 7. After evaluating the systems and testing controls, auditors should send an interim
report to management identifying weaknesses and recommending improvements.
Testing the financial statements
Stage 8 & 9. These tests are concerned with substantiating the figures given in the final
financial statements.
Before designing a substantive procedure, it is essential to consider whether any errors
produced could be significant. If errors are not significant, there is no point in performing a
test.
Stage 10. Review the financial statements to determine overall reliability of the account by
making a critical analysis of content and presentation.
Stage 11. Express an opinion
Stage 12. Management Letter – purpose is to make further suggestion for
improvements in the systems and to place on record specific points in connection
with the audit and the accounts
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CHAPTER TWO PROFESSIONAL ETHICS AND INDEPENDENCE
A profession is distinguished by certain characteristics including:
• Mastery of a particular intellectual skill, acquired by training and education;1
• Adherence by its members to a common code of values and conduct established
by its administrating body, including maintaining an outlook which is essentially
objective; and
• Acceptance of a duty to society as a whole (usually in return for restrictions in use
of a title or in the granting of a qualification).
Members’ duty to their profession and to society may at times seem to conflict with
their immediate self-interest or their duty of loyalty to their employer.
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Against this background, ACCA laid down ethical requirements for its members to
ensure the highest quality of performance and to maintain public confidence in the
profession.
The Public Interest
A distinguishing mark of a profession is acceptance of its responsibility to the public.
The accountancy profession’s public consists of clients, credit grantors,
governments, employers, employees, investors, the business and financial
community, and others who rely on the objectivity * and integrity of professional
accountants to maintain the orderly functioning of commerce.
This reliance imposes a public interest responsibility on the accountancy profession.
The public interest is defined as the collective well-being of the community of people
and institutions the professional accountant serves.
A professional accountant’s responsibility is not exclusively to satisfy the needs of an
individual client or employer. The standards of the accountancy profession are
heavily determined by the public interest, for example:
• Independent auditors help to maintain the integrity and efficiency of the financial
statements presented to financial institutions in partial support for loans and to
stockholders for obtaining capital;
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• Financial executives serve in various financial management capacities in
organisations and contribute to the efficient and effective use of the organisation’s
resources;
• Internal auditors provide assurance about a sound internal control system, which
enhances the reliability of the external financial information of the employer;
• Tax experts help to establish confidence and efficiency in, and the fair application
of, the tax system; and
• Management consultants have a responsibility toward the public interest in
advocating sound management decision-making.
Professional accountants have an important role in society. Investors, creditors,
employers and other sectors of the business community, as well as the government
and the public at large rely on professional accountants for sound financial
accounting and reporting, effective financial management and competent advice on
a variety of business and taxation matters. The attitude and behaviour of
professional accountants in providing such services have an impact on the economic
well-being of their community and country.
Professional accountants can remain in this advantageous position only by
continuing to provide the public with these unique services at a level which
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demonstrates that the public confidence is firmly founded. It is in the best interest of
the world-wide accountancy profession to make known to users of the services
provided by professional accountants that they are executed at the highest level of
performance and in accordance with ethical requirements that strive to ensure such
performance.
Objectives
The Code recognises that the objectives of the accountancy profession are to work
to the highest standards of professionalism, to attain the highest levels of
performance and generally to meet the public interest requirement. These objectives
require four basic needs to be met:
• Credibility
In the whole of society there is a need for credibility in information and information
systems.
• Professionalism
There is a need for individuals who can be clearly identified by clients, employers
and other interested parties as professional persons in the accountancy field.
• Quality of Services
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There is a need for assurance that all services obtained from a professional
accountant are carried out to the highest standards of performance.
• Confidence
Users of the services of professional accountants should be able to feel confident
that there exists a framework of professional ethics which governs the provision of
those services.
Fundamental Principles
In order to achieve the objectives of the accountancy profession, professional
accountants have to observe a number of prerequisites or fundamental principles.
The fundamental principles are:
• Integrity
A professional accountant should be straightforward and honest in performing
professional services. *
• Objectivity
A professional accountant should be fair and should not allow prejudice or bias,
conflict of interest or influence of others to override objectivity.
• Professional Competence and Due Care
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A professional accountant should perform professional services with due care,
competence and diligence and has a continuing duty to maintain professional
knowledge and skill at a level required to ensure that a client or employer receives
the advantage of competent professional service based on up-to-date developments
in practice, legislation and techniques.
• Confidentiality
A professional accountant should respect the confidentiality of information acquired
during the course of performing professional services and should not use or disclose
any such information without proper and specific authority or unless there is a legal
or professional right or duty to disclose.
• Professional Behaviour
A professional accountant should act in a manner consistent with the good
reputation of the profession and refrain from any conduct which might bring discredit
to the profession. The obligation to refrain from any conduct which might bring
discredit to the profession requires the consideration, the responsibilities of a
professional accountant to clients, third parties, other members of the accountancy
profession, staff, employers, and the general public.
• Technical Standards
A professional accountant should carry out professional services in accordance with
the relevant technical and professional standards.
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Professional accountants have a duty to carry out with care and skill, the instructions
of the client or employer insofar as they are compatible with the requirements of
integrity, objectivity and, in the case of professional accountants in public
practice, * independence. In addition, they should conform with the technical and
professional standards promulgated by:
- IFAC (e.g., International Standards on Auditing);
- International Accounting Standards Board;
- The ACCA; and
- Relevant legislation.
RULES OF CONDUCT
INDEPENDENCE
A member in public practice shall be independent in the performance of professional
services as required by standards promulgated by ACCA.
Interpretations:
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Does investment in a client violate independence?
 Direct investment does regardless of the size of the investment.
 Indirect investment does if investment is material.
Does involvement in management activities violate independence?
 May advise but not make decisions on the client’s behalf.
 Honorary directorships are allowable.
Do the actions of former members of the member firm violate independence?
 Generally, no as long as they are no longer active with the member firm.
 Buy-out payments generally do not affect independence.
Can a member firm provide other services and still be independent with respect to an audit?
 If client is not publicly traded, a member may prepare and audit F/S as long as the
member never appears to be an employee of the client.
 If client is publicly-traded, a member may NOT prepare and audit F/S.
If the audit client is a financial institution, can the member have loans with the client?
 All existing loans do not violate independence if the loan was obtained under normal
lending procedures.
 Newly-created loans (after the MEMBER-client relationship formed) are limited to small
personal loans. Must be obtained under normal lending procedures and may require
collateralization.
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Does legal action between the client and the MEMBER violate the member’s
independence?
 If the lawsuit alleges audit deficiencies or management improprieties, independence is
violated.
 If MEMBER and client are co-defendants in lawsuits, independence is not violated
unless cross-claims alleging audit deficiencies or management improprieties exist.
 Lawsuits between the MEMBER and the client for other causes generally do not violate
independence unless communications between the parties are hindered.
Can the actions of family members impair independence?
 Independence is impaired if a spouse, dependent, or nondependent close relative is
involved in audit sensitive activities.
 Audit sensitive = any activity that is an element of or subject to significant internal
controls.
 Violation requires BOTH a relationship and audit sensitivity.
INTEGRITY AND OBJECTIVITY
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In the performance of any professional service, a member shall maintain objectivity and
integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or
subordinate his or her judgement to others.
Interpretations:
0* Making, permitting, or directing another to make false and misleading entries violates
integrity.
1* A conflict of interest occurs if one's objectivity is impaired. Disclosure of a potential
conflict of interest will eliminate the impairment.
2* Conflict of interest: A situation in which you have a strong desire for an outcome that is
not in the best interest of someone with whom you have a fiduciary duty.
GENERAL STANDARDS
A member will undertake only those services which can be competently completed. The
member will adequately plan and supervise the services and will exercise due professional
care throughout. Sufficient data will be collected to provide a basis for any conclusions
drawn or recommendations made.
Interpretations:
3* Does not assume infallibility of knowledge or judgment.
4* Deficiencies in knowledge can be covered by engaging an expert.
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COMPLIANCE WITH STANDARDS.
A member who performs auditing, review, compilation, consulting services, tax, or other
professional services shall comply with standards promulgated by ACCA.
ACCOUNTING PRINCIPLES
If the financial statements contain a material departure from IAS, the MEMBER will not
express an opinion (using positive or negative assurance) that the financial statements are
in conformity with IAS unless the MEMBER can demonstrate that the use of IAS would
result in misleading financial statements due to unusual circumstances.
Interpretations:
5* Proper accounting treatment is that which will render the financial statements not
misleading. Generally, IAS, but not necessarily so.
6* IASB has been designated as the body to establish accounting principles.
CONFIDENTIAL CLIENT INFORMATION
The member will not disclose confidential client information obtained in the course of a
professional engagement without the consent of the client. The consent of the client is not
needed:
7* To meet obligations of Rules.
8* To comply with a subpoena or summons.
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9* In the conduct of a review of a firm's quality control.
10* To answer inquiries of professional disciplinary boards.
Interpretations:
11* Confidentiality cannot be used to thwart legal or disciplinary actions.
12* Member firm may disclose confidential client information to another member firm, which
has purchased the practice. The potential seller should take precautions to prevent the
disclosure of client information by the potential buyer.
13* Member may release any client information if the client allows it.
CONTINGENT FEES
The member may not charge fees for attestation or tax services that are contingent upon the
findings. Fees may vary with complexity of the services provided. This prohibition does not
apply to fees fixed by the courts or public authorities.
Interpretations:
 Contingent fees may be charged in some areas but never in attestation services
(assurance) and generally not in tax services.
Contingent fees are fees calculated on a predetermined basis relating to the
outcome or result of a transaction or the result of the work performed.
A contingent fee charged by a firm in respect of an assurance engagement
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creates self-interest and advocacy threats that cannot be reduced to an
acceptable level by the application of any safeguard.
ACTS DISCREDITABLE
The MEMBER will not commit an act which is discreditable to the profession.
Interpretations:
14* This rule must be followed by members not engaged in public practice.
15* Must return client's records when they are demanded. The Member’s working papers
are not the client's and do not need to be surrendered.
16* May not discriminate based on race, color, religion, sex, age, or national origin.
17* Negligence in professional services.
18* Failure to follow additional applicable requirements.
19* Solicitation or disclosure of member Exam questions.
ADVERTISING AND OTHER FORMS OF SOLICITATION
The member will not seek to obtain clients by advertising or other forms of solicitation in a
manner that is false, misleading, or deceptive.
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Interpretations:
20* May not imply the ability to influence authorities.
21* May not create false expectations about favorable results.
22* May not state unreasonable fees.
23* A member is responsible for claims made on his or her behalf by third parties.
COMMISSIONS
When providing attestation services, the member may not receive commissions for services
provided to the client or commissions for services provided by the client to other parties.
Interpretations:
24* When the member receives a commission for a non-prohibited act, the commission
should be disclosed to the client.
25* Referral fees, accepted or paid, should be disclosed to the client.
FORM OF PRACTICE AND NAME
The member may practice public accounting in any form of organisation permitted by state
law or regulations whose characteristics conform to resolutions of the Council. The name of
the organisation may not be misleading.
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Interpretations:
26* Firm name must not mislead as to organizational form.
27* Names of past partners may be used (with limits).
28* Regular corporations are allowed if stock is held by persons who are members and able
to practice publicly.
Revision Questions
Q1
Chemonges and Co, Chartered Certified Accountants, recently held a staff training
session on quality control. The session concluded with staff being invited to raise
matters from their experience relating to the ethical rules on independence. Some of
these matters are given below.
(a) Shortly before commencing the final audit of a large listed company, a junior staff
member on the audit team inherited a substantial number of shares in that company.
No action was taken because, although representing a large investment for the staff
member concerned, the number of shares was totally immaterial with respect to the
company. Moreover, the partner knew that, when the company’s results were
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announced, the share price would rise and he did not think it was fair to require the
staff member to sell them now. (5 marks)
(b) The management accountant of another listed company client had an accident
and was away from work for three months. At the time of the accident the audit
senior was winding up the prior year’s audit and, because of his familiarity with the
company’s management accounting system, it was agreed that he would take over
as management accountant for the three months. (5 marks)
(c) In its management letter to another audit client, Chemonges and Co warned the
company that their computer system lacked essential controls. The company
decided to install a totally new computer system and Chemonges and Co’s
management consultancy department was appointed to design the new system. (5
marks)
(d) Chemonges and Co was recently approached by a large company that was not,
then, an audit client, for a second opinion. The company was in dispute with its
existing auditors who were proposing to issue a modified auditor’s report because of
disagreement over inventory valuation. Chemonges and Co’s technical par tner
reviewed the evidence provided by the company and advised the company that its
accounting treatment was in order. Shortly afterwards Chemonges and Co was
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invited to accept nomination as auditors. The reply to the letter of enquiry to the
existing auditors made it clear that the inventory valuation dispute was not as
straightforward as the company had made it out to be. (5 marks)
Required:
Discuss the possibility that Chemonges and Co had impaired their
independence or otherwise acted unprofessionally in each of the
situations described.
(20 marks)
Q2
Accountants in public practice earn much of their revenue from the provision of
external audit services. Companies pay substantial fees for the services of external
auditors. However, the work of the external auditor does not appear to improve
companies’ profitability so it is not immediately apparent what the benefit of an
external audit is.
Required:
(a) Explain the benefits derived from the work of external auditors. (10
marks)
(b) The value of the external audit is dependent upon a number of factors,
sometimes referred to as postulates.
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Identify these factors and explain how they contribute to the
effectiveness of the external audit. (10 marks)
N.B. Marks will reflect the quality of the explanation rather than the number of
factors identified.
(20 marks)
Key terms:
Fraud: Comprises both the use of deception to obtain unjust or illegal financial
advantage and intentional misrepresentation by management, employees or third parties.
Error: Unintentional mistake
Auditor’s duties
 Planning:
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 Discuss with audit team the susceptibility of the entity to material misstatements in the
financial statements resulting from fraud.
 Make enquiries of management
a) To obtain an understanding of:
- Management’s assessment of the risk that financial statements may be
materially misstated as a result of error.
- The accounting and internal control system management has put in place to
address such risk
b) To obtain knowledge of management’s understanding regarding the accounting and
internal control systems in place to prevent or detect error.
c) To determine whether management is aware of any known fraud that has affected
the entity or suspected fraud that the entity is investigating.
d) To determine whether management has discovered any material errors.
 Risk assessment
Auditors consider how financial statements might be materially misstated as a result of fraud
or error. The auditor should consider whether fraud risk factors are presented that indicates
the possibility of either fraudulent financial reporting or misappropriations of assets.
 Designing substantive procedures.
The auditor should address the fraud risk factors that have been identified as being present.
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 Misstatements
Circumstances indicating material misstatements:
Perform procedures to determine whether the financial statements are materially misstated.
When a misstatement is identified, the auditor should consider whether it is indicative of
fraud and consider its implications to other aspects of the audit.
The auditor should obtain written representations from management that:
a) It acknowledges its responsibility for the implementation and operations of accounting
and internal control systems that are designed to prevent and detect fraud or error.
b) It believes that misstatements are immaterial both individually and when aggregated.
c) It has disclosed to the auditor all significant facts relating to its assessment of risk that
financial statements may be materially misstated.
d) Disclosed to the auditor the results of risk assessment.
If auditor identifies misstatements resulting from fraud or suspected fraud, he should
consider his responsibility to communicate that information to management, those charged
with governance and in some circumstances to regulatory and enforcement authorities.
Error – Read and make notes
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Qn: What should the auditor do if he concludes that he cannot continue performing the
audit as a result of misstatement resulting from fraud or suspected fraud?
INTERNAL AUDIT AND INTERNAL REVIEW
Internal audit is an independent activity set up by management to examine and evaluate the
organisations risk management processes and systems control and to make
recommendations for improvement of achieving company objectives.
Other Activities of Internal Audit.
 Examine and evaluate financial and operating information within the organisation.
 Review of the economy, efficiency, and effectiveness of operations.
 Review compliance with external laws and regulations and internal policy and
procedures.
 Review and advise on the development of key organisation systems and on the
implementation of major change.
The IIA board of directors has defined internal auditing as:
'Internal auditing is an independent, objective assurance and consulting activity
designed to add value and improve an organisation's operations. It helps an
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organisation accomplish its objectives by bringing a systematic, disciplined approach
to evaluate and improve the effectiveness of risk management, control and
governance processes.'
Internal auditing is an independent professional service, to serve not just
management but the whole organisation. This means that the internal auditing
customer base includes all those who work in an organisation.
There are four major areas of Internal Audit form the above definition;
 Corporate governance
 Risk
 Organisational control
 Corporate objectives
Internal Audit and Corporate Governance
Corporate governance concerns the way that a company is operated and directed and n
particular encompasses the operation of the board and audit committee, as well as the
overall control and risk management frame work.
Corporate governance varies from country to country and has been more formally developed
during the last ten years. Guidance has been developed in the areas of; the need for
financial controls; the conduct and remuneration of the directors; operational controls and
risk.
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Why corporate governance has had such an Impact on Internal Audit and Review
The Turnbull report emphasises the importance of corporate governance. It says that an
objective and adequately resourced internal audit function should be in position to provide
the board with much of the assurance it requires regarding the effectiveness of the system of
internal control.
Effective corporate governance should encompass the following;
 Evaluate risk requirements
 Consider the nature and extent of the risks regarded as acceptable.
 The threats of such risks realising
 The ability to reduce incidence and impact if risks arise
 Costs and benefits relating to operating relevant controls.
Refer to article on Corporate Governance
Risk Management
Risk can be defined as 'any event or actions that may adversely affect an
organisation to achieve its objectives and execute its strategies'; This definition
means that risk is not just confined to just the financial affairs of the organisation but
to all operations.
Risk can be seen as having three components;
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 Hazard - risk of bad things happening
 Uncertain Outcome - not meeting expectations
 Opportunity - exploiting the upside
Refer to article The role of Internal Audit in Risk Management
Internal Control
The Turnbull Report defined risk management and internal control in the following
way 'An organisation's system of internal control has as its principal aim the
management of risks that are significant to the fulfilment of its objectives, with a view
to safeguarding the organisation's assets and ensure that the organisation is
effectively fulfilling its objectives.'
Underpinning pro-active risk management - which involves identifying risk and
appropriate strategies to mitigate them - is a sound internal control system, which
can:
 Respond to significant risk
 Is embedded in day to day processes
 Capable of responding to external and internal changes
 Immediately report major control weaknesses.
A good internal control system will provide management with reports on:
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 Identification, evaluation and management of key risks
 Assessment of effectiveness of related control
 Actions to remedy weaknesses including considering costs and benefits
 Adequacy of monitoring of internal control systems
 The process that supports reporting
Having such information will provide an organisation's management the reassurance
that not only is meeting regulatory requirements but that the organisation is well run.
The internal auditor as an expert in internal control can provide such assurance.
Organisational Control - Read
Corporate Objectives - Read
Differences between Internal and External Audit - Read
Outsourcing Internal Audit Refer to article
SCOPE FUNCTIONS OF INTERNAL AUDIT WORK
The mission of the internal audit department is to provide independent, objective
assurance and consulting services designed to add value and improve the
organization's operations. It helps the organization accomplish its objectives by
bringing a systematic, disciplined approach to evaluate and improve the
effectiveness of risk management, control, and governance processes.
The scope of work of the internal audit department is to determine whether the
organization’s network of risk management, control, and governance processes, as
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designed and represented by management, is adequate and functioning in a manner
to ensure:
 Risks are appropriately identified and managed.
 Interaction with the various governance groups occurs as needed.
 Significant financial, managerial, and operating information is accurate,
reliable, and timely.
 Employees’ actions are in compliance with policies, standards, procedures,
and applicable laws and regulations.
 Resources are acquired economically, used efficiently, and adequately
protected.
 Programs, plans, and objectives are achieved.
 Quality and continuous improvement are fostered in the organization’s control
process.
 Significant legislative or regulatory issues impacting the organization are
recognized and addressed appropriately.
Opportunities for improving management control, profitability, and the organization’s
image may be identified during audits. They will be communicated to the appropriate
level of management.
ACCOUNTABILITY
The chief audit executive, in the discharge of his/her duties, shall be accountable to
management and the audit committee to:
 Provide annually an assessment on the adequacy and effectiveness of the
organization’s processes for controlling its activities and managing its risks in
the areas set forth under the mission and scope of work.
 Report significant issues related to the processes for controlling the activities
of the organization and its affiliates, including potential improvements to those
processes, and provide information concerning such issues through
resolution.
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 Periodically provide information on the status and results of the annual audit
plan and the sufficiency of department resources.
 Coordinate with and provide oversight of other control and monitoring
functions (risk management, compliance, security, legal, ethics,
environmental, external audit).
INDEPENDENCE
To provide for the independence of the internal auditing department, its personnel
report to the chief audit executive, who reports functionally to the audit committee
and administratively to the chief executive officer in a manner outlined in the above
section on Accountability. It will include as part of its reports to the audit committee a
regular report on internal audit personnel.
RESPONSIBILITY
The chief audit executive and staff of the internal audit department have
responsibility to:
 Develop a flexible annual audit plan using an appropriate risk-based
methodology, including any risks or control concerns identified by
management, and submit that plan to the audit committee for review and
approval as well as periodic updates.
 Implement the annual audit plan, as approved, including as appropriate any
special tasks or projects requested by management and the audit committee.
 Maintain a professional audit staff with sufficient knowledge, skills,
experience, and professional certifications to meet the requirements of this
Charter.
 Evaluate and assess significant merging/consolidating functions and new or
changing services, processes, operations, and control processes coincident
with their development, implementation, and/or expansion.
 Issue periodic reports to the audit committee and management summarizing
results of audit activities.
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 Keep the audit committee informed of emerging trends and successful
practices in internal auditing.
 Provide a list of significant measurement goals and results to the audit
committee.
 Assist in the investigation of significant suspected fraudulent activities within
the organization and notify management and the audit committee of the
results.
 Consider the scope of work of the external auditors and regulators, as
appropriate, for the purpose of providing optimal audit coverage to the
organization at a reasonable overall cost.
AUTHORITY
The chief audit executive and staff of the internal audit department are authorized to:
 Have unrestricted access to all functions, records, property, and personnel.
 Have full and free access to the audit committee.
 Allocate resources, set frequencies, select subjects, determine scopes of
work, and apply the techniques required to accomplish audit objectives.
 Obtain the necessary assistance of personnel in units of the organization
where they perform audits, as well as other specialized services from within or
outside the organization.
The chief audit executive and staff of the internal audit department are not
authorized to:
 Perform any operational duties for the organization or its affiliates.
 Initiate or approve accounting transactions external to the internal auditing
department.
 Direct the activities of any organization employee not employed by the internal
auditing department, except to the extent such employees have been
appropriately assigned to auditing teams or to otherwise assist the internal
auditors.
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