ACCOUNTING FOR AUDITING II COURSES UGdoc

UNIT 1: OVERVIEW OF AUDITING
UNIT 1: OVERVIEW OF AUDITING
Contents
Contents
1.0 Aims and Objectives
1.1
1.1 Introduction
Introduction
1.2
1.2 Definition and Basic Features of Auditing
Definition and Basic Features of Auditing
1.3
1.3 Demand for Audit
Demand for Audit
1.4
1.4 Accounting Vs Auditing
Accounting Vs Auditing
1.5
1.5 Types of Audits and Auditors
Types of Audits and Auditors
1.6
1.6 The Nature of External Auditing in Ethiopia
The Nature of External Auditing in Ethiopia
1.7
1.7 Summary
Summary
1.8
1.8 Glossary
Glossary
1.9
1.9 Answers to Check Your Progress Exercise
Answers to Check Your Progress Exercise
1.10
1.10 Model Exam Questions
Model Exam Questions
1.0 AIMS AND OBJECTIVES
When you have studied this unit you should be able to:

 describe what auditing is.
describe what auditing is.

 describe the nature of financial statement audits.
describe the nature of financial statement audits.

 explain why audits are demanded by society.
explain why audits are demanded by society.

 describe the various types of audits and types of auditors.
describe the various types of audits and types of auditors.
1.1
1.1 INTRODUCTION
INTRODUCTION
Without question, the independent audit function plays an important role in both business and society.
Without question, the independent audit function plays an important role in both business and society.
Numerous third parties, including investors, creditors, and regulators, depend on the competence and
Numerous third parties, including investors, creditors, and regulators, depend on the competence and
professional integrity of independent auditors.
professional integrity of independent auditors.
Economic decisions are typically based upon the information available to the decision maker. To obtain the
Economic decisions are typically based upon the information available to the decision maker. To obtain the
most benefit, users should have economic information that is both relevant and reliable.
most benefit, users should have economic information that is both relevant and reliable.
This need for relevant and reliable financial information creates a demand for accounting and auditing
This need for relevant and reliable financial information creates a demand for accounting and auditing
service.
service.
1.2
1.2 DEFINITION AND BASIC FEATURES OF AUDITING
DEFINITION AND BASIC FEATURES OF AUDITING
Auditing is the accumulation and evaluation of evidence about information to determine and report on the
Auditing is the accumulation and evaluation of evidence about information to determine and report on the
degree of correspondence between the information and established criteria. Auditing should be done by a
degree of correspondence between the information and established criteria. Auditing should be done by a
competent and independent person.
competent and independent person.
Auditing enable the auditor to express opinion whether the financial statements are prepared, in all material
Auditing enable the auditor to express opinion whether the financial statements are prepared, in all material
respects, in accordance with an identified financial reporting framework. This framework (criterion) might
respects, in accordance with an identified financial reporting framework. This framework (criterion) might
be generally accepted accounting principles (GAAP), or the national standard of a particular country.
be generally accepted accounting principles (GAAP), or the national standard of a particular country.
Financial statements include balance sheet, income statement, and statement of cash flow, notes and
Financial statements include balance sheet, income statement, and statement of cash flow, notes and
explanatory material that are identified as being part of financial statements.
explanatory material that are identified as being part of financial statements.
The phrases used to express the auditor’s opinion are that the financial statements ‘give a trued and fair
The phrases used to express the auditor’s opinion are that the financial statements ‘give a trued and fair
view’ or ‘present fairly in all material respective’.
view’ or ‘present fairly in all material respective’.
Note that the auditor does not certify the financial statements or guarantee that the financial statements are
Note that the auditor does not certify the financial statements or guarantee that the financial statements are
correct, he reports that in his opinion they give a ‘true and fair view’, or present fairly’ the financial
correct, he reports that in his opinion they give a ‘true and fair view’, or present fairly’ the financial
position.
position.
1.3
1.3 DEMAND FOR AUDIT
DEMAND FOR AUDIT
There is a need for auditing when ownership is separated from control. At a practical level, it helps prevent
There is a need for auditing when ownership is separated from control. At a practical level, it helps prevent
or detect misstatements-errors or fraud. It may prevent or detect misstatements on the part of (1) the
or detect misstatements-errors or fraud. It may prevent or detect misstatements on the part of (1) the
employees who actually handle the money, or (2) management. Auditing is needed to enhance the
employees who actually handle the money, or (2) management. Auditing is needed to enhance the
credibility of financial information prepared by an entity. The independent audit requirement fulfils the
credibility of financial information prepared by an entity. The independent audit requirement fulfils the
need to ensure that those financial statements are objective, free from bias and manipulation and relevant to
need to ensure that those financial statements are objective, free from bias and manipulation and relevant to
the needs of users.
the needs of users.
Check
Check Your
our Progress Exercise – 1
rogress Exercise – 1
Why auditors cannot provide absolute assurance?
Why auditors cannot provide absolute assurance?
1

1.4
1.4 ACCOUNTING VS AUDITING
ACCOUNTING VS AUDITING
Accounting is the collecting (recording, classifying), summarizing, reporting and interpreting of financial
Accounting is the collecting (recording, classifying), summarizing, reporting and interpreting of financial
data. Auditing is the testing of those accounting records for fairness, appropriateness. An accountant only
data. Auditing is the testing of those accounting records for fairness, appropriateness. An accountant only
needs to know generally accepted accounting principles (GAAP). The auditor needs to know GAAP, plus
needs to know generally accepted accounting principles (GAAP). The auditor needs to know GAAP, plus
how to select and evaluate evidence related to the assertions of financial statements.
how to select and evaluate evidence related to the assertions of financial statements.
Accounting is constructive. It starts with the raw financial data to process and produce financial statements.
Accounting is constructive. It starts with the raw financial data to process and produce financial statements.
Auditing on the other hand is analytical work that starts with financial statement to lend credibility and
Auditing on the other hand is analytical work that starts with financial statement to lend credibility and
fairness of the measurements.
fairness of the measurements.
1.5
1.5 TYPES OF AUDITS AND AUDITORS
TYPES OF AUDITS AND AUDITORS
A. Types of Audits
Types of Audits
Audits are often viewed as falling into three major types:
Audits are often viewed as falling into three major types:
(1)
(1) Audits of financial statements,
Audits of financial statements,
(2)
(2) Operational audits, and
Operational audits, and
(3)
(3) Compliance audits.
Compliance audits.
1.
1. Audits of financial statements: -
Audits of financial statements: - The goal is to determine whether the financial statements
The goal is to determine whether the financial statements
have been prepared in conformity with generally accepted accounting principles.
have been prepared in conformity with generally accepted accounting principles.
2.
2. Operational audits: -
Operational audits: - An operational audit is study of some specific unit of an organization
An operational audit is study of some specific unit of an organization
for the purpose of measuring its performance. The operation of a unit can be evaluated for its
for the purpose of measuring its performance. The operation of a unit can be evaluated for its
effectiveness and efficiency.
effectiveness and efficiency.
3.
3. Compliance audits: -
Compliance audits: - Compliance audit determines whether the specified rules, regulations,
Compliance audit determines whether the specified rules, regulations,
or procedures are being carried out or followed.
or procedures are being carried out or followed.
B. Types of Auditors
B. Types of Auditors
The most known types of auditors are
The most known types of auditors are
1.
1. Independent auditors,
Independent auditors,
2.
2. Internal auditors,
Internal auditors,
3.
3. Government auditors.
Government auditors.
1. Independent (external auditors): -
1. Independent (external auditors): - Independent auditors have no connection to the firm as an owner or
Independent auditors have no connection to the firm as an owner or
employee/manager. The basic task of independent auditor is to confirm to the owners that the
employee/manager. The basic task of independent auditor is to confirm to the owners that the
employees are correctly reporting on their financial position and performance.
employees are correctly reporting on their financial position and performance.
2. Internal auditor: -
2. Internal auditor: - An internal auditor is paid salary as employee on the organization that is being audits.
An internal auditor is paid salary as employee on the organization that is being audits.
He/she is responsible to appraise and investigation the performance of unit and/or units within the
He/she is responsible to appraise and investigation the performance of unit and/or units within the
organization and give recommendation to top management.
organization and give recommendation to top management.
3. Government audit: -
3. Government audit: - The government auditor is paid a salary by the government. He/she is responsible
The government auditor is paid a salary by the government. He/she is responsible
to the legislature or executive.
to the legislature or executive.
Check you
Check you Progress
Exercise – 2
What is the contribution of internal auditor in the audit of annual financial statements?
What is the contribution of internal auditor in the audit of annual financial statements?
1.6
1.6 THE NATURE OF EXTERNAL AUDITING IN ETHIOPIA
THE NATURE OF EXTERNAL AUDITING IN ETHIOPIA
In Ethiopia audits seem to be done primary on account of government regulation. For example, NGO
In Ethiopia audits seem to be done primary on account of government regulation. For example, NGOS
S
are
are
audited because the assets of the NGO
audited because the assets of the NGOS
S
are deemed a “national asset,” the use of which is ultimately
are deemed a “national asset,” the use of which is ultimately
accountable to the government of Ethiopia.
accountable to the government of Ethiopia.
Auditing in Ethiopia could be viewed in five main areas.
Auditing in Ethiopia could be viewed in five main areas.
1.
1. The office of the auditor general (OAG
The office of the auditor general (OAG)
)
The powers and functions of the office of the OG are circumscribed through the proclamations that
The powers and functions of the office of the OG are circumscribed through the proclamations that
established it, its sphere of activity lies in government audit.
established it, its sphere of activity lies in government audit.
2.
2. The audit Service Corporation
The audit Service Corporation. The duty and functions of this entity
. The duty and functions of this entity
involve mostly commercial audits of commercial and productive enterprises wholly or partially
involve mostly commercial audits of commercial and productive enterprises wholly or partially
owned by government.
owned by government.
3.
3. Private audit firms.
Private audit firms.
4.
4. Ministry of finance audit and inspection
Ministry of finance audit and inspection.
.
Auditing activity in this area includes audit of ministries and government departments by MF
Auditing activity in this area includes audit of ministries and government departments by MF
auditors and inspectors, including tax audit by Inland Revenue authorities.
auditors and inspectors, including tax audit by Inland Revenue authorities.
5.
5. State corporations’ and enterprises’ auditors
State corporations’ and enterprises’ auditors.
.
2

These are audits performed by internal auditors within enterprise.
These are audits performed by internal auditors within enterprise.
1.7 SUMMARY
1.7 SUMMARY
This unit should have given you good understanding on the nature of the audit. The objectives of an audit
This unit should have given you good understanding on the nature of the audit. The objectives of an audit
have also been covered and need to borne in mind at all times. It has also covered the three major types of
have also been covered and need to borne in mind at all times. It has also covered the three major types of
audits and auditors. It has dealt with the basic areas of auditing in Ethiopia.
audits and auditors. It has dealt with the basic areas of auditing in Ethiopia.
1.8. GLOSSARY
1.8. GLOSSARY
-
- Audit of financial statements:
Audit of financial statements: Examination of
Examination of
financial statements to determine that the statements are in conformity with specified criteria, usually
financial statements to determine that the statements are in conformity with specified criteria, usually
GAAP.
GAAP.
-
- Auditing:
Auditing: A systematic process of objectively
A systematic process of objectively
obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain
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
the degree of correspondence between those assertions and established criteria and communicating the
results to interested users.
results to interested users.
-
- Compliance Audit:
Compliance Audit: An audit that attempts to measure
An audit that attempts to measure
the degree to which an auditee complies with some predetermined criteria.
the degree to which an auditee complies with some predetermined criteria.
-
- Government Auditors:
Government Auditors: Auditors employed by
Auditors employed by
government entities.
government entities.
-
- Independent auditors Certified public accountants who
Independent auditors Certified public accountants who
have an audit practice and offer auditing services to the public.
have an audit practice and offer auditing services to the public.
-
- Internal Auditors:
Internal Auditors: Full-time employees of private
Full-time employees of private
organizations who conduct audits for the organization.
organizations who conduct audits for the organization.
-
- Operational Audit:
Operational Audit: An audit that measures the
An audit that measures the
effectiveness and efficiency of an organization.
effectiveness and efficiency of an organization.
1.9 ANSWER TO CHECK YOUR PROGRESS EXERCISES
1.9 ANSWER TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress Exercise – 1
Auditors can provide only reasonable assurance. They cannot provide absolute assurance due to the
Auditors can provide only reasonable assurance. They cannot provide absolute assurance due to the
inherent limitation of auditing principles and standards, inherent limitations of accounting principles, use of
inherent limitation of auditing principles and standards, inherent limitations of accounting principles, use of
samples in auditing, and the existence of human error.
samples in auditing, and the existence of human error.
The contribution of internal auditor in the audit of annual financial statements is to assist the external
The contribution of internal auditor in the audit of annual financial statements is to assist the external
auditors.
auditors.
1.10 MODEL EXAM QUESTIONS
Part I. Short Answer
(a) Give a definition of an audit, and explain the basic features of auditing.
(a) Give a definition of an audit, and explain the basic features of auditing.
(b) What is the principal use and significance of auditing to users of financial statements?
(b) What is the principal use and significance of auditing to users of financial statements?
Part II. Multiple Choices
Part II. Multiple Choices
1.
1. How does an independent audit aid in the communication of economic data?
How does an independent audit aid in the communication of economic data?
a)
a) It confirms the accuracy management’s financial representations.
It confirms the accuracy management’s financial representations.
b)
b) It lends credibility to the financial statements.
It lends credibility to the financial statements.
c)
c) It guarantees that financial data are fairly presented.
It guarantees that financial data are fairly presented.
d)
d) It assures the readers of financial statements that any fraudulent activity has been corrected.
It assures the readers of financial statements that any fraudulent activity has been corrected.
2.
2. What is the essence of the external audit function?
What is the essence of the external audit function?
a)
a) To detect fraud
To detect fraud
b)
b) To examine individual transactions so that the auditor may certify their validity.
To examine individual transactions so that the auditor may certify their validity.
c)
c) To determine whether the client’s financial statements are fairly stated.
To determine whether the client’s financial statements are fairly stated.
d)
d) To assure the consistent application of correct accounting procedures.
To assure the consistent application of correct accounting procedures.
3.
3. Primary purpose of an operational audit is to provide:
Primary purpose of an operational audit is to provide:
a)
a) Means of assurance that internal control structure is functioning as planned.
Means of assurance that internal control structure is functioning as planned.
b)
b) a measure of management performance in meeting organizational goals.
a measure of management performance in meeting organizational goals.
c)
c) The results of internal audits of financial and accounting matters to a company’s top-level
The results of internal audits of financial and accounting matters to a company’s top-level
management.
management.
d)
d) aid to the independent auditor who is conducting the audit of the financial statements.
aid to the independent auditor who is conducting the audit of the financial statements.
3

4. Compared to the eternal auditor, what is more likely to concern an intern auditor?
4. Compared to the eternal auditor, what is more likely to concern an intern auditor?
a)
a) Fairness of the financial statements
Fairness of the financial statements c) Management policies and procedures
c) Management policies and procedures
b)
b) Cost accounting procedures
Cost accounting procedures d) Generally accepted accounting principles.
d) Generally accepted accounting principles.
5. Which of the following criteria is unique to the auditor’s function?
5. Which of the following criteria is unique to the auditor’s function?
a)
a) General competence
General competence
b)
b) Familiarity with the particular industry of which the client is a part.
Familiarity with the particular industry of which the client is a part.
c)
c) Due professional care
Due professional care d) Independence.
d) Independence.
UNIT 2: THE AUDITING PROFESSION
UNIT 2: THE AUDITING PROFESSION
Contents
Contents
2.1
2.1 Introduction
Introduction
2.2
2.2 Independence
Independence
2.3
2.3 Professional Qualification Requirements
Professional Qualification Requirements
2.4
2.4 Professional Ethics
Professional Ethics
2.5
2.5 Legal Responsibility and Liability
Legal Responsibility and Liability
2.6
2.6 Summary
Summary
2.7
2.7 Glossary
Glossary
2.8
2.9
o
o Understand independence in fact and in appearance.
Understand independence in fact and in appearance.
o
o Understand the AICPA code of professional ethics.
Understand the AICPA code of professional ethics.
o
o Define the major legal concepts that relate to auditors’ liability.
Define the major legal concepts that relate to auditors’ liability.
o
o Describe the auditor’s responsibility for the detection of fraud and error.
Describe the auditor’s responsibility for the detection of fraud and error.
2.1
2.1 Introduction
Introduction
This unit covers the basic codes of professional conduct, which the auditors need to bear in mind in carrying
This unit covers the basic codes of professional conduct, which the auditors need to bear in mind in carrying
out their duties. The main source of material for code of professional conduct in this unit is the AICPA’s
out their duties. The main source of material for code of professional conduct in this unit is the AICPA’s
code of professional ethics.
code of professional ethics.
This unit also covers the duties and legal liabilities of auditors.
This unit also covers the duties and legal liabilities of auditors.
Broadly defined, the term
Broadly defined, the term ethics
ethics represents the moral principles or rules of conduct recognized by an
represents the moral principles or rules of conduct recognized by an
individual or group of individuals. Ethics apply when an individual has to make a decision from various
individual or group of individuals. Ethics apply when an individual has to make a decision from various
alternatives regarding moral principles.
alternatives regarding moral principles.
2.2 INDEPENDENCE
2.2 INDEPENDENCE
The AICPA code of professional conduct requires a member in public practice to be independent in the
The AICPA code of professional conduct requires a member in public practice to be independent in the
performance of professional services as required by standards promulgated by bodies designated by council.
performance of professional services as required by standards promulgated by bodies designated by council.
The requirement is stated in terms of “standards promulgated by bodies designated by council” to
The requirement is stated in terms of “standards promulgated by bodies designated by council” to
conveniently permit inclusion or exclusion of independence requirements for certain types of services
conveniently permit inclusion or exclusion of independence requirements for certain types of services
provided by CPA firms. For example, independence is required for audits of annual financial statement but
provided by CPA firms. For example, independence is required for audits of annual financial statement but
a CPA firm can do tax return and provide management services without being independent. Independence
a CPA firm can do tax return and provide management services without being independent. Independence
in auditing means an unbiased viewpoint in the performance of audit test, the evaluation of results, and the
in auditing means an unbiased viewpoint in the performance of audit test, the evaluation of results, and the
issuance of the audit report.
issuance of the audit report.
Independence has two distinct aspects. First, the public accountants must
Independence has two distinct aspects. First, the public accountants must in fact
in fact be independent toward any
be independent toward any
enterprise they audit. Second, the relationships of public accountants with audit clients must be such that
enterprise they audit. Second, the relationships of public accountants with audit clients must be such that
they will
they will appear
appear independent to third parties.
independent to third parties.
Independences in fact refers to the auditor’s ability to maintain unbiased and impartial mental attitude or
Independences in fact refers to the auditor’s ability to maintain unbiased and impartial mental attitude or
state of mind in all aspects of work. As such independence in fact is not subject to objective measurement
state of mind in all aspects of work. As such independence in fact is not subject to objective measurement
and therefore can be judged only by the auditor.
and therefore can be judged only by the auditor.
Independence in appearance refers to the auditor’s freedom from conflict of interest, which third parties may
Independence in appearance refers to the auditor’s freedom from conflict of interest, which third parties may
infer from circumstantial evidence.
infer from circumstantial evidence.
The following paragraphs illustrate some of the common situations, which may impair independence.
The following paragraphs illustrate some of the common situations, which may impair independence.
4


 Investment interest in audit client: -
Investment interest in audit client: - An auditor’s investment in shares, bonds,
An auditor’s investment in shares, bonds,
mortgage, and notes of an audit client or its associates, either direct or indirect, may impair
mortgage, and notes of an audit client or its associates, either direct or indirect, may impair
independence. In this situation, an auditor may be in a position to issue an opinion or to influence the
independence. In this situation, an auditor may be in a position to issue an opinion or to influence the
client’s financial statements for personal financial gains at the expense of his/her capacity as auditor.
client’s financial statements for personal financial gains at the expense of his/her capacity as auditor.
Such an investment is not limited to the auditor but also applies to his or her immediately family and to
Such an investment is not limited to the auditor but also applies to his or her immediately family and to
partners and their immediate families.
partners and their immediate families.

 Non audit functions and services: -
Non audit functions and services: - Certain functions are incompatible with the
Certain functions are incompatible with the
auditing function. These include functioning as a director, officers or employee of an audit client. The
auditing function. These include functioning as a director, officers or employee of an audit client. The
auditor’s involvement in these functions and services creates a conflict of interest.
auditor’s involvement in these functions and services creates a conflict of interest.

 Litigation between CPA firm and client:
Litigation between CPA firm and client: When there is a lawsuit or intent to start a
When there is a lawsuit or intent to start a
lawsuit between a CPA firm and its client, the ability of the CPA firm and client to remain objective is
lawsuit between a CPA firm and its client, the ability of the CPA firm and client to remain objective is
questionable.
questionable.

 Hospitality or goods and services: -
Hospitality or goods and services: - This will affect independence unless it is
This will affect independence unless it is
modest.
modest.

 Undue dependence on income: -
Undue dependence on income: - If the amount of income from a client is very large
If the amount of income from a client is very large
as compared to the total annual income of the audit firm, independence will be impaired since the
as compared to the total annual income of the audit firm, independence will be impaired since the
auditors want to maintain this financial interest.
auditors want to maintain this financial interest.
2.3 PROFESSIONAL QUALIFICATION REQUIREMENTS
2.3 PROFESSIONAL QUALIFICATION REQUIREMENTS
A professional accountant should perform professional services with due care, competence and diligence
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
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
client or employer receives the advantage of competent professional service based on up-to-date
development in practice, legislation and techniques.
development in practice, legislation and techniques.
Auditing standards require auditors to have adequate educational requirement as well as other moral and
Auditing standards require auditors to have adequate educational requirement as well as other moral and
legal criteria fulfillment. The educational requirements are composed of theoretical knowledge and
legal criteria fulfillment. The educational requirements are composed of theoretical knowledge and
practical experience.
practical experience.
2.4 PROFESSIONAL ETHICS
2.4 PROFESSIONAL ETHICS
All recognized professions have developed codes of professional ethics. Professional ethics refer to the
All recognized professions have developed codes of professional ethics. Professional ethics refer to the
basic principles of right action for the member of a profession. Professional ethics may be regarded as a
basic principles of right action for the member of a profession. Professional ethics may be regarded as a
mixture of moral and practical concepts. Thus the professional ethics of an accountant would signify his
mixture of moral and practical concepts. Thus the professional ethics of an accountant would signify his
behavior towards his fellows in the profession and other professions and towards members of the public.
behavior towards his fellows in the profession and other professions and towards members of the public.
The fundamental purpose of such codes is to provide members with guidelines for maintaining a
The fundamental purpose of such codes is to provide members with guidelines for maintaining a
professional attitude and conducting themselves in a manner that will enhance the professional stature of
professional attitude and conducting themselves in a manner that will enhance the professional stature of
their discipline.
their discipline.
The AICPA code of professional conduct considers the following to be followed by auditors (accountants)
The AICPA code of professional conduct considers the following to be followed by auditors (accountants)
in the conduct of professional relations with others.
in the conduct of professional relations with others.
-
- Integrity: -
Integrity: - An accountant should be straightforward,
An accountant should be straightforward,
honest and sincere in his approach to his professional work.
honest and sincere in his approach to his professional work.
-
- Objectivity: -
Objectivity: - An accountant should be fair and should
An accountant should be fair and should
not allow bias to override his objectivity. When reporting on financial statements, which come his
not allow bias to override his objectivity. When reporting on financial statements, which come his
review, he should maintain an impartial attitude.
review, he should maintain an impartial attitude.
-
- Independence: -
Independence: - When in public practice, an
When in public practice, an
accountant should
accountant should both be and appear to be
both be and appear to be free of any interest which might be regarded, whatever its
free of any interest which might be regarded, whatever its
actual effect, as being incompatible with integrity and objectivity.
actual effect, as being incompatible with integrity and objectivity.
-
- Confidentiality
Confidentiality: - A professional accountant should
: - A professional accountant should
respect the confidentiality of information acquired in the course of his work and should not disclose any
respect the confidentiality of information acquired in the course of his work and should not disclose any
such information to a third party without specific authority or unless there is a legal or professional duty
such information to a third party without specific authority or unless there is a legal or professional duty
to disclose.
to disclose.
-
- Technical
Technical standards: -
standards: - An accountant should carry out
An accountant should carry out
his professional work in accordance with the technical and professional standards relevant to that work.
his professional work in accordance with the technical and professional standards relevant to that work.
-
- Professional competence: -
Professional competence: - An accountant has a duty
An accountant has a duty
to maintain his level of competence throughout his professional career. He should only undertake
to maintain his level of competence throughout his professional career. He should only undertake
works, which he or his firm can expect to complete with professional competence.
works, which he or his firm can expect to complete with professional competence.
5

-
- Ethical behavior: -
Ethical behavior: - An accountant should conduct
An accountant should conduct
himself with a good reputation of the profession and refrain from any conduct, which might bring
himself with a good reputation of the profession and refrain from any conduct, which might bring
discredit to the profession.
discredit to the profession.
-
- Contingent fess: -
Contingent fess: - The AICPA code of professional
The AICPA code of professional
conduct prohibits a CPA firm from rendering any professional services on a contingent fee basis.
conduct prohibits a CPA firm from rendering any professional services on a contingent fee basis.
-
- Responsibilities to colleagues: -
Responsibilities to colleagues: - The auditor should
The auditor should
promote cooperation and good relations with other members of the profession.
promote cooperation and good relations with other members of the profession.
-
- Advertising: -
Advertising: - The advertising should not be false or
The advertising should not be false or
misleading,” should not contravene “professional good taste,” should not make “unfavorable reflection
misleading,” should not contravene “professional good taste,” should not make “unfavorable reflection
on the competence or integrity of the profession,” and should not” involve a statement the contents of
on the competence or integrity of the profession,” and should not” involve a statement the contents of
which” cannot be substantiated.
which” cannot be substantiated.
Check
Check Your
our Progress
Exercise – 1
1.
1. What is the basic purpose of a code of ethics for a profession?
What is the basic purpose of a code of ethics for a profession?
2.
2. Who makes the ultimate decision as to whether or not auditors maintain an
Who makes the ultimate decision as to whether or not auditors maintain an
appearance of independence from their audit clients?
appearance of independence from their audit clients?
a.
a. auditors
auditors
b.
b. client
client
c.
c. audit committee
audit committee
d.
d. public
public
3.
3. In which of the following situations would a CPA firm be in violation of the rules
In which of the following situations would a CPA firm be in violation of the rules
of professional conduct in determining it fess?
of professional conduct in determining it fess?
a.
a. A fee based on whether or not the auditor’s report leads to the
A fee based on whether or not the auditor’s report leads to the
approval of the client’s application for a bank loan.
approval of the client’s application for a bank loan.
b.
b. A fee to be established at a later date by the court due to the
A fee to be established at a later date by the court due to the
bankruptcy of the client.
bankruptcy of the client.
c.
c. A fee base on the nature of engagement rather than upon the actual
A fee base on the nature of engagement rather than upon the actual
time spent on the engagement.
time spent on the engagement.
d.
d. A fee based on the fee charged by the client’s former auditors.
A fee based on the fee charged by the client’s former auditors.
2.5 LEGAL RESPONSIBILITY AND LIABILITY OF AUDITORS
2.5 LEGAL RESPONSIBILITY AND LIABILITY OF AUDITORS
The auditor is responsible for his report. The auditor then has certain duties to fulfill to the users of the
The auditor is responsible for his report. The auditor then has certain duties to fulfill to the users of the
financial statements that he reports on.
financial statements that he reports on.
Responsibilities impose liabilities if things go wrong.
Responsibilities impose liabilities if things go wrong.
Liable for what?
Liable for what?
The CPA can be sued under the following legal concepts.
The CPA can be sued under the following legal concepts.
(i)
(i) Prudent man concept: -
Prudent man concept: - The auditor is responsible for exercising due professional care, and he
The auditor is responsible for exercising due professional care, and he
is subject to lawsuit if he fails to do so.
is subject to lawsuit if he fails to do so.
(ii)
(ii) Liable for acts of others: -
Liable for acts of others: - The partners are jointly liable for civil actions against a partner.
The partners are jointly liable for civil actions against a partner.
(iii)
(iii) Lack of privileged communication: -
Lack of privileged communication: - CPA
CPAS
S
do not have the right under common law to
do not have the right under common law to
withhold information from the courts on the grounds that the information is privileged.
withhold information from the courts on the grounds that the information is privileged.
Definition of Terms
Definition of Terms
Negligence:
Negligence: is violation of legal duty to exercise a degree of care that an ordinary prudent person would
is violation of legal duty to exercise a degree of care that an ordinary prudent person would
exercise under similar circumstances with resultant damages to another party.
exercise under similar circumstances with resultant damages to another party.
Gross negligence:
Gross negligence: is lack of event slight care. Many jurisdictions consider gross negligence equivalent to
is lack of event slight care. Many jurisdictions consider gross negligence equivalent to
constructive fraud
constructive fraud.
.
Fraud:
Fraud: is defined a misrepresentation by a person of a material fact, known by that person to be untrue.
is defined a misrepresentation by a person of a material fact, known by that person to be untrue.
Constructive fraud:
Constructive fraud: differs from fraud as defined above in that constructive fraud does not involve a
differs from fraud as defined above in that constructive fraud does not involve a
misrepresentation with the intent to deceive.
misrepresentation with the intent to deceive.
Privity:
Privity: is the relationship between parties to a contract.
is the relationship between parties to a contract.
Breach of contact:
Breach of contact: is failure of one or both parties to a contract to perform in accordance with the contract’s
is failure of one or both parties to a contract to perform in accordance with the contract’s
provisions.
provisions.
Proximate cause:
Proximate cause: exists when damage to another is directly attributable to a wrongdoer’s act.
exists when damage to another is directly attributable to a wrongdoer’s act.
6

Contributory negligence:
Contributory negligence: is negligence on the part of the client that has contributed to his or her having
is negligence on the part of the client that has contributed to his or her having
incurred a loss.
incurred a loss.
A. Auditors’ liability to their clients
A. Auditors’ liability to their clients
When CPA
When CPAS
S
take on any type of engagement, they are obliged to render due professional care. This
take on any type of engagement, they are obliged to render due professional care. This
obligation exists whether or not it is specifically set forth in the written contract with the client. Thus, CPA
obligation exists whether or not it is specifically set forth in the written contract with the client. Thus, CPAS
S
are liable to their clients for any losses proximately caused by the CPA’
are liable to their clients for any losses proximately caused by the CPA’S
S
failure to exercise due professional
failure to exercise due professional
care. That is to recover its losses, an injured client need only prove that the auditors were guilty of
care. That is to recover its losses, an injured client need only prove that the auditors were guilty of
negligence and that the auditors’ negligence was the proximate cause of the client’s losses.
negligence and that the auditors’ negligence was the proximate cause of the client’s losses.
B. Auditors’ liability to third parties
B. Auditors’ liability to third parties
Bankers and other creditors or investors who utilize financial statements covered by an audit report can
Bankers and other creditors or investors who utilize financial statements covered by an audit report can
recover damages from the auditors if it can be shown that the auditors were guilty of fraud or gross
recover damages from the auditors if it can be shown that the auditors were guilty of fraud or gross
negligence in the performance of their professional duties.
negligence in the performance of their professional duties.
Moreover, the auditors can be held liable for negligence to a limited class of third parties if the auditors have
Moreover, the auditors can be held liable for negligence to a limited class of third parties if the auditors have
actual knowledge of such third parties or if there exists a special relationship between the auditors and the
actual knowledge of such third parties or if there exists a special relationship between the auditors and the
third parties.
third parties.
The clients (plaintiffs) must prove that they sustained losses, that they relied on the audited financial
The clients (plaintiffs) must prove that they sustained losses, that they relied on the audited financial
statements, which were misleading, that this reliance was the primate cause of their losses, and that the
statements, which were misleading, that this reliance was the primate cause of their losses, and that the
auditors were negligent.
auditors were negligent.
C. Auditors’ responsibility for the detection of fraud and error
C. Auditors’ responsibility for the detection of fraud and error
The detection and prevention of error and fraud is the management’s responsibility by designing and
The detection and prevention of error and fraud is the management’s responsibility by designing and
implementing appropriate internal control systems. The auditor is not responsible for the prevention and
implementing appropriate internal control systems. The auditor is not responsible for the prevention and
detection of error and fraud. The auditor is responsible to design audit procedures to reduce the risk of not
detection of error and fraud. The auditor is responsible to design audit procedures to reduce the risk of not
detecting a material error or fraud, to an appropriate level to provide reasonable assurance. Accordingly, the
detecting a material error or fraud, to an appropriate level to provide reasonable assurance. Accordingly, the
auditor must exercise due care in planning, performing, and evaluating the results of audit procedures.
auditor must exercise due care in planning, performing, and evaluating the results of audit procedures.
Check
Check You
our Progress Exercise – 2
1.
1. A CPA firm will be liable for any fraudulent scheme it does not detect.
A CPA firm will be liable for any fraudulent scheme it does not detect.
a)
a) true
true
b)
b) false
false
2.
2. A CPA firm will not be liable if it can show that it exercised the ordinary care and skill of a
A CPA firm will not be liable if it can show that it exercised the ordinary care and skill of a
reasonable man in the conduct of its own affairs.
reasonable man in the conduct of its own affairs.
a)
a) true
true
b)
b) false
false
2.6 SUMMARY
2.6 SUMMARY
Independence and confidentiality are very important principles which have given rise to detailed rules by
Independence and confidentiality are very important principles which have given rise to detailed rules by
the AICPA.
the AICPA.
The determination of the extent to which auditors should be legally responsible for the reliability of
The determination of the extent to which auditors should be legally responsible for the reliability of
financial statements is rel
financial statements is rel
UNIT 6:
UNIT 6: COMPUTER AUDIT
COMPUTER AUDIT
Content
Content
6.1
6.1 Introduction
Introduction
6.2
6.2 Uses of Computers in Audit
Uses of Computers in Audit
6.3
6.3 Characteristics of Computer Audit
Characteristics of Computer Audit
6.4
6.4 Controls in CIS
Controls in CIS
6.5
6.5 Computer Assisted Auditing Techniques (CAATS)
Computer Assisted Auditing Techniques (CAATS)
6.6
6.6 Summary
Summary
6.7
6.7 Glossary
Glossary
6.8
6.8 Answer for Check Your Progress Exercises
Answer for Check Your Progress Exercises
6.9
7

When you have studied this unit, you should be able to:
When you have studied this unit, you should be able to:

 understand the problems of auditing computer information systems (CIS).
understand the problems of auditing computer information systems (CIS).

 understand the controls operated by a client in a CIS.
understand the controls operated by a client in a CIS.

 explain the use of CAATS.
explain the use of CAATS.
6.1 INTRODUCTION
6.1 INTRODUCTION
Computers may affect the work of the auditor in two ways:
Computers may affect the work of the auditor in two ways:

 The client may use a computer to produce all or part of the financial accounting data.
The client may use a computer to produce all or part of the financial accounting data.

 The auditor may be able to use a computer to assist in his audit, particularly when the client has a
The auditor may be able to use a computer to assist in his audit, particularly when the client has a
computer system.
computer system.
6.2 USE OF COMPUTERS IN AUDIT
6.2 USE OF COMPUTERS IN AUDIT
A microcomputer may be used by the auditor in the following ways to assist his audit work.
A microcomputer may be used by the auditor in the following ways to assist his audit work.
a)
a) Flowcharting a client’s systems
Flowcharting a client’s systems. Specialist flowcharting packages can assist
. Specialist flowcharting packages can assist
the auditor in the production of clear, well presented flowcharts.
the auditor in the production of clear, well presented flowcharts.
b)
b) Evaluation of audit risk.
Evaluation of audit risk. The auditor can input into the computer his
The auditor can input into the computer his
assessment of the audit risk for the various transactions and balanced in the client’s systems.
assessment of the audit risk for the various transactions and balanced in the client’s systems.
c)
c) Preparation of audit programmes.
Preparation of audit programmes. Audit programs can be typed into a word
Audit programs can be typed into a word
processor, which again will allow for easy updating in the following years.
processor, which again will allow for easy updating in the following years.
d)
d) Analytical procedures.
Analytical procedures. A standard template can be let up on a spreadsheet
A standard template can be let up on a spreadsheet
package. Onto this template, the auditor inputs key details such as balance sheet totals from the
package. Onto this template, the auditor inputs key details such as balance sheet totals from the
financial statements. The spreadsheet then calculates key accounting ratios to assist the auditor with
financial statements. The spreadsheet then calculates key accounting ratios to assist the auditor with
the analytical procedures.
the analytical procedures.
e)
e) Preparation of audit working papers.
Preparation of audit working papers. When a computer is available to audit
When a computer is available to audit
staff at the client’s premises, it can be used to type up audit working papers.
staff at the client’s premises, it can be used to type up audit working papers.
6.3
6.3 CHARACTERISTICS OF COMPUTER AUDIT
CHARACTERISTICS OF COMPUTER AUDIT
There are a number of distinguishing features of computer-based systems that must be recognized and
There are a number of distinguishing features of computer-based systems that must be recognized and
considered by the auditor. The following are the main features.
considered by the auditor. The following are the main features.
a.
a. Concentration of controls in the computer department.
Concentration of controls in the computer department. The need to standardized and
The need to standardized and
utilize the computer resources of a business has led to a concentration of controls in the computer
utilize the computer resources of a business has led to a concentration of controls in the computer
department which represents a potential weakness. Generally the number of persons involved in the
department which represents a potential weakness. Generally the number of persons involved in the
processing of information in a CIS environment will be fewer than those in a manual environment.
processing of information in a CIS environment will be fewer than those in a manual environment.
b.
b. Concentration of programs and data
Concentration of programs and data. Transactions, master files, and program data
. Transactions, master files, and program data
are often held together and there is a corresponding increased potential for unauthorized access to
are often held together and there is a corresponding increased potential for unauthorized access to
programs and data.
programs and data.
c.
c. Absence of input documentation
Absence of input documentation.
.
In some systems conventional journal will not be maintained and manual authorizations are usually
In some systems conventional journal will not be maintained and manual authorizations are usually
replaced by computer authorizations.
replaced by computer authorizations.
d.
d. Lack of visible transaction trial and output
Lack of visible transaction trial and output.
.
Modern systems are usually designed to limit the volume of printed data, and data is often quickly
Modern systems are usually designed to limit the volume of printed data, and data is often quickly
overwritten with new data. The auditor must assess the implications of this at the planning stage.
overwritten with new data. The auditor must assess the implications of this at the planning stage.
e.
e. Ease of access to data and computer programs
Ease of access to data and computer programs. The problem is again, one of
. The problem is again, one of
unauthorized access where data can be altered from remote terminals.
unauthorized access where data can be altered from remote terminals.
f.
f. Vulnerability of discs, and tapes
Vulnerability of discs, and tapes.
.
Data is more vulnerable than it would be in a manual system to loss, and destruction.
Data is more vulnerable than it would be in a manual system to loss, and destruction.
8

g.
g. System generated transactions
System generated transactions. Many systems are capable of generating transactions
. Many systems are capable of generating transactions
automatically without user intervention. The lack of authorization and documentation can be a
automatically without user intervention. The lack of authorization and documentation can be a
significant issue if a significant number of transactions are generated in this way.
significant issue if a significant number of transactions are generated in this way.
h.
h. Single transaction /multiple update
Single transaction /multiple update.
.
An incorrect entry may result in incorrect data in may different accounts, particularly in database
An incorrect entry may result in incorrect data in may different accounts, particularly in database
systems.
systems.
I. Programmed controls.
I. Programmed controls.
Programmed controls may limit the visibility of data, and limit input of data.
Programmed controls may limit the visibility of data, and limit input of data.
6.4 CONTROLS IN CIS
6.4 CONTROLS IN CIS
The controls that must be exercised by the auditor when micro computers are used in his audit work include
The controls that must be exercised by the auditor when micro computers are used in his audit work include
the following:
the following:
a)
a) Backup of files.
Backup of files.
Backup of all audit files kept on the computer should be made regularly. These backup copies
Backup of all audit files kept on the computer should be made regularly. These backup copies
should be kept in a separate location from the microcomputer.
should be kept in a separate location from the microcomputer.
b)
b) Security of files.
Security of files.
Audit information on client can be very sensitive. Adequate procedures must therefore be in force to
Audit information on client can be very sensitive. Adequate procedures must therefore be in force to
ensure that only authorized audit staff can gain access to the audit information.
ensure that only authorized audit staff can gain access to the audit information.
c)
c) Adequacy of documentation.
Adequacy of documentation.
There is a danger with computers that not all the data or reasoning used to reach a particular decision
There is a danger with computers that not all the data or reasoning used to reach a particular decision
will be documented. Adequate documentation should therefore be kept, including print – outs of all
will be documented. Adequate documentation should therefore be kept, including print – outs of all
major documents, for future reference, together with the reasons for the decisions made.
major documents, for future reference, together with the reasons for the decisions made.
d)
d) Testing of programs.
Testing of programs.
Before any program is used on audits, it should be tested to ensure that it is as fast as possible error
Before any program is used on audits, it should be tested to ensure that it is as fast as possible error
free
free
Check your progress Exercise – 1
Check your progress Exercise – 1
Say true or false
Say true or false
1.
1. Internal control in a CIS department requires not only subdivision of duties but
Internal control in a CIS department requires not only subdivision of duties but
also the maintenance of adequate documentation.
also the maintenance of adequate documentation.
2.
2. Computers are able to create, update, and erase data in computer based records
Computers are able to create, update, and erase data in computer based records
without any visible evidence of a change being made.
without any visible evidence of a change being made.
3.
3. When a company uses CIS consolidation of activities and integration of
When a company uses CIS consolidation of activities and integration of
functions are to be expected.
functions are to be expected.
4.
4. Every electronic data processing system should have adequate security
Every electronic data processing system should have adequate security
controls to safeguard files and programs.
controls to safeguard files and programs.
6.5 COMPUTE ASSISTED AUDITING TECHNIQUES (CAATS)
6.5 COMPUTE ASSISTED AUDITING TECHNIQUES (CAATS)
The absence of input documents, or audit trial, or output, might necessitate the use of CAATS.
The absence of input documents, or audit trial, or output, might necessitate the use of CAATS.
Auditors may use audit software during many audit testing procedures. The use of audit software is
Auditors may use audit software during many audit testing procedures. The use of audit software is
particularly appropriate during substantive testing of transactions and balances, as scrutinize large volumes
particularly appropriate during substantive testing of transactions and balances, as scrutinize large volumes
of data and extract information leaving skilled manual resources to concentrate upon the investigation of the
of data and extract information leaving skilled manual resources to concentrate upon the investigation of the
results.
results.
Typical uses of such programs include:
Typical uses of such programs include:
i.
i. Calculation of checks: Example: - the program adds the value of
Calculation of checks: Example: - the program adds the value of
open items on a file to ensure that they agree with control records.
open items on a file to ensure that they agree with control records.
9

ii.
ii. Detecting violation of system rules: Example, the program
Detecting violation of system rules: Example, the program
checks all accounts on the sales ledger to ensure that no customer has a balance above a specified credit
checks all accounts on the sales ledger to ensure that no customer has a balance above a specified credit
limit.
limit.
iii.
iii. Detecting unreasonable items: Example, a check that no
Detecting unreasonable items: Example, a check that no
customer is allowed trade discount of more than 5%.
customer is allowed trade discount of more than 5%.
iv.
iv. Conducting new calculations and analysis: Example: - obtaining
Conducting new calculations and analysis: Example: - obtaining
a sample of sales ledger balances to be used as a basis for a circularisation of accounts receivable.
a sample of sales ledger balances to be used as a basis for a circularisation of accounts receivable.
v.
v. Selection of items for audit testing: Example: - obtaining a
Selection of items for audit testing: Example: - obtaining a
sample of sales ledger balances to be used as a basis for a circularisation of accounts receivable.
sample of sales ledger balances to be used as a basis for a circularisation of accounts receivable.
vi.
vi. Completeness checks:
Completeness checks: Example, checking continuity of sales
Example, checking continuity of sales
invoices to ensure they are all accounted for.
invoices to ensure they are all accounted for.
6.6 SUMMARY
6.6 SUMMARY
The auditor can use microcomputers to assist in the management and carrying out his audit work. Computer
The auditor can use microcomputers to assist in the management and carrying out his audit work. Computer
based systems have a number of special features which must be recognized and considered by the auditor in
based systems have a number of special features which must be recognized and considered by the auditor in
planning his audit approach.
planning his audit approach.
6.7 GLOSSARY
6.7 GLOSSARY
Computer-assisted audit techniques (CAAT)
Computer-assisted audit techniques (CAAT) The
The tools and techniques, such as audit software and test
tools and techniques, such as audit software and test
data, used by the auditor with the computer to aid in effective and efficient performance of an audit.
data, used by the auditor with the computer to aid in effective and efficient performance of an audit.
6.8 ANSWER TO CHECK YOU PROGRESS EXERCISE
6.8 ANSWER TO CHECK YOU PROGRESS EXERCISE
1.
1. True
True
2.
2. True
True
3.
3. True
True
4.
4. True
True
1.
1. What are the special features of a computer – based systems?
What are the special features of a computer – based systems?
2.
2. Discuss briefly the internal controls that should be established over the
Discuss briefly the internal controls that should be established over the
operation of a microcomputer.
operation of a microcomputer.
UNIT 7: CASH AUDIT
UNIT 7: CASH AUDIT
Contents
Contents
7.1
7.1 Introduction
Introduction
7.2
7.2 Nature of Cash
Nature of Cash
7.3
7.3 Audit Objectives
Audit Objectives
7.3.1
7.3.1 Internal Control Over Cash
Internal Control Over Cash
7.3.2
7.3.2 Internal Control Over Cash Disbursements
Internal Control Over Cash Disbursements
7.3.3
7.3.3 Control Over Petty Cash
Control Over Petty Cash
7.4
7.4 Audit Program for Cash
Audit Program for Cash
7.5
7.5 Summary
Summary
7.6
7.6 Glossary
Glossary
7.7
7.7 Answer to Check Your Progress Exercise
Answer to Check Your Progress Exercise
10

7.8
7.8 Model Examination Question
Model Examination Question

 devise appropriate tests for cash.
devise appropriate tests for cash.

 explain the nature of cash receipts and disbursements.
explain the nature of cash receipts and disbursements.

 explain the fundamental internal controls over each receipts and cash disbursement.
explain the fundamental internal controls over each receipts and cash disbursement.

 describe the nature of appropriate procedures to accomplish the objectives of cash audit.
describe the nature of appropriate procedures to accomplish the objectives of cash audit.
7.1 INTRODUCTION
7.1 INTRODUCTION
This unit examines the audit of cash. For the audit of cash much reliance is placed on third party
This unit examines the audit of cash. For the audit of cash much reliance is placed on third party
confirmation of cash balance.
confirmation of cash balance.
You should bear in mind that the control of cash is of prime importance in any business. The overall
You should bear in mind that the control of cash is of prime importance in any business. The overall
objective of the audit of cash is to determine that cash is fairly presented in conformity with generally
objective of the audit of cash is to determine that cash is fairly presented in conformity with generally
accepted accounting principles. In most audits, the primary assertions that generate audit risk for cash are
accepted accounting principles. In most audits, the primary assertions that generate audit risk for cash are
existence, completeness, right and obligation, and presentation and disclosure.
existence, completeness, right and obligation, and presentation and disclosure.
7.2 NATURE OF CASH
7.2 NATURE OF CASH
Cash and bank balances are liquid assets and include:
Cash and bank balances are liquid assets and include:
a)
a) Notes and units.
Notes and units.
b)
b) Bank current accounts.
Bank current accounts.
c)
c) Bank deposit accounts.
Bank deposit accounts.
Because of their liquidity, these assets represent the most vulnerable of all the company’s assets. On the
Because of their liquidity, these assets represent the most vulnerable of all the company’s assets. On the
other hand, they are the most easily verified, because they can be confirmed directly by third parties or by
other hand, they are the most easily verified, because they can be confirmed directly by third parties or by
physical counts.
physical counts.
7.3 THE AUDITORS’ OBJECTIVES IN EXAMINATION OF CASH
7.3 THE AUDITORS’ OBJECTIVES IN EXAMINATION OF CASH
The auditors have five objectives in the audit of cash
The auditors have five objectives in the audit of cash:
:
1.
1. Consider
Consider internal control
internal control over cash transactions.
over cash transactions.
2.
2. Determine the
Determine the existence
existence of recorded cash and the client’s ownership of this asset.
of recorded cash and the client’s ownership of this asset.
3.
3. Establish the
Establish the completeness
completeness of recorded cash.
of recorded cash.
4.
4. Establish the
Establish the clerical accuracy
clerical accuracy of cash schedules.
of cash schedules.
5.
5. Determine that the
Determine that the statement presentation
statement presentation of cash is appropriate.
of cash is appropriate.
The overall objective of the audit of cash is to determine that cash is fairly presented in conformity with
The overall objective of the audit of cash is to determine that cash is fairly presented in conformity with
generally accepted accounting principles.
(a)
(a) Control Objectives
Control Objectives
The central control objectives are that:
The central control objectives are that:

 All sums are received and subsequently accounted for.
All sums are received and subsequently accounted for.

 No payments are made which should not be made.
No payments are made which should not be made.

 All receipts and payments are promptly and accurately recorded.
All receipts and payments are promptly and accurately recorded.
(b)
(b) Control Procedures
Control Procedures
11

A detailed study of the operating routines of the individual business is necessary in developing the most
A detailed study of the operating routines of the individual business is necessary in developing the most
efficient control procedures. These universal rules for achieving internal control over cash may be
efficient control procedures. These universal rules for achieving internal control over cash may be
summarized as follows:
summarized as follows:
1.
1. Do not permit any one employee to handle transaction from beginning to end.
Do not permit any one employee to handle transaction from beginning to end.
2.
2. Separate cash handling from record keeping.
Separate cash handling from record keeping.
3.
3. Centralize receiving of cash as much as possible.
Centralize receiving of cash as much as possible.
4.
4. Record cash receipts immediately.
Record cash receipts immediately.
5.
5. Encourage customers to obtain receipts and observe cash register totals.
Encourage customers to obtain receipts and observe cash register totals.
6.
6. Deposit each day’s cash receipts intact.
Deposit each day’s cash receipts intact.
7.
7. Make all disbursements by cheques with the exception of small from petty cash.
Make all disbursements by cheques with the exception of small from petty cash.
8.
8. Have monthly bank Reconciliation prepared by employees not responsible for the issuance or
Have monthly bank Reconciliation prepared by employees not responsible for the issuance or
custody of cash. The completed reconciliation should be reviewed promptly by an appropriate
custody of cash. The completed reconciliation should be reviewed promptly by an appropriate
official.
official.
9.
9. Forecast expected cash receipts and disbursements and investigate variances from forecasted
Forecast expected cash receipts and disbursements and investigate variances from forecasted
amounts.
amounts.
(a)
(a) Internal control over cash receipts.
Internal control over cash receipts.
Cash receipts resulted from a variety of activities. For example, cash is received from revenue transactions,
Cash receipts resulted from a variety of activities. For example, cash is received from revenue transactions,
short and long term borrowings, the issuance of stock, and the sale of marketable securities, long term
short and long term borrowings, the issuance of stock, and the sale of marketable securities, long term
investments, and other assets. The scope of this section is limited to cash receipts from cash sale and
investments, and other assets. The scope of this section is limited to cash receipts from cash sale and
collection from customers on credit sales. The basic internal controls over cash receipts include the
collection from customers on credit sales. The basic internal controls over cash receipts include the
following:
following:

 Authority to collect cash should be clearly defined.
Authority to collect cash should be clearly defined.

 Collections should be recorded when received.
Collections should be recorded when received.

 The collector’s cash receipts should be reconciled to the eventual banking.
The collector’s cash receipts should be reconciled to the eventual banking.

 Receipts should be banked immediately.
Receipts should be banked immediately.

 Each day’s receipts should be recorded promptly in the cashbook.
Each day’s receipts should be recorded promptly in the cashbook.

 Sales ledger account should have not access to the cash.
Sales ledger account should have not access to the cash.
The processing of receipts from cash and credit sales involves the following cash receipts functions:
The processing of receipts from cash and credit sales involves the following cash receipts functions:
-
- Receiving cash receipts.
Receiving cash receipts.
-
- Depositing cash in bank.
Depositing cash in bank.
-
- Recording the receipts.
Recording the receipts.
Segregation of duties in performing these functions is an important internal control activity.
Segregation of duties in performing these functions is an important internal control activity.
Receiving cash receipts
Receiving cash receipts
A major risk in processing cash receipts transactions is the possible theft of cash before and after a record of
A major risk in processing cash receipts transactions is the possible theft of cash before and after a record of
cash is made. Thus, control procedures should provide reasonable assurance that documentation establishing
cash is made. Thus, control procedures should provide reasonable assurance that documentation establishing
accountability is created at the moment cash is received and that the cash is subsequently safeguarded.
accountability is created at the moment cash is received and that the cash is subsequently safeguarded.
Depositing cash in bank
Depositing cash in bank
Proper physical controls over cash require that all cash receipts be deposited
Proper physical controls over cash require that all cash receipts be deposited intact
intact daily. Intact means all
daily. Intact means all
receipts should be deposited; that is cash disbursements should not be made out of un-deposited receipts.
receipts should be deposited; that is cash disbursements should not be made out of un-deposited receipts.
Recording the receipts
Recording the receipts
This function involves journalizing over the counter and mail receipts and posting mail receipts to customer
This function involves journalizing over the counter and mail receipts and posting mail receipts to customer
accounts. Controls should ensure that only valid receipts are entered and that all actual receipts entered at
accounts. Controls should ensure that only valid receipts are entered and that all actual receipts entered at
the correct amount.
the correct amount.
To ensure that only valid transactions are entered, physical access to the accounting records or computer
To ensure that only valid transactions are entered, physical access to the accounting records or computer
terminals used in recording should be restricted to authorized personnel.
terminals used in recording should be restricted to authorized personnel.
12

Check Your Progress Exercise -1
1.
1. What functions are involved in the processing of cash receipts transactions?
What functions are involved in the processing of cash receipts transactions?
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
………………………………………………………………….
………………………………………………………………….
13

2.
2. What is the meaning of
What is the meaning of deposited intact daily
deposited intact daily?
?
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
………………………………………………………………….
………………………………………………………………….
7.3.2
7.3.2 Internal Control Over Cash Disbursements
Internal Control Over Cash Disbursements
There are two cash disbursements functions as follows
There are two cash disbursements functions as follows:
:
1.
1. Paying the liability
Paying the liability
2.
2. Recording the cash disbursements.
Recording the cash disbursements.
These functions should not be performed by the same department or individual. The basic internal controls
These functions should not be performed by the same department or individual. The basic internal controls
over cash disbursements include:
over cash disbursements include:

 Unused checks should be held in a secure place.
Unused checks should be held in a secure place.

 The person who prepares checks should have no responsibility over purchase ledger or sales
The person who prepares checks should have no responsibility over purchase ledger or sales
ledger.
ledger.

 Checks should be signed only when evidence of a properly approved transaction is available.
Checks should be signed only when evidence of a properly approved transaction is available.

 These checks should be evidenced by signing the supporting documents.
These checks should be evidenced by signing the supporting documents.

 Check signatories should be restricted to the minimum practical number.
Check signatories should be restricted to the minimum practical number.

 Two signatories at least should be required except perhaps for checks of small amounts.
Two signatories at least should be required except perhaps for checks of small amounts.

 Checks should be crossed before being signed.
Checks should be crossed before being signed.

 Supporting documents should be cancelled as paid to prevent their use to support further check
Supporting documents should be cancelled as paid to prevent their use to support further check
payments.
payments.

 Checks should preferably dispatch immediately.
Checks should preferably dispatch immediately.
7.3.3
7.3.3 Control Over Petty Cash
Control Over Petty Cash

 The level and location of cash floats should be laid down formally.
The level and location of cash floats should be laid down formally.

 Cash should securely hold.
Cash should securely hold.

 There should be restricted access to the floats.
There should be restricted access to the floats.

 All expenditure should require a voucher system signed by a responsible official, not the petty
All expenditure should require a voucher system signed by a responsible official, not the petty
cashier.
cashier.

 Vouchers should be produced before the check is signed for reimbursement.
Vouchers should be produced before the check is signed for reimbursement.

 A maximum amount should be placed on a petty cash payment to discourage normal purchase
A maximum amount should be placed on a petty cash payment to discourage normal purchase
procedures being by passed.
procedures being by passed.

 Periodically the petty cash should be reconciled by an independent person.
Periodically the petty cash should be reconciled by an independent person.
Check Your Progress Exercise - 2
State the functions that apply to cash disbursements transactions.
State the functions that apply to cash disbursements transactions.
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
………………………………………………………………….
………………………………………………………………….
7.4 AUDIT PROGRAM FOR CASH
7.4 AUDIT PROGRAM FOR CASH
The following audit program indicates the general pattern of work performed by the auditors in the
The following audit program indicates the general pattern of work performed by the auditors in the
verification of cash.
verification of cash.
A.
A. Consider internal control for cash.
Consider internal control for cash.
1.
1. Obtain an understanding of internal control for cash.
Obtain an understanding of internal control for cash.
2.
2. Assess control risk and design additional tests of controls for cash.
Assess control risk and design additional tests of controls for cash.
3.
3. Perform additional tests of control for those controls, which the auditors plan to consider in
Perform additional tests of control for those controls, which the auditors plan to consider in
their assessment of control risk.
their assessment of control risk.
(a) Test the accounting records and reconciliation by re-performance.
(a) Test the accounting records and reconciliation by re-performance.
14

(b)
(b) Compare the detail of a sample of recorded disbursements in cash payments journal to
Compare the detail of a sample of recorded disbursements in cash payments journal to
accounts payable postings, purchase orders, receiving reports, invoices, and paid checks.
(c)
(c) Compare the detail of a sample of recorded cash receipts listings to the cash receipts, journal,
Compare the detail of a sample of recorded cash receipts listings to the cash receipts, journal,
accounts receivable postings, and authenticated deposit slips.
accounts receivable postings, and authenticated deposit slips.
4.
4. Reassess control risk and design substantive tests for cash.
Reassess control risk and design substantive tests for cash.
B.
B. Perform substantive tests of cash transaction and balances
Perform substantive tests of cash transaction and balances.
.
1.
1. Obtain analysis of cash balances and reconcile to the general ledger.
Obtain analysis of cash balances and reconcile to the general ledger.
2.
2. Send standard confirmation forms to banks to verify amounts on deposit.
Send standard confirmation forms to banks to verify amounts on deposit.
3.
3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date and consider the
Obtain or prepare reconciliation of bank accounts as of the balance sheet date and consider the
need to reconcile bank activity for additional months.
4.
4. Obtain a cutoff bank statement containing transactions of at least seven business days subsequent to
Obtain a cutoff bank statement containing transactions of at least seven business days subsequent to
balance sheet date.
balance sheet date.
5.
5. Count and risk cash on hand.
Count and risk cash on hand.
6.
6. Verify the client’s cutoff of cash receipts and disbursements.
Verify the client’s cutoff of cash receipts and disbursements.
7.
7. Trace all bank transfers for last week of audit year and first week of following year.
Trace all bank transfers for last week of audit year and first week of following year.
8.
8. Evaluate proper financial statement presentation and disclosure of cash.
Evaluate proper financial statement presentation and disclosure of cash.
A.
A. Consider internal control for cash.
Consider internal control for cash.
1. Obtain an understanding of internal control
1. Obtain an understanding of internal control
By understanding internal control over cash receipts and cash disbursements helps auditors to observe
By understanding internal control over cash receipts and cash disbursements helps auditors to observe
whether there is appropriate segregation of duties and to enquire who performed various functions
whether there is appropriate segregation of duties and to enquire who performed various functions
throughout the year.
2.
2. Assess control risk and design additional tests of control.
Assess control risk and design additional tests of control.
After obtaining an understanding of the client’s internal control for cash receipts and disbursements, the
After obtaining an understanding of the client’s internal control for cash receipts and disbursements, the
auditors perform their initial assessment of control risk.
auditors perform their initial assessment of control risk.
3.
3. Perform additional tests of control.
Perform additional tests of control.
Tests directed toward the effectiveness of control help to evaluate the client’s internal control and
Tests directed toward the effectiveness of control help to evaluate the client’s internal control and
determine the extent to which the auditors are justified in reducing the assessed levels of control risk for
determine the extent to which the auditors are justified in reducing the assessed levels of control risk for
assertions about the cash account.
assertions about the cash account.
The following are examples of typical tests of controls
The following are examples of typical tests of controls.
.

 Test the accounting records and Reconciliation by re-performance.
Test the accounting records and Reconciliation by re-performance.

 Compare detail of cash receipts listings to cash receipts journal, accounts receivable
Compare detail of cash receipts listings to cash receipts journal, accounts receivable
postings, and authenticated deposit slips.
postings, and authenticated deposit slips.

 Compare detail of a sample of recorded disbursements in cash payments journal,
Compare detail of a sample of recorded disbursements in cash payments journal,
15

4.
4. Reassess control risk and design substantive tests.
Reassess control risk and design substantive tests.
When the auditors have completed the procedures described above, they should reassess control risk and
When the auditors have completed the procedures described above, they should reassess control risk and
design substantive tests of cash transactions and balances.
design substantive tests of cash transactions and balances.
B. Substantive tests

 Obtain analyses of cash balances and reconcile to the general ledger.
Obtain analyses of cash balances and reconcile to the general ledger.

 Send standard confirmation forms to banks to verify amounts on deposit.
Send standard confirmation forms to banks to verify amounts on deposit.

 Obtain or prepare reconciliation’s of bank accounts as of the balance sheet date and consider the
Obtain or prepare reconciliation’s of bank accounts as of the balance sheet date and consider the

 Obtain a cut off bank statement.
Obtain a cut off bank statement.

 Count and list cash on hand.
Count and list cash on hand.

 Verify the client’s cutoff of cash receipts and disbursements.
Verify the client’s cutoff of cash receipts and disbursements.

 Trace all bank transfers for the last week of audit year and first week of following year.
Trace all bank transfers for the last week of audit year and first week of following year.

 Investigate any cheques representing large or unusual payments to related parties.
Investigate any cheques representing large or unusual payments to related parties.

 Determine proper financial statement presentation and disclosure of cash.
Determine proper financial statement presentation and disclosure of cash.
Check You Progress Exercise – 3
Check You Progress Exercise – 3
Choose the best answer.
Choose the best answer.
1.
1. Which of the following is the objective of major substantive tests of cash transactions and
Which of the following is the objective of major substantive tests of cash transactions and
balance?
balance?
a.
a. Clerical accuracy.
Clerical accuracy.
b.
b. Existence and ownership.
Existence and ownership.
c.
c. Completeness.
Completeness.
d.
d. All of the above.
All of the above.
2.
2. The balance sheet figure for cash should include all cash received on the final day of the
The balance sheet figure for cash should include all cash received on the final day of the
year and none receive subsequently.
year and none receive subsequently.
a.
a. True
True
b.
b. False
False
16

7.5 SUMMARY
7.5 SUMMARY
Cash balances are verified with a third party. Auditors can also use to bank letter to questions related to
Cash balances are verified with a third party. Auditors can also use to bank letter to questions related to
cash balances.
cash balances.
7.6 GLOSSARY
7.6 GLOSSARY
Negative confirmation:
Negative confirmation: A statement of balances due that is addressed to the customer with the request that
A statement of balances due that is addressed to the customer with the request that
the customer respond directly to the auditor only if the amount shown is incorrect.
the customer respond directly to the auditor only if the amount shown is incorrect.
Positive confirmation:
Positive confirmation: A statement of balances due that is addressed to the customer with the request that
A statement of balances due that is addressed to the customer with the request that
the customer respond directly to the auditor regardless of whether the balance is correct or incorrect.
the customer respond directly to the auditor regardless of whether the balance is correct or incorrect.
7.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
7.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check your progress Exercise -1
1.
1. -
- Receiving cash receipts, Depositing cash in bank, and Recording the receipts.
Receiving cash receipts, Depositing cash in bank, and Recording the receipts.
2. All receipts should be deposited; that is cash disbursements should not be made out of un-deposited
2. All receipts should be deposited; that is cash disbursements should not be made out of un-deposited
receipts
receipts.
.
Check your progress Exercise
Check your progress Exercise -
-2
2
1.
1. D
D 2. A
2. A
7.8 MODEL EXAM QUESTION
1.
1. The auditors’ work on cash may include an understanding of internal control and performing
The auditors’ work on cash may include an understanding of internal control and performing
tests of controls. Which of these two steps should be performed first? What is the purpose of tests of
tests of controls. Which of these two steps should be performed first? What is the purpose of tests of
controls?
controls?
2.
2. State one broad general objective of internal control for cash of the following: Cash receipts,
State one broad general objective of internal control for cash of the following: Cash receipts,
cash disbursements, and balance.
cash disbursements, and balance.
UNIT 8: RECEIVABLE / SALES AUDIT
UNIT 8: RECEIVABLE / SALES AUDIT
Contents
Contents
8.0
Aims and Objectives
8.1
8.1 Introduction
Introduction
8.2
8.2 Sources and Nature of Receivables
Sources and Nature of Receivables
8.3
8.3 Financial Reporting Standards
Financial Reporting Standards
8.4
8.4 Audit Objectives
Audit Objectives
8.5
8.5 Internal Control of Sales and Receivables
Internal Control of Sales and Receivables
8.6
8.6 Audit Program for Receivables and Sales Transactions
Audit Program for Receivables and Sales Transactions
8.7
8.7 Summary
Summary
8.8
8.10 Model Examination Questions
8.10 Model Examination Questions

 devise appropriate tests for receivables.
devise appropriate tests for receivables.
17


 explain the nature of sales and collection of receivables.
explain the nature of sales and collection of receivables.

 describe the auditors’ objectives for the audit of receivables and sales.
describe the auditors’ objectives for the audit of receivables and sales.

 describe the nature of the audit procedures to accomplish the auditors’ objectives for the audit of
describe the nature of the audit procedures to accomplish the auditors’ objectives for the audit of
receivables and sales.
receivables and sales.
8.1 INTRODUCTION
8.1 INTRODUCTION
This unit examines the audit of sales and receivables. You should bear in mind in the audit of receivables
This unit examines the audit of sales and receivables. You should bear in mind in the audit of receivables
that receivables are a product of the sales cycle and therefore the control objectives of the sales cycle are
that receivables are a product of the sales cycle and therefore the control objectives of the sales cycle are
relevant. Receivable is a general term that may refer to many types of receivables whose origin and nature
relevant. Receivable is a general term that may refer to many types of receivables whose origin and nature
may be different.
may be different.
Receivables include amounts due from customers, employees, and affiliates on open accounts, notes, and
Receivables include amounts due from customers, employees, and affiliates on open accounts, notes, and
loans and accrued interest on such balances.
loans and accrued interest on such balances.
8.2 SOURCES AND NATURE OF RECEIVABLE
8.2 SOURCES AND NATURE OF RECEIVABLE
The sales and collection cycle including the receiving of orders from customers are delivery and billing of
The sales and collection cycle including the receiving of orders from customers are delivery and billing of
merchandise to customers, and the recording and collection of receivables. Receivables from customers
merchandise to customers, and the recording and collection of receivables. Receivables from customers
include both accounts receivable and various types of notes receivable.
include both accounts receivable and various types of notes receivable.
It is important to differentiate the origin and nature of receivables to ensure their appropriate classification
It is important to differentiate the origin and nature of receivables to ensure their appropriate classification
and valuation.
and valuation.
8.3 FINANCIAL REPORTING STANDARDS
8.3 FINANCIAL REPORTING STANDARDS
Financial reporting standards for receivables require:
Financial reporting standards for receivables require:

 separation of trade from non – trade receivables.
separation of trade from non – trade receivables.

 establishment of genuine of trade receivables transactions ensuring “arms length deal”, and terms of
establishment of genuine of trade receivables transactions ensuring “arms length deal”, and terms of
sales.
sales.

 assurance of ownership disclosure.
assurance of ownership disclosure.

 assurance of collectibility of receivables.
assurance of collectibility of receivables.

 assurance of consideration for returns and allowances.
assurance of consideration for returns and allowances.

 appropriate classification of current and non - current.
appropriate classification of current and non - current.
1.4
1.4 AUDIT OBJECTIVES
AUDIT OBJECTIVES
The audit objectives for the receivables and sales relate to obtain to sufficient competent evidence about
The audit objectives for the receivables and sales relate to obtain to sufficient competent evidence about
each significant financial statement assertion that pertains receivables and sales transactions and balances.
each significant financial statement assertion that pertains receivables and sales transactions and balances.
To achieve each of these specific audit objectives, the auditors employ various parts of the audit planning
To achieve each of these specific audit objectives, the auditors employ various parts of the audit planning
and audit testing methodology.
and audit testing methodology.
The auditors’ objectives in the examination of receivables and sales are:
The auditors’ objectives in the examination of receivables and sales are:
1.
1. To consider internal control over receivables and sales transactions.
To consider internal control over receivables and sales transactions.
2.
2. To determine the existence of receivables, the clients ownership of these assets, and the
To determine the existence of receivables, the clients ownership of these assets, and the
occurrence of sales transactions.
occurrence of sales transactions.
3.
3. To establish the completeness of receivables and sales transactions.
To establish the completeness of receivables and sales transactions.
4.
4. To establish the clerical accuracy of records and supporting schedules of receivables and
To establish the clerical accuracy of records and supporting schedules of receivables and
sales.
sales.
5.
5. To determine that the valuation of receivables is at appropriate net realizable values.
To determine that the valuation of receivables is at appropriate net realizable values.
18

6.
6. To determine that the statement presentation of receivables and sales is adequate.
To determine that the statement presentation of receivables and sales is adequate.
Figure 8.1 Selected specific audit objectives for receivables and sales
Figure 8.1 Selected specific audit objectives for receivables and sales
Assertion
Assertion
Category
Category
Transaction class
Transaction class
Audit objective
Audit objective
Account balance
Account balance
Audit objective
Audit objective
Category
Category
Existence or
Existence or
Occurrence
Occurrence
Recorded sales transactions represent
Recorded sales transactions represent
goods shipped during the period.
goods shipped during the period.
Recorded cash receipts transactions
Recorded cash receipts transactions
represent cash received during the
represent cash received during the
period.
period.
Accounts receivable include all
amounts owed by the customers
amounts owed by the customers
exists at the balance sheet date.
exists at the balance sheet date.
Completeness
Completeness
All sales, cash receipts sales adjustments
All sales, cash receipts sales adjustments
that occurred during the period have
that occurred during the period have
been recorded.
been recorded.
claims on customers at the
claims on customers at the
balance sheet date.
balance sheet date.
Rights and
Rights and
Obligations
Obligations
The entity has rights to the receivables
The entity has rights to the receivables
and cash resulting from sales
and cash resulting from sales
transactions.
transactions.
Accounts receivable at the
Accounts receivable at the
balance sheet date represents
balance sheet date represents
legal claims of the entity.
legal claims of the entity.
Valuation
Valuation All sales, cash receipts and sales
All sales, cash receipts and sales
adjustments transactions are correctly
adjustments transactions are correctly
journalized, summarized, and posted.
journalized, summarized, and posted.
Accounts receivable represent
Accounts receivable represent
gross claims, On customers at
gross claims, On customers at
the balance sheet date. The
the balance sheet date. The
allowance for uncollectible
allowance for uncollectible
accounts represent a reasonable
accounts represent a reasonable
estimate.
estimate.
Presentation ad
Presentation ad
disclosure
disclosure
The details of sales, cash receipts and
The details of sales, cash receipts and
sales adjustments support their
sales adjustments support their
presentation in the financial statements.
presentation in the financial statements.
Accounts receivables are
Accounts receivables are
properly identified and
properly identified and
classified.
classified.
19

8.5 INTERNAL CONTROL OF SALES AND RECEIVABLES
8.5 INTERNAL CONTROL OF SALES AND RECEIVABLES
The objectives of internal controls over receivables are to ensure:
The objectives of internal controls over receivables are to ensure:
a.
a. All goods dispatched are invoiced.
All goods dispatched are invoiced.
b.
b. Invoicing is at correct price and discount.
Invoicing is at correct price and discount.
c.
c. Goods are only dispatched on credit to approved customers.
Goods are only dispatched on credit to approved customers.
d.
d. Invoices are recorded and related to subsequent cash receipts.
Invoices are recorded and related to subsequent cash receipts.
e.
e. Receivables are controlled and bad debts pursued.
Receivables are controlled and bad debts pursued.
f.
f. Credit notes approved.
Credit notes approved.
In addition the internal over receivables should be such that the possibility of any falsification of the
In addition the internal over receivables should be such that the possibility of any falsification of the
receivables accounts is eliminated. An important part of the controls would be to ensure that the cashier
receivables accounts is eliminated. An important part of the controls would be to ensure that the cashier
does not have access to the sales ledger, and the sales ledger clerk does not have access to cash received.
does not have access to the sales ledger, and the sales ledger clerk does not have access to cash received.
Control procedures, over sales and receivables include the following.
Control procedures, over sales and receivables include the following.
a.
a. Orders.
Orders.
-
- The orders should be checked against the customer’s account.
The orders should be checked against the customer’s account.
-
- All orders received should be recorded on pre – numbered sales
All orders received should be recorded on pre – numbered sales
order documents.
order documents.
-
- All orders should be authorized before goods are dispatched.
All orders should be authorized before goods are dispatched.
b. Dispatch.
b. Dispatch.
-
- Dispatch notes should be pre - numbered and a register kept of them
Dispatch notes should be pre - numbered and a register kept of them
to relate to sales invoices and orders.
to relate to sales invoices and orders.
-
- Goods dispatch notes should be authorized as goods leave.
Goods dispatch notes should be authorized as goods leave.
c. Invoicing
c. Invoicing
-
- Sales invoices should be authorized by a responsible official.
Sales invoices should be authorized by a responsible official.
-
- Sales invoices should be checked for prices and calculations by a
Sales invoices should be checked for prices and calculations by a
person other than the one preparing the invoice.
person other than the one preparing the invoice.
-
- All invoices should be pre – numbered consecutively.
All invoices should be pre – numbered consecutively.
-
- Copies of cancelled invoices should be retained.
Copies of cancelled invoices should be retained.
d.
d. Receivables.
Receivables.
-
- A receivable ledger control account should be prepared and checked
A receivable ledger control account should be prepared and checked
to individual sales ledger balances.
to individual sales ledger balances.
-
- Receivables ledger personnel should be independent of dispatch and
Receivables ledger personnel should be independent of dispatch and
cash receipt functions.
cash receipt functions.
-
- Statements should be sent regularly to customers.
Statements should be sent regularly to customers.
e.
e. Bad debts.
Bad debts.
-
- The authority to write off a bad debt should be given in writing and
The authority to write off a bad debt should be given in writing and
adjustments made to the accounts receivable ledger.
adjustments made to the accounts receivable ledger.
-
- The use of court action or write – off of a bad debt should be
The use of court action or write – off of a bad debt should be
authorized by an official independent of the cash receipts function.
authorized by an official independent of the cash receipts function.
8.6 AUDIT PROGRAM FOR RECEIVABLES AND SALES TRANSACTIONS
8.6 AUDIT PROGRAM FOR RECEIVABLES AND SALES TRANSACTIONS
The following audit procedures are typical of the work done in the verification of notes, accounts
The following audit procedures are typical of the work done in the verification of notes, accounts
receivable, and sales transaction.
receivable, and sales transaction.
A.
A. Consider internal control for receivables and sales
Consider internal control for receivables and sales.
.
20

1.
1. Obtain an understanding of internal control for receivables and sales. The auditors’
Obtain an understanding of internal control for receivables and sales. The auditors’
consideration of internal controls over receivables and sales may begin with the preparation of a
consideration of internal controls over receivables and sales may begin with the preparation of a
written narrative or flow chart and the completion of an internal control questionnaire. As the
written narrative or flow chart and the completion of an internal control questionnaire. As the
auditors’ confirm their understanding of the sales and collection cycle, they will observe whether
auditors’ confirm their understanding of the sales and collection cycle, they will observe whether
there is appropriate segregation of duties, and enquire as to who performed various functions
there is appropriate segregation of duties, and enquire as to who performed various functions
2.
2. Assess control risk and design additional tests of controls for receivables and sales. After
Assess control risk and design additional tests of controls for receivables and sales. After
obtain an understanding of the client’s internal control for receivables and sales transactions, the
obtain an understanding of the client’s internal control for receivables and sales transactions, the
auditors perform their initial assessment of control risk for the variant financial statement assertions.
auditors perform their initial assessment of control risk for the variant financial statement assertions.
3.
3. Perform additional tests and controls: Tests directed towards the effectiveness of control help
Perform additional tests and controls: Tests directed towards the effectiveness of control help
to evaluate the client’s internal control, and determine the extent to which the auditors are justified
to evaluate the client’s internal control, and determine the extent to which the auditors are justified
in reducing their assessed levels of control risk for the assertion about the receivables and sales
in reducing their assessed levels of control risk for the assertion about the receivables and sales
accounts. The following are examples of additional tests:
accounts. The following are examples of additional tests:
A.
A. Examine significant aspects of a sample of sales transactions.
Examine significant aspects of a sample of sales transactions.
B.
B. Compare a sample of shipping documents to related sales invoices.
Compare a sample of shipping documents to related sales invoices.
C.
C. Review the use and authorization of credit memoranda.
Review the use and authorization of credit memoranda.
D.
D. Reconcile selected cash register tapes and sales invoices with sales journals.
Reconcile selected cash register tapes and sales invoices with sales journals.
4.
4. Reassess control risk and design substantial tests.
Reassess control risk and design substantial tests. When auditors have completed the
When auditors have completed the
procedures described in the preceding sections, they should assess the extent of control risk for
procedures described in the preceding sections, they should assess the extent of control risk for
each financial statement assertions regarding receivables and sales transactions. The assessment
each financial statement assertions regarding receivables and sales transactions. The assessment
will determine the nature, extent, and timing of auditors’ substantive tests for receivables and sales.
will determine the nature, extent, and timing of auditors’ substantive tests for receivables and sales.
1.
1. Obtain an aged trail balance of trade accounts receivable and analyses of other accounts
Obtain an aged trail balance of trade accounts receivable and analyses of other accounts
receivable and reconcile to ledgers. When trial balances or analyses of accounts receivable
receivable and reconcile to ledgers. When trial balances or analyses of accounts receivable
are furnished to the auditors by the client’s employees, some independent verification of the
are furnished to the auditors by the client’s employees, some independent verification of the
listings is essential.
listings is essential.
2.
2. Obtain analyses of notes receivable and related interest.
Obtain analyses of notes receivable and related interest.
3.
3. Inspect notes on hand and confirm those not on hand with holders.
Inspect notes on hand and confirm those not on hand with holders.
4.
4. Confirm receivables with debtors.
Confirm receivables with debtors.
5.
5. Receive the year-end cutoff of sales transactions.
Receive the year-end cutoff of sales transactions.
6.
6. Perform analytical procedures for accounts receivable, sales, notes receivable, and interest
Perform analytical procedures for accounts receivable, sales, notes receivable, and interest
revenue.
revenue.
7.
7. Verify interest earned on notes and accrued interest receivable.
Verify interest earned on notes and accrued interest receivable.
8.
8. Evaluate the propriety of the client’s accounting for receivables and sales.
Evaluate the propriety of the client’s accounting for receivables and sales.
9.
9. Determine adequacy of allowance for uncollectible accounts.
Determine adequacy of allowance for uncollectible accounts.
10.
10. Ascertain whether any receivables have been pledged.
Ascertain whether any receivables have been pledged.
11.
11. Investigate fully any notes or accounts receivable from related parties.
Investigate fully any notes or accounts receivable from related parties.
12.
12. Evaluate financial statement presentation and disclosure.
Evaluate financial statement presentation and disclosure.
Check your Progress Exercise – 1
Check your Progress Exercise – 1
1.
1. Which of the following can be used as substantive test for receivables and sales
Which of the following can be used as substantive test for receivables and sales
transactions?
transactions?
(a)
(a) Confirm receivable with debtors.
Confirm receivable with debtors.
(b)
(b) Perform analytical procedures.
Perform analytical procedures.
(c)
(c) Review the year-end cutoff of sales transactions.
Review the year-end cutoff of sales transactions.
(d)
(d) All of the above.
All of the above.
2.
2. Which of the following is (are) primary audit objective for receivables/sales?
Which of the following is (are) primary audit objective for receivables/sales?
(a)
(a) Clerical accuracy
Clerical accuracy
(b)
(b) Existence
Existence
(c)
(c) Valuation
Valuation
(d)
(d) Statement Presentation
Statement Presentation
(e)
(e) All of the above
All of the above
21

3.
3. Which assertions relating to receivables/sales are addressed when auditors select
Which assertions relating to receivables/sales are addressed when auditors select
a sample of sales invoices and compare details to shipping documents?
a sample of sales invoices and compare details to shipping documents?
(a)
(a) Existence
Existence
(b)
(b) Ownership
Ownership
(c)
(c) Valuation
Valuation
(d)
(d) All
All
8.7
8.7 SUMMARY
SUMMARY
Accounts receivable may be a major asset of a company and the major procedure involves confirmation of
Accounts receivable may be a major asset of a company and the major procedure involves confirmation of
receivable with debtors. There are a large number of controls that may be required in the sales cycle due to
receivable with debtors. There are a large number of controls that may be required in the sales cycle due to
the importance of this area and the possible opportunities that exist for diverting sales away from the
the importance of this area and the possible opportunities that exist for diverting sales away from the
business and other persons benefiting.
business and other persons benefiting.
22

8.8
8.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE
ANSWER TO CHECK YOUR PROGRESS EXERCISE
1. d
1. d
1.
1. e
e
2.
2. d
d
8.9
MODEL EXAM QUESTIONS
1.
1. List control objectives for a sales cycle.
List control objectives for a sales cycle.
2.
2. How can analytical procedures assist in the audit of account receivables?
How can analytical procedures assist in the audit of account receivables?
23

UNIT 9: INVENTORY /PURCHASE AUDIT
UNIT 9: INVENTORY /PURCHASE AUDIT
Contents
Contents
9.1
9.1 Introduction
Introduction
9.2
9.2 The auditors’ Objectives in the Examination of Inventories and Purchases
The auditors’ Objectives in the Examination of Inventories and Purchases
9.3
9.3 Internal Control Over Inventories and Purchases
Internal Control Over Inventories and Purchases
9.4
9.4 Audit Procedures
Audit Procedures
9.5
9.5 Summary
Summary
9.6
9.6 Glossary
Glossary
9.7
9.8
9.8 Model Examination Question
Model Examination Question
9.0
AIMS AND OBJECTIVES

 identify fundamental internal controls over inventories and purchases.
identify fundamental internal controls over inventories and purchases.

 describe the auditors’ objectives for the audit of inventories.
describe the auditors’ objectives for the audit of inventories.

 describe the nature of the audit procedures to accomplish the auditors’ objectives for the audit
describe the nature of the audit procedures to accomplish the auditors’ objectives for the audit
of inventories.
of inventories.
9.1 INTRODUCTION
9.1 INTRODUCTION
Inventories are major items on the balance sheet, i.e. in total assets, especially in the current asset section.
Inventories are major items on the balance sheet, i.e. in total assets, especially in the current asset section.
Inventories play also a very significant and important role in preparation of income statement and
Inventories play also a very significant and important role in preparation of income statement and
determination of net income or loss.
determination of net income or loss.
This unit discusses the typical internal control procedures and the auditors’ objectives in the examination of
This unit discusses the typical internal control procedures and the auditors’ objectives in the examination of
inventories /purchases.
inventories /purchases.
The processing of purchases transactions involves the following purchasing functions:
The processing of purchases transactions involves the following purchasing functions:
-
- Requisitioning goods and services.
Requisitioning goods and services.
-
- Preparing purchase orders.
Preparing purchase orders.
-
- Receiving the goods.
Receiving the goods.
-
- Storing goods received for inventory.
Storing goods received for inventory.
-
- Preparing the payment voucher.
Preparing the payment voucher.
-
- Recording the liability.
Recording the liability.
9.2 THE AUDITORS’ OBJECTIVES IN THE EXAMINATION OF INVENTORIES AND
9.2 THE AUDITORS’ OBJECTIVES IN THE EXAMINATION OF INVENTORIES AND
PURCHASES
PURCHASES
The auditors’ have the following objectives in the examination of inventories and purchases.
The auditors’ have the following objectives in the examination of inventories and purchases.
i.
i. To consider internal control over inventories and purchases.
To consider internal control over inventories and purchases.
ii.
ii. To determine the existence of inventories, and the client’s ownership of these assets.
To determine the existence of inventories, and the client’s ownership of these assets.
iii.
iii. To establish the completeness of inventories and purchase transaction.
To establish the completeness of inventories and purchase transaction.
iv.
iv. To establish clerical accuracy of records and supporting schedules for inventories and
To establish clerical accuracy of records and supporting schedules for inventories and
purchases.
purchases.
v.
v. To determine that the valuation inventories is based on appropriate methods.
To determine that the valuation inventories is based on appropriate methods.
vi.
vi. To determine the statement presentation of inventories is adequate, including disclosure of
To determine the statement presentation of inventories is adequate, including disclosure of
classification of inventories, accounting records and any inventories pledged as collateral for loans.
classification of inventories, accounting records and any inventories pledged as collateral for loans.
24

State the functions that apply to purchases transactions.
State the functions that apply to purchases transactions.
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………
…………………………………………………………………
…………………………………………………………………
25

9.3 INTERNAL CONTROL OVER INVENTORIES AND PURCHASES CONTROL OBJECTIVES
9.3 INTERNAL CONTROL OVER INVENTORIES AND PURCHASES CONTROL OBJECTIVES
Although inventory records may vary considerably from client to client, the control objectives of a sound
Although inventory records may vary considerably from client to client, the control objectives of a sound
system of internal control over inventories are the same in all cases, namely:
system of internal control over inventories are the same in all cases, namely:
o
o Authorization and purchase procedures.
Authorization and purchase procedures.
o
o Control over goods inwards.
Control over goods inwards.
o
o Inventory records substantiated by physical counts.
Inventory records substantiated by physical counts.
o
o Control over dispatches and goods outwards.
Control over dispatches and goods outwards.
o
o Inventory levels should be controlled so that materials are available when required but that
Inventory levels should be controlled so that materials are available when required but that
inventory is not unnecessarily large. Control procedures over inventories.
inventory is not unnecessarily large. Control procedures over inventories.
Internal control procedures for inventories affect nearly all the functions involved in producing and
Internal control procedures for inventories affect nearly all the functions involved in producing and
disposing of the company’s products, purchasing, receiving, storing, issuing, processing, and shipping are
disposing of the company’s products, purchasing, receiving, storing, issuing, processing, and shipping are
the physical functions directly connected with inventories. The basic internal control procedures are the
the physical functions directly connected with inventories. The basic internal control procedures are the
following:
following:
Approval and control of documents
Approval and control of documents

 Issues from inventories should be recorded only on properly authorized requisitions.
Issues from inventories should be recorded only on properly authorized requisitions.

 Reviews of damaged, obsolete and slow moving inventories should be carried out. Any write -
Reviews of damaged, obsolete and slow moving inventories should be carried out. Any write -
offs should be authorized.
offs should be authorized.
Arithmetical accuracy
Arithmetical accuracy

 All receipts and issues should be recorded on inventory cards.
All receipts and issues should be recorded on inventory cards.

 The costing department should allocate direct and overhead costs to
The costing department should allocate direct and overhead costs to
the value of work – in – progress according to the stage of completion reached.
the value of work – in – progress according to the stage of completion reached.
Control accounts
Control accounts

 Total inventory records may be maintained and integrated with the
Total inventory records may be maintained and integrated with the
main accounting system.
main accounting system.
Comparison of assets to records
Comparison of assets to records

 Inventory levels should be checked against the records by a person independent
Inventory levels should be checked against the records by a person independent
of the stores personnel, and material differences investigated.
of the stores personnel, and material differences investigated.

 Where continuous inventory records are not kept adequately a full count should
Where continuous inventory records are not kept adequately a full count should
be held at least once a year.
be held at least once a year.

 Maximum and minimum inventory levels should be pre – determined and
Maximum and minimum inventory levels should be pre – determined and
regularly reviewed for adequacy.
regularly reviewed for adequacy.
Assess to assets and records
Assess to assets and records

 Separate centers should be identified at which goods are held.
Separate centers should be identified at which goods are held.

 Inventories should be held in their locations so that they are
Inventories should be held in their locations so that they are
safe from damage or theft.
safe from damage or theft.

 All 8 inventories should be identified and held together.
All 8 inventories should be identified and held together.

 Access to the stores should be restricted.
Access to the stores should be restricted.
9.4 AUDIT PROCEDURES
9.4 AUDIT PROCEDURES
The following audit procedures for the verification of inventories and purchases may be used by auditors:
The following audit procedures for the verification of inventories and purchases may be used by auditors:
(A)
(A) Consider internal control for inventories and purchases
Consider internal control for inventories and purchases
(1)
(1) Obtain an understanding of internal control for inventories and purchases.
Obtain an understanding of internal control for inventories and purchases.
26

In obtaining an understanding of internal control over inventory, the auditor should become
In obtaining an understanding of internal control over inventory, the auditor should become
thoroughly conversant with the procedures for purchasing, receiving, storing, and issuing
thoroughly conversant with the procedures for purchasing, receiving, storing, and issuing
goods as well as acquiring an understanding of the cost accounting system and the perpetual
goods as well as acquiring an understanding of the cost accounting system and the perpetual
records.
records.
(2)
(2) Assess control risk and design additional tests of control for inventories and purchases.
Assess control risk and design additional tests of control for inventories and purchases.
After obtaining an understanding of the client’s internal control over inventories and
After obtaining an understanding of the client’s internal control over inventories and
purchases, the auditors perform their initial assessment of control risk for the various
purchases, the auditors perform their initial assessment of control risk for the various
financial statement assertions.
financial statement assertions.
(3)
(3) Perform additional tests of controls.
Perform additional tests of controls.
Tests directed toward the effectiveness of controls help to evaluate the client’s internal
Tests directed toward the effectiveness of controls help to evaluate the client’s internal
control and to determine the extent to which the auditors are justified in reducing their
control and to determine the extent to which the auditors are justified in reducing their
assessed level of control risk for the assessments about the inventory and purchase accounts.
assessed level of control risk for the assessments about the inventory and purchase accounts.
The following are examples of typical additional test.
The following are examples of typical additional test.
a.
a. Examine significant aspects of a sample of purchase transactions.
Examine significant aspects of a sample of purchase transactions.
b.
b. Test the cost accounting system.
Test the cost accounting system.
(4)
(4) Reassess control risk and design substantive tests.
Reassess control risk and design substantive tests.
B.
B. Substantive test.
Substantive test.
1.
1. Obtain listings of inventory and reconcile to ledgers.
Obtain listings of inventory and reconcile to ledgers.
2.
2. Evaluate the client’s planning of physical inventory.
Evaluate the client’s planning of physical inventory.
3.
3. Observe the taking of physical inventory and make test counts.
Observe the taking of physical inventory and make test counts.
4.
4. Review the year – end cutoff of purchases and sales transactions.
Review the year – end cutoff of purchases and sales transactions.
5.
5. Obtain a copy of the completed physical inventory, test its clerical accuracy,
Obtain a copy of the completed physical inventory, test its clerical accuracy,
and trace test counts.
and trace test counts.
6.
6. Evaluate the bales and methods of inventory pricing.
Evaluate the bales and methods of inventory pricing.
7.
7. Review inventory quality and condition.
Review inventory quality and condition.
8.
8. Perform analytical procedures.
Perform analytical procedures.
9.
9. Determine whether any inventories have been pledged and review purchase
Determine whether any inventories have been pledged and review purchase
and sales commitments.
and sales commitments.
10.
10. Evaluate financial statement presentation of inventories, including the
Evaluate financial statement presentation of inventories, including the
adequacy of disclosure.
adequacy of disclosure.
Say true or false
Say true or false
1.
1. Inventories play significant role in the preparation of both balance sheet and
Inventories play significant role in the preparation of both balance sheet and
income statement.
income statement.
2.
2. The financial statement assertion of valuation is not related to inventories.
The financial statement assertion of valuation is not related to inventories.
3.
3. Adjustments to inventory records should be authorized.
Adjustments to inventory records should be authorized.
4.
4. Efficient and effective inventory taking requires careful planning in advance.
Efficient and effective inventory taking requires careful planning in advance.
5.
5. Auditors should not observe the quality or condition of inventories
Auditors should not observe the quality or condition of inventories
9.5 SUMMARY
9.5 SUMMARY
This unit discusses the following key points for inventories and purchases:
This unit discusses the following key points for inventories and purchases:
o
o Inventory controls focus goods movements, authorization procedures and physical counts.
Inventory controls focus goods movements, authorization procedures and physical counts.
o
o Tests of control for inventory focus on material movement authorization, and the control of
Tests of control for inventory focus on material movement authorization, and the control of
inventory against records.
inventory against records.
o
o The observation of physical count by auditors helps them to identify an inventory of
The observation of physical count by auditors helps them to identify an inventory of
questionable quality or condition.
questionable quality or condition.
9.6 GLOSSARY
9.6 GLOSSARY
27

Confirmation: -
Confirmation: - A type of documentary evidence that is created outside the client and transmitted directly
A type of documentary evidence that is created outside the client and transmitted directly
to the auditors.
to the auditors.
Observation: -
Observation: - The auditors’ evidence – gathering technique that provides physical evidence.
The auditors’ evidence – gathering technique that provides physical evidence.
Purchase commitment: -
Purchase commitment: - A contractual obligation to purchase goods at fixed prices, entered into well in
A contractual obligation to purchase goods at fixed prices, entered into well in
advance of scheduled delivery dates.
advance of scheduled delivery dates.
Sales commitments: -
Sales commitments: - A contractual obligation to sell goods at fixed prices, entered into well in advance of
A contractual obligation to sell goods at fixed prices, entered into well in advance of
scheduled delivery dates.
scheduled delivery dates.
9.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISE
9.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISE
B.
B. Refer Section 9.3
Refer Section 9.3
1. True
1. True 2. False
2. False 3. True
3. True 4. True
4. True 5. False
5. False
28

The observation of a client’s physical inventory is mandatory auditing procedure when practicable and
The observation of a client’s physical inventory is mandatory auditing procedure when practicable and
possible for the auditors to carry out and when inventories are material.
possible for the auditors to carry out and when inventories are material.
Required
Required
a.
a. Why is the observation of physical inventory a mandatory procedure?
Why is the observation of physical inventory a mandatory procedure?
Explain.
Explain.
b.
b. Under what circumstances is observation of physical inventory
Under what circumstances is observation of physical inventory
impracticable or impossible?
impracticable or impossible?
evanting to both the profession and society. Clearly the existence of legal responsibility is an important
evanting to both the profession and society. Clearly the existence of legal responsibility is an important
deterrent to the inadequate and even dishonest activities of some auditors.
deterrent to the inadequate and even dishonest activities of some auditors.
2.7
2.7 GLOSSARY
GLOSSARY
Ethics:
Ethics: The moral principles or rules of conduct recognized by an individual or particular group of
The moral principles or rules of conduct recognized by an individual or particular group of
individuals.
individuals.
Fraud
Fraud: Knowing intent to deceive.
: Knowing intent to deceive.
Gross negligence:
Gross negligence: Fragrant negligence that is tantamount to a reckless departure from the standard of due
Fragrant negligence that is tantamount to a reckless departure from the standard of due
care.
care.
Privity:
Privity: A contractual relationship.
A contractual relationship.
1.
1. The basic purpose of a code of ethics is to provide members with professional attitude and
The basic purpose of a code of ethics is to provide members with professional attitude and
maintain the confidence of users.
maintain the confidence of users.
2.
2. d
d 3. a
3. a
Check Your Progress Exercise
– 2
1.
1. b
b 2. b
2. b
2.
2. Auditors must not only to be appear independent; they must also be independent in fact.
Auditors must not only to be appear independent; they must also be independent in fact.
Required
Required
(a) Explain the concept of an “auditor’s independence” as it applies to third-party reliance upon financial
(a) Explain the concept of an “auditor’s independence” as it applies to third-party reliance upon financial
statements.
statements.
(b)
(b) What determines whether or not an auditor is independent in fact?
What determines whether or not an auditor is independent in fact?
(c)
(c) Explain how an auditor may be independent in fact but not appear to be
Explain how an auditor may be independent in fact but not appear to be
independent.
independent.
3.
3. How does the prudent man concept affect the liability of the auditor?
How does the prudent man concept affect the liability of the auditor?
29

4.
4. What is meant by “contributory negligence”? Under what conditions will this likely to be a
What is meant by “contributory negligence”? Under what conditions will this likely to be a
successful defense?
successful defense?
Part II. Select the Best Answer
Part II. Select the Best Answer
1.
1. The CPA should not undertake an engagement if the fee is based upon which
The CPA should not undertake an engagement if the fee is based upon which
of the following?
of the following?
a)
a) The findings of a taxing authority.
The findings of a taxing authority.
b)
b) A percentage of audit net income
A percentage of audit net income
c)
c) Per diem rates.
Per diem rates.
d)
d) Rates set by a city ordinance.
Rates set by a city ordinance.
2.
2. In a common law action against an accountant, the lack of privity is a viable
In a common law action against an accountant, the lack of privity is a viable
defense if the plaintiff:
defense if the plaintiff:
a)
a) is a creditor of the client who sues the accountant for negligence.
is a creditor of the client who sues the accountant for negligence.
b)
b) can prove the presence of gross negligence, which amounts to a
can prove the presence of gross negligence, which amounts to a
reckless disregard for the truth
reckless disregard for the truth
c)
c) is the accountant’s client.
is the accountant’s client.
d)
d) bases his action on fraud.
bases his action on fraud.
UNIT 3: AUDITING PRINCIPLES AND TOOLS
UNIT 3: AUDITING PRINCIPLES AND TOOLS
Contents
Contents
3.1
3.1 Introduction
Introduction
3.2
3.2 Auditing Objectives
Auditing Objectives
3.3
3.3 Auditing Principles
Auditing Principles
3.4
3.4 Audit Standards
Audit Standards
3.5
3.5 Audit Planning and Audit Program
Audit Planning and Audit Program
3.6
3.6 Audit Working Papers
Audit Working Papers
3.7
3.7 Audit Sampling
Audit Sampling
3.8
3.8 Summary
Summary
3.9
3.9 Glossary
Glossary
3.10
3.11
3.0 AIMS AND OBJECTIVE
3.0 AIMS AND OBJECTIVE

 Be aware of basic auditing principles.
Be aware of basic auditing principles.

 Be aware of planning issues for an audit.
Be aware of planning issues for an audit.

 State the typical contents of working papers.
State the typical contents of working papers.

 Describe sampling as applied to auditing.
Describe sampling as applied to auditing.
3.1
3.1 INTRODUCTION
INTRODUCTION
The objectives of each audit must be clearly specified in order to ensure appropriate goal achievement.
The objectives of each audit must be clearly specified in order to ensure appropriate goal achievement.
Appropriate auditing principles and standards should be developed by auditors to direct the objectives.
Appropriate auditing principles and standards should be developed by auditors to direct the objectives.
Audit planning is a vital area of the audit which is primarily conducted at the beginning of the audit process.
Audit planning is a vital area of the audit which is primarily conducted at the beginning of the audit process.
This unit also considers the basic contents of audit working papers and audit sampling.
This unit also considers the basic contents of audit working papers and audit sampling.
3.2
3.2 AUDIT OBJECTIVES
AUDIT OBJECTIVES
The objective of the ordinary examination of financial statements by the auditor is expression of an opinion
The objective of the ordinary examination of financial statements by the auditor is expression of an opinion
on the fairness of the financial statements. It is customary in the audit to identify audit objectives for the
on the fairness of the financial statements. It is customary in the audit to identify audit objectives for the
audit in general and for each account reported in the financial statements. These objectives are derived from
audit in general and for each account reported in the financial statements. These objectives are derived from
management’s assertions.
management’s assertions.
The auditor’s objectives are closely related to management assertions. Audit objectives are intended to
The auditor’s objectives are closely related to management assertions. Audit objectives are intended to
provide a framework to help the auditor accumulate sufficient and competent evidence required by the third
provide a framework to help the auditor accumulate sufficient and competent evidence required by the third
standard of fieldwork and decide the proper evidence to accumulate given the circumstances of the
standard of fieldwork and decide the proper evidence to accumulate given the circumstances of the
engagement.
engagement.
30

A distinction must be made between general audit objectives and specific audit objectives for each account
A distinction must be made between general audit objectives and specific audit objectives for each account
balance. The general audit objectives discussed here are applicable to every account balance but stated in
balance. The general audit objectives discussed here are applicable to every account balance but stated in
broad terms. Specific audit objectives are applied to each account balance on the financial statement.
broad terms. Specific audit objectives are applied to each account balance on the financial statement.
The relevance of the audit evidence should be considered in relation to the general audit objectives of
The relevance of the audit evidence should be considered in relation to the general audit objectives of
statements. To achieve this objective the auditor needs to support the following financial statement
statements. To achieve this objective the auditor needs to support the following financial statement
assertions (i.e. assertions by management embodied in the financial statements).
assertions (i.e. assertions by management embodied in the financial statements).
1.
1. Existence: -
Existence: - an asset or liability exists at a given date. Auditors spend a great deal of time on this
an asset or liability exists at a given date. Auditors spend a great deal of time on this
assertion confirming the existence of assets such as inventories, plant assets, receivable, and cash.
assertion confirming the existence of assets such as inventories, plant assets, receivable, and cash.
Clearly this is a fundamental assertion; no other assertion is relevanting if the asset or liability does
Clearly this is a fundamental assertion; no other assertion is relevanting if the asset or liability does
not exist.
not exist.
2.
2. Completeness: -
Completeness: - there are no unrecorded assets or liabilities, transaction or events.
there are no unrecorded assets or liabilities, transaction or events.
3.
3. Occurrence: -
Occurrence: - a transaction or event occurred during the relevant accounting period (i.e. has correct
a transaction or event occurred during the relevant accounting period (i.e. has correct
cut-off been applied?).
cut-off been applied?).
4.
4. Measurement: -
Measurement: - a transaction or event is recorded at the proper amount and in the correct period.
a transaction or event is recorded at the proper amount and in the correct period.
5.
5. Ownership: -
Ownership: - an asset pertains (i.e. belongs) to the entity.
an asset pertains (i.e. belongs) to the entity.
6.
6. Valuation: -
Valuation: - the asset or liability is recorded at an appropriate carrying value.
the asset or liability is recorded at an appropriate carrying value.
7.
7. Presentation and disclosure: -
Presentation and disclosure: - must be in accordance with the relevant legislation and accounting
must be in accordance with the relevant legislation and accounting
standards (i.e. the applicable financial reporting framework).
standards (i.e. the applicable financial reporting framework).
After the general objectives are understood, specific objectives for each account balance on the financial
After the general objectives are understood, specific objectives for each account balance on the financial
statements can be developed.
statements can be developed.
Check Your Progress Exercise-1
Check Your Progress Exercise-1
1. What are assertions and what are the seven classifications of assertions?
1. What are assertions and what are the seven classifications of assertions?
3.3
3.3 AUDITING PRINCIPLES
AUDITING PRINCIPLES
Auditing principles are generally, guidelines that help direct or chart goals and aims. Principles are based
Auditing principles are generally, guidelines that help direct or chart goals and aims. Principles are based
on concepts or assumptions, and/or developed from particular observations. The following are the basic
on concepts or assumptions, and/or developed from particular observations. The following are the basic
principles:
principles:
(a)
(a) Integrity, objectivity and independence
Integrity, objectivity and independence. The auditor should be straightforward, honest, and
. The auditor should be straightforward, honest, and
sincere in his approach to his professional work.
sincere in his approach to his professional work.
(b)
(b) Confidentiality: -
Confidentiality: - the audit should respect the confidentiality of information acquired in the course
the audit should respect the confidentiality of information acquired in the course
of his work and should not disclose any such information to a third party without specific authority
of his work and should not disclose any such information to a third party without specific authority
unless there is legal or professional duty to disclose.
unless there is legal or professional duty to disclose.
(c)
(c) Skills and competence: -
Skills and competence: - the audit should be performed and the reports prepared with due
the audit should be performed and the reports prepared with due
professional care by persons who have adequate training, experience and competence in auditing.
professional care by persons who have adequate training, experience and competence in auditing.
(d)
(d) Documentation: -
Documentation: - the auditor should document matters which are important in providing evidence
the auditor should document matters which are important in providing evidence
that the auditor was carried out with the basic principles.
that the auditor was carried out with the basic principles.
(e)
(e) Planning: -
Planning: - the auditor should plan his work to enable him to conduct an effective audit in efficient
the auditor should plan his work to enable him to conduct an effective audit in efficient
and timely manner.
and timely manner.
(f)
(f) Audit evidence:
Audit evidence: - the auditor should obtain sufficient appropriate audit evidence through the
- the auditor should obtain sufficient appropriate audit evidence through the
performance of compliance and substantive procedures to enable him to draw conclusion there from
performance of compliance and substantive procedures to enable him to draw conclusion there from
and give opinion on the financial statements.
and give opinion on the financial statements.
(g)
(g) Accounting system and internal control:
Accounting system and internal control: The auditor should gain or understanding of the
The auditor should gain or understanding of the
accounting system and related internal controls to determine the nature, extent, and timing of audit
accounting system and related internal controls to determine the nature, extent, and timing of audit
procedures.
procedures.
3.4 AUDIT STANDARDS
3.4 AUDIT STANDARDS
Standards are authoritative rules for measuring the quality of performance. The existence of generally
Standards are authoritative rules for measuring the quality of performance. The existence of generally
accepted auditing standards is evidence that auditors are very concerned with the maintenance of a
accepted auditing standards is evidence that auditors are very concerned with the maintenance of a
uniformly high quality of audit work by all independent public accountants.
uniformly high quality of audit work by all independent public accountants.
The 10 GAAS are stated in their entirety as follows:
The 10 GAAS are stated in their entirety as follows:
General Standards
General Standards
2.
2. The examination is to be performed by a person or persons having adequate technical
The examination is to be performed by a person or persons having adequate technical
training and proficiency as auditor.
training and proficiency as auditor.
31

3.
3. In all matters relating to the assignment, an independence in mental attitude is to be
In all matters relating to the assignment, an independence in mental attitude is to be
maintained by the auditor or auditors.
maintained by the auditor or auditors.
4.
4. Due professional care is to be exercised in the performance of the examination and the
Due professional care is to be exercised in the performance of the examination and the
preparation of the report.
preparation of the report.
Standards of fieldwork
1.
1. The work is to be adequately planned and assistants, if any, are to be properly supervised.
The work is to be adequately planned and assistants, if any, are to be properly supervised.
2.
2. The auditor should obtain a sufficient understanding of the internal control structure to plan
The auditor should obtain a sufficient understanding of the internal control structure to plan
the audit and to determine the nature, extent and timing of tests to be performed.
the audit and to determine the nature, extent and timing of tests to be performed.
3.
3. Sufficient competent evidential matter is to be obtained through inspection, observation,
Sufficient competent evidential matter is to be obtained through inspection, observation,
inquiries, and confirmation to afford a reasonable basis for an opinion regarding the financial statements
inquiries, and confirmation to afford a reasonable basis for an opinion regarding the financial statements
under examination.
under examination.
Standards of reporting
Standards of reporting
1.
1. The report shall state whether the financial statements are presented in accordance with
The report shall state whether the financial statements are presented in accordance with
2.
2. The report shall identify those circumstances in which such principles have not been
The report shall identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period.
consistently observed in the current period in relation to the preceding period.
3.
3. Informative disclosures in the financial statements are to be regarded as reasonably adequate
Informative disclosures in the financial statements are to be regarded as reasonably adequate
unless otherwise stated in the report.
unless otherwise stated in the report.
4.
4. The report shall either contain an expression of opinion regarding the financial statements,
The report shall either contain an expression of opinion regarding the financial statements,
taken as a whole, or an assertion to the effect than an opinion cannot be expressed.
taken as a whole, or an assertion to the effect than an opinion cannot be expressed.
Keep in mind, however, that these standards represent the minimum requirements for all audit engagements.
Keep in mind, however, that these standards represent the minimum requirements for all audit engagements.
What three categories are GAAS divided into?
What three categories are GAAS divided into?
3.5 AUDIT PLANNING AND AUDIT PROGRAM
3.5 AUDIT PLANNING AND AUDIT PROGRAM
The first standard of fieldwork states:
The first standard of fieldwork states:
“The work is to be adequately planned, and assistants, if any, are to be properly supervised.”
“The work is to be adequately planned, and assistants, if any, are to be properly supervised.”
The concept of adequate planning includes investigating a prospective client before deciding whether to
The concept of adequate planning includes investigating a prospective client before deciding whether to
accept the engagement, obtaining an understanding of the client’s business operations, and developing an
accept the engagement, obtaining an understanding of the client’s business operations, and developing an
overall strategy to organize, coordinate, and schedule the activities of the audit staff.
overall strategy to organize, coordinate, and schedule the activities of the audit staff.
In planning the audit the auditor needs to consider the following:
In planning the audit the auditor needs to consider the following:
1.
1. The terms of the engagement and the expected date of the report.
The terms of the engagement and the expected date of the report.
2.
2. The nature of the client’s business, include applicable statutory and contractual requirements.
The nature of the client’s business, include applicable statutory and contractual requirements.
3.
3. The experience gained during previous audit engagements.
The experience gained during previous audit engagements.
4.
4. The accounting policies and degree of complexity of the accounting system.
The accounting policies and degree of complexity of the accounting system.
5.
5. Materiality and the components of audit risk.
Materiality and the components of audit risk.
6.
6. Any involvement of other auditor.
Any involvement of other auditor.
7.
7. Any involvement of internal auditors and persons having special expertise.
Any involvement of internal auditors and persons having special expertise.
8.
8. The intended reliance on internal control.
The intended reliance on internal control.
9.
9. The level of experience and the number of audit staff for the engagement.
The level of experience and the number of audit staff for the engagement.
10.
10. The timing and effectiveness of performing of the audit procedures.
The timing and effectiveness of performing of the audit procedures.
(a)
(a) Client acceptance
Client acceptance
The auditors should investigate the history of the prospective client, including such matters as the identities
The auditors should investigate the history of the prospective client, including such matters as the identities
and reputations of the directors, officers, and major shareholders, its financial statements and audit report.
and reputations of the directors, officers, and major shareholders, its financial statements and audit report.
Sources of information
Sources of information

 Communication with predecessor auditors.
Communication with predecessor auditors.

 Make enquiries of other third parties (e.g. banker.).
Make enquiries of other third parties (e.g. banker.).
 Consult the client’s legal counsel.
Consult the client’s legal counsel.
(b)
(b) Obtaining the engagement
Obtaining the engagement
After the auditors have collected the necessary information on the potential client, they will be in a position
After the auditors have collected the necessary information on the potential client, they will be in a position
to assess the various risk involved with the audit and determine whether to attempt to obtain the
to assess the various risk involved with the audit and determine whether to attempt to obtain the
engagement. Often they will be asked to submit a proposal which will include information on the nature of
engagement. Often they will be asked to submit a proposal which will include information on the nature of
32

services that the firm wills offer, the qualification of the firm’s personnel, and other information to convince
services that the firm wills offer, the qualification of the firm’s personnel, and other information to convince
the prospective client to select the firm.
the prospective client to select the firm.
Fee arrangement:
Fee arrangement: when the business engages the services of independent public accountant, it will usually
when the business engages the services of independent public accountant, it will usually
ask for an estimate of the cost of the audit.
ask for an estimate of the cost of the audit.
Engagement letter:
Engagement letter: The preliminary understandings with the client should be summarized by the auditors in
The preliminary understandings with the client should be summarized by the auditors in
an engagement letter, making clear the nature of the engagement, any limitations on the scope of the audit,
an engagement letter, making clear the nature of the engagement, any limitations on the scope of the audit,
work to be performed by the client’s staff, schedule dates for performance and completion of examination,
work to be performed by the client’s staff, schedule dates for performance and completion of examination,
and the basis for computing the auditors’ fee.
and the basis for computing the auditors’ fee.
(c) Obtaining an understanding of the client’s business.
(c) Obtaining an understanding of the client’s business.
After the engagement is accepted, the auditors must obtain a detailed understanding of such factors as the
After the engagement is accepted, the auditors must obtain a detailed understanding of such factors as the
client’s financial position and operating results, organization structure, product lines, and methods of
client’s financial position and operating results, organization structure, product lines, and methods of
production and distribution. This will help auditors to evaluate the appropriateness of the accounting
production and distribution. This will help auditors to evaluate the appropriateness of the accounting
principles in use or the reasonableness of the many estimates and assumptions embodied in the client’s
principles in use or the reasonableness of the many estimates and assumptions embodied in the client’s
financial statements.
(d) Developing an overall audit strategy
(d) Developing an overall audit strategy
After obtaining knowledge of the client’s business, the auditor should formulate an overall audit strategy for
After obtaining knowledge of the client’s business, the auditor should formulate an overall audit strategy for
the upcoming engagement. The best audit strategy is the approach that results in the most
the upcoming engagement. The best audit strategy is the approach that results in the most efficient
efficient audit.
audit.
In planning an audit, the auditors must consider carefully the appropriate levels of
In planning an audit, the auditors must consider carefully the appropriate levels of materiality
materiality and
and audit risk.
audit risk.
Materiality:
Materiality: In planning the audit, auditors should design their audit procedures to avoid wasting time
In planning the audit, auditors should design their audit procedures to avoid wasting time
searching for immaterial misstatements that cannot affect their report.
searching for immaterial misstatements that cannot affect their report.
Audit risk:
Audit risk: The term audit risk refers to the possibility that the auditors may unknowingly fail to
The term audit risk refers to the possibility that the auditors may unknowingly fail to
appropriately modify their opinion on financial statements that are materially misstated.
appropriately modify their opinion on financial statements that are materially misstated.
In developing an audit plan, the auditors must consider factors that affect audit risk.
In developing an audit plan, the auditors must consider factors that affect audit risk.
(e) Audit plans
(e) Audit plans
The planning process is documented in the audit working papers through the presentation of
The planning process is documented in the audit working papers through the presentation of audit plans,
audit plans,
audit programs,
audit programs, and
and time budget.
time budget. An audit plan is an overview of the engagement, outlining the nature and
An audit plan is an overview of the engagement, outlining the nature and
characteristics of the client’s business operations and the overall audit strategy. A typical audit plan
characteristics of the client’s business operations and the overall audit strategy. A typical audit plan
includes the following:
includes the following:
2.
2. Description of the client’s company-its structure, nature of business, & organization.
Description of the client’s company-its structure, nature of business, & organization.
3.
3. Objectives of the audit.
Objectives of the audit.
4.
4. Nature and of extent of other services.
Nature and of extent of other services.
5.
5. Timing and scheduling of audit work.
Timing and scheduling of audit work.
6.
6. Work to be done by the client’s staff.
Work to be done by the client’s staff.
7.
7. Staffing requirement during the engagement.
Staffing requirement during the engagement.
8.
8. Target dates for completing major segments of the engagement.
Target dates for completing major segments of the engagement.
9.
9. Preliminary judgment about materiality and risk levels for the engagement.
Preliminary judgment about materiality and risk levels for the engagement.
(f) Designing audit programs
(f) Designing audit programs
An audit program is a detailed list of audit procedures to be performed in the course of the examination. An
An audit program is a detailed list of audit procedures to be performed in the course of the examination. An
audit program is designed to accomplish certain objectives with respect to each major account in the
audit program is designed to accomplish certain objectives with respect to each major account in the
financial statements. These objectives follow directly from the assertions that are contained in the client’s
financial statements. These objectives follow directly from the assertions that are contained in the client’s
3.6 AUDIT WORKING PAPERS
3.6 AUDIT WORKING PAPERS
Working papers are records kept by the auditor of the procedures applied, the test performed, the
Working papers are records kept by the auditor of the procedures applied, the test performed, the
information obtained, and the pertinent conclusions reached in the audit. For example, when samples are
information obtained, and the pertinent conclusions reached in the audit. For example, when samples are
takes for audit tests, the items drawn must be recorded and computations must be made.
takes for audit tests, the items drawn must be recorded and computations must be made.
Working papers provide:
Working papers provide:

 The principal support for the auditor’s report.
The principal support for the auditor’s report.

 A means for coordinating and supervising the audit, and.
A means for coordinating and supervising the audit, and.

 Evidence that the audit was made in accordance with GAAS.
Evidence that the audit was made in accordance with GAAS.
Working papers normally include the audit plan and programs, documentation of the auditor’s
Working papers normally include the audit plan and programs, documentation of the auditor’s
understanding of the internal control structure, the assessed level of control risk, account analyses
understanding of the internal control structure, the assessed level of control risk, account analyses
explaining the composition of account balances, reconciliation of related records, letters of confirmation and
explaining the composition of account balances, reconciliation of related records, letters of confirmation and
33

representation, recommended journal entries if necessary to correct the accounts, and trial balances and
representation, recommended journal entries if necessary to correct the accounts, and trial balances and
other schedules that summarize the contents of other working papers.
other schedules that summarize the contents of other working papers.
3.7 AUDIT SAMPLING
3.7 AUDIT SAMPLING
1.
1. Definition:
Definition: Application of audit procedures to less than 100 % of the items within an account
Application of audit procedures to less than 100 % of the items within an account
balance or class of transactions to obtain and evaluate audit evidence about some characteristic of the
balance or class of transactions to obtain and evaluate audit evidence about some characteristic of the
items selected in order to form or assist in forming a conclusion concerning the population.
items selected in order to form or assist in forming a conclusion concerning the population.
Sampling risk
Sampling risk
Because the auditor dose not examine all the items in the population when applying audit sampling, there is
Because the auditor dose not examine all the items in the population when applying audit sampling, there is
a risk that the conclusion that he draws will be different from that which he would have drawn had he
a risk that the conclusion that he draws will be different from that which he would have drawn had he
examined the entire population. This is ‘sampling risk’.
examined the entire population. This is ‘sampling risk’.
The following are the basic factors affecting sample size:
The following are the basic factors affecting sample size:

 Population size.
Population size.

 Standard deviation.
Standard deviation.

 Materiality.
Materiality.

 Reliability.
Reliability.
Statistical and non-statistical sampling
Statistical and non-statistical sampling
Statistical sampling involves the use of mathematical procedures, such as probability theory to draw
Statistical sampling involves the use of mathematical procedures, such as probability theory to draw
conclusions reached about the population. Non-statistical sampling techniques rely on the auditors’
conclusions reached about the population. Non-statistical sampling techniques rely on the auditors’
judgment to draw conclusions.
judgment to draw conclusions.
2. Constructing sampling.
2. Constructing sampling.
The steps involved in sampling can be summarized as follows:
The steps involved in sampling can be summarized as follows:
o
o Sample design: -
Sample design: - when designing an audit sample, the auditor should consider the specific
when designing an audit sample, the auditor should consider the specific
audit objectives, the population from which the auditor wishes to sample, and the sample size.
audit objectives, the population from which the auditor wishes to sample, and the sample size.
o
o Selection of the sample: -
Selection of the sample: - the auditor should select sample items in such a way that the
the auditor should select sample items in such a way that the
sample clan be expected to be representative of the population.
sample clan be expected to be representative of the population.
o
o Evaluation of the sample: -
Evaluation of the sample: - having carried out, on each sample item; those audit procedures
having carried out, on each sample item; those audit procedures
that are appropriate to the particular audit objective, the auditor should:
that are appropriate to the particular audit objective, the auditor should:
(a)
(a) Analyze any errors detected in the sample.
Analyze any errors detected in the sample.
(b)
(b) Project the errors found in the sample to the population, and
Project the errors found in the sample to the population, and
(c)
(c) Reassess the sampling risk.
Reassess the sampling risk.
1.
1. Define sampling risk.
Define sampling risk.
3.8 SUMMARY
3.8 SUMMARY
This is an important unit that covers the need for properly documented planning, risk analysis, and the
This is an important unit that covers the need for properly documented planning, risk analysis, and the
production of an overall audit plan and audit program.
production of an overall audit plan and audit program.
Working papers are important as they record the various elements of audit evidence obtained sampling is a
Working papers are important as they record the various elements of audit evidence obtained sampling is a
necessary and valid means of forming conclusions on audit evidence. The Sampling process involves
necessary and valid means of forming conclusions on audit evidence. The Sampling process involves
sample design, selection of the sample, and evaluation of the sample.
sample design, selection of the sample, and evaluation of the sample.
3.9 GLOSSARY
3.9 GLOSSARY
Client assertions:
Client assertions: Explicit or implicit representations by management that are embodied in the financial
Explicit or implicit representations by management that are embodied in the financial
statements.
statements.
Working papers:
Working papers: The trial balances, checklists, programs, and other documentations that compose
The trial balances, checklists, programs, and other documentations that compose
evidence that the auditor has performed the audit in conformity with generally accepted auditing standards.
evidence that the auditor has performed the audit in conformity with generally accepted auditing standards.
3.10 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
Assertions are explicit or implicit representations by management that are embodied in the financial
Assertions are explicit or implicit representations by management that are embodied in the financial
statements. These financial statement assertions are completeness, occurrence, measurement, ownership,
statements. These financial statement assertions are completeness, occurrence, measurement, ownership,
valuation, and presentation and disclosure.
valuation, and presentation and disclosure.
1.
1. General standards
General standards
34

2.
2. Standards of fieldwork
3.
3. Standards of reporting.
Standards of reporting.
1.
1. Sampling risk is the auditor’s conclusion based on a sample may be different from the conclusion he
Sampling risk is the auditor’s conclusion based on a sample may be different from the conclusion he
or she would reach if the test were applied to an entire population.
or she would reach if the test were applied to an entire population.
3.11 EXAM TYPE QUESTIONS
3.11 EXAM TYPE QUESTIONS
Part I. Select the Best Answer
Part I. Select the Best Answer
1.
1. Which of the following should the auditors obtain form the predecessor auditor before
Which of the following should the auditors obtain form the predecessor auditor before
accepting the engagement?
accepting the engagement?
(a)
(a) Analysis of balance sheet accounts.
Analysis of balance sheet accounts.
(b)
(b) Analysis of income statement accounts.
Analysis of income statement accounts.
(c)
(c) All matters of continuing accounting significance.
All matters of continuing accounting significance.
(d)
(d) Facts that might bear on the integrity of management.
Facts that might bear on the integrity of management.
2.
2. Which of the following is an element of sampling risk?
Which of the following is an element of sampling risk?
(a)
(a) Choosing an audit procedure that is inconsistent with the audit objective.
Choosing an audit procedure that is inconsistent with the audit objective.
(b)
(b) Concluding that no material misstatement exists based on taking a sample that includes no
Concluding that no material misstatement exists based on taking a sample that includes no
misstatements from a materially misstated population.
misstatements from a materially misstated population.
(c)
(c) Failing to detect an error an error on a document that has been inspected by an auditor.
Failing to detect an error an error on a document that has been inspected by an auditor.
(d)
(d) Failing to perform audit procedures that are required by the sampling plan.
Failing to perform audit procedures that are required by the sampling plan.
Part II. Short Answer
Part II. Short Answer
1. Financial statements contain certain broad assertions regarding the accounts and classes of transaction
1. Financial statements contain certain broad assertions regarding the accounts and classes of transaction
included in the financial statements.
included in the financial statements.
(a)
(a) Who makes the assertions?
Who makes the assertions?
(b)
(b) List and describe each of the assertions
List and describe each of the assertions
UNIT 4:
UNIT 4: THE AUDITING PROCESS
THE AUDITING PROCESS
Contents
Contents
4.1
4.1 Introduction
Introduction
4.2
4.2 The Examination Process
The Examination Process
4.3
4.3 Audit Evidence
Audit Evidence
4.3.1
4.3.1 Sufficient, Appropriate Evidence
Sufficient, Appropriate Evidence
4.3.2
4.3.2 Procedures to Obtain Evidence
Procedures to Obtain Evidence
4.3.3
4.3.3 Sufficiency of Evidence
Sufficiency of Evidence
4.3.4
4.3.4 Appropriateness of Audit Evidence
Appropriateness of Audit Evidence
4.4
4.4 Working Papers
Working Papers
4.4.1
4.4.1 Functions of working Papers
Functions of working Papers
4.4.2
4.4.2 Confidential Nature of Working Papers
Confidential Nature of Working Papers
4.4.3
4.4.3 Organization of the Working Papers
Organization of the Working Papers
4.4.4
4.4.4 Contents of Working Papers
Contents of Working Papers
4.5
4.5 Summary
Summary
4.6
4.6 Glossary
Glossary
4.7
4.8
o
o describe why auditors seek audit evidence
describe why auditors seek audit evidence
o
o Explain audit evidence in terms of its competence and relative strength of persuasiveness.
Explain audit evidence in terms of its competence and relative strength of persuasiveness.
o
o Indicate the factors that affect the sufficiency and competency of evidential matter.
Indicate the factors that affect the sufficiency and competency of evidential matter.
o
o Explain the nature and purpose of audit working papers.
Explain the nature and purpose of audit working papers.
4.1
4.1 INTRODUCTION
INTRODUCTION
35

When auditors are employed to express an opinion on the financial statements of an entity, they must ensure
When auditors are employed to express an opinion on the financial statements of an entity, they must ensure
that they have
that they have sufficient competent
sufficient competent evidence on which to base such an opinion. In this unit you will learn
evidence on which to base such an opinion. In this unit you will learn
to answer the question what constitute sufficient competent evidence.
to answer the question what constitute sufficient competent evidence.
Audit evidence is a fundamental concept in auditing. Audit evidence consists of underlying accounting data
Audit evidence is a fundamental concept in auditing. Audit evidence consists of underlying accounting data
and all corroborative information available to the auditor.
and all corroborative information available to the auditor.
Both categories of evidential matter are required in making an audit in accordance with GAAS.
Both categories of evidential matter are required in making an audit in accordance with GAAS.
The principal types of corroborating information areas follow:
The principal types of corroborating information areas follow:
Analytical evidence
Analytical evidence
Analytical evidence involves comparison of current period client data, such as total revenues or return on
Analytical evidence involves comparison of current period client data, such as total revenues or return on
assets, with expected values for the data based on (1)historical or budgeted amounts for the client or (2)
assets, with expected values for the data based on (1)historical or budgeted amounts for the client or (2)
industry data.
industry data.
The reliability of analytical evidence is dependent on the relevance of the comparable data.
The reliability of analytical evidence is dependent on the relevance of the comparable data.
Documentary Evidence
Documentary Evidence
Documentary evidence includes a wide variety source documents as well as such items as minutes of board
Documentary evidence includes a wide variety source documents as well as such items as minutes of board
of director or executive committee meetings, lease agreements various other contracts, and bank statements.
of director or executive committee meetings, lease agreements various other contracts, and bank statements.
Confirmations
Confirmations
Confirmations constitute a special class of documentary evidence involving direct written responses by
Confirmations constitute a special class of documentary evidence involving direct written responses by
knowledgeable third parties to specific requests for factual information.
knowledgeable third parties to specific requests for factual information.
Written representations
Written representations
Written representations are signed statements by responsible and knowledgeable individuals that bear on
Written representations are signed statements by responsible and knowledgeable individuals that bear on
one or more of management’s assertions.
one or more of management’s assertions.
Mathematical evidence
Mathematical evidence results from recompilations by the auditor and comparison of those results the
Mathematical evidence results from recompilations by the auditor and comparison of those results the
client’s computations.
client’s computations.
Oral evidence
Oral evidence
During the audit, an auditor receives oral responses to numerous inquiries directed to officers and
During the audit, an auditor receives oral responses to numerous inquiries directed to officers and
employees of the client and others.
employees of the client and others.
Physical evidence
Physical evidence
Physical evidence is obtained from the physical examination or inspection of tangible assets.
Physical evidence is obtained from the physical examination or inspection of tangible assets.
4.2 DOCUMENTS AND RECORD EXAMINATION
4.2 DOCUMENTS AND RECORD EXAMINATION
In the early stages of an audit, the external auditors must become familiar with many aspects of the client’s
In the early stages of an audit, the external auditors must become familiar with many aspects of the client’s
business. For example, the auditors must obtain knowledge of the client’s organization plan, financial
business. For example, the auditors must obtain knowledge of the client’s organization plan, financial
structure, physical facilities, products, accounting policies, and the control procedures. However,
structure, physical facilities, products, accounting policies, and the control procedures. However,
information about the internal activities of the client is not in itself sufficient.
information about the internal activities of the client is not in itself sufficient.
If this information is to be interpreted and evaluated in a proper perspective, the auditor must also
If this information is to be interpreted and evaluated in a proper perspective, the auditor must also
understand the business environment in which the client operates. The auditors can gain considerable
understand the business environment in which the client operates. The auditors can gain considerable
information about both the client’s business environment and internal operations by examining the client’s
information about both the client’s business environment and internal operations by examining the client’s
general records. The term general records is used to include the following categories:
general records. The term general records is used to include the following categories:
1.
1. Non-financial records
Non-financial records

 Articles and certificates of corporations and bylaws
Articles and certificates of corporations and bylaws

 Partnership contract
Partnership contract

 Minutes of directors and shareholders meetings
Minutes of directors and shareholders meetings

 Contracts with customers and suppliers
Contracts with customers and suppliers

 Contracts with officers and employees
Contracts with officers and employees

 Government regulations directly affecting the enterprise
Government regulations directly affecting the enterprise

 Correspondence files
Correspondence files
2. Financial records
2. Financial records

 Income tax returns of prior years.
Income tax returns of prior years.

 Financial statements and annual reports of prior years.
Financial statements and annual reports of prior years.
3. Accounting records
3. Accounting records

 General ledger.
General ledger.
36


 General journal.
General journal.
1.
1. Identify the two categories of evidential matter.
Identify the two categories of evidential matter.
2.
2. List the types of corroborative information that may be obtained in an audit.
List the types of corroborative information that may be obtained in an audit.
4.3 AUDIT EVIDENCE
4.3 AUDIT EVIDENCE
During financial statement audits, the auditors gather and evaluate evidence to form an opinion on whether
During financial statement audits, the auditors gather and evaluate evidence to form an opinion on whether
financial statements follow the appropriate criteria, usually
financial statements follow the appropriate criteria, usually GAAP.
GAAP.
Gathering sufficient appropriate audit evidence is the very essence of auditing. The third standard of
Gathering sufficient appropriate audit evidence is the very essence of auditing. The third standard of
fieldwork states:
fieldwork states:
Sufficient appropriate evidence should be obtained by such means as inspection, observation, enquiry,
Sufficient appropriate evidence should be obtained by such means as inspection, observation, enquiry,
confirmation, computation and analysis, to afford a reasonable basis to support the content of the report
confirmation, computation and analysis, to afford a reasonable basis to support the content of the report
4.3.1
4.3.1 Sufficient, Appropriate Evidence
Sufficient, Appropriate Evidence
The auditor’s judgment as to what constitutes sufficient appropriate evidence is influenced by such factors
The auditor’s judgment as to what constitutes sufficient appropriate evidence is influenced by such factors
as:
as:
b.
b. Materiality of the item.
Materiality of the item.
c.
c. Inherent risk and control risk considerations.
Inherent risk and control risk considerations.
d.
d. The experience gained during previous audit examination as to the reliability of the
The experience gained during previous audit examination as to the reliability of the
client’s records and representation.
client’s records and representation.
e.
e. The persuasions of the evidence.
The persuasions of the evidence.
f.
f. Fraud or error while performing as audit procedures.
Fraud or error while performing as audit procedures.
1.
1. What are the three general records that the auditors can examine to obtain
What are the three general records that the auditors can examine to obtain
understanding of the client’s internal activities and the business environment?
understanding of the client’s internal activities and the business environment?
2.
2. List three factors, which may influence the sufficiency and
List three factors, which may influence the sufficiency and
appropriateness of evidence?
appropriateness of evidence?
4.3.2
4.3.2 Procedures to Obtain Evidence
Procedures to Obtain Evidence
Audit evidence is any information that corroborates or refutes an assertion. Here we will briefly recap a
Audit evidence is any information that corroborates or refutes an assertion. Here we will briefly recap a
number of audit procedures.
number of audit procedures.
Physical examination: -
Physical examination: - means to review physical evidence of an asset. For example, the auditors might
means to review physical evidence of an asset. For example, the auditors might
physically examine plant equipment or inventory items to obtain evidence as to their existence or condition.
physically examine plant equipment or inventory items to obtain evidence as to their existence or condition.
Confirmation: -
Confirmation: - is the process of obtaining evidence by written, direct communication with the debtor,
is the process of obtaining evidence by written, direct communication with the debtor,
creditor, or other party of the transaction.
creditor, or other party of the transaction.
Tracing: -
Tracing: - is the proof establishing the completeness of transaction processing by following a transaction
is the proof establishing the completeness of transaction processing by following a transaction
forward through the accounting records.
forward through the accounting records.
Vouching: -
Vouching: - is the process of establishing other accuracy of recorded transactions by following a transaction
is the process of establishing other accuracy of recorded transactions by following a transaction
back to supporting documents from a prior processing step.
back to supporting documents from a prior processing step.
Re-performance: -
Re-performance: - is the process of repeating a client activity.
is the process of repeating a client activity.
Observation: -
Observation: - is the process of viewing a client activity. For example, the auditors may observe the
is the process of viewing a client activity. For example, the auditors may observe the
application of internal control procedures.
application of internal control procedures.
Inspection:
Inspection: -
- involves a reading or point – by – point review of a document or second. For example, the
involves a reading or point – by – point review of a document or second. For example, the
auditors may inspect a loan agreement.
auditors may inspect a loan agreement.
Reconciliation:
Reconciliation: - are used to establish agreement between two sets of independently maintained but related
- are used to establish agreement between two sets of independently maintained but related
records.
records.
Enquiries:
Enquiries: - are questions directed toward appropriate client reasoned. The responses to the question may
- are questions directed toward appropriate client reasoned. The responses to the question may
be oral or in written.
be oral or in written.
Analytical procedures: -
Analytical procedures: - are evaluations of financial information made by a study of expected relationships
are evaluations of financial information made by a study of expected relationships
among financial and non-financial data.
among financial and non-financial data.
1. Define audit evidence.
1. Define audit evidence.
37

The term sufficient relates to the quantity of evidence the auditors should obtain. The amount of evidence
The term sufficient relates to the quantity of evidence the auditors should obtain. The amount of evidence
that is considered sufficient to support the auditor’s opinion is a matter of professional judgment. However,
that is considered sufficient to support the auditor’s opinion is a matter of professional judgment. However,
the following considerations may be useful in evaluating the sufficiency of audit evidence.
the following considerations may be useful in evaluating the sufficiency of audit evidence.
1.
1. The amount of evidence that is sufficient in a specific situation varies inversely with the
The amount of evidence that is sufficient in a specific situation varies inversely with the
appropriateness of evidence available. Thus, the more appropriate the evidence, the less the amount
appropriateness of evidence available. Thus, the more appropriate the evidence, the less the amount
of evidence that is needed to support the auditors’ opinion.
of evidence that is needed to support the auditors’ opinion.
2.
2. The need for audit evidence is closely related to the concept of materiality. The more material a
The need for audit evidence is closely related to the concept of materiality. The more material a
financial statement amount, the greater the need for more evidence as to its validity.
financial statement amount, the greater the need for more evidence as to its validity.
3.
3. As the relative risk associated with a particular engagement increases, the auditors should require
As the relative risk associated with a particular engagement increases, the auditors should require
more evidence to support their opinion.
more evidence to support their opinion.
The appropriateness of audit evidence refers to its quality or reliability. To be appropriate, evidence must
The appropriateness of audit evidence refers to its quality or reliability. To be appropriate, evidence must
be both valid and relevant.
be both valid and relevant.
The competency (or reliability) of accounting records is directly related to the effectiveness of the client’s
The competency (or reliability) of accounting records is directly related to the effectiveness of the client’s
internal controls. Strong internal controls enhance the accuracy and reliability of the financial records.
internal controls. Strong internal controls enhance the accuracy and reliability of the financial records.
The competency of corroborative information depends on many factors. The considerations that have the
The competency of corroborative information depends on many factors. The considerations that have the
widest applicability in audit are:
widest applicability in audit are:
-
- relevance
relevance
-
- source
source
-
- timeliness
timeliness
-
- objectivity
objectivity
Several factors contribute to the quality of evidence, including the following:
Several factors contribute to the quality of evidence, including the following:
1.
1. When auditors obtain evidence from independent sources outside of the client company, the
When auditors obtain evidence from independent sources outside of the client company, the
reliability of the evidence is increased.
reliability of the evidence is increased.
2.
2. Strong internal control contributes substantially to the quality of accounting records and other
Strong internal control contributes substantially to the quality of accounting records and other
evidence created within the client organization.
evidence created within the client organization.
3.
3. The quality of evidence is enhanced when the auditors obtain information directly, - that is, by first
The quality of evidence is enhanced when the auditors obtain information directly, - that is, by first
hand observation, correspondence, or computation, rather than by obtaining the information second
hand observation, correspondence, or computation, rather than by obtaining the information second
hand.
hand.
4.4 WORKING PAPERS
4.4 WORKING PAPERS
Working papers are vitally important tools of the auditing profession.
Working papers are vitally important tools of the auditing profession.
Working papers are the connecting link between the client's accounting records and the auditors report.
Working papers are the connecting link between the client's accounting records and the auditors report.
They document all of the work performed by the auditors and provide the justification for the auditors’
They document all of the work performed by the auditors and provide the justification for the auditors’
report.
report.
The documentation of audit evidence is provided in working papers. Working papers provide
The documentation of audit evidence is provided in working papers. Working papers provide
-
- The principal support for the auditor’s report.
The principal support for the auditor’s report.
-
- A means for coordinating and supervising the audit.
A means for coordinating and supervising the audit.
-
- Evidence that the audit was made in accordance with GAAS.
Evidence that the audit was made in accordance with GAAS.
Audit working papers assist auditors in several major ways: they
Audit working papers assist auditors in several major ways: they
a)
a) Provide a means of assigning and coordinating audit work;
Provide a means of assigning and coordinating audit work;
b)
b) Aid seniors, managers, and partners in supervising and reviewing the work of
Aid seniors, managers, and partners in supervising and reviewing the work of
assistants;
assistants;
c)
c) Provide the support for the auditors’ report;
Provide the support for the auditors’ report;
d)
d) Document the auditors’ compliance with GAAS; and
Document the auditors’ compliance with GAAS; and
e)
e) Aid in planning and conducting future audits of the client.
Aid in planning and conducting future audits of the client.
Much of the information gained in confidence by the auditors is recorded in their working papers;
Much of the information gained in confidence by the auditors is recorded in their working papers;
consequently, the working papers are confidential in nature. Since audit working papers are highly
consequently, the working papers are confidential in nature. Since audit working papers are highly
confidential; they must be safeguarded at all times.
confidential; they must be safeguarded at all times.
4.4.3
4.4.3 Organization of the Working Papers
Organization of the Working Papers
The auditors usually maintain two files of working papers for each client:
The auditors usually maintain two files of working papers for each client:
38

1)
1) Current files for every completed examination and
Current files for every completed examination and
2)
2) A permanent file of relatively unchanging data.
A permanent file of relatively unchanging data.
Working papers would normally include the following matters:
Working papers would normally include the following matters:

 Information concerning the legal and organizational structure of the entity.
Information concerning the legal and organizational structure of the entity.

 Copies of important legal documents, agreements and minutes.
Copies of important legal documents, agreements and minutes.

 Information concerning the industry, and economic environment.
Information concerning the industry, and economic environment.

 Evidence of the planning process.
Evidence of the planning process.

 Evidence of the auditors’ understanding of the accounting and internal control systems.
Evidence of the auditors’ understanding of the accounting and internal control systems.

 Evidence of inherent and control risk asses ments.
Evidence of inherent and control risk asses ments.

 Analysis of transactions and balances.
Analysis of transactions and balances.

 Analysis of significant ratios and trends.
Analysis of significant ratios and trends.

 Details of procedures regarding components whose financial statements are audited by other
Details of procedures regarding components whose financial statements are audited by other
auditors.
auditors.

 Copies of communications with other auditors, experts, and other third parties.
Copies of communications with other auditors, experts, and other third parties.

 Letters of representation by the client’s management.
Letters of representation by the client’s management.

 Copies of the approved financial statements and auditors’ reports.
Copies of the approved financial statements and auditors’ reports.
1.
1. Which of the following is not a primary purpose of audit working papers?
Which of the following is not a primary purpose of audit working papers?
a)
a) To coordinate the examination.
To coordinate the examination.
b)
b) To assist in preparation of audit report.
To assist in preparation of audit report.
c)
c) To support the financial statements.
To support the financial statements.
d)
d) To provide evidence of audit work performed.
To provide evidence of audit work performed.
2.
2. Which of the following is the most persuasive evidence?
Which of the following is the most persuasive evidence?
a)
a) Information detained through inquiry direct from independent sourced audit
Information detained through inquiry direct from independent sourced audit
the client organization.
the client organization.
b)
b) Information obtained through inquiry from the management the organization.
Information obtained through inquiry from the management the organization.
c)
c) Evidence obtained by re-performing calculations and reconciliation made by
Evidence obtained by re-performing calculations and reconciliation made by
the client.
the client.
d)
d) Evidence obtained by observing employment while performing their tasks..
Evidence obtained by observing employment while performing their tasks..
4.5 SUMMARY
4.5 SUMMARY
In this unit we have examined the matters relating to audit evidence. The financial statements are explained
In this unit we have examined the matters relating to audit evidence. The financial statements are explained
in terms of the primary assertions management makes in them, and these assertions are identified as the
in terms of the primary assertions management makes in them, and these assertions are identified as the
focal points of the auditors’ procedural evidence gathering work. The unit closes with some basic points
focal points of the auditors’ procedural evidence gathering work. The unit closes with some basic points
about the purpose, confidentiality, and content of audit working papers.
about the purpose, confidentiality, and content of audit working papers.
4.6 GLOSSARY
4.6 GLOSSARY
Confirmation: A
Confirmation: A technique in which the auditors request a written response from a specific third party
technique in which the auditors request a written response from a specific third party
about a particular item affecting the financial statements.
about a particular item affecting the financial statements.
Current file:
Current file: The working paper file that includes information relevant to an audit client for a particular
The working paper file that includes information relevant to an audit client for a particular
year.
year.
Inquiry:
Inquiry: A technique of asking questions to gather audit evidence
A technique of asking questions to gather audit evidence.
.
Permanent file:
Permanent file: The
The working paper file that includes information of continuing relevance in performing
working paper file that includes information of continuing relevance in performing
recurring engagement for an audit client.
recurring engagement for an audit client.
1.
1. -
- Accounting data
Accounting data
- Corroborative information available to the auditor
- Corroborative information available to the auditor
2. Analytical evidence
2. Analytical evidence
-
- Documentary evidence
Documentary evidence
-
- Confirmations
Confirmations
-
- Mathematical evidence
39

-
- Oral evidence
Oral evidence
-
- Physical evidence
Physical evidence
1.
1. Non-financial records financial records and accounting.
Non-financial records financial records and accounting.
2.
2. Materiality of the item
Materiality of the item
-
- Inherent risk and control risk consideration
Inherent risk and control risk consideration
-
- The persuasiveness of the evidence
The persuasiveness of the evidence
Audit evidence is any information that corroborates or refutes an assertion.
Audit evidence is any information that corroborates or refutes an assertion.
1. C
1. C 2. C
2. C
Part I. Choose the best answer
Part I. Choose the best answer
1. Which of the following is the
1. Which of the following is the least
least persuasive type evidence?
persuasive type evidence?
a.
a. Bank statement obtained from the client.
Bank statement obtained from the client.
b.
b. Computation made by the auditor.
Computation made by the auditor.
c.
c. Pre-numbered client sales invoices.
Pre-numbered client sales invoices.
d.
d. Vendor’s invoice.
Vendor’s invoice.
2. An auditor’s working papers should:
2. An auditor’s working papers should:
a.
a. not be permitted to serves as a reference source for the client
not be permitted to serves as a reference source for the client
b.
b. not contain critical comments concerning management
not contain critical comments concerning management
c.
c. show shat the accounting records agree or reconcile with the financial
show shat the accounting records agree or reconcile with the financial
d.
d. be considered the primary support for the financial statements being audited .
be considered the primary support for the financial statements being audited .
3. The strongest criticism of the reliability of audit evidence that the auditor physical observes is that:
The strongest criticism of the reliability of audit evidence that the auditor physical observes is that:
a.
a. the client may conceal items from the auditor
the client may conceal items from the auditor
b.
b. the auditor may not be qualified to evaluate the items observed
the auditor may not be qualified to evaluate the items observed
c.
c. such evidence is too costly in relation to its reliability
such evidence is too costly in relation to its reliability
d.
d. the observation must occur at a specific time, which is often difficult to
the observation must occur at a specific time, which is often difficult to
arrange
arrange
Part II.
Part II. Give short answers for the following questions
Give short answers for the following questions.
.
1.
1. What are the factors that may influence the auditors’ judgement on the sufficiency and
What are the factors that may influence the auditors’ judgement on the sufficiency and
appropriateness audit evidence?
appropriateness audit evidence?
2.
2. “Audit papers are the property of auditors, who may destroy the papers, sell them or give
“Audit papers are the property of auditors, who may destroy the papers, sell them or give
them away.” Criticize this quotation.
them away.” Criticize this quotation.
UNIT 5: AUDITORS’ REPORTS
UNIT 5: AUDITORS’ REPORTS
Contents
Contents
5.0
Aims and Objectives
5.1
5.1 Introduction
Introduction
5.2
5.2 The auditors’ Standard Report
The auditors’ Standard Report
5.3
5.3 Expression of an Opinion
Expression of an Opinion
5.4
5.4 The Unqualified Report
The Unqualified Report
5.5
5.5 Qualified Opinions
Qualified Opinions
5.6
5.6 Summary
Summary
5.7
5.7 Glossary
Glossary
5.8
5.9

 prepare audit reports to meet different specified situations.
prepare audit reports to meet different specified situations.
 Understand the basic elements of audit report.
Understand the basic elements of audit report.
 Discuss and explain the concept of “true and fair”.
Discuss and explain the concept of “true and fair”.
40

5.1 INTRODUCTION
5.1 INTRODUCTION
The audit report is usually the only channel of communication between the shareholders of the company
The audit report is usually the only channel of communication between the shareholders of the company
whose financial statements have been subject to audit and the auditors. As such the report acts as a bridge
whose financial statements have been subject to audit and the auditors. As such the report acts as a bridge
taking the large volume of information possessed by auditors and conveying it to the shareholders in a much
taking the large volume of information possessed by auditors and conveying it to the shareholders in a much
abbreviated form.
abbreviated form.
In order to convey information in a succinct form the audit report has become an extremely formalized
In order to convey information in a succinct form the audit report has become an extremely formalized
group of phrases, each of which has special significance.
group of phrases, each of which has special significance.
5.2 THE AUDITORS’ STANDARD REPORT
5.2 THE AUDITORS’ STANDARD REPORT
For convenient reference, the auditors’ standard (unqualified) report is presented below.
For convenient reference, the auditors’ standard (unqualified) report is presented below.
Auditors’ report to the shareholders of XYZ
Auditors’ report to the shareholders of XYZ
we have audited the accompanying balance sheet of the XYZ Company as of December 31, 19 x 1, and the
we have audited the accompanying balance sheet of the XYZ Company as of December 31, 19 x 1, and the
related statements of income, retained earnings, and cash flows for the year then ended. There financial
related statements of income, retained earnings, and cash flows for the year then ended. There financial
statements are the responsibility of the company’s management. Our responsibility is to express an opinion
statements are the responsibility of the company’s management. Our responsibility is to express an opinion
on those financial statements based on our audit.
on those financial statements based on our audit.
We conducted an audit in accordance with generally accepted auditing standards. Those standards require
We conducted an audit in accordance with generally accepted auditing standards. Those standards require
that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free
that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts
of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements. An audit also includes assessing the accounting policies used
and disclosures in the financial statements. An audit also includes assessing the accounting policies used
and significant estimates made by management, as well as evaluating the overall financial statements
and significant estimates made by management, as well as evaluating the overall financial statements
presentation. We believe that our audit provide a reasonable basis for our audit opinion.
presentation. We believe that our audit provide a reasonable basis for our audit opinion.
In our opinion, the financial statements give a true and fair view of (or present fairly in all material
In our opinion, the financial statements give a true and fair view of (or present fairly in all material
respects) the financial position of the company as of December 31, 19 x 1 and the results of its operations
respects) the financial position of the company as of December 31, 19 x 1 and the results of its operations
and its cash flows for the year then ended in accordance with GAAP.
and its cash flows for the year then ended in accordance with GAAP.
ABC Auditors
ABC Auditors
Date
Date
Address
Address
This report contains the following important elements:
This report contains the following important elements:
-
- Title:
Title: Auditing standards require that the report be titled and include
Auditing standards require that the report be titled and include
the word independent.
the word independent.
-
- Address:
Address: The audit report is addressed to the individual or group
The audit report is addressed to the individual or group
that engaged the auditors.
that engaged the auditors.
-
- Introductory paragraph: -
Introductory paragraph: - The first paragraph of the report does
The first paragraph of the report does
three things:
three things:

 Specifies the financial statements to which the
Specifies the financial statements to which the
report relates,
report relates,

 Specifies the respective responsibilities of directors
Specifies the respective responsibilities of directors
and auditors, and;
and auditors, and;

 It makes the simple statement that the auditor has
It makes the simple statement that the auditor has
done an audit.
done an audit.
-
- Scope paragraph: -
Scope paragraph: -The scope paragraph describes the nature of an
The scope paragraph describes the nature of an
audit. The scope paragraph states the following:
audit. The scope paragraph states the following:

 The auditors followed GAAS,
The auditors followed GAAS,

 The audit is designed to obtain a reasonable
The audit is designed to obtain a reasonable
assurance about whether the financial statements are free of material misstatements.
assurance about whether the financial statements are free of material misstatements.

 The audit evidence accumulated and the auditor
The audit evidence accumulated and the auditor
believes the evidence accumulated was appropriate for the circumstances to express the opinion
believes the evidence accumulated was appropriate for the circumstances to express the opinion
presented.
presented.
-
- Opinion paragraph:
Opinion paragraph: The final paragraph in the standard report
The final paragraph in the standard report
states the auditors’ conclusion based on the results the audit examination.
states the auditors’ conclusion based on the results the audit examination.
-
- Name of the audit firm.
Name of the audit firm.
-
- Audit report date
Audit report date. The appropriate data for the audit report is the
. The appropriate data for the audit report is the
one on which the auditor has completed the most important auditing procedures in the field.
one on which the auditor has completed the most important auditing procedures in the field.
41

5.3 EXPRESSION OF AN OPINION
5.3 EXPRESSION OF AN OPINION
The auditors’ opinions when expressing an opinion on financial statements may be summarized as follows:
The auditors’ opinions when expressing an opinion on financial statements may be summarized as follows:
1.
1. An unqualified opinion – standard report.
An unqualified opinion – standard report.
2.
2. A qualified opinion.
A qualified opinion.
3.
3. An adverse opinion.
An adverse opinion.
4.
4. A denial opinion.
A denial opinion.
All significant reasons for the issuance of a qualified, adverse, or denial of opinion should be set forth in a
All significant reasons for the issuance of a qualified, adverse, or denial of opinion should be set forth in a
reservation paragraph between the scope and opinion paragraph.
reservation paragraph between the scope and opinion paragraph.
Auditors must qualify their report whenever there are
Auditors must qualify their report whenever there are material
material deficiencies in the client’s financial
deficiencies in the client’s financial
statements.
statements.
5.4 THE UNQUALIFIED REPORT
5.4 THE UNQUALIFIED REPORT
The unqualified report is used when the following conditions are met:
The unqualified report is used when the following conditions are met:
1.
1. All statements - balance sheet, income statement, statements of retained
All statements - balance sheet, income statement, statements of retained
earnings, and statement of cash flows are included in the financial statement.
earnings, and statement of cash flows are included in the financial statement.
2.
2. The three general standards have been followed in all respects on the
The three general standards have been followed in all respects on the
engagements.
engagements.
3.
3. Sufficient evidence has been accumulated.
Sufficient evidence has been accumulated.
4.
4. The financial statements are presented in accordance with generally accepted
The financial statements are presented in accordance with generally accepted
accounting principles.
accounting principles.
5.
5. There are no circumstances requiring the addition of an explanatory paragraph
There are no circumstances requiring the addition of an explanatory paragraph
or modification of the wording of the report.
or modification of the wording of the report.
In general, auditors express an unqualified opinion on the client’s financial statements when there has been
In general, auditors express an unqualified opinion on the client’s financial statements when there has been
no material departure from GAAP and there have been no material unresolved restrictions on the scope of
no material departure from GAAP and there have been no material unresolved restrictions on the scope of
their audit.
their audit.
Under certain circumstances, however, auditors may add additional wording to the standard report even
Under certain circumstances, however, auditors may add additional wording to the standard report even
though they are issuing an unqualified opinion. This additional wording draws attention to certain statutory
though they are issuing an unqualified opinion. This additional wording draws attention to certain statutory
requirements or a specific matter. Another modification of a standard audit report is the auditors’ emphasis
requirements or a specific matter. Another modification of a standard audit report is the auditors’ emphasis
of a matter regarding the client’s financial statements. Emphasis of matter may require in the auditor’s
of a matter regarding the client’s financial statements. Emphasis of matter may require in the auditor’s
unqualified report (1) to highlight a matter regarding a going concern problem and (2) when there is a
unqualified report (1) to highlight a matter regarding a going concern problem and (2) when there is a
significant uncertainty (other than going concern problem), the resolution of which is dependent upon future
significant uncertainty (other than going concern problem), the resolution of which is dependent upon future
events and which may affect the financial statements.
events and which may affect the financial statements.
Part I. Select the best answer
Part I. Select the best answer
1. The auditors’ report should be dated as of the date the:
1. The auditors’ report should be dated as of the date the:
b)
b) Report is delivered to the client.
Report is delivered to the client.
c)
c) Examination is substantially completed.
Examination is substantially completed.
d)
d) Fiscal period under audit ends.
Fiscal period under audit ends.
e)
e) Review of the working papers is completed.
Review of the working papers is completed.
2.
2. An auditor’s responsibility to express opinion on the financial statements is
An auditor’s responsibility to express opinion on the financial statements is
represented in the:
represented in the:
a)
a) Introductory paragraph.
Introductory paragraph.
b)
b) Scope paragraph.
Scope paragraph.
c)
c) Opinion paragraph.
Opinion paragraph.
d)
d) Explanatory paragraph.
Explanatory paragraph.
3.
3. Assume that the opinion paragraph of an auditor’s report begins as follows:
Assume that the opinion paragraph of an auditor’s report begins as follows:
“with the foregoing explanation, these financial statements present fairly” This is:
“with the foregoing explanation, these financial statements present fairly” This is:
a)
a) An unqualified opinion.
An unqualified opinion.
b)
b) A denial opinion.
A denial opinion.
c)
c) An except for opinion.
An except for opinion.
d)
d) Adverse opinion.
Adverse opinion.
5.5 QUALIFIED OPINIONS
5.5 QUALIFIED OPINIONS
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Auditors may issue opinions other than unqualified opinion when (1) they do not agree with the accounting
Auditors may issue opinions other than unqualified opinion when (1) they do not agree with the accounting
principles used in preparing financial statements or when they believe disclosures in the statement are
principles used in preparing financial statements or when they believe disclosures in the statement are
inadequate; (2) a change in accounting principle is not applied properly a as per GAAP, and is not
inadequate; (2) a change in accounting principle is not applied properly a as per GAAP, and is not
adequately disclosed in the financial statements; (3) there are limitations on scope of examination; and /or
adequately disclosed in the financial statements; (3) there are limitations on scope of examination; and /or
(4) there is major uncertainty affecting a client’s business’.
(4) there is major uncertainty affecting a client’s business’.
Qualified opinion -except for
Qualified opinion -except for: This is issued when there is a limitation of Scope; or the auditor disagrees
: This is issued when there is a limitation of Scope; or the auditor disagrees
with an accounting treatment or disclosure. The opinion states that
with an accounting treatment or disclosure. The opinion states that except for
except for the effects of some material
the effects of some material
departure from GAAP, or some material limitation in the scope of the auditors’ examination, the financial
departure from GAAP, or some material limitation in the scope of the auditors’ examination, the financial
statements are presented fairly.
statements are presented fairly.
The auditors’ reports should have a separate reservation paragraph disclosing the reasons for the
The auditors’ reports should have a separate reservation paragraph disclosing the reasons for the
qualification.
qualification.
A.
A. Adverse opinion:
Adverse opinion: This is a stronger form of ‘except for’ opinion – the
This is a stronger form of ‘except for’ opinion – the
disagreement is so material that the financial statements as a whole are misreading. When the
disagreement is so material that the financial statements as a whole are misreading. When the
auditors express an adverse opinion, they must have accumulated sufficient appropriate evidence to
auditors express an adverse opinion, they must have accumulated sufficient appropriate evidence to
support their unfavourable opinion.
support their unfavourable opinion.
Whenever the auditors issue an adverse opinion, they should disclose in a separate paragraph of their
Whenever the auditors issue an adverse opinion, they should disclose in a separate paragraph of their
report the reasons for the adverse opinion and the principal effects of the adverse opinion on the
report the reasons for the adverse opinion and the principal effects of the adverse opinion on the
client company’s financial position and operating results.
client company’s financial position and operating results.
Example, an audit report that included an adverse opinion might have an opinion paragraph such as
Example, an audit report that included an adverse opinion might have an opinion paragraph such as
the one as follows:
the one as follows:
In our opinion, because of the effects of the matters discussed in the preceding paragraph, these financial
In our opinion, because of the effects of the matters discussed in the preceding paragraph, these financial
statements do not present fairly the financial positions of the company as at December 31, 19 x 1, and the
statements do not present fairly the financial positions of the company as at December 31, 19 x 1, and the
results of its operations and cash flow position for the year then ended, in accordance with generally
results of its operations and cash flow position for the year then ended, in accordance with generally
accepted accounting principles.
B.
B. Denial of opinion.
Denial of opinion. A denial (disclaimer) of opinion is no opinion. In an audit
A denial (disclaimer) of opinion is no opinion. In an audit
engagement, a denial is required when very significant restrictions on the scope of the audit preclude
engagement, a denial is required when very significant restrictions on the scope of the audit preclude
compliance with generally accepted auditing standards.
compliance with generally accepted auditing standards.
A very significant scope limitation may be caused by the client or by the timing of the auditors’
A very significant scope limitation may be caused by the client or by the timing of the auditors’
appointment and their audit work or by factors beyond the control of the client or the auditors, rather
appointment and their audit work or by factors beyond the control of the client or the auditors, rather
than by restrictions imposed by the client.
than by restrictions imposed by the client.
Summary of auditors’ reports
Materiality
Materiality
of the issue
of the issue
Type of report
Type of report
Not material
Not material
Material
Material
Departure from
Departure from
GAAP
GAAP scope limitation
scope limitation
Qualified ‘except for’
Qualified ‘except for’ qualified ‘except for’
qualified ‘except for’
Very
Very
material
material adverse
adverse denial
denial
1.
1. Identify the four basic types of opinions that an auditor may issue.
Identify the four basic types of opinions that an auditor may issue.
2.
2. What is meant by the term reservation?
What is meant by the term reservation?
5.6 SUMMARY
5.6 SUMMARY
This unit covers the four basic types of audit opinions and explain when each is appropriate. Depending on
This unit covers the four basic types of audit opinions and explain when each is appropriate. Depending on
the circumstances, the auditor’s report may take one of the following forms :(1) a standard report that
the circumstances, the auditor’s report may take one of the following forms :(1) a standard report that
contains an unqualified opinion, (2) a report that contains an unqualified opinion with added explanatory
contains an unqualified opinion, (2) a report that contains an unqualified opinion with added explanatory
language, or (3) a report that expresses one of three other types of opinion-qualified ‘except for’, adverse or
language, or (3) a report that expresses one of three other types of opinion-qualified ‘except for’, adverse or
disclaimer.
disclaimer.
43
Unqualifie
d

5.7
5.7 GLOSSARY
GLOSSARY
Adverse opinion:
Adverse opinion: A type of opinion issued by an auditor that states that the financial statements do not
A type of opinion issued by an auditor that states that the financial statements do not
present fairly the financial position, results of operation, and cash flows in conformity with generally
present fairly the financial position, results of operation, and cash flows in conformity with generally
Audit opinion:
Audit opinion: That part of the audit reports that presents the conclusions reached by the auditor.
That part of the audit reports that presents the conclusions reached by the auditor.
Audit report:
Audit report: The auditor’s entire communication about what was done and what conclusions reached in
The auditor’s entire communication about what was done and what conclusions reached in
the audit.
the audit.
Disclaimer of opinion:
Disclaimer of opinion: A report by the auditor that states that an opinion cannot be expressed.
A report by the auditor that states that an opinion cannot be expressed.
Going concern:
Going concern: An entity able to continue for a period at least one year beyond the balance sheet date.
An entity able to continue for a period at least one year beyond the balance sheet date.
5.8 ANSWERS TO CHECK YOU PROGRESS EXERCISE
5.8 ANSWERS TO CHECK YOU PROGRESS EXERCISE
1.
1. B
B
2.
2. A
A
3.
3. A
A
(1) 1. Qualified opinion
(1) 1. Qualified opinion
2. Unqualified opinion
2. Unqualified opinion
3. Adverse opinion and
3. Adverse opinion and
4. Disclaimer
4. Disclaimer
(2) Reservation is a term used to signify the auditors’ inability to express an unqualified opinion; adverse
(2) Reservation is a term used to signify the auditors’ inability to express an unqualified opinion; adverse
opinion, or a denial of opinion.
opinion, or a denial of opinion.
5.9 MODEL EXAMINATION QUESTIONS
5.9 MODEL EXAMINATION QUESTIONS
Part I. Indicate the best answer choice for each of the following multiple-choice questions.
Part I. Indicate the best answer choice for each of the following multiple-choice questions.
1.
1. If a publicly held company issues financial reports that purport to present its financial position and
If a publicly held company issues financial reports that purport to present its financial position and
results of operation but omits the statement of cash flows, the auditor ordinarily will express a(an)
results of operation but omits the statement of cash flows, the auditor ordinarily will express a(an)
a.
a. Unqualified opinion.
Unqualified opinion.
b.
b. Adverse opinion.
Adverse opinion.
c.
c. qualified opinion
qualified opinion
d.
d. disclaimer of opinion
disclaimer of opinion
2. An auditor may reasonably issue an “except for” qualified opinion for
2. An auditor may reasonably issue an “except for” qualified opinion for
Inadequate disclosure
Inadequate disclosure Scope limitation
Scope limitation
1. Yes
1. Yes yes
yes
2. Yes
2. Yes no
no
3. no
3. no yes
yes
4. no no
4. no no
3. What type of audit report (unqualified opinion, except for opinion, adverse opinion, denial of opinion)
3. What type of audit report (unqualified opinion, except for opinion, adverse opinion, denial of opinion)
should the auditors generally issue in each of the following situations? Explain.
should the auditors generally issue in each of the following situations? Explain.
a)
a) Client imposed restriction limit very significantly the scope of the auditors’
Client imposed restriction limit very significantly the scope of the auditors’
procedures.
procedures.
b)
b) The auditors decide that it is necessary to make reference to their report of another
The auditors decide that it is necessary to make reference to their report of another
public accounting firm (the secondary auditors).
public accounting firm (the secondary auditors).
c)
c) The auditors believe that the financial statements have been stated in conformity
The auditors believe that the financial statements have been stated in conformity
with generally accepted accounting principles in all respects other than the treatment and
with generally accepted accounting principles in all respects other than the treatment and
disclosure of a material uncertainty.
disclosure of a material uncertainty.
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