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CAT FAU Foundations in Audit 1
Contents
1. Business Environment and audit framework!......................................................3
2. The ACCA code of ethics and conduct!.............................................................15
3. The regulatory framework!.................................................................................23
4. Audit risk!...........................................................................................................27
5. Tests of control or substantive tests?!...............................................................39
6. Assertions and audit evidence!..........................................................................45
7. Obtaining audit evidence sampling!...............................................................51
8. The use of experts and other third parties!........................................................57
9. Audit evidence: computer assisted auditing techniques (CAAT)!......................61
10. Documentation!..................................................................................................65
11. Internal control!..................................................................................................75
12. Examples of internal control and tests of control!..............................................81
13. Substantive testing!...........................................................................................91
14. Final stages of the audit!.................................................................................103
15. The audit report!..............................................................................................107
16. Answers to Tests!............................................................................................113
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Chapter 1
BUSINESS ENVIRONMENT AND
AUDIT FRAMEWORK
1. The purpose and scope of an audit
Shareholders are the legal owners of companies. In very small businesses, such as family
businesses, the shareholders will also take part in the day to day management of the
company. However, once businesses grow, shareholders appoint directors and managers to
run their company.
Shareholders (also known as members) are the principals, and directors are the agents of the
shareholders. Agents should act in the best interests of the principals so, therefore, directors
should act in the best interest of shareholders. However, this can introduce conflicts of
interest between the two parties. Shareholders want large profits but the directors might want
large salaries, generous pensions and bonuses, first class travel and expensive cars.
Companies are required to produce annual financial statements (accounts) for presentation
to their shareholders. These should show how their company has got on during the year. The
directors are responsible for producing the financial accounts and there is obviously a
temptation for them not to report results accurately or fairly. For example, directors might try
to overstate profits so as to keep their jobs or to qualify for bonuses.
Therefore, auditors are appointed by the members of the company to scrutinise

independently the financial statements and to report to the members on whether the financial
statements show a true and fair view of the companys affairs and its results. Auditors
conclusions are published as part of the financial statements in the audit report.
In addition to the terms agent and principal, stewardship is sometimes used to describe
the duty that directors have to look after the interests of the shareholders.
2. What auditors dont do

Auditors do not:
Prepare the financial statements: that is the job of the directors.
Double check every transaction in the company: that would take too long and be very
expensive.
Manage the company.
Warn shareholders that the company has made a loss: that will be shown in the
financial statements.
Undertake to discover every fraud or error that might have taken place in the
company: auditors look only for material misstatements (see later).
3. Advantages and disadvantages of an audit
3.1! Advantages
Independent scrutiny and a report on the financial statements
Greater credibility (believability) of the financial statements. This could help in raising
finance.
Professional expertise applied to the financial statements. Especially important when
directors and shareholders might not have financial experience.
Review of the companys internal control system (the accounting system used by the
company) and recommendations for its improvement.
3.2! Disadvantages
Cost: auditors charge for their work
Time and disruption. Auditors have to ask employees questions and have to find
documents. This distracts employees from their day-to-day tasks.
A feeling of not being trusted. Auditors are always looking for independent evidence
and are reluctant to take employees word for anything. This can make staff feel that
they are not trusted.
4. Accounting records
Accounting records consist of:
Nominal or general ledger. This has accounts for assets (such as non-current assets,
receivables), liabilities (such as amounts owed to suppliers and loans), income (such
as sales) and expenses (such as rent, wages and electricity).
Cash book. This shows cash receipts and payments.
Receivables ledger. This shows how much each credit customer owes. This ledger is
sometimes known as the debtors ledger or sales ledger. The total of these amounts
should agree with the summary receivables account that is part of the nominal ledger.
Payables ledger. This shows how much is owed to each supplier. This is sometimes
known as the creditors ledger or purchase ledger. The total of these amounts should
agree with the summary payables account that is part of the nominal ledger.
Non-current asset register. This shows details of each non-current asset, such as
purchase date, cost, depreciation rate, location, date last physically verified and
depreciation to date. The total of the non-current asset register should agree to the
summary accounts in the nominal ledger. The non-current asset register might
sometimes still be referred to as the fixed asset register.
Inventory records. Lists inventory details such as cost, location number of items,
deliveries and receipts.
The exact nature of the accounting records vary from business to business. For example, a
small grocery shop will not have a receivables ledger because all sales are for cash. An
architects practice will not have inventory records because they sell services, not goods.
Some very small businesses keep little more than a cash book on a day-to-day basis and
fuller accounting records are produced at year end.
5. Financial statements
Auditors report on a companys financial statements. These will have been produced from the
financial records. Financial statements consist of:
A statement of financial position

A statement of profit or loss
A cash flow statements
Notes to the financial statements
Statement of movement in reserves
Together with the documents above, companies also produce directors reports, chairmans
statements, graphs, forecasts and public relations material and combine the whole lot into
their annual report. The annual report will also include the auditors report. For large
companies this is often a glossy booklet designed to impress shareholders and potential
investors.
However, the audit report covers only the financial statements, not the other documents that
might be included.
6. The audit report
6.1 ! Prime purpose
The prime purpose of the audit report is to state whether or not the financial statements give a
true and fair view of the financial position of the company at its year end and of its
performance during the year.
True:! implies that the financial statements are factually correct, have been
prepared according to an applicable reporting framework (such as the
International Financial Reporting Standards) and that they do not contain
any material misstatements that may mislead the users. Misstatements may
result from material errors or omissions in the financial statements. True also
implies that the financial statements are materially accurate.
Fair:! implies that the financial statements present the information faithfully without
any element of bias and they reflect the economic substance of
transactions rather than just their legal form. Presentation is an important
element of fairness.
For example:
The statement of financial position should show current assets and current liabilities
separately and in detail. Thus current assets and current liabilities might show:
Current assets
Inventory 10,000
Receivables 4,000
Cash 2,000
16,000
Current liabilities
Trade payables 12,000
This shows that the liquidity of the company is poor as suppliers expect $12,000 within the
next few weeks but, although inventory is high, there is not much coming from customers or in
cash with which to pay suppliers. Inventory can take a long time to be sold and to turn into
cash.
If the presentation were as follows:
Current assets 16,000
Current liabilities 12,000
then users might have a very wrong impression. The amounts are true (correct), but
concealing the large amount of inventory that contributes to the current assets is likely to
mislead ie not a fair presentation.
6.2 ! Detail in the audit report
Reproduced below is the audit report for Marks and Spencer Plc, a large UK retail group:
1 Independent auditors' report

2 We have audited the financial statements of Marks and Spencer Group plc for the 52 weeks ended 30 March 2013 which
comprise the Consolidated income statement, the Consolidated statement of comprehensive income, the Consolidated and
Company statements of financial position, the Consolidated statement of changes in equity and Company statement of changes
in shareholders equity, the Consolidated cash flow information and Company statement of cash flows and the related notes. The
financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting
Standards (IFRSs) as adopted by the European Union and, as regards the parent company financial statements, as applied in
accordance with the provisions of the Companies Act 2006.
3 Respective responsibilities of directors and auditors

As explained more fully in the Directors Responsibilities Statement set out within the other Disclosures page, the directors are
responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view. Our
responsibility is to audit and express an opinion on the financial statements in accordance with applicable law and International
Standards on Auditing (UK and Ireland). Those standards require us to comply with the Auditing Practices Boards Ethical
Standards for Auditors.
This report, including the opinions, has been prepared for and only for the Companys members as a body in accordance with
4 Chapter 3 of Part 16 of the Companies Act 2006 and for no other purpose. We do not, in giving these opinions, accept or assume
responsibility for any other purpose or to any other person to whom this report is shown or into whose hands it may come save
where expressly agreed by our prior consent in writing.
5 Scope of the audit of the financial statements

An audit involves obtaining evidence about the amounts and disclosures in the financial statements sufficient to give
reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error. This
includes an assessment of: whether the accounting policies are appropriate to the Groups and the parent companys
circumstances and have been consistently applied and adequately disclosed; the reasonableness of significant accounting
estimates made by the directors; and the overall presentation of the financial statements. In addition, we read all the financial
and non-financial information in the Annual report and financial statements 2013 to identify material inconsistencies with the
audited financial statements. If we become aware of any apparent material misstatements or inconsistencies we consider the
implications for our report.
6 Opinion on financial statements

In our opinion:
the financial statements give a true and fair view of the state of the Groups and of the parent companys affairs as at 30
March 2013 and of the Groups profit and Groups and parent companys cash flows for the 52 weeks then ended;
the Group financial statements have been properly prepared in accordance with IFRSs as adopted by the European Union;
the parent company financial statements have been properly prepared in accordance with IFRSs as adopted by the
European Union and as applied in accordance with the provisions of the Companies Act 2006; and
the financial statements have been prepared in accordance with the requirements of the Companies Act 2006 and, as
regards the Group financial statements, Article 4 of the lAS Regulation.
7 Opinion on other matters prescribed by the Companies Act 2006

In our opinion:
the part of the Remuneration report to be audited has been properly prepared in accordance with the Companies Act 2006;
and
the information given in the Directors Report for the financial year for which the financial statements are prepared is
consistent with the financial statements.
8 Matters on which we are required to report by exception

We have nothing to report in respect of the following:
Under the Companies Act 2006 we are required to report to you if, in our opinion:
adequate accounting records have not been kept by the parent company, or returns adequate for our audit have not been
received from branches not visited by us; or
the parent company financial statements and the part of the Remuneration report to be audited are not in agreement with
the accounting records and returns; or
certain disclosures of directors remuneration specified by law are not made; or
we have not received all the information and explanations we require for our audit.
Under the Listing Rules we are required to review:
the directors statement, set out within the Other Disclosures page, in relation to going concern;
the parts of the Corporate Governance Statement relating to the Companys compliance with the nine provisions of the UK
Corporate Governance Code specified for our review;
and certain elements of the report to shareholders by the Board on directors remuneration.
Stuart Watson (Senior Statutory Auditor) for and on behalf of PricewaterhouseCoopers LLP
9 Chartered Accountants and Statutory Auditors London
20 May 2013
The numbered paragraphs have the following significance:
(1) A clear title Independent auditors report.
(2) Defining what the audit covers the financial statements and the financial reporting
framework.
(3) Pointing out what the directors are responsible for and what the auditors are
responsible for. This reduces the expectations gap because many users of financial
statements think that the auditors are responsible for their preparation. It also states
that the audit was carried out in line with the International Standards of Auditing. This
establishes the approaches and methods used during the audit.
(4) An attempt to limit the auditors responsibilities to the members of the company and
not, for example, to lenders and suppliers.
(5) Again, reducing the expectations gap. Auditors give reasonable assurance that the
financial statements are free from material misstatement, whether caused by
fraud or error. There are no guarantees: reasonable assurance only and material
misstatements only.
Although the auditors do not routinely report on matters that are not in the financial
statement they have a duty to report if other information in the companys report is
inconsistent with the financial statements.
(6) The important part: the opinion paragraph, clearly headed so that it can be easily
found. Here the auditors state whether in their opinion the financial statements give a
true and fair view, comply with laws and financial reporting standards.
This type of assurance is known as positive assurance or reasonable assurance
because the auditors are definitive about their view on the financial statements
(7) Other matters on which the auditors report explicitly.
(8) Other matters on which the auditors report by exception:

Proper accounting records kept
Proper returns received from branches not visited
Financial statements in agreement with the accounting records
All explanations and information required have been obtained.
Matters requiring review:
Going concern review
Corporate governance compliance
Directors remuneration
(9) Signed and dated. The date is important because the audit is still in progress until
then.
7. Auditors rights
Auditors duties are to report on the matters as set out in the audit report above. They also
have a legal duty to report certain matters to the authorities; this is covered in more detail
later under auditors ethical duty to maintain client confidentiality.
! To fulfil their duties auditors are given certain rights by law:

Access to the companys records. This includes not only he accounting records but
also documents such as contracts, correspondence and board minutes.
To be given all information and explanations they requires.

Attendance at general meetings and notice thereof.
A right to speak at general meetings. This is a very important right that auditors have:
the right to speak directly to those being reported to.
A right to receive copies of written resolutions.
A right to require that a general meeting is held at which the accounts can be laid
before (ie presented to) members.
8. Appointment of auditors
With public companies the directors appoint the first auditor of the company and the auditor
holds office until the end of the first meeting of the company at which the directors lay its
accounts before the members. The members can then re-appoint the auditor, or appoint a
different auditor to hold office until the end of the next meeting at which the accounts are laid.
Therefore, auditors are reappointed annually by the members. If a public company fails to
appoint an auditor the Secretary of State may appoint one or more persons to fill the vacancy.
In a private company, if the members do not pass a resolution appointing an auditor for a
particular year the auditor in office is deemed to be re-appointed until the members pass a
resolution to reappoint him/her or remove him/her from office. However this does not apply if
the auditor was appointed by the directors or where the articles of association require
reappointment.
9. Resignation and removal of auditors
9.1 ! Introduction
If an auditor resigns or is removed there is always the fear that they are going for some
reason that members ought to know about. For example, the auditors might have concluded
that the directors of the company are concealing important information or are committing a
fraud on the company. In such cases the auditors are likely to resign because it will be
impossible for them to carry out a thorough audit. Therefore, upon either resignation or
removal the auditor must deposit a statement of circumstance at the companys registered
office.
If the company is not quoted on a stock exchange the auditor may simply state that there are
no circumstances that need to be brought to the attention of the companys members or
creditors.If the auditor believes that there are matters that need to be brought to the attention
of the companys members or creditors then the auditor must deposit a statement of the
circumstances in connection with leaving office.
If the company is quoted on a stock exchange the auditor must deposit a statement setting
out the circumstances of leaving of office irrespective of any matter that should be brought to
the attention of its members or creditors
9.2! Resignation
The steps are:
(1) Deposit a written notice with the company informing them of the resignation
together with the relevant statement of circumstance/no circumstance.
(2) Notify the Registrar of Companies and also provide the statement of circumstance
(3) Notify everyone entitles to receive financial statements - principally the members of
the company.
(4) Require the directors to hold an extraordinary general meeting. This enables the
resignation to be discussed with the member.
9.3! Removal
Auditors cannot be removed by the board. They can only be removed by the members (on
whose behalf they act). This gives the auditors much greater strength should they disagree
with the directors on some audit point: the directors cannot simply find more amenable
auditors. However, directors can have great influence over the members and might
recommend removal of the auditors even though the auditors are doing a good job.
Therefore, the auditors are entitled to make representations to the members at a general
meeting, arguing why they should not be removed.
If the resolution to remove them is passed, then:
(1) The auditors must deposit a statement of circumstance/no circumstance with the
company.
(2) The company must notify the Registrar of Companies and also provide the statement
of circumstance.
(3) Notify everyone entitled to receive financial statements - principally the members of
the company.
10. Auditors liability
10.1! Introduction
Occasionally auditors get it wrong and they put their name to a set of financial statements
which contain a material misstatement. Obviously, if users of the financial statements have
relied on those statements to make investment decisions, they could suffer financial harm
because they would have been misled.
When auditors are appointed they send an engagement letter to the company. Essentially,
this is a contract setting out both the auditors and the companys responsibilities. It is
possible for the auditors to breach this contract and so be liable for damages, but the main
legal risk that auditors suffer is from the tort of negligence.
For a claimant to prove a negligence claim, it must be shown that:
A duty of care to the claimant existed

The duty was breached
Monetary loss was suffered.
10.2! Duty of care
The English courts have been very reluctant to extend an auditors duty of care beyond the
members of the company as a whole. The key case is known as the Caparo case where a
company was taken over by Caparo on the basis of financial statements Caparo claimed
were misleading. The House of Lords (the UKs highest court then) concluded that the
auditors of the company taken over owed no duty of care to members of the public at large,
such as potential investors.
In partial contrast, in the Bannerman case it was held that auditors could owe a duty of care
to a bank if the auditors knew that the bank was relying on the audited financial statements
and the auditors did not disclaim their liability to the bank.
Paragraph 4 in the audit report above is known as the Bannerman clause because it
specifically warns users of the financial statements, other than the members as a whole, not
to rely on the financial statements for any purpose except where specifically agreed.
10.3! Breach of the duty of care
If the auditors carried out their audit in accordance with the International Standards in
Auditing it will be difficult to prove that they fell short of their duty of care.
10.4! Monetary loss
Negligence is a practical matter: monetary loss has to have occurred before the courts are
interested.
Question 1
Auditors can be removed from office by the directors of the company

Is this statement true or false?
Question 2
Which two of the following tasks do auditors undertake?

A! Preparation of the financial statements
B! Provide independent scrutiny of the financial statements
C! Prepare an audit report
D! Warn shareholders that their company is loss-making
Question 3
Which (several) of the following are part of the financial statements?

A! Directors report
B! Statement of financial position
C! Statement of profit or loss
D! Chairmans statement
E! Cash flow statement
Question 4
When discussing directors shareholders, who are the principals and who are the
agents?
Question 5
How frequently must auditors of a public company be re-elected?
Question 6
Auditors have a right to speak at general meetings

Question 7
What is a statement of circumstance?
Question 8
Incoming auditors are not allowed to communicate with outgoing auditors.

Question 9
Which of the following statements best describes auditors liability to users of financial
statements?
A! They are liable to all users of financial statements
B! They are liable only to the members
C! They are liable to members and can be liable to others
D! They are not liable to anyone because they only provide reasonable assurance that the
financial statements are free for material misstatement.
Chapter 2
THE ACCA CODE OF ETHICS AND
CONDUCT
1. Introduction
All members and students of the ACCA must follow the provisions of this code. Note that it
applies to:
Students
ACCA members acting as auditors
ACCA members acting in some other accounting roll.
Failure to comply with the code can lead to fines, to members being excluded from
membership, or to students being removed from the student register.
Ethics are not just an add on: they are regarded as being fundamental to being an ACCA
member or student. If poor ethical standards were allowed, then accountants lose much of
their value. They might be technically able to prepare or audit financial statements, but it the
financial statements lack credibility what is their point? Ethics give added value. Not only can
the accountant prepare financial information, but that information is also more reliable (and so
more valuable) because it has been prepared by someone adhering to ethical standards
2. The ethical framework

The ethical framework:
Establishes five fundamental principles

Recognises that these come under threat, and categorises those threats
Explains how many of the threats can be reduced or avoided altogether.
You might feel that some of the examples of threats described below are trivial, but it is
important that the accountant is not only seen to be acting ethically, but that there is no
danger of a suspicion of unethical conduct. In some situations, judgement is required as to
the severity of the threat.
3. The fundamental principles and their threats
3.1! The five fundamental principles
Principle Meaning
1 Integrity Members should be straightforward and honest in business

and professional relationships. Integrity is more than
honesty. It also means sticking up for what you believe is
right and following up areas of concern. For example, you
would not be acting with integrity if, upon seeing what might
be a fraudulent transaction you decide to not investigate it
further ie you turn a blind eye.
2 Objectivity Members should not allow bias, conflicts of interest or undue

influence to interfere with their professional or business
judgement. For example, if you were producing a budget
that will be used for a purchaser of the business, it will be
difficult to be objective as there will be an understandable
desire to draft an optimistic budget.
3 Professional conduct Members must keep up-to-date with legislation, accounting

and due care standards, auditing standards and so on. Members must
ensure that enough time, resources and care are devoted to
tasks so that they are carried out correctly.
4 Confidentiality Accountants frequently have access to confidential

information. Auditors see financial results before
shareholders; accountant in business might see everyones
remuneration. Therefore, accountants must not disclose
information unless:
> They have the clients permission to do so. For example,

the audit firm might have been asked to carry out tax
computations and to submit these to the revenue
authorities.
> There is a legal or professional right or duty to disclose

information. For example, many countries have anti-
money laundering legislation which compels auditors to
alert the authorities if they have even a suspicion of
money laundering. A right to disclose information can
arise if the audit firm had to defend itself in court against
allegations of negligence.
> A public duty to disclose information. The concept of

public interest is not defined by statute, and an auditor
would be advised to seek legal advice on these matters.
For example, is there a public duty to disclose that a
client pays staff below minimum wages. You might think
that morality is of disclosure, but the auditors prime duty
is to report on the financial statements, not to be a
watchdog for every breach of rules and regulations.
Principle Meaning
5 Professional behaviour Members must avoid any action that would bring the
profession into disrepute. For example, being found guilty of
theft (or even fare evasion) is likely land a member or student
in trouble with the ACCA.
Although not listed as one of the fundamental ethical principles, the concept of
independence is very important. It is more difficult to act with integrity and objectivity if you
are not independent from a client. The ACCAs code of ethics and conduct requires members
no only to be independent but also to be seen to be independent.
3.2! The threats
Title Meaning
1 Self-interest For example, financial self-interest
2 Self review For example, checking your own work and verifying your
own judgements and decisions
3 Advocacy For example, promoting a client to others
4 Familiarity For example, personal relationships that can interfere with

objectivity and professional scepticism
5 Intimidation For example, a physical threat (thankfully rare) or the threat

of losing your job
3.3! The safeguards
These can be categorised as:
Safeguards created by the profession. For example, adhering to professional

standards and following the ACCA S Code of Ethics and Conduct.
Safeguards created by the work environment. For example, a policy rotating
members of an audit team to avoid familiarity with a client, and providing training and
review procedures to ensure professional competence is not threatened.
Safeguards created by individual members. For example, staying up -to-date with new
accounting and auditing standards.
4. Threats and how to avoid or reduce them to an acceptable

level
4.1! Self-interest threats
Example of threat How it can be avoided or reduced to an

acceptable level
Financial interest arising from holding Shares in clients must not be owned by members of
shares in a client. the audit team or their immediate family members.
Contingent fees, such as an audit fee Contingent fees for audit work are not permitted.
of $50,000 for a clean audit report,
but only $25,000 if the audit report is
qualified.
Gifts and hospitality, such the audit Gifts and hospitality should not be accepted unless
team being taken out to dinner by a clearly insignificant.
client.
High fees from a single client. A very Fees from any one client should be kept under
high fee from one client can mean review. If the client is a public interest client (such
that the auditor is very dependent on as a listed company or a charity) the fees from that
that client, is desperate to keep that client should not exceed 15% of the firms total
client, and so will go easy on the fees. If the fees are greater than this then the matter
client. need to be reviewed independently.
Overdue fees. If an audit client still The auditor should not commence an audit if fees
hasnt paid last years fees, then the are outstanding
audit firm will want the clients
business to survive so that the fees
are paid. This might lead to a clean
audit report when really there are
problems.
Loans from a client. Unless it is the clients normal business to make

loans (for example, the client is a bank) and any
loans are made on normal business terms, auditors
should not accept loans from clients.
Accepting employment from a client. Simultaneous employment with a client and the
audit firm is not permitted. Additionally, if a lead
audit partner leaves the partnership he or she
should not join a public interest client as an
employee until at least a year has passed
A partner serving on the board of a This is not permitted.

client firm.
4.2! Self review threats

acceptable level
Preparing financial statements then In non-public interest companies this is

auditing them. permitted provided completely separate
teams are used for each function. Except
for emergencies, the preparation of
financial statements by auditors is not
permitted for listed or other public interest
companies.
Designing and implementing internal Evaluating internal control is often an

control systems. important audit procedure, so if the
auditors had designed the controls they
might be blind to any deficiencies and
they might be reluctant to subsequently
criticise the system.
Valuation Even if the audit firm were professionally

competent to do so, valuing, for example,
property for the purposes of financial
statements that the firm subsequently
audited is not permitted.
Taking on management responsibility. The auditors should avoid this

For example, participating in board
meetings, advising on which
strategies to follow
4.3! Advocacy threats

acceptable level
Promoting the audit client to potential Auditors should avoid assignments likely to
investors or siding with a client in a cause an advocacy threat.
legal dispute.
4.4! Familiarity threats

acceptable level
The audit partner is a close relative of Another partner should run that audit.
the clients finance director Close relative is not defined. Does it
include brother and sisters, children,
nephews and nieces, remote cousins?
Judgement must be used and the auditor
must be seen to be independent.
Friendships. Familiarity threats can Familiarity is a matter of judgement, but the

arise even if there is no legal auditor being the life-long best friend of the
relationship. finance director would be hard to justify.
Familiarity can arise through long-

association between audit and client staff.
For public interest clients a partner cannot
be in charge of the audit for more than
seven consecutive years and there must be
a gap of at least two years before further
involvement.
4.5! Intimidation threats

acceptable level
Threat of litigation. For example, the Resign as auditors.

client alleges that the auditor had
been negligent over some matter in
the past.
Threat of reporting the auditor to Resign as auditors.

regulatory authorities.
Question 1
What are the five fundamental ethical principles of the ACCA?
Question 2
All students of ACCA are bound by its Code of Ethics and Conduct. Is this statement true or
false?
Question 3
What is the ethical framework?
Question 4
What are the threats to an auditors independence?
Question 5
When may an auditor disclose confidential information about an audit client?
Question 6
For an auditor of a public interest company, what is the maximum fees that can
regularly arise from any once client?
A! 5%
B! 10%
C! 15%
D! 20%
Chapter 3
THE REGULATORY FRAMEWORK
1. Sources of regulation
The auditing profession is regulated at three levels:
National
International
Professional bodies, such as the ACCA
These are not in a hierarchy. For example, some matters to do with auditing and its regulation
are set out in national laws and auditors have to comply with the law in the country in which
they are operating. No international law or professional rule will override national laws without
the agreement of the national government. However, laws are often silent on matters of ethics
and, as was seen in the previous chapter, the ACCAs Code of Ethics and Conduct have
strict rules on ethical behaviour to which auditors and accountants must adhere.
2. National level
Laws and regulations vary greatly from country to country. For example, on matters of
corporate governance, the Sarbanes Oxley Act in United States of America is very
prescriptive and sets out in great detail how companies should be governed. By contrast, in
Europe, corporate governance is much more principles-based than rules based.
National legislation, when it exists, is more powerful than international laws or professional
rules. In particular national legislation determines who can be an auditor. This function can be
carried out directly by government or delegated to a Recognised Supervisory Body. The
ACCA is a Recognised Supervisory Body (RSB).
RSBs are required to ensure that:
Their members hold appropriate qualifications

Are open only to fit and proper persons
Have adequate rules and practices to ensure professional integrity and
independence. These include monitoring members and disciplinary procedures.
RSBs are also Recognised Qualifying Bodies and will:
Set out appropriate entry requirements

Determine appropriate theoretical instruction and professional experience
Set examinations
3. The international level
3.1! Introduction
As businesses and investment have become more and more international, there has been a
need to make financial statements from companies operating in different countries more
comparable. It is very difficult to compare companies if their financial statements are
produced using different approaches. Similarly, standards of auditing could vary widely so
that financial statements from some countries were much less reliable than those from others.
3.2! IFAC (the International Federations of Accountants)
IFAC is the international organisation of accountancy bodies, dedicated to serving the public
interest by strengthening the profession and contributing to the development of international
economies. IFAC is based in New York and its formal mission is to:
serve the public interest by: contributing to the development of high-quality standards
and guidance; facilitating the adoption and implementation of high-quality standards and
guidance; contributing to the development of strong professionalaccountancy organisations
and accounting firms and to high-quality practices by professional accountants, and
promoting the value of professional accountants worldwide; and speaking out on public
interest issues.
IFAC's view is that a fundamental way to protect and serve the public interest is to develop,
promote, and enforce high-quality, internationally recognised standards for:
auditing and assurance

education
ethics, and
public sector accounting.
These standards and related regulation are essential to ensuring the credibility of information
upon which investors and other stakeholders depends and to achieving sustainable global
economic development. As a result, IFAC supports the following independent standard-
setting boards:
International Auditing and Assurance Standards Board

International Accounting Education Standards Board
International Ethics Standards Board for Accountants
International Public Sector Accounting Standards Board
It promotes convergence to the standards issued by the boards as well as to the International
Financial Reporting Standards (IFRSs) set by the International Accounting Standards Board.
It also collaborates with member bodies and works with organisations throughout the world to
support the growth and development of the accountancy profession in emerging economies.
More recently The Public Interest Oversight Board (PIOB) has been established. The PIOB
ensures that these activities are properly responsive to the public interest; that due process is
followed, including international exposure and consultation; and that the views of all those
affected by new standards are thoroughly considered. Before the PIOB was established,
there was a danger that IFAC and the standard setting bodies were too inward-looking. Now
a much wider range of interested parties is represented.
The ACCA is a member of IFAC.
3.3 ! The International Auditing and Assurance Standards Board (IAASB).
The IAASB is a sub-committee of IFAC and is responsible for setting the International
Standards on Auditing (ISAs). As of November 2011, over 75 jurisdictions are using or have
signalled their intent to use the ISAs. The IAASB also sets assurance standards, including
those for review engagements, as well as standards for related services.
The ISAs set out how various aspects of auditing should be carried out for material items in
the financial statements. Auditors are expected to comply with the ISAs in all but the most
exceptional circumstances or where national legislation prevents compliance.
The ISAs (and other examinable documents) covered by this syllabus are:
The accounting knowledge that is assumed for Paper FAU is the same as that examined in
Paper FA1 and Paper FA2. Therefore, candidates studying for Paper FAU should refer to the
Accounting Standards listed under Paper FA1 and Paper FA2. Candidates will also be
expected to be familiar with Paper FFA.
International Standards on Auditing (ISAs)
Glossary of Terms
Preface to International Standards on Quality Control, Auditing, Review, Other Assurance and
Related Services
ISA 200 ! Overall Objectives of the Independent Auditor and the Conduct of an Audit
in Accordance with ISAs
ISA 220 ! Quality Control for an Audit of Financial Statements
ISA 230 ! Audit Documentation
ISA 260 ! Communication with Those Charged with Governance
ISA 265 ! Communicating Deficiencies in Internal Control to Those Charged with
Governance and Management
ISA 300! Planning an Audit of Financial Statements
ISA 315 ! Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment
ISA 320 ! Materiality in Planning and Performing an Audit
ISA 330 ! The Auditors Responses to Assessed Risks
ISA 450 ! Evaluation of Misstatements Identified During the Audit
ISA 500 ! Audit Evidence
ISA 501 ! Audit Evidence Specific Considerations for Selected Items
ISA 505 ! External Confirmations
ISA 520 ! Analytical Procedures
ISA 530 ! Audit Sampling
ISA 540 ! Auditing Accounting Estimates, Including Fair Value Accounting Estimates
and Related Disclosures
ISA 560 ! Subsequent Events
ISA 570 ! Going Concern
ISA 580 ! Written Representations
ISA 700 ! Forming an Opinion and Reporting on Financial Statements
ISA 705 ! Modifications to the Opinion in the Independent Auditors Report
Other Documents
ACCAs Code of Ethics and Conduct
Question 1
The international organisation of accountancy bodies, dedicated to serving the public

interest by strengthening the profession and contributing to the development of
international economies is known as
A! IASSB
B! IESBA
C! IFAC
B! IAS
Question 2
What is the function of the Public Interest Oversight Board?
Question 3
Which sub-committee sets the international Standards on Auditing?
Question 4
The rules set out in the International Standards on Auditing always override national
regulations governing the audit of the financial statements of companies
Chapter 4
AUDIT RISK
1. Introduction
Audit risk is the risk that the auditor gives an inappropriate opinion on the financial
statements.
For example, the auditors state that the financial statements are true and fair but they actually
contain a material misstatement.
There are no guarantees or absolute assurance in auditing: there is only reasonable

assurance that there are no material misstatements. Therefore, the auditor is subject to the
risk that the opinion might be wrong and the auditor must manage this risk and must weigh
up:
the amount of audit work that has to be done

the damage to reputation that will be done if the audit report is incorrect
the type of business
the audit fee
the potential damages that might have to be paid
whether or not it is worth having the client at all.
2. Client acceptance
2.1! Investigations
It is, of course, flattering to be asked to be a companys auditor. The assumption is that the
company has heard good reports and a new audit means new fees. However, risk
management starts with an investigation of whether or not the firm should take on the new
company at all or not. There are ethical, practical and risk-related issues:
Is it ethical to take on the new work? For example, there might be close personal
relationships to consider or the new fee income would make the auditor unduly reliant
on that client.
Will the auditor be able to meet the professional competence and due care criteria?
For example, the potential client might be an insurance company but the auditor has
no experience of auditing such specialist businesses.
Is it practicable to take on the new work given the size of the job and the auditors
current staffing levels and commitment to existing clients?
What is known about the type of business, its directors and its owners? Some types of
business are more risky than others, some businesses might be in business sectors
the auditor feels might cause reputational damage, and some directors can have
shady pasts.
Is the fee acceptable?
The steps that an auditing firm should take before agreeing to become the auditors of a new
client are therefore:
Ensure that it is professionally qualified to act on both ethical and legal grounds.
Ensure that existing resources are adequate to cover both the required expertise and
the time that the new work will take
Investigate the company, its owners and directors
Communicate with the present /outgoing auditor.
The last step is obligatory: the outgoing auditor will be well-placed to tell the new auditor if
there are professional or other reasons why the work should not be accepted. For example,
the out-going auditor might simply say that they think that the client had become too big for
them and that they were not able to continue. Alternatively, if they say something like there
were serious disagreements over the financial statements and the directors were not willing to
amend them, then the new auditors might think twice about becoming involved with what
might be a difficult set of directors.
The full process when taking over from a previous auditor is as follows:
Ask the client for permission to contact the outgoing auditor. If the new client refuses,
the appointment should be refused (what are they trying to hide?)
Contact the outgoing auditor and ask if there are any reasons why they should not
accept appointment.
The outgoing auditor has to ask the clients permission to contact the new auditor
(confidentiality rules require this). If the client refuses, the appointment should be
refused (what are they trying to hide?)
Assess any information received in the reply, together with other evidence collected
independently.
2.2! Engagement letter
Assuming that the auditor wants to accept the new client, then a letter of engagement will be
sent out to the client. This forms the contract between auditor and client, so it is a very
important document. Typical matters covered in the latter include:
Setting out the respective responsibilities of management and auditors

The scope of the audit (reasonable assurance, financial statements, material
misstatements, not primarily trying to detect fraud)
The financial reporting framework to be used.
The form of any reports to be issued
The auditors entitlement to see all documentation and receive all explanations
necessary for the audit.
Practical arrangements, such as timing and the involvement of internal audit.
The fee.
3. The audit process
3.1! Introduction
Once the audit has been accepted then the audit process can begin. There are essentially
three stages to most audits:
Planning. This will often require a meeting with the client certainly in the first year of
a new audit. Subsequently, a planning phone call might suffice for smaller clients. For
new audits the auditor will want to meet senior staff and to see clients premises. They
will want to discuss any problems that might have arisen in previous audits or any
special reports needed by the client. In subsequent years, the auditor will be
particularly interested in changes that the client has undertaken during the year such
as a new accounting system, additional premises, changes in senior personnel and
accounting or trading problems.
An interim audit. This takes place typically four or five months before the end of the
accounting period. This is when the accounting system and internal controls are
examined and tested.
A Final audit. This happens typically a few weeks after the accounting period end to
allow the client to prepare the draft financial statements. It is on these statements that
the auditor will be reporting.
A more detailed depiction of an audit is as shown below:
Planning the audit
Understand the
entity and its
environment
Preliminary
estimate of
materiality
Assessment of
risks
Responses to
risk
Good internal Poor internal

control expected control expected
Test internal
control
P
(le oor in
tte
Good r to terna
internal ma l co
na n
control ge trol
me
expected nt)
Full
Restricted substantive
substantive testing
testing
Final review
Report
3.2 ! Planning the audit
This is an essential stage in any audit. Indeed, in the audit report the auditor states that the
audit was planned.
The first step is to understand the entity (client) and its environment. Information that will be
collected includes:
Nature of the clients business

Key customers, competitors and suppliers
Location of operations, factories, shops and so on
Organisational structure
Recent sets of financial statements
Industry comparatives
Names of directors
Organisational objectives
Changes to the IT system

Industry regulation
Industry growth/decline
Accounting policies
Initial assessment of internal control procedures
Based on this information preliminary estimates of materiality can be made. Risks arise from
material misstatements so it is necessary to have an early idea of what sizes of errors are
likely to be material.
This information will also give the auditor some insight into the higher risk areas of the audit.
Risk would be increased, for example, if:
The business operates with cash sales

Inventory consists of small high value items (such a jewellery)
There are many dispersed locations
A new IT system has been introduced.
The auditor will respond to the risk assessment by designing appropriate audit procedures
aimed at supplying sufficient appropriate audit evidence that the financial statements are free
from material misstatement.
For example, in the case of inventory consisting of small high value items it will be necessary
to take great care over the audit of inventory. If a new IT system had been introduced during
the year, the auditor will have to carry out additional work on accounting entries just after its
implementation because the transition from old to new system might not have gone smoothly.
3.3! The purposes of audit planning
Planning an audit involves establishing the overall audit strategy for the engagement and
developing an audit plan. Adequate planning benefits the audit of financial statements in
several ways, including the following:
Helping the auditor to devote appropriate attention to important areas of the audit.
Helping the auditor identify and resolve potential problems on a timely basis.
Helping the auditor properly organise and manage the audit engagement so that it is
performed in an effective and efficient manner.
Assisting in the selection of engagement team members with appropriate levels of
capabilities and competence to respond to anticipated risks, and the proper
assignment of work to them.
Facilitating the direction and supervision of engagement team members and the
review of their work.
Assisting, where applicable, in coordination of work done by auditors of components
and experts.
3.4! Audit strategies and audit plans
Auditors are expected to produce and document both audit strategies and audit plans.
In establishing the overall audit strategy, the auditor shall:
(a) Identify the characteristics of the engagement that define its scope;
(b) Ascertain the reporting objectives of the engagement to plan the timing of the audit
and the nature of the communications required. This will include the timing of any
reports needed, the nature of the reports and for whom the reports are being
prepared.
(c) Consider the factors that, in the auditors professional judgment, are significant in
directing the engagement teams efforts. For example, ensuring that looking carefully
a whether the company is likely to survive in the foreseeable future.
(d) Consider the results of preliminary engagement activities and, where applicable,
whether knowledge gained on other engagements performed by the engagement
partner for the entity is relevant; and
(e) Ascertain the nature, timing and extent of resources necessary to perform the
engagement. This will includes deciding the number staff needed, their experience
and seniority. It will also include deciding to what extend third parties might needed
for some of the audit work, for example, surveyors might be needed to assess the
stage of completion of a building.
The audit plan will include:
(a) The nature, timing and extent of planned risk assessment procedures. This can be in
considerable detail as shown below.
(b) The nature, timing and extent of planned further audit procedures
(c) Other planned audit procedures that are required to be carried out so that the
engagement complies with ISAs
An excerpt form an audit plan relating to receivables is:
Circularise a sample of customers asking them to Circularise:

confirm their amounts owing at year end. All customer with balances >
$100,000
50 with balances > $50,000
$100,000
25 with balances <= $50,000
Assess the recoverability of a sample of invoices All invoices over $20,000

that have been outstanding for more than three 20 invoices <= $20,000
months
For a sample of invoices trace to cash received All invoices >$50,000

after year end. 10 invoices <=$50,000
This part of the plan is a detailed audit program which sets out exactly the work that has to be
done.
As a result of the audit planning, a detailed budget will be developed telling staff how long
they should spend on each element of the audit.
4. Materiality
4.1! Introduction
An item is material if its omission or misstatement could reasonably be expected to

alter the economic decisions of users of the financial statements.
An item can be material through its size, incidence and nature. For example, directors
remuneration has to be disclosed in the financial statements and no misstatement of these is
likely to be considered immaterial. Similarly there is no excuse for failing to state the cash at
bank figure accurately. However, with inventory, there can often be considerable judgement
needed to arrive at a fair value, and materiality will be less strict.
Materiality is ultimately a matter for the judgement of the audit partner. Just how will
shareholders be influenced by a figure? Are they all likely to be influenced the same way?
Although it will be up to the partner to make the final decision, it is important for members of
the audit team, many of whom are very junior and inexperienced, to be given some guidance.
There is little point on an auditor spending a lot of time asking for a $5 error to be corrected in
the financial statements of a multi-national company. Therefore, they work with preliminary
indicators of materiality and if an error exceeds these then is should be brought to
managements attention and, if not corrected, should be noted for the partners consideration.
4.2! Common benchmarks for materiality
Common materiality benchmarks (and you need to know these for your exam) are:
Profit before tax:! 5% 10%

Revenue:! ! % - 1%
Total assets! ! 1% - 2%
4.3! Performance materiality
Performance materiality means the amount or amounts set by the auditor at less than
materiality for the financial statements as a whole to reduce to an appropriately low level the
probability that the aggregate of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole. If applicable, performance materiality also
refers to the amount or amounts set by the auditor at less than the materiality level or levels
for particular classes of transactions, account balances or disclosures.
Consider this example: wages, electricity, depreciation, rent are all understated by 3%. Each
item on its own might have an immaterial effect on profits, but taken together, because the
errors add up the same way, the effect could be material. Therefore, the concept of
performance materiality was developed so that materiality levels are reduced during testing
so that more errors will be reported.
5. Analytical procedures
5.1! Introduction
Analytical procedures are extremely useful at the planning stage of an audit. The term
analytical procedures means evaluations of financial information through analysis of
plausible relationships among both financial and non-financial data. For example, if sales rise
you might also expect the packaging cost to rise. Analytical procedures includes
investigation of identified fluctuations or relationships that are inconsistent with other relevant
information or that differ from expected values by a significant amount. So, if packaging costs
do not rise in line with sales, the fear is that there has been an accounting error. Of course,
the apparent discrepancy might be explained by the company having adopted cheaper
packaging.
5.2! Type of analytical procedures
Analytical procedures include comparison of the entitys financial information with, for
example:
Comparable information for prior periods.

Anticipated results of the entity, such as budgets or forecasts, or expectations of the
auditor, such as an estimation of depreciation.
Similar industry information, such as a comparison of the entitys ratio of sales to
accounts receivable with industry averages or with other entities of comparable size in
the same industry.
Comparison of financial and related non-financial information. For example, number of
hotel guests x average price per room should be approximately equal to room
revenue.
Various methods may be used to perform analytical procedures. These methods range from
performing simple comparisons to performing complex analyses using advanced statistical
techniques.
6. The audit risk model
6.1! Introduction
At the start of this chapter, audit risk was defined as the risk that the auditor gives an
inappropriate opinion on the financial statements. Proper planning is essential to reduce audit
risk by, for example, giving appropriate attention to important of high risk areas of the audit.
However, this common sense approach to audit has an extremely important theoretical
foundation that shows how risk can build up or be reduced.
6.2! The components of audit risk
Audit risk = Inherent risk x Control risk x Detection risk
Inherent risk:! the susceptibility of an assertion to misstatement that could be

materialassuming that there were no related internal controls. In
other words, the risk of an error occurring in the first place.
Control risk:! the risk that the misstatement will not be prevented, detected and
corrected on a timely basis by the entitys internal control
Detection risk:! the risk that the auditors procedures will not detect the
misstatement.
Therefore, for a material error to get into the published financial statements together with in
inappropriate audit report, three things have to happen:
(1) The error has to have occurred (inherent risk)

(2) It must not have been picked up by the clients internal control system (control risk)
The error is now in the financial statements that are about to be audited, and together these
two risks determine the risk of a material misstatement occurring.
(3) The financial statements are audited, but the auditor does not detect the misstatement
The error will now be in the published financial statements that have an inappropriate audit
report and which are sent to shareholders.
6.3! What causes the risks?
Inherent risk can be increased by factors such as:
Complex transactions
Inexperienced staff
Time pressure
New IT systems
Pressure to perform (leading to optimistic estimates)
Cash businesses
Control risk can be increased by:
A poor internal control system
Poor supervision
Poor compliance with internal control procedures
In-experienced staff
Shortcuts
An unfavourable control environment (not supportive of internal controls).
Detection risk is decreased by:
Performing more audit work eg larger samples are tested.

Performing different audit work eg by attending inventory locations in every branch or
by enlisting the help of experts.
Assigning more experienced staff.
Careful supervision and review of the audit work
Peer reviews (one partner reviewing the work of another)
6.3! What can be done about the risks?
The auditor can do little about the inherent risk. Over time the auditor might be able to
decrease the control risk by writing to the client and making recommendations about how the
internal control system could be improved or more consistently implemented. However, that
auditor can affect the detection risk as that is determined by the amount and nature of the
audit work carried out.
Therefore, if inherent risk and/or control risks are high, the auditor can reduce audit risk to an
acceptable level by performing more audit work.
If inherent risk and control risk are both low, the auditor will perform less work because there
is only a low risk of an error having occurred and then only a low risk that the clients system
will not detect the misstatement.
6.4! Professional scepticism
The amount of audit work that has to be carried out should be influenced by the concept of
professional scepticism. If you are sceptical it means that you do not know whether or not
something is true; you would have a questioning attitude and would not believe something in
the absence of reasonable evidence.
Auditors must adopt this attitude. This does not mean that they suspect all directors and
employees in the client company of telling lies and deliberately misleading them, but they are
aware that everyone makes mistakes, everyone can be a victim of unrealistic optimism, and
that everyone can give quick but incorrect replies if under time pressure. Of course, human
nature being what it is, occasionally auditors will be deliberately given incorrect information.
Therefore, professional scepticism means walking a tight-rope between being completely

disbelieving and completely accepting of all management statements.
Professional scepticism affects the amount of audit work that has to be carried out. It includes
being alert to, for example:
Audit evidence that contradicts other audit evidence obtained.

Information that brings into question the reliability of documents and responses to
inquiries to be used as audit evidence.
Conditions that may indicate possible fraud.
Circumstances that suggest the need for audit procedures in addition to those
required by the ISAs.
Maintaining professional scepticism throughout the audit is necessary if the auditor is, for
example, to reduce the risks of:
Overlooking unusual circumstances.

Over generalising when drawing conclusions from audit observations.
Using inappropriate assumptions in determining the nature, timing and extent of the
audit procedures and evaluating the results thereof.
6.4! Fraud
It is not the auditors responsibility to detect fraud though if it gives rise to a material
misstatement, an audit should give rise to reasonable assurance that the fraud is discovered.
Fraud may involve sophisticated and carefully organised schemes designed to conceal it.
Therefore, the procedures used to gather audit evidence may not be effective for detecting
an intentional misstatement that involves, for example, collusion to falsify documentation
which may cause the auditor to believe that audit evidence is valid when it is not.
Nevertheless, as part of planning the audit, the engagement team members and the
engagement partner must discuss on how and where the entitys financial statements may be
susceptible to material misstatement due to fraud, including how fraud might occur.
Question 1
What are the three components of audit risk and which can the auditor most easily
affect?
Question 2
It is the auditors responsibility to detect fraud.
Question 3
Professional scepticism means not trusting anyone
Question 4
Which two of the following would increase the risk of a misstatement in the draft
financial statements presented to an auditor to audit?
A! Inexperienced accounting staff
B! Inexperienced auditors
C! Complex transaction
D! A good system of internal control
Question 5
What are the commonly used preliminary estimates of materiality in terms of profit,
turnover and total assets?
Question 6
What is the purpose of an engagement letter?
Question 7
What are the four things an auditor must consider before accepting a new
appointment?
Chapter 5
TESTS OF CONTROL OR
SUBSTANTIVE TESTS?
1. Introduction
The previous chapter introduced both the following diagram of the audit process and the
components of audit risk:
Planning the audit
Understand the
entity and its
environment
Preliminary
estimate of
materiality
Assessment of
risks
Responses to
risk
Good internal Poor internal

control expected control expected
Test internal
control
P
(le oor in
tte
Good r to terna
internal ma l co
na n
control ge trol
me
expected nt)
Full
Restricted substantive
substantive testing
testing
Final review
Report
and the audit risk mode
Audit risk = Inherent risk x Control risk x Detection risk
We now bring these concepts together to determine how the audit will proceed.
2. Test internal controls or use full substantive testing?
2.1 ! Test internal controls
If the internal control system of the company is good, then the control risk is low and this will
result in a low audit risk provided the controls are being carried out as they should be.
The audit will therefore proceed down the left hand side of the diagram and will substantially
rely on testing the internal controls for their design and their operation. Testing controls
means what it says: the auditor tests that the controls are operating rather than testing
amounts in the financial statements.
For example, if an internal control is that all overtime claims have to be authorised by a
supervisor, then the auditor would choose a sample of the claims to inspect them for the
supervisors signature. As part of this test, the auditor is not really concerned with the amount
of overtime: if the supervisor has been doing his or her job properly, the overtime payments
will have been approved.
2.2! Substantive tests
If the internal control system is poor the auditor has few controls to test because the client has
not implemented any. The control risk is high. Therefore, the only way that the auditor can get
evidence that amounts are correct is to carry out more audit detection work by performing
substantive tests, and the audit will proceed down the right hand side of the diagram.
Substantive tests attempt to verify directly the items in the financial statements. There are two
types of substantive tests:
Analytical procedures
Tests of detail
So, using the overtime example, now the claims have not been authorised by the supervisor,
so that auditor has do find evidence that the overtime cost is correct.
Analytical procedures:
Compare to the previous year

Compare to budget
Compare month by month and investigate very high or low amounts
Try to tie in overtime payments to production volume
Compare overtime payments amongst staff in the same department to see if anyone
appears to be consistently paid large amounts.
Tests of detail
Inspect and compare a large number of overtime claims to work records.

Enquire of the supervisor and management about why any particularly large overtime
payments had been necessary.
2.3! Internal controls not operating effectively
Sometimes the auditor will start the audit on the assumption that there is a good internal
control system, but then discover that the controls are not operating effectively.
In such a case the auditor will have to change approach and switch to the full substantive
approach at least for the areas where internal control is not effective.
A management letter will be sent by the auditors to the companys management explaining:
The nature of the internal control weakness.

The possible consequences
How the internal control deficiency can be fixed.
2.4! Restricted substantive testing
Even where companies have very good systems of internal control, testing controls is never
exclusively relied upon and there is always some substantive tests performed on material
amounts in the financial statements.
Internal controls have some inherent limitations which mean that relying on them exclusively
would be dangerous. The inherent limitations are:
Human error and judgement ! human error may lead to breakdowns

in internal control. For example, in the
design of computer processing
controls.
Failure to understand or take action! there may be ineffective controls

because individuals may not
understand the purpose of a specific
control. For example, the purpose of
a payroll exception report.
Inappropriate management override of controls! management may purposefully

override existing controls. For
example, a sales director may
choose to opt to extend credit to a
long-standing customer in order to
create customer goodwill, in
contravention of laid down credit
control procedures.
Collusion by two or more people! leading to circumnavigation of

controls. For example, between a
factory employee, factory manager
and a wages data processing clerk
to claim, authorise and process a
fraudulent payment for overtime
wages.
Management judgement ! with regard to the nature and extent

of risk the company faces. For
example, management might
underestimate the risk of fraud.
Cost benefit consideration! For example, the cost of employing

additional accounts staff to ensure
adequate segregation of duties may
outweigh the maximum benefit to be
derived from improved internal
control.
Ability to cope with non-routine transactions! the ability to predict the likelihood of
non-routine transactions arising
means that it is less likely that
systems will be designed to cope
with such transactions. For example,
the purchase of a very expensive
non-current asset.
2.5! Audit efficiency
If there is a good internal control system, and this is verified by testing the operation and
effectiveness of the controls, then that can be substantially relied upon to prevent material
errors occurring in the financial statements. This will result in a very efficient audit because
relatively few instances of the control operating have to be tested: typically about 30.
Therefore in a multi-million $ enterprise with thousands of invoices being processed, the
auditor can collect sufficient appropriate audit evidence that, for example, an invoice cannot
be paid twice by inspecting around 30 paid invoices to make sure that they have been
marked Paid or cancelled in some other way. Marking the invoices Paid is part of the
internal control system and if all invoices inspected have been properly cancelled the auditor
will assume that the control is operating correctly. This is obviously a very efficient audit
approach. Its not foolproof, of course, as there could be invoices that have slipped through
the system and which were paid twice, but the audit test will provide reasonable assurance
that there are no misstatements.
If 5 out of the 30 invoices inspected had not been cancelled, then the auditor will probably
look at another 30 to see the extent of the internal control breakdown. If there is a high
number in the additional invoices not cancelled, then the auditor might conclude that the
control cannot be relied upon and will have to turn to substantive testing in which a very large
number of payments might have to be inspected.
If the internal control system had originally been judged to be poor, then the substantive route
would have been taken from the start and this usually means high volume testing of
transactions. This is usually a much less efficient route to collect the sufficient appropriate
audit evidence.
Occasionally, the substantive route might be taken even if controls do exist. For example,
auditors may decide that 100% testing appropriate where there are a small number of high
value items that make up a population, or when there is a significant risk of material
misstatement and other audit procedures will not provide sufficient appropriate audit
evidence. An example would be a property company that has have 20 purchase/sale
transactions in the year. Each transaction is likely to be material and there is no gain in
efficiency or audit effectiveness by not looking at all 20.
Question 1
What are the two classes of substantive test?
Question 2
Which approach to auditing will normally result in a more efficient audit? An audit
relying primarily on:
A! Tests of control
B! Substantive tests
Question 3
If internal control is very good, auditors can rely on tests of control and do not need to carry
out any substantive testing.
Question 4
What are the three elements of a management letter?
Chapter 6
ASSERTIONS AND AUDIT EVIDENCE
1. Introduction
When a figure appears in financial statements it is making a number of assertions. For
example, if the receivables figure is $2,453,000, then figure is asserting:
The amount has been properly valued

The receivables are owned by the company
The receivables exist
The receivables are complete
The amount is indeed properly described as receivables.
It is not possible to simply audit $2,453,000 in one go: each assertion that figure is making
requires audit evidence.
2. The assertions
2.1! Introduction
The full list of assertions is often remembered by the acronym ACCA COVER:
Accuracy
Completeness
Cut-off (that an event or transaction has been included in the correct period)
Allocation (that correct labour and overhead costs are included in inventory)
Classification and understandability
Occurrence
Valuation
Existence
Rights and obligations (for example, is the asset owned outright or leased).
However in ISA 315 the assertions are divided into three groups. The names of the assertions
are as set out in ISA 315; in ACCA cover, above, they were slightly altered to allow the
acronym.
2.2 ! Assertions relating to presentation and disclosure
(a) Occurrence and rights and obligationsdisclosed events, transactions, and other
matters have occurred and pertain to the entity.
(b) Completenessall disclosures that should have been included in the financial
statements have been included.
(c) Classification and understandabilityfinancial information is appropriately presented

and described, and disclosures are clearly expressed.
(d) Accuracy and valuationfinancial and other information are disclosed fairly and at
appropriate amounts.
2.3! Assertions relating to classes of transactions and events for the period under
audit
(a) Occurrencetransactions and events that have been recorded have occurred and
pertain to the entity.
(b) Completenessall transactions and events that should have been recorded have
been recorded.
(c) Accuracyamounts and other data relating to recorded transactions and events have
been recorded appropriately.
(d) Cutofftransactions and events have been recorded in the correct accounting period.
(e) Classificationtransactions and events have been recorded in the proper accounts.
2.4! Assertions relating to account balances at year end
(a) Existenceassets, liabilities, and equity interests exist.
(b) Rights and obligationsthe entity holds or controls the rights to assets, and liabilities
are the obligations of the entity.
(c) Completenessall assets, liabilities and equity interests that should have been
recorded have been recorded.
(d) Valuation and allocationassets, liabilities, and equity interests are included in the
financial statements at appropriate amounts and any resulting valuation or allocation
adjustments are appropriately recorded.
3. Audit evidence
3.1! Audit procedures for obtaining audit evidence
These are the possible procedures:
Inspection
Observation
External confirmation
Recalculation
Reperformance
Enquiry
For the sake of easy learning they are sometimes written to (almost) form the vowels AEIOU:
Enquiry and confirmation
Inspection
Observation
RecalcUlation and reperformance
There are no methods to collect evidence that cannot be categorised under one of these
headings.
All methods can be used for substantive testing; all except analytical procedures can be
used for tests of control.
3.2! Examples of evidence collecting procedures
Procedure Example of use in tests of Example of use in

control substantive tests
Analytical procedures Comparison of receivables

collection period from one
year to the next to test the
assertion of valuation.
Enquiry and confirmation Ask the sales order clerk if he/ Ask the directors if all
she performs a credit check liabilities have been included
before accepting an order. in the financial statements to
test the assertion of
completeness.
Confirm the amounts in

receivables by obtaining
written confirmation form
debtors.
Inspection Inspect times sheets to ensure Inspect computers in the

that they have been signed by office to test the assertion of
the supervisor as authorisation existence.
Observation Observe warehouse staff Observe the process of

counting goods as they arrive despatch and sales
to ensure the quantity is as recording to test the
ordered. assertion of completeness.
Recalculation and Reperform the bank Recalculate the year-end

reperformance reconciliation to ensure that it is receivables ageing analysis
being carried out correctly and subsequent provision for
doubtful receivables to test
the assertion of valuation
Note that for each substantive test, the assertion tackled by the procedure is described. Note
that a test of control, tests the operation of a control. Tracing amounts from invoices to the
nominal ledger is not a test of control: this is a test of detail (a substantive test). Inspecting the
invoices to see that the nominal ledger account code had been independently checked by a
member of staff is testing a control.
3.4! Sufficient, appropriate audit evidence
The sufficiency and appropriateness of audit evidence are interrelated.
Sufficiency relates to the quantity of audit evidence. The quantity of audit evidence needed is
affected by the auditors assessment of the risks of misstatement (the higher the assessed
risks, the more audit evidence is likely to be required) and also by the quality of such audit
evidence (the higher the quality, the less may be required). Obtaining more audit evidence,
however, may not compensate for its poor quality.
Appropriateness relates to the quality of audit evidence: its relevance and its reliability in
providing support for the conclusions on which the auditors opinion is based. The reliability
of evidence is influenced by its source and by its nature.
The following can be useful in assessing the quality of audit evidence:
External evidence is stronger than internal evidence.

Written is stronger than oral.
Evidence is better if the internal control system is strong.
Evidence obtained directly by the auditor is better than evidence obtained via the
client.
Originals are better than photocopies.
Therefore, a director simply telling the auditor something is very weak evidence (internal,
oral). A bank writing to the auditor and certifying the bank balance is very strong evidence
(written, external, obtained directly by the auditor).
Question 1
What are the audit assertions (ACCA COVER)
Question 2
Which assertions relate to balances at period end?
Question 3
What are the ways in which audit evidence can be collected (AEIOU)
Question 4
An auditor requires xxxxxxxxxx xxxxxxxxxx audit evidence that the financial statements are
free form material misstatement.
What are the missing terms?
Question 5
Which of the following pairs of terms represents stronger audit evidence?
Written Oral
Obtained via the client Auditor direct obtained
Internal External
Photocopies Originals
Chapter 7
OBTAINING AUDIT EVIDENCE
SAMPLING
1. Introduction
It is rare for 100% of transactions or balances to be examined during an audit. If internal
controls are being relied upon, relatively few operations of the controls are examined (say 20
50) to establish with reasonable certainty that the control is operating effectively. Even with
substantive testing it is usually impracticable to look at all transactions unless the business is
very small or there are only a very few transactions. Therefore, samples are picked from the
population and the audit tests are performed on the sample.
It is important that the samples are, as far as possible, representative of the population as a
whole otherwise wrong conclusions will be drawn about the population. For example, looking
only at overtime authorisations that took place in March will give weak evidence about the
operation of the control throughout the year.
2. Statistical sampling
2.1! What this means
Statistical sampling means that every member of a population has an equal chance of being
picked in the sample. In particular it means that the sample will not be biased so does not
favour one group or type of items.
Only statistical sampling can be used to draw valid conclusions about the characteristics of a
population.
2.2! Methods of statistical sampling

Random selection or random sampling. Each member of the population is
numbered consecutively and a random number generator used to determine which
item should be selected. For example, if there are 10,000 sales invoices that had been
issued with consecutive numbers from 15,001 to 25,000 and a sample size of 30 is
required, the random number generator (one is available in Excel) would be
programmed to pick 30 random numbers in the range 15,001 to 25,000. This results in
a statistical sample. This approach will probably work well for documents issued by
the firm because these will often be consecutively numbered. However, documents
such as purchase invoices from suppliers are unlikely to be consecutively numbered
because they come from a range of suppliers. Therefore, the first step in using
random sampling would be to number them consecutively. This will often be
impracticable, so other methods are used that will approximate random selection.
Systematic sampling. In this method, to pick 30 items from 10,000, a constant
interval is chosen as 10,000/30 = 333. The first item will be chosen randomly from the
first 333 items in the file then every 333rd item through the file is picked. Care is
needed to ensure that the interval does no resonate with a pattern in the data. For
example, if a shop traded 5 days a week and you were wanting to do audit tests on
amounts banked, if you chose an interval of every 10th day, you would always be
picking the same day of the week.
Monetary unit sampling. Consider this list of receivables:
Customer Balance $ Cumulative $
A 100 100
B 2,345 2,445
C 312 2,757
D 6,846 9,603
E 7,423 17,026
F 124 17,150
G 89 17,239
I 2,678 19,917
J 151 20,068
K 9,467 29,535
L 5,732 35,267
M 733 36,000
36,000
Assume the sample size in to be 4.
This would split the total value of receivables into 36,000/4 = 9,000
The first amount is chosen at random in the range 1 9,000, say 2,741.
The next items will, by cumulative value, increase from this at $9,000/item, so 11,741,
20,741, 29,741.
These values imply that the following receivables will be chosen:
Customer Balance $ Cumulative $
A 100 100
B 2,345 2,445
C 312 2,757 Value 2,741 falls in this cumulative value( ie

between 2,445 and 2,757)so customer C will be
chosen
D 6,846 9,603
E 7,423 17,026 Cumulative value 11,741 falls here, so customer

E will be chosen
F 124 17,150
G 89 17,239
I 2,678 19,917
J 151 20,068
K 9,467 29,535 Cumulative value 20,741 falls here, so customer

K will be chosen
L 5,732 35,267 Cumulative value 29,741 falls here, so customer

L will be chosen
M 733 36,000
36,000
Instead of picking customers at random, monetary values are chosen by systematic

sampling. This method is much more likely to choose large balances than small ones,
but it is a form of random sampling.
Stratified sampling. In this approach, the population is divided into groups or strata. For
example, a receivables ledger might be stratified as follows:
Number of Balances
customers
20 >$100,000
100 $20,000 100,000
500 <20,000
The auditor might decide to pick all of the balances >$100,000, 25 chosen randomly
from the middle range and 30 chosen randomly from the low range.
Provided items from each stratum are properly chosen, valid statistical conclusions be
drawn about each stratum and also about the population.
The method has the advantage of ensuring high value items are all examined and this
might be important when deciding on bad debt allowances. If simple random sampling
of 75 items had been used there would be a high chance that none of the largest
balances would have been picked.
2.3! Methods of non-statistical sampling

Haphazard sampling. Here the auditor uses judgement to pick a sample. There is a
high probability that the auditor, perhaps unwittingly, introduces bias.
Block (sequence) sampling. A block of consecutive documents or transactions is
chosen. This will generally not produce a representative sample. It can be used on
occasions where the auditor wants to ensure that the sequence is complete.
3. Audit risk revisited
3.1! Introduction
You should remember from a previous chapter that audit risk is the risk that the auditor comes
to the wrong conclusion about the financial statements and gives an inappropriate opinion.
One of the contributors to audit risk was detection risk the auditor failing to spot a
misstatement.
Detection risk has two causes: sampling risk and non-sampling risk.
3.2! Sampling risk
This can be described as bad luck. For example, a population contains 10% of documents
that have not been properly approved. If a sample of 10 items were randomly chosen there is
approximately a 35% chance (0.910) that no non-approved items have been chosen. If the
auditor only happens to pick 10 good invoices the auditor will conclude that the internal
control is working well when, in fact, 10% of invoices are not approved.
Sampling risk is reduced by increasing the sample size. If 30 were chosen then the chance of
not finding a bad invoice is reduced to 4%.
Sample size should be large enough to reduce sampling risk to an acceptably low level.
For tests of controls sample size is affected by:
The extent to which the auditor relies on the control

The desired level of assurance
The expected rate of deviation. The higher the rate of deviation the greater the sample
size needs to be to draw conclusions.
For substantive tests sample size is affected by:
The risk of material misstatement

What other audit work can be done to address the same assertion
The desired level of assurance.
3.3! Non-sampling risk
Non-sampling detection risk is defined as any risk not arising from sampling. For example, if
transactions were very complex and the auditor lacked the right knowledge to examine the
documents properly, it wouldnt matter if 100% were selected as the auditor would not be
capable of finding any errors. The auditor simply doesnt know what to look for.
Non-sampling risk is reduced by:
Assigning more experienced staff to the audit

Proper direction and supervision
Careful review
Training
Question 1
Identify each of the following as a method of Statistical sampling (S) or nNon-statistical

sampling (N)
N or S
Haphazard sampling
Monetary unit sampling
Systematic sampling
Block sampling
Question 2
How can sampling risk be reduced
Question 3
How can non-sampling risk be reduced
Question 4
Explain what is meant by the term statistical sampling
Question 5
Explain what is meant by the term stratified sampling
Chapter 8
THE USE OF EXPERTS AND OTHER
THIRD PARTIES
1. Introduction
From time to time both clients and auditors have use experts to help them with some items in
the financial statements or to help with the audit. Examples include the use of:
Estate agents to value property.

Surveyors to assess the degree of completion of construction contracts.
Actuaries to assess pension liabilities and surpluses
Lawyers to estimate the likelihood of damages or penalties having to be paid
Internal auditors who might be involved in helping the external audit
The use of experts does not remove the external auditors responsibility to be satisfied that
sufficient appropriate audit evidence has been collected to support the financial statement
assertions and to provide reasonable assurance that the financial statements are free of
material misstatement. The external auditor signs the audit report and responsibility for its
contents remains firmly there.
2. Types of experts
2.1! Managements experts
A managements expert is an individual or organisation possessing expertise in a field other

than accounting or auditing, whose work in that field is used by the entity to assist the entity in
preparing the financial statements. For example, an actuary or the companys lawyer.
If information to be used as audit evidence has been prepared using the work of a
managements expert, the auditor shall, to the extent necessary, having regard to the
significance of that experts work for the auditors purposes:
Evaluate the competence, capabilities and objectivity of that expert. This could be
obtained by discussion with the expert and by investigating the experts qualifications
and experience
Obtain an understanding of the work of that expert. For example, whether any
professional or other standards apply; what assumptions and methods are used by
the managements expert, and whether they are generally accepted within that
experts field; the nature of internal and external data or information the managements
expert uses.
Evaluate the appropriateness of that experts work as audit evidence for the relevant
assertion. For example, the relevance and reasonableness of that experts findings or
conclusions and their consistency with other audit evidence; if that experts work
involves use of significant assumptions and methods, the relevance and
reasonableness of those assumptions and methods.
2.2! Auditors experts
An auditors expert is an individual or organisation possessing expertise in a field other than

accounting or auditing, whose work in that field is used by the auditor to assist the auditor in
obtaining sufficient appropriate audit evidence. An auditors expert may be either an auditors
internal expert, or an auditors external expert.
The auditor must assess the experts:
Competence: the nature and level of expertise of the auditors expert.

Capabilities: the ability of the auditors expert to exercise that competence in the
circumstances of the engagement. Factors that influence capability may include, for
example, geographic location, and the availability of time and resources.
Objectivity: relates to the possible effects that bias, conflict of interest, or the influence
of others may have on the professional or business judgment of the auditors expert.
For example, it would be dangerous to obtain property valuations form an estate agent
which relied on the client for substantial amounts of work.
It is important that the auditors expert undertakes to maintain confidentiality about the clients
affairs as usually to produce their report they have to have access to sensitive client
information.
It is important that the auditor evaluates the adequacy of the experts work. This can include:
Inquiries of the auditors expert.

Reviewing the auditors experts working papers and reports.
Corroborative procedures, such as:
Observing the auditors experts work;
Discussing the experts findings;
Examining published data, such as statistical reports from reputable sources
to determine if the experts opinion is consistent with that data.
Confirming relevant matters with third parties;
Performing detailed analytical procedures;
Re-performing calculations;
Examining the source data used.
So, if an estate agent were valuing properties, the auditor should:
Use statistical information to compare valuation changes with overall market changes
in the same geographical area.
Ensure that all properties owned at year end (and only those properties) are covered
by the report.
Re-perform some of the calculations, such as ensuring that the valuation schedule
adds up correctly.
Question 1
Using an expert allows the auditor to avoid responsibility in areas where the expert gives his
or her opinion
Question 2
If an auditor appoints an expert what three qualities must be investigated?
Chapter 9
AUDIT EVIDENCE: COMPUTER
ASSISTED AUDITING TECHNIQUES
(CAAT)
1. Introduction
Even very small businesses will usually maintain their computer records on computer. There
are many advantages to this, not least that trial balances will usually balance and control
accounts will reconcile to the underlying detailed records. However, the absence of as many
hand-written data and documents data can make auditing more difficult. For example, it can
be difficult to test whether a computer is carrying out a procedure correctly and it can be
more difficult to see and examine the information and records than in a manual system.
Computer Assisted Audit Techniques (CAAT) have been developed to assist the auditor
when the client maintains computerised records.
2. Types of CAAT
2.1! Audit software
Audit software (or audit programs) is software developed and used by auditors. Audit
software allows clients accounting data files to be read and examined.
Auditors Reads Clients accounting

audit software database
The processes carried out by the auditors software commonly include:
Adding up the records. For example, inventory values and receivables balances. The
totals are the amounts that should appear in the statement of financial position.
Performing calculations for analytical reviews.
Identifying and printing details of unusual items for further investigation, such as credit
balances on a receivables ledger or negative inventory balances.
Picking samples. For example, that audit software can be programmed to create a
stratified sample or a pure random sample.
Picking all items with particular characteristics, such as all sales orders approved by a
certain employee.
Once it is set up, audit software can quickly, efficiently and economically examine every item
on a data file. This which would often be difficult or impossible if attempted manually. It can
greatly speed up audit completion and reduce costs.
2.2! Test data
Test data is auditors data that is operated on by clients program. It is used to test the
workings and resilience of programs.
Auditors Is processed by Clients accounting

audit software database
The results produced by client programs are compared with predictions of what should
happen and any discrepancies are investigated.
Test data is designed to:
Test that calculations are carried out correctly by client software. For example, enter
time sheet data of 50 hours worked and ensure that the correct wages and tax are
calculated.
Test that programmed controls and procedures are carried out correctly. For example,
if a clients system should reject orders from customer over their credit limit, test that
such orders are indeed rejected by entering an order that should be rejected. Another
example of a programmed control would be testing that only staff members who are
allocated certain privileges can log-on and change someones salary: log-on with
what should be inadequate rights and ensure that you cannot change a salary.
Test how resilient software is against input errors. For example, test what happens if
an account number is entered incorrectly, or a negative amount of stock is ordered, or
an impossible date is entered.
Test data might be the only way in which certain controls can be verified. For example, a
company web-site might properly reject an order from a customer, but there might be no
permanent record available to the auditors to verify that this control is happening.
3. Problems with CAAT techniques

Technical/set-up problems. Initially, additional time and technical expertise will be
needed to set up audit software and test data properly. The time and expenses of this
should be repaid in subsequent years.
Clients can be reluctant to let auditors interfere with their computer records. This is
more of a problem with test data where deliberately false transactions are processed
to test the system. The normal way round this is for the auditor to use a copy of the
clients system and to process their test data against that. This technique is known as
dead test data. There is a risk, of course, that the programs being used by the client
are different to the copies being used by the auditor.
Question 1
What is meant by the term dead test data?
Question 2
Which of audit test data (TD) or audit software (AS) would be more useful for the
following audit objectives?
To determine what would happen if a negative

amount of goods were ordered.
To find and print out negative inventory amounts.

To select receivables balances for verification
To re-perform an aged receivables analysis
To determine how receivables are followed up:
statements, reminder letter, more urgent letters
etc.
Question 3
Which two of the following statements are correct?

A! Audit software belongs to the client and acts on auditors data.
B! Audit software belongs to the auditor and acts on client data.
C! Test data is the clients and is acted on by audit software.
D! Test data is the auditors and is acted on by clients programs.
Question 4
Which several of the following are true?!

A! CAAT techniques can allow a 100% examination of transactions.
B! CAAT techniques are easy to set up.
C! CAAT techniques allow some procedures to be tested that would be difficult to test in
any other way.
D! Once set up CAAT will normally allow better and more efficient audits.
Chapter 10
DOCUMENTATION
1. Introduction
Before the auditor can assess and test a clients system of internal control, the accounting
system must be documented and understood. These processes, as are tests of control, are
usually carried at the interim audit stage.
The accounting system documentation will be filed in the auditors permanent audit file for the
client. Each year, before starting the audit process the documentation has to be reviewed
and updated for any changes in the clients system
2. Control objectives, control procedures and tests of control
2.1! Control objectives
The objective of controls is to prevent loss or damage to the client. For example, a company
does not want:
Purchase invoices to be paid twice
Goods to be delivered to non-credit worthy customers
Overtime to be paid for if not worked
Inventory or cash to be stolen
Non-current asset to be bought without proper authorisation.
2.2! Control procedures
Control procedures are specific ways in which control objectives can be met. For example,
the above objectives could be met by:
Objective: to prevent Possible procedures (controls)
Purchase invoices to be paid twice Cancel invoices when paid
Goods to be delivered to non-credit Credit check before delivery

worthy customers
Overtime to be paid for if not worked Timesheets or clock cards to be authorised by

supervisor
Inventory or cash to be stolen Physically safeguarding these assets
Non-current asset to be bought All non-current asset purchases to have a properly

without proper authorisation. authorised purchase order
2.3! Tests of control
Once control procedures have been identified then they can be tested to see if they are
operating properly.
Objective: to prevent Possible procedures Test of control

(controls)
Purchase invoices to Cancel invoices when paid Select 20 paid invoices and
be paid twice inspect them to ensure that they
have been cancelled.
Goods to be delivered Credit check before delivery Select 20 purchase orders and
to non-credit worthy inspect them to see if they are
customers marked as having been
approved for credit.
Overtime to be paid Timesheets or clock cards to be Select 15 timesheets and

for if not worked authorised by supervisor inspect them to ensure that all
have been signed by the
supervisor as authorisation.
Inventory or cash to Physically safeguarding these Observe how inventory and

be stolen assets cash is safeguarded.
Non-current asset to All non-current asset purchases Select 10 purchase orders for
be bought without to have a properly authorised non-current assets and inspect
proper authorisation. purchase order them to ensure that they have
all been properly authorised.
3. Methods of documenting the internal control system
3.1! Narrative
Short descriptive passages are written setting out the various stages in the accounting
system. For example:
When inventory falls below the reorder level, a pre-numbered purchase requisition is raised
and signed by the stores supervisor. This is passed to the purchasing department where
three suppliers are asked for prices. A three-part order is raised for the cheapest supplier
and the order sign by the purchasing manager.
Narrative is quick to produce but lacks rigour and uniformity. For example, in the above
system no information has been given about where the purchase requisitions are stored or
what happens each of the three parts of the order.
Narrative notes tend to be used in smaller, simpler accounting systems.
3.2! Flowcharts
A flowchart is drawn showing documents, files processes and controls. Standard symbols are
used and the process is much more formal. For example, every document introduced to the
flowchart should be accounted for eg by filing, sending to the next department, or sending
outside the organisation. A special symbol is used to identify controls as these are important
for the audit.
Flowcharts can be time-consuming to draw and amend, but they produce very structured
and well-disciplined descriptions of the clients system. Each symbol can be numbered and
cross-referenced to the internal control procedures and test procedures that have to be
carried out.
Flowcharts would normally be reserved for larger more complex accounting systems.
3.3! Internal control evaluation questionnaires ICEQ) and Internal control

questionnaires (ICQ)
An internal control evaluation questionnaire (ICEQ) asks about control objectives. For
example:
Question Answer Justification for answer Flowchart

reference
Can invoices form No Invoices are cancelled by the P10

suppliers be paid twice? purchase ledger clerk when they are
paid.
Can despatches be No Copy despatch notes are maintained S12

made to customers in numerical sequence and have
which are not invoiced copy invoices stapled to them. This
for? file is periodically reviewed to ensure
invoicing is complete.
In ICEQs if questions are answered No then that is good news for the auditor.
An internal control questionnaire (ICQ) asks if specific controls are present. For example:
Question Answer Justification for answer Flowchart

reference
Are invoices form Yes Invoices are cancelled by the P10

customers cancelled purchase ledger clerk when they are
after payment? paid.
Are despatch notes Yes Copy despatch notes are maintained S12
matched to invoices to in numerical sequence and have
ensure all despatches copy invoices stapled to them. This
are invoiced? file is periodically reviewed to ensure
invoicing is complete.
ICEQs require a greater degree of skill to complete as they leave it up to the auditor to decide
if a control objective has been met in some way or other.
ICQs are simpler to answer, but can be inflexible as control objectives might be met by
another control procedure.
Note the flowchart references: narratives, flowcharts and ICEQs/ICQs are not mutually
exclusive.
4. Walk-though tests
Whenever documentation of a system has been completed for the first time, a walk-through
test is performed. This means that a particular transaction is followed through from start to
finish to check that the documentation is accurate. So a sales system would be verified by
tracing from sales order, despatch notes, invoice, receivables ledger, receipt of payment into
the bank.
In subsequent years walk-through tests will be performed again to verify that the
documentation still accurately describes the accounting system.
5. Audit files
5.1! Introduction
It is essential that auditors carefully document all parts of their audit, including:
Planning
Information about the client
The accounting system/internal control system
Tests of internal control
Substantive tests.
Careful documentation is needed to:
Provide evidence of planning and risk assessment

Provide evidence of the audit work performed.
To facilitate review of the work, by supervisors, then managers, then the partner.
To ensure that the work is carried out completely and in an orderly manner.
It is normal to divide the documentation over two files, the permanent audit file and the
current audit file.
5.2! Permanent audit file
As its name might suggest, the permanent audit file holds information which is relatively
permanent and which can be carried forward from year to year.
Typical contents are:
Nature of the business

Addresses of offices, factories etc
Names of directors and senior accounting personnel
An organisation chart
Documentation of the accounting system eg flowcharts
Previous sets of financial statements
A schedule setting out a history of important ratios (for analytical procedures)
The letter of engagement
Memorandum and articles of association.
5.3! Current audit file
This file contains details of the audit work done for the current audit and will have two main
parts:
Work carried out to test the system of internal control

Work carried out to directly audit the financial statements substantive tests.
As they progress through their work the audit team creates working papers (now usually on
computer). Each working paper should show:
The name of the client and the date of the financial statements being audited.
The date of the test
The audit test being performed
Cross referencing to ICQs or figures on the financial statements
Why the audit test is being performed
The evidence seen
How exceptions were followed up
The conclusions that can be drawn from the test
The identity of the audit team member carrying out the test
The identity of those who review the work and the dates of their reviews.
When the final audit is being carried out, the draft financial statements will usually be placed
at the beginning of the file, and each figure will be referenced to files sections where details
of the audit work are set out.
For example
Egremont Plc
Statement of financial position 31/12/2014
$000
Non-current assets F1 23,000
Current assets
Inventory S1 5,000
Receivables R1 3,000
Cash C1 2,500
.
. .
Schedule prepared by A Smith 12/2/2015
Egremont Plc y/e 31/12/2014! ! ! F1

$000
Non-current assets
Premises F2 20,000
Machinery F3 2,000
Motor vehicles F4 1,000
SOFP 23,000
Egremont Plc y/e 31/12/2014! ! ! F2

$000
Non-current assets
Premises
Cost F7 23,000
Depreciation (buildings) F7 (3,000)
F1 20,000
Ownership rights assertion tested by inspecting the

land registry
Existence assertion tested by inspecting all
premises.
Conclusion: ownership and existence assertions

satisfactorily tested.
Therefore, as the working papers are created, the cross-referencing system allows reviewers
to easily see the audit work carried out to test every figure and ever assertion.
5.4! The review process
The staff who go to a client to perform the audit consist of an auditor in charge (sometimes
called an audit senior of supervisor) and usually one or more junior assistants.
The auditor senior delegates work to the assistants and then reviews the work that they have
done by examining the working papers. Sometimes it is decided to perform additional work if
the initial results are unsatisfactory. The reviewer will sign off each page reviewed, together
with the date of the review.
When work at the client is completed, back at the auditors office the audit manager in charge
of the job will review the whole file again. More work or clarification might be requested at this
stage also. The audit manager signs off each page of working paper.
Finally, when all outstanding points have been completed, the audit file is reviewed by the
partner in charge. Usually it is the audit senior who takes the file to the partner because the
partner will often want to ask questions that only someone directly involved in examining
clients records can answer. Sometimes, even at this late stage, the partner will request
additional work to be performed.
The file has now been reviewed at least three times. If all is well with the file and the financial
statements, the partner will be prepared to sign the audit report.
5.5! Peer review
As part of auditors efforts to produce high quality work, most firms will engage in peer
reviews. These are reviews of audits but they are carried out by a partner, or team of
partners, independent from the original audit. Often a partner from another office carries out
the review.
There are two types of peer review;
Cold review: this is carried out after the audit has been completed and the audit report
signed. It will examine all aspects of the audit: risk assessment, planning, audit evidence,
conclusions, completion of all documentation and the audit report. Any shortcomings in the
audit process will be documented and reported to the partner, manager and perhaps more
junior staff.
Hot review: this is carried out while the audit is still in progress and can therefore be
disruptive as all audit files have to be made available to the reviewers. It is usually performed
if risk assessment has shown that the audit, or some part of it, is high risk. The hot review
therefore provides some additional safeguards that will be effective before the audit report is
signed.
Question 1
When are tests of control usually carried out?

A! Interim audits
B! Final audits
Question 2
What are the three ways of documenting an accounting system?
Question 3
What is a walk though test and for what ii it used?
Question 4
On what documents would the following questions typically appear?

1! Are goods checked against orders when received?
2! Can inventory be misappropriated?
Question 5
Is the following a control objective, a control procedure or a test of control?
All purchases of non-current assets exceeding $1,000 are authorised by the finance
director
Chapter 11
INTERNAL CONTROL
1. Introduction
The function of internal controls is to prevent, detect and correct errors in the accounting
system. The main control objectives they are aimed at are:
All assets should be safeguarded.

All revenue is recorded.
Only legitimate expenses and purchases should be undertaken
All costs are properly recorded
All liabilities are recognised
This chapter looks at the components of internal control and the main control procedures
available.
2. The elements of internal control
2.1! The components of internal control
These are:
The control environment

Risk assessment procedures
Information systems
Control procedures
Monitoring control
2.2! The control environment
The control environment refers to the culture of the organisation:
Are internal controls regarded as being important?

Does management like a well-disciplined office and careful records?
Does management appreciate good accounting information?
Does management require careful recording of events and transactions?
All of these give a favourable control environment.
Contrast this with an organisation which:
Is careless with its records

Is lax about recording transactions
Has an untidy office
An attitude which thinks that internal controls are unnecessary, a nuisance and
actually interfere with the businesss operations.
All of these give an unfavourable control environment.
It is difficult for an internal control system to be effective if the control environment is

unfavourable. A good system might have been designed, but it will quickly fall into disuse.
2.3! Risk assessment procedures
The purposes of internal control are to prevent errors, detect errors and fix errors. To
accomplish this effectively, management must be aware about where errors could occur and,
in particular, where they are likely to occur. High risk of errors implies that controls are
necessary to counter that risk.
Furthermore, businesses do not stand still. They change and evolve as they try to remain
successful or to increase profits. As businesses change new risks will emerge and
management has to devise new controls.
For example:
(a) A business starts to export. Therefore there will be additional risks arising from
exchange rate fluctuations and that goods are damaged in transit.
(b) A business starts to trade over the internet. Therefore there are additional risks posed
by hackers and credit card fraud.
New risks imply new controls.
2.4! Information systems
Example of an information systems are:
(a) Monthly management accounts.
(b) Aged receivables listings
(c) Aged inventory listings
These systems are by-products of the requirement to keep financial records and they help
internal control as follows:
Monthly management account allow comparisons to be made between actual and

budget. If actual expenses are running much higher, this might indicate an accounting
error, or even fraud.
Aged receivables listings help with credit control and might prevent more goods
being sent to customers who are credit risks.
Aged inventory listings will indicate which goods should be marked down for a quick
sale and which should not be ordered again.
2.5! Control procedures
Control procedures are the specific ways in which an internal control can be designed and
implemented. Procedures include:
Segregation of duties
Segregation of duties means that each transaction should be broken up and that each part
should be carried out by a separate person. Therefore, for a purchase transaction, each of
the following should be done by a separate person:
Purchase requisition
Raising the purchase order
Receiving the goods
Posting the invoice
Paying suppliers
Similarly, the following should be carried out by different people:
Authorising salary levels

Authorising overtime
Paying salaries
Segregation of duties has two advantages:
More than one mind is involved so that errors made by one person have a good
chance of being picked up by the next.
Fraud is more difficult because it would require cooperation (collusion) between
several people.
Segregation of duties can be difficult for small businesses to achieve because they simply do
not have enough staff to allow transactions to be divided up. In small businesses more
emphasis is placed on the close supervision that owners and top management can exercise
Authorisation
For example, the following should all be authorised:
Purchases of non-current assets

Changes to wages and salaries
Writing-off a bad debt
Setting a credit limit
Paying invoices
Authorisation is usually carried out by someone in authority signing or stamping a document.

In a computer system, a persons log-on details can give them authority to approve
transactions.
Computer controls
For example:
Taking regular backups

Keeping passwords secure
Physical security of the server
Edit checks (unusual data rejected)

Comparison
For example:
Compare goods received to order quantities

Compare wages month-to-month and investigate discrepancies
Compare stock count results to book stock
Arithmetic controls
For example:
Ensure purchase invoices have been correctly calculated

Check that quotations sent to customers have been correctly prepared
Accounting reconciliations
For example:
Bank reconciliations
Reconcile suppliers statements to payables ledger accounts
Physical controls
For example:
Ensuring that inventory is kept securely

Banking cash regularly
Locking laptops away in the evenings
Maintaining a trial balance and control accounts
Ensure that these are reconciled regularly
3. Control weaknesses
3.1! Introduction
A control weakness can arise because a control has not been properly designed or because
a specified control is not being carried out properly by staff.
The auditor shall communicate in writing on a timely basis significant deficiencies in internal
control identified during the audit to those charged with governance and, unless
inappropriate, to management.
The auditor shall also communicate to management at an appropriate level of responsibility

on a timely basis other deficiencies in internal control that, in the auditors professional
judgment, are of sufficient importance to merit managements attention.
Examples of matters that the auditor may consider in determining whether a deficiency or
combination of deficiencies in internal control constitutes a significant deficiency include:
The likelihood of the deficiencies leading to material misstatements in the financial

statements in the future.
The susceptibility to loss or fraud of the related asset or liability.
3.2! Management letters
The written communication of deficiencies in internal control are often by way of what is called
a management letter. This is a letter from the auditor to management and it is often set out in
the following format:
Nature of the internal Potential consequences How to remedy the

control deficiency deficiency
Example:
Stores are not locked at Stock could be stolen Ensure that stores are fitted
lunchtimes or in the with a secure lock and that
evenings this is used when the stores
are unmanned.
Question 1
What are the elements of an internal control system?
Question 2
What are the three sections of a management letter?
Question 3
What is meant by the term segregation of duties?
Question 4
Which one of the following is not a type of control procedure?

A! Authorisation
B! Posting expense invoices to the Dr side of expense accounts
C! Carrying out bank reconciliation
D! Ensuring anti-virus and anti-hacking programs always run on the IT system
Question 5
To whom should significant deficiencies in internal control by notified?
Chapter 12
EXAMPLES OF INTERNAL
CONTROL AND TESTS OF CONTROL
1. Introduction
This chapter looks at internal control procedures commonly found in accounting systems
relating to:
Sales
Purchases
Wages and salaries
Non-current assets
The aims of all systems should be:
Only proper transactions are processed

It must be possible to trace from the earliest stage of a transaction through to its end
and in reverse order. This audit trail should be watertight
No transaction can go missing part way through.
Think: What could go wrong? and try to devise a control that will prevent or detect errors.
The systems below are not universal, but they illustrate very typical approaches to internal
controls.
2. Sales systems
2.1! Overview
The sales system can be represented as:
Granting credit and establishing a credit limit
Order processing
Despatch
Invoice and receivables
Receipt of payment
2.2! Granting credit and establishing a credit limit
Before any credit sales are made there should be control procedures in place to try to ensure
that only credit-worthy customers are accepted. A suitable initial credit limit should be
established.
Controls therefore involve: examining recent financial statements, enquiries to credit

reference agencies and the customers bank.
2.3! Order processing
As soon as an order is received it should be recorded, for example, by entering details in a

register. Later it should be possible to ensure that all approved orders have resulted in a sale.
Orders should be compared to the customers balance and credit limit to ensure the credit
limit is not breached.
Orders should be compared to inventory to ensure that inventory is present.
The customer should be informed if there is going to be a delay either because of credit or
inventory problems.
If these checks are passed, then a multi-part pre-numbered despatch note should be raised.
One copy will remain in number order in the order processing department. Other copies of
the despatch notes are passed to the warehouse.
2.4! Despatch
The despatch notes are used to pick and pack the goods ordered. An independent check
should be performed in the warehouse to ensure that the goods conform to what was
ordered.
One copy of the despatch can be packed with the goods (it will bear the customers order
number so that this can be checked when received by the customer).
One copy will go with the despatch as a gate release copy. As goods leave the company,
there is often a security gate where despatches are compared to despatch notes to ensure
only authorised sales leave the premises.
One copy can be sent to the accounting department for an invoice to be raised. One copy
can go back to the order processing department where it can be attached to the order to
show that ordered goods have been despatched.
The file of orders should be reviewed regularly for long-outstanding orders awaiting
despatch; these should be investigated.
The despatch note that accompanies the goods should be signed by the customer as proof
of receipt and returned to the company where it can be files in numerical order.
2.5! Invoicing
Invoices will be raised from the despatch notes and price lists. If manually raised, these
should be independently arithmetically checked.
One copy of each invoice will be sent to the customer.
One copy attached to the despatch note to ensure that all despatches are invoiced. This
copy can also be used to post the receivables ledger.
Invoices should be listed in a sales day book, then individual invoices posted to each
customers account. The sum of the sales day book can be posted to the receivables controls
account. Regular reconciliations should be performed between the controls account and the
sum of the individual ledger accounts.
Copy invoices should be marked Posted and a regular review should be carried out to
ensure that all invoices are accounted for and have been posted to the receivables ledger.
2.6! Receipt of payment
Receipts should be posted to each customers account and the cash book, and the sum of
receipts posted to the control account. Postings to the cash book should show the invoice
number of the invoice being paid
Aged receivables reports should be prepared regularly and slow payers followed up. A Stop
should be placed on the accounts of very slow payers to prevent the situation deteriorating.
Statements should be sent each month to customers both to remind them of what they owe
and also to allow them to check the sellers version of the account.
3. Purchases systems
3.1! Overview
The purchases system can be represented as:
Finding suitable suppliers and establishing a credit

limit
Order processing
Receipt of goods
Invoice and payables
Payment
3.2! Finding suitable suppliers and establishing a credit limit
Before any purchases are made there should be control procedures in place to try to ensure
that suitable suppliers are used. A suitable supplier might be one where a good discount has
been negotiated or where quality is very high. Sometimes companies have a policy to ensure
that they have several suppliers for each type of purchase and that quotes are always
received from each before an order is placed. A credit limit should be agreed with each
supplier.
3.3! Order processing
The store-keeper should regularly review inventory and raise a sequentially pre-numbered 2-
part purchase requisition when an item of inventory is below or close to its reorder level.
Inventory records should record the requisition number to ensure that the goods are not
inadvertently ordered again. A copy of each requisition should be filed in stores in numerical
sequence.
A copy of the requisition note is passed to the purchasing department which will raise a
sequentially pre-numbered multi-part purchase order from a suitable supplier. The purchase
price should be stated on the order. One copy will stay in the purchasing department, one will
go to the goods received area of the warehouse and one copy will be sent to the supplier.
Long-outstanding orders and requisitions should be followed up: goods not received will hold
up production and jeopardise sales.
3.4! Receipt of goods
When goods are received they should be checked to the order to ensure that they are what
was ordered, counted and inspected for damage. A multi-part good received note (GRN) will
be raised when goods are received. This can be attached to the order and the two
documents passed to accounts.
Stores records and purchase department records should be updated from the copy goods
received notes.
Inventory should passed to stores where it should be correctly placed in the correct location.
3.5 ! Receipt of invoices
The GRN/order pair are in the accounting department, awaiting an invoice being received.
When an invoice is received it should be checked to these documents to ensure that only
invoices for properly ordered and received goods are processed. The invoice can be
attached to the matched order/GRN.
Invoices should be analysed for expense category, input VAT etc. The analyses should be
independently checked.
Invoices will be listed in a purchases day book. Individual invoices will be credited to the
appropriate account in the purchase ledger, and the total of the purchases day book posted
to the credit of the payables ledger control account. Appropriate expenses accounts should
be debited.
Invoices should be marked Posted.
If Order/GRN pair are outstanding for a long period, the company should investigate why this
is the case and, if so, alert the supplier that an invoice seems to be missing.
Statements received from suppliers should be reconciled to the payables balances.
3.6! Payment
Payments might be made to every supplier after a set period of time, or a list of invoices
outstanding might be printed out for manual approval and cash flow management.
Once payments have been made, the invoices should be cancelled. Payments should be
debited to individual supplier accounts and the total payments debited to the receivables
control account.
4. Wages and salaries
4.1! Overview
The wages and salaries system can be represented as:
Authorised recruitment
Authorised rates of pay
Weekly/monthly pay calculations
Payments to employees, tax authorities etc
Departure of employee
4.2! Authorised recruitment
Recruitment of additional or replacement employees should be authorised at an appropriate

level in the organisation. There should be a written record of the recruitment decision.
The employees bank details must be recorded.
4.3! Authorised rates of pay
The wage and salary rates should also be authorised at a senior level for new employees and
for salary amendments. There should be authorised rate of pay forms for each employee and
only authorised personnel should be able to alter rates.
4.4! Weekly/monthly pay calculations
Some pay calculations will be very simple. For example, many salaried employees will
receive the same amount each month. There might occasionally be bonus payments to make
and these require separate authorisation.
Some calculations are more complex. Hourly paid employees will be paid on the basis of time
spent working and there might be overtime and shift allowances. IN such as case there
should be controls in place to ensure that staff are only paid for time or output. Typically,
clock cards are used to allow the employee to record arrival time and leaving time on a time
recording system. This has to be monitored to ensure that employees dont clock each other
out and in to inflate their hours.
Based on salaries or hourly rates/time, gross pay, tax and other deductions can be
calculated. If this is done manually, it will have to be independently checked. Normally it will
be done by computer.
4.5! Payments to employees, tax authorities etc
The payroll amounts should be scrutinised by a senior member of management who will be
looking for consistencies with previous periods.
If wages are paid by cash, the payroll cash should be held securely until paid out. Employees
need to present identification and must sign when they receive their wages. Special
arrangements should be in place to allow substitute employees to pick up wages on behalf of
absent colleagues.
Credit transfer payments are much easier and safer.
Every month, a senior member of management should ensure that deductions are paid over
to the tax authorities etc.
4.6! Departure of employees
There should be standard systems and documentation in place to ensure that details of all
leaving employees are sent to the payroll department.
Every year, all managers should be circulated with a list of their employees who are on the
wages system and they should verify that the employee is still actually employed and that the
rate of pay is correct.
5. Non-current assets
5.1! Overview
The purchases system can be represented as:
Finding suitable suppliers and establishing a credit

limit
Order processing
Receipt of goods
Invoice and payables
Payment
The controls needed here are very similar to those for other purchases. The main difference is
that capital expenditure is usually
(1) Carefully budgeted because buying non-current assets sucks cash out of a business
(whereas purchases of goods for resale should produce revenue reasonably quickly).
Therefore, expenditure needs to be authorised carefully by a relatively senior figure.
(2) One a non-current asset is bought the company is stuck with it for some years, so it
important to choose carefully.
(3) Often a single purchase can be for a significant amount, so again care is needed to
get competitive quotes.
(4) The assets should be inspected every year to ensure that they are still there and are
still being used.
(5) Appropriate depreciation policies should be adopted.
6. Tests of control
The precise internal control systems used by the client will be documented by the auditor. As
previously described the auditor can use narrative, flowcharts ICQs or ICEQs (or a
combination of methods).
The consistent and effective operation of the controls then needs to be tested: the auditor has
to collect evidence that the control is operating properly.
Evidence about the operation of controls can be collected by:

Inspection
Observation
Recalculation and re-performance.
Some examples of evidence of controls operating were given in chapter 6. Here are some
more examples of audit tests that tie in to some of the systems described above:
Control procedure Evidence
Sales system
All goods despatched notes should have a Inspect the file of copy despatch notes in
copy of the invoice attached to them. the accounting department to ensure that
each of 20 despatch notes chosen at
[A control procedure to meet the control random has a copy invoice attached
objective that no dispatches can be made
without invoicing]
Purchases system
All purchases of >$1,000 should have three Inspect 15 orders in copy order files for
supplier prices quoted and be awarded to evidence of competitive tendering.
the lowest price supplier.
[A control procedure to meet the control

objective that goods are not bought at
inflated prices]
Wages and salaries system
All clocking-in and clocking-out by staff is Observe staff arriving and leaving on 3
supervised by the factory manager. separate days to ensure the processes are
supervised by the factory manager.
objective that unworked hours are not paid
for.]
Non-current assets
All non-current assets of net book value > Inspect 10 records in the fixed asset register
$1,000 should are physically verified each of non-current assets with NBV>$1,000 to
year for existence and continued use. ensure that the physical inspection date
noted is within the previous12 months
objective that no non-current assets need to
be written down (impaired)]
Question 1
What are the four ways in which internal control can be tested?
Question 2
What is meant by the term audit trail
Question 3
A manufacturing company is evaluating its internal control system for purchases.
State FOUR objectives of the internal control that should be exercised over the
purchases and trade payables system of the company.
Question 4
Describe three internal control objectives of a wages and salaries system.
Chapter 13
SUBSTANTIVE TESTING
1. Introduction
Substantive testing is generally carried out during the final audit when the draft financial
statements have been produced. Each material amount on the statements has to be audited
for all its assertions.
To recap, methods of gathering evidence for substantive tests are:
Enquiry and conformation
Inspection
Observation
RecalcUlation and reperformacne.
And the assertions are:
Relevant to Relevant to Relevant to

presentation transactions period end
and disclosure and events balances
Accuracy X X
Completeness X X X
Cut-off X
Allocation X
Classification and understandability X X
Occurrence X X
Valuation X X
Existence X
Rights and obligations X
This chapter looks at typical substantive tests for:
Inventory
Receivables
Cash
Trade payables
Contingent liabilities and assets
Non-current assets
Accruals and prepayments
2. Inventory
2.1! Introduction
Inventory is one of the most challenging items to audit. There are difficulties ensuring that the
physical quantities are correct and then ensuring that inventory is properly valued at the lower
of cost and net realisable value. Valuation is especially difficult with goods the company has
manufactured itself and with work-in-progress.
2.2! Inventory counts (stock takes)
If inventory is material to the financial statements, it is normal to have a year-end stock take
and the auditor will normally attend this. It is not the auditors responsibility to count the stock
(that is the responsibility of clients staff) but the auditor has to observe the stocktake and to
ensure that it is begin carried out correctly so that the results can be relied upon. The auditor
will perform a few test counts only.
The normal sequence of a stock take and the auditors involvement is as follows:
Instructions should be issued to client staff and they should be briefed about how the
count should proceed. This is important because counts might be done only once per
year so it is not a process with which staff are familiar. Many staff might not have been
involved previously. The auditor must review the instructions and make
recommendations to the client as necessary.
The count should be planned for a date and time when stock movements are not
taking place. New Years Day is often chosen (popular with both client staff and
auditors!)
Inventory has to be sorted, tidied and arranged in an orderly fashion. This might be
relatively easy in a retail environment, but think how difficult it can be in an
engineering company, a builders premises or a wood yard.
Damaged inventory should be identified and labelled,
Each inventory location should be labelled and the labels should have space for:
Location reference/description
Product code
Product description
Quantity counted
Count sheet number
Initials/signature of 1st counter
Initials/signature of 2nd counter
Counters should be in teams of two. Both counters should not be from stores because
they can have incentive to cover-up stock shortfalls. If both counters are from the
accounting department, they are likely not to be able to identify properly what they are
counting. A mixed pair is good: one form stores, one from accounts.
Sequentially pre-numbered count sheets are issued to each counting team and the
count progresses. The label in each inventory location is filled in as are the stock
sheets with produce description and quantities. The stock sheets and location labels
are cross-referenced.
The auditor should perform some test counts: from stock locations, recount and trace
details to the count sheets, and from stock sheets trace to stock locations and
recount. Discrepancies should be noted.
The auditor should make a note of the last 10 or so goods received notes and
despatch notes issued in the year. These will be used later for cut-off tests (see
below).
The auditor should be alert to any inventory that seems to be damaged and should
make a note of this and raise the matter at the time with the manager in charge of the
count.
All count sheets should be collected in and the numerical sequence verified as being
complete.
2.3! After the stocktake
When the stocktake is complete the company should have records of the physical quantities
of inventory; this can be compared to book records (if any) and discrepancies investigates.
Occasionally a recount of certain items might be needed.
The inventory now needs to be valued at the lower of cost and net realisable values.
The cost of purchased goods can be established by inspecting recent purchase invoices.
The cost of goods manufactured by the company and work-in-progress should include
material, labour and manufacturing costs. The auditor will have to examine the cost
accounting records to check on production times, wage rates and overhead absorption rates.
Although the auditor can inspect WIP it will be difficult to ascertain its degree of completion
and the auditor will have to place some reliance on management representations about its
completion stage.
Net realisable value becomes relevant if this is lower than cost.
The auditor should identify slow-moving lines of inventory by examining stock records
and also by calculating days of inventory as at year end. A rise in this ratio might
indicate that inventory will not sell easily and might have to be written down in value.
The auditor will consult records relating to damaged stock identified during the stock-
take.
The auditor can use analytical procedures to determine if the days of inventory seem
to be high.
The auditor can look at post year-end sales to ensure that the selling prices of
inventory are above cost.
The auditor will ask for management representations stating that all items of inventory
are valued at the lower of cost and NRV.
Once all costs/NRVs have been determined and entered on the count sheets, the value of
each line of inventory can be worked out (eg quantity x cost) and the values added up. It is
essential that the auditor reperforms these calculations. Remember, every extra $1 in
inventory value is an extra $1 on profit.
3. Cash in hand and at bank

Cash is one of the easiest assets to audit. Most businesses will have a relatively immaterial
amount of cash in hand (in the petty cash box), and that can be counted if necessary.
Some businesses, like retail businesses which keep cash for sales registers, will have more
material amounts and some of these should be counted by the auditor on a test basis.
For most businesses, their material amounts of cash will be on deposit or in current accounts
at their bank(s). The standard procedure is for the auditors to receive a bank certificate from
clients banks setting out the balances and any security that the bank has for loans. A bank
certificate is very strong audit evidence.
The amount certified by the bank is not necessarily the amount that will appear in the
statement of financial position and a bank reconciliation will have to be performed by the
client and re-performed by the auditor to ensure that the cash book balance (ie the amount in
the financial statements) can be reconciled to the bank certificate.
4. Receivables
4.1! Introduction
Receivables are likely to be material when businesses make sales on credit. A particular
difficulty is to test the valuation assertion as sometimes receivables go bad and will never be
paid.
4.2! Receivables circularisations
This is a key technique for verifying existence and ownership of receivables.
First, the auditor must ensure that the receivables figure in the financial statements is based
on the sum of individual customer balances. The assets being audited are the individual
receivables balances not the total balance. If the control account and the sum of the
individual balances does not reconcile then there is no basis for the receivables figure in
the financial statements.
Then a sample of receivables balances is chosen. Typically this will be a stratified sample.
Say that the receivables balances were as follows:
Number of customers Size of balances owing

$
20 >100,000
50 20,000 100,000
200 <20,000
A typical sample might be:
All the customers owing >$100,000

50% of those owing $20,000 $100,000
50 balances from those owing <$20,000
In addition, customers with credit balances and very old balances would be circularised, as
would a selection of customers with Nil balances.
The letters to the customers will be written on client notepaper, setting out what the client
thinks is owed. and the customer will be asked to reply directly to the auditor. Remember,
auditor direct obtained evidence is better than evidence that comes through the client.
Usually a stamped addressed envelope is enclosed to make this convenient for the client.
There are two types of circularisation:
Positive circularisation: ! debtors are asked to reply either agreeing the amount owed or
stating what they think they owe.
Negative circularisation: ! debtors are asked to reply only if they disagree with the amount
states on the letter.
Positive circularisation is a much stronger test. In negative circularisation the auditor can
never be sure of a nil reply means agreement or that the debtor has simply not bothered to
reply.
A schedule is maintained of replies, showing agreements and disagreements. Disagreements

can often be explained by timing differences. For example, the client issues an invoice 29/12
but that wasnt processed by their customer until 2/1.
After a couple of weeks, with the clients permission, debtors who have not replied will be
sent a reminder letter by the auditor. If there is still no reply then, for very material receivable
balances, and again with clients permission, the auditor might attempt to get telephone
confirmation.
4.3 ! Valuation of receivables
A positive reply to a circularisation is only of partial help in valuing those receivables. It will
confirm agreement of amounts owing (which is important) but does not necessarily give any
assurance that the debt will be paid. A devious customer who cant pay might decide to reply
to the circularisation letter to avoid raising suspicions.
The valuation assertion can be addressed by:
Examining aged receivables reports. Older debts are less likely to be paid.
Performing analytical procedures on receivables balances. For example, debtor
collection days.
Reviewing cash receipts after year end. If the full amount is received after year end
there is obviously no valuation problem at year end.
Reviewing correspondence with customers and lawyers.
Reviewing board minutes (large debts that might go bad are probably discussed at
board meetings).
4.4! After year end credit notes
Credit notes issues in the first month or so after year end should be scrutinised to ensure that
any sales and receivables balances as at year end are reduced appropriately. Occasionally,
it is found that an invoice has been deliberately raised and posted before year end then a
credit note issued against is after year end as a mechanism for fraudulently boosting sales.
5. Trade payables
5.1! Introduction
In many ways rather similar to the audit of receivables. The first essential step is to ensure
that the trade payables figure in the financial statements reconciles to the sum of the
individual payables balances.
5.2! Supplier statements/circularisations
In many countries it is common for suppliers to send statements regularly to their customers.
If statements are received then it will not be necessary to circularise payables because
statements are third party written evidence about what is owed.
5.3! Post year end payments
Payments made in the first month or so after year end should examined to ensure that they
were either in the payables ledger or accrued for if the expense relates to the year being
audited.
One of the particular fears of auditors is that liabilities are incomplete and payments made
after year end give a way of detecting such liabilities.
5.4! Analytical procedures
Analytical procedures such as the calculation of payables days and comparison with
previous ratios might indicate that payables are incorrect.
5.5! Management representations
Because of the difficulty in ensuring that all liabilities have been included, in addition to the
work described above, it is normal to ask management to give a written representation to the
effect that all liabilities have been included in the financial statements.
6. Contingent liabilities and contingent assets
6.1! Contingent liabilities
A contingent liability is where as a result of a past event there might be an outflow of

resources to settle a present or possible obligation whose existence will be confirmed only by
the occurrence or non-occurrence of some possible future event outside the entitys control.
An example is a damages claim against the company.
Date of incident that might give rise to damages: 12/07/2014

Year end date: 31/12/2014.
Court case to be heard on 30/9/2015
So, for the financial statements to 31/12/2014, the event has happened. However, the
outcome of the court case will not be known until long after the year end and after the audit
will be complete.
The accounting rules for such contingent liabilities are:
If the outflow of resources is probable, a provision should be set up and its nature
disclosed in the notes to the financial statements (ie Dr Expense Cr Liabilities)
If the outflow of resources is merely possible, the event should be disclosed in the
notes but no provision should be set up.
If the likelihood of outflow of resources is remote (ie very unlikely) no reference to the
matter needs to be made at all.
The auditor has to collect evidence about the possible size of any liability and also the
likelihood that an amount will have to be paid.
Evidence can be obtained from:
Board minutes
Correspondence with the claimant and his/her lawyers
Correspondence with the clients own lawyers
Management representations.
Occasionally, the auditor might seek expert evidence directly by asking a suitably
experienced lawyer for an opinion.
6.2! Contingent assets
A contingent asset is where as a result of a past event there is a possible asset whose
existence will be confirmed only by the occurrence or non-occurrence of some possible
future event outside the entitys control.
An example is a damages claim by the company against a supplier.
The accounting rules for such contingent assets are:
If the inflow of economic benefits is virtually certain the asset is not contingent so the
company should recognise it fully.
If the inflow of economic benefits is probable, the event should be disclosed in the
notes but no asset should appear in the financial statements.
If the inflow of economic benefits is not probable no reference to the matter needs to
be made at all.
The auditor has to collect evidence about the possible size of any asset and also the
likelihood that there will be economic benefit
Evidence can be obtained from:
Board minutes
Correspondence with the party against whom the claim is being made and his/her
lawyers
Correspondence with the clients own lawyers.
Management representations.
Occasionally, the auditor might seek expert evidence directly by asking a suitably
experienced lawyer for an opinion.
7. Accruals and prepayments
7.1! Introduction
These are often, but not always relatively small amounts. If so audit work can be kept to a
minimum. Very often they will be similar to previous years figures.
7.2! Prepayments
Look at the previous years audit file. Many payments are standard (for example, car
insurance always paid 1 June for the next 12 months) so there is an expectation for
last years prepayments to be similar to last periods (adjusted for inflation).
Inspect invoices paid in the last few months of the period. This is where the most
serious prepayments will lurk (more months likely to be prepaid).
Enquire of management about prepayments.
7.3! Accruals
Look at the previous years audit file. Many payments are standard (for example,
electricity always paid 28/2 for the previous three months, so there is an expectation
for last years accruals to be similar to last periods (adjusted for inflation).
Inspect invoices paid in the first few months of the new period looking for payments
relating to the previous period
Include a statement about prepayments and liabilities in the letter of representation.
8. Non-current assets
8.1! Acquisitions and disposals
Verify amounts by inspecting sale and purchase agreements and invoices.
Large movements should be referred to in board minutes.
8.2! Ownership
Verify ownership by inspecting documents of title, such as land registry entries for land and
buildings.
8.3! Existence and completeness.
Verify existence by inspecting assets. Verify completeness by reconciling the figures in the
financial statements to the sum of the items in the fixed asset register.
8.5! Valuation
Verify valuation by inspecting depreciation rates and ensuring these are with industry norms
and are consistent with previous years. Recalculate depreciation for a number of assets.
Perform an analytical; procedure to verify that the total depreciation charges for each type of
asset is reasonable.
Inspect assets to ensure that they appear to be in working order and that they are still used
by the company.
Obtain management representations that they do not intend to dispose of major assets in the
near future (eg by closing down part of the business). That would imply that assets should be
valued on a net realisable value basis rather than cost less depreciation.
9. Cut-off
9.1 ! Introduction
Cut-off is one of the assertions: it means that that transactions should be allocated to the
correct period. For example, sales made in January 2014 should not be included as revenue
in the 12 months ended 31/12/2013.
However, often the term cut-off has a more subtle meaning and it refers to consistency
between sales, purchases and inventory.
For example, goods might have been despatched around 28/12/2014, but not invoiced until
January 2015. Generally, the sale is to be recognised when goods are despatched. The
goods will not have been counted in closing inventory at 31/12/2014, yet the sale might not
have been recognised until the invoice was issued in the following year (Dr Receivables Cr
Sales).
Similarly, goods might have been received 27/12/2014, but the invoice not received until
January 2015. The goods will be in closing inventory (they are physically present), but the
purchase will not have been put through the accounts (Dr Purchases Cr Supplier) until the
invoice is received.
Consistency in the transactions is very important. The rules are:
Goods received just before year end
Goods will be in closing inventory

Cost should be included in purchases
Liability should be recognised.
If an invoice was received before year end, the liability (payable) will automatically be
accounted for provided all invoices are posted. If the invoice is not received until after year
end, an accrual should be established ie a purchase reserve.(Dr Purchases, Cr Purchase
reserve).
Goods received just after year end
Goods will not be in closing inventory

If the invoice has been received before year end, this should not be posted
There should be no asset in respect of these goods in closing inventory, no expense
and no liability.
Goods despatched just before year end
Goods will not be in closing inventory

Sales amount should be in sales
A receivable should be set up even if not invoiced until after year end
Goods despatched just after year end
Goods will be in inventory

The sale has not been made
Even if invoiced in advance, the amount should not be included in sales or
receivables.
Question 1
Why is it important to ensure that the receivables and payables control accounts (total
receivables and total payables accounts) reconcile to the detailed balances in the
receivables and payables ledger?
Question 2
A customer of a client slipped on a wet floor on 1/9/2014 and is suing your client. Legal
advice suggests that your client will possibly have to pay compensation of $25,000.
How should this be treated in the financial statements?
Question 3
At a stock take it is the auditors responsibility to count the inventory?

! ! ! ! ! ! ! ! ! ! True/False
Question 4
Why do auditors take an interest in cash received from customers after year end?
Question 5
Why do auditors take an interest in payments made by the company in the first month
of the next financial period?
Question 6
What evidence would you look for to verify the valuation of a non-current asset bought
in the period?
Question 7
A goods received not is dated 24/12/2014. An invoice for the goods is received 15/1/2015.
What is the correct treatment of this transaction in the financial statements to

31/12/2104?
A! Goods not included in inventory; no expense; no purchase.
B! Goods included in inventory; no expense; no purchase.
C! Goods included in inventory; expense in purchases; purchase reserve established.
D! Goods included in inventory; expense in purchases; suppliers account credited.
Chapter 14
FINAL STAGES OF THE AUDIT
1. Introduction
Until the audit report is signed, the auditors have an active duty to look for evidence or events
that might alter their opinion on the financial statements
This chapter deals with:
Events after the period end (post balance sheet events)

Going concern considerations
Letters of representation
2. Events after period end
2.1! Introduction
Imagine that a set of financial statements has been produced for the year to 31/12/2014 and
then on 15/1/2015, the company has a really bad day:
A customer who owed $250,000 as at 31/12/2014, and who has paid nothing
subsequently, goes into liquidation with little chance of creditors receiving anything;
The companys factory burns down.
How should these events be treated in the financial statements?
2.1! Adjusting and non-adjusting events
The rule is that if the event gives more evidence about the state of affairs that existed at the
period end date, then the event is an adjusting event: the financial statement amounts in the
profit and loss account and statement of financial position will be changed.
Otherwise the event is a non-adjusting event. No adjustments are made to the profit and loss
account and statement of financial position, but if material the matter should be disclosed in
notes to the financial statements.
Therefore the treatment of the two incidents outlined above will be:
The customer who went into liquidation must have been in a poor state at the period
end and the debt was to all intents and purposes irrecoverable then. Going into
liquidation gives evidence about the debts valuation as at 31/12/2014. Therefore,
write down the debt as at 31/12/2014
The factory destruction happened 15/12/2015, but the factory was perfectly healthy
and existed on 31/12/2014. This is a non-adjusting event. Because it is so serious, a
note would be added to the financial statements disclosing the incident.
Until the audit report is signed the auditors have an active duty are to look out events after the
period end and to consider whether they are adjusting events or non-adjusting events
requiring disclosure in the financial statements.
3. Going concern
Financial statements are normally drawn up on a going concern basis which is the
assumption that the organisation will continue trading in the foreseeable future (usually taken
to be 12 months).
If there is doubt about whether the going concern assumption is valid, then this should be
disclosed by way of a note in the financial statements.
It looks inevitable that the organisation will soon fail, then the financial statements should be
drawn up on a break-up basis.
Indicators of going concern problems include:
Negative cash flows

Losses
Borrowing facilities not renewed or extended
Poor liquidity ratios (such as a low current ratio)
High gearing
Taking longer to pay suppliers
Loss of key personnel
Loss of key customers
Technological advances
Legal and regulatory changes
Bad publicity
It is managements responsibility when preparing the financial statements to review the

companys going concern position and the auditors must audit managements conclusions.
Audit work will include:
Review the work that management has carried out on going concern
Obtain cash flow forecasts and budgets for the forthcoming 12 months and review the
assumptions on which these are based.
Examine the trading pattern of the first weeks (or months) after the period end to
ensure that this appears adequate to support a going concern assumption.
Calculation of liquidity interest cover and gearing ratios
Review correspondence with the companys bankers.
Obtain a letter of representation form management which includes their belief that the
company is a going concern.
4. Letter of representation
This is a letter sent by management to the auditor, just before the auditor sign the audit
report. It is an essential piece of audit evidence.
(Note: do not confuse the letter of representation with the management letter. The latter is a
letter from the auditors to management pointing out weaknesses in internal control.)
Typical contents of a letter of representation include:
All liabilities have been included

Inventory is valued at the lower of cost and net realisable value
There is no intention to discontinue or close down any part of the business
Receivables are stated at their recoverable amounts
There have been no financial irregularities
The financial statements are free of misstatements
Related party transactions have been disclosed
All charges on assets have been disclosed
The letter of representation does not take the place of other audit evidence, except where
other evidence cannot be reasonably expected to exist (for example, managements
intentions about the future of the business). Its purpose is to supply corroboration and
support to other audit evidence, and to focus managements attention on their
responsibilities.
Question 1
How long is foreseeable future for going concern purposes?
Question 2
Sales have rapidly decreased in the first few months after the period being audited.
Could that be an adjusting event?
Question 3
A letter of representation is no substitute for other audit work, so auditors will be prepared to
sign an audit report without receiving such a letter.
Question 4
A flood of the clients warehouse occurs on 23/1/2015 ruining most of the inventory (material
to the financial statements).
Is that an adjusting event?
Chapter 15
THE AUDIT REPORT
1. Introduction
Chapter 1 reproduced an entire audit report. This looks at how audit reports can be changed
from the basic unqualified report.
Informally, people often talk about an audit report when they really mean an audit opinion. An
audit report is typically a whole page setting out responsibilities, defining the financial
statements, explaining work done and trying to limit liabilities. Only a small part of that report
is the opinion paragraph.
If the opinion is changed the proper terminology is to say that the opinion has been
modified. Unfortunately, people often say that the report has been modified (which can
mean something else) or they say that the opinion or report has been qualified (which is only
one type of modification).
2. Changes to the audit report which do not affect the audit

opinion
2.1! An emphasis of matter paragraph
This a paragraph added after the opinion paragraph which refers users to a note in the
financial statements. The auditor wants to be sure that users do not overlook this note
because it is very important to the proper appreciation of the financial statements.
A typical example, is where management has included a note explaining that going concern
might be in doubt. It is obviously important that users see this note. Therefore, the auditors
include an emphasis of matter paragraph telling users to go and look at the note. Its like the
auditors waving a big red flag at users.
However, an emphasis of matter paragraph is not a criticism of the financial statements. All
relevant matters have been properly disclosed. The report has been changed (or modified)
but the opinion is unmodified.
Here is an example:
Without qualifying our opinion above, we draw attention to Note 12 to the

financial statements. Ten days before the directors formally approved the
financial statements, the company received notification that they are to be named
as defendants in a proposed legal action . At this early stage it is not possible
to estimate the ultimate outcome of this matter, and no provision has been
included within the financial statements.
If the matter had not been disclosed properly then the opinion paragraph would have to be
altered as set out below.
2.2! An other matter paragraph
This is used when the auditor wants to draw users attention to a matter which is not in the
financial statements. A good example would be where a claim in the chairmans statement
conflicted with information in the financial statements. If the financial statement version is
correct, the audit opinion cannot be modified; the chairmans statement is not covered by the
audit report (it is not part of the financial statements) yet the auditors have a duty to inform
members when such conflicts exist.
The other mater paragraph appears after the opinion paragraph and would explain the nature
of the discrepancy.
3. Changes to the audit report which do affect the audit

opinion modified opinions
3.1! Modified opinions
Auditors will modify their opinion if:
The financial statements contain a material misstatement; or

The auditors have been unable to obtain sufficient appropriate audit evidence.
Modifications can be of two degrees of seriousness.
If the matter is material but not pervasive then the report will be qualified using the
exceptfor format.
If the matter is pervasive then the audit report will be adverse (financial statements do
not give a true and fair view), or the auditors will give a disclaimer (the auditors do not
give an opinion on the financial statements).
The word pervasive is used to mean very serious; if something is pervasive it means that it
affects everything and that the financial statements are fatally flawed. Adverse opinions are
given when the material misstatement is pervasive. Disclaimers are given when the lack of
sufficient audit evidence is pervasive.
Except..for means that the problem is isolated and some use can still be made from the
The options can be set out in the table shown:
Material but not pervasive Pervasive
Financial statements contain

a material misstatement exceptfor Adverse opinion
Unable to obtain sufficient exceptfor

Disclaimer of opinion
appropriate audit evidence
If the opinion is unmodified, the opinion paragraph is headed up Opinion. However, to

warn users that something is amiss, this paragraphs title changes when the opinion is
modified:
If it is a qualified opinion, it is headed up Qualified opinion.

If it is an adverse opinion it is headed up Adverse opinion
If it is a disclaimer opinion it is headed up Disclaimer of opinion
3.2! Basis of opinion paragraphs
When an opinion is modified, a paragraph has to be included immediately before the opinion
paragraph to explain details of the modification. This allows the opinion paragraph to be kept
short and to the point.
The additional paragraph will be entitled variously:
If it is a qualified opinion, it is headed up Basis of qualified opinion.

If it is an adverse opinion it is headed up Basis of adverse opinion
If it is a disclaimer opinion it is headed up Basis of disclaimer of opinion
In effect the title in the basis paragraph matches the title of the opinion paragraph.
3.3! Examples of modified opinions
Qualified opinion [because of material misstatement]
Basis of qualified opinion As discussed in paragraph 13, no depreciation has been

providednot in accordance with International Accounting
StandardsThe provision for the year should have been
$X.profits would be decreased by $Y.
Qualified opinion In our opinion, except for the matter referred to in the basis
of qualified opinion paragraph, the financial statements give
a true and fair view
Qualified opinion [because of lack of sufficient appropriate audit evidence]
Basis of qualified opinion We were unable to observe the counting of inventories at

31/12/200Xand have been unable to determine inventory
quantities by other methods
Qualified opinion In our opinion, except for the matter referred to in the basis
of qualified opinion paragraph, the financial statements give
a true and fair view
Adverse opinion
Basis of adverse opinion no provision for irrecoverable debts has been established
for a major customer owing $5M and who has gone into
liquidation with little prospect of recovery of amounts owed.
If this amount had been fully provided then receivables
would be reduced from $8m to $3m and profits would be
reduced from $10m to $5
Adverse opinion In our opinion, because of the matter referred to in the basis
of adverse opinion paragraph the financial statements do
not give a true and fair view
Disclaimer of opinion
Basis of disclaimer of opinion We were unable to observe the counting of inventories at

31/12/200Xand have been unable to determine inventory
quantities by other methods
Disclaimer of opinion Because of the significance of the matter described in the

Basis for Disclaimer of Opinion paragraph, we have not
been able to obtain sufficient appropriate audit evidence to
provide a basis for an audit opinion. Accordingly, we do not
express an opinion on the financial statements.
Note that whenever the auditors feel that there is a material misstatement in the financial
statements they describe what the financial statements would state had that error been
corrected. This is obviously useful to users of the financial statements. It is not possible to
suggest similar adjustments if the is a lack of sufficient appropriate audit evidence: there is a
gap in knowledge (the figure could be right or wrong as they stand) so adjustments cannot
be suggested.
4. Wrong audit report signed
4.1! Financial statements not issued
Occasionally, after the audit report is signed information become available which means that
the audit report is incorrect. For example, it turns out that a large receivable balance is not
recoverable.
After the audit report is signed the auditors have a passive duty to be aware of events
affecting the financial statements. If the bad debt comes to their attention they are then
aware that the financial statements contain a material misstatement, but that the audit report
has not highlighted that.
The auditors must then try to persuade the directors not to issue the financial statements as
they are, but to amend them, after which a new audit report will be signed for the new
If the directors refuse to do this, the auditor will have an opportunity to address members at
the next annual general meeting and to tell them that the financial statements contain a
material misstatement.
4.2! Financial statements issues and AGM already held
This is a rare occurrence, but if it happens the auditors must try to persuade the directors to
withdraw the financial statements and to issue a corrected set with a new audit report.
If the directors refuse, in some countries the auditors have a right to circularise the members
with a correcting statement.
Question 1
What are the three types of modified audit opinion?
Question 2
What are the two ways in which an audit report can be altered but which are not
modifications of the audit opinion.
Question 3
What term is used if a matter is material enough to result in an adverse opinion or a

disclaimer of opinion.
Question 4
The opinion paragraph in an audit report contains the phrase Except for the financial
statements show a true and fair view..
What title should the opinion paragraph have?

A! Opinion
B! Qualified opinion
C! Adverse opinion
D! Disclaimer of opinion
Question 5
There are going concern doubts about a companys future. These are disclosed in a
note to the financial statements.
What type of audit report is required?
A! Qualified opinion
B! Adverse opinion
C! Emphasis of matter
D! Other matter
Question 6
There are going concern doubts about a companys future. These are disclosed in the
What type of audit report is required?
A! Qualified opinion
B! Adverse opinion
C! Emphasis of matter
D! Other matter
ANSWERS TO TESTS
Chapter 1
Question 1
False. Auditors can be removed only by the members of the company.
Question 2
A, D
Question 3
B, C, E
Question 4
Directors = agents; shareholders = principals
Question 5
Annually
Question 6
True. Auditors can speak on matters relevant to the financial statements and their audit.
Question 7
A statement of circumstance is provided by an auditor upon resignation of removal explaining why
the resignation/removal has taken place.
Question 8
False. In fact they must communicate with the outgoing auditors.
Question 9
C
Chapter 2
Question 1
Integrity, objectivity, confidentiality, professional conduct and due diligence, professional behaviour.
Question 2
True
Question 3
There are ethical principles. These are subject to threats. The threats can be reduced or avoided by
appropriate safeguards.
Question 4
Self-interest, self-review, advocacy, familiarity, intimidation.
Question 5
With the clients permission, legal duty, legal or professional right, a public duty.
Question 6
C
Chapter 3
Question 1
IFAC: the International Federation of Accountants
Question 2
The PIOB allows a wide range of users of financial statements to contribute to standards and rule-
setting.
Question 3
the IAASB, the International Auditing and Assurance Standards Board.
Question 4
False. National laws win.
Chapter 4
Question 1
Inherent risk, control risk and detection risk. The auditor can most easily alter the detection risk by
altering the amount of audit work to be carried out.
Question 2
No, it is managements responsibility. However, the auditor should detect material misstatements
whether caused by error or fraud.
Question 3
Profession scepticism means not knowing. Evidence is needed before the auditor can make a
decision about an item in the financial statements. It does not mean distrusting everyone, but means
that auditors are aware that honest errors are made.
Question 4
B, D
Inexperienced auditors would not affect error rates in the draft statements prepared by the clients
accounting staff.)
Question 5
- 1% of revenue; 1 2% of total assets; 5 -10% of profit before tax.
Question 6
It is the contract between the auditor and client. It sets out requirements, responsibilities, duties, fees
and timings.
Question 7
(1) Ensure that it the firm is professionally qualified to act on both ethical and legal grounds.
(2) Ensure that existing resources are adequate to cover both the required expertise and the time
that the new work will take.
(3) Investigate the company, its owners and directors.
(4) Communicate with the present /outgoing auditor.
Chapter 5
Question 1
Analytical procedures; tests of detail.
Question 2
A! tests of control
Question 3
False. Some substantive testing is always carried out.
Question 4
A management letter will be sent by the auditors to the companys management explaining:
The nature of the internal control weakness.
The possible consequences
How the internal control deficiency can be fixed.
Chapter 6
Question 1
Accuracy
Completeness
Cut-off (that an event or transaction has been included in the correct period)
Allocation (that correct labour and overhead costs are included in inventory)
Classification and understandability
Occurrence
Valuation
Existence
Rights and obligations (for example, is the asset owned outright or leased).
Question 2
Existenceassets, liabilities, and equity interests exist.
Rights and obligationsthe entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
Completenessall assets, liabilities and equity interests that should have been recorded have
been recorded.
Valuation and allocationassets, liabilities, and equity interests are included in the financial
statements at appropriate amounts and any resulting valuation or allocation adjustments are
appropriately recorded.
Question 3
Analytical procedures,
Inspection
Observation
Recalculation and reperformance
Question 4
An auditor requires sufficient appropriate audit evidence that the financial statements are free form
material misstatement.
Question 5
Written Oral
Obtained via the client Auditor direct obtained
Internal External
Photocopies Originals
Chapter 7
Question 1
N or S
Haphazard sampling N
Monetary unit sampling S
Systematic sampling S
Block sampling N
Question 2
Increase sample size.
Question 3
Increase the standard of training, assignment of work to more experienced staff, better direction,
supervision and review.
Question 4
Each member of the population has an equal chance of selection
Question 5
The population is divided into strata and separate rules are established for drawing samples from
each stratum. For example, 50% of the population sampled where valances >$20,000, 20% for
balances 10,000 20,000, 50 items for balances < 10,000.
Chapter 8
Question 1
False
Question 2
Competence, capabilities, objectivity.
Chapter 9
Question 1
Dead test data is test data processed in a duplicate system so that clients real data is not corrupted.
Question 2
Which of audit test data (TD) or audit software (AS) would be more useful for the following audit
objectives?!
To determine what would happen if a negative amount of goods were ordered. TD
To find and print out negative inventory amounts. AS
To select receivables balances for verification AS
To re-perform an aged receivables analysis AS
To determine how receivables are followed up: statements, reminder letter, more TD
urgent letters etc.
Question 3
B, D
Question 4
A, C, D
Chapter 10
Question 1
Tests of control are usually carried out at the interim audit stage.
Question 2
Narrative, flowcharts and questionnaires (ICQs and ICEQs)
Question 3
A walk through test is when a transaction is walked though the system. These tests are used to
verify the accuracy of the recording and understanding of the system
Question 4
1! Are goods checked against orders when received?:! ICQ
2! Can inventory be misappropriated?! ICEQ
Question 5
Control procedure a specific part of the internal control system.
Chapter 11
Question 1
The control environment
Risk assessment procedures
Information systems
Control procedures
Monitoring control
Question 2
Nature of the internal control Potential consequences How to remedy the deficiency
deficiency
Question 3
Segregation of duties means that each transaction should be broken up and that each part should
be carried out by a separate person. Segregation of duties has two advantages:
More than one mind is involved so that errors made by one person have a good chance of being
picked up by the next.
Fraud is more difficult because it would require cooperation (collusion) between several people.
Question 4
B! (this is just normal processing).
Question 5
Significant control weaknesses should be notified to those charged with governance!
Chapter 12
Question 1
Inspection
Observation
Recalculation and re-performance
Question 2
The ability to trace a transaction forwards and backwards through the accounting system,
Question 3
The objectives of the internal control system in purchases and trade payables are (only four
required):
(1) To ensure that only necessary goods and services are purchased
(2) To ensure that all goods and services bought are received by the company
(3) To ensure that goods and services are bought from approved suppliers or are bought on the
basis of competitive tendering.
(4) To ensure that goods and services bought are of sufficient quality.
(5) To ensure that goods and services are bought at the correct time to prevent stock-outs and
over-stocking.
(6) To ensure that goods and services are bought on competitive trading terms taking into account
price, quality, and payment terms.
(7) To ensure that all purchase transactions are accurately and completely recorded in the
companys accounting records.
(8) To ensure that payments are made only in respect of goods or services properly ordered and
received.
Question 4
(Only three required)
(1) To ensure that employees are properly paid for work performed.
(2) To ensure that only the employment decision I authorised
(3) To ensure that wage and salary rates are authorised
(4) To ensure wage and salary calculations are carried out correctly.
(5) To ensure that overtime and bonuses etc cannot be paid without authorisation.
(6) To ensure cash or credit transfers paid to the correct employees
(7) To ensure that deductions (such as income tax) are paid on time to the authorities).
(8) To ensure that payments do no continue to employees who have left.
Chapter 13
Question 1
The receivables and payables figures in the statement of financial position are made up of many
individual balances. Only the individual amounts owing form customers or owing to suppliers can be
audited. Therefore it is important to know that whats being audited agrees with the figures in the
Question 2
This is a possible outflow of resources so should be disclosed in the notes to the financial
statements. No expense/liability should be set up
Question 3
It is the clients responsibility to count inventory. The auditor observes the process.
Question 4
Cash received after year end give information about the valuation of receivables.
Question 5
This will give evidence about accruals and other liabilities.
Question 6
Purchase price inspect invoice
! Depreciation inspect company accounting policy for that class of asset
! Depreciation reperform the calculations
Depreciation ensure machine is being sued and the impairment (write-down) is not needed
(unlikely for a new machine)
Question 7
C
Chapter 14
Question 1
12 months from the date of the statement of financial position.
Question 2
Yes. For example, it calls into question the valuation of year-end inventory.
Question 3
False. Letter of representation is an essential piece of audit evidence. Think: why wont the directors
provide one? Are they hiding something?
Question 4
It is a non-adjusting event. Warehouse and inventory were all fine at 31/12/2014.
Chapter 15
Question 1
Qualified; adverse; disclaimer. [Emphasis of matter or other matter do not give rise to modified
opinions]
Question 2
Emphasis of matter; other matter
Question 3
Pervasive
Question 4
B
Question 5
An emphasis of matter paragraph should be added just after the opinion paragraph
!
Question 6
The non-disclosure means that the financial statements do no show a true and fair view. Therefore,
the opinion must be modified to an adverse opinion

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2. The ACCA code of ethics and conduct!.............................................................15

3. The regulatory framework!.................................................................................23

5. Tests of control or substantive tests?!...............................................................39

6. Assertions and audit evidence!..........................................................................45

7. Obtaining audit evidence sampling!...............................................................51

8. The use of experts and other third parties!........................................................57

9. Audit evidence: computer assisted auditing techniques (CAAT)!......................61

11. Internal control!..................................................................................................75

12. Examples of internal control and tests of control!..............................................81

13. Substantive testing!...........................................................................................91

14. Final stages of the audit!.................................................................................103

15. The audit report!..............................................................................................107

16. Answers to Tests!............................................................................................113

Therefore, auditors are appointed by the members of the company to scrutinise

2. What auditors dont do

3. Advantages and disadvantages of an audit

A statement of financial position

6. The audit report

6.1 ! Prime purpose

If the presentation were as follows:

Current assets 16,000

Current liabilities 12,000

6.2 ! Detail in the audit report

1 Independent auditors' report

3 Respective responsibilities of directors and auditors

5 Scope of the audit of the financial statements

6 Opinion on financial statements

7 Opinion on other matters prescribed by the Companies Act 2006

8 Matters on which we are required to report by exception

The numbered paragraphs have the following significance:

(1) A clear title Independent auditors report.

(7) Other matters on which the auditors report explicitly.

(8) Other matters on which the auditors report by exception:

! To fulfil their duties auditors are given certain rights by law:

To be given all information and explanations they requires.

9. Resignation and removal of auditors

The steps are:

If the resolution to remove them is passed, then:

10. Auditors liability

For a claimant to prove a negligence claim, it must be shown that:

A duty of care to the claimant existed

10.2! Duty of care

10.3! Breach of the duty of care

10.4! Monetary loss

Auditors can be removed from office by the directors of the company

Which two of the following tasks do auditors undertake?

Which (several) of the following are part of the financial statements?

How frequently must auditors of a public company be re-elected?

Auditors have a right to speak at general meetings

What is a statement of circumstance?

Incoming auditors are not allowed to communicate with outgoing auditors.

2. The ethical framework

Establishes five fundamental principles

3. The fundamental principles and their threats

3.1! The five fundamental principles

1 Integrity Members should be straightforward and honest in business

2 Objectivity Members should not allow bias, conflicts of interest or undue