Audit

---

Help From Steve in Audit Papers

Student studying auditing will be faced with challenging papers.  They are a challenge because if students do not work in audit, or if they have never come across the principles involved in audit, the papers can be particularly overwhelming.

This article considers some of the ‘tips’ students studying audit papers should take on board to help them prepare for their exam.

Principles of audit

The first thing students need to understand when studying for audit papers is WHY the audit is undertaken in the first place.  Is it true auditors are there to check up on the finance staff?

The actual purpose of the audit is to ensure that the financial statements give a true and fair view of the state of the entity’s affairs.  This is more than just checking figures add up and that there are invoices to represent the items that make up (say) ‘postage and stationery’.  The audit looks at the company’s internal controls and assesses the effectiveness of those controls.  By looking at a company’s internal control environment the auditor can determine the extent to which they have to undertake their detailed testing (substantive testing).  Consider the following examples:

Illustration 1

Watkins Enterprises Inc operates in the ‘Do-it-Yourself’ industry.  It is an owner-managed business with twenty-five employees.  The directors are also the shareholders.

The audit firm, Smyth & Co have looked at the company’s internal controls.  The books are kept manually on pieces of paper, purchase orders are dealt with by all staff on a ‘need-to-order’ basis and invoices are paid when the Director has time.  The tills are checked by staff as they finish their duty and banked by the trainee warehouse operative.

Illustration 2

Bury Enterprises Inc operates in the food industry. It purchases bread from a well-known bakery and sells it on to the end consumer.  Purchase orders are dealt with by a dedicated purchasing team and all backing information (purchase orders, delivery notes etc) are attached to the back of the purchase invoice.

All takings are dealt with by the finance department and are banked by the Director on a daily basis.  All cash is recorded daily and the company maintains its books on a well-known accounting software package.

So in terms of planning, what will the auditors conclude from the above illustrations?

In illustration 1, Watkins Enterprises has little (if any) internal control systems at all.  The accounts are produced on bits of paper, there appears to be little control over the company’s ordering (in a DIY company, goods will be ordered on a daily basis to maintain stocks).  In terms of internal controls, the auditor cannot rely on any of them and as stock is likely to be a material amount in the financial statements, the auditor will have to adopt a mainly substantive approach to their audit.  In other words, they will not rely on the internal controls – instead they will undertake their sampling using more detailed audit testing (substantive testing).

In illustration 2, Bury Enterprises appears to have a strong internal control environment.  On the assumption that this is not a first year audit then the auditor can rely on the internal controls of the company and reduce their detailed substantive testing accordingly.  The auditor will plan to check the controls operate as they understand and if this is the case, reliance can be placed on the controls accordingly (note internal controls are normally tested in full at least every third audit).

The above examples illustrate the inverse relationship between control risk and detection risk.  Control risk is the risk that the financial statements contain a material misstatement due to ineffective internal controls.  Detection risk is the risk that the auditor will not detect a material misstatement within the financial statements.

In illustration 1, the auditor is not relying on internal controls and is going to perform a substantive audit (the alternative to relying on internal controls).  If control risk is high (as is the case in illustration 1) then detection risk becomes low as they are performing more detailed testing on the transactions and balances.

In illustration 2, the auditor is relying on internal controls therefore detection risk becomes high (as there is more chance the auditor will not detect a material misstatement) and control risk becomes low (the auditor has deemed internal controls satisfactory, so the risk of material misstatement due to ineffective controls is low).

Exam Technique

In auditing papers, you will be faced with a largely discursive paper.  There will be hardly any calculations to perform, though you may be asked to calculate materiality or, for those well-prepared candidates, you may want to undertake your own calculations, for example, undertaking calculations for analytical review purposes.

Consider the following question:

You are the audit manager of Alex Inc, a firm of Chartered Certified Accountants, and are undertaking the audit of Alicia Inc for the year ended 30 June 2008.  During the course of the audit you have come across various journals which appear to have been written off to the income statement with the narrative “correction to closing balance”.  In isolation these items are immaterial, though become material when aggregated.

Required:

You are required to describe the procedures and action you would take regarding the various journals. (15 marks)

Answer 1

Well, if that were me, I would tell the audit manager coz it’s a journal, it’ll be a fraud.  I would tell the manager that I have come across various journals which appear to have been written off to the income statement with the narrative “correction to closing balance” and that these items are immaterial but when they are put together they are material.

Answer 2

In accordance with ISA 320 (revised and redrafted) (Materiality), misstatement (including omissions) are considered to be material in isolation or in aggregate if they could reasonably be expected to influence the decisions taken by users of the financial statements, for example potential investors.

ISA 500 (Audit Evidence) stipulates six methods of obtaining audit evidence:

• Analytical review;
• Inquiry;
• Observation;
• Reperformance/recalculation;
• Confirmation;and
• Inspection.

We would need to perform substantive testing on the journals to ascertain their appropriateness, as they could be indicative of fraud, which the auditor has to take into consideration as per ISA 240 (redrafted) (The Auditors Responsibility to Consider Fraud in an Audit of Financial Statements).  This would involve tracing the journals from the underlying source documentation through to their ultimate destination in the financial statements, and reviewing their appropriateness.  We could also use analytical review procedures to determine the effect the journal entries have had on the financial statements.

In addition, we should also enquire with management as to the circumstances surrounding the journal entries to confirm their appropriateness.

Moreover, the journals could be indicative of a weakness in the internal controls, especially the financial reporting systems and therefore these weaknesses will need to be notified to those charged with governance as per ISA 260 (revised and redrafted) (Communication of Audit Matters to those Charged with Governance).

If we conclude that the journals result in the financial statements being misstated then we would need to inform those charged with governance as soon as is reasonably practical (per ISA 260).  If management refuse to correct the journals then this would have consequences on our audit opinion.  As per ISA 700 (revised) (The Independent Auditors Report on a Complete Set of General Purpose Financial Statements) if management refuse to correct the material misstatements, then we should modify our opinion accordingly.

If the journal adjustments result in the financial statements failing to give a true and fair view, then we should issue an adverse opinion.

Answer 1

This answer would be lucky to receive any marks.  The answer states:

“…..I would tell the audit manager…..”.  Clearly the candidate has not read the scenario properly.  You ARE the audit manager – so would you tell yourself that you have found these journal entries?

In addition, the candidate has merely copied out chunks of the question in their answer.  They have failed to reach a conclusion, they have failed to say what audit procedures they would adopt and they have failed to consider all the situations that may give rise to journal entries (e.g. correction of error) – the candidate clearly lacks even the most basic of knowledge if they assume that journals are fraudulent.  The candidate has reached an assumption that the journals are as a result of fraud.  How has the candidate reached that conclusion?  How would the candidate think the client would react if they were accused of fraud when the journals were merely correction of errors?

The professionalism of the answer is also non-existent.  Auditing papers are largely discursive, and the candidate should answer in a way that reflects professionalism.  The word ‘coz’ is not a word!

It is important that just because something may seem odd (i.e. journal narratives saying “correction to closing balance” ) that students do not go into ‘autopilot’ and assume that management are corrupt!  Read the scenario carefully and consider all circumstances that may give rise to an issue within the scenario.  Unless you are specifically told there is a fraud going on you can’t assume that just because journal entries are correcting closing balances that this gives rise to fraud.

Answer 2

This is more like it.  The candidate here is well-prepared.  The candidate has discussed the concepts of materiality and how omissions or misstatements would influence the user of the financial statements as the introduction.  The candidate also has the ability to ‘think outside of the box’ as they have considered other auditing standards in their answer.

In this answer the candidate has not merely regurgitated the provisions of ISA 500 (Audit Evidence), but the candidate has thought about how the provisions of other auditing standards may affect this situation, for example inappropriate journal entries might be indicative of fraud (ISA 240). The candidate has also ‘tailored’ the provisions of ISA 500 to the scenario presented by picking out some of the methods to support the appropriateness of the journal entries in the scenario (e.g. inquiry).

The candidate has drawn a conclusion, has brought in technical knowledge, has answered the question well and has structured their answer in a logical way.

Some auditing papers contain ‘professional marks’ and these marks can be the difference between a pass or a fail.  It is important when answering auditing questions that you plan your answer and structure it in such a way that the answer flows in a logical manner.

Audit Techniques

When studying auditing papers it is important to appreciate the various testing techniques auditors use and when they are appropriate.  For example, in the illustrations above, the auditor would not rely on internal controls in illustration 1 because they hardly exist, and those that do may not operate efficiently.  Therefore, the auditor should use substantive techniques.  Let us consider some techniques auditors can use:

Substantive testing
This is where the auditor will trace a sample of transactions from their underlying documentation through to their ultimate destination in the financial statements (cost of sales, perhaps).  For example, let us start from the goods received note in a purchases sample:

From the goods received note, the auditor will trace it to:

• The invoice (checking the GRN has been signed to say the goods have been received) and checking the quantities, prices and calculations are correct;
• Stock records;
• The suppliers purchase ledger account;
• The VAT account (if applicable);
• The creditors control account; and
• The nominal ledger.

Analytical review
This is where the auditor will look for unusual trends/characteristics within the financial statements that the auditor should look into.  For example, an unexpected fall in gross profit margin might be indicative of incomplete sales or an error in the closing stock valuation.

Stratified sampling
This is a technique where the auditor will split items in a sample into their various strata’s.  For example, in a payroll sample the auditor might split the sample between full-time males, full-time females, part-time males and part-time females and work out the percentage of the strata in the population (the population being the total amount that makes up a figure). For example if 30% of the population are full-time males, 40% full-time females, 20% part-time males and 10% part-time females, then the sample will consist of 30% full-time males, 40% full-time females etc.

Tests of control
This is where the auditor will test the effectiveness of the client’s internal controls to see if they operate efficiently.  If they do, the auditor can reduce the extent of their substantive testing.  If they don’t the auditor should increase their substantive testing.  Detailed tests of control are normally carried out at least every third audit.

Circularisation
This where (say) customer’s are written to in order to confirm the balance at the year end on their purchase ledger.  This evidence can support the existence of trade receivables.  The letter can either be a positive circularisation (where the customer is asked to confirm the amount is correct) or a negative circularisation (where the customer is asked to confirm if the amount is not correct).

It is also necessary to understand when a procedure is appropriate and when it is not.  For example, if you are auditing a client in the service sector (say a firm of Solicitors) whose fixed assets are immaterial but whose work-in-progress represents 20% of their net assets; you will spend less time auditing fixed assets than you would auditing work-in-progress.  You would also not just test work-in-progress for ‘existence’ but you would test it for ‘valuation’ and ‘completeness’.

The Assertions

Auditing is primarily concerned with ensuring the financial statements give a true and fair view.  There are various financial statement assertions that need to be considered:

• Completeness
• Accuracy
• Existence
• Rights and obligations
• Classification
• Valuation
• Cut-off

Transactions are checked for: occurrence, completeness, accuracy, cut-off and classification.

Balances are checked for: existence, rights and obligations, completeness, valuation and disclosure.

Presentation and Disclosures are checked for: occurrence, rights and obligations, completeness, classification, accuracy and valuation.

Reports

A key document in the audit process is the audit report.  This is only outcome of the audit the client receives.  It is crucial that students understand the appropriateness of the opinion – this is a basic fundamental requirement in auditing papers.  If you fail to understand the appropriateness of an opinion, you need to go back to this area and study it thoroughly.  Examiners will require students to understand when an opinion is appropriate and is a subject often tested in auditing exams. You could be asked what you think the audit opinion should be in a given scenario.

Knowing the forms of opinion is just one key aspect.  Knowing the contents of the report is also another.  The auditors report should contain:

• Title;
• Addressee;
• Introductory paragraph;
• Management responsibility for the financial statements;
• Auditor’s responsibility;
• Auditor’s opinion;
• Other reporting responsibilities;
• Auditor’s signature;
• Date of the auditor’s report; and
• Auditor’s address.

The auditor’s opinion is derived from the evidence obtained from the audit. The opinions can be:

Unqualified opinion
Internationally known as an unmodified opinion, this is given where the financial statements represent a true and fair view of the entity’s affairs.

Qualified opinion
Internally known as a modified opinion, this is given where the financial statements contain (say) a breach in accounting standard or provision(s) under the Companies Acts or a disclosure that is required to be disclosed is omitted or incorrect.  The qualified opinion in the auditor’s report is always followed by ‘except for’ which states that other than the matter(s) giving rise to the qualification, the financial statements otherwise represent a true and fair view.

Adverse opinion
This is where the financial statements contain a material omission or misstatement that gives rise to the financial statements NOT giving a true and fair view.  This can occur, for example, if a client has a defined benefit pension scheme and the surplus or deficit on the pension scheme has not been brought on to the balance sheet (statement of financial position).

Disclaimer
This is where the auditor cannot form an opinion on the financial statements because of significant uncertainty.  For example, earlier in the article we illustrated Watkins Enterprises that had no internal controls at all; this could well give rise to the auditor issuing a disclaimer.

In addition, there are also Emphasis of Matter paragraphs.  Students should be aware that an emphasis of matter paragraph does not affect the auditor’s opinion.  The emphasis of matter paragraph always comes after the auditor’s opinion.  An emphasis of matter paragraph is used by the auditor to highlight a matter(s) found during the course of the audit which might have inherent uncertainties.  For example, where the entity has an investment overseas that is seeing interest rates become volatile – there could be uncertainty as to the future viability of the investment.  It may well be that the investment at the date of the auditor’s report is viable, is fairly stated and is profitable – but circumstances beyond the control of the investment may give rise to an emphasis of matter paragraph.

So what does the examiner expect from me?

Examiners want to see an auditing student demonstrate a basic (but broad) knowledge of the syllabus.  The answers of a well-prepared student will:

• Bring in technical knowledge (ISAs/IAS/FRS) appropriate to the scenario;
• Answer the question set, not the question the candidate wanted to be set;
• Be professional (i.e. how they would address the issues to their client);
• Be appropriate to their position in the examination e.g. as audit manager or audit senior (you must take notice of your position within the audit);
• Be well-structured and flow in a logical manner;
• Contain good argument and form conclusions based thereon; and
• Be in the right format (e.g. a report/briefing notes/memo/letter etc).

The ability to gain the above skills only comes with question practice.  For those students who do not work in audit or who have never studied audit papers previously, a good, basic knowledge of the syllabus is required.  As audit papers are largely discursive, a high standard of written skills are also essential to passing as most papers contain ‘professional marks’.

Students who demonstrate a lack of knowledge in auditing and throw in jargon because they think it will ‘look good’ will fail the paper.  The examiner is looking for answers that are appropriate to the scenario given and that present a logical argument.  Candidates should also avoid ‘buffing’ their answers by copying out chunks of the question/scenario – it is a waste of time and doesn’t earn you any marks.

Conclusion

The auditing papers are very challenging and are often based on real-life experiences.  Students need to appreciate that when they are dealing with auditing papers, they can expect to deal with similar issues in real-life so it is vital that students practice as many exam standard questions as possible to help them pass their exams.

Students should appreciate that model answers in auditing papers are often longer than those that would be expected in the examination.  Students should also appreciate that just because their answer is not replicated in the model answers, it does not mean that their answer may not receive credit.  If your answers are logical, tailored to the scenario, have a reasoned argument and form a reasonable conclusion based on the technical aspects of the question, you will not go far wrong.

Steve Collings FMAAT ACCA is Audit Manager at Leavitt Walmsley Associates (http://www.lwaltd.com) and is also a partner in AccountancyStudents.  He holds a Diploma in the ACCA Diploma in International Financial Reporting Standards.  Questions arising from this article can be directed to .(JavaScript must be enabled to view this email address)