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CONTENT
1. Nature and purpose of an audit
- Nature and objectives of an audit
- Development of audit (early audit and modern audit)
- Users of audited financial statements
- Features of audits
- Distinction between auditing and accounting
- Types and classification of audits
- Situations when different audits are performed (interim, continuous, final, operational)
- Advantages and disadvantages of various types of audits
- Nature of work done for different audits
- Inherent limitations of an audit
2. Assurance and non- assurance engagements
- Definition and objectives of assurance engagements
- Audit as an assurance engagement
- Elements of an assurance engagement
- Types of assurance engagements (Audit, Review assignments)
- Differences between audit and review engagements
- International Standard on Assurance Engagement-ISAE 3000
- Accepting appointment to perform assurance engagement
- Review of interim financial information – ISRE 2410
- Levels of assurance and reports issued on assurance engagements
- Non-assurance engagements (Agreed upon procedures engagement -ISRS 4400 and compilation assignments-ISRS 4410
- Attestation and direct reporting engagements
3. Legal and professional framework
- Regulatory framework for external audits
- Appointment of the auditors
- Qualifications and disqualifications of auditors
- Removal and resignation of auditors
- Remuneration of the auditors
- Rights and duties of auditors
- Mechanisms of regulations of auditors-role of professional bodies, Audit committee, rotation of audit firms
- Professional ethics/code of ethics for professional accountants
- Importance of the professional ethics
- Basic/fundamental principles for Code of Ethics for accountants
- Other professional guidelines on audit fees, conflict of interest, advertising and publicity and opinion shopping by clients
- Auditors independence /objectivity and its importance
- Threats to independence and safeguards.
- Threats on adherence to other fundamental principles and safeguards to the threats
- Development and status of ISAs in execution of audits
- Relationship between International Standards of Auditing and National Auditing Standards
- Purposes/importance of adoption of ISA in the audit.
4. Planning and Risk Assessment
- Obtaining, accepting and retention of an audit engagement
- Matters to consider before and after acceptance of nomination
- Pre-conditions of an audit
- Engagement letter, procedure of sending letter, purposes and contents of the letter-ISA 210
- Circumstances for revision of engagement terms
- Understanding the entity and its environment
- Background information about the entity or client.
- Ways of gathering knowledge about the business
- Reasons/importance of information gathered about the client
- Reasons of review of previous audit files and communication with previous auditors
- Overview of audit process
5. Audit risk assessment
- Components of audit risk (Inherent, Control and Inherent risks)
- Assessment of different types of audit risks
- Factors leading to increase or decrease of inherent, control and detectionRisks
- Adoption of risk based audit, reasons and procedure
- Advantages and Disadvantages of the approach
- Evaluating and prioritising risk and control factors
- Mechanisms to minimise the risks associated with client audits.
6. Audit planning
- Purpose and challenges in audit planning
- Planning for new and existing clients
- Development of the overall audit strategy
- Contents of audit planning memorandum/ overall plan
- Relationship between audit strategy and audit plan
- Design of audit programs, importance and problems of the programs
- Impact of material misstatements on audit strategy and degree of work done
- Influence of interim audit work on the year end/final audit.
7. Audit documentation
- Reasons and importance of audit documentation
- Sources, features and purposes of working papers
- Storage of working papers-permanent audit file and current audit file, auditors note book or diary
- Lien or custody on working papers
- Standardisation of working papers – advantages and disadvantages
- Safe custody and retention of working papers
- Form and content of working papers
- Automated working papers
- Quality control policies and procedures implemented by audit firm
- Objectives of quality controls to the audit firm/ auditors
- Peer review and its objectives
8. Internal control systems and Internal Audit Function
Internal control systems (ICS)
- Objectives of internal control system
- Component of internal control system
- Features of Internal control system
- Designing of internal control system.
- Auditors and management responsibility over ICS
- Advantages and disadvantages /inherent limitations of ICS
- Indicators of weaknesses in ICS and actions taken by management
- The evaluation of internal control systems by auditors using Internal Control Questionnaire, Flow charts and narrative notes
- Tests of controls on specific control environments
- Internal controls theory and practice-sales and debtors, purchases and creditors, inventories and work in progress, fixed assets, salaries and wages
- Communication of improvements on ICS weaknesses/ risks associated – Management letter.
Internal Audit Function
-
- Overview of Forensic Accounting, Errors, Frauds and Irregularities
- Errors, Frauds and Irregularities
- Audit evidence
- Auditing in the public sector
- Auditors Reports
- Auditing in a computerised system
- Contemporary and emerging issues in audit
TOPIC 1
NATURE AND PURPOSE OF AN AUDIT
NATURE AND OBJECTIVES
Definition of an Audit:
An audit is the examination of the financial report of an organisation – as presented in the annual report – by someone independent of that organisation. The financial report includes a balance sheet, an income statement, a statement of changes in equity, a cash flow statement, and notes comprising a summary of significant accounting policies and other explanatory notes.
The purpose of an audit is to form a view on whether the information presented in the financial report, taken as a whole, reflects the financial position of the organisation at a given date, for example:
• Are details of what is owned and what the organisation owes properly recorded in the balance sheet?
• Are profits or losses properly assessed?
When examining the financial report, auditors must follow auditing standards which are set by a government body. Once auditors have completed their work, they write an audit report, explaining what they have done and giving an opinion drawn from their work. Generally, all listed companies and limited liability companies are subject to an audit each year. Other organisations may require or request an audit depending on their structure and ownership.
The objective of an audit is to enable the auditor express an opinion whether financial statements show a true and fair view of the company state of affairs in accordance with an identified financial reporting framework.
The purpose of an audit is not to provide additional information but rather it is intended to provide the users of the accounts with assurance that the information provided to then by directors is reliable. However, the users should not assume the auditor’s opinion is one to efficiency with which management has conducted the affairs of the entity.
Financial statement: According to the Companies Act, the company accounts refers to the balance sheet and the profit and loss account but due to development in business practice and shareholders information needs, these are inadequate as to the information regarding financial position and performance of the company. Since most balance sheets and profit and loss accounts are summarized statements amplified by notes to the statements, the business community and the accountancy profession require that a cash flow statement as well as a statement of changes in equity be prepared. The terms company accounts and financial statements have the same meaning.
Financial Reporting framework: According to International Auditing Standards (ISA 200, the framework of international standards of auditing), financial statements are usually prepared and presented annually and are directed at common informational needs of a wide range of users.
Many of the users rely on the financial statements as their major source of additional information to meet their specific information needs. Therefore financial statements need to be prepared in accordance with one or combination of:
• International Financial Reporting Standards (IFRS)or IASs
• National accounting standards
• Any other authoritative and comprehensive financial reporting framework designed for use in financial reporting and is identified in the financial statements. In Kenya the financial reporting framework adopted is as prescribed by IFRS.
Scope of-the Audit
The auditor’s opinion on the financial statements deals with whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework: Such an opinion is common to all audits of financial statements.
The auditor’s opinion therefore does not assure, for example, the future viability of the entity nor the efficiency or effectiveness with which management has conducted the affairs of the entity. In some jurisdictions, however, applicable law or regulation may require auditors to provide opinions on other-specific matters, such as the effectiveness of internal control, or the consistency of a separate management report with the financial statements.
While the ISAs include requirements and guidance_ in relation to such matters to the extent that they are relevant to forming an opinion on the financial statements, the auditor would be required to undertake further work if the auditor had additional responsibilities to provide such opinions.
STAGES OF AN AUDIT
The suggested audit approach is designed to gather sufficient and reliable evidence to support the audit opinion in the most efficient and effective way and to enable the engagement team to fully understand the client’s business. There is no difference between an audit of a large and a small entity except that the procedures adopted may differ depending on the particular circumstances of each audit
i. Preliminary Engagement Activities
ii. Planning
iii. Execution
iv. Review and Completion
i) Preliminary Engagement Activities
At the Pre-planning stage, the engagement partner ensures that:
– The client acceptance and continuation procedures have been carried out;
– The terms of engagement have been agreed in writing;
– The quality control aspects for the assignment have been reviewed including review of the competency of the team to carry out the assignment, review of compliance with the ethical requirements, including review of the independence requirements.
Planning
Planning is an essential component in focusing the audit efforts. The key components of
Identifying the scope of the assignment
Developing an audit strategy taking into consideration the scope of the engagement; the business and the regulatory environment in which the entity operates; entity specific issues including reliance on the work of internal audit; reporting objectives, timing of the audit and the nature of communication required; matters affecting the direction of the audit including preliminary setting of materiality levels, preliminary review of risk including fraud risk, preliminary review of internal control including the control environment, the process adopted by the entity to identify, measure, monitor and control risks.
– Developing, based on the above, the overall audit plan detailing the nature, timing and extent of the audit procedures to be performed in order to reduce the audit risk to an acceptably low level; the nature of tests to be adopted; procedures to be adopted at the assertion level; and tailoring the audit programmes.
– Ascertaining the nature and the extent of the resources required to perform the audit.
iii) Execution
– The key components of the execution stage are:
– Carrying out the test of controls and substantive tests on transactions and balances including substantive analytical procedures to obtain sufficient and appropriate audit evidence to enable the engagement team to draw reasonable conclusions on which to base the audit opinion.
– Evaluating significant assumptions used in fair value measurement to determine the reasonableness of the basis used and the disclosures.
– Identification of related parties and obtaining sufficient and appropriate audit evidence in respect of measurement and disclosure of related party transactions.
– Documenting the nature, timing and extent of the audit procedures performed and the results and conclusions drawn from the audit evidence obtained
While pre-printed forms and programmes are available in the Manual, the extent and the timing of the tests should be tailored to the specific assignment. Different tests and different levels will be appropriate for each assignment. The control of the audit at this stage must be maintained by a senior team member with the appropriate experience and expertise.
iv) Review and Completion
The review and completion procedures focus on ensuring that sufficient and appropriate evidence has been obtained to support the audit opinion. This involves ensuring that:
– All outstanding matters have been cleared.
– Consultations on difficult or contentious matters have been documented and adequately resolved and conclusions therefrom implemented.
– Analytical procedures have been performed to form a conclusion on whether the financial statements taken as a whole are consistent with the firm’s knowledge of the business.
– Where other appropriate audit evidence cannot be reasonably obtained, written management representations have been obtained on areas material to the financial statements.
– Review has been carried out of any material uncertainty relating to events or conditions that may exist which alone or in aggregate cast a significant doubt on the entity’s ability to continue as a going concern.
– There is evidence that the engagement team has considered and confirmed that the financial reporting framework adopted by the entity is suitable, and that the financial statements comply with the framework as to both recognition and measurement and presentation and disclosure. In the context of Kenya, this in most cases will be the IFRS’s.
– The engagement partner has reviewed the audit file and is satisfied that sufficient and appropriate evidence has been obtained to support the conclusions derived and the audit opinion to be issued. As much of the audit evidence obtained is persuasive rather than conclusive, absolute certainty is rarely obtainable and therefore the engagement partner should ensure that the audit risk is reduced to the lowest level possible.
– Where applicable, sufficient and appropriate procedures have been performed to identify subsequent events tip to the date of the audit report and ensure that all items that require adjustment or disclosure in the financial statements have been appropriately dealt with:
– Where appropriate, an engagement quality control review has been undertaken and all the issues arising from the review have been fully dealt with and cleared with the reviewer.
– At the end of each audit, the engagement team is de-briefed, the audit objectives set out for the assignment have been achieved and that the engagement team has gained experience from the assignment which will enhance their personal development.
Though not covered by the terms of audit engagement, the engagement team may, as part of the audit process carry out a business review of the key issues facing the entity and take a strategic look at the business and at areas where the firm can add value to the entity. In providing other value added services, the firm and in particular the engagement partner should be conscious of the independence requirements of the code of ethics
AUDIT AS AN ASSURANCE ENGAGEMENT
It is often not possible to check things for yourself, whether quality, accuracy, performance or existence.
You might not have the skills or the time, or you might be in the wrong location. Therefore you must rely on someone else to give you assurance. This means you have to decide:
– What standards should be applied?
– What represents ‘good’, ‘acceptable’ or ‘unacceptable?
– How much checking should be done? All checking and assurance has an associated cost
Audit is one form of assurance
An audit is defined as: the independent examination of and expression of opinion on the financial statements of an entity by a duly appointed auditor in pursuit of that appointment.
The important words here are ‘independent’ and ‘opinion’.
Independence is essential and underlies the value of auditing.
Opinion really means that one auditor could look at a set of financial statements and disagree with the opinion of another auditor.
Judgment is essential to all auditing, there are no certainties and there are no certifications of correctness or accuracy.
DEVELOPMENT OF AUDIT (EARLY AUDIT AND MODERN AUDIT)
A review of the historical development of auditing has shown that the objective of auditing and the role of auditors are constantly changing as they are highly influenced by contextual factors such as the critical historical events (e.g. the collapsed of big corporations), the verdict of the courts, and technological developments (e.g. advancement of computing systems and CAATs). It can be observed that any major changes in these contextual factors are likely to cause a change in the audit function and the role of auditors. As a result, auditing is seen to be evolving at all times.
However, it is important to note that the change in society’s expectation and the response of the auditing profession towards these changes are not always at the same pace. Hence there is a natural time gap between the changing expectation of the users and the response by the profession and due to this time gap there arises what has been stated as the expectation gap or audit expectation gap. Even though the existence of such a natural time gap is inevitable, auditors should be sensitive to the changing expectation of the relevant groups while at the same time containing these expectations within the constraints of what is possible. There are inevitably economic and practical limitations on what an audit can do, and this is something which those who wish the benefit must understand.
The evolution of auditing practices
Prior to 1840
Generally, the early historical development of auditing is not well documented (Lee, 1994). Auditing in the form of ancient checking activities was found in the ancient civilizations of China, Egypt and Greece. The ancient checking activities found in Greece (around 350 B.C.) appear to be closest to the present-day auditing.
Similar kinds of checking activities were also found in the ancient Exchequer of England. When the Exchequer was established in England during the reign of Henry 1(1100-1135), special audit officers were appointed to make sure that the state revenue and expenditure transactions were properly accounted for. The person who was responsible for the examinations of accounts was known as the “auditor”. The aim of such examination was to prevent fraudulent actions.
1840s-1920s
The practice of auditing did not become firmly established until the advent of the industrial revolution during the period 1840s-1920s in the UK. According to Brown (1962), the large-scale operations that resulted from the industrial revolutions drove the corporate form of enterprise to the foreground. Large factories and machine-based production were established. As a result, a vast amount of capital was needed to facilitate this huge amount of capital expenditure. The emergence of a “middle class” during the industrial revolution period provided the funds for the establishment of large industrial and commercial undertakings. However, the share market during this period was unregulated and highly speculative. As a consequence, the rate of financial failure was high and liability was not limited. Innocent investors were liable for the debts of the business. In view of this environment, it was apparent that the growing number of small investors was in dire need of protection (Porter, et al, 2005). Hence, the time was ripe for the profession of auditing to emerge (Brown, 1962).
In response to the socio-developments in the UK during this period, the Joint Stock Companies Act Was passed in 1844. The Joint Stock Companies Act stipulated that “Directors shall cause the Books of the Company to be balanced and a full and fair Balance Sheet to be made up”. In addition the Act provided the appointment of auditors to check the accounts of the company. However, the annual presentation of the balance sheet to the shareholders and the requirement of a statutory audit were only made compulsory in .1900 under the Companies Act 1862 (UK).
According to Porter, et al (2005) the accountant particularly in the early years of this period, was normally the company manager and his duties were to ensure proper use of the funds entrusted to him. The auditors during this period were merely shareholders chosen by their fellow members. The auditors during this period were required to perform complete checking of transactions and the preparation of correct accounts and financial statements. Little attention was paid to internal control of the company.
1920s-1960s
The growth of the US economy in the 1920s-1960s had caused a shift of auditing developthent from the UK to the USA. In the years of recovery following the 1929 Wall Street Crash and ensuing depression, investment in business entities grew rapidly. Meanwhile, the advancement of the securities markets and credit-granting institutions had also facilitated the development of the capital market in this period. As companies grew in size, the separation of the ownership and management functions became more evident. Hence to ensure that funds continued to flow from investors to companies, and the financial markets function smoothly, there was a need to convince the participants in the financial markets that the company’s financial statement provided a true and fair portrayal of the relevant company’s financial position and performance. In view of the economic condition, the audit function was mainly to provide credibility to the financial statements prepared by company managers for their shareholders. Consensus were generally achieved that the primary objective of an audit function is adding credibility to the financial statement rather than on the detection of fraud and errors.
The concept of materiality and sampling techniques were used in auditing during this period. The development of material Concept and sampling technique was due to the voluminous transactions involved in the conduct of business by. large corporations operating in. widespread locations., It is no longer practical for auditors to verify all the transactions. Consequently, sampling and the development of judgment of materiality were essential.
The major characteristics of the audit approach during this period included:
i. Reliance on internal control of the company and sampling techniques were used;
ii. Audit evidence was gathered through both internal and external source;
iii. Emphasis on the truth and fairness of financial statements;
iv. Gradually shifted to the audit of Profit and Loss Statement but Balance Sheet remained important; and
v. Physical observation of external and other evidence outside the “book of account”
1960s to 1990s
The world economy continued to grow in the 1960s-1990s. This period marked an important development in technological advancement and the size and complexity of the companies. Auditors in the 1970s played an important role in enhancing the credibility of financial information and furthering -the operations of an effective capital market. The duties of auditors. among others, were to affirm the truthfulness of financial statements and to ensure that financial statements were fairly presented.
Hence, the role of auditors with regard to the audit of financial statement generally remained the same as per the previous period.
Despite the overall audit objectives remaining similar, auditing had undergone some critical developments in this period. In the earlier part of this period, a change in audit approach can be observed from “verifying transaction in the books” to “relying on system”. Such a change was due to the increase in the number of transactions which resulted from the continued growth in size and complexity companies where it is unlike for auditors to play the role of verifying transactions. As a result, auditors in this period had placed much higher reliance on companies’ internal control in their audit procedures. Furthermore, auditors were required to ascertain and document the accounting system with particular consideration to information flows and identification of internal controls. When internal control of the company was effective, auditors reduced the level of detailed substance testing. In the early 1980 there was a readjustment in auditors’ approaches where the assessment of internal control systems was found to be an expensive process and so auditors began to cut back their systems work and make greater use of analytical procedures. An extension of this was the development during the mid-1980s of risk-based auditing. Risk-based auditing is an audit approach where an auditor will focus on those areas which are more likely to contain errors. To adopt the use of risk-based auditing, auditors are required to gain a thorough understanding of their audit clients in term of the organization, key personnel, policies, and their industries. Hence, the use of risk-based auditing had placed strong emphasis on examining audit evidence derived from a wide variety of sources, i.e. both internal and external information for the audit client. Most of the companies in this period had introduced computer systems to process their financial and other data, and to perform, monitor and control many of their operational and administrative processes. Similarly, auditors placed heavy reliance on the advanced computing auditing tool to facilitate their audit procedures. In addition to the auditing of financial statement, auditors at the same time were providing advisory services to the audit clients.
1990s-present
The auditing profession witnessed substantial and rapid change since 1990s as a result of the accelerating growth at the world economies. It can be observed that auditing in the present day has expanded beyond the basic financial statement attest function. Present-day auditing has developed into new processes that build on a business risk perspective of their clients. The business risk approach rests on the notion that a broad range of the client’s business risks are relevant to the audit. Advocates of the business risk approach opined that many business risks, if not controlled, will eventually affect the financial statement. Furthermore by understanding the full range of risks in businesses, the auditor will be in a better position to identify matters of significance and relevance to the audit profession on a timely basis. Since the early 1990s, the audit profession began to take increased responsibility to detect and report fraud and to assess, and report more explicitly, doubts about an auditee’s ability to continue in conformance with society’s and regulators’ increasing concern about corporate governance matters. Adoption of the business risk approach in turn enhances auditor’s ability to fulfill these responsibilities. Presently, the ultimate objective of auditing is to lend credibility to financial and non-financial information provided by management in annual reports; however, audit firms have been largely providing consultancy services to businesses
Although the overall audit objectives in the present period remained the same, i.e. lending credibility to the financial statement, critical changes have been made to the audit practice as a result of the extensive ‘reform in various countries. Such reform has implicated the auditing profession in the following ways:.
i. The role of auditors is expected to Converge: refocusing on the public interest, redefining -audit relationship, ensuring integrity of financial reports, separation of non-audit function and other advisory services;
ii. The audit methods revert to basics i.e. risk attention, fraud awareness, objectivity and independence, and.
iii. Increase attention on the needs of financial statement users”
Features of audits
The audit is structured into activities that follow a logical sequence. The audit will focus on the management and delivery of the electronic device, which supposes fluxes of electronic devices and procedures of treatment specific associated.
There are six essential features or characteristics of auditing are;
1. Systematic process.
2. Three-party relationship.
3. Subject matter.
4. Evidence.
5. Established criteria.
6. Opinion.
The essential features of Auditing are explained below;
1. Systematic process
Auditing is a systematic and scientific process that follows a sequence of activities, which are logical, structured, and organized.
2. Three-party relationship
The audit process involves three parties, that is, shareholders, managers, and auditors.
3. Subject matter
Auditors give assurance on a specific subject matter. However, the subject matter may differ considerably, such as – data, systems or processes and behavior.
4. Evidence
The auditing process requires collecting the evidence, that is, financial and non-financial data, and examining thereof.
5. Established criteria
The evidence must be evaluated regarding established criteria, which include International Accounting Standards, International Financial Reporting Standards, Generally Accepted Accounting Principles, industry practices, etc.
6. Opinion
The auditor has to express an opinion as to the reasonable assurance on the financial statements of the entity.
DISTINCTION BETWEEN ACCOUNTING AND AUDITING
In terms of
1. Definition:
Accounting is keeping records of the financial transactions and preparing financial statements; but auditing is critical examination of the financial statements to give an opinion on their fairness.
2. Timing:
Accounting is carried out on continuous basis with daily recording of financial transactions; while auditing is basically a periodic process and carried out after the preparation of final accounts and financial statements, usually on yearly basis.
3. Beginning:
Accounting starts usually where book-keeping ends; while auditing always starts where accounting ends.
4. Period:
Accounting mainly concentrates on the current financial transactions and activities; while auditing concentrates on the past financial statements.
5. Coverage:
Accounting covers all transactions, records and statements having financial implications; while auditing mainly covers final financial statements and records.
6. Level of Detail:
Accounting is very detailed and captures all details related to financial transactions, records and statements; while auditing generally uses financial statements and records on sample basis.
7. Type of Checking:
Accounting involves checking and verifying details related with all financial statements and records; while auditing may be carried out through test checking or sample checking.
8. Focus:
The primary focus of accounting is to accurately record and present all financial transactions and statements; while the primary focus of auditing is to verify the accuracy and reliability of the financial statements, and to judge whether the financial statements provide a true picture of the actual financial position of the entity.
9. Objective:
Objective of accounting is to determine the financial position, profitability and performance; while objective of auditing is to add credibility to the financial statements and reports of the company.
10. Legal Status:
Accounting is governed by Accounting Standards with some degree of discretion; but auditing is governed by Standards on Auditing and does not provide much flexibility.
11. Performed by:
Accounting is performed by accountants; while auditing is performed generally by qualified auditors.
12. Status:
Accounting is usually carried out by an internal employee of the company; but auditing is carried out by an external person or independent agency.
13. Appointment:
Accountant is appointed by the management of the company; while the auditor is appointed by the shareholders of the company, or a regulator.
14. Qualification:
Any specific qualification is not compulsory for an accountant; but some specific qualification is compulsory for an auditor.
15. Remuneration Type:
Accounting is carried out by a company employee who gets a salary; while a specific auditing fee is paid to the auditor.
16. Remuneration Fixation:
Accountant’s remuneration, i.e., salary is fixed by the management; while auditor’s fee is fixed by the shareholders.
17. Scope Determination:
The scope of accounting is determined by the management of the company; while the scope of auditing is determined by the relevant laws or regulations.
18. Necessity:
Accounting is necessary for all organizations in the day-to-day or routine operations; while auditing is not necessary in the day-to-day operations.
19. Deliverables:
Accounting prepares financial statements e.g. Income Statement or P/L, Balance Sheet, Cash Flow Statement, etc.; while auditing provides Audit Report.
20. Report Submission:
Accounts are submitted to the management of the organization; while audit report is submitted to the shareholders.
21. Guidance:
Accountants may make suggestions for the improvement of accounting and related activities to the management; whereas auditor usually does not make suggestions, except in some cases with specific requirements, e.g. improvement in internal controls.
22. Liability:
Accountant’s liability generally ends with the preparation of the accounts; while auditor has liability after preparation and submission of the audit report.
23. Shareholders’ Meetings:
Accountant does not attend the shareholders’ meeting; while an auditor may attend the shareholders’ meeting.
24. Professional Misconduct:
An Accountant is not usually prosecuted for professional misconduct; whereas an auditor can be prosecuted for professional misconduct as per the applicable legal procedure.
25. Removal:
Accountant can be removed by the management; while an auditor can be removed by the shareholders.
TYPES OF AUDITS AND LIMITATIONS
• Audits can be classified into two broadways.
• According to terms of engagement i.e. nature of work done.
• According to the approach to the work to be done/ timing.
According to nature of work done, audits may be either statutory of private.
Statutory audits
These are carried out as per the requirements of various statutes e.g. Companies Act Cap 486 requires that all public limited companies to have their financial statements subjected to an independent audit. The objective of the audit is to enable the auditor express an opinion whether the financial statements have a true and fair view of the company’s state of affairs.
The rights and duties of the auditor are laid down in the relevant statute. The powers of appointment of the auditors are vested on the shoulders.
Private audits
These are not governed by statutes. They are performed by independent auditors because the owners, members or interested parties require them carried out. Private audits are carried out for organizations such as non governmental organizations, partnerships and clubs and among others. Appointment of auditors is carried out as a private contract between the auditor and the relevant shareholder. The scope and objective of the work as well as rights and duties of the auditor are determined by the agreed terms between the auditor and the client. The auditor is not liable to third parties.
According to approach of the work to be done, audits can be continuous, interim or final.
Continuous audits
This is an approach whereby an audit is carried out throughout the financial period usually at predetermined intervals. This approach is ideal for large organizations with tight reporting deadlines e.g. multinational banks. The approach ensures accounts are kept up to date, errors and frauds are discovered in early stages and better audit reports are developed since more time is taken.
However, this approach is expensive considering amount of time taken, has frequent interruptions of client work and auditors‟ independence may be affected by their continuous presence at clients premises.
Interim audits
This is an audit carried out halfway through the financial period. It usually precedes the final audit and is a preparation for the final audit. It is ideal for dynamic businesses, cheaper compared to continuous audits and enhances keeping of up to date records.
Final audits
These are usually done at the end of the year as either a continuation of the interim audit for large and medium size companies or as a single audit for small companies at end of financial period.
Other types of audits
Procedural audits – These require examination of procedures or records for reliability and accuracy. They usually relate to company’s internal control systems, laid down guidelines and procedures and records of the company.
Management audits -These involve investigation of the company’s entire management to ascertain whether the directors are running the company in the most optimal way for the benefit of the shareholders. It improves quality and efficiency of management in addition to checking the budgetary system.
Balance sheet audits -This tests the strength of internal control system by working backwards to get the initial transactions using assertion methodology.
Internal Audit
Management upon realizing the advantages of an audit have established within the company „an independent activity to examine and evaluate the organizations risk management process and systems of control and to make recommendations for the achievement of the company’s objective‟. This activity is called internal auditing. The duties of internal audit personnel are:
• Reviewing the economic efficiency and effectiveness of the company’s operations.
• Reviewing the company’s compliance with external laws and regulations and internal policies and procedures.
• Reviewing and advising the management on development of key organizational systems and implementation of major changes.
The focus of internal auditing is adding value to an organization through improvement in risk control.
In 1999, the institute of internal auditors (IIA) defined internal auditing as „an independent objective assurance and consulting activity designed to add value and improve an organization’s operations, help it achieve its objective and improve the effectiveness of risk management, control and governance process.
Aspect Internal Auditing External Auditing
Objectives The main objective is to advice management on whether organization has sound internal control systems to protect it against loss. The objective is to provide an opinion as to whether or not the financial statements show a true and fair view
Of the company’s state affairs.
Legal basis Internal auditing is not a legal requirement but corporate governance advises and recommends that a company should have an internal audit department. It is a legal requirement for limited liability companies and public bodies to have their accounts audited.
Scope It covers all areas of organization i.e. operational as well as financial. It has a purely financial focus.
Approach It is increasingly risk based. The approach is to assess risks, evaluate systems of control and test operation of the systems and finally make recommendations for improvement. Its increasingly risk based as it only tests underlying transactions that form having of financial statements.
Responsibility The responsibility is to advise and make recommendations on
internal controls and corporate governance The Responsibility is to form an opinion on whether financial statements show a true and fair view.
Scope & Objectives of Internal audit function
This depends on the size and structure of the entity and the responsibility assigned to it by management. Ordinarily these would include:
• Review of accounting internal control systems. The management is responsible for establishing internal control system. The system requires proper attention and continuous review, a function usually assigned to internal audit. Internal Audit function designs a plan on areas and control procedures that will be reviewed during the financial year.
• Carrying out examination of financial and operational information. This may include detailed testing of transactions and operation procedures.
• Review of the economic efficiency and effectiveness of operations including non financial controls of the entity.
• Review of company’s compliance with external laws and regulation. The internal audit functions checks whether procedure are in place to ensure that all relevant laws and regulations are adhered to.
• Review of entity’s compliance with management policies and other internal requirements.
• Carrying out independent investigations into company affairs as required by management e.g. investigation areas of suspected fraud or misuse of company’s resources.
Similarities between internal audit and external audit
• Both auditors are concerned about the strength and proper functioning of the internal control system. The internal auditor is concerned it is his or her responsibility while the external auditor is concerned as he or she relies on the strength of internal control system to carry out systems based audits.
• Both auditors have as part of their duties to ensure that the company adheres to all relevant laws and regulations.
• Both auditors interested in ensuring that the company keeps proper books of records. The internal auditor uses the company accounts to appraise the functioning of the internal control system while external auditor uses them to collect audit evidence to corroborate his audit opinion.
• Both auditors are concerned about prevention and detection of errors and frauds. The internal auditor ensures errors or frauds are prevented and detected by having strong internal control system while the external auditor has the incidental duty of detecting and preventing material errors and frauds which would otherwise distort the true and fair view of the financial statements.
• Both auditors have interest in safeguarding company assets. The internal auditor through strong internal control system ensures safety of company’s assets while external auditor must ensure that company assets are safeguarded against theft and misuse so that the true of fair view of financial statements is maintained.
External auditor’s reliance on work of internal auditor
Before deciding on whether to rely on work of internal audit function with the intention of reducing audit procedures, the external auditor should evaluate the internal audit function to determine the scope of the function its independence and the extent to which its work can be relied on. In evaluating internal audit function, the external auditor considers the following factors:
• Organization status. Since internal audit function is part of the entity, it cannot be totally independent. To aid in its independence, the internal audit function should report to the highest level of management. The internal auditor should also be free from duties such as accounting functions which may bring about conflict of interest. The internal auditor should not have any restrictions upon him or her from management which could impair effectiveness of doing his or her work.
• Scope of the function. The external auditor should ascertain the nature and depth of coverage of internal audit assignments. Also, to be considered are the management actions on the recommendations of internal auditor. In case the management does not follow up on the recommendations, the external auditor must reduce his reliance on work of internal audit function as this means it is weak.
• Technical competence. The external auditor should assess the competence experience, qualifications, technical training and proficiency of the staff members in the internal audit function.
• Due professional care. The external auditor should ascertain whether due professional care has been observed in doing the work of the internal audit function e.g. whether there were work plans, supervision and documentation of audit evidence in executing internal audit functions.
• Availability of resources. The external auditor should consider whether the internal audit function has adequate resources to enable it carry out its functions as expected e.g. adequate staff and time.
Advantages of Internal Audit function
• It reinforces application of internal controls thus enables the company to operate in an orderly and efficient way.
• It prevents and detects errors and frauds through periodic comparison of budgets, routine and surprise checks.
• Assists management in implementation of company policies through reporting on adherence or non adherence to laid down policies of the company.
• Assists external auditor in highlighting areas of weaknesses in internal control system. This reduces audit time for the external auditor and thus there is a saving on audit fees.
• Assists the company in achieving its objective by ensuring that all laid down rules, procedures and policies are followed e.g. adherence to budgets and forecasts assists in decision making.
• The internal audit function guards company’s resources against theft and misuse through proper functioning of the internal control system and periodic verification of assets.
Limitations of an Internal Audit
• The cost of installing and maintaining an internal audit function is high and in particular for large companies as they may require highly qualified staff while for small companies the department may not be justifiable.
• If management ignores the recommendations of internal audit function, members of internal audit function may be frustrated as errors and frauds may continue being undetected.
• Management may deny the internal audit function its due independence by assigning it accounting duties or even management responsibilities.
• If company operations are few or has complex technical aspects may limit the proper functioning of the internal audit function.
• The internal audit department may fail e.g. if it points out problems without giving solutions or ignoring some departments within the company.
• The internal audit may lack the necessary support from top level management if top management views the function as not important.
Factors necessitating growth in Internal Audit
• Increase in business size. As business grow, it becomes more and more necessary to have a function that checks all the increasing levels of internal control and operation.
• Dynamic technology– the frequent changes in technology has made some companies to have their controls updated on a continuous basis. This calls for constant feedback on controls requiring updating through use of expert advice for internal audit function.
• Legislation and regulatory requirements. As the concept of corporate governance becomes necessary in business management, the need of internal audit has increased. Companies are now required by regulations to have audit committees to oversee operation of controls within the company and to which the internal audit function reports.
• Competition. High competition in business calls for efficient operations by companies so as to survive. This can be achieved through strong controls and cost effectiveness which is enhanced by internal audit.
Risk and Materiality (ISA 320 Materiality)
ISA 320 discusses the concepts of risk and materiality. An audit risk is the risk that an auditor may give an inappropriate opinion i.e. an opinion that contradicts the true nature of the financial situation of the company. Materiality plays a role in each of the following two stages.
a. Planning stage. (in planning what audit work should be done)
b. Reporting stage (in deciding what opinion to give.)
The international auditing and assurance standards board (IAASB) in its framework for preparation and presentation of financial statement defines materiality as follows; „information is material if its omission or misstatement could influence the decision of users taken on basis of the financial statements.‟ Therefore materiality provides a threshold or cut off point rather than being a primary qualitative characteristic which information must have if it is to be useful.
ISA 320 further states a number of audit principles as follows:
• The auditor should consider materiality and its relationship to audit risk when conducting an audit. If the auditor assesses the risk associated with an account balance or internal control system to be high, it will be reflected in a lower level of materially thus additional testing will be required.
• The objective of an audit is to enable the auditor express an opinion whether financial statements are prepared in all material respects and in accordance with the identified financial reporting framework. The auditor needs to establish an appropriate materiality level so that quantitatively, material misstatements which are likely to destroy the true and fair view of financial statements are identified.
• Materiality at planning stage is usually set at lower level than necessary in order to reduce risk of undiscovered misstatements and to deal with the problem of having to adjust materially at later date in light of evidence obtained.
• Materiality should be considered by the auditor when;
Determining nature, timing and extent of audit procedures
Evaluating effect of misstatements
The auditor should plan sufficient audit procedures so that he or she has reasonable expectation of detecting material misstatements in financial statements. Any immaterial item will not affect the truth and fair view of the financial statement and thus can be ignored.
Materiality and judgment
Auditors consider the following before appropriately testing whether an item is material or not.
1. Qualitative aspects: these may include inadequate or inaccurate descriptions of an accounting policy.
2. Cumulative effect of small amounts: small errors at a month end procedure could individually be immaterial but continuous errors of this kind throughout the financial year could be material.
3. Relatively of materiality. A figure of Kshs. 100,000 may be absolutely immaterial for a large company but absolutely material for a small company. An amount must be considered in relation to:
Items on the overall financial statements level.
Items at individual account balance or transaction level
Legal and other disclosure requirements which may require disclosure regardless of the monetary value e.g. director’s fees.
The corresponding amount in the previous year
4. The degree of latitude allowable in deciding on the amount attributable to a particular item. While some items such as director’s fees are capable of an exact definition, others such as depreciation and allowance for doubtful debts are at best an intelligent estimate. In some countries e.g. US, the security exchange commission estimate materiality as follows;
• Errors greater than 10% are material
• Errors between 5% and 10% may be material
• Errors below 5% are not material
5. In evaluating the true and fair presentation of financial statement, the auditor should assess whether the aggregate of uncorrected misstatements that have been identified in the audit is material. The auditor should reconsider all uncorrected misstatements and check whether this total is material.
True and fair view
The true and fair view is a concept of the Companies Act. However, the Companies Act does not define or even describe what is true and fair view. The companies Act requires that all limited liability companies to appoint an auditor whose task is to express an independent opinion as to whether financial statement show true and fair view of the financial performance and position of the company. True and fair view implies that the financial statements are not prejudicial to any user of the financial statements. Financial statements will present a true and fair view if:
• They contain in all material respects with the disclosure requirement of the Company Act and other relevant regulations.
• They contain material matter and not full of needless details.
• They are complete in every respect within the constraints of materiality and the inevitable estimation of some items.
• The values attributed to the items in the financial statements are reasonable amounts within a range in which if a major decision was taken on their basis the user would not make a material error.
• The information contained therein is presented and disclosed without bias and all relevant information for evaluation and decision making is available.
Assertion Methodology
In preparing financial statements which show true and fair view of the company’s financial position and performance, the management explicitly or implicitly makes certain assertions. These assertions are categorized as:
i. Existence
ii. Completeness
iii. Occurrence
iv. Rights & obligation
v. Measurement
vi. Valuation, presentation and disclosure.
vii. Classification
viii. Cut-off
ix. Accuracy
x. Allocation
Existence
This is the assertion that an asset or liability exists at a given date. It is either true or not true that an asset or liability reflected in the balance sheet was in existence at the balance sheet date.
Rights and obligation
This is the assertion that an asset or liability in financial statements pertains to the entity at a given date i.e. an asset is a right of the entity and a liability a genuine obligation of the entity.
Occurrence
This is the assertion that a transaction or event took place which pertains to the entity during the financial period or that a recorded event or transaction actually took place as recorded and it is a valid transaction pertaining the entity. It is either the transaction took place as recorded or not.
Completeness
This is the assertion that there are no unrecorded assets, liabilities, transactions or undisclosed items. It would suggest 100% completion and accuracy however, this is impossible under accrual basis of accounting. The users of the financial statements do not expect 100% completeness in financial statements but completeness within a certain range such that they can still make justifiable decisions. This assertion is therefore assessed for reasonableness as some transactions may be excluded if they are not material.
Valuation
This is the assertion that an asset or liability is recorded at an appropriate carrying value. It is the most crucial assertion of all the assertions. In arriving at appropriate carrying value of an asset or liability, the management considers.
1. Overall valuation basis. The management must consider the entity as a whole and make an assessment whether it is appropriate to apply the going concern assumption in preparing the financial statements. The basis of preparing financial statement when entity is going concern is radically different from preparing financial statement on basis that the entity is not a going concern.
2. Suitable accounting policies. In determining carrying amount of an asset or liability appropriate accounting policies must be followed. The accounting policies must be in line with the generally accepted accounting principles (GAAPs), appropriate to the circumstances of the entity, applied consistently, be in conformity with entity’s industry practices and be adequately disclosed.
3. Desirable qualitative characteristics. The suitable accounting policy adopted must be applied after taking into consideration the qualitative characteristics of materiality, prudence and substance over form. Since it may subjective whether an entity is a going concern or not, the accounting policy adopted can be subsequently subjective thus the assertion of valuation can only be assessed for reasonableness.
Measurement
This is the assertion that a transaction or an event is recorded and proper amounts of revenue and expense are allocated to the proper period for proper reporting purposes. Whether a transaction brings into being an asset or liability, revenue or expense depends largely on the capitalization policy of an entity i.e. the guidance as to what items are revenue items and capital items.
The period in which a transaction took place may be influenced by management’s desire to reflect a given financial position. However, where revenue or expense of an item is spread over more than one accounting period is called allocation rather than measurement and is a component of valuation.
Presentation and disclosure
This is the assertion that an item is disclosed, classified and described in accordance with the applicable financial reporting framework. The information in financial statements should be presented without bias, be relevant to the needs of the users and meet qualitative characteristics of understandability, relevance, reliability and comparability. This assertion is not assessed for truth but rather adequacy or reasonableness.
In conclusion, truth and fairness of financial statements can be assessed on these seven assertions i.e. the financial statements will reflect a true and fair view of company’s financial position and performance if the seven assertions are used as guidelines in preparing the financial statements.
Classification
Are transactions recorded in appropriate accounts?
Cut-off
Are transactions recorded in appropriate period?
Accuracy
Are the amounts disclosed in the financial statements appropriate?
Allocation
Are account balances included in appropriate accounts?
THE USERS OF AUDITED FINANCIAL STATEMENTS AND AUDITOR REPORTS
The annual accounts and report are primarily prepared by the directors to the shareholders. However, the following parties need financial statements.
1. Those parties with vested interests in a business.
– Employees.
– Creditors or suppliers
– Lenders and debenture holders
– The management
– The shareholders to whom the financial statements are addressed.
– Credit rating agencies.
2. Those with potential interests
– Potential shareholders
– Trustees
– Suppliers Customers
3. Those with representative interests
– Lawyers
– The government
– The general public.
4. Others
– Competitors
– Stock brokers
– Statisticians
– Financial journalists
– Trade unions.
• Present and potential investors. These risk capital providers and their advisors are concerned with the risk that is inherent in their investment. They need information to help them determine whether they should buy more shares, hold on to the shares they have or sell the shares they have.
• Employees. These and their representative groups such as trade unions are interested in information about the stability and profitability of their employers. They are also interested in information which enable them assess the ability of the company to provide adequate remuneration, retirement benefits and employment opportunities.
• Lenders. These are interested in information that enables them determine whether their loans and interests arising from the loans will be paid back when due.
• Suppliers and other trade creditors. These users are interested in information that enables them determine whether the amounts owing to them will be paid when due. Their interest in the company is of shorter period than lenders while they are dependent upon the continuation of the company as a major customer.
• Customers. These have interest in information about the continuance of the company especially when they have long term involvement and or are dependent as the company.
• Government. The main interest of the government is allocation of resources. It also requires information in order to regulate the activities of the enterprise, determine taxation policies and obtain national income statistics.
• Public. A company affects public in a variety of ways. A company may make substantial contribution to the local economy by employing people and obtaining supplies locally.
• Financial statements assist the public in information on trends and recent developments of the company in the economy.
Advantage of Audit of Financial Statement
1. Protect the interest of fund providers: It safeguards the financial interests of persons who are not associated with the management of the organisation e.g. partners or shareholders.
2. Moral check on employees: It acts as a moral check on employees from committing defalcations or embezzlement.
3. Settlement of Taxes, etc: Auditing statements of accounts are helpful in settling of taxes, negotiating loans and for determining the purchase consideration for a business.
4. Settlement of Trade Disputes: Audited statements are useful for settling trade disputes for higher wages or bonus.
5. Detection of Wastages: Audited statements also help in detection of wastages and losses and shows the different ways by which these might be checked especially those that occurred due to absence or inadequacy of internal checks or internal control measures.
6. Proper maintenance of books of account: Independent audit ascertains whether the necessary books of account and allied records have been properly kept and helps the client in making good deficiencies or inadequacies in this respect.
7. Appraisal of controls: As an appraisal function, audit reviews the existence and operations of various controls in the organisations and reports weaknesses, inadequacies etc.
8. Admission/retirement of Partner: Audited accounts are of great help in the settlement of accounts at the time of admission or death of the partner.
9. Grant of License: Government may require audited and certified statements before it gives assistance or issues the license for a particular trade.
Inherent limitations of an audit
As per SA 200 “Overall Objectives of the Independent Auditor and the Conduct of an Audit in
accordance with Standards on Auditing” the auditor is not expected to, and cannot, reduce audit risk to zero and cannot therefore obtain absolute assurance that the financial statements are free from material misstatement due to fraud or error. This is because there are inherent limitations of an audit, which result in most of the audit evidence on which the auditor draws conclusions and bases the auditor’s opinion being persuasive rather than conclusive. The inherent limitations of an audit arise from:
1. The Nature of Financial Reporting
The preparation of financial statements involves judgment by management in applying the requirements of the entity’s applicable FRF to the facts and circumstances of the entity. Consequently, some financial statement items are subject to an inherent level of variability which cannot be eliminated by the application of additional auditing procedures.
2. Nature of Audit Procedures
There are practical and legal limitations on the auditor’s ability to obtain audit evidence. For example:
– Management & others do not provide complete information intentionally/unintentionally.
– Audit procedures used to gather audit evidence may be ineffective against fraud detection.
– Audit is not an official investigation into alleged wrongdoings.
3. Timeliness of Financial Reporting & the Balance between Benefit & Cost
– User expectation that the auditor will form an opinion on the F. S. within a reasonable period of time and at a reasonable cost.
– It results into use of Test checking and putting most of efforts over the areas having risk of material misstatement with corresponding less efforts in other areas.
4. Other Matters that Affect the Limitations of an Audit
In the case of certain assertions or subject matters, the potential effects of the limitations on the auditor’s ability to detect material misstatements are particularly significant. Such assertions or subject matters include:
(a) Fraud, particularly fraud involving senior management or collusion.
(b) The existence and completeness of related party relationships and transactions.
(c) The occurrence of non-compliance with laws and regulations.
(d) Future events or conditions that may cause an entity to cease to continue as a going concern.
I need the notes for audit and assurance
I NEED AUDITING AND ASSURANCES NOTES FOR THE NEW SYLLIBUS PLEASE
I need auditing and assurance notes for the new syllabus