1.

Audit framework and regulation

Matters to be communicated with those charged with governance:
- Planned scope and timing of audit
- Significant findings
o Changes in accounting policies
o Effect on FS of any material risks and exposures
 Ex – pending litigation
o Audit adjustments
o Material uncertainties that may affect company’s going concern
o Disagreements with management
o Expected modifications to auditor’s report
o Material weakness in internal controls
 Recommendations

5 Fundamental principles of ethical behaviour:

1. Integrity
2. Objectivity
a. No conflicts of interest, uncompromised, no influence from others
3. Professional competence and due care
a. Attain and maintain professional knowledge and skill so that the client
receives competent professional service based on current technical and
professional standards and relevant legislation
b. Act according to the aforementioned technical and professional standards
4. Confidentiality
a. Respect the confidentiality of information gained as a result of professional
and business relationships
b. Do not disclose client information
c. There are circumstances where the auditor does not need permission and is
responsible to disclose client information to a relevant authority
i. Obligatory responsibility – suspicion of fraud, money laundering, drug
trafficking
ii. Voluntary disclosure – auditor feels information is in the public
interest eg. management is involved in fraud or to defend themselves
against a claim of negligence or if suing for unpaid fees.
5. Professional behaviour
a. Comply with relevant laws and regulations
b. Avoid any conduct that may discredit the profession

Threats to independence – 5
1. Self-interest
a. Financial or other interest resulting in loss of objectivity
b. Aligning interests with the client
c. Examples
i. Undue dependence on fees generated by client – if client fees > 15%
of total fees received by audit firm for 2 consecutive years:
 I. Disclose this to those charged with governance
II. Obtain an external quality control review before or after
issuing audit opinion on the 2nd year’s financial statements
III. Seek other clients to ↧dependence
IV. Consider resigning from auditing such client
ii. Owning shares, loan to/from client, overdue fees, contingent fees,
business relationships (joint ventures)

2. Self-review
a. Re-evaluate work the firm has previously performed
b. Might not assess work objectively – tempted to ignore any mistakes
c. Examples:
i. Preparation of FS and auditing the same company – not allowed for
listed audit clients
I. Auditors might not audit the FS properly as they are bound to
be right
ii. Calculation of tax figure
iii. Being both internal and external auditors

3. Advocacy
a. Auditor represents their client, promoting a position or opinion
b. ↧objectivity
i. Examples
I. Acting as an advocate on behalf client in litigation or dispute
II. Promoting stock exchange listing
III. Attending bank meeting to explain the audited FS

4. Familiarity
a. Auditors become too sympathetic to the interests of their client
b. ↧objectivity and failing to scrutinise decisions or opinions of client’s staff
c. ↧professional scepticism
d. Examples
i. Having a family/personal relationship with director of client
ii. Acceptance of gifts/hospitality unless modest in value
iii. Long association with client
I. For listed companies, audit partners should be rotated at least
every 7 years

5. Intimidation
a. Auditors are deterred from acting objectively because of being threatened
b. Examples:
i. Threats of dismissal
ii. Threat of litigation
iii. Unreasonable time restraints
c. Strongly associated with the self-interest threat
i. A threat might only be significant to a firm if they have significant self-
interest in client – matter of professional judgement
 I. A threat of loss of a client representing 12% of total firm
income would be considered more significant than a threat of
losing s client representing 0.5% off income

Safeguards to the threats

- Use different staff - familiarity and self-review threats
- Rotate engagement partners and senior staff – familiarity threat
- Use a second partner to review a completed audit file before it is signed off –
familiarity and intimidation
- Decline offers to carry out additional services – self-review and self-interest

Differences between internal and external audit

External audit Internal audit

Express an opinion on the Improve a company’s operations, by reviewing the
Objective truth and fairness of the FS efficiency and effectiveness of the company’s internal
controls
Report to the shareholders Normally report to management or those charged with
or members of the company. governance. Internal audit reports are not publicly
Reporting External audit reports are available and are only intended to be seen by the
contained within the FS and addressee of the report. The reports are normally
hence are publicly available. provided to the BOD and those charged with
governance such as the audit committee.
Limited to verifying the truth Have a wide scope and it is determined by the
and fairness of the FS of the requirements of management or those charged with
Scope of work company governance. Commonly internal audit focus on the
company’s internal control environment, but any other
are of a company’s operations can be reviewed.
External auditors are Internal auditors are appointed by management. As
Relationship appointed by the company’s internal auditors are normally employees of the
with company shareholders. They are company they lack independence. However, the internal
independent from the audit department can be outsourced and this can
company. increase independence.
2. Planning and risk assessment

External audit process:

Obtaining and accepting client

Planning and risk assessment

Will determine how effective controls

Testing of internal controls are – will impact the level of substantive
testing performed after YE
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ Year end _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ __ _

Audit evidence Substantive testing of FS

Review Subsequent events, going concern and

written representations

Reporting

Preconditions of an audit
1) Financial reporting framework to be applied in preparation of FS is acceptable
a. Ask management what the framework is
b. Review past FS
c. Consider any relevant law and regulation
2) Obtaining an agreement with the management acknowledging (written
representation prepared by the auditors):
a. Understanding that company should prepare FS
b. Internal controls are sufficient to ensure FS free from material misstatements
c. Access to auditor to all information and personnel

If the preconditions of the audit are not present, auditors will:

- Discuss matter with management or
- Can reject the audit engagement

Engagement letter
- Written agreement between the auditor and the client to minimise the possibility of
misunderstandings between both parties
- Should be sent before audit starts
 - Must be updated regularly for changes in laws and regulations, standards or changes
in the client or if there is evidence that the client does not understand the nature of
the audit relationship
- Clauses:
o Objective and scope of the audit
o Management’s responsibility – prepare FS and strong internal controls
o Auditor’s responsibilities
o Access to all records and documentation
o Arrangements for planning the audit
o Agreement of management to provide a letter of representation
o Description of any other letters or reports the auditor expects to issue to the
client
o Basis on how the fees are computed and any billing arrangements

Quality control procedures

- Audit partner should ensure that audit work is planned, directed, supervised and
reviewed in a manner that provides reasonable assurance that the work being done
is performed in a competent manner
- Direction
o Engagement partner leads his team
o Engagement planning meeting
 Responsibilities as auditors
 Objectives
 Nature of the client’s business and any significant issues
 How to deal with any problems that may arise
 Detailed approach to the performance of the audit
o Planning meeting is led by the partner and should include the whole team
- Supervision
o Continuous during the engagement
o Main focus: audit team is working according to the audit plan
o Significant matters should be brought to the attention of senior staff – rectify
problems immediately
- Review
o All audit work should be reviewed by a more senior audit staff member
o Reviewer should consider:
 Work was carried out according to audit standards and firm’s
procedures
 Work is sufficiently documented
 Significant audit matters have been raised for further consideration
 Objectives of audit procedures have been achieved
 Conclusions are consistent with all work performed
o Engagement partner should
 Carry out an overall review of the WPs
 Examine all key areas of judgement and all audit evidence relating to
high risk areas
  Ensure WPs contain sufficient appropriate evidence to support
auditors conclusion for the audit report to be issued
o Must be finished before the audit report is signed (aka hot review)
o Listed entities -> require an engagement quality control review for all FS
audits
o The audit firm should have an ongoing consideration and evaluation of the
firm’s system of quality control, including a periodic inspection of a selection
of completed engagements (aka cold reviews)
 Performed by senior partner to identify areas to improve
- Consultation
o Any controversial or difficult matters are discussed with either a professional
outside the engagement team or with someone outside the audit firm
o Consultations must be documented to show what issues are being discussed
and the result of such consultation.

Audit planning
- To establish the overall audit strategy, develop an audit plan and reduce audit risk to
an acceptably low level
- Audit work will be performed in an effective, efficient and timely manner
- Modern day auditing -> Risk-based approach
o Tailor audit work around particular circumstances surrounding the client
o Helps auditors to
 Identify main risk areas in the planning stage
 Base audit plan around such risks (tests of control VS substantive
tests)
 Carry out an efficient audit – minimising audit risk and detection risk
 Reduce the chance of a negligence claim against the auditor
- Advantages of planning an audit
o Focus on important areas
o Identify and resolve potential problems on a timely basis
o Selection of engagement team members – appropriate level of skills,
competence and assignment of work
o Directing and supervising engagement team and reviewing their work
o Assisting, where applicable, in the coordination of work done by the other
auditors and experts
o Develop an audit strategy – nature, timing and extent of the audit work
 Size of client
 Auditor’s familiarity/history with the client
 Complexity of audit
 Any specific reporting requirements – tight deadlines
- End of planning process
o Audit plan (aka audit planning memorandum) – detailed schedule of work to
be undertaken
o Audit strategy document

Audit strategy
- Characteristics of the engagement that define its scope
 o Norm: pure statutory audits in line with company law and accounting
standards
o Some firms might have characteristics that extend the scope of the audit
 Ex. – highly regulated industry -> consideration of laws and regulation
o Reporting objectives to plan the timing and the nature of communications
 Ex. Listed company audit
 Completed by the filing deadlines required by listing
companies – 6 months after YE
 More communications required –audit report should include
key audit matters
o Significant factors – professional judgements such as materiality and
professional scepticism
o Relevant past knowledge of client and results of prior audits
 Or info passed from the predecessor auditors in a new client
o The nature, timing and extent of resources necessary to perform audit
 Who is in the audit team
 How long audit is expected to last
 Inventory count visits – particular branches to be visited

Understanding the entity and its environment

- Initial understanding
o Latest set of FS – perform analytical review
o Meeting with management and internal audit team – key factors relevant to
audit
o Due diligence on client – internet for articles and reports
o Request permission to meet with current auditors and or to review their
audit files
- What to consider when obtaining an understanding
o Industry, regulatory and other external factors – market competition,
financial reporting framework, general economic conditions
o Nature of entity – revenue streams, locations, key customers and suppliers
o Selection and application of accounting policies – ex. new/changes
accounting standards
o Objectives, strategies, related business risks – ex. new products, expansion
o Measurement and review of company’s financial performance – KPIs
o Internal controls
- Risk assessment
o Vital to completely understand client -> effective audit
o Any risks identified early can be addressed in a timely manner
o Risk analysis
 Reduce risk of an inappropriate audit opinion
o Assess if client is a going concern or not

Audit risk
- The risk that he auditor will give out an incorrect opinion on the FS being audited
 o Failing to modify an audit opinion when the FS contain a material
misstatement
- Made up of 2 components
o Risk of material misstatement existing in the FS x risk that auditor does not
discover those errors
 AKA inherent risk, control risk and detection risk

Audit risk = inherent risk x control risk x detection risk

- Inherent risk x control risk

o Risk that material misstatements exist in the FS
o Outside the control of auditor
- Detection risk
o Risk that auditors fail to detect existing errors
o Controllable by auditor – adjusting amount and type of work carried out

Inherent risk (nature of business)

- The risk that an assertion about a class of transactions, account balance or disclosure
is susceptible to a material misstatement, either individually or when aggregated
with other misstatements, before the consideration of related controls. It arises due
to the nature of the business or the external pressures placed on the business.
o Risk that the numbers in the FS are materially misstated
- Higher inherent risk is present when
o Company is a cash-based business – higher risk of theft
o Company has complex accounting transactions – higher risk of error

Control risk (failure of internal controls)

- The risk that a material misstatement that could occur in an assertion about a class
of transaction, account balance or disclosure will not be prevented, or detected and
corrected on a timely basis by the entity’s internal control system.
- Examples of high control risk
o New IT system installed (more mistakes are made)
o High staff turnover (more mistakes are made)
o Directors do not think controls are important – controls are not enforced
- Preliminary assessment of controls -> judge level of control risk exists

Detection risk (failure of detecting)

- The risk that the auditor’s procures fail to detect a material misstatement
- Only risk that can be directly controlled
- Made up of:
o Sampling risk
 Samples chosen are unrepresentative of the populations from which
they are drawn
 Reduced by selecting a larger sample
o Non-sampling risk
 Any factor that causes the auditor to reach an incorrect conclusion
that is not related to the sample size
  Ex. using inappropriate audit tests, misinterpretation of evidence
 Reduced by using a more experienced audit team
At the planning stage, auditor has to assess inherent and control risk to determine level of
detection risk and thus the level of audit work to be carried out.

Materiality, fraud, laws and regulations

- Materiality – an item is considered material when if its omission or misstatement
could influence the economic decisions of users
Chapter 4:

Assertions to focus on when testing balances (substantive

procedures)

Trade receivables
- Existence and valuation
o Recoverability of debt
 See if receivable amount exists – customer disputes the debt is valid
 Will they pay all of it? Write off?
o Receivables circularisation
- Cut-off
o Dr receivable, Cr Revenue
 Would want to squeeze in more sales into this year’s FS even if sale
took place in the following year
o Goods despatched notes prior to YE and matching this with invoice

Receivables circularisation
- Writing to a sample of customers to confirm whether they agree that the debt is
correctly stated
- Assertions
o Existence – acknowledgment of debt by 3rd party
o Rights and obligations – receivable confirms amount is owed by the company
o Valuation – will dispute any amounts that do not relate that account or that
they have requested credit for
o Cut-off – identify reconciling items such as sales invoices/cash in transit.
These should be verified to initial documents to ensure that items are
recorded in the appropriate period
 Debt is not reduced on the company’s books until the company
receives the cash payments
- Procedure
o Client provides listing of the YE trade receivables
o Cast the listing and reconcile total to the nominal ledger
o Anything unusual? Ex. negative balance – payables and receivables have been
wrongly netted off (classification)
o Select sample of customers to circularise – focus on material and overdue
amounts
o Circularisation letter should be on client’s paper with a copy of the current
statement attached. It should request that reply should be sent directly to
the auditor.
 No reply
 Auditor should phone customer
 Alternative procedures
 o Check if invoices on the listing have been paid after YE
o Check invoices back to customer order (less persuasive)
o Delivery note signed by client

Audit procedure Reason

Obtain list of receivables balances – - List is accurate
check that it casts - Total represents the individual
balances
Total of receivables list agrees to - Receivables recorded accurately
nominal ledger and FS
Perform analytical procedures by - Indicates accuracy and
comparing trade receivables listing completeness of the list
with prior periods. - Increased trade receivables days
could indicate debt is overstated
Calculate trade receivables days and (existence of bad debts)
compare to prior year

Significant variations should be

investigated and substantiated –
importance given to old outstanding
amounts
Review aged receivables listing for any - Receivables are not overstated –
old unpaid amounts. Discuss reasons valuation test
why amounts are unpaid and include
suitable provision if necessary
Circularisation to a sample of - Existence, valuation, cut-off and
receivables to confirm outstanding rights and obligations
balances
If they do not reply – check receipts - Receivables are not overstated –
after YE from cashbook or bank valuation test
statements

Prepayments
- Obtain schedule of prepayments – reconcile to FS
- Depending on materiality level – perform simple analytical procedures
o Ex. confirming the components of the prepayments balance compared to last
year
- Further testing: obtain client’s backup schedule for the calculation of the
prepayment
o Vouch to the cash book and invoice documentation
- Mathematical accuracy of prepayment

Inventory
- 2 distinct aspects of the final YE balance
o Valuation
 o Quantity
- Valuation
o Lower of cost and NRV
 Cost = purchase cost + conversion costs + other costs bringing the
inventories to their present location and conditions
o To audit valuation
 Sample of inventory items on the final inventory sheets, cost should
be traced to the original purchase invoices
o Manufacturing company – components of cost are
 Materials
 Purchase invoices and quantities can be verified by inspections
 Labour
 Labour rates agree to payroll records and hours worked from
timesheets
 OH
 Only production OH have been included
o