ISA 530 states that when designing audit procedures, the auditor should determine appropriate means for selecting items for testing so as to gather sufficient appropriate audit evidence to meet the objectives of the audit procedures. Auditors do not examine all information that is available to them as it is impractical to do so and as a result audit sampling is used to produce valid conclusions.
Audit sampling involves the application of audit procedures to less than 100% of items within a class of transactions or account balance such that all sampling units have a chance of selection. Audit sampling can use either a statistical or a non-statistical approach. Types of risk
- Sampling risk arises from the possibility that the auditor’s conclusion, based on a sample may be different from the conclusion reached if the entire population were subjected to the same audit procedure. There are two types of sampling risk:
- The risk the auditor will conclude that controls are more effective than they actually are, or that a material error does not exist when in fact it does. This type of risk affects audit effectiveness and is more likely to lead to an inappropriate audit opinion; and
- The risk the auditor will conclude that controls are less effective than they actually are, or that a material error exists when in fact it does not. This type of risk affects audit efficiency as it leads to additional work to establish that initial conclusions were incorrect.
- Non-sampling risk arises from factors that cause the auditor to reach an erroneous conclusion for any reason not related to the size of the sample. For example, the auditor might use inappropriate audit procedures, or the auditor might misinterpret audit evidence and fail to recognise an error.
Types of selection
Selecting All Items (100% examination)
The auditor may decide that it will be most appropriate to examine the entire population. 100% examination is unlikely in the case of tests of controls. It is more common for tests of details where for example, there are a small number of large value items, when there is a significant risk, or when the repetitive nature of a calculation or other process performed automatically by an information system makes it cost effective through the use of computerassisted audit techniques (CAATs). This process does not involve sampling.
Selecting Specific Items
The auditor may decide to select specific items from a population based on such factors as the auditor’s understanding of the entity, the assessed risk of material misstatement, and the characteristics of the population being tested. The judgmental selection of specific items is subject to non-sampling risk. Specific items selected may include high value or key items, all items over a certain amount, items to obtain information or items to test procedures.
While selective examination will often be an efficient means of gathering audit evidence, it does not constitute audit or statistical sampling. The results cannot be projected to the entire population. The auditor considers the need to obtain sufficient appropriate evidence regarding the rest of the population when that remainder is material.
The auditor may decide to apply audit sampling to a class of transactions or account balance. Audit sampling can be applied using either non-statistical or statistical sampling methods.
In determining the sample size, the auditor should consider whether sampling risk is reduced to an acceptably low level that the auditor is willing to accept. The lower the risk the auditor is willing to accept, the greater the sample size will need to be. The sample size can be determined by the application of a statistically-based formula or through the exercise of professional judgment objectively applied to the circumstances.
Statistical sampling means any approach to sampling that has the characteristics of random selection and the use of probability theory to evaluate sample results. Sampling that does not have these characteristics is considered to be non-statistical sampling.
Selecting Items for Testing to Gather Audit Evidence
The decision whether to use a statistical or non-statistical sampling approach is a matter for the auditor’s judgment regarding the most efficient manner to obtain sufficient appropriate audit evidence and having regard to the risk of material misstatement related to the assertion. For example, in the case of tests of controls the auditor’s analysis of the nature and cause of errors will often be more important than the statistical analysis of the count of errors. In such a situation, non-statistical sampling may be most appropriate.
Selecting the audit sample
The auditor should select items for the sample with the expectation that all sampling units in the population have a chance of selection.
Statistical sampling requires that sample items are selected at random so that each sampling unit has a known chance of being selected.
With non-statistical sampling, an auditor uses professional judgment to select the items for a sample. Because the purpose of sampling is to draw conclusions about the entire population, the auditor should endeavour to select a representative sample by choosing sample items which have characteristics typical of the population, and the sample needs to be selected so that bias is avoided.
The auditor needs to consider the nature of the evidence, possible error conditions and the rate of error he expects to be present in the population.
Methods of selection include random, systematic, haphazard and sequence or block selection.
Tolerable error is the maximum error that the auditor would be willing to accept. Larger sample sizes will be required when errors are expected, in order to conclude that the actual error is less than the tolerable error.
Evaluation of sample results
The auditor will need to analyse the errors to establish whether:
- They are true errors or just miss-postings between accounts,
- Alternative procedures need to be applied,
- There are any qualitative aspects of the errors including cause and nature.
The auditor will then project the errors to derive the probable estimate of errors in the population. He then needs to reassess the sampling risk if the error exceeds the tolerable error. If risk is still present he needs to extend the auditing procedures or perform alternative testing. If the actual error still exceeds the tolerable error at this stage, then there is a need to re-assess control risk or in the case of substantive testing, consider an adjustment to the accounts.
ISA 520 states the auditor should apply analytical procedures:
- As risk assessment procedures to obtain an understanding of the entity and its environment.
- At or near the end of the audit when forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditors understanding of the entity.
In addition, the procedures can also be used as substantive procedures to obtain evidence directly.
When analytical procedures identify significant fluctuations or relationships:
- that are inconsistent with other relevant information or
- that deviate from predicted amounts,
The auditor should investigate and obtain adequate explanations and appropriate audit evidence by way of enquiries with management and then corroboration of management’s responses by comparing them with the auditor’s own knowledge of the entity’s business and with any other evidence obtained during the course of the audit. If the procedures are carried out as substantive procedures, the auditor should undertake additional audit procedures where appropriate to confirm the explanations received.
Analytical procedures are important at all stages of the audit, such as planning, substantive procedures and the overall review.
It consists of comparing items like current financial information with prior year financial and non-financial information and analysing predictable relationships such as the relationship between debtors and sales, or payroll costs and number of employees and considering anticipated results and predictions.
Sources of information include interim financial information, budgets, management accounts, non-financial information, bank and cash records, VAT returns, board minutes and discussion with the client at the year-end.
When deciding to use analytical procedures, the auditor must consider:
- The plausibility and predictability of the relationships, such as the strong relationship between turnover and sales commission.
- The objectives of the procedures and the extent to which their results are reliable.
- The detail to which information can be analysed, such as info at dept. level.
- The availability of information both financial and non-financial.
- The comparability of the information. Ratios, on their own, are of little use. They should be comparable to previous years and other similar companies.
- The knowledge gained during previous audits such as effectiveness of controls.
Important accounting ratios
- Gross profit margins
- Average collection period
- Stock turnover
- Current ratio
- Acid test ratio
- Debt to equity capital Return on capital employed
- Payables and purchases
- Inventories and cost of sales
- Non-current assets and depreciation, repairs and maintenance
- Loans and interest
- Receivables and bad debts
- Receivables and sales
When placing reliance on the results of analytical procedure the auditor should consider:
- Materiality of the items involved,
- Other audit procedures directed toward the same assertions,
- The accuracy with which the expected results can be predicted, The fluency with which a relationship is observed, • An assessment of inherent and control risks.
Auditors will need to consider testing controls, if any, over the preparation of information used in applying analytical procedures. When such controls are effective, the auditors will have greater confidence in the reliability of the information. Other analytical techniques include:
- Examining related accounts
- Trend analysis
- Reasonableness tests such as that on depreciation.
Working papers will need to include:
- The programme of work carried out,
- The summary of significant figures and their relationships,
- A summary of comparisons made with budgets and previous years,
- Details of all significant fluctuations or unexpected relationships,
- Details of further investigations,
- The audit conclusions reached,
- Any information considered necessary for assisting in the planning of subsequent audits.
- GOING CONCERN
ISA 570, when planning and performing audit procedures and in evaluating the results, the auditor should consider the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements.
Going concern is viewed as continuing in business for the foreseeable future with neither the intention nor need to cease trading. Assets and liabilities are recorded on the basis that one can realise assets and discharge liabilities in the normal course of business.
When preparing the financial statements, management should make an assessment of the company’s ability to continue as a going concern. This assessment involves making a judgment, at a particular point in time, about the future outcome of events or conditions that are inherently uncertain. The following factors are relevant:
- The degree of uncertainty increases significantly the further into the future a judgment is being made about the outcome of an event or condition.
- Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events can contradict this.
- The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors all affect the judgment regarding the outcome of events or conditions.
Possible indicators of ‘going concern’ problems:
- Net liability or net current liability position
- Necessary borrowing facilities have not been agreed
- Loans nearing maturity without realistic prospects of renewal or repayment Excessive reliance on short-term borrowings to finance long-term assets
- Major debt repayment falling due where refinancing is necessary.
- Major restructuring of debt.
- Indications of withdrawal of financial support by debtors and other creditors
- Negative operating cash flows and adverse key financial ratios
- Substantial operating losses or significant deterioration in the value of assets.
- Major losses or cash flow problems since the balance sheet date.
- Arrears or discontinuance of dividends
- Inability to pay creditors on due dates
- Inability to comply with the terms of loan agreements
- Reduction in normal terms of trade credit by suppliers
- Change from credit to cash-on-delivery transactions with suppliers
- Inability to obtain financing for essential new product development.
- Substantial sales of fixed assets not intended to be replaced
- Loss of key management and staff without replacement
- Loss of a major market, franchise, licence, or principal supplier
- Labour difficulties or shortages of important supplies
- Unable to adapt to fundamental changes in the market or technology.
- Excessive dependence on a few product lines where the market is depressed.
- Technical developments that render a key product obsolete.
- Non-compliance with capital or other statutory requirements
- Pending legal proceedings that are unlikely to be satisfied
- Changes in legislation expected to adversely affect the entity
The significance of such events can often be mitigated by other factors.
- The effect of an entity being unable to make its normal debt repayments may be counter-balanced by management’s plans such as by disposal of assets or rescheduling of loan repayments.
- Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable alternative source of supply.
The auditor’s responsibility is to consider:
- The appropriateness of management’s use of the ‘going concern’ assumption in the preparation of the financial statements and
- Are there any material uncertainties about the entity’s ability to continue as a going concern that need to be disclosed in the financial statements.
In obtaining an understanding of the entity and in performing audit procedures throughout the audit, the auditor should consider whether there are events or conditions and related business risks that may cast significant doubt on the entity’s ability to continue as a going concern.
The auditor should review management’s assessment to determine whether they have identified events or conditions and what plans they have to address them. If management has not yet made an assessment, the auditor should discuss with them their basis for the intended use of the ‘going concern’ assumption.
The auditor should evaluate management’s assessment of the entity’s ability to continue as a going concern. If management’s assessment covers a period of less than twelve months from the balance sheet date, the auditor should ask them to extend its assessment period to twelve months from the balance sheet date.
The auditor does not have a responsibility to design audit procedures other than inquiry of management. However, he may become aware of such known events or conditions during the planning and performance of the audit, including subsequent events procedures. He should therefore inquire of management as to its knowledge of events or conditions beyond the period of assessment that may cast significant doubt on the entity’s ability to continue as a going concern.
Since the degree of uncertainty associated with the outcome of an event or condition increases further into the future the indications of going concern issues will need to be significant before the auditor considers taking further action. The auditor may need to ask management to determine the potential significance on their going concern assessment.
In evaluating management’s assessment, the auditor should consider:
- The process management followed to make its assessment, The assumptions on which the assessment is based and
- Management’s plans for future action.
Generally, there is no need for a detailed assessment by management and extensive review by the auditor if the company has a good history of profitable operations and access to sufficient financial resources.
Additional audit procedures
When events or conditions have been identified, the auditor should:
- Review management’s plans for future actions based on its assessment,
- Confirm or dispel whether or not a material uncertainty exists through carrying out audit procedures considered necessary and
- Seek written management representations regarding its future action plans.
Such procedures may include:
- Analysing and discussing cash flows and other forecasts with management.
- Analysing and discussing the latest available interim financial statements.
- Reviewing terms of loan agreements for any breaches.
- Reading minutes of the meetings for reference to financing difficulties.
- Inquiring of the entity’s lawyer regarding the existence of litigation and claims and the reasonableness of management’s assessments of their outcome and the estimate of their financial implications.
- Confirming the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assessing the financial ability of such parties to provide additional funds.
- Considering the entity’s plans to deal with unfilled customer orders.
- Reviewing after period end to identify mitigating events or otherwise.
When analysis of cash flow is a significant factor in considering the future outcome of events or conditions the auditor should consider the reliability of the entity’s information system for generating such information. He should also consider whether there is adequate support for the assumptions underlying the forecast and whether the comparability of prospective financial information with historical results and results to date is reasonably accurate.
Audit Conclusions and Reporting
Based on the audit evidence obtained, the auditor should determine if, in his judgment, a material uncertainty exists related to events or conditions that alone or in aggregate, may cast significant doubt on the entity’s ability to continue as a going concern.
If the use of the going concern assumption is appropriate but a material uncertainty exists, the auditor considers whether the financial statements:
- Adequately describe the principal events or conditions that give rise to the significant doubt on the entity’s ability to continue in operation and management’s plans to deal with these events or conditions; and
- State clearly that there is a material uncertainty therefore it may be unable to realise its assets and discharge its liabilities in the normal course of business.
If adequate disclosure is made in the financial statements, the auditor should express an unqualified opinion but modify the auditor’s report by adding an emphasis of matter paragraph that highlights the existence of a material uncertainty and draws attention to the note in the financial statements.
If adequate disclosure is not made in the financial statements, the auditor should express a qualified or adverse opinion. The report should include specific reference to the fact that there is a material uncertainty that may cast significant doubt about the entity’s ability to continue as a going concern.
If, in the auditor’s judgment, the entity will not be able to continue as a going concern, the auditor should express an adverse opinion if the financial statements have been prepared on a going concern basis regardless of whether or not disclosure has been made.
If management is unwilling to make or extend its assessment when requested to do so by the auditor, the auditor should consider the need to qualify the auditor’s report as a result of the limitation on the scope of the auditor’s work.
ISA 560, the auditor should consider the effect of subsequent events (events after the balance sheet date) on the financial statements and on the auditor’s report.
Events after the balance sheet date deals with the treatment in financial statements of events, both favourable and unfavourable, that occur between the balance sheet date and the date when the financial statements are authorised for issue and identifies two types:
- Those that provide evidence of conditions that existed at the balance sheet –adjusting events and
- Those which are indicative of conditions that arose after the balance sheet date, i.e.
Events occurring up to the date of the auditor’s report
The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence that all events up to the date of the auditor’s report that may require adjustment of, or disclosure in, the financial statements have been identified. When the auditor becomes aware of events that materially affect the financial statements, it is his responsibility to consider whether such events are properly accounted for and adequately disclosed.
These procedures are in addition to procedures that may be applied to specific transactions occurring after period end (normal year-end work) to obtain audit evidence as to account balances as at period end, for example, the testing of stock cut-off, receipts from debtors and payments to creditors.
The audit procedures should be performed as near as possible to the date of the auditor’s report and should take into account the auditor’s risk assessment and include the following:
- Reviewing management procedures ensuring such events are identified.
- Reading minutes of meetings of shareholders and directors held after period end and inquiring about matters for which minutes are not yet available.
- Reading the entity’s latest available interim financial statements
- Inquiring of the entity’s legal counsel concerning litigation and claims.
- Inquiring of management as to whether any subsequent events have occurred which might affect the financial statements such as:
♦ The current status of items based on preliminary or inconclusive data.
♦ New commitments, borrowings or guarantees
♦ Major sales or acquisition of assets occurred or planned
♦ Issue of new shares or debentures or agreement/plans to merge or liquidate ♦ Assets appropriated by government or destroyed by fire or flood.
♦ Developments regarding risk areas and contingencies
♦ Unusual accounting adjustments made or contemplated
♦ Any events which will bring into question the appropriateness of accounting policies used in the financial statements.
Facts discovered after the date of the auditor’s report but before the financial statements are issued
The auditor does not have any responsibility to perform audit procedures or make any inquiry regarding the financial statements after the date of the auditor’s report. During the period from the date of the auditor’s report to the date the financial statements are issued, the responsibility to inform the auditor of facts that may affect the financial statements rests with management.
Where the auditor becomes aware of a fact that may materially affect the financial statements, he should consider whether the financial statements need amendment. He should discuss the matter with management and should take the action appropriate in the circumstances.
When management amends the financial statements, the auditor would carry out additional audit procedures as necessary and would issue a new report on the amended financial statements. The new report would be dated not earlier than the amended financial statements signed or approved by management.
When management does not amend the financial statements in circumstances where the auditor believes they need to be amended and the auditor’s report has not been released to the entity, the auditor should express a qualified opinion or an adverse opinion.
When the auditor’s report has been released to the entity, the auditor would notify management not to issue the financial statements and the auditor’s report thereon to third parties.
If they are subsequently released, the auditor needs to take action to prevent reliance on the audit report. The action taken will depend on the auditor’s legal rights and obligations and the recommendations of the auditor’s lawyer.
Facts discovered after the financial statements have been issued
After the financial statements are issued, the auditor has no obligation to make any further inquiry.
When, after the financial statements have been issued, the auditor becomes aware of a fact which existed at the date of the auditor’s report and which, if known at that date, may have caused the auditor to qualify his report, the auditor should consider whether the financial statements need revision, should discuss the matter with management, and should take the action appropriate in the circumstances.
Where the auditor becomes aware of a fact relevant to the audited financial statements that did not exist at the date of the auditor’s report there are no statutory provisions for revising financial statements. The auditor should discuss with management whether they should withdraw the financial statements and where management decide not to do so the auditor may wish to take advice on whether it might be possible to withdraw their report. A possible course of action may include making a statement by management or the auditor at the annual general meeting. In any event legal advice may be helpful.
When management revises the financial statements, the auditor should carry out the audit procedures necessary in the circumstances and should review the steps taken by management to ensure that anyone in receipt of the previously issued financial statements together with the auditor’s report thereon is informed of the situation. The auditor would issue a new report on the revised financial statements. The new auditor’s report should include an emphasis of a matter paragraph referring to a note to the financial statements that more extensively discusses the reason for the revision of the previously issued financial statements and to the earlier report issued by the auditor. The new auditor’s report would be dated not earlier than the date the revised financial statements are approved.
When management do not take the necessary steps to ensure that anyone in receipt of the previously issued financial statements together with the auditor’s report thereon is informed of the situation and does not revise the financial statements in circumstances where the auditor believes they need to be revised, the auditor would notify management that action will be taken by the auditor to prevent future reliance on the auditor’s report. The action taken will depend on the auditor’s legal rights and obligations and the recommendations of the auditor’s lawyers.
ISA 540, the auditor should obtain sufficient appropriate evidence regarding accounting estimates.
Estimates mean an approximation of the amount of an item in the absence of a precise means of measurement. For example, provisions to reduce stock and debtors to their estimated realisable values, accrued revenue, deferred tax, provisions for warranty claims.
Management is responsible for making estimates included in the financial statements. These estimates are often made in conditions of uncertainty regarding the outcome of events and involve the use of judgement. The risk of material misstatement therefore increases when accounting estimates are involved. Audit evidence supporting estimates is generally less than conclusive and so auditors need to exercise greater judgement than in other areas of the audit.
The auditor should design and perform further audit procedures to obtain sufficient appropriate evidence as to whether the accounting estimates are reasonable in the circumstances and when required, appropriately disclosed. He needs to gain an understanding of the procedures and methods used by management to make accounting estimates. The auditor should adopt one or a combination of the following approaches in the audit of an accounting estimate:
- Review and test the process used by management to develop the estimate,
- Use an independent estimate for comparison with that prepared by management or
- Review subsequent events which provide audit evidence of the reasonableness of the estimate made.
Evaluation of results of audit procedures
The auditor should make a final assessment of the reasonableness of the entity’s accounting estimates based on the auditor’s understanding of the entity and its environment and whether estimates are consistent with other audit evidence obtained during the audit.
Auditors must assess the differences between the amount of an estimate supported by evidence and the estimate calculated by management. If the auditor believes that the difference is unreasonable then an adjustment should be made. If the management refuses to revise the estimate, then the difference is considered a misstatement and will be treated as such.
COMMITMENTS AND CONTINGENCIES
The auditor needs to ensure there has been correct classification according to IAS 37, provisions and contingent liabilities.
- A provision is a liability of uncertain timing or amount.
- A liability is a present obligation of an enterprise arising from past events, the settlement of which is expected to result in an outflow.
- A contingent liability is a:
- possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise
- present obligation that arises from past events but is not recognised because it is not probable that an outflow of resources will be required to settle the obligation or the amount of the obligation cannot be measured with sufficient reliability.
IAS 37 lays out the following conditions:
- A contingent asset should not be accounted for unless its realisation is virtually certain. If an inflow of economic benefits has become probable, the asset should be disclosed.
- Where there is a present obligation that probably requires an outflow of resources, then a provision should be recognised and disclosed.
- Where there is a possible or present obligation that may, but probably will not, require an outflow of resources then no provision should be recognised but disclosures are required for the contingent liability.
- Where there is a possible or present obligation where the likelihood of an outflow of resources is remote, then no provision is recognised and no disclosure is required.
- A contingent liability also arises in the rare case where there is a liability that cannot be recognised because it cannot be measured reliably. Disclosures are required in this instance.
Examples of contingencies disclosed by companies are guarantees for other group companies, staff pension schemes, completion of contracts, discounted bills of exchange, law-suits or claims pending and options to purchase assets.
Obtaining audit evidence of contingencies
The auditor should carry out audit procedures in order to become aware of any litigation and claims involving the entity, which may result in a material misstatement of the financial statements. Such procedures could include:
- Making inquiries of management including obtaining representations, Reviewing minutes of management meetings and legal correspondence,
- Examining legal expense accounts.
When the auditor assesses a risk of material misstatement regarding litigation or claims that have been identified or when the auditor believes they may exist, the auditor should seek direct communication with the entity’s legal counsel. This will help to obtain evidence as to whether potential material litigation and claims are known and management’s estimates of the financial implications, including costs are reliable.
The letter, prepared by management and sent by the auditor, should request the entity’s legal counsel to communicate directly with the auditor. When it is considered unlikely that the entity’s legal counsel will respond to a general inquiry, the letter would ordinarily specify the following:
- A list of litigation and claims,
- Management’s assessment of the outcome of the litigation or claim and its estimate of the financial implications, including costs involved,
- A request that the entity’s legal counsel confirm the reasonableness of management’s assessments and provide the auditor with further information if the list is considered to be incomplete or incorrect.
If management refuses to give the auditor permission to communicate with the entity’s legal counsel, this would be a scope limitation and could lead to a qualified/disclaimer of opinion.
Where the entity’s legal counsel refuses to respond in an appropriate manner and the auditor is unable to obtain sufficient appropriate audit evidence by applying alternative audit procedures, the auditor should consider whether there is a scope limitation that may lead to a qualified opinion or a disclaimer of opinion.
ISA 580 states that the auditor should obtain appropriate representations from management. These are an important source of evidence. Indeed these may be the only suitable evidence available where knowledge of such facts are confined to management or may even be one of judgement and opinion. They may be oral or written and may be obtained either on a formal or informal basis. The auditors will include this information in their audit working papers where it forms part of their total audit evidence. Written confirmation should be obtained before the audit report is issued.
Acknowledgment by Management of its Responsibility for the Financial Statements
The auditor should obtain audit evidence that management acknowledges its responsibility for the fair presentation of the financial statements in accordance with the applicable financial reporting framework, and has approved the financial statements. This normally occurs when the auditor gets a signed copy of the financial statements which usually includes a statement of management responsibilities. On the other hand the auditor can obtain audit evidence from minutes of meetings by obtaining a written representation from management.
Representations by Management as Audit Evidence
The auditor should obtain written representations from management on matters material to the financial statements when other audit evidence cannot reasonably be expected to exist. It may be necessary to inform management of the auditor’s understanding of materiality. The possibility of misunderstandings between the auditor and management is reduced when oral representations are confirmed by management in writing.
The auditor should obtain written representations from management that:
- It acknowledges its responsibility for the design and implementation of internal control to prevent and detect error and
- It believes the effects of those uncorrected misstatements aggregated by the auditor during the audit are immaterial to the financial statements when taken as a whole.
During the course of an audit, management makes many representations to the auditor, either unsolicited or in response to specific inquiries. When such representations relate to matters which are material to the financial statements, the auditor will need to:
- Seek corroborative evidence from sources inside or outside the entity,
- Evaluate whether the representations made by management appear reasonable and consistent with other audit evidence obtained and
- Consider whether the individuals making the representations can be expected to be well informed on the particular matters.
Representations by management cannot be a substitute for other audit evidence that the auditor could reasonably expect to be available. If the auditor is unable to obtain sufficient appropriate audit evidence and such audit evidence is expected to be available, this will constitute a limitation in the scope of the audit, even if a representation has been received on the matter.
If a representation by management is contradicted by other audit evidence, the auditor should investigate the circumstances and, when necessary, reconsider the reliability of other representations made by management.
Documentation of Representations by Management
The auditor would ordinarily include in audit working papers evidence of management’s representations in the form of a summary of oral discussions with management or written representations from management.
A written representation is ordinarily more reliable audit evidence than an oral representation and can take the form of:
- A representation letter from management,
- A letter from the auditor outlining his understanding of management’s representations, duly acknowledged and confirmed by management,
- Relevant minutes of meetings of the board of directors or similar body or a signed copy of the financial statements
Basic Elements of a Management Representation Letter
When requesting a management representation letter, the auditor would request that it be addressed to the auditor, contain specified information and be appropriately dated and signed. It would ordinarily be dated the same date as the auditor’s report. A management representation letter would ordinarily be signed by the members of management who have primary responsibility for the entity and its financial aspects (ordinarily the senior executive officer and the senior financial officer) based on the best of their knowledge and belief.
Action if Management Refuses to Provide Representations
If management refuses to provide a representation that the auditor considers necessary, this constitutes a scope limitation and the auditor should express a qualified opinion or a disclaimer of opinion. In such circumstances, the auditor would evaluate any reliance placed on other representations made by management during the course of the audit and consider if the other implications of the refusal may have any additional effect on the auditor’s report.
USE OF EXPERTS
ISA 620 Using the work of others states that the auditor is not expected to have the expertise of a person trained for or qualified to engage in the practice of another profession or occupation, such as an actuary or engineer. For this reason an auditor may need to use the work of an expert to obtain sufficient, appropriate audit evidence. “Expert” means a person or firm possessing special skill, knowledge and experience in a particular field other than accounting and auditing.
When using the work performed by an expert, the auditor should obtain sufficient appropriate audit evidence that such work is adequate for the purposes of the audit. If unable to obtain such evidence, the auditor should consider the need to modify the auditor’s report. Although the auditor may use the work of an expert, the auditor has sole responsibility for the audit opinion.
The expert can be engaged by the client or the auditor. When the expert is employed by the auditor, he will be able to rely on his own systems for recruitment and training to determine that expert’s capabilities and competence.
If neither the auditor nor the entity employs an expert, the auditor may ask management to engage one subject to the auditor being satisfied as to the expert’s competence and objectivity. If management is unable or unwilling, the auditor may consider engaging an expert or whether sufficient appropriate audit evidence can be obtained from other sources. Otherwise, the auditor might need to consider modifying the audit report. Determining the Need to Use the Work of an Expert
The auditor may need to obtain audit evidence in the form of reports, opinions, valuations and statements of an expert. Examples are:
- Valuations of land and buildings, plant and machinery and works of art,
- Determination of quantities of minerals stored in stockpiles, underground petroleum reserves, and the remaining useful life of plant and machinery,
- An actuarial valuation, The measurement of work completed and to be
completed on contracts,
- Legal opinions re interpretations of agreements, statutes and regulations.
When determining the need to use an expert, the auditor should consider:
- The engagement team’s knowledge and previous experience of the matter,
- The risk of material misstatement based on the nature, complexity and
materiality of the matter being considered, and
- The quantity and quality of other audit evidence expected to be obtained.
Competence and Objectivity of the Expert
When planning to use the work of an expert, the auditor should evaluate the professional competence of the expert. He needs to consider the expert’s professional certification or membership in an appropriate professional body and his experience and reputation in the field.
The auditor should also evaluate the objectivity of the expert. The risk that an expert’s objectivity will be impaired increases when the expert is employed by the entity or related in some other manner to the entity, for example, by being financially dependent upon or having an investment in the entity.
If the auditor is concerned he needs to discuss any reservations with management and consider whether sufficient appropriate audit evidence can be obtained concerning the work of an expert. He may need to undertake additional audit procedures or seek audit evidence from another expert. If the auditor is unable to obtain sufficient appropriate audit evidence concerning the work of an expert, the auditor needs to consider modifying the auditor’s report.
Scope of the Expert’s Work
The scope of the expert’s work needs to be adequate for the purposes of the audit. Audit evidence may be obtained through a review of the terms of reference. Such terms may cover matters such as:
- The objectives and scope of the expert’s work,
- A general outline of the specific matters the auditor expects,
- The intended use by the auditor of the expert’s work, including the possible communication to third parties of the expert’s identity,
- The extent of the expert’s access to appropriate records and files,
- Clarification of the expert’s relationship with the entity, if any,
- Confidentiality of the entity’s information,
- Information regarding the assumptions and methods intended to be used by the expert and their consistency with those used in prior periods.
Evaluating the Work of the Expert
The auditor should evaluate the appropriateness of the expert’s work as audit evidence regarding the assertion being considered. This will involve evaluation of whether the substance of the expert’s findings is properly reflected in the financial statements or supports the assertions, and consideration of:
- Source data used,
- Assumptions and methods used and their consistency with prior periods, When the expert carried out the work,
- Results of the expert’s work in the light of the auditor’s overall knowledge of the business and of the results of other audit procedures.
When considering whether the expert has used source data which is appropriate in the circumstances, the auditor would consider the following procedures:
- Making inquiries regarding any procedures undertaken by the expert to establish whether the source data is relevant and reliable and
- Reviewing or testing the data used by the expert.
The appropriateness and reasonableness of assumptions and methods used and their application are the responsibility of the expert. The auditor does not have the same expertise and, therefore, cannot always challenge the expert’s assumptions and methods. However, the auditor will need to obtain an understanding of the assumptions and methods used and to consider whether they are appropriate and reasonable, based on the auditor’s knowledge of the business and the results of other audit procedures. Results of the expert
If the results of the expert’s work do not provide sufficient appropriate audit evidence or if the results are not consistent with other audit evidence, the auditor should resolve the matter. This may involve discussions with the entity and the expert, applying additional audit procedures, including possibly engaging another expert, or modifying the auditor’s report. Reference to an Expert in the Auditor’s Report
When issuing an unmodified auditor’s report, the auditor should not refer to the work of an expert. Such a reference might be misunderstood to be a qualification of the auditor’s opinion or a division of responsibility, neither of which is intended. Sole responsibility lies with the auditor.
If, as a result of the work of an expert, the auditor decides to issue a modified auditor’s report, in some circumstances it may be appropriate, in explaining the nature of the modification, to refer to or describe the work of the expert (including the identity of the expert and the extent of the expert’s involvement). In these circumstances, the auditor would obtain the permission of the expert before making such a reference. If permission is refused and the auditor believes a reference is necessary, the auditor may need to seek legal advice. Internal audit
If the client has an internal audit department, it may sometimes be possible for the external auditor to make use of their work in arriving at an audit opinion (ISA610).
The external auditor should consider the activities of internal auditing and their effect, if any, on external audit procedures.
The external auditor should obtain an understanding of internal audit activities and assess the risks of material misstatement of the financial statements and to design and perform further audit procedures.
The external auditor should perform an assessment of the internal audit function when internal audit is relevant to the external auditors’ risk assessment.
When the external auditor intends to use specific work of internal auditing, the external auditor should evaluate and perform audit procedures on that work to confirm its adequacy for the external auditor’s purposes.
Opening balances are based on the closing balances of the prior period and reflect transactions of and accounting policies applied to the prior period.
ISA 510 provides guidance on when the financial statements are audited for the first time and when the prior period was audited by another auditor. Initial audit engagements
For initial audit engagements, the auditor should obtain sufficient appropriate audit evidence that:
- The opening balances do not contain misstatements that materially affect the current period’s financial statements;
- The prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, have been restated;
- Appropriate accounting policies are consistently applied or changes in accounting policies have been properly accounted for and adequately presented and disclosed
Appropriate and sufficient evidence is required and will depend on:
- The accounting policies followed,
- Whether the prior periods were audited and the audit report was modified,
- The nature of the accounts and the risk of misstatement,
- The materiality of the opening balances,
Prior periods audited by another auditor
Where the prior periods financial statements were audited by other auditors, the current auditor may be able to obtain sufficient appropriate audit evidence regarding opening balance by reviewing the other auditor’s working papers. The current auditor should consider the professional competence and independence of the other auditor. If the previous audit report was qualified, the auditor should pay particular attention in the current period to those matters that resulted in the qualification.
Lack of sufficient appropriate evidence
Where the prior period accounts were not audited or where the auditor has not obtained sufficient appropriate evidence, he must perform other procedures. Examples would include:
- In respect of current assets and liabilities, some audit evidence can usually be obtained as part of the current periods audit procedures such as the collection of opening debtors during the current period. This will provide some evidence of their existence, rights and obligations, completeness and valuation at the beginning of the period.
- The opening stock position may require the observing of a current physical count and then reconciling it back to the opening position, testing the valuation of the opening stock items and carrying out testing on gross margins and cut off procedures.
- For non-current assets and liabilities, the auditor may be able to obtain external confirmation of opening balances with third parties e.g. long term debt and investments.
Audit conclusion and reporting
If, after performing additional audit procedures, the auditor is unable to obtain sufficient appropriate audit evidence concerning opening balances, the auditor’s report should include:
- A qualified opinion,
- A disclaimer of opinion or
- In those jurisdictions where it is permitted, an opinion which is qualified or disclaimed regarding the results of operations and unqualified regarding financial position.
If the opening balances contain misstatements which could materially affect the current financial statements, the auditor should inform management and (after having obtained management’s authorisation) the previous auditor, if any. If the effect of the misstatement is not properly accounted for and adequately presented and disclosed, the auditor should express a qualified opinion or an adverse opinion, as appropriate.
If the current period’s accounting policies have not been consistently applied in relation to opening balances and if the change has not been properly accounted for and adequately presented and disclosed, the auditor should express a qualified opinion or an adverse opinion as appropriate.
If the entity’s prior period auditor’s report was qualified, the auditor should consider the effect on the current period’s financial statements. For example, if there was a scope limitation, such as one due to the inability to determine opening inventory in the prior period, the auditor may not need to qualify or disclaim the current period’s audit opinion. However, if a modification regarding the prior period’s financial statements remains relevant and material to the current period’s financial statements, the auditor should modify the current auditor’s report accordingly.
ISA 710 establishes the standards and provides guidance in this area. The auditor should determine whether the comparatives comply in all material respects with the financial reporting framework applicable to the financial statements being audited. Different countries have different reporting frameworks.
The auditor should obtain sufficient appropriate audit evidence that amounts derived from the preceding period’s financial statements are free from material misstatement and are appropriately incorporated in the financial statements for the current period.
Corresponding figures are amounts and other disclosures for the preceding period that are included as part of the current period financial statements and are intended to be read in relation to the amounts and other disclosures relating to the current period. They are not presented as complete financial statements capable of standing alone, but are an integral part of the current period financial statements intended to be read only in relation to the current period figures.
Comparative financial statements are amounts and other disclosures for the preceding period that are included for comparison with the financial statements of the current period, but do not form part of the current period financial statements. Comparatives are presented in compliance with the applicable financial reporting framework.
The essential audit reporting differences are that:
- For corresponding figures, the auditor’s report only refers to the financial statements of the current period; whereas,
- For comparative financial statements, the auditor’s report refers to each period for which financial statements are presented. This could be part of a document for preparation for a stock exchange listing.
The extent of audit procedures performed on the corresponding figures is significantly less than for the audit of the current period figures.
The auditor should obtain sufficient appropriate audit evidence that:
- The accounting policies used for the corresponding amounts are consistent with the current period and appropriate adjustments and disclosures have been made,
- The corresponding amounts agree with the amounts and other disclosures presented in the preceding period and are free from errors and
- Where corresponding amounts have been adjusted as required by relevant legislation and accounting standards, appropriate disclosures have been made.
When the comparatives are presented as corresponding figures, the auditor should issue an audit report in which the comparatives are not specifically identified because the auditor’s opinion is on the current period financial statements as a whole, including the corresponding figures.
Where the auditor’s report on the prior period, as previously issued, included a qualified opinion, disclaimer of opinion, or adverse opinion and the matter that gave rise to the modification is:
- Unresolved, and results in a modification of the auditor’s report regarding the current period figures, the auditor’s report should also be modified regarding the corresponding figures.
- Unresolved, but does not result in a modification of the auditor’s report regarding the current period figures, the auditor’s report should be modified regarding the corresponding figures only.
- Resolved and properly dealt with in the financial statements, the current report does not need a reference to the previous modification. However, if the matter is material to the current period, the auditor may include an emphasis of matter paragraph dealing with the situation.
During the course of the current audit the auditor may become aware of a previously undetected material misstatement that affects the prior period financial statements on which an unqualified report had been previously issued.
- If the prior period financial statements have been revised and reissued with a new auditor’s report, the auditor should obtain audit evidence that the corresponding figures agree with the revised financial statements
- If the prior period financial statements have not been revised and reissued, and the corresponding figures have not been properly restated and/or appropriate disclosures have not been made, the auditor should issue a modified report on the current period financial statements modified with respect to the corresponding figures included therein.
- If prior period financial statements have not been revised and an auditor’s report has not been reissued, but the corresponding figures have been properly restated and/or appropriate disclosures have been made in the current period financial statements, the auditor may include an emphasis of matter paragraph describing the circumstances and referencing to the appropriate disclosures.
When the prior period financial statements are not audited, the incoming auditor should state in the auditor’s report that the corresponding figures are unaudited. This does not relieve the auditor, though, of his responsibilities to perform appropriate audit procedures regarding opening balances.
If the auditor is not able to obtain sufficient appropriate audit evidence regarding the corresponding figures, or if there is not adequate disclosure, the auditor should consider the implications for his report.
In situations where the incoming auditor identifies that the corresponding figures are materially misstated, the auditor should request management to revise the corresponding figures or if management refuses to do so, appropriately modify the report.
Comparative financial statements
The auditor should obtain sufficient appropriate audit evidence that the comparative financial statements meet the requirements of the applicable financial reporting framework. This involves evaluating whether:
- Accounting policies of the prior period are consistent with the current period,
- Prior period figures agree with the amounts and other disclosures presented in the prior period and Appropriate adjustments and disclosures have been made.
When the comparatives are presented as comparative financial statements, the auditor should issue a report in which the comparatives are specifically identified because the auditor’s opinion is expressed individually on the financial statements of each period presented.
Since the auditor’s report on comparative financial statements applies to the individual financial statements presented, the auditor may express a qualified or adverse opinion, disclaim an opinion, or include an emphasis of matter paragraph with respect to one or more financial statements for one or more periods, while issuing a different report on the other financial statements.
When reporting on the prior period financial statements in connection with the current year’s audit, if the opinion on such prior period financial statements is different from the opinion previously expressed, the auditor should disclose the substantive reasons for the different opinion in an emphasis of matter paragraph. This may arise when he becomes aware of circumstances or events that materially affect the financial statements of a prior period during the course of the audit of the current period.
Where the financial statements of the prior period were audited by another auditor:
- The previous auditor may reissue the audit report on the prior period with the incoming auditor only reporting on the current period or
- The incoming auditor’s report should state the prior period was audited by another auditor, the type of report issued by the other auditor (if qualified – the reasons) and the date of that report.
In the course of the current audit the incoming auditor may become aware of a previously undetected material misstatement that affects the prior period accounts on which the previous auditor had previously unqualified.
In these circumstances, the incoming auditor should discuss the matter with management and, after having obtained management’s authorisation, contact the previous auditor and propose that the prior period financial statements be restated. If the previous auditor agrees to reissue the audit report on the restated financial statements of the prior period, the auditor should only report on the current period.
If the previous auditor does not agree with the proposed restatement or refuses to reissue the audit report on the prior period financial statements, the introductory paragraph of the current auditor’s report should indicate that the previous auditor reported on the financial statements of the prior period before restatement. In addition, if the incoming auditor applies sufficient audit procedures to be satisfied as to the appropriateness of the restatement adjustment, he may include a paragraph in his report.
When the prior period financial statements are not audited, the incoming auditor should state in the auditor’s report that the comparative financial statements are unaudited. This statement does not relieve the auditor of the requirement to carry out appropriate audit procedures regarding opening balances.
In situations where the incoming auditor identifies that the prior year unaudited figures are materially misstated, the auditor should request management to revise the prior year’s figures or if management refuses to do so, appropriately qualify the report.