You have received a request form XYZ Ltd. to accept an appointment as their auditor for the financial year ending 31 December 2001.
Explain the preliminary procedures you would carry out upon your appointment.
What is the importance of a preliminary review? (4 marks)
- Why is it important for the auditor to hold discussions with the client‘s senior staff?
- State why it is important for an incoming auditor to hold consultations with the
outgoing auditor. (4 marks)
(Total: 20 marks)
The steps I would take after appointment at the AGM include: –
- I would obtain instructions from the client as to the scope of the work and whether this is in addition to what is assigned to me by the Company‘s Act in
which case it should be put or referred to in a letter of engagement.
- Considered whether my appointment was legally carried out as per the requirements of the company‘s Act. In particular I would obtain a copy of the resolution passed at the AGM appointing my firm as the auditors of the
- I would issue a letter of engagement to the client. This letter would serve the purpose of defining the scope of my audit work and as a formal acceptance of the audit work.
- I would seek for background information about the client. This would include the nature of its business, the owners of the company and its financial information. Such information will assist in evaluating the potential risk in associating with the client and also in planning the approach to be adopted in carrying out the work.
A preliminary review is important as it helps the audit firm to screen out potentially risky audit clients and also identify any factors that could affect the nature of the
work to be performed and also the approach to be adopted by the auditor. The considerations which are relevant in deciding whether a client is a high risk include:-
- evidence of client engagement in fraudulent or illegal activities
- the state of the economic sector in which the client operates (a depressed sector may indicate risk)
- the nature of the industry and the clients product lines
- the clients previous audit history (frequent changes of auditors, and/or qualified reports are indicators of high risk clients) -The general abilities of the client management
- Understanding of the directors of their own role and that of the auditor
- Evidence of management intentionally failing to record a material transaction.
- It is important for an auditor to hold discussions with the clients senior staff in order to:-
- Agree on the terms of engagement which clearly state and specify the scope of the audit.
- Determine any changes that have taken place in the client entity such as:-
- changes in accounting policies used
- changes in senior management -changes in product lines.
- To ensure management clearly understand their responsibilities especially in regards to preparing financial statements that show a true and fair view.
- To obtain as much information as possible about the client e.g, the current trading circumstances the reliability of the accounting and internal control system which will help the auditor in formulating an appropriate approach for the conduct of the audit.
- It is important for an incoming auditor to hold consultations with the outgoing auditor because: –
It is a matter of professional courtesy
- To enable him to obtain all the pertinent matters relevant to the audit from the outgoing auditors. This includes issues which would influence his decision as to whether or not to accept the appointment. The outgoing auditor will be able to provide information such as the reasons behind their removal as auditors of the company. Scuh information will be useful in deciding whether to accept the appointment or to decline.
- Why is an external audit necessary for companies registered under the Companies Act? (3 marks)
- Under what circumstances is one ineligible for appointment as an auditor of a company? (4 marks)
- Explain the procedure a company has to follow when changing its auditors. In your
discussion explain ‗dismissal‘ and ‗appointment‘ of auditors by a company? (8 marks)
- List the rights and duties of an independent auditor. (5 marks)
(Total: 20 marks)
- The main reason why an external audit is carried out for companies registered under the Company‘s Act is to fulfill statutory requirements. The Company‘s Act requires that every limited company shall within nine months after the end of its financial period hold a general meeting where audited financial statements shall be laid out before its members.
Other reasons why an audit may be carried out (advantages of an audit not necessarily for limited companies) include: –
- To provide assurance and credibility to the accounts in the audit report which is crucial to all parties who have an interest in the company.
- Third parties who do not take an active role in the running of the business are protected by the audit. The auditor issues a report as to whether the financial statements show a true and fair view.
- The audit could assist in the detection and prevention of errors and frauds in the
- An audit will keep the client‘s accountants vigilant and up-to-date. This ensures that complete and accurate records are maintained.
- Audited accounts by independent auditors minimize chances of disputes among partners in a business e.g. in profit and asset sharing
- In case a new partner wants to join, audited accounts will serve as a basis for such admission to determine how much such a partner has to contribute to existing capital.
- In case of a retiring or dead partner the audited accounts will serve as a basis of determining what is due to the beneficiaries of the deceased.
- The audited accounts are used as a basis for borrowing finance from banks and other financial institutions as this will highlight the performance (financial) of the company.
- Audited accounts are acceptable as a basis of ascertaining tax liability and these are usually accepted by the Income Tax Department for the settlement of income tax for the year.
- The Company‘s Act section 161 covers the circumstances under which one is ineligible for appointment as an auditor section 161(1): A person or firm is not qualified for appointment as an auditor (or in the case of a firm, every partner of the firm) unless he is a holder of a practicing certificate issued pursuant to Section 21 of the Accountants Act 1977. Such a certificate is issued under the following conditions: –
- A person with CPA (III) qualification
- A person with at least 3 years post graduate experience in auditing or an
- A person registered with RAB (Registration of Accountants Board)
- A person registered with KASNEB
- A person who is a member of ICPA (K.)
Section 161 (2): None of the following persons shall be qualified as an auditor of a company
- A servant of a company
- A person who is a partner or is in employment of an officer or servant of a company
- A body corporate
Section 161 (3): A person cannot be qualified for appointment if he has by virtue of subsection (2) above, been disqualified as an auditor of a body corporate which is that company‘s subsidiary or holding company or subsidiary of that company‘s holding company.
- Dismissal of an auditor refers to the removal of an auditor, which is dealt with by Section 160 of the Company‘s Act.
A special notice shall be required for resolution at the company‘s AGM appointing as an auditor another person other than a retiring auditor and providing expressly that a retiring auditor shall not be reappointed.
Section 160 (2)
On receipt of the notice of such intended resolution the company shall forthwith send a copy thereof to the retiring auditor if any.
Section 160 (3)
Where a notice is given as a foresight, the retiring auditor will make with respect to the intending resolutions, representations in writing to the company not exceeding a reasonable length and the company shall send this together with the notice of the annual general meeting to all shareholders of the company and to other parties to whom such notice is sent.
Representations may however, not be sent to shareholders if they are received too late for the company to do so or if it is due to the auditors default.
However, the auditor may read such representations at the AGM (Annual general meeting). These representations need not be read at the AGM if on the application of a member or any other aggrieved party, the court is satisfied that the right confirmed on the auditor by this sub-section is being used to secure needless publicity for a defamatory matter. In addition the court may order the auditor to pay the cost of such a suit either in part or in whole as the case may be.
Appointment of the auditor
This is dealt with by Section 159 of the Company‘s Act.
Section 159(1): Appointment at the AGM: –
Every company shall, at its AGM appoint an auditor to hold office from the conclusion of that meeting to the conclusion of the next AGM.
Section 159 (2): Automatic reappointment of the auditor
Not withstanding the provisions of sub-section (1) above, a retiring auditor however appointed shall be automatically reappointed without a resolution being passed unless:-
- He is not qualified for reappointment
- A resolution has been passed at that meeting appointing someone else or providing expressly that he or she shall not be reappointed.
- He has given notice in writing of his unwillingness to be reappointed, provided that prior notice is given of the intended resolution to appoint some other person in place of the retiring auditor.
Section 159(3): Appointment by registrar of companies:-
When at an AGM no auditor is appointed or deemed to be reappointed the registrar of companies may appoint an auditor to fill such a vacancy.
Section 159 (5): Appointment of the first auditor:-
As herein provided the first auditors of a company shall be reappointed by the directors anytime before the next AGM and the auditor so appointed shall hold office, up to the conclusion of the next AGM provided that:-
Section 159 (5) (1): The company may at an AGM remove such an auditor and appoint in their place any other person who has been nominated for appointment by any member of the company not less than 28 days before the date of that meeting.
Section 159(5)(2): If the directors of a company fail to exercise their powers then under this subsection the company will at the AGM appoint the first auditor. Therefore the aforesaid powers of the directors shall automatically cease.
Section 159 (6): States: –
The directors may fill any, casual vacancy in the office of the auditor, but while any such vacancy continues the surviving or continuing auditor or auditors, if any, may act.
Rights and duties of an independent auditor
This stems out from the statutes (Section 162 (1) -(4)) as well as from case law based on decisions made by the courts on auditors duties and rights.
Rights of an auditor
Right of access to books of accounts and vouchers of a business at all times. This includes:-
- Right of access to statutory books of accounts.
- Right of access to returns from branches
- Right of access to documents, books and vouchers kept by third parties on behalf of the company.
- Right to call for information and explanations which the auditor considers necessary for the purpose of forming an opinion. It includes: –
- Right to obtain all information from the company‘s books and vouchers.
- Right to obtain all information in form of management representations contained in a letter of representation which contains matters for which an auditor could not readily get documentary evidence
- The right to obtain information from third parties which have had
previous dealing with the company
- Right to receive notices of and attend the general meetings.
- Right to attend the Annual General Meeting (AGM) regardless of whether accounts are subject to discussion or not this includes:-
- Right to read his representation at an AGM if these were received too late for the company to send them to each shareholder to whom notice of the AGM is sent or if the company is in default.
- Right to answer questions at the AGM if they have been channelled through the chairman of the AGM.
- Right to make presentations or to add to his report any material information which has come to his knowledge after his report has been dispatched but before the AGM. However, an auditor does not have a right to make up for any negligent omission on his Report during an AGM.
- Right to make a statement at an AGM:-
- To correct a wrong impression given to the shareholders by the board of
- Right to make a statement on the condition of the company‘s internal control system, particularly if it has been persistently weak.
6) Right to indemnity:- An auditor has a right to be indemnified out of the company‘s assets if he has been injured during the course of his audit in so far as such injuries may have occasioned the auditor loss to his name as a professional or to his person as an individual.
- Right to visit branches: –
- Right to information and explanations relating to activities of branches so far as they affect the company‘s affairs.
- Right to examine branch accounts and to request for returns submitted to the headquarters.
- Right to communicate and receive information from third parties to such
- Right to receive representations from those branches over those matters where the auditor could not have sufficient documentary evidence.
- Right to remuneration:-
- To be paid his fees as and when they fall due.
- To have his expenses re-imbursed by the client
- To withhold his report until his fees have been paid (right to lien)
- Right to legal and technical advice.
Duties – Section 161
- To make a statement or report arising from his examination of books of accounts which is a requirement of the Company‘s Act and such a report is essential before an AGM can be convened.
- Duty to state the following in his report:-
- Whether the auditor has received all information and explanation which to the best
of his knowledge is necessary for his audit.
- Whether the accounts portray the true and fair view of the company‘s
state of affairs and of the company‘s assets and liability.
- Whether the auditor has received adequate returns submitted from branches and
whether the company has kept proper books of accounts.
- Duty to prepare working papers i.e. permanent audit file and current audit file. An auditor has a duty to provide working papers to assist investigators on the
- Duty to certify the profit and loss account and the balance sheets in the prospectus where a company issues new shares to the public, such a company must prepare a prospectus that must contain audited financial statements for not less than 5 years preceding the public issue.
- What are the main objectives of an internal control system? (5 marks)
- What are the disadvantages of rigidly adhering to a system of internal control? (5 marks)
- Explain the matters that have to be considered in respect of a system of internal control for cash sales in a service station that sells petrol and repairs motor vehicles. (10 marks)
(Total: 20 marks)
- According to paragraph 13 of ISA 400, ―Risk assessments and
internal control‖the objectives of internal controls is: –
- To enable management carry out the business in an orderly and efficient manner. Internal controls lay out the various procedures to be followed in conducting the affairs of the organisation. E.g. there will be procedures laying out the procedures to be followed in procuring raw materials to ensure that only necessary materials are procured which meet the quality standards of the
- To ensures adherence to management policies
Management policies vary from the broad objectives to the detailed policy matters necessary to make those objectives realisable. Internal controls also serve a check to ensure that management policies are followed, e.g. if there is a requirement that quotations should be obtained when procuring materials, checks could be carried out to ensure that this is actually being met.
- To safeguard the company‘s assets
Some controls are designed specifically to ensure the assets of the company are protected from theft, destruction and that they are used in the best interest of the company.
This can either be directly through physical locking up or indirectly through recording. It includes assessing assets and ensuring that any access is authorised.
- ICS help in ensuring completeness and accuracy of the records maintained. The company‘s Act requires that a company keep proper books of accounts.
These records are the basis for the preparation of the financial statements.
- Strong internal controls help in preventing and detecting errors and frauds. The responsibility for the prevention and detection of fraud and error rests with management. This is achieved through the implementation and continuous operation of an adequate system of internal controls. Such a system reduces but does not eliminate the possibility of fraud and error.
- The disadvantages of rigidly adhering to a strong internal control system include:-
- Most internal controls tend to be directed at routine transactions rather than nonroutine transactions. As a result it is important to ensure that where necessary the internal control procedures are adjusted to cover any non routine transactions.
Rigidly adhering to the existing system could result in some transactions being carried out without appropriate controls.
- The potential for human error due to carelessness, distraction, mistakes of judgment and the misunderstanding of instructions. The possibility of this
happening could increase where employees rigidly follow an existing system. This
will undermine the effectiveness of the system iii) The possibility that management procedures become inadequate due to changes in conditions and compliance with procedures may deteriorate. If the existing system is rigidly followed without reviewing the control procedures to ensure that they address the current circumstances then this will undermine the effectiveness of the system.
The matters to be considered in respect of a system of internal control for cash sales in a service station are whether the internal control procedures operate as expected. I would expect to find the following controls in place: –
Each shift should have an overall supervisor who does not perform routine duties of filling the tanks. He should however, be responsible for receiving the money and checking that the pump meter reading is in accordance with the money received
from the pump attendant.
The fuel tanks should be dipped and quantity determined at the beginning and at the end of every shift. Thus a hand over register must be maintained and signed by
the supervisors as they take over or hand over on change of shifts.
Meter readings at the end and the beginning of every shift should be taken and reconciled to the readings from dipping.
Quantity reconciliation‘s should be carried out and differences investigated
Security measures should be in place to ensure that theft of stock is minimized and the cash collected is safeguarded.
A register should be maintained to monitor sales and stock quantities on daily basis.
A bank account should be maintained where all the day‘s collections are banked on a daily basis
If possible, the pump attendants should be assigned to specific pumps on a daily basis so that they can be held responsible for any shortages.
Use of modern electronic pumps that measure sales accurately.
Bank the sales regularly, so that as little cash as possible is kept in the station at any one time.
The mechanics undertaking the repairs should maintain a record of all the vehicles that they have repaired and the amount charged. A supervisor should
review this and the cash collected reconciled to the record.
The station should employ trustworthy people who should be properly trained in the roles that they perform at the station.QUESTION FOUR
In the course of the audit of ABC Stationers Ltd. for the year ended 30 June 2001, you have noted and recorded in the audit working papers, the following evidential matters:
- Flowcharts of the company‘s payroll prepared by your audit assistant backed up by tests of controls.
- An oral statement by the production director that the expected working life of plant acquired during the year is ten years.
- A letter to the managing director from the company‘s bank manager indicating that the bank intends to extend overdraft facilities for a period of one year.
- A list of items of inventory counted by a member of your audit team during observation of the company‘s annual stock count.
- A letter from a customer to your firm in reply to a confirmation request indicating agreement with the balance recorded in the books of ABC Stationers Ltd.
With respect to each matter listed above, explain its relevance to the overall audit objective of forming an opinion and reporting on the financial statements. (10 marks)
Explain your judgment on the reliability of the audit evidence obtained in five ways
listed above. (10 marks)
(Total: 20 marks)
(a) and( b)(i)
The audit assistant has used a flow chart to document his understanding of the accounting and internal control system over the company‘s procedure. This is an important step in the audit because it assists in building the auditor‘s understanding of the system. The test of controls are carried out where the auditor wishes to rely on some of the controls to reduce the level of substantive testing to be carried out on the payroll expenses. The results of the test of controls are therefore important to support the level of substantive testing that the audit assistant has planned to carry out and ultimately to support his conclusion on whether
there is any misstatement in the payroll expenses.This evidence is reliable because it has been prepared by the auditor and is in writing.
- The statement provides evidence as to the appropriateness of the depreciation policy adopted by management. This would be necessary to inquire further the reasons behind the choice of ten years as the expected useful life and where possible to get this in writing. Further evidence could be obtained by considering the useful
lives of similar items of plant in the past or consulting trade journals, which may detail the relevant information. If the depreciation policy adopted is considered reasonable then the auditor should re-compute the depreciation charge for the year
as a test for completeness and accuracy of what the client has provided for.
To make the oral representation from management more reliable the auditor should seek to obtain other information to corroborate what the directors have indicated.
- The letter provides evidence that the company will be able to access credit facilities in the next foreseeable future and therefore mitigate any factors that could be raising questions as to the going concern of the company. As the evidence is from a source external to the company, it is reliable but would be more so if the letter had been sent direct to the auditors.
- Attendance at a clients stock-take and performance of test counts provide evidence as to the existence of stock and whether the stock take was properly conducted and the whether the results can be relied upon. As the evidence was documentary, prepared by a member of the audit firm, and is based on physical inspection, it is very reliable. The items counted should be agreed to the final stock valuation by the client to confirm the completeness and accuracy of the stock valuation.
Direct confirmation from a debtor provides reliable evidence as to the existence and accuracy of the debtors figures included in the balance sheet as the evidence is documentary, and from a source external to the company. To further support the evidence, the receipt of cash from the debtor, after the year end could be checked
- Define and explain the meaning of an audit programme. (4 marks)
- List three disadvantages of using standardized audit programmes and how these
disadvantages can be avoided. (6 marks)
- Draft an online audit programme for the fixed assets of a large manufacturing company.
(Total: 20 marks)
An audit program sets out the nature, timing and extent of planned audit procedures required to implement the overall audit plan. Audit programmes consists of are a list of the audit objectives and the audit procedures to be performed by audit staff in order to obtain sufficient appropriate audit evidence and to be able to form a conclusion on the relevant account balance or event. The procedures consist of an appropriate mix of tests of control and substantive procedures based on the planned audit approach for each material financial statement assertion.
The program will also serve as a means of monitoring and co-ordinating the progress of an audit. The programme should be designed with columns alongside each procedure for staff members to enter their initials and date of completion of the performance of each procedure and to note the reference of the working paper detailing the results of the tests performed and conclusions drawn.
Audit programs may either be standardized or tailored to clients‘ requirements.
It used to be common for audit firms to preprint standardized audit programmes, usually one set for larger entities and another set for smaller entities.
The advantages were: –
- A consistent approach to all audits
- Reduced risk of procedures being omitted
- Reviewers could quickly check the progress of the audit being familiar with the contents of the programme.
- They stifle initiative in that audit staff consider procedures laid out in audit program as the maximum they need to do
- Different clients may require different procedures to be carried out yet with a standardized program, the procedures are the same.
- A lot of flexibility is required in the design of audit procedures so as to ensure all unique features of a client are addressed. This is not possible with a standardised audit program.
These disadvantages can be overcome by the use of tailored audit programmes. Although most firms continue to provide model audit programmes, these can be tailored to the specific circumstances of each engagement. The benefits of this approach are: –
- The design of procedures and the names of the documents and records detailed in the programme match the actual accounting system and the entity.
- The balance between tests of control and substantive procedures can be varied to match the preliminary assessment of inherent and control risk separately for each
major financial statement assertion.
- It provides engagement staff with greater control over the audit based on their knowledge of the entity and the specific audit risks. This, in turn, results in a better understanding of the purpose of each procedure since the staff member performing the procedure will have been involved in designing the programmes being followed.
AUDIT PROGRAMME AUDIT AREA: – Fixed assets Prepared by:
Period: Reviewed by:
- a) Tests of control:
Tests of controls
- Confirm that acquisitions and disposals of fixed assets are properly authorized.
- Verify that a fixed assets register is maintained and the balance reconciles to the ledger
Substantive procedures: –
Freehold and leasehold land and buildings:
Examine a sample of title deeds, land registry certificates, conveyance, documentation from solicitors and leases. Pay particular attention to any encumbrances i.e. mortgages or other securities held over assets. (This tests
ownership, right and obligations and disclosures).
Inspect directors‘ minute book to ensure all title deeds, conveyances, tenancy agreements and leases are properly authorized (occurrence). Check a sample of entries in the fixed asset register and trace back to source documentation to ensure assets are properly stated at cost. (valuation).
Review company policies for depreciation (with exception of freehold land) and ensure appropriate in the light of the useful life of the building (commonly over 50 years) and ensure that freehold land is not depreciated
(valuation and measurement).
Check a sample of calculations of depreciation and ensure that it is done accurately and in line with company policy (measurement).
Review assets and establish the need for any write down for impairments in value. Discuss with management (valuation).
If freehold or leasehold assets are let to third parties inspect tenancy agreements and perform analytical procedures on rental income (Rights and obligations).
Ensure freehold land and buildings are stated at cost or valuation less accumulated depreciation. If revaluation is performed in one year of audit, give the name and qualification of the valuer and state the basis of valuation
Physically inspect a sample of assets (existence).
Ensure that the fixed asset register reconciles to the nominal ledger.
Plant, machinery, fixtures and fittings
- Examine a sample of invoices contracts, finance leases or other evidence of
title to assets including vehicle registration documents (ownership).
- Review company policies for depreciation and ensure it is appropriate in the
light of the useful life of the assets.
- Check a sample of calculations of depreciation and ensure that it is done
accurately and in line with company policy (measurement)
- Review assets and establish the need for any write down for impairments in
value. Discuss with directors (valuations).
- Ensure that VAT is appropriately capitalized where it is not recoverable
(valuation). vi) Physically inspect a sample of assets (existence).
You have been the auditor of Crossborder Trading Company Ltd. for a number of years.
The company‘s head office is in Nairobi, Kenya and if has considerable overseas operations. At each accounting year end, there are large debts due from overseas agents of the company (Sh. 270 million out of total debts of Sh. 680 million as at 31 December 2000). In the past, these debts have always been settled after year end but you have insisted that the debts be the subject of a specific representation made by the company‘s director.
- Outline the purpose of a letter of representation from management to the auditor.
- Draft a paragraph for a letter of representation appropriate to the circumstances
described above. (3 marks)
- Outline the audit work which should be performed when seeking evidence to substantiate the management‘s representations as drafted and indicated the value of the directors‘ representations in these circumstances. You should present your answer
under the following headings:
- Existence and title. (3 marks)
- (2 marks)
- (2 marks)
- State what action you would take if the directors refused to provide you with a letter of
representation. (5 marks)
(Total: 20 marks)
- Representations by management are one source of audit evidence. They may be an important part of audit evidence in the audit of companies of all sizes.
ISA 580 management representations, requires that auditors obtain written confirmation of appropriate representations before the audit report is issued.
Representations are required:-
- To allow directors to acknowledge their collective responsibility for the
preparation of financial statements and to confirm that they have approved them.
- To confirm matters material to the financial statements where the representations
are critical to obtaining sufficient, appropriate audit evidence.
- Critical representations will be those where knowledge of the facts is confined to management (e.g. management‘s intention to dispose off major assets) and those where the matter is principally one of judgment and opinion (e.g. with respect to litigation process or on the trading position of one particular customer or the appropriateness of change in accounting policy)
NB: _ Representations are not a substitute for other evidence that should be available and auditors should ensure that representations are reasonable and consistent with the auditor‘s knowledge of the business. Any contradiction between the representations made and other evidence obtained should be thoroughly investigated.
- ―With respect to the debts due from the overseas agent, we acknowledge: –
- That we have included all such amounts as owed and no amounts outstanding are unrecorded.
- That as at 31 December 2000, the amounts owed by the agent total to Sh.270
- That there is no reason to believe that the amount is not recoverable from the agent overseas. However, in the determination of provision for doubtful debts, this figure is included to determine the general provision.
- Audit procedures
Existence and title
- Carry out a debtors circularisation i.e. send the debtor a circular. If they reply, then at least one can be assured they exist and whether or not they owe the company any money.
- Verify if there are any payments that have been received from these debtors after year end.
- In the absence of any contradiction, the directors‘ representations would be relied upon.
- I would check that the balance is made up of specific invoices relating to recent
transactions and enquiring into any balances which appear to be dispute or old.
- Verify if there are any payments that have been received from these debtors after year end.
- I would discuss with management the recoverability of balances that are in
dispute or appear doubtful.
- Seek any information that could indicate that some of the debtors might be unable to pay e.g. bankruptcy of a debtor.
- Compare the method of disclosure adopted by management with what is recommended by IAS and company‘s Act e.g. is the debt shown net of any provisions if necessary. Verify that the debtors are correctly classified as current assets;
- Management should confirm in their representation that they have disclosed all the relevant information in relation to debtors.
Management maybe unwilling to sign letters of representations. If management declines the auditor should inform management that he will himself prepare a statement in writing setting out his understanding of any representations that may have been made during the course of the audit and then sends this statement to management with a request for confirmation that the auditor‘s understanding of the
representation is correct.
If management disagrees with the auditor‘s statement of representation, discussions should be held to clarify the matters in doubt and if necessary a revised statement prepared and agreed. Should management fail to reply the auditor should follow the matter up to try to ensure that his understanding of the position as set out in his
statement is correct.
In rare circumstances the auditor may be completely unable to obtain written representations, which he requires. E.g. because of refusal by management to cooperate, or because management properly declines to give representations required on the grounds of its own uncertainty regarding that particular issue. In such circumstances the auditor may have to conclude that he has not received all the information and explanations required and consequently may need to consider qualifying his audit report on the grounds of limitation in the scope of the audit
- Describe the circumstance under which an auditor may be liable for damages for materials misstatements in published accounts on which he has expressed an audit opinion.
Under what circumstances can be avoid liability? (4 marks)
- Identify the categories of parties who may institute successful legal claims against an auditor emphasizing the basis a court of law would use to assess the value of damages. (7 marks)
- What specific actions can an individual auditor or audit firm take to minimize liability arising from audit risk? (5 marks)
(Total: 20 marks)
- The auditors‘ liability may be grouped into two: –
- Liability under statute either civil or criminal liability
- Liability arising from negligence under common law.
Liability for damages for material misstatements in published accounts, may arise from any of the following situations:
- His failure to detect material error or fraud, that he would have been reasonably expected to detect.
- Carelessness and/or dishonesty on the part of the auditor iii. Falsification of accounting records or documents
- Publishing a misleading statement intended to deceive members or creditors.
- In any proceedings for negligence, breach of duty or breach of trust, the court may
relieve the auditor from his liability if: – vi. He acted reasonably and honestly vii. Having regard to all circumstances of the case he ought fairly to be excused for the negligence or default. viii. If he carried out his work in accordance with generally accepted auditing standards.
- The company‘s Act recognizes the auditors responsibilities to: –
- His client whom he owes a primary duty of care.
- To third parties under tort of negligence.
- Government under criminal law.
Under the law of contract, only persons in a contractual relationship with the auditor can sue i.e. the client company.
NB:- Individual Shareholders do not have a contract with the auditor hence they cannot sue in contract.
In the tort of negligence, the plaintiff i.e. the third party must prove that:-
- The defendant (i.e. auditor) owes a duty of care.
- The defendant has breached the appropriate standard of care i.e. has been negligent
- The plaintiff has suffered a financial loss as a direct result of the defendants breach.
Audit risk may be minimized in two ways:-
- By ensuring that planning is adequate.
- By following ISA 220 on quality control
If an auditor plans an audit properly, those areas of the audit that are potentially risky will have been identified, and the auditor can ensure that resources are devoted to those areas to minimize the risk of misstatement in the financial statements.
- Ensuring that the audit objectives are known e.g. statutory audit only, and therefore ensure that the client accepts this by sending a signed copy of the engagement letter back to the auditor. The auditor is not looking for any immaterial fraud as this would not affect the true and fair view given by the financial statements.
- Planning the audit will ensure that work is directed to cover the whole of the company‘s accounting systems. Thus reviewing last year‘s files and discussions with management will identify all the accounting systems – adequate audit programmes can then be written to cover all of these systems.
- If particularly difficult or critical areas come to light then additional resources will be devoted to these to investigate the problem fully. Thus last year‘s file
may note a difficult stock-take; therefore an experienced senior may be sent to attend this year rather than a semi-senior or junior staff member.
The aim of planning, therefore, is to identify risk areas early in the audit and to ensure that appropriate action is taken to minimize the potential risk that they pose.
ISA 220 notes that if the auditor ensures that all jobs are done to a high standard, this in itself will minimize the amount of risk involved. A complete, well presented and referenced audit file is likely to prove of much more value in court than a shoddy and only partly referenced file.
Particular procedures to employ to ensure that audit work is of a high standard include:
- observing all Auditing Standards
before accepting any appointment, ensuring that there are no conflicts of interest between the firm‘s duty as auditors and other non-professional
situations e.g., client being a close relative;
- following from above, also ensuring that potential clients are of a good standing
e.g. not potentially insolvent; management have integrity.
- ensuring that the firm has the skills necessary to perform the service for the client e.g., detailed use of computer auditing if the client has a highly computerized accounting system;
- ensuring that consultative procedures are available to reconcile problems between staff and partners;
ensuring that full file reviews are carried out either by another auditing firm, or by another office of the same firm.QUESTION EIGHT
Your client, ABC Ltd. has a system for inputting purchase and expense invoice where the operator inputs the following from each item.
Order number (a code 2221 is used for items like electricity)
Supplier code number
Revision Questions and Answers
First four letters of nominal account name (entered on invoice by purchase department manager)
Nominal account code (entered by purchase department manager) Date Goods inward note number Net amount VAT amount
- Suggest manual operation and controls which might previously have applied to these invoices. (6 marks)
- Suggest input controls that might be applied by the program to these items. (8 marks)
- List some audit tests that could be applied to these items indicating the purpose of each
test and the relevant audit evidence obtained. (6 marks)
(Total: 20 marks)
Manual operations and controls that might have been applied to this invoice are:
- A proper system for the preparation of invoices:
- Independent preparation – invoices should have been prepared and sales journals entered up (or invoices summarized, where journals were not kept) by a section separate from the sales ledger sections. This section should also have been separate from the dispatch of goods and cash collection.
- Sales prices of goods should be authorized in writing. A responsible official, who should have been independent of the accounts department, should authorize discount and special terms.
- Controls to ensure that all invoices and credit notes are entered in the books.
- Pre numbering invoices – invoices and credit notes should have been pre-numbered and filed, after entry in the books in numerical order.
- The processed invoice should have been received and any missing numbers investigated. A responsible official independent of the sales ledger & cash receipts personnel should have authorized any spoilt, cancelled or altered invoice.
- A control to ensure that all authorized transactions are recorded in the sales ledger.
- Authorized invoices should be pre-listed determining a total for posting to an independent control account, before the ledger personnel process them. The totals of the ledger posting runs (both nominal and personal account) should have been agreed back to the control account.
Input controls serve to ensure the completeness, accuracy and authorization of input. To ensure completeness the following controls can be set up:
- One for one checks i.e. each input is checked to output.
- Batch control totals and hash totals. These controls are often used where documents (e.g. invoices) are grouped together and processed in a single block.
- batch total is the sum of one of the numerical fields on the documents in the batch e.g. gross amount of the purchase invoice. This total is calculated normally and the documents are then input into the computer. The computer then calculates the batch total and this is compared with the manually calculated total. If they are different, then an error has occurred, perhaps an invoice value has been mis-keyed or a document may have been omitted from input altogether.
A hash total works in exactly the same way as a batch total but a different type of field is used e.g. the supplier code number. Unlike the batch total, the value of the hash total is meaningless but is still used for control purposes to detect errors on input or omissions.
- Document counts.
- Sequence checks.
- Matching each master file record to a transaction record.
To ensure accuracy, the following controls can be set up:
- Check digits
These are a means of control in that they ascertain whether or not a number is valid. A formula is used to calculate the number itself. The computer will then detect if the number is ever input correctly.
- Reasonableness: Checks to ensure data is within certain ranges.
- Existence checks: e.g. to check that the supplier account exists.
- Manual controls e.g. batch and arithmetic checks.
To ensure input is properly authorized, the following controls can be set up.
- Manual authorization
- Clerical review of transactions.
- One for one checking of amendments to standing data. – Programmed checks on authorization limits.
- Audit Tests
- The auditor should inspect the invoice for the date to ensure that it relates to the client‘s financial period.
- The auditor should consider whether the supplier‘s name appears on the list for authorized suppliers of the company to determine whether orders to such supplier are authorized.
- The auditor should recompute the value of the invoice and compare with that on the invoice to ensure arithmetic accuracy of the invoice.
- The auditor should compare the goods inward note content with the stock records to ensure that goods were infact received by the company.