JUNE 2012                                                                                                    3 hours


Answer any FIVE questions. ALL questions carry equal marks.



(a)         List and briefly explain four objectives of an audit of financial statements.  (8 marks)

(b)             Outline and explain four ways in which the objectives of an audit of financial  statements have changed over the years.   (8 marks)

(c) It is often argued that: ―The external auditor adds credibility to the financial statements produced by a business entity.‖


Briefly comment on this statement.                                              (4 marks)

(Total: 20 marks) 





( i)


Forming an Opinion

The main objective to enable auditors to express an opinion as to whether the financial statements give a true and fair view of the state of affairs of the company in question, and whether they‘ve been prepared in accordance with the applicable reporting framework.

( ii)



Audited financial information portray a positive image of an entity. It shows to the public what the entity is in existence for and the purpose of its activities. This reduces suspicion and improves relations with external entities.

( iii)


Detection and Prevention of Frauds

Though not the principle objective of an audit the procedures set out by the auditor to achieve this objective highlights to management the weaknesses of the company‘s control system and puts on alert anyone who may have intention of defrauding the company.

( iv)



Assistance in clerical accounting work and advice

The auditor should ideally not involve himself in the operations of the entity. He should not take any part of decision making and neither should he make it a primary concern to prepare the entity‘s financial statements. However, in the course of his work, the auditor could assist client staff in basic accounting functions and once in a while advice management on proper course of actions to take depending on circumstances in question.

( i)


Separate Entities

Over the years, the company, as a legal entity has come into existence. This is distinct from the owners (shareholders) of the entity (company) hence the objective in recent years has been to protect the interests of these shareholders. It entails reviewing the work of directors (managers).

( ii)


Approach Shifting

The emphasis in approaching an audit has shifted from detailed checking of individual items towards an overall review of the systems in operation followed by an examination of the records and financial statements prepared thereof.

( iii)



With emergence of technology, companies have embraced the use of computers. For an auditor, the primary objective is the same though he now has to understand the functioning of a computer, understand the client‘s computer information system, for him to carry out a good audit.

( iv) Auditor‘s legal position

With change in legal system, the auditor has been forced to assess his risk before taking upon himself any engagement, to reduce any liability as a result of loss suffered by third parties. This has made it an objective for an auditor to carry out a risk assessment with respect to a client‘s business.




While an internal audit function deals with appraisal of the internal activities through monitoring, examining and evaluating the adequacy and effectiveness of accounting and internal controls for management purposes, it may not be sufficient since the process is likely to be subjective. An external auditor is objective and comes in with more robust procedures to carry out the same appraisal, mainly for external reporting as well.


An internal auditor is answerable to management hence is more prone to manipulation to give a positive view. An external auditor is independent and his main concern is whether the financial statements are free from material misstatements.


The external auditor has sole responsibility for the audit opinion expressed and that responsibility is not reduced by an use made of internal auditing. All judgements relating to the audit of the financial statements are those of the external auditor.


  • Clearly outline the statutory responsibilities of an external auditor in relation to the audit of a company‘s financial statements. (6 marks)
  • What are the responsibilities of the directors of a company in relation to a

company‘s financial statements?                                           (6 marks)

( c)        (i)Briefly explain the nature and purpose of a letter of engagement.  (4 marks)

(ii)        Under what circumstances would it be appropriate for an external auditor    to issue a new letter of engagement?            (4 marks)

(Total: 20 marks)


  1. Preparation of Audit Report

It is the statutory responsibility of the external auditor to make a statement/report arising from his examination of the books of account.


  1. Stating explicitly


  • Whether he has received all information and explanation which to the best of his knowledge is necessary for his report.
  • Whether the financial statements portray a true and fair view of the company‘s state of affairs.
  • Whether he has received adequate return submitted from branches.
  • Whether the company has kept proper books of accounts.

All the above should be included in the Auditor‘s report.

  • Call for confirmation     This would be with respect to;
  • Whether the company‘s securities cover its bans adequately.
  • Whether personal expenses have been charged to profit & loss a/c.
  • Working papers

The auditor has the duty to prepare working papers and to avoid them to investigators investigating the company affairs.


  1. v)        Certification of financial statements

It is the auditor‘s duty to certify the profit and loss account and other financial statements in the company‘s prospectus and also when managing trustees resign.


  1. It is the directors‘ duty to prepare financial statements which show a true and fair view of the financial affairs of the company.
  2. They should ensure that these financial statements are prepared in accordance with recognized International Accounting Standards and guidelines.
  • Ensure that the financial statements comply with the Companies Act as far as
  1. The directors have a responsibility to maintain proper books of account required by the Companies Act. These include journals, registers schedules etc necessary to record all the transactions of a company.
  1. They should ensure that the financial statements are in agreement with the underlying books of account.




  1. Ensure that the financial statements are timely availed to all users. This demands that they co-ordinate the accounting staff properly.


  1. c) (i)

A letter of engagement is basically a statement issued by the auditor to his client preferably before the commencement of the audit to help avoid mis-understandings with respect to the engagement.


The letter documents and confirms the auditor‘s acceptance of the appointment, the objective and scope of the audit, the extent of auditor‘s responsibilities to the client and the form of any reports.


It enables the client and auditor know and understand their responsibilities. It also reminds management of their duty towards accounts and the internal control system.


It would be helpful to the auditor in case of supporting himself when charged with negligence.



  • When there is indication that the client mis-understands the objective and scope of the audit or he issues new instructions.
  • There is a revised or special term of engagement.
  • When there is recent change in senior management, B.O.D or ownership.
    • afeguarding of assets. This could entail physical controls such as lock and key, documentation e.g. asset register. The auditor is interested in knowing that thehen there‘s significant change in nature and size of client‘s business. – Legal requirements or enforcement of a new auditing guideline etc.


      • What are the objectives of an internal control system? (4 marks)
      • Identify the basic division of duties one would expect to find in an internal control

      system.                                                                                     (4 marks)

      • List the main control features one would expect to find in the following activities related to the buying function in an organization:
        • Buying of goods (4 marks)
        • Receipt of goods (4 marks)
        • Payment of outstanding balances. (4 marks)

      (Total: 20 marks)


      1. a)
      2. Carry out business of an entity in an orderly and efficient manner to satisfy the needs of different stakeholders e.g. shareholders.
      3. Ensure adherence to management policies. These policies provide one of the framework within which the internal control system operates.
    • Through sequence checking, it‘s possible to verify that all credit customers dealt with over the accounting period are indeed in the debtors‘ control account            ient‘s assets have been subjected to safeguarding controls.
      1. Prevention and detection of fraud and error.
      2. Ensure accuracy and completeness of accounting records. vi. Ensure the timely preparation of reliable financial information.


      1. c) With respect to transactions the following segregation of duties could be applicable:


      1. Authorisation:

      This function should be segregated such that different managers are given positions of authority depending on position in the organization, remuneration, qualification etc.


      1. Execution of Duties

      This limits authority i.e. a person who authorizes a given transaction can not execute it that is carry it out.


      • Custody of resultant assets

      An official organizing a given expenditure shouldn‘t keep on asset arising from such an expenditure.


      1. Recording

      This should be done by a person with sufficient knowledge and expertise and who is accorded powers to record transactions.



      1. Buying of goods
        • Only goods/items that are needed by the organization are ordered for clear indication of type and quantity of each item should be shown.
        • All orders should be made out of the company‘s order forms and signed by the purchasing officer after verification from the manager of the requisitioning
        • Purchasing of goods should be from authorized supplies, approved by the Board for the given period.
        • There should be controls to ensure all purchase invoices have been received and correctly entered in the books.


      1. Receipt of goods
        • Goods should be inspect on receipt without delay to ensure that they all are the goods which were ordered and that they are in good condition.
        • Goods received note should be serially numbered and all numbers accounted for by person independent of the receipt and ordering.

      Invoices should be checked against Goods Received Note before payment.

      • A listing and evaluation of unmatched goods received enables unrecorded liability for goods taken into stocks, but for which no invoices have been received to be ascertained.


      • Payment of Outstanding balances
        • There should be schedule indicating creditors against duration of dues before authorization for payments.
        • Before payment, a responsible official in accounts department should approve the invoices. This person should be independent of those responsible for any purchasing function.
        • Before approving invoices for payment, the official should see that invoice shave properly been initiated to him and evidenced that checking is complete.
        • Cheques written to respective creditors should have been authorized by all the signatories for transactions involving material sums of money.



      (a)        Identify and explain four factors that would influence the size of a sample selected   by an external auditor to enable him carry out a compliance test.         (8 marks)  (b)     In the context of audit sampling, distinguish between the following terms:

      • Sampling risk and non-sampling risk (4 marks)
      • Tolerable error and expected error (4 marks)
      • Audit risk and detection risk (4 marks)




      1. Auditor‘s Intended reliance on systems of control

      If the auditor has more assurance or intends to obtain more assurance from accounting and internal control systems, it means his assessment of control risk is low and for this reason a larger sample size will be needed. This is because the auditor needs to gather more audit evidence to support his assessment of control risk.


      1. Tolerable Error

      This refers to the rate of deviation from the prescribed control procedure the auditor is willing to accept. The lower the rate of deviation the larger the sample size needs to be.


      • Expected Error

      This is the rate of deviation from the prescribed control procedure the auditor expects to find in the population. The higher the expected error, the larger the


      sample size needs to be so that the auditor can be in a position to make a reasonable estimate of the actual rate of deviation.


      1. Confidence Level Required by Auditor

      The greater the degree of confidence that the auditor expects/requires that the results of the sample are in fact indicative of the actual incidence of error in the population, the large the sample size needs to be.


      1. Number of sampling units in the population

      This factor mostly affects small businesses, where population is likely to be small. For large populations, the actual size of the population has very little effect on sample size. However when population is small, audit sampling may not be as efficient as alternative means of obtaining sufficient appropriate audit evidence.



      1. Sampling Risk and Non-Sampling Risk

      Sampling risk is the risk that the auditor‘s conclusion, based on a given sample may be different from the conclusion reached if the entire population were subjected to the same audit procedure i.e. either the auditor wrongly concludes that control risk is higher than it actually is or that a material error exists when in fact it does not.


      Non-sampling risk refers to risks arising from factors that cause the auditor to reach an erroneous conclusion for any reason not related to the sample size e.g. use of inappropriate procedures on the mis-interpretation of audit evidence.


      1. Tolerable Error and Expected Error

      Tolerable error refers to the maximum error in the population that the auditor would be willing to accept and still conclude that the result from the sample has achieved his audit objective.


      Expected error on the other hand refers to the rate of deviation from the prescribed control procedure that the auditor expects to find in the population. This determine the sample size taken by the auditor i.e. the higher the expected error, the smaller the sample size.


      • Audit Risk and Detection Risk

      Audit risk is the chance of damage that may occur to the audit firm as a result of giving wrong audit opinion. This could be in form of monetary damages to client as compensation or loss of reputation.


      Detection risk is part of audit risk and is the risk that an auditor‘s substantive procedures will not detect a misstatement in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes.



      (a)        Explain the importance of preparing regular bank reconciliation statements.

      (4 marks)


      ( b)       Explain the reliability of bank statements as audit evidence.            (4 marks)

      (c)           Outline the audit work you would undertake to obtain reasonable assurance that

      the following items appearing in the balance sheet of Ujuzi Ltd. are not materially misstated:

      • Trade creditors(6 marks)
      • Specific provision for bad and doubtful debts. (6 marks)

      (Total: 20 marks)



      1. There is need for an entity to keep abreast with bank transactions directly affecting this entity‘s operation. Bank charges and standing orders never get to reach the

      client‘s cashbook until a bank reconciliation is carried out.

      1. Uncredited deposits. Certain payments by customers using cheques will be recorded in the cashbook, but before the cheque reaches the bank, there will be inconsistent balances between cash book balance and bank balance hence a need for reconciliation.



      reason hence inconsistent balances between entity‘s cash book and their bank.

      1. Direct Deposits. These are, for instance monies received by an entity through its bank account without prior notice. This receipt will thus not be reflected in the cash

      book until a bank statement is received when reconciliation can be done.

      1. Bank reconciliation statements clear any misunderstandings between the entity and their bank since all transactions by both parties are accounted for in one statement

      for sake of clarity.

      1. Assist in the prevention of fraud. This is because, any discrepancy that causes mismatch between bank balance and cashbook balance will be thoroughly scrutinized, hence making it undesirable for one to commit fraud.



      Given the fact that a bank statement is an audit evidence from an external source, it‘s more reliable than if it were generated from within the entity. This is because an internal source of evidence is more likely to be distorted, intentionally or otherwise, than an external source of audit evidence.


      A bank statement is in document form hence more reliable than if it were, say oral, since in the case of documents, references and confirmations can easily be carried out.


      If the auditor directly makes an inquiry in writing, to the client‘s bank, then the bank statement would be a reliable audit evidence than if one of client staff was to do this.


      However, internally generated audit evidence, say the bank statement was brought from a file in the client‘s office, would be reliable if the systems of internal controls were effective.



      i) Trade Creditors
      Obtain a schedule of the trade creditors with appropriate age analysis and check
      this with the control account of the creditors ledger.
      Review the individual accounts with the largest through put of transactions
      during the period.
      Debit and credit balances should be separated; debit balances should be
      included in debtors (grossing up(.
      Review the year-end cut-off procedures for purchases.
      Review the internal control over the purchases system which ensures that all
      goods received are properly recognized as liabilities of the entity.
      On testing individual balances that are suspicious, consider:

      Is the balance made up of specific items outstanding within a reasonable





      Have all the items been authorized for payment?

      Can the amount be reconciled with creditors statement?

      Perform analytical procedures on creditors, comparing age analysis with previous periods and creditors days.
      ii) Specific provision for bad and doubtful debts

                    For customers who are considered potential risks (hence provision made)

      review previous experiences with the particular debtor.

                To justify the specific provision, the debtor must exist, hence auditor should

      send debtors‘ circulirasion to the respective debtor(s).
      • Carry out an age analysis for all debtors. Specific provision is made for longstanding debts.



      • Review post balance sheet events to verify whether debtor paid hence need to

                     cancel the provision earlier made.

      • Check authority for making the provisions (specific)

      For debts considered risky, review the respective individual accounts of the customers and those that appear irregular by nature, composition or size of the balances or transactions therein.




      • What are ―errors and irregularities‖ in the contest of an external audit of a limited

      company?                                                                                 (2 marks)

      • Briefly explain the ways in which the directors of a company discharge their duties             with regard to the prevention and detection of errors and irregularities. (8 marks)
      • You have recently been appointed external auditor of ABC Ltd. What typical   planning procedures would you undertake when planning the audit of ABC Ltd.? (6 marks) (d)             Identify four common problems that may hinder the proper implementation of an         audit plan.         (4 marks)

      (Total: 20 marks)



      1. a) Error: it is used to refer to unintentional mistakes in financial statements, such as:
      • Mathematical or clerical mistakes in the underlying records and accounting data.
      • Oversight or misinterpretation of facts -Misapplication of accounting policies.


      An irregularity is a lack of compliance with set procedures and controls by either a staff or the management.


      1. b)

      Management/directors will first discharge their duties by setting up systems of internal controls (assuming non existed before). This should be consistent with policies laid down.


      Directors should be the first to adhere to the Internal control system since the employees will do what the directors do with respect to the controls. Director: should thus ensure adherence to the internal control systems and ensure any new employee is made aware of this.

      Directors should constantly review the internal controls to ensure they are being followed and in the event of any loop hole that could result in an error or irregularity, they should be made aware immediately so as to take the necessary steps.


      Constant review and assessment of staff members should be done by management without notice. This will make staff to be alert and vigilant hence chances of errors will be reduced.


      Directors should implement a thorough training session for new employees and emphasize the need for accuracy and competence in assignments and the need to comply with laid out policies.


      Directors could reward competent employees, say with a promotion due to their astuteness and accuracy in their work. This will motivate other employees to follow the same, hence reducing possibilities of continued commission of errors.


      1. c)
      2. Knowledge of the Business. This entails getting information on general economic factors and industry conditions affecting client‘s business. Also ascertaining,

      important characteristics of the business is necessary.

      1. Understanding the Accounting and I.C.S: The auditor should find out to what extent he can rely on the client‘s internal control system.
      • Risk and Materiality: The auditor should identify audit risk areas and inform his team about them. He should consider setting materiality levels.
      1. Nature, timing and extent of procedures: auditor should ascertain the possibility of change of emphasis on specific audit areas; time spent on the various audit areas should be budgeted for.



      1. Coordination, Direction, Supervision and Review: Here, the auditor considers the involvement of other auditors in the audit of components e.g. subsidiaries. He‘ll

      also consider need for experts, staffing requirements and areas to visit.

      1. Terms of engagement: These should be formally recorded and agreed with the
      • Extent of internal audit department involvement: The auditor would consider the degree of reliance on client‘s internal audit department.
      • Effect of Accounting and Auditing Standards: Auditor should consider the effect of accounting and auditing standards on the audit work.


      1. Size and complexity of client‘s entity: The amount of audit work may overwhelm audit staff later on despite proper planning, as a result of increasing audit and

      verification procedures, need to visit all branches etc.

      1. Auditor‘s other assignments: the auditor could have two client firms with same calendar/accounting year ends hence he faces a problem of staffing.
      • Lack of management support: If the support the auditor was expecting from management is not forthcoming, he may have to change the audit plan, say, seek

      alternative evidence. This may mess up his whole plan.

      1. High Control Risk: if material mis-statements are not detected by the internal control system, the auditor may form a wrong opinion or have to review all his audit procedures which is time consuming.



      • What is the purpose of an audit report? (2 marks)
      • List six contents of an unqualified audit report (6 marks)
      • Identify and briefly explain four situations under which an auditor would consider qualification of his audit report. (8 marks)
      • Explain the meaning of the following terms in relation to audit reports.
        • Limitation in the scope of the audit. (2 marks)
        • Emphasis of matter (2 marks)




      The purpose of an audit report is to reflect a clear written expression of the auditor‘s opinion on the financial statements taken as a whole. This entails indicating explicitly whether the financial statements give a true and fair view of the state of affairs of the company.


      The auditors have a statutory duty to make a report to the members on the accounts examined by them and on the financial statements, at the A.G.M, during the period they hold office.



      1. Opening Paragraph

      This identifies the financial statements of the entity that have been audited.


      1. Scope Paragraph

      Indicating that all information and explanations necessary for the opinion were provided.


      • Opinion Paragraph

      That the financial statements presents a true and fair view of the operating results and financial position of the organization.


      1. Books of Account

      That proper books of account were kept and these met the requirements of the Companies Act.


      1. Financial Statements and Underlying records

      That financial statements prepared reflect a true and fair view and agree with the underlying records including the books of account.


      1. Date of the report vii) Auditor‘s address and signature.




      1. Subject to Qualification

      This indicates that there are some material matters about which the auditor has reasons to disagree.


      1. Except for‘ qualification

      This indicates that there are some material matters which have quite significant effect and thus the financial statements give untrue information e.g. where no provision is made for doubtful debts.


      • Adverse Qualification

      Here, there is disagreement over a particular matter which is not only material but also fundamental. E.g. non-compliance of accounting principles.


      1. Disclaimer‘ Qualification

      Here, the auditor refuses to express any opinion. For instance where there is uncertainty regarding some item of financial statements or it is not possible to substantiate Cash transactions.



      ( i)        Limitation in the scope of the audit

      This arises in a situation where in the auditor‘s duties have been compromised by the entity, e.g. where the terms of engagement specify that the auditor will not carry out an audit procedure he believes is necessary. In such a case, the auditor would attempt to carry out reasonable alternative procedures to obtain sufficient appropriate audit evidence to support an unqualified opinion.


      ( ii)       Emphasis of matter

      This is a statement included in a note to the financial statements to highlight a matter affecting the financial statements. This statement does not affect the auditor‘s opinion. It would preferably be included after the opinion paragraph and would ordinarily refer to the fact that the auditor‘s opinion is not qualified in this respect. The matter could be with respect significant uncertainty about a going concern problem, the resolution of which is dependent upon future events and which may affect the financial statements.



      ( a)        What are computer assisted audit techniques (CAATs)?                  (3 marks)

      • Briefly explain the following terms in relation to the audit of          computerized accounting systems.
        • Lack of visible evidence.(3 marks)
        • Systematic errors. (3 marks)
        • Test data (3 marks)
      • Explain how you would use a computer audit programme to verify the year-end             debtors balances.            (8 marks)

      (Total: 20 marks)



      1. a) CAATs are procedures which are performed through a computer. The audit approach thus shifts from conventional to the use of computer system. Use of CAATs is governed by ISA 1009 and describes two of the main types of CAATs as:
      • Audit Software
      • Test Data



      The elements of the auditors’ report include the following: (ISA 700)



      Appropriate title-The auditor‘s report should have an appropriate title such as ‗the independent auditors report‘ to distinguish the auditor‘s report from any other reports   that may be annexed to the annual report and financial statements.



      Addressee-The Auditor‘s report should be appropriately addressed as required by the circumstances of the engagement and local regulations. Usually the auditors report is   addressed to the members on whose behalf the audit is carried out.


      Introductory Paragraph-This identifies the Financial Statements audited including the date of and period covered by the financial statements. Under the Companies Act, financial statements or accounts consist primarily of the Balance Sheet, Profit and Loss account and notes to the account. International Accounting Standards on Cash Flow Statements requires auditors to recognize the Cash Flows as     part of the Financial Statements;



      Paragraph on the scope of the audit-The auditor‘s report should describe the scope of the audit by stating that the audit was conducted in accordance with the International Standards on Auditing (ISAs) or in accordance with relevant national standards or practices as appropriate. Scope refers to the auditor‘s ability to perform audit procedures deemed necessary in the circumstances. The report should include a statement that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material   misstatements. The auditor‘s report should describe the audit as including;



      Opinion Paragraph– The report should clearly state the auditor‘s opinion as to whether

      the financialreporting framework and whether they comply with the companies Act requirements. statements give a true and fair view in accordance with the relevant financial

      The terms used to express the auditor‘s opinion are ―give a true and fair view‖or―presents fairly, in all material respects‖ and are equivalent. Both terms indicate, amongst other things, that the auditor considers only those matters   that are material to the financial statements.



      Dating the audit report– the auditor should date the report as of completion date of the audit. This informs the reader that the auditor has considered the effect on the financial statements and on the report of events and transactions of which the auditor became   aware ad that occurred up to that date.



      Auditor‘s address-The report should name a specific location, which is ordinarily the city where   the auditor maintains the office that is responsible for the audit.



      Auditor‘s signature-The report should be signed in the name of the audit firm, the personal  name of the auditor or both, as appropriate.



          since each debtor is sequenced.

    • Summary processing. Here the totals of debtors balances are tested for completeness and accuracy by comparing them with the sum calculated in the control accounts.
    • Record counts and cash totals will assist to verify whether the debtors balances in the master files tally with final balances in the balance sheet.
    • Verify accuracy and completeness of debtors transactions, say on a weekly basis by use of batch totals.
    • Given the client deals with customers in transactions not exceeding a certain amount ofmoney e.g. Kshs. 100,000 at a go, programmed check digit verification could be used where a check digit is included in a reference number (the amount in figure) and is arithmetically checked to ensure it bears the required relationship to the rest of the

    numbers (amounts) and not any in excess.

    • Programmed reasonableness checks to check whether there is any transaction with a debtor involving huge amounts of money that could be material.

    Programmed existence checks. Here customers would have codes to identify them uniquely hence this check ensures/verifies existence


    Unpresented cheques. These also need to be reconciled since the accounting year end may arrive before a certain cheque issued to a customer and credited as such in the cashbook, has not been presented for payment by customer for whichever


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