AUDITING AND ASSURANCE May 2009

 

QUESTION ONE

• Give four merits of using a flowchart to record an accounting system. (4 marks)
• Explain how an Internal Control Evaluation Questionnaire (ICEQ) differs from an

Internal Control Questionnaire (ICQ).                                                (4 marks)

• List six examples of key control questions that would be suitable for inclusion in an

ICEQ for a wages accounting system.                                                      (6 marks)

• Explain the meaning of the following audit terms:
• Tests of control. (3 marks)  ii. Substantive tests.  (3 marks)

 

(4 marks)

 

QUESTION ONE

 

(a)	A flow chart is a diagrammatical representation of an accounting system. Use of
	flow charts has the following advantages: –
	•         Easy to prepare •         Since the information is presented in a standard form, flow charts are easy to
	follow and review.       They generally ensure that the system is recorded in full, all the documents have
 	to be traced from beginning to the end.  They eliminate the need for lengthy narratives and can be very effective in highlighting the salient features of internal controls and any weaknesses in the system.
(b)	The main difference is that an internal control questionnaire (ICQ) is used to determine whether controls exist which meet specific control objectives whereas an internal control evaluation questionnaire (ICEQ) is used to establish whether specific errors or frauds could occur rather than establishing whether certain desirable controls are present. Only few key control questions are used concentrating on the significant errors or omissions that could occur at each phase of a transaction cycle.
(c)	Is there reasonable assurance that: – (i)                Employees are only paid for work done? (ii)              Employees are paid the correct amount (gross and net)?
	(iii)             The right employees actually receive the right amount? (iv)             Accounting for payroll costs and deductions is accurate? (v)              Employees paid are bonafide employees of the organization and not ghost
	workers? (vi)        Payroll deductions are not misappropriated.
(d)	According to the ISA glossary on definition of terms, the following terms are defined as:- (i)                   Tests of Control: – These are tests performed to obtain audit evidence
	about the effectiveness of the: – a. Design of the accounting and internal control systems that is, whether they are suitably designed to prevent or detect and correct material
	misstatements. b. Operation of the internal controls throughout the period. Tests of controls therefore aim at determining whether the identified controls have operated effectively as designed throughout the financial period and can be relied upon to reduce the extent of substantive
	testing. (ii) Substantive procedures refer to tests performed to test the management assertions made in the preparation of financial statements. They are of two types: –

• Tests of detail of transactions and balances
• Analytical procedures

 

These procedures seek to provide audit evidence as to financial statement assertions such as completeness, existence, valuations, occurrence, measurement, rights and obligations and presentation and disclosure.

 QUESTION TWO

• Explain the meaning of the ‗audit evidence‘.
• Write a brief explanatory notes on the following terms in relation to audit evidence:
• Relevance. (2 marks) ii. Reliability. (2 marks) iii. Sufficiency.             (2 marks)
• Describe the various procedures of obtaining audit evidence giving an example of each     by way of illustration.     (10 marks)

(Total: 20 marks)

QUESTION TWO

 

• Audit evidence refers to the information obtained by the auditor in arriving at the

conclusions on which the audit opinion on the financial statements is based. Audit evidence comprises source documents and accounting records underlying the financial statements and corroborating information from other sources. For example a confirmation from the bank on the client‘s bank balance is evidence that

the auditor could use in verifying the existence of the bank balance.

Audit evidence is obtained by carrying out both compliance and substantive              procedures.

• Relevance of audit evidence
  • Relevance refers to the ability of the evidence to assist the auditor in testing management‘s assertions or to test the audit objective;
  • Relevance of audit evidence should be considered in relation to the overall audit objective of forming an opinion and reporting on the financial statements. To achieve this objective the auditor needs to obtain evidence to enable him to draw reasonable conclusions on various management assertions made in preparing the financial statements.

 

Reliability of audit evidence

 

The reliability of audit evidence refers to the credibility of the evidence.

This credibility is influenced by its source; whether from internal sources or external sources and by its nature; whether visual, documentary or oral. Reliability of the evidence depends on individual circumstances but we can make the following

generalizations:

n

Audit evidence from external sources e.g. a third party (e.g. a debtor) confirming amount     owing to the company is more reliable than evidence generated internally;

n

Audit evidence generated internally e.g. from accounting records is more reliable when the  

• related accounting and internal controls are effective;

n

Evidence obtained by the auditor himself is more reliable than that obtained from the

• entity;

n

Evidence in the form of documents and written representations is more reliable than oral   representations.

 

Sufficiency of audit evidence

 

• Sufficiency is the measure of the quantity of audit evidence;
• Sufficiency is therefore the question of how much information is needed to be able to conclude on the financial statements.

 

Procedures of obtaining audit evidence:-

 

• Inspection:- This is the physical review of examination of records, documents and tangible assets. An example of a test of control is examining sales invoices for authorization: An example of a substantive procedure would be to check the physical existence of a tangible asset. Additional work may be required to determine ownership, valuation and contractual obligations.

 

 

 

• Observation:- This involves looking at a process or procedure being performed. An example is the distribution of wage packets to see that internal control procedures are adhered to or the observation by auditors of stock being counted in accordance with stock taking instructions.

 

• Enquiry and confirmation: – Seeking relevant information from knowledgeable persons inside or outside the enterprise, whether formally or informally, orally or in writing. The reliability of this technique depends on the qualification and integrity of the source. An example is the seeking of formal representations from management on the value of a material subsidiary company in an overseas country or the circularization of debtors

for independent verification of year-end balances.

.

• Computation: – This involves checking the arithmetical accuracy of records or performing independent calculations e.g. recomputing the depreciation charge and comparing with the client‘s figure.

 

• Analytical review- Analytical review can be defined as the study of

relationships between element of financial information expected to

conform to a predictable pattern based on the organization‘s experience

and between financial information and non-financial information. Analytical procedures concern not only analysis (of ratios, trends and

relationships) but also the investigation of fluctuations. The analysis usually

considers both comparisons and relationships.

For example the auditor can compute the debtors days ratio for the current year and compare this with the previous year. This will provide valuation information in evaluating whether customers are settling their accounts when due and if there is need to create a provision for doubtful accounts.

QUESTION THREE

 

The director of one of your growing clients have decided to create an internal audit function in their organizational structure.

 

Required:

• List and briefly describe the duties you would expect the internal audit staff to perform.

(10 marks)

• List and explain the criteria which you would consider before deciding to rely on the

work of the internal audit function.                                                              (5 marks)

• State the extent to which you, as an external auditor, can rely on the work of the internal

audit function.               (5 marks)                       (Total: 20 marks)

QUESTION THREE

 

• Internal audit is an appraisal or monitoring activity established by management for the review of accounting and internal control systems as a service to the entity. It examines, evaluates and reports to management on the adequacy and effectiveness of the systems.

 

Other activities include:-

 

• Review of the accounting and internal control systems. Management is responsible for establishing an internal control system. These systems demand proper attention and continuous review, a function that is usually assigned to internal audit. The internal audit function designs a work plan that shows the areas and control procedures that will be reviewed during the year.
• Carrying out examination of financial and operating information. This may

include detailed testing of transactions and accounting and operating procedures.

• Review of the economy, efficiency and effectiveness of operations including non-

financial controls of an entity.

• Review of the entity‘s compliance with laws and regulations. The internal audit function reviews whether the company has put in place appropriate procedures to ensure that all the relevant laws and regulations are adhered to. This will include review of adherence to laws such as taxation legislation, stock exchange

listing regulations among others.

• Review of the entity‘s compliance with management policies and other internal

requirements

• Carrying out independent investigations into the affairs of the company as required by management. The internal audit function will carry out investigations e.g. where frauds are suspected, where there is suspected inefficiency in the use of the company resources e.t.c

 

• Before deciding whether to rely on the work of the internal audit function with the intention of reducing audit procedures the external auditor should evaluate the internal audit function to determine the scope of the function, its independence and hence how much reliance can be placed on the work that it carries out. The external auditor can only rely on the work of the internal auditor as one element of the internal control system.

 

In evaluating this function the external auditor should consider the following factors:

 

• Organization status

Since internal audit function is part of the entity it cannot be totally independent. To boost it‘s independence the status of the function within the organization should be such that the internal auditor reports to the highest level of management. The internal auditor should also be free of any other operating responsibility such as performing accounting functions, which may conflict with his role as an independent watchdog of controls and operations of the entity. There should be no restrictions placed upon his work by

management. Such restrictions could impair the effectiveness of the function.

• Scope of the function

The external auditor should ascertain the nature and depth of coverage of internal audit assignments. He should also ascertain whether management considers and acts upon internal audit recommendations. Where the recommendations are not acted upon this represents a weakness in the

                     function and hence the level of reliance should consequently be reduced.

• Technical competence

The external auditor should ascertain whether internal audit work is performed by persons having adequate technical training and proficiency as auditors.

Qualifications and experience of the internal audit staff should be considered.         

 Due professional care

The external auditor should ascertain whether internal audit work appears to be properly planned, supervised, reviewed and documented. Exercise of due professional care is evidenced by the existence of adequate audit manuals, work  programs and working papers. 

Internal audit reports

The external auditor should consider the quality of the internal audit reports prepared and submitted for management action. He should ascertain whether management considers, responds to and acts upon internal audit reports and  whether there is evidence to prove that action. 

 Level of resources available

The external auditor should consider whether internal audit has adequate resources to be able to carry out their duties effectively. Such resources would include staff and computer facilities.

 

  When an auditor decides that he can place reliance on the internal auditors work, the extent of his reliance will be influenced by the results of his evaluation of the internal auditors work.

 

This evaluation will involve:-

 

• Discussion with the clients internal auditor about the timing of internal work, test levels, sample selection and the form of documentation to be
• Consideration of:-

Revision Questions and Answers

• The materiality of the items or areas to be tested, and also of the

information that can be obtained from internal audit.

• The level of audit risk inherent in the areas or items to be tested or in the information to be obtained.
• The level of judgment required
• The sufficiency of complementary audit evidence
• Specialist skills possessed by internal audit staff

 

• Setting out the extent of planned reliance on internal audit, together with reasons for deciding on that extent, in a planned memorandum.  (iv) Review of the manner in which the internal audit work is being controlled

particularly:-

• Consider whether work has been properly supervised and also

reviewed in detail when it has been completed.

Compare the results of the work with those of external auditors staff on similar audit areas or items

Satisfy himself that any exceptions or unusual matters that have to

come to light as a result of the work have been properly resolved.

Examine reports relating to the work produced by internal audit and management‘s response to those reports.

From time to time, determine whether internal audit will be able to complete the program that it has agreed to undertake and if not make appropriate arrangements.

Ensuring that the working papers relating to the work of internal audit, on which reliance is being placed, are up to an acceptable standard.

 

Conclusion: Since the internal auditor cannot meet the prime criteria of independence, the external auditor cannot fully rely on the work of the internal auditor. The extent of reliance will be determined by applying judgement 

QUESTION FOUR

Write briefly explanatory notes on the following types of audit:

Statutory audit;             (2 marks)

Private audit;             (2 marks)

Balance sheet audit;                (2 marks)

Management audit;                  (2 marks)

Explain the value derived from the work of external auditors. (5 marks)

Outline the statutory provisions with regard to duties of external auditors. (7 marks)

(Total: 20 marks)

QUESTION FOUR

Statutory audit

 

This is an audit carried out as per the requirements of the Company‘s Act for limited companies be they private or public. The Company‘s Act, Cap 486 requires that all limited companies submit their returns at the end of the financial period to the registrar of companies and that these returns should include the audit report. In

these audits, the auditors appointment is as per Section 159 (1) – (6) of the

Company‘s Act. His rights and duties are defined in Section 162 (1) – (12). This Act opens up the auditors scope, rights and duties and extensions of his liabilities which cannot be limited by any powers be they the shareholders or Board of Directors.

 

 

During such audits the auditor is free to obtain all the information and explanations he considers necessary for the purpose of forming an opinion.

 

(ii)      Private audit also known as non-statutory audit.

 

These are audits conducted for private institutions, which are not required by any statutes to have their financial statements audited. The audits are not mandatory but are carried out for the convenience of such organizations.

 

By virtue of its nature the auditor‘s scope, rights and duties are defined by an agreement between the auditors and owners or agents of the company. The

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auditor‘s obligations are contractual since they are based on an agreement between the auditor and his clients.

 

This agreement is crucial as it forms the basis for defining the auditor‘s duties, rights and obligations. Thus the auditor should ensure that the agreement between him and the client clearly defines his scope.

 

In such audits, the auditors rights and scope may be limited and due to such limitations the auditors opinion will usually contain a disclaimer clause.

 

• Balance Sheet audit

 

These are audits in which the auditor starts his audit work from the balance sheet and traces entries to their original posting in a bid to prove their authencity. This audit concentrates on balance sheet entries and falls under partial audits as the auditor will not check all entries but will rely on evidence obtained on balance sheet entries to form conclusions as to whether all other entries are authentic. For this reason, this audit is only appropriate for organizations which have a strong internal control system or when conducting a special audit assignment where the client requires the auditor to only report on the balance sheet items.

 

• Management audit

 

These involve the investigation of the company‘s entire management to ascertain their decision making process, especially of the top management and their attitude towards the operation of the internal control system, personal relationships with employees and their ability to manage an efficient and viable company.

 

It is ideal: –

• Where there are dynamic operations in an organization.
• For company‘s using high technology

 

• Advantages of an audit

 

• It provides assurance and credibility to the accounts in the audit report.
• Disputes between management may be more easily settled. E.g. a partnership which has complicated profit sharing arrangements may require an independent examination of those accounts to ensure as far as possible an accurate assessment

and division of those profits

• Major changes in ownership may be facilitated if past accounts contain an unqualified audit report. For instance, where two sole traders merge their business to form a new partnership.
• Applications to third parties for finance may be enhanced by audited accounts due to the credibility created by having the financial statements audited.
• The audit is likely to involve an in-depth examination of the business and so may enable the auditor to give more constructive advice to management on improving the efficiency of the business.

 

• Auditors‟Duties – Section 161
• To report to the members on each set of accounts laid before the company in the general meeting, whether in his opinion.

The balance sheet gives a true and fair view of the state affairs of the company  as at the balance sheet date.  The profit and loss gives a true and fair view of the profit (or loss) for the period ended on that date.

 

• The accounts comply with the requirements of the company‘s Act.
• Duty to state the following in his report.
  • Whether the auditor has received all the information and explanations which in

his opinion was necessary for his audit.

• Whether he received adequate returns from branches not visited by the auditor during the audit.
• Whether in his opinion proper accounting records have been maintained.
• Whether the accounts are in agreement with the underlying records.

• Duty to provide working papers.

An auditor has a duty to assist investigators in to the company‘s affairs by providing his working papers, which are summaries of significant matters identified

by the auditor during the course of the audit.

• Duty to certify the Profit and Loss account and Balance Sheet in a prospectus. A prospectus is the publication prepared by the company that is intending to sell

shares to the public.

• To include in his report any required information about the directors‘ remuneration,which has been omitted from the accounts.
  • A walk-through refers to the auditor selecting a particular transaction and tracing (or walking) it through the accounting information system from the time it was firstTo consider if any information in the directors report is inconsistent with the accounts and to report the facts if there are any such instances.

QUESTION FIVE

Write brief explanatory notes on the following audit terms:

• Control procedures;(4 marks)
• Internal check; (4 marks)
• Vouching audit; (4 marks)

• Walk-through tests;(4 marks)
• Weakness tests; (4 marks)

(Total: 20 marks)

QUESTION FIVE

 

•  Control procedures are those policies and procedures in addition to the control environment which management has established to achieve the entity‘s specific Control procedures include the following:
  • Preparation and review of reconciliation‘s;
  • Checking the arithmetical accuracy of the records;
  • Having proper segregation of duties;
  • Physical controls to safeguard the assets of the company;
  • Controlling applications & environment of computer information systems

e.g. by establishing controls over:

• Changes to computer programs.
• Access to data files.
  • Approving and controlling the use of documents.
  • Limiting direct physical access to assets and records.

 

• Internal check is an element of the internal control system which ensures that the activities of an individual in the organization or entity, is automatically, checked by another individual.

 

Internal check is boosted by the segregation of duties such that no person can carry out a transaction from initiation to conclusion without his work coming under the

            check of another person.

Internal checks can also be defined as: ―The checks on the day to day transactions which operate continuously as part of the routine system whereby the work of one person is proved independently or is complementary to the work of another, the objective being the prevention or early detection of errors and fraud‖.

 

• A vouching audit is also known as a substantive audit.

This audit approach involves checking the authenticity of recorded transactions by inspecting the document(s) used in processing of the transaction. It is proving that the transactions occurred, they are complete, correctly measured and they relate to the correct period if they are of a revenue or expense nature.