- What is an audit? (2 marks)
- Explain the importance of audit to a limited liability company.(10 marks)
- In addition to shareholders, many different parties are interested in the audited accounts of a company. Name FOUR such parties and state the significance of audited accounts to each one of them. (8 marks)
(Total: 20 marks)
The explanatory foreword to the International Standards on Auditing (ISA) describes audit as the independent examination of and expression of an opinion on the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.
The objective of an audit is to enable auditors to express an opinion whether the financial status give a true and fair view and have been properly prepared in accordance with the relevant statutory requirements.
NB: – The auditor does not certify the financial status but reports that in his opinion they give a true and fair view.
- Importance of audit to a limited company
- An audit protects the interests of the shareholders who are separated from the management of the company. This is especially the case for minority shareholders who have little say in the management of their company.
- An audit being an independent examination of the financial statements gives credibility to the financial statements. The various users can therefore place reliance on them;
- The audit ensures that the directors have fulfilled their statutory obligations and acts as a precaution against frauds on the part of employees.
- The auditors experience will enable him to make recommendations on ways of improving the accounting, internal control system and in the standards of the company‘s reporting to its members.
- An audit ensures that the financial statements are prepared in accordance with the generally accepted accounting standards. This improves the comparability of the financial statements.
- Users of financial statements
- Tax authorities: Audited accounts give a true picture of the entity‘s profits and can be relied upon by tax authorities for the assessment of tax on the company.
- Lenders:- audited accounts are credible and therefore can be relied upon to assess the credit worthiness of the entity.
- Employees – Are interested in whether the entity is a going concern, which can be established from the audited accounts to ensure job security.
- Customers – those who rely on entity‘s products are interested on whether the entity will be producing in future (going concern) or whether they ought to look for alternative suppliers
- Potential/actual investors need to know whether investing in the company is worthwhile i.e are they bound to benefit financially in terms of dividends and capital gains.
- Describe the following types of Audits:
- Statutory Audits;
- Internal Audits;
- Private Audits;
- Management Audits;
- What are the similarities and differences between internal and external audits?
- Statutory auditsThese are carried out as per the requirements of the various statutes e.g. the Companies Act cap 486 requires that all public limited companies must have their financial statements subjected to an independent audit. The objectives of the audit are to express an opinion as to whether the balance sheet and the profit and loss account show a true and fair view. The rights and duties of the auditor are laid out in the Companies Act or the relevant statute. The powers of appointment of the auditor are vested on the shareholders.
- Internal audits
Internal audits is an appraisal or monitoring activity established by management for the review of accounting and Internal Control System as a service to the entity. It examines, evaluates and reports to management on the adequacy and effectiveness of the systems.
Other activities include: –
- Examination and evaluation of financial and operating information.
- Review of the economy, efficiency and effectiveness of operations including non-financial controls
- Review of compliance with external laws and regulations and internal policies and procedures.
- Carrying out special investigations including fraud investigations as required by management.
It is important to note that internal audit is a management function established to carry out a continuous appraisal on the internal controls system and report this to management.
- Private audits
These are audits that are not governed by the Companies Act or any other statute. These are performed by an independent auditor because the owners, members or other interested parties require them and not because the law requires them to be carried out. Private audits are carried out for organisations such as NGOs, partnerships, clubs and charities among others. The appointment of the auditor is usually carried out as a private contract between the auditor and the relevant stakeholder. The scope and objective of the work is determined by the agreed terms between the auditor and the client. The auditors‘ rights and duties are also laid out in the contract.
- Management audits
Management audits relate to the review and evaluation of the management structure within the organization and the performance of the management. It includes the appraisal of the environment for the exercise of management skills as well as the measurement of external management performance against established criteria.
Similarities between internal and external audits
- Both functions require the auditors to adhere to the international standards on
- n Both are carried out by competent auditors
Both are interested in evaluating and testing the effective operations of the internal
- control system
Both functions give recommendations to management on ways of improving the internal control system. The external auditor achieves this through the management letter, which is addressed to management.
Area of difference Internal Auditor External auditor 1.Scope Determined by
Determined by statute 2.Approach To ensure accounting To satisfy himself that the system is efficient and financial statements to be providing management presented to the with accurateinformation shareholders portray a true and fair view 3.Responsibility Report to management Report to the shareholders of the
- Distinguish between internal audit and internal check (4 marks)
- Explain the matters you would consider and the work you would perform to enable
you assess the extent to which you would rely on the work of the internal audit
department of your client (12 marks)
- Give four examples of internal audit work that may e used by the external auditor
(Total: 20 marks)
Internal Audit is an appraisal or monitoring
- Internal check is an element of the internal controls system where the activities of an individual in the organization/entity is automatically checked by another. This is facilitated by segregation of duties where by the various activities in transaction processing are carried out by independent persons. For example in the purchase of raw materials the person paying the supplier‘s invoices counterchecks to ensure that the amount billed by the supplier agrees with the cost of the purchase as per the authorised purchase order. This independent check is an example of internal check. On the other hand internal audit Internal audits is an appraisal or monitoring activity established by management for the review of accounting and Internal Control System as a service to the entity. It examines, evaluates and reports to management on the adequacy and effectiveness of the systems.
- 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.
In evaluating this function the external auditor should consider the following factors:
n 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.
n 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.
n Technical competence
The external auditor should ascertain whether internal audit work is performed by persons having adequate technical as auditors. Qualifications and experience of the
internal audit staff should be considered.
n 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
nInternal 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.
nLevel 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.
After carrying out this assessment the external auditor will then decide whether the function is effective and the auditor can therefore rely on some of the work
- carried out by internal audit.
If the external auditor wishes to rely on some specific work carried out by internal audit the following factors should be considered:
- The work is performed by staff who have adequate technical training and
proficiency as internal auditors;
- the work of assistants is properly supervised, reviewed and documented;
- sufficient appropriate audit evidence is obtained to form a reasonable basis for the conclusions reached;
- the conclusions reached are appropriate;
- reports by the internal audit are consistent with the results of the work
- any exceptions and unusual matters disclosed by internal audit are properly
- amendments to the external audit programme are required as a result of matters identified by the internal audit work;
- there is a need to test the work of internal audit to confirm its adequacy.
- Examples of internal audit work that can be used by the external auditor includes:
- The physical verification of assets. The internal auditor could undertake a physical verification of assets to confirm their existence; the results of such work could be
relied upon by the external auditor.
- To undertake on behalf of the external auditor to observe the stock take exercise, cash counts, and attendance at wage payments.
- Point out areas where there have been fundamental changes in accounting, management and internal control system all of which could have an impact on the audit approach;
The internal auditor could also perform some substantive procedures on behalf of the external auditor such as evaluating the recoverability of debtors balances
You are the audit manager in charge of Car Alarms Ltd. Whose financial year ended on 31 March 1993. Due to the tight schedule of your programmes you are unable to devote anytime at the client‘s premises. Therefore you have delegated the responsibility to the audit senior.
- State the procedures you would follow to control the audit up to completion stage.
- Explain the matters you would pay attention to in order to achieve you firm‘s quality control targets. (4 marks)
(Total: 20 marks)
(i) As the audit manager has decided to delegate his responsibilities to the audit senior, he must ensure that his senior has the appropriate experience, training, proficiency and independence required in order to be able to carry out the audit of Car Alarms Ltd efficiently and effectively.
Having decided to delegate he must ensure that the audit senior receives the direction and supervision necessary to be able to conduct the audit in the best way possible. The degree of supervision requested will depend on the complexity of the assignment and the experience and proficiency of the audit senior,
In the course of directing the audit senior, he should inform him of his responsibilities and the objectives of the procedures that he is to perform. He should also inform him of the routine of the business carried out by Car Alarms ltd and the possible accounting or auditing problems that may affect the nature, timing and extent of audit procedures with which they are involved.
When supervising the auditor he should:-
- Monitor the progress of the work to determine that: –
- the audit senior appears to have the necessary skill and competence carry out the audit of Car Alarms Ltd
- he appears to have understand the audit directions and the work is being carried
out in accordance with the audit programme and other planning documents.
- Become informed of significant auditing questions raised during the audit, assess their significant and modify the audit programme where appropriate.
In addition to the above, he should review the work performed by the audit senior to determine whether: –
n The work performed and results obtained have been adequately documented.
n No significant audit matters remain unresolved.
The objectives of the audit procedures have been achieved and the conclusions expressed are consistent with the results of the work performed and support the audit seniors opinion on the final stages
In order to achieve the firm‘s quality control targets the following matters should be considered:
- Personnel qualities: Personnel in the firm should adhere to the principles of
integrity, objectivity, independence and confidentiality.
- Skills and competence: The firm should be staffed by personnel who have attained and maintain the skills and competence required to enable them to fulfil their
- Assignment: Audit work should be assigned to personnel who have the degree of
technical training and proficiency required in the circumstances.
- Director and supervision at all levels to provide the firm with reasonable assurance that the work performed by the firm meets appropriate standards of quality.
- Acceptance and continuance of clients: In making such decisions, the firms should consider its own ability to service a client properly and the integrity of the client‘s
- Monitoring: The firm should monitor the effectiveness of its quality control policies and procedures.
The auditing guideline on „recording‟ requires audit working papers to be sufficient complete and detailed so that an experienced auditor who has no previous connection with theaudit is able to subsequently ascertain from working papers the work performed and to further support the conclusions reached thereon.
- State four benefits that the auditor will obtain from the working papers that meet the above requirements. (4 marks)
- Outline the contents of a typical:
- Current audit file; (10 marks)
- Permanent audit file. (6 marks)
(Total: 20 marks)
- a) Benefits of working papers
The reporting partner needs to satisfy himself that work delegated by him has been properly performed. This is only possible by reviewing detailed working papers prepared by the audit staff who performed the work. This also aids in supervision and review of work done by audit assistants.
Working papers provide details of problems encountered together with evidence of work performed and conclusions drawn there from in arriving at the conclusions reached. These details can also serve as a good reference point for future audits.
Preparation of working papers encourages the auditor to adopt a methodical approach to his work.
- Working papers assist in the planning and performance of audits in future financial periods.
- n If sued for negligence working papers act as evidence of work done.
They are used for training of audit staff. Working papers contain audit programs and specimen schedules, which audit assistants, can refer to when conducting an audit.
Current Audit File (CAF):
This file will contain matters only relevant to the current year‘s audit only. It will contain:
n A copy of the accounts being audited signed by the directors;
n A file index showing the contents of the file;
- documentation;A description of the internal control system inform of questionnaires, flowcharts or forms of
Audit programmes showing the audit objectives and planned audit procedures for each of the areas to be audited;
n A schedule of each item in the balance sheet. Each schedule should show:
- Balance at the beginning of the year, changes during the year and balance at the end of the year.
- Details of work performed on each balance, results and the conclusions made
A schedule for each item in the profit and loss account showing the audit work carried out, results obtained and the conclusion reached;
- Check list for compliance with statutory disclosure requirements and accounting standards; n Record of queries raised during the audit and coming forward from previous audit.
- Schedule of important statistics e.g. output, net composition, liquidity ratios; profit margin, gross profit margin, sales
n A record or abstract from the minutes of:
- The company
- The directors
- Any internal committee of the company whose deliberations are important to the auditor.
n The management letter setting out weaknesses in the internal control;
Letters of representation obtained from the client‘s management.
The permanent file usually contains documents and matters of continuing importance, which are required for more than one financial period. Information contained in a PAF include:
Statutory material: governing the conduct of the audit e.g. for companies, the Companies Act (Cap 486). For a quoted company a copy of the Nairobi Stock Exchange regulations (NSE) is required.
Rules and regulations of the enterprise. E.g. for a company, the Memorandum and Articles of Association. For a partnership, a partnership agreement.
- Copies of documents of continuing importance and relevance to the auditor. -Letter of engagement and minutes of appointment of the auditor. – Trade license.
- Debenture deeds.
- Lease agreements – Guarantees and indemnities entered into.
- Addresses carried on at each.of the registered office and all other premises with a short description of the work
n An organisation chart showing: –
- Principal departments and subdivision thereof.
- Names of responsible officials showing lines of responsibility.
n A list of directors their shareholdings and service contracts;
n A list of company‘s advisors, bankers, stockbrokers, solicitors, valuers.
John Mutiso bought shares of Sh.2 million six months ago in Kenya Company Limited which has since gone into liquidation. He intends to sue XYZ & Co. Certified Public Accountants for the imminent loss of Sh. 2 million which he is likely to suffer. XYZ & Co. had audited the Kenya Company Ltd. The previous year and issued an unqualified report. John Mutiso claims that he solely relied on the audit report when he took that investment decision.
- Do the auditors, XYZ & Co. have any liability to Mr. John Mutiso? (4 marks)
- What circumstances must Mr. John Mutiso demonstrate if he has to succeed against the auditors? (6 marks)
- State the measures XYZ & Co. should undertake to minimize potential liability for
professional negligence. (10 marks)
(Total: 20 marks)
- a) NO: A shareholder cannot sue the auditor individually if he relied solely on audited financial statements as a basis for investing in a company.
However the auditor could be liable if he knew that his report would be used to make investment decision ‗Hedley Byrne principle‘
―Third parties entitled to recover damages under this principle are be limited to thosewho by reason of the accountants negligence in preparing reports, accounts or financial statements suffered financial loss and where the accountant knew or ought to have known that the report, accounts or financial statements in question were being reported for specific purpose or transactions which gave rise to the loss or that they
will be shown to, and relied upon by third parties in that particular connection. This position was supported by the decision In Re: Candler Vs Crank Christmas & Co(UK case)
Candler was induced to invest money in a company on the strength of audited financial statements and subsequently he lost his investment when the company wound up.
Lord Denning stated that, ― accountants owe theirduty of course, to their employer orclients and also, I think to any 3rd person to whom they themselves show the accounts or to whom the know their employer is going to show the accounts so as to induce him to invest money or take some action on them. I do not think, however, the duty can be extended still further so as to include strangers of whom they have heard nothing and to whom their employer without their knowledge may choose to show the accounts‖
This judgment appears to imply that various users of audited financial statements such as creditors, potential investors e.t.c may not be able to sue the auditor for
negligence by virtue of their placing reliance on audited financial statements.
Basing on this judicial precedence it appears that John Mutiso cannot successfully sue XYZ certified accountants.
- Mutiso must prove that: –
i That XYZ company indeed carried out the audit work negligently ii That as a direct consequence of XYZ‘s negligence he suffered financial loss iii That XYZ knew or ought to have known that the accounts will be relied upon for investment decisions by John Mutiso i.e prove that XYZ Co. owed him a duty of care.
ivThat Mr. Mutiso actually relied on the report. No other external auditors whatsoever influenced his decision making but just that of the audit report.
- The auditor should ensure that he is competent enough to carry out the audit assignment in order to be able to carry it out according to the professional standards. He should also ensure that he actually conducts this audit in accordance to the standards set by both professional and ethical bodies and in utmost care. By doing so, he will be able to prove that the audit was not carried out negligently.
The audit should be carried out in detail and every aspect of it taken seriously. If the information necessary in one area are unavailable. The auditor should obtain a letter of representation in order to ensure that he makes an informed decision and he can be able to prove so, if the need arises.
The auditor can enter into an agreement with his client that his report should not be used by another person apart from the client.
Include a disclaimer of liability clause in the relevant document or report. Example of such a clause would be ― while every care has been taken in the preparation of this document, it may contain errors for which we cannot be held responsible‖
Taking professional indemnity insurance cover.
You have been asked by the partners of your firm to prepare a draft memorandum on materiality which will provide guidance to members of staff in conducting the audit of theaccounts of limited companies.
- Define materiality. (4 marks)
- Explain the importance of this concept to the auditor.(6 marks)
- Suggest some criteria for determining cut-off point in order to assess the materiality of an error. (10 marks)
(Total: 20 marks)
- The auditor should consider materiality when conducting his audit. Materiality is defined as follows. ―Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements‖. Materiality depends on the size of the item or error judged in the
particular circumstances of its omission or misstatement.
Thus materiality provides a threshold or cut off point rather than being a primary qualitative characteristic which information must have if it is to be useful. The concept of materiality is key to the auditor when he is concluding whether financial statements show a true and fair view. The auditor can only report that the financial statements do not show a true and fair view on issues that are material. In designing the audit plan, the auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements. However, both the amount (quantity) and nature (quality) of misstatements need to be considered. Examples of qualitative misstatements would be inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled by the description and failure to disclose the breach of regulatory requirements when it is likely that the consequent imposition
of regulatory restrictions will significantly impair operating capability.
The auditor should consider materiality at both the overall financial statements level and in relation to individual account balances, classes of transactions and disclosures
- Materiality is important to an auditor because: –
Auditors should consider materiality and its relationship with audit risk when conducting an audit. The auditors responsibility is to plan and perform an audit to provide reasonable assurance that the financial statements are free of material
misstatement and give a true and fair view. Thus anything that would distort the view given by the financial statements must lead to a qualification but only if its material.
procedures.Auditors should consider materiality when determining the nature, timing and extent of audit
Materiality assessments during planning assists in the determination of an efficient and effective audit approach. It helps the auditor decide on matters such as what items to examine and whether to use sampling techniques.
In evaluating whether the financial statement give a true and fair view, auditors should assess the materiality of the aggregate of uncorrected misstatements.
If the auditor believes that the aggregate of uncorrected misstatements may be material, he should extend his audit procedures to obtain more audit evidence in the relevant area or request management to adjust the financial statements.
If management refuses any adjustments the auditor should consider the implications for his audit report.
Therefore materiality provides a reference point in making decisions on the effects of misstatements on the financial statements.
Materiality guidelines can be derived by answering the following questions:-
- nWho are the relevant users of the financial information?
- What are their decision making needs?
- n For a given item, what is the appropriate context for assessing its materiality?
- n In what range of values do items become critical in terms of materiality?
- How should particular items in these critical ranges be decided and reported?
The auditor should also consider:-
Is the item so fundamental that the accounts can no longer be said to give a true and
- fair view?
Materiality is a relative factor and the item must be considered in relation to the accounts as a whole, the total of which it would form part and the corresponding amount in the previous years.
Some items are capable of exact calculations others like depreciation are merely estimated and providing the estimate is reasonable, should be acceptable.
However, it is generally accepted that:-
- Errors over 10% are material
- Errors between 5 – 10% may be material
- Errors under 5% may not be material.
Explain why auditors carry out circularisation of debtors. (6 marks) (b) Distinguish between ‗positive‘ and ‗negative‘ debtors circularisation procedures.
Describe in detail the work you would carry out in scrutinizing the replies to the debtors
circularisation and in confirming whether the debtors balances are collectable in the following situations:
where the debtor does not agree with the balance and states a difference; (6 marks) ii. where the debtor reports that he cannot confirm the balance (2 marks) iii. where no reply is received from the debtor (4 marks)
(Total: 20 marks)
The most effective way of confirming debtor balances is by the auditor communicating directly with the customers of the client to seek direct confirmation of the amounts outstanding.
Circularization satisfies the following objectives: –
Strong evidence whether debtors are overstated – Customers can usually be relied upon to complain if the balance they are supposed to owe is overstated (i.e.
completeness and accuracy). However, it is a weaker source of evidence on whether
debtors are unde
- too small. rstated – customers are less likely to kiliicomplain if the balance is
Evidence of the functioning of controls i.e. if the ICS over debtors is strong, there
- will be few discrepancies regarding what is stated by the debtors and what is stated in the clients records
- n Evidence of the efficiency of cut-off procedures if carried out at year-end.
- Evidence regarding irregularities such as ―teeming and lading‖ and window dressing.
- Provides reliable evidence on existence of debtors.
- In positive circularization the debtor is asked to confirm to the auditor directly if he agrees or disagrees with the balance whereas in negative circularization, the customer is only asked to respond if he disagrees with the balance stated in the request letter. Positive circularisation is mainly used where the debtors‘ balances are material and the internal controls are not very reliable while negative circularisation is mainly used where the debtors‘ balances are not very significant.
- Debtors‘ circularisation
Where the debtor does not agree with the balance and states a different balance
The fact that the debtor has replied and stated a different balance confirms the existence of the debtor. However, the auditor will need to carry out the following procedures to confirm completeness, accuracy and collectability of the debt:
Evaluate the causes of the difference between the balance in the client‘s ledger and the amount the debtor has confirmed. This could be as a result of either invoices or payments in transit. Invoices in transit refers to instances where the client has sent invoices for sales to the customer but these have not been recorded in the customer‘s books. Payments in transit refers to instances where the debtor has made some payments but these have not yet reached the client or maybe the client has received the payment but has not posted this in the ledger. Where payments has received the
- payment the client will need to post these in the ledger;
Other variances should be investigated and management should provide appropriate explanations. Where necessary adjustments should be made record
- any unrecorded transactions;
Check any payments received after year end as evidence of collectability of the debtors
Analyse the account to confirm that the balance is within the credit terms and discuss with management the recoverability of the balance.
- Where the debtor reports that he cannot confirm the balance
- nThe fact the debtor has replied confirms existence;
To confirm the completeness of the amount the auditor should analyse the
- debtors account to ensure that the balance is made of specific invoices supporting sales to the debtor;
n The auditor should discuss with management the collectability of the balance.
- Where no reply has been received
Where no reply has been received implies that the auditor has not been able to confirm the existence of the debtor. The auditor will need to carry out alternative audit procedures, which include:
- n Inspecting correspondence between the client and the debtor. This will assist in confirming existence of the debtor;
- n AnalysingThe auditor can inspect a sample of these invoices; the debtor‘s account to verify that the balance is made up of specific invoices.
Verifying if there are any payments that have been received after the yearend. This will confirm existence and collectability of the balance. Where the entire amount has been settled in one single payment this could also assist
- in confirming the completeness of the balance;
n The auditor should discuss the account with management if there are any indications that the balance is doubtful.