Your firm is the newly appointed external auditor to a large company that sells, maintains and leases office equipment and furniture to its customers and you have been asked to cooperate with internal audit to keep total audit costs down. The company wants the external auditors to rely on some of the work already performed by internal audit.
The internal auditors provide the following services to the company:
- A cyclical audit of the operation of internal controls in the company‘s major functions (operations, finance, customer support and information services);
- A review of the structure of internal controls in each major function every four years;
- An annual review of the effectiveness of measures put in place by management to minimise the major risks facing the company.
During the current year, the company has gone through a major internal restructuring in its information services function and the internal auditors have been closely involved in the preparation of plans for restructuring, and in the related post-implementation review.
Explain the extent to which your firm will seek to rely on the work of the internal
auditors in each of the areas noted above. (6 marks)
- Describe the information your firm will seek from the internal auditors in order for you to determine the extent of your reliance. (6 marks)
- Describe the circumstances in which it would not be possible to rely on the work of the
internal auditors. (4 marks)
- Explain why it will be necessary for your firm to perform its own work in certain audit
areas in addition to relying on the work performed by internal audit. (4 marks)
(Total: 20 marks)
Reliance on work of internal auditors
- As requested, the external auditors will seek to rely on the work of internal audit to the maximum extent possible. This might cover planning, risk assessment, tests of controls
and substantive testing.
- In all cases, the external auditor should be aware that the purpose of internal audit‘s work will not be primarily directed towards the financial statements.
- In relation to the audit of internal controls, it may be possible to rely on the work of internal audit in relation to all of the areas noted, but only if the internal controls audited affect the financial statements. It may be that internal audit‘s work on operations and
customer support is less relevant than its work in other areas.
- In relation to the four-year review of internal controls – the extent of reliance will depend on how long ago the last review was conducted. If it was conducted recently, it will provide help in relation to the external auditor‘s assessment of the accounting and
internal control systems.
- In relation to risk management – the relevance of internal audit work depends on the extent to which risks in relation to reporting in general, and the financial statements in particular, have been addressed separately by management. This work will be relevant to
the external auditor‘s risk assessment and planning
- The information required to determine the extent of external audit reliance on
internal audit‘s will be:
- Internal audit‘s systems documentation (the work on information systems and finance may include documentation of the company‘s accounting and internal
- Internal audit‘s planning documentation, which may cover a risk analysis, tests of controls and substantive procedures;
- The results of tests of control and substantive procedures;
- Documentation on the four-year review of internal controls, particularly in relation to the finance and information services functions.
- The external auditors should ask to see all documentation relating to the work performed by internal audit on information services restructuring during the year because the external auditor‘s assessment and testing of systems will be split into two parts, pre- and post-restructuring.
- Other documentation requested will include internal audit‘s operating procedures manuals and documentation relating to the recruitment, training and development of internal audit staff, and management responses to internal audit recommendations. This information is required to enable the external auditor to form an opinion on the competence and effectiveness of the internal audit function.
Circumstances in which it would not be possible to rely on the work of internal audit
It may not be possible to rely on the work of internal auditors if they:
- Are not competent (this relates to experience as well as qualifications); – Lack integrity;
- Do not properly plan or document their work, or if management does not act on (or at least respond to) recommendations made;
- Do not perform work relevant to the external auditor.
It will also not be possible to rely on internal audit if internal audit is insufficiently independent within the organisation, i.e. where internal auditors have insufficient operational freedom, where they are reporting to those who control the functions that they work on, or where they are reporting on their own work.
External auditor work
- External auditors will wish to perform work independently, regardless of internal audit work, in all areas that are material to the financial statements. For immaterial areas in which internal audit work can be shown by testing and review to be adequate, it may be possible to rely on the work of internal audit without performing any other work.
- Areas material to the financial statements are likely to be long and short-term leasing receivables and inventory. Leases may be complex and the auditors will wish to ensure that accounting policies are appropriate and that they have been properly applied. The valuation of inventory will have a direct effect on the profit for the period. This is an area that is easy to manipulate and external auditors will wish to ensure that this has not happened.
- External auditors will also wish to perform their own risk analysis and final review of financial statements in order to ensure that no high risk areas have been overlooked.
- Internal controls over non-current assets are designed to ensure the orderly and efficient running of the business, adherence to management policies, safeguarding of assets, the prevention of fraud and error and the completeness and accuracy of the accounting records.
List the internal controls that a small printing company with office equipment, motor vehicles and plant and machinery should have in place to achieve the objectives described above. (10 marks)
- Audit sampling is a technique for drawing conclusions about the characteristics of a population by testing a sample drawn there from. Internal and external auditors use it for both tests of controls, and substantive testing.
Describe the following:
Judgement sampling and statistical sampling;
A representative sample;
- Two different methods of selecting a representative sample;
- The extrapolation of errors.
NB: Parts (i) – (v) carry equal marks. (10 marks)
(Total: 20 marks)
Controls contributing to the orderly and efficient running of the business, safeguarding the assets and adherence to management policies would include the following:
- Physical controls over access to the assets such as the locking of doors and the maintenance of an appropriate fire and flood resistant environment; n Insurance against disaster and contingency plans;
- The use of passwords for access to computers and plant and equipment;
- n The numerical or other tagging of all equipment, referenced to an asset register;
- n Performing periodic asset audits;
Internal regulations requiring staff who take equipment such as laptops and motor
- vehicles home to ensure that they are secure, and prohibiting staff from using their own software on company equipment;
- The maintenance of firewalls and virus checking software.
Controls contributing to the prevention of fraud and error, and the completeness and accuracy of the accounting records would include the following;
The preparation and monitoring of capital expenditure budgets together with authorisation
- of capital expenditure,
Disposals and depreciation rates by independent persons at an appropriate level
- records or assets;within the organisation who do not have day -to-day responsibility for the related
- themselves;The maintenance of an asset register that is reconciled to the general led ger and the assets
The periodic checking and review of asset lives, and fully depreciated assets, to ensure that assets are being depreciated correctly, over an appropriate period of time.
- Judgement and statistical sampling
Judgement sampling uses the auditor‘s judgement to select the number of items to be tested, which items to be tested, and to interpret the results. Statistical sampling uses probability theory to do the same. Some judgement is always used in statistical sampling in the assessment of materiality and in the determination of what constitutes tolerable error, for example.
- Representative sample
A representative sample is one whose characteristics are the same as, or similar to, the characteristics of the population as a whole. All sample selection methods attempt to select samples that are representative.
For example, a sample of invoices that have not been properly authorised in 5% of cases will be representative of all invoices if the population as a whole also has around 5% of invoices not authorised.
- Tolerable error
Tolerable error is the maximum error that the auditor is prepared to accept and still conclude that the audit objective has been achieved.
For example, in relation to receivables, the auditor may be prepared to form the conclusion that receivables are not materially misstated if sampling shows that the receivables population has a value that is within plus or minus, say, 5% of the figure in the financial statements.
- Different methods of sample selection
Random selection requires the use of random number tables in order to select a representative sample.
Haphazard selection may be deemed to approximate to random selection provided that no bias is displayed. Interval (or systematic) selection involves taking every nth item, starting at random. Monetary unit sampling is also a form of systematic selection.
Block selection methods (taking one full part of the population) will probably not result in a representative selection.
Block selection might involve obtaining confirmation of receivables from one region of the country only, for example.
NB: Only two examples are required.
Extrapolation of errors
Errors found in a sample are extrapolated across the population as a whole, in order to enable the auditor to form a conclusion on whether the population is materially misstated. It is important to remember that there is not necessarily a direct, linear relationship between errors in samples and errors in the populations from which they are drawn.
The objectivity of the external auditor may be threatened or appear to be threatened where:
- There is undue dependence on any audit client or group of clients;
- The firm, its partners or staff have any financial interest in an audit client;
- There are family or other close personal or business relationships between the firm, its partners or staff and the audit client; (iv) The firm provides other services to audit clients.
- For each of the four examples given above, explain why the objectivity of the external auditor may be threatened, or appear to be threatened, and why the threat is important.
- Flowers Anytime sells flowers wholesale. Customers telephone the company and their orders are taken by clerks who take details of the flowers to be delivered, the address to which they are to be delivered, and account details of the customer. The clerks input these details into the company‘s computer system (whilst the order is being taken), which is integrated with the company‘s inventory control system. The company‘s standard credit terms are payment one month from the order (all orders are dispatched within 48 hours) and most customers pay by bank transfer. An accounts receivable ledger is maintained and statements are sent to customers once a month.
Credit limits are set by the credit controller according to a standard formula and are automatically applied by the computer system, as are the prices of flowers.
Describe and explain the purpose of the internal controls you might expect to see in the sales system at Flowers Anytime over the:
|(i) Receipt, processing and recording of orders.||(6 marks)|
|(ii) Collection of cash.||(4 marks)|
|(Total: 20 marks)|
Why external auditor objectivity may be, or appear to be, threatened
- Undue dependence
If the auditor depends, or relies on a particular client or group of connected clients because the firm takes a large part of its fee income from the client, the auditor may be less likely to challenge accounting policies or disclosures proposed by the client, for fear of upsetting them. This typically happens when the firm is small, but the client is large.
Where the firm feels that an audit qualification may be necessary, it may be reluctant to issue it for fear of losing the client and the fee income. This applies regardless of whether the fee income is audit fee income or income for other work.
The issue is important because if the auditor does not issue a qualified audit report where appropriate, the firm may be sued for negligence. Where a large client is involved, the firm‘s professional indemnity insurance may not cover the claim.
- Financial interest
Where a partner or member of staff in a firm (or the firm itself) holds shares in a client, they have an interest in the client‘s performance. If the client performs well, the value of the shares may rise. A qualified audit report is not usually associated with good performance and the firm may therefore be reluctant to issue one where appropriate. This is important for the reasons noted above.
Even if there is no question of a qualified audit report, there may be a temptation to help the client present the results in the best possible light, instead of presenting a balanced view. There is also a financial interest where partners, staff or the firm make loans to, or guarantee the borrowings of the client or vice versa. Significantly overdue fees of amounts that are significant to either auditor or client are akin to loans.
- Family or other close personal or business relationships
Where there are family or other close personal or business relationships between client and audit firm, the individuals concerned may try to influence the firm in its dealings with the client in order to protect the family or personal relationship, or the mutual business interest.
If, for example, an audit partner is married to the finance director of a client, it is less likely that the client will receive a qualified audit report than it would be if the relationship did not exist. This is important in any case but more so where the effect of a qualified (or modified) audit report is likely to result in, say, withdrawal or non-renewal of banking facilities which might result in the business ceasing to be a going concern. If the firm does not issue a modified audit report in such circumstances, the firm may be exposed to claims of negligence by the bank.
If there are close business relationships between client and auditor, both parties have an interest in each other‘s performance and there is therefore a double pressure to present the results in the best possible light and not to issue a qualified audit report.
Many audit firms provide their audit clients with services other than audit services. It is very common for to provide their very small audit clients with accountancy services, for example.
Other services that can be provided include tax, management consulting, IT and human resources advice. Some firms not only provide consulting advice, but also perform IT and other functions for some of their clients.
There are two threats to objectivity where other services are provided. Firstly, the firm may find that it is reporting on a system that the firm itself has set up or advised on, or reporting on information that the firm itself has prepared. This means that it is reporting on its own work and it may be difficult to be objective in such circumstances. Secondly, the fee income from other services may well exceed the fee income from the audit and the client may pressure the firm to give an unqualified audit report by threatening to take the other services to another firm if a qualified report is given.
Receipt, processing and recording
All orders taken should be recorded on a pre-numbered multi-part document generated by the computer. One part might be a copy for the customer, one might form the invoice, one might be for the dispatch department and one might be retained for accounts receivable ledger purposes.
Manual or computer systems should perform checks on the completeness of the sequence of pre-numbered documents at various stages. Any documents unaccounted for should be traced and investigated.
The computer system should apply the credit limits set by the credit controller and the system should reject any orders that exceed customer credit limits at the point at
- limits should be authorised by the credit controller.which the order is taken, so that the customer can be advised. Any override of credit
From time to time, there should be an independent check to ensure that the credit limits within the system are being properly calculated and properly applied to individual transactions. Similar considerations apply to prices maintained within the system. The computer system should also reject any order for which there are no flowers available so that orders cannot be taken for flowers that cannot be delivered.
All invoices should be posted to the sales daybook, the accounts receivable ledger and the accounts receivable control account automatically by the system and the accounts receivable ledger and the accounts receivable control account should be
- reconciled each month in order for sales and receivab les records to be kept up to
There should be controls in place to deal with credit notes and other discrepancies involving the price, type or quality of flowers delivered in order to maintain the accuracy of records and customer goodwill.
(ii) Collection of cash
At the end of each period, the system should produce a list of overdue receivables.
There should be procedures for chasing these customers and for putting a ‗stop‘ on
- accounts where amounts are significant in order to control bad debts;
When bank transfers are received from customers, they should be input into the system and matched with individual transactions and controls should ensure that the correct amounts are allocated to the correct customers and transactions.
An exception report should be produced for any unallocated bank transfers. Exceptions should be promptly investigated. This will ensure that receivables information is accurate and up to date and that customers are not chased for
- amounts that have been paid
Bank reconciliation should be performed on a monthly basis in order to ensure that the company‘s cash records are complete, accurate and up to date.
Company A has a number of long and short-term payables, accruals and provisions in its balance sheet.Required:
Describe the audit procedures you would apply to each of the three items listed below, including those relating to disclosure.
- A 10-year bank loan with a variable interest rate and an overdraft both from the same (5 marks)
- Expense accruals. (4 marks
- Trade payables and purchase accruals. (6 marks)
Company B has a provision in its balance sheet for claims made by customers for product defects under 1-year company warranties.
Describe the matters you would consider and the audit evidence you would require for the provision. (5 marks)
(Total: 20 marks)
10-year bank loan and bank overdraft
n Authorisation for the loan and overdraft should be checked to the minutes of a board or other relevant meeting.
The details of contracts with the bank and any relevant correspondence should be examined. Any covenants restricting the use of securities held against the loans should be examined and the client‘s compliance with the covenant checked. If covenants have
should be considered.not been complied with, the implications for the company and the financial statemen ts
The response to the year-end bank confirmation should be examined. It should provide details of the amounts outstanding and the amounts paid and payable during the year in terms of both interest (loan and overdraft) and capital (loan only). In both cases, details of any security held for the loan and overdraft should be requested.
n Analytical procedures should be applied to the interest paid in the income statement, and to the interest and capital paid and outstanding at the period-end for the loan.
The bank reconciliation should be checked to ensure that the overdraft has been properly reconciled to the records, and that there are no old or significant outstanding amounts that need to be adjusted for.
The amount payable at the year-end should include amounts payable in one year, which should be included in current payables, and amounts payable in over one year. The notes to the financial statements should also disclose amounts payable in over five years.
The auditors should ensure that appropriate disclosures are made in the notes to the accounts in accordance with legislation and International Financial Reporting Standards. In particular, where assets are held as security, this should be disclosed in the notes relating to the assets.
If accruals are material to the financial statements, more evidence will be required than if they are not. If accruals are not material, analytical procedures may be sufficient audit
A schedule of accruals should be obtained and checked for arithmetical accuracy. Individual accruals should be reviewed by comparison with prior periods and budgets and any significant variations investigated, particularly if accruals have been made in previous periods but have not been made in the current period;
The amounts paid after the period-end should be checked to the bank statement and the calculation of a sample of amounts payable should be checked for accuracy, by reference to subsequent invoices;
If any accruals are payable more than one year after the balance sheet date, an appropriate split should be made in the balance sheet.
Trade payables and purchase accruals
The nature and extent of testing will depend on the quality of controls over trade payables, as evidenced by interim testing of internal controls. Evidence in relation to the
completeness of trade payables and accruals is important, but not always easy to obtain;
n The auditors should form an opinion as to whether direct confirmation of trade payablesto provide valuable audit evidence by discussion with the client. is likely
It is sometimes possible to rely on supplier statement reconciliations instead of direct confirmation, but this depends on the availability of supplier statements. Where supplier statement reconciliations are performed, it is important to be aware of the possibility of forged or altered statements – originals rather than copies should be examined. Some combination of supplier statement reconciliations and direct confirmation is often used.
If a decision to obtain direct confirmation of trade payables is taken, the client‘s cooperation is required in authorising the requests and in helping the auditors sort out any differences between the balances recorded by the company and those recorded by suppliers.
Particular care should be taken if there are material balances for which there are no supplier statements or no response to a request for confirmation. Consideration should be given to telephoning the supplier in this case.
Analytical procedures should be applied to the ageing and level of trade payables by comparison with prior periods;
Variations should be in vestigated and substantiated, with particular attention being paid to old
- outstanding amounts;
- representative sample of individual trade payables should be traced back through the system from the schedules supporting the financial statements to the ledgers, daybooks and source documentation to ensure that the amounts recorded are accurate. The size of the sample will depend on the auditor‘s assessment of risk in this area;
A schedule of purchase accruals should be obtained and checked for arithmetical accuracy and completeness by comparison with prior periods and invoices received after the period-end. As with trade payables generally, there is a risk of unrecorded items.
Both trade payables and purchase accruals should be tested for the accuracy of cut-off by reference to invoices and inventory records for an appropriate period each side of the
- review of correspondence with trade creditors should be performed and any legal department
- should be requested to provide details of disputes with creditors;
If any trade payables are payable more than one year after the balance sheet date, an appropriate split should be made in the balance sheet.
- Provisions for manufacturing warranty claims are heavily dependent on the judgement of directors. The auditors should establish how the directors have arrived at the provision and assess it for reasonableness in the light of previous provisions and claims. More work will be required if there has been a significant discrepancy between provisions and claims in the past and more work will be required if the company does
not have significant experience in dealing with this type of warranty claim.
- IAS 37 ‗Provisions, Contingent Liabilities and Contingent Assets‘ states that a provision is a liability of uncertain timing or amount which should only be recognised when there is a present obligation, as a result of a past event, and where it is probable that an outflow of resources will be required to settle the obligation, the amount of which can be reliably estimated. It would appear that the warranty claim fits this description.
- Auditors should check the calculation of the provision for arithmetical accuracy and to ensure that it is calculated in accordance with the method determined by directors. This can be achieved by reviewing the level of claims and payments both before and after the period-end.
- If there has been a change in the method of calculating the provision, the auditors should ensure that it is reasonable in the light of evidence available and that it is properly disclosed, if material. If there has been a change in the product mix to which the warranty applies, this should also be considered, particularly if there are new, relatively untried products which carry a higher risk of claims in the first few years.
- If any previous provisions have been released in the current period because of overprovisions in previous periods, the auditors should ensure that the amount released is reasonable, and is properly disclosed in the income statement as appropriate. ‗Soft‘
provisions such as these can be manipulated by the client and particular care therefore needs to be taken.
A review of correspondence with customers should be performed and any legal department should be requested to provide details of disputes with customers relating to claims
Auditors obtain several different confirmations from various sources during the course of their audit.
Describe the audit evidence provided by each of the confirmations listed below, the practical difficulties in obtaining them and the alternative audit evidence available when they are not provided:
- Management representations.(7 marks)
- Direct confirmation of receivables. (7 marks)
- Confirmation of inventory held by third parties. (6 marks)
(Total: 20 marks)
Management representations Evidence
- Auditors obtain written representations from management on material matters where other sufficient appropriate audit evidence cannot reasonably be expected to exist. ISA 580 ‗Management Representations‘ deals with this subject.
- Such matters might include confirmation that all related party transactions have been disclosed in the financial statements and confirmation of all matters that rely principally on the exercise of judgement by directors – such as ‗soft‘ provisions. The letter also usually includes confirmation that all matters occurring since the balance sheet date that should be brought to the attention of auditors have been brought to their attention, and that all of the accounting records have been made available to the auditors.
- Management representations should not conflict with other audit evidence. If they do, the matter should be investigated and resolved.
- In practice, it is not always easy to obtain a signed management representation letter. The letter should be addressed from the client to the auditor, but it can take the form of a letter from the auditor to management that is acknowledged by management, or
signed minutes of a board or similar meeting.
- If management refuses to provide representations, this may be grounds for a qualification of the audit report on the basis of a limitation in the scope of the audit. However, this is an extreme step and auditors will always discuss with directors alternative wordings that will be acceptable to them before considering qualification of the audit report. There may be genuine uncertainty on the part of management as to the reasonableness of the representations that auditors request them to make.
- Unfortunately, because of the content of these letters, there is very little alternative evidence; that is why the letter is requested in the first place.
- Auditors need to think carefully about the content of the letter if management refuses to sign altogether, and consider whether there is alternative evidence, whether the matters are truly material and whether an audit qualification is needed. Auditors can exert some pressure on management to sign by making this threat, in practice.
Direct confirmation of receivables
- Auditors often seek direct confirmation of receivables to ensure that the amounts stated in the entity‘s accounts receivable ledger are not overstated. Confirmation also provides evidence in relation to certain frauds and the quality of internal controls.
- Confirmation that an amount is owed is not confirmation that the amount will be paid and auditors need additional evidence on the recoverability of receivables.
- There are two types of confirmation, positive and negative. In the former case, the customer is requested to reply in any case, and the auditor can either insert the balance to be confirmed or the customer can be requested to do so. In the latter case, a reply is only requested if the customer disagrees. This method is only suitable where receivables are well controlled.
- The response rate to requests for confirmations is not always satisfactory and repeated requests may be necessary. It is not uncommon for replies to be inaccurate, especially
where the amount stated is too low.
- Where the customer is requested to insert the balance, the reconciliation can sometimes be very difficult, even with the help of the client, and the customer‘s assistance may be needed.
- Where no reply is received it is important that alternative evidence is obtained on the same balance (and not to test another balance). Where there is a discrepancy between the client‘s records and the customer‘s records, the matter should be investigated and resolved.
- Sometimes, the customer can provide a reconciliation, particularly if the matter only relates to timing differences. On other occasions there may be a dispute and a provision may be necessary.
- Alternative evidence for receivables includes payment of the amount after the periodend, a review of contracts and signed delivery notes, and analytical procedures on the ageing of receivables.
Confirmation of inventory held by third parties
- It is often not possible for auditors to confirm inventory held by third parties by attendance at an inventory count and therefore the only evidence available is
confirmation from the third party.
- It is particularly important to ensure that the confirmation is genuine because of the possibility of fraudulent collusion between the third party and the client to inflate
inventory and profit figures.
- The reliability of service from the third party and the quality of documentation and correspondence are all taken account of as part of the auditor‘s risk assessment in this area.
- Both the quality and quantity of inventory held should be confirmed. It is common for third parties to use different descriptions or units of measurement in their records to
those used by the client and it is necessary to reconcile these items.
- It may be possible for the auditor of the third party to provide some evidence in relation to the amounts held.
- If the inventory held by the third party is likely to be material, the auditor must consider the possibility of visiting the third party and attending the inventory count.
- The auditor may review and test the controls over the movement of inventory to and from the third party and the related records, in order to reduce the level of substantive
evidence needed at the period-end.
- Records that show ‗negative‘ inventory (more ‗outs‘ than ‗ins‘) at either the client or the third party may be indicative of misclassifications, for example.
ISA 400 Risk Assessments and Internal Control deals with internal control objectives and internal controls. ISA 500
Audit Evidence deals with audit objectives and audit procedures. A proper understanding ofinternal controls is essential to auditors in order that they understand the business and are able to effectively plan and execute tests of controls and an appropriate level of substantive procedures.
You are the auditor of a small manufacturing company, that pays its staff in cash and by bank transfer and Maintains its payroll on a small stand-alone computer.
- For the payroll department, describe the:
- Internal control objectives that should be in place; (4 marks)
- Internal control environment and internal control procedures that should be in place to achieve the internal control objectives. (6 marks)
- For the payroll charges and payroll balances (including cash) in the financial statements:
- Describe the external auditor audit objectives; (4 marks)
- List the tests of control and substantive procedures that will be applied in order to achieve
the audit objectives identified in (b) (i) above. (6 marks)
(Total: 20 marks)
Internal control objectives
Control objectives include policies and procedures designed by management to:
Achieve the orderly and efficient running of the business including adherence to internal
payments.policies – this would include the regular, accurate processing and recording of payroll
Safeguard assets – this would include the physical safeguarding of cash and safeguarding money held in bank accounts by means of other controls.
Prevent and detect fraud and error – fraud and error would include incorrect payments or deductions from the payroll and payments of incorrect amounts for tax and NSSF, payments for work not performed and payments to dummy employees, for example.
Achieve accuracy and completeness of the accounting records and timely preparation of reliable financial information; this would include making correct payments and deductions from the payroll, correct payments for tax and (NSSF, NHIF), and making payments for work performed only (not to dummy employees, for example), in order that quarterly or half-yearly accounts can be prepared (possibly), but in any case in order that annual accounts can be prepared within the time limits for small companies.
Internal control environment and control procedures
The control environment relates to:
Management‘s overall style in encouraging awareness of the need for good controls, for
The existence of organisational controls such as review of the payroll by an independent person such as the managing director, and the rotation of payroll duties amongst staff responsible for processing it – this helps achieve all of the objectives set out above.
Segregation of duties and supervisory controls to avoid the misappropriation of cash
- and to avoid fraudulent collusion to create, for example, dummy employees or to make
- inflated payments Internal control procedures include:– this prevents the loss of assets and/or inaccurate records.
Limiting direct physical access to the cash, such as the use of a security firm to deliver cash, locking doors to areas where cash is held, keeping cash in a fire-proof safe and the protection of the computer by password controls – this will help safeguard assets and ensure the completeness and accuracy of the records and financial statements.
Controls over computerised applications, checking the arithmetical accuracy of documents and the maintenance of control accounts – this can be achieved by, for example, the use of timesheets or clockcards, the use of reliable software with programmed controls for the calculation of deductions, and the use of batch and hash
orderly and efficient running of thetotals for information that is input into the computer system business and the accuracy and completeness of records and financial statements. – this helps achieve the
Approval and control of documents, such as the authorisation of the payroll itself, and authorisation for the bank to make transfers and to deliver cash.
Audit objectives, tests of control and substantive procedures
|Tests of control and substantive procedures
|Existence: of assets and liabilities such as||Testing controls over the security of cash to|
|cash on hand and in the bank, and of the||ensure that they are operating effectively|
|liability to pay staff and the associated tax||throughout the period.|
|and NSSF contributions.
|Performing cash counts, with reconciliations to the records and observing cash payments to staff, ensuring that appropriate signatures are obtained and that unclaimed cash ispromptly re-banked, for example.
Making checks on the physical existence ofstaff to ensure that the related expenses andliabilities are genuine.
Checking after date payments to staff andfor tax and NSSF contributions.
|Occurrence: payroll transactions occurred||Performing cut off tests to ensure that|
|during the relevant accounting period.
|payroll costs incurred during the period have been recorded during the period by examining entries in the payroll records just before and just after the period end and checking back to source documentation,such as timesheets or clock cards|
|Completeness: there are no unrecorded||Performing starters and leavers tests to|
|assets or liabilities such as cash on hand and||ensure that staff are not paid before they join|
|in the bank or transactions such as payroll||the company and are not paid after they|
|leave. This involves checking the payroll for two separate periods and examining entries relating to starters and leavers in theintervening period.
Manually checking the accuracy of payroll calculations to ensure that correct payments and deductions are being made in accordance with approved pay rates andapproved deduction rates for tax and NSSF.
Reviewing evidence of authorisation controlsto ensure that the payroll has already beenchecked.
|Measurement: transactions such as payroll||Same as for completeness, above, and|
|payments are recorded at the correct||checking entries relating to hours or time|
|amounts and are recorded in the correct||worked in the payroll to source|
|Presentation and disclosure: an item is||Reviewing the financial statements with the|
|disclosed and described in accordance with||aid of a disclosure checklist to ensure that|
|accounting standards and legislation.
|disclosure requirements have been met.Reviewing the overall presentation of payrolltransactions and balances.|
- Describe external auditor‘s responsibilities and the work that the auditor should perform in relation to the going concern status of companies. (5 marks)
- Describe the possible audit reports that can be issued where the going concern status of a company is called into question; your answer should describe the circumstances in which they can be issued. (5 marks)
Celtel is a large telecommunications company that is listed on the Nairobi Stock Exchange. It is highly geared because, like many such companies, it borrowed a large sum to pay for a license to operate a mobile phone network with technology that has not proved popular.
The company‘s share price has dropped by 50% during the last three years and there have been several changes of senior management during that period. There has been considerable speculation in the press over the last six months about whether the company can survive without being taken over by a rival. There have been three approaches made to the company by other companies regarding a possible takeover but all have failed, mainly because the
bidders pulled out of the deal as a result of the drop in share prices generally.
The company has net assets, but has found it necessary to severely curtail its capital investment program. Some commentators consider this to be fundamental to the future growth of the business, others consider that the existing business is fundamentally sound. It has also been necessary for the company to restructure its finances. Detailed disclosures of all of these matters have always been made in the financial statements. No reference has been made to the going concern status of the company in previous auditor‘s reports on financial statements and the deterioration in circumstances in the current year is no worse than it has been in previous years.
- On the basis of the information provided above, describe the audit report that you consider is likely to be issued in the case of Celtel, giving reasons. (4 marks)
- Explain the difficulties that would be faced by Celtel and its auditors if Celtel‘s audit
report made reference to going concern issues. (6 marks)
(Total: 20 marks)
External auditor responsibilities – going concern ISA 570 Going Concern deals with this issue.
- Auditors are required to consider the going concern status of companies and any disclosures regarding going concern in forming their audit opinion. Companies that are listed on stock exchanges may be required to make additional disclosures in relation to going concern issues.
- Auditors are required to assess the adequacy of the means (the processes) by which directors have satisfied themselves that the going concern basis is appropriate and that adequate disclosures have been made. Auditors conduct an initial analysis at the planning stage of the audit as well as assessments at later stages.
- Auditors should make enquiries of the directors and examine appropriate documentation supporting the company‘s going concern status such as budgets and cash flow forecasts.
- Auditors consider whether the period to which directors have paid particular attention is adequate. This should normally be at least 12 months from the balance sheet date. Auditors also enquire of management as to their knowledge of events or conditions beyond this period that may cast significant doubt on the entity‘s ability to continue as a going concern.
- Auditors need to consider the appropriateness of assumptions which directors have made, the sensitivity of assumptions to external and internal changes, any obligations, guarantees or undertakings arranged with other entities, the existence and adequacy of borrowing facilities and the directors‘ plans to deal with any going concern problems.
- Auditors are required to document the extent of any concerns, taking account of matters that have come to their attention during the course of the audit and in particular, financial, operational, or other indicators of going concern problems that are present.
- Indicators of going concern issues would include trading losses, impairment of assets, net liabilities, defaults on loans, liquidity problems, an inability to refinance loans where necessary, fundamental changes in the markets or technology having an adverse effect on the company, loss of management, staff, customers or suppliers, or major litigation, for example.
- Auditors should consider the need to obtain written management representations.
- Auditors should consider the adequacy of any disclosures in the financial statements.
Possible audit reports and circumstances
- Where the auditors consider that there is a significant level of concern about the entity‘s ability to continue as a going concern (but do not disagree with the going concern basis), and where adequate disclosures of the situation are made, they modify (but do not qualify) their opinion by including an ‗emphasis of matter‘ paragraph highlighting the existence of a material uncertainty as to the going concern status of the entity and drawing attention to the relevant note in the financial statements. Where adequate disclosures are not made, a qualified or adverse opinion will be issued.
- Where the period to which directors have paid particular attention is less than 12 months from the balance sheet date, the auditors should consider the need to modify the audit report as a result of a limitation in the scope of the audit.
- Where the auditors disagree with the preparation of the financial statements on the going concern basis, they should issue an adverse opinion. This is very rare because auditors rarely have sufficient evidence to be sure.
- If the auditors are unable to form an opinion on the going concern status of a company because of a limitation in the scope of the audit, they will issue an ‗except for‘ opinion, or ‗disclaimer of‘ opinion – but this is unusual.
Report issued to Celtel
- In the case of Celtel, there are some indicators of going concern problems. However, the company may still be a going concern and the fact that the company has been approached by take-over bidders does not necessarily mean that there is a going concern problem (possibly quite the opposite).
- The audit opinion issued on Celtel in the current year is not likely to make reference to the going concern status of the company, as in previous years. The situation has not deteriorated significantly in the current year and it will be difficult for auditors to justify any change in their opinion from previous years.
Difficulties associated with reporting on going concern
- If the auditors of Celtel were to report on a going concern problem, the mere act of reporting might of itself create a going concern problem (a ‗self-fulfilling prophecy‘). This is particularly the case with large ‗blue-chip‘ companies where the issue of an audit report that is modified in any way is unusual and might well cause the company‘s share price to drop, thus precipitating a going concern problem.
- This means that it is very difficult for companies such as Celtel and their auditors to send out any clear signal to the markets without running the risk of creating a panic.
- However, recent events show that the consequences of companies and auditors failing to report where severe financial difficulties are encountered can be disastrous for both the company (its employees and shareholders) and auditors alike.
- Auditors are failing in their professional duties if they do not report on going concern problems of which they are aware; however, situations involving large companies are rarely clear cut and auditors who propose to make any changes at all to the audit report
are likely to encounter fierce resistance from management who may genuinely believe that to make such a report would be wrong.
In the company‘s annual financial statements, it is not the place of the auditor of Celtel to substitute his judgement for that of directors. However, where large companies involved in complex financing arrangements are concerned, auditors may have to fight hard against vested and powerful interests if they disagree with the directors‘ judgements and decide to make reference to the matter in the auditor‘s report. An auditor making reference to going concern issues in an audit report in such circumstances may lose the audit (and any other work) and may run a significant risk of litigation
You are an audit manager in an audit firm with 250 staff. Your firm is the auditor of Sunrise, a chain of Supermarkets. Your firm has been the auditor of this client for many years.
All of the planning work and tests of control have been completed for Sunrise for the year ended 31 December 2003. Staff are still working on substantive procedures. The company operates a continuous inventory checking system with good records and you have tested this
system and will be relying on the records for the year-end balance.
The company is intending to invest a substantial amount in opening new stores during the next year and it has been negotiating with both banks and property companies in relation to leases.
- Describe the objectives of the following and how these objectives will be met in the audit of Sunrise:
- Overall review of financial statements; (4 marks)
- Review of working papers.(6 marks)
- Describe the:
- Auditor‘s responsibilities with regard to subsequent events; (6 marks)
- Procedures that should be applied during the subsequent events review at Sunrise. (4 marks)
(Total: 20 marks)
Objectives and how they are met: overall review of financial statements
- The objective of a review of financial statements is to provide the auditor with sufficient audit evidence, when taken together with the conclusions drawn from the other audit work, to form an opinion on the financial statements. This includes determining whether the information in the financial statements is properly presented and disclosed in accordance with accounting standards, legislation and other regulatory requirements. The usual means of achieving this is by the completion of a disclosure checklist.
- Auditors should consider the appropriateness of accounting policies in particular and whether they have been consistently applied, particularly where changes have been made. There is no indication that any such changes have been made.
- Auditors should also consider whether the financial statements as a whole are consistent with the auditor‘s knowledge of the business. This involves consideration of the aggregate effect of uncorrected misstatements, any overall bias in presentation and will normally involve analytical procedures on the final financial statements. This exercise involves the application of professional judgement and, in the case of Sunrise, it is likely to be carried out by the senior manager and/or the audit engagement partner with the assistance of the audit manager.
Objectives and how they are met: review of working papers
- The objective of a review of working papers is to ensure that all work has been properly planned, executed and recorded and that all outstanding matters have been followed up.
- In the case of Sunrise, it is likely that some work will have already been reviewed. It is common for audit seniors and audit managers to review the work of audit juniors, and for senior managers and partners to review the work of managers and seniors. There will
also be a final partner review of the file.
- Where working papers are prepared manually, staff normally evidence review of working papers by initialling the working paper. Review comments are often written in red and referred to the person preparing the working paper or to the partner where significant
matters of judgement are concerned. Where papers are prepared electronically, electronic ‗signatures‘ can be used.
- It is important that a detailed review of working papers takes place in areas that are critical to the audit. In this case, critical areas are likely to include inventory (despite the
fact that it is well-controlled, it is still a material item), cash and non-current assets.
- It is also important during the final stages of the audit of Sunrise that all outstanding areas (i.e. the substantive areas) are completed, reviewed and any issues arising followed up. It is very easy for apparently insignificant matters to ‗slip through the net‘ at this stage where both auditors and client are under pressure.
ISA 560 Subsequent Events deals with this issue.
- Auditors should perform procedures designed to obtain sufficient appropriate audit evidence that all material subsequent events up to the date of the audit report which require adjustment or disclosure in the financial statements have been properly made.
- If matters requiring adjustment or disclosure are discovered after the date of the audit report but before the financial statements are issued, or even after they have been presented, auditors should ascertain whether and how any necessary changes are to be made to the financial statements.
- The decision as to whether financial statements should be changed is that of the directors. Auditors cannot ‗change their minds‘ once the audit report has been signed but if new
financial statements are issued they can issue a new audit report which should make reference to the previous financial statements and audit report.
- If auditors consider that the financial statements contain material errors or are misleading, they may exercise an right to speak at general meetings and to make written representations to members.
- If matters are discovered long after the financial statements have been issued, it is common to deal with the matter as a prior period adjustment in the subsequent financial statements. 14
Subsequent events review procedures
- These include making enquiries of management as to how they have ensured that subsequent events have been identified, although it is likely that in this case the company
will rely on the audit firm to help them with this.
- Auditors will read the minutes of management, shareholders and other meetings and review relevant accounting records. In this case, they are likely to review any budgets or cash flow forecasts. It is likely that these will have been prepared as a result of the negotiations with the bank.
- In the case of Sunrise, the auditors are likely to enquire as to the possibility of any new share or loan issue to fund the expansion which may require disclosure. They may also enquire as to any significant changes in the property market that might (if the supermarket properties are carried at valuation) require either disclosure or adjustment in the accounts.
- Auditors will also consider the need for disclosure of significant leasing transactions occurring early in the following year.