Evidence p7

Exam focus


More than one question in the exam is likely to feature a requirement to design relevant audit or assurance procedures. It is essential that you understand the principles of audit     and can apply this knowledge to the scenario and design procedures relevant to the area being tested or the risk to be addressed.


1      The principles of   evidence

Audit procedures are designed to obtain     in response to the assessment of risk at the planning stage.


gathered must be sufficient and appropriate to reduce assessed risk to an acceptable level.


If, at the review stage, the senior audit staff deem that the risk of misstatement has not been reduced to an acceptable level, more     will be required.


2      Obtaining audit    


ISA 500 Audit     requires the auditor to obtain sufficient appropriate     to be able to draw reasonable conclusions. [ISA 500, 4]




A measure of quantity, i.e. does the auditor have enough     to draw a conclusion.


Affected by risk and materiality of the balances and quality of    . [ISA 500, 5e]




Measures quality of     – relevance and reliability. [ISA 500, 5b]


Reliability of     depends on several factors [ISA 500, A31]:


– Independent, externally generated     is better than     generated internally by the client.


– Effective controls imposed by the entity, generally improve the reliability of    .


–     obtained directly by the auditor is more reliable than     obtained indirectly or by inference.


– It is better to get written, documentary     rather than verbal confirmations.


– Original documents provide more reliable     than photocopies or facsimiles.


Relevance means the     relates to the financial statement assertions being tested. [ISA 500, A27]


Financial statement assertions

Addressing disclosures in the audit of financial statements


Disclosures are an important part of the financial statements and seen as a way for communicating further information to users. Poor quality disclosures may obscure understanding of important matters.


Concerns have been raised about whether auditors are giving sufficient attention to disclosures during the audit. The IAASB believes that where the term financial statements is used in the ISAs it should be clarified that this is intended to include all disclosures subject to audit.


Recent changes to ISAs include:


Emphasis on the importance of giving appropriate attention to addressing disclosures.


Focus on matters relating to disclosures to be discussed with those charged with governance, particularly at the planning stage.


Emphasis on the need to agree with management their responsibility to make available the information relevant to disclosures, early in the audit process.


Audit procedures for obtaining    


The methods of obtaining     are:


Inspection of records, documents or physical assets.


Observation of processes and procedures, e.g. inventory counts.


External confirmation obtained in the form of a direct written response to the auditor from a third party.


Recalculation to confirm the numerical accuracy of documents or records. Re-performance by the auditor of procedures or controls.

Analytical procedures.


Enquiry of knowledgeable parties.


[ISA 500, A14 – A22]


The auditor obtains     to draw conclusions on which to base the audit opinion. This is achieved by performing procedures to:


Obtain an understanding of the entity and its environment, including internal control, to assess the risks of material misstatement by performing risk assessment procedures.


Test the operating effectiveness of controls in preventing, detecting and correcting material misstatements by performing tests of controls.


Detect material misstatements by performing substantive procedures. [ISA 500, A10]


Tests of control and substantive procedures


Tests of controls are designed to check that the audit client’s internal control systems operate effectively.


Examples of tests of controls:


Inspect purchase invoices for     of authorisation by a manager before payment is made.


Observe the process for despatch of goods to ensure the warehouse staff check the goods to the order before despatch.


Using test data, enter a dummy order over a customer’s credit limit


to verify that the system won’t allow the order to be accepted.


Substantive procedures are designed to find material misstatements in the financial statements (fraud and error).


Substantive procedures can be tests of detail or analytical procedures.


Substantive tests of detail look at the supporting     for individual transactions and traces them through to the financial statements to ensure they are dealt with appropriately.


Examples of tests of detail:


Inspect a purchase invoice for the amount and trace it into the purchase day book to ensure it has been recorded accurately.


Recalculate an allowance for doubtful receivables using the client’s formula to verify arithmetical accuracy.


Substantive analytical procedures test the balances as a whole to identify any unusual relationships e.g. comparison of a gross profit margin year on year might highlight that revenue is overstated if there is no known reason for the GPM to increase. An analytical procedure tests the ‘reasonableness’ of a balance.


Examples of analytical procedures:


Calculate the receivables days ratio and compare with credit terms offered to customers to identify any possible overstatement. If receivables days appears too high, discuss with management the need for an increase in the allowance for doubtful receivables.


Obtain a breakdown of sales by month and analyse the seasonal trend to ensure it is consistent with the auditor’s knowledge of the business. Discuss any unusual fluctuations with management.


Calculate the expected interest charge for a loan by multiplying the outstanding loan amount with the interest rate and compare with the client’s figure. Discuss any significant difference with management.



Recap: Example audit procedures


Non-current assets


Select a sample of assets from the asset register and physically inspect them to verify existence.


Select a sample of assets visible at the client premises and inspect the asset register to ensure they are included to verify completeness.


Recalculate the depreciation charge to verify arithmetical accuracy. Inspect the physical condition of assets to assess valuation.


Review any valuation reports to confirm valuation.


Inspect title deeds or registration documents for the client’s name to verify rights and obligations.




Inspect the inventory listing to ensure damaged/obsolete items have been written down to NRV.


Inspect the inventory listing for the items on the last GRNs and GDNs obtained to ensure cut-off is correctly applied.


Trace items on the count sheets obtained during the count into the inventory listing to ensure the quantities have not been changed.


Calculate inventory days ratio and compare with prior year to identify any slow-moving items requiring write down.


Inspect the aged inventory listing for old items and discuss the need for write down with management.


Inspect purchase invoice to verify cost. Inspect post year-end sales invoices to verify NRV and ensure inventory is valued at the lower of the two figures.


Review calculations of overheads included in WIP and ensure only production related overheads are included.




Request direct confirmation from customers to confirm the balance.


Inspect GDNs and invoices included in the listing to confirm accuracy of the amount recorded.


Inspect cash received post year-end to confirm valuation.


Calculate receivables days and compare with credit terms to assess the recoverability of the debts.


Enquire with management about any long overdue debts and discuss the need for write down with management.


Inspect correspondence with customers for     of disputes which may indicate overvaluation.




Obtain a bank confirmation letter for all bank accounts held to verify rights and existence.


Obtain bank reconciliations for all bank accounts and cast to confirm accuracy.


Agree the balance per the cash book to the ledger.


Agree the balance per the bank statement to the bank letter.


Agree unpresented cheques to the post year-end bank statements to confirm they have cleared in a reasonable time.


Agree outstanding lodgements to the paying in book and post year-end bank statements.




Inspect purchase invoices and GRNs included on the listing to confirm accuracy of recording.


Obtain/perform supplier statement reconciliations to identify discrepancies which could impact completeness, existence or valuation.


Obtain direct confirmation of balances from suppliers where supplier statements are not available.


Inspect post year-end bank statements for payments made which may indicate unrecorded liabilities.


Calculate payables days ratio and compare with credit terms given to identify unusual differences and discuss with management.


Inspect GRNs for before the year-end to ensure completeness.




Enquire with management the basis of the provision to assess reasonableness.


Recalculate the provision to confirm arithmetical accuracy.


Obtain written representation from management as to the adequacy and completeness of the provision.


For a legal provision obtain confirmation from lawyers regarding the amount and probability.


Inspect board minutes to confirm an obligation exists at year-end. Review subsequent events for further    .


ISA 501 Audit     – Specific Considerations for Selected Items


In accordance with ISA 501 auditors are required to obtain sufficient appropriate     with regard to three specific matters, as follows:


  • The existence and condition of inventory


–    Attendance at the inventory count


–    Evaluate management’s instructions


–    Observe the count procedures


–    Inspect the inventory


–    Perform test counts


– Perform procedures with regard to final inventory records to ensure they reflect actual inventory count results.


[para 4]


  • The completeness of litigation and claims involving the entity


–    Enquiry of management and in-house legal counsel.


– Reviewing minutes of board meetings and meetings with legal counsel.


–    Inspecting legal expense accounts.


– If there is a significant risk of material misstatement due to unidentified litigation or claims the audit should seek direct communication with the entity’s external legal counsel.


[para 9, 10]


  • The presentation and disclosure of segmental information


– Understand, evaluate and test methods used by management to determine segmental information.


–    Perform analytical procedures.


[para 13]



ISA 505 External confirmations


External confirmations are written responses received from third parties directly by the auditor to help them obtain sufficient appropriate    . [para 6a]


Examples include: receivables circularisations and bank letters.


As these form external, written    , they are considered to be reliable sources of    . In order to ensure that the     sought remains reliable auditors should maintain control over this process.


To do this they should:


Determine the information to be confirmed. Select the appropriate third party.

Design the confirmation requests and provide return information for responses to be sent directly to the auditor.


Send the requests, including a follow up when no response is received.


[para 7]


If management refuses to allow the auditor to send such requests the auditor should consider whether this is reasonable or not in the circumstances. This may affect the auditor’s fraud risk assessment and reliance upon written representations from management. The auditor should perform alternative procedures to obtain the    . [para 8]


If the auditor concludes that management’s request is unreasonable and they cannot obtain sufficient appropriate     by any other means, the matter should be communicated to those charged with governance. [para 9]


The auditor must be alert to the risk of interception, alteration or fraud and maintain appropriate professional scepticism when considering the reliability of responses which may have been received indirectly or appear not to come from the intended party. [para A11]



ISA 530 Audit Sampling


Auditors rarely test every transaction, balance and disclosure relevant to a set of financial statements. ISA 530 states that auditors should select appropriate samples for testing that provide a reasonable basis to draw conclusions about the population from which the sample is selected. [para 4]


When selecting samples the auditor should:


Consider the purpose of the procedure and the characteristics of the population from which the sample will be drawn.


Ensure the sample size is sufficient to reduce sampling risk to an acceptable level.


Ensure each sampling unit has a chance of selection.


[para 6]


If the auditor identifies any misstatements or deviations, the nature and cause should be investigated. [para 12]


If a misstatement is identified when performing tests of details, the misstatement should be projected across the population. [para 14]


When choosing a sampling method there are two broad approaches:


Statistical sampling, where items in the population are selected randomly so that probability theory may be used to evaluate the results (through extrapolation to the whole population). [para 5g]


Non-statistical, which is a method that does not meet the characteristics of statistical. [para 5g]


The auditor uses judgment to select sample items (e.g. focusing on high value, or known high risk items). Extrapolation cannot be used when bias has been introduced into the sample because the sample is no longer representative of the whole population.



3      Substantive analytical procedures


ISA 520 Analytical Procedures states that the use of analytical procedures as substantive     is generally more applicable where:


There are large volumes of transactions [ISA 520, A6]


Relationships exist amongst the data and are believed to be predictable over time [ISA 520, A6]


Controls are working effectively [ISA 520, A9]


In order to design an analytical procedure the auditor should:


Determine the suitability of analytical procedures for the given assertion. Evaluate the reliability of data from which the expectation is developed.

Develop an expectation and evaluate whether it is sufficiently precise to identify a material misstatement.


Determine the difference between expected amount and recorded amount. [ISA 520, 5]


If analytical procedures identify fluctuations or relationships that are inconsistent with the auditor’s knowledge of the business then the auditor should investigate those peculiarities through:


Enquiry of management.


Other procedures, as deemed necessary, for example, when management’s response is considered inadequate.


[ISA 520, 7]



Current issue: The Growing Use of Data Analytics in an Audit


In the past, CAATs have been used to analyse data. The CAATs were tailored to the specific client who required significant investment and as a result were not widely used across all audits.


Technological development means it is now possible to capture and analyse entire datasets allowing for the interrogation of 100% of the transactions in a population – data analytics (DA). Whilst DA can be developed for bespoke issues, a key characteristic is that there is development of standard tools and techniques which allows for more widespread use. Some of the more widely used DA tools started out as bespoke CAATs and have been developed for wider application.




Data analytics is the science and art of discovering and analysing patterns, deviations and inconsistencies, and extracting other useful information in the data of underlying or related subject matter of an audit through analysis, modelling, visualisation for the purpose of planning and performing the audit.


Big data refers to data sets that are large or complex.


Big data technology allows the auditor to perform procedures on very large or complete sets of data rather than samples.


Features of data analytics


Data analytics allows the auditor to manipulate 100% of the data in a population quickly which reduces audit risk.


Results can be visualised graphically which may increase the user-friendliness of the reports.


Data analytics can be used throughout the audit to help identify risks, test the controls and as part of substantive procedures. The results of data analytics still need to be evaluated using the professional skills and judgment of the auditor in order to analyse the results and draw conclusions.


As with analytical procedures in general, the quality of data analytics depends on the reliability of the underlying data used.


Data analytics can incorporate a wider range of data. For example data can be extracted and analysed from social media, public sector data, industry data and economic data.




The auditor may use data analytics to analyse journals posted. The analysis identifies:


The total number of journals posted.


The number of journals posted manually.


The number of journals posted automatically by the system.


The number of people processing journals.


The time of day the journals are posted.


The auditor may conclude there is a higher risk of fraud this year compared with last if:


The number of manual versus automatic journals increases significantly.


The number of people processing journals increases. Journals are posted outside of normal working hours.


Benefits of data analytics


Audit procedures can be performed more quickly and to a higher standard. This provides more time to analyse and interpret the results rather than gathering the information for analysis.


Audit procedures can be carried out on a continuous basis rather than being focused at the year-end.


Reporting to the client and users will be more timely as the work may be completed within weeks rather than months after the year-end.


May result in more frequent interaction between the auditor and client over the course of the year.


Reduction in billable hours as audit efficiency increases. Whilst this is good news for the client it will mean lower fees for the auditor.


What it means for the profession


Larger accountancy firms are developing their own data analytic platforms. This requires significant investment in computer hardware and software, training of staff and  .


Small firms are unlikely to have the resources available to develop their own software as the cost is likely to be too prohibitive. However, external computer software companies have developed audit systems that work with popular accounting systems such as Sage, Xero and Intuit which many clients of small accountancy firms may be using.


Medium sized firms may also find the level of investment too restrictive and may therefore be unable to compete with the larger audit firms for listed company audits. However, these firms may find that listed companies require systems and controls assurance work which their auditors would not be allowed to perform under ethical standards.


Developments within the profession


Currently, ISAs are based on the systems based approach to audit, which seeks to obtain audit     by placing reliance on internal controls rather than on carrying out extensive substantive testing. The development of data analytics represents a significant progression away from traditional auditing methods. Therefore, as they become more widely used, ISAs will need to be updated to reflect this innovation in auditing techniques.


The IAASB has a responsibility to develop standards that reflect the current environment and facilitate a high quality audit. Auditors, audit oversight authorities and standard setters need to work together to explore how developments in technology can support enhanced audit quality.


Auditors and businesses operate in an environment with larger volumes of transactions, greater complexity and greater regulation as a result of corporate failures. Technological change means information systems are capable of capturing, analysing and communicating significantly more data than previously. As a result stakeholders are expecting the auditor to perform an audit that includes greater use of technology including DA.



The quality of the audit can be enhanced by the use of DA. DA enables the auditor to obtain a greater understanding of the entity and its environment. Professional scepticism and professional judgment are improved when the auditor has a better understanding.


Limitations of Data Analytics


There are still limitations to the audit and therefore auditors need to be careful not to place too much confidence into the use of DA which could have a negative impact on audit quality.


The data may not be complete, well-controlled or from a reliable source.


Financial statements still contain a significant amount of estimates.


DA will not replace the need for auditors to use professional scepticism and professional judgment.


As a result of these limitations the auditor is still only able to give reasonable assurance.


Challenges that impact the use of Data Analytics


Data acquisition and retention – The entity’s data will need to be transferred to the auditor raising concerns over data security and privacy as well as creating storage problems for such large data sets.


Conceptual challenges – Auditors will be asking questions they have never asked in the past and the client may be hesitant to provide all of the information requested.


Legal and regulatory challenges – Regulations may prohibit data leaving the jurisdiction the entity is located. This may pose a problem if the IT facilities of the client are located in a different country.


Resource availability – Data scientists may form part of a centralised department which supports all engagement teams within the firm. The resources are likely to be limited which will put a strain on resources.


How regulators and audit oversight authorities maintain oversight – These bodies have little experience themselves of inspecting audits using DA.


Investment in retraining and reskilling auditors – Changing the auditor’s mind-set from traditional audit methods will require time and investment.


The use of DA and developments in auditing standards will impact:


Risk assessment – DA may improve the risk assessment process.


  – Audit firms will need to consider how specialist teams are supervised and how they interact with the audit teams they support. Firms will need to consider the integrity of the DA software to ensure it does what it is supposed to.



Group audits – DA may help by enabling better analytical procedures to be performed in respect of components that are not significant components. Also, the audit procedures may be more centralised enabling the group auditor to perform more procedures rather than relying on the work of a component auditor.


Estimates and fair values – Due to large volumes of data that feed into the models used to develop accounting estimates, DA may be valuable in addressing audit risks associated with these data sources.


Smaller audit firms – Smaller firms may not be able to make the required investment to develop DA tools. Audits of public sector entities may prove challenging as home-grown systems are more prevalent and data capture may be more difficult.


Education – Auditors and accountants will need to be re-skilled to realise the potential of DA. Training and qualifications will need to reflect the increased use of DA for new entrants to the profession.


Ethics – Due to auditors having access to large volumes of client data, there may be a need to update the Code of Ethics to enhance the requirements for confidentiality.


Other auditing standards – There is also likely to be a need to revise other auditing standards such as ISA 240 (Fraud), ISA 320 (Materiality), ISA 330 (Responses to risks), ISA 500 (Audit    ), ISA 520 (Analytical Procedures) and ISA 530 (Audit Sampling).


FRC Audit Quality Thematic Review – The Use of Data Analytics in the Audit of Financial Statements


With the increasing use of data analytics, the FRC has performed a review to identify what is working well with a view of sharing information to promote continuous improvement in audit quality. The Audit Quality Review team assessed the use of DA in the six largest audit firms.


Current use of data analytics


Analyse all transactions in a population, stratify the population and identify outliers for further examination.


Re-perform calculations


Match transactions as they pass through the system Assist in segregation of duties testing

Compare client data with externally obtained data Perform sensitivity analysis.


Impact on audit quality


Audit quality is a driver for the implementation of DA. DA can:


Deepen the auditor’s understanding of the entity.


Facilitate testing of the highest risk areas through stratification. Enhance the use of professional scepticism.


Improve consistency on group audits


Enable the auditor to test entire datasets. Improve audit efficiency.

Increase the possibility of identifying fraud.


Provide a channel for enhanced communication with audit committees.


Good practices observed during the AQR


Focused roll out of a DA tool.


Clear positioning within the audit methodology. Testing or trial running the DA tool.


Using specialist staff and clearly defined roles between the specialists and the core engagement team.


Central running of DA for group audits.


Clearly documenting the DA tool using flowcharts.


Summary of key findings


The introduction of mandatory retendering in the UK has provided incentive for firms to develop DA tools as this acts as a key differentiator.


UK firms are at the forefront of developing DA tools.


The pace of change is not as fast as expected by audit committees and investors.


Whilst some firms are investing heavily in DA tools, they are not monitoring their use by audit teams or effectiveness at providing appropriate    .


Some audit teams have overemphasised their use to audit committees. In some cases DA have been used to provide insight to the audit committee rather than being used to generate audit    . In another case a firm described a DA tool as launched in a report but was described to the Audit Quality Review team as being in pilot stage.


All firms used DA to assist with journal entry testing, however, most firms are not using DA tools routinely in other audit areas.


For complex entities it can take two years to achieve the full benefits of a DA approach.


The main barrier to effective use relates to difficulties obtaining entity data and audit teams often lack expertise to extract the data required.


The use of DA techniques was higher at firms where the audit methodology clearly defines the purpose of the DA.


In the audits tested, insufficient     audit     was retained on file.


–    Criteria input into the DA tool was not retained.


–    Screenshots omitted important information.


–        produced by specialists was omitted.


–    Firm’s archiving tools were not able to archive DA    .


– It may not be technically, practically or legally possible for the audit firm to retain audit     for the file retention period required by auditing standards.


Computer assisted audit techniques (CAATs)


In the past, Computer assisted audit techniques (CAATs) have been used to analyse data. The CAATs were tailored to the specific client who required significant investment and as a result were not widely used across all audits.


CAATs include test data and audit software.


Test data is used to test the programmed controls within a computer system allowing the auditor to test aspects that would otherwise not be capable of testing manually.


Audit software is used to:


Calculate ratios for use in analytical procedures.


Identify exceptional transactions, i.e. those unusual transactions that exceed predefined limits, i.e. a member of management being paid in excess of $20,000 in any one month. This helps identify balances that require further audit testing.


Extract samples in a non-biased manner.


Check the calculations in client prepared reports.


Prepare lead schedules for the auditor to use in working papers.




Allows continual auditing of processes and delivery of more frequent reports.


Facilitates processing of large volumes of data and performing large volumes of calculations, many more than could reasonably be performed manually.


Test data tests the underlying system data, rather than copies and printouts.


Once software has been written for a client it can then be applied to their system with few further costs.


Reduces the need for audit staff to perform procedures, hence further cost savings for clients.


Reduces the need for paper audit trails (hence reduced environmental impact of the audit process).




There is an initial high cost of designing the software package, although this cost can be recouped over a number of years of use.


Software may interfere with the client’s system and could potentially increase the risk of viruses and data corruption.


Clients may be concerned for the security of their data.


They are only usually cost effective if the client’s accounting systems are integrated, otherwise auditors would need different software programmes for different systems.


Lead times tend to be long and the planning has to be carried out well in advance – not just three or four weeks before the start of fieldwork, but perhaps a whole year in advance.


Audit firms will need to recruit increasingly from an IT, rather than an accounting, background.


Software has to be tested on a ‘live’ system before the auditor knows whether it will work or not (i.e. high risk of corrupting that system).


If the client wishes to change their system the auditor has to incur further costs changing their audit software.

There are two types of expert an auditor may use:


  • Management’s expert – an employee of the client or someone engaged by the audit client who has expertise that is used to assist in the preparation of the financial statements.


  • Auditor’s expert – an employee of the audit firm or someone engaged by the audit firm to provide sufficient appropriate .


Relying on the work of a management’s expert


ISA 500 Audit     provides guidance on what the auditor should consider before relying on the work of a management’s expert. This guidance is very similar to that given for relying on the work of an auditor’s expert.


The auditor must:


Evaluate the competence, capabilities and objectivity of that expert. Obtain an understanding of the work of that expert.

Evaluate the appropriateness of that expert’s work as audit     for the relevant assertion.


[ISA 500, 8]


The rest of this section focuses on the work of an auditor’s expert.


Relying on the work of an auditor’s expert


ISA 620 Using the Work of an Auditor’s Expert provides guidance to auditors.


If the auditor lacks the required technical knowledge to gather sufficient appropriate     to form an opinion, they may have to rely on the work of an expert.


Examples of such circumstances include:


The valuation of complex financial instruments, land and buildings, works of art, jewellery and intangible assets.


Actuarial calculations associated with insurance contracts or employee benefit plans.


The estimation of oil and gas reserves.


The interpretation of contracts, laws and regulations.


The analysis of complex or unusual tax compliance issues.


[ISA 620, A1]


The auditor must determine if the expert’s work is adequate for the auditor’s purposes. [ISA 620, 5b]


To fulfil this responsibility the auditor must evaluate whether the expert has the necessary competence, capability and objectivity for the purpose of the audit. [ISA 620, 9]


Evaluating competence


Information regarding the competence, capability and objectivity on an expert may come from a variety of sources, including:


Personal experience of working with the expert. Discussions with the expert.

Discussions with other auditors.


Knowledge of the expert’s qualifications, memberships of professional bodies and licences.


Published papers or books written by the expert.


The audit firm’s   procedures.


[ISA 620, A15]


Evaluating objectivity


Assessing the objectivity of the expert is particularly difficult, as they may not be bound by a similar code of ethics as the auditor and, as such, may be unaware of the ethical requirements and threats with which auditors are familiar. It may therefore be relevant to:


Make enquiries of the client about known interests or relationships with the chosen expert.


Discuss applicable safeguards with the expert.


Discuss financial, business and personal interests in the client with the expert.


Obtain written representation from the expert.


[ISA 620, A20]


Agreeing the work


Once the auditor has considered the above matters they must then obtain written agreement from the expert of the following:


The nature, scope and objectives of the expert’s work.


The roles and responsibilities of the auditor and the expert.


The nature, timing and extent of communication between the two parties. The need for the expert to observe confidentiality.

[ISA 620, 11]


Evaluating the work


Once the expert’s work is complete the auditor must scrutinise it and evaluate whether it is appropriate for audit purposes.


In particular, the auditor should consider:


The reasonableness of the findings and their consistency with other    .


The significant assumptions made.


The use and accuracy of source data.


[ISA 620, 12]


Reference to the work of an expert


Auditors cannot devolve responsibility for forming an audit opinion. The auditor has to use their professional judgment whether the     produced by the expert is sufficient and appropriate to support the audit opinion.


The use of an auditor’s expert is not mentioned in an unmodified auditor’s report unless required by law or regulation. Reference to the work of an expert may be included in a modified report if it is relevant to the understanding of the modification. This does not diminish the auditor’s responsibility for the opinion. [ISA 620, 14 & 15]


Relying on internal audit


ISA 610 Using the Work of Internal Auditors provides guidance.


An internal audit department forms part of the client’s system of internal control. If this is an effective element of the control system it may reduce control risk, and therefore reduce the need for the auditor to perform detailed substantive testing.


Additionally, auditors may be able to co-operate with a client’s internal audit department and place reliance on their procedures in place of performing their own.


Before relying on the work of internal audit, the external auditor must assess the effectiveness of the internal audit function and assess whether the work produced by the internal auditor is adequate for the purpose of the audit.


Evaluating the internal audit function


The extent to which the internal audit function’s organisational status and relevant policies and procedures support the objectivity of the internal auditors).


The competence of the internal audit function.


Whether the internal audit function applies a systematic and disciplined approach.


[ISA 610, 15]


Evaluating objectivity


Whether the internal audit function reports to those charged with governance or has direct access to those charged with governance.


Whether the internal audit function is free from operational responsibility.


Whether those charged with governance are responsible for employment decisions such as remuneration.


Whether any constraints are placed on the internal function by management or those charged with governance.


Whether the internal auditors are members of a professional body which requires compliance with ethical requirements.


[ISA 610, A7]


Evaluating competence


Whether the resources of the internal audit function are appropriate and adequate for the size of the organisation and nature of its operations.


Whether there are established policies for hiring, training and assigning internal auditors to internal audit engagements.


Whether internal auditors have adequate technical training and proficiency, including relevant professional qualifications and experience.


Whether the internal auditors have the required knowledge of the entity’s financial reporting and the applicable financial reporting framework and possess the necessary skills to perform work related to the financial statements.


Whether the internal auditors are members of a professional body which requires continued professional development.


[ISA 610, A8]


Evaluating the systematic and disciplined approach


Existence, adequacy and use of internal audit procedures and guidance.


Application of   standards such as those in ISQC 1.


[ISA 610, A11]


If the auditor considers it appropriate to use the work of the internal auditors they then have to determine the areas and extent to which the work of the internal audit function can be used (by considering the nature and scope of work) and incorporate this into their planning to assess the impact on the nature, timing and extent of further audit procedures. [ISA 610, 17]


Evaluating the internal audit work


The auditor must evaluate whether:


The work was properly planned, performed, supervised, reviewed and documented.


Sufficient appropriate     has been obtained.


The conclusions reached are appropriate in the circumstances. The reports prepared are consistent with the work performed.


[ISA 610, 23]


To evaluate the work adequately, the external auditor must re-perform some of the procedures that the internal auditor has performed to ensure they reach the same conclusion. [ISA 610, 24]


The extent of the work to be performed on the internal auditor’s work will depend on the amount of judgment involved and the risk of material misstatement in that area. [ISA 610, 24]


When reviewing and re-performing some of the work of the internal auditor, the external auditor must consider whether their initial expectation of using the work of the internal auditor is still valid. [ISA 610, 25]


Note that the auditor is not required to rely on the work of internal audit. In some jurisdictions, the external auditor may be prohibited or restricted from using the work of the internal auditor by law.


Responsibility for the auditor’s opinion cannot be devolved and no reference should be made in the auditor’s report regarding the use of others during the audit.


Using the internal audit to provide direct assistance


External auditors can consider whether the internal auditor can provide direct assistance with gathering audit     under the supervision and review of the external auditor. ISA 610 provides guidance to aim to reduce the risk that the external auditor overuses the internal auditor.


The following considerations will be made:


Direct assistance cannot be provided where laws and regulations prohibit such assistance, e.g. in the UK. [ISA 610, 26]


The competence and objectivity of the internal auditor. Where threats to objectivity are present, the significance of them and whether they can be managed to an acceptable level must be considered. [ISA 610, 27]


The external auditor must not assign work to the internal auditor which involves significant judgment, a high risk of material misstatement or with which the internal auditor has been involved. [ISA 610, 30]


The planned work must be communicated with those charged with governance so agreement can be made that the use of the internal auditor is not excessive. [ISA 610, 31]


Where it is agreed that the internal auditor can provide direct assistance:


Management must agree in writing that the internal auditor can provide such assistance and that they will not intervene in that work.


[ISA 610, 33a]


The internal auditors must provide written confirmation that they will keep the external auditors information confidential. [ISA 610, 33b]


The external auditor will provide direction, supervision and review of the internal auditor’s work. [ISA 610, 34]


During the direction, supervision and review of the work, the external auditor should remain alert to the risk that the internal auditor is not objective or competent. [ISA 610, 35]




The auditor should document:


The evaluation of the internal auditor’s objectivity and competence.


The basis for the decision regarding the nature and extent of the work performed by the internal auditor.


The name of the reviewer and the extent of the review of the internal auditor’s work.


The written agreement of management mentioned above. The working papers produced by the internal auditor.

[ISA 610, 37]


Note that for UK syllabus, direct assistance by the internal auditor is not allowed.


Use of service organisations


Many companies use service organisations to perform business functions such as:


Payroll processing


Receivables collection Pension management.



If a company uses a service organisation this will impact the audit as audit     will need to be obtained from the service organisation instead of, or in addition to, the client. This needs to be taken into consideration when planning the audit.


ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation provides guidance to auditors.


Planning the audit


The service organisation is an additional element to be taken into account when planning the audit and greater consideration needs to be made regarding obtaining sufficient appropriate    .


The auditor will need to:


Obtain an understanding of the service organisation sufficient to identify and assess the risks of material misstatement.


Design and perform audit procedures responsive to those risks.


[ISA 402, 1]


This requires the auditor to obtain an understanding of the service provided:


Nature of the services and their effect on internal controls. Nature and materiality of the transactions to the entity.


Level of interaction between the activities of the service organisation and the entity.


Nature of the relationship between the service organisation and the entity including contractual terms.


[ISA 402, 9]


The auditor should determine the effect the use of a service organisation will have on their assessment of risk. The following issues should be considered:


Reputation of the service organisation


Existence of external supervision


Extent of controls operated by service provider. Experience of errors and omissions.

Degree of monitoring by the user.


Sources of information about the service organisation


Obtaining a type 1 or type 2 report from the service organisation’s auditor.


A Type 1 report provides a description of the design of the controls at the service organisation prepared by the management of the service organisation. It includes a report by the service auditor providing an opinion on the description of the system and the suitability of the controls. [ISA 402, 8bi]



A Type 2 report is a report on the description, design and operating effectiveness of controls at the service organisation. It contains a report prepared by management of the service organisation. It includes a report by the service auditor providing an opinion on the description of the system, the suitability of the controls, the effectiveness of the controls and a description of the tests of controls performed by the auditor. [para 8bii]


If the auditor intends to use a report from a service auditor they should consider:


– The competence and independence of the service organisation auditor.


–    The standards under which the report was issued.


Contacting the service organisation through the client. Visiting the service organisation.

Using another auditor to perform tests of controls.


[ISA 402, 12]


Responding to assessed risks


The auditor should determine whether sufficient appropriate     is available from the client and if not, perform further procedures or use another auditor to perform procedures on their behalf. [ISA 402, 15]


If controls are expected to operate effectively:


Obtain a type 2 report if available and consider:


–    Whether the date covered by the report is appropriate for the audit.


–    Whether the client has any complementary controls in place.


–    The time elapsed since the tests of controls were performed.


– Whether the tests of controls performed by the auditor are relevant to the financial statement assertions.


[ISA 402, 17]


Perform tests of controls at the service organisation. Use another auditor to perform tests of controls. [ISA 402, 16]


The auditor should enquire of the client whether the service organisation has reported any frauds to them or whether they are aware of any frauds. [ISA 402, 19]


Impact on the auditor’s report


If sufficient appropriate     has not been obtained, a qualified or disclaimer of opinion will be issued. [ISA 402, 20]


The use of a service organisation auditor is not mentioned in an unmodified auditor’s report unless required by law or regulation. Reference to the work of a service organisation auditor may be included in a modified report if it is relevant to the understanding of the modification. This does not diminish the auditor’s responsibility for the opinion. [ISA 402, 21]


Benefits to the audit


Independence: because the service organisation is external to the client, the audit     derived from it is regarded as being more reliable than     generated internally by the client.


Competence: because the service organisation is a specialist, it may be more competent in executing its role than the client’s internal department resulting in fewer errors.


Possible reliance on the service organisation’s auditors: it may be possible


for the client’s auditors to confirm information directly with the service organisation’s auditors.




The main disadvantage of outsourced services from the auditor’s point of view concerns access to records and information.


Auditors generally have statutory rights of access to the client’s records and to receive answers and explanations that they consider necessary to enable them to form their opinion.


They do not have such rights over records and information held by a third party such as a service organisation.


If access to records and other information is denied by the service organisation, this may impose a limitation on the scope of the auditor’s work. If sufficient appropriate     is not obtained this will result in a modified auditor’s report.


ISAE 3402: Reporting on Controls at a Service Organisation


ISAE 3402 Assurance Reports on Controls at a Service Organisation deals with assurance engagements undertaken to provide a report for use by entities engaging the services of another organisation and the user entities’ auditors. It provides guidance to the assurance provider to ensure that where the service is relevant to the user entity’s internal controls relating to financial reporting, the reports prepared provide sufficient appropriate audit     as required by ISA 402, para 1.


In order to provide sufficient appropriate    , these assurance engagements are required to provide reasonable assurance. The engagements are performed as attestation engagements.


The objective of the engagement is to obtain reasonable assurance that:


The service organisation’s description of its system fairly presents the system as designed and implemented


The controls were suitably designed


The controls operated effectively throughout the specified period, and


To report on the above matters.


[para 8]


The evaluation of the suitability of the design and operating effectiveness of the controls would need to be performed to the same standard as an evaluation performed by the external auditor.


The assurance provider can rely on the service entity’s internal audit function, in the same way that the external auditor would, where the work of the internal audit function is relevant to the engagement. [para 30]


An assessment of whether the work of the internal auditor is likely to be adequate for the purposes of the engagement should be performed which considers the same matters as those required by ISA 610 e.g. objectivity, competence, etc. [para 32]


5      Related parties


ISA 550 Related Parties provides guidance.

Risks with related party transactions


There is nothing wrong with an entity dealing with a related party.


Related party transactions may increase the potential for the financial results to be manipulated as transactions may be carried out on a basis other than ‘arms length’. In these circumstances it is appropriate for such transactions to be brought to the attention of shareholders [IAS 24 Related Party Disclosures].


The auditor should obtain sufficient appropriate     that the financial statements achieve fair presentation of the related party relationships and transactions and have been accounted for in accordance with the financial reporting framework. [ISA 550, 9]


Disclosure should be made of the following:


The nature of the related party relationship.


Information about the transactions including the amount and any balances outstanding at the year-end.


Any allowance for doubtful receivable or expense recognised in respect of irrecoverable debts.


[IAS 24, para 18-19]


If transactions have not been disclosed in accordance with those requirements, the potentially significant deficiency in the internal control system should be reported to those charged with governance.


Even once related parties have been identified it can be difficult to spot associated transactions with them:


Directors may be reluctant to disclose transactions, particularly in the case of family members.


Transactions may not be easy to identify from the accounting systems because they are not separately identified from ‘normal’ transactions.


Transactions may be concealed in whole, or in part, from auditors for fraudulent purposes.


As a result of the risks above, related party transactions are generally deemed material by nature.


Indicators of related party transactions


Related parties are often difficult to identify in practice. It can be hard to establish exactly who, or what, are the related parties of an entity. Indicators of related party transactions include:


Transactions which are overly complex.


Transactions with abnormal terms of trade.


Transactions that appear not to have a logical business reason. Transactions that are not processed in the usual or routine way.

High volumes of transactions, or high value or otherwise significant transactions with individual customers or suppliers.


Unrecorded transactions such as rent free accommodation, or services provided at no cost.


Risk assessment procedures


The auditor should obtain an understanding of:


The identity of related parties, nature of related party relationships and the type and purpose of transactions with these related parties. [ISA 550, 13]


The controls established by the client such as approval and authorisation of the transactions. [ISA 550, 14]


Other procedures


Inspecting prior year working papers.


Inspecting shareholder records for details of principal shareholders.


Inspecting minutes of shareholders’ meetings and other relevant minutes and records.


Enquiring of other auditors involved with the audit.


Inspecting the entity’s income tax returns and other information supplied to the regulatory authorities.


Inspection of bank and legal confirmations.


Where not prohibited by law or regulation the auditor should:


Confirm transactions with banks, law firms, or other intermediaries. Confirm the terms of related party transactions with the related party.


Read the financial statements or other relevant financial information of the related party for     of the transactions.


[ISA 550, A32]


Members of the audit team need to be aware that they should consider the possibility of undisclosed related party transactions when they carry out audit procedures.


If the auditor identifies related parties that were not previously identified or disclosed they should:


Communicate that information to the rest of the engagement team.


Request that management identifies all transactions with the related party and enquire why they failed to identify them.


Perform appropriate substantive procedures relating to transactions with these entities.


Reconsider the risk that other, unidentified, related parties may exist.


Evaluate the implications if the non-disclosure by management appears intentional.


[ISA 550, 22]


If the auditor identifies related party transactions outside the entity’s normal course of business they should also:


Inspect the underlying contracts or agreements to establish:


–    the business rationale


–    the terms of the transaction


–    whether appropriate disclosures have been made.


Obtain     that the transactions were appropriately authorised. [ISA 550, 23]


6      Estimates and fair values


ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures requires auditors to obtain sufficient appropriate     about whether estimates (including fair values) are reasonable and adequately disclosed in the financial statements. [para 6]


Examples of balances where fair values are relevant include:


Defined benefit pension schemes


Share based payment schemes


Investments in shares Investment property

Property within PPE if the revaluation model is used Net assets of a subsidiary at the acquisition date


Risk assessment


The auditor should consider:


How management identifies transactions and balances requiring estimation such as fair values and financial instruments. [ISA 540, 8b]


How management makes the estimates including:


–    The method and models used


– Relevant controls (control environment, risk management processes, information systems, documented system of internal control, appropriate accounting policies)


–    Use of an expert


–    Assumptions underlying the estimates


–    Changes since the prior period


–    How management assesses the effect of uncertainty.


[ISA 540, 8c]


Whether the valuation techniques are commonly used by other market participants. [ISA 540, A26]


The competence and objectivity of those responsible for the valuations. [ISA 540, A27]


To assist with this process the auditor should consider the outcome of estimates made in the prior period. [ISA 540, 9]


Professional scepticism is required for the auditor to be alert to possible management bias.


Audit procedures


Determining whether events up to the date of the auditor’s report provide additional     with regard to the appropriateness of estimates. [ISA 540, 13a]


Testing how management made their estimates and evaluating whether the method is appropriate. [ISA 540, 13b]


Testing the effectiveness of controls over estimations. [ISA 540, 13c]


Developing a point estimate to use in comparison to managements’. [ISA 540, 13d]


If there are significant risks associated with estimates the auditor should also enquire whether management considered any alternative assumptions and why they rejected them and whether the assumptions used are reasonable in the circumstances. [ISA 540, 15]


Obtain written representations from management confirming that they believe the assumptions used in making estimates are reasonable. [ISA 540, 22]


Verify the external prices used to value financial instruments.


Current issue: Proposed revisions to ISA 540


The exposure draft of proposed ISA 540 (Revised) includes enhanced requirements for risk assessment procedures and the audit work to respond to the assessed risks of material misstatement.


The audit risks and responses are affected by complexity, the need for use of judgment by management and estimation uncertainty.


ED 540 contains several key provisions designed to enhance the auditor’s application of professional scepticism and consideration of management bias including:


Enhanced risk assessment to enable better assessment of the risks of material misstatements in relation to accounting estimates. This includes obtaining an understanding of the financial reporting framework, the recognition criteria, measurement bases and disclosure requirements. The regulatory factors relevant to the estimates should also be understood.



More granular requirements regarding obtaining audit     when inherent risk is not low.


The requirement to stand back and evaluate the audit     obtained regarding estimates.


ED 540 recognises that accounting estimates with low inherent risk may not require as many procedures to obtain sufficient appropriate    . Where inherent risk is high, the auditor should design further audit procedures to obtain     about matters relating to:


Complexity in making the accounting estimate such as the extent to which the method involves specialised skills.


The need for judgment by management and potential for management bias.


Estimation uncertainty including the extent to which the estimate is sensitive to the different methods or variations in assumptions.


Terminology within the ED is also considered. In the current version of ISA 540 the term ‘reasonable’ is used for accounting estimates and ‘adequate’ for disclosures. This may be interpreted that disclosures are less important than the estimate it relates to. In the ED both accounting estimates and disclosures are described as ‘reasonable’.


There is further consideration of whether ‘reasonable’ is a sufficiently clear and high threshold. The term itself is subjective which could undermine the exercise of professional scepticism. To overcome this, further guidance is given in the application material on how to assess reasonableness of an estimate and disclosure.



Challenges in Auditing Fair Value Accounting Estimates


IAASB Practice Alert (IAASB – October 2008): Challenges in Auditing Fair Value Accounting Estimates in the Current Market Environment


The practice alert has been prepared in light of difficulties in the credit markets and therefore has a focus on financial instruments. Recent market experience has highlighted the difficulties that arise in valuing financial instruments when market information is either not available or sufficient information is difficult to obtain.


In the current environment obtaining reliable information relevant to fair values has been one of the greatest challenges faced by preparers, and consequently by auditors. The nature and reliability of information available to management to support the making of a fair value accounting estimate vary widely, and thereby affect the degree of estimation uncertainty associated with that fair value.


The alert is a comprehensive and lengthy document. A summary of some of the key points is included below:


Due to the complex nature of certain financial instruments, it is vital that both the entity and the auditor understand the instruments in which the entity has invested or to which it is exposed, and the related risks.


The auditor’s understanding of the instruments may be developed by understanding the entity’s processes for investing in particular instruments.


Factors that may influence the auditor’s risk assessment with regard to financial instruments include:


– Whether the entity has control procedures in place for making investment decisions.


– The level of due diligence associated with particular investments.


– The expertise of those responsible for making investment decisions.


– Whether the entity has the ability to subsequently value the instruments.


– Management’s track record for assessing the risks of particular instruments.


In the case of fair value accounting estimates, it is necessary that the audit engagement team include one or more members sufficiently skilled and knowledgeable about fair value accounting in order to comply with the required   procedures.


Depending on the nature, materiality and complexity of fair values, management representations about fair value measurements and disclosures contained in the financial statements may also include representations about the following:


– The appropriateness of the measurement methods and the consistency in application of the methods.


– The completeness and appropriateness of disclosures related to fair values.


– Whether subsequent events require adjustment to the fair value measurements.


7      Initial engagements – audit considerations


Where the prior period was audited by another auditor or unaudited, the auditors will need to perform additional work in order to satisfy themselves regarding the opening position.


ISA 510 Initial Engagements – Opening Balances requires that when auditors take on a new client, they must ensure that:


Opening balances do not contain material misstatements


Appropriate accounting policies have been consistently applied, or changes adequately disclosed.


[ISA 510, 3]


Audit procedures


Read the most recent financial statements and auditor’s report for information relevant to opening balances and disclosures. [ISA 510, 5]


Determine whether the prior period’s closing balances have been correctly brought forward or restated. [ISA 510, 6a]


Determine whether the opening balances reflect the application of appropriate accounting policies. [ISA 510, 6b]


Review the previous auditor’s working papers. [ISA 510, 6ci]


Evaluate whether audit procedures performed in the current period provide     relevant to opening balances. [ISA 510, 6cii]


Substantive testing of any opening balances where the above procedures are unsatisfactory. [ISA 510, 6ciii]


[UK syllabus: The predecessor auditor is required to provide access to all relevant information concerning the entity including information concerning the most recent audit in accordance with ISQC 1 (UK).]


Implications for the auditor’s report


If there is an inability to obtain sufficient appropriate     over the opening balances, a qualified or disclaimer of opinion will be issued. [ISA 510, 10]


If the opening balances are materially misstated or the accounting policies have not been consistently applied, a qualified or adverse opinion will be issued. [ISA 510, 11]



Initial engagements – further considerations


Were the previous financial statements audited?


If the previous financial statements were audited, was the opinion modified?


If the previous opinion was modified, has the matter been resolved since then?


Were any adjustments made as a result of the audit? If so, has the client adjusted their accounting ledgers as well as the financial statements?


Difficulties may arise where the prior period auditor’s report was modified and the matter remains unresolved. If the matter is material to the current period’s financial statements then the current auditor’s report will also need to be modified.


For example, if there was a modification on the grounds of a material misstatement of closing inventory in the prior period, this will affect the current period’s statement of profit or loss as last year’s closing inventory is this year’s opening inventory.


8      Corresponding figures and comparative financial statements


ISA 710 Comparative Information – Corresponding Figures and Comparative Financial Statements requires the auditor to obtain sufficient appropriate     about whether comparative information included in the financial statements has been presented in accordance with the financial reporting framework. [ISA 710, 5a]


Two categories of comparative information exist:


Corresponding figures – where preceding period figures are included as an integral part of the current period financial statements (i.e. figures shown to the right of the current year figures). [ISA 710, 6b]


Comparative financial statements – where preceding period amounts are included for comparison with the current period (i.e. the prior year’s full financial statements are included within the current year annual report). [ISA 710, 6c]




Audit procedures


Audit procedures in respect of corresponding figures should be significantly less than for the current period and are limited to ensuring that:


Comparative information agrees to the prior year financial statements. [ISA 710, 7a]


Accounting policies reflected in the comparative information are consistently applied or any changes have been properly accounted for and adequately disclosed. [ISA 710, 7b]


The auditor should request a written representation regarding any restatement made to correct a material misstatement that affects the comparative information. [ISA 710, 9]


Implications for the auditor’s report Corresponding figures

The auditor’s opinion does not refer to the corresponding figures because the opinion is on the current period financial statements as a whole including the corresponding figures. [ISA 710, A2]


If the prior period’s auditor’s report was modified and the a matter which gave rise to the modification is unresolved, the current auditor’s opinion will also have to be modified either because of the effects on the current period or because of the effects of the unresolved matter on the comparability of the current and corresponding figures. [ISA 710, 11]


If a material misstatement is identified in the prior period financial statements on which an unmodified opinion was issued, a modified opinion should be given in respect of the corresponding figures. [ISA 710, 12]


If a prior year adjustment has been put through to correct material misstatements arising in the prior year, an unmodified opinion can be issued. An emphasis of matter paragraph will be needed to draw attention to the disclosure note explaining the reason for the restatement of the opening balances. [ISA 710, A6]


Comparative financial statements


The auditor’s opinion will refer to each period. [ISA 710, 15]


If the prior period financial statements were audited by a different auditor, or were not audited, the auditor may refer to this in an Other Matter paragraph. [ISA 710, 17 & 18]


Comparative information


If the prior period financial statements were audited by a different auditor, or were not audited, the auditor may refer to this in an Other Matter paragraph. [ISA 710, 13, 14, 16, 19]

ISA 230 Audit Documentation deals specifically with audit documentation and requires:


Timely preparation of audit documentation necessary to provide a sufficient and appropriate record of the basis for the auditor’s report, and     that the audit was carried out in accordance with ISAs and applicable legal and regulatory requirements. [ISA 230, 5a]


Audit documentation sufficient to enable an experienced auditor, having no previous connection with the audit, to understand the audit work performed, the results and audit     obtained, and the significant matters identified and conclusions reached thereon. [ISA 230, 8]



UK syllabus: PN 23


Special considerations in auditing financial instruments


Financial instruments are susceptible to estimation uncertainty which is the susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement.


Detection risks when auditing financial instruments


The auditor may not understand the financial instruments.


may be difficult to obtain.


Undue reliance may be placed on certain individuals who exert significant influence on the financial instrument transactions.


Transactions may not be significant in value but the risks and exposures associated with them may be significant.



Risk of material misstatement


The risk of material misstatement increases when those responsible for the fair values and estimates:


Do not fully understand the risks and have insufficient experience to manage those risks.


Do not have the expertise to value them appropriately in accordance with the financial reporting framework.


Do not have sufficient controls in place over the financial instruments.


Inappropriately hedge risks.


Significant transactions may increase the risk of misappropriation of assets.


The risk of fraud may be higher if the employees responsible for accounting for financial instruments are more knowledgeable than management and those charged with governance.


Audit planning considerations


Understanding the accounting and disclosure requirements.


Understanding the purpose and risks of the financial instruments.


Determining whether specialised skills and knowledge are needed in the audit.


Understanding and evaluating the system of internal control. Understanding the internal audit function.


Understanding management’s process for valuing financial instruments.


Assessing and responding to the risks of material misstatement.


Assessing and responding to the risks of material misstatement


Testing the controls will be effective in an organisation with well-established controls and systems and where there are significant volumes of transactions which would mean substantive procedures alone would not suffice.


Organisations with few financial instrument transactions are less likely to have effective controls in place and management may only have a limited understanding which would lead to a substantive approach being taken.


Substantive analytical procedures may not be effective as complex interplay of the drivers of the valuation may mask unusual trends.


For non-routine transactions, a substantive approach will be the most effective means of obtaining audit    .


As valuations can change significantly in a short period of time, they should be tested at the year-end rather than during the interim audit.



UK syllabus: PN 25


Attendance at Stocktaking


ISA 501 Audit     – Specific Considerations for Selected items includes requirements and application material relating to inventory (stock) and in particular, obtaining audit     by attendance at physical inventory counts (stock takes).


Practice Note 25 Attendance at Stocktaking contains further guidance including how the requirements of other ISAs may be applied in relation to attendance at stocktaking, in particular in relation to obtaining     relating to the existence assertion.


The Practice Note covers:


Assessment of risks and internal controls including factors relating to risk of material misstatement in the context of the existence of stocks (e.g. timing of stocktakes relative to the year-end date).


Audit     obtained from attendance at stocktaking, in particular the principal sources of     relating to the existence of stocks (e.g. substantive     from physical inspection of stock).


The principal procedures that should be performed when attending a stocktake, including:


– the need for procedures to be performed by audit staff who are familiar with the entity’s business


–    the need for advance planning


–    procedures before, during and after the stocktake


–    inspection of work-in-progress


the use of expert valuers and stocktakers


– the need to obtain sufficient appropriate     over stock held by third parties or in public warehouses.


In 2017, the FRC proposed the withdrawal of PN 25.



UK syllabus: PN 26


Practice Note 26 Guidance on Smaller Entity Audit Documentation provides guidance on the application of documentation requirements contained within ISAs to the audit of financial statements of smaller entities in an efficient manner.


The guidance is aimed at auditors of smaller, simpler entities, which choose to have a voluntary audit such as small subsidiary companies, small charities, and simple larger entities. It excludes smaller entities with complex operations or the audit of complex and subjective matters.


The Practice Note highlights that it is neither practicable nor necessary to document every matter considered, or professional judgment made, in an audit. It encourages:


The use of structured forms (instead of narrative notes) to document understanding of the entity.


Focusing on how the main transaction cycles operate at highlighting the risks of material misstatement when documenting smaller entities’ accounting systems.


Not documenting matters that would normally have been documented solely to inform or instruct members of the audit team, when the engagement partner is performing the work themselves (as smaller audit teams are common in audits of smaller entities).



Test your understanding 1 – Queens Cars


Your firm has recently been appointed as auditor of Queens Cars Co, a new and second hand motor vehicle dealer with six sites. You are currently planning the audit for the year ended 29 February 20X4. The draft financial statements show revenue of $23.3 million

(20X3: $18.1 million), profit before tax of $2.6 million (20X3: $1.4 million)

and total assets of $15.8 million (20X3: $12.6 million).


New cars are purchased on a consignment basis from a single supplier. Queens Cars pays the invoice price (plus a 2% display fee) six months after delivery, or on sale of the vehicle if sooner. Currently Queens Cars records the purchase of the vehicles when the invoice is paid because their supplier legally owns the vehicles and may demand their return at any point prior to settlement. Although, the FD has told you that this has yet to happen.


The value of all new cars held across the various sites at the year-end, according to management records, was $2.4 million (20X3: $1.9 million). The value of used cars held at the year-end, according to inventory records, was $600,000 (20X3: $600,000).


Whilst less popular with new cars, many customers like to pay cash, using this as leverage to barter for a cash discount. In addition, Queens Cars also accept cars in part exchange. One of their current promotions is that they will accept any vehicle for a minimum of $500 trade in value.


The MD of Queens Cars has informed you that he has employed his nephew, a trainee accountant, to manage and record the spare parts inventory across all branches. It was his responsibility to conduct the yearend count. However, you have been told that the year-end fell during the nephew’s reading week and he was on holiday at the time. Therefore he conducted the count the week before the year-end and then reconciled the movements on his return. The year-end valuation of spare parts inventory was $200,000 (20X3: $150,000).


During the year Queens Cars purchased a brand of simple fitting replacement parts that it will now supply on all servicing and repair jobs. As part of this purchase $700,000 was paid for the brand name “Quick Fit.” This has been capitalised as an intangible asset. However, Queens Cars are not amortising the brand following the advice of the MD’s nephew, who argued that the brand was so strong that its useful life was indefinite.


All new cars come with a warranty of three years or 30,000 miles, whichever is sooner. Second hand cars are offered with a six month guarantee. At the end of the year the warranty provision was $800,000 (20X3: $700,000). The FD believes that despite the increase in the number of cars sold there is no need to increase the warranty provision because the company has focused more heavily on new car sales this year, which, according to him, require less after sales repairs than used cars.




Prepare briefing notes for the engagement partner that:


  • Evaluate the audit risks that should be considered when planning the audit of Queens Cars for the year ended 29 February 20X4.


(9 marks)


  • Describes the principal audit procedures that would be carried out in

respect of the amortisation of the Quick Fit brand.                                                                                                                        (5 marks)


Professional marks will be awarded for the presentation, logical flow and

clarity of explanation of the briefing notes.                                                                                                                                    (4 marks)


(Total: 18 marks)


Test your understanding 2 – Financial instruments


You are planning the audit of Gig Co for the year ended 31 December

20X1. During the period, Gig Co entered into the following transactions:


On 1 April 20X1 Gig Co purchased 1 million shares in Concert Co for

$5 per share. This amounts to a 6% holding of Concert Co’s issued share capital, and is not sufficient to give significant influence or control. The shares of Concert Co are not listed.


Gig Co required additional finance and on 1 January 20X1, it issued

1 million $10 bonds at par. Interest is payable at a rate of 5% of the par value annually in arrears. The bonds will be redeemed at a premium on 31 December 20X3. The bonds are held in the financial statements at $10 million and the interest paid during the period has been charged to profit or loss.




Explain the principal audit procedures to be performed in respect of:


  • The investment in the shares of Concert Co.


  • The bonds.


(10 marks)


Test your understanding 1 – Queens Cars


Study Note: Throughout your answer you must remain specific to the scenario presented in the question. The majority of the marks are for application of knowledge. Simply restating the information from the scenario will not score enough for a pass.


Note the use of structure (short paragraphs, headings, briefing note format). This generally leads to more succinct answers, which are easier to mark. There are also professional marks available for use of appropriate format, introduction, conclusion and the quality of the presentation/flow.


  • Briefing notes


To:                         Audit partner


From:                   Audit manager


Date:                     8 April 20X4


Subject:              Planning of the year-end audit of Queens Cars Co




These briefing notes evaluate the audit risks to be considered when planning the audit of Queens Cars Co. Procedures to be performed in respect of the useful life of the brand name are also included.


New car inventories


In legal terms Queens Cars do not own the consignment inventory held on site at the year-end. However, Queens have never returned a vehicle and in substance they should record the purchase of inventory in their accounting records at the point of delivery. There is therefore a risk that new car inventories, and the consequent liabilities, are understated.


Finance costs


There is also an associated risk that finance costs are understated in the statement of profit or loss. The 2% display fee should be treated as a finance cost in the statement of profit or loss.


Second hand inventories


There is a risk that second hand inventories are overstated. At $0.6m these are material to total assets. The case suggests that it is common for customers to barter for discounts, which could lead to vehicles being sold for less than cost.


Queens also offer a fixed part exchange value for any vehicle and it is therefore likely that they may receive vehicles in part exchange that do not have a resale value of $500 or more. It will be necessary to establish whether such vehicles have a resale value above their part exchange value.


Spare parts inventories


Spare parts inventory total $0.2m and are therefore material to total assets. There is a risk that quantities have been incorrectly determined at the year-end due to the fact that the year-end count was performed before the year-end. This increases the risk that inventory balances are misstated.




The ‘Quick Fit’ brand name valued at $0.7m is material to total assets. Intangible assets should be amortised over their useful life unless the life is indefinite, in accordance with IAS 38 Intangible Assets. Indefinite means the company has sufficient resources to maintain the brand strength. In the absence of amortisation, Queens Cars must perform an annual impairment review. Therefore there is a risk that the intangible asset is overstated and impairment charges are understated.




There is a risk that revenue is misstated due to discounts for cash sales. There is a risk that the sale may be recorded at the original amount, rather than the renegotiated value. There is also an increased risk of theft by sales persons, who could record a higher cash discount in the accounts and keep some of the cash for themselves resulting in understatement of revenue.


Warranty provision


There is a risk that the warranty provision is understated in the statement of financial position. $0.8m is material to total assets. Whereas revenue has increased by 29% the provision has only increased by 14%, which suggests that the provision does not reflect the increased activity of the business. IAS 37 Provisions, Contingent Liabilities and Contingent Assets suggests that a provision should be recorded for all probable liabilities and given that all cars are sold with a warranty there is a suggestion that the provision should be increased accordingly.



New audit client


This is our first year of audit. Given our lack of cumulative audit knowledge and experience there is a greater exposure to audit risk. In response it may be prudent to perform increased substantive procedures this year.


Given the multiple sites it will be necessary to visit at least a sample to assess the accounting/control environment. This could increase the time taken to perform the audit and will have consequences for the budget.


  • Audit work on useful life


– Review the history of the Quick Fit brand. Most importantly assess how long the brand has been trading under that name.


– Inspect advertising invoices to confirm the amount spent on marketing the Quick Fit brand during the accounting year which may extend the life of the brand.


– Compare the amortisation policies of known competitor brands within the same industry. The accounts should be publicly available and an accounting policy note should be included for amortisation of intangibles.


–    Inspect any forecasts/budgets available to assess the level of marketing considered necessary to maintain the brand name.


– Compare the performance of the brand on a month by month basis since acquisition to the present day to identify if performance continues to improve, or at least remain healthy to confirm management’s assumption of brand strength.


– Inspect a breakdown of the repairs and maintenance account after the year-end to identify any possible concerns over the quality of the replacement parts which would indicate possible impairment of the brand.


– Review industry journals to identify the risk of new entrants or substitute products to the spare parts industry which may indicate impairment of the brand.


– Inspect any impairment tests carried out by management, or make enquiries of management to the same effect.


– Make enquiries of management about the basis of their assumptions with regard to the strength of the brand and their strategy for maintaining its market position.


– Obtain written representations from management to corroborate the results of enquiries with management with regard to areas of judgment and estimation.





The audit risks explained above indicate that the audit of Queens Cars is a relatively high risk engagement. Appropriate audit responses will need to be designed to address these risks and ensure that audit risk is reduced to an acceptable level.



Test your understanding 2 – Financial instruments


  • Shares


– Agree the cash paid of $5 million on the purchase of the shares to bank statements and the cash book.


– Inspect the board minutes of Gig Co, or other internal documents, for     that the investment has been classified to be measured at fair value through other comprehensive income (FVOCI).


– If classified to be measured at fair value through other comprehensive income, enquire of management to confirm that they do not intend to trade the shares in the short-term.


– Inspect profit and cash flow forecasts to verify that the shares are not expected to be sold within the next year.


– Review past share sales and assess if Gig Co has a history of trading shares in the short-term.


– Enquire of management if legal or broker fees were incurred on the share issue. If so, agree to invoices and ensure that the treatment is appropriate (they should be expensed if the investment is measured at fair value through profit or loss (FVPL), but added onto the carrying amount if measured at FVOCI).


– Enquire of management as to how the fair value of non-listed shares has been determined.


– Review the fair value calculation for accuracy and assess the reasonableness of the assumptions used. Assess the level of input used as per IFRS 13 Fair Value Measurement.


– Inspect the financial statements to see where the revaluation loss has been recorded and assess if this is consistent with the classification of the financial asset (FVPL or FVOCI).


–    Inspect the financial statement disclosures, particularly around the level of input used to measure the fair value of the shares.


  • Bonds


– Agree the cash receipt of $10 million to the bank statements and cash book.


– Agree the interest payment to the bank statement and cash book.


– Obtain documentation relating to the bond issue to verify the interest rate and the redemption premium.


– Enquire of management if legal or broker fees were incurred on the bond issue. If so, agree to invoices. An audit adjustment would need to be proposed to deduct these from the initial carrying amount of the liability.


– Recalculate the effective rate of interest on the bonds to confirm arithmetical accuracy.


– Calculate the audit adjustment required so that the finance cost in profit or loss is based on the effective rate of interest.


– Inspect the financial statements to ensure that the liability in respect of the bonds is correctly classified as non-current.


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