course menu
However, you should note that some pages are not featured
in this printed pdf version. These are:
• answers to questions
• answers to exercises
• mock assessment
• tables of contents for each module
You will see that, because of this, sometimes the printed
document appears to ‘miss’ a page in the numbering on the
navigation menu.
The primary objectives of this course are: The course includes questions and interactive exercises
• to explain the role of the International Federation of which you should complete before moving on. Avoid
Accountants (IFAC) skimming the material in the hope that you will glean the
• to examine the basic principles and essential procedures appropriate points - you won’t, you must set aside time to
of ISAs on a standard-by-standard basis study the material fully.
• to provide guidance on how to apply ISAs in practice, with
the aid of illustrations and activities If you do need to get in touch with the course administrator
click here (NB. For your enquiry to be dealt with as quickly as
possible the subject line should read “Certificate in
International Auditing”).
Course navigation
To move from page to page, click the next and previous To access external web pages, all you need to do is click
buttons at the top and bottom of each page. the link that appears within the text of the page. Off-page
links always look and behave like this (this will launch the
Once in the course, all you need to do is click course menu at ACCA home page). Here are some tips for using external
the top of this page and select the module that you wish to pages:
study. • some external web pages are large, for example the IFAC
website at www.ifac.org; for ease of navigation maximize
To navigate directly to any page within the current module, your browser window using the maximize button (the
click centre button of the three at the top right of the window
module contents at the top of the page. frame)
• when you have finished with the external page use your
During exercises and activities you are invited to enter your browser’s close button (or File Close) to close the window;
answer and review the answers of others within the course the ACCA e-qualification course will remain open in
blog. another window for you to continue studying
You decide when you want or need to learn; you decide just
how long you will spend reviewing and revising a topic, and
you decide when you are ready to move on.
Standards on auditing
• the International Federation of Accountants (IFAC)
• the International Auditing and Assurance Standards Board
(IAASB)
• the framework of International Standards on Auditing
(ISAs)
• ISAs - what they represent and how they are set
Introduction
This module gives an overview of the standard setting The IAASB has recently completed its ‘Clarity Project’,
process and the role of International Standards on the objective of which has been to improve the
Auditing (ISAs). understandability of the ISAs, and to encourage
consistent application of them.
This update takes into account the changes that have taken
place since the last edition of this course was completed. In some cases the standards have undergone significant
changes and have been “revised” as well as “re-drafted”.
The new “Clarity” form standards will be effective for all audits
for periods beginning on or after 15 December 2009. These
materials reflect the content of the revised and redrafted ISAs.
www.ifac.org/About/MemberBodies.tmpl
IFAC
International International International International Professional Developing Compliance Transnational Small and Nominating
Auditing and Ethics Accounting Public Accountants Nations Advisory Auditors Medium Committee
Assurance Standards Education Sector in Business Committee Panel Committee Practices
Standards Board for Standards Acounting Committee (TAC) Committee
Board Accountants Board Standards
(IAASB) (IESBA) (IAESB) Board
(IPSAB)
In recent years IFAC has implemented a series of reforms 1. PIOB – the Public Interest Oversight Board was
to increase confidence in the quality of its standards and established in February 2005, comprising 10 members
practices in auditing and assurance. appointed by regulators, to oversee IFAC’s audit and
assurance, ethics and education standard-setting activities. It
The reforms provide the following: also oversees IFAC’s Member Body Compliance Program;
• more transparent standard setting processes this is designed to encourage member bodies to adopt
• greater public and regulatory input into the processes international standards and to implement quality assurance
• regulatory monitoring and discipline programs in the areas of ethics (including
• public interest oversight independence), quality control, auditing and assurance.
2. MG – The Monitoring Group, comprising international
regulators and related organisations will update the PIOB
regarding significant events in the regulatory environment. It
is also the vehicle for dialogue between regulators and the
international accounting profession.
3. IRLG – The IFAC Regulatory Leadership Group,
includes the IFAC President, Deputy President, Chief
Executive, the Chairs of the IAASB, the Transnational
Auditors Committee, The Forum of Firms, and up to four other
members designated by the IFAC Board. The IRLG works
with the MG and addresses issues related to the regulation of
the profession.
“To serve the public interest by setting high quality Subcommittee studies background information
auditing and assurance standards and by
Subcommittee issues an exposure draft
facilitating the convergence of international
for consideration by IAASB
standards, thereby enhancing the quality and
uniformity of practice throughout the world and If approved, ED is widely distributed for
strengthening public confidence in the global comment by member bodies
auditing and assurance profession.” Comments received are considered by IAASB
(and a revised ED issued if appropiate)
Module review
There are two matters which you should appreciate at It is stated in the auditor’s report:
this stage: “These financial statements are the responsibility of the
company’s management. Our responsibility is to express an
An audit of financial statements is a specific example of opinion on these financial statements based on our audit.
an assurance service provided by a professional
accountant. Although the remainder of this course is devoted We conducted our audit in accordance with international
to specific international standards on auditing, many of the standards on auditing.”
basic principles and essential procedures can be applied to
other assurance and review engagements. This continues:
Although the auditor’s responsibilities to consider fraud
“Those standards require that we plan .... the audit ....”
in the audit of financial statements has been described in
Planning is the subject of the next module.
some detail, the primary responsibilities for the
prevention and detection of fraud lies with management.
The requirements which are described throughout the
remainder of this course are concerned with how the auditor
detects and reports on misstatement in the financial
statements however caused.
Question 1
The revised preface to “international standards on quality control, auditing, review and other related services” describes the scope
and authority of documents issued by the International Auditing and Assurance Standards Board.
Question 2
Which of the following is not a standard setting board of IFAC?
Question 3
Which of the following statements is not true of International Standards on Auditing?
Introduction
This module is key to your understanding of what is required
of auditors under the ISAs. ISA 200 establishes the overall
objective and conduct of an audit and acts as an underpinning
for all of the other standards.
You will find that all of the concepts introduced in this module
are revisited in greater depth as you study the other more
detailed standards, each of which sets requirements for a
particular stage of the audit or for a particular procedure.
Auditor’s responsibility
Compliance with auditing standards Our responsibility is to express an opinion on these financial statements
based on our audit. We conducted our audit in accordance with International
Standards on Auditing. Those standards require that we comply with ethical
requirements and plan and perform the audit to obtain reasonable
assurance whether the financial statements are free from material
misstatement.
Opinion
Opinion paragraph In our opinion, the financial statements give a true and fair view of (or
“present fairly, in all material respects,”) the financial position of ABC
Company as of December 31, 20X1, and of its financial performance
and its cash flows for the year then ended in accordance with
Financial reporting framework International Financial Reporting Standards.
The phrases “give a true and fair view” and “present fairly, in
all material respects,” when used to express the auditor’s
opinion, are equivalent.
• the term is not defined in ISAs and “definitions” should • materiality is an expression of relative significance or
therefore be regarded with caution importance of a matter in the context of the financial
• truth relates to factual accuracy (bearing in mind statements as a whole
materiality)
• fairness relates to presentation of information and the • a matter is material if its omission or misstatement would
view conveyed to the reader reasonably influence the decisions of an addressee of the
• a degree of imprecision is inevitable because of inherent auditor’s report
limitations
• “view” indicates that a professional judgment has been
reached
• the concept of a “true and fair” view is constantly changing
(e.g. with developments in accounting standards)
• that the phrase is preceded in the statutes by the
indefinite article (“a”) suggests that more than one form of
presentation may satisfy the requirement
• a true and fair view generally implies that IFRSs, IASs and
IFRIC interpretations (of the IASC’s Financial Reporting
Interpretations Committee) have been complied with
ISAs provide objectives and requirements (i.e. basic Auditors may also conduct the audit in accordance with both
principles and essential procedures) and related guidance ISAs and auditing standards of a specific jurisdiction or
(i.e. application and other explanatory material). country.
Overall objectives - general principles - sufficient appropriate audit evidence and audit risk
• management are responsible for identifying business risks
“To obtain reasonable assurance the auditor shall and responding to them
• the auditor is ultimately concerned only with risks that may
obtain sufficient appropriate audit evidence to affect the financial statements
reduce audit risk to an acceptably low level and • the concept of reasonable assurance acknowledges that
thereby enable the auditor to draw reasonable there is a risk the audit opinion is inappropriate
• the risk that an auditor expresses an inappropriate opinion
conclusions on which to base the auditor’s when the financial statements are materially misstated is
opinion .” known as audit risk
• audit risk is a function of the risk of material misstatement
of the financial statements (prior to audit) and the risk that
the auditor will not detect such misstatement (“detection
risk”)
An audit conducted in accordance with ISAs must have In summary, this covers:
regard to the requirements of:
Agree terms of
• ISAs (i.e. to plan, evaluate controls, obtain evidence, form
engagement
conclusions and report) Obtain
• relevant professional bodies (e.g. ACCA) Form opinion in
understanding
auditor’s report
• legislation and regulations (e.g. Companies Acts) of business
• the terms of the audit engagement and reporting
requirements
Obtain
management Plan
representations
Documentation
Assess risk
Analytical and internal
procedures controls
Module review
This module has given you an introduction to the framework
of principles that underlie the ISAs.
Question 1
The objective an audit of financial statements is to enable the auditor to:
Question 2
The “financial statements” referred to in an auditor’s report does not include:
A An income statement
B An accounting policies note
C A five year summary of results
D A statement of changes in equity
Question 3
When conducting an audit in accordance with ISAs the auditor must have regard to the
requirements of which of the following?
1. Ethical codes
2. Legislation and regulations
3. The terms of the audit engagement
4. None
A 1 only
B 2 and 3
C 1, 2 and 3
D4
Question 4
Which of the following factors is not an inherent limitation in an audit affecting the auditor’s
ability to detect material misstatements?
Question 5
Preparing working papers is important, because doing so:
Introduction
ISAs are not only prescriptive in terms of how an audit should
be conducted, but also in terms of what must be documented
at each stage of the audit. This will help the audit run
smoothly and also provide a record of what work was done
and conclusions drawn in case the auditor’s judgement is
challenged later.
Standardization
Exercise - standardization
Please review the following exercises:
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
Questionnaires
Internal control questionnaires (ICQs) are designed to
indicate which parts of a system are strong or weak and so
make a preliminary assessment of the extent to which the
auditor seeks to place reliance (if any) on internal controls.
“In documenting the nature, timing and extent of The auditor shall document discussions of significant
audit procedures performed, the auditor shall matters with management and others on a timely basis. It
is particularly important that the known, relevant facts of all
record the identifying characteristics of the specific significant matters (e.g. of principle, judgment and concern)
items or matters being tested.” are recorded at the time conclusions were reached. One of
the reasons why the auditor’s report is dated is to establish
Recording the identifying characteristics enables the the point in time after which new evidence would not have
audit team to be accountable for its work and facilitates been considered in reaching the audit opinion.
the investigation of exceptions or inconsistencies.
If the auditor has identified information that contradicts
or is inconsistent with the auditor’s final conclusion
regarding a significant matter, the auditor shall document
how the auditor addressed the contradiction or inconsistency
in forming the final conclusion.
Audit documentation - changes to audit documentation in exceptional circumstances after the date of
the auditor’s report
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
Module review
In this module you have seen the basic requirements of ISA
230 in respect of audit documentation. Audit firms operate in
an environment of ever closer scrutiny and oversight so it is
important that they not only perform their work to the highest
professional standards, but that they have documented all of
the evidence and conclusions that support their audit
opinions.
Question 1
During the course of an audit, the auditor may use the following documents:
Which of these are acceptable if prepared by the client as a basis for further audit work?
A None
B 1 only
C 1 and 2
D 1, 2 and 3
Question 2
“The use of standardized working papers may improve the efficiency with which such working
papers are prepared and reviewed”.
A An engagement letter
B A letter of request for a bank report
C An overall audit strategy
D A letter of representation
Question 3
Auditors’ working papers are conventionally divided into current and permanent files for both
convenience and control.
Which of the following letters is most likely to appear on the permanent audit file rather than
the current audit file?
A Engagement letter
B Report on deficiencies in internal control
C Management representation letter
D Bank confirmation letter
Question 4
Which of the following is most likely to constitute an error, rather than fraud?
Introduction
The responsibility of auditors in respect of preventing and
detecting fraud is a common area of misunderstanding. The
earlier modules have set out the auditor’s key responsibilities
and this module explains what is expected of the auditor
under ISAs with regard to frauds.
Definitions - “Error”
Unintentional misstatement in financial statements including
omissions.
Definitions - “Fraud”
Intentional act of deception by one or more individuals to
obtain an unjust or illegal advantage.
Fraud in an audit of financial statements - responsibilities of those charged with governance & of
management
Primary responsibility for prevention and detection of
fraud lies with those charged with governance of the
entity and with management.
The auditor’s professional duty to maintain Although the auditor’s report is not explained until much
confidentiality of client information may preclude later it should be noted that if a matter is immaterial there will
reporting fraud to a party outside the client entity. Where this be no grounds for qualifying the audit report. Thus immaterial
is the case seek legal advice to determine the appropriate fraud is not drawn to the attention of the users of financial
course of action. This may be necessary to consider the statements.
public aspect interests of identified fraud.
Exercise - communication
Please review the following exercise:
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
The auditor shall: • The auditor may also meet with those charged with
• discuss the entity’s susceptibility to fraud and error corporate governance to discuss such high level issues as:
amongst the audit team; and a. the risk of management fraud;
• inquire of management: b. management’s competence and integrity in discharging
a. management’s own risk assessment of fraud (and their responsibilities, e.g. whether recommendations for
management of such risk); improvements in internal controls are implemented
b. their understanding of the accounting and internal • Knowledge of fraud or material errors suspected or found
control systems necessary to discharge their is important in:
responsibilities for the prevention and detection of a. identifying possible internal control weaknesses (if
error; control procedures failed to prevent something); and
c. any fraud or material error suspected and/or found. b. providing evidence about the effective operation of
• discuss within the audit team to raise awareness of the control procedures (in detecting anomalies)
potential for material misstatement
• discuss with management will include the role of internal
audit
Risk assessment
The auditor’s assessment of inherent risk and control risk
As well as considering how the financial is detailed in paragraph 25 and 26 of ISA 315 “identifying
“
statements could be materially misstated due to and assessing the risks of material misstatement through
understanding the entity and its environment”.
fraud or error, the auditor shall consider whether
fraud risk factors exist to suggest the possibility of The existence of fraud risk factors may indicate that
fraud of either of the two types previously control risk cannot be assessed at less than high for
certain financial statement assertions.
described. Fraud risk factors identified should be
documented (in accordance with ISA 230 However, tests of controls on internal control procedures
documentation) .” designed to mitigate those fraud risk factors may support a
less than high control risk assessment.
Management bias arising from: Industry conditions (i.e. economic and regulatory
• bonuses, share options etc. dependent on meeting environment):
aggressive operating/financial targets • new regulatory, accounting or statutory requirements that
• a need to maintain share price, earnings per share, etc. could impair the financial stability or profitability of the
• tax-motivated reasons entity (e.g. environmental legislation)
• a highly competitive or saturated market (with declining
A lax attitude towards internal control and financial margins) and/or technologically obsolete products
reporting, e.g.:
• significant disregard for regulatory authorities Operating characteristics and financial stability including
• failure to correct known material internal control nature and complexity of the entity, its transactions,
weaknesses on a timely basis financial condition and profitability:
• significant pressure to obtain necessary finance (e.g. for
Strained relationships between management and current capital expenditure)
or predecessor auditors, concerning, for example: • significant related party or complex transactions
• disagreements about financial reporting matters • bank accounts and/or operations in tax-haven jurisdictions
• unreasonable time constraints on completion of audit work • high vulnerability to interest rate changes
• attempts to influence the scope of the audit work • a threat of imminent bankruptcy, foreclosure or hostile
takeover
Weak or ineffective corporate governance structure (e.g.
a lack of non-executive directors (NEDs)
You can then review the ideas of other students on this subject.
The auditor’s design of substantive procedures to reduce The auditor’s substantive procedures shall include the
detection risk to an acceptably low level is explained in following procedures related to the financial statements
paragraph 18 of ISA 330, “the auditor’s responses to closing process:
assessed risks”. Paragraphs 13 and A42 to A44 of ISA 200, • agreeing the financial statements to the underlying
“overall objectives of the independent auditor and the conduct accounting records
of an audit in accordance with international standards on • examining material journal entries and other adjustments
auditing” give details of what detection risk is. made during the course of preparing the financial
statements
Substantive procedures are performed in order to detect
material misstatements at the assertion level, and When, in accordance with paragraphs 26 to 28 of ISA 315,
include: the auditor has determined that an assessed risk of
• tests of details of classes of transactions, account material misstatement at the assertion level is a
balances and disclosures significant risk, the auditor shall perform substantive
• substantive analytical procedures procedures that are specifically responsive to that risk.
Irrespective of the assessed risk of material
misstatements, the auditor shall design and perform For example, if management are under pressure to meet
substantive procedures for each material class of shareholders’ or a stock exchange’s expectation of
transactions, account balance, and disclosure. earnings then there may be a risk that management is
inflating sales by, for example, invoicing sales before
This is because the auditor’s assessment of risk is shipment. In these circumstances the auditor may have to
judgemental and may not be sufficiently precise to identify all design the audit tests which allow for such an occurrence to
risks of material misstatement. be detected.
Examples of circumstances:
• concerning management (and its integrity) Implications for the auditor’s report are explained in ISA
• accounting matters 700 “forming an opinion and reporting on financial
• problems in obtaining sufficient appropriate audit evidence statements”.
crucial to drawing reasonable conclusions on which to
base the audit opinion
• transactions which are unusual
• accounting and internal control weaknesses
• control mechanisms
• specific to a computer information system environment
• other
Consider your answer to the question, when you are ready click next to
“The auditor shall evaluate whether it may be enter it into the course blog.
indicative of fraud; and if so, the implications for the You may wish to discuss this with a colleague before finally submitting it.
audit particularly the reliability of written You can then review the ideas of other students on this subject.
representations.”
Auditors should obtain written acknowledgement of • it has disclosed to the auditor its knowledge of any
management’s responsibility for the financial statements allegations of fraud, or suspected fraud, affecting the
(see ISA 580, “written representations”). entity’s financial statements communicated by employees,
former employees, analysts, regulators or others
The auditor shall obtain written representations from
management that: Due to the nature of fraud and the difficulties
• it acknowledges its responsibility for the design and encountered by auditors in detecting material
implementation of internal control to prevent and detect misstatements in the financial statements resulting from
fraud fraud, it is important that the auditor obtains a written
• it has disclosed to the auditor the results of its assessment representation from management confirming that it has
of the risk that the financial statements may be materially disclosed to the auditor the results of management’s
misstated as a result of fraud assessment of the risk that the financial statements may be
• it has disclosed to the auditor its knowledge of fraud or materially misstated as a result of fraud and its knowledge of
suspected fraud affecting the entity involving: actual, suspected or alleged fraud affecting the entity.
a. management
b. employees who have significant roles in internal control
c. others where the fraud could have a material effect on
the financial statements
Fraud in an audit of financial statements - withdrawal - inquiry from a proposed (successor) auditor
The extent to which an existing auditor can advise his
successor (“nominee”) depends on:
• whether or not the client gives permission to discuss its
affairs
• ethical requirements (e.g. IFAC’s Code of Ethics for
Professional Accountants [“The Code”])
The documentation of the auditor’s responses to the The extent to which these matters are documented is for
assessed risks of material misstatement shall include: the auditor to determine using professional judgement.
• the overall responses to the assessed risks of material
misstatements due to fraud at the financial statement level
and the nature, timing and extent of audit procedures, and
the linkage of those procedures with the assessed risks of
material misstatement due to fraud at the assertion leve
• the results of the audit procedures, including those
designed to address the risk of management override of
controls
Module review
In this module you have learned the requirements imposed on
auditors by ISA 240. The basic requirement is driven by the
auditor’s responsibility to assess the risk of material
misstatement.
On the one hand, the standard makes it clear that it is not the
auditor’s job to detect every fraud that may occur in an entity.
On the other hand it also emphasises that any discovery or
suspicion of fraud must be considered in terms of its
implications for other areas of the audit. The principle of
professional scepticism means that in circumstances where
there is suspicion of fraud at a high level within the company,
any representations obtained from management must be
treated with caution.
Question 1
During the examination of transactions around the year end an auditor finds numerous
alterations which post-date suppliers’ invoices, with the result that they are not included in
trade payables. The auditor also discovers that several copy sales invoices have been ante-
dated and included in sales for the year and figures on physical inventory records have been
altered.
Question 2
Which of the following statements best expresses the auditor’s duty of confidentiality to his
client in respect of information acquired in the course of professional work?
Question 3
ISA 240 the auditor’s responsibilities relating to fraud in an audit of financial statements,
specifically requires the auditor to do all of the following except:?
Question 4
According to ISA 240 “the auditor’s responsibilities relating to fraud in an audit of financial
statements”, which of the following is not an error:
Question 5
According to ISA 240 “the auditor’s responsibilities relating to fraud in an audit of financial
statements”, which of the following circumstances does not indicate the possibility of fraud:
Introduction
Module 5 describes the “core” standard on planning (ISA
300) which explains the essential procedures of the
planning process. This ISA 300 has been redrafted under
the Clarity project. This “core” standard introduces the need
for other standards which are also covered in this module:
• understanding the entity and its environment (ISA 315)
• the importance of materiality as an auditing concept (ISA
320)
Other standards linked to this area will be covered in later
modules:
• assessing the risk of material misstatement (Module 6 -
ISA 315)
• accounting and internal control systems (Module 6 - ISA
315)
• nature, timing and extent of procedures - including tests of
controls and substantive procedures (Module 8 - ISA 501
and 505)
Objective
Definition Requirement
Planning entails: The auditor shall document the overall audit strategy.
• establishing the overall audit strategy for the engagement
• developing a detailed approach for the nature, timing and
extent of audit procedures – the “audit program” – in order
to reduce audit risk to an acceptably low level
Role
• to devote appropriate attention to important areas
• to identify and resolve potential problems on a timely
basis
• to complete work in an effective and efficient manner (i.e.
expeditiously)
• to assist in assigning/directing/supervising/coordinating
audit work
Planning an audit of financial statements - overall audit strategy - form and content
Must be sufficiently detailed to facilitate the development
of the audit program.
Planning an audit of financial statements - overall audit strategy - typical content of an audit strategy
Terms of the engagement
The work to be done i.e. audit work, accounting work to be
done for the client, tax work, letters to be sent. Including
reports required and client expectations.
Planning an audit of financial statements - overall audit strategy - typical content of an audit strategy
Group structure
The auditor shall document the audit plan. (This The auditor should perform the following activities prior
document is more commonly referred to as the audit to starting an initial audit:
program). • perform procedures regarding the acceptance of the client
relationship and the specific audit engagement
This serves as a record of the proper planning of the • communicate with the previous auditor, where there has
audit procedures that can be reviewed and approved prior to been a change of auditors, in compliance with relevant
their performance. ethical requirements
The overall audit strategy and audit plan should be Typical contents:
updated and changed as necessary during the audit. The • audit objectives
reasons for any significant changes must be documented. • audit procedures
• time budget
• timing of tests of controls and substantive procedures
“The objective of the auditor is to identify and • ISA 315 “identifying and assessing the risks of material
assess the risks of material misstatement, whether misstatement through understanding the entity and its
environment” has been redrafted under the Clarity project
due to fraud or error, at the financial statement and
• to explain the relevance of understanding the entity and
assertion levels, through understanding the entity its environment to the audit process
and its environment, including the entity’s internal
The auditor’s understanding of the entity and its
control, thereby providing a basis for designing and
environment consists of an understanding of the
implementing responses to the assessed risks of following aspects:
material misstatement. • industry, regulation, and other external factors, including
the applicable financial reporting framework
• nature of the entity, including its operations, its ownership
The members of the engagement team shall discuss and governance structures, its investments and finance
the susceptibility of the entity’s financial statements arrangements
• the entity’s selection and application of accounting
to material misstatements.”
policies
• objectives and strategies and the related business risks
that may result in a material misstatement of the financial
statements
• measurement and review of the entity’s financial
performance
• internal control
The auditor shall obtain an understanding of the nature of The auditor shall obtain an understanding of the entity’s
the entity. The nature of the entity includes: selection and application of accounting policies and
• its operations consider whether they are appropriate for its business and
• its ownership consistent with the application of financial reporting
• its governance framework and accounting policies used in the relevant
• the type of investments that it makes industry. The understanding encompasses:
• the way that the entity is structured • the methods the entity uses to account for significant and
• the way that the entity is financed unusual transactions
• the effect of significant accounting policies in controversial
or emerging areas for which there is a lack of authoritative
Understanding the nature of the entity enables the auditor guidance or consensus
to understand the classes of transactions, account balances, • changes in the entity’s accounting policies and the impact
and disclosure to be expected in the financial statements. of those changes on the entity’s financial statements
Performance measures, whether external or internal, Understanding an entity’s performance measures assists
create pressures on the entity that, in turn, may motivate the auditor in considering whether pressures have resulted in
management to take action to improve the business an increased risk of material misstatement and whether these
performance or to misstate the financial statements. measures are precise enough to detect such material
misstatements.
Understanding the entity and its environment - new audits - matters to consider
Financial performance
Industry
Business
Reporting environment
What you have learned -understanding the entity and its environment
Having reviewed each of the topics above, you should
now be able to:
• explain the need for and use of understanding the entity
and its environment
• identify sources of knowledge to help you understand new
and existing clients
Objective
The International Accounting Standards Board’s ISA 320 sets out a frame of reference for auditors to use
Framework for the Preparation and Presentation of in determining materiality if there is no discussion of the
Financial Statements states that: concept of materiality in the applicable financial
“Information is material if its omission or misstatement could framework:
influence the economic decisions of users taken on the basis • misstatements are considered to be material if they
of the financial statements....” individually, or in aggregate, could reasonably be
expected to influence the economic decisions of users
taken on the basis of the financial statements
• judgements about materiality are made in the light of
Materiality depends on the size of the item or error surrounding circumstances, and are affected by the size or
judged in the particular circumstances of its omission or nature of a misstatement, or a combination of both
misstatement. It provides a threshold or cut-off point rather • judgements about matters that are material to users of the
than being a primary qualitative characteristic which financial statements are based on a consideration of the
information must have if it is to be useful. common financial information needs of users as a group
The ISA refers to “professional judgement” and the Investors and advisers
“amount” and “nature” of misstatements as Providers of capital are concerned with the risk and return of
considerations. It also recognises that the auditor’s their investment. They need information:
determination of materiality is affected by the auditor’s • for decision-making (buy, hold or sell?)
perception of the information needs of users of the financial • to assess the enterprise’s ability to pay dividends
statements and says that it is reasonable for the auditor to
assume that users: Employees
• have a reasonable knowledge of business and economic • stability and profitability of employers
activities and accounting and are willing to study the • ability to provide remuneration, retirement benefits and
financial statements with reasonable diligence employment opportunities
• understand that financial statements are prepared and
audited to levels of materiality Lenders (i.e. banks)
• recognize the uncertainties inherent in measurements • whether loans and interest will be paid when due
based on estimates, judgement and the consideration of
future events Suppliers and creditors
• make reasonable economic decisions on the basis of the • whether amounts owing will be paid when due
information in the financial statements
Customers
In practical terms the information needs of users will vary. • continuance - important for long-term involvement with, or
dependence on, the enterprise
Management
• to plan, make decisions and control operational activities
In designing the audit plan, the auditor sets acceptable As a “yardstick”, materiality must be relevant to the user
materiality levels so as to detect quantitatively material rather than the preparer of financial statements. “Critical
misstatements. points” include those at which:
profit → loss
When establishing the overall audit strategy the auditor net current assets → net current liabilities
shall determine materiality for the financial statements as a
whole. Note that although net current assets (liabilities) is a required
disclosure for UK companies, it is not a balance drawn by IAS
1 “presentation of financial statements”.
In general context
In a particular context
Look at an item in relation to financial statements as a whole,
e.g. comparison to: Comparing an item to a category as a whole e.g. an inventory
• revenue error of $50,000 compared to total inventory value of
• profit before taxation $650,000.
• total assets
• capital and reserves Misstatements of relatively small amounts could,
cumulatively, have a material effect on financial
statements, e.g. an error in a month end procedure could be
repeated each month. These could remain undetected if the
audit plan was based around the overall materiality level.
Performance materiality
In addition to the overall materiality level, ISA 320 • key disclosures in the industry in which the entity operates
requires auditor to establish a performance materiality (for example, research and development costs for a
level. Performance materiality means the amount or amounts pharmaceutical industry)
set by the auditor at less than materiality for the financial
statements as a whole, to reduce to an appropriately low level • where attention is focused on a particular aspect of the
the probability that the aggregate of uncorrected and entity’s business that is separately disclosed (for example,
undetected misstatements exceeds materiality for the a newly acquired business)
financial statements as a whole.
Some balances are capable of “precise determination” -
others are not.
Materiality levels for particular classes of transactions,
account balances or disclosures. There may be particular Capable of “precise determination”:
items where misstatements of lesser amounts than materiality • e.g. directors’ emoluments and share capital
for the financial statements as a whole could be reasonably • any error (however small) may be considered material and
expected to influence the economic decisions of users: adjusted
• where users’ expectations of the measurement or
disclosure of certain items are affected by law, regulation Not capable of “precise determination”:
or the applicable accounting framework (for example the • e.g. inventory provisions and contingent liabilities
disclosure of management remuneration) • some degree of latitude is acceptable
5 - 10% profit
0.5 - 1% net assets
Less than lower limit is immaterial; greater than
1 - 2% total assets upper limit is material
0.5 - 1% revenue
Revenue $5,000,000 You may wish to discuss this with a colleague before finally submitting it.
Total assets $6,250,000
You can then review the ideas of other students on this subject.
Profit before tax $417,000
The auditor’s understanding of the entity and its Assessment of materiality helps the auditor decide what
environment helps the auditor to establish materiality and items to examine and the extent to which the auditor can
to evaluate whether the judgement about materiality remains use sampling and substantive analytical procedures. This
appropriate as the audit progresses. enables the auditor to select audit procedures that, in
combination, can be expected to reduce audit risk to an
As seen in Module 2 acceptably low level.
Audit risk is the risk that the auditor expresses an The relationship between materiality and the level of audit
inappropriate audit opinion when the financial statements risk is described as “inverse” (i.e. the higher the materiality
are materially misstated. Audit risk is a function of the risks level, the lower the audit risk and vice versa). Low monetary
of material misstatement and detection risk. materiality equals higher audit risk which leads to more tests
of controls or substantive procedures.
Materiality and audit risk are considered throughout the
audit, in particular when: Revision as the audit progresses
• identifying and assessing the risks of material
misstatement The auditor shall revise materiality for the financial
• determining the nature, timing and extent of further audit statements as a whole (and performance materiality and
procedures levels of materiality for particular classes of transactions,
• evaluating the effect of uncorrected misstatements, if any, account balances or disclosures) if the auditor becomes
on the financial statements and in forming the opinion in aware of information during the audit that would have caused
the auditor’s report the auditor to have determined a different amount (or
amounts) initially).
In the auditor’s report, the auditor’s responsibility is to Further considerations, if aggregate may be material:
conclude whether reasonable assurance has been obtained • any further adjustments which management propose or
about whether the financial statements as a whole are free are prepared to make; management are more likely to
from material misstatement. adjust for a specific misstatement than a projected error
• the impact (if any) on critical points
The auditor shall accumulate misstatements identified • whether projected errors can be reduced (to bring the
during the audit, other than those that are clearly trivial. aggregate below an acceptable threshold) by extending
The auditor shall determine whether the audit strategy and audit procedures
audit plan need to be revised if:
• the nature and circumstances of the misstatements If management refuses to adjust the financial statements
indicate that other misstatements may exist that, and the results of extended audit procedures do not enable
aggregated with misstatement accumulated during the the auditor to conclude that the aggregate of uncorrected
audit, could be material, or misstatements is not material, the auditor should consider the
• the aggregate of misstatements accumulated during the appropriate modification to the auditor’s report in accordance
audit approaches materiality with ISA 700 “forming an opinion and reporting on financial
statements”.
Uncorrected misstatements = specific misstatements +
best estimate of other misstatements.
Trade accounts receivable Overstated by $40,000 You may wish to discuss this with a colleague before finally submitting it.
Inventories Overstated by $58,000
You can then review the ideas of other students on this subject.
Trade payables Understated by $80,000
When can percentages be used to decide if something is Care should always be exercised when using
material? percentages for establishing materiality. As a general rule
the following provides a rough guide:
Probably not
<5% < 0.5% <1%
material
Possibly material >5% and <10% >0.5% and <1% >1% and < 2%
Module review
Question 1
A document whose primary purpose is to describe the scope and content of an audit is
commonly known as:
A An engagement letter
B An audit strategy
C An audit program
D A management letter
Question 2
The principal reason for planning an audit is so as to:
Question 3
The primary purpose of an audit plan (audit program) is to provide:
Question 4
The auditor’s primary objective in obtaining an understanding of the entity is:
Question 5
On which of the following matters is understanding the business least likely to be
relevant to the auditor?
Question 6
Which of the following best describes a material item of information?
Question 7
The following errors, which all affect profit, are discovered during an audit:
If $50,000 is considered to be material, the minimum adjustment that must be made for the
presentation of the financial statement to be evaluated as fair is:
A Nil
B $39,000
C $50,000
D $89,000
Introduction
This module examines in detail the need to obtain an
understanding of the entity and its environment and
assessing the risks of material misstatement. It also deals
with the auditor’s procedures in response to assessed risk.
The audit risk standards (ISA 315, ISA 330) have been
redrafted under the Clarity Project principles. The
components of audit risk are discussed in the revised and
redrafted ISA 200 “overall objectives of the independent
auditor and the conduct of an audit in accordance with
international standards on auditing”.
“The objective of the auditor is to identify and To describe the concept of materiality and its relationship
assess the risks of material misstatement, whether with audit risk.
due to fraud or error, at the financial statement and
assertion levels, through understanding the entity
and its environment, including the entity’s internal Risk assessment procedures include:
• inquiries of management and of others within the entity
control, thereby providing a basis for designing and • analytical procedures
implementing responses to the assessed risks of • observation and inspection
material misstatement.”
When the auditor has determined that it is not possible or Performing risk assessment procedures provides the
practicable to reduce the risks of material misstatement auditor with evidence that an entity has, and is using,
at the assertion level to an acceptably low level with audit relevant controls whereas performing tests of the operating
evidence obtained only from substantive procedures, the effectiveness of controls provides the auditor with evidence
auditor should perform tests of relevant controls to obtain that the controls operate effectively.
audit evidence about their operating effectiveness.
If the auditor plans to use audit evidence about the When the auditor has determined that an assessed risk of
operating effectiveness of controls obtained in prior material misstatement at the assertion level is a
periods, the auditor shall obtain audit evidence about significant risk and the auditor plans to rely on the operating
whether changes in those specific controls have occurred effectiveness of controls intended to mitigate that significant
subsequent to the prior period. The auditor should obtain this risk, the auditor shall obtain the audit evidence about the
evidence by performing inquiry in combination with operating effectiveness of those controls from tests of controls
observation or inspection to confirm the understanding of performed in the current period.
those specific controls.
Irrespective of the assessed risk of material When the auditor has determined that an assessed risk of
misstatement, the auditor shall design and perform material misstatement at the assertion level is a
substantive procedures for each material class of significant risk, the auditor should perform substantive
transactions, account balance, and disclosure. procedures that are specifically responsive to that risk.
Responding to assessed risks of material misstatements - substantive procedures - nature & timing
Nature of substantive procedures Timing of substantive analytical procedures
Substantive procedures are either substantive analytical When substantive procedures are performed at an interim
procedures or tests of details. date, the auditor shall perform further substantive
procedures or substantive procedures combined with
The auditor should link the direction of testing with the tests of controls to cover the remaining period that provide a
audit assertion (i.e. for overstatement – existence or reasonable basis for extending the audit conclusions from the
occurrence select items from financial statements and for interim date to the period end, or if the auditor determines that
understatement – completeness select items from an it is sufficient, further substantive procedures only.
alternative population, that indicating that an item should be
included in the relevant financial statement amount and If misstatements are detected in classes of transactions
investigate whether it has been so included). or account balances at an interim date, the auditor
ordinarily modifies the related assessment of risk and planned
nature, timing, or extent of the substantive procedures
covering the remaining period that relate to such classes of
transactions or account balances, or extends or repeats such
audit procedures at the period end.
Sufficiency of evidence
If the auditor has not obtained sufficient appropriate audit
evidence as to a material financial statement assertion,
“Based on the audit procedures performed and the the auditor shall attempt to obtain further audit evidence. If the
audit evidence obtained, the auditor shall evaluate auditor is unable to obtain sufficient appropriate audit
evidence, the auditor should express a qualified opinion or a
whether the assessments of the risks of material
disclaimer of opinion.
misstatement at the assertion level remain
appropriate.
“The risk that the auditor gives an inappropriate The relationship between materiality and the level of audit
audit opinion when the financial statements are risk is described as “inverse” (i.e. the higher the materiality
level, the lower the audit risk and vice versa).
materially misstated.”
For example, if acceptable materiality level is lower, audit
Audit risk is also called “ultimate risk” risk is increased. The auditor compensates for this by either:
• reducing the assessed risk of material misstatement (if
Audit risk is a function of the risk of material possible) and carrying out extended or additional tests of
misstatement (inherent risk and control risk – i.e. the risk that controls, or
the financial statements are misstated prior to audit) and the • reducing detection risk by modifying the nature, timing and
risk that the auditor will not detect such misstatement extent of planned substantive procedures
(“detection risk”).
State at which level, financial statements or assertion, the 10. Numerous locations and geographical spread of
following factors would be evaluated: production facilities.
11. Changes in consumer demand.
1. Doubts about the integrity of management. 12. Transactions not subject to ordinary processing.
2. Management inexperience in the preparation of the
financial statements.
3. Accounts which involve a high degree of estimation. Consider your answer to the question, when you are ready click next to
4. Entity lacks sufficient capital to continue operations. enter it into the course blog.
5. Potential for technological obsolescence of products and
services. You may wish to discuss this with a colleague before finally submitting it.
6. Complex underlying transactions and events which might
You can then review the ideas of other students on this subject.
require using the work of an expert.
7. Complex capital structure.
8. Highly desirable and movable assets (e.g. cash)
susceptible to loss or misappropriation (e.g. theft,
embezzlement).
9. Unusual and complex transactions completed at or near
the period end.
“The risk that a misstatement that could occur (at Consider your answer to the question, when you are ready click next to
enter it into the course blog.
the assertion level) and be material will not be
prevented; or detected and corrected on a timely You may wish to discuss this with a colleague before finally submitting it.
basis by the accounting and internal control You can then review the ideas of other students on this subject.
system.”
In other words, given that risks arise (inherent risk),
control risk is the risk that they are not dealt with by the
client’s systems.
Please review the following exercise: Answer all the following statements for all three methods:
a. easy to read/understand
Indicate the relative advantages of the following three b. little formal training required
methods. Use Y for an advantage, X for not an advantage
c. quick
and a ? for possibly an advantage. The three methods are:
1. Narrative Notes. d. comprehensive
2. Flowcharts. e. diagrammatic/visual
3. Questionnaires. f. highlights key features/controls
g. standardised
h. little narrative necessary
i. “story” approach
j. easy to amend
k. used to assess controls
Consider your answer to the question, when you are ready click next to
enter it into the course blog.
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
Definition
Objectives
• to reduce procedures to basic components and Document (e.g. sales File with letter in centre:
emphasize logical relationships order) ‘A’ for alphabetical order
• to facilitate tracing a connected pattern of activity from ‘N’ for numerical order
‘D’ for date order
beginning to end Account book ‘T’ (TA, TN or TD) for
• to depict a sequence of events and the temporary filing
department/function responsible for each
Pre-numbered set Document flow
Symbols
Three parts or copies Information flow
The following symbols are used within typical flowcharts:
Connect to additional
Alternative routine
chart e.g. ref: A4
Sales
Invoice 1 ledger
raised Invoice
Quantities 2
checked
Posted 3 D
weekly
Alternative structure
You can then review the ideas of other students on this subject.
Assessing the risks of material misstatements - internal control evaluations - ICEs description
An ICE may be used as well as or instead of an ICQ. Many
audit firms make no distinction between an ICQ and an ICE.
Methods For example, where inherent and control For a given level of audit risk, the acceptable level of
risk are high detection risk bears an inverse relationship to the
1. Change nature of → Direct tests towards independent assessment of the risk of material misstatement at the
audit work parties rather than documentation
within entity
assertion level. The greater the risk of material misstatement
the auditor believes exists, the less the detection risk that can
→ Use tests of detail in addition to
analytical procedures be accepted. Conversely, the less the risk of material
misstatement the auditor believes exists, the greater the
detection risk that can be accepted.
2. Change extent of → Use a larger sample size
audit work
Communicating deficiencies in internal control to those charged with governance and management –
ISA 265
Communicating deficiencies in internal control to those Where the auditor has identified one or more deficiencies in
charged with governance and management – ISA 265 internal control, the auditor shall determine whether
individually or in combination, they constitute significant
deficiencies.
“The objective of the auditor is to communicate A significant deficiency in internal control is one that, in the
appropriately to those charged with governance and auditor’s professional judgment, is of sufficient importance to
merit the attention of those charged with governance.
management deficiencies in internal control that the Significant deficiencies should be communicated in writing on
auditor has identified during the audit and that, in the a timely basis. This written communication should include a
auditor’s professional judgment, are of sufficient description of the deficiencies and their potential effects.
“The objectives of the auditor, when the entity uses A client may use a service organisation such as one that
the services of a service organisation, are: executes transactions and maintains related accountability or
records transactions and processes related data. A good
(a) To obtain an understanding of the nature and example is a computer systems service organisation.
significance of the services provided by the service
organisation and their effect on the entity’s internal If the entity uses a service organisation, certain policies,
procedures and records maintained by the service
control relevant to the audit, sufficient to organisation may be relevant to the audit of the financial
identify and assess the risks of material statements of the client.
misstatement; and
A service organisation may establish and execute
(b) To design and perform audit procedures policies and procedures that affect the entity’s internal
responsive to those risks.” control. These policies and procedures are physically and
operationally separate from the entity.
Objective
What you have learned - audit considerations relating to entities using service organisations
Having reviewed each of the topics above, you should
now be able to:
• illustrate the use of service organizations
• describe the implications of the use of service
organizations on risk assessments
• explain the role of service organization auditor’s reports as
audit evidence
If an audit is performed in accordance with ISAs, is it No, it is not mandatory. ISA 315 requires tests of controls to
mandatory to perform tests of controls? be performed in two circumstances:
• if the preliminary assessment of risk contains an
assumption that controls are operating effectively, and
To reveal our answer, click below: • If it is not possible to obtain sufficient appropriate
evidence through substantive procedures (this may be
the case in high volume processing with IT systems)
Module review
The proper identification and assessment of audit risk
appears to be key to carrying out an appropriate audit
under the current standards. The audit risk standards are
key to this approach and the way these standards deal with
audit risk must be understood. There has been a shift in
emphasis from the old approach which centred around the
audit risk model.
Question 1
The susceptibility of an account balance or class of transactions to material misstatement is
known as:
A Audit risk
B Control risk
C Inherent risk
D Detection risk
Question 2
Detection risk in the context of the audit of the financial statements of a company is the risk
that:
A The company’s accounting system will not
prevent or detect and correct material
misstatements
B The auditor’s procedures will not detect
material misstatement
C The auditor will be held liable to other
parties due to the failure to detect a
material misstatement
D Arises from the susceptibility of
transactions and balances to material
misstatements
Question 3
In what circumstances should the auditor document an understanding of a client’s accounting
and internal control systems?
Question 4
According to ISA 315 “identifying and assessing the risks of material misstatement through
understanding the entity and its environment”, which of the following is not part of the role of
the discussion among the audit team members:
Question 5
What are control activities according to ISA 315 “identifying and assessing the risks of
material misstatement through understanding the entity and its environment”?
Question 6
An extract from the systems description of a supermarket states that all cash received
during the day by the cashiers must be deposited in the night safe by the store
manager after the close of business.
Question 7
According to ISA 315 “identifying and assessing the risks of material misstatement through
understanding the entity and its environment”, which category of policies and procedures are
not likely to be considered as control activities that may be relevant to an audit:
A Corporate restructuring
B Performance reviews
C Physical controls
D Segregation of duties
Question 8
The purpose of the procedure of tracing a few transactions through the accounting system
(known as a “walk-through” test) is to:
Question 9
Which of the following conditions may indicate the existence of risks of material misstatement:
A 1 and 3 only
B 1 and 4 only
C 2, 3 and 4 only
D 1, 2, 3 and 4
Question 10
According to ISA 200 “overall objectives of the independent auditor and the conduct of an
audit in accordance with international standards on auditing”, what risk is defined as:
The risk that a misstatement that could occur in an assertion and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or detected
and corrected, on a timely basis by the entity’s internal control?
A Audit risk
B Control risk
C Detection risk
D Inherent risk
Question 11
According to ISA 200 “overall objectives of the independent auditor and the conduct of an
audit in accordance with international standards on auditing”, what risk is defined as:
A Audit risk
B Control risk
C Detection risk
D Inherent risk
Question 12
According to ISA 200 “overall objectives of the independent auditor and the conduct of an
audit in accordance with international standards on auditing”, what risk is defined as:
The risk that the procedures performed by the auditor to reduce audit risk to an acceptably
low level will not detect a misstatement that exists and that could be material, either
individually or when aggregated with other misstatements?
A Audit risk
B Control risk
C Detection risk
D Inherent risk
Question 13
Which of the following activities outsourced by an entity to an external service provider is least
likely to be relevant to the entity’s external auditor?
Question 14
A finance company uses a service organisation to process a high volume of its most complex
transactions. Which of the following circumstances would be most likely to affect the finance
company auditor’s ability to form an opinion?
Question 15
Which of the following matters is not included in a type A report prepared by a service
organisation for the restricted use of its management, customers and client auditors?
Question 16
According to ISA 330 “the auditor’s responses to assessed risks”, which of the following is not
a factor influencing the auditor’s judgement as to what constitutes sufficient appropriate audit
evidence?
Question 17
The primary purpose of performing tests of control is to provide reasonable assurance that:
Question 18
Which of the following would the auditor NOT consider in deciding if an internal control
deficiency were significant?
A The financial statement amounts exposed
to the deficiencies
B The volume of activity exposed to the
deficiency
C The planned audit work on the financial
statement area exposed to the deficiency
D The cause and frequency of the
exceptions detected as a result of the
deficiency
Question 19
How should significant deficiencies in internal control be communicated?
Introduction
• the risk of misstatement – the greater the risk the more When information produced by the entity is used by the
audit evidence is likely to be required auditor to perform audit procedures, the auditor should
• the quality of the audit evidence – the higher its quality, obtain audit evidence about the accuracy and completeness
the less of it is likely to be required of the information.
• higher quantity of audit evidence may not compensate for
its poor quality Although the auditor should consider the relationship
• nature of accounting and internal control systems e.g. if between the cost of obtaining audit evidence and the
computerized usefulness of the information obtained, difficulty or
• risk assessment and evaluation of the effectiveness of expense is not a valid reason for omitting a necessary audit
internal controls procedure. If audit evidence is not sufficient, the implications
• Cumulative auditors’ knowledge & experience (“CAKE”) for the audit opinion must be considered.
gained in previous audits
• materiality of items – immaterial items may require little, if
any, evidence
• audit findings (e.g. fraud or error)
• reliability of the information to be used as audit evidence
Consistency:
• consistency increases persuasiveness (i.e. provides
cumulative assurance)
• any inconsistency creates doubt (giving rise to further
work) until resolved otherwise consider audit opinion
Exercise - appropriateness
Please review the following exercise:
Audit evidence is obtained from an appropriate mix of • when substantive procedures alone do not provide
“risk assessment procedures”, “tests of controls” and sufficient appropriate audit evidence. The auditor is
“substantive procedures”. required to perform tests of controls to obtain audit
evidence about their operating effectiveness
1. Risk assessment procedures
3. Substantive procedures
The auditor always performs risk assessment procedures
to provide a satisfactory basis for the assessment of The auditor plans and performs substantive procedures
risks at the financial statements level and assertion level. to be responsive to the related assessment of the risks of
Risk assessment procedures by themselves do not provide material misstatement, which includes the results of tests
sufficient appropriate evidence on which to base the audit of controls, if any. The auditor’s risk assessment is
opinion, however, and are supplemented by further audit judgemental, however, and may not be sufficiently precise to
procedures in the form of tests of controls, when necessary, identify all risks of material misstatement. Further there are
and substantive procedures. inherent limitations to internal control, including the risk of
management override, the possibility of human error and the
2. Tests of controls effect of systems changes. Therefore, substantive procedures
Tests of controls are necessary in two circumstances: for material classes of transactions, account balances, and
• when the auditor’s risk assessment includes an disclosures are always required to obtain appropriate audit
expectation of the operating effectiveness of controls. The evidence.
auditor is expected to test those controls to support the
risk assessment
Exercise - procedures
Please review the following exercise:
2. Observation. You can then review the ideas of other students on this subject.
4. Recalculation.
Please review the following exercise: Consider your answer to the question, when you are ready click next to
enter it into the course blog.
Suggest audit evidence for additions to plant and equipment: You may wish to discuss this with a colleague before finally submitting it.
Completeness You can then review the ideas of other students on this subject.
Occurrence
Measurement
Existence
Module review
This module has introduced the framework of requirements
that the auditor must follow when gathering audit evidence.
This evidence must be sufficient, and appropriate (relevant
and reliable). ISA 500 also defines the three main types of
procedures, risk assessment procedures, tests of controls
and substantive procedures.
Question 1
Physical inspection of tangible assets is primarily aimed at the financial statement assertion
of:
A Ownership of the assets
Question 2
Which of the following is likely to be the least reliable form of audit evidence?
A Bank Certificate
Question 3
When deciding on the amount of evidence required to form an opinion on a particular matter,
the auditor should be least influenced by the:
Question 4
ISA 500 “audit evidence” states that “....the reliability of evidence is dependent on individual
circumstance....”
Which of the following would generally be regarded as the most reliable source of audit
evidence?
Question 5
Which of the following is a test of control?
Question 6
Which of the following is a substantive procedure on the revenue figure in a set of financial
statements?
Introduction
In the previous module you learned about the basic principles
of audit evidence as set out in ISA 500. In this module you will
learn about two further standards which are based on these
principles and apply them to specific items. These standards
are:
• ISA 501 “audit evidence – specific considerations for
selected items”
• ISA 505 “external confirmations”
To describe further aspects of audit evidence relating to ISA 505 “external confirmations” deals with:
specific financial statement amounts and other • relationships of external confirmation procedures to the
disclosures. auditor’s assessments of risk of material misstatements
• design of the external confirmation request
This part covers: • use of positive and negative confirmations
ISA 501 “audit evidence - specific considerations for • the external confirmation process
selected items” contains objectives dealing with
obtaining sufficient appropriate evidence regarding the:
• Existence and condition of inventory
• Completeness of litigation and claims against the client
• Presentation and disclosure of segment information in
accordance with the applicable financial reporting
framework.
You can then review the ideas of other students on this subject.
Specific items - physical inventory count - types of inventory records and stock taking
Regulations
During = attendance:
Click here to review an example of an audit program (pages 8-12 of the
• observe compliance with instructions pdf relate to the audit of inventory).
• perform test counts (from physical to record and vice
versa)
• take copies of stock-sheets
• record details of unused stock sheets
• obtain details of damaged inventory
• note cut-off details
“The auditor shall design and perform audit Actual and pending liabilities arising from litigation and
claims may have a material impact and require disclosure
procedures in order to identify litigation and claims and/or provision in the financial statements.
involving the entity which may give rise to a risk of
material misstatement, including: Direct communication with the entity’s lawyers should be
sought when litigation or claims are identified or may exist.
(a) Inquiry of management and, where applicable, The letter should:
others within the entity, including in-house legal a. be prepared by management
b. be sent by the auditor
counsel;
c. request direct communication with the auditor
(b) Reviewing minutes of meetings of those
charged with governance and correspondence Ordinarily specifies:
a. a list of litigation and claims
between the entity and its external legal counsel; b. management’s assessment of the outcome and
and financial estimate (including costs)
(c) Reviewing legal expense accounts.”
Requests lawyer to:
a. confirm reasonableness of management’s assessments
b. provide further information if the list is
incomplete/incorrect
“External confirmation – Audit evidence obtained Positive confirmation request – A request that the confirming
as a direct written response to the auditor from a party respond directly to the auditor indicating whether the
confirming party agrees or disagrees with the information
third party (the confirming party), in paper form, or in the request, or providing the requested information.
by electronic or other medium.”
Negative confirmation request – A request that the confirming
party respond directly to the auditor only if the confirming
party disagrees with the information provided in the request.
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
The factors to be considered when determining the need Received directly by the auditor from independent third
for external confirmations are: parties, therefore relatively reliable.
• characteristics of the prevailing environment
• practice of potential respondents in dealing with such However, the auditor must exercise control over
requests confirmation requests and responses.
The weaker internal controls are (i.e. the higher control The characteristics of the respondents and restrictions
risk is), the more important external confirmation. imposed by management (e.g. not to request balances from
certain customers) may impair reliability.
Confirming balances (e.g. accounts receivable) on a test
basis may reduce the scope of detailed tests on related
transactions (e.g. sales).
Factors to be considered:
• the need for professional scepticism
• any implications regarding management’s integrity
• the possible existence of fraud or error
Yours faithfully
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
Specific items - external confirmations - causes and frequency of exceptions and evaluating results
Causes and frequency of exceptions
To reveal our answer, click below: However, the entity may count inventories at an interim date,
in which case the auditor would attend that count and would
also have to design procedures to test the entity’s records of
transactions arising between that date and the reporting date.
If the entity has a perpetual inventory system, then no year
end count will take place and the auditor will place more
emphasis on testing the inventory records, including
performing tests of controls such as the observation of a
sample of the periodic inventory counts that the entity may
have put in place as a control over the accuracy of the
records.
Module review
This module has covered more practical detail on how the
requirements of ISAs on audit evidence are applied in specific
circumstances and you should be able to explain the main
issues and requirements relating to the audit of specific items,
namely inventories, claims and litigation, and segment
information. You should also be able to identify when it is
appropriate to use direct confirmations to obtain audit
evidence, how they are performed and to explain the issues
surrounding their evaluation.
Question 1
The primary purpose of the auditor’s attendance at a physical inventory count is to confirm the
inventory’s:
A Existence
B Ownership
C Valuation
D Completeness
Question 2
The auditor’s main task when attending the year end physical inventory count of a client
company is to:
Question 3
Which of the following procedures is unlikely to provide evidence concerning contingent
liabilities?
Question 4
Direct confirmation of trade receivable balances is most relevant and sufficient to which of the
following audit objectives?
A Valuation
B Classification
C Existence
D Completeness
Question 5
The managing director of a client company has requested the auditor not to write to a major
customer, xyz, selected for direct confirmation, as xyz is a close personal friend who may be
offended by the request.
Introduction
This module looks at certain key audit techniques, which have
all been referred to in overview in earlier modules. Here you
will learn in detail about when analytical procedures are used
during an audit, and you will see some practical examples of
their use. You will also learn about the requirements relating
to audit sampling and about when it is appropriate to seek
written representations from client management, and the role
of these representations as audit evidence.
11,900
Budget
12,000
Actual
10,000
forecasts)
ISA 520 “analytical procedures”:
Evaluation of financial information made by a study of Predictive estimates Depreciation for year ≈ 15% x year end cost
plausible relationships among both financial and non-financial Similar industry information Receivables turnover vs. industry average
data.
• obtain relevant and reliable audit evidence when using As substantive procedures at the detailed testing stage -
substantive analytical procedures; and when more effective or efficient than tests of detail, i.e.
• design and perform analytical procedures near the end of optional.
the audit that assist the auditor when forming an overall
conclusion as to whether the financial statements are As an overall review, to conclude whether financial
consistent with the auditor’s understanding of the entity. statements as a whole are consistent with auditor’s
understanding of the entity.
The auditor should apply analytical procedures as risk Deterioration in financial performance and cash
assessment procedures to obtain an understanding of availability potentially increases inherent risk as
the entity and its environment. deliberate misstatement/manipulation is more likely.
Ability to meet debts as they fall due underlies the going
concern basis of preparation of financial statements.
“Preliminary” analytical procedures are used to:
• help identify the existence of unusual transactions or How it is assessed:
events, and amounts, ratios, and trends that might indicate • short-term - liquidity indicators such as the current ratio
matters that have financial statement and audit • long-term - gearing and profitability indicators, e.g.:
implications a. debt/equity ratio
• increase understanding of the entity through the b. return on capital employed (ROCE)
accumulation of information on trends in key relationships c. gross profit (GP)%
• determine the nature, timing and extent of further audit d. earnings per share (EPS)
procedures • loans and borrowings - defaults in and renegotiation of
repayments
Based on: • cash flow projections - receipts from operations less than
• interim financial and non-financial information maturing debt
• budgets/forecasts and management accounts
• draft financial statements
Analytical procedures can themselves provide sufficient Payroll Analytical procedures Tests of detail (ideas
audit evidence where an item can be verified directly by (assertions) in outline)
reference to another (valid) item (e.g. commission on sales, Completeness Compare cost with budget/prior Postings from payroll
period(s) - month on month and to general ledger
bank interest, rental expense, depreciation). for year
“Proof in total” Personnel records
Analytical procedures may be effective in testing for
Occurrence Compare cost with budget/prior Cash book payments
understatement (i.e. completeness). For example, in period(s) and similar
predicting sales from purchases and known margins. organisation/industry
Ratio analysis e.g. average cost Starters and leavers
Where sufficient substantive evidence is not obtained by per employee by department
analytical procedures alone, some tests of detail will also Measurement Compare accruals (e.g. statutory Postings from payroll
be required. (amount and in deductions, holiday pay, etc. to general ledger
correct period) with prior period(s)
Labour turnover (should Sample of payroll
decrease with increasing transactions
remuneration) (accuracy, etc.)
Presentation Compare disclosure with prior Disclosure checklist
and disclosure year financial statements
Ratios e.g. payroll to cost of Postings from general
sales, average pay per ledger to payroll
employee
Albatros Ltd had 100 employees last year with total wages of
$840,000 and 100 employees this year with a wage bill of Consider your answer to the question, when you are ready click next to
enter it into the course blog.
$950,000, an increase of 13%. The annual pay rise was 6%
and the level of business has remained approximately You may wish to discuss this with a colleague before finally submitting it.
constant.
You can then review the ideas of other students on this subject.
1. Suggest two reasons other than error or irregularity which
could account for the greater than expected increase.
Selection methods
• items should be selected for testing by appropriate means
“The objective of the auditor, when using audit so as to gather sufficient appropriate audit evidence to
sampling, is to provide a reasonable basis for the meet the objectives of the audit procedures
• any one or a combination of:
auditor to draw conclusions about the population a. selecting all items (100% examination)
from which the sample is selected.” b. selecting specific items
c. audit sampling
Risk considerations
• professional judgement should be used to:
a. assess audit risk (which includes inherent and
control risk)
b. design further audit procedures to reduce audit risk
to an acceptably low level
• this requires consideration of:
a. the risk of material misstatement (inherent and
control) and detection risk
b. sampling and non-sampling risk
You can then review the ideas of other students on this subject.
Specific items
• high-value or key items e.g. risk prone or with a history of
error
• all items over a certain amount to verify a large proportion
of the population
• items to obtain information e.g. about the nature of
transactions and accounting and internal control system
• items to test control activities
You can then review the ideas of other students on this subject.
Diagram notes:
1. For example, “customers exist” or “receivables are Appropriate Sampling Stratification
recoverable”. Value-weighted selection may be particularly and complete unit (into subgroups)
efficient in testing for overstatement. Note 2 Note 3 Note 4
2. Must be appropriate (may be a “reciprocal” population for
Considerations
understatement tests) and complete.
3. An item number n (e.g. GRN) or a $.
4. Involves dividing a population into subgroups (“strata”) to
create relatively homogeneous groups in which variations Sampling risk Tolerable error Expected error
(acceptably low?) (=maximum
in characteristics are likely to be small. When testing for error/deviation rate
overstatement, effort is directed to higher value items. willing to accept)
Consider your answer to the question, when you are ready click next to
“In determining the sample size the auditor shall enter it into the course blog.
determine a sampling size sufficient to reduce You may wish to discuss this with a colleague before finally submitting it.
sampling risk to an acceptably low level.” You can then review the ideas of other students on this subject.
Tests of controls
If the sampling error rate is higher than originally assessed,
modify planned procedures e.g.
• extend sample size
• test an alternative control
• extend substantive procedures
Substantive procedures
If maximum potential and/or most likely error exceeds
tolerable misstatement:
• request management adjust for identified errors
• re-evaluate unadjusted errors
You may wish to discuss this with a colleague before finally submitting it.
You can then review the ideas of other students on this subject.
Objective
Illustration
Refusal to provide representations The auditor shall disclaim an opinion on the financial
statements in accordance with ISA 705 (see Module 11) if:
Management should expect to provide written • the auditor concludes that there is sufficient doubt about
representations if necessary (as referred to in the the integrity of management such that the written
engagement letter). Therefore management’s refusal is most representations on management’s responsibilities are not
likely to signify reservations about the representation. reliable
• management does not provide these representations
1. If tests of detail are more effective in obtaining substantive 1. Substantive analytical procedures are optional - however,
audit evidence than analytical procedures (e.g. because analytical procedures are essential at the planning and overall
there are no established trends and predictive information review stages in compliance with ISA 520. At the planning
is not available) why would an auditor perform analytical stage, they assist in understanding the key financial and non-
procedures at all? financial relationships within the client’s business. At the
2. Analytical procedures should be done at almost every review stage, they help to assess the completeness and
stage of the audit - but is it really that useful as it is only reasonableness of figures in the financial statements.
comparing one number to last year’s?
2. The term analytical procedures covers a wide range of
audit procedures. While it does include a simple comparison
To reveal our answer, click below: of (say) trade receivables to last year, it also includes:
• comparisons with relevant industry statistics
• calculation and comparisons of key ratios (e.g. margins,
return on capital, current ratio, receivable days)
• proofs in total whereby the reasonableness of one number
is confirmed by reference to one or more numbers which
have already been audited (e.g. if a loan has been
confirmed at $1m and the interest rate per the loan
agreement is 5%, then the interest charge should be
$50,000 per year). Provided the figure in the financial
statements is materially the same as this figure, no further
work is necessary
• overall reconciliations (e.g. opening inventory + purchases
- sales closing inventory, or if not, then further work is
required)
© 2008 Association of Chartered Certified Accountants
1. Statistical sampling is based on very detailed mathematical 1. Not the detail. The mathematical basis of the approach
theories - does the theory have to be understood for allows, for example, that the sample size needed to achieve
statistical methods to be used? the required level of assurance be determined objectively. It
2. Am I likely to have to calculate a sample size for a multiple also facilitates the interpolation of results across the
choice question? population being tested.
3. Do representations by management have any value and, if 2. No, but you should know the factors which affect sample
not, why obtain them? size (and how).
3. They have value for two reasons:
• they remind directors of their responsibilities in relation to
To reveal our answer, click below: the preparation and presentation of financial statements
• they improve the reliability of oral evidence by
corroborating it in writing
However, as representations are made by management, they
may have limited value because of their potential bias. Even
after obtaining the written representations, the auditor has to
reconsider whether sufficient evidence has been obtained. On
quite a few occasions, an audit qualification on limitation of
scope has been issued despite the receipt of management
representations.
Module review
In this module you have learned about the requirements of
ISAs in respect of three key aspects of audit work.
Question 1
At which of the following audit stages is the auditor unlikely to use analytical
procedures?
A Planning the audit
C As substantive procedures
Question 2
The primary purpose of analytical procedures at the planning stage of the audit is to:
Question 3
Which of the following is not a typical analytical procedure?
Question 4
Which of the following statements most accurately describes the effectiveness of analytical
procedures?
Question 5
Analytical procedures based on the year-end trade receivables and revenue figures shows
that the average collection period (i.e. time taken by credit customers to pay what they owe)
has increased from 73 days in 2007 to 87 days in 2008.
Question 6
When considering the choice of sample size from a large number of items in a population,
which of the following items would be taken into account by the auditor?
1. Stratification.
2. Number of items in the population.
3. Tolerable misstatement.
A None
B 1 only
C 1 and 2
D 1 and 3
Question 7
An auditor plans to place reliance on the internal control system in respect of purchases and
payments and designs tests of control to ensure that controls have been operating effectively
for the whole accounting period. The results of testing show that one control was not
operating effectively for one month in the year during the employment of a temporary clerk.
Follow-up of the deviations shows that they did not lead to errors in the accounting records.
Which of the following conclusions is most appropriate?
Question 8
As part of the audit testing to satisfy the audit objective “trade receivables are not overstated”,
the audit senior of a manufacturing company plans to circulate statements of account to a
sample of customers and request them to confirm the balance.
Which of the following approaches to sample selection would be most appropriate in these
circumstances?
Question 9
When using statistical sampling in carrying out an audit test, the auditor may attempt to
reduce the non-sampling risk by:
Question 10
During the planning stage of an audit the auditor judged that an error of $30,000 was likely to
be material to profits, and planned samples and tests accordingly. The only errors found as a
result of the planned audit work were two items of inventory, each overvalued by $5,000. The
finance director is unwilling to adjust the financial statements except to avoid a modified audit
opinion.
Question 11
The purpose of obtaining written representations from management is to:
Question 12
During the course of an audit an auditor will receive oral representations from management
for which independent evidence is not available. The auditor should seek written confirmation
of these representations from management to:
Question 13
Management’s refusal to provide a written representation that the auditor considers necessary
would be:
Question 14
Based on the following timetable, what is the most appropriate date for an auditor to obtain a
letter of representation?
Introduction
Many companies have an internal audit function as part of
their internal control. The internal auditors are often involved
in the monitoring and testing of controls, and in other areas
that could be relevant to the external audit.
ISA 610 “using the work of internal auditors” has been External Internal
redrafted in Clarity form. The objective of the external Role Management, usually in
Statute (typically)
auditor is to determine: required by: larger organisations
• whether, and to what extent, to use specific work of the Appointed Shareholders (usually) or
Management
internal auditors by: directors
• if so, whether such work is adequate for the purposes of Shareholders (primary
statutory duty) and
the audit Reports to:
management (professional
Management
responsibility)
For companies listed on a recognized stock exchange it Reports on: Financial statements Internal controls
is regarded as good practice to establish internal audit Adequacy of ICs as a
functions to undertake regular monitoring of key controls and Forms
contribution to the
opinions “True and fair view” (or similar)
procedures therefore listed companies might be expected to on:
economic, efficient and
have them. effective use of resources
Employee (therefore
Status: Independent of client company
potentially less objective)
May also be members of
Usually ACCA, ICAEW, ICAI,
Qualification: other professional bodies
ICAS, CPA or equivalent
(e.g. IIA) or unqualified
Scope of Unlimited, to fulfil statutory
Prescribed by management
assignment: obligation
Similar stages - planning,
Conduct of
In accordance with ISAs evaluation of A & IC
audit:
system, evidence, reporting
Module review
This module has concentrated on internal auditing in its
context as a potential source of evidence for the external
auditor. It completes a group of modules (modules 7 to 10)
that focus on the principles of audit evidence and the various
procedures used to gather that evidence.
Question 1
The management of a company has requested that their external auditors make use of the
company’s internal audit department.
Which of the following statements most accurately reflects the relationship between these
external and internal auditors?
A The ultimate responsibility for the audit
opinion lies with the external auditor who
should not therefore use the work of
internal auditing
B Using the work of internal auditing is
desirable as it reduces the external
auditor’s exposure to legal liability
C The external auditor should evaluate the
work of internal auditing and, if satisfied,
use specific work but only in areas of low
audit risk
D When intending to use specific work of
internal auditing the external auditors
should confirm its adequacy
Question 2
A large quoted company has recently set up an internal audit department. The board consists
of both executive and non-executive directors. In order to secure the greatest degree of
objectivity internal auditing should report to:
A The chief executive
B The finance director
C A committee of non-executive directors
D A committee of executive directors
Question 3
In which of the following areas should internal auditing not routinely operate?
Introduction
This module returns to the objective of an audit of financial The first part of this module describes the ISAs relevant
statements, namely: to reporting and the second part deals with the auditor’s
considerations in respect of going concern at all stages
of the audit.
“.... to enable the auditor to express an opinion It has been left as the last topic because the reporting
whether the financial statements are prepared, in all implications in relation to going concern are an application of
the standards on reporting covered in this module.
material respects, in accordance with an applicable
financial reporting framework.”
The auditor's report on financial statements - ISAs 700, 705 and 706
Objective
Considerations:
• the financial reporting framework (e.g. IFRS)
• statutory requirements
The auditor's report on financial statements Nature of audit An audit involves performing procedures to obtain audit
examination evidence about the amounts and disclosures in the
financial statements. The procedures selected depend on
the auditor’s judgement, including the assessment of the
Illustration risks of material misstatement of the financial statements,
On whose behalf is INDEPENDENT AUDITOR’S REPORT whether due to fraud or error. In making those risk
audit undertaken (Appropriate addressee) assessments, the auditor considers internal control
relevant to the entity’s preparation and fair presentation of
Report on the financial statements the financial statements in order to design audit
We have audited the accompanying financial statements procedures that are appropriate in the circumstances, but
of ABC Company, which comprise the balance sheet as not for the purpose of expressing an opinion on the
Reference can be
at December 31, 20X1, and the income statement, effectiveness of the entity’s internal control. An audit also
by page numbers statement of changes in equity and cash flow statement includes evaluating the appropriateness of accounting
for the year then ended, and a summary of significant policies used and the reasonableness of accounting
accounting policies and other explanatory notes. estimates made by management, as well as evaluating
Unmodified implies the overall presentation of the financial statements.
Management’s responsibility for the financial that changes in
statements accounting principles We believe that the audit evidence we have obtained is
Management is responsible for the preparation and fair sufficient and appropriate to provide a basis for our audit
presentation of these financial statements in accordance
etc. have been
opinion.
with International Financial Reporting Standards. This properly determined
Responsibilities responsibility includes: designing, implementing and and disclosed Opinion
maintaining internal control relevant to the preparation In our opinion, the financial statements give a true and fair
and fair presentation of financial statements that are free view of (or ’present fairly, in all material respects,’) the
from material misstatement, whether due to fraud or financial position of ABC Company as of December 31,
error; selecting and applying appropriate accounting 20X1, and of its financial performance and its cash flows
policies; and making accounting estimates that are Relevant financial for the year then ended in accordance with International
reasonable in the circumstances. reporting framework Financial Reporting Standards.
The objective of the auditor is to express clearly an The opinion will only be modified over matters that the
appropriately modified opinion on the financial auditor judges to be material. The wordings used will
statements in two circumstances: depend on the auditor’s judgement about the pervasiveness
1. When the auditor concludes, based on the audit evidence of the effects or possible effects of the matter.
obtained, that the financial statements as a whole are not
free from material misstatement (disagreement). Pervasive - a term used to describe:
2. When the auditor is unable to obtain sufficient appropriate • the effects on the financial statements of misstatements;
audit evidence to conclude that the financial statements or
are free from material misstatement (limitation on scope). • the possible effects on the financial statements of
misstatements, if any, that are undetected due to an
The grounds should always be apparent because they are inability to obtain sufficient appropriate audit evidence
mutually exclusive - there must be sufficient evidence in
situations for disagreement. Pervasive effects on the financial statements are those
that in the auditor’s judgement:
ISA 705 outlines three types of modifications to be used, • are not confined to specific elements, accounts or items of
the financial statements
depending on the circumstances and the pervasiveness of the
• if so confined, represent or could represent a substantial
effects or possible effects of the matter on the financial
proportion of the financial statements
statements.
• in relation to disclosures, are fundamental to users’
understanding of the financial statements
Decision 2
Decision 1
Both material and
Material
pervasive
Inability to
Unable to
obtain sufficient Qualified i.e.
express an opinion
appropriate “except for”
Disclaimer
evidence
The auditor's report on financial statements - the basis for modification paragraph
Basis for qualified opinion , Basis for adverse Material misstatement that
• Description of the nature of the omitted
‘ ’ ‘ information
opinion’, or ‘Basis for disclaimer of opinion’, as relates to non-disclosure
• Include the omitted disclosures, provided
of information required to
appropriate ”. be disclosed that it is practicable to do so and is not
prohibited by law or regulation
Inability to obtain sufficient
appropriate audit evidence • Reasons for the inability
The audit assignments of four companies (continues on the A. Jasper (profit before tax $150,000)
following page) with year end 31 March 20X1, are nearing On 23 April 20X1 a letter was received informing the company
completion. Please answer the following questions for each that a customer, who owed Jasper $30,000 as at the year
of the four companies. end, had been declared bankrupt on 17 April. It is expected
that unsecured creditors, such as Jasper, will receive nothing
1. Assess materiality (e.g. $A represents x% of profit before in respect of amounts owing to them. Jasper’s management
tax and is therefore material or immaterial as appropriate). refuses to change the accounts to provide for the loss, on the
grounds that bankruptcy was declared after the year end
2. Identify relevant accounting requirements and state date.
compliance or otherwise with them (e.g. non-compliance IAS
16 as asset must be depreciated). Total trade receivables shown in the statement of financial
position amounted to $700,000.
3. State a suitable audit opinion (just one, e.g. modified
“except for”).
The auditor's report on financial statements - emphasis of matters and other matters - ISA 706
Emphasis of matter paragraph When the auditor includes an Emphasis of Matter paragraph
A paragraph included in the auditor’s report that refers to a the auditor shall:
matter appropriately presented or disclosed in the financial • include it immediately after the Opinion paragraph in the
statements that, in the auditor’s judgement, is of such auditor’s report
importance that it is fundamental to users’ understanding of • use the heading “Emphasis of Matter” (or other
the financial statements. appropriate heading)
• include in the paragraph a clear reference to the matter
The emphasis of matter does NOT affect the auditor’s opinion being emphasised and to where relevant disclosures that
fully describe the matter can be found in the financial
Other matter paragraph statements
A paragraph included in the auditor’s report that refers to a • indicate that the auditor’s opinion is not modified in
matter other than those presented or disclosed in the financial respect of the matter emphasised
statements that, in the auditor’s judgement, is of such
importance that is relevant to users’ understanding of the Circumstances in which an Emphasis of Matter paragraph
audit, the auditor’s responsibilities to the auditor’s report. may be necessary:
• an uncertainty relating to the future outcome of
These definitions are taken from ISA 706 “emphasis of matter
exceptional litigation or regulatory action
paragraphs and other matter paragraphs in the independent
• early application of a new accounting standard (where
auditor’s report”.
permitted) that has a pervasive effect on the financial
statements in advance of its effective date
• a major catastrophe that has had, or continues to have, a
significant effect on the entity’s financial position
The auditor's report on financial statements - emphasis of matters and other matters - illustration
Emphasis of matter Other matters - requirements
To explain the auditor’s responsibilities for the going • to obtain sufficient appropriate audit evidence about the
concern assumption used in preparation of financial appropriateness of management’s use of the going
statements, including consideration of management’s concern assumption in the preparation and presentation of
assessment of the enterprise’s ability to continue as a going the financial statements
concern. • to conclude, based on the audit evidence obtained,
whether a material uncertainty exists that may cast doubt
on the entity’s ability to continue as a going concern
• to determine the implications for the auditor’s report
Enterprise will continue Generally a period of at Financial statements should be prepared on a going
in operation for the least one year after concern basis unless that basis is inappropriate.
foreseeable future reporting date
To consider:
• management’s use of the going concern assumption
• whether material uncertainties require disclosure
Management’s plans to maintain adequate cash flows by The auditor shall remain alert for audit evidence of such
alternative means: events or conditions and related business risks which
• disposal of assets may cast significant doubt on the entity’s ability to continue as
• rescheduling of loan repayments a going concern. If identified the auditor should:
• obtaining additional capital • perform additional procedures
The auditor must assess the feasibility of plans and the • consider whether they affect the auditor’s assessment of
likelihood that they will improve the situation. the risks of material misstatement
Material uncertainty
Description of:
• principal events or conditions raising substantial doubt
• management’s plans, including mitigating factors
Exercise - reporting
Please review the following exercise: Situation 3: The going concern assumption is appropriate
but material uncertainty exists, but adequate
For each of the following six situations : disclosure is not made.
1. Suggest an appropriate audit report modification, (if any); Situation 4: The going concern assumption is
a. unmodified inappropriate but the financial statements
b. unqualified with emphasis of matter have been prepared on a going concern
c. qualified “except for” basis.
d. adverse Situation 5: The going concern assumption is
e. disclaimer inappropriate and the financial statements
2. State the grounds for such a modification. have been prepared on an alternative basis,
a. none which is adequately disclosed.
b. significant uncertainty(disagreement) Situation 6: Management does not make an assessment
c. inability to obtain sufficient evidence (limitation on for a period of at least 12 months from the
scope) balance sheet date when asked to do so.
→ Do not modify report → Unqualified with → Qualified or → Adverse opinion → Unqualified with
(assuming any mitigating emphasis adverse opinion emphasis of
factors adequately of matter matter
disclosed)
See illustration 1 See illustration 2
(next page) (next page)
“Without qualifying our opinion we draw attention to note In our opinion, except for the omission of the information
x in the financial statements which states that the included in the basis of qualified opinion paragraph, the
Company incurred a net loss of xxx during the year financial statements give a true and fair view of the financial
ended December 31 20X1 and, as of that date, the position of the Company at December 31 20X1 and the
Company’s current liabilities exceeded its total assets by xxx. results of its operations and its cash flows for the year then
These conditions, along with other matters as set out in note ended in accordance with....”
x, indicate the existence of a material uncertainty which may
cast significant doubt about the Company’s ability to continue An adverse opinion should be expressed when the
as a going concern.” financial statements as a whole do not give a true and fair
view (or fairly present) the financial position (e.g. if
Illustration 2 - inadequate disclosure → basis of qualified management were considering ceasing to trade or filing for
opinion bankruptcy).
“The Company’s financing arrangements expire and
amounts outstanding are payable on (date). The Company Note that if a company is not a going concern, an adverse
has been unable to re-negotiate or obtain replacement opinion should be expressed if the financial statements
financing. This situation indicates the existence of a material are prepared on a going concern basis. This is irrespective
uncertainly which may cast significant doubt on the of any disclosure made. “Inappropriate accounting treatments
Company’s ability to continue as a going concern and are not rectified by disclosure of the accounting policies used
therefore it may be unable to realise its assets and discharge or by notes or explanatory materials” IAS 1 “presentation of
its liabilities in the normal course of business. The financial financial statements”.
statements (and notes thereto) do not disclose this fact.
If an auditor’s report is qualified in respect of going concern, it Definitely not. A decision to modify on going concern
might affect the client’s ability to raise funds and so lead to means, for example:
the company ceasing to trade. Should this affect the auditor’s • that the enterprise is not a going concern (adverse
decision whether and how to modify the auditor’s report? opinion)
• that the client has failed to make necessary disclosures
about factors affecting the company’s future viability
To reveal our answer ,click below:
(“except for” – material lack of disclosure)
• although the going concern assumption is appropriate a
material uncertainty exists which is adequately disclosed
(emphasis of matter)
Module review
Having completed this module and this course you
should now be fully conversant with those international
standards on auditing most relevant to fulfilling the objective
of an audit of financial statements - that is expressing an
opinion.
Question 1
An auditor’s opinion must be qualified on the grounds of inability to obtain sufficient
appropriate evidence where senior management:
Question 2
A company’s financial statements include an amount due from a customer which is material.
The auditors do not believe that any part of the balance will be paid.
A Unmodified
B Disclaimer
C Adverse
D Except for
Question 3
The accounting records of a company were destroyed by fire shortly before the year end. The
financial statements have been prepared on the basis of estimates, but it has not been
possible for the auditor to carry out many audit procedures (ISA 700 “forming an opinion and
reporting on financial statements”).
Question 4
The financial statements of a company show a profit before tax of $15 million and net assets
of $100 million. Certain products in inventory shown in the statement of financial position at a
cost of $6 million are slow moving. The company’s management is confident that all these
products will eventually be sold but the auditors consider that a provision of $2 million is
required. Management has refused to adjust the financial statements.
Question 5
An auditor is of the opinion that a company cannot continue to trade due to a change in
legislation making the business of the company illegal. The financial statements are prepared
on a going concern basis and the facts are fully disclosed in the notes.
Question 6
Which of the following factors is not relevant when an auditor is deciding whether or not to
refer to a going concern problem when reporting on the financial statements of a subsidiary of
a listed company?
Question 7
Although there is materiality uncertainty about a company’s ability to continue as a going
concern, the company’s directors have prepared the financial statements on a going concern
basis and the auditors agree with its use. The financial statements disclose the conditions that
give rise to significant doubts and the nature of adjustments that would be necessary if the
financial statements were prepared on an alternative authoritative basis.
Glossary - A
A & IC Accounting and internal control(s) Audit evidence The information obtained by the auditor in
Adverse The auditor is reporting a misstatement that is both arriving at the conclusions on which the audit opinion is
material and pervasive and a qualification is not adequate to based; it comprises source documents and accounting
disclose the extent to which the financial statements are records underlying the financial statements and corroborating
misleading or incomplete information from other sources
Adverse opinion Expressed when the effect of a Audit strategy General strategy for the audit which sets out
misstatement is so material and pervasive to the financial the direction for the audit, describes the expected scope and
statements that the auditor concludes that a qualification of conduct and provides guidance for the development of the
the report is not adequate to disclose the misleading or audit program
incomplete nature of the financial statements Audit program Sets out the nature, timing and extent of
Analytical procedures The analysis of significant ratios and planned audit procedures required to implement the overall
trends including the resulting investigation of fluctuations and audit strategy; it serves as a set of instructions to assistants
relationships that are inconsistent with other relevant involved in the audit and as a means to control
information or which deviate from predictable amounts the proper execution of the work
Application package A program unique to a particular Audit risk The risk that the auditor gives an inappropriate
function/use e.g. payroll, accounts audit opinion when the financial statements are materially
Assertions Representations by management, explicit or misstated; the components of audit risk are inherent risk,
otherwise, that are embodied in the financial statements, as control risk and detection risk
used by the auditor to consider the different types of potential Audit risk standards See Risk ISAs
misstatements that may occur.
Audit sampling Involves the application of audit procedures
Audit The objective of an audit of financial statements is to
to less than 100% of items within an account balance or class
enable the auditor to express an opinion whether the financial of transactions such that all sampling units have a chance of
statements are prepared, in all material respects, in selection; this will enable the auditor to obtain and evaluate
accordance with an identified financial reporting framework audit evidence about some characteristic of the items
Audit documentation The record of audit procedures selected in order to form or assist in forming a conclusion
performed, relevant audit evidence obtained, and conclusions concerning the population from which the sample is drawn;
the auditor reached (terms such as “working papers” or audit sampling can be used with a statistical or non-statistical
“workpapers” are also sometimes used). approach
© 2011 Association of Chartered Certified Accountants 0
Glossary Certificate in International Auditing
Glossary - B , C
Batch total A control total Control environment Includes the governance and
management functions and the attitudes, awareness and
Business risk A risk resulting from significant conditions,
actions of those charged with governance and management
events, circumstances, actions or inactions that could
concerning the entity’s internal control and its importance in
adversely affect an entity’s ability to achieve its objectives and
the entity. The control environment is a component of internal
execute its strategies, or from the setting of inappropriate
control.
objectives and strategies.
Control procedures Those policies and procedures in
CAATs Computer-assisted audit technique
addition to the control environment which management has
Check digit A number added to the end of a code that established to achieve the entity’s specific objectives
facilitates checking for transcription, transposition & random
Control risk The risk that a misstatement (that could occur
errors e.g. using the “modulus 11 algorithm” is summing the
in an account balance or class of transactions and that
digits, dividing by 11, the remainder gives the check digit
could be material individually or when aggregated with other
Conforming amendments Those amendments which were misstatements) will not be prevented or detected and
made to other ISAs as a result of revising another standard or corrected on a timely basis by the accounting and internal
the development of a new standard control system
Control total Summed both manually (e.g. for input) and
Component A division, branch, subsidiary, joint venture,
automatically (e.g. on processing) and the totals compared
associated company or other entity whose financial
and agreed (or reconciled); both totals may be determined
information is included in financial statements audited by the
automatically
principal auditor
Corporate governance Those charged with corporate
Computer bureau An entity that specializes in offering
governance are responsible for overseeing the systems of
computer-related services e.g. data entry and programming
risk monitoring, financial control and compliance with legal
requirements
Glossary - D, E, F
Deficiency in internal control This exists when: Engagement letter Documents and confirms the auditor’s
a. A control is designed, implemented or operated in such a acceptance of the appointment, the objective and scope of
way that it is unable to prevent, or detect and correct, the audit, the extent of the auditor’s responsibilities to the
misstatements in the financial statements on a timely basis; client and the form of any reports
or
Error (in general) An unintentional mistake in financial
b. A control necessary to prevent, or detect and correct,
statements
misstatements in the financial statements on a timely basis
is missing. Error (in audit sampling) Either control deviations (when
performing tests of controls ) or misstatements (when
Detection risk The risk that the procedures performed by the
performing substantive procedures)
auditor to reduce audit risk to an acceptably low level will not
detect a misstatement that exists and that could be material, External confirmation Audit evidence obtained as a direct
either individually or when aggregated with other written response to the auditor from a third party (the
misstatements. confirming party), in paper form, or by electronic or other
medium.
Disclaimer The possible effect of an inability to obtain
evidence is so material and pervasive that sufficient evidence Financial statements The statements of financial position
has not been obtained as a basis for expressing an opinion (balance sheets), income statements (or profit and loss
accounts), statements of changes in financial position (which
Disclaimer of opinion Expressed when the possible effect of
may be presented in a variety of ways (e.g. as a cash flow
misstatements that could be undetected due to the inability to
statement), notes and other statements and explanatory
obtain sufficient appropriate audit evidence is so material and
material which are identified as being part of the financial
pervasive that the auditor is unable to express an opinion on
statements
the financial statements
Financial statement assertions Assertions by
Emphasis of Matter paragraph A paragraph included in the
management, explicit or otherwise, that are embodied in the
auditor’s report that refers to a matter appropriately presented
financial statements and can be categorized as accuracy,
or disclosed in the financial statements that, in the auditor’s
existence, rights and obligations, occurrence, cut-off,
judgment, is of such importance that it is fundamental to users’
completeness, valuation, allocation, classification
understanding of the financial statements.
Glossary - F, G, H, I, J
Format checks Check that data conforms to the specified IFAC International Federation of Accountants
alphanumeric format and length e.g. if product code is a letter
followed by three numbers then S512 is valid but 5512, IFRIC Interpretations Interpretations of the International
S5122 and SS12 would be invalid Financial Reporting Interpretations (IFRIC) deal with issues of
reasonably widespread importance covering:
Fraud An intentional act by one or more individuals among
• mature issues (where there is unsatisfactory practices
management, employees or third parties which results in a
within the scope of existing IFRSs/IASs)
misrepresentation of financial statements; three categories
• emerging issues
broadly are (1) defalcation (unauthorized obtaining of assets),
(2) misrepresentation (production of financial information not Inherent risk The susceptibility of an account balance or
derived from authorized transactions), (3) computer misuse class of transactions to misstatement that could be material,
individually or when aggregated with other misstatements,
Fraud risk factors Events or conditions that provide an
assuming that there were no related internal controls
opportunity, a motive or a means to commit fraud, or indicate
that fraud may already have occurred Internal control system All the policies and procedures
(internal controls) adopted to assist in achieving
General controls (in CIS) The framework of overall control
management’s objective of ensuring, as far as practicable, the
over CIS activities to provide a reasonable level of assurance
orderly and efficient conduct of the entity’s business (including
that the overall objectives of internal control are achieved
adherence to management policies, safeguarding assets,
Going concern Continuing in operation for the foreseeable prevention and detection of fraud and error, the accuracy and
future; the enterprise has neither the intention nor the need to completeness of the accounting records, and the timely
liquidate or curtail materially the scale of its operations - as a preparation of reliable financial information)
result assets are valued on the basis of continued use, such
Inventories Assets (1) held for sale in the ordinary course of
as historical cost or replacement cost rather than net
business; (2) in the process of production for sale; (3)
realisable value or liquidation value
materials/supplies to be consumed in producing
Hash total A meaningless sum of inappropriate fields (e.g. goods/rendering services
employee numbers) for checking accuracy (completeness
ISA International Standards on Auditing
and correctness) of input and processing
Glossary - K, L, M, N, O
Key control One whole failure (1) could lead to material Non-sampling risk Arises from factors that cause the
misstatement and (2) is not compensated for by another auditor to reach an erroneous conclusion for any reason not
control (a control which is compensated for is not “key”) related to the sample size e.g. most audit evidence is
persuasive rather than conclusive, the auditor might use
Lien A right to retain possession of the owner’s property inappropriate procedures or misinterpret evidence and fail to
until the owner pays what he owes to the person in recognize an error
possession
Non-statistical sampling A sampling approach that does
Management Officers and others who also perform senior not have all the necessary characteristics of statistical
managerial functions; management includes directors and the sampling
audit committee only in those instances when they perform
such functions Objectivity A combination of impartiality, intellectual
honesty and freedom from conflicts of interest
Materiality Information is material if its omission or
misstatement could influence the economic decisions of users On-line Connected to the computer; in real-time and on-line
taken on the basis of the financial statements systems, terminals must be continuously connected
to the computer
Misstatement A mistake in financial information which
would arise from errors and fraud On-line system Data is input through a computer terminal
as it arises (and some checking may be carried out
Modified auditor’s report If the report is qualified, or has an immediately), but it is then stored temporarily for later
adverse opinion or disclaimer of opinion processing and updating
Glossary - P,Q,R
Password A sequence of characters known only to the user Range checks Data has to lie within certain values
which allows access to a computer system (or part thereof); Reasonable assurance In an audit engagement, the auditor
ideally, it should not be a word in a dictionary and neither too provides a high, but not absolute, level of assurance,
short nor too long expressed positively in the audit report as reasonable
Performance materiality The amount or amounts set by the assurance, that the information subject to audit is free of
auditor at less than materiality for the financial statements as material misstatement
a whole to reduce to an appropriately low level the probability Reasonableness checks Test whether data is reasonable
that the aggregate of uncorrected and undetected when compared to a standard (e.g. hours worked, interest
misstatements exceeds materiality for the financial rates) or previous input (e.g. consumption, purchase prices)
statements as a whole. If applicable, performance materiality
also refers to the Risk assessment procedures Audit procedures to obtain
amount or amounts set by the auditor at less than the an understanding of the entity and its environment
materiality level or levels for particular classes of transactions, Risk ISAs International Statements on Auditing (ISA) 315,
account balances or disclosures. 330 and 500 are collectively known as the risk ISAs (or audit
Pilot operation (1) Retrospective parallel running processes risk standards)
historic data and compares new system results with those Risk of material misstatement The risk that the financial
already known; this parallel running “out-of phase” is statements are materially misstated prior to audit. This
effectively a large test data exercise (2) a limited number of consists of two components, described as follows at the
transactions are processed live though less rigorous than (1) assertion level:
it is less costly than duplicated entry a. Inherent risk - The susceptibility of an assertion about a
Population The entire set of data from which the auditor class of transaction, account balance or disclosure to a
wishes to sample in order to reach a conclusion e.g. all of the misstatement that could be material, either individually or
items in an account balance or a class of transactions when aggregated with other misstatements, before
constitute a population; a population may be divided into consideration of any related controls.
strata, or sub- populations, with each stratum being examined b. Control risk - The risk that a misstatement that could occur
separately; the term population is used to include the term in an assertion about a class of transaction, account
stratum balance or disclosure and that could be material, either
individually or when aggregated with other misstatements,
Qualitative characteristics Attributes that make information will not be prevented, or detected and corrected, on a
provided in financial statements useful to users, timely basis by the entity’s internal control.
encompasses understandability, relevance, reliability and
comparability
© 2011 Association of Chartered Certified Accountants
Glossary Certificate in International Auditing
Glossary - S
Sampling risk Arises from the possibility that the auditor’s Sequence checks Test that a series of transactions are
conclusion, based on a sample, may be different from the completely input/processed in (number) order
conclusion that would be reached if the entire population were
Service organisation A third-party organisation (or segment
subjected to the same audit procedure; there are two types of
of a third-party organisation) that provides services to user
sampling risk:
entities that are part of those entities’ information systems
1. The risk the auditor will conclude that control risk is lower
relevant to financial reporting.
than it actually is (in the case of a test of control) or that a
material error does not exist when in fact it does (in the Significant deficiency in internal control A deficiency or
case of a substantive test); this type of risk affects audit combination of deficiencies in internal control that, in the
effectiveness and is more likely to lead to an inappropriate auditor’s professional judgment, is of sufficient importance to
audit opinion. merit the attention of those charged with governance.
2. The risk the auditor will conclude that control risk is higher
Stratification The process of dividing a population into sub-
than it actually is (in the case of a test of control) or that a
populations, each of which is a group of sampling units which
material error exists when in fact it does not (in the case of
have similar characteristics (often monetary value)
a substantive test); this type of risk affects audit efficiency
as it would usually lead to additional work to establish that Statistical sampling Any approach to sampling that has the
initial conclusions were incorrect. following characteristics: (1) random selection of a sample
and (2) use of probability theory to evaluate sample results,
Sampling units The individual items constituting a
including measurement of sampling risk
population e.g. credit entries on bank statements, sales
invoices, trade receivable balances, or a monetary unit (e.g. Substantive procedures Tests performed to obtain audit
$1) evidence to detect material misstatements in the financial
statements, and are of two types: (1) tests of details of
Segregation of duties Separation of the responsibility for
transactions and balances, and (2) analytical procedures
the custody of assets from the records which account for
them
Glossary - T, U, V, W
Tests of controls Performed to obtain audit evidence about Validation Includes consistency, format and range checks
the effectiveness of the:
• design of the accounting and internal control systems, that Walk-through test Involves tracing a few transactions
is, whether they are suitably designed to prevent or detect through the financial reporting system.
and correct material misstatements
• operation of the internal controls throughout the period Working papers A record of the auditor’s planning; nature,
timing and extent of the auditing procedures performed and
Those charged with governance The person(s) or
results of such procedures and the conclusions drawn from
organisation(s) (for example, a corporate trustee) with
the evidence obtained; working papers may be in the form of
responsibility for overseeing the strategic direction of the
data stored on paper, film, electronic media or other media
entity and obligations related to the accountability of the
entity. This includes overseeing the financial reporting
Written representation A written statement by management
process. For some entities in some jurisdictions, those
provided to the auditor to confirm certain matters or to support
charged with governance may include management
other audit evidence. Written representations in this context
personnel, for example, executive members of a governance
do not include financial statements, the assertions therein, or
board of a private or public sector entity, or an owner-
supporting books and records.
manager.
Unmodified opinion The opinion expressed by the auditor
when the auditor concludes that the financial statements are
prepared, in all material respects, in accordance with the
applicable financial reporting framework.
Users Present and potential investors, employees, lenders,
suppliers, customers, governments and the public