F8 Course Notes

Audit and Assurance
Paper F8
Course Notes
For Exams from December 2014
ISBN: 9781472722577
2
F8 Audit and Assurance
Study Programme
Step 1 Taught Phase Study Programme
Page
Introduction to the paper and the course .......................................................................................... 4
1 The concept of audit and other assurance engagements ..................................................... ..15
2 Statutory audit and regulation.................................................................................................. 31
3 Corporate governance............................................................................................................. 43
4 Professional ethics .................................................................................................................. 57
5 Internal audit............................................................................................................................ 83
6 Risk assessment ................................................................................................................... 101
Checkpoint 1 117
7 Audit planning and documentation ........................................................................................ 119

8 Introduction to audit evidence................................................................................................ 129
9 Internal control....................................................................................................................... 139
10 Tests of controls .................................................................................................................... 155
11 Audit procedures and sampling............................................................................................. 197
Checkpoint 2 215
12 Non-current assets ................................................................................................................ 217

13 Inventory................................................................................................................................ 225
14 Receivables ........................................................................................................................... 233
15 Bank and cash....................................................................................................................... 239
16 Liabilities, capital and directors emoluments ........................................................................ 247
17 Not-for-profit organisations.................................................................................................... 257
18 Audit review and finalisation.................................................................................................. 263
19 Reports .................................................................................................................................. 279
Checkpoint 3 293
20 Answers to Lecture Examples............................................................................................... 295

21 Question and Answer bank ................................................................................................... 329
22 Appendix A: Assumed knowledge from Paper F3................................................................. 349
23 Course Exam 1 and 2 Questions only................................................................................... 365
3
INTRODUCTION
Introduction to Paper F8 Audit and Assurance
Overall aim of the syllabus

To develop knowledge and understanding of the process of carrying out the assurance
engagement and its application in the context of the professional regulatory framework.
The syllabus
The broad syllabus headings are:
A Audit framework and regulation

B Planning and risk assessment
C Internal control
D Audit evidence
E Review and reporting
Main capabilities
On successful completion of this paper, candidates should be able to:
Explain the concept of audit and assurance and the functions of audit, corporate
governance, including ethics and professional conduct, describing the scope and
distinguishing between the functions of internal and external audit.
Demonstrate how the auditor obtains and accepts audit engagements, obtains an
understanding of the entity and its environment, assesses the risk of material misstatement
(whether arising from fraud or other irregularities) and plans an audit of financial statements.
Describe and evaluate internal controls, techniques and audit tests, including IT systems to
identify and communicate control risks and their potential consequences, making
appropriate recommendations.
Identify and describe the work and evidence obtained by the auditor and others required to
meet the objectives of audit engagements and the application of the International Standards
on Auditing
Explain how consideration of subsequent events and the going concern principle can inform
the conclusions from audit work and are reflected in different types of audit report, written
representations and the final review and report.
4
INTRODUCTION
Links with other papers
Governance, risk and Advanced Audit and Assurance

ethics (P1) (P7)
Corporate and Financial Audit &

Business Law (F4) Reporting (F7) Assurance (F8)
This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist
between this paper and other papers that may precede or follow it.
Although ACCA's diagram shows Paper F7 feeding into Paper F8, the accounting knowledge
assumed in the F8 exam will only be that covered within Paper F3 Financial Accounting.
5
INTRODUCTION
Taught Phase Aims
Achieving ACCA's Study Guide Outcomes
A Audit framework and regulation
A1 The concept of audit and other assurance engagements Chapter 1

A2 External audits Chapter 2
A3 Corporate governance Chapter 3
A4 Professional ethics and the ACCA's Code of Ethics and Conduct Chapter 4
A5 Internal audit and governance and the differences between external and Chapter 5
internal audit
A6 The scope of the internal audit function, outsourcing and internal audit Chapter 5
assignments
B Planning and risk assessment
B1 Obtaining and accepting audit engagements Chapter 6

B2 Objective and general principles Chapter 6
B3 Assessing audit risks Chapter 6
B4 Understanding the entity and its environment Chapter 6
B5 Fraud, laws and regulations Chapter 6
B6 Audit planning and documentation Chapter 7
C Internal control
C1 Internal control systems Chapter 9

C2 The use and evaluation of internal control systems by auditors Chapter 9
C3 Tests of control Chapter 10
C4 Communication on internal control Chapter 10
6
INTRODUCTION
D Audit evidence
D1 Financial statement assertions and audit evidence Chapter 8

D2 Audit procedures Chapter 11
D3 Audit sampling and other means of testing Chapter 11
D4 The audit of specific items Chapters
12 - 16
D5 Computer-assisted audit techniques Chapter 11
D6 The work of others Chapter 11
D7 Not-for-profit organisations Chapter 17
E Review and reporting
E1 Subsequent events Chapter 18

E2 Going concern Chapter 18
E3 Written representations Chapter 18
E4 Audit finalisation and the final review Chapter 18
E5 Audit reports Chapter 19
7
INTRODUCTION
The Examination Paper

The examination is a three hour paper with 15 minutes reading and planning time. All questions
are compulsory. Some questions will adopt a scenario/case study approach. All questions will
require some form of written response although questions on planning or review may require the
calculation and interpretation of some basic ratios.
100% Discussion
10% Knowledge 90% Application
Format of the Exam Marks

Section A Comprises 8 two mark and 4 one mark multiple choice questions. 20
Section B Comprises:
Four 10 mark questions. These will tend to test one of the five 40
syllabus areas of the Study Guide (A, B, C, D or E).
Two 20 mark questions. The 20 mark questions will predominantly 40
examine one or more aspects of audit and assurance from planning
and risk assessment, internal control or audit evidence, although
topics from other syllabus areas may also be included.
100
Time pressure warning
Section A Section B
8
INTRODUCTION
Key to icons
The following icons appear in this set of study notes
Question practice
This is a question from the Exam Question and Answer Bank in the Study Text
which we recommend you attempt to reinforce your learning on a key topic
Section reference in the Study Text

You could further consolidate your knowledge in this area with additional
reading from the Study Text.
Formula to learn
9
INTRODUCTION
10
SKILLS BANK
Key skills required to pass

Our analysis of the examiners comments on past exams, together with our experience of preparing
students for this type of exam, suggests that to pass Paper F8, Audit and Assurance, you will need to
develop a number of key skills.
1 Effective use
5 Producing a of the 15 minutes
tailored answer to the reading time at
scenario in the exam the start of the
question exam
4 Tackling multiple
choice questions 2 Quick and accurate
analysis of a questions
requirements
3 Disciplined
time management
to ensure that all
parts of the
question are
answered in the
time allowed
11
SKILLS BANK
Skill 1 Effective use of reading time
All of the questions in this paper are compulsory so there is no choice to make in terms of which
questions you will attempt, but you should give some thought to the order in which you attempt them.
Section A comprises multiple choice questions so you would be better to spend your reading time
concentrating on the longer questions in Section B. Focus particularly on questions which include a
scenario. The scenarios are likely to contain some detailed narrative about a client company and its
systems and may also include some numerical information. To answer these types of questions
successfully you will need to use the information in the scenario so make sure you read the requirements
and then spend your reading time annotating key information from the scenario.
Skill 2 Analysis of a question's requirements
You need to be aware of the meaning of the verbs used by the examiner.
You dont need to learn each term precisely but it is important that you appreciate the difference between
them, for example explain means clarifying an issue or developing a point, whereas discuss means
critically examining an issue or considering the pros and cons.
Also the requirements of a question often contain a number of sub-requirements; you need to make sure
these are clearly identified on the question paper by highlighting or underlining them so that your answer
is comprehensive.
Skill 3 Disciplined time management
Section B (the written questions) will undoubtedly be more time pressured than Section A (multiple
choice questions). You are allocated 1.8 minutes for each mark available in the exam and so it is
imperative that you allocate 36 minutes to Section A as a whole, 18 minutes to each 10 mark question in
Section B and 36 minutes to each 20 mark question in Section B.
Skill 4 Tackling multiple choice questions
When answering multiple choice questions firstly read the requirement and have a think about what
you think the correct answer may be. Next try to locate the correct answer. Even if you see the
correct answer make sure that you still check the other answers just in case you have made a common
mistake. Read the requirement again to be sure that you are answering the correct question and then
choose your answer. Never leave a question unanswered guess if you have to!
12
SKILLS BANK
Skill 5 Producing a tailored answer to the exam scenario
You are expected to apply your theoretical knowledge to the specifics of the question set in the exam.
The best way to tailor your answer is to look for clues in the scenario and then to build them in to your
answer.
Also make sure you write your answer in a manner which reflects your role in the questions and your
intended addressee. For example if you are writing a report to the Board of Directors you should write
using professional language and avoid jargon.
13
SKILLS BANK
14
The concept of audit and
other assurance
engagements
How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past paper questions
Identify and describe the objective and general
principles of external audit engagements
Explain the nature and development of audit and
other assurance engagements
Discuss the concepts of accountability,
stewardship and agency
Define and provide the objectives of an
assurance engagement
Explain the five elements of an assurance
engagement
Describe the types of assurance engagement
Explain the level of assurance provided by an Q7 Section A pilot paper

external audit and other review engagements
and the concept of true and fair presentation
Describe the limitations of external audits
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1: THE CONCEPT OF AUDIT AND OTHER ASSURANCE ENGAGEMENTS
Overview
The concept of audit and other

assurance engagements
The purpose of external audit The audit report Assurance
Accountability, stewardship
and agency
Levels of assurance
16
1 The purpose of external audit

1.1 The purpose of external audit is to enhance the degree of confidence of users in the
financial statements.
1.2 Definition
External audits provide assurance to shareholders that the financial statements are
prepared, in all material respects, in accordance with an applicable financial reporting
framework.
An audit is conducted in accordance with International Standards on Auditing (ISAs) and
relevant ethical requirements.
Auditors must be independent and impartial of the company they are auditing, and so are in
a position to provide an opinion to the companys owners that the financial statements are
presented fairly.
The phrase presented fairly is interpreted as meaning:
Factual
Free from bias
Reflect the commercial substance of the businesss transactions
1.3 Most national legislation requires the directors of all companies to produce financial
statements for presentation to their shareholders. This is a recognition of the division
between those who own the company the shareholders and those who run it on a
day-to-day basis management/ directors.
1.4
Appoint
independent
Auditor
Adds credibility
Measure
performance Financial Prepare
Statements
Appoint
Shareholders Management
Own Company Manage
17
1.5 Management are required to account for the stewardship of the assets placed under their
control. They achieve this by preparing financial statements which are presented to the
shareholders.
1.6 An external audit is another legal requirement for incorporated entities, although many
smaller entities are exempt from the requirement. The directors' statements have to be
examined by an independent expert, the auditor, who is required to give an opinion on their
truth and fairness.
1.7 The auditors opinion enhances the credibility of the financial statements by providing
reasonable assurance from an independent source that the financial statements taken as a
whole are free from material misstatement. Reasonable assurance is a high level of
assurance.
2 The audit report

2.1 The ultimate aim of the audit process is for the auditors to be in a position to express their
opinion to the shareholders as to whether the financial statements have been prepared, in
all material respects, in accordance with the applicable financial reporting framework.
2.2 This is done by issuing an audit report. If the auditors are happy with the financial
statements, then they will issue a report which gives an unmodified opinion.
Example audit report
INDEPENDENT AUDITORS REPORT

[Appropriate Addressee]
Report on the financial statements
We have audited the accompanying financial statements of ABC Company, which comprise
the statement of financial position as at 31 December 20X1, and the statement of profit or
loss and other comprehensive income, statement of changes in equity and statement of
cash flows for the year then ended, and a summary of significant accounting policies and
other explanatory information.
Managements responsibility for the financial statements
Management is responsible for the preparation and fair presentation of these financial
statements in accordance with International Financial Reporting Standards, and for such
internal control as management determines is necessary to enable the preparation of
financial statements that are free from material misstatement, whether due to fraud or error.
Auditors responsibility
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 about whether the financial statements are free from
material misstatement.
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An audit involves performing procedures to obtain audit evidence about the amounts and
disclosures in the financial statements. The procedures selected depend on the auditors
judgement, including the assessment of the risks of material misstatement of the financial
statements, whether due to fraud or error. In making those risk assessments, the auditor
considers internal control relevant to the entitys preparation and fair presentation of the
financial statements in order to design audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
entitys internal control. An audit also includes evaluating the appropriateness of accounting
policies used and the reasonableness of accounting estimates made by management, as
well as evaluating the overall presentation of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide
a basis for our audit opinion.
Opinion
In our opinion, the financial statements present fairly, in all material respects, (or give a true
and fair view of) the financial position of ABC Company as at 31 December 20X1, and (of)
its financial performance and its cash flows for the year then ended in accordance with
International Financial Reporting Standards.
Report on other legal and regulatory requirements
[Form and content of this section of the auditors report will vary depending on the nature of
the auditors other reporting responsibilities.]
[Auditors signature]
[Date of the auditors report]
[Auditors address]
Fair presentation/ true and fair

2.3 (a) The auditor is required to report that the financial statements present fairly, in all
material respects, (or give a true and fair view of) the financial position, financial
performance and cash flows of the company concerned.
(b) ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with ISAs does not define the term fair.
However, under IFRSs, IAS 1 Presentation of Financial Statements interprets it as
meaning a faithful representation of assets, liabilities, income and expenses as set
out in the Framework.
(c) Ultimately true and fair may need to be decided by a court where there is contention.
The courts will treat compliance with the identified financial reporting framework as
prima facie evidence that the financial statements are presented fairly.
Materiality
2.4 The objective of an audit of financial statements is to enable the auditor to express an
opinion on whether the financial statements are prepared in all material respects, in
accordance with an identified financial reporting framework.
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2.5 What is materiality?

(a) Misstatements, including omissions, are material if they could influence the
economic decisions of users taken on the basis of the financial statements.
(b) Judgements about materiality are affected by the size or nature of a misstatement, or
a combination of both.
(c) The auditor will determine materiality through their professional judgement, affected
by their perception of the needs of the users of the financial statements. (Chapter 6
covers this area in more detail).
(d) The auditor is not responsible for the detection of misstatements that are not material
to the financial statements as a whole.
Reasonable assurance
2.6 No auditor can give 100% assurance. The highest level of assurance given, as in the case
of statutory audit, is described as 'reasonable assurance'.
'Reasonable assurance' is not absolute assurance because there are inherent limitations of
an audit which result in the auditor forming an opinion on evidence that is persuasive rather
than conclusive.
Limitations of the audit and materiality

2.7 The assurance given by auditors is governed by the fact that auditors use judgement in
deciding what audit procedures to use and what conclusions to draw, and also by the
limitations of every audit. These are illustrated in the following diagram:
20
2.8 Auditors reports are covered in more detail in Chapter 19.
3 Assurance
3.1 The ACCA F8 syllabus extends beyond audit to the wider context of assurance.
Definition
3.2 'An assurance engagement is an engagement in which a practitioner expresses a
conclusion designed to enhance the degree of confidence of the intended users other than
the responsible party about the outcome of the evaluation or measurement of a subject
matter against criteria.' [International Framework for Assurance Engagements]
21
3.3 There are five elements to an assurance engagement. These are illustrated by the diagram
below
Practitioner
Criteria
Subject
matter
Users Responsible
party
3.4 One way to remember the five elements of an assurance engagement is using the
mnemonic CREST:
Criteria
Report
Evidence
Subject matter
Three party relationship (responsible party, user, practitioner)
3.5 In essence, assurance describes the process whereby one party is trying to give some level
of comfort to another party about a subject matter.
3.6 The statutory audit is therefore an example of an assurance engagement.
3.7 The purpose of the audit is primarily to give assurance to the shareholders (the main
stakeholders) but there are advantages to many other user groups of having the financial
statements audited. These groups include potential investors, lenders, employees,
customers and suppliers.
3.8 Many assurance engagements are undertaken voluntarily but they may also happen as a
result of a requirement imposed on the entity by another party (for example in the case of
the statutory audit).
3.9 Other examples of assurance engagements include:

A review of the effectiveness of an entitys internal control or computer systems
A review of threats to an entitys going concern
A review of an entitys half year results
22
Lecture example 1 Idea generation
What other examples of assurance and assurance reports exist?

Consider the following scenarios:
Solution
(1) You are currently thinking of buying a house built in 1900. What assurance report could you
obtain and who might provide this?
(2) Your friend is considering meeting up with someone they have met on an on-line dating
website. What assurances do you think they should seek before meeting up?
(3) You work for a local council which is just about to issue a $10,000 grant to an organisation
which runs sports activity courses for children with special needs. What assurance report
could you obtain and who might provide this?
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3.10 An assurance report provides the following benefits to the users of information:
Independent opinion from an external source that enhances the credibility of the
information
Management bias is reduced
Any non-standard or modified opinion draws attention to risk
The relevance of the information may be improved by the expertise and knowledge of
the assurance firm.
3.11 All assurance engagements, whether subjected to legal regulation such as statutory audit or
a contractual arrangement should be performed in a similar manner:
Agree the scope of work to be performed
Formalise all of the terms of the engagement in a contract (engagement letter)
Plan the work. The level of work should be based on the risk and level of assurance
desired
Obtain sufficient appropriate evidence on which to base the conclusion
Perform overall review and form opinion
Issue report to the client.
4 Levels of assurance
4.1 An assurance engagement will provide the user with either reasonable assurance or limited
assurance.
Type of engagement Evidence gathering The assurance report

procedures
Reasonable assurance Sufficient appropriate Positive expression (section
e.g. statutory audit evidence is obtained by: 4.2)
Obtaining an
understanding of the
entity
Assessing risk
Responding to risk
Performing further
procedures (sampling)
to draw a conclusion
Limited assurance The evidence gathered is Negative expression
e.g. review of half year limited, involving techniques (section 4.2)
results such as enquiry and
analytical procedures
24
4.2 Reporting different levels of assurance:
Positive expression 'In our opinion internal control is effective, in all material
respects, based on XYZ criteria.'
Negative expression 'Based on our work described in this report, nothing has
come to our attention that causes us to believe that
internal control is not effective, in all material respects,
based on XYZ criteria.'
Examples of different types of assurance engagements and their level of assurance:
Engagement Level of Assurance Examples
External audit Reasonable assurance Statutory external audit

Positive expression
Review Limited assurance Review of interim (half
Negative expression year) financial statements
Agreed-upon procedures None Examination of statement
of financial position
Examination of segmental
sales and profit
Compilation None Preparation of financial
statements
Preparation of tax returns
25
26
Additional
Notes
27
5 Accountability, stewardship and agency

5.1 Agency theory
Section 2
The role of external audit is often explained in relation to the economic model of agency
theory.
Agents are people employed or used to provide a particular service. In the case of a company, the
people being used to provide the service of managing the business also have the second role of
being people in their own right trying to maximise their personal wealth.
5.2 An agency relationship
Principal Agent
eg an owner Engages another person
to perform a service on
their behalf
Delegates some decision-
making authority
Problems
Principal may have concerns over motives
of agents?
Principal may question the trust they have
placed in the agent?
Principal and agent may have different
attitude to risk
Possible solutions
Set up mechanisms to align the interests
of agents with principles (e.g. performance
related pay)
Monitoring mechanisms (e.g. the audit)
28
The agency relationship in audit

5.3 In the case of a company, management acts as the agents of the body of shareholders, the
principals. Management are accountable for their stewardship of the company.
The shareholders have limited access to information about the operations of the company.
They may lack trust in the directors and may believe that the information in the financial
statements is biased.
The external auditor, therefore, performs a statutory audit to address a simple agency
conflict between shareholders and directors.
5.4 In addition, the auditor can be seen as an agent of the shareholders. Under law, they report
to and are appointed by the shareholders (see Chapter 2).
This raises more concerns with regard to trust and confidence. One key factor here is the
importance that shareholders place on the auditors' independence from the directors.
Auditors have an important incentive to maintain independence and protect their reputation
in order to keep and win more audit work. The profession also imposes guidance in relation
to independence (see Chapter 4).
6 Chapter summary
Section Topic Summary
1 The purpose of The purpose of external audit is to promote
external audit confidence and trust in financial information.
2 The audit report The objective of any audit or assurance engagement is
to produce an opinion in the form of a report.
3 Assurance Audit is only one type of assurance engagement.
4 Levels of assurance Reasonable assurance is usually reported in terms of
positive expression.
Limited assurance is usually reported in terms of
negative expression.
5 Accountability, Audit can be explained in relation to agency theory.
stewardship and
agency
29
END OF CHAPTER
30
Statutory audit and
regulation

Describe the regulatory environment within which
external audits take place
Discuss the reasons and mechanisms for the
regulation of auditors
Explain the statutory regulations governing the
appointment, rights, removal and resignation of
auditors
Explain the regulations governing the rights and
duties of auditors
Explain the development and status of
International Standards on Auditing (ISAs)
Explain the relationship between International
Standards on Auditing (ISAs) and national
standards
31
2: STATUTORY AUDIT AND REGULATION
Overview
Statutory audits
The regulatory framework
Appointment, removal Mechanisms for the Development and Regulation by the

and resignation of regulation of auditors status of ISAs profession
auditors IFAC/IAASB
National law and
standards
ACCA/the
profession
Note: throughout these

notes the abbreviation ISA
will be used to refer to the
International Standards on
Auditing
32
1 The regulatory framework

1.1 The auditing profession is subject to regulation from a range of sources.
National legislation
National regulation and standard-setting
International standard-setting
Professional bodies, e.g. ACCA.
1.2 Legislation will normally establish:

Rights and duties of auditors
Eligibility to act as auditor
In the UK the relevant legislation is the Companies Act 2006.
Auditors' rights and duties

Section 1.3 1.3 Rights Duties
Access to books and records Report opinion

of the company on
Information and explanations
Receive notice of/attend the FS are fairly Additional statutory
general meetings presented requirements to
Speak at general meetings adhere to
local law
Right to receive a copy of
any written resolution adequate
proposed records and
returns
Accounts agree to
records
Consistency of
other information
Disclosure of
directors benefits
The Companies Act 2006 makes it an offence for a companys officer knowingly or recklessly to
make a statement in any form to an auditor which is misleading, false or deceptive.
Eligibility
1.4 Most legal frameworks require auditors to be members of an appropriate professional body
such as ACCA.
33
2 Appointment, removal and resignation of auditors

2.1 Chapter 1 identified the importance of the auditor being independent and an agent of the
shareholders.
In most jurisdictions this is established in the law relating to appointment, removal and
resignation of auditors.
2.2 Overview of regulations

Appointment Normally appointed annually
By shareholders ordinary resolution
In particular circumstances, e.g. first auditors, casual vacancy,
directors can appoint auditors
Removal Resolution by shareholders
Auditors entitled to:
Notice of resolution
Make written representation saying why they ought to stay
in office
Speak at shareholders' meetings until their term of office
would have expired
Auditors must deposit a statement of circumstances at
companys registered office within 14 days of ceasing to hold
office and send a statement to the regulatory authority
Resignation Auditors may resign at any time
Give written notice with a statement of circumstances to
members/creditors
Notice of resignation is sent by the company to the regulatory
authority.
Auditors can require directors to call a general meeting, within
21 days, to discuss the circumstances of resignation.
Right to speak at the general meeting on matters which
concern them as auditors.
34
3 International Federation of Accountants (IFAC)

3.1 Role Membership
Not for profit organisation 157 members (accountancy
IFAC
bodies of good standing e.g.
ACCA)
(1) Elects members of Board 1 representative from each

Council
(2) Determines financial member
contributions
Supervises IFAC's work President + representatives

Board
programme from 16 countries (elected
every 3 years)
Carry out IFAC's work e.g. compliance, ethics,

Committees
programme Transnational Auditors
Committee
(1) Set high quality auditing IAASB 18 members nominated by

(ISAs) and assurance IFAC Board
(IASEs) standards
(2) Facilitates convergence
of international and
national standards
(3) Strengthen public
confidence in profession
See Sections 3, 4 and 5 for further detail.
3.2 IFAC was set up in 1977.

It is a non-profit, non-governmental and non-political international organisation of
accountancy bodies.
Mission
3.3 The mission of IFAC is, to serve the public interest, strengthen the global accountancy
profession and contribute to the development of strong international economies by
establishing and promoting adherence to high-quality professional standards, furthering the
international convergence of such standards, and speaking out on public interest issues
where the profession's expertise is most relevant.
35
Membership
3.4 Membership in IFAC is open to accountancy bodies recognised by law/general consensus
within their countries as substantial national organisations of good standing. Through IFAC,
members are automatically registered as members of the International Accounting
Standards Board (IASB). There were 157 member bodies from 123 countries representing
over 2.5 million accountants worldwide as at June 2008.
Council
3.5 This consists of one representative from each member body of IFAC. It elects the members
of the Board and establishes the basis of financial contributions by members.
Board
3.6 The Board consists of the President and representatives from 16 countries elected by the
Council for three-year terms. Elections to the Board are held annually so that one third of
the Board retires each year.
The role of the Board is to supervise the general IFAC work program.
The work program itself is implemented by smaller working groups or the following standing
technical committees:
International Auditing and Assurance Standards Board
Compliance Committee
Education Committee
Ethics Committee
Financial and Management Accounting Committee
Public Sector Committee
Transnational Auditors Committee (executive arm of the Forum of Firms).
4 International Auditing and Assurance Standards

Board (IAASB)
4.1 The IAASB was established to develop and issue standards and statements on auditing,
assurance and related services on behalf of the IFAC Board.
4.2 The 18 members of the IAASB are nominated by the IFAC Board based on names put
forward by the member bodies and Forum of Firms.
4.3 The objective of the IAASB, on behalf of the IFAC Board, is to serve the public interest by
setting high quality auditing and assurance standards and by facilitating the convergence of
international and national standards, thereby enhancing the quality and uniformity of
practice throughout the world and strengthening public confidence in the global auditing and
assurance profession. The IAASB achieves this objective by:
36
Establishing high quality auditing standards and guidance for financial statement
audits that are generally accepted and recognised by investors, auditors,
governments, banking regulators, securities regulators and other key stakeholders
across the world
Establishing high quality standards and guidance for other types of assurance
services on both financial and non-financial matters
Establishing high quality standards and guidance for other related services
Establishing high quality standards for quality control covering the scope of services
addressed by the IAASB; and
Publishing other pronouncements on auditing and assurance matters, thereby
advancing public understanding of the roles and responsibility of professional auditors
and assurance service providers.
5 The scope and authority of IAASB pronouncements

5.1 The IAASBs pronouncements govern assurance and related services that are conducted in
Section 4
accordance with International Standards. They do not override the local laws or regulations.
The pronouncements of the IAASB examinable fall into two categories:
International Standards on Auditing (ISAs)
International Standards on Assurance Engagements (ISAEs)
5.2 The IAASBs Standards contain basic principles and essential procedures together with
related guidance in the form of explanatory and other material. The basic principles and
essential procedures are to be understood and applied in the context of the explanatory and
other material that provide guidance for their application. It is therefore necessary to
consider the whole text of a Standard to understand and apply the basic principles and
essential procedures.
In exceptional circumstances, a professional accountant may judge it necessary to depart
from a requirement of a Standard to achieve more effectively the objective of the
engagement. When such a situation arises, the professional accountant should be prepared
to justify the departure.
ISAs and national standard-setters

5.3 Many national standard-setters are moving towards the adoption of ISAs in place of their
previous local auditing standards. By the end of 2009 over 100 countries had adopted or
incorporated ISAs into their national auditing standards or are using ISAs as a basis for
preparing national auditing standards.
37
Liaison with national standard setters

5.4
Liaison group of national standard
IAASB setters
e.g. UK Auditing Practices Board
Two-way communication
(APB)
Annual meetings with liaison group to: Standard setters who:
Share knowledge on international and Are significantly active in the
national developments affecting the development of national auditing
priority of topics on future standard standards
setting agendas Have adopted or plan to adopt ISAs,
Bringing the strengths of the IAASB and or are demonstrably committed
national auditing standard setters to bear towards the achievement of
on standards at an early stage in their convergence of international and
development national standards
Achieve close cooperation and Are sufficiently resourced to
strengthened communication e.g. by participate actively in collaborative
closer collaboration on projects and efforts
minimising duplication Represent the world's largest
Achieve wider involvement by national economies
auditing standard setters in IAASB task
forces or to advance research agendas
The process in the development of IAASB Standard

5.5
Research and consultation

A project task force is established to develop a draft standard or practice statement.
Transparent debate
A proposed standard is discussed at a meeting, open to the public.
Exposure for public comment

Exposure drafts are put on the IAASBs website and widely distributed for comment for a
minimum of 120 days.
Consideration of comments
Any comments as a result of the exposure draft are considered at an open meeting of the
IAASB, and it is revised as necessary.
Affirmative approval
Approval is made by the affirmative vote of at least 2/3 of IAASB members.
38
Status of ISAs
5.6 As statutory audit is governed by local legislation, the status of ISAs will vary between
countries:
National standards may continue to exist, but aligned with the principles of ISAs.
The ISAs could be adopted without any additional guidance relating to national
circumstances (e.g. South Africa).
The ISAs could be adopted but with additional specific guidance added (e.g. ISAs
(UK and Ireland)).
The IAASB Clarity Project

5.7 In 2004, the IAASB began a comprehensive program to enhance the clarity of its ISAs by
setting an overall objective for each ISA and improving the overall readability and
understandability through structural and drafting improvements.
At the end of 2008, the IAASB had finalised all its clarified ISAs, and auditors all over the
world now have access to 36 newly updated and clarified ISAs and a clarified ISQC.
The improvements arising from the Clarity project can be summarised below:
Identifying the auditor's overall objectives when conducting an audit
Setting an objective in each ISA and establishing the auditor's obligation in relation
to that objective
Clarifying the obligations imposed on auditors by the requirements of ISAs and the
language used to communicate these requirements
Eliminating any possible ambiguity about the auditors requirements
Improving the overall readability and understandability of the ISAs through
structural and drafting improvements
39
6 Regulation by the profession

Bodies such as ACCA play a part in the regulation of the profession.
6.1 Role of the ACCA
Education and As a member of IFAC, ACCA must comply with IFAC's
training of auditors international standards and guidelines on
Pre-qualification education and training
Continuing professional education
Implementation and IFAC member bodies such as ACCA must prepare ethical
enforcement of requirements based on IFAC's International Code of Ethics for
ethical requirements Professional Accountants.
Member bodies must provide high standards of professional
conduct and ensure that ethical requirements are observed.
Disciplinary action should normally be taken in the following
instances:
Failure to observe the required standard of professional
care, skills or competence;
Non-compliance with the rules of ethics; or
Discreditable or dishonourable conduct.
The power for disciplinary action may be provided by legislation
or by the constitution of the professional body.
40
7 Chapter summary
1 The regulatory Auditors rights and duties are governed by
framework national legislation.
2 Appointment, removal Appointment and removal require shareholders'
and resignation of resolutions. Auditors may resign at any time by
auditors giving notice in writing.
3 International IFAC is an international organisation of accountancy
Federation of bodes. Its mission is to establish and promote
Accountants adherence to high-quality professional standards.
4 International Auditing The IAASB, an operating board of IFAC produces
and Assurance international standards on auditing, assurance
Standards Board and related services.
5 The scope and IAASB pronouncements do not overrule local laws or
authority of IAASB regulations but where they form part of the regulatory
pronouncements framework (e.g. in the UK) they are mandatory.
6 Regulation by the Professional bodies, such as ACCA, establish
profession regulations relating to education and training and
ethics.
41
END OF CHAPTER
42
Corporate governance

Discuss the objectives, relevance and
importance of corporate governance
Discuss the provisions of international codes of
corporate governance (such OECD) that are
most relevant to auditors
Describe good corporate governance
requirements relating to directors responsibilities
(e.g. for risk management and internal control)
and the reporting responsibilities of auditors
Analyse the structure and roles of audit
committees and discuss their benefits and
limitations
43
3: CORPORATE GOVERNANCE
Overview
Corporate governance
Definition
The UK Corporate Governance Code Audit committees
44
1 Corporate governance
Definition
1.1 Corporate governance relates to the internal systems or means by which companies are
directed and controlled.
1.2 It describes the framework of rules and practices by which a board of directors ensures
accountability, fairness, and transparency in a company's relationship with each of its
stakeholders.
1.3 In recent decades there have been several reviews performed in many different countries in
order to try to establish a set of principles for corporate governance.
The OECD Principles of Corporate Governance

1.4 The OECD (Organisation for Economic Co-operation and Development) has developed its
own Principles of Corporate Governance.
1.5 These Principles provide best practice recommendations on corporate governance and are
used worldwide as a benchmark for establishing guidelines on this area.
1.6 The Principles address the following six areas:

I Consistency with the law
II The rights of shareholders
III The equitable treatment of shareholders
IV The role of stakeholders
V Disclosure and transparency
VI The responsibility of the board
1.7 The OECD document provides detailed recommendations expanding on each of the
principles.
1.8 In reality, each country can then develop its own corporate governance code for companies
to follow.
45
2 The UK Corporate Governance Code

2.1 In the UK, the UK Corporate Governance Code gives guidance to companies as to how they
Section 1.3
should be directed and controlled.
2.2 It offers guidance under the following headings:
Leadership
Effectiveness
Accountability
Remuneration
Relations with shareholders
2.3 The Code applies to listed companies and is part of the UK Stock Exchange listing rules.
2.4 Listed companies must include a corporate governance report in their annual report. The
report should describe how the company applies the principles in the Code and should
include a statement as to whether or not the company complies with the provisions of the
Code.
2.5 Where the company does not comply with certain provisions of the Code, the corporate
governance report should provide an explanation for the non-compliance.
Introduction and client background

Dress You Like Co is a clothing manufacturer, based in the United Kingdom, which has been
trading for over 10 years. It operates from two sites, a factory where clothes are made and a head
office where the administration is carried out. Completed inventory orders are despatched from
both the factory and the head office.
In an effort to reduce costs, Dress You Like Co now imports its material from one sole supplier
based in China. Dress You Like Cos accounting system uses the American dollar as its currency;
however, most of its Chinese suppliers business contacts are based in Europe and so it both
invoices and requires payment in Euros.
Dress You Like sells its finished products to small independent retailers and also one major
supermarket chain. The supermarket chain often requires additional deliveries without much prior
notice and so Dress You Like Co has to maintain a high level of inventory should this occur. Credit
terms are normally 30 days, but the supermarket is given 60 day credit terms.
Dress You Like Co is not a listed company but its directors believe that the companys annual
report should provide as much information as possible to shareholders. Consequently, they have
voluntarily included a corporate governance report each year in their annual report.
Required
As the audit senior, you have been asked to review Dress You Like Cos corporate governance
report for the year ended 30 September 20X0. Your firm did not complete the audit for the year
in question and your audit manager has given you a series of questions to answer in order to get a
better understanding as to how the company is directed and controlled.
Review the corporate governance report extract below and answer the questions which follow.
46
Dress You Like Co

Corporate Governance Report extract for the year ended 30 September 20X0
As a clothing manufacturer, Dress You Like Co, operates within a particularly challenging sector. I
believe that in order to conquer modern economic challenges, we must continue to act responsibly
in all of our business decisions and monitor our performance closely. Strong leadership
(governance) and tight control are fundamental to the success of our business.
Leadership
As Chairman of the Board of Directors, my role is to lead the board and make sure that each of our
directors is fulfilling their role effectively. I will ensure that the board is unified, ably supported by
our non-executive directors and offers a greater service to the company as a board than its
members could individually.
On 1 January 20X0 I appointed Mary Batter to take over from me as Chief Executive Officer.
Relinquishing this position has meant that I could concentrate solely on my role as Chairman
rather than dividing my time between the two roles.
As Chief Executive Officer, Mary and her team will seek to develop the companys strategy and
steer the company through the years ahead.
Effectiveness
During the year an independent consultant conducted a Board evaluation. This included individual
interviews with each director to gather their opinions on issues ranging from how effective the
current board is and risk management to how we can better conduct our relationships with
shareholders. To be consistent with best practice, this evaluation will now become an annual
occurrence.
As mentioned above Mary Batter joined us this year. She was appointed on the recommendation
of the Nomination Committee and completed a tailored induction process.
All directors are offered training throughout the year and all directors are subject to annual re-
election.
Accountability
The Board is responsible for risk management and for maintaining a system of internal controls.
The risks affecting the company are widespread however key risks are firstly the ability to predict
customer demand in terms of tastes and fashions and secondly security of inventory. We have an
internal audit department which we outsource to an independent firm.
The audit committee reviews the effectiveness of the Boards risk management procedures.
Gary Lewis (Chairman)
47
Our Board
Gary Lewis (Chairman) Mary Batter (CEO) Katie Escombe (Chief Finance
Chairman of Nomination Committee Member of Nomination Committee Officer) Executive Director
Bob Part (Non-Executive Director) Adam Knight (Non-Executive Director) Jeremy Flage (Non-Executive
Chairman of the Audit Committee Chairman of Remuneration Committee Director)
Member of Remuneration and Member of Audit and Nomination Member of Audit, Remuneration and
Nomination Committees Committees Nomination Committees
Solution
1. Why should the role of the Chairman and the Chief Executive Officer ideally be carried out by
two different people?
2. How does Dress You Like Co ensure that board members are properly equipped to do their
job?
48
3. Why do you think the directors are re-elected each year?
4. How is the responsibility for risk management shared in Dress You Like Co?
5. Why does the company have both executive and non-executive directors?
6. Which sub-committees do the non-executive directors form and what are their roles?
49
Auditors and the UK Corporate Governance Code

2.6 In the UK, auditors are required to review whether listed companies have complied with
specific provisions in the Code. They must then report this to shareholders in the auditors
report.
There are nine specific provisions auditors must review and report on.
Below is an example of the type of work programme the auditor may use to determine
whether the specific provisions have been complied with:
Yes No
Provision

(a) Is the directors responsibility for preparing the annual report
and accounts explained in the report?
Have the directors reviewed and reported on the

(b) effectiveness of the risk management and internal control
systems?
Has the board established an audit committee of at least

(c) three non-executive directors (or at least two non-executive
directors for smaller companies)?
(d) Does the audit committee have written terms of reference?
(e) Are the terms of reference for the audit committee available/
described in the annual report?
(f) Does the audit committee arrange methods for staff to report
impropriety in financial reporting?
(g) Does the audit committee monitor and review the

effectiveness of the internal audit activities?
(h) Does the audit committee have primary responsibility for the
appointment of the external auditors?
Are there procedures in place to ensure that auditor

(i) independence is maintained where the external auditor
provides non-audit services?
50
3 Audit committees
Responsibilities of the audit committee
3.1
Q4 Corporate
Governance
To monitor To review internal

financial controls and risk
statements management systems
To monitor and
review
To implement policy effectiveness of
on supply of non- internal audit
audit services by department
external auditor
Audit Where there is no

To review and Committee internal audit
monitor function, to
independence and consider annually
objectivity of whether there is
external auditor need for one
To approve To monitor
remuneration and arrangements
engagement terms safeguarding the
of external auditor privacy of whistle
blowers
To recommend
appointment,
reappointment and
removal of external
auditor
51
Advantages and disadvantages of audit committees

3.2
Advantages Disadvantages
(a) It will lead to increased confidence in (a) There may be difficulty selecting
the credibility and objectivity of sufficient non-executive directors
financial reports. with the necessary competence in
(b) By specialising in the problems of auditing matters for the committee to
financial reporting and thus, to some be really effective.
extent, fulfilling the directors' (b) The establishment of such a
responsibility in this area, it will allow formalised reporting procedure
the executive directors to devote their may dissuade the auditors from
attention to management. raising matters of judgement and
(c) In cases where the interests of the limit them to reporting only on
company, the executive directors and matters of fact.
the employees conflict, the audit (c) Costs may be increased.
committee might provide an impartial
body for the auditors to consult.
(d) The internal auditors will be able to
report to the audit committee.
(e) The external auditors have an
independent point of reference.
52
Additional
Notes
53
4 The UK Corporate Governance Code (revisited)

4.1 As mentioned earlier in this chapter, the UK Corporate Governance Code is an example of
how the OECD principles can be implemented and the requirements listed companies must
adhere to in order to satisfy the UK Stock Exchange listing rules.
4.2 Detailed below are the main issues companies should address in their corporate
governance report.
Principles of the UK Corporate Governance Code (for listed UK companies)

Leadership
Every company should be headed by an effective board, which is collectively responsible for
the success of the company.
There should be a clear division of responsibilities at the head of the company between the
running of the board and the executive responsibility for the running of the company's
business. No one individual should have unfettered powers of decision.
The chairman is responsible for leadership of the board and ensuring its effectiveness on all
aspects of its role.
As part of their role as members of a unitary board, non-executive directors should
constructively challenge and help develop proposals on strategy.
Effectiveness
The board and its committees should have the appropriate balance of skills, experience,
independence and knowledge of the company to enable them to discharge their respective
duties and responsibilities effectively.
There should be a formal, rigorous and transparent procedure for the appointment of new
directors to the board.
All directors should be able to allocate sufficient time to the company to discharge their
responsibilities effectively.
All directors should receive induction on joining the board and should regularly update and
refresh their skills and knowledge.
The board should be supplied in a timely manner with information in a form and of a quality
appropriate to enable it to discharge its duties.
The board should undertake a formal and rigorous annual evaluation of its own performance
and that of its committees and individual directors.
All directors should be submitted for re-election at regular intervals, subject to continued
satisfactory performance.
54
Principles of the UK Corporate Governance Code (for listed UK companies)

Accountability
The board should present a balanced and understandable assessment of the company's
position and prospects.
The board is responsible for determining the nature and extent of the significant risks it is
willing to take in achieving its strategic objectives. The board should maintain sound risk
management and internal control systems.
The board should establish formal and transparent arrangements for considering how they
should apply the corporate reporting and risk management and internal control principles and
for maintaining an appropriate relationship with the company's auditors.
Remuneration
Levels of remuneration should be sufficient to attract, retain and motivate directors of the
quality required to run the company successfully, but a company should avoid paying more
than is necessary for this purpose. A significant proportion of executive directors'
remuneration should be structured so as to link rewards to corporate and individual
performance.
There should be a formal and transparent procedure for developing policy on executive
remuneration and for fixing the remuneration packages of individual directors. No director
should be involved in deciding his or her remuneration.
Relations with shareholders
There should be a dialogue with shareholders based on the mutual understanding of
objectives. The board as a whole has responsibility for ensuring that satisfactory dialogue
with shareholders takes place.
The board should use the AGM to communicate with investors and to encourage their
participation.
55
5 Chapter summary

1 Corporate governance The OECD has developed Principles of Corporate
Governance as a reference point for national policy
makers.
2 The UK Corporate The UK Corporate Governance Code issued by the
Governance Code Financial Reporting Council in the UK requires listed
companies to include a corporate governance report in
the annual report detailing how the company has been
directed and controlled in terms of leadership,
effectiveness of the Board, accountability, remuneration
and relations with shareholders.
3 Audit committees All listed companies should have an audit committee
which should be made up of at least three non-
executive directors. Some of the main roles of the audit
committee are to monitor the integrity of the
financial statements and the auditors
independence and also to review the companys
internal controls and risk management systems.
4 The UK Corporate This section lists the main issues companies should
Governance Code address in their corporate governance report.
(revisited)
END OF CHAPTER
56
Professional ethics

Define and apply the fundamental principles of Q5 Section A pilot paper
professional ethics of integrity, objectivity,
professional competence and due care,
confidentiality and professional behaviour
Define and apply the conceptual framework, Q1(a) Section B pilot paper
including the threats to the fundamental
principles of self-interest, self-review, advocacy,
familiarity and intimidation
Discuss the safeguards to offset the threats to Q1(a) Section B pilot paper
the fundamental principles
Describe the auditors responsibility with regard
to auditor independence, conflicts of interest and
confidentiality
Discuss the requirements of professional ethics
in relation to the acceptance of new audit
engagements
Explain the preconditions for an audit
Explain the process by which an auditor obtains
an audit engagement
Justify the importance of engagement letters and
their contents.
57
4: PROFESSIONAL ETHICS
Overview
Professional
ethics
Fundamental principles of Enforcement of the ACCA

professional ethics code
Threats Safeguards Confidentiality
Obtaining and accepting new

audit engagements
Engagement letters
58
1 ACCA code of ethics and conduct

1.1 The ACCA has adopted the Code of Ethics for Professional Accountants (the Code) which is
issued by the International Ethics Standards Board for Accountants (IESBA).
1.2 The Code applies to all members, affiliates and students of the ACCA. These individuals
are referred to in the code as professional accountants.
The fundamental principles

1.3 The Code sets out five fundamental principles that professional accountants should comply
with:
Integrity Professional accountants should be straightforward and

honest in all professional and business relationships.
Integrity also implies fair dealing and truthfulness.
Objectivity Professional accountants should not allow bias, conflicts
of interest or the undue influence of others to override
their professional or business judgement.
Professional competence Professional accountants should maintain professional
and due care knowledge and skill at the level required to ensure that
clients or employers receive competent professional
service.
They should also act diligently in accordance with
applicable technical and professional standards when
providing professional services.
Confidentiality Professional accountants must respect the
confidentiality of information acquired as a result of
professional and business relationships.
They should not disclose any such information to third
parties without proper and specific authority or unless
there is a legal or professional right or duty to disclose.
Confidential information acquired as a result of
professional and business relationships should not be
used for the personal advantage of the professional
accountant or third parties.
Professional behaviour Professional accountants should ensure they comply with
relevant laws and regulations and should avoid any action
that discredits the profession.
59
2 Threats to the fundamental principles

2.1 There are many circumstances, relationships and situations that could threaten the
professional accountants ability to satisfy the fundamental principles.
2.2 These threats fall into one or more of the five categories below:
(a) Self-interest threat
Relates to the risk that a financial or other interest in a client will inappropriately
influence the professional accountants judgement or behaviour.
For example: owning shares in an audit client or receiving gifts from an audit client.
(b) Self-review threat
This arises where a professional accountant from the audit firm performs work for the
client and this work must later be reviewed by the same person or another
professional accountant from the same firm in order to arrive at a judgement on the
subject matter.
For example: preparing the financial statements of an entity which are to be audited
by your firm.
(c) Advocacy threat
Relates to the risk that a professional accountant promotes a clients position to the
point that the professional accountants objectivity is compromised.
For example: acting as an advocate on behalf of an assurance client in litigation or
disputes or promoting shares in a listed audit client.
(d) Familiarity threat
This arises where, due to a long or close relationship with a client, the professional
accountant could be too sympathetic to their interests or too accepting of their work.
For example: if a firm has audited the same client for several years they may not
question the information presented by the client as closely as in the initial years.
(e) Intimidation threat
Relates to the risk that the professional accountant is deterred from acting objectively
because of actual or perceived pressures, including attempts to exercise undue
influence over the professional accountant.
For example: being pressured to reduce inappropriately the extent of work performed
in order to reduce the fees charged.
2.3 Where the above threats exist, appropriate safeguards must be put in place to eliminate or
reduce them to an acceptable level.
60
3 Application of the conceptual framework approach to

independence
3.1 Professional accountants who provide assurance services are required to be independent
of the assurance client.
Q6 Confidentiality 3.2 Independence has two aspects to it:
and
Independence (a) Independence of mind and
(b) Independence in appearance.
3.3 Much of the guidance in relation to ethical guidance applies to all company audits, however
there are sometimes additional requirements relating purely to public interest entities.
3.4 Public interest entities are defined as:
(a) All listed entities
(b) Entities that are of significant public interest because of their business, size or number
of employees or because they have a wide range of stakeholders.
Examples include banks, insurance companies and pension firms.
Lecture example 1 Exam standard for 12 marks
You are a manager in the audit firm Check and Co which has annual revenue in the region of
$2,400,000. The following situations have arisen with different audit clients of your firm.
1) In an initial meeting with the finance director of Weadon Co, an audit client, you learn that the
entire audit team will be invited to the company's annual summer social event, a weekend at
an exclusive spa hotel.
2) Mr Walker has been the engagement partner for a client, Stewards Co, for nine years. He has
excellent knowledge of the client and knows all of the directors of Stewards Co very well.
Stewards Co is considered to be a public interest entity.
3) Mrs Sayer is the engagement partner for a client, Aspen Co. Her daughter Holly joined Aspen
Co 6 months ago and is working as an assistant to the receivables ledger clerk whilst she
studies for her first set of accountancy exams.
4) Overdue fees from Evergreen Co have built up to include all bills submitted by your firm in the
last twelve months.
5) For the last few years your firms most important client, Emerald Co, has generated a high
level of fee income to Check and Co. This year the client has also requested that you perform
a detailed review of the companys internal control systems. The fee for this work would be
$150,000 and this would take the total revenue earned during the year from Emerald Co to
$480,000.
6) Due to time pressure and staff shortages in the accounts department, the finance director of
Green Co has sought assistance from your firm with year end procedures including the
preparation of the annual financial statements for the company. Green Co is not considered to
be a public interest entity.
61
Required
(a) Explain the ethical threats which may affect the independence of Check and Co in respect of
each of the client audits, and
(b) For each threat explain how it may be reduced.
Solution
Threat Safeguards
62
3.5 Threats arising from financial matters
(a) Financial (b) Loans and

interests guarantees
FINANCIAL
MATTERS
(d) Gifts and (c) Fees

hospitality
(a) Financial interests

e.g. holding shares in a client by:
The firm
A member of the assurance team
An immediate family member of a team member
63
Threats Safeguards
Self interest threat arises as the firm or Disposal of shares (only option if firm
individual team member would benefit holds shares)
personally if the client's financial Remove individual from team
statements exceed market expectations Inform audit committee
Independent partner review
(b) Loans and guarantees
Threats Safeguards
Clients that are banks

Loans or guarantees to the firm
no threat if immaterial and on
normal terms
if material, apply safeguards Review by professional accountant from
outside the firm
Loans to members of the assurance
team
not a threat to independence if on
normal commercial terms
No safeguard can reduce the threat
Clients that are not banks
unless the loan is immaterial to client
Loans or guarantees to/from the firm
and firm/team member
or members of the assurance team.
(c) Fees and pricing
Threats Safeguards
(i) Self interest threat arises when total Discuss with audit committee
fees from a client represent a large Resign from some services
portion of the firm's total fees. The External quality control review
firm may issue a favourable opinion Consult ACCA or another professional
rather than risk losing such a
accountant on any key audit areas
significant income stream. requiring judgement
If the audit client is a public interest entity then there are additional ethical
requirements.
If the total fees from the client represent more than 15% of the total fees received
by the firm for 2 consecutive years then there is likely to be undue dependence
on the client and the firm should put safeguards in place.
64
(ii) Overdue fees Discuss with audit committee

These could give rise to intimidation Consider resignation if overdue fees
and self interest threats. The client not paid
could use outstanding fees to
pressure the firm into providing a
favourable opinion.
The firm may issue a favourable
opinion rather than possibly lose the
amounts owed.
(iii) Contingent fees No safeguards acceptable - contingent
The fee is dependent on the result fees are not allowed for audit services
of the work performed. This would
create a self interest and advocacy
threat.
(iv) Lowballing Appropriate time and quality staff
assigned to engagement.
An assurance engagement is won
by offering a fee below the market All applicable standards are complied
rate. This gives rise to a self interest with.
threat as the firm may either take
shortcuts to make a reasonable
recovery on the engagement or
need to perform the engagement for
a number of years before achieving
a reasonable profit.
(d) Gifts and hospitability
Threat Safeguards
Acceptance of gifts from a client may Gifts and hospitality should not be
create a self interest threat because the accepted unless the value is trivial
firm/ individual may feel obliged to give a and inconsequential.
favourable opinion. Acceptance of gifts
may also be perceived as a bribe.
Hospitality from clients may give rise to a
familiarity threat.
65
3.6 Threats arising from employment and other relationships
(a) Business (b) Personal

relationships relationships
RELATIONSHIPS
(e) Actual or (d) Long (c) Employment

threatened association
litigation
(a) Business relationships

e.g. Holding an interest in a joint venture with a client
Distribution of a client's products
Threat Safeguards
Self interest threat arises as the firm Disposal of interests unless clearly
would benefit from the favourable insignificant
performance of the joint venture or
client's products.
(b) Personal relationships
Threat Safeguards
Family or close personal relationships Remove individual from team.

between assurance team members and Discuss with audit committee.
client staff give rise to self interest,
Independent partner review.
familiarity or intimidation threats.
66
(c) Employment
e.g. Member of an assurance team or partner becomes a director or employee of a
client in a position to exert influence on the financial statements or vice versa.
Threat Safeguards
Previous employment by the firm of a Consider modification of audit plan.

director or employee of a client creates Change members of audit team.
self interest, familiarity and intimidation
Independent partner review.
threat.
Quality control review.
For public interest entities, an
Audit partner should not accept a
managerial position with their audit
client unless > 12 months have
passed.
Former director or employee of client has Individual should not be assigned to

joined assurance firm. audit team if the work they
performed whilst employed by the
client is to be evaluated in the
current period as part of the current
audit engagement.
(d) Long association
Threat Safeguards
Using the same senior staff on an Independent partner review

engagement may create a familiarity
Independent quality control review
threat.
Rotate senior staff
For public interest entities:
Rotate Do not
after return for
Key audit 7 yrs 2 yrs
partner*
* A key audit partner is defined as:
The engagement partner;
The individual responsible for the engagement quality control review and
Other audit partners on the engagement team who are responsible for key
decisions or judgments on significant matters with respect to the audit of the
financial statements on which the firm will express an opinion.
67
(e) Actual and threatened litigation
Threat Safeguards
When litigation takes place or appears Disclose to the audit committee

likely between the firm or member of the Removal of individual involved in
assurance team and the assurance litigation from the assurance team
client, a self-interest or intimidation threat Refuse to perform the assurance
may be created. engagement.
3.7 Threats arising from provision of non-assurance services
(a) Preparing accounting (b) Tax services

records and financial
statements
NON-ASSURANCE
SERVICES
(c) Internal audit

services
68
(a) Preparing accounting records and financial statements
Threat Safeguards
Self review threat arises if accounting If the client is not a public interest entity:
assistance includes making management Accounting services should not be
decisions e.g. approving transactions performed by audit team staff.
because it is unlikely that the firm will Client must provide all source data.
criticise its own work and decisions.
Client must approve all journal
entries.
Discuss non-audit services with
audit committee.
If the client is a public interest entity:
No accounting services should be
provided unless in an emergency
(e.g. the financial controller is taken
ill two weeks prior to the year end).
(b) Tax services
e.g. compliance, planning, assistance in resolving tax issues.
Threats Safeguards
Self review threat arises if tax Tax computation must not be

computation is prepared by firm as it is prepared by audit team staff.
unlikely to be criticised by audit staff. Independent partner review to ensure
tax computation is audited rigorously.
(c) Internal audit services
Threats Safeguards
Self review threat arises if audit team Remind client (in engagement letter)
plan to rely on the work of the internal that it is their responsibility to
audit department. establish, maintain and monitor a
system of internal controls.
Internal audit services should not be
provided by audit team members.
Independent partner review to ensure
appropriate reliance is placed on
internal audit and that its work is
rigorously audited.
A managerial threat may arise if the firm Client is reminded that it must
makes decisions on behalf of the client evaluate and determine which
when provided the internal audit service. recommendations of the firm should
be implemented.
69
70
Additional
Notes
71
4 Safeguards to offset the threats

4.1
Three categories of safeguard
Created by In the Created

the profession, legislation work by the
or regulation environment individual
Education, training and Ethics and conduct Complying with CPD

experience programmes requirements
requirements Recruitment Using an independent
Continuing professional procedures mentor
development (CPD) Strong internal controls Maintaining contact
requirements Disciplinary processes with legal advisors and
Corporate governance Leadership that professional bodies
codes stresses importance of
Professional standards ethical behaviour
Professional or Quality control
regulatory monitoring procedures
and disciplinary Training and education
procedures Different partners and
teams for provision of
non-assurance
services
Procedures to
empower employees to
communicate ethical
concerns to senior
levels without fear of
retribution
Consultation with
another appropriate
professional
accountant
72
5 Confidentiality
Members acquiring information in the course of their professional
work should not disclose any such information to third parties without
first obtaining permission from their clients. Likewise, students and affiliates
must treat any information given by members in the strictest confidence.
There are, however, circumstances where members may disclose information

to third parties without first obtaining permission.
Obligatory disclosure Voluntary disclosure
Where required by law In the public interest

eg terrorism, treason, To protect a member's
money laundering interests e.g. to defend
By process of law eg against legal action or to
Court order sue for fees
Reporting to regulators Authorised by statute
To non-governmental
bodies
6 Enforcement mechanisms
6.1 Regulation and monitoring of audit and assurance is normally imposed by statute. In many
countries this is delegated to professional bodies, such as ACCA. This places ACCA under
an obligation to:
Have systems to check that members are qualified and eligible to undertake regulated
work (such as statutory audit)
Monitor members conduct and the standard of their regulated work
Take regulatory action against members who do not meet requirements.
73
ACCAs disciplinary structures

6.2
If prima facie case
Investigated by exists, refer to
Complaint ACCA Professional Disciplinary
Conduct Department Committee
External, e.g.
from client Investigate
Internal, e.g. Can make orders
unsatisfactory including
visit from Expulsion from
ACCAs membership
monitoring unit Reprimand
Withdrawal of
certificates
Fines
Compensation
payments
Enforcement and statutory regulation

6.3 In many countries, the most serious complaints about auditors conduct, especially those
related to public interest entities will be dealt with by statutory regulators, not just by their
own professional body.
7 Obtaining audit engagements

7.1 Subject to the rules which follow, members may seek publicity for their services and
achievements and may advertise their services and products in any way they think fit.
7.2 Members may inform the public of the services they are capable of providing by means of
advertising or other forms of promotion subject to the general requirement that the medium
should not reflect adversely on the member, ACCA or the accountancy profession.
7.3 Advertisements and promotional material prepared or produced by members or firms should
not (either in content or presentation):
(a) Bring ACCA into disrepute or bring discredit to the member, firm or the accountancy
profession
(b) Discredit the services offered by others whether by claiming superiority for the
members or firms own services or otherwise
(c) Be misleading, either directly or by implication
(d) Fall short of the requirements of the UK Advertising Standards Authoritys Code of
Advertising and Sales Promotion, notably as to legality, decency, clarity, honesty, and
truthfulness.
74
7.4 An advertisement should be clearly distinguishable as such.
7.5 Care should be taken to ensure that any reference to fees does not mislead the reader as to
the precise range of services and time commitment that the reference is intended to cover.
Any promotional activities should not amount to harassment of prospective clients.
Commissions, fees or rewards in return for the introduction of a client are permitted,
provided appropriate safeguards are put in place such as disclosure to the client.
8 Acceptance
8.1 New auditors should ensure that they have been appointed in a proper and legal manner.
(a) Before accepting nomination the auditor must
ACCEPTANCE PROCEDURES
Ensure professionally Consider whether disqualified on legal or ethical
qualified to act grounds
Ensure existing resources Consider available time, staff and technical
adequate expertise
Obtain references Make independent enquiries if directors not
personally known
Communicate with present Enquire whether there are
auditors reasons/circumstances behind the change which
the new auditors ought to know, also courtesy
75
(b) An appointment decision chart is shown below.
(c) After accepting nomination

Ensure outgoing auditors removal/resignation properly conducted in
accordance with national regulations
Ensure new appointment properly conducted obtain a copy of the resolution
passed
Agree the terms of the engagement
ISA 210 Agreeing the terms of audit engagements

8.2 The objective of the auditor is to accept or continue an audit engagement only when the
basis upon which it is performed has been agreed, through:
Establishing certain preconditions for an audit are present and
Confirming that there is a common understanding between the auditor and
management of the terms of the engagement
76
8.3 Preconditions for an audit:

The use by management of an acceptable financial reporting framework in the
preparation of financial statements
Obtain managements agreement (written representation) that it acknowledges and
understands its responsibilities for:
preparing the financial statements
establishing internal control to ensure the financial statements are free of
material misstatement
provide the auditor with access to all records and documents and staff
If the preconditions are not present the auditor shall not accept the proposed engagement.
8.4 The engagement letter

The terms of the engagement are agreed in the form of a letter, to avoid misunderstanding.
The audit engagement letter must include the following:
The objective and scope of the audit
The auditors responsibilities
Managements responsibilities
Identification of the applicable financial reporting framework for the preparation of the
financial statements
Reference to the expected form and content of any reports to be issued by the auditor
and a statement that there may be circumstances in which a report may differ from its
expected form and content
77
The audit engagement letter may also make reference to the following:
Elaboration of scope, including reference to legislation, regulations, ISAs, ethical and
other pronouncements
Form of any other communication of results of the engagement
The fact that due to the inherent limitations of an audit and those of internal control,
there is an unavoidable risk that some material misstatements may not be detected,
even though the audit is properly planned and performed in accordance with ISAs
Arrangements regarding planning and performance, including audit team composition
Expectation that management will provide written representations
Agreement of management to provide draft financial statements and other information
in time to allow auditor to complete the audit in accordance with proposed timetable
Agreement of management to inform auditor of facts that may affect the financial
statements, of which management may become aware from the date of the auditors
report to the date of issue of the financial statements
Fees and billing arrangements
Request for management to acknowledge receipt of the letter and agree to the terms
outlined in it
Involvement of other auditors and experts
Involvement of internal auditors and other staff
Arrangements to be made with predecessor auditor
Any restriction of auditors liability
Reference to any further agreements between auditor and entity
Any obligations to provide audit working papers to other parties
An example of an engagement letter has been included below.
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9 Specimen engagement letter (for information

purposes)
9.1 To the appropriate representative of management or those charged with governance of ABC
Company:
[The objective and scope of the audit]
You have requested that we audit the financial statements of ABC Company, which
comprise the statement of financial position as at 31 December 31 20X1, and the income
statement, statement of changes in equity and statement of cash flows for the year then
ended, and a summary of significant accounting policies and other explanatory information.
We are pleased to confirm our acceptance and our understanding of this audit engagement
by means of this letter. Our audit will be conducted with the objective of our expressing an
opinion on the financial statements.
[The responsibilities of the auditor]
We will conduct our audit in accordance with International Standards on Auditing (ISAs).
Those standards require that we comply with ethical requirements and plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free from
material misstatement. An audit involves performing procedures to obtain audit evidence
about the amounts and disclosures in the financial statements. The procedures selected
depend on the auditors judgement, including the assessment of the risks of material
misstatement of the financial statements, whether due to fraud or error.
An audit also includes evaluating the appropriateness of accounting policies used and the
reasonableness of accounting estimates made by management, as well as evaluating the
overall presentation of the financial statements. Because of the inherent limitations of an
audit, together with the inherent limitations of internal control, there is an unavoidable risk
that some material misstatements may not be detected, even though the audit is properly
planned and performed in accordance with ISAs.
In making our risk assessments, we consider internal control relevant to the entitys
preparation of the financial statements in order to design audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the entitys internal control. However, we will communicate to you in writing
concerning any significant deficiencies in internal control relevant to the audit of the financial
statements that we have identified during the audit.
[The responsibilities of management and identification of the applicable financial reporting
framework (for purposes of this example it is assumed that the auditor has not determined
that the law or regulation prescribes those responsibilities in appropriate terms; the
descriptions in paragraph 6(b) of this ISA are therefore used).]
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Our audit will be conducted on the basis that [management and, where appropriate, those
charged with governance] acknowledge and understand that they have responsibility:
(a) For the preparation and fair presentation of the financial statements in accordance
with International Financial Reporting Standards;
(b) For such internal control as [management] determines is necessary to enable the
preparation of financial statements that are free from material misstatement, whether
due to fraud or error; and
(c) To provide us with:
(i) Access to all information of which [management] is aware that is relevant to the
preparation of the financial statements such as records, documentation and
other matters;
(ii) Additional information that we may request from [management] for the purpose
of the audit; and
(iii) Unrestricted access to persons within the entity from whom we determine it
necessary to obtain audit evidence.
As part of our audit process, we will request from [management and, where appropriate,
those charged with governance], written confirmation concerning representations made to
us in connection with the audit.
We look forward to full cooperation from your staff during our audit.
[Other relevant information]
[Insert other information, such as fee arrangements, billings and other specific terms, as
appropriate.]
[Reporting]
[Insert appropriate reference to the expected form and content of the auditors report.]
The form and content of our report may need to be amended in the light of our audit
findings.
Please sign and return the attached copy of this letter to indicate your acknowledgement of,
and agreement with, the arrangements for our audit of the financial statements including our
respective responsibilities.
XYZ & Co.
Acknowledged and agreed on behalf of ABC Company by
(signed)
......................
Name and Title
Date
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10 Chapter summary
1 ACCA code of ethics The code applies to members, affiliates and students
and conduct of the ACCA and details the fundamental principles of
integrity, objectivity, professional competence
and due care, confidentiality and professional
behaviour.
2 Threats to the There are many circumstances which can lead to
fundamental principles threats to the fundamental principles. These
circumstances will fall into one or more of the five
categories of: self-interest, self-review, advocacy,
familiarity and intimidation.
Where threats exist, safeguards should be put in
place to eliminate or reduce the threat.
3 Application of the The ACCA Code adopts a principle rather than rule
conceptual framework based approach but gives many examples of specific
approach to situations where independence can be threatened
independence and the relevant safeguards that may mitigate these.
4 Safeguards to offset Safeguards are created by the profession, in the work
the threats environment and by the individual.
5 Confidentiality The auditor must not disclose information obtained in
his professional work without prior consent unless
there is an obligation to do so.
6 Enforcement The ACCA has disciplinary processes to enforce
mechanisms the Code.
7 Obtaining audit The ACCA Code imposes some restrictions on how
engagements firms market their services.
8 Acceptance Specific rules exist in the Code in relation to obtaining
and accepting new engagements.
An engagement letter is issued to confirm
acceptance and agree terms.
9 Specimen engagement You will not need to reproduce an engagement letter
letter but must be familiar with its contents.
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END OF CHAPTER
82
Internal audit

Discuss the factors to be taken into account when
assessing the need for internal audit
Discuss the elements of best practice in the
structure and operations of internal audit with
reference to appropriate international codes of
corporate governance
Compare and contrast the role of external and Q1(b) Section B pilot paper
internal audit
Discuss the scope of internal audit and the
limitations of the internal audit function
Discuss the responsibilities of internal and external
auditors for the prevention and detection of fraud
and error
Explain outsourcing
Explain the advantages and disadvantages of
outsourcing the internal audit function
Discuss the nature and purpose of internal audit Q3 Section A pilot paper
assignments including value for money, IT,
financial, regulatory compliance, fraud
investigations and customer experience
Discuss the nature and purpose of operational
internal audit assignments
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5: INTERNAL AUDIT
Overview
Internal audit Corporate governance
Audit Committee Internal Audit
The role of internal and

external audit
Nature and purpose of internal audit assignments
VFM Financial Fraud Operational

audits audits investigations audits
IT Regulatory Customer
audits compliance experience
Scope and limitations of Outsourcing internal audit

internal audit
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5: INTERNAL AUDIT
1 Corporate governance and internal audit

1.1 In Chapter 3 we saw that corporate governance relates to the internal systems or means by
Q7 ZX which companies are directed and controlled.
1.2 The UK Corporate Governance Code includes a section on accountability and this
introduces the requirement for the Board to maintain sound risk management and internal
control systems
1.3 One way in which this requirement can be satisfied is for the Board to create an internal
audit function to assess and monitor internal control policies and procedures.
1.4 Corporate governance guidance does not require all listed companies to have an internal
audit function, although many listed companies do have one.
1.5 Companies which do not have an internal audit function need to review whether or not the
company would benefit from having one on an annual basis.
Factors to be considered when assessing the need for internal audit

1.6 When considering the need for an internal audit function, the board should consider:
Any trends or current factors relevant to the company's activities, markets or other
aspects of its external environment that have increased risks
Internal factors such as organisational restructuring or changes in reporting processes
or underlying information systems
Adverse trends evident from the monitoring of internal control systems
Increased incidence of unexpected occurrences.
The Board, the Audit Committee and the Internal Audit Function
1.7 The corporate governance requirement to maintain sound risk management and internal
control systems is often met by a partnership between the Board, the Audit Committee and
the internal audit function.
1.8 The Board, which consists of all the directors (executive and non-executive), has the overall
responsibility for ensuring that the company meets corporate governance requirements.
1.9 The Audit Committee is a sub-committee of the Board and comprises at least three non-
executive directors (two in the case of a smaller company).
The Audit Committee has many responsibilities (chapter 3) including:
To review the internal control and risk management systems that the Board has put in
place and
To monitor and review the effectiveness of the internal audit function
1.10 The internal audit function is essentially an internal control available to management. The
tasks they carry out vary greatly but will include assessing the effectiveness of the Boards
internal control and risk management systems.
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5: INTERNAL AUDIT
1.11 The diagram below summarises this relationship:
Overall responsibility for the

analysis of risk and implementation
of internal controls
BOARD
Monitor
management's
AUDIT COMMITTEE responsiveness to
IA findings and
recommendations
Monitor and review Meet Regular report

effectiveness of IA Head of IA on results of IA work
Approve appointment/ at least once Direct access to
termination of appointment a year Board chairman
of Head of IA without and Audit Committee
Review and assess management Accountable to
annual IA work plan present Audit Committee
INTERNAL AUDIT FUNCTION
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5: INTERNAL AUDIT
2 Nature and purpose of internal audit assignments

Section 4 Definition
2.1 The role of the internal audit function is to provide independent assurance that a companys
risk management, governance and internal control processes are operating effectively.
2.2 In order to provide such assurance, the internal auditor will examine and evaluate the quality
of risk management, governance and internal control processes across all parts of a
company and report this directly and independently to the most senior level of management.
2.3 Unlike external auditors, the internal audit function looks beyond the financial statements
and considers wider issues such as the companys reputation, compliance with laws and
regulations, growth, its impact on the environment and employee satisfaction levels.
This is because the key to a companys success is often managing such risks effectively.
Scope
2.4 There are many types of work that the internal auditor can perform. Those listed in the
syllabus are:
Value for money audits
Information technology (IT) audits
Financial audits
Audits to verify regulatory compliance
Fraud investigations
Customer experience audits and
Operational audits.
2.5 Value for money audits are covered in section 2.6 whilst the other audits are addressed in
the additional notes section to this chapter.
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5: INTERNAL AUDIT
Value for money audits

2.6 Value for money (VFM) audits may be performed by the internal audit function and try to
determine whether the optimal combination of goods/ services have been obtained for the
lowest level of resources.
2.7 VFM audits tend to focus on three areas: economy, efficiency and effectiveness. These are
commonly known as the three Es:
Economy Buying the resources needed at the cheapest cost
Efficiency Using the resources purchased as wisely as possible
Effectiveness Doing the right things and meeting the organisations objectives
2.8 Management will need to set objectives for each of the three areas which will detail the
goals/ aims they hope to achieve in terms of the companys economic purchase of
resources, efficient use of resources and the effectiveness of achieving the companys
objectives.
2.9 Once the objectives have been set, they will then need to put controls in place to ensure
each objective is met.
trading for over 10 years. It operates from two sites, a factory where the clothes are made and a
head office where the administration is carried out. Completed inventory orders are despatched
from both the factory and the head office.
Required
Suggest TWO objectives Dress You Like Co may set in each of the areas of economy, efficiency
and effectiveness and describe the controls you would expect to be put in place to ensure they are
achieved.
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5: INTERNAL AUDIT
Solution
Objective Control
Economy
Efficiency
Effectiveness
2.10 Audits which are concerned solely with the economy objective are often termed best
value audits.
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5: INTERNAL AUDIT
3 Scope and limitations of internal audit

The scope of internal audit
3.1 From section 2 we can see that the scope of work undertaken by the internal audit is vast
and varied.
3.2 The Audit Committee should review the internal audit functions work plan each year to
ensure that their work is appropriately focused to the needs of the business.
Limitations of the internal audit function

3.3 If the internal audit function is to be effective, then both they and their work need to possess
certain qualities.
3.4 These qualities include independence, objectivity and due skill and care.
3.5 Independence
Internal auditors should be independent of the activities they audit. For example
internal auditors should not generally be involved in designing, installing and
operating systems. Rather their role is to review the effectiveness of them.
Internal audit departments should be granted sufficient status to achieve
independence from the various company functions.
Internal audit reports should be considered appropriately by directors and
recommendations acted upon.
Internal auditors must have a reporting line that is independent of the function they
are auditing highest level of management/ Audit Committee.
3.6 Objectivity
Objectivity is all about maintaining an independent mental attitude when they
conduct their work, the internal auditors should consider the facts in front of them
without having any pre-conceived ideas.
3.7 Due skill and care

Need for internal auditors to have wide ranging skills (accounting, auditing, business
and management skills).
Need for a multi-disciplinary internal audit team
Need for on-going training
Adherence to internal audit quality control manuals / procedures
Work should be planned, documented, supervised and reviewed.
3.8 Note that internal auditors are not normally subject to any regulatory authority.
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5: INTERNAL AUDIT
4 Outsourcing internal audit

4.1 The internal audit function can either be provided internally by employees of the company or
may be outsourced externally, for example to an accountancy or consultancy firm.
There are both advantages and disadvantages of outsourcing a companys internal audit function.
Required:
Explain FOUR advantages and disadvantages to a company of outsourcing the internal audit
function.
Solution
4.2 Note that where the internal audit function is outsourced to the companys external auditor,
there may be a self-review threat to the auditors independence (chapter 4).
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5: INTERNAL AUDIT
5 The role of external and internal audit

5.1 The concept of audit and the role of the auditor was introduced in chapter 1.
5.2 When undertaking an external audit, the auditor is carrying out a statutory duty to report as
to whether the financial statements present fairly the activities of the business.
5.3 The external audit will be conducted in accordance with the International Standards on
Auditing and local law/ legislation.
5.4 The purpose of the internal audit function however is to assist the Board in achieving their
corporate objectives.
Abbie Jones has recently signed a training contract with Check and Co, a firm of Chartered
Certified Accountants and is working in the firms audit department. She has been reviewing some
of the firms client audit files in an attempt to gain a better understanding of what an audit is. She
has noticed that some clients seem to have an internal audit function whilst others do not.
Abbie is a little confused as to the difference between her role as an external auditor and the role
of the internal audit function.
Required:
You are an audit senior in Check and Co and have been asked to complete the following table for
Abbie which distinguishes between the key elements of the roles of the external and internal
auditor.
Solution
External auditor Internal Auditor
Objectives
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5: INTERNAL AUDIT
Reports to
Status
Qualification
Responsibilities for fraud and error

5.5
Prevention and
detection of fraud and error
External Internal
auditors auditors
No responsibility for prevention Directors responsible for prevention

and detection
Responsibility to consider the risk of
material misstatement in the Internal audit can assist directors
financial statements due to fraud with the prevention of fraud and error
and error by assessing the effectiveness of
internal control systems
Provide reasonable assurance that
financial statements are free from Existence of IA department may act
material misstatement as deterrent
Responsibility to detect fraud and Can contribute to detection by
error which has a material impact reporting suspicions
on the financial statements May be called on to investigate
suspected fraud
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5: INTERNAL AUDIT
Use of the internal auditors work by the external auditor

5.6 It is possible that the objectives of some of the work performed by the internal audit
department may overlap with those of the external auditor.
5.7 In these cases, it may be possible for the external auditor to rely on the work of the internal
auditor.
5.8 However, certain conditions must be satisfied:
S cope of work
O rganisational status
D ue skill and care
I ndependence
T echnical competence
94
Additional
Notes
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5: INTERNAL AUDIT
6 Nature and purpose of internal audit assignments

Section 4
(cont.)
6.1 As well as the value for money audits covered earlier in the chapter, there are several other
types of internal audit assignments included in the syllabus. These are:
Information technology (IT) audits
Financial audits
Audits to verify regulatory compliance
Customer experience audits and
Operational audits.
Information technology audits

6.2 Computer, or IT, systems have become increasingly important to businesses and the way in
which they are run. It is fundamental therefore that a business knows it has appropriate IT
systems in place and that they are operating effectively.
6.3 An IT system could simply comprise a standalone computer on which a business maintains
its accounting records, produces invoices and sends and receives emails.
6.4 Alternatively, IT systems could comprise a database, an integrated inventory control system
or a companys e-commerce activities.
6.5 Whatever the extent of IT systems used by a business, it is essential that a company has
internal controls in place to make sure that the systems operate effectively.
6.6 An information technology audit will involve these internal controls being tested to ensure
that they are operating effectively.
6.7 It is likely that an internal audit function will include a computer specialist who can carry out
specific tests of controls, especially where the controls are embedded into the computer
system.
Financial audits
6.8 The Board of Directors has a statutory responsibility to prepare financial statements and
maintain proper (accounting) books and records. They will also produce management
accounts on a monthly basis in order to assess the performance of the business.
6.9 Management will make decisions based on this information and therefore need to know that
it is reliable.
6.10 Financial audits involve the internal audit function reviewing the financial information
produced and gathering evidence to substantiate it.
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5: INTERNAL AUDIT
6.11 For example, in order to be able to report about the accuracy of the figure for sales revenue,
the internal audit function may perform tests of controls to ensure that all orders processed
are despatched to customers and then invoiced.
6.12 Similarly, in order to be able to report on the accuracy of the figure for property, plant and
equipment, the internal audit function may carry out an inspection of assets to ensure that
the figure agrees to the list of assets in the non-current asset register and that these assets
exist and are being used by the business.
Regulatory compliance
6.13 Most businesses are subject to regulation such as health and safety requirements.
However some businesses face additional regulation due to the nature of the products and
services they sell, for example banks and other financial institutions.
6.14 Where an entity is heavily regulated non-compliance could have a severe impact on their
business. For example an entity may incur fines or have their licence to trade revoked.
6.15 It is essential that management are up to date with the regulatory requirements applicable to
their business and put internal controls in place to ensure compliance and detect any
instances of non-compliance.
6.16 In such businesses it is likely that the internal audit function will include a member of staff
who has specific knowledge and training in these areas so that non-compliance can be
prevented and detected.
6.17 The Board of Directors are responsible for assessing the entitys risk from fraud and
maintaining a system of internal controls which prevent and detect fraud and error.
6.18 The internal audit functions general work on internal controls may identify instances of
fraud. The Board may also instruct the internal audit function to perform a specific
investigation where fraud is suspected.
Customer experience audits

6.19 Satisfied customers often means repeat business for an entity and so many businesses now
devote a lot of time and resources to finding out how customers would rate their experience
with the entity.
6.20 The internal audit function may be involved in conducting such reviews or in collating the
feedback obtained and making recommendations regarding changes which could improve
customer experience in the future.
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5: INTERNAL AUDIT
Operational audits
6.21 Operational audits are also known as management or efficiency audits and they involve the
internal audit function monitoring management's performance to ensure company policy is
adhered to.
6.22 Approach to operational internal audit assignments
Two aspects
Ensure policies Ensure policies

are adequate work effectively
Read policies Identify controls

Discuss with staff Observe them
of relevant department Test them
(this is similar to the
techniques
outlined in chapter 10)
Assess adequacy
Advise management
of improvements required
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5: INTERNAL AUDIT
7 Chapter summary
1 Corporate governance Having an internal audit function is one way in which
and internal audit the Board of Directors can demonstrate good
corporate governance. The internal audit function
should report regularly to the Audit Committee and the
Audit Committee should review and assess the internal
audit functions work plan.
2 Nature and purpose of The role of the internal audit function is extremely wide
internal audit and varied. Value for money audits assess whether
assignments the business has obtained the best goods/ services for
the lowest level of resources. It focusses on economy,
efficiency and effectiveness.
3 Scope and limitations For the work of the internal audit function to be
of internal audit effective, internal auditors must be independent and
objective and carry out their work with due skill and
care.
4 Outsourcing internal Some companies outsource internal audit to
audit accountancy or consultancy firms.
5 The role of external The role of the external auditor is clearly defined in
and internal audit statute; the role of the internal audit function is
decided by the management of a specific company.
6 Nature and purpose of As well as performing value for money audits, the
internal audit internal audit function may also conduct IT audits,
assignments (cont.) financial audits, audits to verify regulatory
compliance, fraud investigations, customer
experience audits and operational audits.
99
5: INTERNAL AUDIT
END OF CHAPTER
100
Risk assessment

Identify the overall objectives of the auditor and the
need to conduct an audit in accordance with ISAs
Explain the need to plan and perform audits with
an attitude of professional scepticism, and to
exercise professional judgement
Explain the components of audit risk Q10 Section A pilot paper
Explain the audit risks in the financial statements Q5(a) Section B pilot paper
and explain the auditors response to each risk
Explain how auditors obtain an initial
understanding of the entity and its environment
Define and explain the concepts of materiality and
performance materiality
Explain and calculate materiality levels from
financial information
Discuss the effect of fraud and misstatements on
the audit strategy and extent of audit work
Explain the auditors responsibility to consider laws
and regulations
Describe and explain the nature and purpose of
analytical procedures in planning
Compute and interpret key ratios used in analytical
procedures
101
6: RISK ASSESSMENT
Overview
Risk assessment
Professional scepticism
Understanding the entity and Audit risk Materiality and performance

its business environment materiality
Effect of fraud and Analytical procedures in audit

misstatements planning
102
6: RISK ASSESSMENT
1 General principles
Professional scepticism
1.1 ISA 200 Overall objectives of the independent auditor and the conduct of an audit in
accordance with International Standards on Auditing states that auditors must plan and
perform an audit with professional scepticism recognising that circumstances may exist
that cause the financial statements to be materially misstated.
This requires:
Critical assessment, with a questioning mind, of the validity of evidence obtained
Alertness to contradictory evidence
Neither the assumption that management is dishonest nor the assumption of
unquestioned honesty.
Professional judgement
1.2 ISA 200 also requires the auditor to exercise professional judgement in planning and
performing an audit of financial statements. Professional judgement is required in the
following areas:
Materiality and audit risk

Nature, timing and extent of audit procedures
Evaluation of whether sufficient appropriate audit evidence has been obtained
Evaluating managements judgements in applying the applicable financial reporting
framework
Drawing conclusions based on the audit evidence obtained
Risk-based approach to audit

1.3 The ISAs require auditors to adopt a risk based approach to auditing. This means the
auditor must:
Analyse the risk in the clients business, transactions and systems that could lead to
material misstatement
Direct their testing to risky areas
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6: RISK ASSESSMENT
2 Audit risk
2.1 ISA 200 states that 'to obtain reasonable assurance, the auditor shall obtain sufficient
Section 1 appropriate audit evidence to reduce audit risk to an acceptably low level and thereby
enable the auditor to draw reasonable conclusions on which to base the auditors opinion.
2.2 Audit risk is the 'risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated'.
It is made up of 3 component parts, inherent risk, control risk and detection risk:
THE AUDIT RISK MODEL

AR = IR x CR x DR
Control Risk
Audit Risk
Inherent Risk
Detection Risk
Sampling Risk Non-sampling Risk
Inherent risk and control risk together form the 'risk of material misstatement' or 'financial
statement risk'.
Inherent risk
2.3 This is the susceptibility of an assertion to a misstatement that could be material, either
individually or when aggregated with other misstatements, assuming that there were no
related internal controls.
2.4 The risk of such misstatement is greater for some assertions and related classes of
transactions, account balances, and disclosures than for others. For example,
Complex calculations are more likely to be misstated than simple calculations
Accounts consisting of amounts derived from accounting estimates pose greater risks
than accounts consisting of relatively routine, factual data.
External circumstances giving rise to business risks may also influence inherent risk.
Control risk
2.5 This is the risk that a misstatement could occur in an assertion that could be material, either
individually or when aggregated with other misstatements, that will not be prevented, or
detected and corrected, on a timely basis by the entity's internal control.
2.6 Some control risk will always exist because of the inherent limitations of internal control.
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6: RISK ASSESSMENT
Detection risk
2.7 This is the risk that the auditor's procedures will not detect a misstatement that exists in an
assertion that could be material either individually or when aggregated with other
misstatements.
Detection risk is primarily the consequence of the fact that the auditor does not, and cannot,
examine all available evidence (sampling risk).
2.8 Factors which increase non-sampling risk are

Auditor's lack of experience
Time pressure
Financial constraints
Poor planning
New client
Lack of industry knowledge
3 Materiality in planning and performing an audit

(ISA 320)
3.1 The auditor should consider materiality and its relationship with audit risk when conducting
an audit.
3.2 Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.
The auditor must be concerned with identifying 'material' errors, omissions and
misstatements. Both the amount (quantity) and nature (quality) of misstatements
need to be considered. e.g. lack of disclosure regarding ongoing litigation is likely to
be considered material.
To put this into practice the auditor therefore has to set his own materiality levels
this will always be a matter of judgement and will depend on the level of audit risk.
The higher the anticipated risk, the lower the value of materiality will be.
The level set has a critical impact on two key areas:
(a) The nature, timing and extent of audit procedures. The lower the materiality
level is set, the more work will need to be performed to ensure audit risk is kept
at an acceptably low level; and
(b) Evaluating the effect of misstatements:
(i) Whether to seek adjustments; or
(ii) The degree of any auditors report modification.
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6: RISK ASSESSMENT
The calculation of materiality

3.3 (a) During planning, the auditor establishes materiality for financial statements as a whole
by exercising judgement
(b) A set criteria is used as a starting point
For example:
between and 1% of revenue
between 1 and 2% of total assets; or
between 5 and 10% of profit before tax.
The figure chosen will depend on the confidence the auditor has in the client's figures,
the uses the financial statements will be put to and any other factors affecting the
auditor's judgement.
The auditor must also determine performance materiality.
Performance materiality
3.4 Performance materiality is less than materiality calculated during the planning stage of the
audit, to reduce the risk that the aggregate of uncorrected and undetected misstatements
exceed materiality for the financial statements as a whole.
Performance materiality also refers to the amount or amounts set by the auditor at less than
the materiality level or levels for particular classes of transactions, account balances or
disclosures.
Determining performance materiality involves the auditors professional judgement. It is
affected by their understanding of the entity and the results of risk assessment procedures.
It can be qualitative and quantitative.
For example, if there are particular account balances that could reasonably be expected to
significantly influence the decisions of users (for example, turnover for the year) then the
auditors may decide to use performance materiality when performing their audit procedures.
Revising materiality as the audit progresses

3.5 Materiality may need to be revised due to events that occur during the audit, new
information, or a change in the auditors understanding of the entity and its operations as a
result of performing further audit procedures.
3.6 In evaluating whether the financial statements give a true and fair view, the auditor should
assess the materiality of the aggregate of uncorrected misstatements. This is normally
documented on a schedule of unadjusted differences.
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6: RISK ASSESSMENT
Documentation of materiality
3.7 ISA 320 requires the following to be documented:
Materiality for the financial statements as a whole
Materiality level or levels for particular classes of transactions, account balances or
disclosures if applicable
Performance materiality
Any revision of the above as the audit progressed
Introduction and client background

You are an audit senior in Check and Co and you are commencing the planning of the audit of
Dress You Like Co for the year ending 30 September 20X1. This audit was won by your firm in
January 20X1 following an extremely competitive tender to secure the work.
Personnel
Also as part of the cost cutting exercise mentioned above, Dress You Like Co froze the finance
directors salary this year despite giving other directors a 5% salary increase. This decision was
made based on the fact that the finance role was no more demanding than in previous years. The
finance director was not happy about this decision and left the company in March 20X1. He is now
suing the company for constructive dismissal; the company is not proposing to make any provision
or disclosure of this as they do not believe the ongoing claim has any merit. The finance director
has not yet been replaced and his work is being done by his assistant on top of her existing work
load.
107
6: RISK ASSESSMENT
Dress You Like Co had previously outsourced their internal audit department but cancelled this
contract in May 20X1 in a further effort to cut costs. The internal audit department used to perform
monthly bank and supplier statement reconciliations and a monthly check on the controls over
inventory despatch at each location.
Required
Using the information provided, describe SIX audit risks, and explain the auditors response to
each risk, in planning the audit of Dress You Like Co.
Solution
108
Additional
Notes
109
6: RISK ASSESSMENT
4 Understanding the entity and its environment

4.1 ISA 315 Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and its Environment
Perform risk assessment procedures to understand the entity

and its environment
Assess the risk of material misstatement at the financial

statement and assertion level
4.2 Matters to consider when obtaining an understanding of the entity.

Industry, regulatory and other Market and competition
external factors, including the Product technology
applicable financial reporting Accounting principles
framework Tax / legislation
Interest rates / inflation
Nature of the entity Revenue sources

Products or services
Locations
Key customers/suppliers
Financing
Investment
Objectives and strategies and related New products/services

business risks Expansion
Use of IT
Measurement and review of the Trends

entity's financial performance Ratios, KPIs
Budgets and forecasts
Selection and application of Changes in accounting policies

accounting policies New legislation
Internal control Will be covered in detail in Chapter 9
110
6: RISK ASSESSMENT
Assessing risk
4.3 Risk assessment includes:
(a) Identifying risks by considering the entity and its environment, including its internal
control (audit risk, business risk and significant risks)
(b) Relating the identified risks to what can go wrong at the assertion level i.e. the impact
the risks could have on figures in the financial statements.
(c) Considering the significance and likelihood of the risks
(d) Establishing materiality and evaluating whether the original level set remains
appropriate as the audit progresses
(e) Developing expectations for use when performing analytical procedure
(f) Designing and performing further audit procedures to reduce audit risk to an
acceptably low level
(g) Evaluating the sufficiency and appropriateness of audit evidence
4.4 Risk assessment includes both an assessment of:

Audit risk and its component parts
Business risk resulting from the entity's failure to meet its objectives and strategies
that may result in material misstatement of the financial statements
Business risk
4.5 Business risks 'result from significant conditions, events, circumstances, action or inactions
that could adversely affect the entity's ability to achieve its objectives and execute its
strategies, or from the setting of inappropriate objectives and strategies' [ISA 315].
It is usually split into financial risk, operational risk and compliance risk.
The auditor should obtain an understanding of the entity's process for:
identifying business risks relating to financial reporting objectives
deciding about actions to address those risks, and the results thereof.
4.6 As part of the risk assessment, the auditor shall determine whether any of the risks are
significant risks.
Significant risks are those that require special audit consideration.
The following factors indicate that a risk might be significant:
Risk of fraud
Its relationship with recent economic, accounting or other developments
The degree of subjectivity in the financial information
It is an unusual transaction
It is a significant transaction with a related party
The complexity of the transaction
111
6: RISK ASSESSMENT
Risk at the assertion level

4.7 ISA 315 states that the auditor must use assertions for classes of transactions, account
balances, and presentation and disclosures in sufficient detail to form the basis for the
assessment of risks of material misstatement and the design and performance of further
audit procedures (Chapter 8).
5 Risk assessment procedures

5.1 ISA 315 requires auditors to perform the following procedures to obtain an understanding of
the entity and its environment, including its internal control:
Enquiries of management and others within the entity
Analytical procedures
Observation and inspection.
The members of the audit team should also discuss the susceptibility of the entity's
financial statements to material misstatements.
Effect of fraud and misstatements

5.2 ISA 240 The auditor's responsibilities relating to fraud in an audit of financial statements
contains very similar requirements to those listed in paragraph 4.1 above. It has a particular
Section 6 emphasis on:
Obtaining an understanding of how those charged with governance exercise
oversight over the identification of the fraud risks and the implementation of controls.
5.3 Where the risk assessment suggests there may be material misstatements arising from
fraud the main effects on the audit strategy will relate to:
Assignment and supervision of personnel
Consideration of accounting policies
Unpredictability in nature, timing and extent of audit procedures.
ISA 520 Analytical procedures

5.4 Analytical procedures mean the analysis of relationships to identify inconsistencies and
unexpected relationships.
5.5 The auditor should apply analytical procedures as risk assessment procedures and in the
overall review at the end of the audit.
They can also be used as a source of substantive audit evidence when their use is more
effective or efficient than tests of details in reducing detection risk for specific financial
statement assertions.
112
6: RISK ASSESSMENT
5.6 Analytical procedures include the following type of comparisons:

(a) Prior periods
(b) Budgets and forecasts
(c) Industry information
(d) Predictive estimates i.e. expectations
(e) Relationships between elements of financial information, i.e. ratio analysis
(f) Relationships between financial and non-financial information, e.g. payroll costs to the
number of employees.
Analytical procedures as risk assessment procedures

5.7 The auditor should apply analytical procedures as risk assessment procedures to obtain an
understanding of the entity and its environment.
Application of analytical procedures may indicate aspects of the entity of which the auditor
was unaware and will assist in assessing the risks of material misstatement in order to
determine the nature, timing and extent of further audit procedures.
Common ratios for use in analytical review

5.8 (a) Profitability
Profit before interest and tax (PBIT)
(i) Return on Capital Employed =
(ROCE) Share capital reserves NC liabilities
PBIT
(ii) Net profit margin =
Revenue
Revenue
(iii) Asset turnover =
Share capital + reserves + NC liabilities
Gross profit
(iv) Gross margin =
Revenue
(b) Liquidity
CA
(i) Current ratio =
CL
CA - Inventories
(ii) Quick ratio (Acid Test) =
CL
Inventories
(iii) Inventory turnover = 365 days
COS
COS
or No. of times turnover
Inventories
Trade receivables
(iv) Trade receivables days = 365 days
Credit sales
113
6: RISK ASSESSMENT
Trade payables
(v) Trade payables days = 365 days
Credit purchases
(c) Gearing
Interest bearing debt
(i) Debt/equity =
Share capital and reserves
Lecture example 2 Based on a past exam question
You have also been provided with the following draft accounts of Dress You Like Co for the year
ended 30 September 20X1:
Extracts from the draft statement of financial position as on 30 September 20X1
Draft Actual
20X1 20X0
$000 $000
Inventory: finished goods 13,800 4,900
Receivables: trade (supermarket) 11,800 8,300

trade (other) 700 600
Bank: 0 200
Payables: trade 2,060 1,470

other 500 450
Bank overdraft: 750 0
Extracts from the draft statement of profit or loss for the year ended 30 September 20X1
Draft Actual
20X1 20X0
$000 $000
Revenue (supermarket) 53,500 49,000
Revenue (other) 8,200 6,700
Cost of sales (supermarket) (51,895) (45,080)
Cost of sales (other) (7,380) (5,900)
Gross profit 2,425 4,720
Other expenses (1,400) (2,450)
Profit before taxation 1,025 2,270
Required
(a) Calculate THREE ratios, for BOTH years, which would assist the audit senior in planning the
audit; and
(b) Using the ratios calculated, describe the main audit risk and explain the auditors response
to this risk in the planning of Dress You Like Co.
114
6: RISK ASSESSMENT
Solution
115
6: RISK ASSESSMENT
6 Chapter summary
1 General principles Audits must be planned with an attitude of
professional scepticism.
2 Audit risk The auditor must plan to minimise audit risk.
Audit risk is a combination of inherent risk, control
risk and detection risk.
3 Materiality in Planning Materiality must be assessed during audit planning. It
and Performing an has both quantitative and qualitative aspects.
Audit (ISA 320)
4 Understanding the The auditor must obtain a knowledge of the business,
entity and its including an understanding of business risk, audit
environment risk, significant risks and assertions.
5 Risk assessment Analytical procedures should be used as part of risk
procedures assessment.
END OF CHAPTER
116
Checkpoint (Progress Test) 1
To reinforce your learning to date you should now access your Checkpoint Guidance and Progress Test.
In order to do well in your final exam, it is vitally important that you carry out structured study sessions in
between lectures with your tutor. The Checkpoint Guidance will help you do this in the most effective
way.
The Checkpoint Guidance will include some or all of the following: -

High level summary of Key Knowledge and Skills youve covered recently
For each Chapter in the Course Notes:
The key areas to revisit
Recommended Question Practice
Any additional resources you could look at
Progress Tests
The progress tests are a key tool in checking your understanding of topics covered to date. They enable
timely review and, if necessary, the opportunity to seek clarification from your tutor.
117
118
Audit planning and
documentation

Identify and explain the need for and importance of
planning an audit
Identify and describe the contents of the overall
audit strategy and audit plan
Explain and describe the relationship between the
overall audit strategy and the audit plan
Explain the difference between interim and final
audit
Describe the purpose of an interim audit, and the Q6 Section A pilot paper
procedures likely to be adopted at this stage in the
audit
Describe the impact of the work performed during
the interim audit on the final audit
Explain the need for and the importance of audit
documentation
Describe the form and contents of working papers
and supporting documentation
Explain the procedures to ensure safe custody and
retention of working papers
119
7: AUDIT PLANNING AND DOCUMENTATION
Overview
Audit planning and documentation
The need for planning Audit documentation
The audit strategy and the Interim and final audit

audit plan
120
1 Overview of the statutory audit

1.1 Activities
Later chapters in these notes will cover the activities of the statutory audit in detail. The
following diagram summarises the main areas.
Plan the audit
Understand the entity (including documenting and confirming

the accounting systems and internal control) (Chapter 6, 9)
Assess risk of material misstatement (Chapter 6)
Select audit procedures to respond to risk of material misstatement (Chapter 9)
Where risk assessment Risk assessment does

includes expectation not include expectation
that controls operate that controls operate
effectively (Chapter 9) effectively (Chapter 9)
Tests of controls (to confirm expectation)

(Chapter 10)
Unsatisfactory Report
to management
Satisfactory
Restricted Full
substantive tests substantive tests
(Chapters 11 to 16) (Chapters 11 to 16)
Overall review of
(Chapter 18)
Report to
management
(Chapter 10)
Auditors
report
(Chapter 19)
121
2 The need for planning

2.1 An effective and efficient audit relies on proper planning procedures. ISA 300 Planning an
audit of financial statements states the auditor shall plan the audit work so that the
engagement will be performed in an effective manner.
2.2 Planning an audit involves establishing the overall audit strategy for the engagement and
developing an audit plan.
2.3 The form and nature of planning is affected by

Size of the entity
Complexity of the audit
Auditors experience with the entity
Knowledge of the business
Commercial environment
Method of processing transactions
Reporting requirements
2.4 Objectives of planning

Ensuring that appropriate attention is devoted to important areas of the audit
Ensuring that potential problems are identified
Ensuring that the work is completed expeditiously
Proper assignment of work to assistants
Coordination of work done by other auditors and experts; and
Facilitating review.
2.5 Changes to planning decisions

During the audit the auditor may need to modify the overall audit strategy and audit plan,
due to unexpected events, changes in conditions or audit evidence obtained. All decisions
must be documented.
122
Additional
Notes
123
3 The audit strategy and the audit plan

3.1 Overview
Section 1.2
The audit strategy
Financial reporting framework
Industry-specific reporting requirements
Entitys timetable for reporting
Locations
Expected audit coverage
Specialist knowledge required by the auditors
Availability of client personnel and data
Availability of work by internal auditors
Determination of materiality
Entitys use of service organisations
Expected use of controls testing and substantive testing
Expected use of CAATs
Selection of the engagement team
Assignment of work to team members
Engagement budgeting
Guides the
development of
The audit plan

More detailed than the audit strategy
Nature, timing and extent of audit procedures timetable and staff allocation
Audit procedures for each material class of transactions, account balance or disclosure
Planning these procedures takes place over the course of the audit
124
Section 1.3
4 Interim and final audit
4.1 The main audit procedures are likely to be carried out in two phases, the interim and final
audit.
A typical timeframe for a client with a 31 December year end might be:
Planning
1 January visit 31 December
Interim Final
audit audit
4.2 Planning visit

Procedures are likely to include:
Review of client's business
Review of client's current operations and performance year to date
Preliminary client meeting
Prepare audit strategy
Prepare detailed audit plan
4.3 Interim audit

Analytical procedures
Tests of controls
Updating risk assessments
Review of relevant internal audit reports
Substantive testing (of transactions in first part of year)
4.4 Final audit

At this stage a set of draft financial statements or at least a trial balance will be available.
Completion of tests of controls and substantive tests of transactions started at interim
Analytical procedures on financial statements
Detailed substantive testing of financial statements.
125
5 Audit documentation
5.1 Audit documentation is the record of audit procedures performed, relevant evidence
obtained and conclusions reached. Also known as working papers.
ISA 230 Audit documentation states that the auditor shall prepare audit documentation on a
timely basis.
Purpose of working papers:
Assist in the planning and performance of the audit
Assist in the supervision and review of audit work
Enable the audit team to be accountable for its work
Retain a record of matters of continuing significance to future audits ('points carried
forward'); and
Enable quality control reviews to be performed.
5.2 Contents
Sufficiently complete and detailed to enable an experienced auditor with no previous
connection with the audit subsequently to ascertain from them what work was
performed and to support the conclusions reached
Should record information on the auditors planning the audit, the nature, timing and
extent of the audit procedures performed, and the results thereof, and the conclusions
drawn from the audit evidence obtained
Auditors reasoning on all significant matters requiring exercise of judgement, with
auditors conclusions thereon
Types of documentation
5.3
Engagement letters
Permanent File
Legal documents such as prospectuses, leases,
(information of continuing
sales agreement
importance)
Details of the history of the client's business
Previous years' signed accounts and management
letters
Accounting systems notes, previous years' control
questionnaires
126
Financial statements
Current File
Accounts checklists
(information of relevance to
current year's audit) A summary of unadjusted errors
Review notes
Audit strategy
Audit plan
Time budgets and summaries
Letter of representation
Management letter
Notes of board minutes
Communications with third parties
Lead schedule including details of the figures to be
included in the accounts
Problems encountered and conclusions drawn
Audit programmes
Details of substantive tests and tests of control
5.4 Custody and retention

The firm should establish policies and procedures designed to maintain the confidentiality,
safe custody, integrity, accessibility and retrievability of documentation, for example:
Passwords to restrict access to electronic documentation to authorised users
Back-up routines
Confidential storage of hard copy documentation.
The ACCA recommends seven years as a minimum retention period.
127
6 Chapter summary
1 Overview of the An outline of the main stages of a statutory audit.
statutory audit
2 The need for planning Planning is carried out so that the audit is performed in
an effective manner.
3 The audit strategy and The overall approach to the audit is documented in the
the audit plan audit strategy.
The audit plan documents specific procedures for each
class of transactions, balance or disclosure.
4 Interim and final audit The audit is usually carried out in two phases, the
interim audit and the final audit.
5 Audit documentation All audit evidence that supports the auditor's opinion
must be documented.
END OF CHAPTER
128
Introduction to audit
evidence

Explain the assertions contained in the financial Q4(a) Section B pilot paper
statements about classes of transactions and
events, account balances at the period end and
presentation and disclosure
Describe audit procedures to obtain audit
evidence, including inspection, observation,
external confirmation, recalculation, re-
performance, analytical procedures and enquiry
Discuss the quality and quantity of audit evidence
Discuss the relevance and reliability of audit Q2 Section A pilot paper
evidence
Discuss substantive procedures for obtaining audit
evidence
Discuss and provide examples of how analytical
procedures are used as substantive procedures
Discuss the difference between tests of control Q2(a) Section B pilot paper
and substantive procedures
129
8: INTRODUCTION TO AUDIT EVIDENCE
Overview
Audit evidence Quality of evidence
Financial statement Procedures for obtaining

assertions evidence
Use of assertions in obtaining Tests of controls and

audit evidence substantive procedures
Analytical Inspection Recalculation

procedures
Enquiry and Observation

confirmation
130
1 Introduction
1.1 When undertaking an audit, the auditor needs to find evidence through testing of processes,
transactions, account balances and data to support his opinion.
ISA 500 Audit Evidence outlines the requirements when conducting an external audit under
International Standards on Auditing.
2 Quality of evidence
2.1 The auditor should obtain sufficient, appropriate audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion. (ISA 500)
2.2
ISA 500 Audit Evidence
Sufficient Appropriate
Quantity Sufficient to
support the audit opinion
Factors to consider are: Relevant Reliable
Risk assessment The evidence External better than
Nature of accounting and gathered must cover internal
internal control systems the financial
Internal more reliable
Materiality of the item statement assertions.
when controls effective
Experience gained during
Auditor generated better
previous audits than client generated
Results of audit
procedures Documentary better than
oral
Source and reliability of
information available Original documents more
reliable than copies/ faxes
131
2.3 Evidence must be relevant to the particular financial statement assertion the auditor is
trying to test. There are three categories:
Section 2
Assertions about Occurrence:
classes of transactions and events that have been recorded have occurred and pertain
transactions for to the entity.
the period under Completeness:
audit all transactions and events that should have been recorded have been
recorded.
O Cut-off:
C transactions and events have been recorded in the correct accounting period.
C Classification:
C transactions and events have been recorded in the proper accounts.
A Accuracy:
amounts and other data relating to recorded transactions and events have
been recorded appropriately.
Assertions about Completeness:
account all assets, liabilities and equity interests that should have been recorded have
balances at the been recorded.
period-end Obligations and rights:
the entity holds or controls the rights to assets, and liabilities are the
C obligations of the entity.
O Valuation and allocation:
V assets, liabilities, and equity interests are included in the financial statements
E at appropriate amounts and any resulting valuation or allocation adjustments
are appropriately recorded.
Existence:
assets, liabilities, and equity interests exist.
Assertions about Occurrence and rights and obligations:
presentation and disclosed events, transactions and other matters have occurred and pertain to
disclosures the entity.
Completeness:
O all disclosures that should have been included in the financial statements
C have been included.
C Classification and understandability:
A financial information is appropriately presented and described, and
disclosures are clearly expressed.
Accuracy and valuation:
financial and other information are disclosed fairly and at appropriate
amounts.
132
2.4 Sometimes an entity will use an expert, for example a chartered surveyor, to assist them in
the preparation of the financial statements. A managements expert is an individual or
organisation possessing expertise in a field other than auditing or accounting, whose work is
used by the entity to assist in the preparation of the financial statements.
ISA 500 states that when wanting to rely on the work of the expert, the auditor must
evaluate the competence, capabilities and objectivity of the expert, obtain an understanding
of the work done, and evaluate the appropriateness of the work done as audit evidence.
2.5 If the auditor is unable to obtain sufficient, appropriate evidence, then he should consider
the implications for the auditor's report (Chapter 19).
3 Procedures for obtaining audit evidence

3.1 There is rarely one piece of audit evidence that gives sufficient appropriate evidence over a
class of transactions, account balance or presentation and disclosure. Rather audit
evidence is obtained by performing an appropriate mix of audit procedures.
3.2 There are two types of audit procedure:

(a) Tests of controls
These are procedures to test the effectiveness of the entitys internal controls in
preventing or detecting material misstatements.
(b) Substantive procedures
These are procedures to detect material misstatements. There are two types:
Tests of detail (for example vouching amounts back to invoices, physical

inspection of assets)
Analytical procedures (for example variance analysis and ratio analysis)
Section 2.1 Generating audit procedures in the exam

3.3 (a) Analytical procedures The evaluation of financial information by a comparison to
financial and non-financial data and the investigation of
significant differences and relationships which are
inconsistent with other information.
(b) Enquiry and Seeking information of knowledgeable persons throughout
confirmation the entity or outside the entity (enquiry) and
obtaining representations directly from a third party
(confirmation).
(c) Inspection Examining records, documents and tangible assets.
(d) Observation Looking at a process or procedure being performed by
others.
133
(e) recalcUlation Verifying the arithmetical accuracy of documents or records

and the auditor's independent execution of procedures and
reperformance of controls.
3.4 Analytical procedures and confirmation are purely substantive procedures.
3.5 Enquiry, inspection, observation and recalculation can all be used as either a test of control
or as a substantive procedure.
The use of analytical procedures as a substantive procedure

3.6 There are three main types of analytical procedures which an auditor can use:
Variance analysis - the review of current year financial information in comparison to
the prior period or budgeted information.
Ratio analysis the calculation of ratios and analysis and investigation of significant
differences.
Proof in total the use of interrelationships between data (financial and non-financial)
to estimate an expected value in the financial statements, again with the investigation
of significant differences.
Required
Describe an analytical procedure that could be used to give evidence on the following assertions:
(1) Completeness of administrative expenses (using variance analysis)
(2) Cut-off of sales revenue (using ratio analysis)
(3) Accuracy of loan interest expense (using a proof in total)
134
(4) Accuracy of wages expense (using a proof in total)
Factors to consider when using analytical procedures

3.7 The auditor will need to consider:
(a) The suitability of analytical procedures to a particular assertion
(b) The reliability of the data from which the expected amounts or ratios are developed
(c) Whether the expectation is sufficiently precise to identify a material misstatement
(d) The amount of any difference that is acceptable without further investigation being
required
Tests of detail
3.8 Tests of detail are a further type of substantive procedure and describe the process of
gathering audit evidence through detailed inspection of invoices, documents and assets.
3.9 Examples of tests of details include:

Inspection of invoices to verify the accuracy of the amounts recorded in the financial
statements
Physical inspection of non-current assets and inventory to verify their existence
Review of board meeting minutes for evidence of any provisions for legal claims
which should be included in the financial statements
Review of after date monies received per the cash book in order to gain evidence
over the valuation of receivables.
3.10 There are further examples of tests of detail later on in the course.
135
4 Tests of control vs. substantive procedures

4.1 Gaining audit evidence through tests of control is very different from gaining audit evidence
through substantive procedures. For example consider audit tests to check the
completeness of the payables balance:
Tests of control Substantive testing
These focus on the auditor checking their These focus on the auditor performing detailed
understanding of the control being in place and checks on the numbers in the financial
testing that it has operated effectively statements.
throughout the period Source documentation financial statements
This includes: This includes:

Observing the control taking place AEIOU
Reperforming the control
Inspecting evidence that the control has
taken place
Enquire from management the process used to Analytically review the amounts owed to major
reconcile supplier statements. suppliers at the year end compared to the prior
period.
For a sample of supplier statement
reconciliations, inspect the reconciliation to see Enquire from management the reasons for any
evidence that the reconciliation has been significant differences.
performed and any differences investigated and Circularise a sample of year end payables and
resolved. Verify that any necessary changes to request them to confirm the balance owed at
the accounting system have been authorised the year end.
and processed.
Inspect the cash book payments in the post
Reperform the reconciliation to ensure it has year end period for any significant payments to
been completed accurately. suppliers to ensure the year end liability is
Inspect the reconciliation to verify it has been accurately recorded.
reviewed by an appropriate level of Calculate the payables days ratios and
management. compare to the prior period. Discuss any
Observe a supplier statement reconciliation significant differences with management.
being performed.
Does the control operate efficiently? Is the balance complete?

This will depend on the level of errors in the This will depend on the level of errors in the
sample, i.e. the number of times the control sample, i.e. the monetary value of any errors.
did not operate.
136
5 Chapter summary
1 Introduction Auditors need to gain audit evidence in order to
support the audit opinion they give.
2 Quality of evidence ISA 500 requires the auditor to obtain sufficient
appropriate audit evidence. Evidence is appropriate
if it is both relevant (to the financial statement
assertion being tested) and reliable.
3 Procedures for There are two types of audit procedures: tests of
obtaining audit control and substantive procedures. Substantive
evidence procedures are broken down into two further
categories: analytical procedures and tests of detail.
The mnemonic 'AEIOU' serves to remind you of the
ways in which you can generate audit procedures.
4 Tests of control vs. Tests of control involve identifying and repeatedly
substantive procedures testing an entitys internal controls in order to gather
audit evidence. Substantive procedures are used by
the auditor to detect material misstatements.
137
END OF CHAPTER
138
Internal control

Explain why an auditor needs to obtain an
understanding of internal control relevant to the
audit
Describe and explain the five components of an Q12 Section A pilot paper
internal control system; the control environment,
the entitys risk assessment process, the
information system, control activities relevant to
the audit and monitoring of controls
Explain how auditors record internal control
systems including the use of narrative notes,
flowcharts, internal control questionnaires and
internal control evaluation questionnaires
Evaluate internal control components, including
deficiencies and significant deficiencies in internal
control
Discuss the limitations of internal control
components
Describe computer system controls including Q4 Section A pilot paper
general IT controls and application controls
Explain the importance of internal control and risk
management
139
9: INTERNAL CONTROL
Overview
Internal control
Internal control systems Use of internal control Computer system controls

systems by auditors
Responsibilities of Documenting the system

management and auditors
Examples of internal
control
General controls Application controls
Limitations of internal
control
140
9: INTERNAL CONTROL
1 Internal control systems

Section 1 Definition
1.1 Internal control describes the process designed, implemented and maintained by those
charged with governance, management and other personnel to provide them with
reasonable assurance that an entity will achieve its objectives with regard to
The reliability of financial reporting (internal and external)
The effectiveness and efficiency of operations and
Compliance with applicable laws and regulations.
Components of an internal control system

1.2 There are five components of an internal control system:
The control environment Governance and management functions

Attitudes, awareness and actions of management
Sets the tone by creating a culture of honesty
and ethical behaviour
Provides an appropriate foundation for the other
components of internal control
The entitys risk assessment How management identifies risks and decides
process upon actions to manage them
The information system Consists of infrastructure, software, people,

procedures and data
The related accounting records, supporting
information and specific accounts in the financial
statements that are used to record, process and
report transactions
Control activities The policies and procedures that help ensure that
management directives are carried out.
The categories most relevant to an audit are:
Performance reviews
Information processing
Physical controls
Segregation of duties
Monitoring of controls Assess the design and operation of controls over

time
Ongoing monitoring is part of regular
management activity
Separate monitoring may be performed by the
internal audit function
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9: INTERNAL CONTROL
The importance of internal control and risk management

1.3 Implementing a sound system of internal control will help a business safeguard both the
companys assets and shareholder's investment.
1.4 The risks faced by a company change continually.
An internal control system will only help a company achieve its objectives and protect it from
fraud and error if the Board of Directors performs a thorough and regular evaluation of the
nature and extent of risks to which the company is exposed.
1.5 Profits are, in part, the reward for successful risk-taking, and so the purpose of the internal
control system is to help manage and control risk appropriately rather than to eliminate it
altogether.
Responsibilities of management and auditors

1.6
Identify and evaluate risks
Board of Directors Design, operate and monitor a suitable system
of internal control
Set policies on internal control
Seek regular assurance that the system is
functioning effectively
May employ internal Ensure that the internal control system is
audit to monitor controls effective in managing risks
Obtain understanding of the business and the

risks it faces
External auditors Ascertain nature of internal control system
Done in order to design appropriate audit
procedures
May report any control deficiencies identified
Required:
Consider each of the following examples. What checks/ internal controls would you expect to be
carried out in each situation?
142
9: INTERNAL CONTROL
Solution
1 The postman knocks at your front door and
hands you a letter which has been sent by
recorded delivery.
2 You submit a claim for expenses to your
line manager.
3 You need to work an extra day over and
above your normal hours to clear a
backlog of work and will expect to be
paid overtime for this.
4 You are responsible for maintaining the
cash book and have just been passed
the latest bank statement.
5 You have just received a monthly
statement from your main supplier.
6 You are responsible for payroll
processing and you have just received
notification from human resources that
an employee wants to take advantage of
a season ticket loan offered by your
company. Your password does not give
you permission to amend employee
deductions.
7 You have just returned from a 3 month
holiday and are trying to log on to your
computer.
8 You are preparing to pay an invoice
received from a supplier.
9 You have prepared a bank reconciliation
for your supervisor.
10 You are entering 75 sales invoices into
the accounting records and want to
check the accuracy of your posting.
11 You have been working on the computer
but have now gone away to make a cup
of tea leaving the computer inactive for a
period of time.
12 You have a Saturday job operating the till
in a small corner shop which is closing
for the night.
13 You work in a shop that sells diamond
jewellery; the jeweller is very keen to
keep his inventory secure.
143
9: INTERNAL CONTROL
Limitations of internal control

1.7 Unfortunately, even with the best system of internal control, there is no guarantee that a
company will be able to fulfil all of its objectives and be fully protected from fraud and error.
1.8 This is due to the inherent limitations in any system of internal control. These include:
Human error
Processes being deliberately circumvented by employees and others
Management overriding controls
The occurrence of unforeseen circumstances
2 Use of internal control systems by auditors

2.1 ISA 315 Identifying and assessing the risks of material misstatement through understanding
the entity and its environment states that 'the auditor should obtain an understanding of
internal control relevant to the audit'.
2.2 This is used to:
Identify types of potential misstatements
Consider factors that affect the risks of material misstatement
Design the nature, timing and extent of further audit procedures.
144
9: INTERNAL CONTROL
Overview of the statutory audit
2.3
Plan the audit
Understand the entity (including documenting and confirming

the accounting systems and internal controls) (Chapter 6, 9)
Assess risk of material misstatement (Chapter 6)
Select audit procedures to respond to risk of material misstatement (Chapter 9)
Where risk assessment Risk assessment does

includes expectation not include expectation
that controls operate that controls operate
effectively (Chapter 9) effectively (Chapter 9)
Tests of controls (to confirm expectation)

(Chapter 10)
Report
Unsatisfactory to management
Satisfactory
Restricted Full
substantive tests substantive tests
(Chapters 11 to 16) (Chapters 11 to 16)
Overall review of
(Chapter 18)
Report to
management
(Chapter 10)
Auditors
report
(Chapter 19)
145
9: INTERNAL CONTROL
Obtaining an understanding of the entitys internal controls

Section 2.1 2.4 The auditor must obtain and document an understanding of the entitys internal controls
regardless of whether he wants to gain audit evidence by relying on the internal controls.
2.5 This can be done using several methods:
Narrative notes
Flow charts
Internal control questionnaires (ICQs)
Internal control evaluation questionnaires (ICEQs)
Narrative notes and flow charts

2.6 Narrative notes tend to be used to document simple internal control systems.
They are usually typed and detail and explain each stage of the entitys systems.
2.7 It can be difficult to see the wood from the trees when using narrative notes to detail a
more complex system and an alternative to this is to use a flow chart to show each stage of
the process.
Internal control questionnaires

2.8 Internal control questionnaires (ICQs) comprise a series of questions on each key
transaction cycle (sales, purchases etc) which seek to determine whether a control exists.
Examples of questions on an ICQ are:
Is a bank reconciliation performed each month? Yes / No / Comments
Is the bank reconciliation reviewed by a supervisor or member of Yes / No / Comments
management?
2.9 ICQs identify where internal controls exist, are quick to prepare and can be completed by
junior staff.
2.10 They can, however, give a distorted view of the entitys internal controls as there is no
weighting of more important controls. They may not be relevant to unusual systems.
146
9: INTERNAL CONTROL
Internal control evaluation questionnaires

2.11 Internal control evaluation questionnaires (ICEQs) are slightly more robust in that they
ask questions which enable the auditor to elicit the controls which exist.
An example of a question on an ICEQ is:
Is there reasonable assurance that Goods cannot be received without an associated
liability being recorded in the accounting records?
2.12 The idea behind the above question is that the person responsible for this part of the
purchases cycle will answer:
Yes, because a sequentially numbered, multi-part goods received note is generated upon
receipt of the goods and one copy passed to the accounts department. This is then filed
whilst we wait for the suppliers invoice. This file is then reviewed at the end of each
month and an accrual made for any goods received which have not yet been invoiced.
2.13 The auditor would only ever test the internal controls to gain audit evidence if the initial
assessment indicates that the controls are relevant to the financial statement assertions and
appear to be operating effectively.
Testing internal controls to gather audit evidence

2.14 The diagram in section 2.3 shows that the auditor will make an initial assessment as to
whether or not the companys internal controls appear to be operating effectively.
2.15 If the internal controls appear to be strong, then the auditor will carry out tests of control
(chapter 10) to gather evidence that the controls
Are properly designed and
Have operated effectively throughout the period.
2.16 If the results of the tests of control support the auditors initial assessment then the auditor
will conduct restricted substantive procedures.
2.17 Some substantive testing is always necessary due to the inherent limitations in any system
of internal control (section 1.8).
2.18 Where the results of the tests of control indicate that the internal controls are not effective,
the auditor will
Report the deficiencies in internal controls to those charged with governance (chapter
10) and
Perform full substantive testing.
147
9: INTERNAL CONTROL
148
Additional
Notes
149
9: INTERNAL CONTROL
3 Types of computer control (ISA 315)

3.1 As part of the risk assessment process, the auditor should obtain an understanding of how
Section 4 the entity has responded to the risks arising from information technology.
3.2 The controls which the auditor would expect to find can be considered in two categories:
(a) General controls: policies and procedures that relate to many applications and
ensure the proper operation of application controls.
(b) Application controls: manual or automated procedures that typically operate at a
business process level. Application controls can be preventative or detective in nature
and are designed to ensure the integrity of the accounting records. Accordingly,
application controls relate to procedures used to initiate, record, process and report
transactions or other financial data.
3.3 Application controls and general controls are inter-related. Strong general controls
contribute to the assurance which may be obtained by an auditor in relation to application
controls. Unsatisfactory general controls may undermine strong application controls.
150
9: INTERNAL CONTROL
4 General controls
4.1 General controls are policies and procedures that relate to many applications and support
the proper operation of information systems. They commonly include the following:
General controls Examples

Development of Standards over systems design, programming and documentation
computer Full testing procedures using test data
applications
Approval by computer users and management
Segregation of duties so that those responsible for design are not
responsible for testing
Installation procedures so that data is not corrupted in transition
Training of staff in new procedures and availability of adequate
documentation
Prevention or Segregation of duties
detection of Full records of program changes
unauthorised
Password protection of programs so that access is limited to
changes to programs
computer operations staff.
Restricted access to central computer by locked doors, keypads
Maintenance of programs logs
Virus checks on software: use of anti-virus software and policy
prohibiting use of non-authorised programs or files
Back-up copies of programs being taken and stored in other
locations
Control copies of programs being preserved and regularly compared
with actual programs
Stricter controls over certain programs (utility programs) by use of
read-only memory
Testing and Complete testing procedures
documentation of Documentation standards
program changes
Approval of changes by computer users and management
Training of staff using programs
Controls to prevent Operation controls over programs
wrong programs or Libraries of programs
files being used
Proper job scheduling
Controls to prevent Password protection
unauthorised Access restricted to authorised users only
amendments to data
files
151
9: INTERNAL CONTROL
General controls Examples

Controls to ensure Storing extra copies of programs and data files off-site
continuity of Protection of equipment against fire and other hazards
operation
Back-up power sources
Disaster recovery procedures e.g. availability of back-up computer
facilities.
Maintenance agreements and insurance
5 Application controls
5.1 Application controls ensure that all transactions are authorised and recorded, and are
processed completely, accurately and on a timely basis. Application controls include the
following:
Control Examples
Controls over input: Manual or programmed agreement of control totals
completeness Document counts
One-for-one checking of processed output to source documents
Programmed matching of input to an expected input control file
Procedures over resubmission of rejected controls
Controls over input: Programmes to check data fields (for example value, reference
accuracy number, date) on input transactions for plausibility:
Digit verification (e.g. reference numbers are as expected)
Reasonableness test (e.g. sales tax to total value)
Existence checks (e.g. customer name)
Character checks (no unexpected characters used in reference)
Necessary information (no transaction passed with gaps)
Permitted range (no transaction processed over a certain value)
Manual scrutiny of output and reconciliation to source
Agreement of control totals (manual/programmed)
Controls over input Manual checks to ensure information input was:
authorisation: Authorised
Input by authorised personnel
Controls over Similar controls to input must be in place when input is completed, for
processing example, batch reconciliations
Screen warnings can prevent people logging out before processing is
complete
Controls over master One-to-one checking
files and standing Cyclical reviews of all master files and standing data
data Record counts (number of documents processed) and hash totals
(for example, the total of all the payroll numbers) used when master
files are used to ensure no deletions
Controls over the deletion of accounts that have no current balance
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9: INTERNAL CONTROL
6 Chapter summary
1 Internal control A companys internal control system is the Board of
systems Directors responsibility and comprises:
The control environment
The entity's risk assessment process
The information system
Control activities, and
Monitoring of controls
Examples of internal controls include approval/

authorisation, reconciliations, computer controls
(passwords, sequence checks), review and physical
controls.
There are inherent limitations in any system of

internal control.
2 Use of internal control The auditor must obtain an understanding of
systems by auditors internal control to:
Identify types of potential misstatement
Assess risks
Design appropriate audit procedures
The auditor must then document their understanding

of the companys internal controls using narrative
notes, flow charts, ICQs and/ or ICEQs.
Where controls appear to operate effectively, the

auditor will test the controls to gain audit evidence.
Some substantive testing must always be done due

to the inherent limitations of internal controls.
3 Types of computer The auditor needs to consider both general and
control application controls in his assessment of control risk.
4 General controls General controls need to be designed and
implemented to mitigate risks arising from information
technology.
5 Application controls Application controls are needed to prevent and detect
errors that can arise when data is input and
processed.
153
9: INTERNAL CONTROL
END OF CHAPTER
154
Tests of controls

Describe control objectives, control procedures, Q6(a) Section B pilot paper
activities and tests of control in relation to:
The sales (revenue) system
The purchases system
The payroll system
The cash system
The inventory system
Revenue and capital expenditure (non-current
assets)
Discuss and provide examples of how the
reporting of significant deficiencies in internal
control and recommendations to overcome those
significant deficiencies are provided to
management
155
10: TESTS OF CONTROLS
Overview
Audit evidence Internal audit reports
Tests of controls
Sales Purchases Payroll
Bank and cash Inventory Revenue and capital

expenditure
Communication of deficiencies in Communication with those charged

internal control with governance
156
1 Audit evidence (recap)

Sources of evidence
1.1 In chapter 8 we saw that there are two main ways in which an auditor can gather audit
evidence. These were:
Tests of controls
Substantive procedures
Procedures for obtaining evidence

1.2 The mnemonic AEIOU can help generate different audit procedures.
1.3 (a) Analytical procedures Evaluation of financial information by a comparison to
financial and non-financial data and the investigation of
identified fluctuations and relationships inconsistent with
other information.
(b) Enquiry and Seeking information of knowledgeable persons throughout
confirmation the entity or outside the entity (enquiry) and
obtaining representations directly from a third party
(confirmation).
(c) Inspection Examining records, documents and tangible assets.
(d) Observation Looking at a process or procedure being performed by
others.
(e) recalcUlation Checking the arithmetical accuracy of documents or
records and the auditor's independent execution of
procedures and reperformance of controls.
1.4 Analytical procedures and confirmation are purely substantive procedures.
1.5 Enquiry, inspection, observation and recalculation can all be used as either a test of control
or as a substantive procedure.
157
2 Tests of controls
2.1 Internal controls are implemented by management to prevent or detect fraud and error.
2.2 The auditor will only ever carry out tests of controls if their initial risk assessment suggests
that the entitys internal controls operate effectively.
2.3 If this is the case, then the auditor will perform tests of controls to gather audit evidence
about relevant audit assertions.
2.4 The auditor must test that the control:
Is properly designed
Exists, and
Has operated throughout the period.
2.5 Failures of internal controls (or deviations) should be recorded and investigated regardless
of the amount involved.
The auditor must assess whether deviations are isolated departures or indicate existence of
errors in accounting records.
2.6 If the results of the tests of control are unsatisfactory, then the auditors preliminary
assessment of control risk is not supported and the auditor must modify the nature, timing
and extent of his planned substantive procedures.
2.7 Tests of controls include enquiry in combination with other audit procedures, for example:
Inspection of documents supporting controls or events to gain audit evidence that
controls have operated effectively, for example verifying that a transaction has been
authorised
Observation of the entity's control procedures, for example observing an inventory
count to ensure it is being conducted in accordance with the inventory count
instructions
Reperformance of the application of a control to ensure it was performed correctly,
for example reperforming a bank reconciliation to verify that it has been done properly
Examination of evidence of management reviews, for example minutes of board
meetings
Testing of the control activities performed by a computer, using for example
computer-assisted audit techniques (CAATs).
158
3 Transaction cycles
3.1 There are six transaction cycles detailed in the syllabus:
(1) Revenue
(2) Purchases
(3) Payroll
(4) Bank and cash
(5) Inventory
(6) Revenue and capital expenditure
3.2 The first three cycles are covered in section 3 whilst the other cycles are addressed in the
additional notes section to this chapter.
Sales (Revenue) Cycle

3.3 The sales cycle/ sales system consists of four main stages. Each stage has its own key
documentation.
(1) Order placed Order form
(2) Despatch of Goods despatch

goods note (GDN)
(3) Goods invoiced Invoice

and recorded
(4) Payment Remittance advice

received
159
based in China. Dress You Like Cos accounting system uses the American dollar as its currency
however most of its Chinese suppliers business contacts are based in Europe and so it both
You are an audit senior in Check and Co and you are carrying out the controls work on the sales
system for the year ended 30 September 20X1. You have access to the systems notes that Dress
You Like Co provided to their previous auditors for the year ended 30 September 20X0 and you
have spoken to several members of Dress You Like Co staff to obtain more information about the
sales system.
Extract from Dress You Like Cos sales systems notes for the year ended 30 Sept 20X0
Order Placed
Customers contact Dress You Like Co by phone or email and inform the sales team which
products they require. A member of the sales team completes a standard form with all of the
customer details and forwards this to the warehouse for despatch to the customer.
Despatch of Goods
The warehouse manager collates all of the orders from the previous day and passes them to the
picking team. This team then picks the items, packages them and produces a goods despatch
note detailing all of the products. The warehouse manager then organises delivery of the products
for the following day.
Goods Invoiced and Recorded
Each day the finance team receive copies of the GDNs completed by the warehouse staff and use
these to generate invoices. Each invoice has the customer details, the products despatched and
the standard prices. The supermarket chain has its own price list, which is significantly discounted
on the other retailer prices.
Payment Received
Customers can pay by cash, cheque or BACS and should return a remittance advice with all
payments. There is no formal process for monitoring old debts. Bank reconciliations are
performed on a weekly basis by the accounts team and monthly by the internal audit department.
160
Transcripts of conversations with Dress You Like Co staff (available as video clips)
Interview with Jenny Bristow, sales team
You: So Jenny, can you tell me a little more about the standard form that you complete
when you receive an order?
Jenny: Sure. The order form is three part, we complete it by hand using the information the
customer has provided by phone or email. We refer back to the standard product list,
which all our customers have a copy of, to ensure that we have the correct product
codes for each item. Once the form is complete we send one copy to the customer
(either by post or scanned and emailed), one copy is sent to the warehouse and we
retain one copy here.
You: OK, is the process any different for the supermarket?
Jenny: No, not really. For the supermarket we send the order straight to the despatch team
in the warehouse so the order can be sent quickly, rather than sending it to the
warehouse manager.
You: Thanks. Oh, one more question. What happens with new customers?
Jenny: How do you mean?
You: Well, do you have any specific checks on new customers or any prescribed credit
limits?
Jenny: Umm, no not really. We just record their details on the form as normal and then pass
the order onto the warehouse.
You: Brilliant, thanks very much.
Jenny: Youre welcome.
Interview with David Furber, warehouse manager

You: Hi David, thank you for taking the time to help me today.
David: Fine, but this had better be quick, Im very busy.
You: OK. Can you tell me how the process for despatching goods works?
David: Well, I get the orders from the sales team through the day, then at the beginning of
the next day I allocate them to the boys in the warehouse to pick and pack while I sort
out delivery drivers for the day after. Simple really.
You: Good, well can you give me a bit more detail on the picking and packing? What
happens if you are out of stock of any item?
David: The boys pick the goods that are on the customer order and they put them in boxes.
Then they write a GDN based on what is in the box. If there is something out of stock
they mark it on the customer order and then pass it back to me. I can then allocate
that order back out to someone to pick tomorrow or the next day. I keep a file with all
of the orders that havent been fully despatched and I check it every day. The
customer might have to wait a few days, but they always get the whole order in the
end.
161
You: OK, do you check this outstanding file back to any other information?
David: Yes, at the end of each month I sit down with Jenny from the sales team. We go
through the outstanding orders file and copies of all of the GDNs to make sure all
orders have been captured.
You: Lovely, thank you very much.
David: Great, I can get back to some proper work now.
Interview with Edward Times, finance assistant

You: Hi Ed, is now a good time to talk about the invoicing process?
Ed: Sure, no problem, what would you like to know?
You: Well, I understand that you get copies of the GDNs from the warehouse team and
you use them to generate invoices, can you give me a bit more detail?
Ed: OK. Every day I get a pile of GDNs from the warehouse for the stuff despatched the
day before and I copy the details from here into the invoicing software. I copy across
the products despatched and the customer details and then the system automatically
applies prices.
You: Does everyone pay the same price?
Ed: No, the supermarket has a special price structure which the system automatically
applies when I record the customer details and everyone else pays the same.
You: OK, can you override the prices in any way, say to offer a special discount?
Ed: No, I cant do that, but Katie can.
You: Katie?
Ed: Yes, Katie Escombe, the acting Finance Director/ Chief Finance Officer.
You: Oh yes. So how does she do that?
Ed: She has a special login to the system which then allows her to amend prices, I dont
really know much more than that except that any changes she makes are reviewed by
another director.
You: Great. I think thats all for now, thanks very much.
Ed: OK, see you later.
162
Interview with Claire Wilson, accounts receivable clerk

You: Thanks for taking the time to meet me Claire. I was hoping to find out a bit more
about the process for receiving payment for invoices?
Claire: OK. Well, customers send us money either in the post or put it straight into the bank.
They should send us remittance advices, so we know what the money is for, but they
dont always do it, especially for the payments direct into the bank.
You: So what do you do if they dont send a remittance advice?
Claire: Well, we try to guess what the amount is for, so if it matches the most recent
statement etc we allocate it to those invoices, but if we cant guess we just allocate it
to the oldest invoices.
You: Right, so what do you do to make sure old debts are paid?
Claire: Well, I dont really have any formal process. I just look out for customers who havent
paid in a long time and give them a call when I have chance.
You: Do you send statements or do any aged receivables analysis?
Claire: Oh, Ive heard about aged receivables analysis, but I dont know if our system will
produce one, Ive never tried.
You: OK, one final thing. Do you do bank reconciliations?
Claire: Not me personally but Simon does them each week.
You: Great, I think thats it. Thanks
Claire: Thanks
Required
Using the Dress You Like Co scenario, identify THREE deficiencies in the sales system of Dress
You Like Co. Explain the possible implications of these and suggest a recommendation (internal
control) to address each deficiency.
163
Solution
Deficiency Implication Recommendation
164
Required
Continuing with the Dress You Like Co scenario, identify THREE controls within the sales system
and recommend a test of control that could be carried out for each control.
Solution
Control Test of control
165
Purchases Cycle
3.4 As with the sales system, the purchases cycle/ purchases system also consists of four main
stages and has key documentation at each stage.
(1) Order stage Purchase requisition

Order form
(2) Goods received Goods received note

(GRN)
(3) Goods invoiced Invoice

and recorded
(4) Payment made Remittance advice
166
You are now carrying out the work on the purchases system at Dress You Like Co. You again
have access to the systems notes that Dress You Like Co provided to their previous auditors for
the year ended 30 September 20X0 and you have spoken to several members of Dress You Like
Co staff to obtain more information about the purchases system.
Extract from Dress You Like Cos purchases systems notes for the year ended 30 Sept 20X0
Order Stage
Re-order levels exist for all items of inventory. When the level of inventory falls to the re-order
level, a standard order form is automatically generated by the inventory system to order a set
quantity of material. The order form details the name of the buyer responsible for that inventory
line and a copy of the order is forwarded to the warehouse where goods are received.
Goods Received
On receipt of the goods, the quality of the materials is checked and then the warehouse manager
generates a sequentially numbered, multi-part goods received note.
Goods Invoiced and Recorded
Each day the finance team receive copies of the GRNs completed by the warehouse staff. These
are filed in sequential number order to await receipt of the associated invoice.
Payment Made
All invoices in the file are automatically paid at the end of each month. The Chinese supplier
sends a monthly statement but this is not reconciled to the purchase ledger account. Bank
reconciliations are performed on a weekly basis by the accounts team and monthly by the internal
audit department.
Transcripts of conversations with Dress You Like Co staff (available as video clips)
Interview with Ivan Higster, purchasing department
You: So Ivan, can you give me some more information about the re-order levels that are
set?
Ivan: Yes, its quite simple really, because were involved in the fashion industry we need to
make sure our products meet current trends so every season the buyers monitor
which items sell well and then adjust the re-order levels for each product in the
current season based on our past experience.
You: Thanks. So what checks do the buyers perform when orders are generated for their
inventory lines?
Ivan: None really, we just get the order through and then place it with our supplier. We do
forward a copy of the order to the warehouse though.
You: Great, thanks for your time.
Ivan: No worries!
167
Interview with David Furber, warehouse manager

You: Hi David, sorry to be asking you some more questions but Im looking at the
purchases system now. Have you got 5 minutes?
David: I wish you auditors would get organised and do all your questions in one go!
You: Sorry David, it shouldnt take long. Would you talk me through what happens when
an order for goods is received in to the warehouse?
David: Well, the goods arrive with a list of whats in each crate and I get the boys to unpack
it. They check the condition of each roll of material and make sure the quality looks
satisfactory and that it was packaged securely. Once theyve confirmed to me what
was received, I generate a sequentially numbered, multi-part goods received note. I
send one part of this to the finance team.
You: OK, do you check the details on the goods received note back to any other
information?
David: No, all of our deliveries come from our Chinese supplier so I dont need to make any
checks.
You: Right, thanks then.
David: Thats OK.
Interview with Sadie Thomas, finance assistant

You: Hi Sadie, would it be OK to have a quick chat about the process for recording
purchase invoices?
Sadie: Hi, yes, I was expecting you!
You: Thanks! David tells me that you get copies of the GRNs from the warehouse team.
Can you tell me what happens next in the process?
Sadie: Sure, each day David passes me the GRNs generated by the warehouse for items
that have been received from our Chinese supplier the day before. I file these in
sequential number order so I have them ready for when the supplier invoice arrives.
You: What happens when the invoice arrives?
Sadie: I identify the GRN that it relates to and check the details to the GRN so I know that
weve been invoiced for the right items in terms of product code, quantity and price. I
initial the invoice to show that this has been checked and enter the invoice into the
accounting system. I allocate each invoice the same number as the related GRN and
then staple them together in the file.
You: That sounds very comprehensive. Thanks Sadie.
Sadie: No problem!
168
Interview with Lauren White, accounts payable clerk

You: Hi Lauren, Sadie gave me your name and said you would be the best person to
speak to about the process for paying invoices. Have you got a few minutes?
Lauren: Sure.
You: Great, can you explain to me how invoices get paid?
Lauren: Yes, at the end of each month, I have a look in Sadies file and identify all of the
invoices which are matched to GRNs which are unpaid and then pay them.
You: How do you know which invoices are unpaid?
Lauren: Well theres two ways of knowing really firstly once I pay an invoice I mark it with a
stamp saying paid. Secondly, we always pay all of the invoices received in the
month, so for example, at the end of June I would know that all of the invoices
received in June that have been matched to GRNs need to be paid.
You: Do you have set credit terms with the supplier?
Lauren: Yes they give us 30 days credit from the end of the month so an invoice dated 14th
June would have to be paid by the end of July.
You: OK. Does the supplier send statements?
Lauren: Yes they send us a statement each month which details all of the transactions we
have had with them during the month. I file this in their correspondence file.
You: So how is the actual payment made?
Lauren: We pay by bank transfer. I prepare a schedule detailing the invoices and the total
amount we need to pay. Each of the buyers sign off to say that they authorise the
payments. I then prepare the bank payment authorisation and give all of this
information to Katie to check and authorise the bank transfer.
Required
Using the Dress You Like Co scenario, identify TWO deficiencies in the purchases system of
Dress You Like Co. Explain the possible implications of these and suggest a recommendation
(internal control) to address each deficiency.
169
Solution
170
Required
Continuing with the Dress You Like Co scenario, identify TWO controls within the purchases
system and recommend a test of control that could be carried out for each control.
Solution
171
Wages (Payroll) Cycle

3.5 The wages system has two main areas to consider:
The role of the Human Resources (HR) function
The role of the payroll processing function.
3.6 The HR function tends to focus on areas such as the appointment and removal of staff, staff
appraisals and notifications of salary changes.
3.7 The payroll function deals purely with the processing of payroll information each month.
3.8 Ideally these two distinct roles would be carried out by different members of staff/
departments however this may not be possible in smaller businesses.
3.9 There are inherent risks within a payroll system, including:
Fraud, for example
Establishing fake payroll records
Changing pay rates without authorisation
Claiming payment for more hours than genuinely worked
Cash theft (where wages are paid in cash)
Errors arising from complexities relating to tax and other deductions
3.10 The wages cycle/ payroll system consists of three main stages with documentation at each
stage:
(1) Work Time sheets

recorded
(2) Recognition of Payroll records

payroll liability
(3) Payment made Payslips
172
You are now carrying out the work on the wages system at Dress You Like Co. You have been
given the following information concerning the wages system for the year ended 30 September
20X1.
(i) The factory and warehousing staff record the number of hours worked using a clocking in/
out system which is observed by a supervisor. On arrival at work each morning and at the
end of each days work, each worker enters their unique employee number on a keypad.
Any employee who does not clock out at the end of their shift is automatically clocked out by
the system.
(ii) In order to claim overtime, employees need to complete an overtime claim form and submit
it to the wages clerk.
(iii) The wages clerk, Jake Newman, works in the finance team and is responsible for making
amendments to the computerised wages system in respect of employee holidays and
illness. He also sets up and maintains all employee records and processes the monthly
payroll.
(iv) The computerised wages system calculates deductions from gross pay, such as employee
taxes, and net pay. Each month a list of net cash payments for each employee is produced
and this is reviewed and authorised by the acting finance director before the employees are
paid by BACS transfer. Deductions are checked by Jake Newman on a periodic basis.
Required
Using the Dress You Like Co scenario, identify TWO deficiencies in the wages system of Dress
You Like Co. Explain the possible implications of these and suggest a recommendation (internal
control) to address each deficiency.
Solution
173
Required
Continuing with the Dress You Like Co scenario, identify TWO controls within the wages system
and recommend a test of control that could be carried out for each control.
Solution
174
4 Communication of deficiencies in internal control

4.1 ISA 265 Communicating deficiencies in internal control to those charged with governance
and management states that significant deficiencies in internal control should be
communicated in writing to those charged with governance.
4.2 This will take the form of a report to management.
4.3 A significant deficiency in internal control is a deficiency or combination of deficiencies in
internal control that, in the auditors professional judgement, is of sufficient importance to
merit the attention of those charged with governance.
Determining whether a deficiency is significant

4.4 The auditor should consider the following matters when determining whether a deficiency in
internal control is a significant deficiency:
The susceptibility to
The likelihood of the loss or fraud of the The subjectivity and
deficiencies resulting in related asset or liability complexity of
material misstatements determining estimated
in the financial amounts
statements
The cause and frequency Consider The amounts exposed

of the exceptions to the deficiencies
identified as a result of
the deficiencies
The volume of activity

The importance of the
that has occurred or
controls to the financial
could occur
reporting process
175
Reports to management
4.5 Once the auditor has decided that there are significant deficiencies which need to be
communicated to those charged with governance, they should include this information in a
report to management.
4.6 In the exam you may be asked only to identify deficiencies in internal control, explain the
implications of the deficiencies and make a recommendation to address these.
4.7 Alternatively you may be asked to include the above information in a report to management.
176
Specimen format for a report to management

4.8
Check and Co
Auditors Address
United Kingdom
Board of Directors
Dress You Like Co
Companys Address
United Kingdom
Date: exam date
Dear Sirs
Audit of Dress You Like Co for the year ended 30 September 20X1
Please find enclosed the report to management on significant deficiencies in internal controls
identified during the audit for the year ended 30 September 20X1.
The report considers deficiencies in the sales system, implications of those deficiencies and
provides recommendations to address those deficiencies.
No credit checks are made The company may well A standard new customer
before new customers are accept an order and form should be created which
accepted and credit limits are despatch goods to a bad must be completed before
not prescribed. credit risk. This may mean orders are accepted from new
that goods are sold to a customers. This form should
customer who cannot pay require a credit check to be
for them leading to a loss of made in relation to the
revenue and inventory. customer and a credit limit
allocated. Standard tiers of
credit limits could be applied
for different customers. All
completed new customer
forms should be authorised
by Edward Times or Katie
Escombe prior to goods being
despatched. The
authorisation should be
evidenced on the form.
Please note that this report only addresses any significant deficiencies identified during the
audit and if further testing had been performed then more deficiencies may have been
reported. It is not therefore a comprehensive list of all deficiencies.
This report is solely for the use of management and if you have any further questions then
please do not hesitate to contact us.
Yours faithfully
Check and Co
177
Reports to management by the internal audit function

4.9 In the example above, the report to management was produced by the external auditor.
4.10 In chapter 5 we saw that one of the roles of the internal audit function is often to review an
entitys internal controls and to report their findings (including any deficiencies) to
management.
4.11 It is very possible therefore that a report on deficiencies, implications and recommendations
might be prepared by the internal audit function. The format of such a report will be
determined by management and is much more flexible than the above report by the external
auditor.
4.12 An example internal audit report is included in the additional notes section of this chapter.
178
Additional
Notes
179
5 Other transaction cycles: Bank and cash

5.1 Another transaction cycle included in the syllabus is bank and cash.
5.2 The main objectives/ stages of the internal controls in this cycle are to ensure:
All monies received are recorded
All monies received are banked
Cash and cheques are safeguarded against loss or theft
All payments are authorised, made to correct payees and recorded
Payments are not made twice for the same liability.
5.3 To a large extent many of these objectives overlap with the final stages of the sales and
purchases cycles.
Stage: All monies received are recorded

Risk Controls Tests of Controls
That monies are There should be a segregation of Observe the process of the post
received but not duties in place between those being opened and monies received
recorded. receiving the monies and those recorded to ensure the entitys
recording them in the accounting internal controls are being adhered
system. to.
Two people should open the post Inspect documentation such as the
and record the amounts received on receipts listing and the bank paying
a receipts listing. This information in slip for evidence of each staff
should then be passed to another member carrying out their separate
member of staff who will then record part of the process.
the entries in the cash book and write
out the bank paying in slip.
Another member of staff should be
responsible for banking any monies
received.
Stage: All monies received are banked
That monies Bank reconciliations should be Re-perform the bank reconciliation to
received are not performed on a weekly/ monthly ensure it has been done accurately.
banked. basis by someone not responsible for Review the bank reconciliation for
the banking and the reconciliation evidence of the supervisor/ manager
reviewed by a supervisor/ manager. review being performed.
180
Stage: Cash and cheques are safeguarded against loss or theft

That cash/ Unbanked receipts should be kept in Physically verify the location of
cheques are a locked safe at all times. unbanked receipts/ cheque books to
misappropriated. Cheque books should be kept by a ensure they are kept securely.
supervisor/ manager and stored in a
secure location such as a locked
drawer/ cash tin or safe.
Stage: All payments are authorised, made to correct payees and recorded
That invoices are All invoices should be authorised for Inspect a sample of invoices for
paid without being payment and coded to the relevant authorisation and appropriate coding.
authorised/ paid to supplier by the appropriate budget
the wrong supplier holder prior to the invoice being paid.
and/ not recorded Authorisation/ coding should be
accurately in the evidenced by a signature.
accounting Statements received from suppliers Review a sample of supplier
records. should be reconciled to the relevant statement reconciliations to ensure
purchase ledger account on a that they have been completed
monthly basis. Any subsequent accurately and any resultant changes
changes to the accounting records authorised.
must be authorised.
Stage: Payments are not made twice for the same liability
That an invoice is Once paid the invoice should be Inspect a sample of invoices for
paid twice. stamped paid. evidence that calculations have been
re-performed and the invoice
stamped as paid.
Attempt to process a payment for an
Purchase invoices should be
invoice which has previously been
sequentially numbered and the
paid to determine whether the
invoice recorded as paid on the
system will block the payment.
system so that the computer will not
allow the same invoice to be paid
twice.
181
6 Other transaction cycles: Inventory

6.1 Another transaction cycle included in the syllabus is inventory.
6.2 The main objectives/ stages of the internal controls in this cycle are to ensure:
Only goods required by the entity are accepted
Damaged goods are not accepted
The business is not interrupted due to stock outs
Inventory is kept securely (not damaged or stolen).
6.3 As with bank and cash, to a large extent many of these objectives overlap with the middle
stages of the purchases cycle.
Stage: Only goods required by the entity are accepted

That goods which A copy of the authorised order form Inspect a sample of GRNs for
have not been should be passed to the warehouse. evidence of a signature verifying that
ordered are When goods are received, they the goods received were traced back
accepted. should be matched to the order form to an authorised order form.
and only accepted if they were
ordered.
The GRN should be signed to
evidence that it has been vouched
back to the order form.
Stage: Damaged goods are not accepted
That damaged/ On receipt of goods all items are to Observe the receipt of goods by staff
faulty goods are be verified to ensure they are in to confirm the control is carried out.
accepted. satisfactory condition.
Stage: The business is not interrupted due to stock outs
That goods On receipt of goods the warehouse Observe the receipt of goods into the
ordered are not should raise a multi-part, sequentially warehouse to ensure all goods are
received, numbered goods received note recorded and a GRN generated.
potentially leading (GRN). One part of the GRN should Verify that the GRN is matched to the
to stock outs. be passed to the purchasing order form by the purchasing
department to be matched to the department.
order form.
Unmatched orders should be Enquire as to the action taken where
reviewed on a periodic basis and orders are unfulfilled and re-perform
suppliers chased. this process.
182
Stage: Inventory is kept securely (not damaged or stolen)

That inventory is Inventory should be stored in an Inspect the environment in which
damaged/ stolen. appropriate environment (for inventory is stored to ensure is it
example perishable inventory should suitable for the nature of the
be kept at the right temperature/ inventory.
refrigerated if necessary).
Access to inventory should only be Inspect the identity cards of
granted to the appropriate personnel. employees working within the
inventory area.
Items should only be issued from Inspect a sample of GDNs to verify
inventory if accompanied by a copy that they relate to bona fide customer
of a customer sales order form. orders.
7 Other transaction cycles: Revenue and Capital

Expenditure
7.1 Another transaction cycle included in the syllabus is revenue and capital expenditure.
7.2 Many of the objectives overlap with the initial stage of the purchases cycle where an entity
must ensure that only goods required are ordered and that all orders are authorised.
7.3 The principle internal controls in this cycle which have not already been detailed in the
purchases cycle are to ensure:
That revenue and capital expenditure is appropriately classified in the accounting
records
That capital items are recorded in the non-current asset register.
183
Stage: That revenue and capital expenditure is appropriately classified in the

accounting records
That revenue Separate order forms should be used
expenditure is for the purchase of inventory items
recorded as (see purchases cycle) and capital
capital items.
expenditure or For capital items, the order should be
vice versa. authorised by one or two managers/
directors depending on the value of Inspect a sample of orders for capital
items ordered. The order should be items. Vouch that the appropriate
coded to the appropriate non-current level of authorisation has been made
asset account. and evidenced by a signature. Verify
Periodically review the revenue and that the account code relates to the
capital expenditure nominal ledger item ordered.
accounts for evidence of large/ Discuss with management the
unusual items which may have been outcome of the nominal ledger
incorrectly recorded. reviews. Inspect any journals made
to correct errors to ensure that they
have been authorised.
Stage: That capital items are recorded in the non-current asset register
That capital items Periodically review the non-current For a sample of non-current assets,
are not recorded assets held by the business and inspect the non-current asset register
in the non-current trace them through to verify that they to ensure that they have been
asset register. are recorded in the non-current asset included.
register.
On a monthly basis, reconcile the Review the reconciliation to see the
totals on the non-current asset level of adjustments required.
nominal ledger codes to the balance Discuss with management why errors
per the non-current asset register. have occurred and the action being
Investigate any differences. taken to reduce future errors.
Authorise all adjustments.
184
8 The sales system revisited

8.1 The sales system was covered in section 3 using a practical scenario for the entity Dress
You Like Co.
8.2 In exam questions it is important to use the scenario to generate your answer rather than
rote learn lots of internal controls and tests of controls.
8.3 You should try to complete as many practice questions on this area as possible. To help
you in this, we have included some other examples of internal controls and tests of controls
below.
Stage: Order Placed

That an order is Conduct a credit check on all new Inspect a sample of new customer
accepted from customers prior to accepting an accounts to ensure that credit checks/
and goods order. The credit check should be references were obtained before the
despatched to a undertaken by someone separate order was accepted.
customer who is from sales department.
not credit worthy. For a sample of customer accounts,
Once accepted, new customers attempt to process an order that will
should be given a credit limit these take a customer over their credit limit
should be reviewed regularly. to determine whether the order is
rejected.
That an order is Orders should be completed on Using a computer (or manually) test
not fulfilled sequentially numbered order forms the numerical sequence to ensure it is
leading to loss of and sequentially numbered goods complete.
future business despatched notes (GDN) generated Review a sample of unfulfilled orders
from dissatisfied from the same information. and enquire as to why these remain
customer. outstanding.
A copy of the GDN should be passed
to the sales department by the
warehouse team once the order is
despatched.
The sales team should regularly
review any order forms which are not
matched to GDNs.
That the wrong Spot checks should be conducted on Vouch a sample of items packed to
items, wrong goods once they have been packed the GDNs and order form to ensure
quantity or to ensure the goods packed are in the goods packed are accurate.
damaged goods good condition and agree to the order Physically inspect a sample of goods
are despatched. form. which have been packed.
Review customer complaint files for
evidence of incorrectly despatched
goods.
185
Stage: Despatch of Goods

That goods are On receipt of the goods, the customer Review a sample of GDNs for
not despatched signs the multi part GDN. evidence of the customers signature.
to the required
destination. One copy should then be left with the
customer and the others returned with
the delivery driver (and one copy
passed to the sales team, one
retained in the warehouse and one
passed to the invoicing department).
Stage: Goods Invoiced and Recorded
That goods Invoices should be sequentially Match a sample of GDNs with the
despatched are numbered and generated using the corresponding invoice.
not invoiced/ not information on the GDNs.
invoiced Perform a sequence check of
correctly. All invoices should be authorised and invoices to ensure all invoices are
details agreed to price lists/ credit recorded.
terms. Compare a sample of invoices with
the authorised price list and credit
terms to ensure they are accurate.
That invoices Periodically review customer Review customer correspondence
are posted to the accounts for any unpaid amounts. files for evidence of any complaints/
wrong customer instances of incorrect invoices being
account. Send statements to customers on a
applied to a customers account.
monthly basis.
Stage: Payment Received
That cash is not Produce an aged receivables report Review the aged receivables report
received. on a monthly basis and actively and discuss the action taken on old/
pursue old/ overdue balances. overdue balances with credit control.
That payments There should be segregation of duties Observe the procedures in place to
received are between those who update ensure segregation of duties.
misappropriated. receivables ledger and those who:
raise invoices
raise credit notes
follow up statement queries
open and count cash.
Cash/ cheques should be kept Observe the procedures for banking
securely and banked promptly. cash/ cheques.
186
9 The purchases system revisited

9.1 As with the sales system, we have included some other examples of internal controls and
tests of controls below.
Stage: Order Stage

That an order is Orders should only be raised on Review a sample of orders for
unauthorised receipt of an authorised purchase evidence that the purchase
and not for requisition which is approved by the requisition was authorised and the
business use department manager. goods are for business use.
That the entity Orders should only be placed with a For a sample of orders, vouch that
does not buy supplier which is on the entitys list of the suppliers used are on the
items at the most preferred suppliers which have been preferred supplier listing.
competitive approved in terms of cost and quality.
price. For non-standard items separate
quotations may be required.
Stage: Goods Received
That goods On receipt of goods the warehouse Observe the receipt of goods into the
ordered are not should raise a multi-part, sequentially warehouse to ensure all goods are
received, numbered goods received note recorded and a GRN generated.
potentially (GRN). One part of the GRN should Verify that the GRN is matched to
leading to stock be passed to the purchasing the order form by the purchasing
outs. department to be matched to the department.
order form.
Unmatched orders should be
reviewed on a periodic basis and
Enquire as to the action taken where
suppliers chased.
orders are unfulfilled and re-perform
this process.
That faulty goods On receipt of goods all items are to be Observe the receipt of goods by staff
are accepted. verified to ensure they are in to confirm the control is carried out.
satisfactory condition.
187
Stage: Goods Invoiced and Recorded

That the liability Another part of the GRN should be For a sample of GRNs trace through
for goods passed to the accounts department. to corresponding invoice and verify
received is not Invoices received from suppliers that the invoice has been recorded in
recognised in the should then be matched to the GRN. the accounting records.
accounting Where no invoice has been received
Unmatched GRNs should be
records. verify that the relevant accrual has
reviewed periodically and an accrual
posted for the associated liability. been recorded.
That a liability is Upon receipt of a supplier invoice, it For a sample of invoices recorded,
recognised for should be matched to the sequentially vouch the details back to the GRN
goods which numbered GRN and order form. The and order form to verify that the
have not been invoice should be allocated the same goods were received.
received. sequential number.
Stage: Payment Made
That payments All invoices should be authorised for Inspect a sample of invoices for
are made to the payment and coded to the relevant authorisation and appropriate coding.
wrong supplier. supplier by the appropriate budget
holder prior to the invoice being paid.
Authorisation/ coding should be
evidenced by a signature.
Statements received from suppliers Review a sample of supplier
should be reconciled to the relevant statement reconciliations to ensure
purchase ledger account on a that they have been completed
monthly basis. Any subsequent accurately and any resultant changes
changes to the accounting records authorised.
must be authorised.
That an invoice Prior to being paid all invoices should Inspect a sample of invoices for
is paid twice/ is be agreed to the GRN and order form evidence that calculations have been
for the wrong and calculations such as unit price, re-performed and the invoice
amount. sales tax, quantities and discounts stamped as paid.
agreed to the appropriate records.
Once paid the invoice should be
stamped paid.
10 The payroll system revisited

10.1 As with the sales and purchases systems, we have included some other examples of
internal controls and tests of controls for the wages/ payroll system below.
188
Stage: Work recorded

That hours worked are Hours worked should be recorded Observe a sample of
not recorded accurately. using timesheets or a clocking in and employees clocking in and
out system. out to ensure it is done
Hours recorded to be reviewed by according to the entitys
responsible official. procedures.
Inspect a sample of
timesheets for evidence
that they have been
reviewed by a responsible
official.
That additional hours are Overtime must be authorised by an For a sample of overtime
recorded which have not appropriate supervisor/ manager in payments, trace back to the
been worked. advance of the overtime being carried overtime authorisation form
out and an overtime authorisation form and inspect the form for
completed. evidence of the overtime
being authorised.
Stage: Recognition of payroll liability
That fictitious employees Where new joiners are taken on/ Obtain a list of joiners/
are paid. current employees leave human leavers during the period
resources (HR)/ staff manager should and trace a sample through
complete and sign a joiners/ leavers to ensure that appropriate
form which should be passed to payroll. HR documentation was
Payroll must acknowledge receipt of completed and the payroll
the form/ changes to the payroll system system amendment
should be made and amendments to accurately.
the system subsequently reviewed by a
supervisor.
That wages are paid/ Any changes to standing data for Review a sample of the
deductions made at the payroll (employee salaries/ hourly reports showing changes
wrong rate. rates/ deductions from gross wages/ made to standing data to
tax codes etc) should be authorised by ensure that changes made
human resources/ staff manager using were appropriately
appropriate documentation. authorised and accurately
A report of changes to standing data made.
should be printed on a monthly basis Recalculate PAYE and
and reviewed by an appropriate other deductions to ensure
manager to ensure all changes are they have been correctly
bona fide and accurately made. calculated.
189
Stage: Payment made

That employees are not Each month a print out of all amounts Review the print out to
paid the amount that they due to be paid to employees should be determine whether any
are due to receive per printed and reviewed for any unusual unusual items were followed
payroll records/ their amounts/ employees. up. Discuss the outcome with
payslip. management.
Recast the schedule in order
The total of the amount to be paid
to ensure it has been
should be recast.
accurately cast.
If employees are paid by BACS transfer For a sample of employees re-

then the employees bank account perform the controls in place
number should be verified and the to ensure they have been
amount due to each employee agreed completed accurately.
back to the payroll system and payslip.
Vouch the authorisation of the
The BACS transfer should then be
payroll manager/ finance
authorised by the payroll manager/
director.
finance director
If employees are paid in cash then an
Observe cash payment
additional check should be made that
the amount included in the wage packet process.
agrees back to the payslip.
Wage packets should be made up by
two payroll staff and employees
required to sign to confirm receipt of the
wage packet.
11 Internal audit reports

11.1 In chapter 5 we saw that the role of the internal audit function is wide and varied.
In most cases once the internal audit function has completed an assignment, it would be
Chapter 5
Section 5 usual for them to prepare a report which summarises their findings.
11.2 Internal audit reports are therefore flexible and can take different formats depending on the
nature of the assignment.
The format of the report would be agreed with management before the assignment is
undertaken.
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11.3 The following is a brief example of a systems review report which has been produced
following an assignment carried out by the internal audit function.
More complicated assignments are likely to summarise the main findings and include a
number of appendices containing detailed information.
REPORT
To: Board of Directors of Robinson Co
From: Internal audit department
Subject: Review of sales system
Period of fieldwork: March 20XX
Terms of Reference
The scope of the assignment was to carry out a thorough review of the sales system.
This involved performing tests of controls on the existing sales system to determine
whether the controls were operating effectively.
In addition, we considered the key risks surrounding the sales function and identified any
risks for which we found no related controls.
We have been able to make recommendations regarding existing controls as well as
suggest new controls where we believe they are needed.
Executive Summary
The main findings from our review are:
The sales system, on the whole, comprises adequate controls
Some specific control deficiencies were identified and recommendations are given
in the Appendix to the report.
Follow-up
Responsibilities have been allocated for introducing/ improving control procedures which
we found to be deficient.
We propose a follow-up review in six months time.
Dated Signed.
Head Internal Auditor
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APPENDIX
Detailed identification of deficiencies, risks and recommendations
Deficiency Risk Recommendation Responsibility Timescale

There is no These new All new customers To be June 20XX
credit check of customers should be subject to a implemented by
new could credit check and the the head of the
customers represent an computer system credit control
prior to increased risk should generate a department.
accepting an of request for
order from irrecoverable authorisation of the
them. debts. new customer before a
sales order can be
accepted.
There is no Any There should be a To be May 20XX

follow up of dissatisfaction monthly reconciliation implemented and
sales orders from between the months managed by the
unmatched to customers not sales orders and the head of the sales
GDNs. receiving their related GDNs. Any department.
goods as unmatched orders
ordered should be followed up
decreases the with queries being
likelihood of directed to head of
repeat sales.
purchases.
Customers are This could lead The proof of delivery To be June 20XX
not asked to to disputes as should be a multi-part implemented by
sign a proof of to whether document. All copies head of the sales
delivery. goods have must be signed by the department.
actually been customer. One copy
delivered, loss should be left with the
of customer customer and the other
goodwill and copy retained within
increased the sales department
irrecoverable along with the order
debts. and invoice.
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12 ISA 260: Communication with those charged with

governance
12.1 In this chapter and also chapters 3 and 5, we have seen that there are often occasions
where the external auditor needs to communicate audit matters with those charged with
governance.
Definition
12.2 ISA 260 defines those charged with governance as the person(s) or organisation(s) with
responsibility for overseeing the strategic direction of the entity and obligations relating to
the accountability of the entity.
Matters the auditor would communicate to those charged with

governance
12.3
The fact that it is the

responsibility of those
The auditors charged with
governance to prepare An overview of the
responsibilities to form
the financial statements planned scope and
and express an opinion
timing of the audit
on the financial
statements
Matters
For listed entities:
A statement confirming their Significant findings from the audit:
independence Views on accounting policies/
Any relationships that may estimates and financial statement
impact their independence disclosures
Safeguards that have been Significant difficulties
implemented to eliminate/ encountered during the audit
reduce threats to Significant deficiencies in the
independence to an design, implementation or
acceptable level effectiveness of internal controls
Written representations
requested by the auditor
Other matters which are
significant to the oversight of the
financial reporting process
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Third parties interested in communications to those charged with

governance
12.4 Occasionally those charged with governance may wish to provide third parties, for example
bankers or certain regulatory authorities, with copies of a written communication from the
auditors.
It is important that the auditor ensures that third parties who see the communication
understand that it was not prepared with them in mind.
12.5 To that effect, written communication from the auditors will include certain caveats:
The report has been prepared for the sole use of the entity
It must not be disclosed to a third party, or quoted or referred to, without the written
consent of the auditors; and
No responsibility is assumed by the auditors to any other person.
13 Chapter summary
1 Audit evidence (recap) Audit evidence can be gained using tests of controls
and/ or substantive procedures.
2 Tests of controls Tests of controls involve repeatedly testing specific
internal controls to ensure that they are properly
designed, exist and have operated throughout the
period.
Internal controls can be tested using enquiry,
inspection, observation and re-performance.
3 Transaction cycles There are six transaction cycles in the syllabus, each
of them could be tested but the most important ones
are sales, purchases and payroll.
Questions on this area will be scenario based and so
you need to be able to identify internal controls and/
or internal control deficiencies from a given scenario.
4 Communication of Significant deficiencies in internal control noted by the
deficiencies in internal auditor will be communicated via a report to
control management. You may need to produce this in the
exam and so will need to be familiar with its contents.
Reports on internal control deficiencies may also be
undertaken by the internal audit function (section 11).
5 Other transaction Controls over bank and cash tend to focus on having
cycles: Bank and cash good segregation of duties, physical controls to
ensure the security of the assets and reconciliations.
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6 Other transaction Most inventory controls are covered by the purchases
cycles: Inventory cycle however it is important that controls exist to
ensure that inventory is safeguarded and kept
securely.
7 Other transaction Again, many of these controls are covered by the
cycles: Revenue and purchases cycle, however additional controls are
Capital Expenditure required to ensure capital expenditure is properly
authorised and recorded in the nominal ledger and
that the non-current assets purchased are recorded in
the non-current asset register.
8 The sales system This section provides additional examples of the risks
revisited that could be present in a sales system scenario and
the types of controls/ tests of controls that could exist.
9 The purchases system This section provides additional examples of the risks
revisited that could be present in a purchases system scenario
and the types of controls/ tests of controls that could
exist.
10 The payroll system This section provides additional examples of the risks
revisited that could be present in a wages system scenario and
the types of controls/ tests of controls that could exist.
11 Internal audit reports Whenever the internal audit function carries out an
assignment, they are likely to produce a report which
details their findings. The reports will vary according
to the type of assignment the internal audit function
has performed. You should be able to describe the
form and content of internal audit reports.
12 ISA 260: There are many different matters which the external
Communication with auditor may communicate with those charged with
those changed with governance. These range from responsibilities for the
governance financial statements, planning issues, audit issues,
internal control deficiencies and the auditors
independence.
195
END OF CHAPTER
196
Audit procedures and
sampling

Discuss the problems associated with the audit and
review of accounting estimates
Describe why smaller entities may have different
control environments and describe the types of
evidence likely to be available in smaller entities
Define audit sampling and explain the need for
sampling
Identify and discuss the differences between statistical
and non-statistical sampling
Discuss and provide relevant examples of, the Q1 Section A pilot paper
application of the basic principles of statistical
sampling and other selective testing procedures
Discuss the results of statistical sampling, including
consideration of whether additional testing is required
Explain the use of computer-assisted audit techniques
in the context of an audit
Discuss and provide relevant examples of the use of
test data and audit software for the transaction cycles
and balances included in the syllabus
Discuss why auditors rely on the work of others
Discuss the extent to which auditors are able to rely on Q8 Section A pilot paper
the work of experts, including the work of internal audit
Discuss the audit considerations relating to entities
using service organisations
Explain the extent to which reference to the work of
others can be made in audit reports
197
11: AUDIT PROCEDURES AND SAMPLING
Overview
Audit procedures and sampling
Sampling Computer-assisted audit Using the work of others

techniques
Experts Service Internal audit

organisations
Audit Test
software data
Audit of accounting Auditing smaller

estimates entities
198
1 Selecting items for testing

1.1 The overall aim of the audit is for the auditor to give an opinion as to whether the financial
statements are free from material misstatement (present fairly).
1.2 The auditor does not test everything and so they need to decide the extent of testing they
will perform.
1.3 ISA 530 Audit Sampling states that the auditor should
determine an appropriate means of selecting items for testing.
Selecting all items Selecting specific Audit sampling

(100% testing) items
Appropriate for: Appropriate for: See section 2

Population with small High value or key
number of items and items
high risk
All items over a
Repetitive calculations certain amount
performed using See 1.4
computer assisted
audit techniques
(section 3)
More common for
tests of detail
1.4 Sometimes the auditor may want to ensure that they test certain items. For example they
may decide they want to review the monies received post year-end from the clients 10
largest receivables balances in order to gather evidence over the valuation of receivables.
1.5 This is not sampling but is often called stratification. This is because the receivables
population has been divided into two discrete sub-populations. One sub-population has the
10 largest balances in it and each of these will be tested. The second sub-population
contains all remaining receivables and the auditor may also test a sample of these balances.
199
2 Sampling
Definition
2.1 Audit sampling means the application of audit procedures to less than 100% of the items
within a class of transactions or account balance such that all sampling units have an equal
chance of selection, in order to provide the auditor with a reasonable basis for forming a
conclusion on the entire population [ISA 530].
Types of sampling
2.2 There are two types of sampling: statistical sampling and non-statistical sampling.
2.3 Non-statistical sampling does not use any mathematical basis for selecting a sample.
2.4 An example of non-statistical sampling is haphazard selection. Here the auditor selects
the items to be included in the sample without following a structured technique but which
avoids any conscious bias or predictability (for example the auditor should not exclude items
which are difficult to locate from the sample purely because of the inconvenience).
2.5 Statistical sampling uses
Mathematical number tables to choose a sample which is free from bias and
Probability theory to evaluate the results of the testing.
2.6 Examples of statistical sampling methods include:
Random selection this process uses random number tables (or a computerised
random number generator) to select the items in the sample
Systematic selection here the number of units in the population is divided by the
sample size to give a sampling interval. For example if the auditor has a population
with 1,000 items and requires a sample containing 200 items then the sampling
interval is 5 (1,000 200). A random starting point within the first 5 is then
determined (say 2) and the auditor will test every 5th item after item number 2 (i.e. 2
then 7 and so on)
Value weighted selection (or monetary unit sampling) here the population is
randomly ordered and items are selected for sampling by weighting the items in
proportion to their value
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Lecture example 1 Preparation
You are the auditor of XYZ Co and are intending to audit trade receivables by circularising a
sample of the year-end balances. The trade receivables listed below have been randomly
tabulated. At the year-end trade receivables amount to $1 million and materiality is $100,000.
Required
State which receivable balances will be selected for sampling using value weighted selection
(MUS).
Solution
Customer Balance ($) Cumulative total ($) Selected (Y/N)
1 60,000
2 70,000
3 90,000
4 105,000
5 28,000
6 100,000
7 46,000
8 1,000
9 84,000
10 94,000
11 108,000
12 34,000
13 160,000
14 20,000
1,000,000
2.7 Advantages and disadvantages of monetary unit sampling (MUS)
The auditor can design and evaluate the Selecting the sample can be time
sample quickly and in a cost effective consuming if CAATs cannot be used to
way using CAATs (section 3) select the sample
All material items are automatically MUS does not cope where there are
selected ensuring all material items are negatively valued items in the population
tested.
MUS will not be effective if the
population is not randomly ordered.
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Sampling risk
2.8 Sampling risk is the risk that auditors conclusion, based on a sample, may be different from
the conclusion that would have been reached if the entire population were subjected to the
same audit procedure. Sampling risk must be reduced to an acceptably low level.
2.9 If the auditor judges that sampling risk is high then he will need to select a larger sample in
order to have reasonable assurance that the results are free from material misstatement.
2.10 There is therefore a direct relationship between sampling risk and sample size.
2.11 Other factors which affect sample size include:
Factor Effect on sample size

Risk of material If the auditor assesses the level of inherent risk and control
misstatement risk to be high then detection risk needs to be low in order to
reduce audit risk to an acceptably low level.
Detection risk includes both sampling and non-sampling risk
and in order for sampling risk to be low a larger sample size
is needed.
Required confidence This describes how confident the auditor needs to be that
level the sample results are representative of the population as a
whole.
The greater the degree of confidence the auditor requires,
the larger the sample size needs to be.
Expected error This relates to the level of errors the auditor expects to find
in the population.
If the level of expected error is high then the sample size will
need to be larger in order to make a reasonable estimate of
the actual amount of the error in the population.
Tolerable error/ This relates to the level of error or misstatement that the
misstatement auditor can accept in the population before he is concerned
that there is a material misstatement.
The lower the level of tolerable errors that can be accepted,
the larger the sample size needs to be.
Evaluation of sample results

2.12 Once the audit procedures have been carried out on the sample, the auditor should evaluate
the sample results to determine whether they are satisfactory or whether further work is
required.
202
2.13 Where there are errors in the sample, the auditor should consider:
The nature and cause of the error
Whether the error is a one-off (anomalous) error or a recurrent issue
Whether the error affects other areas of the audit
2.14 Tests of detail

Where sampling has been used to perform tests of detail, the auditor should project the
monetary errors found in the sample to the population as a whole and compare this to the
level of tolerable error/ misstatement.
Where an error has been established as an anomalous error, it may be excluded when
projecting sample errors to the population (but it still needs to be considered overall in
addition to the projection of the non-anomalous errors).
You are auditing trade receivables and have obtained the following results based on your sample:
Total value of the population $1,000,000
Number of items in the population 400
Number of items tested 20
Total value of the sample $200,000
Error in the sample $9,000
Required
(a) Assuming the errors are not anomalous ones, calculate the expected error in the population.
(b) Assuming that tolerable error/ misstatement was set at $40,000, explain what action should
be taken.
Solution
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2.15 Tests of controls

When sampling has been used to test controls, no explicit projection of errors is necessary
since the sample error rate is also the projected rate of error for the population as a whole.
For example, if the auditor has performed tests of controls on a sample of 20 items and has
found 2 deviations, this represents an error rate of 10% (2/20 100). The auditor must then
decide if this error rate is acceptable.
You are auditing the internal controls relating to the authorisation of adjustments made to a clients
inventory system in order to determine the accuracy and validity of the adjustments. You have
obtained the following results based on your sample:
Total number of adjustments made to inventory records during the year 1,500
Number of adjustments tested in the sample 225
Number of occasions when adjustments tested were not authorised 18
Required
(a) Assuming the errors are not anomalous ones, calculate the error rate in the population.
(b) Assuming that tolerable error/ misstatement was set at an error rate of 13%, explain what
action should be taken.
Solution
2.16 If the evaluation of sample results indicates that there may be significant issues, the auditor
may:
(a) Request management to investigate identified errors and the potential for further
errors and make any necessary adjustments; and/or
(b) Modify the nature, timing and extent of further audit procedures; and/or
(c) Consider the effect on the auditor's report.
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3 CAATs
3.1 Computer-assisted audit techniques (CAATs) involve using a computer to perform audit
work. Computers can be used to perform either substantive tests or tests of controls.
Audit software (used for substantive testing)

3.2 Audit software consists of computer programs used by the auditor, as part of his auditing
procedures, to process data of audit significance from the entitys accounting system.
Audit software can be Read and extract data from a clients system and produce
used to: a report in a specified format, for example,
- the auditor could download the clients sales ledger
on to their own software to get their own (trusted)
software to produce an aged receivables listing. This
can then be used as a basis for testing the valuation
of receivables
- or an aged inventory report.
Select information, for example,
- a sample of suppliers to circularise to test
completeness of the payables balance (perhaps
using MUS)
- or to identify missing, large or unusual items or items
outside specified parameters.
Perform calculations, for example,
- to calculate variances and ratios used in analytical
review
- or to check the accuracy of the casting of the trial
balance or ledger listings
Print reports in specified formats, for example,
- letters to be sent out in a receivables confirmation.
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Test data (used for tests of controls)

3.3 Test data techniques are audit procedures which enter data into an entitys computer
system, and compare the results obtained with pre-determined results.
3.4 Test data is a fictitious set of test transactions which are input in to the client's system in
order to determine whether the internal controls within the entitys computer systems have
operated effectively throughout the period.
3.5 Should an auditor wish to gather audit evidence using test data, he will need significant
co-operation from his client, especially in terms of the time required to access their computer
systems.
3.6 There are two typical uses of test data
(a) Test data used to test specific controls in computer programs
For example, an auditor could try to access data or areas of the computer system
which are password protected in order to determine whether the control is operating
effectively.
(b) Test transactions
Here the auditor processes a series of transactions and monitors the output from the
computer systems in order to determine whether the transactions have been
processed correctly.
This can be conducted 'live' (when the computer systems are operational) or 'dead'
(when the computer system is not in business use). Test transactions normally
involve submitting both valid and invalid data for processing.
Invalid data could include, for example, zero quantity items, negative prices or
extraordinary high prices. The auditor would expect the valid data to be processed
properly and the invalid data to be rejected.
Some computer systems have an embedded test facility. This may comprise a
dummy unit to which test transactions are posted throughout the period or a
systems control and review file (SCARF) where real transactions are replicated and
stored for later review by the auditor.
206
Additional
Notes
207
4 Using the work of others

4.1 Whilst auditors are highly trained individuals, it is possible that when conducting an audit
they encounter issues which are outside the scope of their expertise, for example, valuation
of buildings.
4.2 Additionally, it is increasingly common for companies to outsource specific functions, for
example payroll, to service organisations that have more expertise than the entity.
4.3 As such, the auditor must consider the availability and reliability of the evidence provided by
such experts and by the work of service organisations.
4.4 Also, in some cases, external auditors may want to rely on work done by internal audit.
4.5 When the auditors plan to use the work of others, whether experts, service organisations or
internal audit they must consider:
Scope of work the work of others must be evaluated to determine if it is sufficient and
appropriate.
Organisational status (relevant to internal audit only). The external auditor must evaluate
the status of the internal audit department within the entity. How seriously are its reports
taken? Are its recommendations for improvements implemented?
Due skill and care the auditor must determine that the work of others is completed with
due skill and care i.e. that it is planned, directed, supervised and adequately reviewed.
Independence the auditor must determine that the expert, service organisation or internal
audit department is independent of the client to ensure no bias is reflected in their work.
Technical competence the work of others must be of appropriate quality to be relied upon
by the auditor and hence the expert, service organisation or internal auditor must have the
technical ability and/or qualifications to provide such work.
5 ISA 620 Using the work of an auditors expert

5.1 External auditors may make use of work of an auditors expert, internal auditor and service
organisations and their auditors when carrying out audit procedures.
5.2 An auditors expert is defined as being an individual or organisation possessing expertise in
a field other than accounting or auditing, whose work in that field is used by the auditor to
assist the auditor in obtaining sufficient appropriate audit evidence.
5.3 An auditors expert may provide evidence on the:

(i) Valuations of land and buildings;
(ii) Determination of inventory quantities or physical condition;
(iii) Legal opinions concerning interpretations of agreements, statutes and regulations, or
on the outcome of litigation or disputes.
208
5.4 ISA 620 requires the auditor to evaluate whether the auditors expert has the necessary
competence, capabilities and objectivity. Where the auditors expert is external, the
evaluation of objectivity will include inquiry of interests and relationships that could create a
threat to objectivity.
5.5 Information on these areas may come from the following sources:
Personal experience with previous work done by the expert
Discussions with the expert
Discussions with other people who are familiar with the experts work
Knowledge of the experts qualifications, membership of a professional body or
industry association, licence to practise etc
Published papers or books by the expert
The auditors firms quality control policies and procedures
5.6 When using an auditors expert, the audit shall agree in writing the following matters:
The nature and objectives of that experts work;
The respective roles and responsibilities of the auditor and that expert;
The nature, timing and any report to be provided by that expert; and
The need for the auditors expert to observe confidentiality requirements.
5.7 The auditor should evaluate the appropriateness of the expert's work as audit evidence.
This will involve evaluation of whether the substance of the experts findings is properly
reflected in the financial statements or supports the assertions, and consideration of:
Source data.
Assumptions and methods used and their consistency with prior periods.
Results of the experts work in the light of the auditors overall knowledge of the
business and the results of other audit procedures.
5.8 When issuing an unmodified audit report, the auditor should not refer to the work of an
expert.
5.9 Note: ISA 620 distinguishes between an auditors expert and managements expert.
Managements expert is an individual or organisation with expertise in a field other than
accounting or auditing which is used to assist the entity in preparing the financial
statements.
209
6 ISA 402: Audit considerations relating to an entity

using a service organisation
6.1 Service organisations provide a wide variety of services to businesses. Examples include:
Maintenance of accounting records
Payroll
Credit control
Data entry / information processing.
6.2 Where service organisations are relevant to the financial statements, the auditors (referred
to as user auditors in ISA 402) are required to perform the following procedures:
Understanding the services provided
The auditors must understand the nature of the services provided, the materiality of
transactions processed or the financial reporting processes affected.
They need to determine the effect of the service organisation on internal control, to
enable them to assess the risk of material misstatement in the financial statements.
They can either obtain this from the entity using the service organisation, or by
obtaining a report from the service auditor (an auditor who at the request of the
service organisation, provides an assurance report on the controls of the service
organisation), if this is available.
6.3 Responding to the assessed risks of material misstatement

The user auditor needs to determine whether a sufficient understanding of the nature and
significance of the services provided and their effect on internal control has been obtained to
allow for the identification and assessment of risks of material misstatement in the financial
statements. If they have not, they must perform further audit procedures to obtain such
evidence. e.g. visiting the service organisation or using another auditor to perform
procedures at the service organisation.
6.4 Reporting by the user auditor

The user auditor has sole responsibility for the opinion on the financial statements. They
must be assured that they have sufficient appropriate audit evidence to form an opinion on
the financial statements. They should not refer to the work of a service auditor in the audit
report.
210
7 Use of the internal auditors work for the external audit

7.1 During the course of their planning, the external auditors should perform an assessment of
the internal audit function if they consider that it may be possible, and desirable, to rely on
some of internal audit's work. If the external auditor can rely on the work conducted by the
internal auditor, the volume of detailed work undertaken by the external auditor may be
reduced.
Evaluation of internal audit work

7.2 When the external auditor intends to use the specific work of the internal audit function, the
external auditor should evaluate and perform audit procedures on that work to confirm its
adequacy for the external auditors purposes.
Factors to consider include:
(a) Adequacy of technical training and proficiency
(b) Whether work of assistants is properly supervised, reviewed and documented
(c) Sufficiency and appropriateness of audit evidence to be able to draw reasonable
conclusions
(d) Whether conclusions are appropriate and reports are consistent with work performed
(e) Whether any exceptions or unusual matters disclosed are properly resolved
Auditors report
7.3 The external auditor cannot make reference to work done by the internal auditor in his
auditor's report.
8 ISA 540 Auditing accounting estimates

8.1 Examples of accounting estimates are:
Allowances to reduce inventory and accounts receivable to estimated realisable value
Depreciation
Provisions
accrued revenue
Management often make these estimates in conditions of uncertainty over outcomes and
with the use of judgement. The risk of misstatement is increased, and the evidence available
to detect a material misstatement will often be more difficult to obtain and less persuasive
than that relating to other items in the financial statements.
211
8.2 The auditor is required to obtain sufficient appropriate evidence about whether the
accounting estimates and related disclosures are reasonable. To do this, they perform the
following procedures:
Risk assessment procedures and related activities
They must understand how management identifies the need for accounting estimates
and how these accounting estimates are calculated, including the underlying
accounting assumptions.
Identifying and assessing the risks of material misstatement
Evaluate the degree of uncertainty associated with an accounting estimate.
8.3 Based on the assessed risk of material misstatement, the auditor can determine whether
the estimates are reasonable.
9 Auditing smaller entities

9.1 As detailed in chapter 1, most limited liability companies are generally required by statute to
have their financial statements audited with the exception of dormant companies and
companies which meet the small company exemption criteria.
9.2 The problem of control

(a) Many of the controls which would be relevant to a large enterprise are neither
practical nor appropriate for the smaller entity.
(b) In particular, small enterprises are likely to have poor segregation of duties due to
limited numbers of staff.
(c) Additionally, management override of controls is likely to be an issue as a result of the
close involvement of directors and/or proprietors.
(d) To compensate for these deficiencies, management should instigate additional
physical authorisation, arithmetical, accounting and supervisory procedures.
(e) The attitudes, awareness and actions of management are of particular importance to
the auditors understanding of a smaller entitys control environment.
9.3 Substantive or systems based auditing?

(a) It is important to appreciate that such additional controls will not, and can not, be
relied upon by the auditor as in a systems based approach. However, such controls
within smaller entities do provide overall comfort to the auditor, particularly when
determining whether to seek to rely on management assurances and representations.
(b) As a result, the audit of smaller entities will focus on substantive procedures in order
to provide an opinion on the Financial Statements.
212
10 Chapter summary
1 Selecting items for The auditor needs to decide which items he will select
testing for testing. It is most common for the auditor to carry
out sampling however there may be situations where
he tests 100% of items or where he stratifies the
population in order to test specific items.
2 Sampling Sampling relates to the application of audit
procedures to less than 100% of the population in
order to form a conclusion on the population as a
whole.
Statistical sampling methods provide more comfort
that the sample is free from bias and the sampling
results representative of the population as a whole.
Any errors identified in the sample must be
extrapolated and the impact on the population as a
whole considered.
3 CAATs CAATs describe any process where the auditor uses
a computer to help him carry out his audit procedures.
CAATs used to perform tests of detail (substantive
procedures) are known as audit software whilst
CAATs used to carry out tests of controls are called
test data.
4 Using the work of
others
5 Using the work of an
Auditors may need to place reliance on the work of
auditors expert
others, namely experts, service organisations or
6 Service organisations internal audit.
7 Use of internal
auditors work for the
external audit
8 Auditing accounting Accounting estimates involve judgements and so can
estimates be high risk items in the financial statements.
9 Auditing smaller Smaller entities tend to have more limited internal
entities controls than larger entities and so an auditor auditing
a smaller entity will tend to focus on substantive
procedures.
213
END OF CHAPTER
214
way.

Progress Tests
215
216
Non-current assets

Explain the audit objectives and the audit
procedures relating to:
Tangible and intangible non-current assets:
(i) Evidence in relation to non-current assets and Q6(b) Section B pilot paper
(ii) Depreciation
(iii) Profit/ loss on disposal Q2(b) Section B pilot paper
(iv) The related profit or loss section (income
statement) entries.
217
12: NON-CURRENT ASSETS
Overview
Non-current assets
Evidence on statement of
profit or loss entries
Depreciation
Tangible non-current Intangible non-current Gains/losses on disposals
assets assets Impairments
218
1 Tangible non-current assets

1.1 Non-current assets are usually material balances on the statement of financial position.
1.2 These assets are listed on a non-current asset register which exists outside the double
entry system and reconciles to the balances on the statement of financial position.
Extract - Non Current Asset Register for S Company
Year end 31.12.X9
Purchase Depreciation Accumulated Carrying
Asset date Rate Cost depreciation amount
$ $ $
Computer A 1/1/X8 3 years SL 3,000 1,000 2,000
Computer B 1/1/X7 3 years SL 3,000 2,000 1,000
Computer C 1/1/X8 3 years SL 3,000 1,000 2,000
Office desks 1/1/X5 5 years SL 50,000 40,000 10,000
Office chairs 1/1/X6 5 years SL 25,000 15,000 10,000
84,000 59,000 25,000
1.3 The auditors role is to test that the carrying amount per the non current asset register (in
this example $25,000) is reasonable. Sections 3 and 4 of this chapter discuss the
procedures used.
2 Key assertions
2.1 Completeness, obligations and rights, valuation and existence are key assertions
relating to the audit of non-current assets.
Audit Procedures: TANGIBLE NON-CURRENT ASSETS

COMPLETENESS Obtain or prepare a summary of tangible non-current assets showing
how:
Cost/ valuation
Accumulated depreciation
Carrying amount
reconcile with the opening position.
Compare non-current assets in the general ledger with the non-current
assets register and obtain explanations for differences.
For a sample of assets which physically exist agree that they are
recorded in the non-current asset register.
If a non-current asset register is not kept, obtain a schedule showing
the original costs and present depreciated value of major non-current
assets.
Reconcile the schedule of non-current assets with the general ledger.
EXISTENCE Confirm that the company physically inspects all items in the non-
current asset register each year.
Inspect assets, concentrating on high value items and additions in-
219

year. Confirm that items inspected:
Exist
Are in use
Are in good condition
Have correct serial numbers
Review records of income-yielding assets.
Reconcile opening and closing vehicles by numbers as well as
amounts.
VALUATION Verify valuation to valuation certificate.
Consider reasonableness of valuation, reviewing:
Experience of valuer
Scope of work
Methods and assumptions used
Valuation bases are in line with accounting standards
Reperform calculation of revaluation surplus.
Confirm whether valuations of all assets that have been revalued have
been updated regularly by inquiries of Finance Director and inspection
of previous financial statements.
Inspect draft accounts to verify that client has recognised in the
statement of profit or loss and other comprehensive income
revaluation losses unless there is a credit balance in respect of that
asset in equity, in which case it should be debited to equity to cancel
the credit. All revaluation gains should be credited to equity.
Review depreciation rates applied in relation to:
Asset lives
Residual values
Replacement policy
Past experience of gains and losses on disposal
Consistency with prior years and accounting policy
Possible obsolescence
Review non-current assets register to ensure that depreciation has
been charged on all assets with a limited useful life.
For revalued assets, ensure that the charge for depreciation is based
on the revalued amount by recalculating it for a sample of revalued
assets.
Reperform calculation of depreciation rates to ensure it is correct.
220

Compare ratios of depreciation to non-current assets (by category)
with:
Previous years
Depreciation policy rates
Scrutinise draft accounts to ensure that depreciation policies and rates
are disclosed in the accounts.
Review insurance policies in force for all categories of tangible non-
current assets and consider the adequacy of their insured values and
check expiry dates.
RIGHTS AND Verify title to land and buildings by inspection of:
OBLIGATIONS Title deeds
Land registry certificates
Leases
Obtain a certificate from solicitors/bankers:
Stating purpose for which the deeds are being held (custody only)
Stating deeds are free from mortgage or lien.
Inspect registration documents for vehicles held, confirming that they are in
client's name.
Confirm all vehicles are used for the client's business.
Examine documents of title for other assets (including purchase
invoices, architects' certificates, contracts, hire purchase or lease
agreements).
Review for evidence of charges in statutory books and by company
search.
Review leases of leasehold properties to ensure that company has
fulfilled covenants therein.
Examine invoices received after year-end, orders and minutes for
evidence of capital commitments.
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Lecture example 1
When testing non-current assets in the financial statements, it is the IAS 16 disclosure note as
follows that is being tested:
Land & Furniture

Buildings & Fixtures Total
Carrying amount
Carrying amount at 1/1/20X1 1,600,000 420,000 2,020,000
Additions 400,000 400,000
Revaluation surplus 1,000,000 1,000,000
Charge for year (60,000) (60,000) (120,000)
Disposals (400,000) (400,000)
Carrying amount at 31/12/20X1 2,540,000 360,000 2,900,000
At 31 December 20X1
Cost or valuation 2,900,000 600,000 3,500,000
Accumulated depreciation (360,000) (240,000) (600,000)
Carrrying amount 2,540,000 360,000 2,900,000
At 31 December 20X0
Cost or valuation 2,000,000 600,000 2,600,000
Accumulated depreciation (400,000) (180,000) (580,000)
Carrying amount 1,600,000 420,000 2,020,000
Required
What tests would you perform on each area?
Solution
1 Opening balances?
2 Additions?
222
3 Revaluations? (assume an independent valuation)
4 Depreciation charge for year?
5 Disposals?
3 Intangible non-current assets

3.1 Development expenditure
The audit work undertaken must serve to ensure that the expenditure meets the IAS 38
criteria. Remember that under IAS 38 an entity must capitalise development expenditure if
it satisfies all of the following criteria:
Probable future economic benefits
Intention to complete and use/sell asset
Resources adequate and available to complete and use/sell asset
Ability to use/sell the asset
Technical feasibility of completing asset for use/sale
Expenditure can be measured reliably
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3.2 Audit tests

(a) Review the accounting records to ensure that the expenditure can be readily
measured, e.g. separate cost centre or nominal ledger code.
(b) Review invoices to verify materials expenditure on the project.
(c) Verify wages costs to supporting documentation such as time sheets.
(d) Discuss the technical feasibility with the company's engineers or technical staff.
(e) Consider probability of future economic benefits (i.e. commercial viability) and ability
to sell or use the asset in relation to market research results, advance orders, budgets
and forecasts.
(f) Review budgeted revenues and costs. Ensure that they are reasonable based on
results to date, discussion with directors, production forecasts and advance orders.
(g) Review cash flow forecasts to ensure that adequate resources exist to complete the
project. Discuss any shortfalls with the directors.
(h) Obtain representations from management of their intention to complete the intangible
asset and either use or sell it.
4 Chapter summary
1 Tangible non-current The main emphasis in the audit of non-current assets

assets will be on the higher risk areas of:
Depreciation
Disposals
Impairments
2 Key assertions Completeness, existence, valuation and rights and

obligations are the key non-current asset assertions.
3 Intangible non-current This is likely to focus on development expenditure and
assets the capitalisation criteria of IAS 38.
END OF CHAPTER
224
Inventory

procedures in relation to:
Inventory
(i) Inventory counting procedures in relation to
year-end and continuous inventory systems
(ii) Cut-off
(iii) Auditor's attendance at inventory counting
(iv) Direct confirmation of inventory held by third
parties
(v) Valuation
(vi) Other evidence in relation to inventory.
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13: INVENTORY
Overview
Inventory
Inventory counting Cut-off Other evidence

procedures Valuation
Year end
Continuous inventory
Auditor's attendance at
3rd party confirmations
inventory count
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13: INVENTORY
1 Inventory counting
1.1 The audit approach must consider
Quantity normally arrived at by a year end count
Valuation must apply IAS 2
Disclosure
A particular technique to verify quantity of inventories is for the auditor to attend the clients
inventory count.
Attendance at the inventory count

1.2 (a) Before
(i) Planning
Review working papers for previous year to identify risks and familiarise
yourself with the inventories
Determine arrangements with management in advance
Inventories held by/for third parties what arrangements have been
made?
Review clients inventory count instructions
Investigation of differences (where inventory records exist)
Consider the need for an expert
(ii) Determine procedures to cover a representative selection of inventories
(b) During
Ensure staff are following the inventory counting instructions
Test counts from the inventories to the inventory sheets (completeness) and
from the inventory sheets to the inventories (existence).
Note damaged, old or obsolete inventories.
Review WIP for stage of completion
Inventories held by client for third parties: ensure excluded from count
Record the number of, or photocopy, the last GRN and the last GDN
Form an overall impression of inventory levels
Photocopy inventory sheets
(c) After
Agree sequence of inventory sheets
Reperform clients computation of final figure
Trace own test count items through to final inventory summary
Inspect replies from third parties
Inform management of any problems
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13: INVENTORY
Follow up cut-off details

Ensure necessary adjustments to book inventories have been made (where
records are maintained).
Required
You have been provided with the following inventory count instructions by your client. Identify five
matters that you believe will require action by management if the inventory count is to be effective.
Explain how the matters could be rectified.
(a) Mrs Ishbel Curbar, assistant chief accountant, has overall responsibility for the inventory
count but she is to be assisted by Mr Jack Farditch, the warehouse manager, to whom the
inventory counting teams are to report, and who will be responsible for the detailed
organisation of the count.
(b) Five inventory count teams are to carry out the actual count, each team to be responsible for
a predetermined section of the warehouse. Each team comprises 2 persons, one from the
accounting department and the other from the warehouse.
(c) Each inventory count team is to meet Mr Farditch at 07.30 hours on 29 March 20X1 and will
be provided with pre-numbered and pre-printed inventory sheets for the section of the
warehouse for which they are responsible. These inventory sheets have been prepared by
the inventory control department and show the balance of each inventory item on hand as
shown on the inventory records held independently of the warehouse.
(d) During the count both members of the inventory count team are to count the inventories
independently of each other. In the event of differences arising between inventories counted
and the quantity shown on the inventory sheets, the quantity counted is to be entered
alongside the original quantity and must be initialled by the senior member of the count
team.
(e) Each inventory count sheet is to be signed by the senior member of the count team and the
bin or rack cards held in the warehouse are to be adjusted, if necessary, to actual quantities
counted. All cards are to be initialled to show that the count has been made.
(f) Any goods that appear to be in poor condition are to be deducted from the quantity
appearing on the inventory sheets, such action again to be supported by initials of the senior
member of the count team.
(g) Any queries during the count are to be referred to Mr Farditch to whom inventory sheets are
to be returned at the conclusion of the count. Mr Farditch is responsible for ensuring that all
inventory count sheets have been returned and for forwarding them to Mrs Curbar for
valuation.
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13: INVENTORY
Solution
2 Continuous inventory counting/perpetual inventory

2.1 Some businesses keep inventory records and if these are reliable a year end count is not
required. To determine the reliability of the records, it is necessary for the business to count
inventories on a regular basis. This is called continuous inventory counting or perpetual
inventory.
2.2 (a) Review company's procedures

Independence of counters
Frequency of counts
Ensure all lines covered at least once per year
Investigation of discrepancies
Updating of records
(b) Attend at least one of the company's counts to observe procedures and perform test
counts (in both directions)
(c) Review whole year's results
Extent of counting
Accuracy of records
Reasons for discrepancies
Perform test counts at the year end if the continuous inventory system is found
to be flawed
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13: INVENTORY
3 Cut-off
3.1 Cut-off is a test used to ensure that all of the companys transactions have been included in
Section 5 the correct period.
3.2 Purchases cut-off

All purchases for which goods have been received before the year end must be included in
the financial statements as a liability, expense and closing inventories.
Q24 Sitting Pretty
Goods received after the year end should not be included in the financial statements.
3.3 Sales cut-off

Sales for which the goods have left the warehouse should be included within the sales and
trade receivables at the year end, but not in closing inventories.
Sales made after the year end must not be included in the financial statements but should
be included in closing inventories.
3.4 Cut-off is usually tested by obtaining a sample of GRN and GDN either side of the year end
and then matching them to purchase/ sales invoices to ensure they have been included in
the correct account balance(s).
After
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13: INVENTORY
4 Inventory valuation
Per IAS 2 inventory must be valued at the lower of cost and NRV.
Cost
4.1 (a) Record basis of valuation used
(b) Test material costs
Agree to supplier invoices
Ensure FIFO or appropriate basis is being used
Check quantities used WIP/FG
(c) Test labour costs
Check calculations to supporting documentation
Review costing against actual labour and production
(d) Test application of overheads
Ensure only production overheads included
Ensure based on normal levels of activity
NRV
4.2 Tests to determine whether NRV is lower than cost
Compare the selling prices of goods sold after the year end per sales invoices with
their purchase price per supplier statements
Review order book to determine at what price the goods are ordered at
Write down last year are these items still in inventory?
Analytical review of gross profit margin post year end. If decreases may indicate that
some inventory is being sold for less than cost.
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13: INVENTORY
5 Chapter summary
1 Inventory counting Procedures to verify the quantity of inventory will
depend on whether the client uses a year-end
2 Continuous inventory
inventory count or a continuous inventory.
counting / perpetual
inventory The auditor will attend the inventory count to:
Perform tests of controls (observation)
Obtain substantive evidence of quantity (test
counts, cut-off details)
Obtain preliminary evidence of valuation (note
damaged or obsolete inventories)
3 Cut-off Cut-off tests are used to ensure that transactions have
been recorded in the correct accounting period.
4 Inventory valuation Procedures to audit the valuation of inventory must
cover both cost and net realisable value.
END OF CHAPTER
232
Receivables

Explain the audit objectives and audit
Receivables
(i) direct confirmation of accounts receivable Q4(b) Section B pilot paper
(ii) other evidence in relation to receivables and
prepayments, and
(iii) the related profit or loss section (income
statement) entries
233
14: RECEIVABLES
Overview
Receivables
Statement of financial position: receivables and prepayments

Statement of profit or loss: revenue, irrecoverable debts
expense
Direct confirmation Other evidence
234
14: RECEIVABLES
1 Direct confirmation
1.1 A specific technique used to test for the existence and obligation/rights of receivables is a
direct confirmation (alternatively called 'circularisation'). This is conducted as follows:
(a) Obtain listing of trade receivables as at the confirmation date.
(b) Agree total to nominal ledger.
(c) Review for any obvious omissions/mis-statements by comparing this years list with
last years.
(d) Select a sample of accounts for confirmation. An aged receivables report may be
used to make the selection. For example:
Extract - receivables ledger for S Company
Year end 31/12/X9
Customer Total 30 days 60 days 90 days > 90 days

$ $ $ $ $
H & H Co 500 100 400
Bruce Ltd 734 734
Mayes
appliances 581 235 346
TK Allans 345 345
Harrisons Co 1,292 757 535
ABC partners 50 50
3,502 1,437 1,281 734 50
Select the sample from the following balances:
Old, unpaid amounts
Credit balances
Nil balances
Material balances
Letter should be on the client's paper, signed by the client with a copy of the current
statement attached. It should request that the reply be sent direct to the auditor and
reply paid envelopes should be sent.
(e) After reasonable period, send 'follow-up' request.
(f) Follow up by telephone or fax if there is no reply.
(g) No reply:
Confirmation of individual outstanding invoices
Alternative procedures.
- Agree opening balance on account with last year's closing balance.
- Test casts.
- Verify outstanding items to back up documentation, e.g. GDNs and
customer orders
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14: RECEIVABLES
- Review cash received after year end.

- Discuss with responsible company official.
There are two types of confirmation:
A positive confirmation request is where the confirming party responds directly
to the auditor, indicating whether they agree with the information in the request
or provides the requested information.
A negative confirmation request is where the confirming party responds
directly to the auditor only if they disagree with the information in the request.
You have obtained the following results from 3 receivables balances circularised during the audit of
Chewy Co.
Balance per sales Balance per Reason for

ledger circularisation response difference
$ $
Darth Co 25,000 20,000 Cash in transit
Skywalker Co 55,000 45,000 Goods not received
at
year end
Yoda Co 68,000 57,000 Disputed invoice
Required
Detail the tests you would perform on each of these responses.
Solution
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14: RECEIVABLES
2 Other evidence
2.1
Assertion Example tests

COMPLETENESS Agree the balance from the individual sales ledger
accounts to the aged receivables listing and vice versa.
Match the total of the aged receivables listing to the sales
ledger control account.
Cast and cross-cast the aged receivables listing before
selecting any samples to test.
Trace a sample of shipping documentation to sales
invoices and into the sales and receivables ledger.
Complete the disclosure checklist to ensure that all the
disclosures relevant to receivables have been made.
Compare the gross profit % by product line with the
previous year and industry data.
Compare the level of prepayments to the previous year to
ensure the figure is materially correct and complete.
EXISTENCE Perform a receivables circularisation on a sample of
year-end trade receivables
Follow up all balance disagreements and non-replies to
the receivables confirmation.
Perform alternative procedures for any exceptions and
non-replies to the receivables confirmation, such as:
Review after-date cash receipts by inspecting bank
statements and cash receipts documentation.
Examine the customers account and customer
correspondence to assess whether the balance
outstanding represents specific invoices and confirm their
validity.
Examine the underlying documentation (sales order,
dispatch documentation, duplicate sales invoice etc).
Inquire from management explanations for invoices
remaining unpaid after subsequent ones have been paid.
Observe whether the balance on the account is growing
and if so, find out why by discussing with management.
VALUATION Compare receivables turnover and receivables days to
the previous year and/or to industry data.
Compare the aged analysis of receivables to the previous
year.
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14: RECEIVABLES
3 Chapter summary
1 Direct confirmation Direct circularisation of receivables is a key
procedure but does not give evidence on all the
relevant assertions.
2 Other evidence Other important procedures are:
Cut-off tests
Tests to determine recoverability
END OF CHAPTER
238
Bank and cash

Bank and cash:
(i) Bank confirmation reports used in obtaining
evidence in relation to bank and cash
(ii) Other evidence in relation to bank, and
(iii) Other evidence in relation to cash.
239
15: BANK AND CASH
Overview
Bank and cash
Bank confirmation letters Other evidence

Bank reconciliations
240
15: BANK AND CASH
1 Bank and cash

1.1 Objective Example tests
Existence Trace recorded assets and liabilities to bank
confirmation of balances.
Rights and obligations Review bank letter to ensure valid title to
accounts held.
Completeness/ Review bank confirmation letter for details of
Allocation and valuation all accounts held.
Count petty cash balance if material.
Reperform year end bank reconciliations for all
accounts held. Trace outstanding items
(outstanding lodgements and unpresented
cheques) to after date bank statements and
ensure all subsequently cleared.
Review cashbook for unusual items.
Bank confirmations for audit purposes

Introduction
1.2 A commonly adopted procedure in the audit of an entity's financial statements is for the
auditor to obtain direct confirmation from the entity's banker(s) of balances and other
amounts which appear in the balance sheet and other information which may be disclosed
in the notes to the financial statements, for example guarantees and foreign exchange
transactions. Bank confirmations are a valuable source of audit evidence because they
provide independent evidence regarding the reliability of an entity's records.
Authority to disclose
1.3 Banks require the explicit written authority of their customers to disclose the information
requested. This often takes the form of an ongoing standing authority rather than a separate
authority each time information is requested.
Bank confirmation process

1.4 The key steps to be taken by an auditor in initiating the process are as follows:
(a) A request for a bank confirmation is to be issued on the auditors' own headed paper
and sent to the bank branch with which the client has the prime business
arrangement.
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15: BANK AND CASH
(b) The bank confirmation request should specify:

(i) The names of all entities covered by the request;
(ii) Whether the auditor is requesting 'standard information'; and, where
appropriate, the nature of supplementary information required;
(iii) The date for which the auditor is requesting confirmation (the audit confirmation
date i.e. the client's year end);
(iv) A statement that the bank's response will not create a contractual relationship
between the bank and the auditor;
(v) A statement requesting the bank to advise the auditor if the Authority is
insufficient to allow the bank to provide full disclosure of the information
requested; and
(vi) A contact name and telephone number.
(c) The bank confirmation request should reach the branch at least two weeks in
advance of the audit confirmation date.
242
Additional
Notes
243
15: BANK AND CASH
2 Example bank confirmation letter for information

purposes only
Standard request for information
Local practices will vary in the way bank confirmations are requested and carried out. An
example is shown below which demonstrates what used to be UK practice and it covers all
the major areas where confirmation would be required.
AB & Co
Accountants
29 High Street
London N10
The Manager
Clearing Bank Ltd City Branch
Dear Sir/Madam,
.........................................(Name of customer)
STANDARD REQUEST FOR BANK REPORT
FOR AUDIT PURPOSES FOR THE YEAR ENDED ....................
In accordance with your above-named customer's instruction given
(1) hereon )
(2) in the attached authority ) Delete as appropriate
(3) in the authority date .................... already held by you )
please send to us, as auditors of your customer for the purpose of our business, without entering into any
contractual relationship with us, the following information relating to their affairs at your branch as at the close of
business on ....................... and, in the case of items 2, 4 and 10 during the period since .................... For each
item, please state any factors which may limit the completeness of your reply; if there is nothing to report, state
'none'.
We enclose an additional copy of this letter, and it would be particularly helpful if your reply could be given on the
copy letter in the space provided (supported by an additional schedule stamped and signed by the bank where
space is insufficient). If you find it necessary to provide the information in another form, please return the copy
letter with your reply.
It is understood that any replies given are in strict confidence.
Information requested Reply
Bank accounts
(1) Please give full titles of all accounts whether in sterling or in
any other currency together with the account numbers and
balances thereon, including NIL balances:
(a) where your customer's name is the sole name in the
title;
(b) where your customer's name is joined with that of
other parties;
(c) where the account is in a trade name.
NOTES
(i) Where the account is subject to any restriction (e.g.
a garnishee order or arrestment), this information
should be stated.
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15: BANK AND CASH
(ii) Where the authority upon which you are providing

this information does not cover any accounts held
jointly with other parties, please refer to your
customer in order to obtain the requisite authority of
the other parties. If this authority is not forthcoming
please indicate.
(2) Full titles and dates of closure of all accounts closed during
the period.
(3) The separate amounts accrued but not charged or credited
at the above date, of:
(a) provisional charges (including commitment fees);
and
(b) interest.
(4) The amount of interest charged during the period if not
specified separately in the bank statement.
(5) Particulars (i.e. date, type of document and accounts
covered) of any written acknowledgement of set-off, either by
specific letter of set-off, or incorporated in some other
document or security.
(6) Details of:
(a) overdrafts and loans repayable on demand,
specifying dates of review and agreed facilities;
(b) other loans specifying dates of review and
repayment;
(c) other facilities.
Customer's assets held as security
(7) Please give details of any such assets whether or not
formally charge to the bank.
If formally charged, give details of the security including the
dates and type of charge. If a security is limited in amount or
to a specific borrowing, or if there is to your knowledge a
prior, equal or subordinate charge, please indicate.
If informally charged, indicate nature of security interest
therein claimed by the bank.
Whether or not a formal charge has been taken, give
particulars of any undertaking given to the bank relating to
any assets.
Customer's other assets held
(8) Please give full details of the customer's other assets held,
including share certificates, documents of title, deed boxes
and any other items in your Registers maintained for the
purpose of recording assets held.
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15: BANK AND CASH
Contingent liabilities
(9) All contingent liabilities:
(a) total of bills discounted for your customer, with
recourse;
(b) date, name of beneficiary, amount and brief
description of any guarantees, bonds or indemnities
given to you by the customer for the benefit of third
parties;
(c) date, name of beneficiary, amount and brief
description of any guarantees, bonds or indemnities
given by you, on your customer's behalf, stating
where there is recourse to your customer and/or to
its parent or any other company within the group;
(d) total of acceptances;
(e) total sterling equivalent of outstanding forward
foreign exchange contracts;
(f) total of outstanding liabilities under documentary
credits;
(g) others please give details.
Other information
(10) A list of other banks, or branches of your bank, or associated
companies where you are aware that a relationship has been
established during the period.
Yours faithfully,
........................................
(Official stamp of bank)
........................................
(Authorised signatory)
........................................
(Position)
3 Chapter summary
1 Bank and cash Bank confirmation letters are a reliable source of
evidence in respect of the main financial statement
assertions relating to bank and cash.
The clients bank reconciliation must also be tested in
detail, in order to verify that reconciling items are
genuine.
2 Example bank Standard request for information from the clients bank.
confirmation letter
END OF CHAPTER
246
Liabilities, capital and
directors emoluments

Explain the audit objectives and audit procedures
in relation to:
Payables and accruals
(i) Supplier statement reconciliations and direct
confirmation of accounts payable,
(ii) Obtain evidence in relation to payables,
accruals and
(iii) Purchases and other expenses.
Non-current liabilities, provisions and

contingencies
(i) Evidence in relation to non-current liabilities
(ii) Provisions and contingencies. Q2(b) Section B pilot paper
Share capital, reserves and directors emoluments:

(i) Evidence in relation to share capital, reserves
and directors emoluments and
(ii) The related profit or loss section (income
statement) entries
247
16: LIABILITIES, CAPITAL AND DIRECTORS EMOLUMENTS
Overview
Liabilities, capital and directors

emoluments
Payables and accruals Non-current liabilities Share capital

Purchases and expenses Provisions and
Reserves
contingencies
Finance costs Directors emoluments
248
1 Payables and accruals

1.1 When testing payables, the auditor must focus on understatement (i.e. completeness).

(a) Existence Circularise/suppliers statements.
Cut-off tests purchases/ payables
(b) Rights and obligations Circularise trade payables (the procedure is
similar to that used for trade receivables).
Reconcile balance at year end to a supplier's
statement. The reconciling items must be
verified. These could include cash in transit or
goods in transit.
Both these tests also provide evidence of
completeness and valuation.
(c) Completeness Review payables analytically comparing to
previous year end or budgets, e.g. calculate
payables days or compare accruals listing to
prior year.
Review goods received notes around the year
end to ensure purchases are recorded in
correct accounting period.
Review unpaid invoice files for liabilities not
provided for.
Review after date payments for liabilities not
recorded.
Inspect the supplier statement reconciliations
to ensure that all outstanding invoices are
accrued.
(d) Allocation and valuation Reperform calculation of closing accruals to
ensure in accordance with accounting policies
and are consistent year on year.
Recalculate to ensure provisions have been
recognised in accordance with IAS 37.
249
2 Non-current liabilities
2.1 This will include bank loans, debentures, and other loans repayable more than one year
after the year end date.

(a) Existence Obtain confirmation from banks and other
lenders
(b) Rights and obligations Review confirmation letters from lenders
(c) Completeness Obtain breakdown of liabilities, compare to
prior year audit working papers and for any
items no longer included agree to
Repayment amount in cashbook
Inclusion as current liability if
reclassified
Review board minutes for evidence of any new
borrowings which might not be recorded
(d) Accuracy Perform proof in total of finance charges
Agree capital and interest amounts to
confirmation letters
Recalculate finance charges agreeing interest
rates to loan agreements
(e) Classification and Agree that liabilities are correctly classified as
understandability current/non-current by reference to the
repayment dates in the loan agreements
3 Tests on provisions and contingencies

Section 4
3.1 Obtain a detailed analysis of all provisions showing opening balances, movements and the
closing balance. Also obtain details of all contingencies which have been disclosed.
3.2 For each material provision:

(a) Determine whether the company has a present obligation as a result of a past event
at the year end date by:
(i) Review of correspondence and other documentation relating to the item.
(ii) Discussion with the directors. Have they created a valid expectation in other
parties that they will discharge the obligation, i.e. established a constructive
obligation? Review evidence of past practices, published policies and
statements made.
250
(b) Determine whether it is probable that an outflow of resources will be required to settle
the obligation by:
(i) Checking whether any payments have been made in the post year end period
in respect of the item.
(ii) Review of correspondence with solicitors, banks, customers, insurance
company and suppliers both pre and post year end.
(iii) Sending a letter to the solicitor to obtain their views (where relevant).
(iv) Discussing the position with similar past provisions with the directors. Were
these provisions eventually settled?
(c) Determine whether provisions represent the best estimate of liability by:
(i) Recalculating all provisions made.
(ii) Comparing the amount provided with any post year end payments and with any
amount paid in the past for similar items and considering opinions given by
independent experts.
(iii) In the event that it is not possible to estimate the amount of the provision,
check that this contingent liability is disclosed in the accounts.
3.3 Consider the nature of the clients business. Would you expect to see provisions e.g.
warranties?
3.4 For all material provisions and contingencies obtain a written representation.
3.5 Check that appropriate disclosures have been made in accordance with IAS 37.
251
4 Capital
4.1 This includes share capital, distributions and reserves.

Existence Agree authorised share capital to statutory records (e.g.
Memorandum and Articles of Association).
Agree issue of shares in year to board minutes.
Vouch cash received on issue of shares to cash and bank
statement.
Agree dividend paid to cash book and bank statements.
Inspect board minutes for authorisation of dividend payment.
Rights and obligations Review statutory records for shares and board minutes for
obligation to pay dividends.
Completeness Compare share capital with prior year.
Agree share issues authorised in board minutes to share
capital in nominal ledger.
Agree authorisation of dividend payment to nominal ledger or
disclosure in the financial statements.
Accuracy Recalculate value of dividend paid.
Recalculate consideration received from issue of shares.
Classification and Review disclosure in the financial statements of share issues
understandability and dividends paid in year.
5 Directors emoluments
5.1 Directors emoluments are a sensitive area and would therefore be deemed to be material
by its nature. It is important therefore that the disclosure of directors emoluments is made
accurately.

Existence Agree the directors emoluments disclosed in the financial
statements to a schedule of directors emoluments for the
year for each director. The schedule should show separately
the individual components of emoluments: salary, bonuses,
benefits, pension contributions and any other amounts such
as golden hellos
Vouch salary and pension contributions amounts to monthly
payroll records and bank statements.
Vouch bonuses and any one-off payments to board
meeting minutes and payroll records and bank statements.
252
Rights and obligations Verify the emoluments paid to directors during the year to
their contracts of employment to ensure the directors
entitlements to these amounts.
Completeness Review board meeting/ remuneration committee minutes to
verify the amounts of any directors bonuses and any other
amounts and also to check that these payments have been
appropriately authorised.
Review the cash book during the year and in the post year
end period and ensure any significant sums have been
appropriately accounted for.
Ask directors to confirm in writing that the emoluments
disclosed in the financial statements are complete and
accurately recorded.
Analytically review the directors emoluments for each
director in comparison to both the prior year emoluments and
expected emoluments given the businesses activities during
the year.
Accuracy Re-cast the addition of the schedule of directors
emoluments.
Verify that the amounts disclosed in the financial statements
agree to this schedule.
Classification and Obtain a copy of the returns made to the tax authorities in
understandability respect of each director and verify that all benefits have been
properly disclosed in the financial statements.
Review the adequacy of the disclosure in the directors
emoluments note to ensure it is in accordance with
applicable accounting standards and local law.
253
Lecture example 1
You are responsible for auditing the directors emoluments of ABC Co and have been provided
with the information below:
Termination Incentive
Salary Bonuses payments payments Total
$ $ $ $ $
Director A 120,000 90,000 - - 210,000
Director B 80,000 50,000 - - 130,000
Director C 50,000 5,000 15,000 - 70,000
Director D 20,000 5,000 - 10,000 35,000
270,000 150,000 15,000 10,000 445,000
Required
State what audit tests would you perform.
Solution
254
6 Chapter summary
1 Payables and accruals Substantive tests on liabilities will cover all the
financial statement assertions but with an emphasis
on testing for understatement i.e. completeness.
A circularisation of trade payables may be carried out

but is often not necessary as supplier statements
will provide documentary evidence from third parties.
2 Non-current liabilities Bank letters and loan agreements will be key

evidence in respect of loans.
3 Provisions and Procedures on provisions and contingencies will

contingencies focus on the criteria established in accounting
standards for their recognition, i.e.
Is there a present obligation as a result of
past events?
Is an outflow of benefits probable?
Has the amount been estimated reasonably?
4 Capital Statutory records and board minutes are the key
sources of evidence.
5 Directors emoluments Directors emoluments are material by their nature. It
is imperative therefore that they are accurately
recorded and disclosed.
255
END OF CHAPTER
256
Not-for-profit
organisations

Apply audit techniques to small not-for-profit
organisations
257
17: NOT-FOR-PROFIT ORGANISATIONS
Overview
Not-for-profit organisations
Types of not-for-profit
organisations
Comparison with audit of for- Application of audit

profit organisations techniques
258
1 Introduction
1.1 Examples of not-for-profit organisations are charities, clubs and societies. Their primary
objective is to provide a service and not to generate profits. Such entities are keen to keep
their costs to a minimum.
1.2 Such organisations may fall within the scope of statutory audit if the entities concerned are
limited liability companies.
1.3 Organisations not incorporated may require an assurance engagement due to the
requirements of regulatory or governing bodies, e.g. the Charity Commission.
2 Planning the audit

Section 2
2.1 The planning procedures undertaken for not-for-profit organisations will differ very little
from those for profit making organisations.
2.2 However, the auditor should have specific regard to any laws, regulations or guidelines
imposed on the entity by any regulatory body.
2.3 The scope of the auditor's work will be detailed in the engagement letter.
3 Risk assessment
3.1 The auditor should, during the planning stage, fully assess the risks associated with the not-
for-profit organisation.
3.2 INHERENT RISK

Key factors to consider include:
The complexity and extent of regulation
The significance of donations and cash receipts
Restrictions imposed by the objectives and powers given by the entitys governing
documents on how donations can be distributed.
The sensitivity of certain key statistics such as proportion of resources used in
administration
The need to maintain adequate resources whilst avoiding the build up of resources
which could appear excessive
3.3 CONTROL RISK

Key factors to consider include:
Competence, training and qualification of paid staff and volunteers
Reliability of accounting systems / computer systems
Controls over compliance with laws and regulations
Power of trustees
259
4 Audit evidence
4.1 When designing substantive procedures for not-for-profit organisations, the auditor should
Section 3 give special attention to the possibility of:
Understatement (i.e. completeness) of income, including gifts in kind, cash donations
and legacies
Incorrect accounting treatment of lifetime subscriptions
Q28 'Tap!'
Overstatement (i.e. existence) of cash grants or expenses
Misanalysis or misuse of funds
Misstatement or omission of assets including donated properties
Misallocation of expenses to disguise excessive administration expenditure
5 Reporting
5.1 For incorporated not-for-profit organisations, the reporting requirements of ISA 700 Forming
an Opinion and Reporting on Financial Statements apply.
5.2 Additionally, the reporting requirements of the governing body will need to be encompassed
in the auditor's report.
5.3 For organisations not incorporated under statute, the nature of the report will be determined
in accordance with the terms of appointment detailed in the letter of engagement.
'Save the Accountants' is a charitable foundation set up to provide financial assistance to

accountants who have fallen on hard times. Its principal sources of income are:
Cash donations collected on the high streets of major towns
Regular donations by the 'Big 4' accountancy firms
Annual donations by wealthy individuals.
Required
What audit procedures would you do to test the completeness of income?
Solution
260
6 Chapter summary
1 Introduction Not-for profit organisations include charities, clubs
and societies.
2 Planning the audit All relevant regulations must be understood.
3 Risk assessment Particular risk areas for the auditor of not-for-profit
entities are:
Complexity of regulation
High level of cash receipts
Competence of staff and volunteers
4 Audit evidence The audit approach is likely to be mainly substantive.
5 Reporting The auditor must consider the requirements of ISA
700 as well as any specific regulations.
261
END OF CHAPTER
262
Audit review and
finalisation

Explain the purpose of a subsequent events
review
Explain the responsibilities of auditors regarding
subsequent events
Discuss the procedures to be undertaken in Q11 Section A pilot paper
performing a subsequent events review
Define and discuss the significance of the
concept of going concern
Explain the importance of and the need for going
concern reviews
Explain the respective responsibilities of auditors
and management regarding going concern
Identify and explain potential indicators that an
entity is not a going concern
Discuss the procedures to be applied in Q5(b) Section B pilot paper
performing going concern reviews
Discuss the disclosure requirements in relation
to going concern issues
Explain the purpose of and procedure for
obtaining written representations
Discuss the quality and reliability of written
representations as audit evidence
Discuss the circumstances where written
representations are necessary and the matters
on which representations are commonly
obtained
263
18: AUDIT REVIEW AND FINALISATION

Discuss the importance of the overall review of
evidence obtained
Discuss the procedures an auditor should
perform in conducting their overall review of
Explain the significance of uncorrected
misstatements
Evaluate the effect of dealing with uncorrected Q3(a) Section B pilot paper
misstatements
264
Overview
Overall review of evidence
Audit review and finalisation
Uncorrected misstatements
Subsequent events Going concern Written representations
265
1 ISA 560 Subsequent events

1.1 Financial statements may be affected by events that occur after the date of the financial
statements. For financial reporting purposes, these events are categorised in one of two
ways:
(a) Those that provide evidence of conditions that existed at the date of the financial
statements and
(b) Those that provide evidence of conditions that arose after that date of financial
statements
1.2 The auditor should consider the effect of subsequent events on the financial statements and
on the auditors report.
Active duty Passive duty
Auditor's
Year F/S
report AGM
end issued
signed
Audit procedures Auditor becomes aware of a Auditor becomes aware of a

undertaken to identify material subsequent event: material subsequent event:
material subsequent (a) Discuss matter with (a) Discuss matter with
events (adjusting and management to determine management
non-adjusting) whether the FS need (b) If management amends FS
(a) Review the amendment. auditor should issue a new
procedures (b) If management amends FS auditor's report including
management has the auditor should extend an emphasis of matter
established to audit procedures to the paragraph to explain the
ensure that items that require revision to the previously
subsequent events adjustment or disclosure issued FS.
are identified. and issue a new, (c) If management refuses to
(b) Read board unmodified auditor's report. make amendment in FS
minutes held after (c) If management refuses to then auditor should
the date of the make amendment in FS
financial Seek legal advice
then auditor should either
statements up to
the date of signing (i) (if not yet released audit
the auditor's report. report) re-issue a
modified report
(c) Read the entity's
latest available or
interim financial (ii) (if have released audit
statements, report)
budgets and cash
flow forecasts. Seek legal advice
266
(d) Enquire, or extend

previous oral or
written enquiries, of
the entitys legal
counsel concerning
litigation and
claims.
(e) Enquire of
management as to
whether any
subsequent events
have occurred
which might affect
the financial
statements.
(f) Obtain a written
representation as
to the
completeness of
subsequent events
identified by
management.
2 ISA 570 Going concern

2.1 When planning and performing audit procedures and in evaluating the results thereof, the
auditor should consider the appropriateness of managements use of the going concern
assumption underlying the preparation of the financial statements.
2.2 Under the going concern assumption, an entity is ordinarily viewed as continuing in business
for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing
trading or seeking protection from creditors pursuant to laws or regulations.
2.3 Managements assessment of the entitys ability to continue as a going concern should
cover a period of at least 12 months after the period end.
2.4 In obtaining an understanding of the entity, the auditor should consider whether there are
events or conditions and related business risks which may cast significant doubt on the
entitys ability to continue as a going concern.
2.5 Based on the audit evidence obtained, the auditor should determine if, in his judgement, a
material uncertainty exists related to events or conditions that alone or in aggregate, may
cast significant doubt on the entitys ability to continue as a going concern.
267
2.6 Examples of events or conditions, which may cast significant doubt on the going concern
assumption include:
Financial
Net liability or net current liability position.
Fixed-term borrowings approaching maturity without realistic prospects of renewal or
repayment; or excessive reliance on short-term borrowings to finance non-current
assets.
Indications of withdrawal of financial support by creditors
Negative operating cashflows.
Adverse key financial ratios, e.g. high gearing, low current ratio, poor profit margins.
Substantial operating losses or significant deterioration in the value of assets used to
generate cash flows.
Arrears or discontinuance of dividends.
Inability to pay creditors on due dates.
Inability to comply with the terms of loan agreements.
Change from credit to cash-on-delivery terms with suppliers.
Inability to obtain new financing.
Operational
Management intention to liquidate the entity or to cease operations.
Loss of key management without replacement.
Loss of a major market, key customer, license, or principal supplier.
Labour difficulties or stock outs.
Emergence of a highly successful competitor.
Other
Non-compliance with capital or other statutory requirements.
Pending legal or regulatory proceedings against the entity that may, if successful,
result in claims that are unlikely to be satisfied.
Changes in legislation or government policy expected to adversely affect the entity.
Uninsured or under-insured catastrophes when they occur.
268
2.7 Relevant audit procedures

(a) Analysing and discussing cash flow, profit and other relevant forecasts with
management.
(b) Analysing and discussing the entitys latest available interim financial statements.
(c) Reading the terms of debentures and loan agreements and determining whether any
have been breached.
(d) Reading minutes of the meetings of shareholders, those charged with governance
and relevant committees for reference to financing difficulties.
(e) Enquiring of the entitys lawyer regarding the existence of litigation and claims and the
reasonableness of managements assessments of their outcome and the estimate of
their financial implications.
(f) Confirming the existence, legality and enforceability of arrangements to provide or
maintain financial support with related and third parties and assessing the financial
ability of such parties to provide additional funds.
(g) Considering the entitys plans to deal with unfilled customer orders.
(h) Reviewing events after period end to identify those that either mitigate or otherwise
affect the entitys ability to continue as a going concern.
(i) Obtaining and reviewing reports or regulatory actions
2.8 When analysis of cash flow is a significant factor in considering the future outcome of events
or conditions the auditor considers:
The reliability of the entitys information system for generating such information, and
Whether there is adequate support for the assumptions underlying the forecast.
In addition the auditor compares:
The prospective financial information for recent prior periods with historical results,
and
The prospective financial information for the current period with results achieved to
date.
2.9 The auditor will form his opinion on the going concern status of the company based on the
outcome of the above.
269
You are planning the audit of Truckers Co whose principal activities are road transport and
warehousing services, and the repair of commercial vehicles. You have been provided with the
draft accounts for the year ended 31 October 20X2.
Draft 20X2 Actual 20X1
$000 $000
Summary statement of profit or loss
Revenue 10,971 11,560
Cost of sales (10,203) (10,474)
Gross profit 768 1,086
Administrative expenses (782) (779)
Finance costs (235) (185)
Profit/(loss) for the period (249) 122
Summary statement of financial position
Non-current assets 5,178 4,670

Current assets
Inventories of parts and consumables 95 61
Receivables 2,975 2,369
3,070 2,430
8,248 7,100
Share capital and reserves 3,544 3,793
Non-current liabilities
Bank loan 750 1,000
Finance lease liabilities 473
1,223 1,000
Current liabilities
Bank loan 250
Overdraft 1,245 913
Trade payables 1,513 1,245
Finance lease liabilities 207
Other payables 203 149
3,481 2,307
8,248 7,100
You have been informed by the managing director that the fall in revenue is due to:
The loss, in July, of a long-standing customer to a competitor; and
A decline in trade in the repair of commercial vehicles.
Due to the reduction in the repairs business, the company has decided to close the workshop and
sell the equipment and spares inventories. No entries resulting from this decision are reflected in
the draft accounts.
270
During the year, the company replaced a number of vehicles funding them by a combination of
leasing and an increased overdraft facility. The facility is to be reviewed in January 20X3 after the
audited accounts are available.
The draft accounts show a loss for 20X2 but the forecasts indicate a return to profitability in 20X3
as the managing director is optimistic about generating additional revenue from new contracts.
Required
From the scenario above identify features which might cause you to have doubts about Truckers'
going concern status.
Solution
3 ISA 580 Written representations

3.1 ISA 580 requires the auditor to request management to provide written representations as
follows:
That it has fulfilled its responsibilities for the preparation of the financial statements,
that all transactions have been recorded and reflected therein and that all information
has been provided to the auditor as requested and has approved the financial
statements
A variety of ISA-specific issues require disclosure (such as fraud, laws & regulations,
estimates, going concern, related parties and subsequent events)
The appropriate use of accounting policies as well as a number of specific disclosures
(such as plans that might affect asset values and details of any contingent liabilities).
271
3.2 The auditor should obtain written representations from management on matters material to
the financial statements when other sufficient appropriate audit evidence cannot reasonably
be expected to exist.
Audit evidence
3.3 The representations should relate to matters where they are critical to obtaining sufficient
appropriate audit evidence. Representations cannot be a substitute for other audit evidence
that auditors expect to be available.
3.4 They should be restricted to matters where the auditor is unable to obtain independent
corroborative evidence and could not reasonably expect it to be available. For example,
Where knowledge of facts is confined to management, e.g. management's intentions.
Where the matter is principally one of judgement, e.g. whether a receivable is a
doubtful debt or not.
Procedures
3.5 (a) Agree procedures at early stage (e.g. letter of engagement).
(b) Discuss letter with client first.
(c) Usually signed by senior executive officer and senior financial officer on behalf of
board.
(d) Should be minuted.
(e) Dated after all other audit work completed but before signing of the auditors report.
If the client refuses to sign

3.6 (a) Auditor should write letter setting out his understanding and ask for management
confirmation.
(b) If management does not reply, auditor should follow up to ascertain that his
understanding is correct.
(c) If management refuses to provide a representation that the auditor considers
necessary, this constitutes a scope limitation and the auditor should express a
qualified opinion or disclaimer of opinion.
4 Overall review of financial statements

4.1 At the finalisation stage the financial statements are reviewed to determine whether they are
consistent with the auditors understanding of the entity. ISA 520 Analytical Procedures
states the auditor should design and perform analytical procedures to assist in forming that
overall conclusion.
4.2 The review will determine whether

Financial statements are prepared using acceptable accounting policies, consistently
applied and appropriate to the entity.
Information included in financial statements is compatible with audit findings
272
Adequate disclosure and proper classification and presentation of information

Financial statements comply with statutory requirements and other regulations
4.3 When considering whether the accounting policies are appropriate, auditors should
consider:
Policies commonly adopted in particular industries;
Policies for which there is substantial authoritative support;
Whether any departures from applicable accounting standards are necessary for the
financial statements to give a true and fair view;
Whether the financial statements reflect the substance of the underlying transactions
and not merely their form.
Uncorrected misstatements
Section 4.4 4.4 During the audit, a schedule will have been maintained of errors identified that have not
been corrected by the client.
Some of these may have been individually immaterial but the schedule must be reviewed at
this stage before the audit opinion is finalised. The effect of the uncorrected misstatements
must be considered in aggregate as their combined effect may be material and thus could
affect the audit opinion.
Communication of uncorrected misstatements

4.5 ISA 450 requires the auditor to communicate uncorrected misstatements and their effect to
those charged with governance, with material uncorrected misstatements being identified
individually. The auditor shall request uncorrected misstatements to be corrected. The
auditor shall also communicate the effect of uncorrected misstatements relating to prior
periods.
The auditor shall request a written representation from management and those charged with
governance whether they believe the effects of uncorrected misstatements are immaterial
(individually and in aggregate) to the financial statements as a whole. A summary of these
items shall be included in or attached to the representation.
Documentation
4.6 ISA 450 requires the auditor to document the following information:
The amount below which misstatements would be regarded as clearly trivial
All misstatements accumulated during the audit and whether they have been
corrected
The auditors conclusion as to whether uncorrected misstatements are material and
the basis for that conclusion
273
274
Additional
Notes
275
5 Example of a written representation letter from

management
This letter includes written representations that are required for audits of financial
statements for periods beginning on or after December 15 2009. It is not intended to be a
standard letter. Representations by management will vary from one entity to another and
from one period to the next.
(Entity Letterhead)
(To Auditor) (Date)
This representation letter is provided in connection with your audit of the financial
statements of ABC Company for the year ended December 31, 20XX for the purpose of
expressing an opinion as to whether the financial statements are presented fairly, in all
material respects, (or give a true and fair view) in accordance with International Financial
Reporting Standards.
We confirm that (to the best of our knowledge and belief, having made such inquiries as we
considered necessary for the purpose of appropriately informing ourselves):
Financial Statements
We have fulfilled our responsibilities, as set out in the terms of the audit engagement
dated [insert date], for the preparation of the financial statements in accordance with
International Financial Reporting Standards; in particular the financial statements are
fairly presented (or give a true and fair view) in accordance therewith.
Significant assumptions used by us in making accounting estimates, including those
measured at fair value, are reasonable. (ISA 540)
Related party relationships and transactions have been appropriately accounted for
and disclosed in accordance with the requirements of International Financial
Reporting Standards. (ISA 550)
All events subsequent to the date of the financial statements and for which
International Financial Reporting Standards require adjustment or disclosure have
been adjusted or disclosed. (ISA 560)
The effects of uncorrected misstatements are immaterial, both individually and in the
aggregate, to the financial statements as a whole. A list of the uncorrected
misstatements is attached to the representation letter. (ISA 450)
[Any other matters that the auditor may consider appropriate (see paragraph
A10 of this ISA).]
Information Provided
We have provided you with:
Access to all information of which we are aware that is relevant to the
preparation of the financial statements such as records, documentation and
other matters;
Additional information that you have requested from us for the purpose of the
audit; and
276
Unrestricted access to persons within the entity from whom you determined it
necessary to obtain audit evidence.
All transactions have been recorded in the accounting records and are reflected in the
We have disclosed to you the results of our assessment of the risk that the financial
statements may be materially misstated as a result of fraud. (ISA 240)
We have disclosed to you all information in relation to fraud or suspected fraud that
we are aware of and that affects the entity and involves:
Management;
Employees who have significant roles in internal control; or
Others where the fraud could have a material effect on the financial
statements. (ISA 240)
We have disclosed to you all information in relation to allegations of fraud, or
suspected fraud, affecting the entitys financial statements communicated by
employees, former employees, analysts, regulators or others. (ISA 240)
We have disclosed to you all known instances of non-compliance or suspected non-
compliance with laws and regulations whose effects should be considered when
preparing financial statements. (ISA 250)
We have disclosed to you the identity of the entitys related parties and all the related
party relationships and transactions of which we are aware. (ISA 550)
Any other matters that the auditor may consider necessary.
Management
277
6 Chapter summary
1 Subsequent events The auditor has a duty to perform procedures to identify
subsequent events up to the date of the auditors
report.
If further events are discovered after the date of the
report the auditor should discuss with client
management and take appropriate action.
2 Going concern The auditor must consider the appropriateness of the
going concern assumption.
3 Written representations The auditor should obtain written representations on
from management material matters where
Knowledge of the facts is confined to
management, and
The matter involves judgement
4 Overall review of Before issuing the audit opinion, the auditor should
financial statements carry out an overall review of the financial statements.
5 Written representation Example of a written representation letter.
letter
END OF CHAPTER
278
Reports

Identify and describe the basic elements of the
auditors report
Explain unmodified audit opinions in the auditors
report
Explain modified audit opinions in the audit Q3(b) Section B pilot paper
report
Describe the format and content of emphasis of Q9 Section A pilot paper
matter and other matter paragraphs
Discuss the reporting implications of the findings
of going concern reviews
279
19: REPORTS
Overview
Reports
Auditors reports
Standard report Changes to the audit

unmodified opinion reports
Unmodified opinions with Modified on matters that do affect

additional communication the auditor's opinion
Emphasis of matter Other

paragraph matter
'Without qualifying paragraph Material misstatement
Insufficient or inappropriate
our opinion .'
(E.g. 6) audit evidence
Material but Material and Material but Material and

not pervasive pervasive not pervasive
Qualified Disclaimer pervasive Adverse
'except for' 'do not express Qualified '. do not give
(E.g. 4) an opinion' 'except for' a true and fair
(E.g. 5) (E.g. 2) view'
(E.g. 3)
280
19: REPORTS
1 ISA 700: Forming an opinion and reporting on

Whole chapter
1.1 ISA 700 Forming an opinion and reporting on financial statements requires the auditor to
give an opinion on whether the financial statements are prepared, in all material respects, in
accordance with the applicable financial reporting framework.
1.2 To do this, the auditor needs to consider the following:

(a) Whether sufficient appropriate audit evidence has been obtained (ISA 330)
(b) Whether uncorrected misstatements are material (ISA 450)
Basic elements of the auditors report

Q33 Builders 1.3 The auditor's report should include the following basic elements, normally in this order:
Merchants
(a) Title
(b) Addressee
(c) Introductory paragraph
(d) Managements' responsibility for the financial statements
(e) Auditor's responsibility
(f) Auditor's opinion
(g) Other reporting responsibilities
(h) Auditor's signature
(i) Date of the auditor's report
(j) Auditor's address
1.4 Unmodified opinion

An unmodified opinion is 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.
1.5 Example 1: Unmodified report
INDEPENDENT AUDITORS REPORT

[Appropriate addressee]
Report on the financial statements
We have audited the financial statements of ABC company, which comprise the statement
of financial position as at 31 December 20X1, and statement of profit or loss and other
comprehensive income, statement of changes in equity and statement of cash flows for the
year then ended, and a summary of significant accounting policies and other explanatory
information.
281
19: REPORTS
Management's responsibility for the financial statements

Management is responsible for the preparation and fair presentation of these financial
statements in accordance with International Financial Reporting Standards, and for such
internal control as management determines is necessary to enable the preparation of
financial statements that are free from material misstatement, whether due to fraud or error.
Auditor's responsibility
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 about whether the financial statements are free from
An audit involves performing procedures to obtain audit evidence about the amounts and
disclosures in the financial statements. The procedures selected depend on the auditor's
judgement, including the assessment of the risks of material misstatement of the financial
statements, whether due to fraud or error. In making those risk assessments, the auditor
considers internal control relevant to the entity's preparation and fair presentation of the
financial statements in order to design audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
entity's internal control. An audit also includes evaluating the appropriateness of accounting
policies used and the reasonableness of accounting estimates made by management, as
well as evaluating the overall presentation of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide
a basis for our audit opinion.
Opinion
In our opinion the financial statements present fairly, in all material respects, (or give a true
and fair view of) the financial position of ABC Company as at 31 December 20X1, and (of)
its financial performance and its cash flows for the year then ended in accordance with
Report on other legal and regulatory requirements
[Form and content of this section of the auditor's report will vary depending on the nature of
the auditor's other reporting responsibilities.]
[Auditors signature]
[Date of the auditors report]
[Auditors address]
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2 ISA 705 Modifications to the opinion in the

independent auditors report
2.1 The auditor will give a modified audit report when:
(a) The auditor concludes, based on the evidence obtained, that the financial statements
as a whole are not free from material misstatement; or
(b) The auditor is unable to obtain sufficient appropriate audit evidence to conclude that
the financial statements as a whole are free from material misstatement.
2.2 In both circumstances there can be two levels of modified opinion:

(i) Material but not pervasive where the circumstances prompting the misstatement are
material
(ii) Material and pervasive where the financial statements could be mis-leading.
Pervasive is used to describe the effects or possible effects on the financial
statements of misstatements or undetected misstatement.
A pervasive opinion means either that:
It is not possible for the auditors to provide an opinion on the financial
statements; or
There is a fundamental disagreement between themselves and management
over the accounting treatment or disclosures.
2.3 Types of modified opinion
Nature of circumstances Material but not Material and pervasive

pervasive
Financial statements are QUALIFIED OPINION ADVERSE OPINION
materially misstated
Auditor unable to obtain QUALIFIED OPINION DISCLAIMER OF OPINION
sufficient appropriate audit
evidence
2.4 Qualified opinion financial statements are materially misstated

Material misstatements could arise in respect of:
The appropriateness of selected accounting policies
The application of selected accounting policies
The appropriateness or adequacy of disclosures in the financial statements
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Example 2: Qualified opinion due to material misstatement of inventories

Basis for Qualified Opinion
The companys inventories are carried in the statement of financial position at xxx.
Management has not stated inventories at the lower of cost and net realisable value but has
stated them solely at cost, which constitutes a departure from International Financial
Reporting Standards. The companys records indicate that had management stated the
inventories at the lower of cost and net realisable value, an amount of xxx would have been
required to write the inventories down to their net realisable value. Accordingly, cost of sales
would have been increased by xxx, and income tax, net income and shareholders equity
would have been reduced by xxx, xxx and xxx, respectively.
Qualified Opinion
In our opinion, except for the effects of the matter described in the Basis for Qualified
Opinion paragraph, the financial statements present fairly, in all material respects, (or give a
true and fair view of) the financial position of ABC Company as at 31 December 20X1, and
(of) its financial performance and its cash flows for the year then ended in accordance with
2.5 Example 3: Adverse opinion due to material misstatement with a pervasive effect
Basis for Adverse Opinion

As explained in Note X, the company has included houses built for re-sale (including related
land) at a cost of $X as non-current assets and depreciated them at a rate of X%, resulting
in depreciation of $X. Under International Financial Reporting Standards, these should have
been included as inventory in the financial statements and no depreciation should have
been provided in respect of these. The carrying value of the houses represent 90% of the
companys total assets and the companys records indicate that [explanation of the effect
on amounts presented in the financial statements].
Adverse Opinion
In our opinion, because of the significance of the matter discussed in the Basis for Adverse
Opinion paragraph, the financial statements do not present fairly (or do not give a true and
fair view of) the financial position of ABC Company as at 31 December 20X1, and (of) its
financial performance and its cash flows for the year then ended in accordance with
2.6 Qualified opinion auditor unable to obtain sufficient appropriate audit evidence
The auditors inability to obtain sufficient appropriate audit evidence could arise from:
Circumstances beyond the entitys control (e.g. accounting records destroyed)
Circumstances relating to the nature or timing of the auditors work (e.g. the timing of
the auditors appointment prevents the observation of the physical inventory count)
Limitations imposed by management (e.g. management prevents the auditor from
requesting external confirmation of specific account balances)
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Example 4: Qualified opinion due to inability to obtain sufficient appropriate audit

evidence about the carrying amount of inventory (material but not pervasive)
Basis for Qualified Opinion

With respect to inventory having a carrying amount of $X the audit evidence available to us
was limited because we did not observe the counting of the physical inventory as at 31
December 20X1, since that date was prior to our appointment as auditor of the company.
Owing to the nature of the companys records, we were unable to obtain sufficient
appropriate audit evidence regarding the inventories quantities by using other audit
procedures.
Qualified Opinion
In our opinion, except for the possible effects of the matter described in the Basis for
Qualified Opinion paragraph, the financial statements present fairly, in all material respects,
(or give a true and fair view of) the financial position of ABC Company as at 31 December
20X1, and (of) its financial performance and its cash flows for the year then ended in
accordance with International Financial Reporting Standards.
2.7 Disclaimer of opinion - auditor unable to obtain sufficient appropriate audit evidence
An opinion must be disclaimed when the auditor:
Cannot obtain sufficient appropriate audit evidence on which to base the opinion
and
Concludes that the possible effects on the financial statements of undetected
misstatements, if any, could be both material and pervasive.
The opinion must also be disclaimed in situations involving multiple uncertainties when it
is not possible to form an opinion on the financial statements due to the potential
interaction of the uncertainties and their possible cumulative effect on the financial
statements.
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Example 5: Disclaimer of opinion due to inability to obtain sufficient appropriate audit

evidence about multiple elements of the financial statements (inventories and
accounts receivable material and pervasive)
Basis for Disclaimer of Opinion

We were not appointed as auditors of the company until after 31 December 20X1 and thus
did not observe the counting of physical inventories at the beginning and end of the year.
We were unable to satisfy ourselves by alternative means concerning the inventory
quantities held at 31 December 20X0 and 20X1 which are stated in the statement of
financial position at xxx and xxx, respectively. In addition, the introduction of a new
computerised accounts receivable system in September 20X1 resulted in numerous errors
in accounts receivable. As of the date of our audit report, management was still in the
process of rectifying the system deficiencies and correcting the errors. We were unable to
confirm or verify by alternative means accounts receivable included in the statement of
financial position at a total amount of xxx as at 31 December 20X1. As a result of these
matters, we were unable to determine whether any adjustments might have been found
necessary in respect of recorded or unrecorded inventories and accounts receivable, and
the elements making up the income statement, statement of changes in equity and
statement of cash flows.
Disclaimer of Opinion
Because of the significance of the matters described in the Basis for Disclaimer of Opinion
paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide
a basis for an audit opinion. Accordingly, we do not express an opinion on the financial
statements.
3 ISA 706 Emphasis of matter paragraphs and other

matter paragraphs
3.1 Emphasis of matter paragraph
An emphasis of matter paragraph is a paragraph included in the auditors report. It refers
to a:
Matter appropriately presented or disclosed in the financial statements; but that
In the auditors judgement, is of such importance that it is fundamental to users
understanding of the financial statements.
3.2 Where an emphasis of matter paragraph is used:

(a) It comes immediately after the opinion paragraph
(b) It is entitled Emphasis of matter
(c) The paragraph makes a clear reference to the matter being emphasised and where
The relevant disclosures are in the financial statements
(d) The paragraph must state that the auditors opinion is not modified in respect of the
matter emphasised
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19: REPORTS
Examples include:
An uncertainty relating to the future outcome of exceptional litigation or regulatory
action
A major catastrophe that has had, or continues to have, a significant effect on the
entitys financial position
Example 6: Emphasis of Matter paragraph
Emphasis of Matter
We draw attention to Note X to the financial statements which describes the uncertainty
related to the outcome of the lawsuit filed against the company by XYZ Company. Our
opinion is not qualified in respect of this matter.
3.3 Other matter paragraph

An other matter paragraph is a paragraph included in the auditors report that refers to a
matter other than those presented or disclosed in the financial statements (outside the
scope of the financial statements) that, in the auditor's judgement, is relevant to users
understanding of the audit, the auditors responsibilities or the auditors report. Examples
include the situation where the Chairmans Report is not consistent with the financial
statements or the prior year figures have not been audited.
The following issues have arisen during the audit of Little Bees Co. Profit before tax is $175,000.
(i) Little Bees Co has valued a certain inventory line at its total cost price of $17,000. These
inventory items have not been sold for a number of years and it is unlikely that they can be
sold in the future unless the price is reduced to $3,000.
(ii) Little Bees Co has a computerised wages and salaries system. You have tested the internal
controls in relation to this area and have found that in the month of February, the wages
records were corrupted. There are no back-ups for the wages and salaries system. Wages
and salaries for February are $20,125.
Required
Discuss each of these issues and describe the impact on the audit report if the above issues
remain unresolved.
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19: REPORTS
Solution
Inventory
Discussion of issue:
Calculation of materiality:
Type of audit report modification required (if any):
Impact on the audit report:
Wages and salaries

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4 Going concern
Responsibilities of directors and auditors
4.1 It is the directors responsibility to determine whether or not an entity is a going concern.
4.2 It is the auditors responsibility to make an assessment as to whether the directors

conclusion is appropriate. This should be based on the results of the going concern review
performed by the auditor.
4.3 The auditor must consider:

(a) Whether the use of the going concern basis is appropriate
(b) Whether adequate disclosure has been made of any material uncertainties affecting
going concern, and
(c) Whether management's assessment was adequate.
4.4 If there is concern about any if the items above, then the auditor should consider the
implications for their report.
Auditor's report implications

4.5 There are three main scenarios:
4.6 Scenario 1
The going concern basis is believed to be appropriate,

but a material uncertainty exists
The material uncertainty is adequately The material uncertainty is not

disclosed in the financial statements adequately disclosed in the financial
statements
The auditor should express an The auditor should express a qualified or

unqualified opinion but add an adverse opinion due to material
emphasis of matter paragraph misstatement
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19: REPORTS
4.7 Scenario 2
The going concern basis is believed to be inappropriate
The auditor should express an adverse opinion due to material misstatement
4.8 Scenario 3
The directors are unwilling/ unable to make an assessment as to whether or not the
going concern basis is appropriate
The auditor should express a qualified or disclaimer of opinion due to insufficient

appropriate evidence
The following issues have arisen during two of your firms audits:
(i) The directors of Difficult Times Co have prepared the financial statements on the going
concern basis but the auditor does not believe that the company is a going concern. The
directors refuse to amend the financial statements.
(iii) The directors of Tradings Hard Co have made appropriate disclosures relating to worries
over going concern in the financial statements. The auditor has a significant level of
concern regarding the going concern basis but is happy with the disclosure and does not
disagree with the use of the going concern basis.
Required
Describe the impact on the audit report of each company.
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19: REPORTS
Solution
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5 Chapter summary
1 ISA 700: basic The elements of the auditor's report are specified by
elements ISA 700.
Auditor's report may be unmodified or modified.
2 ISA 705 Modifications Auditors will modify their opinions when the financial
to the opinion in the statements are not free from material misstatement or
independent auditors when they have been unable to obtain sufficient
report appropriate evidence. There are two levels of modified
opinions auditors can give - material but not
pervasive and material and pervasive.
3 ISA 706 Emphasis of A report may be modified by an emphasis of matter or
matter paragraphs and other matter paragraph. These are often given in
other matter relation to going concern matters but do not affect the
paragraphs opinion.
4 Going concern It is the directors responsibility to determine whether an
entity is a going concern and the auditors responsibility
to assess whether this is appropriate. Uncertainty over
going concern will lead to an emphasis of matter
paragraph (provided that the issue is adequately
disclosed). Material misstatement in relation to going
concern is likely to be one of the rare circumstances
where an adverse opinion is issued.
END OF CHAPTER
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way.

Progress Tests
293
294
Answers to
Lecture Examples
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20: ANSWERS TO LECTURE EXAMPLES
Chapter 1
Answer to Lecture Example 1
(1) Here you would want some comfort as to whether or not the house you plan to buy is
structurally sound, whether the roof is in a good condition, whether there is any damp and
so on. Most house buyers would have a survey carried out by a building surveyor prior to
completing a purchase. This survey is carried out by an independent party who is
professionally qualified and would give you confidence/ comfort that there are no major
issues with the property you plan to purchase.
(2) One of the primary risks of meeting someone you have met on-line must be the risk that
they are not who they say they are and that instead of being a funny, loveable, friendly
companion they are actually someone who is out to harm you. Your friend should therefore
consider the checks that the website make on each of their members and they could also
sound out any mutual friends or acquaintances you have as to the type of person they are
about to meet. They could also consider checking any public registers such as the sex
offenders register.
(3) Here the council body will be concerned that the money they have given is used for the
designated purpose. They will need assurance that the money has been spent on sports
equipment, sports hall premises, staff and so forth rather than on items which are not related
to this cause. The council could require the organisation to provide them with a report
stating that the money was spent in accordance with the stipulations of the grant. This
report would need to be produced by an independent body, perhaps an accountant.
Chapter 2
No Lecture Examples
Chapter 3
1. The Chairmans role is to run/direct the Board of directors so that its members can undertake
their roles effectively. These duties include ensuring that the Board is appropriately balanced
(in terms of the numbers of executive and non-executive directors) and that each director is
aware of their responsibilities and equipped to fulfil them.
The Chief Executive Officers role is to decide on the companys strategy and put procedures
in place to achieve these.
These are very different roles and so should be ideally undertaken by two separate people.
Also separating the roles will not allow one person to have too much power (as in the case of
Robert Maxwell).
2. Dress You Like undertakes a Board evaluation each year which allows directors to voice their
concerns as to how the Board is being run.
It also makes training available to its directors and offers a full induction to new directors.
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3. Directors should only remain in position if they are performing in their role. Having the annual
re-election of directors allows companies to remove directors who are not performing and also
encourages directors to work effectively for the company/ shareholders.
4. Board of Directors:
The responsibility for risk management lies with the Board of Directors. It is the directors
responsibility to assess the risks that the business is exposed to. All businesses are exposed
to general risks; however there are additional, specific risks relevant to each business. Dress
You Like is a clothing manufacturer and so there are lots of risks inherent in the business
two of these are mentioned in the scenario: changing fashion trends and the security of
inventory.
Once the Board has identified the key risks to which the business is exposed, it must then
implement a system of internal controls (or procedures) to prevent and/ or detect these risks
occurring.
Internal controls could range from performing continual market research into consumer fashion
tastes to installing security cameras in the factory to deter theft of inventory.
The existence of an internal audit function is often cited as a positive form of risk management
and internal control.
Audit Committee:
As well as giving the Board of Directors the responsibility for risk management, corporate
governance principles require a company to establish an audit committee. This should
comprise at least three non-executive directors (two non-executive directors for a small
company).
The audit committee has a responsibility to review the companys risk management and
internal control systems and should include at least one non-executive director with financial
knowledge.
The audit committee must also review the effectiveness of the internal audit department where
one exists. If there is no internal audit department, then the audit committee should consider
annually whether or not there is a need for one.
5. Executive directors are responsible for the day-to-day running of the company and perform
operational and strategic business functions such as entering into contracts, safeguarding
company assets and managing people.
Non-executive directors are not involved in the day-to-day running of the business. Instead
they should use their experience and expertise to provide independent advice and objectivity
to the Board as a whole. They also perform a supervisory role and will review and monitor the
executive directors to ensure that they are fulfilling their duties and running the company in the
best interests of the shareholders.
In order to improve their independence, non-executive directors should not be reliant on the
company for their main source of income. They often work part time for the company and can
have a specialist role within the organisation.
All directors, executive and non-executive, are required to attend as many board meetings as
they reasonably can.
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Also there is no legal distinction between executive and non-executive directors each has
the same responsibilities and rights under law.
Dress You Like has three executive and three non-executive directors which makes the Board
very well balanced.
6. As well as forming part of the Board of Directors as a whole, the non-executive directors also
sit on the audit committee, remuneration committee and nomination committee. These are
sub committees of the Board of Directors.
The audit committee is responsible, amongst other things, for reviewing the effectiveness of
the Boards risk management processes.
The remuneration committee is responsible for making sure that the company offers a
performance related remuneration package which is sufficient to attract and retain quality
directors (but not excessive).
The nomination committee is responsible for identifying and approving the appointment of new
directors to the Board, for example Mary Batter the new Chief Executive Officer.
Non-executive directors have a very important role to play in each of these sub committees
and their independence and objectivity can improve the quality and relevance of the decisions
taken.
Chapter 4
Threat Safeguards
Weadon Co
This involves a self-interest threat because
Gifts and hospitality should not be accepted
the auditors may wish to continue enjoying
lavish hospitality so may be reluctant to raise unless the value is trivial and
inconsequential.
any problems in their auditors report.
There is also a familiarity threat because In this case it would be appropriate to decline
involvement in social events with the client is the weekend away so as not to impair the
likely to increase the audit staff's familiarity firms independence.
with the client staff and make them more likely
to accept explanations without adequate
questioning.
Stewards Co
Mr Walker should be rotated off the audit and
This involves a familiarity threat because Mr
Walker has been the engagement partner for another partner assigned to the client. Given
nine years and his long association with the that Stewards Co is a public interest entity,
key audit partners (such as the engagement
client could mean that he does not question
judgements made by the client and does not partner) should serve for no more than 7
years before being rotated off. They should
exercise sufficient professional scepticism.
not return to having involvement in the client
for a period of 2 years.
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Aspen Co
Mrs Sayer should be removed from the audit
Given that the partners daughter works for
team and replaced by an independent
the audit client a self-interest threat could
partner.
arise if the partner did not want to
If it is felt that Holly does not have any
disadvantage her daughter financially from
influence over the audit process and
any pay rise/ bonus by identifying errors in her
therefore that Mrs Sayer can remain as
work.
partner then the Board/ Audit Committee of
An intimidation threat could also exist if the Aspen Co should be informed.
daughter tries to pressure her mother into An independent partner review should also
making inappropriate decisions in relation to be conducted on the audit.
audit judgements.
Evergreen Co The firm should:
This could be viewed as a combination of an Use normal credit control procedures to
intimidation threat and a self-interest chase payment of all overdue balances.
threat.
Have a policy of refusing to start any new
The directors could use the outstanding fees work for a client until overdue bills have
as a means of pressuring the audit firm into been paid.
giving a favourable audit opinion. Discuss the outstanding debt with the
The auditors' self-interest could lead them to Audit Committee if one exists
issue a favourable opinion rather than risk Consider resignation if the overdue fees
losing the amounts owed to them. are not paid
Emerald Co
This scenario represents a self-interest
threat because the firm may issue a There is no evidence that Emerald Co is a
favourable opinion rather than risk losing such public interest entity, if it were then the
additional work should not be undertaken as
a significant income stream. If the additional
work is undertaken then 20% ($480,000 / the firm would generate more than 15% of its
total income from one client. This is a threat
$2,400,000) of the firms income will come
to independence.
from Emerald Co. If the work is not
However, even if the client is not a public
undertaken the percentage will fall to 13%
interest client then the firm must consider
($330,000 / $2,400,000).
how generating such a large proportion of
income from one client would be perceived
by third parties.
The firm should consider not accepting/
resigning from some services.
It may also require an external quality control
review.
Completing the additional work may also It should consult with the ACCA on any key
constitute a self-review threat as the auditor areas of audit judgement.
may rely on tests of controls as part of their
audit and will not want to report any See points on Green Co below.
deficiencies noted.
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Green Co
This scenario poses a self-review threat as The client is not a public interest entity and
the audit team are unlikely to criticise the so the provision of accountancy services is
financial statements which have been permitted. However:
prepared by the firm.
The accounting services should not be
provided by a member of the audit
team.
The client must provide all source data
and make decisions on judgemental
figures e.g. allowances for receivables.
A review by an independent partner
should be undertaken to ensure that
the financial statements were
thoroughly audited.
Chapter 5
Objective Control
Economy
To ensure that material is purchased at The prices from the Chinese supplier
the best possible price for the quality should be checked regularly against
required. those offered by other suppliers. Where
alternative suppliers offer better value for
money, these suppliers should be used
or prices re-negotiated with the Chinese
supplier.
A list of preferred suppliers, who have
been vetted for price and quality, should
be established and orders only placed
with these suppliers.
Establish a tender process whereby
suppliers are invited to quote for the
supply of materials. This may take place
on a season by season or 6 monthly
basis.
To ensure that transportation and Identify a list of companies who import
delivery costs are minimised whilst goods from China and invite them to
ensuring goods are received on a timely tender for the delivery contract.
basis.
Regularly review the price paid under the
tender to ensure it is competitive against
other companies.
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To ensure that the accommodation costs If premises are rented, review the rental
of the factory and head office are charged in relation to similar properties in
minimised. the same location. Attempt to
renegotiate the rent favourably whenever
the lease comes up for renewal.
If premises are owned establish an
ongoing schedule of maintenance for the
property to avoid unexpected repair
costs.
Establish a capital expenditure budget to
ensure monies are not wasted continually
repairing machines which should be
replaced.
Efficiency
To ensure that the clothes manufacturing The factory machines should be serviced
process is as efficient as possible and according to a rolling schedule of
minimises waste. maintenance in order for them to work
efficiently.
To ensure that machine down time due Orders for different clothing items should
to changing the machine set up for be collated and scheduled into a weekly
different clothing items is minimised. plan of work in order to minimise the
requirement to set up machines to
manufacture different clothing items.
Effectiveness
To ensure that all additional deliveries A record should be maintained of the
ordered by the supermarket are principal inventory lines ordered by the
completed within the required supermarket and a buffer of inventory for
timescales. these items maintained. The level of this
buffer should be reviewed on a
fortnightly/ monthly basis.
To minimise the level of inventory which A fortnightly/ monthly count of inventory
becomes obsolete/ un-saleable due to held should be conducted and compared
changing seasons/ fashions. to the schedule of work planned for the
next fortnight/ month to ensure that only
sufficient quantities of inventory are
manufactured to supply orders and
maintain the required buffer.
To monitor the companys cash flow to Monthly cash flow forecasts should be
ensure that the company does not suffer produced by management to monitor
from short term cash flow problems when cash is due to be received from all
given the 60 day terms given to the customers and when cash needs to be
supermarket. paid out to suppliers and employees.
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Establish an overdraft facility with the

companys bank to cover short term
deficits in cash flow.
Implement strong credit control
procedures whereby customers are
contacted as soon as their account
becomes overdue. Send regular
customer statements to all customers
and letters to those with overdue
accounts.
Note that only TWO points were required under each heading.
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A company can benefit from the services If a company already has an internal
provided by an internal audit function audit function and makes them redundant
without incurring the time and cost in order to outsource the function, the
involved in recruiting staff. redundancies may prove very expensive.
Furthermore, the company would lose in-
house skills.
Also remaining staff may oppose
outsourcing if it has come about as a
result of colleagues being made
redundant. This could reduce staff
morale.
Outsourcing the internal audit function may The staff that come to perform the regular
well increase their independence as the internal audit services may vary from
role will be performed by a third party month to month. This will mean that staff
rather than employees who may fear from the company will need to spend
losing their jobs if they report adversely on more time explaining systems and
the companys management. processes to them than if the internal
audit function were company employees.
There will be no need for the company to The outsourced staff may lack specific
train internal audit staff as those providing knowledge of the company.
the service will be trained by their own
employer.
As well as buying in regular services, it Outsourcing the internal audit function
may also be able to take advantage of ad will require the company to allow a third
hoc engagements provided that the party access to commercially sensitive
company to which services are outsourced data.
has spare capacity. Despite the fact that any engagement
letter would stipulate that confidentiality
be maintained, data could still be lost or
disclosed.
Internal auditors supplied by a bespoke The cost of outsourcing the internal audit
outsourcing company are likely to possess function may well increase over time and
relevant accounting and auditing skills become more expensive than employing
which will increase the reliability of the your own staff.
internal auditors work.
Note that only FOUR advantages and disadvantages were required
303
External auditor Internal Auditor

Objectives Give an opinion as to whether Varied and wide ranging
the financial statements Determined by management/ Board but may
present fairly the activities include:
of the business and
Review of accounting/ internal control systems
proper accounting records
have been kept Examination of financial/ operating information
Value for money (VFM) reviews
Review of implementation of corporate
policies, laws and regulations
Special investigations, e.g. suspected fraud
Procurement, marketing, treasury and HR
reviews
Reports to Shareholders of the company Board of Directors/ Audit Committee
Status Independent of / external to Company employee/ outsourced to a 3rd party
company they are auditing
Qualification Audit partner will be qualified and No formal qualifications required
hold a practising certificate as a
registered auditor.
Not all team members will be
qualified
Chapter 6
Audit risk Auditors response
The audit is a new audit for the firm, the firm The auditors should spend time ensuring they
may not have as good an understanding of fully understand the nature of the business, its
the client as they would have for an products or services, its locations, revenue
established client and so there is likely to be sources, key customers and suppliers, internal
an increased level of detection risk. controls and any external pressures or laws
and regulations it is subject to in order to best
assess the risk of material misstatement in the
This information must be communicated to all
members of the audit team.
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The audit was won after a competitive tender Check and Co must put safeguards in place to
and so the profit margin on the audit may be ensure that both the firms quality control
lower than usual leading to pressure on fees procedures and auditing standards are
and therefore the time audit staff are allowed complied with despite the potential pressure
to spend on each area. This increases the on fees.
risk that a material misstatement may go This may require an independent partner
undetected. review of key risk areas to determine whether
Furthermore, Check and Co may be hoping to sufficient appropriate evidence has been
keep client for the long term in order to gained.
maximise profit from the audit or obtain
additional work. This also increases audit
risk.
Dress You Like Co is a clothing manufacturer An aged inventory report should be obtained
whose inventory will be subject to changing to identify items of slow moving or non-
seasons and trends. It is possible that some saleable inventory.
inventory items may be difficult to sell and The saleability of these items should then be
may be overvalued at the year end if they are discussed with management and their
recorded at cost rather than at the lower of valuation in the financial statements reviewed
cost and net realisable value as required by to ensure they are valued at the lower of cost
IAS 2. and net realisable value.
Dress You Like Co has two sites where Review the inventory counting instructions of
inventory is held/ despatched. There is the Dress You Like Co to determine whether
possibility that some items are counted twice controls exist to ensure that all inventory items
(once at each location), and that some are not are counted only once.
counted at all leading to a risk that inventory Where inventory count instructions are not
may be under or over stated. sufficient, discuss this with management
before the count so that changes can be
made to counting procedures.
Dress You Like is reliant on one supplier for Discuss with management whether Dress You
its purchases. Should they encounter a Like has any alternative suppliers in the event
problem or delay with its supply chain then it that the supply chain is interrupted.
may not be able to fulfil its orders (especially Review Dress You Likes contract with the
to the supermarket chain). This could lead to supermarket chain and any other customers
dissatisfaction from their customers and to determine whether there are any penalties
ultimately the loss of the customer. This in payable should deliveries be delayed and
turn could lead to going concern problems. whether they could cancel their contract with
Dress You Like.
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Invoices and payments are made in Euros but Enquire from management as to the
the accounting records are maintained in US exchange rates used to translate invoices
dollars. when they are recorded in the accounting
system.
The invoices and payments will need to be
recorded in the accounting system in US Recalculate the translation of a sample of
dollars. There is a risk that these amounts invoices to ensure that they have been
may not be translated accurately leading to a accurately recorded.
material misstatement in inventory or
payables in the financial statements.
Dress You Like Co allows its supermarket Request that management produce cash flow
customer 60 day credit terms. This may place forecasts for the year ahead to identify any
a strain on cash flow and lead to potential deficits in cash flow.
going concern problems. Consider the reasonableness of the
assumptions on which these are based
(especially relating to the timing of cash flows
from the supermarket).
Consider whether there are any known
concerns about the supermarkets ability to
settle its debts.
Determine from management whether they
have access to any short term finance should
any cash flow problems arise.
The finance director is suing the company for Review correspondence from both the director
constructive dismissal but no mention of this and the entitys legal advisers relating to the
has been made in the year end financial legal claim in order to establish the likely
statements (i.e. no provision or contingent outcome of the claim.
liability). Discuss the appropriate accounting treatment
The case has been going on for some time for the claim with the directors.
which suggest that at least disclosure of a Review minutes of board meetings and events
contingent liability is required and so there is a after the reporting period to determine
risk that provision/ contingent liability whether the claim was settled.
disclosures may not be complete.
There has not been a finance director in place Determine from management whether there
for the last 6 months of the year (since March will be appropriate personnel available to
20X1). There is therefore a lack of answer the audit teams queries and provide
experience at this high level and the assistant the information they require for the audit.
is also overloaded. The assistant may not
have the time or ability to answer queries from
the audit team.
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The internal audit function used to perform A detailed review of the year end bank
reviews on the bank reconciliation and reconciliation and supplier statement
supplier statement reconciliations which would reconciliations should be performed in order
increase the reliability of the bank and to determine the accuracy and completeness
payables balances, especially in view of the of bank and payables.
foreign currency invoices and payments. A larger sample size may be necessary if it is
The fact that there is now no longer any anticipated that there will be a high level of
internal audit function means that there is an errors.
increased likelihood that material errors will A detailed review of reconciling items and
not have been detected by the client staff. payments made in the post year end period
should be conducted.
Note only SIX points were needed to score 12 marks.

(a)
20X1 20X0
Gross profit margin (supermarket) 1,605 3,920

53,500 49,000
= 3% = 8%
Gross profit margin (other) 820 800
8,200 6,700
= 10% = 12%
Receivables days (supermarket) 11,800 8,300
365 365
53,500 49,000
= 81 days = 62 days
Receivables days (other) 700 600
365 365
8,200 6,700
= 31 days = 33 days
Inventory days 13,800 4,900
365 365
59,275 * 50,980 ^
= 85 days = 35 days
* 59,275 = 51,895 + 7,380,
^ 50,980 = 45,080 + 5,900
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(b)
Audit risk Auditors response
The draft financial statement extracts indicate Discuss the going concern status of Dress
that there may be cash flows problems You Like Co with management.
leading to concern over going concern. Obtain a copy of the cash flow forecasts
Dress You Like Co has seen falling gross produced by management and consider
profit margins during the year. For the whether the assumptions on which they are
supermarket customer these are from 8% in based are reasonable, particularly in terms of
20X0 to 3% in 20X1 and for other customers the timings of cash received from customers.
12% (20X0) to 10% (20X1). Discuss with management whether Dress You
The receivable days for the supermarket Like Co has any alternative funding available
customer are 81 days in 20X1 compared to 62 in the event that it struggles with cash flow.
days in 20X0. For other customers Discuss with management whether any
receivables days are largely stable at 31 and disclosures relating to going concern have
33 days. been made in the financial statements.
Inventory days have risen from 35 days in
20X0 to 85 days in 20X1 largely due to
stockpiling for last minute orders.
Overall the fall in margins, lack of credit
control and increased inventory holdings
mean that the company has gone from a cash
position of $200,000 in 20X0 to an overdraft of
$750,000 in 20X1.
This further compounds cash flow and going
concern worries and worries that inventory
may be overstated.
Chapter 7
No Lecture Examples
Chapter 8
(1) Completeness of administrative expenses
Provided that there have been no significant changes in the entitys business during
the year under audit, it is reasonable for the auditor to expect that administrative
expenses would be similar from year to year or that they would increase in line with
any growth in the size of the company.
The auditor should obtain a breakdown of each of the items within the administrative
expenses figure for the current and prior period and then work out the variance year
on year. Any significant differences may indicate a material misstatement/ omission
308
and so should be discussed with management and the responses from management
verified (preferably with documented evidence).
(2) Cut-off of sales revenue
Calculate the gross profit margin for both the current year and prior period (or current
year budget) and investigate any significant differences in the ratio from year to year
(or year to budget).
Generally speaking an entitys gross profit margin tends to remain relatively stable
and so any unexpected changes should be investigated as they could indicate that
material misstatements exist. For example, an unexpected increase in gross profit
margin could indicate a cut-off error where sales after the year-end have been
included in the year-end figures.
(3) Accuracy of loan interest expense
This assertion lends itself to a proof in total. The auditor calculates an expected
amount of loan interest for the period.
For example he can verify the amount of loan capital outstanding throughout the
period to the bank confirmation letter or bank statements and also the interest rate to
the loan agreement.
The expected interest charge is:
average loan balance average interest rate
This expected interest charge is compared to the actual expense recognised in the
financial statements and explanations sought for any significant differences.
(4) Accuracy of wages expense
This could also be audited through a proof in total calculation. The detail would vary
depending on the nature of the business, and might have to be performed separately
for different departments. An outline of how the expected amount could be calculated
is:
no. of employees current year
Prior year wages expense % pay increase
no. of employees prior year
Given the level of risk in respect of the wages expense it is unlikely that the auditor
would rely solely on analytical procedures but this would provide a piece of reliable,
auditor-generated evidence which could then be backed up by some (reduced) tests
of details.
309
Chapter 9
1 The postman knocks at your front door You should be required to sign for the letter on
and hands you a letter which has been the postmans handset.
sent by recorded delivery.
2 You submit a claim for expenses to your You should need to evidence the claim by
line manager. presenting the receipt, the line manager should
sign the claim form to authorise payment.
3 You need to work an extra day over and You should submit a request that the overtime
above your normal hours to clear a be authorised prior to it being completed and this
backlog of work and will expect to be authorisation request should be signed by your
paid overtime for this. line manager.
4 You are responsible for maintaining the You should perform a bank reconciliation to
cash book and have just been passed verify the completeness and accuracy of the
the latest bank statement. cash book.
5 You have just received a monthly You should reconcile the balance per the
statement from your main supplier. supplier statement to the purchase ledger
balance.
6 You are responsible for payroll You should be provided with a copy of the letter
processing and you have just received signed by the employee which authorises the
notification from human resources that deductions and a hierarchical password should
an employee wants to take advantage of be required to amend the standing data.
a season ticket loan offered by your
company. Your password does not give
you permission to amend employee
deductions.
7 You have just returned from a 3 month Your password should have expired and the
holiday and are trying to log on to your computer should automatically require you to
computer. change your password.
8 You are preparing to pay an invoice You should verify that the goods have been
received from a supplier. received by checking to a goods received note,
vouch the prices to the suppliers price list and
re-calculate the sales tax and addition of the
invoice. The invoice should then be authorised
for payment and this evidenced by a signature.
9 You have prepared a bank reconciliation Your supervisor should review the bank
for your supervisor. reconciliation to verify it has been done properly
and sign to evidence that the review has taken
place.
310
10 You are entering 75 sales invoices into You should perform a batch reconciliation
the accounting records and want to whereby you manually count the number of
check the accuracy of your posting. invoices posted and verify to the system or
manually total the value of the invoices and
verify that the revenue, sales tax and
receivables accounts have increased by the
corresponding amounts.
Provided that the invoices are sequentially
numbered, you should also perform a sequence
check to determine whether any invoice
numbers have been omitted.
11 You have been working on the computer You should log out / lock your computer prior to
but have now gone away to make a cup leaving your work station.
of tea leaving the computer inactive for a If you do not lock your computer then the
period of time. computer should time out after a certain period
of time and require you to re-enter your log on/
password details before you can resume work.
12 You have a Saturday job operating the till The cash in the till should be counted at the end
in a small corner shop which is closing of the day and reconciled to the till receipt.
for the night. Money should be kept in a safe overnight.
13 You work in a shop that sells diamond The shop should have CCTV in operation, the
jewellery, the jeweller is very keen to front door should be locked with a door bell
keep his inventory secure. which must be rung to gain entry, jewellery
should be kept in locked cabinets and stored
overnight in a safe/ secure vault and grilles
pulled down over the shop windows.
Chapter 10
Many parts of the sales system Completing items by hand The computer system should
process are completed by could lead to an increased risk generate a blank standard
hand/ manually. of manual error in filling out the order form for the sales team
For example, the order form is form or errors in processing if to complete electronically.
completed by hand and is then handwriting cannot easily be Once completed, this should
read.
passed (by hand) to the be emailed to the customer
warehouse. Additional time is also taken and sent electronically to the
photocopying/ scanning orders warehouse.
which are then posted/ emailed
to customers.
There could also be delays in
passing the order to the
warehouse.
311
The goods despatched note If errors are made in the The GDN should be generated
(GDN) is not generated from packing process, then the as an electronic copy of the
the order form but is simply customer could be despatched order form and detail the
written up from what is packed items that they did not order or product code and quantity
in the boxes. may not receive items they did ordered. Where an item is not
order, even if they are not out in stock this should be
There is also no double check
of stock. recorded on the GDN.
that the items on the GDN are
those items packed in the Spot checks should be carried
boxes. out to verify that the contents
packed agree to the order
form.
Monies received from The company does not have Monies received with
customers are not always an accurate record of remittance advices should be
accompanied by a remittance outstanding invoices and so allocated against the specific
advice and so cannot always cannot chase overdue invoices which are being paid.
be allocated to specific amounts efficiently. Where a remittance advice is
outstanding invoices. This will also mean that not received, the accounts
Sometimes monies are simply disputed invoices are not receivables clerk should
allocated to the oldest necessarily identified. contact the customer by
invoices. This could lead to a loss of
telephone to determine the
breakdown of invoices being
cash flow and/ or irrecoverable
paid.
debts.
Note that only THREE deficiencies were required for this lecture example.
However there were many other deficiencies in the lecture example and these are detailed
below for completeness.
The order form is not pre- The situation may arise where Order forms should be pre-
numbered. more than one order is given numbered and sequentially
the same order number numbered
causing confusion in the sales
team when dealing with
customer queries.
If the order forms are not pre-
numbered then it is also more
difficult to file them in a logical
order and thus resolve any
customer queries quickly and
efficiently.
Orders for the supermarket The warehouse manager has All orders should be passed to
chain are sent directly to the responsibility to ensure that all the warehouse manager who
despatch team and not to the orders received are allocated can then allocate the jobs to
warehouse manager. to a team of pickers. He also the despatch team on a timely
monitors that orders are basis.
subsequently fulfilled where
items are initially out of stock.
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Passing the order directly to

the despatch team may mean
that these unfulfilled orders are
not later despatched leading to
dissatisfaction from the
companys major customer.
No credit checks are made The company may well accept A standard new customer
before new customers are an order and despatch goods form should be created which
accepted and credit limits are to a bad credit risk. This may must be completed before
not prescribed. mean that goods are sold to a orders are accepted from new
customer who cannot pay for customers. This form should
them leading to a loss of require a credit check to be
revenue and inventory. made in relation to the
customer and a credit limit
allocated. Standard tiers of
credit limits could be applied
for different customers. All
completed new customer
forms should be authorised by
Edward Times or Katie
Escombe prior to goods being
despatched. The authorisation
should be evidenced on the
form.
The invoice process is also Any errors in the GDN will An electronic invoice should be
completed manually and the result in errors on the invoice. generated from the electronic
items to be invoiced are This will lead to staff time order form and GDN using the
manually input from the details being taken up to correct the standard product codes and
on the GDN. errors and could lead to prices.
customer dissatisfaction if the
level of errors is high.
The prices charged to the Any errors in the pricing Each time that prices change,
supermarket are automatically standing data will mean that a report showing the pricing
generated by the system the supermarket could be standing data should be
without any checks being charged for goods at too low a generated and reviewed by a
made. price, thus losing the entity supervisor/ manager to ensure
revenue, or at too high a price all changes are accurate. This
which would potentially lead to review should be evidenced by
customer dissatisfaction. a signature.
313
There is no formal process to If overdue amounts are not A formal process should be
monitor overdue amounts. chased as soon as they fall adopted to chase outstanding
overdue then there is an customer balances.
Customer statements are not
increased risk of non-payment.
sent each month and no aged Statements should be
receivables analysis is prepared on a monthly basis
produced, and sent to each customer
detailing the transactions with
the customer during the month
and the balance outstanding at
the end of the month.
The aged receivables report
should also be produced on a
monthly or at least quarterly
basis to identify amounts which
have been overdue for some
time.
Customers with overdue
accounts should be contacted
by telephone as soon as
possible and a letter
requesting payment sent if no
payment is received.
Accounts should be placed on
stop if a customer exceeds
their credit limit until such time
that the balance is repaid.

When completing an order form, the sales team For a sample of orders throughout the year,
refer to the standard product list in order to vouch the product codes on the order form to
verify that the correct product codes have been the standard product list to verify that the
used and that the order is accurate. correct product codes have been used.
Any changes to standard data, such as For a sample of customers who are not entitled
discounts, requires hierarchical authorisation by to a discount, attempt to process a discount to
the acting finance director. determine whether a prompt will be received
requesting an appropriate login.
314
Bank reconciliations are performed each week For a sample of bank reconciliations, re-perform
to monitor the completeness, accuracy and the reconciliation to ensure it has been
validity of the information held in the cash book. completed properly. Vouch the balances per
the bank statement and cash book to the bank
The reconciliations are also performed by
statement and the accounting records and re-
someone other than the accounts receivables
cast the arithmetical accuracy of the
clerk which strengthens the control due to the
reconciliation. Trace through any reconciling
segregation of duties.
items to ensure that they are reasonable.
If the bank reconciliation was reviewed, inspect
the reconciliation for evidence of the review
taking place.
Note that only THREE controls were required for this lecture example.
However there were several other controls in the lecture example and these are detailed
Orders which have been received but have not Observe the warehouse manager review these
been completed because the item is out of orders and follow up to ensure that they have
stock are reviewed daily to ensure that been allocated to a picking team and fulfilled
customer orders are completed as efficiently as within an appropriate timescale.
possible. Observe the review of outstanding orders to
A full review of outstanding orders is also done ensure it is conducted each month.
each month with the sales team.
Invoicing is carried out daily once the GDNs are For a sample of GDNs trace through to the
received from the warehouse. This ensures related invoice and vouch the date to ensure
that goods despatched are invoiced on a timely that the invoice was sent out shortly after the
basis thus improving cash flow. goods were despatched.

The goods received into the Goods may be accepted which The warehouse manager
warehouse are not checked have not been ordered and should request that his team
back to the order form. therefore are not needed by vouch the items received on
the business. the delivery against the copy of
the order from which is
forwarded to them by the
purchasing department.
Furthermore goods which are
The purchasing department
actually required may have
been omitted from the delivery should be notified of any items
ordered which have not been
which could lead to stock-outs
received so that they can
and business interruption.
follow this up with the supplier
to ensure that stock-outs do
not occur.
315
Supplier statements are not Any errors made when Each month, the accounts
reconciled to the balance per recording the invoices in the payable clerk should reconcile
the purchase ledger account. accounting system may not be the balance per the purchase
detected meaning that the ledger account to the balance
balance in the accounting per the supplier statement.
records could be over or This reconciliation should be
understated. reviewed by the department
supervisor/ manager. Any
journals required as a result of
the reconciliation should also
be authorised as above.
Note that only TWO deficiencies were required for this lecture example.
However there were several other deficiencies in the lecture example and these are detailed
The buyers do not review/ Any errors in the orders could Each day/ week, orders
authorise the orders which are go undetected and orders generated by the system
automatically generated by the could be placed for inventory should be passed to the buyer
inventory system. which is not required. responsible for that inventory
line. The buyer should then
verify that the order is required
and authorise the order,
evidencing this with a
signature.
Supplier invoices are being The entity may well be paying A prompt should be put in the
paid in the month in which they invoices too early and accounting system which
are received rather than when therefore losing out on the identifies when each invoice
they fall due. cash flow benefit of retaining needs to be paid according to
cash and paying invoices on the suppliers credit terms.
time. Each month a report should
then be produced detailing the
invoices which are due for
payment. These invoices only
should be paid, unless a
discount is offered for early
payment.
316

Invoices received are vouched back to the For a sample of invoices which have been
GRNs to ensure that the entity is only invoiced matched to GRNs re-perform the calculations
for items which have been delivered. The conducted by the finance assistant to ensure
invoice details in terms of product codes and that they have been done properly.
unit costs are also verified. These procedures Inspect the invoice for evidence of the finance
are evidenced by the initials of the finance assistants initials.
assistant.
Payments to the supplier are authorised prior to Observe the process/ inspect a copy of the
the invoice being paid. The bank payment bank payment authorisation and associated
authorisation is approved by the acting finance invoices for evidence of the authorisation.
director prior to payment being made.
Note that only TWO controls were required for this lecture example.
However there were several other controls in the lecture example and these are detailed
Re-order levels exist for each inventory line and For a sample of inventory lines discuss the re-
these are reviewed each season to ensure that order level with the appropriate buyer to
they are appropriate to the sales pattern of the determine when the re-order level was last
business. updated and the process used by the buyer to
determine the appropriate re-order level.
Goods received by the warehouse are checked Observe goods being received by the
to ensure that only goods in good condition and warehouse staff to verify that quality control
of appropriate quality are accepted. procedures are being carried out.
Invoices are marked with a stamp saying paid Inspect a sample of invoices which are
once they have been paid. This should reduce recorded in the accounting system as having
the risk of an invoice being paid twice. been paid for evidence of a stamp saying
paid.
317

Overtime does not have to be Employees could claim for The entity should establish a
authorised by a supervisor/ overtime which has not been request for overtime form.
manager in order to be paid. worked. This should be completed by
the employee after discussion
Also the entity cannot budget
with the department manager
its cash flow properly if
to determine why and whether
overtime is not planned in
overtime is necessary. The
advance and authorised.
department manager should
sign to evidence their
authorisation for the overtime
to be performed.
Once the overtime has been
completed, both the request
for overtime and overtime
claim forms should be signed
by the department manager
and forwarded to the wages
clerk.
The wages clerk is able to The wages clerk has too much At least two people should be
amend the standing data on influence over the payroll involved in the payroll process.
the payroll system and also system and could carry out One person should have
processes payroll on a day to fraudulent activity such as responsibility for amending
day basis. setting up fictitious employees standing data and joiners and
and changing rates of pay if he leavers and the second person
wanted to. should process the day to day
payroll.
All amendments to standing
data should be authorised
before they are made and an
exception report of changes
made printed each month and
review for any unexpected
changes.
318

Hours worked are recorded by a clocking in/ out Observe the clocking in/ out process to ensure
system with each employee using their unique that each employee has to enter their own
employee number. Employees are employee number.
automatically clocked out at the end of their Attempt to clock in using an incorrect employee
shift reducing the risk that employees are paid number to verify that the system will not allow
for hours not worked. the entry.
For a valid employee number, do not clock out
at the end of the day and inspect the system
records to ensure that the employee has been
logged out by the system.
The listing of employee pay details is reviewed Observe the monthly payroll being processed
by the acting finance director before payments and reviewed by the acting finance director.
are made to the employees. This reduces the Inspect a copy of the payroll listing to vouch the
risk of fraudulent/ erroneous payments. finance directors signature authorising the
payment.
Chapter 11
CUSTOMER BALANCE CUMULATIVE SELECTED (Y/N)
TOTAL
1 60,000 60,000 N
2 70,000 130,000 Y
3 90,000 220,000 Y
4 105,000 325,000 Y
5 28,000 353,000 N
6 100,000 453,000 Y
7 46,000 499,000 N
8 1,000 500,000 Y
9 84,000 584,000 N
10 94,000 678,000 Y
11 108,000 786,000 Y
12 34,000 820,000 Y
13 160,000 980,000 Y
14 20,000 1,000,000 Y
1,000,000
319

(a) Error rate in sample x total value of population
$9,000
$1,000,000 = $45,000
$200,000
(b) The projected error is above the tolerable error/ misstatement limit. This means that
further evidence is needed. This could be done by:
Extending the sample tested in the procedure and then reperforming the
extrapolation, or
Designing and performing additional substantive procedures.
If the further evidence allows the auditor to conclude that the actual error in the
population does not exceed tolerable error/ misstatement, then the auditor will
conclude that no adjustment is necessary, although the error of $9,000 will be noted
on a schedule of uncorrected misstatements.
If the further evidence indicates that there is a misstatement that exceeds tolerable
error/ misstatement then the auditor will ask the client to make an adjustment to the

(a) Error rate in sample:
18
= 8%
225
(b) The projected error rate is below the tolerable error/ misstatement limit of 13%.
This means that the internal control is believed to have operated effectively
throughout the period and the auditor can rely on it when assessing the accuracy and
validity of adjustments made to the inventory system.
No further testing is required, however any monetary errors resulting from the 18
failures of the internal control should be noted on the schedule of uncorrected
misstatements.
Chapter 12
Tests on:
1 Opening balances
These should be agreed to the previous years audit file and signed financial
statements.
320
2 Additions
A list of additions should be obtained and the total agreed to the financial
statements.
A sample of assets should be selected and their value should be traced to
invoices. The amount capitalised should be checked to verify that it excludes
recoverable sales tax.
Legal costs capitalised should be agreed to invoices from the company
solicitor.
3 Revaluations
Trace the revalued amount to the valuer's report and confirm that the surplus is
$1,000,000.
Agree that the $1,000,000 has been transferred to a revaluation reserve
through scrutiny of the nominal ledger.
Agree the basis of valuation to the valuer's report. Verify the disclosure of this
to the notes to the financial statements.
Recalculate depreciation to confirm that it is based on revalued amount.
Review the notes to the financial statements to confirm that the revaluation has
been disclosed.
4 Depreciation Charge for Year
Obtain details of the accounting policy from the notes to the financial
statements.
Confirm against last years financial statements that there have been no
changes to these policies.
Recalculate depreciation on a sample of assets. Compare the calculations to
the depreciation charge in the non-current assets register for each item in the
sample. Alternatively perform a proof in total of depreciation charge for each
category of asset by taking the average cost balance (opening cost + closing
cost/2) and multiplying by depreciation rate.
Confirm that depreciation rates are reasonable.
5 Disposals
A list of disposals should be obtained and the total agreed to the financial
statements.
For material disposals:
Agree the cost of the asset sold to the non-current asset register
Recalculate the depreciation up to the date of disposal, based on the
company's accounting policy
Trace the proceeds to the cash book and the bank statement
321
Recalculate the profit and loss on disposal and agree to the nominal
ledger; and
If the profit or loss is material, verify to the income statement that it is
separately disclosed in accordance with IAS 1.
Chapter 13
Five matters which will require action by management if the inventory count is to be effective
together with corrective action are:
(a) By allowing Mr Farditch to take responsibility for the detailed organisation of the
count, the present instructions permit the person with day-to-day responsibility for the
inventory area to supervise one of the most important control checks on that area.
This represents a deficiency in the company's system of internal check, since the
opportunity is afforded to Mr Farditch to cover up any inadequacies there may be in
the operational efficiency of controls in the area of inventories.
Mrs Curbar should take more direct responsibility for the detailed organisation of the
count.
(b) By giving to those members of staff responsible for the physical count of the
inventories an indication of the quantity which is expected to be in inventory, there is a
risk that this may prejudice their opinion in the event of there being a discrepancy.
More importantly, it will tend to reduce the benefits which it is intended to derive from
having an independent check on the inventory records by having to reconcile them
with the quantities determined by a physical count.
The pre-printed inventory sheets should not show the balance of each inventory item
on hand as shown on the inventory records held independently of the warehouse.
(c) At the moment clear instructions do not appear to have been given of the action
required in the event of there being a discrepancy in the counts arrived at by the two
members of the counting team. Unless precise instructions are given, there would be
a tendency to accept the quantity determined by the senior member of the count
team, which is not necessarily going to be the correct one.
The teams of counters should be instructed that in the event of their independent
counts of the inventory quantities not agreeing a further count should take place. If
they are still unable to agree then a note of this fact should be made on the inventory
count tag so that a further check may be by the inspection team.
(d) A number of teams of checkers (2 or 3) should be appointed to go around after the
counters. The task of these checkers would be to:
Carry out sample tests on the accuracy of the original counters
Ensure that inventory count completion tags have been left by the counters at
each inventory location.
The appointment of checkers will improve the efficiency of the overall count by acting
as a check on both the accuracy and completeness of the count.
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(e) Allowing the members of staff involved in the count to deduct any goods in poor
condition from the quantities appearing on the inventory sheets increases the risk that
(i) Errors of judgement are made, or
(ii) This procedure could be used deliberately to cover up past or future
misappropriations of inventory.
The staff involved in the count should be instructed to identify any goods that appear
to be in poor condition on the inventory sheets and these can then be reviewed by a
more senior employee.
Goods should only be written off on the authorisation of that more senior employee.
Chapter 14
Darth Co
The cash in transit should be traced to the cash receipts book post year end. I would
expect it to be received within a few days of the year end.
I would also trace the cash to the bank paying in slip. Again, this should be stamped
by the bank post year end.
Skywalker Co
The goods in transit should be traced to a GDN dated prior to the year end.
If inventory records exist the despatch could be traced to the records to confirm that it
was sent prior to the year end.
Yoda Co
The reason for the dispute and my clients views on it should be obtained from the
correspondence file between Yoda Co and my client.
Credit notes post year end should be scrutinised to determine whether a credit was
given for the disputed goods.
Cash receipts should be reviewed post year end to determine whether Yoda Co paid
the full balance.
If the amount is outstanding at the audit date, discuss recoverability with the credit
controller.
Chapter 15
No Lecture Examples
323
Chapter 16
Salary:
Vouch salary amounts to monthly payroll records and bank statements to ensure the
amounts are accurate.
For Directors C and D, obtain their leaving/ start dates from the HR department and
vouch this to board meeting minutes. Recalculate their salaries on a pro-rata basis to
ensure they are accurately recorded.
Bonuses:
Vouch the level of bonuses awarded to board meeting minutes, payroll records and
bank statements to ensure they have been authorised and are accurately recorded.
Discuss with management the reasons why Director C was awarded a bonus despite
leaving the company during the year. Support any explanations with written
documentation where possible (for example Director Cs contract).
Termination payments/ incentive payments:

Review the employment contracts for Directors C and D to verify that there is a clause
outlining that these payments are applicable.
Vouch the level of these payments to board meeting minutes, payroll records and
bank statements.
General:
Re-cast the schedule to ensure the note is accurate.
Review the disclosure to ensure that it is in accordance with applicable law and
accounting standards.
Chapter 17
Cash collections
Discuss procedures for cash collection with management and assess risk of fraud,
loss, robbery or error
Discuss selection criteria for collectors and collection procedures with management
Observe the cash collection, recording and banking process
Trace a sample of cash received control lists to cash records and bank statements
Reperform a reconciliation of total cash received to income
Perform an analytical review of cash donations per month vs previous year taking into
account factors such as number of collectors and weather
324
Regular donations by the 'Big 4' and wealthy individuals

Obtain and compare analysis of major/regular contributions with previous year
Send circularisation letters to confirm material amounts donated by Big 4 and wealthy
individuals
Circularise tax authorities to confirm contributions made where tax deductions have
been claimed.
Chapter 18
The following factors might cause me to have doubts about Trucker's going concern status:
Fall in gross profit margin (20X2: 7%; 20X1: 9.4%). This will make a return to
profitability difficult.
Truckers are making losses. This will make negotiations with the bank difficult.
Debtors are taking longer to pay (20X2: 99 days; 20X1: 75 days). This will squeeze
cash flow coming into the business. Bad debts will increase the existing loss.
Worsening liquidity ratio (0.88 in 20X2; 1.05 in 20X1). Loan and lease commitments
may not be met.
Increasing reliance on short term finance. The overdraft can be recalled by the bank
at any time. It should not be used to finance long term investment.
Increased gearing (20X2: 63% [750+250+1,245/3,544]; 20X1: 50%
[1,000+913/3,793]). Interest on debt must be paid from a decreasing cash position.
Loss of major customer. Other customers may follow, worsening the company's
prospects.
Loss of commercial customers. This represents loss of regular income. Damage to
companys reputation.
Overdraft facility to be reviewed 3 months after the year end. This short period is
probably not long enough to see any improvement in the company's future prospects
and therefore may not be renewed.
Despite the managing directors optimism, there is no evidence to support the
forecasts of additional revenue from new contracts.
325
Chapter 19
Inventory
Little Bees Co has not valued inventory at the lower of cost and net realisable value on a line by
line basis which is contrary to the accounting standard IAS 2.
If it had, then the inventory line would have been written down by $14,000 ($17,000 cost less
$3,000 NRV).
The error is material as it represents 8% of profit before tax ($14,000 / $175,000) and so
management should correct this error in the financial statements.
If management refuse to amend this error then the audit report will need to be modified. As
management has not complied with IAS 2 and the error is material but not pervasive then a
qualified opinion would be necessary.
A basis for qualified opinion paragraph would need to be included explaining the material
misstatement in relation to the inappropriate valuation of inventory and the effect on the financial
statements.
The opinion paragraph would be qualified except for due to material misstatement.
Wages and salaries
Little Bees Co wages records have been corrupted leading to a loss of payroll data for one month.
The auditors should attempt to adopt alternative audit procedures to verify the wages and salaries
cost for this month. If they are unable to do this, then the payroll for the whole year would not have
been verified.
Wages and salaries for the month represent 11% of profit before tax ($20,125 / $175,000) and is
therefore a material balance for which evidence has not been available.
The auditors will need to modify the audit report as they are unable to obtain sufficient appropriate
evidence in relation to a material but not pervasive element of wages and salaries and therefore a
qualified opinion would be necessary.
A basis for qualified opinion paragraph would be required to explain the limitation in relation to lack
of evidence over one month of payroll records.
The opinion paragraph would be qualified except for due to insufficient appropriate evidence.
326

(i) The directors of Difficult Times Co have prepared the financial statements on the
going concern basis but the auditors do not feel that this is appropriate.
This is certainly material and likely to be material and pervasive as going concern is
fundamental to the basis on which the financial statements are prepared.
An adverse opinion would therefore be required.
A basis for adverse opinion paragraph would need to be included explaining the
material misstatement in relation to the inappropriate use of the going concern basis
and the effect on the financial statements.
The opinion paragraph would show an adverse opinion stating that the financial
statements do not present fairly due to material misstatement.
(ii) The directors of Tradings Hard Co have made appropriate disclosures of worries over
going concern in the financial statements and the auditor is happy with this disclosure.
The audit opinion will therefore be unqualified.
Significant concern still exists however and so, due to the importance of the issue, the
auditor will include an emphasis of matter paragraph after the opinion paragraph.
The emphasis of matter paragraph must contain a clear reference to the disclosures
in the financial statements and state that the auditors opinion is not modified in
respect of this matter.
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END OF ANSWERS TO LECTURE EXAMPLES

328
Question and
Answer bank
329
Index to Question and
Answer bank
Page
Questions Answers
1 Section A Objective test questions............................................................................ 331 ................... 337

2 Audit and assurance engagements........................................................................... 334 ................... 338
3 ZX .............................................................................................................................. 334 ................... 340
4 Audit planning and documentation ............................................................................ 334 ................... 342
5 Audit evidence considerations................................................................................... 335 ................... 343
6 Internal control systems............................................................................................. 335 ................... 344
7 Using the work of others............................................................................................ 335 ................... 345
8 Homes r Us .............................................................................................................. 336 ................... 347
330
21: QUESTION AND ANSWER BANK
Question 1
Section A
Objective test questions
1 Which of the following statement is correct in relation to external statutory audits?
A External audits give absolute assurance that the financial statements are free from all
misstatement.
B External audits give limited assurance that the financial statements are free from
C External audits give reasonable assurance that the financial statements are free from
material misstatement. (1 mark)
2 The International Standards on Auditing are issued by which of the following bodies?
A IAESB
B IAASB
C IASB
D FRC (2 marks)
3 Which TWO of the following statements are correct with regards to the International
Standards on Auditing (ISA)?
(1) The ISAs aim to ensure that audits performed on different companies, in different
jurisdictions, adhere to common standards.
(2) Where it is not possible to comply with one or several of the ISAs in an audit, the
auditor should explain the reason for the non-compliance in the auditors report.
(3) The ISAs apply to the audit of smaller entities.
A 1 and 2
B 1 and 3
C 2 and 3 (2 marks)
4 To ensure transparency, the internal audit team should report to:

A The companys directors
B The audit committee
C Both the directors and the audit committee
D The shareholders (2 marks)
331
5 F Co is an oil and gas company mining for crude oil reserves in sub-Saharan Africa. In the
external audit of F Co, to which of the following might specific performance materiality levels
apply?
(1) Directors remuneration
(2) Exploration and development costs
(3) The financial statements as a whole to reduce to an appropriately low level the
probability that the aggregate of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole
(4) The financial statements as a whole to determine whether misstatements identified
during the audit should be accumulated and communicated to management
A 1, 2 and 3
B 1, 2 and 4
C 1 and 2
D 2 and 4 (2 marks)
6 Which of the following matters would the overall audit strategy include?
A The applicable financial reporting framework
B The nature, timing and extend of audit procedures at the assertion level
C The timetable of planned audit work (1 mark)
7 Existence is an assertion about account balances at the period end.

Is this statement true or false?
A True
B False (1 mark)
8 The audit team of which you are a member is in the process of documenting the audit
clients system of internal controls. You wish to assess what specific errors or frauds may
occur, in order to identify the key controls that the team will then need to test during control
testing.
Which of the following methods for recording control systems should you use?
A ICQ
B ICEQ
C Narrative notes
D Flowcharts (2 mark)
332
9 To ensure that the recorded sales transactions represent goods that have actually been
despatched, D Cos sales system only record sales if there is matching despatch
documentation.
Which of the following would be an appropriate test of control to confirm that the control is
operating effectively?
A For a sample of sales invoices, verify that there are matching goods despatched
notes.
B For a sample of goods despatched notes, verify that there are matching sales
invoices.
C Verify that the numerical sequence of sales invoices is complete.
D Inspect the open-order file for unfulfilled orders. (2 marks)
10 As the external auditor of G Co, you have performed analytical procedures which have
highlighted a 40% increase in revenue compared to the previous period.
Which further audit procedures would you perform in response to this?
(1) For a sample of sales invoices around the period end, inspect the dates and compare
with the dates of goods despatch and the dates recorded in the sales and receivables
ledger to confirm the application of correct cut-off.
(2) Trace a sample of shipping documentation to sales invoices and into the sales and
receivables ledger.
(3) For a sample of sales transactions recorded in the ledger, vouch the sales invoice
back to customer orders and shipping documentation.
(4) For a sample of sales invoices, examine for proper classification into revenue
accounts.
A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4 (2 marks)
11 Auditors have no obligations to perform procedures or make enquiries regarding the

financial statements after they have been issued.
Is this statement true or false?
A True
B False (1 mark)
12 Due to disruptions caused by the recent transition to a new accounting system, one month
of H Cos inventory records have been lost. The auditors performing the statutory audit for
the twelve-month period have determined that the possible effects of undetected
misstatements could be material, but not pervasive.
What form of audit opinion would the auditor give?
A Unmodified opinion with an emphasis of matter paragraph
B Qualified opinion
C Adverse opinion
D Disclaimer of opinion (2 marks)
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2 Audit and assurance engagements 18 mins

(a) Explain the difference between negative and positive assurance in the context of the
external audit and review engagements. State some of the limitations of the external audit.
(4 marks)
(b) The audit opinion sets out explicit opinions which must be stated in the audit report. State
what these are and outline the possible implied opinions, which are only reported on by
exception. (3 marks)
(c) Auditors have certain rights to allow them to carry out their duties. State and explain what
these rights are, using the UK as an example. (3 marks)
(Total = 10 marks)
3 ZX 36 mins
You are a recently qualified Chartered Certified Accountant in charge of the internal audit
department of ZX, a rapidly expanding company. Revenue has increased by about 20% pa for the
last five years, to the current level of $50 million. Net profits are also high, with an acceptable
return being provided for the four shareholders.
The internal audit department was established last year to assist the board of directors in their
control of the company and to prepare for a possible listing on the stock exchange. The Managing
Director is keen to follow the principles of good corporate governance with respect to internal audit.
However, he is also aware that the other board members do not have complete knowledge of
corporate governance or detailed knowledge of International Auditing Standards.
Required
Write a memo to the board of ZX that:
(a) Explains how the internal audit department can assist the board of directors in fulfilling their
obligations under the principles of good corporate governance. (10 marks)
(b) Explains the advantages and disadvantages to ZX of an audit committee. (10 marks)
(Total = 20 marks)
4 Audit planning and documentation 18 mins

(a) Explain the difference between the overall audit strategy and the audit plan and state the
key contents of the overall audit strategy document. (4 marks)
(b) Briefly explain the reasons for auditors documenting their work. (3 marks)
(c) Many audit firms use standardised working papers. List the advantages and disadvantages
of audit firms using standardised working papers to document their audit work. (3 marks)
(Total = 10 marks)
334
5 Audit evidence considerations 18 mins

(a) Discuss how analytical procedures can be used as substantive audit procedures to provide
audit evidence. Illustrate your answer with an example. (5 marks)
(b) ISA 500 Audit evidence requires auditors to obtain sufficient appropriate audit evidence to
be able to draw reasonable conclusions on which to base their audit opinion. Discuss the
different sources of evidence available to auditors and assess their relative appropriateness.
(5 marks)
(Total = 10 marks)
6 Internal control systems 18 mins
An understanding of internal control assists the auditor in identifying potential misstatements and
factors that affect the risks of material misstatement, and in designing the nature, timing and extent
of further audit procedures.
(a) Explain the limitations of internal control systems. (4 marks)
One method of recording an audit clients accounting and internal control system is using narrative
notes.
(b) (i) Describe two advantages and two disadvantages of using narrative notes to
document accounting and control systems. (4 marks)
(ii) Briefly describe two alternative methods of documenting accounting and control
systems. (2 marks)
(Total = 10 marks)
7 Using the work of others 18 mins

(a) ISA 402 Audit considerations relating to an entity using a service organisation provides
guidance to auditors whose clients use service organisations.
Required
In the context of an audit, explain what a service organisation is and explain what the
auditors responsibilities are in relation to gaining an understanding of a service organisation
used by an audit client. (4 marks)
(b) ISA 620 Using the work of an auditors expert provides guidance to auditors on relying on
work carried out by an auditors expert.
Required
(i) List four examples of audit evidence that might be obtained from the use of an
auditors expert. (2 marks)
(ii) Describe the factors that should be considered by the auditor when evaluating the
work carried out by the expert. (2 marks)
(iii) Explain the actions the auditor should take if he concludes that the results of the
expert's work do not provide sufficient, appropriate audit evidence or if the results are
inconsistent with other audit evidence. (2 marks)
(Total = 10 marks)
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8 HomesrUs 36 mins
HomesrUs is a large listed construction company based in the north of the country, whose
activities encompass housebuilding and development. Its annual revenue is $550 million and profit
before tax is $70 million.
You are the audit senior involved with the audit of HomesrUs for the year ended 31 December
20X7. The following matters have come to your attention during the review stage of the audit in
April 20X8.
(i) Customer going into liquidation
One of HomesrUs major commercial customers has gone into liquidation shortly after the
year-end. As at the year-end, the customer owed the company $7.5 million. (7 marks)
(ii) Claim for unfair dismissal
One of the companys construction workers, Basil Evans, was dismissed in November 20X7
after turning up to work under the influence of alcohol. In December 20X7, Mr Evans began
a case against the company for unfair dismissal. Lawyers for the company have advised
that it will be highly unlikely that he will be successful in his claim. (7 marks)
(iii) In March 20X8 a fire was started by vandals at one of the companys ten storage depots,
destroying $1 million worth of building materials. (6 marks)
Required
For each of the three events at HomesrUs mentioned above:
(a) Describe the additional audit procedures you will carry out.
(b) State whether the accounts will need to be amended and explain your reasoning.
(c) Discuss the potential impact on the audit report, fully explaining your answers.
Note: The mark allocation is shown against each of the three events. (Total = 20 marks)
END OF QUESTION BANK
336
Answers
1 Section A
Objective test answers
1 C Statutory audits give reasonable assurance. It is not possible to give absolute
assurance, given the inherent limitations of audit. Limited assurance is given in review
engagements, where the audit opinion is expressed in a negative form.
2 B The ISAs are issued by the International Auditing and Assurance Standards Board
(IAASB), a technical standing committee of the IFAC. The International Accounting
Education Standards Board (IAESB), also part of the IFAC, publishes the
International Education Standards aiming to increase the competence of the global
accountancy profession. The International Accounting Standards Board (IASB)
issues the International Financial Reporting Standards. The Financial Reporting
Council (FRC) issues ISAs (UK & Ireland), not the international standards.
3 B All of the ISAs must be complied with in an audit of historical financial information. A
comply-or-explain approach is not possible here. The ISAs also apply to smaller
entities, although specific guidance is given on how certain requirements may be met
in this case.
4 C Best practice indicates that the internal audit function should have a dual reporting
relationship, reporting both to management and the audit committee. If the internal
audit function does not report to the audit committee, management may be able to
unduly influence the internal audit plan and scope, thus compromising the
effectiveness of internal audit. The external auditors, not the internal auditors, report
to the shareholders.
5 A Performance materiality may be set for particular classes of transactions, account

balances or disclosures. Directors remuneration is an account where law and
regulation affect users expectations regarding disclosure. A lower level of
performance materiality therefore should be applied. Exploration and development
costs are material due to the industry in which the company operates, and therefore
merits a lower performance materiality level.
ISA 320 requires performance materiality to be set to reduce to an appropriately low

level the probability that the aggregate of uncorrected and undetected misstatements
exceeds materiality for the financial statements as a whole. All uncorrected
misstatements should be cumulated and communicated to management, unless they
are clearly trivial.
6 A The applicable financial reporting framework would be expected to be covered in an

overall audit strategy document. The nature, timing and extent of audit procedures at
the assertion level should be included in the more detailed audit plan, as should the
timetable for audit work.
337
7 A The statement is true. Existence asserts that asset, liabilities and equity interests
exist.
8 B ICEQs would be best suited to help auditors identify the key controls for controls
testing. ICQs focus on whether the desirable controls are present, and so would not
identify the areas at risk of specific errors or frauds. Narrative notes describe and
explain the system, but its detailed nature makes it difficult to identify control
exceptions at a glance. Flowcharts also describe the system but does not highlight
exceptions.
9 A The direction of the test is important here. The sample is taken from sales invoices,
as this tests whether each sales order has been fulfilled (the assertion of occurrence).
If the sample is taken from goods despatched notes, this would instead confirm
whether the goods sold had been correctly invoiced (the assertion of completeness).
C and D both test for completeness.
10 B The risk here is the overstatement of sales revenue. Audit procedure 1 tests for cut-
off, where potential errors may cause revenue to be overstated. Audit procedure 3 is
a test of occurrence, also focusing on the overstatement of revenue. Audit procedure
2 tests for completeness, so therefore identifies the understatement of revenue
instead. Audit procedure 4 relates to classification this assertion has no impact on
the overall revenue balance.
11 A This statement is true. However, if the auditor does become aware of a fact that, had
it been known at the date of the auditors report, may have caused the auditor to
amend the auditors report, the auditor shall discuss the matter with management and
determine whether the financial statements need amendment.
12 B A qualified opinion is appropriate, because the matter is considered to be material,

but not pervasive. An unmodified opinion with an emphasis of matter paragraph is not
relevant: it serves to draw the attention of users to a matter appropriately presented or
disclosed in the financial statements, which is fundamental to the users
understanding of the financial statements.
2 Audit and assurance engagements

(a) Assurance engagements are engagements in which a professional accountant expresses a
conclusion which provides the intended user with a level of assurance about a particular
subject matter. External audits and review engagements are examples of assurance
engagements.
An external audit provides only reasonable assurance because of the inherent limitations of
the audit such as the fact that not all the transactions in the accounts can be tested and that
judgement is required in the audit of provisions, for example.
Review engagements only provide negative assurance. This means that nothing has come
to the attention of the auditor which indicates that the accounts have not been prepared
according to the applicable framework.
Limitations of the external audit:
338
Not all items in the financial statements are tested.

Judgement is required.
There are limitations in the accounting and control systems.
The audit report is often issued a while after the statement of financial position date.
(b) The explicit opinions stated in the audit report:
The state of the company's affairs at the end of the financial year in the statement of
financial position.
The company's profit or loss for the financial year in the statement of profit or loss and
other comprehensive income.
Implied opinions are reported on in the audit report only by exception and could include the
following:
Adequate accounting records have been kept.
Returns adequate for the audit have been received from branches not visited.
The accounts are in agreement with the accounting records and returns.
All information and explanations have been received by the auditors and they have
had access at all times to the company's books, accounts and records.
Details of directors' emoluments and other benefits have been correctly disclosed in
the accounts.
Particulars of loans and other transactions in favour of directors and others have been
correctly disclosed in the accounts.
(c) Using the UK as an example, auditors have the following rights:
Access to records: Auditors have a right to access at all times, the books, accounts
and vouchers of the company.
Information and explanations: Auditors have a right to require from the company's
officers any information and explanations that they consider necessary for the
performance of their duties.
Attendance at and notices of general meetings: Auditors have a right to attend any
general meetings of the company and to receive all notices of and communications
relating to such meetings which any member of the company is entitled to receive.
Right to speak at general meetings: Auditors have a right to be heard at general
meetings which they attend on any part of the business that concerns them as
auditors.
Rights in relation to written resolutions: Auditors have a right to receive a copy of any
written resolution proposed.
Right to require laying of accounts: Auditors have a right to give notice in writing that a
general meeting is held for the purpose of the laying of accounts and reports before
the company.
339
3 ZX
From: Chief Internal Auditor
To: Board of ZX Co
Subject: Role of Internal Audit and Audit Committee
Date: Today
(a) Areas where the internal audit department can assist the directors with the implementation
of good corporate governance include:
(i) Internal controls
The directors are responsible for assessing the risks faced by the company,
implementing appropriate controls and monitoring the effectiveness of those controls.
The internal audit department could assist the board in a number of ways:
They could review the directors' risk assessment and report on its adequacy.
In certain areas (perhaps in respect of the accounting system) they could
actually carry out the risk assessment.
They could review and report on the adequacy of the controls that are to be
implemented.
They could carry out annual audits of the effectiveness of controls (performing
tests of the controls), identifying weaknesses and making recommendations for
improvements.
It would be inappropriate for them to be involved at every stage, ie assessing risks,
designing controls and reviewing their effectiveness as this would mean that they are
checking their own work. This would undermine the credibility of their reports.
In some sense the existence of an internal audit serves as a control procedure in its
own right. An example would be that the existence of an internal audit department is
likely to act as a deterrent against fraud, and so helps the directors meet their
responsibilities to implement appropriate controls to prevent and detect fraud.
(ii) Financial statements
Good corporate governance requires the directors to prepare financial statements that
give a balanced and understandable view. As the internal audit department has
experience in accounting and auditing and is led by a qualified Chartered Certified
Accountant it can assist the directors in applying accounting standards and meeting
the expectations of readers of the accounts (particularly as these expectations will
greatly increase if ZX proceeds with the possible listing).
(iii) Board reports
A principle of good corporate governance is that the board should be properly briefed.
The internal audit department can review the reports that are presented to the board
to ensure that they are properly prepared and presented in a way that can be easily
understood.
340
(iv) Communication with external auditors

Although it is mainly the audit committee (if one has been established) that will act as
a channel of communication between the external auditors and the board, it will often
be the case that the external and internal auditors will work together on some areas.
This could be the case if the external auditor found it appropriate to rely on internal
audit reports on some areas (for example, on periodic inventory counting procedures)
or where the external auditor wants to extend computer assisted testing over the
whole year under the supervision of the internal auditors. This could add value to
information available to the board where areas have been considered by both groups
of auditors.
(v) Knowledge of corporate governance and auditing standards
As qualified professionals the internal audit department will have up to date
knowledge of corporate governance requirements and of developments in auditing
standards. They will be able to help the board keep up to date with what is expected
of them under the codes of corporate governance and with what will be expected of
them from the external auditors.
(b) Advantages and disadvantages of an audit committee
(i) Advantages
Proposed listing
If ZX is listed it will in all probability have to follow tighter requirements such as the UK
Corporate Governance Code. The establishment of an audit committee is considered
good practice under this code. If ZX did not establish one it would have to disclose the
non-compliance with the code in that respect and this might affect shareholder
confidence in respect of the accounting and auditing functions within the company.
'Critical friend' of the board
An effective audit committee will be made up of individuals with relevant knowledge
and experience, who are independent of the day-to-day running of the company. This
will give the shareholders confidence that there is some independent oversight of the
board which should help ensure that the company is being run in the best interests of
the shareholders. They should also be able to advise the executive directors on areas
such as corporate governance where their own knowledge may be incomplete.
Communication
The existence of an audit committee gives an effective channel of communication for
the external auditors. It means there is a quasi-independent body with whom the
external auditor can discuss contentious audit issues such as disagreements over
accounting treatments rather than going directly to the board who have made the
decisions on those matters.
This may increase stakeholders' confidence in the financial statements and the audit
process.
Financial reporting
The non-executive directors are expected to have a good knowledge of financial
reporting. In the case of ZX this should prove a useful source of advice to the board.
Also, externally, it should increase confidence in the financial reporting processes and
reports of ZX.
341
Appointment of external auditors

The audit committee, rather than the board, would recommend which auditors should
be appointed. They would also review annually any circumstances, such as provision
of other services, which might threaten the perceived independence of the external
auditor. This should again increase the confidence that readers of the financial
statements have in the objectivity of the opinion given by the external auditors and
hence the credibility of the financial statements.
(ii) Disadvantages
Cost
Although the non-executive directors will not require full time salaries, the level of fees
that will be required to attract suitably experienced individuals may be significant but
must be weighed against the benefits which will be derived especially in view of the
planned listing.
Knowledge and experience
The board may question whether individuals from outside ZX will have adequate
experience of the business to make a useful contribution to the board. As explained
above, it is their very independence that adds value to their role as well as their
particular experience in respect of financial accounting and corporate governance
issues.
Responsibilities
The current board may be concerned that the establishment of an audit committee of
non-executive directors may diminish their powers in running the company. It could be
seen as another tier of management. They should be assured that the audit
committee would act in support of the board, not as an alternative to it.
4 Audit planning and documentation

(a) The overall audit strategy is a document that outlines the general strategy of the audit. It
sets the direction of the audit, describes the expected scope and conduct of the audit and
provides guidance for the development of the audit plan.
The audit plan is a more detailed document than the overall audit strategy and includes
instructions to the audit team that set out the audit procedures the auditors intend to adopt.
The audit plan may also contain references to other matters such as audit objectives, timing,
sample sizes and the basis of selection for each account area. It also serves as a means to
control and record the proper execution of the audit work.
Key contents of an overall audit strategy:
Section on understanding the company's environment
Section on understanding the company's accounting and internal control system
Risk and materiality considerations
Nature, timing and extent of audit procedures
Section on co-ordination, direction, supervision and review
Any other matters
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(b) ISA 230 Audit documentation requires auditors to document their audit work. Audit work
needs to be documented for a number of reasons which are outlined below.
Audit documentation provides evidence of the auditor's basis for a conclusion about the
achievement of the auditor's objectives and evidence that the audit was planned and
performed in accordance with ISAs and other applicable legal and regulatory requirements.
It also assists the engagement team to plan and perform the audit; it assists team members
responsible for supervision to direct and supervise the audit work; it enables the team to be
accountable for its work; it allows a record of matters of continuing significance to be
retained; and it allows for the conduct of quality control reviews and inspections (both
internal and external).
(c) Standardised audit working papers
Advantages
May improve efficiency of audit work, through the use of checklists and specimen
letters, for example
Automated working paper packages may make documenting audit work easier,
because they include features such as automatic cross-referencing, for example
Facilitate review
Can lead to time saving
Disadvantages
May lead to a mechanical approach without applying audit judgement
May not be applicable to all clients
New audit staff will require training to use the audit documentation system used by
the audit firm
5 Audit evidence considerations

(a) Analytical procedures can be used at the planning stage, as substantive procedures, and at
the review stage of the audit. Analytical procedures consist of the analysis of significant
ratios and trends including the resulting investigations of fluctuations and relationships that
are inconsistent with other relevant information or which deviate from predictable amounts.
Analytical procedures include comparisons with similar information from prior periods,
comparisons to budgets and forecasts, comparisons with predictions prepared by auditors,
and comparisons with industry information.
When using analytical procedures as substantive tests, auditors need to consider the
information available in terms of its availability, relevance and comparability. They also need
to consider the plausibility and predictability of the relationships they are testing. Other
factors to consider include materiality, other audit procedures, the accuracy with which the
expected results can be predicted, the frequency with which a relationship is observed and
the assessments of inherent and control risks.
An example of an analytical procedure that can be used as a substantive test is a proof in
total test on depreciation and amortisation. In this test, the auditor predicts the expected
charge for the year for depreciation and amortisation by using the client's accounting policy
for depreciation and applying this to the brought forward figures for non-current assets from
the prior year audited financial statements, factoring in additions and disposals for the year.
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The figure obtained can be compared to the charge in the draft financial statements to
assess its reasonableness and accuracy.
(b) Audit evidence is available to auditors in a variety of forms. These include auditor-generated
evidence (eg analytical procedures), external sources of evidence from third parties (eg
solicitors' correspondence, valuation reports from surveyors for land and buildings), internal
sources of evidence from within the entity being audited (eg minutes of meetings from the
Board of directors, reports generated from the accounting system), and oral or written
evidence. Another factor to consider is whether the evidence, if written, is from an original
document or a copy.
Audit evidence from external sources to the entity is more reliable than that obtained from
the entity's records. Evidence from the entity's records is more reliable when the related
internal control system is operating effectively. Auditor-generated evidence is more reliable
than that obtained indirectly or by inference. Evidence in the form of documents or written
representations is more reliable than oral representations. Where evidence is written,
original documents are more reliable than photocopies which can be altered by the client
relatively easily.
6 Internal control systems

(a) Limitations of accounting and control systems
Management can only obtain a certain level of assurance (reasonable assurance) that
internal control objectives have been achieved because of certain inherent limitations of
accounting and control systems. These limitations include the following.
(1) Control systems still rely on human input and compliance. Therefore there is always a
possibility of human error rendering the control ineffective.
(2) Employees can collude to bypass controls. For example one employee may sign in
or clock in another employee to bypass controls designed to monitor hours worked.
(3) Management can use their authority to override controls.
(4) Controls are usually designed to cope with routine transactions. When a non-routine
or unusual transaction occurs, the system may not be adequately designed to ensure
it is properly recorded.
(5) The costs of implementing controls should not outweigh the benefits. This means that
controls are not always implemented where management has taken the view they
would rather accept the risk of certain errors occurring than incur the cost of
implementing a preventative control.
(b) (i) Narrative notes
Advantages
Narrative notes are relatively simple to record and can facilitate understanding by all
audit team members.
They can be applied to any system and are therefore a flexible method of
documenting systems.
Updating narrative notes in future years can be relatively easy if they are
computerised notes.
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Disadvantages
Narrative notes can be time consuming to prepare compared to alternative methods.
When using narrative notes it can be difficult to identify missing internal controls
because notes record the detail of systems but may not identify control exceptions
clearly.
They are difficult to update if prepared manually.
Note: Only two advantages and two disadvantages were needed.
(ii) Alternative methods of documenting accounting and control systems include:
Flowcharts
Flowcharts are graphic illustrations of the physical flow of information through the
accounting system. Flowlines represent the sequences of processes, and other
symbols represent the inputs and outputs to a process.
Internal Control Questionnaires (ICQs)
ICQs comprise a list of questions designed to determine whether desirable controls
are present. Often the questions are phrased to ask whether the desirable control is
present, so the user can answer yes or no. A no answer will then indicate a
potential deficiency. There is usually a list of questions to cover each of the major
transaction cycles.
Internal Control Evaluation Questionnaires (ICEQs)
This is a questionnaire designed to assess (evaluate) whether specific errors (or
frauds) are possible, rather than establishing whether certain desirable controls are
present. This is achieved by reducing the control criteria for each transaction stream
down to a handful of key questions (or control questions). These questions
concentrate on the significant errors or omissions that could occur at each phase of
the appropriate cycle if controls are weak.
Checklists
Checklists may be used to document and evaluate the internal control system. They
include statements (rather than questions) to mark off and tick boxes are used to
indicate where the statement holds true. Those statements not marked off will indicate
potential deficiencies.
Note: Only two alternative methods were needed.
7 Using the work of others

(a) Service organisations
A service organisation is a third party organisation that provides services to user entities that
are part of those entities' information systems relevant to financial reporting. A user entity is
an entity that uses a service organisation and whose financial statements are being audited
An auditor who audits and reports on the financial statements of a user entity is known as a
user auditor and a user auditor must obtain an understanding of the services provided by
the service organisation that are relevant to the audit. An relevant example is where the
audit client outsources its payroll processes to an external organisation.
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This understanding obtained by the user auditor must include the following:
The nature of services provided and the significance of these to the user entity,
including effect on user entity's internal control
The nature and materiality of transactions processed or financial reporting processes
affected
The degree of interaction
The nature of relationship including contractual terms
When obtaining an understanding of the internal control relevant to the audit, the user
auditor must also evaluate the design and implementation of relevant controls at the user
entity that relate to the services provided by the service organisation.
(b) (i) Audit evidence that could be obtained from an expert
Valuations of assets such as land and buildings, plant and machinery, works of
art, precious stones
Determination of quantities or physical condition of assets
Determination of amounts using specialised techniques or methods, such as an
actuarial valuation
Measurement of work completed and to be completed on contracts in progress
Legal opinions concerning interpretations of agreements, statutes and
regulations
(Note: Only four were required.)
(ii) Factors to consider when evaluating the work carried out by an auditors expert
When evaluating the experts work the auditor should consider how relevant the work
is, the standard of the work and its consistency with other audit evidence
The auditor should also consider the relevance and reasonableness of any
assumptions and methods used along with the relevance, completeness and
accuracy of any source data used.
(iii) Actions to take if evidence is not sufficient or results are inconsistent
If the results of the expert's work do not provide sufficient, appropriate audit evidence
or are inconsistent with other audit evidence, the auditor needs to resolve the matter.
This could be done through discussions with the entity and the expert or applying
additional audit procedures, including engaging another expert.
The auditor must consider the need to modify the auditor's opinion in the auditors
report (this is a last resort if the issues are still unresolved after all the other avenues
have been explored).
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8 HomesrUs
(i) Customer going into liquidation
Audit procedures
Assess the likelihood of recovery of this amount by discussion with the directors of
HomesrUs.
Confirm the amount of the amount outstanding as at the year-end by inspection of the
receivables ledger and correspondence with the customer.
Review any correspondence between the company and the customer to assess the
likelihood of recovery of any amounts.
Obtain a written representation point regarding the amount outstanding from the
customer from the directors of HomesrUs.
Confirm the details of the bankruptcy to documents received by HomesrUs from the
liquidator.
Impact on accounts
The financial statements will need to be amended as this is an example of an adjusting
event after the reporting period. It provides additional information concerning the
recoverability of the debt at the reporting date.
Revenue, profit and net assets will all be overstated by $7.5 million if the accounts are not
adjusted. The amount represents 10.7% of profit before tax and 1.4% of revenue so is
clearly material.
An adjustment is required in the financial statements to reduce the receivables balance and
profits.
Effect on audit report
The effect of the matter on the financial statements is clearly material. If the adjustments
required are made, then there would be no effect on the audit report.
If the directors refused to make the adjustment required, the audit opinion would be modified
on the basis that the accounts are not free from material misstatement and a qualified
except for opinion would be issued, as the matter is material but not pervasive.
(ii) Claim for unfair dismissal
Audit procedures
Discuss the case for unfair dismissal with the directors of HomesrUs to find out
background of case, date when claim was lodged and assessment of success.
Review lawyers correspondence regarding this case as it may have an impact for
next years audit.
Review any press reports in the local or national papers about this claim against the
company.
Review minutes of board meetings regarding this case and any other claim cases
against the company.
Obtain written representations on this matter from the directors of HomesrUs.
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Impact on accounts
A provision for this claim is not required since the requirements for recognising a provision
under IAS 37 Provisions, contingent liabilities and contingent assets are not met. Under IAS
37, a provision should be recognised when there is a present obligation as a result of a past
event, it is probable that a transfer of economic benefits will be required to settle it and a
reliable estimate can be made.
In this case, it appears unlikely that Mr Evans will be successful in his claim and so no
provision should be recognised in the financial statements for the year ended 31 December
20X7.
Disclosure of a contingent liability is also unlikely to be required since the possibility of any
transfer in settlement appears to be remote.
There would be no effect on the audit report as a result of this matter as no amendment
would be required to the financial statements. An unmodified report on the financial
statements could therefore be issued.
(iii) Fire
Audit procedures
Discuss fire with management of HomesrUs to clarify facts of the situation.
Read minutes of board meetings and any reports submitted by insurers.
Review insurance documents to confirm that damage cause by the fire is covered.
Impact on accounts
The fire at the storage depot is a non-adjusting event after the reporting period it does not
relate to conditions which existed at the year-end. It is unlikely that the fire is significant
enough to impact on the going concern of the company. Disclosure of the event surrounding
the fire should be made, together with an estimate of the financial effect.
Provided that adequate disclosure has been made of the event and its financial impact,
there would be no need to modify the audit opinion as a result of this incident. An emphasis
of matter paragraph drawing attention to this issue is probably not likely to be required,
provided adequate disclosure has been made in the notes to the financial statements.
END OF ANSWER BANK

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Appendix A: Assumed
Knowledge from
Paper F3
349
22: APPENDIX A: ASSUMED KNOWLEDGE FROM PAPER F3
1 Introduction
1.1 The accounting knowledge that is assumed for F8 Audit and Assurance is the same as the
accounting standards examined in F3 Financial Accounting.
1.2 The purpose of this appendix is to provide you with a recap of the accounting standards
covered in the F3 syllabus which could feature in F8 questions.
2 Proforma financial statements

2.1 The financial statements of a limited liability company are subject to regulation and must
follow a prescribed format in terms of the way they are presented.
2.2 Much of the prescribed format is determined by IAS 1. This accounting standard states what
should be included in a set of financial statements and how they should be presented.
A complete set of financial statements in accordance with IAS 1 comprises:
(a) A statement of financial position as at the end of the period
(b) A statement of profit or loss and other comprehensive income for the period
(c) A statement of changes in equity for the period
(d) A statement of cash flows for the period; and
(e) Notes, comprising a summary of significant accounting policies and other explanatory
notes.
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2.3 Statement of financial position as at 31 March 20X7

$'000
ASSETS
Non-current assets
Property, plant and equipment X
Other intangible assets X
X
Current assets
Inventories X
Trade receivables X
Other current assets X
Cash and cash equivalents X
X
Total assets X
EQUITY AND LIABILITIES

Equity
Share capital X
Share premium account X
Revaluation reserve X
Retained earnings X
X
Non-current liabilities
Long term borrowings X
Long term provisions X
X
Current liabilities
Trade payables X
Short term borrowings X
Current tax payable X
Short term provisions X
X
Total equity and liabilities X
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2.4 Statement of profit or loss and other comprehensive income

This statement shows all of the realised gains and losses from the statement of profit or
loss and the unrealised gains and losses from the statement of financial position in one
statement of performance.
Statement of profit or loss Statement of financial position
Realised Unrealised
gains and losses gains and losses
e.g. profit for the year e.g. revaluation gains/losses
Statement of profit or loss and other comprehensive income
The statement can be presented in one of two ways:

As one single statement (proforma 1)
As two separate statements (proforma 2)
Proforma 1 one single statement
Statement of profit or loss and other comprehensive income for the year ended 31
March 20X7
20X7 20X6
$000 $000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Finance costs (X) (X)
Investment income X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year X X
Other comprehensive income:
Gains on property revaluation X X
Total comprehensive income for the year X X
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Proforma 2 two separate statements
Statement of profit or loss for the year ended 31 March 20X7

20X7 20X6
$000 $000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Finance costs (X) (X)
Investment income X X
Profit before tax X X
Income tax expense (X) (X)
Statement of other comprehensive income for the year ended 31 March 20X7
20X7 20X6
$000 $000
Other comprehensive income:
Gains on property revaluation X X
Total comprehensive income for the year X X
2.5 Statement of changes in equity

Proforma
Share Reval-
Share premium uation Retained Total
capital account reserve earnings equity
$000 $000 $000 $000 $000
Balance at 31 March 20X6 X X X X X
Changes in accounting policy _ _ _ X X
Restated balance X X X X X
Issue of share capital X X X
Dividends (X) (X)
Total comprehensive _ _ X X X
income
Balance at 31 March 20X7 X X X X X
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2.6 Statement of cash flows for the year ended 31 March 20X7
$000 $000
Cash flows from operating activities
Profit before taxation X
Adjustment for:
Depreciation X
Investment income (X)
Interest expense X
XX
Increase in trade and other receivables (X)
Decrease in inventories X
Decrease in trade payables (X)
Cash generated from operations XX
Interest paid (X)
Income taxes paid (X)
Net cash from operating activities XXX
Cash flows from investing activities

Purchase of property, plant and equipment (X)
Proceeds from sale of equipment X
Interest received X
Dividends received X
Net cash used in investing activities (XXX)
Cash flows from financing activities

Proceeds from issue of share capital X
Proceeds from long-term borrowings X
Dividends paid* (X)
Net cash used in financing activities (XXX)
Net increase in cash and cash equivalents XXX

Cash and cash equivalents at beginning of period XXXXX
Cash and cash equivalents at end of period XXX
* This could also be shown as an operating cash flow.
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3 Notes to the accounts

Notes are included in a set of financial statements to give users extra information. You
should be aware of the following notes:
3.1 Property, plant and equipment

Land and Office
buildings Machinery equipment Total
$ $ $ $
Carrying amount at 1 April 20X6 X X X X
Additions X X X X
Revaluation surplus X X
Depreciation charge (X) (X) (X) (X)
Disposals (X) (X) (X) (X)
Carrying amount at 31 March 20X7 X X X X
At 31 March 20X7
Cost or valuation X X X X
Accumulated depreciation (X) (X) (X) (X)
Carrying amount X X X X
At 31 March 20X6
Cost or valuation X X X X
Accumulated depreciation (X) (X) (X) (X)
Carrying amount X X X X
3.2 Intangible non-current assets

Development
expenditure
$
Carrying amount at 1 April 20X6 X
Additions X
Amortisation charge (X)
Disposals (X)
Carrying amount at 31 March 20X7 X
At 31 March 20X7
Cost X
Accumulated amortisation (X)
Carrying amount X
At 31 March 20X6
Cost X
Accumulated amortisation (X)
Carrying amount X
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3.3 Provisions
$
At 1 April 20X6 X
Increase in period X
Released in period (X)
At 31 March 20X7 X
3.4 Contingent liabilities

Unless remote, disclose for each contingent liability:
(a) A brief description of its nature; and where practicable
(b) An estimate of the financial effect
(c) An indication of the uncertainties relating to the amount or timing of any outflow; and
(d) The possibility of any reimbursement
3.5 Contingent assets

Where an inflow of economic benefits is probable, an entity should disclose
(a) A brief description of its nature; and where practicable
(b) An estimate of the financial effect
3.6 Events after the reporting period

In respect of non-adjusting events after the reporting period disclose
(a) The nature of the event
(b) An estimate of its financial effect (or a statement that an estimate cannot be made).
4 Inventory (IAS 2)
4.1 The inventories figure in the financial statements comprises two elements:
QUANTITY VALUATION
Quantity
4.2 The quantity of inventories a business has at the year end is normally ascertained by
completing an inventory count at the end of the accounting period or by continuous
inventory records.
Valuation
4.3 The valuation of inventories is much more subjective and so guidance is provided in IAS 2.
4.4 The basic rule per IAS 2: Inventories is:
'Inventories should be measured at the lower of cost and net realisable value.'
4.5 This is another example of prudence in presenting financial information.
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Cost
4.5 The cost of an item of inventory includes:
For example:
Purchase price
Import duties
Cost of purchase
But not:
Sales tax
Relating to productions:
Direct labour
Costs of conversion Direct/variable overheads
An allocation of fixed
overheads (based on
normal level of activity)
Other costs incurred in bringing
the inventories to their present For example:
location and condition Carriage inwards
Net realisable value (NRV)

4.6 The net realisable value of an item is essentially its net selling proceeds after all costs have
been deducted.
4.7 It is calculated as:

$
Estimated selling price X
Less: estimated costs of completion (X)
Less: estimated selling and distribution costs (X)
X
No netting off
4.8 The IAS 2 rule 'lower of cost and net realisable value' should be applied as far as
possible on an item by item (or line by line) basis.
5 Property, plant and equipment (IAS 16)

Definition
5.1 Property, plant and equipment comprises assets which:
(a) Are held for use in the production or supply of goods or services or for administrative
purposes; and
(b) Are expected to be used during more than one period.
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Cost
5.2 Property, plant and equipment should initially be recorded at cost.
Cost includes:
Purchase price: excluding sales tax and trade discounts but including import
duties
Directly attributable costs to bring the asset to its intended location and ready to
use. These include:
(a) Initial delivery and handling costs
(b) Installation and assembly costs
(c) Costs of testing whether the asset is working properly
(d) Professional fees
The following costs may not be included:
(a) The cost of maintenance contracts
(b) Administration and general overhead costs
(c) Staff training costs
5.3 The asset can then be kept at cost and depreciated or the entity may choose to revalue its
tangible non-current assets.
Depreciation
5.4 Assets will eventually be worn out (used up) and so there is a cost of generating income.
This cost should be shown in the income statement to 'match' against the income.
This is called depreciation.
5.5 Depreciation results in the property, plant and equipment being systematically charged to
the income statement over several accounting periods in recognition of the fact that the
asset will contribute to the income-generating activities of each of these periods.
A formal definition is given by the accounting standard, IAS 16:
"the systematic allocation of the depreciable amount of an asset over its useful life."
'Depreciable amount' = cost/revalued amount residual value

'Residual value' = the amount the asset is expected to be sold for at the end of its
useful life (scrap value).
5.6 Land normally has an unlimited useful life and is therefore not depreciated. Buildings have
a limited life and, therefore, are depreciable assets.
5.7 There are two main methods for calculating depreciation, the straight line method and the
reducing balance method.
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Straight line method

5.8 Here the depreciation charge is the same every year and it is calculated using the following
formula:
cost residual value
Depreciation or (Cost Residual value) %
useful life (years)
where:
Residual value = expected proceeds/scrap value at the end of the asset's useful life.
Useful life = the number of years the business expects to make use of the asset.
5.9 This method is suitable for assets which are used up evenly over their useful life.
Reducing balance depreciation

5.10 This method is suitable for those assets which generate more revenue in earlier years than
in later years; for example a machine which may become progressively less efficient as it
gets older.
Under this method the depreciation charge will be higher in the earlier years and reduce
over time.
It is calculated using the following formula:
Depreciation = Depreciation rate (%) Carrying amount (CA)
where: carrying amount (CA) = cost accumulated depreciation to date
Disposal of property, plant and equipment

5.11 When a non-current asset is disposed of, its carrying amount needs to be removed from the
statement of financial position.
The sales proceeds received are unlikely to be exactly the same as the asset's carrying
amount and so a profit or loss on disposal will arise.
If:
Sales proceeds > CA profit on disposal
Sales proceeds < CA loss on disposal
This is not a 'true' profit or loss, but rather a book adjustment to reflect the fact that the
depreciation charged over the asset's life wasn't completely accurate.
Revaluations
5.12 If an entity owns a property it may notice that its value increases over time.
5.13 IAS 16 requires property, plant and equipment to initially be recorded at cost. The entity can
then either keep the asset at cost (and depreciate it) or choose to revalue it (depreciation is
still required).
This is a choice of accounting policy.
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5.14 If an entity chooses a policy of revaluation then all items in the same class of assets must be
revalued.
Examples of classes of assets are:
Land and buildings
Plant and machinery
Motor vehicles
5.15 Revaluations must be carried out sufficiently often so that the assets carrying value is not
materially different from its market value.
Steps and accounting treatment

5.16 (1) Adjust cost account to revalued amount.
(2) Remove accumulated depreciation charged on the asset to date.
(3) Put the balance to the revaluation surplus.
5.17 The required journal is:

Dr Non-current asset cost
Dr Accumulated depreciation
Cr Revaluation surplus
5.18 Depreciation should now be based on the revalued amount.
6 Intangible assets (IAS 38)

Definitions
6.1 (a) Research is original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
(b) Development is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial production or
use.
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Accounting treatment
6.2
Research Development
No certainty that the expenditure Future profits are expected

will generate future profit
Show as an expense in income MUST capitalise as an intangible non-

statement current asset if all of the relevant criteria
(PIRATE see below) are satisfied
Dr Research expense (SPL) Dr Intangible non-current assets (SOFP)
Cr Bank/payables Cr Bank/payables
P robable future economic benefits

I ntention to complete and use/sell asset
R esources adequate and available to complete
and use/sell asset
A bility to use/sell the asset
T echnical feasibility of completing asset for
use/sale
E xpenditure can be measured reliably
Amortise asset over its useful life once

asset is ready for use
Amortisation of capitalised development expenditure

6.3 Property, plant and equipment, for example a machine, is capitalised and then depreciated
over its useful life. This is to allocate its cost over the accounting periods which benefit from
its use.
6.4 In the same way development expenditure which is incurred now will generate revenue and
profits in the future.
The cost of the development expenditure should be matched against the revenue it
produces. This is called amortisation.
6.5 The 'depreciable amount' (cost less residual value) should be amortised over the useful life
in the same way that revenues are expected to be generated.
6.6 Amortisation should begin when the asset is ready for use.
6.7 It is an expense in the income statement and is accounted for using the following entry:
Dr Amortisation expense (SPL)
Cr Accumulated amortisation (SOFP)
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7 Provisions, contingent liabilities and contingent

assets (IAS 37)
Provisions
7.1 Definition
A provision is a liability of uncertain timing or amount.
7.2 Recognition
A provision should only be recognised (i.e. included in the financial statements) when:
(a) An entity has a present obligation (legal or constructive) as a result of a past event;
(b) It is probable that an outflow of economic resources will be required to settle the
obligation; and
(c) A reliable estimate can be made of the amount of the obligation.
Unless all three conditions are met, no provision can be recognised.
7.3 Legal obligation

A legal obligation usually arises out of a contract.
Illustration
Grass Co sells lawnmowers and offers a one-year warranty on all models.
Once Grass Co sells a lawnmower (the past event) it has a legal obligation to repair any
defects according to the warranty agreement.
It should therefore make an estimate of the probable costs of repair and make a provision
for this amount in its financial statements.
7.4 Constructive obligation

A constructive obligation arises through past behaviour and actions where the entity has
raised a valid expectation that it will carry out a particular action.
Illustration
Seed Co also sells lawnmowers. It does not offer a warranty on its products; however it has
a reputation for making free reasonable repairs to lawnmowers bought from the business.
Customers buying from Seed Co all expect to receive this benefit.
Here no warranty is offered and so Seed Co does not have a legal obligation. Its past
actions however have created a constructive obligation. It should also therefore make a
provision for the probable costs of repairs.
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7.5 Accounting treatment

The provision represents both a cost to the business and a potential liability:
Dr Expense (SPL)
Cr Provision (SOFP)
The required provision will be reviewed at each year end and increased or decreased as
necessary.
Contingent liabilities
7.6 A contingent liability is an uncertain liability that does not meet the three criteria for
recognising a provision.
IAS 37 defines a contingent liability as the following:
(a) A possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity; or
(b) A present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of economic resources will be required to
settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
Contingent liabilities should be disclosed in the notes unless probability of an outflow of
resources embodying economic benefits is remote.
Illustrative example
7.7 Company A has entered into an agreement to act as guarantor on a bank loan taken out by
Mr Smith. Mr Smith is a financially secure individual, and the directors are of the opinion that
the chances of him defaulting on the loan are slim.
How should company A account for this guarantee?
Solution
7.8 Company A has a present obligation (it is legally obliged to honour the guarantee).
However, as the likelihood of Company A having to pay out under the guarantee is not
probable then no provision for the liability should be made. Instead, the guarantee should be
disclosed in the notes as a contingent liability (unless considered remote, in which case it
should be ignored altogether).
Contingent assets
7.9 A possible asset that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within
the control of the entity.
Contingent assets should be disclosed in the notes where an inflow of economic benefits is
probable, otherwise they should be ignored.
If the probability of an inflow of economic benefits is virtually certain then the asset is not a
contingent asset and should be recognised in the financial statements.
363
8 Events after the reporting period (IAS 10)

Definition
8.1 Events after the reporting period: events, both favourable and unfavourable, that occur
between the end of the reporting period and the date when the financial statements are
authorised for issue.
8.2 There are two types of event after the reporting period.
Adjusting and non-adjusting events

8.3
Adjusting events Non-adjusting events
Events which provide evidence of Events that relate to conditions which

conditions which existed at the end of the arose after the end of the reporting
reporting period. period
Examples: Examples:
(1) resolution of a court case (1) destruction of major asset, e.g. by
(2) bankruptcy of a major customer flood or fire
(3) evidence of NRV of inventories (2) major share transactions
(4) discovery of fraud or errors that show (3) announcement of a plan to close part
the financial statements were incorrect of a business
Accounting treatment: Accounting treatment:

Change the amounts in the financial Disclose non-adjusting event in a note to
statements the financial statements
8.4 (a) Dividends proposed or declared after the end of reporting period but before the
financial statements are approved should be disclosed in a note to the financial
statements.
(b) A non-adjusting event that affects going concern becomes an adjusting event.
END OF APPENDIX A
364
ACCA Fundamentals Level
Paper F8
Audit and Assurance
Course Examination 1
Question Paper
Time allowed
Reading and Planning 7 minutes

Writing 1 hours
ALL questions are compulsory and MUST be attempted
During reading and planning time only the question paper may be annotated
Instructions:
Please attempt this exam under test conditions.
Take a few moments to review the notes on the inside of this page titled, Get into good exam habits now!
before attempting this exam.
DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER
EXAMINATION CONDITIONS
DEC 2014 / JUNE 2015 EDITION

Get into good exam habits now!
Take a moment to focus on the right approach for this exam.
Effective time management

Watch the clock, allocate 1.8 minutes to each mark and move on if you get behind.
Take a few moments to think what the requirements are asking for and how you are going to
answer them.
Remember one mark is usually allocated for each valid point you give in a discursive question.
Effective planning
This paper is half the real exam.
Read the requirements carefully: focus on mark allocation, question words (see below) and
potential overlap between requirements.
Identify and make sure you pick up the easy marks available in each question.
Effective layout
Present your numerical solutions using the standard layouts you have seen. Show and
reference your workings clearly.
With written elements try and make a number of distinct points using headings and short
paragraphs. You should aim to make a separate point for each mark.
Ensure that you explain the points you are making i.e. why is the point a strength, criticism or
opportunity?
Give yourself plenty of space to add extra lines as necessary; it will also make it easier for the
examiner to mark.
Common terminology
Advise To counsel, inform or notify
Analyse Examine in detail the structure of
Calculate/compute To ascertain or reckon mathematically
Compare and contrast Show the similarities and/or differences
Define Give the exact meaning of
Describe Communicate the key features of
Discuss To examine in detail by argument
Distinguish Highlight the differences between
Evaluate To appraise or assess the value of
Explain Make clear or intelligible/state the meaning of
Identify Recognise, establish or select after consideration
Interpret Process information to explain its meaning
Justify To produce reasons in support of
List State short pieces of information on separate lines
Prepare To make or get ready for use
Recommend To advise on a course of action
Summarise To express the most important facts of
366 DEC 2014 / JUNE 2015 EDITION

Section A
All SIX questions are compulsory and MUST be attempted

1 Which of the following is NOT a statutory right of auditors?
A A right of access at all times to the books and records of the company
B A right to attend any general meeting of the company
C A right to be heard on any matter at general meetings of the company
D A right to receive information and explanations
(2 marks)
2 Which of the following ARE included within the statutory duties of an auditor?
(1) To give an opinion on the financial statements.
(2) To report on the effectiveness of the entitys internal control system.
(3) To discuss any unresolved audit issues with the Audit Committee.
(4) To report by exception if the disclosures in the financial statements relating to directors are not
appropriate.
A (1) and (2)
B (1) and (3)
C (1) and (4)
D (2) and (3)
(2 marks)
3 Which of the following ARE included in the responsibilities of the Audit Committee?
(1) To ensure the privacy of whistle blowers is safeguarded.
(2) To review the entitys internal controls and risk management procedures.
(3) To make recommendations as to the directors remuneration.
(4) To monitor the independence of the external auditor.
(5) To appoint/ re-appoint the external auditor.
A (3), (4) and (5)
B (1), (3) and (4)
C (2), (3) and (4)
D (1), (2) and (4)
(2 marks)
4 Which of the following assignments are the internal audit function LEAST likely to carry out?
A Review of the errors found during an inventory count at the entitys warehouse
B Implementation of a new accounting system for the entity
C Variance analysis on the entitys monthly management accounts
D Review of customer complaints received by the entity
(2 marks)
5 Is the following statement true or false?
At least one member of the Audit Committee must be a qualified accountant?
A True
B False
(1 mark)
DEC 2014 / JUNE 2015 EDITION 367

6 Which ONE of the following components of audit risk is the auditor able to control?
A Inherent risk
B Control risk
C Detection risk
(1 mark)

Section B
All THREE questions are compulsory and MUST be

attempted
1 Manly
Mary Lee is a partner in a firm of Chartered Certified Accountants, Davis & Co. She is the engagement
partner on the audit of Manly, a listed company and is reviewing the audit file for the year ended 31 March
20X9.
At the front of the audit file is a memorandum from the audit manager recommending the issue of a modified
audit opinion. This is because the audit manager believes there is a material problem with the financial
statements.
Manly's major customer is known to be in financial difficulties however the company has not made an
allowance against the amount owed to Manly. This amount is considered to be material. Manly's finance
director is arguing that the customer has nearly completed the development of a new product, sales of which
will enable the company to repay all its debts. He claims to have consulted another firm of accountants who
have indicated that an allowance might not be necessary.
Mary has concerns over the situation for several reasons. Firstly, she is reasonably certain that if she issues
a modified audit opinion on the financial statements, the directors of Manly will recommend that another firm
of auditors be appointed next year.
Secondly, Marys firm has always supplied many other non-audit services to Manly such as tax and
consultancy which bring in twice as much revenue as the audit and are more profitable. It is highly unlikely
the audit firm would continue to be asked to provide these services if the audit is lost. In total, fees paid by
Manly for the audit and these other services amount to 13% of the audit firm's total revenue.
Lastly, Mary has been the engagement partner for ten years. She has worked closely with the finance
director over that time and has no reason to doubt his integrity. She is prepared to believe his assertion that
the debt will be repaid however, she also accepts that evidence in the audit file is equally persuasive that the
customer is, currently, in financial difficulty.
Required:
(i) Explain FIVE ethical threats which may affect the independence of Davis & Cos audit of Manly and
(5 marks)
(ii) For each threat explain how it might be avoided. (5 marks)
(Total: 10 marks)
2 Internal Control
(a) State the FIVE components of an internal control system and give a brief explanation of each
component. (5 marks)
(b) Explain why the external auditor needs to obtain an understanding of a clients internal control
system. (3 marks)
(c) Define a test of control and a substantive procedure. (2 marks)
(Total: 10 marks)

3 SeaPass
(a) Define materiality and explain the concept of true and fair presentation.
(5 marks)
SeaPass is a ferry company which operates daily ferry crossings from the United Kingdom (UK) to France.
The companys year end is 30 June 20X9. You are the audit senior and you have started planning the audit.
Your audit manager has asked you to have a planning meeting with the client and to identify any relevant
audit risks so that the audit plan can be completed.
You obtained the following information at the meeting:
SeaPass has had a challenging year. The current economic crisis and worries about the future of the Euro
currency, has meant that many passengers who might previously have booked ferry crossings to France are
now choosing to spend their holiday within the UK. SeaPass is under continual pressure from its
shareholders to show consistent performance.
In an attempt to win new passengers and generate additional income, SeaPass spent $800,000 on an
advertising campaign which featured both in the national press and on national television. The campaign
took place in May 20X9 and the company is convinced that this will vastly improve customer numbers during
summer 20X9. Consequently the finance director is proposing to match most of the advertising cost against
summer revenues and has shown $600,000 of the $800,000 spent as a prepayment at the year end.
When customers book their ferry crossing they are required to pay an upfront deposit of 20% of the total
cost. In previous years this has been recognised as revenue in the month that the ferry crossing is made.
However this year SeaPass have recognised the revenue when the deposit is received. The finance director
has explained that this is because the company has spent the money as it was received in order to finance the
advertising campaign. The balance of 80% is taken by the company on the day of departure.
SeaPass want their customers to have an excellent experience when they travel with them. With this in mind
they offer a money back guarantee. If customers are excessively delayed or they are not happy with the
service provided by SeaPass, then they can claim compensation under the companys money back guarantee.
Despite the companys very best efforts to improve customer satisfaction, compensation payments are made
on a regular basis.
SeaPass has also found that the price of fuel has risen sharply during the course of the year and they have
not been able to pass this price rise on to their customers in the form of higher ticket prices. This has meant
that its operating costs have increased considerably, leading to falling profit margins.
The company does hold some cash reserves in the form of bank deposits. However, these cannot be
accessed for 6 months and so the company has had to take out a short term overdraft. The finance director
is pleased that the financial statements will show a net positive cash position as the bank deposits will be
greater than the overdraft at the year end.
Required
(b) Using the information provided, describe FIVE audit risks and explain the auditors response to each
risk in the planning of the audit of SeaPass. (10 marks)
(c) List and explain the elements of an assurance engagement. (5 marks)
(Total: 20 marks)

Student self-assessment
Having completed this paper take a few minutes to consider what you did well and what you found difficult.
Use this as a basis to focus your future study on effectively improving your performance.
Common problems Future emphasis if you answer Yes
Timing and planning

Did you finish too early? Y/N Focus your planning time on generating more ideas.
Use models to help develop breadth to your thinking.
Did you overrun? Y/N Focus on allocating your time better.
Practise questions under strict timed conditions.
If you get behind leave space and move on.
Did you waffle? Y/N Focus your planning time on developing a logical structure to
your answer.
Layout
Was your answer difficult to follow? Y/N Use headings and subheadings.
Use numbering sequences when identifying points.
Leave space between each point.
Did you fail to explain each
point clearly? Y/N Show why the point identified answers the question set.
Did you fail to show any workings
or were your workings unclear? Y/N Give yourself time and space to make the marker's job easy.
Content
Did you struggle with:
Interpreting the questions? Y/N Learn the meaning of common terminology (inside front cover).
Learn subject jargon (key terms in study text).
Read questions carefully noting all the parts.
Practise as many questions as possible.
Understanding the subject? Y/N Review your notes/text.
Work through easier examples first.
Please contact your tutor for further help.
Remembering the notes/text? Y/N Quiz yourself constantly as you study. You need to develop
your memory as well as your understanding of a subject.

ACCA Fundamentals Level
Paper F8
Audit and Assurance
Course Examination 2
Question Paper
Time allowed
Reading and Planning 15 minutes

Writing 3 hours
ALL questions are compulsory and MUST be attempted
During reading and planning time only the question paper may be annotated
Instructions:
Please attempt this exam under test conditions.
Take a few moments to review the notes on the inside of this page titled, Get into good exam habits now!
before attempting this exam.
DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER
EXAMINATION CONDITIONS
DEC 2014 / JUNE 2015 EDITION

Get into good exam habits now!
Take a moment to focus on the right approach for this exam.
Effective time management

Watch the clock, allocate 1.8 minutes to each mark and move on if you get behind.
Take a few moments to think what the requirements are asking for and how you are going to
answer them.
Remember one mark is usually allocated for each valid point you give in a discursive question.
Effective planning
This paper is in exactly the same format as the real exam. You should read through the paper
and plan the order in which you will tackle the questions.
Read the requirements carefully: focus on mark allocation, question words (see below) and
potential overlap between requirements.
Identify and make sure you pick up the easy marks available in each question.
Effective layout
Present your numerical solutions using the standard layouts you have seen. Show and
reference your workings clearly.
With written elements try and make a number of distinct points using headings and short
paragraphs. You should aim to make a separate point for each mark.
Ensure that you explain the points you are making i.e. why is the point a strength, criticism or
opportunity?
Give yourself plenty of space to add extra lines as necessary; it will also make it easier for the
examiner to mark.
Common terminology
Advise To counsel, inform or notify
Analyse Examine in detail the structure of
Calculate/compute To ascertain or reckon mathematically
Compare and contrast Show the similarities and/or differences
Define Give the exact meaning of
Describe Communicate the key features of
Discuss To examine in detail by argument
Distinguish Highlight the differences between
Evaluate To appraise or assess the value of
Explain Make clear or intelligible/state the meaning of
Identify Recognise, establish or select after consideration
Interpret Process information to explain its meaning
Justify To produce reasons in support of
List State short pieces of information on separate lines
Prepare To make or get ready for use
Recommend To advise on a course of action
Summarise To express the most important facts of

Section A
All TWELVE questions are compulsory and MUST be

attempted
1 Which of the following is not a limitation of auditing?
A Sampling is used as an audit tool
B Internal control systems have inherent limitations
C Client staff may collude in fraud
D Unqualified staff may be used on audit assignments
(2 marks)
2 Which of the following procedures should NOT be carried out after the audit firm has decided to
accept appointment as auditors?
A Perform checks to ensure there are no legal or ethical reasons why the new audit firm cannot
act as auditors.
B Ensure that the outgoing auditors removal/resignation has been properly conducted.
C Ensure that the shareholders have passed an appropriate resolution to appoint the new
auditors.
D Submit a letter of engagement to the directors.
(2 marks)
3 'To ensure that goods and services are only supplied to customers with good credit ratings'.
This statement describes:
A A risk
B A control objective
C A control activity
D A test of control
(2 marks)
4 Which of the following statements BEST reflects the auditors duty of confidentiality?
A Auditors must never, under any circumstances, disclose any matters of which they become
aware during the course of the audit to third parties, unless they have the permission of the
client
B Auditors may disclose any matters in relation to criminal activities to the police or taxation
authorities if requested to do so by the police or a tax inspector
C Auditors may disclose matters to third parties without their clients consent if it is in the public
interest, and they must do so if there is a statutory duty to do so
D Auditors may only disclose matters to third parties without their clients consent if the public
interest or national security is involved
(2 marks)

5 An assurance firm might cast the list of year-end payables to gather evidence in an assurance
engagement. What type of procedure does this test illustrate?
A Confirmation
B Recalculation
C Reperformance
(1 mark)
6 Which body is responsible for issuing International Standards on Auditing?
A International Accounting Standards Board
B International Auditing and Assurance Standards Board
C International Federation of Accountants
(1 mark)
7 The payables ledger clerk at Margate Co compares supplier statements with the payables ledger
accounts on a monthly basis. Which ONE of the following assertions does this action support?
A Classification
B Rights and obligations
C Existence
D Completeness
(2 marks)
8 Which of the following is NOT true in relation to substantive audit procedures?
A Substantive procedures should be focused on areas of the financial statements where there
may be a high risk of material misstatement
B Substantive procedures are tests to obtain audit evidence to detect material misstatements in
the financial statements
C Substantive procedures should be based upon the assumption that internal controls are
operating effectively
D Substantive procedures may consist of analytical procedures and other procedures such as
tests of details on transactions, account balances and disclosures
(2 marks)
9 Which of the following are assurance reports NOT required to contain?
A Date of the report
B Professional accountants opinion on whether subject matter gives a true and fair view
C The name of the firm or practitioner, and a specific location
D Identification and description of the subject matter information
(2 marks)

10 Which of the following are NOT benefits of the statutory audit?
(1) An audit report may give additional confidence to parties other than the shareholders alone
(2) The use of sampling for the obtainment of audit evidence means that the auditor can never be
liable to the audit client
(3) The fact that the accounting systems on which assurance providers may place a degree of
reliance also have inherent limitations means that the level of assurance provided must always
be restricted to a level that is less than absolute
(4) The existence of an independent check might help prevent errors or frauds being made and
may reduce the risk of management bias
A (1) and (3)
B (2) and (3)
C (2) and (4)
D (3) and (4)
(2 marks)
Batch reconciliations are an example of an application control.
A True
B False
(1 mark)
The directors are responsible for the detection of fraud and error. The external auditor is expected to
plan their audit procedures to detect fraud.
A True
B False
(1 mark)

Section B All SIX questions are compulsory and MUST
be attempted
1 Battersby
You work for Cast Co, a firm of Chartered Certified Auditors which has eight partners. The audit firm has
been invited by Mr Smith, the managing director and majority shareholder of Battersby Co, to accept
appointment as statutory auditor of the company. The present firm of auditors will not be re-appointed when
its term of office expires.
The principal activity of Battersby Co is the manufacture and distribution of healthcare products. Your firm
has several companies operating in the healthcare sector in its client portfolio.
Mr Smith has requested that your firm assists with the preparation of the companys tax computation, and
provides consultancy services on an on-going basis in connection with his plans to grow the business.
He has also suggested that a partner in your firm joins the board of Battersby Co as a non-executive director.
Required
(a) (i) Explain THREE ethical threats which may affect the independence of Cast Cos audit of
Battersby Co and (3 marks)
(ii) For each threat explain how it might be avoided. (3 marks)
(b) Describe FOUR benefits to audit firms and their clients of having audit and non-audit services
provided by the same firm of accountants. (4 marks)
(Total: 10 marks)

2 Subsequent events and going concern
You are the senior in charge of the audit of Thorsen, a company which produces sophisticated electronic
laboratory equipment. The company imports a high proportion of the components it uses from the Far East.
The equipment is used by some laboratories dealing with hazardous chemicals.
As the audit draws to a close, the partner in charge has asked you to ensure that all procedures relating to
subsequent events and going concern are properly performed. You are to consider the audit work to be
performed in relation to ISA 560 Subsequent events and ISA 570 Going concern.
Required
(a) Describe the auditors responsibilities for subsequent events occurring between:
(i) The year end date and the date the auditors report is signed and
(ii) The date the auditors report is signed and the date the financial statements are issued.
(5 marks)
(b) Going concern relates to the judgement that an entity will continue to trade for the foreseeable future.
(i) Explain the responsibilities of directors and auditors in relation to going concern. (2 marks)
(ii) Explain the audit procedures the auditor could carry out when conducting the going concern
review of Thorsen. (3 marks)
(Total: 10 marks)

3 Cremorne
You are the audit manager of Rams and Co and you are currently reviewing the audit files of several of your
audit clients for which the audit fieldwork is complete. The audit seniors have raised the following issues:
Cremorne
Cremorne is a listed construction company with annual revenue of $350 million and its draft statement of
profit or loss shows a profit before tax for the year ended 31 December 20X8 of $40 million.
During the year ended 31 December 20X5 the company purchased two computer controlled earth movers at
a cost of $2,500,000 each and a further two at the same price during the year ended 31 December 20X6.
Depreciation has been provided at 10% straight line, the same basis as it previously depreciated conventional
earth movers. This year, 20X8, the company has decided that improvements in technology made it
worthwhile scrapping their first two computer controlled earth movers and replacing them with the latest
model at a cost of $6,000,000 each. The company provides a full years depreciation charge in the year of
acquisition and none in the year of disposal.
The company's chief engineer tells you that technology is developing so rapidly it appears likely they will
continue to replace these machines every five years. In spite of this the finance director claims that the
depreciation rate of 10% is in line with the industry standard and reflects the physical life of the machines. He
argues that continued improvements in technology cannot be foreseen and that there is no justification for
increasing depreciation to 20% because of the possibility of technological obsolescence.
Smooth Runners
Smooth Runners is another construction company but it is not listed. It has annual revenue of $70 million
and its draft statement of profit or loss shows a profit before tax for the year ended 31 December 20X8 of $8
million.
The company is being sued for $10 million by the Highways Agency for defective work on a recently
completed road. The company maintains that it met the Highways Agency's specification and it is the
Agency's engineers who are at fault in drawing up the specification. Smooth Runners maintains that it has no
case to answer, that the possibility of loss is remote and that the claim need not be disclosed as a contingent
liability. An investigative journalist has recently published an article suggesting that other roads constructed
by the company exhibit similar faults. The managing director has admitted that the company's road building
techniques are under investigation by the Highways Agency. If the company were to lose the case its future
going concern would be threatened. No disclosure has been made in the financial statements.
Required
For each of the clients above:
(i) Discuss the issue, including an assessment of whether it is material; and (5 marks)
(ii) Describe the impact on the audit report if the issue remains unresolved. (5 marks)
(Total: 10 marks)

4 Sable Co
(a) Explain TWO financial statement assertions which are especially relevant to asset balances at the
period end. (2 marks)
(b) You are the audit senior of Dibby and Co and your team has just been appointed auditor of Sable Co,
whose year end is 30 June 20X6. Sable Co is a book wholesaler that sells both fiction and non-fiction
books to hundreds of independent book shops. Due to the high number of customer balances at the
year end you have decided to conduct a receivables circularisation in order to gather evidence over the
receivables balance. At the planning meeting you were also informed that in March 20X6 Sable Cos
Board of Directors decided to outsource its internal audit function which resulted in the redundancy of
the 4 members of its current internal audit department with effect from 30 June 20X6. A redundancy
provision has been included in the draft financial statements.
Required:
(i) Explain the difference between a positive and a negative circularisation and the financial
statement assertions for which a positive circularisation provides evidence. (4 marks)
(ii) Describe substantive procedures you should perform to confirm the redundancy provision at
the year end. (4 marks)
(Total: 10 marks)

5 HWG
You are the senior responsible for planning the audit of Here We Go (HWG) for the year ended 31 May 20X8.
HWG runs a football club which was promoted to the top division in the league this season. The football
season starts on 1 September and ends on 31 May so that the players get a break over the summer months.
HWG own their football stadium which now has the capacity to seat 25,000 people. Of the 25,000 seats,
19,000 are allocated to HWG supporters (home supporters) and are sold to season ticket holders only. The
remaining 6,000 tickets are for away supporters and cannot be sold to HWG supporters.
Season tickets cost $260 for adults and $175 for children. Following their recent promotion all the season
tickets have been sold this year with 70% of season tickets sold to adults and the remaining 30% to children.
Tickets for away supporters are always sold at $20 per ticket regardless of whether the ticket is sold to an
adult or a child. On average 50% of away supporter tickets have been sold for each of the 14 home games
played at HWGs stadium during the football season.
HWGs other revenue streams include the sale of football kits and other memorabilia from the club shop, and
food and drink sales from the club snack bars.
Following promotion to the top division, the club added an extra stand to the stadium to increase the seating
capacity to the current level of 25,000. Other existing areas of the stadium also underwent maintenance in
order to restore them to their original condition. The work was carried out during June and July 20X7 and
cost a total of $3,360,000. To finance this HWG took out a $2,900,000 loan on 1 June 20X7. The loan
carries an interest rate of 7% and is repayable over the next five years. The loan is secured on the stadium.
The directors feel that the clubs greatest assets (other than the stadium) are the football players themselves.
The players have performed so well this year that some of the other football clubs in the same division have
made preliminary offers to buy 3 of HWGs players. HWG is particularly pleased about this as these players
joined the club through their youth academy programme. Consequently the directors would like to value
these 3 players as intangible non-current assets in HWGs financial statements. The players will be valued at
the offer price received from the other clubs; the directors feel this is a prudent valuation because they are
confident that the eventual selling price would be much higher than the preliminary offer.
One of the major drawbacks of the clubs promotion has been that the club has had to increase the level of
players salaries. The total salary expense for the year is estimated to be in the region of $2,800,000. This is
a particularly surprising figure as it is higher than the other operating costs for the year which are estimated
at $2,400,000.
HWG has just appointed a team of internal auditors. They have not been in position long enough to help you
with your audit work but the directors are keen for the internal auditors to improve the companys internal
controls in relation to the club shop and snack bars.
Required
(a) Using the information provided, describe FIVE audit risks and explain the auditors response to each
risk in planning the audit of HWG. (10 marks)
(b) Describe how the auditor could perform a proof in total calculation to confirm each of HWGs revenue
from ticket sales, loan interest and payroll expense for players salaries. (4 marks)
(c) Explain THREE internal controls the internal auditors of HWG should implement in relation to the club
shop and snack bars. State the objective of each control. (6 marks)
(Total: 20 marks)

6 Chingford Potteries
Your firm is the external auditor of Chingford Potteries, and you recently attended the year-end inventory
count at the company's warehouse. The company manufactures high quality tableware (plates, cups and
saucers etc.) and it maintains an integrated computerised system that shows the inventory held at any given
point in time.
At the year-end inventory count, reports showing the various categories of inventories (but not the quantities)
are printed off the system and the quantities of inventories actually counted are inserted manually by the
counters. Later the quantities are compared with those per the computer system.
The count instructions were received by both you and the counters the day before the count was due to take
place. The instructions included the following details:
1. Counters must arrive at 8am on the morning of the count
2. They will work in teams of 2 people.
3. Each team will be assigned a specific area of the warehouse to count. They will receive inventory
sheets listing the products to be found in their area.
4. The inventory sheets are pre-numbered.
5. Once the counters have finished the inventory count, the inventory sheets must be handed to the
warehouse manager.
Your notes from the attendance at the count include the following observations:
Many areas in which the count took place were untidy and inventory was sometimes difficult to find because
it was not in the allocated area. The same categories of inventories were sometimes found in several
different areas and some inventory was incorrectly labelled.
The count was conducted in a hurry in order to close the warehouse before a public holiday and there were
insufficient counters to conduct the count properly in the time available. The issue and receipt of inventory
sheets (on which the quantities were recorded by counters) was not properly controlled. It was difficult to
reconcile the inventory quantities recorded at the count to the computerised records and some significant
differences remain outstanding.
Although no finished goods were dispatched during the inventory count, a large delivery of raw materials was
received into the warehouse.
Required
(a) For the inventory count conducted by Chingford Potteries:
(i) Identify and explain FOUR deficiencies in the count
(ii) Explain the possible implication of each deficiency and
(iii) Provide a recommendation to address each deficiency. (12 marks)
(b) Describe the audit procedures the auditor should perform at the year end to confirm each of the
following:
(i) the existence of inventory (3 marks)
(ii) the completeness of inventory (2 marks)
(iii) the valuation of inventory. (3 marks)
(Total: 20 marks)

Student self-assessment
Having completed this paper take a few minutes to consider what you did well and what you found difficult.
Use this as a basis to focus your future study on effectively improving your performance.
Common problems Future emphasis if you answer Yes
Timing and planning

Did you finish too early? Y/N Focus your planning time on generating more ideas.
Use models to help develop breadth to your thinking.
Did you overrun? Y/N Focus on allocating your time better.
Practise questions under strict timed conditions.
If you get behind leave space and move on.
Did you waffle? Y/N Focus your planning time on developing a logical structure to
your answer.
Layout
Was your answer difficult to follow? Y/N Use headings and subheadings.
Use numbering sequences when identifying points.
Leave space between each point.
Did you fail to explain each
point clearly? Y/N Show why the point identified answers the question set.
Did you fail to show any workings
or were your workings unclear? Y/N Give yourself time and space to make the marker's job easy.
Content
Did you struggle with:
Interpreting the questions? Y/N Learn the meaning of common terminology (inside front cover).
Learn subject jargon (key terms in study text).
Read questions carefully noting all the parts.
Practise as many questions as possible.
Understanding the subject? Y/N Review your notes/text.
Work through easier examples first.
Please contact your tutor for further help.
Remembering the notes/text? Y/N Quiz yourself constantly as you study. You need to develop
your memory as well as your understanding of a subject.

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F8 Course Notes

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Audit and Assurance

7 Audit planning and documentation ........................................................................................ 119

12 Non-current assets ................................................................................................................ 217

20 Answers to Lecture Examples............................................................................................... 295

Introduction to Paper F8 Audit and Assurance

Overall aim of the syllabus

A Audit framework and regulation

Links with other papers

Governance, risk and Advanced Audit and Assurance

Corporate and Financial Audit &

Taught Phase Aims

Achieving ACCA's Study Guide Outcomes

A Audit framework and regulation

A1 The concept of audit and other assurance engagements Chapter 1

B Planning and risk assessment

B1 Obtaining and accepting audit engagements Chapter 6

C1 Internal control systems Chapter 9

D1 Financial statement assertions and audit evidence Chapter 8

E Review and reporting

E1 Subsequent events Chapter 18

The Examination Paper

10% Knowledge 90% Application

Format of the Exam Marks

Time pressure warning

Section reference in the Study Text

Key skills required to pass

Skill 1 Effective use of reading time

Skill 2 Analysis of a question's requirements

Skill 3 Disciplined time management

Skill 4 Tackling multiple choice questions

Skill 5 Producing a tailored answer to the exam scenario

How have the syllabus learning outcomes been examined?

Explain the level of assurance provided by an Q7 Section A pilot paper

The concept of audit and other

The purpose of external audit The audit report Assurance

1 The purpose of external audit

Own Company Manage

2 The audit report

Example audit report

INDEPENDENT AUDITORS REPORT

Fair presentation/ true and fair

2.5 What is materiality?

Limitations of the audit and materiality

2.8 Auditors reports are covered in more detail in Chapter 19.

3.6 The statutory audit is therefore an example of an assurance engagement.

3.9 Other examples of assurance engagements include:

Lecture example 1 Idea generation

What other examples of assurance and assurance reports exist?

Type of engagement Evidence gathering The assurance report

4.2 Reporting different levels of assurance:

Examples of different types of assurance engagements and their level of assurance:

Engagement Level of Assurance Examples

External audit Reasonable assurance Statutory external audit

5 Accountability, stewardship and agency

5.2 An agency relationship

The agency relationship in audit

How have the syllabus learning outcomes been examined?

The regulatory framework

Appointment, removal Mechanisms for the Development and Regulation by the

Note: throughout these

1 The regulatory framework

1.2 Legislation will normally establish:

Auditors' rights and duties

Access to books and records Report opinion