Chapter 1

AUDIT & ASSURANCE

INTRODUCTION -AN OVERVIEW OF AUDITING:

Economic decisions in every society must be based upon the information available at the time the decision is made. For example, the decision of a bank to make a loan to a business is based upon previous financial relationships with that business, the financial condition of the company as reflected by its financial statements and other factors. As a means of overcoming the problem of unreliable information, the decision-maker must develop a method of assuring him that the information is sufficiently reliable for these decisions. In doing this he must weigh the cost of obtaining more reliable information against the expected benefits. A common way to obtain such reliable information is to have some type of verification (audit) performed by independent persons. The audited information is then used in the decision making process on the assumption that it is reasonably complete, accurate and unbiased.

Audit is an independent examination of financial statements of an entity that enables an auditor to express an opinion whether the financial statements are prepared (in all material respects) in accordance with an identified and acceptable financial reporting framework (e.g. international or local accounting standards and national legislations). "Auditing is such an examination of books of accounts and vouchers of business, as will enable the auditors to satisfy himself that the balance sheet is properly drawn up, so as to give a true and fair view of the state of affairs of the business and that the profit and loss account gives true and fair view of the profit/loss for the financial period, according to the best of information and explanation given to him and as shown by the books; and if not, in what respect he is not satisfied." This view of audit is presented by ISA 200 Objective and General Principles Governing an Audit of Financial Statements. The phrases used; to express the auditors opinion means that the financial statements give a true and fair view or have been presented fairly in all material respects. True and fair presentation means that the financial statement are prepared and presented in accordance with the requirements of the applicable International Financial Reporting Standards (IFRS) and local pronouncements/legislations.

What is an Audit?

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What we can understand as the essential features of an audit from the above definition and explanation are as under: An auditor involves in examination of financial statements, the auditor is not responsible for the Preparation of the financial statements. The end result of an audit is an opinion to assist the user of the financial statements. Auditing therefore relies heavily on professional judgment, not merely on the facts. The auditors opinion makes reference to true and fair or fair presentations but true and fair is again a matter of judgment. It is not precisely defined for the auditor. In order to make the user of the auditors report able to feel confident in relying on such report, the auditor should be independent of the entity. Independent essentially means that the auditor has no significant personal interest in the entity. This allows an objective, professional view to be taken.

 a. Audit is a systematic and scientific examination of the books of accounts of a business; b. Audit is undertaken by an independent person or body of persons who are duly qualified for the job. c Audit is a verification of the results shown by the profit and loss account and the state of affairs as shown by the balance sheet. d. Audit is a critical review of the system of accounting and internal control. e. Audit is done with the help of vouchers, documents, information and explanations received from the authorities. f. The auditor has to satisfy himself with the authenticity of the financial statements and report that they exhibit a true and fair view of the state of affairs of the concern. G. The auditor has to inspect, compare, check, review, scrutinize the vouchers supporting the transactions and examine correspondence, minute books of share holders, directors, Memorandum of Association and Articles of association etc., in order to establish correctness of the books of accounts.

FEATURES OF AUDITING

OBJECTIVES OF AUDITING
There are two main objectives of auditing. The primary objective and the secondary or incidental objective.
a) Primary objective the primary duty (objective) of the auditor is to report to the owners whether the balance sheet gives a true and fair view of the Companys state of affairs and the profit and loss A/c gives a correct figure of profit of loss for the financial year. Secondary objective it is also called the incidental objective as it is incidental to the satisfaction of the main objective. The incidental objective of auditing are:
i. Detection and prevention of Frauds, and ii. Detection and prevention of Errors.

b)

Fraud refers to intentional misrepresentation of financial information with the intention to deceive. Frauds can take place in the form of manipulation of accounts, misappropriation of cash and misappropriation of goods. It is of great importance for the auditor to detect any frauds, and prevent their recurrence. Errors refer to unintentional mistake in the financial information arising on account of ignorance of accounting principles i.e. principle errors, or error arising out of negligence of accounting staff i.e. Clerical errors.

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Benefit of opinion: It improves credibility of financial statements. Assurance: statement made to give confidence. It can also be evidence.

All Assurance Engagements require:- User Subject matter Practitioner (provides professional services with competence, objectivity, independence and to expected standards)for example the AUDITOR. The practitioner is responsible for determining the timing, the nature and extend of procedures and is required to pursue anything that leads the practitioner to question whether a material modification should be made to the subject matter information Responsible party (the person supplying goods/ services): the person responsible for the information and assertions. Intended user: are the person(s) for whom the practitioner prepares the assurance report. The responsible party can be one of the intended user. Subject matter information (agent's details, FS..) Criteria (your expectation against which you'll decide your purchase is worthwhile): are benchmarks used to evaluate or measure subject matter. Criteria need to be available to the intended users to allow them to understand how subject matter , has been evaluated or measured. Engagement process involves: Agree terms of engagement (engagement letter) Decide methodology for evidence gathering, evaluation measurement to support a conclusion Type of report(unqualified report or qualified report)

What are the different stages of audit?

Auditing is essentially a practical task. The auditor always needs to reflect the nature of the circumstances of the entity under audit. It is unlikely that any two audit assignments will ever identical. It is however possible to identify a number of standard stages in a typical external audit. These are as follows: - Audit appointment - Engagement letter - Initial planning Knowledge of the business Risk Assessment Internal control review (procedures) Control procedures (authorities/approvals/segregation of duties) - Preparation of the audit plan - Accounting system review - Analytical review techniques (Compliance procedures-Application of control test procedures) like purchasing are according to the controls established. - Considering the ways in which audit evidence can be sought - Substantive testing (transaction level procedures) - Reasonable assurance - Review of the financial statements (compliance with the standards/material misstatement etc.) - Preparation and signing of report

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. This responsibility includes: designing, implementing and maintaining internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances.

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 whether the financial statements are free from material misstatement.

Responsibility for the Financial Statements:

Responsibilities for preparing and presenting the financial statements are that of management. Auditors responsibility is to express an opinion thereon.

Positive Assurance
Companies prepare annual Financial Statements. Shareholders need to be assured that they are accurate. A team of auditors (qualified accountants) from outside the company will come in to check whether the FS are true and fair - a term meaning that the FS have no material (important) errors. The criteria that the auditors will use to check the FS are the accounting standards. An audit report will be written to the shareholders, stating whether, in the auditors opinion, the FS do, or do not, present a true and fair view (i.e. positive assurance).

Internal audit
Companies have many internal systems risk management, internal controls, accounting systems. The Directors need to be assured that the systems are working. A team of auditors, who may be from inside or outside the company, will check whether these systems are working properly. The criteria that the auditors will use are likely to be their own experience of what makes a good system, combined with legal requirements and corporate governance. An audit report will be written to the Directors, stating whether the systems are working and making recommendations for future improvement.

The importance of independence in assurance

Assurance reports are written for the benefit of the people reading them. The readers need to be able to trust that the reports are reliable and correct. If they sense any links between the auditors and the things being audited, they may not trust the opinions given. If there are any links between the auditors and the things being audited, the report loses credibility and the assurance is undermined. It is therefore a requirement if the auditors are independent of those they are auditing.

THE EXTERNAL AUDIT TIMELINE

Interim audit; The detailed audit planning and assessment of internal controls are often carried out on an interim audit, which can be done without waiting for the accounting year to end. On very large audits, more than one interim audit visit may be necessary. Year end; At the client year end, a number of audit procedures are likely to occur: = Attend client's year end stock-take = Perform a debtor circularization = Perform a creditor circularization = Request Bank Letter. Final audit; The Draft (unaudited) Financial Statements are now available. The main focus is substantive testing results of control tests determine how much substantive testing is required.

Reasonable assurance, true and fair view, materiality

REASONABLE ASSURANCE What is reasonable assurance? A conclusion that the financial statements are not materially misstated. An auditor cannot obtain absolute assurance because of limitations described in Para below. How reasonable assurance is achieved? It is achieved by obtaining audit evidence. Factors affecting reasonable assurance; i) Inherent limitation of an audit, i.e. failure of audit procedures to detect material misstatements in financial statements because of: a) The use of testing (application of procedures on samples). b) The inherent limitations of accounting and internal control system. c) Persuasive nature of audit evidence rather than conclusive (Persuasive: one leading to an opinion; one which causes to believe; Conclusive: final, convincing). ii) Exercise of judgment by the auditor in gathering of evidence and drawing of conclusion. iii) Existence of other limitations like related parties etc Auditors cannot test every single transaction ... and even if they did, it is usually impossible to know for sure that things have been correctly recorded. As a result, auditors carry out their work until they are reasonably assured (not 100% certain!) that the Financial Statements are true and fair (no clear errors, and presented with no bias). Since not all transactions have been tested, the auditors can only be assured that the Financial Statements are free from material errors or misstatements. In other words, there are no mistakes that anyone reading the Financial Statements would want to know about.

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Reasonable Assurance(positive assurance): Gathers sufficient appropriate evidence Concludes subject matter conforms in all material respects with identified suitable criteria (information given is reliable) His opinion- positive assurance Reasonable Assurance(negative assurance): Gathers sufficient appropriate evidence to be satisfied that subject matter is plausible in the circumstances Gives his report- negative assurance

Assurance report/ opinion is not an absolute opinion, why?

1. 2. 3. 4. Because of lack of precision often associated with subject matter (FS subject to estimation and judgment) Nature, timing and extent of procedures Evidence is persuasive rather than conclusive Evidence is gathered on test basis

Reporting the outcome of assurance engagement

Practitioner > reports > user

Two types of reports a) positive assurance

b) negative assurance

Audit of Co's (annual, statutory, FS these are collectively called General Purpose FS by IASB) are the most common assurance engagement Reports are directed to different STAKEHOLDERS who have different reporting needs, these are Mgt + those in charge of governance: how effective the Co's systems are as a mechanism for producing FS, showing fair & true view and safeguarding of CO's assets Lenders (Banks, Financial Institutions): often on a limited assurance basis require reports on financial viability of a Co Management: employment and environmental practices to satisfy demands of employees+ local community groups

Review Engagement(limited assurance):

The objectives of a review engagement: is to enable to practitioner to state whether, on the basis of procedures which don't provide all the evidence that would be required in an audit, anything that has come to the practitioner attention that causes the practitioner to believe that the financial statements are not prepared, in all material respects, in accordance with an applicable financial reporting framework. Characteristics of review engagement: A review engagement has all the attributes of assurance engagement: The practitioner who conducts the work. The user who commissioned (means specially-made)the work A responsible party The subject matter The subject matter information Criteria Sufficient appropriate evidence which needs to be documented. A report

1. 2. 3. 4. 5. 6. 7. 8.

Knowing the audit profession and other services?

Auditing firms do not describe themselves as auditors. They describe themselves as Chartered Accountants. Auditing firms are composed of accountants who perform audits for their clients. They also perform other services. The small chartered accountant firms especially may spend more time on other services than on auditing. The other services may include: a. Writing up books of accounts (Book keeping) b. Balancing books of accounts (Extracting trial balance) c. Preparing final accounts d. Tax management e. Statutory form filling f. Financial consultancy g. Management and system consultancy h. Liquidation and receivership work i. Investigations (Fraud audit)

There is a legal requirement for accounts to be produced by Mgt on a regular basis to account to shareholders for their STEWARDSHIP of the business. The recognition of the need for these accounts to be checked in some way by someone INDEPENDENT of the managers (the AUDITOR) STEWARDSHIP:-the responsibility to take good care of resources, and STEWARD: person entrusted with mgt of another person's property, he is accountable for the way he carries out his role FIDUCIARY RELATIONSHIP: the relationship where one person has a duty of care towards someone else it is a relationship of good faith between shareholders and directors of CO Separation of ownership (shareholders) and control (directors) Therefore, directors must take decisions in the interests of the shareholders rather than their own selfish personal interests ACCOUNTABILITY: people in positions of power can be held to account for their actions, therefore compelled to explain their decisions criticized/ punished if they have abused their position accountable for using Co's assets efficiently and effectively

We have two issues on reporting area:-

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AGENCY RELATIONSHIP: 1. Occur when one party (principal) employs another party (agent) to perform a task on their behalf. 2. It is a relationship between various stakeholders in a Co are described in term of agency theory Directors are agent for shareholder Employees " " directors Auditors " " shareholders 3. Co's mgt account for their stewardship of Co at regular intervals by producing FS 4. What if FS contains errors, or even worse, are fraudulent?? There was a need for independent audit 5. A need for 100% verification of FS and that they are correct, there is a problem 1. Too expensive due to amount of work 2. May prove to duly disruptive of Co's operations Therefore auditors are established as forming an independent opinion about:1. Truth and fairness of FS 2. FS comply with legal and regulatory requirements 1. And, this is a typical assurance engagement (and NOT an absolute assurance) that 1. gives confidence to SH that FS are true & fair view 2. Reduce risk of misstatement

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EXTERNAL AUDIT It is a requirement by Law in most developed countries that its objective is to enable auditors to express an opinion on whether FS presented fairly in all material respects (true & fair view) prepared in accordance with an applicable financial reporting framework (which vary from country to another) GENERAL PRINCIPLES 1. Compliance with applicable ethical principles (IFAC code of ethics for professional accountants) and ethical pronouncements of auditors' professional body (e.g. ACCA rules of professional conduct) 2. Compliance with applicable auditing standards (IAASB/ ISA) 3. Planning and performing the audit with the attitude of professional skepticism recognizes that FS may be materially misstated

APPOINTMENT OF EXTERNAL AUDITORS

In most countries, the auditors are reporting to the shareholders, so are appointed by the shareholders. The Board of Directors will propose a Firm and this will then be voted on by the shareholders. Usually, they are appointed on an annual basis at the AGM. If auditors are needed mid-year (e.g. because the previous Firm resigned) then it is often possible for the Board of Directors to appoint a Firm up till the next AGM. In most large companies, there will be a specialist Board Committee that will recommend a Firm to the main Board this committee is called the Audit Committee.

WHO IS ALLOWED TO BE AN EXTERNAL AUDITOR?

To be allowed to do external audits, someone must go through an approval process. This helps to ensure quality. The process includes: = Must pass an approved set of professional examinations, set by a Recognised Qualifying Body (RQB). Examples of RQBs include the ACCA and ICAEW = Must become a member (and stay a member!) of a Recognised Supervisory Body (RSB). The ACCA and ICAEW are also examples of RSBs. To be allowed to do the external audit of a particular company, there are additional rules: = the auditor must not be a Director or Employee of the company, or of any associated companies = the auditor must not be an Employee or Business Partner of a Director or Employee of the company, or of any associated companies. Beyond these rules, governments typically leave further detailed guidance to the RSB to decide.