Auditing: Page 1 Definition of Auditing Auditing is the process by which a competent, independent person accumulates and includes evidence about quantifiable information related to a specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria. a. Competent, Independent Person Competence Qualified to understand the criteria used. Know the types and amount of evidence to accumulate to reach the proper conclusion after the evidence has been examined. Independence Have an independent mental attitude (be independent in fact and in professionalism). Unbiased information and objective thinking are needed for the judgment and decisions to be made. b. Accumulating & Evaluating Evidence Evidence-Any information used by the auditor to determine whether the quantifiable information being audited is stated in accordance with the established criteria. Deciding the amount of audit evidence-planning. Accumulation of evidence – implementation. Evaluation of evidence – implementation. Drawing conclusion based on these evidences. Final stage. Quality and volume of evidence – must satisfy the audit objective. c. Quantifiable Information & Established Criteria Quantifiable-Information in a verifiable form (can be assessed against some criteria/standard/ benchmarks). Established Criteria–Standards against which quantifiable information will be assessed. Example: GAAP, IAS (International Accounting Standards), Companies Act, Accounting Standards, Tax Ordinance, SEC Act, Auditors’ judgment based on professional skepticism. Criteria used depend upon the objective of the audit. d. Economic Entity: Legal entity e.g. Corporation, unit of govt., partnership, division, department & even individual. Scope of the auditors’ responsibility – identified by defining the economic entity. e. Reporting Reporting (final stage in audit process) preparing audit report and communicating findings to users of financial statements. Audit is one of the assurance services provided by the competent and qualified professional accountants. Definition by American Accounting Association (AAA): “Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.” Definition by International Federation of Accountants (IFAC): “An audit is an independent examination of financial statements or related financial information of an entity, whether profit oriented or not, and irrespective of its size, or legal form, when such an examination is conducted with a view to expressing an opinion thereon.” Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 2 Need for & Purpose of Audit The purpose of auditing is to provide information for – 1. Making decisions concerning the use of limited resources, including the indication of crucial decision areas and the determination of objectives and goals. 2. Effectively directing and controlling an organization’s human & material resources. 3. Maintaining and reporting on the custodianship of resources. 4. Facilitating social functions and controls. The American Association of Accountants (AAA) in a statement of Basic Auditing concepts (ASOBAC) had identified some factors that created demand for auditing1. Conflict of interest between preparer and users of information: User of information percentages on actual or potential conflict of interest between him and prepares of information. Because the quality of information is thus suspect, explicit performance of the audit (attest) function by someone free from the perceived conflict of interest to required. 2. Consequence of information to users: When the existence of biased, misleading, irrelevant or incomplete information could lead to incorrect decisions which are harmful to the user or those significantly influenced by such decisions. 3. Complexity of subject matter and the audit process: As the subject matter becomes more complex, the possibility of unintentional errors creeping into the information – increases. Audit in the process through which satisfaction as to the quality of information can be achieved. 4. Remoteness of users from subject matter and prepare: Remoteness prevents the user from directly assessing the quality of information received. Remoteness can be caused – i. A separation between the user of information and the subject matter and prepares of information. ii. Physical separation by legal or institutional barriers to access to the subject matter and preparation. iii. By time and cost constraints.
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Auditing: Page 3
Classification of Audit
A. Classification by Legal Requirement 1. Statutory Audit: Audit subject to be governed by some statute (Act, ordinance, Rules or other statutory regulation). Corporate entities Companies Act 1994 Bank Companies Act 1991. Insurance Act 1938 Electricity Act 1910. SEC Act 1993 SEC Ordinance 1969 SEC Rules 1987 Income tax Ordinance 1984 NGO receiving foreign donations: Foreign donations regulations Rules 1978. Co-operative Society: Co-operative Societies Ordinance, 1984. Public Sector Corporation: At three levelsa. Corporations Internal Audit Dept. b. Independent Professional Audit firms. c. Comptroller and Auditor General (C&AG) 2. Non- Statutory audit: An audit performed voluntarily by an entity and this requirement is not subject to be governed by any Act, ordinance, rules or other statutory regulations. Internal audit and operational audit e.g. B. Classification by types of activities done by auditors 1. Financial Statement Audit: The obtaining of evidence on the financial statement assertions of an entity and using such evidences to ascertain adherence of the assertions to GAAP or other comprehensive basis of accounting. 2. Compliance Audit: Involves obtaining and evaluating evidence to determine certain financial or operating activities of an entity confirming to specific or prescribed conditions, rules or regulations. E.g. Income tax audit by the assessment offices (DCT). 3. Performance or Value for Money Audit: Audit of an entity. Usually of a govt. department, a charity or other non-profit making organization. To assess whether or not it is functioning efficiently & giving value of the money it spends. This is the audit about three E’s: Efficiency, economy and effectiveness. 4. Comprehensive Audit: Commonly performed in public sectors. Accounts of enterprises under Sector Corporation in BD are subject to comprehensive audit. It encompasses – Financial audit Compliance Audit Performance Audit Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 4 5. Social Audit: Social audit is an audit of the impact of an organization on society. Environment audit is one kind of social audit. 6. Internal Audit: Any systematic investigation or appraisal of procedures or operations by an employee of the concerned entity for the purpose of determining conformity with prescribed criteria. C. Classification by Objectives 1. Financial Audit. 2. Compliance audit 3. Operational audit A systematic review of an organizational activities in relations to specific objectives for the purpose of assessing performance, identifying opportunities for improvement & developing recommendations for improvement or further action. Points of Difference Financial Audit Compliance Audit Operational Audit Subject Matter Financial assertions Person’s or entity’s All parts of organizational actions activities Criteria GAAP Laws & Regulations Specified objectives of org. Reporting On fairness of the On compliance On recommended financial conformity with criteria improvements with GAAP D. Classification by Affiliation of Auditors 1. External Audit Is performed by Charter Accountants who are independent of the entity. All the companies registered under the companies act are subject to external audit. Auditors are appointed by those who are external to the entity – shareholders. 2. Internal Audit Objective–Assist members of the organization in the effective discharge of their responsibilities. Internal auditing furnishes them with analysis, appraisals recommendations, counsel, and information concerning the activities reviewed. 3. Govt. Audit Audit of govt. departments, undertaking, govt. bodies are done by govt. auditor. President of the country appoints “The Comptroller and Auditor General of BD C& AG is the Prime authority of Govt. audit hierarchy”. C&AG submits the audit report of accounts under his jurisdiction to the president. The report of the C&AG is laid before the parliament for a “debate” on it.
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Auditing: Page 5 E. Classification by Periodicity 1. Continuous Audit:/Detailed Audit: Involves detailed examination of the books of accounts at regular intervals. Visits clients at regular or irregular intervals during FY
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Checks each & every transaction during the period
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Checks income statement and the B/S at the end of the year Businesses where Continuous Audit is appropriate are as follows: Where it is desired to present the accounts just after the close of the FY as is the case of bank. Where the volume of transactions is very large. Where the statement of accounts is required to be presented to the mgt. after every month or quarter. Where no satisfactory system of internal check is in operations. 2. Periodic or Final or Complete Audit: At the close of the financial or trading period–when all accounts have been balanced and a trading and P\L account and B/S have been prepared. 3. Interim Audit: It’s conducted in between the two annual audits–with a view to find out interim profits. 4. Occasional Audit: Conducted once a while whenever the need arises and the client desires it to be carried out. F. Classification by Subject Matter 1. Financial Audit 2. Operational Audit 3. Cost Audit: Checking of–cost accounts, costing methods, techniques, and systems followed by the entity. Cost Auditors are appointed by BOD. Report submitted to mgt. & to the govt. 4. Management Audit: Critical review of policy and practices of mgt.
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Auditing: Page 6 Primary and Secondary Objective of Audit Primary objective- Expression of Expert opinion Secondary objectives- Prevention and detection of material misstatements in the financial statements, which are referred to frauds and errors; and communication of weaknesses in the accounting and internal control systems.
Primary Objective- Expression of Expert opinion As per requirements of the Companies act 1994 (applicable for all the companies) the auditor’s responsibilities of reporting as follow: The auditor’s report shall state whether, in his opinion and to the vest of his information and according to the explanation given to him, “the accounts, balance sheet and profit and loss account and every other document to be part of or annexed to the balance sheet or profit and loss accounts” give the information required by the Companies Act in the manner so require and give a true and fair view In the case of the balance sheet, of the state of the company’s affairs as at the end of the financial year; In the case of the profit and loss accounts, of the profit or loss or its financial year [sec. 213(3)] The auditors’ report shall also state Whether he has obtained all the information and explanation which to the best of his knowledge and belief were necessary for the purposes of his audit; Whether, in his opinion, proper books of account as required by law have been kept by the company so far as it appears from his examination of those books and proper returns adequate for the purpose of his audit have been received from branches not visited by him; Whether the company’s balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and return. [Sec. 213(4)] Secondary Objective- Prevention & Detection of Material Misstatements Definition of fraud: The term ‘fraud’ refers to an intentional act by one or more individuals among management, those charged with governance, employees or third parties, involving the use of deception to obtain an unjust or illegal advantage. Types of fraud: Two types of intentional misstatements are relevant to the auditors’ consideration of fraud: 1. Misstatements resulting from fraudulent financial reporting; and 2. Misstatements resulting from misappropriation of assets. Auditor’s Responsibility with respect to Fraud & Error The primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and the management of an entity (paragraph 1 &10 of BSA 240). An audit conducted in accordance with ISAs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 7 fraud or error. The fact that an audit is carried out may act as a deterrent, but the auditor is not and cannot be held responsible for the prevention of fraud and error (paragraph 13 of BSA 240). Some Important Terms Audit Administration/Overall Audit Plan-“The entire process of managing and conducting an audit” Audit Planning (BSA-300): Planning means developing a general strategy and a detailed approach for the expected nature, timing and extent of the audit. Audit Program: Audit program sets out the nature, timing and extent of planned audit procedures required to implement the overall audit plan. (Para 10 of BSA 300). Audit Methodology: Methods used by the auditor during the course of an audit.
Audit Process 1. Accepting the Audit Engagement: First Phase of the Audit Process a. Client intimation to be appointed as auditor i. Auditor has to receive the client’s intimation. ii. Soliciting clients or professional work either directly or indirectly by circular, advertisement, personal communication, interview or by any other means will be treated as professional misconduct. [Under Para 9 of schedule C, part-1 vide page-law 134 of the BD chartered Accountants page-laws, 2004]. b. Evaluate Integrity of management i. Communicate with predecessor auditor or review the communication made by the predecessor auditor. On the ethical ground any intending auditor should communicate the predecessor auditor for his clearance. Code of ethics – The existing auditor should advise whether there are any professional reasons why the proposed successor auditor should reject the engagement. ii. Make inquires of other third parties iii. Review previous experience with existing clients c. Identify special circumstances and unusual risk i. Identify intended users of audited F/S: Auditor should consider the clients status as private or public ltd. company. ii. Assess prospective client’s legal and financial stability: iii. Evaluate entities’ audit ability: Audit ability declines- Poor or absent condition of accounting records. No or poor internal control system. Previous incidence of imposing restrictions to conduct any audit. d. Assess competence to perform audit Following steps to be consideredi. Identify the audit team – including the partners, seniors and staff assistants who will do the audit job. Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 8 ii. Consider need for consultation and the use of specialists. iii. Competence of auditing in a Computer Information Systems (CIS) environment. iv. Competence of auditing in service organization. e. Evaluate independence: Maintain independence in fact and in appearance. Following main considerations: i. Identify threats to independence. ii. Evaluate whether these threats are clearly insignificant. iii. In case of not clearly insignificant threats- identify and apply appropriate safeguards to eliminate or reduce the threats to an acceptable level and iv. In situations when no safeguards are available to reduce the threat to an acceptable level, the only possible actions are to eliminate the activities or interest creating the threat or to refuse to accept or continue the assurance engagement. f. Determine ability to use due care: Auditor should apply the required professional care throughout each level of the audit process. Following considerations: i. Assess timing of appointment for training the opportunity to employ all the audit tests and ii. Consider the scheduling of field work which should start as such a point of that there is a reasonable period to complete the interim work before preparing the B/S and also to complete the yearend audit work after preparing the F/Ss. g. Preparation of engagement letter (BSA 210): It is in the interest of both client and auditor that the auditor sends an E\L, preferably before the commencement of the engagement (para.5). It documents and confirms the auditor’s acceptance of the appointment, the objective and scope of the audit, the extent of the auditor’s responsibilities to the client and the form of any reports (para.5). Principal Contents of E/L (Para: 6) are as follows: The objective of the audit of F\S; Management’s responsibility for the F\S; The scope of the audit, including reference to applicable legislation, regulations, or pronouncements; The form of any reports or other communication of results of the engagement; The fact that because of the test nature and other inherent limitations of an audit, together with the inherent limitations of any accounting and ICS, there is an unavoidable risk that even some material misstatement may remain undiscovered; and Unrestricted access to whatever records, documentation and other information requested in connection with the audit. The auditor may also include- (Para: 7) Arrangements regarding the planning of the audit; Expectation if receiving firm management written confirmation concerning representations made in connection with the audit; Request for the client to confirm the terms of the engagement by acknowledging receipt of the E\L; Basis on which fees are computed and any billing arrangements.
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Auditing: Page 9 When relevant, the following points could also be made (Para: 8) Arrangements concerning the involvement of other auditors and experts in some aspects of the audit; Arrangements concerning the involvement if internal auditors and other client staff; Arrangements to be made with the predecessor auditor, if any, in the case of an initial audit; Any restriction of the auditor’s liability when such possibility exists; A reference to any further agreements between the auditor and the client. Audits of components (Para: 9) Recurring Audits (Para: 10 & 11) Acceptance of changes in engagements (Para: 12….) 2. Planning the audit: It is the 2nd phase of audit process. Adequate planning of the audit work is because– Appropriate attention is devoted to important areas of the audit. Potential problems are identified and The work is completed expeditiously. Planning also helps In proper assignment of work to assistants, In coordination of work done by other auditors and experts. a. Familiarization: i. Obtain understanding of client’s business and industry. Understanding of the entity and its environment. Sufficient to identify and assess the risks of material misstatement of F/Ss whether due to fraud or error. Sufficient to design and perform further audit procedures. Following steps are followed: (I) Review prior years’ working papers: Applicable only if current audit is a continuing engagement. (II) Review industry and business data: May be collected from various industry publications. Review the memorandum of association and the articles of association and various by laws of the entity. Read the minutes of the meetings of the Board of Directors and AGM of the shareholders or any other extraordinary shareholders meeting to obtain information about such events as dividend announcements and shareholders’ approval of business reorganization. Analyze recent annual and interim F/Ss, income tax returns, VAT returns and other reports submitted to regularly agencies. Become familiar with applicable laws & govt. regulations. Read important continuing contracts such as lease agreements, loan agreements, and labor contracts. Read trade and industry publications by the Bangladesh Bank, Bangladesh Bureau of Statistics, and other international bodies concerning current business and industry developments. Information obtained must be documented by the auditor and retained in permanent file for future use. Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 10 (III) Visit client operations: Visit the operating facilities and offices to obtain knowledge about a new client’s operating characteristics. Plant tour: Plant lay-out The operating or manufacturing process. Storage facilities. Potential problem spots. Office tour: Aware about the types and locations of accounting records, and EDP facilities. Work habits of the personnel. (IV) Make inquiries of mgt: Inquiries of mgt. are useful to understand the recent business developments of the entity. (V) Determine existence of related parties: Perform audit procedure designed to obtain sufficient appropriate audit evidence regarding the identifications and disclosures of mgt. of related parties and effect of related party transactions that are material to the F/Ss. Auditor should review information provided by BOD and mgt. to identify the names of all knows related parties. Following procedures: Review prior year working papers for names of known R.Ps. Review of the entity’s procedures for identification of R.Ps. Inquire as to the affiliation of directors and officers with other activities. Review shareholders record to determine the names of principal shareholders or, if appropriate, obtain a listing of principal shareholders from the share register. Review minutes of the meetings of shareholders and the BOD and other relevant statutory records such as register of director’s interest. Inquire of other auditors currently involved in the audit, or predecessor auditors as to their knowledge of additional related parties, and Review the entity’s income tax returns and other information supplied to regulatory agencies. (VI) Consider impact of applicable accounting and auditing pronouncements. Highly knowledgeable about the GAAP. Highly knowledgeable about IAS/BASs Highly knowledgeable about ISAS/BSAs. Consider the impact of special accounting and auditing pronouncements. Evaluate the MGT’s use of the going concern assumption in the preparation of F/S: Auditor’s responsibility is to consider the appropriateness of mgt’s use of the going concern assumption in the preparation of the F/S. Consider whether there are material uncertainties about the entity’s ability to continue as a going concern that need to be disclosed in the F/S. In planning the audit, the auditor should consider whether there are events or conditions which may cast significant doubt or the entity’s ability to continue as a going concern. Md. Azim Ferdous BBA-11th Batch, Section-B
ii.
Auditing: Page 11 b. Performance of analytical Procedures: Analytical procedures means the analysis of significant ratios & trends including the resulting investigation of fluctuations & relationships that are inconsistent with other relevant information or deviate from predicted amounts. Steps for analytical procedures: i. Identify calculations/comparisons to be made: Analytical procedures used in planning vary
based on –
ii.
iii.
iv.
v.
Size and complexity of the clients business. Availability of data. Professional judgment of the auditor. Develop expectations: Underlying premise of analytical procedure. Relationships among data may be expected to continue in the absence of knows conditions to the contrary. Develop expectations from a variety of sources: Internal client source: Historical and future oriented data which may be financial or non-financial. External sources: Industry data published by Govt. and private organizations (financial/non-financial). Examples: Client financial information for comparable prior periods giving consideration to known changes Anticipated results based on formal budgets or forecasts Relationships among elements of financials information within the periods Relationships of financial information with relevant non-financial information Including data Perform the calculations/comparisons: Initially data are accumulated with respect to year to date and for projected year end data of the client entity and also the relevant industry data. Computer software to commonly use to perform the calculations or comparisons. Analyze data and identify significant difference: Calculations and comparisons are analyzed. Significant differences are identified: Analysis of current and quick ratios helps to understand the liquidity positions. A key part of the analysis identifying fluctuations in the data that are unexpected or the absence of expected fluctuations that may signal on increased risk of management. The process of determining whether a difference is significant or insignificant involves the exercise of professional judgment and the concept of materiality. Investigate effects on audit planning: Investigation must conduct regarding the significant unexpected differences. Usually involves: Making inquiries of mgt, and Reconsidering the methods and factors used in developing expectations. New information & revising the expectations: Management responses to inquiries should be corroborated with evidential matters. Computer software to commonly use to perform the calculations of comparisons. Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 12 vi. Determine effects on audit planning: Unexplained significant differences – indicating an additional risk of misstatement in the account or occasions. Auditor plans to perform more detailed tests of the account or accounts. At planning stage the AP may contribute a more effective and efficient audit by directing the auditor’s attention to areas of increased risk.
c. Making Preliminary Judgments about Materiality Level Definition of Materiality: Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful. Auditor’s preliminary judgment about materiality is referred to as planning materiality. This materiality may ultimately differ from the materiality levels that are used at conclusion of the audit in evaluating the findings of the audit because the surrounding circumstances may change & additional information about the client will have been obtained during the course of the audit. Quantifying planning materiality at the overall financial statement level: Auditing standards require auditor to consider materiality when planning the audit, but they are not required to quantity the amount. Many CA firms have found it beneficial to quantity planning materiality to make sure that all of the professional stages or an audit – view materiality for the audit in the same way. Quantitative considerations of materiality: Auditors use various approaches/rules of thumbs: 5% to 10% of Net Income before tax Percentage ½% to 1% of total assets. 5% - 10% ½% to 1% of total revenue ½% - 1% 1½% of total equity ½% - 1% 1½% Sliding Scale If the greater of total assets or total revenue is Over But not over Tk. 0 Tk. 30,000 Tk. 30,000 Tk. 1,00,000 Tk. 1,00,000 Tk. 3,00,000 quantitative measures/ Of……….. Net Income Before Tax Total Assets Total Revenue Total Equity
Materiality is Times The Excess Over 0+.05000 Tk. 0 1780+.03100 Tk. 30,000 3470+.02140 Tk. 1,00,000
Qualitative considerations of materiality: Materiality depends not only on the amount of the item, but also on its nature. An illegal payment of a relatively small amount might be considered material to the company’s financial statement. A misstatement of the financial statements that would affect a company’s compliance with a contractual agreement might be material regardless of its amount. A misstatement that reverses a trend of earnings for the company might be material regardless of its amount. Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 13 d. Consideration of audit risk exposure Audit Risk: “The risk that the auditor expresses on inappropriate audit opinion when the financial statements are materiality misstated”. Components of audit risk arei. Inherent Risk: “Inherent risk” is the susceptibility of assertions to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming that there are no related controls.” ii. Control Risk: “Control Risk” is the risk that a misstatement that could occur in an assertion and that could be material, either individually or when aggregated with other misstatements will not be prevented or detected and corrected or a timely basis by the entities internal control.” iii. Detection Risk: “Detection risk” is the risk that the auditor will not detect a misstatement that exists in an assertion that could be material, either individually or when aggregated with other misstatements. Audit risks are of mainly two types: i. Risk of material misstatement of the financial statements: Risk that financial statements are materiality misstated is prior to audit. This sort of audit risk is also known as “The risk of material misstatement of the assertion level.” ii. Detection Risk 3 Categories of assertions (Para 17, BSA 500) i. Assertions about classes of transaction & events for the period under audit: Assertions about classes of transaction & events for the period under audit Occurrence- Transactions & events that have been recorded have occurred & pertain to the entity. Completeness- All transactions & events that should have been recorded have been recorded. Accuracy- Amounts & other data relating to recorded transactions & events have been recorded appropriately. Cutoff- Transactions & events have been recorded I the correct accounting period. Classification- Transactions & events have been recorded in the proper accounts. ii. Assertion about account balances at the period end: Existence- Assets, liabilities & equity interest exist. Rights & obligations- The equity holds or controls the rights to assets, and liabilities are the obligations of the entity. Completeness- All assets, liabilities & equity interests that should have been recorded have been recorded. Valuation & allocation- Assets, liabilities & equity interests are included in the financial statements at appropriate amounts & any resulting valuation or allocation adjustments are appropriately recorded.
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Auditing: Page 14 iii. Assertions about presentation and disclosure: Occurrence & rights and obligations- Disclosed events, transactions and other matters have occurred and pertain to the entity. Completeness- All disclosures that should have been included in the financial statements have been included. Classification & understandability- Financial information is appropriately presented & described, & disclosures are clearly expressed. Accuracy & valuation- Financial & other information are disclosed fairly & at appropriate amount.
i) Two risk components at assertions level: i. Inherent Risk ii. Control Risk In order to design audit procedures to determine whether there are misstatements that are material to the financial statement as a whole audit consider risk of material misstatement at two levels. a) The overall financial statement level b) In relation to classes of transactions account balances and disclosures and the related assertions. a) Risk of material misstatement at the overall financial statement level: This refers to risks of material misstatement that relate pervasively to the financial statement as a whole and potentially affect many assertions. Relate to entity’s control environment. Declining economic conditions. * Such risk may be especially relevant to the auditors’ consideration of the risk of material misstatement arising from fraud. b) Risk of material misstatement at the class of transactions, account balance and disclosure level: Such consideration directly assists in determining the nature, timing and extent of further audit procedures at assertions level. ii) Detection Risk: There is an inverse relationship between detection risk and the combined level of inherent risk and control risk. e.g. when inherent risk and control risk are high acceptable levels of detection risk need to be low to reduce AR to an acceptably low level. The auditors assessment of inherent risk – are made primarily in the planning stage. Auditors determine a planned assessed level of control risk and detection risk for each significant financial statement assertion – is the planning stage of the audit.
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6. Understanding Client’s ICS
Understanding of the internal control is a prerequisite to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error. Operating effectiveness of controls helps in preventing or detecting and correcting material misstatements. Internal control is the process designed and affected by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. According to Para 43 of BSA 315, IC consists of the following components: a. Control environment i. The governess and management fractions and the attitudes awareness and actions of those charged with governess and management concerning the entity internal control and its importance in the entity, Para 67, 315 ii. It is the foundations for effective internal control, providing discipline and structure. b. The entity’s risk assessment process (II) The process for identifying business risk relevant to financial reporting objectives and deciding about actions to address those risks, and the results thereby. (III) Risk assessment process – forms the basis for how management determines the risks to be, managed. [para-76, 315] c. The information systems including the related business process, relevant to financial reporting and communications [Para 80, 315] This includes – spiciest – Para 81, 315 d. Control Activities: Control activities are the policies and procedures that help to ensure that management directives are carried out, for example – those necessary actions are taken to addresses risks – that threaten the achievement of the entity’s objectives. Example of specific control activities are as follows: Authorization Performance reviews Information processing Physical controls Segregating of duties [Para 90, 315] (Distributing Duties) e. Monitoring the controls – Overtime [Para 97, 315]
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Auditing: Page 16
Objectives of Internal Control
A. Objectives of ICS under BSA 315 are as follows: 1. Providing reasonable assurance about the achievement of the entity’s objectives with regard to: Reliability of financial reporting Effectiveness and efficiency of operations and Compliance with applicable laws & regulations. 2. Addressing identified business risks that threaten the achievement of any of the entity’s goals. 3. The operating effectiveness of controls helps in preventing, or detecting and correcting, material misstatements at the assertion level. B. Objectives of ICS under BSA 400 are as follows: Assisting in achieving management’s objective of ensuring the orderly & efficient conduct of biz. Assisting for adherence to management policies. Assisting in safeguarding of assets. Assisting in preventing and detecting fraud and error. Assisting in ensuring the accuracy & completeness of the accounting records. Assisting in the timely preparation of reliable financial information.
Basic Principles of Governing accounting systems and related Internal Control
1. Clearly defined duties and the limits of authority of the staff members: Adequate system for organizing recording and accounting for business transactions should be established, preferably in writing is an accounting manual form. The duties and limits of authority members is the staff – define in a hierarchical manner. 2. System of authorization for recording: Accounting records must be at first authorized by designated personnel and then must be recorded based on these authorized documents only. 3. Separation of duties: The rational recognition that all business transactions is practice entail three fundamental elements – i. Authorization: The initiation of contractual obligations on the entity’s behalf. ii. Custody: The handling of asset involved in the transaction and iii. Recording: The creation of documentary evidence of the transaction and its entry in the accounting records. 4. Effective internal check: Internal check involves the arrangements of book keeping and other clerical duties is such a way as to ensure – i. That no single task is executed from its beginning to its conclusion by only one person. ii. That the work of each staff member engaged upon a task is subject on independent check in the course of other duties. 5. No payment without authorization and approval. 6. Regular balancing and reconciling. 7. Rotation of duties. 8. Ensuring continuity in normal function of internal check system. 9. Internal auditing 10. Controlled access to assets and important documents 11. Arrangement of providing important summary information in time. 12. Periodic analysis variance between recorded fact and physical existence. Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 17 05. 03. Performing Audit Tests Performing audit tests means the process of collection and evaluation of evidence related to various audit tests. The phase of performing audit tests involves following steps: 1. Obtain evidential matter through audit tests. 2. Evaluate the evidence obtained for sufficiency and appropriateness. 3. Document the audit evidence in working paper. 1. Obtain evidential matter through audit tests: To obtain evidential matter; following audit tests are performed – i. Tests of control (referred to as compliance test prior to 1988): Tests of control are performed to obtain audit evidence about the effectiveness of thea. Design of the accounting and internal control systems, i.e. whether they are, suitably designed to prevent and detect and correct material misstatements. b. Operation of the internal control throughout the period. Test of control may include – Inspection of documents Inquiries about and observations of internal controls. Re-performance of internal control. ii. Substantive tests: Substantive tests are tests of details and analytical procedures performed to detect material misstatements in the account balance, transactions class and disclosure components of F/S. Substantive tests are the following – a. Analytical procedures: Analytical procedure involves the analysis of significant ratios and trends including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predictable amount b. Tests of details of transactions: Examining the evidential support for the individual debits and credits to an account and are done through – vouching and tracing. Vouching: Selecting entries is the accounting records and inspecting the documentation that served as the basis for the entries with a view to ascertaining the propriety and validity of the recorded transaction. Vouching of cash transaction- Chapter V (Tandon) Verification and valuation of assets & liabilities - Chapter VIII (Tandon) Tracing: Inspecting documents created when transactions were executed and ascertains that information from the documents were properly recorded in the accounting records. iii. Test of details of balances: Examining the evidential support for the ending balance directly. The rationale for testing control is to reduce the extent of substantive tests. To obtain evidential matter – following steps. a. Determine the objective test: Over all purpose of audit tests – obtain audit evidence to detect material misstatements in F/Ss and evaluate effectiveness of ICS. Based n the objective of tests, substantive tests or tests of control are to be performed. Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 18 b. Determine the procedure to meet objectives: 3 alternatives(I) Examining the entire population: If it is appropriate to examine the entire population of items that make the account balance or class of transaction. May some time occur in substantive tests. When inherent risk and control risk are high, the auditor may find it cost effective to examine entire population. (II) Selective testing (selecting specific items): Selective testing is the examination of specific items within the population based on Auditor’s knowledge of the client’s business. Preliminary assessments of inherent and control risks and The characteristics of the population being testes Specific items selected may include High value of key items. All items over a certain amt Items to obtain information Items to test procedures (III) Audit samplings: Involves the application of audit procedures to less than 100% of items within as account balance or class of transactions such that all sampling units have a chance of selection. Enable the auditor to obtains and evaluate audit evidence about some characteristics of the items selected in order to form or assist in forming conclusion concerning the population from which the sample is drawn. 2. Evaluate the evidence obtained for sufficiency & appropriateness: By applying combinations of substantive tests and tests of control, the auditor should be able to obtain evidence to satisfy in forming an opinion on financial statements. 3. Document the audit evidence in working paper Auditor should document properly in working paper because this is the basis for forming the audit opinion. The auditor should prepare working papers which are sufficiently complete and detailed to provide an overall understanding of the audit.(p-5) The extent of working papers is a matter of professional judgment since it is neither necessary nor practical to document every matter the auditor considers. In assessing the extent of WPs to be prepared & retained, it may be useful for the auditor to consider what would be necessary to provide another auditor who has no previous experience with the audit. (Para- 7)
Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 19 Definition of documentation: Documentation means the material (Working Paper) prepared by and for, or obtained and retained by the auditor in connection with the performance of the audit. Working papers may be in the form of data stored on papers, film, electronic media or other media. Need for Working Paper: a. Assist in the planning and performance of the audit; b. Assist in the supervision and review of the audit work; & c. Record the audit evidence resulting from the audit work performed to support the auditor’s opinion. The auditor should record in the working papers – a. Information on planning the audit work b. The nature , timing and extent of the audit procedures & the results thereof, c. The conclusions drawn from the audit evidence obtained (Para-6) Working Papers ordinarily include the following- (para-11) a. Information concerning the legal and organizational structure of the entity. b. Extracts or copies of important legal documents, agreements & minutes. c. Information concerning the industry, economic environment and legislative environment within which the entity operates. d. Evidence of the planning process including audit programs and any changes thereto. e. Evidence of the auditor’s understanding of the accounting and ICS. f. Evidence of IR & CR assessments and any revisions thereof. g. Evidence of the auditor’s consideration of the work of internal auditing and conclusions reached. Confidentiality, Safe custody, retention & ownership of Working Papers (Para -13 &14): The auditor should adopt appropriate procedures for Maintaining the confidentiality and safe custody of the working papers Retaining them for a period sufficient to meet the needs of the practice and in accordance with legal and professional requirements of record retention. Working papers are property of the auditor.
Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 20 05. 04. Reporting the Findings Expressing an independent and expert opinion on the fairness of financial statements is the most frequently performed service rendered by the auditor. This opinion provides users of financial statements with reasonable assurance that the statements are in conformity with GAAP. The auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements.
Basic elements of the Auditor’s Report: The auditor’s report includesa. Title; b. Addressee c. Opening or introductory paragraph; i) Identification of the financial statements audited; ii) A statement of the responsibility of the entity’s management and the responsibility of the auditor; d. Scope paragraph (describing the nature of an audit) i) A reference to the BSAs or relevant national standards of practices; ii) A description of the work the auditor performed; e. Opinion paragraph containing i) Reference to the financial reporting framework used to prepare the F/Ss (including identifying the country of origin of the financial reporting framework when the framework used is not BAS); and ii) An expression of opinion on the financial statements; f. Date of the report; g. Auditor’s address; and h. Auditor’s signature.
Md. Azim Ferdous BBA-11th Batch, Section-B
Auditing: Page 21 Different types of audit opinion 1. An unqualified opinion- standard report: Expresses s “clean opinion” & may be issued only the following two conditions have been meti. The financial statements are presented in conformity with GAAP, including adequate disclosure. ii. The audit was performed in accordance with GAAS, with no significant scope limitations preventing the auditors from gathering the evidence necessary to support their opinion.
2. An unqualified opinion-with explanatory language: In certain circumstances explanatory language is added to the auditors’ report with no effect on the auditors’ opinion. Examples: When the company changes accounting principles, when there is substantial doubt about a
company’s ability to continue as a going concern. 3. A qualified opinion: A qualified opinion states that the financial statements are presented fairly in conformity with GAAP “except for” the effects of some matter. Qualified reports are issued when The financial statements depart materially from GAAP. Limitations are placed on the scope of the auditors’ procedures. 4. An adverse opinion: An adverse opinion states that the financial statements are not presented fairly in conformity with GAAP. Auditors issue an adverse opinion when the deficiencies in the financial statements are so significant that the financial statements taken as a whole are misleading. All significant reasons for the issuance of an adverse opinion should be set forth in an explanatory paragraph. 5. A disclaimer of opinion: A disclaimer of opinion means that due to a significant scope limitation, the auditors were unable to form an opinion or did not form an opinion on the financial statements. A disclaimer is not an opinion. It simply states that the auditor does not express an opinion on the financial statements.
Md. Azim Ferdous BBA-11th Batch, Section-B