Auditing is a systematic and independent examination of data, statements or reports, operations and performance on the true and fair view or in material respect of the financial position in accordance with international reporting standards. It is a documented process for acquiring audit evidence and evaluating it objectively to ascertain the extent to which the environment management system audit criteria set by the organization are fulfilled.
Internal auditors are those who are hired by the firm that they audit. They primarily provide audits associated with the effectiveness of the firm's internal controls over financial reporting. They also assess the efficacy of management's internal controls over financial reporting and provide a recommendation if required.
Internal auditors are not independent of the firm they perform audit procedures for, however they sometimes do not report directly to management, so as to reduce the risk that they will be swayed to produce biased assessments.
External auditors are independent auditing/accounting corporations that are employed by companies subject to an audit. External auditors express their own opinions on whether the financial statements of the firm in question are free of material misstatements, these could be as a result of fraud, error or otherwise. They could also be needed to give an opinion on the effectiveness of internal controls over financial reporting.
a) Audit Plan
Audit planning is developing an overall strategy for the audit. The nature, extent, and timing of planning varies with size and complexity of the entity, experience with the entity, and knowledge of the entity's business.
Components of Audit Plan
Understanding the Client's Business and Industry
ISA 310 needs a rational understanding of the client's business and industry. The nature of the client's business and industry affects client business risk and also the risk of material misstatement in the financial statements. Auditors use the information of these risks to decide the suitable amount of audit proof to collect. Auditors have been exposed to issues occurring from the auditor's failure to interpret comprehensively the nature of transactions in client's industry.
The auditor should further have an understanding of the client's external environment, as well as economic conditions, effect of competition, reporting responsibilities, legal and regulatory requirements. The auditor must source this data by reading regulatory requirements and industry trade publications.
The auditor ought to establish factors such as major sources of financial gain, sources of finance, key customers and suppliers, associated parties and transactions with associated parties requiring disclosure that might be high-risk areas within the client. The auditor ought to make inquiries of management and others within the entity in correspondence to the above. Visiting the client's premises is additionally helpful in this regard since it offers a chance to observe operations firsthand and to meet key employees. Transactions with related parties are vital to auditors since the International Accounting Standards require that such transactions be disclosed in the financial statements if they are material.
The auditor ought to understand the client's objectives associated with reliability of financial reporting, efficiency and effectiveness of operations and compliance with laws and regulations. Auditors need knowledge concerning operations to assess client business risk and inherent risk in the financial statements. The auditor ought to make inquiries of management, review previous year operating papers, and examine legal documents such as share options and pension plans, minutes of conferences and important contracts.
The client's internal controls and its components need to be understood by the auditor. They refer to all policies and procedures towards;
- Orderly and efficient conduct of business
- Adherence to internal policies
- Safeguarding of assets
- Prevention of fraud and error
- Accuracy and completeness of accounting records and timely preparation of reliable financial information.
Components of internal controls include;
' Control environment
- Communication and enforcement of integrity and ethical values.
- HR policies and practices
' Client's risk assessment process
- If the procedures are strong, risks of misstatement is lower.
' Information system
- System relevant to financial reporting; recording, initiating, processing and reporting transactions.
' Control activities
- Performance review
- Physical controls
- Segregation of duties
' Monitoring of controls
- Process of evaluating effectiveness of controls over time and taking necessary remedial action.
Assess Client's Business Risk
The auditor uses information gained from the strategic understanding of the client business and industry to assess client business risk, the risk that client can fail to attain its objectives. It is management's obligation to recognize the business risks facing the firm and respond consequently to those risks. The auditor's main concern is the risk of material misstatement in the financial statements due to client business risk. It is vital to notice that not all business risks can turn into risks leading to material misstatement in the financial statements.
The types of audit risks include;
i) Control Risk ' a risk that a misstatement will not be prevented or detected and corrected on a timely basis by the entity's internal controls.
ii) Inherent Risk ' susceptibility of a class of transactions of material misstatement before consideration of related controls.
iii) Detection Risk ' risk that the procedures performed by the auditor to reduce audit risk to an acceptable level will not detect material misstatement.
ISA 315 stresses the significance of all members of the audit team understanding the potential risk of misstatements in every client's financial statements. In particular, the standard institutes the concept that the auditor is required to acquire an understanding of business risks and important risks to the extent that they are applicable to the financial statements.
Analytical procedures applied at the planning stage can assist the auditor in gaining an understanding of the client's business and in assessing client business risk. ISA 520 states, 'The auditor should apply analytical procedures at the planning and overall review stages of the audit.'
Analytical procedure has three purposes;
- Understanding the client's business and industry by calculating key ratios for the client's business and compare them with industry's average.
- Assess going concern by calculating the debt to equity ratio and compare it with previous years and successful companies in the industry and to also check the list of indicators of going concern problems.
- Indicate possible misstatement, for example, compare at random expense accounts for two or three years to check if there are looking for large fluctuations.
Application of analytical procedures might indicate characteristics of the business of which the auditor was unaware. So as to obtain a better understanding of the client's business and industry, the auditor will calculate typical ratios and contrast the company ratios to those of the industry. Analytical procedures establish important deviation from foreseen amounts that show the auditor where to increase procedures to acquire corroborative proof.
Materiality is fundamental to the presentation and classification of data in the financial statements. Information is material if its omission or misstatement could influence the economic decisions of the users of the financial statements.
According to ISA 320;
- It is a must to establish materiality level at the planning stage, often at a low level to reduce the risk of undiscovered misstatement.
- Relationship between materiality and audit risk, when the materiality levels are low, additional testing is required.
- Materiality should be considered when deciding on the nature, timing and audit procedures and evaluating the effect of misstatements.
An assessment of the risk of material misstatement, whether triggered by error or fraud ought to be made throughout the planning. The auditor's understanding of internal control may enhance or reduce the auditor's concern regarding the risk of material misstatement. In considering audit risk, the auditor ought to specifically assess the risk of material misstatement of the financial statements due to fraud. The auditor ought to think about the impact of these assessments on the overall audit strategy and also the expected conduct and scope of the audit.
After the auditor has planned the audit the auditor has to gather adequate suitable audit evidence on which to base his/her audit opinion. The Auditor's operational standard states that 'the auditor ought to acquire applicable and reliable audit proof sufficient to enable him/her to make reasonable conclusions therefrom.
Audit evidence is information, written or oral, acquired by the auditor to assist the conclusions on which his/her bases his/her opinion on the financial statements. Sources of audit evidence comprise of the client's accounting system, tangible assets, and underlying documentation, management and other employees, suppliers, customers and other third parties who have business relations with, or information of, the client's business.
The auditor can hardly be sure that the accounts on which he/she is reporting show a true and fair view. Nevertheless, he/she needs to acquire relevant, reliable and adequate proof as a basis for his/her opinion on any matters associated to the financial statements.
The auditor has to execute substantive procedures to acquire adequate and appropriate audit evidence to convey an audit opinion. The assertions, either per business relation, balance or disclosure, together with the risks recognized throughout the planning phase guide the auditor in advancing substantive procedures.
Importance of Audit Planning
According to International Standard on Auditing (ISA) 300, the auditor ought to plan the audit work so that the engagement will be executed in an effective manner. Specifically, planning is required and important for the following reasons:
- To ensure that appropriate attention is given to crucial areas of the audit and that potential problems are recognized in a timely basis.
- It helps the auditor acquire adequate appropriate evidence for the circumstances
- It helps keep audit costs at a reasonable level and helps prevent misunderstandings with the client.
- To develop a general strategy and detailed approach for the specific nature, timing and extent of the audit work. This will help to ensure that the audit is carried out in an effective and timely manner.
- To act as a foundation for the production of the audit program
- To issue a document as a reference for an existing discussion of the approach to the audit with the company's audit committee. The plan will also help make certain that audit work is coordinated with client staff.
b) Audit Risks and Auditor's Responses
Audit risks 1
The finance director of Symonds Ltd is planning to capitalize the full RM5 million of development expenditure incurred. Nevertheless in order to be capitalized it must meet all of the criteria under IAS 38 intangible assets. There is a risk that some projects might not reach final development stage and thus ought to be expensed rather than capitalized. Intangible assets could be overstated and this risk is increased due to the loan covenant requirements to observe a minimum level of assets.
A breakdown of the development expenditure must be assessed and examined in detail to make sure that only projects which meet the capitalization criteria are included as an intangible asset, with the balance being expensed.
Audit risk 2
The standard costing method used by Symonds for inventory valuation. Symonds has not upgraded their standard cost from when the product was first developed and thus there is a risk that the standard cost may be out of date, causing an overvalued or undervalued inventory.
The standard cost for the inventory valuation must be examined in details and compared to the actual cost. In case of significant variations, this should be discussed with management to make sure that the valuation is suitable.
Audit risk 3
At the end of the year the work in progress is likely to be material, nevertheless there is a risk that due to the nature of the production procedure the audit team might not be sufficiently certified to evaluate the quantity and value of work in progress leading to inaccurate work in progress.
Consideration must be given as to whether an independent specialist is needed to determine the importance of work in progress. If so this will require to be arranged with permission from management and in time for the year end accounts.
Audit risk 4
Above one third of Symonds' warehouses belong to third parties. Appropriate and sufficient evidence will need to be collected to confirm the quantities of goods in stock held in these locations in order to verify completeness and existence.
Additional procedures will be needed to make sure that stock quantities have been verified for both the company and third parties.
Audit risk 5
In December Symonds Ltd established a new accounting system. This is a critical system for the accounts preparation and if there were any mistakes that happened during the changeover procedure, these might have an impact on the final amount in the trial balance.
The new system will need to be recorded in full and examining should be conducted over the transfer of data from the old system to the new system.
a) Substantive procedures involve confirmation of transactions and account balances to supporting records such as invoices and ledgers. The aim of substantive procedures is to recognize material misstatements in the financial statements.
Appropriate procedures would include:
' Reconcile the sales statistics to the recorded sales in the accounting records.
' Compare trends this year to those of previous years to verify they are reasonable.
' During this connection take into account any changes in client circumstances and exercise professional skepticism as these statistics are created internally.
' Discuss with management the analyses they have made and the actions they have taken as a result of the statistical data available to them. They would probably use them, for example, in determining whether or not reprints of books are necessary.
' On a test basis ensure that the customer codes on the customer master 'le are properly entered to make certain that the type of customer is correctly identi'ed.
' Review reports from sales staff to make certain that data on college take-up of books is correct.
b) Substantive tests are those designed to substantiate the effectiveness, accuracy and completeness of amounts appearing in the financial statements and related notes.
Appropriate substantive tests to satisfy the auditor that the royalties charge is accurate and complete include;
' Test 1 ' compare the royalties charge with stated sales gain and acquire an explanation from management if the figures do not appear reasonable.
Objective ' to please the auditor that the royalties charge in the income statement is reasonable in relation to stated sales income.
' Test 2 ' contrast budgeted royalties figure with actual figure. If variations are significant, acquire clarification from management.
Objective ' to satisfy the auditor that the actual figures has been predicted by management, therefore providing evidence as to their reliability.
' Test 3 ' compute the expected level of royalty payment based on monthly trend data for type of customer. Acquire sales figures and multiple by 10%. Contrast expectations to actual royalties and obtain clarification from management for any important variations.
Objective ' this test ought to provide the auditor with evidence as to the completeness and validity of royalties paid.
c) Inherent Risk is the probability of loss arising out of situations or existing in an environment, in the absence of any action to control or change the circumstances.
Two inherent risks Border's operations include;
' Poor counting of goods in stock at the end of the period ' this is a risk because if the amount of inventories at the end of the period are inaccurate, it will affect the financial reports and records of the company, which will also affect the sales of the following period.
' Some books may not be saleable due to lack of demand ' this is a risk because if there is no demand for the books then the company will suffer a loss and this will affect the growth and stability of the company.
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