Fundamentals of Auditing (ACC311) book HANDOUTS / POWER POINT SLIDES in pdf

Fundamentals of Auditing (ACC311) book HANDOUTS / POWER POINT SLIDES in pdf

Fundamentals of Auditing –ACC 311 VU

Lesson 01

FUNDAMENTALS OF AUDITING

AN INTRODUCTION

What is an Audit?

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)

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 auditor’s 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 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 auditor’s 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 auditor’s 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.

You will note that this is a wide concept of an audit which can be applied to any entity, not just to limited companies. However, in this course, we are concerned primarily with audits of limited companies (often known as statutory or external audits). Any other audit applications will be clearly indicated for you in the text.

Why is there a need for an audit?

The problem that has always existed at the time when the manager reports to the owners is that: whether the owners will believe the report or not? This is because the reports may:

a. Contain errors

b. Not disclose fraud

c. Be inadvertently misleading

d. Be deliberately misleading

e. Fail to disclose relevant information

f. Fail to conform to regulations

The solution to this problem of credibility in reports and accounts lies in appointing an independent person called an auditor to examine the financial statements and report on his findings.

A further point is that modern companies can be very large with multi-national activities. The preparation of the accounts of such groups is a very complex operation involving the bringing together and summarizing of accounts of subsidiaries with differing conventions, legal systems and accounting and control systems. The examination of such accounts by independent experts who are trained in the assessment of financial information is of benefit to those who control and operate such organizations as well as to owners and outsiders.

Many financial statements must conform to statutory or other requirements. The most notable is that all company accounts have to conform to the requirements of the Companies Ordinance 1984 but many other

Fundamentals of Auditing –ACC 311 VU

bodies (like: Charities, Building Societies, Financial Services business etc) have detailed accounting

requirements as required by the relevant legislations. In addition all accounts should conform to the

requirements of International Financial Reporting Standards (IFRSs).

It is essential that an audit of financial statements should be carried out to ensure that they conform to these requirements.

What is the distinction between auditing and accounting?

Relationship between auditing and accounting

Auditing and accounting are closely connected but both are separate activities. The directors of a company are responsible for establishing books of accounts that will accurately record financial information and that are used for preparing the annual financial statements. It is similarly the responsibility of the directors to adopt consistent and appropriate accounting policies in order to prepare and present the financial statements. The financial statements have to comply with national legislative requirements and International

Financial Reporting Standards (IFRSs).

Accounting is the process of recording, classifying, summarizing and reporting financial information in a logical/systematic manner for the purpose of decision making. To provide relevant & reliable information,accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the financial statements.

In auditing the financial statements, the concern is with determining whether the presented financial

statements properly (true and fair) reflect the financial information that occurred during the accounting period. Since auditors are primarily concerned with the end result of this work i.e. do the financial statements show a true and fair view? In order to arrive at their conclusion the auditors must have a deep knowledge and understanding of accounting (including applicable accounting standards) and in practice, the directors will consult with the auditors as to appropriate accounting policies to follow.

Many financial statement users and members of the general public confuse auditing with accounting. The confusion results because most auditing is concerned with accounting information, and many auditors have considerable expertise in accounting matters. The confusion is increased by giving the title “Chartered Accountant” to individuals performing a major portion of the audit function.

Who can be an auditor?

For appointment as auditor of:

a) a Public Company or

b) a Private Company which is a subsidiary of a Public Company.

c) a Private Company having paid up capital of three million rupees or more.

The person must be a Chartered Accountant within the meaning of the Chartered Accountants Ordinance,1961.

For listed companies an auditor must have a satisfactory QCR (quality control review) rating issued by ICAP.

Fundamentals of Auditing –ACC 311 VU

Lesson 02

Fundamentals of Auditing

Auditing – An Introduction

What is an auditor’s report?

The primary aim of an audit is to enable the auditor to say “these accounts show a true and fair view” or, of course, to say that “they do not show a true and fair view”.

At the end of his audit, when he has examined the entity, its record, and its financial statements, the auditor produces a report addressed to the owners/stake holders in which he expresses his opinion of the truth and fairness, and sometimes other aspects, of the financial statements.

Standard format of Auditor’s Report as per the Companies Ordinance 1984:

FORM 35A AUDITORS’ REPORT

We have audited the annexed balance sheet of COMPANY NAME as at THE DATE and the related profit and loss account, cash flow statement and statement of changed in equity together with the notes forming part thereof, for the year then ended and we state that we have obtained all the information and explanations which to the best of our knowledge and belief were necessary for the purposes of our audit. It is the responsibility of the company’s management to establish and maintain a system of internal control and prepare and present the above said statements in conformity with the approved accounting standards and the requirements of the Companies Ordinance, 1984. Our responsibility is to express an opinion on these statements based on our audit.

We conducted our audit in accordance with the auditing standards as applicable in Pakistan. These

standards require that we plan and perform the audit to obtain reasonable assurance about whether the

above said statements are free of any material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the above said statements. An audit also includes assessing the accounting policies and significant estimates made by management, as well as evaluating the overall presentation of the above said statements. We believe that our audit provides a reasonable basis for our opinion and, after due verification, we report that:

a) In our opinion, proper books of accounts have been kept by the company as required by the

Companies Ordinance, 1984

b) In our opinion:

i. The balance sheet and profit and loss account together with the notes thereon have been

drawn-up in conformity with the Companies Ordinance, 1984, and are in agreement with the

books of account and are further in accordance with accounting policies consistently applied

ii. The expenditure incurred during the year was for the purpose of the company’s business; and

iii. The business conducted investments made and the expenditure incurred during the year were

in accordance with the objects of the company.

c) In our opinion and to the best of our information and according to the explanations given to us, the

balance sheet, profit and loss account, cash flow statement and statement of changes in equity together with the notes forming part thereof conform with approved accounting standards as applicable in Pakistan and, give the information required by the Companies Ordinance, 1984, in the manner so required and respectively give a true and fair view of the state of the company’s affairs as at DATE and of the profit/loss its cash flows and changes in equity for the year then ended; and

d) In our opinion Zakat deductible at source under the Zakat and Usher Ordinance, 1980 was deducted by the company and deposited in the Central Zakat Fund established under Section 7 of that Ordinance.

Date Signature

Place (Name(s) of Auditors)

Fundamentals of Auditing –ACC 311 VU

Standard format of Auditor’s Report as per the International Auditing Standards:

INDEPENDENT AUDITOR’S REPORT

[Appropriate Addressee]

Introductory Paragraph

We have audited the accompanying financial statements of ABC Company, which comprise the balance sheet as at December 31, 20X1, and the income statement, statement of changes in equity and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory notes.

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. 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.

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 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 auditor’s judgment, 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 give a true and fair view of (or” present fairly, in all material

respects,”) the financial position of ABC Company as of December 31, 20X1, and of its financial

performance and its cash flows for the year then ended in accordance with International Financial

Reporting Standards.

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.]

[Auditor’s signature]

[Date of the auditor’s report]

[Auditor’s address]

What stands for auditor’s opinion?

The auditor, in his report, does not say that the financial statements do show a true and fair view. He can only say that in his opinion the financial statements show a true and fair view. The reader or user of financial statements will know from his knowledge of the auditor whether or not to rely on the auditor’s opinion. If the auditor is known to be independent, honest, and competent, then his opinion will be relied upon.

Fundamentals of Auditing –ACC 311 VU

What are the different types of audit?

Three types of audits are discussed in general, i.e.,

1. Financial statement audits

2. Operational audits

3. Compliance audits

Financial Statement Audits

An audit of financial statements is conducted to determine whether the overall financial statements (the quantifiable information being verified) are stated in accordance with specified criteria. Normally, the criteria are the requirements of the applicable International Financial Reporting Standards (IFRSs) and the Companies Ordinance 1984. The financial statements most commonly comprises of the Balance Sheet,Income Statement, Statement of Changes in Equity, Cash Flow Statement, and Notes to the accounts.

The assumption underlying an audit of financial statements is that these will be used by different groups for different purposes. Therefore, it is more efficient to have one auditor who will perform an audit and draw conclusions that can be relied upon by all users than to have each user perform his or her own audit. If a user believes that the general audit does not provide sufficient information for his or her purposes, the user has the option of obtaining more data. For example, a general audit of a business may provide sufficient financial information for a banker considering a loan to the company, but a corporation considering a merger with that business may also wish to know the replacement cost of fixed assets and other information relevant to the decision. The corporation may use its own auditors to get the additional information.

Operational Audits

An operational audit is a review of any part of an entity’s operating procedures and methods for the

purpose of evaluating efficiency and effectiveness. At the completion of an operational audit,

recommendations to management for improving operation are normally expected.

An example of an operational audit is evaluating the efficiency and accuracy of processing payroll

transactions in a newly installed computer system. Another example, where most accountants would feel less qualified is evaluating the efficiency, accuracy, and customer satisfaction in processing the distribution of letters and parcels by a courier company such as TCS.

Because of the many different areas in which operational effectiveness can be evaluated, it is impossible to characterize the conduct of a typical operational audit. In one organization, the auditor might evaluate the relevancy and sufficiency of the information used by management in making decisions to acquire new fixed assets, while in a different organization the auditor might evaluate the efficiency of the paper flow in processing sales.

In operational auditing, the reviews are not limited to accounting. They can include the evaluation of

organization structure, computer operations, production methods, marketing, and any other area in which the auditor is qualified.

The conduct of an operational audit and the reported results are less easily defined than for either of the other two types of audits. Efficiency and effectiveness of operations are far more difficult to evaluate objectively than compliance or the presentation of financial statements in accordance with accounting conventions and principles; and establishing criteria for evaluating the quantifiable information in an operational audit is an extremely subjective matter.

In this sense, operational auditing is more like “management consulting” than what is generally regarded as “auditing”. Operational auditing has increased in importance in the past decade.

Compliance Audits

The purpose of a compliance audit is to determine whether the entity is following specific procedures, rules,or regulations set down by some higher authority.

A compliance audit for a private business could include determining whether accounting personnel are following the procedures prescribed by the company controller, reviewing wage rates for compliance with minimum wage laws, or examining contractual agreements with bankers and other lenders to be sure the company is complying with legal requirements.

In the audit of governmental units such as districts school, there is extensive compliance auditing due to extensive regulation by higher government authorities. In virtually every private and non profit organization,

Fundamentals of Auditing –ACC 311 VU

there are prescribed policies, contractual agreements, and legal requirements that may call for compliance auditing.

Results of compliance audits are typically reported to someone within the entity being audited rather than to a broad spectrum of users.

Management, as opposed to outside users, is the primary group concerned with the extent of compliance with certain prescribed procedures and regulations. Hence, a significant portion of work of this type is done by auditors employed by the entity itself.

There are exceptions; when an organization wants to determine whether individuals or entities that are obligated to follow its requirements are actually complying, the auditor is employed by the entity issuing the requirements.

An example is the auditing of taxpayers for compliance with the federal tax laws, where the auditor is

employed by the government to audit the taxpayers’ tax returns.

Following table summarizes the three types of audits and includes an example of each type and an

illustration of three of the key parts of the definition of auditing applied to each type of audit.

Examples of the Three Types of Audits

TYPES OF
AUDIT
EXAMPLE QUANTIFIABLE
INFORMATION
ESTABLISHED
CRITERIA
AVAILABLE
EVIDENCE
Financial
Statement Audit
Annual Audit of
General Motors’
financial
statements
General Motors
financial statements
International
Financial
Reporting
Standards
Documents,
records, and
outside sources
of evidence
Operational
Audit
Evaluate whether
the computerized
payroll processing
for subsidiary is
operating
efficiently and
effectively
Number of payroll
records processed
in a month, costs of
the department, and
number of errors
made
Company
standards for
efficiency and
effectiveness in
payroll
department
Error reports,
payroll records,
and payroll
processing costs
Compliance
Audit
Determine if
bank
requirements for
loan continuation
have been met
Company records Loan agreement
provisions
Financial
statements and
calculations by
the auditor

Fundamentals of Auditing –ACC 311 VU

Lesson 03

FUNDAMENTALS OF AUDITING

AUDITING – AN INTRODUCTION

What are the advantages and disadvantages of auditing?

Advantages of an audit

We have seen that the need for an external audit in the case of companies arises primarily from the

existence of split-up of ownership from control. There are however, certain advantages in having financial statements audited even where no statutory requirement exists for such an audit in the case of a sole-tradership,

partnership, or non-profit organizations for example.

These advantages can be summarized as follows:

a) Disputes between management may be more easily settled. For instance, a partnership which has

complicated profit sharing arrangements may require an independent examination of those

accounts to ensure, as far as possible, an accurate assessment and distribution of the profits.

b) Major changes in ownership may be facilitated if past accounts contain an independent audit report,

for instance, where two sole traders merge their business to form a new partnership.

c) Application to lenders/financial institutions for finance may be strengthened by the submission of

audited accounts. However do remember that a bank, for instance, is likely to be far more

concerned about the future of the business and available security, than by the past historical

accounts, audited or otherwise.

d) The audit is likely to involve an in depth examination of the business and so may enable the auditor

to give more constrictive advice to management on improving the efficiency of the business.

Disadvantages of an audit

Like most thing in life, audits are not entirely without their disadvantages. There are two main points to make here:

b) The audit fee! Clearly the services of an auditor must be paid for. It is for this reason that few

partnerships and even fewer sole traders are likely to have their accounts audited.

c) The audit involves the client’s staff and management in giving time to providing information to

the auditor. Professional auditors should therefore plan their audit carefully to minimize the

disruption which their work will cause.

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

At the stage of considering the ways of seeking audit evidence the auditor will make a preliminary evaluation

of the entity’s control system:

Fundamentals of Auditing –ACC 311 VU

1. If the controls are likely to lead to a true and fair set of financial statements the auditor will test

those controls.

2. If they appear weak he will not rely on the controls but carry out extensive testing of the

transactions and balances which appear in the financial statements by means of substantive

procedures.

3. If the controls are operating effectively, the auditor can reduce the amount of substantive testing

described above and adopt a reliance approach.

4. If not then the auditor will be forced into a extensive substantive approach

What are the features of auditing profession?

In Pakistan auditing profession is allied with the Institute of Chartered Accountants of Pakistan (ICAP). It

is an autonomous body incorporated under the Chartered Accountants Ordinance 1961.

ICAP is a regulatory body that enjoys a self regulatory status. Its affairs are run by a council which is elected

by its member (Chartered Accountants).

Only those members of the ICAP are eligible of doing audit who have obtained license for the purpose,

these are known are practicing members.

Management of ICAP

The President is the Chief Executive of the Institute. The administrative head of the Institute is the

Executive Director/Secretary who functions under the directions of the Council, Executive Committee,

The President and the Vice Presidents

The Executive Director in performance of his functions is assisted by:

• Secretary

• Director Technical Services

• Director Professional Standards Compliance

• Director Education & Training

• Director Examinations

• Regional Director North

The prime responsibilities of Executive Director include Personnel Management; Financial Management;

Office Administration; Publications; Information Systems; Conducting and performing Secretarial functions for the Council and Executive Committee Meetings.

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)

Fundamentals of Auditing –ACC 311 VU

Lesson 04

OBJECTIVE AND GENERAL PRINCIPLES GOVERNING

AN AUDIT OF FINANCIAL STATEMENTS

Objective of an Audit:

Objective of an audit of financial statements is to enable an auditor to express an opinion whether the

financial statements are prepared, in all material respects, in accordance with an identified financial reporting

framework (e.g. International or Local Accounting Standards).

The terms used to express the opinion are “give a true and fair view” or “present fairly in all material

respects”.

Benefit of opinion

It improves credibility of financial statements.

What an opinion does not achieve?

It does not provide any assurance about

i) Future viability of the entity; and

ii) Efficiency or effectiveness of management.

General Principles of an Audit:

Professional Ethics

There are a number of ethical matters that are extremely important for auditors to consider when

performing their work. It is vital to the public image and credibility of the profession that the

auditor is seen to be behaving in an acceptable manner in addition to actually complying with the

ethical requirements.

It is important to recognize that many groups in society rely on accountant’s work, not just the

shareholders on whose behalf the accountant is working. The accountant therefore has a public

accountability.

In the light of this, ICAP’s ethical guidelines emphasis the following key points about the

characteristics of accountants:

a) Independence:

Auditor is independent of management i.e. he is not under the control or influence of

management.

b) Integrity:

Auditor is honest and is not corrupt. He is straight forward in performing his professional

work

c) Objectivity:

He obtains the evidence needed to form an opinion and his opinion is based on that

evidence alone. He is not subjective in forming his opinion.

d) Professional Competence and Due Care:

Auditor has attained certain professional qualification, has acquired the requisite skill and

has attained the experience necessary for the audit and performs his work with planning

and due diligence.

e) Confidentiality:

Auditor neither discloses the information obtained during the course of his audit without

permission of his client (except when required in a court of law) nor uses that information

himself.

f) Professional Behavior:

He should not only act in a professional manner but should also appear to be a

professional. He should maintain his professional knowledge and skill at a level required to

ensure that a client or employer receives the benefit of competent professional service

based on up-to-date developments in auditing practice and relevant legislation.

g) Technical Standards:

Audit should be performed by following certain standards, international or national.

Fundamentals of Auditing –ACC 311 VU

International Standards on Auditing (ISAs)

The auditor should follow basic principles and essential procedures together with related guidance

as contained in ISAs.

International Standards on Auditing (ISAs) are issued by the International Auditing Practices

Committee (IAPC). The IAPC is a standing committee of the Council of the International

Federation of Accountants (IFAC), which was formed in 1977 and is based in New York. IFAC

has more than 150 member bodies, representing over 2 million accountants in more than 100

countries, and membership of IFAC automatically confers

The IAPC issued standards and statements on auditing and related services in order to improve the

degree of uniformity of auditing practice and related services throughout the world.

The IAPC works closely with its members and national standard setters in order to gain acceptance

of international Standards of Auditing (ISAs). Member bodies have increasingly sought to align the

national position with the international positions IFAC and the IASC have gained influence and

recognition. Standard setters increasingly refer to the international position in their consultative

documents as authoritative support for a particular view.

International auditing and accounting standards do not at present override local regulations.

Neither IFAC nor the IASC can currently compel any organization to comply with international

standards; nor are there specific sanctions where organizations claim to have complied with

international standards, but have not done so.

The preface to International Standards on Auditing and Related Services (ISA 100) states that IAPC guidance

falls into two categories:

􀂃 International Standards on Auditing (ISAs).

ISAs contain basic principles and essential procedures (identified in bold type black lettering),

together with related guidance in the form of explanatory and other material (in plain type)

including appendices.

The basic principles and essential procedures are to be understood and applied in the context of

explanatory and other material that provides guidance for their application. The text of a whole

standard is considered in order to understand and apply the basic principles and essential

procedures.

􀂃 International Auditing Practice Statements (IAPSs).

In conducting an audit in accordance with ISAs, the auditor is also aware of and considers

International Auditing Practice Statements (IAPSs) applicable to the audit engagement.

IAPSs provide practical assistance to auditors in implementing standards and promote good

practice. They are not intended to have the authority of standards.

The auditor may also conduct the audit in accordance with both ISAs and auditing standards of a specific jurisdiction

or country.

Professional Skepticism

The audit should be planned and performed with an attitude of professional skepticism i.e. forming

an opinion only after obtaining sufficient and appropriate audit evidence instead of blindly

accepting any information or explanation given by the management.

An attitude of professional skepticism means the auditor makes a critical assessment, with a

questioning mind, of the validity of audit evidence obtained and is alert to audit evidence that

contradicts or brings into question the reliability of documents and responses to inquiries and other

information obtained from management and those charged with governance.

SCOPE OF AN AUDIT

What does it mean?

The term “scope of an audit” refers to the audit procedures that, in the auditor’s judgment and

based on the ISAs, are deemed appropriate in the circumstances to achieve the objective of the

audit.

Fundamentals of Auditing –ACC 311 VU

􀂃 Audit opinion

􀂃 Reasonable assurance

􀂃 Sufficient appropriate audit evidence

􀂃 Audit procedures (based on ISAs)

Audit-Evidence:

It is obtained by applying necessary audit procedures. Audit procedures should be based on requirements of

ISAs, relevant professional bodies, legislation, regulations, and the terms of the audit engagement and

reporting requirements.

Auditing is concerned with the verification of accounting date and with determining the accuracy and

reliability of accounting statements and reports.

Verification does not mean seeking proof or absolute certainty in connection with the data and reports

being audited. It means looking for sufficient evidence depends on what experience and knowledge of

contemporary auditing standards tells one is satisfactory.

An auditor obtains audit evidence regarding management’s assertions for the following areas:

a. Existence: an asset or liability exists at the Balance Sheet date. This is an obvious assertion with such

items as land and buildings, stocks and others

b. Rights and obligations: an asset or liability pertains to the entity at the Balance Sheet date. This

means that the enterprise has for example ownership of an asset. Ownership as an idea is not simple

and there may be all sorts of rights and obligations connected with a given asset or liability.

c. Occurrence: a transaction or event took place which pertains to the enterprise during the relevant

period. It may be possible for false transactions (e.g. sales or purchases) to be recorded. The assertion is

that all recorded transactions actually took place.

d. Completeness: there are not unrecorded assets, liabilities, transactions or events or undisclosed items.

This is important for all accounts items but is especially important for liabilities.

e. Valuation: an asset or liability is recorded at an appropriate carrying value Appropriate may mean in

accordance with generally accepted accounting principles, the companies Act rules, Accounting

Standards requirements and consistent with statements of accounting policies consistently applied.

f. Measurement: a transaction or event is recorded at the proper amount and revenue or expense

allocated to the proper period.

g. Presentation and disclosure: an item is disclosed, classified and described in accordance with

applicable reporting framework. For example fixed assets are subject to the Companies Ordinance rules

and to IAS 16.

An example:

We will look at an item in a balance sheet, bank overdraft Rs. 10,250. In reporting this item in the balance

sheet, the directors are making these assertions:

a. That there is a liability to the company’s bankers.

b. That at the balance sheet date this liability was Rs. 10,250.

c. That this amount is agreed by the bank

d. That the overdraft was repayable on demand. If this were not so, it would not appear amongst the

current liabilities and terms would be stated.

e. That the overdraft was not secured. If it were secured this fact would need to be stated.

f. That the company has the Authority to borrow from its Memorandum and Articles.

g. That a bank reconciliation statement can be prepared.

h. That the bank is willing to let the overdraft continue.

If no item ‘bank overdraft’ appeared in the balance sheet, it would represent an assertion by the directors

that no overdraft liability existed at the balance sheet date.

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

Fundamentals of Auditing –ACC 311 VU

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.

Audit Risk and Materiality

Guidance provided by ISA 200 in this matter is discussed in later chapters which specifically and exclusively

discuss it.

Responsibility for the Financial Statements:

Responsibilities for preparing and presenting the financial statements are that of management. Auditor’s

responsibility is to express an opinion thereon.

Fundamentals of Auditing –ACC 311 VU

Lesson 05

REASONABLE ASSURANCE

What is reasonable assurance?

It means a conclusion that the financial statements are not materially misstated. An auditor cannot obtain

absolute assurance because of limitations described in paragraph below.

Reasonable assurance through audit evidence

Audit evidence:

• For internal control

• For transactions & accounts balances

• For financial statements

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.

Inherent Limitations of Accounting and Internal Control

• Management over rides

• Collusion with employees

• Collusion with third party

• Unaffordable cost of internal control

• Human error

Accordingly, because of the factors described above an audit is not a guarantee that the financial statements

are free from material misstatement, because absolute assurance is not attainable. Further, an audit opinion

does not assure the future viability of the entity nor the efficiency or effectiveness with which management

has conducted the affairs of the entity

AUDIT RISK AND MATERIALITY

Entities pursue strategies to achieve their objectives, and depending on the nature of their operations and

industry, the regulatory environment in which they operate, and their size and complexity, they face a

variety of business risk. Management is responsible for identifying such risks and responding to them.

However, not all risks relate to the preparation of the financial statements. The auditor is ultimately

concerned only with risks that may affect the financial statements.

The auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the financial

statements give a true and fair view or are presented fairly, in all material respects, in accordance with the

applicable financial reporting framework. The concept to reasonable assurance acknowledges that there is a

risk the audit opinion is inappropriate. The risk that the auditor expresses an inappropriate audit opinion

when the financial statements are materially misstated is known as “audit risk”.

Audit Risk

The risk that the auditor expresses inappropriate audit opinion when the financial statements are

materially misstated.

The concept of reasonable assurance acknowledges that there is a risk the audit opinion is in

appropriate.

Fundamentals of Auditing –ACC 311 VU

Materiality

Risk of material misstatement levels:

• Overall Financial Statement level

• Often relates to entity’s control environment

• Also relates to declining economic conditions

• Transactions, account balances, & disclosures level

Auditor is not responsible for detection of misstatements that are not material.

The auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is

consistent with the objective of an audit

Responsibility for the Financial Statements:

Responsibilities for preparing and presenting the financial statements are that of management. Auditor’s

responsibility is to express an opinion thereon.

This responsibility includes:

• Designing, implementing and maintaining internal control relevant to the preparation and

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.

Fundamentals of Auditing –ACC 311 VU

Lesson 06

LEGAL CONSIDERATION REGARDING AUDITING

The Audit Requirement

• Not all limited companies are required to have their financial statements audited. Nor are all

companies required to produce financial statements in the same formats as many exemptions may

apply to small and medium sized companies.

• Broadly speaking, small companies are exempt from the audit requirement, small and medium sized

companies may file abbreviated accounts with the registrar of companies and small companies may

prepare accounts with reduced disclosures for their members.

Appointment, Duties, Rights and Liabilities of Auditor

Appointment:

First Auditors

a) The first auditors of a company shall be appointed by the directors within 60 days of

incorporation of the company [252(3)]

b) The first auditors will hold office till the first annual general meeting [252(3)].

c) If the directors fail to appoint the first auditors, the members shall appoint the first

auditors, provided further that the auditors such appointed shall not be removed during

the tenure expect through a special resolution [(252(6)].

d) Where the first auditors are not appointed either by the directors or by the members within

120 days of incorporation of the company, the Securities & Exchange Commission of

Pakistan (Commission) will appoint the auditor [252(6)].

Subsequent Auditors

(a) At each annual general meeting the company (members) shall appoint the auditors [252(1)].

(b) The auditors shall hold office from the conclusion of that meeting till the conclusion of

next annual general meeting [Section 252(1)].

To exercise this power the company must give notice to Commission within one week of

these powers having become exercisable [252(7)].

Note: Provided that an auditor or auditors appointed in a general meeting may be removed before

conclusion of the next annual general meeting through a special resolution [252(1)].

Casual Vacancy

a) Any casual vacancy shall be filled by directors. [Sec 252(4)].

b) Auditors so appointed shall hold office till next annual general meeting.[Sec 252(5)]

c) If directors do not appoint auditors to fill casual vacancy within 30 days, Commission may

appoint an auditor.[Sec 252(6)]

Commission’s powers to appoint auditors [252(6)]

The Securities & Exchange Commission of Pakistan may appoint an auditor if the following situations arise:

a) First auditors are not appointed within 120 days from incorporation;

b) Subsequent auditors are not appointed in annual general meeting;

c) Casual vacancy is not filled within 30 days; and

d) Auditors appointed are unwilling to act as auditors.

To exercise this power, the company must give notice to Commission within one week of its powers

becoming exercisable.

Fundamentals of Auditing –ACC 311 VU

SUMMARY

Auditors Time of

appointment

Appointing

Authority

Term of

Office

Appointing

Authority in

default

Remarks

First 1st

Auditors

Within 60 days

Incorporation

Directors Till first

AGM

Members Members shall appoint 1st

auditors at a general meeting

within 120 days. After 120

days SECP may make the

appointment.

Subsequent

Auditors

AGM Members Till next

AGM

SECP If auditors are not appointed

in Auditors AGM. AGM,

SECP may appoint auditors.

Casual

Vacancy

Within 30 days

of the vacancy

Directors Till next

AGM

SECP After 30 days of vacancy.

Vacancy of the vacancy

AGM SECP may appoint

auditors.

Remuneration of Auditors [252(8)]

Fixation of remuneration of auditors depends upon the authority appointing the auditors, i.e.

i) If auditors are appointed by directors, directors shall fix the remuneration.

ii) If auditors are appointed by COMMISSION, COMMISSION shall fix remuneration.

iii) In all other cases, the members (Company) shall fix the remuneration.

Note: Minimum hourly rates are also recommended by The Institute of Chartered Accountants of Pakistan

(ICAP) which is specified in members’ Handbook Volume II (Part II ATR-14).

SUMMARY

Appointing Authority Remuneration Fixed by

a) Directors Directors

b) Commission Commission

c) In all other case Members (Company)

Procedure for Change of Subsequent Auditors/ Removal of Auditors / Appointment of New

Auditors (Section-253)

New auditors can be appointed in place of retiring auditors if the following requirements are fulfilled.

a) Notice from a member is required for a resolution at the AGM (253(1)).

b) The member shall give notice to the company at least 14 days before the AGM that he

intends to propose the appointment of another person as auditor (253(2)).

c) On receipt of the notice the company shall send a copy of such notice to the:

i) retiring auditor, forthwith

ii) members, at least seven days before the AGM. (253(2))

d) In case of a listed company, notice shall be published at least in one issue of an English

and an Urdu daily newspaper having circulation in the province where the stock

exchange(s) is situate on which the shares of the company are listed.

e) The retiring auditor can make representations and the company shall send a copy of

representation to a member or it may be read at AGM.

Provided that the representation cannot be sent OR read at the AGM if the Registrar does not

permit so on the application of the company or any other person. (253 (3)).

f) A company within 14 days after the AGM shall notify to the Registrar of the

i) appointment of new auditors with their consent letter. 253(5).

Fundamentals of Auditing –ACC 311 VU

ii) retirement or removal of auditors. Section 253(6)

Note: Under the Schedule-I Part-I of the Chartered Accountant Ordinance, 1961 new auditor accepting

the appointment without communicating with the previous auditor shall be deemed to be guilty of

professional misconduct. The Institute of Chartered Accountant of Pakistan has issued Auditing Technical

release (ATR-2) explaining what does the word "Communication" means. Therefore, it is necessary for the

new auditors to communicate with the previous auditors before accepting the appointment to ascertain that

he has no objection on professional grounds, regarding the appointment. Clause 7 of the Schedule requires

that incoming auditor should ensure before accepting the appointment, that requirements of the Companies

Ordinance, 1984 regarding his appointment have been fulfilled.

Change of Auditors - Checklist

Actions Required Timing

Notice from a member from the date of AGM At least 14 days

Send Copy of the notice to:

a) The retiring auditor forthwith

b) Members At least 7 days before

The date of AGM Publication of the fact in newspapers anytime before the AGM. That notice has been

received. Representation by auditors Sent to members before AGM or read at AGM.

Notification of the change to the Registrar within 14 days after the date of AGM.

Removal of Auditors

i) First auditor appointed by the directors may be removed by the members in a general

meeting.

ii) Another person nominated by a member shall be appointed in place of the outgoing

auditor.

iii) The notice of nomination of the proposed auditor should be given to the member’s at least

14 days before the general meeting and all the procedure stated above would be required to

be followed in this case also.

iv) An auditor or auditors appointed in an annual general meeting may be removed before

conclusion of the next annual general meeting through a special resolution.

v) In the above case, SECP may appoint the auditor(s) of the company.

Qualification & Disqualification of Auditors

Qualification 254(1)

For appointment as auditor of:

a) a Public Company or

b) a Private Company which is a subsidiary of a Public Company.

c) a Private Company having paid up capital of three million rupees or more.

The person must be a Chartered Accountant within the meaning of the Chartered Accountants Ordinance,

1961.

Note: For listed companies an auditor must have a satisfactory QCR (quality control review) rating issued

by ICAP.

Disqualifications 254(3)

Following persons are not qualified to become auditors of a company:

i) Present directors, other officer or employees of the company or who held these offices

during the last three years.

ii) A partner or employee of a director, other officer or employee of the company.

iii) A spouse of a director.

Fundamentals of Auditing –ACC 311 VU

iv) A person who is indebted to the company.

v) A body corporate.

vi) A person or his spouse or minor children or in case of firm all partners of such firm who

holds any shares of an audit client or any of its associated companies.

Provided that if such a person holds shares prior to his appointment as auditors, whether as an individual or

a partner in a firm the fact shall be disclosed on his appointment as auditor and such person shall disinvest

such shares within ninety days of such appointment.

vii) A person disqualified for appointment as an auditor due to above reasons is disqualified

from holding the office of auditor of another company which is a subsidiary or holding

company of that company 254(4).

Fundamentals of Auditing –ACC 311 VU

Lesson 07

RIGHTS, DUTIES AND LIABILITIES OF AUDITOR

Powers/Rights of an Auditor (255)

i) Right of access to books of account and vouchers 255(1).

ii) Right to receive information and explanations.

iii) Right of access to books and papers of branch 255(2).

iv) Right to receive notices of general meetings and to attend those meetings. (255(6)).

v) Right to make representation where another person is being appointed as auditor. (253(3)).

Duties of an Auditor

a) Duties of auditor under section. (255(3)) are:

i) To give a report to the members on the accounts, books of account, balance sheet and

profit and loss account examined by him. (255(3)).

ii) Where any matter reported upon is answered in the negative or with a qualification the

report shall include reasons for such qualification with factual position.

iii) To include in the report of the company such matters as directed by the Federal

Government.

iv) To attend those general meetings of a listed company, either himself or through authorized

person, in which the balance sheet, profit and loss account and the auditors' report are to

be considered.

b) To make report for inclusion in prospectus. (Section 53 read with Part I of Schedule II).

c) To certify receipts and payments account in the statutory report (Section 157).

d) To make report on declaration of solvency in case of voluntary winding up.

e) To exercise reasonable care and skill in carrying out his duties and make such inquiries as

considered necessary.

Note: Students should know the contents of report from examination point of view. Please see section 255(3) of the

Companies Ordinance, 1984

Reading and Inspection of Auditors' Report (Section-256)

Auditor’s report shall be read in general meeting and shall be open to inspection by the members.

Signature & Date On Auditors' Report (Section-257).

(a) The person appointed as auditor shall sign the auditors' report or other documents required under

the law.

(b) The report should indicate the date and place.

Audit of Cost Accounts

Where a company is required to maintain any records relating to its costs of production etc., it will also get

these accounts audited. The auditor, in this case, shall be a Chartered Accountant or a Cost and

Management Accountant.

Auditors’ Liabilities

The liabilities of auditors of a company can be studied under following heads:

a) Civil Liabilities.

Civil liabilities mean the disputes over losses caused to one party by acts of another. The civil liabilities of an

auditor can be for:-

i) Negligence ii) Misfeasance

i) Liability for Negligence (under law of agency)

Auditor being agent of the Shareholders is required to carry out his duties with reasonable care and skill. If

he fails to do so, he is liable to make good any loss caused to the third party.

Major legal decision

1) Arthur E. Green & Company Vs Central Advance & Discount Corporation Ltd.

(1920).

It was held that auditor is guilty of negligence. Auditor accepted the schedule of bad debts furnished by the

client, though it was apparent that debts were not recoverable.

Fundamentals of Auditing –ACC 311 VU

2) The London Oil Storage Co. Ltd. Vs Sear Hasluck & Co.

In this case, auditors were held liable for negligence. Auditors failed to verify the physical

existence of cash in hand. Cash balance as per books did not agree with the physical

balance, the difference was misappropriated by the cashier.

3) Irish Woolen Co. Ltd. Vs Tyson and Others.

In this case auditors were held liable for negligence. Profits were overstated by not

recording purchase invoices. He was held liable for having failed to exercise reasonable

care and skill.

4) Kingston Cotton Mills Co. Ltd.

In this case auditors were not held liable for negligence. It was held that it is not the duty

of auditors to take stock, if they accept certificate in the absence of any suspicion, he has

carried out reasonable care and skill.

5) In Mckesson V Robbins (American case).

It was held that it was duty of auditors to test check the physical stock.

Conclusion:

Auditors should inspect securities, test check stock wherever it is practicable and where it is not he should

state in his report that he has accepted a certificate. In the light of Part-A of Addendum to ISA-8,

“Attendance at Physical Inventory Counting” and SAP - 3 “Verification of Inventories”, the position of

auditors as held in Kingston Cotton Mills Co. Ltd. is no longer valid.

ii) Liability for Misfeasance

The term misfeasance means breach of duty. If auditor does something wrong in the performance of his

duties resulting in a financial loss to the company, he is guilty of misfeasance.

For example auditor’s duties are laid down in section 255 of the Companies Ordinance, 1984. If auditor

does not perform his duties properly and the company suffers loss he is liable for misfeasance.

Major Case Laws

1) London and General Bank Ltd.

In this case auditors were held liable for misfeasance. The auditors failed to report that Balance Sheet was

not properly drawn:-

Large sums were advanced to the customers and interest thereon was accrued, in fact neither advance nor

accrued interest was receivable. No provision for bad debts was made and the company paid dividend.

2) Under section 260 of the Companies Ordinance, 1984 if the auditors fail to report to the members

material misstatement of facts or give untrue picture to the members, and the default is willful, auditors

shall be punishable with fine which may extend to two thousand rupees.

b) Criminal Liabilities.

Section

260

If auditor fails to comply with the requirements of Sections 157, 255 or 257, he shall be punishable with fine

up to Rs. 100,000/-. If he knowingly makes a false report for profit to himself or to put another person to a

disadvantage or loss for a material consideration, he shall also be punishable with imprisonment for a period

of one year.

417

If charges of forgery are brought against an auditor, he may be liable to imprisonment for a term which may

be extended to 2 years or fine up to Rs. 20,000 or both.

492

If in any report the auditor makes a false statement he shall be liable to imprisonment for a term up to 3

years and a fine not exceeding Rs. 20,000.

Fundamentals of Auditing –ACC 311 VU

Lesson 08

LIABILITIES OF AN AUDITOR

Auditors’ Liabilities

• Civil Liabilities (arising from law suits/Liability for negligence)

• Under law of contract (initiated by the audit client)

• Under law of tort (initiated by other users of FS)

• Criminal Liabilities

– Under sections 157, 255, & 257

– Against charges of forgery (evidence created / documents forged etc.)

– Against false statement (regarding opinion in report)

Civil Liabilities

Civil liabilities arise in the situation when there is absence of reasonable care and skill that can be expected

of a person in a set of circumstances.

When negligence of an auditor is being evaluated, it is in terms of what other competent auditors would

have done in the same situation

Duty of care under contract Law

The company has a contract with the auditor and hence can sue the auditor for breach of contract if the

auditor is negligent in carrying out the terms of the contract. Note that only the company can sue the

auditor in contract as other people, such as banks, creditors and shareholders are not in a contractual

relationship with the company.

• When carrying out their duties the auditors must exercise reasonable care and skill. This is required

by the accountant’s rule of professional conduct.

• Members should carry out their professional work with due skill, care diligence and expedition and

with proper regard for the technical and professional standards expected of them as members.

• The degree of skill and care expected of an auditor in a particular situation depends on the

circumstances. There is no general standard of skill and care; the auditor is respected to react to the

situation and circumstances he is facing

Breach of contract

A contract breaches when failure of one or both parties in a contract to fulfill the requirements of the

contract arises.

An example is the failure of a CA firm to deliver a tax return on the agreed upon date.

Parties who have a relationship that is established by a contract are said to have privity of contract.

Typically, CA firms and clients sign an engagement letter to formalize their agreement about the services to

be provided, fee, and timing.

There can be privity of contract without a written agreement, but an engagement letter defines the contract

more clearly

Tort action of negligence

Failure of auditors to meet their obligations, thereby causing injury to another party (other than audit client)

A typical tort action against a CA firm is a bank’s claim that an auditor had a duty to uncover material

misstatements in financial statements that had been relied on in making a loan.

Fundamentals of Auditing –ACC 311 VU

Jeb Fasteners v Marks Bloom (1980)

The plaintiff acquired the share capital of the company. The audited accounts, due to the negligence of the

auditors, did not show a true and fair view of the state of affairs of the company. It was accepted that at the

time of the audit the defendant auditors did know of the plaintiffs but did not know that they were

contemplating a take over bid.

HELD: whilst recognizing that the auditors owed a duty of care in this situation. It was decided that the

auditors were not liable because the plaintiff had not suffered any loss. It was proved that the plaintiffs

would have bought the share capital of the company at the agreed price whatever the accounts had said.

Therefore, whether or not a duty of care existed was not directly relevant to the decision.

How to minimize the liabilities

• Not being negligent

• Following the ISAs

• Agreeing the engagement letter

• Defining in report the work undertaken

• Defining the purpose for the report

• By limiting liabilities to third parties

• By defining the scope of professional competence

Fundamentals of Auditing –ACC 311 VU

Lesson 09

BOOKS OF ACCOUNT & FINANCIAL STATEMENTS

Books of Account to be Kept by Company [SECTION-230]

A company should keep proper books of account in respect of:

a) Cash received and expended by the company;

b) Sales and purchases of goods by the company

c) All Assets and liabilities of the company; and

d) In case of a company engaged in production, processing, manufacturing, or mining

activities, a production record as may be required by the Commission through a general or

special order;

Books of account should be preserved for ten years;

Books of account are to be kept at the registered office of the company. If kept at any other place, the

registrar should be informed;

Books of account should give a true and fair view of the state of affairs of the company and should contain

explanation of transactions.

Directors can inspect the books of account during the business hours.

If company fails to comply with the above provisions a director, including chief executive and chief

accountant:

(a) of listed company is liable to imprisonment for one year and a fine of not less than Rs.

20,000 not more than Rs. 50,000, and a further fine of Rs. 5000 per day during which the

default continues; or

(b) of other companies is liable to imprisonment for six months and with a fine, which may

extend to Rs. 10,000

Accounting Cycle

• Transaction

• Document

• Voucher

• Books of original entry/journal/day book

• Books of secondary entry/ledger

• Financial statement

Transaction Source Document

Sale Invoice Issue

Purchase Invoice Receive

Sales return Credit Note Issued

Purchases return Credit Note Received

Cash received Receipt/Cash Memo Issue

Cash paid Receipt/Cash Memo Received

Lease/Hire Purchase Agreement

Voucher

• Receipt voucher

• Payment voucher

• Journal voucher

• Petty cash voucher

Books of Original Entry

• Purchase journal

• Sale journal

• Purchase return journal

• Sales return journal

• Cash book (two/three column)

• Petty cash book

Fundamentals of Auditing –ACC 311 VU

• General journal/ transfer journal

Books of Secondary Entry

• Main ledger

• Subsidiary ledger

Financial Statement

• Balance sheet

• Income statement

• Statement of changes in equity

• Cash flow statement

• Notes to the accounts

Recording of Transactions from Source Documents

To enter into a transaction we need approval from our responsible managers. When, after having approval of

a manager, transaction takes place, such transaction should be evidenced by a document. Because, to record a

transaction into the books of account, a bookkeeper needs an evidence of proper approval of transaction

and authorization of documents, therefore, a voucher is prepared on which all of the descriptions of the

transaction are written up and with which all of the evidences of approvals and authorized document are

attached. Such voucher is finally authorized by accounts manager which is then recorded in the books of

accounts by a bookkeeper.

To have a more clear understanding of the above paragraph, lets have a step by step example of purchasing

an air conditioning plant for workshop.

1. Production manager will send a requisition to the general manager for air conditioning the workshop

to improve the working environment.

2. The general manager will approve the requisition (if he gets convinced that workshop is in real need of

air conditioning plant) and will send this approval to the purchase department.

3. The purchase department will call a tender and after having received several quotations the purchase

department will place a purchase order to the vendor quoting lowest rate. (All of the above procedure

is properly documented).

4. The vendor company (supplier) will send an invoice (purchase invoice) to the business along with the

air conditioning plant. Such air conditioning plant will be inspected by the expert and finally the invoice

will be approved for payment.

5. Now all of the documents along with the purchase invoice shall be send to the bookkeeping office

where a voucher will be prepared and will also be approved by the concerned manager for recording

this transaction in the books of accounts.

Source Documents:

Following are the few examples of source documents which are required to support different types of

transactions.

Sr. No. Transaction Source Documents

1 Sales Sales Invoice issued

2 Purchase Purchase Invoice received

3 Sales Return Credit Note issued

4 Purchase Return Credit Note received

5 Cash received Cash Memo/receipt issued

6 Cash paid Cash Memo/receipt received

7 Leases/Hire purchase Agreements

8 Staff Salaries Approved Payrolls

9 Electricity, Gas, Water, Tele. Phone Metered Bills/Invoices.

Recording in the Books

Approved voucher are recorded in the books of accounts, many businesses now a days use computers for

recording of transactions. However, an understanding of book of accounts is necessary whether

transactions are recorded manually or electronically.

Basically, there are two types of books of accounts which are used to record the business transactions

Fundamentals of Auditing –ACC 311 VU

Purchases

Journal

Sales Journal Returns

Inward

Journal

Returns

Outward

Journal

General

Journal

For credit

purchases

For credit

sales

For sales

return

For

purchases

return

For all other

transactions

Source Documents

Invoices

Issued

Credit

Note

Issued

Credit Note

Received

Depends upon

the nature of

Transaction

Invoices

Received

Figure 3.1

To record credit transaction

BOOKS OF ACCOUNT

Books of Original

Entries (Journal)

Cash

Book

For cash

receipts &

payments

Main Ledger Subsidiary Ledger

Other

Ledger

Debtors

Ledge

Creditors

Ledger

Materials

Ledger

To extract trial balance and to

prepare financial statements

To keep memorandum

Books of Secondary

Entries (Ledger)

To record cash transaction

Cash

Memos

1. Books of original entries.

2. Books of secondary entries.

These are further subdivided according to the needs of the business and/or complexity of the transaction.

Following diagram best describes the different books of accounts which are used in the business for

recording transactions.

Just after analyzing a transaction or event for its debit and credit effects it is required to record them in a

systematic way. So the books of accounts in which Debit and Credit are initially recorded in a systematic

way are known as books of original entry (BOE). In accounting system of business concern books of

original entries possess a very important position.

Fundamentals of Auditing –ACC 311 VU

JOURNAL:

It depends upon the complexity of transactions and size of the business that what books of original entries

are required to record the transactions. For a very little business, having very few cash and credit

transactions, a general purpose journal is sufficient to record each type of transactions.

Journal is the very first book of account in which all of the business transactions and events are recorded. In

this book transactions and events are recorded in a chronological (date) sequence. Both of the accounting

effects (Debit & Credit) are recorded in it in a systematic way. Information recorded in the journal for a

transaction or an event is known as journal entry.

Sketch of a Journal & Journal Entry

Date

2003

Particulars Post

Ref.

Debit

(Rs)

Credit

(Rs)

Jan. 10 Salaries Account (Debit)

Cash Account (Credit)

(Staff salaries paid in cash).

50,000

Figure 3.2

From the above illustration we can understand that on 10th January 2003, business paid cash Rs.50,000 as staff

salaries. It is customary that the accounting head analyzed as debit is written firstly in the particulars’ column

and its amount is written in the debit column whereas the accounting head analyzed as credit is written under

the debit accounting head but after indenting a little space from the left side, its amount is written in the

credit column. The column of post reference cannot be very well understood without having knowledge of

Ledger, any how, the column post reference shows page numbers of the Ledger in which salaries and cash

accounts are posted. Words written within the parenthesis in the particulars column are known as

“Narration of a transaction or event”; it is an integral part of a journal entry. Narration explains the

accounting treatments to a layman.

Subdivision of Journal:

As discussed earlier in 1.2 that the journal is sub-divided based on complexity of the transactions or size of

business. This happens only when there are a number of cash transactions in a day and also there are so

many transactions for credit purchases and credit sales. This large numbers of transactions create a mess in

bookkeeping office; therefore, separate bookkeeping clerks are given responsibilities for separate types of

transactions along with separate journals. For example,

For cash transactions there is a separate cash office in which only cash transactions are analyzed and

recorded in a book named as cash book.

For purchases there is a purchase journal in which only and only credit transactions for purchases are

recorded. In the same way sales journal for credit transaction of sales is maintained. And if there are a large

number of returns then separate journals for sales return and purchase return are also maintained.

Now that, after having separate journals for credit sales, credit purchases, sales & purchases return and cash

transactions, all of the remaining transactions and events like sale and purchase of assets on credit, loss by

fire etc. shall be recorded in general journal.

To learn more about subdivision of journal, firstly have a re-look on figure 3.1.

SALES JOURNAL:

Need for Sales Journal

In case of a small business, there is very little number of transactions of credit sales. As we can have an

example of a barber’s shop, a tailor, a retailer etc. they mostly sell their services or goods on cash terms. But

as business expands, the sales of it also grow in terms of cash as well as in terms of credit. The cash sales are

now recorded in the cash book as a receipt, and the credit sales are recorded in a separate journal named as

sales journal (sales day book). In sales journal, no other transactions are recorded except the transaction for

sales on credit terms.

Supporting Document:

As shown in the figure 3.1 the source document supporting credit sales is sale invoice. It is made up in

duplicate or triplicate (depending upon the accounting systems developed for the recording of credit sales)

Cash

Memos

Fundamentals of Auditing –ACC 311 VU

one of these copies is sent to the debtor (credit customer) along with the goods/services sold. A standard

format of sales invoice looks like below;

Name of Vendor Co.

Address of Vendor Co.

Sale Invoice No. Date:

Name & Address of Customer

Purchase Order Ref. No.

Sr. No. Particulars/Description Quantity Rate Amount

Trade discount

Total

***

(***)

***

Settlement terms. 2/10, n/30

Figure 3.3

Purchase Order Reference No:

When a customer asks a vendor for supply of some goods, such order is evidenced through a purchase

order form. Purchase order form discloses the quantity and quality of goods ordered along with its rates and

discounts both trade and settlement. Each purchase order has its unique number which is put on the sales

invoice for reference.

Trade Discount:

Amount of trade discount is not required to be recorded in the books of accounts. Actually it is the

discount which is agreed before entering into the transaction of sales or purchase, therefore, it is just

formally show on the face of the invoice, otherwise it has no other financial effects.

Settlement Terms:

It is also known as prompt payment terms. These terms are in fact offered to lure the customer for having

more discounts by making payment for the invoice earlier. In this term, for example 2/10, n/30, the first

part 2/10 contemplates that if customer pays cash within 10 days of the invoice, he will be offered a

discount of 2%, the second part of it n/30 contemplates that after 10 days there will be no discount offer

but the customer has to pay the amount of invoice net of trade discount within the thirty days of the date of

invoice.

This term sounds as two ten net thirty (2/10, n/30).

How this will sound 5/20, n/60 and what do you understand by this term?

Entering the Transaction of Credit Sales in Sale Journal:

In case of credit sales the business is very much interested in the name and addresses of the credit customer

(Debtor), therefore, sales journal is so designed to cover following information;

Date--------------------- Date of invoice

Name of Debtor -------Mentioned in the invoice

Invoice number ------- It helps to trace the other details of invoice.

Post reference ---------Page number of subsidiary ledger (will be discussed later on)

Amount of invoice ---- Net of Trade Discount

Brain Storming

Fundamentals of Auditing –ACC 311 VU

Sketch of Sales Journal

Date Name of Debtor Invoice

No.

Post.

Ref.

Amount

Rs.

You would have noticed in the sales journal, there is only one column for amount. It might have created

confusion in your mind that why we are not having two columns for amount, one for debit and other for

credit, like in journal. Remember, here in sales journal all of the transactions are of same nature (credit sales)

and the purpose of sales journal is just to avoid over working for recording the debits and credits of each

transaction again & again. So, the role of sales journal in an accounting system is to precise all of the credit

transactions of sales for a month or so and give effect of debit to debtors and credit to sales with total

amount of such period.

Purchase Journal:

Need for a Purchase Journal

After knowing the need of sales journal (as discussed in previous section) it will be very easy to understand

that for a large business having frequent transactions of credit purchases it is necessary to maintain a

separate book for recording the transactions of purchases on credit terms. This book is named as purchase

day book. Obviously like a sales journal no cash transactions relating to purchase shall be recorded in this

book.

Supporting Document:

As shown in the diagram the supporting document for transactions of credit purchases is purchase invoice.

It is exactly the same document as we looked into the diagram of previous section. Purchase invoice is in

fact the copy of sales invoice in the hands of customer. It is issued to the purchaser by the

seller/vendor/supplier. So from the stand point of a purchasing business, the business after having received

the invoice will put an internal number on it and will file it as evidence of the transaction and also for the

purpose to remember that amount of this invoice is still outstanding for payment according to the

settlement terms as discussed in section.

Entering the Transaction of Credit Purchases in Purchase Journal:

The basic contents of a purchase journal are exactly the same as discussed in the case of a sales journal with

the exception of one thing that now in the second column there is the name of Creditors instead of

Debtors. Obviously, we remember the person from whom goods are purchased on credit is creditor of the

business.

Sketch of Purchase Journal

Date Name of creditor Inv.

No.

Post.

Ref.

Amount

A purchase journal is a list of all credit purchases in a stipulated time period. All of the credit purchases

recorded in a purchased journal during a period is totaled and then for such total amount debit effect is

given to the purchases account and credit effect is given to the creditors account. You noticed here that the

rules of debit and credit remain same all the time.

Sales Return Journal: (Returns Inward Journal)

Need for Sales Return Journal

As the business expands the number of complaints and returns inwards also increases. Such return inwards

can be recorded in the sales journal as a negative entry if these are very little in number. But because of its

reverse nature it is recommended to maintain a separate journal to record sales return. Here one very

Fundamentals of Auditing –ACC 311 VU

important concept should be remembered that in sales return journal only the returns against credit sales

(from Debtors) are recorded. Normally, it doesn’t happen that return of goods sold against cash are

accepted by a business because certainly against such return the business would have to make refund of

money already received. That’s why in coming practice you will not find any such transaction. But obviously if

you have any example of such transaction in your business, it will be recorded in cash book as a payment.

Supporting document:

When a business receives back its sold goods it issues a “credit note” to the debtor returning goods, which

evidences that we have received the returned goods and accept that money for such sales will not be

received in future. A “credit note” issued is an evidence of reduction in sales income and also in the amount

of debtors. It is also said that a “credit note” is a reversal document of an “invoice” which cancels the effect

of it. Like an “invoice”, a credit note is also given a number and also possesses a reference of sales invoice against

which such return were made. Rest of the contents of credit note are commonly understood, such as:

􀂃 Name & Address of the business (Seller)

􀂃 Name & Address of the customer

􀂃 Date

􀂃 Particulars

􀂃 Quantity

􀂃 Rate

􀂃 Amount

Sketch of Credit Note

Name of Vendor Co.

Address of Vendor Co.

Credit Note No: Date:

Customer’s Name

Customer’s Address

Ref. Invoice No Account No:

Item No. Description Quantity Rate Trade

Discount

Net Amount

Total

Figure 3.6

Purchase return journal: (Returns outward journal)

Need for a Purchase Return Journal?

Purchase return journal has the same story as we just have discussed in previous unit. The only thing to

remember is that it is also known as return outward journal/daybook. Obviously these transactions (for

purchase returns) could also be recorded in the purchase journal as negative entry but same as for sales

return journal it is required to have a separate journal for purchase returns because of its reverse nature to

the purchases. The total of purchase return journal will cause a reduction in the purchases expenses and also

a reduction in the amount of creditors.

Supporting document:

Although purchase returns are evidenced by a copy of credit note received from the seller, which is treated as

a reversal document against purchase invoice. But here we shall also discuss the need of a “Debit Note”. A

“debit note” is in fact a request, put to the seller by the purchaser business, for issuance of a credit note. A copy

of debit note is sent to the seller along with the rejected goods, in which all of the particulars of goods

rejected and returned along with the reference of relevant invoice number are entered. Remember, a

business cannot record purchases returns considering a debit note as a supporting document because the

Fundamentals of Auditing –ACC 311 VU

effects of purchase invoice are not considered cancelled unless acceptance of rejected goods is received

from the seller in shape of a copy of credit note.

Entering Transactions in Purchases Return Journal:

you will find nothing new in this section except the treatment of total of purchase return journal which is

debited to the creditors account and credited to the purchases return account.

Sketch of a Purchase Return Journal

Date Creditor Name Credit

Note No.

Post.

Ref.

Amount

Figure 3.7

Cash Book:

Cash book is a book of original entries in which all of the cash transactions are recorded very firstly. If we

refer to the figure 3.1, we can notice that the (books of original entry) journal is subdivided for two types of

transactions i.e. credit transactions and cash transactions. As discussed in previous units, all credit

transactions are recorded in different journals. The cash transaction of a concern needs a separate book

named as cash book.

A cash book is divided into two sections, one for cash receipts and the other for cash payments. Each of

the section is formatted for date, particulars, post reference and amount. See below for its proper sketch;

Cash book

Date Particulars Post

Ref.

Amount Date Particulars Post

Ref.

Amount

Figure 3.8

Left hand side of a cash book is known as receipt side and right hand side is known as payment side. In a

way, we can say that within a cash book, we prepare two cash journals, one, cash receipt journal and second,

cash payment journal.

Supporting Documents:

For Cash Receipts

All cash receipts are evidenced by a copy of cash memo/receipts retained by the business. These cash

memos/receipt are already serially pre-numbered and for each receipt of cash, the cash office issues an

original copy of the cash memo/receipt to the person making payment and retains a carbon copy or

counterfoil of it within the office which are used to record receipts of cash in the cash book.

For Cash Payments

All cash payments are evidenced by an original copy of cash memo/receipts issued by the recipient

business. These are attached with a cash voucher as evidence that cash was paid to recipient who issued this

cash memo/receipt.

Fundamentals of Auditing –ACC 311 VU

Lesson 10

BOOKS OF ACCOUNT & FINANCIAL STATEMENTS

1. Books of Account to be kept by Company [Section-230]

1.1 A company should keep proper books of account in respect of:

e) Cash received and expended by the company;

f) Sales and purchases of goods by the company;

g) All Assets and liabilities of the company; and

h) In case of a company engaged in production, processing, manufacturing, or mining activities, a

production record as may be required by the Commission through a general or special order;

1.2 Books of account should be preserved for ten years;

1.3 Books of account are to be kept at the registered office of the company. If kept at any other place,

the registrar should be informed;

1.4 Books of account should give a true and fair view of the state of affairs of the company and should

contain explanation of transactions.

1.5 Directors can inspect the books of account during the business hours.

1.6 If company fails to comply with the above provisions a director, including chief executive and chief

accountant:

(a) of listed company is liable to imprisonment for one year and a fine of not less than Rs. 20,000

not more than Rs. 50,000, and a further fine of Rs. 5000 per day during which the default

continues; or

(b) of other companies is liable to imprisonment for six months and with a fine, which may extend

to Rs. 10,000

2. Annual Accounts and Balance Sheet [Section 233]

2.1 First annual accounts of a company must be presented before the AGM within eighteen months

from the date of incorporation.

2.2 A subsequent annual accounts should be presented once at least in every calendar year before an

AGM. In other words, the accounts should be presented in the AGM within three months of the

date of balance sheet. However, in the case of a listed company the Commission and in other cases

the registrar can extend this period for a term not exceeding two months.

2.3 The accounts should be made up, in the case of first accounts, from the date of incorporation, and

in the case of subsequent accounts, from the date of the preceding accounts to a date not earlier

than the date of the meeting by more than four months.

2.4 The accounts shall be prepared for a period not exceeding 12 months, except in case where

permission is granted by the registrar for preparation of accounts for a longer period.

2.5 Profit and Loss account and Balance Sheet shall be audited by the auditor and auditor’s report

should be attached thereto.

2.6 Copy of accounts, auditor’s report and directors’ report should be sent to every member at least

twenty-one days before the Annual General Meeting (AGM).

2.7 Listed companies are required to send five copies of their audited accounts to the registrar, the

Commission and the stock exchange within 30 days.

3. Contents of Balance Sheet [Section 234]

3.1 General:

a) Balance Sheet and Profit & Loss Account should give a true and fair view of the state of the

company’s affairs and of the profit or loss of the company.

b) An item of expenditure fairly chargeable to income shall be brought into account.

c) Any expenditure which in fairness can be distributed over several years but is incurred in one

year should be so distributed and reasons for doing so should be given.

3.2 For Listed Companies and Private or Non Listed Public Companies Which is a Subsidiary

of a Listed Company:

a) Balance Sheet and profit and loss account should be prepared in accordance with Fourth

Schedule;

Fundamentals of Auditing –ACC 311 VU

b) A statement of changes in equity and cash flow statement.

c) Accounting policies should be stated and, where there is any change in accounting polices

the auditor shall report whether he agrees with the change.

d) International Financial Reporting Standards as adopted by SECP should be followed in

preparation of accounts.

3.3 For Other Companies:

a) Balance Sheet and profit and loss account shall be prepared in accordance with the

Fifth Schedule;

b) A statement of changes in equity and cash flow statement.

c) Accounting policies should be stated and, where there is any change in accounting

polices the auditor shall report whether he agrees with the change.

d) International Financial Reporting Standards as adopted by SECP should be

followed in preparation of accounts.

Limited Liability Company

Balance Sheet

As on December 31, 2006

Rs. Rs.

Assets

Non Current Assets

Fixed Assets

Tangible Assets ***

Intangible Assets *** ***

Long Term Investments ***

Long Term Advances, Deposits & Prepayments ***

Deferred Cost ***

Current Assets ***

Current Liabilities (***) ***

Capital Employed ***

Financed By

Owners’ Equity

Ordinary Share Capital ***

Reserves

Capital Reserves ***

Revenue Reserves *** *** ***

Non Current Liabilities

Loan Stocks/Term Finance Certificates ***

Loan from financial institutions ***

Finance lease liability *** ***

***

Chief Executive Director

Fundamentals of Auditing –ACC 311 VU

Limited Liability Company

Income Statement

For the Year ended December 31, 2006

Rs. Rs.

Sales ***

Cost of goods sold (***)

Gross profit ***

Operating expenses

Administrative expense ***

Selling & Marketing expenses *** ***

Profit from operations ***

Other income ***

Financial expenses ***

Profit before tax ***

Income tax expense ***

Profit after tax ***

Limited Liability Company

Statement of changes in equity

For the year ended December 31, 2006

Rs. Rs.

Retained profits b/f ***

Profit after tax ***

Dividend paid ***

Transfer to reserves *** (***)

Retained profits c/f ***

Chief Executive Director

Fundamentals of Auditing –ACC 311 VU

4. Treatment of Surplus Arising on Revaluation of Fixed Assets [Section 235]

4.1 Any surplus on revaluation of fixed assets should be transferred to an account named “Surplus on

revaluation of fixed assets account”.

4.2 This account should be shown in the balance sheet after capital and reserves;

4.3 Surplus on revaluation shall not be set off or reduced except:

a) For setting of any decrease in revaluation of asset; or

b) When revalued asset is disposed of, surplus relating to it can be adjusted or set off.

4.4 Depreciation on assets which are revalued shall be determined with reference to the value assigned

to such assets on revaluation and depreciation charge for the period shall be taken to the Profit and

Loss Account;

4.5 An amount equal to incremental depreciation for the period shall be transferred from “Surplus on

Revaluation of Fixed Assets Account” to un-appropriated profit / accumulated loss through

Statement of Changes in Equity to record realization of surplus to the extent of the incremental

depreciation charge for the period;

4.6 An amount equal to incremental depreciation charged in previous years may be transferred from

“Surplus on Revaluation of Fixed Assets Account” to un-appropriated profit / accumulated loss

through Statement of Changes Equity.

5. Director’s Report [Section 236]

5.1 Director’s report shall be attached to the Balance Sheet.

5.2 It shall state business affairs, proposed dividend, if any, amounts set aside to reserve, if any.

5.3 In the case of a public company or a private company which is a subsidiary of a public company

director’s report shall also include:-

a) Disclosure of any material changes and commitments affecting the financial position which

have occurred between the year end and the date of report;

b) Disclosure of any material changes in the nature of business etc., which have occurred

during the year, if the disclosure is necessary for understanding the state of the company’s

affairs.

c) Explanation to any qualification in auditor’s report.

d) Pattern of holding of shares (percentage of shares held by the parties).

e) Name and country of incorporation of holding company if any, where such holding

company is established outside Pakistan.

f) The earning per share.

g) Reasons for incurring loss and reasonable indication of future prospects of profit, if any.

h) Information about defaults in payment of debts, if any, and reasons thereof.

5.4 The directors of a holding company required to prepare consolidated financial statements under

section 237 shall make out and attach to consolidated financial statements, a report with respect to

the state of group’s affairs and all provisions of subsection (2), (3) and (4) shall apply to such

report.

5.5 Director’s Report shall be signed by the chairman or the chief executive, if so authorized by the

directors; otherwise by the chief executive and a director.

6. Balance Sheet of Holding Companies [Section 237]

6.1 Consolidated Financial Statements

(1) There shall be attached to the financial statements of a holding company having a

subsidiary or subsidiaries, at the end of the financial year at which the holding company's

financial statements are made out, consolidated financial statements of the group presented

as those of a single enterprise and such consolidated financial statements shall comply with

the disclosure requirement of the Fourth Schedule and International Accounting Standards

notified under sub-section (3) of section 234.

(2) Where the financial year of a subsidiary precedes the day on which the holding company's

financial year ends by more than three months, such subsidiary shall make an interim

closing on the day on which the holding company's financial year ends, and prepare

financial statements for consolidation purposes.

Fundamentals of Auditing –ACC 311 VU

(3) Every auditor of a holding company appointed under section 252 shall also report on

consolidated financial statements and exercise all such powers and duties as are vested in

him under section 255.

(4) All interim financial statements of a subsidiary as required under sub-section (3) shall be

reviewed by the auditors of that subsidiary appointed under section 252 who shall report

on such financial statements in the prescribed form.

(5) There shall be disclosed in the consolidated financial statements,-

(a) any qualifications contained in the auditors' reports on the accounts of subsidiary or

subsidiaries for the financial year ending with or during the financial year of the

holding company; and

(b) any material note or explanation on a qualification, regarding to but not covered in the

financials statements of a parent company.

(6) Every consolidated financial statement shall be signed by the same persons by whom the

individual balance sheet and the profit and loss account or income and expenditure

account of the holding company are required to be signed under section 241.

(7) All provisions of sections 233, 242, 243, 244 and 245 shall apply to a holding company

required to prepare consolidated financial statements under this section as if for the word

"company" appearing in these section, the words "holding company" were substituted.

(8) The Commission may, on an application or with the consent of the directors of a holding

company, direct that in relation to any subsidiary, the provisions of this section shall not

apply to such extent only as may be specified in the direction.

(9) If a holding company fails to comply with any requirement of this section, every officer of

the holding company shall be punishable with fine which may extend to fifty thousand

rupees in respect of each offense unless he shows that he took all reasonable steps for

securing compliance by the holding company of such requirements and that the noncompliance

or default on his part was not willful and intentional".

6.2 The directors shall ensure that year-end of the holding and its subsidiary companies shall coincide

except where there are good reasons against it. The SECP shall facilitate the companies in this

regard by allowing them to prepare accounts of extended period, hold AGM accordingly and file

annual return after the holding of extended AGM. [Section 238]

7. Balance Sheet of Modaraba Company [Section 240]

Modaraba companies are required to attach financial statements and other reports circulated to

Modaraba certificate holders with their financial statements.

8. Authentication of Balance Sheet [Section- 241]

8.1 Accounts should be approved by the Board of Directors.

8.2 Balance Sheet shall be signed by the chief executive and one director. If chief executive is out of

Pakistan for the time being then it shall be signed by two directors and a statement shall be given by

the directors explaining reasons thereof.

9. Copy of Balance Sheet to be forwarded to the Registrar (Section 242)

9.1 Three copies of listed company’s audited accounts and the auditor’s report duly signed by the

management and auditors should be filed with the registrar within thirty days from the AGM.

9.2 In other cases two copies are required.

9.3 Private Companies are not required to file their accounts with the registrar.

10. Right of Members/Debenture-Holders of Company to Copy of the Accounts and the

Auditor’s Report [Section-243 & 247]

Members have the right to get copy of annual accounts etc. of company on payment. The same

rights are available to debenture-holders or trustees for debenture-holders.

11. Quarterly Accounts of Listed Companies [Section (245)]

All listed companies shall within one month of the close of every quarter of their year of account,

prepare and transmit to the members and the stock exchange(s) on which their shares are listed, a

Fundamentals of Auditing –ACC 311 VU

profit and loss account for, and balance sheet as at the end of that quarter, whether audited or

otherwise. They shall file with the registrar and the Commission three copies thereof.

Quarterly accounts shall be circulated for the 1st, 2nd and 3rd quarter within one month of the close

of that quarter.

Approval of the board of directors will be mandatory for circulation of the quarterly accounts.

If a company fails to comply with any of the requirements of this section, every director including

chief executive and chief accountant of the company who has knowingly by his act or omission

been the cause of such default shall be liable to a fine of not exceeding one hundred thousand

rupees and to a further fine of not exceeding one thousand rupees per day during which default

continues.

12. Additional Statement of Accounts and Reports [Section 246]

12.1 The SECP may by general or special order, require companies, or a class of companies or any

particular company, to prepare and send to the members, the registrar, the SECP, a stock exchange

and any other person such periodical statements of accounts, information or other reports in such

form and manner and within such time, as may be specified in the order.

12.2 The Securities and Exchange Commission of Pakistan vide circular No. 23/2005, has directed to all

listed companies and their subsidiaries to provide: -

a) Other Information contained in their annual report, as such term is defined in International

Standard on Auditing 720 (Other Information in the Documents Containing Audited Financial

Statements), to their external auditor (s); and

b) Sufficient time to their external auditor (s) to review and comment upon any “material

inconsistencies” found in such Other Information where the other information may contradict the

information contained in the audited financial statements. Listed companies and their subsidiaries

are required to comply with this directive from the period commencing 1st January 2006.

Auditor’s interest in the statutory books

The auditor is interested in the statutory books because:

– They are directly concerned with the Accounts

– They are audit evidence to be used in verifying detailed items in the accounts; for example the

total share capital shown by the sum of the individual share holdings in the register of members

must agree with the share capital recorded in the books of accounts

– Failure to maintain proper records of any sort casts doubt upon the accuracy and reliability of

the records generally.

Fundamentals of Auditing –ACC 311 VU

Lesson 11

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

Introduction

The standard requires that auditor should obtain an understanding of the entity and its environment,

including its internal control, sufficient to identify and assess the risks of material misstatement of the

financial statements whether due to fraud or error, and sufficient to design and perform other audit

procedures.

The standard provides guidance on the following:

1. Risk assessment procedures and sources of information about the entity and its

environment including its internal control.

2. Understanding the entity and its environment, including its internal control.

3. Assessing the risk of material misstatement.

4. Communicating with those charged with governance and management.

5. Documentation.

1. Risk Assessment Procedures and Sources of Information about the Entity and Its Environment

Including Its Internal Control

Risk Assessment Procedures & Sources of Information

The auditor should perform the following risk assessment procedures to obtain an understanding of the

entity and its environment, including its internal controls.

a) Inquiries of management and others within the entity;

b) Analytical procedures; and

c) Observation and inspection.

The auditor is not required to apply all the risk assessment procedures for each aspect of the understanding

required. However, all the above risk assessment procedures are applied in the course of obtaining the

required understanding.

In addition to the above procedures, the auditor may obtain information by making inquiries of the entity’s

legal counsel or of valuation experts that the entity has used. Reviewing information obtained from external

sources such as reports by analysts, banks, or rating agencies, trade and economic journals or regulatory or

financial publications may also be useful in obtaining information about the entity.

a) Inquiries

The auditor obtains information from management and those responsible for financial reporting. However,

useful information can be obtained from others within the entity like production staff, internal audit

personnel and other employees. Inquiries from others may provide an auditor with the following

information:

• Inquiries directed towards those charged with governance may help the auditor understand

the environment in which the financial statements are prepared. (such persons include the

representatives of board of directors, Chief finance officers who are responsible of

designing internal control)

• Inquiries directed towards internal audit personnel may relate to their activities concerning

the monitoring and effectiveness of the entity’s internal control and whether management

has satisfactorily responded to any findings from these activities.

• Inquiries of employees involved in initiating, processing or recording complex or unusual

transactions (like; accounts managers etc.) may help the auditor in evaluating the

appropriateness of the selection and application of certain accounting policies.

• Inquiries directed towards in-house legal counsel (like; company secretary, legal advisor

etc.) may relate to such matters as litigation, compliance with laws and regulations,

knowledge of fraud or suspected fraud affecting the entity, warranties, post-sales

obligations, arrangements (such as joint ventures) with business partners and the meaning

of contract terms.

Fundamentals of Auditing –ACC 311 VU

• Inquiries directed towards marketing or sales personnel may relate to changes in the

entity’s marketing strategies, sales trends, or contractual arrangements with its customers.

b) Analytical procedures

These include ratio analysis, trend analysis, and common size analysis of financial as well as non

financial information pertaining to the entity.

These procedures enable auditor to identify situation where significant fluctuations exist,

relationships are not present as per expectations or unexpected relationships exist.

c) Observation and Inspection (walk through procedures)

It may support inquiries of management and others and also provide information about the entity

and its environment. Such audit procedures ordinarily include the following:

• Observation of entity activities and operations

• Inspection of documents (such as business plans and strategies), records and internal

control manuals.

• Reading reports prepared by management (such as quarterly management reports and

interim financial statements) and those charged with governance (such as minutes of board

of directors’ meetings).

• Visits to the entity’s premises and plant facilities.

• Tracing transactions through the information system relevant to financial reporting (walkthrough).

Discussion among the Audit Team

The members of the engagement team should discuss the susceptibility of the entity’s financial

statements to materials misstatements. Such discussion would foster sharing of knowledge and

exchange of information.

Fundamentals of Auditing –ACC 311 VU

Lesson 12

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

2. Understanding the Entity and Its Environment, including Its Internal Control

The auditor’s understanding of the entity and its environment consists of an understanding of the following

aspects:

(a) Industry, regulatory, and other external factors, including the applicable financial reporting

framework (like; insurance companies, leasing companies, banking companies, textile

industry etc.).

(b) Nature of the entity, including the entity’s selection and application of accounting policies

(like; sugar, textile, hotel, tourism, services, etc.).

misstatement of the financial statements (like; growth maximization, cost effectiveness,

quality leadership, downsizing, etc.).

(d) Measurement and review of the entity’s financial performance.

(e) Internal control.

a) Industry, regulatory and other External Factors, including the Applicable Financial

Reporting Framework

The auditor should obtain information about these. Such knowledge includes information about

competitors, suppliers, customers, technological developments, the regulatory environment, legal and

political environment and the environmental requirements affecting the industry and the entity. The auditor

should also consider general economic conditions.

Examples of matters an auditor may consider include the following:

• Industry conditions

􀂉 The market and competition, including demand, capacity, and price competition.

􀂉 Cyclical or seasonal activity

􀂉 Product technology relating to the entity’s products

􀂉 Energy supply and cost

• Regulatory environment

􀂉 Accounting principles and industry specific practices

􀂉 Regulatory framework, for a regulated industry (like; baking sector)

􀂉 Legislation and regulation that significantly affect the entity’s operations

􀂙 Regulatory requirements (like; labor laws, minimum wage rate)

􀂙 Direct supervisory activities (like; NAB, Excise & taxation Dept)

􀂉 Taxation (corporate and other)

􀂉 Government policies currently affecting the conduct of the

entity’s business.

􀂙 Monetary, including foreign exchange controls

􀂙 Fiscal

􀂙 Financial incentives (for example, government aid

programs)

􀂙 Tariffs, trade restrictions

􀂉 Environmental requirements affecting the industry and the

entity’s business.

• Other external factors currently affecting the entity’s business.

􀂉 General level of economic activity (for example, recession, growth)

􀂉 Interest rates and availability of financing

􀂉 Inflation currency revaluation.

b) Nature of the Entity

The nature of an entity refers to the entity’s operations, its ownership and governance, the types of

investments that it is making and plans to make, the way that the entity is structured and how it is financed.

Fundamentals of Auditing –ACC 311 VU

An understanding of the nature of an entity enables the auditor to understand the classes of transactions,

account balances, and disclosures to be expected in the financial statements.

The auditor should obtain an understanding of the accounting policies selected and their application. It

includes understanding the methods to account for significant and unusual transactions, the effect of

significant accounting policies in controversial areas and changes in accounting policies. The auditor should

assess appropriateness, of accounting policies selected and their consistency with financial reporting

framework and industry practice.

Examples of matters an auditor may consider include the following:

Business Operations

• Nature of Business (for example, manufacturer, wholesaler, banking, insurance or other

financial services, import/export trading, utility, transportation and technology products

and services.

• Products or services and markets (for example, major customers and contracts, terms of

payment, profit margins, market share, competitors, exports, pricing policies, reputation of

products, warranties, order book, trends, marketing strategy and objectives, manufacturing

processes).

• Conduct of operations (for example, stages and methods of production, business

segments, delivery of products and services, details of declining or expanding operations).

• Alliances, joint ventures and outsourcing activities

• Involvement in electronic commerce, including internet sales and marketing activities.

• Geographic dispersion and industry segmentation.

• Location of production facilities, warehouses, and offices.

• Key customers.

• Important supplies of goods and services (for example, long-term contracts, stability of

supply, terms of payment, imports, methods of delivery such as “just-in-time”).

• Employment (for example, by location, supply, wage levels, union contracts, pension and

other post employment benefits, stock option or incentive bonus arrangements, and

government regulation related to employment matters).

• Research and development activities and expenditures.

• Transactions with related parties.

Investments

• Acquisitions, mergers or disposals of business activities (planned or recently executed).

• Investments and dispositions of securities and loans.

• Capital investment activities, including investments in plant and equipment and

technology, and any recent or planned changes.

• Investments in non-consolidated entities, including partnerships, joint ventures and

special-purpose entities.

Financing

• Group structure – major subsidiaries and associated entities, including consolidated and

non-consolidated structures.

• Debt structure, including covenants, restrictions, guarantees, and off-balance-sheet

financing arrangements.

• Leasing of property, plant or equipment for use in the business.

• Beneficial owners (local, foreign, business reputation and experience)

• Related parties

• Use of derivative financial instruments.

Financial Reporting

• Accounting principles and industry specific practices.

• Revenue recognition practices.

• Accounting for fair values.

• Inventories (for example, locations, quantities).

Fundamentals of Auditing –ACC 311 VU

• Foreign currency assets, liabilities and transactions.

• Industry-specific significant categories (for example, loans and investments for banks,

accounts receivable and inventory for manufacturers, research and development for

pharmaceuticals).

• Accounting for unusual or complex transactions including those in controversial or

emerging areas (for example, accounting for stock-based compensation).

• Financial statement presentation and disclosure.

Fundamentals of Auditing –ACC 311 VU

Lesson 13

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

RECAP

Sources of Obtaining Understanding

Auditor obtains an understanding of the entity and environment, including its internal control through:

1. Risk assessment procedures and sources of information about the entity and its environment

including its internal control.

2. Understanding the entity and its environment, including its internal control.

3. Assessing the risk of material misstatement.

4. Communicating with those charged with governance and management.

5. Documentation

1. Risk Assessment Procedures & Sources of Information

Risk assessment procedures to obtain an understanding

a) Inquiries directed towards:

• Those charged with governance

• Internal audit personnel

• Middle management (employees)

• Legal counsel

• Marketing or sales personnel

b) Analytical procedures

• Financial

• Non financial

c) Observation and inspection of:

• Observations of Activities and operations

• Inspection of Documents and records

• Reading Management reports

• Visit to premises and plant facilities

2. Understanding the Entity and Its Environment, Including Its Internal Control

The auditor’s understanding of the entity and its environment consists of an understanding of the following

aspects:

a) External Factors:

• Industry conditions

• Regulatory environment

• Macro economic level factors

b) Nature of the entity:

• Business operations

• Investments

• Financing

• Financial reporting

c) Objectives and strategies and the related business risks

• Potential related business risk at existence of objective:

a) Industry developments

b) New products and services

c) Expansion of the business

d) New accounting requirements

e) Regulatory requirements

f) Current and prospective financing requirements

g) Use of IT

• Potential related business risk at implementing a strategies:

a) Effects leading to new accounting requirements

Fundamentals of Auditing –ACC 311 VU

d) Measurement and review of the entity’s financial performance.

e) Internal control.

2. Understanding the Entity and Its Environment, including Its Internal Control

The auditor’s understanding of the entity and its environment consists of an understanding of the

following aspects:

(a) Industry, regulatory, and other external factors, including the applicable financial reporting

framework (like; insurance companies, leasing companies, banking companies, textile

industry etc.).

(b) Nature of the entity, including the entity’s selection and application of accounting policies

(like; sugar, textile, hotel, tourism, services, etc.).

misstatement of the financial statements (like; growth maximization, cost effectiveness,

quality leadership, downsizing, etc.).

(d) Measurement and review of the entity’s financial performance.

(e) Internal control.

c) Objectives and Strategies and Related Business Risks

The auditor should obtain an understanding of the entity’s objectives and strategies and the related

business risks that may result in material misstatement of the financial statements.

Business Risk is the risk that objectives and strategies would not be met

Examples of matters an auditor may consider include the following:

• Existence of objectives with reference to:

􀂉 Industry developments (a potential related business risk might be, for example,

that the entity does not have the personnel or expertise to deal with the changes

like technological changes in the industry).

􀂉 New products and services (a potential related business risk might be, for example,

that there is increased product liability).

􀂉 Expansion of the business (a potential related business risk might be, for example,

that the demand has not been accurately estimated).

􀂉 New accounting requirements (a potential related business risk might be, for

example, incomplete or improper implementation, or increased costs).

􀂉 Regulatory requirements (a potential related business risk might be, for example

that there is increased legal exposure).

􀂉 Current and prospective financing requirements (a potential related business risk

might be, for example, the loss of financing due to the entity’s inability to meet

requirements).

􀂉 Use of IT (a potential related business risk might be, for example, that systems and

processes are incompatible).

• Effects of implementing a strategy, particularly any effects that will lead to new accounting

requirements (a potential related business risk might be, for example, incomplete or

improper implementation)

The auditor should keep in mind that business risk is broader than the risk of material misstatement.

Business risks, at times, do not cause any misstatement in the financial statements but affect the going

concern.

Conditions and events that may indicate risks of material misstatements are as follows:

The following are examples of conditions and events that may indicate the existence of risks of material

misstatement. The examples provided cover a broad range of conditions and events; however, not all

conditions and events are relevant to every audit engagement and the list of examples is not necessarily

complete.

• Operations in regions that are economically unstable, for example, countries with significant

currency devaluation or highly inflationary economies.

• Operations exposed to volatile markets, for example, futures trading.

• High degree of complex regulation.

• Going concern and liquidity issues including loss of significant customers.

• Constraints on the availability of capital and credit.

Fundamentals of Auditing –ACC 311 VU

• Changes in the industry in which the entity operates.

• Changes in the supply chain.

• Developing or offering new products or services, or moving into new lines of business.

• Expanding into new locations.

• Changes in the entity such as large acquisitions or reorganizations or other unusual events.

• Entities or business segments likely to be sold.

• Complex alliances and joint ventures.

• Use of off-balance-sheet finance, special-purpose entities, and other complex financing

arrangements.

• Significant transactions with related parties.

• Lack of personnel with appropriate accounting and financial reporting skills.

• Changes in key personnel including departure of key executive.

• Weaknesses in internal control, especially those not addressed by management.

• Inconsistencies between the entity’s IT strategy and its business strategies.

• Changes in the IT environment.

• Installation of significant new IT systems related to financial reporting.

• Inquiries into the entity’s operations or financial results by regulatory or government bodies.

• Past misstatements, history of errors or a significant amount of adjustments at period end.

• Significant amount of non-routine or non-systematic transactions including inter-company

transactions and large revenue transactions at period end.

• Transactions that are recorded based on management’s intent, for example, debt refinancing, assets

to be sold and classification of marketable securities.

• Application of new accounting pronouncements.

• Accounting measurements that involve complex processes.

• Events or transactions that involve significant measurement uncertainty, including accounting

estimates.

• Pending litigation and contingent liabilities for example, sales warranties, financial guarantees and

environmental remediation.

Fundamentals of Auditing –ACC 311 VU

Lesson 14

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

Risk

assessment

procedures

Understanding

consists of:

Inquiries

Analytical procedures

Observation & Inspection

External Factors

Nature of entity

Objectives and strategies and the related business risks

Measurement & review of financial performance

Internal Control

Assessing the risk of material

misstatement

Communication

Documentation

How

obta

und

erst

andi

d) Measurement and Review of the Entity’s Financial Performance

The auditor should obtain an understanding of the measurement and review of the entity’s financial

performance. Performance measures, internal and external, some times create pressures on the

entity and motivate management to misstate the financial statements.

Internally generated information may highlight entity’s position vis-à-vis, its competitors and

reports from credit rating agencies and analysts may provide information useful to the auditors

understanding of the entity and its environments.

Examples of matters an auditor may consider include the following:

• Key ratios and operating statistics

• Key performance indicators

• Employee performance measures and incentive compensation policies.

• Trends

• Use of forecasts, budgets and variance analysis

• Analyst reports and credit rating reports

• Competitor analysis

• Period –on-period financial performance (revenue growth, profitability leverage)

e) Internal Control

Understanding of Internal Control is used by the auditor to identify types of potential

misstatements and to consider factors that affect the risks of material misstatements and design the

nature, timing and extent of further audit procedures.

Fundamentals of Auditing –ACC 311 VU

Definition of internal control

Internal controls is the process designed and effected 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. It follows that internal control is

designed and implemented to address identified business risks that threaten the achievement of any

of these objectives.

Components of internal control

(a) The control environment

(b) The entity’s risk assessment process

reporting and communication.

(d) Control activities

(e) Monitoring of controls

Fundamentals of Auditing –ACC 311 VU

Lesson 15

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

e) Internal Control.

Understanding of Internal Control is used by the auditor

1. to identify types of potential misstatements;

2. to consider factors that affect the risks of material misstatements; and

3. to design the nature, timing and extent of further audit procedures.

Definition of Internal Control

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:

1. Reliability of financial reporting,

2. Effectiveness and efficiency of operations and

3. Compliance with applicable laws and regulations.

It follows that internal control is designed and implemented to address identified business risks that

threaten the achievement of any of these objectives.

Components of Internal Control

i) The control environment

ii) The entity’s risk assessment process

iii) The information system, including the related business processes relevant to financial

reporting and communication.

iv) Control activities

v) Monitoring of controls

i) The Control Environment

It encompasses the following elements:

(a) Communication and enforcement of integrity and ethical values.

(b) Commitment to competence

(d) Management’s philosophy and operating style

(e) Organizational structure

(f) Human resource policies and practices

Auditor should evaluate how these components have been incorporated into the entity’s processes.

ii) The Entity’s Risk Assessment Process

It is the process of identifying and responding to business risks that affect entity’s financial reporting.

Such process includes how management:

1. identifies risks that affect entity’s ability to produce financial statement that give true and

fair view,

2. estimates their significance,

3. estimates likelihood of their occurrence and

4. Decides upon actions to manage them.

Risks relevant to financial reporting include:

– internal events, and

– external events and circumstance

That may occur and adversely affect an entity’s ability to:

• initiate,

• record,

• process, and

• report the financial information.

Risks can arise due to circumstances such as the following: (internal/external)

Fundamentals of Auditing –ACC 311 VU

a) Changes in operating environment

b) New personnel

c) New or revamped information systems

d) Rapid growth

e) New technology

f) New business models, product or activities

g) Corporate restructurings

h) Expanded foreign operations

i) New accounting pronouncements

iii) Information system, including the related business processes, relevant to financial

reporting and communication

The information system consists of:

1. infrastructure (physical and hardware components),

2. software

3. people

4. procedures and

5. data

Infrastructure and software will be absent, or have less significance, in systems that are exclusively or

primarily manual. Many information systems make extensive use of IT.

Importance of Information System

Accordingly, an information system encompasses methods and records that:

• Identify and record all valid transaction.

• Describe on a timely basis the transaction in sufficient detail to permit proper classification of

transactions for financial reporting.

• Measure the value of transactions in a manner that permits recording their proper monetary value

in the financial statements.

• Determine the time period in which transactions occurred to permit recording of transactions in

the proper accounting period.

• Present properly the transactions and related disclosures in the financial statements.

Communication

• Communication involves:

– providing an understanding of individual roles and responsibilities pertaining to internal

control,

– understanding roles of others and

– doing exception reporting to higher level management.

• Communication takes such forms as:

– policy manuals,

– accounting and financial reporting manuals and memorandum.

• It may also be made

– electronically,

– orally and

– through the actions of management

iv) Control Activities

Control activities include:

a) Performance reviews

b) Information processing

c) Physical controls

d) Segregations of duties

a) Performance reviews

These control activities include:

– reviews and analyses of actual performance versus budgets, forecasts, and prior period

performance;

Fundamentals of Auditing –ACC 311 VU

– relating different sets of data - operating or financial - to one another, together with

analyses of the relationships and investigative and corrective actions;

– comparing internal data with external sources of information; and

– review of functional or activity performance, such as a bank's Consumer loan manager's

review of reports by branch, region, and loan type for loan approvals and collections

b) Information processing

A variety of controls are performed to check accuracy, completeness, and authorization of

transactions.

The two broad groupings of information systems control activities are:

i. application controls and

ii. general IT controls.

Application controls apply to the processing of individual applications. These controls help ensure that

transactions occurred, are authorized, and are completely and accurately recorded and processed.

General IT-controls commonly include controls over data center and network operations; system software

acquisition, change and maintenance; access security; and application system acquisition, development, and

maintenance. These controls apply to main-frame, mini-frame and end-user environments.

c) Physical controls

These activities encompass the:

i. physical security of assets, including adequate safeguards such as secured facilities access to

assets and records;

ii. authorization for access to computer programs and data files; and

iii. periodic counting and comparison with amounts shown on control records (for example

comparing the results of cash, security and inventory counts with accounting records).

d) Segregation of duties

Assigning different people the responsibilities of authorizing transactions, recording transactions, and

maintaining custody of assets is intended to reduce the opportunities to allow any person to be in a position

to both commit and conceal errors or fraud in the normal course of the person's duties. Examples of

segregation of duties include reporting, reviewing and approving reconciliations, and approval and control

of documents.

v) Monitoring of Control

The auditor should obtain an understanding of the major types of activities that

i. the entity uses to monitor internal control over financial reporting, and

ii. how the entity initiates corrective actions to its controls.

Monitoring means and includes:

Ensuring that internal controls are operating as intended.

– If monitoring is not done, people may stop performing the functions they are required to

perform.

– It also involves assessing the quality of internal control performance over times.

– Monitoring may be ongoing activities, separate evaluations or a combination of the two.

Monitoring includes:

a) Supervisions, functions of managers

b) Internal audit

c) Communication from external parties indicating areas requiring

3. Assessing the Risk of Material Misstatement

The auditor should identify and assess the risks of material misstatement at the financial statement level, and

at the assertion level for classes of transactions, account balances, and disclosures. For this purpose, the

auditor:

• Identifies risks throughout the process of obtaining an understanding of the entity and its

environment, including relevant controls that relate to the risks, and by considering the

classes of transactions, account balances, and disclosures in the financial statements.

• Relates the identified risks to what can go wrong at the assertion level;

• Considers whether the risks are of a magnitude that could result in a material misstatement

of the financial statements; and

Fundamentals of Auditing –ACC 311 VU

• Considers the likelihood that the risks could result in a material misstatement of the

financial statements.

Significant Risks that require Special Audit Considerations

Significant risks

These relate to:

• non-routine transactions (unusual)

• judgmental matters (e.g. accounting estimates)

• non-routine transactions arising from matters such as:

􀂃 greater management intervention to specify the accounting treatment

􀂃 greater manual intervention for data collection and processing

􀂃 complex calculations or accounting principles.

For significant risks, to the extent the auditor has not already done so, the auditor should evaluate the

design of the entity’s related controls, including relevant control activities, and determine whether they have

been implemented.

If management has not appropriately responded by implementing controls over significant risks and if, as a

result, the auditor judges that there is a material weakness in the entity’s internal control, the auditor

communicates this matter to those charged with governance as required in paragraph 8. In these

circumstances, the auditor also considers the implications for the auditor’s risk assessment.

Risks for which substantive procedures alone do not provide sufficient appropriate audit evidence

As part of the risk assessment as described in the above paragraph, the auditor should evaluate the design

and determine the implementation of the entity’s controls, including relevant control activities, over those

risks for which, in the auditor’s judgment, it is not possible or practicable to reduce the risks of material

misstatement at the assertion level to an acceptably low level with audit evidence obtained only from

substantive procedures.

Examples of situations where the auditor may find it impossible to design effective substantive procedures

that by themselves provide sufficient appropriate audit evidence that certain assertions are not materially

misstated include the following:

• An entity that conducts its business using IT to initiate orders for the purchase and delivery of

goods based on predetermined rules of what to order and in what quantities and to pay the related

accounts payable based on system-generated decisions initiated upon the confirmed receipt of

goods and terms of payment. No other documentation of orders placed or goods received is

produced or maintained, other than through the IT system.

• An entity that provides services to customers via electronic media (for example, an Internet service

provider or a telecommunications company) and uses IT to create log of the services provided to

its customers, initiate and process its billings for the services and automatically record such

amounts in electronic accounting records that are part of the system used to produce the entity’s

financial statements.

Revision of Risk Assessment

While performing tests of controls or substantive procedures auditor finds that controls are not performing

effectively and misstatements found are not in accordance with expectations of misstatements, the auditor

should revise his assessment of risk and modify the further planned audit procedures.

4. Communicating with those Charged with Governance and Management

The auditor should make those charged with governance or management aware, as soon as practicable, and

at an appropriate level of responsibility, of material weaknesses in the design or implementation of internal

control which have come to the auditor’s attention.

5. Documentation

The auditor should document:

(a) The discussion among the engagement team regarding the susceptibility of the entity’s financial

statements to material misstatement due to error or fraud, and the significant decisions reached;

Fundamentals of Auditing –ACC 311 VU

(b) Key elements of the understanding obtained regarding each of the aspects of the entity and its

environment, including each of the internal control components, to assess the risks of material

misstatement of the financial statements; the sources of information from which the understanding

was obtained; and the risk assessment procedures;

assertion level; and

(d) The risks identified and related controls evaluated.

Fundamentals of Auditing –ACC 311 VU

Lesson 16

ASSIGNMENT

Match each term or phrase on the left with the best description on the right. Descriptions may be used

once, more than once, or not at all.

1. Control environment. (a) Accounting system.

2. Management's philosophy (b) Adequate documents and record.

3. Functioning of the audit committee. (c) Control procedures.

4. Identify and record all valid transactions. (d) Element of the internal control structure.

5. Permit proper classification of transactions. (e) Factor that affect control environment.

6. Segregation of duties. (f) Financial statement assertion.

7. Adequate documents and records. (g) Independent check on performance.

8. Pre-numbered receiving reports (h) internal controls objective.

9. Preparation of reliable financial reports.

10. Reconciliation

ANSWER

1. (d) 2. (e) 3. (g) 4. (h) 5. (a)

6. (c) 7. (a) 8. (c) 9. (h) 10. (c)

Fill in the blanks by selecting the most appropriate word/phrase:

1. Members can appoint the auditors if they are not appointed by the Directors within 60 days of

incorporation.

i) SECP, directors, the company, members

ii) Directors, members, SECP, the company

2. The part of the Statutory Report which relates to the Receipt and Payments is required to be

certified by the auditors.

i) First extraordinary general meeting, statutory report, Annual General Meeting, First AGM

ii) Receipts and Payments, Financial Statements, Balance Sheet, Income Statement

Fundamentals of Auditing –ACC 311 VU

Lesson 17

DOCUMENTING THE INTERNAL CONTROL SYSTEM

Benefits of Internal Control to the entity

Based on our previous studies we can now identify the following principal benefits that may arise for an

entity from a sound system of internal control:

a) Assurance that all transactions are completely and accurately processed.

b) Confidence that only authorized transactions takes place.

c) Assurance that adequate documentation supporting transactions is created and retained.

d) Assurance that the company’s assets and liabilities are correctly stated, in order for them to

make informed decisions on the operations of the business.

e) Minimization of the risk of fraud and misappropriation of assets.

Benefits of Internal Control to the auditor

Of course, if the audit client benefits from a sound system of internal control, it is likely that the auditor will

also be benefited. All of the above stated benefits help to promote a situation where the financial statements

present a true and fair view. In simple terms, a good system of internal control will make life easier for the

auditor.

Auditor’s work on the Internal Control

International standards on auditing emphasize the importance of internal control to the auditor by stating

that auditor should:

a) Obtain an understanding of the accounting and internal control system sufficient to plan the

audit and develop an effective audit approach, and

b) Use professional judgment to assess the components of audit risk and to design audit

procedures to ensure it is reduced to an acceptably low level.

At an early stage in their work auditors will have to decide the extent to which they wish to place reliance on

the internal controls of the enterprise. As the audit proceeds, that decision will be kept under review and,

depending on the results of their examination, they may decide to place more or less reliance on these

controls.

Categories of Internal Control

These are often summarized by using the mnemonic SOAP MAPS as follows:

a) Supervision

b) Organization

c) Arithmetic and Accounting

d) Physical

e) Management and Monitoring

f) Authorization

g) Personnel

h) Segregation of duties

a) Supervision

There should be adequate supervision of work to ensure that controls are being complied with.

Possible application: a supervisor or manager reviews and checks the work of a subordinate.

b) Organization

Enterprises should have a formal, documented organization structure with clear lines of

responsibility.

Possible application: lines of authority within an organization make it clear which individuals are responsible

for decisions and transactions

c) Arithmetic and Accounting

The company should ensure that there are adequate controls to ensure the completeness and

accuracy of its financial records.

Fundamentals of Auditing –ACC 311 VU

Possible application: standard accounting procedures such as the use of control accounts, reconciliation

procedures and the performance of arithmetic checks on accounting records.

d) Physical

There should be adequate physical control to ensure the security and safekeeping of its assets such

as plant and machinery, valuable inventory items and cash.

Possible application: banking cash immediately, controlling access to inventory areas; electronic tagging of

inventory and portable non-current assets.

e) Management and Monitoring

There should be sufficient controls in existence to ensure management can effectively control the

business operations.

Possible application: the use of budgeting and standard costing systems; the establishment of an internal

audit department

f) Authorization

All transactions should be authorized.

Possible application: authorization of purchases, cash and bank payments, sale of non-current assets, sales

to customers on credit, bad debt write offs.

g) Personnel

Employees should be appropriately qualified and of suitable caliber to perform the required tasks.

Possible application: recruiting the right people for the job; training them effectively, motivating and

rewarding employees in an appropriate way.

h) Segregation of duties

There should be an appropriate division of responsibilities to reduce the opportunity for fraud and

manipulation.

This is a fundamental control procedure designed to ensure that one person does not have sole

charge of a transaction from beginning till end. Perfect segregation of duties exists where each of

the main stages in a transaction are under the control of a different person.

Possible application:

Consider an inventory purchasing system in a manufacturing company:

Stage Documentation Responsibility

Initiation Stores requisition Stores keeper

Authorization Purchase order Purchasing officer

Custody Goods received note Receiving officer

Recording Invoice Account department

Documenting the system

Documenting the system is an extremely important stage in the audit;

Auditing standards state that in planning the audit, auditors should obtain and document an understanding

of the accounting system and control environment sufficient to determine their audit approach.

The various methods of ascertaining and recording the system may be summarized as follows:

1. Organization chart

2. Narrative notes

3 Flowcharts

4 Internal control questionnaires (ICQs)

5 Internal control evaluation checklists (ICEC)

Fundamentals of Auditing –ACC 311 VU

Organization Chart

Managing Director

Production

Director

Sales

Director

Finance

Director

Production

Planning

Factory

Manager

Purchases

Controller

Distribution

Manager

Advertising

Manger

Manager

Accounts

Chief

Accountant

Narrative Notes

This is a simple and apparently convenient way of describing systems. Having ascertained the system, the

auditor draws up a narrative description of it for the audit files. An example might be:

Sales invoices are prepared by Mr._____ They are checked by Mr. _____ and then passed to Mr. _____ for

recording in the customer’s account in the sales ledger etc.

Shortcomings of the method:

1. Notes can take up a disproportionate amount of space

2. Notes may be difficult to interpret

3. What happens it personnel change?

Flowcharts

This is becoming an increasingly widely used technique for recording accounting systems in audit files.

A flowchart is a diagrammatical representation of an accounting system.

A good flowchart will be supplemented with narrative.

Flowcharts have the following advantages:

(i) They portray the flow of documents through the system and enable the auditor to relate those

movements with procedures and checks carried out as part of that system.

(ii) They show the movement of documents in such a way that, when properly prepared, the

sources and destinations of all documents will be clear.

(iii) They help to highlight weaknesses in the control of the business.

(iv) They enable audit tests to be clearly related to weaknesses in the accounting system.

Standard symbols are used to represent documents, operations and checks carried out.

Flow lines are used to join up the symbols and represent the movement of documents.

Dotted lines are used to represent the flow of information between documents.

Essentials of flowchart

Internal control evaluation flowcharts must highlight the following:

(a) the sequence of operations happening to each document (e.g. authorization, checking, matching, filing)

(b) the segregation of staff duties and who is responsible for each operation.

Fundamentals of Auditing –ACC 311 VU

Symbols used in manual systems flowcharts

• A document

• A multi-part set of documents

• Pre-numbered document

• A book of account

• An operation performed on a document

• A check performed on a document

• Filing a book or document

• Document flow

• Information flow

• Connector with another page/flow-line

Fundamentals of Auditing –ACC 311 VU

Flowchart of purchases

Narratives:

1 Requisition note raised when goods

are at a pre-set re-order level. Order

quantity is pre-determined by use of a

copy of the previous purchase order.

2 Signed by store manager.

3 Buyer checks authorization.

4 Purchase order set prepared.

8 P02 filed temporarily to act as a check

on overdue deliveries.

10 P04 and P05 are filed until goods are

received.

11 Weekly check on overdue deliveries.

12 Goods checked to PO to ensure they

are in agreement.

13 If not damaged, goods are accepted

and a goods received note set is raised.

Where quantity received is below order a

shortage memo set is also raised and a

note made on the purchase order.

14 P05 is sent back to the warehouse to

act as the next requisition note.

Commentary on the above flowchart

(a) All operations and checks are positioned on vertical lines within a particular department.

(b) Horizontal lines show the movement of a document between departments.

note/day books/payables ledger/cash book etc. The

flow-lines at the bottom of the page would continue to page 2 of the flowchart.

(d) Note that the narrative to the flowchart does not deal with all of the operation numbers since some

should be self-explanatory e.g. operation 9 represents the

numerical filing of P03 in the buying department.

Fundamentals of Auditing –ACC 311 VU

Lesson 18

EVALUATING THE INTERNAL CONTROL SYSTEM

Flow Charts and Internal Control Questionnaires:

Use of the major symbols in flow charts

The Document symbol

Each document in the flowchart should have a vertical flow-line. Such vertical flow-lines represent a

movement in time within a particular department. When the document is moved to another

department, this movement in position will be represented by a horizontal line; departments are

therefore listed across the page.

Here the document is originated in Dept

A. It is moved to Dept B, then Dept D and then Dept C. Note that only vertical and horizontal lines are

used, never diagonal lines.

The Operation symbol

Various operations will be performed on a document.

It will, for instance: be prepared, added up, used to prepare other documents, etc.

Any operation, other than a check function, is represented by the cross symbol.

Each operation symbol should be supported by a brief narrative explaining the nature of the operation.

Invoice

etc.

Kamran totals the invoice

Note that the operation symbol is positioned on a

vertical flow-line. It should never appear on a

horizontal flow-line since that would suggest in this

case that Kamran totals the invoice while it is

moving from one department to another.

Fundamentals of Auditing –ACC 311 VU

The Information flow symbol Here one document is

prepared from

another.

The movement of

information to the

sales invoice is shown

by a dotted line. Such

information flow-lines

are always horizontal,

never vertical.

Note that flow-lines

then continue for both

the order and the

invoice.

Sales

order

Fauzia prepares an invoice

from the sales order

This example is wrong because:

(a) no narrative exists to explain

the nature of the operation;

(b) the sales invoice has no

flow-line, it disappears into

thin air.

Sales

order

Sales

Invoice

The Check symbol

Sales

Invoice

Sattar totals the invoice

Wajid checks the totals

This example

shows a simple

check on a single

document.

Delivery

Note

Sales

Invoice

Pasha checks that all

goods dispatched have

been invoiced.

This shows a check

between two

documents.

Note the use of the

information flow-line

again and that both the

delivery note and the

sales invoice continue

with vertical flow-lines

of their own.

Fundamentals of Auditing –ACC 311 VU

The filing symbol

Once documents have been processed they will often be filed away.

Such files are either permanent or temporary.

The two sorts of file are denoted by the same symbol but the

temporary files are marked with a letter ‘T’.

It will often be useful to indicate the order of filing either numerically,

alphabetically or in chronological order. This can be done by

marking the symbol with the letter N, A, or D.

Purchase

Order

Filed awaiting delivery of

goods.

Checked by Zahoor

(weekly) got late delivery

When goods are received

purchase order initialed by

Safdar

Note that with the temporary

filing symbol the flow-line of the

document must continue.

With the permanent filing symbol

the flow-line stops since the

document has reached its

ultimate destination

The book of account symbol

The flowchart should use the book symbol to show the book which is

already in existence. It should also show the book being re-filed once the

posting is completed.

Sales

Invoice

Sales

Daybook

Sohail posts invoices to the SDB

Note that the same flow-line principles apply to books as to documents. A vertical flowline

is needed which ends with the re-filing of the sales day book which will be kept

chronologically.

Fundamentals of Auditing –ACC 311 VU

Depicting multi-part sets of documents

Requisition

Note

Purchase

order

To supplier

Rauf prepares

purchase order sets

Note that each part of the set must have a flow-line emanating from it. In this

example; PO1 is sent to the supplier, PO2 goes off to another department and PO3

is filed numerically

Preliminary Evaluation of the System

Having ascertained, confirmed and recorded the system, the auditor now needs to carry out a preliminary

evaluation of the system in order to make a decision as to whether he will:

• Rely on internal controls and adopt a systems audit approach, or,

• Perform extensive substantive testing. Using a verification approach to the audit.

Internal Control Questionnaire

Features:

• Used in large company audit

• Used to place reliance on internal controls

• Used to design audit approach

Definition:

An ICQ is a formal and usually standardized document which comprises:

1. A list of internal controls in existence and

2. Highlights any weaknesses.

Objectives:

(i) To ascertain a clients systems of accounting and internal control

(ii) To evaluate the control system thus recorded, and hence

(iii) To identify those controls which indicate strengths in the system upon which the auditor

will seek to place reliance, and

(iv) To identify those areas over which there are weak or no controls and which therefore

must be subjected to more extensive substantive testing and reported by inclusion in the

Management Letter.

Construction of an ICQ

I) It is good practice when designing ICQs to state, as a brief introduction:

i. A list of control objectives which each sub-system under consideration should

seek to achieve

ii. Any business considerations specific to the enterprise under review which

should be taken into account.

Fundamentals of Auditing –ACC 311 VU

The reason for this is essentially to highlight for the audit staff key areas for their consideration to the audit

staff.

II) The questions in an ICQ should be designed to ascertain whether the control objectives are being

achieved and should therefore cover such aspects as:

a. Instructions given to staff in the performance of their duties

b. Authorization procedures

c. Documents and procedures used to originate transactions

d. Recording procedures

e. Sequence of procedures

f. Custody procedures

g. Relative independence of the persons involved at each stage

of a transaction (i.e. segregation of duties).

III) The questions should be framed such that a Yes/No answer is given, with a No answer usually

indicating a control weakness.

IV) An ICQ should carry such basic information as:

(a) The name of the document (ICQ)

(b) the system to which it relates (e.g. purchasing cycle)

(d) the accounting period under review

(e) evidence of who has prepared and reviewed the document

(f) the provision of columns for:

- Yes and No answers

- comments where neither Yes or No are applicable

- indicating the significance or otherwise of apparent weaknesses

- references to audit programs

- references to Management Letters.

Fundamentals of Auditing –ACC 311 VU

Lesson 19

INTERNAL CONTROL QUESTIONNAIRE

Having ascertained, confirmed and recorded the system, the auditor now needs to carry out a preliminary

evaluation of the system in order to make a decision as to whether he will:

• Rely on internal controls and adopt a systems audit approach, or,

• Perform extensive substantive testing. Using a verification approach to the audit.

Internal Control Questionnaire

An ICQ is a formal and usually standardized document which comprises:

3. A list of internal controls in existence and

4. Highlights any weaknesses.

Features:

• Used in large company audit

• Used to place reliance on internal controls

• Used to design audit approach

Objectives:

(i) To ascertain a clients systems of accounting and internal control

(ii) To evaluate the control system thus recorded, and hence

(iii) To identify those controls which indicate strengths in the system upon which the auditor

will seek to place reliance, and

(iv) To identify those areas over which there are weak or no controls and which therefore

must be subjected to more extensive substantive testing and reported by inclusion in the

Management Letter.

Construction of an ICQ

(I) It is good practice when designing ICQs to state, as a brief introduction:

(a) a list of control objectives which each sub-system under consideration should seek to achieve

(b) any business considerations specific to the enterprise under review which should be taken into

account.

The reason for this is essentially to highlight for the audit staff key areas for their consideration to the audit

staff.

II) The questions in an ICQ should be designed to ascertain whether the control objectives are being

achieved and should therefore cover such aspects as:

(a) instructions given to staff in the performance of their duties

(b) authorization procedures

(d) recording procedures

(e) sequence of procedures

(f) custody procedures

(g) relative independence of the persons involved at each stage of a transaction (i.e. segregation of

duties).

(III) The questions should be framed such that a Yes/No answer is given, with a No answer usually

indicating a control weakness.

(IV) An ICQ should carry such basic information as:

(a) the name of the document (ICQ)

(b) the system to which it relates (e.g. purchasing cycle)

(d) the accounting period under review

(e) evidence of who has prepared and reviewed the document

(f) the provision of columns for:

- Yes and No answers

- comments where neither Yes or No are applicable

- indicating the significance or otherwise of apparent weaknesses

Fundamentals of Auditing –ACC 311 VU

- references to audit programs

- references to Management Letters.

Example of part of an ICQ

INTERNAL CONTROL QUESTIONNAIRE

Prepared by: ________ Date: ________

CLIENT: ___________ PERIOD: _____

Reviewed by:________ Date: ________

THE PURCHASING CYCLE

(a) Control objectives.

(b) Business considerations.

a) Control objectives

To ensure that:

(i) Purchased goods/services are ordered under proper authorities and procedures

(ii) Purchased goods/services are only ordered as necessary for the proper conduct of the business

operations and are ordered to suitable suppliers

(iii) Goods/services received are effectively inspected for quality, quantity and condition

(iv) Invoices and related documentation are properly checked and approved as being valid before

being entered as trade payables

(v) All transactions relating to trade payables are valid (suppliers invoices, credit notes and

adjustments), and only those valid transactions should be accurately recorded in the accounting

records.

b) Business considerations

Points Effect on audit procedures and on financial statements

(i) Nature of the company’s - Auditor must be aware of the

purchases. Varying nature of goods purchased.

(ii) The existence of a - As far as possible ordering should

purchasing department. be centralized.

(iii) The company’s - The fixing of minimum/maximum

purchasing policy. Inventory and re-order levels should ensure efficient control. However,

buying in bulk, with resulting higher inventory levels may be part of a

company policy to reduce unit costs, in which case inventory

obsolescence and storage cost problems may arise.

(iv) The selection of suppliers. - The purchasing department should maintain a supplier’s register to

record past purchases, prices, and satisfaction received etc. The constant

seeking of alternative sources of supply at keener prices is an indication of

efficient management

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Yes/ Initiation and authorization No Comments References

• Are standard (Purchase) order

forms (SOFs) issued showing

names of suppliers, quantities

ordered and prices?

• Are copies of SOFs retained on

file?

• Who authorizes orders and

what are their authority limits?

• Are the persons in 3 above

independent of those who issue

requisitions?

• Is a record kept, of orders placed

but not executed? (If yes, specify

type of record kept and filing

sequence).

Custody

• Are goods from suppliers

inspected on arrival as to quantity

and quality?

• How is the receipt of supplies

recorded (e.g. by Goods Received

Notes)?

• Are these records prepared by a

person independent of those

responsible for:

- ordering functions?

- processing and

- recording?

Criticism on ICQs

• ICQs represent an attempt at a formalized, systematic, approach to the audit of large complex

organizations.

• It is however increasingly apparent that such questionnaires can become too complex, lengthy and

detailed for meaningful evaluation of accounting systems.

• There is a danger that ICQs can provoke too formalized an approach to an assignment; that will be

concentrating as they do on the controls themselves rather than upon the fraud or irregularity that the controls

are designed to prevent.

Internal Control Evaluation Checklists

To overcome the above discussed possible shortcomings, many auditing practices have amended their

approach to internal control evaluation by the adoption of a different type of document, Internal Control

Evaluation Checklists (ICEC).

The ICEC is designed to determine; whether desirable internal controls are present?, using key control

questions to ascertain where specific frauds or errors are possible.

It is normally employed where system’s information has already been recorded (usually in the form of

flowcharts).

Key questions are asked in an ICEC, the answers to which prompt further supplementary questions.

Reference is made to a supporting flowchart which is the means of ascertaining the existing systems. This

makes the ICEC document shorter and less complex, but it may require more skill and judgment on the

part of the auditor to interpret the completed form.

Note that virtually all the rules applicable to the construction of an ICQ apply to the construction of an

ICEC.

Fundamentals of Auditing –ACC 311 VU

Example of ICEC

INTERNAL CONTROL EVALUATION CHECKLIST

Prepared by: ________ Date: ________

CLIENT: ___________ PERIOD: _____

Reviewed by:________ Date: ________

PURCHASES – PAYABLES – PAYMENTS

(a) Control objectives.

(b) Business considerations.

a) Control Objectives

As per ICQ

b) Business Consideration

As per ICQ

c) The Checklist

1 Purchases

Comments Reference

1.1 Can goods be purchased without authority?

(a) purchase requisitions and order approvals?

(b) limit of buyers authority to order?

accounts payable and inventory records?

(d) un issued orders safeguarded against loss?

1.2 Can liabilities be incurred although goods

not received?

(a) receiving segregated from purchasing,

accounts payable and inventory records?

(b) are all goods passed directly to stores?

(d) adequate comparison with order, claims for

short shipment etc?

(e) invoices, GRNs, direct to accounts payable not

purchasing?

(f) invoices checked to order and GRNs, prices

checked?

(g) check of extensions, additions, discounts?

(h) documents cancelled to prevent re-use?

(i) unmatched documents investigated regularly?

(j) freight checked, bills matched to

consignments?

(k) purchase returns and allowances controlled -

follow-up?

(I) forward purchases controlled?

1.3 Can cut-off errors occur?

(a) time lapse from receipt of goods to invoice processing?

(b) valuation of unmatched GRNs?

1.4 Can invoices be wrongly allocated?

(a) nominal ledger analysis?

(b) analysis independently checked?

(d) independent and regular review?

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1.5 Can liabilities be recorded for goods or services not ordered?

(a) goods received without authority?

2 Payables

2.1 Can liabilities be incurred but not recorded?

(a) payables balances agreed periodically?

(b) suppliers statements independently reconciled?

(d) forward contracts?

(e) order backlog follow up?

(f) debit balances controlled?

3 Payments

3.1 Can payments be made if not properly supported?

(a) discounts taken?

(b) control over invoices before validating complete?

preparation?

(d) signatories examine support for payment,

check completeness, cancel support?

(e) control over signature plates or pre-signed

cheques?

(f) control where one signature?

(g) frequency with which cheques mailed?

(h) independent regular bank reconciliation, with

cheques directly from bank and review

reconciliation?

(i) cheques crossed account payee only,

continuity accounted for, control over unused

cheques?

(j) bank transfers controlled - standing orders?

(k) issue of bearer or cash’ cheques?

(I) advances and loans controlled?

(m) bank transfer payments, traders credits, direct

debits?

3.2 Can payments for non-routine purchases be made if not authorized or properly

supported?

(a) services, expense accounts, taxation payments

in advance, staff purchases and goods on

consignment?

3.3 Can non-current assets be acquired or removed without proper authorization and recording?

(a) approved work orders for non-current assets

and major repairs?

(b) approval of cost over-runs?

(d) detailed non-current asset register, regular

physical inspection and review of values?

(e) periodic insurance appraisals, adequate

coverage?

(f) control over loose tools?

Limitations of the effectiveness of Internal Control

It is possible to reduce the volume of transaction testing required in conducting an audit if the internal

controls are sound and are operating effectively, but it is not likely that an auditor will be able to rely on

internal controls entirely. This is because all control systems have inherent limitations such as:

a) The need to balance the cost of the control with its benefits

Fundamentals of Auditing –ACC 311 VU

b) The fact that internal controls are applied to regular, recurring transactions, not one off year

end adjustments or unusual transactions, which are often large and subject to error.

c) The potential for human error

d) The possibility of fraudulent collusion (two or more persons operating together) to ‘get round’

controls that segregate duties. For example; the supervisor responsible for checking and

authorizing overtime claims could collude with employees, to enable excess overtime payments

to be claimed.

e) The abuse of authority and override of controls by senior managers or the owners of the

business. Abuse of authority might involve ordering personal goods through the firm. It is very

easy for directors and managers of organizations of any size to instruct staff to bypass normal

procedures such as the requirement for authorization for payments.

f) The obsolescence of controls which have not changed to reflect changes in the business

activities or organization.

In practice, the training of auditors always involves a warning never to rely on internal controls entirely, no

matter how effective they may appear to be. Hence some verification of transactions is always carried out as

part of the auditor’s work.

Fundamentals of Auditing –ACC 311 VU

Lesson 20

AUDIT TESTS

Audit evidence through Audit Procedures

The auditor needs to generate sufficient appropriate audit evidence that will allow a conclusion to be

reached based on this. Audit evidence, is obtained from audit procedures performed during the course of

audit, such as:

• Test of control (compliance test)

• Test of details (substantive test)

• Analytical procedures (substantive test)

Audit Procedures based on the understanding of Internal Control

Auditor’s understanding of the control environment, determines the audit procedures.

A strong control environment would provide more confidence about the effectiveness of internal control

and the reliability of audit evidence generated internally within the entity and thus, for example, allows the

auditor to conduct some audit procedures at an interim date rather than at period end.

If there are weaknesses in the control environment, the auditor ordinarily conducts more audit procedures

at period end rather than at an interim date, seeks more extensive audit evidence from substantive

procedures, modifies the nature of audit procedures to obtain more persuasive audit evidence, or increases

the number of locations to be included in the audit scope.

Appropriate Audit Approach

The auditor’s understanding of the internal control would enable him to select an appropriate audit

approach. These audit approaches may be as follows:

1. Apply tests of control only for a particular assertion.

2. Apply substantive procedures only for a particular assertion may be because auditor failed to

identify any effective controls relevant to assertion.

3. Combined approach i.e. applying both tests of operating effectiveness of control’s and

substantive procedures for the same assertion.

However, irrespective of the approach selected, the auditor designs and performs substantive procedures

for each material class of transactions, account balance and disclosures.

In the case of very small entities, there may not be control activities and auditor may have to apply only

substantive procedures.

Considering the Nature, Timing and Extent of Audit Procedures

Nature

The nature refers to:

• the purpose i.e. (tests of controls or substantive procedures) and

• their type, i.e. inspections, observation, inquiry confirmation, recalculation, re-performances

or analytical procedures.

Timing

Timing refers to when audit procedures are performed or the period or date to which the audit evidence

applies.

Extent

Extent refers to sample size or number of observations of a control activity (quantity of audit evidence). It

depends on auditor’s judgment after considering materiality, the assessed risk and the degree of assurance

the auditor plans to obtain.

Nature

The nature refers to the purpose i.e. (tests of controls or substantive procedures) and their type, that is,

inspections, observation, inquiry confirmation, recalculation, re-performances or analytical procedures.

Certain audit procedures may be more appropriate for some assertions than others.

Fundamentals of Auditing –ACC 311 VU

The types of procedures to be performed and their combination would be affected by the auditor’s

assessment of the risk. The higher the risk, the more reliable audit procedure would be required.

In determining the audit procedures to be performed, auditor considers inherent and control risks

associated with the particular account balance or class of transactions.

Auditor is required to obtain audit evidence about the accuracy and completeness of information produced

by the entity’s information system when that information is used for performing audit procedures.

Timing

Timing refers to when audit procedures are performed or the period or date to which the audit evidence

applies.

Tests of control and substantive procedures may be performed either at an interim date or at period end.

The higher the risk of material misstatement, the more likely it is that the auditor may consider it more

effective to perform substantive procedures near to or at the period end rather than at an earlier date or to

apply audit procedures unannounced or at unpredictable times. On the other hand performing audit

procedures before the period end may assist the auditor in identifying significant matters at early stage of

the audit, which in turn would help in resolving them or developing an effective audit strategy.

In considering when to perform audit procedures, the auditor also considers such matters as the following:

• The control environment

• When relevant information is available (for example, electronic files may subsequently be

overwritten or procedures to be observed may occur only at certain times).

• The nature of the risk (for example, if there is a risk of inflated revenues to meet earnings

expectations by subsequent creation of false sales agreements, the auditor may wish to examine

contracts available on the date of the period end).

• The period or date to which the audit evidence relates.

Certain audit procedures can be performed only at the period end.

Examples are:

• Agreeing the financial statements to the accounting records.

• Examining adjustments made during the course of preparing the financial statements.

• To cover the risk of overstatement the auditor ordinarily inspects transaction near the period end.

Extent

Extent refers to sample size or number of observations of a control activity (quantity of audit evidence). It

depends on auditor’s judgement after considering materiality, the assessed risk and the degree of assurance

the auditor plans to obtain. Extent of audit procedures is increased when the risk of material misstatement

increases.

The use of computer-assisted audit techniques (CAATs) may enable more extensive testing of electronic

transaction and account files. Such techniques can be used to select sample transaction from key electronic

files, to sort transactions with specific characteristics or to test an entire population instead of a sample.

Valid conclusions may be drawn using sampling approaches. However, in certain circumstances

examination of entire population may be more appropriate to reach a valid conclusion about that

population.

Test of Control

The auditor is required to perform tests of controls when the internal controls are operating effectively or when

substantive procedures alone do not provide sufficient appropriate audit evidence at the assertion level.

Tests of controls comprise of testing three things:

1. Design – that the internal controls are properly designed to cover the risk it is meant for.

(examined through ICQs and ICECs)

2. Implementation – that the internal controls have been put into operation.(examined through a

walk through test with a little sample)

3. Operating effectiveness – that the systems of internal control were operating effectively at

relevant times during the period. ( examined through compliance tests based on a judgmental

sample)

Fundamentals of Auditing –ACC 311 VU

Nature of Tests of Controls

These are as follows:

• Inquiry and observation (e.g. inquiry about and observation of controls over opening of mail to

verify controls over cash receipts).

• Re-performance (e.g. preparation of bank reconciliation statement);

• Inspection of documentation relevant to performance of controls;

• Applying CAATs.

• Tests of controls and tests of details may be applied simultaneously on the same transaction; tests

of control see whether e.g. invoice is approved and tests of details to detect material misstatement

in that invoice.

Timing of Tests of Controls

These may be performed at

1. a particular time or

2. on the information relating to the entire audit period.

– If performed at a particular time, it would provide evidence of operating effectiveness of

controls at that particular time. Such evidence may be sufficient for the auditor e.g.

observation of counting of inventories.

– However, if auditor wants to obtain evidence about the effective operation of controls

throughout the period under audit, then tests of control’s should be applied on

transactions of the entire period.

If auditor wants to rely on controls tested in prior periods, he should make inquiry that there is no change

in such controls. If these controls have changed, these should be tested for operating effectiveness first

before relying on these.

The auditor may not test all the controls every audit if there is no change in them. However, such controls

must be tested at least every third audit.

Extent of tests of controls

The auditor designs tests of controls to obtain sufficient appropriate audit evidence that the controls

operated effectively throughout the period of reliance. Matters the auditor may consider in determining the

extent of the tests of controls include the following:

1. The frequency of the performance of the control by the entity during the period.

2. The length of time during the audit period that the auditor is relying on the operating effectiveness

of the control.

3. The relevance and reliability of the audit evidence to be obtained in supporting that the control

prevents, or detects and corrects, material misstatements.

4. The extent to which the auditor plans to rely on the effectiveness of the control (and thereby

reduce substantive procedures based on the reliance on such control).

5. The expected deviation from the control.

Substantive Procedures

Substantive procedures are performed in order to detect material misstatements at the assertion level, and

include tests of details of classes of transactions, account balances and disclosures and substantive analytical

procedures.

The auditor plans and performs substantive procedures to be responsive to the related assessment of the

risk of material misstatement.

Irrespective of the assessment of risk of material misstatement, the auditor should design and perform

substantive procedures for each material class of transactions, account balance, and disclosure.

The auditor’s substantive procedures should include the following audit procedures related to the financial

statement closing process:

• Agreeing the financial statements to the underlying accounting records; and

• Examining material journal entries and other adjustments made during the course of preparing

the financial statements.

Fundamentals of Auditing –ACC 311 VU

When the auditor has determined that an assessed risk of material misstatement at the assertion level is a

significant risk, the auditor should perform substantive procedures that are specifically responsive to that

risk.

Nature of Substantive Procedures

Substantive analytical procedures are applied on large volume of transactions, which are predictable over

time. Tests of details are ordinarily more appropriate to obtain audit evidence regarding certain assertions

about account balances, including existence and valuation.

In designing substantive analytical procedures, the auditor considers such matters as the following:

• The suitability of using substantive analytical procedures given the assertions.

• The reliability of the data, whether internal or external from which the expectation of recorded

amounts or ratios is developed.

• Whether the expectation is sufficiently precise to identify a material misstatement at the desired

level of assurance.

• The amount of any difference in recorded amounts from expected values that is acceptable.

Timing of Substantive Procedures

When substantive procedures are performed at an interim date, the auditor should perform further

substantive procedures or substantive procedures combined with tests of controls to cover the remaining

period that provide a reasonable basis for extending the audit conclusions from the interim date to the

period end.

In considering whether to perform substantive procedures at an interim date the auditor considers such

factors as the following:

• The control environment and other relevant controls.

• The availability of information at a later date that is necessary for the auditor’s procedures.

• The objective of the substantive procedure.

• The assessed risk of material misstatement.

• The nature of the class of transactions or account balance and related assertions.

• The ability of the auditor to perform appropriate substantive procedures or substantive procedures

combined with tests of controls to cover the remaining period in order to reduce the risk that

misstatements that exist at period end are not detected.

If substantive procedures are performed at an interim date, the auditor may sometimes consider applying

tests of controls also on the transactions of remaining period while extending his substantive procedures

from interim date to the period end.

In situations of actual or expected fraud, auditor may prefer applying substantive procedures at period end.

If misstatements are detected in classes of transactions or account balances at an interim date, the auditor

ordinarily modifies the related assessment of risk and the planned nature, timing or extent of the substantive

procedures covering the remaining period.

Substantive procedures applied in a prior period are not sufficient to address a risk of material misstatement

in the current year except in certain circumstances.

Extent of performance of substantive procedures

Greater the risk of material misstatement due to weaknesses in the system of internal control, the greater

would be the risk of material misstatement in the financial statements.

In designing tests of details, the auditor may use either audit sampling or may choose to select items to be

tested by some other selective means of testing.

Adequacy of Presentation and Disclosure

The auditor should perform audit procedures to evaluate whether the overall presentation of the financial

statements, including the related disclosures, are in accordance with the applicable financial reporting

framework.

Fundamentals of Auditing –ACC 311 VU

Lesson 21

SUBSTANTIVE PROCEDURES

Auditing

Auditor’s Opinion (depends upon)

Reasonable Assurance (depends upon)

Sufficient Appropriate Audit evidence

(depends upon)

Audit procedures

» Test of Control

» Substantive Procedures

• Test of details

• Analytical procedures

Test of Control

The auditor is required to perform tests of controls:

• When the internal controls are operating effectively or

• When substantive procedures alone do not provide sufficient appropriate audit evidence at the

assertion level.

Tests of controls comprise of testing three things:

1. Design – that the internal controls are properly designed to cover the risk it is meant for.

2. Implementation – that the internal controls have been put into operation.

3. Operating effectiveness – that the systems of internal control were operating effectively at

relevant times during the period.

How to perform test of control

• Testing the Design:

– Proper design of internal control is tested through ICQs and ICEC.

• Testing the Implementation:

– Implementation of internal control is tested through walk through test with a little sample

size.

• Testing the Operating effectiveness:

– Here the test is performed through a compliance test based on a judgmental sample.

Substantive Procedures

Substantive procedures are performed in order to detect material misstatements at the assertion level (like;

occurrence, completeness, accuracy, valuation, existence, rights and control), and include tests of details of

classes of transactions, account balances and disclosures and substantive analytical procedures.

The auditor plans and performs substantive procedures to be responsive to the related assessment of the

risk of material misstatement.

Irrespective of the assessment of risk of material misstatement, the auditor should design and perform

substantive procedures for each material class of transactions, account balance, and disclosure.

Fundamentals of Auditing –ACC 311 VU

The auditor’s substantive procedures should include the following audit procedures related to the financial

statement closing process:

• Agreeing the financial statements to the underlying accounting records; and

• Examining material journal entries and other adjustments made during the course of preparing

the financial statements.

When the auditor has determined that an assessed risk of material misstatement at the assertion level is a

significant risk, the auditor should perform substantive procedures that are specifically responsive to that

risk.

Types of Substantive Procedures

• Test of details

– Land Registry

– Debtors Circular

– Building rent Deed/Agreement

• Analytical procedures

– Payroll Turnover ratio

Comparing with previous

month’s salary

– Production Cost Comparing with the number of

units produced

Comparing with the previous month’s

cost of production

Nature of Substantive Procedures

Substantive analytical procedures are applied on large volume of transactions, which are predictable over

time.

• Tests of details are ordinarily more appropriate to obtain audit evidence regarding certain assertions

about account balances, including existence and valuation.

• Analytical procedures are applied on large volume of transactions, which are predictable over time.

(cost of goods sold, payroll, sale)

In designing substantive analytical procedures, the auditor considers such matters as the following:

• The suitability of using analytical procedures given the assertions.

If controls, over sales order processing, are weak; the auditor may place more reliance on tests of details

rather than substantive analytical procedures for assertions related to debtors.

When auditing the collectibility of accounts receivable, the auditor may apply substantive analytical

procedures to an aging of customers’ accounts in addition to tests of details on subsequent cash receipts.

• The reliability of the data;

In determining whether data is reliable for purposes of designing substantive analytical procedures, the

auditor considers the following:

o Information is ordinarily more reliable when it is obtained from independent sources outside the

entity

o Comparability of the information available

o Nature and relevance of the information available (whether budgets have been established as

results to be expected rather than as goals to be achieved.

o Controls over the preparation of the information (controls over the preparation, review and

maintenance of budgets)

• Whether the expectation is sufficiently precise to identify a material misstatement at the desired level of

assurance.

For this the auditor considers the following facts:

i. The accuracy with which the expected results of substantive analytical procedures can be

predicted (comparison of GP ratio should be consistent rather than the ratio of discretionary

expenses like entertainment)

Fundamentals of Auditing –ACC 311 VU

ii. The degree to which information can be disaggregated (effective analysis will be of a component

not of the entity as a whole)

iii. The availability of the information, both financial and non financial (budgets are financial,

whereas units of production are non financial)

• The amount of any difference in recorded amounts from expected values that is acceptable.

Depends upon the:

i. materiality

ii. Possibility of misstatement in the specific account balance, class of transactions, or disclosure

Timing of Substantive Procedures

YEAR END SUBSTANTIVE PROCEDURES ARE ALWAYS MORE RELIABLE

When substantive procedures are performed at an interim date, the auditor should perform further

substantive procedures or substantive procedures combined with tests of controls to cover the remaining

period that provide a reasonable basis for extending the audit conclusions from the interim date to the

period end.

In considering whether to perform substantive procedures at an interim date the auditor considers such

factors as the following:

• The control environment and other relevant controls. (Like payroll disbursement)

• The availability of information at a later date that is necessary for the auditor’s procedures (prov for

doubtful debts can be investigated interim but debtor and inventory can be verified at the year end).

• The objective of the substantive procedure.

• The assessed risk of material misstatement (prefer always at year end).

• The nature of the class of transactions or account balance and related assertions (like frequency of

occurrence of the transactions e.g. salaries are paid monthly whereas bonuses are paid annually).

• The ability of the auditor to perform appropriate substantive procedures or substantive procedures

combined with tests of controls to cover the remaining period in order to reduce the risk that

misstatements that exist at period end are not detected (staffing problem that cannot make the

auditor able to extend till the year end)

If substantive procedures are performed at an interim date, the auditor may sometimes consider applying

tests of controls also on the transactions of remaining period while extending his substantive procedures

from interim date to the period end.

In situations of actual or expected fraud, auditor may prefer applying substantive procedures at period end.

If misstatements are detected in classes of transactions or account balances at an interim date, the auditor

ordinarily modifies the related assessment of risk and the planned nature, timing or extent of the substantive

procedures covering the remaining period.

Substantive procedures applied in a prior period are not sufficient to address a risk of material misstatement

in the current year except in certain circumstances.

Extent of performance of substantive procedures

Greater the risk of material misstatement due to weaknesses in the system of internal control, the greater

would be the risk of material misstatement in the financial statements.

In designing tests of details, the auditor may use either audit sampling or may choose to select items to be

tested by some other selective means of testing.

Adequacy of Presentation and Disclosure

The auditor should perform audit procedures to evaluate whether the overall presentation of the financial

statements, including the related disclosures, are in accordance with the applicable financial reporting

framework.

Assertions in obtaining Audit Evidence

(a) Assertions about classes of transactions and events for the period under audit;

i. Occurrence – transactions and events that have been recorded have occurred and pertain

to the entity;

Fundamentals of Auditing –ACC 311 VU

ii. Completeness – all transactions and events that should have been recorded have been

recorded;

iii. Accuracy – amounts and other data relating to recorded transactions and events have been

recorded appropriately.

iv. Cutoff – transactions and events have been recorded in the proper period.

v. Classification – transactions and events have been recorded in the proper accounts.

(b) Assertions about account balances at the period end.

i. Existence – assets, liabilities, and equity interests exist;

ii. Rights and obligations – the entity holds or controls the rights to assets, and liabilities are

the obligations of the entity;

iii. Completeness – all assets, liabilities and equity interests that should have been recorded

have been recorded;

iv. Valuation and allocation – assets, liabilities, and equity interests are included in the financial

statements at appropriate amounts and any resulting valuation or allocation adjustments

are appropriately recorded.

i. Occurrence and rights and obligations – disclosed events, transactions and other matters

have occurred and pertain to the entity;

ii. Completeness – all disclosures that should have been included in the financial statements

have been included;

iii. Classification and understandability – financial information is appropriately presented and

described, and disclosures are clearly expressed;

iv. Accuracy and valuation – financial and other information are disclosed fairly and at

appropriate amounts.

Audit Procedures for obtaining Audit Evidence

The auditor uses one or more types of audit procedures described below:

(i) Inspection of Records or Documents

It consists of examining records or documents whether internal or external, in paper form, electronic form,

or other media. Inspection provides evidence of varying degrees of reliability depending on their nature and

source and in the case of internal records, on effectiveness of controls over their production.

(ii) Inspection of Tangible Assets

It consists of physical examination of the assets. It may provide reliable audit evidence of their existence

cannot necessarily about other assertions.

(iii) Inquiry

It means seeking information of knowledgeable persons throughout the entity or outside the entity. Those

may be formal written or informal oral. It provides an auditor with new information or corroborative

evidences. It may also bring to high information different from the one possessed by the auditor. Certain

oral inquiries might be got confirmed through written representations.

(iv) Confirmations

It is a specific type of inquiry. It is the process of obtaining a representation of information or an existing

condition directly from a third party. Confirmations are sought from debtors, creditors, bankers, legal

advisors etc.

Fundamentals of Auditing –ACC 311 VU

Lesson 22

AUDIT EVIDENCE

Auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on

which to base the audit opinion.

Concept of Audit Evidence

Audit evidence is all the information used by the auditor in arriving at the conclusions on which his opinion

is based and includes the information contained in the accounting records underlying the financial

statements and other information. It is obtained from audit procedures performed during the course of

audit and may include audit evidence obtained from other sources such as pervious audits and a firm’s

quality control procedures for client acceptance and continuance.

Accounting records generally include the records of initial entries and supporting records, such as checks

and records of electronic fund transfers; invoices; contracts; the general and subsidiary ledgers, journal

entries and other adjustments to the financial statements that are not reflected in formal cost allocations,

computations, reconciliations and disclosures. The entries in the accounting records are often initiated,

recorded, processed and reported in the electronic form. In addition, the accounting records may be part of

integrated systems that share data and support all aspects of the entity’s financial reporting, operations and

compliance objectives.

Auditor obtains most of the audit evidence from accounting records of the entity. If accounting records do

not provide sufficient audit evidence, the auditor obtains other audit evidence.

Other information that the auditor may use as audit evidence includes:

• minutes of meetings;

• confirmations from third parties,

• analysis’ reports;

• comparable data about competitors (benchmarking);

• controls manuals;

• information obtained by the auditor from such audit procedures as inquiry, observation; and

inspection;

• and other information developed by, or available to, the auditor that permits the auditor to reach

conclusions through valid reasoning.

Sufficient appropriate Audit Evidence

Sufficiency: The measure of quantity of audit evidence.

Appropriateness: The measure of quality i.e. relevance and reliability in providing support of

detecting misstatements in account balance classes of transactions and disclosures and relevant assertions.

The quantity of audit evidence needed is affected by:

- the risk of misstatement (the greater the risk, the more audit evidence is likely to be required); and

- the quality of such audit evidence (the higher the quality, the less may be required).

Accordingly sufficiency and appropriateness are interrelated. However, merely obtaining more audit

evidence may not compensate for its poor quality.

Audit evidence obtained through same audit procedures may be relevant to certain assertions but not

relevant to other assertions.

The auditor often obtains evidence about an assertion from different sources or of different nature.

Evidence about an assertion is not a substitute for evidence regarding another assertion.

Sources of obtaining Audit Evidence

i) Internal source - through accounting system, management, employees, underlying documentation

etc.

ii) External source - third parties, i.e. suppliers, customers bankers legal advisers and other parties

who have knowledge of the enterprise.

Fundamentals of Auditing –ACC 311 VU

Nature of Audit Evidence

i) Visual

ii) Oral

iii) Documentary

Reliability of Audit Evidence - Generalizations

Following generalizations are considered useful in assessing the reliability of audit evidence (subject to

certain important exceptions):

i) Audit evidence obtained from independent sources outside the entity is more reliable.

ii) Evidence generated internally is more reliable when related controls are effective.

iii) Evidence obtained by an auditor directly is more reliable than that obtained indirectly or by

interference e.g. Bank balance confirmation certificate received by an auditor is more reliable than the bank

statement obtained from the management or observation of a control rather than making inquiry about the

application of a control.

iv) Written evidence is more reliable than oral representation.

v) Audit evidence provided by original documents is more reliable than that provided by

photocopies and facsimiles.

Other factors relating to Audit Evidence

i) Information on which audit procedures are based should be sufficiently accurate and

complete. Therefore, auditor should also test the system for generating such information

while using it for his procedures.

ii) Auditor’s reliance increases when audit evidence obtained from one source is consistent

with another source; if it is inconsistent further procedures may be performed.

iii) Cost of obtaining the audit evidence is also considered when obtaining it.

iv) While forming an audit opinion, the auditor does not have to examine all the items or

obtain all the evidences which might be available. He can reach a conclusion by examining

a sample of such transactions. He also relies on persuasive evidences. However, if evidence

is less than persuasive, he does not consider it reliable.

Assertions in obtaining Audit Evidence

(a) Assertions about classes of transactions and events for the period under audit;

(i) Occurrence – transactions and events that have been recorded have occurred and

pertain to the entity;

(ii) Completeness – all transactions and events that should have been recorded have

been recorded;

(iii) Accuracy – amounts and other data relating to recorded transactions and events

have been recorded appropriately.

(iv) Cutoff – transactions and events have been recorded in the proper period.

(v) Classification – transactions and events have been recorded in the proper

accounts.

(b) Assertions about account balances at the period end.

(i) Existence – assets, liabilities, and equity interests exist;

(ii) Rights and obligations – the entity holds or controls the rights to assets, and

liabilities are the obligations of the entity;

(iii) Completeness – all assets, liabilities and equity interests that should have been

recorded have been recorded;

(iv) Valuation and allocation – assets, liabilities, and equity interests are included in the

financial statements at appropriate amounts and any resulting valuation or

allocation adjustments are appropriately recorded.

(i) Occurrence and rights and obligations – disclosed events, transactions and other

matters have occurred and pertain to the entity;

(ii) Completeness – all disclosures that should have been included in the financial

statements have been included;

Fundamentals of Auditing –ACC 311 VU

(iii) Classification and understandability – financial information is appropriately

presented and described, and disclosures are clearly expressed;

(iv) Accuracy and valuation – financial and other information are disclosed fairly and

at appropriate amounts.

Audit procedures for obtaining audit evidence

Auditor performs audit procedures to obtain an understanding of the entity, its environment and to assess

risks of material misstatement. Procedures are also applied to test operating effectiveness of internal

controls and for detection of material misstatements at assertion level.

The auditor always performs risk assessment procedures to provide a satisfactory basis for assessment of

risks at financial statement level. In addition to these risk assessment procedures, which alone are not

sufficient, the auditor performs audit procedures in the form of tests of control and substantive procedures.

Tests of controls are applied when auditor expects to rely on operating controls. Through tests of controls,

he tests the controls to support the risk assessment. These are also applied when substantive procedures

alone do not provide sufficient appropriate audit evidence.

Nature and timing of audit procedures may be affected by the entity’s data retention policies or their

practice to convert source documents into computer images through scanning, means of communication

being used by the entity e.g. electronic messaging rather than written purchase orders.

The auditor uses one or more types of audit procedures described below:

(i) Inspection of Records or Documents

It consists of examining records or documents whether internal or external, in paper form,

electronic form, or other media. Inspection provides evidence of varying degrees of reliability

depending on their nature and source and in the case of internal records, on effectiveness of

controls over their production.

(ii) Inspection of Tangible Assets

It consists of physical examination of the assets. It may provide reliable audit evidence of their

existence cannot necessarily about other assertions.

(iii) Inquiry

It means seeking information of knowledgeable persons throughout the entity or outside the entity.

Those may be formal written or informal oral. It provides an auditor with new information or

corroborative evidences. It may also bring to high information different from the one possessed by

the auditor. Certain oral inquiries might be got confirmed through written representations.

(iv) Confirmations

It is a specific type of inquiry. It is the process of obtaining a representation of information or an

existing condition directly from a third party. Confirmations are sought from debtors, creditors,

bankers, legal advisors etc.

(v) Recalculation

It consists of checking the mathematical accuracy of documents or records. It can be performed

through use of information technology.

(vi) Re-performance

It is the auditor’s independent execution of procedures or controls that were originally performed

as part of the entity’s internal control, either manually or through the use of CAATs, for example,

re-performing the aging of accounts receivable.

(vii) Analytical procedures

It consists of evaluations of financial information made by a study of plausible relationship among

both financial and non-financial data. It includes investigation of significant fluctuations found and

the relationship that are inconsistent.

Fundamentals of Auditing –ACC 311 VU

Lesson 23

SUFFICIENT APPROPRIATE AUDIT EVIDENCE

AND

TESTING THE SALES SYSTEM

Recap:

Audit evidence includes: the information contained in the accounting records underlying the financial

statements.

Audit evidence might include:

• Documents (invoices, credit notes, cash receipts)

• Accounting entries (write down to NRV, depreciation)

• Answers from the management (Provisions)

• Information from third parties (banks, debtors)

• Computations (depreciation, accruals, provisions)

• Observations (inventory count)

Sufficiency: The measure of quantity of audit evidence.

Appropriateness: The measure of quality i.e. relevance and reliability of audit evidence.

Key questions for the auditor to consider therefore will be:

1. Do I have enough evidence to reach a conclusion on this audit area?

2. Is the evidence that I have, reliable enough to, allow me to reach a conclusion on this area of the

audit?

Assertions in obtaining Audit Evidence

(a) Assertions about classes of transactions and events for the period under audit;

i. Occurrence – transactions and events that have been recorded have occurred and pertain

to the entity;

ii. Completeness – all transactions and events that should have been recorded have been

recorded (accruals & depreciation);

iii. Accuracy – amounts and other data relating to recorded transactions and events have been

recorded appropriately. (valuation and estimations)

iv. Cutoff – transactions and events have been recorded in the proper period.

v. Classification – transactions and events have been recorded in the proper accounts.

(b) Assertions about account balances at the period end.

i. Existence – assets, liabilities, and equity interests exist;

ii. Rights and obligations – the entity holds or controls the rights to assets, and liabilities are

the obligations of the entity;

iii. Completeness – all assets, liabilities and equity interests that should have been recorded

have been recorded;

iv. Valuation and allocation – assets, liabilities, and equity interests are included in the financial

statements at appropriate amounts and any resulting valuation or allocation adjustments

are appropriately recorded.

i. Occurrence and rights and obligations – disclosed events, transactions and other matters

have occurred and pertain to the entity;

ii. Completeness – all disclosures that should have been included in the financial statements

have been included;

iii. Classification and understandability – financial information is appropriately presented and

described, and disclosures are clearly expressed;

iv. Accuracy and valuation – financial and other information are disclosed fairly and at

appropriate amounts.

Audit procedures for obtaining Audit Evidence

The auditor uses one or more types of audit procedures described below:

Fundamentals of Auditing –ACC 311 VU

(i) Inspection of Records or Documents

It consists of examining records or documents whether internal or external, in paper form,

electronic form, or other media. Inspection provides evidence of varying degrees of reliability

depending on their nature and source and in the case of internal records, on effectiveness of

controls over their production.

(ii) Inspection of Tangible Assets

It consists of physical examination of the assets. It may provide reliable audit evidence of their

existence cannot necessarily about other assertions.

(iii) Inquiry

It means seeking information of knowledgeable persons throughout the entity or outside the entity.

Those may be formal written or informal oral. It provides an auditor with new information or

corroborative evidences. It may also bring to high information different from the one possessed by

the auditor. Certain oral inquiries might be got confirmed through written representations.

(iv) Confirmations

It is a specific type of inquiry. It is the process of obtaining a representation of information or an

existing condition directly from a third party. Confirmations are sought from debtors, creditors,

bankers, legal advisors etc.

(v) Recalculation

It consists of checking the mathematical accuracy of documents or records. It can be performed

through use of information technology.

(vi) Re-performance

It is the auditor’s independent execution of procedures or controls that were originally performed

as part of the entity’s internal control, either manually or through the use of CAATs, for example,

reperforming the aging of accounts receivable.

(vii) Analytical procedures

It consists of evaluations of financial information made by a study of plausible relationship among

both financial and non-financial data. It includes investigation of significant fluctuations found and

the relationship that are inconsistent.

TESTING THE SALES SYSTEM

Control Objectives

For many businesses, sales are made on credit and so objectives for the sales cycle includes control debtors

as well.

These control objectives include:

a) Customers' orders should be authorized, controlled and recorded in order to execute them

promptly

b) Goods shipped and work completed should be controlled to ensure that invoices are issued and

revenue recorded for all sales.

c) Goods returned and claims by customers (for example, in respect of damaged goods) should be

controlled in order to determine the liability for goods returned and claims received. .

d) Invoices and credits should be appropriately checked for accuracy and should be authorized before

being entered in the receivables' records.

e) Authorized customer transactions, and only those transactions, should be accurately entered in the

accounting records.

f) There should be procedures to ensure that sales invoices are subsequently paid by customers and

that doubtful amounts are identified in order to determine any provisions or write offs required

Control procedures over sales and debtors

There are a large number of controls that may be required in the sales cycle due to the importance of this

area in any business and the possible opportunities that exist for diverting sales and cash receipts away from

the business.

Typical control procedures at key stages of the sales cycle are:

1. Orders

2. Dispatch

3. Invoicing and credit notes

Fundamentals of Auditing –ACC 311 VU

4. Returns inwards

5. Receivables

6. Bad Debts

(a) Orders

(i) Existing customers should be allocated a credit limit and it should be ascertained whether this limit

is to be exceeded if the new order is accepted. If so the matter should be referred to credit control.

(ii) Any new customer should be referred to the credit control department before the order is accepted.

(iii) All orders received should be recorded on pre-numbered sales order documents so that a check can

be made that all orders have been dealt with -a completeness check.

(iv) All orders should be authorized before any goods are dispatched.

(v) The sales order document should be used to produce a dispatch note for the goods outwards

department. No goods may be dispatched without a dispatch note.

(b) Dispatch

(i) Dispatch notes should be pre-numbered and a register kept of them to enable them to be matched

with relate to sales invoices and customer orders.

(ii) Dispatch notes should be authorized before goods leave the company.

(iii) Regular checks should be made to ensure that all dispatches have been invoiced.

(i) Sales invoices should be authorized by a responsible official and matched with the authorized order

and dispatch note.

(ii) All invoices and credit notes should be entered In daybook records, the sales ledger, and sales

ledger control account. Batch totals should be maintained for this purpose.

(iii) Sales invoices and credit notes should be checked for prices. casts and calculations by a person

other than the one preparing the invoice.

(iv) All invoices and credit notes should be serially pre-numbered and regular sequence checks should

be carried out.

(v) Credit notes should be authorized by someone unconnected with dispatch or sales ledger functions.

(vi) Copies of cancelled invoices should be retained.

(vii) Any cancellation of an invoice should lead to a cancellation of the related dispatch note.

(viii) Cancelled (and free of charge) invoices should be signed by a responsible official.

(ix) Each invoice should distinguish between different types of sales and, if relevant, different rates of

VAT or sales tax. Any coding of invoices should be periodically checked independently

(d) Returns

(i) Any goods returned by the customer should be checked for obvious damage and, when accepted. a

document should be raised.

(ii) All goods returned should be used to prepare appropriate credit notes

(e) Receivables/Debtors

(i) A receivables ledger control account should be prepared regularly and checked to individual sales

ledger balances by an Independent official.

(ii) Receivables ledger personnel should be independent of dispatch and cash receipt functions.

(iii) Statements should be sent regularly to customers.

(iv) Formal procedures should exist for following up overdue debts which should be highlighted either

by the preparation of an aged list of balances or by the preparation of regular customer statements.

(v) Letters should be sent to customers for collection of overdue debts. A policy should be in place for

the Institution of legal proceeds where appropriate.

f) Bad debts

(i) The authority to write off a bad debt should be in writing. Appropriate adjustments should be

made to the sales ledger and the control account

Fundamentals of Auditing –ACC 311 VU

(ii) The use of court action or the writing-off of a bad debt should be authorised by an official

independent of the cash receipt function.

Tests of Control

Tests of control should be designed to check that the control procedures are being applied and that

objectives are being achieved. Tests may be appropriate under the following broad headings.

(a) Carry out sequence test checks on invoices, credit notes, dispatch notes and orders. Ensure that all

items are included and that there are no omissions or duplications.

(b) Check the existence of evidence for authorization in respect of:

i. acceptance of the order (the creditworthiness check)

ii. dispatch of goods

iii. raising of the invoice or credit note

iv. pricing and discounts

v. write-off of bad debts.

Check both that the relevant signature exists and that the control has been applied.

i. invoices, including pricing, and VAT and sales tax calculations

ii. credit notes,

This is often done by means of a 'grid stamp' containing several signatures on the face of the document.

Ensure that the control has been applied by checking the accuracy of such invoices and credit notes.

(d) Check dispatch notes and goods returned notes to ensure that they are matched with invoices and

credit notes.

(e) Check that control account reconciliations have been performed and reviewed.

In all cases, tests should be performed on a sample basis.

Fundamentals of Auditing –ACC 311 VU

Lesson 24

TESTING THE SALES SYSTEM

Control Objectives

For many businesses, sales are made on credit and so objectives for the sales cycle includes control debtors

as well.

These control objectives include:

a) Customers' orders should be authorized, controlled and recorded in order to execute them

promptly

b) Goods shipped and work completed should be controlled to ensure that invoices are issued and

revenue recorded for all sales.

c) Goods returned and claims by customers (for example, in respect of damaged goods) should be

controlled in order to determine the liability for goods returned and claims received. .

d) Invoices and credits should be appropriately checked for accuracy and should be authorized before

being entered in the receivables' records.

e) Authorized customer transactions, and only those transactions, should be accurately entered in the

accounting records.

f) There should be procedures to ensure that sales invoices are subsequently paid by customers and

that doubtful amounts are identified in order to determine any provisions or write offs required

Control Procedures over Sales and Debtors