UNIT 3: AUDITING PRINCIPLES AND TOOLS UNIT 3: AUDITING PRINCIPLES AND TOOLS
3.0 AIMS AND OBJECTIVE 3.0 AIMS AND OBJECTIVE
When you have studied this unit you should be able to: When you have studied this unit you should be able to:
be aware of basic auditing principles.be aware of basic auditing principles.
be aware of planning issues for an audit.be aware of planning issues for an audit.
state the typical contents of working papers.state the typical contents of working papers.
describe sampling as applied to auditing.describe sampling as applied to auditing.
3.1
3.1 INTRODUCTIONINTRODUCTION
The objectives of each audit must be clearly specified in order to ensure appropriate goal The objectives of each audit must be clearly specified in order to ensure appropriate goal achievement. Appropriate auditing principles and standards should be developed by auditors to achievement. Appropriate auditing principles and standards should be developed by auditors to direct the objectives.
direct the objectives.
Audit planning is a vital area of the audit which is primarily conducted at the beginning of the Audit planning is a vital area of the audit which is primarily conducted at the beginning of the audit process.
audit process.
This unit also considers the basic contents of audit working papers and audit sampling. This unit also considers the basic contents of audit working papers and audit sampling.
3.2
3.2 AUDIT OBJECTIVESAUDIT OBJECTIVES
The objective of the ordinary examination of financial statements by the auditor is expression of The objective of the ordinary examination of financial statements by the auditor is expression of an opinion on the fairness of the financial statements. It is customary in the audit to identify an opinion on the fairness of the financial statements. It is customary in the audit to identify audit objectives for the audit in general and for each account reported in the financial statements. audit objectives for the audit in general and for each account reported in the financial statements. These objectives are
These objectives are derived fromderived from management’s assertions. management’s assertions.
The auditor’s objectives are closely related to management assertions.
The auditor’s objectives are closely related to management assertions. Audit objectives areAudit objectives are intended to provide a framework to help the auditor accumulate sufficient and competent intended to provide a framework to help the auditor accumulate sufficient and competent evidence required by the third standard of fieldwork and decide the proper evidence to evidence required by the third standard of fieldwork and decide the proper evidence to accumulate given the circumstances of the engagement.
accumulate given the circumstances of the engagement.
A distinction must be made between
account balance but stated in broad terms. Specific audit objectives are applied to each account account balance but stated in broad terms. Specific audit objectives are applied to each account balance on the financial statement.
balance on the financial statement.
The relevance of the audit evidence should be considered in relation to the general audit The relevance of the audit evidence should be considered in relation to the general audit objectives of statements. To achieve this objective the auditor needs to support the following objectives of statements. To achieve this objective the auditor needs to support the following financial statement assertions (i.e. assertions by management embodied in the financial financial statement assertions (i.e. assertions by management embodied in the financial statements).
statements). 1.
1. Existence: - an asset or liability exists at a given date. Auditors spend a great deal ofExistence: - an asset or liability exists at a given date. Auditors spend a great deal of time on this assertion confirming the existence of assets such as inventories, plant assets, time on this assertion confirming the existence of assets such as inventories, plant assets, receivable, and cash. Clearly this is a fundamental assertion; no other assertion is receivable, and cash. Clearly this is a fundamental assertion; no other assertion is relevant if the asset or liability does not exist.
relevant if the asset or liability does not exist. 2.
2. Completeness: - there are no unrecorded assets or liabilities, transaction or events.Completeness: - there are no unrecorded assets or liabilities, transaction or events. 3.
3. Occurrence: - a transaction or event occurred during the relevant accounting period (i.e.Occurrence: - a transaction or event occurred during the relevant accounting period (i.e. has correct cut-off been applied?).
has correct cut-off been applied?). 4.
4. Measurement: - a transaction or event is recorded at the proper amount and in theMeasurement: - a transaction or event is recorded at the proper amount and in the correct period.
correct period. 5.
5. Ownership: - an asset pertains (i.e. belongs) to the entity.Ownership: - an asset pertains (i.e. belongs) to the entity. 6.
6. Valuation: -Valuation: - the asset or liability is recorded at an appropriate carrying value. the asset or liability is recorded at an appropriate carrying value. 7.
7. Presentation and disclosure: -Presentation and disclosure: - must be in accordance with the relevant legislation and must be in accordance with the relevant legislation and accounting standards (i.e. the applicable financial reporting framework). E.g.
accounting standards (i.e. the applicable financial reporting framework). E.g.
Is n/r with 5 years maturity presented under investment?Is n/r with 5 years maturity presented under investment?
Is land held for sale purpose presented under investment section?Is land held for sale purpose presented under investment section?
Is gain from sale of fixed asset presented under other income?Is gain from sale of fixed asset presented under other income?
After the general objectives are understood, specific objectives for each account balance on the After the general objectives are understood, specific objectives for each account balance on the financial statements can be developed.
financial statements can be developed.
Check Your Progress Exercise-1 Check Your Progress Exercise-1
1. What are assertions and what are the seven classifications of assertions? 1. What are assertions and what are the seven classifications of assertions?
……… ……… ……… ……… ……….
3.3
3.3 AUDITING PRINCIPLESAUDITING PRINCIPLES
Auditing principles are generally, guidelines that help direct or chart goals and aims. Principles Auditing principles are generally, guidelines that help direct or chart goals and aims. Principles are based on concepts or assumptions, and/or developed from particular observations. The are based on concepts or assumptions, and/or developed from particular observations. The following are the basic principles:
following are the basic principles:
(a)
(a) Integrity, objectivity and independenceIntegrity, objectivity and independence. The auditor should be straightforward,. The auditor should be straightforward, honest, and sincere in his approach to his professional work.
honest, and sincere in his approach to his professional work. (b)
(b) Confidentiality: -Confidentiality: - the audit should respect the confidentiality of information acquired in the audit should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party the course of his work and should not disclose any such information to a third party without specific authority unless there is legal or professional duty to disclose.
without specific authority unless there is legal or professional duty to disclose. (c)
(c) Skills and competence: -Skills and competence: - the audit should be performed and the reports prepared with the audit should be performed and the reports prepared with due professional care by persons who have adequate training, experience and due professional care by persons who have adequate training, experience and competence in auditing.
competence in auditing. (d)
(d) Documentation: -Documentation: - the auditor should document matters which are important in providing the auditor should document matters which are important in providing evidence that the auditor was carried out with the basic principles.
evidence that the auditor was carried out with the basic principles. (e)
(e) Planning: -Planning: - the auditor should plan his work to enable him to conduct an effective audit the auditor should plan his work to enable him to conduct an effective audit in efficient and timely manner.
in efficient and timely manner. (f)
(f) Audit evidence:Audit evidence: - the auditor should obtain sufficient appropriate audit evidence through - the auditor should obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable him to draw the performance of compliance and substantive procedures to enable him to draw conclusion there from and give opinion on the financial statements.
conclusion there from and give opinion on the financial statements. (g)
(g) Accounting system and internal control:Accounting system and internal control: The auditor should gain or understanding of The auditor should gain or understanding of the accounting system and related internal controls to determine the nature, extent, and the accounting system and related internal controls to determine the nature, extent, and timing of audit procedures.
timing of audit procedures.
3.4 AUDIT STANDARDS 3.4 AUDIT STANDARDS
Standards are authoritative rules for measuring the quality of performance. The existence of Standards are authoritative rules for measuring the quality of performance. The existence of generally accepted auditing standards is evidence that auditors are very concerned with the generally accepted auditing standards is evidence that auditors are very concerned with the maintenance of a uniformly high quality of audit work by all independent public accountants. maintenance of a uniformly high quality of audit work by all independent public accountants. The 10 GAAS are stated in their entirety as follows:
The 10 GAAS are stated in their entirety as follows:
1.
1. The examination is to be performed by a person or persons having adequate technicalThe examination is to be performed by a person or persons having adequate technical training and proficiency as auditor.
training and proficiency as auditor. 2.
2. In all matters relating to the assignment, an independence in mental attitude is to beIn all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors.
maintained by the auditor or auditors. 3.
3. Due professional care is to be exercised in the performance of the examination and theDue professional care is to be exercised in the performance of the examination and the preparation of the report.
preparation of the report.
Standards of fieldwork Standards of fieldwork 1.
1. The work is to be adequately planned and assistants, if any, are to be properly supervised.The work is to be adequately planned and assistants, if any, are to be properly supervised. 2.
2. The auditor should obtain a sufficient understanding of the internal control structure to planThe auditor should obtain a sufficient understanding of the internal control structure to plan the audit and to determine the nature, extent and timing of tests to be performed.
the audit and to determine the nature, extent and timing of tests to be performed. 3.
3. Sufficient competent evidential matter is to be obtained through inspection, observation,Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmation to afford a reasonable basis for an opinion regarding the financial inquiries, and confirmation to afford a reasonable basis for an opinion regarding the financial statements under examination.
statements under examination.
Standards of reporting Standards of reporting 1.
1. The report shall state whether the financial statements are presented in accordance withThe report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.
generally accepted accounting principles. 2.
2. The report shall identify those circumstances in which such principles have not beenThe report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
consistently observed in the current period in relation to the preceding period. 3.
3. Informative disclosures in the financial statements are to be regarded as reasonably adequateInformative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.
unless otherwise stated in the report. 4.
4. The report shall either contain an expression of opinion regarding the financial statements,The report shall either contain an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect than an opinion cannot be expressed.
taken as a whole, or an assertion to the effect than an opinion cannot be expressed.
Keep in mind, however, that these standards represent the minimum requirements for all audit Keep in mind, however, that these standards represent the minimum requirements for all audit engagements.
engagements.
Check Your Progress Exercise -2 Check Your Progress Exercise -2
What three categories are GAAS divided into? What three categories are GAAS divided into?
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3.5 AUDIT PLANNING AND AUDIT PROGRAM 3.5 AUDIT PLANNING AND AUDIT PROGRAM
The first standard of fieldwork states: The first standard of fieldwork states:
“The work is to be adequately planned, and assistants, if any, are to be properly supervised.” “The work is to be adequately planned, and assistants, if any, are to be properly supervised.” The concept of adequate planning
The concept of adequate planning includesincludes investigating a prospective client before deciding investigating a prospective client before deciding whether to accept the engagement, obtaining an understanding of the client’s business whether to accept the engagement, obtaining an understanding of the client’s business operations, and developing an overall strategy to organize, coordinate, and schedule the activities operations, and developing an overall strategy to organize, coordinate, and schedule the activities of the audit staff.
of the audit staff.
In planning the audit the auditor needs to consider the following: In planning the audit the auditor needs to consider the following:
1.
1. The terms of the engagement and the expected date of the report.The terms of the engagement and the expected date of the report. 2.
2. The nature of the client’s business.The nature of the client’s business. 3.
3. The experience gained during previous audit engagements.The experience gained during previous audit engagements. 4.
4. The accounting policies and degree of complexity of the accounting system.The accounting policies and degree of complexity of the accounting system. 5.
5. Materiality and the components of audit risk.Materiality and the components of audit risk. 6.
6. Any involvement of other auditor.Any involvement of other auditor. 7.
7. Any involvement of internal auditors and persons having special expertise.Any involvement of internal auditors and persons having special expertise. 8.
8. The intended reliance on internal control.The intended reliance on internal control. 9.
9. The level of experience and the number of audit staff for the engagement.The level of experience and the number of audit staff for the engagement. 10.
10. The timing and effectiveness of performing of the audit procedures.The timing and effectiveness of performing of the audit procedures.
(a)
(a) Client acceptanceClient acceptance
The auditors should investigate the history of the prospective client, including such matters as The auditors should investigate the history of the prospective client, including such matters as the identities and reputations of the directors, officers, and major shareholders, its financial the identities and reputations of the directors, officers, and major shareholders, its financial statements and audit report.
statements and audit report.
Sources of information Sources of information
Communication with predecessor auditors. Communication with predecessor auditors.
Make enquiries of other third parties (e.g. banker.). Make enquiries of other third parties (e.g. banker.).
Consult the client’s legal counselor. Consult the client’s legal counselor.
(b)
After the auditors have collected the necessary information on the potential client, they will be in After the auditors have collected the necessary information on the potential client, they will be in a position to assess the various risk involved with the audit and determine whether to attempt to a position to assess the various risk involved with the audit and determine whether to attempt to obtain the engagement. Often they will be asked to submit a proposal which will include obtain the engagement. Often they will be asked to submit a proposal which will include information on the nature of services that the firm will offer, the qualification of the firm’s information on the nature of services that the firm will offer, the qualification of the firm’s personnel, and other information to convince the prospective client to select the firm.
personnel, and other information to convince the prospective client to select the firm.
Fee arrangement:
Fee arrangement: when the business engages the services of independent public accountant, it when the business engages the services of independent public accountant, it will usually ask for an estimate of the cost of the audit.
will usually ask for an estimate of the cost of the audit.
Engagement letter:
Engagement letter: The preliminary understandings with the client should be summarized by theThe preliminary understandings with the client should be summarized by the auditors in an engagement letter, making clear the nature of the engagement, any limitations on auditors in an engagement letter, making clear the nature of the engagement, any limitations on the scope of the audit, work to be performed by the client’s staff, schedule dates for performance the scope of the audit, work to be performed by the client’s staff, schedule dates for performance and completion of examination, and the basis for computing the auditors’ fee.
(c) Obtaining an understanding of the client’s business. (c) Obtaining an understanding of the client’s business.
After the engagement is accepted, the auditors must obtain a detailed understanding of such After the engagement is accepted, the auditors must obtain a detailed understanding of such factors as the client’s financial position and operating results, organization structure, product factors as the client’s financial position and operating results, organization structure, product lines, and methods of production and distribution. This will help auditors to evaluate the lines, and methods of production and distribution. This will help auditors to evaluate the appropriateness of the accounting principles in use or the reasonableness of the many estimates appropriateness of the accounting principles in use or the reasonableness of the many estimates and assumptions embodied in the client’s financial statements.
and assumptions embodied in the client’s financial statements.
(d) Developing an overall audit strategy (d) Developing an overall audit strategy
After obtaining knowledge of the client’s business, the auditor should formulate an overall audit After obtaining knowledge of the client’s business, the auditor should formulate an overall audit strategy for the upcoming engagement. The best audit strategy is the approach that results in the strategy for the upcoming engagement. The best audit strategy is the approach that results in the most
most efficientefficient audit. audit.
In planning an audit, the auditors must consider carefully the appropriate levels of
In planning an audit, the auditors must consider carefully the appropriate levels of materialitymateriality and
and audit risk.audit risk.
Materiality:
Materiality: In planning the audit, auditors should design their audit procedures to avoid wastingIn planning the audit, auditors should design their audit procedures to avoid wasting time searching for immaterial misstatements that cannot affect their report.
time searching for immaterial misstatements that cannot affect their report.
Audit risk:
Audit risk: The term audit risk refers to the possibility that the auditors may unknowingly fail toThe term audit risk refers to the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated.
appropriately modify their opinion on financial statements that are materially misstated. In developing an audit plan, the auditors must consider factors that affect audit risk. In developing an audit plan, the auditors must consider factors that affect audit risk.
(e) Audit plans (e) Audit plans
The planning process is documented in the audit working papers through the presentation of The planning process is documented in the audit working papers through the presentation of audit plans,
audit plans, audit programs, and audit programs, and time budget.time budget. An audit plan is an overview of the engagement, An audit plan is an overview of the engagement, outlining the nature and characteristics of the client’s business operations and the overall audit outlining the nature and characteristics of the client’s business operations and the overall audit strategy. A typical audit plan includes the following:
strategy. A typical audit plan includes the following:
1.
1. Description of the client’s company-its structure, nature of business, &Description of the client’s company-its structure, nature of business, & organization.
organization. 2.
2. Objectives of the audit.Objectives of the audit. 3.
3. Nature and of extent of other services.Nature and of extent of other services. 4.
4. Timing and scheduling of audit work.Timing and scheduling of audit work. 5.
6.
6. Staffing requirement during the engagement.Staffing requirement during the engagement. 7.
7. Target dates for completing major segments of the engagement.Target dates for completing major segments of the engagement. 8.
8. Preliminary judgment about materiality and risk levels for the engagement.Preliminary judgment about materiality and risk levels for the engagement. (f) Designing audit programs
(f) Designing audit programs
An audit program is a detailed list of audit procedures to be performed in the course of the An audit program is a detailed list of audit procedures to be performed in the course of the examination. An audit program is designed to accomplish certain objectives with respect to each examination. An audit program is designed to accomplish certain objectives with respect to each major account in the financial statements. These objectives follow directly from the assertions major account in the financial statements. These objectives follow directly from the assertions that are contained in the client’s financial statements.
that are contained in the client’s financial statements.
3.6 AUDIT WORKING PAPERS 3.6 AUDIT WORKING PAPERS
Working papers are records kept by the auditor of the procedures applied, the test performed, the Working papers are records kept by the auditor of the procedures applied, the test performed, the information obtained, and the pertinent conclusions reached in the audit. For example, when information obtained, and the pertinent conclusions reached in the audit. For example, when samples are taken for audit tests, the items drawn must be recorded and computations must be samples are taken for audit tests, the items drawn must be recorded and computations must be made.
made.
Working papers provide: Working papers provide:
The principal support for the auditor’s report.The principal support for the auditor’s report.
A means for coordinating and supervising the audit, and.A means for coordinating and supervising the audit, and.
Evidence that the audit was made in accordance with GAAS.Evidence that the audit was made in accordance with GAAS. Working papers normally
Working papers normally includeinclude the audit plan and programs, documentation of the auditor’s the audit plan and programs, documentation of the auditor’s understanding of the internal control structure, the assessed level of control risk, account understanding of the internal control structure, the assessed level of control risk, account analyses explaining the composition of account balances, reconciliation of related records, letters analyses explaining the composition of account balances, reconciliation of related records, letters of confirmation and representation, recommended journal entries if necessary to correct the of confirmation and representation, recommended journal entries if necessary to correct the accounts, and trial balances and other schedules that summarize the contents of other working accounts, and trial balances and other schedules that summarize the contents of other working papers.
papers.
3.7 AUDIT SAMPLING 3.7 AUDIT SAMPLING
1.
characteristic of the items selected in order to form or assist in forming a conclusion characteristic of the items selected in order to form or assist in forming a conclusion concerning the population.
concerning the population.
Sampling risk Sampling risk
Because the auditor dose not examine all the items in the population when applying audit Because the auditor dose not examine all the items in the population when applying audit sampling, there is a risk that the conclusion that he draws will be different from that which he sampling, there is a risk that the conclusion that he draws will be different from that which he would have drawn had he examined the entire population. This is ‘sampling risk’.
would have drawn had he examined the entire population. This is ‘sampling risk’. The following are the basic factors affecting sample size:
The following are the basic factors affecting sample size:
Population size.Population size.
Materiality.Materiality.
Reliability.Reliability.
Statistical and non-statistical sampling Statistical and non-statistical sampling
Statistical sampling involves the use of mathematical procedures, such as probability theory to Statistical sampling involves the use of mathematical procedures, such as probability theory to draw conclusions reached about the population. Non-statistical sampling techniques rely on the draw conclusions reached about the population. Non-statistical sampling techniques rely on the auditors’ judgment to draw conclusions.
auditors’ judgment to draw conclusions.
2. Constructing sampling. 2. Constructing sampling.
The steps involved in sampling can be summarized as follows: The steps involved in sampling can be summarized as follows:
o
o Sample design: - when designing an audit sample, the auditor should consider theSample design: - when designing an audit sample, the auditor should consider the specific audit objectives, the population from which the auditor wishes to sample, and the specific audit objectives, the population from which the auditor wishes to sample, and the sample size.
sample size.
o
o Selection of the sample: - the auditor should select sample items in such a way that theSelection of the sample: - the auditor should select sample items in such a way that the sample clan be expected to be representative of the population.
sample clan be expected to be representative of the population.
o
o Evaluation of the sample: - having carried out, on each sample item; those auditEvaluation of the sample: - having carried out, on each sample item; those audit
procedures that are appropriate to the particular audit objective, the auditor should: procedures that are appropriate to the particular audit objective, the auditor should:
(a)
(a) Analyze any errors detected in the sample.Analyze any errors detected in the sample. (b)
(b) Project the errors found in the sample to the population, and Project the errors found in the sample to the population, and (c)
