Ac08 (CN) Feb19 LR PDF

Audit and Assurance (AA)
Course Notes
For exams in September 2019, December 2019,
March 2020 and June 2020
ISBN: 9781509780471
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2
Audit and Assurance (AA)
Study Programme
Taught Phase Study Programme
Page
Introduction to the exam and the course........................................................................................... 5
1 The concept of audit and other assurance engagements ..................................................... ..15
2 Statutory audit and regulation.................................................................................................. 27
3 Corporate governance............................................................................................................. 37
4 Internal audit............................................................................................................................ 53
Achievement Ladder Step 1 71
5 Professional ethics and quality control procedures ................................................................. 73

6 Risk assessment ..................................................................................................................... 99

7 Audit planning and documentation ........................................................................................ 115
8 Introduction to audit evidence................................................................................................ 125
9 Internal control....................................................................................................................... 137

10 Tests of controls .................................................................................................................... 153
11 Audit procedures and sampling............................................................................................. 195

12 Non-current assets ................................................................................................................ 215
13 Inventory................................................................................................................................ 223
14 Receivables ........................................................................................................................... 231
15 Bank and cash....................................................................................................................... 239
16 Liabilities, capital and directors' emoluments ........................................................................ 249
17 Not-for-profit organisations.................................................................................................... 259
18 Audit review and finalisation.................................................................................................. 265
19 Reports .................................................................................................................................. 281
Achievement Ladder Step 5 301
20 Answers to Lecture Examples............................................................................................... 305

21 Appendix A: Assumed knowledge from Financial Accounting .............................................. 333
22 Step 4 and Step 6 Questions................................................................................................. 349
3
INTRODUCTION
Welcome to Audit and Assurance (AA)

Our aim is to help you confidently prepare for success in your exam in an effective and efficient
way; allowing you to personalise your learning experience, step by step, whilst being supported by
BPP's team of experts.
These Course Notes are one of the components of your Audit and Assurance programme, and are
one of the tools you have at your disposal as a student of BPP. They focus primarily on ensuring
you acquire the technical knowledge and understanding required to pass your exam. They have
been written by our subject matter experts and tutors, and will be delivered to you by our expert
tutor team, be it in centre or online.
These Course Notes play two important roles in your programme:
1. Knowledge – the Course Notes will help you to learn and understand the key knowledge
topics to allow you to progress up the Achievement Ladder
2. Support – you can revisit specific elements in your Course Notes in the light of feedback
you receive as you attempt each step on the Achievement Ladder.
Remember, the Achievement Ladder is the unique tool to allow you to see your own progression
towards being fully prepared for the real exam.
4
INTRODUCTION
Introduction to AA Audit and Assurance
Overall aim of the syllabus

To develop knowledge and understanding of the process of carrying out the assurance
engagement and its application in the context of the professional regulatory framework.
The syllabus
The broad syllabus headings are:
A Audit framework and regulation

B Planning and risk assessment
C Internal control
D Audit evidence
E Review and reporting
Main capabilities
On successful completion of this exam, candidates should be able to:
 Explain the concept of audit and assurance and the functions of audit, corporate
governance, including ethics and professional conduct.
 Demonstrate how the auditor obtains and accepts audit engagements, obtains an
understanding of the entity and its environment, assesses the risk of material misstatement
(whether arising from fraud or other irregularities) and plans an audit of financial statements.
 Describe and evaluate internal controls, techniques and audit tests, including IT systems to
identify and communicate control risks and their potential consequences, making
appropriate recommendations. Describe the scope, role and function of internal audit.
 Identify and describe the work and evidence obtained by the auditor and others required to
meet the objectives of audit engagements and the application of the International Standards
on Auditing (ISAs).
 Explain how consideration of subsequent events and the going concern principle can inform
the conclusions from audit work and are reflected in different types of auditor's report,
written representations and the final review and report.
5
INTRODUCTION
Links with other exams
Strategic Business Advanced Audit and Assurance

Leader (SBL) (AAA)
Corporate Business Financial Audit and

Law (LW) Reporting (FR) Assurance (AA)
This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist
between this exam and other exams that may precede or follow it.
Although ACCA's diagram shows Financial Reporting feeding into Audit and Assurance, the
accounting knowledge assumed in the Audit and Assurance exam will only be that covered within
Financial Accounting.
6
INTRODUCTION
Taught Phase Aims
Achieving ACCA's Study Guide Outcomes
A Audit framework and regulation
A1 The concept of audit and other assurance engagements Chapter 1

A2 External audits Chapter 2
A3 Corporate governance Chapter 3
A4 Professional ethics and the ACCA's Code of Ethics and Conduct Chapter 5
B Planning and risk assessment
B1 Obtaining and accepting audit engagements Chapter 6

B2 Objective and general principles Chapter 6
B3 Assessing audit risks Chapter 6
B4 Understanding the entity and its environment Chapter 6
B5 Fraud, laws and regulations Chapter 6
B6 Audit planning and documentation Chapter 7
C Internal control
C1 Internal control systems Chapter 9

C2 The use and evaluation of internal control systems by auditors Chapter 9
C3 Tests of control Chapter 10
C4 Communication on internal control Chapter 10
C5 Internal audit and governance and the differences between external and Chapter 4
internal audit
C6 The scope of the internal audit function, outsourcing and internal audit Chapter 4
assignments
7
INTRODUCTION
D Audit evidence
D1 Financial statement assertions and audit evidence Chapter 8

D2 Audit procedures Chapter 11
D3 Audit sampling and other means of testing Chapter 11
D4 The audit of specific items Chapters
12 – 16
D5 Computer-assisted audit techniques Chapter 11
D6 The work of others Chapter 11
D7 Not-for-profit organisations Chapter 17
E Review and reporting
E1 Subsequent events Chapter 18

E2 Going concern Chapter 18
E3 Written representations Chapter 18
E4 Audit finalisation and the final review Chapter 18
E5 The Independent Auditor's Report Chapter 19
8
INTRODUCTION
The Examination
Computer-based exams
From exams in June 2019, it will only be possible for candidates to sit Applied Skills exams as a
computer-based exam (CBE). Paper-based exams will no longer be run in parallel.
Exam duration
The Applied Skills module examinations for PM–FM contain a mix of objective and longer type
questions with a duration of 3 hours for 100 marks.
This syllabus is assessed by a computer-based exam (CBE) format. With effect from June 2019 for
TX and September 2019 for all Applied Skills exams, seeded questions have been removed from
CBE exams and the exam duration is 3 hours for 100 marks. Prior to each exam there will be time
allocated for students to be informed of the exam instructions.
For more information on these changes and when they will be implemented, please visit the ACCA
website: www.accaglobal.com
Format of the exam

The exam format will comprise two exam sections:
Section Style of question type Description Proportion of exam %
A Objective test (OT) case  3 questions  10 marks 30
 Each question will
contain 5 subparts each
worth 2 marks
B Constructed Response  1 question  30 marks 70
(Long questions)  2 questions  20 marks
Total 100
Section A questions will be selected from the entire syllabus. This section will contain a variety of
objective test questions. The responses to each question (or subpart in the case of OT cases) are
marked automatically by computer as either correct or incorrect.
Section B questions will mainly focus on the following syllabus areas, although a minority of marks
can be drawn from other areas of the syllabus:
 Planning and risk assessment (syllabus area B)
 Internal control (syllabus area C)
 Audit evidence (syllabus area D)
The responses to these questions are human-marked.
9
INTRODUCTION
Key to icons
The following icons appear in this set of study notes
Question practice
This is a question from the Exam Question and Answer Bank in the Study Text
which we recommend you attempt to reinforce your learning on a key topic
Section reference in the Study Text

You could further consolidate your knowledge in this area with additional
reading from the Study Text.
Formula to learn
10
INTRODUCTION
Key skills required to pass

Our analysis of the examining team's comments on past exams, together with our experience of
preparing students for this type of exam, suggests that to pass Audit and Assurance, you will need
to develop a number of key skills.
1 Effective
5 Producing a reading and
tailored answer to the planning at the
scenario in the exam start of the exam
question
4 Tackling mini-case
style scenario 2 Quick and accurate
questions analysis of a question's
requirements
3 Disciplined
time management
to ensure that all
parts of the
question are
answered in the
time allowed
11
INTRODUCTION
Skill 1 – Effective reading and planning at the start of the

exam
We recommend that you spend time at the beginning of your exam to carefully read your exam,
specifically looking through the requirements of each question (especially in Section B). All of the
questions in this exam are compulsory so there is no choice to make in terms of which questions
you will attempt, but you should give some thought to the order in which you attempt them.
Once you feel familiar with your exam we recommend that you attempt Section A first but please
do not rush through Section A otherwise you will make unnecessary mistakes and lose valuable
marks.
When you are ready to begin the longer constructed response questions in Section B make sure
you focus on the requirements of each of the three questions first so you can decide the order in
which you will attempt them. Once you have decided this, highlight key verbs such as describe,
explain and state to ensure you know how many points you need in your answer. Where the
question includes a scenario you will need to use the information in the scenario. We therefore
recommend that you create a heading for each new area in the constructed response solution box,
and then briefly note down any key information from the scenario.
Skill 2 – Analysis of a question's requirements
You need to be aware of the meaning of the verbs used by the examining team; these are
reproduced in full in the BPP Practice & Revision Kit.
You don't need to learn each term precisely but it is important that you appreciate the difference
between them, for example 'explain' means clarifying an issue or developing a point, whereas
'discuss' means critically examining an issue or considering the pros and cons.
Also the requirements of a question often contain a number of sub-requirements; you need to
make sure these are clearly identified on the exam by highlighting them and establishing headings
in the solution box so that your answer is comprehensive.
Skill 3 – Disciplined time management
Section B (the constructed response questions) will undoubtedly be more time pressured than
Section A (mini-case scenario style questions). In the computer-based exam, you have 1.8
minutes for each mark so you should allocate 54 minutes to Section A as a whole, 54 minutes to
the 30 mark question in Section B and 36 minutes to each 20 mark question in Section B.
12
INTRODUCTION
Skill 4 – Tackling mini-case style scenario questions
When answering mini-case style scenario questions firstly read the requirements for each of the
five sub-questions relating to the scenario information, then read the scenario presented in the
question. Next re-read the requirement for each sub-question and have a think about what you
think the correct answer may be. Next try to locate the correct answer. Even if you see the
correct answer make sure that you still check the other answers just in case you have made a
common mistake. Read the requirement again to be sure that you are answering the correct
question and then choose your answer. Never leave a question unanswered – guess if you have
to!
Skill 5 – Producing a tailored answer to the exam scenario
You are expected to apply your theoretical knowledge to the specifics of the question set in the
exam. The best way to tailor your answer is to look for clues in the scenario and then to build them
in to your answer.
Also make sure you write your answer in a manner which reflects your role in the questions and
your intended addressee. For example if you are writing a report to the Board of Directors you
should write using professional language and avoid jargon.
13
INTRODUCTION
14
The concept of audit and
other assurance
engagements
How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Identify and describe the objective and general
principles of external audit engagements
Explain the nature and development of audit and
other assurance engagements
Discuss the concepts of accountability,
stewardship and agency
Define and provide the objectives of an
assurance engagement
Explain the five elements of an assurance
engagement
Describe the types of assurance engagement
Explain the level of assurance provided by an
external audit and other review engagements
and the concept of true and fair presentation
Describe the limitations of external audits
15
1: THE CONCEPT OF AUDIT AND OTHER ASSURANCE ENGAGEMENTS
Overview
The concept of audit and other

assurance engagements
The objective of an external The auditor's report Assurance

audit
Levels of assurance
16
1 The objective of an external audit

1.1 ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with International Standards on Auditing (ISAs) defines the objective of an
external audit as a process by which the auditor:
'Obtains reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, in order to enable them to
express an opinion on whether the financial statements are prepared, in all material
respects, in accordance with an applicable financial reporting framework.' (ISA 200: para. 11)
1.2
Appoint
independent
Auditor
Adds credibility
Measure
performance Financial Prepare
Statements
Appoint
Shareholders Management
Own Company Manage
1.3 In a company the management act as agents for the body of shareholders (the principals).
They are accountable to the shareholders for their stewardship of the entity's assets which
are placed under their control.
They achieve this by preparing financial statements which are presented to the
shareholders.
1.4 Most incorporated entities are legally required to have their financial statements audited,
although many smaller entities are exempt from the requirement.
1.5 Auditors must be independent of the entity they are auditing, and seek to provide an opinion
to the shareholders as to whether the financial statements are 'presented fairly', or give a
true and fair view.
The phrase 'presented fairly' is interpreted as meaning:
 Factual
 Free from bias
17
1.6 The auditor's opinion enhances the credibility of the financial statements by providing
reasonable assurance that the financial statements are free from material misstatement.
Reasonable assurance is a high level of assurance.
1.7 The auditor can also be seen as an agent of the body of shareholders as they report to and
are appointed by them.
2 The auditor's report – ISA 700 (revised)

2.1 At the end of the audit process the auditors should be in a position to express their opinion
to the shareholders as to whether the financial statements have been prepared, in all
material respects, in accordance with the applicable financial reporting framework.
2.2 The opinion is expressed in the auditor's report. If the auditors are satisfied that the financial
statements are presented fairly, they will issue a report which gives an unmodified opinion.
Example auditor's report – unmodified opinion (listed entity)
INDEPENDENT AUDITOR'S REPORT

To the Shareholders of ABC Company [or Other Appropriate Addressee]
Report on the Audit of the Financial Statements
Opinion
We have audited the financial statements of ABC Company (the Company), which comprise of the
statement of financial position as at 31 December 20X1, and the statement of comprehensive
income, statement of changes in equity and statement of cash flows for the year then ended, and
notes to the financial statements, including a summary of significant accounting policies.
In our opinion, the accompanying financial statements present fairly, in all material respects, (or
give a true and fair view of) the financial position of the Company as at 31 December 20X1, and
(of) its financial performance and its cash flows for the year then ended in accordance with
International Financial Reporting Standards (IFRSs).
Basis for Opinion
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for the
Audit of the Financial Statements section of our report. We are independent of the Company in
accordance with the International Ethics Standards Board for Accountants' Code of Ethics for
Professional Accountants (IESBA Code) together with the ethical requirements that are relevant to
our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements and the IESBA Code. We believe that the
audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion.
18
Key Audit Matters

Key audit matters are those matters that, in our professional judgment, were of most significance in
our audit of the financial statements of the current period. These matters were addressed in the
context of our audit of the financial statements as a whole, and in forming our opinion thereon, and
we do not provide a separate opinion on these matters.
[Description of each key audit matter in accordance with ISA 701.]
Responsibilities of Management and Those Charged with Governance for the Financial
Statements
Management is responsible for the preparation and fair presentation of the financial statements in
accordance with IFRSs and for such internal control as management determines is necessary to
enable the preparation of financial statements that are free from material misstatement, whether
due to fraud or error.
In preparing the financial statements, management is responsible for assessing the Company's
ability to continue as a going concern, disclosing, as applicable, matters related to going concern
and using the going concern basis of accounting unless management either intends to liquidate the
Company or to cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Company's financial reporting
process.
Auditor's Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error, and to issue an auditor's
report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a
guarantee that an audit conducted in accordance with ISAs will always detect a material
misstatement when it exists. Misstatements can arise from fraud or error and are considered
material if, individually or in the aggregate, they could reasonably be expected to influence the
economic decisions of users taken on the basis of these financial statements.
As part of an audit in accordance with ISAs, we exercise professional judgment and maintain
professional scepticism throughout the audit. We also:
 Identify and assess the risks of material misstatement of the financial statements, whether
due to fraud or error, design and perform audit procedures responsive to those risks, and
obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion.
The risk of not detecting a material misstatement resulting from fraud is higher than for one
resulting from error, as fraud may involve collusion, forgery, intentional omissions,
misrepresentations, or the override of internal control.
 Obtain an understanding of internal control relevant to the audit 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 Company's internal control.
 Evaluate the appropriateness of accounting policies used and the reasonableness of
accounting estimates and related disclosures made by management.
19
 Conclude on the appropriateness of management's use of the going concern basis of

accounting and, based on the audit evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt on the Company's ability to
continue as a going concern. If we conclude that a material uncertainty exists, we are
required to draw attention in our auditor's report to the related disclosures in the financial
statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions
are based on the audit evidence obtained up to the date of our auditor's report. However,
future events or conditions may cause the Company to cease to continue as a going
concern.
 Evaluate the overall presentation, structure and content of the financial statements,
including the disclosures, and whether the financial statements represent the underlying
transactions and events in a manner that achieves fair presentation.
We communicate with those charged with governance regarding, among other matters, the
planned scope and timing of the audit and significant audit findings, including any significant
deficiencies in internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with
relevant ethical requirements regarding independence, and to communicate with them all
relationships and other matters that may reasonably be thought to bear on our independence, and
where applicable, related safeguards.
From the matters communicated with those charged with governance, we determine those matters
that were of most significance in the audit of the financial statements of the current period and are
therefore the key audit matters. We describe these matters in our auditor's report unless law or
regulation precludes public disclosure about the matter or when, in extremely rare circumstances,
we determine that a matter should not be communicated in our report because the adverse
consequences of doing so would reasonably be expected to outweigh the public interest benefits
of such communication.
The engagement partner on the audit resulting in this independent auditor's report is [name].
[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate
for the particular jurisdiction]
[Auditor Address]
[Date]
20
Materiality
2.3 Materiality is covered in detail in Chapter 6; however, for now it should be noted that
'misstatements, including omissions, are material if they could reasonably influence the
economic decisions of users taken on the basis of the financial statements'. (ISA 320: para. 2)
Reasonable assurance
2.4 No auditor can give a 100% guarantee that the financial statements are free from material
misstatement but 'reasonable assurance' is the highest level of assurance that can be given.
2.5 Reasonable assurance is not absolute assurance because there are inherent limitations of
an audit which result in the auditor forming an opinion on evidence that is persuasive rather
than conclusive.
Limitations of the audit and materiality

2.6 The assurance given by auditors is limited by the fact that auditors use judgement in
deciding what audit procedures to use and what conclusions to draw, and also by the
limitations of every audit. These are illustrated in the following diagram:
'
'
21
3 Assurance
3.1 The ACCA AA syllabus extends beyond audit to the wider context of assurance.
Definition
3.2 'An assurance engagement is an engagement in which a practitioner expresses a
conclusion designed to enhance the degree of confidence of the intended users other than
the responsible party about the outcome of the evaluation or measurement of a subject
matter against criteria.'
(International Framework for Assurance Engagements, 2005: para. 7)
3.3 There are five elements to an assurance engagement. These are illustrated by the diagram
below:
Practitioner
Criteria
Subject
matter
Users Responsible
party
3.4 One way to remember the key features of an assurance engagement is using the mnemonic
CREST:
 Criteria
 Report
 Evidence
 Subject matter
 Three party relationship (responsible party, user, practitioner)
3.5 Assurance describes the process whereby one party is trying to provide a level of comfort to
another party about a subject matter.
3.6 Many assurance engagements are undertaken voluntarily; however, some, such as the
statutory audit, happen as a result of a requirement imposed on the entity by another party
(for example, legislation, a regulator or a bank). (IFAC, 2017)
22
Lecture example 1 Idea generation
Required
What other examples of assurance and assurance reports exist?
Consider the following scenarios:
Solution
(1) You are currently thinking of buying a house built in 1900. What assurance report could you
obtain and who might provide this?
(2) Your friend is considering meeting up with someone they have met on an online dating
website. What assurances do you think they should seek before meeting up?
(3) You work for a local council which is just about to issue a $10,000 grant to an organisation
which runs sports activity courses for children with special needs. What assurance report
could you obtain and who might provide this?
23
3.7 Examples of assurance engagements include:
A review of the
effectiveness of an
entity's internal controls A review of cash flow
Statutory audit forecasts which will be
presented to a bank to
obtain funding
Examples
A review of threats which

A review of an entity's could affect the business's
financial results for the ability to continue as a
first half of the year going concern
A review of an entity's
compliance with:
• Corporate governance
• Environmental issues
• Contracts
• Other regulation
3.8 Assurance engagements should be performed according to the following process:

(1) Agree the scope of work to be performed
(2) Formalise all of the terms of the engagement in a contract (engagement letter)
(3) Plan the work required based on the risk and level of assurance desired
(4) Obtain sufficient appropriate evidence on which to base the conclusion
(5) Perform overall review and form opinion
(6) Issue report to the client
3.9 An assurance report provides the following benefits to the users of information:
 It provides an independent opinion from an external source that enhances the
credibility of the information.
 Management bias is reduced.
 Any non-standard or modified opinion draws attention to risk.
 The relevance of the information may be improved by the expertise and knowledge of
the assurance firm.
24
4 Levels of assurance
4.1 An assurance engagement will provide the user with either:
 Reasonable assurance; or
 Limited assurance.
Evidence–gathering
Type of engagement procedures The assurance report
Reasonable assurance Sufficient appropriate Positive expression

eg statutory audit evidence is obtained by: (Section 4.2)
 Obtaining an
understanding of the
entity
 Assessing risk
 Responding to risk
 Performing further
procedures (sampling)
to draw a conclusion
Limited assurance The evidence gathered is Negative expression
eg review of cash flow limited, involving techniques (Section 4.2)
forecasts such as enquiry and
analytical procedures
4.2 The wording of the assurance report will vary according to the level of assurance provided
by the report:
Positive expression 'In our opinion internal control is effective, in all material
respects, based on XYZ criteria.'
Negative expression 'Based on our work described in this report, nothing has
come to our attention that causes us to believe that internal
control is not effective, in all material respects, based on
XYZ criteria.'
25
5 Chapter summary
Section Topic Summary
1 The objective of an The objective of an external audit is to provide an
external audit independent opinion on the financial statements.
2 The auditor's report The objective of any audit or other assurance
engagement is to produce an opinion in the form of a
report.
3 Assurance Audit is only one type of assurance engagement.
4 Levels of assurance Reasonable assurance is usually reported in terms of
positive expression.
Limited assurance is usually reported in terms of
negative expression.
END OF CHAPTER
26
Statutory audit and
regulation

Describe the regulatory environment within which
external audits take place
Discuss the reasons and mechanisms for the
regulation of auditors
Explain the statutory regulations governing the
appointment, rights, removal and resignation of
auditors
Explain the regulations governing the rights and
duties of auditors
Explain the development and status of
International Standards on Auditing (ISAs)
Explain the relationship between International
Standards on Auditing (ISAs) and national
standards
27
2: STATUTORY AUDIT AND REGULATION
Overview
Statutory audits
The regulatory framework
Appointment, removal Mechanisms for the Development and Regulation by the

and resignation of regulation of auditors status of ISAs profession
auditors  IFAC/IAASB
 National law and
standards
 ACCA/the
profession
Note. Throughout these

notes the abbreviation ISA
will be used to refer to the
International Standards on
Auditing
28
1 The regulatory framework

1.1 The auditing profession is subject to regulation from a range of sources:
 National legislation
 National regulation and standard setting
 International standard setting
 Professional bodies, eg ACCA
1.2 Legislation will normally establish:

 Rights and duties of auditors
 Eligibility to act as auditor
In the UK the relevant legislation is the Companies Act 2006.
Auditors' rights and duties

Section 1.3 1.3 Rights Duties
 Access to books and records Report opinion

of the company on
 Information and explanations
 Receive notice of/attend The FS are fairly Additional statutory
general meetings presented requirements:
 Speak at general meetings  Adhere to local

law
 Right to receive a copy of
any written resolution  Maintain adequate
proposed records and
returns
 Ensure financial
statements agree
to records
 Ensure
consistency of
other information
 Ensure disclosure
of director's
benefits
The Companies Act 2006 makes it an offence for a company's officer knowingly or recklessly to
make a statement in any form to an auditor which is misleading, false or deceptive.
29
Eligibility
1.4 Most legal frameworks require auditors to be members of an appropriate professional body
such as ACCA.
2 Appointment, removal and resignation of auditors

2.1 Chapter 1 identified the importance of the auditor being independent and an agent of the
shareholders.
In most jurisdictions this is established in the law relating to appointment, removal and
resignation of auditors.
2.2 Overview of regulations

Appointment  Normally appointed annually
 By shareholders' ordinary resolution
 In particular circumstances, eg first auditors, casual vacancy,
directors can appoint auditors
Removal  Resolution by shareholders
 Auditors entitled to:
– Notice of resolution
– Make written representation saying why they ought to stay
in office
– Speak at shareholders' meetings until their term of office
would have expired
 Auditors must deposit a statement of circumstances at
company's registered office within 14 days of ceasing to hold
office and send a statement to the regulatory authority
Resignation  Auditors may resign at any time
 Give written notice with a statement of circumstances to
members/creditors
 Notice of resignation is sent by the company to the regulatory
authority
 Auditors can require directors to call a general meeting, within
21 days, to discuss the circumstances of resignation
 Right to speak at the general meeting on matters which
concern them as auditors
30
3 International Federation of Accountants (IFAC)

3.1 Role Membership
Not for profit organisation Over 175 members and
IFAC
associates (accountancy
bodies of good standing
eg ACCA)
(1) Elects members of Board One representative from

Council
each member
(2) Determines financial
contributions
Supervises IFAC's work President and not more than

Board
programme 22 members from many
countries (elected every
3 years)
Carries out IFAC's work Audit Committee,

Committees
programme Governance Committee,
Planning and Finance
Committee and Public Policy
and Regulation Advisory
Group
(1) Set high-quality auditing IAASB 18 members nominated by

(ISAs) and assurance IFAC Board
(ISAEs) standards
(2) Facilitates convergence
of international and
national standards
(3) Strengthen public
confidence in profession
See Sections 3, 4 and 5 for further detail.
3.2 IFAC was set up in 1977.
It is a non-profit, non-governmental and non-political international organisation of
accountancy bodies.
31
Mission
3.3 The mission of IFAC is 'to serve the public interest, strengthen the global accountancy
profession and contribute to the development of strong international economies by
establishing and promoting adherence to high-quality professional standards, furthering the
international convergence of such standards, and speaking out on public interest issues
where the profession's expertise is most relevant.' (IFAC, 2017)
Membership
3.4 Membership in IFAC is open to accountancy bodies recognised by law/general consensus
within their countries as substantial national organisations of good standing. Through IFAC,
members are automatically registered as members of the International Accounting
Standards Board (IASB).
Council
3.5 This consists of one representative from each member body of IFAC. It elects the members
of the Board and establishes the basis of financial contributions by members.
Board
3.6 The Board consists of the President and not more than 22 members elected by the Council
for 3-year terms. Elections to the Board are held annually so that one-third of the Board
retires each year.
The role of the Board is to supervise the general IFAC work programme.
The work programme itself is implemented by smaller working groups or the following
standing technical committees:
 International Auditing and Assurance Standards Board
 Compliance Committee
 Education Committee
 Ethics Committee
 Financial and Management Accounting Committee
 Public Sector Committee
 Transnational Auditors Committee (executive arm of the Forum of Firms)
4 International Auditing and Assurance Standards

Board (IAASB)
4.1 The IAASB was established to develop and issue standards and statements on auditing,
assurance and related services on behalf of the IFAC Board.
4.2 The 18 members of the IAASB are nominated by the IFAC Board based on names put
forward by the member bodies and Forum of Firms.
32
4.3 The objective of the IAASB, on behalf of the IFAC Board, is to serve the public interest by
setting high-quality auditing and assurance standards and by facilitating the convergence of
international and national standards, thereby enhancing the quality and uniformity of
practice throughout the world and strengthening public confidence in the global auditing and
assurance profession. The IAASB achieves this objective by:
(a) Establishing high-quality auditing standards and guidance for financial statement
audits that are generally accepted and recognised by investors, auditors,
governments, banking regulators, securities regulators and other key stakeholders
across the world
(b) Establishing high-quality standards and guidance for other types of assurance
services on both financial and non-financial matters
(c) Establishing high-quality standards and guidance for other related services
(d) Establishing high-quality standards for quality control covering the scope of services
addressed by the IAASB
(e) Publishing other pronouncements on auditing and assurance matters, thereby
advancing public understanding of the roles and responsibility of professional auditors
and assurance service providers
5 The scope and authority of IAASB pronouncements

5.1 The IAASB's pronouncements govern assurance and related services that are conducted in
Section 4
accordance with international standards. They do not override the local laws or regulations.
The pronouncements of the IAASB examinable fall into two categories:
 International Standards on Auditing (ISAs)
 International Standards on Assurance Engagements (ISAEs)
5.2 The IAASB's standards contain basic principles and essential procedures together with
related guidance in the form of explanatory and other material. The basic principles and
essential procedures are to be understood and applied in the context of the explanatory and
other material that provide guidance for their application. It is therefore necessary to
consider the whole text of a standard to understand and apply the basic principles and
essential procedures.
In exceptional circumstances, a professional accountant may judge it necessary to depart
from a requirement of a standard to achieve more effectively the objective of the
engagement. When such a situation arises, the professional accountant should be prepared
to justify the departure.
ISAs and national standard setters

5.3 Many national standard setters are moving towards the adoption of ISAs in place of their
previous local auditing standards. By the end of 2009 over 100 countries had adopted or
incorporated ISAs into their national auditing standards or are using ISAs as a basis for
preparing national auditing standards.
33
Liaison with national standard setters

5.4
Liaison group of national standard
setters
IAASB
eg UK Financial Reporting Council
Two-way communication (FRC)
Annual meetings with liaison group to: Standard setters who:

 Share knowledge on international and  Are significantly active in the
national developments affecting the development of national auditing
priority of topics on future standard- standards
setting agendas
 Have adopted or plan to adopt ISAs,
 Bring the strengths of the IAASB and or are demonstrably committed
national auditing standard setters to bear towards the achievement of
on standards at an early stage in their convergence of international and
development national standards
 Achieve close co-operation and
 Are sufficiently resourced to
strengthened communication eg by
participate actively in collaborative
closer collaboration on projects and
efforts
minimising duplication
 Achieve wider involvement by national  Represent the world's largest
auditing standard setters in IAASB task economies
forces or to advance research agendas
The process in the development of IAASB standards

5.5
Research and consultation
A project task force is established to develop a draft standard or practice statement.
Transparent debate
A proposed standard is discussed at a meeting, open to the public.
Exposure for public comment

Exposure drafts are put on the IAASB’s website and widely distributed for comment for
a minimum of 120 days.
Consideration of comments
Any comments as a result of the exposure draft are considered at an open meeting of
the IAASB, and it is revised as necessary.
Affirmative approval
Approval is made by the affirmative vote of at least 2/3 of IAASB members.
34
Status of ISAs
5.6 As statutory audit is governed by local legislation, the status of ISAs will vary between
countries:
 National standards may continue to exist, but aligned with the principles of ISAs.
 The ISAs could be adopted without any additional guidance relating to national
circumstances (eg South Africa).
 The ISAs could be adopted but with additional specific guidance added (eg ISAs
(UK)).
6 Regulation by the profession

Bodies such as ACCA play a part in the regulation of the profession.
6.1 Role of the ACCA
Education and As a member of IFAC, ACCA must comply with IFAC's
training of auditors international standards and guidelines on:
 Pre-qualification education and training
 Continuing professional education
Implementation and IFAC member bodies such as ACCA must prepare ethical
enforcement of requirements based on IFAC's International Code of Ethics for
ethical requirements Professional Accountants.
Member bodies must provide high standards of professional
conduct and ensure that ethical requirements are observed.
Disciplinary action should normally be taken in the following
instances:
 Failure to observe the required standard of professional
care, skills or competence;
 Non-compliance with the rules of ethics; or
 Discreditable or dishonourable conduct.
The power for disciplinary action may be provided by legislation
or by the constitution of the professional body.
35
7 Chapter summary
1 The regulatory Auditors' rights and duties are governed by
framework national legislation.
2 Appointment, removal Appointment and removal require shareholders'
and resignation of resolutions. Auditors may resign at any time by
auditors giving notice in writing.
3 International IFAC is an international organisation of accountancy
Federation of bodes. Its mission is to establish and promote
Accountants adherence to high-quality professional standards.
4 International Auditing The IAASB, an operating board of IFAC, produces
and Assurance international standards on auditing, assurance
Standards Board and related services.
5 The scope and IAASB pronouncements do not overrule local laws or
authority of IAASB regulations but where they form part of the regulatory
pronouncements framework (eg in the UK) they are mandatory.
6 Regulation by the Professional bodies, such as ACCA, establish
profession regulations relating to education and training and
ethics.
END OF CHAPTER
36
Corporate governance

Discuss the objectives, relevance and
importance of corporate governance
Discuss the provisions of international codes of
corporate governance (such OECD) that are
most relevant to auditors
Describe good corporate governance
requirements relating to directors' responsibilities
(eg for risk management and internal control) and
the reporting responsibilities of auditors
Evaluate corporate governance deficiencies and Q2 Section A – Dec 2016
provide recommendations to allow compliance
with international codes of corporate governance
Analyse the structure and roles of audit Q1 Section A – Dec 2016
committees and discuss their benefits and
limitations
Explain the importance of internal control and risk
management
Discuss the need for auditors to communicate
with those charged with governance
37
3: CORPORATE GOVERNANCE
Overview
Corporate governance
Definition
The UK Corporate Governance Code Audit committees
38
1 Corporate governance
Definition
1.1 Corporate governance relates to the internal systems or means by which companies are
directed and controlled.
1.2 It describes the framework of rules and practices by which a board of directors ensures
accountability, fairness, and transparency in a company's relationship with each of its
stakeholders.
1.3 In recent decades there have been several reviews performed in many different countries in
order to try to establish a set of principles for corporate governance.
The OECD Principles of Corporate Governance

1.4 The Organisation for Economic Co-operation and Development (OECD) has developed its
own Principles of Corporate Governance.
1.5 These Principles provide best practice recommendations on corporate governance and are
used worldwide as a benchmark for establishing guidelines on this area.
1.6 The Principles address the following six areas:

(i) Ensuring the basis of an effective corporate governance framework
(ii) The rights of shareholders and key ownership functions
(iii) The equitable treatment of shareholders
(iv) The role of stakeholders in corporate governance
(v) Disclosure and transparency
(vi) The responsibility of the board
1.7 The OECD document provides detailed recommendations expanding on each of the
principles.
1.8 In reality, each country can then develop its own corporate governance code for companies
to follow.
39
2 The UK Corporate Governance Code

2.1 In the UK, the UK Corporate Governance Code gives guidance to companies as to how they
Section 1.3
should be directed and controlled.
2.2 The UK Corporate Governance Code was revised by the Financial Reporting Council (FRC)
in July 2018 and offers guidance under the following headings:
 Board leadership and company purpose
 Division of responsibilities
 Composition, succession and evaluation
 Audit, risk and internal control
 Remuneration
2.3 The Code applies to listed companies and is part of the UK Stock Exchange listing rules.
2.4 Listed companies must include a corporate governance report in their annual report. The
report should describe how the company applies the principles in the Code and should
include a statement as to whether or not the company complies with the provisions of the
Code.
2.5 Where the company does not comply with certain provisions of the Code, the corporate
governance report should provide an explanation for the non-compliance.
Introduction and client background

Dress You Like Co is a clothing manufacturer, based in the UK, which has been trading for over
ten years. It operates from two sites, a factory where clothes are made and a head office where
the administration is carried out. Completed inventory orders are despatched from both the factory
and the head office.
In an effort to reduce costs, Dress You Like Co now imports its material from one sole supplier
based in China. Dress You Like Co's accounting system uses the US dollar as its currency;
however, most of its Chinese supplier's business contacts are based in Europe and so it both
invoices and requires payment in Euros.
Dress You Like Co sells its finished products to small independent retailers and also one major
supermarket chain. The supermarket chain often requires additional deliveries without much prior
notice and so Dress You Like Co has to maintain a high level of inventory should this occur. Credit
terms are normally 30 days, but the supermarket is given 60-day credit terms.
Dress You Like Co is not a listed company but its directors believe that the company's annual
report should provide as much information as possible to shareholders. Consequently, they have
voluntarily included a corporate governance report each year in their annual report.
Required
As the audit senior, you have been asked to review Dress You Like Co's corporate governance
report for the year ended 30 September 20X0. Your firm did not complete the audit for the year in
question and your audit manager has given you a series of questions to answer in order to get a
better understanding as to how the company is directed and controlled.
Review the corporate governance report extract below and answer the questions which follow.
40
Dress You Like Co

Corporate Governance Report extract for the year ended 30 September 20X0
As a clothing manufacturer, Dress You Like Co operates within a particularly challenging sector.
I believe that in order to conquer modern economic challenges, we must continue to act
responsibly in all of our business decisions and monitor our performance closely. Strong
leadership (governance) and tight control are fundamental to the success of our business.
Board leadership and company purpose
As Chairman of the board of directors, my role is to lead the board and make sure that each of our
directors is fulfilling their role effectively. I will ensure that the board is unified, ably supported by
our non-executive directors and offers a greater service to the company as a board than its
members could individually.
On 1 January 20X0 I appointed Mary Batter to take over from me as Chief Executive Officer.
Relinquishing this position has meant that I could concentrate solely on my role as Chairman
rather than dividing my time between the two roles.
As Chief Executive Officer, Mary and her team will seek to develop the company's strategy and
steer the company through the years ahead.
Composition, succession and evaluation
During the year an independent consultant conducted a board evaluation. This included individual
interviews with each director to gather their opinions on issues ranging from how effective the
current board is and risk management to how we can better conduct our relationships with
shareholders. To be consistent with best practice, this evaluation will now become an annual
occurrence.
As mentioned above Mary Batter joined us this year. She was appointed on the recommendation
of the Nomination Committee and completed a tailored induction process.
All directors are offered training throughout the year and are subject to annual re-election.
Audit, risk and internal control
The board is responsible for risk management and for maintaining a system of internal controls.
The risks affecting the company are widespread; however, key risks are firstly the ability to predict
customer demand in terms of tastes and fashions and secondly security of inventory. We have an
internal audit department which we outsource to an independent firm.
The audit committee reviews the effectiveness of the board's risk management procedures.
Gary Lewis (Chairman)
41
Our board
Gary Lewis (Chairman) Chairman of Nomination Committee
Mary Batter (CEO) Member of Nomination Committee
Katie Escombe (Chief Finance Officer) Executive Director
Bob Part (Non-executive Director) Chairman of the Audit Committee
Member of the Remuneration and Nomination
Committees
Adam Knight (Non-executive Director) Chairman of the Remuneration Committee
Member of the Audit and Nomination Committees
Jeremy Flage (Non-executive Director) Member of the Audit, Remuneration and Nomination
Committees
Solution
(1) Why should the role of the Chairman and the Chief Executive Officer ideally be carried out
by two different people?
(2) How does Dress You Like Co ensure that board members are properly equipped to do their
job?
42
(3) Why do you think the directors are re-elected each year?
(4) How is the responsibility for risk management shared in Dress You Like Co?
(5) Why does the company have both executive and non-executive directors?
(6) Which sub-committees do the non-executive directors form and what are their roles?
43
Auditors and the UK Corporate Governance Code

2.6 In the UK, auditors are required to review whether listed companies have complied with
specific provisions in the Code. They must then report this to shareholders in the auditor's
report.
There are nine specific provisions auditors must review and report on.
Below is an example of the type of work programme the auditor may use to determine
whether the specific provisions have been complied with:
Yes No
Provision
 
(a) Is the directors' responsibility for preparing the annual report
and accounts explained in the report?
(b) Have the directors reviewed and reported on the

effectiveness of the risk management and internal control
systems?
(c) Has the board established an audit committee of at least

three non-executive directors (or at least two non-executive
directors for smaller companies)?
(d) Does the audit committee have written terms of reference?
(e) Are the terms of reference for the audit committee available/
described in the annual report?
(f) Does the audit committee arrange methods for staff to report
impropriety in financial reporting?
(g) Does the audit committee monitor and review the

effectiveness of the internal audit activities?
(h) Does the audit committee have primary responsibility for the
appointment of the external auditors?
(i) Are there procedures in place to ensure that auditor

independence is maintained where the external auditor
provides non-audit services?
44
3 Audit committees
Responsibilities of the audit committee
3.1
To monitor To review internal

financial controls and risk
statements management systems
To monitor and
review
To implement policy effectiveness of
on supply of internal audit
non-audit services department
by external auditor
Audit Where there is no

To review and Committee internal audit
monitor function, to
independence and consider annually
objectivity of whether there is
external auditor need for one
To monitor
To approve arrangements
remuneration and safeguarding the
engagement terms privacy of whistle
of external auditor blowers
To recommend
appointment,
reappointment and
removal of external
auditor
45
Advantages and disadvantages of audit committees

3.2
Advantages Disadvantages
(a) It will lead to increased confidence in (a) There may be difficulty selecting
the credibility and objectivity of sufficient non-executive directors with
financial reports. the necessary competence in
(b) By specialising in the problems of auditing matters for the committee to
financial reporting and thus, to some be really effective.
extent, fulfilling the directors' (b) The establishment of such a
responsibility in this area, it will allow formalised reporting procedure
the executive directors to devote may dissuade the auditors from
their attention to management. raising matters of judgement and limit
(c) In cases where the interests of the them to reporting only on matters of
company, the executive directors and fact.
the employees conflict, the audit (c) Costs may be increased.
committee might provide an impartial
body for the auditors to consult.
(d) The internal auditors will be able to
report to the audit committee.
(e) The external auditors have an
independent point of reference.
46
Additional
Notes
47
4 The UK Corporate Governance Code (revisited)

4.1 As mentioned earlier in this chapter, the UK Corporate Governance Code is an example of
how the OECD Principles can be implemented and the requirements listed companies must
adhere to in order to satisfy the UK Stock Exchange listing rules.
4.2 Detailed below are the main issues companies should address in their corporate
governance report.
Principles of the UK Corporate Governance Code (for listed UK companies)

Board Leadership and Company Purpose
A A successful company is led by an effective and entrepreneurial board, whose role is to
promote the long-term sustainable success of the company, generating value for
shareholders and contributing to wider society.
B The board should establish the company’s purpose, values and strategy, and satisfy itself
that these and its culture are aligned. All directors must act with integrity, lead by example
and promote the desired culture.
C The board should ensure that the necessary resources are in place for the company to meet
its objectives and measure performance against them. The board should also establish a
framework of prudent and effective controls, which enable risk to be assessed and managed.
D In order for the company to meet its responsibilities to shareholders and stakeholders, the
board should ensure effective engagement with, and encourage participation from, these
parties.
E The board should ensure that workforce policies and practices are consistent with the
company’s values and support its long-term sustainable success. The workforce should be
able to raise any matters of concern.
(FRC UK Corporate Governance Code: Section 1)
48

Division of Responsibilities
F The chair leads the board and is responsible for its overall effectiveness in directing the
company. They should demonstrate objective judgement throughout their tenure and
promote a culture of openness and debate. In addition, the chair facilitates constructive
board relations and the effective contribution of all non-executive directors, and ensures that
directors receive accurate, timely and clear information.
G The board should include an appropriate combination of executive and non-executive (and,
in particular, independent non-executive) directors, such that no one individual or small group
of individuals dominates the board’s decision-making. There should be a clear division of
responsibilities between the leadership of the board and the executive leadership of the
company’s business.
H Non-executive directors should have sufficient time to meet their board responsibilities. They
should provide constructive challenge, strategic guidance, offer specialist advice and hold
management to account.
I The board, supported by the company secretary, should ensure that it has the policies,
processes, information, time and resources it needs in order to function effectively and
efficiently.
Composition, Succession and Evaluation
J Appointments to the board should be subject to a formal, rigorous and transparent
procedure, and an effective succession plan should be maintained for board and senior
management. Both appointments and succession plans should be based on merit and
objective criteria and, within this context, should promote diversity of gender, social and
ethnic backgrounds, cognitive and personal strengths.
K The board and its committees should have a combination of skills, experience and
knowledge. Consideration should be given to the length of service of the board as a whole
and membership regularly refreshed.
L Annual evaluation of the board should consider its composition, diversity and how effectively
members work together to achieve objectives. Individual evaluation should demonstrate
whether each director continues to contribute effectively.
Audit, Risk and Internal Control
M The board should establish formal and transparent policies and procedures to ensure the
independence and effectiveness of internal and external audit functions and satisfy itself on
the integrity of financial and narrative statements.
N The board should present a fair, balanced and understandable assessment of the company’s
position and prospects.
O The board should establish procedures to manage risk, oversee the internal control
framework, and determine the nature and extent of the principal risks the company is willing
to take in order to achieve its long-term strategic objectives.
49

Remuneration
P Remuneration policies and practices should be designed to support strategy and promote
long-term sustainable success. Executive remuneration should be aligned to company
purpose and values, and be clearly linked to the successful delivery of the company’s
long-term strategy.
Q A formal and transparent procedure for developing policy on executive remuneration and
determining director and senior management remuneration should be established. No
director should be involved in deciding their own remuneration outcome.
R Directors should exercise independent judgement and discretion when authorising
remuneration outcomes, taking account of company and individual performance, and wider
circumstances.
50
5 Chapter summary
1 Corporate governance The OECD has developed Principles of Corporate
Governance as a reference point for national policy
makers.
2 The UK Corporate The UK Corporate Governance Code issued by the
Governance Code Financial Reporting Council in the UK requires listed
companies to include a corporate governance report
in the annual report detailing how the company has
been directed and controlled in terms of board
leadership and company purpose, division of
responsibilities, composition, succession and
evaluation, audit, risk and internal control and
remuneration.
3 Audit committees All listed companies should have an audit committee
which should be made up of at least three
non-executive directors. Some of the main roles of the
audit committee are to monitor the integrity of the
financial statements and the auditor's
independence and also to review the company's
internal controls and risk management systems.
4 The UK Corporate This section lists the main issues companies should
Governance Code address in their corporate governance report.
(revisited)
51
END OF CHAPTER
52
Internal audit

Discuss the factors to be taken into account when
assessing the need for internal audit
Discuss the elements of best practice in the Q3 Section A – Dec 2016
structure and operations of internal audit
Compare and contrast the role of external and Q4 Section A – Specimen exam
internal audit
Discuss the scope of internal audit and the
limitations of the internal audit function
Explain outsourcing and the associated
advantages and disadvantages of outsourcing the
internal audit function
Discuss the nature and purpose of internal audit Q4 Section A – Dec 2016
assignments including value for money, IT, Q16(c) Section B – March/June 2018
financial, regulatory compliance, fraud
investigations and customer experience
Discuss the nature and purpose of operational Q5 Section A – Dec 2016
internal audit assignments
Discuss the responsibilities of internal and external Q17(a) Section B – March/June 2018
auditors for the prevention and detection of fraud
and error
53
4: INTERNAL AUDIT
Overview
Internal audit Corporate governance
Audit committee Internal Audit
The role of internal and

external audit
Nature and purpose of internal audit assignments
VFM Financial Fraud Operational

audits audits investigations audits
IT Regulatory Customer
audits compliance experience
Scope and limitations of Outsourcing internal audit

internal audit
54
4: INTERNAL AUDIT
1 Corporate governance and internal audit

1.1 In Chapter 3 we saw that corporate governance relates to the internal systems or means by
which companies are directed and controlled.
1.2 The UK Corporate Governance Code includes a section on audit, risk and internal control
and this introduces the requirement for the board to 'establish procedures to manage risk,
oversee the internal control framework, and determine the nature and extent of the principal
risks the company is willing to take in order to achieve its long-term strategic objectives’
(FRC UK Corporate Governance Code: Principle O).
1.3 One way in which this requirement can be satisfied is for the board to create an internal
audit function to assess and monitor internal control policies and procedures.
1.4 Corporate governance guidance does not require all listed companies to have an internal
audit function, although many listed companies do have one.
1.5 Companies which do not have an internal audit function need to review whether or not the
company would benefit from having one on an annual basis.
Factors to be considered when assessing the need for internal audit

1.6 When considering the need for an internal audit function, the board should consider:
 Any trends or current factors relevant to the company's activities, markets or other
aspects of its external environment that have increased risks
 Internal factors such as organisational restructuring or changes in reporting processes
or underlying information systems
 Adverse trends evident from the monitoring of internal control systems
 Increased incidence of unexpected occurrences
The board, the audit committee and the internal audit function
1.7 The corporate governance requirement to 'manage risk and oversee the internal control
framework' (FRC UK Corporate Governance Code: Principle O) is often met by a
partnership between the board, the audit committee and the internal audit function.
1.8 The board, which consists of all the directors (executive and non-executive), has the overall
responsibility for ensuring that the company meets corporate governance requirements.
1.9 The audit committee is a sub-committee of the board and comprises at least three
non-executive directors (two in the case of a smaller company).
The audit committee has many responsibilities (Chapter 3) including:
 To review the internal control and risk management systems that the board has put in
place
 To monitor and review the effectiveness of the internal audit function
1.10 The internal audit function is essentially an internal control available to management. The
tasks they carry out vary greatly but will include assessing the effectiveness of the board's
internal control and risk management systems.
55
4: INTERNAL AUDIT
1.11 The diagram below summarises this relationship:
Overall responsibility for the

analysis of risk and implementation
of internal controls
BOARD
Monitor
management's
AUDIT COMMITTEE responsiveness to
IA findings and
recommendations
 Monitor and review Meet  Regular report

effectiveness of IA Head of IA on results of IA work
 Approve appointment/ at least once  Direct access to
termination of appointment a year board chairman
without
of Head of IA and audit committee
management
 Review and assess present  Accountable to
annual IA work plan audit committee
INTERNAL AUDIT FUNCTION
56
4: INTERNAL AUDIT
2 Nature and purpose of internal audit assignments

Section 4 Definition
2.1 The role of the internal audit function is to provide independent assurance that a company's
risk management, governance and internal control processes are operating effectively.
2.2 In order to provide such assurance, the internal auditor will examine and evaluate the quality
of risk management, governance and internal control processes across all parts of a
company and report this directly and independently to the most senior level of management.
2.3 Unlike external auditors, the internal audit function looks beyond the financial statements
and considers wider issues such as the company's reputation, compliance with laws and
regulations, growth, its impact on the environment and employee satisfaction levels.
This is because the key to a company's success is often managing such risks effectively.
Scope
2.4 There are many types of work that the internal auditor can perform. Those listed in the
syllabus are:
 Value for money audits
 Information technology (IT) audits
 Financial audits
 Audits to verify regulatory compliance
 Fraud investigations
 Customer experience audits
 Operational audits
2.5 Value for money audits are covered in Section 2.6 whilst the other audits are addressed in
the additional notes section to this chapter.
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4: INTERNAL AUDIT
Value for money audits

2.6 Value for money (VFM) audits may be performed by the internal audit function and try to
determine whether the optimal combination of goods/services have been obtained for the
lowest level of resources.
2.7 VFM audits tend to focus on three areas: economy, efficiency and effectiveness. These are
commonly known as 'the three Es':
Economy Buying the resources needed at the cheapest cost
Efficiency Using the resources purchased as wisely as possible
Effectiveness Doing the right things and meeting the organisation's objectives
2.8 Management will need to set objectives for each of the three areas which will detail the
goals/aims they hope to achieve in terms of the company's economic purchase of
resources, efficient use of resources and the effectiveness of achieving the company's
objectives.
2.9 Once the objectives have been set, they will then need to put controls in place to ensure
each objective is met.
Lecture example 1 Preparation question
ten years. It operates from two sites, a factory where the clothes are made and a head office
where the administration is carried out. Completed inventory orders are despatched from both the
factory and the head office.
Required
Suggest TWO objectives Dress You Like Co may set in each of the areas of economy, efficiency
and effectiveness and describe the controls you would expect to be put in place to ensure they are
achieved.
58
4: INTERNAL AUDIT
Solution
Objective Control
Economy
Efficiency
Effectiveness
2.10 Audits which are concerned solely with the 'economy' objective are often termed 'best
value' audits.
59
4: INTERNAL AUDIT
3 Scope and limitations of internal audit

The scope of internal audit
3.1 From Section 2 we can see that the scope of work undertaken by the internal audit is vast
and varied.
3.2 The audit committee should review the internal audit function's work plan each year to
ensure that their work is appropriately focused to the needs of the business.
Limitations of the internal audit function

3.3 If the internal audit function is to be effective, then both they and their work need to possess
certain qualities.
3.4 These qualities include independence, objectivity and due skill and care.
3.5 Independence
(a) Internal auditors should be independent of the activities they audit. For example,
internal auditors should not generally be involved in designing, installing and
operating systems. Rather their role is to review the effectiveness of them.
(b) Internal audit departments should be granted sufficient status to achieve
independence from the various company functions.
(c) Internal auditor's reports should be considered appropriately by directors and
recommendations acted upon.
(d) Internal auditors must have a reporting line that is independent of the function they
are auditing – highest level of management/audit committee.
3.6 Objectivity
Objectivity is all about maintaining an independent mental attitude – when they conduct their
work, the internal auditors should consider the facts in front of them without having any
pre-conceived ideas.
3.7 Due skill and care

 Need for internal auditors to have wide-ranging skills (accounting, auditing, business
and management skills)
 Need for a multi-disciplinary internal audit team
 Need for ongoing training
 Adherence to internal audit quality control manuals/procedures
 Work should be planned, documented, supervised and reviewed
3.8 Note that internal auditors are not normally subject to any regulatory authority.
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4: INTERNAL AUDIT
4 Outsourcing internal audit

4.1 The internal audit function either can be provided internally by employees of the company or
may be outsourced externally, for example to an accountancy or consultancy firm.
Lecture example 2 Exam Standard Section B – 8 marks
There are both advantages and disadvantages of outsourcing a company's internal audit function.
Required
Explain FOUR advantages and disadvantages to a company of outsourcing the internal audit
function.
Solution
4.2 Note that where the internal audit function is outsourced to the company's external auditor,
there may be a self-review threat to the auditor's independence (Chapter 5).
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4: INTERNAL AUDIT
5 The role of external and internal audit

5.1 The concept of audit and the role of the auditor was introduced in Chapter 1.
5.2 When undertaking an external audit, the auditor is carrying out a statutory duty to report as
to whether the financial statements 'present fairly' the activities of the business.
5.3 The external audit will be conducted in accordance with the International Standards on
Auditing and local law/legislation.
5.4 The purpose of the internal audit function, however, is to assist the board in achieving its
corporate objectives.
Abbie Jones has recently signed a training contract with Check & Co, a firm of Chartered Certified
Accountants, and is working in the firm's audit department. She has been reviewing some of the
firm's client audit files in an attempt to gain a better understanding of what an audit is. She has
noticed that some clients seem to have an internal audit function whilst others do not.
Abbie is a little confused as to the difference between her role as an external auditor and the role
of the internal audit function.
Required
You are an audit senior in Check & Co and have been asked to complete the following table for
Abbie which distinguishes between the key elements of the roles of the external and internal
auditor.
Solution
External auditor Internal auditor
Objectives
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4: INTERNAL AUDIT

Reports to
Status
Qualification
Responsibilities for fraud and error

5.5
Prevention and
detection of fraud and error
External Internal
auditors auditors
 No responsibility for prevention  Directors responsible for prevention

and detection
 Responsibility to consider the risk of
material misstatement in the  Internal audit can assist directors
financial statements due to fraud with the prevention of fraud and error
and error by assessing the effectiveness of
internal control systems
 Provide reasonable assurance that
financial statements are free from  Existence of IA department may act
material misstatement as deterrent
 Responsibility to detect fraud and  Can contribute to detection by
error which has a material impact reporting suspicions
on the financial statements  May be called on to investigate
suspected fraud
63
4: INTERNAL AUDIT
ISA 610 (Revised) – Using the work of internal auditors

5.6 It is possible that the objectives of some of the work performed by the internal audit
department may overlap with those of the external auditor.
5.7 In these cases, it may be possible for the external auditor to rely on the work of the internal
auditor.
5.8 However, certain 'conditions' must be satisfied:
 S cope of work
 O rganisational status
 D ue skill and care
 I ndependence
 T echnical competence
Direct assistance
5.9 It is also possible that the external auditors may use the internal auditors to provide direct
assistance to them. Direct assistance refers to the use of the internal auditors to perform
audit procedures under the direction, supervision and review of the external auditor.
5.10 When deciding whether the internal auditors should provide direct assistance the external
auditor should consider:
(a) The amount of judgement involved in planning and performing the relevant audit
procedures, and in evaluating the audit evidence gathered;
(b) The assessed risk of material misstatement; and
(c) The existence and significance of threats to the objectivity and the level of
competence of the internal auditors.
5.11 Where the external auditors have used direct assistance from the internal auditors they
should document:
(a) The evaluation of the existence and significance of threats to the objectivity of the
internal auditors, and the level of competence of the internal auditors used;
(b) The basis for the decision regarding the nature and extent of the work performed by
the internal auditors; and
(c) Who reviewed the work performed and the date and extent of the review.
5.12 The audit opinion remains the responsibility of the external auditor at all times.
64
Additional
Notes
65
4: INTERNAL AUDIT
6 Nature and purpose of internal audit assignments

Section 4
(cont.)
6.1 As well as the value for money audits covered earlier in the chapter, there are several other
types of internal audit assignments included in the syllabus. These are:
 Information technology (IT) audits
 Financial audits
 Audits to verify regulatory compliance
 Fraud investigations
 Customer experience audits
 Operational audits
IT audits
6.2 Computer, or IT, systems have become increasingly important to businesses and the way in
which they are run. It is fundamental therefore that a business knows it has appropriate IT
systems in place and that they are operating effectively.
6.3 An IT system could simply comprise a standalone computer on which a business maintains
its accounting records, produces invoices and sends and receives emails.
6.4 Alternatively, IT systems could comprise a database, an integrated inventory control system
or a company's e-commerce activities.
6.5 Whatever the extent of IT systems used by a business, it is essential that a company has
internal controls in place to make sure that the systems operate effectively.
6.6 An IT audit will involve these internal controls being tested to ensure that they are
operating effectively.
6.7 It is likely that an internal audit function will include a computer specialist who can carry out
specific tests of controls, especially where the controls are embedded into the computer
system.
Financial audits
6.8 The board of directors has a statutory responsibility to prepare financial statements and
maintain proper (accounting) books and records. They will also produce management
accounts on a monthly basis in order to assess the performance of the business.
6.9 Management will make decisions based on this information and therefore need to know that
it is reliable.
6.10 Financial audits involve the internal audit function reviewing the financial information
produced and gathering evidence to substantiate it.
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4: INTERNAL AUDIT
6.11 For example, in order to be able to report about the accuracy of the figure for sales revenue,
the internal audit function may perform tests of controls to ensure that all orders processed
are despatched to customers and then invoiced.
6.12 Similarly, in order to be able to report on the accuracy of the figure for property, plant and
equipment, the internal audit function may carry out an inspection of assets to ensure that
the figure agrees to the list of assets in the non-current asset register and that these assets
exist and are being used by the business.
Regulatory compliance
6.13 Most businesses are subject to regulation such as health and safety requirements.
However, some businesses face additional regulation due to the nature of the products and
services they sell, for example banks and other financial institutions.
6.14 Where an entity is heavily regulated non-compliance could have a severe impact on their
business. For example an entity may incur fines or have its licence to trade revoked.
6.15 It is essential that management are up to date with the regulatory requirements applicable to
their business and put internal controls in place to ensure compliance and detect any
instances of non-compliance.
6.16 In such businesses it is likely that the internal audit function will include a member of staff
who has specific knowledge and training in these areas so that non-compliance can be
prevented and detected.
Fraud investigations
6.17 The board of directors is responsible for assessing the entity's risk from fraud and
maintaining a system of internal controls which prevent and detect fraud and error.
6.18 The internal audit function's general work on internal controls may identify instances of
fraud. The board may also instruct the internal audit function to perform a specific
investigation where fraud is suspected.
Customer experience audits

6.19 Satisfied customers often means repeat business for an entity and so many businesses now
devote a lot of time and resources to finding out how customers would rate their experience
with the entity.
6.20 The internal audit function may be involved in conducting such reviews or in collating the
feedback obtained and making recommendations regarding changes which could improve
customer experience in the future.
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4: INTERNAL AUDIT
Operational audits
6.21 Operational audits are also known as management or efficiency audits and they involve the
internal audit function monitoring management's performance to ensure company policy is
adhered to.
6.22 Approach to operational internal audit assignments
Two aspects
Ensure policies Ensure policies

are adequate work effectively
 Read policies  Identify controls

 Discuss with staff  Observe them
of relevant department  Test them
(This is similar to the
techniques
outlined in Chapter 10)
 Assess adequacy
 Advise management
of improvements required
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4: INTERNAL AUDIT
7 Chapter summary
1 Corporate governance Having an internal audit function is one way in which
and internal audit the board of directors can demonstrate good
corporate governance. The internal audit function
should report regularly to the audit committee and the
audit committee should review and assess the internal
audit function's work plan.
2 Nature and purpose of The role of the internal audit function is extremely wide
internal audit and varied. Value for money audits assess whether
assignments the business has obtained the best goods/services for
the lowest level of resources. They focus on economy,
efficiency and effectiveness.
3 Scope and limitations For the work of the internal audit function to be
of internal audit effective, internal auditors must be independent and
objective and carry out their work with due skill and
care.
4 Outsourcing internal Some companies outsource internal audit to
audit accountancy or consultancy firms.
5 The role of external The role of the external auditor is clearly defined in
and internal audit statute; the role of the internal audit function is
decided by the management of a specific company.
6 Nature and purpose of As well as performing value for money audits, the
internal audit internal audit function may conduct IT audits, financial
assignments (cont.) audits, audits to verify regulatory compliance, fraud
investigations, customer experience audits and
operational audits.
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4: INTERNAL AUDIT
END OF CHAPTER
70
Achievement Ladder Step 1
You have now covered the Topics that will be assessed in Step 1 of your Achievement Ladder.
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the near future.
You will receive feedback on your performance, and you can use the wide range of online resources and
ongoing BPP support to help address any improvement areas. This will help you to tailor your learning
exactly to your own individual requirements.
Course Notes
Topic name Subtopic/Chapter name
chapter
The concept of audit and assurance 1
Audit and assurance
Regulation 2
Corporate governance 3
Governance
Internal audit 4
71
Achievement ladder
72
Professional ethics and
quality control
procedures

Define and apply the fundamental principles of
professional ethics of integrity, objectivity,
professional competence and due care,
confidentiality and professional behaviour
Define and apply the conceptual framework, Q1 Section A – Specimen exam
including the threats to the fundamental Q11, Q12, Q13 Section A – Sept 16
principles of self-interest, self-review, advocacy,
Q16(c) Section B – March/June 2017
familiarity and intimidation
Discuss the safeguards to offset the threats to Q2, Q3, Q5 Section A – Specimen exam
the fundamental principles Q11, Q14 Section A – Sept 16
Describe the auditor's responsibility with regard Q15 Section A – Sept 16
to auditor independence, conflicts of interest and Q16(d) Section B – Dec 2016
confidentiality
Q16(a) Section B – Sept/Dec 2017
Discuss the requirements of professional ethics Q16(a) Section B – Dec 2016
and ISAs in relation to the acceptance/
continuance of audit engagements
Explain the preconditions for an audit Q17(a) Section B – Sept/Dec 2017
Explain the process by which an auditor obtains
an audit engagement
Discuss the importance of engagement letters
and their contents
Explain the overall objectives and importance of
quality control procedures in conducting an audit
Explain the quality control procedures that should be Q18(c) Section B – Sept 16
in place over engagement performance, monitoring
quality and compliance with ethical requirements
73
5: PROFESSIONAL ETHICS AND QUALITY CONTROL PROCEDURES
Overview
Professional ethics and quality

control procedures
Fundamental principles of Quality control

professional ethics
Threats Safeguards Confidentiality
Obtaining and accepting new

audit engagements
Engagement letters
74
1 ACCA Code of Ethics and Conduct

1.1 The ACCA Code is based on the Code of Ethics for Professional Accountants (the Code)
which is issued by the International Ethics Standards Board for Accountants (IESBA).
1.2 The Code applies to all members, affiliates and students of the ACCA. These individuals are
referred to in the code as 'professional accountants' (ACCA Rulebook, 2018: p.271).
The fundamental principles

1.3 The Code sets out five fundamental principles that professional accountants should comply
with:
Integrity To be straightforward and honest in all professional and
business relationships.
Objectivity To not allow bias, conflicts of interest or the undue
influence of others to override their professional or
business judgement.
Professional competence To maintain professional knowledge and skill at the level
and due care required to ensure that clients or employers receive
competent professional services based on current
developments in practice, legislation and techniques and
act diligently and in accordance with applicable technical
and professional standards.
Confidentiality To respect the confidentiality of information acquired as a
result of professional and business relationships and,
therefore, not disclose any such information to third
parties without proper and specific authority, unless there
is a legal or professional right or duty to disclose, nor use
the information for the personal advantage of the
professional accountant or third parties.
Professional behaviour To comply with relevant laws and regulations and should
avoid any action that discredits the profession.
75
2 Threats to the fundamental principles

2.1 There are many circumstances, relationships and situations that could threaten the
professional accountant's ability to satisfy the fundamental principles.
2.2 These threats fall into one or more of the five categories below:
(a) Self-interest threat
Relates to the risk that a financial or other interest in a client will inappropriately
influence the professional accountant's judgement or behaviour.
For example, owning shares in an audit client or receiving gifts from an audit client.
(b) Self-review threat
This arises where a professional accountant from the audit firm performs work for the
client and this work must later be reviewed by the same person or another
professional accountant from the same firm in order to arrive at a judgement on the
subject matter.
For example, preparing the financial statements of an entity which are to be audited
by your firm.
(c) Advocacy threat
Relates to the risk that a professional accountant promotes a client's position to the
point that the professional accountant's objectivity is compromised.
For example, acting as an advocate on behalf of an assurance client in litigation or
disputes or promoting shares in a listed audit client.
(d) Familiarity threat
This arises where, due to a long or close relationship with a client, the professional
accountant could be too sympathetic to their interests or too accepting of their work.
For example, if a firm has audited the same client for several years they may not
question the information presented by the client as closely as in the initial years.
(e) Intimidation threat
Relates to the risk that the professional accountant is deterred from acting objectively
because of actual or perceived pressures, including attempts to exercise undue
influence over the professional accountant.
For example, being pressured to reduce inappropriately the extent of work performed
in order to reduce the fees charged.
2.3 Where the above threats exist, appropriate safeguards must be put in place to eliminate or
reduce them to an acceptable level.
76
3 Application of the conceptual framework approach to

independence
3.1 Professional accountants who provide assurance services are required to be independent
of the assurance client.
3.2 Independence has two aspects to it:
(a) Independence of mind; and
(b) Independence in appearance.
3.3 Much of the guidance in relation to ethical guidance applies to all company audits. However,
there are sometimes additional requirements relating purely to public interest entities.
3.4 Public interest entities are defined as:
(a) All listed entities
(b) Entities that are of significant public interest because of their business, size or number
of employees or because they have a wide range of stakeholders
Examples include banks, insurance companies and pension firms.
Lecture example 1 Preparation question – 4 marks
You are an audit manager of Check and Co. The following situations have arisen with different
audit clients of your firm.
(1) In an initial meeting with the finance director of Weadon Co, an audit client, you learn that
the entire audit team will be invited to the company's annual summer social event, a
weekend at an exclusive spa hotel.
(2) Mr Walker has been the Engagement Partner for a client, Stewards Co, for nine years. He
has excellent knowledge of the client and knows all of the directors of Stewards Co very
well. Stewards Co is considered to be a public interest entity.
Required
(a) Explain the ethical threats which may affect the independence of Check and Co in respect of
each of the client audits.
(b) For each threat explain how it may be reduced.
Solution
Threat Safeguards
77
Lecture example 2 Exam Standard Section A – 6 marks
The following scenario relates to questions 1–3.

You are an audit manager of Check and Co which has annual revenue in the region of $2,400,000.
You have recently been assigned the audit of Emerald Co (Emerald), a public interest entity.
Mrs Sayer, a partner in Check and Co, is the Audit Engagement Partner for Emerald. Her
daughter, Holly, joined Emerald six months ago and is working as an assistant to the receivables
ledger clerk whilst she studies for her first set of accountancy exams.
Mrs Sayer has informed you that Emerald is one of your firm's most important clients as it
generates fees of approximately $480,000 for Check and Co. Unfortunately Emerald has fallen
behind on its payments to Check and Co and overdue fees have built up, including the invoices
issued during the last six months.
In an initial meeting with the Finance Director of Emerald, you learn that due to time pressure and
staff shortages in the accounts department the Finance Director has requested assistance from
your firm with year-end procedures, including the preparation of the annual financial statements for
the company.
1 From a review of the information above, your audit assistant has highlighted some of the
potential risks to independence in respect of the audit of Emerald.
(1) Audit engagement partner's daughter works for Emerald.
(2) Audit fee is significant to Check and Co.
(3) Overdue fees exist.
(4) Firm has been asked to help provide accountancy services.
For each of the above risks place a tick in the box which correctly identifies the
appropriate threat to independence. You may tick more than one box for each threat.
Intimidation Self-interest Self-review

Risk (1)   
Risk (2)   
Risk (3)   
Risk (4)   
78
2 In relation to the audit fee being significant to Check and Co:

Which of the following safeguards should be implemented in order to comply with
ACCA's Code of Ethics and Conduct?
 Use one team to conduct the year-end audit and a separate team to perform any
non-audit work.
 Appoint a second partner from Check and Co to perform an independent partner

review on the audit of Emerald which should focus on areas of judgement and
estimates.
 Discuss the situation with Emerald's audit committee and consider resigning from
some services.
 Rotate the audit engagement partner every seven years.
3 In relation to Check and Co providing accountancy services to Emerald:
Which of the following safeguards should be implemented in order to comply with

ACCA's Code of Ethics and Conduct?
 The directors of Emerald must provide all source data and approve all journal entries.
 Use one team to conduct the year-end audit and a separate team to provide
accountancy services.
 Appoint a second partner from Check and Co to perform an independent partner

review on the audit of Emerald which should focus on areas of judgement and
estimates.
 Check and Co should decline the offer to prepare the financial statements.
3.5 Threats arising from financial matters
(a) Financial (b) Loans and

interests guarantees
FINANCIAL
MATTERS
(d) Gifts and (c) Fees

hospitality
79
(a) Financial interests

Eg holding shares in a client by:
 The firm
 A member of the assurance team
 An immediate family member of a team member
Threats Safeguards
Self-interest threat arises as the firm or  Disposal of shares (only option if

individual team member would benefit firm holds shares)
personally if the client's financial
statements exceed market expectations  Remove individual from team
 Inform audit committee
 Independent partner review
(b) Loans and guarantees
Threats Safeguards
Clients that are banks:

 Loans or guarantees to the firm
– No threat if immaterial and on
normal terms
– If material, apply safeguards Review by professional accountant from
outside the firm
 Loans to members of the assurance
team
– Not a threat to independence if
on normal commercial terms
No safeguard can reduce the threat
Clients that are not banks:
unless the loan is immaterial to client
 Loans or guarantees to/from the firm and firm/team member
or members of the assurance team
(c) Fees and pricing
Threats Safeguards
(i) Self-interest threat arises when total  Discuss with audit committee
fees from a client represent a large  Resign from some services
portion of the firm's total fees. The
 External quality control review
firm may issue a favourable opinion
rather than risk losing such a  Consult ACCA or another professional
significant income stream. accountant on any key audit areas
requiring judgement
80
Threats Safeguards
If the audit client is a public interest entity then there are additional ethical
requirements.
If the total fees from the client represent more than 15% of the total fees received
by the firm for 2 consecutive years then there is likely to be undue dependence
on the client and the firm should put safeguards in place.
(ii) Overdue fees  Discuss with audit committee

These could give rise to intimidation  Consider resignation if overdue fees
and self-interest threats. The client not paid
could use outstanding fees to
pressure the firm into providing a
favourable opinion.
The firm may issue a favourable
opinion rather than possibly lose the
amounts owed.
(iii) Contingent fees  No safeguards acceptable –
The fee is dependent on the result contingent fees are not allowed for
of the work performed. This would audit services
create a self-interest and advocacy
threat.
(iv) Lowballing  Appropriate time and quality staff
assigned to engagement
An assurance engagement is won
by offering a fee below the market  All applicable standards are complied
rate. This gives rise to a self-interest with
threat as the firm may either take
shortcuts to make a reasonable
recovery on the engagement or
need to perform the engagement for
a number of years before achieving
a reasonable profit.
(d) Gifts and hospitality
Threat Safeguards
Acceptance of gifts from a client may  Gifts and hospitality should not be
create a self-interest threat because the accepted unless the value is trivial
firm/individual may feel obliged to give a and inconsequential.
favourable opinion. Acceptance of gifts
may also be perceived as a bribe.
Hospitality from clients may give rise to a
familiarity threat.
81
3.6 Threats arising from employment and other relationships
(a) Business (b) Personal

relationships relationships
RELATIONSHIPS
(e) Actual or (d) Long (c) Employment

threatened association
litigation
(a) Business relationships

Eg  Holding an interest in a joint venture with a client
 Distribution of a client's products
Threat Safeguards
Self-interest threat arises as the firm  Disposal of interests unless clearly

would benefit from the favourable insignificant
performance of the joint venture or
client's products.
(b) Personal relationships
Threat Safeguards
Family or close personal relationships  Remove individual from team

between assurance team members and  Discuss with audit committee
client staff give rise to self-interest,  Independent partner review
familiarity or intimidation threats.
82
(c) Employment
Eg Member of an assurance team or partner becomes a director or employee of a
client in a position to exert influence on the financial statements or vice versa.
Threat Safeguards
Previous employment by the firm of a  Consider modification of audit plan

director or employee of a client creates  Change members of audit team
self-interest, familiarity and intimidation
threat.  Independent partner review
 Quality control review
 For public interest entities, an
audit partner should not accept a
managerial position with their audit
client unless > 12 months have
passed
Former director or employee of client has  Individual should not be assigned to

joined assurance firm. audit team if the work they
performed whilst employed by the
client is to be evaluated in the
current period as part of the current
audit engagement.
(d) Long association
Threat Safeguards
Using the same senior staff on an  Independent partner review

engagement may create a familiarity  Independent quality control review
threat.  Rotate senior staff
For public interest entities:
Rotate Do not
after return for
Key audit Seven Two years
partner* years
*A key audit partner is defined as:

(a) The engagement partner;
(b) The individual responsible for the engagement quality control review; or
(c) Other audit partners on the engagement team who are responsible for key
decisions or judgements on significant matters with respect to the audit of the
financial statements on which the firm will express an opinion.
83
(e) Actual and threatened litigation
Threat Safeguards
When litigation takes place or appears  Disclose to the audit committee

likely between the firm or member of the  Removal of individual involved in
assurance team and the assurance litigation from the assurance team
client, a self-interest or intimidation threat  Refuse to perform the assurance
may be created. engagement
3.7 Threats arising from provision of non-assurance services
(a) Preparing accounting records and (b) Tax services

financial statements
NON-ASSURANCE
SERVICES
(c) Internal audit

services
84
(a) Preparing accounting records and financial statements
Threat Safeguards
Self-review threat arises if accounting If the client is not a public interest entity:
assistance includes making management  Accounting services should not be
decisions eg approving transactions performed by audit team staff
because it is unlikely that the firm will
criticise its own work and decisions.  Client must provide all source data
 Client must approve all journal
entries
 Discuss non-audit services with
audit committee
If the client is a public interest entity:
 The provision of accounting or
bookkeeping services is no longer
permitted (even in the case of an
emergency)
(b) Tax services

eg Compliance, planning, assistance in resolving tax issues.
Threats Safeguards
Self-review threat arises if tax  Tax computation must not be

computation is prepared by firm as it is prepared by audit team staff.
unlikely to be criticised by audit staff.  Independent partner review to ensure
tax computation is audited rigorously.
(c) Internal audit services
Threats Safeguards
Self-review threat arises if audit team  Remind client (in engagement letter)
plan to rely on the work of the internal that it is their responsibility to
audit department. establish, maintain and monitor a
system of internal controls.
 Internal audit services should not be
provided by audit team members.
 Independent partner review to ensure
appropriate reliance is placed on
internal audit and that its work is
rigorously audited.
A managerial threat may arise if the firm  Client is reminded that it must
makes decisions on behalf of the client evaluate and determine which
when providing internal audit services. recommendations of the firm should
be implemented.
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86
Additional
Notes
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4 Confidentiality
4.1
Members acquiring information in the course of their professional
work should not disclose any such information to third parties without
first obtaining permission from their clients. Likewise, students and affiliates
must treat any information given by members in the strictest confidence.
There are, however, circumstances where members may disclose information

to third parties without first obtaining permission.
Obligatory disclosure Voluntary disclosure
 Where required by law  In the public interest

eg terrorism, treason,  To protect a member's
money laundering interests eg to defend
 By process of law eg against legal action or to
court order sue for fees
 Reporting to regulators  Authorised by statute
 To non-governmental
bodies
Non-compliance with laws and regulations ('NOCLAR')

4.2 ISA 250 (Revised) Consideration of Laws and Regulations in an Audit of Financial
Statements provides guidance for auditors in the area of suspected or identified instances of
non-compliance with laws and regulations.
4.3 Non-compliance (NOCLAR) refers to:
Acts of omission or commission, intentional or unintentional, committed by the entity, or by
those charged with governance, by management or by other individuals working for or under
the direction of the entity, which are contrary to the prevailing laws or regulations.
Non-compliance does not include personal misconduct unrelated to the business activities
of the entity. (ISA 250 (Revised): para. 12)
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4.4 The objectives of the auditor when responding to NOCLAR are:

(a) To comply with the fundamental principles of integrity and professional behaviour;
(b) By alerting management or, where appropriate, those charged with governance of the
client, to seek to:
(i) Enable them to rectify, remediate or mitigate the consequences of the identified
or suspected non-compliance; or
(ii) Deter the commission of the non-compliance where it has not yet occurred; and
(c) To take such further action as appropriate in the public interest.
(ACCA Code of Ethics and Conduct: s.225.4)
4.5 Examples of laws and regulations covered by the Code include the following:
(a) Fraud, corruption and bribery
(b) Money laundering, terrorist financing and proceeds of crime
(c) Securities markets and trading
(d) Banking and other financial products and services
(e) Data protection
(f) Tax and pension liabilities and payments
(g) Environmental protection
(h) Public health and safety
(ACCA Code of Ethics and Conduct: s.225.6)
4.6 Procedures suggested for the auditor when considering NOCLAR are to:
(a) Obtain an understanding of the NOCLAR matter.
(b) Discuss with an appropriate level of management (at least one above those parties
involved or potentially involved).
(c) Advise the client to rectify the consequences, deter any future instances or disclose to
whoever is considered in a position to need to know.
(d) Consider the client's response and whether it indicates any concerns over their
integrity.
(e) Consider whether disclosure to an appropriate authority should be made (if applicable
laws and regulations allow) or if withdrawal from the engagement may be necessary.
(f) Document all decisions, discussions and judgements.
(ACCA Code of Ethics and Conduct: s.225.12-225.38)
5 Obtaining audit engagements

5.1 Subject to the rules which follow, members may seek publicity for their services and
achievements and may advertise their services and products in any way they think fit.
5.2 Members may inform the public of the services they are capable of providing by means of
advertising or other forms of promotion subject to the general requirement that the medium
should not reflect adversely on the member, ACCA or the accountancy profession.
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5.3 Advertisements and promotional material prepared or produced by members or firms should
not (either in content or presentation):
(a) Bring ACCA into disrepute or bring discredit to the member, firm or the accountancy
profession
(b) Discredit the services offered by others whether by claiming superiority for the
member's or firm's own services or otherwise
(c) Be misleading, either directly or by implication
(d) Fall short of the requirements of the UK Advertising Standards Authority's Code of
Advertising and Sales Promotion, notably as to legality, decency, clarity, honesty, and
truthfulness
5.4 An advertisement should be clearly distinguishable as such.
5.5 Care should be taken to ensure that any reference to fees does not mislead the reader as to
the precise range of services and time commitment that the reference is intended to cover.
Any promotional activities should not amount to harassment of prospective clients.
Commissions, fees or rewards in return for the introduction of a client are permitted,
provided appropriate safeguards are put in place such as disclosure to the client.
6 Acceptance
6.1 New auditors should ensure that they have been appointed in a proper and legal manner.
(a) Before accepting nomination the auditor must:
Acceptance procedures
Ensure professionally Consider whether disqualified on legal or ethical
qualified to act grounds
Ensure existing resources Consider available time, staff and technical
adequate expertise
Obtain references Make independent enquiries if directors not
personally known
Communicate with present Enquire whether there are reasons/
auditors circumstances behind the change which the new
auditors ought to know, also courtesy
(b) The new auditors should communicate with the present auditors to determine whether
there are any professional reasons as to why they should not accept appointment as
auditors.
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3
Present auditor New auditor
6
4
1
5 Audit client 2
If at any point in the above process the audit client refuses permission to correspond
then the new auditor should not accept appointment as auditor.
(c) After accepting nomination
(i) Ensure outgoing auditor's removal/resignation properly conducted in
accordance with national regulations
(ii) Ensure new appointment properly conducted – obtain a copy of the resolution
passed
(iii) Agree the terms of the engagement
ISA 210 – Agreeing the terms of audit engagements

6.2 The objective of the auditor is to accept or continue an audit engagement only when the
basis upon which it is performed has been agreed, through:
 Establishing certain preconditions for an audit are present; and
 Confirming that there is a common understanding between the auditor and
management of the terms of the engagement.
6.3 Preconditions for an audit:

(a) The use by management of an acceptable financial reporting framework in the
preparation of financial statements
(b) Obtain management's agreement (written representation) that it acknowledges and
understands its responsibilities for:
(i) Preparing the financial statements
(ii) Establishing internal control to ensure the financial statements are free of
material misstatement
(iii) Providing the auditor with access to all records and documents and staff
If the preconditions are not present the auditor shall not accept the proposed engagement.
6.4 The engagement letter

The terms of the engagement are agreed in the form of a letter, to avoid misunderstanding.
The audit engagement letter must include the following:
(a) The objective and scope of the audit
(b) The auditor's responsibilities
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(c) Management's responsibilities

(d) Identification of the applicable financial reporting framework for the preparation of the
(e) Reference to the expected form and content of any reports to be issued by the auditor
and a statement that there may be circumstances in which a report may differ from its
expected form and content
The audit engagement letter may also make reference to the following:
(a) Elaboration of scope, including reference to legislation, regulations, ISAs, ethical and
other pronouncements
(b) Form of any other communication of results of the engagement
(c) The fact that due to the inherent limitations of an audit and those of internal control,
there is an unavoidable risk that some material misstatements may not be detected,
even though the audit is properly planned and performed in accordance with ISAs
(d) Arrangements regarding planning and performance, including audit team composition
(e) Expectation that management will provide written representations
(f) Agreement of management to provide draft financial statements and other information
in time to allow auditor to complete the audit in accordance with proposed timetable
(g) Agreement of management to inform auditor of facts that may affect the financial
statements, of which management may become aware from the date of the auditor's
report to the date of issue of the financial statements
(h) Fees and billing arrangements
(i) Request for management to acknowledge receipt of the letter and agree to the terms
outlined in it
(j) Involvement of other auditors and experts
(k) Involvement of internal auditors and other staff
(l) Arrangements to be made with predecessor auditor
(m) Any restriction of auditor's liability
(n) Reference to any further agreements between auditor and entity
(o) Any obligations to provide audit working papers to other parties
An example of an engagement letter has been included at the end of the chapter (this is for
information purposes only).
7 Quality control on an individual audit

7.1 Auditors must implement quality control procedures over each individual audit engagement
so that they have reasonable assurance that:
(a) The audit complies with professional standards and relevant legal and regulatory
requirements; and
(b) The auditor's report issued is appropriate.
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7.2 The audit engagement partner:

(a) Has overall responsibility to ensure that quality control procedures have been
adhered to
(b) Should be satisfied that all members of the engagement team and any auditor's
experts are competent to perform the audit
(c) Must take responsibility for the direction, supervision, performance and review of the
audit
(d) Must ensure that where difficult or contentious matters arise that the audit team has
taken appropriate consultation on the matter to reach an appropriate conclusion and
that such conclusions are properly recorded
7.3 If a specific audit is to comply with quality control procedures then it must also by definition
comply with ethical requirements.
Quality control reviews

7.4 Quality control reviews are required for audits of listed entities and any other engagements
where the audit firm has determined a quality control review is required.
7.5 The quality control reviewer should objectively evaluate:

(a) Significant judgements made by the engagement team
(b) The conclusions reached in formulating the auditor's report
7.6 This work will include:

(a) A discussion of significant matters with the engagement partner
(b) A review of the financial statements and the proposed auditor's report
(c) A review of audit documentation relating to significant judgements made by the
engagement team and the related conclusions
(d) An evaluation of the conclusions reached in formulating the auditor's report and
consideration as to whether the report is appropriate
7.7 Furthermore, for listed audits, the quality control reviewer should consider:
(a) The firm's independence in relation to the audit
(b) Whether appropriate consultation has taken place on difficult or contentious matters
(c) Whether audit documentation on such matters supports the conclusions reached
7.8 The quality control reviewer should document:

(a) That the firm's required quality control procedures have been performed
(b) That the quality control review was completed on or before the date of the auditor's
report
(c) That they are not aware of any unresolved matters that would render significant
judgements and conclusions made by the engagement team inappropriate
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8 Specimen engagement letter (for information

purposes)
8.1 To the appropriate representative of management or those charged with governance of ABC
Company:
[The objective and scope of the audit]
You have requested that we audit the financial statements of ABC Company, which
comprise the statement of financial position as at 31 December 20X1, and the income
statement, statement of changes in equity and statement of cash flows for the year then
ended, and a summary of significant accounting policies and other explanatory information.
We are pleased to confirm our acceptance and our understanding of this audit engagement
by means of this letter. Our audit will be conducted with the objective of our expressing an
opinion on the financial statements.
[The responsibilities of the auditor]
We will conduct our audit in accordance with International Standards on Auditing (ISAs).
Those standards require that we comply with ethical requirements and plan and perform the
audit to obtain reasonable assurance about 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 judgement, including the assessment of the risks of material
misstatement of the financial statements, whether due to fraud or error.
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. Because of the inherent limitations of an
audit, together with the inherent limitations of internal control, there is an unavoidable risk
that some material misstatements may not be detected, even though the audit is properly
planned and performed in accordance with ISAs.
In making our risk assessments, we consider internal control relevant to the entity's
preparation 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. However, we will communicate to you in writing
concerning any significant deficiencies in internal control relevant to the audit of the financial
statements that we have identified during the audit.
[The responsibilities of management and identification of the applicable financial reporting
framework (for purposes of this example it is assumed that the auditor has not determined
that the law or regulation prescribes those responsibilities in appropriate terms; the
descriptions in paragraph 6(b) of this ISA are therefore used).]
Our audit will be conducted on the basis that [management and, where appropriate, those
charged with governance] acknowledge and understand that they have responsibility:
(a) For the preparation and fair presentation of the financial statements in accordance
with International Financial Reporting Standards;
(b) For such internal control as [management] determines is necessary to enable the
preparation of financial statements that are free from material misstatement, whether
due to fraud or error; and
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(c) To provide us with:

(i) Access to all information of which [management] is aware that is relevant to the
preparation of the financial statements such as records, documentation and
other matters;
(ii) Additional information that we may request from [management] for the purpose
of the audit; and
(iii) Unrestricted access to persons within the entity from whom we determine it
necessary to obtain audit evidence.
As part of our audit process, we will request from [management and, where appropriate,
those charged with governance], written confirmation concerning representations made to
us in connection with the audit.
We look forward to full co-operation from your staff during our audit.
[Other relevant information]
[Insert other information, such as fee arrangements, billings and other specific terms, as
appropriate.]
[Reporting]
[Insert appropriate reference to the expected form and content of the auditor's report.]
The form and content of our report may need to be amended in the light of our audit
findings.
Please sign and return the attached copy of this letter to indicate your acknowledgement of,
and agreement with, the arrangements for our audit of the financial statements including our
respective responsibilities.
XYZ & Co.
Acknowledged and agreed on behalf of ABC Company by
(signed)
......................
Name and Title
Date
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9 Chapter summary
1 ACCA Code of Ethics The Code applies to members, affiliates and students
and Conduct of the ACCA and details the fundamental principles of
integrity, objectivity, professional competence
and due care, confidentiality and professional
behaviour.
2 Threats to the There are many circumstances which can lead to
fundamental principles threats to the fundamental principles. These
circumstances will fall into one or more of the five
categories of: self-interest, self-review, advocacy,
familiarity and intimidation.
Where threats exist, safeguards should be put in
place to eliminate or reduce the threat.
3 Application of the The ACCA Code adopts a principle- rather than
conceptual framework rule-based approach but gives many examples of
approach to specific situations where independence can be
independence threatened and the relevant safeguards that may
mitigate these.
4 Confidentiality The auditor must not disclose information obtained in
their professional work without prior consent unless
there is an obligation to do so.
5 Obtaining audit The ACCA Code imposes some restrictions on how
engagements firms market their services.
6 Acceptance Specific rules exist in the Code in relation to obtaining
and accepting new engagements.
An engagement letter is issued to confirm
acceptance and agree terms.
7 Quality control on an The audit engagement partner is ultimately
individual audit responsible for ensuring that an audit has been
carried out in accordance with the firm's quality
control procedures.
8 Specimen engagement You will not need to reproduce an engagement letter
letter but must be familiar with its contents.
END OF CHAPTER
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You have now covered the Topics that will be assessed in Step 2 of your Achievement Ladder. This
mainly focuses on the shaded topics below but will also include some recap questions on earlier
topics.
Course Notes
chapter
Audit and assurance
Regulation 2
Governance
Internal audit 4
Professional ethics and quality control
Ethics 5
procedures
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Achievement ladder
98
Risk assessment

Identify the overall objectives of the auditor and the
need to conduct an audit in accordance with ISAs
Explain the need to plan and perform audits with
an attitude of professional scepticism, and to
exercise professional judgement
Explain the components of audit risk Q16(a) Section B – Specimen exam
Q16(a) Section B – March/June 2017
Explain the audit risks in the financial statements Q16(b) Section B – Specimen exam
and explain the auditor's response to each risk Q18(b) Section B – Sept 16
Q16(c) Section B – Dec 2016
Q16(b) Section B – March/June 2017
Q17(c) Section B – Sept/Dec 2017
Define and explain the concepts of materiality and
performance materiality
Explain and calculate materiality levels from
financial information
Explain how auditors obtain an initial
understanding of the entity and its environment
Describe and explain the nature and purpose of Q16(a) Section B – Sept/Dec 2018
analytical procedures in planning
Compute and interpret key ratios used in analytical Q16(b) Section B – Dec 2016
procedures Q16(b) Section B – Sept/Dec 2018
Discuss the effect of fraud and misstatements on
the audit strategy and extent of audit work
Explain the auditor's responsibility to consider laws
and regulations
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6: RISK ASSESSMENT
Overview
Risk assessment
Professional scepticism
Understanding the entity and Audit risk Materiality and performance

its business environment materiality
Effect of fraud and Analytical procedures in audit

misstatements planning
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6: RISK ASSESSMENT
1 General principles
Professional scepticism
1.1 ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with International Standards on Auditing states that auditors must plan and
perform an audit with professional scepticism recognising that circumstances may exist
that cause the financial statements to be materially misstated.
This requires:
 Critical assessment, with a questioning mind, of the validity of evidence obtained
 Alertness to contradictory evidence
 Neither the assumption that management is dishonest nor the assumption of
unquestioned honesty
Professional judgement
1.2 ISA 200 also requires the auditor to exercise professional judgement in planning and
performing an audit of financial statements. Professional judgement is required in the
following areas:
 Materiality and audit risk

 Nature, timing and extent of audit procedures
 Evaluation of whether sufficient appropriate audit evidence has been obtained
 Evaluating management's judgements in applying the applicable financial reporting
framework
 Drawing conclusions based on the audit evidence obtained
Risk-based approach to audit

1.3 The ISAs require auditors to adopt a risk-based approach to auditing. This means the
auditor must:
 Analyse the risk in the client's business, transactions and systems that could lead to
material misstatement
 Direct their testing to risky areas
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6: RISK ASSESSMENT
2 Audit risk
2.1 ISA 200 states that 'to obtain reasonable assurance, the auditor shall obtain sufficient
Section 1 appropriate audit evidence to reduce audit risk to an acceptably low level and thereby
enable the auditor to draw reasonable conclusions on which to base the auditor's opinion'
(ISA 200: para. 11).
2.2 Audit risk is the 'risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated' (ISA 200: para. 13c).
It is made up of three component parts, inherent risk, control risk and detection risk:
THE AUDIT RISK MODEL

AR = IR  CR  DR
Control risk
Audit risk
Inherent risk
Detection risk
Sampling risk Non-sampling risk
Inherent risk and control risk together form the 'risk of material misstatement' or 'financial
statement risk'.
Inherent risk
2.3 This is the susceptibility of an assertion to a misstatement that could be material, either
individually or when aggregated with other misstatements, assuming that there were no
related internal controls.
2.4 The risk of such misstatement is greater for some assertions and related classes of
transactions, account balances, and disclosures than for others. For example:
 Complex calculations are more likely to be misstated than simple calculations
 Accounts consisting of amounts derived from accounting estimates pose greater risks
than accounts consisting of relatively routine, factual data
External circumstances giving rise to business risks may also influence inherent risk.
Control risk
2.5 This is the risk that a misstatement could occur in an assertion that could be material, either
individually or when aggregated with other misstatements, that will not be prevented, or
detected and corrected, on a timely basis by the entity's internal control.
2.6 Some control risk will always exist because of the inherent limitations of internal control.
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6: RISK ASSESSMENT
Detection risk
2.7 This is the risk that the auditor's procedures will not detect a misstatement that exists in an
assertion that could be material either individually or when aggregated with other
misstatements.
Detection risk is primarily the consequence of the fact that the auditor does not, and cannot,
examine all available evidence (sampling risk).
2.8 Factors which increase non-sampling risk are:

 Auditor's lack of experience
 Time pressure
 Financial constraints
 Poor planning
 New client
 Lack of industry knowledge
3 Materiality in planning and performing an audit

(ISA 320)
3.1 The auditor should consider materiality and its relationship with audit risk when conducting
an audit.
3.2 Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.
(a) The auditor must be concerned with identifying 'material' errors, omissions and
misstatements. Both the amount (quantity) and nature (quality) of misstatements need
to be considered, eg lack of disclosure regarding ongoing litigation is likely to be
considered material.
(b) To put this into practice the auditor therefore has to set their own materiality levels –
this will always be a matter of judgement and will depend on the level of audit risk.
The higher the anticipated risk, the lower the value of materiality will be.
(c) The level set has a critical impact on two key areas:
(i) The nature, timing and extent of audit procedures. The lower the materiality
level is set, the more work will need to be performed to ensure audit risk is kept
at an acceptably low level; and
(i) Evaluating the effect of misstatements:
 Whether to seek adjustments; or
 The degree of any auditor's report modification.
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6: RISK ASSESSMENT
The calculation of materiality

3.3 (a) During planning, the auditor establishes materiality for financial statements as a whole
by exercising judgement.
(b) A set criteria is used as a starting point.
For example:
 Between ½% and 1% of revenue;
 Between 1% and 2% of total assets; or
 Between 5% and 10% of profit before tax.
The figure chosen will depend on the confidence the auditor has in the client's figures,
the uses the financial statements will be put to and any other factors affecting the
auditor's judgement.
The auditor must also determine performance materiality.
Performance materiality
3.4 Performance materiality is less than materiality calculated during the planning stage of the
audit, to reduce the risk that the aggregate of uncorrected and undetected misstatements
exceed materiality for the financial statements as a whole.
Performance materiality also refers to the amount or amounts set by the auditor at less than
the materiality level or levels for particular classes of transactions, account balances or
disclosures.
Determining performance materiality involves the auditor's professional judgement. It is
affected by their understanding of the entity and the results of risk assessment procedures.
It can be qualitative and quantitative.
For example, if there are particular account balances that could reasonably be expected to
significantly influence the decisions of users (for example, turnover for the year) then the
auditors may decide to use performance materiality when performing their audit procedures.
Revising materiality as the audit progresses

3.5 Materiality may need to be revised due to events that occur during the audit, new
information, or a change in the auditor's understanding of the entity and its operations as a
result of performing further audit procedures.
3.6 In evaluating whether the financial statements give a true and fair view, the auditor should
assess the materiality of the aggregate of uncorrected misstatements. This is normally
documented on a schedule of unadjusted differences.
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6: RISK ASSESSMENT
Documentation of materiality
3.7 ISA 320 requires the following to be documented:
 Materiality for the financial statements as a whole
 Materiality level or levels for particular classes of transactions, account balances or
disclosures if applicable
 Performance materiality
 Any revision of the above as the audit progressed
Lecture example 1 Exam Standard Section B - 12 marks
Introduction and client background

You are an audit senior in Check and Co and you are commencing the planning of the audit of
Dress You Like Co for the year ending 30 September 20X1. This audit was won by your firm in
January 20X1 following an extremely competitive tender to secure the work.
ten years. It operates from two sites, a factory where the clothes are made and a head office
Personnel
Also as part of the cost-cutting exercise mentioned above, Dress You Like Co froze the finance
director's salary this year despite giving other directors a 5% salary increase. This decision was
made based on the fact that the finance role was no more demanding than in previous years. The
finance director was not happy about this decision and left the company in March 20X1. He is now
suing the company for constructive dismissal; the company is not proposing to make any provision
or disclosure of this as it does not believe the ongoing claim has any merit. The finance director
has not yet been replaced and his work is being done by his assistant on top of her existing
workload.
Dress You Like Co had previously outsourced their internal audit department but cancelled this
contract in May 20X1 in a further effort to cut costs. The internal audit department used to perform
monthly bank and supplier statement reconciliations and a monthly check on the controls over
inventory despatch at each location.
Required
Using the information provided, describe SIX audit risks, and explain the auditor's response to
each risk, in planning the audit of Dress You Like Co.
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6: RISK ASSESSMENT
Solution
106
Additional
Notes
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6: RISK ASSESSMENT
4 Understanding the entity and its environment

4.1 ISA 315 Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment
Perform risk assessment procedures to understand the entity

and its environment
Assess the risk of material misstatement at the financial

statement and assertion level
4.2 Matters to consider when obtaining an understanding of the entity:

Industry, regulatory and other  Market and competition
external factors, including the  Product technology
applicable financial reporting  Accounting principles
framework  Tax/legislation
 Interest rates/inflation
Nature of the entity  Revenue sources

 Products or services
 Locations
 Key customers/suppliers
 Financing
 Investment
Objectives and strategies and related  New products/services

business risks  Expansion
 Use of IT
Measurement and review of the  Trends

entity's financial performance  Ratios, KPIs
 Budgets and forecasts
Selection and application of  Changes in accounting policies

accounting policies  New legislation
Internal control  Will be covered in detail in Chapter 9
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6: RISK ASSESSMENT
Assessing risk
4.3 Risk assessment includes:
(a) Identifying risks by considering the entity and its environment, including its internal
control (audit risk, business risk and significant risks)
(b) Relating the identified risks to what can go wrong at the assertion level, ie the impact
the risks could have on figures in the financial statements
(c) Considering the significance and likelihood of the risks
(d) Establishing materiality and evaluating whether the original level set remains
appropriate as the audit progresses
(e) Developing expectations for use when performing analytical procedure
(f) Designing and performing further audit procedures to reduce audit risk to an
acceptably low level
(g) Evaluating the sufficiency and appropriateness of audit evidence
4.4 Risk assessment includes an assessment of both of the following:

 Audit risk and its component parts
 Business risk resulting from the entity's failure to meet its objectives and strategies
that may result in material misstatement of the financial statements
Business risk
4.5 Business risks 'result from significant conditions, events, circumstances, action or inactions
that could adversely affect the entity's ability to achieve its objectives and execute its
strategies, or from the setting of inappropriate objectives and strategies' (ISA 315 (Revised):
para. 4c).
It is usually split into financial risk, operational risk and compliance risk.
The auditor should obtain an understanding of the entity's process for:
 Identifying business risks relating to financial reporting objectives
 Deciding about actions to address those risks, and the results thereof
4.6 As part of the risk assessment, the auditor shall determine whether any of the risks are
significant risks.
Significant risks are those that require special audit consideration.
The following factors indicate that a risk might be significant:
 Risk of fraud
 Its relationship with recent economic, accounting or other developments
 The degree of subjectivity in the financial information
 It is an unusual transaction
 It is a significant transaction with a related party
 The complexity of the transaction
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6: RISK ASSESSMENT
Risk at the assertion level

4.7 ISA 315 states that the auditor must use assertions for classes of transactions, account
balances, and presentation and disclosures in sufficient detail to form the basis for the
assessment of risks of material misstatement and the design and performance of further
audit procedures (Chapter 8).
5 Risk assessment procedures

5.1 ISA 315 requires auditors to perform the following procedures to obtain an understanding of
the entity and its environment, including its internal control:
 Enquiries of management and others within the entity
 Analytical procedures
 Observation and inspection
The members of the audit team should also discuss the susceptibility of the entity's
financial statements to material misstatements.
Effect of fraud and misstatements

5.2 ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements
contains very similar requirements to those listed in Paragraph 4.1 above. It has a particular
Section 6 emphasis on obtaining an understanding of how those charged with governance exercise
oversight over the identification of the fraud risks and the implementation of controls
5.3 Where the risk assessment suggests there may be material misstatements arising from
fraud the main effects on the audit strategy will relate to:
 Assignment and supervision of personnel
 Consideration of accounting policies
 Unpredictability in nature, timing and extent of audit procedures
ISA 520 Analytical Procedures

5.4 Analytical procedures mean the analysis of relationships to identify inconsistencies and
unexpected relationships.
5.5 The auditor should apply analytical procedures as risk assessment procedures and in the
overall review at the end of the audit.
They can also be used as a source of substantive audit evidence when their use is more
effective or efficient than tests of details in reducing detection risk for specific financial
statement assertions.
110
6: RISK ASSESSMENT
5.6 Analytical procedures include the following types of comparisons:

(a) Prior periods
(b) Budgets and forecasts
(c) Industry information
(d) Predictive estimates ie expectations
(e) Relationships between elements of financial information, ie ratio analysis
(f) Relationships between financial and non-financial information, eg payroll costs to the
number of employees
Analytical procedures as risk assessment procedures

5.7 The auditor should apply analytical procedures as risk assessment procedures to obtain an
understanding of the entity and its environment.
Application of analytical procedures may indicate aspects of the entity of which the auditor
was unaware and will assist in assessing the risks of material misstatement in order to
determine the nature, timing and extent of further audit procedures.
Common ratios for use in analytical review

5.8 (a) Profitability
Profit before interest and tax (PBIT)
(i) Return on capital employed =
(ROCE) Share capital  reserves  NC liabilities
PBIT
(ii) Net profit margin =
Revenue
Revenue
(iii) Asset turnover =
Share capital  reserves  NC liabilities
Gross profit
(iv) Gross margin =
Revenue
(b) Liquidity
CA
(i) Current ratio =
CL
CA – Inventories
(ii) Quick ratio (acid test) =
CL
Inventories
(iii) Inventory turnover =  365 days
COS
COS
or  No. of times turnover
Inventories
Trade receivables
(iv) Receivables collection period =  365 days
Credit sales
111
6: RISK ASSESSMENT
Trade payables
(v) Payables payment period =  365 days
Credit purchases
(c) Gearing
Interest bearing debt
(i) Debt/equity =
Share capital and reserves
You have also been provided with the following draft accounts of Dress You Like Co for the year
ended 30 September 20X1:
EXTRACTS FROM THE DRAFT STATEMENT OF FINANCIAL POSITION
AS ON 30 SEPTEMBER 20X1
Draft Actual
20X1 20X0
$'000 $'000
Inventory: Finished goods 13,800 4,900
Receivables: Trade (supermarket) 11,800 8,300

Trade (other) 700 600
Bank: 0 200
Payables: Trade 2,060 1,470

Other 500 450
Bank overdraft: 750 0
EXTRACTS FROM THE DRAFT STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED
30 SEPTEMBER 20X1
Draft Actual
20X1 20X0
$'000 $'000
Revenue (supermarket) 53,500 49,000
Revenue (other) 8,200 6,700
Cost of sales (supermarket) (51,895) (45,080)
Cost of sales (other) (7,380) (5,900)
Gross profit 2,425 4,720
Other expenses (1,400) (2,450)
Profit before taxation 1,025 2,270
Required
(a) Calculate THREE ratios, for BOTH years, which would assist the audit senior in planning the
audit.
(b) Using the ratios calculated, describe the MAIN audit risk and explain the auditor's response
to this risk in the planning of Dress You Like Co.
112
6: RISK ASSESSMENT
Solution
113
6: RISK ASSESSMENT
6 Chapter summary
1 General principles Audits must be planned with an attitude of
professional scepticism.
2 Audit risk The auditor must plan to minimise audit risk.
Audit risk is a combination of inherent risk, control
risk and detection risk.
3 Materiality in Planning Materiality must be assessed during audit planning.
and Performing an It has both quantitative and qualitative aspects.
Audit (ISA 320)
4 Understanding the The auditor must obtain a knowledge of the business,
entity and its including an understanding of business risk, audit
environment risk, significant risks and assertions.
5 Risk assessment Analytical procedures should be used as part of risk
procedures assessment.
END OF CHAPTER
114
Audit planning and
documentation

Identify and explain the need for and importance of
planning an audit
Identify and describe the contents of the overall Q16(c) Section B – Specimen exam
audit strategy and audit plan Q17(b) Section B – Sept/Dec 2017
Explain and describe the relationship between the
overall audit strategy and the audit plan
Explain the difference between interim and final Q16(d) Section B – Specimen exam
audit
Describe the purpose of an interim audit, and the
procedures likely to be adopted at this stage in the
audit
Describe the impact of the work performed during Q16(e) Section B – Specimen exam
the interim audit on the final audit
Explain the need for and the importance of audit
documentation
Describe the form and contents of working papers
and supporting documentation
Explain the procedures to ensure safe custody and
retention of working papers
115
7: AUDIT PLANNING AND DOCUMENTATION
Overview
Audit planning and documentation
The need for planning Audit documentation
The audit strategy and the Interim and final audit

audit plan
116
1 Overview of the statutory audit

1.1 Activities
Later chapters in these Course Notes will cover the activities of the statutory audit in detail.
The following diagram summarises the main areas:
Plan the audit
Understand the entity (including documenting and confirming

the accounting systems and internal control) (Chapters 6, 9)
Assess risk of material misstatement (Chapter 6)
Select audit procedures to respond to risk of material misstatement (Chapter 9)
Where risk assessment Risk assessment does

includes expectation not include expectation
that controls operate that controls operate
effectively (Chapter 9) effectively (Chapter 9)
Tests of controls (to confirm expectation)

(Chapter 10)
Unsatisfactory Report
to management
Satisfactory
Restricted Full
substantive tests substantive tests
(Chapters 11 to 16) (Chapters 11 to 16)
Overall review of
(Chapter 18)
Report to
management
(Chapter 10)
Auditor's
report
(Chapter 19)
117
2 The need for planning

2.1 An effective and efficient audit relies on proper planning procedures. ISA 300 Planning an
Audit of Financial Statements states the auditor shall plan the audit work so that the
engagement will be performed in an effective manner.
2.2 Planning an audit involves establishing the overall audit strategy for the engagement and
developing an audit plan.
2.3 The form and nature of planning is affected by:

 Size of the entity
 Complexity of the audit
 Auditor's experience with the entity
 Knowledge of the business
 Commercial environment
 Method of processing transactions
 Reporting requirements
2.4 Objectives of planning:

 Ensuring that appropriate attention is devoted to important areas of the audit
 Ensuring that potential problems are identified
 Ensuring that the work is completed expeditiously
 Proper assignment of work to assistants
 Co-ordination of work done by other auditors and experts
 Facilitating review
2.5 Changes to planning decisions:

 During the audit the auditor may need to modify the overall audit strategy and audit
plan, due to unexpected events, changes in conditions or audit evidence obtained. All
decisions must be documented.
118
Additional
Notes
119
3 The audit strategy and the audit plan

3.1 Overview
Section 1.2
The audit strategy
 Financial reporting framework
 Industry-specific reporting requirements
 Entity's timetable for reporting
 Locations
 Expected audit coverage
 Specialist knowledge required by the auditors
 Availability of client personnel and data
 Availability of work by internal auditors
 Determination of materiality
 Entity's use of service organisations
 Expected use of controls testing and substantive testing
 Expected use of CAATs
 Selection of the engagement team
 Assignment of work to team members
 Engagement budgeting
Guides the
development of
The audit plan

 More detailed than the audit strategy
 Nature, timing and extent of audit procedures – timetable and staff allocation
 Audit procedures for each material class of transactions, account balance or disclosure
 Planning these procedures takes place over the course of the audit
120
Section 1.3
4 Interim and final audit
4.1 The main audit procedures are likely to be carried out in two phases, the interim and final
audit.
A typical time frame for a client with a 31 December year end might be:
Planning
1 January visit 31 December
Interim Final
audit audit
4.2 Planning visit

Procedures are likely to include:
 Review of client's business
 Review of client's current operations and performance year to date
 Preliminary client meeting
 Prepare audit strategy
 Prepare detailed audit plan
4.3 Interim audit

 Analytical procedures
 Tests of controls
 Updating risk assessments
 Review of relevant internal auditor's reports
 Substantive testing (of transactions in first part of year)
4.4 Final audit

At this stage a set of draft financial statements or at least a trial balance will be available.
 Completion of tests of controls and substantive tests of transactions started at interim
 Analytical procedures on financial statements
 Detailed substantive testing of financial statements
121
5 Audit documentation
5.1 Audit documentation is the record of audit procedures performed, relevant evidence
obtained and conclusions reached. Also known as working papers.
ISA 230 Audit Documentation states that the auditor shall prepare audit documentation on a
timely basis.
Purpose of working papers:
 Assist in the planning and performance of the audit
 Assist in the supervision and review of audit work
 Enable the audit team to be accountable for its work
 Retain a record of matters of continuing significance to future audits (points carried
forward)
 Enable quality control reviews to be performed
5.2 Contents
(a) Sufficiently complete and detailed to enable an experienced auditor with no previous
connection with the audit subsequently to ascertain from them what work was
performed and to support the conclusions reached
(b) Should record information on the auditor's planning of the audit, the nature, timing
and extent of the audit procedures performed, and the results thereof, and the
conclusions drawn from the audit evidence obtained
(c) Auditor's reasoning on all significant matters requiring exercise of judgement, with
auditor's conclusions thereon
Types of documentation
5.3
 Engagement letters
Permanent file
(information of continuing  Legal documents such as prospectuses, leases,
importance) sales agreement
 Details of the history of the client's business
 Previous years' signed accounts and management
letters
 Accounting systems notes, previous years' control
questionnaires
122
 Financial statements
Current file
(information of relevance to  Accounts checklists
current year's audit)
 A summary of unadjusted errors
 Review notes
 Audit strategy
 Audit plan
 Time budgets and summaries
 Letter of representation
 Management letter
 Notes of board minutes
 Communications with third parties
 Lead schedule including details of the figures to be
included in the accounts
 Problems encountered and conclusions drawn
 Audit programmes
 Details of substantive tests and tests of control
5.4 Custody and retention

The firm should establish policies and procedures designed to maintain the confidentiality,
safe custody, integrity, accessibility and retrievability of documentation, for example:
 Passwords to restrict access to electronic documentation to authorised users
 Back-up routines
 Confidential storage of hard copy documentation
The ACCA recommends seven years as a minimum retention period.
123
6 Chapter summary
1 Overview of the An outline of the main stages of a statutory audit.
statutory audit
2 The need for planning Planning is carried out so that the audit is performed in
an effective manner.
3 The audit strategy and The overall approach to the audit is documented in the
the audit plan audit strategy.
The audit plan documents specific procedures for each
class of transactions, balance or disclosure.
4 Interim and final audit The audit is usually carried out in two phases, the
interim audit and the final audit.
5 Audit documentation All audit evidence that supports the auditor's opinion
must be documented.
END OF CHAPTER
124
Introduction to audit
evidence

Explain the assertions contained in the financial Q7 Section A – Specimen exam
statements about classes of transactions and Q11, Q15 Section A – Dec 2016
events and related disclosures; and account
balances and related disclosures at the period end
Describe audit procedures to obtain audit
evidence, including inspection, observation,
external confirmation, recalculation,
re-performance, analytical procedures and enquiry
Discuss the quality and quantity of audit evidence
Discuss the relevance and reliability of audit Q8 Section A – Specimen exam
evidence Q12 Section A – Dec 2016
Discuss substantive procedures for obtaining audit Q14 Section A – Dec 2016
evidence
Discuss and provide examples of how analytical Q13 Section A – Dec 2016
procedures are used as substantive procedures Q16(a) Section B – Sept/Dec 2018
Discuss the difference between tests of control
and substantive procedures
125
8: INTRODUCTION TO AUDIT EVIDENCE
Overview
Audit evidence Quality of evidence
Financial statement Procedures for obtaining

assertions evidence
Use of assertions in obtaining Tests of controls and

audit evidence substantive procedures
Analytical
procedures Inspection Recalculation
Enquiry and
confirmation Observation
126
1 Introduction
1.1 When undertaking an audit, the auditor needs to find evidence through testing of processes,
transactions, account balances and data to support their opinion.
ISA 500 Audit Evidence outlines the requirements when conducting an external audit under
International Standards on Auditing.
2 Quality of evidence
2.1 The auditor should obtain sufficient, appropriate audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion. (ISA 500: para. 4)
2.2
ISA 500 Audit Evidence
Sufficient Appropriate
Quantity – Sufficient to
support the audit opinion
Factors to consider are: Relevant Reliable
 Risk assessment The evidence  External better than
 Nature of accounting and gathered must cover internal
internal control systems the financial  Internal more reliable
 Materiality of the item statement assertions. when controls effective
 Experience gained during
 Auditor generated better
previous audits than client generated
 Results of audit
procedures  Documentary better than
oral
 Source and reliability of
information available  Original documents more
reliable than copies/faxes
127
2.3 Evidence must be relevant to the particular financial statement assertion the auditor is
trying to test. There are two categories:
Section 2 Assertions about Occurrence:
classes of Transactions and events that have been recorded or disclosed have occurred
transactions and and pertain to the entity.
events and Completeness:
related All transactions and events that should have been recorded have been
disclosures recorded and all related disclosures that should have been included in the
financial statements have been included.
O Cut-off:
C Transactions and events have been recorded in the correct accounting period.
C Classification:
C Transactions and events have been recorded in the proper accounts.
A Accuracy:
P Amounts and other data relating to recorded transactions and events have
been recorded appropriately, and related disclosures have been appropriately
measured and described.
Presentation:
Transactions and events are appropriately aggregated or disaggregated and
are clearly described, and related disclosures are relevant and
understandable in the context of the requirements of the applicable financial
reporting framework.
Assertions about Completeness:
account All assets, liabilities and equity interests that should have been recorded have
balances and been recorded and all related disclosures that should have been included in
related the financial statements have been included.
disclosures at Obligations and rights:
the period end The entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
C Valuation and allocation:
O Assets, liabilities, and equity interests are included in the financial statements
V at appropriate amounts and any resulting valuation or allocation adjustments
E are appropriately recorded and related disclosures have been appropriately
C measured and described.
P Existence:
Assets, liabilities, and equity interests exist.
Classification:
Assets, liabilities, and equity interests have been recorded in the proper
account.
Presentation:
Assets, liabilities and equity instruments are appropriately aggregated or
disaggregated and are clearly described, and related disclosures are relevant
and understandable in the context of the requirements of the applicable
financial reporting framework.
128
2.4 Sometimes an entity will use an expert, for example a chartered surveyor, to assist them in
the preparation of the financial statements. A management's expert is an individual or
organisation possessing expertise in a field other than auditing or accounting, whose work is
used by the entity to assist in the preparation of the financial statements.
ISA 500 states that when wanting to rely on the work of the expert, the auditor must
evaluate the competence, capabilities and objectivity of the expert, obtain an understanding
of the work done, and evaluate the appropriateness of the work done as audit evidence.
2.5 If the auditor is unable to obtain sufficient, appropriate evidence, then they should consider
the implications for the auditor's report (Chapter 19).
3 Procedures for obtaining audit evidence

3.1 There is rarely one piece of audit evidence that gives sufficient appropriate evidence over a
class of transactions, account balance or presentation and disclosure. Rather audit evidence
is obtained by performing an appropriate mix of audit procedures.
3.2 There are two types of audit procedure:

(a) Tests of controls
These are procedures to test the effectiveness of the entity's internal controls in
preventing or detecting material misstatements.
(b) Substantive procedures
These are procedures to detect material misstatements. There are two types:
 Tests of detail (for example vouching amounts back to invoices, physical
inspection of assets)
 Analytical procedures (for example variance analysis and ratio analysis)
Section 2.1 Generating audit procedures in the exam

3.3 (a) Analytical procedures – The evaluation of financial information by a comparison to
financial and non-financial data and the investigation of
significant differences and relationships which are
inconsistent with other information
(b) Enquiry and – Seeking information of knowledgeable persons throughout
confirmation the entity or outside the entity (enquiry) and
obtaining representations directly from a third party
(confirmation)
(c) Inspection – Examining records, documents and tangible assets
(d) Observation – Looking at a process or procedure being performed by
others
(e) recalcUlation – Verifying the arithmetical accuracy of documents or records
and the auditor's independent execution of procedures and
reperformance of controls
129
3.4 Analytical procedures and confirmation are purely substantive procedures.
3.5 Enquiry, inspection, observation and recalculation can all be used as either a test of control
or as a substantive procedure.
The use of analytical procedures as a substantive procedure

3.6 There are three main types of analytical procedures which an auditor can use:
(a) Variance analysis – the review of current year financial information in comparison to
the prior period or budgeted information
(b) Ratio analysis – the calculation of ratios and analysis and investigation of significant
differences
(c) Proof in total – the use of interrelationships between data (financial and non-financial)
to estimate an expected value in the financial statements, again with the investigation
of significant differences
Factors to consider when using analytical procedures

3.7 The auditor will need to consider:
(a) The suitability of analytical procedures to a particular assertion
(b) The reliability of the data from which the expected amounts or ratios are developed
(c) Whether the expectation is sufficiently precise to identify a material misstatement
(d) The amount of any difference that is acceptable without further investigation being
required
Tests of detail
3.8 Tests of detail are a further type of substantive procedure and describe the process of
gathering audit evidence through detailed inspection of invoices, documents and assets.
3.9 Examples of tests of details include:

 Inspection of invoices to verify the accuracy of the amounts recorded in the financial
statements
 Physical inspection of non-current assets and inventory to verify their existence
 Review of board meeting minutes for evidence of any provisions for legal claims
which should be included in the financial statements
 Review of after-date monies received per the cash book in order to gain evidence
over the valuation of receivables
3.10 There are further examples of tests of detail later on in the course.
130
HMA Co (HMA) is a marketing company that designs advertisements which are then placed in
newspapers and magazines and on websites.
You are an audit senior of Check & Co and are currently conducting the audit of HMA for the year
ended 30 September 20X2. During the course of the audit a number of events and issues have
been brought to your attention.
Expenses
HMA rents an office in an upmarket location in order to promote itself as a fashionable and quality
marketing company. HMA currently has a Human Resource team, Accounts department and Sales
team and also employs a significant number of design staff.
On 1 January 20X2 HMA decided that it needed to occupy a second floor in its current office
premises in order to be able to create a specialist publishing department so that the designers'
adverts can be modified in-house which would then allow them to be used across different
publishing platforms (both published products and online). The directors decided to take out a loan
to help fund the cost of this in the short term.
1 The following information is available in relation to the loan:
$
Finance charge in the statement of profit or loss 81,000
Opening loan liability on 1 January 20X2 400,000
The loan carries a fixed rate of interest of 2% per month and interest is paid at the end of
each month. HMA repaid capital of $50,000 on 1 April 20X2. In order to verify the finance
charge for the year you have been asked to perform a proof in total.
What is the expected finance charge for the above loan for the year ended
30 September 20X2 and the resultant impact on profit for the period?
 Finance charge should be $6,000, profit is overstated
 Finance charge should be $72,000, profit is understated
131
2 In relation to the rent expense for the office premises:

Which of the following audit procedures would provide the auditor with the MOST
reliable audit evidence regarding the rent expense?
 Calculate the rent expense variance this year compared to last year and discuss any
significant differences with management
 Obtain a copy of the latest rental agreement and recalculate the expected rent
expense for the year
 Agree the rent expense to copies of invoices provided by management
 Determine the general level of rent increases during the year for offices near to
HMA's location and recalculate the expected rent expense. Discuss any significant
differences with management
3 The audit assistant who has been assigned to help you appears to be unsure as to which
audit procedures provide audit evidence in relation to different financial statement
assertions.
Which of the following audit procedures provide evidence over the CUT OFF
assertion for revenue?
 Obtain a breakdown of revenue for the period and vouch a sample of revenue values
to sales invoices
 Calculate the gross profit margin for the years ended 30 September 20X2 and 20X1
and investigate any significant differences in the ratio with management
 Review credit notes issued post year end to determine the levels of returns and
whether any adjustment is required in the financial statements
 Review cash book receipts during the post year end period to determine whether any
sales need to be removed due to irrecoverable debts
Solution
132
4 Tests of control vs substantive procedures

4.1 Gaining audit evidence through tests of control is very different from gaining audit evidence
through substantive procedures. For example, consider audit tests to check the
completeness of the payables balance:
Tests of control Substantive testing
These focus on the auditor checking their These focus on the auditor performing detailed
understanding of the control being in place and checks on the numbers in the financial
testing that it has operated effectively statements.
throughout the period Source documentation → financial statements
This includes: This includes:

 Observing the control taking place  AEIOU
 Reperforming the control
 Inspecting evidence that the control has
taken place
Enquire from management the process used to Analytically review the amounts owed to major
reconcile supplier statements. suppliers at the year end compared to the prior
period.
For a sample of supplier statement
reconciliations, inspect the reconciliation to see Enquire from management the reasons for any
evidence that the reconciliation has been significant differences.
performed and any differences investigated and Circularise a sample of year-end payables and
resolved. Verify that any necessary changes to request them to confirm the balance owed at
the accounting system have been authorised the year end.
and processed.
Inspect the cash book payments in the post
Reperform the reconciliation to ensure it has year end period for any significant payments to
been completed accurately. suppliers to ensure the year-end liability is
Inspect the reconciliation to verify it has been accurately recorded.
reviewed by an appropriate level of Calculate the payables days' ratios and
management. compare to the prior period. Discuss any
Observe a supplier statement reconciliation significant differences with management.
being performed.
Does the control operate efficiently? Is the balance complete?

This will depend on the level of errors in the This will depend on the level of errors in the
sample, ie the number of times the control did sample, ie the monetary value of any errors.
not operate.
133
5 Chapter summary
1 Introduction Auditors need to gain audit evidence in order to
support the audit opinion they give.
2 Quality of evidence ISA 500 requires the auditor to obtain sufficient
appropriate audit evidence. Evidence is appropriate
if it is both relevant (to the financial statement
assertion being tested) and reliable.
3 Procedures for There are two types of audit procedures: tests of
obtaining audit control and substantive procedures. Substantive
evidence procedures are broken down into two further
categories: analytical procedures and tests of detail.
The mnemonic AEIOU serves to remind you of the
ways in which you can generate audit procedures.
4 Tests of control vs Tests of control involve identifying and repeatedly
substantive procedures testing an entity's internal controls in order to gather
audit evidence. Substantive procedures are used by
the auditor to detect material misstatements.
END OF CHAPTER
134
topics.
Course Notes
chapter
Audit and assurance
Regulation 2
Governance
Internal audit 4
Ethics 5
procedures
Audit risk Risk assessment 6
Planning and documentation 7
Audit planning
Introduction to audit evidence 8
135
Achievement ladder
136
Internal control

Explain why an auditor needs to obtain an
understanding of internal control relevant to the
audit
Describe and explain the five components of
internal control; the control environment, the
entity's risk assessment process, the information
system, including the related business process,
relevant to financial reporting and communication,
control activities relevant to the audit and
monitoring of controls
Explain how auditors record internal control Q16(a) Section B – Sept 16
systems including the use of narrative notes, Q16(b) Section B – Sept/Dec 2017
flowcharts and questionnaires
Evaluate internal control components, including
deficiencies and significant deficiencies in internal
control
Discuss the limitations of internal control
components
Describe computer system controls including
general IT controls and application controls
137
9: INTERNAL CONTROL
Overview
Internal control
Internal control systems Use of internal control Computer system controls

systems by auditors
Responsibilities of Documenting the system

management and auditors
Examples of internal
control
General controls Application controls
Limitations of internal
control
138
9: INTERNAL CONTROL
1 Internal control systems

Section 1 Definition
1.1 Internal control describes the process designed, implemented and maintained by those
charged with governance, management and other personnel to provide them with
reasonable assurance that an entity will achieve its objectives with regard to:
 The reliability of financial reporting (internal and external);
 The effectiveness and efficiency of operations; and
 Compliance with applicable laws and regulations.
Components of an internal control system

1.2 There are five components of an internal control system:
The control environment  Governance and management functions

 Attitudes, awareness and actions of management
 Sets the tone by creating a culture of honest and
ethical behaviour
 Provides an appropriate foundation for the other
components of internal control
The entity's risk assessment  How management identifies risks and decides
process upon actions to manage them
The information system  Consists of infrastructure, software, people,

procedures and data
 The related accounting records, supporting
information and specific accounts in the financial
statements that are used to record, process and
report transactions
Control activities  The policies and procedures that help ensure that
management directives are carried out
The categories most relevant to an audit are:
 Performance reviews
 Information processing
 Physical controls
 Segregation of duties
Monitoring of controls  Assess the design and operation of controls over

time
 Ongoing monitoring is part of regular
management activity
 Separate monitoring may be performed by the
internal audit function
139
9: INTERNAL CONTROL
The importance of internal control and risk management

1.3 Implementing a sound system of internal control will help a business safeguard both the
company's assets and shareholder's investment.
1.4 The risks faced by a company change continually.
An internal control system will only help a company achieve its objectives and protect it from
fraud and error if the board of directors performs a thorough and regular evaluation of the
nature and extent of risks to which the company is exposed.
1.5 Profits are, in part, the reward for successful risk taking, and so the purpose of the internal
control system is to help manage and control risk appropriately rather than to eliminate it
altogether.
Responsibilities of management and auditors

1.6
 Identify and evaluate risks
Board of directors  Design, operate and monitor a suitable system
of internal control
 Set policies on internal control
 Seek regular assurance that the system is
May employ internal functioning effectively
audit to monitor controls  Ensure that the internal control system is
effective in managing risks
 Obtain understanding of the business and the

External auditors risks it faces
 Ascertain nature of internal control system
 Done in order to design appropriate audit
procedures
 May report any control deficiencies identified
Required
Consider each of the following examples. What checks/internal controls would you expect to be
carried out in each situation?
140
9: INTERNAL CONTROL
Solution
(1) The postman knocks at your front door and hands you a letter which has been sent by
recorded delivery.
(2) You submit a claim for expenses to your line manager.
(3) You need to work an extra day over and above your normal hours to clear a backlog of work
and will expect to be paid overtime for this.
(4) You are responsible for maintaining the cash book and have just been passed the latest
bank statement.
(5) You have just received a monthly statement from your main supplier.
(6) You are responsible for payroll processing and you have just received notification from
human resources that an employee wants to take advantage of a season ticket loan offered
by your company. Your password does not give you permission to amend employee
deductions.
(7) You have just returned from a three-month holiday and are trying to log on to your computer.
(8) You are preparing to pay an invoice received from a supplier.
(9) You have prepared a bank reconciliation for your supervisor.
(10) You are entering 75 sales invoices into the accounting records and want to check the
accuracy of your posting.
(11) You have been working on the computer but have now gone away to make a cup of tea,
leaving the computer inactive for a period of time.
(12) You have a Saturday job operating the till in a small corner shop which is closing for the
night.
(13) You work in a shop that sells diamond jewellery; the jeweller is very keen to keep their
inventory secure.
141
9: INTERNAL CONTROL
Limitations of internal control

1.7 Unfortunately, even with the best system of internal control, there is no guarantee that a
company will be able to fulfil all of its objectives and be fully protected from fraud and error.
1.8 This is due to the inherent limitations in any system of internal control. These include:
 Human error
 Processes being deliberately circumvented by employees and others
 Management overriding controls
 The occurrence of unforeseen circumstances
2 Use of internal control systems by auditors

2.1 ISA 315 Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment states that 'the auditor shall obtain an
understanding of internal control relevant to the audit' (ISA 315 (Revised): para. 12).
2.2 This is used to:
 Identify types of potential misstatements
 Consider factors that affect the risks of material misstatement
 Design the nature, timing and extent of further audit procedures
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9: INTERNAL CONTROL
Overview of the statutory audit
2.3
Plan the audit
Understand the entity (including documenting and confirming

the accounting systems and internal controls) (Chapter 6, 9)
Assess risk of material misstatement (Chapter 6)
Select audit procedures to respond to risk of material misstatement (Chapter 9)
Where risk assessment Risk assessment does

includes expectation not include expectation
that controls operate that controls operate
effectively (Chapter 9) effectively (Chapter 9)
Tests of controls (to confirm expectation)

(Chapter 10)
Report
Unsatisfactory to management
Satisfactory
Restricted Full
substantive tests substantive tests
(Chapters 11 to 16) (Chapters 11 to 16)
Overall review of
(Chapter 18)
Report to
management
(Chapter 10)
Auditor's
report
(Chapter 19)
143
9: INTERNAL CONTROL
Obtaining an understanding of the entity's internal controls

Section 2.1 2.4 The auditor must obtain and document an understanding of the entity's internal controls
regardless of whether they want to gain audit evidence by relying on the internal controls.
2.5 This can be done using several methods:
 Narrative notes
 Flow charts
 Internal control questionnaires (ICQs)
 Internal control evaluation questionnaires (ICEQs)
Narrative notes and flow charts

2.6 Narrative notes tend to be used to document simple internal control systems.
They are usually typed and detail and explain each stage of the entity's systems.
2.7 It can be difficult to 'see the wood from the trees' when using narrative notes to detail a more
complex system and an alternative to this is to use a flow chart to show each stage of the
process.
Internal control questionnaires (ICQs)

2.8 ICQs comprise a series of questions on each key transaction cycle (sales, purchases etc)
which seek to determine whether a control exists.
Examples of questions on an ICQ are:
'Is a bank reconciliation performed each month?' Yes / No / Comments
'Is the bank reconciliation reviewed by a supervisor or member of Yes / No / Comments
management?'
2.9 ICQs identify where internal controls exist, are quick to prepare and can be completed by
junior staff.
2.10 They can, however, give a distorted view of the entity's internal controls as there is no
weighting of more important controls. They may not be relevant to unusual systems.
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9: INTERNAL CONTROL
Internal control evaluation questionnaires (ICEQs)

2.11 ICEQs are slightly more robust in that they ask questions which enable the auditor to elicit
the controls which exist.
An example of a question on an ICEQ is:
Is there reasonable assurance that 'Goods cannot be received without an associated
liability being recorded in the accounting records?'
2.12 The idea behind the above question is that the person responsible for this part of the
purchases cycle will answer:
'Yes, because a sequentially numbered, multi-part goods received note is generated upon
receipt of the goods and one copy passed to the accounts department. This is then filed
whilst we wait for the supplier's invoice. This file is then reviewed at the end of each month
and an accrual made for any goods received which have not yet been invoiced.'
2.13 The auditor would only ever test the internal controls to gain audit evidence if the initial
assessment indicates that the controls are relevant to the financial statement assertions and
appear to be operating effectively.
Testing internal controls to gather audit evidence

2.14 The diagram in Section 2.3 shows that the auditor will make an initial assessment as to
whether or not the company's internal controls appear to be operating effectively.
2.15 If the internal controls appear to be strong, then the auditor will carry out tests of control
(Chapter 10) to gather evidence that the controls:
 Are properly designed; and
 Have operated effectively throughout the period.
2.16 If the results of the tests of control support the auditor's initial assessment then the auditor
will conduct restricted substantive procedures.
2.17 Some substantive testing is always necessary due to the inherent limitations in any system
of internal control (Section 1.8).
2.18 Where the results of the tests of control indicate that the internal controls are not effective,
the auditor will:
 Report the deficiencies in internal controls to those charged with governance
(Chapter 10); and
 Perform full substantive testing.
145
9: INTERNAL CONTROL
146
Additional
Notes
147
9: INTERNAL CONTROL
3 Types of computer control (ISA 315 Revised)

3.1 As part of the risk assessment process, the auditor should obtain an understanding of how
Section 4 the entity has responded to the risks arising from information technology.
3.2 The controls which the auditor would expect to find can be considered in two categories:
(a) General controls: policies and procedures that relate to many applications and
ensure the proper operation of application controls.
(b) Application controls: manual or automated procedures that typically operate at a
business process level. Application controls can be preventative or detective in
nature and are designed to ensure the integrity of the accounting records.
Accordingly, application controls relate to procedures used to initiate, record, process
and report transactions or other financial data.
3.3 Application controls and general controls are interrelated. Strong general controls contribute
to the assurance which may be obtained by an auditor in relation to application controls.
Unsatisfactory general controls may undermine strong application controls.
4 General controls
4.1 General controls are policies and procedures that relate to many applications and support
the proper operation of information systems. They commonly include the following:
General controls Examples

Development of Standards over systems design, programming and documentation
computer Full testing procedures using test data
applications
Approval by computer users and management
Segregation of duties so that those responsible for design are not
responsible for testing
Installation procedures so that data is not corrupted in transition
Training of staff in new procedures and availability of adequate
documentation
148
9: INTERNAL CONTROL
General controls Examples

Prevention or Segregation of duties
detection of Full records of program changes
unauthorised
Password protection of programs so that access is limited to
changes to programs
computer operations staff
Restricted access to central computer by locked doors, keypads
Maintenance of programs logs
Virus checks on software: use of anti-virus software and policy
prohibiting use of non-authorised programs or files
Back-up copies of programs being taken and stored in other
locations
Control copies of programs being preserved and regularly compared
with actual programs
Stricter controls over certain programs (utility programs) by use of
read-only memory
Testing and Complete testing procedures
documentation of Documentation standards
program changes
Approval of changes by computer users and management
Training of staff using programs
Controls to prevent Operation controls over programs
wrong programs or Libraries of programs
files being used
Proper job scheduling
Controls to prevent Password protection
unauthorised Access restricted to authorised users only
amendments to data
files
Controls to ensure Storing extra copies of programs and data files off-site
continuity of Protection of equipment against fire and other hazards
operation
Back-up power sources
Disaster recovery procedures eg availability of back-up computer
facilities
Maintenance agreements and insurance
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9: INTERNAL CONTROL
5 Application controls
5.1 Application controls ensure that all transactions are authorised and recorded, and are
processed completely, accurately and on a timely basis. Application controls include the
following:
Control Examples
Controls over input: Manual or programmed agreement of control totals
completeness Document counts
One-for-one checking of processed output to source documents
Programmed matching of input to an expected input control file
Procedures over resubmission of rejected controls
Controls over input: Programs to check data fields (for example value, reference number,
accuracy date) on input transactions for plausibility:
 Digit verification (eg reference numbers are as expected)
 Reasonableness test (eg sales tax to total value)
 Existence checks (eg customer name)
 Character checks (no unexpected characters used in reference)
 Necessary information (no transaction passed with gaps)
 Permitted range (no transaction processed over a certain value)
Manual scrutiny of output and reconciliation to source
Agreement of control totals (manual/programmed)
Controls over input: Manual checks to ensure information input was:
authorisation  Authorised
 Input by authorised personnel
Controls over Similar controls to input must be in place when input is completed, for
processing example batch reconciliations
Screen warnings can prevent people logging out before processing is
complete
Controls over master One-to-one checking
files and standing Cyclical reviews of all master files and standing data
data
Record counts (number of documents processed) and hash totals
(for example, the total of all the payroll numbers) used when master
files are used to ensure no deletions
Controls over the deletion of accounts that have no current balance
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9: INTERNAL CONTROL
6 Chapter summary
1 Internal control A company's internal control system is the board of
systems directors' responsibility and comprises:
 The control environment
 The entity's risk assessment process
 The information system
 Control activities
 Monitoring of controls
Examples of internal controls include approval/
authorisation, reconciliations, computer controls
(passwords, sequence checks), review and physical
controls.
There are inherent limitations in any system of
internal control.
2 Use of internal control The auditor must obtain an understanding of

systems by auditors internal control to:
 Identify types of potential misstatement
 Assess risks
 Design appropriate audit procedures
The auditor must then document their understanding
of the company's internal controls using narrative
notes, flow charts, ICQs and/or ICEQs.
Where controls appear to operate effectively, the
auditor will test the controls to gain audit evidence.
Some substantive testing must always be done due
to the inherent limitations of internal controls.
3 Types of computer The auditor needs to consider both general and

control application controls in their assessment of control
risk.
4 General controls General controls need to be designed and

implemented to mitigate risks arising from information
technology.
5 Application controls Application controls are needed to prevent and detect

errors that can arise when data is input and
processed.
151
9: INTERNAL CONTROL
END OF CHAPTER
152
Tests of controls

Describe control objectives, control procedures, Q17(a) Section B – Specimen exam (sales)
activities, key controls and tests of control in Q16(b) Section B – Sept 16 (sales)
relation to: Q16(c) Section B – Sept 16 (payroll)
The sales system Q17 Section B – Dec 2016 (cash receipts)
The purchases system Q18(a),(b) Section B – March/June 2017
The payroll system (various)
The cash system Q16(c) Section B – Sept/Dec 2017
The inventory system (purchases/payables)
Non-current assets Q16(a),(b) Section B – March/June 2018
(payroll)
Q17(a) Section B – Sept/Dec 2018 (cash
receipts and payments)
Discuss the requirements and methods of reporting Q17(a) Section B – Sept/Dec 2018
significant deficiencies in internal control to
management and those charged with governance
Explain, in a format suitable for inclusion in a
management letter, significant deficiencies within
an internal control system and provide
recommendations for overcoming these
deficiencies to management
Discuss the need for auditors to communicate with
those charged with governance
Describe the format and content of audit review
reports and make appropriate recommendations to
management and those charged with governance
153
10: TESTS OF CONTROLS
Overview
Audit evidence Internal auditor's reports
Tests of controls
Sales Purchases Payroll
Bank and cash Inventory Capital expenditure
Communication of deficiencies in Communication with those charged

internal control with governance
154
1 Audit evidence (recap)

Sources of evidence
1.1 In Chapter 8 we saw that there are two main ways in which an auditor can gather audit
evidence. These were:
 Tests of controls
 Substantive procedures
Procedures for obtaining evidence

1.2 The mnemonic AEIOU can help generate different audit procedures.
1.3 (a) Analytical procedures – Evaluation of financial information by a comparison to
financial and non-financial data and the investigation of
identified fluctuations and relationships inconsistent with
other information
(b) Enquiry and – Seeking information of knowledgeable persons throughout
confirmation the entity or outside the entity (enquiry) and
obtaining representations directly from a third party
(confirmation)
(c) Inspection – Examining records, documents and tangible assets
(d) Observation – Looking at a process or procedure being performed by
others
(e) recalcUlation – Checking the arithmetical accuracy of documents or
records and the auditor's independent execution of
procedures and reperformance of controls
1.4 Analytical procedures and confirmation are purely substantive procedures.
1.5 Enquiry, inspection, observation and recalculation can all be used as either a test of control
or as a substantive procedure.
155
2 Tests of controls
2.1 Internal controls are implemented by management to prevent or detect fraud and error.
2.2 The auditor will only ever carry out tests of controls if their initial risk assessment suggests
that the entity's internal controls operate effectively.
2.3 If this is the case, then the auditor will perform tests of controls to gather audit evidence
about relevant audit assertions.
2.4 The auditor must test that the control:
 Is properly designed;
 Exists; and
 Has operated throughout the period.
2.5 Failures of internal controls (or deviations) should be recorded and investigated regardless
of the amount involved.
The auditor must assess whether deviations are isolated departures or indicate existence of
errors in accounting records.
2.6 If the results of the tests of control are unsatisfactory, then the auditor's preliminary
assessment of control risk is not supported and the auditor must modify the nature, timing
and extent of their planned substantive procedures.
2.7 Tests of controls include enquiry in combination with other audit procedures, for example:
(a) Inspection of documents supporting controls or events to gain audit evidence that
controls have operated effectively, for example verifying that a transaction has been
authorised
(b) Observation of the entity's control procedures, for example observing an inventory
count to ensure it is being conducted in accordance with the inventory count
instructions
(c) Reperformance of the application of a control to ensure it was performed correctly,
for example reperforming a bank reconciliation to verify that it has been done properly
(d) Examination of evidence of management reviews, for example minutes of board
meetings
(e) Testing of the control activities performed by a computer, using for example
computer-assisted audit techniques (CAATs)
156
3 Transaction cycles
3.1 There are six transaction cycles detailed in the syllabus:
(1) Sales
(2) Purchases
(3) Payroll
(4) Bank and cash
(5) Inventory
(6) Capital expenditure
3.2 The first three cycles are covered in Section 3 whilst the other cycles are addressed in the
additional notes section to this chapter.
Sales cycle
3.3 The sales cycle/sales system consists of four main stages. Each stage has its own key
documentation.
(1) Order placed Order form
(2) Despatch of Goods despatch

goods note (GDN)
(3) Goods invoiced Invoice

and recorded
(4) Payment Remittance advice

received
157
ten years. It operates from two sites: a factory where the clothes are made and a head office
You are an audit senior in Check and Co and you are carrying out the controls work on the sales
system for the year ended 30 September 20X1. You have access to the systems notes that Dress
You Like Co provided to its previous auditors for the year ended 30 September 20X0 and you have
spoken to several members of Dress You Like Co staff to obtain more information about the sales
system.
Extract from Dress You Like Co's sales systems notes for the year ended 30 September
20X0
Order Placed
Customers contact Dress You Like Co by phone or email and inform the sales team which
products they require. A member of the sales team completes a standard form with all of the
customer details and forwards this to the warehouse for despatch to the customer.
Despatch of Goods
The warehouse manager collates all of the orders from the previous day and passes them to the
picking team. This team then picks the items, packages them and produces a goods despatch note
detailing all of the products. The warehouse manager then organises delivery of the products for
the following day.
Goods Invoiced and Recorded
Each day the finance team receives copies of the GDNs completed by the warehouse staff and
uses these to generate invoices. Each invoice has the customer details, the products despatched
and the standard prices. The supermarket chain has its own price list, which is significantly
discounted on the other retailer prices.
Payment Received
Customers can pay by cash, cheque or BACS and should return a remittance advice with all
payments. There is no formal process for monitoring old debts. Bank reconciliations are performed
on a weekly basis by the accounts team and monthly by the internal audit department.
158
Transcripts of conversations with Dress You Like Co staff (available as video clips)
Interview with Jenny Bristow, sales team
You: So Jenny, can you tell me a little more about the standard form that you complete
when you receive an order?
Jenny: Sure. The order form is three-part; we complete it by hand using the information the
customer has provided by phone or email. We refer back to the standard product list,
which all our customers have a copy of, to ensure that we have the correct product
codes for each item. Once the form is complete we send one copy to the customer
(either by post or scanned and emailed), one copy is sent to the warehouse and we
retain one copy here.
You: OK, is the process any different for the supermarket?
Jenny: No, not really. For the supermarket we send the order straight to the despatch team in
the warehouse so the order can be sent quickly, rather than sending it to the
warehouse manager.
You: Thanks. Oh, one more question. What happens with new customers?
Jenny: How do you mean?
You: Well, do you have any specific checks on new customers or any prescribed credit
limits?
Jenny: Umm, no not really. We just record their details on the form as normal and then pass
the order on to the warehouse.
You: Brilliant, thanks very much.
Jenny: You're welcome.
Interview with David Furber, Warehouse Manager

You: Hi David, thank you for taking the time to help me today.
David: Fine, but this had better be quick, I'm very busy.
You: OK. Can you tell me how the process for despatching goods works?
David: Well, I get the orders from the sales team through the day, then at the beginning of
the next day I allocate them to the boys in the warehouse to pick and pack while I sort
out delivery drivers for the day after. Simple really.
You: Good, well can you give me a bit more detail on the picking and packing? What
happens if you are out of stock of any item?
David: The boys pick the goods that are on the customer order and they put them in boxes.
Then they write a GDN based on what is in the box. If there is something out of stock
they mark it on the customer order and then pass it back to me. I can then allocate that
order back out to someone to pick tomorrow or the next day. I keep a file with all of the
orders that haven't been fully despatched and I check it every day. The customer might
have to wait a few days, but they always get the whole order in the end.
159
You: OK, do you check this outstanding file back to any other information?
David: Yes, at the end of each month I sit down with Jenny from the sales team. We go
through the outstanding orders file and copies of all of the GDNs to make sure all
orders have been captured.
You: Lovely, thank you very much.
David: Great, I can get back to some proper work now.
Interview with Edward Times, Finance Assistant

You: Hi Ed, is now a good time to talk about the invoicing process?
Ed: Sure, no problem, what would you like to know?
You: Well, I understand that you get copies of the GDNs from the warehouse team and you
use them to generate invoices, can you give me a bit more detail?
Ed: OK. Every day I get a pile of GDNs from the warehouse for the stuff despatched the
day before and I copy the details from here into the invoicing software. I copy across
the products despatched and the customer details and then the system automatically
applies prices.
You: Does everyone pay the same price?
Ed: No, the supermarket has a special price structure which the system automatically
applies when I record the customer details and everyone else pays the same.
You: OK, can you override the prices in any way, say to offer a special discount?
Ed: No, I can't do that, but Katie can.
You: Katie?
Ed: Yes, Katie Escombe, the acting Finance Director/Chief Finance Officer.
You: Oh yes. So how does she do that?
Ed: She has a special login to the system which then allows her to amend prices; I don't
really know much more than that except that any changes she makes are reviewed by
another director.
You: Great. I think that's all for now, thanks very much.
Ed: OK, see you later.
160
Interview with Claire Wilson, Accounts Receivable Clerk

You: Thanks for taking the time to meet me, Claire. I was hoping to find out a bit more
about the process for receiving payment for invoices.
Claire: OK. Well, customers send us money either in the post or put it straight into the bank.
They should send us remittance advices, so we know what the money is for, but they
don't always do it, especially for the payments direct into the bank.
You: So what do you do if they don't send a remittance advice?
Claire: Well, we try to guess what the amount is for, so if it matches the most recent
statement etc we allocate it to those invoices, but if we can't guess we just allocate it
to the oldest invoices.
You: Right, so what do you do to make sure old debts are paid?
Claire: Well, I don't really have any formal process. I just look out for customers who haven't
paid in a long time and give them a call when I have a chance.
You: Do you send statements or do any aged receivables analysis?
Claire: Oh, I've heard about aged receivables analysis, but I don't know if our system will
produce one, I've never tried.
You: OK, one final thing. Do you do bank reconciliations?
Claire: Not me personally but Simon does them each week.
You: Great, I think that's it. Thanks.
Claire: Thanks.
Required
Using the Dress You Like Co scenario, identify THREE deficiencies in the sales system of Dress
You Like Co. Explain the possible implications of these and suggest a recommendation (internal
control) to address each deficiency.
161
Solution
Deficiency Implication Recommendation
162
Required
Continuing with the Dress You Like Co scenario, identify THREE controls within the sales system
and recommend a test of control that could be carried out for each control.
Solution
Control Test of control
163
Purchases cycle
3.4 As with the sales system, the purchases cycle/purchases system also consists of four main
stages and has key documentation at each stage.
(1) Order stage Purchase requisition

Order form
(2) Goods received Goods received note

(GRN)
(3) Goods invoiced Invoice

and recorded
(4) Payment made Remittance advice
164
You are now carrying out the work on the purchases system at Dress You Like Co. You again
have access to the systems notes that Dress You Like Co provided to its previous auditors for the
year ended 30 September 20X0 and you have spoken to several members of Dress You Like Co
staff to obtain more information about the purchases system.
Extract from Dress You Like Co's purchases systems notes for the year ended
30 September 20X0
Order Stage
Reorder levels exist for all items of inventory. When the level of inventory falls to the reorder level,
a standard order form is automatically generated by the inventory system to order a set quantity of
material. The order form details the name of the buyer responsible for that inventory line and a
copy of the order is forwarded to the warehouse where goods are received.
Goods Received
On receipt of the goods, the quality of the materials is checked and then the warehouse manager
generates a sequentially numbered, multi-part goods received note.
Goods Invoiced and Recorded
Each day the finance team receives copies of the GRNs completed by the warehouse staff. These
are filed in sequential number order to await receipt of the associated invoice.
Payment Made
All invoices in the file are automatically paid at the end of each month. The Chinese supplier sends
a monthly statement but this is not reconciled to the purchase ledger account. Bank reconciliations
are performed on a weekly basis by the accounts team and monthly by the internal audit
department.
Transcripts of conversations with Dress You Like Co staff (available as video clips)
Interview with Ivan Higster, purchasing department
You: So Ivan, can you give me some more information about the reorder levels that are
set?
Ivan: Yes, it's quite simple really; because we're involved in the fashion industry we need to
make sure our products meet current trends so every season the buyers monitor
which items sell well and then adjust the reorder levels for each product in the current
season based on our past experience.
You: Thanks. So what checks do the buyers perform when orders are generated for their
inventory lines?
Ivan: None really, we just get the order through and then place it with our supplier. We do
forward a copy of the order to the warehouse, though.
You: Great, thanks for your time.
Ivan: No worries!
165
Interview with David Furber, Warehouse Manager

You: Hi David, sorry to be asking you some more questions but I'm looking at the
purchases system now. Have you got five minutes?
David: I wish you auditors would get organised and do all your questions in one go!
You: Sorry David, it shouldn't take long. Would you talk me through what happens when an
order for goods is received into the warehouse?
David: Well, the goods arrive with a list of what's in each crate and I get the boys to unpack
it. They check the condition of each roll of material and make sure the quality looks
satisfactory and that it was packaged securely. Once they've confirmed to me what
was received, I generate a sequentially numbered, multi-part goods received note. I
send one part of this to the finance team.
You: OK, do you check the details on the goods received note back to any other
information?
David: No, all of our deliveries come from our Chinese supplier so I don't need to make any
checks.
You: Right, thanks then.
David: That's OK.
Interview with Sadie Thomas, Finance Assistant

You: Hi Sadie, would it be OK to have a quick chat about the process for recording
purchase invoices?
Sadie: Hi, yes, I was expecting you!
You: Thanks! David tells me that you get copies of the GRNs from the warehouse team.
Can you tell me what happens next in the process?
Sadie: Sure, each day David passes me the GRNs generated by the warehouse for items
that have been received from our Chinese supplier the day before. I file these in
sequential number order so I have them ready for when the supplier invoice arrives.
You: What happens when the invoice arrives?
Sadie: I identify the GRN that it relates to and check the details to the GRN so I know that
we've been invoiced for the right items in terms of product code, quantity and price. I
initial the invoice to show that this has been checked and enter the invoice into the
accounting system. I allocate each invoice the same number as the related GRN and
then staple them together in the file.
You: That sounds very comprehensive. Thanks Sadie.
Sadie: No problem!
166
Interview with Lauren White, Accounts Payable Clerk

You: Hi Lauren, Sadie gave me your name and said you would be the best person to
speak to about the process for paying invoices. Have you got a few minutes?
Lauren: Sure.
You: Great, can you explain to me how invoices get paid?
Lauren: Yes, at the end of each month, I have a look in Sadie's file and identify all of the
invoices which are matched to GRNs which are unpaid and then pay them.
You: How do you know which invoices are unpaid?
Lauren: Well there's two ways of knowing really – firstly once I pay an invoice I mark it with a
stamp saying 'paid'. Secondly, we always pay all of the invoices received in the month
so, for example, at the end of June I would know that all of the invoices received in
June that have been matched to GRNs need to be paid.
You: Do you have set credit terms with the supplier?
Lauren: Yes, they give us 30 days' credit from the end of the month so an invoice dated
14 June would have to be paid by the end of July.
You: OK. Does the supplier send statements?
Lauren: Yes, they send us a statement each month which details all of the transactions we
have had with them during the month. I file this in their correspondence file.
You: So how is the actual payment made?
Lauren: We pay by bank transfer. I prepare a schedule detailing the invoices and the total
amount we need to pay. Each of the buyers sign off to say that they authorise the
payments. I then prepare the bank payment authorisation and give all of this
information to Katie to check and authorise the bank transfer.
1 From a review of the information above, your audit assistant has highlighted some potential
deficiencies in respect of the purchases system at Dress You Like Co.
One such deficiency is that the goods received into the warehouse are not checked back to
the order form and your audit assistant feels this deficiency could have implications for the
company.
Which TWO of the following statements describe valid implications of the above
deficiency?
 Goods may be accepted which have not been ordered and therefore are not needed
by the business.
 Goods may be accepted by the business which are of insufficient quality.
 Goods which are actually required for production may have been omitted from the
delivery which could lead to stock outs and business interruption.
 Orders may be placed for goods which are not required.
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2 A second deficiency relates to the fact that the balance per the purchase ledger account is
not reconciled to supplier statements.
Which of the following recommendations would NOT be appropriate to address this
deficiency?
 The accounts payable clerk should reconcile the balance per the purchase ledger to
the balance per the supplier statement each month
 Invoices on the supplier statement which relate to goods received but not invoiced
should not be included in the purchase ledger to avoid the payables balance being
overstated at the year end
 Any journals processed as a result of the reconciliation should be authorised by the
department supervisor
 The reconciliation performed by the accounts payable clerk should be reviewed by the
department supervisor
3 The report to those charged with governance at Dress You Like Co will recommend that a
notification is added to the accounting system which identifies when an invoice is due for
payment.
Which of the deficiencies in Dress You Like Co's purchases system will this
recommendation BEST address?
 That supplier invoices are not recorded accurately in the purchase ledger
 That supplier invoices are incorrectly coded
 That supplier invoices are paid too late
 That supplier invoices are paid too early
The following questions relate to the information in Lecture Example 3.

1 In order to ensure that Dress You Like Co is only invoiced for items which have been
received the finance assistant vouches the details on the invoices to the goods received
note.
Which of the following statements is a valid test of control that the auditor could
perform in order to conclude whether this control operates effectively?
 Observe a sample of goods being received in the warehouse to ensure that the goods
received note is completed accurately
 Inspect a sample of invoices recorded in the ledger to verify that they have been
allocated the correct product code
 For a sample of invoices which have been matched to goods received notes
reperform the calculations to ensure they have been done properly
 Analytically review the level of purchases made each month to the budget and
investigate any significant variances
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2 Your audit assistant is planning to inspect a sample of the bank payment authorisation
documents for evidence of the Finance Director's signature.
For which of the following internal control objectives would this provide sufficient,
appropriate audit evidence?
 That payments to the supplier are made on a timely basis
 That payments to the supplier are reviewed and authorised prior to payment
 That payments to the supplier are accurately recorded in the ledger
 That payments to the supplier are for valid business expenses only
Solution
Wages (payroll) cycle

3.5 The wages system has two main areas to consider:
 The role of the Human Resources (HR) function
 The role of the payroll processing function
3.6 The HR function tends to focus on areas such as the appointment and removal of staff, staff
appraisals and notifications of salary changes.
3.7 The payroll function deals purely with the processing of payroll information each month.
3.8 Ideally these two distinct roles would be carried out by different members of staff/
departments; however, this may not be possible in smaller businesses.
3.9 There are inherent risks within a payroll system, including:
 Fraud, for example:
– Establishing fake payroll records
– Changing pay rates without authorisation
– Claiming payment for more hours than genuinely worked
– Cash theft (where wages are paid in cash)
 Errors arising from complexities relating to tax and other deductions
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3.10 The wages cycle/payroll system consists of three main stages with documentation at each
stage:
(1) Work Timesheets

recorded
(2) Recognition of Payroll records

payroll liability
(3) Payment made Payslips
You are now carrying out the work on the wages system at Dress You Like Co. You have been given
the following information concerning the wages system for the year ended 30 September 20X1.
(i) The factory and warehousing staff record the number of hours worked using a clocking
in/out system which is observed by a supervisor. On arrival at work each morning and at the
end of each day's work, each worker enters their unique employee number on a keypad.
Any employee who does not clock out at the end of their shift is automatically clocked out by
the system.
(ii) In order to claim overtime, employees need to complete an 'overtime claim' form and submit
it to the wages clerk.
(iii) The Wages Clerk, Jake Newman, works in the finance team and is responsible for making
amendments to the computerised wages system in respect of employee holidays and
illness. He also sets up and maintains all employee records and processes the monthly
payroll.
(iv) The computerised wages system calculates deductions from gross pay, such as employee
taxes and net pay. Each month a list of net cash payments for each employee is produced
and this is reviewed and authorised by the acting finance director before the employees are
paid by BACS transfer. Deductions are checked by Jake Newman on a periodic basis.
170
Required
Using the Dress You Like Co scenario, identify TWO deficiencies in the wages system of Dress
You Like Co. Explain the possible implications of these and suggest a recommendation (internal
control) to address each deficiency.
Solution
Required
Continuing with the Dress You Like Co scenario, identify TWO controls within the wages system
and recommend a test of control that could be carried out for each control.
171
Solution
4 Communication of deficiencies in internal control

4.1 ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance
and Management states that significant deficiencies in internal control should be
communicated in writing to those charged with governance.
4.2 This will take the form of a report to management.
4.3 A significant deficiency in internal control is a deficiency or combination of deficiencies in
internal control that, in the auditor's professional judgement, is of sufficient importance to
merit the attention of those charged with governance.
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Determining whether a deficiency is significant

4.4 The auditor should consider the following matters when determining whether a deficiency in
internal control is a significant deficiency:
The susceptibility to
The likelihood of the loss or fraud of the The subjectivity and
deficiencies resulting in related asset or liability complexity of
material misstatements determining estimated
in the financial amounts
statements
The cause and frequency Consider The amounts exposed

of the exceptions to the deficiencies
identified as a result of
the deficiencies
The volume of activity

The importance of the
that has occurred or
controls to the financial
could occur
reporting process
Reports to management
4.5 Once the auditor has decided that there are significant deficiencies which need to be
communicated to those charged with governance, they should include this information in a
report to management.
4.6 In the exam you may be asked only to identify deficiencies in internal control, explain the
implications of the deficiencies and make a recommendation to address these.
4.7 Alternatively you may be asked to include the above information in a report to management.
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Specimen format for a report to management

4.8
Check and Co
Auditor's Address
Board of Directors
Dress You Like Co
Date: exam date
Dear Sirs
Audit of Dress You Like Co for the year ended 30 September 20X1
Please find enclosed the report to management on significant deficiencies in internal controls
identified during the audit for the year ended 30 September 20X1.
The Appendix to the report considers deficiencies in the sales system, implications of those
deficiencies and provides recommendations to address those deficiencies.
Please note that this report only addresses any significant deficiencies identified during the
audit and if further testing had been performed then more deficiencies may have been
reported. It is not therefore a comprehensive list of all deficiencies.
This report is solely for the use of management and if you have any further questions then
please do not hesitate to contact us.
Yours faithfully
Check and Co
Appendix:
No credit checks are made The company may well A standard new customer
before new customers are accept an order and form should be created which
accepted and credit limits are despatch goods to a bad must be completed before
not prescribed. credit risk. This may mean orders are accepted from new
that goods are sold to a customers. This form should
customer who cannot pay require a credit check to be
for them, leading to a loss made in relation to the
of revenue and inventory. customer and a credit limit
allocated. Standard tiers of
credit limits could be applied
for different customers. All
completed new customer
forms should be authorised
by Edward Times or Katie
Escombe prior to goods being
despatched. The
authorisation should be
evidenced on the form.
174
Reports to management by the internal audit function

4.9 In the example above, the report to management was produced by the external auditor.
4.10 In Chapter 5 we saw that one of the roles of the internal audit function is often to review an
entity's internal controls and to report their findings (including any deficiencies) to
management.
4.11 It is very possible therefore that a report on deficiencies, implications and recommendations
might be prepared by the internal audit function. The format of such a report will be
determined by management and is much more flexible than the above report by the external
auditor.
4.12 An example internal auditor's report is included in the additional notes section of this
chapter.
175
176
Additional
Notes
177
5 Other transaction cycles: Bank and cash

5.1 Another transaction cycle included in the syllabus is bank and cash.
5.2 The main objectives/stages of the internal controls in this cycle are to ensure:
 All monies received are recorded
 All monies received are banked
 Cash and cheques are safeguarded against loss or theft
 All payments are authorised, made to correct payees and recorded
 Payments are not made twice for the same liability
5.3 To a large extent many of these objectives overlap with the final stages of the sales and
purchases cycles.
Stage: All monies received are recorded

Risk Controls Tests of controls
That monies are There should be a segregation of Observe the process of the post
received but not duties in place between those being opened and monies received
recorded. receiving the monies and those recorded to ensure the entity's
recording them in the accounting internal controls are being adhered
system. to.
Two people should open the post Inspect documentation such as the
and record the amounts received on receipts listing and the bank paying
a 'receipts listing'. This information in slip for evidence of each staff
should then be passed to another member carrying out their separate
member of staff who will then record part of the process.
the entries in the cash book and write
out the bank paying in slip.
Another member of staff should be
responsible for banking any monies
received.
Stage: All monies received are banked
That monies Bank reconciliations should be Reperform the bank reconciliation to
received are not performed on a weekly/monthly basis ensure it has been done accurately.
banked. by someone not responsible for the Review the bank reconciliation for
banking and the reconciliation evidence of the supervisor/manager
reviewed by a supervisor/manager. review being performed.
178
Stage: Cash and cheques are safeguarded against loss or theft

That cash/ Unbanked receipts should be kept in Physically verify the location of
cheques are a locked safe at all times. unbanked receipts/cheque books to
misappropriated. Cheque books should be kept by a ensure they are kept securely.
supervisor/manager and stored in a
secure location such as a locked
drawer/cash tin or safe.
Stage: All payments are authorised, made to correct payees and recorded
That invoices are All invoices should be authorised for Inspect a sample of invoices for
paid without being payment and coded to the relevant authorisation and appropriate coding.
authorised/paid to supplier by the appropriate budget
the wrong supplier holder prior to the invoice being paid.
and not recorded Authorisation/coding should be
accurately in the evidenced by a signature.
accounting Statements received from suppliers Review a sample of supplier
records. should be reconciled to the relevant statement reconciliations to ensure
purchase ledger account on a that they have been completed
monthly basis. Any subsequent accurately and any resultant changes
changes to the accounting records authorised.
must be authorised.
Stage: Payments are not made twice for the same liability
That an invoice is Once paid the invoice should be Inspect a sample of invoices for
paid twice. stamped 'paid'. evidence that calculations have been
reperformed and the invoice stamped
as 'paid'.
Purchase invoices should be Attempt to process a payment for an
sequentially numbered and the invoice which has previously been
invoice recorded as 'paid' on the paid to determine whether the
system so that the computer will not system will block the payment.
allow the same invoice to be paid
twice.
179
6 Other transaction cycles: Inventory

6.1 Another transaction cycle included in the syllabus is inventory.
6.2 The main objectives/stages of the internal controls in this cycle are to ensure:
 Only goods required by the entity are accepted
 Damaged goods are not accepted
 The business is not interrupted due to stock outs
 Inventory is kept securely (not damaged or stolen)
6.3 As with bank and cash, to a large extent many of these objectives overlap with the middle
stages of the purchases cycle.
Stage: Only goods required by the entity are accepted

That goods which A copy of the authorised order form Inspect a sample of GRNs for
have not been should be passed to the warehouse. evidence of a signature verifying that
ordered are When goods are received, they the goods received were traced back
accepted. should be matched to the order form to an authorised order form.
and only accepted if they were
ordered.
The GRN should be signed to
evidence that it has been vouched
back to the order form.
Stage: Damaged goods are not accepted
That damaged/ On receipt of goods all items are to Observe the receipt of goods by staff
faulty goods are be verified to ensure they are in to confirm the control is carried out.
accepted. satisfactory condition.
Stage: The business is not interrupted due to stock outs
That goods On receipt of goods the warehouse Observe the receipt of goods into the
ordered are not should raise a multi-part, sequentially warehouse to ensure all goods are
received, numbered goods received note recorded and a GRN generated.
potentially leading (GRN). One part of the GRN should Verify that the GRN is matched to the
to stock outs. be passed to the purchasing order form by the purchasing
department to be matched to the department.
order form.
Unmatched orders should be Enquire as to the action taken where
reviewed on a periodic basis and orders are unfulfilled and reperform
suppliers chased. this process.
180
Stage: Inventory is kept securely (not damaged or stolen)

That inventory is Inventory should be stored in an Inspect the environment in which
damaged/stolen. appropriate environment (for inventory is stored to ensure it is
example, perishable inventory should suitable for the nature of the
be kept at the right temperature/ inventory.
refrigerated if necessary).
Access to inventory should only be Inspect the identity cards of
granted to the appropriate personnel. employees working within the
inventory area.
Items should only be issued from Inspect a sample of GDNs to verify
inventory if accompanied by a copy that they relate to bona fide customer
of a customer sales order form. orders.
7 Other transaction cycles: Capital expenditure

7.1 Another transaction cycle included in the syllabus is capital expenditure.
7.2 Many of the objectives overlap with the initial stage of the purchases cycle where an entity
must ensure that only goods required are ordered and that all orders are authorised.
7.3 The principal internal controls in this cycle which have not already been detailed in the
purchases cycle are to ensure:
 That capital expenditure is appropriately classified in the accounting records
 That capital items are recorded in the non-current asset register
Stage: That capital expenditure is appropriately classified in the accounting records

That revenue Separate order forms should be used
expenditure is for the purchase of inventory items
recorded as (see purchases cycle) and capital
capital items.
expenditure or For capital items, the order should be Inspect a sample of orders for capital
vice versa. authorised by one or two managers/ items. Vouch that the appropriate
directors depending on the value of level of authorisation has been made
items ordered. The order should be and evidenced by a signature. Verify
coded to the appropriate non-current that the account code relates to the
asset account. item ordered.
Periodically review the revenue and Discuss with management the
capital expenditure nominal ledger outcome of the nominal ledger
accounts for evidence of reviews. Inspect any journals made
large/unusual items which may have to correct errors to ensure that they
been incorrectly recorded. have been authorised.
181
Stage: That capital items are recorded in the non-current asset register
That capital items Periodically review the non-current For a sample of non-current assets,
are not recorded assets held by the business and inspect the non-current asset register
in the non-current trace them through to verify that they to ensure that they have been
asset register. are recorded in the non-current asset included.
register.
On a monthly basis, reconcile the Review the reconciliation to see the
totals on the non-current asset level of adjustments required.
nominal ledger codes to the balance Discuss with management why errors
per the non-current asset register. have occurred and the action being
Investigate any differences. taken to reduce future errors.
Authorise all adjustments.
8 The sales system revisited

8.1 The sales system was covered in Section 3 using a practical scenario for the entity
Dress You Like Co.
8.2 In exam questions it is important to use the scenario to generate your answer rather than
rote learn lots of internal controls and tests of controls.
8.3 You should try to complete as many practice questions on this area as possible. To help you
in this, we have included some other examples of internal controls and tests of controls
below.
Stage: Order Placed

That an order is Conduct a credit check on all new Inspect a sample of new customer
accepted from customers prior to accepting an accounts to ensure that credit checks/
and goods order. The credit check should be references were obtained before the
despatched to a undertaken by someone separate order was accepted.
customer who is from sales department. For a sample of customer accounts,
not creditworthy. Once accepted, new customers attempt to process an order that will
should be given a credit limit – these take a customer over their credit limit
should be reviewed regularly. to determine whether the order is
rejected.
That an order is Orders should be completed on Using a computer (or manually) test
not fulfilled sequentially numbered order forms the numerical sequence to ensure it is
leading to loss of and sequentially numbered goods complete.
future business despatched notes (GDN) generated Review a sample of unfulfilled orders
from dissatisfied from the same information. and enquire as to why these remain
customer. A copy of the GDN should be passed outstanding.
to the sales department by the
warehouse team once the order is
despatched.
182
Stage: Order Placed

The sales team should regularly
review any order forms which are not
matched to GDNs.
That the wrong Spot checks should be conducted on Vouch a sample of items packed to
items, wrong goods once they have been packed the GDNs and order form to ensure
quantity or to ensure the goods packed are in the goods packed are accurate.
damaged goods good condition and agree to the order Physically inspect a sample of goods
are despatched. form. which have been packed.
Review customer complaint files for
evidence of incorrectly despatched
goods.
Stage: Despatch of Goods
That goods are On receipt of the goods, the customer Review a sample of GDNs for
not despatched signs the multi-part GDN. evidence of the customer's signature.
to the required One copy should then be left with the
destination. customer and the others returned with
the delivery driver (and one copy
passed to the sales team, one
retained in the warehouse and one
passed to the invoicing department).
Stage: Goods Invoiced and Recorded
That goods Invoices should be sequentially Match a sample of GDNs with the
despatched are numbered and generated using the corresponding invoice.
not invoiced/not information on the GDNs. Perform a sequence check of
invoiced All invoices should be authorised and invoices to ensure all invoices are
correctly. details agreed to price lists/credit recorded.
terms. Compare a sample of invoices with
the authorised price list and credit
terms to ensure they are accurate.
That invoices are Periodically review customer Review customer correspondence
posted to the accounts for any unpaid amounts. files for evidence of any
wrong customer complaints/instances of incorrect
Send statements to customers on a
account. invoices being applied to a
monthly basis.
customer's account.
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Stage: Payment Received

That cash is not Produce an aged receivables report Review the aged receivables report
received. on a monthly basis and actively and discuss the action taken on old/
pursue old/overdue balances. overdue balances with credit control.
That payments There should be segregation of duties Observe the procedures in place to
received are between those who update ensure segregation of duties.
misappropriated. receivables ledger and those who:
 Raise invoices
 Raise credit notes
 Follow up statement queries
 Open and count cash
Cash/cheques should be kept Observe the procedures for banking
securely and banked promptly. cash/cheques.
9 The purchases system revisited

9.1 As with the sales system, we have included some other examples of internal controls and
tests of controls below.
Stage: Order Stage

That an order is Orders should only be raised on Review a sample of orders for
unauthorised receipt of an authorised purchase evidence that the purchase
and not for requisition which is approved by the requisition was authorised and the
business use. department manager. goods are for business use.
That the entity Orders should only be placed with a For a sample of orders, vouch that
does not buy supplier which is on the entity's list of the suppliers used are on the
items at the most preferred suppliers which have been preferred supplier listing.
competitive approved in terms of cost and quality.
price. For non-standard items separate
quotations may be required.
184
Stage: Goods Received

That goods On receipt of goods the warehouse Observe the receipt of goods into the
ordered are not should raise a multi-part, sequentially warehouse to ensure all goods are
received, numbered goods received note recorded and a GRN generated.
potentially (GRN). One part of the GRN should Verify that the GRN is matched to
leading to stock be passed to the purchasing the order form by the purchasing
outs. department to be matched to the department.
order form.
Unmatched orders should be Enquire as to the action taken where
reviewed on a periodic basis and orders are unfulfilled and reperform
suppliers chased. this process.
That faulty goods On receipt of goods all items are to be Observe the receipt of goods by staff
are accepted. verified to ensure they are in to confirm the control is carried out.
satisfactory condition.
Stage: Goods Invoiced and Recorded
That the liability Another part of the GRN should be For a sample of GRNs trace through
for goods passed to the accounts department. to corresponding invoice and verify
received is not Invoices received from suppliers that the invoice has been recorded in
recognised in the should then be matched to the GRN. the accounting records.
accounting Where no invoice has been received
Unmatched GRNs should be
records. verify that the relevant accrual has
reviewed periodically and an accrual
posted for the associated liability. been recorded.
That a liability is Upon receipt of a supplier invoice, it For a sample of invoices recorded,
recognised for should be matched to the sequentially vouch the details back to the GRN
goods which numbered GRN and order form. The and order form to verify that the
have not been invoice should be allocated the same goods were received.
received. sequential number.
Stage: Payment Made
That payments All invoices should be authorised for Inspect a sample of invoices for
are made to the payment and coded to the relevant authorisation and appropriate coding.
wrong supplier. supplier by the appropriate budget
holder prior to the invoice being paid.
Authorisation/coding should be
evidenced by a signature.
Statements received from suppliers Review a sample of supplier
should be reconciled to the relevant statement reconciliations to ensure
purchase ledger account on a that they have been completed
monthly basis. Any subsequent accurately and any resultant changes
changes to the accounting records authorised.
must be authorised.
185
Stage: Payment Made

That an invoice Prior to being paid all invoices should Inspect a sample of invoices for
is paid twice/is be agreed to the GRN and order form evidence that calculations have been
for the wrong and calculations such as unit price, reperformed and the invoice stamped
amount. sales tax, quantities and discounts as 'paid'.
agreed to the appropriate records.
Once paid the invoice should be
stamped 'paid'.
10 The payroll system revisited

10.1 As with the sales and purchases systems, we have included some other examples of
internal controls and tests of controls for the wages/payroll system below.
Stage: Work recorded
That hours worked are Hours worked should be recorded Observe a sample of
not recorded accurately. using timesheets or a clocking in and employees clocking in and
out system. out to ensure it is done
Hours recorded to be reviewed by according to the entity's
responsible official. procedures.
Inspect a sample of
timesheets for evidence
that they have been
reviewed by a responsible
official.
That additional hours are Overtime must be authorised by an For a sample of overtime
recorded which have not appropriate supervisor/manager in payments, trace back to the
been worked. advance of the overtime being carried overtime authorisation form
out and an overtime authorisation form and inspect the form for
completed. evidence of the overtime
being authorised.
Stage: Recognition of payroll liability
That fictitious employees Where new joiners are taken on/ Obtain a list of
are paid. current employees leave Human joiners/leavers during the
Resources (HR)/staff manager should period and trace a sample
complete and sign a joiners/leavers through to ensure that
form which should be passed to payroll. appropriate HR
Payroll must acknowledge receipt of documentation was
the form/changes to the payroll system completed and the payroll
should be made and amendments to system amendment was
the system subsequently reviewed by a made accurately.
supervisor.
186
Stage: Recognition of payroll liability

That wages are Any changes to standing data for Review a sample of the
paid/deductions made at payroll (employee salaries/hourly reports showing changes
the wrong rate. rates/deductions from gross wages/tax made to standing data to
codes etc) should be authorised by ensure that changes made
HR/staff manager using appropriate were appropriately
documentation. authorised and accurately
A report of changes to standing data made.
should be printed on a monthly basis Recalculate PAYE and
and reviewed by an appropriate other deductions to ensure
manager to ensure all changes are they have been correctly
bona fide and accurately made. calculated.
Stage: Payment made

That employees are not Each month a printout of all amounts Review the printout to
paid the amount that they due to be paid to employees should be determine whether any
are due to receive per printed and reviewed for any unusual unusual items were
payroll records/their amounts/employees. followed up. Discuss the
payslip. outcome with management.
The total of the amount to be paid Recast the schedule in
should be recast. order to ensure it has been
accurately cast.
If employees are paid by BACS transfer For a sample of employees
then the employees' bank account reperform the controls in
number should be verified and the place to ensure they have
amount due to each employee agreed been completed accurately.
back to the payroll system and payslip. Vouch the authorisation of
The BACS transfer should then be the payroll
authorised by the payroll manager/ manager/finance director.
finance director.
If employees are paid in cash then an Observe cash payment
additional check should be made that process.
the amount included in the wage packet
agrees back to the payslip.
Wage packets should be made up by
two payroll staff and employees
required to sign to confirm receipt of the
wage packet.
187
11 Internal auditor's reports

11.1 In Chapter 4 we saw that the role of the internal audit function is wide and varied.
Chapter 5 In most cases once the internal audit function has completed an assignment, it would be
Section 5 usual for them to prepare a report which summarises their findings.
11.2 Internal auditor's reports are therefore flexible and can take different formats depending on
the nature of the assignment.
The format of the report would be agreed with management before the assignment is
undertaken.
11.3 The following is a brief example of a systems review report which has been produced
following an assignment carried out by the internal audit function.
More complicated assignments are likely to summarise the main findings and include a
number of appendices containing detailed information.
REPORT
To: Board of Directors of Robinson Co
From: Internal audit department
Subject: Review of sales system
Period of fieldwork: March 20XX
Terms of Reference
The scope of the assignment was to carry out a thorough review of the sales system.
This involved performing tests of controls on the existing sales system to determine
whether the controls were operating effectively.
In addition, we considered the key risks surrounding the sales function and identified any
risks for which we found no related controls.
We have been able to make recommendations regarding existing controls as well as
suggest new controls where we believe they are needed.
Executive Summary
The main findings from our review are:
 The sales system, on the whole, comprises adequate controls
 Some specific control deficiencies were identified and recommendations are given
in the Appendix to the report
Follow-up
Responsibilities have been allocated for introducing/improving control procedures which
we found to be deficient.
We propose a follow-up review in six months' time.
Dated……………………… Signed………………………….
Head Internal Auditor
188
APPENDIX
Detailed identification of deficiencies, risks and recommendations
Deficiency Risk Recommendation Responsibility Timescale

There is no These new All new customers To be June 20XX
credit check of customers should be subject to a implemented by
new could credit check and the the head of the
customers represent an computer system credit control
prior to increased risk should generate a department.
accepting an of request for
order from irrecoverable authorisation of the
them. debts. new customer before a
sales order can be
accepted.
There is no Any There should be a To be May 20XX

follow-up of dissatisfaction monthly reconciliation implemented and
sales orders from between the month's managed by the
unmatched to customers not sales orders and the head of the sales
GDNs. receiving their related GDNs. Any department.
goods as unmatched orders
ordered should be followed up
decreases the with queries being
likelihood of directed to head of
repeat sales.
purchases.
Customers are This could lead The proof of delivery To be June 20XX
not asked to to disputes as should be a multi-part implemented by
sign a proof of to whether document. All copies head of the sales
delivery. goods have must be signed by the department.
actually been customer. One copy
delivered, loss should be left with the
of customer customer and the other
goodwill and copy retained within
increased the sales department
irrecoverable along with the order
debts. and invoice.
189
12 ISA 260: Communication with those charged with

governance
12.1 In this chapter and also Chapters 3 and 4, we have seen that there are often occasions
where the external auditor needs to communicate audit matters with those charged with
governance.
Definition
12.2 ISA 260 defines those 'charged with governance' as the person(s) or organisation(s) with
responsibility for overseeing the strategic direction of the entity and obligations relating to
the accountability of the entity (ISA 260 (Revised): para. 10a).
Matters the auditor would communicate to those charged with

governance
12.3
The fact that it is the

responsibility of those
The auditor's charged with
governance to prepare An overview of the
responsibilities to form
the financial statements planned scope and
and express an opinion
timing of the audit
on the financial
statements
For listed entities: Matters

Significant findings from the audit:
 A statement confirming their
independence  Views on accounting policies/
estimates and financial statement
 Any relationships that may disclosures
impact their independence
 Significant difficulties
 Safeguards that have been encountered during the audit
implemented to eliminate/
reduce threats to  Significant deficiencies in the
independence to an design, implementation or
acceptable level effectiveness of internal controls
 Written representations
requested by the auditor
 Other matters which are
significant to the oversight of the
financial reporting process
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Third parties interested in communications to those charged with

governance
12.4 Occasionally those charged with governance may wish to provide third parties, for example
bankers or certain regulatory authorities, with copies of a written communication from the
auditors.
It is important that the auditor ensures that third parties who see the communication
understand that it was not prepared with them in mind.
12.5 To that effect, written communication from the auditors will include certain caveats:
 The report has been prepared for the sole use of the entity;
 It must not be disclosed to a third party, or quoted or referred to, without the written
consent of the auditors; and
 No responsibility is assumed by the auditors to any other person.
13 Chapter summary
1 Audit evidence (recap) Audit evidence can be gained using tests of controls
and/or substantive procedures.
2 Tests of controls Tests of controls involve repeatedly testing specific
internal controls to ensure that they are properly
designed, exist and have operated throughout the
period.
Internal controls can be tested using enquiry,
inspection, observation and reperformance.
3 Transaction cycles There are six transaction cycles in the syllabus; each
of them could be tested but the most important ones
are sales, purchases and payroll.
Questions on this area will be scenario based and so
you need to be able to identify internal controls and/or
internal control deficiencies from a given scenario.
4 Communication of Significant deficiencies in internal control noted by the
deficiencies in internal auditor will be communicated via a report to
control management. You may need to produce this in the
exam and so will need to be familiar with its contents.
Reports on internal control deficiencies may also be
undertaken by the internal audit function (Section 11).
5 Other transaction Controls over bank and cash tend to focus on having
cycles: Bank and cash good segregation of duties, physical controls to
ensure the security of the assets and reconciliations.
191

6 Other transaction Most inventory controls are covered by the purchases
cycles: Inventory cycle; however, it is important that controls exist to
ensure that inventory is safeguarded and kept
securely.
7 Other transaction Again, many of these controls are covered by the
cycles: Revenue and purchases cycle; however, additional controls are
capital expenditure required to ensure capital expenditure is properly
authorised and recorded in the nominal ledger and
that the non-current assets purchased are recorded in
the non-current asset register.
8 The sales system This section provides additional examples of the risks
revisited that could be present in a sales system scenario and
the types of controls/tests of controls that could exist.
9 The purchases system This section provides additional examples of the risks
revisited that could be present in a purchases system scenario
and the types of controls/tests of controls that could
exist.
10 The payroll system This section provides additional examples of the risks
revisited that could be present in a wages system scenario and
the types of controls/tests of controls that could exist.
11 Internal auditor's Whenever the internal audit function carries out an
reports assignment, they are likely to produce a report which
details their findings. The reports will vary according
to the type of assignment the internal audit function
has performed. You should be able to describe the
form and content of internal auditor's reports.
12 ISA 260: There are many different matters which the external
Communication with auditor may communicate with those charged with
Those Charged with governance. These range from responsibilities for the
Governance financial statements, planning issues, audit issues,
internal control deficiencies and the auditor's
independence.
END OF CHAPTER
192
topics. As a reminder, Step 4 must be completed and submitted in order to be able to qualify for Pass
Assurance. It is Step 4 and can also be found at the back of these Course Notes.
Course Notes
chapter
Audit and assurance
Regulation 2
Governance
Internal audit 4
Ethics 5
procedures
Audit planning
Internal controls 9
Internal control systems
Tests of controls 10
193
Achievement ladder
194
Audit procedures and
sampling

Discuss the problems associated with the audit and
review of accounting estimates
Describe why smaller entities may have different
control environments and describe the types of
evidence likely to be available in smaller entities
Define audit sampling and explain the need for
sampling
Identify and discuss the differences between statistical
and non-statistical sampling
Discuss and provide relevant examples of, the
application of the basic principles of statistical
sampling and other selective testing procedures
Discuss the results of statistical sampling, including Q4 Section A – Sept 16
consideration of whether additional testing is required
Explain the use of computer-assisted audit techniques
and data analytics in the context of an audit
Discuss and provide relevant examples of the use of Q5 Section A – Sept 16
test data and audit software and other data analytics
tools
Discuss why auditors rely on the work of others
Discuss the extent to which auditors are able to rely on Q18 (b) (i) Section B – Specimen exam
the work of experts, including the work of internal audit
Discuss the audit considerations relating to entities
using service organisations
Explain the extent to which reference to the work of
others can be made in the independent auditor's
report
195
11: AUDIT PROCEDURES AND SAMPLING
Overview
Audit procedures and sampling
Sampling Computer-assisted audit Using the work of others

techniques
Experts Service Internal audit

organisations
Audit Test
software data
Audit data
analytics Audit of accounting Auditing smaller
estimates entities
196
1 Selecting items for testing

1.1 The overall aim of the audit is for the auditor to give an opinion as to whether the financial
statements are free from material misstatement (present fairly).
1.2 The auditor does not test everything and so they need to decide the extent of testing they
will perform.
1.3 ISA 530 Audit Sampling states that the auditor should
determine an appropriate means of selecting items for testing.
(ISA 530: para. 8)
Selecting all items Selecting specific Audit sampling

(100% testing) items
Appropriate for: Appropriate for: See Section 2

 Population with small  High value or key
number of items and items
high risk
 All items over a
 Repetitive calculations certain amount
performed using  See Section 1.4
computer-assisted
audit techniques
(Section 3)
 More common for
tests of detail
1.4 Sometimes the auditor may want to ensure that they test certain items. For example, they
may decide they want to review the monies received post year end from the client's ten
largest receivables balances in order to gather evidence over the valuation of receivables.
1.5 This is not sampling but is often called stratification. This is because the receivables
population has been divided into two discrete sub-populations. One sub-population has the
ten largest balances in it and each of these will be tested. The second sub-population
contains all remaining receivables and the auditor may also test a sample of these balances.
197
2 Sampling
Definition
2.1 Audit sampling means the application of audit procedures to less than 100% of the items
within a class of transactions or account balance such that all sampling units have an equal
chance of selection, in order to provide the auditor with a reasonable basis for forming a
conclusion on the entire population (ISA 530).
Types of sampling
2.2 There are two types of sampling: statistical sampling and non-statistical sampling.
2.3 Non-statistical sampling does not use any mathematical basis for selecting a sample.
2.4 An example of non-statistical sampling is haphazard selection. Here the auditor selects the
items to be included in the sample without following a structured technique but which avoids
any conscious bias or predictability (for example the auditor should not exclude items which
are difficult to locate from the sample purely because of the inconvenience).
2.5 Statistical sampling uses:
 Mathematical number tables to choose a sample which is free from bias; and
 Probability theory to evaluate the results of the testing.
2.6 Examples of statistical sampling methods include:
(a) Random selection – this process uses random number tables (or a computerised
random number generator) to select the items in the sample.
(b) Systematic selection – here the number of units in the population is divided by the
sample size to give a sampling interval. For example, if the auditor has a population
with 1,000 items and requires a sample containing 200 items then the sampling
interval is 5 (1,000 ÷ 200). A random starting point within the first 5 is then determined
(say 2) and the auditor will test every 5th item after item number 2 (ie 2 then 7 and so
on).
(c) Value weighted selection (or monetary unit sampling (MUS)) – here the
population is randomly ordered and items are selected for sampling by weighting the
items in proportion to their value.
198
Lecture example 1 Preparation
You are the auditor of XYZ Co and are intending to audit trade receivables by circularising a
sample of the year-end balances. The trade receivables listed below have been randomly
tabulated. At the year end trade receivables amount to $1 million and materiality is $100,000.
Required
State which receivable balances will be selected for sampling using value weighted selection (MUS).
Solution
Customer Balance Cumulative total Selected (Y/N)
$ $
1 60,000
2 70,000
3 90,000
4 105,000
5 28,000
6 100,000
7 46,000
8 1,000
9 84,000
10 94,000
11 108,000
12 34,000
13 160,000
14 20,000
1,000,000
2.7 Advantages and disadvantages of monetary unit sampling (MUS)
 The auditor can design and evaluate the  Selecting the sample can be time
sample quickly and in a cost-effective consuming if CAATs cannot be used to
way using CAATs (Section 3). select the sample.
 All material items are automatically  MUS does not cope where there are
selected ensuring all material items are negatively valued items in the
tested. population.
 MUS will not be effective if the
population is not randomly ordered.
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Sampling risk
2.8 Sampling risk is the risk that the auditor's conclusion, based on a sample, may be different
from the conclusion that would have been reached if the entire population were subjected to
the same audit procedure. Sampling risk must be reduced to an acceptably low level.
2.9 If the auditor judges that sampling risk is high then he will need to select a larger sample in
order to have reasonable assurance that the results are free from material misstatement.
2.10 There is therefore a direct relationship between sampling risk and sample size.
2.11 Other factors which affect sample size include:
Factor Effect on sample size

Risk of material If the auditor assesses the level of inherent risk and control
misstatement risk to be high, then detection risk needs to be low in order to
reduce audit risk to an acceptably low level.
Detection risk includes both sampling and non-sampling risk
and in order for sampling risk to be low a larger sample size
is needed.
Required confidence This describes how confident the auditor needs to be that
level the sample results are representative of the population as a
whole.
The greater the degree of confidence the auditor requires,
the larger the sample size needs to be.
Expected error This relates to the level of errors the auditor expects to find
in the population.
If the level of expected error is high then the sample size will
need to be larger in order to make a reasonable estimate of
the actual amount of the error in the population.
Tolerable error/ This relates to the level of error or misstatement that the
misstatement auditor can accept in the population before he is concerned
that there is a material misstatement.
The lower the level of tolerable errors that can be accepted,
the larger the sample size needs to be.
Evaluation of sample results

2.12 Once the audit procedures have been carried out on the sample, the auditor should evaluate
the sample results to determine whether they are satisfactory or whether further work is
required.
200
2.13 Where there are errors in the sample, the auditor should consider:
 The nature and cause of the error
 Whether the error is a 'one-off' (anomalous) error or a recurrent issue
 Whether the error affects other areas of the audit
2.14 Tests of detail

Where sampling has been used to perform tests of detail, the auditor should project the
monetary errors found in the sample to the population as a whole and compare this to the
level of tolerable error/misstatement.
Where an error has been established as an anomalous error, it may be excluded when
projecting sample errors to the population (but it still needs to be considered overall in
addition to the projection of the non-anomalous errors).
You are auditing trade receivables and have obtained the following results based on your sample:
Total value of the population $1,000,000
Number of items in the population 400
Number of items tested 20
Total value of the sample $200,000
Error in the sample $9,000
Required
(a) Assuming the errors are not anomalous ones, calculate the expected error in the population.
(b) Assuming that tolerable error/misstatement was set at $40,000, explain what action should
be taken.
Solution
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2.15 Tests of controls

When sampling has been used to test controls, no explicit projection of errors is necessary
since the sample error rate is also the projected rate of error for the population as a whole.
For example, if the auditor has performed tests of controls on a sample of 20 items and has
found 2 deviations, this represents an error rate of 10% (2/20  100). The auditor must then
decide if this error rate is acceptable.
You are auditing the internal controls relating to the authorisation of adjustments made to a client's
inventory system in order to determine the accuracy and validity of the adjustments. You have
obtained the following results based on your sample:
Total number of adjustments made to inventory records during the year 1,500
Number of adjustments tested in the sample 225
Number of occasions when adjustments tested were not authorised 18
Required
(a) Assuming the errors are not anomalous ones, calculate the error rate in the population.
(b) Assuming that tolerable error/misstatement was set at an error rate of 13%, explain what
action should be taken.
Solution
2.16 If the evaluation of sample results indicates that there may be significant issues, the auditor
may:
(a) Request management to investigate identified errors and the potential for further
errors and make any necessary adjustments;
(b) Modify the nature, timing and extent of further audit procedures; and/or
(c) Consider the effect on the auditor's report.
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3 Computer-assisted audit techniques (CAATs)

3.1 Computer-assisted audit techniques (CAATs) involve using a computer to perform audit
work. Computers can be used to perform either substantive tests or tests of controls.
Audit software (used for substantive testing)

3.2 Audit software consists of computer programs used by the auditor, as part of their auditing
procedures, to process data of audit significance from the entity's accounting system.
Audit software can be  Read and extract data from a client's system and produce
used to: a report in a specified format, for example:
- The auditor could download the client's sales ledger
onto their own software, and use their own (trusted)
software to produce an aged receivables listing; this
can then be used as a basis for testing the valuation
of receivables
- Or an aged inventory report
 Select information, for example:
- A sample of suppliers to circularise to test
completeness of the payables balance (perhaps
using MUS)
- Or to identify missing, large or unusual items or items
outside specified parameters
 Perform calculations, for example:
- To calculate variances and ratios used in analytical
review
- Or to check the accuracy of the casting of the trial
balance or ledger listings
 Print reports in specified formats, for example:
- Letters to be sent out in a receivables confirmation
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Test data (used for tests of controls)

3.3 Test data techniques are audit procedures which enter data into an entity's computer
system, and compare the results obtained with predetermined results.
3.4 Test data is a fictitious set of test transactions which are input into the client's system in
order to determine whether the internal controls within the entity's computer systems have
operated effectively throughout the period.
3.5 Should an auditor wish to gather audit evidence using test data, they will need significant
co-operation from their client, especially in terms of the time required to access their
computer systems.
3.6 There are two typical uses of test data:
(a) Test data used to test specific controls in computer programs
For example, an auditor could try to access data or areas of the computer system
which are password protected in order to determine whether the control is operating
effectively.
(b) Test transactions
Here the auditor processes a series of transactions and monitors the output from the
computer systems in order to determine whether the transactions have been
processed correctly.
This can be conducted 'live' (when the computer systems are operational) or 'dead'
(when the computer system is not in business use). Test transactions normally
involve submitting both valid and invalid data for processing.
Invalid data could include, for example, zero quantity items, negative prices or
extraordinarily high prices. The auditor would expect the valid data to be processed
properly and the invalid data to be rejected.
Some computer systems have an embedded test facility. This may comprise a
'dummy unit' to which test transactions are posted throughout the period or a 'systems
control and review file' (SCARF) where real transactions are replicated and stored for
later review by the auditor.
Audit data analytics (ADA)

3.7 The ongoing increase in companies’ use of technology has meant that more and more data
can be collected and analysed.
3.8 Audit data analytics goes beyond the traditional use of CAATs (which seeks to identify
errors and misstatements) as it seeks to discover normal relationships and patterns. Where
there are variations in these, this could be indicative of a misstatement.
3.9 Big data is a broad term that describes the complex data sets that can be held by modern
computers, encompassing information from both internal and external sources, such as
transactions, social media and mobile devices.
Companies can use this data to adapt their products and services to better meet customer
needs and find new sources of revenue.
204
3.10 In the context of the financial statement audit, data analytics is 'the science and art of
discovering and analysing patterns, deviations and inconsistencies, and extracting
other useful information in the data underlying or related to the subject matter of an
audit through analysis, modelling and visualisation for the purpose of planning or
performing the audit' (IAASB Data Analytics Working Group Request for Input, September
2016).
3.11 Current auditing techniques focus on a risk management approach to auditing and on
testing samples rather than entire populations.
3.12 The use of data analytics software will initially involve significant costs on the part of the
auditor and extensive training, however it could offer auditors the ability to examine all of
an entity's data and test entire populations. This is turn should improve both audit
efficiency and audit quality.
3.13 Examples of how auditors might use data analytics include:
 Analyse patterns relating to revenue or costs per product or per customer
 Trace the matching of orders to goods despatched/goods received documentation
and to the invoice, in order to determine whether revenue and costs should be
recognised
 Interrogate journals to determine whether there are any patterns (regarding who has
processed certain journals) where fraud is suspected
3.14 The Audit and Assurance examining team requires you to have a broad understanding of
what data analytics is, how it may be used in an audit, and how it may improve audit
efficiency.
205
206
Additional
Notes
207
4 Using the work of others

4.1 Whilst auditors are highly trained individuals, it is possible that when conducting an audit
they encounter issues which are outside the scope of their expertise, for example, valuation
of buildings.
4.2 Additionally, it is increasingly common for companies to outsource specific functions, for
example payroll, to service organisations that have more expertise than the entity.
4.3 As such, the auditor must consider the availability and reliability of the evidence provided by
such experts and by the work of service organisations.
4.4 Also, in some cases, external auditors may want to rely on work done by internal audit.
4.5 When the auditors plan to use the work of others, whether experts, service organisations or
internal audit, they must consider:
Scope of work – the work of others must be evaluated to determine if it is sufficient and
appropriate.
Organisational status – (relevant to internal audit only). The external auditor must evaluate
the status of the internal audit department within the entity. How seriously are its reports
taken? Are its recommendations for improvements implemented?
Due skill and care – the auditor must determine that the work of others is completed with
due skill and care, ie that it is planned, directed, supervised and adequately reviewed.
Independence – the auditor must determine that the expert, service organisation or internal
audit department is independent of the client to ensure no bias is reflected in their work.
Technical competence – the work of others must be of appropriate quality to be relied upon
by the auditor and hence the expert, service organisation or internal auditor must have the
technical ability and/or qualifications to provide such work.
5 ISA 620 – Using the work of an auditor's expert

5.1 External auditors may make use of work of an auditor's expert, internal auditor and service
organisations and their auditors when carrying out audit procedures.
5.2 An auditor's expert is defined as being an 'individual or organisation possessing expertise in

a field other than accounting or auditing, whose work in that field is used by the auditor to
assist the auditor in obtaining sufficient appropriate audit evidence' (ISA 620: para.6(a)).
5.3 An auditor's expert may provide evidence on the:

(a) Valuations of land and buildings
(b) Determination of inventory quantities or physical condition
(c) Legal opinions concerning interpretations of agreements, statutes and regulations, or
on the outcome of litigation or disputes
208
5.4 ISA 620 requires the auditor to evaluate whether the auditor's expert has the necessary
competence, capabilities and objectivity. Where the auditor's expert is external, the
evaluation of objectivity will include inquiry of interests and relationships that could create a
threat to objectivity.
5.5 Information on these areas may come from the following sources:
 Personal experience with previous work done by the expert
 Discussions with the expert
 Discussions with other people who are familiar with the expert's work
 Knowledge of the expert's qualifications, membership of a professional body or
industry association, licence to practise etc
 Published papers or books by the expert
 The auditor's firm's quality control policies and procedures
5.6 When using an auditor's expert, the auditor shall agree in writing the following matters:
 The nature and objectives of that expert's work
 The respective roles and responsibilities of the auditor and that expert
 The nature, timing and any report to be provided by that expert
 The need for the auditor's expert to observe confidentiality requirements
5.7 The auditor should evaluate the appropriateness of the expert's work as audit evidence.
This will involve evaluation of whether the substance of the expert's findings is properly
reflected in the financial statements or supports the assertions, and consideration of:
 Source data
 Assumptions and methods used and their consistency with prior periods
 Results of the expert's work in the light of the auditor's overall knowledge of the
business and the results of other audit procedures
5.8 When issuing an unmodified audit report, the auditor should not refer to the work of an
expert.
5.9 Note. ISA 620 distinguishes between an 'auditor's expert' and 'management's expert'
(para. 6). Management's expert is an individual or organisation with expertise in a field
other than accounting or auditing which is used to assist the entity in preparing the financial
statements.
209
6 ISA 402: Audit considerations relating to an entity

using a service organisation
6.1 Service organisations provide a wide variety of services to businesses. Examples include:
 Maintenance of accounting records
 Payroll
 Credit control
 Data entry/information processing
6.2 Where service organisations are relevant to the financial statements, the auditors (referred
to as 'user auditors' in ISA 402 (para. 8h)) are required to perform the following procedures:
(a) Understanding the services provided.
(b) The auditors must understand the nature of the services provided, the materiality of
transactions processed or the financial reporting processes affected.
(c) They need to determine the effect of the service organisation on internal control, to
enable them to assess the risk of material misstatement in the financial statements.
(d) They can either obtain this from the entity using the service organisation, or by
obtaining a report from the service auditor (an auditor who, at the request of the
service organisation, provides an assurance report on the controls of the service
organisation), if this is available.
6.3 Responding to the assessed risks of material misstatement

The user auditor needs to determine whether a sufficient understanding of the nature and
significance of the services provided and their effect on internal control has been obtained to
allow for the identification and assessment of risks of material misstatement in the financial
statements. If they have not, they must perform further audit procedures to obtain such
evidence eg visiting the service organisation or using another auditor to perform procedures
at the service organisation.
6.4 Reporting by the user auditor

The user auditor has sole responsibility for the opinion on the financial statements. They
must be assured that they have sufficient appropriate audit evidence to form an opinion on
the financial statements. They should not refer to the work of a service auditor in the audit
report.
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7 ISA 610 (Revised): Using the work of internal auditors

7.1 During the course of their planning, the external auditors should perform an assessment of
the internal audit function if they consider that it may be possible, and desirable, to rely on
some of internal audit's work. If the external auditor can rely on the work conducted by the
internal auditor, the volume of detailed work undertaken by the external auditor may be
reduced.
Evaluation of internal audit work

7.2 When the external auditor intends to use the specific work of the internal audit function, the
external auditor should evaluate and perform audit procedures on that work to confirm its
adequacy for the external auditor's purposes.
Factors to consider include:
(a) Adequacy of technical training and proficiency
(b) Whether work of assistants is properly supervised, reviewed and documented
(c) Sufficiency and appropriateness of audit evidence to be able to draw reasonable
conclusions
(d) Whether conclusions are appropriate and reports are consistent with work performed
(e) Whether any exceptions or unusual matters disclosed are properly resolved
Direct assistance
7.3 It is also possible that the external auditors may use the internal auditors to provide direct
assistance to them. Direct assistance refers to the use of the internal auditors to perform
audit procedures under the direction, supervision and review of the external auditor.
7.4 When deciding whether the internal auditors should provide direct assistance the external
auditor should consider:
(a) The amount of judgement involved in planning and performing the relevant audit
procedures, and in evaluating the audit evidence gathered;
(b) The assessed risk of material misstatement; and
(c) The existence and significance of threats to the objectivity and the level of
competence of the internal auditors.
7.5 ISA 610 (Revised) prohibits the use of internal auditors to provide direct assistance to
perform procedures that:
(a) Involve making significant judgements in the audit;
(b) Relate to higher assessed risks of material misstatement where more than a limited
degree of judgement is required, for example internal auditors may verify the ageing
of receivables but may not assess the valuation of receivables;
(c) Relate to work with which the internal auditors have been involved; and
(d) Relate to decisions the external auditor makes regarding the internal audit function
and the use of its work or direct assistance.
211
7.6 Where the external auditors have used direct assistance from the internal auditors they
should document:
(a) The evaluation of the existence and significance of threats to the objectivity of the
internal auditors, and the level of competence of the internal auditors used;
(b) The basis for the decision regarding the nature and extent of the work performed by
the internal auditors; and
(c) Who reviewed the work performed and the date and extent of the review.
Auditor's report
7.7 The external auditor cannot make reference to work done by the internal auditor in their
auditor's report.
8 ISA 540: Auditing accounting estimates

8.1 Examples of accounting estimates are:
 Allowances to reduce inventory and accounts receivable to estimated realisable value
 Depreciation
 Provisions
 Accrued revenue
Management often make these estimates in conditions of uncertainty over outcomes and
with the use of judgement. The risk of misstatement is increased, and the evidence available
to detect a material misstatement will often be more difficult to obtain and less persuasive
than that relating to other items in the financial statements.
8.2 The auditor is required to obtain sufficient appropriate evidence about whether the
accounting estimates and related disclosures are reasonable. To do this, they perform the
following procedures:
(a) Risk assessment procedures and related activities
(b) Understand how management identifies the need for accounting estimates and
determine how these accounting estimates are calculated, including the underlying
accounting assumptions
(c) Identifying and assessing the risks of material misstatement
(d) Evaluate the degree of uncertainty associated with an accounting estimate
8.3 Based on the assessed risk of material misstatement, the auditor can determine whether
the estimates are reasonable.
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9 Auditing smaller entities

9.1 As detailed in Chapter 1, most limited liability companies are generally required by statute to
have their financial statements audited with the exception of dormant companies and
companies which meet the small company exemption criteria.
9.2 The problem of control

(a) Many of the controls which would be relevant to a large enterprise are neither
practical nor appropriate for the smaller entity.
(b) In particular, small enterprises are likely to have poor segregation of duties due to
limited numbers of staff.
(c) Additionally, management override of controls is likely to be an issue as a result of the
close involvement of directors and/or proprietors.
(d) To compensate for these deficiencies, management should instigate additional
physical authorisation, arithmetical, accounting and supervisory procedures.
(e) The attitudes, awareness and actions of management are of particular importance to
the auditor's understanding of a smaller entity's control environment.
9.3 Substantive or systems based auditing?

(a) It is important to appreciate that such additional controls will not, and cannot, be relied
upon by the auditor as in a 'systems' based approach. However, such controls within
smaller entities do provide overall comfort to the auditor, particularly when
determining whether to seek to rely on management assurances and representations.
(b) As a result, the audit of smaller entities will focus on substantive procedures in order
to provide an opinion on the financial statements.
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10 Chapter summary
1 Selecting items for The auditor needs to decide which items they will
testing select for testing. It is most common for the auditor to
carry out sampling; however, there may be situations
where they test 100% of items or where they stratify
the population in order to test specific items.
2 Sampling Sampling relates to the application of audit
procedures to less than 100% of the population in
order to form a conclusion on the population as a
whole.
Statistical sampling methods provide more comfort
that the sample is free from bias and the sampling
results representative of the population as a whole.
Any errors identified in the sample must be
extrapolated and the impact on the population as a
whole considered.
3 CAATs CAATs describe any process where the auditor uses
a computer to help them carry out their audit
procedures. CAATs used to perform tests of detail
(substantive procedures) are known as audit
software whilst CAATs used to carry out tests of
controls are called test data. Data analytics is the
examination of data to try to identify patterns, trends
or correlations.
4 Using the work of
others
5 Using the work of an
Auditors may need to place reliance on the work of
auditor's expert
others, namely experts, service organisations or
6 Service organisations internal audit.
7 Use of internal
auditor's work for the
external audit
8 Auditing accounting Accounting estimates involve judgements and so can
estimates be high-risk items in the financial statements.
9 Auditing smaller Smaller entities tend to have more limited internal
entities controls than larger entities and so an auditor auditing
a smaller entity will tend to focus on substantive
procedures.
END OF CHAPTER
214
Non-current assets

Explain the audit objectives and the audit
procedures to obtain sufficient, appropriate
evidence in relation to:
Tangible and intangible non-current assets:
(i) Evidence in relation to non-current assets and Q7 Section A – Specimen exam
Q17 (b) Section B – Specimen exam
Q18 (b) (i) Section B – Specimen exam
Q17(a) (i) Section B – Sept 16
(ii) Depreciation Q6 Section A – Specimen exam

(iii) Profit/ loss on disposal
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12: NON-CURRENT ASSETS
Overview
Non-current assets
Evidence on statement of
profit or loss entries
 Depreciation
Tangible non-current Intangible non-current  Gains/losses on disposals
assets assets  Impairments
216
1 Tangible non-current assets

1.1 Non-current assets are usually material balances on the statement of financial position.
1.2 These assets are listed on a 'non-current asset register' which exists outside the double
entry system and reconciles to the balances on the statement of financial position.
EXTRACT – NON-CURRENT ASSET REGISTER FOR S COMPANY
YEAR END 31 DECEMBER 20X9
Purchase Depreciation Accumulated Carrying
Asset date rate Cost depreciation amount
$ $ $
Computer A 1.1.X8 3 years SL 3,000 1,000 2,000
Computer B 1.1.X7 3 years SL 3,000 2,000 1,000
Computer C 1.1.X8 3 years SL 3,000 1,000 2,000
Office desks 1.1.X5 5 years SL 50,000 40,000 10,000
Office chairs 1.1.X6 5 years SL 25,000 15,000 10,000
84,000 59,000 25,000
1.3 The auditor's role is to test that the carrying amount per the non-current asset register (in
this example $25,000) is reasonable. Sections 3 and 4 of this chapter discuss the
procedures used.
2 Key assertions
2.1 Completeness, obligations and rights, valuation and existence are key assertions
relating to the audit of non-current assets.
Audit procedures: Tangible non-current assets

Completeness  Obtain or prepare a summary of tangible non-current assets showing
how the following reconcile with the opening position:
– Cost/valuation
– Accumulated depreciation
– Carrying amount
 Compare non-current assets in the general ledger with the non-current
assets register and obtain explanations for differences.
 For a sample of assets which physically exist agree that they are
recorded in the non-current asset register.
 If a non-current asset register is not kept, obtain a schedule showing
the original costs and present depreciated value of major non-current
assets.
 Reconcile the schedule of non-current assets with the general ledger.
Existence  Confirm that the company physically inspects all items in the
non-current asset register each year.
217

 Inspect assets, concentrating on high value items and additions
in-year. Confirm that items inspected:
– Exist
– Are in use
– Are in good condition
– Have correct serial numbers
 Review records of income-yielding assets.
 Reconcile opening and closing vehicles by numbers as well as
amounts.
Valuation  Verify valuation to valuation certificate.
 Consider reasonableness of valuation, reviewing:
– Experience of valuer
– Scope of work
– Methods and assumptions used
– Valuation bases are in line with accounting standards
 Reperform calculation of revaluation surplus.
 Confirm whether valuations of all assets that have been revalued have
been updated regularly by inquiries of Finance Director and inspection
of previous financial statements.
 Inspect draft accounts to verify that client has recognised in the
statement of profit or loss and other comprehensive income
revaluation losses unless there is a credit balance in respect of that
asset in equity, in which case it should be debited to equity to cancel
the credit. All revaluation gains should be credited to equity.
 Review depreciation rates applied in relation to:
– Asset lives
– Residual values
– Replacement policy
– Past experience of gains and losses on disposal
– Consistency with prior years and accounting policy
– Possible obsolescence
 Review non-current assets register to ensure that depreciation has
been charged on all assets with a limited useful life.
 For revalued assets, ensure that the charge for depreciation is based
on the revalued amount by recalculating it for a sample of revalued
assets.
 Reperform calculation of depreciation rates to ensure it is correct.
218

 Compare ratios of depreciation to non-current assets (by category)
with:
– Previous years
– Depreciation policy rates
 Scrutinise draft accounts to ensure that depreciation policies and rates
are disclosed in the accounts.
 Review insurance policies in force for all categories of tangible
non-current assets and consider the adequacy of their insured values
and check expiry dates.
Rights and  Verify title to land and buildings by inspection of:
obligations – Title deeds
– Land registry certificates
– Leases
 Obtain a certificate from solicitors/bankers:
– Stating purpose for which the deeds are being held (custody only)
– Stating deeds are free from mortgage or lien
 Inspect registration documents for vehicles held, confirming that they
are in client's name.
 Confirm all vehicles are used for the client's business.
 Examine documents of title for other assets (including purchase
invoices, architects' certificates, contracts, hire purchase or lease
agreements).
 Review for evidence of charges in statutory books and by company
search.
 Review leases of leasehold properties to ensure that company has
fulfilled covenants therein.
 Examine invoices received after year end, orders and minutes for
evidence of capital commitments.
219
Lecture example 1
When testing non-current assets in the financial statements, it is the IAS 16 disclosure note as
follows that is being tested:
Land & Furniture

buildings & fixtures Total
Carrying amount $ $ $
Carrying amount at 1.1.X1 1,600,000 420,000 2,020,000
Additions 400,000 – 400,000
Revaluation surplus 1,000,000 – 1,000,000
Charge for year (60,000) (60,000) (120,000)
Disposals (400,000) – (400,000)
Carrying amount at 31.12.X1 2,540,000 360,000 2,900,000
At 31 December 20X1
Cost or valuation 2,900,000 600,000 3,500,000
Accumulated depreciation (360,000) (240,000) (600,000)
Carrying amount 2,540,000 360,000 2,900,000
At 31 December 20X0
Cost or valuation 2,000,000 600,000 2,600,000
Accumulated depreciation (400,000) (180,000) (580,000)
Carrying amount 1,600,000 420,000 2,020,000
Required
What tests would you perform on each area?
Solution
(1) Opening balances?
(2) Additions?
220
(3) Revaluations? (assume an independent valuation)
(4) Depreciation – charge for year?
(5) Disposals?
3 Intangible non-current assets

3.1 Development expenditure
The audit work undertaken must serve to ensure that the expenditure meets the IAS 38
Intangible Assets criteria. Remember that under IAS 38 an entity must capitalise
development expenditure if it satisfies all of the following criteria:
Probable future economic benefits
Intention to complete and use/sell asset
Resources adequate and available to complete and use/sell asset
Ability to use/sell the asset
Technical feasibility of completing asset for use/sale
Expenditure can be measured reliably
221
3.2 Audit tests

(a) Review the accounting records to ensure that the expenditure can be readily
measured, eg separate cost centre or nominal ledger code.
(b) Review invoices to verify materials expenditure on the project.
(c) Verify wages costs to supporting documentation such as timesheets.
(d) Discuss the technical feasibility with the company's engineers or technical staff.
(e) Consider probability of future economic benefits (ie commercial viability) and ability to
sell or use the asset in relation to market research results, advance orders, budgets
and forecasts.
(f) Review budgeted revenues and costs. Ensure that they are reasonable based on
results to date, discussion with directors, production forecasts and advance orders.
(g) Review cash flow forecasts to ensure that adequate resources exist to complete the
project. Discuss any shortfalls with the directors.
(h) Obtain representations from management of their intention to complete the intangible
asset and either use or sell it.
4 Chapter summary
1 Tangible non-current The main emphasis in the audit of non-current assets

assets will be on the higher-risk areas of:
 Depreciation
 Disposals
 Impairments
2 Key assertions Completeness, existence, valuation and rights and

obligations are the key non-current asset assertions.
3 Intangible non-current This is likely to focus on development expenditure and

assets the capitalisation criteria of IAS 38.
END OF CHAPTER
222
Inventory

procedures to obtain sufficient, appropriate audit
Inventory
(i) Inventory counting procedures in relation to
year-end and continuous inventory systems
(ii) Cut-off testing
(iii) Auditor's attendance at inventory counting
(iv) Direct confirmation of inventory held by third
parties
(v) Valuation Q18 (b) (ii) Section B – Specimen exam
Q17 (a) (ii) Section B – Sept 16
Q16(d) Section B – Sept/Dec 2018
(vi) Other evidence in relation to inventory
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13: INVENTORY
Overview
Inventory
Inventory counting Cut-off Other evidence

procedures  Valuation
 Year end
 Continuous inventory
Auditor's attendance at
Third party confirmations
inventory count
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13: INVENTORY
1 Inventory counting
1.1 The audit approach must consider:
 Quantity – normally arrived at by a year-end count
 Valuation – must apply IAS 2 Inventories
 Disclosure
A particular technique to verify quantity of inventories is for the auditor to attend the client's
inventory count.
Attendance at the inventory count

1.2 (a) Before
(i) Planning
 Review working papers for previous year to identify risks and familiarise
yourself with the inventories
 Determine arrangements with management in advance
 Inventories held by/for third parties – what arrangements have been
made?
 Review client's inventory count instructions
 Investigation of differences (where inventory records exist)
 Consider the need for an expert
(ii) Determine procedures to cover a representative selection of inventories
(b) During
 Ensure staff are following the inventory counting instructions
 Test counts from the inventories to the inventory sheets (completeness) and
from the inventory sheets to the inventories (existence)
 Note damaged, old or obsolete inventories
 Review work in progress (WIP) for stage of completion
 Inventories held by client for third parties: ensure excluded from count
 Record the number of, or photocopy, the last goods received note (GRN) and
the last goods despatch note (GDN)
 Form an overall impression of inventory levels
 Photocopy inventory sheets
(c) After
 Agree sequence of inventory sheets
 Reperform client's computation of final figure
 Trace own test count items through to final inventory summary
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13: INVENTORY
 Inspect replies from third parties

 Inform management of any problems
 Follow up cut-off details
 Ensure necessary adjustments to book inventories have been made (where
records are maintained)
Lecture example 1 Exam standard for 10 marks
Required
You have been provided with the following inventory count instructions by your client. Identify FIVE
matters that you believe will require action by management if the inventory count is to be effective.
Explain how the matters could be rectified.
(a) Mrs Ishbel Curbar, Assistant Chief Accountant, has overall responsibility for the inventory
count but she is to be assisted by Mr Jack Farditch, the warehouse manager, to whom the
inventory counting teams are to report, and who will be responsible for the detailed
organisation of the count.
(b) Five inventory count teams are to carry out the actual count, each team to be responsible for
a predetermined section of the warehouse. Each team comprises two persons, one from the
accounting department and the other from the warehouse.
(c) Each inventory count team is to meet Mr Farditch at 7:30am on 29 March 20X1 and will be
provided with pre-numbered and pre-printed inventory sheets for the section of the
warehouse for which they are responsible. These inventory sheets have been prepared by
the inventory control department and show the balance of each inventory item on hand as
shown on the inventory records held independently of the warehouse.
(d) During the count both members of the inventory count team are to count the inventories
independently of each other. In the event of differences arising between inventories counted
and the quantity shown on the inventory sheets, the quantity counted is to be entered
alongside the original quantity and must be initialled by the senior member of the count
team.
(e) Each inventory count sheet is to be signed by the senior member of the count team and the
bin or rack cards held in the warehouse are to be adjusted, if necessary, to actual quantities
counted. All cards are to be initialled to show that the count has been made.
(f) Any goods that appear to be in poor condition are to be deducted from the quantity
appearing on the inventory sheets, such action again to be supported by initials of the senior
member of the count team.
(g) Any queries during the count are to be referred to Mr Farditch to whom inventory sheets are
to be returned at the conclusion of the count. Mr Farditch is responsible for ensuring that all
inventory count sheets have been returned and for forwarding them to Mrs Curbar for
valuation.
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13: INVENTORY
Solution
2 Continuous inventory counting/perpetual inventory

2.1 Some businesses keep inventory records and if these are reliable a year-end count is not
required. To determine the reliability of the records, it is necessary for the business to count
inventories on a regular basis. This is called continuous inventory counting or perpetual
inventory.
2.2 (a) Review company's procedures:

 Independence of counters
 Frequency of counts
 Ensure all lines covered at least once per year
 Investigation of discrepancies
 Updating of records
(b) Attend at least one of the company's counts to observe procedures and perform test
counts (in both directions)
(c) Review whole year's results
 Extent of counting
 Accuracy of records
 Reasons for discrepancies
 Perform test counts at the year end if the continuous inventory system is found
to be flawed
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13: INVENTORY
3 Cut-off
3.1 Cut-off is a test used to ensure that all of the company's transactions have been included in
Section 5 the correct period.
3.2 Purchases cut-off

All purchases for which goods have been received before the year end must be included in
the financial statements as a liability, expense and closing inventories.
Q24 Sitting Pretty
Goods received after the year end should not be included in the financial statements.
3.3 Sales cut-off

Sales for which the goods have left the warehouse should be included within the sales and
trade receivables at the year end, but not in closing inventories.
Sales made after the year end must not be included in the financial statements but should
be included in closing inventories.
3.4 Cut-off is usually tested by obtaining a sample of GRNs and GDNs either side of the year
end and then matching them to purchase/sales invoices to ensure they have been included
in the correct account balance(s).
After

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13: INVENTORY
4 Inventory valuation
Per IAS 2 inventory must be valued at the lower of cost and net realisable value (NRV).
Cost
4.1 (a) Record basis of valuation used
(b) Test material costs:
 Agree to supplier invoices
 Ensure first in, first out or appropriate basis is being used
 Check quantities used WIP/Finished Goods
(c) Test labour costs:
 Check calculations to supporting documentation
 Review costing against actual labour and production
(d) Test application of overheads:
 Ensure only production overheads included
 Ensure based on normal levels of activity
NRV
4.2 Tests to determine whether NRV is lower than cost:
 Compare the selling prices of goods sold after the year end per sales invoices with
their purchase price per supplier statements
 Review order book to determine at what price the goods are ordered
 Write down last year – are these items still in inventory?
 Analytical review of gross profit margin post year end; if decreases may indicate that
some inventory is being sold for less than cost
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13: INVENTORY
5 Chapter summary
1 Inventory counting Procedures to verify the quantity of inventory will
depend on whether the client uses a year-end
2 Continuous inventory
inventory count or a continuous inventory.
counting/perpetual
inventory The auditor will attend the inventory count to:
 Perform tests of controls (observation)
 Obtain substantive evidence of quantity (test
counts, cut-off details)
 Obtain preliminary evidence of valuation (note
damaged or obsolete inventories)
3 Cut-off Cut-off tests are used to ensure that transactions have
been recorded in the correct accounting period.
4 Inventory valuation Procedures to audit the valuation of inventory must
cover both cost and net realisable value.
END OF CHAPTER
230
Receivables

Explain the audit objectives and audit
Receivables
(i) Direct confirmation of accounts receivable Q9, Q10, Q13, Q14 Section A – Specimen exam
(ii) Other evidence in relation to receivables Q18(a) (iii) Section B – Dec 2016
and prepayments Q18(b) Section B – Sept/Dec 2017
(iii) Other evidence in relation to current assets
(iv) Completeness and occurrence of revenue Q16(d) Section B – Sept 16

Q15 Section A – Dec 2016
Q18(a) (i) Section B – Dec 2016
Q16(e) Section B – Sept/Dec 2018
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14: RECEIVABLES
Overview
Receivables
Statement of financial position: receivables and prepayments

Statement of profit or loss: revenue, irrecoverable debts
expense
Direct confirmation Other evidence
232
14: RECEIVABLES
1 Direct confirmation
1.1 A specific technique used to test for the existence and obligation/rights of receivables is a
direct confirmation (alternatively called 'circularisation'). This is conducted as follows:
(a) Obtain listing of trade receivables as at the confirmation date
(b) Agree total to nominal ledger
(c) Review for any obvious omissions/misstatements by comparing this year's list with
last year's
(d) Select a sample of accounts for confirmation. An aged receivables report may be
used to make the selection. For example:
EXTRACT – RECEIVABLES LEDGER FOR S COMPANY
YEAR END 31 DECEMBER 20X9
Customer Total 30 days 60 days 90 days >90 days

$ $ $ $ $
H & H Co 500 100 400
Bruce Ltd 734 734
Mayes
appliances 581 235 346
TK Allans 345 345
Harrisons Co 1,292 757 535
ABC partners 50 50
3,502 1,437 1,281 734 50
Select the sample from the following balances:
 Old, unpaid amounts
 Credit balances
 Nil balances
 Material balances
Letter should be on the client's paper, signed by the client with a copy of the current
statement attached. It should request that the reply be sent direct to the auditor and
reply-paid envelopes should be sent.
(e) After reasonable period, send 'follow-up' request.
(f) Follow up by telephone or fax if there is no reply.
(g) No reply:
 Confirmation of individual outstanding invoices
 Alternative procedures:
- Agree opening balance on account with last year's closing balance
- Test casts
- Verify outstanding items to back up documentation, eg GDNs and
customer orders
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14: RECEIVABLES
- Review cash received after year end

- Discuss with responsible company official
There are two types of confirmation:
 A positive confirmation request is where the confirming party responds directly
to the auditor, indicating whether they agree with the information in the request
or provides the requested information.
 A negative confirmation request is where the confirming party responds
directly to the auditor only if they disagree with the information in the request.
You have obtained the following results from three receivables balances circularised during the
audit of ABC Co.
Balance per sales Balance per Reason for

ledger circularisation response difference
$ $
Customer 1 25,000 20,000 Cash in transit
Customer 2 55,000 45,000 Goods not received
at year end
Customer 3 68,000 57,000 Disputed invoice
Required
Detail the tests you would perform on each of these responses.
Solution
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14: RECEIVABLES
2 Other evidence
2.1
Assertion Example tests

Completeness  Agree the balance from the individual sales ledger
accounts to the aged receivables' listing and vice versa.
 Match the total of the aged receivables' listing to the sales
ledger control account.
 Cast and cross-cast the aged receivables listing before
selecting any samples to test.
 Trace a sample of shipping documentation to sales
invoices and into the sales and receivables' ledger.
 Complete the disclosure checklist to ensure that all the
disclosures relevant to receivables have been made.
 Compare the gross profit percentage by product line with
the previous year and industry data.
 Compare the level of prepayments to the previous year to
ensure the figure is materially correct and complete.
Existence  Perform a receivables circularisation on a sample of
year-end trade receivables.
 Follow up all balance disagreements and non-replies to
the receivables confirmation.
 Perform alternative procedures for any exceptions and
non-replies to the receivables' confirmation.
 Review after-date cash receipts by inspecting bank
statements and cash receipts documentation.
 Examine the customer's account and customer
correspondence to assess whether the balance
outstanding represents specific invoices and confirm their
validity.
 Examine the underlying documentation (sales order,
dispatch documentation, duplicate sales invoice etc).
 Inquire from management explanations for invoices
remaining unpaid after subsequent ones have been paid.
 Observe whether the balance on the account is growing
and, if so, find out why by discussing with management.
Valuation  Compare receivables turnover and the receivables
collection period with the previous year and/or with industry
data.
 Compare the aged analysis of receivables with the
previous year.
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14: RECEIVABLES
The following scenario relates to Questions 1–3.

Gem Threads is a clothing wholesaler that sells high-quality, decorative clothing to high street
clothing retailers. You are an audit senior of Check & Co and are currently conducting the audit of
Gem Threads for the year ended 31 March 20X5. During the course of the audit a number of
events have been brought to your attention.
Inventory and receivables
Inventory is subject to changing tastes and fashions and demand can vary significantly between
different seasons, with the majority of sales being earned in the summer and winter seasons. Your
firm observed the year-end inventory count and was satisfied that it was carried out in a
satisfactory manner.
Although Gem Threads has many customers, the majority of its sales are to 25 key retailers.
Standard credit terms are 40 days.
1 You are responsible for auditing the valuation of inventory and have performed several
procedures as a follow up to the work done during the year-end inventory count.
Which of the following audit procedures is the LEAST appropriate to test the
VALUATION assertion for inventory?
 Obtain an aged analysis of inventory at the year end and discuss the saleability of
slow moving inventory items with management
 Review the order book at the year end to confirm the level of future orders placed by
key customers
 Review sales made in the post year end period
 Trace the last goods despatched and goods received notes to the ledger to ensure
that they have been correctly recorded
2 Your audit assistant is about to begin testing of the receivables balance and you are keen
for them to use computer-assisted audit techniques (CAATs) in order to save time and cost.
They have approached you with a list of procedures they intend to perform using CAATs.
Which of the following procedures could NOT be performed using computer-assisted
audit techniques?
 Selection of a sample of receivables for confirmation
 Calculation of receivables days
 Evaluation of the adequacy of the allowance for irrecoverable receivables
 Production of receivables confirmation letters
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14: RECEIVABLES
3 Your audit assistant has now calculated receivables days for each of Gem Threads's key
customers. One customer, JK Co, has receivables days of 62 days.
Which of the following audit procedures should the audit assistant perform next?
 Request a written representation from the directors stating that the balance due from
JK Co is fairly stated in the financial statements
 Review credit notes issued post year end in relation to the balance due from JK Co
 Agree the balance due from JK Co to supporting invoices and goods despatched
notes
 Vouch any changes in JK Co's credit limit to supporting documentation to determine
whether the change was properly authorised
Solution
237
14: RECEIVABLES
3 Chapter summary
1 Direct confirmation Direct circularisation of receivables is a key
procedure but does not give evidence on all the
relevant assertions.
2 Other evidence Other important procedures are:
 Cut-off tests
 Tests to determine recoverability
END OF CHAPTER
238
Bank and cash

Bank and cash:
(i) Bank confirmation reports used in obtaining
Q18(b) Section B – Sept/Dec 2018
evidence in relation to bank and cash
(ii) Other evidence in relation to bank
(iii) Other evidence in relation to cash
239
15: BANK AND CASH
Overview
Bank and cash
Bank confirmation letters Other evidence

 Bank reconciliations
240
15: BANK AND CASH
1 Bank and cash

1.1
Objective Example tests
Existence Trace recorded assets and liabilities to bank
confirmation of balances.
Rights and obligations Review bank letter to ensure valid title to
accounts held.
Completeness/ Review bank confirmation letter for details of all
Allocation and valuation accounts held.
Count petty cash balance if material.
Reperform year-end bank reconciliations for all
accounts held. Trace outstanding items
(outstanding lodgements and unpresented
cheques) to after-date bank statements and
ensure all subsequently cleared.
Review cash book for unusual items.
Bank confirmations for audit purposes

Introduction
1.2 A commonly adopted procedure in the audit of an entity's financial statements is for the
auditor to obtain direct confirmation from the entity's banker(s) of balances and other
amounts which appear in the balance sheet and other information which may be disclosed
in the notes to the financial statements, for example guarantees and foreign exchange
transactions. Bank confirmations are a valuable source of audit evidence because they
provide independent evidence regarding the reliability of an entity's records.
Authority to disclose
1.3 Banks require the explicit written authority of their customers to disclose the information
requested. This often takes the form of an ongoing standing authority rather than a separate
authority each time information is requested.
Bank confirmation process

1.4 The key steps to be taken by an auditor in initiating the process are as follows:
(a) A request for a bank confirmation is to be issued on the auditors' own headed paper
and sent to the bank branch with which the client has the prime business
arrangement.
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15: BANK AND CASH
(b) The bank confirmation request should specify:

(i) The names of all entities covered by the request;
(ii) Whether the auditor is requesting 'standard information'; and, where
appropriate, the nature of supplementary information required;
(iii) The date for which the auditor is requesting confirmation (the audit confirmation
date ie the client's year end);
(iv) A statement that the bank's response will not create a contractual relationship
between the bank and the auditor;
(v) A statement requesting the bank to advise the auditor if the authority is
insufficient to allow the bank to provide full disclosure of the information
requested; and
(vi) A contact name and telephone number.
(c) The bank confirmation request should reach the branch at least two weeks in
advance of the audit confirmation date.
242
Additional
Notes
243
15: BANK AND CASH
2 Example bank confirmation letter – for information

purposes only
Standard request for information
Local practices will vary in the way bank confirmations are requested and carried out. An
example is shown below which demonstrates what used to be UK practice and it covers all
the major areas where confirmation would be required.
AB & Co
Accountants
29 High Street
London N10
The Manager
Clearing Bank Ltd City Branch
Dear Sir/Madam,
.........................................(Name of customer)
STANDARD REQUEST FOR BANK REPORT
FOR AUDIT PURPOSES FOR THE YEAR ENDED ....................
In accordance with your above-named customer's instruction given
}
(1) hereon
(2) in the attached authority Delete as appropriate
(3) in the authority date .................... already held by you
please send to us, as auditors of your customer for the purpose of our business, without
entering into any contractual relationship with us, the following information relating to their
affairs at your branch as at the close of business on ....................... and, in the case of
items 2, 4 and 10 during the period since .................... For each item, please state any
factors which may limit the completeness of your reply; if there is nothing to report, state
'none'.
We enclose an additional copy of this letter, and it would be particularly helpful if your
reply could be given on the copy letter in the space provided (supported by an additional
schedule stamped and signed by the bank where space is insufficient). If you find it
necessary to provide the information in another form, please return the copy letter with
your reply.
It is understood that any replies given are in strict confidence.
Information requested Reply
Bank accounts
(1) Please give full titles of all accounts whether in
sterling or in any other currency together with
the account numbers and balances thereon,
including nil balances:
(a) Where your customer's name is the sole
name in the title
244
15: BANK AND CASH
(b) Where your customer's name is joined

with that of other parties
(c) Where the account is in a trade name
Notes
1 Where the account is subject to any
restriction (eg a garnishee order or
arrestment), this information should be
stated.
2 Where the authority upon which you are
providing this information does not cover
any accounts held jointly with other
parties, please refer to your customer in
order to obtain the requisite authority of
the other parties. If this authority is not
forthcoming please indicate.
(2) Full titles and dates of closure of all accounts
closed during the period.
(3) The separate amounts accrued but not charged
or credited at the above date, of:
(a) Provisional charges (including
commitment fees); and
(b) Interest.
(4) The amount of interest charged during the
period if not specified separately in the bank
statement.
(5) Particulars (ie date, type of document and
accounts covered) of any written
acknowledgement of set-off, either by specific
letter of set-off, or incorporated in some other
document or security.
(6) Details of:
(a) Overdrafts and loans repayable on
demand, specifying dates of review and
agreed facilities
(b) Other loans specifying dates of review
and repayment
(c) Other facilities
245
15: BANK AND CASH
Customer's assets held as security

(7) Please give details of any such assets whether
or not formally charged to the bank.
If formally charged, give details of the security
including the dates and type of charge. If a
security is limited in amount or to a specific
borrowing, or if there is to your knowledge a
prior, equal or subordinate charge, please
indicate.
If informally charged, indicate nature of security
interest therein claimed by the bank.
Whether or not a formal charge has been taken,
give particulars of any undertaking given to the
bank relating to any assets.
Customer's other assets held
(8) Please give full details of the customer's other
assets held, including share certificates,
documents of title, deed boxes and any other
items in your Registers maintained for the
purpose of recording assets held.
Contingent liabilities
(9) All contingent liabilities:
(a) Total of bills discounted for your
customer, with recourse
(b) Date, name of beneficiary, amount and
brief description of any guarantees,
bonds or indemnities given to you by the
customer for the benefit of third parties
(c) Date, name of beneficiary, amount and
brief description of any guarantees,
bonds or indemnities given by you, on
your customer's behalf, stating where
there is recourse to your customer and/or
to its parent or any other company within
the group
(d) Total of acceptances
(e) Total sterling equivalent of outstanding
forward foreign exchange contracts
(f) Total of outstanding liabilities under
documentary credits
(g) Others – please give details
246
15: BANK AND CASH
Other information
(10) A list of other banks, or branches of your bank,
or associated companies where you are aware
that a relationship has been established during
the period.
Yours faithfully,
........................................
(Official stamp of bank)
........................................
(Authorised signatory)
........................................
(Position)
3 Chapter summary
1 Bank and cash Bank confirmation letters are a reliable source of
evidence in respect of the main financial statement
assertions relating to bank and cash.
The client's bank reconciliation must also be tested in
detail, in order to verify that reconciling items are
genuine.
2 Example bank Standard request for information from the client's bank.
confirmation letter
247
15: BANK AND CASH
END OF CHAPTER
248
Liabilities, capital and
directors' emoluments

Explain the audit objectives and audit procedures
to obtain sufficient, appropriate evidence in relation
to:
Payables and accruals
(i) Supplier statement reconciliations and direct Q1, Q2, Q3 Section A – Sept 16
confirmation of accounts payable,
(ii) Obtain evidence in relation to payables,
Q18(a) (ii) Section B – Dec 2016
accruals,
Q16(d) Section B – March/June 2018
(iii) Obtain evidence in relation to current

liabilities; and
(iii) Purchases and other expenses. Q16(d) Section B – Sept/Dec 2017
Non-current liabilities, provisions and
contingencies
(i) Evidence in relation to non-current liabilities
(ii) Provisions and contingencies. Q17(a) (iii) Section B – Sept 16
Share capital, reserves and directors' emoluments:

(i) Evidence in relation to share capital, reserves
and directors' emoluments. Q17(d) Section B – March/June 2017
249
16: LIABILITIES, CAPITAL AND DIRECTORS' EMOLUMENTS
Overview
Liabilities, capital and directors'

emoluments
 Payables and accruals  Non-current liabilities  Share capital

 Purchases and expenses  Reserves
 Provisions and
contingencies  Directors' emoluments
 Finance costs
250
1 Payables and accruals

1.1 When testing payables, the auditor must focus on understatement (ie completeness).
1.2 Objective Example tests:

(a) Existence  Circularise/suppliers' statements.
 Cut-off tests – purchases/payables.
(b) Rights and obligations  Circularise trade payables (the procedure is
similar to that used for trade receivables).
 Reconcile balance at year end to a supplier's
statement. The reconciling items must be
verified. These could include cash in transit or
goods in transit.
Both these tests also provide evidence of
completeness and valuation.
(c) Completeness  Review payables analytically comparing to
previous year end or budgets, eg calculate
payables days or compare accruals listing to
prior year
 Review goods received notes around the year
end to ensure purchases are recorded in
correct accounting period
 Review unpaid invoice files for liabilities not
provided for
 Review after-date payments for liabilities not
recorded
 Inspect the supplier statement reconciliations
to ensure that all outstanding invoices are
accrued
(d) Allocation and valuation  Reperform calculation of closing accruals to
ensure in accordance with accounting policies
and are consistent year on year
 Recalculate to ensure provisions have been
recognised in accordance with IAS 37
Provisions, Contingent Liabilities and
Contingent Assets
251
2 Non-current liabilities
2.1 This will include bank loans, debentures, and other loans repayable more than one year
after the year-end date.
2.2 Objective Example tests

(a) Existence  Obtain confirmation from banks and other
lenders
(b) Rights and obligations  Review confirmation letters from lenders
(c) Completeness  Obtain breakdown of liabilities, compare to
prior year audit working papers and for any
items no longer included agree to:
– Repayment amount in cash book
– Inclusion as current liability if
reclassified
 Review board minutes for evidence of any new
borrowings which might not be recorded
(d) Accuracy  Perform proof in total of finance charges
 Agree capital and interest amounts to
confirmation letters
 Recalculate finance charges agreeing interest
rates to loan agreements
(e) Classification and  Agree that liabilities are correctly classified as
understandability current/non-current by reference to the
repayment dates in the loan agreements
3 Tests on provisions and contingencies

Section 4
3.1 Obtain a detailed analysis of all provisions showing opening balances, movements and the
closing balance. Also obtain details of all contingencies which have been disclosed.
3.2 For each material provision:

(a) Determine whether the company has a present obligation as a result of a past event
at the year-end date by:
(i) Review of correspondence and other documentation relating to the item.
(ii) Discussion with the directors. Have they created a valid expectation in other
parties that they will discharge the obligation, ie established a constructive
obligation? Review evidence of past practices, published policies and
statements made.
252
(b) Determine whether it is probable that an outflow of resources will be required to settle
the obligation by:
(i) Checking whether any payments have been made in the post year end period
in respect of the item.
(ii) Review of correspondence with solicitors, banks, customers, insurance
company and suppliers both pre and post year end.
(iii) Sending a letter to the solicitor to obtain their views (where relevant).
(iv) Discussing the position with similar past provisions with the directors. Were
these provisions eventually settled?
(c) Determine whether provisions represent the best estimate of liability by:
(i) Recalculating all provisions made.
(ii) Comparing the amount provided with any post year end payments and with any
amount paid in the past for similar items and considering opinions given by
independent experts.
(iii) In the event that it is not possible to estimate the amount of the provision,
check that this contingent liability is disclosed in the accounts.
3.3 Consider the nature of the client's business. Would you expect to see provisions eg
warranties?
3.4 For all material provisions and contingencies obtain a written representation.
3.5 Check that appropriate disclosures have been made in accordance with IAS 37.
253
4 Capital
4.1 This includes share capital, distributions and reserves.

Existence  Agree authorised share capital to statutory records (eg
Memorandum and Articles of Association).
 Agree issue of shares in year to board minutes.
 Vouch cash received on issue of shares to cash and bank
statement.
 Agree dividend paid to cash book and bank statements.
 Inspect board minutes for authorisation of dividend payment.
Rights and obligations  Review statutory records for shares and board minutes for
obligation to pay dividends.
Completeness  Compare share capital with prior year.
 Agree share issues authorised in board minutes to share
capital in nominal ledger.
 Agree authorisation of dividend payment to nominal ledger or
disclosure in the financial statements.
Accuracy, valuation and  Recalculate value of dividend paid.
allocation  Recalculate consideration received from issue of shares.
Classification and  Review disclosure in the financial statements of share issues
presentation and dividends paid in year.
5 Directors' emoluments
5.1 Directors' emoluments are a sensitive area and would therefore be deemed to be material
by its nature. It is important therefore that the disclosure of directors' emoluments is made
accurately.

Existence  Agree the directors' emoluments disclosed in the financial
statements to a schedule of directors' emoluments for the
year for each director. The schedule should show separately
the individual components of emoluments: salary, bonuses,
benefits, pension contributions and any other amounts such
as 'golden hellos'.
 Vouch salary and pension contribution amounts to monthly
payroll records and bank statements.
 Vouch bonuses and any 'one-off' payments to board meeting
minutes and payroll records and bank statements.
254

Rights and obligations  Verify the emoluments paid to directors during the year to
their contracts of employment to ensure the directors'
entitlements to these amounts.
Completeness  Review board meeting/remuneration committee minutes to
verify the amounts of any directors' bonuses and any other
amounts and also to check that these payments have been
appropriately authorised.
 Review the cash book during the year and in the post year
end period and ensure any significant sums have been
appropriately accounted for.
 Ask directors to confirm in writing that the emoluments
disclosed in the financial statements are complete and
accurately recorded.
 Analytically review the directors' emoluments for each
director in comparison to both the prior year emoluments and
expected emoluments given the business's activities during
the year.
Accuracy, valuation and  Re-cast the addition of the schedule of directors'
allocation emoluments.
 Verify that the amounts disclosed in the financial statements
agree to this schedule.
Classification and  Obtain a copy of the returns made to the tax authorities in
presentation respect of each director and verify that all benefits have been
properly disclosed in the financial statements.
 Review the adequacy of the disclosure in the directors'
emoluments note to ensure it is in accordance with
applicable accounting standards and local law.
255
Lecture example 1
You are responsible for auditing the directors' emoluments of ABC Co and have been provided
with the information below:
Termination Incentive
Salary Bonuses payments payments Total
$ $ $ $ $
Director A 120,000 90,000 – – 210,000
Director B 80,000 50,000 – – 130,000
Director C 50,000 5,000 15,000 – 70,000
Director D 20,000 5,000 – 10,000 35,000
270,000 150,000 15,000 10,000 445,000
Required
State what audit tests would you perform.
Solution
256
6 Chapter summary
1 Payables and accruals Substantive tests on liabilities will cover all the
financial statement assertions but with an emphasis
on testing for understatement ie completeness.
A circularisation of trade payables may be carried out

but is often not necessary as supplier statements
will provide documentary evidence from third parties.
2 Non-current liabilities Bank letters and loan agreements will be key

evidence in respect of loans.
3 Provisions and Procedures on provisions and contingencies will

contingencies focus on the criteria established in accounting
standards for their recognition, ie:
 Is there a present obligation as a result of
past events?
 Is an outflow of benefits probable?
 Has the amount been estimated reasonably?
4 Capital Statutory records and board minutes are the key

sources of evidence.
5 Directors' emoluments Directors' emoluments are material by their nature. It

is imperative therefore that they are accurately
recorded and disclosed.
257
END OF CHAPTER
258
Not-for-profit
organisations

Apply audit techniques to not-for-profit
organisations
259
17: NOT-FOR-PROFIT ORGANISATIONS
Overview
Not-for-profit organisations
Types of not-for-profit
organisations
Comparison with audit of Application of audit

for-profit organisations techniques
260
1 Introduction
1.1 Examples of not-for-profit organisations are charities, clubs and societies. Their primary
objective is to provide a service and not to generate profits. Such entities are keen to keep
their costs to a minimum.
1.2 Such organisations may fall within the scope of statutory audit if the entities concerned are
limited liability companies.
1.3 Organisations not incorporated may require an assurance engagement due to the
requirements of regulatory or governing bodies, eg the Charity Commission.
2 Planning the audit

Section 2
2.1 The planning procedures undertaken for not-for-profit organisations will differ very little
from those for profit-making organisations.
2.2 However, the auditor should have specific regard to any laws, regulations or guidelines
imposed on the entity by any regulatory body.
2.3 The scope of the auditor's work will be detailed in the engagement letter.
3 Risk assessment
3.1 The auditor should, during the planning stage, fully assess the risks associated with the
not-for-profit organisation.
3.2 Inherent risk

Key factors to consider include:
 The complexity and extent of regulation
 The significance of donations and cash receipts
 Restrictions imposed by the objectives and powers given by the entity's governing
documents on how donations can be distributed
 The sensitivity of certain key statistics such as proportion of resources used in
administration
 The need to maintain adequate resources whilst avoiding the build-up of resources
which could appear excessive
3.3 Control risk

Key factors to consider include:
 Competence, training and qualification of paid staff and volunteers
 Reliability of accounting systems/computer systems
 Controls over compliance with laws and regulations
 Power of trustees
261
4 Audit evidence
4.1 When designing substantive procedures for not-for-profit organisations, the auditor should
Section 3 give special attention to the possibility of:
 Understatement (ie completeness) of income, including gifts in kind, cash donations
and legacies
 Incorrect accounting treatment of lifetime subscriptions
Q28 'Tap!'
 Overstatement (ie existence) of cash grants or expenses
 Misanalysis or misuse of funds
 Misstatement or omission of assets including donated properties
 Misallocation of expenses to disguise excessive administration expenditure
5 Reporting
5.1 For incorporated not-for-profit organisations, the reporting requirements of ISA 700 Forming
an Opinion and Reporting on Financial Statements apply.
5.2 Additionally, the reporting requirements of the governing body will need to be encompassed
in the auditor's report.
5.3 For organisations not incorporated under statute, the nature of the report will be determined
in accordance with the terms of appointment detailed in the letter of engagement.
Lecture example 1 Exam standard for 4 marks
'Save the Accountants' is a charitable foundation set up to provide financial assistance to

accountants who have fallen on hard times. Its principal sources of income are:
 Cash donations collected on the high streets of major towns
 Regular donations by the 'Big 4' accountancy firms
 Annual donations by wealthy individuals
Required
What audit procedures would you do to test the completeness of income?
Solution
262
6 Chapter summary
1 Introduction Not-for profit organisations include charities, clubs
and societies.
2 Planning the audit All relevant regulations must be understood.
3 Risk assessment Particular risk areas for the auditor of not-for-profit
entities are:
 Complexity of regulation
 High level of cash receipts
 Competence of staff and volunteers
4 Audit evidence The audit approach is likely to be mainly substantive.
5 Reporting The auditor must consider the requirements of
ISA 700 as well as any specific regulations.
263
END OF CHAPTER
264
Audit review and
finalisation

Explain the purpose of a subsequent events
review
Explain the responsibilities of auditors regarding Q12 Section A – Specimen exam
subsequent events Q6 Section A – Sept 16
Discuss the procedures to be undertaken in Q7, Q8 Section A – Sept 16
performing a subsequent events review Q8 Section A – Dec 2016
Define and discuss the significance of the concept
of going concern
Explain the importance of and the need for going
concern reviews
Explain the respective responsibilities of auditors Q9 Section A – Dec 2016
and management regarding going concern
Identify and explain potential indicators that an
entity is not a going concern
Discuss the procedures to be applied in Q17 (b) Section B – Sept 16
performing going concern reviews Q18(c) Section B – Sept/Dec 2018
Discuss the disclosure requirements in relation to Q18(d) Section B – Sept/Dec 2018
going concern issues
Explain the purpose of and procedure for
obtaining written representations
Discuss the quality and reliability of written
representations as audit evidence
Discuss the circumstances where written
representations are necessary and the matters on
which representations are commonly obtained
265
18: AUDIT REVIEW AND FINALISATION

Discuss the importance of the overall review in
ensuring that sufficient, appropriate evidence has
been obtained
Discuss the procedures an auditor should perform Q7 Section A – Dec 2016
in conducting their overall review of financial
statements
Explain the significance of uncorrected
misstatements
Evaluate the effect of dealing with uncorrected
misstatements
266
Overview
Overall review of evidence
Audit review and finalisation
Uncorrected misstatements
Subsequent events Going concern Written representations
267
1 ISA 560: Subsequent Events

1.1 Financial statements may be affected by events that occur after the date of the financial
statements. For financial reporting purposes, these events are categorised in one of two
ways:
(a) Those that provide evidence of conditions that existed at the date of the financial
statements; and
(b) Those that provide evidence of conditions that arose after that date of financial
statements.
1.2 The auditor should consider the effect of subsequent events on the financial statements and
on the auditor's report.
Active duty Passive duty
Auditor's
Year F/S
report AGM
end issued
signed
Audit procedures Auditor becomes aware of a Auditor becomes aware of a

undertaken to identify material subsequent event: material subsequent event:
material subsequent (a) Discuss matter with (a) Discuss matter with
events (adjusting and management to determine management
non-adjusting) whether the FS need (b) If management amends FS
(a) Review the amendment. auditor should issue a new
procedures (b) If management amends FS auditor's report including
management has the auditor should extend an emphasis of matter
established to audit procedures to the paragraph to explain the
ensure that items that require revision to the previously
subsequent events adjustment or disclosure issued FS.
are identified. and issue a new, (c) If management refuses to
(b) Read board unmodified auditor's report. make amendment in FS
minutes held after (c) If management refuses to then auditor should seek
the date of the make amendment in FS legal advice.
financial then auditor should either:
statements up to
the date of signing (i) (If not yet released
the auditor's report. auditor's report) reissue
a modified report; or
(c) Read the entity's
latest available (ii) (If have released
interim financial auditor's report) seek
statements, legal advice.
budgets and cash
flow forecasts.
268
(d) Enquire, or extend

previous oral or
written enquiries, of
the entity's legal
counsel concerning
litigation and
claims.
(e) Enquire of
management as to
whether any
subsequent events
have occurred
which might affect
the financial
statements.
(f) Obtain a written
representation as
to the
completeness of
subsequent events
identified by
management.
2 ISA 570: Going Concern

2.1 When planning and performing audit procedures and in evaluating the results thereof, the
auditor should consider the appropriateness of management's use of the going concern
assumption underlying the preparation of the financial statements.
2.2 Under the going concern assumption, an entity is ordinarily viewed as continuing in business
for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing
trading or seeking protection from creditors pursuant to laws or regulations.
2.3 Management's assessment of the entity's ability to continue as a going concern should
cover a period of at least 12 months after the period end.
2.4 In obtaining an understanding of the entity, the auditor should consider whether there are
events or conditions and related business risks which may cast significant doubt on the
entity's ability to continue as a going concern.
2.5 Based on the audit evidence obtained, the auditor should determine if, in their judgement, a
material uncertainty exists related to events or conditions that, alone or in aggregate, may
cast significant doubt on the entity's ability to continue as a going concern.
269
2.6 Examples of events or conditions, which may cast significant doubt on the going concern
assumption, include:
Financial
 Net liability or net current liability position
 Fixed-term borrowings approaching maturity without realistic prospects of renewal or
repayment; or excessive reliance on short-term borrowings to finance non-current
assets
 Indications of withdrawal of financial support by creditors
 Negative operating cash flows
 Adverse key financial ratios, eg high gearing, low current ratio, poor profit margins
 Substantial operating losses or significant deterioration in the value of assets used to
generate cash flows
 Arrears or discontinuance of dividends
 Inability to pay creditors on due dates
 Inability to comply with the terms of loan agreements
 Change from credit to cash-on-delivery terms with suppliers
 Inability to obtain new financing
Operational
 Management intention to liquidate the entity or to cease operations
 Loss of key management without replacement
 Loss of a major market, key customer, licence, or principal supplier
 Labour difficulties or stock outs
 Emergence of a highly successful competitor
Other
 Non-compliance with capital or other statutory requirements
 Pending legal or regulatory proceedings against the entity that may, if successful,
result in claims that are unlikely to be satisfied
 Changes in legislation or government policy expected to adversely affect the entity
 Uninsured or underinsured catastrophes when they occur
270
2.7 Relevant audit procedures

(a) Analysing and discussing cash flow, profit and other relevant forecasts with
management
(b) Analysing and discussing the entity's latest available interim financial statements
(c) Reading the terms of debentures and loan agreements and determining whether any
have been breached
(d) Reading minutes of the meetings of shareholders, those charged with governance
and relevant committees for reference to financing difficulties
(e) Enquiring of the entity's lawyer regarding the existence of litigation and claims and the
reasonableness of management's assessments of their outcome and the estimate of
their financial implications
(f) Confirming the existence, legality and enforceability of arrangements to provide or
maintain financial support with related and third parties and assessing the financial
ability of such parties to provide additional funds
(g) Considering the entity's plans to deal with unfilled customer orders
(h) Reviewing events after period end to identify those that either mitigate or otherwise
affect the entity's ability to continue as a going concern
(i) Obtaining and reviewing reports or regulatory actions
2.8 When analysis of cash flow is a significant factor in considering the future outcome of events
or conditions the auditor considers:
 The reliability of the entity's information system for generating such information; and
 Whether there is adequate support for the assumptions underlying the forecast.
In addition, the auditor compares:
 The prospective financial information for recent prior periods with historical results;
and
 The prospective financial information for the current period with results achieved to
date.
2.9 The auditor will form their opinion on the going concern status of the company based on the
outcome of the above.
271
You are planning the audit of Truckers Co whose principal activities are road transport and
warehousing services, and the repair of commercial vehicles. You have been provided with the
draft accounts for the year ended 31 October 20X2.
Draft 20X2 Actual 20X1
$'000 $'000
SUMMARY STATEMENT OF PROFIT OR LOSS
Revenue 10,971 11,560
Cost of sales (10,203) (10,474)
Gross profit 768 1,086
Administrative expenses (782) (779)
Finance costs (235) (185)
Profit/(loss) for the period (249) 122
SUMMARY STATEMENT OF FINANCIAL POSITION
Non-current assets 5,178 4,670

Current assets
Inventories of parts and consumables 95 61
Receivables 2,975 2,369
3,070 2,430
8,248 7,100
Share capital and reserves 3,544 3,793
Non-current liabilities
Bank loan 750 1,000
Finance lease liabilities 473 –
1,223 1,000
Current liabilities
Bank loan 250 –
Overdraft 1,245 913
Trade payables 1,513 1,245
Finance lease liabilities 207 –
Other payables 203 149
3,481 2,307
8,248 7,100
You have been informed by the managing director that the fall in revenue is due to:
 The loss, in July, of a long-standing customer to a competitor; and
 A decline in trade in the repair of commercial vehicles.
Due to the reduction in the repairs business, the company has decided to close the workshop and
sell the equipment and spares inventories. No entries resulting from this decision are reflected in
the draft accounts.
272
During the year, the company replaced a number of vehicles, funding them by a combination of
leasing and an increased overdraft facility. The facility is to be reviewed in January 20X3 after the
audited accounts are available.
The draft accounts show a loss for 20X2 but the forecasts indicate a return to profitability in 20X3
as the managing director is optimistic about generating additional revenue from new contracts.
Required
From the scenario above identify features which might cause you to have doubts about Truckers'
going concern status.
Solution
3 ISA 580: Written Representations

3.1 ISA 580 requires the auditor to request management to provide written representations as
follows:
(a) That it has fulfilled its responsibilities for the preparation of the financial statements,
that all transactions have been recorded and reflected therein and that all information
has been provided to the auditor as requested and has approved the financial
statements.
(b) A variety of ISA-specific issues require disclosure (such as fraud, laws and
regulations, estimates, going concern, related parties and subsequent events).
(c) The appropriate use of accounting policies as well as a number of specific disclosures
(such as plans that might affect asset values and details of any contingent liabilities).
273
3.2 The auditor should obtain written representations from management on matters material to
the financial statements when other sufficient appropriate audit evidence cannot reasonably
be expected to exist.
Audit evidence
3.3 The representations should relate to matters where they are critical to obtaining sufficient
appropriate audit evidence. Representations cannot be a substitute for other audit evidence
that auditors expect to be available.
3.4 They should be restricted to matters where the auditor is unable to obtain independent
corroborative evidence and could not reasonably expect it to be available. For example:
 Where knowledge of facts is confined to management, eg management's intentions
 Where the matter is principally one of judgement, eg whether a receivable is a
doubtful debt or not
Procedures
3.5 (a) Agree procedures at early stage (eg letter of engagement)
(b) Discuss letter with client first
(c) Usually signed by senior executive officer and senior financial officer on behalf of
board
(d) Should be minuted
(e) Dated – after all other audit work completed but before signing of the auditor's report
If the client refuses to sign

3.6 (a) Auditor should write letter setting out their understanding and ask for management
confirmation.
(b) If management does not reply, auditor should follow up to ascertain that their
understanding is correct.
(c) If management refuses to provide a representation that the auditor considers
necessary, this constitutes a scope limitation and the auditor should express a
qualified opinion or disclaimer of opinion.
4 Overall review of financial statements

4.1 At the finalisation stage the financial statements are reviewed to determine whether they are
consistent with the auditor's understanding of the entity. ISA 520 Analytical Procedures
states the auditor should design and perform analytical procedures to assist in forming that
overall conclusion (ISA 520: para. 6).
274
4.2 The review will determine whether:

 Financial statements are prepared using acceptable accounting policies,
consistently applied and appropriate to the entity
 Information included in financial statements is compatible with audit findings
 There is adequate disclosure and proper classification and presentation of
information
 Financial statements comply with statutory requirements and other regulations
4.3 When considering whether the accounting policies are appropriate, auditors should
consider:
 Policies commonly adopted in particular industries
 Policies for which there is substantial authoritative support
 Whether any departures from applicable accounting standards are necessary for the
financial statements to give a true and fair view
 Whether the financial statements reflect the substance of the underlying transactions
and not merely their form
Uncorrected misstatements
Section 4.4 4.4 During the audit, a schedule will have been maintained of errors identified that have not
been corrected by the client.
Some of these may have been individually immaterial but the schedule must be reviewed at
this stage before the audit opinion is finalised. The effect of the uncorrected misstatements
must be considered in aggregate as their combined effect may be material and thus could
affect the audit opinion.
Communication of uncorrected misstatements

4.5 ISA 450 Evaluation of Misstatements Identified during the Audit requires the auditor to
communicate uncorrected misstatements and their effect to those charged with governance,
with material uncorrected misstatements being identified individually. The auditor shall
request uncorrected misstatements to be corrected. The auditor shall also communicate the
effect of uncorrected misstatements relating to prior periods.
The auditor shall request a written representation from management and those charged with
governance whether they believe the effects of uncorrected misstatements are immaterial
(individually and in aggregate) to the financial statements as a whole. A summary of these
items shall be included in or attached to the representation.
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Documentation
4.6 ISA 450 requires the auditor to document the following information:
 The amount below which misstatements would be regarded as clearly trivial
 All misstatements accumulated during the audit and whether they have been
corrected
 The auditor's conclusion as to whether uncorrected misstatements are material and
the basis for that conclusion
(ISA 450: para. 15)
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Additional
Notes
277
5 Example of a written representation letter from

management
This letter includes written representations that are required for audits of financial
statements for periods beginning on or after 15 December 2009. It is not intended to be a
standard letter. Representations by management will vary from one entity to another and
from one period to the next.
(Entity Letterhead)
(To Auditor) (Date)
This representation letter is provided in connection with your audit of the financial
statements of ABC Company for the year ended 31 December 20XX for the purpose of
expressing an opinion as to whether the financial statements are presented fairly, in all
material respects, (or give a true and fair view) in accordance with International Financial
Reporting Standards.
We confirm that (to the best of our knowledge and belief, having made such inquiries as we
considered necessary for the purpose of appropriately informing ourselves):
Financial Statements
 We have fulfilled our responsibilities, as set out in the terms of the audit engagement
dated [insert date], for the preparation of the financial statements in accordance with
International Financial Reporting Standards; in particular the financial statements are
fairly presented (or give a true and fair view) in accordance therewith.
 Significant assumptions used by us in making accounting estimates, including those
measured at fair value, are reasonable. (ISA 540)
 Related party relationships and transactions have been appropriately accounted for
and disclosed in accordance with the requirements of International Financial
Reporting Standards. (ISA 550)
 All events subsequent to the date of the financial statements and for which
International Financial Reporting Standards require adjustment or disclosure have
been adjusted or disclosed. (ISA 560)
 The effects of uncorrected misstatements are immaterial, both individually and in the
aggregate, to the financial statements as a whole. A list of the uncorrected
misstatements is attached to the representation letter. (ISA 450)
 [Any other matters that the auditor may consider appropriate (see paragraph A10 of
this ISA).]
Information Provided
 We have provided you with:
– Access to all information of which we are aware that is relevant to the
preparation of the financial statements such as records, documentation and
other matters;
– Additional information that you have requested from us for the purpose of the
audit; and
278
– Unrestricted access to persons within the entity from whom you determined it
necessary to obtain audit evidence.
 All transactions have been recorded in the accounting records and are reflected in the
financial statements.
 We have disclosed to you the results of our assessment of the risk that the financial
statements may be materially misstated as a result of fraud. (ISA 240)
 We have disclosed to you all information in relation to fraud or suspected fraud that
we are aware of and that affects the entity and involves:
– Management;
– Employees who have significant roles in internal control; or
– Others where the fraud could have a material effect on the financial
statements. (ISA 240)
 We have disclosed to you all information in relation to allegations of fraud, or
suspected fraud, affecting the entity's financial statements communicated by
employees, former employees, analysts, regulators or others. (ISA 240)
 We have disclosed to you all known instances of non-compliance or suspected
non-compliance with laws and regulations whose effects should be considered when
preparing financial statements. (ISA 250)
 We have disclosed to you the identity of the entity's related parties and all the related
party relationships and transactions of which we are aware. (ISA 550)
 Any other matters that the auditor may consider necessary.
Management
279
6 Chapter summary
1 Subsequent events The auditor has a duty to perform procedures to identify
subsequent events up to the date of the auditor's
report.
If further events are discovered after the date of the
report the auditor should discuss with client
management and take appropriate action.
2 Going concern The auditor must consider the appropriateness of the

going concern basis of accounting.
3 Written representations The auditor should obtain written representations on

from management material matters where:
 Knowledge of the facts is confined to
management; and
 The matter involves judgement.
4 Overall review of Before issuing the audit opinion, the auditor should
financial statements carry out an overall review of the financial statements.
5 Written representation Example of a written representation letter.

letter
END OF CHAPTER
280
Reports

Identify and describe the basic elements Q11 Section A – Specimen exam
contained in the independent auditor's report Q9 Section A – Sept 16
Explain unmodified audit opinions in the auditor's Q15 Section A – Specimen exam
report Q10 Section A – Sept 16
Explain modified audit opinions in the auditor's Q15 Section A – Specimen exam
report Q18 (c) Section B – Specimen exam
Q18(b) Section B – Dec 2016
Q18(d) Section B – Sept/Dec 2017
Describe the format and content of emphasis of
matter and other matter paragraphs
Discuss the reporting implications of the findings Q10 Section A – Dec 2016
of going concern reviews Q18(d) Section B – Sept/Dec 2018
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19: REPORTS
Overview
Reports
Auditor's reports
Standard report Changes to the auditor's

'unmodified opinion' report
Unmodified opinions with Modified on matters that do affect

additional communication the auditor's opinion
Emphasis of Other
matter paragraph matter
'Our opinion is paragraph Insufficient or inappropriate Material misstatement
not modified in (eg 8) audit evidence
respect of this
matter'
(eg 7)
Material Material and Material Material and
but not pervasive but not pervasive
pervasive Disclaimer pervasive Adverse
Qualified 'do not Qualified 'do not give
'except for' express an 'except for' a true and fair
(eg 5) opinion' (eg 3) view'
(eg 6) (eg 4)
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1 ISA 700 (Revised): Forming an opinion and reporting

Whole chapter
on financial statements
1.1 ISA 700 (Revised) Forming an Opinion and Reporting on Financial Statements requires the
auditor to give an opinion on whether the financial statements are prepared, in all material
respects, in accordance with the applicable financial reporting framework.
1.2 To do this, the auditor needs to consider the following:

(a) Whether sufficient appropriate audit evidence has been obtained (ISA 330)
(b) Whether uncorrected misstatements are material (ISA 450)
Basic elements of the auditor's report

1.3 The auditor's report should include the following basic elements, normally in this order:
(a) Title
(b) Addressee
(c) Auditor’s opinion
(d) Basis for opinion
(e) Going concern (if relevant)
(f) Emphasis of matter paragraph (if relevant)
(g) Key audit matters (KAM) (for audits of listed entities only)
(h) Other matter paragraph (if relevant)
(i) Responsibilities for the financial statements
(j) Auditor's responsibilities for the audit of the financial statements
(k) Report on other legal and regulatory requirements (if relevant)
(l) Name of audit engagement partner
(m) Signature of the auditor
(n) Auditor's address
(o) Date of the auditor's report
1.4 Unmodified opinion

An unmodified opinion is the opinion expressed by the auditor when the auditor concludes
that the financial statements are prepared, in all material respects, in accordance with the
applicable financial reporting framework.
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1.5 Example 1: Unmodified auditor's report with unmodified opinion (listed entity)
INDEPENDENT AUDITOR'S REPORT

To the Shareholders of ABC Company [or Other Appropriate Addressee]
Report on the Audit of the Financial Statements
Opinion
We have audited the financial statements of ABC Company (the Company), which comprise the
statement of financial position as at 31 December 20X1, and the statement of comprehensive
income, statement of changes in equity and statement of cash flows for the year then ended, and
notes to the financial statements, including a summary of significant accounting policies.
In our opinion, the accompanying financial statements present fairly, in all material respects, (or
give a true and fair view of) the financial position of the Company as at December 31 20X1, and
(of) its financial performance and its cash flows for the year then ended in accordance with
International Financial Reporting Standards (IFRSs).
Basis for Opinion
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for the
Audit of the Financial Statements section of our report. We are independent of the Company in
accordance with the International Ethics Standards Board for Accountants' Code of Ethics for
Professional Accountants (IESBA Code) together with the ethical requirements that are relevant to
our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements and the IESBA Code. We believe that the
audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion.
Key Audit Matters
Responsibilities of Management and Those Charged with Governance for the Financial
Statements
Management is responsible for the preparation and fair presentation of the financial statements in
accordance with IFRSs and for such internal control as management determines is necessary to
enable the preparation of financial statements that are free from material misstatement, whether
due to fraud or error.
In preparing the financial statements, management is responsible for assessing the Company's
ability to continue as a going concern, disclosing, as applicable, matters related to going concern
and using the going concern basis of accounting unless management either intends to liquidate the
Company or to cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Company's financial reporting
process.
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19: REPORTS
Auditor's Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error, and to issue an auditor's
report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a
guarantee that an audit conducted in accordance with ISAs will always detect a material
misstatement when it exists. Misstatements can arise from fraud or error and are considered
material if, individually or in the aggregate, they could reasonably be expected to influence the
economic decisions of users taken on the basis of these financial statements.
As part of an audit in accordance with ISAs, we exercise professional judgment and maintain
professional scepticism throughout the audit. We also:
 Identify and assess the risks of material misstatement of the financial statements, whether
due to fraud or error, design and perform audit procedures responsive to those risks, and
obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion.
The risk of not detecting a material misstatement resulting from fraud is higher than for one
resulting from error, as fraud may involve collusion, forgery, intentional omissions,
misrepresentations, or the override of internal control.
 Obtain an understanding of internal control relevant to the audit 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 Company's internal control.
 Evaluate the appropriateness of accounting policies used and the reasonableness of
accounting estimates and related disclosures made by management.
 Conclude on the appropriateness of management's use of the going concern basis of
accounting and, based on the audit evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt on the Company's ability to
continue as a going concern. If we conclude that a material uncertainty exists, we are
required to draw attention in our auditor's report to the related disclosures in the financial
statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions
are based on the audit evidence obtained up to the date of our auditor's report. However,
future events or conditions may cause the Company to cease to continue as a going
concern.
 Evaluate the overall presentation, structure and content of the financial statements,
including the disclosures, and whether the financial statements represent the underlying
transactions and events in a manner that achieves fair presentation.
We communicate with those charged with governance regarding, among other matters, the
planned scope and timing of the audit and significant audit findings, including any significant
deficiencies in internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with
relevant ethical requirements regarding independence, and to communicate with them all
relationships and other matters that may reasonably be thought to bear on our independence, and
where applicable, related safeguards.
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19: REPORTS
From the matters communicated with those charged with governance, we determine those matters
that were of most significance in the audit of the financial statements of the current period and are
therefore the key audit matters. We describe these matters in our auditor's report unless law or
regulation precludes public disclosure about the matter or when, in extremely rare circumstances,
we determine that a matter should not be communicated in our report because the adverse
consequences of doing so would reasonably be expected to outweigh the public interest benefits
of such communication.
Report on Other Legal and Regulatory Requirements
[The form and content of this section of the auditor's report would vary depending on the nature of
the auditor's other reporting responsibilities prescribed by local law, regulation, or national auditing
standards. The matters addressed by other law, regulation or national auditing standards (referred
to as 'other reporting responsibilities') shall be addressed within this section unless the other
reporting responsibilities address the same topics as those presented under the reporting
responsibilities required by the ISAs as part of the Report on the Audit of the Financial Statements
section. The reporting of other reporting responsibilities that address the same topics as those
required by the ISAs may be combined (ie, included in the Report on the Audit of the Financial
Statements section under the appropriate subheadings) provided that the wording in the auditor's
report clearly differentiates the other reporting responsibilities from the reporting that is required by
the ISAs where such a difference exists.]
The engagement partner on the audit resulting in this independent auditor's report is [name].
[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate
for the particular jurisdiction]
[Auditor Address]
[Date]
2 ISA 701: Communicating key audit matters (KAMs) in

the independent auditor's report
2.1 The communication of KAMs is only relevant to the audit of listed entities.
Definition
2.2 A KAM is a matter which, in the auditor's professional judgement, is significant in the audit of
the financial statements for the current period. It is an issue which has required significant
auditor attention during the course of the audit and would also have been communicated in
writing to those charged with governance in accordance with ISA 260 (Revised)
Communication with Those Charged with Governance.
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19: REPORTS
2.3 Examples include:

(a) Areas where the risk of material misstatement has been assessed as high at the
planning stage, for example complex accounting transactions;
(b) Areas of the financial statements where management have had to exercise significant
judgement, for example asset valuations or accounting estimates where there is a
high level of uncertainty; and
(c) The effect on the audit of significant events or transactions that occurred during the
period, for example the acquisition of a subsidiary.
2.4 KAMs relate to matters which are already included in the financial statements.
2.5 No separate audit opinion is issued in relation to each KAM.
Presentation of KAMs in the auditor's report

2.6 Each KAM detailed in the auditor's report should refer to the related disclosure in the
financial statements and will explain:
(a) Why the matter was considered to be significant and therefore a KAM; and
(b) How the matter was addressed in the audit.
2.7 Example 2: Key audit matters disclosure
Key Audit Matters

Goodwill
Under IFRSs, the Group is required to annually test the amount of goodwill for impairment. This
annual impairment test was significant to our audit because the balance of $X as of
31 December 20X1 is material to the financial statements. In addition, management's assessment
process is complex and highly judgmental and is based on assumptions, specifically [describe
certain assumptions], which are affected by expected future market or economic conditions,
particularly those in [name of country or geographic area].
Our audit procedures included, among others, using a valuation expert to assist us in evaluating
the assumptions and methodologies used by the Group, in particular those relating to the
forecasted revenue growth and profit margins for [name of business line]. We also focused on the
adequacy of the Group's disclosures about those assumptions to which the outcome of the
impairment test is most sensitive, that is, those that have the most significant effect on the
determination of the recoverable amount of goodwill.
The Company's disclosures about goodwill are included in Note 3, which specifically explains that
small changes in the key assumptions used could give rise to an impairment of the goodwill
balance in the future.
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19: REPORTS
2.8 Where the auditor's opinion is modified (Section 3) in relation to a KAM, the issue would not
be disclosed in the KAM, paragraph but in the 'Basis for modified opinion' paragraph.
2.9 Any concerns relating to an entity's ability to continue as a going concern would not be
disclosed in the KAM, paragraph but in the 'Material uncertainty relating to going concern'
paragraph.
3 ISA 705 (Revised): Modifications to the opinion in the

independent auditor's report
3.1 The auditor will give a modified audit opinion when:
(a) The auditor concludes, based on the evidence obtained, that the financial statements
as a whole are not free from material misstatement; or
(b) The auditor is unable to obtain sufficient appropriate audit evidence to conclude that
the financial statements as a whole are free from material misstatement.
3.2 In both circumstances there can be two 'levels' of modified opinion:

(a) Material but not pervasive, where the circumstances prompting the misstatement
are material
(b) Material and pervasive, where the financial statements could be misleading
3.3 Modified opinions:

Modified
Due to insufficient appropriate evidence Due to material misstatement

 Evidence which should be available to  The appropriateness or application of
the auditor is not available, for example: selected accounting policies
– Inadequate accounting records/  The appropriateness or adequacy of
records lost or destroyed disclosures in the financial statements
– Auditor appointed after the period
end
– Management prevents the auditor
from requesting/obtaining audit
evidence
Material but not Material and pervasive Material but not Material and pervasive
pervasive pervasive
Qualified opinion Disclaimer of opinion Qualified opinion Adverse opinion

'Except for' 'We do not express an 'Except for' 'Do not present fairly'
opinion'
(Example 5) (Example 6) (Example 3) (Example 4)
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19: REPORTS
3.4 Example 3: Qualified opinion due to material misstatement of inventories
Qualified Opinion
We have audited the financial statements of ABC Company (the Company), which comprise
the statement of financial position as at 31 December 20X1, and the statement of
comprehensive income, statement of changes in equity and statement of cash flows for the
year then ended, and notes to the financial statements, including a summary of significant
accounting policies.
In our opinion, except for the effects of the matter described in the Basis for Qualified
Opinion section of our report, the accompanying financial statements present fairly, in all
material respects, (or give a true and fair view of) the financial position of the Company as at
31 December 20X1, and (of) its financial performance and its cash flows for the year then
ended in accordance with International Financial Reporting Standards (IFRSs).
Basis for Qualified Opinion
The company's inventories are carried in the statement of financial position at xxx.
Management has not stated inventories at the lower of cost and net realisable value but has
stated them solely at cost, which constitutes a departure from IFRSs. The company's
records indicate that had management stated the inventories at the lower of cost and net
realisable value, an amount of xxx would have been required to write the inventories down
to their net realisable value. Accordingly, cost of sales would have been increased by xxx,
and income tax, net income and shareholders' equity would have been reduced by xxx, xxx
and xxx, respectively.
Key Audit Matters
Key audit matters are those matters that, in our professional judgment, were of most
significance in our audit of the financial statements of the current period. These matters
were addressed in the context of our audit of the financial statements as a whole, and in
forming our opinion thereon, and we do not provide a separate opinion on these matters. In
addition to the matter described in the Basis for Qualified Opinion section we have
determined the matters described below to be the key audit matters to be communicated in
our report.
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19: REPORTS
3.5 Example 4: Adverse opinion due to material misstatement with a pervasive effect
Adverse Opinion
In our opinion, because of the significance of the matter discussed in the Basis for Adverse
Opinion section of our report, the accompanying financial statements do not present fairly
(or do not give a true and fair view of) the financial position of ABC Company as at
31 December 20X1, and (of) its financial performance and its cash flows for the year then
ended in accordance with IFRSs.
Basis for Adverse Opinion
As explained in Note X, the company has included houses built for re-sale (including related
land) at a cost of $X as non-current assets and depreciated them at a rate of X%, resulting
in depreciation of $X. Under International Financial Reporting Standards, these should have
been included as inventory in the financial statements and no depreciation should have
been provided in respect of these. The carrying value of the houses represent 90% of the
company's total assets and the company's records indicate that … [explanation of the effect
on amounts presented in the financial statements].
Key Audit Matters
Except for the matter described in the Basis for Adverse Opinion section, we have
determined that there are no other key audit matters to communicate in our report.
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19: REPORTS
3.6 Example 5: Qualified opinion due to inability to obtain sufficient appropriate audit
evidence about the carrying amount of inventory (material but not pervasive)
Qualified Opinion
In our opinion, except for the possible effects of the matter described in the Basis for
Qualified Opinion section of our report, the accompanying financial statements present
fairly, in all material respects, (or give a true and fair view of) the financial position of ABC
Company as at 31 December 20X1, and (of) its financial performance and its cash flows for
the year then ended in accordance with IFRSs.
Basis for Qualified Opinion
With respect to inventory having a carrying amount of $X the audit evidence available to us
was limited because we did not observe the counting of the physical inventory as at
31 December 20X1, since that date was prior to our appointment as auditor of the company.
Owing to the nature of the company's records, we were unable to obtain sufficient
appropriate audit evidence regarding the inventories quantities by using other audit
procedures.
Key Audit Matters
addition to the matter described in the Basis for Qualified Opinion section we have
our report.
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3.7 Example 6: Disclaimer of opinion due to inability to obtain sufficient appropriate audit
evidence about multiple elements of the financial statements (inventories and
accounts receivable – material and pervasive)
Disclaimer of Opinion
We were engaged to audit the financial statements of ABC Company (the Company), which
comprise the statement of financial position as at 31 December 20X1, and the statement of
We do not express an opinion on the accompanying financial statements. Because of the
significance of the matters described in the Basis for Disclaimer of Opinion section of our
report, we have not been able to obtain sufficient appropriate audit evidence to provide a
basis for an audit opinion on these financial statements.
Basis for Disclaimer of Opinion
We were not appointed as auditors of the company until after 31 December 20X1 and thus
did not observe the counting of physical inventories at the beginning and end of the year.
We were unable to satisfy ourselves by alternative means concerning the inventory
quantities held at 31 December 20X0 and 20X1 which are stated in the statement of
financial position at xxx and xxx, respectively. In addition, the introduction of a new
computerised accounts receivable system in September 20X1 resulted in numerous errors
in accounts receivable. As of the date of our auditor's report, management was still in the
process of rectifying the system deficiencies and correcting the errors. We were unable to
confirm or verify by alternative means accounts receivable included in the statement of
financial position at a total amount of xxx as at 31 December 20X1. As a result of these
matters, we were unable to determine whether any adjustments might have been found
necessary in respect of recorded or unrecorded inventories and accounts receivable, and
the elements making up the income statement, statement of changes in equity and
statement of cash flows.
Key Audit Matters
addition to the matter described in the Basis for Disclaimer of Opinion section we have
our report.
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4 ISA 706 (Revised): Emphasis of matter paragraphs

and other matter paragraphs
Emphasis of matter paragraph
4.1 An emphasis of matter paragraph is a paragraph included in the auditor's report which
aims to draw users' attention to a matter:
 Which is appropriately presented or disclosed in the financial statements; but
 Which is of such importance, in the auditor's judgement, that it is fundamental to
users' understanding of the financial statements.
4.2 Examples of circumstances where the auditor may include an emphasis of matter paragraph
are:
 An uncertainty relating to the future outcome of exceptional litigation or regulatory
action;
 A significant subsequent event that occurs between the date of the financial
statements and the date of the auditor's report, for example a fire at the entity's
production facilities;
 Early application (where permitted) of a new accounting standard that has a material
effect on the financial statements; and
 A major catastrophe that has had, or continues to have, a significant effect on the
entity's financial position.
4.3 An emphasis of matter paragraph is not used to highlight any going concern issues. Such
issues would be disclosed in a 'material uncertainty related to going concern' paragraph
(Section 5).
4.4 For listed entity audits, the same issue would not be included within the emphasis of matter
paragraph and the KAM paragraph.
(a) If the issue is fundamental to users' understanding and has required significant audit
attention then it should be disclosed as a key audit matter.
(b) However, if the issue is fundamental to users' understanding but has not required
significant audit attention, for example a subsequent event, then it should be
disclosed within the emphasis of matter paragraph.
4.5 Where an emphasis of matter paragraph is used:

(a) It can come immediately before or after the key audit matters, depending on the
significance of the information.
(b) It is entitled 'Emphasis of matter'.
(c) The paragraph makes a clear reference to the matter being emphasised and to where
the relevant disclosures that fully describe the matter can be found in the financial
statements.
(d) The paragraph must state that the auditor's opinion is not modified in respect of the
matter emphasised.
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19: REPORTS
4.6 Example 7: Emphasis of matter paragraph
Emphasis of Matter
We draw attention to Note X of the financial statements, which describes the effects of a fire
in the company's production facilities. Our opinion is not modified in respect of this
matter.
Key Audit Matters
forming our opinion thereon, and we do not provide a separate opinion on these matters.
Other matter paragraph

4.7 An other matter paragraph is a paragraph included in the auditor's report that refers to a
matter:
(a) Which is not presented or disclosed in the financial statements (because it is outside
the scope of the financial statements); but
(b) Which is of such importance, in the auditor's judgement, that it is relevant to users'
understanding of the audit, the auditor's responsibilities or the auditor's report.
4.8 Examples of circumstances where the auditor may include an other matter paragraph are
where the prior year financial statements:
 Have not been audited; or
 Have been audited by another auditor.
4.9 For listed entity audits, the same issue would not be included within the other matter
paragraph and the KAM paragraph.
4.10 Where an other matter paragraph is used:

(a) It usually comes immediately after the key audit matters
(b) It is entitled 'Other matter'
4.11 Example 8: Other matter paragraph
Other Matter
The financial statements of ABC Company for the year ended 31 December 20X0 were
audited by another auditor who expressed an unmodified opinion on those statements on
31 March 20X1.
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19: REPORTS
5 Going concern
Responsibilities of directors and auditors
5.1 It is the directors' responsibility to determine whether or not an entity is a going concern.
5.2 It is the auditor's responsibility to make an assessment as to whether the directors'

conclusion is appropriate. This should be based on the results of the going concern review
performed by the auditor.
5.3 The auditor must consider:

(a) Whether the use of the going concern basis is appropriate;
(b) Whether adequate disclosure has been made of any material uncertainties affecting
going concern; and
(c) Whether management's assessment was adequate.
5.4 If there is concern about any of the items above, then the auditor should consider the
implications for their report.
Auditor's report implications

5.5 There are three main scenarios:
5.6 Scenario 1
The going concern basis is believed to be appropriate, but a material uncertainty

exists
The material uncertainty is adequately The material uncertainty is not

disclosed in the financial statements adequately disclosed in the financial
statements
The auditor should express an The auditor should express a qualified or

unqualified opinion but add a adverse opinion due to material
material uncertainty related to misstatement
going concern paragraph
(Example 9)
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19: REPORTS
5.7 Example 9: Material uncertainty related to going concern
Material uncertainty related to going concern

We draw attention to Note X in the financial statements, which indicates that the company
incurred a net loss of $Z during the year ended 31 December 20X1, and as of that date, the
company's current liabilities exceeded its total assets by $Y. As stated in Note X, these
events or conditions, along with other matters as described in Note X, indicate that a
material uncertainty exists that may cast significant doubt on the company's ability to
continue as a going concern. Our opinion is not modified in respect of this matter.
Key Audit Matters
addition to the matter described in the Material Uncertainty Related to Going Concern
section, we have determined the matters described below to be the key audit matters to be
communicated in our report.
5.8 Scenario 2
The going concern basis is believed to be inappropriate
The auditor should express an adverse opinion due to material and pervasive
misstatement
5.9 Scenario 3
The directors are unwilling/unable to make an assessment as to whether or not the
going concern basis is appropriate
The auditor should express a qualified or disclaimer of opinion due to insufficient

appropriate evidence
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19: REPORTS
The following scenario relates to Questions 1–5.

You are the audit manager of Check & Co and are reviewing the key issues identified in the files of
several audit clients, each of which has a year end of 30 September 20X2.
The first audit client is Little Bees Co (LB). The fieldwork stage for this audit has been completed
and the draft financial statements show a profit before tax of $175,000.
1 LB has valued a certain inventory line at its total cost price of $17,000. These inventory
items have not been sold for a number of years and it is unlikely that they can be sold in the
future unless the price is reduced to $3,000. The finance director is confident that the issue
will be resolved and no write down was made with regards to this balance.
Which of the following options correctly summarises the impact on the auditor's
report if the issue remains unresolved?
 Adverse opinion
 Disclaimer of opinion
 Qualified 'except for'
 Unmodified opinion
The second audit client is Hayden Co (Hayden).
2 On 1 January 20X2 Hayden implemented a new accounting system; this was generally a
success, with the exception of February 20X2 when one month of Hayden's inventory
records were lost. Despite several attempts the audit team was unable to perform alternative
audit procedures to verify material inventory transactions in February 20X2, although the
year-end inventory count went smoothly.
Which of the following options correctly summarises the impact on the auditor's
report of the above issue?
 Disclaimer of opinion
 Qualified 'except for'
 Unmodified opinion
 Unmodified opinion with emphasis of matter paragraph
The third audit client is Maker Co (Maker), a listed construction company which specialises in
residential housebuilding.
297
19: REPORTS
3 One of Maker's construction workers, Edward Shift, was dismissed in August 20X2 after
turning up for work under the influence of alcohol. In September 20X2, Mr Shift began a
case against Maker for unfair dismissal.
Which TWO of the following audit procedures should be performed in order to form a
conclusion as to the appropriate accounting treatment of the above claim in the year
end financial statements?
 Recalculate Mr Shift's wages and salaries for the year to verify that he was only paid
up to the date of dismissal
 Review the construction work performed by Mr Shift in August 20X2 to determine
whether there are any concerns over the quality of his work and whether Maker's
health and safety procedures were followed
 Review legal correspondence relating to the claim in order to determine Maker's
lawyers' opinion as to the likely outcome of the claim
 Review the post year end cash book in order to determine whether any payments
were made to Mr Shift
4 Mr Shift has sent such a huge amount of paperwork to Maker detailing the extent of his claim
along with supporting medical documentation and character references that the audit team
has had to devote a significant amount of audit attention to this area of the audit. The directors
have not made any reference to the claim in the financial statements and you agree with
Maker's lawyers' indication that it is highly unlikely that Mr Shift will be successful in his claim.
Based on the above information indicate whether the audit opinion should be modified or
unmodified and the appropriate disclosure which should be made in the auditor's report:
Modified Unmodified
Emphasis of matter Key audit matter Other matter Material uncertainty

paragraph paragraph paragraph related to going
concern paragraph
Audit opinion Disclosure in the auditor's report
The final audit client is TH Co (TH). The audit fieldwork is complete; however, your audit senior
has raised an outstanding issue.
298
19: REPORTS
5 The directors of TH have made appropriate disclosures relating to worries over going
concern in the financial statements. Your audit senior has a significant level of concern
regarding the going concern basis but feels the disclosure is appropriate and agrees with
the use of the going concern basis. You concur with the audit senior's conclusions.
Based on the above information indicate whether the audit opinion should be
qualified 'except for' or unmodified and the appropriate disclosure which should be
made in the auditor's report:
Qualified 'except Unmodified

for'
Emphasis of matter Material uncertainty

paragraph related to going
concern paragraph
Audit opinion Disclosure in the auditor's report
299
19: REPORTS
6 Chapter summary
1 ISA 700 (Revised) The elements of the auditor's report are specified by
Forming an Opinion ISA 700 (Revised).
and Reporting on Auditor's report may be unmodified or modified.
Financial Statements
2 ISA 701 For listed entity audits the auditor should report areas of
Communicating Key the audit which have required significant audit attention
Audit Matters in the as key audit matters. These should also be reported to
Independent Auditor's those charged with governance.
Report
3 ISA 705 (Revised) Auditors will modify their opinions when the financial
Modifications to the statements are not free from material misstatement or
Opinion in the when they have been unable to obtain sufficient
Independent Auditor's appropriate evidence. There are two levels of modified
Report opinions auditors can give – material but not pervasive
and material and pervasive.
4 ISA 706 (Revised) A report may be modified by an emphasis of matter or
Emphasis of Matter other matter paragraph. These do not affect the
Paragraphs and Other opinion.
Matter Paragraphs
5 Going Concern It is the directors' responsibility to determine whether an
entity is a going concern and the auditor's responsibility
to assess whether this is appropriate. Uncertainty over
going concern will lead to the inclusion of a 'Material
uncertainty related to going concern' paragraph being
included in the auditor's report (provided that the issue
is adequately disclosed). Material misstatement in
relation to going concern is likely to be one of the rare
circumstances where an adverse opinion is issued.
END OF CHAPTER
300
You have now covered the Topics that will be assessed in Step 5 in your Achievement Ladder. This
topics.
Course Notes
chapter
The concept of assurance 1
Audit and assurance
Regulation 2
Governance
Internal audit 4
Ethics 5
procedures
Audit planning
Internal controls 9
Audit procedures and sampling 11
Audit evidence I
Non-current assets 12
Inventory 13
Audit evidence II Receivables 14
Bank and cash 15
301
Achievement ladder
Course Notes
chapter
Liabilities and equity 16
Audit evidence III
Not-for-profit organisations 17
Audit finalisation 18
Audit completion
Audit reports 19
302
In the final run up to your exam, you should attempt Step 6 as the final check that you are fully prepared
to move onto the revision phase of your studies. As a reminder, Step 6 must be completed and submitted
in order to be able to qualify for Pass Assurance. It is Step 6 and can also be found at the back of these
Course Notes.
It covers all the Topics in your course. As ever, you will receive feedback on your performance, and you
can use the wide range of online resources to help address any final areas where you need to fine tune
your knowledge or technique.
Course Notes
chapter
The concept of assurance 1
Audit and assurance
Regulation 2
Governance
Internal audit 4
Ethics 5
procedures
Audit planning
Internal controls 9
Audit procedures and sampling 11
Audit evidence I
Non-current assets 12
Inventory 13
Audit evidence II Receivables 14
Bank and cash 15
Liabilities and equity 16
Audit evidence III
Not-for-profit organisations 17
Audit finalisation 18
Audit completion
Audit reports 19
303
Achievement ladder
304
Answers to
Lecture Examples
305
20: ANSWERS TO LECTURE EXAMPLES
Chapter 1
Answer to Lecture Example 1
1 Here you would want some comfort as to whether or not the house you plan to buy is
structurally sound, whether the roof is in a good condition, whether there is any damp and
so on. Most house buyers would have a survey carried out by a building surveyor prior to
completing a purchase. This survey is carried out by an independent party who is
professionally qualified and would give you confidence/comfort that there are no major
issues with the property you plan to purchase.
2 One of the primary risks of meeting someone you have met online must be the risk that they
are not who they say they are and that instead of being a funny, loveable, friendly
companion they are actually someone who is out to harm you. Your friend should therefore
consider the checks that the website make on each of their members and they could also
sound out any mutual friends or acquaintances you have as to the type of person they are
about to meet. They could also consider checking any public registers such as the sex
offenders register.
3 Here the council body will be concerned that the money they have given is used for the
designated purpose. They will need assurance that the money has been spent on sports
equipment, sports hall premises, staff and so forth rather than on items which are not related
to this cause. The council could require the organisation to provide them with a report
stating that the money was spent in accordance with the stipulations of the grant. This report
would need to be produced by an independent body, perhaps an accountant.
Chapter 2
No Lecture Examples
Chapter 3
1 The Chairman's role is to run/direct the board of directors so that its members can undertake
their roles effectively. These duties include ensuring that the board is appropriately balanced
(in terms of the numbers of executive and non-executive directors) and that each director is
aware of their responsibilities and equipped to fulfil them.
The Chief Executive Officer's role is to decide on the company's strategy and put
procedures in place to achieve these.
These are very different roles and so should ideally be undertaken by two separate people.
Also separating the roles will not allow one person to have too much power (as in the case
of Robert Maxwell).
2 Dress You Like Co undertakes a board evaluation each year which allows directors to voice
their concerns as to how the board is being run.
It also makes training available to its directors and offers a full induction to new directors.
306
3 Directors should only remain in position if they are performing in their role. Having the
annual re-election of directors allows companies to remove directors who are not performing
and also encourages directors to work effectively for the company/shareholders.
4 Board of directors:
The responsibility for risk management lies with the board of directors. It is the directors'
responsibility to assess the risks that the business is exposed to. All businesses are
exposed to general risks; however, there are additional, specific risks relevant to each
business. Dress You Like Co is a clothing manufacturer and so there are lots of risks
inherent in the business – two of these are mentioned in the scenario: changing fashion
trends and the security of inventory.
Once the board has identified the key risks to which the business is exposed, it must then
implement a system of internal controls (or procedures) to prevent and/or detect these risks
occurring.
Internal controls could range from performing continual market research into consumer
fashion tastes to installing security cameras in the factory to deter theft of inventory.
The existence of an internal audit function is often cited as a positive form of risk
management and internal control.
Audit committee:
As well as giving the board of directors the responsibility for risk management, corporate
governance principles require a company to establish an audit committee. This should
comprise at least three non-executive directors (two non-executive directors for a small
company).
The audit committee has a responsibility to review the company's risk management and
internal control systems and should include at least one non-executive director with financial
knowledge.
The audit committee must also review the effectiveness of the internal audit department
where one exists. If there is no internal audit department, then the audit committee should
consider annually whether or not there is a need for one.
5 Executive directors are responsible for the day to day running of the company and perform
operational and strategic business functions such as entering into contracts, safeguarding
company assets and managing people.
Non-executive directors are not involved in the day to day running of the business. Instead
they should use their experience and expertise to provide independent advice and
objectivity to the board as a whole. They also perform a supervisory role and will review and
monitor the executive directors to ensure that they are fulfilling their duties and running the
company in the best interests of the shareholders.
In order to improve their independence, non-executive directors should not be reliant on the
company for their main source of income. They often work part time for the company and
can have a specialist role within the organisation.
All directors, executive and non-executive, are required to attend as many board meetings
as they reasonably can.
307
Also there is no legal distinction between executive and non-executive directors – each has
the same responsibilities and rights under law.
Dress You Like Co has three executive and three non-executive directors which makes the
board very well balanced.
6 As well as forming part of the board of directors as a whole, the non-executive directors also
sit on the audit committee, remuneration committee and nomination committee. These are
sub-committees of the board of directors.
The audit committee is responsible, amongst other things, for reviewing the effectiveness of
the board's risk management processes.
The remuneration committee is responsible for making sure that the company offers a
performance-related remuneration package which is sufficient to attract and retain quality
directors (but not excessive).
The nomination committee is responsible for identifying and approving the appointment of
new directors to the board, for example Mary Batter, the new Chief Executive Officer.
Non-executive directors have a very important role to play in each of these sub-committees
and their independence and objectivity can improve the quality and relevance of the
decisions taken.
Chapter 4
Objective Control
Economy
To ensure that material is purchased at The prices from the Chinese supplier should be
the best possible price for the quality checked regularly against those offered by other
required. suppliers. Where alternative suppliers offer better value
for money, these suppliers should be used or prices
renegotiated with the Chinese supplier.
A list of preferred suppliers, who have been vetted for
price and quality, should be established and orders only
placed with these suppliers.
Establish a tender process whereby suppliers are
invited to quote for the supply of materials. This may
take place on a season by season or six-monthly basis.
To ensure that transportation and Identify a list of companies which import goods from
delivery costs are minimised whilst China and invite them to tender for the delivery
ensuring goods are received on a timely contract.
basis. Regularly review the price paid under the tender to
ensure it is competitive against other companies.
308
Objective Control
To ensure that the accommodation costs If premises are rented, review the rental charged in
of the factory and head office are relation to similar properties in the same location.
minimised. Attempt to renegotiate the rent favourably whenever the
lease comes up for renewal.
If premises are owned establish an ongoing schedule of
maintenance for the property to avoid unexpected
repair costs.
Establish a capital expenditure budget to ensure
monies are not wasted continually repairing machines
which should be replaced.
Efficiency
To ensure that the clothes manufacturing The factory machines should be serviced according to a
process is as efficient as possible and rolling schedule of maintenance in order for them to
minimises waste. work efficiently.
To ensure that machine down time due Orders for different clothing items should be collated
to changing the machine set up for and scheduled into a weekly plan of work in order to
different clothing items is minimised. minimise the requirement to set up machines to
manufacture different clothing items.
Effectiveness
To ensure that all additional deliveries A record should be maintained of the principal inventory
ordered by the supermarket are lines ordered by the supermarket and a buffer of
completed within the required inventory for these items maintained. The level of this
timescales. buffer should be reviewed on a fortnightly/monthly basis.
To minimise the level of inventory which A fortnightly/monthly count of inventory held should be
becomes obsolete/un-saleable due to conducted and compared to the schedule of work
changing seasons/fashions. planned for the next fortnight/month to ensure that only
sufficient quantities of inventory are manufactured to
supply orders and maintain the required buffer.
To monitor the company's cash flow to Monthly cash flow forecasts should be produced by
ensure that the company does not suffer management to monitor when cash is due to be
from short-term cash flow problems received from all customers and when cash needs to be
given the 60-day terms given to the paid out to suppliers and employees.
supermarket. Establish an overdraft facility with the company's bank
to cover short-term deficits in cash flow.
Implement strong credit control procedures whereby
customers are contacted as soon as their account
becomes overdue. Send regular customer statements
to all customers and letters to those with overdue
accounts.
Note. Only two points were required under each heading.
309

A company can benefit from the services If a company already has an internal audit
provided by an internal audit function without function and makes them redundant in order to
incurring the time and cost involved in recruiting outsource the function, the redundancies may
staff. prove very expensive.
Furthermore, the company would lose in-house
skills.
Also remaining staff may oppose outsourcing if
it has come about as a result of colleagues
being made redundant. This could reduce staff
morale.
Outsourcing the internal audit function may well The staff that come to perform the regular
increase their independence as the role will be internal audit services may vary from month to
performed by a third party rather than month. This will mean that staff from the
employees who may fear losing their jobs if they company will need to spend more time
report adversely on the company's explaining systems and processes to them than
management. if the internal audit function were company
employees.
There will be no need for the company to train The outsourced staff may lack specific
internal audit staff as those providing the service knowledge of the company.
will be trained by their own employer.
As well as buying in regular services, it may be Outsourcing the internal audit function will
able to take advantage of ad hoc engagements require the company to allow a third party
provided that the company to which services are access to commercially sensitive data.
outsourced has spare capacity. Despite the fact that any engagement letter
would stipulate that confidentiality be
maintained, data could still be lost or disclosed.
Internal auditors supplied by a bespoke The cost of outsourcing the internal audit
outsourcing company are likely to possess function may well increase over time and
relevant accounting and auditing skills which will become more expensive than employing your
increase the reliability of the internal auditors' own staff.
work.
Note. Only four advantages and disadvantages were required.
310

Objectives Give an opinion as to whether: Varied and wide ranging
 The financial statements Determined by management/board but may
'present fairly' the activities of include:
the business; and  Review of accounting/internal control
 Proper accounting records systems
have been kept.  Examination of financial/operating
information
 Value for money (VFM) reviews
 Review of implementation of corporate
policies, laws and regulations
 Special investigations, eg suspected fraud
 Procurement, marketing, treasury and HR
reviews
Reports to Shareholders of the company Board of directors/audit committee
Status Independent of/external to Company employee/outsourced to a third
company they are auditing party
Qualification Audit partner will be qualified and No formal qualifications required
hold a practising certificate as a
registered auditor
Not all team members will be
qualified
Chapter 5
Threat Safeguards
Weadon Co
This involves a self-interest threat because Gifts and hospitality should not be accepted
the auditors may wish to continue enjoying unless the value is trivial and
lavish hospitality so may be reluctant to raise inconsequential.
any problems in their auditor's report.
There is also a familiarity threat because In this case it would be appropriate to decline
involvement in social events with the client is the weekend away so as not to impair the
likely to increase the audit staff's familiarity firm's independence.
with the client staff and make them more likely
to accept explanations without adequate
questioning.
311
Threat Safeguards
Stewards Co
This involves a familiarity threat because Mr Mr Walker should be rotated off the audit and
Walker has been the engagement partner for another partner assigned to the client. Given
nine years and his long association with the that Stewards Co is a public interest entity,
client could mean that he does not question key audit partners (such as the engagement
judgements made by the client and does not partner) should serve for no more than seven
exercise sufficient professional scepticism. years before being rotated off. They should
not return to having involvement in the client
for a period of two years.

1 The correct answer is:
Intimidation Self-interest Self-review

Risk (1) 
Risk (2) 
Risk (3)  
Risk (4) 

Discuss the situation with Emerald's audit committee and consider resigning from some
services.
Check & Co should decline the offer to prepare the financial statements.
Chapter 6
Audit risk Auditor's response
The audit is a new audit for the firm; the firm The auditors should spend time ensuring they
may not have as good an understanding of fully understand the nature of the business, its
the client as it would have for an established products or services, its locations, revenue
client and so there is likely to be an increased sources, key customers and suppliers, internal
level of detection risk. controls and any external pressures or laws
and regulations it is subject to in order to best
assess the risk of material misstatement in the
This information must be communicated to all
members of the audit team.
312

The audit was won after a competitive tender Check & Co must put safeguards in place to
and so the profit margin on the audit may be ensure that both the firm's quality control
lower than usual leading to pressure on fees procedures and auditing standards are
and therefore the time audit staff are allowed complied with despite the potential pressure
to spend on each area. This increases the risk on fees.
that a material misstatement may go This may require an independent partner
undetected. review of key risk areas to determine whether
Furthermore, Check & Co may be hoping to sufficient appropriate evidence has been
keep the client for the long term in order to gained.
maximise profit from the audit or obtain
additional work. This also increases audit risk.
Dress You Like Co is a clothing manufacturer An aged inventory report should be obtained
whose inventory will be subject to changing to identify items of slow moving or
seasons and trends. It is possible that some non-saleable inventory.
inventory items may be difficult to sell and The saleability of these items should then be
may be overvalued at the year end if they are discussed with management and their
recorded at cost rather than at the lower of valuation in the financial statements reviewed
cost and net realisable value as required by to ensure they are valued at the lower of cost
IAS 2. and net realisable value.
Dress You Like Co has two sites where Review the inventory counting instructions of
inventory is held/despatched. There is the Dress You Like Co to determine whether
possibility that some items are counted twice controls exist to ensure that all inventory items
(once at each location), and that some are not are counted only once.
counted at all leading to a risk that inventory Where inventory count instructions are not
may be under- or overstated. sufficient, discuss this with management
before the count so that changes can be
made to counting procedures.
Dress You Like Co is reliant on one supplier Discuss with management whether Dress You
for its purchases. Should it encounter a Like Co has any alternative suppliers in the
problem or delay with its supply chain then it event that the supply chain is interrupted.
may not be able to fulfil its orders (especially Review Dress You Like Co's contract with the
to the supermarket chain). This could lead to supermarket chain and any other customers
dissatisfaction from its customers and to determine whether there are any penalties
ultimately the loss of the customer. This in payable should deliveries be delayed and
turn could lead to going concern problems. whether they could cancel their contract with
Dress You Like Co.
313

Invoices and payments are made in Euros but Enquire from management as to the
the accounting records are maintained in US exchange rates used to translate invoices
dollars. when they are recorded in the accounting
system.
The invoices and payments will need to be
recorded in the accounting system in US Recalculate the translation of a sample of
dollars. There is a risk that these amounts invoices to ensure that they have been
may not be translated accurately, leading to a accurately recorded.
material misstatement in inventory or
payables in the financial statements.
Dress You Like Co allows its supermarket Request that management produce cash flow
customer 60-day credit terms. This may place forecasts for the year ahead to identify any
a strain on cash flow and lead to potential deficits in cash flow.
going concern problems. Consider the reasonableness of the
assumptions on which these are based
(especially relating to the timing of cash flows
from the supermarket).
Consider whether there are any known
concerns about the supermarket's ability to
settle its debts.
Determine from management whether they
have access to any short-term finance should
any cash flow problems arise.
The finance director is suing the company for Review correspondence from both the director
constructive dismissal but no mention of this and the entity's legal advisers relating to the
has been made in the year-end financial legal claim in order to establish the likely
statements (ie no provision or contingent outcome of the claim.
liability). Discuss the appropriate accounting treatment
The case has been going on for some time for the claim with the directors.
which suggests that at least disclosure of a Review minutes of board meetings and events
contingent liability is required and so there is a after the reporting period to determine
risk that provision/contingent liability whether the claim was settled.
disclosures may not be complete.
There has not been a finance director in place Determine from management whether there
for the last six months of the year (since will be appropriate personnel available to
March 20X1). There is therefore a lack of answer the audit team's queries and provide
experience at this high level and the assistant the information they require for the audit.
is also overloaded. The assistant may not
have the time or ability to answer queries from
the audit team.
314

The internal audit function used to perform A detailed review of the year-end bank
reviews on the bank reconciliation and reconciliation and supplier statement
supplier statement reconciliations which would reconciliations should be performed in order
increase the reliability of the bank and to determine the accuracy and completeness
payables balances, especially in view of the of bank and payables.
foreign currency invoices and payments. A larger sample size may be necessary if it is
The fact that there is now no longer any anticipated that there will be a high level of
internal audit function means that there is an errors.
increased likelihood that material errors will A detailed review of reconciling items and
not have been detected by the client staff. payments made in the post year end period
should be conducted.
Note. Only six points were needed to score 12 marks.

(a)
20X1 20X0
Gross profit margin (supermarket) 1,605 3,920

53,500 49,000
= 3% = 8%
Gross profit margin (other) 820 800
8,200 6,700
= 10% = 12%
Receivables collection period 11,800 8,300
× 365 × 365
(supermarket) 53,500 49,000
= 81 days = 62 days
Receivables collection period 700 600
× 365 × 365
(other) 8,200 6,700
= 31 days = 33 days
Inventory days 13,800 4,900
× 365 × 365
59,275 * 50,980 ^
= 85 days = 35 days
* 59,275 = 51,895 + 7,380
^ 50,980 = 45,080 + 5,900
315
(b)
The draft financial statement extracts Discuss the going concern status of Dress
indicate that there may be cash flow You Like Co with management.
problems leading to concern over going Obtain a copy of the cash flow forecasts
concern. produced by management and consider
Dress You Like Co has seen falling gross whether the assumptions on which they are
profit margins during the year. For the based are reasonable, particularly in terms
supermarket customer these are from 8% in of the timings of cash received from
20X0 to 3% in 20X1 and for other customers customers.
12% (20X0) to 10% (20X1). Discuss with management whether Dress
The receivables days for the supermarket You Like Co has any alternative funding
customer are 81 days in 20X1 compared to available in the event that it struggles with
62 days in 20X0. For other customers cash flow.
receivables days are largely stable at 31 and Discuss with management whether any
33 days. disclosures relating to going concern have
Inventory days have risen from 35 days in been made in the financial statements.
20X0 to 85 days in 20X1 largely due to
stockpiling for last minute orders.
Overall the fall in margins, lack of credit
control and increased inventory holdings
mean that the company has gone from a
cash position of $200,000 in 20X0 to an
overdraft of $750,000 in 20X1.
This further compounds cash flow and going
concern worries and worries that inventory
may be overstated.
Chapter 7
No Lecture Examples
Chapter 8
1 The correct answer is: Finance charge should be $66,000, profit is understated
$
1.1.X2–31.3.X2
$400,000 × 2% = $8,000 × 3 months 24,000
1.4.X2–30.9.X2
($400,000 – $50,000) × 2% = $7,000 × 6 months 42,000
Total 66,000
316
2 The correct answer is: Obtain a copy of the latest rental agreement and recalculate the
expected rent expense for the year
The latest rental agreement is documented evidence from a third party and should stipulate
the rental charge for both floors which are now occupied by HMA.
3 The correct answer is: Calculate the gross profit margin for the years ended 30 September
20X2 and 20X1 and investigate any significant differences in the ratio with management
Generally speaking an entity's gross profit margin tends to remain relatively stable and so
any unexpected changes should be investigated as they could indicate that material
misstatements exist. For example, an unexpected increase in gross profit margin could
indicate a cut-off error where sales after the year end have been included in the year-end
figures.
Chapter 9
1 The postman knocks at your front door You should be required to sign for the letter on
and hands you a letter which has been the postman's handset.
sent by recorded delivery.
2 You submit a claim for expenses to your You should need to evidence the claim by
line manager. presenting the receipt; the line manager should
sign the claim form to authorise payment.
3 You need to work an extra day over and You should submit a request that the overtime
above your normal hours to clear a be authorised prior to it being completed and this
backlog of work and will expect to be authorisation request should be signed by your
paid overtime for this. line manager.
4 You are responsible for maintaining the You should perform a bank reconciliation to
cash book and have just been passed verify the completeness and accuracy of the
the latest bank statement. cash book.
5 You have just received a monthly You should reconcile the balance per the
statement from your main supplier. supplier statement to the purchase ledger
balance.
6 You are responsible for payroll You should be provided with a copy of the letter
processing and you have just received signed by the employee which authorises the
notification from human resources that deductions and a hierarchical password should
an employee wants to take advantage of be required to amend the standing data.
a season ticket loan offered by your
company. Your password does not give
you permission to amend employee
deductions.
7 You have just returned from a Your password should have expired and the
three-month holiday and are trying to log computer should automatically require you to
on to your computer. change your password.
317
8 You are preparing to pay an invoice You should verify that the goods have been
received from a supplier. received by checking to a goods received note,
vouch the prices to the supplier's price list and
recalculate the sales tax and addition of the
invoice. The invoice should then be authorised
for payment and this evidenced by a signature.
9 You have prepared a bank reconciliation Your supervisor should review the bank
for your supervisor. reconciliation to verify it has been done properly
and sign to evidence that the review has taken
place.
10 You are entering 75 sales invoices into You should perform a batch reconciliation
the accounting records and want to whereby you manually count the number of
check the accuracy of your posting. invoices posted and verify to the system or
manually total the value of the invoices and
verify that the revenue, sales tax and
receivables accounts have increased by the
corresponding amounts.
Provided that the invoices are sequentially
numbered, you should also perform a sequence
check to determine whether any invoice
numbers have been omitted.
11 You have been working on the computer You should log out/lock your computer prior to
but have now gone away to make a cup leaving your work station.
of tea, leaving the computer inactive for a If you do not lock your computer then the
period of time. computer should 'time out' after a certain period
of time and require you to re-enter your log on/
password details before you can resume work.
12 You have a Saturday job operating the till The cash in the till should be counted at the end
in a small corner shop which is closing of the day and reconciled to the till receipt.
for the night. Money should be kept in a safe overnight.
13 You work in a shop that sells diamond The shop should have CCTV in operation, the
jewellery; the jeweller is very keen to front door should be locked with a door bell
keep their inventory secure. which must be rung to gain entry, jewellery
should be kept in locked cabinets and stored
overnight in a safe/secure vault and grilles pulled
down over the shop windows.
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Chapter 10
Many parts of the sales system Completing items by hand The computer system should
process are completed by could lead to an increased risk generate a blank standard
hand/manually. of manual error in filling out the order form for the sales team
For example, the order form is form or errors in processing if to complete electronically.
completed by hand and is then handwriting cannot easily be Once completed, this should
read.
passed (by hand) to the be emailed to the customer
warehouse. Additional time is also taken and sent electronically to the
photocopying/scanning orders warehouse.
which are then posted/emailed
to customers.
There could also be delays in
passing the order to the
warehouse.
The goods despatched note If errors are made in the The GDN should be generated
(GDN) is not generated from packing process, then the as an electronic copy of the
the order form but is simply customer could be despatched order form and detail the
written up from what is packed items that they did not order or product code and quantity
in the boxes. may not receive items they did ordered. Where an item is not
order, even if they are not out in stock this should be
There is also no double check
of stock. recorded on the GDN.
that the items on the GDN are
those items packed in the Spot checks should be carried
boxes. out to verify that the contents
packed agree to the order
form.
Monies received from The company does not have Monies received with
customers are not always an accurate record of remittance advices should be
accompanied by a remittance outstanding invoices and so allocated against the specific
advice and so cannot always cannot chase overdue invoices which are being paid.
be allocated to specific amounts efficiently. Where a remittance advice is
outstanding invoices. This will also mean that not received, the accounts
Sometimes monies are simply disputed invoices are not receivables clerk should
allocated to the oldest necessarily identified. contact the customer by
invoices. telephone to determine the
This could lead to a loss of
breakdown of invoices being
cash flow and/or irrecoverable
paid.
debts.
Note. Only THREE deficiencies were required for this lecture example.
However, there were many other deficiencies in the lecture example and these are detailed below
for completeness.
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The order form is not The situation may arise where Order forms should be
pre-numbered. more than one order is given pre-numbered and sequentially
the same order number numbered.
causing confusion in the sales
team when dealing with
customer queries.
If the order forms are not
pre-numbered then it is also
more difficult to file them in a
logical order and thus resolve
any customer queries quickly
and efficiently.
Orders for the supermarket The warehouse manager has All orders should be passed to
chain are sent directly to the responsibility to ensure that all the warehouse manager who
despatch team and not to the orders received are allocated can then allocate the jobs to
warehouse manager. to a team of pickers. He also the despatch team on a timely
monitors that orders are basis.
subsequently fulfilled where
items are initially out of stock.
Passing the order directly to
the despatch team may mean
that these unfulfilled orders are
not later despatched leading to
dissatisfaction from the
company's major customer.
No credit checks are made The company may well accept A standard 'new customer' form
before new customers are an order and despatch goods should be created which must
accepted and credit limits are to a bad credit risk. This may be completed before orders are
not prescribed. mean that goods are sold to a accepted from new customers.
customer who cannot pay for This form should require a credit
them, leading to a loss of check to be made in relation to
revenue and inventory. the customer and a credit limit
allocated. Standard tiers of
credit limits could be applied for
different customers. All
completed 'new customer' forms
should be authorised by Edward
Times or Katie Escombe prior to
goods being despatched. The
authorisation should be
evidenced on the form.
320

The invoice process is also Any errors in the GDN will An electronic invoice should be
completed manually and the result in errors on the invoice. generated from the electronic
items to be invoiced are This will lead to staff time order form and GDN using the
manually input from the details being taken up to correct the standard product codes and
on the GDN. errors and could lead to prices.
customer dissatisfaction if the
level of errors is high.
The prices charged to the Any errors in the pricing Each time that prices change,
supermarket are automatically standing data will mean that a report showing the pricing
generated by the system the supermarket could be standing data should be
without any checks being charged for goods at too low a generated and reviewed by a
made. price, thus losing the entity supervisor/manager to ensure
revenue, or at too high a price all changes are accurate. This
which would potentially lead to review should be evidenced by
customer dissatisfaction. a signature.
There is no formal process to If overdue amounts are not A formal process should be
monitor overdue amounts. chased as soon as they fall adopted to chase outstanding
Customer statements are not overdue then there is an customer balances.
sent each month and no aged increased risk of non-payment. Statements should be
receivables analysis is prepared on a monthly basis
produced. and sent to each customer
detailing the transactions with
the customer during the month
and the balance outstanding at
the end of the month.
The aged receivables report
should also be produced on a
monthly or at least quarterly
basis to identify amounts which
have been overdue for some
time.
Customers with overdue
accounts should be contacted
by telephone as soon as
possible and a letter
requesting payment sent if no
payment is received.
Accounts should be placed 'on
stop' if a customer exceeds
their credit limit until such time
that the balance is repaid.
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When completing an order form, the sales team For a sample of orders throughout the year,
refer to the standard product list in order to vouch the product codes on the order form to
verify that the correct product codes have been the standard product list to verify that the
used and that the order is accurate. correct product codes have been used.
Any changes to standard data, such as For a sample of customers who are not entitled
discounts, require hierarchical authorisation by to a discount, attempt to process a discount to
the acting finance director. determine whether a prompt will be received
requesting an appropriate login.
Bank reconciliations are performed each week For a sample of bank reconciliations, reperform
to monitor the completeness, accuracy and the reconciliation to ensure it has been
validity of the information held in the cash book. completed properly. Vouch the balances per the
bank statement and cash book to the bank
The reconciliations are also performed by
statement and the accounting records and
someone other than the accounts receivables
recast the arithmetical accuracy of the
clerk which strengthens the control due to the
reconciliation. Trace through any reconciling
segregation of duties.
items to ensure that they are reasonable.
If the bank reconciliation was reviewed, inspect
the reconciliation for evidence of the review
taking place.
Note. Only three controls were required for this lecture example.
However, there were several other controls in the lecture example and these are detailed below for
completeness.
Orders which have been received but have not Observe the warehouse manager review these
been completed because the item is out of orders and follow up to ensure that they have
stock are reviewed daily to ensure that been allocated to a picking team and fulfilled
customer orders are completed as efficiently as within an appropriate timescale.
possible. Observe the review of outstanding orders to
A full review of outstanding orders is also done ensure it is conducted each month.
each month with the sales team.
Invoicing is carried out daily once the GDNs are For a sample of GDNs trace through to the
received from the warehouse. This ensures that related invoice and vouch the date to ensure
goods despatched are invoiced on a timely that the invoice was sent out shortly after the
basis thus improving cash flow. goods were despatched.

1 The correct answers are:
Goods may be accepted which have not been ordered and therefore are not needed by the
business; and
Goods which are actually required for production may have been omitted from the delivery
which could lead to stock outs and business interruption.
322
Goods received should be vouched to the order form in order to ensure that the business
receives exactly what it ordered; however, this process will not stop orders being processed
unnecessarily. Furthermore, a separate quality check should be performed on the goods
received.
2 The correct answer is: Invoices on the supplier statement which relate to goods received but
not invoiced should not be included in the purchase ledger to avoid the payables balance
being overstated at the year end.
Where goods have been received before the month end/year end a corresponding liability
should be recognised even if the invoice has not been received.
3 The correct answer is: That supplier invoices are paid too early
At Dress You Like Co supplier invoices are currently being paid in the month in which they
are received rather than when they fall due. Therefore having some sort of
prompt/notification in the accounting system which identifies when each invoice needs to be
paid according to the supplier's credit terms will reduce the risk that invoices are paid too
early.

1 The correct answer is: For a sample of invoices which have been matched to goods
received notes reperform the calculations to ensure they have been done properly
Reperforming the calculations will enable the auditor to conclude whether the finance
assistant has accurately vouched the details on the invoice to the goods received note.
Note that analytical review is a substantive procedure, not a test of control.
2 The correct answer is: That payments to the supplier are reviewed and authorised prior to
payment
The Finance Director signs the bank payment authorisation to demonstrate that she has
reviewed the list of invoices being paid and approves the payment.

Overtime does not have to be Employees could claim for The entity should establish a
authorised by a supervisor/ overtime which has not been 'request for overtime' form.
manager in order to be paid. worked. This should be completed by
the employee after discussion
Also the entity cannot budget
with the department manager
its cash flow properly if
to determine why and whether
overtime is not planned in
overtime is necessary. The
advance and authorised.
department manager should
sign to evidence their
authorisation for the overtime
to be performed.
Once the overtime has been
completed, both the 'request
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for overtime' and 'overtime
claim' forms should be signed
by the department manager
and forwarded to the wages
clerk.
The wages clerk is able to The wages clerk has too much At least two people should be
amend the standing data on influence over the payroll involved in the payroll process.
the payroll system and also system and could carry out One person should have
processes payroll on a day to fraudulent activity such as responsibility for amending
day basis. setting up fictitious employees standing data and joiners and
and changing rates of pay if he leavers and the second person
wanted to. should process the day to day
payroll.
All amendments to standing
data should be authorised
before they are made and an
exception report of changes
made printed each month and
review for any unexpected
changes.

Hours worked are recorded by a clocking in/out Observe the clocking in/out process to ensure
system, with each employee using their unique that each employee has to enter their own
employee number. Employees are automatically employee number.
clocked out at the end of their shift, reducing the Attempt to clock in using an incorrect employee
risk that employees are paid for hours not number to verify that the system will not allow
worked. the entry.
For a valid employee number, do not clock out
at the end of the day and inspect the system
records to ensure that the employee has been
logged out by the system.
The listing of employee pay details is reviewed Observe the monthly payroll being processed
by the acting finance director before payments and reviewed by the acting finance director.
are made to the employees. This reduces the Inspect a copy of the payroll listing to vouch the
risk of fraudulent/erroneous payments. finance director's signature authorising the
payment.
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Chapter 11
Customer Balance Cumulative total Selected (Y/N)
1 60,000 60,000 N
2 70,000 130,000 Y
3 90,000 220,000 Y
4 105,000 325,000 Y
5 28,000 353,000 N
6 100,000 453,000 Y
7 46,000 499,000 N
8 1,000 500,000 Y
9 84,000 584,000 N
10 94,000 678,000 Y
11 108,000 786,000 Y
12 34,000 820,000 Y
13 160,000 980,000 Y
14 20,000 1,000,000 Y
1,000,000

(a) Error rate in sample  total value of population
$9,000
× $1,000,000 = $45,000
$200,000
(b) The projected error is above the tolerable error/misstatement limit. This means that further
evidence is needed. This could be done by:
 Extending the sample tested in the procedure and then reperforming the
extrapolation; or
 Designing and performing additional substantive procedures.
If the further evidence allows the auditor to conclude that the actual error in the population
does not exceed tolerable error/misstatement, then the auditor will conclude that no
adjustment is necessary, although the error of $9,000 will be noted on a schedule of
uncorrected misstatements.
If the further evidence indicates that there is a misstatement that exceeds tolerable error/
misstatement then the auditor will ask the client to make an adjustment to the financial
statements.
325

(a) Error rate in sample:
18
= 8%
225
(b) The projected error rate is below the tolerable error/misstatement limit of 13%.
This means that the internal control is believed to have operated effectively throughout the
period and the auditor can rely on it when assessing the accuracy and validity of
adjustments made to the inventory system.
No further testing is required; however, any monetary errors resulting from the 18 failures of
the internal control should be noted on the schedule of uncorrected misstatements.
Chapter 12
Tests on:
1 Opening balances
 These should be agreed to the previous year's audit file and signed financial
statements.
2 Additions
 A list of additions should be obtained and the total agreed to the financial statements.
 A sample of assets should be selected and their value should be traced to invoices.
The amount capitalised should be checked to verify that it excludes recoverable sales
tax.
 Legal costs capitalised should be agreed to invoices from the company solicitor.
3 Revaluations
 Trace the revalued amount to the valuer's report and confirm that the surplus is
$1,000,000.
 Agree that the $1,000,000 has been transferred to a revaluation reserve through
scrutiny of the nominal ledger.
 Agree the basis of valuation to the valuer's report. Verify the disclosure of this to the
notes to the financial statements.
 Recalculate depreciation to confirm that it is based on revalued amount.
 Review the notes to the financial statements to confirm that the revaluation has been
disclosed.
326
4 Depreciation – Charge for year

 Obtain details of the accounting policy from the notes to the financial statements.
 Confirm against last year's financial statements that there have been no changes to
these policies.
 Recalculate depreciation on a sample of assets. Compare the calculations to the
depreciation charge in the non-current assets register for each item in the sample.
Alternatively perform a proof in total of depreciation charge for each category of asset
by taking the average cost balance (opening cost + closing cost/2) and multiplying by
depreciation rate.
 Confirm that depreciation rates are reasonable.
5 Disposals
 A list of disposals should be obtained and the total agreed to the financial statements.
 For material disposals:
– Agree the cost of the asset sold to the non-current asset register;
– Recalculate the depreciation up to the date of disposal, based on the
company's accounting policy;
– Trace the proceeds to the cash book and the bank statement;
– Recalculate the profit and loss on disposal and agree to the nominal ledger;
and
– If the profit or loss is material, verify to the income statement that it is separately
disclosed in accordance with IAS 1 Presentation of Financial Statements.
Chapter 13
Five matters which will require action by management if the inventory count is to be effective
together with corrective action are:
1 By allowing Mr Farditch to take responsibility for the detailed organisation of the count, the
present instructions permit the person with day to day responsibility for the inventory area to
supervise one of the most important control checks on that area. This represents a
deficiency in the company's system of internal check, since the opportunity is afforded to
Mr Farditch to cover up any inadequacies there may be in the operational efficiency of
controls in the area of inventories.
Mrs Curbar should take more direct responsibility for the detailed organisation of the count.
2 By giving to those members of staff responsible for the physical count of the inventories an
indication of the quantity which is expected to be in inventory, there is a risk that this may
prejudice their opinion in the event of there being a discrepancy. More importantly, it will
tend to reduce the benefits which it is intended to derive from having an independent check
on the inventory records by having to reconcile them with the quantities determined by a
physical count.
327
The pre-printed inventory sheets should not show the balance of each inventory item on
hand as shown on the inventory records held independently of the warehouse.
3 At the moment clear instructions do not appear to have been given of the action required in
the event of there being a discrepancy in the counts arrived at by the two members of the
counting team. Unless precise instructions are given, there would be a tendency to accept
the quantity determined by the senior member of the count team, which is not necessarily
going to be the correct one.
The teams of counters should be instructed that in the event of their independent counts of
the inventory quantities not agreeing a further count should take place. If they are still
unable to agree then a note of this fact should be made on the inventory count tag so that a
further check may be made by the inspection team.
4 A number of teams of checkers (two or three) should be appointed to go around after the
counters. The task of these checkers would be to:
 Carry out sample tests on the accuracy of the original counters
 Ensure that inventory count completion tags have been left by the counters at each
inventory location
The appointment of checkers will improve the efficiency of the overall count by acting as a
check on both the accuracy and completeness of the count.
5 Allowing the members of staff involved in the count to deduct any goods in poor condition
from the quantities appearing on the inventory sheets increases the risk that:
(a) Errors of judgement are made; or
(b) This procedure could be used deliberately to cover up past or future
misappropriations of inventory.
The staff involved in the count should be instructed to identify any goods that appear to be in
poor condition on the inventory sheets and these can then be reviewed by a more senior
employee.
Goods should only be written off on the authorisation of that more senior employee.
Chapter 14
Customer 1
 The cash in transit should be traced to the cash receipts book post year end. I would expect
it to be received within a few days of the year end.
 I would also trace the cash to the bank paying in slip. Again, this should be stamped by the
bank post year end.
Customer 2
 The goods in transit should be traced to a GDN dated prior to the year end.
 If inventory records exist the despatch could be traced to the records to confirm that it was
sent prior to the year end.
328
Customer 3
 The reason for the dispute and my client's views on it should be obtained from the
correspondence file between Customer 3 and my client.
 Credit notes post year end should be scrutinised to determine whether a credit was given for
the disputed goods.
 Cash receipts should be reviewed post year end to determine whether Customer 3 paid the
full balance.
 If the amount is outstanding at the audit date, discuss recoverability with the credit
controller.

(1) The correct answer is: Obtain an aged analysis of inventory at the year end and discuss the
saleability of slow moving inventory items with management
Tracing the last goods despatched and goods received notes to the ledger to ensure that
they have been correctly recorded will provide evidence of cut-off rather than valuation.
(2) The correct answer is: Evaluation of the adequacy of the allowance for irrecoverable
receivables
Computer-assisted audit techniques (CAATs) can be used to extract samples and perform
calculations but they cannot evaluate this information.
(3) The correct answer is: Review credit notes issued post year end in relation to the balance
due from JK Co
The concern here is over the recoverability (valuation) of the balance due from JK Co.
Requesting a written representation from the directors will provide some audit evidence but
this is a relatively weak source of evidence. Reviewing credit notes issued post year end
would enable the auditor to see whether the amount due at the year end has been reduced
in any way.
Chapter 15
No Lecture Examples
Chapter 16
Salary:
 Vouch salary amounts to monthly payroll records and bank statements to ensure the
amounts are accurate.
 For Directors C and D, obtain their leaving/start dates from the HR department and vouch
this to board meeting minutes. Recalculate their salaries on a pro-rata basis to ensure they
are accurately recorded.
329
Bonuses:
 Vouch the level of bonuses awarded to board meeting minutes, payroll records and bank
statements to ensure they have been authorised and are accurately recorded.
 Discuss with management the reasons why Director C was awarded a bonus despite
leaving the company during the year. Support any explanations with written documentation
where possible (for example Director C's contract).
Termination payments/incentive payments:
 Review the employment contracts for Directors C and D to verify that there is a clause
outlining that these payments are applicable.
 Vouch the level of these payments to board meeting minutes, payroll records and bank
statements.
General:
 Recast the schedule to ensure the note is accurate.
 Review the disclosure to ensure that it is in accordance with applicable law and accounting
standards.
Chapter 17
Cash collections
 Discuss procedures for cash collection with management and assess risk of fraud, loss,
robbery or error
 Discuss selection criteria for collectors and collection procedures with management
 Observe the cash collection, recording and banking process
 Trace a sample of cash received control lists to cash records and bank statements
 Reperform a reconciliation of total cash received to income
 Perform an analytical review of cash donations per month vs previous year taking into
account factors such as number of collectors and weather
Regular donations by the 'Big 4' and wealthy individuals
 Obtain and compare analysis of major/regular contributions with previous year
 Send circularisation letters to confirm material amounts donated by Big 4 and wealthy
individuals
 Circularise tax authorities to confirm contributions made where tax deductions have been
claimed
330
Chapter 18
The following factors might cause me to have doubts about Trucker's going concern status:
 Fall in gross profit margin (20X2: 7%; 20X1: 9.4%). This will make a return to profitability
difficult.
 Truckers is making losses. This will make negotiations with the bank difficult.
 Debtors are taking longer to pay (20X2: 99 days; 20X1: 75 days). This will squeeze cash
flow coming into the business. Irrecoverable debts will increase the existing loss.
 Worsening liquidity ratio (0.88 in 20X2; 1.05 in 20X1). Loan and lease commitments may not
be met.
 Increasing reliance on short-term finance. The overdraft can be recalled by the bank at any
time. It should not be used to finance long-term investment.
 Increased gearing (20X2: 63% [750 + 250 + 1,245/3,544]; 20X1: 50% [1,000 + 913/3,793]).
Interest on debt must be paid from a decreasing cash position.
 Loss of major customer. Other customers may follow, worsening the company's prospects.
 Loss of commercial customers. This represents loss of regular income. Damage to
company's reputation.
 Overdraft facility to be reviewed three months after the year end. This short period is
probably not long enough to see any improvement in the company's future prospects and
therefore may not be renewed.
 Despite the managing director's optimism, there is no evidence to support the forecasts of
additional revenue from new contracts.
Chapter 19
1 The correct answer is: Qualified 'except for'.
LB has not valued inventory at the lower of cost and net realisable value on a line by line
basis, which is contrary to the accounting standard IAS 2 Inventories.
If it had, then the inventory line would have been written down by $14,000 ($17,000 cost
less $3,000 NRV).
The error is material as it represents 8% of profit before tax ($14,000/$175,000), so
management should correct this error in the financial statements.
As the Finance Director has refused to amend this error then the auditor's opinion will need
to be modified. As management has not complied with IAS 2 and the error is material but
not pervasive, a qualified opinion 'except for' would be necessary.
The auditor's report would include a qualified opinion section, together with a basis for
qualified opinion section explaining both the material misstatement in relation to the
inappropriate valuation of inventory, and quantifying its effect on the financial statements.
331
2 The correct answer is: Qualified 'except for'.

Check & Co has been unable to gather sufficient appropriate audit evidence over the
inventory transactions which occurred in February 20X2, and these are considered to be
material.
It has, however, been able to gather sufficient appropriate audit evidence over the year-end
inventory balance and so this issue is considered to be material but not pervasive.
As such a qualified opinion 'except for' would be expressed, and a basis for qualified opinion
section would be included to explain the potential impact of the loss of inventory records.
An emphasis of matter paragraph would not be issued as the issue is not believed to be
fundamental to the financial statements.
3 The correct answers are:
Review legal correspondence relating to the claim in order to determine Maker's lawyers'
opinion as to the likely outcome of the claim.
Review the post year end cash book in order to determine whether any payments were
made to Mr Shift.
Recalculating Mr Shift's wages and salaries for the year to verify that he was only paid up to
the date of dismissal and reviewing the construction work performed by Mr Shift in August
20X2 to determine whether there are any concerns over the quality of his work and whether
Maker's health and safety procedures were followed are audit procedures relating to wages
and salaries and inventory rather than to the accounting treatment of the claim itself.
4 The correct answer is: Unmodified audit opinion with a key audit matter disclosure
The directors have not made any reference to the claim in the financial statements. This
seems appropriate as you agree with the lawyer's indication that the claim will not be
successful. Therefore an unmodified audit opinion would be issued.
However, Maker is a listed entity and the claim has taken up a significant amount of audit
time and so this would be included within the key audit matters section.
The issue would not be included as an emphasis of matter (since it has been dealt with as a
key audit matter) and there is no indication that it impacts Maker's ability to continue as a
going concern.
5 The correct answer is: Unmodified audit opinion with material uncertainty relating to going
concern section
TH's directors have made appropriate disclosures of worries over going concern in the
financial statements, and the auditor feels that the disclosure is appropriate. The audit
opinion will therefore be unmodified.
However, significant concern over going concern still exists and so the auditor will include a
'material uncertainty relating to going concern' section in their report.
Note. The emphasis of matter paragraph is used to highlight matters which are fundamental
to users' understanding of the financial statements, with the exception of matters relating to
going concern.
END OF ANSWERS TO LECTURE EXAMPLES

332
Appendix A: Assumed
Knowledge from
Financial Accounting
333
21: APPENDIX A: ASSUMED KNOWLEDGE FROM FINANCIAL ACCOUNTING
1 Introduction
1.1 The accounting knowledge that is assumed for Audit and Assurance is the same as the
accounting standards examined in Financial Accounting.
1.2 The purpose of this appendix is to provide you with a recap of the accounting standards
covered in the Financial Accounting syllabus which could feature in Audit and Assurance
questions.
2 Proforma financial statements

2.1 The financial statements of a limited liability company are subject to regulation and must
follow a prescribed format in terms of the way they are presented.
2.2 Much of the prescribed format is determined by IAS 1 Presentation of Financial Statements.
This accounting standard states what should be included in a set of financial statements and
how they should be presented.
A complete set of financial statements in accordance with IAS 1 comprises:
(a) A statement of financial position as at the end of the period
(b) A statement of profit or loss and other comprehensive income for the period
(c) A statement of changes in equity for the period
(d) A statement of cash flows for the period
(e) Notes, comprising a summary of significant accounting policies and other explanatory
notes
334
2.3 STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X7

$'000
ASSETS
Non-current assets
Property, plant and equipment X
Other intangible assets X
X
Current assets
Inventories X
Trade receivables X
Other current assets X
Cash and cash equivalents X
X
Total assets X
EQUITY AND LIABILITIES

Equity
Share capital X
Share premium account X
Revaluation reserve X
Retained earnings X
X
Non-current liabilities
Long-term borrowings X
Long-term provisions X
X
Current liabilities
Trade payables X
Short-term borrowings X
Current tax payable X
Short-term provisions X
X
Total equity and liabilities X
335
2.4 Statement of profit or loss and other comprehensive income

This statement shows all of the realised gains and losses from the statement of profit or
loss and the unrealised gains and losses from the statement of financial position in one
statement of performance.
Statement of profit or loss Statement of financial position
Realised Unrealised
gains and losses gains and losses
eg profit for the year eg revaluation gains/losses
Statement of profit or loss and other comprehensive income
The statement can be presented in one of two ways:

 As one single statement (proforma 1)
 As two separate statements (proforma 2)
Proforma 1 – one single statement
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 MARCH 20X7
20X7 20X6
$'000 $'000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Finance costs (X) (X)
Investment income X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year X X
Other comprehensive income:
Gains on property revaluation X X
Total comprehensive income for the year X X
336
Proforma 2 – two separate statements
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MARCH 20X7

20X7 20X6
$'000 $'000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Finance costs (X) (X)
Investment income X X
Profit before tax X X
Income tax expense (X) (X)
STATEMENT OF OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED

31 MARCH 20X7
20X7 20X6
$'000 $'000
Other comprehensive income:
Gains on property revaluation X X
Total comprehensive income for the year X X
2.5 STATEMENT OF CHANGES IN EQUITY

Proforma
Share
Share premium Revaluation Retained Total
capital account reserve earnings equity
$'000 $'000 $'000 $'000 $'000
Balance at 31 March 20X6 X X X X X
Changes in accounting policy _ _ _ X X
Restated balance X X X X X
Issue of share capital X X X
Dividends (X) (X)
Total comprehensive
income _ _ X X X
Balance at 31 March 20X7 X X X X X
337
2.6 STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MARCH 20X7
$'000 $'000
Cash flows from operating activities
Profit before taxation X
Adjustment for:
Depreciation X
Investment income (X)
Interest expense X
XX
Increase in trade and other receivables (X)
Decrease in inventories X
Decrease in trade payables (X)
Cash generated from operations XX
Interest paid (X)
Income taxes paid (X)
Net cash from operating activities XXX
Cash flows from investing activities

Purchase of property, plant and equipment (X)
Proceeds from sale of equipment X
Interest received X
Dividends received X
Net cash used in investing activities (XXX)
Cash flows from financing activities

Proceeds from issue of share capital X
Proceeds from long-term borrowings X
Dividends paid* (X)
Net cash used in financing activities (XXX)
Net increase in cash and cash equivalents XXX

Cash and cash equivalents at beginning of period XXXXX
Cash and cash equivalents at end of period XXX
*This could also be shown as an operating cash flow.
338
3 Notes to the accounts

Notes are included in a set of financial statements to give users extra information. You
should be aware of the following notes:
3.1 PROPERTY, PLANT AND EQUIPMENT

Land and Office
buildings Machinery equipment Total
$ $ $ $
Carrying amount at 1 April 20X6 X X X X
Additions X X X X
Revaluation surplus X – – X
Depreciation charge (X) (X) (X) (X)
Disposals (X) (X) (X) (X)
Carrying amount at 31 March 20X7 X X X X
At 31 March 20X7
Cost or valuation X X X X
Accumulated depreciation (X) (X) (X) (X)
Carrying amount X X X X
At 31 March 20X6
Cost or valuation X X X X
Accumulated depreciation (X) (X) (X) (X)
Carrying amount X X X X
3.2 INTANGIBLE NON-CURRENT ASSETS

Development
expenditure
$
Carrying amount at 1 April 20X6 X
Additions X
Amortisation charge (X)
Disposals (X)
Carrying amount at 31 March 20X7 X
At 31 March 20X7
Cost X
Accumulated amortisation (X)
Carrying amount X
At 31 March 20X6
Cost X
Accumulated amortisation (X)
Carrying amount X
339
3.3 Provisions
$
At 1 April 20X6 X
Increase in period X
Released in period (X)
At 31 March 20X7 X
3.4 Contingent liabilities

Unless remote, disclose for each contingent liability:
(a) A brief description of its nature; and where practicable
(b) An estimate of the financial effect
(c) An indication of the uncertainties relating to the amount or timing of any outflow
(d) The possibility of any reimbursement
3.5 Contingent assets

Where an inflow of economic benefits is probable, an entity should disclose:
(a) A brief description of its nature; and where practicable
(b) An estimate of the financial effect.
3.6 Events after the reporting period

In respect of non-adjusting events after the reporting period disclose:
(a) The nature of the event
(b) An estimate of its financial effect (or a statement that an estimate cannot be made)
4 Inventory (IAS 2)
4.1 The inventories figure in the financial statements comprises two elements:
QUANTITY  VALUATION
Quantity
4.2 The quantity of inventories a business has at the year end is normally ascertained by
completing an inventory count at the end of the accounting period or by continuous
inventory records.
Valuation
4.3 The valuation of inventories is much more subjective and so guidance is provided in IAS 2
Inventories.
4.4 The basic rule per IAS 2 is:
'Inventories should be measured at the lower of cost and net realisable value.' (IAS 2:
para. 9)
4.5 This is another example of prudence in presenting financial information.
340
Cost
4.5 The cost of an item of inventory includes:
For example:
 Purchase price
 Import duties
Cost of purchase
But not:
 Sales tax
Relating to productions:
 Direct labour
Costs of conversion  Direct/variable overheads
 An allocation of fixed
overheads (based on
normal level of activity)
Other costs incurred in bringing
the inventories to their present For example:
location and condition  Carriage inwards
Net realisable value (NRV)

4.6 The net realisable value (NRV) of an item is essentially its net selling proceeds after all costs
have been deducted.
4.7 It is calculated as:

$
Estimated selling price X
Less estimated costs of completion (X)
Less estimated selling and distribution costs (X)
X
No netting off
4.8 The IAS 2 rule 'lower of cost and net realisable value' (IAS 2: para. 9) should be applied
as far as possible on an item by item (or line by line) basis.
5 Property, plant and equipment (IAS 16)

Definition
5.1 Property, plant and equipment comprises assets which:
(a) Are held for use in the production or supply of goods or services or for administrative
purposes; and
(b) Are expected to be used during more than one period.
341
Cost
5.2 Property, plant and equipment should initially be recorded at cost.
Cost includes:
 Purchase price, excluding sales tax and trade discounts but including import duties
 Directly attributable costs to bring the asset to its intended location and ready to
use. These include:
– Initial delivery and handling costs
– Installation and assembly costs
– Costs of testing whether the asset is working properly
– Professional fees
The following costs may not be included:
– The cost of maintenance contracts
– Administration and general overhead costs
– Staff training costs
5.3 The asset can then be kept at cost and depreciated or the entity may choose to revalue its
tangible non-current assets.
Depreciation
5.4 Assets will eventually be worn out (used up) and so there is a cost of generating income.
This cost should be shown in the income statement to 'match' against the income.
This is called depreciation.
5.5 Depreciation results in the property, plant and equipment being systematically charged to
the income statement over several accounting periods in recognition of the fact that the
asset will contribute to the income-generating activities of each of these periods.
A formal definition is given by the accounting standard, IAS 16 Property, Plant and
Equipment:
'…the systematic allocation of the depreciable amount of an asset over its useful life.'
(IAS 16: para. 6)
'Depreciable amount' = cost/revalued amount – residual value

'Residual value' = the amount the asset is expected to be sold for at the end of its
useful life (scrap value)
5.6 Land normally has an unlimited useful life and is therefore not depreciated. Buildings have
a limited life and, therefore, are depreciable assets.
5.7 There are two main methods for calculating depreciation, the straight line method and the
reducing balance method.
342
Straight line method

5.8 Here the depreciation charge is the same every year and it is calculated using the following
formula:
cost  residual value
Depreciation  or (Cost – Residual value)  %
useful life (years)
where:
Residual value = expected proceeds/scrap value at the end of the asset's useful life.
Useful life = the number of years the business expects to make use of the asset.
5.9 This method is suitable for assets which are used up evenly over their useful life.
Reducing balance depreciation

5.10 This method is suitable for those assets which generate more revenue in earlier years than
in later years; for example a machine which may become progressively less efficient as it
gets older.
Under this method the depreciation charge will be higher in the earlier years and reduce
over time.
It is calculated using the following formula:
Depreciation = Depreciation rate (%)  Carrying amount (CA)
where: CA = cost – accumulated depreciation to date
Disposal of property, plant and equipment

5.11 When a non-current asset is disposed of, its CA needs to be removed from the statement of
financial position.
The sales proceeds received are unlikely to be exactly the same as the asset's CA and so a
profit or loss on disposal will arise.
If:
Sales proceeds > CA  profit on disposal
Sales proceeds < CA  loss on disposal
This is not a 'true' profit or loss, but rather a book adjustment to reflect the fact that the
depreciation charged over the asset's life wasn't completely accurate.
Revaluations
5.12 If an entity owns a property it may notice that its value increases over time.
5.13 IAS 16 requires property, plant and equipment to initially be recorded at cost. The entity can
then either keep the asset at cost (and depreciate it) or choose to revalue it (depreciation is
still required).
This is a choice of accounting policy.
343
5.14 If an entity chooses a policy of revaluation then all items in the same class of assets must be
revalued.
Examples of classes of assets are:
 Land and buildings
 Plant and machinery
 Motor vehicles
5.15 Revaluations must be carried out sufficiently often so that the asset's carrying value is not
materially different from its market value.
Steps and accounting treatment

5.16 (1) Adjust cost account to revalued amount.
(2) Remove accumulated depreciation charged on the asset to date.
(3) Put the balance to the revaluation surplus.
5.17 The required journal is:

Dr Non-current asset cost
Dr Accumulated depreciation
Cr Revaluation surplus
5.18 Depreciation should now be based on the revalued amount.
6 Intangible Assets (IAS 38)

Definitions
6.1 (a) Research is original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
(b) Development is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial production or
use.
344
Accounting treatment
6.2
Research Development
 No certainty that the expenditure  Future profits are expected

will generate future profit
 Show as an expense in income  Must capitalise as an intangible

statement non-current asset if all of the relevant
criteria (PIRATE – see below) are satisfied
 Dr Research expense (SPL)  Dr Intangible non-current assets (SOFP)
Cr Bank/payables Cr Bank/payables
P robable future economic benefits

I ntention to complete and use/sell asset
R esources adequate and available to
complete and use/sell asset
A bility to use/sell the asset
T echnical feasibility of completing asset
for use/sale
E xpenditure can be measured reliably
 Amortise asset over its useful life once

asset is ready for use
Amortisation of capitalised development expenditure

6.3 Property, plant and equipment, for example a machine, is capitalised and then depreciated
over its useful life. This is to allocate its cost over the accounting periods which benefit from
its use.
6.4 In the same way development expenditure which is incurred now will generate future
economic benefit.
The cost of the development expenditure should be matched against the future economic
benefit it produces. This is called amortisation.
6.5 The 'depreciable amount' (cost less residual value) should be amortised over the useful life
of the intangible asset and shall reflect the pattern in which the asset's future economic
benefits are expected to be consumed by the entity.
6.6 Amortisation should begin when the asset is ready for use.
6.7 It is an expense in the statement of profit or loss and is accounted for using the following
entry:
Dr Amortisation expense (SPL)
Cr Accumulated amortisation (SOFP)
345
7 Provisions, contingent liabilities and contingent

assets (IAS 37)
Provisions
7.1 Definition
A provision is a liability of uncertain timing or amount.
7.2 Recognition
A provision should only be recognised (ie included in the financial statements) when:
(a) An entity has a present obligation (legal or constructive) as a result of a past event;
(b) It is probable that an outflow of economic resources will be required to settle the
obligation; and
(c) A reliable estimate can be made of the amount of the obligation.
Unless all three conditions are met, no provision can be recognised.
7.3 Legal obligation

A legal obligation usually arises out of a contract.
Illustration
Grass Co sells lawnmowers and offers a one-year warranty on all models.
Once Grass Co sells a lawnmower (the past event) it has a legal obligation to repair any
defects according to the warranty agreement.
It should therefore make an estimate of the probable costs of repair and make a provision
for this amount in its financial statements.
7.4 Constructive obligation

A constructive obligation arises through past behaviour and actions where the entity has
raised a valid expectation that it will carry out a particular action.
Illustration
Seed Co also sells lawnmowers. It does not offer a warranty on its products; however, it has
a reputation for making free reasonable repairs to lawnmowers bought from the business.
Customers buying from Seed Co all expect to receive this benefit.
Here no warranty is offered and so Seed Co does not have a legal obligation. However, its
past actions have created a constructive obligation. It should also therefore make a
provision for the probable costs of repairs.
346
7.5 Accounting treatment

The provision represents both a cost to the business and a potential liability:
Dr Expense (SPL)
Cr Provision (SOFP)
The required provision will be reviewed at each year end and increased or decreased as
necessary.
Contingent liabilities
7.6 A contingent liability is an uncertain liability that does not meet the three criteria for
recognising a provision.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets defines a contingent liability
as the following:
(a) A possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity; or
(b) A present obligation that arises from past events but is not recognised because:
(i) It is not probable that an outflow of economic resources will be required to
settle the obligation; or
(ii) The amount of the obligation cannot be measured with sufficient reliability.
Contingent liabilities should be disclosed in the notes unless probability of an outflow of
resources embodying economic benefits is remote.
(IAS 37: para. 28)
Illustrative example
7.7 Company A has entered into an agreement to act as guarantor on a bank loan taken out by
Mr Smith. Mr Smith is a financially secure individual, and the directors are of the opinion that
the chances of him defaulting on the loan are slim.
How should Company A account for this guarantee?
Solution
7.8 Company A has a present obligation (it is legally obliged to honour the guarantee).
However, as the likelihood of Company A having to pay out under the guarantee is not
probable then no provision for the liability should be made. Instead, the guarantee should be
disclosed in the notes as a contingent liability (unless considered remote, in which case it
should be ignored altogether).
Contingent assets
7.9 A possible asset that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within
the control of the entity.
Contingent assets should be disclosed in the notes where an inflow of economic benefits is
probable, otherwise they should be ignored.
347
If the probability of an inflow of economic benefits is virtually certain then the asset is not a
contingent asset and should be recognised in the financial statements.
8 Events after the reporting period (IAS 10)

Definition
8.1 Events after the reporting period: events, both favourable and unfavourable, that occur
between the end of the reporting period and the date when the financial statements are
authorised for issue.
8.2 There are two types of event after the reporting period.
Adjusting and non-adjusting events

8.3
Adjusting events Non-adjusting events
Events which provide evidence of conditions Events that relate to conditions which
which existed at the end of the reporting arose after the end of the reporting period
period
Examples: Examples:
(1) Resolution of a court case (1) Destruction of major asset, eg by
(2) Bankruptcy of a major customer flood or fire
(3) Evidence of NRV of inventories (2) Major share transactions
(4) Discovery of fraud or errors that show (3) Announcement of a plan to close part
the financial statements were incorrect of a business
Accounting treatment: Accounting treatment:

Change the amounts in the financial Disclose non-adjusting event in a note to
statements the financial statements
8.4 (a) Dividends proposed or declared after the end of the reporting period but before the
financial statements are approved should be disclosed in a note to the financial
statements.
(b) A non-adjusting event that affects going concern becomes an adjusting event.
END OF APPENDIX A
348
ACCA Audit and Assurance (AA)
Achievement Ladder
Step 4 Questions
Questions
Time allowed: 1 hour and 38 minutes

(indicative timing based on paper based exam time)
Please allow 1 hour 30 minutes if sitting the computer based exam
ALL questions are compulsory and MUST be attempted
Sept19/Dec19/March20/June20 EDITION 349

Get into good exam habits now!
Take a moment to focus on the right approach for this exam.
Effective time management

 Watch the clock, allocate 1.95 minutes to each mark and move on if you get behind.
 Take a few moments to think what the requirements are asking for and how you are going to
answer them.
 Remember one mark is usually allocated for each valid point you give in a discursive
question.
Effective planning
 This exam is half the real exam.
 Read the requirements carefully: focus on mark allocation, question words (see below) and
potential overlap between requirements.
 Identify and make sure you pick up the easy marks available in each question.
Effective layout
 Present your numerical solutions using the standard layouts you have seen. Show and
reference your workings clearly.
 With written elements try to make a number of distinct points using headings and short
paragraphs. You should aim to make a separate point for each mark.
 Ensure that you explain the points you are making ie why is the point a strength, criticism or
opportunity?
 Give yourself plenty of space to add extra lines as necessary; it will also make it easier for the
examining team to mark.
Common terminology
Advise To counsel, inform or notify
Analyse Examine in detail the structure of
Calculate/compute To ascertain or reckon mathematically
Compare and contrast Show the similarities and/or differences
Define Give the exact meaning of
Describe Communicate the key features of
Discuss To examine in detail by argument
Distinguish Highlight the differences between
Evaluate To appraise or assess the value of
Explain Make clear or intelligible/state the meaning of
Identify Recognise, establish or select after consideration
Interpret Process information to explain its meaning
Justify To produce reasons in support of
List State short pieces of information on separate lines
Prepare To make or get ready for use
Recommend To advise on a course of action
Summarise To express the most important facts of
350 Sept19/Dec19/March20/June20 EDITION
Section B
BOTH questions are compulsory and MUST be attempted.
Question 1 SeaPass
(a) List and explain the elements of an assurance engagement. (5 marks)
SeaPass is a ferry company which operates daily ferry crossings from the UK to France. The
company's year end is 30 June 20X9. You are the audit senior and you have started planning the
audit. Your audit manager has asked you to have a planning meeting with the client and to identify
any relevant audit risks so that the audit plan can be completed.
You obtained the following information at the meeting:
SeaPass has had a challenging year. The current economic crisis and worries about the future of
the Euro currency have meant that many passengers who might previously have booked ferry
crossings to France are now choosing to spend their holiday within the UK. SeaPass is under
continual pressure from its shareholders to show consistent performance.
In an attempt to win new passengers and generate additional income, SeaPass spent $800,000 on
an advertising campaign which featured both in the national press and on national television. The
campaign took place in May 20X9 and the company is convinced that this will vastly improve
customer numbers during Summer 20X9. Consequently the finance director is proposing to match
most of the advertising cost against summer revenues and has shown $600,000 of the $800,000
spent as a prepayment at the year end.
When customers book their ferry crossing they are required to pay an upfront deposit of 20% of the
total cost. In previous years this has been recognised as revenue in the month that the ferry
crossing is made. However, this year SeaPass has recognised the revenue when the deposit is
received. The finance director has explained that this is because the company has spent the
money as it was received in order to finance the advertising campaign. The balance of 80% is
taken by the company on the day of departure.
SeaPass wants its customers to have an excellent experience when they travel with them. With
this in mind it offers a 'money back guarantee'. If customers are excessively delayed or they are
not happy with the service provided by SeaPass, then they can claim compensation under the
company's money-back guarantee. Despite the company's very best efforts to improve customer
satisfaction, compensation payments are made on a regular basis.
SeaPass has also found that the price of fuel has risen sharply during the course of the year and it
has not been able to pass this price rise on to its customers in the form of higher ticket prices. This
has meant that its operating costs have increased considerably, leading to falling profit margins.
The company does hold some cash reserves in the form of bank deposits. However, these cannot
be accessed for six months and so the company has had to take out a short-term overdraft. The
finance director is pleased that the financial statements will show a net positive cash position as
the bank deposits will be greater than the overdraft at the year end.
Required
(b) Using the information provided, describe FIVE audit risks and explain the auditor's response to
each risk in the planning of the audit of SeaPass.
Note. Prepare your answer using two columns headed Audit risk and Auditor's response
respectively. (10 marks)

You have always carried out the audit of SeaPass using substantive procedures because SeaPass's
internal controls have been relatively limited. However, the finance director has told you that the
company is considering establishing an internal audit function and as a result he expects a significant
improvement in the company's internal controls. The internal audit work will be outsourced to an
external consultancy firm. On hearing this news your audit manager mentioned that your firm might be
able to change the way it carries out the audit of SeaPass.
Required
(c) State the FIVE components of an internal control system and give a brief explanation of each
component. (5 marks)
(d) Explain why the external auditor needs to obtain an understanding of a client's internal control
system. (3 marks)
(e) Explain how and why the external auditor will try to rely on internal controls wherever possible
when carrying out their audit and the implications for the audit if the auditor concludes that controls
are not operating effectively. (5 marks)
(f) Define a 'test of control' and a 'substantive procedure'. (2 marks)
(Total = 30 marks)

Question 2 Jaffa Co
(a) Explain what analytical procedures are and explain how the auditor uses analytical procedures
during the course of the audit. (4 marks)
You are planning the audit of Jaffa Co, whose principal activity is the manufacture, sale and
distribution of tableware and cookware. You are preparing for your planning meeting with the
finance director and have obtained, in advance of the meeting, a copy of the draft accounts for the
year ended 31 March 20X2. Your initial review of the draft accounts identified the following
significant changes over the 20X1 figures.
STATEMENT OF PROFIT OR LOSS (EXTRACT)
Draft Actual Increase/
20X2 20X1 (decrease)
$'000 $'000 %
Revenue 16,759 13,298 26
Cost of sales (8,039) (7,114) 13
Gross profit 8,720 6,184 41
STATEMENT OF FINANCIAL POSITION (EXTRACT)
Draft Actual Increase/
20X2 20X1 (decrease)
$'000 $'000 %
Non-current assets
Property, plant and equipment 5,479 2,379 130
Current assets
Trade receivables 3,459 2,127 63
Current liabilities
Bank overdraft 1,891 503 276
Trade payables 918 1,134 (19)
During a telephone conversation the finance director informed you that the company had had a
good year, mainly due to securing a new contract to supply a number of major new customers in
the UK.
He also stated that there has been no revaluation of non-current assets but there has been
extensive refurbishment and improvement of the company's manufacturing facility and its plant and
machinery.
You have also learned that the company introduced a new accounting system three months before
the year end. All balances were transferred from the old system to the new one which will form the
basis of the numbers in the financial statements. Training for accounts staff on this new system is
ongoing.
Required
(b) Using the information provided, describe SIX audit risks and explain the auditor's response to each
risk in the planning of the audit of Jaffa Co.

(c) Following your initial planning visit you receive a letter from the finance director of Jaffa Co which
expresses grave concern that a previously undetected fraud has been discovered. Over the last
few years, office staff have taken between $50 and $100 each month from petty cash and used the
funds for non-business use. He demands to know why the auditors have not picked this up on
previous audits and is considering replacing your firm.
Describe the auditor's responsibilities in relation to fraud and explain why your firm is unlikely to
detect a fraud such as the one described by the director during the course of the audit. (4 marks)
(Total = 20 marks)

ACCA Audit and Assurance (AA)
Achievement Ladder
Step 6 Questions
Questions
Time allowed: 2 hours and 36 minutes

(indicative timing based on paper based exam time)
Please allow 2 hours 24 minutes if sitting the computer based exam
ALL questions are compulsory and MUST be attempted

Get into good exam habits now!
Take a moment to focus on the right approach for this exam.
Effective time management

 Watch the clock, allocate 1.95 minutes to each mark and move on if you get behind.
 Take a few moments to think what the requirements are asking for and how you are going to
answer them.
 Remember one mark is usually allocated for each valid point you give in a discursive
question.
Effective planning
 This exam is 80% of the real exam.
 Read the requirements carefully: focus on mark allocation, question words (see below) and
potential overlap between requirements.
 Identify and make sure you pick up the easy marks available in each question.
Effective layout
 Present your numerical solutions using the standard layouts you have seen. Show and
reference your workings clearly.
 With written elements try and make a number of distinct points using headings and short
paragraphs. You should aim to make a separate point for each mark.
 Ensure that you explain the points you are making ie why is the point a strength, criticism or
opportunity?
 Give yourself plenty of space to add extra lines as necessary; it will also make it easier for the
examining team to mark.
Common terminology
Advise To counsel, inform or notify
Analyse Examine in detail the structure of
Calculate/compute To ascertain or reckon mathematically
Compare and contrast Show the similarities and/or differences
Define Give the exact meaning of
Describe Communicate the key features of
Discuss To examine in detail by argument
Distinguish Highlight the differences between
Evaluate To appraise or assess the value of
Explain Make clear or intelligible/state the meaning of
Identify Recognise, establish or select after consideration
Interpret Process information to explain its meaning
Justify To produce reasons in support of
List State short pieces of information on separate lines
Prepare To make or get ready for use
Recommend To advise on a course of action
Summarise To express the most important facts of
Section A
ALL 10 questions are compulsory and MUST be attempted.
Each question is worth 2 marks.
You are an audit manager of Adams & Co which has just won a contract for the tender of a new audit
client, Zen Co (Zen). Zen has been in business for five years and provides spa facilities for a national
hotel group.
One key factor in awarding the audit contract to Adams & Co was the fact that one of Adams & Co's
audit managers, Anthony Davidson, is married to the financial controller at Zen, Liz Davidson. The audit
engagement partner assigned to Zen is Carol Lamb.
In an initial meeting with the finance director of Zen, you learn that the employees of Adams & Co will
be entitled to a staff membership rate for the spa which is 50% of the standard membership rate and
that this will then entitle the member to 75% off spa treatments. This is the same benefit afforded to
Zen's employees.
Furthermore, the finance director has asked Carol if she will sit on the board of directors at Zen Co as a
non-executive director. He has also indicated that he will need Adams & Co to confirm the figures on an
insurance claim to be submitted in respect of a fire in the treatment centre just prior to the year end.
Zen has one major competitor, Revitalise, a large members-only spa, which started business two years
ago. Adams & Co has just been invited to tender for the audit of the company which owns Revitalise.
1 In relation to Adams & Co accepting appointment as auditors of Zen:
Which TWO of the following statements are correct?
 Adams & Co will have a right to attend all directors' meetings and receive all notices and
communications relating to such meetings.
 Adams & Co should obtain management's acknowledgement that they are responsible for
establishing internal control to ensure that the financial statements are free from material
misstatement.
 Adams & Co must deposit a statement of circumstances within 14 days of accepting
appointment as auditor.
 Adams & Co must agree the objective and scope of the audit in an engagement letter.

2 From a review of the information above, your audit assistant has highlighted some of the potential
risks to independence in respect of the audit of Zen.
Place a tick in ONE box in each row to indicate which of these risks represents an
advocacy, familiarity or self-interest threat.
Risk Threat
Advocacy Familiarity Self-interest
(1) Audit manager married to financial controller
(2) Adams & Co’s employees to be offered
reduced cost spa membership
(3) Audit partner to serve as a non-executive
director
(4) Adams & Co to represent Zen in an
insurance claim
3 In relation to the employees of Adams & Co being offered a reduced cost spa membership:
Which of the following safeguards should be implemented in order to comply with ACCA's
Code of Ethics and Conduct?
 The value of the gift should be assessed and only accepted if its value is not material to the
 The gift can be accepted as it is no more beneficial than the rate offered to Zen's employees.
 The gift should only be accepted for those employees of Adams & Co that form part of the
audit team.
 The gift should only be accepted if its value is trivial and inconsequential.
4 In relation to the request that Carol Lamb serve as a non-executive director on the board of Zen:
Which of the following safeguards should be implemented in order to comply with ACCA's
Code of Ethics and Conduct?
 Carol may perform the role and continue as the audit engagement partner but an independent
review partner should also be appointed to the audit.
 Carol may perform the role but should not act as the audit engagement partner, although she
may serve as the independent review partner.
 Carol may perform the role but should be removed from the audit team.
 Carol should not accept the offer to serve as a non-executive director.

5 The partners of Adams & Co are very keen to tender for the audit of Revitalise but are aware that
auditing both companies could establish a conflict of interest.
Which TWO of the following actions should Adams & Co take in the above situation?
 Draw up confidentiality agreements to be signed by the board of directors of Zen and
Revitalise
 Inform the management of both Zen and Revitalise of the potential conflict of interest and
obtain their consent to act for both parties
 Prevent physical access to the information relating to both company audits
 Use separate audit teams for each audit with a common independent review partner to
determine whether confidentiality has been maintained

You are the audit manager of James Co and currently have several audit clients at the fieldwork stage
as well as some clients which are entering the review and finalisation stage of their audits.
One audit client is WGH Co (WGH), a company which operates a chain of premium restaurants across
the country and which has a year end of 30 June 20X3. The audit is in its final stages and the draft
financial statements show revenue for the year to be $90 million and profit before taxation as $4.8 million.
6 In July 20X3, the company's flagship restaurant in the South West of the UK was badly flooded
following unprecedented levels of rainfall. All kitchen equipment and much of the restaurant's
furniture and fittings had to be disposed of. WGH's insurance is expected to cover the repairs to
the property and replacement furniture and fittings. However, it will be some time before the
restaurant is ready to re-open and some revenue will be lost. The directors do not propose to
disclose details of the event in the financial statements on the basis it occurred after the year end.
Which TWO of the following audit procedures should be performed in order to form a
conclusion as to whether the financial statements require amendment?
 Discuss with directors the measures they intend to take to reduce the risk of the restaurant
flooding in the future
 Obtain a written representation to confirm that WGH's going concern status is not impacted by
the forced closure and lost revenue
 Agree the original cost of the kitchen equipment to purchase invoices
 Review any correspondence from the insurers, confirming that the cost of the restaurant
repairs and replacement furniture and fittings can be recovered

7 Assume that the damage to the business caused by the flood and the lost business revenue is
material to the financial statements.
Which of the following statements describes the actions that James Co should take?
 Request that the directors recognise the loss suffered due to the flood as an adjusting event
and disclose the potential insurance pay-out as a non-adjusting event and issue a qualified
opinion 'except for' due to material misstatement if this is not done
 Request that the directors recognise the loss suffered due to the flood as an adjusting event
and disclose the potential insurance pay-out as a non-adjusting event and issue a qualified
opinion 'except for' due to insufficient appropriate evidence if this is not done
 Request that the directors disclose the flood as a non-adjusting event and issue a qualified
opinion 'except for' due to material misstatement if this is not done
 Request that the directors disclose the flood as a non-adjusting event and issue a qualified
opinion 'except for' due to insufficient appropriate evidence if this is not done
A second audit client, PTL Co (PTL), is a small listed company which designs mountain bikes and track
bikes to a high specification. PTL's year end is 31 August 20X3 and this year PTL's design team have
developed a new lightweight track bike which uses an alternative to carbon fibre as its main
construction material. Initial prototypes did not perform well during testing and consequently the audit
team had to undertake significant audit testing on the area of research and development in order to
ensure that PTL's intangible assets were not overstated.
8 Sales of the new bike went really well during the year and consequently the Design and Production
directors have each been paid a bonus on top of their annual salaries. The bonus was not paid
until the September 20X3 payroll but was accrued as part of the total wages and salaries expense
for the year ended 31 August 20X3. However, PTL's Finance Director does not want to disclose
the bonus separately in the financial statements as part of the directors' emoluments note for two
reasons. Firstly he does not want to draw the bonus to the attention of the other directors who did
not receive a bonus and secondly he does not want to risk any negative publicity for paying a
bonus during difficult economic conditions.
Which TWO of the following audit procedures are MOST relevant to form a conclusion as to
whether the financial statements require amendment?
 Vouch the payment of the bonus to the bank statement for September/October 20X3
 Review local company legislation to determine whether separate disclosure of the bonus is
required
 Agree the bonus to the wages and salaries expense for the year
 Consider whether the bonus is material to the current year financial statements

9 Based on all of the above information and assuming that the directors do not make disclosure of
the bonus in the financial statements:
Which TWO of the following options correctly shows the impact on the auditor's report?
 An unmodified opinion
 A qualified opinion with a basis for qualified opinion paragraph
 A key audit matter paragraph
 An emphasis of matter paragraph
The final audit client is DT Co (DT) which has endured extremely challenging trading conditions this
year. DT has lost several significant customers this year to more environmentally friendly suppliers and
this has placed a lot of pressure on cash flow at a time when their bank has refused to advance further
funding.
10 Your audit senior has informed you that one of the main reasons that DT's bank has refused to
advance further funding is that the Government has recently announced that environmental
legislation relating to DT's main product will be changed in the next six months and this will require
a fundamental change to the manufacturing process and that DT is unlikely to be able to operate
under these conditions. Your audit senior has also told you that DT's directors have prepared the
financial statements on the going concern basis.
Which of the following options correctly summarises the impact on the auditor's report if
the above issue remains unresolved?
 Adverse opinion only
 Adverse opinion with emphasis of matter paragraph
 Adverse opinion with key audit matter paragraph
 Adverse opinion with material uncertainty relating to going concern paragraph
(Total = 20 marks)

Section B
ALL THREE questions are compulsory and MUST be attempted
Question 11 HWG
You are the senior responsible for planning the audit of Here We Go (HWG) for the year ended
31 May 20X8.
HWG runs a football club which was promoted to the top division in the league this season. The football
season starts on 1 September and ends on 31 May so that the players get a break over the summer
months. HWG owns their football stadium which now has the capacity to seat 25,000 people. Of the
25,000 seats, 19,000 are allocated to HWG supporters (home supporters) and are sold to season ticket
holders only. The remaining 6,000 tickets are for away supporters and cannot be sold to HWG
supporters.
Season tickets cost $260 for adults and $175 for children. Following their recent promotion all the
season tickets have been sold this year, with 70% of season tickets sold to adults and the remaining
30% to children. Tickets for away supporters are always sold at $20 per ticket regardless of whether the
ticket is sold to an adult or a child. On average 50% of away supporter tickets have been sold for each
of the 14 home games played at HWG's stadium during the football season.
HWG's other revenue streams include the sale of football kits and other memorabilia from the club
shop, and food and drink sales from the club snack bars.
Following promotion to the top division, the club added an extra stand to the stadium to increase the
seating capacity to the current level of 25,000. Other existing areas of the stadium also underwent
maintenance in order to restore them to their original condition. The work was carried out during June
and July 20X7 and cost a total of $3,360,000. To finance this HWG took out a $2,900,000 loan on
1 June 20X7. The loan carries an interest rate of 7% and is repayable over the next 5 years. The loan is
secured on the stadium.
The directors feel that the club's greatest assets (other than the stadium) are the football players
themselves. The players have performed so well this year that some of the other football clubs in the
same division have made preliminary offers to buy three of HWG's players. HWG is particularly pleased
about this as these players joined the club through their youth academy programme. Consequently the
directors would like to value these three players as intangible non-current assets in HWG's financial
statements. The players will be valued at the offer price received from the other clubs; the directors feel
this is a prudent valuation because they are confident that the eventual selling price would be much
higher than the preliminary offer.
One of the major drawbacks of the club's promotion has been that the club has had to increase the
level of players' salaries. The total salary expense for the year is estimated to be in the region of
$2,800,000. This is a particularly surprising figure as it is higher than the other operating costs for the
year which are estimated at $2,400,000.
HWG has just appointed a team of internal auditors. They have not been in the position long enough to
help you with your audit work but the directors are keen for the internal auditors to improve the
company's internal controls in relation to the club shop and snack bars.

Required
(a) Describe how the auditor could perform a proof in total calculation to confirm each of HWG's
revenue from ticket sales, loan interest and payroll expense for players' salaries. (4 marks)
(b) Using the information provided, describe FIVE audit risks and explain the auditor's response to
each risk in planning the audit of HWG.
(c) Explain THREE internal controls the internal auditors of HWG should implement in relation to the
club shop and snack bars. State the objective of each control. (6 marks)
(Total = 20 marks)

Question 12 Chingford Potteries
Your firm is the external auditor of Chingford Potteries, and you recently attended the year-end
inventory count at the company's warehouse. The company manufactures high-quality tableware
(plates, cups and saucers etc) and it maintains an integrated computerised system that shows the
inventory held at any given point in time.
At the year-end inventory count, reports showing the various categories of inventories (but not the
quantities) are printed off the system and the quantities of inventories actually counted are inserted
manually by the counters. Later the quantities are compared with those per the computer system.
The count instructions were received by both you and the counters the day before the count was due
to take place. The instructions included the following details:
(i) Counters must arrive at 8am on the morning of the count.
(ii) They will work in teams of two people.
(iii) Each team will be assigned a specific area of the warehouse to count. They will receive inventory
sheets listing the products to be found in their area.
(iv) The inventory sheets are pre-numbered.
(v) Once the counters have finished the inventory count, the inventory sheets must be handed to the
warehouse manager.
Your notes from the attendance at the count include the following observations:
Many areas in which the count took place were untidy and inventory was sometimes difficult to find
because it was not in the allocated area. The same categories of inventories were sometimes found in
several different areas and some inventory was incorrectly labelled.
The count was conducted in a hurry in order to close the warehouse before a public holiday and there
were insufficient counters to conduct the count properly in the time available. The issue and receipt of
inventory sheets (on which the quantities were recorded by counters) was not properly controlled. It
was difficult to reconcile the inventory quantities recorded at the count to the computerised records and
some significant differences remain outstanding.
Although no finished goods were dispatched during the inventory count, a large delivery of raw
materials was received into the warehouse.
Required
(a) For the inventory count conducted by Chingford Potteries:
(i) Identify and explain FOUR deficiencies;
(ii) Recommend a control to address each of these deficiencies; and
(iii) Describe a TEST OF CONTROL the auditor should perform to assess if each of these
controls, if implemented, is operating effectively to reduce the identified deficiency.
Note. Prepare your answer using three columns headed Control deficiency, Control
recommendation, and Test of control respectively. The total marks will be split equally
between each part. (12 marks)

(b) Describe the audit procedures the auditor should perform at the year end to confirm each of the
following:
(i) The existence of inventory (3 marks)
(ii) The completeness of inventory (2 marks)
(iii) The valuation of inventory (3 marks)
(Total = 20 marks)
Question 13 Car Juice Co
You are the external auditor of Car Juice Co (Car Juice) for the year ended 31 March 20X1. Car Juice
operates 12 petrol stations in central England. As well as selling petrol, each petrol station has a
convenience shop and a car washing facility.
Each petrol station is responsible for its own inventory procurement and produces monthly
management accounts which are sent to the central accounts department at Car Juice.
Car Juice is financed by a $250,000 bank loan which is repayable at a rate of $50,000 per annum over
each of the next five years starting on 31 December 20X1.
It also has an overdraft facility of $100,000 which it uses in full. The bank overdraft facility is due for
renewal on 1 June 20X2.
The bank has already told the company that it will need to prepare a cash flow forecast for the two
years from 1 April 20X2 in order for the bank to decide whether or not the overdraft facility will be
renewed. The bank has also said it will require a report from the external auditors to confirm the
accuracy of the forecast.
Required
(a) Define the term analytical procedures and describe how they can be used during the various
stages of an audit. (4 marks)
(b) Describe FOUR analytical procedures the external auditor could perform to confirm Car Juice's
revenue and profit. (4 marks)
(c) Describe substantive procedures the external auditor should adopt to verify each of the following
assertions:
(i) The valuation of inventory (4 marks)
(ii) The completeness of payables (4 marks)
(d) Describe substantive procedures the external auditor should perform to confirm Car Juice's bank
loan. (4 marks)
(Total = 20 marks)


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Audit and Assurance (AA)

Copyright © IFRS Foundation

Improving study material and removing errors

5 Professional ethics and quality control procedures ................................................................. 73

6 Risk assessment ..................................................................................................................... 99

9 Internal control....................................................................................................................... 137

11 Audit procedures and sampling............................................................................................. 195

Achievement Ladder Step 6 303

20 Answers to Lecture Examples............................................................................................... 305

Welcome to Audit and Assurance (AA)

Introduction to AA Audit and Assurance

Overall aim of the syllabus

A Audit framework and regulation

Links with other exams

Strategic Business Advanced Audit and Assurance

Corporate Business Financial Audit and

Taught Phase Aims

Achieving ACCA's Study Guide Outcomes

A Audit framework and regulation

A1 The concept of audit and other assurance engagements Chapter 1

B Planning and risk assessment

B1 Obtaining and accepting audit engagements Chapter 6

C1 Internal control systems Chapter 9

D1 Financial statement assertions and audit evidence Chapter 8

E Review and reporting

E1 Subsequent events Chapter 18

Format of the exam

Section reference in the Study Text

Key skills required to pass

Skill 1 – Effective reading and planning at the start of the

Skill 2 – Analysis of a question's requirements

Skill 3 – Disciplined time management

Skill 4 – Tackling mini-case style scenario questions

Skill 5 – Producing a tailored answer to the exam scenario

How have the syllabus learning outcomes been examined?

The concept of audit and other

The objective of an external The auditor's report Assurance

1 The objective of an external audit

Own Company Manage

2 The auditor's report – ISA 700 (revised)

Example auditor's report – unmodified opinion (listed entity)

INDEPENDENT AUDITOR'S REPORT

Key Audit Matters

 Conclude on the appropriateness of management's use of the going concern basis of

Limitations of the audit and materiality

Lecture example 1 Idea generation

3.7 Examples of assurance engagements include:

A review of threats which

3.8 Assurance engagements should be performed according to the following process:

Reasonable assurance Sufficient appropriate Positive expression

How have the syllabus learning outcomes been examined?

The regulatory framework

Appointment, removal Mechanisms for the Development and Regulation by the

Note. Throughout these

1 The regulatory framework

1.2 Legislation will normally establish:

Auditors' rights and duties

 Access to books and records Report opinion

 Speak at general meetings  Adhere to local