Planning the audit assignment

Transcription

1 3 Plaig the audit assigmet this chapter covers... I this chapter we look at the way that audits are plaed, how auditors assess audit risk ad how they set materiality levels. We explai how auditors documet their cliet s fiacial systems, ad how iteral cotrols are idetified. Fially we explai how the audit pla is put together. The chapter covers: kowledge of the busiess plaig the audit the audit process assessig audit risk materiality the Permaet File documetig the systems iteral cotrol cotrol activities ad procedures iteral cotrol questioaires

2 p l a i g t h e a u d i t a s s i g m e t 4 3 K N O W L E D G E O F T H E B U S I N E S S Before begiig the plaig process, the auditors should fid out as much detailed iformatio as they ca about their ew cliet, its maagemet ad staff, ad the busiess eviromet i which it operates. ISA 315 Idetifyig ad assessig the risks of material misstatemet through uderstadig the etity ad its eviromet, states: Obtaiig a uderstadig of the etity ad its eviromet, icludig the etity s iteral cotrol (referred to hereafter as a uderstadig of the etity ), is a cotiuous, dyamic process of gatherig, updatig ad aalysig iformatio throughout the audit. The uderstadig establishes a frame of referece withi which the auditor plas the audit ad exercises professioal judgmet throughout the audit. t h e b u s i e s s e v i r o m e t Durig the course of the relatioship with the cliet, the auditor should costatly gather iformatio about the busiess eviromet i which the cliet operates. This will iclude: iformatio about the cliet s positio ad reputatio withi its idustry sector the geeral ecoomic coditios withi the idustry sector, icludig the level of competitiveess ad political or ecoomic factors the possible effect of techological chage or evirometal factors ay cyclical or seasoal aspects of the busiess or ay vulerability to factors such as chages i fashio ay major legislative or regulatory impacts which might affect the cliet ecoomic coditios such as iterest rates or iflatio Iformatio ca be gathered from a variety of sources icludig: idustry specific publicatios, trade jourals ad websites previous experiece of other cliets i the same idustry discussios with previous auditors govermet publicatios, statistics, surveys fiacial jourals

3 4 4 a u d i t i g t u t o r i a l t h e b u s i e s s, i t s m a a g e m e t a d s t a f f Auditors caot begi to carry out ay work o verifyig the fiacial statemets uless they have a complete uderstadig of the followig: the structure of the orgaisatio its divisios, departmets or subsidiaries the maagemet structure the products ad processes the fiacial systems This type of iformatio ca oly be successfully obtaied by direct cotact with the cliet s maagemet ad staff. They are the oly real source of the detailed iformatio that will allow the auditors to fully uderstad the who, what, why, where ad whe of the cliet s day-to-day activities. The auditors should have a clear uderstadig of: the cliet the cliet s busiess activities the iteral ad exteral eviromets i which the cliet operates The auditors will the be i a positio to decide what audit work is required to esure that the correct audit opiio is reached. P L A N N I N G T H E A U D I T A S S I G N M E N T It is very importat for auditors to properly pla the audit work to be carried out. Without proper plaig the objectives of the audit will ot be achieved ad the auditor rus the risk of failig to detect a material misstatemet. I additio to this, a lack of evidece of proper plaig could led support to a case for professioal egligece, which we looked at i Chapter 2. Poor audit work ofte arises because: there was o plaig the audit started before the plaig process was complete the audit was based o a pla which had ot bee updated for several years the auditors did ot fully uderstad the busiess ad how it operated The key to proper plaig is settig plaig objectives. The plaig objectives for a audit are:

4 p l a i g t h e a u d i t a s s i g m e t 4 5 decidig audit priorities ad establishig the most cost-effective meas of achievig audit objectives esurig audit work geerates sufficiet evidece to support the audit opiio esurig that there is clear directio ad cotrol of the day-to-day audit work esurig sufficiet attetio is devoted to critical aspects of audit work where systems are complex or the audit risk is cosidered to be high esurig audit work is completed withi predetermied time ad cost budgets T H E A U D I T P R O C E S S We will ow examie the way i which a audit process works. The steps which a auditor will go through, from beig asked to take up a appoitmet to sigig the auditor s report, are ormally as follows: fid out as much as possible about the potetial cliet before acceptig the assigmet carry out detailed ivestigatios ad documet the cliet s structure, maagemet, systems ad accoutig processes draft a programme of audit work carry out ivestigatios ad receive explaatios ecessary to support the audit opiio sig the auditor s report The separate elemets of this process will be dealt with i more detail, step by step, i subsequet chapters i this book.

5 4 6 a u d i t i g t u t o r i a l There is aother importat factor to cosider ad that is the timescale of this process. There are deadlies for compaies to file accouts with the Registrar of Compaies, ad there is also a deadlie for sedig accouts to shareholders. Shareholders must receive a copy of the fial audited accouts ot less tha 21 days before the date of ay Aual Geeral Meetig, so oce a date for that has bee set, the timescale for the work has to be based o that deadlie. I reality, most compaies will wat to fialise their accouts withi a few moths of the year ed, so i most cases fial audits are carried out the. The Case Study that follows illustrates the way i which these timescales work. Case Study T I M PA N I LT D : T I M E S C A L E O F T H E A U D I T s i t u a t i o Auditors Crash & Co have bee approached to be the first auditors of Timpai Ltd ad have accepted. The fiacial year ed is 31 December ad they have bee told that the AGM will be held o 21 April. It is ow early September ad the audit has to be completed i time to sed the accouts to the shareholders. r e q u i r e d You are the audit maager ad have bee told to draw up a outlie pla of how the audit assigmet will be arraged. This will form the basis of detailed plaig later. s o l u t i o Your approach is to idetify the key tasks ad decide how much time will be eeded to carry out each oe. You kow that the accouts have to be set to the shareholders 21 days before the date of the AGM ad so your real deadlie is 31 March. The duratio of each task is based o your estimate of how much work there is to be doe ad how log you thik it will take based o your experiece. As this is the first audit Timpai Ltd has had, the tasks may take more or less time ad the pla should allow for this. You draw up a basic pla which is show o the ext page. This pla depeds upo Timpai s accouts staff havig the accouts ad supportig schedules ready o time. This is why prelimiary discussios with their staff are importat so that everybody kows what they have to do, ad by what date.

6 p l a i g t h e a u d i t a s s i g m e t 4 7 Task Duratio Date Visit Timpai for a itroductory meetig to explai the role of the auditor ad the auditig process. Also to discuss what will be expected of Timpai i terms of preparig accouts ad makig iformatio available to the auditors 1 day Immediate Plaig visit by audit team to documet Timpai s accoutig system 1 week late September Pla a programme of audit work ad meet with Timpai s staff to agree timigs 1 day by early October First audit visit 1 week early November Year ed work eg ivetory cout etc 1 day 31 December Fial audit visit 2 weeks late February Review fiacial statemets by auditors ad discussio with maagemet 1 day mid March Sig auditor s report 1 day by 31 March We have already idetified that durig the plaig process the auditors must gai a good uderstadig of the cliet s busiess ad must cosider the followig factors: the eviromet i which the compay operates, ie its market, its competitors, the way it is fiaced, the quality of its maagemet, its curret fiacial positio etc ad the compay s iteral processes together with the iteral cotrols i its accoutig systems. These factors will directly affect the possibility of a misstatemet or fraud i the fiacial statemets. For example, weak or ieffective cotrols could allow errors to slip through udetected. The auditors must evaluate the compay ad its systems ad decide whether there is a possibility that a serious misstatemet could go udetected. This will directly affect the auditors decisio as to the level of audit risk which we will ow cosider i the ext sectio.

7 4 8 a u d i t i g t u t o r i a l A S S E S S I N G A U D I T R I S K The correct assessmet of audit risk is vital, ad is probably oe of the most importat aspects of audit that you have to study. The whole approach that the auditors take to their audit work is based o how they assess the level of risk that their audit cliet represets. Basically, if the auditors thik that the cliet represets a high level of risk they will eed to carry out much more detailed audit work tha if they assess it as beig low risk. We will ow look at what we mea by risk i the cotext of auditig. w h a t i s a u d i t r i s k? Audit risk is the risk that after carryig out all the audit work the auditors give a icorrect opiio of the cliet s fiacial statemets. The auditors may certify that the fiacial statemets give a true ad fair view whe they do ot. I other words the fiacial statemets cotai a sigificat error or misstatemet which the auditors have failed to detect. a u d i t r i s k a d f r a u d Oe thig that must be stressed is that audit risk has othig directly to do with fraud. It is ot the auditors job to set out to detect fraud. As we have see, they are ot bloodhouds but watchdogs. Therefore, whe auditors are assessig risk they are ot assessig the risk that they might fail to detect a fraud. Note, however, that ISA 240 The Auditors resposibilities relatig to fraud i a audit of fiacial statemets requires auditors to approach ay audit assigmet with a degree of professioal scepticism ad says that they must bear the possibility of fraud i mid whe plaig audit work. This meas that auditors should idetify areas where the compay s assets are at greatest risk or where its cotrols are weakest. r i s k a s s e s s m e t ISA 315 Idetifyig ad assessig risks of material misstatemet through uderstadig the etity ad its eviromet requires auditors to idetify ad documet areas of sigificat audit risk where they cosider there could be a material misstatemet, for example: i the fiacial statemets as a whole for idividual disclosures withi the fiacial statemets

8 p l a i g t h e a u d i t a s s i g m e t 4 9 Auditors have to uderstad ad idetify risk arisig both out of the compay s operatios ad from its systems of iteral cotrol by carryig out a risk assessmet. This is doe by a combiatio of: aalytical review procedures, ie idetifyig icosistecies i the figures beig audited (see Chapter 4) discussios with maagemet ad other relevat people i the compay observatio ad ispectio of the compay s procedures ad cotrols A quick plaig meetig with the fiacial director is ot sufficiet! Whe the risks have bee idetified, the auditors have to desig audit procedures so that these risks are reduced to a acceptable level. Auditors also have to idetify whether there are risks which are so great that they deserve special audit cosideratio, ie so sigificat that ormal audit testig processes will ot be sufficiet to validate the disclosures i the fiacial statemets. Auditors must fully documet all the steps i their risk assessmet. Oe importat poit which ISA 315 stresses is that the risk assessmet must be commuicated ad discussed with the whole audit team so that everyoe o the assigmet is aware of potetial areas of risk. c a t e g o r i e s o f r i s k Auditors will measure the levels of audit risk so that they ca estimate how likely it is that they will give a wrog audit opiio. Audit risk is defied i ISA 200 Overall objectives of the idepedet auditor ad the coduct of a audit i accordace with Iteratioal Stadards o Auditig ad comprises two thigs: the risks of a material misstatemet i the fiacial statemets as a whole or i the disclosure of idividual trasactios ad balaces detectio risk the risk that the auditor s ow procedures will fail to detect a material error or misstatemet We will look at materiality later. For the momet the word sigificat is a good substitute. Therefore audit risk is cocered with the risk of a sigificat error or mistake ot beig detected. Auditors assess audit risk usig their professioal judgemet; this assessmet is a key part of the plaig process. There are two compoets to the risk of material misstatemet: Iheret risk Cotrol risk We will ow look at each of these i tur, ad the at detectio risk.

9 5 0 a u d i t i g t u t o r i a l i h e r e t r i s k Iheret risk is the risk that a item or items i the accouts will cotai a material error or misstatemet, simply because of the characteristics of the compay or the characteristics of the particular item. The followig tables show the key sigs of iheret risk that the auditors will look out for ad the effect those factors may have. INHERENT RISK maagemet & owership of the busiess potetial risk areas domieerig ower or director relatioships betwee maagers level of maagemet expertise expectatios of stakeholders the effect may ifluece the attitude of other directors ad seior maagemet towards disclosure i the fiacial statemets or i the operatio of the busiess direct relatioships (eg i family compaies) betwee maagers or directors could reduce the effectiveess of the iteral cotrols iexperieced or uqualified maagemet may ot appreciate the likelihood of error expected levels of divideds by shareholders guaratees about profit levels give to leders whe applyig for credit the accouts of the busiess potetial risk areas complex accouts the effect complex fiacial structures ivolvig subsidiary or associated busiesses compaies egaged i complex trade eg foreig currecy or share tradig, freight forwardig, high tech busiesses items relyig o judgemet the this requires objectivity o the part of the cliet staff makig judgemets (eg high levels of provisios at the year ed) cash trasactios tracig cash trasactios is always more difficult tha tracig credit trasactios

10 p l a i g t h e a u d i t a s s i g m e t 5 1 the busiess potetial risk areas ature of the busiess idustry factors theft of assets iformatio techology staffig the effect over-depedece o a sigle customer, product or supplier busiess operatig a trade which ivolves cash or goods which are easy to steal products which are out of fashio or obsolete (this ca give problems with fiished goods ivetory valuatios) a highly competitive tradig eviromet regulatory requiremets which result i substatial cost to the busiess ivetory or other assets which could be easily stole ad coverted ito cash, eg computers, alcohol ad cigarettes large amouts of cash held i the busiess lack of computer systems documetatio reliace o a few key experts security issues costat staff chages low staff morale little or o traiig There are, of course, may more iheret risks uique to specific compaies. As auditors it is importat to remember that if some aspect of the busiess appears uusual or poses a sigificat iheret risk, the it must be cosidered whe assessig the level of audit risk. If a compay has several areas of iheret risk, the auditor is likely to grade the level of iheret risk as high. Read the Case Study that follows. Case Study I N H E R E N T R I S K M U C K E R S L I M I T E D s i t u a t i o You have bee approached to be the ew auditors of Muckers Limited Muckers Ltd is a costructio compay egaged i the costructio of housig projects, small office complexes ad factory uits. Its mai trade is i acquirig disused or derelict lad ad buildigs ( browfield sites) at a low cost ad buildig developmets which they the sell to busiesses lookig for premises. They have bee quite successful as the Developmet Director, Roger

11 5 2 a u d i t i g t u t o r i a l Radom, has bee able to fid attractive sites which the compay ca acquire quite cheaply. They also build ew housig developmets, mostly o greefield sites i developmet areas o the edge of tow. The Developmet Director, Roger Radom, has recetly haded i his otice as he is leavig to joi a larger costructio firm. Muckers is owed ad ru by the Mucker family. Cyril Mucker, Chairma ad Chief Executive, ows 60% of the shares. The oly other director, apart from Roger Radom, is Cyril s brother, Hugo Mucker, who is resposible for overseeig the buildig cotracts. The fiacial accoutig sectio is ru by Paula Poppett (who is ot a qualified accoutat) ad produces a set of maagemet accouts quarterly. There are o budgets or maagemet accouts as Cyril Mucker believes that watchig the bak balace is the way to ru the busiess. The compay has recetly had some difficulty with two of its sites. O the browfield site ispectors have discovered cotamiatio from a old asbestos factory ad have forbidde ay further developmet util it is decotamiated by specialist cotractors. Muckers will have to pay for this. O a greefield housig project Muckers built twelve houses but have oly sold two, as there are rumours that the local authority have decided to put i plas to cetral govermet for a dual carriageway bypass ext to the ew developmet. The compay employs a large umber of temporary casual staff who are paid weekly i cash. r e q u i r e d Before you take o this cliet what would be your assessmet of iheret risk? s o l u t i o The iheret risk ivolved i this cliet is high for a umber of reasos, icludig: The compay is uder the cotrol of a very small group of shareholders all of whom are related. Oe of them, Cyril Mucker, is a major shareholder. Cyril is also the chairma ad chief executive, so this makes him a domiat force i the compay. There is a very weak fiace fuctio, with o represetative at director level. It seems ulikely that Paula Poppett could stad up to Cyril Mucker if there was ay dispute about the figures. There is o proper maagemet accoutig system or budgetig. They have recetly lost a key employee, Roger Radom, who was resposible for much of the compay s success i the past. They have problems with two of their buildig developmets. It is ot kow what the fiacial effect might be, but it is likely to be substatial. The busiess might the come uder fiacial pressure.

12 p l a i g t h e a u d i t a s s i g m e t 5 3 The busiess trades i a highly-regulated eviromet, particularly with regard to plaig costraits, Health & Safety ad evirometal rules about disposal of materials. This requires costat moitorig to esure that the compay complies with all the appropriate statutory regulatios. A large umber of staff are paid i cash, which results i a higher risk of theft. c o t r o l r i s k Cotrol risk the secod elemet of audit risk is the risk that the iteral cotrols of the compay beig audited are ot operatig properly ad so do ot prevet or detect material errors or misstatemets. This could mea: a sigificat error may pass through the system udetected trasactios may be missed out completely trasactios may be wrogly recorded Iteral cotrols are the safeguards that the cliet has built ito the systems ad processes to miimise risk or error. This will iclude procedures such as matchig ivoices to orders ad delivery otes before the ivoice is processed ad authorisig the ivoice before it is paid. A key part of the auditors prelimiary work is to evaluate these iteral cotrols. Later i this chapter we will see how auditors go about doig this. If the auditors are satisfied that the iteral cotrols are workig well, the they may be able to assess the cotrol risk as low. Sigificat weakesses i the iteral cotrols will lead to the auditors assessig the cotrol risk as high. If iteral cotrols are assessed as beig weak this will limit the reliace the auditors ca place o the accoutig systems. d e t e c t i o r i s k Detectio risk is the risk that the auditors ow tests will fail to detect material errors or misstatemets i the fiacial statemets. If we thik about iheret ad cotrol risk, either of these ca be iflueced by the auditors. Detectio risk is differet i that it is the oly elemet of audit risk which is withi the auditors cotrol. Suppose that, after carryig out their assessmet of the iheret risk ad cotrol risks, the auditors assess the risk of a material misstatemet as high. Because audit risk is a combiatio of the risk of material misstatemet ad detectio risk, i order to make the level of audit risk acceptable, the auditors will have to do a large amout of audit testig i order to make the detectio risk low.

13 5 4 a u d i t i g t u t o r i a l O the other had, if, after carryig out their risk assessmet, the auditors judge iheret ad cotrol risk to be low, ad hece the risk of material misstatemet as low, they will be able to reduce their audit work to a more reasoable level, makig the detectio risk higher, but still acceptable. u m e r i c a l s c o r i g o f r i s k As accoutats you are used to attachig umerical values to thigs, so you may well look at this system of risk assessmet ad thik it is a bit vague. Auditors sometimes use a umerical scorig system for each of the categories of risk i order to arrive at a overall estimate. Remember that i every case the evaluatio of risk ultimately requires skill ad judgemet o the part of the auditor which is gaied through traiig, qualificatio ad experiece. Lastly, it is very importat to remember that risk must be costatly reviewed durig the course of the audit. Factors may come to light durig audit testig that will chage the level of risk, ad this will have a immediate impact o the amout ad focus of audit work. M AT E R I A L I T Y The cocept of materiality is closely liked to the auditor s cosideratio of the level of audit risk. Remember that part of the process of establishig the level of audit risk requires the auditor to review the risk of a material misstatemet ot beig detected either by his/her ow procedures or by the cliet s iteral cotrols. w h a t d o w e m e a b y m a t e r i a l i t y? ISA 320 Materiality i plaig ad performig a audit states: Misstatemets, icludig omissios, are cosidered to be material if they, idividually or i the aggregate, could reasoably be expected to ifluece the ecoomic decisios of users take o the basis of the fiacial statemets ad The auditor s determiatio of materiality is a matter of professioal judgmet, ad is affected by the auditor s perceptio of the fiacial iformatio eeds of users of the fiacial statemets. Materiality is effectively a measuremet of how importat somethig is withi the fiacial statemets. ISA 320 states that somethig will be

14 p l a i g t h e a u d i t a s s i g m e t 5 5 cosidered to be material if leavig it out of the fiacial statemets or gettig it wrog would give the reader/user a misleadig view of the state of the compay s affairs. There are three key poits to uderstad about materiality before we look at it i detail: the auditors will use their professioal judgemet to decide what is material it caot be defied as oe specific value the auditors decisio about whether a error is material depeds o how it fits i the cotext of the fiacial statemets as a whole m i s s t a t e m e t s Before we look at materiality i detail there is aother auditig stadard which we must cosider whe reviewig materiality, ad that is ISA 450 Evaluatio of misstatemets idetified durig the audit. ISA 450 defies misstatemet as: the differece betwee the amout, classificatio, presetatio, or disclosure of a reported fiacial statemet item ad the amout, classificatio, presetatio, or disclosure that is required for the item to be i accordace with the applicable fiacial reportig framework. Misstatemets ca arise from error or fraud. I other words a misstatemet is the differece betwee: the size of a figure as show i the fiacial statemets or how it has bee disclosed or preseted ad the size it should be if it had bee properly calculated, or what its correct disclosure or presetatio should be if the relevat accoutig stadards had bee applied correctly Misstatemets ca iclude: amouts icorrectly take from the accoutig records ad icluded i the fiacial statemets, for example calculatio error or simple mistakes i postig figures amouts or statutory disclosures omitted, for example failig to fully disclose directors emolumets icorrect estimates arisig from misiterpretig facts or overlookig somethig which is relevat to the calculatio of the estimate, for example uderstatig a allowace for doubtful debts by igorig some overdue amouts

15 5 6 a u d i t i g t u t o r i a l estimates based o judgemets which are clearly excessive or ureasoable i the circumstaces. This icludes the use of accoutig policies which are ureasoable or iappropriate, for example depreciatig computer equipmet over 10 years where its useful life is cosiderably less The auditors must cosider all the misstatemets, or errors, they detect durig the course of their audit work ad make a judgemet about how they could affect the fiacial statemets. This will ivolve discussio with the maagemet about amedig the fiacial statemets where idividual misstatemets are material. If the misstatemets are idividually small this will ivolve decidig whether, collectively, they are sigificat eough to affect the presetatio of the accouts; lots of small errors ca add up to a large oe! p e r f o r m a c e m a t e r i a l i t y Durig the plaig process the auditors will review the iformatio they have obtaied about the cliet s fiacial results for the period ad make a prelimiary estimate of materiality for the fiacial statemets as a whole. They will also look at particular classes of trasactios, for example ivetories, where these are importat figures i the accouts, ad make a estimate of what they would cosider to be a material misstatemet for that class of trasactio. However, durig the actual audit work the auditors will set performace materiality at a lower level of materiality tha they had durig the plaig stage, ie smaller items ow become material. ISA 320 defies performace materiality as: the amout or amouts set by the auditor at less tha materiality for the fiacial statemets as a whole to reduce to a appropriately low level the probability that the aggregate of ucorrected ad udetected misstatemets exceeds materiality for the fiacial statemets as a whole. If applicable, performace materiality also refers to the amout or amouts set by the auditor at less tha the materiality level or levels for particular classes of trasactios, accout balaces or disclosures. The itetio behid settig this lower level of materiality whe the audit work is carried out is to miimise the risk that the sum of amouts that are idividually immaterial plus ay possible udetected misstatemets exceeds the plaed materiality limit set before the audit bega. The discovery of a huge error which is obviously sigificat will result i the auditors askig the maagemet to amed the fiacial statemets. Performace materiality aims to esure that smaller errors, which o their ow would ot require the fiacial statemets to be altered, added to a

16 p l a i g t h e a u d i t a s s i g m e t 5 7 allowace for ay misstatemets the auditors have ot detected, do ot collectively add up to somethig which would also require the fiacial statemets to be altered. The levels of plaed materiality ad performace materiality should be costatly reviewed durig the audit ad revised as appropriate. Somethig ca be material to the fiacial statemets for qualitative or quatitative reasos. q u a l i t a t i v e a s p e c t s Qualitative meas that a error or omissio that the auditors have discovered is material because of the ature of the item, regardless of its fiacial value. I this case the error or omissio is uacceptable ad the auditor must highlight this to the cliet maagemet for adjustmet. Examples of items that are measured for qualitative reasos iclude: a disclosure required by the Compaies Act or Accoutig Stadards which has bee omitted completely or partially from the accouts, eg director s emolumets a item which is misstated, eg a short-term loa show as a log-term loa a item which might affect the accouts but which has ot bee icluded because it caot be quatified with a reasoable degree of certaity, eg the outcome of a sigificat court case It is the resposibility of the auditors to remid the directors of their duty to comply with legislatio ad with relevat Accoutig Stadards ad to rectify errors ad omissios. q u a t i t a t i v e a s p e c t s Whereas qualitative refers to the ature of errors ad omissios, quatitative refers to quatity, ie to the size (value i ) of ay errors foud durig the audit. The auditors must take a view as to whether the value of errors foud, idividually, or take all together, is sufficietly sigificat (material) for the auditors to request the maagemet to adjust the fiacial statemets. Remember that, as we saw above, for the purposes of the audit work the level of performace materiality will be lower tha the level set at the plaig stage. I order to determie a umerical value for materiality, the auditors will ofte use percetages of some of the key umbers i the draft fiacial statemets, for example: 5% - 10% of pre-tax profits

17 5 8 a u d i t i g t u t o r i a l 1% of turover 5% of et asset value Alteratively, they may decide to calculate these figures ad the to use a combiatio of all three. The figures o which the auditors will base their calculatio of materiality will deped o the ature of the cliet beig audited. It is importat to uderstad that these figures are give as examples oly ad that you should ot see them as a defiitive guide to settig materiality. It is also importat for materiality levels to be costatly reviewed durig the course of the audit where the level of iheret or cotrol risk chages or where errors are foud i audit testig. Whe, durig the audit, the auditors fid errors i the accouts, these should be oted o a schedule of errors ad misstatemets. At the ed of the audit all errors ad misstatemets that have bee foud should be aggregated ad cosidered together. The auditors must the assess whether they have a material impact o the fiacial statemets ad also whether they affect the truth ad fairess of the fiacial statemets. I most cases the directors will be happy to adjust the fiacial statemets for errors foud by the auditors because they are kee for the accouts to be as accurate as possible. However, if the directors refuse to amed the accouts, the auditors will have to cosider whether the error or mistake is serious eough that they should highlight it i their fial audit report. This issue will be covered i detail i Chapter 7. Case Study M AT E R I A L I T Y: L E M O N LT D s i t u a t i o You are the audit maager coverig the year-ed audit of Lemo Ltd. You are reviewig the audit files before sedig them to the audit parter for fial review. Two specific poits have bee draw to your attetio by the audit staff. (a) The draft fiacial statemets curretly do ot iclude ay referece to the fact that the cliet s Sales Director ows 15% of Toic Ltd, a major supplier to Lemo Ltd. (b) Oe of the compay s major customers has goe ito liquidatio, owig them 40,000 which is ulikely to be recovered. Profits for the year are 200,000 ad receivables are show i the Statemet of Fiacial Positio at 650,000. Audit materiality o the audit has bee set at 10% of the pre-tax profit. However, the cliet s maagemet say they have ot provided for this, as it is ot material ad if ecessary they will write it off ext year. r e q u i r e d What recommedatios will you make to the audit parter regardig these two issues?

18 p l a i g t h e a u d i t a s s i g m e t 5 9 s o l u t i o (a) This is automatically material (for qualitative reasos) ad must be disclosed. The director has a iterest i a major supplier to the busiess ad the Compaies Act requires that this type of iformatio is disclosed i the Fiacial Statemets. (b) This is ot automatically material as there is o requiremet o the compay to disclose this item simply due to its ature. The auditor must look at the issue i the cotext of the accouts as a whole. Would failure to amed the accouts for this item mea that the fiacial statemets were misleadig to the reader? I this case the profits would be reduced by 20% to 160,000 ad receivables by about 6% to 610,000. Whilst the effect o the Statemet of Fiacial Positio may ot be cosidered material the reductio i profit is large. The materiality here is clearly quatitative. The audit parter should therefore ecourage the directors of Lemo Ltd to provide for this debt i the Fiacial Statemets for the curret year. T H E A U D I T O R S P E R M A N E N T F I L E Before the auditors ca decide o the ature ad volume of audit work they have to carry out, they eed to gai a clear uderstadig of the way i which the cliet operates. This will iclude a uderstadig of the cliet s busiess, its maagemet ad its fiacial systems. Much of this iformatio will remai uchaged from oe year to the ext, ad oce recorded by the auditor, will require oly miimal updatig each year. Iformatio that remais permaet for the busiess is recorded i the Permaet Audit File. t h e p e r m a e t f i l e As its ame suggests, the permaet file is used to documet those aspects of the cliet s busiess which are expected to remai more or less uchaged from year to year. The permaet file should cotai sufficiet iformatio so that ay member of the audit team who has o previous kowledge of the cliet ca pick it up ad gai a clear picture of the cliet compay, its owership, maagemet, activities, ad very importatly, its fiacial systems. The iformatio icluded i the permaet file will be obtaied largely from the cliet s maagemet ad staff. Before recordig ay iformatio i the permaet file, the auditors must satisfy themselves that all iformatio to be icluded is accurate. Cosequetly, at the plaig stage of each aual audit visit, the permaet file must be reviewed to esure that it cotiues to be relevat, up-to-date ad accurate.

19 6 0 a u d i t i g t u t o r i a l g a t h e r i g i f o r m a t i o f o r t h e p e r m a e t f i l e Auditors ca obtai iformatio about their cliet by: tourig the cliet s premises ad askig questios about what is goig o talkig to the employees iterviewig directors, maagers ad other key persoel reviewig origial documetatio such as miutes of meetigs, iteral reports ad maagemet accouts approachig baks ad other leders for details of fiace arragemets always with permissio from the cliet It is importat that, wherever possible, the auditors obtai iformatio from as wide a rage of sources as possible ad obtai idepedet evidece to support the iformatio icluded o the permaet file. Ay copies of documets to be icluded i the file should be take directly by the auditors from the origial documets. These copies should the be iitialled ad dated to evidece that the origial of the documet has bee ispected. c o t e t s o f t h e p e r m a e t f i l e The permaet file should iclude: a descriptio of the cliet s busiess activities details of owership, icludig lists of shareholders, if relevat details of group structure, divisios or braches where appropriate maagemet structure icludig relatioships betwee the cliet s owers/directors ad other seior executives fiacial structure, icludig details of loa ad overdraft arragemets sigificat stakeholders other tha owers ad leders who might ifluece busiess activities, eg a major customer or supplier the auditors view of the busiess approach adopted, eg risk-takig ad uplaed, or coservative ad plaed relatioships with other auditors or specialists ivolved i the audit a overall risk assessmet a assessmet of the cotrol eviromet the siged egagemet letter detailed descriptios of the fiacial systems A typical idex to a permaet file is show i the Appedix o page 272. D O C U M E N T I N G T H E C L I E N T S F I N A N C I A L S Y S T E M S The fial poit o the list of items icluded i the permaet file is probably

20 p l a i g t h e a u d i t a s s i g m e t 6 1 the most importat. I order for the auditors to pla their audit work they must have a thorough uderstadig of the cliet s fiacial systems. To that ed the auditors must prepare detailed descriptios of these systems. The mai cliet systems that eed to be documeted are: reveue purchases wages ad salaries o-curret assets ivetory ivestmets Documetatio of the systems should iclude as much iformatio as possible relatig to: all documets ivolved icludig where they are kept the way i which trasactios are verified the persoel ivolved i the various systems ad their roles levels of resposibility of staff reportig schedules the books of accouts maitaied ad where they are located There are two mai methods of documetig the cliet s systems: arrative otes flowcharts a r r a t i v e o t e s Compilig a series of arrative otes is the simplest way of recordig the cliet s systems. It is best to record the fial versio o computer file, as it makes them easier to update. A set of hadwritte otes prepared o previous audit visits ca be time-cosumig to revise ad is ot recommeded. Auditors must esure that the otes that they produce describig the cliet systems cotai sufficiet detail for the user to gai a good uderstadig of how the system operates. f l o w c h a r t i g The dager of usig complex arrative otes to documet a fiacial system is that they ca become extremely detailed ad ultimately may become cofusig to the reader, who gets lost i the detail. It is much easier for the reader to have a diagram showig how the fiacial system operates. With this i mid, auditors will ofte use flowcharts, together with brief arrative otes, where ecessary, to describe ad explai

21 6 2 a u d i t i g t u t o r i a l the system. Flowcharts show the systems i picture form with commo symbols used to represet particular documets, ad their physical movemet. Flowcharts ca be used to show the flow of iformatio as well as documets. As with arrative otes, the auditors will review these charts each year ad update for chages ad developmets i the systems. The basic flowchartig symbols f l o w c h a r t s y m b o l s f o r f i a c i a l s y s t e m s commoly used are show below. documet flow iformatio flow operatio purchase order documet time flow of documet YES NO operatio with a yes/o choice ivoice documet produced i multiple copies documets crossig check or ispectio accout book PM coectig to (eg to a perso or a computer file) TA to a file A = alphabetical N = umerically sorted D = date order T = temporary + A,N,D f l o w c h a r t i g r u l e s There are some key rules for flowchartig: use stadard flowchartig symbols wherever possible keep the charts simple uless the system is very simple do ot try to get it all o oe sheet; break the chart up ito a series of sub-systems ad lik them together documet flows should start at the top left of the sheet ad fiish at the bottom right chart all documets from cradle to grave ie from their origiatio to their fial filig, ad do ot leave ay loose eds

22 p l a i g t h e a u d i t a s s i g m e t 6 3 coectig lies should ot cross uless this is uavoidable A simple flowchart of a goods received ad ivoice processig system is show o the ext page. You should otice three thigs whe you look at this flowchart: each operatio withi the flowchart is separately umbered with a brief arrative where required the chart is divided by fuctioal departmets, makig it easier to see which departmet is resposible for which fuctio, ad where resposibility for checkig trasactios lies f l o w c h a r t f o r r e c e i p t o f d o c u m e t a t i o f r o m s u p p l i e r arrative o. Goods Iward Purchase ledger Goods received ote (GRN) raised by Goods Iwards Departmet 1 GRN 1 2 Copy filed i Goods Iwards Departmet 2 D supplier ivoice Supplier s ivoice give sequetial umber ad checked for arithmetical accuracy. 3 Ivoice matched ad attached to GRN 4 If ot all goods received, file i temporary file 5 YES NO TA Documets checked to see that all items have bee checked ad iitialled. 6 Passed to purchasig maager for authorisatio 7 PM

23 6 4 a u d i t i g t u t o r i a l the chart does ot attempt to describe the whole system at oce, for example it does ot deal with paymets which would be icluded i a differet chart; this simplifies reportig ad makes idetificatio of iteral cotrols easier a d v a t a g e s a d d i s a d v a t a g e s o f f l o w c h a r t s The advatages of flowcharts are: they ca be prepared relatively quickly by likig flowcharts eve quite complex systems ca be described relatively clearly as stadard symbols are used they ca be easily followed by ayoe familiar with flowchartig procedures flowcharts make ay weakesses or gaps i the system or sub-system beig described relatively easy to spot there are a umber of computerised flowchartig software packages available The disadvatages of flowcharts are: they have to be redraw if systems chage, eve to a limited extet they are fie for stadard systems but for o-stadard trasactios they may become uwieldy ad require too may arrative otes they are fie for describig accoutig processes where documets are movig through the system, but oce the documets stop movig they caot describe cotrols for example, flowcharts ca describe procedures for cotrollig goods iward ad goods outward but ot the cotrols over ivetory i the stores w a l k t h r o u g h t e s t s Whe the flowcharts ad accompayig arrative descriptios have bee drafted, the auditors should test out the systems to esure that they work as documeted. These tests are kow as walk through tests. To carry out a walk through test you should: choose a small sample of trasactios, two or three, from the part of the system beig verified follow them through the system, usig the flowcharts as a guide esure that the flowchart ad ay otes accurately record the system as it operates i practice A walk through test should be performed each year before ay audit testig begis to esure that there have bee o chages sice the precedig audit. Auditors must documet their walk through tests, recordig details of the

24 p l a i g t h e a u d i t a s s i g m e t 6 5 trasactios they have chose to follow through the system, ad keep the details o their permaet file. As soo as the auditors cosider that they have a sufficiet uderstadig of the cliet s systems they ca create a programme of audit work to test the iteral cotrols withi the system. The way i which the auditors produce the audit programme will be covered i detail i Chapter 4 but at this poit we must esure that you have clear uderstadig of what is meat by iteral cotrol. I N T E R N A L C O N T R O L ISA 315 Idetifyig ad assessig the risks of material misstatemet through uderstadig the etity ad its eviromet separates iteral cotrol ito five compoet parts The ISA states: The divisio of iteral cotrol ito the followig five compoets provides a useful framework for auditors to cosider how differet aspects of a etity s iteral cotrol may affect the audit: (a) the cotrol eviromet (b) the etity s risk assessmet process (c) the iformatio system, icludig the related busiess processes, relevat to fiacial reportig, ad commuicatio (d) cotrol activities; ad (e) moitorig of cotrols. As you will appreciate, at some time or aother, everybody makes mistakes. A good fiacial system has withi it a series of checks ad procedures desiged to prevet, detect ad correct mistakes or errors that could occur durig the processig of trasactios. The prime aim of these checks is to esure that as may errors as possible are picked up so that there are o material errors i the fiacial statemets. I all but the very smallest compaies there will be a umber of layers of maagemet, each with their ow role i supervisig ad directig areas of the busiess ad its workforce. The maagers will therefore be the key to the effective operatio of these cotrols withi the compay s systems. They will be the idividuals resposible for the checks, authorisatios ad approvals that will make up the iteral cotrols of the busiess. It is importat for you to uderstad that iteral cotrols are ot there

25 6 6 a u d i t i g t u t o r i a l primarily to detect fraud. The purpose of iteral cotrol is to provide assurace to maagers that: the risk of serious error or misstatemet i the fiacial records is miimised the assets of the busiess are safeguarded all liabilities are idetified ad properly recorded INTERNAL CONTROL f i a c i a l records are kept upto-date ad as accurately as possible cotrol eviromet cotrol activities/procedures Iteral cotrol is made up of two elemets: the cotrol eviromet cotrol activities ad procedures t h e c o t r o l e v i r o m e t ISA 315 Idetifyig ad assessig the risks of material misstatemet through uderstadig the etity ad its eviromet states: The cotrol eviromet icludes the goverace ad maagemet fuctios ad the attitudes, awareess, ad actios of those charged with goverace ad maagemet cocerig the etity s iteral cotrol ad its importace i the etity. The cotrol eviromet sets the toe of a orgaisatio, ifluecig the cotrol cosciousess of its people. The cotrol eviromet is, fudametally, the philosophy ad operatig style of the orgaisatio as set by its directors ad seior maagemet, ie the maagerial attitude to, ad awareess of, iteral cotrols. I order to assess the iteral cotrols, auditors must to able to uderstad

26 p l a i g t h e a u d i t a s s i g m e t 6 7 Case Study the culture of a orgaisatio ad the way it is reflected i: the attitude of its maagemet ad staff, ad the effect this attitude has o the orgaisatio s procedures What makes a good iteral cotrol eviromet? It should have the followig characteristics: clear commuicatio to staff of the ethical values of the orgaisatio reiforcig a commitmet to itegrity i busiess dealigs. This commitmet is see as a essetial elemet i ifluecig the effectiveess of the desig, admiistratio ad moitorig of cotrols competet, reliable staff who demostrate a high level of itegrity ad commitmet i their attitude to work a clear, well-uderstood maagemet structure with defied authority limits ivolvemet by the maagemet i the day-to-day activities of the busiess operatig procedures which are uderstood ad accepted by the employees who have to implemet them It is importat that you uderstad key aspects of evaluatig a cotrol eviromet. The followig Case Study will illustrate these mai poits. C O U N T I T & C O : T H E C O N T R O L E N V I R O N M E N T s i t u a t i o You are a audit maager for Coutit & Co, a firm that has recetly gaied two ew audit cliets of a similar size. Your audit staff have completed their prelimiary ivestigatios of the two cliets. You are reviewig their otes which ca be summarised as follows: Cliet 1 - Floggers Ltd Floggers Ltd is a old-fashioed family compay which has bee i busiess for over a hudred years ad trades as wholesalers of fruit ad vegetables. Its maagemet structure is divided ito five layers ragig from supervisor, deputy maager, maager, seior maager ad director. The seior maagers ad directors have bee with the compay for may years. Each level of maagemet has clear authority limits set dow i the compay maual, which also sets out detailed writte procedures for every job.

27 6 8 a u d i t i g t u t o r i a l Maagemet at all levels geerally has a uforgivig attitude to errors ad iefficiecies. Most of the systems are paper-based, although the accoutig ledgers are maitaied o a computer ad there are rigid systems of authorisatio before trasactios ca be processed. Staff turover i clerical posts ad at supervisor ad deputy maager level is high. Cliet 2 - Creatit Ltd Creatit Ltd is a ew compay set up six moths ago. It trades as a website desig busiess ad as a advertisig agecy. Creatit Ltd is ru by two brothers who maage the busiess joitly. Creatit Ltd mostly employs creative people but it does have a small clerical staff to deal with billig ad time recordig. The approach to work is casual, spotaeous ad rather ucotrolled. Error detectio is ot see as a priority. The maagemet s view is that they will deal with errors ad problems whe they arise. Staff are happy ad so staff turover is low. r e q u i r e d I your review of the cotrol eviromet for each of these cliets, what coclusios would you draw about the risk of error arisig i the accouts? s o l u t i o Floggers Ltd The key poits are as follows: Floggers has very rigid systems with a high level of iteral cotrol where error detectio is see as a priority ad mistakes are ot tolerated the seior maagemet of Floggers is separated from the day-to-day activities of the busiess by several layers of admiistrative hierarchy Floggers has a high level of staff turover which may idicate that staff have a low level of commitmet to the compay followig o from the poit above there is a higher risk that frequet mistakes could be made by ew, utraied staff there may be a temptatio for staff to hide mistakes because of the attitude of the maagemet

28 p l a i g t h e a u d i t a s s i g m e t 6 9 Floggers maagemet may take a egative approach to the audit ad see it as a itrusio ito their busiess Creatit Ltd The key poits are as follows: Creatit has a much more hads o approach to maagemet ad a more forgivig attitude to errors; their priority is the product rather tha the accouts Creatit s fiacial systems will cotai little i the way of formal iteral cotrol checks, but maagers are much more aware of what is happeig o a day-to-day basis as they are actively ivolved i the compay the low level of staff turover idicates that the employees are loyal to the busiess ad have a strog commitmet to the compay Your coclusios from a audit poit of view are: 1 Providig the systems at Floggers are workig correctly there would be very little likelihood of mistakes beig made whe recordig trasactios i the fiacial systems. The risk is more likely to be trasactios which are ot beig recorded at all. Cosequetly the audit approach would focus o omissios rather tha errors. 2 The busiess that Floggers operates ivolves processig large umbers of trasactios of easily idetifiable goods. Their systems have bee i existece for years which meas that the risk of postig errors ca be assessed as low. 3 As far as Creatit is cocered, the fiacial statemets may well cotai errors or omissios ad the lack of formal procedures might give cause for cocer. However, the close ivolvemet of the maagemet ad the commitmet of the staff to the orgaisatio would idicate that they will take a positive approach to the audit rather tha see it as a itrusio. 4 The trade of Creatit is project work which carries a higher level of audit risk. Your estimate is that the cotrol eviromet i both compaies is geerally good, although the focus of your audit work i each busiess will differ. C O N T R O L A C T I v I T I E S A N D P R O C E D U R E S ISA 315 Idetifyig ad assessig the risks of material misstatemet through uderstadig the etity ad its eviromet states: Cotrol activities are the policies ad procedures that help to esure maagemet directives are carried out Cotrol activities, whether withi IT or maual systems, have various objectives ad are applied