Chapter 9: Audit procedures

Chapter learning objectives

When you have completed this chapter you will be able to:

• Explain the assertions contained in the financial statements;
• Provide examples of procedures used to audit specific balances;
• Discuss and provide examples of how analytical procedures are used as substantive procedures;
• Apply audit techniques to small and not-for-profit organisations; and
• Discuss the problems associated with the audit and review of accounting estimates.

1 General principles

We dealt with the principles of audit evidence in an earlier chapter. This chapter deals with the application of those principles.

It is a starting point to help you familiarise yourself with the basic auditing techniques to allow you to apply them to questions. It is not an exhaustive summary of all audit tests, this would simply not be possible in one volume.

2 Financial statements assertions

The objective of audit testing is to assist the auditor in coming to a conclusion as to whether the financial statements are free from material misstatement.

However, the auditor does not simply design tests with the broad objective to identify material misstatement. This is a difficult conclusion to reach and can only be based upon a series of detailed tests, each designed with a specific testing objective relating to certain areas of the financial statements.

For example: auditors have to assess whether inventory balances are free from material misstatement. Unfortunately, there are many ways inventory could be misstated:

• items could be missed out of inventory;
• items from the next accounting period could be accidentally included;
• it might not be valued at the lower of cost and net realisable value;
• damaged or obsolete stock might not be identified;
• purchase cost may not be recorded accurately; or
• the stock count may not be performed thoroughly.

Each of these concerns could result in misstatement, which ultimately could (alone or in aggregate) be material.

For this reason auditors have to perform a range of tests on the significant classes of transaction, account balances and disclosures to be reasonably sure that they are not misstated. These tests focus on what are known as financial statements assertions:

Occurrence – did the transactions and events recorded actual occur and pertain to the entity?

Completeness – have all transactions, assets, liabilities and equity interests been recorded that should have been recorded?

Accuracy – have amounts, data and other information been recorded and disclosed appropriately?

Cut-off – have transactions and events been recorded in the correct accounting period?

Classification and understandability – have transactions and events been: recorded in the proper accounts; and described and disclosed clearly?

Existence – do assets, liabilities and equity interests exist?

Rights and obligations – does the entity hold or control the rights to assets and are liabilities the obligations of the entity?

Valuation and allocation – are assets, liabilities and equity interests included in the financial statements at appropriate values?

Linking assertions to tests

When the auditor designs further audit procedures they must ensure that they test a range of the assertions listed. For transactions (i.e. incomes and expenses recorded in the income statement) the auditor should test:

• occurrence;
• completeness;
• accuracy;
• cut-off; and
• classification

For accounts balances (i.e. those balances recorded on the statement of financial position) the auditor should test:

• existence;
• rights and obligations;
• completeness; and
• valuation and allocation.

Whilst the testing of accounts balances and transactions will probably be the focus of the audit, the auditor must also design tests to ensure that transactions, balances and other relevant information/matters are appropriately disclosed in the financial statements. Assertions relevant to the disclosures are:

• occurrence;
• rights and obligations;
• completeness;
• classification and understandability; and
• accuracy and valuation.

To assist your studies and simplify this process consider the following four questions that an auditor needs to answer when approaching testing:

(1)Should items be in the accounts at all? (occurrence, existence, rights and obligations, cut-off).

(2)Are they included at the right value? (accuracy, valuation).

(3)Are there any more? (completeness).

(4)Are they disclosed properly? (classification, allocation, understandability).

A further warning

In the sections that follow, we will consider specific audit areas and suggest how these are usually tested. You may be tempted to learn these tests and repeat them 'parrot fashion' in the exam. This would be unwise. Audit procedures are designed to reflect the unique risks of an audit and the nature of items and assertions under scrutiny. You must always try and make your answers specific to any scenarios presented in the exam. This requires both knowledge and application skills.

3 The audit of receivables

Key assertions

• Existence – the receivable actually exists;
• Rights and obligations – the company has rights to receive the benefit from receivables;
• Valuation and allocation – receivables are included in the financial statements at the correct amount, including provisions for bad and doubtful debt;
• Completeness â€“ all receivables relating to the period have been accounted for; and
• Classification and understandability – receivables (including provisions) are appropriately disclosed in the financial statements.

Audit procedures

Existence

• Perform a receivables circularisation ( a direct confirmation from external sources - see below).
• Select a sample of receivables and trace amounts due to the original sales invoice to confirm that a transaction has taken place;

Rights and obligations

• Receivables circularisation;
• Select a sample of receivables and confirm the trade terms to original credit agreements and sales invoices.

Valuation and allocation

• Inspect the ageing profile of receivables to identify any significant, long outstanding balances that may require a provision.
• Analytically review the ageing profile in comparison to previous periods to identify any deterioration in credit control.
• Inspect post year-end cash book/bank statements and trace payments received to year-end receivables to confirm that amounts were indeed collectable.
• Discuss the results of the ageing and cash receipts analysis with management to identify if any further provisions are required for old, unpaid balances.
• Discuss the assumptions underlying any general provisions with management to ensure they are appropriate.
• Recalculate the provision based on management’s assumptions and agree to the figure in the financial statements.
• Inspect invoices relating to prepaid balances, agree cost to calculations made.
• Inspect bank statements to confirm prepaid amounts have been paid.

Completeness

• Obtain a list of receivables balances, cast this and agree it to the receivables control account total at the end of the year. Differences should be reconciled.
• Perform a receivables circularisation.
• Inspect receivables ledger for credit balances and obtain explanations from management.
• Inspect a sample of the last five to ten goods despatched notes immediately prior to the year-end. Trace these through to year-end receivables to ensure they have been recorded.

Classification and understandability

• Inspect the draft financial statements and agree the receivables figures and disclosures to nominal ledger balances.

Also note the effect of directional testing, e.g. directly testing receivables for overstatement also indirectly tests revenue for understatement (Dr: Receivables, Cr: Revenue).

Receivables circularisations

If successful, circularisations provide evidence directly from the receivables themselves. These are considered to be reliable because they are external, third party confirmations. Circularisations are also written and original.

Procedure

• Select a sample of receivables to be circularised and notify client of those selected;
• Extract details of each receivable from the relevant ledger and prepare letters. This should state the balance outstanding at the year-end and include a reply slip for receivables to confirm the balance;
• Ask the chief accountant at the client (or other responsible official) to sign the letters;
• The auditor posts or faxes the letters to the individual receivables;
• Receivables complete the reply slips, confirming the amounts they owe the client at the year-end, and post them directly to the auditor; and
• The auditor investigates any disagreement by receivables.

Considerations

Whilst circularisations are undoubtedly a useful and efficient tool for providing good quality evidence, their success does depend on response rates. It must be remembered that the audit client's customers are under no obligation to reply and, for this reason, responses may be limited. If the response rate is poor then other forms of evidence must be sought. To maximise the response rate auditors should ensure:

• Letters are sent out as soon as possible after the year-end;
• That the outstanding balance is clearly displayed and all that receivables have to do is confirm whether this is correct or not;
• A reply slip is attached to minimise the work of the receivable; and
• Pre-paid return envelopes are supplied.

Example confirmation letter

Customer Ltd

Customer’s address

Date of circularisation

Dear Sirs

As part of their normal audit procedures we have been requested by our auditors, Auditor & Co, to ask you to confirm the balance on your account with us at 31 December 2009, our year-end.

The balance on your account, as shown by our records, is shown below. After comparing this with your records will you please be kind enough to sign the confirmation and return a copy to the auditor in the prepaid envelope enclosed. If the balance is not in agreement with your records, will you please note the items making up the difference in the space provided.

Please note that this request is made for audit purposes only and has no further significance.

Your kind co-operation in this matter will be greatly appreciated.

Yours faithfully

Auditor & Co

Auditor’s address

Dear Sirs

We confirm that, except as noted below^×, a balance of $10,000 was owing by us to Client Limited at 31 December 2009.

(space for customer's signature)

^×Details of differences:

4 The audit of inventories

Key assertions

• Existence – does the inventory recorded actually exist?
• Completeness â€“ have all inventory balances been recorded?
• Rights and obligations – does the company have the rights to receive the benefits from inventories?
• Valuation and allocation – are inventories valued appropriately (i.e. at the lower of cost and net realisable value and net of any provisions for damaged and slow moving goods)?
• Cut-off – are inventory movements around the year-end recorded in the correct period?
• Classification and understandability – are inventories (including provisions) appropriately disclosed in the financial statements?

The inventory count

Principles

• A typical inventory count happens at the year-end, although continuous counting is possible throughout the year.
• The purpose of the count is to confirm that the quantities of inventory recorded on the client's system are accurate.
• Whilst the count is being performed items that are damaged and/or obsolete should be identified for either scrapping or sale at a discounted price.
• From an audit perspective, attendance at the count helps provide evidence regarding the existence, completeness and valuation of inventory balances.
• Inventory counting is the responsibility of the client. The auditor merely attends the count to help gather evidence to form an opinion regarding whether inventory is free from material misstatement or not.

Inventory counting procedures

Before the count

• Obtain the client's counting instructions and review them for obvious flaws in the counting process. This may also help identify if there are any significant or risky elements of inventory that require special attention, or even precautions.

During the count

• Observe the count as it proceeds to ensure:
  • the counting instructions are being followed
  • all items are being counted and recorded
  • there is no risk of double counting
  • evidence of damaged or slow moving goods is being recorded
  • deliveries and despatches are not being made during the count
  • count recording sheets are being properly controlled (i.e. pre-numbered and filled in with ink).
• Conduct test counts, on a suitable sample selection basis, as follows:
  • select a sample of items from the inventory records and physically observe the items on the warehouse floor to prove the items exist.
  • select a sample of physical items from the warehouse floor and trace them to the inventory records to ensure that the latter is complete.
• Record cut-off information by obtaining details of the last deliveries and despatches prior to the year-end. These will then be traced to inventory records during final audit procedures.

Continuous inventory systems

The procedures suggested above apply to all inventory counts, whether as a one-off, year-end exercise or where inventory is counted on a rolling basis throughout the year. The objective is the same:

• To identify whether the client's inventory system reliably records, measures and reports inventory balances.

Where the client uses a continuous counting system lines of inventory are counted periodically (say monthly) throughout the year so that by the end of the year all lines have been reviewed. There are both advantages and disadvantages of this for the auditor.

Advantages

• The auditor is less time constrained and can pick and choose particular locations and inventory lines to count at any time to ensure the system is reliable.
• Slow moving and damaged inventory should be identified and adjusted for in the client's records on a continuous basis therefore, thus improving the valuation at the year-end.

Disadvantages

• The auditor will need to gain sufficient evidence that the system operates effectively at all times, not just at the time of the count.
• Additional procedures will need to be devised to ensure that the year-end inventory total is reliable, particularly with regard to cut-off and year-end provisions/estimates.

Inventory held at third parties

• Where the client has inventory at locations not visited by the auditor, the auditor normally obtains confirmation of the quantities, value and condition from the holder. The auditor needs to consider whether the holder is sufficiently independent to be able to provide relevant, reliable evidence.
• As with confirmations from receivables, the auditor requests details from the party holding the inventory on behalf of the client to confirm its existence.
• The confirmation request will be sent by the client to those parties identified by the auditor.
• The reply should be sent directly to the auditor to prevent it being tampered with by the client.
• Problems can occur if the third party uses a different description to that of the client and as always, a response is not guaranteed.

Final audit procedures

Completeness

• Obtain an inventory list showing each line of inventory categorised between finished goods, WIP and raw materials. Cast the list to ensure it is arithmetically correct. Make sure the totals agree to amounts disclosed in the financial statements.
• Trace the items counted during the inventory count to the final inventory list to ensure it is the same as the one used at the year-end and to ensure that any errors identified during counting procedures have been rectified.

Cut-off

• Trace the GRN's from immediately prior to the year-end (identified during the count) to year-end payables and inventory balances.
• Trace the GDN's from immediately prior to the year-end (identified during the count) to the nominal ledgers to ensure the items were removed from inventory prior to the year-end and have been recorded in receivables prior to the year-end.

Presentation and disclosure

• Inspect the financial statements and ensure that the figures disclosed agree to the audited nominal ledger balances and that inventories have been correctly analysed between finished goods, raw materials and work in progress.

Valuation

• Trace a sample of inventory items back to original purchase invoices to agree their cost.
• Trace a sample of inventory items to post-year-end sales invoices to determine if the appropriate cost or net realisable value has been used.
• Inspect the ageing of inventory items to identify any old/slow moving amounts that may require provision.
• Trace the above items to any inventory provisions and, if they have not been provided, discuss the reason with management.
• Recalculation of work in progress and finished goods using payroll records for labour costs and utility bills for overhead absorption.
• Calculate inventory turnover/days and compare to last year to assess whether inventory is being held longer and therefore requires greater provisions.
• Calculate gross profit percentage and compare to prior year to identify any significant fluctuations that may indicate either error or changes in inventory holding policies.

5 The audit of payables, accruals, provisions and contingent liabilities

Key assertions

• Existence – the payables actually exist;
• Rights and obligations – the company has obligations to settle all payables;
• Valuation and allocation – payables are included in the financial statements at the correct amount;
• Completeness â€“ all payables relating to the period have been accounted for.
• Classification and understandability – all payables are appropriately disclosed in the financial statements.

Completeness is usually the key consideration when testing payables due to the timing and nature of the items included. Provisions and accruals accounting do offer an opportunity for creative accounting to manipulate reported profits. Auditors therefore have to consider indicators that additional liabilities may exist, such as:

• payables not including known major suppliers and those accrued for in the prior year;
• payables not including the significant suppliers from the equivalent list last year;
• traditionally recurring accruals not being made, e.g.: rent, utilities, telephone, etc.
• expected finance accruals not being made, e.g.: hire purchase, mortgages, loans etc.
• non-provision of tax balances, including: corporation tax, payroll taxes, sales taxes, etc.
• suppliers revealed only after a review of payments after the year-end; and
• suppliers revealed by a review of unpaid invoices at and after the year-end.

Classification and understandability

• Inspect financial statements to ensure that all liabilities from the nominal ledger have been adequately and accurately disclosed.

Existence

• Circularise a sample of trade payables to confirm the balance at the end of the year (this is uncommon and would only be performed in the absence of supplier statements).
• Inspect year-end statements of accounts sent by suppliers. Any differences between the statement and the nominal ledger should be reconciled.
• Trace a sample of payable/accruals balances to purchase invoices and/or contracts. In particular identify the date of receipt of the invoice and any evidence of payment (such as signatures).

Completeness

• Cast the payables ledger to ensure its accuracy.
• Inspect year-end statements of accounts sent by suppliers. Any differences between the statement and the nominal ledger should be reconciled.
• Investigate any major (by value of purchases in the year) or known regular suppliers that were shown on last year's payables listing but do not have a balance showing in this year's list of balances.
• Enquire of management why the above suppliers do not feature in this year's payables list.
• Inspect after date payments in the cash book and bank statements and ensure they have been provided for at the year-end, as appropriate.
• Perform analytical procedures on the list of payables, such as: payables days, payables as a percentage of purchases, monthly payables levels. Investigate any unusual variances.
• Compare the purchase ledger control account to the list of payables. Reconcile any variations.
• Inspect the list of balances for debit balances. Discuss results with management.

Cut-off

• Select a sample of GRN's raised immediately prior to the year-end and trace them through to year-end payables.
• Likewise, select a sample of GRN's raised immediately after the year-end and trace them to the nominal ledger to ensure they have been recorded in the next accounting period.

Again, note the effect of directional testing, e.g. directly testing payables for understatement also indirectly tests expenses/cost of sales for understatement (Dr: Expenses/Cost of sales, Cr: Payables).

Supplier statements

Companies may send out monthly statements of account as part of their credit control procedures. Therefore it is likely that audit clients will receive a number of these statements from suppliers at the year-end. These can be reconciled to their own payables control account to ensure that their records are correct. This is known as a supplier statement reconciliation and is an important source of audit evidence. Like most statements sent through the post there are a number of reasons why there may be variances:

(1)Timing differences:

• Invoices sent by the supplier but not yet received by the client.
• Payments sent by the client but not yet received by the supplier.
• Returns and credit notes not yet appearing on the supplier’s statement.

(2)Errors

• Supplier errors that will remain as part of the reconciliation until the supplier corrects them.
• Client errors, which the client needs to adjust.

Auditors can inspect or reperform the supplier statement reconciliations to ensure the completeness, existence and valuation of payable balances. They are a reliable source of evidence because they are produced by the suppliers, who are (usually) independent, external sources (but note suppliers may be related parties/intergroup companies, and therefore not independent).

Accruals

• Inspect invoices received after the year-end that relate to services provided before the year-end. Trace them to any accruals made to ensure completeness and accuracy of the amounts.
• Obtain the list of accruals from the client, cast it to confirm arithmetical accuracy.
• Agree the figure per the schedule to the general/nominal ledger and financial statements
• Recalculate a sample of accrued costs by reference to contracts and payment schedules (e.g. loan interest).
• Analytically review in comparison to previous period to try and identify if any balances are perhaps missing.

Tax balances

• Corporation/Profits taxes – agree to tax computations.
• Payroll taxes – agree to payroll records.

Overdrafts, loans, etc.

• Agree to bank letter confirmation of outstanding amounts.

Leases, hire purchase

• Agree details to underlying agreement/contracts and recalculate interest amounts and the split between current and non-current.

Loan payables

• Agree the year-end loan balance to any available loan statements to confirm obligations, existence and valuation.
• Agree interest payments to the loan agreement and the bank statements.
• Analyse relevant disclosures of interest rates, amounts due (e.g. between current and non-current payables) to ensure complete and accurate.
• Recalculate the interest accrual to ensure arithmetical accuracy.

Provisions and contingencies

Provisions are a form of payable where the amount or timing of payment is uncertain. As such they are harder to audit.

Where the likelihood of payment is only possible, rather than probable, no amounts will be entered in the accounts. However, the matter (contingent liability) must be adequately disclosed.

• Discuss the matter giving rise to the provision with the client to verify whether an obligation exists.
• Obtain confirmation from the clients lawyers as to the possible outcome and probability of having to make a payment.
• Review subsequent events. By the time the final audit is taking place the matter may have been settled.
• Obtain a letter of representation from the client as the matter is one of judgement and uncertainty (see 'Completion' chapter for further discussion).
• Recalculate the provision if possible, e.g. warranty provisions for repairs.

6 The audit of bank and cash

Key assertions

• Existence – cash and bank balances actually exist;
• Rights and obligations – the company has rights to receive the benefit from those balances;
• Valuation and allocation – balances are included in the financial statements at the correct amount;
• Completeness – all balances have been accounted for.
• Classification and understandability – balances are appropriately disclosed in the financial statements?

The bank letter

• This is a direct confirmation of bank balances from the bank that gives the auditor independent, third-party evidence.
• The format of the letter is usually standard and agreed between the banking and auditing professions.
• Issues covered are:
  • the client’s name
  • the confirmation date
  • balances on all bank accounts held
  • any documents or other assets held for safekeeping
  • details of any security given
  • details of any contingent arrangements – guarantees, forward currency purchases or sales, letters of credit.
• The auditor needs the client to give the bank authorisation to disclose the necessary information (in some jurisdictions such disclosures are illegal so bank letters cannot be used at all).
• Ensure that all banks that the client deals with are circularised.
• The balances for each account should be agreed to the relevant bank reconciliation at the year end;
• Details of loans should be agreed to the disclosure in the statement of financial position as either current or non-current.

Example bank confirmation letter

Manager (Audit Confirmations)
National Bank Anytown Branch
High Street, Anytown
AT1 1HS

1 January 20X1

Dear Sir,

Re: Blakes Co.

In accordance with the agreed practice for provision of information to auditors, please forward information on our mutual client as detailed below on behalf of the bank, its branches and subsidiaries. This request and your response will not create any contractual or other duty with us.

Company name: Blakes Co.

Main account number: 01789311

Sort code: 4-83-12

Information required

• Derivative and commodity trading
• Custodian arrangements
• Other information (see attached)

Audit confirmation date: 31/12/X0

The Authority to Disclose Information signed by your customer is already held by you. This is dated 30/08/X0. Please advise us if this Authority is insufficient for you to provide full disclosure of the information requested.

The contact name is: James Hodges (Audit Partner)
Telephone: 01234 123456

Yours Faithfully,

Whites & Harper Inc.

Bank and cash – other evidence

• Obtain a list of all bank accounts, cash balances and bank loans and overdrafts and agree to totals to figures included in current assets and current liabilities in the financial statements.
• Obtain a copy of the client's bank reconciliation, cast and agree the balances to the cash book and bank letter.

Example bank reconciliation

Bank reconciliation as at 31 December 20X0

• Trace all outstanding lodgements and unpresented cheques to pre-year-end cash book and post-year-end bank statements.
• Ensure all accounts in the bank letter are included in the financial statements.
• Ensure bank loans and overdrafts are not offset against positive bank balances in the financial statements.
• Count the petty cash in the cash tin at the end of the year and agree the total to the balance included in the financial statements.

Presentation and disclosure

• Inspect the draft financial statements and ensure that amounts are disclosed correctly as either assets (positive balances) or liabilities (overdrafts) and that the amounts recorded agree to the nominal ledger.

7 The audit of tangible non-current assets

Key assertions

• Existence – assets actually exist;
• Rights and obligations – the company has rights to receive the benefit from those assets;
• Valuation and allocation – assets are included in the financial statements at the correct amount;
• Completeness – all assets have been accounted for.
• Classification and understandability – assets are appropriately disclosed in the financial statements?

Existence

• Select a sample of assets from the non-current asset register and physically inspect them.

Completeness

• Select a sample of assets visible at the client premises and inspect the asset register to ensure they are included.
• Examine the repairs and maintenance accounts in the general ledger for large and unusual items that may be capital in nature. These should be included in the statement of financial position, not expenses.

Valuation

• Cast the non-current asset register to ensure arithmetical accuracy.
• Recalculate the depreciation charge for a sample of assets.
• Analytically review depreciation charges in comparison to the prior year.
• Perform a proof in total by adjusting the prior year figure for all additions, disposals and revaluations and then calculating total depreciation based upon this figure.
• Compare depreciation methods and policies in comparison to the previous year to ensure consistency.
• If any assets have been revalued during the year:
  • agree new valuation to valuer’s report
  • verify that all assets in the same class have been revalued
  • reperform depreciation calculation to verify that charge is based on new carrying value.
• When physically inspecting assets, take note of their condition and usage in case of impairment.
• For a sample of asset additions, agree the cost to purchase invoices (or other relevant documentation).
• If any assets have been constructed by the company, obtain analysis of costs incurred and agree to supporting documentation (timesheets, materials invoices, etc.).

Rights and obligations

• For a sample of recorded assets, obtain and inspect ownership documentation:
  • title deeds for properties
  • registration documents for vehicles
  • insurance documents may also help to verify ownership (and asset values).
• Where assets are leased, inspect the lease document to assess whether the lease is operating or finance (if the latter, the asset should be included on the company’s statement of financial position).

Disclosure

• Agree opening balances with prior year financial statements.
• Compare depreciation rates in use with those disclosed.
• For revalued assets, ensure appropriate disclosures made (e.g. name of valuer, revaluation policy).
• Agree breakdown of assets between classes with the general ledger account totals.

8 The audit of share capital, reserves and directors' remuneration

Directors' remuneration is a key audit area as it is invariably material by nature.

Key assertions

• Existence – do share capital balances and reserves actually exist;
• Rights and obligations – the company has obligations regarding equity balances;
• Valuation and allocation – equity is included in the financial statements at the correct amount;
• Completeness – all equity balances, directors' remuneration and other transactions with directors have been accounted for.
• Classification and understandability – relevant disclosures have been made in the financial statements, particularly with regard to directors' remuneration.

Share capital

• Agree authorised share capital and nominal value disclosures to underlying shareholding agreements, such as company memorandums, articles of association and lists of registered members;
• Inspect cash book for evidence of cash receipts from share issues;
• Inspect terms of share certificates and reconcile to cash receipts and new share capital totals;
• Inspect board minutes to identify if any dividends have been declared prior to the year-end;

Directors' remuneration

• Reconcile reported directors' salaries to payroll records;
• Inspect board minutes for evidence of directors' bonus announcements;
• Reconcile directors' bonuses to cash payments in the cash book;
• Inspect board minutes for approval of related party transactions;
• Obtain a written representation from directors that they have disclosed all related party transactions and director remunerations to the auditor.

Reserves

• Reconcile closing profit reserves to: opening reserves, profit for the year and dividend paid and proposed during the year;
• Compare opening reserves to closing reserves reported in the prior year's financial statements;
• Reconcile movements in revaluation reserves to the non-current asset register;
• Corroborate revaluations by comparing to independently produced reports.

9 Accounting estimates

Accounting estimates are of particular concern to the auditor as, by their nature, there may not be any physical evidence to support them and they are prone to inaccuracy. They are also subjective and therefore prone to management bias. If the directors wished to manipulate the accounts in any way, accounting estimates are an easy way for them to do this. The auditor must take care when auditing estimates to ensure this has not been the case.

In accordance with ISA 540 Auditing Accounting Estimates auditors need to obtain an understanding of:

• How management identifies those transactions, events and conditions that give rise to the need for estimates; and
• How management actually makes the estimates, including the control procedures in place to minimise the risk of misstatement.

ISA 540 also requires the auditor to:

• Evaluate the degree of uncertainty associated with an accounting estimate; and
• Consider if estimates with a high degree of uncertainty give rise to significant risks.

In response to this assessment auditors should perform the following further procedures:

• Review of the outcome of the estimates made in the prior period (or their subsequent reestimation);
• Consider events after the reporting date that provide additional evidence about estimates made at the year-end;
• Test the basis and data upon which management made the estimate (e.g. review mathematical methods);
• Test the operating effectiveness of controls over how estimates are made;
• Develop an independent estimate to use as a point of comparison; and
• Consider whether specialist skills/knowledge are required (e.g. lawyer).

Smaller entities

Smaller commercial entities will usually have the above attributes. This can lead to both advantages and disadvantages:

• Lower risk: Smaller entities may well be engaged in activity that is relatively simple and therefore lower risk. However, this will not be true for small – often one person businesses – where there is a high level of expertise in a particular field, e.g. consultancy businesses, creative businesses, the financial sector.
• Direct control by owner managers is a strength because they know what is going on and have the ability to exercise real control. They are also in a strong position to manipulate the figures or put private transactions ‘through the books’.
• Simpler systems: Smaller entities are less likely to have sophisticated IT systems, but pure, manual systems are becoming increasingly rare. This is good news in that many of the bookkeeping errors associated with smaller entities may now be less prevalent. However, a system is only as good as the person operating it.

Evidence implications

• The normal rules concerning the relationship between risk and the quality and quantity of evidence apply irrespective of the size of the entity.
• The quantity of evidence may well be less than for a larger organisation.
• It may be more efficient to carry out 100% testing in a smaller organisation.

Problems

• Management override – Smaller entities will have a key director or manager who will have significant power and authority. This could mean that controls are lacking in the first place or they are easy to override.
• No segregation of duties – Smaller entities tend to have few accounts clerks that processes information. To overcome this the directors should authorise and review the all work performed.
• Less formal approach – Smaller entities tend to have simple systems and very few controls due to the trust and the lack of complexity. It is therefore difficult to test the reliability of systems and substantive testing tends to be used more.

Not-for-profit organisations

Not for profit (NFP) organisations include charities and public sector entities. The most important differences from privately owned companies are that NFP entities:

• do not have profit maximisation as their main objective. These will be either social or philanthropic;
• do not have external shareholders; and
• will not distribute dividends.

Potential problems auditing a NFP entity

Some NFP entities, particularly small charities, may have weaker systems due to:

• lack of segregation of duties, as the organisation will be restricted with the amount of staff;
• the use of volunteers, who are likely to be unqualified and have little awareness of the importance of controls;
• the use of less formalised systems and controls.

Significantly, with many charities, much of the income received is by way of donation. These transactions will not be accompanied by invoices, orders or despatch notes.

Assessing the going concern of a NFP entity may also be more difficult, particularly for charities who are reliant on voluntary donations. Many issues, such as the state of the economy, could impact on their ability to generate revenue in the short term.

Audit implications

Auditors of not for profit organisations will be required to assess whether the aims of the organisation are being met in an economic, efficient and effective manner. For this reason "value for money" audits are much more appropriate. These are discussed in more detail in the internal audit chapter.

Testing tends to concentrate on substantive procedures where control systems are lacking. In the absence of documentary evidence procedures rely heavily on analytical review, enquiry and management representation.

The volumes of transactions in not for profit organisations may be lower than a private one, therefore auditors may be able to test a larger % of transactions.

Ultimately, if sufficient appropriate evidence is not available the auditor will have to modify their audit report.

Test your understanding 1

List and explain FOUR assertions from ISA 315 Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and its Environment that relate to the recording of classes of transactions.

Test your understanding 2

List FOUR assertions relevant to the audit of tangible non-current assets and state one audit procedure which provides appropriate evidence for each assertion.

Test your understanding 3

(a)Define 'tests of control' and explain why they are an important procedure in the statutory audit of any company.

You are an audit senior working at a medium sized firm of auditors. One of your clients is an exclusive hotel called ‘Numero Uno’ situated in the centre of Big City. As part of your audit procedures you are assessing the controls surrounding payroll. You have read last year’s audit file and have obtained the following information:

The hotel employs both full and part time staff. Due to the nature of the business most of the work is done in shifts. All staff are paid on a monthly basis.

New members of staff are given an electronic photo identification card on the day they join by the personnel department. This card is used to ‘clock in’ and ‘clock out’ at the start and end of the shift to record the hours worked.

At the end of each week the information recorded on the system is sent automatically to the payroll department and also to the head of each of the three main operating divisions: Rooms, Food & Beverage and Corporate Events. Each division head must reply back to the payroll department by email to authorise the hours worked by their staff.

The payroll clerk collates all the authorised information and then inputs the hours worked into a standardised computerised payroll package. This system is password protected using an alphanumerical password that only the payroll clerk and the finance manager know.

Once the hours have been inputted, the calculations of gross pay and taxation are calculated automatically along with any other statutory deductions. At the end of the calculations a payroll report is produced and printed. The finance manager reviews the report and compares the data to last month to identify and follow up any unusual variances. When he is satisfied with the information he authorises the payroll run by signing the payroll report and the payroll clerk submits the data.

Payslips are sent to the home address of each employee and payment is made by bank transfer.

‘Numero Uno’ prides itself on delivering a first class dining experience and is renowned for its standards of service and cooking that few restaurants in the country come close to. Its inventory therefore consists of the very best foods and beverages from across the globe.

Food products held in inventory are mostly fresh as the head chef will only work with the very best ingredients. ‘Food’ inventory is stored in the kitchens and managed by the head chef himself.

The majority of beverages held at the hotel are expensive wines that have been sourced from exclusive vineyards. The hotel also stocks a wide range of spirits and mixers. All beverages are stored either in the hotel cellar or behind the bar. The cellar can only be accessed by the duty manager who holds the key. As part of your audit procedures you will attend the year end inventory count of the hotel’s beverages.

Required:

(b)With reference to the scenario:

(c)Describe the audit procedures an auditor would conduct before and whilst attending the inventory count of the beverages in the hotel.

(d)Identify and explain THREE financial statement assertions that are most relevant to inventory.

(e)Apart from attending the inventory count, describe the substantive procedures an auditor would carry out to confirm the valuation of the wine and spirits held in inventory at the year end.

Test your understanding 4

(a)Describe the steps an auditor should take when conducting a trade receivables confirmation (circularisation) test.

(b)Explain why a direct confirmation test may not provide sufficient appropriate audit evidence on its own.

You are the audit manager in charge of the audit of Builders Mate, a limited liability company. The company’s year end is 31 March, and Builders Mate has been an audit client for three years. Builders Mate sells small tools, plant and equipment exclusively to the building trade. They have 12 warehouse style shops located throughout the country. Builders Mate does not manufacture any products themselves.

The audit fieldwork is due to commence in 3 weeks time and you are preparing the audit work programme for the trade receivables section of the audit. Extracts from the clients trial balance show the following information.

From your review of last year’s audit file you have determined that last year there were 2 specific provisions of $5k and $2k as well as a 3% general provision.

Initial conversations with the client indicate that there are no specific provisions that are to be made this year however they intend to reduce the general provision from 3% to 2%.

You are aware that two of Builders Mate’s major customers went into administration during the year and they are likely to be liquidated in the near future. Both of these customers owed material amounts at the year-end.

Required:

(c)Describe substantive procedures the auditor should perform on the year-end trade receivables of Builders Mate.

(d)Describe how audit software could facilitate the audit of trade receivables.

10 Chapter summary

Test your understanding answers

Test your understanding 1

Assertions: classes of transactions

• Occurrence: The transactions and events that have been recorded have actually occurred and pertain to the entity.
• Completeness: All transactions and events that should have been recorded have been recorded.
• Accuracy: The amounts and other data relating to recorded transactions and events have been recorded appropriately.
• Cut-off: Transactions and events have been recorded in the correct accounting period.
  Classification. Transactions and events have been recorded in the proper accounts.

Test your understanding 2

Tangible non-current assets: assertions

• Completeness: ensure that all non-current assets are recorded in the non-current asset register by agreeing a sample of assets physically verified back to the register.
• Existence: ensure non-current assets exist by taking a sample of assets from the register and physically seeing the asset.
• Valuation and allocation: ensure assets are correctly valued by checking the reasonableness of depreciation calculations.
• Rights and obligations: ensure the company owns the asset by seeing appropriate document of ownership for example, a purchase invoice.
• Presentation and disclosure assertions: ensure all necessary financial statements disclosures have been made by reviewing the financial statements.

Test your understanding 3

(a)Tests of control

A test of control tests the operating effectiveness of controls in preventing, detecting or correcting material misstatements.

It is important for the external auditor to test controls to ensure their initial understanding obtained when assessing the control environment and internal controls is appropriate.

This will allow the auditor to identify and assess the risks of material misstatements in the financial statements and to determine to what extent to rely on the internal control system during the audit.

The auditor will then be able to design sufficient and appropriate substantive audit procedures to reduce detection risk, and therefore audit risk, to an acceptable level.

(b)Payroll system strengths and tests of control

Strengths in the control environment at the hotel in respect of payroll are set out below including the test of control to be performed by the auditor.

(c)Procedures before the count

• Review prior year working papers to understand the inventory count process and identify any issues that would need to be taken into account this year.
• Contact Numero Uno (client) to obtain stocktaking instructions for this year to understand how the count will be conducted and assess the effectiveness of the count process. 
• Book audit staff to attend the inventory count.
• Ascertain whether any inventory is held by third parties and if applicable determine how to gather sufficient audit evidence. 
• Consider the need for using an expert to assist in valuing the inventory being counted. There may be some speciality wines and spirits that require expert valuation.

• Observe the count to ensure that the instructions are being followed.
• Inspect the bottles being counted for evidence of damage or obsolescence that may affect the net realisable value and hence overall valuation of inventory.
• Perform a test count. Select a sample of beverages from the inventory count sheets and physically observe the items in the cellar or bar to confirm they exist.
• Perform a test count. Select a sample of physical beverages from the cellar or bar and trace to the inventory count sheets to ensure that they are recorded accurately and therefore that the records are complete.
• Record cut off information by obtaining details of the last deliveries prior to the year end. This information will be used in final audit procedures to ensure that no further amendments have been made thereby overstating or understating inventory.

(d)Inventory assertions

(e)Substantive procedures

Quantity

• For the audit test counts performed during the inventory count trace and agree the quantities to the final inventory records to ensure the integrity of the data.

The beverages should be valued at the lower of cost and net realisable value.

• For a sample of beverages on the inventory records, trace the cost of those items to the original purchase invoice, ensuring that the description of goods on the invoice matches the beverage.
• For beverages sold to customers after the year end, check a sample of restaurant bills/invoices back to the final inventory records ensuring that the sales value exceeds the cost. Where sales value is less than cost, ensure that the beverage is stated at the realisable value.
• For high value items such as Champagne, vintage wine and exotic spirits use an expert valuer to review the net realisable value of a sample of items to ensure the value is reasonable.
• Inventory noted during the count as possibly obsolete or damaged should be traced to the inventory records to ensure the valuation has been adjusted to take this into account. The expert valuer may provide assistance with these valuations.

Test your understanding 4

(a)Trade receivables circularisation

Several steps should be performed by an auditor when performing a trade receivables circularisation audit test:

• Audit client approval should be obtained in advance to perform the direct confirmation test of trade receivables.
• The population for the sample should be determined and a suitable sample selected using an appropriate sampling technique.
• The confirmation letter should be designed and prepared for each receivable ensuring the contact details are correct and return details clearly state that the reply should be made direct to the auditor.
• A business reply envelope, addressed to the auditor, could be included for this purpose.
• The sending of letters, including any follow-up requests, should be controlled  and performed by the auditor to ensure the integrity of the test.
• Replies should be matched or reconciled to the audit client’s receivables accounting records.
• Alternative audit procedures will be required for all non-responses to the confirmation letter.

(b)Sufficiency of the evidence from a direct confirmation test.

Several factors influence the sufficiency of evidence gathered during a direct confirmation of trade receivables and other evidence may be required by an auditor to form an opinion in this area:

• There is often a low response rate from trade receivables meaning that other audit procedures will be required for these balances.
• The type of confirmation letter, whether a positive or negative confirmation request, will influence the sufficiency of evidence gathered. Negative confirmations provide less persuasive audit evidence than positive confirmations and it is unlikely that a negative confirmation will provide sufficient evidence on its own.
• The reliability of the responses to the confirmation requests may be in doubt for example if there is a risk of fraud being perpetrated.
• Mistakes and errors may be present in the accounting records of the trade receivables confirming the balance outstanding.

(c)Substantive procedures for trade receivables.

• Trace and agree the receivables balances on the trial balance to Builders Mate’s accounting system and the draft financial statements.
• Confirm the trade receivables control account balance matches the sum of the individual trade receivables ledger accounts.
• For a sample goods dispatched notes around the year-end trace to the sales invoice and ledger accounts to ensure that the transactions have been recorded in the correct accounting period.
• Cast a sample of trade receivable ledger accounts to confirm arithmetical accuracy.
• Select a sample of individual trade receivables and perform a direct confirmation test using a positive confirmation letter.
• For non-responses to the direct confirmation test confirm cash has been received post year-end for the outstanding amounts.
• Cash receipts recorded in the trade receivables ledger account should be traced and agreed to their remittance advice as well as the cash book and bank statements.
• Recalculate the general provision based on the 2% figure to ensure arithmetical accuracy.
• Discuss with the Builders Mate management why the general provision has reduced from 3% to 2% and assess the reasonableness of the explanations provided.
• Obtain or prepare an aged receivables analysis to identify aged debts that may require a specific provision. Discuss with management any such balances and ensure specific provisions are made if appropriate.
• Trace and confirm that the specific provisions made in the prior year were either written off or the cash was recovered in the current accounting period.
• Discuss with management the reason for not making specific provisions for the two customers in administration who owe material amounts at the year-end.
• Consider and discuss with management the potential implications of failing to make specific provisions on the audit opinion.
• Compare a sample of individual trade receivables to their prior year balance and investigate any unusual or unexpected changes between the balances.

(d)Audit software

Audit software can be used to improve the effectiveness and efficiency of the audit process of trade receivables.

• Audit software can be used to prepare an aged receivables analysis and to identify potential irrecoverable debts using a range of criteria set by the auditor.
• It can analyse the receivables ledger for credit balances or negative balances.
• Audit software will be more efficient and accurate at casting and recalculating figures, totals and balances such as the general provision or casting of the receivables ledgers.
• It could also select a sample for testing and prepare direct confirmation letters.

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