Course Module

Auditing - II

Addis Ababa, Ethiopia

December, 2020

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Auditing II Acct. 412

Table of Contents
Contents Pages
Unit 1: Overview of Auditing 2

Unit 2: The Auditing Profession 10

Unit 3: Auditing Principles and Tools 20

Unit 4: The Auditing Process 32

Unit 5: Auditors’ Reports 44

Unit 6: Computer Audit 53

Unit 7: Cash Audit 58

Unit 8: Receivables /Sales Audit 68

Unit 9: Inventory/Purchase Audit 75

UNIT 1: OVERVIEW OF AUDITING

1.0 AIMS AND OBJECTIVES

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When you have studied this unit you should be able to:
 describe what auditing is.
 describe the nature of financial statement audits.
 explain why audits are demanded by society.
 describe the various types of audits and types of auditors.

1.1 INTRODUCTION

Auditing II develops the knowledge of Auditing I by:

- Extending the basic awareness of professional codes to a detailed
understanding of rules of professional conduct.
- Introducing computer audit.
- Critically evaluating procedures and reports.
- Introducing the audit of cash, receivables and sales, and inventory and
purchases.
1.2 DEFINITION AND BASIC FEATURES OF AUDITING

Auditing is the accumulation and evaluation of evidence about information to determine

and report on the degree of correspondence between the information and established
criteria. Auditing should be done by a competent and independent person.

Auditing enable the auditor to express opinion whether the financial statements are
prepared, in all material respects, in accordance with an identified financial reporting
framework. This framework (criterion) might be generally accepted accounting
principles (GAAP), or the national standard of a particular country.

Financial statements include balance sheet, income statement, statement of cash flow,
notes and explanatory material that are identified as being part of financial statements.
The phrases used to express the auditor’s opinion are that the financial statements ‘give a
trued and fair view’ or ‘present fairly in all material respective’.

Note that the auditor does not certify the financial statements or guarantee that the
financial statements are correct, he reports that in his opinion they give a ‘true and fair
view’, or present fairly’ the financial position.

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1.3 DEMAND FOR AUDIT

There is a need for auditing when ownership is separated from control. At a practical
level, it helps prevent or detect misstatements-errors or fraud. It may prevent or detect
misstatements on the part of (1) the employees who actually handle the money, or (2)
management. Auditing is needed to enhance the credibility of financial information
prepared by an entity. The independent audit requirement fulfils the need to ensure that
those financial statements are objective, free from bias and manipulation and relevant to
the needs of users.
Check Your Progress Exercise – 1
Why auditors cannot provide absolute assurance?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……….

1.4 ACCOUNTING VS AUDITING

Accounting is the collecting (recording, classifying), summarizing, reporting and

interpreting of financial data.

Auditing is the testing of those accounting records for fairness, appropriateness. An

accountant only needs to know generally accepted accounting principles (GAAP). The
auditor needs to know GAAP, plus how to select and evaluate evidence related to the
assertions of financial statements.

Accounting is constructive. It starts with the raw financial data to process and produce
financial statements.

Auditing on the other hand is analytical work that starts with financial statement to lend
credibility and fairness of the measurements.

1.5 TYPES OF AUDITS AND AUDITORS

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A. Types of Audits
Audits are often viewed as falling into three major types:
(1) Audits of financial statements,
(2) Operational audits, and
(3) Compliance audits.

1. Audits of financial statements: - The goal is to determine whether the financial

statements have been prepared in conformity with generally accepted accounting
principles.
2. Operational audits: - An operational audit is study of some specific unit of an
organization for the purpose of measuring its performance. The operation of a unit
can be evaluated for its effectiveness and efficiency.
3. Compliance audits: - Compliance audit determines whether the specified rules,
regulations, or procedures are being carried out or followed.

B. Types of Auditors
The most known types of auditors are
1. Independent auditors,
2. Internal auditors,
3. Government auditors.

1. Independent (external auditors): - Independent auditors have no connection to the

firm as an owner or employee/manager. The basic task of independent auditor is to
confirm to the owners that the employees are correctly reporting on their financial
position and performance.

2. Internal auditor: - An internal auditor is paid salary as employee on the organization

that is being audits. He/she is responsible to appraise and investigation the performance
of unit and/or units within the organization and give recommendation to top management.

3. Government audit: - The government auditor is paid a salary by the government.

He/she is responsible to the legislature or executive.

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Check you Progress Exercise – 2
What is the contribution of internal auditor in the audit of annual financial statements?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……….

1.6 THE NATURE OF EXTERNAL AUDITING IN ETHIOPIA

In Ethiopia audits seem to be done primary on account of government regulation. For

example, NGOS are audited because the assets of the NGOS are deemed a “national
asset,” the use of which is ultimately accountable to the government of Ethiopia.

Auditing in Ethiopia could be viewed in five main areas.

1. The office of the auditor general (OAG)
The powers and functions of the office of the OG are circumscribed through the
proclamations that established it, its sphere of activity lies in government audit.
2. The audit service corporation. The duty and functions of this entity involve
mostly commercial audits of commercial and productive enterprises wholly or
partially owned by government.
3. Private audit firms.
4. Ministry of finance audit and inspection.
Auditing activity in this area includes audit of ministries and government departments by
MF auditors and inspectors, including tax audit by Inland Revenue authorities.
5. State corporations’ and enterprises’ auditors.
These are audits performed by internal auditors within enterprise.

1.7 SUMMARY

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This unit should have given you good understanding on the nature of the audit. The
objectives of an audit have also been covered and need to borne in mind at all times. It
has also covered the three major types of audits and auditors. It has dealt with the basic
areas of auditing in Ethiopia.

1.8.GLOSSARY

- Audit of financial statements: Examination of financial statements to determine

that the statements are in conformity with specified criteria, usually GAAP.
- Auditing: A systematic process of objectively obtaining and evaluating evidence
regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and communicating
the results to interested users.
- Compliance Audit: An audit that attempts to measure the degree to which an auditee
complies with some predetermined criteria.
- Government Auditors: Auditors employed by government entities.
- Independent auditors Certified public accountants who have an audit practice and
offer auditing services to the public.
- Internal Auditors: Full-time employees of private organizations who conduct audits
for the organization.
- Operational Audit: An audit that measures the effectiveness and efficiency of an
organization.

1.9 ANSWER TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise – 1

Auditors can provide only reasonable assurance. They cannot provide absolute assurance
due to the inherent limitation of auditing principles and standards, inherent limitations of
accounting principles, use of samples in auditing, and the existence of human error.

Check Your Progress Exercise – 2

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The contribution of internal auditor in the audit of annual financial statements is to assist
the external auditors.
1.10 MODEL EXAM QUESTIONS

Part I. Short Answer

(a) Give a definition of an audit, and explain the basic features of auditing.
(b) What is the principal use and significance of auditing to users of financial statements?

Part II. Multiple Choices

1. How does an independent audit aid in the communication of economic data?
a) It confirms the accuracy management’s financial representations.
b) It lends credibility to the financial statements.
c) It guarantees that financial data are fairly presented.
d) It assures the readers of financial statements that any fraudulent activity has been
corrected.
2. What is the essence of the external audit function?
a) To detect fraud
b) To examine individual transactions so that the auditor may certify their validity.
c) To determine whether the client’s financial statements are fairly stated.
d) To assure the consistent application of correct accounting procedures.
3. Primary purpose of an operational audit is to provide:
a) means of assurance that internal control structure is functioning as planned.
b) a measure of management performance in meeting organizational goals.
c) The results of internal audits of financial and accounting matters to a company’s
top-level management.
d) aid to the independent auditor who is conducting the audit of the financial
statements.
4. Compared to the eternal auditor, what is more likely to concern an intern auditor?
a) Fairness of the financial statements c) Management policies and procedures
b) Cost accounting procedures d) Generally accepted accounting
principles.
5. Which of the following criteria is unique to the auditor’s function?

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 a) General competence
b) Familiarity with the particular industry of which the client is a part.
c) Due professional care d) Independence.

UNIT 2: THE AUDITING PROFESSION

2.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
o understand independence in fact and in appearance.
o understand the AICPA code of professional ethics.

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 o define the major legal concepts that relate to auditors’ liability.
o describe the auditor’s responsibility for the detection of fraud and error.

2.1 Introduction

This unit covers the basic codes of professional conduct, which the auditors need to bear
in mind in carrying out their duties. The main source of material for code of professional
conduct in this unit is the AICPA’s code of professional ethics.

This unit also covers the duties and legal liabilities of auditors.

Broadly defined, the term ethics represents the moral principles or rules of conduct
recognized by an individual or group of individuals. Ethics apply when an individual has
to make a decision from various alternatives regarding moral principles.
2.2 INDEPENDENCE

The AICPA code of professional conduct requires a member in public practice to be

independent in the performance of professional services as required by standards
promulgated by bodies designated by council.

The requirement is stated in terms of “standards promulgated by bodies designated by

council” to conveniently permit inclusion or exclusion of independence requirements for
certain types of services provided by CPA firms. For example, independence is required
for audits of annual financial statement but a CPA firm can do tax return and provide
management services without being independent. Independence in auditing means an
unbiased viewpoint in the performance of audit test, the evaluation of results, and the
issuance of the audit report.

Independence has two distinct aspects. First, the public accountants must in fact be
independent toward any enterprise they audit. Second, the relationships of public
accountants with audit clients must be such that they will appear independent to third
parties.

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Independences in fact refers to the auditor’s ability to maintain unbiased and impartial
mental attitude or state of mind in all aspects of work. As such independence in fact is
not subject to objective measurement and therefore can be judged only by the auditor.

Independence in appearance refers to the auditor’s freedom from conflict of interest,

which third parties may infer from circumstantial evidence.

The following paragraphs illustrate some of the common situations, which may impair
independence.

 Investment interest in audit client: - An auditor’s investment in shares, bonds,

mortgage, and notes of an audit client or its associates, either direct or indirect, may
impair independence. In this situation, an auditor may be in a position to issue an
opinion or to influence the client’s financial statements for personal financial gains at
the expense of his/her capacity as auditor. Such an investment is not limited to the
auditor but also applies to his or her immediately family and to partners and their
immediate families.
 Non audit functions and services: - Certain functions are incompatible with the
auditing function. These include functioning as a director, officers or employee of an
audit client. The auditor’s involvement in these functions and services creates a
conflict of interest.
 Litigation between CPA firm and client: When there is a lawsuit or intent to start a
lawsuit between a CPA firm and its client, the ability of the CPA firm and client to
remain objective is questionable.
 Hospitality or goods and services: - This will affect independence unless it is
modest.

 Undue dependence on income: - If the amount of income from a client is very large
as compared to the total annual income of the audit firm, independence will be
impaired since the auditors want to maintain this financial interest.

2.3 PROFESSIONAL QUALIFICATION REQUIREMENTS

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A professional accountant should perform professional services with due care,
competence and diligence and has a continuing duty to maintain professional knowledge
and skill at a level required to ensure that a client or employer receives the advantage of
competent professional service based on up-to-date development in practice, legislation
and techniques.

Auditing standards require auditors to have adequate educational requirement as well as

other moral and legal criteria fulfillment. The educational requirements are composed of
theoretical knowledge and practical experience.

2.4 PROFESSIONAL ETHICS

All recognized professions have developed codes of professional ethics. Professional

ethics refer to the basic principles of right action for the member of a profession.
Professional ethics may be regarded as a mixture of moral and practical concepts. Thus
the professional ethics of an accountant would signify his behavior towards his fellows in
the profession and other professions and towards members of the public.

The fundamental purpose of such codes is to provide members with guidelines for
maintaining a professional attitude and conducting themselves in a manner that will
enhance the professional stature of their discipline.

The AICPA code of professional conduct considers the following to be followed by

auditors (accountants) in the conduct of professional relations with others.

- Integrity: - An accountant should be straightforward, honest and sincere in his

approach to his professional work.
- Objectivity: - An accountant should be fair and should not allow bias to override his
objectivity. When reporting on financial statements, which come his review, he
should maintain an impartial attitude.
- Independence: - When in public practice, an accountant should both be and appear
to be free of any interest which might be regarded, whatever its actual effect, as being
incompatible with integrity and objectivity.

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- Confidentiality: - A professional accountant should respect the confidentiality of
information acquired in the course of his work and should not disclose any such
information to a third party without specific authority or unless there is a legal or
professional duty to disclose.
- Technical standards: - An accountant should carry out his professional work in
accordance with the technical and professional standards relevant to that work.
- Professional competence: - An accountant has a duty to maintain his level of
competence throughout his professional career. He should only undertake works,
which he or his firm can expect to complete with professional competence.
- Ethical behavior: - An accountant should conduct himself with a good reputation of
the profession and refrain from any conduct, which might bring discredit to the
profession.
- Contingent fess: - The AICPA code of professional conduct prohibits a CPA firm
from rendering any professional services on a contingent fee basis.
- Responsibilities to colleagues: - The auditor should promote cooperation and good
relations with other members of the profession.
- Advertising: - The advertising should not be false or misleading,” should not
contravene “professional good taste,” should not make “unfavorable reflection on the
competence or integrity of the profession,” and should not” involve a statement the
contents of which” cannot be substantiated.
Check Your Progress Exercise – 1
1. What is the basic purpose of a code of ethics for a profession?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……….
2. Who makes the ultimate decision as to whether or not auditors maintain an
appearance of independence from their audit clients?
a. auditors
b. client
c. audit committee

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 d. public
3. In which of the following situations would a CPA firm be in violation of the rules of
professional conduct in determining it fess?
a. A fee based on whether or not the auditor’s report leads to the approval of the
client’s application for a bank loan.
b. A fee to be established at a later date by the court due to the bankruptcy of the
client.
c. A fee base on the nature of engagement rather than upon the actual time spent
on the engagement.
d. A fee based on the fee charged by the client’s former auditors.

2.5 LEGAL RESPONSIBILITY AND LIABILITY OF AUDITORS

The auditor is responsible for his report. The auditor then has certain duties to fulfill to
the users of the financial statements that he reports on.

Responsibilities impose liabilities if things go wrong.

Liable for what?
The CPA can be sued under the following legal concepts.
(i) Prudent man concept: - The auditor is responsible for exercising due
professional care, and he is subject to lawsuit if he fails to do so.
(ii) Liable for acts of others: - The partners are jointly liable for civil actions
against a partner.
(iii) Lack of privileged communication: - CPAS do not have the right under
common law to withhold information from the courts on the grounds that the
information is privileged.
Definition of Terms
Negligence: is violation of legal duty to exercise a degree of care that an ordinary
prudent person would exercise under similar circumstances with resultant damages to
another party.

Gross negligence: is lack of event slight care. Many jurisdictions consider gross
negligence equivalent to constructive fraud.

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Fraud: is defined a misrepresentation by a person of a material fact, known by that
person to be untrue.
Constructive fraud: differs from fraud as defined above in that constructive fraud does
not involve a misrepresentation with the intent to deceive.

Privity: is the relationship between parties to a contract.

Breach of contact: is failure of one or both parties to a contract to perform in accordance
with the contract’s provisions.
Proximate cause: exists when damage to another is directly attributable to a wrongdoer’s
act.

Contributory negligence: is negligence on the part of the client that has contributed to his
or her having incurred a loss.A. Auditors’ liability to their clients
When CPAS take on any type of engagement, they are obliged to render due professional
care. This obligation exists whether or not it is specifically set forth in the written
contract with the client. Thus, CPA S are liable to their clients for any losses proximately
caused by the CPA’S failure to exercise due professional care. That is to recover its
losses, an injured client need only prove that the auditors were guilty of negligence and
that the auditors’ negligence was the proximate cause of the client’s losses.

B. Auditors’ liability to third parties

Bankers and other creditors or investors who utilize financial statements covered by an
audit report can recover damages from the auditors if it can be shown that the auditors
were guilty of fraud or gross negligence in the performance of their professional duties.

Moreover, the auditors can be held liable for negligence to a limited class of third parties
if the auditors have actual knowledge of such third parties or if there exists a special
relationship between the auditors and the third parties.

The clients (plaintiffs) must prove that they sustained losses, that they relied on the
audited financial statements, which were misleading, that this reliance was the primate
cause of their losses, and that the auditors were negligent.

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C. Auditors’ responsibility for the detection of fraud and error
The detection and prevention of error and fraud is the management’s responsibility by
designing and implementing appropriate internal control systems. The auditor is not
responsible for the prevention and detection of error and fraud. The auditor is
responsible to design audit procedures to reduce the risk of not detecting a material error
or fraud, to an appropriate level to provide reasonable assurance. Accordingly, the
auditor must exercise due care in planning, performing, and evaluating the results of audit
procedures.

Check Your Progress Exercise – 2

1. A CPA firm will be liable for any fraudulent scheme it does not detect.
a) true
b) false
2. A CPA firm will not be liable if it can show that it exercised the ordinary care and
skill of a reasonable man in the conduct of its own affairs.
a) true
b) false

2.6 SUMMARY

Independence and confidentiality are very important principles which have given rise to
detailed rules by the AICPA.

The determination of the extent to which auditors should be legally responsible for the
reliability of financial statements is relevant to both the profession and society. Clearly
the existence of legal responsibility is an important deterrent to the inadequate and even
dishonest activities of some auditors.

2.7 GLOSSARY

Ethics: The moral principles or rules of conduct recognized by an individual or particular

group of individuals.
Fraud : A Knowing intent to deceive.

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Gross negligence: Fragrant negligence that is tantamount to a reckless departure from
the standard of due care.
Privity: A contractual relationship.

2.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress Exercise – 1

1. The basic purpose of a code of ethics is to provide members with professional attitude
and maintain the confidence of users.
2. d 3. a

Check Your Progress Exercise – 2

1. b 2. b

2.9 MODEL EXAM QUESTIONS

Part I. Short Answer

1. Auditors must not only to be appear independent; they must also be independent in
fact.
Required
(a) Explain the concept of an “auditor’s independence” as it applies to third-party reliance
upon financial statements.
(b) What determines whether or not an auditor is independent in fact?
(c) Explain how an auditor may be independent in fact but not appear to be
independent.
2. How does the prudent man concept affect the liability of the auditor?
3. What is meant by “contributory negligence”? Under what conditions will this likely
to be a successful defense?

Part II. Select the Best Answer

1. The CPA should not undertake an engagement if the fee is based upon which of the
following?
a) The findings of a taxing authority.

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 b) A percentage of audit net income
c) Per diem rates.
d) Rates set by a city ordinance.
2. In a common law action against an accountant, the lack of privity is a viable defense
if the plaintiff:
a) is a creditor of the client who sues the accountant for negligence.
b) can prove the presence of gross negligence, which amounts to a reckless
disregard for the truth
c) is the accountant’s client.
d) bases his action on fraud.

UNIT 3: AUDITING PRINCIPLES AND TOOLS

3.0 AIMS AND OBJECTIVE

When you have studied this unit you should be able to:
 be aware of basic auditing principles.
 be aware of planning issues for an audit.
 state the typical contents of working papers.
 describe sampling as applied to auditing.

3.1 INTRODUCTION

The objectives of each audit must be clearly specified in order to ensure appropriate goal
achievement. Appropriate auditing principles and standards should be developed by
auditors to direct the objectives.

Audit planning is a vital area of the audit which is primarily conducted at the beginning
of the audit process.

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This unit also considers the basic contents of audit working papers and audit sampling.

3.2 AUDIT OBJECTIVES

The objective of the ordinary examination of financial statements by the auditor is

expression of an opinion on the fairness of the financial statements. It is customary in the
audit to identify audit objectives for the audit in general and for each account reported in
the financial statements. These objectives are derived from management’s assertions.

The auditor’s objectives are closely related to management assertions. Audit objectives
are intended to provide a framework to help the auditor accumulate sufficient and
competent evidence required by the third standard of fieldwork and decide the proper
evidence to accumulate given the circumstances of the engagement.

A distinction must be made between general audit objectives and specific audit objectives
for each account balance. The general audit objectives discussed here are applicable to
every account balance but stated in broad terms. Specific audit objectives are applied to
each account balance on the financial statement.

The relevance of the audit evidence should be considered in relation to the general audit
objectives of statements. To achieve this objective the auditor needs to support the
following financial statement assertions (i.e. assertions by management embodied in the
financial statements).
1. Existence: - an asset or liability exists at a given date. Auditors spend a great
deal of time on this assertion confirming the existence of assets such as
inventories, plant assets, receivable, and cash. Clearly this is a fundamental
assertion; no other assertion is relevant if the asset or liability does not exist.
2. Completeness: - there are no unrecorded assets or liabilities, transaction or
events.
3. Occurrence: - a transaction or event occurred during the relevant accounting
period (i.e. has correct cut-off been applied?).
4. Measurement: - a transaction or event is recorded at the proper amount and in
the correct period.
5. Ownership: - an asset pertains (i.e. belongs) to the entity.
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 6. Valuation: - the asset or liability is recorded at an appropriate carrying value.
7. Presentation and disclosure: - must be in accordance with the relevant
legislation and accounting standards (i.e. the applicable financial reporting
framework).

After the general objectives are understood, specific objectives for each account balance
on the financial statements can be developed.

Check Your Progress Exercise-1

1. What are assertions and what are the seven classifications of assertions?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……….

3.3 AUDITING PRINCIPLES

Auditing principles are generally, guidelines that help direct or chart goals and aims.
Principles are based on concepts or assumptions, and/or developed from particular
observations. The following are the basic principles:

(a) Integrity, objectivity and independence. The auditor should be

straightforward, honest, and sincere in his approach to his professional work.
(b) Confidentiality: - the audit should respect the confidentiality of information
acquired in the course of his work and should not disclose any such information
to a third party without specific authority unless there is legal or professional duty
to disclose.
(c) Skills and competence: - the audit should be performed and the reports prepared
with due professional care by persons who have adequate training, experience
and competence in auditing.
(d) Documentation: - the auditor should document matters which are important in
providing evidence that the auditor was carried out with the basic principles.
(e) Planning: - the auditor should plan his work to enable him to conduct an
effective audit in efficient and timely manner.
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 (f) Audit evidence: - the auditor should obtain sufficient appropriate audit evidence
through the performance of compliance and substantive procedures to enable him
to draw conclusion there from and give opinion on the financial statements.
(g) Accounting system and internal control: The auditor should gain or
understanding of the accounting system and related internal controls to determine
the nature, extent, and timing of audit procedures.

3.4 AUDIT STANDARDS

Standards are authoritative rules for measuring the quality of performance. The existence
of generally accepted auditing standards is evidence that auditors are very concerned with
the maintenance of a uniformly high quality of audit work by all independent public
accountants.
The 10 GAAS are stated in their entirety as follows:

General standards
1. The examination is to be performed by a person or persons having adequate technical
training and proficiency as auditor.
2. In all matters relating to the assignment, an independence in mental attitude is to be
maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the examination and
the preparation of the report.

Standards of fieldwork
1. The work is to be adequately planned and assistants, if any, are to be properly
supervised.
2. The auditor should obtain a sufficient understanding of the internal control structure
to plan the audit and to determine the nature, extent and timing of tests to be
performed.
3. Sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and confirmation to afford a reasonable basis for an opinion
regarding the financial statements under examination.

Standards of reporting
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1. The report shall state whether the financial statements are presented in accordance
with generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period.
3. Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect than an opinion cannot be
expressed.

Keep in mind, however, that these standards represent the minimum requirements for all
audit engagements.

Check Your Progress Exercise -2

What three categories are GAAS divided into?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………

3.5 AUDIT PLANNING AND AUDIT PROGRAM

The first standard of fieldwork states:

“The work is to be adequately planned, and assistants, if any, are to be properly

supervised.”
The concept of adequate planning includes investigating a prospective client before
deciding whether to accept the engagement, obtaining an understanding of the client’s
business operations, and developing an overall strategy to organize, coordinate, and
schedule the activities of the audit staff.

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In planning the audit the auditor needs to consider the following:
1. The terms of the engagement and the expected date of the report.
2. The nature of the client’s business, include applicable statutory and contractual
requirements.
3. The experience gained during previous audit engagements.
4. The accounting policies and degree of complexity of the accounting system.
5. Materiality and the components of audit risk.
6. Any involvement of other auditor.
7. Any involvement of internal auditors and persons having special expertise.
8. The intended reliance on internal control.
9. The level of experience and the number of audit staff for the engagement.
10. The timing and effectiveness of performing of the audit procedures
(a) Client acceptance
The auditors should investigate the history of the prospective client, including such
matters as the identities and reputations of the directors, officers, and major shareholders,
its financial statements and audit report.
Sources of information
 Communication with predecessor auditors.
 Make enquiries of other third parties (e.g. banker.).
 Consult the client’s legal cousel.

(b) Obtaining the engagement

After the auditors have collected the necessary information on the potential client, they
will be in a position to assess the various risk involved with the audit and determine
whether to attempt to obtain the engagement. Often they will be asked to submit a
proposal which will include information on the nature of services that the firm will offer,
the qualification of the firm’s personnel, and other information to convince the
prospective client to select the firm.

Fee arrangement: when the business engages the services of independent public
accountant, it will usually ask for an estimate of the cost of the audit.

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Engagement letter: The preliminary understandings with the client should be
summarized by the auditors in an engagement letter, making clear the nature of the
engagement, any limitations on the scope of the audit, work to be performed by the
client’s staff, schedule dates for performance and completion of examination, and the
basis for computing the auditors’ fee.

(c) Obtaining an understanding of the client’s business.

After the engagement is accepted, the auditors must obtain a detailed understanding of
such factors as the client’s financial position and operating results, organization structure,
product lines, and methods of production and distribution. This will help auditors to
evaluate the appropriateness of the accounting principles in use or the reasonableness of
the many estimates and assumptions embodied in the client’s financial statements.
(c) Developing an overall audit strategy
(d) After obtaining knowledge of the client’s business, the auditor should formulate
an overall audit strategy for the upcoming engagement. The best audit strategy is
the approach that results in the most efficient audit.
In planning an audit, the auditors must consider carefully the appropriate levels of
materiality and audit risk.

Materiality: In planning the audit, auditors should design their audit procedures to avoid
wasting time searching for immaterial misstatements that cannot affect their report.

Audit risk: The term audit risk refers to the possibility that the auditors may unknowingly
fail to appropriately modify their opinion on financial statements that are materially
misstated.
In developing an audit plan, the auditors must consider factors that affect audit risk.

(e) Audit plans

The planning process is documented in the audit working papers through the presentation
of audit plans, audit programs, and time budget. An audit plan is an overview of the
engagement, outlining the nature and characteristics of the client’s business operations
and the overall audit strategy. A typical audit plan includes the following:

24
 1. Description of the client’s company-its structure, nature of business, &
organization.
2. Objectives of the audit.
3. Nature and of extent of other services.
4. Timing and scheduling of audit work.
5. Work to be done by the client’s staff.
6. Staffing requirement during the engagement.
7. Target dates for completing major segments of the engagement.
8. Preliminary judgment about materiality and risk levels for the
engagement.

(f) Designing audit programs

An audit program is a detailed list of audit procedures to be performed in the course of
the examination. An audit program is designed to accomplish certain objectives with
respect to each major account in the financial statements. These objectives follow
directly from the assertions that are contained in the client’s financial statements.

3.6 AUDIT WORKING PAPERS

Working papers are records kept by the auditor of the procedures applied, the test
performed, the information obtained, and the pertinent conclusions reached in the audit.
For example, when samples are takes for audit tests, the items drawn must be recorded
and computations must be made.

Working papers provide:

 The principal support for the auditor’s report.
 A means for coordinating and supervising the audit, and.
 Evidence that the audit was made in accordance with GAAS.

Working papers normally include the audit plan and programs, documentation of the
auditor’s understanding of the internal control structure, the assessed level of control risk,
account analyses explaining the composition of account balances, reconciliation of
related records, letters of confirmation and representation, recommended journal entries if

25
necessary to correct the accounts, and trial balances and other schedules that summarize
the contents of other working papers.

3.7 AUDIT SAMPLING

1. Definition: Application of audit procedures to less than 100 % of the items within an
account balance or class of transactions to obtain and evaluate audit evidence about
some characteristic of the items selected in order to form or assist in forming a
conclusion concerning the population.

Sampling risk
Because the auditor dose not examine all the items in the population when applying audit
sampling, there is a risk that the conclusion that he draws will be different from that
which he would have drawn had he examined the entire population. This is ‘sampling
risk’.
The following are the basic factors affecting sample size:
 Population size.
 Standard deviation.
 Materiality.
 Reliability.

Statistical and non-statistical sampling

Statistical sampling involves the use of mathematical procedures, such as probability
theory to draw conclusions reached about the population. Non-statistical sampling
techniques rely on the auditors’ judgment to draw conclusions.
2. Constructing sampling.
The steps involved in sampling can be summarized as follows:
o Sample design: - when designing an audit sample, the auditor should consider the
specific audit objectives, the population from which the auditor wishes to sample,
and the sample size.
o Selection of the sample: - the auditor should select sample items in such a way
that the sample clan be expected to be representative of the population.
26
 o Evaluation of the sample: - having carried out, on each sample item; those audit
procedures that are appropriate to the particular audit objective, the auditor
should:
(a) Analyze any errors detected in the sample.
(b) Project the errors found in the sample to the population, and
(c) Reassess the sampling risk.
Check your progress Exercise -3
1. Define sampling risk.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………

3.8 SUMMARY

This is an important unit that covers the need for properly documented planning, risk
analysis, and the production of an overall audit plan and audit program.

Working papers are important as they record the various elements of audit evidence
obtained sampling is a necessary and valid means of forming conclusions on audit
evidence. The Sampling process involves sample design, selection of the sample, and
evaluation of the sample.
3.9 GLOSSARY

Client assertions: Explicit or implicit representations by management that are embodied

in the financial statements.
Working papers: The trial balances, checklists, programs, and other documentations that
compose evidence that the auditor has performed the audit in conformity with generally
accepted auditing standards.

3.10 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

27
Check Your Progress Exercise -1
Assertions are explicit or implicit representations by management that are embodied in
the financial statements. These financial statement assertions are completeness,
occurrence, measurement, ownership, valuation, and presentation and disclosure.

Check Your Progress Exercise -2

1. General standards
2. Standards of fieldwork
3. Standards of reporting.

Check Your Progress Exercise -3

1. Sampling risk is the that the auditor’s conclusion based on a sample may be different
from the conclusion he or she would reach if the test were applied to an entire
population.

3.11 EXAM TYPE QUESTIONS

Part I. Select the Best Answer

1. Which of the following should the auditors obtain form the prodecessor auditor
before accepting the engagement?
(a) Analysis of balance sheet accounts.
(b) Analysis of income statement accounts.
(c) All matters of continuing accounting significance.
(d) Facts that might bear on the integrity of management.
2. Which of the following is an element of sampling risk?
(a) Choosing an audit procedure that is inconsistent with the audit objective.
(b) Concluding that no material misstatement exists based on taking a sample that
includes no misstatements from a materially misstated population.
(c) Failing to detect an error an error on a document that has been inspected by an
auditor.
(d) Failing to perform audit procedures that are required by the sampling plan.

28
Part II. Short Answer
1. Financial statements contain certain broad assertions regarding the accounts and
classes of transaction included in the financial statements.
(a) Who makes the assertions?
(b) List and describe each of the assertions

UNIT 4: THE AUDITING PROCESS

4.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
o describe why auditors seek audit evidence
o explain audit evidence in terms of its competence and relative strength of
persuasiveness.
o indicate the factors that affect the sufficiency and competency of evidential
matter.
o explain the nature and purpose of audit working papers.

4.1 INTRODUCTION

29
When auditors are employed to express an opinion on the financial statements of an
entity, they must ensure that they have sufficient competent evidence on which to base
such an opinion. In this unit you will learn to answer the question what constitute
sufficient competent evidence.

Audit evidence is a fundamental concept in auditing. Audit evidence consists of

underlying accounting data and all corroborative information available to the auditor.
Both categories of evidential matter are required in making an audit in accordance with
GAAS.
The principal types of corroborating information areas follow:
Analytical evidence
Analytical evidence involves comparison of current period client data, such as total
revenues or return on assets, with expected values for the data based on (1) historical or
budgeted amounts for the client or (2) industry data.
The reliability of analytical evidence is dependent on the relevance of the comparable
data.
Documentary Evidence
Documentary evidence includes a wide variety source documents as well as such items as
minutes of board of director or executive committee meetings, lease agreements various
other contracts, and bank statements.
Confirmations
Confirmations constitute a special class of documentary evidence involving direct written
responses by knowledgeable third parties to specific requests for factual information.
Written representations
Written representations are signed statements by responsible and knowledgeable
individuals that bear on one or more of management’s assertions.
Mathematical evidence
Mathematical evidence results from recompilations by the auditor and comparison of
those results the client’s computations.
Oral evidence
During the audit, an auditor receives oral responses to numerous inquiries directed to
officers and employees of the client and others.

30
Physical evidence
Physical evidence is obtained from the physical examination or inspection of tangible
assets.

4.2 DOCUMENTS AND RECORD EXAMINATION

In the early stages of an audit, the external auditors must become familiar with many
aspects of the client’s business. For example, the auditors must obtain knowledge of the
client’s organization plan, financial structure, physical facilities, products, accounting
policies, and the control procedures. However, information about the internal activities
of the client is not in itself sufficient.
If this information is to be interpreted and evaluated in a proper perspective, the auditor
must also understand the business environment in which the client operates. The auditors
can gain considerable information about both the client’s business environment and
internal operations by examining the client’s general records. The term general records is
used to include the following categories:
1. Non-financial records
 Articles and certificates of corporations and bylaws
 Partnership contract
 Minutes of directors and shareholders’ meetings
 Contracts with customers and suppliers
 Contracts with officers and employees
 Government regulations directly affecting the enterprise
 Correspondence files
2. Financial records
 Income tax returns of prior years.
 Financial statements and annual reports of prior years.

3. Accounting records
 General ledger.
 General journal.

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Check Your Progress Exercise -1
1. Identify the two categories of evidential matter.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………
2. List the types of corroborative information that may be obtained in an audit.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………

4.3 AUDIT EVIDENCE

During financial statement audits, the auditors gather and evaluate evidence to form an
opinion on whether financial statements follow the appropriate criteria, usually GAAP.

Gathering sufficient appropriate audit evidence is the very essence of auditing. The third
standard of fieldwork states:

Sufficient appropriate evidence should be obtained by such means as inspection,

observation, enquiry, confirmation, computation and analysis, to afford a reasonable
basis to support the content of the report
4.3.1 Sufficient, Appropriate Evidence
The auditor’s judgment as to what constitutes sufficient appropriate evidence is
influenced by such factors as:
a. Materiality of the item.
b. Inherent risk and control risk considerations.
c. The experience gailed during previous audit examination as to the reliability of
the client’s records and representation.
d. The persuasions of the evidence.
e. Fraud or error while performing as audit procedures.

32
Check Your Progress Exercise -2
1. What are the three general records that the auditors can examine to obtain
understanding of the client’s internal activities and the business environment?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………
2. List three factors, which may influence the sufficiency and appropriateness of
evidence?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

4.3.2 Procedures to Obtain Evidence

Audit evidence is any information that corroborates or refutes an assertion. Here we will
briefly recap a number of audit procedures.
Physical examination: - means to review physical evidence of an asset. For example, the
auditors might physically examine plant equipment or inventory items to obtain evidence
as to their existence or condition.

Confirmation: - is the process of obtaining evidence by written, direct communication

with the debtor, creditor, or other party of the transaction.
Tracing: - is the proof establishing the completeness of transaction processing by
following a transaction forward through the accounting records.
Vouching: - is the process of establishing other accuracy of recorded transactions by
following a transaction back to supporting documents from a prior processing step.
Re-performance: - is the process of repeating a client activity.
Observation: - is the process of viewing a client activity. For example, the auditors may
observe the application of internal control procedures.
Inspection: - involves a reading or point – by – point review of a document or second.
For example, the auditors may inspect a loan agreement.

33
Reconciliation: - are used to establish agreement between two sets of independently
maintained but related records
Enquiries: - are questions directed toward appropriate client reasoned. The responses to
the question may be oral or in written.
Analytical procedures: - are evaluations of financial information made by a study of
expected relationships among financial and non-financial data.

Check Your Progress Exercise - 3

1. Define audit evidence.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

4.3.3 Sufficiency of Evidence

The term sufficient relates to the quantity of evidence the auditors should obtain. The
amount of evidence that is considered sufficient to support the auditor’s opinion is a
matter of professional judgment. However, the following considerations may be useful in
evaluating the sufficiency of audit evidence.
1. The amount of evidence that is sufficient in a specific situation varies inversely
with the appropriateness of evidence available. Thus, the more appropriate the
evidence, the less the amount of evidence that is needed to support the auditors’
opinion.
2. The need for audit evidence is closely related to the concept of materiality. The
more material a financial statement amount, the greater the need for more
evidence as to its validity.
3. As the relative risk associated with a particular engagement increases, the auditors
should require more evidence to support their opinion.
4.3.4 Appropriateness of Audit Evidence
The appropriateness of audit evidence refers to its quality or reliability. To be
appropriate, evidence must be both valid and relevant.

34
The competency (or reliability) of accounting records is directly related to the
effectiveness of the client’s internal controls. Strong internal controls enhance the
accuracy and reliability of the financial records.

The competency of corroborative information depends on many factors. The

considerations that have the widest applicability in audit are:
- relevance
- source
- timeliness
- objectivity

Several factors contribute to the quality of evidence, including the following:

1. When auditors obtain evidence from independent sources outside of the client
company, the reliability of the evidence is increased.
2. Strong internal control contributes substantially to the quality of accounting records
and other evidence created within the client organization.
3. The quality of evidence is enhanced when the auditors obtain information directly, -
that is, by first hand observation, correspondence, or computation, rather than by
obtaining the information second hand.

4.4 WORKING PAPERS

Working papers are vitally important tools of the auditing profession.

Working papers are the connecting link between the client's accounting records and the
auditors report. They document all of the work performed by the auditors and provide
the justification for the auditors’ report.

The documentation of audit evidence is provided in working papers. Working papers

provide
- The principal support for the auditor’s report.
- A means for coordinating and supervising the audit.
- Evidence that the audit was made in accordance with GAAS.

4.4.1 Functions of working Papers

35
Audit working papers assist auditors in several major ways: they
a) Provide a means of assigning and coordinating audit work;
b) Aid seniors, managers, and partners in supervising and reviewing the work of
assistants;
c) Provide the support for the auditors’ report;
d) Document the auditors’ compliance with GAAS; and
e) Aid in planning and conducting future audits of the client.
4.4.2 Confidential Nature of Working Papers
Much of the information gained in confidence by the auditors is recorded in their working
papers; consequently, the working papers are confidential in nature.
Since audit working papers are highly confidential, they must be safeguarded at all times.

4.4.3 Organization of the Working Papers

The auditors usually maintain two files of working papers for each client:
1) Current files for every completed examination and
2) A permanent file of relatively unchanging data.

4.4.4 Contents of Working Papers

Working papers would normally include the following matters:
 Information concerning the legal and organizational structure of the entity.
 Copies of important legal documents, agreements and minutes.
 Information concerning the industry, and economic environment.
 Evidence of the planning process.
 Evidence of the auditors’ understanding of the accounting and internal control
systems.
 Evidence of inherent and control risk asses ments.
 Analysis of transactions and balances.
 Analysis of significant ratios and trends.
 Details of procedures regarding components whose financial statements are
audited by other auditors.
 Copies of communications with other auditors, experts, and other third parties.
 Letters of representation by the client’s management.
36
  Copies of the approved financial statements and auditors’ reports.

Check Your Progress Exercise - 4

1. Which of the following is not a primary purpose of audit working papers?
a) To coordinate the examination.
b) To assist in preparation of audit report.
c) To support the financial statements.
d) To provide evidence of audit work performed.
2. Which of the following is the most persuasive evidence?
a) Information detained through inquiry direct from independent sourced audit the
client organization.
b) Information obtained through inquiry from the management the organization.
c) Evidence obtained by re-performing calculations and reconciliation made by the
client.
d) Evidence obtained by observing employment while performing their tasks..

4.5 SUMMARY

In this unit we have examined the matters relating to audit evidence. The financial
statements are explained in terms of the primary assertions management makes in them,
and these assertions are identified as the focal points of the auditors’ procedural evidence
gathering work. The unit closes with some basic points about the purpose,
confidentiality, and content of audit working papers.

37
4.6 GLOSSARY

Confirmation: A technique in which the auditors request a written response from a

specific third party about a particular item affecting the financial statements.
Current file: The working paper file that includes information relevant to an audit client
for a particular year.
Inquiry: A technique of asking questions to gather audit evidence.
Permanent file: The working paper file that includes information of continuing
relevance in performing recurring engagement for an audit client.

4.7 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your Progress Exercise -1

1. - Accounting data
- Corroborative information available to the auditor
2. Analytical evidence
- Documentary evidence
- Confirmations
- Mathematical evidence
- Oral evidence
- Physical evidence
Check Your Progress Exercise -2
1. Non-financial records, financial records and accounting.
2. Materiality of the item
- Inherent risk and control risk consideration
- The persuasiveness of the evidence
Check Your Progress Exercise -3
Audit evidence is any information that corroborates or refutes an assertion.
Check Your Progress Exercise -4
1. C 2. C
4.8 MODEL EXAM QUESTIONS

38
Part I. Choose the best answer
1. Which of the following is the least persuasive type evidence?
a. Bank statement obtained from the client.
b. Computation made by the auditor.
c. Pre-numbered client sales invoices.
d. Vendor’s invoice.
2. An auditor’s working papers should:
a. not be permitted to serves as a reference source for the client
b. not contain critical comments concerning management
c. show shat the accounting records agree or reconcile with the financial
d. be considered the primary support for the financial statements being audited .
3. The strongest criticism of the reliability of audit evidence that the auditor physical
observes is that:
a. the client may conceal items from the auditor
b. the auditor may not be qualified to evaluate the items observed
c. such evidence is too costly in relation to its reliability
d. the observation must occur at a specific time, which is often difficult to arrange

Part II. Give short answers for the following questions.

1. What are the factors that may influence the auditors’ judgement on the sufficiency
and appropriateness audit evidence?
2. “Audit papers are the property of auditors, who may destroy the papers, sell them or
give them away.” Criticize this quota

UNIT 5: AUDITORS’ REPORTS

5.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
 prepare audit reports to meet different specified situations.
 understand the basic elements of audit report.

39
  discuss and explain the concept of “true and fair”.

5.1 INTRODUCTION

The audit report is usually the only channel of communication between the shareholders
of the company whose financial statements have been subject to audit and the auditors.
As such the report acts as a bridge taking the large volume of information possessed by
auditors and conveying it to the shareholders in a much abbreviated form.

In order to convey information in a succinct form the audit report has become an
extremely formalized group of phrases, each of which has special significance.

5.2 THE AUDITORS’ STANDARD REPORT

For convenient reference, the auditors’ standard (unqualified) report is presented below.

Auditors’ report to the shareholders of XYZ

we have audited the accompanying balance sheet of the XYZ Company as of December
31, 19 x 1, and the related statements of income, retained earnings, and cash flows for
the year then ended. There financial statements are the responsibility of the company’s
management. Our responsibility is to express an opinion on those financial statements
based on our audit.

We conducted an audit in accordance with generally accepted auditing standards. Those

standards require that we plan and perform an audit to obtain reasonable assurance
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting policies used and
significant estimates made by management, as well as evaluating the overall financial
statements presentation. We believe that our audit provide a reasonable basis for our
audit opinion.

In our opinion, the financial statements give a true and fair view of (or present fairly in
all material respects) the financial position of the company as of December 31, 19 x 1

40
and the results of its operations and its cash flows for the year then ended in accordance
with GAAP.
ABC Auditors
Date
Address
This report contains the following important elements:
- Title: Auditing standards require that the report be titled and include the word
independent.
- Address: The audit report is addressed to the individual or group that engaged the
auditors.
- Introductory paragraph: - The first paragraph of the report does three things:
 Specifies the financial statements to which the report relates,
 Specifies the respective responsibilities of directors and auditors, and;
 It makes the simple statement that the auditor has done an audit.
- Scope paragraph: -The scope paragraph describes the nature of an audit. The scope
paragraph states the following:
 The auditors followed GAAS,
 The audit is designed to obtain a reasonable assurance about whether the
financial statements are free of material misstatements.
 The audit evidence accumulated and the auditor believes the evidence
accumulated was appropriate for the circumstances to express the opinion
presented.
- Opinion paragraph: The final paragraph in the standard report states the auditors’
conclusion based on the results the audit examination.
- Name of the audit firm.
- Audit report date. The appropriate data for the audit report is the one on which the
auditor has completed the most important auditing procedures in the field.

5.3 EXPRESSION OF AN OPINION

The auditors’ opinions when expressing an opinion on financial statements may be

summarized as follows:
41
 1. An unqualified opinion – standard report.
2. A qualified opinion.
3. An adverse opinion.
4. A denial opinion.
All significant reasons for the issuance of a qualified, adverse, or denial of opinion should
be set forth in a reservation paragraph between the scope and opinion paragraph.
Auditors must qualify their report whenever there are material deficiencies in the client’s
financial statements.

5.4 THE UNQUALIFIED REPORT

The unqualified report is used when the following conditions are met:
1. All statements - balance sheet, income statement, statements of retained earnings,
and statement of cash flows are included in the financial statement.
2. The three general standards have been followed in all respects on the
engagements.
3. Sufficient evidence has been accumulated.
4. The financial statements are presented in accordance with generally accepted
accounting principles.
5. There are no circumstances requiring the addition of an explanatory paragraph or
modification of the wording of the report.
In general, auditors express an unqualified opinion on the client’s financial statements
when there has been no material departure from GAAP and there have been no material
unresolved restrictions on the scope of their audit.
Under certain circumstances, however, auditors may add additional wording to the
standard report even though they are issuing an unqualified opinion. This additional
wording draws attention to certain statutory requirements or a specific matter. Another
modification of a standard audit report is the auditors’ emphasis of a matter regarding the
client’s financial statements. Emphasis of matter may require in the auditor’s unqualified
report (1) to highlight a matter regarding a going concern problem and (2) when there is a
significant uncertainty (other than going concern problem), the resolution of which is
dependent upon future events and which may affect the financial statements.
42
Check Your Progress Exercise - 1
Part I. Select the best answer
1. The auditors’ report should be dated as of the date the:
a) Report is delivered to the client.
b) Examination is substantially completed.
c) Fiscal period under audit ends.
d) Review of the working papers is completed.
2. An auditor’s responsibility to express opinion on the financial statements is
represented in the:
a) Introductory paragraph.
b) Scope paragraph.
c) Opinion paragraph.
d) Explanatory paragraph.
3. Assume that the opinion paragraph of an auditor’s report begins as follows: “with the
foregoing explanation, these financial statements present fairly” This is:
a) An unqualified opinion.
b) A denial opinion.
c) An except for opinion.
d) Adverse opinion.

5.5 QUALIFIED OPINIONS

Auditors may issue opinions other than unqualified opinion when (1) they do not agree
with the accounting principles used in preparing financial statements or when they
believe disclosures in the statement are inadequate; (2) a change in accounting principle
is not applied properly a as per GAAP, and is not adequately disclosed in the financial
statements; (3) there are limitations on scope of examination; and /or (4) there is major
uncertainty affecting a client’s business’.

A. Qualified opinion -except for: This is issued when there is a limitation of Scope;
or the auditor disagrees with an accounting treatment or disclosure. The opinion
states that except for the effects of some material departure from GAAP, or some

43
 material limitation in the scope of the auditors’ examination, the financial
statements are presented fairly.
The auditors’ reports should have a separate reservation paragraph disclosing the reasons
for the qualification.
B. Adverse opinion: This is a stronger form of ‘except for’ opinion – the
disagreement is so material that the financial statements as a whole are
misreading. When the auditors express an adverse opinion, they must have
accumulated sufficient appropriate evidence to support their unfavourable
opinion.

Whenever the auditors issue an adverse opinion, they should disclose in a separate
paragraph of their report the reasons for the adverse opinion and the principal effects of
the adverse opinion on the client company’s financial position and operating results.

Example, an audit report that included an adverse opinion might have an opinion
paragraph such as the one as follows:

In our opinion, because of the effects of the matters discussed in the preceding
paragraph, these financial statements do not present fairly the financial positions of the
company as at December 31, 19 x 1, and the results of its operations and cash flow
position for the year then ended, in accordance with generally accepted accounting
principles.

C. Denial of opinion. A denial (disclaimer) of opinion is no opinion. In an audit

engagement, a denial is required when very significant restrictions on the scope of
the audit preclude compliance with generally accepted auditing standards.

A very significant scope limitation may be caused by the client or by the timing of the
auditors’ appointment and their audit work or by factors beyond the control of the client
or the auditors, rather than by restrictions imposed by the client.

Summary of auditors’ reports

Materiality Type of report
of the issue

44
Not material
Unqualifi
ed
Departure from
GAAP scope limitation
Material
Qualified ‘except for’ qualified ‘except for’
Very
adverse denial
material

Check Your Progress Exercise – 2

1. Identify the four basic types of opinions that an auditor may issue.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………
2. What is meant by the term reservation?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………

5.6 SUMMARY

This unit covers the four basic types of audit opinions and explain when each is
appropriate. Depending on the circumstances, the auditor’s report may take one of the
following forms:(1) a standard report that contains an unqualified opinion, (2) a report
that contains an unqualified opinion with added explanatory language, or (3) a report that
expresses one of three other types of opinion-qualified ‘except for’, adverse or
disclaimer.

5.7 GLOSSARY

45
Adverse opinion: A type of opinion issued by an auditor that states that the financial
statements do not present fairly the financial position, results of operation, and cash flows
in conformity with generally accepted accounting principles.
Audit opinion: That part of the audit reports that presents the conclusions reached by the
auditor.
Audit report: The auditor’s entire communication about what was done and what
conclusions reached in the audit.
Disclaimer of opinion: A report by the auditor that states that an opinion cannot be
expressed.
Going concern: An entity able to continue for a period at least one year beyond the
balance sheet date.
5.8 ANSWERS TO CHECK YOU PROGRESS EXERCISE

Check Your Progress Exercise – 1

1. B
2. A
3. A

Check Your Progress Exercise -2

(1) 1. Qualified opinion
2. Unqualified opinion
3. Adverse opinion and
4. Disclaimer
(2) Reservation is a term used to signify the auditors’ inability to express an unqualified
opinion; adverse opinion, or a denial of opinion.

5.9 MODEL EXAMINATION QUESTIONS

Part I. Indicate the best answer choice for each of the following multiple-choice
questions.
1. If a publicly held company issues financial reports that purport to present its financial
position and results of operation but omits the statement of cash flows, the auditor
ordinarily will express a(an)
46
 a. unqualified opinion.
b. Adverse opinion.
c. qualified opinion
d. disclaimer of opinion
2.An auditor may reasonably issue an “except for” qualified opinion for
Inadequate disclosure Scope limitation
1. yes yes
2. yes no
3. no yes
4. no no
3. What type of audit report (unqualified opinion, except for opinion, adverse opinion,
denial of opinion) should the auditors generally issue in each of the following situations?
Explain.
a) Client imposed restriction limit very significantly the scope of the auditors’
procedures.
b) The auditors decide that it is necessary to make reference to their report of
another public accounting firm (the secondary auditors).
c) The auditors believe that the financial statements have been stated in
conformity with generally accepted accounting principles in all respects other
than the treatment and disclosure of a material uncertainty

47
UNIT 6: COMPUTER AUDIT

6.0 AIMS AND OBJECTIVES

When you have studied this unit, you should be able to:
 understand the problems of auditing computer information systems (CIS).
 understand the controls operated by a client in a CIS.
 explain the use of CAATS.

6.1 INTRODUCTION

Computers may affect the work of the auditor in two ways:

 The client may use a computer to produce all or part of the financial accounting
data.
 The auditor may be able to use a computer to assist in his audit, particularly when
the client has a computer system.

6.2 USE OF COMPUTERS IN AUDIT

A microcomputer may be used by the auditor in the following ways to assist his audit
work.

48
 a) Flowcharting a client’s systems. Specialist flowcharting packages can assist the
auditor in the production of clear, well presented flowcharts.
b) Evaluation of audit risk. The auditor can input into the computer his assessment
of the audit risk for the various transactions and balanced in the client’s systems.
c) Preparation of audit programmes. Audit programs can be typed into a word
processor, which again will allow for easy updating in the following years.
d) Analytical procedures. A standard template can be let up on a spreadsheet
package. Onto this template, the auditor inputs key details such as balance sheet
totals from the financial statements. The spreadsheet then calculates key
accounting ratios to assist the auditor with the analytical procedures.
e) Preparation of audit working papers. When a computer is available to audit
staff at the client’s premises, it can be used to type up audit working papers.

6.3 CHARACTERISTICS OF COMPUTER AUDIT

There are a number of distinguishing features of computer-based systems that must be

recognized and considered by the auditor. The following are the main features.
a. Concentration of controls in the computer department. The need to standardized
and utilize the computer resources of a business has led to a concentration of
controls in the computer department which represents a potential weakness.
Generally the number of persons involved in the processing of information in a
CIS environment will be fewer than those in a manual environment.
b. Concentration of programs and data. Transactions, master files, and program
data are often held together and there is a corresponding increased potential for
unauthorized access to programs and data.
c. Absence of input documentation.
In some systems conventional journal will not be maintained and manual authorizations
are usually replaced by computer authorizations.
d. Lack of visible transaction trial and output.
Modern systems are usually designed to limit the volume of printed data, and data is
often quickly overwritten with new data. The auditor must assess the implications of this
at the planning stage.
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 e. Ease of access to data and computer programs. The problem is again, one of
unauthorized access where data can be altered from remote terminals.
f. Vulnerability of discs, and tapes.
Data is more vulnerable than it would be in a manual system to loss, and destruction.
g. System generated transactions. Many systems are capable of generating
transactions automatically without user intervention. The lack of authorization
and documentation can be a significant issue if a significant number of
transactions are generated in this way.
h. Single transaction /multiple update.
An incorrect entry may result in incorrect data in may different accounts, particularly in
database systems.
I. Programmed controls.
Programmed controls may limit the visibility of data, and limit input of data.

6.4 CONTROLS IN CIS

The controls that must be exercised by the auditor when micro computers are used in his
audit work include the following:
a) Backup of files.
Backup of all audit files kept on the computer should be made regularly. These backup
copies should be kept in a separate location from the microcomputer.
b) Security of files.
Audit information on client can be very sensitive. Adequate procedures must therefore
be in force to ensure that only authorized audit staff can gain access to the audit
information.
c) Adequacy of documentation.
There is a danger with computers that not all the data or reasoning used to reach a
particular decision will be documented. Adequate documentation should therefore be
kept, including print – outs of all major documents, for future reference, together with the
reasons for the decisions made.
d) Testing of programs.

50
Before any program is used on audits, it should be tested to ensure that it is as fast as
possible error free

Check your progress Exercise – 1

Say true or false
1. Internal control in a CIS department requires not only subdivision of duties but also
the maintenance of adequate documentation.
2. Computers are able to create, update, and erase data in computer based records
without any visible evidence of a change being made.
3. When a company uses CIS consolidation of activities and integration of functions are
to be expected.
4. Every electronic data processing system should have adequate security controls to
safeguard files and programs.

6.5 COMPUTE ASSISTED AUDITING TECHNIQUES (CAATS)

The absence of input documents, or audit trial, or output, might necessitate the use of
CAATS.
Auditors may use audit software during many audit testing procedures. The use of audit
software is particularly appropriate during substantive testing of transactions and
balances, as scrutinize large volumes of data and extract information leaving skilled
manual resources to concentrate upon the investigation of the results.
Typical uses of such programs include:
i. Calculation of checks: Example: - the program adds the value of open items on a file
to ensure that they agree with control records.
ii. Detecting violation of system rules: Example, the program checks all accounts on the
sales ledger to ensure that no customer has a balance above a specified credit limit.
iii. Detecting unreasonable items: Example, a check that no customer is allowed trade
discount of more than 5%.
iv. Conducting new calculations and analysis: Example: - obtaining a sample of sales
ledger balances to be used as a basis for a circularisation of accounts receivable.
v. Selection of items for audit testing: Example: - obtaining a sample of sales ledger
balances to be used as a basis for a circularisation of accounts receivable.
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vi. Completeness checks: Example, checking continuity of sales invoices to ensure they
are all accounted for.
6.6 SUMMARY

The auditor can use microcomputers to assist in the management and carrying out his
audit work. Computer based systems have a number of special features which must be
recognized and considered by the auditor in planning his audit approach.
6.7 GLOSSARY

Computer-assisted audit techniques (CAAT) The tools and techniques, such as audit
software and test data, used by the auditor with the computer aid in effective and
efficient performance of an audit.
6.8 ANSWER TO CHECK YOU PROGRESS EXERCISE

Check Your Progress Exercise – 1

1. True 3. True
2. True 4. True

6.9 MODEL EXAM QUESTIONS

1. What are the special features of a computer – based systems?

2. Discuss briefly the internal controls that should be established over the operation of a
microcomputer.
UNIT 7: CASH AUDIT

7.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
 devise appropriate tests for cash.
 explain the nature of cash receipts and disbursements.
 explain the fundamental internal controls over each receipts and cash
disbursement.
 describe the nature of appropriate procedures to accomplish the objectives of cash
audit.

52
7.1 INTRODUCTION

This unit examines the audit of cash. For the audit of cash much reliance is placed on
third party confirmation of cash balance.

You should bear in mind that the control of cash is of prime importance in any business.
The overall objective of the audit of cash is to determine that cash is fairly presented in
conformity with generally accepted accounting principles. In most audits, the primary
assertions that generate audit risk for cash are existence, completeness, right and
obligation, and presentation and disclosure.

7.2 NATURE OF CASH

Cash and bank balances are liquid assets and include:

a) Notes and units.
b) Bank current accounts.
c) Bank deposit accounts.

Because of their liquidity, these assets represent the most vulnerable of all the company’s
assets. On the other hand, they are the most easily verified, because they can be
confirmed directly by third parties or by physical counts.

7.3 THE AUDITORS’ OBJECTIVES IN EXAMINATION OF CASH

The auditors have five objectives in the audit of cash:

1. Consider internal control over cash transactions.
2. Determine the existence of recorded cash and the client’s ownership of this asset.
3. Establish the completeness of recorded cash.
4. Establish the clerical accuracy of cash schedules.
5. Determine that the statement presentation of cash is appropriate.

The overall objective of the audit of cash is to determine that cash is fairly presented in
conformity with generally accepted accounting principles.
7.3.1 Internal Control Over Cash
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(a) Control Objectives
The central control objectives are that:
 All sums are received and subsequently accounted for.
 No payments are made which should not be made.
 All receipts and payments are promptly and accurately recorded.
(b) Control Procedures
A detailed study of the operating routines of the individual business is necessary in
developing the most efficient control procedures. These universal rules for achieving
internal control over cash may be summarized as follows:
1. Do not permit any one employee to handle transaction from beginning to end.
2. Separate cash handling from record keeping.
3. Centralize receiving of cash as much as possible.
4. Record cash receipts immediately.
5. Encourage customers to obtain receipts and observe cash register totals.
6. Deposit each day’s cash receipts intact.
7. Make all disbursements by cheques with the exception of small from petty cash.
8. Have monthly bank Reconciliation prepared by employees not responsible for the
issuance or custody of cash. The completed reconciliation should be reviewed
promptly by an appropriate official.
9. Forecast expected cash receipts and disbursements and investigate variances from
forecasted amounts.
(c) Internal control over cash receipts.
Cash receipts resulted from a variety of activities. For example, cash is received from
revenue transactions, short and long term borrowings, the issuance of stock, and the sale
of marketable securities, long term investments, and other assets. The scope of this
section is limited to cash receipts from cash sale and collection from customers on credit
sales. The basic internal controls over cash receipts include the following:
 Authority to collect cash should be clearly defined.
 Collections should be recorded when received.
 The collector’s cash receipts should be reconciled to the eventual banking.
 Receipts should be banked immediately.

54
  Each day’s receipts should be recorded promptly in the cashbook.
 Sales ledger account should have not access to the cash.
The processing of receipts from cash and credit sales involves the following cash receipts
functions:
- Receiving cash receipts.
- Depositing cash in bank.
- Recording the receipts.
Segregation of duties in performing these functions is an important internal control
activity.

Receiving cash receipts

A major risk in processing cash receipts transactions is the possible theft of cash before
and after a record of cash is made. Thus, control procedures should provide reasonable
assurance that documentation establishing accountability is created at the moment cash is
received and that the cash is subsequently safeguarded.
Depositing cash in bank
Proper physical controls over cash require that all cash receipts be deposited intact daily.
Intact means all receipts should be deposited; that is cash disbursements should not be
made out of un-deposited receipts.

Recording the receipts

This function involves journalizing over the counter and mail receipts and posting mail
receipts to customer accounts. Controls should ensure that only valid receipts are entered
and that all actual receipts entered at the correct amount.
To ensure that only valid transactions are entered, physical access to the accounting
records or computer terminals used in recording should be restricted to authorized
personnel.

Check Your Progress Exercise -1

1. What functions are involved in the processing of cash receipts transactions?
………………………………………………………………………………………………
………………………………………………………………………………………………

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………………………………………………………………………………………………
………
2.`What is the meaning of deposited intact daily?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……….

7.3.2 Internal Control Over Cash Disbursements

There are two cash disbursements functions as follows:
1. Paying the liability
2. Recording the cash disbursements.
These functions should not be performed by the same department or individual. The basic
internal controls over cash disbursements include:
 Unused checks should be held in a secure place.
 The person who prepares checks should have no responsibility over purchase
ledger or sales ledger.
 Checks should be signed only when evidence of a properly approved transaction
is available.
 These checks should be evidenced by signing the supporting documents.
 Check signatories should be restricted to the minimum practical number.
 Two signatories at least should be required except perhaps for checks of small
amounts.
 Checks should be crossed before being signed.
 Supporting documents should be cancelled as paid to prevent their use to support
further check payments.
 Checks should preferably dispatch immediately.

7.3.3 Control Over Petty Cash

 The level and location of cash floats should be laid down formally.
 Cash should securely hold.
 There should be restricted access to the floats.
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  All expenditure should require a voucher system signed by a responsible official,
not the petty cashier.
 Vouchers should be produced before the check is signed for reimbursement.
 A maximum amount should be placed on a petty cash payment to discourage
normal purchase procedures being by passed.
 Periodically the petty cash should be reconciled by an independent person.

Check Your Progress Exercise - 2

State the functions that apply to cash disbursements transactions.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……….

7.4 AUDIT PROGRAM FOR CASH

The following audit program indicates the general pattern of work performed by the
auditors in the verification of cash.
A. Consider internal control for cash.
1. Obtain an understanding of internal control for cash.
2. Assess control risk and design additional tests of controls for cash.
3. Perform additional tests of control for those controls, which the auditors plan to
consider in their assessment of control risk.
(a) Test the accounting records and reconciliation by re-performance.
(b) Compare the detail of a sample of recorded disbursements in cash
payments journal to accounts payable postings, purchase orders, receiving
reports, invoices, and paid checks.
(c) Compare the detail of a sample of recorded cash receipts listings to the
cash receipts, journal, accounts receivable postings, and authenticated
deposit slips.
4. Reassess control risk and design substantive tests for cash.

B. Perform substantive tests of cash transaction and balances.

57
 1. Obtain analysis of cash balances and reconcile to the general ledger.
2. Send standard confirmation forms to banks to verify amounts on deposit.
3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date and
consider the need to reconcile bank activity for additional months.
4. Obtain a cutoff bank statement containing transactions of at least seven business
days subsequent to balance sheet date.
5. Count and risk cash on hand.
6. Verify the client’s cutoff of cash receipts and disbursements.
7. Trace all bank transfers for last week of audit year and first week of following
year.
8. Evaluate proper financial statement presentation and disclosure of cash.
A. Consider internal control for cash.
1. Obtain an understanding of internal control
By understanding internal control over cash receipts and cash disbursements helps
auditors to observe whether there is appropriate segregation of duties and to enquire who
performed various functions throughout the year.
2. Assess control risk and design additional tests of control.
After obtaining an understanding of the client’s internal control for cash receipts and
disbursements, the auditors perform their initial assessment of control risk.

3. Perform additional tests of control.

Tests directed toward the effectiveness of control help to evaluate the client’s internal
control and determine the extent to which the auditors are justified in reducing the
assessed levels of control risk for assertions about the cash account.
The following are examples of typical tests of controls.
 Test the accounting records and Reconciliation by re-performance.
 Compare detail of cash receipts listings to cash receipts journal, accounts
receivable postings, and authenticated deposit slips.

58
  Compare detail of a sample of recorded disbursements in cash payments journal,
accounts payable postings, purchase orders, receiving reports, invoices, and paid
checks.
4. Reassess control risk and design substantive tests.
When the auditors have completed the procedures described above, they should reassess
control risk and design substantive tests of cash transactions and balances.

B. Substantive tests
 Obtain analyses of cash balances and reconcile to the general ledger.
 Send standard confirmation forms to banks to verify amounts on deposit.
 Obtain or prepare reconciliation’s of bank accounts as of the balance sheet date
and consider the need to reconcile bank activity for additional months.
 Obtain a cut off bank statement.
 Count and list cash on hand.
 Verify the client’s cutoff of cash receipts and disbursements.
 Trace all bank transfers for the last week of audit year and first week of following
year.
 Investigate any cheques representing large or unusual payments to related parties.
 Determine proper financial statement presentation and disclosure of cash.
Check You Progress Exercise – 3
Choose the best answer.
1. Which of the following is the objective of major substantive tests of cash transactions
and balance?
a. Clerical accuracy.
b. Existence and ownership.
c. Completeness.
d. All of the above.
2. The balance sheet figure for cash should include all cash received on the final day of
the year and none receive subsequently.
a. True b. False
7.5 SUMMARY

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 Cash balances are verified with a third party. Auditors can also use to bank letter to
questions related to cash balances.
7.6 GLOSSARY

Negative confirmation: A statement of balances due that is addressed to the customer

with the request that the customer respond directly to the auditor only if the amount
shown is incorrect.
Positive confirmation: A statement of balances due that is addressed to the customer
with the request that the customer respond directly to the auditor regardless of whether
the balance is correct or incorrect.
7.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check your progress Exercise -1

1. - Receiving cash receipts, depositing cash in bank, and Recording the receipts.
2. All receipts should be deposited; that is cash disbursements should not be made out of
un-deposited receipts.
Check your progress Exercise -2
1. D 2. A

7.8 MODEL EXAM QUESTION

1. The auditors’ work on cash may include an understanding of internal control and
performing tests of controls. Which of these two steps should be performed first?
What is the purpose of tests of controls?
2. State one broad general objective of internal control for cash of the following: Cash
receipts, cash disbursements, and balance.
UNIT 8: RECEIVABLE / SALES AUDIT
Introduction

Auditing II develops the knowledge of Auditing I by:

- Extending the basic awareness of professional codes to a detailed

understanding of rules of professional conduct.
- Introducing computer audit.
- Critically evaluating procedures and reports.
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 - Introducing the audit of cash, receivables and sales, and inventory and
purchases.

8.10 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
 devise appropriate tests for receivables.
 explain the nature of sales and collection of receivables.
 describe the auditors’ objectives for the audit of receivables and sales.
 describe the nature of the audit procedures to accomplish the auditors’ objectives
for the audit of receivables and sales.

8.1 INTRODUCTION

This unit examines the audit of sales and receivables. You should bear in mind in the
audit of receivables that receivables are a product of the sales cycle and therefore the
control objectives of the sales cycle are relevant. Receivable is a general term that may
refer to many types of receivables whose origin and nature may be different.

Receivables include amounts due from customers, employees, and affiliates on open
accounts, notes, and loans and accrued interest on such balances.

8.2 SOURCES AND NATURE OF RECEIVABLE

The sales and collection cycle including the receiving of orders from customers are
delivery and billing of merchandise to customers, and the recording and collection of
receivables. Receivables from customers include both accounts receivable and various
types of notes receivable.

It is important to differentiate the origin and nature of receivables to ensure their

appropriate classification and valuation.

8.3 FINANCIAL REPORTING STANDARDS

Financial reporting standards for receivables require:

61
  separation of trade from non – trade receivables.
 establishment of genuine of trade receivables transactions ensuring “arms length
deal”, and terms of sales.
 assurance of ownership disclosure.
 assurance of collectibility of receivables.
 assurance of consideration for returns and allowances.
 appropriate classification of current and non - current.

8.4 AUDIT OBJECTIVES

The audit objectives for the receivables and sales relate to obtain to sufficient competent
evidence about each significant financial statement assertion that pertains receivables and
sales transactions and balances.

To achieve each of these specific audit objectives, the auditors employ various parts of
the audit planning and audit testing methodology.

The auditors’ objectives in the examination of receivables and sales are:

1. To consider internal control over receivables and sales transactions.
2. To determine the existence of receivables, the clients ownership of these assets,
and the occurrence of sales transactions.
3. To establish the completeness of receivables and sales transactions.
4. To establish the clerical accuracy of records and supporting schedules of
receivables and sales.
5. To determine that the valuation of receivables is at appropriate net realizable
values.
6. To determine that the statement presentation of receivables and sales is adequate.

Figure 8.1 Selected specific audit objectives for receivables and sales

Assertion Transaction class Account balance

Category Audit objective Audit objective
Category Existence Recorded sales transactions represent goods Accounts receivable include all
or Occurrence shipped during the period. Recorded cash amounts owed by the customers

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 receipts transactions represent cash received exists at the balance sheet date.
during the period.
All sales, cash receipts sales adjustments Accounts receivable include all
Completeness that occurred during the period have been claims on customers at the balance
recorded. sheet date.
The entity has rights to the receivables and Accounts receivable at the balance
Rights and
cash resulting from sales transactions. sheet date represents legal claims of
Obligations
the entity.
Valuation All sales, cash receipts and sales Accounts receivable represent gross
adjustments transactions are correctly claims, On customers at the balance
journalized, summarized, and posted. sheet date. The allowance for
uncollectible accounts represent a
reasonable estimate.
Presentation ad The details of sales, cash receipts and sales Accounts receivables are properly
disclosure adjustments support their presentation in the identified and classified.
financial statements.

8.5 INTERNAL CONTROL OF SALES AND RECEIVABLES

The objectives of internal controls over receivables are to ensure:

a. All goods dispatched are invoiced.
b. Invoicing is at correct price and discount.
c. Goods are only dispatched on credit to approved customers.
d. Invoices are recorded and related to subsequent cash receipts.
e. Receivables are controlled and bad debts pursued.
f. Credit notes approved.

In addition, the internal over receivables should be such that the possibility of any
falsification of the receivables accounts is eliminated. An important part of the controls
would be to ensure that the cashier does not have access to the sales ledger, and the sales
ledger clerk does not have access to cash received. Control procedures, over sales and
receivables include the following.

a. Orders.
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 - The orders should be checked against the customer’s account.
- All orders received should be recorded on pre – numbered sales order
documents.
- All orders should be authorized before goods are dispatched.

b. Dispatch.
- Dispatch notes should be pre - numbered and a register kept of them to relate
to sales invoices and orders.
- Goods dispatch notes should be authorized as goods leave.
c. Invoicing
- Sales invoices should be authorized by a responsible official.
- Sales invoices should be checked for prices and calculations by a person other
than the one preparing the invoice.
- All invoices should be pre – numbered consecutively.
- Copies of cancelled invoices should be retained.
d. Receivables.
- A receivable ledger control account should be prepared and checked to
individual sales ledger balances.
- Receivables ledger personnel should be independent of dispatch and cash
receipt functions.
- Statements should be sent regularly to customers.
e. Bad debts.
- The authority to write off a bad debt should be given in writing and
adjustments made to the accounts receivable ledger.
- The use of court action or write – off of a bad debt should be authorized by
an official independent of the cash receipts function.

8.6 AUDIT PROGRAM FOR RECEIVABLES AND SALES TRANSACTIONS

The following audit procedures are typical of the work done in the verification of notes,
accounts receivable, and sales transaction.
A. Consider internal control for receivables and sales.

64
 1. Obtain an understanding of internal control for receivables and sales. The
auditors’ consideration of internal controls over receivables and sales may begin
with the preparation of a written narrative or flow chart and the completion of an
internal control questionnaire. As the auditors’ confirm their understanding of the
sales and collection cycle, they will observe whether there is appropriate
segregation of duties, and enquire as to who performed various functions
throughout the year.
2. Assess control risk and design additional tests of controls for receivables and
sales. After obtain an understanding of the client’s internal control for receivables
and sales transactions, the auditors perform their initial assessment of control risk
for the variant financial statement assertions.
3. Perform additional tests and controls: Tests directed towards the effectiveness
of control help to evaluate the client’s internal control, and determine the extent
to which the auditors are justified in reducing their assessed levels of control
risk for the assertion about the receivables and sales accounts. The following
are examples of additional tests:
A. Examine significant aspects of a sample of sales transactions.
B. Compare a sample of shipping documents to related sales
invoices.
C. Review the use and authorization of credit memoranda.
D. Reconcile selected cash register tapes and sales invoices with
sales journals.
4. Reassess control risk and design substantial tests. When auditors have
completed the procedures described in the preceding sections, they should
assess the extent of control risk for each financial statement assertions regarding
receivables and sales transactions. The assessment will determine the nature,
extent, and timing of auditors’ substantive tests for receivables and sales.
B. Substantive tests
1. Obtain an aged trail balance of trade accounts receivable and analyses of
other accounts receivable and reconcile to ledgers. When trial balances or
analyses of accounts receivable are furnished to the auditors by the client’s
employees, some independent verification of the listings is essential.
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 2. Obtain analyses of notes receivable and related interest.
3. Inspect notes on hand and confirm those not on hand with holders.
4. Confirm receivables with debtors.
5. Receive the year-end cutoff of sales transactions.
6. Perform analytical procedures for accounts receivable, sales, notes
receivable, and interest revenue.
7. Verify interest earned on notes and accrued interest receivable.
8. Evaluate the propriety of the client’s accounting for receivables and sales.
9. Determine adequacy of allowance for uncollectible accounts.
10. Ascertain whether any receivables have been pledged.
11. Investigate fully any notes or accounts receivable from related parties.
12. Evaluate financial statement presentation and disclosure.
Check your Progress Exercise – 1
1. Which of the following can be used as substantive test for receivables and sales
transactions?
(a) Confirm receivable with debtors.
(b) Perform analytical procedures.
(c) Review the year-end cutoff of sales transactions.
(d) All of the above.
2. Which of the following is (are) primary audit objective for receivables/sales?
(a) Clerical accuracy (d) Statement Presentation
(b) Existence (e) All of the above
(c) Valuation
3. Which assertions relating to receivables/sales are addressed when auditors select a
sample of sales invoices and compare details to shipping documents?
(a) Existence (c) Valuation
(b) Ownership (d) All
(e)
8.7 SUMMARY

Accounts receivable may be a major asset of a company and the major procedure
involves confirmation of receivable with debtors. There are a large number of controls
66
that may be required in the sales cycle due to the importance of this area and the possible
opportunities that exist for diverting sales away from the business and other persons
benefiting.
ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. d 2. E 3. d

8.8 MODEL EXAM QUESTIONS

1. List control objectives for a sales cycle.

2. How can analytical procedures assist in the audit of account receivables?

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UNIT 9: INVENTORY /PURCHASE AUDIT

9.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
 identify fundamental internal controls over inventories and purchases.
 describe the auditors’ objectives for the audit of inventories.
 describe the nature of the audit procedures to accomplish the auditors’
objectives for the audit of inventories.

9.1 INTRODUCTION

Inventories are major items on the balance sheet, i.e. in total assets, especially in the
current asset section.

Inventories play also a very significant and important role in preparation of income
statement and determination of net income or loss.

This unit discusses the typical internal control procedures and the auditors’ objectives in
the examination of inventories /purchases.

The processing of purchases transactions involves the following purchasing functions:

- Requisitioning goods and services.
- Preparing purchase orders.
- Receiving the goods.
- Storing goods received for inventory.
- Preparing the payment voucher.
- Recording the liability.

9.2 THE AUDITORS’ OBJECTIVES IN THE EXAMINATION OF

INVENTORIES AND PURCHASES

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The auditors’ have the following objectives in the examination of inventories and
purchases.
i. To consider internal control over inventories and purchases.
ii. To determine the existence of inventories, and the client’s ownership of these
assets.
iii. To establish the completeness of inventories and purchase transaction.
iv. To establish clerical accuracy of records and supporting schedules for inventories
and purchases.
v. To determine that the valuation inventories is based on appropriate methods.
vi. To determine the statement presentation of inventories is adequate, including
disclosure of classification of inventories, accounting records and any inventories
pledged as collateral for loans.

Check Your Progress Exercise -1

State the functions that apply to purchases transactions.
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9.3 INTERNAL CONTROL OVER INVENTORIES AND PURCHASES
CONTROL OBJECTIVES

Although inventory records may vary considerably from client to client, the control
objectives of a sound system of internal control over inventories are the same in all cases,
namely:
o Authorization and purchase procedures.
o Control over goods inwards.
o Inventory records substantiated by physical counts.
o Control over dispatches and goods outwards.
o Inventory levels should be controlled so that materials are available when
required but that inventory is not unnecessarily large. Control procedures
over inventories.

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Internal control procedures for inventories affect nearly all the functions involved in
producing and disposing of the company’s products, purchasing, receiving, storing,
issuing, processing, and shipping are the physical functions directly connected with
inventories. The basic internal control procedures are the following:
Approval and control of documents
 Issues from inventories should be recorded only on properly authorized requisitions.
 Reviews of damaged, obsolete and slow moving inventories should be carried out.
Any write - offs should be authorized.
Arithmetical accuracy
 All receipts and issues should be recorded on inventory cards.
 The costing department should allocate direct and overhead costs to the value of
work – in – progress according to the stage of completion reached.
Control accounts
 Total inventory records may be maintained and integrated with the main accounting
system.
Comparison of assets to records
 Inventory levels should be checked against the records by a person independent of
the stores personnel, and material differences investigated.
 Where continuous inventory records are not kept adequately a full count should
be held at least once a year.
 Maximum and minimum inventory levels should be pre – determined and
regularly reviewed for adequacy.

Assess to assets and records

 Separate centers should be identified at which goods are held.
 Inventories should be held in their locations so that they are safe from damage or
theft.
 All 8 inventories should be identified and held together.
 Access to the stores should be restricted.

9.4 AUDIT PROCEDURES

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The following audit procedures for the verification of inventories and purchases may be
used by auditors:

(A) Consider internal control for inventories and purchases

(1) Obtain an understanding of internal control for inventories and purchases.
In obtaining an understanding of internal control over inventory, the auditor should
become thoroughly conversant with the procedures for purchasing, receiving, storing, and
issuing goods as well as acquiring an understanding of the cost accounting system and the
perpetual records.
(2) Assess control risk and design additional tests of control for inventories
and purchases.
After obtaining an understanding of the client’s internal control over inventories and
purchases, the auditors perform their initial assessment of control risk for the various
financial statement assertions.
(3) Perform additional tests of controls.
Tests directed toward the effectiveness of controls help to evaluate the client’s internal
control and to determine the extent to which the auditors are justified in reducing their
assessed level of control risk for the assessments about the inventory and purchase
accounts.
The following are examples of typical additional test.
a. Examine significant aspects of a sample of purchase transactions.
b. Test the cost accounting system.
(4) Reassess control risk and design substantive tests.
B. Substantive test.
1. Obtain listings of inventory and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test counts.
4. Review the year – end cutoff of purchases and sales transactions.
5. Obtain a copy of the completed physical inventory, test its clerical accuracy,
and trace test counts.
6. Evaluate the bales and methods of inventory pricing.
7. Review inventory quality and condition.

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 8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and review purchase
and sales commitments.
10. Evaluate financial statement presentation of inventories, including the
adequacy of disclosure.
Check Your Progress Exercise - 2
Say true or false
1. Inventories play significant role in the preparation of both balance sheet and income
statement.
2. The financial statement assertion of valuation is not related to inventories.
3. Adjustments to inventory records should be authorized.
4. Efficient and effective inventory taking requires careful planning in advance.
5. Auditors should not observe the quality or condition of inventories
9.5 SUMMARY

This unit discusses the following key points for inventories and purchases:
o Inventory controls focus goods movements, authorization procedures and physical
counts.
o Tests of control for inventory focus on material movement authorization, and the
control of inventory against records.
o The observation of physical count by auditors helps them to identify an inventory
of questionable quality or condition.

9.6 GLOSSARY

Confirmation: - A type of documentary evidence that is created outside the client and
transmitted directly to the auditors.
Observation: - The auditors’ evidence – gathering technique that provides physical
evidence.
Purchase commitment: - A contractual obligation to purchase goods at fixed prices,
entered into well in advance of scheduled delivery dates.

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Sales commitments: - A contractual obligation to sell goods at fixed prices, entered into
well in advance of scheduled delivery dates.

9.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress Exercise - 1

D. Refer Section 9.3

Check Your Progress Exercise - 2

1. True 2. False 3. True 4. True 5. False

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9.8 MODEL EXAM QUESTION

The observation of a client’s physical inventory is mandatory auditing procedure when

practicable and possible for the auditors to carry out and when inventories are material.

Required
a. Why is the observation of physical inventory a mandatory procedure?
Explain.
b. Under what circumstances is observation of physical inventory impracticable or
impossible?

Name________________________
Id. No________________________
P.O.Box______________________
City (Town)___________________
Region (Zone)_________________

QUEENS’ COLLEGE

Worksheet for Auditing II

This is a test paper you are expected to do on your own. It carries 15 points. Do
not try to complete the worksheet until you have covered all the lessons and
exercises in the course material.
Any questions in the course that you have not been able to understand should be
stated on a separate sheet of paper and attached to this worksheet. Your tutor
will clarify them for you.

After completing this test paper, be certain to write your Name, Id.No and
Address on the first page. Your Name and d.No on the other pages.

Part I. Give short and brief answers for the following questions. (10 marks)

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1. Discuss the relationship of auditing to accounting. Are the two terms synonymous?
Why or why not? (2marks)
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2. Why is independent such an important concept for CPA? (2 marks)
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3. What various defenses may an auditor use in defending against a suit brought by a
client? (2mark)
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4. What are the common substantive audit tests accounts receivable? (4marks)
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Part II. Indicate the best answer for each of the following multiple-choice
questions. (5 marks)
1. Which of the following procedures would ordinarily expected best reveal unrecorded
sales at the balance sheet date?
a. Compare shipping documents with sales records.
b. Apply gross margin rates to inventory dispose of during the period.
c. Trace payments received subsequent to the balance sheet date.
d. Send accounts receivable confirmation requests.
2. The auditor most likely give unqualified opinion when:
a. The financial statements are re materially misstated.
b. There is scope imitation to apply GAASs properly.
c. The financial statements are prepared in accordance with GAAPs
d. There is disagreement with management as to accounting policies.
3. The standard of fieldwork include the following except:
a. Due professional care.
b. Adequate planning and control.
c. Sufficient understanding of the internal control structure.
d. Obtain and evaluate sufficient and appropriate audit evidence.
4. How are management’s responsibility and the auditor’s responsibility represented in
the standard auditor’s report?

Management’s Auditor’s
responsibility responsibility
a. Explicitly Explicitly
b. Implicitly Implicitly
c. Implicitly Explicitly
d. Explicitly Implicitly
5. An auditor most likely would review an entity’s periodic accounting for the numerical
sequence of shipping documents and invoices to support management’s assertion of:

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a. Existence c. Valuation
b. Rights and obligations d. Completeness.

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