AAT

Level 4
Diploma in Professional
Accounting

Audit and
Assurance

Course Book

For assessments from

September 2022

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 First edition 2021
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 Contents
Page
Introduction to the course iv
Skills bank vii

1 Principles of auditing and professional ethics 1

2 Systems of internal control 39
3 Obtaining audit evidence 75
4 Planning: audit risk 99
5 Planning: audit procedures 117
6 Evaluation 151

Activity answers 171

Test your learning: answers 195
Glossary of terms 207
Bibliography 209
Index 211

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 Introduction to the course
Syllabus overview
As many organisations and businesses now operate in the global marketplace, the role of audit
and assurance is becoming increasingly important as it is seen as providing a measure of
confidence in the rapidly changing accounting and business environment. This is as a result of
their impact upon the overall success of a business and achievement of strategic objectives. Audit
and assurance services have also come under increased scrutiny from the profession following
high-profile corporate failures.
This unit aims to develop a wider understanding of the principles and concepts, including the
legal and professional rules of audit and assurance services. The unit will provide students with an
awareness of the audit process from planning and risk assessment to the final completion and
production of the audit report. The unit also aims to provide a practical perspective on audit and
assurance, with an emphasis on the application of audit and assurance techniques to current
systems. Students will be equipped with the skills required to undertake an audit under
supervision and will gain an understanding of relevant regulatory frameworks and ethical
requirements.
Students will explore issues such as independence as well as the audit process, from the initial
planning process, including risk assessments and gathering evidence, through to completion and
reporting findings. The unit places an emphasis upon the application of techniques to current
situations and as such, offers a practical as well as a theoretical perspective. Throughout the unit,
the concept of professional scepticism is explored and challenged.
Test specification for this unit assessment

Assessment method Marking type Duration of assessment

Computer based assessment Partially computer / partially 2 hours 30 minutes

human marked

Learning outcomes and objectives Weighting

1 Demonstrate an understanding of the audit and assurance framework 10%

2 Demonstrate the importance of professional ethics 15%
3 Evaluate the planning process for audit and assurance 25%
4 Evaluate procedures for obtaining sufficient and appropriate evidence 35%
5 Review and report findings 15%
Total 100%

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 Assessment structure
2 hours 30 minutes duration.
Competency is 70%.
Refer to the start of each chapter for more details of what the Audit and Assurance (AUDT)
assessment could entail.
Your assessment will consist of six tasks each broken down into a series of sub-requirements of
varying marks and styles, including multiple choice, picklist, true/false and written. The two AAT
sample assessments for AUDT contain five and six written sub-requirements respectively,
connected to a scenario and worth a total of 42 marks in each assessment.

Learning outcomes and Max Study

Task Chapter ref
objectives marks complete
1 Demonstrate an understanding of the 10 Chapters 1 and 2
audit and assurance framework
 The concepts and principles
 The regulatory environment
 The role of corporate governance
in the audit and assurance process
 The role of internal audit.

2 Demonstrate the importance of 15 Chapter 1

professional ethics
 Principles and characteristics of
ethical codes and the implications
for the auditor
 Threats to the independence of
auditors
 Safeguards to eliminate or reduce
threats to the independence of
auditors
 The fundamental ethical principles
in relation to internal and external
audit.

3 Evaluate the planning process for audit 25 Chapters 4, 5

and assurance and 6
 The concept of risk
 The concept of materiality
 Audit procedures
 The role of audit working papers.

4 and 5 Evaluate procedures for obtaining 20 and Chapters 2, 3, 4

sufficient and appropriate evidence 15 and 5
 Methods used to obtain audit
evidence
 Audit techniques in an IT
environment
 Different sampling techniques
 Audit approach
 Audit assertions.

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 Learning outcomes and Max Study
Task Chapter ref
objectives marks complete
6 Review and report findings 15 Chapter 6
 Matters to be referred to senior
colleagues
 External audit opinion
 Report audit findings to
management

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 Skills bank
Our experience of preparing students for this type of assessment suggests that to obtain
competency, you will need to develop a number of key skills.

What do I need to know to do well in the assessment?

It requires good overall awareness of many parts of your AAT studies so far and should be seen as
an ideal way of applying much of what you have already learnt as context for the new content
that you will see, showing how audits are conducted in practice.
To be successful in the assessment you need to:
 Know the new material introduced in each chapter, having practised a number of tasks
that reflect the real assessment.
 Apply the techniques demonstrated to 'real life' situations as presented in each task. These
will often be tested using scenarios where you can consider what would really happen if
you were the auditor.

Assumed knowledge
Audit and Assurance is one of the optional Level 4 units. You need to understand the two Level 2
units, Introduction to Bookkeeping and Principles of Bookkeeping Controls, the Level 3 unit,
Financial Accounting: Preparing Financial Statements and Drafting and Interpreting Financial
Statements, covered at Level 4, before taking this unit. At Level 4, the coverage of internal
controls in the Audit and Assurance unit will reinforce the knowledge and skills required in Internal
Accounting Systems and Controls.

Assessment style
In the assessment you could complete tasks by:
1 Entering narrative by selecting from drop down menus of narrative options known as
picklists
2 Using drag and drop menus to enter narrative
3 Typing in numbers, known as gapfill entry
4 Entering ticks
5 Entering text by writing an answer to a discursive requirement (there are UP TO SIX such
tasks in your assessment).
You must familiarise yourself with the style of the online questions and the AAT software before
taking the assessment. As part of your revision, log in to the AAT website and attempt its online
practice assessments, found within the 'Lifelong Learning Portal'.

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 Answering written questions
In your AUDT assessment there will be written questions based on a given scenario. The main
verbs used for these questions are as follows, along with their meanings:
Analyse – Examine in detail
Determine – Confirm by process of logic
Discuss – Construct arguments in order examine in detail
Evaluate – Appraise by an assessment of value
Explain – Set out in detail the meaning of
Identify – Analyse and select for presentation
Recommend – Provide a solution
Topic areas that you might encounter in your assessment include:
 Identifying and explaining audit risks
 Recommending suitable audit procedures
 Evaluating the actions of others from the audit team
 Analysing financial information
 Preparing extracts for a report to management or those charged with governance
Before answering the question set, you need to read the scenario carefully to make sure that you
identify the relevant points.

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 Introduction to the assessment
The question practice you do will prepare you for the format of tasks you will see in the Audit and
Assurance assessment. It is also useful to familiarise yourself with the introductory information
you may be given at the start of the assessment. For example, the following appears at the start
of the Audit and Assurance AAT sample assessment:

This assessment contains 6 tasks and you should attempt to complete every task.
Each task is independent. You will not need to refer to your answers to previous tasks.
The total numer of marks for this assessment is 100.
Read every task carefully to make sure you understand what is required.
Where the date is relevant, it is given in the task data.
Both minus signs and brackets can be used to indicate negative numbers unless task
instructions state otherwise.
You must use a full stop to indicate a decimal point. For example, write 100.57 not 100,57 or
10057.
You may use a comma to indicate a number in the thousands, but you don't have to. For
example, 10000 and 10,000 are both acceptable.

1 As you revise, use the BPP Passcards to consolidate your knowledge. They are a pocket-
sized revision tool, perfect for packing in that last-minute revision.
2 Attempt as many tasks as possible in the Question Bank. There are plenty of assessment-
style tasks which are excellent preparation for the real assessment.
3 Always check through your own answers as you will in the real assessment, before looking
at the solutions in the back of the Question Bank.

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 Key to icons

Key term A key definition which is important to be aware of for the

KEY assessment
TERM

Formula to learn A formula you will need to learn as it will not be provided
in the assessment

Formula provided A formula which is provided within the assessment and

generally available as a pop-up on-screen

Activity An example which allows you to apply your knowledge

to the technique covered in the Course Book. The
solution is provided at the end of the chapter
Illustration A worked example which can be used to review and see
how an assessment question could be answered

Assessment focus point A high-priority point for the assessment

Open book reference Where use of an open book will be allowed for the
assessment

Real life examples A practical real life scenario

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 AAT qualifications
The material in this book may support the following AAT qualifications:
AAT Diploma in Professional Accounting Level 4 and AAT Diploma in Professional Accounting at
SCQF Level 8.

Supplements
From time to time we may need to publish supplementary materials to one of our titles. This can
be for a variety of reasons, from a small change in the AAT unit guidance to new legislation
coming into effect between editions.
You should check our supplements page regularly for anything that may affect your learning
materials. All supplements are available free of charge on our supplements page on our website at:
www.bpp.com/learning-media/about/students

Improving material and removing errors

There is a constant need to update and enhance our study materials in line with both regulatory
changes and new insights into the assessments.
From our team of authors BPP appoints a subject matter expert to update and improve these
materials for each new edition.
Their updated draft is subsequently technically checked by another author and from time to time
non-technically checked by a proof-reader.
We are very keen to remove as many numerical errors and narrative typos as we can but given
the volume of detailed information being changed in a short space of time we know that a few
errors will sometimes get through our net.
We apologise in advance for any inconvenience that an error might cause. We continue to look
for new ways to improve these study materials and would welcome your suggestions. Please feel
free to contact our AAT Head of Programme at nisarahmed@bpp.com if you have any
suggestions for us.

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 Principles of auditing and
professional ethics

Syllabus learning outcomes / objectives

Having studied this chapter you will be able to:

1. Demonstrate an understanding of the audit and assurance framework

1.1 The concepts and principles

Learners need to understand: Learners need to be able to:
1.1.1 the meaning of the term 'audit' 1.1.10 apply a questioning attitude to
1.1.2 the meaning of the term 'assurance' all audit activities.

1.1.3 the general principles of audit and

assurance
1.1.4 the audit expectation gap
1.1.5 the difference between reasonable and
limited assurance
1.1.6 the difference between positive and
negative expression of assurance
1.1.7 the benefits gained from assurance
1.1.8 the meaning of:
– true and fair view
– presents fairly
– faithful representation as applied
to the external audit
1.1.9 the importance of professional
scepticism and professional judgement.

1.2 The regulatory environment

Learners need to understand:
1.2.1 the approach to the regulation of audits in the UK
1.2.2 the use of audit standards in the UK
1.2.3 the role of the:
– accountancy profession in the regulation of audits
– International Auditing and Assurance Standards Board (IAASB)
1.2.4 the role of law (detail contained in the Companies Act in relation to the requirement
for a statutory audit, directors’ responsibilities and auditors’ responsibilities).

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 1.3 The role of corporate governance in the audit and assurance process
Learners need to understand:
1.3.1 the principles of good governance
1.3.2 the comply or explain principle
1.3.3 the respective responsibilities of management, internal auditors and external
auditors in relation to the financial statements
1.3.4 the importance of an effective audit committee.

2 Demonstrate the importance of professional ethics

2.1 Principles and characteristics of ethical codes and the implications for the
auditor
Learners need to understand: Learners need to be able to:
2.1.1 the importance of a code of ethics for 2.1.6 apply the AAT Code of
the profession, including the AAT Code Professional Ethics to audit
of Professional Ethics activities.
2.1.2 the consequences of failing to comply
with the AAT Code of Professional Ethics,
including damages, and legal and
professional penalties
2.1.3 the auditor's liability to the company
and shareholders under contract, and
liability to third parties under tort of
negligence
2.1.4 the requirement for professional
indemnity insurance
2.1.5 the supervisory requirements for
accounting technicians when carrying
out an audit.

2.2 Threats to the independence of auditors

Learners need to understand: Learners need to be able to:
2.2.1 how audit and assurance work may 2.2.4 evaluate circumstances that
compromise the fundamental principles may threaten the application of
of: the fundamental principles.
– integrity
– objectivity
– professional competence
– due care
– confidentiality
– professional behaviour
2.2.2 the significance of independence and its
relationship with objectivity
2.2.3 the threats of:
– self-interest
– self-review
– advocacy
– familiarity
– intimidation.

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 2.3 Safeguards to eliminate or reduce threats to the independence of auditors
Learners need to be able to:
2.3.1 evaluate firm-wide safeguards:
– use of different personnel with different reporting lines for the provision of
non-assurance services to an audited entity
– procedures for monitoring and managing the reliance on revenue received
from a single client
– procedures that will enable the identification of interests or relationships
between the firm or members of the audit team and clients
– disciplinary mechanisms to promote compliance with policies and
procedures
2.3.2 evaluate audit safeguards:
– independent review of audit working papers
– consultation with an independent third party
– disclosure and discussion of ethical issues with those charged with
governance
– rotation of senior personnel
– evaluate matters that should be referred to senior members of audit staff.

2.4 The fundamental ethical principles in relation to internal and external audit
Learners need to be able to:
2.4.1 recognise:
– when to disclose information with or without clients' permission
– when to take precautions if acting for competing clients
– the importance of data security.

Assessment context
This topic introduces a number of terms that you will see examined as part of the Audit and
Assurance assessment. The contents of this topic make up the first two tasks in the assessment,
so it is crucial that you understand the concepts discussed and how they could be examined.

Qualification context
Although there are some terms here that you may be familiar with from earlier parts of your AAT
studies (such as ethics and company law), you may need to consider the context in which they
are examined.

Business context
While seen as an unnecessary expense for a number of organisations, the bureaucracy and 'red
tape' attached to being incorporated and then audited can help to provide a degree of
confidence to the many stakeholders of a company. This topic will start to address the confidence
or assurance provided by auditors, especially when their ethical credibility has been reinforced
by adhering to a code of ethics.

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 Chapter overview

What is a company?

 Stakeholders
 Benefits

Responsibilities of The agency

a company problem

 Keep accounting records  True and fair?

 Provide financial statements  The solution? – Audit

What is an ISA 200

audit?

 Audit appointments  Regulation

 Exemptions (IAASB and FRC)
 Responsibilities
 Benefits of an audit
 Professional liability and
negligence
 Audit failure
 Restriction of liability
AAT Code of
 Assurance
Professional Ethics
 Fraud
 Judgement
 Independence
 Evidence
 Fundamental principles
(PIPCO)  Reporting
 Conceptual framework
(ASIFS)
 Safeguards
 Confidentiality and
conflicts of interest

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 1 What is a company?
A company is an organisation set up ('incorporated') for a specific purpose, usually commercial.
It is a separate legal entity and is registered under a piece of UK legislation called the Companies
Act 2006.
A company may be viewed like this – a collection of related stakeholders:

Investors

Banks Shareholders
For some owner-managed
businesses, these may be the
same people
The company

Employees Directors

Suppliers Government

Customers

Registration under the Companies Act 2006 provides a company with specific rights but also
forces upon it certain responsibilities, both of which we shall look at now.

1.1 Benefits of being a company

Companies are incorporated for many reasons. One of these reasons is the concept of limited
legal liability where, in the event of any losses suffered by the company, the most that any
investor can ever lose by being involved with that company is their investment. The company is
consequently a separate legal entity from its shareholders.

2 Responsibilities of being a company

The Companies Act 2006 has over 1,300 different sections and covers over 750 pages of text, so
a company's duties are too numerous to mention in full! However, there are two that are of
particular interest to you for this course:
 The duty to keep accounting records (Companies Act 2006: s.386)
 The need to provide financial statements (Companies Act 2006: s.394)

2.1 Duty to keep accounting records

Section 386 of the Companies Act 2006 specifies the responsibilities of a company regarding the
accounting records that must be kept.
Activity 1: Companies Act

Listed below are extracts from Section 386 of the Companies Act 2006.
Required
For each item highlighted, suggest a suitable example or accounting record.
(1) Every company must keep adequate accounting records.

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 (2) Adequate accounting records means records that are sufficient:
(a) To show and explain the company's transactions
(b) To disclose with reasonable accuracy, at any time, the financial position of the
company at that time, and
(c) To enable the directors to ensure that any accounts required to be prepared comply
with the requirements of this Act (and, where applicable, of Article 4 of the IAS
Regulation).
(3) Accounting records must, in particular, contain:
(a) Entries from day to day of all sums of money received and expended by the
company and the matters in respect of which the receipt and expenditure take
place, and
(b) A record of the assets and liabilities of the company.
(4) If the company's business involves dealing in goods, the accounting records must contain:
(a) Statements of stock (inventory) held by the company at the end of each financial
year of the company
(b) All statements of stock-takings from which any statement of stock, as is mentioned
in paragraph (a), has been or is to be prepared, and
(c) Except in the case of goods sold by way of ordinary retail trade, statements of all
goods sold and purchased, showing the goods and the buyers and sellers in
sufficient detail to enable all these to be identified.

Accounting records for

transactions:
Accounting records for
financial position:
Matters in respect of
which the receipt and
expenditure takes place:
Assets and liabilities:

Statements of stock held

by the company:

Section 388 of the Companies Act 2006 tells a company where and for how long such
accounting records should be kept:
 In the case of a private company (Ltd), for three years from the date on which they are
prepared.
 In the case of a public company (plc), for six years from the date on which they are
prepared.
 A company's accounting records must be kept at its registered office or such other place
as the directors think fit and must at all times be open to inspection by the company's
officers and auditors.

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 2.2 The need to provide financial statements
Activity 2: Company concerns

Required
Consider the overview of a typical company. Assume that you represent the shareholders only
and that the company's directors are separate people. What concerns might you have about
them?

Investors

Banks Shareholders

The company

Employees Directors

Suppliers Government

Customers

3 The agency problem

You already know from your AAT studies that the Companies Act requires company accounts to
be produced – the logic of this seems more apparent now. Forcing company directors to produce
financial statements goes some way towards alleviating shareholders' concerns over the trust
and visibility issues raised as part of agency theory.
This is only half the story, though – we have seen plenty of examples of companies whose
financial statements were misleading to the point of fraud (and beyond, taking Enron as a case in
point). In some cases, financial statements can be misstated due to unintentional error, but what
happens if directors attempt to cover their actions by deliberately falsifying the company's
financial statements?
True and fair view (or presents fairly in all material respects)
'True' can be defined as honest and factual while 'fair' means unbiased and free from
discrimination. Sometimes, the term 'presents fairly in all material respects' is used instead: this
has the same meaning as 'true and fair view' but is often preferred in jurisdictions outside the UK.
Faithful representation
In 2018, the International Accounting Standards Board (IASB) revised the Conceptual Framework
for Financial Reporting (IASB, 2018), introducing the term 'faithful representation' as a
fundamental qualitative characteristic of useful financial information. You will cover the
Conceptual Framework in more detail in another unit. Faithful representation is defined as
follows:
A faithful representation reflects economic substance rather than legal form, and is:
 Complete – all information necessary for understanding the phenomenon being depicted is
present

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  Neutral – without bias, supported by the exercise of prudence (prudence is the exercise of
caution when making judgements under conditions of uncertainty)
 Free from error – processes and descriptions are without error. This does not mean
perfectly accurate in all respects: it just explains any issues that might affect accuracy,
such as the need to present an accounting estimate of some kind. (Conceptual Framework:
paras. 2.12 - 2.15, 2.18)
The Companies Act puts in a control which is designed to review the financial statements and
supporting disclosures and collect enough of the right kind of evidence to be able to conclude
with some certainty that directors have been both honest and factual as well as unbiased and
free from discrimination when reporting the company's position and performance. We will
explore the idea of challenging the perception that directors should always be trusted when we
discuss professional scepticism later in this chapter.

This control over financial statements is called the external audit and we will spend the rest of this
unit looking at how auditors substantiate the terms 'faithful representation', 'true and fair view'
and 'presents fairly in all material respects'.

4 What is an audit?
How does an audit address the agency problem? An external audit provides assurance to those
who need it, which in this case is those stakeholders who rely on the financial statements of a
company.
Audit
An audit is an independent review of the financial statements and disclosures produced by
directors to ensure that they are both honest and unbiased.
Assurance
Assurance is a degree of confidence that is provided by a practitioner when reviewing subject
matter produced by a responsible party for the benefit of the users of that subject matter.
Assurance can be expressed in different ways and to different extents.
Illustration 1: Assurance engagements

The following diagram illustrates a typical assurance engagement:

Practical uses of assurance:

- Audits
- Internal control reports
- Reviews of business
plans
- Sustainability and
corporate social
responsibility reports
- Reviews of management
performance via KPIs,
adherence to voluntary
codes etc

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 Activity 3: Assurance engagements

Assume that the following diagram represents an audit as an example of an assurance

engagement – fill in the gaps from the box to describe how the audit would work.

Picklist:
The report = Auditor's report (including their opinion)
The criteria = Auditing, accounting and other standards
The responsible party = Directors
The practitioner = External auditor
The subject matter = Financial statements
The evidence = Outcome of sampling and testing
The users = Shareholders

4.1 Audit appointment

Auditors are usually appointed by shareholders at an Annual General Meeting (AGM) but can be
appointed by directors in certain circumstances (such as the date of incorporation, or if the
existing auditors resign and replacements need to be appointed before the next AGM). Auditors
are usually re-elected annually at the AGM but in private (Ltd) companies that happens
automatically unless they are removed by shareholders or they resign (Companies Act 2006:
s.485).

4.2 Audit exemptions

While the external audit provides valuable assurance to many stakeholders and acts as a
deterrent against fraud and error, as a process it can be expensive, time consuming and
inconclusive. In the event of a company being owner-managed (as suggested by the diagram
above) the benefit of being provided with an assessment of one's own work can also have limited
value.
As a result of these issues, the Companies Act 2006 allows for some companies to be exempt
from both full reporting and audit requirements, although some information is still required by
Companies House.
To qualify for the audit exemption, a company has to satisfy at least two of the following
requirements for two consecutive years:

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  Turnover (revenue) of not more than £10.2 million during the year
 Balance sheet total (statement of financial position) of not more than
£5.1 million
 Not more than 50 employees
(Department for Business, Innovation and Skills, 2016)

The audit exemption cannot be claimed if a company falls into one of the following:
 A public, or listed, company (plc)
 A bank or insurance company
 A company that is part of a group of companies that are public companies, banks or
insurance companies.
Dormant companies (those which have not recorded any transactions within the relevant
accounting period) are also exempt from audit provided: they are not a bank or insurance
company; they are not required to produce group accounts; and they fulfil two of the three
criteria above. However, they can be a plc (Companies Act 2006, s.477–481).

4.3 Benefits gained from assurance

Despite the cost and disruption associated with the audit, and the fact that owner-managers
may feel they have no agency problem to address, many companies that are exempt from audit
still choose to have one – why do you think this is?
 There is obvious value from having an independent, qualified accountant review the
business including its financial records and systems (including the staff it employs and the
technology it relies upon).
 It satisfies external stakeholders such as banks and shareholders that the business is
operating satisfactorily.
 It can act as a deterrent against the threat of fraud occurring in the business.
 The business may grow to levels beyond the exemption threshold one day so getting used
to an audit now makes it less difficult to have one in the future.
Now that we know why people have audits, we will look in more detail at what an audit actually is
and how it is done, including the various forms of report that can be used to provide the
assurance offered by the auditor.

5 ISA 200 Overall Objectives of the Independent

Auditor and the Conduct of an Audit in
Accordance with International Standards on
Auditing (ISAs)
An audit helps to provide the required assurance via its report to shareholders by following a
series of procedures laid down by auditing standards known as International Standards on
Auditing (ISAs). You will need to be familiar with the detail of a number of these ISAs which you
will find within this Course Book. The first and perhaps most important one, ISA 200 Overall
Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with
International Standards on Auditing, covers the basics of audit and introduces an amount of
useful terminology using the following paragraphs.

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 'Overall Objectives of the Auditor
In conducting an audit of financial statements, the overall objectives of the auditor are:
(a) To obtain reasonable assurance about whether the financial statements as a whole are
free from material misstatement, whether due to fraud or error, thereby enabling the
auditor to express an opinion on whether the financial statements are prepared, in all
material respects, in accordance with an applicable financial reporting framework; and
(b) To report on the financial statements, and communicate as required by the ISAs, in
accordance with the auditor's findings.'
(ISA 200: para. 11)

5.1 Regulation

'The purpose of an audit is to enhance the The opinion that is delivered via the
degree of confidence of intended users in auditor's report will be covered in a later
the financial statements. This is achieved by chapter. Such an opinion uses the terms
the expression of an opinion by the auditor 'true' and 'fair' view (defined earlier) or
on whether the financial statements are 'presents fairly in all material respects'.
prepared, in all material respects, in The auditor is therefore reporting on the
accordance with an applicable financial 'faithful representation' of the accounts
reporting framework. In the case of most too.
general purpose frameworks, that opinion is
on whether the financial statements are
'Applicable financial reporting framework'
presented fairly, in all material respects, or
refers to the generally accepted
give a true and fair view in accordance with
accounting principles or GAAP that is in
the framework. An audit conducted in
place and which regulates the format of
accordance with ISAs and relevant ethical
the financial statements. It is the auditor's
requirements enables the auditor to form
job to make sure that the financial
that opinion.'
statements presented are in agreement
(ISA 200: para. 3) with this GAAP. The audit will need to be
carried out in line with recognised
auditing standards (such as ISAs which
are produced by the International
Auditing and Assurance Standards Board
(IAASB) and adopted by the Financial
Reporting Council (FRC) in the UK).

The Financial Reporting Council (FRC) is the independent regulator of accounting and auditing in
the UK. The Government has delegated responsibility for standard-setting to the FRC as well as
quality inspections, corporate governance and disciplinary action across the accountancy
profession.
The International Audit and Assurance Standards Board (IAASB) is an independent body, part of
the International Federation of Accountants (IFAC), which sets international standards for auditing.
The ISAs set by the IAASB have been adopted by the UK's FRC as national requirements in the UK.
The IAASB is committed to setting high-quality standards for auditing. It also seeks to enable
convergence between national and international standards so that globally, the quality of
auditing is increased and auditing practice becomes more uniform around the world. It is thought
that this will help ensure public confidence in the audit process (IAASB, 2011).
New standards are researched and consulted on, then subjected to public debate. The resulting
draft standards are exposed to the public for comment. Any comments arising are considered
and acted upon if necessary. A new standard is then issued when at least two-thirds of the
IAASB's members approve it.
The ISAs contain objectives, requirements and application and other explanatory material to help
an auditor obtain reasonable assurance. The auditor must follow the requirements of relevant
ISAs and must also have an understanding of the whole text of an ISA to enable requirements to
be applied properly.

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 5.2 Responsibilities for producing financial statements

'The financial statements subject to audit

are those of the entity, prepared by
This part of the ISA confirms that there are
management of the entity with oversight
different parties 'in charge' of a company
from those charged with governance. ISAs
(the audit client in this case):
do not impose responsibilities on
management or those charged with  Management prepare the financial
governance and do not override laws and statements and are responsible to
regulations that govern their responsibilities. the board of directors.
However, an audit in accordance with ISAs is
conducted on the premise that management  The board of directors is
and, where appropriate, those charged with responsible to shareholders (this is
governance have acknowledged certain known as governance).
responsibilities that are fundamental to the
conduct of the audit. The audit of the
financial statements does not relieve
management or those charged with
governance of their responsibilities.'
(ISA 200: para. 4)

Are there any responsibilities that apply to auditors? We know that ISAs must be followed by
auditors, but what else must the auditor consider? Some of this is illustrated by ISA 250
Consideration of Laws and Regulations in an Audit of Financial Statements which states that the
auditor needs to be aware of the following:

 Laws (such as the UK Companies Act 2006)

 Regulations (such as the UK Corporate Governance Code)
 Case Law (ISA 250: para. A7)

Corporate governance
You may know this term already: it has various definitions, but in its simplest form, corporate
governance is 'the system by which companies are directed and controlled' (FRC, 2018), and one
which attempts to address the agency problem we discussed earlier by introducing transparency
and accountability into the way that directors run a company.
Using the UK Corporate Governance Code (FRC, 2018) as an illustration, areas typically covered
by corporate governance include the following:
The principles of board leadership and company purpose
A. A successful company is led by an effective and entrepreneurial board, whose role is
to promote the long-term sustainable success of the company, generating value for
shareholders and contributing to wider society.
B. The board should establish the company’s purpose, values and strategy, and satisfy
itself that these and its culture are aligned. All directors must act with integrity, lead
by example and promote the desired culture.
C. The board should ensure that the necessary resources are in place for the company
to meet its objectives and measure performance against them. The board should also
establish a framework of prudent and effective controls, which enable risk to be
assessed and managed.
D. In order for the company to meet its responsibilities to shareholders and stakeholders,
the board should ensure effective engagement with, and encourage participation
from, these parties.
E. The board should ensure that workforce policies and practices are consistent with the
company’s values and support its long-term sustainable success. The workforce
should be able to raise any matters of concern.

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 The principles of the division of responsibilities
F. The chair leads the board and is responsible for its overall effectiveness in directing
the company. They should demonstrate objective judgement throughout their tenure
and promote a culture of openness and debate. In addition, the chair facilitates
constructive board relations and the effective contribution of all non-executive
directors, and ensures that directors receive accurate, timely and clear information.
G. The board should include an appropriate combination of executive and non-executive
(and, in particular, independent non-executive) directors, such that no one individual
or small group of individuals dominates the board’s decision-making. There should be
a clear division of responsibilities between the leadership of the board and the
executive leadership of the company’s business.
H. Non-executive directors should have sufficient time to meet their board
responsibilities. They should provide constructive challenge, strategic guidance, offer
specialist advice and hold management to account.
I. The board, supported by the company secretary, should ensure that it has the
policies, processes, information, time and resources it needs in order to function
effectively and efficiently
The board should establish risk management procedures, adopt suitable internal
controls, and consider the type and level of risk necessary to achieve its strategic goals
and objectives.
The Code also covers the appointment of suitable board members and how their
performance is appraised, plus remuneration policies that align the interests of the board
with the long-term success of the company. (FRC, 2018)
One of the ways transparency can be demonstrated by directors is the publication of a set of
audited financial statements. In a jurisdiction that adopts a principles-based approach, such as
the UK, directors are required to adopt a principle known as 'comply or explain': either they
comply with the requirements of the code, or they explain how and why they have not complied,
thus supporting an informed decision made by anyone relying on the audited financial
statements for any reason.
Companies that are required to demonstrate best practice in the UK will specifically need to refer
to the following principles in relation to the audited financial statements:

 'The board should establish formal and transparent policies and procedures to ensure the
independence and effectiveness of internal and external audit functions and satisfy itself
on the integrity of financial and narrative statements.
 'The board should present a fair, balanced and understandable assessment of the
company’s position and prospects.' (Principles M and N, UK Corporate Governance Code,
FRC, 2018)

You will learn more about the role of the internal auditors in a later chapter, but in summary, they
support the management of a company by helping to address a number of issues including, but
not limited to, the preparation of the accounting records, and ultimately, the financial
statements. It is the job of the external auditor to review the financial statements and produce an
auditor's report which contains their audit opinion on truth, fairness and faithful representation.
However, taking the UK as an example, you should remember that the external audit is first and
foremost a legal requirement. However, to satisfy the regulatory requirements of the stock
market and other investors, the external audit is also seen as a way of supporting strong
corporate governance.
Audit committees and non-executive directors
One of the underpinning elements of corporate governance is the use of non-executive directors.
These are directors who only sit on the board and therefore have no other day-to-day
responsibilities within the company, which means they can be used to evaluate the performance
of executive directors without any concerns over their objectivity.

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 In order to evaluate both internal and external audit as well as the financial statements, the
board will form an audit committee staffed only by non-executive directors. Taking the UK
Corporate Governance Code (FRC, 2018) as an example, the audit committee will be responsible
for the following:
 Monitoring the integrity of the audited financial statements
 Determining whether the audited financial statements satisfactorily communicate the
company's position, performance and prospects
 Reviewing risk management and internal controls, including the effectiveness of the
internal audit function
 Handling all aspects of the company's relationship with the external auditor (appointment,
removal, remuneration, effectiveness and both independence and objectivity of the
external auditor, especially the impact of any non-audit work that the external auditor
might also perform)

In summary, the non-executive directors on the audit committee are responsible for reviewing the
audited financial statements produced by the executive directors. This makes them an effective
control in addressing the agency problem.

5.3 Professional liability

As we know, the audit is an exercise carried out for the benefit of the shareholders of a company,
as it is addressed to them. It enhances the confidence of users to know that the directors have put
together financial statements that are free from material misstatement.
If the auditors give a poor service; that is, if they perform an audit that is of substandard quality
(for example, which states there are no material misstatements in the financial statements when
there are), they may be liable to the shareholders as a result. Performing a poor-quality audit
may constitute negligence under English law, which is a matter for the courts to decide.
Negligence is the way in which a service is carried out (ie carelessly) and the legal wrong which
arises when a person breaks a legal duty of care that is owed to another and causes loss to that
other.
For negligence to be proven, three separate things must be established:
(1) The fact that a duty of care existed
(2) The fact that this duty of care was breached
(3) The fact that this caused loss to the claimant
(1) Duty of care
Under English law, auditors owe a duty of care to their client. The duty of care is a legal
obligation to meet a required standard of care towards another party. This duty is implied
into the contract between an auditor and a client and cannot be disputed. Therefore, in
negligence cases, if the claimant is the client with whom the audit firm has a contract,
point (1) above needs no further proof.
In the case of auditors, this is slightly complicated by the question of who the client is.
We have noted above that the audit is conducted for the benefit of shareholders.
However, in English law, the shareholders of a company are often not considered in
isolation; that is, as individuals, but as a single body. In that context, the shareholders are
described as being the company.

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 Shareholder
Shareholder Shareholder
Shareholder
Shareholder
Shareholder
Shareholder

THE COMPANY

It is the body of shareholders, known as the company, that is considered to be the client
for the purposes of negligence in audit.
When the body of shareholders (the company) as a whole sues for negligence, point (1)
above does not have to be proven.
The situation is different if an individual shareholder or another third party sues for
negligence.
The audit is primarily carried out for the shareholders. However, other parties may be
interested in the financial statements of a company. In most companies, the following
parties may be interested.
 The bank (often a major lender to the company)
 Suppliers (who may extend credit to the company)
 Customers (who rely on the company to provide a quality service)
 Employees (who rely on the company for income)
 Tax authorities (who want to levy the correct tax from the company)
 If the company is public limited, potential investors (who are considering whether to
invest in the company)
 Individual investors (who might want to increase or decrease their stake in a
company).
While all of these parties may be interested in the audited financial statements, it is
important to remember that the audit is not carried out for their benefit. They are not the
client, and English law has historically substantially restricted the chances of these
parties proving the auditors owed them a duty of care.
One reason for this is that, in the case of these parties, the auditor does not automatically
owe them a duty of care, and they would have to prove that one existed.
The way that a duty of care might exist is if these parties have constructed a relationship
with the auditors, for example by:
 Warning them that they believe a duty of care exists; or
 Telling them they are relying on the audited financial statements for a special
purpose.
However, even then, it is not automatic, and the auditors may be able to disclaim liability
to these parties and say that a duty of care did not exist. Then the courts will have to
decide whether such a duty did exist, examining the facts.
(2) Breach of duty of care
For all parties, not only does a duty of care have to exist, but the claimant must also prove
that this duty was breached.
Again, this is a matter for the courts to determine when presented with the facts. However,
there are some generally accepted principles about auditing which may indicate whether a
duty of care has been met or breached.

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 For example, it is generally accepted that auditors will conduct audits according to
professional standards. We discussed this in Chapter 1. You should bear in mind that if an
audit firm does not carry out audits according to these professional standards, it may
make it easier to prove that a duty of care has been breached by the firm.
(3) Loss caused
This is the third item that needs proving in a case of negligence. The claimant will have to
show not only that he has suffered a loss, usually a financial loss, but also that the loss
was as a result of the breach of the duty of care on the part of the auditors. Again, this
will be determined by the courts.
If the auditors are found to have been negligent, they may have to pay financial reparation
(known as damages) to the claimant.
Activity 4: Duty of care

Select whether the auditors owe a duty of care to the following parties using the drop-down
options.

Company 
Bank 
Individual shareholder 
Creditor 

Picklist:
Automatic
Must be proved
Never

5.4 Audit failure

Performing a poor-quality audit resulting in the auditors being found guilty of negligence can be
described as audit failure, which can have serious consequences for audit firms.
One such consequence of audit failure has already been mentioned. A firm may have to pay out
substantial damages to a claimant if it has been proven that the auditors were negligent. This
would clearly adversely affect the audit firm, and may even cause it to cease to operate, if the
damages were so sizeable as to bankrupt the firm.
Such a legal case against a firm would bring substantial bad publicity, impacting on the firm's
ability to retain and engage clients in the future, even if they did continue to operate.
In addition, audit firms have supervisory bodies that monitor their activities (in the UK, that is the
FRC). The FRC might take disciplinary action against the firm and its partners in the event of
negligence, which could result in its ability to conduct audits being suspended.

5.5 Restriction of liability

The Companies Act 2006 entitles auditors to negotiate liability limitation agreements with their
clients. The effect of such agreements is to restrict the extent of the auditors' liability (the amount
of damages to be paid) in the event that negligence is proved against them. This restriction may
be a specified amount above which an auditor will not be liable (a liability cap) or an agreement
that, if there are other parties contributing to the loss and the damage, the auditor will only be
held liable for his portion of the damage (proportional liability) (Companies Act 2006: s.534).
There are other ways that auditors can restrict their liability. Many firms include a statement in
their auditor's report specifically excluding liability to parties other than the shareholders. This is

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 known as a Bannerman paragraph, after the legal case in which such a course of action was
recommended for auditors to avoid liability to third parties.
Individual audit partners can limit their personal liability for the firm's debts from such matters by
changing how the audit firm is legally formed.
Traditionally, audit firms have been partnerships, where each partner is liable for the debts of the
firm jointly with the other partners. It is now possible to set up audit firms in different legal forms,
such as a limited liability partnership (LLP), where the partners have limited liability in the same
way that shareholders in a company do. There are some drawbacks to forming an LLP, however:
for example, the requirements for increased publicity, such as filing accounts with the Companies
Registrar.
Lastly, a firm may insure against professional liability by taking out professional indemnity
insurance. In fact, many audit firms are required to do this by their supervisory body in the public
interest, so that if a firm is found liable, the injured parties can be compensated.

Notice this is only reasonable

5.6 Reasonable assurance assurance and is later confirmed as
not being absolute due to limitations.
'As the basis for the auditor's opinion, ISAs require the It is therefore not realistic to expect
auditor to obtain reasonable assurance about whether that an audit will pick up all issues,
the financial statements as a whole are free from only those judged as material from the
material misstatement, whether due to fraud or error. evidence collected (which is usually
Reasonable assurance is a high level of assurance. It is only a sample taken from the relevant
obtained when the auditor has obtained sufficient population).
appropriate audit evidence to reduce audit risk (that is,
the risk that the auditor expresses an inappropriate This gives some explanation of why
opinion when the financial statements are materially the auditor delivers an opinion only
misstated) to an acceptably low level. However, and not a guarantee. In paragraph 6
reasonable assurance is not an absolute level of of ISA 200 you will see that the auditor
assurance, because there are inherent limitations of an relies heavily on informed judgement.
audit which result in most of the audit evidence on which
the auditor draws conclusions and bases the auditor's
Note the distinction between fraud
opinion being persuasive rather than conclusive.'
and error – one of the inherent
(ISA 200: para. 5) limitations that the ISA describes.

Audit expectation gap

The term 'expectation gap' is used to describe the difference between the expectations of those
who rely upon an auditor's report concerning the audit work they think should be performed, and
the actual work performed by the auditor. The expectation gap arises due to a general
misunderstanding by the public of the respective responsibilities of both management and the
auditor, and a misunderstanding of the scope of an audit. Such misunderstandings might include
the following perceptions:
 It is the auditor's duty to prevent and detect fraud at an audit client
 The auditor is liable for any errors found in the financial statements
To counter these perceptions and reduce this gap, regulators have attempted to address these
misunderstandings by improving the layout and language of the auditor's report to clarify the
work done by both auditors and management (for example, the sections reproduced above from
ISA 200 on the auditor's need to obtain reasonable, not absolute, assurance).
Activity 5: Types and levels of assurance

Required
Identify whether the following sentences display a type of assurance or an expression of
assurance and, for each one, select the most appropriate description from the picklist below:

'In our opinion, the financial statements present fairly, in all material

respects…'

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 This is provided as part of the auditor's opinion and is classed as high,

but not absolute.
This is not provided for an audit as it is only moderate and is insufficient

for an audit.
'Based on our review, nothing has come to our attention that causes us
to believe that the financial statements are presented unfairly, in all 
material respects…'
Picklist:
Limited assurance
Negative expression of assurance
Positive expression of assurance
Reasonable assurance

5.7 Fraud issues from management and other employees

As stated above, an audit is not designed to uncover fraud. ISA 240 The Auditor's Responsibilities
Relating to Fraud in an Audit of Financial Statements states that primary responsibility for
preventing and detecting fraud rests with those charged with the governance of an entity, and
management (ISA 240: para. 4). When we look at a company's control environment later in this
course, we will see it is primarily through internal controls that a company tries to prevent fraud.
An auditor is still responsible for detecting material misstatements which may have arisen due to
fraud. The inherent limitations discussed above are particularly significant in relation to a fraud
which people are attempting to hide. It may be even more difficult to detect management fraud
than employee fraud because management may be able to manipulate financial records
themselves. It is therefore very important for auditors to have 'professional scepticism', and to be
alert to identifying opportunities for fraud to take place.
Professional scepticism is the attitude of critical assessment and the use of a questioning mind
necessary to prevent overlooking suspicious circumstances or from drawing incorrect conclusions.
The auditor should neither assume that management is dishonest nor fail to question whether
they are honest.
Activity 6: Fraud and error

Required
What do you think is the main difference between fraud and error?
Why will this make fraud more of an issue to auditors than error?

Many of the ISAs in existence use the term 'professional scepticism' on numerous occasions to
alert the auditor to the dangers of placing unrealistic levels of trust in both the management and
other staff employed by the entity being audited. To combat this, the Companies Act 2006

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 (s.507) states that if an employee of the company knowingly or recklessly gives the auditors a
false or deceptive statement they are guilty of a criminal offence.
From the inherent limitations of internal controls to the risks associated with giving an audit
opinion, this seems more and more likely to revolve around not just errors but also fraud, so
auditors need to remember that the risk of material misstatement through fraud is increased when
the auditor is sceptical of management's attitude and/or integrity.
The term 'money laundering' covers most aspects of fraud, including the following:
 Offences that indicate dishonest behaviour – such as tax evasion or not returning
overpayments by customers (where the client has attempted but failed to return such
overpayments, dishonesty is not indicated)
 Offences that involve saved costs (such as where a company is saving money by not
complying with environmental law; for example, by dumping waste illegally rather than
paying a company to remove it)
 Conduct overseas that would be illegal in the UK − for example, bribery of government
officials
The Proceeds of Crime Act 2002 sets down responsibilities for auditors to inform the National
Crime Agency (NCA) of any suspicions they may have regarding money laundering – they must
not alert the suspect, though, as 'tipping off' is classified as a crime as well (Proceeds of Crime
Act 2002, s.333).
Activity 7: Fraud risk and professional scepticism

Required
Identify whether each of the following factors would be likely to cause the auditor a greater or
lesser degree of professional scepticism by selecting the appropriate option.

Greater Lesser
professional professional
scepticism? scepticism?
The finance director has requested that you
complete the audit on time in order to meet head
office reporting deadlines. The finance director has a
profit-related bonus but has always accepted
adjustments that you asked for on previous audits.
The payroll officer has asked that you do not
perform any testing of the payroll until she returns
from her holiday. There are no other members of
staff who can assist you with the payroll audit.
When reviewing the board minutes, you read that
the company has applied for significant funding to
support the currently poor cash flow. From recent
conversations with the chief accountant, however,
you were under the impression that revenue and
cash flow were both healthy and that the company
was performing well.

How do auditors make sure they don't miss any occurrences of fraud?
To illustrate the circumstances that could lead to fraud, ISA 240 Appendix 1 gives some examples
of fraud risk factors for auditors to be alert to using the main conditions that contribute to fraud
occurring, split between misappropriation of assets and fraudulent financial reporting:

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 Fraudulent financial reporting

Incentives/pressures Opportunities Attitudes/rationalisations

 Financial stability/  Significant related-party  Ineffective communication or
profitability is threatened transactions enforcement of the entity’s values or
 Pressure on management  Assets, liabilities, ethical standards by management
to meet the expectations revenues or expenses  Known history of violations of
of third parties based on significant securities laws or other laws and
 Personal financial estimates regulations
situation of management  Domination of  A practice by management of
threatened by the management by a single committing to achieve aggressive or
entity’s financial person or small group unrealistic forecasts
performance  Complex or unstable  Low morale among senior
 Excessive pressure on organisational structure management
management or  Internal control  Relationship between management
operating personnel to components are deficient and the current or predecessor
meet financial targets
auditor is strained

Misappropriation of assets

Incentives/pressures Opportunities Attitudes/rationalisations

 Personal financial obligations  Large amounts of cash on  Overriding existing controls
 Adverse relationships hand or processed  Failing to correct known
between the entity and  Inventory items that are internal control deficiencies
employees with access to small in size, of high value,  Behaviour indicating
cash or other assets or in high demand displeasure or dissatisfaction
susceptible to theft
 Easily convertible assets, with the entity
such as bearer bonds,  Changes in behaviour or
diamonds, or computer chips lifestyle
 Inadequate internal control
over assets

ISA 240 Appendix 3 also provides some examples of circumstances that may indicate the
possibility of fraud:
 Discrepancies in accounting records (eg incomplete, unusual or unsupported transactions)
 Conflicting or missing evidence (eg inventory items, altered documents, unexplained items
and vague or implausible responses from management)
 Difficulties in the relationship between the auditor and management (eg delays in providing
evidence, intimidating behaviour from management and even denial of access to certain
aspects of the audited entity's records or systems)
 Unwillingness to allow the auditor access to those charged with governance
 Unusual accounting policies that are at odds with the rest of the industry or sector
To assist the auditor in responding appropriately to fraud risks and other factors, Appendix 2
of ISA 240 recommends a series of audit procedures that could be used, split between those at
the assertion level and those misstatements that again relate to both fraudulent financial
reporting and the misappropriation of assets:

Assertion level  Surprise visits to locations subject to audit inspection

 Alteration of the audit approach from year to year

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  Investigating manual adjustments and others that appear significant
or unusual
 Making use of automated tools and techniques to analyse data
 Reviewing the use by the client of a management's expert (someone
in possession of skills outside of accounting, such as a surveyor or
legal expert) to determine the appropriateness of their work

Fraudulent financial  Corroborating revenue by confirming amounts recognised with

reporting customers
 Attending inventory counts without any prior notice
 Using an auditor's expert to corroborate any accounting estimates
created by management

Misappropriation of  Counting cash and/or assets as close to the year-end as possible to

assets prevent the risk of manipulation
 Making use of automated tools and techniques to verify payroll
amounts, inventory balances and sales discounts
 Analysing vendor lists and comparing them with payroll to identify
potential supplier-based frauds
 Analyse expense reports submitted by senior management for
appropriateness

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 5.8 Professional judgement

'The concept of materiality is applied by the

auditor both in planning and performing the
audit, and in evaluating the effect of
identified misstatements on the audit and of
uncorrected misstatements, if any, on the
financial statements. In general,
misstatements, including omissions, are
considered to be material if, individually or
Materiality is the measure by which the
in the aggregate, they could reasonably be
auditor decides whether something
expected to influence the economic
needs investigating further or not.
decisions of users taken on the basis of the
financial statements. Judgments about
materiality are made in the light of
surrounding circumstances, and are
The perception of the auditor must be
affected by the auditor's perception of the
extremely clear to ensure that items are
financial information needs of users of the
not ignored – otherwise, the implications
financial statements, and by the size or
for the auditor (summed up by the
nature of a misstatement, or a combination
phrase 'audit risk' used earlier) could be
of both. The auditor's opinion deals with the
severe.
financial statements as a whole and
therefore the auditor is not responsible for Such judgement in the light of applicable
the detection of misstatements that are not laws and regulations (as well as the ISAs)
material to the financial statements as a dictate the approach that the auditor
whole.' uses.
(ISA 200: para. 6)

5.9 Evidence

'The ISAs contain objectives, requirements

and application and other explanatory
material that are designed to support the The terms 'scepticism' and 'judgement'
auditor in obtaining reasonable assurance. appear again to reinforce the alertness
The ISAs require that the auditor exercise required by the auditor.
professional judgment and maintain
professional scepticism throughout the We will see more of the need to
planning and performance of the audit and, understand the entity later in the
among other things: course.

 Identify and assess risks of material Obtaining evidence is how the auditor
misstatement, whether due to fraud reaches a conclusion and forms an
or error, based on an understanding opinion – we will also look at ways of
of the entity and its environment, obtaining evidence. The Companies Act
including the entity's internal control. 2006 assists auditors by giving them a
right of access at all times to all the
 Obtain sufficient appropriate audit company's books, accounts and
evidence about whether material vouchers and to require all company
misstatements exist, through officers to supply whatever information
designing and implementing and explanation they feel is necessary
appropriate responses to the for the audit.
assessed risks.
Scepticism includes learning to tell when
 Form an opinion on the financial things may not be as they appear, even
statements based on conclusions when interviewing clients and
drawn from the audit evidence documenting such discussions.
obtained.'
(ISA 200: para. 7)

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 5.10 Reporting

'The form of opinion expressed by the

auditor will depend upon the applicable The auditor's report varies by jurisdiction
financial reporting framework and any depending on where the audit is taking
applicable law or regulation.' place.
(ISA 200: para. 8)

The auditor's report contains a number of elements that you will learn more about later in this
unit, but in summary it looks like this:
 A title and a suitable addressee
 The auditor's opinion and an explanation of the basis for that opinion including a
description of the scope of the audit
 Issues related to the audited entity's going concern, key audit matters from the audit and
other information (these are not all required for every audit, though)
 Responsibilities of both auditors and management for the financial statements
 Regulatory issues for the jurisdiction concerned
 The auditor's signature, address and date that the report was signed (ISA 700: Appendix).

'The auditor may also have certain other

communication and reporting
responsibilities to users, management, those Auditors face a tricky balancing act in
charged with governance, or parties recognising the importance of
outside the entity, in relation to matters confidential information obtained
arising from the audit. These may be during the course of the audit and the
established by the ISAs or by applicable law need to report any instances of money
or regulation. (ISA 200: para. 9) laundering that they may uncover at
Effective Date any time.
This ISA is effective for audits of financial Auditors should be informed of the date
statements for periods beginning on or after of any shareholder meetings and
December 15, 2009.' allowed to attend and speak about
matters relevant to the audit.
(ISA 200: para. 10)

In cases where the auditor cannot simply

'In all cases when reasonable assurance give a 'true and fair' opinion, there may
cannot be obtained and a qualified opinion
be cases where a different opinion is
in the auditor's report is insufficient in the
circumstances for purposes of reporting to given – one qualified by a statement
the intended users of the financial such as '…except for … the financial
statements, the ISAs require that the auditor statements show a true and fair view…'
disclaim an opinion or withdraw (or resign) Again, we will see more of this in a later
from the engagement, where withdrawal is part of the Course Book.
possible under applicable law or regulation.'
(ISA 200: para. 12)

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 6 The AAT Code of Professional Ethics
The assurance sought by the intended users could be compromised by the external auditor not
being fully independent from the directors of the company being audited. The audit profession
has addressed this issue by creating a number of ethical principles that should underpin all audit
work with concepts such as independence and objectivity as well as recommended courses of
action should any member find themselves exposed, and these can be found within the AAT Code
of Professional Ethics (2014). This Code is made available on the AAT website (www.aat.org.uk)
and AAT members are required to act in accordance with the Code. You should have already met
and studied the Code in earlier units.
Independence is defined by the Code in two ways:
(i) Independence of mind – Independence of mind is the state of mind that permits the
provision of an opinion without being affected by influences that compromise professional
judgement, allowing an individual to act with integrity, and exercise objectivity and
professional judgement; and
(ii) Independence in appearance – Independence in appearance is the avoidance of facts and
circumstances that are so significant that a reasonable and informed third party, having
knowledge of all relevant information, including any safeguards applied, would reasonably
conclude a firm's, or a member of the assurance team's, integrity, objectivity or
professional scepticism had been compromised.
(AAT Code of Professional Ethics: s.290.5)

6.1 Fundamental principles

These are the ethical principles that all accountants and auditors should comply with.
To help understand how this independence can be displayed, there are a series of fundamental
principles that should be complied with:

 Professional competence and due care: to maintain professional knowledge and skill at the
level required to ensure that a client or employer receives competent professional service
based on current developments in practice, legislation and techniques. A member shall act
diligently and in accordance with applicable technical and professional standards when
providing professional services.
 Integrity: to be straightforward and honest in all professional and business relationships.
 Adopt Professional behaviour: to comply with relevant laws and regulations and avoid any
action that brings our profession into disrepute.
 Confidentiality: to, in accordance with the law, respect the confidentiality of information
acquired as a result of professional and business relationships and not disclose any such
information to third parties without proper and specific authority unless there is a legal or
professional right or duty to disclose. Confidential information acquired as a result of
professional and business relationships shall not be used for the personal advantage of the
member or third parties (we will return to this in different situations later).
 Objectivity: to not allow bias, conflict of interest or undue influence of others to override
professional or business judgements.
(AAT Code of Professional Ethics: s.100.5)

You can remember these more easily with the mnemonic 'PIPCO'.

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 Activity 8: Fundamental ethical principles

Required
Match each of the following descriptions with the fundamental ethical principle it represents.

Being dishonest about a business relationship with a client 

Accepting an engagement when not trained to complete it 
Insider trading by deciding to purchase a client's shares 

Picklist:
Confidentiality
Integrity
Objectivity
Professional behaviour
Professional competence and due care

6.2 The conceptual framework

These are potential situations or ethical threats that auditors and accountants should aim to
avoid.
In order to help auditors avoid getting into situations where their independence or objectivity
could be called into question, the Code uses the conceptual framework to illustrate the possible
threats that auditors could be exposed to:

 Advocacy: when a member promotes a position or opinion to the point that subsequent
objectivity may be compromised
 Self-interest: where a financial or other interest will inappropriately influence the member's
judgement or behaviour
 Intimidation: when a member may be deterred from acting objectively by threats, whether
actual or perceived
 Familiarity: when, because of a close or personal relationship, a member becomes too
sympathetic to the interests of others
 Self-review: when a previous judgement needs to be re-evaluated by the member
responsible for that judgement
(AAT Code of Professional Ethics: s.100.12)

You can remember these more easily by the mnemonic 'AS IFS'.
There are actually many circumstances that threaten the application of the fundamental
principles and we will now have a look at each of these threats to see just what can lead to them
appearing.
Illustration 2: Application of the fundamental principles

Advocacy
 Promoting shares in a listed entity when that entity is a financial statement audit client
 Acting as an advocate on behalf of an assurance client in litigation or disputes with third
parties

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 Self-interest
 A financial interest in a client or jointly holding a financial interest with a client
 Undue dependence on total fees from a client
 Having a close business relationship with a client
 Concern about the possibility of losing a client
 Potential employment with a client
 Contingent fees relating to an assurance engagement
 A loan to or from an assurance client or any of its directors or officers
 Discovering a significant error when evaluating the results of a previous professional service
performed by a member of staff working with or for the member
Intimidation
 Being threatened with dismissal or replacement in relation to a client engagement
 An assurance client indicating that he will not award a planned non-assurance contract to
the member in practice if the member in practice continues to disagree with the client's
accounting treatment for a particular transaction
 Being threatened with litigation
 Being pressured to reduce inappropriately the quality or extent of work performed in order
to reduce fees
 Feeling pressured to agree with the judgement of a client employee because the employee
has more expertise on the matter in question
Familiarity
 A member of the engagement team having a close or personal relationship with a director
or officer of the client
 A member of the engagement team having a close or personal relationship with an
employee of the client who is in a position to exert direct and significant influence over the
subject matter of the engagement
 A former partner of the firm being a director or officer of the client or an employee in a
position to exert direct and significant influence over the subject matter of the engagement
 Accepting gifts or preferential treatment from a client, unless the value is clearly
insignificant
 Long association of senior personnel with the assurance client
Self-review
 The discovery of a significant error during a re-evaluation of the work of the member in
practice
 Reporting on the operation of financial systems after being involved in their design or
implementation
 Having prepared the original data used to generate records that are the subject matter of
the engagement
 A member of the assurance team being, or having recently been, a director or officer of
that client
 A member of the assurance team being, or having recently been, employed by the client in
a position to exert significant influence over the subject matter of the engagement
 Performing a service for a client that directly affects the subject matter of the assurance
engagement

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 Activity 9: Ethical threats

Required
Which ONE of the following situations is likely to represent a self-interest threat?


One client represents 25% of the audit firm's total fees for the year
Representing an audit client in a tax investigation
Receiving free VIP tickets to the World Cup Final from a client

6.3 Members in practice

There are certain situations where accountants and auditors who work in practice may be
exposed to ethical threats which we shall now discuss.
 Professional appointment – before accepting an engagement to work for a client,
members should determine whether there are threats to compliance with the fundamental
principles from any illegal activities (such as money laundering), dishonesty on the part of
clients or questionable financial reporting practices. Members should also ensure they are
competent to act before accepting a professional appointment (AAT Code of Professional
Ethics: s.210).
 Second opinions – if asked to provide a second opinion on the application of accounting,
auditing, reporting or any other standards or principles to an entity that is not an existing
client, members need to ensure they are competent to act in such a capacity and have
access to the same relevant facts or evidence as the existing accountant. Members need to
be alert to second opinions being abused by clients especially if they are not permitted to
communicate with the existing accountant (AAT Code of Professional Ethics: s.230).
 Fees and other types of remuneration – members may quote whatever fee they feel is
appropriate for a service but they must be alert to any threats presented by fees being too
low (such as self-interest if the fee quoted to clients is so low that it may be difficult to
perform the engagement in line with applicable technical and professional standards).
Arrangements such as contingent fees and commissions can also present self-interest
threats depending on the engagement and which, without adequate safeguards, are
unacceptable (AAT Code of Professional Ethics: s.240).
 Marketing professional services – like all service providers, accountants need to advertise
to attract clients but they must ensure that they do so in a manner that does not distort the
truth or misrepresent the interests of another professional: otherwise, a self-interest threat
to compliance with the principle of professional behaviour may be created (AAT Code of
Professional Ethics: s.250).
 Gifts and hospitality – it is not uncommon for members and their clients to give and
receive items as part of maintaining their professional relationship. However, such gifts and
hospitality may create self-interest threats if accepted and intimidation threats if made
public. In such cases, the significance of any gifts and hospitality must always be
considered, especially in the context of the UK Bribery Act 2010 (AAT Code of Professional
Ethics: s.260).
 Custody of client assets – members may be asked to look after client assets (such as cash
or valuables) due to possessing better safekeeping controls, but this could create self-
interest threats and others relating to money laundering that they should consider before
accepting this request (AAT Code of Professional Ethics: s.270).
 Objectivity – all services – threats such as familiarity can be created by having a close
personal or business relationship with a client or its directors, officers or the employees of a
client (AAT Code of Professional Ethics: s.280).

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  Independence – assurance engagements – family and other personal or business
relationships, loans, beneficial interests in shares and other investments and gifts and
hospitality can create threats to objectivity and independence by their nature. Members
should evaluate the threats and use professional judgement in applying the conceptual
framework in such cases (AAT Code of Professional Ethics: s.290).

6.4 Members in business

Members in business may be solely or jointly responsible for the preparation and reporting of
financial and other information, which both their employing organisations and third parties may
rely on. They may also be responsible for providing effective financial management and
competent advice on a variety of business-related matters.
A member in business may be, for example, a salaried employee, a partner, a director (whether
executive or non-executive), an owner-manager, a volunteer or another working for one or more
employing organisations.
A member in business has a responsibility to further the legitimate aims of their employing
organisation. The Code seeks not to hinder a member in business from properly fulfilling that
responsibility but to consider circumstances in which conflicts may be created with the duty to
comply with the fundamental principles.
As well as being exposed to the same ethical threats as members working in practice, members in
business may experience the following:
 Self-interest threats from inappropriate personal use of corporate assets, concern over
employment security and commercial pressure from outside their employer (self-interest
threats also occur when members in business are exposed to profit-related bonuses and
share options when in a position to influence the factors that could affect such schemes).
 Self-review threats when reviewing data and making decisions based on the same data.
 Advocacy threats would only exist for a member in business who promotes their employing
organisation if any statements made were either false or misleading.
 Familiarity threats exist where reporting is undertaken by members and those connected
to members, where there is long association with business contacts and where gifts are
given and/or received.
 Intimidation can occur when a member is threatened with either dismissal or replacement
while producing some form of subject matter or when a dominant individual attempts to
influence decisions.
 A threat to the member in business performing duties with the appropriate degree of
professional competence and due care due to insufficient time, resource, training or
information being provided by the employer.
 Gifts and hospitality can be perceived to act as inducements which create both self-
interest and intimidation threats as outlined above.

6.5 Ethical safeguards

As part of the assessment, you will need to be able to evaluate ethical safeguards.
Ethical safeguards either eliminate or reduce threats to objectivity and independence.

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 They can be considered like this:
Illustration 3: Ethical safeguards

Firm-wide safeguards to eliminate or reduce threats to the fundamental ethical principles and
the independence of auditors:

The use of different Necessary for the following engagements to address the likely
personnel with different self-review, self-interest and advocacy threats:
reporting lines for the  Internal audit services
provision of non-assurance  Information technology services
services to an audited entity  Valuation services (including actuarial services)
 Tax services
 Litigation support and legal services
 Recruitment and remuneration services
 Corporate finance services
 Transaction related services
 Restructuring services
 Accounting services

Procedures for monitoring Self-interest and intimidation threats can be mitigated by:
and managing the reliance  Reducing the dependency on the client
on revenue received from a  External quality control reviews
single client  Consulting a third party on key points.

Procedures that will enable Examples of relevant interests or relationships (plus relevant
the identification of interests safeguards where appropriate):
or relationships between the  Financial interests (self-interest, familiarity and intimidation
firm or members of threats can be reduced by a variety of safeguards, usually
the engagement team and removal of either the interest or the individual concerned, or
clients review)
 Loans and guarantees (create a self-interest threat that is
insurmountable unless under normal commercial terms)
 Business relationships (create self-interest and intimidation
threats that are usually insurmountable unless such
transactions are part of normal business and at arm’s length)
 Personal and family relationships (create self-interest,
familiarity and intimidation threats that can usually only be
addressed by removing the affected individual from the
engagement team)
 Switching jobs between engagement firms and the client
(self-interest, self-review, familiarity and intimidation threats
may be created which are so significant that no safeguard
could reduce the threat to an acceptable level – however, if
appropriate, safeguards can include modifying work plans,
appointing experienced staff and review procedures)
 Serving as a director or officer of an assurance client (self-
review, self-interest and advocacy threats here are usually
insurmountable unless the service is limited to matters of a
routine and administrative nature only)
 Gifts and hospitality (self-interest and familiarity threats are
created that are insurmountable unless the value is trivial and
inconsequential)
 Actual or threatened litigation (self-interest and intimidation
threats can be mitigated by withdrawal or review).

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 In most instances, such procedures will require communicating
any interests or relationships to those charged with governance at
the client and documenting the nature of any threats and any
conclusions on the adequacy of safeguards adopted (where
appropriate).
This can include being alert to interests or relationships between the
firm or members of the engagement team and related entities of the
client.

Disciplinary mechanisms to These will be implemented by firms to ensure adherence to the AAT
promote compliance with Code of Ethics (and to punish those who do not follow these
policies and procedures policies and procedures).

Engagement-specific safeguards to eliminate or reduce threats to the fundamental ethical

principles and the independence of auditors:

Independent review of audit As above, many situations can lead to the need for an
working papers independent review of someone’s work:
 Financial interests
 Employment switches between firms and clients
 Litigation threats.
Also necessary in cases where staff require rotating due to the
length of their association with a particular client (see below).

Consultation with an Necessary in such cases as excessive fee dependence on one

independent third party specific client (and with AAT in cases of ethical uncertainty).

Disclosure and discussion of Usually required in cases where interests and relationships exist
ethical issues with those between the firm or members of the engagement team and clients.
charged with governance

Rotation of senior personnel Long association between engagement staff and clients can lead
to familiarity and self-interest threats – depending on the
significance of the threat, rotation away from the engagement
team is an appropriate safeguard to counter this threat, as is a
review of the staff member’s work by a professional accountant
not on the team and regular independent internal and external
quality review.

Matters that should be referred to senior members of audit staff:

These are frequently subjective and require staff members to display suitable judgement (these
will be covered in a subsequent part of the Course Book).

(AAT Code of Professional Ethics: s.300)

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 Activity 10: Ethical safeguards

Required
For each of the following situations, match the ethical threat described with an appropriate
safeguard.

Providing a valuation service to an audit client for assets held by a


subsidiary of that client.

Seven members of the audit firm own shares in the firm's audit clients. 

The audit manager's brother is promoted to become finance director of


that client.

Picklist:
A register of interests and relationships between audit team members and clients
Independent review of working papers
Rotation of senior personnel
Use of different personnel with different reporting lines

6.6 Confidentiality
We've already seen that members are obliged to maintain confidentiality of information acquired
as a result of professional and business relationships, but are there situations where this may not
be appropriate? The Code provides details of three such cases:
(1) Where disclosure is permitted by law and is authorised by the client or the employer (or
any other person to whom an obligation of confidence is owed) such as prospective
auditors asking a client's permission to contact their existing auditor.
(2) Where disclosure is required by law such as in a court case or if required as part of an
investigation by HM Revenue & Customs (HMRC) or the NCA in relation to money
laundering (in such cases, though, great care must be taken by auditors to avoid 'tipping
off' those under suspicion as this represents a crime in itself).
(3) Where there is a professional duty or right to disclose, which is in the public interest, and is
not prohibited by law (this may occur as part of an external quality review or as part of a
regulatory body's inquiry or inspection, and is usually to assist the member in protecting
their own professional interests).
Accountants are unlikely to breach the fundamental principle of confidentiality lightly so legal
and other professional advice is always advised in such situations (AAT Code of Professional
Ethics: s.140).
Security
In practice, security measures by the auditor may be a very important part of keeping the duty of
confidentiality. Security falls into two categories.
First, auditors must be very careful in carrying out their work that they do not discuss their work
in inappropriate places. This may be the case both at the client and outside the client's premises.
For example, the directors may tell the auditors information that they don't want the rest of the
client staff to know. The auditors should only discuss such information when they know other
client staff members cannot overhear them.
For this reason, it is very important that the client provides the auditors with a suitable place to
work when they are carrying out auditing work at a client's premises. They should be given a
private room rather than being asked to work in the middle of the accounts department.
The auditors must be careful in discussing client information away from the client premises.

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 There are many places where it is inappropriate to discuss client information. The general rule is
that client information should not be discussed in a public place or with anyone outside of the
audit firm.
Second, auditors must ensure that the security arrangements over their physical work are
sufficient. Audit files and any computers storing audit work must be kept secure. Auditors are
often issued with lockable cases by their firm so that they can lock audit files away when they are
not in use and can be transported securely.
This may also mean not leaving the office (which the auditors are using at the client) open if the
auditors are not there, not leaving client files in the auditor's car, and ensuring that the storage
facilities for client files at the auditor's own office are secure. If older files are put away in storage,
this should be locked, with only the auditors having access to it.

6.7 Conflicts of interest

Conflicts of interest occur either when a member provides the same service to two competing
clients or employers, or the interests of a member in relation to a service are in conflict with the
interests of a client or employer due to the same service. This can happen in situations when
acting for both parties who are competing for the same contract or assets, and when one party
intends to acquire the other (including the firm) and requires evaluation of the relative
significance of such conflicts.
Once such a conflict of interest has been identified, members are required to disclose the nature
of the conflict and to obtain consent to act from all parties concerned. Without consent, the
service cannot be continued or accepted unless the process of obtaining consent represents a
breach of confidentiality (such as cases of fraud or hostile takeovers) when safeguards must be in
place (usually those relating to preserving confidentiality using information barriers between the
different teams working on each client or employer) (AAT Code of Professional Ethics: s.220).
Activity 11: Confidentiality

Required
For each of the following situations, tick any where the auditor is authorised to disclose
confidential information about an audit client.


A request for information as part of a tax investigation
A change in external auditor following a tender without client approval
A quality control review carried out by the FRC

6.8 Conclusions
The overall aim is for external auditors to ensure that the relationship they find themselves in with
audit clients should only ever be that of 'auditor' and 'client'. Should a member find that they
have failed to comply with any of this, the Code (2014) states:
'Members should note that disciplinary action may be taken for non-compliance with this Code
where the member's conduct is considered to prejudice their status as a member or to reflect
adversely on the reputation of AAT.'
Such disciplinary action could result in suspension of membership and possibly even a fine.

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 6.9 A final note about data security
As well as being able to recognise when to disclose information with or without clients' permission
and when to take precautions if acting for competing clients, auditors also need to understand
the importance of data security.
During the course of an audit (both internal and external) there will be significant amounts of
evidence collected which must be stored securely to maintain confidentiality. In the 21st century,
this is increasingly likely to be some kind of electronic or digital storage due to the significant
advantages of being able to access and share data as part of an efficient audit, sometimes
spread across different locations.
However, this shared access can also create problems, as cyber threats are becoming more
significant and the loss or theft of confidential data can have serious implications for auditors,
who must now invest in ongoing cybersecurity controls to ensure they are adequately protected
from such threats. These implications range from losing clients to being fined for non-compliance
with data protection legislation.
Examples of suitable cybersecurity controls include the following:

 The appointment of qualified IT staff who can implement and support appropriate policies
and controls
 Investment in suitable IT infrastructure such as firewalls and anti-virus software
 Education and awareness of cybersecurity among staff, such as training for staff on
neutralising suspicious emails that might contain a cyber threat
 The adoption of suitable cybersecurity accreditation, such as ISO 27001

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 Chapter summary

 Companies are legal entities that are set up for a specific purpose and have many different
stakeholders (investors such as banks and shareholders, plus employees and directors, customers
and suppliers and the government which is interested in keeping all parties happy!).

 Companies have many responsibilities: in the UK they are laid out by the Companies Act 2006
which specifies two areas for this unit: (i) keeping adequate accounting records and (ii) providing
financial statements.

 Due to the differences between owners and directors of a company, there can be a lack of
visibility and trust over the truth and fairness (or faithful representation) of the company's
financial statements, which leads to something called the agency problem: this can be overcome
by the financial statements being subject to an independent review which is known as an audit.

 Audits are carried out by qualified professionals who are appointed to provide a degree of
credibility for the work done by directors in running the company on behalf of the investors who
own it. This credibility is called 'assurance'. Not all companies require an audit but there can be
benefits from having one voluntarily.

 International Standard on Auditing (ISA) 200 provides a framework for audits carried out using the
standards agreed by most accountants and auditors across the world – these are created by the
International Auditing and Assurance Standards Board (IAASB) and in the UK are adopted and
regulated by the Financial Reporting Council (FRC). Sometimes an expectation gap exists, which
highlights the differences between what some people think an audit is supposed to do and what the
auditor actually does.

 Many responsibilities exist for both managers and auditors of companies subject to audit – included
in these are an awareness of what happens when an audit fails due to auditor negligence and the
techniques used by auditors to control such failures.

 Auditors are expected to collect enough evidence during the audit to be able to provide an
appropriate amount of assurance for their opinion. Part of this evidence gathering requires
auditors to be alert to the threat of fraud such as money laundering: to combat this and other
frauds, auditors are encouraged to display 'professional scepticism' in order to apply their
judgement appropriately.

 The auditor will communicate the findings of the audit to a variety of stakeholders, including
shareholders, those charged with the governance of an entity and regulators, and will do so in a
specific manner using an auditor's report.

 One possible solution to the agency problem is the adoption of corporate governance practices,
which see the appointment of non-executive directors to the board of a company in order to
review the quality of the audited financial statements. They will sit on an audit committee which is
also responsible for addressing issues such as internal audit, risk management, internal control
and all things related to the external auditor.

 To assist auditors and accountants in discharging their duties with the public interest in mind, the
AAT Code of Professional Ethics exists to provide guidance on objectivity and independence (both
of mind and in appearance). Through the fundamental principles (PIPCO) and the conceptual
framework (AS IFS) accountants and auditors both in practice and in business are given guidance
that they can apply when necessary, including ethical safeguards to counter various threats plus
advice on issues regarding confidentiality and conflicts of interest between competing clients.

 Auditors need to be aware of the need to maintain confidentiality over all forms of data, including
the security of digital information that may be vulnerable to cyber threats. Protection can come
from adopting a policy that implements suitable cybersecurity controls that include IT
infrastructure, staff training and external accreditation.

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 Keywords
 Assurance: a degree of confidence that is provided by a practitioner when reviewing
subject matter produced by a responsible party for the benefit of the users of that subject
matter. Assurance can be expressed in different ways and to different extents
 Audit: an independent review of the financial statements and disclosures produced by
directors to ensure that they are both honest and unbiased
 Audit committee: a collection of non-executive directors charged with overseeing various
controls in place over the audited financial statements
 Audit failure: performing a poor-quality audit resulting in the auditors being found guilty of
negligence can be described as audit failure, which can have serious consequences for
audit firms
 Conceptual framework: potential situations or ethical threats that auditors and
accountants should aim to avoid
 Conflicts of interest: occur either when a member provides the same service to two
competing clients or employers, or the interests of a member in relation to a service are in
conflict with the interests of a client or employer due to the same service
 Corporate governance: the system by which companies are directed and controlled
 Cybersecurity and cyber threats: awareness of the issues surrounding the use of digital
means of storing and accessing confidential client information
 Ethical safeguards: either eliminate or reduce threats to objectivity and independence
 Expectation gap: the difference between what users of financial statements think the
external auditor is responsible for and what the external auditor is actually responsible for
 Faithful representation: financial information represents the substance as well as the legal
form, possessing the characteristics of completeness, neutrality and being free from error
 Financial Reporting Council (FRC): the independent regulator of accounting and auditing
in the UK. The government has delegated responsibility for standard-setting to the FRC as
well as quality inspections, corporate governance and disciplinary action across the
accountancy profession
 Fraud: an attempt to gain advantage by some form of deception
 Fundamental principles: ethical principles that all accountants and auditors should comply
with
 Independence in appearance: the avoidance of facts and circumstances that are so
significant that a reasonable and informed third party, having knowledge of all relevant
information, including any safeguards applied, would reasonably conclude a firm's, or a
member of the assurance team's, integrity, objectivity or professional scepticism had been
compromised
 Independence of mind: the state of mind that permits the provision of an opinion without
being affected by influences that compromise professional judgement, allowing an
individual to act with integrity, and exercise objectivity and professional judgement
 International Audit and Assurance Standards Board (IAASB): an independent body, part of
the International Federation of Accountants (IFAC), which sets international standards for
auditing
 Liability limitation agreement: an agreement between an auditor and their client that limits
the amount of auditor liability in the event of any negligence
 Negligence: the way in which a service is carried out (ie carelessly) and to the legal wrong
which arises when a person breaks a legal duty of care that is owed to another and causes
loss to that other It is a key part of determining professional liability
 Non-executive director: a board member whose sole responsibility is to evaluate the
effectiveness of the financial reporting process

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  Professional scepticism: the attitude of critical assessment and the use of a questioning
mind necessary to challenge assumptions and prevent overlooking suspicious
circumstances or from drawing incorrect conclusions
 Proportional liability: where a professional firm agrees to be liable for only a share of any
damages due to a client on respect of negligence or other litigation
 True and fair view (or presents fairly in all material respects): 'true' means honest and
factual, while 'fair' means free from bias. 'Presents fairly in all material respects' is used in
the same way as 'true and fair view'

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 Test your learning
1 Complete the following statement.

 
A(n) is a(n) registered as such under the
Companies Act 2006.
Picklist for line items:
Company
Entity
2 Select which one of the following statements is not an implication of registering a company
by ticking the appropriate box.

It is seen as distinct from its owners.

It is required to have an audit, unless exempt.

It must keep accounting records.

It must be managed by its owners.

3 State whether the following are true or false in respect of a company's accounting records.

Companies must keep records that disclose with reasonable accuracy


the company's position at any time.

All companies must keep records of inventory. 

Picklist:
True
False
4 Complete the following definition of an audit.

 
A(n) is an exercise carried out by to
 
ascertain whether the prepared by the are

(in the UK) in accordance with UK GAAP and the and give what is

known as a(n) .
Picklist for line items:
Audit
Auditors
Companies Act 2006
Directors
Financial statements
True and fair view

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 5 State whether the following statements are true or false in respect of external auditors'
duties and rights.

Auditors are required to report on the truth and fairness of financial


statements.

Auditors have a right of access to a company's books and records at


any time.

Auditors are entitled to obtain explanations from the officers of a


company.

Picklist:
True
False
6 Select which one of the following best describes to whom the auditors owe a duty of care
by ticking the appropriate box.
Auditors owe a duty of care to:

All users of financial statements

The client (that is, the company, comprising all the shareholders)

Shareholders

The client and any other parties with whom they have implied a special relationship
7 Set out what three things need to be proven in a case for negligence.
8 Complete the following definition of confidentiality.

  
is the duty to keep affairs
Picklist:
Client
Confidentiality
Private
9 Set out why security procedures are important to auditors.
10 During the audit of Sneaky Ltd, the audit senior discovered a file of invoices which did not
appear to be included in the financial records, for which the company has been paid in
cash. No VAT has been paid in relation to these sales.
Select which one of the following is the most appropriate action for the audit senior to take
by ticking the appropriate box.
Report the matter to:

The board of directors

HMRC

The audit firm's money laundering reporting officer

All of the above

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 Systems of
internal control

Syllabus learning outcomes / objectives

Having studied this chapter you will be able to:

1. Demonstrate an understanding of the audit and assurance framework

1.4 The role of internal audit

Learners need to understand:
1.4.1 the difference between internal and external audit
1.4.2 the requirement for internal audit
1.4.3 the roles of internal audit including:
– reviewing accounting and systems of internal control
– examining financial operating information
– special investigations, eg fraud
– reviewing compliance with external regulation
– reviewing value for money (VFM)
– risk management
1.4.4 the different types of internal audit work including:
– financial
– operation
– project
– VFM
– social and environmental
– management
1.4.5 the risks associated with a lack of independence.

3. Evaluate the planning process for audit and assurance

3.4 The role of audit working papers

Learners need to be able to:
3.4.6 evaluate internal control systems using systems records:
– flow charts
– internal control questions
– checklists
3.4.7 identify the merits and limitations of using standardised questionnaires and
checklists.

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 4. Evaluate procedures for obtaining sufficient and appropriate evidence

4.4 Audit approach

Learners need to understand: Learners need to be able to:
4.4.1 the definition of internal control and 4.4.8 establish why auditors need to
each of its component’s control activities understand the audited entity's
including: internal controls
– performance reviews 4.4.11 identify how errors and
– information processing irregularities can be mitigated by
control procedures.
– physical controls
– segregation of duties
– monitoring of controls by
management
– monitoring of controls by an
internal audit function
4.4.2 preventative controls
4.4.3 detective controls
4.4.4 the role of internal audit as part of the
internal control environment
4.4.5 limitations of internal controls
4.4.6 factors relating to the operating
environment that influence control risk
4.4.7 factors relating to internal control
systems that influence control risk.

Assessment context
This is a key area in the syllabus and you could see requirements in your assessment testing
aspects of this content in tasks 1, 3, 4 or 5.

Qualification context
This topic includes terminology that you will have seen before in your AAT studies – you should be
able to apply this knowledge to address the practical aspects of some of the systems and
controls addressed.

Business context
Failure to record a company's controls is a critical issue for auditors; hence the importance that is
placed upon it in real audits. You will also see how companies are structured to ensure such
critical systems work to keep track of the many transactions undertaken on a daily (even hourly)
basis.

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 Chapter overview

Introduction to internal control

ISA 315 and components of internal control

Control Information Control Monitoring of

environment system activities controls

Inherent limitations of internal controls

Main features of accounting systems

 Control objectives
 Risks
 Control procedures

Understanding the entity's systems

Ascertaining the Documenting Confirming the Evaluating the

system the system system system

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 1 Introduction to internal control
As part of the audit, it is imperative to understand the controls in place within the client and the
auditor does this at a relatively early stage in proceedings.
What is a control and how does it work?
Before we look at the precise definition, we need to understand what we mean by 'control' and
how it might be 'in place' within the client.
Consider a street light – it is usually in place to meet the need of lighting a street at night for
safety and security purposes. If we consider the darkened street it serves, there could be four
situations in place:

(1) The street light does not exist and the street is in darkness.
(2) The street light exists but is broken (ie not working properly).
(3) The street light exists but has a bulb that does not illuminate the street below (ie it is
ineffective).
(4) The street light exists and illuminates the street effectively, ensuring safety and security.

It is obvious that the auditor will need to understand the various controls in place within an entity
to see which of these four states each control is in – here we will look at what controls there could
be in a variety of systems and then consider the processes that auditors go through in order to
assess them.

2 ISA 315 (Revised) Identifying and Assessing the

Risks of Material Misstatement
Internal control: 'The system designed,
implemented and maintained by those The ISA goes on to describe the
charged with governance, management and components of internal control as the
other personnel, to provide reasonable control environment, the entity’s risk
assurance about the achievement of an assessment process, the information and
entity's objectives with regard to the communication system, control activities
reliability of financial reporting, and the entity's system for monitoring the
effectiveness and efficiency of operations, system of internal control – these are all
and compliance with applicable laws and discussed below with the risk assessment
regulations.' process covered later on in your materials.
(ISA 315 (Revised): para. 12 (m))

The other areas of the entity the auditor needs to understand are:
 Industry, regulatory, and other external factors, including the applicable financial
reporting framework (such as suppliers, competitors, government and technology)
 Nature of the entity, including the entity's selection and application of accounting policies
(plus the role that the various stakeholders play)
 Objectives and strategies and the related business risks that may result in a material
misstatement of the financial statements
 Measurement and review of the entity's financial performance.
The last point (measurement and review of performance) is handled by an organisation's systems
of internal control. In very broad terms, these internal control systems are designed to make sure
that good things happen to an entity while avoiding any bad things at the same time. Not all
entities have the same approach to setting up their internal controls, however, and this is
frequently determined by the control environment – so what is the control environment?

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 2.1 Control environment
The control environment is 'the attitudes, awareness, and actions of those charged with
governance and management concerning the entity's system of internal control and its
importance in the entity' (ISA 315 (Revised): Appendix 3 para. 4).

ISA 315 (Revised) uses the terms 'culture of honesty and ethical behaviour' as well as the
importance of internal controls within an organisation. This 'tone' is what influences 'the control
consciousness of its people'. It stands to reason that the stronger the attitudes, awareness and
actions of those charged with governance and management in respect of the entity's internal
controls, the better these internal controls will be (ISA 315 (Revised): paras. 21 (b) and Appendix 3
para. 4).

There are various ways that a good control environment can be seen in practice:
 Directors communicate and enforce integrity and ethical values.
 Directors and staff are committed to competence.
 Directors participate in control activities.
 Management operates in a way that promotes control.
 The organisation is structured in a way that promotes control.
 Authority and responsibility for controls is assigned to people.
 Human resources policies promote controls.
A bad control environment can be seen when the opposite of some of these is true; for example,
directors who circumvent and ignore controls to get things done.

2.2 Information system

Within information processing controls, there are a number of specific controls that relate to
information technology (IT) systems, although it must be remembered that an information
system could just as easily be:
 A filing cabinet
 An integrated IT system.
According to ISA 315 (Revised) (Appendix 1), the information system relevant to financial reporting
objectives, which includes the financial reporting system, encompasses methods and records
that:
 Identify and record all valid transactions
 Describe on a timely basis the transactions in sufficient detail to permit proper
classification of transactions for financial reporting
 Measure the value of transactions in a manner that permits recording their proper
monetary value in the financial statements
 Determine the time period in which transactions occurred to permit recording of
transactions in the proper accounting period
 Present properly the transactions and related disclosures in the financial statements.

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 IT controls tend to be separated into two categories: general and application.

General IT controls Application IT controls

Policies and procedures relating to many Manual or automated procedures that apply to
applications, supporting the effective the processing of transactions. They can be
functioning of application controls: both preventative and detective in nature:
 Data centre and networks  Initiating, recording, processing and
reporting transactions
 Systems software change, acquisition
and maintenance  Authorisation, completeness, and
accuracy at all stages (eg input data,
 Program change
numerical sequence checks, exception
 Access security reports and correction at point of data
 Application system acquisition, entry)
development and maintenance

Activity 1: Computer controls

What additional controls would you expect to see in the client's computerised accounting
system?

2.3 Control activities

Control activities are the policies and procedures that help ensure that management directives
are carried out (they are often simply known as controls).
There are a variety of control activities that can be used by an organisation:
 Performance reviews – comparing budgets to actual performance
 Information processing – checking that transactions have been processed accurately,
completely and have been authorised
 Physical controls – controls over the physical security of assets
 Segregation of duties – making sure that a number of people are involved in recording
each transaction so that errors are noticed and there is less opportunity for individuals to
carry out fraud
Control activities may include the following:
Authorisation of documents
Transactions should be authorised by an appropriate person, for example, overtime should be
authorised by departmental heads.

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 Controls over computerised applications
These may be general controls or application controls (see above).
Controls over arithmetical accuracy
For example, when invoices are raised or received, a staff member should re-cast the amounts to
ensure that the invoice adds up correctly.
Maintaining control accounts and trial balances
You should know from your accounting studies that these can be useful in ensuring errors have
not been made in financial records, for example, some errors will result in a trial balance not
balancing.
Reconciliations
Reconciling two different sources of information, such as a bank statement and a cashbook, or a
purchase ledger account and a statement from the supplier can also highlight if errors have
occurred.
Such a reconciliation may also involve comparing an external source of information with an
internal source of information – another useful control on whether the internal source is correct.
Comparing assets to records
Again, this helps show if errors have been made in recording transactions or information. For
example, staff might compare the physical non-current assets to what is recorded in the non-
current asset register or the cash in the petty cash tin to what is in the petty cash book.
Restricting access (physical controls)
A good way of restricting errors and particularly fraud or theft is to restrict access to assets – for
example, by locking receipts in a safe until they are deposited at the bank, having codes to
unlock the cash tills, locking the stores where inventory is kept.
A strong control environment is demonstrated by having sound control activities.
Activity 2: Control activities

Required
Select examples for each of the specified control activities from the picklist.

Performance reviews 
Information processing 
Physical controls 
Segregation of duties 

Picklist:
Security staff at a warehouse
Budgetary control meetings
Separate staff for counting, banking and recording cash
Agreeing the sales ledger total to a batch of authorised invoices

2.4 Monitoring of controls

A further component of a good system of internal control is monitoring – those activities that the
entity uses to keep an eye on how well it is achieving its objectives and how the entity initiates
remedial action to address deficiencies in control. Examples of monitoring include:

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  Management controls such as reviewing whether a bank reconciliation is prepared on a
timely basis and following up on any areas of non-compliance. Such controls can be either
preventative controls) (designed to reduce the occurrence of errors and deviations – eg
secure storage of inventory in a warehouse) or detective controls (designed to identify
errors and deviations once they have occurred – eg a burglar alarm). Monitoring the
effectiveness of each will help an entity decide whether it requires more of one or the other
when establishing controls.
 Internal audit (a specific department within an entity that monitors all aspects of the entity
and reports its findings to those charged with governance)
 Other governance arrangements (such as the use of an audit committee staffed with
non-executive directors representing the interests of shareholders)
 Information systems designed not only to report but also to interrogate data
 Communication channels with stakeholders (eg customer feedback or liaison with
regulators

2.5 Inherent limitations of internal controls

However, good any single element of an internal control system might be, an internal control
system can never be perfect, due to inherent limitations.
Internal controls are usually designed to operate as effectively as the entity considers
appropriate in the context of its control environment. However, just as the auditor can only offer
reasonable assurance on the work they have done during the audit, the internal controls in place
within an entity can only provide reasonable assurance that they will achieve the entity's
objectives. In other words, there are always going to be some inherent limitations of internal
controls (ISA 315 (Revised): Appendix 3 paras. 22–24).
Activity 3: Internal control inherent limitations

Required
In what ways might a system of internal controls contain inherent limitations?

As we saw in the previous activity, there is a risk that the integrity of management might have an
impact on the control environment. The auditor needs to take this into account when planning
the audit and designing procedures to assess the truth and fairness of the financial statements.
The use of feedback from management, including system weaknesses, clerical or accounting
mistakes and disagreements over accounting policies or treatment, can assist the auditor when
planning the audit by highlighting issues to be on the lookout for.

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 2.6 Internal audit
We have already mentioned the role that internal audit plays in both corporate governance and
internal control, but you will also need to understand some other aspects of internal audit.
You will remember that the audit committee is responsible for all aspects of the organisation's
auditing requirements, and this includes an overall determination of the requirement for internal
audit within an organisation. Let's look at some governance best practice for guidance on this.

‘The main roles and responsibilities of the audit committee should include… monitoring and
reviewing the effectiveness of the company’s internal audit function or, where there is not one,
considering annually whether there is a need for one and making a recommendation to the
board….’
(UK Corporate Governance Code (FRC, 2018): Provision 25)

Factors that could influence the need for internal audit within a business include:
 The company's size or complexity
 Unexpected risk events or perceived problems in internal control
 A cost vs benefit approach - would it save more money than it costs?
The UK Corporate Governance Code also says:

‘The annual report should describe the work of the audit committee, including…. where there is no
internal audit function, an explanation for the absence, how internal assurance is achieved, and
how this affects the work of external audit….’
(UK Corporate Governance Code (FRC, 2018): Provision 26)

Consequently, it may therefore be helpful to compare and contrast the work that internal audit
does with that of the external auditor. We know that external audit is primarily an examination of
books and records of an organisation with a statutory goal of reporting on the truth and fairness,
or faithful representation, of the organisation's financial statements. How does that compare
with the work of internal audit then?

Internal audit External audit

Responsible to Management Shareholders
Responsible for Any task required by Opinion on truth and fairness and
management or directors compliance with laws and regulations

Activities undertaken Anything Testing via evidence gathering

Standards used Anything Laws and regulations
Auditing standards
Accounting standards

Despite the statutory aspects of having an external audit, it is actually a very narrowly defined
activity when compared with the work that the internal auditor might be asked to perform. The
roles that internal audit could play in an organisation are many and varied and can be
illustrated by the following list:
 reviewing accounting and systems of internal control this could include work on systems
such as revenue, purchases or payroll, as well as management audits where the
performance of management in some capacity is evaluated to determine its effectiveness
 examining financial operating information this could include work that is either financial
(such as profitability) or operational (such as achieving a particular goal or target)
 special investigations, such as fraud (both prevention and detection)
 project work, including social or environmental reviews the scope of such work is very
broad and will depend on the organisation, but it could consider social factors such as

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 working conditions for staff or environmental matters, such as establishing the
organisation's carbon footprint
 reviewing compliance with external regulation which you might see operating within
industries such as petrochemicals or financial services
 reviewing value for money (VFM), which is often associated with public sector
organisations (demonstrating that public money has been wisely and responsibly spent)
but which can also be applied to any organisation keen to make the most of its finite
resources
 risk management, where the internal auditor participates in some or all of the process of
managing risk within an organisation (such as identifying situations where risk is more
likely to occur, and then quantifying those risks in order to determine the most appropriate
action to be taken)
Despite their differences, external auditors may also use the work and skills of internal audit to
reduce the work they need to perform during an external audit, such as performing testing on
systems of internal controls and other parts of the business. However, this will only happen if the
internal audit function is considered effective, which would include an overall assessment by the
audit committee of whether internal audit is able to achieve the objectives it has been set.
In order to evaluate the effectiveness of internal audit, the audit committee must also consider
the overall objectivity and independence of internal audit. This could be adversely affected by
issues such as:
 a lack of authority among internal audit staff who are unable (or unwilling) to challenge
management (poor quality procedures and practices could also undermine the internal
audit function's perceived authority)
 involvement in the implementation of systems that internal audit may ultimately be asked
to review
 familiarity with staff who work at the same organisation (this is exacerbated by appointing
existing operational staff to work within internal audit)
A lack of independence could compromise the extent or effectiveness of any work undertaken, so
care must be taken by the audit committee to establish appropriate reporting and operating
conditions for internal audit to be considered an effective part of internal control.
Reporting is taken care of by making the internal audit function responsible to the audit
committee and not to anyone in an operational capacity. To assess operating conditions, we
could use ISA 610 Using the work of internal auditors (para. 15) which explains that the internal
auditors will be evaluated by the external auditors when deciding whether their work can be relied
upon by the following criteria:
 The extent to which their organisational status and relevant policies and procedures
support their objectivity
 Their level of competence
 Whether they display a systematic and disciplined approach, including quality control
(IAASB, 2018)

3 The main features of accounting systems

3.1 Introduction
You know from your AAT studies already that an entity manages its own financial stability by
having a collection of systems in place. Specific examples of such systems will follow but, for all
of them, in order to reach a valid conclusion for the opinion, for each system the auditor needs to
be able to understand control objectives, risks and control procedures:
(1) Control objectives (what a system is trying to do)
(2) Risks (what a system is trying to avoid)
(3) Control procedures (how a system achieves objectives and manages risks)

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 Activity 4: Control objectives, risks and procedures – introduction

Required
For each of the following, select whether it is a control objective, a control activity, or a test of
control, using the options listed below.

Observe post opening 

Safeguard blank purchase order forms 

Review numerical sequence of goods received notes 

Picklist:
Control activity
Control objective
Test of control

The following is a list of the major accounting systems that you will need to know about:

 Purchases
 Revenue
 Payroll
 Inventory
 Non-current assets
 Cash and bank

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 Activity 5: Control objectives, risks and procedures for systems

Required
For each of the main accounting systems, can you think of some examples of control objectives,
risks and control procedures?

Control Risks Control

objectives procedures
Purchases

Revenue

Payroll

Inventory

Non-current assets

Cash and bank

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 4 Understanding the entity's systems
Previously we saw how controls played a big part in making sure that accounting and other
information systems helped entities achieve their objectives. The auditor needs to understand
these systems and controls in order to reach a conclusion about the truth and fairness of the
financial statements that they help to create and that are prepared in accordance with the
applicable financial reporting framework.

'The auditor shall obtain an understanding of the entity's Understanding the various
information system and communication relevant to the transactions of an entity (eg
preparation of the financial statements, through inflows and outflows) makes it
performing risk assessment procedures' (ISA 315 easier for the auditor to reach a
(Revised): para. 25). conclusion about it.
(a) The classes of transactions in the entity’s
operations that are significant to the financial
statements
Procedures can be both manual
(b) The procedures, within both information or automated – we will look at
technology (IT) and manual systems, by which how to audit IT systems later in
those transactions are initiated, recorded, the Course Book.
processed, corrected as necessary, transferred to
the general ledger and reported in the financial
statements
Auditors need to understand
(c) The related accounting records, supporting the various documents used –
information and specific accounts in the financial invoices, reports, payment
statements that are used to initiate, record, authorisations etc.
process and report transactions; this includes the
correction of incorrect information and how
information is transferred to the general ledger. Part of the auditor’s job is to
The records may be in either manual or electronic observe how systems capture
form such data to ensure they are
(d) How the information system captures events and recorded effectively.
conditions, other than transactions, that are
significant to the financial statements
How many estimates are used
(e) The financial reporting process used to prepare in producing a set of financial
the entity’s financial statements, including statements?
significant accounting estimates and disclosures
(f) Controls surrounding journal entries, including Auditors must make sure that
non-standard journal entries used to record there is sound judgement
non-recurring, unusual transactions or behind all entries on the main
adjustments.' ledgers, including journals.

We are now going to look at how the auditor gains an understanding of such systems from the
following procedures:
 Ascertaining the accounting system
 Documenting the accounting system
 Confirming the accounting system
 Evaluating the accounting system

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 4.1 Ascertaining the accounting system
Activity 6: Ascertaining the accounting system

Required
What methods can the auditor use to understand the accounting system?

4.2 Documenting the accounting system

There are three methods commonly used to document the client's accounting system:
 Narrative notes: written descriptions of the system.
 Internal control checklists (ICCs) or internal control questionnaires (ICQs): the audit firm
will have a standard list of control questions for each type of system in place. The audit
staff can quickly ascertain which, if any, are in operation by the client.
 Flowcharts: diagrammatic representations of the system, usually broken down into
separate activities.
Narrative notes
These are a good way of getting an overview of a particular activity. They are not always
appropriate, as this illustration attempts to demonstrate:
Illustration 1

Three pieces of information need to be recorded – which of the three

techniques described above would work best to document the system of
recording each piece of information?
Your child's performance at Directions to your house Instructions for completion of
school a passport application

Narrative notes work well for all of these tasks, but you may find that something visual like a
flowchart works better for directions and instructions. In the case of directions, a map often
works well and, to ensure that all parts of the passport application are completed appropriately,
a checklist of items that should have been done would work well. Simple tasks are often
recorded best using narrative notes, which is what the auditor will do first.
Internal control checklists or questionnaires

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 Activity 7: Internal control questionnaire

Required
Use the accounting system information for sales at Glad Rags Limited given below to complete
the internal control questionnaire laid out in the solution space.

Accounting system information – Revenue system

The company manufactures clothes to order from a catalogue. When an order is received, the
sales department checks that the customer has not exceeded their credit limit and then issues a
two-part order document. The sales department fill in the appropriate values for the order from
current price lists. One copy is sent to the production department in order for the order to be
completed and the other is filed alphabetically in the customer file in the sales department.
Once the order is completed, two-part despatch notes are raised. When the factory manager, Ian
Jones, has checked the order, one copy of the despatch note is despatched with the goods (to be
signed and returned), and one part is matched to the production department's sales order and
sent to accounts to raise the invoice. Jane Hill raises the invoices from the order and despatch
note, enters them on the computer and sends them out to customers.
Most customers pay in around 60 days. When they come in, cheques are passed to Beth
Simpkins, one of the accounts assistants, and she updates the cash book and the sales ledger.
Cheques are banked twice a week. Cheques are kept securely in the safe until banking.
Jane sends out statements to customers each month. Glad Rags' customers are mostly all
reputable high street stores and there are rarely irrecoverable debts.

Internal control questionnaire – Revenue and receivables system

Question Yes/No Comment

Are orders only accepted from low credit risks?

Are despatches checked by appropriate personnel?

Are goods sent out recorded?

Are customers required to give evidence of receipt of goods?

Are invoices checked to despatch notes and orders?

Are invoices prepared using authorised prices?

Are invoices checked to ensure they add up correctly?

Are sales receipts matched with invoices?

Are statements sent out regularly?

Are overdue accounts reviewed regularly?

Are there safeguards over post received to ensure that

cheques are not intercepted?

Are bankings made daily?

Would it be appropriate to perform tests of control here?

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 Flowcharts
Flowcharts should be kept simple and be clear to read. The following points should help:

 There should be conformity of symbols, with each symbol representing one thing.
 There should be a key of symbols used.
 The chart should flow from top to bottom and from left to right, with no loose ends.
 Connecting lines should only cross where necessary in order to keep the chart simple.

Illustration 2: A list of basic flowcharting symbols

eg Sales Invoice Document (eg Sales invoice)

(SI)

N
eg Delivery Note Document sequentially numbered
DN

3 part document
eg GRN

eg SL Account book or ledger

ADN
File A = alphabetical order
D = date order
N = numerical order
T = temporary (TN would be temporary in
numerical order.)

An operation (but not a check)

A check function

3 A connector (ie to page 3 of the flowchart)

Document flow (ie between departments)

Information flow (ie information is often transferred from

one document to another)

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 An example of a flowchart is shown below:

Mr Smith Mr Jones

Sale

x
N 1
Invoice set prepared Invoice

Sales
Details agreed ledger

Ledger posted D
x x
Activity 8: Documenting systems

Required
From the picklist, select one advantage and one disadvantage for each of the three techniques
used to document the client's accounting system.

Advantages Disadvantages
Narrative notes  
Flowcharts  
Questionnaires  

Picklists:
Client may overstate controls
Confusing if system is complex
Easier to interpret for larger, more complex systems
Easy to delegate to junior staff
Need experience to prepare
Quick to prepare

4.3 Confirming the accounting system

The auditor will confirm the system by performing walk-through tests. This involves following one
or more transactions of each type through the accounting system to confirm that the system has
been documented properly.

4.4 Evaluating the accounting system

The auditor must then evaluate the system to identify the factors that contribute to strengths and
deficiencies in accounting systems. This evaluation must consider the presence or absence of
internal controls, including their impacts, plus an evaluation of the design and also the operation
of the system. The evaluation is undertaken by conducting a series of tests of the system,
recording the results for feeding into the overall audit strategy and, where appropriate, reporting
any weaknesses in controls back to the client.

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 We saw earlier that systems and controls could be both manual and IT based, so we will look at
how auditors review both types of system later on in this chapter.
Following on from confirmation of the system (obtained via walk-through tests, above) the
auditor will generally come to one of two conclusions about the client's systems:

 If they believe controls are effective, they will test them using tests of control and take a
combined approach to the audit, where they test both controls and balances in the
financial statements (we will see more of this balance-led or ‘substantive’ approach later).
 If they do not believe the controls are effective, they will not bother testing them and carry
out substantive testing only instead, which involves testing balances and transactions in
more detail.

Activity 9: Evaluating systems

Required
Read the following narrative notes for the revenue system at MEM Ltd and then consider the
two tasks below.
'Sales orders are taken by the sales department, usually by phone. The sales department consists
of the sales director, Ted Bishop, and his assistant, Sandra Dales. When they take an order from
an existing customer, they check that the customer does not have outstanding orders which
exceed the credit limit on the account. They then record the order on a three-part, pre-numbered
sales order document. Only Ted is allowed to authorise individual sales orders in excess of
£20,000.
When a new customer makes an order, Sandra passes the query to Ted, who carries out a credit
check before the order is accepted and then sets a credit limit based on that check. Only then is
the order accepted and processed.
One copy of the sales order is filed in the client file in the sales department, and two are sent to
the production department to start work on the order. The production controller, Ben Swales,
determines when the order can be fulfilled by, which is written on the two copies of the sales
order. One is then sent to the customer and the other is retained in the “orders pending” file in
Ben's office until the order has been completed.
When the order is ready to be despatched, Ben checks the date and, if the order has been
completed early, telephones the customer to ensure it is okay to despatch the order. Before
goods are despatched, they are checked for quality and quantity against the order by Ian Mellor,
the factory foreman. He then completes a two-part, pre-numbered goods despatch note. One
copy is sent out to the customer with the goods; the other, stamped 'despatched', is matched
with the production copy of the sales order and sent to the accounts department. Goods are not
despatched after 3pm.
At 3:30pm, in the accounts department, Tessa Goodyear raises the invoices based on the goods
despatch notes she has been sent by the production department. The invoices are created on the
computer by her entering the appropriate details. The computer gives her a sequential number
for each invoice. Prices are automatically inserted on the invoice from the price list when she
inputs the inventory number. If a special price has been negotiated, this will be stated on the sales
order attached to the goods despatch note, and she will have to manually override the price
given by the computer. She prints off the invoices and checks that they are calculated correctly.
One copy of the invoice is matched with the order and GDN and filed, numerically, in the
accounts department. The other copy is sent out. The computer automatically updates a sales
day book and the sales ledger for the invoiced sales. Sometimes not all the invoices are
completed until the next morning. The invoices are always sent out in one batch.
The accounts department receives the post at 10am, when it has been sorted by the managing
director's secretary. The post is opened by Tessa Goodyear and Paula Taylor, the cashier, who
makes a list of all the sales ledger receipts. The cheques are placed in the safe until they are
banked in the afternoon, by Paula Taylor. Paula then enters the receipts in the cash book on the
computer. The cash book program automatically updates the sales ledger.

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 The financial controller, Marie Edgehill, reconciles the sales ledger control account on a monthly
basis.
Every Monday, Tessa Goodyear prints an aged receivables report off the sales ledger and reviews
it for potentially irrecoverable debts. She then takes appropriate action, which is usually to
highlight potential problems to Marie, or to telephone customers to ask when they are going to be
able to pay. In rare circumstances, MEM uses a debt collection service to enforce very late debts.'
Task 1
Identify five control procedures operating in this system.
(1)

(2)

(3)

(4)

(5)

Task 2
Using the options listed below, state whether the following are strengths or deficiencies of MEM's
system or potentially both.

Only Ted Bishop is allowed to authorise new customers and orders over 
£20,000.

Orders are recorded on pre-numbered sales orders. 

Goods are sometimes ready for despatch early. 

It is necessary for Tessa to manually override the price system on the 

computer if a special price has been negotiated.

Picklist:
Deficiency
Potentially both
Strength

Recording and communicating the results of testing

Once the auditor has completed work on testing controls, the results are recorded as evidence
and retained for the purposes we described earlier using ISA 230 Audit Documentation. They will
also be used by the auditor to revisit the overall audit strategy and the audit plan to establish if
any changes are required in the light of such evidence. It is entirely likely that the audit will
'evolve' during the course of this process, reinforcing the need for auditors to stay alert to all the
evidence they uncover.

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 Chapter summary

 Internal control is the system designed, implemented and maintained by those charged with
governance (the directors), management and other personnel, to provide reasonable assurance
about the achievement of the entity's objectives with regard to the reliability of financial
reporting, effectiveness and efficiency of operations; and compliance with applicable laws and
regulations.

 Auditors use ISA 315 (Revised) to gain an understanding of the various components of internal
control relevant to forming an opinion on the financial statements of their clients. These are:
– The control environment
– The entity's risk assessment process
– The information system (both general and application controls)
– Control activities
– Monitoring of the system of internal control

 No matter how well designed a system of internal controls might be, there will always be inherent
limitations of that system (including human error, fraud and even freak occurrences).

 Internal audit is considered best practice as part of sound corporate governance and helps to
ensure that other internal controls have been designed and are operating appropriately. Internal
audit also performs a variety of other activities to support an organisation (such as fraud
investigations, value for money studies or risk management).

 The main features of any accounting system (including purchases, revenue, payroll, inventory,
non-current assets and cash and bank) are designed to take account of the system's control
objectives, the risks they are trying to avoid and the control procedures designed to assure the
former and manage the latter.

 When understanding an entity's systems, an auditor will focus on four main areas:
– Ascertaining the system
– Documenting the system (using a variety of activities such as questionnaires, checklists and
flowcharts)
– Confirming the system via walk-through testing
– Evaluating the system (either strengths or weaknesses)

 Recording and communicating the results of these activities inform the rest of the audit and are
documented thoroughly to ensure the audit is effective.

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 Keywords
 Control activities: the policies and procedures that help ensure that management
directives are carried out (they are often simply known as controls)
 Control environment: the attitudes, awareness and actions of management and those
charged with governance regarding internal control and its importance
 Control objectives: what a system is trying to do
 Control procedures: how a system achieves objectives and manages risks
 Internal audit: an independent control designed to evaluate other controls in place within
an organisation and add value throughout
 Internal control: the process used by a client to prevent, detect and report risks and
achieve objectives regarding operations, compliance with laws and regulations and
safeguarding assets
 Inherent limitations of internal controls: however good any single element of an internal
control system might be, an internal control system can never be perfect, due to inherent
limitations
 Risks: what a system is trying to avoid

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 Test your learning
1 Complete the statement below describing an internal control system.

Internal control is the process  , implemented and 

by ,  and other personnel to provide
 about the achievement of the entity's  with regard
to the reliability of  , effectiveness and efficiency of
 and compliance with applicable laws and regulations.
Picklist for line items:
Designed
Financial reporting
Maintained
Management
Objectives
Operations
Reasonable assurance
Those charged with governance
2 Accounting systems have control objectives and control procedures to mitigate the risk that
the control objective is not met.
For each of the following, select whether they are a control objective, risk, or control
procedure.

A company should only pay for work done by employees. 

Company vehicles are used by employees for their own purposes. 

Part C39t99, in regular use in the business, is reordered when inventory 

levels fall below 200.

Picklist:
Control objective
Control procedure
Risk
3 State whether the following statements are true or false in respect of a company's control
environment.

The directors can ensure a good control environment by implementing 

controls themselves and never bypassing them.

The directors should not assign authority for control areas to members of 
staff.

A good control environment always leads to a good system of control 

overall.

Picklist:
True
False

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 4 Select which one of the following statements concerning small and large companies is the
least true by ticking the appropriate box.

Control activities will be similar in all sizes of company over core activities.

A large company is likely to have a more formal control system than a

small company.

A small company is likely to have a less complex information system than a

big company.

A large company is more likely to have a good control environment than a

small company.

5 Select which one of the following best describes who undertakes the role of monitoring
controls at a company by ticking the appropriate box.

Controls are always monitored by an internal audit function, as this is the

purpose of their existence.

Controls are monitored by the directors of a company.

Controls are monitored by the people who operate them, as they are in the
best position to assess whether the objectives of the controls are being
met.

Who monitors controls depends on the size of the company and its
personnel: it may be an internal audit function, but it could also be the
directors, or department heads.

6 The personnel director at Metal Extrusions Midlands Limited (MEM) has contacted the audit
firm and said that she wants to overhaul the internal control system over wages and
salaries at MEM. All members of staff (waged and salaried) are paid by bank transfer.
Waged staff members are paid weekly and salaried staff members are paid monthly. At
present, the payroll is prepared and authorised by the personnel director, who has sole
access to employee records. The bank transfer is authorised by the personnel director but
enacted by the cashier.
Set out the control objectives that the personnel director of MEM should consider when
putting together a new control system for wages and salaries.
7 Listed below are two control procedures that the directors have put into action at MEM as a
result of your recommendations.
For each internal control procedure, use the picklist below to match the procedure with the
control objective.

Internal control procedure

The payroll should be reconciled to other records, such as the cash payment 
for net pay per the bank's records.

The payroll should be authorised by someone other than the personnel 

director.

Picklist:
Employees should only be paid for work done.
Gross pay, net pay and deductions should be correctly recorded on payroll.
Gross pay should be calculated correctly and authorised.
Wages and salaries should be recorded properly in bank records.

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 8 An entity uses internal control procedures in order to mitigate the risk to which it is
exposed. Listed below are two internal control procedures which are applicable to an
entity's non-current assets system.
For each internal control procedure, use the picklist below to match the procedure with the
risk mitigated.

Internal control procedure

Non-current assets are inspected regularly. 

Capital expenditure is approved by the purchasing director on behalf of 

the board.

Picklist:
Assets are bought from inappropriate suppliers at inflated cost.
Assets are depreciated incorrectly.
Assets are not maintained properly for use in the business.
Assets are sold when they are needed for use in the business.
9 An entity uses internal control procedures in order to mitigate the risk to which it is
exposed. Listed below are two internal control procedures which are applicable to an
entity's inventory system.
For each internal control procedure, use the picklist below to match the procedure with the
risk mitigated.

Internal control procedure

Inventory store is kept locked. 

Goods inwards are checked for quality. 

Picklist:
Damaged inventory is valued in the financial statements.
Inventory is counted in the financial statements without a corresponding payable.
Inventory is stolen.
The company fails to order required goods.
10 External auditors use a variety of methods for documenting systems of control, including
flowcharts, internal control questionnaires and checklists.
For each of the following descriptions, select whether it represents a flowchart, internal
control questionnaire or internal control checklist.

A series of questions designed to identify controls in a system. A 'no' 

answer indicates a deficiency in controls

A graphic rendition of the system, using conventional symbols to represent 

controls and documents

Picklist:
Flowchart
Internal Control Checklist
Internal Control Questionnaire

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 Appendix
Accounting systems – control objectives, risks and control procedures
Purchases

Control objective Risk Control procedures

Ordering

A company should only order The company pays for Orders should be authorised only
goods and services that are unnecessary or personal when the need for the items has
authorised by appropriate goods been justified (on a purchase
personnel and are for the requisition, for example)
company's benefit Orders should only be prepared when
authorised purchase requisitions are
received from departments
Orders should be authorised by
separate officers (segregation of
duties)
Orders should be pre-numbered
and blank order forms should be
safeguarded
Orders not yet received should be
reviewed

A company should only order Other suppliers may not A company should have a central
from authorised suppliers supply quality goods or may policy for choosing suppliers
be too expensive

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 Control objective Risk Control procedures
Receipt of goods and invoices

A company should ensure The company may pay for Goods received should be
that goods and services goods/services for personal examined for quality and quantity
received are used for the use Goods received should be recorded
organisation's purposes on pre-numbered goods received
A company should only The company may pay for notes
accept goods that have been goods/services for personal Goods received notes should be
ordered (and appropriately use compared with purchase orders by
authorised) different staff (segregation of
duties)
A company should record all The company fails to pay for
Supplier invoices should be checked
goods and services received goods/services and loses
to orders and goods received notes
suppliers
Supplier invoices should be
A company should not The company pays for goods referenced (numerical order and
acknowledge liability for it has not received supplier reference)
goods it has not recorded
Supplier invoices should be
checked for prices, quantities,
calculations

A company should ensure it The company pays for poor- There should be procedures for
claims all credits due to it quality goods obtaining credit notes from
suppliers
Goods returned should be recorded
on pre-numbered goods returned
notes

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 Control objective Risk Control procedures
Accounting

A company should only The company pays for goods Payments should be authorised and
make authorised payments it has not received only made if goods have been
for goods that have been received
received The purchase ledger control account
should be reconciled to the list of
balances on a regular basis

A company should record The financial statements are Purchases and purchases returns
expenditure accurately in the misstated, and the company should be promptly recorded in
accounting records does not pay for genuine day books and ledgers.
liabilities The purchase ledger should be
A company should record The financial statements are regularly maintained
credit notes received misstated, and the company
correctly in the accounting pays for items unnecessarily
records

A company should record The company pays the Supplier statements should be
liabilities in the correct wrong supplier compared with the purchase ledger
purchase ledger accounts

A company should record The financial statements are Goods received but not yet
liabilities in the correct period misstated by recording invoiced at the year end should be
purchases but not inventory, accrued separately
or recording inventory but
not the associated purchase
liability

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 Control objective Risk Control procedures
Payment

A company should only The company pays the Cheques should be requisitioned
make payments to the wrong supplier and requests evidenced with
correct recipients and for supporting documentation
the correct amounts which Cheque payments should be
are authorised authorised by someone other than a
signatory
A company should only pay The company pays more
for liabilities once than once and the supplier There should be limitations on the
does not correct the error payment amount individual staff
members can sign for
Blank cheques should never be
signed
Signed cheques should be
despatched promptly
Paid cheques should be collected
from the bank (ie after the supplier
has banked them, the company can
get them back as proof)
Electronic payments should be set
up for payment and then separately
authorised by another officer of the
company (segregation of duties)
Electronic payment limits should be
established through the banking
software to ensure that large
payments require at least two
banking authorisations
The bank statement should be
regularly reconciled to the cash book
Cash payments should be limited
and authorised
Payments should be recorded
promptly in the cash book and
ledger

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 Revenue

Control objective Risk Control procedures

Orders and extending credit

A company should only supply Selling to customers who do not Credit terms offered to
goods to customers who are have a good credit rating customers should be
likely to pay for them authorised by senior personnel
and reviewed regularly
A company should encourage The company loses the value
customers to pay promptly of being able to use the money Credit checks should be run
in their business or interest on on new customers
the money in the bank due to Changes in customer data (for
late payment example, their address) should
be authorised by senior
A company should record The company sends the wrong personnel
orders correctly goods to the customer,
causing added cost or risk of Orders should only be
accepted from customers with
loss of the customer
no existing payment problems
A company should fulfil orders The company loses custom after confirming that those
promptly/in full customers are within their
existing credit limit
Order documents should be
sequentially numbered so that
false or missing sales can be
traced

Despatching and invoicing goods

A company should record all Goods are sent out and not Despatch of goods should be
goods it sends out invoiced, and the company authorised by appropriate
loses money personnel and checked back
to order documents
A company should invoice all Insufficient sums are charged (segregation of duties)
goods and services sold and the company loses money
correctly Despatched goods should be
checked for quality and
A company should only invoice The company charges for quantity
goods it has sent out goods in error and loses Goods sent out should be
custom recorded
A company should only issue The company issues credit Records of sent out goods
credit notes where required notes incorrectly and loses should be agreed to customer
money orders, despatch notes and
invoices by separate staff
(segregation of duties)

Despatch notes should be

sequentially numbered and
the sequence checked
regularly
Returned goods should be
checked for quality
Returned goods should be
recorded on goods returned
notes
Customers should sign
despatch notes as proof of
receipt

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 Control objective Risk Control procedures
Invoices should be prepared
using authorised prices and
quantities and should be
checked to despatch notes
Invoices should be checked to
ensure they add up correctly
Credit notes should be
authorised by appropriate
personnel
Invoices and credit notes
should be pre-numbered and
the sequence checked
regularly
Inventory records should be
updated from goods sent out
records
Sales invoices should be
matched with signed delivery
notes and sales orders
Orders not yet delivered should
be regularly reviewed

Recording and accounting for revenue, credit control

A company should record all Revenue is not recorded and Sales invoice sequence should
invoiced revenue in its wrongly omitted from financial be recorded and spoilt invoices
accounting records ie sales statements, and payment is recorded and destroyed
ledger and general ledger not chased as sale was never Sales receipts should be
recorded matched with invoices by
separate staff (segregation of
duties)
Customer remittance advices
A company should record all As above, financial statements
should be retained
credit notes in its accounting likely to be misstated and
records potential to lose custom by Sales returns and price
chasing cancelled debts adjustments should be
recorded separately from the
A company should record all Losing custom by chasing the original sale
invoiced revenue in the correct wrong customer for the debt Procedures should exist to
sales ledger accounts and not receiving the money record revenue in the correct
from the correct customer period
A company must ensure that Errors in the financial Receivable statements should
invoices are recorded in the statements due to counting be prepared regularly
sales ledger in the correct time both the sale and the related Receivable statements should
period inventory as assets or counting be checked regularly
neither

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 Control objective Risk Control procedures
A company must identify The company fails to take Receivable statements should
debts for which payment action until it is too late to be safeguarded so they
might be doubtful retrieve the debt and, in the cannot be amended before
worst case, wrongly records they are sent out
irrecoverable debts as assets in Overdue accounts should be
the financial statements reviewed and followed up
Write-off of irrecoverable
debts should be authorised by
appropriate personnel
The sales ledger control
account should be reconciled
regularly
The sales ledger and profit
margins should be analysed
regularly

Receiving payment (cash)

A company should record all Money could be stolen or lost, There should be safeguards to
money received custom could be lost through protect post received
chasing payments already to avoid interception
made by the customer, the (segregation of duties)
financial statements are likely Two people should be present
to be misstated at post opening, a list of
A company should bank all Money could be stolen or lost receipts should be made and
money received with consequences, as above, post should be stamped with
or the company loses out on the date opened (segregation
interest that could be being of duties)
made on receipts There should be restrictions on
who is allowed to accept cash
A company should safeguard Money may be stolen in the (cashiers or salespeople)
money received in the period interim period
Cash received should be
until it is banked
evidenced (till rolls, receipts)
Cash registers should be
regularly emptied
Till rolls should be reconciled to
cash collections which should
then be agreed to bankings by
separate staff (segregation of
duties)
Cash shortages should be
investigated
Cash records should be
maintained promptly
There should be appropriate
arrangements made when
cashiers are on holiday
Receipts books should be
serially numbered and kept
locked up
Bankings should be made
daily

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 Control objective Risk Control procedures
Paying-in books should be
compared to initial cash
records
All receipts should be banked
together
Opening of new bank accounts
should be restricted and
authorised
Cash floats held should be
limited
There should be restrictions on
making payments from cash
received and restricted access
to cash held on the premises
Cash floats should be checked
by an independent person
sometimes on a surprise basis
Cash should be locked up
outside hours

Payroll

Control objective Risk Control procedures

Setting pay

A company should only pay The company overpays Personnel records should be
employees for work they have employees kept; and wages and salaries
done checked to details held in
them
A company should pay
employees the correct gross Personnel files should be kept
pay, which has previously locked up
been authorised Engaging employees, setting
rates of pay, changing rates
of pay, overtime, non-
statutory deductions from pay
and advances of pay should
all be authorised and recorded
by separate staff members
(segregation of duties)
Changes in personnel and pay
rates should be recorded
Hours worked should be
recorded; time should be
clocked
Hours worked should be
reviewed
Payroll should be reviewed
against budget

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 Control objective Risk Control procedures
Recording wages and salaries

A company should record The company may make Payroll should be prepared,
gross pay, net pay, and incorrect payments to staff/tax checked and approved before
relevant deductions correctly offices and financial statements payment
on the payroll may be misstated

A company should record The financial statements may

payments made in the cash be misstated
and bank records and general
ledger

A company should comply The company could make

with the requirements of the unauthorised disclosures of
Data Protection Act 1998 employee information

Paying wages and salaries

A company should pay the Angry, unpaid workforce Wage cheques for cash
correct employees and/or the company overpays payments should be
the wrong people authorised
Cash should be kept securely
Identity of staff should be
verified before payment
Distributions of cash wages
should be recorded and
undertaken by two employees
(segregation of duties)
Bank transfer lists should be
prepared and authorised
Bank transfer lists should be
compared to the payroll

Deductions

A company should ensure all Breaking the law, calculating Separate employee records
deductions have been properly staff pensions incorrectly should be maintained
calculated and authorised leading to staff displeasure Total pay and deductions
A company should ensure it Breaking the law and incurring should be reconciled month on
pays the correct amounts to fines month
taxation authorities Costs of pay should be
compared to budgets
Gross pay and total tax
deducted should be checked
to returns to the tax
authorities

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 Inventory

Control objective Risk Control procedures

Recording of inventory

Inventory movements Inventory might be stolen Segregation of duties between

authorised and recorded custody of inventory and
recording
Inventory records only Inventory may be overstated in
include items that belong to the financial statements Checking and recording goods
the company or that exist at inwards
all Issues of inventory supported
by appropriate documentation
Inventory quantities have The company may have
been recorded correctly insufficient inventory to Maintaining inventory records
operate efficiently and
inventory may be misstated in
the financial statements

Inventory is not recorded as The financial statements may be

an asset once a sale has misstated
been made or before a
purchase is recognised

Protection of inventory

Inventory is protected from Goods might be stolen or Restriction of access to stores

loss/damage unusable/unsaleable Controls on stores environment
(temperature/damp etc)
Regular inventory counts by
independent people
Reconciliation of inventory
count to book records

Valuation of inventory

Inventory is valued correctly Inventory may be misstated in Calculation of inventory value

the financial statements and checking of calculation

Slow-moving, obsolete and Inventory may be overstated in Regular review of inventory

damaged inventory is noted the financial statements condition
Accounting for scrap and
waste

Inventory levels

Levels of inventory held are The company may not have Maximum and minimum
reasonable sufficient inventory to function inventory levels set
efficiently Reorder limits set

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 Non-current assets

Control objective Risk Control procedures

Buying assets

Non-current asset additions The company buys assets it Capital expenditure is

are authorised does not need and/or at an budgeted for/authorised by a
inappropriate price senior official in the company
(segregation of duties)

Storing and using assets

Non-current assets are kept The assets are stolen A non-current asset register is
securely maintained and compared with
actual assets and general
Non-current assets are The assets are not fit for use in ledger record of assets
maintained properly the business when required
Non-current assets are
inspected regularly to ensure
they are maintained/in
use/secure

Selling assets

Non-current asset disposals The company sells assets it Non-current asset sales or
are authorised needs to operate and/or at an scrappage is authorised/
inappropriate price planned to avoid business
interruption

Recording assets

Non-current assets are The company misstates non- Rates at which depreciation is
properly accounted for and current assets in the financial charged are authorised/
recorded statements checked

Rate at which depreciation is Assets are valued wrongly and Non-current asset register is
charged is reasonable financial statements are maintained
misstated

Proceeds from disposal of Proceeds may be stolen or

non-current assets are omitted from financial
recorded statements, profit or loss on
sale of assets may be
misstated in financial
statements

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 Cash and bank

Control objective Risk Control procedures

All cash should be held Cash is misappropriated Controls to ensure the
securely both in hand and at through either fraud or error completeness of recording
the bank cash receipts

All receipts and payments Lack of visibility over Post-opening procedures to

should be recorded transactions and balances ensure all remittances
are complete (including
Staff should be accountable Transactions and changes to segregation of duties)
for all cash transactions and cash held and in bank Restrictions over who can
balances accounts occur without receive cash, how they
authorisation evidence cash receipts and
regular reconciliations of
The organisation should have Being unable to pay bills as
receipts
the cash available that it needs they fall due and incurring
costs for having insufficient Paying cash and cheques into
funds available the bank promptly
Reconciliation of funds
received via electronic funds
transfer at point of sale
(EFTPOS) to ensure
completeness
Physical controls over blank
cheques and limited access to
creating system-generated
payments (such as BACS)
Petty cash controls (physical,
authorisation, recording)
Cash flow forecasts and
monitoring procedures to
ensure cash needs are met

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 Obtaining audit evidence

Syllabus learning outcomes / objectives

Having studied this chapter you will be able to:

4. Evaluate procedures for obtaining sufficient and appropriate evidence

4.1 Methods used to obtain audit evidence

Learners need to understand: Learners need to be able to:
4.1.1 types of verification techniques: 4.1.5 identify when it is appropriate to use
– inspection each type of verification technique
– observation 4.1.6 evaluate methods used to test:
– external confirmation
– recalculation – controls
– reperformance – transactions
– analytical procedures – balances.
– enquiry
4.1.2 the characteristics of good evidence
4.1.3 the reliability and relevance of
different sources of audit evidence
4.1.4 the differences between tests of
controls and substantive procedures.

4.2 Audit techniques in an IT environment

Learners need to know:
4.2.1 types of automated tools and techniques:
– test data
– integrated test facilities
– audit software
– data analytic tools
4.2.2 how automated tools and techniques are used to test controls and interrogate the
audited entity's files
4.2.3 the benefits and drawbacks of using automated tools and techniques.

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 4.3 Different sampling techniques
Learners need to understand: Learners need to be able to:
4.3.1 statistical and non-statistical 4.3.3 distinguish between statistical and
sampling methods non-statistical sampling
4.3.2 the advantages and disadvantages 4.3.4 determine when it is more
of different sampling methods: appropriate to examine 100% or a
– block selection of items
– haphazard 4.3.5 distinguish between selection
– judgemental methods and when they should be
– random used
– stratified
– systematic. 4.3.6 identify factors affecting sample
sizes
4.3.7 identify appropriate populations
from which to select samples.

4.4 Audit approach

Learners need to be able to:
4.4.9 determine when to use a mixture of
tests of controls and substantive
procedures or substantive
procedures only
4.4.10 identify why it is appropriate to use
a mixture of tests of controls and
substantive procedures or
substantive procedures only

Assessment context
Tasks 4 and 5 in the assessment will be supported by this topic as we look at how to obtain audit
evidence, using a variety of different question types.

Qualification context
There are some new pieces of terminology introduced here – evidence, sampling and computer
audit – but although they are all new, they exist in areas that you have seen elsewhere in your
AAT studies (such as final accounts and accounting software).

Business context
Evidence is the oxygen without which the auditor cannot breathe: the more of it there is, the more
likely it is that the auditor is able to achieve their overall objective – providing an audit opinion. In
the real world, the collection of evidence is the most time-consuming part of any audit.

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 Chapter overview

Methods for collecting evidence

Verification Tests of control Substantive tests

(tests of detail)
A E Only when Always
EE I there is reliance
I O
O UR
UR
Substantive
analytical
procedures

Other information?
When to use a
mixture?

Sufficient appropriate audit evidence

Enough? Reliable? Relevant?

Assertions
Direction of testing

Automated tools
Benefits +
and techniques Client
drawbacks
Test data
Audit
software
Integrated test
facilities
Sampling

Statistical vs Stratification Picking the sample

non-statistical

Confidence
levels
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 1 Methods for collecting audit evidence
In order to reach a valid opinion, you need enough of the right kind of evidence – we will consider
how we determine whether we have this later, but first, let's look at the various techniques that
exist in order to collect evidence.

1.1 Verification techniques

Auditors perform tests to obtain evidence throughout the audit, and such testing usually requires
a number of verification techniques (AEEIOUR):

 Analytical procedures (see below)

 Enquiry (asking questions and confirming facts) and External confirmation (with third
parties for values or conditions)
 Inspection (records or other documents – sometimes called 'vouching' – as well as physical
inspection of tangible assets)
 Observation (of staff performing various activities)
 RecalcUlation (of items and amounts) or Re-performance (of activities and procedures)
(ISA 500: para. A10-25)

Analytical procedures are evaluations of financial information made by a study of financial and
non-financial data. They comprise the following activities:
 Comparison of actual with budget, across different business units or even with similar firms
and industry averages. This could work for absolute amounts, percentages like profit
margin or even indicators such as receivables days and should be performed across a
variety of time frames.
 Calculation of ratios (such as net and gross margins – we will come back to these later)
and explanations to support them (eg a 10% increase in expenditure coming from 10% more
sales activity).
 Credibility checks, such as looking at a year's revenue for a manufacturer and dividing it
by the number of working days to get a 'feel' for the implied level of daily activity, and
proof in total (such as the relationship of payroll costs to the number of employees and
their likely average pay).
A variety of methods can be used to perform these procedures, ranging from simple comparisons
to complex analysis using statistics, on a company level, branch level or individual account level.
The choice of procedures is a matter for the auditors' professional judgement.
Auditors are required to use analytical procedures as part of the risk assessment process at the
planning stage of the audit, to:
 Identify risk areas
 Determine the nature, timing and extent of procedures
The auditor may also use analytical procedures as substantive procedures.
There are a number of factors which the auditors should consider when deciding whether to use
analytical procedures as substantive procedures, such as:
 Whether the procedures are suitable to obtain evidence about the relevant assertions
(given the assessed risk for those assertions)
 Whether the data the auditor is using is reliable, available and relevant
When analytical procedures identify significant fluctuations or unexpected relationships, the
auditors must investigate by obtaining adequate explanations from management and
appropriate corroborative evidence. Investigations will start with enquiries to management and
then confirmation of management's responses.

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 All these verification techniques can be used in a variety of different circumstances: first, let's
think about systems of internal controls and how we might test them.

1.2 Tests of control

Tests of control are tests to obtain evidence about the effective operation of the accounting and
internal control systems.
In general, with the exception of analytical procedures and external confirmations, the
verification techniques described above (EIOUR) can all be used to test controls.
Illustration 1: Tests of control

Consider the following examples of tests of control that could be found in a purchases system:

Audit test and description: Working Performed

paper: by:
(1) Select a sample of 10 invoices from the Purchase Invoice
Listing (PIL) and:
(a) Inspect the invoice for evidence of matching to
goods received note (GRN) and authorisation
(b) Re-perform matching of invoice to GRN
(2) (a) For a sample of 15 PIL totals, recalculate to batch
header slip ensuring the slip is initialled.
(b) Inspect batch book to ensure that all batches have
been returned from the computer bureau and that
any outstanding batches have been followed up.
(3) Observe and enquire into the procedures for preparing
suppliers' statement reconciliations.
(4) Select a sample of 10 invoices from the PIL and:
(a) Ensure casts and extensions have been checked
(b) Re-perform casts and extensions
(5) Select a sample of suppliers' statement reconciliations
(one month in detail; review others) and re-perform these
reconciliations, ensuring those statements not in
agreement have been followed up.
(6) Inspect one month's purchase ledger control account
reconciliation in detail and review for other months.
(7) Review the file of unmatched GRNs and enquire into old
items still outstanding.

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 Activity 1: Controls and tests – purchases

Required
Using the accounting system for purchases described for Glad Rags Limited, identify five
controls and suggest tests of control that could be performed to confirm the application of each
control.

Accounting systems information – Purchases

The company keeps basic stocks of all the fabric and threads required to manufacture goods
from their catalogue. When stocks fall to a certain level, the stores manager requisitions a pre-set
amount of that stock. There are certain fabrics that are only used for a limited number of stocks.
That fabric will only be reordered if a sales order is placed for items requiring the fabric.
When the purchases department receives a requisition, they place the order with the approved
supplier at a pre-arranged price. An order document is written out and kept in the orders pending
file.
When the fabric or thread is received, the stores manager ensures that the quality is suitable and
checks the goods against the order. The order is then passed to the accounts department and
placed in the pending invoices file.
When the invoice is received, the accounts assistant, Beth Simpkins, checks the invoices against
the order to ensure the price and quantity are correct and checks the VAT has been calculated
correctly. She initials the invoices to show that these checks have been carried out and gives the
invoice a sequence number. The invoice is then entered into the purchase ledger on the computer.
Beth prepares cheques for payment at the end of each fortnight and passes them to the director,
Gladys Barton, for signature and approval. The invoices are included with the cheques as
evidence of the money owed.
Most suppliers send statements at the end of the month which Beth reconciles to the purchase
ledger balances. The purchase ledger control account is agreed to the total of the purchase
ledger balances at the end of the month.

Controls Test of controls

(1)

(2)

(3)

(4)

(5)

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 Activity 2: Controls and tests – payroll

Required
Using the accounting system for payroll described for Glad Rags Limited, identify four controls
and suggest tests of control that could be performed to confirm the application of each control.

Accounting systems information – Payroll

There are two payrolls, which are computerised and prepared by the director, Gladys Barton.
Machining staff are paid by piece which is recorded and approved by the factory overseer, Peter
Benning. Machining staff are paid weekly. Office and other administrative staff are paid a
standard salary on a monthly basis.
The weekly payroll produces an exception report if machining staff are paid in excess of 20%
more than their weekly average over the year. This exception report is checked back to the piece
sheets which are prepared and approved by Peter Benning. Machinists are paid in cash which
must be collected personally and signed for by the employee.
Monthly payments are made by automatic bank transfer from Glad Rags' bank account to the
employees' bank account.

Controls Test of controls

(1)

(2)

(3)

(4)

1.3 Substantive testing

Substantive testing is audit procedures designed to detect material misstatement in the financial
statements, so it includes tests of detail of classes of transaction, balances and disclosures, and
analytical procedures.
When performing tests of control, if we trust the controls in place within a system, we can test
them and the results of this testing will provide us with some assurance that the output of such
systems can be used to produce the entity's financial statements.
Testing controls alone, however, is not enough to form an opinion, due to the various limitations
of internal controls that we saw earlier. Consequently, we need to make sure that the actual
balances and amounts themselves, which have been included in the financial statements, can be
trusted (rather than the processes used to generate them). This is referred to as substantive
testing and will always be carried out to some extent during an audit.

 Even if we trusted the controls in place, we would still use an amount of substantive testing
to supplement this, with the extent dependent on the outcome of tests of control.
 If we could place little or no assurance on controls (or, in the case of a smaller entity,
controls were not cost-effective) the level of substantive testing would be increased.

You have already seen the sort of procedures that auditors make use of when performing both
tests of control and substantive testing (AEIOU) but they are sometimes difficult to tell apart and
could form part of a question in your assessment.

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 Activity 3: Controls or substantive?

Required
Are each of the following audit tests a test of control or a substantive test?

Audit test
Selection of ten invoices to test for correct authorisation in line with official 
signatory list
Tracing ten non-current assets back to initial purchases invoices to verify 
their value
Tracing ten non-current assets back to initial purchases invoices to verify 
they were allocated to the correct cost centre

Picklist:
Test of control
Substantive test

1.4 Substantive analytical procedures

We saw the use of analytical procedures earlier; however, under ISA 520 Analytical Procedures,
the auditor now has another way of performing substantive tests:

'The objectives of the auditor are… to obtain relevant and reliable audit evidence when using
substantive analytical procedures.'
(ISA 520: para. 3a)

What are substantive

analytical procedures?

Activity 4: Ginger Ltd (1)

Ginger Ltd is a hotel chain with 10 hotels. Each hotel has 100 rooms and achieves around 55%
occupancy throughout the year. The average room rate is £75 inclusive of all charges. You are
the audit senior and have the draft financial statements for the year just ended.
The audit junior has been tasked with carrying out substantive analytical procedures to verify the
annual revenue figure for Ginger of £15 million but is unsure whether or not he needs any other
information.
Required
Is any further information required for us to verify this balance using substantive analytical
procedures? Select the most appropriate option from the picklist below.
Picklist:

Bar and restaurant spend per customer Length of stay per customer
Number of nights open during the year No further information required

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 Activity 5: Ginger Ltd (2)

Required
Assume that the average room rate for Ginger Ltd is now £50 but the rest of the data is the
same. Prepare extracts for reporting these findings to the audit manager, along with the
implications of these findings for the audit plan.

Findings Implications

1.5 Identifying the most appropriate mixture of tests to use

In your assessment, you are likely to be asked to determine the most appropriate mixture of tests
of control and substantive testing and justify your selection. To help you with this, let's consider
the following activity.
Activity 6: Mixed audit approach or substantive procedures only?

Required
For each of the following scenarios, identify the most suitable audit approach.

Scoot Ltd is a new company that has not been audited before and is 
dominated by its managing director and his informal operating
style. Sales are of greatest importance to him as the company
attempts to break into a competitive retail sector.
Whitney plc is an established listed company that operates in a 
stable market with strong governance procedures, including an
audit committee.
The board of Marine Ltd has just informed its external auditor that it 
wishes to replace its ledger systems due to a number of errors
identified in its management accounts.

Picklist:
Substantive procedures only, with no tests of control
Tests of control and substantive procedures

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 2 Sufficient appropriate audit evidence
Consider the following from ISA 500 Audit Evidence:

'The auditor shall design and perform audit procedures that are appropriate in the circumstances
for the purpose of obtaining sufficient appropriate audit evidence.'
(ISA 500: para. 6)

What does sufficient appropriate

audit evidence mean?

Audit evidence

Sufficiency Appropriateness
('enough of') ('the right kind of')

'Sufficiency' is subjective and

based on the auditor's
professional judgement. Relevance Reliability
Results of systems testing and
assessments of risk and Relevant evidence is Reliable evidence
materiality are used. judged as the right kind if considers the source of
it helps to prove a specific the evidence and ensures
Additional procedures can be
characteristic that a it adds credibility to the
carried out if the auditor feels
balance or transaction overall audit process (see
there is not enough evidence to
should possess (see below).
form a valid conclusion.
below).

2.1 Reliable evidence

There are some generalisations about the reliability of evidence:
 It is more reliable when it is obtained from independent sources outside the entity.
 If internally generated, it is more reliable if the related controls are strong.
 If obtained directly by the auditor (rather than indirectly or by inference) then it is more
reliable.
 It is more reliable when in documentary form (rather than oral).
 It is more reliable when documents are originals, not photocopies or facsimiles.

2.2 Relevant evidence – the use of assertions

Consider all the elements of a set of financial statements – assets, liabilities, income,
expenditure and all their associated disclosures. In order to belong there, each part of the
financial statements has to possess some specific characteristics (a little like membership
requirements for a specific club or society).
The auditor needs to make sure that if something has been included in the financial statements, it
should be there – in order to establish this, the auditor seeks evidence that is relevant to
confirming that the element does possess those characteristics required in order to belong. We
refer to these characteristics as assertions. There are two categories of assertions:

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 Assertions about Occurrence:
classes of transactions and events that have been recorded or disclosed have occurred
transactions and and pertain to the entity.
events and
related Completeness:
disclosures all transactions and events that should have been recorded have been
recorded and all related disclosures that should have been included in the
financial statements have been included.
Accuracy:
amounts and other data relating to recorded transactions and events have
been recorded appropriately, and related disclosures have been
appropriately measured and described.
Cut-off:
transactions and events have been recorded in the correct accounting
period.
Classification:
transactions and events have been recorded in the proper accounts.
Presentation:
Transactions and events are appropriately aggregated or disaggregated
and are clearly described, and related disclosures are relevant and
understandable in the context of the requirements of the applicable
financial reporting framework.

Assertions about Existence:

account balances assets, liabilities, and equity interests exist.
and related
disclosures at the Rights and obligations:
period-end the entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
Completeness:
all assets, liabilities and equity interests that should have been recorded
have been recorded and all related disclosures that should have been
included in the financial statements have been included.
Accuracy, valuation and allocation:
assets, liabilities, and equity interests are included in the financial
statements at appropriate amounts and any resulting valuation or
allocation adjustments are appropriately recorded and related disclosures
have been appropriately measured and described.
Classification:
assets, liabilities and equity interests have been recorded in the proper
accounts
Presentation:
Assets, liabilities and equity instruments are appropriately aggregated or
disaggregated and are clearly described, and related disclosures are
relevant and understandable in the context of the requirements of the
applicable financial reporting framework.

(ISA 315 (Revised): para. A190)

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 2.3 Direction of testing
One important matter to consider is the 'direction' of a test. When devising an audit test, it's
useful to think about the two types of audit evidence available:
 Source documents – these include physical assets (such as an item of inventory or a non-
current asset) and documents (ie invoices, contracts, goods despatched notes, goods
received notes and timesheets)
 Financial records – these include the financial statements and other records which are
agreed to the financial statements (ie cash books, ledgers and non-current asset registers)
If auditors are testing whether something has been understated in the financial statements (for
example, a liability such as trade payables), they must start the test at a source document and
agree the source document to the financial records. If auditors are testing whether something has
been overstated in the financial statements (for example, non-current assets or sales revenue),
they start with the financial records and trace back to source documents – to ensure the item
existed in the first place.
Activity 7: Assertions (1)

Required
Consider each of the following audit tests and then select the most appropriate assertion that
describes the purpose of that test.

Audit test
Select a sample of vehicles from the list of non-current assets and 
obtain their certificates of ownership.
Select a sample of receivables from the statement of financial 
position and agree to original invoices.
Select a sample of receivables from the sales ledger and agree to 
the final amount on the statement of financial position.
Trace a selection of payments included in cost of sales to original 
invoices.

Picklist:
Existence
Rights and obligations
Cut-off
Occurrence
Completeness

Activity 8: Assertions (2)

Required
Consider each of the following situations and select the most appropriate audit procedure for
the assertion used.

Testing cut-off for staff bonuses paid at the end of 

the financial year
Confirming the accuracy of staff bonuses paid at 
the end of the financial year
Confirming the value of cash investments held in a 
savings account by a client

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 Picklist:
Obtaining a letter from the bank stating that a savings account is held by the client
Obtaining a letter from the bank stating the amount of savings held by the client
Reconciling payroll records to a schedule of staff bonus payments authorised by the finance
director
Verifying bonus payments to payroll records to determine their timing

Once the testing is complete and the relevant evidence has been collected, as with all other
outputs from the audit process, it must be recorded and documented in line with ISA 230 Audit
Documentation (paras 2 and 3).

3 Automated tools and techniques

Automated tools and techniques are audit techniques carried out by the auditor using a
computer. They include simple procedures, such as the auditor using spreadsheets to manipulate
data, and more complex computer programs and techniques, such as embedded audit facilities
which allow the auditor continuous review of the client's system. Automated tools and techniques
can be intrusive and should only be used with client permission, as the client will not want the
auditors' software to cause problems in his own computer systems.

Benefits of using automated tools and Drawbacks of using automated tools

techniques and techniques
This technique allows large volumes of data to However, like any system, they require quality
be analysed at great speed, making the audit data for input, otherwise the output of this
process more efficient and allowing the auditor process will not be reliable. Skills and
to focus on other tasks if required. experience (which may not always be
available) are required to both administer and
interpret the findings.

Automated tools and techniques

Audit software Client's own system

Test data Embedded test facilities

Live Dead SCARF ITF

3.1 Audit software

Audit software is primarily used for substantive testing and suitable for the majority of audit
engagements. Data will be downloaded from the client's system to the auditor's computer when
a number of typical tests could be performed, such as:
(a) Reperformance of calculations eg ageing of trade receivables, casts of day books, ledger
listings or inventory reports (additional comfort is gained here as the auditor's own
software is being used to generate evidence)

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 (b) Extraction of samples
(c) Analytical review eg ratio calculations

3.2 Using the client's own system

This is primarily used for tests of control, and more suited to larger audit engagements. Such
testing of controls will require significant co-operation from the client, especially in terms of
computer access time. Typical uses include:
(a) Test data – the submission of 'dummy' data into the client's own system to ensure it is
processed correctly, or not processed if the data is deliberately false. This can be
conducted 'live' or 'dead' ie as part of normal processing or at times when the computer is
not in business use.
(b) Embedded test facilities – Systems Control and Review File (SCARF) and integrated test
facilities (ITF) aim to extend the tests of control more fully throughout the period than test
data. The former produces a diagnostic report of how the system is working, while the
latter offers a 'virtual' copy of the system used for testing purposes.

3.3 Data analytic tools

Recent advances in big data technology have seen automated tools and techniques evolve into
something more sophisticated that could be become a real game-changer for the auditing
profession. The ability to access and interrogate entire populations of client data using data
analytics has meant that the auditor's scope can now be increased, allowing them to concentrate
on interpreting the messages locked inside the data instead of spending all their time simply
trying to analyse it.
Examples of the types of audit activities that could benefit from data analytics include the
following:
 analysing data sets for information on specific locations, products, employees or times for
the purpose of identifying fraud or error
 reconciling activity such as matching orders, despatch notes and invoices for evidence of
misstatement
 inspecting journals to identify patterns that may indicate fraud
Underpinning all of this is the superior processing power that artificial intelligence and machine
learning can introduce to any analysis undertaken by the auditor. Clearly, significant amounts of
training and investment are required to unlock the potential of this technology, but the
possibilities are almost without limit.
Activity 9: Automated tools and techniques

Required
For each of the procedures listed below, select the type of automated tools and technique
which would be used to perform that procedure.

Extraction of all receivables balances older than 120 days to 

perform irrecoverable receivables work
Input of purchases invoices with false customer numbers to ensure 
that the system rejects the invoices
Comparison of suppliers on ledger with previous years to discover 
any new or missing suppliers
Interrogation of a year's transactions to analyse profitability by 
product and store for a retailer

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 Picklist:
Audit software
Data analytic tools
Integrated test facilities
Test data

4 ISA 530 Audit Sampling

'The objective of the auditor, when using audit sampling, is to provide a reasonable basis for the
auditor to draw conclusions about the population from which the sample is selected.' (ISA 530:
para. 4)

Audit sampling is applying audit procedures to less than 100% of items within an account
balance or class of transactions in such a way as to draw a conclusion on the account balance or
class of transactions as a whole.
Statistical sampling is an approach to sampling that involves random selection of the sample
items; and the use of probability theory to evaluate sample results including measurement of
sampling risk (the risk of selecting a non-representative sample) (ISA 530: para. 5).

The key rule of audit sampling is that all 'sampling units' must have an equal chance of being
selected for testing.

Sampling units are the individual items constituting a 'population' (account balance or class of
transaction) − for example, a single receivable balance within total receivables or an individual
sale within total revenue.
As you may have gathered, sampling is closely connected with risk and materiality. Sampling
affects detection risk because, put simply, the more items within a population that are tested, the
higher the chance of the auditor finding a misstatement.
However, if the auditor does not test every single sampling unit in the population, there is a risk
that misstatements will not be detected. However carefully the sample is selected, it is possible
that the sample will not be representative of the population as a whole.
Sampling, therefore, always carries a level of detection risk. The auditor has to determine an
appropriate level of this risk in order to obtain the benefit of sampling (which is that auditors don't
have to test everything!). The larger the sample tested, the lower the detection risk (detection risk
is covered in more detail in Chapter 4).

4.1 Non-statistical sampling

Non-statistical sampling is the use of judgement to select a sample instead of a statistical
technique.
In some instances, auditors will want to exercise judgement and test specific items, rather than
selecting a random sample.
For instance, we have already observed that auditors should test all material items. Therefore, if
the receivables' ledger contains debts that are themselves material to the financial statements,
they should be selected.
This is not a statistical sample by the above definition. As these items have been selected with
bias, the auditor cannot assume that they are reflective of the rest of the population, and should
not project the results of testing on these items to the rest of the population. This more subjective
approach, where the auditor selects samples not randomly but using his professional judgement,
is called non-statistical sampling.

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 Another example of non-statistical sampling is where the auditor believes there is a greater risk of
cut-off errors around the year end, and therefore focuses audit testing on the sales transactions
just before, and just after, the year end.

4.2 Stratification
The remainder of the population should be sampled in a non-biased way. This is known as
stratifying a population. Stratification is dividing a population into smaller sub-populations, each
of which is a group of sampling units, usually by value.
Therefore, instead of testing receivables as a whole, the auditor might test two populations of
receivable balances, individually material receivable balances and individually non-material
receivable balances (the total of which might well be material).
In this circumstance, the auditor would not apply sampling procedures to the first population,
and would instead test all of the material balances. The auditor would apply sampling procedures
to the second population and select balances for testing. Results from the sampled population
could be projected onto the rest of that sub-population to assess if total misstatements are likely
to be material.
In the first population, there would be no need to project results because, if everything has been
tested, there is nothing to project the errors against. All errors in that population should have
been found.
In some audit areas, it might be more appropriate to test 100% of items, or a very high
percentage of items (so that errors in the remaining balance couldn't possibly be material). An
example is often additions to property, plant and equipment, where only one or two material
additions may have been made in the year, and there is no need to select a sample, merely to
test these items.

4.3 How to pick the sample

The important rule above comes in here. It is important that any item in the population has a
chance of being picked – so, in general terms, the auditor should not bias the sample.
For example, if a company has two factories, one 20 miles from the auditor and the other 120
miles from the auditor, it is easier for the auditor to physically verify that the closer one exists.
However, this would be putting an unreasonable bias on the sample selection.
In order to avoid bias, there are several common ways of selecting samples:
(1) By random selection. The auditor uses a computer program or table to (mathematically)
randomly select the sample.
(2) By systematic selection. The auditor randomly selects the first item and then selects all the
others systematically after that. For example, the auditor might pick the fifth receivable on
the list of trade receivables and then every fifth or tenth after that. (This can be described
as interval sampling.)
(3) By haphazard selection. This is the approach most likely to allow audit bias to creep in.
This is a method by which an auditor picks a sample with no structured technique (that is,
what we would call 'at random' although human bias may reduce the mathematical
randomness of the choice). It is crucial that you understand the difference between this
type of sampling and 'random' sampling, outlined above.
(4) By Money Unit Sampling (MUS). This is a value-weighted selection, so (for example, in trade
receivables) every nth £ is selected, rather than every nth receivable. (This is also known as
interval sampling.)
(5) By block selection. This involves selecting a block of continuous items (for example, April's
invoices out of a population of the year's invoices). This is rarely an appropriate sample
technique, as April's invoices may have different characteristics from the rest of the year
and are not therefore representative of the whole population (for example, if they were
posted by a different staff member due to holiday).

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 Activity 10: Sampling (1)

The objective of a substantive test will determine the population from which the sample is
selected.
Required
For each of the objectives set out below, select the population from which the sample should be
selected.

Obtain evidence that sales have not been understated 

Obtain evidence that sales have not been overstated 

Picklist:
Sales ledger
Sales order

4.4 Confidence level

When using a sample, the auditor has to be sufficiently confident that the results given by a
sample reflect the results that would be given by testing the whole population.
Sampling, in many areas of the financial statements, is necessary because it is the only cost-
effective way an audit can be performed (testing everything would take too long and be too
expensive). The size of samples selected will be affected by the auditor's assessment of the
tolerable misstatement. For tests of control, the tolerable misstatement is the maximum rate of
deviation from a control that auditors are willing to accept in the population and still conclude
that the preliminary assessment of control risk is valid. For tests of details (or substantive testing)
the tolerable misstatement is the maximum monetary error in an account balance or class of
transactions that the auditor is willing to accept and still conclude that the financial statements
are true and fair.
If overall risk of misstatement is high, the auditor needs to be very confident that the results from
a sample reflect the results that would come from the whole population. Consequently, detection
risk needs to be reduced to an acceptably low level. This would increase the size of the sample
that the auditor tests. All this is a matter of auditor judgement based on the risks of
misstatements arising and materiality levels. This sort of judgement is taken at the planning stage
and amended, if necessary, as the audit progresses and more facts come to light. It is taken by a
senior member of the audit team and approved by the audit partner.
The auditing standard on audit sampling, ISA 530, outlines factors that impact on sample sizes,
and these are summarised below.

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 Illustration 2: The effect of various factors on sample sizes for tests of
control (ISA 530: Appendix 2)

Factor Effect on sample size for tests of controls

Increase in extent to which auditor Increase – because the more reliance the auditor intends to
intends to rely on controls place on controls, the greater his assurance that they are
operating effectively needs to be
Increase in the tolerable rate of Decrease
deviation
Increase in the expected rate of Increase – because if auditors expect errors to exist, they
deviation need to test more as they need to be satisfied that actual
misstatement is lower than tolerable misstatement
Increase in the auditor's desired Increase – because the more assurance the auditor needs,
level of assurance that actual rate the more items he needs to test
of deviation ≤ tolerable rate of
deviation
Increase of number of sampling Negligible effect
units

Illustration 3: The effect of various factors on sample sizes for substantive

testing (tests of detail) (ISA 530: Appendix 3)

Factor Effect on sample size for tests of details

Increase in auditor's assessment Increase – because the higher inherent and control risk is,
of the risk of material the lower detection risk needs to be (hence, more tests)
misstatement
Increase in the use of other Decrease – because the auditor is obtaining assurance
procedures at the same assertion from the other procedures (for example, analytical
procedures)
Increase in the auditor's desired Increase – because the more assurance the auditor needs,
level of assurance that actual the more items he needs to test
misstatement ≤ tolerable
misstatement

Increase in tolerable misstatement Decrease – because there is more chance of it being found
in the sample

Increase in expected misstatement Increase – because if auditors expect more errors to exist,
they need to test more as they need to be satisfied that
actual misstatement is lower than tolerable misstatement

Stratification of the population Decrease

Number of sampling units in Negligible effect
population

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 Activity 11: Sampling (2)

Determination of sample sizes on an audit is a matter of judgement.

Required
Select the impact the following matters have on the sample sizes for tests of control.

Auditors intend to increase reliance on the company's system 

of internal control for the purposes of the audit.
Auditors believe that there is likely to be a higher deviation rate 
in controls due to a new member of staff.
Increased activity in the factory and new customers, resulting 
in 25% more sales invoices being issued during the year.

Picklist:
Decrease
Increase
No effect

4.5 Advantages and disadvantages of different sampling methods

Sampling Advantages Disadvantages
method
Block Useful if interrogating a defined … but ignores the characteristics of
group of data…. data from outside that block

Haphazard This non-statistical technique is … but can still generate a biased

good for targeting your sample… and non-representative sample

Judgemental Also good for targeting specific … but again, can lead to the
areas of the population…. selection of a non-representative
sample through some form of bias

Random Eliminates bias by relying on a Requires IT expertise or the use of

mathematically-selected sample specialist maths tables to generate
the sample

Stratified Allows a broad range of items to be Can lead to larger or more complex
tested within the sample samples being selected which in turn
may take longer to complete

Systematic Ignores patterns and treats every Still requires some judgement to
item of the population the same determine the starting position and
way, eliminating bias sampling interval so still may not be
fully representative

(ISA 530: Appendix 1 and 4)

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 Chapter summary

 Auditors require evidence in order to be able to form an opinion on the financial statements. This
is collected using a series of different activities (AEEIOUR):
– Analytical procedures
– Enquiry
– External confirmation
– Inspection
– Observation
– Recalculation
– Reperformance

 Tests of control are used to verify the operating effectiveness of accounting systems and use all
the techniques listed above (AEEIOUR) apart from analytical procedures and external
confirmation. They should only be used when there are suitably robust controls in place to be
tested – otherwise, substantive procedures should be used instead.

 Substantive testing includes substantive analytical procedures and should always be used on an
audit – however, in the absence of testing controls, an audit should be conducted on a
substantive basis alone. These are also known as tests of detail.

 Auditors require sufficient (enough) appropriate (both relevant and reliable) audit evidence to
form their opinion. Relevance is determined by using assertions (occurrence, completeness,
accuracy, cut-off, classification/understandability, existence, rights and obligations, valuation
and allocation, and presentation) and specific audit procedures must be used to test each of
these.

 Automated tools and techniques are used to streamline the audit and allow for greater amounts
of data to be tested with improved accuracy. They can include audit software run by the auditor
and test data provided by the client. Recent advances in technology have allowed auditors to
deploy data analytic tools, in order to analyse whole sets of data and use their findings to draw
more accurate conclusions from their work.

 Sampling allows the auditor to gain assurance over large populations of data by selecting
suitable samples for analysis. There are statistical and non-statistical techniques used and, in
each case, care must be taken to ensure the right population is selected and the correct
conclusions drawn. Each of these techniques has advantages and disadvantages that the auditor
needs to be aware of when selecting the most appropriate sample for their testing.

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 Keywords
 Analytical procedures: evaluations of financial information made by a study of financial
and non-financial data
 Assertions: characteristics that all items within the financial statements (including
disclosure notes) should possess in order to 'belong' there
 Audit sampling: applying audit procedures to less than 100% of items within an account
balance or class of transactions in such a way as to draw a conclusion on the account
balance or class of transactions as a whole
 Audit software: software used by the auditor to perform testing on a client's financial
systems and data
 Automated tools and techniques: audit techniques carried out by the auditor using a
computer
 Data analytic tools: the use of technology to interrogate entire data sets
 Integrated test facilities: a 'non-live' environment in a client's systems that allows real data
to be processed and results investigated as part of testing
 Non-statistical sampling: the use of judgement to select a sample instead of a statistical
technique (such as block or haphazard selection)
 Sampling units: the individual items constituting a 'population' (account balance or class of
transaction) − for example, a single receivable balance within total receivables or an
individual sale within total revenue
 Statistical sampling: an approach to sampling that involves random selection of the
sample items; and the use of probability theory to evaluate sample results including
measurement of sampling risk (the risk of selecting a non-representative sample)
 Stratification: dividing a population into smaller sub-populations, each of which is a group
of sampling units, usually by value
 Substantive testing: audit procedures designed to detect material misstatement in the
financial statements, so they include tests of detail of classes of transaction, balances and
disclosures, and analytical procedures
 Test data: 'dummy' data that is fed into a client's real systems to ensure controls are
operating effectively
 Tests of control: tests to obtain evidence about the effective operation of the accounting
and internal control systems
 Tests of detail: another term used to describe substantive testing
 Tolerable misstatement: for tests of control, the maximum rate of deviation from a control
that auditors are willing to accept in the population and still conclude that the preliminary
assessment of control risk is valid. For tests of details (or substantive testing), the maximum
monetary error in an account balance or class of transactions that the auditor is willing to
accept and still conclude that the financial statements are true and fair

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 Test your learning
1 When designing further audit procedures as a result of risk assessment, auditors design
tests which give evidence about financial statement assertions.
Select which category each assertion is relevant to.

Existence 
Accuracy, valuation and allocation 
Cut-off 

Picklist:
Account balances
Classes of transaction
2 Select which ONE of the following statements is the important general rule concerning
audit sampling by ticking the appropriate box.

All sampling units should have an equal chance of being selected for testing.

All audit areas must be subject to sampling.

Auditors must always stratify a population to focus attention on high value items.

The more items there are in a population, the higher the sample sizes must be.
3 When using sampling techniques, auditors must select a sample such that each individual
sampling unit is capable of being selected.
Select which method of sampling will be most suitable in each instance described.

Simran has been asked to select a sample of 12 sales invoices to trace 

from sales order to general ledger. There are 16 folders of sales orders for
the year, stored in the sales office.
Julie has been asked to select a sample of 5 purchase ledger accounts to 
carry out a supplier statement reconciliation. There are 16 purchase
ledger accounts.
Ben is selecting a sample of inventory lines to perform a valuation test. 
The audit team has been instructed to use the computerised techniques
available to them, one of which is a sample selection program.

Picklist:
Haphazard
Random
Systematic

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 4 Determination of sample sizes on an audit is a matter of judgement.
Select the impact the following matters have on the sample sizes for audit tests.

Increase in the auditor's assessment of the risk of material 

misstatement
Increase in tolerable misstatement 
Decision to stratify a large population 

Picklist:
Decrease
Increase
No effect
5 Complete the following statement on automated tools and techniques.
Automated tools and techniques are methods of obtaining

 by using .

 is  that can check  on computer

systems by  or by comparing versions of .

 is a way of checking computer  by inputting real or

false information and observing how the program deals with it.
Picklist for line items:
Audit software
Computers
Data
Evidence
Interrogating
Programming
Programs
Software
Test data

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TT2022
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 Planning: audit risk

Syllabus learning outcomes / objectives

Having studied this chapter you will be able to:

3. Evaluate the planning process for audit and assurance

3.1 The concept of risk

Learners need to understand: Learners need to be able to:
3.1.1 components of the audit risk model: 3.1.6 identify audit risks
– inherent risk 3.1.7 identify analytical procedures that
– control risk could expose understatement or
– detection risk: overstatement of items in the
 sampling financial statements.
 non-sampling risk
3.1.2 relationship between the
components, particularly how
auditors manage detection risk in
order to keep audit risk at an
acceptably low level
3.1.3 how factors such as the entity’s
operating environment and its
system of internal control affect the
assessment of inherent and control
risk
3.1.4 the risk assessment process:
– risk matrix
– low, medium or high
– numerical grade
3.1.5 how analytical procedures can be
used to identify potential
understatement or overstatement of
items in the financial statements.

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 3.2 The concept of materiality
Learners need to understand: Learners need to be able to:
3.2.1 the difference between 'performance 3.2.5 calculate materiality levels.
materiality' and materiality for the
financial statements as a 'whole'
3.2.2 the role of materiality in planning an
audit and evaluating misstatements
3.2.3 methods used to calculate
materiality thresholds
3.2.4 the difference between 'material'
and 'material and pervasive'.

Assessment context
This topic supports a number of tasks in the assessment which are significant and, in the case of
audit risk, will probably feature multiple sub-requirements including those that require a written
answer. You therefore need to ensure you understand all aspects of this topic.

Qualification context
You will by now be starting to see some familiar terms such as those used by ISA 315 (Revised) but
this is the first time you will have seen audit risk and materiality in such detail.

Business context
The 21st century auditor needs to consider the risks associated with their chosen profession.
Although this chapter focuses on overall audit risk, there are plenty of other risks that the auditor
faces on a regular basis – reputation, commercial and litigation risks, to name but three.

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 Chapter overview

Understanding the entity

Financial statement Assertion

level level

Audit risk

Inherent risk Control risk Detection risk

Client factors Auditor driven

Non-sampling
Sampling risk
risk

 Profitability
Analytical  Operating ratios
procedures  Gearing

Performance
Materiality materiality

Calculations: Material but not

5–10% Profit before tax pervasive or
1–2% Revenue Material and
2–5% Total assets pervasive?

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 1 Understanding the entity
We have already seen how ISA 315 (Revised) Identifying and Assessing the Risks of Material
Misstatement provides guidance on systems and controls but, in addition to this, it defines some
key terminology that the auditor needs in order to plan the forthcoming external audit:

'Risk assessment procedures – The audit Risk assessment helps to prepare the
procedures designed and performed to auditor by planning the audit effectively
identify and assess the risks of material to deliver a valid opinion.
misstatement, whether due to fraud or
error, at the financial statement and
assertion levels.' Such an opinion is fraught with
uncertainty, however, and auditors
(ISA 315: para. 12(j)) need to plan for possible cases of fraud
or error jeopardising the truth and
fairness of the financial statements
which they might not detect.

The extract from ISA 315 (Revised) mentions risks at two levels, each of which could influence the
opinion given by the auditor:

 The financial statement level – there is a possibility that certain factors might have a
detrimental effect on the whole set of financial statements. For example, flaws in the
control environment, an overall lack of management integrity or competence or even
adverse economic conditions could lead to the entire set of statements being affected.
 The assertion level – there may only be one specific element of the financial statements
that is at risk of material misstatement due to problems with one or more characteristics of
that element. For example, if material assets listed on the statement of financial position
are incorrectly valued, there is a material misstatement in respect of them due to the
assertions made by management about their value. We will look at assertions in more
detail later.

ISA 315 (Revised) (Appendix 2) goes on to list the circumstances that should be considered as part
of an entity's risk assessment process, using categories that include complexity, subjectivity,
change, uncertainty and the susceptibility to misstatement as a result of fraud or management
bias:
 Changes in the operating environment (regulatory or even competitive)
 New personnel within an organisation
 New or revamped information systems
 Rapid growth
 New technology
 New business models, products or activities
 Corporate restructurings
 Expanded foreign operations
 New accounting pronouncements
The external auditor therefore faces a serious problem when agreeing to deliver an audit opinion
– in the same way as any critic might be at risk when asked for their opinion, this could easily be
discredited if it has not taken into consideration all available information and the auditor's
expertise. How does the auditor make sure such information and expertise has been taken into
consideration? The answer lies in understanding the risks faced by auditors and working to
control them by use of the audit risk model.

2 Audit risk
This is the risk that the auditor does not detect one or more of the risks that relate to an audit and
gives an opinion that the financial statements are true and fair when, in reality, they are
materially misstated in some way, due to incorrect and/or inappropriate accounting or
disclosure. It is a factor of inherent risk, control risk and detection risk.

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 2.1 The audit risk model
The model works by isolating elements of the audit process and reviewing each one to see what
the impact on audit work will be. The various elements are as follows:

Audit risk = Inherent risk  Control risk  Detection risk

Audit risk Inherent risk Control risk

This is the risk that you give Such risk is always present This is another risk only ever
an incorrect opinion – for in areas of the client that present at clients,
example, the auditor may are susceptible or prone representing the risk of
wish to limit the chance of to fraud or error (these controls not preventing or
this happening to only 5% are then prioritised on a detecting fraud or error
(ie working towards 95% spectrum of inherent risk (eg human error or
accuracy) by impact and likelihood) management override)

Where does detection risk come into the formula then?

Note. Together, inherent risk and control risk make up the risk of material misstatement.

Detection risk is the risk that audit procedures will not detect a misstatement. It is a
representation of the acceptable amount of risk faced by the auditor. As inherent and control
risk increase, the level of acceptable detection risk decreases and the auditor therefore performs
more testing to keep audit risk at an acceptable level.

During the process of testing to address detection risk, sampling (which you have already
covered) will be used frequently – however, this exposes the auditor to two types of detection risk
that you need to know about – sampling risk and non-sampling risk:
 Sampling risk – this is the risk that occurs every time a sample is selected and represents
the risk that the sample does not adequately represent the population.
 Non-sampling risk – this is subtly different from sampling risk and occurs from poor
interpretation of a sample by the auditor: for example, the auditor may have limited
experience of sampling and may have selected a suitable sample, but fails to derive the
right conclusions from the data obtained (this may occur if the auditor is short of time or
does not fully understand the client).
In general terms, the audit risk model could be looked at as a mathematical equation where you
are looking for the balancing figure. Detection risk does just that by considering the desired audit
risk and the likely inherent and control risks posed by the client – the auditor then has to
consider the amount of work that needs to be done to balance the equation.
Activity 1: Detection risk

You are the auditor of J Club Ltd and are working out how much work you need to do to stay
within your 95% accuracy figure that you use in your firm's marketing literature.
Required
Show how much 'detective work' you will need to do in each of the following two scenarios if J
Club Ltd has risks, as follows:
(i) Inherent risk = 50% Control risk = 20%
(ii) Inherent risk = 50% Control risk = 40%
Scenario (i) Scenario (ii)
Detection risk = Detection risk =

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 Activity 2: Audit risk

Required
Select whether the following statements in respect of audit risk are true or false.

If inherent and control risk have been determined to be high, auditors will
have to carry out a high level of detailed testing to render overall audit risk 
acceptable.
The head of internal audit has just been suspended from one of your clients

on suspicion of fraud. As a result, you assess that control risk has fallen.
One of your largest retail clients has decided to cease taking cash at all its

stores. You assess that inherent risk will fall for that client.

Picklist:
True
False

2.2 The risk assessment process

Auditors can use graphical means to help them assess risks by assigning each risk a category or
description in terms of two characteristics:
1. Likelihood – how possible a risk is to occur
2. Impact – if it does occur, how significant will it be
Risks can then be plotted on a risk matrix like this:

High
Likelihood

Medium

Low

Low Medium High

Impact

The higher the assessment of risk, the closer to the top right-hand corner it will appear and thus
the risk will be assessed as being more significant.
As an alternative to a graphical representation of risk assessment, a numerical grade may be
assigned using a similar approach. Impact and likelihood are both scored for each risk being
assessed (for example, from 1 to 5) and then these scores are multiplied to give a product (in this
case, anything from 1 to 25). The higher the numerical grade, the higher the risk.
Clearly, any form of assessment will be subjective to some extent, so the auditor's professional
judgement will be important here.

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 2.3 Conditions necessary to demonstrate professional scepticism
In its 2012 publication on professional scepticism, the FRC identified conditions that it felt were
necessary for auditors to be able to demonstrate the appropriate degree of professional
scepticism. As we are currently considering the assessment of audit risk, it now seems appropriate
for us to consider some of the behavioural and organisational factors that support an
appropriately sceptical audit. The required conditions can be applied to various groups involved
in the audit and are summarised in the following table.
Individual auditors Need to be professionally curious, sufficiently informed about the client
and possess the confidence to challenge evidence if required.
Engagement teams Share knowledge about the client, making appropriate decisions and
revisions about the audit that evolve as evidence is collected.
Audit firms Foster a culture of scepticism and a rigorous system of quality via
appropriate recruitment, training, supervision, review, coaching and
consultation. Within the firm, both teams and individual auditors are to be
supported in demonstrating scepticism especially when there is potential
evidence of fraud or error due to directors' actions or motivations.
Audit committees The audit committee has an important role to play in supporting the
and management external audit process by dealing constructively with any challenge made
by the auditor as part of its role in displaying suitable levels of professional
scepticism.

3 Analytical procedures and audit risk

Much of the evidence gathering that the auditor does is based on the verification techniques
outlined earlier in the course (AEEIOUR) and the first of these – analytical procedures – is based
on the auditor's ability to interpret financial information.
At the risk assessment stage of the audit, ISA 315 (Revised) helps to identify aspects of the entity
being audited that the auditor might not have been aware of, using analytical procedures to
identify plausible relationships between items of financial and non-financial information (ISA 315
(Revised): para. 14). Broadly speaking, assets should not be overstated nor liabilities understated
when supported by relevant data (such as revenues or purchases). Examples of the type of
relationships sought could include:

 Consistent amounts of non-current assets, working capital and expenditure for a specific
level of activity (eg consistent receivables and revenues increases)
 Consistent lengths of time taken to collect debts or pay invoices
 Consistent amounts of return for a given amount of investment in non-current assets
 Consistent amounts of debt to equity

The amount of consistency in all these areas is assessed over a number of time frames to allow
the auditor to pinpoint any specific areas of risk. There are a number of important accounting
ratios that could be used for this:
Return on capital employed (ROCE) Operating profit / Capital employed  100
(Where Capital employed = total equity + non-current
liabilities)
Return on shareholders’ funds Profit after tax / Total equity  100

Gross profit margin* Gross profit / Revenue  100

Operating profit margin* Operating profit / Revenue  100

*These two margins should be calculated in total and by product, area and month/quarter if
possible.

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 Expense/revenue percentage Specified expense / Revenue  100

Current ratio Current assets / Current liabilities

(Answer equals X:1)
Quick ratio or ‘acid test’ ratio (Current assets – inventories) / Current liabilities
(Answer equals X:1)
Inventory turnover Cost of sales / Inventories
(Answer equals X times)
Inventory holding period(days) Inventories / Cost of sales  365

Trade receivables collection period Trade receivables / Revenue  365

(days)
Trade payables payment period Trade payables / Cost of sales  365
(days)

Working capital cycle (days) Inventory holding period (days) + trade receivables
collection period (days) – trade payables payment period
(days)
Asset turnover (net assets) Revenue / (Total assets – current liabilities)
(Answer equals X times)
Asset turnover (net current assets) Revenue / Non-current assets
(Answer equals X times)
Interest cover Operating profit / Finance costs (ie, interest)
(Answer equals X times)
Gearing Total debt / (Total debt + total equity)  100
(Where total debt is all non-current liabilities only)

You should be familiar with these ratios from your other studies. Remember that ratios
mean very little when used in isolation. They should be calculated for previous periods and
for comparable companies. Audit working papers should contain summarised accounts and
the chosen ratios for prior years. In addition to looking at the more usual ratios, the auditors
should consider examining other ratios that may be relevant to the particular client's business,
such as revenue per passenger mile for an airline operator client, or fees per partner for a
professional office.
One further important technique is to examine important related accounts in conjunction with
each other. It is often the case that revenue and expense accounts are related to statement of
financial position accounts and comparisons should be made to ensure that the relationships are
reasonable.

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 Activity 3: IZK Ltd

Required
Use analytical procedures to determine four balances from IZK Ltd that you would investigate
further for risk of material misstatement – select your answers from the picklist below.
IZK Ltd
Statement of financial position as at 30 September 20X6

20X6 20X5
£ £
ASSETS
Non-current assets
Property, plant and equipment 46,595 41,675

Current assets
Inventories 60,120 58,675

Trade and other receivables 140,674 124,968

Cash and cash equivalents 17,547 6,617

218,341 190,260

Total assets 264,936 231,935

EQUITY AND LIABILITIES

Equity
Share capital 1,000 1,000

Retained earnings 184,187 142,039

185,187 143,039

Non-current liabilities
Bank loans 4,762 14,910

Current liabilities
Trade and other payables 74,987 73,986

Total liabilities 79,749 88,896

Total equity and liabilities 264,936 231,935

Picklist:
Bank loans
Cash and cash equivalents
Property, plant and equipment
Retained earnings
Share capital
Trade and other payables
Trade and other receivables

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 Activity 4: Bucket Ltd

The external auditor is required to undertake analytical procedures as part of the planning
process in order to identify and evaluate the risks of material misstatement of figures in the
financial statements. The results of the analytical procedures conducted on trade receivables and
trade payables in the financial statements of an audit client are shown below.
Required
Select whether the results indicate that trade receivables and trade payables at Bucket Ltd may
have been under- or overstated.
The results show that, compared with the previous year:

Trade receivables have increased by 25% and revenue has increased by 7% 

Trade payables have decreased by 5% and purchases has increased by 4% 

Picklist:
Overstated
Understated

4 Materiality
If either the omission or misstatement of an item could reasonably affect the economic decisions
of users of a set of financial statements, then that item is considered material to those financial
statements.
We are familiar with the term 'material misstatement' but we have not yet defined the term
'material'. ISA 320 Materiality in Planning and Performing an Audit helps us with this:

'When establishing the overall audit strategy, the

auditor shall determine materiality for the
Items can be material by nature:
financial statements as a whole. If, in the specific
related parties and related
circumstances of the entity, there is one or more
party transactions are
particular classes of transactions, account
considered to be a significant
balances or disclosures for which misstatements
risk because they affect profits
of lesser amounts than materiality for the financial
earned but may not be obvious
statements as a whole could reasonably be
to the audit team – hence they
expected to influence the economic decisions of
should always be prioritised and
users taken on the basis of the financial
reported to senior audit team
statements, the auditor shall also determine the
members to ensure correct
materiality level or levels to be applied to those
treatment in the financial
particular classes of transactions, account statements.
balances or disclosures.'
(ISA 320: para. 10)

Materiality is important as it determines the threshold above which further audit work becomes
necessary, as well as confirming those misstatements or omissions that will have to be
considered as part of the audit opinion.

4.1 Calculation of materiality

The auditor must calculate a suitable level of materiality for the financial statements as a whole.
This will often be a percentage of a significant benchmark in the financial statements.

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 Calculating materiality will always be a matter of professional judgement, so these percentages
will not simply be applied without thought, but a useful guide to materiality levels is to consider
that something is material if it is:
 5–10% of profit before tax
 1–2% of revenue
 2–5% of total assets
The auditor may need to calculate material levels for specific items in financial statements
which are particularly significant to users for any reason. Some items might be material simply
because of what they are. Due to the legal restrictions around directors' remuneration
disclosures in the UK, any matter relating to directors in financial statements is usually
considered to be material.
In addition, a misstatement might be considered material because of its effect. For example, if a
small misstatement made the company breach a covenant made with its bank, it might be
considered material.
Activity 5: Material or not?

Profit is £100,000 and materiality has been set at 5% of profit.

Required
Select whether the following items are likely to be considered material or not material.

There is misstatement in receivables, value £7,500. 

A loan to a director has been disclosed in the financial statement at £2,000.

Actually the correct sum is £2,010.
The company is required to keep a current asset ratio of 2:1. A misstatement
of £100 has been found in receivables, which will cause the ratio to drop 
below this level.

Picklist:
Material
Not material

4.2 Performance materiality

Performance materiality is the amount or amounts set by the auditor at less than materiality for
the financial statements as a whole. This reduces to an appropriately low level the probability
that the aggregate of uncorrected and undetected misstatements exceeds materiality for the
financial statements as a whole.

'The auditor shall determine performance materiality for purposes of assessing the risks of
material misstatement and determining the nature, timing and extent of further audit
procedures.'
(ISA 320: para. 11)

Setting one level of materiality means that there could be items below this level which are
misstated but not classed as material and hence not tested – if there were several of these, there
is a risk that the sum of these could constitute a material misstatement that the auditor never
knew about.
To address this risk, a second level of materiality is set by the auditor and used to select
specific amounts where the risk of aggregate immaterial misstatements is highest. It is again
a matter of professional judgement for the auditor on both the amount and the classes of

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 transaction or account balance selected. This is called 'performance materiality'. You will
explore this idea further when considering ISA 450 Evaluation of Misstatements Identified
During the Audit.

4.3 Revision of materiality as the audit progresses

'The auditor shall revise materiality for the financial statements as a whole (and, if applicable,
the materiality level or levels for particular classes of transactions, account balances or
disclosures) in the event of becoming aware of information during the audit that would have
caused the auditor to have determined a different amount (or amounts) initially.' (ISA 320: para.
12)
'If the auditor concludes that a lower materiality for the financial statements as a whole (and, if
applicable, materiality level or levels for particular classes of transactions, account balances or
disclosures) than that initially determined is appropriate, the auditor shall determine whether it is
necessary to revise performance materiality, and whether the nature, timing and extent of the
further audit procedures remain appropriate.'
(ISA 320: para. 13)

4.4 Documentation
It is logical that, in
'The auditor shall include in the audit documentation the following
order to document
amounts and the factors considered in their determination:
the process of
(a) Materiality for the financial statements as a whole reaching the audit
opinion, as well as
(b) If applicable, the materiality level or levels for particular classes the assumptions
of transactions, account balances or disclosures made, any changes
(c) Performance materiality in those assumptions
should also be
(d) Any revision of (a)-(c) as the audit progressed.' documented.
(ISA 320: para. 14)

4.5 'Material' or 'material and pervasive'?

You may be asked to differentiate between the terms 'material' and 'material and pervasive' when
evaluating the materiality of a misstatement or similar issue. From ISA 705 (revised) Modifications
to the Opinion in the Independent Auditor's Report, the term 'material and pervasive' has the
following definitions:

 Are not confined to specific elements, accounts or items of the financial statements
 If so confined, represent or could represent a substantial proportion of the financial
statements
 In relation to disclosures, are fundamental to users' understanding of the financial
statements (ISA 705: para. 5(a)).

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 Activity 6: Materiality issues

Required
Select whether the following statements in respect of materiality are true or false.

Performance materiality should be set at less than materiality for the financial

statements as a whole.
Materiality is a measure of the importance of items to a reader of financial

statements.
Items may be material due to their size, nature or effect on the financial

statements.
A building carried in the financial statements is judged to be 'material and
pervasive' if it represents 70% of total assets and 150% of profit before tax and is

subject to an impairment review due to extensive damage. It is the only premises
of a trading company that cannot relocate due to commercial pressure.

Picklist:
True
False

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 Chapter summary

 Auditors start to evaluate the planning process by attempting to understand the entity that is
being audited, both at the financial statement level (risks that affect the whole financial
statements) and at the assertion level (more specific issues related to the way that certain
amounts are carried within the financial statements).

 Risk assessment procedures require an understanding of the factors that go into creating audit
risk:
– Inherent risk – the susceptibility of certain things being misstated (this is client-driven).
– Control risk – the inability of systems of internal control to deal with such inherent risks (this is
also client-driven).
– Detection risk – the risk that the auditor does not do enough testing to take account of
inherent and control risk. This is auditor-driven and includes sampling risk (the risk that a
sample is not representative of the population) and non-sampling risk (the risk that results of
testing are misinterpreted).

 Risk can be assessed and expressed both graphically on a risk matrix and numerically by
awarding a suitable grade

 Analytical procedures are used to identify and understand risks within a set of financial
statements and use techniques such as ratios, comparisons and other techniques to understand
profitability, operating and gearing issues presented by an audited entity.

 Materiality is the term used to describe the significance of certain items within the financial
statements depending on the importance placed upon them by users of those financial
statements. It can be assessed numerically (such as a percentage of profit before tax or total
assets) but also qualitatively (by nature, such as a related party transaction). Items can be
assessed as not just 'material' but also 'material and pervasive' if they meet certain criteria
relating to their size and impact which auditors also need to consider.

 Performance materiality is an amount set at below materiality to allow the auditor to test for
items where, in the auditor's judgement, there may be misstatements that are individually
immaterial but in aggregate, they could represent a material misstatement.

 Materiality is one of the single most difficult areas for the auditor due to the heavy reliance on
judgement to make it work effectively.

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 Keywords
 Audit risk: the risk that the auditor does not detect one or more of the risks that relate to an
audit and gives an opinion that the financial statements are true and fair when, in reality,
they are materially misstated in some way, due to incorrect and/or inappropriate
accounting or disclosure. It is a factor of inherent risk, control risk and detection risk
 Control risk: another risk only ever present at clients, representing the risk of controls not
preventing or detecting fraud or error (eg human error or management override)
 Detection risk: the risk that audit procedures will not detect a misstatement. It is a
representation of the acceptable amount of risk faced by the auditor. As inherent and
control risk increase, the level of acceptable detection risk decreases and the auditor
therefore performs more testing to keep audit risk at an acceptable level
 Inherent risk: Such risk is always present in areas of the client that are susceptible or prone to
fraud or error (such as high staff turnover, cash transactions, complex calculations, high value
items or those requiring estimation or judgement)
 Material and pervasive:
– Are not confined to specific elements, accounts or items of the financial statements
– If so confined, represent or could represent a substantial proportion of the financial
statements
– In relation to disclosures, are fundamental to users' understanding of the financial
statements
 Materiality: if either the omission or misstatement of an item could reasonably affect the
economic decisions of users of a set of financial statements, then that item is considered
material to those financial statements
 Non-sampling risk: subtly different from sampling risk and occurs from poor interpretation
of a sample by the auditor: for example, the auditor may have limited experience of
sampling and may have selected a suitable sample, but fails to derive the right conclusions
from the data obtained (this may occur if the auditor is short of time or does not fully
understand the client)
 Performance materiality: the amount or amounts set by the auditor at less than
materiality for the financial statements as a whole. This reduces to an appropriately low
level the probability that the aggregate of uncorrected and undetected misstatements
exceeds materiality for the financial statements as a whole
 Sampling risk: the risk that occurs every time a sample is selected and represents the risk
that the sample does not adequately represent the population

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 Test your learning
1 Complete the statement.
The auditors must gain an understanding of the following areas of a business:
.............................................................
.............................................................
.............................................................
.............................................................
.............................................................
2 Select which ONE of the following statements best summarises why auditors must gain an
understanding of the entity using the appropriate tick box.

In order to understand internal control systems

In order to be able to assess risks

In order to see what items there are to be audited

In order to eliminate items from testing

3 Complete the definitions using the items in the picklist below.

 risk is the risk that the auditors give an  opinion on

the financial statements.

 risk is the risk that the entity's internal control system will not prevent
or detect and correct errors.

 risk is the risk that items will be misstated due to their

 or due to their 
.

 risk is the risk that misstatements will exist in financial statements and
the auditors will not discover them.
Picklist for line items:
Audit
Context
Control
Detection
Inappropriate
Incorrect
Inherent
Nature
4 Select whether the following statements concerning audit risks are true or false.

Auditors cannot affect inherent and control risk as inherent and control
risks are the risks that errors will arise in the financial statements as a

result of control problems or the nature of items in the financial
statements of the entity. The auditors cannot control those factors.
If inherent and control risk are high, detection risk should be rendered
low to come to an overall acceptable level of risk. In order for detection 
risk to be low, the auditors will have to carry out a lower level of testing.

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 Picklist:
True
False
5 When planning an audit of financial statements, the auditor is required to consider how
factors such as the entity's operating environment and its system of control affect the risk
of material misstatement in the financial statements.
Select whether the following factors are likely to increase or reduce the risk of
misstatement.

The control environment is weak and there is considerable


pressure on management to improve results year on year.
Management has implemented improvements in controls as a

result of weaknesses identified last year.

Picklist:
Increase
Reduce
6 Select whether the following statements in respect of materiality are true or false.

Materiality is the concept of significance to users of the financial


statements.
Performance materiality will usually be higher than materiality

assessed for the financial statements as a whole.

Picklist:
True
False
7 When planning an audit of financial statements, the auditor is required to consider how
factors such as the entity's nature and operating environment affect the risk of material
misstatement in the financial statements.
Select whether the following factors are likely to increase or reduce the risk of
misstatement.

The company has diversified its operations during the year. 

The company has discontinued operations in its riskiest operating

area during the year.

Picklist:
Increase
Reduce

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 Planning: audit
procedures

Syllabus learning outcomes / objectives

Having studied this chapter you will be able to:

3. Evaluate the planning process for audit and assurance

3.3 Audit procedures

Learners need to be able to:
3.3.1 develop procedures to obtain sufficient appropriate evidence in respect of the
relevant assertions for key figures in the financial statements, particularly:
- non-current assets
- inventory
- receivables
- cash and bank
- borrowings
- payables
- provisions
- revenue
- purchases
- payroll and other expenses
- other payables and other receivables.

4. Evaluate procedures for obtaining sufficient and appropriate evidence

4.5 Audit assertions

Learners need to know: Learners need to be able to:
4.5.1 assertions contained in the financial 4.5.2 identify audit procedures to test
statements: financial statement assertions.
– payables
– receivables
– inventories
– bank and cash
– non-current assets
– non-current liabilities.

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 Assessment context
Although there are only two learning outcomes listed here, they are both likely to be assessed as
written requirements within a task and could each be worth up to 10 marks, so this topic is
essential for you to engage with.

Qualification context
Most of this chapter will be application of terms previously seen in your AAT studies, although the
use of some terms may not initially be clear. Try to refer to previous units if there are elements of
terminology that you are unfamiliar with.

Business context
Inventory and work in progress (WIP) often represent a significant asset on the statement of
financial position, with the value of inventory also having a direct impact on profit. A considerable
amount of audit effort is usually devoted to this area because of these factors – talk to any
seasoned audit professional and they will usually have the most engaging stories to tell about
either the nature of an inventory count (eg smoked haddock stored in a cold, draughty shed) or
the timing (eg 6am on New Year's Day!).

The audit of other assets is often a major part of the audit for an audit firm, as it usually requires
significant work on valuation and existence to counter the risk of overstated amounts. Given the
nature of the agency problem that we saw in the first topic, it is entirely possible that the
directors of an entity may try to make their company seem as big as possible, meaning that
auditors will usually have their work cut out for them.

The audit of liabilities is quite a change for the auditor – instead of being on the lookout for
overstated assets used to bolster a potentially fragile statement of financial position, you are now
faced with the possibility of items being either understated or even ignored. Remember that
visibility (or rather lack of it) is the biggest audit risk here – the collapse of the Enron Company in
2001 was partly due to hidden off balance sheet financing.

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 Chapter overview

Audit risk

Factors that increase or decrease the

risk of material misstatement within the
financial statements

Audit procedures

Written task

Non-current assets Inventory Receivables

 Capital items  Inventory count  Circularisation

 Leases  Raw materials
 WIP
 Finished goods
 Cut-off

Cash and bank Borrowings Payables

 Bank reconciliation  Amounts  Completeness

 Bank letter  Disclosures  Valuation

Provision Revenue Payroll

 Judgement  Double entry  Completeness

 Existence

Purchases Accruals Prepayments

 Occurrence

Bills
Insurance
Expenses

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 1 Audit risk analysis for a given situation
We've already seen how the auditor can use the various elements of the audit risk model (inherent
risk, control risk and detection risk) to understand the risks presented by an audit client. However,
you are likely to be asked to complete a written task within the assessment where you identify
areas of audit risk from a given set of circumstances in a scenario.
Activity 1: Risk of misstatement

When planning an audit of financial statements, the external auditor is required to consider how
factors such as the entity's operating environment and its system of internal control affect the
risk of misstatement in the financial statements.
Required
Select whether the following factors are likely to increase or reduce the risk of misstatement.

The entity is to be sold and the purchase consideration will be determined 

as a multiple of reported profit.

The company has a history of being slow to follow new accounting 

standards and guidance.

Picklist:
Increase
Reduce

Activity 2: Pebbles Ltd

Pebbles Ltd is a private limited company which owns a number of fish and chip shops in seaside
resorts on the south coast.
The owners of the company are Mark O'Neill and John White. They each own 50% of the share
capital and are both directors. John is responsible for the financial side of the business. He is
thinking of selling his stake in the company but wants to wait until the audited accounts are
available.
The trade is very seasonal, with high turnover and profits in the summer. However, the restaurants
remain open throughout the year as they make sales to weekend and Christmas holidaymakers.
All sales are made on a cash basis. Purchases are made on credit from a number of suppliers.
Stocks (inventory) are kept in refrigerators on the premises and have to be used within one week
of purchase.
During the summer months, a large number of casual workers are employed. Many are at school
or college and are taking a holiday job. Some only last a few days and are never seen again!
During the rest of the year, there are around 30 people on the payroll. This element of the
workforce is fairly stable.
The company owns some of the premises from which the business is run. Others are leased.
Identify and describe FOUR factors from the scenario that could increase the risk of
misstatement in the financial statements of Pebbles Ltd.

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 (1)

(2)

(3)

(4)

2 Audit procedures
When using substantive procedures to test the various items on the statement of financial
position, the auditor considers the appropriate assertions for these balances as they help
auditors to gather evidence in order to form a conclusion about each specific item.

2.1 Non-current assets

Non-current assets are assets held for continuing use in the business.
We saw from earlier chapters that, for assets and liabilities, the relevant assertions are:

 Existence
 Completeness
 Rights and obligations (or ownership)
 Valuation
 Disclosure (or description)

We will now look at other items that are classified as either assets or debit balances (usually
both, but not always). First is the asset balance that is usually the largest for an entity: non-
current assets. Inventory, one important area of the audit, is covered in detail in section 2.2 of
this chapter.
An important test when reviewing non-current assets is to ensure that only capital expenditure is
included on the statement of financial position.

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 Activity 3: JICS driving school

You are the audit senior working on the audit of JICS driving school. You are testing non-current
assets for overstatement (existence). Based on your review of the non-current assets register, you
have noted that it includes the items listed below.
Required
Identify four items from the picklist that you do not believe to be capital in nature.

Picklist:
10  Ford Fiestas
2  PCs and monitors for the office
2  desk telephones
10  mobile telephones
Car insurance
Car servicing
Installation of dual controls in cars
Replacement tyre for car no. 6
Repairs to bumper of car no. 4
Office fixtures and fittings
'JICS' signs to go on top of cars

Activity 4: Campey Ltd non-current assets

Below is a schedule of non-current assets at Campey Ltd.

Required
Set out, in a manner suitable for inclusion in the audit plan, the audit procedures to be
undertaken for each assertion in order to ensure that non-current assets are fairly stated in the
financial statements. You have already verified the opening balances to the prior year audit file.

Land Buildings Vehicles Fittings Total

£ £ £ £ £
Cost at 1 October 20X8 1,000,000 3,500,000 60,000 125,150 4,685,150
Additions – – 15,000 800 15,800
Disposals – – – – –
Cost at
30 November 20X9 1,000,000 3,500,000 75,000 125,950 4,700,950
Accumulated
depreciation at
1 October 20X8 – 140,000 26,250 37,545 203,795
Depreciation charge – 70,000 12,188 18,893 101,081
Accumulated
depreciation at
30 November 20X9 – 210,000 38,438 56,438 304,876
Carrying amount at 30
November 20X9 1,000,000 3,290,000 36,562 69,512 4,396,074
Carrying amount at
1 October 20X8 1,000,000 3,360,000 33,750 87,605 4,481,355

Note. Depreciation rates are 2% straight line for buildings, 25% diminishing balance for vehicles
and 15% straight line for fittings.

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 Completeness

Rights and obligations

Existence

Valuation

Leases (IFRS 16)

Leases are studied in the Level 4 Drafting and Interpreting Financial Statements unit. You do not
need detailed knowledge of the financial reporting standard Leases (IFRS 16) for the Audit and
Assurance unit. However, you do need to understand the key risk associated with this item, which
is that it may be materially misstated in the financial statements.
A lease is 'a contract, or part of a contract, that conveys the right to use an asset (the underlying
asset) for a period of time, in exchange for consideration'. (IFRS 16: Appendix A)
The underlying leased asset is referred to as a 'right of use' asset. The entity that has the right to
use this leased asset is known as the lessee. IFRS 16 requires recognition of all leases in the
lessee's statement of financial position except short-term leases (those with a lease term of 12
months or less) and leases where the asset is of low value (taken on a case by case basis).
Lease disclosure in the financial statements of lessees
The financial statements of a lessee will have the following headings in relation to a leased asset:
Statement of financial position (extract)

£
Non-current assets
Right-of-use asset X
Non-current liabilities
Lease liability X
Current liabilities
Lease liability X
X

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 Statement of profit or loss and other comprehensive income (extract)

£
Depreciation charge (in relevant expense category) X
Finance charges X

Audit risk for leases

The auditors must test leased items to verify that they are correctly accounted for in line with IFRS
16. This might include the following issues:
 recognition of an asset as a right-of-use asset when it does not qualify (such as short term
or low value leases, or any that do not satisfy the criteria from IFRS 16, such as control or
identification)
 non-recognition of a leased asset which should be classified as a right-of-use asset
 material misstatement in the accounting treatment of a right-of-use asset (such as
incorrect calculation of any lease assets or liabilities, or the amount to be charged in
depreciation)
 incorrect classification between current and non-current lease liabilities

2.2 Inventory
The audit approach for inventory must include the three main elements of inventory balances
seen in the statement of financial position: quantity, valuation, and disclosure.
One audit test in particular gives evidence in relation to completeness, rights and obligations (ie
ownership) and existence. This test is attending the physical inventory count carried out by the
entity being audited and it provides evidence of inventory quantity. It can also provide
corroborative evidence of the likely valuation of such an asset due to recording information
about the condition of inventory as well.
There are three methods for an entity to physically count its inventory:

 Year-end count, where the entire inventory of the entity is counted as close to the reporting
period end as possible to provide a figure for the closing inventory balance
 Interim count with follow through to year end − as above, but the count occurs during the
year and all items both inwards and outwards are reconciled to arrive at a calculated
amount
 Continuous inventory records and perpetual inventory − an automated system records all
items inwards and outwards, and maintains an ongoing balance of inventory at any one
time – this is tested periodically as part of the entity’s normal controls assessment

The auditor will attend the entity's physical inventory count to verify inventory quantities but it is
not the auditor's responsibility to count the inventory. This is carried out as part of the legal
responsibilities of the management of the entity to keep accounting records in line with the
Companies Act 2006.
Quantity
The most common method for the auditor to gain evidence as to the amount of inventory held at
the end of the reporting period is to attend the year end inventory count.
Activity 5: Paper Products Ltd

You are the senior on the audit of Paper Products Ltd. Your client imports paper from Scandinavia
and supplies it to major publishers and stationery suppliers in the UK. A new team member will be
attending the annual inventory count this Saturday. It is your responsibility to brief him on how he
should prepare for the count and what he should do when he is there.

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 Required
List the points you will cover during your briefing with the new team member.
Before:

During:

After:

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 Activity 6: Inventory assertions

Required
Consider each of the following tests plus results from the audit file recording attendance at the
annual inventory count of Glad Rags. From the list of assertions supplied, select the most
appropriate assertion for that test.

Test 
Form an opinion of the condition of inventory and record any
instances of damage or obsolescence.
Result
There were 15  10m rolls of fabric stored near the roof of the
warehouse where birds had nested, making the fabric unusable.

Test 
Trace 10  10m rolls of fabric from the inventory sheets to the
relevant shelves of the warehouse.
Result
All 10 rolls were found on the shelves in the locations specified by
the main accounting system.

Test 
Trace 10  10m rolls of fabric from the relevant shelves of the
warehouse to the inventory sheets.
Result
All 10 rolls were traced back to the list generated by the main
accounting system.

Test 
Confirm that the fabric and garments held in the secure off-site
storage facility are to be included in Glad Rags' inventory
balance by verifying them to supporting documentation and
invoices.
Result
All rolls of fabric and garments were traced back to storage
invoices and haulage records, confirming that they belong to Glad
Rags.

Picklist:
Completeness
Rights and obligations
Existence
Valuation

Valuation
Once quantity is established by attending the entity's count, the next characteristic of inventory
must be assessed – valuation. Inventory must be valued at the lower of cost and net realisable
value (NRV) in order to comply with IAS 2 Inventories (para. 9). The auditor will therefore need to
design procedures that establish amounts for each for this comparison to occur.

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 Activity 7: Valuing inventory

Your firm is the external auditor of William Ltd. William Ltd owns a grocery store in a small town.
You are responsible for planning the procedures to be undertaken to test the valuation of
inventories in the financial statements for the year ended 31 March 20X4. An inventory listing will
be prepared as at 31 March 20X4, listing the products held at the year end, the number of each
type of product and their cost.
Required
Set out, in a manner suitable for inclusion in the audit plan, the audit procedures to be
undertaken to test the valuation of the inventory figure in the financial statements for the year
ended 31 March 20X4.
Note. You do not need to discuss audit procedures undertaken at the year end in relation to the
inventory count.

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 Other audit tests for inventory
We saw the use of accounting estimates mentioned in the solution to the previous activity when
discussing the possible impact on the NRV of supermarket inventory of items going literally 'past
their shelf life'. Such a loss requires a degree of judgement by the entity's management and the
auditor needs to establish whether their conclusion is reasonable or not. Similar estimates are
also required for valuing items of raw materials, work in progress (WIP) and finished goods.
We must not forget that the auditor reviews not only the amounts included in the financial
statements but also the way they are presented and disclosed – classification is the appropriate
assertion here and the auditor will make sure that the relevant disclosure requirements are
followed. Typically, disclosure includes:

 Accounting policies used in calculating things such as cost and NRV are fully disclosed
 Ensuring that inventory is sub-classified as raw materials, WIP, and finished goods
(IAS 2: para.9)

Raw materials
Raw materials are tested to ensure that they are held at cost. This is because it is extremely
unlikely that NRV would differ from cost for raw materials, unless they had been damaged or the
value was affected by age.
First, auditors must understand how the company determines the cost of raw materials.
The company might be able to identify each item separately, in which case they can be valued at
their own original cost.
However, it will not be possible to value some inventory in this way because of the nature of it,
and the company will have to use a technique, such as first in first out (FIFO) which you should be
aware of.
Work in progress (WIP)
You should know that accounting standards define 'cost' as 'cost of purchase plus the cost of
conversion'.
The cost of conversion becomes relevant when considering WIP and finished goods. It will include:
 Directly attributable costs (for example, labour, machine costs)
 Other production costs (for example, lighting in the factory)
The auditors will need to test the company's calculation of cost of conversion. In general terms,
the auditors may apply analytical procedures (for example, comparing similar inventory lines
from this year to last year to see if any changes in price appear reasonable).
The allocation of production overheads must be done on the basis of normal activity, and the
auditors must ensure that the overall calculations are reasonable.
Finished goods
Finished goods are most likely to be affected by NRV, as there is a market for them. WIP might
also be affected by NRV, but this would be more difficult to judge.
NRV is the estimated or actual selling price of the goods.
The auditors should ensure any goods they noted as being obsolete or damaged at the inventory
count have been reduced in value.

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 Activity 8: Hodgson Ltd

The following are extracts from the books and records of Hodgson Ltd, a manufacturer of garden
equipment.
Required
Identify the audit work to be performed on these inventory balances, both individually and in
aggregate.

£
Raw materials 164,810
Work in progress 55,000
Finished goods 117,000
336,810

Cut-off
Given the sensitivity of statement of profit or loss items like 'profit' and 'cost of sales' to recorded
amounts of inventory, the main aim of the auditor is to ensure that there is consistency over when
an amount of inventory is either purchased or sold. The aim is to apply the matching concept,
especially at the very start and end of the reporting period to ensure inclusion in the correct year:

The rule is that income and expense is recorded at the point where the risks and rewards of
ownership of that item are transferred (ie based on movement of inventory). The diagram below
shows the treatment of items in the financial statements for the year end for items sold and
purchased both before the year end and afterwards.

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 Illustration 2: Inventory cut-off

Before Year end After

Goods Despatched Note (GDN) Goods Despatched Note (GDN)

Included in: Included in:

Revenues

- Revenue  - Revenue x
- Receivables  - Receivables x
- Inventory x - Inventory 

Goods Received Note (GRN) Goods Received Note (GRN)

Included in: Included in:

Purchases

- Purchases  - Purchases x
- Payables  - Payables x
- Inventory  - Inventory x

Cut-off tests for revenue

(1) Obtain last GDN number at year end

(2) Select a sample of GDNs raised before and after the year end, and ensure the revenue is
accounted for in the correct period. Select a sample of sales invoices posted before and
after the year end and ensure that GDNs are raised in the same period

Cut-off tests for purchases

As for revenues, but replace GDN with GRN and sales invoice with purchase invoice.

Activity 9: Cut-off testing

It is now the final audit of Glad Rags. The inventory cut-off information obtained by your audit
firm at the inventory count is given below. The audit junior has obtained follow-up information to
establish whether cut-off is correct, but is unsure what conclusion he should draw.
Required
Advise the junior whether he should refer the results of his revenue and purchases cut-off tests
to his supervisor or not by highlighting the appropriate action. Materiality has been set at
£50,000.

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 Client: Glad Rags Ltd Prepared by/Date: A Junior 2/1/X5
Reporting date: 30 November 20X4 Reviewed by/Date:
Inventory cut-off
Last deliveries out of the warehouse on 30/11/X4:
Sales order/GDN Customer Agreed to November Sales Day Book
200894/GDN 12403 J Club Ltd 
200895/GDN 12404 IZK Ltd 
200896/GDN 12405 Ginger Ltd 
The above revenue items have all been excluded from the inventory count and a receivable exists.
I reviewed GDN 12406 to 12415 inclusive and all were included in the December Sales Day Book.
Last deliveries into the warehouse on 30/11/X4:
Purchase order/GRN Supplier Agreed to November Purchases Day Book
100552/GRN 1013 Fine Fabrics Ltd 
100553/GRN 1014 Fine Fabrics Ltd 
100554/GRN 1015 Terry's Threads x
All the above purchase items were included in the inventory count but payables for Fine Fabrics
only have been created at the year end. GRNs 1016 to 1025 inclusive were all included in the
December Purchases Day Book.
The invoice for order 100554 was not received until 15 December and was included in December's
Purchases Day Book. The value was £52,476. Terry's Threads has been included in the new year
payables balance – the senior accountant explained that this was a regular order that arrived
early.

Revenues cut-off testing: No further action/Refer to supervisor

Purchases cut-off testing: No further action/Refer to supervisor

2.3 Trade receivables

Trade receivables are the amount owed by customers in respect of credit sales.
Circularisation is a specific technique used to test the receivables balance by writing directly to
customers owing money to the audited entity and asking them to confirm what they believe they
owe. This can then be used to compare against the records held by the entity of sums owed by
that customer and any discrepancies reconciled.
Illustration 3: Circularisation is conducted as follows:

(a) Obtain a listing of trade receivables, as at the year end.

(b) Agree the total to sales ledger control account in the nominal ledger.
(c) Review the listing for any obvious omissions or misstatements.
(d) Select a sample of receivables accounts for positive confirmation. The letter should be on
the client's headed notepaper, signed by the client with a copy of the current statement
attached. It should request that the reply is sent directly to the auditor and reply-paid
envelopes should be included.
(e) After a reasonable period, the auditor should send follow-up requests by post.
(f) If responses are still not forthcoming, then these should be followed up by emails, phone
calls and faxes.
(g) The auditor should investigate any disputed balances.

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 (h)) Often
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oma
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ofesssio
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ccountting
g
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 Activity 10: Circularisation

You are continuing your work at Glad Rags Ltd. The receivables circularised at the year end are
listed below, along with information on the responses you have received and supporting
information from Glad Rags. The reporting date is 30 November 20X4.
Required
Using all of the information given below, decide which of these balances requires referral to
your supervisor.
Sample selected from sales ledger

Amount owed Response from Other information

per sales customer supplied by customer
ledger
British Clothes Stores plc 484,536 439,598 Cheque in post
IZK Ltd 74,973 74,973 n/a
Tisco Stores plc 78,805 71,663 Disputed invoice
J Club Ltd 323,024 323,024 n/a
Cavanaghs Ltd 14,388 nil Goods not received yet
H and T Ltd 18,933 nil Cheques in post
Nice Clothes Ltd 17,231 nil Cheques in post
Ginger Ltd 22,315 22,315 n/a

Cash book extracts (receipts)

Date Details Amount

£
1 December 20X4 BCS sales ledger 44,938
10 December 20X4 H and T sales ledger 8,934
14 December 20X4 Nice Clothes sales ledger 7,392
12 January 20X4 H and T sales ledger 9,999
18 January 20X4 Nice Clothes sales ledger 9,839

Glad Rags warehouse despatch information

GDN 12398 28/11/20X4 British Clothes Stores plc £23,399

GDN 12399 28/11/20X4 Value Mart plc £12,778
GDN 12400 29/11/20X4 Cavanaghs Ltd £14,388
GDN 12401 29/11/20X4 Tisco Stores plc £78,805

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 Illustration 4: Other standard audit tests for receivables

Audit objective Example tests

(a) Completeness/existence (i) Obtain listing of trade receivables and reconcile to
nominal ledger.

(ii) Check details of despatches of goods around the

year end and ensure they are correctly treated (ie
recorded in the correct period for cut-off).

(iii) Check that a sales invoice has been raised for all
despatches during the year.

(iv) Review after date credit notes issued.

(b) Rights and obligations (i) Trace a sample of trade receivables to cash
received post year end.

(ii) Discuss with management and/or review board

minutes to establish whether any trade receivables
have been factored.

(c) Valuation (i) Review consistency of policy and its

appropriateness.

(ii) Discuss significant overdue debts with a company

official using a trade receivables aged analysis.

(iii) Review relevant correspondence.

(iv) Ensure all debts written off were properly

authorised.

(v) Review allocation of after-date cash received.

(d) Disclosure (i) Ensure trade receivables are appropriately

categorised within current assets.

(ii) Ensure classification is correct as per Companies

Act 2006 (trade receivables, other receivables,
prepayments).

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 Activity 11: Pond Ltd

You are the audit senior on the audit of Pond Ltd, a gemstone dealer.
Required
Assuming that the largest balances will be selected, identify four other items from the sales
ledger listing below that you would review, giving reasons for your selection.
Sales ledger listing

£
Affectionado Ltd 76,002
Astra Stones Ltd Nil
B. Trow Ltd 34,726
Bea Myan Ltd 7,013
Crystal Eyes plc 12,997
Engagement Centre Ltd 16,821
Gemba-Gems Ltd 22,032
Gemeyma Ltd 17,152
Jewels 'r' Us Ltd (> 90 days overdue) 3,294
Love Me Tender Ltd 6,111
Magnifique Ltd (> 60 days overdue) 987
Moonglow Ltd 1,342
Pearly Kween Ltd 812
Ruby-Dubie Ltd 467
Ring-ring Ltd 12,142
Wed-Me Ltd (8,429)
203,469

(1)

(2)

(3)

(4)

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 2.4 Cash and bank
Cash and bank will include all bank accounts held by the entity as well as any cash amounts held
on site (such as petty cash and till floats).
The key audit test performed in the area of cash and bank is a review of the audited entity's bank
reconciliation – a process designed to understand the timing differences between the entity's
cash book and the bank's understanding of the entity's bank balance.
Activity 12: Bank reconciliation

You are the audit junior and have been given the bank reconciliation for the year ended 31
December 20X6 for Glad Rags.
Required
(a) Identify and describe the audit tests that you should perform on the bank reconciliation.
(b) Select any item(s) that you would refer to the audit supervisor from your review.
Bank reconciliation for Glad Rags as at 31 December 20X6

£
Balance per cash book 52,296.62

£ £
Balance per statement 54,501.00

Less unpresented cheques

Cheque number:

010 7,834.53

695 19,721.87

696 17.98

(27,574.38)

Add outstanding lodgements

Lodgement number:

095 15,000.00

097 10,000.00

25,000.00

Add bank error 1,000.00

52,926.62

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 (a) Audit tests to be performed on the bank reconciliation:

(b) Items to be referred to the audit supervisor (select those that are appropriate):

 Bank error
 Items to be written off
 Arithmetic
 Disclosure items
 Errors with source data

Illustration 5: Tests for cash and bank

Other than reviewing the bank reconciliation, other tests for cash and bank include:

Audit objective Example tests

(a) Completeness/existence (i) Obtain listing of bank and cash balances and
reconcile to nominal ledger.

(ii) Review bank confirmation letter for details of all

accounts held.

(iii) Count petty cash balance.

(iv) Review cashbook for unusual items.

(b) Rights and obligations (i) Review bank letter to ensure valid title to accounts
held.

(c) Disclosure (i) Review bank letter for any legal right to set off.

(ii) Investigate whether any accounts are secured over

assets of the company.

Practice note 16 – bank report for audit purposes

The practice of obtaining certificates or reports from banks is an important feature in the proper
discharge of the auditors' responsibilities. The difficulty for the auditor is getting hold of
information regarding their client from a third party with whom they have no direct contractual
relationship. The practice note sets out how both sides should act in this regard.

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 Procedures
 A standard letter should be sent in duplicate on each occasion by the auditor on his own
note paper to each bank branch that the client holds an account at, or has had dealings
with, since the end of the previous accounting period.
 Auditors should ensure that the bank receives their client's authority to permit disclosure of
such information to a third party.
Contents of the letter
The core information requested in the standard letter is as follows:
(1) Bank accounts and balances:
 Including details of any restrictions on accounts for balances
 Including details of accounts closed during the period
(2) Details of set-off arrangements.
(3) Loans, overdrafts and associated covenants, guarantees and indemnities, including term
and repayment frequency
(4) Securities charged with reference to items in (3) above
(5) Other banks or branches where the customer has established a relationship during the
period
The supplementary information requested in the bank letter is as follows:
(i) Trade finance:
 Bills discounted with recourse
 Any guarantees, bonds or indemnities given to the bank by the customer on behalf
of third parties
 Other contingent liabilities.
(ii) Securities (Practice Note 16, Appendix 1).

2.5 Borrowings
Non-current liabilities are loans repayable at a date more than one year after the year end.
Examples include bank loans and debentures (generally known as borrowings).
Auditors are concerned with completeness, valuation and disclosure.
Completeness
 Obtain/prepare a schedule of loans outstanding at the end of the reporting period.
 Compare opening balances to the previous year's working papers (closing balances at the
end of last year).
 Test the clerical accuracy of the schedule.
 Compare balances to the general ledger.
 Check the names of lenders to relevant information (such as bank letter or register of
debenture-holders).
 Review minutes and cash book to ensure that all loans have been recorded.
Valuation
 Trace additions and repayments to entries in the cash book.
 Confirm repayments are in accordance with the loan agreement.
 Examine receipts for loan repayments.
 Obtain direct confirmation from lenders about amounts loaned and the terms thereof.
 Verify interest charged for the period and the adequacy of accrued interest.

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 Disclosure
Review the disclosures made in the financial statements and ensure they meet legal requirements.
Activity 13: HEC Ltd

You have noted on the bank letter that your client, HEC Ltd, has a mortgage which is repayable
over 20 years.
Required
Set out, in a format suitable for inclusion in an audit plan, the audit procedures to be carried out
on this loan.

2.6 Payables
Payables are amounts the company owes to its suppliers.
Trade and other payables are not the largest credit balances on the statement of financial
position (loans are usually far bigger) but there are various tests that need to be performed on
them.
Activity 14: Gavilar Ltd

Required
Set out, in a manner suitable for inclusion in the audit plan, the audit procedures to be
undertaken for each assertion in order to ensure that both trade and other payables are fairly
stated in the financial statements of Gavilar Ltd.

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 Gavilar Ltd as at 31 December 20X7
Statement of financial position (extract)
£
Trade payables 476,870
Other payables 123,600
600,470

Audit objective Suggested audit procedures

Completeness

Rights and
obligations

Valuation

Existence

Disclosure

2.7 Provisions (accounting estimates)

An accounting estimate is an approximation of the amount of an item in the absence of a precise
means of measurement. Examples include:
 Allowances to reduce inventories and receivables to their estimated realisable value
 Depreciation charges
 Accrued revenue
 Provision for a loss from a lawsuit
 Provision to meet warranty claims
A provision should be recognised when (i) a company has a present obligation (legal or
constructive) where (ii) a probable outflow of resources embodying economic benefits will be
necessary to settle it and (iii) that benefit can be reliably estimated (IAS 37: para. 14).
Directors and management are responsible for making accounting estimates included in the
financial statements. These estimates are often made in conditions of uncertainty regarding the
outcome of events and involve the use of judgement. The risk of a material misstatement therefore
increases when accounting estimates are involved (and thus inherent risk is higher). Audit
evidence supporting accounting estimates is generally less than conclusive and so auditors need
to exercise significant judgement.
Accounting estimates may be produced as part of the routine operations of the accounting
system, or may be a non-routine procedure at the period end. Where, as is frequently the case, a
formula based on past experience is used to calculate the estimate, it should be reviewed
regularly by management (for example, actual vs estimate in prior periods).

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 Audit procedures
The auditors should gain an understanding of the procedures and methods used by management
to make accounting estimates. This will aid the auditors' planning of their own procedures.
Auditors must carry out one or a mixture of the following procedures.
Procedure 1 – Review and testing the process
The auditors should:
 Evaluate the data and consider the assumptions on which the estimate is based
 Test the calculations involved in the estimate
 Compare estimates made for prior periods with actual results of those periods
 Consider management's/directors' review and approval procedures
Procedure 2 – Use of an independent estimate
Such an estimate (made or obtained by the auditors) may be compared with the accounting
estimate.
Procedure 3 – Review of subsequent events
The auditors should review transactions or events after the period end which may reduce or even
remove the need to test accounting estimates. For example, if directors have estimated an
allowance for an irrecoverable debt, but all debt existing at the end of the reporting period has
been paid by the date of the auditor's report, this provision will no longer be required (ISA 540:
para. 13).

2.8 Revenue
Revenue is often tested at the same time as receivables, due to it being the other side of the
double entry. Revenue testing is usually done by analytical procedures: it should be possible to
see predictable relationships arising.
Key assertions relating to revenue are completeness and accuracy. The auditor wants to confirm
that all relevant revenue has been included and that revenue actually does relate to the correct
year.
Completeness
Revenue is often tested by analytical procedures, as there is usually a great deal of information
available in a company about its revenue and it should be possible to see predictable
relationships arising.
Auditors should:
 Review the level of revenue over the year, comparing it on a month by month basis with
previous years
 Consider the effect that any price rises have had on both the quantity of items sold and
the amount of revenue received
 Consider the level of goods returned, sales allowances and discounts.
In addition, the auditors may test the completeness of recording of revenue in the original records,
for example, tracing from documents that first record revenue right through to the general ledger.
So, for example, the auditor may trace through from a sales order to a goods despatch note to a
sales invoice to the sales day book to the sales ledger to the general ledger.
In a cash business, the auditor may trace from the till roll to the sales day book to the sales ledger
to the general ledger.
Accuracy
The auditors should also check that revenue has been measured correctly by:
 Checking calculations and additions on sales invoices
 Ensuring VAT has been dealt with appropriately
 Checking discounts have been applied properly
 Checking the casting of the sales ledger accounts and control account

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 2.9 Payroll
When the auditors are scrutinising payroll-related payables, they may also carry out substantive
procedures on payroll expense, which is highly likely to be material to the financial statements.
A great deal of testing may be done by analytical procedures, as there are a number of
predictable relationships (number of staff, standard rates of pay, ratio of deductions to pay etc).
However, the auditor may also carry out tests of detail in relation to occurrence, measurement
and completeness.
Occurrence
 Check individual remuneration per payroll to personnel records.
 Confirm existence of employees by meeting them.
 Check benefits to supporting documentation.
Accuracy
 Recalculate benefits.
 Check whether deductions of tax and NI have been made correctly.
 Check validity of other deductions, eg pension contributions to conditions of pension
scheme.
Completeness
 Check a sample of employees from records to the payroll.
 Check whether joiners have been paid in the correct month.
 Check whether leavers have been correctly removed from payroll.
 Check casts of the payroll.
 Confirm payment of pay to bank transfer records.
 Agree net pay per cash book to payroll.
 Scrutinise payroll and investigate unusual items.

2.10 Other expenses – Purchases

When testing purchases, auditors are concerned with whether they have occurred, whether they
are measured correctly, and whether they have been made for valid business reasons.
We have already considered the issue of cut-off on purchases in relation to inventory.
Occurrence
The auditors often test purchases by using analytical procedures.
Auditors should:
 Consider the level of purchases on a month by month basis compared with previous years
 Consider the effect on value of purchases of price changes
 Consider the effect on value of purchases of changes in products purchased
 Compare the ratio of trade payables to purchases with previous years
 Compare the ratio of trade payables to inventory with previous years
 Consider the level of major expenses other than purchases in comparison with previous
years
In addition, the auditors may test the completeness of recording of purchases in the original
records − for example, tracing documents that first record purchases right through to the general
ledger.
Also, to check the validity of purchases in the records, the auditors may test individual items in
the nominal ledger back through the records to the original purchase order and requisition.

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 Activity 15: Adjustments

Required
Indicate whether the following matters require to be adjusted or not.

The auditor has found an invoice for office supplies ordered 

and delivered on the last day of the financial year. The
invoice amount has not been included in the total for
purchases in the statement of profit or loss. The amount for
these supplies is material.

The auditor has completed analytical review of the cost of 

sales for a bakery. This analysis has indicated that
ingredient costs per loaf have increased from 12.8 pence in
the previous year to a figure closer to £3.56 per loaf. The
non-financial information on numbers of loaves has been
corroborated during the audit.

The auditor has selected 20 payments from the purchase 

ledger total and has been tracing them back to invoices for
evidence of both existence and valuation. Of these 20
payments, 19 have been traced successfully back for both
assertions.
The 20th item has no invoice and relates to health and
safety assessments carried out at the entity's head office. A
similar amount was included in last year's statement of
profit or loss and this year's figure can be agreed back to a
quotation that the chief accountant was sent by the
contractor. The audit senior has recorded evidence of this
assessment within the current file as part of the firm's wider
audit testing.

Picklist:
Requires to be adjusted
Does not require to be adjusted

2.11 Other payables (accruals)

Other payables or accruals are made when an entity receives a product or service for which it
has not yet paid (such as a utilities bill). To test other payables, the auditors will:

 Verify the valuation, existence and completeness of such items by reference to subsequent
payments
 Verify the calculation of the item for reasonableness in light of all supporting evidence (for
example, review statement of profit and loss and prior years to consider whether other
accruals are required)
 Perform analytical procedures to assess if additional payables are required
 Review payments made and invoices received after the year end to ascertain if they should
have been accrued

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 PAYE and VAT accruals can be verified by reference to the monthly payroll deductions and the
next VAT return.

2.12 Other receivables (prepayments)

Other receivables or prepayments occur when a company pays for an expense in advance of
receiving the item – examples of this could include insurance premiums, rental of property or
even a telephone line. To test other receivables, auditors will:

 Trace the relevant payments to both cash book and invoice to test existence
 Review the calculation of the payment for accuracy
 Review the statement of profit and loss to ensure that all likely prepayments have been
accounted for
 Perform analytical procedures to assess whether they seem reasonable

Activity 16: Miscellaneous procedures

Required
For each of the following listed procedures, identify the most appropriate area of the financial
statements that is being tested from the picklist below.

Consider the effect of any price rises during the year. 

Review sales ledger for old receivables which are still unpaid. 

Verify amount outstanding by reference to subsequent payments. 

Perform analytical procedures by comparing payments with previous years 

to see if they appear reasonable.

Recalculate amounts due in relation to tax and national insurance payable 

by employees.

Picklist:
A prepaid insurance premium
An allowance for a doubtful debt
An accrual for an unpaid electricity bill
Cash sales from a retail outlet
Deductions paid to HM Revenue & Customs (HMRC)

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 Chapter summary

 Auditors need to be able to explain the areas of audit risk that lead to material misstatements in
the financial statements – this is likely to be tested as a written exercise in your assessment.

 Audit procedures exist for a variety of assertions depending on the area of the financial
statements under review and again you will need to be able to produce written procedures as
part of your assessment:
– Non-current assets – capitalisation and relevant assertions including right-of-use asset leases
– Inventory – the role of the inventory count, plus specific tests for different types of inventory
(raw materials, work in progress or WIP and finished goods) and how to test for the correct
treatment around the year end (cut-off)
– Receivables – procedures are focused on circularisation (including the process itself and
analysing the outcome of such a process)
– Cash and bank – two key controls exist in this area (the bank letter and the bank
reconciliation) so you need to be able to explain how each works
– Borrowings – loans and other long-term liabilities
– Payables – trade and others
– Allowances – including depreciation, impairments to inventory and write-downs on doubtful
debts
– Revenue – using double entry to prove this amount by comparison with receivables
– Payroll – again, using double entry to verify this amount as an expense in the statement of
profit or loss
– Purchases – includes any other expenses
– Accruals – amounts due that have not yet been paid for but require recognising in the
financial statements
– Prepayments – amounts not yet due but paid which also require reconciliation to ensure they
are not misstated

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 Keywords
 Accounting estimate: an approximation of the amount of an item in the absence of a
precise means of measurement
 Bank reconciliation: a process designed to understand the timing differences between the
entity's cash book and the bank's understanding of the entity's bank balance
 Cash and bank: will include all bank accounts held by the entity as well as any cash
amounts held on site (such as petty cash and till floats)
 Circularisation: a specific technique used to test the receivables balance by writing
directly to customers owing money to the audited entity and asking them to confirm what
they believe they owe
 Inventory: sub-classified as raw materials, work in progress (WIP), and finished goods
 Lease: a contract, or part of a contract, that conveys the right to use an asset (the
underlying asset) for a period of time, in exchange for consideration
 Non-current assets: assets held for continuing use in the business
 Non-current liabilities: loans repayable at a date more than one year after the year end.
Examples include bank loans and debentures (generally known as borrowings)
 Other payables or accruals: made when an entity receives a product or service for which it
has not yet paid (such as a utilities bill)
 Other receivables or prepayments: occur when a company pays for an expense in
advance of receiving the item – examples of this could include insurance premiums, rental
of property or even a telephone line
 Payables: amounts the company owes to its suppliers
 Trade receivables: the amount owed by customers in respect of credit sales

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 Test your learning
1 Select whether the following statements are true or false.

Inventory is difficult to audit because it often consists of a large 

number of low value items which are collectively material.

Key assertions to test in relation to inventory are existence, 

completeness and valuation.

Picklist:
True
False
2 Select whether the following statements are true or false.

It is important to record cut-off correctly so that assets are not 

double counted (receivables and inventory).

It is important to record cut-off correctly so that a liability is not 

omitted in respect of an asset (payables and inventory).

For the purposes of the financial statements, it does not matter if the 
company misstates cut-off between raw materials and work in
progress.

Picklist:
True
False
3 The objective of a substantive procedure will determine the source of evidence obtained.
For each of the objectives set out below, select the source of evidence.

Obtain evidence of the value of raw material 

Obtain evidence of the value of finished goods 

Picklist:
Both
Purchase invoice
Sales invoice

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 4 Complete the following statements about how net realisable value is tested.

Net realisable value is tested with reference to after the year end  .

The value of items of inventory is compared to post year end .

This is to ensure that inventory value is equal to or  than net realisable

value of the inventory.
Picklist for line items:
Higher
Lower
Purchases
Purchase invoices
Sales
Sales invoices
5 Auditors will carry out the following tests when auditing inventory.
From the options provided, select which important assertion about inventory each test is
seeking to prove in the first instance.

Attending an inventory count 

Tracing counted items to final inventory sheets 

Reviewing after year end sales invoices 

Picklist:
Completeness
Existence
Valuation
6 Select which of the following statements best summarises the assertions the auditors are
concerned with in respect of non-current assets by ticking the appropriate box.

Auditors are concerned with completeness, existence, rights and

obligations and valuation.
Auditors are concerned with completeness, existence and valuation.

Auditors are concerned with existence, valuation and occurrence.

Auditors are concerned with existence, valuation, occurrence and

accuracy.

7 Auditors usually test receivables by carrying out a circularisation and/or review of receipts
after the year end.
Select which assertions the auditors are seeking evidence about.

Receivables circularisation 

Reviewing sales and receipts after year end 

Picklist:
Both
Rights and obligations
Valuation

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 8 Select which of the following statements concerning the audit of revenue is incorrect by
ticking the appropriate box.

Auditors usually rely 100% on controls over revenue by carrying out only
controls testing.
Auditors may test controls over revenue but will also carry out some
substantive procedures, often restricted to analytical procedures as
there is usually ample evidence concerning a company's revenue.
Auditors will often only test revenue by analytical procedures as there is
usually ample evidence concerning a company's revenue.
Auditors will sometimes test completeness of revenue by tracing a
sample of revenue from sales order to general ledger.

9 State whether the following statements are true or false in respect of bank letter requests.

Bank letter requests are sent out by the auditor directly to the bank. 

Bank letter requests should be made at the year end date. 

Auditors will commonly test cash balances even if they are not 
material.

Picklist:
True
False
10 Select which of the following statements best summarises the issues that auditors are
concerned with in respect of trade payables by ticking the appropriate box.

Auditors are concerned with completeness, existence and valuation.

Auditors are concerned with completeness, existence and obligations.

Auditors are concerned with existence, obligations and occurrence.

Auditors are concerned with existence, obligations, occurrence and

accuracy.

11 State whether the following statements are true or false in respect of supplier statements.

They represent a better source of evidence than replies to a 

receivables circularisation as they are sent direct to the company.

They are only used when the auditor is unable to do a payables 

circularisation.

Testing supplier statements provides evidence that trade payables 

have not been understated.

Picklist:
True
False
12 Complete the following statements about selecting a sample of trade payables.

Auditors should consider that payables might be  and therefore not

simply select large balances to test (although they must select  items).

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  balances should also be incorporated into the test.
Picklist for line items:
Material
Nil
Overstated
Significant
Understated
13 Complete the following definitions.

 are liabilities other than  that arise because the

company has received a benefit it has not yet paid for.

 are loans repayable at a date  one year after the

year end.
Picklist for line items:
Accruals
Equal to
Less than
More than
Non-current liabilities
Other payables
Trade payables
14 Select which of the following statements best summarises the issues that auditors are
concerned with in respect of payroll expense by ticking the appropriate box.

Auditors are concerned with completeness, existence and valuation.

Auditors are concerned with completeness, existence and obligations.

Auditors are concerned with occurrence, accuracy and completeness.

Auditors are concerned with existence, obligations, occurrence and accuracy.

15 Set out the types of accruals you would expect to exist at a manufacturer and the audit
procedures that should be carried out on each.

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 Evaluation

Syllabus learning outcomes / objectives

Having studied this chapter you will be able to:

3. Evaluate the planning process for audit and assurance

3.4 The role of audit working papers

Learners need to understand:
3.4.1 the role of audit documentation in providing evidence as a basis for the auditor’s
opinion
3.4.2 the form and content of working papers and supporting documentation
3.4.3 the importance of retaining working papers for future reference
3.4.4 recording techniques (flow charts, internal control questions and checklists) the
impact of technology on auditing.

5. Review and report findings

5.1 Matters to be referred to a senior colleague

Learners need to be able to:
5.1.1 evaluate misstatements for materiality
5.1.2 identify deviations from an audited entity's prescribed procedures
5.1.3 identify matters including:
– unauthorised transactions
– non-routine transactions
– related party transactions
– transactions above or below market rates
– suspected fraud.

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 5.2 External audit opinion
Learners need to understand: Learners need to be able to:
5.2.1 elements of an audit opinion 5.2.3 identify a suitable audit opinion
5.2.2 elements of an external audit report. arising from:
– significant uncertainties
– material misstatements
– inability to obtain sufficient
and appropriate evidence
(limitation on scope).

5.3 Report audit findings to management

Learners need to understand: Learners need to be able to:
5.3.1 elements of a report on deficiencies 5.3.4 identify the consequences of
in internal control deficiencies in internal controls and
5.3.2 how deficiencies in internal control how the deficiencies can be
are reported to management remedied

5.3.3 how deficiencies in internal control 5.3.5 report findings to management.

are reported to the audit committee.

Assessment context
This topic covers a number of tasks in the assessment, one of which (identifying the consequences
of deficiencies in internal control) is a written assessment so you should consider how to respond
accordingly using the suggested activity.

Qualification context
As this is the final topic of this unit, there is an element of bringing the syllabus together so there
will be plenty that you have seen before here. In order to report on the truth and fairness of the
financial statements, you also need to know what they include, so expect to see some financial
reporting elements within any tasks set.

Business context
For many audit firms, evaluation is the most important element of the whole audit, where any
outstanding issues are addressed prior to communicating the all-important opinion. For others,
the audit opinion is merely the formality attached to the end of a process, necessary only to fulfil
a legal obligation.
The audit profession in the 21st century is under enormous pressure to consider its future in the
wake of ongoing financial reporting scandals: some outside observers feel that auditors should be
subject to greater competition and regulation and be more responsible for the mistakes made by
their clients, while others feel that putting too much pressure on the auditor will simply force
many of them out of this line of work, leaving a skills and experience vacuum that could impact
on quality and therefore increase the risk of mistakes being made by entities.
Recent developments have emerged that will see some professional firms split into audit and non-
audit divisions as a response to the perceived self-interest and self-review issues that are
inevitably raised whenever there is a high-profile corporate collapse (such as Carillion in 2018).
Despite these changes, the role of providing an audit opinion is still considered a cornerstone in
sound financial reporting and takes us back to the start of this unit when we considered how best
to address the agency issue.

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 Chapter overview

Documentation
(working papers)

 Audit procedures
 Regulatory and legal
compliance
 Best practice
 Judgement and conclusions

Reporting

Evaluating Communicating Communicating

misstatements (ISA with those charged deficiencies in
450) with governance internal control
(ISA 260) (ISA 265)

Changes to the
The auditor's report
auditor's report

 Opinion
 Basis
 Going concern Emphasis of Modified audit
 Key audit matters matter opinions
 Other information paragraphs (ISA (ISA 705)
 Responsibilities 706)
 Regulatory issues
 Date and signature  Significant  Qualified
uncertainties
 Adverse
 Disclaimer

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 1 Audit documentation
In order to reach a conclusion, the auditor has to make sense of all the information obtained
during the audit – some of which will be more material than others. There are protocols for storing
and recording such evidence which are laid down in ISA 230 Audit Documentation. The ISA
clarifies the role of documentation as:
 Evidence of the auditor's basis for a conclusion about the achievement of the overall
objectives of the auditor (ultimately supporting the audit opinion)
 Evidence that the audit was planned and performed in accordance with ISAs and
applicable legal and regulatory requirements
 Physical or electronic media (audit files) for storing working papers and other records
specific to the audit engagement.
(ISA 230: paras 2 and 6)
Often this documentation is referred to as working papers.
Working papers are the documentation prepared by and for, or obtained and retained by, the
auditor in connection with the performance of the audit (ISA 230: para. 6).
Activity 1: Documentation

Required
What additional purposes do you think audit documentation might serve?

Auditors must reference working papers with a number of details:

 Name (or initials) of the auditor who prepared the working paper
 Date the working paper was prepared
 Area of the audit being worked on (for example, inventory)
 Identifying characteristics of the item/matters being tested
 Period end of the financial statements being audited
Working papers are reviewed by a member of staff more senior than the one that prepared them.
When a working paper is reviewed, the reviewer also initials the working paper and dates when it
was reviewed.

1.1 Document what?

ISA 230 sets out what auditors must document in a general rule:
'The auditor shall prepare audit documentation on a timely basis' (ISA 230: para. 7).
The auditor shall prepare audit documentation that is sufficient to enable an experienced auditor,
having no previous connection with the audit, to understand:
 'The nature, timing and extent of the audit procedures performed to comply with the ISAs
and applicable legal and regulatory requirements;

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  The results of the audit procedures performed, and the audit evidence obtained; and
 Significant matters arising during the audit, the conclusions reached thereon, and
significant professional judgements made in reaching those conclusions.'
This includes information on:
 Planning the audit
 The nature, timing and extent of the audit procedures performed
 Results of the audit procedures and the audit evidence obtained
 Conclusions drawn from audit evidence obtained from procedures
 Any contentious issues and how they were resolved
 Discussions on significant matters had with client staff/officers
Auditors must document their reasoning on significant matters where they have exercised
judgement and the conclusions they have drawn and how they addressed any inconsistencies
between evidence originally collected and the auditor's final conclusions on any matters (so, if the
auditor's view on internal controls changes through the course of the audit, there should be
documentation to explain this change of viewpoint).
Here is an example of a working paper on payables from The Heavenly Eating Company (HEC)
Ltd:

1.2 Document how much?

The ISA suggests that the auditor should write down enough that an experienced auditor who has
no experience of the particular client could follow and understand what had been done (ISA 230:
para. 8).

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 The form, content and extent of audit documentation will depend on factors such as:
 The nature of the audit procedures
 Risks of material misstatement
 The extent of judgement required
 The significance of the evidence
 The nature and extent of exceptions identified
In other words, the auditor will need to use his judgement in making this decision.

1.3 Standardisation of working papers

There may be cases where working papers, for example checklists or specimen letters, are
standardised, so that the auditor merely has to complete the client details. However, the auditor
must always take care when using standardised working papers; as it is never appropriate to take
a mechanical approach to auditing, audit judgement must always be exercised.
Audit files
Working papers usually include:
 Information about the entity and its environment
 Evidence of the audit planning process
 Evidence of the auditor's consideration of the internal audit function (if relevant)
 Analyses of transactions and balances in the financial statements
 Analyses of significant ratios and trends
 Identified and assessed risks of material misstatements
 Record of the nature, timing and extent of resulting procedures
 Copies of letters concerning matters communicated to, or discussed with, management
such as the terms of the engagement
 Conclusions reached by the auditor on significant aspects of the audit
 Copies of the financial statements and auditor's report
For one audit, this can amount to a lot of working papers. Working papers are therefore
contained in audit files.

Audit regulations usually require that working papers must be kept for at least six years from
the end of the accounting period to which they relate.

1.4 The impact of technology on auditing

You may have observed that much of this discussion on audit working papers and other
documentation seems geared to the 20th Century when it was all about physical documents in
paper form. The 21st century auditor is more likely to make use of technology throughout the
audit, as we saw in an earlier chapter when data analytics were discussed in the context of
automated tools and techniques. Automated drones with cameras are now even being used when
collecting physical evidence from more remote and inaccessible locations!
Email is now far more likely to be the communication method favoured by firms of auditors and
their clients, and can also be used to obtain other forms of audit evidence, such as confirmation
from customers during circularisation or information about bank accounts.
The sight of bulging lever-arch files filled with paper may never fully disappear from the auditor's
workplace, but it is likely that working papers are now going to be stored electronically, allowing
greater opportunities for remote access via cloud-based applications that can make
geographically-dispersed teams work more efficiently and effectively.

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 The process of communication is also likely to be more immediate and cost-effective now
because of reliable remote conferencing software!
Activity 2: Working papers

Required
Identify the purposes of each of the working papers in the table below by selecting the most
appropriate reason for their preparation.

Working paper Reason for preparation

A register of shares in audit client companies owned by staff 
members

A copy of an email sent by the finance director of Curtis Ltd 

explaining a bid that has been made to acquire the company

Briefing notes for the audit team before the start of the audit 
of Gordon Ltd

A reconciliation of circularised responses to a list of 

receivables for an audit client

Picklist:
Demonstrating legal, regulatory and ethical compliance by the auditor
Planning, directing, supervision and review of the audit engagement
Recording matters from an audit that are either unusual or significant
Supporting audit evidence for the auditor's opinion

2 Reporting matters to appropriate individuals

Once all completion procedures have been satisfactorily addressed, the auditor should have all
the evidence required to reach the necessary conclusions for the audit opinion. In order to
completely discharge both legal and best practice responsibilities, the auditor now has a number
of reporting tasks to complete:

 Ensuring that all material and significant errors, deficiencies or other variations from
standard are reported internally within the firm (ISA 450)
 Ensuring that such findings are reported to those charged with governance within the
entity (ISAs 260 and 265)
 Ensuring that the shareholders are given the most appropriate audit report that reflects the
auditor’s experience (ISAs 700, 705 and 706)

2.1 ISA 450 Evaluation of Misstatements Identified During the Audit

It is almost inevitable that, during the course of the audit, a number of misstatements will be
uncovered, some of them material, others clearly trivial. The auditor needs guidance to ensure
that all such misstatements are both identified and recorded and that the most appropriate
action is taken as a result.
The auditor must maintain a record of all identified misstatements (except those that are clearly
trivial). As part of completion procedures, the auditor must evaluate the effect of these identified
misstatements on the audit and the effect of uncorrected misstatements on the financial
statements.

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 ISA 450 Evaluation of Misstatements Identified During the Audit gives guidance about this. The
auditor must consider if the audit strategy and plan need revision if:
 The nature and circumstances of identified misstatements indicate that other unidentified
misstatements exist, the combined total of which might be material.
 The aggregate of identified misstatements approaches the materiality level set by the
auditors during planning (ISA 450: para. 6).
The auditors must make management aware of identified misstatements and request that they
are adjusted. If they refuse, the auditors should take their reasons into account when evaluating
if the financial statements as a whole are free from material misstatement.
Before assessing the effect uncorrected misstatements have on the financial statements, the
auditors should reconfirm that the materiality level remains appropriate. They should then
determine whether the aggregate of the uncorrected misstatements is material.
The auditors should communicate the uncorrected misstatements to those charged with
governance (listed individually). They should obtain a written representation from management
and, where appropriate, from those charged with governance about whether they believe the
uncorrected misstatements to be immaterial.
In addition to the list of uncorrected misstatements, the auditors should document the level below
which items will be considered trivial and the auditor's conclusion as to whether uncorrected
misstatements are material, and the reasons for that conclusion (ISA 450: paras 7 to 15).

2.2 ISA 260 Communication with Those Charged with Governance

The auditor then completes this reporting task by informing those charged with governance at
the entity (remember that these will be board members who have a right to such information as
they act on behalf of the shareholders) of any uncorrected misstatements and their impact on
the financial statements, requesting formal acknowledgement that they accept these
misstatements and believe them to be immaterial to the financial statements. They will also report
any other issues that may have been discovered during the audit (such as the availability of
information or any delays in providing necessary audit evidence).
Such an acknowledgement comes as part of written representations under ISA 580 Written
Representations and is added to the auditor's documentation, which lists all such misstatements
as one of the following:

 Clearly trivial, as they fall below a threshold specified by the auditor

 Those that have been identified and corrected during the course of the audit
 Uncorrected misstatements, along with the auditor’s conclusion as to whether they are
material or not (ISA 580: Appendix 2).

Activity 3: Glad Rags

The audit junior is reviewing his working papers for the audit of Glad Rags and has requested
your help in dealing with two issues that were not previously reported.
Required
In respect of each of these matters, select whether the audit junior should take no further action
or refer it to the supervisor.

When reviewing the bank statements, the chief accountant removed No further action
some of the pages relating to the period of time after the year end. Refer it to the supervisor

During his review of the payroll system, incorrect PAYE income tax No further action
rates were found to have been used. This was retrospectively corrected Refer it to the supervisor
for the following month and all supporting transactions reviewed by
the junior.

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 2.3 ISA 265 Communicating Deficiencies in Internal Control to those
Charged with Governance and Management
A deficiency in internal control is when a control is designed, implemented or operated in such a
way that it is unable to prevent, or detect and correct, misstatements in the financial statements
on a timely basis, or a necessary control is missing (ISA 265: para. 6(a)).

The auditor’s judgement is

'The auditor shall determine whether, on the basis of the audit
called into question here to
work performed, the auditor has identified one or more
determine what merits
deficiencies in internal control. If the auditor has identified one
‘significant’ but we will look at
or more deficiencies in internal control, the auditor shall
this later. The process of
determine, on the basis of the audit work performed,
communication to those
whether, individually or in combination, they constitute
charged with governance will
significant deficiencies. The auditor shall communicate in
include non-executive directors
writing significant deficiencies in internal control identified
who represent shareholders.
during the audit to those charged with governance on a timely
basis (ISA 265, paras 7‒9).'
The auditor shall also communicate to management at an
The auditor may suspect that
appropriate level of responsibility on a timely basis:
members of management may
(a) In writing, significant deficiencies in internal control that be involved in fraud – reporting
the auditor has communicated or intends to this would be technically in line
communicate t o t h o s e c h a r g e d w i t h g o v e r n a n c e , with the ISA but might breach
unless it would be inappropriate to communicate certain criminal protocols (such
directly to management in the circumstances as ‘tipping off’ when dealing
with money laundering).
(b) Other deficiencies in internal control identified during the
audit that have not been communicated to management
by other parties and that, in the auditor’s professional
judgment, are of sufficient importance to merit
management’s attention (ISA 265, para. 10).’ Other parties involved here
might include internal auditors
or regulators, allowing the
external auditor to inform
management of their findings.

'The auditor shall include in the written communication of significant deficiencies in internal
control:
(a) A description of the deficiencies and an explanation of their potential effects
(b) Sufficient information to enable those charged with governance and management to
understand the context of the communication. In particular, the auditor shall explain that:
(i) The purpose of the audit was for the auditor to express an opinion on the financial
statements
(ii) The audit included consideration of internal control relevant to the preparation of the
financial statements in order to design audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the
effectiveness of internal control
(iii) The matters being reported are limited to those deficiencies that the auditor has
identified during the audit and that the auditor has concluded are of sufficient
importance to merit being reported to those charged with governance.'
(ISA 265: para. 11)

Significant means 'in the auditor’s opinion, matters that

warrant the attention of those charged with governance.'
(ISA 265: para. 6(b))

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 Activity 4: Reporting recommendations

Accounting system information – Glad Rags Revenue system

The company manufactures clothes to order from a catalogue. When an order is received, the
sales department checks that the customer has not exceeded their credit limit and then issues a
two-part order document. The sales department fills in the appropriate values for the order from
current price lists. One copy is sent to the production department in order for the order to be
completed and the other is filed alphabetically in the customer file in the sales department.
Once the order is completed, two-part despatch notes are raised. When the factory manager, Ian
Jones, has checked the order, one copy of the despatch note is despatched with the goods (to be
signed and returned), and one part is matched to the production department's sales order and
sent to accounts to raise the invoice. Jane Hill raises the invoices from the order and despatch
note, enters them on the computer and sends them out to customers.
Most customers pay in around 60 days. When they come in, cheques are passed to Beth
Simpkins, one of the accounts assistants, and she updates the cash book and the sales ledger.
Cheques are banked twice a week. Cheques are kept securely in the safe until banking.
Jane sends out statements to customers each month. Glad Rags' customers are mostly all
reputable high street stores and there are rarely irrecoverable debts.

Required
Set out two deficiencies in the accounting systems for revenues at Glad Rags Limited as
described above to be included in a report to those charged with governance. You should also
set out the possible consequence of each deficiency and your recommendation for
improvement.
Deficiency Deficiency

Consequence Consequence

Recommendation Recommendation

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 3 ISA 700 (revised) Forming an Opinion and
Reporting on Financial Statements
You already know that the primary objective of the audit is an expression of an opinion on the
truth and fairness (or fair presentation) of the financial statements. The format of the auditor's
report is laid down in ISA 700 (revised):

INDEPENDENT AUDITOR'S REPORT

To the shareholders of the company [or other appropriate addressee.]
Opinion
[Includes the individual statements and the reporting period under review for the company being
audited. It can use either ‘give a true and fair view’ or ‘presents fairly, in all material respects’ and
states the relevant GAAP adopted.]
Basis for opinion
[This is always presented after the opinion and explains how the audit was conducted: the role of
ISAs and the IESBA code of ethics as well as the audit evidence being sufficient and appropriate
to provide a basis for the auditor’s opinion.]
Material uncertainty relating to going concern
[Where applicable, the auditor shall report in accordance with ISA 570 (Revised) Going Concern]
Key audit matters
[As per ISA 701 Key Audit Matters, matters of most significance from the audit; usually only
required for listed entities.]
Other information
[As per ISA 720 Other Information, communicates that there is nothing to report regarding other
information.]
Responsibilities of management and those charged with governance for the financial
statements
[Preparation and fair presentation of the financial statements, including internal controls, and the
assessment of the company’s ability to continue as a going concern.]
Auditor’s responsibilities for the audit of the financial statements
[A detailed summary of the auditor’s objectives, starting with obtaining reasonable assurance
about the financial statements being free from material misstatements due to fraud or error.
Stresses the role of professional judgement and scepticism over accounting policies and
estimates, judgements, internal controls, presentation, disclosure and communicating key audit
matters and other issues with those charged with governance.]
Report on other legal and regulatory requirements
[Form and content of this section of the auditor's report will vary depending on the nature of the
auditor's other reporting responsibilities.]
Signed
[Auditor's name and/or signature, address and date of the auditor's report.]
(ISA 700: Appendix)

Please note that ISA 701 is not currently examinable; it has been included here for the sake of
completeness.

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 4 Changes to the auditor's report
In some cases, the standard report with unmodified opinion may not be appropriate. We shall
now look at the various circumstances that lead to such variations in the auditor's report and
what each one should take into account.

AUDITORS’ REPORTS

UNMODIFIED MODIFIED AUDIT REPORT WITH MODIFIED AUDIT OPINIONS

OPINIONS UNMODIFIED OPINION

INSUFFICIENT
EMPHASIS /INAPPROPRIATE AUDIT MATERIAL
OF MATTER EVIDENCE MISSTATEMENT
STANDARD

'Without Material Material Material Material

modifying our but not and but not and
opinion, we pervasive pervasive pervasive pervasive
draw attention
to…'

'true and fair view' Qualified opinion Qualified opinion

or 'presents fairly' 'except for…' 'except for'

Disclaimer of opinion Adverse opinion

Multiple 'do not express an 'do not give a true
significant opinion' and fair view'
uncertainties

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 4.1 ISA 706 (revised) Emphasis of Matter paragraphs and Other Matter
Paragraphs in the Independent Auditor's Report
In the auditor's opinion, it may be necessary to draw users' attention to matters appropriately
presented and disclosed within the financial statements that are of such importance they are
fundamental to users' understanding of either the financial statements themselves or the rest of
the audit itself (including the auditor's responsibilities and their report).
An emphasis of matter paragraph draws users' attention to issues within the financial
statements that they need to see in order to understand them properly, such as:

 Significant uncertainties relating to future outcomes of exceptional litigation or regulatory

action
 A significant subsequent event that occurs between the date of the financial statements
and the date of the auditor’s report
 Early application of a new accounting standard that has a material effect on the financial
statements
 A major catastrophe that has had, or continues to have, a significant effect on the entity’s
financial position

This emphasis of matter paragraph should be added after the opinion paragraph, using the
heading 'Emphasis of Matter', including full details of the matter and the location within the
financial statements that explains the issue further.
The paragraph states that the auditor's opinion is not modified in respect of this matter – the use
of such a paragraph must only occur if the matter in question has already been adequately
treated and disclosed in the financial statements and the auditor is in agreement with this (ISA
706: paras 6, A4, A5, A16 and Appendix 3).
Activity 5: Emphasis of matter paragraphs

Required
In respect of the matter described below, select the most appropriate course of action for the
auditor to take.

You are the auditor for a supermarket. A customer has eaten own-brand Unmodified opinion
produce and suffered an allergic reaction to one of the ingredients. The with emphasis of
customer is currently claiming punitive damages for insufficient matter paragraph
information on the food label. If successful, the damages would Unmodified opinion
represent a material amount to the company. The company was with no further
successfully sued for a similar event three years ago, so has created a modification to the
provision for this and has disclosed the matter in full in its financial audit report
statements.

4.2 ISA 705 (revised) Modifications to the Opinion in the Independent

Auditor's Report
There are three types of modified opinion that the auditor can issue (depending on the nature of
the matter giving rise to the modification and the pervasiveness of that matter on the financial
statements):

(1) A qualified opinion

(2) An adverse opinion
(3) A disclaimer of opinion.

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 The types of modification can be summarised as follows by considering the judgements required
by the auditor in two key respects – nature and pervasiveness (ISA 705: paras 2 and A1):

Nature of matter giving Auditor's judgement about the pervasiveness of the

rise to the modification effects or possible effects on the financial
statements
Material but not pervasive Material and pervasive

Financial statements are Qualified opinion Adverse opinion

materially misstated ('except for…') ('the financial statements do
(disagreement) not give a true and fair view…')

Inability to obtain sufficient Qualified opinion Disclaimer of opinion

appropriate audit evidence ('except for…') ('we do not express an
(limitation in scope) opinion…')

We learned earlier that the term 'material and pervasive' has the following definitions and here
they are in the context of selecting the most appropriate opinion, depending on its significance:

 Are not confined to specific elements, accounts or items of the financial statements
 If so confined, represent or could represent a substantial proportion of the financial
statements
 In relation to disclosures, are fundamental to users’ understanding of the financial
statements.
(ISA 705: para. 5(a))

Material misstatements (disagreements)

The circumstances leading to a modification due to material misstatement use the assessments of
materiality already prepared during the audit and could include:

 The appropriateness of selected accounting policies (either inconsistent with the

applicable financial reporting framework or those that do not lead to fair presentation)
 The application of selected accounting policies (either through inconsistency or error)
 The appropriateness or adequacy of disclosures in the financial statements.
(ISA 705: para. 6)

Unable to obtain sufficient appropriate audit evidence (scope limitations)

The circumstances leading to a modification due to being unable to obtain sufficient appropriate
audit evidence, are as follows:

 Circumstances beyond the entity’s control (such as the loss of records in a fire)
 Circumstances relating to the nature or timing of the auditor’s work (eg the auditor being
appointed after the date of the inventory count)
 Limitations on the scope of the audit imposed by management (such as management
denying access to third parties for external confirmations).
(ISA 705: para. 6)

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 Activity 6: Audit opinions

You are the auditor for the external audit of Greenfingers Ltd for the year ended of 31 December
20X2.
On the evening of the year end inventory count at Greenfingers Ltd, the head gardener left a
door to the store room open overnight, which meant that the heat regulation system failed and a
large number of plants subsequently included in the inventory figure died.
These plants have been included in inventory at full value of £67,495 which is material to the
financial statements. The finance director does not wish to amend the financial statements as he
insists that the plants existed at the year end and therefore, it is fair to present that situation and
recognise the loss in the next financial year.
Required
Assuming that the finance director does not amend the financial statements, select the most
appropriate course of action for the auditor from the options below.

Issue a qualified
Issue a qualified
Use an emphasis of opinion on the basis of
Take no action opinion on the basis of
matter paragraph insufficient
material misstatement
appropriate evidence

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 Chapter summary

 Auditors can evaluate the progress they have made in completing the audit by reviewing audit
documentation (or working papers) which are produced for a variety of purposes:
– Demonstrating the findings from audit procedures
– Demonstrating regulatory, ethical, legal and other compliance
– Demonstrating best practice as a professional
– Demonstrating the reasons for their judgement and conclusions
Technology such as email and cloud-computing have allowed digital working papers to become
more commonplace and create efficiencies.

 Auditors then need to be able to deal with any matters arising from the audit appropriately – this
includes understanding what to do in certain situations:
– Evaluating misstatements identified during the course of the audit (using ISA 450)
– Communicating audit findings with those charged with governance (TCWG) of an audited
entity (using ISA 260)
– Communicating deficiencies in internal control to those charged with governance and
management (using ISA 265)

 Formal communication to those stakeholders who use the financial statements is undertaken by
issuing the auditor's report, which has a specific format and layout under ISA 700:
– Title and addressee
– An opinion and the basis for that opinion
– Disclosures relating to material uncertainty relating to going concern, key audit matters and
other information
– Responsibilities of both auditors and management
– Regulatory issues
– Date and signature of the auditor

 In some situations, the auditor's report may require some form of modification:
– If a significant uncertainty exists, there may be a need for an additional form of
communication within the auditor's report – this is called an emphasis of matter paragraph
(ISA 706).
– If the auditor cannot say that the financial statements give a true and fair view (or present
fairly in all material respects) for some reason, both the reason and the extent need to be
communicated via a modification to the auditor's opinion (qualified, adverse or disclaimer, as
explained in ISA 705).

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 Keywords
 Adverse opinion: where the misstatement is both material and pervasive, leading the
auditor to conclude that the financial statements ‘do not show a true and fair view’
 Deficiency in internal control: when a control is designed, implemented or operated in such
a way that it is unable to prevent, or detect and correct, misstatements in the financial
statements on a timely basis, or a necessary control is missing
 Disclaimer of opinion: where the shortage of evidence is both material and pervasive,
leading the auditor to not give an opinion
 Emphasis of matter: paragraph draws users' attention to issues within the financial
statements that they need to see in order to understand them properly
 Qualified opinion: where a matter that is material but not pervasive is identified by the
auditor (‘except for’)
 Significant: in the auditor's opinion, those matters that warrant the attention of those
charged with governance
 Those charged with governance: the directors of a company who are responsible for
managing the company
 Working papers: the material prepared by and for, or obtained and retained by, the
auditor in connection with the performance of the audit

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 Test your learning
1 State FOUR reasons why auditors need to prepare audit working papers.
2 Here is a completed internal control questionnaire about controls in the wages system at
MEM.

Internal control questionnaire: MEM wages system

Question Y/N Comment
Are personnel records kept for each member Yes Kept in wages office
of staff containing details of wage rates?
Does a senior member of staff authorise new Yes Authorised by Richard Bishop or
employees and changes in rates of pay? Mark Bishop
Are any changes in pay rates recorded in the Yes By personnel director, Cathy
personnel records?
Are hours worked recorded on timesheets/ Yes Clock system in use
clocked?
Is overtime approved by a senior member of Yes Department heads review clock
staff? reports weekly
Are hours worked reviewed? Yes As above
Are wages reviewed against budget? No
Is a payroll prepared and approved before Yes Prepared by Cathy, approved by
payment? Richard
Are total pay and deductions reconciled Yes
month on month?
Where wages are paid in cash, is the wage N/A
cheque authorised?
Is cash for wages payment kept securely? N/A
Is the identity of staff verified before cash N/A
payments are made?

Are distributions of cash wages recorded? N/A

Are unclaimed wages kept securely? N/A
Where wages are paid by bank transfer, are Yes Computer produces from payroll,
transfer lists prepared and authorised? Richard authorises

Are transfer lists compared to the payroll? Yes As above

Are details of deductions kept on employees' Yes
individual files?
Are total pay and deductions reconciled Yes Computer highlights any
month on month? discrepancies

Are costs of pay compared to budgets? No

Are gross pay and tax deducted per the Yes Returns to tax office drafted from
payroll reconciled to returns made to the tax payroll by Cathy
authorities?

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 Identify any deficiencies of the wages system at MEM and draft appropriate paragraphs to
appear in a report to management concerning those control deficiencies, their
consequences and suitable recommendations.
3 An audit client is in the middle of legal action with a former employee for sexual
discrimination. If the employee wins the action, the company could have to pay
compensation that would have a material impact on the financial statements.
Set out the implications of this legal action for the auditors.
4 For each of the following situations which have arisen in two unrelated audit clients, select
whether or not the audit opinion on the financial statements would be modified.

The auditors have discovered aggregate misstatements of £25,000 

on the audit of Spring Cleaners Ltd. Materiality has been set at
£100,000. The directors refuse to amend the financial statements.

March Hare Ltd's largest customer has gone into liquidation. The 
directors do not want to write off the debt owed by the customer
which amounts to £25,000, which is material.

Picklist:
Modified
Not modified
5 For each of the following situations which have arisen in two unrelated audit clients, select
whether or not the auditor's opinion on the financial statements would be modified.

Gamma Ltd has included a warranty provision in the financial 

statements this year, having introduced a warranty to be offered to
customers. The auditors have reviewed the warranty terms offered
and believe the assumptions the provision is based on are,
fundamentally, materially wrong.

There is a significant uncertainty about Delta Ltd's ability to 

continue as a going concern. As the directors do not wish to make
the situation any worse, they have not made any reference to going
concern in the notes to the financial statements.

Picklist:
Modified
Not modified

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 Activity answers
CHAPTER 1 Principles of auditing and professional
ethics
Activity 1: Companies Act

Accounting records for Income statement/Statement of profit or loss/Statement of profit

transactions: or loss and other comprehensive income/Statement of cash flows

Accounting records for Balance sheet/Statement of financial position

financial position:
Matters in respect of Revenue (including invoicing details of customers)
which the receipt and Purchases (as above, with invoices for suppliers)
expenditure takes Payroll (including employee records)
place: Stock (inventory)
Investment

Assets and liabilities: Property, plant and equipment

Vehicles
Trading licences
Cash
Stock
Provisions
Loans
Overdrafts

Statements of stock Results from stock count at warehouse, factory, third parties etc
held by the company: (raw materials, work in progress (WIP), finished goods etc)

Activity 2: Company concerns

Concerns about the directors of your company could be many and varied (such as 'Will they do a
good job?', 'Could we have appointed someone better?' and 'Is our money safe?') but in broad
terms, the concerns you have could be summed up by two phrases:
(1) Visibility – as owners of the company, we employ directors for their entrepreneurial skills
and their ability to make money, which is better than our own; hence their appointment.
However, in order to allow them to concentrate on this, we must leave them alone to run
and manage our company as they see fit. Decisions are taken and events occur without us
being involved, meaning that we cannot always see how directors behave. This leads to the
second concern:
(2) Trust – without any visibility of directors' actions and decisions, until the resultant
outcomes become apparent, we must simply trust them to be doing the right thing.
These issues of trust and visibility are known as the agency problem – where agents (directors)
are employed by principals (shareholders), there is always a risk that each party's interests might
not be properly aligned and the company does not behave in the way intended by shareholders.

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 Activity 3: Assurance engagements

The responsible
party = Directors The evidence = Outcome
of sampling and testing

The subject matter = The practitioner =

Financial statements External auditor
The criteria = Auditing,
accounting and other
standards

The report = Auditor’s report

The users = (including their opinion)
Shareholders

Activity 4: Duty of care

Company Automatic
Bank Must be proved
Individual shareholder Must be proved
Creditor Must be proved

The auditors do owe a duty of care to the client; that is, the shareholders as a body (the
company) automatically under UK law. It is always possible that they may also owe a duty of
care to other parties, such as the bank, individual shareholders and creditors, if those parties
have established a special relationship with the auditors.
Activity 5: Types and levels of assurance

'In our opinion, the financial statements present fairly, in all Positive expression of
material respects…' assurance
This is provided as part of the auditor's opinion and is classed as Reasonable assurance
high, but not absolute.
This is not provided for an audit as it is only moderate and is Limited assurance
insufficient for an audit.
'Based on our review, nothing has come to our attention that Negative expression of
causes us to believe that the financial statements are presented assurance
unfairly, in all material respects…'

The amount of work undertaken by auditors allows them to deliver reasonable assurance,
expressed in a positive manner ('In our opinion…').
Other engagements (such as reviews) do not collect the same amount and quality of evidence as
audits, so can only deliver limited assurance, which is a lower level of assurance than reasonable
assurance. Consequently, these are expressed in a negative manner ('Based on our review,
nothing has come to our attention…').

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 Activity 6: Fraud and error
The basic content of this answer comes directly from ISA 240 The Auditor's Responsibilities
Relating to Fraud in an Audit of Financial Statements.
According to ISA 240, fraud refers to misstatements that relate either to the misappropriation or
theft of assets or from fraudulent financial reporting.
One inherent limitation of an audit is that some material misstatements might not be detected,
even though the audit is properly planned and performed in line with ISAs – this is due to the
nature of fraud, which differs from error due to intent.
Three conditions are usually necessary for fraud to exist: an ability to rationalise the fraudulent
action (dishonesty); a perceived opportunity to commit fraud; and an incentive to commit fraud
(motive).
Misstatement issues are more significant with fraud than error, due to the methods of
concealment used by perpetrators (such as forgery and deliberate failure to record
transactions). This can be exacerbated by collusion between parties who work to perpetuate a
fraud by making evidence seem persuasive when, in fact, it is false.
Fraud is even more of an issue for auditors when management of an entity is involved, due to
their ability to manipulate key accounting records. To counter such fraud, the auditor needs to
maintain a sense of professional scepticism and remain alert to the threat of such management
override of controls.
Activity 7: Fraud risk and professional scepticism

Greater professional Lesser professional

scepticism? scepticism?
The finance director has requested There is always a risk of
that you complete the audit on time in managers trying to
order to meet head office reporting influence profit figures to
deadlines. The finance director has a increase their bonus, but
profit-related bonus but has always this seems to be reasonable
accepted adjustments that you asked and does not add to your
for on previous audits. sense of scepticism.
The payroll officer has asked that you Such a case is classic
do not perform any testing of the fraud-masking behaviour.
payroll until she returns from her The fraud can be
holiday. There are no other members perpetrated and kept
of staff who can assist you with the secret by one member of
payroll audit. staff while they are present
and kept secret while they
are away, as no one will be
looking at their work.
This is evidence of a poor
control environment as
well, so casts some doubt
on the integrity (or at least
competence) of
management.
When reviewing the board minutes, Such an oversight is not
you read that the company has likely to be a simple
applied for significant funding to accident, more likely an
support the currently poor cash flow. attempt to mislead the
From recent conversations with the auditor – again, this is a
chief accountant, however, you were symptom of a poor control
under the impression that revenue environment and shows
and cash flow were both healthy and the integrity of
that the company was performing management in a poor
well. light.

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 Activity 8: Fundamental ethical principles

Being dishonest about a business relationship with a client Integrity

Accepting an engagement when not trained to complete it Professional competence and
due care

Insider trading by deciding to purchase a client's shares Confidentiality

Activity 9: Ethical threats

Tick
One client represents 25% of the audit firm's total fees for the year 
Representing an audit client in a tax investigation 
Tutor note. This is an example of an advocacy threat.
Receiving free VIP tickets to the World Cup Final from a client. 
Tutor note. While this may appear to unduly influence the auditor, it does
not represent an interest held, such as an investment of some sort. Due to
this probably being a gift or some form of hospitality (maybe even a
bribe?), it is an example of a familiarity threat.

Activity 10: Ethical safeguards

Providing a valuation service to an audit client for assets held Use of different personnel with
by a subsidiary of that client. different reporting lines

Seven members of the audit firm own shares in the firm's A register of interests and
audit clients. relationships between audit team
Tutor note. This is an example of a firm-wide safeguard as it members and clients
does not relate to a specific engagement.

The audit manager's brother is promoted to become finance Rotation of senior personnel
director of that client.
Tutor note. Independent review of working papers would not
be sufficient to address the familiarity risk so rotation is more
appropriate here.

Activity 11: Confidentiality

Tick
A request for information as part of a tax investigation 
A request for working papers from the incoming auditor during a 
competitive tender without receiving client approval
Tutor note. Had the auditor received client approval, this would have been
allowed.

An external quality control review carried out by the FRC 

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 CHAPTER 2 Systems of internal control
Activity 1: Computer controls
 Passwords
 Usernames
 Usage log
 Firewalls
 Anti-virus software
 Authorisation codes
 Physical security
 Back-ups
Activity 2: Control activities

Performance reviews Budgetary control meetings

Information processing Agreeing the sales ledger total to a batch of authorised invoices

Physical controls Security staff at a warehouse

Segregation of duties Separate staff for counting, banking and recording cash

Activity 3: Internal control inherent limitations

Limitations of internal controls could occur in the following areas:
 Human error – human judgement can sometimes be faulty due to overconfidence, fatigue,
stress etc. Such error can be traced back to either the design or implementation of a
particular internal control.
 Human error might be experienced in the interpretation of results from reports produced by
the internal control system (eg misinterpreting the results of an exception report).
 An entity may make a judgement on the amount of money that a control is designed to
save, compared with the amount that such a control costs to implement (the so-called
'cost-benefit' argument). For this reason, many entities do not arrange insurance cover for
all their assets, as the cost of such premiums would be prohibitive – instead, a fund is set
up to cover potential losses.
 Fraud is one area already discussed where the limitations of internal control are very much
exposed – collusion between two parties can circumvent segregation of duties controls,
while management can choose to ignore the controls in place due to the authority they
hold over their employees.
 Finally, due to the freak nature of some transactions, circumstances or events mean that
no matter how well designed or implemented an internal control is, there is a risk of the
control not being able to cope with such a random item. This can result in some form of loss
for the entity, and may also highlight where an internal control can be improved.
Activity 4: Control objectives, risks and procedures – introduction

Observe post opening Test of control

Safeguard blank purchase order forms Control activity

Review numerical sequence of goods received notes Test of control

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 Activity 5: Control objectives, risks and procedures for systems
Systems such as these are often very complex and there is never one perfect answer – refer to
the Appendix found at the end of Chapter 2 and compare what you have written with the
examples provided.
Activity 6: Ascertaining the accounting system
Review of last year's working papers
Enquiries of client's staff
Review of policies and procedural manuals
Activity 7: Internal control questionnaire

Question Yes/No Comment

Are orders only accepted from low credit Yes Sales staff ensure that customers
risks? have not exceeded their limits

Are despatches checked by appropriate Yes Ian Jones checks the order prior to
personnel? despatch

Are goods sent out recorded? Yes Ian Jones raises a goods despatch
note (GDN)

Are customers required to give evidence of Yes They are required to sign and
receipt of goods? return a copy of the GDN

Are invoices checked to despatch notes and Yes Agreed by Jane Hill
orders?

Are invoices prepared using authorised Yes Sales department check to current
prices? price list

Are invoices checked to ensure they add up No Jane does not appear to complete
correctly? additional work on invoices

Are sales receipts matched with invoices? No No mention of this check being
carried out

Are statements sent out regularly? Yes Monthly

Are overdue accounts reviewed regularly? No Irrecoverable debts are rare so this
check is not completed

Are there safeguards over post received to No No mention of what happens to

ensure that cheques are not intercepted? them before they get to Beth
Simpkins

Are bankings made daily? No Cheques are kept in the safe but
banking is not regular

Would it be appropriate to perform tests of Yes In general, the system of controls is

control here? sound, meaning that the auditor
would test them to provide reliance
on their sound operation.
As a result of this there would be
reduced amounts of substantive
testing of revenue balances

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 Activity 8: Documenting systems

Advantages Disadvantages
Narrative notes Quick to prepare Confusing if system is complex
Flowcharts Easier to interpret for larger, more Need experience to prepare
complex systems

Questionnaires Easy to delegate to junior staff Client may overstate controls

Activity 9: Evaluating systems

Task 1
Any five from the following:
 Sales staff check that outstanding orders are not in excess of the credit amount before
taking orders
 Orders are recorded on pre-numbered sales orders
 Only Ted is allowed to authorise sales orders over £20,000
 Only Ted is allowed to authorise new customers after a credit check has been carried out
 Ian Mellor checks goods to be despatched for quantity and quality
 Invoices created from goods despatch notes and matching sales order
 Prices are automatically inserted on the invoice
 The production of invoices automatically triggers updating of the sales day book and
ledger
 Post is opened by two people
 Processing the cash book automatically updates the sales ledger for receipts
 Marie Edgehill reconciles sales ledger control account on monthly basis
 Tessa Goodyear reviews an aged receivables report for potentially irrecoverable receivables
weekly
Task 2

Only Ted Bishop is allowed to authorise new customers and orders over £20,000. Potentially both
It is good that there is a control over larger purchases, but the fact that it is restricted to one
person means that if Ted Bishop is ill or on holiday, customers may be kept waiting and ultimately
lost, which is a weakness in the system.

Orders are recorded on pre-numbered sales orders. Strength

Orders should not get lost and therefore be unfulfilled.

Goods are sometimes ready for despatch early. Deficiency

This suggests weaknesses in the system to determine when goods can be produced by and may
mean that goods have to be stored on MEM's premises at MEM's risk until they can be
despatched to the customer. It also adds to the delay between MEM spending money on raw
materials and recouping money on sales. The initial prediction of production time should be more
accurate.
It is necessary for Tessa to manually override the price system on the computer if a special price
has been negotiated. Deficiency

This is a weakness as it means that the good controls over price input can be overridden for other
reasons too. It might be better if the sales department set up any special prices agreed within the
system and gave notice to Tessa of the appropriate code. However, controls would need to be
exercised over this addition to standing data on the computer.

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 CHAPTER 3 Obtaining audit evidence
Activity 1: Controls and tests – purchases
Any five from the following:

Controls Tests of control

Necessity for orders is evidenced prior to Reviewed a sample of requisitions. Enquire
ordering and a requisition is raised. about reorder levels with stores manager.
The company has a policy for choosing Review a sample of orders to ensure that the
suppliers. suppliers appear on the approved list.
Goods received are examined for quantity and Observe the stores' manager receiving some
quality. goods.
Observe the stores' manager receiving some
Goods received are checked against the order. goods. For those goods, scrutinise a sample of
orders for evidence of the check.
Observe the accounts assistant checking
Supplier invoices are checked to the order.
supplier invoices to the relevant order.
Supplier invoices are checked for prices;
Scrutinise a sample of supplier invoices for
quantities and calculations are given a
evidence of these checks.
reference number.
Observe the accounts assistant posting the
Purchases are entered on the purchase ledger
purchases invoices. Note the length of time
promptly.
between receiving and posting invoices.
Cheque requests are presented for approval Scrutinise paid invoices for any evidence of
with supporting documentation. approval. Observe the cheque payments
routine.
Supplier statements are reconciled to the Scrutinise a sample of reconciliations. How are
purchase ledger. differences dealt with?
The purchase ledger control account is Scrutinise a sample of reconciliations. Establish
regularly reconciled with the purchase ledger how differences are dealt with.
list of balances.

Activity 2: Controls and tests – payroll

Any four of the following:

Controls Tests of control

Pieces worked are recorded. Review records of pieces worked and test for
accuracy.
Pieces worked are reviewed. Scrutinise the exception report and look for
evidence of authorisation.

Payroll is prepared by director. Review payroll and check that it is indeed

prepared by the director.
Identity of staff is verified prior to cash Attend a wages payout and observe the
payments being made. controls in operation.
The payroll master file (with details of office Interrogate the payroll master file to establish
and administrative staff salaries) can only be whether unauthorised staff can easily access
accessed and amended by authorised or amend details.
individuals.

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 Controls Tests of control
Bank transfers, in respect of payroll, are made Compare a sample of automatic bank transfers
to the correct employee. made with bank account details provided by
employees.

Activity 3: Controls or substantive?

Selection of ten invoices to test for correct authorisation in line with official Test of control
signatory list Substantive test
Tracing ten non-current assets back to initial purchases invoices to verify Test of control
their value Substantive test
Tracing ten non-current assets back to initial purchases invoices to verify Test of control
they were allocated to the correct cost centre Substantive test

As you can see from the last two examples, the same audit test can have both controls and
substantive purposes behind them – this comes out of effective and efficient audit planning.
Activity 4: Ginger Ltd (1)
The correct answer is the number of nights the hotel is open during the year.
Workings
Substantive analytical procedures are used to verify an amount in total, so for Ginger 10  55% 
£75  100  365 nights = £15,056,250 which proves the £15m revenue figure reported is materially
correct.
The other pieces of information may be useful but will not help (we are told that £75 includes all
charges, so bar and restaurant spend are not required). Plus, you cannot just assume 365 nights
a year as there may have been closures in some of them during the year (hence, the 'no further
information required' option is inappropriate).
Activity 5: Ginger Ltd (2)

Findings Implications
The room rate of £50 now The reported amount for revenue may be misstated.
means that the revenue for There may be elements of revenue that we are unaware of – we
Ginger should only be around will need to perform further testing on revenue to ensure there
£10 million – the financial are no flaws in any other assumptions (eg occupancy rate).
statements are still recording
£15 million. We may have to consider the danger that management are
attempting to manipulate the financial statements and should
consider their integrity.
We should inspect management accounts to verify the amounts
recorded for revenue on a monthly basis.
We may need to enquire whether there are any hotel premises
or income streams that we were unaware of and establish if this
changes any of our risk assessments or materiality calculations.

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 Activity 6: Mixed audit approach or substantive procedures only?

Scoot Ltd is a new company that has not been audited before and is Substantive procedures
dominated by its managing director and his informal operating only, with no tests of
style. Sales are of greatest importance to him as the company control
attempts to break into a competitive retail sector.
Whitney plc is an established listed company that operates in a Tests of control and
stable market with strong governance procedures, including an substantive procedures
audit committee.
The board of Marine Ltd has just informed its external auditor that it Substantive procedures
wishes to replace its ledger systems due to a number of errors only, with no tests of
identified in its management accounts. control
Tutor note. This is not straightforward, but if the client is going to
replace their systems, it is likely that they cannot currently be relied
upon and therefore a purely substantive approach would be
appropriate.

Activity 7: Assertions (1)

Select a sample of vehicles from the list of non-current assets and Rights and obligations
obtain their certificates of ownership.

Seeking evidence of ownership proves that the entity has the right
to include such assets within the financial statements (as well as
any obligations that ownership would impose, such as
maintenance).

Select a sample of receivables from the statement of financial Existence

position and agree to original invoices.

The direction of testing is important here – you are testing from

the statements to their source, which is a test that the figures
exists (hence, testing for any overstatement of assets).

Select a sample of receivables from the sales ledger and agree to the Completeness
final amount on the statement of financial position.

The direction of testing is important again here – you are now

testing from the source to the end statements, which is a test that
all sales have been included and are complete (hence testing for
any understatement of assets).

Trace a selection of payments included in cost of sales to original Occurrence

invoices.

This is again a test of overstatement but this time it is for a

transaction, so it is worth remembering that statement of profit or
loss items are tested for occurrence while assets and liabilities are
tested for existence (both can be reviewed for completeness
when testing understatement).

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 Activity 8: Assertions (2)

Testing cut-off for staff bonuses paid at the end of Verifying bonus payments to payroll
the financial year records to determine their timing
Confirming the accuracy of staff bonuses paid at Reconciling payroll records to a schedule
the end of the financial year of staff bonus payments authorised by
the finance director
Confirming the value of cash investments held in a Obtaining a letter from the bank stating
savings account by a client the amount of savings held by the client

Activity 9: Automated tools and techniques

Extraction of all receivables balances older than 120 days to perform Audit software
irrecoverable receivable work

Input of purchases invoices with false customer numbers to ensure that the Test data
system rejects the invoices
Comparison of suppliers on ledger with previous years to discover any new Audit software
or missing suppliers

Interrogation of a year's transactions to analyse profitability by product Data analytic tools

and store for a retailer

Activity 10: Sampling (1)

Obtain evidence that sales have not been understated Sales order
Obtain evidence that sales have not been overstated Sales ledger

Activity 11: Sampling (2)

Auditors intend to increase reliance on the company's system of internal Increase

control for the purposes of the audit.
Auditors believe that there is likely to be a higher deviation rate in controls Increase
due to a new member of staff.
Increased activity in the factory and new customers, resulting in 25% more No effect
sales invoices being issued during the year.

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 CHAPTER 4 Planning: audit risk
Activity 1: Detection risk
(i) 5% = 50%  20%  50%
(ii) 5% = 50%  40%  25%
Detection risk is the risk that audit procedures do not detect a misstatement – it is logical that, in
order to reduce this risk to a figure as close to zero as possible, the auditor must perform
relatively more work; hence, reducing the risks of not detecting a misstatement, whether caused
by fraud or error.
In the examples above, the second scenario shows a company where controls are half as good (or
twice as risky) and, as such, we cannot rely on J Club's controls as much we did in scenario (i). In
order to keep the risk of our firm giving an incorrect opinion to 5% with fewer controls to rely on,
we therefore have to screen more transactions ourselves in the absence of J Club's own controls.
Had J Club's inherent risks changed, this would have affected our detection risk as well, in line
with the equation, and potentially given us a different balancing figure.
Activity 2: Audit risk

If inherent and control risk have been determined True – as detection risk will need to be low,
to be high, auditors will have to carry out a high which means a high level of testing must be
level of detailed testing to render overall audit risk carried out.
acceptable.
The head of internal audit has just been False – being unable to trust the work of the
suspended from one of your clients on suspicion internal auditor means that controls are less
of fraud. As a result, you assess that control risk likely to be relied upon and as such control
has fallen. risk rises.
One of your largest retail clients has decided to True – cash is an inherently risky item due to
cease taking cash at all its stores. You assess that its portability and anonymity, so reducing
inherent risk will fall for that client. the reliance on this as part of the client's
business will mean the inherent risk of the
audit falls.

Activity 3: IZK Ltd

IZK Ltd
Statement of financial position as at 30 September 20X6

20X6 20X5
£ £
ASSETS
Non-current assets
Property, plant and equipment 46,595 41,675

Current assets
Inventories 60,120 58,675

Trade and other receivables 140,674 124,968

Cash and cash equivalents 17,547 6,617

218,341 190,260

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 20X6 20X5
£ £
Total assets 264,936 231,935
EQUITY AND LIABILITIES
Equity
Share capital 1,000 1,000
Retained earnings 184,187 142,039
185,187 143,039
Non-current liabilities
Bank loans 4,762 14,910
Current liabilities
Trade and other payables 74,987 73,986
Total liabilities 79,749 88,896
Total equity and liabilities 264,936 231,935

The four balances most likely to need review from the statement of financial position would be
property, plant and equipment, trade and other receivables, cash and cash equivalents and bank
loans. Non-current assets are usually depreciated, so we would expect to see a fall in their value
but in 20X6 they have increased – this is not unusual, but begs the question of how they could
have increased when:
(a) No revaluation reserve exists
(b) No fresh share capital has been issued
(c) Bank loans have fallen, suggesting that no new debt has been taken out (we may have
seen a repayment of some debt, but see the next point)
(d) Cash has risen, suggesting that cash balances were not used to redeem the bank loan. So
how did the company afford new property, plant and equipment?
There are enough questions here to cause the auditor to be alerted to the risk of material
misstatement in the statement of financial position – further audit procedures will then be
prompted as a result of this basic analysis.
Activity 4: Bucket Ltd

Trade receivables has increased by 25% and revenue has increased by 7% Overstated
Trade payables has decreased by 5% and purchases has increased by 4% Understated

Activity 5: Material or not?

There is an error in receivables, value £7,500. Material

A loan to a director has been disclosed in the financial statement at £2,000. Material
Actually the correct sum is £2,010.
The company is required to keep a current asset ratio of 2:1. An error of £100 Material
has been found in receivables, which will cause the ratio to drop below this
level.

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 Activity 6: Materiality issues

Performance materiality should be set at less than materiality for the financial True
statements as a whole.
Materiality is a measure of the importance of items to a reader of financial True
statements.
Items may be material due to their size, nature or effect on the financial True
statements.
A building carried in the financial statements is judged to be 'material and True
pervasive' if it represents 70% of total assets and 150% of profit before tax and
is subject to an impairment review due to extensive damage. It is the only
premises of a trading company that cannot relocate due to commercial
pressure.
Tutor note. Determining whether something is 'material and pervasive' is
usually going to require a degree of judgement by the auditor. However, in this
case, it is probably more clear-cut as, although this relates to only one item, it
represents a substantial proportion of the financial statements and the
impairment is likely to substantially affect the future of the company.

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 CHAPTER 5 Planning: audit procedures
Activity 1: Risk of misstatement

The entity is to be sold and the purchase consideration will be Increase

determined as a multiple of reported profit.

The company has a history of being slow to follow new accounting Increase
standards and guidance.

Activity 2: Pebbles Ltd

Any four from:
 John White is considering selling his stake in the company. He therefore has an incentive to
manipulate the figures in the accounts in order to achieve a better price for his shares.
 Sales are made on a cash basis. Cash held on the premises is susceptible to
misappropriation and so may be difficult to substantiate in the financial statements.
 Inventory has a short shelf life. Any out of date inventory held at year end will need to be
written off and may be overvalued in the financial statements.
 Casual staff may make errors when recording sales or misappropriate assets within the
business, leading to errors within the financial statements.
 High staff turnover may result in misstatements in the payroll costs recorded in the
financial statements.
 Leased premises may be accounted for incorrectly (for example, leased premises may not
be treated in line with the most appropriate type of lease, leading to misstatements to both
assets and liabilities).
Activity 3: JICS driving school
10  Ford Fiestas There is logic that certain expenditure is capitalised
2  PCs and monitors for the office when servicing (literally) a non-current asset.
However, tyres and repairs are generally regarded
2  desk telephones as fair wear and tear, so in practice they are
referred to as revenue items.
10  mobile telephones
Insurance and servicing are also classified as
Car insurance
ongoing operating costs.
Car servicing
There may be a de minimis level for non-current
Installation of dual controls in cars assets to be created in order to keep such records
manageable, so items like desk telephones may fall
Replacement tyre for car no. 6
beneath this threshold and be lost within normal
Repairs to bumper of car no. 4 operating costs, but they are kept as non-current
assets here for consistency.
Office fixtures and fittings
‘JICS' signs to go on top of cars
Activity 4: Campey Ltd non-current assets
Completeness
(1) Compare non-current assets balance on general ledger with non-current asset register and
reconcile any differences.
(2) Select a sample of non-current assets from knowledge of the business and trace them to
the non-current asset register.
(3) Review any sensitive items within the statement of profit or loss, such as motoring expenses
and building repairs, to ensure that items which should have been capitalised throughout
the year have not been expensed instead.

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 Rights and obligations
(1) Review title deeds for land and buildings to confirm ownership.
(2) Review vehicle registration documents for a sample of company vehicles to confirm
ownership.
(3) Review lease documentation to establish any finance lease obligations regarding non-
current assets.
Existence
(1) Select a sample of assets from the non-current asset register and physically trace them to
those assets.
(2) Inspect the assets to ensure that they exist, are in good order and are obviously being used
by Campey Ltd.
Valuation
(1) As assets have not been revalued during the year, testing should start with additions.
Confirm the amounts included at cost by reviewing the invoices for new vehicles and
fittings.
(2) Recalculate the depreciation charge for a sample of assets.
(3) Review the bases for depreciation to ensure that 2% straight line for buildings, 25%
diminishing balance for vehicles and 15% straight line for fittings are still reasonable.
(4) Use inspection evidence (from existence testing above) to confirm reasonableness of
valuations for assets, especially impairments of land and buildings due to market
conditions, dilapidation etc.
Activity 5: Paper Products Ltd
Before:
(i) Preparation
 Review working papers from the previous year
 Determine arrangements with management in advance
 Become familiar with nature of inventory
 Consider need for an expert
 Inventory held by/for third parties – review procedures to account for this
 Review client's count of physical inventory instructions. This should include the
following:
– In writing
– Two independent counts
– Systematic clearing of areas
– Identification of obsolete damaged inventory
– Supervision
– Cut-off considered
– Count sheets − pre-numbered, written in ink and controlled in distribution and
collection
– Investigation of differences – what happens if two counts disagree?
(ii) Determine audit procedures required to cover a representative selection of inventory and
inventory locations
(iii) Identify potential problem/risk areas

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 During:
(i) Review client staff – are they following the instructions?
(ii) Test counts, from the physical inventory to the records and vice versa
(iii) Note damaged, old and obsolete inventory for valuation purposes
(iv) Review WIP for stage of completion
(v) Inventory held by client for third parties must be excluded from count
(vi) Take note of last goods received note (GRN) and goods despatch note (GDN)
(vii) Form an overall impression of inventory levels/values
After:
(i) Check sequence of inventory sheets
(ii) Check client's computation of final inventory figure
(iii) Trace own test count items through to inventory sheets
(iv) Check replies from third parties
(v) Inform management of general problems
(vi) Follow up cut-off details
Activity 6: Inventory assertions

Test
Form an opinion of the condition of inventory and record any Valuation
instances of damage or obsolescence.
Result
There were 15  10m rolls of fabric stored near the roof of the
warehouse where birds had nested, making the fabric unusable.

Test
Trace 10  10m rolls of fabric from the inventory sheets to the Existence
relevant shelves of the warehouse.
Result
All 10 rolls were found on the shelves in the locations specified by
the main accounting system.

Test
Trace 10  10m rolls of fabric from the relevant shelves of the Completeness
warehouse to the inventory sheets.
Result
All 10 rolls were traced back to the list generated by the main
accounting system.

Test
Confirm that the fabric and garments held in the secure off-site Rights and obligations
storage facility are to be included in Glad Rags' inventory balance
by verifying them to supporting documentation and invoices.
Result
All rolls of fabric and garments were traced back to storage invoices
and haulage records, confirming that they belong to Glad Rags.

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 Activity 7: Valuing inventory
General
Cast the inventory listing to establish that it is mathematically correct.
Confirm that an appropriate basis of valuation (first in first out) is being used, through a
discussion with management.
Compare the gross profit percentage to the previous year or industry data.
Cost
For a sample of products, vouch the purchase prices to suppliers' invoices to ensure cost is
correctly recorded on the inventory listing.
NRV
For a sample of inventory items held at the year end, obtain NRV by reviewing the post year end
sales price.
Where NRV is lower than cost, ensure the items are written down to NRV.
Confirm that inventories are included at lower of cost and NRV in the financial statements.
Activity 8: Hodgson Ltd
(a) Record basis of valuation used in all three categories and ensure disclosure is accurate and
inclusion in each category is appropriate.
(b) Test material costs (all three categories):
(i) Trace back to individual invoices
(ii) Ensure FIFO or appropriate bases being used
(iii) Review quantities used in WIP/finished goods
Test labour costs (all three categories):
(i) Trace calculations to supporting documentation (eg timesheets)
(ii) Review costing against actual labour and production statistics
Test application of overheads (WIP and finished goods only):
(i) Ensure only production overheads are included (and that standard costs are still
appropriate)
(ii) Ensure based on normal activity levels
(c) Review stage of completion of WIP:
(i) Review for reasonableness of assumptions – consider physical inspection
(ii) Test calculations to ensure accurate
(d) Net realisable value of finished goods:
(i) Follow through items noted at inventory count
(ii) Review sales (volumes and prices) after year end
(iii) Review future orders to establish demand and likely sales prices
(iv) Consider any background knowledge obtained during the audit
(v) Establish extent of any write-downs from past year
(vi) Ensure any necessary adjustments to valuations have been made in light of this
evidence (such as impairments to finished goods)
Activity 9: Cut-off testing
Revenues cut-off testing: No further action/Refer to supervisor
Purchases cut-off testing: No further action/Refer to supervisor

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 Regardless of whether the order from Terry's Threads was a regular order that came early or late,
it has to be accounted for consistently and, as such, if it has been accounted for as inventory
received before the year end, there must be a matching purchase cost and payable balance at
the year end as well.
Activity 10: Circularisation

Amount owed Response Other information

per sales from supplied by
ledger customer customer
British Clothes Stores plc 484,536 439,598 Cheque in post
IZK Ltd 74,973 74,973 n/a
Tisco Stores plc 78,805 71,663 Disputed invoice
J Club Ltd 323,024 323,024 n/a
Cavanaghs Ltd 14,388 nil Goods not received yet
H and T Ltd 18,933 nil Cheques in post
Nice Clothes Ltd 17,231 nil Cheques in post
Ginger Ltd 22,315 22,315 n/a

Tisco is the only one where you cannot agree the balance yourself – those that agree (IZK, J Club
and Ginger) need no further work, while British Clothes Stores, H and T and Nice Clothes have all
paid their amounts owed and the only differences are due to timing (missing amounts have
appeared in post year end cash receipts).
The warehouse records show that Cavanaghs' goods were despatched so they should be dealt
with consistently, leaving the disputed invoice for Tisco. It is possible that their goods were not
fully despatched or that some were damaged in transit – you need to perform more work on this
before you can agree the balance as a valid trade receivable.
Activity 11: Pond Ltd
The following balances could be sampled:
Wed-Me Ltd (8,429) Other than size, you would test for collectability and any
Astra Stones Ltd Nil other risks – Astra having a nil balance might be correct,
Jewels 'r' Us Ltd 3,294 but you need to confirm this. Jewels 'r' Us and
Magnifique Ltd 987 Magnifique are both overdue so should be investigated
(and used to assess the company's allowance for
doubtful debts) while any credit balance on the sales
ledger should be investigated further.

Activity 12: Bank reconciliation

(a) Audit tests to be performed on the bank reconciliation:
Agree balance per cash book to cash book
Check arithmetic
Agree balance per bank statement on the reconciliation back to bank statement
Agree balance per bank statement back to bank letter
Vouch unpresented cheques and outstanding lodgements to after-date bank statements
Agree bank error to after-date statements and supporting documentation
Review bank letter for any undisclosed accounts

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 (b) Items to be referred to the audit supervisor:

Bank error There are two issues that you may have spotted with
this bank reconciliation – the first is that one of the
Items to be written off
outstanding cheques seems much older than the
Arithmetic other two from their numbers, which might suggest a
cheque that might never get presented and, as such,
Disclosure items
may require writing off the relevant accounts.
Errors with source data
The second issue is that the bank reconciliation does
not balance (£52,296 vs £52,926). This could be due
to a transposition error when producing the
reconciliation or an error in the cash book or bank
statement – both of which would need following up
with the entity's staff.

Activity 13: HEC Ltd

The following work should be carried out on the loan:
 Obtain a schedule showing what is due in more than one year and what is due in less than
one year.
 Test the calculations to ensure that this analysis is correct, that interest has been treated
correctly and that the total balance payable agrees to the bank letter.
 Ensure that appropriate disclosure has been made in the financial statements.
Activity 14: Gavilar Ltd

Objective Suggested audit procedures

(a) Completeness (i) Review trade payables using analytical procedures, comparing
to previous year or budgets.
(ii) Review goods received notes around the year end to ensure
purchases have been correctly treated for cut-off purposes.
(iii) Review unpaid invoice files for any liabilities not yet provided
for.
(iv) Review after-date payments for any liabilities not recorded.
(v) Obtain a list of trade payables and reconcile to the financial
statements.

(b) Rights and obligations (i) Circularise trade payables (the procedure is similar to that
used for trade receivables).
(ii) Reconcile payables balances at the year end to a supplier's
statement and follow up any discrepancies.

Both these tests also provide evidence of completeness and

valuation.

(c) Valuation Ensure closing provisions/accruals are calculated in accordance

with accounting policies and are consistent.

(d) Existence (i) Circularise trade payable and/or reconcile using suppliers'
statements.
(ii) Perform cut-off tests on purchases and credit notes.

(e) Disclosure Ensure trade payables have been properly analysed between those
due in less than one year and those due in more than one year.

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 Other payables will include amounts due to be paid that do not form part of normal cost of sales
(such as administration overheads, energy costs, rentals and insurance costs). In practice, they
will not be treated any differently to trade payables but their patterns may be different, meaning
that analytical procedures need to take this into account.
Activity 15: Adjustments

The auditor has found an invoice for office supplies ordered and Requires to be adjusted
delivered on the last day of the financial year. The invoice amount has
not been included in the total for purchases in the statement of profit
or loss. The amount for these supplies is material.

The auditor has completed analytical review of the cost of sales for a Requires to be adjusted
bakery. This analysis has indicated that ingredient costs per loaf have
increased from 12.8 pence in the previous year to a figure closer to
£3.56 per loaf. The non-financial information on the numbers of loaves
has been corroborated during the audit.

The auditor has selected 20 payments from the purchase ledger total Does not require to be
and has been tracing them back to invoices for evidence of both adjusted
existence and valuation. Of these 20 payments, 19 have been traced
successfully back for both assertions.
The 20th item has no invoice and relates to health and safety
assessments carried out at the entity's head office. A similar amount
was included in last year's statement of profit or loss and this year's
figure can be agreed back to a quotation that the chief accountant
was sent by the contractor. The audit senior has recorded evidence of
this assessment within the current file as part of the firm's wider audit
testing.

The third example is far from clear-cut without any materiality or risk assessments to refer to, but
is an example of how the auditor looks for corroborative evidence that seems plausible. In this
example, although we have no back-up for this payment, a matching quotation was issued and
the amount is both ongoing and consistent with what the auditors understand of the entity;
hence, both valuation and existence have some persuasive evidence, rather than being
conclusive.
In such a case, it is probable that the weight of evidence is stacked in the entity's favour and the
auditor's opinion (note – this is not a guarantee) is likely to be that the financial statements are
free from material misstatement.
Activity 16: Miscellaneous procedures

Consider the effect of any price rises during the year. Cash sales from a retail outlet

Review sales ledger for old receivables which are still unpaid. An allowance for a doubtful
debt

Verify amount outstanding by reference to subsequent An accrual for an unpaid

payments. electricity bill

Perform analytical procedures by comparing payments with A prepaid insurance premium

previous years to see if they appear reasonable.

Recalculate amounts due in relation to tax and national Deductions paid to HM

insurance payable by employees. Revenue & Customs (HMRC)

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 CHAPTER 6 Evaluation
Activity 1: Documentation
 Assisting the audit team to plan and perform the audit (by reference to the original
planning documents produced when the audit was agreed with the client)
 Assisting with the review and supervision responsibilities carried out by members of the
audit team to ensure quality control
 Ensuring that the audit team is accountable for its work and that anyone not working on
the audit team can understand what occurred during the audit
 Retaining a record of matters of continuing significance to future audits, including
discussions with client management and those charged with governance, as well as any
inconsistencies discovered during the audit
 Allowing internal inspection through systems of quality control review
 Allowing external inspections in accordance with legal, regulatory and other requirements
Activity 2: Working papers

Working paper Reason for preparation

A register of shares in audit client companies owned by Demonstrating legal, regulatory and
staff members ethical compliance by the auditor

A copy of an email sent by the finance director of Curtis Recording matters from an audit that
Ltd explaining a bid that has been made to acquire the are either unusual or significant
company

Briefing notes for the audit team before the start of the Planning, directing, supervision and
audit of Gordon Ltd review of the audit engagement

A reconciliation of circularised responses to a list of Supporting audit evidence for the

receivables for an audit client auditor's opinion

Tutor note. Although each option was used here, and each was only used once, you should be
prepared for some answer options in your assessment to be used either more than once or not at
all.
Activity 3: Glad Rags

When reviewing the bank statements, the chief accountant removed

some of the pages relating to the period of time after the year end.
No further action
This could be a sign that there are integrity issues with the chief
accountant which the audit junior should pass on to the audit Refer it to the supervisor
supervisor.

During his review of the payroll system, incorrect PAYE income tax
rates were found to have been used. This was retrospectively No further action
corrected for the following month and all supporting transactions Refer it to the supervisor
reviewed by the junior.

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 Activity 4: Reporting recommendations

Deficiency Deficiency
When invoices are raised, they are not Post opening procedures appear unsupervised
reviewed to ensure that additions are correct. with no list of initial receipts – customer
remittance information does not appear to be
retained.

Consequence Consequence
Invoices could be overstated (leading to loss of Receipts could be misappropriated or lost once
goodwill from customers) or understated at the company.
(leading to a loss of funds for the company). Funds might not be effectively allocated
against the correct customer, leading to
incorrect records on outstanding amounts and
irrecoverable debts.

Recommendation Recommendation
Invoices should be checked for additions prior A list of all receipts should be created on
to being sent out to customers for correct opening each item of post for completion
additions and VAT. This should be done by purposes and all customer remittances
someone other than Jane (eg Beth) to retained and attached to cheques.
introduce a second pair of eyes.

Activity 5: Emphasis of matter paragraphs

You are the auditor for a supermarket. A customer has eaten Unmodified opinion with
own-brand produce and suffered an allergic reaction to one of emphasis of matter paragraph
the ingredients. The customer is currently claiming punitive Unmodified opinion with no
damages for insufficient information on the food label. If further modification to the audit
successful, the damages would represent a material amount report
to the company. The company was successfully sued for a
similar event three years ago, so has created a provision for
this and has disclosed the matter in full in its financial
statements.

The course of action suggested here seems reasonable as the client has done what seems
prudent, given that it seems likely to be unsuccessful in this case.
Activity 6: Audit opinions

Issue a qualified
Issue a qualified
Use an emphasis of opinion on the basis of
Take no action opinion on the basis of
matter paragraph insufficient
material misstatement
appropriate evidence

The finance director is incorrect as the inventory was impaired before the year end. This could be
called into dispute if the inventory count occurred on the very last day of the reporting period and
the plants died after midnight – we know from the activity that the year end of Greenfingers Ltd
is 31 December, so the inventory count may not have been carried out on New Year's Eve! You can
expect the real assessment to be more specific and not introduce too much conjecture.
Assuming that the inventory was impaired, and the finance director chooses not to amend the
financial statements for this material amount, the statements are materially misstated and a
qualified opinion is appropriate.

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 Test your learning: answers
CHAPTER 1 Principles of auditing and professional
ethics
1 A company is an entity registered as such under the Companies Act 2006.

2 It must be managed by its owners. 

A company does not have to be managed by its owners. However, registering a company
does mean that it is seen as a separate entity from its owners, and that it must satisfy
certain requirements of the Companies Act, such as keeping accounting records and
having its financial statements audited.
3

Companies must keep records that disclose with reasonable accuracy True
the company's position at any time.

All companies must keep records of inventory. Only those companies False
that deal in goods need to fulfil this requirement (other companies
have no stock/inventory to record).

4 An audit is an exercise carried out by auditors to ascertain whether the

financial statements prepared by the directors are (in the UK) in

accordance with UK GAAP and the Companies Act 2006 and give what is known
as a true and fair view .
5

Auditors are required to report on the truth and fairness of financial True
statements.

Auditors have a right of access to a company's books and records at True

any time.

Auditors are entitled to obtain explanations from the officers of a True

company.

6 The client and any other parties with whom they have implied a special relationship 
7 A duty of care existed, it was breached, causing loss.

8 Confidentiality is the duty to keep client affairs private .

9 The auditors must keep their work secure, so that they can keep client affairs private.

10 The audit firm's money laundering reporting officer 

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 CHAPTER 2 Systems of internal control
1 Internal control is the process designed , implemented and maintained

by those charged with governance , management and other

personnel to provide reasonable assurance about the achievement

of the entity's objectives with regard to the reliability of

financial reporting , effectiveness and efficiency of operations

and compliance with applicable laws and regulations.

2

A company should only pay for work done by employees. Control objective

Company vehicles are used by employees for their own purposes. Risk

Part C39t99, in regular use in the business, is reordered when Control procedure
inventory levels fall below 200.

The directors can ensure a good control environment by implementing True

controls themselves and never bypassing them.

The directors should not assign authority for control areas to members of False
staff.

A good control environment always leads to a good system of control False

overall.

A good control environment would usually suggest that the control system is strong, but
this is not always the case. The directors or management who are charged with
governance within the entity should maintain overall authority over the design and
implementation of controls. This function should not be delegated to members of staff.
4 A large company is more likely to have a good control environment than a small company.

Control environment depends on the attitudes, awareness and actions of directors.
Although some small companies may have difficulties in activating controls such as
segregation of duties due to staff restrictions, the attitudes of management will not
necessarily be poorer just because the company is small.
In practice, control activities will be similar in all sizes of company over core activities,
although all companies differ and have some varying objectives, so controls will alter from
company to company to some extent. Large and small companies are likely to be different
in terms of the formality of their control environment, or the formality and extent of their
information systems.

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 5 Who monitors controls depends on the size of the company and its personnel: it may be an
internal audit function, but it could also be the directors, or department heads. 
Who monitors controls will vary from company to company. Larger companies may have
internal audit functions, one of whose key purposes will be to monitor controls. In small
companies, control monitoring is less likely to be formal and is likely to be carried out by
the staff in charge of each function or department.
6 Control objectives over wages:
(1) Employees only paid for work done
(2) Gross pay calculated correctly and authorised
(3) Gross pay, net pay and deductions correctly recorded on payroll
(4) Wages and salaries paid recorded properly in bank records
(5) Wages and salaries recorded correctly in the general ledger
(6) Deductions calculated correctly and authorised
(7) The correct amounts paid to the taxation authorities
7

Internal control procedure

The payroll should be reconciled to other Gross pay, net pay and deductions
records, such as the cash payment for net should be correctly recorded on payroll.
pay per the bank’s records.
The payroll should be authorised by Gross pay should be calculated
someone other than the personnel director. correctly and authorised.
8

Internal control procedure

Non-current assets are inspected regularly. Assets are not maintained properly
for use in the business.
Capital expenditure is approved by the Assets are bought from inappropriate
purchasing director on behalf of the board. suppliers at inflated cost.

Internal control procedure

Inventory store is kept locked. Inventory is stolen.
Goods inwards are checked for quality. Damaged inventory is valued in
the financial statements.

10

A series of questions designed to identify Internal Control Questionnaire

controls in a system. A 'no' answer indicates
a deficiency in controls
A graphic rendition of the system, using Flowchart
conventional symbols to represent controls
and documents

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 CHAPTER 3 Obtaining audit evidence
1

Existence Account balances

Accuracy, valuation and allocation Account balances
Cut-off Classes of transaction

2 All sampling units should have an equal chance of being selected for testing. 
The other statements are all untrue.
3

Simran has been asked to select a sample of 12 Haphazard – where there is such a
sales invoices to trace from sales order to general large population, Simran should
ledger. There are 16 folders of sales orders for the select on a haphazard basis
year, stored in the sales office.
Julie has been asked to select a sample of 5 Systematic – where there is a small
purchase ledger accounts to carry out a supplier population, ordered in a way that
statement reconciliation. There are 16 purchase does not bias the sample (for
ledger accounts. example, alphabetically),
systematic selection is suitable
Ben is selecting a sample of inventory lines to Random – if a random numbers
perform a valuation test. The audit team have been program is available, it could be
instructed to use the computerised techniques used as a suitable method of
available to them, one of which is a sample selection selecting a non-biased sample
program.

Increase in the auditor's assessment of the risk of material misstatement Increase

Increase in tolerable misstatement Decrease
Decision to stratify a large population Decrease

5 Automated tools and techniques are methods of obtaining evidence by using

computers.

Audit software is software that can check data on computer

systems by interrogating or by comparing versions of programs .

Test data is a way of checking computer programming by inputting real

or false information and observing how the program deals with it.

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 CHAPTER 4 Planning: audit risk
1 The auditors must gain an understanding of industry, regulatory and other external
factors, nature of the entity (including selection of accounting policies), objectives and
strategies and business risks, performance measurement, and the internal control system.

2 In order to be able to assess risks 

This will then direct auditors as to what to test and how.

3 Audit risk is the risk that the auditors give an inappropriate opinion on the
financial statements.

Control risk is the risk that the entity's internal control system will not prevent or detect
and correct errors.

Inherent risk is the risk that items will be misstated due to their nature or due to

their context .

Detection risk is the risk that errors will exist in financial statements and the
auditors will not discover them.
4

Auditors cannot affect inherent and control risk as True

inherent and control risks are the risks that errors will
arise in the financial statements as a result of control
problems or the nature of items in the financial
statements of the entity. The auditors cannot control
those factors.
If inherent and control risk are high, detection risk False – detection risk should be
should be rendered low to come to an overall low, but to achieve that auditors
acceptable level of risk. In order for detection risk to should carry out a high level of
be low, the auditors will have to carry out a low level testing
of testing.

The control environment is weak and there is considerable pressure on Increase

management to improve results year on year.

Management has implemented improvements in controls as a result of Reduce

weaknesses identified last year.

Materiality is the concept of significance to users of the financial True

statements.
Performance materiality will usually be higher than materiality assessed False – it will be
for the financial statements as a whole. lower

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 7

The company has diversified its operations during the Increase

year.
The company has discontinued operations in its riskiest Increase – although it might
operating area during the year. seem as though this would
reduce risk, in this year, the
company will have to meet
accounting requirements relating
to the changes, which increases
audit risk

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 CHAPTER 5 Planning: audit procedures
1

Inventory is difficult to audit because it often consists of a large True

number of low value items which are collectively material.
Key assertions to test in relation to inventory are existence, True
completeness and valuation.

It is important to record cut-off correctly so that assets are not True

double counted (receivables and inventory).
It is important to record cut-off correctly so that a liability is not True
omitted in respect of an asset (payables and inventory).
For the purposes of the financial statements, it does not matter if False
the company misstates cut-off between raw materials and work in
progress.

Obtain evidence of the value of raw Purchase invoice

material
Obtain evidence of the value of Both – finished goods will be tested for purchase
finished goods price, cost of conversion, and also net realisable
value (hence testing to after-date sales invoices)

4 Net realisable value is tested with reference to after the year end sales . The value of
items of inventory is compared to post year end sales invoices . This is to ensure that
inventory value is equal to or lower than net realisable value of the inventory.

Attending an inventory count Existence

Tracing counted items to final inventory sheets Completeness
Reviewing after year end sales invoices Valuation

6 Auditors are concerned with completeness, existence, rights and obligations and valuation.


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 7

Receivables circularisation Rights and obligations –

customers might agree that a debt is owed,
but be unable to pay it
Reviewing sales receipts after year end Both – looking at receipts
after-date confirms valuation and that the
company was owed that debt in the first place

8 Auditors usually rely 100% on controls over revenue by carrying out only controls testing.

This is incorrect as revenue is almost certainly a material balance, which must be subject to
some detailed testing (which may be analytical procedures only or tests of detail or a
combination). Auditors may choose not to test controls at all if they appear weak.
9

Bank letter requests are sent out by the auditor True – although the bank will
directly to the bank. only reply if the client has given them
permission to
Bank letter requests should be made at the year False – requests should be made
end date. about a month in advance of the year
end to allow the bank time to process
it
Auditors will commonly test cash balances even if True – because cash is highly
they are not material. susceptible to fraud

10 Auditors are concerned with completeness, existence and obligations. 

11

They represent a better source of evidence than False – this reduces their
replies to a receivables circularisation as they are value as potentially they could be
sent direct to the company. tampered with but they still
represent a good source of third-
party evidence
They are only used when the auditor is unable to False – an auditor would only
do a payables circularisation. carry out a payables circularisation in
exceptional circumstances
Testing supplier statements provides evidence that True
trade payables have not been understated.

12 Auditors should consider that payables might be understated and therefore not
simply select large balances to test (although they must select material items).

Nil balances should also be incorporated into the test.

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 13 Accruals are liabilities other than trade payables that arise because the company
has received a benefit it has not yet paid for.

Non-current liabilities are loans repayable at a date more than

one year after the year end.

14 Auditors are concerned with occurrence, accuracy and completeness. 

15 Accruals at a manufacturer
A manufacturer is likely to have the following accruals:

Wages – if wages are paid in arrears Should be a month's payroll, which can be agreed
to the payroll.
PAYE This should also agree to the payroll as it should be
a month's deductions. It can also be verified to the
after-date payment.
VAT – if the VAT returns are not This should be verifiable to the next VAT return.
coterminous with the year end

Utilities The company is likely to have paid standing

charges for items such as gas, electricity and
water in advance. These can be verified to the
relevant invoices.

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 CHAPTER 6 Evaluation
1 Choose any four of the following:
 A record of audit evidence collected
 Support for any decision made about the auditor’s opinion
 Demonstration of best practice (legal, ethical, professional and regulatory)
 Protection for the firm in the case of litigation (such as negligence)
 Planning, direction, supervision and review of any audit engagement
 A record of any contentious or significant issues identified during the course of the
audit
2 Deficiency: Failure to compare actual payroll costs to budget
No one compares the cost of the payroll (wages, salaries, costs of employers' NI, any
company pension contributions) to the budgeted cost at the start of the year.
Consequence
Errors may arise in the payroll (which could be highlighted by such comparison) and not be
corrected which might result in overpayment of wages or of tax.
Recommendation
The payroll costs should be compared to budget on a monthly basis and variances
investigated. The review should probably be carried out by Richard Bishop when he
approves the payroll, although variance investigation could be carried out by someone
else. This person should be someone other than Cathy to restrict opportunity for payroll
fraud.
3 The auditors need to consider the implications of the litigation on the financial statements
on:
 Potential provision or disclosure required for the compensation
 Potential impact on going concern if the litigation gives ground for further claims
4

The auditors have discovered aggregate misstatements of £25,000 on Not modified

the audit of Spring Cleaners Ltd. Materiality has been set at £100,000.
The directors refuse to amend the financial statements.
March Hare Ltd's largest customer has gone into liquidation. The Modified
directors do not want to write off the debt owed by the customer
which amounts to £25,000, which is material.

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 5

Gamma Ltd has included a warranty provision in the Modified – this is a material
financial statements this year, having introduced a misstatement resulting from an
warranty to be offered to customers. The auditors have accounting policy.
reviewed the warranty terms offered and believe the
assumptions the provision is based on are,
fundamentally, materially wrong.
There is a significant uncertainty about Delta Ltd's Modified – for non-disclosure of
ability to continue as a going concern. As the directors the significant uncertainty
do not wish to make the situation any worse, they have about going concern.
not made any reference to going concern in the notes to
the financial statements.

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 Glossary of terms
It is useful to be familiar with interchangeable terminology including IFRS and UK GAAP (generally
accepted accounting principles).
Below is a short list of the most important terms you are likely to use or come across, together
with their international and UK equivalents.

UK term International term

Profit and loss account Statement of profit or loss (or statement of
profit or loss and other comprehensive
income)

Turnover or Sales Revenue or Sales revenue

Operating profit Profit from operations
Reducing balance depreciation Diminishing balance depreciation
Depreciation/depreciation expense(s) Depreciation charge(s)
Balance sheet Statement of financial position
Fixed assets Non-current assets
Net book value Carrying amount
Tangible assets Property, plant and equipment
Stocks Inventories
Trade debtors or Debtors Trade receivables
Prepayments Other receivables
Debtors and prepayments Trade and other receivables
Cash at bank and in hand Cash and cash equivalents
Long-term liabilities Non-current liabilities
Trade creditors or creditors Trade payables
Accruals Other payables
Creditors and accruals Trade and other payables
Capital and reserves Equity (limited companies)
Profit and loss balance Retained earnings
Cash flow statement Statement of cash flows

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 Accountants often have a tendency to use several phrases to describe the same thing! Some of
these are listed below:

Different terms for the same thing

Nominal ledger, main ledger or general ledger
Subsidiary ledgers, memorandum ledgers
Subsidiary (sales) ledger, sales ledger
Subsidiary (purchase) ledger, purchase ledger

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 Bibliography
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[Accessed March 2021].
Financial Reporting Council. (2010) Practice Note 16 Bank Reports for audit purposes in the United
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(2012). London, FRC.
Financial Reporting Council. (2018) The UK Corporate Governance Code (July 2018). Available
from: https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-
UK-Corporate-Governance-Code-FINAL.pdf [Accessed March 2021].
IFRS Foundation. (2017) IFRS 16 Leases. In International Financial Reporting Standards (2017).
Available from: https://www.ifrs.org/issued-standards/list-of-standards/ifrs-16-leases/ [Accessed
March 2021].
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https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/#standard
[Accessed September 2021]
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Reporting Standards (2014). Available from: http://eifrs.ifrs.org [Accessed March 2021].
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In International Financial Reporting Standards (2020). [Online]. Available from: http://eifrs.ifrs.org
[Accessed March 2021]
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Contingent Assets. In International Financial Reporting Standards (2014). Available from:
http://eifrs.ifrs.org [Accessed March 2021].
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Independent Auditor of an Audit in Accordance with International Standards on Auditing. New
York, IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-international-
quality-control-auditing-review-other-assurance-and-related-services-26 [Accessed March
2021].
International Auditing and Assurance Standards Board. (2018) ISA 230 Audit Documentation. New
York, IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-international-
quality-control-auditing-review-other-assurance-and-related-services-26 [Accessed March
2021].
International Auditing and Assurance Standards Board. (2018) ISA 240 The Auditor's Responsibilities
Relating to Fraud in an Audit of Financial Statements. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 250 (Revised) Consideration of
Laws and Regulations in an Audit of Financial Statements. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 260 (Revised) Communicating
with those Charged with Governance. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 265 Communicating
Deficiencies in Internal Control to those Charged with Governance and Management. New York,
IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-international-quality-
control-auditing-review-other-assurance-and-related-services-26 [Accessed March 2021].

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Bibliography 209
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 International Auditing and Assurance Standards Board. (2019) ISA 315 (Revised) Identifying and
Assessing the Risks of Material Misstatement. New York, IAASB. Available from:
https://www.iaasb.org/publications/isa-315-revised-2019-identifying-and-assessing-risks-
material-misstatement [Accessed October 2021].
International Auditing and Assurance Standards Board. (2018) ISA 320 Materiality in Planning and
Performing an Audit. New York, IAASB. Available from: https://www.iaasb.org/publications/2018-
handbook-international-quality-control-auditing-review-other-assurance-and-related-services-
26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 450 Evaluation of
Misstatements Identified During the Audit. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 500 Audit Evidence. New York,
IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-international-quality-
control-auditing-review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 520 Analytical Procedures.
New York, IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-
international-quality-control-auditing-review-other-assurance-and-related-services-26
[Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 530 Audit Sampling. New York,
IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-international-
quality-control-auditing-review-other-assurance-and-related-services-26 [Accessed March
2021].
International Auditing and Assurance Standards Board. (2018) ISA 540 Auditing Accounting
Estimates, Including Fair Value Accounting Estimates and Related Disclosures. New York, IAASB.
Available from: https://www.iaasb.org/publications/2018-handbook-international-quality-
control-auditing-review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 580 Written Representations.
New York, IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-
international-quality-control-auditing-review-other-assurance-and-related-services-26
[Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 610 Using the work of internal
auditors. New York, IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-
international-quality-control-auditing-review-other-assurance-and-related-services-26
[Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 700 (Revised) Forming an
Opinion and Reporting on Financial Statements. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 701 Communicating Key Audit
Matters in the Independent Auditor’s Report. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 705 (Revised) Modifications to
the Opinion in the Independent Auditor’s Report. New York, IAASB. Available from:
https://www.iaasb.org/publications/2018-handbook-international-quality-control-auditing-
review-other-assurance-and-related-services-26 [Accessed March 2021].
International Auditing and Assurance Standards Board. (2018) ISA 706 (Revised) Emphasis of
Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report. New York,
IAASB. Available from: https://www.iaasb.org/publications/2018-handbook-international-quality-
control-auditing-review-other-assurance-and-related-services-26 [Accessed March 2021].
Proceeds of Crime Act. (2002) SI 2002/29.
Available from: http://www.legislation.gov.uk/ukpga/2002/29/contents [Accessed March 2021].

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210 Diploma in Professional Accounting
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 Index
Corporate governance, 12
A Custody of client assets, 26
AAT Code of Professional Ethics, 23
Customers, 5
Accounting records, 5
Cut-off, 130
Advocacy, 27
Agency, 7, 8
Analytical procedures, 78, 105
Appropriateness, 84
D
Data analytics, 88, 156
Ascertaining the accounting system, 52
Data security and confidentiality, 32
Assertion level, 102
Deficiencies in internal control, 159
Assertions, 84
Detection risk, 103
Assurance engagement, 8
Detective controls, 46
Assurance, 8
Direction of testing, 86
Audit appointment, 9
Directors, 5
Audit committee, 13
Documenting the accounting system, 52
Audit exemptions, 9
Dormant companies, 10
Audit failure, 16
Drawbacks of using automated tools and
Audit files, 156
techniques, 87
Audit plan, 57
Duty of care, 14
Audit procedures, 121
Audit risk, 103, 104, 105, 120
Audit risk model, 103, 104
Audit software, 87
E
Embedded test facilities, 88
Audit strategy, 57
Emphasis of matter paragraph, 163
Auditor’s report, 22
Employees, 5
Automated tools and techniques, 87
Enquiry, 78
Ethical safeguards, 27
Evaluating the accounting system, 55
B Expectation gap, 17
Bank confirmation letter, 138
External audit, 8
Bank reconciliation, 137
External confirmation, 78
Banks, 5
Bannerman paragraph, 16
Benefits of being a company, 5
Benefits of using automated tools and
F
Factors that contribute to strengths and
techniques, 87
deficiencies in accounting systems, 55
Block selection, 90
Faithful representation, 7, 8
Borrowings, 139
Familiarity, 27
Breach of duty of care, 15
Fees and other types of remuneration, 26
Financial Reporting Council (FRC), 11
Financial statement level, 102
C Finished goods, 128
Calculation of materiality, 109
Flowcharts, 52, 54
Capital expenditure, 121
Fraud, 18
Cash and bank, 50, 137
FRC, 11
Companies Act 2006, 5, 6
Fundamental principles, 23
Company, 5
Conceptual framework, 24
Confidence level, 91, 93
Confidentiality, 23, 30
G
Gifts and hospitality, 26, 27
Confirming the accounting system, 55
Government, 5
Conflicts of interest, 31
Control activities, 45
Control environment, 43, 46
Control objectives, 49
H
Haphazard selection, 90
Control procedures, 49
Control risk, 103

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 ISA 705 (revised) Modifications to the
I Opinion in the Independent Auditor's
IAASB, 11
Report, 110, 163
IAS 17 Leases, 123
ISA 706 (revised) Emphasis of Matter
IAS 2 Inventories, 126
paragraphs and Other Matter paragraphs
IAS 37 Provisions, Contingent Liabilities and
in the Independent Auditor's Report, 163
Contingent Assets, 140
ITF (Integrated Test Facilities), 88
Independence in appearance, 23
Independence of mind, 23
Independence, 23, 27
Information processing, 45
L
Leases (IAS 17), 123
Information system, 43
Liability cap, 16
Inherent limitations of internal controls, 46
Liability limitation agreements, 16
Inherent Risk, 103
Limited assurance, 17
Inspection, 78
Limited liability partnership (LLP), 16
Integrity, 23
Loss caused, 15
Internal audit, 46
Internal Control Checklists (ICCs), 52
Internal Control Questionnaires (ICQs), 52
International Auditing and Assurance
M
Marketing professional services, 26
Standards Board (IAASB), 11
Material and pervasive, 110, 164
International Federation of Accountants
Material misstatements (disagreements), 164
(IFAC), 11, 34
Material, 110
International Standards on Auditing (ISAs)
Materiality, 108
(UK and Ireland), 11
Members in business, 27
Intimidation, 27
Members in practice, 26
Inventory, 50, 124
Money laundering, 18, 30, 159
Inventory count, 124
Money Unit Sampling (MUS), 90
Investors, 5
Monitoring of controls, 46
ISA 200 Overall objectives of the
independent auditor and the conduct of
an audit in accordance with International
Standards on Auditing (ISAs), 10 N
ISA 230 Audit Documentation, 57, 154 Narrative notes, 52
ISA 240 The Auditor's Responsibilities National Crime Agency (NCA), 19, 30
Relating to Fraud in Financial Statements, Negative expression of assurance, 17
18 Negligence, 14
ISA 250 Consideration of Laws and Net realisable value (NRV), 126
Regulations in an Audit of Financial Non-current assets, 50, 121
Statements, 12 Non-current liabilities, 139
ISA 260 Communication with Those Non-executive directors, 46, 159
Charged with Governance, 158 Non-sampling risk, 103
ISA 265 Communicating Deficiencies in Non-statistical sampling, 89
Internal Control to those Charged with
Governance and Management, 159
ISA 315 (Revised) Identifying and Assessing O
the Risks of Material Misstatement, 42 Objectives of the Auditor, 11
ISA 320 Materiality in Planning and Objectivity, 23, 26
Performing an Audit, 108 Observation, 78
ISA 450 Evaluation of Misstatements Opinion, 161
Identified During the Audit, 110, 158 Other payables (accruals), 143
ISA 520 Analytical Procedures, 82 Other receivables (prepayments), 145
ISA 530 Audit Sampling, 89
ISA 540 Auditing Accounting Estimates, 142
ISA 580 Written representations, 158 P
ISA 700 (revised) Forming an Opinion and Payables, 140
Reporting on Financial Statements, 161 Payroll, 50, 142
ISA 701 Key Audit Matters, 161 Performance materiality, 109
Performance reviews, 45

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212 Index
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 Physical controls, 45 Second opinions, 26
Positive expression of assurance, 17 Segregation of duties, 45
Presents fairly in all material respects, 8 Self-interest, 27
Preventative controls, 46 Self-review, 27
Proceeds of Crime Act 2002, 19 Shareholders, 5
Professional appointment, 26 Spectrum of inherent risk, 103
Professional behaviour, 23 Stakeholders, 5
Professional competence and due care, 23, Statistical sampling, 89
27 Stratification, 90
Professional indemnity insurance, 16 Substantive analytical procedures, 82
Professional liability, 14 Substantive procedures, 121
Professional scepticism, 18 Substantive testing, 56, 81
Proportional liability, 16 Sufficiency, 84
Provisions (accounting estimates), 140 Suppliers, 5
Purchases, 50, 142 Systematic selection, 90

R T
Random selection, 90 Technology on auditing, 156
Raw materials, 128 Test data, 88
Recalculation, 78 Tests of control, 56, 79
Related parties, 108 Tipping off, 159
Related party transactions, 108 Trade receivables, 132
Relevance, 84 True and fair view, 8
Reliability, 84
Re-performance, 78
Responsibilities of being a company, 5 U
Restriction of liability, 16 Unable to obtain sufficient appropriate audit
Revenue, 50, 142 evidence (scope limitations), 164
Revision of materiality, 110
Risk assessment process, 102
Risk matrix, 104 V
Risks, 49 Vouching, 78

S W
Sampling risk, 103 Walk-through tests, 55
Sampling units, 89 Working papers, 154
SCARF (Systems Control and Review File), Work-in-progress, 128
88

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