TOPIC 4: PRINCIPLES OF AUDITING

CHAPTER 4

PRINCIPLES OF AUDITING

Topic list

  1. Fundamental concepts
  2. Structure of an audit

 

Learning objectives

By the end of this chapter students should be able to:

 Explain the fundamental concepts of auditing

 Explain the stages in the modern audit.

 

Introduction

 

This chapter starts with key fundamental concepts of auditing which are materiality, true and fair view, audit evidence, independence and audit risk. The role of auditing guidelines will also be discussed and close with structure of an audit.

 

1 Fundamental concepts

 

Below are the fundamental auditing concepts (all the concepts have been explained in other chapters of this manual)

 

  • Materiality

Materiality is the expression of the relative importance of a particular matter in the context of the financial statements as a whole. Information is generally considered to be material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

  • Independence

Independence is essentially an attitude of mind characterized by integrity and objective approach to professional work.  An auditor must be and be seen to be independent; this helps the auditor to give an unbiased opinion on the financial statements.

  • Audit evidence

Audit evidence is all the information used by the auditor in arriving at the conclusion on which the audit opinion is based.  Audit evidence is any information that corroborates or refutes an assertion.

  • Audit risk

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

 

  • Auditor’s responsibility to consider fraud and error in the audit of financial statement.

ISA 240 – The auditors’ responsibilities to relating to fraud in audit of financial statements, gives guidance on how auditors should carry out their procedures in relation to fraud and error.

  • True and Fair view.

             

The role of audit guidelines

Rules governing audits

 

We discussed in Chapter 1 the various stakeholders in a company, and the various people who might read company’s financial statements. Consider also that some of these readers will not just be reading a single company’s financial statements, but will also be looking at those of a large number of companies and making comparisons between them.

 

Readers want assurance when making comparisons that the reliability of the financial statements does not vary from company to company. This assurance will be obtained not just from knowing that each set of financial statements has been audited, but knowing that this has been done to common standards. There is a need for audits to be regulated so that auditors follow the same standards. As we see in this chapter, auditors have to follow rules issued by a variety of bodies. Some obligations are imposed by governments in law, or statute. Some obligations are imposed by the professional bodies to which auditors are required to belong, such as the ACCA. International Standards on Auditing (ISAs) are produced by the International Auditing and Assurance Standards Board (IAASB), a technical standing committee of International Federation of Accountants (IFAC), which also issues standards relating to review engagements, other assurance engagements, quality control and related services. An explanation of the workings of the IAASB, the authority of ISAs and so on are laid out in the Preface to the International Standards on Quality Control, Auditing, Review, Other assurance and related services, and these are discussed below.

 

The preface states that the IAASB’s objective is the development of a set of international standards that are accepted worldwide. The IAASB’s pronouncements relate to audit, other assurance and related services that are conducted in accordance with international standards.

 

Within each country, local laws and regulations govern, to a greater or lesser degree, the practices followed in the auditing of financial or other information. Such regulations may be either of a statutory nature, or in the form of statements issued by the regulatory or professional bodies in the countries concerned. For example, Malawi adopted the ISAs and the Companies Act provides legislative regulations.

International Auditing Practice Statements (IAPSs) provide interpretive guidance and practical assistance to professional accountants in implementing ISAs and to promote good practice.

 

Any limitation of the applicability of a specific ISA is made very clear in the Preface. ISAs do not override the local regulations referred to above governing the audit of financial or other information in a particular country;

  • To the extent that ISAs conform with local regulations on a particular subject, the audit of financial or other information in that country in accordance with local regulations will automatically comply with the ISA regarding that subject.
  • In the event that the local regulations differ from, or conflict with, ISAs on a particular subject, member bodies should comply with the obligations of members set forth in the IFAC Constitution as regards these ISAs (ie encourage changes in local regulations to comply with ISAs).The IAASB also publishes other papers, such as Discussion Papers, to promote discussion on auditing, review, other assurance and related services and quality control issues affecting the accounting profession, present findings, or describe matters of interest relating to these engagements.

 

Below is a list of International Standards on Audit (ISA) issued by the International Audit and Assurance Standards Board (IAASB) under the International Federation of Accountants (IFAC) – 2013 Edition:

 

Number          Title

200       Overall objectives of the independent auditor and the conduct of an audit  in accordance with international standards on auditing.

210      Agreeing the terms of audit engagement.

220      Quality control for an audit of financial information.

230      Audit Documentation.

240      The auditors’ responsibilities to relating to fraud in audit of financial  statements.

250      Consideration of laws and regulations in an audit of financial statements.

260      Communication with those charged with governance.

265     Communication deficiencies in internal control to those charged with  governance  and management.

300      Planning an audit of financial statements.

315      Identifying and assessing the risks of material misstatement through  understanding the entity and its environment.

320      Materiality in planning and performing an audit.

330      Auditor’s responses to assessed risk.

402      Audit considerations relating to entities using service organizations. 450      Evaluation of misstatement identified during audit.

  • Audit evidence.
  • Audit evidence – specific consideration for specific items.

505       External confirmations.

510      Initial audit engagements – opening balances.

520         Analytical procedures.

530         Audit sampling.

540      Auditing accounting estimates, including fair value accounting estimates and  related disclosures. 550   Related parties.

560         Subsequent events.

570         Going concern.

580        Written representations.

600      Special considerations – audits of group financial statements (including the work  of component auditors).

610        Using the work of internal auditing.

620         Using the work of an auditor’s expert.

700        Forming an opinion and reporting on financial statement.

  • Modifications to the opinion in the independent auditors’ reports.
  • Emphasis of Matter paragraphs and other matter paragraphs in the independent auditor’s report.

710      Comparative information – corresponding figures and comparative financial  Statements.

720      The auditor’s responsibilities relating to other information in documents  containing audited financial statements.

800      Special considerations- audits of financial statements prepared in accordance with  special purpose frameworks.

805     Special consideration – audits of single financial statement and specific elements,  accounts or items of a financial statement.

810      Engagements to report on summary financial statement.

 

2 Structure of an Audit

 

This section discusses the stages in the modern audit which help the auditor to carry out the audit methodically. There are twelve main stages for modern audits;

 

Planning

 

Stage 1

 

 

The scope of the audit and the general audit approach should be determined. The scope looks at audit procedures necessary to achieve audit objectives.

The letter of engagement will set out the terms of the audit and will be confirmed before the start of any audit.

Auditors must prepare an audit strategy to be placed on the audit file

Stage 2 The aim of the stage is to enable the auditor to obtain information to enable the auditor to assess the risk of material misstatements in the

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financial statements. Procedures include; enquiries of management, observation and inspection and prior period knowledge.

 

Stage 3 The objective at this stage is to determine the flow of documents and the extent of controls in existence. This is a fact finding exercise

 

Stage 4 The objective here is to prepare a comprehensive record for use in the evaluation of the systems.

 

Stage 5 The auditors’ objective here is to confirm that the system recorded is the same as the system in operation. Walk through tests may be used

Stage 6 The purpose of evaluating the system is to assess their reliability and formulate a basis for testing their effectiveness in practice.

 

Control evaluation

 

Stage 7 If controls are assessed as effective in theory, tests should be performed to check that they do work in practice .These are called tests of controls.

 

This should only be performed if controls evaluated have been confirmed as being effective

 

If the auditors know that the controls are ineffective, then there is no point in carrying out tests of controls which confirms what is already known. Instead the auditors should just go straight to substantive procedures.

 

Stage 8            After evaluating the systems and carrying out tests of controls, auditors normally send management a report to management identifying weaknesses and recommending improvements.

 

Detailed substantive testing

 

Stage 9 The auditor must always carry out substantive procedures on material items. These tests are not concerned with the working of the system but substantiating the figures in the accounting records and financial statements.

 

Review and reporting

Stage 10 The aim of the overall review is to determine whether the financial statements are consistent with the auditors’ understanding of the business and the audit evidence obtained, and comply with accounting regulations. The auditors do this by critical analysis of the content and presentation of the financial statements.

 

Stage 11

 

The report to the members is the end product of the audit in which the auditors express an opinion of the accounts
Stage 12 The report to management is an additional end product of the audit. Its purpose is to make further suggestions for the improvements in the systems and to place on record specific points in connection with the audit and accounts.

 

 

END OF CHAPTER QUESTION

 

Question one

  • Explain the legal requirements for incorporated companies and other interest groups to have a statutory audit.

5 Marks

  • Explain the role played by the International Standards on Audit (ISAs) and other related pronouncements in the conduct of the audit.  5 Marks

Total  10 Marks

 

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