Introduction to Auditing

INTRODUCTION TO AUDITING

Sardar Asim Hassan Khan

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Introduction to Auditing Auditors are independent Stakeholders 1- Accuracy of financial statements Checking of financial statements Go deep into the figures Dig out the problems concealed from the public. Past performance of the company 2- Future Forecasting (Going concern issues) 3- Internal Control systems of the company (efficiency of management) Audit: Audit is independent examination and expression of opinion on the financial statements of the company. Positive and Negative Assurance: 1- Positive assurance is given by the auditor when he thinks things are fine. For Example: 1- Account show true and fair view. 2- Internal control system of the company are strong 3- Forecasting is correct 2- Negative assurance is given, when the auditor states that nothing wrong was found. For Example 1- Forecasting doesnt seen to be unreasonable 2- An internal control system of the company doesnt seen to be weak. e.g True and fair Net cuurent assets = current assets current liability 2 m 1.9 m = 100,000/Account reconciliation letter by the auditor to the person who receive this payment. Company is able to clear all its liability Or

Sardar Asim Hassan Khan

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Introduction to Auditing Company assets are capable to clear all its liabilities 2 m is true BUT NOT FAIR IF STOCK is stuck due to change of legislations, technical change etc. The stock has been entered correctly at cost but lost its worth due to internal or external factors. If it is true then it must be practically possible. If negative assurance is given by the auditor then two things are possible. 1- Did the auditor put enough effort to find out the problem? 2- Has the management provided enough evidence that was required by the auditor? May be some information is not provided. Ethics: According to ACCA Conduct of auditor Personality of auditor 1- Integrity in Auditor: It means straight forward and honest to its profession. Honestly and straight forwardly quoted the facts. 2- Objectivity: Without biasness No favoritism Only based on facts (decision) 3- Professional Competence: Qualification Understanding the industry 4- Confidentiality: Auditor has the excess to see all the particular confidential information. 5- Professional Behavior: a- Work level Do no go for personal dinner Do not accept gifts b- Advertisement Level Show your strengths Do not defame other

Sardar Asim Hassan Khan

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Introduction to Auditing

Type 1: Self Threats to professional Ethics: Such circumstances ethics should be threatened 1- Financial Interests: If the auditor have shares of particular company then he is not like to issue unfavorable audit report, because after that share price might go down and he suffer loss and difficult to issue unbiased report. 2- Business Relationship: a- If you have worked in that company, then you have affiliation with the company. b- If you have business relationship, e.g, if you maintained supplier or buyer relationship. 3- Family Relationship: Such as a- Brother b- Uncle 4- Loans and Guarantees: If your audit client is a bank and if you have obtained loans from the bank or the bank extended some guarantee on your behalf, again it would be difficult for the auditor to annoy the bank as after unfavorable report the bank might call back the loans or withdraw the guarantee. 5- Overdue fees: If there has been a overdue fess that has to be recovered by the auditor, it will be threat for the auditor to issue unfavorable report as after that he might no be able to recover it. 6- Contingent Fees: It is an agreement between the auditor and the company that higher fees would be paid, if favorable report is issued or vice versa. 7- Low Balling: It is a practice of quoting a very low audit fees in the hope that profits would be made from some work awarded by the company.

Sardar Asim Hassan Khan

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Introduction to Auditing

Type 2: 1- Recruitment for the client: Recruitment of staff on behalf of client should not be done. Here, the danger is if members of the staff recruited by the auditor then subsequently auditor would be reluctant to criticize the performance of people recruited by him. 2- Internal Audit Services: Sometimes the auditor prepares the financial statement or extends the internal services audit for the client. Thereafter, he would be reluctant to criticize the work he himself performed. Type 3: Advocacy Threat: Sometime, the audit firm supports the company in some form of dispute in a court of law, thereafter; the unfavorable audit report might serve as evidence against that particular case. Type 4: Intimidation Threats: 1- Litigation 2- Black mailing 3- Physical intimidation Concept of Materiality: The matter is material if its omission or misstatement would influence the decision of stakeholders. Audit Report: Independent Audit Report: 1- Paragraph 1: Defines financial statements reviews by auditor. 2- Paragraph 2: Auditors responsibilities are just to express our opinion on just the evidence. 3- Paragraph 3: Auditing standards, which auditing standards will be follow. 4- Paragraph 4: Sardar Asim Hassan Khan Page 5

Introduction to Auditing Opinion paragraph

Favorable Report: True and fair Free from material misstatements 5- Paragraph 5: Other requirements such as according to State Bank requirements to review additional statements. 6789Signature Date Address Contact Numbers

Types of Audit Report: 1- Unmodified Audit Report: It is favorable audit report. True and fair and free from material misstatement. There are not modified changes required in financial statements. Unqualified Decision: o It does not qualify for errors. 2- Modified Audit Report: iMatters that do affect the auditors opinion. There are some errors, issues in audit report due to which auditors opinion are affected. When financial statements need modification 1- Errors: There are errors in financial statements. 2- Evidence : Auditor has unable to obtain sufficient evidence. A/P situation Do not meet with bank manager Qualified opinion iiMatters that do not affect the auditors opinion.

There might be something in financial statements that need to be emphasized so that the user of the audit report does not miss it.

Sardar Asim Hassan Khan

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Introduction to Auditing

1- Emphasis of Matter Decision: The auditor still thinks that financial statement represents fair and true and free from material misstatements. Here the emphasis of material of decision is given because this paragraph draws the attention of the reader to a particular point which has already been disclosed in financial statements but the auditor is worried that reader might miss that point while studying the financial statements. e.g. Contingent Liability Which decision and outcome is not conformed. Our financial statement has to be closed on 31st December but supplier has filed a claim on the 25th December. The proceedings will continue and decision will come out in six to seven months. The company cannot take this claim as a liability. This liability is in the notes. This makes the report true, fair and all materials are complete. The emphasis of matter decision is given here but auditor says that I want to emphasis on Note- 10. ABC has filed a sue against the company of 5 million, however, if the decision goes against so there will be a problem in the going concern of the company otherwise everything is fine. There is a deep linkage between emphasis of matter decision and going concern issues of the company. 1- Negative Operating Cash Flows: Over a long period of time. 1- Inability to paid suppliers in time 2- Partnership Issues 3- Borrowing facilities not agreed by the bank 4- Change in the external environment of the company a. Technology change b. Government Rules and Regulations c. Competitors 5- Non-compliance with regulations Qualification Matrix: One type of error makes financial statement useless. Material but not Pervasive Except for Except for Pervasive Adverse Disclaimer

Errors Evidence

Pervasive: Sardar Asim Hassan Khan Page 7

Introduction to Auditing The issue is large enough 1- Make the financial statements useless. 2- Because of that issue there is a question mark(?) On the normal operations of the company Except For: e.g Every thing is correct except for depreciation otherwise, it will fine. Disclaimer: Auditor refuses to give any decision. No errors he will find.

Sardar Asim Hassan Khan

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Introduction to Auditing

Process of Audit
Plan the Audit

Understand the entity

Assess Risk of Material Misstatment

Effective Controls

Ineffective Controls

Test of Controls (TOC)

Substantive Testing

Limited Substentive Testing

Audit Report Plan the audit: To carry out any work effectively General strategy in a detailed manner o Overall layout o Where head office located o No. of branches o No. of staff required Required skills in staff member Expertise Opinion o Expert person from insurance company You need to identify the important areas Sardar Asim Hassan Khan Page 9

Introduction to Auditing o Financial statements o A/R o Inventory Identify the problematic areas o If company shifted from manual to computer system Co-ordination with the parties (department heads) Understand the Entity: 1234Nature of business Rules and regulations Accounting policies (which policy of accounting they use) Internal control system a. Invoice process b. Inventory process

Assess Risk of Material Misstatement: Risk Analysis: The auditor has analysis the total risk of the company (TR). Total Risk can be sub divided into two categories. 1- Business Risk (BR) 2- Audit Risk (AR) 1Business Risk: Business risk results from the circumstances or from the actions of management that later effect the companys ability to achieve its objectives. (Circumstances include external factors). Business risk will be further divided into three categories. 1- Financial Risk (FR) 2- Operational Risk (OR) 3- Compliance Risk (CR) 1- Financial Risk: It arises from high borrowings. When company under the financial burdens Interest rate increase Circumstances: o Financial risk rises because of interest rate that put the business under swere pressure and that can increase the going concerns of the company. Management: o Financial risk arises from high borrowings. Sardar Asim Hassan Khan Page 10

Introduction to Auditing

2- Operational Risk: Operational risk arises from the operational errors e.g. Quality production, too many warranty claims, products are old fashioned. Circumstances: o New technology Management: o Reputational Risk (RR)

3- Compliance Risk: Compliance risk arises from failure to comply with rules and regulations that mean business may face large penalties or they might be prevented from continuing to trade. Circumstances: o Due to child labor in the company Managements: o Law breakage, drainage 2- Audit Risk (AR): The risk that auditor gives an in appropriate opinion on the financial statement. Audit Risk will be further divided into three categories. 1- Internet Risk (IR): 2- Control Risk (CD): 3- Detection Risk (DR): 1- Internet Risk (IR): Financial statements would actually contain errors and material misstatement e.g. Control system 2- Control Risk (CD): It is the risk that companys own control procedures are not strong enough to locate / pick that error and then corrects it. International Control System o AR=IR x CR = 100% * 100% = 100% 3- Detection Risk (DR): It is basically the failure of the auditor to detect the errors from financial statements, this will be increased if auditor is inexperienced, the planning was poor, the industry is new to him and there have been some time and money pressures. Sardar Asim Hassan Khan Page 11

Introduction to Auditing AR=IR x CR x DR = 100% * 100% * 0 = 0

o Note:

To decrease the detection risk in this case, where the IR is high and CR is also high , the auditor will have to work harder. Audit Risk has to be reduced at two levels 1- Financial Statement Level: Figure appearing in the financial statements can be time but overall effect of financial statement can be misleading. It might not show true and fairview 2- Assertion Level: Claim level, whatever the figures are appearing they are claiming something. Qualities of Figures: Figures appearing in financial statement are making some assertions, claiming something and these figures should be (ACCACOVER) Accurate Complete Cut of his correct Allocated Classified Occurrence Valuation Existence Rights and obligations

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1- Accurate e.g. A/R Value should not be overstated Provision of bad debt also deducted 2- Complete: All account receivables should be included. 3- Cut of his correct: Inventory Cash/AR+

Sardar Asim Hassan Khan

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Introduction to Auditing

4- Allocated: Expense item should be allocated in the proper account. 5- Classified: The transaction should be recorded into proper account with proper amount. 6- Occurrence: Should occur in the same account. 7- Valuation: Should be value properly. 8- Existence: Exist accurate and completely. 9- Rights and Obligations: You should have legal right on that asset. Audit Evidence: There are five sources of audit evidence (AEIOU) 12345Analytical Procedures Enquiry Inspection Observation Recalculation

1- Analytical Procedures: It is basically calculating the ratios and then comparing it with last year results, budget and industry standard. Any dramatic change can give rise to a question of its existence. 2- Enquiry (Enquiry and Conformation): Ask the internal staff and the third parties to conform the actual situation. 3- Inspection: Physical inspection of goods and inventions. 4- Observation: Observing the departments whether the control are being followed or not. 5- Recalculation: Recalculating the figures to check its accuracy and re-performance of the activities to check if final results are accurate or not. 4- Test of Controls (TOC): To check that controls are implemented properly and they have been followed. Sardar Asim Hassan Khan Page 13

Introduction to Auditing

5- Limited Substantive Testing High volume Testing Audit Internal Control Systems: 1- Purchase system: A good purchase system will ensure 1- Goods are ordered when they are needed. 2- They should be ordered at competitive prices in required quantity and except able quantity. 3- Goods should be ordered from the authorized supplier. The goods are received on correct time, quantity and condition. 4- The goods are booked into inventory. 5- Invoices are checked and reconciled to GRN (Good Received Note) and then with the contract to ensure that quantity, quality and rate is correct. 6- Invoices are entered into payable ledger with the correct amount. 7- Payment should be made properly to the supplier. 2- Sales System: 1- Orders should be accepted from the credit worthy system. 2- The goods are properly dispatched (Out Word Gate Pass) 3- The delivery would be invoiced properly and accurate. Invoices are entered into receivable ledger 4- Payment is received when due. Here the auditor would check if the company is preparing age listings. Buyer name Age listing Quantity Overdue days Date Rate Total amount OGP 5- Credit control procedures have been properly implemented. e.g. Credit control 6- The auditor will check the system by reconciling contracts with OGPs, Invoices and receivable ledgers. 3- Wage System: A good internal control system of wages and salaries should ensure. 1- Employees are hired when necessary. 2- Employees are paid competitive rates. 3- Hours worked are accurately recorded. Sardar Asim Hassan Khan Page 14

Introduction to Auditing 4- Net pay and detection are properly calculated. 5- Payments are made accurate to employees. 6- Concept of leavers and joiners. Audit of Receivables: 1234Individual ledger balances will be reconciled with the control accounts. Correspondence of company with customs will scrutinized. The auditor will look at the board minutes and will attend the board meetings. Collection period: The auditor will calculate day sales outstanding ratio and then compare with industry standards. 5- Wait for the payment; the auditor should wait for the payments against sales that have been at the end of the year. 6- Correspondence with customers the auditor will write a letter to the debtors of the company to conform the balances.

Audit of Payables: 1234Individual ledger balances will be reconciled with the control accounts. Correspondence of company with suppliers will scrutinized. The auditor will look at the board minutes and will attend the board meetings. Payable Collection period: The auditor will calculate day sales outstanding ratio and then compare with industry standards. 5- Wait for the payment: The auditor should wait for the payments against sales that have been at the end of the year. 6- Correspondence with suppliers the auditor will write a letter to the creditors of the company to conform the balances.

Contingent Assets and Liabilities: 1- Contingent liabilities: 1- Probable Situation: o If the present obligation probably requires the outflow of resources, then the provision is recognized and disclosure is required. 2- Possible Situation: o Possible obligation means the present obligation will not require the outflow of resources. o No provision is required but disclosure is required by way of a note. 3- Remote Situation: o If the chances for outflow of the resources is remote then no provision and no disclosure is required.

Sardar Asim Hassan Khan

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Introduction to Auditing

2- Contingent Assets: 1- Probable Situation: o If the inflow of benefit is certain, then asset is not contingent. It is a real asset and should be shown in the financial statements. 2- Possible/ Up Probable Situation: o When there are more chances of getting economic benefit but you are not certain so not shown in financial statement but you have to disclosure with the help of a note. 3- Remote Situation: o No disclosure and no provision is required.

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