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ACCA F-8

Audit Evidence

Audit Procedure & Sampling

Audit Evidence gives the guideline to Auditor to design & perform audit procedures in such a
way that it enables auditors to:

- Obtain sufficient, appropriate audit evidence.


- To be able to draw reasonable conclusions.
- To enhance confidence of the user.

Substanstive Procedure:

Substanstive Procedure are tests to obtain audit evidence to detect material


misstatements in the financial statements. They are generally of two types:

- Analytical Procedure
- Tests of detail of transactions, account balances & disclosures.

ISA 330 also requires that, whatever level of substantive procedures are carried out
the auditor must carry out the following procedures:

- Agree or reconcile the financial statements to the underlying accounting


records.
- Examine material journal entries.
- Examine other adjustments made during the course of prepearing the
financial statements.

financial statement assertions is the set of information that the preparer of


financial statements (management) is providing to another party. Financial
statements represent a very complex and interrelated set of assertions. At the
most aggregate level, the financial statements include broad assertions such as
"total liabilities as at 31 December are $50 million", "total revenue for the year is
$9 million" and "net income for the year is $3 million".

Auditors decompose these broad assertions into a detailed set of statements


referred to as management assertions, separated into three categories:

1. Transactions:
o Occurrence — the transactions actually took place
o Completeness — all transactions that should have been recorded have
been recorded
o Accuracy — the transactions were recorded at the appropriate
amounts
o Authorization — all transactions were properly authorized
o Cutoff — the transactions have been recorded in the correct
accounting period
o Classification — the transactions have been recorded in the proper
accounts
2. Accounts balances:
o Existence — assets, liabilities and equity balances exist
o Rights and Obligations — the entity holds or controls the rights to its
assets and owes obligations to its liabilities
o Completeness — all assets, liabilities and equity balances that should
have been recorded have been recorded
o Valuation and Allocation — assets, liabilities and equity balances are
included in the financial statements at appropriate amounts and any
resulting valuation or allocation adjustments are appropriately
recorded.

3. Presentation and disclosure:


o Occurrence — the transactions have occurred
o Rights and Obligations — the transactions pertained to the entity
o Completeness — all disclosures that should have been included in the
financial statements have been included
o Classification and Understandability — financial statements are
appropriately presented and described, and information in disclosures
are clearly expressed.
o Accuracy and Valuation — financial and other information is disclosed
fairly and at appropriate amounts.

Directorial Testing:

Substantive test are designed to discover errors or omissions

- Tests designed to discover errors: Tests should detect any


overstatement & also any understatement through causes other than
omission. For example: if a test is designed to ensure that sales are priced
correctly, it would begin with a sales invoice selected from the sales ledger.
Prices would then be checked to the official price list.

- Tests designed to discover ommisions: These tests must start from


outside the accounting record & then matched back to those records. For
example: to discover whether all purchases are processed properly it must
have GRN (Good Received Note) & post it on Inventory A/C or purchase
ledger.

Analytical Procedure:

Analytical Procedures is one of financial audit skill which help an auditor


understand the client's business and changes in the business, to identify potential
risk areas and to plan other audit procedures.

Analytical Procedures include comparison of financial information (data in financial


statement) with

1. prior periods
2. budgets
3. forecasts
4. similar industries and so on.

It also includes consideration of predictable relationships, such as:


1. gross profit to sales,
2. payroll costs to employees.

Example Question:

You are part of the audit team auditing the financial statements of Sweep Co, a
small office supplies business, for the year ended 31 March 20X9. The company
employed the following staff at the start of the financial year: 7 office and
warehouse managers, 20 warehouse staff and 25 office staff.

The pay ranges for each category of staff is shown below:

Office and warehouse managers: $35-$50k per year

Warehouse and office staff: $18-$25k per year

You have been asked to audit the wages and salaries expense for the year. All staff
were given a 4% pay rise in the year, backdated to the start of the year. One of the
office managers left the company part-way through the year. There were two new
members of warehouse staff and three new members of office staff. The expense
for the year is shown in the draft income statement as $1,249,450.

Required

Using analytical procedures, perform a proof in total on the wages and salaries
expense for the year.

Answer

An expectation of the charge for the year can be developed using the information
provided and compared to the charge in the draft income statement to assess its
reasonableness.

Managers

Based on salary range, average annual salary: $42,500

Applying the 4% rise: $44,200

Total average salary for year (i.e. 7): $309,400

Assume leaver left half-way through year: ($22,100)

Total for managers:

$287,300

Office and warehouse staff

Based on salary range, average annual salary: $21,500


Applying the 4% rise: $22,360

Total average salary for year (i.e. 40, exclude starters): $1,006,200

Assume starters started half-way through year: $55,900

Total for office and warehouse staff:

$1,062,100

Expected total expense for wages and salaries: $1,349,400

Expense per draft income statement: $1,249,450

Difference: 8%

The difference between the expected total and the expense in the draft income
statement is 8%. The auditor needs to consider whether this is acceptable in light
of materiality for the financial statements as a whole and performance materiality
and the risk of material misstatement and whether further explanations from
management may be necessary.

Accounting Estimate

An accounting estimate is an approximation of a monetary amount in the absence


of a precise means of measurement.

Example of accounting estimates:

 Inventory Obscolescence.
 Warranty Obligation.
 Depriciation method or useful life.
 Provision regarding the CV of an investment where there is uncertainty
regarding its recoverability.

Audit Sampling:

Definition
Audit sampling means the application of audit procedures to less
than 100% of the items within a class of transactions or account
balance such that all sampling units have an equal chance of
selection, in order to assist in forming a conclusion concerning
the population from which the sample is drawn [ISA 530].

3.2 Statistical vs non-statistical sampling


Statistical sampling is any approach to sampling that has the
following characteristics: (a) random selection of a
sample, and
(b) use of probability theory to evaluate sample results,
including measurement of sampling risk.
A sampling approach that does not have characteristics (a)
and (b) is considered non- statistical sampling.

Selection of the sample


The auditor should select items for the sample with the
expectation that all sampling units in the population have a
chance of selection. [ISA 530]. While there are a number of
selection methods, four methods commonly used are
(a) Random selection, using a computerised random
number generator or random number tables.
(b) Systematic selection, in which the number of sampling
units in the population is divided by the sample size, to
give a sampling interval, e.g. 50, and having determined a
starting point within the first 50 (preferably randomly),
each 50th sampling unit thereafter is selected. When using
systematic selection, the auditor needs to ensure that the
population is not structured in such a manner that the
sampling interval corresponds with a particular pattern in
the population;
(c) Haphazard selection, in which the auditor selects the
sample without following a structured technique, but which
avoids any conscious bias or predictability (e.g. avoiding
difficult to locate items, or always choosing or avoiding the
first or last entries
on a page). This may be an acceptable alternative to
random selection provided the auditor is satisfied that the
sample is not unrepresentative of the entire population; and
(d) Value weighted selection, where items are selected for
testing by weighting the items in proportion to their value.
It can often be efficient in substantive testing, particularly
when testing for overstatement. It is also known as
‘monetary unit sampling’ (MUS). This is a technique which,
when applied correctly ensures that every $1 in a
population will have an equal likelihood of being selected
for testing. Under MUS, material balances will be
automatically selected.

3.9 Tests of detail


For tests of detail, the auditor should project monetary errors
found in the sample to the population and compare this to the
tolerable error.
Where an error has been established as an anomalous error, it
may be excluded when projecting sample errors to the population
(but still need to be considered overall in addition to the
projection of the non-anomalous errors).
Where a class of transactions or account balance has been
divided into strata, the error is projected for each stratum
separately.

3.10 Tests of controls


For tests of controls, no explicit projection of errors is necessary
since the sample error rate is also the projected rate of error for
the population as a whole.
For example, if the auditor has performed tests of controls on a
sample of 20 items and has found 2 deviations, this represents an
error rate of 10% (2/20 x 100). The auditor must then decide if
this error rate is acceptable.
11: AUDIT PROCEDURES AND
SAMPLING

3.11 If the evaluation of sample results indicates that the


assessment of the relevant characteristic needs to be
revised, the auditor may:
(a) request management to investigate identified errors and the
potential for further errors and make any necessary
adjustments; and/or
(b) modify the nature, timing and extent of further audit
procedures; and/or
(c) consider the effect on the auditor's report.

Lecture example 3

Preparation

You are auditing trade receivables and have obtained the following
results based on your sample:
– Total value of the population $1,000,000
– Number of items in the population 400
– Number of items tested 20
– Sample value $200,000
– Error in sample $9,000
Required
(a) Assuming the errors are not anomalous ones, calculate the
expected error in the population. (b) Assuming that tolerable error was
set at $40,000, explain what action should be taken.

Solution
• Ratio method extrapolation
Error rate in sample x total value in population
Computer-Assisted Audit Techniques (CAATs) which provide a means of accessing
large amounts of data in a format that can provide transparency not attainable through
other auditing procedures. The use of CAAT’s increases audit effectiveness, improves
efficiency and decreases the audit risk.

With the use of a specialized software tool, our team can provide organizations with a
unique and powerful combination of data access, analysis and integrated reporting. Using
the specialized software tool our experts can access and compare enterprise data, flat files
or relational databases, spreadsheets, report files, on PCs or servers, allowing the source
data to remain intact for complete data quality and integrity.

NON-CURRENT ASSETES

Audit objectives for tangible non-current assets

Financial statement assertion

Existence and occurrence

– Additions represent assets acquired in the year and disposal


represent assets sold or scrapped in the year.

– Recorded assets represent those in use at the year-end recorded.

Completeness

– All additions and disposals that occurred in the year have been.
– Balances represent assets in use at the year-end.
Rights and obligations

– The entity has rights to the assets purchased and those


recorded at the year-end.

Accuracy, classification & valuation

– Non-current assets are correctly stated at cost less accumulated


depreciation.

– Additions and disposals are correctly recorded.

Assertions relating to presentation & disclosure

 Disclosures relating to cost, additions and disposals,


depreciation presentation and disclosure policies, useful
lives and assets held under finance leases are
adequate and in accordance with accounting standards
(occurrence and rights and obligations, completeness,
classification and understandability, accuracy and
valuation)

Intangible Non-Current Asset

Key Assertions for Intangible Assets:

Goodwill:

- Check the consideration to sale agreement.


- Consider whether the asset valuation is reasonable.
- Check the method used for goodwill calculation & recalculate if
possible.
- Review the impairment & discuss with management.

Research & Development Cost:

- Check whether it meets the criteria of IAS 38 (Research &


Development Cost)
- Confirm the feasibility & viability by inspection of budgets.
- Recalculate amortization calculation.
- Inspect invoices to verify expenditure incurred on R&D
expenditure.

Other Intangible Assets:

- Assess the purchased documents agreement.


- If required inspect the valuation from expert professionals.
- Review amortization calculation & ensure they are correct by
re-calculation.

Inventory

Assertions related to Inventory

Existance & Occurance

- Recorded Sale & Purchases reconcile with the consumption of


inventory & stock on hand.
- Inventory on the financial statement physically exists.

Completeness

- All purchases & Sales are recorded.


- All inventory in the year end are recorded in the financial
statement.

Accuracy, Classification & Valuation

- Costs accurately recorded in accordance with IAS.


- Inventory is valued correctly (Lower of Cost & NRV).

Cut Off

- All purchases & Sales of inventory are recorded in the current


period.
Presentation & Disclosure

- Inventory is properly classified in the accounts.


- Disclosures relating to classification & valuation are adequate
& in accordance with accounting standard.

Audit Precedure for Inventory

Power Point Slide

Physical Inventory Count

Where inventory is material auditors shall obtain sufficient


appropriate audit evidence regarding its existence & conditions by
attending the physical inventory count to do the following:

- Evaluate management’s instructions & procedure


for physical inventory count.
- Inspect the inventory.
- Perform test counts.

Cut-Off

Auditors should consider whether management has adequate cut-


off procedures. Procedures intended to ensure that movements into,
within & out of inventories are properly identified & reflected in the
accounting records.

Purchase invoice should be recorded only if goods where received


prior to the count. A schedule of GRNs should be prepeared & items on
the list should be accrued for in the accounts. Sales cut-off is generally
more straight forward to achieve correctly. Invoices for good
dispatched after the count should not appear in the I/S for the period.

Audit Program for Receivables


BASIC PROCEDURES

1. Obtain or prepare an aged trial balance of accounts receivable.


a. If the trial balance is prepared by the client, test the clerical accuracy. Do not test the accuracy
of the aging of individual accounts until you start Step 7.
b. Briefly inquire of management as to steps taken to ensure the trial balance is complete, i.e., that
all receivables due the company are included on the trial balance. (See also Step 10.)
c. Reconcile the balance to the general ledger account balance.

2. Review the aged trial balance to determine if there are natural groups within the
total population of accounts.

3. Select those groups that will be confirmed 100% by the use of positive confirmation letters.
a. Identify the accounts selected on the aged trial balance.
b. Review those accounts selected for confirmation with the owner/manager. If the client objects to
a confirmation with a particular customer, determine if this restriction will affect your ability to
accomplish the audit objectives for receivables.
c. Have the client prepare the positive confirmation letters reflecting, if possible, on the face of the
letter or in an attached statement, the individual invoice number, invoice date, and invoice amounts that
make up the customer’s balance.
d. Include the audit firm’s return address on all envelopes to ensure that all confirmation requests
that are undeliverable by the post office are returned directly to the audit firm.

4. For the remaining balance that is not confirmed 100% in Step 3, determine if a sample of the
accounts making up the balance should be selected for confirmation.
a. If sampling is appropriate, document the sampling selection process.
b. Repeat program Steps 3a through 3h on accounts being sampled.

Audit for Cash & Balance at Bank

The article is divided into three main sections:


1. Identifying the audit objectives applicable to cash balances.
2. Discussing considerations relevant to developing the audit plan for cash.
3. Designing and executing an audit programme for cash.

Cash audit objectives

Cash balances include cash on hand and at bank. Cash on hand includes undeposited
receipts and petty cash. Cash at bank includes cash held in current and savings accounts
which is available on demand. Unlike any other account balance, cash may be either an
asset or a liability. The latter arises where the bank with which the entity holds an
account allows the entity to write cheques in excess of the balance in the account up to an
agreed limit known as an overdraft. Using the assertions described in SAS 400 (ISA 500)
the audit objectives to be achieved in verifying cash balances are identified in

Table 1.

Table 1: Specific audit objectives for cash balances


Assertion Account balance audit objective
Existence Recorded cash balances exist at the balance sheet date.
Recorded cash balances include the effects of all cash transactions that
Completeness
have occurred.
The entity has legal title to all cash balances shown at the balance sheet
Rights and obligations
date.
Recorded cash balances are realisable at the amounts stated on the
Valuation
balance sheet.
Presentation and
Cash balances are properly identified and classified in the balance sheet.
disclosure
Lines of credit, loan guarantees and other restrictions on cash balances
are appropriately disclosed.

Tests of details of balances

Substantive tests for cash balances in this category include:

1. Count cash on hand.


2. Confirm bank balances.
3. Verify bank reconciliations.
4. Obtain and use subsequent period's bank statement.

Count cash on hand


This test is often omitted as the amount of cash on hand is rarely material. If it is
performed the following procedures are appropriate:

• control all cash held by the entity until all funds have been counted;
• insist that the custodian of the cash be present throughout the count;
• list each item making up the balance;
• obtain a signed receipt from the custodian on return of the funds;
• ascertain that all undeposited cheques are payable to the order of the entity, either
directly or through endorsement;
• trace each item listed to the subsequent bank deposit.

The control of all funds is designed to prevent transfers by entity personnel of counted
funds to uncounted funds. Having the custodian present and requiring his or her signature
on return of the funds minimises the possibility, in the event of a shortage, of the
custodian claiming that all cash was intact when released to the auditors for counting.
Tracing items to the subsequent deposit tests the possibility of a teeming and lading
fraud.

Confirm bank balances

It is customary for the auditors to confirm cash on deposit and loan balances at balance
sheet date directly with the bank. The procedure in the UK is laid down in APB Practice
Note 16, Bank Reports for Audit Purposes, based on an agreement with the British
Bankers Association. Similar arrangements with the banking industry may exist in other
countries. A confirmation request should be sent to all banks with which the entity had
dealings at any time during the year. In addition to confirmation of the balance
outstanding, the opportunity is also taken to request the bank to furnish other information
such as securities held in safekeeping.

The confirming of cash on deposit provides evidence primarily as to the existence of cash
at bank (because there is written acknowledgement that the balance exists), and as to
rights and obligations (because the balances are in the name of the entity). The response
from the bank also provides some evidence for the valuation assertion for cash at bank in
that the confirmed balance is used in arriving at the correct cash balance at the balance
sheet date. Furthermore, it contributes to the completeness assertion; however, it cannot
be relied on entirely because the bank confirmation usually contains a disclaimer in
favour of the bank. The bank cannot be held liable if the information supplied is
incomplete or inaccurate.

The confirming of overdraft and loan balances provides evidence as to:

• existence, because there is written acknowledgement that the loan balance exists;
• rights and obligations, because the loan is a debt of the entity;
• valuation, because the response indicates the amount of the loan balance.
This test also contributes to the completeness assertion in the same manner as confirming
deposit balances.

Verify bank reconciliations

When the entity prepares bank reconciliations on a regular basis that are expected to be
reliable, the auditors will test reconciliations prepared as at balance sheet date. The test
will normally include:

• comparing the closing bank balance with the balance confirmed by the bank;
• verifying the validity of deposits in transit and outstanding cheques by,
— tracing entries in the bank statement for the last month of the fiscal year to the
cash book or bank reconciliation at the beginning of the month, marking them off
in the process,
— identifying deposits and cheques recorded in the cash book for the last month
of the fiscal year, or in the reconciliation at the beginning of that month not
marked as appearing on the bank statement, and tracing them to the closing
reconciliation,
— clearing the bank reconciliation to ensure that all applicable outstanding
deposits and outstanding cheques are marked as having been traced from the cash
book and that none are fictitious.
• establishing the mathematical accuracy of the reconciliation;
• vouching other reconciling items such as bank charges to supporting
documentation;
• investigating old items such as cheques outstanding for a long period of time and
unusual items;
• tracing outstanding cheques and deposits in transit to the subsequent period's bank
statement.

When the entity does not prepare a bank reconciliation or when control risk over entity
prepared reconciliations is high (such as where it is prepared by the cashier), the auditors
may prepare the bank reconciliation. When the auditors suspect possible material
misstatements, the auditors may obtain the year-end bank statement directly from the
bank for use in preparing the bank reconciliation and not rely on the copy of the bank
statement held by the entity. This procedure will prevent the entity from making
alterations to the data to cover any misstatements.

Testing or preparing a bank reconciliation establishes the correct cash at bank balance at
the balance sheet date. Thus, it is a primary source of evidence for the valuation assertion.
This test also provides evidence for the existence, completeness, and rights and
obligations assertions.

Obtain and use subsequent period's bank statement

The subsequent period's bank statement would normally be issued at the end of the month
following the entity's financial year-end. The entity should be requested to instruct the
bank to send a copy of the subsequent period's bank statement directly to the auditors. In
tracing outstanding cheques the auditors may find that a prior period cheque not on the
list of outstanding cheques has cleared the bank and that some of the cheques listed as
outstanding have not cleared the bank. The latter may be due to delays in mailing the
cheques by the entity or in depositing the cheques by the payees. The auditors should
investigate any unusual circumstances.

When the total of uncleared cheques is material, it may indicate an irregularity known as
window dressing. This is a deliberate attempt to enhance an entity's apparent short-term
solvency. (Assume, at balance sheet date, that the entity's balances show current assets of
£800,000 and current liabilities of £400,000. If £100,000 of cheques to short-term
creditors have been prematurely entered, the correct totals are current assets of £900,000
and current liabilities of £500,000, which results in a 1.8:1 current ratio instead of the
reported 2:1.) Window dressing is normally perpetrated by writing cheques on the last
day of the financial year but not mailing them until several weeks later, when cleared
funds are available at the bank to meet those cheques. If none of a sequence of cheques is
presented for payment on the bank statement for more than two weeks after the balance
sheet date, the auditors should make inquiries of the treasurer. Recipients do not usually
delay banking cheques once received and it is normal for most cheques to clear the bank
statement within a week of issue.

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