ACCA Paper F 8 AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM Lecture 5 : Substantive Testing

DATE: TUTOR:

Autumn 2008

Rules on Materiality:Item is material if it is :-

> 5% of Profit before tax Between 0.5% and 1% of Gross Profit Between 0.5% and 1% of Revenue Between 1 and 2% of Total assets Between 2 to 5% of Net Assets Between 5 10% of profit after tax.

Audit Objectives: 1. Existence 2. Ownership 3. Completeness 4. Valuation 5. Presentation and disclosure

NON- CURRENT ASSETS VERIFICATION Cost/ Valuation: The accounts are prepared under the Historic cost convention. The assets and liabilities, expenses and revenues usually shown in the accounts at actual or original cost. Authorization: The authorization should be obtained before any acquisition of non current assets or disposal of non-current assets (similar for other transactions) Existence: The asset must exist, otherwise it has been misappropriated or lost and it has been badly maintained. Beneficial ownership: Legal ownership of assets and legal ownership of leased assets.

Presentation in the accounts: Comply with accounting standard and Companies legislations.

Accounting Standards:

IAS 16: Property, Plant and Equipment

Disclosure For each class of property, plant, and equipment * Basis for measuring carrying amount * Depreciation method(s) used * Useful lives or depreciation rates. * Gross carrying amount and accumulated depreciation and impairment losses * Loss on sale if material must be disclosed on the face of the income statement. Also, IAS 1 Presentation of Financial statements requires material profits and losses on disposal to be presented separately either on the face of the income statement or as in the notes. * Reconciliation of the carrying amount at the beginning and the end of the period, showing:
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additions; disposals; acquisitions through business combinations; revaluation increases; impairment losses; reversals of impairment losses; depreciation; net foreign exchange differences on translation; other movements

Maintenance expenses should be recognized when incurred.

If property, plant, and equipment is stated at revalued amounts, certain additional disclosures are required: * The effective date of the revaluation * Whether an independent valuer was involved; * The methods and significant assumptions used in estimating fair values; the extent to which fair values were determined directly by reference to observable prices in an active market or recent market transactions on arm's length terms or were estimated using other valuation techniques; * The carrying amount that would have been recognized had the assets been carried under the cost model; * The revaluation surplus, including changes during the period and distribution restrictions. IAS 36 Impairment of Assets At each balance sheet date, review all assets to look for any indication that an asset may be impaired (its carrying amount may be in excess of the greater of its net selling price and its value in use). Indications of Impairment External sources: market value declines negative changes in technology, markets, economy, or laws increases in market interest rates company stock price is below book value

Internal sources: obsolescence or physical damage asset is part of a restructuring or held for disposal worse economic performance than expected An impairment loss should be recognised whenever recoverable amount is below carrying amount. Goodwill should be tested for impairment annually

IAS 24: Related Party Disclosures : If sale was made to related parties disclose separately. IAS 10: Events after Balance Sheet Date. Event after the balance sheet date: An event, which could be favourable or unfavourable, that occurs between the balance sheet date and the date that the financial statements are authorised for issue. Adjusting event: An event after the balance sheet date that provides further evidence of conditions that existed at the balance sheet, including an event that indicates that the going concern assumption in relation to the whole or part of the enterprise is not appropriate. Non-adjusting event: An event after the balance sheet date that is indicative of a condition that arose after the balance sheet date. Non-adjusting events should be disclosed if they are of such importance that nondisclosure would affect the ability of users to make proper evaluations and decisions. Disclose the nature of the event and an estimate of its financial effect or a statement that a reasonable estimate of the effect cannot be made.

VERIFICATION PROCEDURES (METHOD) The non-current assets schedules will show the following and suggest the associated verification procedures. Opening balance: Verify by reference to previous years balance sheet and audit files. Acquisition: * Vouch the cost of acquisition with documentary evidence. * Vouch the authority for the acquisition with relevant documents (e.g. minutes etc) Disposal: * Vouch the authority for disposal * Examine documentation * Verify reasonableness of the disposal proceeds * Verify reasonableness of scrapping of non-current assets (e.g. scrap value) * Accounting policy notes.

Depreciation: * Vouch authorization of depreciation policy * Examine adequacy and appropriateness of policy * Check calculations.

Internal control: * Authorisation for Purchase and disposal * Accounting and maintenance cost of assets are very relevant. Existence and ownership: * Physical inspection of the existence of the assets and inspect the title deed and certificates of ownership. * External verification e.g. bank letters, receivables circularisation Presentation and value: * Appropriate accounting policies must be adopted * Appropriate accounting standards must be adopted * Materiality level must be considered (e.g. in a balance sheet of large company it would be misleading to show an asset such patent in a class by itself it its total value was negligible in relation to other assets). * The classification of assets * The disclosure of an asset as separate items e.g. between non current and current assets.

Other matters related to asset verification: Taxation Insurance Expert advise

Audit work on Land and Building: * Obtain summary of all non-current assets under the categories shown in the balance sheet. * Check casting and compare the opening balance brought forward from previous year. * Obtain schedules of addition during the year for all classes of assets (including intangible assets) * Test check against the suppliers invoices or other independent vouchers to ensure revenue and capital are properly distinguished. * Test capital expenditure for authorization * If the non-current assets constructed using own labour check all the labour cost is properly accounted. * Check the accounting policies and comply with relevant accounting standard. * Obtain schedules of disposals test check the proceeds of sales with independent evidence (Sale agreements). * Check for an assets has been scrapped * Verify that the original cost and accumulated depreciation have been eliminated from non-current assets accounts. * Check calculation of profit or loss on sales and agree with profit and loss account. * Verify the independent valuation * Verify the depreciation policy * Check calculations of depreciation. * Confirm the disclosure requirements * Physical inspection of sample of all type of assets * Verify the adequacy of insurance cover on non-current assets * Reconcile assets register with financial statements

Investments: Objective: * The proof of ownership * Gain or loss arise from the investments * Appropriate method of valuation * Properly disclosed in the financial statements Audit work on investments: * Obtain list of investments check the accuracy of the analysis. * Compare the opening balance with last years working papers * Check the nominal accounts for recording for unusual entries * Obtain third party confirmation Physical examination Review board minutes for authorisation. Review the profit or loss on part disposals Review the treatment of capital distributions, bonus and right issues. Verify the interest received and dividend received and accrued by reference to supporting documents and published data. Verify quoted price for listed investments at balance sheet Determine whether unlisted investments are valued on a reasonable basis. THE AUDIT OF ACCOUNT RECEIVABLES AND PREPAYMENTS AND PROVISION FOR BAD DEBTS ISA 505 External Confirmations: Circularization of account receivables: It is very common in the verification of account receivables is to circularise the account receivables or some of them for direct confirmation. Advantages: Direct external evidence It provides confirmation of the effectiveness of the system of internal control. It assists in the auditors evaluation of cut-off procedures It provides evidence of items in dispute There are two methods: Negative:

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The customers are asked to communicate only if he does not agree the balance. This method is mostly where internal control is very strong. Appropriate when: Internal control systems is strong Large number of small accounts Errors not expected Positive: The customer is asked to reply whether he agrees the balance or not or is asked to supply the balance himself. This approach is used when there is weakness in internal control or suspicious of irregularities or numerous bookkeeping errors is found. Preferred when high assessed risk: Weak internal control systems Suspicion of theft and fraud Numerous book keeping errors Procedures: Select samples from positive, negative balances and all customers can be circularised stating the balance in circularization letter. Letter sent on clients note paper requesting reply to auditors and including stamped addressed envelope to auditors address. The circularization should be carried out auditors without clients interventions. The auditors should follow up any legal disputes between the client and it is customers. Account receivables are the large item among the assets of most companies and their verification is essential. Sales to bona fide customers only All such sales are to approved customers All such sales are recorded Once recorded the debts are only eliminated by receipts of cash or on the authority of a responsible person Debts are collected promptly Balances are regularly reviewed and aged, a proper system for follow up exists and if necessary, adequate provision for bad and doubtful debts is made.

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Test the effectiveness of the system. Obtain a schedule of account receivables Test balances on ledger accounts to the schedule and vice versa Test casts of the schedule Examined make up of balance. They should be composed of specific items. Ensure each account is settled from time to time. Examine and check control accounts Enquire into credit balance and consider the valuation of the account receivables. Provision for bad and doubtful debts: The valuation of account receivables is really a consideration of the adequacy of the provision for bad and doubtful debts. The auditor should consider the following matters: The adequacy of the system of internal control relating to the approval of credit and following up of poor payers. The period of credit allowed and taken. Whether balances have been settled by the date of the audit. Whether an account is made up of specific items or not Whether an account is within the maximum credit approved. The state of legal proceedings and the legal status of the account receivables e.g. in liquidation or bankruptcy Compare account receivables to sales with comparison of the ration with those of previous periods and those achieved by other companies. Is there any evidence of any debt in dispute e.g. for non-delivery, breakage, poor quality. Prepayments: Obtain list of prepayments Verify the prepayments for the expenses Review the income accounts for the details of prepayments Review the disclosure in the Balance sheet as current assets. THE AUDIT OF CASH AND BANK BALANCE The composition of cash: Cash in hand include petty cash and receipt from customers not deposited.

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Cash at bank include cash held in saving, current accounts (assets) and cash overdrawn on current accounts (a liability) Audit test: Check the opening and comparative figures brought forwards and review the previous year working papers. Review activity in the nominal ledger for any unusual transaction requiring investigation. Obtain client summaries, check arithmetic and agree with nominal ledger. Perform analytical procedures Test the cut-off Count un-deposited cash on hand and reconcile with imprest systems Confirm bank balance by sending a confirmation request to all banks used by the client. Verify bank and cash reconciliation Follow up and obtain reasons for any un-cleared items appearing in the year-end reconciliation in the month following the year-end. Check that cash and bank is properly classified in the balance sheet Cash at Bank = Current assets Bank overdraft = Current liability Check disclosure of any charges on cash balances.

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Audit of Inventories Standard: IAS 2 Inventories Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in process), and materials and supplies that are consumed in production (raw materials). IAS 2 Does not apply to work in process arising under construction contracts. This is covered by IAS 11 Construction Contracts. Inventories are required to be stated at the lower of cost and net realisable value (NRV). Costs include:1. Costs of purchase (including taxes, transport, and handling) net of trade discounts received 2. Costs of conversion (including fixed and variable manufacturing overheads) 3. Other costs incurred in bringing the inventories to their present location and condition Write-Down to Net Realisable Value (NRV) NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. Any write-down to NRV should be recognised as an expense in the period in which the write-down occurs. Any reversal should be recognised in the income statement in the period in which the reversal occurs When inventories are sold and revenue is recognized, the carrying amount of those inventories is recognized as an expense (often called cost-of-goods-sold). Any write-down to NRV and any inventory losses are also recognized as an expense when they occur. Disclose:* Accounting policy for inventories. * Carrying amount, generally classified as merchandise, supplies, materials, work in progress, and finished goods. The classifications depend on what is appropriate for the enterprise. * Carrying amount of any inventories carried at fair value less costs to sell. * Amount of any write-down of inventories recognized as an expense in the period.

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* Amount of any reversal of a write-down to NRV and the circumstances that led to such reversal. * Carrying amount of inventories pledged as security for liabilities Auditors duties The auditor must satisfy himself as to the validity of the amount attributed to inventories and work in progress in the balance sheet. Physical inventory counts: 2 type of inventory counts 1. Periodical counts 2. Perpetual counts or continuous counts Periodical counts usually undertaken at the end of the financial year of the enterprises. Perpetual counts is continuous count of inventories held in storage to ensure the inventories are physically inspected to identify any slow moving items and damaged items. The key advantages of continuous counts as follows: - To ensure adequate records are kept on items in storage - Less disruptions to daily business of the enterprises - To ensure adequate internal control systems exist to avoid any theft and misappropriation. Before the count Review previous years working paper and discuss with management any significant changes from previous year. Discuss counting arrangement with management Nature and volume of inventories Location of store Consider cut off point Internal audit Confirmation from 3 parties Expert advise Evaluate the client inventories counting procedures Review the clients internal control procedures Brief audit staff and audit planning issues
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During the count: Observe the counting procedures to ascertain that the clients employees are carrying out the instructions. Check the count of a selected number of lines and crossed reference to the inventory records. Observe and identify the obsolete, damaged and slow moving inventories. Verify the inventories sequences held in store Test the cut-off procedures Identify any high value item To obtain copies the clients inventories records for working paper file After the count: Check the cut-off with details of the last numbers of inventories movement forms and goods inward and goods outward notes during the year after the year end. Test the final inventories records have been properly prepared from the count records. Final check on pricing, casting, summaries Inform the management of any problems encountered during the counts for action in subsequent count. Work in Progress: Examine the costing systems Examine the reliability of the costing systems Examine systems of inspection for scarp and ratification work Valuation basis on IAS 2(Inventories) Determine the progress payments and profit on each contracts. Audit test: Reconciliation of changes in inventories (e.g. Purchases and Sales) Compare the quantities of each kind of inventories held with purchase and sales Consider the movement in gross profit ratios Consider the inventory turnover ratios Review the variance report on inventories and work in progress The auditors duty: Accounting policies adopted for valuing inventories

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Consider the acceptability of the accounting polices Test the inventory records with relevant documents such as Purchase invoice Check and test the treatment of overhead (WIP) Check the arithmetic and accuracy of all calculation Check the consistency with which the amount have been computed Check the disclosure requirements VERIFICATION OF QUANTITIES An entity may ascertained quantities of inventories at it is year-end either by: Performing a full physical count or Extracting balance from its inventories records The latter is acceptable to the auditor if inventories has been physical counted during the year and the results compared with the record-any Discrepancies must be investigated and adjusted- thus giving confidence in the accuracy of those records. It is therefore essential in any audit where inventories are material to attend and observe the clients counting procedures. VERIFICATION OF VALUE IAS 2 requires inventories should be valued at the lower of cost and net realizable value. Cost: All costs incurred in getting inventory to its present location and condition. The cost therefore comprises: Cost of purchase: In getting the inventory to its present location, the following costs will be incurred: - The invoice cost - Carriage inward - Import duties and other taxes - Transport and handling charges Establish these costs with reference will be made to purchase and expense invoices. However where items of inventory cannot be directly related to specific invoices (eg identical items bought at different prices and stored together) it is necessary to make assumptions or to adopt a policy in relation to cost.

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Cost of conversion: IAS 2 states that this should be based on normal levels of activity in normal operating condition, taking one year with another. Conversion cost includes both direct and indirect cost incurred in converting the raw material into finished product. These cost are allocated systematically into product cost or unit cost. In determining what is normal the following should be taken into account: - Production capacity - Budgeted production level - Actual production level Net realisable value: NRV= What can be realised for inventory at their present condition at the balance sheet date in the case of raw material, finished goods and WIP. Valuation method: The IAS 2 requires the inventory valuation should be determined using the FIFO and Weighted average method. Procedure to identity items likely to be valued at lower than cost: Examine inventory records for items marked damages, slow moving or obsolete. Determine items returned by customers for faulty or damaged goods Extract from inventory records, items held longer than their normal turnover period (slow moving) Consider the effects of technological developments and possibility of obsolescence. Check with competitors prices Discuss with management any intended sales, special offer or discounts offer to existing customers. Determine actual selling prices realised from post balance sheet receipts. Procedures to check NRV has been properly calculated: Check post balance sheet sales for actual gross proceeds Check budgets/forecast for estimated gross proceeds Check the post balance sheet cashbook or nominal ledger expense accounts for actual selling and distribution costs.

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Check for estimated selling and distribution etc costs and for further costs to completion. Check repairs costs to put damaged inventories into a saleable condition. Presentation and Disclosure: Presentation: The inventories should be disclosed in Balance sheet as Current Assets. Disclosures: By way of note to the accounts, the following disclosures should be made i.e. proper accounting policy adopted. The categorisation of inventories into: - Raw material and components x - Goods held for resale x - Work in progress x - Finished goods x

IAS 11 : Construction Contracts

A construction contract is a contract specifically negotiated for the construction of an asset or a group of interrelated assets. Contract revenue should include the amount agreed in the initial contract + Revenue from alternations in the original contract work. + Claims and incentive payments that are expected to be collected and that can be measured reliably. Contract costs should include:Costs that relate directly to the specific contract + Costs that are attributable to the contractor's general contracting activity to the extent that they can be reasonably allocated to the contract. + Other costs that can be specifically charged to the customer under the terms of the contract. If the outcome of a construction contract can be estimated reliably, revenue and costs should be recognized in proportion to the stage of completion of contract activity. (Percentage of completion method of accounting). If the outcome cannot be estimated reliably, no profit should be recognized. Instead, contract revenue should be recognized only to the extent that contract costs incurred are expected to be recoverable and contract costs should be expensed as incurred

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The stage of completion of a contract can be determined by:_ The proportion that contract costs incurred for work performed to date bear to the estimated total contract costs. Surveys of work performed Completion of a physical proportion of the contract work

An expected loss on a construction contract should be recognized as an expense as soon as such loss is probable. Disclosures: Amount of contract revenue recognised; Method used to determine revenue Method used to determine stage of completion For contracts in progress at balance sheet date disclose:Aggregate costs incurred and recognised profit Amount of advances received Amount of retentions Presentation * The gross amount due from customers for contract work should be shown as an asset. * The gross amount due to customers for contract work should be shown as a liability Risk associated with holding inventories: High level inventories held in storage resulting poor cash flow management and financial loss for the enterprises. The enterprises may have inadequate inventory records resulting in meeting customers demands. There is lack of internal control in storage area resulting in theft and misappropriation of inventory. High level damages or deterioration due poor storage facilities. Lack of information on inventory held by the enterprise resulting in poor decision and inability to meet the demands and objective of the business. Holding inappropriate or inadequate inventory in storage may lead to lack of demand from customers and from production unit.
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The Audit of Payables Current Liabilities falling due within one year: 1. Trade payables ( amount owing to suppliers) 2. Accrued expenses 3. Short term loans or borrowings 4. Bank overdraft 5. Provisions Non-current liabilities falling due after more than one year: 1. Long term loan and borrowings 2. Debentures 3. Deferred tax 4. Pension obligation or retirement benefit obligation

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THE CURRENT LIABILITIES VERIFICATION: Audit procedures: Request schedule of long and short-term liability from the client. Cut-off procedures are carried out properly: to ensure all trade payable should not included unless the goods were acquired before the year end. Reasonableness: consider the reasonableness of the liability Internal control procedures: to evaluate and test internal control procedures. Authority: both current and non current liabilities should be properly authorised by directors. Presentation and disclosures: Both current and non current liabilities should be disclosed properly in the balance sheet. Documentation: The auditor must examine all relevant documents; these include invoices, correspondence, and debentures deed. Security: some liabilities are secured in various ways, usually by fixed or floating charges. Vouching: the creation of each liability should be vouched, for example the receipt of a loan. Accounting policy: the auditor must satisfy himself that appropriated accounting policies have been adopted and applied consistently. *External verification: with many liabilities it is possible to verify the liability directly with the trade payables. This action will be taken with short term loan, bank overdraft and by a similar technique that used with trade receivables (circularisation). Review post balance sheet events (payment made to suppliers after the balance sheet date) IAS 10 Events after balance Sheet Date. Provisions: IAS 37 Provisions, Contingent Liabilities and Contingent Assets Provision: A liability of uncertain timing or amount Liability: Present obligation as a result of past events

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Settlement is expected to result in an outflow of resources (payment) Contingent liability: A possible obligation depending on whether some uncertain future event occurs, or A present obligation but payment is not probable or the amount cannot be measured reliably Contingent Asset A possible asset that arises from past events, and Whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise. An enterprise must recognise a provision if:A present obligation (legal or constructive) has arisen as a result of a past event (the obligating event), Payment is probable ('more likely than not'), and The amount can be estimated reliably The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. In reaching its best estimate, the company should take into account the risks and uncertainties that surround the underlying events. Expected cash outflows should be discounted to their present values, where the effect of the time value of money is material. In measuring a provision consider future events as follows: Forecast reasonable changes in applying existing technology Ignore possible gains on sale of assets Consider changes in legislation only if virtually certain to be enacted

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Restructuring by sale of an Accrue a provision only after a binding operation sale agreement Restructuring by closure or Accrue a provision only after a detailed reorganisation formal plan is adopted and announced publicly. A Board decision is not enough Warranty Land contamination Accrue a provision (past event was the sale of defective goods) Accrue a provision if the company's policy is to clean up even if there is no legal requirement to do so (past event is the obligation and public expectation created by the company's policy) Accrue if the established policy is to give refunds (past event is the customer's expectation, at time of purchase, that a refund would be available)

Customer refunds

Offshore oil rig must be Accrue a provision when installed, and add removed and sea bed to the cost of the asset restored Abandoned leasehold, four Accrue a provision years to run CPA firm must staff training No provision (there is no obligation to for recent changes in tax law provide the training) A chain of retail stores is No provision until a an actual fire (no past self-insured for fire loss event) Self-insured restaurant, Accrue a provision (the past event is the people were poisoned, injury to customers) lawsuits are expected but none have been filed yet Major overhaul or repairs Onerous contract No provision (no obligation)

(loss-making) Accrue a provision

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Disclosures Reconciliation for each class of provision: Opening balance Additions Used (amounts charged against the provision) Released (reversed) Closing balance For each class of provision, a brief description of: Nature Timing Uncertainties Assumptions Reimbursement Audit Tests:Any amount retained as reasonably necessary for the purpose of providing for any liability or loss which is either likely to be incurred or certain to be incurred but uncertain as to amount or as to the date on which it will arise. The provision is debit balance and the effect on profit or loss. Is for likely or certain future payment. Where the amount or the date of payment is uncertain Review post balance sheet event (outcome after the balance sheet date) Contingences: Pending legal actions Review the clients records for recording of the claims and disputes and the procedures for bringing these to the attention of the board Review the correspondences with the solicitors Discuss with management regarding possible outcome of claims (Obtain letter of representation).

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Examine solicitors fees note against bank payment recording in the clients books and records. Obtain written assurances from directors with an estimate of the possible ultimate liabilities Check the disclosure in the balance sheet. Debentures: Audit of debentures: Obtain a schedule detailing the debentures due at the beginning of the year, addition and redemption during the year and final debentures at year ended. Obtain copies of debentures certificates and verify the details and filed in permanent file. Check the opening balances from previous years working papers file. Obtain copy of directors minutes for any approvals for addition to debentures. Vouch repayments with debentures certificates, cash book to check the correct amount is paid. Vouch interest payments with debentures certificates, cash book to check the correct interest is paid. Agree total amount outstanding with register of debenture holders. If loan is secured, verify charge is registered with relevant regulatory authority. Check the disclosure requirements. Audit of share capital: Audit Procedures: Ensure the issue within limit of Memorandum companies Ensure the issue is subject to directors minute Verify the internal control procedures/Custody of unused certificate. Ensure and verify the shareholder details Ensure the cash receipts for the share issue Review the counter-foils for the share certificates for sequence of issues Vouch the payment of underwriting and other fees and articles of the

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Determine the total of shares of each class as stated in the balance sheet and obtain a list of shareholding, which in total should agree with the balance sheet total. Other relevant standards: IAS 8 : ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 1. Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. 2. A change in accounting estimate is an adjustment of the carrying amount of an asset or liability, or related expense, resulting from reassessing the expected future benefits and obligations associated with that asset or liability. Disclose: * The nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods. * If the amount of the effect in future periods is not disclosed because estimating it is impracticable, this fact should be disclosed. 3. Prior period errors are omissions from, and misstatements in, a companys financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that was available and could reasonably be expected to have been obtained and taken into account in preparing those statements. Such errors result from mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud. Disclosures relating to prior period errors include: The nature of the prior period error; for each prior period presented, to the extent practicable, the amount of the correction:

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for each financial statement line item affected; and for basic and diluted earnings per share (only if the entity is applying IAS 33);

the amount of the correction at the beginning of the earliest prior period presented; and if retrospective restatement is impracticable, an explanation and description of how the error has been corrected.

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