Showing posts with label audit approach. Show all posts
Showing posts with label audit approach. Show all posts

Wednesday, December 23, 2015

Audit Method: Small Business Audit

An audit is designed to evaluate and verify the effectiveness of company’s financial operations. It can also help the management or owner detect circumstances that could lead to financial problems in the future.
But the audit strategies used on bigger companies may not be applied for audits of a small business.  Big companies can rely on their own internal auditors to provide assistance.  But small businesses, given a limited budget, have limited personnel.  With this, auditors of a small business might also need to adjust their audit strategy.
Auditors of a small business may encounter some challenges that affect their audit strategy since small businesses face certain challenges in executing effective internal control, particularly if management of the business perceives internal control as something to be added on rather than integrated with core processes.
Audit in a small businesses is very important so as to minimize the potential risks of material misstatements in the financial statements whether it is caused by error or fraud.
So what do Auditors need to pay attention on auditing a small businesses?
First, auditors should review the systems and examine financial documentation whether it is being processed in a timely manner. Without timely and reliable information, accounting records can become unreliable that may create discrepancies in a company's financial records.
Second, auditors should identify and review each component of the company's accounting system, including journal entries, T-Accounts, general ledger and financial statements.  Analytically work through the accounting system to ensure that all accounts are present, that all journal entries are posted to the general ledger in a timely manner and that the system has the ability to correct human errors, such as calculation errors.
Third, auditors should check into the company's internal controls policies to measure the level of security they provide from theft and fraud.  
Fourth, auditor should compare internal records of cash possessions, income and expenses against external records.   The auditor should check the company's stored external records and compare selected transactions against internal records.   For example, a purchase receipts sent from suppliers for a certain month will be compared against internal purchase records, or compare cash register tapes against revenue recorded on the books.
And finally, auditors should analyze the company's internal tax records and official tax returns.  Auditors should also take a little extra time to review the range of credits and deductions claimed on the most recent tax return, looking for areas of dubious reporting, such as inflated expense numbers.
Efficiency in audit is achieved through a careful audit planning.   One specific example is that auditors review the prior years’ workpapers to familiarize themselves with client issues and to look for past inefficiencies and possible improvements.  Another factor that contributes to audit efficiency is Auditors’ independence and objectivity.  Auditors should be free from bias, conflict of interest and undue influence of others to override professional judgements
Sources: 

Wednesday, December 16, 2015

Audit Method: The Unrecorded Liability

Liability is defined in Conceptual Framework of International Financial Reporting Standards as “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”.
There can be many instances where management will be prone to not record a liability due to various reasons. The management may not record a current liability to improve its current ratio and present its liquidity position higher. Management may also skip to record a long term liability at year end to improver it debt to equity ratio. A high current ratio and low debt to equity ratio makes it easy for the management to obtain new financing for the company.
Auditor should verify the unrecorded liability by applying the following procedures:
  • Vouch a sample of cash disbursements recorded just after year end to receiving reports and vendor invoices. In a voucher system, a voucher is not prepared until the requisition, receiving report, and sellers invoice are reconciled with the purchase order.  Auditors search open files for unmatched documents.
  • In searching for unrecorded payables, the auditor would look at disbursements made after year end to see if they should have been, and were, properly recorded as payables at year end.
  • Tracing a sample of purchase orders and the related receiving reports to the purchases journal and the cash disbursements journal will enable the auditor to determine that the purchases were properly recorded.
  • Analytical procedures.  Accounts payable turnover is very important.   Unusual relations should be investigated.
  • Cash disbursements cutoff test.  Test if cash disbursement and accounts payable reduction are reconcilable. Inspect the last checque written and trace it to the accounts payable subsidiary ledger. Reviewing subsequent cash disbursements enables the auditor to detect items purchased before year end but not yet recorded, i.e., unrecorded accounts payable.
  • Purchases cutoff test tests to determine if goods for which title has passed or not passed are appropriately accounted for. FOB shipping point and FOB destination are critical to this test.
  • Trace subsequent payments to recorded payables.  Match checques issued subsequent to year end with the related payable.  Checque should be issued only for payables that existed on the balance sheet at year end.  Any checque that cannot be matched may represent an unrecorded liability at year end.
  • If confirmations are used, small and zero balances should be sampled as well as large balances.  For example, if orders are placed with a vendor on a consistent basis, a confirmation should be sent to the vendor regardless of the balance due at year end.

Practice

The auditor should check for all the audit assertions while verifying unrecorded liabilities. Valuation assertion will verify whether accounts payable are valued in accord with GAAP/IFRS? Presentation/Disclosure assertion will verify whether the accounts liability balances are properly presented and disclosed? Accounts payable should be listed as a current liability.  Purchases should be listed in the calculation of cost of goods sold. Unusual transactions involving accounts payable should be disclosed, such as related party transactions involving accounts payable. Obtain a management representation letter with assertions relating to accounts payable and purchases.

Wednesday, December 2, 2015

Audit Method: Going Concern Assessment

ISA 570 requires an auditor to obtain and evaluate management’s assessment of the entity’s ability to continue as a going concern. Issues to consider by the auditor while evaluating the going concern assumption by management are as follows.
Are any events or conditions which may cast significant doubt on the entity’s ability to continue as a going concern has been identified? Examples of conditions and events can be traced from paragraphs A2 of ISA 570.

Based on our inquiries of management and our review of their assessment, were any events or conditions noted that may occur shortly beyond the management assessment that were so significant that they may cast doubt on the entity’s ability to continue as a going concern?

If audit team answer to the above two questions is “NO” then the evaluation is complete but if the answer is “YES” then the following additional audit procedures need to be undertaken.

Evaluate management’s plans for future actions in relation to its going concern assessment, whether the outcome of these plans is likely to improve the situation and whether management’s plans are feasible in the circumstances.

Stated plans: Obtain and discuss with management its plans to deal with the identified risks. Indicate the individuals interviewed.
Supporting evidence overcoming substantial doubt: Indicate below the elements of management's plans that are particularly significant to overcoming the substantial doubt about the entity’s ability to continue as a going concern. Examine and describe evidence that supports those elements. Elements include Third-party guarantee, Debt restructuring or new borrowings, Liquidation of assets, Reduction or delay of expenditures, Increase in revenues, Increase in equity etc.
Third party guarantees and other financial restructuring agreements: If there are significant guarantees of financial support from a third party (such as the entity’s parent company, another shareholder, an affiliate or a general partner of a limited partnership):
Prospective financial information: Although this information is not as persuasive as evidence provided by third parties, we usually consider it as necessary to support management's plans.
Management's representation: Obtain written representation from management and where appropriate from those charged with governance regarding management's plans and conclusion about the appropriateness of the going concern assumption and the reasonableness of related disclosures in the financial statements.

Practice
Based on the audit evidence obtained, conclude whether a material uncertainty exists relating to events or conditions, that individually or collectively, and may cast significant doubt on the entity's ability to continue as a going concern. A material uncertainty exists when the magnitude of its potential impact and likelihood of occurrence is such that, in our judgment, appropriate disclosure of the nature and implications of the uncertainty is necessary for the fair presentation of the financial statements.

Other articles on related topic:

Wednesday, November 25, 2015

Audit Method: Accounting Estimates

Accounting estimate as defined in ISA 540 – “An approximation of a monetary amount in the absence of a precise means of measurement. This term is used for an amount measured at fair value where there is estimation uncertainty, as well as for other amounts that require estimation. Where this ISA addresses only accounting estimates involving measurement at fair value, the term “fair value accounting estimates” is used.”

Some financial statement items cannot be measured precisely, but can only be estimated. For purposes of this discussion, such financial statement items are referred to as accounting estimates. The nature and reliability of information available to management to support the making of an accounting estimate varies widely, which thereby affects the degree of estimation uncertainty associated with accounting estimates. The degree of estimation uncertainty affects, in turn, the risks of material misstatement of accounting estimates, including their susceptibility to unintentional or intentional management bias.

Test of accounting estimates for bias
First perform a retrospective review of significant accounting estimates reflected in the financial statements of the prior year to determine whether management judgments and assumptions relating to the estimates indicate a possible bias on the part of management.

The significant accounting estimates selected for testing should include those that are based on highly sensitive assumptions or are otherwise significantly affected by judgments made by management. Consider the results of this retrospective review in evaluating the current-year estimates. If we identify a possible bias on the part of management in making prior-year accounting estimates, we should evaluate whether circumstances producing such a bias represent a risk of a material misstatement due to fraud.

Secondly, consider whether differences between estimates best supported by the audit evidence and the estimates included in the financial statements, even if they are individually reasonable, indicate a possible bias on the part of the entity's management. If so, reconsider estimates taken as a whole.

Practice
For accounting estimates (e.g., liabilities for certain employee benefits plans and legal contingencies), evaluate the reasonableness of the methods and assumptions management used to make the estimates. If management's methods and assumptions were reasonable, test the data and assumptions underlying the estimates, and re-compute the estimates. If management's methods and assumptions were not reasonable, develop an independent range of reasonable estimates and determine whether management's estimates fall within that range. 

Wednesday, October 28, 2015

Audit Method: Interim Audit Procedures

Interim financial information or statement as defined in ISAs’ is “Financial information (which may be less than a complete set of financial statements) issued at interim dates (usually half-yearly or quarterly) in respect of a financial period”. IAS 34 Interim Financial Reporting outlines the recognition, measurement and disclosure requirements for interim reports.

The International Standards on Review Engagements (ISRES) 2400 and 2410 govern the interim review procedures. A review engagement is a limited assurance engagement that provides a moderate level of assurance that the information subject to review is free of material misstatement; this is expressed in the form of negative assurance. The difference between the report issued by auditor for a yearly audit and the report issued for quarterly or half yearly review is as follows.

Audit Report: The Auditor give an opinion as to whether the financial statements, taken as a whole, are fairly presented. This opinion is made after detailed tests are conducted of the accounting records. These tests include but are not limited to confirmation with outside parties, analytical procedures, inquiry of client personnel and a detailed study of the accounting records.

Review Engagement Report: In a review engagement for quarterly or half yearly period, the auditors’ express a limited assurance that they have not noted any items that would require adjustments that should be made to the statements in order for them to be in conformity with the accepted standards. The auditor must conduct a review and be satisfied as to the reasonableness of the statements through inquiry and analytical procedures.

In some circumstances, the auditor may determine that it is effective to perform substantive procedures at an interim date, and to compare and reconcile information concerning the balance at the period end with the comparable information at the interim date to:
(a) Identify amounts that appear unusual;
(b) Investigate any such amounts; and
(c) Perform substantive analytical procedures or tests of details to test the intervening period.


Practice
The Auditor while conducting a review engagement should still practice professional skepticism and should follow the fundamental ethical principles of integrity, objectivity, professional competence and due care, confidentiality and professional behavior.

Wednesday, October 21, 2015

Audit Method: Oil & Gas Industry

The Oil & Gas Industry comprises of three sectors:
The Upstream sector: This is also called the exploration and production sector (E&P). It involves the search for potential underground or underwater crude oil and natural gas.
The Midstream sector: This sector involves the transportation, storage and marketing of petroleum products.
The Downstream sector: this sector is involved in the refining of crude petroleum products and processing and purification of the raw natural gas.

Accounting for oil and gas companies is a bit complicated because it has to reflect the company’s principal assets; the oil and gas reserves, with ownership rights often based on contractual relationships between the oil and gas producing entities and the owners of the mineral rights. 

Some of the specific accounting issues which arise in the Oil and gas sector are as follows: 
  • Joint Arrangements: It is a common term for oil & gas companies to share the risks and costs of exploration and production activities. A separate Joint Venture Account statement is prepared which shows the advances received from working interest owners and how the amount is spent.
  • Revenue recognition: The revenue arising from each transaction is recognized based on the terms of the underlying sales agreement.
  • Exploration & Evaluation Assets and Development Assets: IFRS 6 - Exploration for and Evaluation of Mineral Resources explain the complete accounting for these assets.
  • Depletion, depreciation and amortization (DD&A): The unit of production method is most commonly used to deplete upstream oil and gas assets.
  • Impairment of non-financial assets: IFRS 6 relaxed the rules of annual impairment testing for exploration and evaluation (E&E) assets. IFRS 6 requires these assets to be tested for impairment only when the facts and circumstances suggest that the carrying amount may exceed its recoverable amount and on the transfer of E&E asset to development assets. 
  • Reserves Reporting: The purpose of reserve reporting is to make available information about the oil and gas reserves which are controlled by the company. This information helps to assess the companies’ current performance and future prospects.
  • Provisions for Decommissioning Costs: Due to exploration and evaluation activities oil and gas companies often are required to create a provision for meeting the costs of site restoration, decommissioning and dismantling of assets. It is covered by IAS 37.

Practice

While conducting the audit of oil & gas companies, the auditor should gain thorough and deep understanding of the industry and the practices followed by the oil & gas companies. Audit requirements may vary depending on whether the company is operating in an upstream, midstream or downstream sector. Moreover audit procedures in upstream sector also vary depending on whether the company is an operator or non-operator of and oil or gas well or lease. 

Monday, October 12, 2015

Audit Method: Telecom, Media and Entertainment

Media and Entertainment business include companies for movie studios, TV station groups, Cable distribution companies, Radio broadcasting companies, Advertising companies, Interactive gaming companies, Book publishing companies, Newspaper publishing companies and Internet companies. Media and Entertainment businesses live or die based on how well they identify and manage trends.

Telecommunications is a general term and include a vast array of technologies that transmit and receive voice, data, and video information over varying distances through electronic means. Telecommunications is a huge industry, comprising companies that make hardware, produce software and provide communication services.

The main area of concern for auditors while conducting the audit of a telecom media or entertainment company is to verify their revenue. Telecom operators continue to lose billions of dollars every year due to revenue and fraud leakage. Most telecom companies principally obtain revenue from providing the following telecommunication services: access charges, airtime usage, messaging, interconnect fees, data services and information provision, connection fees and equipment sales. Products and services may be sold separately or in bundled packages. The fast pace of change and intense commercial competition increase the likelihood of mistakes. There is significant complexity in determining the combined effect of interacting systems and processes; and the high-volume, low-value nature of transactions amplifies the financial implications of "small" errors.

Another area of concern for auditor is to verify the license fee paid by media and telecom companies to the government and compliance of companies with the regulations imposed under the provisions of these licenses by the government.

Fixed assets verification particularly in telecom service provider companies is also an area which requires auditor’s significant attention. Telecommunications is a very capital-intensive industry, with the fixed assets of network infrastructure forming a large part of a telecom company’s balance sheet whether it is a fixed line, mobile or fiber network. Fixed assets management remains an important competitive differentiator as it presents significant operational and internal control challenges. Auditor should be diligent in reviewing asset lives manually, as well as in a more sophisticated manner with the use of client integrated ERP systems generated reports.

Additional Thoughts
While conducting the audit of a telecom media or entertainment sector company; the principal rules remain the same for the auditor. The auditor should understand the entity and its environment, in which it is operating and identify and assess the risks of material misstatement. On the basis of this understanding the auditor should frame audit procedures to minimize the audit risk to an acceptable level. 

Wednesday, September 30, 2015

Audit Method: Inventory Count

As per the requirements of ISA 501, if inventory is material to the financial statements, the auditor shall obtain sufficient appropriate audit evidence regarding the existence and condition of inventory by: a) attendance at physical inventory counting; b) performing audit procedures over the entity’s final inventory records to determine whether they accurately reflect actual inventory count results.
An Inventory count is carried out by business either: 
  • to corroborate information contained in their books and records which is the product of a continuous accounting and control system, or
  • to provide an inventory figure for inclusion in financial statement and to use in calculating profit where there is no system of continuous inventory accounting.

 The purposes of the physical inventory observation by auditor are to determine that
 the inventory actually exists,
  • the methods of inventory taking are effective in obtaining accurate counts, and
  • the inventory is in a usable and salable condition in the normal course of business (e.g., not damaged or obsolete).

It should be remembered that while the auditor will himself carry out test counts and extract certain cut-off information he is primarily there to observe that the client’s procedure are satisfactory. Where the client has an efficient system for inventory records, the physical inventory may be carried out on a continuous basis as opposed to counting everything in one go at the year-end. In the case of a client using the continuous basis, the auditor will still be required to observe a part of this continuous inventory counting.
  
Recommendation
When conducting inventory count at year end special attention needs to be paid by the auditor to apply proper cut off procedures (testing last receiving and shipping transaction), reconciling inventory count to the general ledger, testing high value items, testing inventory in transit, testing the inventory at third party warehouses, testing inventory cost including freight charges and testing for lower of cost or net realizable value/market etc. The working paper should be prepared in such a manner that the information can be easily followed up at the final audit visit. Test counts for example should have been traced to the stock sheets to confirm that they are a proper record of the results of the physical inventory.

Tuesday, September 1, 2015

Audit Method: Materiality

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 and in forming the opinion in the auditor’s report. Information is material if it is likely to influence financial statements users’ decisions. The major reason for thinking about materiality is to try to fine tune the audit for effectiveness and efficiency.

Planning Materiality: Auditors use planning materiality at the planning stage to determine which financial statement items, account balances and transactions to test and which to not test. It affects the scope of both tests of controls and substantive tests.

Performance Materiality: To plan the audit of various accounts, auditors need to assign part of the planning materiality to each account or class of transactions. If planning materiality is 1million CU(Currency Unit) and procedures for each account or class of transactions are designed to allow a 1million CU misstatement to go undetected, the total misstatement could obviously be more than acceptable. Therefore, auditors use performance materiality (an amount less than materiality for the financial statements as a whole) to make sure that the aggregate of uncorrected and undetected immaterial misstatements does not exceed materiality for the financial statements as a whole.

Computing Materiality: A number of quantitative approaches may be used by the auditor depending on his professional judgment; two common methods employed are discussed here:

Single Variable Approach This approach uses a single financial variable for computing materiality. Depending on qualitative factors, an auditor would select the variable that was judged to be the most appropriate way to compute materiality for a specific client. Examples of possible common single variables are: 5% of pre-tax income, 1/2% of total assets, 1% of equity, 1/2% of total revenues.

Blend or Average Method This method typically takes four or five variables and then either weights each variable according to some proportion or averages them (an equal weighing). Presumably, the blending or averaging process provides an indirect way of considering qualitative factors. An example of the averaging method would be to take the previously listed four single variables and average them (give each of them a 25% weight).

Recommendation

My recommendation to audit seniors will be that consider the amount (quantity) and nature (quality) of misstatements as both are relevant in deciding what is material. Moreover consider the industry in which your audit client falls and then decide on which financial variable is most relevant to the particular industry. For example for retailers revenue or profit after tax would be more suitable, for business concerned with asset growth e.g. property development an asset based benchmark would be a better measure to use, a not for profit organization or a public sector body could use 0.5% to 1% of expenses since they are normally not concerned with revenue generation or profits.

Wednesday, August 26, 2015

Audit Method: Controls

Control activities are the policies and procedures that help ensure that management directives are carried out. Control activities, whether within IT or manual systems, have various objectives and are applied at various organizational and functional levels. Examples of specific control activities include those relating to the following:

  1. Authorization.
  2. Performance reviews.
  3. Information processing.
  4. Physical controls.
  5. Segregation of duties.


An auditor would be required to conduct a walk through test to confirm the understanding as documented. Identify the preventive (exercised before occurrence of transactions and event) and detective and corrective (exercised after occurrence of transactions and event) controls established by management to support its assertions. Preventive, detective and corrective controls can be:

  1. Application controls
  2. IT-dependent manual controls
  3. Manual controls


Application controls are automated controls processed by the entity’s IT applications without manual interference. Examples of Application controls are Edit Checks, Validations, Automatic calculations, Authorizations etc.
IT-dependent manual controls are controls in which we consider both the manual and automated aspect of the control e.g. a review of a computer generated sales orders report to determine that all sales are invoiced.
Manual controls are those controls that are operated completely manually e.g. bank reconciliations when the entity reconciles cash to bank statement.

Recommendation
Controls are performed to check the accuracy, completeness, and authorization of transactions.  A concept called The Internal Control Stream is introduced by Thomas P. Houck in his book “Why and How Audits Must Change: Practical Guidance to Improve Your Audits”. According to Thomas P. Houck this concept help auditors better understand the many controls that can exist in a company. The "stream" represents the path that a transaction follows as it moves from inception to its ultimate resting place in the financial statements. Controls can be located at different spots along the stream. Upstream controls help to ensure that transactions are properly entered into the computer system. Information technology controls are automated controls that help to prevent misstatements. Downstream controls come into play after information is processed in a computer system. An auditor is required to apply appropriate tests of controls to assess the reasonableness of design of system of internal control by enquiring relevant client personnel and documenting the same.

Wednesday, August 19, 2015

Audit Method: Future of Audit. Technology.

The spaceship of an auditor from Earth landed on the green field of the planet Kepler-3571c. The auditor had a task to participate in a stock take of flying horses herd.
This is not another story from Airstrip One rubric. The purpose of this article is to discuss future application of technology in audit, but not as far as in the above introduction.

Survey
The reason for this post was the report “Audit 2020: A Focus on Change” issued by Forbes and KPMG on changes required in in audit services and profession [1]. The reports identifies number of directions in which audit should evolve: technology, culture and regulations, skills, quality and nature of services.

Technology captured might interest. 58% of respondents say that technology has the biggest impact on audit profession according to report. The technology implementation as mentioned in report is expected to impact audit process in following ways (top three are mentioned):
  1. Provide tools for more sophisticated analysis;
  2. Provide more efficiency;
  3. Flag issues that require deeper investigation.
Current situation
The Big 4 audit firms have already taken measures to address challenges of new IT era. All big audit firms have own departments specialising on IT audit and data analysis. The expansions into the IT and related areas is not only organic, but also by means of acquisitions: KPMG purchased innovative HR firm [2], EY purchased a digital design consultancy [3] in 2015; PwC purchased IT consulting firm earlier in 2012 [4].

Nowadays it is common for auditors to use data analysis software to perform journal entries testing. This is because the complex software is needed to analyse large missives of journal entries downloaded from client’s accounting system. CAAT (Computer assisted audit technique) has become a buzz word in audit text books and instructions.

Auditor’s Future
I think it is time for another step forward in the area IT implementation. Audit firms should consider in which audit procedures audit software might totally replace human auditors. There are some shy thoughts regarding this idea in the report discussing that “audit should become continuous and ongoing to provide real-time analysis” [1]. The way this could be realised is by deploying into client IT system the independent software with the rights of ongoing check what has been entered into the system and do checks following algorithm written my human.

Potentially some procedures could be performed by robot-auditor even with current level of IT development in the world. For example, the procedure of invoice vouching could be done by robot. Robot might have questions and  at this point human auditor might interfere.

The replacement of human auditors by robots should be discussed openly to develop new skills required for future audit profession. A report by Deloitte with the University of Oxford predicts that the robot revolution will displace almost 35% of UK jobs [5] and the audit profession should be ready for these changes.  


Wednesday, August 12, 2015

Audit Method: Audit of Disclosures

In July the International Auditing and Assurance Standards Board (IAASB) issued revised international auditing standards focusing on disclosures with the aim to have consistent approach in audit. In this article I would like to provide a new definition of disclosures and consider planning audit procedures with regards to disclosure notes. The standard will become effective from December 2016.
Definition
First, the IAASB removed the term “related notes” from definition of financial statements and introduced the term “disclosures”.
Disclosures comprise explanatory or descriptive information, set out as required, expressly permitted or otherwise allowed by the applicable financial reporting framework, on the face of financial statement, or in the notes, or incorporated therein by cross-reference.

Explanatory or descriptive information required to be included in the financial statements by the applicable financial reporting framework may be incorporated therein by cross-reference to information in another document, such as a management report or a risk report.

Planning

The revised ISA 300 requires auditor to put “appropriate attention” and “plan adequate time” for the disclosures audit. The standard requires considering following factors in planning procedure for disclosures:

  1. Changes in entity’s environment, financial condition or activities;
  2. Changes in applicable financial reporting framework;
  3. The need  for the involvement of an auditor’s expert;
  4. Matters in disclosures which auditor may wish to discuss with those charged with governance.


Practical considerations

I think the audit of disclosures on some projects could be underestimated and IAASB did the right deed to revise its standards. I would emphasise following points with regards to audit of disclosures:

  1. Disclosures need to be tracked: in my best practice experience there is usually Excel spreadsheet in audit file with list (check list) of all disclosures requiring audit. The disclosure list contains references to work papers where disclosure has been audited. In some case Excel spreadsheet with check list might contain documentation of audit procedures in it: for example, leasing disclosures audited within this Excel workbook.
  2. All audit team members assigned to do the audit must be aware that they are responsible for audit of disclosures from the very beginning of audit. Ideally Excel workbook should contain Excel spreadsheet dedicated to disclosure note. The practice to be avoided is when audit of trial balance figures and disclosures are  carried out by different persons in team.
  3. Considering point 2, the audit procedures in respect of each disclosure note should be carefully designed and elaborated. The practice to be avoided is when disclosures audit shifted to the end of audit and when it appears that disclosures might take more than planned time.
  4. Some disclosures as mentioned by ISA might require expert’s involvement, e.g. pension benefit plans, derivatives valuation, management’s forecasts in strategic report. Significant or complex disclosures might require a) significant input of auditor’s time to carry out the procedure, b) numerous reviews from manager to partner.
  5. During the audit of disclosers the errors might be detected which might affect general ledger. This is because disclosures might provide more information and bigger picture than merely the audit of breakdown. This is another argument to incorporate the audit of disclosures in early stages: the client may be unhappy if errors would be communicated in last stage of audit.



Wednesday, August 5, 2015

Audit Method: Analytical Procedures

The substantive analytical procedures (SAP) are one of the weakest points in audit program when it is come to execution. The authorities both in USA and UK when conducting review of audit work like to point on inappropriateness of evidence gained from analytical procedures.

Generally, the mistakes made when performing analytical procedures are as follows:

1. Insufficient reliability of data used in analytical procedures. For example, the data of average sales per employee taken from not independent source, a client representative. The information should be checked before used in our calculations.

2. Expectations regarding tendencies are not well elaborated and/or not based on understanding of  client business. For example, very often for PL analytics general expectation is used that sales/expenses are expected to grow same level as prior year or to be on the same level as prior year, which is not correct by default.

3. Analytical procedures might be performed well, but insufficient on it is own. Usually the procedures could be limited to SAP in case test of controls (TOC) are effective. But in real life the situation may be different:

  • TOCs are effective but there are some material items within account, that may change picture completely and, hence, need to be tested;
  • The account balance has significant risk, which means that SAP is not sufficient on its own and should be accompanied by test of details.
  • When TOCs are ineffective, then we might talk only about application of SAP for the areas of audit where test of details were performed as well

My special comment to an audit firm new joiners: please, be aware when you are questioning client regarding changes in the account balance and then document explanations. I am sure you have a good guidance in your firm on how to perform inquiries and SAP. Moreover, there are a lot of instructions in internet on this issue.  Please, do not write comments like this, which might be then published in Thomas Houck book*: “Sales increased because the client sold more goods”. He refers sarcastically about these type of explanation as “stellar analytical explanation”. The focus of analytics should be real business reason of change in figures.


*Thomas P. Cook. Why and How Audits Must Change:  Practical guidance

Wednesday, July 29, 2015

Audit Method: list of information requests

A list of information requests (LIR) is method to establish common understanding with audit client: what documents need to be prepared in order to progress with audit. The LIR also known in different audit firms as list of outstanding items, client assistance schedule, prepared by client (PBC) list. LIR is one of the project management tools when auditors track if all required information was provided in appropriate quality and on time.
In theory LIR needs to be very specific and at least have following characteristics: detailed description of the request (e.g. it should mention specific account in trial balance), auditor and client employee responsible for request processing, date when information due, format and if applicable prior year example.
I can give following tips on managing LIRs:
  1. I advise to use Excel in managing LIRs;
  2. The level of details in LIR depends on client: when client is difficult to manage, it might be better to add some more details to be always ready to answer specific questions;
  3. The request should be ideally sent 2-3 weeks before start of the engagement, depending on the timing of audit procedures;
  4. The auditor must meet and discuss LIR with client representative in charge of the audit after sending the first version of LIR. The protocols of  communication would depend on arrangements with client: e.g. the client might prefer the auditors to work directly with each responsible person in LIR;
  5. LIR should be compared with status of audit work at list once a week. I would propose following formula: information received – information processed = unprocessed audit evidence. If there is a lot of unprocessed evidence then it raises questions if audit team have issues with adequate staffing in terms of time and skills of team members.
  6.  LIR should be designed in the way to be able to support audit teams in calculating overruns and defend auditors’ position. This could be achieved by updating LIR once a week, calculating number of days/hours from the due date to current date.
  7. Regular LIR status calls with client should be organised. All audit team members should participate being ready to provide an update on their section of Audit.

Monday, February 6, 2012

Chinese Companies Need Vigilant Audit


Some of my readers have shown their interest to the assurance services in BRIC in the comments to the last post. And guess what? The recent issue of The Economist contains the article “Accounting in China”, which reflects my concerns about audit of companies from BRIC in general (see link). The beginning of the article is quite appealing:
“CAN you trust Chinese accounts? Many investors fear (and several short-sellers are betting) that the answer is “no”. Sino-Forest, a big forestry firm listed in Toronto, is a case in point. Last year Muddy Waters, a short-seller, accused it of running a Ponzi scheme, which it denies. On January 31st Sino-Forest released the final report of independent investigators into the charge. Insiders crow that the gumshoes found no smoking gun. The gumshoes grumbled that, lacking access to all the evidence, they were “not able to reach definitive conclusions”.
America’s SEC is trying to force the Shanghai office of Deloitte Touche Tohmatsu, a big Western accountancy firm, to hand over papers related to Longtop, a Chinese software firm that was delisted by the New York Stock Exchange last year. Deloitte refuses, saying this would violate Chinese laws on “state secrets”. Deloitte may have a point. If it co-operates, its local staff could be jailed under Chinese law.”
So, this is the question, which had to be raised sooner or later: can be the companies transparent while operating in the conditions of non-transparent political system? There are no big traditions of Chinese government accountability to citizens of China. The market incentives to provide true and fair financial statements are seem to be not enough.

How to deal with this issue?
China need not take all the blame for the failure to provide true financial statements. The problem is common for all emerging markets. It could be said that the reason for that is not necessarily deliberate misrepresentation. Errors might happen due to lack of knowledge, the absence of open communication tradition.
According to the article in The Economist one of the Big4 bosses acknowledged the issue and insisted that “the Big Four have greatly increased their vigilance in China”. To generalize this comment one can state an implicit rule for the audit of financial statements in emerging markets: the financial statement risk for all companies originated from emerging markets should be assessed as "high" at the beginning of audit unless otherwise could be proven. The proof of lower risk assessment could be obtained after one or two years of audit, which would provide evidence about low susceptibility of systems to errors and effective control system.
I agree that this proposal could be viewed as a strict and reactionary one, but I stated it to initiate discussion of what could be done regarding accounts provided by BRIC and other emerging markets. I expect you to share your valuable ideas in the comments, and we might discuss them.

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Wednesday, January 25, 2012

Audit Method: Audit Approach



Audit planning is one of the most interesting steps in the audit process. It requires to apply audit specific knowledge, business skills, understanding of the own resources and velocity of their usage.
In this post I am going to make the brief overview of some audit approaches and their applicability in real life.

Audit Process
The audit process could be depicted very simply, but work done and time spent on each stage of audit process have crucial effect on audit efficiency and effectiveness (audit risk). The illustration demonstrates that basically we have two types of approach: business risk approach with controls testing and substantive approach.
Audit Process
The approach in strategy should not be confused with approach in tactics regarding the concrete account connected with business process. In any case, we have to detect most risky and material areas of clients’ financial statements, i.e. substantive testing of all accounts is not reasonable.
         The second step is to identify our tactic regarding concrete type of account and assertion. For example, account is “fixed assets” (FA) and assertion is “valuation”. The process which is reflected by these two elements is “FA purchases” process. So at this point we might decide to test value of FA items substantively or do some preliminary purchases tests of controls to reduce substantive work in later stages. 

To test or not to test?
The outcome of control testing should be combined risk assessment of financial statement risk and audit risk, i.e. the result per well-known models:

         Audit Risk = Inherent Risk x Control Risk x Detection Risk (1);
Audit Risk = Financial Statement Risk x Detection Risk (2).

The audit firms try to formalize risk assessments (low, moderate, high) and spot the point at which it would be reasonable to reduce substantive procedures. However, there is still a problem: test of controls is time and money spent on procedures. And how do we know whether we should even start testing controls? What if after extensive control testing they proved to be ineffective? The mistakes might lead to inefficient audit, harming auditors’ profit margin. Unfortunately, I might say in majority cases the decision is made based on common sense and subjective opinion, i.e. there is no 100% proven scientific way to figure this out. Admittedly, to facilitate a right decision auditors should understand client’s business process, document suggested controls, and do process walk-through. There are also some rules of thumb, e.g. if there are lots of small routine transaction, then tests of controls are likely to be the right option.

Additional factors
The audit with accurate planning stage, through understanding of business processes and risk detection would require highly proficient audit team. However, we live in a real world and we do not always have access to the best dream audit teams J . The point is that the audit approach should be understandable by team members and fit their abilities: for someone it would be easier (time/budget factor) to vouch 1000 transaction than make decision based analytical job of connecting facts from process narrative, walk-through, initial strategy, and audit methodology. I mean, that process need not be overcomplicated. I would suggest following basic principles for establishing strategy:
  1. Efficiency (budget);
  2. Effectiveness (prudence, audit risk);
  3. Complexity/easiness to bring about;
  4. Understandability (and acceptability) for all members of team: from partner to audit staff.
In the future blog posts, it would be interesting to elaborate each of the above principles.

Conclusions
This is only outline of audit approaches. The topic is enormous and I will try to cover most arguable areas. Your comments are welcome as usual.
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