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.

PS Please, do not forget to vote for your top 3 favorite subjects. The polls are going on the right-hand side of the blog. 

Polls on 2012 Top Interesting Subjects

This blog post is aimed to notify my readers about the ability to vote for the subjects, which would interest you in 2012. As I promised I summarised all topics into groups and provide you with opportunity to choose the most interesting. The results of polls would be reflected in my articles, i.e. I am going to write posts on topics preferred by the readers of my blog.

The subject groups are as follows:

1. Scrutiny of ethical issues, audit scandals and relation of the audit political issues. Sample posts are Ethical Auditor; Audit in Politics; The Role of Big4.
2. Audit methodology and technique. Sample articles are Final Stage; Subsequent Events; Group Audit. 
3. Audit education, exam preparation. Sample post is Audit Exam.
4. Business, professional issues and changes regulation in audit area. Sample articles are New Regulations for Auditors; Pure Audit; Shamrock Audit.
5. Audit studies overviews; interesting analysis and observations. Samples of reviews are Audit Opinion and Share Prices; Some Colour to Fraud;  Auditors’ turn to needle Greece.
6. Entertaining posts related with audit, i.e. audit is popular culture, videos, literature etc. Sample posts are Sketches by Monty Python; Commercials; Accountancy in Literature.

Voting Rules

As proud and accurate auditors J we should agree on voting rules:

1. The polls are placed on the right hand side of the blog, right above “about me” section J;
2. The polls will be open for 4 weeks starting from today, 18^th of January. Thus, the polls will be closed on the 15^th of February;
3. There is possibility to vote more than once. I recommend to vote for your top 3 favorite subjects: the averaged percentages will show us preferences of auditorium;
4. The results of polls would be immediately published within the week after the closure date, i.e. till the 22^nd of February.

Comments

Dear readers, once again I would like to ask to you to vote only for your top 3 favorite topics otherwise the picture could be distorted.

If you have any additional suggestions regarding subjects, which we need to discuss in 2012 year,  you are welcome to place comments in my blog or contact me via LinkedIn.

Thank you very much for following “Audit-is-Cool” blog!

2011 Top Audit Events and Hot Topics

My congratulations to all accountants that 2011 year finally ended. I wish you all the luck in 2012 year, hope it would not upset you.

In this post I would like to summarise some hot issues in audit area for 2011 and the most read topics of this audit blog. I don’t claim to be ultimate truth oracle, and, of course, you are welcomed to share your opinions regarding most significant events in audit world for 2011.

Top 3 events of 2011 affecting audit profession

1. The discussions regarding changes in legislation for auditing firm. I think, that this was one of the hottest topics in audit in last year and it has potential significant impact on our industry. European authorities are aware about ethic issues, lack of competition and quality, and expectation gap in our industry. Thus, proposed changes are related with audit firm rotation, creation of pure audit firms, supervision of audit, services provided by auditors.

2. Olympus scandal in Japan. The scandal in audit industry are drivers of changes, just remember what effect had Enron and Arthur Anderson problem. Admittedly, the occurrence of significant change depends on the place where a scandal occurs, to have real effect it should be probably in USA or at least Western Europe. Olympus case involves several Big4 audit firms and is very interesting: strange and costly acquisitions, inflated consultancy fee, not clear intentions of management.

3. Problems in World Economy. We can’t ignore macroeconomic factors affecting audit clients. The news from Europe are murky and there is risk that slow recovery and high indebtedness might result future bankruptcies. Of course, the auditors in the public opinion would be partly responsible for weak balance sheets of their clients J

Top 10 topics of “Audit-is-Cool!!!” Blog        
The process of topic selection is simple and transparent. I just monitor “post” section of Blogspot, which gives me statistics of most popular posts. The chart of top posts is published below.

What can I say about these selection of my readers?

Generally, top 5 positions show that people are interested in: 1) ethics and ethical scandals, 2) self-education, 3) business ideas, 4) politics, and 5) audit technical issues. I am glad that scientific issues in audit area are also appealing to readers: my overview of papers investigating effect of audit opinions on share prices got place in top ten.

What next?

In my next post I am going to ask my readers what topics you would like me to discuss in this blog in 2012. I will try to arrange polls for this purposes.

Again, dear readers if you have your personal opinion regarding most significant or may be most interesting events for 2011, please share them in comments. I would be glad to discuss it with you.              

Week-end: Big4 Audit Career Commercials

How would you assess the creativity of accounting firms? This question is especially relevant in the field of attracting young specialists as new hires.In this post I've decided to pick up career commercials addressed to graduates and potential junior employees made by industry leaders, Big4.

Why Deloitte? I think Deloitte's ad was rather dynamic, with good music, but a bit of trivial.



Why EY? EY has actually disappointed me, I found nothing creative which would look like this remarkable video. Finally, I picked up this video with interview of a nice girl with interesting accent J



Why KPMG? I decided to take KPMG Singapore's ad. The background music really touched me, it's style differs from music which other accounting firms place in their ads. Meanwhile, image could have been more clear.



Why PwC? In my opinion, there was not anything interesting among new PwC's commercials. So I end up selecting relatively old commercial: it might be viewed as pompous and pretentious one, but sometimes I find such kind of creativity rather appealing. I do not know why, but it has reminded me Ayn Rand's "Atlas Shrugged".



What commercials related with graduates hiring do you find interesting? Are there any appealing ones or real masterpieces? Please share information in comments.

Audit Exam Ultimate Pass Key

Last summer I successfully passed ACCA exam, P7 “Advanced Audit & Assurance”. While preparing for the exam, I designed succinct and universal “question tackling plan”, which helped to structure my ideas on auditing. In this post I would like to share my knowledge just before coming ACCA examination session.  

I believe it would be useful for all exams related with financial audit. So the candidates for qualifications like CPA or ICAEW are welcomed to utilize it as well. J

The logic is simple: the plan consists of common subjects/questions and points suggested to be addressed.

Question Tackling Plan

1.      Ethics area question

1.1.   Technical competence;

1.2.Objectivity/Independence (possible threats: self-review, familiarity, intimidation, self-interest, advocacy)

1.3.   Professional behavior;

1.4.   Integrity;

1.5.   Confidentiality.

Mnemonic: TOPIC

2.      Professional (audit business) area question

2.1.   Competence;

2.2.   Resources/costs;

2.3.   Reputation;

2.4.   Staff quality;

2.5.   Quality control: Acceptance; Directorship; Supervision; Review; Consulting; Disputes.

3.      Audit Opinion related question

3.1.   Clarity;

3.2.   Details (standards, amounts, scope);

3.3.   Structure (is heading on the right place?) of opinion and its Consistency (starts like “except for” and finishes like adverse opinion);

3.4.   Types of appropriate opinions. This depends on evidences (sufficient, mistake material and pervasive?);

3.5.   Prior year opinion.

4.      Audit Matters (audit evidence/process) question

4.1.   Materiality;

4.2.   Standard breached (IFRS, recognition, valuation criteria etc.);

4.3.   Risks of misstatement;

4.4.   Impact on Audit Opinion;

4.5.   Reliability (source of evidence).

5.      Audit Evidence question

Mnemonics:

Sources of evidence -  DADA3: Document Asset Director (interview/representations) Accounting record 3rd Party

Procedures AE IOU: Analytical (plausibility/predictability)   Enquiry & Confirm (written/verbal)     Inspection (documents/assets)       Observation (assets, process) RecalcUlation (opening balance check)

Elements of evidence:

5.1.   General: budgets/plans, accounting policy;

5.2.   Calculations: rates, models, risks, probabilities, impairment reviews, useful lives, assumptions reasonableness explanation;

5.3.   Disclosure: draft notes;

5.4.   Documents types:

5.4.1.      Bank statements, invoice, bill, dispatch/delivery note;

5.4.2.      Contract, agreement, insurance policy, title deed;

5.4.3.      Claim litigation copy, insurance claim;

5.4.4.      Log books, time-sheets;

5.4.5.      Minutes, orders, policies;

5.4.6.      Correspondence, letters;

5.4.7.      Tax returns;

5.5.   Reconciliations (with tax authority, debtor), confirmations;

5.6.   Record of discussion, interview, talk with employees;

5.7.   Valuation reports, surveys;

5.8.   Breakdowns (check for misclassification), samples.

Golden Rule:

Your answer should be always close to the question scenario: (1) the answer should be relevant; (2) the question text contains hint for answer.

You are welcomed to share your tips for audit exams. Good Luck! J

          Disclaimer:
"This group is not associated with or approved by ACCA and the views expressed on this page do not necessarily reflect the views of ACCA".

The Role of Big4 in promoting IFRS

The audit of IFRS reports is one of the major services provided by the international accounting networks. This is because they possess necessary knowledge and skills, which could be used all over the world. However, there are negative moments in this process, which could be illustrated by conclusion made by Sucher and Alexander (2002) in their research:

     “Given their power over both the production and audit of IAS accounts, the Big Five firms play a very large role in interpreting and implementing IAS standards in a particular country.  This raises issues of power and responsibility with respect to compliance with IAS that need to be addressed clearly by the IASB”

So this post is going to address this issue and point out on existing problem especially in emerging markets.

Illustrations

The issue was substantially researched by Sucher and Alexander (2002) based on the example of Russia and by Sucher and Jindrichovska (2004) in study of situation in Czech Republic.

The problem is that companies in emerging economies suffer from lack of knowledge and expertise in preparation of IFRS accounts. The probable solution could be to hire IFRS specialist or to outsource reporting process. But on the one hand there is a shortage of qualified and experienced professionals in emerging markets. On the other hand, outsourcing by one and afterwards auditing by another independent firm are seen as superfluous costs. Finally, these companies opt into simple solution – they ask audit firms both to prepare and audit their IFRS accounts. This state of things as honourable auditors we can’t tolerate, can we?

Sucher and Alexander (2002) illustrated the situation by remark of one of Big Five (at the moment of research) interviewees:

“As you know we do not prepare accounts for our clients – it is an independence issue….however, we do provide a degree of assistance….. Some accountants in enterprises crunch the numbers (for IAS) and others say, ‘look guys we pay you to do it.  It is a fairy tale’”

It is not only willingness to save money, the issue is also related with the perception of an audit as no-value-adding activity. Interviewees in Czech Republic complained that the earlier Big 4 audit firm provided such package of services while the latest Big 4 auditors refuse to do this (Sucher and Jindrichovska 2004). One of the Big 4 auditors (interviewee) added fuel to the fire:

“Some financial managers and accountants [in enterprises] do not know what is going on [with IFRS]. They are only the passive receivers. In [X audit firm], there are templates that transform Czech accounting to IAS. The knowledge is kept in the audit company. It is big business [for the audit firm]. You can train companies to do the supporting sheets hut the final bit is done by the audit firm.”(Sucher and Jindrichovska 2004).

Meanwhile, management of the companies would always be keen on saving costs on such things like audit. It is quite likely that such kind of cosy relations are more beneficial to audit firms. At least they could have separated audit and accounting team, but according to research it would be too costly for audit firms and they end up by assigning one team of people to do both jobs, which is a shame.

Problems

The basic issue which arises here is how far should we trust financial statements prepared in emerging markets? To what extent this practice spread in other emerging countries, where corporate governance and law enforcement are not developed enough? I think that it is highly probable that similar “reporting-auditng” is practiced in China, where local management is rather pushy in accounting issues (see Deloitte’s case).

The other question how can we deal with the issue in sensible way. For example, one is audit manager and one is doing audit of IFRS reports of Brazilian company. The resourceful Brazilian finance director provides auditor with financial statements (FS) essentially based on Brazilian GAAP, but with name of IFRS on its face. The trick is that you will do honest auditing, spot discrepancies from real IFRS and provide list of adjustments which need to be done J It is foxy tactic, isn’t it?

What do you think about truthfulness of IFRS accounts of companies from emerging markets listed on global stock exchanges? Have you faced approach mentioned above in your reporting or auditing practice? How to discourage auditors from doing that especially in the context of coming “pure-audit-firms” legislation? Please share your knowledge and experience.

References

Sucher, P. and Alexander, D. (2002) IAS: Issues of Country, Sector and Audit Firm Compliance in Emerging Economies (London: Centre for Business Performance of the Institute of Chartered Accountants in England and Wales).

Sucher P., and Jindrichovska I. (2004) Implementing IFRS: A Case Study of the Czech Republic. EAA, Accounting in Europe, Vol. 1, pp. 109-141.

Audit Procedures: Final Stage

The incentive for writing this post was recent article by Lisa Weaver, ACCA Advanced Audit examiner, on the topic of audit completion. Following essential subjects were covered there:

1)  Review of audit files and evaluation of misstatements (ISA 220, ISA 230, ISA 450);

2)      Final analytical procedures (ISA 520);

3)      Subsequent events and going concern procedures (ISA 560);

4)  Written representation and communication with those charged with governance (ISA 580, ISA 260);

5)      Audit clearance meeting.

The issue of subsequent events and going concern auditing I have already covered in one ofmy previous articles. In this post I would like to consider analytical procedures and meetings with client.

Being analyst

The task of performing analytical procedures in respect of financial statements usually called overall analytical review (OAR). It enables to examine client’s financials in terms of common sense and ensure that test of details were relevant. In addition, for audit senior or manager it is great opportunity to show broadness of mind and deepness of understanding of client. Of course, the quality of work done would influence his/her performance assessment.

Example of Gross Margin Analysis

The major problem, which auditors face in performing OAR is lack of time. This is because at the end of audit project everybody expects deliverables from you, there are lots of work need to be done. So it is necessary to organise audit process in a way that it would save time in future.

One possible solution is to delegate part of work to junior staff while they are doing audit of separate accounting sections. For example, after performing principal audit procedures junior auditor would be responsible to make reasonable analysis from the business point of view. Why inventory item in trial balance increased so dramatically this year? So by the time of doing OAR senior auditor will have preliminary analysis of item in balance sheet, which could be expanded or left as it is if explanation provided is comprehensive and sensible.

Inventory structure analysis

I would also like to emphasise necessity of using understanding of general business tendencies and economic factors while doing OAR. For example, I had following case. The inventory of client increased and accountant explained vaguely that it is due to prices leap. To address this explanation I have undertaken following steps:

1)    Found out what kind of inventory caused increase: it was special alloyed construction steel;

2)  Found out that sales and percentage of this kind of steel in total inventory also increased;

3)   Found out from external sources (steel producers magazines, special business overviews) and internal sources (invoices, contract specifications) that special alloyed construction steel is rather expensive type of metal;

4)   Found out that due to increase of demand on construction steel in China (it was before 2008) price on all types construction steel and its components (e.g., chemical additives) had increased.

So the shift to production of more expensive special alloy steel was driven by market and fit into general economic tendencies, i.e. there was nothing controversial in client’s explanations of increase in inventory value.

I like analytical procedures, because it is creative and intellectual task: it allows you to compare facts from different sources, and find out if client explanations are coherent and persuasive enough.

Being diplomat       

At the end of audit it is necessary to discuss major issues occurred during audit process and their implications. Generally, there are no problems in carrying out this meeting. However, there are some issues arising in case of multilocation audit. Management of subsidiary is usually rather nervous about audit outcomes and sometimes there is a substantial lag between the moment of fieldwork end and issuing of audit opinion. So to my opinion if auditors want to maintain good relations with local management it would be good to communicate some preliminary (flexible) deadlines of finalising work or find words which make client employees understand further steps and ensure your future effective cooperation.

If you have any interesting examples of your experience finalising audit please comment and give some tips.