Audit Method: Quality Review

ISA 220, deals with quality control for an audit of financial statements. Engagement teams have a responsibility to implement quality control procedures that are applicable to the audit engagement and that are within the context of the firm’s system of quality control. The objective of the auditor is to implement quality control procedures at the engagement level that provide the auditor with reasonable assurance that:

• The audit complies with professional standards and applicable legal and regulatory requirements; and
• The auditor’s report issued is appropriate in the circumstances.

ISQC 1, deals with the firm’s responsibilities to establish and maintain its system of quality control for audit engagements. The system of quality control includes policies and procedures that address each of the following elements:

• Leadership responsibilities for quality within the firm;
• Relevant ethical requirements;
• Acceptance and continuance of client relationships and specific engagements;
• Human resources;
• Engagement performance; and
• Monitoring.

For audits of financial statements of listed entities, and those other audit engagements, if any, for which the firm has determined that an engagement quality control review is required, the engagement partner shall:

• Determine that an engagement quality control reviewer has been appointed;
• Discuss significant matters arising during the audit engagement, including those identified during the engagement quality control review, with the engagement quality control reviewer; and
• Not date the auditor’s report until the completion of the engagement quality control review.

Practice

The engagement partner shall take responsibility for the overall quality on each audit engagement to which that partner is assigned. The engagement partner should ensure that

• Appropriate procedures regarding the acceptance and continuance of client relationships and audit engagements have been followed;
• All ethical requirements are met;
• Independence criterion is met;
• Assignment of team members is appropriate;
• Overall direction, supervision and monitoring of the audit engagement is carried out.

Audit Method: Accounting for BREXIT

Auditors should consider the implications of BREXIT? The  EU referendum is carried out today and tomorrow by 9:00 AM Greenwich time we should be able to know the preliminary results.

Lets think about fictional accounting standard "Brexit accounting". We, auditors, have clients who work both in UK and EU and would like to know impact of Brexit outcome. 

I would consider following topics in this standard:

• Accounting for uncertainties;
• Disclosure and recognition of contingent assets;
• Disclosure and recognition of contingent liabilities;
• Disclosure of business risks related with change of UK status in EU

Some questions

• do we need to calculate long term provisions for employment termination  for EU employees from outside UK;
• discontinued operations: is there risk for the business to do that in case Brexit legislation would be enacted
• disclosure of future development in the strategic reports of companies who would benefit from Brexit

Some articles on the topic

EY helps boards to prepare:

http://www.ey.com/Publication/vwLUAssets/ey-helping-boards-assess-and-prepare-for-the-uk-referendum-on-eu-membership/$FILE/ey-helping-boards-assess-and-prepare-for-the-uk-referendum-on-eu-membership.pdf

Careers:

http://www.careersinaudit.com/article/how-will-brexit-affect-auditors-/

PWC involvement:

http://news.sky.com/story/1640482/accounting-giant-pwc-kicks-off-brexit-debate

Tax matters:

http://www.accountancyage.com/2016/04/13/would-brexit-mean-the-end-of-vat-in-the-uk/

Boards readiness:

https://iia.org.uk/media-centre/news/ftse-250-boards-finding-possible-brexit-planning-challenging/

Audit Method: Internal Audit Function

ISA 610 explains the relationship between internal audit function and the external auditor. Internal audit function is an appraisal activity established or provided as a service to the entity. Its functions include, amongst other things, examining, evaluating and monitoring the adequacy and effectiveness of internal control.

Preliminary assessment of the internal audit function

When it appears that internal audit is relevant to the external audit of the financial statements in specific audit areas, we make a preliminary assessment of internal audit by obtaining information about matters such as:

• the objectivity of internal audit function i.e. status and reporting of internal audit function in the entity
• the due professional care of internal audit, especially whether the work is adequately planned, supervised and reviewed
• the technical competence of the internal audit function
• whether management acts on internal audit's reports and recommendations and how this is evidenced

Evaluate and test the work of internal audit

When we intend to use specific work of internal audit, we evaluate and test that work to confirm its adequacy for our purposes.

For evaluation, we check that:

• the work is performed by persons with adequate technical training and proficiency.
• the work of assistants is properly planned, supervised, reviewed and documented.
• sufficient appropriate audit evidence is obtained to afford a reasonable basis for the conclusions reached.
• conclusions are appropriate in the circumstances and reports are consistent with the results of the work performed.
• any exceptions or unusual matters disclosed by internal audit are properly resolved by management.

For testing, we may perform any of the procedures below relating to testing of internal audit that may be considered given specific client circumstances. Our tests of the internal audit function's work may include the following procedures.

• Observe the internal audit function perform audit procedures.
• Re-perform some of the audit procedures previously performed by the internal audit function.
• Perform different audit procedures. For example, we may test controls, transactions or balances other than those the internal audit function tested.
• Examine internal audit's working papers.

Practice

Remember that the external auditor has sole responsibility for the audit opinion expressed, and that responsibility is not reduced by the external auditor's use of the work of the internal auditors. Evaluating the internal audit function becomes relevant only when the external auditor has determined, in accordance with ISA 315, that the internal audit function is likely to be relevant to the audit. The internal audit function is considered relevant when the nature of the internal audit function's responsibilities and activities are related to the entity's financial reporting, and the auditor expects to use the work of the internal auditors to modify the nature or timing, or reduce the extent, of audit procedures to be performed.

Audit Method: Subsequent Events

Subsequent Events as defined in ISA 560 are “Events occurring between the date of the financial statements and the date of the auditor’s report, and facts that become known to the auditor after the date of the auditor’s report.”

The objectives of the auditor for considering subsequent events are:

(a) To obtain sufficient appropriate audit evidence about whether events occurring between the date of the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in, the financial statements are appropriately reflected in those financial statements in accordance with the applicable financial reporting framework; and

(b) To respond appropriately to facts that become known to the auditor after the date of the auditor’s report, that, had they been known to the auditor at that date, may have caused the auditor to amend the auditor’s report.

Perform audit procedures designed to obtain sufficient appropriate audit evidence that all events up to the date of the audit report that may require adjustment of, or disclosure in, the financial statements have been identified

·   Consider changes in the areas which may affect the financial statements and other information in the annual report such as banking arrangements, currency and interest rates, key markets, key products, customers or vendors, key management or employees, government regulation or policy and the ratio of orders to sales and cash receipts and the position of the order book.

·   Consider other significant knowledge gained, for example press comment, internal audit reports, changes in client trading patterns, changes in laws or regulations, currency devaluations, major fires or catastrophes, or technology failures (e.g. computer operations failures) and security incidents.

·   Evaluate procedures management has established to ensure that subsequent events are identified.

·   Inquire of management and, where appropriate, those charged with governance as to whether any subsequent events have occurred which might affect the financial statements.

·   Review the results of the review of minutes of meetings of the entity’s owners, management and those charged with governance, including audit, executive and other Board committees since the balance sheet date.

·   Consider reviewing invoices from lawyers received after the year-end to determine whether any litigation, claims or assessments exist that were not previously identified in our analysis of legal expenses and other procedures.

·   Review the latest available interim financial statements and, as considered necessary and appropriate, budgets, cash flow forecasts and other related management reports. Consider whether they reveal any adverse trends or significant movements in balance sheet headings compared to the audited financial statements. Consider whether the management information is reliable.

Practice

Where a material subsequent event has been identified, determine whether it is reflected in the financial statements in accordance with the applicable financial reporting framework by adequate disclosure and, where appropriate, adjustment of the account balances and transactions affected. Consider also its effect on the audit report.

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: 

http://smallbusiness.chron.com/conduct-financial-audit-10228.html

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.

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:

New Regulations for Auditors: European Revolt

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. 

Audit Method: Testing Revenue

Audit-is-cool continues to supply auditors with information on different topics of audit methodology. This week we provide most popular procedures to provide assurance on financial statement line "Revenue".

TEST OF CONTROLS

• Make a selection of sales transactions from independent source records e.g. shipping records, delivery orders, purchase orders etc.
• Test the completeness of source records by ensuring their numerical sequences.
• Check that sales data is input only once and is subject to validation.
• Access to sales system is restricted by user ID and password.
• Check that prices are charged in accordance with the approved price list.
• Check that the quantity discounts are in accordance with the approved limits.

ANALYTICAL PROCEDURES

• Have the client prepare a comparative monthly analysis of sales by product line, division or other business segment, including gross sales, returns and allowances and discounts. Verify the clerical accuracy of the analysis.
• Perform analytical procedures on sales by developing an expected amount of sales based on prior year’s figures or current period economic conditions and then comparing it with actual amount. Any significant differences should be enquired into and corroborated.

TEST OF DETAILS

• Have the client reconcile totals for gross sales and sales deductions to the general ledger control accounts.
• Verify the sales invoices and check that the customer name, product description and quantities and price are mentioned on the invoice and compare it with the description of sales order.
• Review applicable sales invoices and shipping documents to determine the accuracy and validity of each selected sales transaction and sales tax charged thereof, if applicable.
• Document the criteria for selection of sales invoices for verification purposes and ensure that sample is representative both for volume and amount of transaction.
• Scan the sales journal to check whether there is any duplication of sales invoice numbers or gap in the sequence of invoice numbers to identify invoices cancelled, if any.
• Review significant sales returns and credit memos issued during the period as well as subsequent to the balance sheet date to determine whether they were properly authorized and recorded in the proper period.
• Discuss with appropriate client’s personnel the existence of significant uncertainties at the time
• of sales, if any, like recoverability, warranty and other obligations, price protection agreement or revenue limitation.
• Make a selection of transactions from recorded sales and shipping records for prior and after period-end and ensure proper cut-off.
• Ensure that all sales in foreign currencies are translated using exchange rate prevailing at the date of sale (a rate that approximates the actual rate for example, weekly / monthly average is also acceptable).
• Consider reasonableness of revenue by multiplying the number of units with the average selling price.
• Determine that the accounting policies and methods of revenue recognition are appropriate and are applied consistently.

Audit Method: Sampling

Audit sampling as defined by ISA 530 is “The application of audit procedures to less than 100% of items within a population of audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.”

The means available to the auditor for selecting items for testing are;

• Selecting all items (100% examination)
• Selecting specific items; and
• Audit Sampling

Audit sampling can be applied using either non-statistical or statistical sampling approaches.

Statistical approach has the following characteristics:

• Random selection of the sample items; and
• The use of probability theory to evaluate sample results, including measurement of sampling risk.

 A sampling approach which does not possess the above characteristics is called non-statistical sampling.

Steps in planning the sample are as follows:

• Determining the objectives of the test;
• Defining what errors or deviation are being sought;
• Identifying the population and sampling units; and
• Deciding the size of the sample.

Generally, larger the size of the sample, the more it will be representative of a population. Many audit firms would like to standardize the size of sample based on general and specific risk factors. Errors increase the imprecision of results from sampling. Therefore, if they are expected, a larger sample size is required. Finally in evaluating misstatements, the auditor, should exclude ‘anomalous’ error(s) which are misstatement or deviation that are demonstrably not representative of misstatements or deviations in a population from his projected misstatements. However, such errors may be considered when evaluating all misstatements within the sample and auditors shall obtain sufficient appropriate audit evidence to corroborate the fact that an error or deviation is anomalous.

Practice

Auditors need to consider the specific objectives to be achieved and the combination of audit procedures that is most likely to achieve those objectives. Audit sampling is applicable to both tests of control and substantive procedures.

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.

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.

Audit Method: Written Representations

A written statement by management provided to the auditor to confirm certain matters or to support other audit evidence. Written representations in this context do not include financial statements, the assertions therein, or supporting books and records (ISA-580).

Written representations are audit evidence and are necessary information to arrive at audit conclusions. However on their own they can not be relied upon for audit evidence to support audit conclusions therefore they do not affect the nature and extent of other audit evidence that is to be obtained by the auditor. It should be obtained only from management who has responsibility for preparing and presenting financial statements and is knowledgeable about the relevant matters.

ISA 580 requires the auditor to request management to provide written representations that it has fulfilled certain of its responsibilities. It may therefore be appropriate to make management aware that receipt of such written representations will be expected, together with written representations required by other ISAs and, where necessary, written representations to support other audit evidence relevant to the financial statements or one or more specific assertions in the financial statements.

The following issues may be documented in a written representation letter obtained from the management:

1. Assessment of risk of fraud by management
2. Management’s knowledge of identified or suspected non-compliance with laws and regulations
3. Related parties identification by the management
4. Consideration of all aggregated uncorrected misstatements to be immaterial
5. Assumptions used in making accounting estimates are reasonable
6. Consideration of subsequent events by management
7. Consideration of all possible matters and contingencies in going concern review
8. Any restatement made to correct a material misstatement in prior period financial statements that affect the comparative information.

Recommendation

My recommendation to the audit team would be to gather a list of issues about which it is appropriate to require a written representation. During finalization stage of audit, the audit team should write to the client confirming the issues about which they need a written representation from the management. The client must formally write the representation letter including all the issues pointed out along with other necessary representations, sign it and send it to the auditor. The written representation should be dated as nearly as possible, but not after, the date of audit report. 

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.

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.