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Financial statements of companies are very useful in business profession and the
following people or group of people are likely to want to see and use these:
All these people must be sure that the financial statements can be relied upon. The
problem, which has always existed when managers report to owners is “Can the owners
believe the report?
contain errors
not disclose fraud
be inadvertently misleading
be deliberately misleading
fail to disclose relevant information
fail to conform to regulations
The solution to this problem of credibility in reports and accounts lies in appointing an
independent person called an auditor to investigate the report and report on his findings.
A further point is that modern companies can be very large with multi-national activities.
The preparation of the accounts of such groups is a very complex operation involving the
bringing together and summarizing of accounts of subsidiaries with differing
conventions, legal systems and accounting and control systems. The examination of such
accounts by independent experts trained in the assessment of financial information is of
benefit to those who control and operate such organizations as well as to owners and
outsiders.
Many financial statements must conform to statutory or other requirements. The most
notable is that all company accounts have to conform to the requirements of the
Companies Ordinance, 1984.
The primary aim of auditing is to enable the auditor to say, “these accounts show a true
and fair view” or, of course, to say that they do not. The objects of an auditing are:
Primary:
To produce a report by the auditor of his opinion of the truth and fairness of financial
statements so that any person reading and using them can have belief in them.
Subsidiary:
The following are the matters to be taken into account and the preparation of an audit
plan:
The client and its background - history, products, locations, especially noting
factors like a new managing director, a new computer, a new product.
Important figures and ratios - from previous years and if available, from
management and draft accounts.
Audit risk areas - these might include stock, work in progress, or dealings with a
company under common ownership.
Requirement for involvement of specialists. These may be from within the audit
firm e.g. computer audit or rarely external specialists.
Client assistance. Assistance from the client may be required in providing docu-
ments and analyses, providing computer time, arranging visits to branches.
The audit approach. The extent of reliance on internal control, the use of
substantive tests and analytical review procedures.
Timetable - dates of interim, year end and final audits and of dead lines to meet
e.g. AGM of company.
Staffing requirement.
The operating style (e.g. direction from the top or disseminated decision making)
and control consciousness of directors and management.
Involvement with subsidiaries and their auditors, branches, divisions and other
components of the audit assignment.
Accountants must not only be people of integrity and independence; they must
also be seen to be so. Any interest (e.g. owning shares in a client company) which
might diminish an accountant's objectivity of approach or which might appear to
others, must be avoided.
Points to note:
In some areas they give guidance only. For example in the independence ethical
guide, the 15% fees rule is for guidance only client giving 10% of gross fees may
influence an auditor who fears the loss of income if he loses the client.
In all these ethical matters an accountant must not only behave correctly, he must
also be seen to be behaving correctly.
Auditors become privy to all sorts of information in the course of their work.
Auditor and their staff must regard all such information as totally privileged and
not disclose it to third parties except in circumstances where there is a legal right
or duty to disclose it. They may not also use such information for personal gain,
e.g. by insider trading.
Partners and staff of audit firms can become so familiar with the management or
staff of a client company that they lose their objectivity. This must be avoided
perhaps by rotating the partners and staff involved.
Independence is a big, issue at the time of writing and the practice of audit firms
performing other services for their audit clients has come into some criticism.
Warnings are made in the, ethical guides of the professional bodies of the risks to
objectivity in performing these services but these all fall a long way short of
prohibition. The real question is whether an audit firm can offer a totally
dispassionate opinion if it and/or an associated firm are supplying services like:
• Bookkeeping
• Preparing the annual accounts
• Taxation
• Advice on company secretarial matters
• Management consultancy
• Obtaining staff
• Selecting computer systems
• Litigation support
• Corporate financial advice e.g. on capital raising or takeovers
The directors can engineer a change of auditor if they wish the senior conducting
the audit prepared the final accounts the firm advised the firm on the choice of a
computer firm for the supply of new hardware and software
The firm investigated a company which the client company purchased the firm
advised the client on a complex scheme for tax avoidance.
Internal control is defined as the whole system of controls, financial and otherwise,
established by the management in order to carry on the business of the enterprise in an
orderly and efficient manner, ensure adherence to management policies, safeguard the
assets and secure as far as possible the completeness and accuracy of the records.
If we look into the definition of the internal control, it will find out that the following are
objectives of internal control.
To ensure that all cash and cheques received by post are accounted for and accurately
recorded in the books.
To ensure all such receipts are promptly and intactly deposited in the bank.
To ensure that all cash and cheques received are banked intact.
To ensure that all cash and cheques received are banked without delay at prescribed
intervals, preferably daily.
To ensure that all cash and cheques received are accounted for and recorded accurately.
Cash balances
Bank balances
Cheque payments
To ensure that wages and salaries are paid only to actual employees at authorized rates of
pay.
To ensure that all wages and salaries are computed in accordance with records of work
performed whether in respect of time, output, sales made or other criteria.
To ensure that payrolls are correctly calculated.
To ensure that payments are made only to the correct employees.
To ensure that payrolls deductions are correctly accounted for and paid over to the
appropriate third parities.
To ensure that all transactions are correctly recorded in the books of account.
To ensure that goods and services are only ordered in the quantity, of the quality, and at
the best terms available after appropriate requisition and approval.
Arithmetic and Accounting – This check that the transactions have been
authorized, that they are all included and that they are correctly recorded and
accurately processed.
INTERNAL CONTROL
Internal control is defined as the whole system of controls, financial and otherwise,
established by the management in order to carry on the business of the enterprise in an
orderly and efficient manner, ensure adherence to management policies, safeguard the
assets and secure as far as possible the completeness and accuracy of the records.
The control environment is a new concept in auditing. Internal controls have limitations.
Internal controls are essential features of any organisation that is run efficiently. However
it is important to realise (especially for art auditor) that internal controls have inherent
limitations that include:
Fraud
Requires that auditors’ must always perform some substantive tests of material items as
well as relying on internal controls. The inherent limitations of internal controls are the
reason.
Internal auditing
The essential elements of an internal audit function are: independence, staffing, training;
relationships, due care, planning, controlling, recording, systems controls, evidence and
reporting.
There are differences between internal and external audits in terms of: scope, approach,
responsibility and persons to report to.
Internal auditing is now considered a major discipline and there are many textbooks on
the subject.
It is important that Internal Audit report to the highest level, preferably the Board or an
audit committee.
The guideline has much to say on the objectivity, the staffing and the training of internal
auditors and on planning, control and reporting. These ideas are very similar to those of
guidelines for external audit.
The guideline gives a very good summary of the stages in a systems audit as:
Identify the system, parameters (e.g. the details of a system for identifying bad
credit risks before sales)
Determine the control objectives (e.g. to prevent sales to bad credit risks)
Review the system against expected controls (e.g. is inspection of the sales ledger
account included in the system)
Test the controls designed into the system against control objectives (e.g. are the
sales ledger inspections and other controls adequate [or alternatively too stiff] to
prevent sales to bad risks)
BUYING
RECEIPTS OF GOODS
ACCOUNTING FOR PURCHASES
PAYMENT OF OUTSTANDING BALANCES
The main features of internal control system in the above mentioned functions of
purchases and trade creditors are:
Objectives:
To ensure that goods and services are only ordered in the quantity, of the quality,
and at the best terms available after appropriate requisition and approval.
To ensure that goods and services received are inspected and only acceptable
items are accepted.
To ensure that all invoices are checked against authorized orders and receipt of the
subject matter in good condition.
To ensure that all goods and services invoiced are properly recorded in the books.
Measures
There should be procedures for the requisitioning of goods and services, only by
specified personnel on specified forms with space for acknowledgement of
performance.
Order forms should be pre-numbered and kept, in safe custody. Issue of blank
order form, books should be controlled and recorded.
All goods should be inspected for condition and agreement with order and
counted on receipt. The inspection should be acknowledged., Procedures for
dealing with rejected goods or services should include the creation of debit notes
(pre-numbered) with subsequent sequence checks and follow up of receipt of
suppliers' credit notes.
Invoices should have consecutive numbers put on them and batches should be
pre-listed.
A proper coding system is required for purchase of goods and services so that the
correct nominal accounts are debited.
DESIGNING
Materiality. Petty cash expenditure may be so small that no conceivable error may
affect the true and fair view of the accounts as a whole.
The number of items in the population. If these are few (e.g. land and buildings),
a hundred per cent check may be economic.
STAGES
Audit objectives. Why is this test being carried out? What contribution does
it make to the overall assessment of true and fair view?
The sampling unit. Note that in compliance testing it is the operation of the
control on a transaction not the transaction, which is the sampling unit.
The expected error deviation rate. This is a factor, which is not intuitively
expected by students. In fact, errors increase the impreciseness of
conclusions drawn from sampling and larger sample sizes are required if
there are many errors.
Evaluating the results. This should also be done in stages: Analyse the
errors/ deviations detected in relation to the planning definitions.
Assess the risk of an incorrect solution. This will be related to the amount
of projection of error compared with the tolerable error and the availability
of alternative evidence.
Random - a random sample is one where each item of the population has an equal
(or specified) chance of being selected. Statistical inferences may not be valid
unless the sample is random.
Protective - protective, that is, of the auditor. More intensive auditing should
occur on high value items known to be high risk.
Unpredictable - client should not be able to know or guess which, items will be
examined.
Selecting a sample of appropriate size on the basis of the, auditor's judgement of what is
desirable. This approach has some advantages:
The approach has been used for many years. It is well understood and refined by
experience.
The auditor can bring his judgement and expertise into play. Some auditors seem
to have a sixth sense.
No time is spent on playing with ~ mathematics. All the audit time is spent on
auditing.
It is unscientific.
The sample selection can be slanted to the auditors needs e.g. selection of items
near the year-end to help with cut-off evaluation.
Overall, judgement sampling is still the preferred method by a majority of auditors. Partly
this can be defended on the grounds that the auditor is weighing several strands of
It is scientific.
It is defensible.
It can be used by lower grade staff who would be unable, to apply the judgement
needed by judgement sampling.
Time is spent playing with mathematics which might better be spent on auditing.
It is inflexible.
Often several attributes of transactions or documents are tested at the same time.
Statistics does not easily incorporate this.
A complex check of all the transactions and balances of a business is no longer required
of an auditor. The reasons for this are:
Economic – the complete check would take so long that accounts would be
ancient.
Time – the complete check would take so long that accounts would be ancient
history before users saw them.
Practical – users of accounts do not expect or require 100% accuracy. Materiality
is very important in accounting as well as auditing.
Psychological – a complete check would so bore the audit staff that their work
would become ineffective and errors would be missed.
Fruitfulness – a complete check would not add much to the worth of figures if, as
would be normal, few errors were discovered. The emphasis in auditing should
be on the completeness of record and the true and fair view.
STRATIFIED SAMPLING
Stratified this means dividing the population into sub populations (strata = layers) and is
useful when parts of the population have higher than normal risk (e.g. high value items,
overseas debtors). Frequently high value items form a small part of the population and
are 100% checked and the remainder are sampled.
CLUSTER SAMPLING
Cluster sampling this is useful when data is maintained in clusters (groups or bunches) as
wage records are kept in weeks or sales invoices in months. The idea is to select a, cluster
randomly and then to examine all the items in the cluster chosen. The problem with this
method is that this sample may not be representative.
Vouching is the very essence of auditing. The whole success of the audit depends upon
the intelligence and skill with which this part of the work is performed.
As the primary aim of auditing is to enable the auditor to say, “these accounts show a true
and fair view” or, of course, to say that they do not. The primary objects of an auditing
are to produce a report by the auditor of his opinion of the truth and fairness of financial
statements so that any person reading and using them can have belief in them. Its
subsidiary objects are to detect errors and fraud; to prevent errors and fraud by the
deterrent and moral effect of the audit; to provide spin-off effects. The auditor will be
able to assist his clients with accounting, systems, taxation, financial, and other problems.
And the vouching involves a consideration of each entry in the books and vouching the
available evidence to support each entry. The evidence usually consists of documents
and papers and should satisfy the auditor that:
The auditor should examine the books in which the purchase invoices are recorded and
the file of purchase invoices. Each invoice will be examined and the following points
must be borne in mind:
In vouching audit it is ensured that all bad debts should only be written off after due
investigation and acknowledged authorization by senior management. For this purpose
the following procedure is adopted:
Direct external evidence is available for the existence and ownership of an asset.
Negative
The customer is asked to communicate only if he does not agree the balance. This method
is mostly where internal control is very strong.
Positive
Customer is asked to reply whether he agrees the balance or not or is asked to supply the
balance himself. This method is used where there is:
Obtain the co-operation of the client - only he can ask third parties to divulge
information.
Do not omit - Nil balances - Credit balances - Accounts written off in the period.
Use stratified samples, e.g. all large balances and only some small ones.
Follow up when replies are not received. This is the major problem.
Circularisation is sometimes carried out at dates other than the year-end. This will
occur only when internal control is very strong.
Discuss the specific points which you will keep in view during
5(b) verification of:
DEFERRED COST
As the deferred cost is a heavy expenditure in the nature of revenue incurred and the
benefit of which is likely to extend beyond the financial year in which it takes place. For
verification purposes, it is verify that this is temporarily capitalized and to be spread
equally over number of years for which it is anticipated that benefit would be reaped by
the business.
Event occurring after the date of the balance sheet may assist in the assessment of the
position, as it existed on that date in respect of some of the item appearing in the balance
sheet. These are stated as under:
INVESTMENTS
Before making any investment, it is required to take proper approval of the authority that
should be within the objectives provided in the Memorandum of Association. To verify
the investments, the following work is carried out:
Investments certificates are in the name of owners, and their value is upto
investment and comparing it with its ledger.
Checking the market value with the quotation list at the date of the balance sheet.
Scrutinize each individual investment account to ensure that all interest has either
been received or accrued in books.
In case of the limited companies, enquire into the question of dividend income.
Any amount of uncalled capital relating to shares held as investments and give a
foot-note of it in the balance sheet.
Enquire into the speculative transaction with particular reference to short-term
purchases and sales.
The valuation of debtors is really a consideration of the adequacy of the provision for bad
and doubtful debts. The auditor should consider the following matters:
The adequacy of the system of internal control relating to the approval of credit
and following up of poor payers.
Questions of set-off.
The state of legal proceedings and the legal status of the debtor eg in liquidation
or bankruptcy.
Evidence of any debt in dispute e.g. for non-delivery, breakages, poor quality etc.
Note that:
a. Debts, which are considered irrecoverable, should be written off to the profit and
loss account.
b. Provisions for doubtful debts should be set up against debts, which are considered
doubtful.
Some companies make round-sum or percentage provisions against doubtful debts. This
practice is generally unacceptable to an auditor unless based on good statistical evidence,
which may come from past experience or may come from data about other similar
undertakings which is obtainable from trade associations or which is publicly available.