PROMETRICS Finance : Auditing Concepts and Auditing Standards

Audit Engagement Letter

Accountancy and auditing are pursuits of a noble profession, the conduct of its members is governed by a set of the rules. One of the rules forbids chartered accountants to solicit clients. Clients must themselves find their auditors. A client is anybody or any entity which requires the service of a professional accountant for the audit of the accounts or for any other purpose.

Clients may be individuals, partnership firms, companies, societies, clubs, trust, co-operative societies, government, etc. Of these, the legal requirement to get the accounts audited so far extends only to companies, co-operative societies, and registered societies. In these cases the respective law governs the appointment of auditors and their duties.

In all other cases, it is a matter of contract. The client tells the auditor the nature of service he requires and the auditor, if he is agreeable to undertake the assignment, specifies his terms. He must sign an agreement, if he accepts the work in terms of the agreement subject to professional standards. Clients who are not statutorily required to get their accounts audited may require preparation of accounts for tax-returns, checking of the sales tax-returns, etc. besides audit. There may be a misunderstanding about the exact scope of the work; the auditor may think that he is merely required to prepare accounts while the client may think audit of accounts, is also covered. It is, therefore, of the greatest importance, both for the auditor and client, that each party should be clear about the nature of the engagement: it must be reduced in writing and should exactly specify the scope of the work. The audit engagement letter is sent by the auditor to his client which documents the objective and scope of the audit, the extent of his responsibilities to the client and the form of report. The ICAI has issued SA 210 on the subject. It is in the interest of both the auditor and the client to issue an engagement letter so that the possibility of misunderstanding is reduced to a great extent.

In the case of partnerships, a few more precautions are needed. The appointment of the auditor is normally governed by the partnership deed. The accountant, when he is approached for undertaking a professional assignment by a firm or a partner of a firm, should first get a clear idea of the nature of the service required and then ensure, with reference to the terms of partnership agreement that his appointment is valid. Above all, he should bear in mind that all partners jointly and severally are his clients, though he might have been appointed by only one of them if so, authorised under the partnership deed. He must see that the individual interests of the partners have not been adversely affected in any manner and the provisions of the partnership deed regarding accounting have been fully given effect to.

In case of a recurring audit, the auditor may decide not to send a new engagement letter each period. However, the following factors may make it appropriate to send a new letter:

Any indication that the client misunderstands the objective and scope of the audit.

 Any revised or special terms of the engagement.

 A recent change in senior management, board of directors or ownership.

A significant change in nature or size of the client’s business.

 Legal requirements or pronouncements of the Institute of Chartered Accountants of India, or changes in the existing ones.

Acceptance of a Change in Engagement: An auditor who, before the completion of the engagement, is requested to change the engagement to one which provides a lower level of assurance, should consider the appropriateness of doing so.

A request from the client for the auditor to change the engagement may result from a change in circumstances affecting the need for the service, a misunderstanding as to the nature of an audit or related service originally requested or a restriction on the scope of the engagement, whether imposed by management or caused by circumstances. The auditor would consider carefully the reason given for the request, particularly the implications of a restriction on the scope of the engagement, specially any legal or contractual implications.

If the auditor concludes that there is reasonable justification to change the engagement and if the audit work performed complied with the SAs applicable to the changed engagement, the report issued would be appropriate for the revised terms of engagement. In order to avoid confusion, the report would not include reference to:

(a) the original engagement; or

(b) any procedures that may have been performed in the original engagement, except where the engagement is changed to an engagement to undertake agreed-upon procedures and thus reference to the procedures performed is a normal part of the report.

The auditor should not agree to a change of engagement where there is no reasonable justification for doing so.

Audit Planning

As per Auditing and Assurance Standard 1, “Basic Principles Governing an Audit”, Audit Planning is one of the basic principles.

Accordingly, it states “The auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner. Plans should be based on knowledge of the client’s business.

Plans should be made to cover, among other things :

(a) acquiring knowledge of the client’s accounting systems, policies and internal control procedures;

(b) establishing the expected degree of reliance to be placed on internal control;

(d) coordinating the work to be performed.

Plans should be further developed and revised as necessary during the course of the audit.”

SA-300 further expounds this principle. According to it, planning should be continuous throughout the engagement and involves :

 developing an overall plan for the expected scope and conduct of the audit; and

 developing an audit programme showing the nature, timing and extent of audit procedures.

Changes in conditions or unexpected results of audit procedures may cause revisions of the overall plan of and the audit programme. The reasons for significant changes may be documented.

Objectives of Planning : Adequate audit planning helps to :

ensure that appropriate attention is devoted to important areas of the audit;

     ensure that  potential problems are promptly identified;
     ensure that the work is completed expeditiously;
      utilise the assistants properly; and
       co-ordinate the work done by other auditors and experts.

In planning his audit, the auditor will consider factors such as complexity of the audit, the environment in which the entity operates, his previous experience with the client and knowledge of the client’s business.

The auditor may wish to discuss elements of his overall plan and certain audit procedures with the client to improve the efficiency of the audit and to coordinate audit procedures with work of the client’s personnel. The overall audit plan and the audit programme,however, remain the auditor’s responsibility.

Audit Objective

The auditor must gather sufficient competent evidential matter as a basis for forming his opinion on :

(a) the truth and fairness of the accounts and also their compliance with the provisions of the related laws, rules and regulations;

(b) the proper keeping of the accounting records, and other records and related registers of the client.

These broad objectives may be amplified as follows :

To determine whether :

(1) all assets and liabilities are properly stated and classified on a basis consistent with that of the previous year;

(2) proper disclosure is made of securities for liabilities and of assets charged or secured;

(3) the client has complied with the provisions of the applicable laws and documents created under them, loan agreements and other documents to which he is a party;

(4) income and expenses are properly classified and disclosed and are properly matched.

They relate to the period in which they are reported and have been determined on a basis consistent with that of the previous year;

(5) all contingencies and commitments are properly disclosed;

(6) no material omissions have been made in the financial statements;

(7) no material error or inaccuracy in reporting or disclosing income, expenses, assets and liabilities has been created in the financial statements;

(8) the books and records have been properly kept in accordance with the requirements of the client.

The expression of opinion on the overall balance sheet and profit and loss account involves initially forming an opinion on each of the balance sheet or profit and loss items; it is necessary first to decide what are the essential conditions or pre-requisites for each balance sheet or profit and loss account item in order to give a true and fair view of the particular assets or liabilities or item of income or expense being represented. These conditions are well established and may be illustrated by reference to the areas of sundry debtors and sales revenues.

Sundry Debtors : The audit of sundry debtors should be sufficiently comprehensive to enable the auditor to form an opinion as to whether :

(1) The amounts shown represent bonafide receivables of the company.

(2) The receivables are properly classified.

(3) Adequate provisions have been made for uncollectible receivables and for discounts and freight allowable, returns adjustments, etc.

(4) Any receivables have been pledged, discounted, assigned or sold, and if so whether they are properly disclosed.

Sales Revenues : Specific objectives in the audit of sales revenues are to determine whether:

(1) Sales accounting procedures are operating effectively to produce reliable sales revenue figures for the period.

(2) Sales revenues have been recorded in the proper accounting period and are not overstated through improper credits for fictitious sales of goods neither supplied nor set aside. Conversely, whether sales or other revenues are understated through deferring the recording thereof to subsequent periods or omitting to record sales despatched as sales.

(3) Allowance, returns and other sales deductions are fairly stated and properly treated in the financial statements and that adequate provisions have been made for any significant additional amount that may be anticipated to be paid but not yet finally settled.

(4) Non-operating revenues have been segregated from sales revenues and have been appropriately treated in the profit and loss statement.

What is Audit Risk

Audit risk is the risk that an auditor may give an inappropriate opinion on financial information that is materially mis-stated. For example, an auditor may give an unqualified opinion on financial statements without knowing that they are materially mis-stated. Such risk may exist at overall level or while verifying various transactions and balance-sheet items.

1. Audit risk at the financial statement level : Audit risk is considered at the financial statement level during the audit planning process. At this time, the auditor should undertake an overall audit risk assessment based on his knowledge of the client’s business, industry, management, control environment and operations. Such an assessment provides preliminary information about the general approach to the engagement, the auditor’s staffing needs and the framework within which materiality and audit risk assessments can be made at the individual account balance or class of transactions level. As part of this overall risk assessment, the auditor should consider whether there is potential for pervasive problems, for example, liquidity or going concern problems.

2. Audit risk at the account balance and class of transactions level: The majority of audit procedures are directed to, and carried out at the account balance and class of transactions level. Accordingly, audit risk should be considered by the auditor at this level taking into account the results of the overall audit risk assessment made at the financial statement level. To assess inherent risk, the auditor uses professional judgement to evaluate numerous factors, examples of which are:

At the financial statement level :

 the integrity of management;

 management experience, knowledge and changes during the period (e.g. the in ex- perience of management may affect the preparation of the financial statements of the entity);

 unusual pressures on management (e.g. circumstances that might predispose management to mis-state the financial statements, such as an entity in an industry experiencing a large number of business failures or an entity that lacks sufficient capital to continue operations);

 the nature of the entity’s business (e.g. its technological obsolescence of products and services, complex capital structure, significance of related parties, and the number of locations and geographical spread of its production facilities); factors affecting the industry in which the entity operates (e.g. economic and competitive conditions, and changes in technology, accounting practices common to the industry and, if available, financial trends and ratios);

At the Account balance and class of transaction level:

 financial statement of accounts likely to be susceptible to misstatement (e.g. a financial statement of account which required adjustment in the previous period);

 the complexity of underlying transactions which might require the use of the work of an expert;

 the amount of judgement involved in determining account balances;

 susceptibility of assets to loss or misappropriation;

 the completion of unusual and complex transactions, particularly at or near year end;

Assessment of audit risk by reference to its components : Audit risk has been discussed at length in SA-400. As per SA-400 three components of audit risk are:

 inherent risk (risk that material errors will occur);

 control risk (risk that the client’s system of internal control will not prevent or correct such errors); and

 detection risk (risk that any remaining material errors will not be detected by the auditor).

The nature of each of these types of risk and their interrelationship is discussed below:

Inherent risk is the susceptibility of an account balance or class of transactions to misstatement that could be material, individually or when aggregated with mis-statements in other balances or classes, assuming that there were no related internal controls. It is a function of the entity’s business and its environment and the nature of the account balance or class of transactions. For example, accounts involving a high degree of management judgement, or that are difficult to compute, such as a complex accounting estimate, or that involve highly desirable and movable assets, such as jewellery, or that are particularly susceptible to changes in consumer demand or technology that could affect their value, will involve more inherent risk than other accounts.

Control risk is the risk that misstatement that could occur in an account balance or class of transactions and that could be material, individually or when aggregated with mis- statements in other balances or classes, will not be prevented or detected on a timely basis by the system of internal control. There will always be some control risk because of the intrinsic limitation of any system of internal control. To assess control risk, the auditor should consider the adequacy of control design, as well as test adherence to control procedures. In the absence of such an assessment, the auditor should assume that control risk is high.

Detection risk is the risk that an auditor’s procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes. The level of detection risk relates directly to the auditor’s procedures. Some detection risk would always be present even if an auditor were to examine 100 percent of the account balance or class of transaction because, for example, the auditor may select an inappropriate audit procedure, misapply an appropriate audit procedure or misinterpret the audit results.

Interrelationship of the components of audit risk : Inherent and control risks differ from detection risk in that they exist independently of an audit of financial information. Inherent and control risks are functions of the entity’s business and its environment and the nature of the account balances or classes of transactions, regardless of whether an audit is conducted. Even though inherent and control risks cannot be controlled by the auditor, the auditor can assess them and design his substantive procedures to produce an acceptable level of detection risk, thereby reducing audit risk to an acceptably low level.

Concept of Test Checking , Audit Sampling

Very often we come across this term when an audit is conducted on the basis of a part checking. This, it is said, owes its origin to the statistical theory of sampling.

The auditor according to his best judgment, having regard to the nature, size and materiality of transactions, picks up the entries for examination. Normally, entries involving large amounts or relating to material accounts are seen exhaustively and entries are picked up for verification at random from the remainder according to a certain plan.

Sometimes, entries are checked for a few specified months exhaustively and the rest go unchecked. Though it is stated that the technique is an adaptation of the sampling theory, it is in reality far from it. It lacks any acceptable basis and gives the auditor no idea about the degree of reliability that he can place on the findings for application to the whole set of entries. The so-called random picking is not random in the statistical sense. To be truly random, the selection should be free from any bias and that is possible only through a statistical process and by reference to the random number tables.

The only quality that this technique can claim lies in its keenness to cover larger amounts and material accounts. Even if errors, frauds etc., remain undetected in the part not checked, they are not likely to be too big as to upset the truth and fairness of the financial statement. But auditors cannot be certain about this even after checking 100% of transactions. The cost and time involved in conducting an audit has to be visualised in relation to benefits which shall accrue from such an approach. If fairly lesser amount of checking may lead to admit same conditions there is absolutely no point in checking entire transaction. Moreover, there are constraints within audit has to be completed.

In any audit, the question of fact is more important because essentially the auditor’s job is to test the assertions in financial statements by reference to available evidence, apart from the following aspects:

i. presentation,

ii. disclosure,

(iii) arithmetical accuracy,

(iv) adherence to accepted accounting principles, and

(v) compliance with the requirements of law.

An auditor is also concerned about the existence of errors and frauds in the financial accounts. The few matters listed above are fundamental questions affecting the true and fair concept and due consideration to these are given at the appropriate stage of audit. However, errors and frauds stand on a slightly different footing inasmuch as there is a need to eliminate them if they exist to affect truthfulness and fairness materially. It is therefore necessary that an auditor should have a fair idea about why error and frauds occur, how they are committed and what are the usual means to locate them.

Precautions to be taken in Adopting Test Checking Techniques

Generally, a large manufacturing concern is associated with a large volume of transactions. Also, the nature of the transactions is determined by the nature of the business. For example, one may find numerous purchases of raw materials, stores, spares, etc.; there may be thousands of workers to be paid wages on weekly basis; the wages again may be calculated on a job or time basis. Depending upon the product lines, the sales mechanics may be different for different products - some may be to dealers and agents, some to wholesalers and some others even to retailers and consumers directly. Sales and purchase operations may stretch even to overseas markets. There may be various forms in which such a concern can raise bank finance, like letter of credit, packing credit, overdraft, bills discounted, etc. Basically, in a large manufacturing concern the problem is the problem of volume and variety.

In the circumstances when necessarily the test check technique has got to be adopted for audit work, it should be done by taking certain precautions so that a reliable idea about the truth and fairness of the accounts can be obtained by the auditor. The precautions that should be taken may be the following :

(i) The transactions of the concern should be classified under appropriate heads and may be stratified if wide variations are there between transactions of the same kind.

(ii) Systems and procedures for entering into and processing a transaction right from the beginning to the end should be studied in a sequential order. It involves questions of authorisations, documentation and recording and evidencing the same.

(iii) The whole of the system of internal control in the areas of accounts and finance should be studied and evaluated for its efficiency, soundness and capability for producing reliable accounting and financial data. This can be done by studying the controls and internal checks, evaluating their general soundness in the context of the business of the concern and testing their actual operation. If, and only if, the auditor is satisfied about soundness of the controls and their operation in actuality, can he decide to have test checks. For testing the operation of the control system, he should select a few transactions and check them in depth by the application of procedural tests.

(iv) A properly thought-out test check plan should be prepared and the objective of each check should be clearly understood by the auditing staff. For example, each voucher may be checked by the test check method for a number of objectives - one may be to ensure that the cash payments are properly authorised and acknowledged, others may be to see whether the amount actually payable has in fact been paid and whether the payment has been debited to the proper account. If there is a mix-up in the objectives or the objective is to test a number of variables in one test scheme, the result may not be helpful. Hence it requires a clear definition of the audit objective related to the particular test check plan.

(v) The transactions falling under each test-check plan should be selected in a manner so that bias cannot enter in the selection. For the purpose, selection should be made by reference to the random number tables.

(vi) Identification of the areas where test check may not be done. For example, if there are only 20 overseas sales in the year, it would be preferable to have them all thoroughly checked.

(vii) The number of transactions to be selected for each test-check plan should be predetermined. This can be done by deciding upon the degree of reliance that should be placed on the test-check result and the confidence that can be placed - the result to be obtained should be veering round the degree of reliance set up. Once the degree of reliance and the confidence level required in the audit for expression of the opinion have been decided, the number to be tested out of the given population can be easily known by reference to the statistical tables.

(viii) Errors that may be found may be material or immaterial in the context of the particular audit. Since errors of immaterial nature are not likely to distort the overall truth and fairness of the accounts, it is necessary to decide upon the criteria to judge what constitutes a material error. Further investigation of immaterial error may be avoided and only the material errors may be properly and thoroughly investigated.

Methods of Statistical Sampling

As per SA 530, “Audit Sampling”, the auditor should select sample items in such a way that the sample can be expected to be representative of the population. This requires that all items in the population have an opportunity of being selected.

There are two major methods in which the size of the sample and the selection of individual items of the sample are determined. These methods are : (1) judgmental sampling; and (2) statistical sampling.

Whatever may be the method, judgmental or statistical sampling, the sample must be representative. This means that it must be closely similar to the whole population although not necessarily exactly the same. The sample must be large enough to provide statistical- ly meaningful results.

Judgmental Sampling : Under this method, the sample size and its composition are determined on the basis of the personal experience and knowledge of the auditor. This method has been in common application for many years because of its simplicity in operation. Traditionally, the auditor on the basis of his personal experience, will determine the size of the sample and express it in terms that number of pages or personal accounts in the purchases or sales ledger to be checked. For example, March, June and September may be selected in year one and different months would be selected in the next year. An attempt would be made to avoid establishing a pattern of selection year after year to maintain an element of surprise as to what the auditor is going to check. It is a common practice to check large number of items towards the close of the year so that the adequacy of cut-off procedures can also be determined.

The judgmental sampling is criticised on the grounds that it is neither objective nor scientific. The expected degree of objective cannot be assured in judgmental sampling because the risk of personal bias in selection of sample items cannot be eliminated. The closeness of the qualities projected by the sample results with that of the whole population cannot be measured because the sample has not been selected in accordance with the mathematically based statistical techniques. However, it may be stated that the auditor with his experience and knowledge of the client’s business can evaluate accurately enough the sample findings to make audit decision and the mathematical proof of accuracy in some cases may be a luxury which the auditor cannot afford.

In judgmental sampling the auditor’s opinion determines the sample size but it cannot be measured how far the sample size would fulfill the audit objective. In statistical sampling, the sample results are measurable as to the adequacy and reliability of the audit objectives.

Statistical Sampling : Statistical sampling is a method of audit testing which is more scientific than testing based entirely on the auditor’s own judgment because it involves use of mathematical laws of probability in determining the appropriate sample size in varying circumstances. Statistical sampling has reasonably wide application where a population to be tested consists of a large number of similar items and more in the case of transactions involving compliance testing, debtors’ confirmation, payroll checking, vouching of invoices and petty cash vouchers.

Students may note that it is unnecessary for the auditor to gain indepth knowledge of statistics before making use of statistical sampling for audit testing since published statistical tables are available which indicate the sample size based on pre-determined criteria.

Selection of the Sample

Sample should be selected in such a manner that it is representative of the population from which the sample is being selected. It will necessitate that each item in the population has an equal chance of being included in the sample. Some of the important methods of selecting the sample are discussed below -

Random Sampling : Random selection ensures that all items in the population or within each stratum have a known chance of selection. It may involve use of random number tables. Random sampling includes two very popular methods which are discussed below:—

i. Simple random sampling : Under this method each unit of the whole population e.g. purchase or sales invoice has an equal chance of being selected. The mechanics of selection of items may be by choosing numbers from table of random numbers by computers or picking up numbers randomly from a drum. It is considered that random number tables are simple and easy to use and also provide assurance that the bias does not affect the selection. This method is considered appropriate provided the population to be sampled consists of reasonably similar units and fall within a reasonable range. For example the population can be considered homogeneous, if say, debtors balances fall within the range of Rs. 5,000 to Rs. 25,000 and not in the range between Rs. 25 to Rs.2,50,000.

(ii) Stratified Sampling : This method involves dividing the whole population to be tested in a few separate groups called strata and taking a sample from each of them. Each stratum is treated as if it were a separate population and if proportionate of items are selected from each of these stratum. The number of groups into which the whole population has to be divided is determined on the basis of auditor judgment. For example in the above case, debtors balances may be divided into four groups as follows:-

(a) balances in excess of Rs. 1,00,000;

(b) balances in the range of Rs. 75,000 to Rs. 1,00,000;

(d) balances below Rs. 25,000.

From these above groups the auditor may pick up different percentage of items from each of the group. From the top group i.e. balances in excess of Rs. 1,00,000, the auditor may examine all the items; from the second group 25 per cent of the items; from the third group 10 per cent of the items; and from the lowest group 2 per cent of the items may be selected.

The reasoning behind the stratified sampling is that for a highly diversified population, weights should be allocated to reflect these differences. This is achieved by selecting different proportions from each strata. It can be seen that the stratified sampling is simply an extension of simple random sampling.

2. Interval sampling or systematic sampling : It involves selecting items using a constant interval between selections, the first interval having a random start. The interval might be based on a certain number of items (for example every 20th voucher) or a monetary totals (for example every Rs. 1,000 in the cumulative value of the population). When using systematic selection, the auditor should determine that the population is not structured in such a manner that the sampling interval corresponds with a particular pattern in the population. For example, if in a population of branch sales, a particular branch sales occur only as every 100th item and the sampling interval selected is 100. The result would be that either the auditor would have selected all or none of the sales of that particular branch. To minimise the effect of the possible known buyers through a pattern in the population, more than one starting point may be taken. The multiple random starting point is taken because it minimises the risk of interval sampling pattern with that of the population being sampled.

(i) Block Sampling : This method involves the selection of a defined block of consecutive items. For example take the first 200 sales invoices from the sales day book in the month of September, alternatively take any four blocks of 50 sales invoices. Therefore, once the first item in the block is selected, the rest of the block follows an items to the completion. There is a close similarity between this method and judgmental sampling. Consequently it has similar characteristics, namely, simplicity and economy. On the other hand there is a risk of bias and of establishing a pattern of selection which may be noted by the auditees.

(ii) Cluster sampling : This method involves dividing the population into groups of items known as clusters. A number of clusters are randomly selected from all the clusters rather than individual items of the population. Cluster sampling can be used together with both unrestricted random and stratified sampling, for example 500 to 540, 2015 to 2055 etc. The first item i.e. 500, 2015 is randomly selected from random number tables. The items of selected cluster can either be checked completely or a randomly selected proportion of them can be examined.

The cluster is less effective for a given sample size than unrestricted random and stratified samples as items are not individually selected. However, the time saved can be utilised to have a larger sample to make the sample results more reliable. As per SA 530, when determining the sample size, the auditor should consider sampling risk, the tolerable error, and the expected error. Sampling risk arises from the possibility that the auditor‘s conclusion, based on a sample, may be different from the conclusion that would be reached if the entire population were subjected to the same audit procedure.

Advantages of Statistical Sampling in Auditing

The advantages of statistical sampling may be summarized as follows -

1. The amount of testing (sample size) does not increase in proportion to the increase in the size of the area (universe) tested.

2. The sample selection is more objective and thereby more defensible.

3. The method provides a means of estimating the minimum sample size associated with a specified risk and precision.

4. It provides a means for deriving a “calculated risk” and corresponding precision (sampling error) i.e. the probable difference in result due to the use of a sample in lieu of examining all the records in the group (universe), using the same audit procedures.

5. It may provide a better description of a large mass of data than a complete examination of all the data, since non-sampling errors such as processing and clerical mistakes are not as large.

Under some audit circumstances, statistical sampling methods may not be appropriate. The auditor should not attempt to use statistical sampling when another approach is either necessary or will provide satisfactory information in less time or with less effort, for instance when exact accuracy is required or in case of legal requirements etc.

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