ACCA-FIA: APE – AUDIT REGULATION AND PROFESSIONAL ETHICS

SECTION D

SECTION D

LEARNING OUTCOME

At the end of this section, you should be able to understand this objective:

• 4.1: Audit evidence

• 4.2: Audit procedures
• 4.3: Assertions
• 4.4: Audit sampling

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4.1 Audit Evidence

Definition:
Information used by the auditor in arriving at the conclusions on which the auditor’s opinion is based.
Audit evidence includes both information contained in the accounting records underlying the financial
statements and information obtained from other sources.

The auditor shall design and perform audit procedures that are appropriate in the circumstances for the
purpose of obtaining sufficient and appropriate audit evidence.

(ISA 500, Para 6)

The auditor is required to obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably
low level and thereby enable the auditor to draw reasonable conclusions on which to base the auditor’s
opinion.

(ISA 200, Para 17)

4.1.1 Sufficiency and Appropriateness

“Sufficiency” is the measure of the quantity of audit evidence. The quantity of the audit evidence is
affected by the auditor’s assessment of the risks of material misstatement and also by the quality of such
audit evidence.

“Appropriateness” is the measure of the quality of audit evidence; that is, its relevance and its reliability
in providing support for the conclusions on which the auditor’s opinion is based.

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4.1.2 Interrelationship Between Sufficiency and Appropriateness

The sufficiency and appropriateness of audit evidence are interrelated. Sufficiency is the measure of the
quantity of audit evidence. The quantity of audit evidence needed is affected by the auditor’s assessment
of the risks of misstatement (the higher the assessed risks, the more audit evidence is likely to be required)
and also by the quality of such audit evidence (the higher the quality, the less may be required). Obtaining
more audit evidence, however, may not compensate for its poor quality.

(ISA 540 (Revised), Para A4)

4.1.3 Appropriateness of Audit Evidence

These are the five (5) generalisations about the Reliability of Audit Evidence:

• Audit evidence is more reliable when it is obtained from independent sources outside the entity.
• Audit evidence that is generated internally is more reliable when the related controls imposed by the
entity are effective.
• Audit evidence obtained directly by the auditor (for example, observation of the application of a
control) is more reliable than audit evidence obtained indirectly or by inference (for example, inquiry
about the application of a control).
• Audit evidence is more reliable when it exists in documentary form, whether paper, electronic or other
medium (for example, a contemporaneously written record of a meeting is more reliable than a
subsequent oral representation of the matters discussed).
• Audit evidence provided by original documents is more reliable than audit evidence provided by
photocopies or facsimiles.

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4.1.4 Sufficiency of Audit Evidence

Assessment of Inherent Risk

As inherent risk increases, more audit evidence will be required to reduce detection risk.

Materiality of The Item

A decrease in materiality means that more audit evidence will be required to ensure that no material error
has occurred.

Nature of the Accounting and Control Systems

Where the accounting and control systems are poor then more audit evidence is necessary as less reliance
can be placed on those systems.

Control Risk

Determine the extent to which the directors have implemented a sound system of internal control; poor
internal controls increase control risk, decreasing reliance that can be placed on those controls.

Experience from Previous Audits

Good experience from previous audits will decrease the amount of evidence required as the auditor can
place reliance on previous reviews of clients’ systems.

Result of Audit Procedures

Where the results of different audit procedures agree with each other than overall less evidence is needed
– overall the evidence is more persuasive; however, where results are in conflict then more evidence is
required.

Quality of Information Available

Some sources of audit evidence are more reliable than others – meaning less evidence is needed when
relying on those sources for example, documentary evidence is more reliable than oral evidence.

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4.2 Audit Procedures in obtaining Audit Evidence

The auditor obtains audit evidence to draw reasonable conclusions on which to base the audit opinion.

Introduction

The auditor performs risk assessment procedures to provide a satisfactory basis for the assessment of risks
at the financial statements and assertion levels.

Risk assessment procedures, RAP on its own do does not provide sufficient appropriate audit evidence to
base the audit opinion. RAP assist the auditor in determining the audit approach, whether to adopt the
substantive approach or the combined approach.

The results of test of controls determine the level of detailed testing of transactions and balances
(substantive procedures).

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Audit Procedures Methods – A E I O C R R

Evidence may be obtained by the following methods:

Analytical Evaluation of financial information made by plausible relationships between both
procedures financial and non-financial data.

Enquiry Seeking information from knowledgeable persons.

Inspection Examining records or documents, or physical examination of assets.

Observation Looking at a process or procedure performed by others.

Confirmation The process of obtaining a representation of information or of an existing condition directly

from a third party.

Recalculation Checking the mathematical accuracy of records or documents.

Reperformance Involves the auditor’s independent execution of procedures or controls that were originally
performed as part of the entity’s internal control.

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4.3 Assertions

Assertions are representations by management, explicit or otherwise (implied), that are embodied in the financial statements. The auditor uses these assertions
to consider the different types of potential misstatements that may occur, and design audit procedures that are responsive to the assessed risk.

4.3.1 Use and Application

Auditors are required by ISAs to obtain sufficient & appropriate audit evidence in respect of all material financial statement assertions. The use of assertions
therefore forms a critical element in the various stages of a financial statement audit as described below.

Stage of Audit Application of Assertions

Planning As part of the risk assessment procedures, auditors are required to understand the entity and its environment including the assessment
of the risk of material misstatement (ROMM) due to fraud and error at the financial statement and assertion level.

The assessment of ROMM at the financial statement and assertion level provides the basis for determining the nature, timing and extent
of audit procedures that are necessary to obtain sufficient and appropriate audit evidence in response to those assessed risks.

Testing Substantive tests are performed to identify material misstatements at the assertion level. In case of assertions whose ROMM has been
assessed as significant and no tests of control are planned to be performed, the substantive procedures should include tests of detail (i.e.
substantive analytical procedures alone cannot be considered as sufficient and appropriate audit evidence for assertions with a significant
risk of material misstatement.

Tests of control (TOCs) are performed to assess the operating effectiveness of controls at the financial statement and assertion level.
TOCs are necessary to validate the auditor's expectation of the operating effectiveness of controls (as acquired from the risk assessment
procedures performed at the planning stage) and also in case where the performance of substantive procedures alone cannot provide
sufficient and appropriate audit evidence in respect of a specific assertion.

Completion Auditor shall conclude whether sufficient and appropriate audit evidence has been obtained for all material financial statement
assertions taking into account any revisions in the assessment of ROMM at the assertion level.

Where an auditor is unable to obtain sufficient and appropriate audit evidence in respect of a material financial statement assertion, he
is required to modify the audit report accordingly.

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Assertions assist auditors in considering a wide range of issues that are relevant to the authenticity of
financial statements. The consideration of management assertions during the various stages of audit
helps to reduce the audit risk.

Assertions about classes of transactions and events and related disclosures for the period under
audit
Occurrence Transactions and events that have been recorded or disclosed have occurred
and such transactions and events pertain to the entity.

Completeness All transactions and events that should have been recorded have been
recorded, and all related disclosures that should have been included in the
financial statements have been included.

Accuracy Amounts and other data relating to recorded transactions and events have
been recorded appropriately, and related disclosures have been appropriately
measured and described.

Cut-off Transactions and events have been recorded in the correct accounting period.

Classification Transactions and events have been recorded in the proper accounts.

Presentation Transactions and events are appropriately aggregated or disaggregated and

clearly described, and related disclosures are relevant and understandable in
the context of the requirements of the applicable financial reporting
framework.

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4.3.2 Completeness, Accuracy and Cut-off

These three assertions are related. Completeness is not enough without accuracy. To be accurate, proper
cut-off needs to be carried out as follows:

a) Completeness

When the directors are presenting a set of financial

statements, they are making the assumption that all relevant information has been included. In
other words, there is no understatement of figures.

The assertion of completeness applies to both the items on statement of financial position (SOFP) as
well as income statement (IS).

Example 1

SOFP – account receivables: A Ltd $110,000.

We are assuming that all the sales, receipts and other related transactions related to A Ltd has
been included in that particular account, thus completeness of the transactions.

Audit procedures needed:

Check sales invoices and official receipts immediately after year-end to ensure there are all
related to transactions occur after the year-end.

Example 2

SOPL – sales: $500,000.

We are assuming that all sales for the current year have been included in the above figure.

Audit procedures needed:

Check GDN immediately after the year-end to ensure they are all invoiced in the following year.

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b) Accuracy

Accuracy is more specific than completeness as it ensures no overstatement as well as no

understatement. Being accurate means the amounts and other data have been recorded accurately.
Applying the Accruals Concept of accounting, the amount of transactions related to the current
period must be recorded in that period. Likewise, those transactions recorded in the following period
must be related to the following period.

How is this achieved? Simply by verifying both periods. So, the exercise to achieve this is cut-off.

c) Cut-off

The purpose of cut-off is to ensure that all transactions and events have been recorded in the
correct accounting period.

In short, the aim is to have a clean ‘cut-off’ at the year-end where all transactions are recorded in the
correct accounting period.

d) Occurrence

This assertion applies to IS items. It simply means the item is actually incurred for the business
purpose.

Example 3

B Ltd:

There are two invoices related to air fares:

Invoice No. 1 – Air fare for Mr. A, the marketing director, travelling from Kuala Lumpur to London.
Amount $5,000.

Invoice No. 2 – Air fare for Mrs. A, the wife of Mr. A, accompanying Mr. A to London.

Amount $5,000.

Audit evidence needed:

Employee status, their entitlement, purpose of the trip, the person who authorised the trip and
so forth.

Employee? Entitlement? Purpose of trip Authorisation

Mr. A Yes Yes Business Managing Director
Mr. A No No Non-business Mr. A himself!

Conclusion:

Mr. A’s air-ticket cost will be absorbed by the company as it meets the assertion ‘Occurrence’,
while the cost of Mrs. A’s air ticket will need to be deducted from Mr. A’s salary as it represents
Mr. A’s personal expenses.

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Example 4

C Ltd:

Purchase invoice recorded in the IS: $43,000.

Audit procedure needed:

We need to check the Purchase Request for approval. This is to ensure that it is for business
purpose.

We then need to check the Purchase Order to agree on the purchase with the supplier. In other
words, it is a genuine purchase!

We then need to check the GRN to ensure the goods are actually received thus to be used for
business purpose.

Assertions about accounting balances and related disclosures at the period-end

Existence Assets, liabilities and equity interests exist.

Rights and obligations The entity holds or controls the rights to assets; and liabilities are the
obligations of the entity.

Completeness All assets, liabilities and equity interests that should have
been recorded have been recorded, and all related
disclosures that should have been included in the financial
statements have been included.

Accuracy, valuation and Assets, liabilities and equity interests are included in the financial
allocation statements at appropriate amounts and any resulting valuation or
allocation adjustments are appropriately recorded, and related
disclosures have been appropriately measured and described.

Classification Assets, liabilities and equity interests have been recorded in the proper
accounts.

Presentation Assets, liabilities and equity interests are appropriately aggregated or

disaggregated and clearly described, and related disclosures are
relevant and understandable in the context of the requirements of the
applicable financial reporting framework.

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4.3.3 Valuation and Allocation

a) Allocation

This assertion applies to SOPL items. It simply means the recording of the correct amount. It’s more on
the arithmetic accounting. The items on SOFP will be classified under the assertion ‘Valuation’ (to be
discussed shortly). The obvious audit evidence on allocation would be the invoices used to record the
transactions. However, there should be proper authorisation and acknowledgement of such item.

The typical example would be purchases. The purchase invoice must be supported by purchase orders
for the amount invoiced and there should be arithmetic checking before posting. Thus, for an invoice
of $10,000, if the purchase prices are agreed with the purchase order and the calculations of prices
were done correctly, we can say the measurement of $10,000 was correct and it should be posted to
the ledger as such.

b) Valuation

As mentioned earlier, this assertion applies to items on the SOFP. The issue of choosing the right basis
for valuation on the SOFP has been the debate over the past decade. The recent standards issued by
the IASB have seen the movement towards fair value valuation.

Students need to know the typical valuation issues at FFA level:

• Tangible non-current asset (IAS 16) & Intangible assets (IAS 38)– historical cost less accumulated
depreciation to date or at valuation; asset impairment; revaluation
• Inventory (IAS 2) – the lower of cost and net realisable value.
• Receivables – net of allowance of bad debts.
• Provision (IAS 37) – provision and contingent liabilities for permissible expenses.

4.3.4 Rights and Obligations

The assertion, ‘Rights’, applies to assets on the SOFP while ‘Obligation’ applies to liabilities. In general,
‘Rights’ refers to the ownership while ‘Obligation’ refers to the incurrence of liability when the settlement
can only be done through payment or the exchange of assets.

4.3.5 Existence

This refers to the items on the SOFP which, in actual fact, exist. In other words, what the SOFP is showing
represents what the company actually owns and owes, that is, the assets and the liabilities. Comparatively,
it is much easier to verify the existence of an asset than a liability. However, putting the assertion together,
the existence of an asset does not prove its rights (ownership), nor its valuation as well as its presentation
and disclosure.

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4.3.6 Presentation and Classification

Quite obviously, these assertions apply to both items on SOPL and SOFP. The preparers of financial
statements as well as the auditor of the financial statements must be well-versed with the accounting
standards in order to meet this assertion. To obtain evidence on this assertion, simply check the format of
presentation and its disclosure of any specific item to see if it is in compliance with any applicable
accounting standards or other applicable laws and regulations.

Most audit firms would have account completion checklist and a major part of the checklist may focus on
the presentation and disclosure requirements as well as the way of classification.

The assertion, ‘Presentation’, is to ensure all necessary disclosures are made to make the users of the
financial statements understood the full picture in terms of financial position, results as well as any
potential events that may affect the reporting entity.

The assertions are important because they have an impact on how the auditor gathers audit evidence.

When substantive procedures are performed, the aim is at testing whether these implied assertions are in
fact true or valid. If any of these assertions is not valid, the financial statements are misstated.

4.4 Audit Sampling

Definition
Audit sampling (sampling) – 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.

Population – The entire set of data from which a sample is selected and about which the auditor wishes to
draw conclusions.

Sampling unit – The individual items constituting a population.

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4.5 Practice Question

Practice Question 1 (FAU INT – Jun’11 Sec B Q3)

At a social evening arranged by your firm for its recent intake of trainee auditors, you overheard
the following statements made by your fellow trainees:

a) “At my last audit firm, the only work we did in order to verify the existence, valuation and
ownership of motor vehicles as reported in audit clients’ financial statements, was to
inspect the relevant suppliers’ invoices. I assume this met the required audit objectives…”
(5 marks)

b) “I do not see any point in an auditor sending a bank letter to an audit client’s bank. Any
assurance tat the audit requires in respect of bank balances can be obtained by carrying
out audit procedures on the company’s bank reconciliations…”
(5 marks)

c) “At my interview, I was asked to explain the term ‘professional scepticism’ in the context
of the audit of the financial statements of a limited liability company. I explained that it
simply meant that the auditor should not rely on any audit evidence by the directors of
the company unless it could be corroborated by the evidence obtained directly by the
auditor…”
(5 marks)

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Practice Question 2 (FAU INT - Jul’12 Sec B Q2)

River Co manufactures office furniture and has been an audit client of your firm for many years.
Your firm is planning the audit of the company’s financial statements for the year ending 31 July
2012.

In a recent email to the audit engagement partner, the company’s managing director stated
that, unfortunately, the company would not be able to provide staff to supervise the year-end
inventory count, due to a shortage of available staff with appropriate experience. Given its
knowledge of the company, he therefore requested that your firm provide staff to supervise
the account. He has offered to pay your firm a premium rate fee for the supervision of the count
and considers that it would be money well spent as, in his view, it would mean that the directors
of River Co would not be responsible for the accuracy of the inventory count as a basis for the
value of inventory to be reported in the company’s financial statements.

a)
(i) State the purpose of an auditor’s attendance at a client’s year-end inventory count.
(4 marks)
(ii) Explain how your firm’s audit engagement partner should respond to the request from
River Co’s managing director, to supervise the year-end inventory count.
(5 marks)
b) Explain the audit procedures with regard to inventory that members of your firm’s audit
team should carry out during the year-end inventory count.
(2 marks)

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Practice Question 3

You have identified several audit risks as below. Describe the potential audit procedures to
address those risks as your audit response:

1. Occurrence of sales
2. Completeness of purchase
3. Accuracy of depreciation
4. Accuracy of rental expense
5. Occurrence of rental expense
6. Completeness of rental expense
7. Existence of NCA
8. Valuation of provision for legal claims
9. Completeness of NCA
10. Existence of receivables
11. Valuation of receivables
12. Existence payables
13. Valuation of payables
14. Valuation of furniture
15. Rights & obligation of car
16. Rights & obligation of house
17. Valuation of revalued land
18. Valuation of bank balances
19. Completeness of bank loan
20. Accuracy of finance cost
21. Existence of inventory
22. Valuation of inventory
23. Completeness of inventory
24. Inventory held by 3rd party warehouse

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