A practical guide to external audit work
Ahmad Tariq BhattiFCMA, FPA, MA (Economics), BSc
Dubai, United Arab Emirates
Contents
Definitions of Auditing...................................................................................................................3
The auditing framework.................................................................................................................5
Stages of External Audit Work.......................................................................................................7
Audit Evidence..............................................................................................................................13
Audit Risk & Materiality............................................................................................................24
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Chapter OneDefinitions of Auditing
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Chapter 1
Definitions of Auditing1. Montgomery
Auditing is a systematic examination of books and records of a business or other organization in order to ascertain or verify and to report upon the facts regarding its financial operations and the results thereof.
2. W.W. BiggsAn audit may be said to be such an examination of books, accounts, vouchers of a business, as will enable the auditor to report, whether he is satisfied that the balance sheet is properly drawn-up as to give a true and fair view of the state of affairs of the business and that of the profit or loss for the financial period, according to the best of the information and explanations given to him and as shown by the books, if not, to report in what respect he is not satisfied.
3. Taylor & PerryAn audit is an investigation by an auditor into the evidence from which the final revenue accounts and balance sheet or other statements of an organization have been prepared, in order to ascertain that they present a true and fair view of the summarized transactions for the period under review and of the financial state of the organization at the end date. So, enabling the auditors to report thereon.
4. L.R. DickseeAuditing is an examination of accounting records with a view to establishing whether they correctly and completely reflect the transactions to which they report on.
5. F.M.R. de’ PaulaAudit denotes something much wider, namely the examination of balance sheet and profit and loss account prepared by others. As a result of this examination of the books of accounts, vouchers etc. and of his enquiries, the auditor must satisfy himself that balance sheet and profit and loss account are drawn up properly, so as to exhibit a true and fair view of the state of affairs and the earnings of a particular concern.
6. R.R. CoomberModern audit is the verification of financial statements usually a balance sheet and profit and loss account, in the light of certain accounting principles to establish whether or not it is the true statement and correctly drawn up.
7. J.R. BatliboiAudit is an intelligent and critical scrutiny of books of accounts of a business with the documents and vouchers from which they have been written up, for the purpose of ascertaining whether the working results of a particular period as shown by the profit and
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loss account and also financial position as reflected in the balance sheet, are truly and fairly determined and presented by those responsible for their compilation.
8. R.E. SchlosserAuditing is a systematic examination of financial statements, records, and related operations to determine adherence to generally accepted accounting principles, management policies, or stated requirements.
9. Australian Auditing Standard 104 (AUS 104)A service where auditor’s objective is to provide a high level of assurance through:
(a) the issue of a positive expression of an opinion that enhances the credibility of a written assertion(s) about an accountability matter (attest audit); or
(b) the provision of relevant and reliable information and a positive expression about an accountability matter where the party responsible for the matter does not make a written assertion(s) (‘direct reporting audit’).
10. A.W. Holms & W.S. OvermgerTraditionally, auditing is an objective examination of financial statements prepared by management plus the examination and evaluation of information gathering functions and all phases of management and activities, in order to ascertain if operations are conducted in an effective and efficient manner.
11. Combine Council of Accountancy Bodies
An audit is the independent examination of and expression of opinion on, the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.
12. American Accounting Association (AAA) in A Statement of Basic Auditing Concepts, defined as:
A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.
Detail of key terms used in this definition is given below:
(a) Systematic process: Audits are structured activities that follow a logical sequence.
(b) Objectivity: This is a quality of the methods by which information is obtained and also a quality of the person doing the audit. Essentially it means freedom from bias.
(c) Obtaining and evaluating evidence: This is a matter of examining the underlying support for assertions or representations.
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(d) Assertions about economic actions and events: This is a broad description of the subject matter that is audited. An assertion is essentially a proposition that can be proved or disproved.
(e) Degree of correspondence… established criteria: This means an audit establishes the conformity of assertions with specified criteria.
(f) Communicating results: To be useful, the results of the audit need to be communicated to interested parties by either oral or written means.
13. Spicer & PeglerAn audit is the independent examination of, and expression of opinion on, the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.
14. International Standard on Auditing 1An audit is the independent examination of financial statements or related information of an entity, whether profit oriented or not and irrespective of its size, or legal form, when such an examination is conducted with a view to expressing an opinion thereon.
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The auditing framework
The auditing framework is composed of the following:
Applied knowledge of International Standards on Auditing (ISAs)
Command on applicable laws and regulations for the specific set of financial statements (e.g., CO, 1984, Banking Companies Ordinance, 1962, Insurance Companies Acts, etc., etc.)
Proficiency in applying auditing procedures and techniques Expert knowledge of applicable financial reporting framework to
the specific set of financial statements like IASs, IFRSs etc., etc. Skills in computerized environment like ERP packages Skills in MS Office (Excel, Word etc., etc.) Knowledge of the Industry in which company falls Knowledge of the business of the company Knowledge of the client management and their working style Audit team that has a good mix of skills in above mentioned areas
Chapter TwoStages of External Audit Work
A practical Guide to planning, performing & controlling work
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Chapter 2
Stages of External Audit Work
1. Audit Acceptance Audit accepting and agreeing on terms of reference/engagement is the responsibility
of an engagement partner. All legal, ethical, and professional considerations are dealt for acceptance and
continuance of audit assignments in accordance with Code of Ethics for Chartered Accountants as enacted in CA Ordinance, 1961 (any other applicable) and ISA 220.
Preparing, issuing, and revising engagement letter according to the requirements of ISA 210. The scope and performance of work is covered in the letter along with all important matters relating to the engagement.
2. Audit Planning & Control An auditor should plan an audit in a manner that helps him to finish the engagement
in an efficient and effective manner. A planning file is prepared before an audit starts which is reviewed by the top management of an accounting firm. It reflects all aspects of an audit engagement both financial and non-financial (ISA 300).
The auditor should develop an overall strategy for the audit engagement (ISA 300). Establishing objectives, scope, extent and critical aspects of an audit job. The auditor should develop a planning in order to reduce audit risk to an acceptably
low level. (ISA 300). The identification of sources of audit evidence and its relationship to critical audit
objectives (Audit planning matrix) (ISA 500-501). Establishing materiality levels/standards, sample size, and sampling techniques (ISA
320 & 530). Establishing materiality and evaluating whether the judgment about materiality
remains appropriate as the audit progresses. The auditor should make inquiries of those charged with governance to determine
whether they have knowledge of any actual, suspected or alleged fraud affecting the company under audit. (ISA 240)
Documenting the nature, timing and extent of planned risk assessment procedures sufficient to assess the risks of material misstatements. (ISA 315)
An auditor should perform following risk assessment procedures to obtain an understanding of a company and its environment, including its internal control:
o Inquiries of managemento Analytical procedureso Observation & Inspection (ISA 315)
Analyzing the consistency of financial and related information by substantive analysis.
Designing, documenting, and re-evaluation of an audit plan. Evaluating and documenting management information system details.
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3. Performance and Execution of Audit Work At this stage audit team performs various audit procedures and techniques for
obtaining audit evidence of such quantity that minimizes audit risks to acceptable levels.
An auditor should document a company’s selection and application of accounting policies and review them for their appropriateness with the business-line and ensure consistency with the applicable financial reporting framework of the industry. (ISA 315).
Evaluating and documenting design of accounting and internal control system and determining the extent of reliance to be placed on it. (ISA 315)
Designing interim audit program on an initial assessment of internal controls system. An auditor should obtain understanding of how a company has responded to risks
arising from IT (ISA 315). Identifying and documenting the internal controls working in the system. Performing compliance tests on internal controls. Ascertaining the results of compliance tests and documenting the risk in each area
separately. Recommending additional controls to mitigate the risks identified with the existing
controls. Writing the final audit programme in the light of interim audit findings and audit
objectives set at the planning stage. Applying the substantive analysis and tests in accordance with the final audit
programme. Determining adequacy of substantive tests after the initial results start coming. Devising additional audit tests for risks identified at the later stages. Review the audit work to ensure sufficiency and appropriateness of audit evidence
and overall work quality. At planning and performing stages of work, an auditor is required to ensure the
appropriateness of the going concern assumptions in the preparation of financial statements (ISA 570).
The auditor should obtain audit evidence that management acknowledges the responsibility for the fair presentation of financial statements in accordance with applicable financial reporting framework, and has approved the financial statements (ISA 580).
If management refuses to provide a representation that the auditor considers necessary the auditor should express a qualified opinion or disclaimer of opinion (ISA 580).
The auditor should perform audit procedures designed to obtain sufficient and appropriate audit evidence regarding the identification and disclosure by management of related parties and the effect of related party transactions that are material to the financial statements (ISA 550).
An audit process must be efficient and effective in fulfilling the objectives of an audit engagement. An auditor must minimize the risk of not finding material misstatements in account balances and at the same time complete the audit work on agreed time period.
The auditor should obtain sufficient appropriate audit evidence about compliance with those laws and regulations generally recognized by the auditor to have an effect on the determination of material amounts and disclosures in the financial statements.
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Further, the auditor is required to have sufficient understanding of these laws and regulations in order to consider them when auditing the assertions related to determination of the amounts to be recorded and disclosures to be made (ISA 250).
4. Specific Documentation Requirements
# ISA Title Para
1 210 Terms of an audit engagement 5
2 220 Quality Control for audits of historical financial information
11-14, 16, 25, 27, 30, 31, 33
3 240 The auditor’s responsibility to consider fraud in an audit of financial statements
60, 107-111
4 250 Consideration of laws & regulations 28
5 260 Communication of audit matters with those charged with governance
16
6 300 Planning an audit of financial statements 22-26
7 315 Understanding the entity and its environment and assessing the risk of material misstatement
122-123
8 330 The auditor’s procedures in response to assessed risks 73, 73(a), 73(b)
9 505 External confirmations 33
10 580 Management representations 10
11 600 Using the work of another auditor 14
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5. Audit Reporting and Forming of Audit Opinion Reporting results of audit procedures is the final stage of an audit work. Manager and engagement partners finalize the process of audit reporting. Summarizing the results of audit procedures i.e. accounting adjustments, management
letter etc. etc. Reviewing the sufficiency and appropriateness of audit evidence gathered during the
audit process. Reviewing subsequent events, going concern status, management representations, and
truth and fairness of financial statements. Identifying and recommending appropriate action on weaknesses and findings
surfaced during the audit process. Discussions with client management on all issues highlighted during the audit work
and documenting their feedback. The auditor should inform those charged with governance of those uncorrected
misstatements noted by the auditor during the course of audit that were considered by management as immaterial to the financial statements taken as whole.
Summarizing audit results that highlight the audit procedures applied, audit observations and management comments on each observation.
Forming an audit opinion after audit issues are cleared by client management (ISA 700).
Communicating the final draft to client management. Preparing a final audit report with or without modified opinions. Attending AGM for responding to any audit related queries of members. Determining the potential effects of audit report modification due to subsequent
events (if any), (ISA 560). Documenting audit points for next years’ audit. Documenting the follow up results of the audit.
6. Subject-wise Grouping of ISAs
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# Group Subject coveredNumber of ISAs
1 100-199 Introductory matters -
2 200-299Objectives & General Principles Governing an
Audit of Financial Statements8
3 300-499 Risk Assessment & Response to Assessed Risk 64 500-599 Audit Evidence 115 600-699 Using Work of Others 36 700-799 Audit Conclusion & Reporting 57 800-899 Specialized Areas 4
Total 37
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Discuss with Director Finance or relevant Head about the scope, timing and extent of
audit work.
Ensure Engagement Letter is sent to the client.
Entry meeting with client management to discuss the conduct of audit
Ensure audit testing performed, involving documenting the systems under review,
examining key documents and interviewing staff.
Draft audit results after discussion with client management in exit meeting
Frame audit opinion based on issues after the discussion with client
Issue draft Audit Report to client for further discussions.
Issue final Audit Report
Follow up by audit assurance staff on progress with implementation of audit
recommendations
Planning
Performing
Reporting
Audit Process Defined
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Chapter ThreeAudit Evidence
Description, Collection & Evaluation ProceduresFor Selected Areas from Statement of Financial Position
[As required by International Standards on Auditing]
Chapter Three
Audit EvidenceISA 500 entitled as Audit Evidence (AE) provides definition, collection and evaluation procedures for AE gathered during audit field work.
AE is the information used by an auditor in arriving at the conclusions on which the audit opinion is based.
The information that constitutes AE includes accounting records underlying the financial statements. Examples are as given below:
o Journals, ledgers, subsidiary ledgers,
o Budgets, estimates, projections,
o minutes, internal and external confirmations,
o Actuarial reports, bank reports, control manuals, accounting manuals, operating procedures’ manual
o Cost allocations, reconciliations, computations,
o Supporting documents like invoices, cheques, bills,
o Records of electronic fund transfers,
o Any information requested during the course of an audit from the client
o Other sources of AE are last year audit files and client working papers.
AE is obtained through the following audit procedures:
o Observation
o Inquiry
o Inspection of tangible assets (also of records and documents)
o Re-computation/Recalculation
o Vouching
o Confirmation
o Analytical Procedures
AE is cumulative in nature.
AE should be sufficient and appropriate in order to satisfy an assertion relating to financial reporting.
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Sufficiency is the measure of the quantity of AE whereas appropriateness is the measure of the quality of AE.
Sufficiency and appropriateness of an AE are interrelated.
o Quantity of AE is based of risk assessment.
o Quality of AE is based on reliability of AE.
The reliability of an AE depends on nature and source the following factors:
o AE obtained from external sources is more reliable.
o AE obtained internally is more reliable when related controls are effective.
o AE obtained directly by an auditor is more reliable than the one obtained indirectly or by inference.
o Documented AE is more reliable than oral statements of the management.
o AE obtained from original documents is more reliable than the one obtained through faxes and copies.
An auditor is required to establish the accuracy and completeness of all information provided to him by the client during the course of an audit.
An auditor should use assertions in sufficient detail to form a basis for the assessment of risks of material misstatements.
Assertions about classes of transactions are:
o Occurrence
o Completeness
o Accuracy
o Cut-off
o Classification
Assertions about account balances at the year-end:
o Existence
o Rights & Obligations
o Completeness
o Valuation & allocation
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Assertions about presentation and disclosure:
o Occurrence
o Completeness
o Classification & understandability
o Accuracy & valuation
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Important noteThe audit of financial statements revolves around above mentioned assertions. If audit work is carried out in accordance with the above
mentioned assertions, it shall obtain all its objectives. We have given examples of a few areas from Statement of Financial Position for
which audit programs were designed in the light of above mentioned assertions.
1. Accounts Payables
Assertion Audit objective Audit procedure
Existence Accounts payables are valid obligations to suppliers at the reporting date.
External confirmation Vouching
Completeness Accounts payables include all obligations owed to suppliers at the reporting date.
Out-of-period liability search also known as Omitted liability test.
OccurrenceTransactions giving rise to accounts payables occurred during the period under audit.
Select transactions from accounts payable ledger and agree to supporting documentation.
Rights & Obligations
Accounts payables are obligations owed by the company.
Confirmation from documents.
Measurement Accounts payables are recorded in the correct amount and period.
Cut-off test Casting Agree Dirham value of accounts
payable to supporting documents
Valuation Accounts payables are presented at the appropriate amount.
Re-computation Analytical procedures
Presentation & Disclosure
Accounts payables are properly described and classified in Statement of Financial Position and their disclosures are correct.
Inquiry Scanning ledgers for proper
classification and description.
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2. Cash & Bank Balances
Assertion Audit objective Audit procedure
Existence Reported cash balance existed at the reporting date.
Bank confirmation Tests of bank reconciliations Physical verification of cash on
hand.
Occurrence Recorded receipts and payments related to the audit period as they occurred.
Check supporting documentation. For cash receipts, check remittance advice, for payments, check documents supporting payments.
Completeness Cash account shows all transactions on close of the year.
Tests of bank reconciliation. This is should be done by the client on daily basis.
Rights & Obligations
Cash is owned by the company and not restricted or committed.
Bank confirmation Cash verification with the
cashier
MeasurementCash receipts and payments are recorded in the correct amount and in the correct period.
Check supporting documents to verify Dirham amount of transactions
Check last cash receipts and payments recorded before and after the balancing date
Test clerical accuracy of bank reconciliation
Valuation Cash in the Statement of financial position is stated at the correct amount.
Tests of bank reconciliations
Presentation& Disclosure
Cash balances are properly described and classified in Statement of financial position and related disclosures are correct.
Scanning of cash receipts and cash payment journals
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3. Inventory of raw materials, stores & tools
Assertion Audit objective Audit procedure
Existence Inventories included in Statement of financial position physically exist.
Inspection of physical inventory Analytical procedures Confirm stock held at other locations
Occurrence Transactions of purchases and cash payments recorded when occurred during the period.
Selective vouching from sale journals Selective vouching from cash book
CompletenessInventory quantities include all items on hand or in transit. Inventory listings are accurately compiled and properly included in the inventory accounts.
Inspection of physical inventory Analytical procedures Inquire about stock held at other locations
Rights & Obligations
The company has legal title or ownership rights to inventory items, and inventories exclude items billed to customers or owned by others
Check legal ownership of goods being shipped and goods on consignment
Measurement Inventory transactions are recorded in the correct amount and period.
Check Dirham value of purchases to inventory price list.
Agree Dirham value of cash payments to supporting documents.
Check last documents effecting sales and recoveries.
Check clerical accuracy of inventory listing.
Valuation
Inventories are properly stated with respect to the following:
1. cost determined by an acceptable method consistently applied
2. slow moving, excess, defective, and obsolete items identified
3. reduced to NRV if lower than cost
Tests of pricing and summarization Analytical procedures Observation of physical inventory Inquiry and scanning Check subsequent sales prices and
compare with cost
Presentation & Disclosure
Inventories are properly described and classified in the Statement of financial position and related disclosures are correct.
Inquiry and scanning General procedures
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4. Investments
Assertion Audit objective Audit procedure
Existence
Investments in securities i.e. shares, bonds, and notes etc., physically exist and loans and advances exist on the reporting date.
Physical examination Confirmation
CompletenessAll investments are included in the Statement of financial position.
Reconciliation of confirmed and recorded balance at the reporting date.
Rights & Obligations
The entity owns or has ownership rights to all investments included in Statement of financial position.
Vouching Physical examination Confirmation
Measurement
Investments are recorded in the correct amount. Cut-off is not usually a major issue because there is not a continuous flow of transactions relating to this account. Tests as whether the recording takes place in the correct period are usually included under existence and completeness.
Test clerical accuracy of listing of investments with original investment certificates.
Valuation Investments are valued properly with respect to the accounting standards.
Recomputation, vouching, and tracing Inspection of market quotations or
financial statements.
Presentation & Disclosure
Investments are properly described and classified in Statement of financial position and related disclosures are correct.
General procedures Inquiry Scanning
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5. Non-Current Liabilities
Assertions Audit objective Audit procedure
Existence Debt and similar obligations exist at the reporting date.
Confirmation of identified liabilities
General procedures
Completeness
The Statement of financial position includes all debt and similar
obligations incurred at the reporting date.
Omitted liability test General procedures Analytical procedures
Rights & Obligations
Debt and similar obligations are legal or specific and definite obligations of
the company.
General procedures Inquiry
Measurement
Non-current liabilities are recorded in the correct amount. Cut-off is not
usually a major issue because there is not a continuous flow of transactions relating to this account. Tests as to
whether the recording takes place in the correct period are usually included
under existence and completeness.
Test clerical accuracy of listing of non-current liabilities
Valuation Debt and similar obligations are presented at the proper amounts.
Re-computations Vouching Tracing
Presentation & Disclosure
Debt and similar obligations are properly described and classified and
related disclosures are correct.
General procedures Inquiry
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6. Property, Plant & Equipment (PPE)
Assertion Audit objective Audit procedure
Existence
PPE included in Statement of financial position physically exists on the reporting date. Written down balances are removed from the books.
Vouch the purchases100%. Physical verify additions 100%. Random physical verification of assets
other than additions. Approval of BoD for removing assets
from books. Vouch sold-out assets 100%.
Completeness
PPE includes all capitalisable costs i.e. capitalization costs are not expensed out. All additions/deletions are booked at the reporting date.
Inquiry Scan for, all additions/deletions are
recorded at the reporting date Scanning repairs and maintenance items
that were expensed out rather than capitalized
Rights & obligations
The company has legal title or equivalent ownership rights to PPE included in Statement of financial position and the related lease obligation of capitalized leased assets is recognized.
General procedures Check land registration documents in the
name of client. In the case of leased asset check lease
agreement. Scanning of original documents.
Measurement
PPE is recorded at its appropriate carry value. Cut-off is not an issue because there is not a continuous flow of transactions relating to this account. The tests as to whether the recording takes places in the correct period are usually under existence or completeness.
Test clerical accuracy of PPE listing Agree line item wise total with
respective subsidiary ledgers. Agree line item wise totals with fixed
assets register.
Valuation
PPE are appropriately valued and allowances for depreciation or depletion are computed on the basis of acceptable and consistent methods. Additions only include captalisable cost of assets purchased, constructed, or leased.
Re-computations Apply analytical procedures to verify
depreciation charge for the year Vouching costs to invoices Inquiries about revaluation Inquiries about impairment losses
of PPE.
Presentation & Disclosure
PPE is properly described and classified in Statement of financial position and related disclosures are correct.
General procedures Inquiry Scanning
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7. Accounts Receivables
Assertion Audit objective Audit procedure
ExistenceAccounts receivable are authentic obligations owed by customers at the reporting date.
External confirmation Test from debtors subsidiary ledgers to
supporting documentation of sale
Occurrence Sales recorded when occurred in during the financial year.
Vouching
Completeness Accounts receivable include all amounts owed by customers at the reporting date.
Analytical procedures Vouching (change source of samples
i.e. to and from ledger and journals)
Rights & Obligations
Accounts receivable are owed to the entity and not pledged or subjected to other outside claims.
General procedures Inquiry and scanning Confirmation
Measurement Sales and accounts receivable are included in the correct period.
Cut-off tests Verify prices, quantity and
computation on sales invoices, prices verified to master price list, quantity verified to shipping documentation
ValuationAccounts receivable are presented at a reliable estimate of the net realizable amount.
Review of aged balances i.e. ageing analysis
Analytical procedures Subsequent receipts review
Presentation & Disclosure
Accounts receivable are properly described and classified in Statement of financial position and related disclosures are correct.
Review the draft financial reports
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Chapter FourAudit Risk & Materiality
[As required by International Standards on Auditing]
Chapter Four
Audit Risk & Materiality
Materiality relates to the precision required in the audit of financial statements of a company. Risk relates to the confidence that the audited financial statements are
free from material misstatements.
Audit risk is the risk that the auditor may unknowingly fail to qualify his opinion on financial statements that are materially misstated.
Audit risk is the result of the auditors' findings, conclusions, recommendations, or assurance that may be improper or incomplete, as a result of factors such as
evidence that is not sufficient and/or appropriate, an inadequate audit process, or misleading information due to misrepresentation or fraud.
Factors such as the time frame, complexity, or sensitivity of the work; size of the program in terms of monetary amounts; adequacy of the audited company's
systems and processes to detect in-consistencies, significant errors, or fraud; and auditors' access to records, also impact audit risk.
Audit risk includes the risk that auditors’ procedures will not detect a mistake, inconsistency, significant error, or fraud in the evidence supporting the audit.
The assessment of audit risk involves both qualitative and quantitative considerations. The risk related with audit can be reduced but cannot be eliminated
completely because of selective work.
Audit risk can be reduced by taking actions such as increasing the scope of work; adding experts, additional reviewers, and other resources to the audit team;
changing the methodology to obtain additional evidence, higher quality evidence, or alternative forms of corroborating evidence; or aligning the findings and
conclusions to reflect the evidence obtained.
The auditor minimizes the audit risk to the level where his opinion on the financial statement is acceptable to all users. The auditor plans audit work with lowest
perceived level of audit risk. The lowest level of audit risk is not quantified rather it is based on his judgment about the records prepared by the company.
Overall assessment at financial statement level (rate high, low, medium) Assessment the account balance or class of transactions level
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Materiality is important to auditors because it has direct impact on the work to be done by them.
Important note:Smaller the magnitude of misstatement that is considered to be important, the
greater effort or work is required by the auditors to identify that no such misstatement exists.
ISA 320 entitled Audit Materiality adopts the same definition as given in IASB’s Framework for the preparation and presentation of financial statements, viz:
”Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a
threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.”
This definition does not provide a basis for quantifying the amount of misstatement that is important for a specific audit engagement. This definition makes it a
subjective issue for an auditor. As a result, many different quantitative bases are used in determining the appropriate magnitude for materiality.
Most commonly used bases of materiality are:
Total Assets Net Income Net Assets Current Assets Sales Gross Margin
The percentage approach to define materiality for assets and profits must be dealt with care because underlying assumptions vary from company to company and
sector to sector. An item may be material because of its nature, value and impact.
The assessment of materiality at planning stages should be based on the most recent and reliable financial information.
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Quick Points about Materiality:
It is an expression of the relative significance of a particular matter in the context of financial statements as a whole.
It is based on judgment of an auditor. It can be changed as audit work progresses depending on the results of initial
procedures. Materiality is related with the true and fair view concept. A matter is material if its omission or misstatement would reasonably
influence the decisions of the users of the financial statements. Materiality has both qualitative and quantitative aspects. Materiality defines the nature, timing and extent of work required by the
auditor in order to express his opinion on the financial statements.
Para 15 of ISA 320 goes like this,
“If management refuses to adjust the financial statements and the results of extended audit procedures do not enable the auditor to conclude that the aggregate of unrecorded misstatements is not material, the auditor should consider the appropriate modification to the auditor’s report in accordance with ISA 701.”
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