CHAPTER - 2
BASIC CONCEPTS IN AUDITING
STATISTICS OF THE CHAPTER - Tentative Weightage of Chapter: 5 to 10 Marks
IMPORTANCE OF THE CHAPTER - This chapter clears many concepts of auditing.
SAs COVERED-SA 500, SA 520, SA 320
COVERAGE OF THE CHAPTER
(1) Audit Evidence
(2) Audit Procedures
(3) Analytical Review Procedures
(4) Concept of Materiality
(19) What is “Audit Evidence”? How can auditor determine if the audit evidence is sufficient & appropriate?
► Audit evidence refers to the information used by auditor in arriving at the conclusions on which auditor’s opinion is based.
► Audit evidence includes both information contained in the accounting records underlying the financial statements and other information.
TYPES OF AUDIT EVIDENCE
On the basis of source
⦁ External Eg:
Bank statement
⦁ Internal Eg: Sales invoice
On the basis of Nature
⦁ Documentary Eg: Copy of loan agreement
⦁ Oral Eg: discussions with client
⦁ Visual Eg: Observing stock taking
On the basis of impact
⦁ Persuasive, evidences which are most likely to be true. Eg: management representations
⦁ Conclusive, evidences which are only true. Eg: loan contracts.
► As per SA-200, ‘the auditor should obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable him to draw reasonable conclusions there from on which to base his opinion on the financial information’.
► As per SA-200, sufficiency and appropriateness are inter-related. Sufficiency refers to the quantum of audit evidence obtained while appropriateness relates to its quality i.e. relevance and reliability. The quantity of audit evidence needed is affected by the following:
⦁ auditor’s assessment of risks of misstatement (higher the assessed risks, more evidence is required), and
⦁ quality of such audit evidence (higher the quality, lesser evidence may be required).
(20) Which factors help in assessing the reliability of audit evidence?
The reliability of audit evidence is influenced by its source (internal or external) and by its nature (visual, documentary or oral). Certain generalizations may be useful in assessing the reliability of audit evidence:
1. External evidence is more reliable than internal evidence.
2. Internal evidence is more reliable when related internal control is satisfactory.
3. Evidence obtained by the auditor himself is more reliable than that obtained indirectly.
4. Documented/written evidence is more reliable than oral representations.
5. Original documents are more reliable than photocopies/facsimiles/scanned documents.
In case of suspicious circumstances, the auditor should look for more compelling evidence and should attempt to obtain as much corroborative evidence as may be available.
(21) What are the audit procedures to obtain audit evidences?
As per SA 500 “Audit Evidences”, audit evidences can be obtained by following audit procedures:
1. Risk assessment Procedures: The audit procedures performed to obtain an understanding of the entity and its environment, including entity’s internal control, to identify and assess the risks of material misstatement, whether due to fraud or error.
2. Compliance Procedures: Compliance procedures are tests designed to obtain reasonable assurance that those internal controls on which audit reliance is to be placed are in effect. Obtaining audit evidence from compliance procedure is intended to reasonably assure auditor in respect of following assertions:
a. Existence – that the internal control exists.
b. Effectiveness – that the internal control is operating effectively.
c. Continuity – that the internal control has so operated throughout the period
Compliance tests are carried out to assess the efficiency of internal control system. After the compliance tests auditor determines the nature, timing and extent of substantive procedures.
3. Substantive Procedures
Substantive Procedures (Test of completeness, validity & accuracy of accounting data):
A)Test of Details
A1)Test of transactions (Vouching)
A2)Test of Balances(Verification, casting)
B)Analytical Procedures (Ratios & trends analysis)
Substantive procedures are designed to obtain evidence as to the completeness, accuracy and validity of the data produced by the accounting system. They are of two types:
1. tests of details of transactions and balances;
2. analysis of significant ratios & trends, including enquiry of unusual fluctuations & items.
(22) What are the methods to obtain audit evidence?
As per SA 500, auditor obtains evidence by performing one or more of the following methods:
Methods to obtain Audit Evidence
Inspection-Examining records, etc.
Observation -Looking at a process or procedure being performed
External Confirmation - Seeking direct written response from a third party
Recalculation - Checking Mathematical accuracy
Reperformance - Independent execution of originally performed procedures
Analytical Review Procedures - Studying significant ratios and trends
Inquiry - Seeking appropriate information
1) Inspection: Inspection involves examining records or documents or a physical examination of asset.
2) Observation: Observation consists of looking at a process or procedure being performed by the others. Eg: the auditor may observe the counting of inventories by client personnel.
3) External Confirmation: It represents a direct written response from a third party (confirming party) to the auditor, in paper, electronic or other medium. Eg: debtor’s balance confirmation
4) Recalculation: It consists of checking the mathematical accuracy of documents or records, either manually or electronically. Eg: depreciation calculation
5) Reperformance: It involves the auditor’s independent execution of procedures or controls that were originally performed as part of entity’s internal control. Eg: Bank reconciliation
6) Analytical Review: Analytical review consists of studying significant ratios and trends and investigating unusual fluctuation and item.
7) Inquiry: Inquiry consists of seeking appropriate information from knowledgeable person inside or outside the entity. Inquiries may be written or oral, formal or informal. Responses to inquiries may provide the auditor with information which he did not previously possess or may provide him with corroborative evidence.
(23) Write a note on Analytical Review Procedures?
⦁ MEANING: As per SA 520, “Analytical procedures” means the analysis of significant ratios and trends, including investigation of unusual fluctuations and items. On identification of significant fluctuations, the auditor should investigate to obtain adequate explanations and appropriate corroborative evidence.
⦁ NATURE OF ANALYTICAL PROCEDURES:
⦁ Analytical procedures include comparisons of entity’s financial information with, for example:
1. Comparable information for prior periods.
2. Anticipated results of entity, like budgets or forecasts,
3. Expectations of auditor, like an estimation of depreciation,
4. Similar industry information, like comparison of entity’s ratio of Debtor turnover with industry averages.
⦁ It also include consideration of relationships, for example:
1. Among elements of financial information that conform to a predictable pattern i.e. trend, like gross margin ratio.
2. Between financial and non-financial information, like salary to number of employees.
⦁ It may be applied to consolidated financial statements, components and individual elements of information.
(24) Explain the concept of Materiality in audit.
► MEANING: AS per SA 320, Information is material if its misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information. Auditor has to assess materiality right from the stage of audit planning till the final stage of reaching at his opinion
► RELATIONSHIP BETWEEN MATERIALITY AND AUDIT RISK: auditor should consider materiality and its relationship with audit risk when conducting an audit. There is an inverse relation between audit risk & materiality. The more material an item, the lesser is the risk of misstatement.
► FACTORS TO DETERMINE MATERIALITY: Materiality is a relative term and what may be material in one circumstance may not be material in another. Following factors may be helpful in determining materiality of an item:
1. percentage comparison.
2. the impact that the item has on the profit or loss or on the balance sheet
3. comparison with the corresponding figure of the previous year
4. statutory requirement of disclosure
5. Transaction of abnormal or nonrecurring nature are also considered material
► DISCLOSURE: An auditor has to ensure that a material item is disclosed separately and distinctly or at least clear information about the item is available in the accounting statements.
► MATERIALITY OF SMALL AMOUNTS: Auditor must consider possibility of misstatements of relatively small amounts that, cumulatively, could have a material effect on financial information. Eg: an error during month-end could be an indication of a potential material misstatement if that error is repeated each month.
► REPORTING: An auditor must convey the material misstatements in financial information to the management and should ensure that corrections have been made. In case of presence of material misstatement not intentionally rectified, he should give a qualified opinion.
Practical Questions - Chapter 2: Basic Concepts in Auditing
Question No. 1: X Ltd holds 4 to 5 board meetings per year. The directors are reimbursed to the extent of actual air fair, and in addition an allowance of Rs. 300 per day is paid for covering hotel bills etc. Auditor of company seeks actual bills/vouchers as evidence in respect of stay charges. The director contention is that board attendance register containing the signature of director is sufficient evidence. Give your views as a Chartered Accountant.
Question No. 2: An assistant of X & Co., chartered accountants detected an error of Rs. 5 per interest payment which recurred number of times. The General Manager (Finance) of T Ltd. advised him not to request for passing any adjustment entry as individually the errors were of small amounts. The company had 2000 deposit accounts and interest was paid quarterly. Give your views on the above.
Question No. 3: State whether true or false:
a. Compliance procedures are tests designed to obtain audit evidence as to completeness, accuracy and validity of the data produced by accounting system.
b. There is inverse relationship between materiality and audit risk.
c. Disclosure of fundamental accounting assumptions is necessary.
d. Going concern is a fundamental accounting assumption.