Auditing Questions Answered
Mark Ellis | April 19, 2008 | 0 Comments
Recently there have been a number of questions asked on the AccountancyStudents website
concerning the subject of Audit. In recognition of the fact that audit can be technically complex in
certain areas, our regular contributor Steven Collings has put together a number of questions and
answers which are frequently asked in the area of audit.
What is an Audit?
An audit is official examination of an entity's financial statements and the disclosures therein. It is an
independent examination undertaken by a qualified firm of Accountants who are registered and
authorised to undertake audit work.
What is the outcome of an Audit?
The auditor will form an independent opinion on whether the financial statements give a 'true and
fair' view.
How is an Audit undertaken?
Auditors will plan their audit carefully and devise specific tests on a sampling basis to gather
appropriate audit evidence to satisfy themselves that the financial statements are free from
'material misstatement'. The auditor will use various sampling methods, including the use of
analytical review, to identify unusual trends/characteristics within the financial statements.
So does an Audit confirm the financial statements are totally free from error?
No. The Audit is designed in such a way that the auditor cannot verify the financial statements in
their entirety. Auditors will use various tests : on a substantive basis and by testing controls : to
generate sufficient and appropriate audit evidence to satisfy themselves that the internals controls
adopted by the entity will (a) prevent, (b) detect and (c) correct any material misstatements within
the accounts and that the accounts themselves are either free from 'material misstatement' or not.
What is tolerable error?
Tolerable error (also known as the materiality level) is the error the auditor is willing to accept and
still conclude that the financial statements give a true and fair view.
How do you decide what tolerable error should be?
The auditor has to gain a thorough understanding of the audit client. In gaining this understanding,
the auditor will look at the client and the sector the client operates in, the internal controls adopted
by the client, the accounting policies adopted by the client, and assess the levels of risk. It is then the
auditor will conclude the high/medium risk audit areas and assess the materiality level within that
area.
What does the Auditor do in relation to fraud?
The responsibility of prevention and detection of fraud rests with the audit client. The auditor does
not have a duty to look for fraud, but they do have a duty to expect fraud at the planning stage and
satisfy themselves that fraud has not taken place by undertaking appropriate audit procedures and
gathering sufficient and appropriate audit evidence.
Who does the Auditor report to?
The auditor has a legal obligation to report directly to the shareholders and their report is addressed
to the shareholders, not the directors (though the two may be the same in smaller entities).
What is substantive testing?
Substantive testing is the detailed testing the auditor will undertake on transactions and balances.
For example, in a sales audit, the auditor will start from the initial customer order, trace the order to
the sales invoice, trace the sales invoice to the customer's ledger account, to the debtors control
account, to the VAT account (where appropriate), to the sales within the financial statements and to
eventual payment (where appropriate).
What are tests of control?
Internal controls are the procedures and policies the audit client implements within their entity. An
effective control environment will contribute to effective financial reporting and prevention of fraud.
An ineffective control environment will mean the auditor will have to undertake a wholly
substantive approach to their audit. The auditor will test the internal controls to ensure they operate
and if the auditor concludes that a sufficient internal control environment exists, then the auditor
can reduce their detailed substantive testing.
What is a 'debtor's circularisation'?
This is where the auditor will write to certain trade debtors to verify the balance outstanding on
their purchase ledger at the reporting date.
What is the Auditor's Report?
The report is the only outcome of the audit the client actually sees. The auditor's report is the report
the audit firm gives to the shareholders of an audit client which contains their opinion on whether or
not the financial statements give a true and fair view.
What are the opinions?
There are generally four audit opinions an auditor forms.
Unqualified opinion (internationally known as an unmodified opinion);
Qualified opinion (internationally known as a modified opinion);
Adverse opinion; and
Disclaimer
Unqualified opinions are where the auditor agrees the financial statements are free from material
misstatement.
Qualified opinions are where the auditor disagrees with the accounting treatment/disclosure within
the financial statements and is usually followed by an 'except for' paragraph stating that 'except for'
the disagreement, in all other respects, the financial statements give a true and fair view.
Adverse opinions are where the auditor concludes the financial statements do contain a material
misstatement/error which the client refuses to correct. This is where the auditor concludes the
financial statements do not give a true and fair view.
Disclaimers are where auditor cannot make a conclusion on whether the financial statements give a
true and fair view because of various circumstances (typically due to substantial failings in the
internal controls) and therefore does not give an opinion. This is the worst opinion the auditor can
give and the Government authorities (for example, Companies House) do have the power to demand
the director's correct the financial statements.
Can anyone do an Audit?
No. Only qualified firms of accountants can undertake audit work and they must be Registered
Auditors to do the same.
What sampling methods can auditors use?
Sampling works by obtaining information about a population by examining only part of it.
There are various sampling methods auditors can use when undertaking substantive testing.
Typically haphazard sampling is the most common form of sampling used. This is where a random
sample of a population is tested.
Stratified sampling is where a populations is sub-divided into 'strata's' and tested. An example is as
follows:
If a company employs 130 people on a payroll of which 50 are full time males, 20 are part time
males, 20 are full time females and 40 are part time females, then we have to first work out the
percentage which makes up each 'strata'.
Full-time males % (50/130×100) = 38% Part-time males % (20/130 x 100) = 15% Full-time females %
(20/130 x 100) = 15% Part-time females % (40/130 x 100) = 32%
So if a sample size is 20, then we can see from the above that 38% of the sample should be full time
males, 15% should be part time males, 15% should be full time females and 32% should be part time
females.
Interval sampling can be used where the auditor will sample a population at intervals, so for
example a sales sample could be selected using every 20th invoice.
Directional testing is not particularly widely used these days but it works on the concept of doubleentry i.e. that every debit has a credit. It works by saying that if a debit or credit is misstated then
there is a corresponding misstatement. So for example, if debtors are understated, this then means
that sales are also understated. So by testing for overstatement (as in debtors) then the matching
credits will be tested for understatement.
Those are the most common sampling methods used in everyday audit.
What is 'risk'?
Risk features heavily in audit. There are various types of risk, but the most common types of risk are:
Audit risk This is the risk that the auditor forms the wrong opinion on the financial statements.
Detection risk Is the risk the auditor does not detect a material misstatement.
Inherent risk Is the measure of the auditor's assessment that the financial statements may be
misstated before considering how effective the entity's internal control systems are.
Financial statement risk Is the risk that the financial statements are materially misstated.
Business risks Are the external risks faced by the business for example increases in interest rates.
The auditor has to reduce risk to an acceptable level during the course of their audit if they are to
form the correct opinion.
Why have auditing standards changed so much lately?
Well-publicised corporate disasters such as Enron have contributed to a rigorous 'shake up' of
auditing standards. Fraud features more heavily in the International Auditing Standards than it did in
the now defunct Statements of Auditing Standards (SAS's) and places more responsibility on the
auditor to obtain more sufficient and appropriate audit evidence.
What is the meaning of 'true and fair'?
True and fair is not defined in legislation, but common sense tells us that an entity's financial
statements should be representative of factual information. The Accounting Standards Board and
the Auditing Practices Board are not interested in what companies want to report, more what they
should report and how they should report the information.
Are auditors meant to find errors?
Absolutely not. The audit is commonly viewed as a hindrance and a cost to business. This need not
be the case. An audit is designed to see if improvements can be made to a company's internal
control environment and an opportunity to receive unbiased feedback as to how effective current
internal controls actually are. This helps the company become more efficient and will help
shareholders understand how effective the directors are in running their company.
Steven Collings FMAAT ACCA is Audit Manager at Leavitt Walmsley Associates Limited.