AUDITING I:

Introduction
I am writing this unit to help you understand auditing I easily and to equip you with relevant
technical skills required both at practice and for further studies in auditing. At the ends of each
topic, there are assignments or self-test and activities to enable you understand the topic further.

Objectives
By the end of this unit you should be able to:
i. Define and explain the importance of auditing.
ii. Describe the basic process of auditing
iii. Conduct a simple audit.

TABLE OF CONTENTS

Lecture 1: Title
1.1 Introduction
1.2 Specific Objectives
1.3 Lecture Outline
1.4 Lecture
1.5 End of lecture activities (self –tests)
1.6 Summary
1.7 Suggestion for further reading
 LECTURE ONE: GENERAL AUDITING ENVIRONMENT

1.1 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

1.2 Specific objectives:

At the end of the lecture you should be able:

Define and explain the importance of auditing.
Describe the basic process of auditing
Conduct a simple audit.

1.3 Lecture Outline

1.3.1 Title 1.3.1: Definition of auditing

1.3.2 Title 1.3.2: True and fair view
1.3.3 Title 1.3.3: Objectives of an audit
1.3.4 Title 1.3.4: Distinction between auditing and accounting
1.3.5 Title 1.3.5: Types of audits
1.3.6 Title 1.3.6: Users of audited reports

1.4 Lecture
Definition of Auditing
The word ‘audit’ means independent investigation into the quality of published accounting
information. International Standards on Auditing (ISA) describes audit as an independent
examination and expression of an opinion on the financial statements of an institution by an
appointed auditor in pursuance of that appointment and in compliance with any relevant statutory
obligation. The purpose of an audit is not to provide additional information but rather it is
intended to provide the users of the accounts with assurance that the information
provided/presented to them is reliable.

True and Fair view

The companies Act requires that all limited liability companies’ appoint an auditor whose task is
to express an independent opinion as to whether the financial statements prepared by the
directors show a true and fair view of the financial performance and position of a company.
What constitutes true and fair is not defined by the Act. Previously the auditor was required to
certify as to the truth and correctness of accounts, the phrase true and correct implying arithmetic
accuracy. Such an approach ignored the overall view of the accounts, which are prepared using
subjective accounting policies and would be difficult to prove. It is not possible to certify that
one set of accounts is the correct set, because many accounting areas are subject to a wide variety
of interpretations and therefore presentation. As a result the auditor is only required to express an
opinion as to whether the accounts show a true and fair view of the state of affairs of the
company and of its profit or loss for the period.
Objectives of an audit

The primary objective of an audit of financial statements is to enable the auditor to express an
opinion whether the financial statements are prepared, in all material respects, in accordance
with an identified financial reporting framework. (Financial reporting framework refers to the
international accounting standards, provisions of the companies Act and other relevant statutes
and legislation). The auditor expresses an opinion as to whether the financial statements give a
true and fair view of the financial position and performance of the company.

Other objectives
i. To give credibility to the financial statements. This arises from the fact that the accounts have
been subject to an examination by an independent person.
ii. An audit may assist in the prevention and detection of errors and frauds.
iii. The auditor’s experience will enable him to make recommendations on ways
of improving the accounting and internal control system.

Difference between Auditing and Accounting

Auditing Accounting
Involves examination of financial statements to
prove the true and fair view of company’s Involves preparation of books of accounts
affairs to aid in decision-making.

It is done mainly at year-end after the directors

have prepared the financial statements, although It is a continuous process carried out
the planning work could be carried out earlier. throughout the financial period.
In preparing financial statements and
maintaining books of accounts, the
An audit is mainly governed by the accountant is guided by generally accepted
international standards on auditing (ISA). accounting standards
Accountancy is a management function
The auditor must be independent of all the aimed at assisting management to run the
stakeholders such as management. business in an orderly efficient manner
It is a statutory requirement that all
It is a statutory requirement that financial companies must maintain proper
statements are audited. accounting records.
Types of Audit
Audits can be classified in two broad ways according to: -

1. Terms of engagements i.e. nature of work done

2. Method of approach of work done.

1 Terms of engagement-nature of work done.

Statutory audits
These are carried out as per the requirements of the various statutes e.g. the Companies Act cap
486 requires that all public limited companies must have their financial statements subjected to
an independent audit. The objectives of the audit are to express an opinion as to whether the
balance sheet and the profit and loss account show a true and fair view. The rights and duties of
the auditor are laid out in the Companies Act or the relevant statute. The powers of appointment
of the auditor are vested on the shareholders.

Private audits
These are audits that are not governed by the Act. These are performed by an independent
auditor because the owners, members or other interested parties require them and not because the
law requires them to be carried out. Private audits are carried out for organisations such as
NGOs, partnerships, clubs and charities among others. The appointment of the auditor is usually
carried out as a private contract between the auditor and the relevant stakeholder. The scope and
objective of the work is determined by the agreed terms between the auditor and the client. The
auditors’ rights and duties are also laid out in the contract.

Comparison between private and statutory audits

Similarities
1) Both are carried out by qualified auditors.
2) They involve the assessment of the internal control system.
3) They facilitate detection of errors and frauds.
4) Reports issued by the auditors can be used by third parties.

Differences
Statutory Audits
1. It is a requirement of an Act of parliament e.g. the Companies Act.
2. The scope and objective of work is defined in the Act
3. The report is addressed to the shareholders.
4. Appointment of the auditor is stipulated in the Act (Sec.159). It can either be by
shareholders, directors or registrar of companies.
5. The auditor is liable to third parties.
6. The auditor has full independence.
Private Audits
1. It is not a requirement by the Act.
2. The scope is agreed between a client and the auditor therefore it is limited.
3. Report is addressed to relevant stakeholder.
4. Private appointment by the owner.
5. The auditor is not liable to third parties.

b) Method of approach to work.

Continuos audits
This is an approach whereby the audit is carried out throughout the financial period. The audit
work is carried out at predetermined intervals usually around three audit visits. This approach is
ideal for large organisations with tight reporting deadlines e.g. multinational banks.

Assuming that the work is carried out in three-audit visits spread over duration of four months,
the first audit visit will mainly entail carrying out detailed planning of the audit. Work carried
out will include;
a. Obtaining a good understanding of the clients business or updating the business
understanding obtained in the previous audits.
b. Identifying any developments in the clients business that could have a significant impact
on the audit such as new legislation.
c. Identifying any changes that have taken place at the client’s that could have an impact on
the audit such as changes in management.
d. Determining the number of staff members to be involved in the audit and the level of
experience required and whether there will be need to involve experts.

The second audit visit will be carried out usually half way through the financial period work
carried out will include;

a. Ascertaining, recording and testing the clients internal control systems.

b. Concluding on the level of reliance to be placed on the internal control system.
c. Carrying out limited analytical review on the interim financial performance of the company.
This will include carrying out ratio analysis.
d. Deciding on the level of substantive testing and the nature of substantive procedures to be
carried out.

The final audit visit will mainly entail review of the financial statements at the end of the
financial year. Work carried out will include;

a. Carrying out substantive procedures on the various account balances

b. Concluding whether there are any significant misstatements in the financial statements.
c. Final analytical review to verify whether the information obtained is consistent and whether
the view presented by the financial statements is consistent with the auditors understanding
of the business.
d. Forming an opinion as to whether the financial statements show a true and fair view.
Merits
1 Accounts are usually kept up to date.
2 Errors and frauds are discovered at an early stage.
3 The auditor gathers sufficient knowledge of the business as a result of his frequent visits.
4 Saves time during final audits.
5 Better report is developed, as time spent is more.

Dimerits
1. It is expensive to have a continuos audit due to the amount of time spent.
2. Frequent disruptions of the clients work during the audit.
3. The auditor’s independence may be adversely affected by the continuous presence at the
clients premises.
4. Tendencies to over depend on auditing staff to solve accounting problems.
5. Interference of work, which has already been audited by the client’s staff.

INTERIM AUDITS
This is an audit that is usually carried out mid way through the accounting period. an interim
audit usually precedes a final audit and is ideal for large to medium size companies.

1 Work carried out during an interim audit usually include;

2 Obtaining an understanding of the nature of the client’s business;
3 Evaluating any significant changes in the clients operating environment that could have a
significant impact on the client’s financial statements such as change in the management.
4 Ascertaining, recording and testing the clients accounting and internal control system.
5 Concluding on the level of reliance to be placed on the internal control system.
6 Plan and design the substantive procedures to be carried out during the final audit;
7 Reporting to management on any significant weaknesses identified in the internal control
system.

Merits
1. It is ideal for dynamic businesses.
2. Compared to continuous audits it is cheaper.
3. It facilitates final audits.
4. Up to date accounts are kept.
5. Errors and frauds are prevented and detected at an early stage compared to final audits.

Dimerits
1. Errors are at an advanced stage compared to continuos audits.
2. Over dependence on audit staff to solve accounting problem.

Final audits
Usually done at the end of the year on the financial statements i.e. the balance sheet and the
profit and loss account. A final audit can be conducted in two ways;
1 As a continuation of the interim audit for large to medium size organisations;
2 For small organisations the audit could be carried out in one single session after the end
of the financial period.

After examining the end year financial statements the auditor then forms his opinion as to
whether the financial statements show a true and fair view and reports this to the shareholders.

Other types of audits

Procedural audits
Requires an examination of procedures or records for reliability and accuracy. At the end the
auditor can add new ones, modify existing ones or scrap old ones. Attention is paid mainly to:

a. Company internal control system.

b. Laid down guidelines and procedures.
c. As changes made without auditors’ knowledge.
d. Records of the company.

Merits
1. Reveals any inefficient procedures.
2. Identifies strengths and weaknesses in the internal control system.
3. Creates harmony and co-ordination of company decision making process.
4. Identifies any bureaucracies

Demerits
1. It is expensive.
2. Management can frustrate the whole process if they do not want to reveal inefficiencies.
3. It could lead to duplication of effort.
4. It is tedious especially when many procedures are involved.
5. Sometimes the auditor may not understand technical procedures.
6. Procedures change to respond to changes in the economy on the social setting.
7. Where the internal control system is weak, it is of limited applicability.

Management audits
This involves investigation of the company’s entire management to ascertain whether the
management is running the organisation in the best interest of the stakeholders. It investigates
company’s managerial aspects of the business from high to low management. It assesses the
efficiency of management to run the organisation in the most viable way.

Merits
1. It improves management quality.
2. Help assists in solving any bureaucracies.
3. Reveals weaknesses of management’s.
4. The strengths and weaknesses of the internal control system are also seen.
5. It acts as a check to the efficiency of budgetary system.
6. Corrective measures may be initiated immediately.

Dimerits
1. It lowers the morale of top management.
2. Management is unlikely to reveal its weaknesses when the auditor is present.
3. It is difficult to identify the department that is inefficient as all of them rely on each other
heavily.
5. It could lead to frustration of management as it can easily be biased.
6. It is difficult to monitor human actions and responses.

Balance sheet audits

Tests the strength of the internal control system by working backwards to get the initial
transactions. It is based on verification of assets by checking;

 Description: Mainly of recording entries.

 Ownership: Prove of ownership either by use of logbooks for cars or title deeds for land.
 Value: Cost and method of depreciation.
 Existence: Is the asset really there?

Merits
1. It is cheap compared to other audits.
2. A balanced opinion can be reached.

Dimerits
1. It is a partial audit.
2. Applied only to business with strong internal control system.

Users of audited financial statements

The annual accounts and report are primarily prepared by the directors to the shareholders.
However, the following parties need financial statements.

i. Those parties with vested interests in a business.

1. Employees.
2. Creditors or suppliers
3. Lenders and debenture holders
4. The management
5. The shareholders to whom the financial statements are addressed.
6. Credit rating agencies.
 ii. Those with potential interests
1. Potential shareholders
2. Trustees
3. Suppliers
4. Customers
iii. Those with representative interests
a. Lawyers
b. The government
c. The general public.

iv. Others
i. Competitors
ii. Stock brokers
iii. Statisticians
iv. Financial journalists
v. Trade unions.

1.5 Activities
1. Activity 1:
Discuss the concept value for money audit

2. Activity 2
Discuss why value for money audit is necessary

1.6 Self – Test Questions

Question One:
a) Identify the potential users of audited financial statements.
b) What are the specific needs of the potential users of audited financial
statements you have identified in (a) above?
1.6 Summary
Question Two
In this
(a) (i) lecture youexplain
Briefly have learnt that: of the term “audit”
the meaning
1. The
(ii) Whatword ‘audit’
are the meansofindependent
objectives investigation
an audit according into the quality
to the Companies Act? of
published accounting information
(b) List four advantages to a company of having its accounts audited
(c) Identify and listAct
2. Company the requires
responsibilities of company
that a limited directors
liability in relation
company shouldtoappoint
the
company’s accounting
an independent system.
auditor to express an opinion on whether the financial
(d) List statements
five limitations of an audit
prepared reflect a true and fair view of the company
3. Audit are divided in two broad ways including; Terms of engagements
i.e. nature of work done and Method of approach of work done.
1.7 Suggestion for further reading
Students are recommended to do further reading on the following;
1. The need for an audit in an institution
 LECTURE TWO: PROFESSIONAL ETHICS AND INTERNATIONAL STANDARDS
ON AUDITING

2.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

2.1 Specific objectives:

At the end of the lecture you should be able:

Define and explain the professional ethics guiding auditors
Describe the qualities required by an auditor to be credible in his/her work
Discuss the standards of auditing

2.2 Lecture Outline

2.2.1 Title 2.3.1: Professional Ethics

2.2.2 Title 2.3.2: International Auditing Standards

2.3 Lecture
PROFESSIONAL ETHICS
These are the rules of conduct that govern the behaviour of an accountant. These are issued by
ICPAK.
The auditor gives credibility to financial statements and to do this he must be credible himself.
To be credible, the auditor must possess and be seen to possess certain qualities:
1. Integrity

Straightforward honest and sincere in his approach to his professional work. A member must be
aware of his role in the society and maintain high standards of conduct and should not certify
what he knows is untrue as true and should take caution not to mislead intentionally or
unintentionally.

2. Competence
He should carry out his work with due care and skill in conformity with professional and ethical
standard issued by ICPAK or the laws of Kenya. A member should not undertake or continue
professional work, which he himself is not competent to perform unless he obtains such advice
and assistance as will enable him to perform such work. To be competent a member should be
fully conversant with accounting bookkeeping, auditing, financial management, information
technology, receivership, liquidation and bankruptcy law, contract law, taxation both personal
and corporate and must be aware of the economic environment within which his clients operate.
To be competent, he must also possess sound judgement. This is in professional as well as
economic issues. He should be a good communicator.
3. Confidentiality

The guide to professional ethics states that information acquired in the course of professional
work should not be disclosed except consent has been acquired from clients employer or other
proper source or where there is public duty to disclose or where there is a legal or professional
duty or right to disclose.
A member acquiring information in the course of professional work should neither use nor
appear to use that information for his personal advantage or for the advantage of a third
party.

4. Independence
The guide states that this is a fundamental concept to the accounting profession. It is essentially
an attitude of mind characterised by objectivity and integrity. A member in public practice
should be and should appear to be free in every professional assignment he undertakes of any
interest which might distract him from being objective. He must be impartial and must not allow
prejudice or bias to affect his judgement. A member not in practice may be unable to be or seen
to be free of any interest which might conflict with the proper approach to his professional work.
However this does not diminish his duty of objectivity in relation to that work.

Guidance of matters of Independence

Professional independence is considered to be crucial to the life of a professional accountant.

Therefore guidance is given on the best code of conduct in situations where the accountants
independence may be compromised or impaired.

i. Fees

It is undesirable for a practice to receive to significant a proportion of recurring fee income

from a client or a group of connected clients. A new or old practice in decline may be unable to
comply with the criteria. Therefore when an accountant finds himself with such a client he need
not resign immediately but should in the first instance look for opportunities to reduce the
significance of that client such as by looking for more work.
ii. Personal or family relationships
These relationships can impair independence. Therefore an accountant should take steps to
ensure family or personal relationships do not interfere with objectivity in approach to his work.

iii. Financial involvement with a client.

 Beneficial shareholding: A partner in an accounting firm,

spouse of such a partner and minor children of such partners should not have beneficial
shares in an audit client. If appointed as auditor when possessing such shares the member
should dispose of them at the earliest opportunity. If the company’s articles of
association require that the auditor has qualified shares then the member should take
 minimum number allowed. The shares cannot be used by the member in an annual
general meeting to vote on the appointment of the auditor and his remuneration.
 Loans to and from client: An accounting firm should not accept
loans from its clients or give loans to clients. This includes guarantees. A firm may,
however accept a loan from a client if it is that clients’ ordinary course of business to
give loans. Loans thereof should not be accepted on terms more favourable than those
available to others.

iv. Goods and Services

Members should resist from accepting goods and services from the client on terms more
favourable to the generality of the client’s employees. Undue hospitality poses a similar
threat to a member’s independence.

v. Conflicts of interests.

 Provision of other services to clients; A member should be alert

to the danger posed to his independence by providing accounting and other services
which place him in an executive position to his client. A member should use different
staff for those services and also that the client takes full responsibility for that work.
 Competing clients in conflict; the member should frankly
disclose to both parties and advice them to choose another auditor and then disengage one
of the appointments. However he can also provide advice to resolve the conflict.
 Receiverships and liquidation; If a company, a member is
auditing goes into receivership, the member should not accept an appointment as a
receiver - manager unless at least two years have elapsed. If there is a company which a
member has been a receiver of and the receivership ends, a member who has the receiver
should not accept an appointment unless two years have elapsed. A member who is a
receiver of a company which goes into liquidation should not accept an appointment as
liquidation of that company.
 Previous employment; A member who has been an employee of
a company, having left that employment should not accept appointment as an auditor of
that company until at least 2 years have elapsed.

Publicity Advertising and Obtaining Professional Work

Under the Accountancy Act, advertising is prohibited. Members of ICPAK resolved in 1997 to
permit advertising.

1. General Consideration
A member may seek to promote the services he/she offers through advertising or other means so
long as this is consistent with the dignity of the profession and it does not project an image
inconsistent with that of a professional person bound to high ethical and technical standards. A
member should use judgement in determining whether a course of action will be inconsistent or
not.
2. Advertising
 An advertisement should not mislead through claims that are not
substantial and must observe strict standards as to legality, decency, clarity, honesty and
truthfulness.

 A member may advertise services subject to the general

requirements that the media should not, in the opinion of the council of the institute,
reflect adversely on the member, the institute or accountancy profession. The
advertisement in itself should not;

a. As a content or presentation bring the institute into dispute or

discredit to the members, the firm or accountancy profession.
b. Discredit the services offered by other members, whether by proclaiming
superiority for the advertisers of the services or otherwise.
c. Contain comparisons with other members or firms.
d. Contain testimonies or endorsements.
Particular care should be exercised if references to size or quality are to
be included in the advertisement for example it is difficult to establish
whether a claim to be the largest firm is in reference to number of partners
or staff, or to offices or the amount of fees income.
e. A claim to be the best firm is subjective and not sustainable.

 Although advertisement may refer to the bases on which fees are calculated and where
they contain any statements concerning the hourly rate charged by the firm, care should
be taken to avoid giving the impression that lower quality performance is provided than
that expected from professional persons.

1. Publicity
Publicity for members is accepted as long as it does not cast the institute and the accounting
profession into disrepute or project the member in any way that is inconsistent with the dignity
of the profession.

2. Solicitation
A member may contain or seek professional work by any direct approach to a prospective client.

Charging for professional work

Statement number 9 of ethical guidelines provides that fees for professional services should not
be charged on a percentage or similar benefit unless where that source is authorised by statute or
is a generally accepted practice for certain specialist’s work nor, should instructions be accepted
on a contingency basis for example a bonus of 5% on profits. The explanatory not amplifying
this statement states that:
The principle is that the independence of judgement of the member should not be impaired by
the hope of a financial gain. Therefore any basis of fees which may influence the practising
members judgement or findings or which may even subject him in the public eye to the suspicion
that his judgement was improperly influenced is to be extended. Therefore, fees should be
computed in reference to:

 The skill and knowledge required for the type of work involved for example if the work
required an expert the fees would be higher.
 The seniority of the person necessarily engaged in the work.
 The time necessarily engaged on each person on the work.
 Nature of responsibility, which the work entails.

INTERNATIONAL STANDARDS ON AUDITING

Within each country, local regulations govern to a greater or lesser degree, the practices followed
by the auditors. Such regulations may either be of a statutory nature of in the form of statements
issued by the regulatory or professional bodies in the country concerned.

National standards on auditing published in may countries differ in form and content.
International Auditing Practices Committee (IAPC) takes cognisance of such documents and
differences and in the light of such knowledge issues auditing standards which are intended for
international acceptance.

These standards:

a. Are applied in the audit of financial statements or to the audit of other information.
b. Contain basic principles and essential procedures together with related guidance in form of
explanatory and other material.
c. Have to be understood wholly and not in part so as to understand and apply them.
e. May be departed from in exceptional circumstance so as to more effectively achieve the
objective of an audit.

2.4 Activities
Activity 1:
Discuss the various professional values and ethics that guide auditors to practice

Activity 2
List and explain the advantages for an auditor to adopt professional values and
ethical code of conduct in their work
2.5 Self – Test Questions

Question One:

In additions to the guidelines issued by ICPAK on professional independence,

suggest other steps that may be undertaken to improve auditors’ independence.

Question Two

Discuss the two levels of auditor’s independence and explain their significance

2.6 Summary

In this lecture you have learnt that:

i. Professional ethics are rules of conduct that govern the behaviour of
an accountant
ii. Discuss the importance of International Standards on auditing

2.7 Suggestion for further reading

Students are recommended to do further reading on the following;
i. How to safeguard auditors independence
ii. How an auditor can avoid possible conflict of interest
 LECTURE FOUR: STAGES OF AUDITING

4.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

4.1 Specific objectives:

At the end of the lecture you should be able:

Discuss the stages of auditing

4.2 Lecture Outline

4.2.1 Introduction to stages of an audit
4.2.2 Stages of an audit

4.3 Lecture
In carrying out an audit the following are the main stages. However, note that the steps followed
will vary from client to client and from auditor to auditor.

STAGES OF AN AUDIT

1. Determining the scope of the audit work. For statutory audits the scope is clearly laid out
in the provisions of the Companies Act and is formally contained in the letter of
engagement.
2. Ascertain nature of the client’s business. The auditor seeks to obtain some background
information of the nature of the client’s business.
3. Planning the audit; the auditor prepares a planning memorandum that shows the general
strategy in to be followed in conducting the audit.
4. Ascertaining and evaluating clients accounting systems and internal controls, use of flow
charts and evaluating using key questions.
5. Carrying out tests of controls: This enables the auditor to determine the level of reliance
to be placed on the internal control system and therefore reduce the level of substantive
testing.
6. Planning the level of substantive testing and formulating the substantive tests to be
carried out.
7. Carrying out substantive testing on the selecting account balances.
8. Carrying out the final analytical review and concluding whether the financial statements
show a true and fair view.
9. Drafting the audit opinion and any other reports to be issued under the terms of
engagement e.g. the management letter.
4.4 Activities

Activity 1:
Discuss the various stages of an audit

Activity 2:
Discuss how an auditor can ascertain the nature of a business before commencing
auditing process

4.5 Self – Test Questions

Question One:

State and explain the substantive tests to be carried out by an auditor

Question Two

Explain how an auditor can ascertain the clients accounting systems

4.6 Summary

In this lecture you have learnt that:

i. There are at least nine stages of auditing
4.7 Suggestion for further reading
Students are recommended to do further reading on the following;
i. The issues to be included in the planning memorandum by an
auditor
ii. Analytical review procedures
iii. Auditors opinion
 LECTURE FIVE: AUDIT PLANNING

5.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

5.1 Specific objectives:

At the end of the lecture you should be able:

Define and explain audit planning
Describe the factors affecting audit planning
Explain the contents of audit planning memorandum

5.2 Lecture Outline

5.2.1 Audit Planning Definition
5.2.2 Advantages of good audit planning
5.2.3 Sources of information on Client business
5.2.4 Factors affecting audit planning
5.2.5 Audit planning Memorandum
5.2.6 Audit Programs

5.3 Lecture

Audit planning

Refer to ISA 300

Planning refers to developing a general strategy and a detailed approach for the expected nature,
timing and extent of the audit.
The auditor should plan his work to enable him to conduct an effective audit in an efficient and
timely manner. The form and nature of the planning required for an audit will be affected by the
size and complexity of the organization, the commercial environment in which it operates,
method of processing transactions and reporting requirements to which it is subject.

ADVANTAGES OF GOOD AUDIT PLANNING

i. It establishes the intended means of achieving the objectives of the audit.
ii. It assists in the direction and control of the work. A good plan assists in the proper utilization
of assistants and in the coordination of work done by other auditors and specialists.
iii. It helps to ensure that attention is devoted to important areas of the audit. The planning
process identifies potential problematic areas. E.g. areas with weak internal controls where
more detailed substantive testing should be carried out.
iv. It helps to ensure that audit work is completed expeditiously through more efficient use of
time and proper allocation of work to audit staff.
v. Ensures proper division of work between interim and final audit to avoid repetition of work
already done.
vi. The audit plan takes into consideration times when information needed for audit purposes is
available and when the client is not very busy. This encourages co-operation by ensuring less
disruption of client’s work.

Audit planning covers;

 Developing an overall plan for the expected scope and conduct of the audit. The overall plan
is recorded in a planning memorandum.
 Developing an audit programme showing the nature, timing and extent of audit procedures to
be applied at every level of audit testing.

In order to plan his work adequately the auditor need to understand the nature of the clients
business, its organization, its methods of operating and the industry in which it operates. This is
to enable the auditor appreciate which events and transactions are likely to have a significant
effect on the financial statements.

Sources of information on the nature of client’s business

Refer to ISA 310

In performing an audit on the financial statements, the auditor should have or obtain knowledge
of the business sufficient to enable him to identify and understand events, transactions and
practices that in the auditor’s judgment may have significant effect on the financial statements or
on the audit report. Prior to accepting an engagement, the auditor would obtain a preliminary
knowledge of the industry and of the ownership, management and operations of the entity to be
audited. After accepting to act as the company’s auditor, further and more detailed information
would be obtained. Obtaining the required knowledge of the business is a continuous and
cumulative process. The auditor can obtain knowledge of the industry and the client from a
number of sources;

 Previous experience with the entity and the industry;

 Discussion with people within the entity e.g. directors and employees;
 Discussion with internal audit personnel and review of internal audit reports;
 Discussion with other auditors and with legal and other advisors who have provided services
to the entity;

 Publications related to the industry e.g. journals;

 Visits to the entity’s place of business and plant facilities
 Documents such as minutes of meetings, annual financial reports, operations & systems
manuals, budgets, marketing and sales plans.

Using the knowledge

Knowledge on the nature of clients business assists the auditor in;
 Assessing risks and identifying problems that could affect the audit;
 Coming with a good plan as to how the audit will be carried out effectively and efficiently;
 Evaluating audit evidence obtained;
 Providing better service to the client.

The auditor should ensure that assistants to an audit engagement obtain sufficient knowledge of
the business to enable them to carry the audit work delegated to them.

Factors to consider when formulating the audit plan

The auditor should consider the audit approach he wishes to adopt, including the extent to which
he may rely on internal controls and any aspects of the audits, which need particular attention.
Matters to consider by the auditor in developing overall audit plan include;

 Understanding the accounting and internal control systems

 the auditor should seek to understand the accounting policies adopted by the entity and
changes in these policies. The auditor’s cumulative knowledge of the accounting and internal
control systems and the relative emphasis expected to be placed on tests of control and
substantive procedures.
 Reviewing matters raised in the previous year’s audit, which may have continuing relevance
in the current year. This is done by reviewing previous year’s working papers. The auditor
will be able to identify areas noted as having weak controls or specific accounting problems.
Attention should be paid to such areas in the audit plan.
 Assessing the effects of any changes in legislation or accounting practice affecting the
financial statements of the company. The audit plan should include a review of these changes
and whether the client has complied.
 The auditor should consult with management and staff of the organization about current
trading circumstances and any significant changes in the business carried on and the
management of the enterprise. E.g. changes in management might weaken the internal
control system.
 Identify any significant changes in the clients accounting procedures such as installation of a
new computer information system. Changes to a computerized system could result in weak
controls.
 Conditions requiring special attention such as the existence of related parties.
 Consider any current or impending financial difficulties, which could face the company. E.g.
shortage of raw materials or failure to raise working capital.
 The auditor should check the nature and timing of reports and other communications with the
client so that the audit plan accommodates such timings e.g. he should consider the dates of
the annual general meeting, stock taking, dates when management reports are available.
 Set materiality levels for audit purposes and in particular identify areas with material
transactions, which call for more audit work.
 The assessment of internal audit department and level of reliance to be place on its work.
 The auditor should also determine the number of audit staff required, experience and special
skills required and the timing of the audit visits.
Audit planning memorandum
Having considered the above factors the auditor should prepare the audit-planning memorandum.
This sets out;
The outline audit approach;

 How, by whom and when each item in the financial statements will be audited;
 Timing requirements to be met for each item;
 Staff usage with time budgets for each set of audit work
 Contents of an audit-planning memorandum

The nature of information contained in an audit-planning memorandum will vary from one audit
to the other, but generally may include:

 A summary of the terms of engagement to lay out the nature and scope of the work;
 Job timetable giving the provisional dates of the timing of the audit e.g. date of planned
commencement of the audit.
 Record of any changes in the client since the last audit e.g. changes in the nature of the
client’s business, change in management structure;
 Details of the planning decisions such as areas identified as having weak internal controls
requiring more detailed audit work, areas where the advise of an expert is needed e.t.c
 Extent of reliance expected on internal audit;

Audit programs
Refer to ISA 300 Para 10 & 11
ISA 300 Para 10 “the auditor should develop and document an audit program setting out the
nature, timing and extent of planned audit procedures required to implement the overall audit
plan. The program serves the following purposes;
 As a set of instructions to audit assistants involved in the audit;
 As a means to control and record the proper execution of the work

An audit program contains;

 The audit objectives for each area being audited;

 The audit procedures to be carried out in meeting the objective;
 A time budget in which hours are budgeted for the various audit areas or procedures

Problems encountered in developing and implementing audit plans

 A firm may have many clients with similar year- end making time and staff allocation
difficult.
 Abrupt changes in the client’s business may call for more audit time outside the planned time
e.g. changes in accounting and internal control systems.
 Lack of co-operation from the client e.g. providing information in good time.
 Staff turnover.
Steps to safeguard these problems
 Close liason with the client. This will aid in reducing delays in receiving the required
information for the audit.
 Continuous staff recruitment by the firm.
 Long term strategic project planning.

5.4 Activities

Activity 1:
Discuss the factors to consider when formulating audit plan

Activity 2
Discuss how an auditor can benefit from information gathered during audit
planning

5.5 Self – Test Questions

Question One:

Explain the auditor’s planning process when planning for an audit of a new
client.

Question Two

How does audit planning assist in the conduct of an audit?

5.6 Summary

In this lecture you have learnt that:

i. Planning refers to developing a general strategy and a detailed
approach for the expected nature, timing and extent of the audit.
ii. An audit program contains;
 The audit objectives for each area being audited;
 The audit procedures to be carried out in meeting the
objective;
 A time budget in which hours are budgeted for the various
audit areas or procedures
5.7 Suggestion for further reading
Students are recommended to do further reading on the following;
i. Challenges auditor encounter in developing a good audit plan
ii. How the auditors can overcome the above challenges

LECTURE SIX: AUDIT RECORDING

6.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

6.1 Specific objectives:

At the end of the lecture you should be able:

Define and explain the importance of audit recording
Describe the various types of audit recording
State and explain the components included in the audit working papers

6.2 Lecture Outline

6.3 Lecture
Refer to ISA 230- documentation
Recording refers to documentation in the form of working papers prepared or obtained by the
auditor and retained by him in connection with the performance of his audit. Audit working
papers should always be sufficiently complete and detailed to enable an experienced auditor
having no previous connection with the audit to ascertain the work that was performed supports
the conclusions reached.
The auditor should record all relevant information known to him at the time, the conclusions
reached based on that information and the views of management.

Why the need for preparing good working papers?

(a) The reporting partner needs to satisfy himself that work delegated by him has been properly
performed. This is only possible by reviewing detailed working papers prepared by the audit
staff who performed the work. This also aids in supervision and review of work done by
audit assistants.
(b) Working papers provide details of problems encountered together with evidence of work
performed and conclusions drawn there from in arriving at the conclusions reached. These
details can also serve as a good reference point for future audits.
(c) Preparation of working papers encourages the auditor to adopt a methodical approach to his
work.
(d) Working papers assist in the planning and performance of audits in future financial periods.
(e) If sued for negligence working papers act as evidence of work done.
(f) They are used for training of audit staff. Working papers contain audit programs and
specimen schedules, which audit assistants can refer to when conducting an audit.

Auditing guidelines do not define precisely the form of working papers but it indicates what
might typically be contained therein;
(a) Information of continuing importance to the audit such as letter of engagement,
memorandum of association e.t.c.
(b) Planned audit approach as contained in the planning memorandum.
(c) Auditor’s assessment of the client’s accounting system, his review and evaluation of internal
controls.
(d) Details of audit work carried out, notes of errors or exceptions noted and action taken
together with conclusions drawn by the audit staff.
(e) Evidence that the work of staff has been properly reviewed.
(f) Record of relevant balances and other financial information that is subject of the audit.
(g) Analysis of significant ratios and trends
(h) Copies of communications with other auditors, experts and other third parties
(i) Letters of representations received from management.

Working papers are subdivided into the current audit file (CAF) and the permanent audit file
(PAF).

The Permanent File

The permanent file usually contains documents and matters of continuing importance, which are
required for more than one financial period. Information contained in a PAF include:

a. Statutory material: governing the conduct, accounts and audit of the enterprise for companies
a Companies Act (Cap 486). For a quoted company a copy of the Nairobi Stock
Exchange regulations (NSE) is required.
b. Rules and regulations of the enterprise. The Memorandum and Articles of Association. For
a partnership, a partnership agreement.
c. Copies of documents of continuing importance and relevance to the auditor.

 Letter of engagement and minutes of appointment of the auditor.

 Trade license.
 Debenture deeds.
 Leases.
 Guarantees and indemnities entered into.

d. Addresses of the registered office and all other premises with a short description of the work
carried on at each.
e. An organisation chart showing: -
 Principal departments and subdivision thereof.
 Names of responsible officials showing lines of responsibility.
f. List of books and other records and where they are kept names, positions, specimen
signatures and initials of persons responsible for books and documents account codes and
classifications should be held.
g. An outline of history of the organisation special mention or reserves, share capital,
h. Prospectus, acquisitions of businesses and provisions.
i. Accounting policies used for material areas suchas stock, work in progress, depreciation,
research and development.
 Notes of interviews and correspondence of internal control matters and all past
management letters.A note of the position the company in the group and all subsidiaries
and associated
companies with holding therein.
j. A list of directors their shareholdings and service contracts.
k. A list of company’s advisors, bankers, stockbrokers, solicitors, valuers.

The Current File

This file will contain matters pertinent to the current year’s audit. It will contain:

1. A copy of the accounts being audited signed by the directors.

2. An index to the file.
3. A description of the internal control system inform of questionnaires, flowcharts or
written documents together with specimen documents.
4. Audit programme.
5. A schedule of each item in the balance sheet. Each schedule should show:

 Balance at the beginning of the year, changes during the year and balance at the end
of the year.
 Details of its existence, ownership and appropriate disclosure have been verified.

6. A schedule for each item in the profit and loss account showing its make up.
7. Check list for compliance with statutory disclosure requirements. Accounting standards
and auditing standards.
8. Record of queries raised during the audit and coming forward from previous audit.
9. Schedule of important statistics e.g. output, net profit margin, gross profit margin, sales
composition, liquidity ratios.
1. A record or abstract from the minutes of:

 The company
 The directors
 Any internal committee of the company whose deliberations are important to the
auditor.

11. Letters to the client setting out weaknesses in the internal control.
12. Letters of representation.

Other Working Papers

a) Manuals: Most audit firms of any size have printed audit manuals which complement
internal instruction given to staff. They contain general instructions on the firm’s method
of auditing in each area and on the audit firm’s procedures generally.
b) Audit notebooks. These were common at one time but now most notes made by audit
staff are incorporated in the current or permanent files.
c) Time sheets: These are not strictly a part of the audit working papers but are of great
importance in controlling the work of audit staff and making proper change to the clients.
d) Audit control and review sheets. These again are usually incorporated in the working
files.

Standardization working papers

This refers to predetermined format of presenting/documenting audit findings formulated by
individual audit firms e.g. specimen letters, checklists e.t.c

Advantages of using standardized working papers

 This improves the efficiency the efficiency with which they are prepared.
 They act as guidelines or instructions to audit staff and facilitates delegation of work
 They provide a means to control the quality of audit work by ensuring that minimum quality
standards are maintained.
 Ensures that all relevant issues in the audit area are addressed.

Disadvantages
 It is not appropriate to follow mechanically a standardized approach to the conduct and
documentation of the audit work without regard to the need to exercise judgment.
 Work becomes mechanical
 Client’s staff may become familiar with the method.
 The initiative of the audit staff may be stifled.

6.4 Activities

Activity 1:
Discuss the types of working papers used by an auditor

Activity 2
Discuss the position of external auditor with reference to audit working papers
6.5 Self – Test Questions

Question One:

Enumerate and describe the components of the types of audit working papers

Question Two

Explain why standardisation of audit working papers is essential in audit

environment

6.6 Summary

In this lecture you have learnt that:

i. Recording refers to documentation in the form of working papers
prepared or obtained by the auditor and retained by him in connection
with the performance of his audit.
ii. Standardized working papers refers to predetermined format of
presenting/documenting audit findings formulated by individual audit
firms

6.7 Suggestion for further reading

Students are recommended to do further reading on the following;

i. Challenges in developing good audit working papers

 LECTURE SEVEN: AUDIT EVIDENCE

7.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

7.1 Specific objectives:

At the end of the lecture you should be able:

Define audit evidence.
Describe the basic process of auditing
Conduct a simple audit.

7.2 Lecture Outline

1. Definition of audit evidence

2. Reliability of audit evidence
3. Obtaining audit evidence
4. Management assertions
5. Methods of obtaining audit evidence

7.3 Lecture

Audit evidence
Reference should be made to ISA 500- Audit evidence
“ The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion”

Audit evidence refers to the information obtained by the auditor in arriving at the conclusions on
which the audit opinion on the financial statements is based.
Audit evidence comprises source documents and accounting records underlying the financial
statements and corroborating information from other sources.
The sources and amount of evidence needed to achieve the required level of assurance is
determined by the auditor’s judgment. His judgment will be influenced by the materiality of the
item being examined, the relevance and reliability of evidence available from each source and
the time and cost involved in obtaining it.
Audit evidence is obtained from an appropriate mix of tests of controls and substantive
procedures. Where the internal control system is considered weak, evidence maybe obtained
entirely from substantive procedures.

Tests of controls
Compliance tests are procedures performed to obtain audit evidence about the effectiveness of
the:
(a) Design of the accounting and internal control system i.e. whether it is suitably designed to
prevent and correct material misstatements.
(b) Operation of the internal controls throughout the period.

Substantive procedures
These are audit tests carried out to test the accuracy and validity of the accounting records.
Substantive procedures are mainly of two types i.e. analytical review procedures and tests of
details.

Meaning of sufficient appropriate audit evidence

Sufficiency is the measure of the quantity of audit evidence.
Appropriateness is the measure of the quality of audit evidence and its relevance to a particular
assertion and its reliability. In forming an opinion the auditor does not examine all the
information available but uses judgmental or statistical sampling procedures to form conclusions
on account balances, class of transactions or controls.
Factors influencing the auditor’s judgment as to what is sufficient appropriate audit evidence.

1. The degree of risk of misstatement- this may be affected by;

 The nature of the item e.g. cash has a greater degree of misstatement than fixed assets
 Strength of the internal control system, where the system is weak there is a greater risk of
misstatement.
 Nature and size of business being carried out.
 Financial position of the company.

2. Materiality of the item being examined in relation to the financial statements as a whole.
3. The auditor’s experience with the client gained during the previous audits e.g. the reliability
of management and accounting records.
4. Results of other audit procedures including fraud or error, which may have been detected.
5. Sources and reliability of information available.

Meaning of relevance of audit evidence

Relevance of audit evidence should be considered in relation to the overall audit objective of
forming an opinion and reporting on the financial statements. To achieve this objective the
auditor needs to obtain evidence to enable him to draw reasonable conclusions on various
management assertions made in preparing the financial statements. Relevance therefore refers to
the ability of the evidence to assist the auditor in testing management’s assertions.

Refer latter on in this lesson for the meaning of management’s assertions.

Reliability of audit evidence

The reliability of audit evidence refers to the credibility of the source of the evidence.
This credibility is influenced by its source; whether from internal sources or external sources and
by its nature; whether visual, documentary or oral. Reliability of the evidence depends on
individual circumstances but we can make the following generalizations:
1. Audit evidence from external sources e.g. a third party (e.g. a debtor) confirming amount
owing to the company is more reliable than evidence generated internally.
2. Audit evidence generated internally e.g. from accounting records is more reliable when the
related accounting and internal controls are effective.
3. Evidence obtained by the auditor himself is more reliable than that obtained from the entity.
4. Evidence in the form of documents and written representations is more reliable than oral
representations.

The auditor seeks evidence from different sources. Evidence is more persuasive when evidence
from different sources is consistent. Conversely, when audit evidence obtained from one source
is inconsistent with that obtained from another, the auditor should perform further procedures to
resolve the inconsistency.

When in doubt as to any assertion of material significance, the auditor should attempt to obtain
sufficient appropriate evidence to remove such doubt. If he is unable to obtain sufficient
appropriate evidence, he should express a qualified or a disclaimer of opinion.

Obtaining audit evidence

Audit evidence is obtained by carrying out compliance (tests of control) and substantive tests. In
carrying out compliance tests (tests of controls), the auditor is concerned with;

a. Whether controls exists

b. The effectiveness of those controls.
Substantive procedures are defined as those tests of transactions and account balances, which
seek to provide audit evidence as to the completeness, accuracy and validity of information
contained in the accounting records or in the financial statements. Substantive tests are of
two types;

c. Tests of details- these are designed to substantiate individual items in the accounts and to
gain assurance about their validity or the details that underlies the account balances.
d. Analytical review procedures

Management assertions
When preparing financial statements the management is making certain explicit or implicit
assertions about the financial affairs of the company. Consequently when the auditor is obtaining
evidence from substantive procedures, he is concerned about testing or substantiating the truth of
these assertions. These assertions are categorized as follows;

i. Existence- that an asset or liability exists at a given date. E.g. that closing stock physically
exists.
ii. Rights and obligations- an asset is a right of the entity and a liability is an obligation of the
entity. E.g. land belongs to the company and the title documents are in the name of the
company.
iii. Occurrence- that a transaction or event took place which pertains to the entity during the
period.
iv. Completeness- there are no unrecorded assets, liabilities, transactions or undisclosed items.
v. Valuation- that a transaction is recorded at an appropriate carrying value. E.g. that land and
buildings are carried at an appropriate value.
vi. Measurement- that a transaction is recorded at the proper amount and revenue and expenses
allocated to the proper period.
vii. Presentation and disclosure- an item is disclosed classified and described in accordance
with the applicable with the applicable financial reporting framework.

The auditor seeks to obtain audit evidence to prove each financial statement assertion. The
nature, timing and extent of substantive procedures to be carried out to prove the financial
assertions varies. One substantive procedure can prove evidence about more than one assertion.
E.g. collection of an amount owed by debtors may provide evidence as to both existence and
valuation of the debt.

METHODS OF OBTAINING EVIDENCE

The auditor may rely on sufficient appropriate evidence obtained by substantive testing to form
his opinion. Alternatively he may be able to obtain assurance from the presence of a reliable
internal control system and therefore reduce the extent of substantive testing. The auditor obtains
evidence in performing compliance and substantive procedures using the following methods;

 Inspection
This consists of examining records, documents or tangible assets. The reliability of the
evidence obtained from inspection of records and documents depends on the nature, source
and effectiveness of the internal control system. Inspection of tangible assets provides
evidence with respect to their existence but not as to their value and ownership.
 Observation
This involves looking at procedures being performed by others. E.g. observing the counting
of stock by the client’s personnel.
 Inquiry and confirmation
Inquiry consists of seeking information from knowledgeable persons inside or outside the
entity. This ranges from formal written inquiries addressed to 3rd parties to oral inquiries
addressed to persons within the entity. The information may be new to the auditor or may
corroborate evidence from other sources. Confirmation is the response to an enquiry to
corroborate information contained in the accounting records.
 Computation
This involves checking the arithmetical accuracy of source documents and accounting
records or performing independent computations. E.g. re-computing the amount of provision
for depreciation and comparing this against that computed by the client.
 Analytical procedures
The analysis of relationships such as between items of financial data to identify consistencies
and predicted patterns or significant fluctuations and unexpected relationships and the results
of investigations thereof.
Refer to ISA 520 on the nature and purpose of analytical review.
7.4 Activities
Activity 1:
Discuss the term audit evidence
Activity 2
Explain the various methods used by an auditor to obtain evidence

7.5 Self – Test Questions

Question One:
Discuss the circumstances which an auditor should use to ascertain reliability of audit
evidence
Question Two
You are the manager responsible for the audit of Aspersion, a limited liability company,
which mainly provides national cargo services with a small fleet of aircraft. The draft
accounts for the year ended 30 September 2001 show profit before taxation of Kshs2·7
million (2000 ñ Kshs2·2 million) and total assets of Kshs10·4 million (2000 ñ Kshs9·8
million). The following issues are outstanding and have been left for your attention:

(1) The sale of a cargo carrier to Abra, a private limited company, during the year
resulted in a loss on disposal of Kshs400,000. The aircraft cost Kshs1·2 million when
it was purchased in October 1992 and was being depreciated on a straight-line basis
over 20 years. The minutes of the board meeting at which the sale was approved
record that Aspersionís finance director, Iain Jolteon, has a 30% equity interest in
Abra.
(2) As well as cargo carriers, Aspersion owns two light aircraft which were purchased in
1998 to provide business passenger flights to a small island under a three year service
contract. It is now known that the contract will not be renewed when it expires at the
end of March 2002. The aircraft, which cost Kshs450,000 each, are being depreciated
over fifteen years.

(3) Deferred tax amounting to Kshs570,000 as at 30 September 2001 has been calculated
relating to tangible non-current assets at a tax rate of 30% using the full provision
method (IAS 12 ëIncome Taxesí). On 1 December 2001, the government announced
an increase in the corporate income tax rate to 34%. The directors are proposing to
adjust the draft accounts for the further liability arising.
Required:
For each of the above points:
(i) Comment on the matters that you should consider; and
(ii) State the audit evidence that you should expect to find, in undertaking your review of
the audit working papers and financial statements of Aspersion.
7.6 Summary

In this lecture you have learnt that:

i. The reliability of audit evidence refers to the credibility of the source of
the evidence.
ii. Sufficiency is the measure of the quantity of audit evidence.
iii. Audit evidence refers to the information obtained by the auditor in
arriving at the conclusions on which the audit opinion on the financial
statements is based.

7.7 Suggestion for further reading

Students are recommended to do further reading on the following;
i. Primary Audit evidence
ii. Secondary Audit evidence
iii. Circumstantial audit evidence
iv. Hearsay audit evidence
 LECTURE EIGHT: AUDIT SAMPLING

8.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

8.1 Specific objectives:

At the end of the lecture you should be able:

Define and explain the importance of audit sampling
Describe the basic process of auditing
Conduct a simple audit.

8.2 Lecture Outline

8.2.1 Definition of sampling
8.2.2 Why Auditors adopt sampling
8.2.3 Stages in audit sampling
8.2.4 Qualities of a good sample

8.3 Lecture

Definitions

Sampling
Audit sampling involves the application of substantive or compliance procedures to less than
100% of items within an account balance or class of transactions to be enable the auditor obtain
and evaluate some characteristics of the balance and form a conclusion concerning that
characteristic.

Population

This refers to the entire set of data from which a sample is selected and about which the auditor
wishes to draw conclusions. E.g. all items in an account balance or class of transactions
constitute a population. The individual items that make up the population are known as sampling
units.

Sampling risk
This arises from the possibility that the auditor’s conclusion based on the tests performed on the
selected sample may be different from the conclusion reached if the entire population was
subjected to the same procedure.
Non sampling risk
Arises from factors that cause the auditor to reach an erroneous conclusion for any reason not
related to the size of the sample e.g. use of inappropriate audit procedures leading to failure to
identify an error.

Tolerable error
Refers to the maximum error in the population that the auditor is willing to accept and still
conclude that the results from the sample have achieved the audit objective. Tolerable error is
considered during the planning stage and is related to the auditor’s judgment on materiality. The
smaller the tolerable error the larger the sample size.

Confidence level
Refers to the degree of confidence that the auditor requires that the results of the sample are
indicative of the actual error in the population.

Stratification
This is the process of dividing the population into sub-populations so that items within each sub
population are expected to have similar characteristics in certain aspects e.g. same monetary
value.

Why auditors adopt a sampling approach

A complete check of all transactions and balances of a business is no longer required by/ of an
auditor. The reasons are:

a. Economic - The cost in terms of expensive audit resources would be prohibitive.

b. Time - The complete check would take too long such that financial accounts would be of
no use by the time the audit is completed.
c. Practical - Users of accounts do not expect or require 100% accuracy. Materiality is
important in auditing as well as in accounting.
d. Psychological - A complete check would so bore the audit staff and their work would end
up being ineffective.
e. Fruitfulness: A complete check would not add much to the worth of figures if, as would
be normal, a few errors are discovered. The emphasis of audits should be on
completeness of record and their true and fair view.
The objective of auditing sampling is to enable the auditor carry out procedures designed
to obtain sufficient appropriate audit evidence to determine with reasonable confidence
whether the financial statements are free of material misstatement.
f. The use of sampling with properly thought out objectives and properly constructed tests
allows more valid conclusions to be reached than when as many transactions as possible
are test
ed. This is because detailed testing is carried out on the sample units.use of sampling
enables the auditor to give more precise information to the client in the management
letter.

Stages in audit sampling

(a) Planning the sample
When planning how to carry out the sampling the auditor should consider the following:
 The objective of the test and the combination of audit procedures which are likely to achieve
these objectives;
 The population and sampling units. The population should be appropriate to the objective of
the sampling procedure. E.g. if the auditor’s objective is to test for overstatement of debtors
an appropriate population would be the debtors listing;
 Definition of errors in substantive testing and deviations in compliance testing. Before
performing tests on the chosen sample, the auditor should define clearly those test results and
conditions that will be considered errors or deviations by reference to the audit objective. For
substantive testing the auditor should project monetary errors found in the sample to the
population and should consider the effect of the projected error on the particular test
objectives.

(b) Determination of the sample size

The auditor needs to determine an appropriate size of the sample on which the audit
procedures will be applied. The size is determined by:

 The tolerable error or deviation rate- the larger the tolerable error or deviation rate, the
smaller the sample size.
 Auditor’s assessment of inherent risk. The higher the auditor’s assessment of inherent risk,
the larger the sample size. Higher inherent risk implies that there is a greater risk that the
financial balance will be misstated. To reduce this risk the auditor will need to extend the
level of testing. This is achieved by testing a larger sample.
 Auditor’s assessment of control risk. The higher the auditor’s assessment of control risk, the
larger the sample size. A high control risk implies that little reliance can be placed on
effective operation of internal controls. To reduce the audit risk the auditor will need to
extend the level of testing, this is achieved by increasing the size of the sample.
 Expected error. This refers to the total error that the auditor expects to find in the population.
The greater the amount of error the auditor expects to find in the population, the larger the
size of the sample needed in order to make a reasonable estimate of the actual amount of
error in the population.
 Auditor’s required confidence level. The greater the degree of confidence that the auditor
requires that the results of the sample are in fact representative of the actual amount of error
in the population, the larger the sample needs to be.

(c) Selecting the items to be tested

The sample selected should be representative of the population so that the auditor can draw
conclusions about the entire population. All sampling units should have an equal chance of
being selected. Common methods of selecting samples include:

 Random sampling by use of random number tables or use of computers to select

sampling units
 Systematic selection
 Haphazard selection
(d) Testing the items
After selecting the sample units, the auditor should carry out the pre- determined audit tests
on each item.

(e) Evaluating the results of the tests

The following procedures should be followed in evaluating the results of the tests:
 All errors identified and deviations should be evaluated;
 Projection of error. The auditor should estimate the expected error or deviation rate in the
whole population by projecting the results of the sample to the population so as to obtain
a broad view of possible error or deviation rates in the entire population. This will then be
compared with the established tolerable error or deviation rate;

 Assessing the risk of incorrect conclusion. In general the expected error or deviation is
rarely a precise measure of the actual error or deviation rate present in the population.
Actual error rate may be greater or smaller than projected error. The auditor must
therefore consider on the basis of his sample results and relevant evidence obtained from
other audit procedures, the possible levels which the actual error or deviation rate might
take and particularly the likelihood that the actual error or deviation rate may exceed
tolerable error or deviation rate.

Approaches to sampling
The two main approaches that can be applied in sampling:

 Judgmental sampling:
 Statistical sampling

Judgmental sampling also known as non-statistical sampling

Involves using experience and knowledge of clients business and circumstances to select and test
the sample without any mathematical or statistical tools. The auditor does not rely on probability
theory and requires the use of judgment in making sampling decisions.

Advantages of judgmental sampling

 Its well understood and refined by experience.
 Opportunity to bring expertise and knowledge into play in selecting and testing sample units.
 No special statistics knowledge required.
 No time wasted on the mechanics of statistical tools. More time is spent on auditing the
sample units and less on the mechanics of constructing the sample and computing the
mathematical implications of the results obtained.

Disadvantages
 Unscientific it does not form a strong basis for defense, i.e., it is difficult to justify why one
selected some items and left out others.
 Wasteful and large samples are selected. This is because in an effort to reduce the sampling
risk the auditor attempts to select as many items as possible as opposed to statistical sampling
where the size of the sample is precisely determined using probability theory.
 Samples may not be representative of the population and the results cannot be extrapolated.
 Danger of personal bias in sample selection.

Statistical sampling
Statistical sampling involves:
 Use of random selection of a sample;
 Use of probability theory to determine the sample size, evaluate quantitatively the sample
results and measure sampling risk.
 Statistical sampling differs from non- statistical sampling in that the auditor uses probability
theory to measure sampling risk and to evaluate the sample results.

Advantages
 It is scientific and defensible. The auditor can justify the items selected because these are
selected randomly.
 Elimination of personal bias. The sample selected is unbiased.
 Efficient as small samples are picked. Probability theory is applied in determining the precise
sample size required.
 Uniformity in different auditing firms hence comparisons are made possible.

Disadvantages
 Difficult to extract samples especially if documents are not sequentially numbered.
 The need to follow a predetermined statistical approach may stifle initiative and the need to
apply judgment.
 The results may be misunderstood if the audit staffs are not properly trained in the use of the
technique.
 It may not be suitable for all applications. Probability theory works best for large populations
and therefore cannot be applied for small populations.
 It is expensive due to the need for staff training.

Factors to consider before adopting statistical techniques

 Number of clients to whom it is appropriate as set up and training costs are high.
 Large populations must exist, as statistics is the science of large numbers.
 Adequate controls must exist where there are no controls it is impossible to use statistical
techniques.
 Population being tested must be homogenous in materiality. Some system of control must
exist in each of them.
 Too many variables cannot be tested at once.
 Items must be separately identifiable therefore sequential numbering is essential.
 Expectation of error must be low, i.e. that the internal control system must be reliable.
 Risk factor; the level of risk allowable and the degree of risk attached to the item being
tested.

Qualities of a good Sample

 It should be random: A random sample is one in which each item in the sample has an
equal chance of being selected. Statistical inferences may not be valid unless the sample is
random.
 It should be representative: the sample should be representative of the differing items in
the whole population. For example it should contain a similar proportion of high and low
value items of the population.
 Protective: Protective of the auditor. More intensive auditing should occur on high value
items known to be high risk.
 Unpredictable - client should not be able to know which items will be examined.

Factors to consider whether or not to sample

 Materiality: Expenditure such as motor vehicle expenses may be so small that no
conceivable error may affect the true and fair view of the accounts as a whole.
 The number of items in a population. If these are few (for example land and buildings)
100% check may be economical.
 Reliability of other forms of evidence: Analytical review (e.g. wages relate closely to
number of employees, budgets, previous years) -Proof in total (VAT calculations). If other
evidence is very strong, then a detailed check of population (100% of a sample may be
necessary).
 Cost and time consideration: Can be relevant in choosing between evidence seeking
methods.
 A combination of evidence seeking methods is often the optimal solution.

When not to sample

i. When populations are small. In cases it is more economical and effective to test the entire
population.
ii. For transactions, or balances, though few in number are of great significance in terms of
materiality.
iii. Any situation where the auditor is put on enquiry as a result of earlier tests or information
received. E.g. where the auditor has received some indication of material fraud in a certain
accounting area.
iv. For statutory disclosure items such as directors salaries where a full audit check will be
desirable despite the relative materiality of the items concerned.
v. For non-homogeneous populations where sorting of the information will have to take place
before sampling can be attempted.

Using the work of an expert

An expert is a person possessing specialised skills, knowledge and experience in another field
other than auditing and accounting. From his training and experience an auditor only has general
knowledge on matters outside his profession and he is not expected to have the skills of a person
trained or qualified to work in another profession. Consequently the auditor may need advice of
other experts e.g. lawyers in arriving at the legal interpretation of legal cases against a client

Situations where the auditor may require advice of an expert

1. Legal interpretation of contracts, laws and regulations
2. Valuation of certain types of assets e.g. land and buildings, precious stones and minerals.
3. In determining quantities and physical condition of assets e.g. underground
minerals/quarries.
4. Actuarial valuations
5. Measurement of work completed/to be completed in contracts.

When deciding whether to use the work of an expert the auditor should consider:

1. The materiality of the item being examined in relation to the financial statements as a
whole;
2. Nature and complexity of the item, including the risk of error or misstatements;
3. The other audit evidence available with respect to the item.

Factors to consider before relying on the work of an expert

The auditor should seek reasonable assurance that the expert’s work constitutes appropriate audit
evidence in support of the financial statements. The auditor should consider;

a. The skills and competence of the expert

b. The auditor should consider the expert’s skills and competence in the particular profession.
This is done by considering the expert’s professional qualifications, license or membership
of an appropriate professional body. The experience and reputation in the field in which the
auditor is seeking evidence.
c. Objectivity and independence of the expert
d. The auditor should consider whether the expert is independent from the client. The risk of
independence being impaired increases where the expert is employed by the client; in such
cases he owes his loyalty to the client, or where he is related financially with the client.
e. The sources of data used by the expert in arriving at his opinion. If the source of the data
can be regarded as reliable, then the auditor can reasonably use the work of the expert as
audit evidence.
f. The assumptions and methods used.
g. The auditor should consider whether the methods used by the expert in arriving at his
opinion are appropriate to the circumstances. He should also obtain an understanding of
those assumptions and methods to determine that they are reasonable based on the auditor’s
knowledge of the client’s business and the results of his other audit procedures.

Communication with the expert

It should cover matters such as:
i. Objectives and scope of his work.
ii. Outline of items the auditor expects to be covered in the report.
 iii. Intended use by the auditor and disclosure to third parties as to expert’s identity and extent of
involvement.
iv. Access of records and files by expert.
v. Clarification of expert’s relationship and client.
vi. Confidentiality of client’s information.
vii. Assumptions and methods intended to be used by the expert.
viii. Recording of any further information as audit evidence.

8.4 Activities

Activity 1:
Discuss the following concepts as used in audit sampling
 Population
 Sample
 Stratification
 Sampling risk
 Judgmental sampling
 Statistical sampling
 Materiality

Activity 2
Discuss the qualities of a good sample

8.5 Self – Test Questions

Question One:

i. What is audit sampling?

ii. Distinguish between audit risk and sampling risk

Question Two

i. Discuss the conditions necessary to carry out sampling

You have been asked by your firm to examine the payment vouchers of a
company to establish the level of errors and then decide whether better results can
be obtained through statistical techniques.

Required:
a. State the steps you would take in order to test the vouchers for the errors.
b. Why is it not satisfactory to pick vouchers from a limited period?
c. State under what circumstances statistical sampling is a good technique.
8.6 Summary

In this lecture you have learnt that:

 There are two approaches of sampling which include; Judgmental
sampling and Statistical sampling
 Audit sampling involves the application of substantive or compliance
procedures to less than 100% of items

8.7 Suggestion for further reading

Students are recommended to do further reading on the following;
i. Circumstances under which sampling cannot be used in auditing
ii. Advantages and disadvantages of audit sampling

LECTURE NINE: SUBSTANTIVE TESTS

9.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one
 9.1 Specific objectives:

At the end of the lecture you should be able:

Define substantive tests
Describe the techniques used directional tests

9.2 Lecture Outline

9.2.1 Substantive Tests

9.2.2 Directional Tests

9.3 Lecture
SUBSTANTIVE TESTS:
Compliance tests provide the auditor with indirect evidence, the auditor therefore cannot on the
strength of compliance test alone reach a conclusion as to whether or not a balance is fairly
stated. The auditor therefore carries out substantive testing to obtain more assurance on the
reported balances.
Substantive tests are those tests balances and transactions and other procedures such as analytical
review, which seek to provide audit evidence as to the completeness and accuracy and validity of
information contained in the records and or the financial statements. Substantive tests are those
tests carried out by auditors to confirm the assertions of the management i.e. existence, rights and
obligations, occurrence, completeness, valuation, measurement and presentations and disclosure.

Existence:
For tangible assets existence can be confirmed through physical inspection. During the
inspection the auditor also considers the condition of those tangible assets as valuable evidence
to the reasonableness of valuation.
For liabilities and assets such as debtors, cash at bank; the auditor would be satisfied with third
party confirmations. Intangible assets such as goodwill and deferred development expenditure;
the prevailing circumstances give guidance as to whether that intangible asset exists.

Right of obligations:
The ownership rights to assets can be confirmed through the inspection of title documents to
confirm that such the title documents are in the name of the company. Documents of title
include: title deeds and motor vehicle registration. Where there is no document of title proof of
purchase and possession will suffice. That is evidence that the client ordered for the goods, paid
for them or is acknowledging liability for them, they are in his possession and there’s no
evidence to indicate any other party has a claim to those goods then the client has a right to those
goods.
Occurrence:
Testing for occurrence involves verifying that a transaction actually took place during the year.
This is tested through inspection of the documents raised in carrying out the transaction. E.g. the
occurrence of a purchase transaction can be verified by inspection of the purchase order raised at
the initiation of the transaction and the resulting purchase invoices raised by the supplier.
Completeness:
Completeness tests are designed to confirm that there are no unrecorded assets, liabilities or
transactions.

1. For documents that are pre-numbered the auditor can test for the numerical sequence
investigating any missing numbers.
2. Cut-off procedures are performed to confirm that transactions with their related movement of
assets have been fully recorded in the same and correct accounting periods.
3. Review of reconciliation between control accounts and subsidiary records and between
subsidiary records and third party records.

Valuation:
Most balances are valued at cost plus or minus a provision. Both cost and provision will involve
an accounting policy considered most appropriate by the client for their circumstances:
The auditor will:

1. Determine the clients accounting policy

2. They will then test the suitability of that policy
3. If suitable test the application of that policy.

Measurement:
It involves determining that recorded events or transactions have been recorded in the correct
amounts and if it’s revenue or expense it has been allocated to the correct period.
Measurement is closely related to occurrence and valuation and in addition therefore to the
procedures discussed under occurrence and valuation the company’s capitalization policy is
critically reviewed for its continued suitability.

Presentation and Disclosure:

The categorization, classification, description and disclosure of transactions and balances in the
books of accounts or financial statements may be governed by the company’s act disclosure
requirements, accounting standards or other regulations. Usually by use of a checklist the auditor
compares the clients presentation and disclosure with the presentation and disclosure
requirements.
Analytical review tests, which are included in the description of substantive tests, provide
evidence as to the completeness and occurrence and measurement of events and balances.
Exceptions of substantive tests:
In substantive tests transactions speak for themselves therefore any error or deviation is
measured for its materiality or effect on the financial statement or the recorded balance.
Compliance tests give indirect evidence to the auditor and if the conclusion from them is positive
then it assures the auditor that there were measures in place to minimize misstatements. This then
reduces the extent of detailed substantive testing. It is possible to carry out a purely substantive
audit and make a valid conclusion without any reliance on any internal controls.
After the substantive test the auditor can conclude that proper records have been kept and that the
accounting system is adequate and is a reliable basis for the preparation of financial statements.

DIRECTIONAL TESTS:
A general assumption that audit firm have, that companies overstate assets and understate
liabilities. It also has to do with double entry system. e.g. creditors and purchases. If one is
correct then most likely the other is correct also.
The techniques used are:
i) Review payments after balance sheet date and matching them against related invoices
specifically noting dates on invoices to ensure that the invoice was accounted for in the
correct accounting period.
ii) Cut-off tests, which involve selecting goods, received notes raised before the year-end and
ensuring that the related invoices have been included in the purchases daybook before year-
end as well as individual creditors accounts. If no invoices have been received to match
those goods received notes than a reasonable liability should have been set up.
iii) Comparison of the present list of creditors with the previous year’s list and investigations
being carried out on those creditors on the list of the previous year missing from current
years list to confirm that they are properly excluded through settlement during the year
under review.
iv) Reviewing reconciliation of creditors statements with the creditors individual ledger
accounts ensuring that any reconciling items are valid and genuine.
v) Reviewing lending contracts or agreements for breach of contract accusations to
determine where claims would be made against the company.
vi) Reviewing correspondence with professional advisers e.g. lawyers for claims that they
may have made against the company but not recorded.

9.4 Activities

Activity 1:

Discuss the substantive tests used by an auditor

Activity 2

State and explain the directional tests used by an auditor

9.5 Self – Test Questions

Question One:

Enumerate and describe the tests carried out by auditors to confirm the assertions
of the management

9.6 Summary

In this lecture you have learnt that:

i. Substantive tests are those tests balances and transactions and other
procedures such as analytical review, which seek to provide audit evidence
as to the completeness and accuracy and validity of information contained
in the records and or the financial statements.
ii. Substantive tests are those tests carried out by auditors to confirm the
assertions of the management i.e. existence, rights and obligations,
occurrence, completeness, valuation, measurement and presentations and
disclosure.

9.7 Suggestion for further reading

Students are recommended to do further reading on the following;
i. Analytical review procedures
ii. Internal Control system

LECTURE TEN: ANALYTICAL REVIEW

10. Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one
 10.1 Specific objectives:

At the end of the lecture you should be able:

Define and explain the analytical review procedures used by an auditor
Describe extent of use of analytical review procedures

10.2 Lecture Outline

10.2.1 Definition of Analytical Review Procedure

10.2.2 Timing of Analytical Review Techniques
10.2.3 Extent of use Analytical Review Procedures
10.2.4 Analytical Review Procedures in practice

10.3 Lecture
Analytical review can be defined as the study of relationships between element of financial
information expected to conform to a predictable pattern based on the organization’s experience
and between financial information and non-financial information.
Under analytical review information is compared with comparable information for prior records
with anticipated results and with information relating to similar organizations.
In an actual case, analytical review can be applied by examining: -
a) Increases in magnitude corresponding to inflation
b) Changes in amounts consequent on changes in output levels
c) Comparison with previous periods
d) Trends and ratios
e) Comparisons with budgets and forecasts
f) Comparisons with other similar organizations e.g. inter-firm comparison

The Timing of Analytical Review Techniques

This will be applied throughout the audit but the specific occasions will include:
a. At the planning stage: at this stage the auditors will hope to identify areas of potential risk
or new developments so that he can plan his other audit procedures in these areas.
b. During the audit as a substantive procedure for obtaining audit evidence: modern audits
with their emphasis on efficiency and economy depend heavily on analytical review as a
valid audit technique used alone on in conjunction with the internal control reliance and
substantive testing. It can be reasonable to obtain assurance of the completeness, accuracy
and validity of transactions and balances by analytical review as by other types of audit
evidence. E.g. if the relative amounts under different expense headings repeat the pattern of
previous years, the auditor will have evidence of the accuracy of expense invoice coding.
c. At the final review stage of the audit: analytical review techniques can provide support for
the conclusions arrived at as a result of other work. E.g. indications from external sources
 that profit margins have declined by 10% may support the declined profit figure in a segment
of the company whose figures have audited by other means and found to be correct. The
techniques are also used to assess the overall reasonableness of the financial statements taken
as a whole.

Extent of use of analytical review procedures

The factors which might affect the extent of use of analytical review include:
1. The nature of the entity and its operations: e.g. a long established chain of similar shops
which changed little in the period under review will offer many opportunities for analytical
review to be used as a primary source of audit evidence. Conversely a newly established
manufacturer of high-tech products will not provide such an opportunity.
2. Knowledge gained from previous audits of the enterprise: the auditors will have
experience of those areas where errors and difficulties arose and those areas of greatest
audit risk.
3. Management’s own use of analytical review procedures: if management has a reliable
system of budgetary control then the auditors will have already made source of explanation
for variances. If management uses information that has been subjected to internal audit
review, the reliability of that information is enhanced. If the staff who produce the
information are competent and have integrity again the reliability of information is
enhanced.
4. Availability of non-financial information to back up financial information
5. The cost effectiveness of the use of analytical review in relation to other forms of
evidence: in general analytical review is cheap but requires high quality staff. Some
techniques can be expensive if they involve statistical techniques.
6. Availability of staff: analytical review requires high quality staff with much intelligence,
experience and training.

The auditor’s procedures:

a) Identify the factors likely to have an effect on items in the accounts
b) Ascertain or assess the probable relationship between these factors and the items.
c) Predict the value of the item in the light of the factors.
d) Compare the predicted value with the actual recorded amount.
e) Consider the implications of significant fluctuations, unusual items, or relationships that are
unexpected or inconsistent with evidence from other sources. Similarly consider the
implications or predicted fluctuations that fail to occur.
f) Discuss with management any significant variations therefore management will usually have
an explanation for the variation. Seek independent evidence to support management
explanations.
g) React to significant fluctuations or unexpected values. The auditors reaction depends on the
stage of the audit at which he is carrying out analytical review. If at the planning stage- plan
suitable detailed substantive tests. If during the audit-then further audit tests will be
indicated. All fluctuations and unexpected values must be fully indicted and sufficient audit
evidence obtained.
h) As with all audit work analytical review procedures should be fully documented in the
working papers. Files should include:-

a) The information examined with detailed calculations and explanations of influences

expected.
b) The management explanation of significant fluctuation
c) The verification of these explanations
d) The conclusions drawn by the auditor
e) Details of further tests if any

Please note the following:

 Any relationship perceived between variables must be plausible ie the relationship found
should be reasonable and relevant to audit objectives. E.g. debtors and sales have a plausible
relationship but there’s no plausible relationship between selling expenses and work in
progress (W.I.P.) in a manufacturing account.
 Also note that the nature of analytical review includes the comparison over time and the use
of past experience on the audit therefore it is desirable for the auditor to build up a picture of
the organisation and the relationship between magnitudes in the permanent audit files.
 Materiality is very important thus those areas not judged to be material, the auditor will very
often rely wholly on analytical review to conclude. But material areas require a combination
of compliance testing, analytical review and detailed substantive testing.

Analytical review in practice:

1. The auditor will always establish a trend analysis most common trend analysis being a 5-year
side-by-side balance sheet and detailed profit and loss account.
2. A trend analysis of key profit and loss figures within the year under review such as a monthly
summary of the sales and related expenses.
3. Ratio analysis: for the profit and loss account growth in percentage terms of key figures will
be worked out.

The figures will also be compared with the budget with variations being expressed maybe in
percentage terms. The previous years figures may also be put alongside. Gross profit margin is
also a figure that is worked out along the same lines. Gross profit margin will be compared to
that of the previous year and that of the budget usually the Gross profit margin is expected to be
steady. If it has fluctuated significantly then the components that make up the Gross profit figure
particularly sales, purchases and closing stocks are further investigated.
The proportion to sales of those items that have a plausible relationship with sales is worked out.
These could include selling and distribution expenses such as advertising and motor vehicle
running expenses.
If industry averages are available the organisation’s figures are also compared to those averages.
Balance sheet ratios that are usually considered:-
a. Fixed Assets (FA):
(i) The utilisation of FA’s is usually worked out. This is: Turnover
FA (NBV)
To determine how much sales are generated for every shilling invested in FA’s. It is
normally called the FA turnover ratio.

(ii) Global depreciation ratio is also worked out which involves taking the NBV of the
FA’s divided by the depreciation charge in the profit and loss account. The resultant
figure gives a rough estimate of the average remaining useful life of the assets. Too
big a figure indicating that maybe the rates of depreciation used are too low.
b. Stocks:
The percentage increase is calculated and is compared with the corresponding percentage
increases in purchases. If the two increases do not correspond, it may indicate that the
provision for obsolescence is inadequate.
The stock turnover ratio is also worked out. To ensure that we’re comparing like with like,
the cost of sales figure is used and not the sales figure. A slowing down turnover ratio may
also indicate that the provision for obsolescence is also inadequate therefore it would appear
that the demand for the products of the organisation may be diminishing.
c. Debtors:
The percentage increase in debtors is worked out and this is compared with the percentage
increase in turnover. It is usually being expected that an increase in turnover ordinarily
should have a corresponding increase in debtors. Debtors to sales ratio is also worked out to
determine the number of days sales in debtors. This number of days is compared with the
normal allowed credit period. It measures the effectiveness of credit control and
consequently the adequacy provision for bad and doubtful debts.
d. Liquidity ratios are then worked out, the most common of which are:

 The current ratio

 The acid test ratio

e. For cash at bank an additional measure is consideration of the overdraft limit for trade
creditors. The percentage increase is worked out and compared with the increase in the cost
of sales. Also the number of days purchases in creditors worked out to measure the difference
between credit taken and credit allowed by suppliers.
f. The gearing ratio is worked out to measure the company’s exposure or the cost of external
capital to the organisation.
4. VOUCHING AUDIT
Vouching is checking the authenticity of recorded transactions. It is proving that the transactions
occurred, they are complete correctly measured and they relate to the correct period if they are of
a revenue or expense nature.

Usage of vouching:
a) In very small audits when the number of transactions are not too large.
b) In audits whose internal control is weak or non-existent.
c) In certain types of specialized audits such as that of trusts or estates

Method:
a. The vouching audit involves a consideration of each entry in the books and vouching the
available evidence to support each entry. The evidence usually consists of documents and
papers and should satisfy the auditor that:
b. The transaction was authorised by management
c. The transaction came within the aims and objects of the organisation
d. The transaction was correctly and adequately described by the entry in the books.
e. The entry is correctly incorporated in the final accounts

NOTE: The above is the guideline for all vouching procedures

10.4 Activities

Activity 1:

Describe the analytical review procedures to be carried out in the following assets

 Intangible assets
 Plants and Machinery
 Land
 Equipment

10.5 Self – Test Questions

Question One:

State and discuss the factors which might affect the extent of use of analytical
review procedures

Question Two

Discuss the methods used during the vouching audit

10.6 Summary

In this lecture you have learnt that:

i. Analytical review is the study of relationships between element of
financial information expected to conform to a predictable pattern based
on the organization’s experience and between financial information and
non-financial information.
ii. Vouching is checking the authenticity of recorded transactions

10.7 Suggestion for further reading

Students are recommended to do further reading on the following;

i. Extent to which control systems are integrated to analytical review
procedures
ii. How analytical review procedures are used by an auditor to help form
an opinion

LECTURE ELEVEN: AUDIT REPORT

10.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

11.1 Specific objectives:

At the end of the lecture you should be able:

Discuss the contents of auditors report
Describe types of audit opinion
Conduct and form an opinion on a simple audit.

10.1 Lecture Outline

10.1.1 Auditors report to shareholders
10.1.2 Elements of auditors report
10.1.3 Audit Opinions

10.2 Lecture

THE AUDITOR’S REPORTS TO THE SHAREHOLDERS

The companies Act Cap 486 requires that the auditor of a limited liability company to report to
the members, whether the financial statements laid before the AGM, show a true and fair view of
the state of affairs of the company and comply with the requirements of the companies Act. The
audit report is therefore the means by which the auditor reports his opinion as to whether the
financial statements show a true and fair view of the state of affairs. The report is addressed to
the shareholders.

The requirements of the Companies Act with regard to the Auditor’s Report:
S.162 (1) of the Companies Act (CA): Stipulates the statements that should be expressly stated in
the Auditors Report. These statements are;

 Whether they have obtained all the information and explanations, which to the best of their
knowledge and belief were necessary for the purposes of their audit.
 Whether in their opinion, proper books of account have been kept by the company, so far as
it appears from their examination of those books, and proper returns adequate for the
purposes of their audit have been received from branches not visited by them.
 Whether, the company’s balance sheet and profit and loss account dealt by the report are in
agreement with the books of accounts and returns.
 Whether, in their opinion and to the best of their information and according to the
explanations given to them, the financial statements give the information required by the Act
in the manner so required and give a true and fair view:
o In the case of the balance sheet, of the state of the company’s affairs as at the end of its
financial year; and
 o In the case of the profit and loss account, of the state of the profit or loss for its financial
year.
o In the case of a holding company submitting group financial statements whether in their
opinion, the group financial statements have been properly prepared in accordance with
the provisions of the Act so as to give a true and fair view of the state of affairs and profit
or loss of the company and its subsidiaries.

Basic elements of the auditor’s report

The Companies Act does not stipulate the form the auditors report should take. The auditing
standard seeks to ensure that the auditor’s report is clear and unambiguous. To this end, it seeks
to standardize the form of the auditor’s report. It seeks to do this by giving to basic elements of
the auditor’s report.

 Appropriate title

An appropriate title such as the independent auditors report distinguishes the Auditor’s
Report from any other reports that may be annexed to the annual report and Financial
Statements.

 The Auditor’s report should be appropriately addressed

Usually the auditors report is addressed to the members on whose behalf the audit
is carried out. For practical reasons, it also limits the users of the auditor’s report.

 Introductory paragraph

This identifies the Financial Statements audited. Under the Companies Act, Financial
Statements or Accounts consist primarily of the Balance Sheet, Profit and Loss account and
notes to the account. International Accounting Standards on Cash Flow Statements requires
auditors to recognized the Cash Flows as part of the Financial Statements.
The auditor’s report relates to the above statements only. However, the published Financial
Statements that are sent to the readers include other reports that may contain financial
information such as the Chairman’s Statement. The Directors Report, the detailed Profit and
Loss account and other statistical information.
Although the auditor reviews these other statement or reports, he does not report on them. It
must therefore be clear in his report that he is not reporting on these other
statements otherwise the financial information contained therein could have anunmerited air
of authenticity.

It is felt that most readers of auditors reports and Financial Statements assume that
the auditor prepared the Financial Statements. It’s necessary for the auditor to clarify that the
preparation of Financial Statements is the responsibility of the directors.

 Paragraph on the scope of the audit

 The reader requires assurance that the auditors procedures were authoritative and through.
The auditor therefore needs to state that they have audited in accordance with International
Standards of Auditing.
It is felt within the profession that readers expert auditors to detect and report on material
errors and frauds. It is not practicable within the constraints of auditingto detect all material
misstatements be they as a result of frauds or errors. And even though an audit shouldn’t be
relied upon for the detection of errors and irregularities, the auditor must arrange his audit in
such a manner as to have reasonable assurance that the Financial Statements are free of
material misstatements.It is important to inform the reader that auditing is a limited exercise
that cannot guarantee 100% completeness and accuracy. That the auditor examines items a
test basis not all of them and that in valuing assets and liabilities there is subjectivity
involved.

 Opinion paragraph

The report should clearly state the auditor’s opinion as to whether the financial statements
give a true and fair view in accordance with the relevant financial reporting framework and
whether they comply with the companies Act requirements.
 Dating the audit report:

Clearly specifies the date the auditor committed himself

to his opinion so that any subsequent developments are considered in the light of
that date.

 Auditor’s address

 Signature in the name of the audit firm and location of the auditor i.e. office.

AUDIT OPINIONS
Types of audit opinions
i. Unqualified opinion
ii. Qualified opinion
iii. Disclaimer of opinion
iv. Adverse opinion

a) Unqualified opinion
When the auditor is satisfied in all material respects that enables him to express the required
opinion on the financial statements without any reservations. This is sometimes called a clean
opinion. This is expressed when the auditor concludes that the financial statements give a true
and fair view in accordance with the relevant financial reporting framework.

Emphasis of matter report:

There are occasions when the auditor has no reservations as to the financial statements but where
there exists an unusual event, condition or accounting policy, he feels that unless the reader’s
attention was drawn to the unusual matter the reader may not reach a proper understanding of the
financial position and results. In such circumstances the auditor should express an unqualified
opinion but also include an extra paragraph called on ‘Emphasis of matter’ paragraph to draw the
readers attention to the unusual matter.

The addition of such an emphasis of matters paragraph does not lead to a qualification of the
audit opinion but is intended to enable the reader to obtain a better understanding. To avoid this
being understood as a qualification the emphasis of matter should be included after the opinion
paragraph and should contain the phrase “without qualifying our opinion above”

Practical examples of emphasis of matter

1. An unusual condition would include distraction of assets after the balance sheet date but the
company remains a going concern.
2. The company being insolvent on the face of its own balance sheet but the auditor has letters
of support which he is satisfied can be fulfilled by the other party. Thus he will accept the
appropriateness of the going concern assumption. Unusual events could include changes in
legislation that could have a material impact on the entity’s business subsequent to the
balance sheet date. Unusual accounting policies that may lead to an emphasis of matter
would usually involve those matters not covered by any accounting standard such as
accounting for agricultural produce or livestock
3. Inherent uncertainties that may call for emphasis of matter would include contingencies at
the balance sheet date which have not been resolved as at the date of signing the auditor’s
report.
4. They could also include negotiations for financing which have not been finalized by the date
of signing the auditors report.

Qualifications in audit reports

When the auditor has reservations on any matter that is considered material to the financial
statements he may introduce qualifying remarks in his audit report. The auditor’s reservations
could arise out of the following;

a. There is a limitation on the scope of his work;

b. There is a disagreement with management
c. There is a significant uncertainty affecting the financial statements, the resolution of which is
dependent upon future events.

b) Qualified audit opinion (except for opinion)

This is expressed when the auditor concludes that an unqualified opinion cannot be expressed but
that the effect of any disagreement with management or limitation on scope is not so material
and pervasive as to require an adverse opinion or disclaimer of opinion. A qualified report
implies that all other aspects of the financial statements are okay except for the effects of the
matter to which the qualification relates.
c) Disclaimer of opinion
This is issued when the possible effect of a limitation on scope or uncertainty is so material and
pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and as
a result he is unable to express an opinion on the financial statements. A disclaimer of opinion
implies that the auditor is unable to form an opinion because sufficient audit evidence could not
be obtained.

d) Adverse opinion
This is expressed when the effects of a disagreement is so material and pervasive to the financial
statements that the auditor concludes that a qualification of the report is not adequate to disclose
the misleading or incomplete nature of the financial statements. The auditor states that due to the
nature of the disagreement in his opinion the financial statements do not show a true and fair
view.

Limitation of scope
If for any reason the auditor is unable to receive all the information and explanation he deems
necessary for the purposes of his audit then there has been a limitation in the scope of his work.
It means that the auditor is unable to conclude objectively.

This could arise due to the following circumstances:

a. Refusal by management to allow the auditor to examine certain documents or records.

b. If the auditor is denied the opportunity to carry out an auditing procedure he considers
important and he cannot conclude through alternative procedures, then there is a limitation of
scope.
c. Destruction of accounting records or documents through fire or other disaster meaning that
such records are not available to be examined by the auditor.
d. Being appointed auditor after the year-end with the result that certain evidence will not be
collected.

Effect of a limitation in scope on the auditor’s opinion

If the possible effect of a limitation on scope of an audit is material but not fundamental to the
financial statements the auditor issues a qualified opinion (except for opinion)
If the possible effect of a limitation on scope of an audit is of fundamental importance that the
auditor is unable to express an opinion on the financial statements, the auditor issues a disclaimer
of opinion as mentioned above.
When there is a limitation on the scope of the auditor’s work that requires the expression of a
qualified opinion or disclaimer of opinion, the auditor should describe the nature of the limitation
in his report and indicate the possible adjustments to the financial statements that might have
been determined to be necessary, had the limitation not existed.
Inherent Uncertainties
Inherent uncertainties result from circumstances in which it is not possible for the auditor to
reach any objective conclusion as to the outcome of a situation due to the circumstances
themselves rather than a limitation on scope of the audit. Such uncertainties are only resolved
through the passage of time e.g. to wait for the outcome of a litigation however time is a great
constraint and Financial Statements must be prepared within the required time. The auditor
should form an opinion on the adequacy of the accounting treatment of such inherent
uncertainty. This will involve consideration of:

 The appropriateness of any accounting policies adopted by management in treating the effect
of such uncertainties.
 The reasonableness of the estimates included in the Financial Statements.
 The adequacy of disclosure.

Some inherent uncertainties are fundamental. These are uncertainties where the degree of
uncertainty and its potential impact on the view given by the financial statements may be very
great. In determining whether an inherent uncertainty is fundamental the auditors consider:

 The risk of the estimate included in the Balance Sheet may be subject to change.
 The range of possible outcomes.
 The consequences of those outcomes on the view given by the financial statements.

Inherent uncertainties are considered as fundamental when they involve a significant level of
concern about the validity of the going concern basis or other matters whose potential effect on
the Financial Statements is unusually great.

Disagreement
Under disagreement the auditor is able to conclude objectively. He has received all the
information and explanations he considers necessary for the purpose of the audit. But his
conclusion is at variance with the position adopted by management or the view given by the
accounts.

Circumstances giving rise to disagreements include:

(a) Application of inappropriate accounting policies by management;

(b) They can disagree on amounts and facts included in the financial statements. E.g. the auditor
might feel that the amount provided for as a contingent loss arising from a legal suit against
the company is too low.
(c) They can disagree on interpretation of an accounting standard or even legislation.
(d) Disagree as to the manner or extent of disclosure of facts or amounts in the financial
statements.
(e) They can disagree on the mode of the disclosure of information.
Where the auditor disagrees with the accounting treatment or disclosure of a matter in the
financial statements and in the auditor’s opinion the effect of that disagreement is material to the
financial statements, the auditor should;
 Include in his report a description of all the factors giving rise to the disagreement;
 The implications of such factors on the financial statements;
 A quantification of the effect on the financial statements.

Effects of disagreements on the audit opinion

When the auditor concludes that the effect of the matter-giving rise to the disagreement is so
fundamental that the financial statements are misleading the auditor should issue an adverse
opinion.
If the nature of the disagreement is material but not fundamental the auditor should issue a
qualified opinion indicating that all other aspects of the financial statements are okay except for
the matter giving rise to the disagreement.

Material but not pervasive

Auditors may not include qualifying remarks in their audit reports unless the matter is material.
Material but not pervasive means that the reservation that the auditor has is material in the
context of a segment of the financial statements but not the financial statements taken as a whole.

Material and pervasive

A matter becomes material and pervasive when it is material in the context of the financial
statements taken as a whole. A limitation of scope becomes pervasive when it makes the
financial statements misleading for decision-making purposes or of little information of value for
decision-making purposes. A disagreement becomes pervasive when it makes the financial
statements taken as a whole to be totally misleading.

Qualification matrix
This summarises the forms qualification issued by the auditor under different circumstances.

Nature of circumstance Material but not significant Fundamental

Limitation on Qualified opinion (except for Disclaimer of opinion

scope/uncertainty opinion)

Disagreement Qualified opinion (except for Adverse opinion

opinion)

10.3 Activities

Activity 1:

Discuss how auditors present their opinion to shareholders

10.4 Self – Test Questions

Question One:

Discuss the various opinions formed by an auditor

Question Two

State and describe the major elements contained in the audit report

10.5 Summary

In this lecture you have learnt that:

i. The companies Act Cap 486 requires that the auditor of a limited
liability company to report to the members, whether the financial
statements laid before the AGM, show a true and fair view of the state of
affairs of the company and comply with the requirements of the
companies Act.
ii. The auditor’s reservations could arise out of the following;

a. There is a limitation on the scope of his work;

b. There is a disagreement with management
c. There is a significant uncertainty affecting the financial statements, the
resolution of which is dependent upon future events.

10.6 Suggestion for further reading

Students are recommended to do further reading on the following;
i. Circumstances in which an auditor can be held liable by a third
party
ii. How an auditor can minimise his/her liability to a third party
 LECTURE TWELVE: REPRESENTATIONS BY MANAGEMENT

11.0 Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing one

11.1 Specific objectives:

At the end of the lecture you should be able:

Define and explain management representations
Discuss the extent to which an auditor can rely on management representation letter

11.2 Lecture Outline

11.2.1 Definition of management representation letter
11.2.2 Management refusal to give representation letter

11.3 Lecture
Representations by management are a source of audit evidence normally sought from the
directors at the concluding stages of an audit to confirm various matters stated in the accounts
particularly those which concern questions of facts or judgement which are difficult for the
auditor to prove objectively e.g. there is no need to obtain a letter of representation on the bank
balance as this can be proved objectively but there is need to obtain a representation that all
contingent liabilities have been properly stated because this is difficult to prove.
Management makes various oral representations throughout the audit in response to specific
inquiries. The auditor should not rely on unsupported oral representations of management as
being sufficient reliable evidence when they relate to matters that are material to the financial
information. The auditor should obtain written representations from management on matters
material to the financial information when other sufficient appropriate audit evidence cannot
reasonably be expected to exist.
After receiving representations from management the auditor should;

 Seek other audit evidence from sources inside or outside the entity that supports or disprove
the representations given.
 Evaluate whether the representations made by management are consistent with other audit
evidence available.
 Consider whether the person making the representation appear to be well informed on the
matter in question.

Representations by management should not be taken as a substitute for other evidence that the
auditor could reasonably expect to be available, it is simply an additional source of evidence. If
the auditor is unable to obtain sufficient appropriate evidence regarding a matter, which has a
material effect on the financial statements, this constitutes a limitation in the scope of the audit
even if representations have been obtained.
Representations by management are mainly used where no other evidence exists or would
reasonably be expected to exist, where a matter is material to the financial statements and written
confirmation is required or where the auditor is seeking evidence to support other audit evidence
gathered using other means.
If a representation by management is contradicted by other evidence, the auditor should
investigate the circumstances and where necessary reconsider the reliability of other
representations made by management.
A written representation is better audit evidence than oral representations and can take the form
of;
A letter of representation addressed to the auditor and signed by management.

 A letter from the auditor explaining the auditor’s understanding of management’s

representations duly acknowledged and accepted by management.
 Relevant minutes of the board of directors.

The auditor should inform management at an early stage i.e. in the letter of engagement that he
might require written representations from time to time to avoid refusal by management in
providing such representations.

REFUSAL BY MANAGEMENT TO GIVE REPRESENTATIONS

Management maybe unwilling to sign letters of representations or pass minutes required by the
auditor. If management declines the auditor should inform management that he will himself
prepare a statement in writing setting out his understanding of any representations that may have
been made during the course of the audit and then sends this statement to management with a
request for confirmation that the auditor’s understanding of the representation is correct.
If management disagrees with the auditor’s statement of representation, discussions should be
held to clarify the matters in doubt and if necessary a revised statement prepared and agreed.
Should management fail to reply the auditor should follow the matter up to try to ensure that his
understanding of the position as set out in his statement is correct.
In rare circumstances the auditor may be completely unable to obtain written representations,
which he requires. E.g. because of refusal by management to co-operate, or because management
properly declines to give representations required on the grounds of its own uncertainty
regarding that particular issue. In such circumstances the auditor may have to conclude that he
has not received all the information and explanations required and consequently may need to
consider qualifying his audit report on the grounds of limitation in the scope of the audit.
11.4 Activities

Activity 1:
Discuss the action taken by an auditor in the following cases;
 Non receipt of management representation letter
 After receipt of management representation letter

11.5 Self – Test Questions

Question One:
Two important communications between the auditors and the management or
board of directors of the client entity are commonly referred to as letter of
representations and the management report or letter of weaknesses. Both
communications are referred to in ISA210. Terms of audit engagement. The
letter of representation is additionally the subject of ISA 580 management
representations and the management report is referred to in ISA 400 risk
assessments and internal control.

Required:

i. Explain the purpose of the letter of representation and the extent to

which it constitutes sufficient appropriate audit evidence.

ii. Describe three matters you might find in a letter of representation

(other than acknowledgement by the management of its responsibility
for the financial statements)

iii. Explain the effect on the audit if the management refuses to make one
or more of the representations requested.
11.6 Summary

In this lecture you have learnt that:

i. Representations by management are a source of audit evidence normally
sought from the directors
ii. Management makes various oral representations throughout the audit in
response to specific inquiries.
iii. Representations by management are mainly used where no other
evidence exists or would reasonably be expected to exist, where a matter
is material to the financial statements and written confirmation is
required or where the auditor is seeking evidence to support other audit
evidence gathered using other means

11.7 Suggestion for further reading

Students are recommended to do further reading on the following;
i. Management representation on financial statements
ii. Management representation on non – current assets
iii. Management representation on contingent liabilities

Recommended Readings
1. Millichamp AH. Auditing – 8th edition – London: Contirum, 2002.
2. Rittenberg: Larry E. & Schwieger, BJ: Auditing: Concepts for a changing
environment– 4th edition – Australia: Thomson South Western, 2003.
3. Arens, A A and Loebbecke, J K: Auditing: An Integrated Appraoch: 8th ed. – New
Jersey: Prentice Hall, 2000

Further reading.
1. Watne; D A and Turney, Peter B.B: Auditing EDP Systems. – 2nd ed. – Durban: Pearson
Education, 2002.
2. Puttick, G. and Van Esch, Sandy: The Principles and Practice of Auditing – 8th ed –
Lansdowne; Juta, 2003.