An audit can be carried out on organisations, both large and small, and both new and well-established. This unit focuses on the cycle or stages in the modern audit of an established company which is big enough to have a comprehensive system of accounting and record keeping and a system of controls over those records.
At the end of this unit, you should be able to:
- explain audit cycle
- outline the stages in the audit cycle
- describe the stages in the audit.
3.1 Audit Cycle and Procedures
Audit cycle refers to the stages in the conduct of an audit from the beginning to the end. The stages in the modern audit can be summarised as follows.
- Background research;
- Preparation of the audit plan;
- Accounting system review;
- Internal control system review;
- Substantive testing;
- Analytical review techniques;
- Analytical review of financial statements;
- Preparation and signing of report.
These stages will be explained below.
3.1.1 Background Research
Before commencing the audit proper, the auditor must discover as much as possible:
- the present condition and future prospects of the industry of which his client is a part;
- the past history and the present condition and future prospects of his client;
- the management and key personnel of his client and recent changes;
- the products and manufacturing and trading processes of the client and recent changes;
- the locations of all his client’s operations;
- difficulties encountered by the client in manufacturing, trading, expanding, contracting, labour relations or financing;
- problems in accounting or in internal control systems;
- problems in accounting measurement like in stock valuation and income recognition;
- problems likely to lead to audit risk like the difficulty of assessing the value of long-term contracts in a civil engineering business;
- problems likely to be met in carrying out the audit, for example, distant locations, tight timing problems, or large staff requirements on stocktaking attendance;
- changes in law or accounting practice which may affect the client.
This background research will be done by reading or interviewing the following.
(i) Previous years’ audit files;
(ii) Members of staff of audit who have been previously engaged on the audit;
(iii) Published material concerning the client’s company and industry; (iv) The company’s interim, internal and management accounts; (viii) The management of the enterprise.
The auditor must focus his audit, particularly on areas of special difficulty and risk in order to carry out a comprehensive and effective audit which is nevertheless efficient in terms of time spent. In addition, the evaluation of many areas in the financial statements must entail a consideration of the whole circumstances of the client.
3.1.2 The Audit Plan
The auditor must plan his audit in some detail and the plan will involve preparation of an overall audit plan showing:
(a) an outline of the audit work to be done on each area of the client’s systems and financial statements;
(b) the staff who will do the work;
(c) the location of the audit;
(d) the timing of the work to be done;
(e) a budget of time and costs.
The plan must be made to fit in with the client’s timing requirement and with the client’s ability to produce necessary analyses and summaries.
3.1.3 Accounting System Review
The auditor must:
(a) ascertain by asking questions;
(b) record on paper;
(c) corroborate his record (confirm that the record is correct);
(d) review for adequacy and for planning of tests;
(e) test to determine that it always works as it is supposed to;
(f) evaluate and
(g) form a conclusion on the adequacy of the client’s system for documenting and recording the transactions, assets and liabilities of the client in the books of account and other records. This is
because: (i) the Companies Act requires the auditor to investigate and report on the company keeping of “proper” accounting records; (ii) the books of account and other records form the basis for the preparation of the financial statements.
3.1.4 Internal Control System Review
Be reminded that internal controls are procedures which ensure that all transactions, assets and liabilities are recorded correctly.
The auditor should:
(c) corroborate the record;
(f) evaluate and
(g) form a conclusion on the adequacy of the client’s system of internal control.
The objectives of the accounting systems and internal control systems investigations are to enable the auditor to have evidence that:
(i) the client maintains adequate books and records;
(ii) the client has a system of internal controls over the processing and recording of transactions such that all transactions are recorded correctly both numerically and in principle;
(iii) the books of account can be relied on to form a reliable basis for the preparation of the accounts.
Thus, it is not necessary for the auditor to vouch for every transaction recorded in the books. He will rely upon the system. If the system is satisfactory, then he can substitute an investigation and test of the system for a detailed examination of every entry. This is both more economical and is more effective because it is only by examining the system that he can have evidence that all the transactions are recorded. However, in practice, some areas of the firm’s internal controls may not exist or may be weak. In such cases, the auditor cannot rely on the controls and other evidence need to be sought for, for the completeness and accuracy of the record.
SELF-ASSESSMENT EXERCISE 2
- Explain audit cycle.
- In the audit cycle, what does the preparation of the audit plan entail?
3.1.5 Substantive Testing
Substantive testing is defined as:
…those tests of transactions and balances, and other procedures such as analytical review, which seek to provide audit evidence as to the completeness, accuracy and validity of the information contained in the accounting records or in the financial statements.
You have seen that the reliability of the records is established by the auditor, by his investigating the system. However, not all data can be verified in this indirect way. Thus, some transactions, balances and items in the financial statements must be verified by direct evidence. In particular, substantive tests are applied to the followings.
(a) Transaction records where internal controls are weak or non- existent and where the system cannot be relied on.
(b) Unusual, extraordinary or one-off transactions and transactions which are not covered by a system. For example, if the client sold a part of its premises, this transaction is clearly rare and the client will not have a system for dealing with it, and thus, the auditor must seek evidence that the transaction was fully and accurately recorded and was carried out with proper authority.
audit evidence, but additional audit evidence is always sought. In practice, an auditor has to consider on grounds of effectiveness and cost, whether to rely on systems controls or whether to carry out substantive tests in each area of audit. In some areas, sufficient evidence can be obtained by analytical review. In many areas, a combination of internal control reliance, substantive testing and analytical review provide the necessary audit evidence.
.1.6 Analytical Review Techniques
This is defined as:
…the study of relationships between elements of financial information expected to conform to a predictable pattern based on the organisation’s experience and between financial and non-financial information. Information is compared with compatible information for a prior period or periods, with anticipated results and with information relating to similar organisations.
In general, audit evidence is gained from internal control, from substantive tests and increasingly from analytical review.
3.1.7 Analytical Review of Financial Statements
At the conclusion of the detailed work of the audit, when all the systems testing and substantive testing has been done, the auditor will have audit evidence that:
- proper books of account have been kept which form a reliable basis for the preparation of accounts;
- the accounts have been properly drawn up from those books
- all assets, liabilities and transactions, balances and items in the account have been confirmed indirectly by systems investigation and /or directly by substantive testing.
Nonetheless, the auditor will then subject the financial statements to an overall final analytical review to determine whether:
(i) acceptable, consistent and appropriate accounting policies have been applied. For example, the accounts would not show a true and fair view if the depreciation policy had been changed from
straight line to reducing balance without this being disclosed.
(ii) all the information in the financial statements is compatible with all other information. For example, an industrial firm using straight line depreciation may have items of plant which have
been fully depreciated. However, in determining product cost for valuing work in progress and finished goods, notional depreciation on fully depreciated plant may have been taken.
(iii) all items in the accounts are compatible with the auditor’s knowledge of the enterprise and its circumstances. For example, the auditor may have read in the press that new processes have been invented in a client’s industry which makes some of the client’s plant obsolete.
(iv) there is adequate disclosure of all items requesting disclosure. Numerous disclosure requirements are in the Companies Act and also some items may require special disclosure for proper
understanding of the accounts.
(v) the accounting requirements of the Companies Act and other regulations have been complied with.
(vi) overall, the auditor has sufficient evidence to enable him to give an opinion on the truth and fairness of the accounts.
3.1.8 Preparation and Signing of Report
The ultimate aim of an audit is the report by the auditor to his client. This is a formal statement giving:
(a) a title identifying the persons to whom the report is addressed (e.g. Auditors’ report to the members of the ABC Plc.).
(b) an introductory paragraph identifying the financial statements
audited (e.g., Profit and Loss Account, Balance Sheet, etc.).
(i) respective responsibilities of directors and auditors;
(ii) the basis of the auditors’ opinion (We conducted our audit in accordance with Auditing Standards …..);
(iii) the auditors’ opinion (e.g., the financial statements give a true and fair view …..).
(d) the manuscript or printed signature of the auditors.
(e) the date of the report.
SELF-ASSESSMENT EXERCISE 3
Outline the areas where substantive tests are applied relative to the audit cycle.
You must have learnt from the study of this unit that:
- although the stages in conducting the modern audit have been described, the audit is not done all at one time, but it is spread out over a period of time.
b. the modern audit is concerned largely with a search for evidence. Evidence can be of several kinds including;
c. internal control reliance:
i. substantive testing;
ii. analytical review.