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  1. 1. Makerere University MBA Auditing College of Business Studies CHAPTER ONE THE NATURE, PURPOSE AND SCOPE OF AUDITING After completion of this lecture, you should be able to:  Describe the nature and function of auditing.  Identify the place of auditing within the profession of accounting.  Distinguish between different types of audits.  Describe the professional standards required of auditors.  Describe the statutory requirements for the audit of the financial statements of companies. What Is Auditing? "a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users The most common application of auditing is a financial report audit, although other types of audit are explained. The Place of Auditing in the Accounting Profession © 2014 1
  2. 2. Makerere University MBA Auditing College of Business Studies Auditors are members of the accounting profession, which in most countries is organised into professional bodies. It is usual that official registration as an auditor is only available to members of professional accounting bodies. It is also useful to compare the accounting and auditing process. Whereas accounting creates new information, which is usually presented in the form of financial reports, auditing evaluates these financial reports and provides the results of the evaluation in the form of an audit report. Key Terms 1. Accountability: Is the quality or state of being accountable that is being required or expected to justify actions and decisions. It suggests an obligation or willingness to accept responsibility for one’s actions. 2. Stewardship: Is the practice of being a steward, i.e. being employed to manage another’s property; 3. Agents: Agents are people employed or used to provide a particular service. In case of a company, the people being used to provide the service, managing the business also have the second role of being people in their own right trying to maximise their personal wealth. © 2014 2
  3. 3. Makerere University MBA Auditing College of Business Studies The auditor can give assurance to the owner that their agents have accounted properly for their actions, so that owners can assess how well management have discharged their stewardship. DIFFERENT TYPES OF AUDITS Six different types of audits are; 1. Financial report audit is the most common type of audit and will be discussed in detail throughout the study. 2. Compliance audit involves obtaining and evaluating evidence to determine whether certain financial or operating activities of an entity conform to specified conditions, rules or regulation. It is most relevant to the public sector. 3. Performance audit involves obtaining and evaluating evidence about the economy and effectiveness of an entity's operating activities in relation to specified objectives. It is closely related to internal auditing. 4. Comprehensive audit is more common in the public sector and includes financial, compliance and performance audits. It usually occurs when an auditor undertakes a range of audit and audit-related services. 5. Environmental audit covers environmental matters, which may have an impact on the financial statements. The activities of a business may impact on reported assets and profits due to their effects on the environment and environmental regulations. © 2014 3
  4. 4. Makerere University MBA Auditing College of Business Studies 6. Internal audit refers to any of the activities listed above, but conducted by auditors employed by the organisation. Internal audit is a management tool used by the organisation to enhance internal control In order to give an objective opinion, auditors must be independent from both owners and managers. The nature of an audit Key term – Audit objective The 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. The phrases used to express the auditor’s opinion are to give a “True and Fair” view or present fairly in all material respects, which are equivalent terms. To express an opinion The purpose of an audit is to enable auditors to give an opinion on the financial statements. While an audit might produce by-products such as advise to the directors on how to run the business, the point of an audit is to report solely to shareholders. © 2014 4
  5. 5. Makerere University MBA Auditing College of Business Studies Truth and Fairness (Not defined in law or audit) True: Information is factual and conforms to reality, not false. In addition, the information conforms to required standards and law. The accounts have been correctly extracted from the books and records. Fair: Information is free from discrimination and bias and is compliant with expected standards and rules. The accounts should reflect the commercial substance of the company’s underlying transactions. Legal Opinion: On the status of true and fair in relation to accounting standards An International Accounting Standard (IAS) is a declaration by the IASC on behalf of its constituent professional bodies that save in exceptional circumstances, accounts that do not give a true and fair view. The rest of the opinion is relevant:  Accounts will not be true and fair unless the information they contain is sufficient to quantity and quality to satisfy reasonable expectations of readers to whom they are addressed.  The expectation of readers will have been influenced by normal practices of accountants  International Accounting Standards serve the following purposes. - They crystallise professional opinion about what may be expected in accounts that are true and fair © 2014 5
  6. 6. Makerere University MBA Auditing College of Business Studies - Because accounts are obliged to comply with IASs, readers will thus expect the accounts to conform to IASs  IASs therefore have an indirect but important effect on truth and fairness. The courts will treat compliance with accepted accounting principles as prima-facie evidence that accounts are true and fair. Equally, the deviation from accounting principles will be prima-facie evidence that they are not. Truth and fairness is a dynamic (constantly changing) subject. GUIDANCE ON AUDITING Auditing Standards The auditing standards contain: . the basic principles and essential procedures with which the auditor is required to comply in the planning, conduct and reporting of an audit; and . explanatory and other material to assist the auditor in interpreting and applying the basic principles and essential procedures. Professional accounting bodies throughout the world generally publish guidelines for the practice of auditing by their members. These guidelines are known as statements of auditing standards and are often backed by statements of auditing practice covering the procedures to be used in carrying out audits. It is useful to classify auditing standards under the following headings: © 2014 6
  7. 7. Makerere University MBA Auditing College of Business Studies General Standards - these relate to the qualifications and personal qualities required of auditors in carrying out their work. Performance Standards - cover the conduct of the audit and outline the responsibilities placed upon auditors in their work. Reporting Standards - relate to the provision of an audit opinion and are often related to legal requirements for audit e.g., in relation to companies. IFAC – International Standards on Auditing ISA 200 Objectives and general principles governing an audit of financial statements The auditors should comply with the code of ethics for professional accountants issued by the International Federation of Accountants – ISA 200.4 The auditor should conduct an audit in accordance with International Standards on Auditing (ISAs) The Audit Report: An Introduction We will discuss audit reports in more detail in another chapter. As an introduction to the types of reports, which may be given, the following provides a guide: - An unqualified report: this is the most common type of report issued. It is usually in prescribed language and consists of a scope and opinion sections. © 2014 7
  8. 8. Makerere University MBA Auditing College of Business Studies - A modified audit report: is issued when the auditor expresses a qualified opinion, or adds explanatory language to draw attention to or emphasise a matter that is relevant to users. A qualified opinion is issued when: 1. there is a disagreement with management; 2. there is a conflict between financial reporting frameworks; or 3. there is a limitation on the scope of the audit. Three types of qualified opinions may result: 1. an "except for" opinion; 2. an adverse opinion; or 3. an inability to form an opinion. Further, an emphasis of matter paragraph may be added to an unqualified audit report in circumstances such as when additional disclosures contrary to accounting standards are made; or there are inherent uncertainties (including those in relation to going concern) which are adequately disclosed; or there is inconsistent other information; or subsequent events have occurred Auditors’ general approach to audit work © 2014 8
  9. 9. Makerere University MBA Auditing College of Business Studies The auditor should plan and perform the audit with an attitude of professional scepticism recognising; the auditor would not simply accept what managers say during an audit of the entity but would look for supporting evidence. The procedures required to conduct an audit in accordance with ISAs should be determined by the auditor having regard to the requirements of ISAs, relevant professional bodies, legislation, regulation and where appropriate, the terms of the audit engagement and reporting requirements. There are provisions. The auditors’ opinion is not:  A guarantee of the future viability of the entity  An assurance of management’s effectiveness and efficiency. Responsibility of directors While the auditor is responsible for forming and expressing an opinion on financial statements, the responsibility for preparing and presenting the financial statements is that of the management of the entity. The auditor of financial statements does not relieve management of its responsibilities Scope of External Audit © 2014 9
  10. 10. Makerere University MBA Auditing College of Business Studies Statutory and Non Statutory Audits Statutory Audit This is required under national standards or laws/statutes. It applies for limited liability companies. Non-statutory Audit Performed by independent auditors because the owners, proprietors, trustees, professional and governing bodies or interested parties want them rather than because law requires them. The auditor must take into account the regulation contained in the internal rules or constitution of the undertaking. Advantages of audits  Verification of accounts  Recommendations of accounting and control systems  Possible detection of errors and fraud  Provide a means of setting accounts between partners  Audited accounts make the accounts more acceptable to taxation authorities. © 2014 10
  11. 11. Makerere University MBA Auditing College of Business Studies  The sale of the business or the reorganisation of a loan or overdraft facilities may be facilitated if the firm is able to produce audited accounts. The expectations gap This is the difference between what auditors do and what people in general think that they do. It is misconception in relation to the role of the auditor. For example -Auditors report to the directors of the company and not to the members. -A favourable audit report is more favourable than an unqualified audit report and the reverse is true -Perception that it is the auditor’s duty to detect fraud when in fact directors should be the detectors of fraud. The auditor and fraud External auditor does not have a statutory duty to prevent and detect fraud. The risk of fraud is the material misstatement of financial statements. Reviews: © 2014 11
  12. 12. Makerere University MBA Auditing College of Business Studies The objective of a review engagement is to enable an auditor to state whether on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to his/her attention that causes the auditor to believe that the financial statements are not prepared in all material respects in accordance with an identified financial reporting framework. The level of assurance recipients’ get from a review is not as high as that from an audit. The procedures carried out in a review engagement are similar to an audit. Assurance – Auditors’ satisfaction as to the reliability on assertions made by one party for use by another party (i.e. by management for use by the readers of the accounts). Auditors assess evidence collected as a result of procedures conducted and then express a conclusion. Audit and other engagements. Audit engagement – Auditor provides a high but not absolute level of assurance that information audited is free from material misstatements. (Reasonable assurance) Review engagement – Auditor provides moderate level of assurance that information subject to review is free from material misstatements (Negative assurance) © 2014 12
  13. 13. Makerere University MBA Auditing College of Business Studies Agreed-upon procedures – The auditor simply provides a report of the actual findings so no assurance is expressed. Users of the report must instead judge for themselves the auditors’ procedures and findings and draw their own conclusions from the auditors’ work. Compilation engagement – Users of compiled information gain some benefit from the accountants (as opposed to auditors’) involvement, but no assurance is expressed in the report. Negative assurance – When the auditor gives an assurance that nothing has come to his attention, which indicates that financial statements have not been prepared according to the framework. In other wards, he gives his assurance in the absence of any evidence to the contrary. Limitations of an audit. Auditors use judgement in deciding what audit procedures to use and what conclusions to draw. Limitations of every audit 1. Auditing is not a purely objective exercise. Auditors have to make judgement in areas such as risk assessment, what constitutes a significant error, what tests to perform and what opinion to give © 2014 13
  14. 14. Makerere University MBA Auditing College of Business Studies 2. Auditors do not check every item in the accounting records i.e. they check a sample of items. 3. Limitations of accounting and internal control systems; these may not be able to deal with unusual transactions and may not be flexible to deal with changing circumstances. 4. Client management or staff may not tell the truth or may collude in fraud – segregation of duties fails. 5. Audit evidence indicates what is probable rather than what is certain. Some figures are estimates; others require significant degree of judgement. 6. Auditors are reporting some months after the balance sheet date. There is a change in the financial position/situation of client from balance sheet date to date. However, if auditors report soon after balance sheet date, evidence about certain figures in the balance sheet may be insufficient. 7. Limitations of an audit report – The standard format of the audit report is not likely to reflect all aspects of the audit. Therefore, auditors can not certify that the accounts are correct, they can only express an opinion © 2014 14
  15. 15. Makerere University MBA Auditing College of Business Studies The concept of materiality Auditors are not responsible to establish whether the accounts are correct because:  It takes a great deal of time and trouble to check the correctness of even a very small transaction and the resulting benefit may not justify the effort.  Financial accounting involves a degree of estimation, which means that financial statements can never be precise. Definition: Materiality is an expression of relevant significance or importance of a particular matter in the context of financial statements as a whole. A matter is material if its omission or misstatement would reasonably influence the decisions of an addressee of the auditor’s report. Materiality may also be considered in the context of any individual primary statement within the financial statement or of individual items included in them. Materiality is not capable of general mathematical definition as it has both qualitative and quantitative aspects. © 2014 15
  16. 16. Makerere University MBA Auditing College of Business Studies Duties of auditors of limited companies They must satisfy themselves that:  Proper accounting records have been kept  The accounts are in agreement with the accounting records  Accounts have been prepared in accordance with the companies Act, and relevant accounting standards  The balance sheet shows a true and fair view if the company’s affairs and the profit and loss account show a true and fair view of the results for the period. Auditors’ work for any client  Making such tests and inquiries, as they consider necessary to form an opinion as to reliability of the accounting records as basis for the preparation of accounts.  Checking the accounts against the underlying records.  Reviewing the accounts for compliance with the Company’s Act and accounting standards. Stages of an audit © 2014 16
  17. 17. Makerere University MBA Auditing College of Business Studies The systems audit- Refer to appendix Stage 1 to 3 Self explanatory Stage 4 Confirm that the system recorded is the same as that in operation. This is achieved by performing walkthrough tests. These involve tracing a handful of transactions through the system and observing the operation of controls over them Auditors need to determine what is actually done, than believe what staff say should be done. Assess the system and internal controls Stage 5. Evaluate the systems to gauge their reliability and formulate a basis for testing their effectiveness in practice. Test the system and internal controls Stage 6. If controls from stage 5 are effective, tests should be designed to establish compliance with the system should be selected and performed. Tests of controls should be carried out. If controls are strong, the records should be reliable and the amount of detailed testing can be reduced. If controls are ineffective, in practice, more extensive substantive procedures should be required. © 2014 17
  18. 18. Makerere University MBA Auditing College of Business Studies Stage 7. After evaluating the systems and testing controls, auditors should send an interim report to management identifying weaknesses and recommending improvements. Testing the financial statements Stage 8 & 9. These tests are concerned with substantiating the figures given in the final financial statements. Before designing a substantive procedure, it is essential to consider whether any errors produced could be significant. If errors are not significant, there is no point in performing a test. Stage 10. Review the financial statements to determine overall reliability of the account by making a critical analysis of content and presentation. Stage 11. Express an opinion Stage 12. Management Letter – purpose is to make further suggestion for improvements in the systems and to place on record specific points in connection with the audit and the accounts © 2014 18
  19. 19. Makerere University MBA Auditing College of Business Studies CHAPTER TWO PROFESSIONAL ETHICS AND INDEPENDENCE A profession is distinguished by certain characteristics including: • Mastery of a particular intellectual skill, acquired by training and education;1 • Adherence by its members to a common code of values and conduct established by its administrating body, including maintaining an outlook which is essentially objective; and • Acceptance of a duty to society as a whole (usually in return for restrictions in use of a title or in the granting of a qualification). Members’ duty to their profession and to society may at times seem to conflict with their immediate self-interest or their duty of loyalty to their employer. © 2014 19
  20. 20. Makerere University MBA Auditing College of Business Studies Against this background, ACCA laid down ethical requirements for its members to ensure the highest quality of performance and to maintain public confidence in the profession. The Public Interest A distinguishing mark of a profession is acceptance of its responsibility to the public. The accountancy profession’s public consists of clients, credit grantors, governments, employers, employees, investors, the business and financial community, and others who rely on the objectivity * and integrity of professional accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on the accountancy profession. The public interest is defined as the collective well-being of the community of people and institutions the professional accountant serves. A professional accountant’s responsibility is not exclusively to satisfy the needs of an individual client or employer. The standards of the accountancy profession are heavily determined by the public interest, for example: • Independent auditors help to maintain the integrity and efficiency of the financial statements presented to financial institutions in partial support for loans and to stockholders for obtaining capital; © 2014 20
  21. 21. Makerere University MBA Auditing College of Business Studies • Financial executives serve in various financial management capacities in organisations and contribute to the efficient and effective use of the organisation’s resources; • Internal auditors provide assurance about a sound internal control system, which enhances the reliability of the external financial information of the employer; • Tax experts help to establish confidence and efficiency in, and the fair application of, the tax system; and • Management consultants have a responsibility toward the public interest in advocating sound management decision-making. Professional accountants have an important role in society. Investors, creditors, employers and other sectors of the business community, as well as the government and the public at large rely on professional accountants for sound financial accounting and reporting, effective financial management and competent advice on a variety of business and taxation matters. The attitude and behaviour of professional accountants in providing such services have an impact on the economic well-being of their community and country. Professional accountants can remain in this advantageous position only by continuing to provide the public with these unique services at a level which © 2014 21
  22. 22. Makerere University MBA Auditing College of Business Studies demonstrates that the public confidence is firmly founded. It is in the best interest of the world-wide accountancy profession to make known to users of the services provided by professional accountants that they are executed at the highest level of performance and in accordance with ethical requirements that strive to ensure such performance. Objectives The Code recognises that the objectives of the accountancy profession are to work to the highest standards of professionalism, to attain the highest levels of performance and generally to meet the public interest requirement. These objectives require four basic needs to be met: • Credibility In the whole of society there is a need for credibility in information and information systems. • Professionalism There is a need for individuals who can be clearly identified by clients, employers and other interested parties as professional persons in the accountancy field. • Quality of Services © 2014 22
  23. 23. Makerere University MBA Auditing College of Business Studies There is a need for assurance that all services obtained from a professional accountant are carried out to the highest standards of performance. • Confidence Users of the services of professional accountants should be able to feel confident that there exists a framework of professional ethics which governs the provision of those services. Fundamental Principles In order to achieve the objectives of the accountancy profession, professional accountants have to observe a number of prerequisites or fundamental principles. The fundamental principles are: • Integrity A professional accountant should be straightforward and honest in performing professional services. * • Objectivity A professional accountant should be fair and should not allow prejudice or bias, conflict of interest or influence of others to override objectivity. • Professional Competence and Due Care © 2014 23
  24. 24. Makerere University MBA Auditing College of Business Studies A professional accountant should perform professional services with due care, competence and diligence and has a continuing duty to maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service based on up-to-date developments in practice, legislation and techniques. • Confidentiality A professional accountant should respect the confidentiality of information acquired during the course of performing professional services and should not use or disclose any such information without proper and specific authority or unless there is a legal or professional right or duty to disclose. • Professional Behaviour A professional accountant should act in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession. The obligation to refrain from any conduct which might bring discredit to the profession requires the consideration, the responsibilities of a professional accountant to clients, third parties, other members of the accountancy profession, staff, employers, and the general public. • Technical Standards A professional accountant should carry out professional services in accordance with the relevant technical and professional standards. © 2014 24
  25. 25. Makerere University MBA Auditing College of Business Studies Professional accountants have a duty to carry out with care and skill, the instructions of the client or employer insofar as they are compatible with the requirements of integrity, objectivity and, in the case of professional accountants in public practice, * independence. In addition, they should conform with the technical and professional standards promulgated by: - IFAC (e.g., International Standards on Auditing); - International Accounting Standards Board; - The ACCA; and - Relevant legislation. RULES OF CONDUCT INDEPENDENCE A member in public practice shall be independent in the performance of professional services as required by standards promulgated by ACCA. Interpretations: © 2014 25
  26. 26. Makerere University MBA Auditing College of Business Studies Does investment in a client violate independence?  Direct investment does regardless of the size of the investment.  Indirect investment does if investment is material. Does involvement in management activities violate independence?  May advise but not make decisions on the client’s behalf.  Honorary directorships are allowable. Do the actions of former members of the member firm violate independence?  Generally, no as long as they are no longer active with the member firm.  Buy-out payments generally do not affect independence. Can a member firm provide other services and still be independent with respect to an audit?  If client is not publicly traded, a member may prepare and audit F/S as long as the member never appears to be an employee of the client.  If client is publicly-traded, a member may NOT prepare and audit F/S. If the audit client is a financial institution, can the member have loans with the client?  All existing loans do not violate independence if the loan was obtained under normal lending procedures.  Newly-created loans (after the MEMBER-client relationship formed) are limited to small personal loans. Must be obtained under normal lending procedures and may require collateralization. © 2014 26
  27. 27. Makerere University MBA Auditing College of Business Studies Does legal action between the client and the MEMBER violate the member’s independence?  If the lawsuit alleges audit deficiencies or management improprieties, independence is violated.  If MEMBER and client are co-defendants in lawsuits, independence is not violated unless cross-claims alleging audit deficiencies or management improprieties exist.  Lawsuits between the MEMBER and the client for other causes generally do not violate independence unless communications between the parties are hindered. Can the actions of family members impair independence?  Independence is impaired if a spouse, dependent, or nondependent close relative is involved in audit sensitive activities.  Audit sensitive = any activity that is an element of or subject to significant internal controls.  Violation requires BOTH a relationship and audit sensitivity. INTEGRITY AND OBJECTIVITY © 2014 27
  28. 28. Makerere University MBA Auditing College of Business Studies In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgement to others. Interpretations: 0* Making, permitting, or directing another to make false and misleading entries violates integrity. 1* A conflict of interest occurs if one's objectivity is impaired. Disclosure of a potential conflict of interest will eliminate the impairment. 2* Conflict of interest: A situation in which you have a strong desire for an outcome that is not in the best interest of someone with whom you have a fiduciary duty. GENERAL STANDARDS A member will undertake only those services which can be competently completed. The member will adequately plan and supervise the services and will exercise due professional care throughout. Sufficient data will be collected to provide a basis for any conclusions drawn or recommendations made. Interpretations: 3* Does not assume infallibility of knowledge or judgment. 4* Deficiencies in knowledge can be covered by engaging an expert. © 2014 28
  29. 29. Makerere University MBA Auditing College of Business Studies COMPLIANCE WITH STANDARDS. A member who performs auditing, review, compilation, consulting services, tax, or other professional services shall comply with standards promulgated by ACCA. ACCOUNTING PRINCIPLES If the financial statements contain a material departure from IAS, the MEMBER will not express an opinion (using positive or negative assurance) that the financial statements are in conformity with IAS unless the MEMBER can demonstrate that the use of IAS would result in misleading financial statements due to unusual circumstances. Interpretations: 5* Proper accounting treatment is that which will render the financial statements not misleading. Generally, IAS, but not necessarily so. 6* IASB has been designated as the body to establish accounting principles. CONFIDENTIAL CLIENT INFORMATION The member will not disclose confidential client information obtained in the course of a professional engagement without the consent of the client. The consent of the client is not needed: 7* To meet obligations of Rules. 8* To comply with a subpoena or summons. © 2014 29
  30. 30. Makerere University MBA Auditing College of Business Studies 9* In the conduct of a review of a firm's quality control. 10* To answer inquiries of professional disciplinary boards. Interpretations: 11* Confidentiality cannot be used to thwart legal or disciplinary actions. 12* Member firm may disclose confidential client information to another member firm, which has purchased the practice. The potential seller should take precautions to prevent the disclosure of client information by the potential buyer. 13* Member may release any client information if the client allows it. CONTINGENT FEES The member may not charge fees for attestation or tax services that are contingent upon the findings. Fees may vary with complexity of the services provided. This prohibition does not apply to fees fixed by the courts or public authorities. Interpretations:  Contingent fees may be charged in some areas but never in attestation services (assurance) and generally not in tax services. Contingent fees are fees calculated on a predetermined basis relating to the outcome or result of a transaction or the result of the work performed. A contingent fee charged by a firm in respect of an assurance engagement © 2014 30
  31. 31. Makerere University MBA Auditing College of Business Studies creates self-interest and advocacy threats that cannot be reduced to an acceptable level by the application of any safeguard. ACTS DISCREDITABLE The MEMBER will not commit an act which is discreditable to the profession. Interpretations: 14* This rule must be followed by members not engaged in public practice. 15* Must return client's records when they are demanded. The Member’s working papers are not the client's and do not need to be surrendered. 16* May not discriminate based on race, color, religion, sex, age, or national origin. 17* Negligence in professional services. 18* Failure to follow additional applicable requirements. 19* Solicitation or disclosure of member Exam questions. ADVERTISING AND OTHER FORMS OF SOLICITATION The member will not seek to obtain clients by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive. © 2014 31
  32. 32. Makerere University MBA Auditing College of Business Studies Interpretations: 20* May not imply the ability to influence authorities. 21* May not create false expectations about favorable results. 22* May not state unreasonable fees. 23* A member is responsible for claims made on his or her behalf by third parties. COMMISSIONS When providing attestation services, the member may not receive commissions for services provided to the client or commissions for services provided by the client to other parties. Interpretations: 24* When the member receives a commission for a non-prohibited act, the commission should be disclosed to the client. 25* Referral fees, accepted or paid, should be disclosed to the client. FORM OF PRACTICE AND NAME The member may practice public accounting in any form of organisation permitted by state law or regulations whose characteristics conform to resolutions of the Council. The name of the organisation may not be misleading. © 2014 32
  33. 33. Makerere University MBA Auditing College of Business Studies Interpretations: 26* Firm name must not mislead as to organizational form. 27* Names of past partners may be used (with limits). 28* Regular corporations are allowed if stock is held by persons who are members and able to practice publicly. Revision Questions Q1 Chemonges and Co, Chartered Certified Accountants, recently held a staff training session on quality control. The session concluded with staff being invited to raise matters from their experience relating to the ethical rules on independence. Some of these matters are given below. (a) Shortly before commencing the final audit of a large listed company, a junior staff member on the audit team inherited a substantial number of shares in that company. No action was taken because, although representing a large investment for the staff member concerned, the number of shares was totally immaterial with respect to the company. Moreover, the partner knew that, when the company’s results were © 2014 33
  34. 34. Makerere University MBA Auditing College of Business Studies announced, the share price would rise and he did not think it was fair to require the staff member to sell them now. (5 marks) (b) The management accountant of another listed company client had an accident and was away from work for three months. At the time of the accident the audit senior was winding up the prior year’s audit and, because of his familiarity with the company’s management accounting system, it was agreed that he would take over as management accountant for the three months. (5 marks) (c) In its management letter to another audit client, Chemonges and Co warned the company that their computer system lacked essential controls. The company decided to install a totally new computer system and Chemonges and Co’s management consultancy department was appointed to design the new system. (5 marks) (d) Chemonges and Co was recently approached by a large company that was not, then, an audit client, for a second opinion. The company was in dispute with its existing auditors who were proposing to issue a modified auditor’s report because of disagreement over inventory valuation. Chemonges and Co’s technical par tner reviewed the evidence provided by the company and advised the company that its accounting treatment was in order. Shortly afterwards Chemonges and Co was © 2014 34
  35. 35. Makerere University MBA Auditing College of Business Studies invited to accept nomination as auditors. The reply to the letter of enquiry to the existing auditors made it clear that the inventory valuation dispute was not as straightforward as the company had made it out to be. (5 marks) Required: Discuss the possibility that Chemonges and Co had impaired their independence or otherwise acted unprofessionally in each of the situations described. (20 marks) Q2 Accountants in public practice earn much of their revenue from the provision of external audit services. Companies pay substantial fees for the services of external auditors. However, the work of the external auditor does not appear to improve companies’ profitability so it is not immediately apparent what the benefit of an external audit is. Required: (a) Explain the benefits derived from the work of external auditors. (10 marks) (b) The value of the external audit is dependent upon a number of factors, sometimes referred to as postulates. © 2014 35
  36. 36. Makerere University MBA Auditing College of Business Studies Identify these factors and explain how they contribute to the effectiveness of the external audit. (10 marks) N.B. Marks will reflect the quality of the explanation rather than the number of factors identified. (20 marks) Key terms: Fraud: Comprises both the use of deception to obtain unjust or illegal financial advantage and intentional misrepresentation by management, employees or third parties. Error: Unintentional mistake Auditor’s duties  Planning: © 2014 36
  37. 37. Makerere University MBA Auditing College of Business Studies  Discuss with audit team the susceptibility of the entity to material misstatements in the financial statements resulting from fraud.  Make enquiries of management a) To obtain an understanding of: - Management’s assessment of the risk that financial statements may be materially misstated as a result of error. - The accounting and internal control system management has put in place to address such risk b) To obtain knowledge of management’s understanding regarding the accounting and internal control systems in place to prevent or detect error. c) To determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating. d) To determine whether management has discovered any material errors.  Risk assessment Auditors consider how financial statements might be materially misstated as a result of fraud or error. The auditor should consider whether fraud risk factors are presented that indicates the possibility of either fraudulent financial reporting or misappropriations of assets.  Designing substantive procedures. The auditor should address the fraud risk factors that have been identified as being present. © 2014 37
  38. 38. Makerere University MBA Auditing College of Business Studies  Misstatements Circumstances indicating material misstatements: Perform procedures to determine whether the financial statements are materially misstated. When a misstatement is identified, the auditor should consider whether it is indicative of fraud and consider its implications to other aspects of the audit. The auditor should obtain written representations from management that: a) It acknowledges its responsibility for the implementation and operations of accounting and internal control systems that are designed to prevent and detect fraud or error. b) It believes that misstatements are immaterial both individually and when aggregated. c) It has disclosed to the auditor all significant facts relating to its assessment of risk that financial statements may be materially misstated. d) Disclosed to the auditor the results of risk assessment. If auditor identifies misstatements resulting from fraud or suspected fraud, he should consider his responsibility to communicate that information to management, those charged with governance and in some circumstances to regulatory and enforcement authorities. Error – Read and make notes © 2014 38
  39. 39. Makerere University MBA Auditing College of Business Studies Qn: What should the auditor do if he concludes that he cannot continue performing the audit as a result of misstatement resulting from fraud or suspected fraud? INTERNAL AUDIT AND INTERNAL REVIEW Internal audit is an independent activity set up by management to examine and evaluate the organisations risk management processes and systems control and to make recommendations for improvement of achieving company objectives. Other Activities of Internal Audit.  Examine and evaluate financial and operating information within the organisation.  Review of the economy, efficiency, and effectiveness of operations.  Review compliance with external laws and regulations and internal policy and procedures.  Review and advise on the development of key organisation systems and on the implementation of major change. The IIA board of directors has defined internal auditing as: 'Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation's operations. It helps an © 2014 39
  40. 40. Makerere University MBA Auditing College of Business Studies organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.' Internal auditing is an independent professional service, to serve not just management but the whole organisation. This means that the internal auditing customer base includes all those who work in an organisation. There are four major areas of Internal Audit form the above definition;  Corporate governance  Risk  Organisational control  Corporate objectives Internal Audit and Corporate Governance Corporate governance concerns the way that a company is operated and directed and n particular encompasses the operation of the board and audit committee, as well as the overall control and risk management frame work. Corporate governance varies from country to country and has been more formally developed during the last ten years. Guidance has been developed in the areas of; the need for financial controls; the conduct and remuneration of the directors; operational controls and risk. © 2014 40
  41. 41. Makerere University MBA Auditing College of Business Studies Why corporate governance has had such an Impact on Internal Audit and Review The Turnbull report emphasises the importance of corporate governance. It says that an objective and adequately resourced internal audit function should be in position to provide the board with much of the assurance it requires regarding the effectiveness of the system of internal control. Effective corporate governance should encompass the following;  Evaluate risk requirements  Consider the nature and extent of the risks regarded as acceptable.  The threats of such risks realising  The ability to reduce incidence and impact if risks arise  Costs and benefits relating to operating relevant controls. Refer to article on Corporate Governance Risk Management Risk can be defined as 'any event or actions that may adversely affect an organisation to achieve its objectives and execute its strategies'; This definition means that risk is not just confined to just the financial affairs of the organisation but to all operations. Risk can be seen as having three components; © 2014 41
  42. 42. Makerere University MBA Auditing College of Business Studies  Hazard - risk of bad things happening  Uncertain Outcome - not meeting expectations  Opportunity - exploiting the upside Refer to article The role of Internal Audit in Risk Management Internal Control The Turnbull Report defined risk management and internal control in the following way 'An organisation's system of internal control has as its principal aim the management of risks that are significant to the fulfilment of its objectives, with a view to safeguarding the organisation's assets and ensure that the organisation is effectively fulfilling its objectives.' Underpinning pro-active risk management - which involves identifying risk and appropriate strategies to mitigate them - is a sound internal control system, which can:  Respond to significant risk  Is embedded in day to day processes  Capable of responding to external and internal changes  Immediately report major control weaknesses. A good internal control system will provide management with reports on: © 2014 42
  43. 43. Makerere University MBA Auditing College of Business Studies  Identification, evaluation and management of key risks  Assessment of effectiveness of related control  Actions to remedy weaknesses including considering costs and benefits  Adequacy of monitoring of internal control systems  The process that supports reporting Having such information will provide an organisation's management the reassurance that not only is meeting regulatory requirements but that the organisation is well run. The internal auditor as an expert in internal control can provide such assurance. Organisational Control - Read Corporate Objectives - Read Differences between Internal and External Audit - Read Outsourcing Internal Audit Refer to article SCOPE FUNCTIONS OF INTERNAL AUDIT WORK The mission of the internal audit department is to provide independent, objective assurance and consulting services designed to add value and improve the organization's operations. It helps the organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. The scope of work of the internal audit department is to determine whether the organization’s network of risk management, control, and governance processes, as © 2014 43
  44. 44. Makerere University MBA Auditing College of Business Studies designed and represented by management, is adequate and functioning in a manner to ensure:  Risks are appropriately identified and managed.  Interaction with the various governance groups occurs as needed.  Significant financial, managerial, and operating information is accurate, reliable, and timely.  Employees’ actions are in compliance with policies, standards, procedures, and applicable laws and regulations.  Resources are acquired economically, used efficiently, and adequately protected.  Programs, plans, and objectives are achieved.  Quality and continuous improvement are fostered in the organization’s control process.  Significant legislative or regulatory issues impacting the organization are recognized and addressed appropriately. Opportunities for improving management control, profitability, and the organization’s image may be identified during audits. They will be communicated to the appropriate level of management. ACCOUNTABILITY The chief audit executive, in the discharge of his/her duties, shall be accountable to management and the audit committee to:  Provide annually an assessment on the adequacy and effectiveness of the organization’s processes for controlling its activities and managing its risks in the areas set forth under the mission and scope of work.  Report significant issues related to the processes for controlling the activities of the organization and its affiliates, including potential improvements to those processes, and provide information concerning such issues through resolution. © 2014 44
  45. 45. Makerere University MBA Auditing College of Business Studies  Periodically provide information on the status and results of the annual audit plan and the sufficiency of department resources.  Coordinate with and provide oversight of other control and monitoring functions (risk management, compliance, security, legal, ethics, environmental, external audit). INDEPENDENCE To provide for the independence of the internal auditing department, its personnel report to the chief audit executive, who reports functionally to the audit committee and administratively to the chief executive officer in a manner outlined in the above section on Accountability. It will include as part of its reports to the audit committee a regular report on internal audit personnel. RESPONSIBILITY The chief audit executive and staff of the internal audit department have responsibility to:  Develop a flexible annual audit plan using an appropriate risk-based methodology, including any risks or control concerns identified by management, and submit that plan to the audit committee for review and approval as well as periodic updates.  Implement the annual audit plan, as approved, including as appropriate any special tasks or projects requested by management and the audit committee.  Maintain a professional audit staff with sufficient knowledge, skills, experience, and professional certifications to meet the requirements of this Charter.  Evaluate and assess significant merging/consolidating functions and new or changing services, processes, operations, and control processes coincident with their development, implementation, and/or expansion.  Issue periodic reports to the audit committee and management summarizing results of audit activities. © 2014 45
  46. 46. Makerere University MBA Auditing College of Business Studies  Keep the audit committee informed of emerging trends and successful practices in internal auditing.  Provide a list of significant measurement goals and results to the audit committee.  Assist in the investigation of significant suspected fraudulent activities within the organization and notify management and the audit committee of the results.  Consider the scope of work of the external auditors and regulators, as appropriate, for the purpose of providing optimal audit coverage to the organization at a reasonable overall cost. AUTHORITY The chief audit executive and staff of the internal audit department are authorized to:  Have unrestricted access to all functions, records, property, and personnel.  Have full and free access to the audit committee.  Allocate resources, set frequencies, select subjects, determine scopes of work, and apply the techniques required to accomplish audit objectives.  Obtain the necessary assistance of personnel in units of the organization where they perform audits, as well as other specialized services from within or outside the organization. The chief audit executive and staff of the internal audit department are not authorized to:  Perform any operational duties for the organization or its affiliates.  Initiate or approve accounting transactions external to the internal auditing department.  Direct the activities of any organization employee not employed by the internal auditing department, except to the extent such employees have been appropriately assigned to auditing teams or to otherwise assist the internal auditors. © 2014 46
  47. 47. Makerere University MBA Auditing College of Business Studies © 2014 47