Course Code 416 Course Title Auditing Reference books

Course Code: 416; Course Title: Auditing Reference books: 1. Alvin A. Arens, Randal J. Elder : Auditing and Assurance Services, Prentice Hall. 2. Assurance–Study Manual : CA Professional Stage Knowledge Level, ICAB, Dhaka. 3. Audit and Assurance–Study Manual: CA Professional Stage Application Level, ICAB, Dhaka. 1

SCOPE OF THIS COURSE Owners / External Users of FSs i. e. stakeholders Company owned by Shareholders and it is govern by agency i. e. Bo. D/Management Client i. e. company Auditor issues report relied upon by users/owners Owners hire Auditor through AGM / Bo. D / Management Auditor issues report based Upon information provided By Management Auditor 2

Agency Relationship 3

Audit and auditor Audit: An exploratory, critical review of the underlying internal controls and accounting records of a business enterprise. Auditor: "Auditor" is used to refer to the person or persons conducting the audit, usually the engagement partner or other members of the engagement team. • An audit team implies that more than one auditor is involved in conducting the audit engagement. • Audit engagement refers to the process of agreeing to a contract for the services of an external auditor. 4

Duties Audit Team/engagement team 5

Definition of Auditing Financial Statements (including footnotes) Persons who rely on the financial reports Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria GAAP and communicating the results to Auditor's Report/ interested users. Other Reports • Creditors • Investors • Stakeholders, etc 6

The important terms of this definition • • • Systematic process — audits are structured activities; Objectivity — freedom from bias; Obtaining and evaluating evidence — allows the auditor to determine the support for assertions or representations; Assertions about economic actions and events — describes the subject matter of an audit; Degree of correspondence…established criteria — the purpose of the audit is to determine conformity with some specified criteria; and Communicating results — the results must be communicated to interested parties. 7

HISTORY OF THE AUDIT FUNCTION • • Audits have been performed at least since thirteenth century. Audits until the early 1900 s focused on the company’s solvency and the detection of fraud and error. Since the 1940 s: the overall objective of auditing has been the expression of an opinion as to whether the financial report is materially misstated. Audits from early 1900 s to 1940 s: added objectives of verification of financial report accuracy and attestation to financial report credibility. 8

Historical Background • The role of auditor goes back many hundreds of years. There are records from ancient Egypt and Rome, showing that people were employed to review work done by tax collector and estate managers. • The emphasis was very much on the detection of fraud and other irregularities. • Stewardship requires an outsider with sufficient independence and objectively to review the accounts of stewardship and to express an opinion as to their honesty or otherwise. • STEWARDSHIP is responsibility for taking good care of resources entrusted to one, e. g. , Boards of Directors must show good stewardship towards the company for which they are a board member. 9

DEVELOPMENT OF MODERN AUDITING • Modern auditing as developed since the concept of a company as a separate legal entity came into existence in the late ninetieth century. • This led to the separation of ownership (shareholders) from control (directors) and consequent need to safeguard the interests of the owners, who in all but the smallest of business were not involved in the day to day decisions made by the management. • In previous years it was part of the appointed auditor duties to discover fraudulent misrepresentations, the detection of fraud and error become the major objective of company audits. • However in later part of nineteenth century, there was a growing school of thought that the prevention of fraud and error (as opposed to its detection) should be the major objective of the auditor (both external and internal) and that the management of a company should play a greater part and accept a larger degree of responsibility in this respect. 10

Objectives of AUDITING The auditor’s overall objectives: • To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and • To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. 11

Audit Process • • Phase I - Client Acceptance Phase II - Planning Phase III - Testing and Evidence Phase IV - Evaluation and Judgment 12

Phase I Client Acceptance Objective: The client acceptance phase of the audit plan, Phase I, involves deciding whether to accept a new client or continue with an existing one. Procedures: (1) Evaluate the client's background and reasons for the audit. (2) Determine whether the auditor is able to meet the ethical requirements regarding the client. (3) Determine need for other professionals. (4) Communicate with predecessor auditor; (5) Prepare client proposal. (6) Select staff to perform the audit, and (7) Obtain an engagement letter. 13

Phase II Planning the audit Objective: Determine the amount and type of evidence and review required to give the auditor assurance that there is no material misstatement of the financial statements. Procedures (1) Perform audit procedures to understand the entity and its environment, including the entity’s internal control; (2) Assess the risks of material misstatements of the financial statements. (3) Determine materiality; and (4) Prepare the planning memorandum and audit program, containing the auditor’s response to the identified risks. Audit plan: A document used by the auditor to record the auditor's plans to conduct an audit. 14

Phase III Testing and Evidence • Objective: Test for evidence supporting internal controls and the fairness of the financial statements. • Procedures: (1) Tests of controls: An audit procedure designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level. (2) Substantive procedures: An audit procedure designed to detect material misstatements at the assertion level. Substantive procedures comprise: (i) Tests of details (of classes of transactions, accounts balances, and disclosures (ii) Substantive analytical procedures. 15

Phase III Testing and Evidence • Objective: Test for evidence supporting internal controls and the fairness of the financial statements. • Procedures: (1) Tests of controls: An audit procedure designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level. (2) Substantive procedures: An audit procedure designed to detect material misstatements at the assertion level. Substantive procedures comprise: (i) Tests of details (of classes of transactions, accounts balances, and disclosures (ii) Substantive analytical procedures. 16

Phase IV, Evaluation and Reporting Objective: Complete the audit procedures and issue an opinion. Procedures: (1) Evaluate governance evidence; (2) Perform procedures to identify subsequent events; (3) Review financial statements and other report material; (4) Perform wrap-up procedures; (5) Prepare Matters of Attention for Partners; (6) Report to the board of directors; and (7) Prepare Audit report. 17

TRUE AND FAIR VIEW In Bangladesh, the auditor will normally express his/her audit opinion by reference to the ‘true and fair view’, which is requirement of companies Act 1994. Whilst this term is at the heart of the audit, ‘true’ and ‘fair’ are not defined in law or audit guidance. However, for practical purposes the following definitions are generally accepted. True: Information is factual and conforms with reality, not false. In addition the information conforms with required standards and law. The accounts have been correctly extracted from the books and records. Conform-obedience to some standard considered normal by the majority. Confirm-to provide support for the truth or validity of sth. 18

True and fair view contd…. . Fair: Information is free from discrimination and bias in compliance with expected standards and rules. The accounts should reflect the commercial substance of the company’s underlying transactions. True and fair view has become a term of art. It is generally understood to mean presentation of accounts drawn up according to accepted accounting principles using accurate figures as far as possible and reasonable estimates otherwise, and arranging them so as to show within the limits of current accounting practice as objective picture as possible free from willful bias, distortion, manipulation or concealment of material facts. 19

The key elements of an audit engagement: 1. Three people or groups of people involved – The practitioner (Chartered Accountant) – The intended users (stakeholders) – The responsible party (the person(s) who prepared the subject matter i. e. management) 2. A subject matter As we shall see below, the subject matter of an audit engagement may vary considerably. However, it is likely to fall into one of three categories: – Data (for example, financial statements or business 20 projections)

The key elements of an audit engagement contd……… – Systems or processes (for example, internal control systems or computer systems) – Behavior (for example, social and environmental performance or corporate governance) Assertions : Representations by management, explicit or otherwise, that are embodied in the financial statements, as used by the auditors to consider the different types of potential misstatements that may occur. 21

The key elements of an audit engagement contd……. 3. Suitable criteria Criteria The benchmarks used to evaluate or measure the subject matter including, where relevant, benchmarks for presentation and disclosure. Criteria can be formal or less formal. There can be different criteria for the same subject matter. The person providing the auditing service must have something by which to judge whether the information is reliable and can be trusted. For example, in an audit engagement relating to financial statements, the criteria might be accounting standards, auditing standards etc. 22

The key elements of an audit engagement contd. The practitioner will be able to test whether the financial statements have been put together in accordance with accounting standards, auditing standards. Characteristics of Suitable Criteria : (a) Relevance: Relevant criteria contribute to conclusions that assist decision-making by the intended users. (b) Completeness: Criteria are sufficiently complete when relevant factors that could affect the conclusions in the context of the engagement circumstances are not omitted. 23

The key elements of an audit engagement contd. (c ) Reliability: Reliable criteria allow reasonably consistent evaluation or measurement of the subject matter including, where relevant, presentation and disclosure, when used in similar circumstances by similarly qualified practitioners. (d) Neutrality: Neutral criteria contribute to conclusions that are free from bias. (e) Understandability: Understandable criteria contribute to conclusions that are clear, comprehensive, and not subject to significantly different interpretations. 24

The key elements of an audit engagement contd……. 4. Sufficient appropriate evidence to support the audit opinion The practitioner must confirm the opinion that he draws in order that the user can have confidence that it is reliable. The practitioner must obtain evidence as to whether the criteria have been met. Evidence : Evidence includes all the information contained within the accounting records underlying the financial statements and other information gathered by the auditors, such as confirmations from third parties, observations etc. 25

The key elements of an audit engagement contd…… 5. A written report in appropriate form Lastly, auditors issued an audit report in a written and prescribed form. It is required that audit reports are provided to the intended users in a written form and contain certain specified information. 26

The Distinction Between Accounting and Auditing Accounting is the recording, classifying, and summarizing of economic events for the purpose of providing financial information used in decision making. Auditing is determining whether recorded information properly reflects the economic events that occurred during the accounting period. 27

Difference between Accountants and Auditors • To be an accountant, it is necessary to have accounting knowledge. – Understand business transactions – Know what information to capture – Know controls needed for activity and information – Be able to report it for various purposes – Be able to record it according to accounting standards • To be an auditor, it is also necessary to have accounting knowledge, and must have knowledge about audit processes and financial reporting etc. 28

Difference in Accountants and Auditors contd…. . When accountants’ work finished then auditors work start. 29

ADVANTAGES OF AUDIT – Directors § Assurance that statutory responsibilities concerning accounts have been carried out § Assistance with statutory responsibilities concerning accounts § Availability of expert professional advice § The letter of weakness – To shareholders § Assurance that accounts show a true and fair view and comply with statutory requirements § Assurance that directors have fulfilled their statutory responsibilities for books and accounts, and the safeguarding of assets § Assurance that directors have fulfilled their statutory responsibilities for books of accounts and the safeguarding of assets § Assurance that all directors remuneration has been disclosed – Other organization with published accounts § Assurance to all users of accounts , that the accounts show a true and fair view and comply with statute § Assurance that ‘stewards’ have fulfilled their accounting and financial responsibilities – Private organizations such as partnerships § Assurance that accounts are reliable § Reasonable assurance that all fraud of consequence has been disclosed. 30 – In addition they provide reliable accounts to regulatory bodies such as the

DISADVANTAGES OF AUDIT – The audit involves the client’s staff and management in giving time to providing information to the auditor. Professional auditors should therefore plan their audit carefully to minimize the disruption, which their work will cause. – The audit fee, clearly the services of an auditor must be paid for. It is for this reason that few partnership and even fewer sole trader are likely to have their accounts audited. The accountant’s role as the preparer of financial statements, as tax adviser and general financial adviser, becomes much more important to such concerns. 31

Value of an Audit • To society: capital markets benefit • To owners and prospective owners: remote ownership, complex transactions, investment decisions • To corporate governance, the Board of Directors and audit committee: representing shareholders’ interests • To management – running the company with good information – cost of and access to capital – operating efficiency and effectiveness – credibility of performance indicators – properly accounting for complex transactions • Constituents: society, owners and prospective owners, corporate governance, management • All of these constituents need good information. Even nonpublic companies elect to have audits, although they are not required to do so by any law or regulation. 32

Types of Audits Operational Audit Ø Involves evaluation of any part of an organization’s operating efficiency and effectiveness. Ø Not limited to accounting areas. Compliance Audit Determine whether the auditee has complied with specific procedures, rules, or regulations set by some higher authority. Financial Statement Audit Ø Determine whether overall financial statements are stated in accordance with specified criteria. Ø Generally accepted accounting principles are normally the criteria, although other basis of accounting are at 33 times used.

Operational Audit Example Evaluate computerized payroll system for efficiency and effectiveness Information Number of records processed, cost of the department, and number of errors Established Criteria Company standards for efficiency and effectiveness in payroll department Available Evidence Error reports, payroll records, and payroll processing costs Compliance Audit Example Determine whether bank requirements for loan continuation have been met Information Company records Established Criteria Loan agreement provisions Available Evidence Financial statements and calculations by the auditor 34

Financial Statement Audit Example Information Established Criteria Available Evidence Annual audit of Boeing’s financial statements Boeing's financial statements Generally accepted accounting principles Documents, records, and outside sources of evidence 35

Types of Auditors q External or Independent Auditors – CAs are the only group permitted to provide financial statement audits. Such audits are required of all publicly traded companies. q Internal auditors – Auditors who are employees of the companies. 36

• • • TYPES OF AUDIT Statutory Audit: Carried because the law requires them. Statutes include Companies Act Private audits: Because of desire and not because of law e. g. sole trader and partnership Internal audits: It is the one conducted by an employee of a business into any aspect of its affairs. Management audit: It is an inquiry into efficiency and effectiveness of management Public sector audit: Contract audit , computer audit etc 37

INTERNAL AND EXTERNAL AUDITING It is important to understand recognize the differences and commonalities between internal and external audit. Internal and external auditor should work closely together, in particular to coordinate activity and maximize effectiveness and where appropriate external audit may rely on the work of internal audit. However, there are number of fundamental differences in their objectives, scope and responsibility. 38

INTERNAL AND EXTERNAL AUDITING Internal auditing Objectives External auditing To advise management on whether To provide an opinion on whether the organization has sound systems the financial statements provide a of internal controls to protect the true and fair view organization against loss Legal basis All areas of the organization, operational as well as financial Financial focus Scope All areas of the organization, operational as well as financial Financial focus Approach Increasingly risk base Assess risks Evaluate system of controls Test operation of system Make recommendation for improvements Increasingly risk based Test underlying transactions that form the basis of the financial statements Responsibil To advice and make ity recommendations on the internal 39 To form opinion on whether the financial statements provide a

Prohibited Services to Audit Clients The following services are prohibited to an audit client: 1) bookkeeping and related services 2) design or implementation of financial information systems 3) appraisal or valuation services 4) actuarial services 5) internal audit outsourcing 6) management or human resources services 7) investment or broker/dealer services 8) legal and expert services (unrelated to the audit) Professional service firms may provide client tax services (with some restrictions) and other non-prohibited services to audit clients if the company’s audit committee has approved them in advance. 40

Expectation Gap Expectations gap – meaning that there is a gap between what the assurance provider understands he is doing and what the user of the information believes he is doing. • It can lead to difficulties arising from the difference between what shareholders expect to achieve and what is designed to achieve. • The public increasing expect the following types of questions to be answered: üIs the company a going concern? üIs the company managed effectively? üIs there an adequate system of controls? üIs the company susceptible to fraud? 41

Expectation Gap contd. This is defined as: ‘the gap between society’s expectations of auditors and auditors’ performance as perceived by society. ’ • There are three components of this expectation gap: • – The reasonableness gap between what society expects auditors to achieve and what they can reasonably be expected to accomplish; – The performance gap arising from deficient standards; and – The performance gap arising from deficient performance by auditors. 42

LIMITATION OF AUDIT The limitations of assurance services include: • The fact that testing is used – the auditors do not oversee the process of building the financial • • statements from start to finish. The fact that the accounting systems on which assurance providers may place a degree of reliance also have inherent limitations. The fact that most audit evidence is persuasive rather than conclusive. The fact that assurance providers would not test every item in the subject matter (this would be prohibitively expensive for the responsible party, so a sampling approach is used – see later). The fact that the client's staff members may collude in fraud that can then be deliberately hidden from the auditor or misrepresent matters to them for the same purpose. The fact that assurance provision can be subjective and professional judgments have to be made (for example, about what aspects of the subject matter are the most important, how much evidence to obtain, etc). The fact that assurance providers rely on the responsible party and its staff to provide correct information, which in some cases may be impossible to verify by other means. The fact that some items in the subject matter may be estimates and are therefore uncertain. It is impossible to conclude absolutely that judgmental estimates are correct. The fact that the nature of the assurance report might itself be limiting, as every judgment and conclusion the assurance provider has drawn cannot be included in it. 43

Positive Thinking 44

NONAUDIT SERVICES Other Management Consulting Certain Management Consulting Non-assurance services Accounting and Bookkeeping Tax Services 45