Paper 2'6 Audit and Internal Review

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Paper 2.6 Audit and Internal Review

• Lecturer Danielle McWall
• Room 3E/15
• Extension 66466
• Email dm.mcwall_at_ulster.ac.uk
• Module Code ACC026J4

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Audit and Internal Review

• AIMS
• To develop knowledge and understanding of the
  audit process and its application in the context
  of the external regulatory framework and for
  business control and development.
• SYLLABUS CONTENT
• Audit framework.
• Internal audit and review.
• Regulation.
• Planning and risk.
• Internal control.
• Other evidence.
• Reporting
• KEY AREAS
• Professional ethics
• Risk assessment
• Role of internal audit
• Internal controls
• Substantive audit evidence

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Audit Internal Review

• The Exam
• 3 hours
• Pass mark 50
• Two Sections
• Section A 3 compulsory questions 60
• Section B 2 from 3 optional questions 40
• 100

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Audit and Internal Review
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Audit and Internal Review
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Audit and Internal Review

• Week 1 - Nature, Purpose Scope of Audit
  Review
• Explain the
• Nature and development of audit and review.
• Concepts of accountability, stewardship and
  agency.
• Concepts of materiality, true and fair and
  reasonable assurance.
• Reporting as a means of communication to
  different stakeholders.
• Need for auditors to communicate with those
  charged with governance.
• Differing levels of assurance from audits,
  reviews and other assignments.
• Also stages of an audit covered this week.

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What is assurance?

• BPP text
• An assurance engagement is essentially an
• Impartial
• Knowledgeable
• Scrutiny, and
• Review.
• See Laine and Glyn case study Page 4.

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What is assurance?

• An assurance engagement is one in which a
  practitioner expresses a conclusion designed to
  enhance the degree of confidence of the intended
  users other than the responsible party about the
  outcome of the evaluation or measurement of a
  subject matter against criteria.
• BPP page 7 (IFAE definition)

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What is an audit?

• Verification of data or processes in order to
  provide assurance on their accuracy or
  effectiveness of operation
• There are 2 types of audit
• External
• Internal

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Historical background

• Records of auditing activity in early Babylonian
  times (c.3,000 BC).
• Ancient China, Greece and Rome
• The Latin meaning of the word 'auditor' was a
  'hearer or listener' because in Rome auditors
  heard taxpayers.
• Modern auditing dates to beginning of the modern
  corporation.
• Modern meanings for audit are
• Review
• Check
• Inspection
• Examination
• Assessment
• Appraisal
• Stocktaking

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Brief History of Audit

• The attitude of profit maximization from end
  middle ages - merchant houses in Italy.
• Double-entry bookkeeping was first described in
  Italy (Pacioli 1496).
• Industrial Revolution Great-Britain 1780 lead to
  the emergence of large industrial companies.
• 1853 the Society of Accountants in Edinburgh was
  founded.

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Demand for audit services explained by several
different theories

• The Policeman Theory
• The Lending Credibility Theory
• The Theory of Inspired Confidence
• Agency Theory Key concept!

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The Lending Credibility Theory

• Is the company a going concern?
• Is it free of fraud?
• Is it managed properly?
• Is there integrity in its database?
• Do directors have proper and adequate information
  to make decisions?
• Are there adequate controls?
• What effect does the company's products and
  by-products have on the environment?
• Can an unfortunate mistake bring this company
  to its knees?

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The Agency Relationship

• The agency relationship exists
• Between the owner/shareholder and the manager.
• In large companies owners are separate from
  managers.
• This in turn produces a natural conflict of
  interests because of information asymmetry.
• Information asymmetry generally means the manager
  has more information than the owner about the
  true state of the finances of the business.

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The Agency Relationship

• In general
• If both parties seek to maximise self interest.
• It is likely the manager will not act in the best
  interest of the absentee owner.
• For example, the manager may manipulate the
  reported earnings in order to earn a larger bonus.

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The Agency Relationship

• Hence the owner will wish to protect against the
  possibility of manager self interest by invoking
  the function of the audit ie getting assurance!!
• ie In order for owners to believe management
  reports they may wish to have them independently
  verified ie audited!

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The Agency Relationship

• In summary
• Directors act as stewards of the shareholders
  investments and as such they are agents of the
  shareholders and are accountable to the
  shareholders as owners of the company.

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Purpose of an external audit
Auditor
Financial Statements
Shareholders
Directors
Company
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The Companies Acts 1948-1989

• Requires auditors to
• Express an opinion on the truth and fairness of
  the Profit and loss account and the balance Sheet
• 1948 Act consolidated and updated by the 1985 and
  1989 Acts.
• This is known as a statutory audit as it is
  required by law.
• Limits set re turnover, net assets and employee
  numbers.

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The Companies Acts 1948-1989

• Requires directors to
• Produce annual financial statements which give a
  true and fair view of the affairs of the company
  and its profit or loss for the period.
• Communicate with shareholders on issues such as
  directors remuneration, going concern and risk
  management.

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The small company audit

• Why do small companies need an Audit?
• Reassures shareholder that financial statements
  prepared by directors are true and fair.
• BUT two parties may be same.
• Relax regulations?
• E.g. UK audit exempt if
• Revenue lt 5.6m
• Assets less liabilities lt 2.8m
• See separate handout

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Objectives of an Audit

• Today the APB define an audit as an exercise, the
  objective of which is to
• Enable auditors to express an opinion whether the
  financial statements
• Give a true and fair view of
• The entitys affairs at the period end, and of
• Its profit and loss for the period then ended.
• And have been properly prepared in accordance
  with the applicable reporting framework.

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Objectives of an Audit

• According to ISA 200 Objective and General
  Principles Governing and Audit of Financial
  Statements state that the objective of an audit
  is to
• Enable the auditor to express an opinion whether
  the financial statements are prepared, in all
  material respects, in accordance with the
  applicable reporting framework.
• Equivalent phrases
• give a true and fair view
• present fairly in all material respects

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Benefits of an Audit

• Gives credibility to financial statements and
  financial information
• Users of this information (stakeholders)
• Shareholders
• Banks other lending institutions
• Trade creditors
• Tax authorities
• Employees
• Management
• Society as a whole

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Benefits of an Audit

• Inherent advantages
• In settling disputes between management.
• Facilitate major changes in ownership.
• To enhance applications to third parties for
  finance.
• To allow the auditor to give constructive advice
  to management.
• Detection of fraud and error???
• Disadvantages??

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Non-statutory audit

• Used by small limited companies and other
  entities e.g. clubs, charities, sole traders and
  partnerships.
• Auditors need to take into consideration the
  regulations surrounding these entities e.g. their
  governing documents i.e. partnership agreements,
  constitutions, trust deeds etc.
• As well as the benefits of audit whether
  statutory or non-statutory the non-statutory
  audit has the following benefits
• Settling accounts
• Tax authority acceptance of accounts
• Sale of business or loan negotiation
• Helps the sleeping partner if there is one.

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Types of engagement

• Financial statement audits statutory and
  non-statutory.
• Internal audit
• Review engagement
• Agreed-upon procedures
• Compilation

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Internal Audit

• An independent appraisal activity established by
  management for the review of the accounting and
  internal control system.

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Difference between External and Internal Audit

• Internal auditors are employed as part of the
  organisations system of controls and their
  responsibilities are determined by management and
  may be wide-ranging. They are different from
  external auditors in the following areas
• Objectives
• Legal basis
• Scope
• Approach
• Responsibility

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Accounting v- Auditing

• Accounting
• Creative
• Involved
• Not necessarily qualified.

• Auditing
• Critical
• Unbiased
• Has to be qualified a qualified accountant and
  recognised by one of the RSBs.

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Review Engagement

• Auditor provides
• A moderate level of assurance
• Not as high a level of assurance as an audit
• Less detailed procedures and testing
• Information provided is subject to review

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Internal Review

• Internal review assignments include
• Operational reviews
• Systems reviews
• VFM reviews
• Financial reviews
• Reviews may be done by internal auditors or by an
  external consulting/audit firm

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Agreed Upon Procedures

• The auditor simply provides
• A report of the factual finding
• No level assurance is expressed
• Users assess for themselves
• Drawing their own conclusions

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Compilation engagements

• The accountant rather than the auditor
• Use accounting expertise to
• Collect
• Classify and
• Summarise financial information
• Again the users must derive their own conclusions
  from the summaries produced.

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Assurance and Reports

• Opinion on Truth and Fairness
• What is true
• What is fair

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Truth in accounting terms

• Truth in accounting terms is quite different form
  scientific truth (ie it is not a guarantee of
  absolute accuracy).
• Information is factual and conforms with reality
  not false.
• Conforms with required standards and law.
• Accounts have been correctly extracted from the
  books and records.
• The word fair can have the following meanings.
• Clear , distinct and plain.
• Impartial, just and equitable.
• Free from discrimination and bias.
• Auditor provides reasonable assurance on truth
  and fairness of the financial statements
• Not a guarantee!
• Not absolute assurance!
• True and fair within a reasonable margin of error
  materiality.

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Attempts at definition

• Lee has attempted to define true and fair as
• .true and fair has become a term of art. It is
  generally understood to mean a 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 from wilful bias, distortion,
  manipulation or concealment of material facts
• Taken from Foulks Lynch Study Text

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Materiality

• Concept fundamental to the presentation and
  classification of data in accounts!
• ISA 320 Audit Materiality
• Materiality linked with audit risk
• A matter is material if its omission or
  misstatement would reasonably influence the
  decisions of an addressee of the auditors report.

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Levels of Assurance

• Audit engagement reasonable assurance
• Review engagement negative assurance
• Negative assurance nothing has come to light

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Levels of Assurance
Positive opinions Subject matter conforms in all
material respects with identified criteria
Negative opinions Nothing has come to the
auditors attention that causes him to believe
NOT free from material misstatement
No opinion E.g. Compilations
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Stages of an audit

• Plan the audit
• Ascertain the systems
• Record the systems
• Evaluate the systems
• Test the systems
• Review the FSs
• Express an opinion

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Plan the audit
Understand entity
Assess risk of material misstatement
Respond to risk
Expect effective controls
Expect ineffective controls
Unsatisfactory
Tests of controls
Report to management
Satisfactory
Full substantivetests
Restricted substantive tests
Overall review of F/S
Report to management
Auditors report
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Audit and Internal Review

• Week 1 - Nature, Purpose Scope of Audit
  Review
• Explain the
• Nature and development of audit and review.
• Concepts of accountability, stewardship and
  agency.
• Concepts of materiality, true and fair and
  reasonable assurance.
• Reporting as a means of communication to
  different stakeholders.
• Need for auditors to communicate with those
  charged with governance.
• Differing levels of assurance from audits,
  reviews and other assignments.
• Also stages of an audit covered this week.