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In carrying outan audit assignment, the auditor should:a Consider his responsibilities as defined in the terms of engagement;b Familiarise himself with the client’s business and organisa
1 AUDIT PL ANNING AND CONTROL PLANNING 1.0 LEARNING OBJECTIVES After studying this chapter, readers should be able to understand: 1.1 ! The general concept of audit strategy ! The Importance of audit strategy as an effective plan for an audit ! Internal control systems, evaluation and assessment ! Audit documentation ! Relationship with experts ! Audit risks and its relative importance to audit ! Components of audit risks ! How to assess audit risks INTRODUCTION Auditing has developed over many years, but it was not until the late nineteenth century (with the formation of joint stock companies, the predecessors to present day limited liability companies) that auditing became widely accepted in the United Kingdom and by extension, in other parts of the world Individual firms of accountants have refined their approach to auditing from time to time and the professional accountancy bodies in various countries have published guidelines to their members on auditing procedures 1.2 CONCEPTS OF AUDIT STRA TEG Y STRATEG TEGY Audit strategy is directed to the gathering of relevant and reliable audit evidence in order to support the expression of an opinion on the accounts In carrying out an audit assignment, the auditor should: (a) Consider his responsibilities as defined in the terms of engagement; (b) Familiarise himself with the client’s business and organisation; (c) Obtain a preliminary understanding of the principal features of the client’s accounting system and internal control procedures; (d) Determine and record the audit strategy to be adopted; (e) Where it is proposed to carry out a detailed evaluation of all or certain internal controls with a view to placing some reliance on such controls, obtain a more detailed description of the accounting system and internal control procedures and review selected transactions to confirm that he has understood and recorded the system properly; ADVANCED AUDIT AND ASSURANCE (f) (g) (h) (i) (j) Review critically and evaluate those aspects of the client’s accounting system, procedures and internal controls on which he intends to place some reliance; Discuss any weakness in the system with the client in order, inter alia, to ascertain whether they are compensated by some other controls; Test the system to determine whether the controls on which he intends to place reliance were operating during the period; Report apparent weakness and breakdown in internal control to the client in a management letter; and Based on the results of the work described above, carry out a programme of audit work to substantiate the amounts appearing in the accounts and related notes so as to ensure that the accounts show a true and fair view of the state of affairs and the results of the business The above paragraph summarises the basic procedures that an auditor should carry out in order to express an opinion on the accounts It should be noted, however, that the procedures and terminology used in practice may vary, even though, the fundamental concept may be the same Furthermore, the extent to which the auditor places reliance on the work of an internal audit department may significantly affect the nature, timing and extent of his work 1.3 DETERMINA TION OF THE AUDIT STRA TEG Y DETERMINATION STRATEG TEGY 1.3.1 Purpose The purpose of determining an audit strategy is to enable the auditor familiarise himself with the client’s business and organisation as well as to obtain a preliminary understanding of the client’s accounting system This will entail the preliminary identification of those internal controls on which he proposes to rely upon The auditor should then determine and record his audit strategy before commencing any detailed audit work In doing so, the auditor will need to identify the optimum balance between, on one hand, relying on internal controls and reducing the level of his substantive tests, and on the other hand, placing little or no reliance on internal controls and seeking audit satisfaction from a higher level of validation procedures The purpose of making this assessment is to enable the auditor to carry out the audit in the most effective and efficient manner Determination of the audit strategy requires a high degree of professional judgement Consequently, the audit assignment should be carried out by an experienced staff, with the involvement of the audit partner In particular, the determination of the audit strategy for a new client will usually require considerably more time and effort than for existing clients, except where the circumstances of existing clients have changed significantly since the last audit However, this does not mean that a AUDIT PLANNING AND CONTROL formal determination of the audit strategy is not necessary for existing clients whose circumstances not change significantly from year to year In all cases, a formal record of the audit strategy is essential The overall strategy should focus on a more efficient and effective audit 1.3.2 Audit Plans and Audit Planning Memorandum In order to ensure a high standard of performance, it is important that the auditor should prepare adequately for his work Planning for an audit, just like every human endeavour, is essential for the smooth performance of the audit work and its successful completion Planning ahead for an audit work will not only guarantee a valid audit opinion but will also help the auditor to ensure that: (a) (b) (c) (d) The audit objective is established and achieved; The audit is properly controlled and adequately directed at all stages; High risk and critical areas of the engagement are not omitted but that adequate attention is focused on these areas; and The work is completed economically and expeditiously, hence, savings on audit resources It is important to distinguish between an audit planning memorandum Audit plan relates to preparations made by the auditor for one specific audit engagement While audit planning memorandum is a standing arrangement made by the auditor for the continuing engagement of a particular client Hence, an audit plan for the audit of one client for one year while audit planning memorandu is a standing plan for the continuing audit of a client from year to year Points for Consideration in Audit Planning Audit planning requires a high degree of discipline on the part of the auditor In order to make the planning more meaningful, the auditor shouldtake into consideration the following matters in relation to the audit engagement: (a) Preliminary Work to be Done in Addition to the Real Audit Work This will include such matters as stocktaking, cash count, debtors’circularisation and review of previous year’s working papers This will remind the auditor of those matters brought forward from the previous year and any other points to be resolved in the current year or problems anticipated (b) Changes in Legislation or any Auditing Standards or Guidelines The promulgation of the Companies and Allied Matters Act, Cap C 20, LFN 2004, brought with it a lot of changes in accounting ADVANCED AUDIT AND ASSURANCE and auditing requirements of companies Such legislations whether in respect of all companies or particular industrial group, must be reviewed ahead of the engagement in order to determine their effects on the operations or reporting requirements of the enterprise (c) Analytical Review of Available Management Accounts and Other Management Information that Relate to the Accounts This will assist in establishing valuable ratios and indicators that will guide the auditor For instance, the computation of the gross profit percentage compared with that of the previous year will provide a good indicator to the auditor of the accuracy and reliability of sales and cost of sales (d) Changes in the Business or Management The appointment of a new Finance Controller and the establishment of a new business line or the creation of a new branch are significant changes in the circumstances of the company which will necessitate changes in the existing audit plans (e) Changes in the Accounting System The introduction of computers such that when a company introduces significant changes in its operating procedures will require a review and evaluation of the system of internal control (f) Deadlines Established for the Submission of Audit Report Where a client has set deadlines for its statutory activities such as the annual general meeting, it is important for the auditor to work in line with such programmes (g) Use of R otational TTesting esting and V erification Rotational Verification In practice, the auditor may not carry out a hundred percent testing or verification of the client’s transactions or segments of the business Where rotational testing or verification is adopted, it will be necessary for the auditor to determine ahead of the date of the engagement which aspects of the business should be selected for testing or verification An example of rotational testing could be applied on the client’s branches to be visited Points for Consideration in Audit Planning Memorandum Audit planning memorandum should cover the following standing matters which are designed to achieve the desired audit objectives: (a) Terms of Engagement In the case of a new audit engagement, a letter of engagement should be prepared as part of the overall plan of the audit Even in subsequent visits,the letter of engagement should be reviewed AUDIT PLANNING AND CONTROL in the light of current circumstances to ensure that all aspects of the work undertaken for the client are covered in the letter especially as they relate to taxation, accountancy, staff development and executive search (b) Audit Risk Areas The auditor should critically review all the areas of high risk in order to ensure that the planned procedures adequately cover such areas and that competent staff have been assigned to these areas High risk areas may relate to the nature of the items, such as cash for a retail establishment with numerous collection points and outdoor disbursement locations Risk may also relate to a high probability of error as in the case of stocks whose quantities are subject to estimation and are susceptible to pilferage The risk may also relate to the structure of the organisation especially in cases of joint ownership of an organisation, where the owners are not equally represented in the management There is therefore the risk of withholding key information from some of the directors (c) Assets and Liabilities These will require detailed plans since they are of continuing relevance to the financial statements of many years and the relevant vouchers may not be readily accessible The plans relating to assets should clearly disclose their history such that current movements may easily be ascertained and adequately verified These will apply mainly to plant and long term loans (d) Presence of Internal Auditor Wherever an internal auditor exists in an organisation, the auditor should develop suitable plans to review the technical competence of the internal auditor, his degree of independence and scope and quality of his work in order to determine the extent of reliance to be placed on his work and to identify the areas of work overlap (e) The Need for Specialists The auditor should determine ahead of his visit those aspects of the work that may require the services of specialists This may be internal or external specialists as relates to stocks, specialist valuation for insurance or computer applications (f) Audit Approach Based on the review of the system of internal control, the auditor should be able to decide on the audit approach to adopt This will be based on the extent of reliance to be placed on the system of internal control ADVANCED AUDIT AND ASSURANCE (g) Timetable A critical aspect of the audit is the timetable The auditor should establish plans to ensure that for each year, the audit is completed within any stated deadline for submission of the report (h) Staffing The auditor should plan for adequate number of staff with the required skill for the audit The training of audit staff is a long term process which will require that even from the initial appointment of the auditor, he should take steps to train suitable staff in sufficient number to handle the audit of the client (i) Fees Based on plans already established in terms of time, staff and materials, the auditor should plan for his fees to cover staff salaries, overhead costs and leave a sufficient margin for the partners’ share of profit and pension scheme The planned fees must be discussed with the client, if not already agreed Understanding the Client’s Business The extent of the knowledge gained of the client’s industry and business organisation greatly facilitates the performance of the engagement staff It is essential therefore that all staff engaged in the audit are encouraged to gain an understanding of the client’s business operations Such understanding, in addition to enhancing the overall audit performance, also facilitates communication with client’s staff and in assessing the reliability of representations from management and making judgement regarding the appropriateness of the accounting policies adopted and their disclosure The auditor may obtain knowledge of the client’s business by: (a) Personal visits to the client’s premises and operating bases and holding discussions with key officials of the company; (b) Reading minutes of meetings and correspondence with the client; (c) Reading internal audit report; (d) Reading previous year’s audit files and permanent audit files; (e) Reading other materials from within the firm, e.g management consultancy reports and feasibility reports; and (f) Reading relevant materials relating to the business e.g trade journals, investment analysis and stockbroker’s report Other significant factors which should be considered by the auditor to determine the audit strategy are as follows: (a) The auditor’s responsibilities in accordance with the terms of the engagement; (b) The nature of the client’s business; (c) The nature and significance of items in the year’s accounts; and AUDIT PLANNING AND CONTROL (d) The principal features of the client’s accounting system and the extent and effectiveness of the related internal accounting controls, which may be gained from a preliminary understanding of the system Consideration of the above factors should enable the auditor determine an appropriate audit strategy which should be set out in writing, in an audit strategy memorandum, which should be approved by the audit partner However, the auditor should recognise that this strategy may, if necessary as a result of changing factors, be reviewed and revised as the audit progresses For existing clients, the auditor should have much of the information he needs to determine his audit strategy in his audit files Nevertheless, he should still discuss with the clients management whether there have been any changes in the company’s circumstances that might affect his audit approach The external auditor is appointed to carry out audit in accordance with specific regulatory or statutory requirements, such as the Companies and Allied Matters Act or in accordance with generally accepted auditing standards within the country concerned In these circumstances, the terms and conditions will not call for any special consideration when determining the audit strategy The auditor should, however, consider whether additional responsibilities arise from request by the client’s management or because the client is required to conform to special regulatory or other requirements 1.4 FAMILIARISA TION WITH THE CLIENT ’S BUSINESS AND ORGANISA TION AMILIARISATION CLIENT’S ORGANISATION The auditor needs reasonable knowledge of both the business of the client and the industry in which the client operates, how and in what places its activities are carried on, in addition to the basic financial information which will be obtained for the audit in order to understand and interpret the financial statements on which he is reporting In order to familiarise himself with the business and organisation of a new client, the auditor would normally: (a) Examine publications emanating from: (i) The client, such as annual reports or interim financial statements; (ii) Others, regarding the client’s industry or business; (b) Have meetings with the client’s management, in order to identify the major types of transactions entered into by the client; and (c) Examine the client’s important internal documents, such as: (i) procedure manuals; (ii) legal documents, i.e memorandum and articles of association, contracts; lease and loan agreements; ADVANCED AUDIT AND ASSURANCE (iii) (iv) (v) minutes of meetings of the Board/AGM (and/or any important Committees thereof); policy statements; and internal management accounts The auditor should also tour the client’s principal places of business, such as plants, factories, shops and offices The auditor of a manufacturing concern, for instance should undertake a tour of the company’s factory in order to familiarise himself with the production process, to see the types of scrap items and the manner of their disposal and the form of the finished products In all other concerns, the auditor should make himself familiar with the market in which the business operates and with its methods of marketing Having adequate knowledge and background of the business will make the auditor to determine whether the system of accounting and internal control disclosed by his detailed review is appropriate for the business and properly records all its transactions Such knowledge will also give the auditor an awareness of the physical realities behind the accounting records and financial statements which he examines and will enable him consider their significance more intelligently The auditor’s task of familiarising himself with the client’s business and organisation will often involve his spending additional time on the first audit of a new client In contrast, the need for him to spend additional time for this purpose on the audit for the second and subsequent years may be fairly limited, as he may only need to have brief meetings with key members of the client’s staff to consider any changes in the client’s circumstances and systems since the previous year However, the importance to the auditor of updating his knowledge and understanding of the client’s system in this way, before carrying out any audit test, cannot be over-emphasised 1.4.1 The Nature and Significance of Items in the Accounts Normally, the most important factor in the determination of the audit strategy will be a review of recent accounts and other available financial information in order to assess the relative significance of items appearing in the balance sheet and the profit and loss account The auditor should obtain information on the nature and approximate volume of transactions, which result in significant account balances The assessment will need to take into account any audit risks identified when analysing the clients business Those account balances, which are considered to be insignificant, can be subjected thereafter to only limited audit procedures AUDIT PLANNING AND CONTROL 1.4.2 Preliminary Understanding of the System In order to evaluate the potential for reliance on internal control in respect of all significant items in the financial statements, the auditor should gain a preliminary understanding of the principal features of the client’s accounting system giving rise to these items, together with the related internal control procedures This involves a consideration of the methods of and control over, processing and the principal accounting records maintained for each significant transaction type This preliminary understanding and evaluation of the potential for reliance on internal control should be documented, normally by way of overview flow charts However, this preliminary evaluation, which is made for the purpose of determining the audit strategy, should be distinguished from the detailed evaluation using the internal control questionnaire Nevertheless, apparent weakness in internal control, which comes to the auditor’s attention in the course of the preliminary evaluation, should be brought to the client’s attention The record of the accounting system prepared for the purpose of determining the audit strategy may need to be supplemented by a more detailed description of the accounting system if the auditor intends to carry out a detailed evaluation of internal controls However, it should, generally, prove adequate for the purpose of planning and performing substantive tests During the course of the auditor’s preliminary review of the accounting system and controls, he should be able to identify those items in the accounts which because of the limited volume of transactions or other factors, can be audited more efficiently through the application of substantive tests rather than reliance on internal controls Examples of such account balances are share capital, long term debts and related interest expense, investments and related income (except when a large portfolio of investments is held) In a similar vein, he may decide to ignore internal controls entirely, either for reasons of efficiency or because the controls are not operating properly, and carry out extended validation for all balance sheet and profit and loss account items The auditor should identify any procedures the client applied to significant items in preparing the financial statements because they will influence the extent of the detailed evaluation of internal controls Examples of such procedures are the counting of stocks, the reconciliation of bank balances and the establishment of provisions against doubtful debts ADVANCED AUDIT AND ASSURANCE 1.4.3 Documentation of the Audit Strategy It will normally be desirable to document the audit strategy in a memorandum, which together with the necessary supporting documentation, should be prepared in the first year of an engagement and revised annually thereafter The auditor can obtain information as to changes that may be required as a result of the experience gained from using the audit strategy adopted in the previous year The auditor may find it helpful to discuss the planned audit strategy with the client, for example, to inform him of a proposed reduction in the extent to which the audit will involve the evaluation of internal control procedures In some cases, the client may wish such an evaluation to take place and the auditor will need to explain that, while he would be glad to comply, it is likely to have the effect of increasing cost The matters set out below are those which will normally be relevant and material in determining the audit approach and which should be addressed by the audit strategy memorandum Other matters will almost certainly be relevant to particular audit clients and will need to be incorporated in the memorandum: (a) Whether the terms of the engagement vary from the requirements of the Companies and Allied Matters Act and approved auditing standards and guidelines; (b) Whether the report and accounts will include any supplementary information, and, if so, whether an audit opinion is to be given on it; (c) Particular risk factors or problem areas; (d) The number of accounting locations and the audit approach in respect of each, that is, whether to be covered by full audit or not to be visited with reasons for the decision Where there are a number of accounting locations, certain elements of the strategy may have to be determined and recorded for each location; (e) Balance sheet amounts and those likely to be: (i) Insignificant; and (ii) Significant (f) Types and volume of transactions that contribute to material balance sheet amounts; (g) Assessment of the potential for reliance on the internal controls over the transactions, in particular, whether the audit of significant items in the balance sheet are to be based: (i) Principally on reliance on internal controls with limited substantive tests; or (ii) Principally or entirely on substantive tests with reasons for the decision (h) The control objectives to be evaluated (specifying whether a computer or manual will be adopted); 10