REVISION NOTES: AUDIT OBJECTIVES

AUDITING AND INVESTIGATIONS

The primary objective of an audit is to express an opinion of the fairness of the presentation in the financial statements. However, auditors also have secondary objectives are as follows: to ascertain compliance with legal & regulatory requirements to assess the adequacy and reliability of books of account and records to detect errors and fraud and recommend measures for prevention. to advise management on the adequacy and effectiveness of internal controls

Role of auditors in detecting and preventing frauds - auditors are expected to plan the audit such that they can detect material misstatements in the financial statements resulting from irregularities and fraud. - this depends on the type of organization and different interested parties e.g. in a financial institution, risks are high. - auditors are not only responsible for frauds, but also illegal acts e.g. money laundering - NB: its the primary responsibility of directors to detect and prevent fraud and safeguard assets of the organization by designing and implementing adequate internal controls. MANAGEMENT AUDIT A management audit is normally conducted so as to: ascertain the appropriateness of the decision making process of the top management ascertain attitudes of management towards the Internal Control System evaluate personal relations with employees

evaluate managements ability to manage an efficient and viable company.

Advantages of Management Audits a) improves the quality of the top management in particular from the public point of view, efficient management of resources, achievement of budgeted goals, and effective management of time. b) minimizes bureaucracy in a company which will lead to efficient operations achieved through proper planning, faster implementation of policies and proper personnel management policies. c) reveals weakness in Internal Control Systems which is due to management failure to sustain strong controls and this will boost managerial supervision and motivation. d) reveals the management's weakness to operate a viable company e.g. failure in credit control policies, financial controls all of which need to be reorganized to ensure a viable company. e) does not disrupt the clients work as it deals with human attributes for organization, controlling and directing of human and material resources of the company so as to enable it achieve its objectives. f) Increases the company's ability to operate profitably and attract debt finance or other finances, increase company share prices and shareholders return as a result of good and appropriate policies DUTIES OF AUDITOR Generally, an auditor, generally, has two main duties: (a) to audit accounts of the company (b) to report to the members on the accounts Article 130 of Table A of the Companies Act states that the duties of an auditor shall be as laid down in sections 159 to 162 of the Companies Act as follows: - They must acquaint themselves with their duties as laid down in the Articles of Association of the company being audited and also with the Companies Act.

- They must report to the members on the accounts laid before the company in a general meeting, during their tenure of office. The report must contain statements as to the matters contained in the Seventh Schedule. - They must be honest and exercise reasonable skill and care while carrying out their responsibilities as auditors. - They must carry out investigations to determine if proper accounting records have been kept and proper returns from branches (at least branches not visited by the auditor) have been received

QUALITIES OF AN AUDTOR General Good Communication Diplomacy Perseverance Knowledge and Endurance Professional 1. Integrity 2. Independence 3. Objectivity 4. logical ability 5. tactfulness There are many qualities which an auditor should have. First of all he must be well versed in the fundamental principles and theory of all branches of accounting that is general accounting and cost accounting. He should possess a sound knowledge of the techniques of audit and be conversant with the decided legal cases in the field of theory and practice of auditing. This store of knowledge must be constantly replenished and kept up to data.

He must possess a sound working knowledge of taxation laws of his country. He should be quite familiar with the company and mercantile laws. He should have a thorough training in business organization, management and finance. He should have an understanding of the general principles of economics and business statistics. The word integrity implies complete honesty together with strength of mind. Integrity and keeping its flag flying up should be kept by an auditor as a guiding inflexible rule. He must be tactful and scrupulously honest. He must possess qualities of withstanding and resisting the influence in the course of discharge of his duties. He should not disclose the secrets of his clients. He should never compromise his principles without being rigid in his attitude. He must be competent with his work he must be discipline an auditor must have a life of integrity he must be have a God fearing spirit in him An auditor should be independence he should be able to provide an evidence

ADVANTAGES OF AN AUDIT Advantages an organization is likely to realize by having its books of accounts and records audited regularly by a qualified auditor: ADVANTAGES TO BUSINESS Advantages of audit for the business are: 1. Satisfaction of Owner It is because of audit that the owner will be satisfied about the business operations and working of its various departments. 2. Detection and Prevention of Errors The errors whether committed innocently or deliberately are discovered by the process of audit and its presence prevents their occurrence in the future. No one will try to commit an error or fraud as the accounts are subject to audit and hence they will have a fear of being detected.

3. Verification of Books Another advantage of audit is the verification. of the books of accounts, which helps in maintaining the records up to date at all times. 4. Independent Opinion Auditing is very useful in obtaining the independent opinion of the auditor about business condition. If the accounts are audited by an independent auditor, the report of the auditor will be true and fair in all respects and it will be of extreme importance for the management of the company. 5. Detection and Prevention of Frauds Just like errors, frauds are discovered by audit and its presence minimizes future possibility if not eliminated totally. 6. Moral Check The process of audit will establish a check on the minds of the staff working in the business and they will not be able to commit any irregularity, as they will have a fear and will also be aware that the accounts will be examined in the near future and that action would be taken against them if any irregularity is discovered. Thus the audit prevents the happening of any irregularity before it starts and the staff hence becomes more active and responsible. The fear of their getting caught act as a moral check on the staff of the company. 7. Protection of the Rights and Interests of Shareholders Audit helps in protecting the interests of shareholders in case of joint stock company. Audit gives assurance to the shareholders that the accounts of the company are being maintained properly and their interest will not suffer under any circumstances. 8. Reliance by Outsiders Outsiders like creditors, debenture holders and banks etc. will rely on the business accounts if they are audited by an independent authority (external auditor). 9. Loan Facility Money can be borrowed easily on the basis of audited balance sheet from financial institutions. If accounts are audited the true picture will be visible to banks and it will be easy for them to issue loans as early as possible. 10. Easy Valuation

It becomes easier to evaluate property etc. if the accounts are audited when the business is disposed off and as a result no dispute whatsoever will arise. 11. Upto Date Record Due to the fear of audit the work of accounting always remains upto date and correct in all respects. 12. Reliance by Partners If a new partner is to be inducted in the business, the audited balance sheet will be a good base to estimate the value of good will. Moreover, the audited accounts of a company by an independent person will minimize the chances of misunderstanding among the partners. 13. Reliance by Shareholders In case of joint stock company, the shareholders have no hand in the actual running of the business because the management was in the hands of the directors. So the shareholders are assured in the presence of the process of audit that the directors have not taken any undue advantage of their status and position. ADVANTAGES TO THE PUBLIC Advantages of audit for the public are given below: 1.Safety from Exploitation The interest of the public and shareholders is safe and guaranteed in the presence of audit. Otherwise they may have been exploited by the management. This is the main reason for which the audit has been made mandatory for public limited companies. 2. Facility for Prospective Investor The prospective investor can easily analyze the position of the company gaining through the audited financial statements of the company and can make the decision to invest or not in the company. 3. Satisfaction about Business Operations In the presence of audit, the public in general and the owner of the business in particular receive the reliable statement of accounts, indicating the true financial position of the concern and they can collect result from it and feel satisfaction about it in every respect. ADVANTAGES TO THE STATE

Advantages of audit to the state are as under: 1. Privatization of Industries If the nationalized industries are running in losses, the government may denationalize them after going through the audited accounts of such industries. 2. Easy Assessment of Tax In the presence of audited accounts the assessment of tax becomes very easy because the tax is imposed on the basis of audited accounts. 3. Quick Recovery of Taxes As the assessment orders can easily be made it will lead to early recovery of taxes. 4. Leading to Economic Progress The joint stock companies play a vital role in giving a boost to the economic progress of a country. The successful operation of the companies would have not been possible without the presence of audit. So we can easily say that presence of audit leads to economic progress of the country.

USERS OF AUDITED FINANCIAL STATEMENTS Users of audited financial statements and their interests in such statements: OWNERS e.g. shareholders expect a return on viable performance of business activities LENDERS e.g. financial institutions, creditors, who offer credit and loans on the ability to repay GOVERNMENT e.g. Kenya revenue Authority rely on credible and sufficient financial data EMPLOYEES e.g. trade union leaders base their demand for more pay on profit levels. INVESTORS e.g. potential investors would like to put their money in profitable activities

Prospective financial information

- forecasts are of significance interest to users of financial statements - this is an area in which the auditors can therefore provide an alternative service to audit, in the form of a review or assurance engagement - prospective financial information is difficult to give assurance about because it is subjective. It is impossible to give the same level of assurance about PFI as it is on HFI but negative assurance may be given Assurance Engagement One in which the practitioner expresses 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 the subject matter against criteria. There are two general types of assurance engagement: a. assertion based: auditor declares that a given assertion is correct or not. b. direct reporting: reporting issues that have come to his attention during the/his evaluation. - a Prospective Financial Information is information that is based on assumptions about events that may occur in the future and possible actions by the entity NB: - the auditor should not accept an engagement, or should withdraw from an engagement, when the assumptions are clearly unrealistic or when the auditor believes that the prospective financial information will be inappropriate for its intended use. Procedures: - in carrying out their review, the general matters to which attention should be directed are: the nature and background of the companys business the accounting policies normally followed by the company

 the assumptions on which the forecast is based the procedures followed by the company in preparing the forecast Actual PFI procedures could include: analytical review (against similar historic projects) verification of projected expenditure to quotes or estimates - the following specific matters in the form of procedures are considered relevant when assessing prospective financial information:1. Profit forecasts:verify projected income figures to suitable evidence. This may involve: comparison of the basis of projected income to similar existing projects of the firm review of current market prices for that product or service i.e. what competitors in the market charge successfully - verify projected expenditure figures to suitable evidence. There is likely to be more evidence available about expenditure in the form of: quotations or estimates provided to the firm current bills for things such as services which can be used to reliably estimate market prices, e.g. for advertising interest rate assumptions can be compared to the banks current rates costs such as depreciation should correspond with relevant capital expenditure projections 2. Capital expenditure

- the auditor should check the capital expenditure for reasonableness e.g if the projection relates to buying land and developing it, it should include a sum for land projected costs should be verified to estimates and quotations where possible the projections can be reviewed for reasonableness, including a comparison prevailing market rates where such information is available e.g. for property

3. Cash forecasts the auditors should review cash forecasts to ensure the timings involved are reasonable e.g. it is not reasonable to say the building will be bought on day1, as property transactions usually take longer than that. the auditor should check the cash forecast for consistency with the profit forecasts (income/expenditure should be the same, just at different times) if there is no comparable profit forecast, the income and expenditure items should be verified as they would have been on a profit forecast. Expressing an opinion on PFI - it is suggested that auditors express an opinion including:o a statement of negative assurance that as to whether the assumptions provide a reasonable basis for the PFI o an opinion as to whether the PFI is properly prepared on the basis of the assumptions and the relevant reporting framework o appropriate caveats as to the achievability of the forecasts. Chronology of an Audit:

1. determine audit Approach: carry out the risk assessment procedures. 2. ascertain the systems and controls: i.e. flow of documents, extent of controls, record the systems in operation and check what they should be doing (client) instead of what is actually done. 3. assess the systems and internal controls: i.e. evaluate the system to gauge reliability and test effectiveness. 4. Test the system and internal controls: i.e. carry out tests of control to determine their effectiveness and report to management any other matters arising. 5. Test the financial statements: i.e. substantiate the figures in the final accounts to determine any significant errors or omissions. 6. Review the financial statements: i.e. critical analysis of content and presentation. 7. Express an opinion: i.e. report to management, shareholders and other stakeholders and make suggestions for improvement to place on record specific points.

Fundamental Principles and Professional Guidance 1. Public interest: key reason why auditors need code of ethics is because people rely on them and their expertise. 2. Fundamental Principles: (a) Integrity: straightforwardness and honesty. (b) Objectivity: no bias, conflict of interest or undue influence on others. (c) Competence and due professional care: should act diligently, skillfully and be up date on professional matters (d) Confidentiality: not to disclose information without proper or specific authority, unless there is a legal or professional right or duty to disclose. (e) Professional behaviour :comply with relevant laws and regulations to avoid actions that discredit the profession. 3. Ethical Framework prevents auditors from narrowly interpreting legalistic requirements. Instead observing a set of rules.

Independence - identify threats to independence TEN audit risks likely to be found in planning an audit modern audit firms are increasingly adopting a risk based audit approach. Audits are divided into normal and high risk audits. Individual audits are divided into normal high risk areas and high risk areas. Normal risk areas: these emphasize on key controls and analytical review. High risk areas: most audits are based on such areas Identifying high risk areas is a vital skill in auditing. Factors affecting audit risk predictability of error occurring materiality of an audit previous experience discussions with internal audit staff usage of cash and other instruments assessment of managerial competence internal control efficiency and effectiveness possibility of collusion by staff results of ratio analysis budget variances

Additional audit services that may impair independence 1. Taxation:- it is routine for auditors to verify the companys tax liability and also enter into correspondence with tax authorities Conflict if interest may arise where there is a dispute between the company and its directors. Auditors would be advised to consider relinquishing either their audit role or tax advisory role 2. Accounts preparation:-

This gives the auditor a good opportunity to understand the clients performance and also foresee possible audit problems There is risk that the auditors independence will be threatened because the auditor will find it difficult to detach himself I carrying out audit of accounts they have prepared 3. Advise to directors:Auditors will quite often obtain knowledge of the company while giving advise of all kinds. There is risk that auditors independence will be compromised if the advise turns out to be a mistake. E.g. auditors may prepare optimistic profit forecast for the client for purposes of obtaining credit, and which is eventually rejected. The auditor might find it difficult to reflect the actual results in the year end accounts. 4. Attending meetings of board of directors:it is normal for auditors to attend board meetings, especially where matters affecting them as auditors are being discussed, and in the process may influence decisions made. There is risk of independence being compromised by being closely involved in the running of the company (refer to Companies Act definition of a director). It would be advisable for the auditor to attend board meetings only at which annual accounts are being approved by the directors.

Auditors professional and social responsibilities Social responsibilities Professional auditors have the social responsibility provide independent verification of company reports for the public good. The code of professional

ethics, however, assumes that all auditors have the ethical ability to deal with moral crises. The auditors societal role arises from the need for expert and independent examination and the need for an expert and independent opinion based on that examination. The function is rooted in the confidence that society places in the effectiveness of the audit and in the opinion of the auditor. This confidence is therefore a condition for the existence of that function; if the confidence is betrayed, the function, too, is destroyed since it becomes useless. Professional responsibilities Auditors are bound by the Code of Professional Conduct which requires that they provide professional services with competency. In carrying out their responsibilities as professionals, auditors should exercise sensitive professional and moral judgments in all their activities. In the delivery of their services, auditors shall adhere to the following Principles of Professional Conduct:The Public Interest Members should accept the obligation to act in a way that will serve the public interest, honor the public trust and demonstrate commitment to professionalism. Integrity To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity. Objectivity and Independence A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. Due Care A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability.

Conditions suitable for statistical sampling Researchers rarely survey the entire population because the cost of a census is too high. The three main advantages of sampling are that the cost is lower, data collection is faster, and since the data set is smaller it is possible to ensure homogeneity and to improve the accuracy and quality of the data. What are related party transaction and how to ensure they are undetectable during audits? - transactions where one party has ability to exercise significant influence over the policies and decision making of the other party e.g. parent, subsidiary and associated company directors and senior management trusts, pension funds and company they control - Transaction entered not at arms length e.g. loans made to companys directors owned by directors of a quoted company and money advanced to directors to buy the shares. - Chairman of a public company owned a majority interest in an advertising agency that handled all company adverts. - A public company guaranteed an overdraft of a company owned by a major shareholder who is also a director. Presentation: Identify the related parties Seek out transactions with related parties Enquire of management Review minutes of director

Procedures in an audit investigation Obtain written instructions from client (TOR) Communicate with auditors who previously did the work i.e. observe professional etiquette to obtain cooperation Organize the investigation i.e. programme, any setting aims, time, cost and appropriateness of staff

 Obtain background and preliminary information about subject matter i.e. history, prospects, etc Investigation proper: Aim of the assignment Redraft accounts with exclusions and inclusions Seek corroborative evidence Use questionnaires

Draft the report Verbally discuss the report with client Submit report Follow up and feedback

Forms of final report (in an audit investigation) Reference to instructions (agreed between client and investigator) A summary of instructions Statement of the precise instructions (what the clients wants) Statement of documents used An outline of the wok actually done A summary of information obtained Further information which may be of use to the client but which may not flow from the investigation proper viii. Recommendations to the client (these should not be leading statements, but adequate for the client to form own judgment) Types of audit investigations - an audit investigation is an enquiry into something or somebody, commissioned by a client for some specific purpose - auditors are trained in investigative techniques and are known to be independent and being people of high integrity - although an investigation is not part of their statutory work, they can perform such tasks. o Interest acquisition: i. ii. iii. iv. v. vi. vii.

Whether to buy or not to buy If he is to buy, at what price and for what consideration? Obtain written instructions (TOR) Obtain background information from the company, client, accountants, or auditors Examine and redraft the accounts for the year ( usually various accounting policies) Establish the reality of the accounts Consider commercial considerations upon change of ownership Evaluate future prospects Miscellaneous matters e.g. reasons for sale

o Fraud and errors: This depends on the instructions given. The particular problems are:- the past period that need to be investigated e.g. a few days or 20 years - scope of investigation e.g. investigating the work of a specific person or the work or the whole department or company - the questioning of individuals:- this may be difficult and should include: the person being interrogated should have a colleague present the questioning should be privately conducted if necessary, judicial or judges procedures should be observed NB: - Indications of Fraud missing documents or vouchers evidence of falsified documents unsatisfactory explanations evidence of disputes unexplained items on suspense account or reconciliations evidence of weak internal control systems evidence of unduly lavish life styles of officers and employees failure of figures to agree with expectations produced fro analytical review

NB: - fraud and errors should only be investigated if they are material. o Back Duty: - this is the investigation into unpaid or under declaration of taxes due under statement of income Procedures and issues to note: The past period to be covered The apparent cash available for living compared with taxpayers actual standards of living The accumulation of capital compared with compared with the known sources of such capital Existence of other sources of capital and income must be investigated The result of the investigation may expose other sources of income

Management audit:- this is an enquiry into the appropriateness of policies of directors in pursuing the objectives of the company as stated in its memorandum and articles of association; the execution of such policies in terms of efficiency. - whether or not the shareholders interests have been carried out in all respects - whether or not the company is well managed e.g. The directors may be negligent The directors may exercise bad judgment The directors may be incompetent The directors may concentrate on short term success at the expense of long term failure

Areas normally subjected to an investigation:- objectives of the company - relationship with the public and third parties

relationship with the shareholders, creditors, etc relationship with the unions and employees morale within the organization financial ratios compared with previous years flow of information modern management techniques use of specialists social audits / environmental audits wastage, extravagance and restrictive practices corruption and undesirable trade practices NB:- before taking an investigative assignment, an accountant should ensure 1. he is competent to execute 2. his office organization can take on the extra work load 3. his professional indemnity insurance covers the assignment

Special problems of audit of small companies Unreliable internal control system Dominance by one manager/staff means no control over his actions Error and fraud occur frequently due to lack of controls. Full books of accounts not usually kept Completeness of recording is usually difficult Temptations by the manager/owner to manipulate financial statements Components of evidential matter according to KAS on audit evidence - evidential matter would refer to records, representations and any information gathered from the business, management, staff and third parties, in connection with the audit - if evidential matter is relevant to audit objectives and is reliable to any extent, it becomes audit evidence. Components according to KAS

Quality Control (audit should be a quality product) o audit work must be controlled o audit work must be subject to reviews o reviews are carried out by a variety of categories of persons from inside/outside the firm o Peer review: this is a review of a firms complete setup by another firm o Independent review by persons not known to the firm with detailed knowledge of an audit can lead to discovery that: i. Firms procedures are not always followed ii. There are gaps in the procedures iii. There are technical matters of general interest which need investigation iv. Staff and partners are over worked v. Deadlines are too tight vi. There are deficiencies in the quality of staff or in their training o Quality control can be seen in several stages: i. ii. iii. iv. v. vi. Proper organization of the firm and its procedures Planning for each audit Control for each audit Working papers Review of audit work Review of organization and procedures

NB: always distinguish between procedures aimed at ensuring that the firm provides high standard service AND procedures aimed at ensuring that each individual engagement is properly carried out. Verification of Assets (coded as CAVEBOP) - the following aspects of each asset and liability must be ascertained:o o o o ( C) cost ( A ) authorization ( V ) value ( E ) existence

o ( B O ) ownership (beneficial ownership) o ( P ) presentation in the accounts Verification procedures for assets Schedule of each asset Cost verification Register of assets Internal control Physical inspection Title deeds, log books, etc (and other documents of legal entitlement) SSAPs Classification Representation letters External confirmation Authorization to transactions Minutes and correspondence Security for obligations Capital or revenue items Other than Balance Sheet date items (post balance sheets events) Materiality Put upon enquiry Insurance Lessening in value i.e. depreciation or/and impairment Events after balance sheet date Disposals Compliance with Companies Act Assets held by others Auxiliary evidence Revaluation Taxation Compliance with KAG Proper accounting records

Verification of Liabilities o Verify existence, amount, adequate of disclosure of liabilities

o o o o o

Adequacy of provisions and reserves Confirmation from legal advisors on pending legal matters Distinguish between provisions and reserves Distinguish between contingencies and post balance sheet events letters of representation may be acceptable evidence of inclusion in the balance sheet

Verification procedures for liabilities Schedule or classes of each liability Cutoff procedures Reasonableness Internal control Previous date clearance Terms and conditions Authority Description Documents Security Vouching Accounting policies Letter of representation Disclosure requirements External verification Materiality Post balance sheet events

Audit of stocks and Work-in-Progress - the audit for stocks and WIP is best considered in relation to audit work necessary before, during and after the stocktaking., as follows: Before stocktaking:- the auditor will need to: study the clients stocktaking procedures and instructions

 evaluate clients procedures and instructions for adequacy in the prevailing circumstances the factors to be considered to determine adequacy of procedures and instructions include locations at which stocks are held, the stock quantities and values, and possibility of obsolete or slow moving stocks. During stocktaking:- at this stage, the auditor will be concerned with: ascertaining whether or not the employees involved in stocktaking are complying with the procedures and instructions selecting sample stock items for counting and recounting and to trace such items through stock records and make necessary notes details of stock items noted by auditors as being obviously defective, damaged or slow-moving. instances of where clients stocktaking procedures and instructions were not carried out. After stocktaking:- information obtained during the exercise should be followed up when finally reviewing the amounts at which the stock is stated in the accounts, by carrying out: a check of the cut-off using details of stock movements and the last number of goods inwards and outwards notes by tracing treatment of GRNs received immediately before and after year end to ensure correctness of the inclusion / exclusion from stocks and creditors and also for sales invoices checked for proper treatment of stocks and debtors.

Accounting for Research and Development expenditure (audit procedures) - all research costs (pure and applied) should be written off, while development expenditure or costs, may be capitalized. - Conditions for capitalization of development costs are:a. b. c. d. e. Clearly defined project for which costs relate Expenditure relating to the project is separately identifiable Success of the project is reasonable certain Expected future revenues are greater than costs If development is not complete, there are sufficient funds to finance the further development work required

- fixed assets of R&D department may be capitalized with a view to being written off over their useful life Post balance Sheet Events (audit procedures) - whether an item is treated as adjusting or non adjusting event would largely depend on whether or not there was any evidence to that effect during the year. - Management should ensure that all events after balance sheet date are identified, considered and properly evaluated as to their effect on the financial statements e.g. known risk areas and contingencies, minutes of shareholders, directors and correspondence, relevant information which has come to the auditors attention from outside sources e.g. public knowledge of competitors, suppliers and customers. Audit controls for a new computer program 1. supervision over programming and testing of programs 2. individual testing of programs testing of module programs prior to testing as a system 3. dummy testing of the system using dummy data 4. authorization for each department users 5. testing by users this is the final stage of testing

Role of auditors in detecting and preventing frauds - auditors are expected to plan the audit such that they can detect material misstatements in the financial statements resulting from irregularities and fraud. - This depends on the type of organization and different interested parties e.g. in a financial institution, risks are high - Auditors are not only responsible for frauds, but also illegal acts e.g. money laundering - NB: its the primary responsibility of directors to detect and prevent fraud and also their responsibility to safeguard assets of the organization by designing and implementing adequate internal controls. Indicators of failure or pending failure as a going concern failure to generate sufficient profits reduction in liquidity loss of important customers shortage of raw materials extended credit by customers over trading i.e. rapidly increasing sales, hence more money tied in stocks and debtors or buying more plant and equipment due to increased demand, hence draining liquid funds and consequently being unable to settle current liabilities redemption of loan capital at a time when the firm is unable to finance from own sources adverse movements in exchange rates reduction in R*D expenditure changes in policy that indicate difficulties in raising funds e.g. leasing instead of buying fixed assets NB: general indicators of a liquidity crisis

Distinction between Exceptional and Extra Ordinary items

Exceptional items: - consists of items of unusual size or unusual incidence derived from ordinary activities of business e.g. redundancy or reorganization costs Extraordinary items: - consists of items outside normal business activities e.g. discontinuance of a business segment through disposal or termination NB:- both depend on circumstances. Quality control for audit work (policies and procedures for the firm) Audit firm: - personnel in the firm to adhere to statements of professional ethics i.e. principles of independence, objectivity, integrity, confidentiality and professional behaviour - firm to be staffed with skills and competence through attainment and maintenance of technical standards and professional competence - prospective and existing clients evaluated and reviewed on an ongoing basis. Evaluate clients upon the occurrence of specified events to determine whether the relationship ought to be continued - establish qualifications and guidelines for evaluating potential hirees at each professional level - inform applicants and new personnel of firms policies and procedures relevant to them - avail to personnel information about current developments in professional and technical standards - provide programmes to fill the firms need for expertise personnel in specialized audit areas and industries - establish qualifications deemed necessary for the various levels of responsibility within the firm - evaluate personnel and advise them of their progress and also counsel them on the same - assign responsibility for making decisions - review the work performed by each assistant by personnel with more competence and experience - reviews should be done on a timely basis

- process review to focus on specific areas of audit judgment and draft an audit report prior to its publication and distribution Audit investigations responsibilities - report to management i.e. directors, courts, but not members - terms of investigation are stated in the special engagement letter of assignment, not normal audit engagement letter - consideration of not only financial statements, but also other factors e.g. economic environment, production functions, future potential, etc. Statutory audit is only concerned with financial information for a single period and all other factors are secondary or of minor consequence - approach adopted depends on terms of engagement. In a statutory audit, approach follows audit guidelines and standards - obtain information as stated in the engagement letter. For statutory audits, audit guidelines are followed - responsibility for confidentiality and cannot disclose information to any party without the consent of directors or the person who has engaged the auditor. Statutory audits are normally publicized Management Fraud Meaning: - deception by those in authority which may result in loss or disadvantage to the organization or those dealing with it i.e. creditors It takes the form of :- misappropriation of assets - manipulation of financial information to induce others to enter into disadvantageous transactions Conditions that provide opportunity for management fraud excessive authority vested in one person poor quality middle level management weak accounting systems and controls complex corporate structures and/or transaction sequence related party trading

- accounting policies that rely heavily upon judgments of future events Auditors Operational Standards This is the most important document for auditors. Each of the clauses below is expanded in the auditing guidelines:i. Universal application an audit must be carried out by applying the standards. There are no shortcuts. ii. Planning, controlling, recording planning is important for efficient and economical accomplishment of the work. Controlling involves directing staff, supervising them and reviewing the work. Recording involves assembling work papers. iii. Accounting systems it is vital to ensure that proper accounting records are kept and that financial statements are in agreement with the books of account and records. iv. Audit evidence this is information that tends to establish facts. It has to be relevant, sufficient, reliable and capable of having reasonable conclusion drawn from it. v. Internal controls if the auditor is to place reliance on the controls, he must ascertain, evaluate and perform compliance tests on them. vi. Review of financial statements the financial statements as a whole must show a true and fair view and conform to the statutory requirements. Factors to consider when choosing a sample size Population size: - i.e. whether the population from which the sample is being drawn is high or risk Level of confidence:- e.g. a 5% level of confidence means that there is a 19 chances out of 20, that the sample is representative of the population. Precision interval:- e.g. confidence interval. To conclude that there is 95% certainty error rate Risk:- e.g. high risk areas require large samples and vice versa. Materiality:- e.g. populations that are material to the overall audit opinion need smaller precision intervals but higher confidence levels and vice versa.

 Subjectivity factors:- these are influenced and based on the auditors perception of the clients business and firm. Expected error/deviation rate:- sample size required is a function of error/deviation rate. Example:Below are selected R-factors i.e. based on the above factors: Confidence Level 99% 95% 86% R-factors 4.6 3.0 2.3

sample size = Monetary Population / J 63% 50% 1.0 0.7

Monetary level / R-factor 90% 3.0

Why sampling? Sampling is necessary for economic, time, practicability, psychological (boredom) and value or (faithfulness) Objectives of sampling - to obtain relevant and reliable evidence - to obtain sufficient evidence

Audit Risk i.e. the dangers of using a sample to make a wrong conclusion about a population 1. Inherent risk:- this is attached or associated with a particular population because of factors like type of industry, previous experience, etc. 2. Control risk:- the likelihood that internal controls will not detect and prevent material errors. If risk is considered large, it is recommended to use both substantive and compliance tests and a large sample and vice versa 3. Detection risk:- this is the risk that substantive and analytical review procedures will not detect material errors. 4. Tolerable error:- this is the maximum error in a particular situation acceptable without marring the true and fair view notion. (Tolerable error is auditing materiality). To sample or Not to Sample!!! This decision depends on:o Materiality of the issue at hand e.g. petty cash expenditure may be too small that no conceivable error may affect the true and fair view of the accounts as a whole. o Population size o Reliability of other forms of evidence o Cost and time Stages in sampling: i. ii. iii. iv. planning the sample:- consider audit objectives, population and sample size selection of sample size to be tested testing the sample evaluation of sample results; i.e. analysis, detection of errors / deviations and risk assessment

Monetary Unit sampling (MUS)

- This is a new concept in audit sampling that is appropriate to large variance populations e.g. debtors or stocks, where populations are widely different sizes - It is suitable where errors are not expected - It indirectly solves the problem of materiality Procedures: Determine the sample size Determine the minimum unacceptable error rate (related to materiality) Determine the eta risk desired Example:- suppose 250 account balances of debtors are to be audited by sampling. Assume the following table has been extracted in preparation for the audit.

Debtor Name

Account Balance Cumul. Balance Sh000 Sh000 620 4 1,320 220 4,197 . etc 384,,200 620 624 1,944 2,164 6,361 . etc 384,200

J B X P S . .c

- if a sample size was 100% and e.g. Sh.1,402 and every 384th item were to be selected, then the population of debtors is not the 1,250 debtors but 384,200 single shillings. .. (read more) - MUS is useful in testing overstatements where significant underestimates are not expected.

Calculating sample risk An auditor would wish to design a sample test to determine if debtors are overstated. He subjectively considers:o Overall audit risk as 5% o Inherent risk based on past experience and his knowledge of the industry as 70% o Control risk based on his assessment of internal control compliance as 30% o Detection risk based on assumption that errors will not be detected through substantive tests and analytical procedures as 60% Sample size = Ar r IR X CR X DR 0.05 r 0.7 X 0.3 X 0.6

= 40%rof the population NB: the degree of assurance required on the population (as a % of probability) can be achieved by being 60% certain from the sampling procedures. This is because the overall risk of 5% is considered as the acceptable risk. - if the contributions towards assurance were nil (e.g. other risks were 0%), then 70%, 30% and 60% would be replaced by 100%, giving a sampling risk of 5% i.e. 0.05 0.01 = 5%

- it is possible that the contribution from other forms of evidence may give a sampling risk greater than 1. that would mean there is sufficient evidence without sampling procedures at all e.g.

0.05 r 0.7 X 0.3 X 0.6

= 104%r - Risk is the degree of assurance an auditor requires in an audit assignment. In statistical sampling, this is related to level of confidence required. - Materiality is also important because it manifests itself in the term tolerable error which is related to the statistical term precision interval.

Auditors Professional and Legal Requirements Additional services taxation accounts preparation advise to directors investment advice o conflict of interest may in many cases arise where additional services are provided to the client e.g. KRA v Client. o Auditors may not apply expected levels of skill and care in carrying out the audit of accounts prepared by them o Independence may be compromised if a mistake arises based on the auditors advise to client

Fees and independence - Shareholders normally vote in favour of directors proposals on auditors.

- Directors have powers to change auditors of subsidiary companies, they being nominee shareholders - Fees is fixed by directors through powers given to them by shareholders o Maintaining independence is a matter of professional integrity i.e. attitude of mind o Auditors who compromise their independence of mind, risk being liable for negligence Auditors Liability - may be held negligent in failing to appreciate significance of material post balance sheet events - may be held negligent in failing to qualify a report for no disclosure of essential information in compliance with the Companies Act or Accounting Standards - may be held negligent in failing to exercise reasonable skill and care (assuming records were available and that were not concealed by directors). - NB: on fraud and errors, auditors cannot generally be liable because it is the directors responsibility to install adequate controls to prevent and detect errors, fraud and illegal acts. Materiality of the fraud also should be addressed. This is because the cost of detecting a fraud may exceed the amounts recoverable or involved in the alleged fraud. - Practically, if auditors are given enough time and manpower they would detect most frauds. However, due limitations in audit time budgets and contractual obligations, they do not have enough time and resources to detect most frauds. - NB: auditors should detect fraud and other irregularities which give rise to material errors in financial statements. The primary responsibility of detecting and preventing fraud rests with the directors. - There is also a problem of defining what is a fraud

Circumstance that will prove auditors negligence - auditors may be considered negligent in failing to :-

 appreciate the significance of material post balance sheet, adjusting and non-adjusting events qualify the audit report for non-compliance with IFRS, IAS and the Companies Act carry out adequate audit procedures as expected and as stipulated by the accounting and auditing standards and guidelines Criteria for determining auditors liability - auditors will be regarded as being liable for negligence, if and only if it can be proved that: there is a clear case of negligence financial loss has been suffered the financial loss is as a consequence of relying on the negligently prepared financial statements and NOT to any other cause the auditor knew (or ought to have known) that it was to be relied upon in that particular circumstance.

Audit Report Forms of qualifications Nature of circumstances Uncertainty Disagreement Material but not fundamental Fundamental subject to opinion Disclaimer of opinion Except for opinion Adverse opinion

Compliance tests:these are tests designed to obtain audit evidence that internal controls are being applied as prescribed.

Reliance on other specialists:- in assessing reliability of work and advise of specialists, auditors would consider:o o o o materiality of the subject matter qualifications, experience and reputation of the expert independence of the expert Reasonableness of the experts opinion upon cross-checking with other experts in that field of specialization.

Going concern concept (factors that would indicate theta firm is not a going concern) failure to generate sufficient profits reductions in liquidity (due to overtrading) loss of important customers shortage of materials vital to a companys manufacturing process taking of extended credit by customers overtrading by the company, when liquid funds are scarce need to redeem loan capital when internal funds to finance the redemption are scarce - reduction in research and development expenditure, due to scarce funds - drastic changes in policies, that are an indication of going concern difficulties - NB: use of basic accounting ratios may help determine going concern difficulties

Audit of special institutions (key issues) Pension Funds - examining the trust deed that sets up the fund and its provisions

- deductions of expenses from the sponsoring organization; refunds to employees leaving the scheme; payment of pensions and overheads - verification of portfolio of investments - verification of fund assets and their sufficiency to meet future pension obligations - consideration of the actuarial valuation and actuarial opinion on the future operation of the scheme - discussions with actuary on expected returns and mortality rates - test checking the investment register i.e. for income and cost - authorization and approval of sale/purchase of investments - anticipated investment returns - rates of mortality - appraisal of the schemes operations - method of funding i.e. funded or unfunded - nature of investments held - basis for determining benefits payable i.e. defined v contributory benefits Financial reporting o trustee reports o actuarial statement o investment report Charities (and Unit Trusts) deeds of covenant received through banks tax reclaimed on covenants donations received through post income from other activities fairs and raffles analyze other incomes e.g. legacies, etc, received analyze bank deposits interests charged or received Building Societies - relevant statute is the Building Societies Act - records of valuation of security (houses) - granting of mortgages (procedures)

reimbursement of deposits revenue and appropriation annual returns books of accounts and maintenance of ICS main assets are loans on mortgages ensure loans are made at an amount less than the security of houses custody over title deeds held liabilities are called and paid up deposits (seek direct information from investors) - ensure that there are no fictitious advances ghost customers Banks - relevant statute is the Companies Act, Banking Act and CMA regulations - adequacy of provisions for bad debts. (inadequate policies have led to insolvency and liquidation) - external auditors to report to CBK and CMA (or as provided by Auditing Standards) - formation of audit committees - adequate exposure and disclosure in compliance with IAS on financial institutions - segregation of duties e.g. Board of Directors, Chairman, Managing Director and Management - ensure staff of external audit firm do not seek or obtain banking facilities from client interim and final management letters should be sent to CBK and CMA - negligent banks to be blacklisted and sued Insurance companies relevant statute is the Insurance Act and Commission of Insurance check provisions for unexpired risks e.g. on fire and accident policies check the adequacy for outstanding claims current (discounted values) of contracted future benefits under annuities, life assurance, and pensions contracts using actuarial valuations. The auditor should enquire into methods used.

- auditors report in a certificate| to indicate categorically satisfaction or otherwise with particular aspects of accounts Hire Purchase companies ( Refer to the Hire Purchase Act) Cooperative Societies - Cooperative societies Act empowers the societies to appoint auditors in the AGM - Audited accounts are tabled in the AGM which is held 3 months after the end of year. This is a separate meeting from that held to appoint an auditor. (auditors appointment other than the report) - auditors must be members of the professional body - annual financial statements in respect of directors and employees to include: advances to directors advances to other officers and employees of the society advances to persons connected to the directors and officers of the society - interest on loans granted from SACCOs - income other than interest, dividends and rent Professional Rules What is a profession? it is a calling or vocation involving some branch of learning. Whether a person is called or feels a vocation towards accountancy is more doubtful issue/ Ethics: - the general points are:professional independence integrity independence consult the professional body if unsure of course of conduct avoid conflict of interest advertising;- should not reflect adversely on the advertiser; should not discredit other audit services; should not be misleading

- obtaining professional work:- may not approach a prospective client or give any commission to third parties for introducing clients - remuneration - insider dealing Ethical problem - this arises when an individual is morally or ethically required to take an action that conflicts with ones immediate self interest e.g. audit staff who is sampling inventory begins by finding obsolete stocks, but is not sure. The auditor staff fears to reveal this problem for fear of being regarded as stupid or incompetent. Ethical dilemma - this occurs when a persons experiences conflicts with moral duties e.g. assisting a junior staff complete accounts receivables, at the expense of the audit time budget How to deal with ethical issues choose actions that create the greatest good for the majority (Utilitarian theory) choose actions according to rights of parties involved (Rights theory) e.g. 1st order - life, autonomy, human dignity 2nd order - civil, legal, property rights 3rd order - social rights e.g. education and health care 4th order - non essential e.g. playing golf

Stages in an Audit background research about the client audit plan accounting system review internal control review substantive testing

- analytical review - preparation and signing of the report Timing of Audit work - audit work is usually accomplished on several visits to the clients premises - the work is usually distributed between:o interim audit during the financial year o a year end attendance o final audit after year end - interim audit is usually for investigating and testing of systems and recording and internal controls - the year end work is usually for observation and testing of stock count, but also the examination of cash balances and investment certificates o o o o testing systems for the period from interim audit to the year end substantive testing of transactions and balances analytical review preparation and signing of the audit report

Conduct of an Audit o auditors interest in the clients accounting system - whether proper accounting records have been kept and proper returns made for branches not visited - whether companys balance sheet and profit and loss account are in agreement with accounting records and returns o managements interest in an accounting system the business is controlled debtors and creditors are recorded financial statements can be prepared statutes are observed

- accounting is done for PAYE, NHIF, VAT, etc o auditors procedures obtain knowledge of clients business and accounting system ascertain the system record the system i.e. flow charts evaluate the ICS evaluate evidence collected

Internal control (types of control) organization structure segregation of duties physical controls authorizations and approvals arithmetic and accounting controls personnel i.e. competitive supervision management controls acknowledge of performance budgeting i.e. qualitative plans of action

Internal check independent proving complimentary work Types of Audit tests walk through checks:- tests the recording of transactions to determine if the auditor has obtained a correct description and understanding of a system compliance tests:- adherence to policies and procedures substantives tests:- validity tests

Audit of specialized institutions o Common procedures: - obtain copy of any statutory material relating to: the conduct of the enterprise accounts audits - obtain copy of the rules, constitution or other documents on governance of the enterprise - engagement letter - copy of minutes relating to appointment of the auditor o Common procedures on accounting records - revenue and expenses:- types and problems that arise in controlling and recording transactions - assets and liabilities:- types of problems that might arise in verifying ownership, existence, valuation and presentation in the accounts - internal controls:- special; problems - accounting policies:- problems of accounting measurement which might affect accounts - NB: banks and insurance companies are subject to special exemptions from the Companies Act requirements as to the true and fair view.

Reports on Prospectus (Accountants Report) - the Prospectus must contain a report giving financial information by a reporting accountant who may be an auditor - the report should cover five years - adjustments may need to be made to the originally reported figures to ensure consistency and comparability or to correct fundamental accounting errors or to reflect changes in the group structure - current accounting policies should be used throughout

- the reporting accountant may be required to give letter of consent, comfort letter on working capital requirements, borrowings or other financial matters Unaudited financial statements - these are Balance sheets and income statements in which an opinion has not been expressed by an auditor Small business audit - the small size means difficulties in complying with KAS and KAG and there is need to adapt to change - major control problems are: domination of accounting and financial management by one person limitations in effectiveness if ICS - problems of domination by the owner: top management overrides the existing ICs and hence greater management fraud tendency for minority to dominate the management structure, leading to inefficiency - effects of the above problems on the audit: no reliance on ICS increased amount of testing due to poor and unreliable ICS more reliance on management representations than third party confirmations requires auditors judgment and caution - audit reports of small businesses faced with high control risks and detection risks should be prepared according to KAG

- EDP and small businesses uses micro-systems with no special controls domination by one person on the system encourages fraud chaos might build up over time systems are often poorly developed Approach o Systems review o Systems testing to ascertain reliability o Review and testing of manual controls o Substantive tests and analytical review procedures and techniques

Cost benefit analysis of an audit - results from the need to balance between audit costs and audit quality - maintenance of reputation demands more investment of time and high quality/caliber of staff in audit work - shifts towards emphasis on cost rather than quality of service is due to the increasing competitive market for audit services (i.e., competition is fee based) - the ability to meet time budgets, if necessary by under reporting time worked, is considered a vital factor affecting advancement in the audit firms - there is widespread competitive tendering for audit work at prices below full cost and this threatens the auditors independence and audit quality i.e. quality v credibility) - the audit industry is labour intensive and therefore fees are strongly related to labour costs - time budgets are routinely and deliberately inadequate for the proper performance of planned audit work

Audit in an IT environment - a large number of companies now use computer systems to run their business and therefore financial information is processed on a computer system - this means that several controls which auditors are required to put in place to safeguard the assets of the shareholders are incorporated into the system - the auditor must understand how an organization initiates, records, processes and reports financial information. - The International Auditing Standards (ISA 401 (Auditing in a computer information systems environment), provides the guidelines on procedures to be followed when an audit is conducted in an IT environment. - For purposes of ISA 401, an IT environment exists when a computer of any type or size is used in the processing by the entity of financial information of significance to the audit, whether the computer is operated by the entity or by a third party e.g. bureau. Testing of controls - the auditor should evaluate the policies, procedures and practices in place to prevent material misstatements in the financial statements assertions - a test of control involves gathering evidence on how effectively and consistently the current control system is operating - these tests include inquiries, observations, inspection of documents or electronic files and reprocessing transactions. Unlike manual systems, tests on automated systems are more complex. Some techniques to test automated systems are as follows:Computer assisted audit techniques There are three different computer assisted audit techniques that an auditor can use:-

 Auditing around the computer Auditing with the computer Auditing through the computer Auditing around the computer - with this technique, auditors test the reliability of the computer generated information by first calculating the expected results from the transactions entered into the system and then comparing these calculations with the processing or output results - if they prove to be accurate and valid, then it is assumed that the system of controls is effective and that the system is operating properly - This method is adequate when the automated systems are relatively not complicated the systems must however leave an audit trail where outputs can be effectively traced to their inputs. NB:- the only weakness with this technique is that the accuracy of program logic cannot be confirmed, and also cannot reveal how the system is responding to errors. Auditing with the computer - this approach normally uses various techniques often referred to as computer assisted audit techniques (CAATs). - audit of computer based accounting techniques (CAATs) are classified into 1. test data techniques 2. systems testing techniques 3. problem solving techniques - the auditors use a computer to aid them in performing substantive tests, and to some limited extent, tests of control. A widely used CAAT to perform substantive tests is the General Audit Software(GAS) - the only disadvantage of this approach is that it requires extensive experience in using the software. However, some of the techniques of auditing with the computer does not require extensive IT experience.

Auditing through the computer - the techniques employed in this approach are designed to est the effectiveness of automated controls and programming logic of the system. - the approach assumes that if programs are properly developed, regularly reviewed and programmed checks are incorporated, then errors and irregularities may not occur undetected - this approach is normally appropriate in testing of controls in complex systems. It embraces several techniques which include: test data technique:- employs a set of hypothetical transactions to audit the programmed checks and program logic. It is time consuming but does not require extensive background in IT. The test data technique is recommended for auditors with little IT experience. parallel simulation:- attempts to simulates the organization's actual processing results. Past period transactions are input, processed and compared with the actual results of a live production. integrated test data facility ITF:- enables data to be continually evaluated when transactions are being processed by online systems to ensure the reliability of the output. embedded audit module:- is a programmed module that is inserted into an application program. Its purpose is to collect and monitor data based on transactions particularly those processed by online systems. The data is then used by the auditor in the tests of control and in the evaluation of control risk NB:- the usage of this method requires the auditor to have a working knowledge of computers, esp. the programming field Implications - it is possible to build controls into computerized accounting systems. However, a balance has to be struck between the degree of control and the requirement for a user friendly system - controls can be classified into:a. security controls:

- is there a security policy in place? i.e. physical security e.g. locked doors and windows access security e.g. use of passwords data security e.g. virus shields

- is there strict monitoring and compliance with security policy? - Is the security policy efficient and sufficient

b. integrity controls - integrity can be subdivided into: data security is when data is the same as it is preserved in source documents and has not been accidentally or intentionally altered, destroyed or disclosed. Systems integrity refers to systems operation conforming to the design specifications despite attempts (deliberate or accidental) to make it behave incorrectly.

c. contingency controls - measures taken to ensure that risks are mitigated - the two key risks are: virus attack the system is not at risk by a virus hacking:- the system is not at risk of invasion by unauthorized users who could affect the smooth operation of the system, and/or obtain sensitive commercial information - the client should have a contingency plan in the event of the system being affected by the risks identified above

Internal control system in an EDP environment - the auditor is interested in the integrity if the data because it is the data which is incorporated into the financial statements. - Auditors focus on the general and application controls, which relate to security and policies for data input Types of controls in an EDP system authorizations and approvals to retrieve and/or update data segregation of duties in the system i.e. over input/output and processing access to the system controls over transactions and standing data operators working in shifts laying down disciplinary standards defining clearly operating standards interventions by operators should be recorded automatically by the system program amendments must be authorized backup files should be created frequently users should be logged-in and a record of their activities kept at appropriate levels - write protecting data kept in storage media e.g. disks and tapes - operating staff should not be allowed to initiate transactions and amend files without authority - preventive maintenance should be enhance e.g. power backups, cable insulations, ventilation, etc Assessment of the computerized accounting system effectiveness of the internal control system is generally assessed by means of undertaking a systems audit auditors assess the quality and effectiveness of the accounting system as a whole it is vital to ensure that the computerized system is as reliable as could be expected, and whether it is the best system that the company could be using, at the given cost. the reliability of the system is established by assessing:-

- management policy: does management have a written policy structure with regard to computer system? it is compatible with management policies in other areas? is there compliance with policy? is it sufficient and effective? is it reviewed and updated regularly? - segregation of duties: is there adequate segregation of duties with regard to data input? are there adequate systems security controls i.e. passwords, to enforce segregation of duties?

************** END *******************