INTRODUCTION TO AUDITING AND THE AUDIT PROCESS

INTRODUCTION

 What is the purpose of an audit?

- Auditors need to provide an audit opinion on the financial statements.
- In order to do so, there are important concepts and considerations we introduce you to
regarding the audit process.
 what is the audit process, and how do you pull all the pieces together

Stage 2
- overall financial statement level risk of material misstatement helps with planning materiality
- and audit procedures
WHAT IS THE PURPOSE OF ACCOUNTING RECORDS?

 Without financial accounting, we would not have the need for auditing at all.
- important to understand some concepts around accounting records, as these fundamentally
impact on our understanding of auditing.
1. Why accounting records are necessary.
2. What accounting records are telling the users of the financial statements about decisions
or transactions that took place within a business.
3. How this information is viewed from an audit perspective.

 Record of transactions / account balances

 P/L and SFP

 Quantitative = numbers
- AFS = backwards looking
 Qualitative = notes
- Integrated reports
 Can be forward looking

 Users
- Current / potential investors or shareholders
- Management
- SARS = assessing whether tax paid has been reasonable
- Competitors
- Employees
- Creditors etc

 Responsible?
- Management and employees

 Companies act
- Says which companies must be audited in terms of their Public Interest score
- Also guidelines as to what needs to be part of AFS, when they need to be prepared by, how
long to keep them for
 Process
- Source document  often go back to source document to see if it is complied with the
assertions
- Journal
- GL
- Ledger
- Summarised in AFS

 Relevant
- Timing = companies act requires to finalise within 6 months
 But is it too delayed to be useful?
- Complex

Understanding Accounting Records and Financial Statements

What are Accounting Records?
 Info presented in a certain way that is dictated by IFRS or other accounting standards
 Info is then summarised in a certain way after being collated

What is the Purpose of Accounting Records?

 As business became more complex and management were separated from stakeholders - so the
need for accurate record keeping increased
 For effective management and decision making:
- Record transactions and keep track
 - Timely for decision making
- Measures results, evaluates performance – all stakeholders
- Accountability for management
- Financial statements – legal requirements (Co Act)
 Types of decisions and use of information depends on the user!
 Created from a flow of information in an accounting system – from a source document or decision
through to the “face” of the accounting records.

 Source information is used by auditors

The Objective of Accounting Records?
 Conceptual Framework (IFRS): financial information that is useful to wide range of users
- Presented in terms of accepted accounting practice.
 Focus on past events, not forward looking (retrospective – one of the downfalls)
- Although “fair value” concept requires consideration of future
- Limiting factor
 Directors’ use of company resources and the results thereof
- Shareholder accountability

Who is Responsible for Accounting Records?

 Board of directors responsible for:
- Proper accounting records
- Prepare and approve financial statements
- Fair presentation (otherwise guilty section 29 Co Act).

 Can delegate day-to-day finance function

- Role of the Chief Financial Officer (CFO), financial managers and accounting department
 Oversight role of audit committee.
 Assurance of external auditors
 Auditors provide assurance pertaining to information prepared or presented by one party to
another party with the intention of inspiring confidence in the “fairness” of the information which is
being prepared or presented

Financial Statement Assertions

 Account balances = SFP (At a point in time)
 Transaction balances = SPLOCI (over a point in time)

 It represents a transaction that has happened

- Occurrence
- Account balances in SFP and P/L
 It is legal
- Validity (SFP and SPLOCU_
- E.g. may have issued shares but may not be valid (no special resolution etc)
 It is recorded at the correct amount
- Valuation (SFP)  look at IFRS standard
- Accuracy (SPLOCI)  look at IFRS standard
 It is recorded in the correct period
- Completeness (SFP and SPLOCI)
- Cut-off (SFP and SPLOCI)
 Early cut off (recognised in next period but should be in current period) or late cut off
(recognise in current period but should be in next period) can affect completeness or
occurrence
 It contains all the information that it should
- Completeness (SFP and SPLOCI)
 It is included in the Annual Financial Statements, in terms of appropriate accounting standards
and adopted policies
- Presentation and disclosure (SFP and SPLOCI)
 Do we own the asset / liability for the debt?
- Rights and obligations
THE NEED FOR EXTERNAL AUDIT
 records of the financial performance of companies need to be reliable, as they are relied upon to
make decisions.
- This necessity is what has ultimately led to the development of the auditing profession.
- Although the profession has evolved over time, it relies on certain key principles and contains
certain limitations.
 The auditing profession, both locally in South Africa and globally, has recently come under the
spotlight, given a string of corporate and government scandals.
- It is therefore more important than ever to not only clarify the role of the auditor, but also to
clarify the limitations inherent in the work that they perform.
 As technology changes, so will the profession, and we may see some of the challenges and
limitations being replaced by other new challenges, over time.
 So how did the need for 'auditing' arise? By looking at its history, it will help us to understand why
this function became necessary.

The History of Audit

 auditing turned into a profession, and hence, why it is now governed by a professional framework
that guides what auditors need to do, how they should act, and who can become an auditor.
 In South Africa, the IRBA oversees the auditing profession, and the profession adopts the
International Standards of Auditing (ISA), which provide guidance on how audits are performed.
 As a future chartered accountant who will register with SAICA, you will also be able to register
with the IRBA and practise as an auditor within South Africa

The need for the external audit

 Arose out of the need to provide assurance
- Stakeholders not always involved in every day practices
Owner vs manager vs external stakeholders

Conflicting interest creates needs for independent assurance

- Auditors, directors, stakeholders, shareholders

External audit has other value for stakeholders

 External audit can add value to other stakeholders:
- Confidence for equity investment/finance
- Tax assessment
- Operating efficiency for management (control systems)
- Accountability to shareholders
 Directors know all actions will be recorded

Limitations of an audit

 Level of assurance limited

- Cant provide 100% assurance because of cost-benefit
- Focus on high risk and samples
 Independence?
- Hard to be truly independent because you earn money from the client
 Historic focused and untimely
- Hypothetical to provide assurance about forward-looking information
 Complexity of modern company operations and corporate structures
- E.g. Steinhoff – impractical or difficult to gain assurance
 Financial accounting assumptions and estimations
- Fair valuation = allowed to place hypothetical values  management bias because of
estimates instead of merely cost accounting
 Reliance of management integrity

Principles of a good audit

IMPORTANT CONCEPTS OF AUDITING

 A common mistake that we see students making is not understanding the difference between how
an auditor and a business owner would view a scenario when it is presented to them.
 Sometimes, a question will be asked from only one perspective. At other times, a question may be
asked from both perspectives. It is therefore important to understand how these perspectives
could be different.
 In this lesson we will discuss the difference between a business owner and auditor and how they
apply a different framework of thinking, how auditing can validate retrospective and prospective
information and how this impacts the audit work performed, and what professional scepticism
means and how it should be applied on an audit.

Similarities between auditor and business owner

 Need appropriate skills and competence for financial reporting and tax
- Audit = need to design audit procedures to gather evidence
- Business owner to be aware of how things should be accounted for
 Both need to be comfortable of controls
 - Auditor – helps assess audit risk
- Business owner – responsible to make sure free of material misstatement
 Audit risk = could result in a material misstatement
- Material = affects decision making of users
- Misstatement = incorrect and non-complying with accounting standards or legal requirements
- Impacts one of audit assertions (asset/liab or IS assertion)
 Risk that one of the assertions have not been complied with
 Fraud
- Audit – ISA 240 requirement of the auditor
- Management – don’t want assets or liabilities to be missapropriated

Differences between auditor and business owner

 Evidence
- Auditors must validate evidence and design procedures
- Business owner creates evidence and recording / file so that there is an audit trail

 Risks
- Auditors = Audit risk – focus on if
- Owner = Audit risk but also risks that impact the business’s operations
 Operating risk = business owner is concerned about but not necessarily auditor is worried
about
 Legislative risk = both auditor and management concerned about
 Accounting risk
- E.g. returning products
 Audit risk = returns may be understated
 Business risk = reputation, customer satisfaction, unreliable supplier if product is faulty
 Independence / conflict of interest
- Independence = auditor
- Conflict of interest = client
 Often incentivised to achieve certain performance
 Transparency vs profitability
- Transparency (disclosure) = auditor
- Profitability = client

Professional Scepticism
 The ISA standards require that auditors adopt an attitude of professional scepticism BUT
 This is ALSO relevant for you as a student as you need to develop this way of thinking so as to
apply it to your test or exam scenarios AND in your professional career.

Important characteristics:
1. Banishing bias
2. Asking the right questions
3. Adopting a critical mindset
4. Asking “ does this make sense?”

Banishing Bias
 Change in mindset
 What I “think” is correct to what is factually “correct”
 Removing emotions from decisions making
 Avoiding conflicts of interest  need to be independent
 Using legislation to argue a point, not a feeling
- Say specifically why something is not or is correct

Asking the right questions

 Being comfortable with “it depends”
 Being able to argue both for and against something
 Understanding the financial accounting and legal implications of a decision
 Cause and effect awareness – if this has happened then I would expect XYZ to also happen

Adopting a critical mindset

 sceptical
 This is happening, but what could go wrong?
 How would I commit fraud in this situation?
 Where is there a risk of error? What would its impact be?
 If something has gone wrong, how would I identify the error and understand the error?

Always asking “Does this make sense?”

 Applying logic to a situation and professional judgement
 Assume people have made an error or could make an error
 Get proper understanding of why things have been done in a certain way

THE AUDIT PROCESS

 Preliminary stage

 this is the same with an existing audit client (you will have to do some research, but you
won’t have to follow the same extensive procedures as you would have to do with a new
audit client).
 Planning your route = Planning stage

 During this stage, we will identify risks from the information gathered, while doing
research in preliminary activities.
 Existing audit client = may be aware of previous risks
 But check if new risks or old ones no longer exist
 Going on holiday = Risk response stage (Gathering evidence stage)

 During this stage, we will follow the (audit) plan that we developed and look out for risks
that we pre-empted on our way.
 Existing audit client = pay additional attention to areas where we know there are risks
 New client = confirm risks identified at planning stage, and look out for additional risks
that had not yer been recognised
 Writing a review = Concluding and reporting stage

 During this stage, we look back at the audit that we planned and issue an audit report,
based on the work that we performed.
 Wont do pre-engagement activities in the bridging
 Legal (CPC and Co Act), risk assessment
 TOC – control system and how to test
- Wont look at cycles in detail but will cover the procedures
 Concluding and reporting
- Not ISA700s
- Misstatement and how to correct and report
 Ethics
- Challenges at each stage
- Ethics POV from auditing, accounting, tax and man acc POV

Details of each stage of the audit process

1. Pre-engagement
2. Planning
3. Gathering Evidence
4. Concluding reporting

Prelim Engagement
 Get understanding of client, its business and management
- Integrity
- Reputation
- Industry
 Assess audit firms ability to accept the client
- Staff – skills and availability
- Audit fee
- Do we want to be associated with the client
 Agree terms of engagement

Planning
 If accept the client
1. Develop audit strategy
- Scope, timing and direction
2. Risk assessment and materiality
- Inherent risks
 - Control systems – initial control assessment to see if can rely on controls
- Planning materiality
3. Develop audit plan
- Nature, timing and extent of audit work we plan on doing in gathering audit evidence
Gathering audit evidence
 Substantive procedures only
- Analytical review or
- Test of detail
 Substantive procedures and test of controls

 Decision Based on risk assessment

 Aim of gathering audit evidence = to support audit opinion

- May conclude AFS are free from material misstatement?
 Assertions have been met?
- Or not and to what extent

Concluding
 Assess misstatements identified
- In isolation and aggregate
- Final materiality
 Consider whether audit evidence sufficient and appropriate
 Subsequent events testing
 Impact on next year

Reporting
 Going Concern assessment
 Audit report and opinion
 Impact on next year’s audit

Common Mistakes
1. You need to be sure from whose perspective you are viewing the scenario or question.

- Financial manager or external auditor or internal auditor

2. You need to be sure you understand where you are in the audit process, in the context of what
has been asked AND what has happened in the scenario presented to you.
3. Prelim vs planning

- Some overlap from prelims that filter through to planning stage

- E.g. audit fees

 Under prelim = if client went through financial difficulties. Answer will be can they afford my
audit fee?
 Planning = risk associated with financial difficulty – going concern?

- Finalisation stage and misstatement to salaries

 Further audit procedures?

 Cant say look at contracts, schedules etc
 Need to look at audit procedures for concluding as it is at finalisation stage
 Thus have discussions with management, extrapolate sample etc