Ch01 Fundamentals of Auditing.docx

FUNDAMENTALS OF AUDITING AN INTRODUCTION What is an Audit? Audit is an independent examination of financial statements of an entity that enables an auditor to express an opinion whether the financial statements are prepared (in all material respects) in accordance with an identified and acceptable financial reporting framework (e.g. international or local accounting standards and national legislations) This view of audit is presented by ISA 200 Objective and General Principles Governing an Audit of Financial Statements. The phrases used; “to express the auditor’s opinion” means that the financial statements give a true and fair view or have been presented fairly in all material respects. True and fair presentation means that the financial statement are prepared and presented in accordance with the requirements of the applicable International Financial Reporting Standards (IFRS) and local pronouncements/legislations. What we can understand as the essential features of an audit from the above definition and explanation are as under: An auditor involves in examination of financial statements, the auditor is not responsible for the preparation of the financial statements. The end result of an audit is an opinion to assist the user of the financial statements. Auditing therefore relies heavily on professional judgment, not merely on the facts. The auditor’s opinion makes reference to “true and fair” or “fair presentations” but “true and fair” is again a matter of judgment. It is not precisely defined for the auditor. In order to make the user of the auditor’s report able to feel confident in relying on such report, the auditor should be independent of the entity. Independent essentially means that the auditor has no significant personal interest in the entity. This allows an objective, professional view to be taken. You will note that this is a wide concept of an audit which can be applied to any entity, not just to limited companies. However, in this course, we are concerned primarily with audits of limited companies (often known as statutory or external audits). Any other audit applications will be clearly indicated for you in the text. Why is there a need for an audit? The problem that has always existed at the time when the manager reports to the owners is that: whether the owners will believe the report or not? This is because the reports may: Contain errors Not disclose fraud Be inadvertently misleading Be deliberately misleading Fail to disclose relevant information Fail to conform to regulations The solution to this problem of credibility in reports and accounts lies in appointing an independent person called an auditor to examine the financial statements and report on his findings. A further point is that modern companies can be very large with multi-national activities. The preparation of the accounts of such groups is a very complex operation involving the bringing together and summarizing of accounts of subsidiaries with differing conventions, legal systems and accounting and control systems. The examination of such accounts by independent experts who are trained in the assessment of financial information is of benefit to those who control and operate such organizations as well as to owners and outsiders. Many financial statements must conform to statutory or other requirements. The most notable is that all company accounts have to conform to the requirements of the Companies Ordinance 1984 but many otherbodies (like: Charities, Building Societies, Financial Services business etc) have detailed accounting requirements as required by the relevant legislations. In addition all accounts should conform to the requirements of International Financial Reporting Standards (IFRSs). It is essential that an audit of financial statements should be carried out to ensure that they conform to these requirements. What is the distinction between auditing and accounting? Relationship between auditing and accounting Auditing and accounting are closely connected but both are separate activities. The directors of a company are responsible for establishing books of accounts that will accurately record financial information and that are used for preparing the annual financial statements. It is similarly the responsibility of the directors to adopt consistent and appropriate accounting policies in order to prepare and present the financial statements. The financial statements have to comply with national legislative requirements and International Financial Reporting Standards (IFRSs). Accounting is the process of recording, classifying, summarizing and reporting financial information in a logical/systematic manner for the purpose of decision making. To provide relevant & reliable information, accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the financial statements. In auditing the financial statements, the concern is with determining whether the presented financial statements properly (true and fair) reflect the financial information that occurred during the accounting period. Since auditors are primarily concerned with the end result of this work i.e. do the financial statements show a true and fair view? In order to arrive at their conclusion the auditors must have a deep knowledge and understanding of accounting (including applicable accounting standards) and in practice, the directors will consult with the auditors as to appropriate accounting policies to follow. Many financial statement users and members of the general public confuse auditing with accounting. The confusion results because most auditing is concerned with accounting information, and many auditors have considerable expertise in accounting matters. The confusion is increased by giving the title “Chartered Accountant” to individuals performing a major portion of the audit function. Who can be an auditor? For appointment as auditor of: a Public Company or a Private Company which is a subsidiary of a Public Company. a Private Company having paid up capital of three million shillings or more. The person must be a Chartered Accountant within the meaning of the Chartered Accountants Ordinance, 1961. For listed companies an auditor must have a satisfactory QCR (quality control review) rating issued by ICAP. What is an auditor’s report? The primary aim of an audit is to enable the auditor to say “these accounts show a true and fair view” or, of course, to say that “they do not show a true and fair view”. At the end of his audit, when he has examined the entity, its record, and its financial statements, the auditor produces a report addressed to the owners/stake holders in which he expresses his opinion of the truth and fairness, and sometimes other aspects, of the financial statements. Standard format of Auditor’s Report as per the Companies Ordinance 1984: FORM 35A AUDITORS’ REPORT We have audited the annexed balance sheet of COMPANY NAME as at THE DATE and the related profit and loss account, cash flow statement and statement of changed in equity together with the notes forming part thereof, for the year then ended and we state that we have obtained all the information and explanations which to the best of our knowledge and belief were necessary for the purposes of our audit. It is the responsibility of the company’s management to establish and maintain a system of internal control and prepare and present the above said statements in conformity with the approved accounting standards and the requirements of the Companies Ordinance, 1984. Our responsibility is to express an opinion on these statements based on our audit. We conducted our audit in accordance with the auditing standards as applicable in Pakistan. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the above said statements are free of any material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the above said statements. An audit also includes assessing the accounting policies and significant estimates made by management, as well as evaluating the overall presentation of the above said statements. We believe that our audit provides a reasonable basis for our opinion and, after due verification, we report that: In our opinion, proper books of accounts have been kept by the company as required by the Companies Ordinance, 1984 In our opinion: The balance sheet and profit and loss account together with the notes thereon have been drawn-up in conformity with the Companies Ordinance, 1984, and are in agreement with the books of account and are further in accordance with accounting policies consistently applied The expenditure incurred during the year was for the purpose of the company’s business; and The business conducted investments made and the expenditure incurred during the year were in accordance with the objects of the company. In our opinion and to the best of our information and according to the explanations given to us, the balance sheet, profit and loss account, cash flow statement and statement of changes in equity together with the notes forming part thereof conform with approved accounting standards as applicable in Pakistan and, give the information required by the Companies Ordinance, 1984, in the manner so required and respectively give a true and fair view of the state of the company’s affairs as at DATE and of the profit/loss its cash flows and changes in equity for the year then ended; and In our opinion Zakat deductible at source under the Zakat and Usher Ordinance, 1980 was deducted by the company and deposited in the Central Zakat Fund established under Section 7 of that Ordinance. Fundamentals of Auditing Standard format of Auditor’s Report as per the International Auditing Standards: INDEPENDENT AUDITOR’S REPORT [Appropriate Addressee] Introductory Paragraph We have audited the accompanying financial statements of ABC Company, which comprise the balance sheet as at December 31, 20X1, and the income statement, statement of changes in equity and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory notes. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards. This responsibility includes: designing, implementing and maintaining internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances. Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements give a true and fair view of (or” present fairly, in all material respects,”) the financial position of ABC Company as of December 31, 20X1, and of its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. Report on Other Legal and Regulatory Requirements [Form and content of this section of the auditor’s report will vary depending on the nature of the auditor’s other reporting responsibilities.] What stands for auditor’s opinion? The auditor, in his report, does not say that the financial statements do show a true and fair view. He can only say that in his opinion the financial statements show a true and fair view. The reader or user of financial statements will know from his knowledge of the auditor whether or not to rely on the auditor’s opinion. If the auditor is known to be independent, honest, and competent, then his opinion will be relied upon. What are the different types of audit? Three types of audits are discussed in general, i.e., Financial statement audits Operational audits Compliance audits Financial Statement Audits An audit of financial statements is conducted to determine whether the overall financial statements (the quantifiable information being verified) are stated in accordance with specified criteria. Normally, the criteria are the requirements of the applicable International Financial Reporting Standards (IFRSs) and the Companies Ordinance 1984. The financial statements most commonly comprises of the Balance Sheet, Income Statement, Statement of Changes in Equity, Cash Flow Statement, and Notes to the accounts. The assumption underlying an audit of financial statements is that these will be used by different groups for different purposes. Therefore, it is more efficient to have one auditor who will perform an audit and draw conclusions that can be relied upon by all users than to have each user perform his or her own audit. If a user believes that the general audit does not provide sufficient information for his or her purposes, the user has the option of obtaining more data. For example, a general audit of a business may provide sufficient financial information for a banker considering a loan to the company, but a corporation considering a merger with that business may also wish to know the replacement cost of fixed assets and other information relevant to the decision. The corporation may use its own auditors to get the additional information. Operational Audits An operational audit is a review of any part of an entity’s operating procedures and methods for the purpose of evaluating efficiency and effectiveness. At the completion of an operational audit, recommendations to management for improving operation are normally expected. An example of an operational audit is evaluating the efficiency and accuracy of processing payroll transactions in a newly installed computer system. Another example, where most accountants would feel less qualified is evaluating the efficiency, accuracy, and customer satisfaction in processing the distribution of letters and parcels by a courier company such as TCS. Because of the many different areas in which operational effectiveness can be evaluated, it is impossible to characterize the conduct of a typical operational audit. In one organization, the auditor might evaluate the relevancy and sufficiency of the information used by management in making decisions to acquire new fixed assets, while in a different organization the auditor might evaluate the efficiency of the paper flow in processing sales. In operational auditing, the reviews are not limited to accounting. They can include the evaluation of organization structure, computer operations, production methods, marketing, and any other area in which the auditor is qualified. The conduct of an operational audit and the reported results are less easily defined than for either of the other two types of audits. Efficiency and effectiveness of operations are far more difficult to evaluate objectively than compliance or the presentation of financial statements in accordance with accounting conventions and principles; and establishing criteria for evaluating the quantifiable information in an operational audit is an extremely subjective matter. In this sense, operational auditing is more like “management consulting” than what is generally regarded as “auditing”. Operational auditing has increased in importance in the past decade. Compliance Audits The purpose of a compliance audit is to determine whether the entity is following specific procedures, rules, or regulations set down by some higher authority. A compliance audit for a private business could include determining whether accounting personnel are following the procedures prescribed by the company controller, reviewing wage rates for compliance with minimum wage laws, or examining contractual agreements with bankers and other lenders to be sure the company is complying with legal requirements. In the audit of governmental units such as districts school, there is extensive compliance auditing due to extensive regulation by higher government authorities. In virtually every private and non-profitorganization,there are prescribed policies, contractual agreements, and legal requirements that may call for compliance auditing. Results of compliance audits are typically reported to someone within the entity being audited rather than to a broad spectrum of users. Management, as opposed to outside users, is the primary group concerned with the extent of compliance with certain prescribed procedures and regulations. Hence, a significant portion of work of this type is done by auditors employed by the entity itself. There are exceptions; when an organization wants to determine whether individuals or entities that are obligated to follow its requirements are actually complying, the auditor is employed by the entity issuing the requirements. An example is the auditing of taxpayers for compliance with the federal tax laws, where the auditor is employed by the government to audit the taxpayers’ tax returns. Following table summarizes the three types of audits and includes an example of each type and an illustration of three of the key parts of the definition of auditing applied to each type of audit. Examples of the Three Types of Audits TYPES OF EXAMPLE QUANTIFIABLE ESTABLISHED AVAILABLE AUDIT INFORMATION CRITERIA EVIDENCE Financial Annual Audit of General Motors International Documents, Statement Audit General Motors’ financial statements Financial records, and financial Reporting outside sources statements Standards of evidence Operational Evaluate whether Number of payroll Company Error reports, Audit the computerized records processed standards for payroll records, payroll processing in a month, costs of efficiency and and payroll for subsidiary is the department, and effectiveness in processing costs operating number of errors payroll efficiently and made department effectively Compliance Determine if Company records Loan agreement Financial Audit bank provisions statements and requirements for calculations by loan continuation the auditor have been met What are the advantages and disadvantages of auditing? Advantages of an audit We have seen that the need for an external audit in the case of companies arises primarily from the existence of split-up of ownership from control. There are however, certain advantages in having financial statements audited even where no statutory requirement exists for such an audit in the case of a sole-trader-ship, partnership, or non-profit organizations for example. These advantages can be summarized as follows: Disputes between management may be more easily settled. For instance, a partnership which has complicated profit sharing arrangements may require an independent examination of those accounts to ensure, as far as possible, an accurate assessment and distribution of the profits. Major changes in ownership may be facilitated if past accounts contain an independent audit report, for instance, where two sole traders merge their business to form a new partnership. Application to lenders/financial institutions for finance may be strengthened by the submission of audited accounts. However do remember that a bank, for instance, is likely to be far more concerned about the future of the business and available security, than by the past historical accounts, audited or otherwise. The audit is likely to involve an in depth examination of the business and so may enable the auditor to give more constrictive advice to management on improving the efficiency of the business. Disadvantages of an audit Like most thing in life, audits are not entirely without their disadvantages. There are two main points to make here: The audit fee! Clearly the services of an auditor must be paid for. It is for this reason that few partnerships and even fewer sole traders are likely to have their accounts audited. The audit involves the client’s staff and management in giving time to providing information to the auditor. Professional auditors should therefore plan their audit carefully to minimize the disruption which their work will cause. What are the different stages of audit? Auditing is essentially a practical task. The auditor always needs to reflect the nature of the circumstances of the entity under audit. It is unlikely that any two audit assignments will ever identical. It is however possible to identify a number of standard stages in a typical external audit. These are as follows: Audit appointment Engagement letter Initial planning Knowledge of the business Risk Assessment Internal control review (procedures) Control procedures (authorities/approvals/segregation of duties) Preparation of the audit plan Accounting system review Analytical review techniques (Compliance procedures-Application of control test procedures) like purchasing are according to the controls established. Considering the ways in which audit evidence can be sought Substantive testing (transaction level procedures) Reasonable assurance Review of the financial statements (compliance with the standards/material misstatement etc.) Preparation and signing of report At the stage of considering the ways of seeking audit evidence the auditor will make a preliminary evaluation of the entity’s control system: Fundamentals of Auditing If the controls are likely to lead to a true and fair set of financial statements the auditor will test those controls. If they appear weak he will not rely on the controls but carry out extensive testing of the transactions and balances which appear in the financial statements by means of substantive procedures. If the controls are operating effectively, the auditor can reduce the amount of substantive testing described above and adopt a reliance approach. If not then the auditor will be forced into a extensive substantive approach What are the features of auditing profession? In Pakistan auditing profession is allied with the Institute of Chartered Accountants of Pakistan (ICAP). It is an autonomous body incorporated under the Chartered Accountants Ordinance 1961. ICAP is a regulatory body that enjoys a self regulatory status. Its affairs are run by a council which is elected by its member (Chartered Accountants). Only those members of the ICAP are eligible of doing audit who have obtained license for the purpose, these are known are practicing members. Management of ICAP The President is the Chief Executive of the Institute. The administrative head of the Institute is the Executive Director/Secretary who functions under the directions of the Council, Executive Committee, The President and the Vice Presidents The Executive Director in performance of his functions is assisted by: Secretary Director Technical Services Director Professional Standards Compliance Director Education & Training Director Examinations Regional Director North The prime responsibilities of Executive Director include Personnel Management; Financial Management; Office management; Publications; Information Systems; Conducting and performing Secretarial functions for the Council and Executive Committee Meetings. Knowing the audit profession and other services? Auditing firms do not describe themselves as auditors. They describe themselves as Chartered Accountants. Auditing firms are composed of accountants who perform audits for their clients. They also perform other services. The small chartered accountant firms especially may spend more time on other services than on auditing. The other services may include: Writing up books of accounts (Book keeping) Balancing books of accounts (Extracting trial balance) Preparing final accounts Tax management Statutory form filling Financial consultancy Management and system consultancy Liquidation and receivership work Investigations (Fraud audit) OBJECTIVE AND GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS Objective of an Audit: Objective of an audit of financial statements is to enable an auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework (e.g. International or Local Accounting Standards). The terms used to express the opinion are “give a true and fair view” or “present fairly in all material respects”. Benefit of opinion It improves credibility of financial statements. What an opinion does not achieve? It does not provide any assurance about Future viability of the entity; and Efficiency or effectiveness of management. General Principles of an Audit: Professional Ethics There are a number of ethical matters that are extremely important for auditors to consider when performing their work. It is vital to the public image and credibility of the profession that the auditor is seen to be behaving in an acceptable manner in addition to actually complying with the ethical requirements. It is important to recognize that many groups in society rely on accountant’s work, not just the shareholders on whose behalf the accountant is working. The accountant therefore has a public accountability. In the light of this, ICAP’s ethical guidelines emphasis the following key points about the characteristics of accountants: Independence: Auditor is independent of management i.e. he is not under the control or influence of management. Integrity: Auditor is honest and is not corrupt. He is straight forward in performing his professional work Objectivity: He obtains the evidence needed to form an opinion and his opinion is based on that evidence alone. He is not subjective in forming his opinion. Professional Competence and Due Care: Auditor has attained certain professional qualification, has acquired the requisite skill and has attained the experience necessary for the audit and performs his work with planning and due diligence. Confidentiality: Auditor neither discloses the information obtained during the course of his audit without permission of his client (except when required in a court of law) nor uses that information himself. Professional Behavior: He should not only act in a professional manner but should also appear to be a professional. He should maintain his professional knowledge and skill at a level required to ensure that a client or employer receives the benefit of competent professional service based on up-to-date developments in auditing practice and relevant legislation. Technical Standards: Audit should be performed by following certain standards, international or national. International Standards on Auditing (ISAs) The auditor should follow basic principles and essential procedures together with related guidance as contained in ISAs. International Standards on Auditing (ISAs) are issued by the International Auditing Practices Committee (IAPC). The IAPC is a standing committee of the Council of the International Federation of Accountants (IFAC), which was formed in 1977 and is based in New York. IFAC has more than 150 member bodies, representing over 2 million accountants in more than 100 countries, and membership of IFAC automatically confers The IAPC issued standards and statements on auditing and related services in order to improve the degree of uniformity of auditing practice and related services throughout the world. The IAPC works closely with its members and national standard setters in order to gain acceptance of international Standards of Auditing (ISAs). Member bodies have increasingly sought to align the national position with the international positions IFAC and the IASC have gained influence and recognition. Standard setters increasingly refer to the international position in their consultative documents as authoritative support for a particular view. International auditing and accounting standards do not at present override local regulations. Neither IFAC nor the IASC can currently compel any organization to comply with international standards; nor are there specific sanctions where organizations claim to have complied with international standards, but have not done so. The preface to International Standards on Auditing and Related Services (ISA 100) states that IAPC guidance falls into two categories: International Standards on Auditing (ISAs). ISAs contain basic principles and essential procedures (identified in bold type black lettering), together with related guidance in the form of explanatory and other material (in plain type) including appendices. The basic principles and essential procedures are to be understood and applied in the context of explanatory and other material that provides guidance for their application. The text of a whole standard is considered in order to understand and apply the basic principles and essential procedures. International Auditing Practice Statements (IAPSs). In conducting an audit in accordance with ISAs, the auditor is also aware of and considers International Auditing Practice Statements (IAPSs) applicable to the audit engagement. IAPSs provide practical assistance to auditors in implementing standards and promote good practice. They are not intended to have the authority of standards. The auditor may also conduct the audit in accordance with both ISAs and auditing standards of a specific jurisdiction or country. Professional Skepticism The audit should be planned and performed with an attitude of professional skepticism i.e. forming an opinion only after obtaining sufficient and appropriate audit evidence instead of blindly accepting any information or explanation given by the management. An attitude of professional skepticism means the auditor makes a critical assessment, with a questioning mind, of the validity of audit evidence obtained and is alert to audit evidence that contradicts or brings into question the reliability of documents and responses to inquiries and other information obtained from management and those charged with governance. SCOPE OF AN AUDIT What does it mean? The term “scope of an audit” refers to the audit procedures that, in the auditor’s judgment and based on the ISAs, are deemed appropriate in the circumstances to achieve the objective of the audit. Audit opinion Reasonable assurance Sufficient appropriate audit evidence Audit procedures (based on ISAs) Audit-Evidence: It is obtained by applying necessary audit procedures. Audit procedures should be based on requirements of ISAs, relevant professional bodies, legislation, regulations, and the terms of the audit engagement and reporting requirements. Auditing is concerned with the verification of accounting date and with determining the accuracy and reliability of accounting statements and reports. Verification does not mean seeking proof or absolute certainty in connection with the data and reports being audited. It means looking for sufficient evidence depends on what experience and knowledge of contemporary auditing standards tells one is satisfactory. An auditor obtains audit evidence regarding management’s assertions for the following areas: Existence: an asset or liability exists at the Balance Sheet date. This is an obvious assertion with suchitems as land and buildings, stocks and others Rights and obligations: an asset or liability pertains to the entity at the Balance Sheet date. Thismeans that the enterprise has for example ownership of an asset. Ownership as an idea is not simple and there may be all sorts of rights and obligations connected with a given asset or liability. Occurrence: a transaction or event took place which pertains to the enterprise during the relevantperiod. It may be possible for false transactions (e.g. sales or purchases) to be recorded. The assertion is that all recorded transactions actually took place. Completeness: there are not unrecorded assets, liabilities, transactions or events or undisclosed items.This is important for all accounts items but is especially important for liabilities. Valuation: an asset or liability is recorded at an appropriate carrying value Appropriate may mean inaccordance with generally accepted accounting principles, the companies Act rules, Accounting Standards requirements and consistent with statements of accounting policies consistently applied. Measurement: a transaction or event is recorded at the proper amount and revenue or expenseallocated to the proper period. Presentation and disclosure: an item is disclosed, classified and described in accordance with applicable reporting framework. For example fixed assets are subject to the Companies Ordinance rules and to IAS 16. An example: We will look at an item in a balance sheet, bank overdraft Rs. 10,250. In reporting this item in the balance sheet, the directors are making these assertions: That there is a liability to the company’s bankers. That at the balance sheet date this liability was Rs. 10,250. That this amount is agreed by the bank That the overdraft was repayable on demand. If this were not so, it would not appear amongst the current liabilities and terms would be stated. That the overdraft was not secured. If it were secured this fact would need to be stated. That the company has the Authority to borrow from its Memorandum and Articles. That a bank reconciliation statement can be prepared. That the bank is willing to let the overdraft continue. If no item ‘bank overdraft’ appeared in the balance sheet, it would represent an assertion by the directors that no overdraft liability existed at the balance sheet date. REASONABLE ASSURANCE What is reasonable assurance? A conclusion that the financial statements are not materially misstated. An auditor cannot obtain absolute assurance because of limitations described in Para below. How reasonable assurance is achieved? It is achieved by obtaining audit evidence. Factors affecting reasonable assurance Fundamentals of Auditing Inherent limitation of an audit, i.e. failure of audit procedures to detect material misstatements in financial statements because of: The use of testing (application of procedures on samples). The inherent limitations of accounting and internal control system. Persuasive nature of audit evidence rather than conclusive (Persuasive: one leading to an opinion; one which causes to believe; Conclusive: final, convincing). Exercise of judgment by the auditor in gathering of evidence and drawing of conclusion. Existence of other limitations like related parties etc. Audit Risk and Materiality Guidance provided by ISA 200 in this matter is discussed in later chapters which specifically and exclusively discuss it. Responsibility for the Financial Statements: Responsibilities for preparing and presenting the financial statements are that of management. Auditor’s responsibility is to express an opinion thereon. REASONABLE ASSURANCE What is reasonable assurance? It means a conclusion that the financial statements are not materially misstated. An auditor cannot obtain absolute assurance because of limitations described in paragraph below. Reasonable assurance through audit evidence Audit evidence: For internal control For transactions & accounts balances For financial statements Factors affecting reasonable assurance Inherent limitation of an audit, i.e. failure of audit procedures to detect material misstatements in financial statements because of: The use of testing (application of procedures on samples). The inherent limitations of accounting and internal control system. Persuasive nature of audit evidence rather than conclusive (Persuasive: one leading to an opinion; one which causes to believe; Conclusive: final, convincing). Exercise of judgment by the auditor in gathering of evidence and drawing of conclusion. Existence of other limitations like related parties etc. Inherent Limitations of Accounting and Internal Control Management over rides Collusion with employees Collusion with third party Unaffordable cost of internal control Human error Accordingly, because of the factors described above an audit is not a guarantee that the financial statements are free from material misstatement, because absolute assurance is not attainable. Further, an audit opinion does not assure the future viability of the entity nor the efficiency or effectiveness with which management has conducted the affairs of the entity AUDIT RISK AND MATERIALITY Entities pursue strategies to achieve their objectives, and depending on the nature of their operations and industry, the regulatory environment in which they operate, and their size and complexity, they face a variety of business risk. Management is responsible for identifying such risks and responding to them. However, not all risks relate to the preparation of the financial statements. The auditor is ultimately concerned only with risks that may affect the financial statements. The auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the financial statements give a true and fair view or are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. The concept to reasonable assurance acknowledges that there is a risk the audit opinion is inappropriate. The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated is known as “audit risk”. Audit Risk The risk that the auditor expresses inappropriate audit opinion when the financial statements are materially misstated. The concept of reasonable assurance acknowledges that there is a risk the audit opinion is in appropriate. Materiality Risk of material misstatement levels: Overall Financial Statement level Often relates to entity’s control environment Also relates to declining economic conditions Transactions, account balances, & disclosures level Auditor is not responsible for detection of misstatements that are not material. The auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit Responsibility for the Financial Statements: Responsibilities for preparing and presenting the financial statements are that of management. Auditor’s responsibility is to express an opinion thereon. This responsibility includes: Designing, implementing and maintaining internal control relevant to the preparation and presentation of financial statements that are free from material misstatement, whether due to fraud or error; Selecting and applying appropriate accounting policies; and Making accounting estimates.