Question

Question 6 Audit Report

Before the audit report was signed, the audit team encountered the following situation. Treat each situation independently and assume the remaining financial statements are fine.

1) A property owned by Cook’s Furniture Ltd was sold to Lidia Preston, the wife of Howard Cook in June 2020 (refer to case description in part A). The property has a market value of four million and was sold at 3.2 million. Management did not disclose this in the financial statement because they believed this was a private matter. The disposal of this asset has been appropriately accounted for on the financial statements (e.g. the asset was removed from PPE and the loss of disposal was correctly recognized as an expense).

2) The subsequent selling price of the ready-made furniture range suggests the inventory valuation as of 30 June 2020 should be written down by $48,000 but management only wrote $38,000 off as per the financial statements because they were confident that they can increase the selling price again in 2021 after people settling back to normality.

3) Carl Cook decided to retire in 2021 due to health reasons, Carl is willing to sell his shareholding to the remaining shareholders. However, the BoD decided to explore the potential of selling the business. By the time to sign the 2020 financial statements, the company has not commenced negotiations with any potential buyer. The BoD said to the auditor that they may not sell the business if they cannot get a good deal. Carl’s retirement decision is disclosed on the financial statements, but not the intention to sell the business.

REQUIRED: For each of the above situation:

a) Discuss the audit procedure that the auditor needs to perform in relation to each situation.

b) Explain which audit opinion is appropriate for each situation.

Answer 1

REQUIRED: For each of the above situation:

a) Discuss the audit procedure that the auditor needs to perform in relation to each situation.

b) Explain which audit opinion is appropriate for each situation.

SOLUTION:-

Part(A.)

Step 1 – Identify the assertion tested

Audit procedures are performed in order to test financial statement assertions. Therefore, the first step in explaining an audit procedure is to identify the assertion that needs to be tested.

The assertions embodied in the financial statements, as used by the auditor to consider the different types of potential misstatements that may occur, may take the following forms:

Transactions and events	Account balances at the period-end	Presentation and disclosure
Occurrence Completeness Accuracy Cutoff Classification	Existence Rights and obligations Completeness Valuation and allocation	Occurrence and rights and obligations Completeness Classification and understandability Accuracy and valuation

A brief explanation of the various assertions is as follows:

Completeness
This means that all transactions have been recorded in the financial statements – ie all assets, liabilities, equity interests (capital and reserves) and other disclosures have been included in the financial statements.

Occurrence
This assertion means that transactions and events and other matters that have been recorded actually took place – and relate to this organisation.

Valuation and allocation
This means that all items have been included in the financial statements at appropriate amounts according to company policy and the relevant financial reporting framework. Furthermore, any allocations or valuation adjustments required (like impairment) have been made and financial and other information is disclosed fairly and at appropriate amounts.

Classification and understandability
Financial information is appropriately presented and disclosed, and disclosures are clearly expressed so as to make them understandable to the users. For this, the disclosures should use simple language and state matters clearly and concisely.

Accuracy
Accuracy means that amounts and other data relating to transactions and events have been recorded at the correct amounts – ie at the amounts appearing in the source documents.

Rights and obligations
This means that the entity has a right to its assets – ie it is free to use or dispose of the assets as it sees fit. Furthermore, the entity is obliged to pay off the liabilities that are shown in the statement of financial position.

Existence
This means that assets, liabilities and equity interests (capital and reserves) are physically present/belong to the entity on the reporting date.

Cutoff
This means that transactions and events have been recorded in the correct accounting period – for example, if goods are delivered prior to year end, they are included in the cost of goods sold, not inventory.

Step 2: Identify the audit procedure

	Explanation				Example of substantive procedure relating to valuation of property, plant and equipment (PPE)
1	Choose the assertion that will be tested				Choose an assertion from Completeness, Valuation and allocation, Rights and obligations and Existence if you are testing the period-end balance of PPE; valuation of non-current assets is the assertion tested
2	Identify the risk that will cause a material misstatement in the financial statements – the audit risk is the total value of PPE that may be misstated due to over-valuation/ undervaluation of PPE				One risk relates to the revalued assets not representing fair values, thus under/overstating PPE
3	Think of the audit procedures that should be performed in order to avoid the risk mentioned in step 1 (refer to ‘AEIOU’ below)				The auditor will agree the availability of a revaluation report (a source document for the revaluation) and confirm that the value mentioned in the valuation report matches the amount at which the PPE is revalued and shown in the financial statements. Furthermore, the auditor will recalculate the revaluation surplus in accordance with the provisions of IAS 16, Property, Plant and Equipment to confirm the correctness of the accounting entries relating to revaluation surplus. The amount added to revaluation surplus should be the difference between the net book value of PPE and the revalued amounts. The auditor should agree the assumptions used in the report for reasonableness. For example, the value per square feet in the valuation report should be similar to the value per square feet of other similar properties in that locality. There are many more procedures that will apply to this risk.

Follow the above method for testing other assertions too.

Choose audit procedures from AEIOU

A: Analytical procedures
E: Enquiry and confirmation directly from a third party – ie inquiry
I: Inspection of records and assets
O: Observation
U: recalcUlation and reperformance

Step 3: Note the following while writing down the audit procedure

1 Write it clearly
Audit procedures should be written in such a way that even a junior auditor will be able to understand what is to be done. For example, avoid vague procedures like ‘check goods received notes’. This is vague as it does not explain what is to be examined in the goods received notes. Is it the description of items received, the quantity received or the name of the vendor?

2 Write down the reason for performing the audit procedure
The audit procedure ‘check goods received notes’ does not mention why the goods received notes are to be checked. Instead, write the audit procedure as: ‘agree the description of items and the quantities ordered mentioned on the goods received note with the descriptions on the purchase orders raised on the vendor’. This confirms that the entity has procured goods based on an authorised purchase order.

3 Use audit terminology
Use terminology relating to audit like ‘cast’, ‘agree’, ‘trace’, etc.

• Use the word ‘cast’ to mean totalling up a list – for example, ‘cast the trial balance’.

Use the words ‘agree’ or ‘trace’ to mean matching information from two documents/ records – for example, ‘agree the total sales of the sales day book to the general ledger account’; or ‘trace a sample of trade payables to the purchase invoices, to confirm the existence of the rights to the goods purchased’.

A complete audit procedure would read as follows:
The auditor will agree a sample of items from the inventory sheets to the raw material inventory (1) to ensure that the inventory recorded on the sheets actually exists (2). This will confirm the assertion of existence of inventory as an asset in the financial statements (3).

(1 = the audit procedure; 2 = the reason for the audit procedure; 3 = the assertion).

If the above mentioned procedure is written as ‘The auditor will check a sample of items from the inventory sheets to the raw material inventory’, it is incomplete as it does not mention why the audit procedure is being performed.

Common errors that must be avoided

The examiner’s reports mention various errors that candidates make while writing audit procedures. Here is a summary of the common errors.

While writing audit procedures, avoid the following:

• Writing an audit procedure without explaining the reason for the procedure – for example, ‘The auditor will check a sample of items from the inventory sheets to the inventory.’
• Stating an assertion word as a reason for performing a procedure – for example, ‘confirming the occurrence of sales’.
• Writing what the internal control system should do rather than stating the audit procedure – for example, ‘for all goods received, there should be a goods received note raised’.
• Writing vague procedures – for example, ‘check the invoice’, ‘check the goods received note’, etc. These procedures are inappropriate as they do not mention what is to be checked and the reason for checking them.
• Quoting incorrect assertions – for example, ‘tracing details from the purchase orders to the goods received notes in order to confirm existence of the goods’ – the completeness assertion would apply here.
• Including procedures that cannot be carried out – for example, ‘agree individual items of physical inventory to the sales invoice’. It will not be possible to agree the physical goods to the sales invoice as the goods will already be sold.
• Including procedures that are incorrect – for example, ‘agree details from the purchase orders (like description of items ordered, quantities ordered) to the goods held in the inventory store’. This is an incorrect audit procedure as goods received notes (not purchase orders) are used to update inventory.
• Writing impractical procedures – for example, suggesting a segregation of duties between the person authorising petty cash vouchers, recording petty cash vouchers and dispensing the petty cash.
• Writing irrelevant audit procedures – for example, when you are asked to write audit procedures relating to depreciation of a non-current asset, it will be inappropriate to provide general audit procedures relating to audit of non-current assets.

Part(B.)

An auditor requires to form an audit opinion on whether the entity prepares financial statements considering all the material aspects. The material aspects shall be in accordance with the applicable financial reporting framework. An auditor shall conclude whether the financial statements are free from material misstatements, fraud or error.

Auditor Shall Evaluate the Following Factors

• Whether the entity appropriately follows and applies significant accounting policies while preparing financial statements. He also needs to evaluate that it makes appropriate disclosure regarding the same.
• It follows the accounting policies on a consistent basis with the applicable financial reporting framework.
• Estimates made by the management are reasonable or not.
• The financial statements of an entity shall provide relevant, reliable easy to understand and comparable information.
• Proper disclosures made for material transactions for a better understanding of intended users.
• Terms used in financial statements are appropriate or not.

The auditor should state in the opinion paragraph whether the entity prepares the financial statements in all material respects. Also, it shall state whether it complies with the applicable financial reporting framework.

The auditor should state whether he has obtained sufficient and appropriate audit evidence. He should express his audit opinion on the financial statements of an entity as to whether the financial statements give a true and fair view in accordance with the applicable financial reporting framework and statutory requirements.

Types of Audit Opinion

• Unqualified opinion
• Qualified opinion
• Disclaimer of opinion
• Adverse opinion

Unqualified Opinion

An auditor expresses an unqualified audit opinion when he concludes that the financial statements of an entity are prepared in accordance with the applicable financial reporting framework, considering all the material aspects.

Auditor expresses an unqualified audit opinion when in his opinion and based on the information provided to him and audit evidence obtained by he considers that the financial statements of an entity give a true and fair view.

An unqualified audit opinion assures that any changes made in the accounting policies or method followed by the entity on a continuous basis and their effects have been considered and disclosed in the financial statements appropriately.

Modified Opinion

When an auditor expresses his opinion other than an unqualified audit opinion it is said he is modifying his opinion. When an auditor expresses a qualified opinion or disclaimer of opinion or an adverse opinion it is said he has modified his opinion.

Audit Report is Considered to be Modified when

Matters that do not affect the Auditor’s Opinion

There are some matters included in the financial statements which in the auditor’s opinion are of such importance that it is very useful for the users understanding of the financial statements. In such cases, an auditor may modify his report by adding an emphasis of matter paragraph to highlight such matter for users understanding.

Adding an emphasis of matter paragraph does not affect the auditor’s opinion. An auditor modifies his opinion by adding an emphasis of matter paragraph if he considers that the going concern of an entity is questionable, uncertainty regarding future events which may affect the financial statements.

For Example: When there is uncertainty regarding pending litigation matters, such matters can be disclosed in the emphasis of matter paragraph.

Matters that affect the Auditor’s Opinion

There are some circumstances in the auditor’s professional judgment when he cannot express an unqualified audit opinion.

An auditor may modify his opinion when the effect of the matter has a material effect on the financial statements of the entity. Some circumstances are as follows:-

• When there is a limitation on the scope of his work.
• When there is a dispute with management regarding accounting policies followed, the method adopted.

Qualified opinion

The auditor shall express a qualified opinion when he concludes that unqualified opinion cannot be expressed and the misstatements individually or in aggregate are material but not pervasive as to require an adverse opinion or the limitation of scope is not material as to require a disclaimer of opinion.

The auditor should express a qualified opinion as being “subject to” or “Except for” the effects of material items which are qualified.

For example: When an auditor is unable to obtain sufficient and appropriate audit evidence regarding investment made in a foreign company. We consider the auditor’s inability to obtain sufficient and appropriate audit evidence material but not pervasive. Auditor’s opinion is Qualified for the misstatement.

Disclaimer of opinion

An auditor expresses a disclaimer of opinion when he is unable to obtain sufficient and appropriate audit evidence. Another reason is that he considers that the undetected misstatements could be both material and pervasive.

The auditor should disclaim an opinion when there is a limitation on the scope effect of which is both material and pervasive and he is unable to obtain sufficient and appropriate audit evidence.

Adverse opinion

An auditor expresses an adverse opinion when he considers that the misstatement is so material and pervasive that a qualification of the report is not adequate to disclose such misstatements of financial statements.

The auditor shall express an adverse opinion after obtaining sufficient and appropriate audit evidence.

Thus, on the basis of such evidence, he concludes that the misstatements, individually or in aggregate are material and pervasive to the financial statements.

Solved Example For You

Question: Differentiate between qualified opinion and adverse opinion.

Ans: An auditor expresses a qualified opinion when he considers that an unqualified opinion cannot be expressed and the misstatements individually or in aggregate are not so material and pervasive to the financial statements of the entity.

An auditor expresses adverse opinion when he considers that the misstatements either individually or in aggregate are both material and pervasive to the financial statements of the entity.