Audit Risk and Materiality – Desired and Achieved Audit Risk

Audit risk is the risk that the financial statements are materially misstated and the auditor fails to detect such a misstatement.

Audit risk and materiality are closely related. Materiality must be established before audit risk has any meaning. For example, a 4% risk of a $20,000 misstatement of income has a completely different meaning than a 4% risk of a $200,000 misstatement.

Desired audit risk is the subjectively determined risk that the auditor is willing to take that the financial statements are not fairly stated after the audit is completed and an unqualified opinion has been reached. The lower the desired audit risk, the more sure the auditor wants to be that the financial statements are not materially misstated. Zero risk would be certainty, and a 100% risk would be complete uncertainty. Audit risk can range anywhere from zero to one (0 to 100 percent), but no more or less. Complete assurance (zero risk) of the accuracy of the financial statements is not economically practical. The auditor cannot guarantee the complete absence of material errors and irregularities.

The concept of desired audit risk can be more easily understood by thinking in terms of a large number of audits, say ten thousand. What portion of these audits could include material errors without having an adverse effect on society? Certainly, the portion would be below ten percent. It is probably much closer to one or one-half of 1% or perhaps even one-tenth of 1%. If an auditor feels the appropriate percentage for a given audit is one, desired audit risk is 1%.

Achieved audit risk is the actual level of risk, after the audit is completed and an unqualified opinion issued, that the statements are materially misstated. Achieved risk must be less than desired risk or the auditor should not issue an unqualified opinion.

The auditor achieves a reduction of audit risk by gathering evidence. The lower the desired audit risk, the more evidence the auditor must obtain. Since an increased amount of evidence means increased cost, the decision concerning the proper audit risk is one of cost versus benefit. The important question is : at what point does the cost of acquiring more evidence exceed the benefit obtained from the additional information? When the desired risk is reached, the auditor should stop accumulating evidence.

The auditor will have sufficient competent evidence when the achieved audit risk equals desired audit risk. Lower audit risk could be achieved, but cost would be increased.

If the auditor believes the additional cost exceeds the additional benefit from continuing the accumulate evidence, but audit risk is still not satisfactory, he has several options. He may negotiate for a higher audit fee, issue a disclaimer of opinion, bear the additional costs himself, or withdraw from the engagement (Hrd).

Source of this article : Auditing – An Integrated Approach, Alvin A.Arens & James K. Loebbecke

The Nature of Audit Risk and Materiality

Audit risk is the risk that the financial statements are materially misstated and the auditor fails to detect such a misstatement. The auditor must perform the audit to reduce audit risk to a low level.

Audit risk is a function of two components :

1. Risk of material misstatement, which is the risk that an account or disclosure item contains a material misstatement, and
2. Detection risk, which is the risk that the auditor will not detect such misstatements.

To reduce audit risk to a low level requires the auditor to :

1. Assess the risk of material misstatement, and, based on that assessment,
2. Design and perform further audit procedures to reduce overall audit risk to an appropriately low level.

The concept of materiality recognizes that some matters are more important for the fair presentation of the financial statements than others. In performing your audit, you are concerned with matters that, individually or in the aggregate, could be material to the financial statements. Your responsibility is to plan and perform the audit to obtain reasonable assurance that you detect all material misstatement, whether caused by error or fraud.

The accounting standards define Materiality as the magnitude of an omission or misstatement of accounting information that, in light or surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed by the omission or misstatement.

Thus, materiality is influenced by your perception of the needs of financial statement users who will rely on the financial statements to make judgments about your client.

ISA 320 Materiality in Planning and Performing an Audit, in paragraph A1 states that :

In conducting an audit of financial statements, the overall objectives of the auditor are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. The auditor obtains reasonable assurance by obtaining sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.

Materiality and audit risk are considered throughout the audit, in particular, when :

1. Identifying and assessing the risks of material misstatement;
2. Determining the nature, timing and extent of further audit procedures; and
3. Evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.

Source : WILEY – Practitioner’s Guide to GAAS 2010, Steven M.Bragg and ISA 320 Materiality in Planning and Performing an Audit

Materiality in the Context of an Audit

ISA 320 Materiality in Planning and Performing an Audit paragraph 2 states that financial reporting frameworks often discuss the concept of materiality in the context of the preparation and presentation of financial statements. Although financial reporting frameworks may discuss materiality in different terms, they generally explain that :

• Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements;
• Judgments about materiality are made in light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both; and
• Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users as a group. The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered.

Para. 3 states that such a discussion, if present in the applicable financial reporting framework, provides a frame of reference to the auditor in determining materiality for the audit. If the applicable financial reporting framework does not include a discussion of the concept of materiality, the characteristics referred to in para. 2 provide the auditor with such a frame of reference.

The auditor’s determination of materiality is a matter of professional judgment, and is affected by the auditor’s perception of the financial information needs of users of the financial statements. In this context, it is reasonable for the auditor to assume that users :

1. Have a reasonable knowledge of business and economics activities and accounting and a willingness to study the information in the financial statements with reasonable diligence;
2. Understand that financial statements are prepared, presented and audited to levels of materiality;
3. Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment and the consideration of future events; and
4. Make reasonable economic decisions on the basis of the information in the financial statements

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.

In planning the audit, the auditor makes judgments about the size of misstatements that will be considered material. These judgments provide a basis for :

1. Determining the nature, timing and extent of risk assessment procedures;
2. Identifying and assessing the risks of material misstatements; and
3. Determining the nature, timing and extent of further audit procedures

The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in the aggregate, will always be evaluated as immaterial. The circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are below materiality. Although it is not practicable to design audit procedures to detect misstatements that could be material solely because of their nature, the auditor consider not only the size but also the nature of uncorrected misstatements, and the particular circumstances of their occurrence, when evaluating their effect on the financial statements (Hrd).

PricewaterhouseCoopers and Ernst & Young amongst the Forbes : America’s Largest Private Companies

On November 3, 2010, Forbes Magazine has published its special report of ‘America’s Largest Private Companies’.

Within this 26th ranking of the largest privately held firms in the U.S which ranked 223 private companies that qualified as the largest in America, Cargill Inc., a privately held, multinational corporation based in Minneapolis, Minnesota in the U.S with the estimation of $109.84 billion in revenue and 130,500 employees picked on top of the list.

At the second place of the list was Koch Industries, Inc., an American private energy conglomerate based in Wichita, Kansas with the estimation revenue of $100 billion and 70,000 employees. Following by Bechtel Corporation, the largest engineering company in the United States with the headquarter in the Financial District of San Francisco at the third place with $30.80 billion of revenue and 49,000 employees.

There are two of the Big Four Accounting Firms within the top ten biggest companies. PricewaterhouseCoopers ranked at #7 with $26.57 billion in revenue and 161,718 employees, and Ernst & Young at #9 with $21.26 billion in revenue and 141,000 employees.

Here is the list of the top ten biggest companies :

1. Cargill (ranked #1 in 2009)
2. Koch Industries (ranked #2 in 2009)
3. Bechtel (ranked #5 in 2009)
4. HCA (ranked #7 in 2009)
5. Mars (ranked #6 in 2009)
6. Chrysler (ranked #3 in 2009)
7. PricewaterhouseCoopers (ranked #8 in 2009)
8. Publix Super Markets (ranked #9 in 2009)
9. Ernst & Young (ranked #10 in 2009)
10. C&S Wholesale Grocers (ranked #12 in 2009)

Read the complete publication : America's Largest Private Companies and the Complete List

Changes to the Rules of Financial Information Compilation Engagements

The IAASB on October 28, 2010 released for public comment the exposure draft of Proposed International Standard on Related Services (ISRS) 4410, Compilation Engagements as the revision of the extant ISRS 4410, Engagements to Compile Financial Statements.

Within the Explanatory Memorandum of the ED, the IAASB noted that it believes the proposed ISRS will help practitioners performing compilation engagements around the world converge on use of a globally accepted benchmark for such engagements.

There are several key principles within the revision of ISRS 4410 which underlying the financial information compilation engagement :

1. Clearly distinguishable from audits and reviews of financial statements (that is, assurance engagements)
2. Meaningful for users, in context of the benefit delivered from application of professional expertise in accounting and financial reporting, and compliance with relevant professional standards and ethical principles
3. Able to be performed on a cost-effective basis

The proposed ISRS 4410 makes clear that the procedures employed in a compilation engagement are not designed, and do not enable the practitioner, to express any assurance on the financial information. It explains, however, that users of the compiled financial information derive benefit from application of the practitioner’s expertise in accounting and financial reporting and compliance with professional standards, including delivering the service in accordance with the ethical principles of integrity, objectivity, professional competence and due care.

The proposed engagement standard has also been developed to be capable of being used on a stand-alone basis for engagement performance purposes, without the need for practitioners to refer to the International Standards on Auditing (ISAs) or the review engagement standards. This recognizes that practitioners who regularly undertake compilations in their professional practices may not necessarily perform assurance engagements, and therefore may not maintain up-to-date familiarity with developments in assurance standards.

Within the Scope of Proposed ISRS 4410, the IAASB emphasized the importance to obtain respondents’ views on the intended scope of proposed ISRS 4410, which is different from the scope of extant ISRS 4410.

It said that the practitioners can have many different forms of involvement in compiling information in different situations to meet various types of needs. Practitioners may also provide a variety of communications in the course of providing various types of services commonly referred to as “accounting services.” The IAASB determined that the focus of proposed ISRS 4410, however should be on where the practitioner compiles historical financial information using the applicable financial reporting framework specified in the terms of the compilation engagement. This is the most common context for compilation engagements encountered in practice, and is the most relevant to a broad range of users of historical financial information, in particular in the SME sector.

Accordingly, the IAASB determined that proposed ISRS should be focused to apply in the following circumstances :

1. When the practitioner is engaged to compile historical financial information in accordance with the proposal ISRS; and
2. Where the practitioner provides a report for the engagement in accordance with the requirements of the proposed ISRS.

Proposed ISRS 4410 is premised on the basis that a firm providing compilation engagements under the standard is required to apply, or has applied, ISQC 1 or requirement that are at least as demanding.

The proposed ISRS also requires the practitioner to determine, at the time of accepting the engagement, that the applicable financial reporting framework to be used for the compilation is acceptable, in the practitioner’s judgment, in view of the intended use of the financial information and the intended users. The practitioner cannot accept an engagement under the proposed ISRS if this overall test is not met (see Proposed ISRS 4400 (revised), paragraph 23(b)).

Read further the publication of ED ISRS 4410 from the IFAC Press Center : IAASB Addresses Compilation Engagements; Exposes Enhanced Standard

The requirements of an independent auditor in forming an opinion on the audited financial statements

ISA 700 states that the objectives of the auditor (independent auditor) are :

1. To form an opinion on the financial statements based on an evaluation of the conclusions drawn from the audit evidence obtained; and
2. To express clearly that opinion through a written report that also describes the basis for that opinion

In this ISA, the meaning of financial statements is a complete set of general purpose financial statements, including the related notes, which ordinarily comprise a summary of significant accounting policies and other explanatory information.

Regarding the financial statements, the auditor (independent auditor) shall form an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

As stated in para. 11 of ISA 700, in order to form that opinion, the auditor shall conclude as to whether the auditor has obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. That conclusion shall take into account :

1. The auditor’s conclusion, in accordance with ISA 330, whether sufficient appropriate audit evidence has been obtained;
2. The auditor’s conclusion, in accordance with ISA 450, whether uncorrected misstatements are material, individually or in aggregate; and
3. The evaluations required by paragraphs 12-15.

Then, para. 12 states that the auditor shall evaluate whether the financial statements are prepared, in all material respects, in accordance with the requirements of the applicable financial reporting framework. This evaluation shall include consideration of the qualitative aspects of the entity’s accounting practices, including indicators of possible bias in management’s judgments.

Following, para. 13 states that in particular, the auditor shall evaluate whether, in view of the requirements of the applicable financial reporting framework :

1. The financial statements adequately disclose the significant accounting policies selected and applied;
2. The accounting policies selected and applied are consistent with the applicable financial reporting framework and are appropriate;
3. The accounting estimates made by management are reasonable;
4. The information presented in the financial statements is relevant, reliable, comparable, and understandable;
5. The financial statements provide adequate disclosures to enable the intended users to understand the effect of material transactions and events on the information conveyed in the financial statements; and
6. The terminology used in the financial statements, including the title of each financial statement, is appropriate.

Further, para. 14 of ISA 700 prescribes that when the financial statements are prepared in accordance with a fair presentation framework, the evaluation required by paragraphs 12-13 shall also include whether the financial statements achieve fair presentation. The auditor’s evaluation as to whether the financial statements achieve fair presentation shall include consideration of :

1. The overall presentation, structure and content of the financial statements; and
2. Whether the financial statements, including the related notes, represent the underlying transactions and events in a manner that achieves fair presentation.

While, para. 15 requires the auditor to evaluate whether the financial statements adequately refer to or describe the applicable financial reporting framework (Hrd).

A guide to an initial assessment of Control Risk

Control Risk is the risk that a material error in an account will not be prevented or detected on a timely basis by the client’s internal control structure.

Assessing control risk is the process of evaluating the effectiveness of an entity’s internal control structure in preventing or detecting material misstatements in the financial statements.

Control risk must ultimately be assessed in terms of financial statement assertions. For example, there should be separate assessments of the existence and completeness assertions for sales.

Control risk may be assessed at the maximum level or below the maximum.

An initial assessment of control risk at the maximum occurs when (1) controls do not pertain to an assertion, (2) controls that pertain are unlikely to be effective, or (3) evaluating the effectiveness of relevant controls would be inefficient. An assessment of control risk below the maximum means that there are effective controls to prevent or detect misstatements in a financial statement assertion. The assessment of control risk below the maximum should be based on evidence of the operating effectiveness of the controls.

Control risk may be expressed qualitatively such as low, moderate, or high. Alternatively, the risk may be stated quantitatively as a percentage or a numerical probability such as .75 or 1.0. The initial assessment of control risk starts with the auditor’s understanding of the control environment followed by his knowledge of the accounting system. If management’s attitude toward controls is good, the likelihood of making an initial assessment of control risk below the maximum is enhanced. In some cases, the initial assessment may be based on the effectiveness of the controls in the prior year’s audit, provided that the auditor has determined that such controls are still effective in the current year.

Assessing control risk is a matter of professional judgment. In making the assessment, it is necessary for the auditor to :

1. Identify misstatements that could occur in financial statement assertions.
2. Identify the controls that could likely prevent or detect the misstatements.
3. Obtain evidence from test of controls as to whether the controls are operating effectively.

The first two steps should be performed for all material financial statement assertions. The third step is required only when the auditor assesses control risk below the maximum (Hrd).

Source : Modern Auditing – Walter G. Kell, William C. Boynton & Richard E. Ziegler

Audit of leases, the audit objectives and audit program to be prepared while auditing the lessee obligation

For accounting and financial reporting purposes, an entity as the lessee has two alternatives in classifying a lease : (1) Operating Lease, (2) Finance Lease. The proper classification of a lease is determined by the circumstances surrounding the leasing transaction. According to IAS 17 : Leases, whether a lease is a finance lease or not will have to be judged based on the substance of the transaction, rather than on its mere form. If substantially all of the benefits and risks of ownership have been transferred to the lessee, the lease should be classified as a finance lease. Besides, IAS 17 also stipulates that substantially all of the risks or benefits of ownership are deemed to have been transferred if a lease transaction meets any one of criteria as prescribed in para. 10 and para. 11 of IAS 17.

While conducting an audit of lease transaction, the auditor shall take notes of the following principal objectives :

• Determine that all finance leases are recorded in the balance sheet with appropriate classification of the leased asset and the obligation
• Ascertain that depreciation expenses and interest expense relating to finance leases and rent expense on operating leases have been calculated and reported properly in the income statement
• Ascertain that footnote disclosure of finance lease and operating lease obligations are adequate and are in compliance with the disclosure requirements of IAS 17

The auditing procedures related to lessee obligations consist principally of a careful examination and study of the lease documents to determine the substance of the transaction and the proper accounting treatment. During the examination of the lease agreements, the auditor normally prepares a summary of the terms and provisions of each lease for his or her permanent file working papers documentation.

Then, how the auditor should prepare his or her audit program in relation with the audit of lease transaction ?

An audit program for lease obligations would include the following steps :

• Examine lease agreements and prepare a summary of key terms and pertinent data for the permanent file
• Determine that leases have been properly classified as either finance leases or operating leases using the criteria of IAS 17
• For capitalized leases, check the present value computations and determine the appropriateness of the discount rate used
• Determine that lease payments and expenses included in the accounts are in agreement with the provisions of the lease contracts
• Determine that executory costs to be paid by the lessee (property taxes, insurance, etc.) have been properly accrued and included in expenses
• Determine that any additional contingent rents payable have been accrued (such contingent rents may result from escalation clauses, gross receipts, provisions, etc.)
• Ascertain that footnote and balance sheet disclosures are in accordance with IAS 17

Source : Accountants’ Handbook – Lee.J.Seidler and D.R.Carmichael

For further reference, read also :

• The right way to classify a lease
• How is the treatment of land and buildings lease transaction ?
• Effect of operating and finance leases on lessee financial statements and key financial ratios

Risk Assessment Procedures and Related Activities

ISA 315, Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment, para. 5 to 10 prescribes the audit risk assessment procedures and related activities.

The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial statement and assertion levels. Risk assessment procedures by themselves, however, do not provide sufficient appropriate audit evidence on which to base the audit opinion.

The risk assessment procedures shall include the following :

(a)  Inquiries of management, and of others within the entity who in the auditor's judgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. Much of the information obtained by the auditor's inquiries is obtained from management and those responsible for financial reporting. However, the auditor may also obtain information, or a different perspective in identifying risks of material misstatement, through inquiries of others within the entity and other employees with different levels of authority.

(b)  Analytical procedures; the analytical procedures performed as risk assessment procedures may identify aspects of the entity of which the auditor was unaware and may assist in assessing the risk of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks. Analytical procedures performed as risk assessment procedures may include both financial and non-financial information, for example, the relationship between sales and square footage of selling space or volume of goods sold.

(c)  Observation and inspection; the observation and inspection procedures may support inquiries of management and others, and may also provide information about the entity and its environment. Examples of such audit procedures include observation or inspection of the following : (i) the entity's operations, (ii) documents (such as business plans and strategies), records, and internal control manuals, (iii) reports prepared by management (such as quarterly management reports and interim financial statements) and those charged with governance (such as minutes of board of directors' meetings), (iv) the entity's premises and plant facilities.

The auditor shall consider whether information obtained from the auditor's client acceptance or continuance process is relevant to identifying risks of material misstatement.

If the engagement partner has performed other engagements for the entity, the engagement partner shall consider whether information obtained is relevant to identifying risks of material misstatement.

Where the auditor intends to use information obtained from the auditor's previous experience with the entity and from audit procedures performed in previous audits, the auditor shall determine whether changes have occurred since the previous audit that may affect its relevance to the current audit. This is because changes in the control environment, for example, may affect the relevance of information obtained in the prior year. To determine whether changes have occurred that may affect the relevance of such information, the auditor may make inquiries and perform other appropriate audit procedures, such as walk-through of relevant systems.

The auditor's previous experience with the entity and audit procedures performed in previous audits may provide the auditor with information about such matters as : (i) past misstatements and whether they were corrected on a timely basis, (ii) the nature of the entity and its environment, and the entity's internal control (including deficiencies in internal control), (iii) significant changes that the entity or its operations may have undergone since the prior financial period, which may assist the auditor in gaining a sufficient understanding of the entity to identify and assess risks of material misstatement.

Further, the standard states that the engagement partner and other key engagement team members shall discuss the susceptibility of the entity's financial statements to material misstatement, and the application of the applicable financial reporting framework to the entity's facts and circumstances. The engagement partner shall determine which matters are to be communicated to engagement team members not involved in the discussion (Hrd) ***

The U.S. 2010 Top 100 Accounting Firms

The INSIDE Public Accounting (IPA) through its August 2010, Vol. 24, Number 8 publication released the list of "The 2010 Top 100 Firms - The Largest Accounting Firms in the U.S."

INSIDE Public Accounting is an independent newsletter for reporting and analyzing news, trends, strategies and politics, published monthly by The Platt Consulting Group. Read more : http://insidepublicaccounting.com/

Here is a little quotation from the publication :

The headline this year focuses on the ability of the IPA Top 100 to move, pivot, change and adapt. Throughout the country, strategic discussions took place among owners to figure out how to react to the challenging economy and how to best position their firms to success once a recovery begins. "TIGHTEN THE BELT!" was the battle cry for most. But beyond that, strategies were as varied as the firms that pursued them.

In the list of the 2010 Top 100 Firms, which was ranked based on the U.S Net Revenue, Deloitte LLP & Subsidiaries of New York seated at the top, ranked #1 with the total revenue of $10,938,000,000. Following, in the 2nd place was Ernst & Young LLP of New York with total revenue of $7,620,000,000. While PricewaterhouseCoopers LLP of New York ranked in the 3rd place with total revenue of $7,369,000,000.

KPMG LLP of New York, RSM McGladrey Inc. and McGladrey & Pullen LLP of Minneapolis and Grant Thornton LLP of Chicago took the 4th, 5th and 6th places respectively.

The ranked of #1 until #12 remain unchanged from that of in 2009. Read further the publication : INSIDE Public Accounting - The 2010 Top 100 Firms

Audit Documentation Requirement

Auditors support the conclusions in their reports with the audit documentation, also referred to as working papers or work papers. Audit documentation also facilitates the planning, performance, and supervision of the engagement and provides the basis for the review of the quality of the work by providing the reviewer with written documentation of the evidence supporting the auditor’s significant conclusions.

The auditor shall prepare audit documentation on a timely basis, which must be sufficient to enable an experienced auditor (an individual who has practical audit experience, and a reasonable understanding of (i) audit processes, (ii) ISAs and applicable legal and regulatory requirements. (iii) the business environment in which the entity operates, and (iv) auditing and financial reporting issues relevant to the entity’s industry), having no previous connection with the audit, to understand :

(a) the nature, timing and extent of the audit procedures performed to comply with the ISAs and applicable legal and regulatory requirements;

(b) the results of the audit procedures performed, and the audit evidence obtained; and

(c) significant matters arising during the audit, the conclusions reached thereon, and significant professional judgments made in reaching those conclusions.

In documenting the nature, timing and extent of audit procedures performed, the auditor shall record :

(a) the identifying characteristics of the specific items or maters tested;

(b) who performed the audit work and the date such work was completed; and

(c) who reviewed the audit work performed and the date and extent of such review.

ISA 230 Audit Documentation, para. 14-16 regulates the assembly of the final audit file. The auditor shall assemble the audit documentation in the audit file and complete the administrative process of assembling the final audit file on a timely basis after the date of the auditor’s report. After the assembly of the final audit file has been completed, the auditor shall not delete or discard audit documentation of any nature before the end of its retention period.

Audit documentation may be recorded on paper or on electronic or other media. Examples of audit documentation include audit programs, analyses, issues memoranda, summaries of significant matters, letters of confirmation and representation, checklist and also correspondence (including e-mail) concerning significant matters.

International Standard on Quality Control (ISQC) 1 requires firms to establish policies and procedures for the timely completion of the assembly of audit files. An appropriate time limit within which to complete the assembly of the final audit file is ordinarily not more than 60 days after the date of the auditor’s report.

The completion of the assembly of the final audit file after the date of the auditor’s report is an administrative process that does not involve the performance of new audit procedures or the drawing of new conclusions. Changes may, however, be made to the audit documentation during the final assembly process if they are administrative in nature. Example of such changes include :

• Deleting or discarding superseded documentation
• Sorting, collating and cross-referencing working papers
• Signing off on completion checklist relating to the file assembly process
• Documenting audit evidence that the auditor has obtained, discussed and agreed with the relevant members of the engagement team before the date of the auditor’s report.

ISQC 1 also requires firms to establish policies and procedures for the retention of engagement documentation. The retention period for audit engagements ordinarily is no shorter than 5 (five) years from the date of the auditor’s report, or, if later, the date of the group auditor’s report.

While PCAOB in its Auditing Standard No. 3 Audit Documentation requires the auditor to retain audit documentation for seven years from the date the auditor grants permission to use the auditor’s report in connection with the issuance of the company’s financial statements (report release date), unless a longer period of time is required by law. If a report is not issued in connection with an engagement, then the audit documentation must be retained for seven years from the date that fieldwork was substantially completed. If the auditor was unable to complete the engagement, then the audit documentation must be retained for seven years from the date the engagement ceased. Read further

“The skill of an accountant can always be ascertained by an inspection of his working papers.” – Robert H. Montgomery, Montgomery’s Auditing, 1912

IAASB proposed enhanced standard on using the work of Internal Auditors, revised to ISA 315 and ISA 610

On July 15, 2010, IAASB issued an Exposure Draft (ED) for the proposed revision of ISA 610, Using the Work of Internal Auditors. The standard is being revised in recognition of developments in the internal auditing environment as well as the evolving relationship between internal and external auditors. As a result of the revision of ISA 610, changes are also being proposed to ISA 315, Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment.

The IAASB's objective in revising ISA 315 and ISA 610 is to enhance the performance of external auditors by, (a) enabling them to better consider and leverage, as appropriate, the knowledge and findings of an entity's internal audit function in making risk assessments in the external audit, and (b) strengthening the framework for the evaluation and, where appropriate, use the work of internal auditors in obtaining audit evidence. The IAASB believes that the proposed revision will enhance the quality of audits internationally.

In determining whether the work of the Internal Audit function can be used, the IAASB proposes that the external auditor's initial assessment should be based on an evaluation of the internal audit function's degree of objectivity (as supported by its organization status, and relevant policies and procedures), level of competence and application of a systematic and disciplined approach, including quality control. The related requirements and guidance on factors to consider in making this evaluation have been updated to reflect developments in internal audit practice.

In some jurisdictions, internal auditors provide direct assistance to the external auditor through performance of audit procedures on the audit engagement under the direction, supervision, and review of the external auditor. Extant ISA 610 states explicitly that it does not deal with such instances. There is ambiguity about whether the fact that ISA 610 does not deal with direct assistance meant that the IAASB does not support its use, or whether it was simply not addressed in the scope of the ISA. However, national auditing standards of a number of jurisdictions allow for direct assistance, and it is common practice in many; while in others, it is not allowed. The IAASB concluded that continued ambiguity about its intent is not in the public's interest.

The IAASB believes, that, the proposed requirements will :

(a)  provide a framework for determining the nature and extent of the work of the internal audit function that can justifiably the used in the external audit; and

(b)  set out clear boundaries to guard against use of the work of the internal audit function in circumstances in which it would be inappropriate.

Comments for this ED are requested by November 15, 2010. Respondents are asked to submit their comments electronically through the IAASB website (www.iaasb.org), using the "Submit a Comment" link on the Exposure Draft and Consultation Papers page.

Comments can also be faxed to the attention of the IAASB Technical Director at +1 (212) 856-9420, or mailed to : Technical Director - International Auditing and Assurance Standards Board, 545 Fifth Avenue, 14th Floor, New York, New York 10017 USA.

Copies of the exposure draft may be downloaded free of charge from the IAASB website at www.iaasb.org, or just follow the download link in here : Proposed ISA 315 (Revised), Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment, and ISA 610 (Revised), Using the Work of Internal Auditors

The new rules of Audit Confirmation Process

The Public Company Accounting Oversight Board (PCAOB) on July 13, 2010 approved the publication of a proposed auditing standard regarding Confirmation. In a statement issued with the proposed new standard, PCAOB Acting Chairman Daniel L. Goelzer said the proposal modernizes the current confirmation standard, AU Section 330, The Confirmation Process, and strengthens the confirmation requirements to better protect investors and other users of audited financial statements.

This proposed standard comprises of 36 paragraphs which provides guidance about the confirmation process in audits performed in accordance with generally accepted auditing standards.

It defines the confirmation process (see par. 04), discusses the relationship of confirmation procedures to the auditor’s assessment of audit risk (see par. 05 through 10), describes certain factors that affect the reliability of confirmations (see par. 16 through 27), provides guidance on performing alternative procedures when responses to confirmation requests are not received (see par. 31 and 32). It also provides guidance on evaluating the results of confirmation procedures as states in par. 33.

In par. 05 the standards states that in determining the audit procedures to be applied, including whether they should include confirmation procedure, the auditor uses the audit risk assessment.

In relation with the audit risk assessment (read about the concept of audit risk in here), par. 07 states that the greater the combined assessed level of inherent and control risk, the greater the assurance that the auditor needs from substantive tests related to the financial statement assertion. In this situation, the auditor might use confirmation procedures rather than or in conjunction with tests directed toward documents or parties within the entity.

While par. 06 states that confirmation is undertaken to obtain evidence from third parties about financial statement assertions made by management. In general, as states in Section 326, Evidential Matter, it is presumed that “when evidential matter can be obtained from independent sources outside an entity, it provides greater assurance of reliability for the purposes of an independent audit than that secured solely within the entity.”

There are two types of confirmation requests : the positive and the negative form. If the auditor uses the positive form of confirmation, he or she should considering since there is a risk that recipients of a positive form of confirmation request with the information to be confirmed contained on it may sign and return the confirmation without verifying that the information is correct, blank forms may be used as one way to mitigate this risk.

When the auditor has not received replies to positive confirmation requests, he or she should apply alternative procedures to the non-responses to obtain evidence necessary to reduce audit risk to an acceptably low level. However, the omission of alternative procedures may be acceptable in several circumstances as stated in par. 31 to the standard.

The nature of alternative procedures varies according to the account and assertion in question. In the examination of account receivable, for example, the auditor may conduct the examination of subsequent cash receipts, shipping documents, or other client documentation to provide evidence for the existence assertion.

The complete proposed standard and another related materials are downloadable in here

Comments for the proposed auditing standard are due on September 13, 2010.

Audit the Opening Balances, how far should the Auditor go?

ISA 510 Initial Audit Engagements – Opening Balances para. A3 – A7 underlines the nature and extent of audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances which depend on such matters as follows :

(a) the accounting policies followed by the entity

(b) the nature of the account balances, classes of transactions and disclosures and the risks of material misstatement in the current period’s financial statements

(c) the significance of the opening balance relative to the current period’s financial statements

(d) whether the prior period’s financial statements were audited and, if so, whether the predecessor auditor’s opinion was modified

If the prior period’s financial statements were audited by a predecessor auditor, the auditor may be able to obtain sufficient appropriate audit evidence regarding the opening balances by reviewing the predecessor auditor’s working paper. Whether such a review provides sufficient appropriate audit evidence is influenced by the professional competence and independence of the predecessor auditor.

Audit evidence about opening balances for current assets and liabilities may be obtained as part of the current period’s audit procedures. For example, the collection (payment) of opening account receivable (account payable) during the current period will provide some audit evidence of their existence, rights and obligations, completeness and valuation at the beginning of the period.

In the case of inventories, however, the current period’s audit procedures on the closing inventory balance provide little audit evidence regarding inventory on hand at the beginning of the period. Therefore, additional audit procedures may be necessary, and one or more of the following may provide sufficient appropriate audit evidence : (1) observing a current physical inventory count and reconciling it to the opening inventory quantities, (2) performing audit procedures on the valuation of the opening inventory items, (3) performing audit procedures on gross profit and cutoff.

For non-current assets and liabilities, such as property, plant and equipment, investments and long-term debt, some audit evidence may be obtained by examining the accounting records and other information underlying the opening balances. In certain cases, the auditor may be able to obtain some audit evidence regarding opening balances through confirmation with third parties, for example, for long-term debt and investments. In other cases, the auditor may need to carry out additional audit procedures.

So, now can you figure it out how far should the auditor go for the audit of opening balances ?

The Opening Balances

Some questions may arise when we are appointed to replace the former auditor of a company or when the previously financial statements were not audited. What kind of audit procedures have to be conducted by the auditor at the initial audit engagement within this condition ? If the auditor did not apply any audit procedure regarding on the opening balance of the current period’s financial statements, would it be affected to the audit opinion ?

International Standard on Auditing (ISA) 510 Initial Audit Engagements – Opening Balances rules this conditions clearly. This ISA is effective for audits of financial statements for periods beginning on or after December 15, 2009.

Para.3 of this ISA states that in conducting an initial audit engagement (wherein the financial statements for the prior period were not audited, or were audited by a predecessor auditor), the objective of the auditor with respect to opening balance is to obtain sufficient appropriate audit evidence about whether :

(a) opening balances contain misstatements that materially affect the current period’s financial statements; and

(b) appropriate accounting policies reflected in the opening balances have been consistently applied in the current period’s financial statements, or changes thereto are appropriately accounted for and adequately presented and disclosed in accordance with the applicable financial reporting framework.

Following are several audit procedures that should be done by the successor auditor regarding the opening balance of financial statements :

1. the auditor shall read the most recent financial statements, if any, and the predecessor auditor’s report thereon, if any, for information relevant to opening balances, including disclosures.

2. the auditor shall obtain sufficient appropriate audit evidence about whether the opening balance contain misstatements that materially affect the current period’s financial statements by :

(a) determining whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, have been restated;

(b) determining whether the opening balance reflect the application of appropriate accounting policies, and

(c) performing one or more of the following : (i) where the prior year financial statements were audited, reviewing the predecessor auditor’s working papers to obtain evidence regarding the opening balances, (ii) evaluating whether audit procedures performed in the current period provide evidence relevant to the opening balance, or (iii) performing specific audit procedures to obtain evidence regarding the opening balances.

If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances, the auditor shall express a qualified opinion or disclaim an opinion on the financial statements, as appropriate, in accordance with ISA 705.

If the auditor concludes that the opening balances contain a misstatement that materially affects the current period’s financial statements, and the effect of the misstatement is not appropriately accounted for or not adequately presented or disclosed, the auditor shall express a qualified opinion or an adverse opinion.

If the auditor concludes that : (a) the current period’s accounting policies are not consistently applied in relation to opening balances in accordance with the applicable financial reporting framework, or (b) a change in accounting policies is not appropriately accounted for or not adequately presented or disclosed in accordance with the applicable financial reporting framework, the auditor shall express a qualified opinion or an adverse opinion (Hrd).

Reference : ISA 510 Initial Audit Engagements – Opening Balances

The Physical Count of Inventory

Timing and Extent of Inventory Observation

The timing and extent of inventory observation are determined by the client's inventory system and the effectiveness of its inventory controls. If the client maintains perpetual inventory records and the inventory controls are effective, the auditor may limit the extent of his or her observation and may observe the physical count at various times during the year.

If the client has a periodic inventory system, a physical inventory should be taken at least once during the year. No matter how many times during the year the client takes a physical inventory, the auditor should observe the count that occurs at or near year-end.

When quantities of inventory are determined solely by physical count and all counts are made as of the balance sheet date or within a reasonable time before or after the balance sheet date, the auditor should ordinarily be present when inventory is counted.

If the records are well kept and checked by the client periodically by comparisons with physical counts, the auditor may observe inventory either during or after the end of the period under audit.

Necessity to Observe Physical Count

The auditor should make or observe, some physical counts of the ending inventory. Tests of the accounting records alone are not sufficient for the auditor to become satisfied about inventory quantities at the balance sheet date.

Sometimes the auditor may not have observed the beginning inventory of a period he or she is being asked to report on. Ordinarily, this occurs in new engagement.

If the auditor is satisfied about the current year-end inventory, he or she may be able to satisfy himself or herself of prior period inventories by the following procedures :

1. Tests of prior transactions;
2. Reviews of records of prior counts;
3. Tests of gross profit.

The two major steps in the observation of a physical inventory are as follows :

1. Planning the physical inventory
2. Taking the physical inventory

Planning the physical inventory before conducting the physical count is essential. The auditor should review or prepare the client instructions and should work closely with the client in the planning stage. The inventory should be taken at a time when operations are suspended or minimal.

The client has primary responsibility for planning and conducting the physical inventory. Because of the auditor's important role in the taking of the inventory, however, he or she should participate in the planning stage.

Before taking the inventory, the client should submit a plan containing the following :

1. Date and time inventory is to be taken
2. Locations of inventory
3. Method of counting and recording
4. Instructions to employees
5. Provisions for the following : (a) receipts and shipments of inventory during the counts, (b) segregation of inventory not owned by client, (c) physical arrangement of inventory.

(Source : WILEY - Practitioner's Guide to GAAS 2010 - Steven M.Bragg)

Audit Approach

The Audit Approach is a risk analysis methodology that focuses on the combined impact of the environment in which a client operates, the client's management information and financial results, and the effectiveness of the client's internal controls. It is based on a thorough, up-to-date understanding of the client's business and industry, which is obtained through a comprehensive analysis of the external and internal operating environments. It enables us to design an audit programme that includes the most effective and efficient combination of test responsive to a client's unique circumstances. In addition, it provides a uniform method for developing and documenting the basis for the audit programme.

The Audit Approach enables us to plan our effort to be proportionate to the risk of material error in specific accounts and transactions. This provides the basis for planning the minimum effort necessary to limit audit risk in each area to a low level. As a result, every audit procedure has a specific purpose that is related to the company's particular situation – nothing is "routine" and hence potentially unnecessary. By following this approach we can avoid overauditing and underauditing, and we can distribute our audit work more evenly throughout the year.

MATERIALITY AND AUDIT RISK

Professional standards require us to consider materiality and audit risk when planning the nature, timing and extent of our audit procedures, and when evaluating the results of those procedures. Materiality is determined at two levels during the initial planning stage :

1. An overall level as relates to the accounts taken as a whole – planning materiality; and
2. An individual balance or class of transactions level – tolerable error.

Audit risk is defined as the risk that an auditor may unknowingly fail to modify his or her opinion on accounts that are materially misstated. We address materiality and audit risk at an overall level to help us develop an audit strategy that will provide sufficient evidence to enable us to evaluate whether the accounts are materially misstated.

At the account balance or class of transactions level, audit risk is the product of the risks that :

1. Factors in a company's internal or external operating environment, before considering the functioning of internal controls, will lead to a material error – inherent risk;
2. A material error will not prevented or detected on a timely basis by the system of internal control – control risk; and
3. The auditor's procedures will fail to detect a material error not detected by the system of internal control – detection risk.

The Audit Approach provides a methodology for relating these risk concepts to materiality and correlating them to the nature, timing, and extent of our audit procedures. This is accomplished through the Specific Risk Analysis and the Preliminary Audit Approach.

SPECIFIC CONTROL OBJECTIVES

A key element of the Audit Approach is the relationship of specific control objectives to transactions and accounts. Specific control objectives are derived from the five general control objectives that an accounting system should be expected to achieve. The first three of the five – authorization, recording, and safeguarding – relate to establishing the system of accountability and provide for the prevention of errors and irregularities. The fourth general objective – reconciliation – ties together the system of accountability established by the first three and, along with the fifth objective – valuation – provides for the detection of errors and irregularities.

We have translated these general objectives into specific control objectives that are related to the accounts and transactions of a business. Specific control objectives relate to the activities in each operating component that originate and process transactions. Each type of transaction results in either debits or credits to various accounts. Because a number of accounts and transactions are normally affected by a single specific control objective, the specific control objectives provide convenient and efficient reference points for considering the inputs to the Specific Risk Analysis.

PHASES OF THE AUDIT APPROACH

We can divide an audit into three phases – initial planning, programme development, and programme execution. On paper, each phase – and each step within it – appears as a separate activity. However, in practice, the phases and steps are closely interrelated and should not be regarded as distinct steps that are set aside when done. Throughout any audit, we should be alert for new developments that may affect the client's business or industry. We should continue to challenge the effectiveness and efficiency of audit procedures, and modify them if necessary (Hrd).

Responsibilities of Management and The Independent Auditor over the Audited Financial Statements

The fundamental to a financial statement audit is the division of responsibility between management and the independent auditor. The critical distinction is :

• Management is responsible for preparing the financial statements and the contents of the statements are the assertions of management
• The independent auditor is responsible for examining management’s financial statements and expressing an opinion on their fairness

Management’s responsibility for the fairness of the representations in the financial statements carries with it the privilege of determining which disclosures it considers necessary. Although management has the responsibility for the preparation of the financial statements and the accompanying footnotes, the auditor may assist in the preparation of financial statements. For example, he may counsel management as to the applicability of a new accounting principle, and, during the course of the audit, he may propose adjustments to the client’s statements. However, acceptance of his advice and the inclusion of the suggested adjustments in the financial statements do not alter the basic separation of responsibility. Ultimately, management is responsible for all decisions concerning the form and content of the statements.

In the event that management insists on financial statement disclosure that the auditor finds unacceptable, the auditor can either issue an adverse or qualified opinion or withdraw from the engagement.

The auditor’s responsibility is limited to performing the audit investigation and reporting the results in accordance with generally accepted auditing standards. In most cases, any material errors and omissions will be discovered if the audit has been so performed. Yet the possibility always exists that the auditor’s selected evidence will fail to uncover a material error. In this event, the auditor’s best defense is that the audit was performed and the report prepared with due care in accordance with generally accepted auditing standards.

If the auditor were responsible for making certain that all the representations in the statements were correct, it would make him a guarantor or insurer of the reliability of the financial statements. If auditors had that responsibility, evidence requirements and the resulting cost of the audit function would be increased to such an extent that audits would not be economically feasible.

It is usually more difficult for auditors to uncover irregularities (intentional misstatement of financial statements or misappropriation of assets) than errors (unintentional mistakes). This is because of the intended deception associated with irregularities. The auditor’s responsibility for uncovering irregularities deserves special mention.

References :

1)  Auditors Responsibility for Fraud Detection (JofA)

2)  Auditors’ Responsibilities Formalized Under SAS 109 (CPA Journal)

3)  New Fraud Guidance (JofA)

4)  ISA 240 (redrafted) : Auditors and Fraud

5)  IFAC.org Projects

Audit Risk Model, an introduction

ISA 315 states that the auditor should identify and assess the risks of material misstatement of the financial statement level, and  at the assertion level for classes of transactions, account balances, and disclosures.

Audit risk, as it directly affects the specific audit approach to the engagement, is generally considered at the account balance or class of transaction level.

At this level, audit risk consists of :

• The risk (consisting of inherent and control risk) that the account balance or class of transactions contain misstatements  that could be material to the financial statements whether individually or when aggregated with misstatements in other balances or classes.
• the risk (detection risk) that the auditor will not detect such misstatements.

Audit Risk Model :  AR = IR X CR X DR, where AR = Audit Risk, IR = Inherent Risk, CR = Control Risk, DR = Detection Risk

INHERENT RISK

Inherent risk is the susceptibility of an account balance or class of transactions to material misstatement, individually or when aggregated with misstatements in other balances or classes assuming that there were no related internal controls. The inherent risk of misstatement is greater for some types of transactions or accounts than for others. For example :

• Account balances and transactions subject to complex calculations are more susceptible to error than those based on simple calculations.
• Assets such as cash are more susceptible to theft than assets such as fixed assets.
• Account balances subject to judgment and estimation are more likely to be misstated than account balances based on historical, factual data.

CONTROL RISK

Control risk is the risk that a misstatement, that could occur in an account balance or class of transactions and that could be material individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and corrected on a timely basis by the accounting and internal control systems.

Control risk will vary inversely with the level of effectiveness of the internal control structure. However, because of the inherent limitations of any internal control structure (e.g. those due to human error), there will always be some level of control risk within internal control structure.

It is often difficult to distinguish between inherent and control risk because of the close relationship between the two.

Assume, for example, the auditor believes there is a 50 percent inherent risk that inventory is misstated by more than tolerable error because of technological changes that have taken place in the client's industry during the past year. The auditor also concludes that internal accounting controls are sufficiently effective to assign a control risk of 30 percent.  Using a portion of the audit risk model, AR = IR X CR X DR, the likelihood of an error occurring is 15 percent (IR X CR = 50% X 30%).

Before an auditor can use a control risk of less than 100 percent, he is required to do two things : evaluate how well a client's internal control system functions and test the system for effectiveness.

DETECTION RISK

Detection risk is the risk that auditor's substantive procedures will not detect a misstatement that exist in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes.

Detection risk is a function of the effectiveness of auditor's audit procedures and how well the auditor apply them. Such risk exists partly because auditor typically examine less than 100% of an entity's transactions (sampling risk) and partly because auditor may select inappropriate audit procedures, apply audit procedures incorrectly, or misinterpret the results of audit procedures.

The level of detection risk that auditor can accept varies inversely with the level of inherent and control risk. The higher the inherent and control risk, the less detection risk that auditor can accept to keep the risk of material misstatement at an acceptably low level.

The less detection risk that auditor can accept, the more reliable of substantive procedures must be.

Using the example discussed in the control risk section, assume there was a detection risk of 20 %. The audit risk is therefore 3 % (IR X CR X DR = 0,50 x 0,30 x 0,20). The auditor can conclude there is a 3 percent risk that inventory is misstated by more than tolerable error. This conclusion is based upon the assumption that the auditor can measure the component risks in a precise manner (Hrd) ***

WHY We Need to Know the Client's Business ?

Obtaining an understanding of the client’s business is key to an effective and efficient audit. It enables us not only to tailor our work to meet the individual facts and circumstances of each client, but also to carry out that work and to evaluate our findings in an informed manner. Our knowledge of the client’s business also helps us to develop and maintain a positive professional relationship with the client.

International Standards on Auditing (ISA) 315 states that the auditor should obtain an understanding of the entity and its environment, including its internal control, sufficient to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures.

Understanding the entity is an iterative process, continuing throughout the entire duration of the audit.

Prior the accepting an audit engagement, we should obtain a preliminary knowledge of the industry and of the ownership, management and operations of the entity to be audited.

Detailed information is required at the planning stage of our audit to enable us to plan our work adequately. We need to understand the nature of client’s business, its organization, its method of operation and the industry in which it is involved. This understanding enables us to appreciate which events and transactions are likely to have a significant effect on the financial statements.

Specifically, such an understanding helps us to :

• Identify the areas of high risk where we should concentrate our audit effort
• Maximize efficiency in other areas of audit significance
• Assess the potential for use of analytical procedures, by enabling us to identify the information which we can use to make predictions and comparisons
• Obtain an understanding of the internal control structure
• Assess the inherent and control risks in the key areas of audit significance
• Develop an audit strategy enabling us to obtain the necessary audit evidence in the most effective and efficient manner possible.

Knowing the client’s business helps us in a number of ways both during the conduct of the audit, and when we come to complete our work.

This includes, for example, helping us in :

• Recognising errors in the financial statements
• Asking the right questions and evaluating the reasonableness of the answers we receive
• Making judgements about the appropriateness of the client’s accounting principles, policies and procedures
• Identifying unusual or unexpected transactions and related party transactions
• Interpreting the results of audit tests and evaluating their effect
• Carrying out appropriate procedures to review events occurring after the balance sheet date
• Carrying out an overall review of the financial statements.

Knowledge of the client’s business and the industry in which it operates is essential also to the development of a positive relationship and it helps us as follows :

• In understanding the management’s philosophy and aspirations for the business
• Understanding the business strategy and plans
• Providing relevant and practical business advice to the client
• Identifying areas in which the client might benefit from other professional services which we provide.

ISA 315 states that :

• the auditor should obtain an understanding of relevant industry, regulatory, and other external factors including the applicable financial reporting framework
• the auditor should obtain an understanding of the nature of the entity
• the auditor should obtain an understanding of the entity's selection and application of accounting policies and consider whether they are appropriate for its business and consistent with the applicable financial reporting framework and accounting policies used in the relevant industry
• the auditor should obtain an understanding of the entity's objectives and strategies, and the related business risks that may result in material misstatement of the financial statements
• the auditor should obtain an understanding of the measurement and review of the entity's financial performance.

Each year, the auditor's understanding of the entity should be updated and details of significant changes documented (Hrd) ***

Audit Procedures on Accounting Estimates

An accounting estimate is an approximation of a financial statement element, item, or account in the absence of exact measurement. Examples of accounting estimates include periodic depreciation, the provision for bad debts, net realizable value of inventory, revenues from contracts accounted for by the percentage-of-completion method, and pension and warranty expenses.

Management is responsible for establishing the process and controls for preparing accounting estimates. Judgment is requires in making an accounting estimate. Accounting estimates may have a significant affect on a company’s financial statements.

The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management’s estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Accordingly, when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors.

SAS No. 57, Auditing Accounting Estimates (AU 342.07), states that the auditor’s objective in evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that :

1. All accounting estimates that could be material to the financial statements have been developed;
2. The accounting estimates are reasonable in the circumstances;
3. The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.

In determining whether all necessary estimates have been made, the auditor should consider the industry in which the entity operates, its methods of conducting business, and new accounting pronouncements. To evaluate the reasonableness of an estimate, the auditor should normally concentrate on the key factors and assumptions used by management including those that are :

1. significant to the accounting estimate;
2. sensitive to variations;
3. deviations from historical patterns, and
4. subjective and susceptible to misstatement and bias.

Evidence of the reasonableness of an estimate may be obtained by the auditor from one or a combination of the following approaches :

1. Perform procedures to review and test management’s process in making the estimate;
2. Prepare an independent expectation of the estimate;
3. Review subsequent transactions and events occurring prior to completing the audit that pertain to the estimate.

The procedures to be performed include :

1. considering the relevance, reliability, and sufficiency of the data and factors used by management,
2. evaluating the reasonableness and consistency of the assumptions, and
3. re-performing the calculations made by management.

In some cases, it may be useful to obtain the opinion of a specialist regarding the assumptions.

Because no one accounting estimate can be considered accurate with certainty, the auditor may determine that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may not be significant, and such difference would not be considered to be a likely misstatement. However, if the auditor believes the estimated amount included in the financial statements is unreasonable, he or she should treat the difference between that estimate and the closes reasonable estimate as a likely misstatement (SAS No. 57 AU 342.14).

Baker Tilly International, amongst the world’s top ten Accounting Firms

Baker Tilly International is one of the world’s leading networks of independently owned and managed accountancy and business advisory firms united by a commitment to provide exceptional client service.

Baker Tilly International refers to a worldwide network of member firms of Baker Tilly separate and independent legal entity, with 147 high quality, independent accounting and business advisory firms in 114 countries across four geographic areas of Asia Pacific, Europe, Middle East & Africa, Latin America and North America, with more than 25,000 professionals. In Indonesia, Kantor Akuntan Johan Malonda Astika & Rekan (known also as Baker Tilly Indonesia) is an independent member of Baker Tilly International. Being an independent member that is to say each member firm is a separate and independent legal entity. None of Baker Tilly branded entity, Baker Tilly International, nor any of the other independent member firms of Baker Tilly International has any liability for each other’s acts or omissions.

In 2009, Baker Tilly International had been ranked No. 8 (in the top 10) in Global Accounting Networks based on The 2009 International Accounting Bulletin World Survey.

Accountancy Age in its annual survey of “Top 50 UK Accounting Firms, 2009” ranked Baker Tilly in No. 7, after BDO Stoy Hayward. While in 2010, it ranked Baker Tilly in No. 8 after RSM Tenon Group (Read in here).

In 2010, Accounting Today in its annual Top 100 Firms publication ranked Baker Tilly Virchow Krause in No. 13.

The survey reported that Baker Tilly International has maintained its position as the world’s eighth largest accounting network by combined revenue. Of the 10 largest networks, Baker Tilly International was one of only two to report positive growth in 2009 with a total fee income of $3.13 billion.

Vault.com in it its publication of “Vault Guide to the Top 20 Accounting Firms” ranked Baker Tilly in No. 7 after BDO Stoy Hayward LLP within the survey of “The 20 most prestigious UK accounting firms year 2010”.

Baker Tilly can trace its origins back to 1870, with the founding of Walter Howard. Historical name changes and mergers with many different firms have brought the partnership to where it is today. The name Baker Tilly was created in 1988 through the merger between Howard Tilly and Baker Rooke. Today, Baker Tilly is the 7th largest accountancy and business advisory firm in the UK. It is also a member of Baker Tilly International, the world’s eighth largest network of accountancy firms.

The world headquarter of Baker Tilly International is at : 2 Bloomsbury Street, London WC1B 3ST United Kingdom. Visit the website in here

PCAOB Issues Staff Audit Practice Alert on Auditor Considerations of Significant Unusual Transactions

On April 7, 2010, The Public Company Accounting Oversight Board  issued a Staff Audit Practice Alert to remind auditors of public companies about their responsibilities to assess and respond to the risk of material misstatement of the financial statements due to error or fraud posed by significant unusual transactions.

Staff Audit Practice Alert No. 5, Auditor Considerations Regarding Significant Unusual Transactions (Practice Alert No. 5) compiles relevant requirements from existing PCAOB auditing standards regarding significant unusual transactions to assist the auditor in reviews of interim financial information and audits of financial statements.

"The PCAOB’s message to auditors, in this challenging economic environment, has consistently emphasized attention to audit risk and adherence to existing audit requirements," said Martin F. Baumann, Chief Auditor and Director of Professional Standards.

Practice Alert No. 5 complements Staff Audit Practice Alert No. 3, Audit Considerations in the Current Economic Environment, by further addressing risks of material misstatement associated with significant unusual transactions, a risk that the staff believes continues to exist today.

Practice Alert No. 5 compiles existing requirements from PCAOB auditing standards regarding significant unusual transactions and groups them into the following categories:

• Identifying and assessing risks of material misstatement
• Responding to risks of material misstatement
• Consulting others
• Evaluating financial statement presentation and disclosure
• Communicating with audit committees
• Reviewing interim financial information

"Practice Alert No. 5 will assist auditors as they begin their work related to 2010 quarterly reviews and audits of financial statements," said Mr. Baumann.

These alerts are prepared to highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of PCAOB standards and relevant laws.

Auditors should determine whether and how to respond to these circumstances based on the specific facts presented. The statements contained in Staff Audit Practice Alerts are not rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person.

• Staff Audit Practice Alert No. 5, Auditor Considerations Regarding Significant Unusual Transactions (April 7, 2010)

Source : PCAOB Website

Read also a related article from Journal of Accountancy in here

Accountancy Age’s 2010 UK Top 50 Accountancy Firms

Accountancy Age has released its annual survey of "Top 50 + 50 UK Accountancy Firms 2010." Amongst the top ten list, PricewaterhouseCoopers seated at the top, ranked #1, still unchanged from the last year position with the UK fee income of £2,248 million, Deloitte ranked in #2 (unchanged from 2009) with £1,969 million, KPMG took the place of #3 (unchanged from 2009) with £1,630 million. While Ernst & Young placed in the lowest amongst the big four, ranked #4 (unchanged from 2009) with its revenue of £1,383 million.

Grant Thornton UK and BDO Stoy Hayward stood still at the position of #5 and #6 respectively. While RSM Tenon Group moved up from #9 in 2009 to #7. Baker Tilly moved down from the 7th position to the 8th position and Smith & Williamson also moved down from the 8th position to the 9th position. At the bottom of the top ten was PKF (UK), remain unchanged at #10.

“If you thought that 2009 had been a tough year for the UK's top accounting firms, it's got nothing on 2010. Things have gone from bad to worse for the UK's top accounting firms this year. While there was overall nominal growth in the Top 50, 19 firms failed to improve their incomes on the previous year. The situation was even tougher in the +50, where growth rates stagnated,” said Accountancy Age.

Accountancy Age is published in the UK by Incisive Media, one of the world's leading B2B information provider.

Read the complete report from here : Top 50 + 50 Accountancy Firms 2010

Code of Ethics for Professional Accountants (revised July 2009)

On July 10, 2009, the International Ethics Standards Board for Accountants (IESBA) has issued a revised Code of Ethics for Professional Accountants (the Code), clarifying requirements for all professional accountants and significantly strengthening the independence requirements of auditors. The revised Code has been released following the consideration and approval by the Public Interest Oversight Board (PIOB) of due process and extensive public interest consultation.

"Strong and clear independence standards are vital to investor trust in financial reporting," emphasizes IESBA Chair Richard George. "The increase in trust and certainty that flow from familiarity with standards, including a common understanding of what it means to be independent when providing assurance services, will contribute immeasurably to a reduction in barriers to international capital flows."

The revised Code, which is effective on January 1, 2011, includes the following changes to strengthen independence requirements:

(a)  Extending the independence requirements for audits of listed entities to all public interest entities;

(b)  Requiring a cooling off period before certain members of the firm can join public interest audit clients in certain specified positions;

(c)  Extending partner rotation requirements to all key audit partners;

(d)  Strengthening some of the provisions related to the provision of non-assurance services to audit clients;

(e)  Requiring a pre- or post-issuance review if total fees from a public interest audit client exceed 15% of the total fees of the firm for two consecutive years; 

(f)  Prohibiting key audit partners from being evaluated on or compensated for selling non-assurance services to their audit clients.

The revised Code maintains the principles-based approach supplemented by detailed requirements where necessary, resulting in a Code that is robust but also sufficiently flexible to address the wide-ranging circumstances encountered by professional accountants.

"This approach should also help to facilitate global convergence," points out Mr. George.

The International Federation of Accountants' Statements of Membership Obligations have as a central objective the convergence of a country's national code with the Code of Ethics for Professional Accountants. Further, the requirements specify that member bodies should not apply less stringent standards than those stated in the Code.

"It is especially critical that member bodies focus on the implementation of the revised Code as soon as possible," emphasizes Mr. George. "To help them in this process, the IESBA plans to provide them with some additional support and guidance in the coming months." 

Source of this article : IFAC.org

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