Audit Simulation - some brief help

peugeotpeugeot Experienced MentorRegistered Posts: 624
Hi All,

A couple of queries have come my way about the audit simulation some of you are facing in the New Year. I understand auditing is quite daunting, particularly if you don't have experience of such, so I am hoping I can offer some light in the audit 'tunnel'!

I have written several articles on auditing (some are on the AAT Accounting Technician online magazine, but you might have to do a search and on AccountingWeb). I will provide links to more relevant AAT related audit articles at the end of this thread. On a thread (for obvious reasons), I cannot give a 'tutorial' but I can offer the basics.

Purpose of the audit
The whole purpose of the audit is for the auditors to form an independent opinion on the 'truth' and 'fairness' of the financial statements. Under UK Company legislation, financial statements should give a 'true and fair' view. The auditors form an independent opinion, based on their audit, as to whether a company's financial statements achieve this objective.

Auditors cannot test every component part of the financial statements 100% as this is impractical. What they do instead is to test items by way of 'sampling'. Sampling works by extracting a 'sample' from a 'population' (a 'population' is a number of component parts that make up an account balance e.g. individual sales ledger accounts is the 'population' that makes up the balance on the receivables listing). There are two types of testing:
  • tests of control; and
  • substantive testing.

Tests of control test the internal controls of a company (an internal control could be authorisation of purchase invoices or cheques over a £1,000 should only be signed by a director etc). Substantive testing is also referred to as 'transaction testing' and tests a number of transactions from initiation right through to their ultimate destination in the financial statements. For example, substantive testing on sales would start right from receipt of the order up to and including the sales invoice's destination in the financial statements.

Where the auditor places reliance on a company's internal control systems (i.e. tests of control are reliable), then the auditor can reduce their substantive testing (which is ideally what they want to do). Where internal controls fail, or are insufficient or not appropriate, then the auditor must increase their substantive testing.

In today's modern audit environment assets are usually tested for overstatement, whilst liabilities are usually tested for understatement. The audit follows various financial statement 'assertions'.

Financial statements contain 'assertions'. There are 3 assertions, which are subdivided as follows:

Are tested for: occurrence, completeness, accuracy, cut-off and classification.

Account balances
Are tested for: existence, rights and obligations, completeness, valuation and allocation.

Presentation and disclosure
Are tested for: occurrence, rights and obligations, completeness, classification, accuracy and valuation.

My article An overview of auditing covers these assertions in more detail.

I think if you can get a good understanding of the types of testing you would undertake on certain audit areas, you'll not go far wrong. Take for example the audit of trade receivables (aged debtors). There are various tests the auditor can undertake to ensure the valuation placed on the aged debtors at the balance sheet date is fairly stated (i.e. not overstated).
  • circularisation (where the debtor is written to to confirm the balance on their purchase ledger agrees to the client's sales ledger) - this is an 'existence' test
  • after-date cash. This is where cash received after the balance sheet date is traced to the aged debtors listing. Again, this is an 'existence' test.
  • Analytical review. AR is a substantive procedure and is primarily used to identify unsual trends/characteristics (with debtors, an increase in debtors with reduced revenue could indicate potential bad debts not provided for).
  • Review aged receivables listing at the balance sheet date and concentrate on older items for potential bad debts (valuation and allocation i.e. some may need writing off to the income statement).
  • After date credit notes which relate to invoices issued after the balance sheet date (again, valuation to ensure debtors are not overstated).
  • Invoices are recorded in the correct period (ie cut offs are correct), thus 'completeness' is tested here.
  • Invoices are reviewed to ensure they are bona fide - thus 'rights and obligations' are tested here.

Certain audit areas will require certain audit tests (i.e. you will not perform the same audit tests on provisions or fixed (non-current) assets that you would if you were doing trade receivables (above)). Knowledge of accounting standards is also vital as the audit is not just concerned with ensuring the audit tests work, but also that the financial statements have been prepared correctly under the provisions of IFRS/IAS or FRS/SSAP/UITF. If they have not or if a transaction(s) or (non)disclosure breaches an accounting standard, then depending on how material this breach is, may impact on the audit opinion.

Materiality is set at the planning stage and is always referred to during the course of an audit. An item is 'material' if its omission or non-disclosure would influence the economic decisions made by the user of the financial statements e.g. would the inclusion of a provision for damages change the decision of a potential investor if it had been included/disclosed?

Audit opinion
The opinions can be:

Generally given when the auditors confirm the financial statements are free from MATERIAL misstatement whether caused by fraud or error.

Generally given when the auditor disagrees with an accounting treatment or disclosure (or non-disclosure) in the financial statements e.g. where the client refuses to write off a material bad debt.

More serious than a qualified opinion. This is given where the financial statements contain a fundamental error/omission which gives rise to the financial statements FAILING to give a true and fair view.

This is where the auditor is unable to form an opinion on the financial statements. These opinions are very rare, and are usually given where there are serious failings in the internal control environment.

I have written a number of articles on auditing which helps explain the topic in more detail (one article was written for someone on here who was doing her audit sim). The following may help you:

Help from Steve in Audit Papers
The Auditor and Fraud
An Overview of Auditing
Auditing Questions Answered
Reporting on Audit Clients
Audit Evidence Audit Procedure

I hope the above will help some of you.

Kind regards


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