THE AUDITOR AND THE COMPANIES ACT-Questions and Answers

Audit Test Questions and Answers

QUIZ

1. list the different types of audit opinions.
   1. list the basic elements of the audit report.
   1. List the factors that lead to the qualification of an audit Report.
2. a) Unqualified opinion
   1. Qualified opinion
   1. Disclaimer of opinion
   1. adverse opinion
3. a. an appropriate title
   1. The auditor’s report should be appropriately addressed
   1. The introductory paragraph
   1. a paragraph on the scope of the audit
   1. an opinion paragraph
   1. Dating the audit report g,         The auditors address

h. A Signature in the name of the audit firm and location of the auditor i.e office

• This occurs when;
  • There is a limitation on the scope of his work;
  • There is a disagreement with management
  • There is a significant uncertainty affecting the financial statements, the resolution of

QUESTiON ONE

Going concern concept is a fundamental assumption underlying the preparation of the financial statements. What are the procedures you would perform to ensure that the going concern is appropriate for you audit client.

QUESTION TWO

1. in respect of the going concern concept:
   1. Define ‘going concern’ and state two situations in which it should NOT be applied in the preparation of financial statements.
   1. Explain the directors’ responsibilities and the auditors’ responsibilities regarding financial statements prepared on the going concern principle.
2. list the audit procedures that should be carried out to determine whether or not the going concern basis is appropriate for Green Co.

QUESTION THREE

The Companies act (Cap.486) sets out the duties of the auditors for a company in respect of his report and other matters.

required:

1. State four situations under which the act requires auditors to qualify their report.
   1. State two circumstances in which the auditors may qualify their report owing to inherent uncertainty.
   1. State four types of circumstances in which the auditors may qualify their report as a result of disagreement with the directors

QUESTION FOUR

an extract from the draft audit report produced by an audit junior is given below:

Basis of Opinion

‘We conducted our audit in accordance with auditing Standards. an audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. it also includes an assessment of all the estimates and judgments made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the company’s circumstances, consistently applied and adequately disclosed.

‘We planned and performed our audit so as to obtain as much information and explanation as possible given the time available for the audit. We confirm that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. The directors however are wholly responsible for the accuracy of the financial statements and no liability for errors can be accepted by the auditor. in forming our opinion we also evaluated the overall adequacy of the presentation of information in the company’s annual report.’

Required: identify and explain the errors in the above extract.

SUGGESTED SOLUTIONS

QUESTION ONE

1. The need for an audit. These are the requirements of the Companies act Cap 486.
   1. To prove the true and fair view of the companies state of affairs as at a given date.
   1. To find out whether the company has kept proper books of account.
   1. To write a report to be used by stakeholders.
   1. To provide advice to management on areas of internal weaknesses.
   1. Detection of errors and frauds.
2. procedures for the appointment of an auditor
   1. Upon registration of a company (30 days after) the board of Directors or the registrar of Companies appoints an auditor.
   1. he can also be appointed at the AGM. if this approach is used the outgoing auditor must be given a 28 days notice.
   1. Automatic reappointment. This occurs if there is no resolution to remove the existing auditor, if the existing auditor has not given in writing a notice to resign and if he has not committed an act to disqualify automatic re-appointment.
   1. Casual vacancies may arise and should be filled by the directors of the company except if he resigned in which case it is filled by shareholders Casual vacancies arise if the auditor dies becomes incapacitated or he resigns.
3. Director’s duties with regard to accounting function:
   1. Safeguarding the company assets an preventing fraud and error
   1. Selecting suitable accounting policies and applying them consistently
   1. Ensuring that the company keeps proper accounting records as per the Companies act.
   1. Delivering to the government agency, court or stock exchange a copy of the company’s auditor financial statements within the specified period after year-end.
   1. Stating whether applicable accounting standards have been followed subject to any material departure disclosed and explained in the financial statements.
   1. Prepare the financial statements on a going concern basis unless it is appropriate to presume that the company will continue operations.
   1. Setting up an internal control system to enable all the above responsibilities to be carried out as required.
4. The auditor should make a report to members on accounts examined by them and laid before company in AGM. it must contain statements as to matters mentioned in the 7th schedule. They include:
   1. Whether or not they have obtained all information and explanations which to the best of their knowledge and belief were necessary for the audit.
   1. Whether in their opinion proper books of account have been kept and proper returns adequate for the purpose of the audit have been received from branches not visited.
   1. Whether the profit and loss account and balance sheet are in agreement with the books of account and returns.
   1. Whether in their opinion and to the best of their knowledge and according to explanations given to them financial statements give information required by companies act in the manner so required and give the true and fair view.
   1. In the balance sheet, the stare of affairs at the end of its financial year. In the profit and loss account, the profit or loss for the year.

QUESTION TWO

(a) reliance on work of internal auditors

 as requested, the external auditors will seek to rely on the work of internal audit to the maximum extent possible. This might cover planning, risk assessment, tests of controls and substantive testing.

 in all cases, the external auditor should be aware that the purpose of internal audit’s work will not be primarily directed towards the financial statements.

 in relation to the cyclical audit of internal controls, it may be possible to rely on the work of internal audit in relation to all of the areas noted, but only if the internal controls audited affect the financial statements. It may be that internal audit’s work on operations and customer support is less relevant than its work in other areas.

 in relation to the four-year review of internal controls – the extent of reliance will depend on how long ago the last review was conducted. if it was conducted recently, it will provide help in relation to the external auditor’s assessment of the accounting and internal control systems.

 in relation to risk management – the relevance of internal audit work depends on the extent to which risks in relation to reporting in general and the financial statements in particular, have been addressed separately by management. This work will be relevant to the external auditor’s risk assessment and planning.

• information required
  • The information required to determine the extent of external audit reliance on internal audit’s cyclical audit will be:

 internal audit’s systems documentation (the work on information systems and finance may include documentation of the company’s accounting and internal control systems);

 internal audit’s planning documentation which may cover a risk analysis, tests of controls and substantive procedures;

     The results of tests of control and substantive procedures;

 Documentation on the four-year review of internal controls, particularly in relation to the finance and information services functions.

• The external auditors should ask to see all documentation relating to the work performed by internal audit on information services restructuring during the year because the external auditor’s assessment and testing of systems will be split into two parts, pre- and post-restructuring.
  • other documentation requested will include internal audit’s operating procedures manuals and documentation relating to the recruitment, training and development of internal audit staff, and management responses to internal audit recommendations. This information is required to enable the external auditor to form an opinion on the competence and effectiveness of the internal audit function.
• Circumstances in which it would not be possible to rely on the work of internal audit (i)         it may not be possible to rely on the work of internal auditors if they:
  • Are not competent (this relates to experience as well as qualifications).
  • Lack integrity;
  • Do not properly plan or document their work, or if management does not act on (or at least respond to) recommendations made;
  • Do not perform work relevant to the external auditor.

(ii) It will also not be possible to rely on internal audit if internal audit is insufficiently independent within the organization, i.e. where internal auditors have insufficient operational freedom, where they are reporting to those who control the functions that they work on, or where they are reporting on their own work.

• External auditor work

 External auditors will wish to perform work independently, regardless of internal audit work, in all areas that are material to the financial statements. For immaterial areas in which internal audit work can be shown by testing and review to be adequate, it may be possible to rely on the work of internal audit without performing any other work.

 Areas material to the financial statements are likely to be long and short-term leasing receivables and inventory. leases may be complex and the auditors will wish to ensure that accounting policies are appropriate and that they have been properly applied. The valuation of inventory will have a direct effect on the profit for the period. This is an area that is easy to manipulate and external auditors will wish to ensure that this has not happened.

 External auditors will also wish to perform their own risk analysis and final review of financial statements in order to ensure that no high risk areas have been overlooked.

QUESTION THREE

(a) Six financial statement assertions

            i.          Existence: an asset, liability or equity interest exists;            ii.         Cut off: transactions and events have been recorded in the correct accounting period; iii.        occurrence: a transaction or event that has been recorded took place and pertains to the entity during the period;

1. Accuracy and valuation: financial and other information is disclosed fairly and at appropriate amounts;
2. rights and obligations: the entity holds or controls the rights to assets, and liabilities or obligations of the entity; and
3. Classification: transactions and events have been recorded in the proper accounts.

QUESTION FOUR

• Training material: purpose of external audit and its role
• The external audit has a long history that derives largely from the separation of the ownership and management of assets. Those who own assets wish to ensure that those to whom they have entrusted control are using those assets wisely. This is known as the ‘stewardship’ function.
• The requirement for an independent audit helps to ensure that financial statements are free of bias and manipulation for the benefit of users of financial information.
• Companies are owned by shareholders but they are managed by directors (in very small companies, owners and managers are the same, but many such companies are not subject to statutory audit requirements).
• The requirement for a statutory audit is a public interest issue: the public is invited to invest in enterprises, it is in the interests of the capital markets (and society as a whole) that those investing do so in the knowledge that they will be provided with ‘true and fair’ information about the enterprise. This should result in the efficient allocation of capital as investors are able to make rational decisions on the basis of transparent financial information.
• The requirement for an audit can help prevent investors from being defrauded, although there is no guarantee of this because the external audit has inherent limitations. reducing the possibility of false information being provided by managers to owners is achieved by the requirement for external auditors to be independent of the managers upon whose financial statements they are reporting.
• The purpose of the external audit under international Standards on auditing is for the auditor to obtain sufficient appropriate audit evidence on which to base the audit opinion. This opinion is to the effect that the financial statements give a ‘true and fair view’ (or ‘present fairly in all material respects’) of the position, performance (and cash flows) of the entity. This opinion is prepared for the benefit of shareholders.
  

Auditor’s Report

QUESTION ONE

The procedures to ensure that the Going concern is still appropriate to your clients include:

• Assess the adequacy of the means by which the directors have satisfied themselves that the adoption of the going concern basis is appropriate.
  • Examine all appropriate evidence.
  • Assess the adequacy of the length of time into the future that the directors have looked.
  • Assess the systems or other means by which the directors have identified warnings of future risks and uncertainties.
  • Examine budgets and other future plans and assess the reliability of such budgets by reference to past performance.
  • Examine management accounts and other reports of recent activities
  • Consider the sensitivity of budgets and cash flow forecasts variable factors both within the control of the directors (e.g. capital expenditure) and outside their control (e.g. interest or debt collection)
  • Review any obligations, undertakings or guarantees arranged with other entities for the giving or receiving of support. Other entities may mean lenders, suppliers, customers or other companies in the same group. A Kenyan company may be viable in itself but may have given guarantees to other members of the group and when, say the holding company in Uganda fails, the company goes down with it.
  • Survey the existence, adequacy and terms of borrowing facilities and supplier credit.
  • Appraise the key assumptions underlying the budgets, forecasts and other information used by the directors.
  • Assess the director’s plans for resolving any matters giving rise to concern (if any) about the appropriateness of the going concern basis. Such plans should be realistic, capable of resolving the doubts and the directors should have firm intentions to put them into effect.

 Finally the auditor should review all the information they have and all the audit evidence available and consider whether they can accept the going concern basis. They should always have all their evidence documented and their reasoning explained fully in the working papers.

QUESTiON TWO

1. ( i) Going concern  iaS 1 Presentation of Financial Statements defines the going concern concept as the assumption that the enterprise will continue in operational existence for the foreseeable future.

          an entity will normally use the going concern basis unless: –               it is being liquidated or has ceased trading, or

– The directors have no realistic alternative than to liquidate the company or to cease trading.

(ii) responsibilities

 The directors’ responsibilities regarding going concern is to prepare the financial statements of an entity ensuring that the going concern basis is reasonable. They may also prepare cash and/or profit forecasts for at least 12 months into the future to demonstrate that the entity is likely to continue to trade during this time.

 The auditors’ responsibility regarding going concern is to form an opinion on the appropriateness of management’s assessment of the going concern status of the entity and the adequacy of disclosures, if any. The auditor will collect sufficient and appropriate audit evidence to ensure use of the going concern assumption is valid. To be clear, the auditors are not responsible for ensuring that the company is a going concern; this is a responsibility of the directors.

• audit procedures audit procedures on going concern will include:
  • Obtaining cash and profit forecasts from the directors. Ensure that these have been properly prepared (for example, are arithmetically correct) and show that the firm will continue trading.
  • Review the order books for the firm to determine the level of future sales.
  • Contacting firm’s lawyers to determine the progress, if there are court cases pending.
  • Review the financial status of firm during the audit to identify other indicators of a going concern problem such as failure to repay loans or decrease in sales.
  • Contacting firm’s bank to ascertain whether any loan or overdraft agreements are due for renewal and whether these will be renewed.
  • Obtaining written representation from the directors confirming that they are not aware of any circumstances other than those evaluated by the auditor, so they expect the firm to continue as a going concern.

QUESTION THREE

a)            Four situations under which the act requires auditors to qualify their report.

1. if the auditors are unable to obtain all the information and explanations they consider necessary for the purpose of their audit, for example, if they are unable to obtain satisfactory evidence:
   1. of the existence of ownership of material assets or of the amounts at which they have been stated on the basis adopted.
   1. of the validity of payments
   1. That the records properly reflect all transactions of the business because the evidence has been lost or destroyed or is otherwise not forthcoming or has never existed.
2. if in the opinion of the auditors:
   1. Proper books of accounts have not been kept in accordance with the Companies act.
   1. Proper returns adequate for their audit have not been received from branches nor visited by them.
   1. The balance sheet and the profit and loss account are not in agreement with the accounting books and returns.
3. If in the opinion of the auditors the accounts though based on proper books of account fail to give the information required by the act for example, a failure to comply with specific disclosure requirements of the Companies act in material respects.
4. if in the opinion of the auditors the accounts though otherwise complying with the disclosure requirements fail to disclose a true and fair view for example. because in the auditor’s opinion the underlying accounting policies do no conform to accounting principles appropriate to the circumstances and nature of the business;
   1. Because they are prepared on principles inconsistent with those previously adopted and without adequate explanation and disclosure of the effects of the change
   1. Because the auditors are unable to agree with the amounts at which an asset or a liability is stated
   1. Because the auditors are unable to agree with the amount at which income or expenditure or profit is stated
   1. Because the accounts do not disclose information though not specifically required by the companies act, is necessary for the presentation of a true and fair view
   1. Because the additional information given in a note or in the director’s report materially alters the view otherwise given by the accounts.

b. Circumstances in which the auditors may qualify their report owing to inherent uncertainty. Uncertainty is of two levels material and not fundamental and material and fundamental.  Material and not Fundamental  if the auditor has reservations on only a particular aspect of the accounts and not on the accounts as a whole he is able to form an opinion on the accounts as a whole with particular reservation on a specific matter. He therefore disclaims opinion on only an aspect of the accounts and not the accounts taken as a whole.

            Material and Fundamental

 This is when the impact on the accounts taken as a whole is to make them meaningless for any decision making purposes and to reduce their informational value. in this situation, the auditor is unable to form an opinion on the accounts taken as a whole and he therefore disclaims his opinion altogether by stating he is unable to form an opinion as to when the financial statements give a true and fair view.

QUESTION FOUR

The basis of opinion paragraph may not meet the requirements of iSa 700 for the following reasons:

• The use of the term auditing Standards is not clear, because the report does not state which auditing standards have been used. This provides uncertainty regarding the actual standard of work performed.
• The assessment of estimates and judgments made by the directors normally relates to significant amounts only, rather than all of those estimates and judgments. The use of the word all implies that the audit was more thorough than it probably was. replacing the word all with the word significant will show that there was some limit to the audit testing and that this was probably focused on material amounts only.
• Stating that time was a factor in obtaining information and explanations for the audit is not correct as this implies some factor which could have been avoided and that the audit may therefore be incomplete. The auditor has to plan the audit carefully and ensure that all the information and explanations considered necessary are obtained to form an opinion, not simply stop work when time runs out.
• The auditor does not confirm that the financial statements are free from material misstatement as this implies a degree of accuracy that the auditor simply cannot provide. making the statement could also leave the auditor liable to claims from members or third parties should errors be found in the financial statements later. Rather than make such a categorical statement, the auditor provides reasonable assurance that the financial statements are free from material misstatement, which clearly implies that audit techniques are limited.
• The disclaimer regarding errors appears to be useful in that it limits the auditor’s liability. however, it does not belong in the basis of opinion paragraph as it appears to severely limit the basis of the auditor’s opinion to stating that the directors are responsible for all errors. Directors’ responsibilities are also clearly outlined in another section of the report, and this statement also appears to extend those responsibilities making the audit report overall less clear. This could also imply that the auditor has done little or no work.
• as the auditor is not required to audit the whole of the annual report of a company, it is inappropriate to refer to disclosure in that report when checking overall adequacy of presentation. Adequacy of presentation can only be confirmed regarding items actually audited, which is basically the financial statements.
  

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