Types of Audits
Internal Controls in a Computerized Information System
Risk and Materiality (iSA 320 Materiality)
iSa 320 discusses the concepts of risk and materiality. an audit risk is the risk that an auditor may give an inappropriate opinion i.e. an opinion that contradicts the true nature of the financial situation of the company. materiality plays a role in each of the following two stages.
- planning stage. (in planning what audit work should be done)
- reporting stage (in deciding what opinion to give.)
The international auditing and assurance standards board (iaaSb) in its framework for preparation and presentation of financial statement defines materiality as follows; ‘information is material if its omission or misstatement could influence the decision of users taken on basis of the financial statements.’ Therefore materiality provides a threshold or cut off point rather than being a primary qualitative characteristic which information must have if it is to be useful. iSa 320 further states a number of audit principles as follows:
- The auditor should consider materiality and its relationship to audit risk when conducting an audit. if the auditor assesses the risk associated with an account balance or internal control system to be high, it will be reflected in a lower level of materially thus additional testing will be required.
- The objective of an audit is to enable the auditor express an opinion whether financial statements are prepared in all material respects and in accordance with the identified financial reporting framework. The auditor needs to establish an appropriate materiality level so that quantitatively, material misstatements which are likely to destroy the true and fair view of financial statements are identified.
- materiality at planning stage is usually set at lower level than necessary in order to reduce risk of undiscovered misstatements and to deal with the problem of having to adjust materially at later date in light of evidence obtained.
- Materiality should be considered by the auditor when; • Determining nature, timing and extent of audit procedures
- Evaluating effect of misstatements.
The auditor should plan sufficient audit procedures so that he or she has reasonable expectation of detecting material misstatements in financial statements. Any immaterial item will not affect the truth and fair view of the financial statement and thus can be ignored.
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Materiality and judgment
auditors consider the following before appropriately testing whether an item is material or not.
- Qualitative aspects: these may include inadequate or inaccurate descriptions of an accounting policy.
- Cumulative effect of small amounts: small errors at a month end procedure could individually be immaterial but continuous errors of this kind throughout the financial year could be material.
- Relatively of materiality. A figure of Kshs. 100,000 may be absolutely immaterial for a large company but absolutely material for a small company. an amount must be considered in relation to:
- Items on the overall financial statements level.
- items at individual account balance or transaction level
- legal and other disclosure requirements which may require disclosure regardless of the monetary value e.g. director’s fees.
- The corresponding amount in the previous year.
- The degree of latitude allowable in deciding on the amount attributable to a particular item. While some items such as director’s fees are capable of an exact definition, others such as depreciation and allowance for doubtful debts are at best an intelligent estimate. in some countries e.g. US, the security exchange commission estimate materiality as follows; • Errors greater than 10% are material
- Errors between 5% and 10% may be material
- Errors below 5% are not material
- In evaluating the true and fair presentation of financial statement, the auditor should assess whether the aggregate of uncorrected misstatements that have been identified in the audit is material. The auditor should reconsider all uncorrected misstatements and check whether this total is material.
Risk and Materiality (iSA 320 Materiality)
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True and fair view
The true and fair view is a concept of the Companies act. however, the Companies act does not define or even describe what is true and fair view. The companies Act requires that all limited liability companies to appoint an auditor whose task is to express an independent opinion as to whether financial statement show true and fair view of the financial performance and position of the company. True and fair view implies that the financial statements are not prejudicial to any user of the financial statements. Financial statements will present a true and fair view if:
- They contain in all material respects with the disclosure requirement of the Company act and other relevant regulations.
- They contain material matter and not full of needless details.
- They are complete in every respect within the constraints of materiality and the inevitable estimation of some items.
- The values attributed to the items in the financial statements are reasonable amounts within a range in which if a major decision was taken on their basis the user would not make a material error.
- The information contained there in is presented and disclosed without bias and all relevant information for evaluation and decision making is available.
Assertion Methodology
In preparing financial statements which show true and fair view of the company’s financial position and performance, the management explicitly or implicitly makes certain assertions. These assertions are categorized as:
i Existence ii Completeness iii occurrence iv rights & obligation v measurement vi valuation, presentation and disclosure.
vii Classification viii Cut-off
ix accuracy x allocation
Existence
This is the assertion that an asset or liability exists at a given date. it is either true or not true that an asset or liability reflected in the balance sheet was in existence at the balance sheet date.
Rights and obligation
This is the assertion that an asset or liability in financial statements pertains to the entity at a given date i.e. an asset is a right of the entity and a liability a genuine obligation of the entity.
Occurrence
This is the assertion that a transaction or event took place which pertains to the entity during the financial period or that a recorded event or transaction actually took place as recorded and it is a valid transaction pertaining the entity. it is either the transaction took place as recorded or not.
Completeness
This is the assertion that there are no unrecorded assets, liabilities, transactions or undisclosed items. it would suggest 100% completion and accuracy however, this is impossible under accrual basis of accounting. The users of the financial statements do not expect 100% completeness in financial statements but completeness within a certain range such that they can still make justifiable decisions. This assertion is therefore assessed for reasonableness as some transactions may be excluded if they are not material.
Valuation
This is the assertion that an asset or liability is recorded at an appropriate carrying value. it is the most crucial assertion of all the assertions. in arriving at appropriate carrying value of an asset or liability, the management considers.
- overall valuation basis. The management must consider the entity as a whole and make an assessment whether it is appropriate to apply the going concern assumption in preparing the financial statements. The basis of preparing financial statement when entity is going concern is radically different from preparing financial statement on basis that the entity is not a going concern.
- Suitable accounting policies. in determining carrying amount of an asset or liability appropriate accounting policies must be followed. The accounting policies must be in line with the generally accepted accounting principles (Gaaps), appropriate to the circumstances of the entity, applied consistently, be in conformity with entity’s industry practices and be adequately disclosed.
- Desirable qualitative characteristics. The suitable accounting policy adopted must be applied after taking into consideration the qualitative characteristics of materiality, prudence and substance over form. Since it may subjective whether an entity is a going concern or not, the accounting policy adopted can be subsequently subjective thus the assertion of valuation can only be assessed for reasonableness.
Measurement
This is the assertion that a transaction or an event is recorded and proper amounts of revenue and expense are allocated to the proper period for proper reporting purposes. Whether a transaction brings into being an asset or liability, revenue or expense depends largely on the capitalization policy of an entity i.e. the guidance as to what items are revenue items and capital items.
The period in which a transaction took place may be influenced by management’s desire to reflect a given financial position. However, where revenue or expense of an item is spread over more than one accounting period is called allocation rather than measurement and is a component of valuation.
Presentation and disclosure
This is the assertion that an item is disclosed, classified and described in accordance with the applicable financial reporting framework. The information in financial statements should be presented without bias, be relevant to the needs of the users and meet qualitative characteristics of understandability, relevance, reliability and comparability. This assertion is not assessed for truth but rather adequacy or reasonableness.
In conclusion, truth and fairness of financial statements can be assessed on these seven assertions i.e. the financial statements will reflect a true and fair view of company’s financial position and performance if the seven assertions are used as guidelines in preparing the financial statements .
Classification are transactions recorded in appropriate accounts?
Cut-off are transactions recorded in appropriate period?
Accuracy
Are the amounts disclosed in the financial statements appropriate?
Allocation are account balances included in appropriate accounts?
- The primary objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework.
- The annual accounts and report are primarily prepared by the directors to the shareholders.
- After examining the end year financial statements the auditor then forms his opinion as to whether the financial statements show a true and fair view and reports this to the shareholders.
- The appointment of the auditor is usually carried out as a private contract between the auditor and the relevant stakeholder. The scope and objective of the work is determined by the agreed terms between the auditor and the client. The auditors’ rights and duties are also laid out in the contract.
- The companies act requires that all limited liability companies’ appoint an auditor whose task is to express an independent opinion as to whether the financial statements prepared by the directors show a true and fair view of the financial performance and position
