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Audit Q&A: Clarified ISA issues

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2nd Feb 2012
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With the audit season kicking off for December 2011 year-ends, Steve Collings looks at some of the most commonly asked questions about clarified International Standards on Auditing (ISAs).

Q. I’ve heard that the use of ‘analytical procedures’ are mandatory in external audits, but I’m struggling to understand what they actually are.

A. ISA 520 (UK and Ireland), Analytical Procedures defines analytical procedures as ‘evaluations of financial information made by a study of plausible relationships among both financial and non-financial data.’ Essentially what you’re looking at are fluctuations and relationships which are not considered to be consistent with other information in the financial statements or which deviate from predicted amounts. For example, if the directors tell you that gross profit margins have remained consistent with the previous year, but the variance analysis tells you that they have, in fact, significantly fallen, the auditor would need to design procedures to identify the inconsistency between the directors’ assertion and the financial statements.

You apply analytical procedures as risk assessment procedures in order to obtain an understanding of your client and the environment in which it operates (analytical procedures can also be used as substantive procedures also). Also, don’t forget to apply analytical procedures at, or near the end of, the audit in order to conclude whether the financial statements, as a whole, are consistent with your (the auditor’s) understanding.

Q. Given the uncertain economic times, should I qualify the auditor’s report on my client because I don’t know whether the going concern presumption is appropriate or not?

A. You cannot just simply qualify the auditor’s report on the grounds of economic difficulties. Many companies can still be a going concern despite economic difficulties. You should express a qualified or adverse opinion (as appropriate) if, based on the evidence from your audit, the going concern presumption is appropriate, but a material uncertainty exists and the client has not made adequate disclosure in the financial statements. However, if your audit evidence suggests your client will not be able to continue as a going concern, but they have prepared the financial statements using the going concern presumption you will express an adverse opinion.

Q. I am tendering for an audit which will also include a significant amount of non-audit work. I have suitable safeguards in place to enable my firm to complete the non-audit and the audit work. I’m planning on slashing the price I will charge for the audit in order to secure both the audit and non-audit work as the client has asked that we are ‘as competitive as possible’. Would you foresee any problems with this?

A. Ethical Standard Number 4 (revised) (ES) specifically states at paragraph seven that the audit engagement partner must ensure that audit fees are not influenced or determined by the provision of non-audit services to the audited entity. You must make sure, therefore, that the audit fee appropriately reflects the time spent and the skills and experience of the personnel that will be performing the audit. The ES itself does acknowledge that paragraph seven is intended to prevent any relationship between the appropriate cost of the audit and the actual or potential provision to the client of non-audit services.

Q. I am auditing a client with a year-end of 31 October 2011 and I can’t get a reply from one of my client’s major customers involved in the year-end debtors circularisation. Do I qualify the auditor’s report on the grounds of a limitation of scope?

A. Debtors circularisations do not confirm the valuation assertion of a trade debtor – really they are only used to confirm that a debtor exists at the balance sheet date and therefore you would not qualify the auditor’s report just because the debtor has not sent back their letter (this happens quite frequently). Another test you can perform to confirm the valuation and existence of the debt at the year-end is to do after-date cash testing.

Q. My client has a warehouse in a country located overseas and it is impracticable for us to send one of our staff there to attend the stock count.  What is the position on this where the auditor’s report is concerned?

A. Attendance at stock count is dealt with in ISA 501 (UK and Ireland), Audit evidence, additional considerations for specific items. In your situation you would need to look  to paragraph seven which would require you to consider whether alternative audit procedures would provide you with sufficient appropriate audit evidence relating to the existence and condition of that stock. The paragraph itself gives an example of obtaining documentation relating to the subsequent sale of specific inventory items acquired or purchased prior to the physical inventory count. However, if alternative audit procedures will not give you sufficient appropriate audit evidence, and this stock is material, you would qualify on the grounds of a limitation in the scope of your audit work.

Q. Are there are any other methods of calculating materiality other than the usual average of 1% of turnover, 2% of gross assets and 5% of pre-tax profit?

A. ISA 320 (UK & Ireland), Audit materiality does not specify the manner in which materiality levels are calculated. ISA 320 defines materiality at paragraph three as follows:      

‘Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, 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.’

The method of calculating materiality using turnover, gross assets and pre-tax profit has become an established practice over time. What is important is the judgement  of the auditor and the nature of the amount concerned. For example a £100 overstated prepayment may be immaterial to a £100 million turnover company, but the transfer of £100 worth of shares by the director to, say, a holding company would be material in nature. 

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011). He is also the author of ‘The AccountingWEB Guide to IFRS’ (Sift Media May 2011) and IFRS For Dummies (Wiley April 2012). He was also named Accounting Technician of the Year in the 2011 British Accountancy Awards.

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