Steve Collings runs the rule over the ICAEW’s 2018 audit monitoring report and finds that while audit quality remains relatively consistent, there is still room for improvement.
In this two-part series, Collings examines some of the main weaknesses featured in the report and offers guidance as to how auditors can overcome these failings.
The first part (available here) focuses on some of the key findings from the report and looked at audit evidence and documentation. This second and final part covers audit sampling, written representations and going concern, and also features a case study from the report.
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ISA (UK) 315 Identifying and assessing the risk of material misstatement through understanding the entity and its environment
ICAEW confirms that where the auditor does not adequately assess risk through lack of understanding of the client’s activities and internal controls, this can lead to an inappropriate audit plan and, consequently, audit evidence which fails to address the risks of material misstatement of the financial statements.
This, in turn, increases audit risk (which is the risk that the auditor expresses an incorrect opinion on the financial statements). The audit plan effectively becomes inappropriate because the procedures within that plan will not adequately take into consideration the risks of material misstatement – for example, sample sizes may be too low.
ICAEW has found a number of cases where inspectors are unable to see how well the auditor understands the business and the risks. In addition, inspectors also found cases where there are apparently significant risks which the auditor does not appear to have addressed.
For example, some auditors may consider that fraud is low risk when planning an audit. Paragraph 31 of ISA (UK) 240 considers management override of controls to be a significant risk. Management may override the control environment for personal financial gain (fraud) and hence the auditor must ensure that they apply paragraph 32 of ISA (UK) 240, which requires the auditor to design and perform audit procedures to:
- Test the appropriateness of journal entries and other adjustments made in the preparation of the financial statements. In doing this, the auditor shall:
- make inquiries of individuals who are involved in the financial reporting process about inappropriate/unusual activity relating to the processing of journals and other adjustments;
- select journal entries and other adjustments made at the end of a reporting period; and
- consider the need to test journals and other adjustments throughout the period under audit.
- Review accounting estimates for bias and evaluate whether the circumstances giving rise to the bias represent a risk of material misstatement to fraud. In addition:
- evaluate whether judgments and decisions made by management (even if they are individually reasonable), indicate possible bias on the part of management which may represent a risk of material misstatement due to fraud. Where this is the case, re-evaluate the accounting estimates taken as a whole; and
- perform a retrospective review of management judgments and assumptions relating to significant accounting estimates in the prior year’s financial statements.
- For significant transactions outside the normal course of business (or which otherwise appear to be unusual), evaluate whether the business rationale (or lack thereof) of the transactions suggest they have been entered into for the purpose of fraudulent financial reporting/concealment of assets.
ISA (UK) 530 Audit sampling
Audit sampling must reflect the materiality and audit risk of the relevant balance or class of transaction. The report states that inspectors often find that a sample has been taken from a restricted population (eg overdue trade debtors) with no testing of the material trade debtors within credit terms at the year-end.
Focussing on overdue debts will usually identify whether a client’s general or specific bad debt provision is adequate, but regard must be had to other trade debtors who may be within credit terms to verify the valuation and existence assertions.
The primary focus of the procedures is to test trade debtors for overstatement and hence the sample should be extracted from the entire population, with emphasis placed on trade debtors that are overdue for payment.
ISA (UK) 580 Written representations
ISA (UK) 580 requires certain management representations to be obtained on all audits. ICAEW has found that in areas requiring significant judgement, an auditor has not requested specific management representations to supplement their detailed audit work, where appropriate. Conversely, ICAEW has also found that the auditor has over-relied on representations rather than doing supporting detailed audit work.
Over-reliance on written representations must be avoided as they are designed to complement other forms of audit evidence, and such over-reliance can also increase audit risk (for example requesting a written representation that no material related party transactions have taken place without the auditor performing any further audit procedures to identify if any such transactions have, in fact, taken place).
As they are internally generated by the audit client, written representations alone are insufficient as audit evidence and this is acknowledged at paragraph 4 of ISA (UK) 580 which states that, on their own, written representations do not provide sufficient appropriate audit evidence about any of the matters with which they deal.
ISA (UK) 570 Going concern
Going concern has to be addressed on all audits and the standard requires the auditor to assess the work done, and conclusions reached, by those charged with governance.
In a lot of audits, this assessment is usually straightforward (particularly for smaller audits). However, in other audits it is less straightforward and the report cites businesses which operate on small margins with little headroom over loan covenants and these types of audits will involve difficult judgements.
ICAEW clarifies that it is important the auditor can demonstrate how it has challenged the management’s forecast (which also demonstrates the auditor has applied professional scepticism) when the assumptions contradict recent trading results or other available evidence.
Financial reporting issues (case study)
ICAEW visited a small firm with five audit clients. Two of these files highlighted financial reporting issues.
On the first file, a material liability had been recognised on the balance sheet. Questions asked by the inspector revealed that this was more likely to be a contingent liability, which is disclosed rather than recognised.
On the second file, ICAEW queried a large intra-group debtor which the firm had identified as doubtful and a review of the file also indicated that the doubtful debt was a legitimate concern of the auditor. However, the auditor had not proposed any adjustments to the client and had expressed an unqualified audit opinion.
Potentially, the unqualified opinion could be incorrect if the ‘large’ debt was also material (either in aggregate or in combination with other misstatements) because profit and assets would be materially overstated.
It may well be the case that the auditor simply did not include the doubtful debt on the summary of unadjusted misstatements because of an oversight, but that does not make the issue go away.
ICAEW confirms in its report that these issues indicate an ineffective review process of the audit work at the firm. The report confirms that the firm in question agreed to discuss these points with the clients at the next audit and ICAEW was satisfied that this was an appropriate response in the circumstances.
While ICAEW was satisfied with the firm’s response, it was a significant concern and they subsequently made a report to the ARC to recommend imposing external hot file reviews of all audits (to include a review of the draft financial statements) until ICAEW is satisfied that the quality of the financial statements is of an appropriate standard.
About Steven Collings
Steve Collings, FMAAT FCCA is the audit and technical partner at Leavitt Walmsley Associates Ltd where Steve trained and qualified.