Audit and Assurance Suggested Short Notes

Detection Risk

• Definition: It is the risk that the auditor will not detect a misstatement that exists in an assertion that could be material, either individually or when aggregated with other misstatements.
• Basis of Risk: Detection risk is a function of the effectiveness of an audit procedure and of its application by the auditor.
• Limitations on Reduction: Detection risk cannot be reduced to zero because the auditor usually does not examine all of a class of transactions, account balance, or disclosure and because of other factors.
• Other Contributing Factors: These include the possibility that an auditor might select an inappropriate audit procedure, misapply an appropriate audit procedure, or misinterpret the audit results.
• Addressing Risk Factors: These factors can ordinarily be addressed through:
  • Adequate planning.
  • Proper assignment of personnel to the engagement team.
  • The application of professional skepticism.
  • Supervision and review of the audit work performed.

Date of Auditor‘s Report

• Timing Requirement: The auditor should date the audit report no earlier than the date on which the auditor has obtained sufficient appropriate audit evidence on which to base the opinion on the financial statements.
• Components of Sufficient Evidence: Sufficient appropriate audit evidence must include evidence that:
  • The entity‘s complete set of financial statements has been prepared.
  • Those with the recognized authority have asserted that they have taken responsibility for them.

Materiality and its Assessment

• Definition of Material Information: Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
• Judgment Factors: Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.
• Function of Materiality: It provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.
• Role of Professional Judgment: The assessment of what is material is a matter of professional judgment. The auditor should consider materiality and its relationship with audit risk when conducting an audit.
• Application Stages: The concept of materiality is applied by the auditor both in:
  • Planning and performing the audit.
  • Evaluating the effect of identified misstatements on the audit.
  • Evaluating uncorrected misstatements, if any, on the financial statements.
• Contextual Decisions: The decision to judge the materiality of the item (whether in aggregation, presentation, or classification) depends upon the judgment of preparers on the circumstances of the particular case.

Going Concern Assumption

• Fundamental Principle: The going concern assumption is a fundamental principle in the preparation of financial statements.
• Core Definition: Under this assumption, an entity is ordinarily viewed as continuing in business for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading, or seeking protection from creditors pursuant to laws or regulations.
• Basis for Recording: Assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business.
• Financial Indicators of Issues:
  • Net liability or net current liability position.
  • Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment.
  • Excessive reliance on short-term borrowings to finance long-term assets.
  • Indications of withdrawal of financial support by debtors and other creditors.
  • Negative operating cash flows indicated by historical or prospective financial statements.
  • Adverse key financial ratios.
  • Substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
  • Arrears or discontinuance of dividends.
  • Inability to pay creditors on due dates.
  • Inability to obtain financing for essential new product development or other essential investments.

Benefits of Implementing IFRS or Equivalent National Standards

• Benefits to the Economy:
  • Facilitates the maintenance of orderly and efficient capital markets as markets expand globally.
  • Helps increase capital formation and thereby economic growth.
• Benefits to the Investors:
  • Provides information that is more relevant, reliable, timely, and comparable across various jurisdictions for those willing to invest abroad.
  • Helps investors better understand investment opportunities at a little cost compared to using differing national standards.
• Benefits to the Industry:
  • Industry can raise capital from foreign markets at a lower cost.
  • Creates confidence in foreign investors that financial statements comply with globally accepted accounting standards.

Government Audit in Nepal

• Objective and Philosophy: Government audit aims to promote good governance through independent, efficient, and effective audit services. It is as old as the history of states and has developed with political, social, and economic progress.
• Mandate and Scope: Independent institutions set up through constitutional or legal provisions are empowered to audit all receipts, expenditure, and other matters regarding regularity, economy, efficiency, effectiveness, and propriety.
• Office of the Auditor General (OAG): In Nepal, government audit is performed by the OAG, an independent constitutional body.
• Constitutional Authority: The Constitution of Nepal ($2072$) provides the Auditor General the power to conduct audits of all public sector entities. The Auditor General is appointed on the recommendation of the Constitutional Council.
• Audit Act, $2048$: the Auditor General may conduct final audits of financial and relating activities of offices under its jurisdiction on a detail, sporadic, or random basis. Fact-based critical comments are presented in reports.
• Reporting Structure: The Auditor General submits an annual report to the President. The President causes the report to be tabled at the parliament for discussion through the Prime Minister.
• Auditor General Directives: Subject to the Constitution and prevailing laws, the Auditor General may issue directives to Government Offices and Corporate Bodies (wholly or substantially owned by the Government of Nepal) regarding accounts and regularity. It is the duty of these offices to abide by such directives.
• Core Features:
  • Public auditing is handled by a Supreme Audit Institution (OAGN in Nepal).
  • Financial Comptroller General maintains public accounting.
  • Scope includes Value-for-Money (VFM) auditing (economy, efficiency, effectiveness).
  • Includes audit of regularity and propriety.
  • Performance audits are intended to be constructive, not just critical of the past.

Written Representations

• Definition: A written statement by management provided to the auditor to confirm certain matters or support other audit evidence.
• Exclusions: It does not include financial statements, the assertions therein, or supporting books and records.
• Classification and Value: Written representations are necessary information required by the auditor and are considered audit evidence. However, they do not provide sufficient appropriate audit evidence on their own.
• Reliability and Limitations: Providing reliable representations does not affect the nature or extent of other audit evidence obtaining regarding management responsibilities.
• Request Protocols: The auditor requests these from management with appropriate responsibility and knowledge. Key categories include:
  • Preparation of the Financial Statements.
  • Information Provided and Completeness of Transactions.
  • Other responsibilities.
• Corroborative Role: Management representations are taken to corroborate audit evidence but cannot substitute for other evidence expected to be available. If knowledge of facts is confined to management, it may be the only evidence.
• Handling Contradictions: If contradicted by other evidence, the auditor must examine the circumstances and reconsider management's reliability.

Impairment of Assets

• Rationale: Beyond annual depreciation (for wear and tear, obsolescence), impairment loss is provided to reinstate the correct value based on future cash flows.
• Formula: The difference between the carrying amount of an asset and its recoverable amount is termed as impairment loss, expressed as: $\text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount}$.
• Accounting Treatment: Similar to depreciation but can be reinstated in the future if the recoverable amount exceeds the carrying amount.
• Compliance: Auditors must ensure provisions of NAS $36$ (Impairment of Assets) are followed.

Audit Note-book and Working Papers

• Audit Note-book Definition: A bound book used to record variety of matters observed during the audit. It forms part of audit working papers and a fresh one is maintained each year.
• File Classification: If working papers are split into permanent and current, the audit note book is part of the current file, though it remains a permanent record for future reference.
• Utility:
  • Helps pick up links of work when staff are absent or work is stopped.
  • Records queries raised and their state of disposal.
  • Records explanations obtained and evidence seen for disposed queries.
• Audit Working Papers: Evidence obtained/created by the auditor. They are the property of the auditor and act as a link between the report and the client's records. They serve as a means of controlling work and supporting the audit.
• Permanent Audit File: Used in recurring audits for documents relevant to multiple engagements. Updated regularly, it includes:
  • Legal/organizational structure (Memorandum and Articles of Association).
  • Copies of legal documents/agreements/minutes.
  • Evaluation of internal controls.
  • Previous years' audited financial statements.
  • Significant ratios and trends analysis.
  • Management letters.
  • Communication with retiring auditors.
  • Notes on significant accounting policies.

Subsequent Events (NSA $560$)

• Scope: Events occurring between the date of the financial statements and the date of the auditor‘s report, and facts known after the report date.
• Definition: It also refers to significant events occurring up to the audit report date of a specific component.
• Effective Period: From the balance sheet date until the audit report is signed.

Vouching of Advances to Suppliers

• Procedures:
  • Obtain a schedule of debit balances in trade payables and pay attention to age.
  • Scrutinize the bought ledger.
  • Inquire about long unadjusted outstanding items and check for provisioning needs.
  • Ensure advances are not shown as "deposits" in the balance sheet.
  • Obtain confirmations of balances and perform reconciliations for discrepancies.

Ethical Threats and Professional Skepticism

• Employment with Audit Client: Creates self-interest and self-review threats. Familiarity or intimidation threats may occur if a former team member or partner takes a significant role at the client.
• Familiarity Threat: Circumstance where a professional accountant becomes too sympathetic to client interests due to close relationship. Examples include having an immediate family member as a client director or long-term association of senior personnel with the client.
• Professional Skepticism: An attitude involving a questioning mind, being alert to conditions indicating misstatement (error or fraud), and critical assessment of evidence. It assumes circumstances may exist causing material misstatements.
• Objectivity: Obligation not to compromise professional or business judgment because of bias, conflict of interest, or undue influence. Standards must be established to identify relationships that impair this principle.

Peer Review and Engagement Quality

• Definition: An independent critical review of one public accounting firm's practices by another firm.
• Purpose: Objective evaluation of the quality of performance, studying quality control policies, and testing compliance.
• Outcomes: Peer reviewers issue a letter of comments for improvements. Failure to correct actions can lead to suspension from membership.
• Review Limits:
  • Professional aspects of the practice.
  • Overall total quality control policies.
  • Professional aspects of accounting and auditing practices.
• Hot File Review: Conducted during or after audit work but before the report is issued. Aimed at finding weaknesses in procedures or misinterpreted results. Usually performed by a senior auditor not connected to the engagement.

Internal Audit and Governance

• Definition: Independent, objective assurance and consulting activity designed to add value and improve operations. Evaluates risk management, control, and governance.
• Independence: Although part of management, the internal auditor evaluations different management levels and must be independent to be effective.
• Reporting Structure: Reports directly to the Board of Directors via the audit committee. Subordination to lower levels affects functioning.
• Role in Corporate Governance: One of the four pillars of corporate governance. Maintains governance by:
  • Reviewing governance/risk systems.
  • Reviewing reliability of reporting and compliance.
  • Suggesting internal control strengths.
  • Reporting critical issues to authorities.

Sampling in Auditing

• Statistical Sampling: Technique of forming an opinion about a population by examining a few items ($< 100\%$).
• Stratified Sampling: A method of random sampling involving dividing the population into groups called strata and taking a sample from each. Each stratum is treated as a separate population.
• Tolerable Misstatement / Tolerable Error:
  • Monetary amount set by the auditor to obtain assurance that the actual misstatement does not exceed this amount.
  • Addresses the risk that individually immaterial misstatements may aggregate to a material level.
  • In tests of control, it is the maximum rate of deviation acceptable.
  • In substantive procedures, it is the maximum monetary error acceptable.
• Sampling Risk: The possibility that the auditor's conclusion based on a sample differs from that reached if the entire population were tested. Can be lowered by increasing sample size.

External Confirmations (NSA $505$)

• Definition: Direct written response from a third party (the confirming party) to the auditor in paper, electronic, or other medium.
• Negative External Confirmation: Respondent replies only if they disagree with the provided information. Provides less reliable evidence as there is no proof the third party received it or verified it. Used when:
  • Assessed inherent/control risk is low.
  • Large number of small balances involved.
  • Substantial number of errors not expected.
  • Auditor believes requests will not be disregarded.
• Process Control: The auditor must maintain control over selecting recipients, preparing and sending requests, and receiving responses directly to minimize bias or interception.

Performance Audit and Corporate Governance

• Performance Audit: Systematic examination for independent assessment of a government organization or program performance. Elements include:
  • Economy
  • Efficiency
  • Effectiveness
• Those Charged with Governance (TCWG): Persons responsible for overseeing strategic direction and accountability, including financial reporting. This includes the Board of Directors or Audit Committee.
• Corporate Governance: System by which organizations are directed and controlled. Involves rights and responsibilities among board, managers, shareholders, and stakeholders. Requires fairness, transparency, independence, integrity, and accountability.

Specialized Audit Environments and Techniques

• EDP Audit: Aims to determine if computer systems safeguard assets, maintain data integrity, and achieve goals efficiently. Overall objectives remain the same as manual audits, but techniques change.
• Environmental Audit: Evaluates environmental compliance and management system gaps. Systematic and documented evaluation of how well environmental issues are managed to assess compliance with laws/conventions.
• Computer Assisted Audit Techniques (CAATs): Tools allowing auditors to receive and analyze data to identify trends or anomalies. Useful for all audit sizes; saves time previously spent manually analyzing data.
• Black Box Approach: Auditing "around" the computer. Computers are treated as mechanical devices; focus is on comparing input vouchers with output reports without examining internal data processing.
• Audit Trail: The ability to relate original input with final output on a one-to-one basis. Often absent in OLRT (On Line Real Time) systems due to direct master file updates and lack of in-between reports.

Fraud and Operational Audit Concepts

• Teeming and Lading (Lapping): A practice to hide information in one customer's account by moving money from another's. Delays showing a payment deficit. Often used by employees to cover personal use of customer money.
• Examination in Depth: Examining a few selected transactions from beginning to end (initiation to final payment/delivery). Checks all stages, documents (invoices, stock entries, certificates), and authorities.
• Cut Off Procedure: Procedures ensuring separation of transactions between consecutive years (e.g., ensuring property-passed goods are in inventory and liabilities provided; ensuring sold goods are excluded).
• Internal Check: Arrangement of duties so the work of one person is automatically checked by another during normal duty as a built-in device.

Audit Staffing and Experts

• Engagement Team Competence: Includes training/experience in similar audits, understanding of professional/regulatory standards, technical/IT knowledge, industry knowledge, and ability to apply professional judgment.
• Auditor‘s Expert: The auditor must assess competence (licensing, membership, reputation) and objectivity. Objectivity is at risk if the expert is employed by or financially dependent on the entity.

Key Audit Matters (KAM)

• Definition: Matters of most significance in the audit of financial statements of the current period, selected from those communicated to TCWG.
• Purpose: To provide transparency and assist users in understanding significant audit matters.
• Requirement: KAM communication is not a substitute for disclosure in financial statements or a substitute for expressing a modified opinion.

Audit Committee Structure (Companies Act)

• Mandate: Required for listed companies with paid up capital of $30,000,000$ rupees or more, or companies fully/partly owned by the Government of Nepal.
• Composition: At least three members. Chairperson must not be involved in day-to-day operations. At least one member must be experienced in accounting/finance (professional certificate or bachelor's degree with experience).

Audit Opinion and Reporting

• Audit Risk Formula: Audit Risk is a function of the Risk of Material Misstatement (Inherent Risk $\times$ Control Risk) and Detection Risk.
• Limited Assurance Engagement: Reduces risk to an acceptable level higher than reasonable assurance. Conclusion is in the negative form: "nothing has come to our attention."
• Adverse Opinion: Expressed when disagreement is so material and pervasive that a qualified report is inadequate. Requires substantive reasons and quantification of effects.
• Disclaimer of Opinion: Expressed when a limitation on scope is so material and pervasive that the auditor cannot obtain sufficient evidence and is unable to express an opinion.
• Modified Auditor‘s Report: Defined as a report with either an Emphasis of Matter paragraph or an opinion other than unqualified (Qualified, Adverse, Disclaimer).
• True and Fair View: Indicates the auditor's opinion that the state of affairs, results, and cash flows are truly and fairly represented without material omissions in accordance with relevant policies.

Inherent Limitations of an Audit

• Reasonable vs Absolute Assurance: An auditor cannot obtain absolute assurance that all material misstatements are detected. Factors include:
  • The use of judgment.
  • The use of testing (sampling).
  • Inherent limitations of internal control.
  • Evidence being persuasive rather than conclusive.

Vouching and Analytical Procedures

• Vouching Duty: Not merely checking if money was paid, but ensuring transactions are recorded in proper accounts, pertain to the entity, were authorized, and are properly classified.
• Analytical Procedures in Planning: Help understand client business and identify potential risk areas. Use both financial data and non-financial information (e.g., number of employees, square feet of space).
• Analytical Review: Substantive procedures involving studying ratios and trends to reduce detection risk or as an overall review in the final stage.

Cost Audit and Insurance

• Cost Audit: Verification of cost accounts and check on adherence to cost accounting plans. Aims to identify wastage and ensure realistic cost of production.
• Qualifying Insurance Policy: Issued by a non-related party (per NAS $16$). Proceeds are used only for defined benefit plans and are not available to the entity's creditors.