Lesson 31
TESTING THE NON-CURRENT
ASSETS
Control objectives
The control objectives
are to ensure that:
(i) Non current assets
are correctly recorded, adequately secured and properly maintained
(ii) Acquisitions and
disposals of non current assets are properly authorized
(iii) Acquisitions and
disposals of non current assets are for the most favorable price possible
(iv) Non current assets
are properly recorded, appropriately depreciated, and written down where
necessary.
Control Procedures over
Non Current Assets:
(i) Annual capital
expenditure budgets should be prepared by someone directly responsible to the
board of
directors.
(ii) Such budgets
should, if acceptable, be agreed by the board and put in the minutes.
(iii) Applications for
authority to incur capital expenditure should be submitted to the board for
approval
and should contain
reasons for the expenditure, estimated cost, and any non current assets
replaced.
(iv) A document should
show what is to be acquired and be signed as authorized by the board or
an
authorized official.
(v) Non current assets
manufactured or constructed by the company itself should be separately
identifiable
in the company's costing
records and should reflect direct costs plus relevant overhead but not
include any profit. This
might apply where, for example, a building company constructs its own office
block.
(vi) Disposal of non
current assets should be authorized and any proceeds from sale should be
related to the
authority.
(vii) A register of non
current assets should be maintained for each major group of assets. The
register
should identify each
item within that group and contain details of cost and depreciation.
(viii) A physical
inspection of non current assets should be carried out periodically and checked
to the non
current asset register.
Any discrepancies should be noted and investigated.
(ix) Assets should be
properly maintained and adequately insured.
(x) Depreciation rates
should be authorized and a written statement of policy produced.
(xi) Depreciation should
be reviewed annually to assess the need for changes in the light of profits or
losses
on disposal, new
technology etc.
(xii) The calculation of
depreciation should be checked for accuracy.
(xiii) Non current
assets should be reviewed for the need for any write-down.
TESTS OF CONTROLS
(i) Check authorization
of purchase to board minutes, capital expenditure budgets and capital
expenditure
form.
(ii) Check authorization
for disposals of significant assets.
(iii) Confirm existence
of non current asset register which adequately identifies assets and comments
on
their current condition.
Ensure register reconciles to nominal ledger.
(iv) Test evidence of
reconciliation of register to physical checks of existence and condition of
assets.
(v) Check authorization
of depreciation rates, and particularly changes in rates.
(vi) Examine evidence of
checking of correct calculations of depreciation.
CONCLUSION
The testing of controls
is established whether they are working effectively. So, by this stage, the
auditor will
know whether a systems
approach is to be used - focusing on the accounting systems supplemented by
a
reduced amount of
substantive testing, or a verification approach with full substantive testing.
103
VERIFICATION APPROACH OF
AUDIT
We are now moving on to
deal with the substantive testing, or verification aspect of the audit. In the
past
lectures we have been
learning the early steps in the time structure of an audit:
• Accepting the
appointment
• Planning, recording,
controlling the audit
• Evaluation internal
controls
• Testing the controls
By this stage, the
auditor will have made a decision on the general approach to be taken to the
audit work. If
the controls systems are
effective and operating as laid down, the amount of verification work will be
reduced.
If the controls are weak
or are not operating effectively, a high level of verification work will be
performed. It
is this verification
work that we are dealing with in this and the next few lectures.
To verify means to
establish the truth of something. This audit work involves the audit in
gathering evidence
this will lead to a
conclusion as to whether classes of transactions, balances and disclosures
reflected in the
client’s financial
statements are properly stated (true and fair).
We have already
discussed in detail the general audit verification principles; here we will
have a brief over view
of those.
Audit Verification
Techniques:
As we have already discussed
in the previous lectures that at the verification stage of the audit, the
auditor is
typically presented with
a set of draft financial statements prepared by the client. The role of the
auditor is to
generate evidence to
allow a conclusion to be reached as to whether the information contained in
these financial
statements, and the way the information is presented and disclosed, give a true
and
fair view.
We already know that
audit evidences are generated by the auditor performing audit tests. Here, in
verification
work, the auditor will
use substantive testing procedures, designed to give evidence relating to the
figures in
the financial
statements, rather than control test, dealing with the systems that produced
those figures.
However, the testing procedures
available to the auditor here are the same as those we saw earlier. As a
reminder, audit-testing
procedures available to the auditor are:
1. Inspection
This covers the physical
review or examination of records, documents and tangible assets. An example in
substantive testing is
examining purchase invoices to ensure that they have been properly recorded and
analyzed in the
financial statements.
2. Observation
This procedure is mainly
applicable to tests of control, but may also be used in substantive testing,
such as the
auditor observing the
client's inventory count to gain evidence that the inventory figure in the
financial
statements had been
arrived at accurately.
3. Enquiry
Seeking relevant
information from knowledgeable persons inside or outside the enterprise.
An example in
substantive testing is asking management for an explanation as to why a
receivable has, or has
not, been treated as
bad.
4. Computation
Checking the
arithmetical accuracy of records or performing independent calculations, for
example computing
or re-computing the
depreciation expense for the year.
5. Analytical procedures
You should note that
these procedures are mainly used in substantive testing rather than as a test
of controls.
They may help the
auditor to understand relationships between figures in the financial
statements. This is
sometimes referred to as
the business approach to auditing.
Choice of Verification
Techniques
There are no specific
rules that exist as to the type(s) of techniques that the auditor should use in
a given set of
circumstances.
This is principally a
matter of audit judgment and the nature of the audit objective(s). The auditor
has to look
at each individual item
in its own right, identify the audit objective(s) for that particular item and
then decide
Lesson 32
104
the most reliable audit
evidence available. The circumstances and evidence available will affect the
type of
technique(s) he uses.
Audit Objectives and
Financial Statement Assertions
As just stated the
type(s) of technique(s) used depend on the audit objectives that the auditor is
seeking to
achieve.
The general objective to
be achieved by audit verification work is to establish whether the financial
statements
present a true and fair
view.
We can identify a number
of more detailed objectives which underlie this overall objective. These more
detailed objectives
allow the auditor to design a series of substantive test on each audit area
(inventory,
receivables, etc) which
will build up the overall bank of evidence necessary to support the overall
audit
opinion.
In carrying out
substantive audit tests (verification work) the auditor will be looking for
evidence on different
assertions at the
financial statements level.
Assertions in obtaining
Audit Evidence:
(a) Assertions about classes
of transactions and events for the period under audit;
(i) Occurrence –
transactions and events that have been recorded have occurred and pertain to
the entity;
(ii) Completeness – all
transactions and events that should have been recorded have been
recorded;
(iii) Accuracy – amounts
and other data relating to recorded transactions and events have been
recorded
appropriately.
(iv) Cutoff –
transactions and events have been recorded in the proper period.
(v) Classification –
transactions and events have been recorded in the proper accounts.
(b) Assertions about
account balances at the period end.
(i) Existence – assets,
liabilities, and equity interests exist;
(ii) Rights and
obligations – the entity holds or controls the rights to assets, and liabilities
are
the obligations of the
entity;
(iii) Completeness – all
assets, liabilities and equity interests that should have been recorded
have been recorded;
(iv) Valuation and
allocation – assets, liabilities, and equity interests are included in the
financial
statements at
appropriate amounts and any resulting valuation or allocation adjustments are
appropriately
recorded.
(c) Assertions about
Presentation and Disclosure:
(i) Occurrence and
rights and obligations – disclosed events, transactions and other matters
have occurred and
pertain to the entity.
(ii) Completeness – all
disclosures that should have been included in the financial statements
have been included;
(iii) Classification and
understandability – financial information is appropriately presented
and described, and
disclosures are clearly expressed;
(iv) Accuracy and
valuation – financial and other information are disclosed fairly and at
appropriate amounts.
This concept takes the
view that draft accounts presented by the client to the auditor are making a
number of
promises, or assertions.
The role of substantive testing is to verify these assertions.
The assertions made by
the financial statements and the related objectives of the substantive testing
objectives
set out above can be
shown as follows:
ASSERTION TESTING
OBJECTIVE
Assets shown include all
rights under the
control of the
enterprise
Completeness
Transactions arising
during the period are
reflected in the
period's financial statements
The amounts at which
assets and liabilities
are stated is
correct
Occurrence
Valuation
105
Assets and liabilities
included on the balance
sheet actually
exist
Assets and liabilities
are shown in the
financial statements
such that the user would
have a clear
understanding of the client's
financial situatio
n
Existence
Presentation and
disclosure
Review of Financial
Statements
Content of Financial
Statements
It is important that you
are clear as to exactly what the financial statements consist of under modern
accounting practice.
They comprise the
following:
a) The primary
statements
i) Balance sheet
ii) Income statement
iii) Statement of
changes in equity
iv) Cash flow statement
v) The notes to the
accounts
b) The directors' report
c) The auditor's report.
The main principles
underlying the preparation and presentation of company financial statements are
now set
out by the International
Accounting Standards Board's document Framework for the Preparation and
Presentation of
Financial Statements.
The major points from
this document are summarized below:
1
The elements of Financial Statements
The starting point here
is definitions of assets and liabilities. The other elements are then defined
in terms of
these.
Assets are rights
or other access to future economic benefits controlled by an entity as a result
of past
transactions or
events.
Liabilities are
obligations of an entity to transfer economic benefits as a result of past
transactions or
events.
Owners' equity is
arrived at by deducting liabilities from assets (capital = assets -
liabilities).
Gains and losses
are determined in terms of increases and decreases in owners' equity.
2
Recognition in financial statements
Recognition essentially
means the recording process. The principles here address such questions as when
is it
acceptable to recognize
(record) an asset or liability and when should assets and liabilities be
de-recognized (no
longer recorded in
financial statements). The main points to note are:
Assets and
liabilities should be recognized when there is evidence of their existence and
they can be
reliably measured.
They should be
derecognized when the right (assets) or obligations (liabilities) no longer
exist.
The Timing of Audit
Procedures:
Whereas tests of control
can be (and usually are) performed by the auditor before the client's year end
- at the
so called interim audit
stage - Substantive Audit Procedures and verification work will be performed
primarily at or very
soon after the client's year end, as these procedures normally rely on the
availability of
draft financial
statements.
Verification of the
individual assets and liabilities by the auditor extends into the post balance
sheet period (i.e.
the period between the
year end date and the date of approval of the financial statements). The
auditors will
use this to their
advantage when seeking to verify amounts stated for contingent liabilities, and
for post
balance sheet events
(These are explained in a later chapter).
SUBSTANTIVE PROCEDURES
Substantive procedures
are performed in order to detect material misstatements at the assertion level
(Like;
occurrence,
completeness, accuracy, valuation, existence, rights and control), and include
tests of details of
classes of transactions,
account balances and disclosures and substantive analytical
procedures.
106
Nature of Substantive
Procedures
• Tests of details are
ordinarily more appropriate to obtain audit evidence regarding certain
assertions about
account balances,
including existence and valuation.
• Analytical procedures
are applied on large volume of transactions, which are predictable over time.
(Cost of
goods sold, payroll,
sale)
Timing of Substantive
Procedures
Year end substantive
procedures are always more reliable
In considering whether
to perform substantive procedures at an interim date the auditor considers such
factors as the
following:
• The control
environment and other relevant controls. (Like payroll disbursement)
• The availability of
information at a later date that is necessary for the auditor’s procedures
(Provision
for doubtful debts can
be investigated interim but debtor and inventory can be verified at the year
end).
• The objective of the
substantive procedure.
• The assessed risk of
material misstatement (Prefer always at year end).
• The nature of the
class of transactions or account balance and related assertions (Like frequency
of
occurrence of the
transactions e.g. salaries are paid monthly whereas bonuses are paid annually).
• The ability of the
auditor to perform appropriate substantive procedures or substantive
procedures
combined with tests of
controls to cover the remaining period in order to reduce the risk that
misstatements that exist
at period end are not detected (Staffing problem that cannot make the
auditor able to extend till
the year end)
If substantive
procedures are performed at an interim date, the auditor may sometimes consider
applying tests
of controls also on the
transactions of remaining period while extending his substantive procedures
from
interim date to the period
end.
Extent of performance of
substantive procedures
Greater the risk of
material misstatement due to weaknesses in the system of internal control, the
greater
would be the risk of
material misstatement in the financial statements.
In designing tests of
details, the auditor may use either audit sampling or may choose to select
items to be
tested by some other
selective means of testing.
107
VERIFICATION OF ASSETS
VOUCHING = Inspection of
supporting documents and records.
VERIFICATION = Inspection,
Observation, Enquiry, Computation, Analysis
A large part of the
final audit stage will be taken up with the verification of the assets and
liabilities appearing
in the balance sheet.
There are well established techniques for verifying specific assets and
liabilities.
Following few lectures
will cover verification of assets, liabilities and equity.
Verification of Assets
Auditor has a duty to
verify all the assets appearing on the balance sheet and also a duty to verify
that there are
no other assets which
ought to appear on the balance sheet.
Following aspects of
assets must be verified:
1. Cost
2. Authorization
3. Value
4. Existence
5. Beneficial Ownership
6. Presentation in the
accounts
These aspects can be
remembered by the mnemonic CAVE BOP.
While verifying assets
at a balance sheet date, it is possible to divide the assets into two
classes:
1. Those acquired during
the year under review.
2. Those held at the
date of the previous balance sheet.
For the assets acquired
during the year it will be necessary to vouch their acquisition. For this
purpose cost and
authorization aspects
are verified.
For the assets held at
the beginning of the year, the acquisition would have been dealt within a
previous year.
The other aspects like
value, existence, beneficial ownership, and presentation in financial
statements are verified in this
regard. Of course, these
need to be consistent with the previous years.
Verification Methods:
a. Make or request from
client's staff a schedule
of each asset. This schedule
will show the following and
suggest the associated
verification procedures:
i. Opening
balance
a. Verify by reference
to previous year's balance sheet and audit files,
ii. Acquisitions
b. Vouch the cost with
documentary evidence e.g invoices.
c. Vouch the authority
for the acquisition with minutes or with authorized delegated
authority.
iii. Disposals
-. Vouch the
authority - minutes or company procedures.
a. Examine
documentation.
b. Verify reasonableness
of the proceeds.
c. Pay special attention
to scrapings.
d. Note accounting
treatment.
iv. Depreciation
amortization and other write downs
a. Vouch authorization
of policy with minutes.
b. Examine adequacy and
appropriateness of policy.
c. Investigate
revaluations.
d. Check
calculations.
v. The above should
reconcile both as to
physical quantity and Rupees value of the closing
balance.
vi. The use of
plant or other asset
registers can be of great use to the auditor.
vii. Internal control
procedures for the purchase, disposal, and maintenance of assets are very
relevant.
b. Existence and
Ownership
Lesson 33
108
These are treated
together but note that existence does not imply ownership. For example, my
television set
exists and is in my
house, but is in fact owned by the person from whom I rent it.
Verification procedures
include:
i) Physical inspection.
Auditors should not sit in offices but should get about
seeing things. Of
course, sitting in a client's office goes to confirm the existence of
that office!
ii) Inspection of title
deeds and certificates of ownership e.g., share certificates. This is a
technique
that confirms together
existence and ownership. Problems arise if the deeds are held by third
parties (a certificate
from the third party is needed) possibly as security for a loan.
iii) External
verification. This applies primarily to 'chases in action' e.g., bank accounts,
debtors,
loans etc. A letter of
acknowledgement is sought from the bank, debtor etc.
iv) Ancillary evidence.
Examples are:
v) Confirmation of the
existence of property by examination of rate (local taxes) demands,
repair
bills and other
outgoings.
vi) Ownership is not
necessarily implied. Investment ownership and existence tend to be
confirmed
by the receipt of
dividends and interest.
c. Presentation and
Value
i) Appropriate
accounting policies must be adopted, consistently applied, and adequately
disclosed.
ii) Accounting Standards
must be followed.
iii) Materiality must be
considered. For example, in a balance sheet of a large company it would
be
misleading to show an
asset such as patents in a class by itself it its total value was negligible in
relation to other
assets.
iv) The classification
of assets can be difficult. Certain industrial structures can be considered as
buildings or as plant
with consequent major differences in depreciation, profit, and asset and
equity values. A number
of interesting examples have cropped up in tax cases. A dry dock
including the cost of
excavation has been held to be plant (Barclay Curie 1969), as has a
swimming pool for use on
a caravan site (Beach Station Caravans 1974). The auditor may take a
contrary view to the tax
courts and of course to the Board of the Company he is auditing.
v) The choice of
disclosure of an asset as a separate item or as part of a single figure
representing a
class of asset is
important for a true and fair view. Also important is the choice of words used
in
the description. In some
cases, assets could be classed as fixed or as current e.g. investments.
vi) The distinction
between revenue and capital is important. Sometimes this is a matter of
accounting policy e.g.
research and development. Sometimes it is a matter of opinion; for example
repair expenditure is
revenue but may include an element of improvement which is capital.
d. Other matters
relevant to verification
i) The letter of
representation. This will be discussed in detail in the next lecture.
ii) Reasonableness and
being 'put upon enquiry'. In all audit assignments, the
auditor investigates
thoroughly and seeks adequate assurances on the truth and
fairness of all the
items in the Accounts. However, he does not do so with a
suspicious mind. He
should not assume that there is something wrong, but if he
comes across something
which seems to him unlikely, unreasonable, suspicious
he is said to be 'put
upon enquiry'. In such circumstances he is required to probe the
matter to the bottom to
adequately assure him-self that there exists nothing untoward or to unearth
the whole matter.
iii) Some assets are pledged
or mortgaged as securities for loans. This may involve deposit of title
deeds etc., with a
lender, or in some cases the asset itself. This creates problems for the
auditor
who must also see that
the liability is properly described as secured.
iv) Taxation. Tax and
capital allowance computations should be in accordance with asset accounts.
Clearly the auditor will
be put upon enquiry if claims for capital allowances are made for items
of
plant which do not
appear in the plant register.
v) Insurance. The
auditor would be put upon enquiry if there were no correspondence between
the
assets in the balance
sheet and the assets insured, and if there were differences between the
balance sheet figures
and the insured values.
109
vi) Other than balance
sheet date verification. Some assets can be verified at dates other than the
balance sheet date. The
techniques are discussed later but in sum (money value) they are:
a. Verify at an earlier
date and reconcile with acquisitions and disposals to balance sheet date.
b. Verify at an earlier
date and then parcel them up and seal the parcels. At balance sheet date
examine acquisitions,
vouch proceeds of disposals, and see all other items are still sealed.
vii) Third parties.
Auditors must take special care to satisfy them-selves that all assets held by
third
parties are included in
the balance sheet and verified. Likewise, no assets owned by third parties
may be included in the
balance sheet.
110
LETTER OF REPRESENTATION
VERIFICATION OF
LIABILITIES
Letter of Representation
It is now normal audit
practice for the auditor to obtain a letter from the management addressed to
the auditor
confirming any
representations given by the management to the auditor. This letter is known as
the
management letter or the
letter of representation.
Representations in this
context can be defined as a statement made to convey an opinion.
Reasons why the letter
of representation is obtained
Auditors are required to
carry out procedures designed to obtain sufficient appropriate audit evidence
to
determine with
reasonable confidence whether the financial statements are free of material
misstatement.
Representations from
management are a source of evidence.
Management
representations as Audit Evidence
In the course of an
audit, numerous questions are asked of the client's management and staff.
Replies are
usually verbal. Most of
the queries are:
a. Not material to the
financial statements. Examples are queries re missing documents or errors in
bookkeeping, or
b. Capable of being
corroborated by other evidence. For example, provisions in respect of
litigation can
be confirmed by the
client's solicitors or the life of plant can be confirmed by examining
technical
literature.
However, in some cases:
a. Where knowledge of
the facts is confined to management, for example, the management's
intentions
to close or keep open a
material loss-making branch. This would have an affect on the value of the
assets at the
branch.
b. Where the matter is
principally one of judgment and opinion, for example, the readability of old
stock. Then:
i. The auditor should
ensure that there is no conflicting evidence;
ii. The auditor may be
unable to obtain corroborating evidence;
iii. The auditor should
obtain written confirmation of any representations made;
The auditor must decide
for himself whether the total of other evidence and management's written
representations are
sufficient for him to form an unqualified opinion.
Procedures
The following procedures
should be adopted:
a. The auditor should summarize
in his working papers all matters that are material and also subject to
uncorroborated oral
representations by management,
b. In addition these
matters should be either.
i. Formally minuted as
approved by the Board of Directors at a meeting ideally attended by the
auditor;
ii. Included in the
signed letter of representation.
c. Standard letters
should not be used as:
i. Each audit is
different;
ii. The letter is
important and should receive very careful attention;
iii. The management
should participate in its production. There should be much drafting,
review
and discussion.
d. The letter should
be:
i. Signed at a high
level – e.g. chief executive, financial director;
ii. Approved and minuted
at a board meeting at which, ideally, the auditor would be present.
e.
The preparation of the
letter should begin at an early stage, e.g. at the beginning of the final audit
in
order to avoid the
possibility of the auditor being faced with a refusal to sign by the
management. If
there is a refusal by
management to cooperate then the, auditor should:
i. do all he can to
persuade management to cooperate;
Lesson 34
111
ii. prepare a statement
setting out his understanding of the principal representations made, with
a request that
management confirm it;
iii. if management
disagree with this statement, discuss and negotiate until a correct
understanding has been
reached;
iv. if management refuse
altogether to cooperate, either on principle or because the are
themselves uncertain
about a particular matter, consider if he has obtained al the
information and
explanations he requires and consequently may need to qualify his
report on grounds of
limitation of scope.
f. The representation
letter or board resolution making representations should be approved as late as
possible in the audit,
after the analytical review, but, as it is audit evidence, before the audit
report is
prepared. If there is a
long delay between the approval of the representation and the audit report, the
auditor may need to do
the: audit work/or obtain a supplementary letter of representation. It is
suggested to dating the
letter on the day the financial statements are approved.
Contents
The contents of the
letter of representation should not include routine matters, for example, that
all fixed
assets exist and are the
property of the company or that stock is valued at the lower of cost and net
realizable
value.
The letter should
include only matters which:
a. are material to the
financial statements, and
b. the auditors cannot
obtain independent corroborative evidence.
Example of a Letter of
Representation
To ABC & Co.
Chartered Accountants
Gentlemen,
We confirm that to the
best of our knowledge and belief, and, having made appropriate enquiries of
other
directors and officials
of the company, the following representations given to you in connection with
your
audit of the company's
financial statements for the year ending 31st December 20x7:
1. We acknowledge
as directors our responsibility for the financial statements, which you have
prepared for
the company. All the
accounting records have been made available to you for the purpose of your
audit and all
the transactions
undertaken by the company have been properly reflected and recorded in the
accounting
records. All other
records and related information, including minutes of all management and
shareholders'
meetings, have been made
available to you.
2. The provision for
warranty claims has been estimated at 2% of annual turnover as in previous
years. This
amount is in accordance
with our opinion of the probable extent of warranty claims. We know of no
events
which would materially
affect the amount of these claims
3. As
stated in Note 12 to the Accounts, there exists a contingent liability in
respect of the company's
guarantee of the bank
overdraft of NBG Ltd, an associated company now in receivership. In our opinion
the
assets of NBG Ltd will
realize sufficient to satisfy the bank and no actual liability will
arise.
4. It
is the intention of the Board of Directors to continue production for at least
the next three years so
that valuation of the
assets and liabilities of that plant should appropriately be on the going
concern basis
Yours Sincerely,
Company Secretary
Signed on behalf of the
Board of XYZ Co Ltd
14 March 20x8
Verification of
Liabilities
A balance sheet will
contain many liabilities grouped under various headings. The headings may
include:
Non Current
Liabilities
Debenture
Bank loans
Current
Liabilities
Trade
creditors
Accrued
expenses
112
Unearned
incomes
Taxation
payable
Provision for
losses
The auditors’ duty is
four-fold:
1. To verify the
existence of liabilities shown in the balance sheet
2. To verify the
correctness of the money amount of such liabilities
3. To verify the
appropriateness of the description given in the accounts and the adequacy of
disclosure
4. To verify that all
existing liabilities are actually included in the accounts
Verification methods:
It is not possible to
detail the procedures for verifying all possible liabilities. However, some
general principles
can be discerned, and
these should be applied according to the particular set of circumstances met
with in
practice or in an
examination. These are:
a. Schedule. Request or
make a schedule for each liability or class of liabilities. This should show
the
make up of the liability
with the opening balance, if any, all changes, and the closing balance.
b. Cut-off. Verify
cut-off. For example a trade creditor should hot be included unless the goods
were
acquired before the year
end.
c. Reasonableness.
Consider the reasonableness of the liability. Are there circumstances which
ought to
excite suspicion?
d. Internal control.
Determine, evaluate and test internal control procedures. This is particularly
important
for trade
creditors.
e. Previous date
clearance. Consider the liabilities at the previous accounting date. Have they
all been
cleared?
f. Terms and conditions,
this applies principally to loans. The auditor should determine that all terms
and conditions agreed when
accepting a loan have been complied with. In recent years many loan
deeds have contained
undertakings by the company borrowing the money that it will keep a minimum
proportion of equity
(ordinary share capital and reserves) in its total capital (equity and loans).
Breach
of this agreement which
has occurred frequently in property companies can lead to the appointment
of a receiver.
g. Authority. The
authority for all liabilities should be sought. This will be found in the
company
minutes or directors' minutes
and for some items the authority of the Memorandum and Articles may
be needed.
h. Description. The
auditor must see that the description in the accounts of each liability is
adequate.
i. Documents. The
auditor must examine all relevant documents. These will include invoices,
correspondence,
debenture deeds etc., according to the type of liability.
j. Security. Some
liabilities are secured in various ways, usually by fixed or floating charges.
The auditor
must enquire into these
and ensure that they have been registered. The Companies Act requires, for
secured liabilities,
that an indication of the general nature of the security be given and also the
aggregate amount of
debts included under the item covered by the security.
k. Vouching. The creation
of each liability should be vouched, for example the receipt of a loan.
l. Accounting policies.
The auditor must satisfy himself that appropriated accounting policies have
been
adopted and applied
consistently.
m. Letter of
representation. This has been discussed in detail.
n. Interest and other
ancillary evidence. The evidence of loans tends to be evidenced by
interest
payments and other
activities which stem from the existence of the loan.
o. Disclosure. All
matters which need to be known to receive a true and fair view from the
accounts
must be disclosed. The
Companies Acts provisions must be complied with
p. External
verification. With many liabilities it is possible to verify the liability
directly with the
creditor. This action
will be taken with short term loan creditors, bank over drafts and, by a
similar
technique to that used
with debtors, the trade creditors,
q. Materiality.
Materiality comes into all accounting and auditing decisions.
r. Post-Balance sheet
events. These are probably more important in this area than in any other. It
is
an independent topic
with its details. To understand it the accounting knowledge of “Events
occurring after the
Balance Sheet Date - IAS 10” is must.
s. Accounting Standards.
Liabilities must be accounted for in accordance with the accounting
standards.
113
t. Risk. Assess the risk
of misstatement.
Students may well
remember these mnemonically. For any given liability all of them will not be
required, but
mentally going through
them should be an excellent guide to what needs to be done.
Inclusion of all
liabilities (There is no liability remained unrecorded)
It is not enough for the
auditor to be satisfied that all the liabilities recorded in the books are
correct and are
incorporated in the
Final Accounts. He must also be satisfied that no other liabilities exist which
are not, for
various reasons, in the
books and the accounts. Examples of such unrecorded liabilities are:
a. Claims by employees
for injury. Note that these should be covered by insurance under the Employers
Liability (Compulsory
Insurance).
b. Claims by ex
employees for unfair dismissal.
c. Contributions to
superannuation schemes.
d. Unfunded pension
liabilities. A company may have a liability to pay past or present employees
a
pension in respect of
past service and have no funds separated out for this purpose.
e. Liability to 'top-up'
pension schemes. When money has been put into separate trusts to pay
pensions,
inflation has often
meant that the amount is insufficient and the company may have to implement
Clauses in the scheme
whereby they have to put in extra money which could run into millions of
pounds.
f. Bonuses under
profit sharing arrangements.
g. Returnable packages
and containers.
h. Value added and other
tax liabilities. The auditor's special knowledge of tax may lead him to suspect
a
liability of which the
directors are blissfully ignorant.
i. Claims under
warranties and guarantees.
j. Liabilities on debts
which have been factored with recourse. To explain: A owes B Rs. 50. B
sells
(factors) the debt to C
for Rs. 45. Thus B has no debt any more but Rs. 45 in the bank. A fails to pay
C. C can claim Rs. 50
from B (he has recourse).
k. Bills receivable
discounted (a special case of j above).
l. Pending law
suits.
It is important that the
auditor appreciates that such liabilities can exist. He also has a positive
obligation to
take reasonable steps to
unearth them.
The actions he would
take would include:
a. Enquiry of the
directors and other officers.
b. Obtain a letter of
representation - see later in the chapter.
c. Examination of post
balance sheet events. This will include an inspection of the purchase
invoices
and the cash book after
date.
d. Examination of
minutes where the existence of unrecorded liabilities may be mentioned.
e. A review of the
working papers and previous years' working papers
f. An awareness of the
possibilities at all times when conducting the audit
114
VERIFICATION OF EQUITY
Equity consists of share
capital and reserves. This part of the balance sheet represents interest of the
owners in
net assets of the
entity.
To verify the owners’
equity the auditor verifies following aspects:
Share capital is
properly classified and described in the accounts
Movement in share
capital is properly authorized and correctly presented
Reserves are
properly classified and presented
Movements in
reserves are properly authorized
Verification Methods
Share capital is
properly classified and described in the accounts in accordance with the
Companies
Ordinance, 1984
1. Check disclosure
using Company Accounts Checklist.
2. Agree authorized
capital with memorandum of association.
3. Agree issued capital
with form A, or obtain certificate from registrar.
4. Obtain list of
shareholders.
Movement in share
capital is properly authorized and correctly shown and described in accordance
with the Companies
Ordinance, 1984
1. Ensure shareholders’
pre-emption rights have been respected.
2. Check that directors
were authorized to allot shares.
3. Ensure proper
authorization for share redemption.
4. Check authority for
share capital reductions.
5. Agree all movements
to statement in lieu of prospectus, board minutes, memorandum and articles
of
association.
6. Consider special
rules for allotments of public company shares.
7. Test allotments with
supporting evidence and trace entries in register.
8. Test payments with
supporting evidence and trace entries in register.
9. Check additions to
allotment lists and cash records and agree totals to recorded movements.
10. Ensure correct
treatment of share premiums.
11. Vouch issue
expenses.
Reserves are properly
classified and described in the accounts in accordance with the Companies
Ordinance, 1984
1. Ensure disclosure
complies with Companies Ordinance, 1984.
2. Ensure whether it is
clear, which reserves are distributable.
Movements in reserves
are properly authorized and currently shown and described in accordance
with the Companies
Ordinance, 1984
1. Check movements to
minutes of Board’s meeting.
2. Check movements do
not contravene statutory restrictions and articles of association.
3. Ensure disclosure of
movements and related tax treatment.
Lesson 35
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