Audit basics
How an external audit works, and the tasks a first-year audit associate actually does.
ACCA exams this helps with: AA Audit and Assurance AAA Advanced Audit and Assurance See the ACCA map
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An audit is an independent check of a company’s accounts, a bit like an MOT for a car. The directors prepare the accounts, and the auditor tests enough of the figures to give an opinion on whether they can be trusted. Most graduates who join an assurance team start by working on audits.
Example. A company says it has £2 million of stock. The auditor doesn’t just take its word for it: they go to the warehouse, count a sample and check the prices.
Key words
- External audit
- An independent check of a company’s financial statements by a qualified auditor from outside the company, who then gives an opinion on them.Example: An audit firm checks a company’s accounts every year and signs the auditor’s report.
- Material misstatement
- An error (or group of errors) in the accounts that is big enough to change the decisions of someone reading them.Example: If materiality is £120,000, an error of £200,000 in revenue is a material misstatement.
- Reasonable assurance
- The level of confidence an audit gives: high, but not complete. Auditors test samples, so they cannot guarantee there are no errors.Example: An unmodified audit opinion gives reasonable assurance that the accounts contain no material errors.
- Assertion
- A statement that the accounts are making, which the auditor tests. The main ones are: it exists, it is complete, the amount is right, and it is in the right year.Example: Showing “Inventory £50,000” makes the assertion that £50,000 of stock really exists and belongs to the business.
- Working papers
- The auditor’s records of the work done, the evidence found and the conclusions reached. A reviewer must be able to follow them.Example: A working paper for receivables lists the balances tested, the evidence seen and the result.
Learn
An external audit is an independent check of a company’s financial statements. The auditor gives an opinion on whether they show a true and fair view and are free from material misstatement, whether that comes from error or fraud. The directors prepare the accounts. The auditor checks them.
Auditors give reasonable assurance: a high level of confidence, but not a guarantee, because they test samples rather than every transaction.
The audit cycle
- Acceptance: ethics and independence checks before taking on the client.
- Planning: understand the business, assess the risks of misstatement and set materiality.
- Fieldwork: gather evidence (see the two kinds of test below).
- Completion: final checks before signing (see below).
- Reporting: issue the audit opinion.
Two kinds of test
- Tests of controls check that the client’s own checks work. Example: pick 25 purchase invoices and see whether each one was approved by a manager before it was paid.
- Substantive procedures look for errors in the figures themselves. There are two kinds:
- Tests of detail: check individual items to evidence. Example: match a sample of sales to delivery notes and invoices.
- Analytical review: compare figures with last year, with the budget or with each other, and ask about anything odd. Example: sales went up by 5% but receivables doubled. Why?
If the controls work well, the auditor can rely on them and do fewer tests of detail.
Completion: the final checks
- Going concern: is the company likely to keep trading for at least the next 12 months? If not, the accounts may need to be prepared differently.
- Events after the year end: things that happen between the year end and signing, such as a big customer going bust, may need to be adjusted for or disclosed.
- Written representations: a letter signed by the directors confirming things only they can know, such as “we have told you about every legal claim”.
- Uncorrected errors: add up the errors the client has not fixed and check that together they are below materiality.
Materiality
A misstatement is material if it could change the decisions of someone reading the accounts. Auditors set a materiality figure using a benchmark:
| Benchmark | Typical percentage |
|---|---|
| Profit before tax | 5% |
| Revenue | 0.5% to 1% |
| Total assets | 1% to 2% |
Performance materiality is set lower, often 50% to 75% of materiality, so that lots of small errors that add up are still caught.
Audit risk
- Inherent risk: how likely an item is to be wrong before any controls, because of what it is. Estimates and complex areas are high risk. Example: a provision for a court case is riskier than the cash balance.
- Control risk: the chance the client’s own checks fail to catch an error.
- Detection risk: the chance the auditor’s tests miss an error.
The auditor can’t change inherent risk or control risk. Where those are high, they do more testing to bring detection risk down.
Assertions: what the auditor is testing
| Assertion | The question it answers |
|---|---|
| Existence / occurrence | Is it real? Did it happen? |
| Completeness | Is everything included? |
| Accuracy and valuation | Is the amount right? |
| Cut-off | Is it in the right period? |
| Rights and obligations | Does the company own it, or owe it? |
| Classification and presentation | Is it in the right account and properly disclosed? |
Evidence
The main types are inspection (looking at documents or assets), observation (watching a process happen), external confirmation (asking a third party, such as the bank, to confirm a balance in writing), recalculation (redoing a sum), reperformance (redoing a control check yourself), analytical procedures and enquiry (asking people). Evidence from an independent third party, such as a bank confirmation, is more reliable than evidence produced by the client. Evidence the auditor gathers directly is the most reliable of all.
Audit opinions
| Problem | Material but not pervasive | Material and pervasive |
|---|---|---|
| Misstatement found | Qualified (“except for”) | Adverse |
| Not enough evidence | Qualified (“except for”) | Disclaimer of opinion |
Pervasive means the problem spreads across the accounts so widely that they can’t be relied on as a whole. A problem limited to one area, such as inventory, is usually material but not pervasive.
If there is no material problem, the opinion is unmodified, often called a clean opinion.
What you’ll do in your first year
- Vouch samples of transactions to invoices, contracts and bank statements.
- Send and chase bank and customer confirmations.
- Attend inventory counts.
- Test cut-off around the year end.
- Recalculate depreciation, accruals and payroll.
- Record your work in the audit file clearly enough that a reviewer can follow it without asking you.
Watch it explained
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Videos from YouTube tutors
These videos are made by independent tutors on YouTube, not by Trial Balance. Some use US terms or older exam names (for example F7 for FR), but the principles are the same.
Worked example
Setting materiality. A client has profit before tax of £2,400,000, revenue of £30,000,000 and total assets of £18,000,000.
| Benchmark | Workings | Result £ |
|---|---|---|
| 5% of profit before tax | 2,400,000 × 5% | 120,000 |
| 1% of revenue | 30,000,000 × 1% | 300,000 |
| 2% of total assets | 18,000,000 × 2% | 360,000 |
For a stable, profit-making company, profit before tax is the usual benchmark, so materiality is £120,000. Performance materiality at 75% is £90,000.
Testing cut-off. Goods were delivered on 30 December but invoiced on 3 January and recorded in next year’s sales. The sale belongs to this year, so revenue is understated. The auditor records the error on a schedule of misstatements. If the errors on that schedule add up to more than materiality, the client is asked to correct them.
Practice questions
Type or choose your answers, then press Check answer. Questions with a New numbers button can be repeated with different figures.