ACCA P7 Chapter 8 Audit of Financial Statements

ACCA P7 lectures Download P7 notes

Chapter 8

Objectives of an audit

The primary objective of the statutory audit is to give an opinion on the truth and fairness of the financial statements of an entity.

During an audit the auditor will assess the risk attaching to the entity together with an assessment of the internal controls in operation. These procedures will assist the management in reducing risk and improving performance.

Example

What are the limitations of the statutory audit?

The auditor will also perform substantive tests on the transactions and balances appearing in the financial statements. In the earlier auditing paper, consideration was given to some of the “easier” audit areas. Let’s look at some of the more exotic areas!

The audit of inventory and construction contracts

Inventory is normally a significant asset of any manufacturing company and is an item that has a direct impact on the profit reported. Therefore inventory is normally a risky and material balance which requires considerable audit effort. The audit of inventory was covered in preparation for the earlier auditing paper, but we need to look again at some of the considerations concerning inventory.

Inventory should be valued at the lower of cost and net realisable value. There are many methods available for the estimation of the cost of an item of inventory. These include FIFO, LIFO, AVCO and standard cost. ( LIFO is no longer an acceptable method!)

Example

Where standard costs are used, what factors would you consider before accepting them as an appropriate basis for the estimation of cost?

Construction contracts

A long term contract is generally a contract entered into for the design, manufacture or construction of a single substantial asset, or the provision of a service, where the time taken is such that the contract activity falls into different accounting periods.

The major risks attaching to such contracts are as follows:

the costs incurred to date may be misstated

the stage of completion may not be accurate leading to errors in the profit recognised in the financial statements

estimates of future costs may be inaccurate

invoices issued and cash received to date may be incorrectly calculated

the account receivable may be irrecoverable

Example

During the audit of Mumbai Crafts Ltd, a shipbuilder, you are provided with the following information relating to a long term contract that the entity is involved in:

Describe the audit work that you would perform on this contract.

The audit of deferred tax

Auditors should obtain sufficient appropriate audit evidence that the deferred tax provision is correctly calculated.

IAS 12 states that deferred tax should be calculated on a full provision basis.

The following substantive procedures would be performed:

• review the tax computation to identify timing differences at the year end.
• recalculate the timing difference and the deferred tax calculation on each item ensuring that the correct tax rate was used.
• prepare a reconciliation of the tax charge in the statement of comprehensive income.
• check the notes to the financial statements to ensure that the disclosure of deferred tax is fairly presented.

The audit of Statements of Cash Flow

An audit opinion covers the cash flow statement.

The audit work required is as follows:

trace and reconcile all details to the working papers.

obtain or prepare a supporting analysis of items, such as tax payments and dividends paid, that do not already appear in the working papers.

cross check the amount of any items (eg depreciation) that appear elsewhere in the financial statements.

The audit of leases

The auditors should ensure that leased assets are correctly classified in the financial statements. The following procedures would be performed:

• obtain a schedule of leases brought forward from last year
• review the lease agreement for each leased asset to determine whether it is a finance lease or an operating lease.
• confirm to board minutes that each lease was authorised.
• recalculate the interest on each finance lease.
• physically verify the existence of assets held under finance lease.
• recalculate depreciation on leased assets.
• check the notes to the financial statements to confirm that correct disclosure is given regarding leased assets.