Auditing Deficiencies Uncovered

The ICAEW have issued their 2018 audit monitoring report which examines the findings of their audit inspections during 2017.  ICAEW conducted 619 monitoring visits, 611 as a UK Recognised Supervisory Body and eight under the Crown Dependencies’ recognised auditor oversight regime.

ICAEW comment in their report that while audit quality remains relatively consistent overall, there is still room for improvement.

In addition, ICAEW also reviewed 1,019 audits including 26 AIM and Nex companies, five market-traded entities (under the Crown Dependencies regime), 199 charities and 44 pension schemes.  473 audits were of entities which would have applied FRS 102 for the first time (excluding early adoption).

Of these reviews:

• 76% were either satisfactory or generally acceptable;
• 16% required improvement; and
• 8% required significant improvement.

ICAEW also reviewed limited aspects of a further 161 audits and 238 engagements completed under the Solicitors’ Regulation Authority’s Accounts Rules which require registered auditor status.

ICAEW are required to make a report to the Audit Registration Committee (ARC) where there are significant concerns about a firm’s compliance with the Audit Regulations.  According to the report, in 2017, one in ten audit monitoring reviews resulted in a report to the ARC.

Poor audit quality has been cited as a key issue by ICAEW in 36 out of 60 reports to the ARC in 2017.  Some, but not all, cases, also contained significant financial reporting issues.  This article will pull out some of the main weaknesses featured in the ICAEW’s audit monitoring report and offer guidance, where applicable, as to how auditors can overcome these failings.  There are issues in the report which deal with the Ethical Standard and eligibility to practise as a registered auditor, but this article will not cover these.

Insufficient audit evidence is the most common significant weakness on audit files according to ICAEW and they have identified the top three ISAs which cause audit quality weaknesses:

• ISA (UK) 500 Audit Evidence
• ISA (UK) 230 Audit Documentation
• ISA (UK) 315 Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and Its Environment

The next three most common ISAs where non-compliance was noted are:

• ISA (UK) 530 Audit Sampling
• ISA (UK) 580 Written Representations
• ISA (UK) 570 Going Concern

ISA (UK) 500 Audit Evidence

ICAEW cite insufficient audit evidence as the main weakness on audit files.  Most issues surround revenue testing, fixed assets, stock and work in progress, and other areas where professional judgement is needed such as goodwill and intangible assets.

Problems frequently encountered include the sufficiency of audit evidence for:

• completeness of revenue;
• ownership;
• rights and obligations relating to fixed assets; and
• the valuation of stock and work in progress.

Completeness of revenue seems to rear its head quite frequently – not only by professional bodies, but also in general file reviews.  It is likely that such criticisms are because auditors are not starting substantive procedures at the right point in the sales cycle.  When testing the completeness of income, the auditor should start from ‘outside’ of the accounting system; i.e. in the sales cycle, the starting point will be the customer’s order.  Some auditors have started from the sales invoice, which may not be the source of the transaction and hence part of the overall test is missed out.

ISA (UK) 230 Audit Documentation

ICAEW have said that there are ‘significant issues’ where audit documentation is concerned.  Common problems include firms failing to record material aspects of their audit work, or the link between the audit evidence and the final conclusion of the audit.

In some (limited) instances, ICAEW have found significant parts of audit files which ‘go missing’ or the file has not been assembled and archived within 60 days of signing the auditor’s report (as required by paragraph A54 of ISQC (UK) 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance and Related Services Engagements).

If there are ‘gaps’ between the audit work performed (or expected to have been performed) and the overall conclusion on the area being audited, this will result in a file being criticised.  Keep in mind that ISA (UK) 230 requires audit documentation to be prepared in such a way that it enables an experienced auditor, with no previous connection to the audit to understand:

• the nature, timing and extent of audit procedures performed to comply with the ISAs (UK) and applicable legal and regulatory requirements;
• the results of the audit procedures performed and the audit evidence obtained; and
• significant matters arising from the audit, the conclusions reached thereon and significant professional judgements made in reaching those conclusions.

ISA (UK) 315 Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and Its Environment

ICAEW confirm 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 have found a number of cases where inspectors are unable to see how well the auditor understands the business and the risks.  In addition, inspectors have 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 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements 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:

o   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;

o   select journal entries and other adjustments made at the end of a reporting period; and

o   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:

o   evaluate whether judgements 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

o   perform a retrospective review of management judgements and assumptions relating to significant accounting estimates in the prior year’s financial statements.

• For significant transactions which are 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 (e.g. 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 have 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 have 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 clarify that it is important that the auditor can demonstrate how it has challenged 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 confirm in their 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 were satisfied that this was an appropriate response in the circumstances.

While ICAEW were 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.

Category: Accounting and standards, Audit