OVERVIEW
Objective
¾
To identify the particular considerations in the audit of small businesses and not for profit organisations.¾ Consideration ¾ Engagement letter
CHARACTERISTICS
ENGAGEMENT AUDIT
APPROACH
¾ Limited segregation of duties ¾ Domination by senior management
¾ Risk assessment ¾ Internal controls ¾ Accountancy work ¾ Completeness ¾ Choosing procedures ¾ Management
representations
NOT-FOR-PROFIT ORGANISATION
1
CHARACTERISTICS
1.1
Limited segregation of duties
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Fewer accounting resources may results in a lack of accounting skills.¾
ConsequencesRecord keeping Accounts preparation
¾ May be informal or inadequate ⇒ greater risk that financial statements will be inaccurate/incomplete.
¾ Greater reliance on auditor assistance
¾ Managers may incorrectly assume they have been relieved of
responsibility for accurate financial reporting.
¾
It is often not practicable to segregate duties among different individuals, therefore it may not be possible to rely on internal control to detect fraud or errors. For example where personnel who are responsible for accounting records also have access to assets that are easily concealed, moved or sold
when it may not be possible to set up a system of independent checking (giving rise to a greater risk that errors will not be detected).
¾
Use of computer facilities may increase control risk. For example, in a microcomputer environment it is common for users to be able to perform two or more of: initiating and authorizing source documents entering data into the system
operating the computer
changing programs and data files
1.2
Domination by senior management or owner
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Active participation in management may dominate the operation of the entity (particularly the internal control systems and production of financial statements).Advantages
Disadvantages
9
Domination cancompensate for otherwise weak ICs eg where owner personally signs all cheques and bank mandates.
8
Ability to override Ics eg exclude transactions8
Risk of management fraud is greater eg owner can make disbursements in the absence of supporting documentation.¾
Confusion of business and personal interests/property may be reflected in financial statements.¾
Owner does not understand purpose of audit accounts preparation of limited relevance agreeing tax liability.
2
ENGAGEMENT
2.1
Considerations
¾
If it is not possible to obtain sufficient evidence to form an opinion on the financial statements because of weaknesses which may arise from inadequate record-keeping (say) the auditor may decide: not to accept the engagement; or
after acceptance:
2.2
Engagement letter
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Additional accountancy services recording transactions in books of prime entry
posting to general ledger
extracting trial balance and preparing draft a/cs
preparing statutory financial statements providing regular management a/cs.
¾
Additional tax services agreeing income tax liabilities with taxation authorities
preparation and submission of returns.
3
AUDIT APPROACH
3.1
Risk assessment
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Risk of material misstatements may increase (↑) or decrease (↓) owner may exercise effective control (↓)
owner’s close involvement may prevent/detect errors (↓) profits may be manipulated (↑).
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Particular difficulties include possible understatement of income (e.g. by the non-recording)
inclusion of expenses which should be categorised as the personal expenses of
senior management/owner.
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Need to take account of previous knowledge of proprietor/business.3.2
Limited formal internal controls
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Extent of reliance – may be able to test and rely on controls operated by the proprietor
established by observation (if not documented).
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Communicating weaknesses – only those which come to light during audit. Recommendations for improvement may also be made.3.3.2
Evidence obtained
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For example, from examining prime documents
calculating balances posting entries.
¾
May not provide sufficient audit evidence on its own (e.g. on recoverability of accounts receivable).3.4
Auditing for completeness
Considerations
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Numerically based system (e.g. to control despatch of goods)¾
Independently recorded population¾
Reconciliations of total goods bought/sold¾
Predictive analytical procedures¾
Review of transactions after the end of the reporting period¾
Representations by proprietor (are not sufficient on their own).3.5
Choosing procedures
¾
Invariably unable to use test of controls to reduce detailed substantive procedures.¾
Accountancy work gives some assurances.¾
Writing up books and a/cs preparation is no substitute for physical inspection
third party confirmation
work on recoverability of accounts receivable searches for unrecorded liabilities
confirmation of terms of material loans tests to ensure completeness of income.
¾
Writing up books may ⇒ great efficiencies. For example, if analytical procedures on margins are satisfactory, audit procedures may be restricted to: bank confirmations
direct confirmations (if efficient) and review of old balances
attendance at physical inventory and review of inventory valuation review of subsequent events
review of accrued expenses and prepayments review of minutes
3.6
Management representations
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Management representations are particularly important: because of the danger of the auditor’s role and responsibility in relation to the financial statements being misunderstood;
to remind management of its responsibility to ensure the completeness and accuracy of accounting records and the safeguarding of the entity’s assets.
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However, the auditor cannot rely solely on representations of management to obtain assurance as to the completeness of the accounting records.4
NOT-FOR-PROFIT ORGANISATIONS
4.1
Types of NFP organisation
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The examiner has stated that questions will focus on assignments in the context of companies and small not-for-profit organisations. Not-for-profit organisations may be: incorporated (i.e. companies);
otherwise required to be audited (e.g. under sector-specific legislation);
subject to specific accounting requirements; regulated (e.g. by a Charities Commission);
small, local single activity operations run by trustees (eg clubs, private schools); very large trading concerns with sophisticated accounting systems (e.g.
International charities).
¾
Candidates will not be required to have a detailed knowledge of any of the above in order to answer a question set under the scenario of a not-for-profit organisation. The audit approach is similar to that applied to small businesses, but note the differences highlighted in Example 1.Example 1
Suggest FOUR features of a charity which are most likely to differ from a commercial entity.
Solution
4.2
Audit work
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In general, the audit of a not-for-profit organisation follows the same basic principles and programmes of any other audit, but perhaps with a particular emphasis on cash.¾
The following notes suggest typical considerations that may be of particular importance when auditing not-for-profit organisations4.2.1
Understanding the entity, its environment and internal control
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Management structure and experience of key personnel¾
Regulatory and reporting requirements (may be specific, eg Charities Act, or general, eg licensing, liquor and entertainment laws for clubs)¾
Constitution and rules of entity (potential breaches of regulations, constitution and/or rules should be specifically considered by the auditor under ISA 250 Consideration oflaws and regulations)
¾
Sources of income and forms of expenditure. This is of particular importance where there are many sources primarily of cash in nature, eg a club will have subscriptions, bar income, gaming machine income, special event income (eg discos, fund raising, raffles).¾
Internal controls, eg to safeguard assets, ensure all transactions are correctly recorded and accounting records are properly maintained (controls over the completeness of income, especially cash, and authorisation of expenditure are of prime importance)4.2.2
Risk
¾
Inherent risk may be high due to nature of management and key workers (see Example 1) and susceptibility to fraud (because of an easily manipulated asset, ie cash).¾
The entity may also be considered as being a public interest entity (eg a national charity, local golf/tennis club (whose membership usually contains local business people and dignitaries)) and therefore high risk because of the risk of bad publicity if inappropriate work is carried out or an inappropriate report is given.¾
Control risk is also likely to be high as, for example, formal controls may be too expensive for the entity to operate (eg employing sufficient people to have effective segregation of duties) and/or inexperienced ‘volunteers’ may operate controls. There may also be over dependence on the honesty of individuals.4.2.3
Materiality
¾
As not-for-profit entities usually attempt to match their expenditure to their income (eg charities collect money to distribute to worthy causes) materiality based around any surplus (excess of income over expenditure) is generally not a useful materiality indicator. Income is likely to be the principal measure of materiality.¾
In addition, materiality ranges may be set lower than for normal, commercialorganisations because of the nature of the entity (eg the general public would expect that all donations to a charity are accounted for and used appropriately – any fraud would be considered material regardless of its size)
4.2.4
Analytical procedures
¾
Generally more audit evidence can be derived from analytical procedures because of the nature of the income and expenditure of not-for-profit entities.¾
Care must be taken to ensure that appropriate procedures are used taking into account the nature of the entity. For example: Proof in total for subscription income (eg number of club members at the appropriate rate)
Controlled usage of equipment and facilities (eg meters, counters, booking schedules at the appropriate rate)
Set percentage mark up (eg bar sales taking into account regular stock counting and allowances for spillage, set payout on games machines say 80% of takings)
Pre-numbered ticketing for events (eg number/range of tickets printed per order/invoice from printers less tickets remaining at their face value. Any complimentary issues must be formally recorded and authorised)
Reconciliations (eg investment income to the capital value of the investment,
covenants from donors for regular (eg fixed annual) donations, costs as a set percentage of income)
Comparisons of key income and expenses with prior periods (eg monthly expenses, monthly bar sales/gross profit, monthly income/profit from regular events)
4.2.5
Reliance on experts
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A typical cash audit programme will be used, but must be tailored to suit the circumstances of the entity, for example: Attend fund raising events, observe procedures in collecting, banking and recording cash and the segregation of duties between, collection, counting and recording
Perform cash counts at regular, unannounced, intervals
Ensure regular rotation of staff who handle cash (eg different individuals at each event)
Ensure access to cash is strongly controlled (eg two keys required to open gaming machines, keys are secure (in a safe), opening procedures rotated between
staff/members)
FOCUS
You should now be able to:
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apply audit techniques to small not-for-profit organisations;EXAMPLE SOLUTION
Solution 1 — Differences between charities and commercial entities
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Sources of income – largely voluntary income (donations), grants, etc. Highly likely to be in the form of pure cash, eg street collections¾
Possible inability to assert completeness of income/(revenue) arising from donations (eg street collections).¾
Branch structure – although this may also be used in commercial entities the “branch” operating structure with a single, centrally administered head office is frequently used by charitable organisations¾
Tax status – there may be some reliefs available specifically to charities¾
Restricted funds (capital or revenue) – may be used only for specified expenditure (eg donation or grant for a specific activity or capital item)¾
Greater public accountability – is expected because their purpose is to serve some public good.¾
Presence of unpaid workers (volunteers) who may: lack sufficient business skills;
possess great dedication, which may compensate for failings in internal control.
¾
Executives may be part-time, retired professionals or complete amateurs. Risk