What is the scope of an audit engagement?

When a company has to go through the audit process, an auditor may use the term "audit engagement." This can mean different things, so it is important that the auditor clarify what he means when he uses the term. Regardless of which definition the auditor follows, however, the auditor always follows specific procedures and guidelines for handling the engagement.

Audit Engagement Definitions

An audit engagement very loosely refers to an audit that an auditor performs, reports Accounting Tools. More specifically, it refers only to the initial stage of an audit during which the auditor notifies the client he has accepted the audit work and clarifies his understanding of the audit's purpose and scope. Even more specifically, the term audit engagement can refer to the engagement letter in auditing, that is, the written letter by which the auditor formally notifies the client he will engage in audit services.

Full Audit Engagement Example

When referring to the audit as a whole, audit engagements encompass several distinct steps, which are organized into planning, testing of controls, substantiation or fieldwork and exit or finalization. The first is sending a letter to the client alerting him of the audit. After this initial contact, the client and auditor meet to pinpoint further how, when and why the audit will happen, as well as the resources the auditor will have at his disposal. The auditor then conducts primary surveys to understand the company and the controls in place. The next step is testing the controls and gathering as much information as possible.

Based on the results, the auditor constructs a draft of the formal audit report, which he shares with the client. As the audit work draws to a finish, the auditor and client schedule an exit meeting. The client responds to the findings in the report and the recommendations the auditor has made. The auditor issues a final report and may ask the client to complete a survey about the auditor's performance and the audit results. Auditors complete the audit by following up with the client, normally within six months.

Initial Audit Step

Viewed as only as the first step of the audit process, the intent of an audit engagement is to get the client and the auditor on the same page. The client describes exactly what he needs the auditor to do. This helps the auditor decide whether the audit is feasible and how to approach it. The audit engagement by itself does not produce any viable results or findings – auditors do this during fieldwork – but it allows the auditor to know how, when and why to get those findings. During this initial stage of the audit, the auditor is concerned with understanding the client and the risks that might produce inaccurate audit results.

Audit Client Acceptance Letter

Auditors generally provide audit engagement letters as one of the final steps in the audit planning stage. The letter summarizes all the information the auditor has gained about the client, the client needs and audit objectives, as well as the scope of the audit and what the client is responsible for doing, suggest Practice Ignition, a company that produces management software for the accounting profession.

Additionally, audit engagement letters clearly indicate the auditor assigned to the audit. They also may indicate additional information the auditor will need during the audit, the auditor's fees, people with whom the auditor will need to speak and how much time the auditor has to finish his work. Also sometimes included are relevant financial and accounting regulations to which the auditors must adhere.

A good audit engagement letter also recognizes that not all clients are familiar with audit procedures and therefore outlines those procedures for clarification. Audit engagement letters are very similar to work contracts in the way they are constructed in that they define duties and relationships, but based on their wording, they are not necessarily legally binding the way a formal contract is.

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Learn more about the nature, scope and purpose of an audit and review.

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What Is Auditing?

Auditing is an independent examination. The word “audit” comes from the Latin word audire, which means “to hear.” In the Middle Ages, accounts of revenue and expenditure were “heard” by the auditor.

Statutory audits (i.e., those carried out in accordance with statutory provisions) became mandatory for companies in 1900. At that time, the purpose of an audit was to detect fraud, technical errors and errors of principle. However, case law recognizes that it is unreasonable to expect auditors to detect all aspects of fraud, even if they exercise reasonable skill and care, so this is not a primary purpose today. Over the last 20 years or so, the auditing profession has sought to broaden its role (e.g., with value for money, operational audits, etc.).

Concepts in Auditing

Stewardship

Directors or other managers of an enterprise have the responsibility of stewardship for the property of that enterprise. Their responsibilities, which may be duties embodied in statute, may include:

• Keeping books of accounts and proper accounting records;
• Producing a balance sheet and income statement that shows a true and fair view;
• Producing a directors’ report which is consistent with the financial statements and contains certain specified information.

Agency

A director can be described as an agent with a fiduciary relationship with a principal or company that employs them (a fiduciary relationship is one of trust). In meeting their responsibilities of stewardship, managers have fiduciary duties to safeguard assets and implement and operate an adequate accounting and internal control system.

Accountability

Auditors act in the interest of the primary stakeholders whilst having regard for the wider public interest. The identity of the primary stakeholders is determined by reference to the statute of the agreement requiring an audit. For companies, the primary stakeholder is the general body of shareholders.

A flow chart explaining audits.

Objective and General Principles of Auditing Financial Statements

The objective of an audit is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework.

It is the management’s responsibility to prepare the financial statements. Whilst the auditor’s opinion adds credibility to the financial statements, it is no guarantee of future viability nor of management’s efficiency or effectiveness. A degree of imprecision is inevitable due to inherent uncertainties and the use of judgment. Only reasonable assurance is given.

The amount of audit work is determined by judgement, professional bodies and legislation requirements, agreed-on terms of engagement, and the need to exercise professional scepticism. The ability to reduce audit risk is limited by the necessity to sample, inherent limitations in any accounting and control systems, possible fraudulent collusion and certain evidence that is not persuasive or conclusive.

Audit Opinion

The audit opinion is given on whether the financial statements give a true and fair view of the entity’s financial statements and whether they have been properly prepared in accordance with the applicable reporting framework. This opinion is reached after:

• Extensive risk assessment has been performed.
• Extensive testing of controls and substantive tests on transactions and balances for validity, accuracy and completeness of recording.
• Extensive verification procedures have been performed to test for existence, ownership, valuation, presentation and disclosure of items in the financial statements.
• Extensive review of whether the financial statements comply with applicable accounting standards and legal requirements.

As such, the audit opinion gives a high level of assurance to the users of financial statements. Whenever an audit is conducted, it must be performed in accordance with ISAs or national auditing standards, and if it is a statutory audit, it cannot be restricted in any way. An example of an audit report is given in ISA 700.

The auditor’s report on financial statements illustrates the high level of assurance given by an audit:

Auditor’s Report to the Shareholders of ABC Company

We have audited the accompanying balance sheet of ABC Company as of 31 December 20X1, and the related statements of income and cash flows for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with International Standards on Auditing (or to relevant national standards). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.

An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements give a true and fair view of (or present fairly, in all material respects) the financial position of the company as of 31 December 20X1 and of the results of its operations and its cash flows for the year then ended in accordance with International Accounting Standards (or title of national standards used) and comply with (title of relevant statute or law):

Auditor Address

Date

Concept of “True and Fair”

• Many countries’ legislation requires that financial statements give a “true and fair view” (e.g. the UK) or “present fairly, in all material respects” (e.g. the USA)
• However, there has never been any definition in legislation as to the meaning of the expression.

The following would be the generally accepted definition (based on legal opinion commissioned by the UK Accounting Standards Committee in 1983):

• The financial statements comply with Accounting Standards whose purpose is to narrow the areas of divergent opinion and practice in accounting—these are the profession’s attempt, in the absence of a statutory definition, to define true and fair view.
• By “true,” it is meant that financial statements are free from material misstatement and based on verifiable evidence.
• By “fair,” it is meant that the financial statements are objectively presented, free from management bias and relevant to the needs of users.
• The concept is a dynamic concept and is incapable of precise lasting legal definition, but to be true and fair, financial statements must live up to the current needs and expectations of users.

Concept of Materiality

Materiality is an important concept in the audit process and affects audit risk evaluation, the nature, timing and extent of audit procedures (e.g. sample sizes), and the determination of whether the financial statements are distorted by misstatements discovered.

ISA 320—Audit Materiality defines the concept as follows:

Transactions, items, events will be material in financial statements if their omission, misstatement, misclassification or non-disclosure would distort the view given by the financial statements and would responsibly influence the understanding and economic decisions of users.

Materiality, however, is not capable of general mathematical definition since it involves qualitative as well as quantitative considerations

For example, materiality can be viewed in terms of size, an item being compared with a transaction or balance class or being compared with the financial statements as a whole (quantitative judgement)

It can also be viewed in terms of the nature of an item irrespective of size—e.g. the non-disclosure of an accounting policy or non-compliance with the requirements of law such as errors or omissions in relation to the disclosure of director’s remuneration (qualitative judgement).

General Principles Governing the Auditor

Ethical Principles

The auditor should comply with the International Federation of Accountants (IFAC) “Code of Ethics for Professional Accountants”:

• Independence
• Integrity
• Objectivity
• Professional competence and due care
• Confidentiality
• Professional behaviour
• Technical standards.

Adherence to Standards on Auditing

An audit should be conducted in accordance with ISAs. ISAs provide:

• Standards (i.e. basic principles and essential procedures); and
• Related guidance (i.e. explanatory and other material).

Professional Skepticism

An audit should be planned and performed (“conducted”) with an attitude of “professional scepticism” recognizing circumstances that may bring about material misstatement in the financial statements.

• An auditor should assume neither dishonesty nor unquestioned honesty.

See also the auditor’s responsibilities for fraud and error.

An infographic displaying the audit process.

The Audit Process

1. Engagement letter – The auditor should send all clients an engagement letter setting out the auditor’s duties and responsibilities.
2. Planning – Planning and controlling audit work is essential to performing work to the required high standard of skill and care.
3. Ascertain accounting systems – auditors enquire into and ascertain the client’s system of accounting and internal controls in order to understand how accounting data is prepared and to gain an impression as to whether systems are reliable.
4. Test controls and transactions – Controls must be tested if the auditor intends to rely on them. Records must be tested to obtain evidence that they are a reliable basis for the preparation of accounts.
5. Verify assets and liabilities – Figures appearing in financial statements must be verified.
6. Review financial statements – To see if, overall, they appear sensible.
7. Obtain management representations – The auditor asks management to confirm the truth and fairness of certain aspects of financial statements formally.
8. Sign auditor’s report – After the directors have approved the accounts.

Purpose of Different Types of Audits

External Auditing

• Gives confidence in the integrity of corporate reporting for the benefit of stakeholders and society as a whole by providing an external and objective view of the reports given by management.

Internal Auditing

An independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations.

• The objective is to assist management and staff in the effective discharge of their duties.

Functions include examining, evaluating and monitoring the adequacy and effectiveness of the accounting and internal control systems, as well as providing analyses, appraisals and recommendations concerning the activities reviewed.

Value for Money Audit

An investigation into whether or not the use of resources is economic, efficient and effective.

• To identify and recommend ways in which the return for resources employed may be maximised.

Environmental Auditing

A performance evaluation which aims to help safeguard the environment.

• Facilitates management control of environmental practices.
• Assesses the degree of compliance with environmental legislation, external regulations and company policies.

Public Sector Auditing

National and local government, agencies, commissions, etc

• Scope and objectives are affected by the interests and requirements of third-party organisations. Specific requirements, relevant regulations, ordinances or ministerial directives may affect the audit mandate.

Scope of an Audit of Financial Statements

Audit Procedures Deemed Necessary

An audit conducted in accordance with ISAs must have regard to the requirements of:

• ISAs (i.e. to plan, evaluate controls, obtain evidence, form conclusions, and report);
• Relevant professional bodies (e.g. ACCA);
• Legislation and regulations (e.g. Companies Acts);
• The terms of the audit engagement and reporting requirements.

Fundamental Concepts

Reasonable assurance – in an audit engagement, the auditor provides a high, but not absolute, level of assurance, expressed positively in the audit report as reasonable assurance, that the information subject to audit (ie the financial statements)is free of material misstatement.

• To provide such assurance, the auditor assesses the evidence collected in respect of the financial statements as a whole and expresses a conclusion thereon.
• Inherent limitations – However, the auditor may not be able to detect all material misstatements because:

Testing is on a sample basis. Any accounting and internal control system have inherent limitations. Most audit evidence is persuasive rather than conclusive (e.g. an asset purchased by an entity, though physically possessed, may no longer be owned if the title has been transferred to another). Transactions between related parties (ie where one has the ability to control or exercise significant influence over the other) may not be identified as such.

The rule of judgement – Judgement is particularly important in gathering audit evidence (e.g. in deciding the nature, timing and extent of audit procedures);

Nature (e.g. whether to test controls over transactions or substantiate them “in-depth” or using analytical procedures);

Extent (e.g. sample sizes);

Timing (e.g. at an interim visit during the year, the year-end or after the year-end at the final audit visit.

Judgment is also important In drawing conclusions based on that evidence (eg in assessing the persuasiveness of conflicting evidence from different sources).

Non-Audit Engagements

There are a number of reporting assignments or engagements which do not give the same degree of assurance as an audit to users.

• Guidance issued by the International Auditing and Assurance Standards Board (IAASB), a body set up by the International Federation of Accountants, is summarized below.
• Non-audit engagements can be classified into two groups as follows:

Reviews: ISA 900—Engagements to Review Financial Statements

• A review engagement enables the auditor to state whether anything has come to the auditor’s attention which causes the auditor to believe that the financial statements are not prepared in all material respects with the applicable financial reporting framework. However, the auditor does not perform extensive testing procedures.
• The main procedures involved comprise enquiries of management, analytical procedures (e.g. ratio analysis, comparisons and trends analysis on total figures rather than individual transactions), and comparison of financial statements with accounting records – without verification to underlying documentation.
• The opinion expressed is called a negative assurance.
• The assurance given is, therefore, much lower than an audit opinion.

Note the following example of a review report and compare it with the audit report above:

Review Report to (Usually the Directors)

We have reviewed the accompanying balance sheet of ABC Company at 31 December 20X1 and the related income statement and cash flow statement for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to issue a report on these financial statements based on our review.

We conducted our review in accordance with the (relevant standard) applicable to review engagements. This standard requires that we plan and perform the review to obtain moderate assurance as to whether the financial statements are free from material misstatement. A review is limited primarily to enquiries of company personnel and analytical procedures applied to financial data and thus provides less assurance than an audit. We have not performed an audit, and accordingly, we do not express an audit opinion.

Based on our review, nothing has come to our attention that causes us to believe that the accompanying financial statements do not give a true and fair view in accordance with accounting standards.

Date

Auditor

Address

Assurance Engagements

These assignments involve a three-way relationship between the accountant, a responsible party (usually client management), and an intended user (e.g. banker or regulator).

The accountant evaluates a subject matter which is the responsibility of the responsible party, against suitable criteria and expresses an opinion providing the intended user with a level of assurance about the subject matter. The subject matter could be historical financial data or prospective financial data. Suitable criteria could be accounting standards, laws, regulations, and contract terms.

Assurance engagements include:

• Direct reporting engagements – the auditor/accountant reports on issues that have come to his attention during the course of the commissioned assignment. Such an assignment would be a due diligence engagement where the auditor/accountant reviews the systems and accounts of a target company and reports to a prospective purchaser.
• Attest or attestation engagements the auditor/accountant declares that a given premise is either correct or not.
• A report on interim accounts might require the auditor to attest whether the accounting policies used are consistent with those used in the annual audited financial statements and whether any material modifications should be made to the interim accounts.

Compilation Engagements

The accountant uses expertise other than auditing in such engagements. For example, the accountant may be commissioned to prepare financial statements from a company’s records. No audit tests will be performed, and management will be solely responsible for the information complied. As stated above, no opinion and hence no assurance is given.

Agreed-upon procedures:

• The accountant reports on factual findings.
• No assurance is given.
• Users draw their own conclusions.
• Thus, client management may commission a report on accounts receivable or accounts payable – the accountant states the results of findings, such as the number of accounts in error and the number of balances agreed with supplier statements or agreed by customers in a debtors circularisation.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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Mazhar Awan on December 16, 2013:

Audit is Systematic Examination of Books and records of a Busniness or Organisations in order to ascertain or verify and to report upon the other facts regarding its financial operation and the result therof.

It is clear that auditing is an independent checking of statements records operations and performance of a concern with a view to expressing an opinion in the form of written report.

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