Systems- based auditing

As already noted above, System based approach is different from substantive based approach.
In the substantive based approach, the auditor does not rely on client’s internal control over
financial reporting so no need of testing. The auditor does carry out vouching of all material
transactions in the statements.

In the system based audit approach, auditors first understand that there is strong internal control
system being used based on the understanding from entity’s management team. Yet, before
relying on the system or internal control, auditors will need to perform full understanding on
client’s internal control over financial reporting. Once they have performed an understanding
of internal control, auditors will then need to perform testing and validating those internal
controls.

This is to ensure that they are strong enough to produce the correct financial reporting. If
auditors concluded that the internal control over financial reporting is strong, they also need to
perform substantive testing but the volume of transactions are not that large as substantive
approach.

Audit testing – Sales system

The following are appropriate tests of control for the documents in a sales cycle:

These should be designed to check that the control procedures are being applied and that the
objectives are being achieved.

• Carry out sequence test checks on invoices, credit notes, dispatch notes and orders.
• Ensure that all items are included and that there are no omissions and duplications.
• Check the authorization for:

Acceptance of the order.

Dispatch of goods
Raising of the invoice or credit note
Pricing and discounts

• Seek evidence of the checking of the arithmetic accuracy of invoices, credit notes,
sales tax, etc. This is often done by means of a stamp requiring several signatures
on the invoice.
• Check dispatch notes and goods returned notes to ensure that they are referenced to
invoices and credit notes.
• Check that control account reconciliation have been performed and reviewed. Re
perform the control by checking the reconciliation to the source documents.
Audit testing – Purchases system
The following are appropriate tests of control for the documents in a purchase

cycle: a) Purchase Order

Test for:

• Evidence of a sequence check.

• Evidence of approval.
• Adherence to authority limits.

b) Goods received note:

Test for evidence of a sequence check.

c) Goods Returned Note:

Test for evidence of sequence check.

d) Purchase Invoice:

Test for:

• Serial numbering.
• Evidence of sequence check.
• Evidence of matching purchase invoices with GRN’s and purchase orders.
• Evidence of checking casts and correct treatment of purchase tax.
• Approval of purchase invoice for further processing.

e) Credit Note

Test for evidence of matching credit notes to goods returned notes.

f) Payable ledger

Test for evidence of authorization of adjustments to the ledger.

g) Payable Ledger Control

Test for:
• Evidence of review of reconciliation of purchase ledger listing.
• Evidence of authorization of adjustments to accounts payable ledger control
account.

In all cases, tests should be performed on sample basis

Audit testing – Wages and salaries (Payroll system)
The following are appropriate tests of control for the documents in a wages and salaries system;

A suggested program of tests of control is set out below. This can, of course, be modified to
suit the p articular circumstances of the client.
• Test sample of time sheets, clock cards or other records, for approval by
responsible official. Pay particular attention to the approval of overtime where
relevant.
• Test authority for payment of casual labor, particularly if in cash.
• Observe wages distribution for adherence to procedures ensuring employees sign
for wages, that unclaimed wages are re-banked etc.
• Test authorization for payroll amendments by reference to personnel records.
• Test control over payroll amendments.
• Examine evidence of checking of payroll calculations (e.g. a signature of
the financial controller).
• Examine evidence of approval of payrolls by a responsible official.
• Examine evidence of independent checks of payrolls (e.g. by internal audit).
• Inspect payroll reconciliations
• Test to check the existence of employees and to find if they are paid at correct rates
• Test to check that all deductions (including PAYE, NSSF etc) are done at correct
rates

Exercise: Identify audit tests necessary for checking a system of cash and bank
VERIFICATION OF ASSETS AND LIABILITIES

Verification is a process by which an auditor physically verifies assets and liabilities by trying
to check for the following principles, commonly known as COVERMP&D

1. Presentation and disclosure/recording process.

2. Ownership, rights and obligations.
3. Valuation.
4. Existence.
5. Authorization/Occurrence.
6. Completeness and measurement.

ASSETS

Verification of Motor Vehicles

1. The auditor of motor should check the authority for acquisition of motor vehicles
usually, from the board of directors and ensure proper authorization.(authorization
assurance principle)
2. Check the execution of authority to ascertain whether the purchase was as per the
company’s policies or whether by tender or any other acceptable method.
3. Check the reasonableness of the price by comparing different quotations from different
suppliers to ensure that the lowest quotations were awarded or accepted other factors
being constant.
4. With ownership the auditor should obtain the log book endorsed in favor of the client
and check the following;

• The make of the vehicle.

• Capacity.
• Engine number.
• The modes.
• Chassis number.
• Chassis number.

All these must be agreed with the physical motor vehicle in all aspects and any differences
investigated.

5. The auditor should obtain the road license and insurance certificate to ascertain whether
they are in the names of the client. (ownership principle)
6. The auditor should check the recording of the motor vehicle in the motor vehicle
registers, accounts and ledgers.
7. In case the vehicle is not physically available for inspection, the auditor should obtain
a letter from its client to verify its location, ownership and existence (existence
principle).
Verification of Land and Buildings

1. Examine the sample of available documents and these may include documents of land
title, land registry, certificates etc.
2. Inspect the director’s minute book to ensure that all documents of title tenancy
agreement and leases are properly authorized.
3. Check the sample of entries in the tangible asset register and trace back to source
documentation to ensure that they are properly stated at cost. (Principle of valuation)
4. Review company policies on depreciation and ensure that they are appropriate, in the
line with the useful life of the building and ensure that land is not depreciated
(Valuation and measurement principle)
5. Check the sample of calculations of depreciation and ensure that they are accurate and
in line with company policies. (Measurement principle).
6. Review assets and establish a need of any write down for impairment in value.
7. If properties are let to third parties, inspect tenancy agreement and perform analytical
procedures on rental income. (look all any costs on the property)
8. Ensure that land and buildings are stated in accordance to International Accounting
Standard 16 at cost less Accumulated Depreciation. If valuation has been performed in
the year of audit, the name of valuer and all his qualifications and the basis of valuation
should be disclosed/given.
9. Physically inspect the sample of the assets.(existence)
10. Ensure that tangible asset register reconciles to the general ledger (completeness and
measurement).

Verification of Expenditure on Investment

An investment is held for wealth generation e.g. dividends earned from investments with
shares, interests from investments and treasury bills etc. and capital growth.

1. Ascertain authority to acquire such expenditure either from the board. The Auditors
should read the board minutes or the annual general meeting minutes and check for;

• The nature of investments.

• Number of investments.
• The issuing company.
• Total capital commitments.

2. Check the Articles of Association to ascertain whether the investments are authorized
to be undertaken.
3. The auditor should verify the title documents/ title deeds such as share certificates. This
should be in the names of the client and in case these are kept by recognized agent the
auditor should communicate with the agent to ascertain whether they are held free of
charge.
4. In case the client has purchased a number of investments, the auditor should verify title
documents in such a way that those verified are sealed to avoid duplication.
 5. For existence, the auditor should not only request to review title documents but also
should ensure that these documents are endorsed in the names of the client.
6. The auditor should prepare schedules of investments and reconcile the purchase price
and market price to date.
7. In case some investments have been pledged as securities, the auditor should obtain
authorization for that action from the annual general meeting or the board minutes.
8. The auditor should ensure that all investment should be categorized as listed or unlisted
investments i.e. quoted or unquoted investments.
9. In case of listed investments the auditor should confirm their value by checking
particular financial papers.
10. The auditor should ensure that no substantial fall of in value of investment has taken
place since the last balance sheet date. In case it has taken place, the auditor should
request Board of Directors and management to write off the difference of the book
value and market value.
11. The auditor should check the recording of the investments in the investment ledger and
ledger to ensure proper disclosure.

LIQUID ASSETS

1. CASH AND BANK

Cash and Bank are liquid Assets and this includes: notes and coins, Bank current Accounts
Bank deposit Accounts.

Major Objectives

1. All sums are received and subsequently accounted for

2. No payments are made which shouldn’t be made
3. All receipts and payments are promptly accurately recorded.

Verification of Cash at Bank

1. The auditor should either obtain a bank reconciliation statement or prepare one and
trace entries in cash/book and those in the bank statement into a reconciled statement.
2. The auditor should ensure that there is no window dressing (i.e. presenting a good
picture yet things are bad) which is manifested with an attempt to overstate the
company’s’ liquid position. This could be through keeping the cash remittances and
hence increase cash at bank and reduce debtors balance by an equivalent amount
3. He should obtain bank statement directly from the bank and check banking and
withdrawals from this statement
4. He should trace items that are outstanding from the bank reconciliation statement of the
bank statement and record items not cleared at the time of the audit..
5. He should verify all bankings to all pay-in-slips, and all withdrawals to counter folios
of the cheque books and check the entries of the cash book.
 6. The auditor should verify bank balance with respect to the standard bank letter, which
should indicate:-

• The bank balance at the end of the year.

• Various accounts held by the bank.
• Any outstanding obligation by the client to the bank.
7. In case the client operates any foreign bank account, the auditor should communicate
with such bank and request for confirmation of the bank balance which should be
converted into local currency using the rates of foreign exchange running at the balance
of sheet date.
8. The auditor should note large deposits and withdrawals close to the end of the financial
period to ascertain whether they are genuine or not.

Verification of Cash at Hand

1. The auditor should pay a surprise visit to the client at the date of financial period, and
count cash at hand, then compare this with the cash book entry.
2. If the client operates several cash centres, the auditor should ensure that cash is counted
simultaneously to avoid shortages in one centre being made up with cash from another
centre.
3. The process of cash counting should be done in the presence of cashiers who in case of
shortage should given a certificate of shortages to the auditor.
4. The auditor should request the client not to keep a large amount of cash, since this may
not only increase fraud but also make it difficult to count.
5. In case cash is kept in different branches, the auditor should pay a surprise visit and
count the cash, where the auditor can’t visit the branches he should request the branch
managers to deposit the cash into the bank and sent the deposit lists.
6. If some cash is held by agents or trustees, the auditor should request for documentary
evidence so as to ascertain cash held by these parties. The auditor should also request
management representation to highlight this.
7. An auditor should ensure that unbanked cheques are subsequently banked and check
bank reconciliation statement to ensure that this has been done.
8. The auditor should ensure that the balances counted are recorded in the cash book and
the relevant ledgers.

2. AUDIT OF STOCK IN TRADE (INVENTORY)

Problems Encountered in Verifying Stock in Trade

1. In case of any misstatement of inventory balances there will be a direct effect on

reported profit. The stock is the easiest asset to manipulate and thus manipulating
profits from one accounting period to another. The auditor should put in a lot of effort
to come up with right and correct stock figures.
 2. Some stock is difficult for auditor to identify since there may be thousands of different
lines of inventory or stock or items of very special nature. E.g. stock taking oil in tanks
is dangerous.
3. The quantities of stock held at a given moment may be difficult to establish and it may
not be possible to cease/stop inventory movements during inventory count.
4. Valuation may be difficult. Difficulties arise due to obsolescence of inventory and as
a result the major value may be hard to establish.
5. The amount at which stock stated in accounts is always material in relation to accounts
report and this calls for more work by the auditor in order to establish a fair value of
stock.
6. Verification problems are associated with allocation of stock in particular or if stock is
held at different points and has to be counted simultaneously to avoid omission of
double counting (i.e. make sure there is no stock transfer at the time).
7. Stock may be overstated by the inclusion of stock sold but not dispatched or may
include stock of non-current assets e.g. furniture, fittings which are not traditional items
to be included in stock in trade.

Duties of an Auditor as regards Stock in Trade

The auditor is not usually required to count stock but he should be present;

o Witness o
Observe the
exercise

His duties as regards stock in trade include;

• Duties before stocktaking.

• Duties during stock-taking.
• Duties after stock-taking.

Duties before Stock Taking

1. He should review the working papers particularly the current audit file to ascertain the
previous year’s stock taking instructions so as to ensure that there are no loopholes
whatsoever.
2. He should familiarize himself with the nature, volume, location of various items of
stock especially items of high value identifying methods of counting the stock.
3. He should ascertain how much and the nature of stock held by the agents, subsidiary or
associate companies.
4. He should review accounting systems relating to stock and identify the potential area
of difficulty.
5. He should consider degree of co-operation expected from the internal audit i.e. areas
they are prepared to cover for the external auditor.
 6. He should ascertain whether expert advice is necessary to substantiate quantities of
stock especially stock of high value.
7. He should evaluate adequacy of stock taking instructions and ensure that it covers all
phases of stock taking procedures. It should be issued in good time and understood
especially by those taking part in the stock taking exercise.

Duties of an Auditor during Stock Taking

1. The auditor must observe and witness the way stocktaking is conducted so as to gain
assurance that the laid down policies are being followed.
2. He should select a number of items to be counted in particular high value stock and
recount them to ascertain whether results obtained agrees with the contents of the
sheets.
3. The auditor should note down items accounted in his current audit file so as to trace
those in the final stock sheets, to ensure that they agree in all aspects.
4. If the auditor is not satisfied in the way in which stocktaking has been conducted, he
should draw this to the attention of management and request a recount if necessary.
5. He should pay attention to stock of high value either individually or as a category of
stock.
6. He should include photocopies or extracts of rough stock sheets in his current audit file
or subsequent stock counts and to confirm these with the final stock sheets.
7. He should conclude whether the stock taking exercise has been properly conducted and
whether it should be relied upon in determining of value of stock and existence of stock
in trade.

Duties of an Auditor after Stock Taking

1. He should consider whether stock taking instructions were completely followed and in
which case he should follow up the matter after stocktaking.
2. He should check final stock sheets and ensure that they are accurate and complete by
comparing them with rough stock sheets.
3. He should ensure that stock records have been adjusted and amounts of stock physically
counted didn’t differ from amounts stated.
4. He should check replies third parties regarding stock kept by them and at the same time
notify management where co-operation was lacking.
5. He should request for a letter of representation to give assurance of the values, volume
and condition of stock in trade held by client.

Audit tests for Stock in Trade

1. Check the figures of stock in trade for the current financial periods and compare them
with that of previous period, then investigate unfavorable variances.
2. Check current year’s working papers and review stock taking methods to ascertain
whether they give assurance as regards to value and volume of stock in trade.
 3. Check the standard costing statements to ascertain the value of stock from the point of
view of the applications of variances.
4. Compute the stock turnover period for the current financial period and compare it with
turnover period of previous financial periods and then investigate any variances.

3. AUDIT OF RECEIVABLES
Control Objectives

• All goods dispatched are invoiced.

• Invoicing is at correct price and discount (if any).
• Goods are only dispatched on credit to approved customers.
• Invoices are recorded and related to subsequent cash receipt.
• Credit notes are approved.
• The cashier doesn’t have to access cash received.

This is relevant in order to curb down on teeming and lading.

(This is the offsetting of a debtor’s cash received against another debtor’s account to cover up
a misappropriation of the first debtor’s cash received).

Substantive procedures

These are tests performed obtain audit evidence to detect material misstatement in the financial
statement;

a) Procedures under the control accounts.

The auditor should obtain a list of receivables balance in the accounts receivable ledger and
agree the total with the total in the control account.

b) Year end balances

• Inquiries from management of the age of debts and possibility of future bad
debts.
• Checking the authority and correspondences of bad debts written off.
• Checking contras with the accounts payable ledger. Contras arise where a
company owes money to a third party and is owed by the same third party.
• Direct confirmation of receivable balances.
• Checking that the balances are made up of specific invoices relating to recent
transactions.
• Review the individual accounts of major customers especially those that appear
irregular either by nature, or the size of the balances.
c) Analytical procedures

(i) A comparison of the receivable days ratio with the budgeted or prior years.

Ratio = receivables * 365

Sales

(ii) A comparison of the proportion of the debts in the current year to prior years.

High or increasing incidents of all old debts may indicate either poor, deterioration of
the economic condition or poor credit control.

d) Bad Debts
The audit procedure to establish the appropriate allowances for bad debts include:-

• Considering company’s previous bad debts experience.

• Evidence from confirmation of accounts receivables.
• Age analysis of receivables.

e) Returns Inwards and Credit Notes

There should be strict internal control over returns inwards and credit notes to prevent
fraudulent cancellation of company’s debt.

f) Goods on sale or returns

Goods on sale or returns should not be included in sales or receivables.

g) Prepayments

Evidence under prepayments will include;

• Considering clients normal accounting system for prepayments.

• Obtaining the schedule of prepayments ensuring that it is cast correctly and comparing
it with prior year prepayments.

VERIFICATION OF LIABILITIES AND CAPITAL

Verification of Long Term Liabilities

LONG TERM BANK LOAN

(a) He should check the authority to acquire such a loan from either Board or annual
general meeting and ascertain;
 • The amount of the loan
• Interest payable
• Repayment of Interest and Principal.

(b) The auditor should check the Articles of Association and Memorandum of Association
to ascertain the whether the company has the power to borrow the amount of money
borrowed.
(c) He should obtain the loan agreement and check this for;

• The amount of the loan

• The nature of the loan
• Interest payable
• Repayment of principal
(d) The auditor should communicate directly with lenders and request confirmation
regarding amount outstanding, interest due and repayment pattern.
(e) He should check the securities pledged to ensure that they adequately cover the loan.
(f) In case the loan was obtained for a specific purpose, the auditor should ascertain
whether it was used for such a purpose, in which case he will need to verify the asset
acquired using the loan.

VERIFICATION OF SHARE CAPITAL

Share Capital is the capital acquired from the issue of shares. The steps involved in the
verification of share capital include the following:-

(a) For existing share capital, the auditor should verify this with reference to the previous
closing balance, which should be equal to the current year’s balance unless there are
any additions.
(b) In case share issues were made the auditor should verify this with reference to company
prospectus to determine ascertain number of shares issued and their value.
(c) The auditor should obtain authorization of issue with reference to the AGM minutes to
ensure that the issue was properly authorized.
(d) He should obtain Articles of Association and Memorandum of Association and check
for;

• The company’s’ authorized share capital.

• The type of shares the company can issue.

All these should agree with contents of the prospectus.

(e) The auditor should verify any share capital raised with advertisements made to check
number of shares sold.
(f) Auditor should obtain letters of allotment and compute the amount received in respect
of these shares and ensure that the allotment is approved by the board.
 (g) He should obtain share ledgers and registers and determine numbers of shares in the
registers and cross check this allotment in the allotment letters.
(h) He should agree dividends proposed unpaid to the Board minutes and ensure that the
payments agree with total share capital issued.
(i) The auditor should ensure that the brokers who participated in sale of shares sign a
report regarding;

• Number of shares sold.

• Value of shares sold.
• Preliminary issuing expenses.

(j) The auditor should verify transfer shares with reference to

• The correspondence between buyers and sellers.

• Completed and stamped transfer forms.
• Genuine share certificates

VERIFICATION OF TRADE CREDITORS (CURRENT LIABILITIES)

(a) The auditor should check the internal control system (ICS) regarding trade creditors
and ensure that it is strong enough to safe guard against possibilities of errors and fraud.
He should ensure that statements for creditors are prepared and dispatched by officials
different from those maintaining ledgers and effecting purchases.
(b) He should prepare a schedule of creditors and compare entries in the schedules with
those of the ledgers, goods received note (GRN) invoices, credit notes, dispatch notes
all of which should agree in amount, date, nature of goods purchased (Ordinary
purchases).
(c) The auditor should select a sample of trade creditors for circularization to confirm
balances from such creditors so as to ascertain amount owed and the period for which
it relates.
(d) The auditor should compute the creditors turnover period and creditors turnover rate
and compare it with the previous rates or periods and check for the variances.
(e) He should reconcile a sample from ledger balances with the supplier’s statement. (f)
He should check the recording in the creditor’s schedules and purchases ledgers.

VERIFICATION OF ACCRUALS

Accruals are expenditures that have been incurred in current period but no payment has been
made for it e.g. water bills, salaries, electricity bills, etc.

Verification could be by;

(a) Obtaining a schedule of Accruals ensuring that it is cast correctly and comparing it with
prior year accruals.
 (b) Scrutinizing payments of such accruals in the current financial year to ascertain whether
payments are not only authorized but also adjustments for them were made where
necessary.
Check the recording of accruals either under outstanding liabilities or in their relevant ledgers