The scope of an audit means extent of work the auditor needs to perform. If the scope of an audit is extensive, the auditor needs to perform extended audit procedures and vice versa. There are hundreds of factors that help an auditor determine the scope of an audit. These factors include but are not limited to the followings. Further, these factors vary depending on the nature of a business.
The auditor needs to understand applicable regulations. For instance, if the audit client operates in the construction industry, the auditor must ensure they comply with the regulations issued by the building department. If the audit client operates in a highly regulated industry, the audit scope needs to be extensive and vice versa.
2- Nature of the business
The auditor needs to understand the nature of business. For instance, the audit client may be in the manufacturing, trading, and services industry etc. So, the audit scope and procedures need to be aligned. If the audit client is in manufacturing, the auditor needs to assess if their cost card is free from material misstatement and if production-related data in the trial balance is correct.
Similarly, if the audit client is in the service industry. In that case, the auditor needs to check the point of revenue recognition as client may be recording revenue when cash is received instead of when services are delivered. Hence, the nature of business plays a key role in setting audit scope.
3- Warehouse locations
If the audit client’s inventory is placed in more than one place, the auditor must plan a simultaneous stock count. Hence, they will need more resources to execute an audit.
4- Special inventory
If the audit client trades in some special kind of inventory, an auditor may be unable to count it. Hence, they may need the services of an expert on a day of inventory count. For instance, an audit client is in the petrochemical industry. It means there is certain professional training required to count/audit these chemicals and auditors may not be able to count the same. Hence, auditors will need to hire some independent professional engineers to carry out the count.
5- Reporting hierarchy
Auditors need to understand the overall control environment. And assessment of reporting hierarchy is one of the main features in identifying the overall control environment. For instance, if the audit client exercises segregation of duties, overall control is good and risk is lower. On the other hand, if there is no segregation of duties, the control environment is not good and the risk is higher. Further, it’s important to note that if the risk is higher the auditor needs to plan/perform extensive audit procedures and vice versa.
6- Sales point
If the audit client has multiple sales points. Auditors need to plan cash and inventory count for the multiple locations. Hence, they will need more resources to conduct an audit/count.
7- Third-party service providers
The auditors need to check if the audit client uses the service of the third-party service provider. If the audit client uses the service of a third-party supplier, auditors need to decide if they would place reliance on the work performed by a third-party vendor. For instance, the audit client has outsourced their internal audit to a firm of professional accountants. The external auditors will need to assess if they will rely on the work performed by internal auditors.
8- Applicable financial reporting framework
The auditor must understand the financial reporting framework applicable to an audit client. For instance, if the audit client follows IFRS, the auditor must have a conceptual understanding to check accounting treatment and other applicable reporting details. Similarly, if the audit client follows US GAPP, the auditor is required to understand provisions of the same.
9- Internal controls implemented by management.
The auditors need to assess the effectiveness of the internal control implemented by the management. The concept is simple if controls are strong, there are few chances of error/fraud and auditor need to plan limited audit procedures. On the other hand, if controls are weak, there are higher chances of misstatement. Hence, auditors need to plan extensive audit procedures.
10- Any judgments used in the accounting.
In accounting, audit client needs to use judgment in different places. For instance, judgment is used in setting the life of fixed assets, selecting depreciation method, calculating value in use for the impairment calculation, any provisions in the financial statement, and any other instance where the audit client has used judgment. In simple words, the auditor needs to find places of judgment and ensure these are logical. If judgments are logical and plausible, that’s fine; otherwise, audit risk increases, and auditors must plan extensive audit procedures.
If the economic environment is unstable, there are higher chances that the audit client might face pressure to window dress the financial statement. For instance, due to the bank covenant to have profit, the client might overstate revenue artificially to covert loss into profit. So, the auditor needs to be skeptical and plan more audit procedures when the unstable economic environment and vice versa.
12-Level of materiality assessed
If auditors assess that the audit client should have higher materiality, they plan limited audit procedures. On the other hand, if auditors assess materiality to be lower, they plan extensive audit procedures. Hence, the audit procedures’ scope depends on the materiality assessment.
13-Data processing software
If the audit client uses some reputable accounting software, the auditor’s reliance on the books increases. For instance, if the client has implemented SAP throughout the company, the auditors have reliance that operations and accounting are highly integrated and there are very few chances of omissions in the financial statement. Hence, auditors can reduce the scope of the work to be performed.
14-Ongoing litigations of the company
Ongoing litigations are disclosed in the section on contingencies and commitments in the financial statements. If contingencies apply to the audit client, auditors must review possible impacts on the financial statement. And if, the potential impact is severe, they would need to disclose it in the audit report through other matter paragraphs/emphasis.
The scope of an audit is different for the different audit clients. For instance, if the audit client is larger with multiple locations for the warehouse, sales, and other operations, their scope/work will be extensive and vice versa.
There are a hundred factors that the auditor needs to consider while setting the audit’s scope. These factors include but are not limited to the nature of the business, applicable regulations on the audit client, special inventory, locations of the warehouse, locations of the sales point, applicable financial reporting framework, judgments used in the accounting, economic environment, ongoing litigations, data processing software used by the audit client, and many other factors.
In simple words, if exposure of the business to the world is higher, the scope/extent of work to be performed will be higher and vice versa.
Also read, elements of financial statement.
Frequently asked questions
What is the scope of an audit?
The scope of audit refers to the extent of audit procedures performed. If operations of the audit client are extensive or their scope is higher, the auditor needs to plan extensive audit procedures and vice versa.
What is the materiality of an audit?
Materiality refers to tolerable misstatement in the financial statements of the company. In simple words, an amount is only material if it impacts the decision of the financial statement user. For instance, if a misstatement amounts to $10,000 in revenue and the total revenue is $100,000. It means the misstatement is 10% of the total revenue. So, this amount can impact the decision of financial statement users. Hence, it’s a material.
What’s the difference between external and internal audits?
External audit means an audit of the financial statement. An independent firm of chartered accountants conducts this type of audit. These external auditors act as an agent of the shareholders and audit on their behalf. On the other hand, an internal audit concerns risks generated by business operations, controls implemented by the management, accounting processes, corporate governance etc.
What’s the objective of an external audit?
An external audit’s prime advantage is forming an opinion on the set of financial statements. The auditors perform procedures to check the accuracy of the accounting records and form an opinion on whether the audit client’s accounting record is sufficient and appropriate.