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ACCA AAA BPP Study Text 2020
P7 - Advanced Audit and Assurance (Association of Chartered Certified Accountants)
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Advanced Audit and
Assurance – International
(AAA – INT)
Workbook
For exams in September 2019,
December 2019, March 2020
and June 2020
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Contents
Contents
Page
Helping you to pass
Essential reading
Introduction to Advanced Audit and Assurance
Essential skills areas
iv
vi
viii
xx
1
International regulatory environments for audit and assurance services
1
2
Code of ethics and conduct
17
3
Fraud and professional liability
31
SKILLS CHECKPOINT 1: Legal and ethical responsibilities
49
4
Quality control
55
5
Obtaining and accepting professional appointments
69
SKILLS CHECKPOINT 2: Practice management
83
6
Planning and risk assessment
91
7
Evidence
109
8
Evaluation and review – matters relating to specific accounting issues
129
9
Group audits and transnational audits
147
SKILLS CHECKPOINT 3: Planning the audit and gathering evidence
165
10
Completion
179
11
Reporting
195
SKILLS CHECKPOINT 4: Completion and reporting
213
12
Audit-related services and other assurance services
223
13
Prospective financial information (PFI)
237
14
Forensic audits
249
15
Social, environmental and public sector auditing
257
16
Current issues
275
SKILLS CHECKPOINT 5: Non-audit engagements and current issues
281
Appendix 1 – Activity answers
Appendix 2 – Essential reading
Further question practice and solutions
Glossary
Bibliography
Index
289
327
545
629
639
645
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Helping you to pass
BPP Learning Media – ACCA Approved Content Provider
As an ACCA Approved Content Provider, BPP Learning Media gives you the opportunity to use study
materials reviewed by the ACCA examining team. By incorporating the examining team's comments
and suggestions regarding the depth and breadth of syllabus coverage, the BPP Learning Media
Workbook provides excellent, ACCA-approved support for your studies.
These materials are reviewed by the ACCA examining team. The objective of the review is to ensure
that the material properly covers the syllabus and study guide outcomes, used by the examining team
in setting the exams, in the appropriate breadth and depth. The review does not ensure that every
eventuality, combination or application of examinable topics is addressed by the ACCA Approved
Content. Nor does the review comprise a detailed technical check of the content as the Approved
Content Provider has its own quality assurance processes in place in this respect.
The PER alert
Before you can qualify as an ACCA member, you not only have to pass all your exams but also fulfil
a three-year practical experience requirement (PER). To help you to recognise areas of the syllabus
that you might be able to apply in the workplace to achieve different performance objectives, we
have introduced the 'PER alert' feature (see the section below). You will find this feature throughout
the Workbook to remind you that what you are learning to pass your ACCA exams is equally useful
to the fulfilment of the PER requirement. Your achievement of the PER should be recorded in your
online My Experience record.
Chapter features
Studying can be a daunting prospect, particularly when you have lots of other commitments. This
Workbook is full of useful features, explained in the key below, designed to help you to get the most
out of your studies and maximise your chances of exam success.
iv
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Introduction
Key to icons
Key term
Key term
Key terms are definitions of important concepts.
PER alert
PER alert
This feature identifies when something you are reading will also be useful for
your PER requirement (see 'The PER alert' section above for more details).
Activity
Activities give you essential practice of techniques covered in the chapter.
Illustration
Illustrations demonstrate how to apply key knowledge and techniques.
Essential Reading
Links to the Essential reading are given throughout the chapter. The Essential
reading is included in the free eBook, accessed via the Exam Success Site (see
inside cover for details on how to access this).
Knowledge diagnostic
Summary of the key learning points from the chapter.
At the end of each chapter you will find a Further study guidance section. This contains suggestions
for ways in which you can continue your learning and enhance your understanding. This can
include: recommendations for question practice from the Further question practice and solutions, to
test your understanding of the topics in the Chapter; suggestions for further reading which can be
done, such as technical articles, and ideas for your own research.
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Introduction to the Essential reading
The digital eBook version of the Workbook contains additional content, selected to enhance your
studies. Consisting of revision materials, activities (including practice questions and solutions) and
background reading, it is designed to aid your understanding of key topics which are covered in the
main printed chapters of the Workbook. The Essential reading section of the eBook also includes
further illustrations of complex areas.
To access the digital eBook version of the BPP Workbook, follow the instructions which can be found
on the inside cover; you’ll be able to access your eBook, plus download the BPP eBook mobile app
on multiple devices, including smartphones and tablets.
A summary of the content of the Essential reading is given below.
Chapter
1
2
3
5
6
7
8
vi
Summary of Essential reading content
International regulatory
environments for audit and
assurance services

Legal and professional framework in place (uses the UK as
an illustrative example)

Corporate governance and audit committees (again, using
UK examples as illustrations)
Code of ethics and
conduct

An overview of the various ethical threats and how the firm
should respond to them using the ACCA and IESBA Codes

Specific guidance on confidentiality and conflicts of interest

A summary of the relevant legal cases used to determine
auditor liability

Advantages and disadvantages of different structures for
firms

Ethical requirements from AA and acceptance/continuance
factors from ISQC 1 plus money laundering and PEPs and
their impact on acceptance decisions

Contents of an engagement letter

Business risks related to emerging trends in IT and
e-commerce

Planning issues: documentation, materiality, initial audits
and audit risk

Professional scepticism and additional information required

Analytical procedures as substantive procedures

Various additional elements of evidence: external
confirmations; opening balances; documentation

Further detail on the auditor's responses to risks presented
by related parties, the use of experts and the use of internal
audit by the external auditor

A revision of the accounting and financial reporting issues
associated with relevant IAS/IFRS from SBR plus suggested
auditing issues relevant to each area covered
Fraud and professional
liability
Obtaining and accepting
professional appointments
Planning and risk
assessment
Evidence
Evaluation and review –
matters relating to specific
accounting issues
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Introduction
Chapter
9
10
11
12
Summary of Essential reading content
Group audits and
transnational audits
Completion
Reporting
Audit-related services and
other assurance services

A recap on group accounting including associates and joint
ventures, plus an overview of consolidation problems and
procedures

Communication with the component auditor

Further reading on ISA 220 and quality control for audits

Additional details on how to apply ISA 560 Subsequent
Events

Discussion documents from the IAASB on the auditor's
report, including the use of KAMs

Illustrations of unmodified and modified auditor's reports

Further considerations when reporting to those charged with
governance and management

Examples of various assurance and audit-related reports for
information

Further detail on how to apply the various assurance and
audit-related services standards
14
Forensic audits

Further detail on how to plan and conduct a forensic audit
engagement
15
Social, environmental and
public sector auditing

An overview of the difficulties encountered by firms when
measuring social and environmental performance

A reminder of the capitals used in the Integrated Reporting
framework as well as some practical issues from their use

Topical issues relevant to the audit profession, including
reforms to the regulation of auditing, big data and data
analytics, professional scepticism and audit quality
16
Current issues
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Introduction to Advanced Audit and Assurance International (AAA - INT)
Overall aim of the syllabus
To analyse, evaluate and conclude on the assurance engagement and other audit and assurance
issues in the context of best practice and current developments.
Brought forward knowledge
The AAA syllabus uses a lot of content that you will have already seen in Audit and Assurance (AA)
and Strategic Business Reporting (SBR) but the crucial difference here is that it is all tested in the
context of more detailed scenarios and requires higher level skills to pass. There are also some new
areas of content that you will need to learn, so you should treat AAA as an exercise in itself, rather
than an extension of AA.
The syllabus
The broad syllabus headings are:
A
B
C
D
E
F
G
Regulatory environment
Professional and ethical considerations
Quality control and practice management
Planning and conducting an audit of historical financial information
Completion, review and reporting
Other assignments
Current issues and developments
Main capabilities
On successful completion of this exam, candidates should be able to:
A
Recognise the legal and regulatory environment and its impact on audit and assurance
practice
B
Demonstrate the ability to work effectively on an assurance or other service engagement within
a professional and ethical framework
C
Assess and recommend appropriate quality control policies and procedures in practice
management and recognise the auditor's position in relation to the acceptance and retention
of professional appointments
D
Identify and formulate the work required to meet the objectives of audit assignments and apply
the International Standards on Auditing
E
Evaluate findings and the results of work performed and draft suitable reports on assignments
F
Identify and formulate the work required to meet the objectives of non-audit assignments
G
Understand the current issues and developments relating to the provision of audit-related and
assurance services.
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Introduction
Links with other subjects
Strategic Business
Reporting (SBR)
Advanced Audit and
Assurance (AAA)
Audit and Assurance
(AA)
This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist
between this exam and others that may precede or follow it.
The Advanced Audit and Assurance syllabus assumes knowledge acquired in Audit and Assurance
and develops and applies this further in greater depth. AAA also assumes accounting knowledge
from SBR.
Achieving ACCA's Study Guide Outcomes
This BPP Workbook covers all the AAA - INT syllabus learning outcomes. The tables below show in
which chapter(s) each area of the syllabus is covered.
A
Regulatory environment
A1
International regulatory frameworks for audit and assurance services
Chapter 1
A2
Money laundering
Chapter 1
A3
Laws and regulations
Chapter 1
B
Professional and ethical considerations
B1
Code of Ethics for Professional Accountants
Chapter 2
B2
Fraud and error
Chapter 3
B3
Professional liability
Chapter 3
C
Quality control and practice management
C1
Quality control (firm-wide)
Chapter 4
C2
Advertising, tendering and obtaining professional work and fees
Chapter 5
C3
Professional appointments
Chapter 5
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D
Planning and conducting an audit of historical financial
information
D1
Planning, materiality and assessing the risk of material misstatement
Chapter 6
D2
Evidence and testing considerations
Chapter 7
D3
Audit procedures and obtaining evidence
Chapter 8
D4
Using the work of others
Chapter 7
D5
Group audits
Chapter 9
E
Completion, review and reporting
E1
Subsequent events and going concern
Chapter 10
E2
Completion and final review
Chapter 10
E3
Auditor's reports
Chapter 11
E4
Reports to those charged with governance and management
Chapter 11
F
Other assignments
F1
Audit-related and assurance services
F2
Specific assignments:
Chapter 12

Due diligence
Chapter 12

Review of interim financial information
Chapter 12

Prospective financial information
Chapter 13

Forensic audits
Chapter 14
F3
The audit of social, environmental and integrated reporting
Chapter 15
F4
The audit of performance information (pre-determined objectives) in the
public sector
Chapter 15
F5
Reporting on other assignments
Chapters 12
and 13
G Current issues and developments
G1
Professional and ethical developments
Chapters 1
and 2
G2
Other current issues
Chapter 16
The complete syllabus and study guide can be found by visiting the exam resource finder on the
ACCA website: www.accaglobal.com/gb/en.html.
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Introduction
The Exam
Computer-based exams
With effect from the March 2020 sitting, ACCA have commenced the launch of computer-based
exams (CBEs) for this exam with the aim of rolling out into all markets internationally over a short
period. Paper-based examinations (PBE) will be run in parallel while the CBEs are phased in. BPP
materials have been designed to support you, whichever exam option you choose. For more
information on these changes and when they will be implemented, please visit the ACCA website.
Approach to examining the syllabus
The exam lasts three hours and fifteen minutes and consists of two sections. Questions will have a
global focus but are set for the appropriate variant (eg UK or INT) and will require no more than
basic calculations at most (for example, to assess materiality and calculate relevant ratios where
appropriate) so candidates should always aim to have a calculator handy when attempting any
study for AAA.
35% Knowledge
65% Application
Format of the Exam
Marks
Question 1 will comprise a Case Study, worth 50 marks, set at the
planning stage of the audit, for a single company, a group of
companies or potentially several audit clients.
50
Candidates will be provided with detailed information, which will vary between
examinations, but is likely to include extracts of financial information, strategic,
operational and other relevant financial information for a client business, as well as
extracts from audit working papers, including results of analytical procedures.
Candidates will be required to address a range of requirements, predominantly from
syllabus Sections A, B, C and D, thereby tackling a real-world situation where
candidates may have to address a range of issues simultaneously in relation to
planning, risk assessment, evidence gathering and ethical and professional
considerations. Other syllabus areas, excluding Section E, may also be drawn on as
part of the Case Study.
Four professional marks will be available in Question 1 and will be awarded based
on the level of professionalism with which a candidate's answer is presented,
including the structure and clarity of the answer provided.
The remainder of the exam will contain two compulsory 25 mark
questions, with each being predominately based around a short
scenario.
50
One question will always predominantly come from syllabus Section E, and
consequently candidates should be prepared to answer a question relating to
completion, review and reporting. There are a number of formats this question could
adopt, including, but not limited to, requiring candidates to assess going concern, the
impact of subsequent events, evaluating identified misstatements and the
corresponding effect on the auditor's report. Candidates may also be asked to critique
an auditor's report or report which is to be provided to management or those charged
with governance.
The other 25 mark question can be drawn from the remaining areas of the syllabus,
including Sections A, B, C, D and F.
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Format of the Exam
Marks
Quality
control
and
ethics
The auditor's assessment of effective quality control procedures and
consideration of ethical issues are fundamental to all stages of the audit
and therefore these concepts could be examined in any section of the
exam.
Current
issues
Content from Section G on current issues is unlikely to form the basis of
any question on its own but instead will be incorporated into any of the
three questions, dependent on that question's content and the topical
issues affecting the profession at the time of writing.
100
Analysis of past exams
The table below provides details of when each element of the syllabus has been examined in the ten
most recent sittings and the question number and section in which each element was examined.
Note that in exams before September 2018 there were two compulsory and three optional questions
(of which two had to be answered) so five questions in total are referenced.
Covered
in
Workbook
Chapter
Dec
2018
(AAA)
Sept
2018
(AAA)
Mar/
Jun
2018
(P7)
Sep/
Dec
2017
(P7)
Mar/
Jun
2017
(P7)
Sep/
Dec
2016
(P7)
Mar/
Jun
2016
(P7)
Sep/
Dec
2015
(P7)
June
2015
(P7)
Dec
2014
(P7)
REGULATORY
ENVIRONMENT
1
International
regulatory frameworks
for audit and
assurance services
1
Money laundering
1
Laws and regulations
5(a)
3(a)
2(a)
3(b)
2(b)
PROFESSIONAL
AND ETHICAL
CONSIDERATIONS
2
Codes of ethics for
professional
accountants
3(b)
3
Fraud and error
1(e)
3
Professional liability
1(d),
2(b),
3(b)
2(a)
3(b),
4
3(a)
4,
5(a)
1(c),
4(b)
4
3(a),
4
1(d),
4(b)
5(c)
4
5(a)
3(a)
QUALITY
CONTROL AND
PRACTICE
MANAGEMENT
xii
4
Quality control
3(b)
5
Advertising,
tendering, obtaining
professional work and
fees
5
Professional
appointments
3
4
2
2(a)
4(a)
1(d)
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Introduction
Covered
in
Workbook
Chapter
Dec
2018
(AAA)
Sept
2018
(AAA)
Mar/
Jun
2018
(P7)
Sep/
Dec
2017
(P7)
Mar/
Jun
2017
(P7)
Sep/
Dec
2016
(P7)
Mar/
Jun
2016
(P7)
Sep/
Dec
2015
(P7)
1(a),
1(b),
1(c)
1
1, 4
1, 2
1, 4
1, 2,
3
1,
2(b),
3(b),
5(a)
1
1(b),
4
1(c)
June
2015
(P7)
Dec
2014
(P7)
ASSIGNMENTS
6, 7, 8
The audit of historical
financial information
including:
(i)
Planning,
materiality and
assessing the risk
of misstatement
1(a)–(c),
1,
2(a), 2, 3(a),
5(b)
3(b),
5(a)–(b)
(ii) Evidence
9
Group audits
5(b)
COMPLETION,
REVIEW AND
REPORTING
10
Completion
2(a),
2(b)
2(a)
11
Auditor’s reports
2(c)
2(a)
11
Communications to
management
11
Other reports
5
5(a)
2
3
5(b)
5(a)
5(b)
3
2(a)
5(b)
5(a)–
(b)
5
5(b)
2
OTHER
ASSIGNMENTS
12
Audit-related services
12
Assurance services
13
Prospective financial
information
14
Forensic audits
15
Social and
environmental
auditing
15
Public sector audit of
performance
information
1(e)
3(a)
3
4(a)
3(a)
2(b)
5(b)
3(c)
3(b)
3(b)–
(c)
2(b)
CURRENT ISSUES
AND
DEVELOPMENTS
1, 2, 3
Professional, ethical
and corporate
governance
16
Other current issues
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IMPORTANT!
The table on the previous page gives a broad idea of how frequently major topics in the syllabus are
examined. It should not be used to question spot and predict for example that Topic X will not be
examined because it came up two sittings ago. The examining team’s reports indicate that the
examining team is well aware some students try to question spot. The examining team avoid
predictable patterns and may, for example, examine the same topic two sittings in a row.
Understanding the question verbs
Verbs that are likely to be frequently used in this exam are listed below, together with their
intellectual levels and guidance on their meaning. Bold text denotes verbs used most frequently
in AAA.
Intellectual level
3
Evaluate/critically
evaluate
Determine the value of, in the light of the arguments for
and against (critically evaluate means weighting the
answer towards criticisms/arguments against)
3
Design
To devise in order to execute a plan
3
Assess
Determine the strengths/weaknesses/importance/
significance/ability to contribute
3
Examine
Critically review in detail
3
Discuss
Examine by using arguments for and against
3
Explore
Examine or discuss in a wide-ranging manner
3
Criticise
Present the weaknesses of/problems with the actions
taken or viewpoint expressed, supported by evidence
3
Construct the case
Present the arguments in favour or against, supported
by evidence
3
Recommend
Advise the appropriate actions to pursue in terms the
recipient will understand
2
Distinguish
Define two different terms, viewpoints or concepts on
the basis of the differences between them
2
Compare and
contrast
Explain the similarities and differences between two
different terms, viewpoints or concepts
2
Contrast
Explain the differences between two different terms,
viewpoints or concepts
2
Analyse
Give reasons for the current situation or what has
happened
1
Define
Give the meaning of
1
Explain
Make clear
1
Identify
Recognise or select
1
Describe
Give the key features
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Introduction
A lower level verb such as define will require a more descriptive answer. A higher level verb
such as evaluate will require a more applied, critical answer. The examining team has stressed
that higher-level requirements and verbs will be most significant in this exam, such as
critically evaluating a statement and arguing for or against a given idea or position. The examining
team is looking to set questions that provide evidence of student understanding.
Certain verbs have given students particular problems.
(a)
Identify and explain
Although these verbs are both Level 1, the examining team sees them as requiring different
things. You have to go into more depth if you are asked to explain than if you are asked to
identify. An explanation means giving more detail about the problem or factor identified,
normally meaning that you have to indicate why it's significant. If you were asked to:
(b)
(i)
Identify the main problem with the same person acting as chief
executive and chairman – you would briefly say excessive power is exercised by
one person.
(ii)
Explain the main problem with the same person acting as chief
executive and chairman – you would say excessive power is exercised by one
person and then go on to say it would mean that the same person was running the
board and the company. As the board is meant to monitor the chief executive, it can't
do this effectively if the chief executive is running the board. Also, you may be asked to
explain or describe something complex, abstract or philosophical in nature.
Evaluate
Evaluate is a verb that the examining team uses frequently. Its meaning may be different from
the way that you have seen it used in other exams. The examining team expects to see
arguments for and against, or pros and cons for what you are asked to evaluate.
Thus, for example, if a question asked you to:
'Evaluate the contribution made by non-executive directors to good corporate governance in
companies'
You would not only have to write about the factors that help non-executive directors make a
worthwhile contribution (independent viewpoint, experience of other industries), you would
also have to discuss the factors that limit or undermine the contribution non-executive directors
make (lack of time, putting pressure on board unity).
If the examining team asks you to critically evaluate, you will have to consider both
viewpoints. However, you will concentrate on the view that you are asked to critically
evaluate, as the mark scheme will be weighted towards that view.
The examining team has stated that 'Evaluate' is likely to be used for risk-based questions,
ie Question 1.
Examinable documents
Audit
International
Knowledge of new examinable regulations issued by 31 August will be examinable in examination
sessions being held in the following exam year. Documents may be examinable even if the effective
date is in the future. This means that all regulations issued by 31 August 2018 will be examinable in
the September 2019 to June 2020 examinations.
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The study guide offers more detailed guidance on the depth and level at which the examinable
documents should be examined. The study guide should therefore be read in conjunction with the
examinable documents list.
Accounting Standards
Audit and Assurance (AA)
The accounting knowledge that is assumed for Audit and Assurance is the same as that examined in
Fundamentals in Financial Accounting (FFA). Therefore, candidates studying for this exam should
refer to the IFRS Standards listed under FFA.
Advanced Audit and Assurance (AAA)
The accounting knowledge that is assumed for Advanced Audit and Assurance is the same as that
examined in Strategic Business Reporting (SBR). Therefore, candidates studying for AAA should refer
to the IFRS Standards listed under SBR.
Note. AAA will only expect knowledge of accounting standards and financial reporting standards
from SBR. Knowledge of exposure drafts and discussion papers will not be expected.
Title
AA
AAA
Glossary of Terms


International Framework for Assurance Engagements


Preface to the International Quality Control, Auditing, Review, Other
Assurance and Related Services Pronouncements


ISA 200
Overall Objectives of the Independent Auditor and the Conduct of an
Audit in Accordance with ISAs


ISA 210
Agreeing the Terms of Audit Engagements


ISA 220
Quality Control for an Audit of Financial Statements


ISA 230
Audit Documentation


ISA 240
The Auditor's Responsibilities Relating to Fraud in an Audit of
Financial Statements


ISA 250
(Revised)
Consideration of Laws and Regulations in an Audit of Financial
Statements


ISA 260
(Revised)
Communication with Those Charged with Governance


ISA 265
Communicating Deficiencies in Internal Control to Those Charged
with Governance and Management


ISA 300
Planning an Audit of Financial Statements


ISA 315
(Revised)
Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment


ISA 320
Materiality in Planning and Performing an Audit


ISA 330
The Auditor's Responses to Assessed Risks


International Standards on Auditing (ISAs)
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Introduction
Title
AA
AAA
ISA 402
Audit Considerations Relating to an Entity Using a Service Organisation


ISA 450
Evaluation of Misstatements Identified during the Audit


ISA 500
Audit Evidence


ISA 501
Audit Evidence – Specific Considerations for Selected Items


ISA 505
External Confirmations


ISA 510
Initial Audit Engagements – Opening Balances
ISA 520
Analytical Procedures


ISA 530
Audit Sampling


ISA 540
Auditing Accounting Estimates, Including Fair Value Accounting
Estimates, and Related Disclosures


ISA 550
Related Parties
ISA 560
Subsequent Events


ISA 570
(Revised)
Going Concern


ISA 580
Written Representations


ISA 600
Special Considerations - Audits of Group Financial Statements
(Including the Work of Component Auditors)
ISA 610
(Revised
2013)
Using the Work of Internal Auditors


ISA 620
Using the Work of an Auditor's Expert


ISA 700
(Revised)
Forming an Opinion and Reporting on Financial Statements


ISA 701
Communicating Key Audit Matters in the Independent Auditor's Report


ISA 705
(Revised)
Modifications to the Opinion in the Independent Auditor's Report


ISA 706
(Revised)
Emphasis of Matter Paragraphs and Other Matter Paragraphs in the
Independent Auditor's Report


ISA 710
Comparative Information – Corresponding Figures and Comparative
Financial Statements
ISA 720
(Revised)
The Auditor's Responsibilities Relating to Other Information








International Standards on Assurance Engagements (ISAEs)
ISAE 3000
(Revised)
Assurance Engagements other than Audits or Reviews of Historical
Financial Information
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Title
AA
AAA
ISAE 3400
The Examination of Prospective Financial Information

ISAE 3402
Assurance Reports on Controls at a Service Organisation

ISAE 3420
Assurance Engagements to Report on the Compilation of Pro Forma
Financial Information Included in a Prospectus

International Auditing Practice Notes
IAPN 1000

Special Considerations in Auditing Financial Instruments
International Standards on Quality Control (ISQCs)
ISQC 1

Quality Control for Firms that Perform Audits and Reviews of Financial
Statements, and Other Assurance and Related Services Engagements
International Standards on Related Services (ISRSs)
ISRS 4400
Engagements to Perform Agreed-Upon Procedures Regarding
Financial Information

ISRS 4410
(Revised)
Compilation Engagements

International Standards on Review Engagements (ISREs)
ISRE 2400
(Revised)
Engagements to Review Historical Financial Statements

ISRE 2410
Review of Interim Financial Information Performed by the Independent
Auditor of the Entity

Exposure Drafts (EDs)
IAASB – Proposed International Standard on Auditing 315 (Revised)
Identifying and Assessing the Risks of Material Misstatement

IAASB – Proposed International Standard on Auditing 540 (Revised)
Auditing Accounting Estimates and Related Disclosures

IESBA – Proposed Application Material Relating to Professional
Scepticism and Professional Judgment

Ethical Guidelines
ACCA's Code of Ethics and Conduct (July 2018)



IESBA's International Code of Ethics for Professional Accountants
(Revised August 2018)
Other documents – Corporate Governance
xviii
The UK Corporate Governance Code as an example of a code of
best practice (Revised July 2018)


FRC Guidance on Audit Committees (Revised April 2016) as an
example of guidance on best practice in relation to audit committees


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Introduction
Title
AA
AAA
Other documents - IAASB
Towards Enhanced Professional Skepticism (August 2017)

The New Auditor's Report – Questions and Answers (November 2016)

Exploring the Increasing Use of Technology in the Audit with a Focus
on Data Analytics (September 2016)

Feedback Statement – Exploring the Growing Use of Technology in
the Audit with a Focus on Data Analytics (January 2018)

Determining and Communicating Key Audit Matters (July 2016)

More Informative Auditor's Reports – What Audit Committees and
Finance Executives Need to Know (March 2016)

IAASB A Framework for Audit Quality: Key Elements that Create an
Environment for Audit Quality (February 2014)

IAASB Practice Alert Challenges in Auditing Fair Value Accounting
Estimates in the Current Market Environment (October 2008)

IAASB Staff Questions & Answers - Applying ISQC1 Proportionately
with the Nature and Size of a Firm (October 2012)

IAASB Practice Alert Audit Considerations in Respect of Going
Concern in the Current Economic Environment (January 2009)

IAASB Applying ISAs Proportionately with the Size and Complexity of
an Entity (August 2009)

IAASB XBRL : The Emerging Landscape (January 2010)

IAASB Auditor Considerations Regarding Significant Unusual or
Highly Complex Transactions (September 2010)

IAASB Questions and Answers Professional Scepticism in an Audit of
Financial Statements (February 2012)

IAASB Integrated Reporting Working Group: Supporting Credibility
and Trust in Emerging Forms of External Reporting: Ten Key
Challenges for Assurance Engagements (January 2018)

Other documents – IESBA and ACCA
NOCLAR overview (January 2018)

Ethical Considerations Relating to Audit Fee Setting in the Context of
Downward Fee Pressure (January 2016)

ACCA's Anti-money Laundering Guidance for the Accountancy
Profession

Note. Topics of exposure drafts are examinable to the extent that relevant articles about them are
published in Student Accountant.
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Essential฀skills฀areas฀to฀be฀successful฀in฀Advanced฀
Audit฀and฀Assurance฀
We฀think฀there฀are฀three฀areas฀you฀should฀develop฀in฀order฀to฀achieve฀exam฀success฀in฀Advanced฀
Audit฀and฀Assurance฀(AAA):฀฀
(1)฀
(2)฀
(3)฀
฀
Knowledge฀application฀
Specific฀AAA฀skills฀
Exam฀success฀skills฀
These฀ are฀ shown฀ in฀ the฀ diagram฀
below.฀฀
aging information
Man
e
se w ri
nt tin
ati g
on
Planning the
audit and
gathering
evidence
Completion
and reporting
Exam success skills
Specific AAA skills
r re
c
o f t i n te
re q r p re t a t i o n
u ire
m e nts
ti v
e c re
Eff d p
an
Non-audit
engagements
and current
issues
Practice
management
Co
Good
ti
manag me
em
en
t
Legal and ethical
responsibilities
g
nin
an
An
sw
er
pl
Efficient numerica
analysis
l
฀
Specific฀AAA฀skills฀
These฀are฀the฀skills฀specific฀to฀AAA฀that฀we฀think฀you฀need฀to฀develop฀in฀order฀to฀pass฀the฀exam.฀฀
In฀ this฀ Workbook,฀ there฀ are฀ five฀ Skills฀ Checkpoints฀ which฀ define฀ each฀ skill฀ and฀ show฀ how฀ it฀ is฀
applied฀in฀answering฀a฀question.฀A฀brief฀summary฀of฀each฀skill฀is฀given฀below.฀฀
Skill฀1:฀Legal฀and฀ethical฀responsibilities฀
The฀AAA฀exam฀will฀always฀test฀the฀application฀of฀your฀knowledge฀of฀this฀area.฀Candidates฀tend฀to฀
remember฀ enough฀ to฀ be฀ able฀ to฀ identify฀ when฀ something's฀ not฀ right฀ in฀ a฀ scenario฀ –฀ however,฀
explaining฀ why฀ something฀ is฀ not฀ right฀ and฀ how฀ the฀ firm฀ should฀ respond฀ appears฀ to฀ be฀ more฀
challenging.฀ You฀ therefore฀ need฀ to฀ be฀ able฀ to฀ develop฀ an฀ approach฀ that฀ will฀ assist฀ you,฀ both฀ in฀
advance฀of฀the฀exam฀and฀on฀the฀day฀itself.฀
While฀ the฀ context฀ and฀ complexity฀ of฀ scenarios฀ testing฀ legal฀ and฀ ethical฀ responsibilities฀ may฀ be฀
different฀ to฀ those฀ you฀ would฀ have฀ seen฀ in฀ the฀ Audit฀ and฀ Assurance฀ exam,฀ the฀ knowledge฀ that฀ you฀
require฀for฀AAA฀should฀not฀be฀new฀to฀you฀–฀it฀is฀therefore฀important฀that฀you฀refresh฀your฀memory฀
using฀the฀technical฀knowledge฀presented฀in฀this฀Workbook฀before฀you฀attempt฀more฀exam฀standard฀
questions.฀
A฀step-by-step฀technique฀for฀applying฀these฀techniques฀is฀outlined฀below.฀
STEP 1฀
฀
Think฀about฀the฀requirement฀and฀consider฀all฀the฀tasks฀that฀you฀are฀being฀asked฀to฀
undertake.฀
STEP 2฀ ฀
Read฀the฀scenario฀and฀identify฀all฀the฀areas฀of฀legal฀and/or฀ethical฀concern฀that฀
you฀can.฀
STEP 3฀ ฀
For฀each฀of฀the฀areas฀that฀you฀have฀identified,฀list฀the฀reasons฀why฀you฀think฀they฀
may฀be฀of฀concern฀to฀you.฀
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Introduction
STEP 4
Add suitable responses to each of the matters listed and their reasons.
STEP 5
Write your answer.
Skills Checkpoint 1 covers this technique in detail through application to a preparation question.
Skill 2: Practice management
This area of the syllabus could either be tested in a discrete, stand-alone way or as part of a larger
question testing professional issues in general – practice management includes both quality control as
well as tendering, fees and acceptance so these could be combined too. There is sometimes even a
cross-over with ethical issues as well, so questions on this topic could vary and you need to be
prepared.
Answering questions related to practice management do require some learned knowledge to inform
your approach – this will also help you identify areas of the scenario that may not look quite right
and which will need some further investigation. The AAA skills and exam success skills in this
checkpoint will help you to develop an approach that you can apply throughout the rest of your
studies.
A step-by-step technique for applying these techniques is outlined below.
STEP 1
Isolate the verbs and confirm what the requirement is looking for.
STEP 2
For theory-based requirements, consider whether there is a list that can be used to
help you create your answer.
STEP 3
For application-based requirements, what information do you need to focus on?
STEP 4
Create an approach that takes steps 1, 2 and 3 into account.
STEP 5
Write your answer.
Skills Checkpoint 2 covers this technique in detail through application to an exam-standard question.
Skill 3: Planning the audit and gathering evidence
Question 1 in the exam will be a 50 mark scenario question with a number of requirements that
should test some, if not all, of the following:




Risks (audit risks, risks of material misstatement or business risks)
Other planning issues
Audit procedures and evidence required to verify specific parts of the scenario
Ethical and professional points related to the scenario
In this skills checkpoint, we will go through an audit risk question, showing you how to use the
scenario to draw up a detailed answer. We will also show you all of the exam success skills as they
relate to Question 1 so you can start to practise them as part of your home study.
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A step-by-step technique for applying these techniques is outlined below.
STEP 1
Confirm the requirement (such as defining audit risk) by reference to the verb the
marks and the timing.
STEP 2
Annotate the scenario with ideas of audit risks.
STEP 3
Perform analytical procedures on the data supplied (including conclusions).
STEP 4
Create an answer plan that takes steps 1, 2 and 3 into account.
STEP 5
Write your answer.
Skills Checkpoint 3 covers this technique in detail through application to an exam-standard question.
Skill 4: Completion and reporting
The ACCA has confirmed that one of the 25 mark questions will always come from syllabus section
E, and consequently candidates should be prepared to answer a question relating to completion,
review and reporting. As a result, this skills checkpoint will cover some of the topics most likely to be
seen in these types of questions and the skills required to produce great answers.
Questions on completion and reporting tend to go well together – when you consider issues such as
going concern, subsequent events and the evaluation of the auditor's findings, inevitably they will
need to considered in the context of the auditor's report and any other communication that might be
necessary.
A step-by-step technique for applying these techniques is outlined below.
STEP 1
Determine which parts of the syllabus the requirement is testing.
STEP 2
Actively read the scenario to identify the key issues.
STEP 3
Consider the implications of the issues identified in Step 2 for the auditor's opinion
(both cause and extent).
STEP 4
Consider whether there are any additional impacts on the auditor's report from the
issues identified in Step 2.
STEP 5
Write your answer.
Skills Checkpoint 4 covers this technique in detail through application to an exam-standard question.
Skill 5: Non-audit engagements and current issues
Remember that although this is an audit exam, the words '…and Assurance' are also in the title. The
syllabus contains a number of non-audit elements that you could be tested on, so this checkpoint will
consider how you can prepare for these if required. Part F of the syllabus covers these subjects.
The AAA examining team also periodically publishes technical articles on subjects deemed to be of
interest to candidates: in some cases, they may recommend exam techniques for syllabus topics that
have been poorly answered in previous exam sittings; in others, they may relate to current issues
which the examining team want candidates to be aware of.
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Introduction
Traditionally, whenever a technical article is published, the content is often examined within the next
couple of sittings, so keeping up to date with these technical articles is essential. You will find
references to relevant technical articles with the 'Further reading' sections of this workbook.
A step-by-step technique for applying these techniques is outlined below.
STEP 1
Think about the question and list all the things that you will need to do.
STEP 2
Read the scenario and identify all the areas that are relevant to producing an
answer.
STEP 3
Is there any other technical knowledge that will help you to produce an answer?
STEP 4
Draw up an answer plan based on your outputs from Steps 1, 2 and 3.
STEP 5
Write your answer.
Skills Checkpoint 5 covers this technique in detail through application to an exam-standard question.
Exam success skills
Passing the AAA exam requires more than applying syllabus knowledge and demonstrating the
specific AAA skills; it also requires the development of excellent exam technique through question
practice.
We consider the following six skills to be vital for exam success. The Skills Checkpoints show how
each of these skills can be applied specifically to the AAA exam.
Exam success skill 1
Managing information
Questions in the exam will present you with a lot of information. The skill is how you handle this
information to make the best use of your time. The key is determining how you will approach the
exam and then actively reading the questions.
Advice on developing managing information
Approach
The exam is 3 hours 15 minutes long. There is no designated 'reading' time at the start of the exam,
however, one approach that can work well is to start the exam by spending 10–15 minutes carefully
reading through all of the questions to familiarise yourself with the exam paper.
Once you feel familiar with the exam paper consider the order in which you will attempt the
questions; always attempt them in your order of preference. For example, you may want to leave to
last the question you consider to be the most difficult.
If you do take this approach, remember to adjust the time available for each question appropriately –
see Exam success skill 6: Good time management.
If you find that this approach doesn't work for you, don't worry – you can develop your own
technique.
Active reading
You must take an active approach to reading each question. Focus on the requirement first,
underlining key verbs such as 'prepare', 'comment', 'explain', 'discuss', to ensure you answer the
question properly. Then read the rest of the question, underlining and annotating important and
relevant information, and making notes of any relevant technical information you think you will need.
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Exam success skill 2
Correct interpretation of the requirements
The active verb used often dictates the approach that written answers should take (eg 'explain',
'discuss', 'evaluate'). It is important you identify and use the verb to define your approach. The
correct interpretation of the requirements skill means correctly producing only what is being
asked for by a requirement. Anything not required will not earn marks.
Advice on developing correct interpretation of the requirements
This skill can be developed by analysing question requirements and applying this process:
Step 1
Read the requirement
Firstly, read the requirement a couple of times slowly and carefully and highlight the
active verbs. Use the active verbs to define what you plan to do. Make sure you
identify any sub-requirements.
Step 2
Read the rest of the question
By reading the requirement first, you will have an idea of what you are looking out
for as you read through the case overview and exhibits. This is a great time saver
and means you don't end up having to read the whole question in full twice. You
should do this in an active way – see Exam success skill 1: Managing Information.
Step 3
Read the requirement again
Read the requirement again to remind yourself of the exact wording before starting
your written answer. This will capture any misinterpretation of the requirements or
any missed requirements entirely. This should become a habit in your approach and,
with repeated practice, you will find the focus, relevance and depth of your answer
plan will improve.
Exam success skill 3
Answer planning: Priorities, structure and logic
This skill requires the planning of the key aspects of an answer which accurately and completely
responds to the requirement.
Advice on developing Answer planning: Priorities, structure and logic
Everyone will have a preferred style for an answer plan. For example, it may be a mind map, bulletpointed lists or simply annotating the question paper. Choose the approach that you feel most
comfortable with, or, if you are not sure, try out different approaches for different questions until you
have found your preferred style.
For a discussion question, annotating the question paper is likely to be insufficient. It would be better
to draw up a separate answer plan in the format of your choosing (eg a mind map or bullet-pointed
lists). For a risk question, you should annotate the scenario noting which areas present the type of
risk being examined and explain why.
Exam success skill 4
Efficient numerical analysis
This skill aims to maximise the marks awarded by making clear to the marker the process of arriving
at your answer. This is achieved by laying out an answer such that, even if you make a few errors,
you can still get some credit for your calculations. It is vital that you do not lose marks purely because
the marker cannot follow what you have done.
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Introduction
Advice on developing efficient numerical analysis
This skill can be developed by applying the following process:
Step 1
Explain your workings where relevant
Materiality calculations or other forms of analytical procedure should have a brief
explanation of their purpose so the examining team can understand what your
calculations are trying to tell them.
Step 2
Show your workings
Keep your workings as clear and simple as possible and ensure they are crossreferenced to the main part of your answer. Where it helps, provide brief narrative
explanations to help the marker understand the steps in the calculation. This means
that if a mistake is made you should not lose any subsequent marks for follow-on
calculations.
Step 3
Keep moving!
It is important to remember that, in an exam situation, it is difficult to get every
number 100% correct. The key is therefore ensuring you do not spend too long on
any single calculation. If you are struggling with a solution then make a sensible
assumption, state it and move on.
Exam success skill 5
Effective writing and presentation
Written answers should be presented so that the marker can clearly see the points you are making,
presented in the format specified in the question. The skill is to provide efficient written answers with
sufficient breadth of points that answer the question, in the right depth, in the time available.
Advice on developing effective writing and presentation
Step 1
Use headings
Using the headings and sub-headings from your answer plan will give your answer
structure, order and logic. This will ensure your answer links back to the requirement
and is clearly signposted, making it easier for the marker to understand the different
points you are making. Underlining your headings will also help the marker.
Step 2
Write your answer in short, but full, sentences
Use short, punchy sentences with the aim that every sentence should say something
different and generate marks. Write in full sentences, ensuring your style is
professional.
Step 3
Do your calculations first and explanation second
Questions sometimes require an explanation with suitable calculations, such as
materiality. The best approach is to prepare the calculation first but present it on the
bottom half of the page of your answer, or on the next page. Then add the
explanation before the calculation. Performing the calculation first should enable you
to explain what you have done.
Exam success skill 6
Good time management
This skill means planning your time across all the requirements so that all tasks have been attempted
at the end of the 3 hours 15 minutes available and actively checking on time during your exam. This
is so that you can flex your approach and prioritise requirements which, in your judgment, will
generate the maximum marks in the available time remaining.
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Advice on developing Good time management
The exam is 3 hours 15 minutes long, which translates to 1.95 minutes per mark. Therefore a
10-mark requirement should be allocated a maximum of 20 minutes to complete your answer before
you move on to the next task. At the beginning of a question, work out the amount of time you should
be spending on each requirement and write the finishing time next to each requirement on your
exam paper. If you take the approach of spending 10–15 minutes reading and planning at the start
of the exam, adjust the time allocated to each question accordingly; eg if you allocate 15 minutes to
reading, then you will have 3 hours remaining, which is 1.8 minutes per mark.
Keep an eye on the clock
Aim to attempt all requirements, but be ready to be ruthless and move on if your answer is not going
as planned. The challenge for many is sticking to planned timings. Be aware this is difficult to
achieve in the early stages of your studies and be ready to let this skill develop over time.
If you find yourself running short on time and know that a full answer is not possible in the time you
have, consider recreating your plan in overview form and then add key terms and details as time
allows. Remember, some marks may be available, for example, simply stating a conclusion which
you don't have time to justify in full.
Question practice
Question practice is a core part of learning new topic areas. When you practice questions, you
should focus on improving the Exam success skills – personal to your needs – by obtaining feedback
or through a process of self-assessment.
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International regulatory
environments for audit
and assurance services
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Explain the need for laws, regulations, standards and other guidance relating to
audit, assurance and related services.
A1(a)
Outline and explain the need for the legal and professional framework including:
A1(b)
(i)
Public oversight of audit and assurance practice
(ii)
The impact of corporate governance principles on audit and assurance
practice
(iii) The role of audit committees and impact on audit and assurance practice
Define 'money laundering' and discuss international methods for combatting
money laundering.
A2(a)
Explain the scope of criminal offences of money laundering and how professional
accountants may be protected from criminal and civil liability.
A2(b)
Explain the need for ethical guidance in this area.
A2(c)
Describe how accountants meet their obligations to help prevent and detect
money laundering including record keeping and reporting of suspicion to the
appropriate regulatory body.
A2(d)
Explain the importance of customer due diligence (CDD) also referred to as know
your customer (KYC) and recommend the information that should be gathered as
part of CDD/KYC.
A2(e)
Recognise potentially suspicious transactions and assess their impact on reporting
duties.
A2(f)
Describe with reasons the basic elements of an anti-money laundering program.
A2(g)
Compare and contrast the respective responsibilities of management and auditors
concerning compliance with laws and regulations in an audit of financial
statements.
A3(a)
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Syllabus
reference no.
Describe the auditors' considerations of compliance with laws and regulations
and plan audit procedures when possible non-compliance is discovered.
A3(b)
Discuss how and to whom non-compliance should be reported.
A3(c)
Recognise and recommend when withdrawal from an engagement is necessary.
A3(d)
Business and exam context
This chapter covers a wide range of regulations that affect the work of audit and assurance
professionals. You need to be aware of the international nature of the audit and assurance market
and the main issues driving the development of regulatory frameworks.
The detailed requirements relating to money laundering are then discussed. You should be prepared
to explain the responsibilities of professional accountants in this area and to outline the procedures
that audit firms should implement.
The final section looks at the auditor's responsibilities in respect of laws and regulations that apply to
an audit client. This is a topic that could be built into a practical case study question. The technical
content of this part of the syllabus is mainly drawn from your earlier studies. Questions in this exam
are unlikely to ask for simple repetition of this knowledge, but are more likely to require explanation
or discussion of the reasons behind the regulations.
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1: International regulatory environments for audit and assurance services
Chapter overview
International regulatory
environments for audit and
assurance services
1. International
regulatory
environment
2. Money laundering
3. ISA 250 (revised)
Consideration of Laws
And Regulations in an
Audit of Financial
Statements
2.1 Money laundering
offences
2.2 ACCA guidance
2.3 Risk-based
approach
3.1 Responsibility of
management
3.2 The auditors'
consideration of
compliance with laws
and regulations
3.3 Audit procedures
when possible NOCLAR
is discovered
3.4 Withdrawal from
the engagement
3.5 The auditor's report
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1 International regulatory environment
Activity 1: Regulating the audit profession
Required
What factors have led to the growth in regulation of the audit profession?
Solution
PER alert
One of the competencies you require to fulfil Performance Objective 18 of the PER is the ability
to use up to date auditing standards and legal and ethical frameworks. You can apply the
knowledge you obtain from this section of the Workbook to help you demonstrate this competency.
Essential reading
See Chapter 1 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the legal and professional framework (including the role of regulators,
standard-setters and those responsible for oversight, as well as a recap of corporate governance and
the audit committee).
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1: International regulatory environments for audit and assurance services
2 Money laundering
Key term
Money laundering: The process by which criminals attempt to conceal the true origin and
ownership of the proceeds of their criminal activity, allowing them to maintain control over
the proceeds and, ultimately, providing a cover for their sources of income.
Money laundering usually consists of three stages:
1
2
Placement of the
proceeds of crime
into the financial
system
Layering by passing
it through several
institutions to mask its
true identity
3
Integration back into the
legitimate economy
2.1 Money laundering offences
The Financial Action Task Force (FATF) has clarified a number of criminal offences relating to
money laundering. Many of these have a significant impact on the auditor and it is therefore
imperative that firms are aware of them and consider the risk that they may be committing an
offence. The key offences are as follows:
(a)
Acquiring, using, possessing or concealing criminal property (this includes
arranging, or becoming involved in an arrangement which might facilitate the acquisition of
criminal property).
(b)
Failing to report knowledge or suspicion of money laundering to the appropriate authority.
For example, in the UK, the National Crime Agency (NCA) receives over 300,000 suspicious
activity reports each year.
(c)
Tipping off a client of suspicions relating to money laundering or disclosing any information
that may prejudice an investigation.
2.1.1 International efforts to combat money laundering
Since 1989, FATF has acted as an intergovernmental body to set standards and develop policies to
combat money laundering and terrorist financing.
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FATF has made 40 recommendations designed to combat money laundering and these have
been adopted across the world.
2.2 ACCA guidance
In order to assist members, the ACCA has included guidance on anti-money laundering
within the ACCA Rulebook (2018) alongside the Code of Ethics and Conduct.
2.2.1 The key elements of the guidance:
Internal controls
and policies
Members should ensure their staff receive regular training to ensure
that client identification procedures are carried out correctly and
that knowledge and suspicions of money laundering or terrorist financing
are reported. Firms should identify to their staff a clear procedure for
reporting suspected money laundering and appoint an individual through
whom reports of suspicions can be channelled to the relevant authority
(Money Laundering Reporting Officer or MLRO; in the UK this role
can also be fulfilled by a separate officer known as a Money
Laundering Compliance Principal or MLCP, although one person
can fulfil both roles if sufficiently senior within the firm).
Client identification
Before any work is undertaken, members should verify the identity of the
potential client – this is known as either 'know your client' (KYC) or
'customer due diligence' (CDD) and requires awareness of the
client's identity, their ownership structure and their operating cashflows. This is discussed in more detail in Section 2.2.2.
Record keeping
Recognition of
suspicion
Members should retain all client identification records for at least
five years after the end of the client relationship. Records of all
transactions and other work carried out, in a full audit trail form, should
be retained for at least five years after the conclusion of the transaction.
Suspicion can be described as being more than speculation but
falling short of proof based on firm evidence. The key to
recognising a suspicious transaction or situation is for members to have
sufficient understanding of clients and their activities.
Special attention should be paid to any transactions without any visible
lawful or economic purpose.
6
Reporting
suspicious
transactions
Where members know or suspect that funds are the proceeds of crime or
relate to terrorist financing, they should request that their MLRO
promptly report their suspicions to the relevant authority (such as
the NCA in the UK).
Tipping off
Members should not 'tip off' a client that a report has been made. If
a suspicion has arisen during the course of client identification
procedures, members should take extra care that carrying out those
procedures will not tip off the client. However, attempts to discourage a
client from breaking the law will not be seen as tipping off.
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1: International regulatory environments for audit and assurance services
Activity 2: Ethics and money laundering
Required
Why is there a need for ethical guidance for accountants in respect of money laundering?
Solution
2.2.2 Client identification
The guidance on members' responsibilities mentions the requirement to gather CDD/KYC information.
This includes:
Who the client is
(company or
individual?)
Who controls it?
The purpose and
intended nature of
the business
relationship
The nature of
the client
The client's
source of funds
The client's
business and
economic purpose
KYC enables the audit firm to understand its client's business well enough to spot any unusual
business activity. This assists the firm in identifying suspicions of money laundering.
In the UK, the Money Laundering Regulations extended the circumstances under which customer due
diligence (CDD) must be carried out from new to existing clients.
CDD is the term used in the Money Laundering Regulations for the steps that businesses must take to:
(a)
Identify the customer and verify their identity using documents, data or information
obtained from a reliable and independent source: for individuals, this could be a passport and
proof of address; for a company, obtaining proof of incorporation or similar.
(b)
Identify any beneficial owner who is not the customer. This is the individual (or
individuals) behind the customer who ultimately owns or controls the customer or on whose
behalf a transaction or activity is being conducted.
(c)
Where a business relationship is established, you will need to understand the purpose and
intended nature of the relationship, such as details of the customer's business or the
source of the funds.
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Businesses must also conduct ongoing monitoring to identify large, unusual or suspicious transactions
as part of CDD. The requirement to confirm the identity of customers and other individuals clearly
links to the concept of KYC described above.
If a potential client's identity cannot be established, no work should be done by the professional
accountant.
2.3 Risk-based approach
On any assignment, the auditor should assess the risk of money laundering activities. Clearly, every
circumstance is different, but the following diagram illustrates some key risk factors:
Secrecy over
transactions
Excessive use of
wire transfers
Transactions routed
through several
jurisdictions
A pattern that after a
deposit, the same (or nearly
the same) amount is wired to
another financial institution
MONEY LAUNDERING
RISK INDICATIONS
High value deposits or
withdrawals not characteristic
of the type of account
Large currency or bearer
instrument transactions
Repeated deposits or withdrawals
just below the monitoring threshold
on the same day
3 ISA 250 (revised) Consideration of Laws and Regulations
in an Audit of Financial Statements
Companies are increasingly subject to laws and regulations with which they must comply. Here are
some examples:
Health and safety regulation
Company law
Employment law
LAWS AND REGULATIONS
Civil law
Contract
Environmental law and
regulation
Tort
When designing and performing audit procedures and in evaluating and reporting the results
thereof, the auditor should recognise that non-compliance by the entity with law or regulations
may materially affect the financial statements.
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1: International regulatory environments for audit and assurance services
Key term
Non-compliance: Refers to acts of omission or commission, intentional or unintentional, committed
by the entity, or by those charged with governance, by management or by other individuals working
for or under the direction of the entity, which are contrary to the prevailing laws or regulations.
Non-compliance does not include personal misconduct unrelated to the business activities of the
entity.
(ISA 250 (revised): para. 11)
Non-compliance with laws and regulations is sometimes referred to as NOCLAR.
3.1 Responsibilities of management
It is management's responsibility to ensure that the entity's operations are conducted in
accordance with laws and regulations. The responsibility for the prevention and detection of
non-compliance also rests with management.
The following policies and procedures, among others, may assist management in discharging its
responsibilities for the prevention and detection of non-compliance:
Monitoring legal requirements
and any changes therein and
ensuring that operating
procedures are designed to
meet these requirements
Instituting and operating
appropriate systems of
internal control
Developing, publicising and
following a Code of Conduct,
and ensuring employees are
properly trained and understand
the Code of Conduct
Monitoring compliance
with the Code of Conduct
and acting appropriately to
discipline employees who
fail to comply with it
Engaging legal advisers
to assist in monitoring legal
requirements
Maintaining a register of
significant laws and
regulations with which the
entity has to comply within its
particular industry and a
record of complaints
In larger entities, these policies and procedures may be supplemented by assigning appropriate
responsibilities to:



An internal audit function
An audit committee
A compliance function
3.2 The auditor's consideration of compliance with laws and
regulations
The auditor is not, and cannot be, held responsible for preventing NOCLAR. The fact
that an audit is carried out may, however, act as a deterrent. The auditor needs to consider the
impact of any non-compliance on the financial statements, and assess the risk of material
misstatement by considering the various laws and regulations which clients must comply with and
how the auditor should respond.

Those that have a direct effect on determining material amounts in the financial statements
(such as tax laws) require the auditor to obtain evidence of compliance.

Those that are fundamental to the operating aspects of the client which have a material (but
not direct) effect on the financial statements (such as compliance with an operating licence)
require the auditor to undertake procedures to identify any non-compliance.
The auditor has no formal responsibility for NOCLAR that has neither a direct nor material effect on
the financial statements, but should respond appropriately should such cases be detected.
Maintaining an awareness of such laws and regulations for clients is obviously a challenge for
auditors, especially if clients attempt to deliberately conceal NOCLAR.
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Examples of laws and regulations that may have either a direct or material effect on the
financial statements include those that relate to:
Environmental
and public
health and
safety
Money
laundering
and other
financial crime
Fraud,
corruption
and bribery
Data
protection
In order to determine whether or not NOCLAR has occurred, the auditor needs to obtain a general
understanding of the legal and regulatory framework and whether the client is complying
with this framework. This takes the form of enquiries of management and reviews of
correspondence with the appropriate regulatory and/or licensing authorities (although ISA 250
(revised) points out that other testing during the audit might provide valuable evidence of noncompliance, so the team needs to be alert throughout the audit).
3.3 Audit procedures when possible NOCLAR is discovered
When the auditor becomes aware of information concerning a possible instance of non-compliance,
the auditor should obtain an understanding of the nature of the act and the circumstances in
which it has occurred, and seek further information to evaluate the possible effect on the
financial statements. This may require amendments to both amounts and disclosures (as well
as casting doubt on the entity's going concern status if sufficiently serious). All such information
and evaluations should be fully documented.
ISA 250 (revised) sets out examples of the type of information that might come to the auditor's
attention that may indicate non-compliance.
Investigation by a regulatory organisation or government department or payment of
fines or penalties
Payments for unspecified services or loans to consultants, related parties, employees or
government employees
Sales commissions or agents' fees that appear excessive in relation to those normally paid by the
entity or in its industry or to the services actually received
Purchasing at prices significantly above or below market price
Unusual payments in cash, purchases in the form of cashiers' cheques payable to bearer or
transfers to numbered bank accounts
Unusual transactions with companies registered in tax havens
Payments for goods or services made other than to the country from which the
goods or services originated
Payments without proper exchange control documentation
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1: International regulatory environments for audit and assurance services
Existence of an information system that fails, whether by design or by accident, to provide
an adequate audit trail or sufficient evidence
Unauthorised transactions or improperly recorded transactions
Adverse media comment
(ISA 250: para. A13)
When evaluating the possible effect on the financial statements, the auditor should consider:
The potential financial consequences, such as fines, penalties, damages, threat of
expropriation of assets, enforced discontinuation of operations and litigation
Whether the potential financial consequences require disclosure
Whether the potential financial consequences are so serious as to call into question the fair
presentation given by the financial statements, or otherwise make the financial statements
misleading
(ISA 250: para. A14)
The auditor should also report any cases of NOCLAR to the appropriate level of management
and, where appropriate, to those charged with governance. However, ISA 250 (revised) does
also state that if there are laws and regulations that prohibit this (for example, where reporting to
either management or those charged with governance would constitute 'tipping off') or if the auditor
suspects that management or those charged with governance are involved in
NOCLAR, then the auditor should communicate the matter to the next higher level of authority (such
as an audit committee or regulator), usually after seeking suitable legal or professional advice to
confirm who this is.
In extreme cases, the auditor may feel compelled to make disclosures about NOCLAR in the public
interest (for example, if a client is wilfully polluting public land) but is still bound by the fundamental
ethical duty of confidentiality. Both ISA 250 (revised) and the IESBA Code of Ethics specifically
encourage auditors to seek legal advice before deciding on how to proceed in such cases.
3.4 Withdrawal from the engagement
The auditor may conclude that withdrawal from the engagement is necessary when the entity does
not take the remedial action that the auditor considers necessary in the circumstances,
even when NOCLAR is not material to the financial statements. However, ISA 250 (revised) and the
IESBA Code also emphasise that withdrawal should not be used by firms as a substitute
for responding appropriately to any NOCLAR at a client (in other words, the auditor
cannot just keep quiet about any NOCLAR they discover, regardless of how difficult it may be for
them to do so).
The process for dealing with laws and regulations can be summarised for auditors like this:
Obtain general
understanding of legal
and regulatory
framework
If NOCLAR is
discovered, obtain
further understanding
Evaluate the impact of
NOCLAR on the
financial statements
Consider withdrawal
from engagement if
client refuses to
co-operate
Report to
appropriate level of
management
(or higher)
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3.5 The auditor's report
3.5.1 Material misstatement
Where the auditor concludes that the non-compliance (such as failing to disclose certain
items within the financial statements) has a material effect on the financial statements which
have not been amended, they should express a qualified or adverse opinion.
3.5.2 Insufficient or inappropriate audit evidence
Where adequate information about compliance or suspected non-compliance cannot be obtained
(either due to obstruction by the client or any other circumstance), the auditor may need to
express a qualified opinion or disclaimer of opinion due to inability to obtain sufficient,
appropriate audit evidence.
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1: International regulatory environments for audit and assurance services
Chapter summary
International regulatory
environments for audit and
assurance services
2. Money
laundering
1. International
regulatory
environment
 International Federation of
Accountants (IFAC)
 See next page
 International Auditing and
Assurance Standards
Board (IAASB)
ISAs
ISREs
ISAEs
ISRSs
2.1 Money
laundering
offences
2.2 ACCA
guidance
 Acquiring, using,
possessing, dealing with
or concealing criminal
property
 Failure to report
knowledge or suspicion
 Tipping off
 Concealing the true
origin and ownership of
the proceeds of crime
 Consists of three stages:
– Placement
– Layering
– Integration
 Financial Action Task
Force role
3. ISA 250 (revised)
Consideration of Laws
and Regulations in an
Audit of Financial
Statements
 Internal controls and policies,
including Money Laundering
Reporting Officer (MLRO) role
(Money Laundering Compliance
Principal or MLCP in the UK) and
training
 Client identification (identity,
ownership and cash flows) via
CDD or KYC
 Record keeping – at least
five years
 Recognition of suspicion – more
than speculation but falling short
of firm proof
2.3 Risk-based
approach
 Secrecy over transactions
 Transfers via several jurisdictions
 High value transactions not in
line with business model
 Excessive use of wire transfers
 Patterns between deposits and
transfers
 Transactions of great value
 Repeated transactions below
monitoring threshold on same
day
 Reporting suspicious transactions
 Tipping off should not be done,
even by accident
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3. ISA 250 (revised)
Consideration of Laws
and Regulations in an
Audit of Financial
Statements

Non-compliance with laws and regulations (omission, commission, deliberate, accidental) is
sometimes referred to as NOCLAR

Management is responsible for operational compliance and also for prevention and
detection of non-compliance

Auditors are responsible for the impact of any non-compliance on the financial statements,
and for assessing the risk of material misstatement due to the following:
–
Those that have a direct effect on the financial statements (eg compliance with enacted
laws) require evidence of compliance
–
Those that have a material (but not direct) effect on the financial statements
(eg compliance with an operating licence) require evidence of any non-compliance
–
Those that have neither a direct nor material effect on the financial statements
require an awareness of any NOCLAR and an appropriate response

Auditors need a general understanding of the legal and regulatory framework in place
(see ISA 315) including environmental/public health and safety, fraud, corruption, bribery,
data protection or other financial crime (such as money laundering)

If NOCLAR is discovered, the following steps should take place:
–
The auditor must understand the matter fully and document their findings
–
They must report cases of NOCLAR to the appropriate level of management or those
charged with governance (TCWG) unless prohibited by law
–
If management and/or TCWG are suspected of involvement in NOCLAR, the auditor
may report to next most higher level of authority (eg audit committee or
regulator)
–
They may need to disclose to others in the public interest
–
In all cases, especially when reporting or disclosing NOCLAR, legal advice should be
sought due to the need for confidentiality

If NOCLAR has not been addressed by a client, the auditor may withdraw from the
engagement, but this should not be seen by auditors as a suitable way of responding to
NOCLAR without any further action being taken

Material NOCLAR can lead to a modified audit opinion:
14
–
Failure to comply with a requirement could lead to a misstatement
–
An obstruction by the client or poor record keeping could lead to insufficient or
inappropriate audit evidence
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1: International regulatory environments for audit and assurance services
Knowledge diagnostic
1.
The various laws, standards, governance structures and regulations in place within
the financial community are essential to protect and enhance the reputation of the profession
within the society it serves.
2.
A key area where guidance and regulations exist is money laundering. Auditors are at risk
of committing various criminal offences regarding money laundering, for example not
reporting suspicious transactions and/or tipping off the client that suspicion has arisen – as
such they must know the requirements before acting in any engagement.
3.
There are three key areas that need to be covered when performing client due diligence
(CDD) or know your customer (KYC) procedures: the identity of the customer; the ownership
of the customer's business; and the likely cash flows of the business.
4.
Auditors should ensure they are familiar with the laws and regulations that the client has to
comply with, and have considered the risk of non-compliance (NOCLAR) at all stages of the
audit.
5.
Auditors must also know how to respond to such cases of NOCLAR, including the need to
disclose to an appropriate level of authority.
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Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 1 'Mr Roy and Mr Fox' is an opportunity to practise some of the theory discussed in this
chapter in an applied situation.
Further reading
There are technical articles on the ACCA website written by members of the AAA examining team which
are relevant to some of the topics covered in this chapter that you should read:

Responding to non-compliance with laws and regulations (NOCLAR)

Laws and regulations

Corporate governance and its impact on audit practice
Own research
Consider your own organisation or one that you are familiar with – what can you learn from the following
to help you with topics from this chapter?

Which laws and regulations matter most? Why do you think this is?

How does an audit committee actually work? Are you aware of its impact?

Have you received training on anti-money laundering procedures? If so, what did it include and are
you aware of any instances of reports that needed to be made to the appropriate authority?

The IESBA prepared a set of slides called 'NOCLAR Overview' published in December 2017 which
explains the issues for all professional accountants, not just auditors. Access them here to see if
anything is relevant to you:
https://www.ifac.org/system/files/publications/files/NOCLAR-Overview.pdf
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Code of ethics
and conduct
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Explain the fundamental principles and the conceptual framework approach.
B1(a)
Identify, evaluate and respond to threats to compliance with the fundamental
principles.
B1(b)
Discuss and evaluate the effectiveness of available safeguards.
B1(c)
Recognise and advise on conflicts in the application of fundamental principles.
B1(d)
Discuss the importance of professional scepticism in planning and performing
an audit.
B1(e)
Consider the ethical implications of the external auditor providing non-audit
services to a client including an internal audit service.
B1(f)
Assess whether an engagement has been planned and performed with an
attitude of professional scepticism, and evaluate the implications.
B1(g)
Discuss emerging ethical issues and evaluate the potential impact on the
profession, firms and auditors.
G1(a)
Discuss the content and impact of exposure drafts, consultations and other
pronouncements issued by IFAC and its supporting bodies (including IAASB,
IESBA and TAC).
G1(b)
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Business and exam context
You have already learnt about ethical principles for auditors in your earlier studies. We will examine
the issues in more detail and consider some of the complex ethical issues that auditors may face.
We also refer to the ethical guidance of the International Federation of Accountants. This is similar to
the ACCA's guidance. Both approach issues of ethics in a conceptual manner.
Some of this chapter is likely to be revision, but that does not mean you should ignore it. Ethics is a
key syllabus area. Complex ethical issues are introduced in this chapter. You particularly need to
work through the questions given so that you practise applying ethical guidelines in given scenarios,
as this is how this topic will be tested in the exam.
Professional ethics are of vital importance to the auditing and assurance profession and a major area
of the syllabus, so this is likely to be a regular feature of the exam. Ethics can be tested in either
Section A or Section B.
Questions are likely to be practical, giving scenarios where you are required to assess whether the
situations presented are acceptable. Some of these can be answered by reference to specific
guidance in the IESBA Code of Ethics but others may require you to apply your understanding of the
fundamental principles underlying the Code. Ethics may be examined alongside other areas within
scenarios; commonly, practice management.
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2: Code of ethics and conduct
Chapter overview
Code of ethics and conduct
1. Sources of
regulation
3. The conceptual
framework
3.1 Responding
to threats
4. Current issues
4.1 Ethical implications
of one firm providing
both internal and
external audit services
3.2 Public
interest entities
2. The fundamental
principles
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4.2 Professional
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4.3 Management
responsibility
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1 Sources of regulation
The IESBA's Code of Ethics for Professional Accountants gives the key reason why accountancy
bodies produce ethical guidance: the public interest.
'A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in
the public interest. A professional accountant's responsibility is not exclusively to satisfy the needs of
an individual client or employing organisation.'
(IESBA Code: para. 100.1 A1)
Key term
Public interest is considered to be the collective wellbeing of the community of people and
institutions the professional accountant serves, including clients, lenders, governments, employers,
employees, investors, the business and financial community, and others who rely on the work of
professional accountants.
The key reason why accountants need to have an ethical code is that people rely on them and
their expertise. Accountants deal with a range of issues on behalf of clients. They often have
access to confidential and sensitive information. Auditors also claim to give an independent
opinion. It is therefore critical that accountants and particularly auditors are, and are seen to be,
independent.
As the auditor is required to be, and seen to be, ethical in their dealings with clients, the ACCA
publishes guidance for its members in its Code of Ethics and Conduct. This guidance is given in
the form of fundamental principles, guidance and explanatory notes. (This guidance is contained
within the ACCA Rulebook, which can be found on the ACCA website and which is of crucial
importance for ACCA members.)
The IESBA (International Ethics Standards Board for Accountants), a body of IFAC, also lays down
fundamental principles in its International Code of Ethics for Professional Accountants.
The fundamental principles of the two associations are extremely similar (much of the ACCA Code is
drawn directly from the IESBA Code). The IAASB also issues quality control standards and auditing
standards (ISAs), which work together to promote auditor independence and audit quality.
PER alert
One of the competencies you require to fulfil Performance Objective 1 of the PER is the ability to
act diligently and honestly, following codes of conduct, taking legislation into account and keeping
up to date with legislation. You can apply the knowledge you have obtained from this chapter of the
Workbook to help demonstrate this competence.
2 The fundamental principles
Key terms
Integrity: Members should be straightforward and honest in all professional and business
relationships (so truth is fundamental).
Objectivity: Members should not allow bias, conflicts of interest or undue influence of
others to override professional or business judgment (therefore fairness is also fundamental).
Professional competence and due care: Members have a continuing duty to maintain
professional knowledge and skill at a level required to ensure that a client or employer receives
competent professional service based on current developments in practice, legislation and
techniques. Members should act diligently and in accordance with applicable technical and
professional standards when providing professional services.
Confidentiality: Members should respect the confidentiality of information acquired as a result
of professional and business relationships and should not disclose any such information to third
parties without proper and specific authority, unless there is a legal or professional right or duty to
disclose. Confidential information acquired as a result of professional and business relationships
should not be used for the personal advantage of members or third parties.
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2: Code of ethics and conduct
Professional behaviour:
Members should comply with relevant laws and regulations and
should avoid any action that discredits the profession.
(ACCA Code: para 100.5)
3 The conceptual framework
Activity 1: Ethical threats
The ACCA Code identifies five circumstances which have the potential to threaten a member or
professional accountant's compliance with the fundamental principles. These are:





The self-interest threat
The self-review threat
The advocacy threat
The familiarity threat
The intimidation threat
Required
What real-world situations could lead to the above threats to compliance with the fundamental
principles?
Solution
Self-interest
Self-review
Advocacy
Familiarity
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Intimidation
3.1 Responding to threats
Having identified threats to compliance with the fundamental principles, the IESBA Code goes on to
give guidance as to appropriate conditions, policies and procedures that may be relevant in
evaluating the level of threats – examples of these include the following:

Corporate governance requirements

Education, training and experience requirements for the profession

Effective complaint systems which enable the professional accountant and the general public
to draw attention to unethical behaviour

An explicitly stated duty to report breaches of ethics requirements

Professional or regulatory monitoring and disciplinary procedures
(IESBA Code: para. 120.8 A2)
Addressing these threats requires the professional accountant to either eliminate them or reduce
them to an acceptable level – this is achieved by one of the following actions:
Eliminating the
circumstances,
including interests
or relationships,
that are creating
the threats
Applying
safeguards, where
available and
capable of being
applied, to reduce
the threats to an
acceptable level
Declining or ending the specific
professional activity
(IESBA Code: para. R120.10–11)
Factors that are relevant in responding appropriately include reviews of significant judgments
made or conclusions reached and the use of 'the reasonable and informed third party
test' (asking if the conclusion reached by the professional accountant would also have been reached
by an independent and informed third party if faced with the same set of circumstances).
The use of professional scepticism (see Section 4.2) is also reinforced as being 'inter-related'
with the fundamental ethical principles (IESBA Code: para. 120.13 A1).
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2: Code of ethics and conduct
Activity 2: Ethical responses
Required
Discuss the ethical issues raised by the following scenarios and recommend suitable responses that
the auditor should take in each case:
1
An audit partner has recently been asked by the finance director of the firm's longest-standing
client to be his son's godfather.
2
A partner of the firm, who is a qualified actuary, wishes to provide valuation services to the
firm's audit clients.
Solution
Issue 1
Issue 2
Essential reading
See Chapter 2 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the various ethical threats and responses given by the IESBA Code.
You should learn these.
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3.2 Public interest entities
The previous activity required you to consider whether any of the firm's clients were public interest
entities. The IESBA Code distinguishes between 'public interest entities' and other entities because the
ethical requirements applicable to public interest entities are frequently stricter than for other entities.
At this level of your studies, you must be able to recognise a public interest entity in a question, and
adapt your answer accordingly.
The term 'public interest entity' is defined as follows.
Public interest entities
Key term
(a)
A listed entity; or
(b)
An entity:
(i)
Defined by regulation or legislation as a public interest entity; or
(ii)
For which the audit is required by regulation or legislation to be conducted in
compliance with the same independence requirements that apply to the audit of listed
entities. Such regulation may be promulgated by any relevant regulator, including an
audit regulator.
(IESBA Code: Glossary)
4 Current issues
4.1 Ethical implications of one firm providing both internal and
external audit services
It stands to reason that a good working relationship should exist in order to facilitate this
process of reliance on the work of internal auditors. Following this through to its logical conclusion,
surely the best form of relationship would be one in which two separate teams from the same
firm (with the same methodology, systems, knowledge sharing etc) carry out both internal and
external audit work simultaneously.
Obviously, this has one major drawback – working for the same firm dramatically increases the
risk of a self-review threat to the external auditor's objectivity. Despite this, however, many
companies choose this arrangement and sell it to their shareholders as a way of improving
quality and reducing agency costs – in some cases, savings of around 30% of all audit costs
have been reported. It raises the question of what serves a company's stakeholders better – greater
audit objectivity or smaller audit fees?
4.2 Professional scepticism
The IESBA Code explains that in order to follow best practice, all professional accountants (including
auditors) are required to exercise professional scepticism when planning and performing audits,
reviews and other assurance engagements in order to scrutinise and challenge what is placed before
them. The Code cites three categories where this can be applied:
Integrity
'Integrity requires the professional accountant to be straightforward and
honest. For example, the accountant complies with the principle of integrity by:
(a) Being straightforward and honest when raising concerns about a
position taken by a client; and
(b) Pursuing inquiries about inconsistent information and seeking further
audit evidence to address concerns about statements that might be
materially false or misleading in order to make informed decisions
about the appropriate course of action in the circumstances.
In doing so, the accountant demonstrates the critical assessment of audit
evidence that contributes to the exercise of professional scepticism.'
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2: Code of ethics and conduct
Objectivity
'Objectivity requires the professional accountant not to compromise
professional or business judgment because of bias, conflict of interest or the
undue influence of others. For example, the accountant complies with the
principle of objectivity by:
(a) Recognising circumstances or relationships such as familiarity with the
client, that might compromise the accountant's professional or business
judgment; and
(b) Considering the impact of such circumstances and relationships on
the accountant's judgment when evaluating the sufficiency and
appropriateness of audit evidence related to a matter material to the
client's financial statements.
In doing so, the accountant behaves in a manner that contributes to the
exercise of professional scepticism.'
Professional
competence and
due care
'Professional competence and due care requires the professional accountant
to have professional knowledge and skill at the level required to ensure the
provision of competent professional service, and to act diligently in
accordance with applicable standards, laws and regulations. For example,
the accountant complies with the principle of professional competence and
due care by:
(a) Applying knowledge that is relevant to a particular client's industry and
business activities in order to properly identify risks of material
misstatement;
(b) Designing and performing appropriate audit procedures; and
(c)
Applying relevant knowledge when critically assessing whether audit
evidence is sufficient and appropriate in the circumstances.
In doing so, the accountant behaves in a manner that contributes to the
exercise of professional scepticism.'
(IESBA Code: para 120.13 A2)
4.3 Management responsibilities
In general, firms cannot accept any management responsibilities for an audit client
(IESBA Code: para. 600.7) and must always actively consider risk factors such as the nature of the
engagement, the nature of the client and the perception of a reasonable and informed third party in
determining the extent of any ethical threats. The Code also prohibits a firm from assuming any
management responsibility for an audit client as it creates self interest, self-review, advocacy and
familiarity threats (ISEBA Code: para. 600.7.A2).
Activity 3: Aventura International
Aventura International, a listed company, manufactures and wholesales a wide variety of products
including fashion clothes and audio-video equipment. The company is audited by Voest, a firm of
Chartered Certified Accountants, and the Audit Manager is Darius Harken. The following matters
have arisen during the audit of the group's financial statements for the year to 31 December 20X7
which is nearing completion:
1
During the annual inventory count of fashion clothes at the company's principal warehouse,
the audit staff attending the count were invited to purchase any items of clothing or equipment
at 30% of their recommended retail prices.
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2
The Chief Executive of Aventura International, Armando Thyolo, owns a private jet. Armando
invoices the company, on a monthly basis, for that proportion of the operating costs which
reflects business use. One of these invoices shows that Darius Harken was flown to Florida in
March 20X7 and flown back two weeks later. Neither Aventura nor Voest have any offices or
associates in Florida.
3
Last week Armando announced his engagement to be married to his personal assistant, Kirsten
Fennimore. Before joining Aventura in September 20X7, Kirsten had been Voest's senior in
charge of the audit of Aventura.
Required
Discuss the ethical, professional and quality control issues raised and the actions which might be
taken by the auditor in relation to these matters.
(15 marks)
Note. Assume it is 6 March 20X8.
Solution
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2:฀Code฀of฀ethics฀and฀conduct฀
Chapter฀summary฀฀
฀
฀
Code฀of฀ethics฀and฀conduct฀
฀
฀
฀
1.฀Sources฀of฀
regulation฀
3.฀The฀conceptual฀
framework฀
฀ IESBA฀and฀
ACCA฀guidance฀
substantially฀
harmonised฀
Threats฀to฀compliance฀with฀
the฀fundamental฀principles:฀
฀ Supports฀the฀
public฀interest฀
฀ Self฀interest฀
฀ Self-review฀
฀ Advocacy฀
฀ Familiarity฀
฀ Intimidation฀
2.฀The฀
fundamental฀
principles฀
4.฀Current฀issues฀
4.1฀Ethical฀
implications฀of฀one฀
firm฀providing฀both฀
internal฀and฀external฀
audit฀services฀
Advantages:฀
฀ Good฀working฀
relationship฀
฀ Integrity฀(straightforward,฀
honest฀or฀TRUE)฀
฀ Objectivity฀(no฀bias฀or฀
conflicts฀of฀interest฀–฀
FAIR)฀
฀ Professional฀competence฀
and฀due฀care฀(knowledge,฀
skills,฀CPD฀etc)฀
฀ Confidentiality฀(no฀
personal฀advantage)฀
฀ Professional฀behaviour฀(no฀
discredit฀to฀the฀profession)฀
฀ Efficiencies฀in฀approach฀
3.1฀Responding฀
to฀threats฀
฀ Reduced฀combined฀fees฀
 Eliminate฀the฀
circumstances฀
฀ Significant฀self-review฀
threat฀
Disadvantages:฀
฀ Apply฀safeguards฀
฀ Decline฀the฀
engagement฀
3.2฀Public฀
interest฀entities฀
 More฀stringent฀
than฀other฀entities฀
4.2฀Professional฀
scepticism฀
฀ Challenge฀and฀
scrutinise฀
sufficiently฀to฀
obtain฀the฀right฀
evidence฀
฀ Either฀listed฀or฀
regulated฀as฀
though฀listed฀
4.3฀Management฀
responsibility฀
฀ Firms฀cannot฀
accept฀any฀
management฀
responsibilities฀฀
฀
฀
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Knowledge diagnostic
1.
The ACCA Code of Ethics and Conduct and IESBA International Code of Ethics for
Professional Accountants explain how accountants should act in the public interest.
2.
Both the ACCA and IESBA Codes are based on five fundamental principles which govern
the general behaviour and characteristics of members: integrity; objectivity; professional
competence and due care; confidentiality; and professional behaviour.
3.
The fundamental principles are themselves underpinned by a conceptual framework which
identifies threats in compliance with the fundamental principles (self-interest, self-review,
advocacy, familiarity and intimidation).
4.
Responses to ethical threats require them to be evaluated and suitable responses adopted:
removing the circumstances leading to the threat; applying safeguards to reduce the threats to
an acceptable level; and declining the activity that leads to the ethical threat.
5.
Professional scepticism is used to challenge and scrutinise the subject matter placed before
the auditor to ensure engagements are undertaken using best practice.
6.
Provision of combined 'internal and external' audit by the same firm can deliver savings and
provide a more 'joined-up' service, but does present threats to audit objectivity.
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2: Code of ethics and conduct
Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 2 'Fundamental principles' is an opportunity to practise some of the theory discussed in this
chapter in an applied situation.

Question 3 'Business assurance' is a discussion question that tests how well you have understood the
theory regarding certain non-audit services.
Further reading
There are technical articles on the ACCA website written by members of the AAA examining team which
are relevant to some of the topics covered in this chapter that you should read:


Exam technique for Advanced Audit and Assurance: Part 1 – ethics
Professional scepticism
Own research
Consider your own organisation or one that you are familiar with – what can you learn from the following
to help you with topics from this chapter?

Do you have a Code of Ethics that you are expected to follow? If so, obtain a copy and see how
closely it matches the content presented here.

Start to keep a diary of events where you believe you needed to consider the ethical implications of
your actions – in each case, do you think you behaved as you should have done? If not, why do you
think this was?
You may find the ACCA's Rulebook helpful to refer to (available on the ACCA website).
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Fraud and
professional
liability
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Identify and develop an appropriate response to circumstances which indicate a
high risk of error, irregularity, fraud or misstatement in the financial statements
or a given situation.
B2(a)
Compare and contrast the respective responsibilities of management and
auditors for fraud and error.
B2(b)
Describe the matters to be considered and procedures to be carried out to
investigate actual and/or potential misstatements in a given situation.
B2(c)
Explain how, why, when and to whom fraud and error should be reported and
the circumstances in which an auditor should withdraw from an engagement.
B2(d)
Consider the current and possible future role of auditors in preventing, detecting
and reporting error and fraud.
B2(e)
Recognise circumstances in which professional accountants may have legal
liability and the criteria that need to be satisfied for legal liability to be
recognised.
B3(a)
Describe the factors to determine whether or not an auditor is negligent and
discuss the auditor's potential liability in given situations.
B3(b)
Compare and contrast liability owed to a client with liability owed to third
parties (ie contract vs establishing a duty of care).
B3(c)
Evaluate the practicability and effectiveness of ways in which liability may be
restricted including the use of liability limitation agreements.
B3(d)
Discuss and appraise the principal causes of audit failure and other factors that
contribute to the 'expectation gap' (eg responsibilities for fraud and error) and
recommend ways in which that gap might be bridged.
B3(e)
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Business and exam context
Auditors have responsibilities to several parties. This chapter explores the various responsibilities
and the liability that can arise in respect of each of them. It also looks at ways of restricting
liability, including professional indemnity insurance.
The auditors' responsibility to members and other readers of the financial statements in tort and
contract can give rise to some form of liability, particularly in the event of negligence. Case law
on this matter is complex and not wholly satisfactory. It results in auditors being liable to some parties
and not others. However, auditors' liability is a dynamic issue in that it evolves as cases are
brought to court.
There are some interesting issues for auditors with regard to liability, for example limited liability
partnerships. The reasons for audit failure and other factors contributing to the 'expectation
gap' are also covered here.
Critically, and contrary to widespread public belief, auditors do not have a responsibility to
detect and prevent fraud. The responsibilities that auditors do have with regard to fraud and
error are outlined here as well. Auditors are required to follow the guidance of ISA 240 The auditor's
responsibilities relating to fraud in an audit of financial statements.
Auditor liability is a key issue facing the profession globally, and is linked in with ongoing debate
about the role of audit in the future. This area can be examined in topical discussion questions, or
in practical scenarios considering whether an auditor may be held to have been negligent in
specific circumstances. It can be tested in either Section A or Section B.
The extent of the auditor's responsibilities in relation to fraud and error is a critical element of the
public's perception of the auditor's role. The requirements of ISA 240 in this respect are core
knowledge for this exam and may have to be applied in practical scenarios.
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3: Fraud and professional liability
Chapter overview
Fraud and professional
liability
1. ISA 240 The Auditor's
Responsibilities Relating
to Fraud in an Audit of
Financial Statements
2. Auditors'
liability
4. The
expectation gap
3. Limiting
auditors' liability
3.1 Insurance
against losses
1.1
Definitions
1.3 Audit
approach
3.2 Managing
liability
2.1 Principles
1.2
Responsibilities
2.2 The client
2.3 Third parties
2.4 Disclaimers
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1 ISA 240 The Auditor's Responsibilities Relating to Fraud in
an Audit of Financial Statements
1.1 Definitions
Key term
Fraud: An intentional act by one or more individuals among management, those charged with
governance (management fraud), employees (employee fraud) or third parties involving the use of
deception to obtain an unjust or illegal advantage.
(ISA 240: para. 11)
Fraud may be perpetrated by an individual, or in collusion with people internal or external to the
business.
Two types of misstatements caused by fraud are relevant to the auditor (ISA 240: paras. 3, A3,
A5):
Misstatements resulting from fraudulent
financial reporting (such as those used
to manipulate financial results, artificially
improving an entity's true position – revenue
recognition is often tested as it is the most
common form of this type of fraud)
Misstatements resulting from
misappropriation of assets (such as
stealing cash from fictitious payments or
inventory for personal use or sale)
1.2 Responsibilities
The primary responsibility for the prevention and detection of fraud rests both with those
charged with governance of the entity and with management. It is up to management to put a
strong emphasis on fraud prevention within the company, putting in place systems to prevent
fraud such as a strong control environment and a culture of honesty and ethical behaviour
(ISA 240: para. 4)
However, the auditor should obtain reasonable assurance that the financial statements as a
whole are free from material misstatement, whether caused by fraud or error. Specific
objectives for achieving this assurance are:

To identify and assess the risks of material misstatement due to fraud

To obtain sufficient appropriate evidence regarding the assessed risks of material
misstatement due to fraud, through designing and implementing appropriate responses; and
To respond appropriately to fraud or suspected fraud identified during the audit

(ISA 240: para.10)
1.3 Audit approach
Members of the engagement team should discuss the susceptibility of the entity's financial
statements to material misstatement due to fraud. An overriding requirement of the ISA is that auditors
are aware of the possibility of there being misstatements due to fraud. The mindset of professional
scepticism is important here, with the auditor always being alert to the possibility that things may
not be as they seem, and that the management who have always appeared honest may not really be
(ISA 240: paras. 12–14).
The auditor should make enquiries of management regarding management's assessment
of the risk that the financial statements may be materially misstated due to fraud and management's
process for identifying and responding to the risks of fraud in the entity.
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3: Fraud and professional liability
The auditor should also determine management's process for identifying and responding to
the risks of fraud and how such a process is communicated, both to those charged with governance
and to staff. The auditor should also enquire about any actual, suspected or alleged fraud
affecting the entity, including discussions about fraud with Internal Audit.
The auditor should obtain an understanding of how those charged with governance exercise
oversight of management's processes for identifying and responding to the risks of fraud
and the internal control that management has established to mitigate these risks as part of its ongoing
risk management procedures.
1.3.1 Examples of fraud risk factors
In determining an approach to fraud, auditors could consider the conditions that lead to fraud:
(1)
(2)
(3)
An incentive or pressure to commit fraud (Motive)
A perceived opportunity to commit fraud (Opportunity)
An ability or attitude to rationalise the fraudulent action (Dishonesty)
(ISA 240: para. A1)
Fraudulent
financial reporting
Incentives/pressures
•
Financial
stability/profitability
is threatened
•
Pressure on
management to meet the
expectations of third
parties
•
•
Personal financial situation
of management threatened
by the entity's financial
performance
Excessive pressure on
management or
operating personnel to
meet financial targets
Opportunities
Attitudes/rationalisations
•
Significant related-party
transactions
•
Assets, liabilities, revenues
or expenses based on
significant estimates
•
•
Domination of management
by a single person or
small group
•
•
•
Complex or unstable
organisational structure
•
Internal control components
•
are deficient
•
Ineffective communication
or enforcement of the
entity's values or ethical
standards by management
Known history of violations
of securities laws or other
laws and regulations
A practice by management
of committing to achieve
aggressive or unrealistic
forecasts
Low morale among senior
management
Relationship between
management and the
current or predecessor
auditor is strained
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Misappropriation
of assets
Incentives/pressures
Opportunities
•
Personal financial
obligations
•
•
Adverse relationships
between the entity and
employees with access to
cash or other assets
susceptible to theft
•
•
•
Attitudes/rationalisations
•
Overriding existing controls
•
Inventory items that are
small in size, of high
•
value, or in high demand
Failing to correct known
internal control deficiencies
Large amounts of cash
on hand or processed
Easily convertible assets,
such as bearer bonds,
diamonds, or
computer chips
•
Behaviour indicating
displeasure or
dissatisfaction with
the entity
Changes in behaviour or
lifestyle
Inadequate internal
control over assets
In accordance with ISA 330 (covered in Chapter 6) the auditor shall determine overall responses
to address the assessed risks of material misstatement due to fraud at the financial
statement level by performing the following:
(a)
Consider the assignment and supervision of personnel
(b)
Consider the selection and application of accounting policies used by the entity
(c)
Incorporate an element of unpredictability in the selection of the nature, timing and extent of
audit procedures
(ISA 240: paras. 28-29)
Similarly, the auditor may have to amend the nature, timing or extent of planned audit
procedures to address assessed risks of material misstatement due to fraud at the assertion level.
Consequently, the auditor should also consider the following:
Audit procedures
responsive to
management
override of controls
Journal entries
and other
adjustments
Business rationale
for significant
transactions
Accounting
estimates
(ISA 240: paras. 30, A41–48)
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3: Fraud and professional liability
1.3.2 Procedures when misstatements are discovered
The auditor evaluates the audit evidence obtained to ensure it is consistent and that it achieves its
aim of answering the risks of fraud. This will include a consideration of results of analytical
procedures and any misstatements found.
The auditor must obtain written representations that management accepts its responsibility for
the prevention and detection of fraud and has made all relevant disclosures to the auditors. However,
when there is a misstatement indicative of fraud, the auditor should consider its implications in
relation to other aspects of the audit, particularly the reliability of those written representations.
The auditor must also document:
The significant decisions reached as a result of the team's discussion of fraud
The identified and assessed risks of material misstatement due to fraud
The overall responses to assessed risks
Results of specific audit tests
Any communications with management
(ISA 240: paras. 44–46)
1.3.3 Communication
When the auditor identifies fraud or suspected fraud, they should communicate it to the
appropriate level of management as soon as practicable.
Fraud should be communicated to those charged with governance where it involves:
(a)
(b)
(c)
Management;
Employees who have significant roles in internal control; and
Others where the fraud results in a material misstatement in the financial statements.
The auditor should communicate to management, and those charged with governance, any material
deficiencies in the design or implementation of internal control to prevent and detect fraud which
have come to the auditor's attention. (ISA 240: paras. 40-41)
The auditor may have a statutory duty to report fraudulent behaviour to regulators outside the
entity. If no such legal duty arises, the auditor must consider whether to do so would breach their
professional duty of confidence. In either event, the auditor should take legal advice.
(ISA 240: paras. A65–66)
1.3.4 Auditor's report
When the auditor confirms that, or is unable to conclude whether, the financial statements are
materially misstated as a result of fraud, the auditor should consider the implications for the auditor's
report:
Insufficient or inappropriate audit evidence
Qualified or disclaimer of opinion
Uncorrected fraud leading to material misstatement
Qualified or adverse opinion
1.3.5 Withdrawal from an engagement
The auditor should consider the need to withdraw from the engagement if they uncover
exceptional circumstances with regard to fraud (ISA 240: para. 38).
If this becomes necessary, it will be necessary to discuss the reasons with management and those
charged with governance, and it may be necessary to make a report to regulators. However,
remember the confidentiality and tipping-off issues from earlier chapters: whenever you are
considering whether to make a public interest disclosure, you should always bear this in mind.
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2 Auditors' liability
2.1 Principles
Auditors could be found guilty of financial market abuse offences, such as insider dealing, since
they are privy to inside information and may use this information for their own gain. Auditors could
also be found guilty of a criminal offence if they knew or suspected a person was laundering
money and they either 'tipped off' or failed to report their suspicions to the proper authority.
The auditor has a contractual relationship with their client. If they breach the contract, then they
can be sued. In addition to this, auditors have a duty to carry out their work with reasonable skill and
care. Negligence is a common law concept under English law. It seeks to provide compensation to
a person who has suffered loss due to another person's wrongful neglect. To succeed in an action for
negligence, an injured party must prove four things:
(a)
A duty of care exists which is enforceable by law;
(b)
This duty of care was breached;
(c)
The breach caused the injured party loss. In the case of negligence in relation to financial
advisers/auditors, this loss must be pecuniary (ie financial) loss; and
(d)
The harm was not too remote a consequence of the breach.
2.2 The client
The company has a contract with the audit firm. In English law, a contract for the supply of a
service such as an audit has a duty of reasonable care implied into it by statute.
Client
Duty of care exists?
Automatic
Breached?
Must be proved
Loss arising?
Must be proved
Not too remote?
Must be proved
In order to prove whether a duty of care has been breached, the court has to give further
consideration to what the duty of reasonable care means in practice. A number of judgments
made in case law show how the auditor's duty of care has been gauged at various points in time
because legislation often does not state clearly the manner in which the auditors should discharge
their duty of care. It is also not likely that this would be clearly spelt out in any contract setting out the
terms of an auditor's appointment.
As a basic rule though, demonstrating that the firm followed auditing standards would
probably be seen as strong defence against claims of negligence from audit clients.
2.3 Third parties
'Third parties' in this context means anyone other than the company (audit client) who
wished to make a claim for negligence. Clearly, this could be many people.
The key difference between third parties and the company is that third parties have no contract
with the audit firm. There is therefore no implied duty of care, but the circumstances of the
relationship between the audit firm and any third party might create a duty of care. The situation is
therefore as follows.
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3: Fraud and professional liability
Third parties
Duty of care exists?
Must be proved
Breached?
Must be proved
Loss arising?
Must be proved
Not too remote?
Must be proved
Essential reading
See Chapter 3 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the various cases that have been used to understand the extent of the
auditor's professional liability. You are not expected to know all the precise details of the relevant
cases for your exam, however; you will be tested on your ability to apply the basic principles to
specific scenarios. It is vital that you use the right kind of language when answering questions in
this area. Your correct use of such terms as duty of care, liability, negligence, proximity and
third party can help to demonstrate to the marker that you are familiar with the subject matter, and
that you are simply applying it to the circumstances in the question.
2.4 Disclaimers
The cases discussed suggest that a duty of care to a third party may arise when an accountant does
not know that their work will be relied on by a third party, but only knows that it is work of a kind
which is liable in the ordinary course of events to be relied on by a third party.
Conversely, an accountant may sometimes be informed or be aware, before they carry out certain
work, that a third party will rely on the results. An example is a report on the business of a client
which the accountant has been instructed to prepare for the purpose of being shown to a potential
purchaser or potential creditor of that business. In such a case, an accountant should assume that
they will be held to owe the same duty to the third party as to their client. The Bannermann case
suggests this will also be necessary for audit work. Since the Bannermann case, many audit firms
have included a disclaimer paragraph in their auditor's report.
When ACCA's Council considered the use of such disclaimers, its view was that:
Standard disclaimers are not an appropriate or proportionate response to the Bannermann
decision. Their incorporation as a standard feature of the auditor's report could have the effect of
devaluing that report.
(ACCA 2008: para. 20)
Activity 1: Moorland
Your firm of Certified Accountants, in common with many other firms of accountants and auditors,
issues to its staff an audit manual which contains, amongst other matters, recommended procedures
to be adopted in carrying out audits. A number of these recommended procedures relate to physical
observation of inventory counts and review of inventory counting instructions. Owing to pressure of
work, you neglected to arrange for the physical observation of inventories at the premises of
Moorland, a limited liability company audit client, at 31 March 20X3, but your review of inventory
counting instructions indicated that company procedures appeared to be in order. You decided to
accept the amount at which inventories were stated in the financial statements at 31 March 20X3 on
the grounds that:
(i)
(ii)
(iii)
The inventory counting instructions appeared to be satisfactory
No problems had arisen in determining physical inventory quantities in previous years
The figures in the financial statements generally 'made sense'
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You issued your unqualified auditor's report on 28 May 20X3 and unbeknown to you, Moorland
used the financial statements and the auditor's report for the purpose of obtaining material additional
finance from a third party in the form of an unsecured long-term loan. Unfortunately, in October
20X3, the company ran into financial difficulties and was forced into liquidation, as a result of
which, the long-term loan holder lost the amount of his loan. During the liquidation proceedings, it
became clear that inventory quantities at 31 March 20X3 had been considerably overstated.
Required
(a)
(b)
Explain the probable legal position (under English law) of your firm in respect of the above
matter, commenting specifically on the following:
(i)
The possibility of demonstrating your firm was negligent
(ii)
The fact that the inventories figure in the financial statements apparently 'made sense'
(iii)
The fact that you were not informed that the financial statements and your auditor's
report were to be used to obtain additional finance
Describe the reasonable steps your firm should take to avoid a recurrence of a matter such as
that described above.
(10 marks)
Solution
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3: Fraud and professional liability
3 Limiting auditors' liability
The auditing profession is concerned about the extent of their liability to third parties. They argue that
although they are required to have insurance, they are unable to get sufficient insurance cover to
meet the potential level of claims. Also, even if other parties, such as directors, share an element of
responsibility for misleading financial statements, audit firms argue that they still bear the burden of
giving financial compensation while trying to act in good faith.
3.1 Insurance against losses
Key terms
Professional indemnity insurance (PII): Insurance against civil claims made by clients and
third parties arising from work undertaken by the firm.
Fidelity guarantee insurance: Insurance against liability arising through any acts of fraud or
dishonesty by any partner, director or employee in respect of money or goods held in trust by the firm.
These types of insurance do not actually restrict the auditor's liability, but rather provide
compensation to the auditor for liabilities that are incurred.
It is important that auditors have insurance so that if negligence occurs:

The audit firm does not find itself with a liability that is too big for it to pay; and

The client can be compensated for the error. An insurance policy would enable this to
happen, even where the compensation is greater than the resources of the firm.
ACCA requires that all firms which hold practising and auditing certificates have PII with a reputable
insurance company (ACCA Rulebook: s2.2.9(1)). If the firm has employees, it must also have fidelity
guarantee insurance (ACCA Rulebook: s2.2.9(1)).
The insurance must cover 'all civil liability incurred in connection with the conduct of the firm's
business by the partners, directors or employees' (ACCA Rulebook: s2.2.9(2)). The cover must
continue to exist for six years after a member ceases to engage in public practice (ACCA
Rulebook: s2.2.9(5)).
Remember that accountants usually trade as partnerships, so all the partners are jointly and
severally liable to claims made against individual partners. However, insurance could be seen to
encourage auditors to take less care than they should, knowing that they are covered for any
potential liability, so it is not the only way of addressing auditors' liability.
3.2 Managing liability
Auditors may reduce the chances of litigation by ensuring they have good procedures over:
Client
acceptance
Quality
control/quality
audits
Performance of
audit work
Compliance
with standards
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The following courses of action have been put forward as possible methods of reducing liability:
Incorporation
This would protect the partners from personal bankruptcy. However, the firm itself could be forced
into liquidation. Further, there could be adverse tax implications and the firm would need to publish
accounts and be subject to an audit, which might be unacceptable to partners. Despite these issues,
many of the world's largest professional firms have incorporated in some way.
Limited Liability Partnerships (LLPs)
The Limited Liability Partnership Act 2000 enabled UK firms to establish limited liability partnerships
as separate legal entities. These combine the flexibility and tax status of a partnership with limited
liability for members.
The effect of this is that the partnership, but not its members, will be liable to third
parties. However, the personal assets of negligent partners will still be at risk.
Several prominent professional partnerships are incorporated as LLPs.
Limited liability partnerships are set up by similar procedures to those for incorporating a company.
An incorporation document is sent to the Registrar of Companies. The Registrar will issue a certificate
of incorporation to confirm that all statutory requirements have been fulfilled.
In a similar way to traditional partnerships, relations between partners will be governed by internal
partner agreements, or by future statutory regulations. Each member of the partnership will still be an
agent of the partnership, unless they have no authority to act and an outside party is aware of this
lack of authority.
Liability limitations
Even with PII and other means of restricting liability, there has been great concern throughout the
audit profession globally about the remaining risks to firms' survival in the face of claims which still
might exceed their insurance cover. One protection against these is to control the liability itself via
agreements between auditors and their clients.
Key terms
Proportionate liability: Allows claims arising from successful negligence claims to be split
between the auditors and the directors of the client company, the split being determined by a judge
on the basis of where the fault was seen to lie. This would require the approval of shareholders.
Capping liability: Sets a maximum limit on the amount that the auditor would have to pay out
under any claim.
Essential reading
See Chapter 3 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the advantages and disadvantages of different structures for firms to
adopt.
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3: Fraud and professional liability
4 The expectation gap
Key term
Expectation gap: This term is used to describe the difference between the expectations of those
who rely upon auditor's reports concerning audit work performed and the actual work performed.
The expectation gap arises due to a general misunderstanding by the public of the respective
responsibilities of both management and the auditor, and a misunderstanding of the
scope of an audit. Such misunderstandings might include the following perceptions:
That it is the auditor's duty to prevent
and detect fraud
That the auditor is liable for any errors in the
financial statements
Clearly, there is still a debate to be had and the continuing occurrence of financial scandals
where fraud was present, despite an audit being conducted, means that this debate is not about to
go away. Logically, the expectations gap could be narrowed in two ways.
1
Educating users
The auditor's report, as outlined in ISA 700 Forming an Opinion and Reporting on Financial
Statements, now includes an explanation of both the auditor's and management's
responsibilities, but also quite extensive discussions of the key matters arising from the audit.
Additionally, the audit firm will reiterate the respective responsibilities of management and the
auditor, and the nature, scope and purpose of an audit, in the engagement letter.
2
Extending the auditor's responsibilities
Research indicates that extra work by auditors, with the inevitable extra costs, is likely to
make little difference to the detection of fraud because:
Most material frauds involve management
More than half of frauds involve misstated financial reporting but do not include diversion of
funds from the company
Management fraud is unlikely to be found in a financial statement audit
Far more is spent on investigating and prosecuting fraud in a company than on its audit
Suggestions for expanding the auditor's role have included:

Requiring auditors to report to boards and audit committees on the adequacy of
controls to prevent and detect fraud

Encouraging the use of targeted forensic fraud reviews (see Chapter 14)

Increasing the requirement to report suspected frauds
However, the adoption (in the UK for example) of caps on auditors' liability has been
seen as a retrograde step in 'building bridges' between the audit profession and those
members of the public who remain sceptical of the auditor's benefits to society and their
apparent reluctance to stop future Enron-style scandals.
In an attempt to redress the balance following audit firm Andersen's involvement in the
Enron collapse, the UK Companies Act 2006 includes an offence aimed at punishing
audit firms that knowingly or recklessly cause an auditor's report to be misleading, false or
deceptive. Committing such an offence would lead to a fine.
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The many different forms of assurance report that we will see in AAA all seem full of
disclaimers that appear to protect the auditor and reduce the amount of reliance that users
can place on these reports. However, without any protection from potentially
unscrupulous clients, auditors are continually exposed to the threat of liability and without
protection, auditors would not consider accepting any such engagement. If this were to
happen, who would perform the audit?
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3: Fraud and professional liability
Chapter summary
2. Fraud and professional
liability
1. ISA 240
The Auditor's
Responsibilities
Relating to Fraud in
an Audit of Financial
Statements
1.1 Definitions
1.2 Responsibilities
 An intentional act involving
the use of deception to obtain
an unjust or illegal advantage
 Primary responsibility for
prevention and detection
rests with management
 Two main types:
 Auditor should obtain
reasonable assurance
that the F/S are free from
material misstatement
whether caused by fraud or
error
– Fraudulent financial
reporting (eg Enron)
– Misappropriation of assets
(eg security guard stealing
from warehouse)
1.3 Audit approach
 Act with professional
scepticism
 Assess risks due to fraud
 Fraud risk factors
– An incentive or pressure
to commit fraud (motive)
– Opportunity to commit
fraud
– Ability to rationalise such
actions (dishonesty)
 Respond to risk at F/S level
(assignment and
supervision; accounting
policies; introduce
unpredictability; reviewing
nature, timing and extent of
audit procedures)
 Respond to risk at assertion
level (sensitive controls;
journals; estimates;
significant transactions)
 Reporting or withdrawing if
necessary
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



2 Auditors' liability
3. Limiting auditors'
liability
2.1 Principles
3.1 Insurance against
losses
Duty of care exists
Duty of care was breached
Loss arose from that breach
Not too remote
 Professional indemnity
insurance (PII) for civil
claims from clients and
3rd parties
2.2 The client
 Fidelity guarantee
insurance (FGI) for losses
due to fraud by firm
employees
 Following auditing standards will
support automatic duty of
reasonable care to clients
3.2 Managing liability
 Avoid litigation by performing
quality audits
2.3 Third parties
 Not guaranteed but may be
present from situations in the
scenario – need to know case law
 Incorporation
 Limited liability
Partnerships (LLPs)
 Proportionate and capping
liability (UK CA 2006)
2.4 Disclaimers
4. The expectation gap
 Bannerman connection
 Need to be used if felt it will
protect auditor's liability
 Discouraged by ACCA as seen
to devalue the auditor's report
 Due to misunderstanding
of auditor's
responsibilities
 Educate users – auditor's
report wording seeks to
close the expectation gap
 Extend auditor's
responsibilities
 Caps vs 'reckless
knowledge' offence
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3: Fraud and professional liability
Knowledge diagnostic
1.
Fraud is a risk that auditors must be aware of. However, the primary responsibility for
prevention and detection lies with the directors of the entity. Auditors have a variety of issues
to consider when fraud is either discovered or suspected and should act appropriately.
2.
Auditors take a considerable risk when signing the auditor's report, since many third parties rely
on the opinion given. If the opinion is proven to have been negligently provided, the auditor
may be liable for financial losses suffered. This leads to the risk of litigation.
3.
Case history has determined that auditors are currently only likely to be liable to the client
itself and the shareholders as a body. Any other third party would have to demonstrate
sufficient proximity, and therefore a duty of care, to be successful in a claim of negligence.
4.
The profession has taken many steps recently to try to limit liability to third parties via caps;
many major firms have changed their legal structure as a result (eg LLPs or limited
companies). All firms hold insurance as part of the requirements for holding a practising
certificate: PII is mandatory for all ACCA firms alongside FGI.
5.
The expectation gap refers to the difference between what the public perceives the role of the
audit to be and the actual responsibilities that the auditor is prepared to accept. This is very
contentious.
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Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 4 'Professional responsibilities' is an opportunity to display your overall knowledge of the
auditor's responsibilities in the areas covered by this chapter.

Question 5 'Mobile Sales' is approaching exam standard and tests how well you can apply this
knowledge to a scenario.
Further reading
There are technical articles on the ACCA website written by members of the AAA examining team which
are relevant to some of the topics covered in this chapter that you should read:

Auditor liability

ISA 240 (redrafted), auditors and fraud
Own research
Consider your own organisation or one that you are familiar with – what can you learn from the following
to help you with topics from this chapter?

Consider the current 'width' that you believe the expectations gap is currently at – is it getting wider
or narrower? Do you think recent corporate failures (for example, such as BHS and Carillion in the
UK) are helping the auditor's case that they are doing as much as they can?

Can you find an example of an auditor's report that includes a disclaimer paragraph?

Find some examples of frauds online and see if you can determine what caused them – if you had
been the external auditor in each case, what might you have done to try and uncover the fraud
yourself?
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SKILLS CHECKPOINT 1
Legal and ethical responsibilities
aging information
Man
An
sw
er
aging information
Man
g
nin
an
pl
An
sw
er
pl
Good
ti
manag me
em
en
t
Legal and ethical
responsibilities
g
nin
an
Legal and ethical
responsibilities
Practice
management
Exam success skills
d
se
Completion
and reporting
nt r itin
ati g
on
Co
an
ti
e c re v
Eff d p cti e
an E ffe pr
Non-audit
engagements
ve and current
issues
s e w r it
nt in g
at i
e
o
w n
r re
c
o f t i n te
re q r p re t a t i o n
u ire
m e nts
Specific AAA skills
Planning the
audit and
gathering
evidence
Efficient numerica
analysis
l
Introduction
The AAA exam will always test the application of your knowledge of this area. Candidates tend to remember
enough to be able to identify when something's not right in a scenario – however, explaining why something is
not right and how the firm should respond appears to be more challenging. You therefore need to be able to
develop an approach that will assist you, both in advance of the exam and on the day itself.
While the context and complexity of scenarios testing legal and ethical responsibilities may be different to those
you would have seen in the Audit and Assurance exam, the knowledge that you require for AAA should not be
new to you – it is therefore important that you refresh your memory using the technical knowledge presented
in this workbook before you attempt more exam standard questions.
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Skills Checkpoint 1: Legal and ethical responsibilities
AAA Skill: Legal and ethical responsibilities
A step by step technique for approaching questions testing this part of the syllabus now follows (you
may find that some of these techniques are suitable for other parts of the syllabus as well – why not
start practising them now?)
STEP 1:
Think about the requirement and
consider all the tasks that you are
being asked to undertake.
STEP 2:
Read the scenario and identify all the
areas of legal and/or ethical concern
that you can.
STEP 3:
For each of the areas you have
identified, list the reasons why you
think they may be of concern to you.
STEP 4:
Add suitable responses to each of the
matters listed and their reasons.
STEP 5:
Write your answer.
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Skills Checkpoint 1
Exam success skills
There are some key exam skills that will help you when answering this kind of question, which are
summarised below:

Managing information. Actively reading the scenario for the key facts will help you create
a good answer – in the case of legal and ethical issues, you need to identify the information
that clarifies the issues presented, as there may be more than one response to an issue but a
specific fact might help point you in the right direction.

Answer planning. It sounds obvious, but in most cases, requirements to questions testing this
part of the syllabus will be phrased along the following lines of: (1) 'What are the issues?'; and
(2) 'How should the firm respond?'. Answers need to do more than this though – answering
the first point needs you to say something along these lines: '… the scenario says this, which is
wrong because …' while the second should feature some form of logic: '… because of … the
firm should therefore do …'.

Effective writing and presentation. Having mined the scenario for all the relevant
information and then planned your answer, you are then faced with the most straightforward
task – writing what you want to say. This can be a challenge though, especially if you do not
practise how to lay out your answer and how your plan will be expanded in full. This will only
come from practice and asking a peer to read through what you've written to make sure it gets
the message across effectively.
Skill activity
STEP 1
Consider the following requirement and write a short list of the tasks you are going
to need to complete in order to satisfactorily answer it.
Required
Comment on the ethical and other professional issues raised by the above matters and recommend
suitable responses.
There are two verbs here – 'comment' and 'recommend' – so you will need to make sure that you
connect the two by some sound logic. This is based on being able to identify the ethical and
professional issues, explain why they require action and then describe what that action should be.
Your task list should therefore include the following:
(a)
(b)
(c)
(d)
Read the scenario, identifying the areas of ethical or professional concern
List these matters with reasons why they might be a problem
Add suitable responses to each matter listed
Write your answer
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STEP 2
So you should
be able to
answer this
without help
from any of the
other partners
Threats may be
more significant
as it is quoted
Read the scenario, identifying the areas of ethical and professional concern.
You are the Ethics Partner at SB & Co, a firm of Chartered Certified
Accountants. The following situations exist.
Tammy is the audit manager assigned to the audit of Recreate Co ('Recreate'),
Not the partner
but still
significant, so
it does matter
a large quoted company. The audit has been ongoing for several weeks.
Yesterday,
Tammy's
husband
inherited
1,000
shares
in
Recreate.
Tammy's husband wants to hold on to the shares as an investment.
The SB & Co pension scheme, which is administered by Friends Benevolent, an
unconnected company, owns shares in Tadpole Group, a listed company with a
number of subsidiaries. SB & Co has recently been invited to tender for the
audit of one of its subsidiary companies, Frog Co.
SB & Co has been the auditor of Kripps Bros, a limited liability company, for a
Creates a
self-interest
threat
…but is it
material and
does it matter
if a 3rd party
is in control?
Another selfinterest threat
but only if
material?
number of years. It is a requirement of Kripps Bros' constitution that the auditor
Creates a
self-interest
threat….
owns a token $1 share in the company.
STEP 3
STEP 4
52
Now list these matters with reasons why they might be a problem.

Audit manager's husband owns shares in a current, quoted audit client = selfinterest threat

The SB & Co pension fund would benefit from the results of Frog Co being as
good as possible – as the prospective auditor of Frog, this also creates a selfinterest threat

Is the investment in Kripps Bros material? Is it essential to have it – why does
it help to have the auditor as a shareholder?
Add suitable responses to each matter listed.

Self-interest threat from shares = either dispose of shares or rotate audit
manager?

Self-interest threat from indirect investment in the pension fund = if both
material and there is some form of control over this investment (unlikely as
controlled by broker) a financial self-interest threat exists, so need to establish
these facts – material?

Confirm materiality of $1 share plus consider whether disposal is possible?
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Skills Checkpoint 1
STEP 5
Write your answer.
Shares
Tammy is at present a member of the assurance team and a member of her immediate family owns a
direct financial interest in the audit client. This creates a self-interest threat (IESBA Code para R510.
A1-4).
In order to mitigate the risk to independence that this poses on the audit, SB & Co needs to apply
one of two safeguards.


Ensure that the connected person disposes of the shares
Remove Tammy from the engagement team
Tammy should be told that these are the options and removed from the team while a decision is
taken regarding whether or not to sell the shares. Tammy's husband appears to want to keep the
shares, in which case Tammy should be removed from the team immediately (IESBA Code: para
510.10.A1-4).
SB & Co should inform the audit committee of Recreate of what has happened and the actions they
have taken. The partners should consider whether it is necessary to bring in an independent partner
to review any audit work that Tammy could have influenced. However, given Tammy's involvement is
subject to the review of the existing engagement partner and she was not connected with the shares
while she was carrying out the work, a second partner review is unlikely to be necessary in this case.
Pension fund
The audit firm has an indirect interest in the parent company of a company it has been invited to
tender for, by virtue of its pension scheme having invested in Tadpole Group (IESBA Code: para
510.10 A13).
This is no barrier to the audit firm tendering for the audit of Frog Co. Should the audit firm win the
tender and become the auditors of Frog Co, it should consider whether it is necessary to apply
safeguards to mitigate against the risk to independence on the audit as a result of the indirect
financial interest.
The factors that the partners will need to consider are the materiality of the interest to either party and
the degree of control that the firm actually has over the financial interest (IESBA Code: para R510.6).
In this case, the audit firm has no control over the financial interest. An independent pension scheme
administrator is in control of the financial interest. In addition, the interest is unlikely to be substantial
and is therefore immaterial to both parties. Only if the threat is significant should the interest be sold.
It is likely that this risk is already sufficiently minimal so as not to require safeguards. However, if the
audit firm felt that it was necessary to apply safeguards, it could consider the following.


Notifying the audit committee of the interest
Requiring Friends Benevolent to dispose of the shares in Tadpole Group.
Kripps Bros
In this case, SB & Co has a direct financial interest in the audit client, which is technically prohibited
by the IESBA Code. However, it is a requirement of any firm auditing the company that the share be
owned by the auditors.
The interest is not material. The audit firm should safeguard against the risk by not voting on its own reelection as auditor. The firm could also recommend to the company that it removes this requirement
from its constitution, as it is at odds with ethical requirements for auditors.
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Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed below
for SB & Co to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Good time
management
This was not explicitly tested here but remember to consider the total
time to answer the question (up to 1.95 minutes per mark) and the
split between reading/thinking/planning time and writing time
(something like ¼ to ¾ respectively of the total time)?
Managing information
Did you pick up on all the information you needed to satisfactorily
answer the question?
Correct interpretation
of requirements
Do you think you were able to 'comment' and 'recommend'
effectively?
Answer planning
Was your logic sound when drawing conclusions about points raised
and the consequent impact on the firm in each case? Note that in
some cases, the IESBA Code only identifies issues and the responses
will still require some form of judgment on your behalf in response to
the specific factors in the scenario.
Effective writing and
presentation
Did you manage to carry all the points from your plan through into
your final answer?
Efficient numerical
analysis
Not applicable for this question
Most important action points to apply to your next question
Summary
Legal and ethical responsibilities provide a very specific challenge when presented with a series of
events and circumstances and the requirement to comment on them in line with the IESBA Code and
any other regulatory framework. Some of them may be perfectly acceptable; some might be clearly
prohibited; however some (and these are likely to be the majority) you can't answer right now, as
there is some further information that you need to uncover. Success comes from technical knowledge
and experience in how to explain your thought process.
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Quality control
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Explain the principles and purpose of quality control of audit and other
assurance engagements.
C1(a)
Describe the elements of a system of quality control relevant to a given firm.
C1(b)
Evaluate the quality control procedures that are in place for a given firm.
C1(c)
Business and exam context
The role performed by auditors represents an activity of significant public interest. Quality
independent audit is crucial, both to users and to the audit profession as a whole. Poor audit quality
damages the reputation of the firm and may lead to loss of clients and thus fees, as well as an
increased risk of litigation and associated professional insurance costs.
Although there are specific standards giving guidance on how auditors should perform their work
with satisfactory quality, these can never cater for every situation. Quality at a general level is dealt
with by ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements,
and Other Assurance and Related Services Engagements.
Issues relating to firm-wide quality control link best with professional and ethical considerations, and
should be distinguished from quality control issues on an individual audit, which are likely to be
examined at the completion stage (Chapter 10).
You could be asked to suggest quality control procedures that a firm should implement in specific
circumstances, or to review a firm's procedures and assess their adequacy. Firm-wide quality control
can be tested in either Section A or Section B.
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Chapter overview
Quality control
1. ISQC 1 Quality Control
for Firms that Perform
Audits and Reviews of
Financial Statements, and
Other Assurance and
Related Services
Engagements
3. Applying ISQC 1
proportionately with the
nature and size of a firm
3.1 Only comply with
relevant requirements
3.2 Structure and
formality is proportionate
2. Elements of a system of
quality control
3.3 Using external
resources
3.4 Documentation
2.1 Leadership
responsibilities
for quality
within the firm
2.4 Human
resources
56
2.2 Relevant
ethical
requirements
2.5
Engagement
performance
2.3 Acceptance
and
continuance of
client
relationships
and specific
engagements
2.6
Monitoring
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4: Quality control
1 ISQC 1 Quality Control for Firms that Perform Audits and
Reviews of Financial Statements, and Other Assurance
and Related Services Engagement
Activity 1: Does quality matter?
Required
Quality control is a key issue for all audit firms. Why do firms want or need good quality control?
Solution
2 Elements of a system of quality control
The firm's system of quality control shall include policies and procedures addressing each of the
following elements:
(a)
(b)
(c)
(d)
(e)
(f)
Leadership responsibilities for quality within the firm
Relevant ethical requirements
Acceptance and continuance of client relationships and specific engagements
Human resources
Engagement performance
Monitoring
(ISQC 1: para. 16)
2.1 Leadership responsibilities for quality within the firm
The firm shall establish policies and procedures designed to promote an internal culture recognising
that quality is essential in performing engagements.
This is achieved in the following ways:
(a)
The firm assigns its management responsibilities so that commercial considerations do not
override the quality of work performed.
(b)
The firm's policies and procedures addressing performance evaluation, compensation and
promotion are designed to demonstrate the firm's overriding commitment to quality.
(c)
The firm devotes sufficient resources for the development, documentation and support of its
quality control policies and procedures.
The firm shall ensure that whoever assumes ultimate responsibility for quality within the firm (which
could be a chief executive officer, the managing board of partners or equivalent) has the sufficient
experience, ability and authority to fulfil this role.
(ISQC 1: paras. 18, 19, A5)
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2.2 Relevant ethical requirements
The firm shall establish policies and procedures designed to provide it with reasonable assurance
that the firm and its personnel comply with relevant ethical requirements (as covered in Chapter 2).
The firm's policies and procedures should emphasise the fundamental principles of the IESBA Code
of Ethics (or others, such as the FRC's Revised Ethical Standard in the UK for example) and reinforce
them through:
(a)
(b)
(c)
(d)
The leadership of the firm
Education and training
Monitoring
A process for dealing with non-compliance
The firm shall establish policies and procedures designed to provide it with reasonable assurance
that the firm, its personnel and, where applicable, others subject to independence requirements
(including network firm personnel) maintain independence where required by relevant ethical
requirements.
At least annually, the firm should obtain written confirmation of compliance with its policies and
procedures on independence from all firm personnel required to be independent by the IESBA Code
and national ethical requirements.
(ISQC 1: paras. 20-25)
2.3 Acceptance and continuance of client relationships and specific
engagements
The firm shall establish policies and procedures for the acceptance and continuance of client
relationships and specific engagements, designed to provide the firm with reasonable assurance that
it will only undertake or continue relationships and engagements where the firm:
(a)
Is competent to perform the engagement and has the capabilities, including time and
resources, to do so;
(b)
Can comply with relevant ethical requirements; and
(c)
Has considered the integrity of the client and does not have information that would lead it to
conclude that the client lacks integrity.
(ISQC 1: paras. 26-28)
2.4 Human resources
The firm shall establish policies and procedures designed to provide it with reasonable assurance
that it has sufficient personnel with the capabilities, competence and commitment to ethical principles
necessary to perform engagements in accordance with professional standards and regulatory and
legal requirements, and to enable the firm or engagement partners to issue reports that are
appropriate in the circumstances.
(ISQC 1: para. 29)
Such policies and procedures address the following personnel issues:







58
Recruitment
Performance evaluation
Capabilities and competence
Career development
Promotion
Compensation
The estimation of personnel needs
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4: Quality control
Activity 2: Capabilities and competence
Required
List examples of appropriate control procedures to ensure the firm's staff have the necessary
capabilities and competence.
Solution
2.4.1 Assignment of personnel to engagements
Audit work is to be assigned to personnel who have the degree of technical training and proficiency
required in the circumstances.
Activity 3: Assignment of teams
Required
What matters would you consider when assigning personnel to a particular audit?
Solution
2.5 Engagement performance
The firm shall establish policies and procedures designed to provide it with reasonable assurance
that engagements are performed in accordance with professional standards and applicable legal
and regulatory requirements, and that the firm or the engagement partner issue reports that are
appropriate in the circumstances (ISQC 1: para. 32).
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Matters to be addressed in the firm's guidance materials include the following:

How engagement teams are briefed on the engagement to obtain an understanding of the
objectives of their work

Processes for complying with applicable engagement standards

Processes of engagement supervision, staff training and coaching

Methods of reviewing the work performed, the significant judgments made and the form of
report being issued

Appropriate documentation of the work performed and of the timing and extent of the review

Processes to keep all policies and procedures current
The engagement process should include both:

Supervision of the work as it is undertaken (including tracking progress to ensure there is
sufficient skill and time to complete the work and to address matters effectively as they arise);
and

Review that it has been performed in accordance with professional and legal requirements,
achieving the objectives of the engagement, and that the evidence obtained is sufficient and
appropriate to support the conclusions drawn and the required report (ISQC 1: paras. A34-35).
2.5.1 Consultation
The firm shall establish policies and procedures designed to provide it with reasonable assurance
that:
(a)
(b)
(c)
(d)
Appropriate consultation takes place on difficult or contentious matters;
Sufficient resources are available to enable appropriate consultation to take place;
The nature and scope of such consultations are documented; and
Conclusions resulting from consultations are documented and implemented (ISQC 1: para. 34).
Consultation includes discussion, at the appropriate professional level, with individuals within or
outside the firm who have specialised expertise, to resolve a difficult or contentious matter.
Effective consultation with other professionals requires that those consulted be given all the relevant
facts that will enable them to provide informed advice on technical, ethical or other matters in order
to maintain suitable quality standards for the engagement.
2.5.2 Engagement quality control reviews
An engagement quality control review is an objective evaluation of the significant judgments made
by the engagement team and the conclusions reached in formulating the report.
Engagement quality control reviews are required for:
(a)
All audits of financial statements of listed entities
(b)
Other audit, assurance and related services engagements meeting appropriate criteria set by
the firm (such as the nature of the engagement and whether it involves a matter of public
interest, any unusual circumstances or risks or whether any laws and regulations require such
a review to be carried out) (ISQC 1: paras. 35 and A41).
This review is performed prior to signing the opinion and is often referred to as a pre-issuance or
'hot' review. The firm must also have standards regarding what constitutes a suitable quality
control review (the nature, timing and extent of such a review, the criteria for eligibility of reviewers
and documentation requirements).
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4: Quality control
Quality control reviews
Nature, timing and
extent (ISQC 1: paras.
37–8)
It ordinarily includes discussion with the engagement partner, review of
the financial statements/other subject matter information and the report,
and consideration of whether the report is appropriate. It will also
involve a selective review of working papers relating to significant
judgments made.
Eligibility (ISQC 1:
paras. 39–41)
The reviewer must have sufficient technical expertise and be objective
towards the assignment.
Documentation (ISQC
1: para. 42)
Documentation showing that the firm's requirements for a review have
been met, that the review was completed before the report was issued
and a conclusion that the reviewer is not aware of any unresolved issues
(especially in respect of significant judgments).
Listed companies
(ISQC 1: paras. 38;
A45)
The review should include:

The engagement team's evaluation of the firm's independence in
relation to the specific engagement

Significant risks identified during the engagement and the responses
to those risks

Judgments made, particularly with respect to materiality and
significant risks

Whether appropriate consultation has taken place on matters
involving differences of opinion or other difficult or contentious
matters, and the conclusions arising from those consultations

The significance and disposition of corrected and uncorrected
misstatements identified during the engagement

The matters to be communicated to management and those charged
with governance and, where applicable, other parties such as
regulatory bodies

Whether working papers selected for review reflect the work
performed in relation to the significant judgments and support the
conclusions reached

The appropriateness of the report to be issued
2.6 Monitoring
The firm shall establish a monitoring process designed to provide it with reasonable assurance that
the policies and procedures relating to the system of quality control are relevant, adequate,
operating effectively.
Such policies and procedures shall include an ongoing consideration and evaluation of the firm's
system of quality control including, on a cyclical basis, inspection of at least one completed
engagement for each engagement partner.
The purpose of monitoring compliance with quality control policies and procedures is to provide an
evaluation of:
(a)
Adherence to professional standards and regulatory and legal requirements;
(b)
Whether the quality control system has been appropriately designed and effectively
implemented; and
(c)
Whether the firm's quality control policies and procedures have been appropriately applied,
so that reports that are issued by the firm or engagement partners are appropriate in the
circumstances.
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The firm entrusts responsibility for the monitoring process to a partner or partners or other persons
with sufficient and appropriate experience and authority in the firm to assume that responsibility (and
obviously, to those who have not performed the engagement itself!). (ISQC 1: paras. 48 and A64)
The monitoring process is focused on completed engagements where the auditor's report has
already been signed and is often referred to as a post-issuance or 'cold' review.
3 Applying ISQC 1 proportionately with the nature and size
of a firm
The IAASB has issued guidance for small firms in applying ISQC 1 in the form of a 'Questions &
Answers' document (IAASB, 2012). Small firms do have to apply ISQC 1 in full, but this should not
result in 'standards overload' because ISQC 1 is drafted in such a way that it can be applied
proportionately.
3.1 Only comply with relevant requirements
Importantly, firms only have to comply with requirements that are relevant to them and to the
services they are providing.
The firm shall comply with each requirement of this ISQC unless, in the circumstances of the firm,
the requirement is not relevant to the services provided in respect of audits and reviews of
financial statements, and other assurance and related services engagements (ISQC 1: para. 14).
So a small practitioner who does not provide audit services would clearly not be required to follow
ISQC 1's requirements in relation to audit services.
3.2 Structure and formality is proportionate
Smaller firms may use less structured means and simpler processes to comply with ISQC 1.
Communications may be more informal than in a larger firm.
Smaller firms still need to read ISQC 1, but they may legitimately use their judgment in tailoring it
to their circumstances. For example, it would not be necessary for a sole practitioner to establish an
explicit process for assigning personnel to engagement teams (because the 'process' in this case
would be the nonsensical statement that there is no process because there are no teams).
3.3 Using external resources
In order to comply with ISQC 1's requirements, it may be necessary to make use of the services of
another organisation, such as another firm or a professional or regulatory body. This may be
particularly helpful where ISQC 1 requires an engagement quality control review, or where
there is a need for monitoring processes which could be carried out by an external person or firm.
3.4 Documentation
ISQC 1 does require all firms to document the operation of its system of quality control. However, the
form and content of this documentation is a matter of judgment and would depend on the size of the
firm and complexity of its organisation. Smaller firms would therefore have less to document, and
could make use of less formal methods of documentation such as manual notes and checklists.
Activity 4: VBMC
Varley, Bell, Murphy and Cobbitt (VBMC) is a small four-partner independent audit firm with a single
office in a regional location. Clients include businesses and companies mainly in the retail and
financial services industries. Two of the firm's biggest clients are listed. VBMC operates in a regime
which has adopted IAASB audit, assurance, quality control and ethical standards as its national
standards.
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4: Quality control
Leadership for quality within the firm
The firm considers quality control very important and endeavours to comply with international
guidance. Mickey Murphy is the partner in charge of quality. He is also Marketing Partner of the firm
due to his commercial awareness. There is no specific quality control department, but Mickey gives
an annual update on the firm's quality control procedures in August when he is not busy.
Annual quality control reviews of audits are not undertaken due to the firm's size: the partners are in
daily contact and discuss quality at their monthly meetings. However, as part of Mickey's annual
marketing review of clients, he identifies any clients perceived as risky due to their size or the firm's
dependence on them.
Human resources
New joiners to the firm are generally accounting graduates from the local university to minimise
training costs. They all attend final interviews with the Senior Partner, Roger Varley. Selection is
based on their exam marks, the ability to speak fluent English, presentation and confidence. Annual
appraisals of all professional staff are conducted by the Senior Partner. He feels that the firm which,
although growing, is still small enough to appraise staff personally.
Promotion is based on a 'balanced scorecard' of four criteria:

Marketing events attended

Completion of audit work on time

Feedback from clients (based on an assessment after each audit)

Punctuality of arrival in the mornings (staff should arrive by 8am, but can leave once their
work is complete)
Audit process
All audit work is reviewed by the auditor in charge (AIC) before presentation of the files to the
engagement partner. The AIC highlights the key risk areas for the partner to perform a second review
on. Files are created and delivered for review entirely electronically. Due to the firm's scanning
facility being oversubscribed, less important physical evidence is discarded at the end of the audit.
The firm is too small to have industry units so clients are spread across the four partners based on
their location.
Technical matters
An ethical helpdesk is staffed by one of the partners, Jonathon Bell (when he's in the office), who is
respected in the firm for his technical knowledge. Staff are encouraged to seek help where they
consider it appropriate. All audit staff are provided annually with a memory stick containing PDFs of
the latest IFAC Pronouncements for reference while conducting audits. Any necessary 'library' data –
exchange rates, share prices etc – are obtained directly by audit staff from the internet. Technical
issues are resolved by the engagement partner on the relevant audit.
Required
Identify and comment on the quality control issues arising from the scenario.
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Solution
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4: Quality control
Chapter summary
Quality control
Applying ISQC 1
proportionately with the
nature and size of a firm
ISQC 1 Quality Control for Firms that
Perform Audits and Reviews of Financial
Statements, and Other Assurance and
Related Services Engagements

Only comply with relevant
requirements (eg sole practitioners or
firms not undertaking audits need not
consider the guidance on audits)

2.2 Relevant ethical
requirements
Structure and formality is
proportionate (more informal
processes can be used as the
practitioner sees fit in order to
comply with ISQC 1)

Using external resources (eg the use
of other firms in carrying out
engagement quality control reviews)
Firm's policy shall emphasise the
fundamental principles:

Documentation is still required but
can be tailored to the firm and its
clients
Elements of a system of
quality control
2.1 Leadership
responsibilities for quality
within the firm


Assign management
responsibility so that
commercial considerations do
not override quality
Overriding commitment to
quality from senior
management down
2.3 Acceptance and
continuance of
client relationships
and specific
engagements

Integrity of client
Firm's competence
Firm's ethical
compliance
–
–
–
–

Leadership
Education & Training
Monitoring
Dealing with non-compliance
Annual confirmation by staff of
independence compliance
2.4 Human
resources

Consider:
–
–
–


Firms shall ensure they
have sufficient personnel
with the capabilities,
competence and
commitment to ethical
principles
Appropriate staff (skills
and experience) shall be
assigned to each
engagement
2.5 Engagement
performance

Consultation
–

2.6 Monitoring

Aim is to ensure that
professional
standards have been
adhered to and that
QC systems have
worked

'Cold ("postissuance") reviews'
carried out after the
audit opinion is
signed and the audit
is completed
Internal or external
Engagement quality control
reviews
–
'Hot ("pre-issuance") reviews'
carried out during the
engagement and BEFORE the
audit opinion is signed
(required for listed clients and
unusual or high risk audits)
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Quality control
3. Applying ISQC 1
proportionately with the
nature and size of a firm
3.1 Only comply with
relevant requirements
3.2 Structure and
formality is proportionate
3.3 Using external
resources
3.4 Documentation
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4: Quality control
Knowledge diagnostic
1.
Quality control is a fundamental issue for all audit firms. The main source of guidance for
firms in relation to quality control comes from ISQC 1 which details the specific elements of a
system of quality control for a professional firm to adopt.
2.
Sound systems of quality include the following:
3.

Leadership responsibilities for quality within the firm;

Ethical requirements including any independence issues;

Acceptance and continuance of client relationships and specific engagements;

Human resources including the assignment of personnel to engagements;

Engagement performance including procedures over adequate consultation if
required and specific quality control reviews; and

Monitoring to ensure compliance with the standard.
ISQC 1 can be applied proportionately by smaller firms, using judgment and processes suitable
to the needs of the firm and its clients.
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Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 6 'Osbourne Co' tests how well you have remembered quality control from AA and that
you can apply the theory to an applied scenario.
Further reading
There is one technical article on the ACCA website written by members of the AAA examining team
which is relevant to some of the topics covered in this chapter that you should read:

Audit quality – a perpetual current issue
You may find it helpful to read alongside the article on 'Professional scepticism' as they both support the
importance of quality auditing.
Own research
If you want to understand the way that regulators are attempting to enhance the quality of audit, you
could research this using resources available where you are studying – for example:

In the UK, the FRC undertakes a series of quality inspections which you may find of use:
https://www.frc.org.uk/auditors/audit-quality-review/thematic-inspections

The IAASB also regularly consults on quality issues: https://www.iaasb.org/focus-audit-quality
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Obtaining and
accepting
professional
appointments
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Evaluate the appropriateness of publicity material including the use of the
ACCA logo and reference to fees.
C2(a)
Outline the determinants of fee-setting and justify the bases on which fees
and commissions may and may not be charged for services.
C2(b)
Discuss the ethical and other professional problems, for example, lowballing,
involved in establishing and negotiating fees for a specified assignment.
C2(c)
Recognise and explain the matters to be considered prior to tendering for an
audit or other professional engagement and explain the information to be
included in the proposal.
C2(d)
Explain the matters to be considered and the procedures that an audit
firm/professional accountant should carry out before accepting a specified
new client/engagement or continuing with an existing engagement,
including:
C3(a)
(i)
(ii)
(iii)
(iv)
Client acceptance
Engagement acceptance (new and existing)
Establish whether the preconditions for an audit are present
Agreeing the terms of engagement
Recognise the key issues that underlie the agreement of the scope and terms
of an engagement with a client.
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C3(b)
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Business and exam context
It is a commercial fact that companies change their auditors. The question that firms of auditors need
to understand the answer to is 'Why do companies change their auditors?' We shall examine some
of the common reasons here.
Related to the fact that entities change their auditors is the fact that many auditing firms advertise
their services. ACCA has set out rules for professional accountants who advertise their services which
we shall also examine.
The audit fee can be a key consideration for an entity when it makes decisions about its auditors.
Determining the price to offer to potential clients can be difficult, but it is just one part of the whole
process that is tendering. Audits are often put out to tender by companies. We shall examine all the
matters firms consider when tendering for an audit.
Linked in with tendering is the process of determining whether to accept the audit engagement if it is
offered. ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements,
and Other Assurance and Related Services Engagements sets out some basic requirements for all
audit firms accepting engagements. Finally, ISA 210 Agreeing the Terms of Audit Engagements sets
out the agreement necessary when an audit is accepted.
Many of the issues in this chapter are ethical. You could be faced with a change in auditor scenario
in the exam. The issues surrounding a change in auditor have often been examined in the past, with
scenarios featuring tendering and practical issues around audit planning. This area could be
examined in either Section A or Section B.
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5: Obtaining and accepting professional appointments
Chapter overview
Obtaining and accepting
professional appointments
1. Reasons why
entities change
their auditors
5. Acceptance
and
continuance
3. Tendering
2. Advertising, publicity
and obtaining
professional
appointments
4. Fees
3.1 Do they want
the work?
2.1 Advertising fees
4.1 Lowballing
3.2 Content of the
proposal document
3.3 Criteria which
might be used to
evaluate the
tender
3.4 UK Companies
2006 Act
requirements for
tendering
6. Terms of audit
engagements
7. Descriptions of
practising firms
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1 Reasons why entities change their auditors
The focus of this topic is on issues surrounding the change of auditors by an entity. It is important that
you are aware of the circumstances that may lead to a need for the auditors to be replaced.
Activity 1: Changing auditors
Required
Can you think of reasons why an entity may need to replace its auditors?
Solution
2 Advertising, publicity and obtaining professional
appointments
Audit firms are allowed to advertise. The ACCA Code states that any advertisements or promotional
material shall not reflect adversely on the professional accountant, ACCA or the accountancy
profession (ACCA Code: para. 250A).
Advertisements and promotional material should not:

Bring ACCA into disrepute or bring discredit to the professional accountant, firm or the
accountancy profession;

Discredit the services offered by others whether by claiming superiority for the professional
accountant's or firm's own services or otherwise;

Be misleading, either directly or by implication; and

Fall short of any local regulatory or legislative requirements, such as the
requirements of the United Kingdom Advertising Standards Authority's Code of Advertising
and Sales Promotion, notably as to legality, decency, clarity, honesty and truthfulness
(ACCA Code: para. 250.2A)
2.1 Advertising fees
It is difficult to explain the service represented by a single fee in the context of an advertisement and
confusion may arise as to what a potential client might expect to receive in return
for that fee (ACCA Code: para. 250.5). This means that it is risky for an accountant to refer to
fees in advertising.
In longer advertisements, where reference is made to fees in promotional material, the basis on
which those fees are calculated (hourly and other charging rates etc) should be clearly stated
(ACCA Code: para. 250.4).
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5: Obtaining and accepting professional appointments
The key issue to remember with regard to advertising fees is that the greatest care should be
taken not to mislead potential clients, particularly if comparing fees with those of
competitors (ACCA Code: para. 250.6). Any reference to fees must be factual, and the
accountant must be able to justify it. It should not make 'unflattering' references to competitors
(ACCA Code: para. 250.11). It is appropriate to advertise free consultations to discuss fee issues
(ACCA Code: para. 250.10). This free consultation will allow fees to be explained, thus avoiding
the risk of confusion.
We will look at how firms should set their fees in Section 4.
3 Tendering
A firm puts together a tender either in response to an open invitation to tender or if it has been
approached by a prospective client and the partners have decided that they are capable of doing
the work for a reasonable fee.
When an audit firm is approached by a prospective client, the first question it has to ask itself is
whether or not it wants the work.
3.1 Do they want the work?
The risk attaching to the client must be considered. The audit firm would wish to consider the
following:
Why has the approach
arisen – first year of audit
or a desire to change
auditors?
What the future plans
of the entity are –
growth, survival,
change etc?
What the client
requires from the audit
firm (for example,
audit, number of visits,
tax work?)
Can the firm afford to
spend time on the
proposal?
Does the proposed
timetable for the work fit
with the current work plan?
Does the firm have suitable
personnel available?
Where will the work be
performed and is it
accessible/cost effective?
Are (non-accounting)
specialist skills necessary?
Will staff need further
training to do the work
and if so, what is the cost
of that further training?
Activity 2: Risks from prospective clients
Required
What work would you perform in order to assess the risk attached to a prospective client?
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Solution
3.2 Content of the proposal document
Assuming a firm is happy that it can manage the risks discussed above, the basic format of the
tender proposal will depend on the circumstances and the prospective client's requirements.
The principal objective is to convince the client to appoint the audit firm. The firm will therefore want
to demonstrate that it has understood the unique features and requirements of the business and
has considered how best it can meet those.
The following matters will usually need to be covered:
The fee and details of how it has been calculated (discussed in Section 4)
An assessment of the requirements of the prospective client
An outline of how the firm proposes to address those requirements for the fee
The assumptions made, for example, regarding deadlines or availability of information
The proposed approach to the engagement
An outline of the firm and the staff involved
If the tender is being submitted to an existing client, some of those details will be unnecessary.
However, if it is a competitive tender, the firm should ensure they submit a comparable tender, even
if some of the details are already known to the client. This is because the tender must be
comparable to competitors and must appear professional.
3.3 Criteria which might be used to evaluate the tender
Academic research has shown that proposals are often won on the quality of service offered, value
for money and the chemistry with the client, rather than simply on fees. The following criteria are
likely to be used by prospective clients to evaluate the tender:

Location

Personal knowledge of the partners and staff

Prior experience of the industry or of a similar sized business

Matching the service offered to the specific needs of the business

Communication, including prior agreement of the impact on fees before any additional work is
undertaken

The development of an effective relationship between the client and the key members of the
audit teams
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5: Obtaining and accepting professional appointments
3.4 UK Companies Act 2006 requirements for tendering
As an example, the UK Companies Act 2006 requires some companies to put the audit out to
tender after ten years, with mandatory rotation after 20 years.
The tender will not always result in a change in auditor – it is possible that the current auditor will
win the tender. But it means that management will have to consider whether the audit meets its
needs, as discussed above.
Under the UK Companies Act 2006, for a quoted (listed) company, an auditor must always submit a
statement of circumstances when they cease to be auditor, even where there are no matters
which the auditor believes should be brought to the attention of members or creditors (Companies
Act 2006: s.519).
In the case of a private company (or an unlisted public company), the auditor does not need to
submit a statement if they are leaving because their term of office has come to an end. If they are
leaving before this, then a statement must be submitted, unless the reasons for leaving are 'exempt
reasons' (eg the auditor is ceasing to practise as an auditor, or the company is now exempt from
audit), and there is nothing that needs to be communicated (Companies Act 2006: s. 519(1)–(3)).
4 Fees
The ACCA Code of Ethics and Conduct states that fees should be 'fair and reasonable'. They
recommend that the basis of charging fees should be mentioned in the engagement letter (ACCA
Code: para 240.2B-C).
Fees should not be charged on a contingency, percentage or similar basis, save where that
course of action is generally accepted practice for certain specialised work. Commission paid
and received as a result of recommendations from and to clients respectively can be accepted, as
long as adequate safeguards exist (usually full disclosure will suffice) (ACCA Code: para 240.3-8).
Fee disputes may arise when the client believes that the fee charged is excessive. If a firm is about
to issue a fee note which is higher than previous fees, it is good practice to explain the reasons for
the variation to the client concerned (ACCA Code: para 240.16).
Assuming there is no dramatic change in the size or complexity of an audit client, it is reasonable
to expect that the audit fee should fall over time. Some reasons why this would be the case
are as follows:
(a)
Time spent on the audit should reduce as the auditors' knowledge of the business
improves over time, allowing the work to be completed more efficiently.
(b)
The client's systems and procedures should be fully documented in the first year.
This is very time consuming; in subsequent years, this information only needs updating if there
have been any major changes.
(c)
The first year of an audit is generally high risk due to a lack of knowledge of the business;
the firm is likely to respond to this risk by assigning more senior staff to the audit, which will
drive the fee up. In subsequent years, this risk should fall and more junior, and
therefore cheaper, staff can be assigned to the audit.
4.1 Lowballing
Lowballing: This refers to the practice of setting the initial audit fee low in order to win the client.
Key term
The ACCA's guidance on quotations states that it is not improper to secure work by quoting a
lower fee, so long as the client has not been misled about the level of work that the fee
represents, and as long as audit quality is not compromised (ACCA 2012: p4 'Fees').
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Section 240 of the ACCA Code also discusses fee levels. The ethical implications of this practice
are:
(a)
Because the fee is set low, the audit firm needs to retain the client for a number of years in
order to recover its initial losses; therefore, independence will be impaired via a self-interest
threat as the audit firm will not wish to lose the client in the short term.
(b)
Professional competence and due care may not be applied if the fee is so low that
adequate levels of quality control cannot be displayed on the engagement.
(c)
This can be seen as unprofessional because it means that smaller practices cannot
compete.
The IESBA also issued a staff publication: Ethical Considerations Relating to Audit Fee Setting in
the Context of Downward Fee Pressure in 2016. The key points are as follows:

Auditors should perform high quality audits irrespective of fees.

Enough time should be allowed for the audit to be performed in line with ISAs.

Audit personnel should be of an appropriate level of experience, ie the auditor must not
save costs by using staff with a lower charge-out rate than is necessary.

Communication with those charged with governance is crucial – if fees are too low to pay
for a quality audit, then they may not fulfil their own duties in relation to audit quality.
5 Acceptance and continuance
There are a number of issues that auditors should consider when their tender proposal has been
accepted by a prospective client:
Does the firm have the necessary technical competence to perform the work?
Does the firm have sufficient resources to perform the work?
Are there any ethical or independence issues if the firm decides to proceed with the work?
Has the firm considered the risks associated with new clients, such as money laundering or the
potential for them becoming a Politically Exposed Person? Such people (known as PEPs) are
usually in the public eye and as such become a target for extortion, blackmail or simple human
frailties such as corruption – this makes any association with them a possible threat to a firm's
reputation.
Has the auditor obtained references for the entity's directors?
Has the auditor obtained professional clearance from the outgoing auditors?
Have the terms of engagement (covered in Section 6) been discussed and agreed prior to
accepting the appointment?
Note that this list is not exhaustive and that many of these relate to questions
asked at the tendering stage.
Why might the firm be offered an engagement that it has submitted a tender for, but then choose not
to proceed with the engagement?
Consider this in the context of a graduate looking for work – they may submit a number of job
applications (like tender proposals) and some of them may lead to interviews and even job offers
from prospective employers (like offers of acceptance by the client). However, in the time between
submission and job offer, factors may have emerged that might mean the graduate is less keen
to work at this particular employer and if they have a number of options available, the graduate may
decide to go with the best one that fits their circumstances at that time.
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5: Obtaining and accepting professional appointments
Essential reading
See Chapter 5 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on acceptance and continuance procedures. This includes an awareness
of the ethical and professional matters required for consideration and the requirements of ISQC 1.
Activity 3: Albion and Baggie
Albert Albion and Chris Baggie are partners in a successful firm of certified accountants. Total fee
income for the firm is $5 million.
Last year, a branch of the large national firm Anders Arthurson opened up in the same town and
since that time, Albion & Baggie Certified Accountants have been losing business.
Albert has therefore launched an advertising campaign, of which he is very proud, to try to win
clients away from Anders Arthurson. The campaign has consisted of the following quarter-page
advert being placed in the local newspaper every day for three weeks:
Audit fee too high?
Lack of personal service?
Problems with your audit?
Anders Arthurson's service is
not as high as their price.
Fixed audit fee of $1,000 for
revenue up to $750,000.
Call us now on 0800 555 H-A-P-P-Y
Albert has also organised a door to door leaflet drop, paying his nephew $3.00 to deliver 500
leaflets to local businesses and personal addresses.
Chris has been reviewing outstanding fee income. He has noticed that one of the partnership's
clients, Virgo, owned by Dick Branston, has still not paid the previous year's audit fee. Virgo has
tendered for a contract to run the National Lottery which has left the company with cash flow
problems. Dick and Chris are very good friends; Chris is sure that Dick would not default on the fee.
In reply to the advertising campaign, a lottery company called Rolling Balls has approached Albion
& Baggie, requesting the firm to act as its auditor. Rolling Balls is a large company which currently
runs the Florida lottery and is also tendering for the National Lottery contract. Albert is immensely
excited about this opportunity, as the audit fee is likely to be in the region of $500,000. As well as
the audit, Rolling Balls would like Albion & Baggie to supply other services including accounts
preparation and compliance monitoring (which would involve ensuring that Rolling Balls is complying
with all lottery regulations).
Chris Baggie has two adult daughters, who both work for Albion & Baggie. Sophie, who has worked
for the partnership for 7 years, has recently taken out a $500,000 mortgage with Midwest bank,
which is an audit client of the partnership.
Maggie, Chris's other daughter, has only recently joined the partnership. Up until three months ago,
she was the financial accountant at Nibbles Pet Foods, which is also an audit client. Chris feels that
Maggie's knowledge of this client will be a great help and is intending to use her as the manager on
this year's audit of Nibbles. Maggie's husband Sid owns $100,000 worth of shares in this
company.
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Required
Comment on the practice management and ethical issues presented by the above scenario.
Solution
6 Terms of audit engagements
ISA 210 Agreeing the Terms of Audit Engagements sets out best practice concerning this issue.
The objective of the auditor is to accept or continue an audit engagement only when the basis on
which it is to be performed has been agreed, through:
Key term
(a)
Establishing whether the preconditions for an audit are present, and
(b)
Confirming that there is a common understanding between the auditor and management
and, where appropriate, those charged with governance of the terms of the audit
engagement.
(ISA 210: para. 7)
The preconditions for an audit are the use by management of an acceptable financial reporting
framework in the preparation of the financial statements and the agreement of management and,
where appropriate, those charged with governance to the premise on which an audit is conducted.
To determine if these preconditions exist, the auditor will assess whether the applicable financial
reporting framework is acceptable, ensuring fair presentation of the financial statements, sufficient
internal control to address material misstatements due to fraud or error and that the auditor has been
provided with access to all the evidence they require for their opinion.
(ISA 210: paras. 4-6)
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5: Obtaining and accepting professional appointments
This will all be confirmed in the engagement letter.
Essential reading
See Chapter 5 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for a reminder of the contents of an engagement letter.
If any of these conditions do not exist (eg the framework used is unacceptable or
management does not acknowledge its responsibilities) or those charged with governance impose a
limitation on the scope of the auditor's work which is likely to result in a disclaimer of
opinion, then the auditor should not accept the engagement, unless legally required to do so
(ISA 210: para. 7).
In a recurring or continuing audit, the auditor must assess whether circumstances have
changed so that the engagement terms need to be changed. The auditor must also assess whether
the entity needs to be reminded of the existing terms (ISA 210: para. 13). There is no need to send a
new letter for each audit unless there is evidence of misunderstanding by the client.
7 Descriptions of practising firms
Members of the ACCA may be either associates or fellows, in which case they are allowed to use the
designatory letters ACCA or FCCA after their names (ACCA Code: para. B4.6).
A firm may describe itself as a firm of 'Chartered Certified Accountants' where:


At least half the partners are ACCA members
Those partners hold at least 51% of voting rights under the partnership agreement
(ACCA Code: para. B4.15)
Such a firm may use the ACCA logo on its stationery and website.
A firm which holds a firm's auditing certificate from ACCA may describe itself as 'Registered
Auditors' and a firm in which all the partners are Chartered Certified Accountants may use the
description 'Members of the Association of Chartered Certified Accountants'.
However, a firm must not use this term as part of its registered practice name (ACCA Code:
para. B4.14) which should be consistent with the dignity of the profession in the sense that it should
not project an image inconsistent with that of a professional bound by high ethical and technical
standards (ACCA Code: para. B4.32).
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Chapter summary
Obtaining and accepting
professional appointments
1. Reasons why entities
change their auditors

Fee is too high or audit is no longer
value for money

Auditor no longer large enough to
service a growing client

Auditor may resign due to not
making enough profit or
independence issues

3. Tendering
3.1 Do they want
the work?






Breakdown in relationship
2. Advertising, publicity and
obtaining professional
appointments

Firms are allowed to advertise…

…but should comply with advertising
standards and not discredit the work
of another member, firm or the
profession

Fees must not be misleading
Risks – what could change?
Enough time and staffing?
Logistics and expertise?
Nature of work?
Why approached?
Cost effective and deadlines?
3.2 Content of the
proposal document






4. Fees



Should be fair and reasonable
Commission OK only if disclosed
No contingent fees for audits
4.1 Lowballing

Practice of setting the initial fee
low in order to win the client

Not unethical but may affect
quality and competition

Auditor may need to retain the
client in subsequent years in
order to recover initial losses
(self-interest threat)
Fee
Client requirements
How firm will address requirements
Assumptions
Proposed approach
3.3 Criteria which might
Outline of firm and staff
be used to evaluate the
tender
2.1 Advertising fees

Needs to explain fees clearly and
what clients will get in return
5. Acceptance and
continuance


Necessary technical competence?
Sufficient resources to complete the work?

Ethical or independence issues?

Obtained references for entity directors (PEPs?)

Obtained clearance from outgoing auditors?

Agreed and discussed the terms of the
engagement prior to acceptance?
ISQC 1 has further details (Essential reading found
in the digital edition of this Workbook)
6. Terms of audit
engagements


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Contractual terms and conditions in
engagement letter (ISA 210)
Pre-conditions for an audit present?

Location

Knowledge of partners and staff

Prior experience of industry

Matching service offered to
needs of business

Communication

Development of effective
relationship
3.4. UK Companies Act
2006 requirements for
tendering

Statement of circumstances
7. Descriptions of
practising firms

At least 50% of partners are ACCA
and have at least 51% of voting rights
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5: Obtaining and accepting professional appointments
Knowledge diagnostic
1.
There is nothing unusual about an entity changing its auditors and there are a number of
reasons why it would wish to do so: fees; client fit; rotation due to independence issues; disputes
etc.
2.
Advertising by audit firms is perfectly acceptable; however, firms should be aware of their
responsibility to the profession and do nothing to bring it into disrepute.
3.
Tendering is a very common way for businesses to select auditors and requires the following
questions to be considered: do we want the work and can we do it profitably? If so, the content
of the tender and how it is likely to be assessed is considered.
4.
Auditors have a professional responsibility to charge fees that are fair and reasonable: all
things being equal, we can expect audit fees for a client to fall over time. Fees must not be so
low to adversely affect audit quality though – this is the practice known as 'lowballing'.
5.
There are a number of considerations the auditor needs to assess before officially accepting a
new engagement: quality control and professional issues are often the most important.
6.
The terms of audit engagements are agreed and recorded in the engagement letter and act
as defined terms of reference for both client and auditor, provided the pre-conditions for an
audit are present.
7.
A firm may only call itself 'certified' if it has at least half its partners as ACCA members
and those partners own at least 51% of the voting rights in the firm.
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Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 7 'PLD Associates'

Question 8 'Scenarios'
Both are excellent practice for applying this knowledge about acceptance and continuance in a scenario
based question – remember to justify your answer with reasons if asked to discuss or comment on
anything.
Further reading
There is one technical article on the ACCA website written by members of the AAA examining team
which is relevant to some of the topics covered in this chapter that you should read:

Acceptance decisions for audit and assurance engagements
Own research

In the UK, the FRC has conducted research into the current state of the audit market – as an example,
you can see how issues you have studied so far interact in the real world by accessing their reports:
https://www.frc.org.uk/auditors/report-on-developments-in-audit
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SKILLS CHECKPOINT 2
Practice management
aging information
Man
An
sw
er
aging information
Man
ve
s e w r it
nt in g
at i
on
Planning the
audit and
gathering
evidence
Completion
and reporting
Exam success skills
Specific AAA skills
Co
ti
e c re
Eff d p
an
Non-audit
engagements
and current
issues
Practice
management
r re Co
c rr
of t inteect
req of rprineteation
uirereq rpretation
m eunirts
e m e nts
Legal and ethical
responsibilities
g
nin
an
Good
ti
manag me
em
en
t
g
nin
an
pl
An
sw
e
Practice
rp
management
l
Efficient numerica
analysis
l
Introduction
This area of the syllabus could either be tested in a discrete, stand-alone way or as part of a larger question
testing professional issues in general – practice management includes both quality control as well as tendering,
fees and acceptance, so these could be combined too. There is sometimes even a cross-over with ethical issues
as well, so questions on this topic could vary and you need to be prepared.
Answering questions related to practice management do require some learned theory to inform your approach –
this will also help you identify areas of the scenario that may not look quite right and which will need some
further investigation. The AAA skills and exam success skills in this checkpoint will help you to develop an
approach that you can apply throughout the rest of your studies.
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Skills Checkpoint 2: Practice management
AAA Skill: Practice management
A step by step technique for approaching questions testing this part of the syllabus now follows (you
may find that some of these techniques are suitable for other parts of the syllabus as well – why not
start practising them now?)
STEP 1:
Isolate the verbs and confirm what
the requirement is looking for.
STEP 2:
For theory-based requirements,
consider whether there is a list that
can be used to help you create an
answer.
STEP 3:
For application-based requirements,
what information do you need to
focus on?
STEP 4:
Create an approach that takes steps
1, 2 and 3 into account.
STEP 5:
Write your answer.
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Skills Checkpoint 2
Exam success skills
There are some key exam skills that will help you when answering questions from this topic which are
summarised below:

Managing information. It is important that you respond appropriately to information
presented in the scenario as it is not put in there by accident! The AAA examining team will
have considered how they want each question to look, including the positioning of certain
pieces of information.
In the Audit and Assurance (AA) exam, for example, you are presented with a scenario and
each issue is documented logically and sequentially, with very little in the way of 'interference'
to confuse you. In the AAA exam, you will need to look around the scenario more carefully –
although there should not be any 'interference' you may need to piece together the facts a little
more to see the whole picture – the question below is a good example of how to piece
information together.

Answer planning. Making use of lists can be a great way to start planning your answer.
While we do not support the use of 'rote learned' generic lists of procedures or tasks that
could be applied in every situation, a framework can be used in certain situations as a starting
point for generating ideas.
It is especially helpful in questions where there is more than one requirement, as a list can help
you with a more factual or theory-based task, as well as when you need to apply the theory
from that list to the scenario. The question below will show you an example of how this can
work.

Correct interpretation of requirements. Whenever you attempt any AAA question (both
as part of your revision and in the real exam) you will usually start with the requirement, so
you know what you are being asked to do. When reading through the requirement, you need
to be sure that you have fully understood what you are being asked to do.
In the case of the question that follows, you need to understand what stage of the process you
are at (post tender, pre-acceptance) so your answer does not discuss things from the wrong
perspective: for example, asking about the previous year's financial statements and the prior
year auditor may be on your generic list of final acceptance procedures, but as the question
has already addressed these, that will score no marks and will waste valuable time.
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Skill Activity
STEP 1
Isolate the verbs and confirm what the requirement is really looking for. Is there
anything in the requirement that you need to take account of?
You are a partner in Hamlyn, Jones and Co, a firm of Chartered Certified Accountants. You have just
successfully tendered for the audit of Lunch Co, a chain of sandwich shops across West London. The
invitation to tender was received 'cold', which means that the company and its officers are not
known to your firm. The company has just been incorporated and has not previously had an audit.
You are almost ready to accept nomination but still have some outstanding tasks to perform.
In the course of your acceptance procedures, you received a reference from a business contact of
yours concerning one of the five directors of Lunch Co, Mr V. Loud. It stated that your business
contact had done some personal tax work for Mr Loud ten years previously, when he had found
Mr Loud to be difficult to keep in contact with and slow to provide information and he had suspected
Mr Loud of being less than entirely truthful when it came to his tax affairs. As a result of this distrust,
he had ceased to carry out work for him.
Required
(a)
Explain the procedures your firm should carry out prior to accepting nomination as auditor of
Lunch Co.
(3 marks)
(b)
Comment on the matters to be considered as part of your firm's acceptance procedures from
the reference received regarding Mr Loud.
(6 marks)
(Total = 9 marks)
There are two verbs here – 'explain' and 'comment': the first is likely to require some theory to help
you generate a series of points; the second is more challenging – commenting requires judgment and
an assessment of what's presented in the scenario. You will therefore need to write more for this to
justify your comments.
The mark scheme is different too – part (b) is worth double the marks compared to part (a), so you
will need to establish how many points each will require to score well.
STEP 2
For theory-based requirements, consider whether there is a list that can be used to
help you create an answer.
We have already explained that rote-learned lists are bad, so why are we recommending the use of
one here?
Basically, all a list does is provide you with a selection of ideas that might be helpful when creating
an answer – later in this workbook, we will look at how mnemonics can help here too. For now, let's
look at the questions that you could ask as part of your decision to accept a prospective
engagement:

Do we have the right skills and experience to undertake this engagement?

Do we have the resources available at the time required to undertake this engagement?

Are there any ethical reasons why we may not be able to undertake this engagement?

Is there anything about the client that might mean we don't want this engagement?

Have we spoken to the outgoing auditors to see if they can tell us anything about this
engagement?
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Skills Checkpoint 2
STEP 3
For application-based requirements, what information do you need to focus on?
The application is required in part (b) – the part of the scenario that deals with the reference is shown
below – so let's highlight the question as we would in an exam with the points that we need to
develop:
May not be a
problem but
could affect the
efficiency of the
audit – why did
he not stay in
touch though?
In the course of your acceptance procedures, you received a reference from a
business contact of yours concerning one of the five directors of Lunch Co,
Mr V. Loud. It stated that your business contact had done some personal tax
work for Mr Loud ten years previously, when he had found Mr Loud to be
difficult to keep in contact with and slow to provide information and he had
suspected Mr Loud of being less than entirely truthful when it came to his tax
This could also
affect the
efficiency of the
audit, especially
if this is the
finance director
– possible that
the directors
don't know how
an audit works?
affairs. As a result of this distrust, he had ceased to carry out work for him.
This is not good – concerns over management
integrity may mean we are unable to accept this
engagement – might he have changed in the
last 10 years though?
STEP 4
Create an approach that takes steps 1, 2 and 3 into account.
For part (a) how many points from our list can we use and how can we tailor it to the specific
circumstances in the scenario?
Do we have the right skills and
experience to undertake this
engagement?
Should have been established at the tender stage, but
greater client knowledge should exist now, so worth
checking to see if anything has changed.
Do we have the resources available at
the time required to undertake this
engagement?
Again, should have already been asked at the tender
stage, but we may have a better idea now if anything's
changed – this would include any logistical issues of
travel and evidence availability.
Are there any ethical reasons why we
may not be able to undertake this
engagement?
There are many issues here – the firm should already
have known if there were any reasons why this
engagement could not be taken on at the tender stage
(eg conflicts of interest with competing clients; staff with
financial interests in Lunch Co etc).
However, the engagement partner may not have been
allocated, so any ethical issues related to you as the
partner should be explored.
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Is there anything about the client that
might mean we don't want this
engagement?
The risks of having Lunch Co as an audit client would
also have been considered at the tender stage (no tender
would have been submitted otherwise).
However, new information may still come to light – for
example, are there any money laundering issues
(especially related to client due diligence) that still exist?
Question such as, 'Will they pay their fees?' and 'Are
there any issues with the company or its directors that we
don't yet know about?' would have been considered at
the tender stage (especially as it is a newly incorporated
business, so there will be very little data to go on).
Have we spoken to the outgoing
auditors to see if they can tell us
anything about this engagement?
Careful! The question says they have never been audited
so there are no previous auditors to contact.
For part (b) we can take the three issues identified from the scenario and consider them in more
detail, asking ourselves what impact these points will really have and what else we could say about
them. An introductory paragraph will help to set the scene as well.
Write your answer.
STEP 5
(a)
(b)
The following procedures should be carried out.
(i)
Ensure that my audit team and I are professionally qualified to act and consider whether
there are ethical barriers to my accepting nomination.
(ii)
Review the firm's overall work programme to ensure that there are sufficient resources to
enable my firm to carry out the audit.
(iii)
Obtain references about the directors, as they are not known personally by me or
anyone else in my firm – any integrity or efficiency issues may affect audit quality.
The auditor must use their professional judgment when considering the responses they get to
references concerning new clients. The guidance cannot legislate for all situations, so it does
not attempt to do so. In the circumstance given above, there is no correct answer, so in practice
an auditor would have to make a justifiable decision which they would then document.
Matters to be considered
The reference raises three issues for the auditor considering accepting nomination:
(i)
(ii)
(iii)
The issue that the director has been difficult to maintain a relationship with in the past
The issue that the director was slow to provide information in the past
The suspicion of a lack of integrity in relation to his tax affairs
The auditor must consider these in the light of several factors:
(i)
(ii)
(iii)
(iv)
(v)
The length of time that has passed since the events
What references which refer to the interim time say
The difference between accepting a role of auditing a company and personal tax work
The director's role in the company and therefore the audit
The amount of control exercised by the director:
(1)
(2)
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Relationships with other directors
Influence
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Skills Checkpoint 2
At this stage, they should not be considering how highly they value the opinion of the
referee. That should have been considered before they sent the reference. At this stage, they
should only be considering the implications of the reference for their current decision.
Auditing a company is different from auditing personal affairs in terms of obtaining
information and contacting personnel. In this case, the key issue is the question over the
integrity of the director.
As we do not have information about interim references and details of the business
arrangements, it is difficult to give a definite answer to this issue. However, Mr Loud is likely to
only have limited control over decisions of the entity being one of five directors, which
might lead to the auditor deciding that the reference was insufficient to prevent him accepting
nomination. If Mr Loud were the finance director, the auditor would be more inclined not to
take the nomination.
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Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed below
for Hamlyn, Jones and Co to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Good time
management
For a 9 mark requirement like this, the total time to answer the
question (up to 1.95 minutes per mark) would have been 17½
minutes; the split between reading/thinking/planning time and writing
time (something like ¼ to ¾ respectively of the total time) would
therefore have been 4½ minutes reading/planning/thinking and 13
minutes writing.
Managing information
Did you pick up on all the information you needed to satisfactorily
answer the question – for example, that there were no previous
auditors?
Correct interpretation
of requirements
Do you think you were able to 'explain' and 'comment' effectively and
do you think your answer was pitched at the right intellectual level in
each case?
Answer planning
Do you think you got all the points you should have done about
acceptance? What would a general list of such matters include and do
you think you'd be able to remember it (for reference purposes only!)
in the exam?
Effective writing and
presentation
Did you manage to carry all the points from your plan through into
your final answer? Did you justify the marks for each of parts (a) and
(b) in your answers?
Efficient numerical
analysis
Not applicable for this question
Most important action points to apply to your next question
Summary
Practice management includes a number of elements that we haven't touched upon here – for
example: quality control; the contents of a tender; determinants of fee-setting; reasons why auditors
change their auditors – and in most cases, they lend themselves to using lists to help generate ideas.
With the exception of quality control, which is driven by ISA 220, most of these lists contain very
practical issues that attempting past exam questions will help you to generate so you have a
framework to run with.
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Planning and risk
assessment
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Define materiality and performance materiality and demonstrate how it
should be applied in financial reporting and auditing.
D1(a)
Evaluate business risks, audit risks and risks of material misstatement for a
given assignment.
D1(b)
Discuss and demonstrate the use of analytical procedures in the planning of
an assignment.
D1(c)
Explain how the result of planning procedures determines the relevant audit
strategy.
D1(d)
Recommend additional information which may be required to effectively
carry out a planned engagement or a specific aspect of an engagement.
D2(c)
Recommend additional information which may be required to assist the
auditor in obtaining an understanding of the entity.
D1(f)
Recognise matters that are not relevant to the planning of an assignment.
D1(h)
Business and exam context
The issue of audit planning should not be new to you. You learnt how to plan an audit in your
previous auditing studies. Why is this chapter here? There are three key reasons:

To provide you with a technical update

To revise the details that should be included in an audit plan and the general
considerations included in planning

To consider some of the finer points of planning from the point of view of the
engagement partner, specifically to consider the issue of the risk associated with the
assignment (which is a personal risk to the partner in the event of litigation arising)
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Risk is an important factor in the audit. It falls into two categories:

Specific assignment risk (known as audit risk), which you have studied previously

Business risk associated with the client, which may form a part of inherent risk and
therefore impacts on the audit
Risk is a key issue in an audit, and most auditors take a risk-based approach to
auditing.
Section A of the exam will feature a case study set in the context of audit planning, identifying risk
areas and planning procedures to audit them. These questions will also draw from other parts of the
syllabus (Sections A – D).
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6: Planning and risk assessment
Chapter overview
Planning and risk assessment
6. ISA 320 Materiality in
Planning and Performing an
Audit
1. ISA 300 Planning an
Audit of Financial
Statements
2. Overview of
IAASB's revised
approach to
audit risk
2.1 ISA 315 (revised)
Identifying and
Assessing the Risks
of Material
Misstatement
through
Understanding the
Entity and its
Environment
3. Audit risk
7. ISA 520 Analytical
Procedures
4. Risk of material
misstatement (RoMM)
5. The business risk
approach
5.1 Financial
2.2 ISA 330 The
Auditor's Responses to
Assessed Risks
5.2 Operational
2.3 Additional
information required?
5.3 Compliance
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1 ISA 300 Planning an Audit of Financial Statements
The objective of ISA 300 is to help the auditor plan the audit so it will be performed in an
effective manner (ISA 300: para. 4). This is done by the adoption of two complementary items:
An audit strategy (characteristics of
the engagement that define its scope,
for example, as well as those factors
that might be felt to be significant in
carrying out the engagement) which
then leads to...
An audit plan (more specific risk
assessment procedures via ISA 315,
responses to such risks via ISA 330
and any other work required to comply
with all other relevant ISAs).
The specific reasons for planning are to:
Ensure that appropriate attention is devoted to important areas of the audit
Ensure that potential problems are identified and resolved on a timely basis
Ensure that the engagement is properly organised and managed in order to be performed in
an effective and efficient manner
Assist in the proper assignment of work to engagement team members
Facilitate the direction, supervision and review of engagement team members
Assist in co-ordination of work done by auditors of components and experts
The nature of the audit might change during the term of the engagement for a variety of reasons
so all such changes and reasons shall be documented. The auditor shall also address as part of
planning those ethical issues under ISA 220 Quality control for an audit of financial statements for
initial audit engagements such as acceptance and communication with previous auditors.
Planning shall not be a one-off process only carried out at the start of the engagement – it is
iterative and so the need for any additional procedures should be constantly reviewed.
PER alert
One of the competences you require to fulfil Performance Objective 18 of the PER is the ability to
determine the level of audit risk and risk areas, including considering any internal or external
information that may have implications for the audit, and to use this to document the audit plan,
designing audit programmes and planning audit tests for an internal or external audit. You can apply
the knowledge you gain from this chapter of the Workbook to help demonstrate this competence.
Activity 1: Johnson
You are the audit manager planning the audit of Johnson, a listed multinational food and drinks
manufacturer. Johnson has plants all over the world and its head office is based in London.
Required
What general matters would you consider when planning the engagement?
Solution
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6: Planning and risk assessment
2 Overview of the IAASB's approach to audit risk
There is a link between ISAs 300, 315 and 330: ISA 300 helps the auditor consider the factors that
need to be taken into account when planning the audit of an entity, but what happens next?
2.1 ISA 315 (revised) Identifying and Assessing the Risks of Material
Misstatement through Understanding the Entity and its
Environment
The auditor then uses ISA 315 to identify those issues that will lead to uncertainty (or risk) in the
financial statements. The standard explains how the auditor identifies and assesses such risks at both
the assertion ('ACCACOVER+P' from Chapter 7) and financial statement level, whether due
to fraud or error (ISA 315: para. 3).
The required understanding includes the entity and its environment, which comprises:
The nature of the entity (operations,
ownership, structure) in order to
understand likely transactions,
balances and disclosures
Relevant industry, regulatory and
other external factors
The entity's objectives,
strategies and related
business risks
Accounting policies selected and how
they are applied (plus reasons for any
changes)
The measurement and review of its
financial performance
This understanding also includes the entity's internal controls (illustrated by the diagram below,
showing the various elements of internal control):
The control environment
The entity's risk
assessment
process
Control
activities
Monitoring of controls
The information
system, including the
related business
processes, relevant to
financial reporting,
and communication
(ISA 315: paras. 14-24)
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Significant risks: Those that require special audit consideration.
Key term
(ISA 315: para. 4)
Some risks identified may be significant risks. The following factors indicate that a risk might be
significant:
Risk of fraud
The degree of subjectivity in the financial information
Unusual transactions
Significant transactions with a related party
Complexity of the transactions
(ISA 315: para. 28)
The auditor will often need to obtain additional information in order to gain the required
understanding of the entity, and in order to perform planned procedures. Much of the time, the auditor
only has incomplete information about the entity being audited, and it is important to be able to
recognise when more is needed.
2.2 ISA 330 The Auditor's Responses to Assessed Risks
Given that the auditor has chronologically reached ISA 330, they must now obtain sufficient
appropriate audit evidence regarding the assessed risks of material misstatements
through designing and implementing appropriate responses to those risks in order to
form an opinion (ISA 330: para. 3). This is where the rest of the audit testing starts to appear.
ISA 330 asks for the auditor to determine whether controls testing is appropriate or not. The
auditor always carries out some substantive testing but where controls are ineffective, these
will not be tested and substantive testing will be relied upon instead.
All conclusions reached using ISAs 300, 315 and 330 must be fully documented to support the
audit opinion.
2.3 Additional information required?
AAA exams often contain a requirement to identify additional information needed in order to either
understand the entity or perform an engagement. These are often easy marks, and to get them, you
need to:


Be specific about what information you need
State why you need the information
It is not necessary at this stage to speculate in too much detail about what might go wrong in each
area. Questions will usually contain a little bit of information – eg that a company runs a bonus
scheme for managers – but with clear gaps in it – eg how the bonuses are determined will not be
stated. All you need to do is to point out this gap and say what information is needed to fill it.
Additional information does not have to be a document, but can be the reason why management has
done something in the scenario, for example.
Essential reading
See Chapter 6 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on additional information required.
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3 Audit risk
ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance
with International Standards on Auditing states that in conducting an audit of financial statements, the
overall objectives of the auditor are:
(a)
To obtain reasonable assurance about whether the financial statements as a whole are
free from material misstatement, whether due to fraud or error, thereby enabling the
auditor to express an opinion on whether the financial statements are prepared, in all material
respects, in accordance with an applicable financial reporting framework; and
(b)
To report on the financial statements, and communicate as required by the ISAs, in
accordance with the auditor's findings (ISA 200: para. 11)
ISA 200 states that the key requirements for the auditor to obtain reasonable assurance and to
express an opinion are:

Ethics: Comply with relevant ethical requirements (ISA 200: para. 14)

Professional scepticism: Plan and perform an audit with professional scepticism,
recognising that circumstances may exist that cause the financial statements to be materially
misstated (ISA 200: para. 15)

Professional judgment: Exercise professional judgment in planning and performing an
audit (ISA 200: para. 16)

Sufficient appropriate audit evidence and audit risk: Obtain sufficient appropriate
audit evidence to reduce audit risk to an acceptably low level (ISA 200: para. 17)
The auditor then fulfils these requirements by conducting the audit in accordance with ISAs.
Formula to learn
Audit Risk = Inherent Risk  Control Risk  Detection Risk
Key terms
Audit risk: The risk that the auditor expresses an inappropriate opinion when the financial
statements are materially misstated.
Inherent risk: This is the susceptibility of an assertion to a misstatement that could be
material, either individually or when aggregated with other misstatements, assuming that there are no
related internal controls.
Control risk: This is the risk that a misstatement that could occur in an assertion, and that could be
material, either individually or when aggregated with other misstatements, will not be
prevented, or detected and corrected, on a timely basis by the entity's internal control.
Detection risk: This is the risk that the auditor will not detect a misstatement that exists in
an assertion that could be material, either individually or when aggregated with other misstatements.
(ISA 200: para. 13)
Essential reading
See Chapter 6 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on professional scepticism, planning documentation, planning an initial
audit engagement and the components of audit risks.
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4 Risk of material misstatement (RoMM)
Risks of material misstatement (RoMM) are the risks that the financial statements are
materially misstated. It stands to reason that RoMM is the equivalent of audit risk but taken from
the perspective of the company whose financial statements are being audited, so matches audit risk
but ignores the detection risk managed by the auditor.
The most obvious examples would be material errors in the statement of profit or loss, or statement of
financial position, but auditors need to consider the financial statements as a whole. For example,
the non-disclosure of a contingent liability, whilst not affecting the figures, would lead to misstated
financial statements as they would not comply with accounting standards.
Activity 2: Bauer
You are an audit partner attending the planning meeting for the audit of Bauer, a large technology
company with two main divisions. The year end is 31 December. The first division manufactures
computer hardware for use by intelligence and security agencies, and the second produces and
distributes bespoke and off-the-shelf software for use on the hardware.
As part of your audit planning, you attend a meeting with Bauer's finance director, Jack. He informs
you that there have been no major changes in the business's operations during the year, but the
following significant events had occurred:
(a)
Owing to an unexplained improvement in the security situation in the Los Angeles area, a
significant contract with the US Government for new hardware has not been renewed. This
was a surprise and as a result, 100 (out of 1,000) US staff were made redundant during
December.
(b)
During the year, development commenced on new software for use in satellite tracking of
vehicles. This has been capitalised as an intangible asset. In order to commence development,
significant staff training costs were incurred.
Required
Identify the risks of material misstatement from items (a) and (b).
Solution
(a)
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6: Planning and risk assessment
(b)
5 The business risk approach
Key term
Business risks: '…result from significant conditions, events, circumstances, actions or inactions that
could adversely affect an entity's ability to achieve its objectives and execute its strategies, or from
the setting of inappropriate objectives and strategies.'
(ISA 315, para. 4)
The business risk model is not a replacement for the traditional audit risk model but
rather a vehicle, or mechanism, for the identification of audit risk, recognising that most business risks
will eventually have financial consequences and, therefore, an effect on the financial statements.
In adopting a business risk approach, the auditor identifies the risks that the business itself faces,
which could threaten the business from meeting its goals, aims and objectives. Once identified, the
auditor is then able to identify any corresponding audit risk.
The approach allows the auditor to gain a greater understanding of the business and the
overall risks it faces and therefore increases the likelihood of identifying the risks of material
misstatement of the financial statements as well as being able to provide constructive business
advice to aid the mitigation (through relevant controls) of such risks.
PER alert
One of the competences you require to fulfil Performance Objective 4 of the PER is the ability to
evaluate activities in your area and identify potential risks of fraud, error or other hazards assessing
their probability and impact. You can apply the knowledge you have obtained from this chapter of
the Workbook to help demonstrate this competence.
Activity 3: Business risks vs audit risks
Required
From the following scenario, identify the business risk and any corresponding audit risk:
Scenario
Business risk
(i)
CD Planet operates a chain of
retail outlets selling chart CDs.
(ii)
Mucha Pasta operates several
Italian restaurants and is subject to
comprehensive and stringent
health and safety food hygiene
legislation.
Audit risk
(iii) XYZ, based in the Eurozone,
trades extensively abroad in the
US and invoices sales in US$.
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Business risks can be split into three categories to enable better identification.
5.1 Financial risk
These are the risks arising from the company's financial activities or the financial
consequences of operations. Examples include the following:
Business continuity
problems (AKA going
concern)
Unrecorded liabilities
Overtrading
High cost of capital
Credit risk
Interest risk
5.2 Operational risk
These are the risks arising from the operations of the business, such as stock-outs, physical disasters,
loss of key staff, poor brand management and loss of orders.
Essential reading
See Chapter 6 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for an overview of operational business risks from current and emerging trends in
information technology (IT) and e-commerce.
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6: Planning and risk assessment
5.3 Compliance risk
These are the risks arising from non-compliance with laws, regulations, policies, procedures and
contracts (as covered in Chapter 1). Examples include the following:
Breach of listing rules
Health and safety risks
Breach of data
protection legislation
Tax penalties
Litigation risk
Sales tax (VAT) problems
Once risks are identified, management must decide whether they accept the risk or what their
control strategy will be to manage the risk.
Management need to be satisfied that systems of risk management and internal controls are working
properly. Internal Audit can make a valuable contribution to the monitoring of risk management.
Activity 4: Melon
Your firm has just been appointed auditor to the Melon Group, which operates a chain of fashion
clothing shops for young women. The head office is based in Madrid. There are 280 shops spread
across the Iberian peninsula and a further 65 shops across the European Union. The clothing is
manufactured mainly in Spain and India by third-party manufacturers and fixed quantities are preordered six months in advance of the season. Most of the shop buildings are held on long leases,
although a small number are owned by the Group.
Approximately 40% of the shops outside the Iberian market are run on a franchise basis whereby
shop fittings are supplied and installed by the Melon Group and paid for by the franchisee over five
years, after which time they are replaced; the clothes are sold at a 40% discount on local retail price
to the franchisees on a sale or return basis. Franchisees choose which lines of the full season's range
of clothes they wish to hold, based on samples.
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Required
Identify and explain FOUR business risks and FOUR audit risks from the Melon Group scenario.
Solution
Business risks
-
-
-
-
Audit risks
-
-
-
-
6 ISA 320 Materiality in Planning and Performing an Audit
Key term
Materiality: Misstatements, including omissions, are considered to be material if they,
individually or in the aggregate, could reasonably be expected to influence the economic decisions
of users taken on the basis of the financial statements.
(ISA 320: para. 2)
An item might be deemed material due to its:
Nature
(such as transactions
with directors)
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Value
Impact
(such as a
significant asset
acquired)
(such as a $1,000
journal that turns a
profit into a loss)
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6: Planning and risk assessment
The level of materiality set at planning will always be a matter of professional judgment. Most
audit firms set criteria for which benchmark figure to use depending on what is most appropriate. For
example:
Formula to learn
Between ½% and 1%
of revenue
Between 1% and 2%
of total assets
Between 5% and 10%
of profit before tax
Illustration 1
If profit before tax is given in the question as $350,000, the lowest amount that would indicate a
material misstatement in a transaction would be 5% = $17,500. Similarly, if total assets are $2
million, a misstatement in a balance of $20,000 would become material. In some cases, such as
inventory, a misstatement might be directly relevant to both transactions and balances, so the auditor
would use judgment to decide which of the two amounts indicated a material misstatement (clearly
though, the lower amount should be used to adopt the spirit of ISA 320).
The percentage guidelines of assets, revenues and profits that are commonly used for materiality must
be handled with care. The auditor must bear in mind the focus of the company being audited: for
example, profit before tax might be more appropriate for a manufacturer judged on its
performance, but revenues may be a more appropriate for a not for profit entity (ISA 320: para. A8).
The materiality level adopted will have an impact on three key areas:
(1)
(2)
(3)
How many and what items to examine
Whether to use sampling techniques
What level of error is likely to lead to a modified audit opinion
ISA 320 also requires the calculation of performance materiality.
Key term
Performance materiality: The amount or amounts set by the auditor at less than materiality for
the financial statements as a whole to reduce to an appropriately low level the probability that the
aggregate of uncorrected and undetected misstatements exceeds materiality for the financial
statements as a whole. If applicable, performance materiality also refers to the amount or amounts
set by the auditor at less than the materiality level or levels for particular classes of transactions,
account balances or disclosures.
(ISA 320: para. 9)
Materiality levels will be determined when planning the audit and may need to be revised if
new information becomes available during the audit that affects the materiality for the financial
statements as a whole.
Essential reading
See Chapter 6 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on performance materiality.
7 ISA 520 Analytical Procedures
The auditor should apply analytical procedures as risk assessment procedures (ISA 315:
para. 6) to obtain an understanding of the entity and its environment and in the overall review at the
end of the audit (covered further in Chapter 10).
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They can also be used as a source of substantive audit evidence when their use is more
effective or efficient than tests of details in reducing detection risk for specific financial statement
assertions (covered further in Chapters 7 and 8).
Essential reading
See Chapter 6 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on analytical procedures.
Analytical procedures include the following type of comparisons, using trend analysis and
reasonableness tests:
Prior periods
Budgets and forecasts
Industry information
Predictive estimates
Relationships between elements of financial information ie ratio analysis
Relationships between financial and non-financial information eg payroll costs to the number of
employees
The following ratios should be considered (although you may not be able to calculate all of them –
the key thing to remember is that if financial data is presented in an exam question, you must do
something with it!)
Gross profit margin, in
total and by product,
area and by
month/quarter if possible
Receivables collection
period
(receivables divided by
revenue × 365)
Inventory holding period
(inventory divided
by cost of sales × 365)
Payables payment
period
(payables divided by
cost of sales × 365)
Current ratio
(current assets to
current liabilities)
Quick or acid test
ratio (liquid assets
to current liabilities)
Gearing ratio
(debt capital to
equity capital)
Return on capital
employed (profit before
tax to total assets less
current liabilities)
Ratios mean very little when used in isolation. They should be calculated for previous periods and
for comparable companies. A ratio on its own says nothing – it should always be
accompanied by a commentary on that ratio. For example:
Stating that revenue has increased by
12% will not score many, if any, marks
at all, as it does not assist the auditor in
planning the audit: Why does it matter?
Commenting that in the context of the
scenario, such a growth in revenue
seems unusual as the company is in an
industry that is experiencing a decline
in demand, therefore should be
explored further, would score most, if
not all, available marks.
The permanent file should contain a section with summarised accounts and the chosen ratios for prior
years.
In addition to looking at the more usual ratios, the auditors should consider examining other ratios
that may be relevant to the particular client's business, such as revenue per passenger mile for
an airline operator client, or fees per partner for a professional office.
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6: Planning and risk assessment
Chapter summary
Planning and risk assessment
1. ISA 300 Planning an
Audit of Financial
Statements
6. ISA 320 Materiality in Planning
and Performing an Audit
Objectives of planning are:

Materiality determines the relative
significance or importance of a matter,
depending on its nature, value or impact

Devote appropriate attention to matters

Identify all potential problems


Performance materiality < materiality levels
Ensure that engagement is properly
organised and managed


Proper assignment of work
Determines what to examine, how much to
sample and what will affect the audit opinion

Facilitate direction, supervision & review

Allows co-ordination of entire team (eg
experts and component auditors)
3. Audit risk
AR = IR  CR  DR
4. Risk of material
misstatement (RoMM)
Risk that F/S are materially misstated
5. The business risk
approach
Significant conditions that could adversely affect the
entity's ability to achieve its objectives: Financial,
Compliance and Operational.
7. ISA 520
Analytical Procedures
2. Overview of IAASB's revised approach to audit risk
ISA 315 Identifying and assessing the risks of material
misstatement through understanding the entity and its
environment
The entity and its environment comprises relevant industry and
regulatory factors; the nature of the entity; its accounting policies;
objectives and strategies and a review of its financial performance.
Internal controls are also assessed, as are significant risks (eg
complex, fraudulent, subjective issues). Requires use of
On the overall
As
As risk
review of the
assessment substantive
audit
procedures
procedures
(COMPLETION)
(PLANNING) (EVIDENCE)
Carried out
as part of
ISA 315
ISA 330 The auditor's responses to assessed risks
The auditor then needs to obtain sufficient appropriate audit evidence
in the light of such risks by designing audit tests (substantive plus a
degree of controls-based depending on the quality of the control
environment and control procedures)
Additional information required? Look for the gaps in the
scenario and say what you need and why you need it.
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Knowledge diagnostic
1.
Planning is the most critical stage of the audit, requiring the production of an audit strategy
and an audit plan, each designed to reduce audit risk to an acceptably low level.
2.
The IAASB approach to planning requires the following tasks:





Perform risk assessment procedures
Assess the risks of material misstatement
Respond to assessed risks
Perform further audit procedures
Evaluate audit evidence obtained
3.
Additional information may be required to understand the entity or perform an engagement
– look for the gaps in the scenario and explain what you need and why.
4.
Audit risk is the risk that an auditor expresses an inappropriate opinion on a set of
financial statements. Audit risk is made up of inherent risk, control risk and detection
risk.
5.
Risk of material misstatement (RoMM) is audit risk from the client's perspective only, so
assesses the risk of the financial statements being materially misstated (inherent and
control risk only).
6.
Business risks – in order to assess audit risks more effectively, auditors are now required
under ISA 315 to understand the risks that a business faces in three areas: financial,
operational and compliance.
7.
Materiality is an expression of the relative significance or importance of a particular
matter in the context of financial statements as a whole – items can be material due to their
nature, value or impact and the materiality chosen helps the auditor to determine what to
examine, whether or not to use sampling techniques and what level of error might lead to a
qualified opinion.
8.
Auditors can use analytical procedures, ratios and other techniques to derive evidence at
various stages of the audit:



106
At the risk assessment stage (as per ISA 315)
As part of substantive procedures
During the overall review at the end of the audit
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6: Planning and risk assessment
Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 9 'Marsden Manufacturing' is excellent practice for evaluating audit risks and testing your
understanding of materiality in an integrated scenario question.

Question 11 'Trendy Group' requires a comparison of business risks and audit risks for a
consolidated group – make sure you can distinguish between these two types of risk as they are often
confused for each other by candidates!
Further reading
There are a number of technical articles on the ACCA website written by members of the AAA examining
team which are relevant to some of the topics covered in this chapter that you should read:

Exam technique for Advanced Audit and Assurance part 2 – risk

The control environment of a company

ISA 315 (Revised) Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and its Environment (related to entity's internal control)

Planning an audit of financial statements

Analytical procedures

Audit risk
Own research

In the UK, the FRC has conducted research into various developments in the auditing profession – as
an example, you could review the briefing paper on professional scepticism and see what it has to
say about risk assessment:
https://www.frc.org.uk/auditors/audit-assurance/audit-and-assurance-research-activities
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Evidence
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Identify and describe audit procedures (including substantive and tests of
control) to obtain sufficient, appropriate evidence from identified sources to
support the financial statement assertions and disclosures.
D2(a)
Assess and describe how IT can be used to assist the auditor and recommend
the use of computer-assisted audit techniques (CAATs) and data analytics
where appropriate.
D2(b)
Explain the planning procedures specific to an initial audit engagement.
D1(e)
Apply the further considerations and audit procedures relevant to initial
engagements.
D2(d)
Apply analytical procedures to financial and non-financial data.
D2(e)
Explain the specific audit problems and procedures concerning related parties
and related party transactions.
D2(f)
Recognise circumstances that may indicate the existence of unidentified related
parties and recommend appropriate audit procedures.
D2(g)
Recognise when it is justifiable to place reliance on the work of an expert (eg
a surveyor employed by the audit client).
D4(a)
Evaluate the potential impact of an internal audit department on the planning
and performance of the external audit.
D4(b)
Assess the appropriateness and sufficiency of the work of internal audit and
the extent to which reliance can be placed on it.
D4(c)
Recognise and evaluate the impact of outsourced functions, such as payroll, on
the conduct of an audit.
D4(d)
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Business and exam context
Audit evidence is a vital part of any audit. The basic issues relating to evidence are that:



Auditors must obtain evidence to support financial statement assertions
This evidence must be sufficient and appropriate
Audit evidence must be documented sufficiently
Related parties are a difficult area to obtain audit evidence on. The auditor must bear in mind who
the evidence is from and how extensive it is.
In special circumstances, notably the first audit, different considerations and procedures must be
followed regarding opening balances.
Sometimes, the evidence the auditor requires is beyond the expertise of the auditor, and they will
need to rely on the work of an expert. We also revise internal audit which you studied in some detail
in your earlier auditing studies. Internal auditors provide services to the management of a company.
Certain considerations arise if the external auditor intends to rely on the work of internal audit. We
also consider the impact on the auditor of a client who has outsourced functions such as payroll or
accounting services.
Specific audit issues examined in this subject are likely to be at a higher level than in your previous
auditing exams. Therefore, the more complex evidence issues of related parties, opening balances
and using the work of others are important. You should consider how they link in with specific
accounting issues in Chapter 8.
These areas can be tested anywhere in the exam, in either Section A or Section B.
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7: Evidence
Chapter overview
2. ISA 530 Audit Sampling
3. ISA 510 Initial Audit
Engagements – Opening
Balances
1. ISA 500 Audit Evidence
1.1 Procedures for
obtaining evidence
3.1 Prior period audited
by another auditor
8. Outsourcing and
ISA 402 Audit
Considerations
Relating to an Entity
Using a Service
Organisation
3.2 Prior period not
audited (ie first time being
audited)
Evidence
3.3 Auditor's report
4. ISA 230 Audit
Documentation
7. ISA 550 Related Parties
8.1 Impact on audit
planning
8.2 Obtaining
evidence on the
quality of a service
organisations' controls
7.1 Audit
conclusions
and reporting
(do not put in
title case)
5. ISA 620 Using the Work
of an Auditor's Expert
6. ISA 610 Using the Work
of Internal Auditors
8.3 Responding to
assessed risks
8.4 Reporting
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1 ISA 500 Audit Evidence
Audit evidence should be:
SUFFICIENT
Quantity of evidence is sufficient to support the audit opinion.
and
APPROPRIATE


Relevant in supporting the financial statement assertions; and
Reliable
Although the use of assertions helps to guide the auditor in obtaining sufficient appropriate audit
evidence under ISA 500 Audit evidence, the assertions themselves are defined within ISA 315
Identifying and assessing the risks of material misstatement through understanding the entity and its
environment – this is to reiterate the approach that risks are assessed at both the financial statement
and assertion level (ISA 315: para. 25).
We need evidence on the validity of the financial statement assertions (essential characteristics for
items to display in order to be included within the financial statements):
Accuracy – An accurate record of the event or transaction
Completeness – Not understated for both events/transactions and assets/liabilities
Cut off – Items have been placed in the appropriate accounting period
Accuracy, valuation and allocation – Assets and liabilities have been valued correctly
Classification – Events/transactions and assets/liabilities recorded in the proper accounts
Occurence – Not overstated in respect of events and transactions
Valuation – Assets or liabilities are recorded at the appropriate amount
Existence – Not overstated in respect of assets and liabilities
Rights and obligations – There is either a right or an obligation in respect of this item
Presentation – All events/transactions and assets/liabilities are appropriately aggregated or
disaggregated, clearly described and all related disclosures are relevant and understandable.
Completeness, rights and obligations, existence, classification, accuracy, valuation and allocation
and presentation relate to assets and liabilities, and related disclosures.
Completeness, cut off, occurrence, accuracy, classification and presentation relate to transactions
and events, and related disclosures (ISA 315: para. A129).
Audit evidence is obtained by performing audit tests.

Tests of control –Tests to obtain audit evidence about the suitability of design and effective
operation of the accounting and internal control systems

Substantive tests – Tests of detail of transactions and balances, and analytical procedures,
performed to obtain audit evidence to detect material misstatements in the financial statements
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7: Evidence
1.1 Procedures for obtaining evidence
The objective of the auditor is to design and perform audit procedures in such a way as to enable
the auditor to obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the auditor's opinion (ISA 500: para. 4).
Procedures (ISA 500: paras. A10–A25)
Inspection of assets
Inspection of assets that are recorded in the accounting records confirms
existence, gives evidence of valuation, but does not confirm rights
and obligations.
Confirmation that assets seen are recorded in the accounting records
gives evidence of completeness.
Inspection of
documentation
Confirmation to documentation of items recorded in accounting records
confirms that an asset exists or a transaction occurred. Confirmation that
items identified in supporting documentation are recorded in accounting
records tests completeness.
Cut-off can be verified by inspecting a reverse population, that is,
checking transactions recorded after the end of the reporting period to
supporting documentation to confirm that they occurred after the end of
the reporting period.
Inspection also provides evidence of valuation/measurement,
rights and obligations and the nature of items (presentation and
disclosure). It can also be used to compare documents (and therefore
test consistency of audit evidence) and confirm authorisation.
Observation
Observation involves watching a procedure being performed (for
example, post opening).
It is of limited use, as it only confirms the procedure took place when
the auditor is watching.
Enquiries
Seeking information from client staff or external sources.
Strength of evidence depends on knowledge and integrity of source of
information.
Confirmation
Seeking confirmation from another source of details in the
client's accounting records, for example confirmation from the bank of
bank balances.
Recalculations
Checking arithmetic of client's records, for example adding up
ledger account.
Re-performance
Re-performance is the auditor's independent execution of procedures
or controls originally performed as part of the entity's internal control,
either manually or using computer-assisted auditing techniques (CAATs).
Data analytics is a more thorough technique where entire populations
can now be audited instead of samples because of the power and
capability of technology (see below for examples of how data analytics
could be used by the auditor).
Analytical
procedures
Analytical procedures consist of evaluations of financial information
made by a study of plausible relationships among both financial and
non-financial data. These can be used as substantive analytical
procedures (see below for examples).
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When assessing the sufficiency and appropriateness of audit evidence, auditors must consider
whether the evidence is consistent. Where contradictory evidence is discovered, for example,
where one piece of evidence suggests that a specific liability has been settled prior to the year end
while another piece of evidence throws doubt on this, the auditors must perform any other
procedures necessary to resolve the inconsistency (ISA 500: para. 11).
1.1.1 Examples of data analytics routines that can be used for gathering evidence
Analysis of sales trends by
product, store, month, sales
operative, supplier
(including margin,
frequency etc) ie more
detailed than traditional
CAATs
Reviewing all purchases to
ensure they can be traced
back to a matching order,
goods received note and
invoice
Reviewing journals for any
that have been posted
outside of office hours and
cross-referencing them by
originator (useful for fraud
or error checks)
Essential reading
See Chapter 16 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on how data analytics is changing the auditor's approach to gathering
evidence.
1.1.2 Examples of substantive analytical procedures
Simple comparisons
A simple year on year comparison could provide very persuasive evidence that an expense such as
rent is correctly stated, providing that the auditor has sufficient knowledge of the business, for
example knowing that the same premises have been leased year on year and that there has been no
rent review.
Comparisons with estimates prepared by the auditors
A common example of this is where a business may have a large number of items of plant and
machinery that are depreciated at different rates. The auditor could perform a quick calculation:
Closing balance of plant
and machinery (cost)
×
Average depreciation
rate
If this estimate was similar to the actual depreciation charge, it would go some way to allowing the
auditor to conclude that the charge was materially correct.
Relationship between financial and non-financial information
In making an estimate of employee costs, probably for one specific department, such as
manufacturing, the auditor might use information about the number of employees in the department,
as well as rates of pay increases. The estimate might be:
Prior year wages expense
×
Average no. of employees current year
× % pay increase
Average no. of employees prior year
If the actual expense does not make sense when compared with the estimate, explanations would
need to be sought and corroborated. For example, management might explain that for several
months of the year, the factory ran double shifts, so a higher proportion of hours worked were paid
at higher overtime rates.
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7: Evidence
Further examination of production records for those months would be required.
If no explanation is available, then more detailed substantive testing will be required, directed
towards possible misstatements, such as mis-postings, or frauds, such as payments to dummy
employees. Auditors are essentially looking for enough reliable audit evidence. Audit evidence
usually indicates what is probable rather than what is definite (it is usually persuasive rather
than conclusive) so different sources are examined by the auditors. However, auditors can only give
reasonable assurance that the financial statements are free from misstatement, so not all
sources of evidence will be examined.
2 ISA 530 Audit Sampling
ISA 530 Audit Sampling is based on the premise that auditors do not normally examine all the
information available to them, as it would be impractical to do so and using audit sampling will
produce valid conclusions.
Key terms
Audit sampling: Involves the application of audit procedures to less than 100% of the items within
a population of audit relevance such that all sampling units have an equal chance of selection in
order to provide the auditor with a reasonable basis on which to draw conclusions about the entire
population.
Statistical sampling: Is any approach to sampling that involves random selection of a sample,
and use of probability theory to evaluate sample results, including measurement of sampling risk.
Population: Is the entire set of data from which a sample is selected and about which an auditor
wishes to draw conclusions.
Sampling units: The individual items constituting a population.
Stratification: Is the process of dividing a population into sub-populations, each of which is a
group of sampling units, which have similar characteristics (often monetary value).
Tolerable misstatement: A monetary amount set by the auditor in respect of which the auditor
seeks to obtain an appropriate level of assurance that the monetary amount set by the auditor is not
exceeded by the actual misstatement in the population.
Tolerable rate of deviation: A rate of deviation from prescribed internal control procedures set
by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that
the rate of deviation set by the auditor is not exceeded by the actual rate of deviation in the
population.
Anomaly: A misstatement or deviation that is demonstrably not representative of misstatements or
deviations in a population.
Sampling risk: Arises from the possibility that the auditor's conclusion, based on a sample, may
be different from the conclusion if the entire population were subjected to the same audit procedure.
Non-sampling risk: Arises from factors that cause the auditor to reach an erroneous conclusion
for any reason not related to the sampling risk. For example, most audit evidence is persuasive rather
than conclusive, the auditor might use inappropriate procedures, or the auditor might misinterpret
evidence and fail to recognise an error.
(ISA 530: para. 5)
Some testing procedures do not involve sampling, such as:

Testing 100% of items in a population

Testing all items with a certain characteristic (for example, over a certain value) as the
selection is not representative of the population
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The ISA distinguishes between statistically based sampling, which involves the use of random
selection techniques from which mathematically constructed conclusions about the population can be
drawn, and non-statistical methods, from which auditors draw a judgmental opinion about the
population (ISA 530: para. A4). However the principles of the ISA apply to both methods. You
should be aware of the major methods of statistical and non-statistical sampling.
The auditor's judgment as to what is sufficient appropriate audit evidence is influenced by a number
of factors.
Risk assessment
The nature of the accounting and internal control systems
The materiality of the item being examined
The experience gained during previous audits
The auditor's knowledge of the business and industry
The results of audit procedures
The source and reliability of information available
If they are unable to obtain sufficient, appropriate audit evidence, the auditors should consider the
implications for their report.
3 ISA 510 Initial Audit Engagements – Opening Balances
Auditors must make special considerations at the planning stage when they are auditing an entity for
the first time, whether because the entity has never required an audit before, or because the entity
has simply changed auditor.
New audits generally require a little more work than recurring engagements. But it is important to
note that this is not because the auditor needs to do a first-time audit more thoroughly than other
audits. Rather, it is because there are specific risks in relation to an auditor's relative lack of
knowledge of new audit clients.
The auditor shall obtain sufficient appropriate audit evidence about whether the opening
balances contain misstatements that materially affect the current period's financial statements
by:
(a)
Determining whether the prior period's closing balances have been correctly brought
forward to the current period or, when appropriate, have been restated;
(b)
Determining whether the opening balances reflect the application of appropriate
accounting policies; and
(c)
Performing one or more of the following:
(i)
Where the prior year financial statements were audited, reviewing the predecessor
auditor's working papers to obtain evidence regarding the opening balances;
(ii)
Evaluating whether audit procedures performed in the current period provide evidence
relevant to the opening balances; or
(iii)
Performing specific audit procedures to obtain evidence regarding the opening
balances
(ISA 510: para. 6)
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7: Evidence
Essential reading
See Chapter 7 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the approach to auditing opening balances.
3.1 Prior period audited by another auditor
Audit procedures:
Review predecessor's working
papers, considering the
professional competence
and independence of the
predecessor auditor
If the prior period auditor's
report was modified, pay
particular attention in the
current period to the matter
which resulted in the
modification
Read the most recent set of
financial statements and
predecessor's auditor's report
for information relevant to
opening balances
3.2 Prior period not audited (ie first time being audited)
Other audit procedures need to be performed, for example:
Collection or payment of
opening accounts
receivable or payable in
the current period
Examination of records
underlying opening
non-current assets and
liabilities, including
confirmation from third parties
where possible
Observation of current
physical inventory count
and reconciliation back to
opening quantities ('roll back')
3.3 Auditor's report
In all cases where there is a new auditor, the auditor's report must contain an Other Matter
paragraph. This applies whether or not the audit opinion being expressed is modified. ISA 510
gives the following example of an Other Matter paragraph in this case (the example is also found in
ISA 710):
Other Matter
The financial statements of the Company for the year ended December 31, 20X0 were audited by
another auditor who expressed an unmodified opinion on those statements on March 31, 20X1.
(ISA 510: Appendix – Illustration 1)
If there was a modification to the opinion and this is still relevant in the current period, the
auditor expresses a modified opinion in this year's auditor's report in line with ISA 705 and ISA 710
(ISA 510: para. 13). Otherwise, the opinion would be modified under the following circumstances:
Unable to obtain sufficient appropriate evidence about the
opening balances
Qualified 'except for' or
disclaimer of opinion
Opening balances contain material misstatements affecting
current period (either not corrected or not adequately disclosed)
Qualified 'except for' or
adverse opinion
This includes the possibility that accounting policies may not be
consistently applied or accounted for/disclosed properly in the
new year.
Listed auditor has difficulty confirming opening balances
Disclose as a Key Audit
Matter in line with ISA 701
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4 ISA 230 Audit Documentation
PER alert
One of the competencies you require to fulfil Performance Objective 19 of the PER is the ability to
carry out and document compliance and substantive tests and other audit work in accordance with
the audit programme. You can apply the knowledge you obtain in this chapter of the Workbook to
help demonstrate this competence.
In general terms, the auditor's documentation should be:
REPEAT
RECORD
Sufficiently complete and detailed to enable an experienced auditor with
no previous connection with the audit subsequently to ascertain from them
what work was performed and to support the conclusions reached.
An accurate record of:
(a) The nature, timing and extent of the audit procedures performed to
comply with the ISAs and applicable legal and regulatory requirements;
(b) The results of the audit procedures performed, and the audit evidence
obtained; and
(c)
Significant matters arising during the audit, the conclusions reached
thereon, and significant professional judgments made in reaching those
conclusions.
This includes the preparation of working papers reviewed by an
appropriately senior and independent personnel.
REASONINGS
The auditor's reasoning and conclusions on all significant matters
requiring exercise of judgment. This helps to support the auditor's report
conclusions should they require any subsequent justification (eg in response
to a negligence claim).
(ISA 230: para. 8)
5 ISA 620 Using the Work of an Auditor's Expert
Key terms
Auditor's expert: An individual or organisation possessing expertise in a field other than
accounting or auditing, whose work in that field is used by the auditor to assist the auditor in
obtaining sufficient appropriate audit evidence. An auditor's expert may be either an auditor's
internal expert (who is a partner or staff, including temporary staff, of the auditor's firm or a network
firm), or an auditor's external expert.
Management's expert: An individual or organisation possessing expertise in a field other than
accounting or auditing, whose work in that field is used by the entity to assist the entity in preparing
the financial statements.
(ISA 620: para. 6)
Relying on the work of a management's expert is covered in ISA 500 Audit Evidence. When relying
on the work of a management expert's work, the auditor must; evaluate the management's expert's
competence, capabilities and objectivity; obtain an understanding of the expert's work, and;
evaluate the appropriateness of the work as audit evidence (ISA 500: para. 8).
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7: Evidence
Reliance on an auditor's expert might be necessary in the following situations:
Valuation of certain types of asset, eg land and buildings, precious stones
Determination of quantities or physical condition of assets
Actuarial valuations on pensions or insurance liabilities
Measurement of work completed and to be completed on contracts where performance
obligations are satisfied over time
Legal opinions re: interpretations of agreements and regulations, or the outcome of litigation
When considering whether to use the work of an expert, the auditors should review:



The importance of the matter being considered in the context of the accounts
The risk of misstatement based on the nature and complexity of the matter
The quantity and quality of other available relevant audit evidence
The auditor may decide to use an auditor's expert even if the entity has already used a
management's expert. This could be the case if:

The nature, scope or objectives of the management expert's work meant that it was
inadequate for audit purposes

The expert was not independent enough of management, eg management could control
the expert

The expert's competence and capabilities were not sufficient
(ISA 620: para. A9)
Essential reading
See Chapter 7 of the Essential Reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the auditor's use of experts within the audit.
6 ISA 610 Using the Work of Internal Auditors
As part of their role, the external auditors will need to seek sufficient appropriate audit
evidence in order to reach an opinion. Given the governance-related work on internal controls
that a company's internal audit function might perform in the 21st century, there is some logic in the
external auditor relying on this work and reducing time spent on the audit.
Considerations that the external auditor might take into account when reviewing internal audit work
include:
Internal audit's organisational status and relevant policies and procedures. Are the internal
auditors objective?
The level of competence of the internal audit function
Whether the internal audit function applies a systematic and disciplined approach, including
quality control
(ISA 610: para. 15)
If any of this is found to be unacceptable, the external auditor is unlikely to rely on internal audit
evidence and will carry out its own testing instead. It may also form part of the external auditor's
overall assessment of risk and the company's control environment.
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Essential reading
See Chapter 7 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for further content on how to assess the internal audit function.
7 ISA 550 Related Parties
Central to a number of government investigations in various countries have been companies trading
with organisations or individuals other than at arm's length. Such transactions were made
possible by a degree of control or influence exercised by directors over both parties to the
transactions. ISA 550 Related Parties covers this area.
Related party: A party that is either:
Key term
(a) A related party as defined in the applicable financial reporting framework; or
(b) Where the applicable financial reporting framework establishes minimal or no related party
requirements:
(i)
A person or other entity that has control or significant influence, directly or indirectly, through
one or more intermediaries, over the reporting entity;
(ii)
Another entity over which the reporting entity has control or significant influence, directly or
indirectly, through one or more intermediaries; or
(iii) Another entity that is under common control with the reporting entity through having:



Common controlling ownership;
Owners who are close family members; or
Common key management.
(ISA 550: para. 10)
Management is responsible for the identification of related party transactions. Such transactions
should be properly approved as they are frequently not at arm's length. Management is also
responsible for the disclosure of related party transactions.
The objectives of the auditor are:
(a)
Irrespective of whether the applicable financial reporting framework establishes related party
requirements, to obtain an understanding of related party relationships and transactions
sufficient to be able:
(i)
To recognise fraud risk factors, if any, arising from related party relationships and
transactions that are relevant to the identification and assessment of the risks of material
misstatement due to fraud; and
(ii)
To conclude, based on the audit evidence obtained, whether the financial statements,
insofar as they are affected by those relationships and transactions:
(a)
(b)
(b)
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Achieve fair presentation (for fair presentation frameworks); or
Are not misleading (for compliance frameworks); and
In addition, where the applicable financial reporting framework establishes related party
requirements, to obtain sufficient appropriate audit evidence about whether related party
relationships and transactions have been appropriately identified, accounted for and disclosed
in the financial statements in accordance with the framework.
(ISA 550: para. 9)
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7: Evidence
Activity 1: Related parties
Required
What audit procedures should be performed to identify related parties?
Solution
During the audit, all members of the audit team should be equally alert for transactions
which may indicate the existence of unidentified related parties. Examples include the following:

Transactions which have abnormal terms of trade such as unusual prices, interest rates,
guarantees and repayment terms

Transactions which lack a logical business reason for their occurrence

Transactions in which substance differs from form

Transactions processed in an unusual manner

High volume or significant transactions with certain customers or suppliers as compared
with others

Unrecorded transactions such as the receipt or provision of services at no charge
The auditor should obtain a written representation from management concerning the
completeness of information provided concerning related parties and the adequacy of disclosures in
the financial statements (ISA 550: para. 26).
Essential reading
See Chapter 7 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for further content on how to respond to the risks of material misstatement due to related
parties.
7.1 Audit conclusions and reporting
If the auditor is unable to obtain sufficient appropriate evidence regarding related parties and
transactions with such parties, this gives rise to a qualified opinion due to insufficient or
inappropriate audit evidence.
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If the auditor concludes that the disclosure of related party transactions is not adequate, this gives
rise to a modified auditor's report based on material misstatement.
8 Outsourcing and ISA 402 Audit Considerations Relating to
an Entity Using a Service Organisation
Outsourcing is the use of external suppliers as a source of finished products, components or services.
It is also known as 'sub-contracting'.
An audit client using an external supplier in this way does not diminish the ultimate responsibility of
the directors for conducting the business of the company.
Business functions that are commonly outsourced include, but are not limited to: payroll, information
technology, accounting, recruitment and internal audit.
ISA 402 uses the following terms:
Key terms
Service organisation: A third-party organisation (or segment of a third-party organisation) that
provides services to user entities that are part of those entities' information systems relevant to
financial reporting.
User entity: An entity that uses a service organisation and whose financial statements are being
audited.
User auditor: An auditor who audits and reports on the financial statements of a user entity.
Service auditor: An auditor who, at the request of the service organisation, provides an assurance
report on the controls of a service organisation.
Type 1 report: A report on the description and design of controls at a service organisation. It
comprises:
(i)
A description, prepared by management of the service organisation, of the service
organisation's system, control objectives and related controls that have been designed and
implemented as at a specified date; and
(ii)
A report by the service auditor with the objective of conveying reasonable assurance that
includes the service auditor's opinion on the description of the service organisation's system,
control objectives and related controls and the suitability of the design of the controls to achieve
the specified control objectives.
Type 2 report: A report on the description, design and operating effectiveness of controls at a
service organisation. It comprises:
(i)
A description, prepared by management of the service organisation, of the service
organisation's system, control objectives and related controls, their design and implementation
as at a specified date or throughout a specified period and, in some cases, their operating
effectiveness throughout a specified period; and
(ii)
A report by the service auditor with the objective of conveying reasonable assurance that
includes:
(a) The service auditor's opinion on the description of the service organisation's system, control
objectives and related controls, the suitability of the design of the controls to achieve the
specified control objectives, and the operating effectiveness of the controls; and
(b) A description of the service auditor's tests of the controls and the results thereof.
(ISA 402: para. 8)
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7: Evidence
A user entity may use a service organisation that executes transactions and maintains
related accountability for them or records transactions and processes related data
(eg a computer systems service organisation). Such an organisation may also carry out facilities
management work or even asset management on behalf of a user.
Service organisations may undertake activities on a dedicated basis for one company, or on a
shared basis, either for members of a single group of entities or for unrelated customers.
User auditors need to obtain sufficient, appropriate audit evidence to express an opinion on
financial statements. They therefore need to consider an approach towards the parts of the audit
affected by the service organisation.
8.1 Impact on audit planning
One factor that has an impact on the audit of a user entity is that the user auditor has no
direct contractual relationship with the service organisation (or indeed the service
auditor) and this may cause problems with access and confidentiality. In practical terms,
however, it is in the interest of the user entity for its service organisation to co-operate with the
user auditor, but this must still be taken into consideration when planning the audit.
User entity
Direct
relationship
User auditor
Service
organisation
Direct relationship
?
?
Direct
relationship
Service
auditor
ISA 402 requires the user auditor to obtain an understanding of the nature and significance of
the services provided by the service organisation, starting with the extent of the relationship between
user entity and service organisation:
(a)
When the services provided by the service organisation are limited to recording and
processing user entity transactions and the user entity retains authorisation
and maintenance of accountability, the user entity may be able to implement effective
policies and procedures within its organisation.
(b)
When the service organisation executes the user entity's transactions and
maintains accountability, the user entity may deem it necessary to rely on policies
and procedures at the service organisation. In such cases, the auditor needs to design
procedures that allow it to manage audit risk effectively.
The auditor needs to understand how a user entity uses the services of the service organisation,
including:

The nature and significance of the service provided, including the effect on the controls at the
user entity

The nature and materiality of the transactions processed or accounts/financial reporting
processes affected

The degree of interaction between the user entity and the service organisation
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
The nature of the relationship between the two, including the contractual terms

If the service organisation maintains accounting records for the user entity, whether the
arrangements affect the auditors' responsibility to report concerning accounting records
Sources of information include:






User manuals
System overviews
Technical manuals
The contract/service level agreement
Reports by the service organisations, internal auditors or regulatory authorities
Reports by the service organisation auditor
(ISA 402: paras. 9 and A1)
8.2 Obtaining evidence on the quality of a service organisations'
controls
The user auditor must evaluate the controls at the user entity that relate to the service organisation
and determine whether this gives the auditor sufficient understanding to provide a basis for assessing
risks of material misstatement in the user entity financial statements.
If the auditor concludes that this is insufficient, they must carry out one of the following four activities.

Obtain Type 1 or Type 2 report from the service organisation, if available

Contact the service organisation to get specific information (with permission)

Visit the service organisation and perform procedures to obtain the information (with
permission)

Use another auditor to perform procedures at the service organisation (with permission)
It is likely that the auditor will be able to obtain a Type 1 or 2 report, and this will be the most
straightforward option. If this action is taken, the auditor needs to be sure that:

The service organisation's auditor is competent and objective

The standards under which the report was issued are adequate for the user entity's auditor's
purposes

The report is for an appropriate date (that is, it covers the period the user entity is reporting
on)

The evidence it is based on is sufficient and appropriate for the user entity's auditor's
understanding of the internal controls

If complementary user entity controls are relevant to the user entity, the auditor has obtained
an understanding of these
8.3 Responding to assessed risks
The auditor needs to assess whether sufficient appropriate audit evidence is available from records at
the user entity. If so, they should carry out appropriate procedures at the user entity. If not, they
should carry out further audit procedures.
When the user auditor expects controls at the service organisation to be operating effectively, they
must obtain evidence that this is the case, by one of the following three methods.



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Obtaining a Type 2 report, if available
Performing test of controls at the service organisation
Using another auditor to perform tests of controls at the service organisation
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7: Evidence
Again, obtaining a Type 2 report is the most likely option, in which case the entity auditor has to:

Check that the report is made up to an appropriate date

Ensure that they have tested complimentary controls at the user entity if necessary

Check the adequacy of the time period covered by the tests of controls and the time elapsed
since those tests of controls were performed

Ensure the tests of controls performed for the purposes of the report are relevant and provide
sufficient appropriate audit evidence for the user entity auditors' purposes
The auditor must also make enquiries of management if they are aware or suspect any fraud,
non-compliance with law and regulations or uncorrected misstatements at the service organisation
that could affect the financial statements of the user entity and evaluate the impact of any matters on
their procedures and report.
8.4 Reporting
The key issue to remember is that if the user auditor cannot obtain sufficient appropriate evidence
about the impact of the service organisation on the user entity, the auditor must modify the auditor's
report, as the scope of the audit has been limited.
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Chapter summary
3. ISA 510 Initial Audit
Engagements – Opening
Balances
1. ISA 500 Audit Evidence

Evidence should be sufficient
(enough) and appropriate
(reliable and relevant)

Need evidence relevant to the
assertions: ACCACOVER+P

Evidence from tests of controls
and substantive testing

Procedures: inspection;
observation; enquiries,
confirmation; recalculations; reperformance and substantive
analytical procedures




Ensure that all b/fwd balances are not
misstated, are b/fwd correctly and that
accounting policies are consistent
Sample selection
methods:

Prior period audited by another
auditor:
– Statistical
– Non-statistical
Evaluation of results
takes cause and impact
into account
–

Review predecessor's working
papers, read report – modified?
Prior period not audited (ie first year
of audit):
–

8. Outsourcing and ISA
402 Audit Considerations
Relating to an Entity Using
a Service Organisation

2. ISA 530 Audit
Sampling
Additional procedures re: current
assets and liabilities
Auditor's report implications
(insufficient and/or inappropriate audit
evidence or material misstatement) plus
OM paragraph if audited by a
previous auditor)
Evidence
4. ISA 230 Audit
Documentation
Planning becomes difficult due to
lack of direct relationship, so need
to assess significance of service
organisation and their relevance to
the audit



Audit procedures include
evidence from site visits and/or
service organisation's auditor (plus
Type 1 and Type 2 reports using
ISAE 3402 in Chapter 12)
Repeat
Record
Reasoning
5. ISA 620 Using the Work of an
Auditor's Expert
May be required for:
7. ISA 550 Related Parties
IAS 24 requires entities to disclose
who they are related to (related
parties) and how they have
interacted (related party
transactions).
The auditor therefore has an
obligation to obtain evidence on all
related parties and associated
transactions and ensure they are all
disclosed in the F/S (they are
material by their nature not
their size).
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6. ISA 610 Using the Work
of Internal Auditors
Criteria for assessment:

Organisational status (including
objectivity)

Level of competence

Systematic and disciplined
approach including quality control

Asset valuations

Actuarial valuations

Inventory counts

Stage of completion on contracts
where performance obligations
are satisfied over time

Legal opinions
Auditor should verify the
credentials of the expert to ensure
they can be trusted as an objective
source of audit evidence
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7: Evidence
Knowledge diagnostic
1.
The auditor must obtain sufficient appropriate evidence to support the audit opinion via the
assertions (ACCACOVER+P). Procedures for obtaining evidence need to be appropriate to the
client.
2.
Auditors can use sampling when testing large populations – this approach requires knowing
which is the best selection method (random, systematic or haphazard) and then how to
evaluate results.
3.
In most situations, the auditor's work in respect of opening balances is quite restricted. More
work is required if it is a new engagement or if the prior period was not audited.
4.
Evidence should be adequately documented and this is usually achieved if they satisfy the
three criteria: Repeat; Record; and Reasoning.
5.
The use of an expert may be required in certain instances (eg valuations, opinions,
measurements). The competence of such an expert will need to be assessed just like any other
form of evidence.
6.
The external auditor will evaluate how much it can rely on the work of the internal auditor
by considering things such as professionalism, supervision, review, judgment and
ethical behaviour (all part of sound quality control).
7.
In line with IAS 24, auditors need to perform a number of tests to ensure that all related
parties and associated transactions have been identified and adequately
disclosed.
8.
Outsourcing is a common practice with many companies engaging service providers to
perform non-core functions, for example internal audit, payroll, recruitment or IT. Clients
use these service organisations for transactions, maintaining records, processing data,
facilities management, training and the maintenance or safe custody of assets. At the planning
stage, the external auditor should assess the impact outsourced activities may have on the audit
and consider performing additional procedures to obtain sufficient appropriate evidence.
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Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 10 'Herzog' tests risks of material misstatement and analytical procedures alongside some
procedures for obtaining audit evidence.
Further reading
There are a number of technical articles on the ACCA website written by members of the AAA examining
team which are relevant to some of the topics covered in this chapter that you should read:

Exam technique for Advanced Audit and Assurance part 4 – audit procedures

Using the work of internal auditors

Auditing in a computer-based environment

Examining evidence

Audit working papers
Own research

In the UK, the FRC has conducted research into how audit processes are changing – as an example,
you can see how issues you have studied so far interact in the real world by accessing their reports:
https://www.frc.org.uk/auditors/report-on-developments-in-audit
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Evaluation and
review – matters
relating to specific
accounting issues
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Design appropriate audit procedures relating to:
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
D3(a)
Inventory (including standard costing systems)
Non-current assets
Fair values
Impairment
Intangible assets
Financial instruments
Investment properties
Assets held for sale and discontinued operations
Borrowing costs
Statement of cash flows
Changes in accounting policy
Taxation (including deferred tax)
Segmental reporting
Leases
Revenue from contracts with customers
Employee benefits
Government grants
Related parties
Earnings per share
Provisions, contingent liabilities and contingent assets
The effects of foreign exchange rates
Share based payment transactions
Business combinations
Biological assets
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Business and exam context
You must be able to consider four key matters in relation to items appearing in financial statements:
risk, materiality, relevant accounting standards and audit evidence. In this chapter, we shall focus
primarily on the last two of these, as the first two will depend more on the scenario presented in any
given question.
You have previously studied the audit of a basic set of financial statements. At this level, the issues
you are presented with will be more complex, but remember that key basic points apply. Bear in
mind the relevant assertions for the financial statement items.
You need a strong knowledge of all the accounting standards you learnt up to SBR Strategic Business
Reporting (formerly P2 Corporate Reporting) to apply in this exam.
These syllabus areas can be tested in any part of the exam: in Section A, requirements would relate
to audit planning and would ask for example procedures or additional information; in Section B,
requirements would relate to audit evidence and could be linked in with audit completion or current
issues.
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8: Evaluation and review – matters relating to specific accounting issues
Chapter overview
Evaluation and review –
matters relating to specific
accounting issues
1. The importance of financial
reporting standards to the
auditor
3. The audit of
inventories
2. The audit of
deferred tax
4. Financial
instruments
6. The audit of leases
5. The audit of
revenue
8. ISA 540 Auditing
Accounting Estimates,
Including Fair Value
Accounting Estimates
and Related
Disclosures
7. The audit of
retirement benefits
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1 The importance of financial reporting standards to the
auditor
This topic deals with the matters that the auditor should consider when testing specific accounting
and financial reporting issues. Remember, when faced with a complex accounting issue, the auditor
should consider a number of different matters which will ensure that all relevant areas are
covered. These matters could be summarised by the following process:
• The materiality of the issue covered
M
• The possible risk(s) of misstatement
R
• What the relevant accounting standards require
S
• The audit evidence required to address the risk
• The audit procedures used to generate this evidence
A
It will not be possible to cover all of the accounting issues mentioned in the
syllabus within this chapter. Some items are assumed knowledge from previous
studies (such as SBR) and others will be covered during the revision phase of your
studies. The skills developed in this topic can be used interchangeably between
accounting issues.
Essential reading
See Chapter 8 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for an overview of all the relevant accounting issues and audit procedures. It is
essential that you are comfortable with this material in advance of the AAA exam.
Let's start by looking at a straightforward illustration of how to put this approach into practice before
we go into something more complex!
2 The audit of deferred tax
The auditor should obtain sufficient appropriate audit evidence that the deferred tax liability is
correctly calculated.
IAS 12 Income taxes requires deferred tax to be calculated on the full provision basis.
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8: Evaluation and review – matters relating to specific accounting issues
Activity 1: Armstrong
You are the manager responsible for the audit of Armstrong, a start-up company producing sporting
equipment for the retail market. The draft financial statements for the year ended December 20X6
show profit before taxation of $3m and total assets of $11.6m.
The following matters relating to deferred tax have been left for your attention:
At the year end, Armstrong had plant and equipment with a carrying amount of $3.6m. The tax
written down value of the plant and equipment was $2.1m. (There was no deferred tax provision in
the prior year as this is the first year of trade.)
The financial statements have disclosed a deferred tax provision of $450,000 based on a tax rate of
30%.
Required
In respect of the amounts relating to deferred tax in the financial statements of Armstrong, comment
on:
(i)
(ii)
The matters that you should consider
The evidence you should expect to find
(6 marks)
Solution
(i)
The matters that you should consider
Materiality
Risk(s) presented
Standards
(ii)
The evidence you should expect to find
Evidence/procedures
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3 The audit of inventories
Inventories are normally a significant asset of any manufacturing company and is an item that has a
direct impact on the profit reported. Therefore inventories is normally a risky and material
balance which requires considerable audit effort. You will have covered the audit of inventories
(using IAS 2 Inventories) in your previous AA studies, focusing on quantity and value. We will
be focusing on the more complex areas for this exam.
The financial reporting rules require that inventories are valued at the lower of cost and net
realisable value. There are several methods available for the estimation of the cost of an item of
inventory. These include first in first out (FIFO), weighted average and standard cost
(which can be affected by issues such as the controls in place over updates and how frequently such
updates are made). Net realisable value may also be influenced by a number of factors.
Activity 2: NRV
Required
Explain why net realisable value may be lower than cost and describe the audit evidence that would
support this.
Solution
4 Financial instruments
The accounting requirements for financial instruments are found in IFRS 9 Financial instruments,
IFRS 7 Financial instruments: disclosures and IAS 32 Financial instruments: presentation.
You need to be familiar with the examinable parts of these standards from your earlier FR/SBR
studies.
Activity 3: Buddy Co
You are the manager on the audit of Holly Co; the audit team have left the following information for
your attention:
In November 20X7, Holly Co purchased 500,000 shares in Buddy Co; this purchase gave Holly
approximately 18% of the issued share capital of Buddy. The shares were purchased for $2 each
and transaction costs amounted to 1% of the value of the shares. The Finance Director of Holly has
stated that he has no intention of selling the shares in the near future as he does not like to speculate
and he sees this as a long-term investment that he may add to in the future.
The share price of Buddy at the year end was $2.25.
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8: Evaluation and review – matters relating to specific accounting issues
You should assume that the purchase price of the shares and the transaction costs are both material
to the financial statements of Holly Co.
Required
In respect of the audit of this transaction, comment on:
(i)
(ii)
The matters you would consider; and
The evidence you would expect to find.
(7 marks)
Solution
5 The audit of revenue
The audit of revenue requires an awareness of IFRS 15 Revenue from Contracts with
Customers which sets out the process of recognising revenue using the following five steps:
Step 1
Identify the
contract(s) with
a customer
Step 2
Identify the
performance
obligations in
the contract
Step 3
Determine the
transaction
price
Step 4
Allocate the
transaction
price to the
performance
obligations in
the contract
Step 5
Recognise
revenue when
(or as) the
entity satisfies
a performance
obligation
Clearly, with so many steps to consider, including meeting the requirements of performance
obligations, IFRS 15 is a very examinable area for AAA.
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Activity 4: Laxman
You are an audit senior on the audit of Laxman Co, a wholesale seller of stationery and office
products.
Recognised within revenue are a series of credit sales of inventory totalling $200,000 that took
place close to the year end. Laxman Co continues to hold the legal title to this inventory.
Laxman Co holds a bank loan whose covenants impose on it a number of conditions, one of which is
that its financial statements show an acid test ratio of more than one.
The following amounts are shown in Laxman Co's draft financial statements.
Revenue
$
1,200,000
Current assets
Inventory
Current liabilities
1,000,000
100,000
800,000
Required
Identify and explain the principal matters to consider when auditing the revenue of Laxman Co.
Solution
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8: Evaluation and review – matters relating to specific accounting issues
6 The audit of leases
IFRS 16 Leases defines a lease as a contract that 'conveys the right to control the use of an
identified asset for a period of time in exchange for consideration' (IFRS 16: para. 9). For lessees,
this includes an assessment of whether the contract allows both of the following:


The right to obtain substantially all the economic benefits from use of the identified asset
The right to direct the use of the identified asset (known as a 'right-of-use asset')
For a right-of-use asset (and hence lease) to be recognised, the asset should:

Not be easily substituted by lessors; and

Not be an exempt item, such as some intellectual property, assets related to mineral extraction,
agricultural items or service contracts.
Revenue and liabilities from maintenance elements for assets must be shown separately from the
lease liability within the lessee's financial statements.
A right-of-use asset is recognised at cost, including any fees and dismantling costs at the end
of the lease term.
Depreciation is on a straight-line basis. Leases can be revalued if market conditions (including
impairment reviews) support this.
A lease liability is created for all right-of-use assets – this includes all relevant financial
commitments, eg the present value of lease payments not yet paid and any purchase options.
Some leased assets can be exempt from this accounting treatment: short-term leases (less than 12
months) and low-value assets (likely to be <$5,000) can be expensed instead.
IFRS 16 requires right-of-use assets and lease liabilities to be shown separately, either on the face of
the statement of financial position (SoFP) or within the notes.
Disclosure includes:

Depreciation charges and carrying amounts for any right-of-use assets held at the reporting
date

Interest expenses on lease liabilities

Gains and losses from sale and leaseback transactions

Expenses incurred on short-term and low-value leases

Total cash outflow for leases
Disclosure is not required for leases where the information is deemed to be non-material.
Lessors follow a different approach under IFRS 16 Leases must be differentiated between 'finance
leases' (where substantially all the risks and rewards of ownership are passed to the lessee, and the
asset is derecognised in the lessor's financial statements once the lease terminates) and 'operating
leases' (basically any other lease where the asset is held on the lessor's SoFP while income is
received from the lessee) in their financial statements.
Activity 5: Leases
Required
What would you consider to be the most significant audit risks for leases?
How would the auditor respond to some of these risks?
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Solution
Audit risks
The auditor's response?
7 The audit of retirement benefits
IAS 19 Employee benefits provides guidance on how companies should account for retirement
benefit schemes. There are two types – defined contribution and defined benefit – and it is
the latter type that tends to be inherently more risky as such schemes are set up to maintain funds for
current and future payments to former employees and their dependants.
Consider the variables that exist in respect of such schemes:
(a)
The fund assets are valued by following the market, which we know is inherently volatile.
(b)
The liabilities of the fund can be affected by the number and turnover of qualifying
employees, their life expectancy, the terms of their benefits and even future rates of pay.
In both cases, there is a risk that, from one year to the next, changes in these variables will result in a
fall in assets or a rise in liabilities, or worse, both of these, which could lead to an overall deficit in
the fund if not adequately managed under the terms of the standards. The auditor should obtain
sufficient appropriate audit evidence that all liabilities and assets are reasonably valued, correctly
accounted for and properly disclosed.
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8: Evaluation and review – matters relating to specific accounting issues
Activity 6: Jake's Pegs
You are planning the audit of Jake's Pegs, a global producer of clothes pegs and other domestic
items. The company has been in existence for 35 years and is profitable. This is the first year your
firm has performed the statutory audit.
The audit planning was virtually complete when the Finance Director informed you that the company
operates a defined benefit pension scheme for all 750 of its employees. When challenged over the
delay, the Finance Director apologised and said the scheme had 'slipped his mind'; he said he was
confident that the scheme was in surplus but he was still waiting for the actuarial report which might
not be available until the week before the reporting deadline.
Required
(a)
What additional audit risks arise due to this new information regarding the pension scheme?
(b)
Assuming the scheme is accounted for in accordance with IAS 19, what audit procedures
would you expect to carry out in respect of the pension scheme for Jake's Pegs?
Solution
Additional risks?
Audit procedures?
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8 ISA 540 Auditing Accounting Estimates, Including Fair
Value Accounting Estimates and Related Disclosures
The auditor should obtain sufficient appropriate audit evidence as to whether an accounting
estimate (such as a provision for warranty costs or an asset revaluation) is reasonable in the
circumstances and, when required, is appropriately disclosed.
8.1 Fair values
Generally, the audit procedures required in respect of fair values will be dependent upon the
complexity of the fair value measurement. If market value has been used, this should be
straightforward to verify by comparison with independently obtained data or a retained expert,
although more volatile markets make this even more complex for the auditor.
If the fair value is derived from management's estimates, however, there would need to be a
review of the past history of management in successfully estimating such figures and enquiries
made as to why a specific value was reached.
8.2 Accounting estimates – general issues
The evidence available to support an accounting estimate is often more difficult to obtain and less
conclusive than evidence available to support other items in the financial statements due to their
subjectivity and the risk of management bias within the context of aggressive earnings
management. Written representations will be obtained from management as to whether
management believes that significant assumptions used in making accounting estimates are
reasonable.
In order to comply with ISA 540, the auditor has to obtain an understanding of the requirements of
the applicable financial reporting framework, the means used by management for identifying such
transactions, events and conditions that require accounting estimates and how management make
such estimates.
8.3 Audit work required
The auditor should evaluate the degree of estimation uncertainty associated with the accounting
estimate and assess whether this gives rise to significant risks. Based on the assessed risks, the
auditor will determine whether the financial reporting framework has been properly
applied and whether methods for making estimates are appropriate and have been applied
consistently. The auditor will also:
Determine whether events occurring up to the date of the auditor's report provide
evidence regarding the accounting estimate
Test how management made the accounting estimate
Test the operating effectiveness of controls with suitable substantive procedures
Develop a point estimate or a range to evaluate the management's point estimate
(ISA 540: para. 13)
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8: Evaluation and review – matters relating to specific accounting issues
For accounting estimates which give rise to significant risks, the auditor should also evaluate the
following:
How management has considered alternative assumptions or outcomes
Whether the significant assumptions used are reasonable
Management intent to carry out specific courses of action and its ability to do so
Management's decision to recognise, or to not recognise, the accounting estimate
The selected measurement basis
(ISA 540: paras. 15, 17)
Essential reading
As a priority, you should note that Chapter 8 of the Essential reading, available in Appendix 2 of the
digital edition of the Workbook, really is essential reading for the AAA exam and covers all
examinable accounting issues and audit procedures, up to and including, the knowledge that you
should have learned for SBR.
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Chapter summary
s
Evaluation and review –
matters relating to specific
accounting issues
1. The importance of financial reporting standards to
the auditor




2. The audit of
deferred tax




Materiality
Risk of misstatement presented
Relevant accounting Standards
Audit evidence and procedures

IFRS 15 Revenue from Contracts
with Customers
IAS 2 Inventories
Quantity (inventory counts)
Valuation (standards and actuals)
Impairment indicators (NRV < Cost)
7. The audit of
retirement
benefits
8. ISA 540 Auditing
Accounting Estimates,
Including Fair Value
Accounting Estimates
and Related Disclosures

IAS 19 Employee
Benefits

Defined contribution
and defined benefit
schemes

Fund assets are valued
by the market (FV)

Fund liabilities depend
on a number of
variables – assessment
by actuary

Auditor needs sufficient
appropriate evidence that
estimate is reasonable and
adequately disclosed

Assessment of any
gains or losses on fund
– amounts posted to
other comprehensive
income

Fair values should be
reviewed for evidence of
management bias

Establishes some certainty
over the estimate by:
5 step process:

Step 1 – Identify contracts

Step 2 – Identify performance obligations

Step 3 – Determine transaction prices

Step 4 – Allocate prices to performance
obligations

Step 5 – Recognise revenue on satisfaction
of a performance obligation
4. Financial
instruments







IAS 12 Income taxes
Full provision basis
Amounts due to temporary differences
Recalculation as audit evidence
5. The audit of revenue
IAS 32, IFRS 7 and IFRS 9
Valuation of instruments
Treatment of changes in value
6. The audit of leases







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3. The audit of
inventories

IFRS 16 Leases
Valid right-of-use asset?
Authorised lease?
Any excluded assets (including low value or short term
leases?)
Verify existence of asset
Recalculate depreciation, lease liability and interest
values
Ensure that disclosure is satisfactory
Fund in surplus or
deficit – balance on
statement of financial
position
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ISA 540 Auditing
accounting estimates,
including fair value
accounting estimates and
related disclosures
–
Looking at events after the
end of the reporting
period
–
Testing how management
made the estimate
–
Looking at relevant
controls
–
Developing a point
estimate to compare
against
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8: Evaluation and review – matters relating to specific accounting issues
Knowledge diagnostic
1.
For AAA you need to consider the following:




The materiality of the issue(s) presented
Risk(s) presented by each accounting issue
What the accounting standard requires
The audit evidence/procedures required
2.
Remember that IAS 12 requires deferred tax to be calculated on a full provision basis –
remember how to apply the 'materiality, risk(s), standards and evidence' approach.
3.
Auditors need to be able to consider the issues surrounding inventory in line with IAS 2 (such as
impairment, value and quantity) especially given the material nature of such balances.
4.
Auditors must use their knowledge of IAS 32, IFRS 7 and IFRS 9 to ensure that this complex
area is accounted for accurately.
5.
The audit of revenue requires the application of the 5 steps from IFRS 15:





6.
Step 1 – Identify contracts in place with customers
Step 2 – Identify performance obligations in the contract
Step 3 – Determine transaction prices
Step 4 – Allocate transaction prices to performance obligations in the contract
Step 5 – Recognise revenue on satisfaction of a performance obligation
You should be familiar with IFRS 16 and be able to consider the audit risks posed:




Is it a right-of-use asset that is not excluded?
Is this a low-value asset or a short-term lease?
Are right of use assets and lease liability values accurate?
Is the accounting disclosure correct?
7.
Defined contribution schemes are usually straightforward but defined benefit schemes
present more risk to auditors and companies due to the possibility of fund assets being
outweighed by fund liabilities, as well as the inherently risky issue of scheme liabilities in the
first place. The treatment of actuarial gains and losses needs to be fully understood as well
– IAS 19 is key here.
8.
There are many estimates used in the production of a set of financial statements so the auditor
needs to be comfortable with the method of their calculation. Fair value is a specific area for
auditors as are those estimates that could lead to significant risks (such as management
bias).
9.
Provisions (under IAS 37) require a constructive obligation, probable occurrence and a
realistic estimate to be recognised – otherwise a contingent liability should be disclosed.
Contingent assets should not be recognised unless virtually certain.
10. Intangible assets include research and development, brands and goodwill and require
professional scepticism to ensure they have not been impaired.
11. Biological assets (IAS 41) is a complex area that requires an understanding of the
differences between agricultural produce and inventory for the financial statements.
12. Investment properties (IAS 40) need to be distinguished from non-current assets such as
PPE (IAS 16), leased assets (IFRS 16) and even assets held for sale (IFRS 5).
13. Government grants (IAS 20) requires an understanding of the grant conditions and an
awareness of whether the grant is capital or income based.
14. Borrowing costs (IAS 23) should be capitalised but only in relation to qualifying activities.
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15. Share based payment transactions (IFRS 2) can be equity and/or cash-settled but
should be traced back to the contracts to ensure they do not present an audit risk.
16. The statement of cash flows (IAS 7) is an important indicator of going concern but must
also be audited as part of the financial statements in an audit.
17. The effect of foreign exchange rates under IAS 21 requires monetary items to be
translated at the closing rate, but non-monetary items to be translated at the date of the
transaction.
18. Segmental reporting is covered by IFRS 8 Operating Segments and is all about
disclosure of reportable segments – you need to know the criteria that identify part of business
as a reportable segment.
19. Earnings per share (EPS) is required under IAS 33 and requires disclosure of basic and
diluted EPS.
20. Changes in accounting policy must be disclosed and applied retrospectively (but changes
in accounting estimates are only applied prospectively).
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8: Evaluation and review – matters relating to specific accounting issues
Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook) where you can start to put the issues covered in this chapter into practice.

Question 13 'Locksley' tests the audit of development expenditure and non-current assets

Question 14 'Bainbridge' tests inventories, PPE and a convertible debenture using the MRSA
approach from the chapter.

Question 16 'Henshelwood' tests share based payment, pension costs and provisions.

Question 17 'Keffler' tests intangibles, PPE and provisions using the MRSA approach from the
chapter.

Question 18 'Griffin' tests group accounting, going concern and laws and regulations using the
MRSA approach from the chapter – however, as some of these issues relate to subsequent chapters,
you may wish to leave this until you have studied them.
Further reading
There are a number of technical articles on the ACCA website written by members of the AAA examining
team which are relevant to some of the topics covered in this chapter that you should read:





Exam technique for Advanced Audit and Assurance part 3 – accounting issues
Audit of estimates and fair values
The importance of financial reporting standards to auditors
Massaging the figures
Accounting issues
Own research

In the UK, the FRC has conducted research into how audit processes are changing – as an example,
you can see how issues you have studied so far interact in the real world by accessing their reports:
https://www.frc.org.uk/auditors/report-on-developments-in-audit
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Group audits and
transnational audits
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Recognise the specific matters to be considered before accepting appointment
as group auditor to a group in a given situation.
D5(a)
Identify and describe the matters to be considered and the procedures to be
performed at the planning stage, when a group auditor considers the use of the
work of component auditors.
D5(b)
Identify and explain the matters specific to planning an audit of group financial
statements including assessment of group and component materiality, the impact
of non-coterminous year ends within a group, and changes in group structure or
a complex group structure.
D5(c)
Recommend and discuss the communications and content therein to be provided
by the group auditor to the component auditor in a given situation.
D5(d)
Recognise the audit problems and describe audit procedures specific to a
business combination, including the classification of investments, the
determination of goodwill and its impairment, group accounting policies, intragroup trading, equity accounting for associates and joint ventures, changes in
group structure, including acquisitions and disposals and accounting for a
foreign subsidiary.
D5(e)
In respect of the consolidation process, identify and explain the relevant audit
risks and audit procedures necessary to obtain sufficient appropriate evidence.
D5(f)
Consider how the group auditor should evaluate the audit work performed by a
component auditor.
D5(g)
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Syllabus
reference no.
Explain the responsibilities of the component auditor before accepting an
appointment, and the procedures to be performed in a group situation.
D5(h)
Justify the situations where a joint audit would be appropriate.
D5(i)
Explain the implications for the auditor's report on the group financial statements
of an entity where the opinion on a component is modified in a given situation.
E3(f)
Discuss how transnational audits may differ from other audits of historical
financial information (eg in terms of applicable financial reporting and auditing
standards, listing requirements and corporate governance requirements).
D1(g)
Business and exam context
This is a new auditing topic for you, one which is concerned with practical difficulties of
communication between auditors and the issues of geography.
When auditing group accounts, as in so many other areas, the auditors require detailed accounting
knowledge in order to fulfil their responsibilities.
Group audits fall into two categories:
(1)
Where the same firm of auditors audits the whole group
(2)
Where one firm of auditors has responsibility for the opinion on the consolidated accounts and
a different firm audits part of the group
Even where the audit of each individual company in the group is carried out by the same firm, there
may be administrative complications where some audits are carried out by different branches,
perhaps overseas, with different practices and procedures.
Group audits can be tested in Section A or Section B of the exam. Questions may focus on any aspect of
the group audit, although auditor reporting will not be examined in Section A. Groups tend to offer plenty
of suitable audit risks for AAA – consequently, it is possible that the scenario in Section A will be a group
audit.
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Chapter overview
1. ISA 600 Special Considerations – Audits of Group Financial
Statements (Including the Work of Component Auditors)
2. Responsibilities
2.1 Significant
components
and
3. Matters to consider
before accepting
appointment as parent
company auditor
4. Issues arising
when a component is
located abroad
Group audits and
transnational audits
2.2 The component
auditor
2.3 Illustration of a
simple group
6. Consolidation
audit procedures
8. Joint audits
5. The correct
classification of
investments
9. Transnational
audits
7. Implications for the
auditor's report where a
component's report has
been modified
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1 ISA 600 Special Considerations – Audits of Group Financial
Statements (Including the Work of Component Auditors)
Essential reading
See Chapter 9 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for an overview of group accounting issues that you should have learned from your
previous studies (including SBR).
As you know from your financial reporting studies, in a group situation the parent company will have
to prepare its own audited financial statements, together with the audited consolidated financial
statements incorporating all component companies.
Key terms
Component: An entity or business activity for which the group or component management
prepares financial information that should be included in the group financial statements.
Component auditor: An auditor who, at the request of the group engagement team, performs
work on financial information related to a component for the group audit.
Component materiality: The materiality level for a component determined by the group
engagement team.
Group: All the components whose financial information is included in the group financial
statements. A group always has more than one component.
Group audit: The audit of the group financial statements.
(ISA 600: para. 9)
2 Responsibilities
The group auditor has sole responsibility for the opinion on the group financial statements. In most
countries, this responsibility is not diminished by reliance on the work of any component
auditors, who are a source of evidence only and are not referred to within the group auditor's
report. There will be a group engagement team led by the group engagement partner
who will be responsible for the performance of the group audit and providing an auditor's report on
the group financial statements.
The group auditor must decide how much reliance they will place on the work performed by the
component auditor. In order to do this, they will consider the qualifications, experience,
competence, ethical standpoint and resources of the component auditors.
ISA 600 states that if a component company is audited by a component auditor and is deemed by
the group auditor either to be significant in size or to pose a significant risk of material
misstatement, they can stipulate:


That further audit procedures must be carried out; and
The extent that the component auditor is involved (if at all).
The group auditor may not be able to access all the information it needs about components or
component auditors, because of laws relating to confidentiality or data privacy, for example. The
effect on the group audit opinion depends on the significance of the component.
If the component is not significant, then it may be sufficient just to have a complete set of
financial statements, the component auditor's report, and information kept by group management.
If the component is significant, then it is possible that there will be an inability to obtain
sufficient appropriate audit evidence about the component, in which case the audit opinion is
either qualified or a disclaimer of opinion is issued. In this instance, it would also be
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impossible to comply with ISA 600's requirement to be involved with the work of the component
auditor (for significant components), which would also lead to an inability to obtain sufficient
appropriate audit evidence.
2.1 Significant components
Key term
Significant component: A component identified by the group engagement team: (a) that is of
individual significance to the group, or (b) that, due to its specific nature or circumstances, is likely to
include significant risks of material misstatement of the group financial statements.
(ISA 600: para. 9(m))
ISA 600 states that a significant component can be identified by using a benchmark (ISA 600:
para. A5). If component assets, liabilities, cash flows, profit or turnover (whichever is the most
appropriate benchmark) exceed 15% of the related group figure, then the auditor may judge
that the component is a significant component.
If a component is financially significant to the group financial statements, then the
group engagement team or a component auditor will perform a full audit based on
the component materiality level.
The group auditor should be involved in the assessment of risk in relation to significant components. If
the component is otherwise significant due to its nature or circumstances, the group auditors will
require one of the following:
An audit of specified
account balances
related to identified
significant risks
Specified audit
procedures relating to
identified significant
risks
A full audit using
component
materiality
Components that are not 'significant components' will be subject to analytical
procedures at a group level – a full audit is not required for the purpose of the group
audit/consolidated financial statements.
2.2 The component auditor
2.2.1 Understanding the component auditor
ISA 600 requires the group engagement team to obtain an understanding of the component
auditor. This involves an assessment of the following:
(a)
Whether the component auditor is independent and understands and will comply with the
ethical requirements that are relevant to the group audit
(b)
The component auditor's professional competence
(c)
Whether the group engagement team will be involved in the work of the component
auditor to the extent that it is necessary to obtain sufficient appropriate audit evidence
(d)
Whether the component auditor operates in a regulatory environment that actively
oversees auditors
2.2.2 Involvement with the component auditor
The extent of involvement by the group auditor at the planning stage will depend on the:



Significance of the component
Risks of material misstatement of the group financial statements
Extent of the group auditor's understanding of the component auditor
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The basic rule is that where the component is significant, the group auditor must be
involved in the component auditor's work.
The component auditor should consider whether there might be any restrictions on them
providing the group auditor with access to information, such as laws relating to confidentiality or
data privacy. It should be borne in mind that in general, the component auditor is not normally
obliged to co-operate with the group auditor (unless they are operating in a jurisdiction which
requires them to do so). In practice, this means that the same audit firm will often be appointed as
auditor of the group and its significant components.
2.2.3 Assessing the component auditor
For all companies in the group, the group auditor is required to perform a review of the work
done by the component auditor. This is normally achieved by reviewing a report or
questionnaire completed by the component auditor which highlights the key issues which have been
identified during the course of the audit. The effect of any uncorrected misstatements and any
instances where there has been an inability to obtain sufficient appropriate audit evidence should
also be evaluated. On the basis of this review, the group auditor then needs to determine whether
any additional procedures are necessary. These may include:

Designing and performing further audit procedures. These may be designed and performed
with the component auditors, or by the group auditor.

Participating in the closing and other key meetings between the component auditors and
component management

Reviewing other relevant parts of the component auditors' documentation
2.2.4 Communicating with the component auditor
The group engagement team shall communicate its requirements to the component
auditor on a timely basis. This communication shall set out the work to be performed, the use to be
made of that work and the form and content of the component auditor's communication with the
group engagement team (ISA 600: para. 40).
The group engagement team shall request the component auditor to communicate
matters relevant to the group engagement team's conclusion with regard to the group audit (ISA
600: para. 41).
Essential reading
See Chapter 9 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on the communication between group and component auditors
(specifically ISA 600: paras. 40-41).
2.2.5 Communicating with group management and those charged with governance
ISA 600 identifies the following as matters which should be communicated to group management.

Material deficiencies in the design or operating effectiveness of group-wide controls

Material deficiencies that the group engagement team has identified in internal controls at
components that are judged to be significant to the group

Material deficiencies that component auditors have identified in internal controls at
components that are judged to be significant to the group

Fraud identified by the group engagement team or component auditors or information
indicating that a fraud may exist
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Where a component auditor is required to express an audit opinion on the financial statements of a
component, the group engagement team will request group management to inform component
management of any matters that they, the group engagement team, have become aware of that may
be significant to the financial statements of the component. If group management refuses to pass on
the communication, the group engagement team will discuss the matter with those charged with
governance of the group. If the matter is still unresolved, the group engagement team shall consider
whether to advise the component auditor not to issue the auditor's report on the component financial
statements until the matter is resolved.
2.2.6 Communication with those charged with governance of the group
The following matters should be communicated to those charged with governance of the group.

An overview of the type of work to be performed on the financial statements of the component

An overview of the nature of the group engagement team's planned involvement in the work to
be performed by the component auditors on significant components

Instances where the group engagement team's evaluation of the work of a component auditor
gave rise to a concern about the quality of that auditor's work

Any limitations on the group audit, for example, where the group engagement team's access
to information may have been restricted

Fraud or suspected fraud involving group management, component management, employees
who have significant roles in group-wide controls or others where fraud resulted in a material
misstatement of the group financial statements
Activity 1: Communication
Communication is a two-way process. This is especially true in the context of the dialogue between
the group auditor and the component auditor.
Required
(i)
Suggest some of the requirements that the group auditor would communicate to the component
auditor.
(ii)
Suggest some of the matters that the component auditor needs to tell the group auditor.
Solution
(i)
(ii)
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2.3 Illustration of a simple group
M&S Co
Y/e 31.12.X7
Auditor = Ernst & Young
100%
T Co
y/e 31.12.X7
Auditor = Ernst & Young
There should not be
a problem here.
M&S = 'Parent'
EY = 'Group Auditor' – has the sole
responsibility for forming the auditor's opinion
on the group financial statements
75%
100%
V Co
y/e 30.9.X7
Auditor = PwC
X GmbH
y/e 31.12.X7
Auditor = KPMG
(Germany)
(1) Non-coterminous y/e not a
problem, as long as within three
months of parent's y/e and there
were no significant events in that
time (otherwise, interim F/S are
required).
For an overseas subsidiary,
the directors of the parent
have a responsibility to
ensure that the group
auditors receive all the
co-operation they require.
T, V and X are
'Components'
PwC and KPMG
are 'Component
Auditors' – still have
the responsibility for
forming the opinion
on the individual
company F/S of V
Co and X GmbH
(2) 'Component auditor' – EY has
the right to require from PwC all
info and explanations as they
require.
(3) 75% ownership – not a problem
as long as the component is
accounted for correctly (in this
case, a subsidiary).
Other considerations:
Are any of the components immaterial? If so, obtain draft financial statements from them and perform
an analytical review only. If this review suggests any errors exist, more detailed work will be needed.
Have there been any changes to the group structure? Changes such as acquisitions, disposals (or
even part-disposals) are required under ISA 600 para. A12 as part of understanding the group. Is
the going concern status of any component dependent on the parent's ongoing support? If so, a
letter of support or comfort letter should be obtained by the auditor.
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Given the nature of most consolidated groups in the 21st century, the group auditor's job is
extremely complex and likely to be subject to a number of risks not faced during the audit of the
parent company alone:
(a)
Understanding the structure of the group, paying close attention to any changes and the
risk of 'hidden' or 'shell' companies, as discovered during the Enron scandal
(b)
Consideration of group-wide controls (controls designed, implemented and maintained by
group management over group financial statements) to ensure there are no inherent problems
in the audit
(c)
The fact that their group opinion is often based upon the work of others and as such,
this demonstrates significant audit risk
Consequently, great care must be taken when deciding whether or not to accept such work.
3 Matters to consider before accepting appointment as
parent company auditor
Taking factors from Section 2 into account, the group auditor should consider whether or not their
participation is sufficient to be able to act as the group auditor. For this purpose, the group
engagement partner must obtain an understanding of the group before acceptance (ISA
600: para. 12) which should include the following:
The materiality of the portion of the financial statements which the group auditor audits (and
therefore, by implication, the proportion that they do not audit)
The group auditor's degree of knowledge regarding the business of the components
The risk of material misstatements in the financial statements of the components audited by the
component auditor(s)
The ability, where necessary, to perform additional procedures to enable them to act as group
auditors
The nature of the group auditor's relationship with the firm acting as component auditor
Under ISA 600, the group auditor will consider the following:

The quality of work from component auditors;

The ability of the group auditor to get involved with component auditors to obtain sufficient
appropriate audit evidence if necessary; or

The availability of information on consolidation from the client.
If the group auditor has concerns about any of these issues and are unlikely to be able to deliver
anything other than a disclaimer of opinion, they should not consider either accepting or
continuing with the engagement (ISA 600: para. 13).
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4 Issues arising when a component is located abroad
When a component is located abroad a number of potential difficulties could arise such as the
following:
Different accounting policies might be used in the foreign country. The
component accounts must be brought into line with the accounting policies used
by the parent company in order to consolidate properly. The group auditor will
use the checklist mentioned above to determine the accounting policies used.
There may be cultural problems unique to the country in which the
component operates. The group auditor will need to be sensitive to these during
dealings with the component auditors. Language problems might also arise
There may be issues in existence which are specific to the country in which
the component operates. For example, some countries are subject to
hyperinflation; accounts produced in these circumstances will need to be adjusted
prior to consolidation with the parent. If the component is located in a developing
country, there may be aspects of business infrastructure missing (eg education,
technology or even anti-bribery legislation). Factors such as these will need to be
identified for each component and tackled as appropriate during the audit.
5 The correct classification of investments
Essential reading
See Chapter 9 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for an overview of Associates and Joint Ventures that you should have learned from your
previous studies (including SBR).
You know from your accounting studies that an investment is treated as a subsidiary when the
parent company has control over that company. Where significant influence is held, the
investment is treated as an associate. It is important that the degree of control exercised by the
parent company is tested by the group auditor.
The auditor needs to consider how an investment fits into the activities of the group. They should
review board minutes for evidence of the degree of influence exercised by the parent. They
should also discuss the matter with the parent directors.
The existence of other significant shareholders may indicate that the parent company has little
influence. The auditor should check the register of members to determine the level of shareholding
and potential influence held by other shareholders.
The auditor should also consider how easy it is to obtain information about another company. This
could also be an indicator of significant influence.
6 Consolidation audit procedures
There are a number of procedures that should be performed by the group auditor:

Confirming the balances extracted from the financial statements of each component prior to
their inclusion on the consolidation schedule

Reviewing the disclosures necessary for the group accounts, such as related parties

Gathering evidence appropriate to the various consolidation adjustments
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Essential reading
See Chapter 9 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for an overview of the problems with consolidations and associated audit procedures
that you should have learned from your previous studies (including SBR).
Activity 2: Consolidation
Required
What are the major types of consolidation adjustment required for group financial statements?
Solution
Goodwill is calculated in accordance with IFRS 3 Business combinations, to provide more
transparency of the value of non-controlling interests (NCI). The standard allows measurement
of NCI, either at share of subsidiary net assets or fair value (FV). The latter results in 100% of
goodwill on acquisition analysed between parent and NCI elements for consolidation.
FV is used to determine assets and liabilities for these calculations. Share price on acquisition is used
for the FV of the NCI. The overall approach the auditor should follow for determining FV can be
summarised as follows:




Obtain an understanding of the entity's process for determining FV
Identify and assess the risks of material misstatement at the assertion level
Perform audit procedures on the data used to develop the FV
Evaluate whether the FV measurements have been properly determined
Activity 3: Wolf Co
You are the group auditor for Bad Co and are currently reviewing the consolidation adjustments for
goodwill in respect of the acquisition of Wolf Co. Bad Co acquired 7½ million of the 10 million
ordinary shares in Wolf Co for $12 million. At the time of acquisition, the FV of Wolf Co's net assets
was $10 million and the share price was $1.50 each. Bad Co operates a policy of valuing NCI at
fair value.
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Required
Calculate goodwill on the acquisition of Wolf Co and explain the principal audit procedures you
would perform on the goodwill calculation schedule.
Solution
$'000
Consideration transferred
NCI
Net assets acquired
Goodwill
NCI at FV
NCI at share of net assets
Goodwill attributable to NCI
Goodwill attributable to Bad Co shareholders
Goodwill attributable to NCI shareholders
7 Implications for the auditor's report where a component's
report has been modified
In a group situation, materiality and risk must be assessed in the context of the group as a whole.
The group auditor must consider the materiality of any modifications to a component's auditor's
report in relation to the whole of the consolidated financial statements.
This can lead to situations where a component may have a material qualification that has no
impact on the group opinion which would then remain unmodified. Similarly, a pervasive
modification in a component's auditor's report may only have a material impact on the group opinion.
Ultimately the decision as to the impact of a modification to a component's auditor's report on the
consolidated opinion is a matter of judgment for the group auditor. Where the group auditor
concludes that adequate evidence about the work of the component auditor cannot be obtained
and has been unable to perform sufficient additional procedures with respect to that component, they
should consider the implications for the auditor's report. A subsequent modification in these
circumstances would be on the grounds of insufficient inappropriate audit evidence.
8 Joint audits
A joint audit means an audit where two or more auditors are responsible for an audit engagement
and jointly produce an auditor's report to the client.
Reasons for joint audits
Two or more firms could act as joint auditors for the following reasons:
(a)
In a new acquisition, the parent may insist that their auditor acts jointly with those of the new
subsidiary.
(b)
A company operating from widely dispersed locations may find it useful to have joint auditors.
(c)
Foreign subsidiaries may need to employ local audit firms to satisfy the laws of the country
in which they operate. These local auditors may act jointly with the group auditors.
(d)
Some companies may prefer to use local accountants, while at the same time, enjoying the
wider range of services offered by a large national firm.
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Before accepting appointment as a joint auditor, it will be necessary to consider the experience
and standards of the other firm.
The allocation of work between the firms needs to be agreed and the auditors should agree whether
joint or separate engagement letters will be sent.
Both firms must sign the auditor's report and both are responsible for the whole audit. They are
jointly liable in the event of litigation. Such joint audits can therefore be seen to be complex to
manage and potentially expensive.
9 Transnational audits
A transnational audit means an audit of financial statements which are, or may be, relied upon
outside the entity's home jurisdiction for purposes of significant lending, investment or
regulatory decisions. This will include audits of all financial statements of companies with listed equity
or debt and other public interest entities which attract particular public attention because of their size,
products or services provided.
The growth in such transnational engagements has led to a number of issues that clients are more
aware of in the 21st century:
(a)
Variations in audit approaches and the role of regulators across different jurisdictions has
led to variable degrees of engagement quality.
(b)
The incomplete nature of ISA adoption worldwide has led to variations in audit approach.
(c)
Cultural differences worldwide have also led to different audit approaches.
In response to this trend towards globalisation and the issues associated with transnational audits, a
Forum of Firms (FOF) was created, initially by the 'Big Four' firms but now with over
20 member firms.
To support and provide guidance to the FOF, the IAASB has set up the Transnational Auditors
Committee.
Specific responsibilities of the TAC include the following:
Identifying audit practice issues. When the issues suggest changes in auditing or assurance standards
may be required, recommending to the appropriate IFAC standard-setting boards that the issue be
reviewed.
Providing a forum to discuss 'best practices' in areas including quality control, auditing practices,
independence, and training and development.
Proposing members to the IFAC Regulatory Liaison Group and identifying qualified candidates to
serve on IFAC standard-setting boards.
Acting as a formal conduit for interaction among transnational firms and international regulators and
financial institutions with regard to audit quality, systems of quality control, and transparency of
international networks.
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Chapter summary
1. ISA 600 Special Considerations – Audits of Group Financial
Statements (Including the Work of Component Auditors)








Group auditor: Sole responsibility for audit opinion on group financial statements
Group engagement team performs the group audit
Component auditor: Used as a source of evidence only - need to be assessed for quality
and reliability
Group auditor can request further work on a component if component is of significant size
and/or risk (with or without component auditor's involvement)
Need to consider issues such as non-coterminous year-ends (<3 months = adjust for
significant events only; >3 months = interim F/S) and part ownership
Group auditor requires from component auditor(s):
- Independence requirements
- Areas of special interest in the component
Component auditor requires questionnaire of timetables
Responsibilities from group auditor
3. Matters to consider
before accepting
appointment as parent
company auditor
2. Responsibilities

Parent company produces own
financial statements, audited
by own auditor

Materiality of components not
audited by group auditor


Components in a group
include:
Knowledge of business of
components not audited

Risk of components not audited:


– Division
– Branch
– Subsidiary
– Joint Venture
– Associate
Group accounts audited by
parent company auditor
Subsidiary accounts audited
by component auditor
–
Ability to perform additional
procedures
–
Nature of relationship with
component auditors
–
Group auditor may consider
that
if insufficient and/or
inappropriate evidence is
available – Disclaimer –
continue or decline?
4. Issues arising when a
component is located
abroad




Group audits and
transnational audits
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Different accounting policies
Cultural problems
Language problems
Country specific problems
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9: Group audits and transnational audits
Group audits and
transnational audits
6. Consolidation audit
procedures






Calculation of goodwill and any
impairments
Cancellation of any inter-company
balances
Provisions for unrealised profits
Fair Value (FV) adjustments
Retranslation of F/S from overseas
components
Correct value of components in
parent F/S
5. The correct classification
of investments



8. Joint audits
Control = subsidiary
Significant influence = associate
Auditor must look for evidence of
who is actually in control (eg
board minutes, correspondence
etc.)




Why?
– New acquisition
– Dispersed location
– Foreign subsidiaries
– Client choice
Need to consider standards
and experience of other firm
Joint liability
Impacts on the profession?
7. Implications for the
auditor's report where a
subsidiary's report has
been modified

Group auditor must assess
materiality for the group as a
whole

The degree of modification
(material or pervasive) may be
different in the component
auditor's report than for the
group
Group auditor uses judgment
to decide whether or not there
is a material impact or a lack
of sufficient/appropriate audit
evidence

9. Transnational audits




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Audits where the F/S may be
relied on in a different country
to where the entity is based
Different
approaches
and
regulations have led to varying
levels of audit quality
Forum of Firms (Big Four plus
others)
IAASB – Transnational
Auditors Committee (TAC):
- Identifying audit practice
issues
- Discussing best practice
- Membership of IFAC
committees
- Formal conduit for
promoting interaction
between firms
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Knowledge diagnostic
1.
Group auditors are responsible for the audit of the parent company and group financial
statements, while component auditors are responsible for the opinion on component
financial statements. The group auditor can ask for more work to be done by the component
auditor or even discount with their opinion if risk of material misstatement dictates.
2.
Auditors must consider whether or not they are happy to accept or continue in such
engagements such as, for example, when there are concerns over the amount known about this
audit or the risk of misstatement on audits not covered by them.
3.
Issues arising when a component is located abroad are often of a very practical nature and can
impact on the auditor's ability to perform the tasks necessary for the audit opinion.
4.
The correct classification of investments is key to how group financial statements are presented Subsidiary vs Associate vs Joint venture vs Investment.
5.
Auditors need to be able to calculate the consolidation adjustments required for the
consolidated accounts, including goodwill based on the correct FV of the group's assets and
liabilities.
6.
Depending on the size and nature of any component modification, the impact may range
from immaterial to pervasive.
7.
In some cases, there may be a need for more than one audit firm to act as group auditor and
each has to be aware of the issues before agreeing to act.
8.
As the impact and financing of consolidated groups become more global, the auditing
profession has set up an FOF supported by the IAASB to address the needs of how best to
provide consistent quality and approaches.
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9: Group audits and transnational audits
Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 19 'Annabella' tests audit planning in a group context, including the audit procedures
required to test a consolidation.

Questions 11 'Trendy Group' and 18 'Griffin' also cover groups, although they have been set for
earlier chapters – make sure you revisit these in the context of what you have learned here.
Further reading
There are a couple of technical articles on the ACCA website written by members of the AAA examining
team which are relevant to some of the topics covered in this chapter that you should read:


Group auditing
Group audit issues
Own research

Find a copy of a set of financial statements for a consolidated group and review them for the various
disclosures made by both management and auditors to see what such an engagement actually
includes.

Use the following link to read up on the Transnational Auditors Committee (TAC) and the Forum of
Firms (FOF):
http://www.ifac.org/about-ifac/forum-firms-and-transnational-auditors-committee
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SKILLS CHECKPOINT 3
Planning the audit and gathering
evidence
aging information
Man
An
sw
er
aging information
Man
g
nin
an
Good
T ood
Manag Gim
e tim
em
e
m
aneag
nteme
nt
pl
An
sw
er
pl
nt r itin
ati g
on
Planning the
audit and
gathering
Planning
the
evidence
audit and
gathering
evidence
Completion
and reporting
Efficient numeric
analysis
l
Efficient numerica
analysis
al
r re Co
c rr
of t inteect
req of rprineteation
uirereq rpretation
m eunirts
e m e nts
d
se
Practice
management
Exam success skills
Specific AAA skills
Co
an
ti
e c re v
Eff d p cti e
an E ffe pr
Non-audit
engagements
ve and current
issues
s e w r it
nt in g
at i
e
o
w n
g
nin
an
Legal and ethical
responsibilities
Introduction
Now that you have reached the midway point of the syllabus it makes sense to start thinking about the exam in
a bit more detail. Question 1 in the exam will be a 50 mark scenario question with a number of requirements
that should test some, if not all, of the following:




Risks (audit risks, risks of material misstatement or business risks)
Other planning issues
Audit procedures and evidence required to verify specific parts of the scenario
Ethical and professional points related to the scenario
In this skills checkpoint, we will go through an audit risk question, showing you how to use the scenario to draw
up a detailed answer. We will also show you all of the exam success skills as they relate to Question 1 so you
can start to practise them as part of your home study.
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Skills Checkpoint 3: Planning the audit and gathering evidence
AAA Skill: Planning the audit and gathering evidence
A step by step technique for approaching questions testing this part of the syllabus now follows (you
may find that some of these techniques are suitable for other parts of the syllabus as well – why not
start practising them now?)
STEP 1:
Confirm the requirement (evaluating
audit risk) by reference to the verb,
the marks and the timing.
STEP 2:
Annotate the scenario with ideas of
audit risks.
STEP 3:
Perform analytical procedures on the
data supplied (including conclusions).
STEP 4:
Create an answer plan that takes
Steps 1, 2 and 3 into account.
STEP 5:
Write your answer.
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Skills Checkpoint 3
Exam success skills
There are some key exam skills that will help you when answering questions from this topic which are
summarised below:

Managing information. Planning in AAA takes the form of risk analysis coupled with the
use of audit procedures to generate sufficient appropriate evidence. You will need to know
what could be misstated in a set of financial statements and how to confirm this via suitable
audit procedures, usually in the context of a scenario where you will need to apply technical
knowledge. Therefore, there are two key areas that you will need to know about in order to
score well.
The first is your technical knowledge of accounting and financial reporting
matters – the AAA examinable documents are the same as those used on Strategic Business
Reporting (SBR) so it is vital that you have studied that subject by the time you attempt AAA.
Chapter 8 of this workbook covers specific accounting issues; there is also an Appendix
that covers these standards in more detail if you require a recap of the key issues.
The second relates to obtaining evidence and it is here that you can use mnemonics to
help you identify evidence and the procedures used to generate it.
Let's start with a question approach for the following type of requirement, usually set in the
context of a quality control review where you need to work out what happened in an
engagement and make sure that the audit team performed the right procedures and generated
the right evidence:
'Comment on the matters to be considered and state the evidence that you should expect to
see'
The mnemonic to use here is MRSA (covered more in Chapter 8):
M
What is the materiality of the item that is being discussed?
R
What is the risk of misstatement presented here?
S
How does the standard suggest this should be dealt with?
A
What audit evidence should the team have collected and put on file for review?
There are other mnemonics that can help you to generate ideas for suitable audit procedures
that are covered in Chapter 7 (AEIOU and ACCACOVER+P).
One final piece of advice when generating an audit procedure is to consider the specific
elements of a good procedure – ideally it should include as many of the following as possible:
WHAT you are doing; WHY and HOW you are doing it; WHERE you may need to go to
do it; to WHOM you will need to speak; and what DOCUMENTATION you will need to
obtain.

Efficient numerical analysis. You will see more of this when the question is attempted
later in this skills checkpoint, but overall, if financial statement extracts and other forms of
financial or non-financial data is presented in a scenario (especially Question 1 of the AAA
exam) you will need to do something with it – it is not there for either decoration or distraction!
The use of suitable analytical procedures will be required in such cases and you should be
using them as a starting point for your analysis and planning.

Correct interpretation of requirements. In Question 1 of the AAA exam, the
requirement will be presented differently to other questions – it is known as an 'embedded
email requirement' and you need to be prepared for it.
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Consider the following example taken from the AAA Specimen Exam Question 1:
Required
Respond to the instruction in the email from the audit engagement partner.
(46 marks)
Note. The split of the mark allocation is shown within the partner's email (Exhibit 1).
Professional marks will be awarded for the presentation and logical flow of the briefing notes
and the clarity of the explanations provided.
(4 marks)
(50 marks)
The partner's email has been embedded earlier in the scenario for that question:
Using this information, I require you to prepare briefing notes for my use, in which you:
(a)
Evaluate the audit risks to be considered in planning the audit of the Group. Your
evaluation should utilise analytical procedures for identifying relevant audit risks.
(20 marks)
(b)
Explain the matters to be considered, and the procedures to be performed, in respect
of planning to use the work of Clapton & Co.
(8 marks)
(c)
Design the principal audit procedures to be performed in respect of the following
balances recognised as non-current assets in the Group statement of financial position:
(i)
(ii)
(d)
$12 million recognised as investment in associate, and
$8 million recognised as a brand name.
(5 marks)
(5 marks)
Using the information provided in Exhibit 4, identify and evaluate any ethical threats
and other professional issues which arise from the requests made by the Group audit
committee.
(8 marks)
Thank you.
It is essential that you split up these requirements into discrete tasks and create a plan that
delivers the minimum number of points for each requirement in line with the mark scheme. This
requires a form of 'scaffolding' that will be discussed in a later skills checkpoint.

Effective writing and presentation. In the example above, taken from the AAA
Specimen Exam, there are 4 professional marks – what are they and how do you earn them?
Basically, these marks allow you to demonstrate an awareness of the professional nature of
how the modern day accountant should communicate, as well as to present answers in a
format that is both professional and appropriate to the circumstances of the scenario.
How can you earn these professional marks? This is what the examining team recently
suggested:
Candidates who presented their answers in a logical and reasoned manner with subheadings and references scored well. Again candidates are advised to consider their
exam technique in this area, for example only one concise paragraph is necessary as
an introduction, not a whole page. Candidates are advised to space out their work and
start a new page for each sub-section.
You should always respond according to what's been requested. The embedded email above
requests answers in the format of a briefing note (a document that presents key details for
someone else to be adequately briefed during a meeting). Other documents might be
requested, for example reports, emails or letters but in most cases, you will probably be
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Skills Checkpoint 3
briefing the audit partner. You must ensure that at no point in your answer do you
mention your own name - the examining team suggests the use of the name 'Audit
Manager' in your answer. Suggested layouts are shown below:
Report
'Title'
Prepared by: A. Manager
Date: 13/7/20X5
Executive summary
Not always required, but can
look extremely professional.
Briefing note/Emails
From: A. Manager
To: A. Partner
Date: 13/7/20X5
Subject: …..
Letter
Your address
Recipient's name
Recipient's address
13/7/20X5
Introduction

Restate requirements
Dear Recipient,
Introduction
Detailed sections
Subject of letter…..
Including terms of reference
and scope of engagement.

Sub-heading 1
Details of letter
Content
Content
'If I can be of any more
help, please do not hesitate
to contact me at the address
above…'
Etc.
'Yours faithfully,'
Detailed sections
Conclusions


Sub-heading 2
Conclusions
Recommendations
Action plans, including staff
responsible for implementing
recommendations and
timescales.

Summary points
Appendices (if required)
or
'Yours sincerely,'
(if addressed to a named
party)
Signed
Appendices
(if addressed to 'Sir' or
'Madam')
Audit Manager
Audit Manager
Your name
Your title
Professional marks are also awarded for an appreciation of the tone of a required
answer – again, as nearly qualified professional accountants, candidates should be able to
produce something appropriate.

Good time management and answer planning. Although there is no separate
reading and planning time in this exam, and no choice of questions either, you still
have a number of key decisions to make when it comes to allocating your timings during
the exam. Skill 3 will discuss how to allocate enough time to individual requirements, but for
now, let's consider the overall balance between (i) reading and planning and (ii) writing your
answer during the exam, and how to use time effectively in each case.
Even if you are not a planner by nature, planning can help you cope with your nerves when
you start the exam. It can also be a way of giving yourself crucial time to think before you start
writing, potentially saving you from wasting time by going down the wrong path. The
examining team recently commented that candidates should
…invest time upfront in analysing what the requirement is asking for rather than
spending time detailing points which do not address the requirement… For candidates
preparing for this exam, it is especially important to focus on tailoring the number of
points written to the marks available and to take note of areas that the requirement flags
as not required.
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Investing time upfront means making a conscious decision to set aside specific reading
and planning time as well as writing time for each question. This should be anything from a
quarter to a third of the time required for each question, and should allow you to fully
understand what's required before you write it. For example, the exam could look like this:
Reading/planning
time
Writing time
Total time for
question
Question 1 = 50
marks
24 minutes
74 minutes
98 minutes
Question 2 = 25
marks
12 minutes
37 minutes
49 minutes
Question 3 = 25
marks
12 minutes
36 minutes
48 minutes
25%
75%
195 minutes
(3¼ hours)
Perhaps you could just use the term 'thinking time' instead of reading and planning to help you
remember to do it!
Here's the question that we will be using for this checkpoint:
Your firm has recently been appointed as the auditor of Forsythia, a small limited liability company
which offers garden landscaping services. You have been assigned the task of planning the audit for
the year ended 31 December 20X9.
Extracts from the draft financial statements are shown below:
Revenue
Gross profit
Operating profit
Year ended
31 December 20X9
$'000
Draft
3,112
301
278
Year ended
31 December 20X8
$'000
Actual
2,549
277
167
412
621
0
155
412
431
22
178
Non-current assets
Trade receivables
Cash in hand and at bank
Trade payables
Forsythia is partly owned by three business associates, Mr Rose, Mr White and Mr Grass, who each
hold 10% of the shares. The major shareholder is the parent company, Poppy Co. This company
owns shares in 20 different companies, which operate in a variety of industries. One of them is a
garden centre, and Forsythia regularly trades with it. Poppy Co is in turn owned by a parent, White
Holdings Co.
The management structure at Forsythia is simple. Of the three non-corporate shareholders, only
Mr Rose has any involvement in management. He runs the day to day operations of the company
(marketing, sales, purchasing etc) although the company employs two landscape gardeners to
actually carry out projects. The accounts department employs a purchase clerk and a sales clerk,
who each deal with all aspects of that function. The sales clerk is Mr Rose's daughter, Justine.
Mr Rose authorises and produces the payroll. The company ledgers are kept on Mr Rose's personal
computer. Two weeks after the year end, the sales ledger records were severely damaged by a
computer virus. Justine has a single printout of the balances at the year end, which shows the total
owed by each customer.
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Skills Checkpoint 3
Forsythia owns the equipment used on projects and pays the gardeners a salary and a bonus based
on performance. Mr Rose is remunerated entirely on a commission basis relating to sales; plus, as a
shareholder, he receives dividends annually, which are substantial.
Forsythia does not carry any inventory. When materials are required for a project, they are
purchased on behalf of the client and charged directly to them. Most customers pay within the
60 day credit period, or take up the extended credit period which Forsythia offers. However, there
are a number of accounts that appear to have been outstanding for a significant period.
Justine and her father do not appear to have a very good working relationship. She does not live at
home and her salary is not significant. However, she appears to have recently purchased a sports
car, which is not a company car.
Required
Evaluate the audit risks to be considered in planning the audit of Forsythia.
(14 marks)
Skill Activity
STEP 1
Confirm the requirement by considering the verb, the marks and the timings
required.
Evaluate the audit risks to be considered in planning the audit of Forsythia.
(14 marks)
Remember that audit risks are the risk of the auditor issuing an incorrect audit opinion – historically at
this level, candidates have sometimes mistaken audit risks for business risks (the risk that an
organisation will not achieve its objectives). Make sure you know what kind of risks you are looking
for!
'Evaluate' is a higher level verb, so will probably score up to 2 marks for each audit risk, but you will
need to work hard to score the full marks – traditionally, the examining team would have allowed ½
mark for each issue that was identified and then a further 1 to 1½ marks for the explanation of why
this represented an audit risk.
Consequently, this might require 7 issues × 2 marks each = 14 marks. However, the results of
analytical procedures might also attract marks as well, up to a ceiling, so you would probably not
need any more than 7 audit risks.
Finally, 14 marks would require just over 27 minutes work – allowing around 25% of this time for
reading/planning/thinking (7 minutes) that would leave 20 minutes to write the answer in full.
STEP 2
Annotate the scenario with ideas of audit risks areas.
Marking up the scenario will help you identify the areas where you believe the risk of issuing an
incorrect opinion will be greatest and allow you to focus on the logic of why.
Any group
Detection risk
Opening balances
Comparatives –
audited or not?
Your firm has recently been appointed as the auditor of Forsythia, a small
limited liability company which offers garden landscaping services. You have
been assigned the task of planning the audit for the year ended 31 December
20X9.
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audit issues?
Who are the
group auditors?
Receivables
likely to be
significant
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Extracts from the draft financial statements are shown below:
Year ended
31 December 20X9
$'000
Draft
3,112
301
278
412
621
0
155
Analyse
variances and
ratios – days,
margins and
changes
Revenue
Gross profit
Operating profit
Non-current assets
Trade receivables
Cash in hand and at bank
Trade payables
Complicated
corporate
structure – why?
Year ended 31
December 20X8
$'000
Actual
2,549
277
167
412
431
22
178
Forsythia is partly owned by three business associates, Mr Rose, Mr White and Mr Grass,
who each hold 10% of the shares. The major shareholder is the parent company, Poppy Co.
This company owns shares in 20 different companies, which operate in a variety of industries.
One of them is a garden centre, and Forsythia regularly trades with it. Poppy Co is in turn
owned by a parent, White Holdings Co.
Key man?
Over reliance?
The management structure at Forsythia is simple. Of the three non-corporate
Controlling
party?
Any connection
to Mr White?
shareholders, only Mr Rose has any involvement in management. He runs the
day to day operations of the company (marketing, sales, purchasing etc)
although the company employs two landscape gardeners to actually carry out
No segregation
of duties
Poor controls
projects. The accounts department employs a purchase clerk and a sales clerk,
Odd that the
business is not
owned by
landscape
gardeners?
who each deal with all aspects of that function. The sales clerk is Mr Rose's
daughter, Justine. Mr Rose authorises and produces the payroll. The company
ledgers are kept on Mr Rose's personal computer. Two weeks after the year
end, the sales ledger records were severely damaged by a computer virus.
Poor controls
Justine has a single printout of the balances at the year end, which shows the
Limitation? And
given below, a
suspicion of
fraud? Teeming
and lading?
total owed by each customer.
Forsythia owns the equipment used on projects and pays the gardeners a salary and a bonus
based on performance. Mr Rose is remunerated entirely on a commission basis relating to
sales; plus, as a shareholder, he receives dividends annually, which are substantial.
Forsythia does not carry any inventory. When materials are required for a
Any relevant
laws and
regulations?
project, they are purchased on behalf of the client and charged directly to
How accounted
for?
Errors possible?
them. Most customers pay within the 60 day credit period, or take up the
extended credit period which Forsythia offers. However, there are a number of
accounts that appear to have been outstanding for a significant period.
Problem with
receivables?
Justine and her father do not appear to have a very good working relationship. She does not
live at home and her salary is not significant. However, she appears to have
Fraud?
recently purchased a sports car, which is not a company car.
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Skills Checkpoint 3
STEP 3
Perform analytical review procedures on the data supplied.
There is no set order or checklist of procedures to perform, but the general rule is that if there are
financial statement or other data presented, you will need to do something with them!
The data are telling you a story; you need to understand the language they use so the story makes
sense.
The broad categories of analytical procedures are as follows, with an overview of the ratios that you
can calculate in each category:
Profitability
Gross margin (gross profit/revenue as a %)
Operating margin (operating profit/revenue as a %)
Efficiency
Receivables days (receivables/revenue  365 days)
Inventory days (closing or average inventory/purchases or cost of sales  365 days)
Payables days (payables/purchases or cost of sales  365 days)
Remember, the reciprocals of these without multiplying by the 365 days will create
turnover figures instead – as the amount gets lower, things will be getting worse for
the audited entity (beware being given a reporting period of lower than 365 days!)
Current ratio (current assets/current liabilities as a ratio)
Quick ratio (as above but excluding inventory, again as a ratio)
Gearing
Debt to equity ratio (can be calculated as debt/debt + equity to be more meaningful)
Interest cover (usually profit before interest and tax/finance costs)
Forsythia's analytical review shows the following:
Revenue
Gross profit
Operating profit
Draft
20X9
$'000
3,112
301
278
Actual
20X8
$'000
2,549
277
167
Non-current assets
Trade receivables
Cash
Trade payables
412
621
0
155
412
431
22
178
Calculations
Gross margin
Operating margin
10%
9%
11%
7%
2,811
72.8
20.1
2,272
61.7
28.6
Assumed Cost of Sales
(required for calculations)
Receivables days
Payables days
Variance
Conclusion
22%
9%
66%
Significant rise – manipulated?
Hasn't increased in line with above
Significant rise – misallocations?
0%
44%
-100%
-13%
Why no movement – error?
Double rise in revenue – why?
Where has this gone – O/D now?
Why fallen – understated?
As above – should both move in
similar direction – misallocations?
Greater than terms – overstated?
Fallen for no reason – understated?
Remember that analytical review without a conclusion will not score many (if any) marks, so you
need to have built the results into your answer – usually they would lead to further questions, as
analytical procedures frequently identify issues that require further investigation.
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STEP 4
Draw up an answer plan using the results of Steps 1, 2 and 3.
Not all the points you notice will necessarily be relevant and you may also find that you do not
have time to mention all the points in your answer. You should prioritise your points in a more
formal answer plan and then write your answer.
Audit risks
Inherent
Control
Related party transactions/group issues
Receivables – increase in amount and days
Fraud – possible indicators, professional
scepticism
Profit driven management – sales and margins
Credit extended – accounting/law and regs
Trade payables – understated?
Non-current assets – why no movement?
Cash – really zero and what if now O/D?
Lack of segregation of duties – op vs gross
margins?
PC/virus
Suspicion of fraud?
Key man insurance
Detection
First audit
Opening bals and comparatives – audited?
Engagement risks
Some questions raised which makes business look odd:


Group (complex/different auditors/who controls?)
Nature of business – yet landscape gardeners hired
Indicators of potential fraud
Possible indicators of money laundering (complex structure/cash business)
STEP 5
Write your solution in full.
Note. Audit risks do not necessarily require the split between inherent/control/detection risks, but if
it helps you to identify them more easily, you should continue to use them.
Audit risks – inherent
Related parties and group issues
Forsythia is part of a complicated group structure. This raises several issues for the audit.

There is a risk of related party transactions existing and not being properly disclosed in the
financial statements in accordance with IAS 24 Related party disclosures.

Similarly, there is a risk that it will be difficult to ascertain the controlling party for disclosure.

There is likely to be some group audit implications. My firm may be required to undertake
procedures in line with the group auditors' requirements if Forsythia is to be consolidated.
Receivables
Forsythia is a service provider, and it extends credit to customers. This is likely to mean that
trade receivables will be a significant audit balance. The draft financial statements show an
increase of 44% in trade receivables for 20X9, with receivables days increasing from 61.7 in 20X8
to 72.8 in 20X9. These both suggest that trade receivables is overstated. However, there is limited
audit evidence concerning trade receivables due to the effects of a computer virus. There are also
indicators of a possible fraud.
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Skills Checkpoint 3
Fraud
There are various factors that may indicate a sales ledger fraud has taken/is taking place.





Lack of segregation of duties
Extensive credit offered (as demonstrated by the increasing receivables days calculations)
The virus only destroyed sales ledger information – too specific?
Poorly paid sales ledger clerk – with expensive lifestyle
Sales ledger clerk is daughter of a well-paid shareholder and they do not have a good
relationship
None of these factors necessarily point to a fraud individually, but added together raise
significant concerns.
Profit-driven management
Mr Rose is motivated for the financial statements to show a profit for two reasons:


He receives a commission (presumably sales driven, which impacts on profit).
He receives dividends as shareholder, which will depend on profits.
From the draft financial statements, revenue has increased by 22% and operating profit has risen by
66%. Operating margin has also risen from 7% to 9%. Consequently, there is a risk that revenue is
overstated in the draft financial statements as a result of management bias.
Credit extended
We should ensure that the credit extended to customers is standard business credit. There are
unlikely to be any complications, for example interest, but if there were, we should be aware of
any laws and regulations which might become relevant when attempting to chase such overdue
debts, and any accounting issues which would be raised by allowances should doubts persist.
Trade payables
The absence of inventory due to the arrangements between Forsythia and its customers appears
unusual, and may be masking either fraud or error. Trade payables have gone down by 13% and
trade payables days have moved from 28.6 days in 20X8 to 20.1 days in 20X9. This indicates
possible understatement of the trade payables balance.
Other areas of possible misstatement
From the analytical procedures performed on the extracts from the draft financial statements, two
further issues emerge – non-current assets have stayed the same and cash has dropped to zero.
Non-current assets should have reduced as depreciation is charged – additions may balance out this
charge, but the firm should investigate this further to ensure there is no misstatement. Similarly, the
cash balance may have dropped to zero, especially if the company's credit control is as poor as it
appears, but the true cash position could be one of overdraft which may have further consequences
(such as bank covenants and going concern issues) that we would need to evaluate as part of the
audit.
Audit risk – control
There are three significant control problems at Forsythia.
Segregation of duties
There appears to be a complete lack of segregation of duties on the three main ledgers. This
may have led to a fraud on the sales ledger. The fact that there is no segregation on payroll is also
a concern as this is an area where fraud typically occurs.
Lack of segregation of duties can also lead to significant errors being made and not being
detected by the system. The draft financial statements show that gross margin has fallen from 11% to
10% but operating profit has risen from 7% to 9%. While not significant, they may indicate
misclassification in costs that indicate misstatements which may be material. This problem also
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means that control risk will have to be assessed as high and significant substantive testing
will need to be undertaken.
Personal computer
A PC is used for the accounting system. This is likely to have poor built-in controls and further
exacerbate the problems caused by the lack of segregation of duties.
The security over PCs is also often poor, as has been the case here, where a virus has destroyed
evidence about the sales ledger.
Key man
The fact that Mr Rose is dominant in management may also be a control problem, particularly if he
were ever to be absent.
Audit risk – detection
The key detection risk is that this is the first audit, so we will have no prior understanding of the
entity to draw on. We have not audited the opening balances and comparatives. We should
have contacted any previous auditors and therefore be aware of whether these have been audited. If
there were no previous auditors, these are unaudited. We must ensure that our auditor's report is
clear on this issue.
There is also significant detection risk in relation to related parties, as discussed above.
Engagement risk
There are several indicators that Forsythia may be an 'odd' company.
The first indicator is that it is part of a complex and unexplained group, and that the group is
not audited by the same firm of auditors, although it is unclear how many firms of auditors are
involved in the group audit. There may be good reasons for this audit policy, but we should
investigate those reasons, in case any other issues arise.
Another indicator is that it seems slightly odd that a small company should exist to provide landscape
gardening services, when it appears that the owners are not landscape gardeners, or at least, if they
are, they do not work in the business. Again, there may be valid reasons for this, but we should
discover and document them.
It is particularly important that these issues are cleared up. A complex group structure and a
company dealing in cash transactions (Forsythia's potentially are) could indicate the possibility that
the owners are trying to launder money. There are also indicators of fraud. If either of these
issues exist, the auditor may have significant responsibility to report and co-operate with
relevant authorities, and the professional relationship of client and auditor could be
compromised. Therefore, the audit firm must ensure that it has suitable 'know your client'
procedures in place and the appropriate systems for making reports should a suspicion arise. The
partners must ensure that staff have appropriate training so that they are able to comply fully with
legal requirements in relation to money laundering.
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Skills Checkpoint 3
Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed below
for Forsythia to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Good time
management
For a 14 mark requirement like this, the total time to answer the
question (up to 1.95 minutes per mark) would have been 27½
minutes; the split between reading/thinking/planning time and
writing time (something like ¼ to ¾ respectively of the total time)
would therefore have been 7½ minutes reading/planning/thinking
and 20 minutes writing.
Managing information
Did you pick up on all the information you needed to satisfactorily
answer the question – for example, the complex ownership structure
and the numerous instances of fraud that were implied?
Correct interpretation
of requirements
Did you evaluate the audit risks by showing sufficient judgment and
justification in your answer?
Answer planning
Did you manage to identify all the points in the solution? You didn't
need them all to pass, so would you still have passed in the time you
had?
Effective writing and
presentation
Did you manage to carry all the points from your plan through into
your final answer?
Efficient numerical
analysis
Did you use the results of your analytical procedures to identify areas
of audit risk?
Most important action points to apply to your next question
Summary
Planning the audit and gathering evidence could represent the majority of the marks you need to
pass this exam, so getting used to the skills and techniques described here is essential. Fortunately,
there are many questions that test these skills in the Practice and Revision Kit, so you should be adept
at this when you come to sit the exam for real.
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Completion
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Design audit procedures designed to identify subsequent events which may
require adjustment to, or disclosure in, the financial statements of a given entity.
E1(a)
Evaluate indicators that the going concern basis may be in doubt and recognise
mitigating factors.
E1(b)
Recommend audit procedures, or evaluate the evidence that might be expected
to be available and assess the appropriateness of the going concern basis in
given situations.
E1(c)
Assess the adequacy of disclosures in financial statements relating to going
concern and explain the implications for the auditor's report with regard to the
going concern basis.
E1(d)
Explain the use of analytical procedures in evaluation and review.
E2(a)
Assess whether an engagement has been planned and performed in
accordance with professional standards and whether reports issued are
appropriate in the circumstances.
E2(b)
Evaluate as part of the final review the matters (eg materiality, risk, relevant
accounting standards) and audit evidence to confirm if sufficient and
appropriate evidence has been obtained.
E2(c)
Justify the review procedures which should be performed in a given assignment,
including the need for an engagement quality control review and recommend
additional procedures or actions needed in the circumstances.
E2(d)
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Syllabus
reference no.
Evaluate the use of written representations from management to support other
audit evidence.
E2(e)
Describe appropriate audit procedures relating to:
D3(a)
(xxi)
Events after the end of the reporting period
Explain how the auditor's responsibilities for corresponding figures, comparative
financial statements and 'other information' are discharged.
D3(b)
Discuss the courses of action available to an auditor if a material inconsistency
or material misstatement exists in relation to other information, such as
contained in the integrated report.
E3(h)
Business and exam context
Towards the end of an audit, a series of reviews and evaluations are carried out. You should be
familiar with them from your previous auditing studies.
We start with the overall review which is undertaken on the financial statements as a whole and
the review of misstatements and potential misstatements. The section then discusses the details of a
quality control review of an individual audit.
Often the auditors will have to rely on written representations about related parties and other
issues. Written representations are subjective evidence, and the auditor must proceed with caution
when dealing with them. The auditor conducts reviews of the period between the period end and the
signing of the auditor's report (subsequent events) and of the going concern presumption.
The issue of comparatives is also discussed. The auditor has different responsibilities for
corresponding figures and for comparative information. Finally, the auditor must review other
information to establish whether it contradicts the financial statements. The detailed procedures
and requirements are discussed in Section 4.
Going concern is a particularly important audit review which could be relevant in risks or evidence
questions. Bear in mind the links with planning, knowledge of the business and analytical
procedures. Subsequent events, corresponding figures and other information could also
come up in an exam question in the context of auditor's reports.
Questions in syllabus sections E – G can only be examined in Section B of the exam, and will not be
part of the audit planning question. It is theoretically possible that events after the reporting period
could be examined in Section A of the exam, but this is very unlikely.
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10: Completion
Chapter overview
Completion
1. Overall review of
financial statements
2. ISA 580 Written
representations
4. ISA 570 Going
concern
6. ISA 720 The
auditor's
responsibilities
relating to other
information
3. ISA 560
Subsequent events
5. ISA 710
Comparative
information –
corresponding
figures and
comparative
financial
statements
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1 Overall review of financial statements
1.1 ISA 220 Quality Control for an Audit of Financial Statements
PER alert
One of the competences you require to fulfil Performance Objective 20 of the PER is the ability to
review the performance of an audit, ensuring the process has been undertaken effectively and that
all work undertaken is accurate and complete and that sufficient evidence has been obtained. You
can apply the knowledge you have obtained from this chapter of the Workbook to help demonstrate
this competence.
At the completion stage, the auditor performs an overall review of all work done to ensure the
audit complies with professional standards and all applicable legal and regulatory
requirements, and that evidence is a suitable basis for the audit opinion (ISA 220: para. 6).
The auditors should also consider whether the accounting policies applied are in accordance with
accounting standards, properly disclosed, consistently applied and appropriate to the entity. When
examining the accounting policies, auditors may use a checklist and should consider the following:
Policies commonly
adopted in particular
industries
Policies for which there
is substantial
authoritative
support
Whether any departures
from applicable
accounting standards
are necessary
The financial
statements reflect the
substance of the
underlying transactions
Some audits (such as those for listed companies and other public interest entities) require an
independent engagement quality control review, which evaluates significant
judgments and conclusions reached by the audit team and ensures this has all been done in full
and before the auditor's report is signed by the engagement partner (ISA 220: para. 20).
Essential reading
See Chapter 10 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on ISA 220.
1.2 ISA 520 Analytical Procedures
Relevant trends and ratios are recalculated by the auditor at the completion stage in order to
ensure the consistency of the final version of the financial statements with the evidence that has been
collected during the audit.
Examples of the areas that the analytical procedures at the final stage must cover:
Important accounting ratios
Related items
Changes in products and/or customers
Price and mix changes
Wages changes
Variances
Trends in production and sales
Changes in material and labour content of production
Other statement of profit or loss expenditure
Variations caused by industry or economic factors
The analytical procedures performed at the completion stage are no different from those performed
elsewhere in the audit process. The only difference is that by this time, the auditor should know
enough about the client to be able to point to evidence explaining the issues highlighted by the
analytical review.
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10: Completion
If the auditor finds a previously unrecognised risk of material misstatement at this stage, then it will
have to revise its assessment of audit risk. This may affect materiality, for example, and may mean
that further audit evidence is needed in certain areas.
PER alert
One of the competences you require to fulfil Performance Objective 19 of the PER is the ability to
evaluate evidence collected, demonstrating professional scepticism, investigating areas of concern
and ensuring documentation is complete and all significant matters and areas of judgement are
highlighted. You can apply the knowledge you gain from this chapter of the Text to help demonstrate
this competence.
1.3 ISA 450 Evaluation of Misstatements Identified During the Audit
By the end of the audit, there may be a number of misstatements (including disclosures) that have
been identified as a result of the auditor's procedures. Those that are clearly trivial will be ignored,
while those that the client has already agreed to amend will be reviewed to ensure this has
occurred. What about any remaining misstatements though?
The auditor must consider the impact on the financial statements of uncorrected misstatements,
especially those that are not individually material, because in aggregate, their cumulative effect
may become material (ISA 450: para.11). The auditor needs to evaluate these misstatements and
differentiate between those that are factual misstatements (those that are clearly misstated),
judgmental misstatements (those relating to accounting policies or estimates) and projected
misstatements (which cannot be quantified specifically) (ISA 450: para. A6).
Should the aggregate of uncorrected misstatements start to become material, then the auditor
can either perform further procedures or request management to adjust the financial
statements. Ultimately, this could lead to a modification of the audit opinion if corrections
are not made, so it is essential to discuss this with those charged with governance.
During this stage of the audit, materiality may change due to adjustments made by management, so
the auditor should be alert to the risk that some misstatements may now become material.
The summary of uncorrected misstatements will not only list misstatements from the current
year, but also those from the previous year(s). This will allow misstatements to be highlighted which
are reversals of misstatements in the previous year, such as in the valuation of closing/opening
inventory. Cumulative misstatements may also be shown, which have increased from year to year.
It is normal to show both the statement of financial position and the statement of profit or loss and
other comprehensive income effect, as in the example given here.
SCHEDULE OF UNCORRECTED MISSTATEMENTS
20X2
Statement of
Statement of
profit or loss
financial position
DEBIT
CREDIT
DEBIT
CREDIT
$
$
$
$
20X1
Statement of
Statement of
profit or loss
financial position
DEBIT
CREDIT
DEBIT
CREDIT
$
$
$
$
4,523
(a)
ABC Co receivable
unprovided
10,470
10,470
(b)
Opening/closing inventory
undervalued*
21,540
21,540
(c)
Closing inventory
undervalued
(d)
4,523
21,540 21,540
34,105
34,105
Opening unaccrued expenses
Telephone*
453
453
453
453
Electricity*
905
905
905
905
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฀฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
(e)฀ Closing฀unaccrued฀expenses฀
฀
Telephone฀
฀
(f)฀
฀427
1,128
Electricity฀
฀
Obsolete฀inventory฀write฀off฀ ฀฀฀2,528 ฀
Total฀
*Cancelling฀items฀
฀
฀
฀
20X2
Statement฀of
Statement฀of
profit฀or฀loss
financial฀position
DEBIT฀ CREDIT
DEBIT
CREDIT
$฀
$
$
$
฀427
1,128
฀ 2,528
฀
฀36,093 ฀35,463 ฀35,463 ฀36,093
฀21,540
฀21,540
฀453
905 ฀
20X1฀
Statement฀of฀
Statement฀of
profit฀or฀loss฀
financial฀position
DEBIT
CREDIT฀ DEBIT฀ CREDIT
$
$฀
$฀
$
฀
฀
฀
฀
฀
฀
3,211
฀฀฀฀฀฀฀฀
฀฀฀฀฀฀฀฀฀฀฀
฀
฀
฀฀
฀ ฀3,211฀
9,092
21,540
21,540
฀
฀
฀฀
฀ ฀9,092฀
฀
฀
฀453
905
฀
฀฀฀฀฀฀฀฀฀฀฀฀ ฀
14,553
34,105
34,105
14,553
฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
2฀ISA฀580฀Written฀Representations฀
The฀objectives฀of฀the฀auditor฀under฀ISA฀580฀are:฀฀
(a)฀฀
To฀obtain฀appropriate฀representations฀from฀management฀and,฀where฀appropriate,฀
those฀charged฀with฀governance฀that฀they฀believe฀that฀they฀have฀fulfilled฀their฀responsibility฀
for฀ the฀ preparation฀ of฀ the฀ financial฀ statements฀ and฀ for฀ the฀ completeness฀ of฀ the฀ information฀
provided฀to฀the฀auditor;฀฀
(b)฀฀
To฀support฀other฀audit฀evidence฀relevant฀to฀the฀financial฀statements฀or฀specific฀assertions฀
in฀the฀financial฀statements฀by฀means฀of฀written฀representations฀if฀determined฀necessary฀by฀the฀
auditor฀or฀required฀by฀other฀ISAs;฀and฀฀
(c)฀฀
To฀respond฀appropriately฀to฀written฀representations฀provided฀by฀management฀and,฀where฀
appropriate,฀those฀charged฀with฀governance,฀or฀if฀management฀or,฀where฀appropriate,฀those฀
charged฀with฀governance฀do฀not฀provide฀the฀written฀representations฀requested฀by฀the฀auditor฀
(ISA฀580:฀para.฀6).฀
2.1฀When฀representations฀are฀appropriate฀evidence฀
In฀some฀cases,฀the฀auditor฀must฀seek฀representations฀from฀those฀charged฀with฀governance,฀not฀
management,฀ to฀ address฀ the฀ possible฀ risk฀ of฀ poor฀ management฀ integrity.฀ Representations฀ are฀
appropriate฀when฀facts฀are฀confined฀to฀management฀and฀when฀it฀is฀a฀matter฀of฀opinion฀
or฀judgment฀(ISA฀580:฀para.฀9).฀
2.2฀If฀the฀client฀refuses฀to฀provide฀representations฀
If฀ the฀ responsible฀ party฀ refuses฀ to฀ provide฀ requested฀ representations,฀ this฀ constitutes฀
'insufficient/inappropriate฀audit฀evidence'฀leading฀ to฀ a฀disclaimer฀of฀ opinion฀(this฀would฀also฀
be฀the฀case฀if฀there฀was฀doubt฀over฀management's฀integrity)฀(ISA฀580:฀paras.฀19-20).฀
2.3฀Contents฀of฀a฀typical฀letter฀of฀representation฀
฀
฀
฀
฀
฀
฀
฀
฀
184฀
Responsibilities฀for฀preparing฀the฀financial฀statements,฀including฀significant฀assumptions฀฀
Related฀party฀relationships฀and฀transactions฀
Events฀subsequent฀to฀the฀date฀of฀the฀financial฀statements฀
The฀effects฀of฀uncorrected฀misstatements฀(and฀confirmation฀that฀they฀are฀not฀material)฀
Confirmation฀that฀access฀has฀been฀granted฀to฀all฀information฀
All฀transactions฀have฀been฀recorded฀in฀the฀accounting฀records฀฀
All฀information฀in฀relation฀to฀fraud฀or฀suspected฀fraud฀that฀management฀is฀aware฀of฀
Known฀instances฀of฀non-compliance฀or฀suspected฀non-compliance฀with฀laws฀and฀regulations฀
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10:฀Completion฀
3฀ISA฀560฀Subsequent฀Events฀
Subsequent฀events฀are฀defined฀as฀'both฀events฀occurring฀between฀the฀period฀end฀and฀the฀date฀of฀the฀
auditor's฀report฀and฀facts฀discovered฀after฀the฀date฀of฀the฀auditor's฀report'฀(ISA฀560:฀para.฀5).฀Such฀
events฀ can฀ be฀ either฀ those฀ that฀ have฀ an฀ effect฀ on฀ the฀ financial฀ statements฀ or฀ those฀ that฀ do฀ not฀
(adjusting฀or฀non-adjusting฀events฀as฀per฀IAS฀10฀Events฀after฀the฀reporting฀period).฀
฀
฀
End฀of฀reporting฀
period฀
฀
฀
Date฀of฀authorisation฀of฀
F/S฀and฀auditor's฀report฀
F/S฀issued
AGM
IAS฀10/IAS฀37฀
฀
'SUBSEQUENT฀EVENTS'
฀
฀
฀ Either฀
 Amend฀F/S฀
฀ Or฀
 Modify฀the฀
auditor's฀report฀
฀
 Discuss฀with฀
management,฀
determine฀whether฀
any฀changes฀are฀
required฀to฀F/S฀and฀
enquire฀how฀
management฀intend฀
to฀deal฀with฀them฀
฀
฀
฀
฀
฀
฀
Either฀ Amend฀F/S,฀review฀
evidence฀and฀issue฀
new฀auditor's฀report
 Modify฀if฀auditor's฀
report฀not฀released฀
to฀entity฀฀
฀
฀
฀
฀
Or
฀
฀
฀
฀
 Discuss฀with฀
management,฀
determine฀whether฀
any฀changes฀are฀
required฀to฀F/S฀and฀
enquire฀how฀
management฀intend฀
to฀deal฀with฀them฀
Either  Revise฀F/S,฀review฀
evidence฀and฀issue฀
new฀auditor's฀report฀
including฀Emphasis฀of฀
Matter฀or฀Other฀Matter฀
paragraph฀referring฀to฀
a฀note฀
 Take฀steps฀to฀prevent฀
Or฀
reliance฀on฀auditor's฀
report฀if฀released฀to฀
entity฀eg:฀
–฀ Seek฀legal฀advice
–฀ Resign฀
–฀ Speak฀at฀AGM฀
Activity฀1:฀Subsequent฀events฀
 Take฀steps฀to฀prevent฀
reliance฀on฀auditor's฀
report฀eg:฀
–฀ Seek฀legal฀advice฀
–฀฀ Resign฀
–฀฀ Speak฀at฀AGM
฀
Required฀
What฀procedures฀should฀the฀auditor฀perform฀just฀prior฀to฀signing฀the฀auditor's฀report฀to฀ensure฀there฀
are฀no฀unidentified฀material฀subsequent฀events฀that฀require฀adjustment฀or฀disclosure฀in฀the฀financial฀
statements?฀
฀
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Solution
Essential reading
See Chapter 10 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on subsequent events, especially how audit procedures can vary
depending on where you are in the subsequent events timeline.
4 ISA 570 Going Concern
4.1 Management and auditor responsibilities
MANAGEMENT
 Assess entity's ability to continue as a going concern and present the
financial statements accordingly.
 The assessment should cover at least 12 months from the date of the
financial statements (the auditor shall request that directors extend their
assessment if this period is not covered).
AUDITOR
 Consider the appropriateness of management's use of the going concern
basis of accounting (even if the local GAAP does not require it).
 Consider if there are material uncertainties threatening the client's going
concern status that need to be disclosed (ISA 570: para. 9).
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4.2 Indicators of going concern problems
Financial
Operational
Other

Net liability or net current
liability position



Inability to pay payables on
due dates
Management
intentions to liquidate
entity or to cease
operations
Uninsured or underinsured
catastrophes when they
occur


Shortage of supplies

Emergence of highly
successful competitor
Non-compliance with capital
or other statutory
requirements

Pending legal or regulatory
proceedings that may, if
successful, result in claims
that are unlikely to be
satisfied

Changes in legislation or
government policy expected
to adversely affect the entity


Arrears/discontinuance of
dividends
Fixed-term borrowings
approaching maturity without
realistic prospects of renewal
or repayment

Loss of key
management without
replacement

Withdrawal of financial
support by receivables and
other payables

Loss of major market,
franchise, licence, or
principal supplier

Negative operating cash
flows


Adverse key financial ratios
Labour difficulties or
shortages of important
supplies

Substantial operating losses
or significant fall in value of
cash generating assets

Inability to comply with terms
of loan agreements

Change from credit to cash
on delivery transactions with
suppliers

Inability to obtain financing
for essential new product
development or other
essential investments
The auditor should evaluate the assessment made by management using a variety of techniques:
Analysing and discussing cash flow, profit and other forecasts with management
Analysing and discussing the entity's latest available interim financial statements
Reading the terms of debentures and loan agreements and determining whether any
have been breached
Reading minutes of the meetings of shareholders, those charged with governance and relevant
committees for reference to financing difficulties
Enquiring of the entity's legal counsel regarding litigation and claims
Confirming the existence, legality and enforceability of arrangements to provide or
maintain financial support with related and third parties and assessing the financial ability of
such parties to provide additional funds
Evaluating the entity's plans to deal with unfilled customer orders
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Performing audit procedures regarding subsequent events to identify those that either
mitigate or otherwise affect the entity's ability to continue as a going concern
Confirming the existence, terms and adequacy of borrowing facilities
Obtaining and reviewing reports of regulatory actions
Determining the adequacy of support for any planned disposal of assets (ISA 570:
para. A16)
4.3 Auditor's report implications
Going concern assumption appropriate, but a material uncertainty exists
If the material uncertainty is adequately disclosed, the auditor should express an unmodified
opinion, but add a separate paragraph called 'Material uncertainty related to going
concern' which also states that the auditor's opinion is not modified in this respect.
If there is inadequate disclosure, the auditor expresses a qualified or adverse opinion.
Going concern assumption inappropriate
The auditor should express an adverse opinion if the financial statements have been prepared on
a going concern basis when this is no longer appropriate for the entity. Assuming an alternative
accounting treatment is applied appropriately (such as on a break-up basis) an Emphasis
of Matter paragraph could be used to draw attention to this.
Management unwilling to make or extend an assessment
This would represent insufficient or inappropriate audit evidence and would lead either to a
qualified or disclaimer of opinion, depending on the severity of the circumstances.
Going concern and the auditor's report are covered in more detail in Chapter 11 Reporting.
5 ISA 710 Comparative Information – Corresponding
Figures and Comparative Financial Statements
According to ISA 710 para. 6, comparative information can be of two types:
(a)
Corresponding figures: Where amounts and disclosures for the preceding period are
included as part of current period financial statements
(b)
Comparative financial statements: Where amounts and disclosures for the preceding
period are included separately as an entire statement for comparison purposes
The auditor's opinion relates to the current period financial statements as a whole, so
corresponding figures are not separately identified. The auditor should obtain sufficient appropriate
evidence that accounting policies used are consistent with those of the current period and that
the amounts agree to those presented in the prior period (ISA 710: para. 7).
The extent of any additional audit procedures and the impact on the auditor's report all
depend on whether the prior period financial statements were audited and, if so, by whom.
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5.1 Preceding period financial statements were NOT audited by our
firm
For both corresponding figures and comparative financial statements:
The preceding period F/S were audited by
another firm
The preceding period F/S were not
audited
If there is no legal prohibition from using one, an
'Other Matter' paragraph states:
This can be stated in an 'Other Matter'
paragraph.

That the F/S were audited by another auditor

The opinion issued plus any modifications

The date of that report
In each case, audit procedures from ISA 510 for agreeing opening balances then apply.
5.2 Preceding period financial statements were audited by our firm
For corresponding figures, there are two separate scenarios that need to be considered:
There was no modification to the
preceding period F/S audit opinion, but a
material issue with these figures is
identified during the audit of the current
period:


If the issue is resolved in the current year's
corresponding figures, the auditor's report
remains unmodified (an Emphasis of
Matter paragraph may be used here).
If the issue remains unresolved in the
corresponding figures, the auditor's opinion
is modified in line with the issue's nature and
extent.
There was modification to the
preceding period F/S audit opinion in
relation to the corresponding figures:

If the issue is now resolved in the
current year's corresponding figures,
the auditor's report remains
unmodified in this respect.

If the issue remains unresolved in the
corresponding figures, the auditor's
opinion is modified in line with the
issue's nature and extent.
For comparative financial statements, the auditor should separately identify each period
reported on within the auditor's report. If the opinion on that period has changed since the original
opinion was issued, an 'Other Matter' paragraph should be used to explain why.
6 ISA 720 The Auditor's Responsibilities Relating to Other
Information
The auditor is required to give an opinion as to whether the financial statements give a true and fair
view.
The annual report containing the audited financial statements will also include other information
which the auditor may be required to report on as a separate engagement, such as:
(a)
(b)
(c)
(d)
(e)
The directors' or management's report, including names of directors
Financial summaries, ratios or highlights
Employment data
Selected quarterly data
An integrated report
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6.1 Material misstatements
The auditor must read the other information and be alert for material inconsistencies:


Between the other information and the financial statements; and/or
Between the other information and the auditor's knowledge obtained during the audit.
If any such material inconsistency appears to exist, the auditor shall discuss this with
management and conclude whether there is a material misstatement in either the other
information or the financial statements, or if the auditor's understanding of the entity and its
environment needs to be updated (ISA 720: para. 16).
In any event, inconsistencies between the other information and the financial statements should
always be communicated to those charged with governance.
Amendment necessary to
Auditor response if uncorrected
Audited financial statements
Consider further audit procedures as required by ISAs
and the effect (if any) on the auditor's report.
Evaluate the misstatement(s) in line with ISA 450.
Understand the issue (an expert may be required) and
ask management to revise the other information if it
still requires restatement (if they refuse, ask those charged
with governance).
The other information
If still not corrected, consider the impact on the
auditor's report (see below) or withdraw from the
engagement.
Auditor's understanding
Respond in line with other ISAs (such as ISA 315).
6.2 Reporting other information in the auditor's report
The auditor's report will always include a separate section on other information, but how it is
presented will vary depending on the circumstances (highlighted for key differences).
When the other information contains no material misstatement:
Other Information
Management is responsible for the other information. The other information comprises the
[information included in the X report, but does not include the financial statements and our auditor's
report thereon.]
Our opinion on the financial statements does not cover the other information and we do not express
any form of assurance conclusion thereon.
In connection with our audit of the financial statements, our responsibility is to read the other
information and, in doing so, consider whether the other information is materially inconsistent with
the financial statements or our knowledge obtained in the audit or otherwise appears to be materially
misstated. If, based on the work we have performed, we conclude that there is a material
misstatement of this other information, we are required to report that fact. We have nothing to report
in this regard.
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The other information may not be available to the auditor, so the following is used instead:
Other Information
Management is responsible for the other information. The other information comprises the
[information included in the X report, but does not include the financial statements and our auditor's
report thereon]. The X report is expected to be made available to us after the date of this auditor's
report.
Our opinion on the financial statements does not cover the other information and we do not express
any form of assurance conclusion thereon.
In connection with our audit of the financial statements, our responsibility is to read the other
information identified above when it becomes available and, in doing so, consider whether the other
information is materially inconsistent with the financial statements or our knowledge obtained in the
audit or otherwise appears to be materially misstated. If, based on the work we have performed, we
conclude that there is a material misstatement of this other information, we are required to report that
fact. We have nothing to report in this regard.
There may be cases where the auditor is able to conclude that there is a material
misstatement to the other information and it has not been corrected by management.
In such cases, the section on other information is moved up the auditor's report to a position
immediately after the 'Basis for opinion' section (above key audit matters):
Other Information
Management is responsible for the other information. The other information comprises the
[information included in the X report, but does not include the financial statements and our auditor's
report thereon.]
Our opinion on the financial statements does not cover the other information and we do not express
any form of assurance conclusion thereon.
In connection with our audit of the financial statements, our responsibility is to read the other
information and, in doing so, consider whether the other information is materially inconsistent with
the financial statements or our knowledge obtained in the audit or otherwise appears to be materially
misstated. If, based on the work we have performed, we conclude that there is a material
misstatement of this other information, we are required to report that fact. We have nothing to report
in this regard. As described below, we have concluded that such a material misstatement of the other
information exists.
[Description of the material misstatement in the other information.]
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Chapter summary
Completion
1. Overall review of financial
statements

ISA 220: Evidence supports the proposed audit opinion, accounting policies are consistent
and (if required) an engagement quality control review (EQCR) has been performed
(dated no earlier than the date of the auditor's report)

ISA 520: Final analytical procedures to confirm consistency with audit evidence

ISA 450: Evaluation of misstatements identified during the audit – consider uncorrected
misstatements (especially their aggregate impact on the F/S) and establish which are
factual, judgmental and projected misstatements
2. ISA 580
Written
Representations
3. ISA 560
Subsequent
Events
Objectives of auditor under
ISA 580:
 Period up to auditor's
report



5. ISA 710
Comparative
Information –
Corresponding
Figures and
Comparative
Financial
Statements
 Period after report is
Obtain written
signed
representations from
management (or those
charged with governance)
that they have fulfilled their
responsibilities for preparing
F/S and supplying all necessary
information
Support audit evidence
obtained by written
representations if more detail is
required (eg related parties,
subsequent events, fraud,
NOCLAR, uncorrected
misstatements etc)
Respond appropriately
when representations are
provided (or when they are not
but should be!)
For more guidance on
both going concern and
completing the audit,
please refer to the
examining team's
technical articles.

Corresponding
figures

Comparative
financial statements
4. ISA 570 Going
Concern
Responsibilities?

Management: Assess ability to
continue as a going concern.

Auditor: Consider appropriateness of
use of going concern basis of
accounting – if uncertainties exist but
are disclosed, the auditor's report
should be modified (see overleaf).
Indicators of going concern problems
Other
Financial
Operational
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6. ISA 720 The
Auditor's
Responsibilities
Relating to Other
Information

Material inconsistencies
between (i) items audited within
F/S, (ii) items presented outside
the F/S and not audited ('Other
Information') and/or (iii) the
auditor's knowledge obtained
during the course of the audit which one needs correction?

Discuss with management to
establish whether there is material
misstatement or if the auditor's
understanding of the entity needs
to be updated:
(i) Amendment required to
F/S? Consider further audit
procedures and possible
modified opinion if not
amended
(ii) Amendment required to
'Other Information'?
Understand, request revision – if
not corrected, either withdraw or
modify report (see overleaf)
(iii) Auditor's understanding
inadequate? Respond in line
with ISAs (such as ISA 315).
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Knowledge diagnostic
1.
Overall review of financial statements will determine whether or not appropriate accounting
policies have been used, if information published is compatible with audit findings, if
disclosure is adequate and if information complies with all statutory and regulatory
requirements. The stage of the audit just before the opinion is signed is crucial and the auditor
must perform a final quality control review. This review will also involve an evaluation of
any misstatements identified during the audit to ensure the correct treatment of any that
remain uncorrected.
2.
Representations from those responsible for the financial statements are used to supplement
the opinion where no other evidence exists. There are procedures for obtaining them and
auditors must be aware of what to do if these representations are either not provided or lead to
further questions.
3.
Auditors need to be aware of any subsequent events (adjusting or non-adjusting) that
may occur either before or after they issue their auditor's report to ensure they still give the right
opinion in light of these events.
4.
Both management and auditors have responsibilities regarding going concern, but
auditors should be mindful of any issues that indicate possible going concern problems in any
financial, operational or other areas of the business.
5.
Auditors need to be aware of the implications for their auditor's reports if there are issues with
either corresponding figures or comparative financial statements in the financial
statements.
6.
As well as the audited accounts, the auditor has to be aware of any other information within
the financial statements and ensure that it is both consistent and factually correct. In the event of
any material misstatements or cases where the auditor's understanding of the
entity and its environment needs to be updated, the auditor must determine what
requires amendment and how best to act.
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Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 20 'Bestwood Electronics' tests theory and application related to subsequent events.

Question 21 'Bingham Engineering' tests your knowledge of going concern and how you might
apply certain procedures when reaching any conclusions about the going concern status of an entity.

Question 22 'Lambley Properties' tests your ability to apply your knowledge of written
representations to a more complex scenario.
Further reading
There are some technical articles on the ACCA website written by members of the AAA examining team
which are relevant to some of the topics covered in this chapter that you should read:



Evaluation of misstatements
Completing the audit
Going concern
Own research

Obtain a copy of a recent set of financial statements for an organisation and find as many real life
examples of the following issues discussed in this chapter as you can:
–
–
–
–
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Going concern
Other information
Subsequent events
Corresponding figures
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Reporting
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Determine the form and content of an unmodified auditor's report and assess
the appropriateness of the contents of an unmodified auditor's report.
E3(a)
Recognise and evaluate the factors to be taken into account when forming an
audit opinion in a given situation and justify audit opinions that are consistent
with the results of audit procedures.
E3(b)
Critically appraise the form and content of an auditor's report in a given
situation.
E3(c)
Assess whether or not a proposed audit opinion is appropriate.
E3(d)
Advise on the actions which may be taken by the auditor in the event that a
modified auditor's opinion is issued.
E3(e)
Recognise when the use of an emphasis of matter paragraph, other matter
paragraph and KAM disclosure would be appropriate.
E3(g)
Critically assess the quality of a report to those charged with governance and
management.
E4(a)
Advise on the content of reports to those charged with governance and
management in a given situation.
E4(b)
Business and exam context
At this level, you are not only expected to know what the audit opinion is and how it is presented,
but are also required to determine audit opinions and also assess the appropriateness of an audit
opinion formed by another person.
In this chapter we shall also consider the form of the auditor's report, the criticism that it receives and
whether it enables an auditor to express properly a true and fair view. Recent developments are
considered, dwelling in detail on the inclusion of key audit matters in some auditor's reports. We
shall also look at the auditor's requirements in relation to reporting to those charged with
governance.
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Auditor reporting questions at this level tend to be challenging, but 'do-able', particularly if you have
practised similar questions and have established a step by step approach to questions on forming an
auditor's opinion. You are very likely to encounter a question on auditor's reports in Section B of the
exam, and are guaranteed a question on syllabus Section E (covering completion, subsequent events
and going concern, and reporting).
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11: Reporting
Chapter overview
Reporting
1 ISA 700 – an overview
2 Standard unmodified
report with unmodified
opinion
3 Modifications to the
auditor's report
4 Modified report with
unmodified opinion
(ISAs 706 and 570)
Emphasis of
Matter
paragraphs
Other Matter
paragraphs
5 Modified audit opinions
(ISA 705)
Going
concern
2.1 ISA 260
Communication with those
Charged with Governance
Insufficient or
inappropriate
audit evidence
Material
misstatement
2.2 ISA 265 Communicating
Deficiencies in Internal Control
to those Charged with
Governance and Management
2.3 ISA 701 Communicating
Key Audit Matters in the
Independent Auditor's Report
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1 ISA 700 – an overview
The primary objective of the audit is to express an opinion on the truth and fairness of the
financial statements. The format of the basic auditor's report is laid down in ISA 700 Forming an
opinion and reporting on financial statements. This is supported by ISA 701
Communicating key audit matters in the independent auditor's report.
PER alert
One of the competences you require to fulfil Performance Objective 20 of the PER is the ability to
prepare auditors' reports in accordance with relevant standards on auditing, or equivalent standards,
and applicable regulations and legislations. You can apply the knowledge you obtain in this chapter
of the Workbook to help demonstrate this competence.
2 Standard unmodified report with unmodified opinion
The standard report as laid down by ISAs 700, 701 and 720 looks like this (in overview):
INDEPENDENT AUDITOR'S REPORT
To the shareholders of the company [or other appropriate addressee.]
Opinion
[Includes the individual statements and the reporting period under review for the company being
audited. It can use either 'give a true and fair view' or 'presents fairly, in all material respects' and
states the relevant GAAP adopted.]
Basis for opinion
[This is always presented after the opinion and explains how the audit was conducted: the role of
ISAs and the IESBA Code of Ethics as well as the audit evidence being sufficient and appropriate to
provide a basis for the auditor's opinion.]
Key audit matters
[As per ISA 701, matters of most significance from the audit; required for all listed entities.]
Other information
[As per ISA 720, communicates that there is nothing to report regarding other information.]
Responsibilities of management and those charged with governance for the
financial statements
[Preparation and fair presentation of the financial statements, including internal controls, and the
assessment of the company's ability to continue as a going concern.]
Auditor's responsibilities for the audit of the financial statements
[A detailed summary of the auditor's objectives, starting with obtaining reasonable assurance about
the financial statements being free from material misstatements due to fraud or error. Stresses the role
of professional judgment and scepticism over accounting policies and estimates, judgments, internal
controls, presentation, disclosure and communicating key audit matters and other issues with those
charged with governance.]
Report on other legal and regulatory requirements
[Form and content of this section of the auditor's report will vary depending on the nature of the
auditor's other reporting responsibilities.]
Signed
[Auditor's name and/or signature, address and date of the auditor's report.]
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11: Reporting
Essential reading
See Chapter 11 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more on the auditor's report, including a full reproduction of the auditor's report.
2.1 ISA 260 Communication with those Charged with Governance
In addition to reporting to shareholders, the external auditor is expected to communicate matters of
audit importance to those charged with governance (TCWG) – usually the directors, but this
could be an audit committee as well, so the auditor should establish to whom they must
report. This should be an ongoing, two-way dialogue and is initiated at the engagement stage to
avoid any omissions, as well as how (in writing) and when (described in the ISA as 'timely').
The items to be communicated relate to the auditor's responsibilities as part of the audit
and information relevant to the audit from TCWG, as well as any issues arising from the audit.
This is sometimes referred to as the Management Letter and includes significant findings from
the audit, such as views about the chosen accounting policies, difficulties encountered during
the audit and any other matters relevant to the oversight of the financial reporting
purpose.
2.2 ISA 265 Communicating Deficiencies in Internal Control to those
Charged with Governance and Management
This standard deals with any specific internal control issues identified to ensure they are
communicated promptly for the right action to be taken. The issues communicated are only those
identified during the course of the audit as necessary to the creation of the financial
statements under review: they are not an assessment of the overall adequacy of the accounting
and internal control systems currently operated by management.
Deficiencies are classified as significant if they warrant the attention of TCWG. Findings are
usually presented along with recommendations and a timescale.
Essential reading
See Chapter 11 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more on how the auditor reports their findings to those charged with governance and
management.
2.3 ISA 701 Communicating Key Audit Matters in the Independent
Auditor's Report
If the auditor has a responsibility to report matters of audit significance under ISAs 260 and
265, why are key audit matters (KAMs) included in the auditor's report? ISA 701 requires the
auditor to determine KAMs from the matters communicated to TCWG and, having already
formed an opinion on the financial statements, communicate those matters to shareholders
and other users of the financial statements by describing them in the auditor's report before
reporting them as KAMs to TCWG.
The auditor should keep appropriate documentation of all KAMs: they are defined as being those
matters that, in the auditor's professional judgment, were of most significance in the audit of the
financial statements of the current period. They are required for all listed entity auditor's
reports and are part of the standard unmodified report (so they are not the same as Emphasis of
Matter or Other Matter paragraphs and do not lead to a modification of the auditor's opinion).
Identifying such matters requires the auditor to use professional judgment – for example:

Material, complex or subjective items, especially any associated misstatements
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
Matters where the auditor encountered difficulty or required extra audit effort

Areas where audit procedures were difficult to apply or where several issues
converged
It should be obvious that KAMs are audit matters, not just difficult areas of financial reporting. The
decision-making framework looks like this:
Matters that were communicated with
those charged with governance
Matters that required
significant auditor
attention
KAMs
=
Matters of most
significance
Source: IAASB Determining and Communicating Key Audit Matters (IAASB 2016b)
KAMs should be disclosed within the 'Key audit matters' section of the auditor's report stating why
they were assessed as KAMs, how they were addressed during the audit and the note from the
financial statements where more detail is supplied by the audited entity. If it is felt that disclosure
would compromise the need for confidentiality (eg in cases of money laundering) or if the law
precludes it, the auditor can choose not to communicate specific KAMs.
It is extremely unlikely that there will be no KAMs from an audit but if this is the case, there is still a
section headed 'Key audit matters' stating that there are none. Going concern uncertainty is not
treated as a KAM, as that would have its own section if required within a modified auditor's report
(see below).
Essential reading
See Chapter 11 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for further details of how the auditor's report has become more informative over recent
years, including the perceived benefits of using KAMs.
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11: Reporting
3 Modifications to the auditor's report
Auditors’ reports
Unmodified
report
Modified report with
unmodified opinion
Emphasis
of matter
Modified audit
opinions
Insufficient/
Inappropriate
evidence
Other
matter
Unmodified
opinion
Material
uncertainty
related to
going
concern
Material
but not
pervasive
Material
and
pervasive
Material
Misstatement
Material
but not
pervasive
Material
and
pervasive
'Without modifying
our opinion, we draw
attention to...'
'true and fair view'
Qualified opinion
'except for...'
Multiple
significant
uncertainties?
Qualified opinion
'except for...'
Disclaimer of opinion
'do not express an
opinion'
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Adverse opinion
'do not give a true
and fair view'
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4 Modified report with unmodified opinion
4.1 ISA 706 Emphasis of Matter Paragraphs and Other Matter
Paragraphs in the Independent Auditor's Report
In the auditor's opinion, it may be necessary to draw users' attention to matters presented
within the financial statements or other information in the annual report that are of such
importance they are fundamental to users' understanding of either the financial statements or the rest
of the audit including the report.
An 'Emphasis of matter' paragraph draws users' attention to issues that are adequately
disclosed within the financial statements that they need to see in order to understand them
properly, such as:
Uncertainties relating to future outcomes of exceptional litigation or regulatory action (where there
are multiple uncertainties, the auditor may feel it is appropriate to express a disclaimer of opinion
instead – however, 'Emphasis of matter' paragraphs are not used to address going
concern uncertainties, as a separate section of the auditor's report is used to communicate such
matters – see below)
Early application of new accounting standards
A major catastrophe that has had, or continues to have, a significant effect on the entity's financial
position
If a new auditor's report is issued (such as when ISA 560 Subsequent events applies)
An item equivalent to a significant KAM but that has not been included in the 'Key audit matters'
section of the auditor's report (items can be in one or the other but not both)
The additional paragraph should be added immediately after the basis for opinion
paragraph in the auditor's report, using the heading 'Emphasis of matter' including full
details of the matter and the location within the financial statements which explains the issue
further. It is up to the auditor's judgment whether to place the Emphasis of Matter paragraph before
or after the 'Key audit matters' section.
The paragraph states that the auditor's opinion is not modified in respect of this matter –
the use of such a paragraph must only occur if the matter in question has been adequately
treated and disclosed in the financial statements and the auditor is in agreement with this.
An 'Other matter' paragraph draws users' attention to issues outside the scope of the
financial statements (so therefore items not addressed by 'Emphasis of matter' paragraphs) and
can include anything else that users need to know about the audit, such as:
Issues related to ISA 510 Initial Engagements – Opening Balances
Items relating to the conduct of the audit (eg being unable to withdraw as auditor)
Disclosure or comment required by laws, regulations or local GAAP
Other Matter paragraphs must not refer to KAMs as other matters are by definition beyond the scope
of the audited financial statements. Similarly, ISA 720 The Auditor's Responsibilities Relating
to Other Information regarding other information does not make use of an 'Other matter'
paragraph either, as this is referred to within a separate section of the auditor's report.
The additional paragraph is headed 'Other matter' and shall be included after the basis for
opinion paragraph, after any 'Emphasis of matter' paragraph and after the 'Key
audit matters' section.
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11: Reporting
4.2 Modification of the auditor's report due to going concern issues
In previous sections of these materials, we learned that if there was a material uncertainty related to
going concern but the use of the going concern assumption was still appropriate, as long as the
disclosure made by the audited entity was deemed adequate by the auditor, an unmodified opinion
could be issued but a separate disclosure was required within the auditor's report.
This appears immediately after the 'Basis for opinion' section: remember that any
uncertainty related to going concern is not a KAM and does not get reported by an Emphasis of
matter paragraph.
The following is an illustration of what this section of a modified auditor's report would look like
(taken from ISA 570 Going Concern):
Material Uncertainty Related to Going Concern
We draw attention to Note 6 in the financial statements, which indicates that the Company incurred
a net loss of ZZZ during the year ended 31 December 20X1 and, as of that date, the Company's
current liabilities exceeded its total assets by YYY. As stated in Note 6, these events or conditions,
along with other matters as set forth in Note 6, indicate that a material uncertainty exists that may
cast significant doubt on the Company's ability to continue as a going concern. Our opinion is not
modified in respect of this matter.
Activity 1: Spot the ball
Required
On the proforma, indicate where the following items would appear on a modified auditor's report:
(1)
A misstatement in the other information presented within the document containing the
financial statements
(2)
A material uncertainty related to going concern adequately disclosed in the financial
statements
(3)
An Emphasis of matter paragraph explaining an uncertainty related to ongoing
litigation
(4)
An Other matter paragraph explaining that the prior year financial statements were
audited by another firm
Solution
INDEPENDENT AUDITOR'S REPORT
Opinion
Basis for opinion
Key audit matters
Other information
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Responsibilities of management and those charged with governance for the
financial statements
Auditor's responsibilities for the audit of the financial statements
Report on other legal and regulatory requirements
Signed
5 Modified audit opinions
5.1 ISA 705 Modifications to the Opinion in the Independent Auditor's
Report
There are three types of modified opinion that the auditor can issue (depending on the cause
or nature of the matter giving rise to any modification and the impact or pervasiveness of
that matter on the financial statements):
(a)
(b)
(c)
A qualified opinion;
An adverse opinion; or
A disclaimer of opinion.
From ISA 705 para. 5a, the term 'pervasive' has the following definitions:
The matters giving rise to any modifications:
Are not confined to specific elements, accounts or items of the financial statements;
If so confined, represent or could represent a substantial proportion of the financial statements;
or
In relation to disclosures, are fundamental to users' understanding of the financial statements.
The types of modification can be summarised as follows by considering the judgments required by
the auditor in two key respects – nature (cause) and pervasiveness (impact):
Auditor's judgment about the pervasiveness of the
effects or possible effects on the financial statements
Nature of matter giving
rise to the modification
Financial statements are
materially misstated
(The term 'Disagreement' is
used in the UK)
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Material but not pervasive
Material and pervasive
Qualified opinion
Adverse opinion
('except for the effects of the
matter described in the basis
for qualified opinion
section…')
('because of the significance of
the matter discussed…the financial
statements do not give a true and
fair view…')
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11: Reporting
Auditor's judgment about the pervasiveness of the
effects or possible effects on the financial statements
Nature of matter giving
rise to the modification
Inability to obtain sufficient
appropriate audit evidence
(The term 'Limitation on scope'
is used in the UK)
Material but not pervasive
Material and pervasive
Qualified opinion
Disclaimer of opinion
('except for the possible
effects of the matter
described in the basis for
qualified opinion section…')
('we do not express an opinion
…because of the significance of
the matter described…')
5.2 Material misstatements
The circumstances leading to a modification due to material misstatement could include:

The appropriateness of selected accounting policies (either inconsistent with the applicable
financial reporting framework or those that do not lead to fair presentation)

The application of selected accounting policies (through either inconsistency or error)

The appropriateness or adequacy of disclosures in the financial statements
5.3 Inability to obtain sufficient appropriate audit evidence
The circumstances leading to a modification due to being unable to obtain sufficient appropriate
audit evidence are as follows:

Circumstances beyond the control of the entity (such as the loss of records in a fire)

Circumstances relating to the nature or timing of the auditor's work (eg the auditor
being appointed after the date of counting physical inventory stocks)

Limitations on the scope of the audit imposed by management (such as management
denying access to third parties for external confirmations)
Essential reading
See Chapter 11 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for illustrations of the wording used when the auditor's opinion is modified.
5.4 Modifications within the report
When the auditor has to issue a modified opinion, the 'Basis for opinion' section should provide a
description of the matter giving rise to the modification, the details of any corrections required (only
possible with misstatement due to being able to quantify such issues, or recommend the required
disclosure) or the uncertainty remaining (by definition, usually unquantifiable). This should be titled
'Basis for qualified/adverse/disclaimer of opinion' and follows the opinion paragraph.
Similarly, for modified opinions, the opinion paragraph should be titled 'Qualified/Adverse
/Disclaimer of opinion' and should use the relevant modification terminology depending on the opinion
chosen.
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5.4.1 Actions when an auditor's report is modified
When a modified opinion is likely, the auditor should consider the following implications:
TCWG need to be
informed of any such issue
and the reason for it
(allowing TCWG
opportunity to respond)
External
consultation with
regulators or others
may be required
Management integrity
may be called into question
(including any representations
supplied) meaning an
EQCR is required
Possible
withdrawal from
the engagement (and
seek legal advice?)
Activity 2: Santa
You are an audit partner. Your firm carries out the audit of Santa, a listed company. Because the
company is listed, you have been asked to perform a second partner review of the audit file for the
year ended 31 December 20X3 before the audit opinion is finalised. Reported profit before tax is
$2.35 million and total assets are $9.5 million.
You have read the following note from the audit file:
'Debt: Rudolph
There is a debt outstanding from Rudolph, a limited liability company, from January 20X3 in respect
of a vehicle developed by Santa to Rudolph's own specification. Rudolph has disputed the quality of
the vehicle and also does not agree that it was made completely to the specification. The company
has submitted the dispute with Santa to arbitration, in accordance with its contractual agreement.
Rudolph was a major customer up until the time of the dispute, often accounting for 50% of sales
ledger total. It has not placed any orders with Santa in 20X3 or 20X4, preferring a French supplier
which is Santa's only real competitor in the European market.
The directors of Santa are confident that at arbitration Rudolph will be required to pay the full bill,
which is in the region of $1 million. They state that the quality of the machine is irrefutable and that
any amendments to the specification were only safety improvements. The arbitral decision, which is
not subject to appeal, is expected after the date of the AGM. Given their confidence, the directors of
Santa have refused to refer to the dispute in the financial statements.
Given that the outcome of this arbitration is by no means certain, the potential overstatement of the
debt is material and the permanent loss of Rudolph's custom could affect the going concern opinion,
the following modification to the auditor's report is proposed:
Disagreement on Accounting Policies – Inappropriate Accounting Method – Adverse
opinion
No allowance has currently been made for the impairment of an outstanding debt from Rudolph in
respect of a dispute over a contract which has currently been submitted to arbitration, which, in our
opinion, is not in accordance with International Financial Reporting Standards. An allowance of
$1 million should be made in respect of this debt. Accordingly, receivables, profit for the period and
retained earnings should be reduced by $1 million. Also, due to its significance, this allowance
should have been disclosed separately in accordance with IAS 1 Presentation of financial statements.
In our opinion, because of the effects of the matters discussed in the preceding paragraph, the
financial statements do not give a true and fair view of the financial position of Rudolph Company as
of 31 December 20X3, and of its financial performance and its cash flows for the year then ended in
accordance with International Financial Reporting Standards.'
Required
Comment on the appropriateness of the proposed audit opinion, and critically appraise the form and
content of the proposed auditor's report, recommending improvements where necessary. (8 marks)
Note. You are not required to redraft the extracts from the auditor's report.
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11: Reporting
Solution
Essential reading
See Chapter 11 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for further details of how to critically appraise an auditor's report.
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Chapter summary
Reporting
1 ISA 700 – an overview



ISA 700 Forming an Opinion and Reporting on Financial Statements
ISA 701 Communicating Key Audit Matters in the Auditor's Report Outside of F/S
ISA 720 The auditor's responsibilities relating to other information
2 Standard unmodified report
with unmodified opinion
3 Modifications to the
auditor's report
Key contents:










Title – independent auditor's report
Addressee
Opinion
Basis for opinion
Key audit matters
Other information
Responsibilities
Legal and regulatory
Signature
Date
5 Modified audit opinions
(ISA 705)
Insufficient or
inappropriate
audit evidence
4 Modified report with unmodified
opinion (ISAs 706 and 570)
Going
concern
paragraph
Emphasis of
matter
paragraph
208

If material to F/S
but not pervasive,
issue a Qualified
opinion ('except
for')

If unable to form an
opinion (both
material and
pervasive) issue a
Disclaimer of
opinion ('we do
not express an
opinion')
Other matter
paragraph

Opinion is
unmodified

Opinion is
unmodified

Opinion is
unmodified

Draws attention
to uncertainty
disclosed in
F/S (not G/C)

Draws
attention to
going
concern
(G/C)
issues only

Draws
attention to
issues
outside of
F/S
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Material
misstatement

If material to F/S
but not
pervasive, issue
a Qualified
opinion
('except for')

If misstatement is
so severe (both
material and
pervasive) issue
an Adverse
opinion ('the
F/S do not give
a true and fair
view')
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11: Reporting
ISA 260 Communication with those Charged with Governance
ISA 265 Communicating Deficiencies in Internal Control to
those Charged with Governance
 ISA 260 addresses management letter points – matters of audit
importance (eg adjustments required, disagreements over treatment)
 ISA 260 also defines those charged with governance (TCWG) at
engagement stage
 ISA 265 ensures that any specific internal control weaknesses
identified during the audit are brought to the attention of those
charged with governance and not subject to management bias.
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Knowledge diagnostic
1.
Auditors' reports are the only tangible output produced by the auditor; it is therefore very
important that the opinion expressed is appropriate in the circumstances and the report
follows the correct approach.
2.
The basic auditor's report uses ISAs 700, 701 and 720 to produce a standardised report
format depending on the jurisdiction applied. ISAs 260 and 265 cover Management
Letter points.
3.
It is important that you understand the different modifications that can be made to the
standard auditor's report, including forms of additional communication.
4.
To ensure that the users of financial statements are not misled, additional information is required
such as Emphasis of matter (drawing attention to matters adequately disclosed within the
financial statements) and Other matter (anything outside the scope of the financial statements)
paragraphs and disclosure of going concern uncertainties.
5.
The auditor has to decide on the nature and pervasiveness of any matters that lead to
opinions such as qualified, adverse or a disclaimer of opinion. Such matters can relate to
material misstatements ('disagreement' in the UK) or insufficient/inappropriate audit evidence
('limitations on scope' in the UK).
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11: Reporting
Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 12 'Illuminations' tests theory and application related to appointments and opening
balances, so should be viewed as good revision of what you have covered so far.

Question 15 Recognition' requires you to think about what's really happening and consider the
implications for the auditor's report.

Question 23 'Maple' is a more traditional question testing fraud as well as your knowledge of
reporting.

Question 24 'Petrie' blends together a number of syllabus areas but requires you to know the impact
on the auditor's report and opinion.
Further reading
There are some technical articles on the ACCA website written by members of the AAA examining team
which are relevant to some of the topics covered in this chapter that you should read:

Exam technique for Advanced Audit and Assurance – part 5 auditor reporting

The new auditor's report

Auditor's reports to those charged with governance

Auditor reporting – an update for P7 students on Key Audit Matters (P7 INT) and the Extended
Auditor's Report (P7 UK)
Own research

Obtain a copy of a recent set of financial statements for an organisation and find as many real life
examples of auditor's reports as you can.
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SKILLS CHECKPOINT 4
Completion and reporting
pl
An
sw
er
pl
g
nin
an
Legal and ethical
responsibilities
Practice
management
Exam success skills
an
d
nt r itin
ati g
on
Efficient numeric
analysis
l
Efficient numerica
s
i
s
y
l
ana
al
Co
Non-audit
engagements
and
current
ve
issues
s e w r it
nt in g
e at i o n
w
Planning the
audit and
gathering
Completion
evidence
and reporting
Completion
and reporting
r re
c
o f t i n te
re q r p re t a t i o n
u ire
m e nts
Specific AAA skills
ti
e c re v
Eff d p cti e
an E ffe pr
se
An
sw
er
g
nin
an
Good
T ood
Manag Gim
e tim
em
e
m
aneag
nteme
nt
aging information
Man
Introduction
The ACCA has confirmed that one of the 25 mark questions will always come from syllabus Section E, and
consequently candidates should be prepared to answer a question relating to completion, review and reporting.
As a result, this skills checkpoint will cover some of the topics most likely to be seen in these types of questions
and the skills required to produce great answers.
Questions on completion and reporting tend to go well together – when you consider issues such as going
concern, subsequent events and the evaluation of the auditor's findings, inevitably they will need to considered
in the context of the auditor's report and any other communication that might be necessary.
If you struggled with any of the terminology or approaches adopted for this part of the syllabus, you are advised
to return to Chapters 10 and 11 now to refresh your memory as this checkpoint assumes you are familiar with
the learning materials.
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Skills Checkpoint 4: Completion and reporting
AAA Skill: Completion and reporting
A step by step technique for approaching questions testing this part of the syllabus now follows (you
may find that some of these techniques are suitable for other parts of the syllabus as well – why not
start practising them now?)
STEP 1:
Determine which parts of the syllabus
the requirement is testing.
STEP 2:
Actively read the scenario to identify
the key issues.
STEP 3:
Consider the implications of the isues
identified in Step 2 for the auditor's
opinion (both cause and extent).
STEP 4:
Consider whether there are any
additonal impacts on the auditor's
report from the issues identified in
Step 2.
STEP 5:
Write your answer.
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Skills Checkpoint 4
Exam success skills
There are some key exam skills that will help you when answering questions from this topic which are
summarised below:

Answer planning. In order to help you tailor your answer to include the correct
number of points, a form of 'scaffolding' to construct your answer plan might help. Let's
consider a recent exam question.
For each of the three matters described above:
(i)
Explain the matters which should be discussed with management in
relation to each of the uncorrected misstatements, and
(ii)
Assuming that management does not adjust the misstatements
identified, evaluate the effect of each on the audit opinion.
Note. The total marks will be split equally between each matter.
(15 marks)
With 195 minutes to find 100 marks, that works out as 1.95 minutes per mark, meaning
this 15 mark requirement should take no more than 29 minutes in total. 25% of that
time would mean 7 minutes for reading, thinking and planning, leaving you 22
minutes to write your answer. What will you need to produce for each of the three matters
mentioned in the requirement?
Matter 1
Matter 2
Matter 3
(i) Matters to be
discussed
(ii) Effect on the
opinion
Marks for each
matter
1)
1)
5 marks
2)
2)
3)
3)
1)
1)
2)
2)
3)
3)
1)
1)
2)
2)
3)
3)
5 marks
5 marks
During your 7 minutes of reading, thinking and planning time, you should devise something
like this and use it as a form of scaffolding to support your answer. We are told in the
requirement that the 15 marks are split equally between the three matters, so each should
score 5 marks, and for each matter, there are two tasks: (i) the matters to be considered and
(ii) the impact on the audit opinion. In general, well-explained points score 1 mark, so to score
5 marks for each matter, you will need two or three points for each task. By filling in as many
of the shaded gaps in the scaffolding above as you can, you are giving yourself the best
chance of tailoring your answer to the requirements.
This approach may seem like a lot to do in only 7 minutes, but it should help you make the
most of your valuable reading, thinking and planning time.
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
Efficient numerical analysis. Questions that test this part of the syllabus are usually going
to require two main areas where you will need to consider calculations: the first is to determine
the level of materiality so you can judge whether or not something is material; the second is
to confirm the amount of any misstatement(s). Let's look at both of these using the
following example:
A company's draft financial statements include an inventory balance of $325,000 for goods
which have recently been banned by legislation. A resale market for similar goods has
appeared but is not expected to generate more than 50% of cost price at best. The draft profit
before tax of the company is $4.25 million. What is the potential impact on the auditor's
opinion if the inventory balance is not amended?
First, the potential misstatement if no changes are made is going to start at $162,500 (50%
of $325,000) but could rise as the resale value is 50% of cost price at best, so if this value
falls, the misstatement would increase. Secondly, materiality would start at 5% of $4.25
million = $212,500 meaning that if the resale value fell to $112,500 (calculated as
$325,000 - $212,500, around 35% of cost price) the misstatement (the amount that the
inventory is overvalued by) would become material, most likely leading to a qualified opinion.
Further work would be required to determine the likely resale value before this could be
confirmed.

Effective writing and presentation. This should be a fairly quick win – a common
criticism of candidates' answers to questions testing completion and reporting is that they are
too vague and often cover a variety of points in the hope that the right one is buried
somewhere within the text (the so-called 'scatter-gun' approach).
You can address this by either committing to a course of action and simply stating your
conclusion or (if there is further uncertainty that cannot be confirmed without further work
being done) presenting a range of options depending on the outcome of that further work.
Make your answers as clear as possible to give yourself the best chance of success.

Good time management. In this exam, the ability to manage your time across all three
questions is vital. When reading through the exam you should calculate how long you
need to spend on each question. However, this should then be broken down into
individual requirements, and should also show when each of these will expire.
Therefore you should annotate the question with the time for each part and when you
should finish it. Remember to use 1.95 minutes per mark here. Once this is matched up
with your 'scaffolding' skills above, you should have a really tight plan.
Continuing the example from above, your plan would have looked like this:
Matter 1
Matter 2
Matter 3
216
(i) Matters to be
discussed
(ii) Effect on
the opinion
Marks for
each matter
1)
1)
5 marks
2)
2)
3)
3)
1)
1)
2)
2)
3)
3)
1)
1)
2)
2)
3)
3)
29 minutes =
start at 11.25
and finish at
11.54
5 marks = 10
minutes =
11.35
5 marks
5 marks
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5 marks = 10
minutes =
11.45
5 marks = 10
minutes =
11.54
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Skills Checkpoint 4
You can permit yourself a slight time overrun to try and finish each question, but no
more than a couple of minutes: you must remember that the more time spent on one
question automatically takes time from the others. You should only aim to overrun on
your best questions, when the extra time is likely to score more marks – don't waste time
finishing off a question that you are unlikely to score well on at the expense of another higher
scoring requirement.
Skill Activity
STEP 1
Determine which part(s) of the syllabus the requirement is testing.
You are an audit partner. Your firm carries out the audit of Branch Co, a public company. Because
the company is a public interest entity, you have been asked to perform a second partner review of
the audit file for the year ended 30 June 20X8 before the audit opinion is finalised. Reported profit
before tax is $1.65 million and the statement of financial position total is $7.6 million.
You have read the following notes from the audit file.
Earnings per share
As required by IAS 33 Earnings per share, the company has disclosed both basic and diluted
earnings per share. The diluted earnings per share has been incorrectly calculated because the share
options held by a director were not included in the calculations. Disclosed diluted earnings per share
are 22.9c. Had the share options held by the director been included, this figure would have been
22.4c. This difference is immaterial.
Financial performance statement
The directors have currently not amended certain financial performance ratios in this statement to
reflect the changes made to the financial statements as a result of the auditors' work. The difference
between the reported ratios and the correct ratios is minimal.
Opinion
We recommend that an unmodified auditor's report be issued.
A corporate governance statement referring to the UK Corporate Governance Code is to be issued
as part of the annual report, but there is no evidence on file that this has been reviewed by the audit
team. You are aware that the company does not have an audit committee.
You are also aware that the director exercised their share options last week.
Required
Comment on the suitability of the proposed audit opinion and other matters arising in the light
of your review. Your comments should include an indication of what form the auditor's report
should take.
Topics covered:
1. Critical appraisal of draft opinion
2. Review of audit evidence collected
3. Other information re: ISA 720
4. Subsequent events?
5. Forming an audit opinion
6. Other reporting?
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STEP 2
Actively read the scenario to identify the key issues, matching them to the syllabus
areas identified in Step 1.
You are an audit partner. Your firm carries out the audit of Branch Co, a public company. Because
the company is a public interest entity, you have been asked to perform a second partner review of
the audit file for the year ended 30 June 20X8 before the audit opinion is finalised. Reported profit
before tax is $1.65 million and the statement of financial position total is $7.6 million.
You have read the following notes from the audit file.
2. Review of
audit evidence
collected –
material by
nature as
relates to a
director, plus
misstated
amount is
relevant to
investors
1. Critical
appraisal of
draft opinion
5. Forming an
audit opinion
Material
misstatement re:
EPS and
possible
misstatement re:
share options
(below)
Earnings per share
As required by IAS 33 Earnings per share, the company has disclosed both basic and diluted
earnings per share. The diluted earnings per share has been incorrectly calculated because
the share options held by a director were not included in the calculations. Disclosed diluted
earnings per share are 22.9c. Had the share options held by the director been included, this
figure would have been 22.4c.
This difference is immaterial.
Financial performance statement
The directors have currently not amended certain financial performance ratios
in this statement to reflect the changes made to the financial statements as a
result of the auditors' work. The difference between the reported ratios and the
correct ratios is minimal.
Opinion
We recommend that an unmodified auditor's report be issued.
A corporate governance statement referring to the UK Corporate Governance
Code is to be issued as part of the annual report, but there is no evidence on
file that this has been reviewed by the audit team. You are aware that the
company does not have an audit committee.
You are also aware that the director exercised their share options last week.
4. Subsequent events – why would a director
exercise their share options? Usually if a new
issue has been made – this would be an
adjusting event so if not disclosed is a material
misstatement
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3. Other
information re:
ISA 720 –
inconsistency –
if material,
need to amend
report
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6. Other
reporting – CG
does not affect
the opinion, but
may need to be
addressed as
part of
reporting under
ISA 720 or
other
responsibilities
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Skills Checkpoint 4
STEP 3
Consider the implications of the issues identified in Step 2 for the auditor's opinion
(both cause and extent).
When determining the impact of an issue on the audit opinion, there are always going to be two
elements to consider if the opinion requires modification: (1) the cause of the modification and (2) the
extent. Let's remind ourselves of the various forms of modification that exist.
Qualified
opinion
Qualified
Adverse
opinion
Qualified
opinion
Disclaimer
of opinion
(2) Material AND pervasive
(2) Material BUT NOT pervasive
(1) Misstatement (amounts or disclosures)
(1) Insufficient, inappropriate audit evidence
Applying this to Branch Co, both the share issue and the EPS calculations represent misstatements –
as they are (i) fairly self-contained, (ii) do not represent a substantial part of the financial statements
and (iii) are unlikely to be fundamental to users' understanding of the financial statements, they are
not pervasive, but are material, so a qualified opinion would be most appropriate here.
STEP 4
Consider whether there are any additional impacts on the auditor's
report from the issues identified in Step 2.
We have already seen the impact on the auditor's opinion from Step 3 – this will require a
modification to the standard auditor's report not only for the opinion section, but also to the basis
section as well.
However, while some matters may not affect the audit opinion, they may still require a modification
to the standard auditor's report. The completion standards in particular (such as those related to
going concern, subsequent events and other information) can fall into this category and we have one
such issue to consider from Branch Co:
The directors have currently not amended certain financial performance ratios in this statement
to reflect the changes made to the financial statements as a result of the auditors' work.
The difference between the reported ratios and the correct ratios is minimal.
If the inconsistency is not amended by Branch Co's
management, we would need to determine
whether or not the inconsistency was material – if
material, this should be disclosed using the 'Other
Information' section of the auditor's report
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STEP 5
Write your answer.
Earnings per share
The problem in the earnings per share (EPS) calculation relates to share options held by a director.
As they are held by a director, it is unlikely that they are immaterial, as matters relating to directors
are generally considered to be material by their nature. The fact that EPS is a key shareholder ratio,
which is therefore likely to be material in nature to the shareholders, should also be considered.
As the incorrect EPS calculation is therefore material to the financial statements, the auditor's report
should be modified in this respect, unless the directors agree to amend the EPS figure. This would be
an 'except for' modification on the grounds of material misstatement.
Share options
The share options have not been included in the EPS calculations. The auditors must ensure that the
share options have been correctly disclosed in information relating to the director, both in the
financial statements and the other information, and that these disclosures are consistent with each
other. If proper disclosures have not been made, the auditor will have to express a modified opinion
due to lack of disclosure in this area.
Exercise of share options
The fact that the director has exercised their share options after the year end does not require
disclosure in the financial statements. However, it is likely that they have exercised them as part of a
new share issue by the company and if so, the share issue would be a non-adjusting event after the
reporting period that would require disclosure in the financial statements. We should check if this is
the case and, if so, whether it has been disclosed. Non-disclosure would be further grounds for
modification.
Financial performance statement
In line with ISA 720, the financial performance statement is 'other information' in the annual report.
The auditor is required to read this other information to identify material inconsistencies with the
financial statements. The whole of the other information must therefore be read.
An inconsistency has been discovered between the ratio figures, and it is the figures in the other
information that are misstated. The figures in the financial statements are not misstated. Therefore the
auditor should request that management revises the other information.
The ISA refers to 'material inconsistencies'. The ratios will be of interest to shareholders, being
investor information and this fact may make them material by their nature. However, as the
difference is negligible in terms of value, on balance, the difference is probably not material. If the
ratios are considered to constitute material inconsistencies, then the 'Other Information' section in the
auditor's report will need to be amended and moved further up to come after the 'Basis' section.
Corporate governance statement
As having an audit committee is a requirement of the UK Corporate Governance Code and the
company does not have one, the corporate governance statement should explain why the company
does not comply with the Code in this respect.
We would not modify our auditor's opinion over the corporate governance statement, as we have no
other reporting responsibilities in relation to it. The statement that the company has complied with the
UK Corporate Governance Code would be a material misstatement under ISA 720. We should first
discuss the matter with management and ask them to include the necessary explanations. If the
corporate governance statement is not amended, then we should ask company management to
consult with the company's legal counsel. We should then consider the advice given before taking
any further action.
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Skills Checkpoint 4
Overall conclusion
None of the matters discussed above, either singly or seen together, are pervasive to the financial
statements. The auditor's opinion should be modified on the material matter of the incorrect EPS
calculation. We should ensure that all the other disclosures are in order and also review the
corporate governance statement. If the corporate governance statement does not adequately address
the issue of the company not having an audit committee, then we may need to take legal advice.
Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed below
for Branch Co to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Good time
management
This was not explicitly tested here but remember to consider the total
time to answer the question (up to 1.95 minutes per mark) and the
split between reading/thinking/planning time and writing time
(something like ¼ to ¾ respectively of the total time)?
Managing information
Did you pick up on all the information you needed to satisfactorily
answer the question – for example, did you identify the various
completion and reporting issues?
Correct interpretation
of requirements
Although you were only asked to 'comment', the requirement did go
on to ask you to 'indicate' what form of auditor's report would be
most appropriate – did you spot this?
Answer planning
Did you differentiate between the issues related to the audit opinion
and those that would only affect the auditor's report?
Effective writing and
presentation
Did you manage to carry all the points from your plan through into
your final answer?
Efficient numerical
analysis
Calculations were not required for this question, but materiality was
assessed qualitatively instead of quantitatively. Did you mention this?
Most important action points to apply to your next question
Summary
Completion and reporting will always be tested in the AAA exam, so you cannot afford to ignore it!
Use the Practice & Revision Kit to attempt as many different questions as you can, including those
from different parts of the syllabus. Make sure you consider the exam skills related to 'scaffolding'
and time management when attempting practice questions so the skills become second-nature.
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Audit-related
services and other
assurance services
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Describe the nature of audit-related services, the circumstances in which they
might be required and the comparative levels of assurance provided by
professional accountants and distinguish between audit-related services and an
audit of historical financial statements and between an attestation engagement
and a direct engagement.
F1(a)
Describe the main categories of assurance services that audit firms can provide
and assess the benefits of providing these services to management and
external users.
F1(b)
Describe the level of assurance (reasonable, high, moderate, limited, negative)
for an engagement depending on the subject matter evaluated, the criteria
used, the procedures applied and the quality and quantity of evidence
obtained.
F1(c)
Specific assignments
F2(a)


Due diligence
Review of interim financial information
For each of the other assignments listed above:
Define and describe the purpose of each type of assignment and analyse the
appropriate level of assurance which may be offered by a professional firm in
relation to these assignments.
Evaluate the matters to be considered before accepting the engagement,
including any ethical and professional considerations.
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F2(b)
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Syllabus
reference no.
Plan the assignment to gather suitable evidence and provide an appropriate
level of assurance in line with the objectives of the assignment.
F2(c)
Discuss the level of assurance that the auditor may provide and explain the
other factors to be considered in determining the nature, timing and extent of
examination procedures.
F2(d)
Describe and recommend appropriate substantive, examination or
investigative procedures which can be used to gather sufficient and
appropriate evidence in the circumstances.
F2(e)
Analyse the form and content of the professional accountant's report for an
assurance engagement as compared with an auditor's report.
F5(a)
Discuss the effectiveness of the 'negative assurance' form of reporting and
evaluate situations in which it may be appropriate to modify a conclusion.
F5(c)
Business and exam context
In this chapter we look at audit-related services and other assurance services.
Audit-related services include review engagements, such as interim financial information reviews and
due diligence reviews. We consider the differences between the external audit and audit-related
services.
Assurance services are also considered in this chapter and we examine the different levels of
assurance that can be provided on such engagements. In particular we look at risk assessments,
performance measurement and value for money audits. Finally in this chapter we look at the ways in
which companies are using IT in their organisations and how this affects business risks.
Assurance and audit-related services are very important areas for auditors in practice. Questions in
this area may come up in Section B of the exam.
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12: Audit-related services and other assurance services
Chapter overview
Audit-related services and
other assurance services
1. Assurance engagements
4. Audit-related services
3. Reviews of
historical
financial
information
Reasonable
assurance
2. ISAE 3000
Assurance
Engagements
Limited
assurance
No
assurance
Due diligence reviews
3.1
ISRE 2400
Engagements
to Review
Financial
Statements
2.1
Assurance
provided
3.2
ISRE 2410
Reviews of
Interim
Financial
Information
4.1
ISRS 4400
AgreedUpon
Procedures
4.2
ISRS 4410
Compilations
2.2
Engagement
type
4.3 Due diligence
reviews
2.3
Reporting
ISAE 3420 Pro Forma Financial Information
ISAE 3402 Controls at a Service Organisation
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1 Introduction to assurance and audit-related services
Key term
Assurance engagement: Where a professional accountant (or 'practitioner') evaluates or
measures a subject matter that is the responsibility of another party against suitable criteria, and
expresses an opinion which provides the intended user with a level of assurance about the subject
matter. It is implied that such an opinion requires evidence to be reached and a report to
communicate it.
Professional firms may not just be asked for assurance reports – they can also be engaged to deliver
a number of audit-related services, providing varying amounts of assurance (if any at all)
depending on the engagement. Audit-related services allow firms to use their skills to support their
clients in any way possible and include reviews, agreed-upon procedures and
compilations.
2 ISAE 3000 Assurance Engagements
ISAE 3000 provides standards for assurance engagements other than audits or reviews of
historical financial information. In substance, many of the requirements are similar to those
required for an audit or a review, including the need for professional scepticism.
Acceptance, planning and completion
Before accepting such an engagement, the practitioner needs to meet the requirements of both the
IESBA Code of Ethics and ISQC 1, which includes agreeing on the terms of the engagement
with the client and confirming these in an engagement letter. Effective planning is required as with
an audit. The appropriateness of the subject matter and the suitability of the criteria to be
used in the engagement should be assessed: such criteria must be relevant, complete, reliable,
neutral and understandable. Sufficient appropriate evidence is required on which to base the
conclusion. Documentation of matters significant in providing evidence to support the assurance
conclusion and report is also required to show that the engagement was performed in
accordance with ISAE 3000.
Elements of an assurance engagement
In order to qualify as an assurance engagement, the practitioner will confirm during acceptance and
the agreement of terms that it exhibits all the following elements:
(a)
A three-party relationship involving:
(i)
(ii)
(iii)
A practitioner;
A responsible party; and
Intended users (ie the person(s) for whom the report is prepared).
(b)
An appropriate subject matter;
(c)
Suitable criteria: ie the benchmarks used to evaluate or measure the subject matter;
(d)
Sufficient appropriate evidence; and
(e)
A written assurance report (providing either reasonable or limited assurance).
The subject matter under review can vary enormously:
(a)
Physical characteristics, such as the capacity of a facility
(b)
Performance of an entity: this could include performance indicators both internally
and externally required, such as those produced within an integrated report or as part
of public sector governance (covered separately in these materials) as well as formal or
informal, financial and non-financial performance, such as the requirement to secure
value for money (VfM) often against budgets or targets
(c)
The operation and reliability of systems and processes: for example, an entity's internal
controls (as seen in AA) or controls over specific IT systems.
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12: Audit-related services and other assurance services
Activity 1: KPIs
Required
Suggest FOUR non-financial key performance measures (KPIs) that a manufacturing business could
use internally that a practitioner could be asked to report on in an assurance engagement.
Solution
1
2
3
4
Activity 2: IT risks
Required
What risks are a business exposed to as a result of unreliable IT systems?
Solution
There are a number of engagements where assurance may still be given but where a different ISAE
applies:
(a)
Prospective financial information where the practitioner reviews planned financial
performance of an entity (ISAE 3400 The Examination of Prospective Financial
Information is covered separately in these materials).
(b)
Due diligence of any potential business change (covered later in this topic).
(c)
Assurance reports on compiled pro forma information – ISAE 3420 Assurance
Engagements to Report on the Compilation of Pro Forma Financial Information
Included in a Prospectus provides guidance where a practitioner has been asked to
assess whether information compiled by the responsible party has been extracted
appropriately from its source. This is usually in the context of supporting information required
by global capital markets in relation to future events or transactions.
(d)
Assurance reports on service organisations – ISAE 3402 Assurance Reports on
Controls at a Service Organisation provides guidance for practitioners who have been
asked to report on the quality of controls in place at a service organisation which provides
financial reporting information on an outsourced basis for an audited client (these reports can
be produced on either a 'Type 1' or 'Type 2' basis and are covered in Chapter 7 when ISA
402 Audit Considerations Relating to an Entity Using a Service Organisation is
discussed).
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2.1 Assurance provided
2.1.1 Reasonable assurance
Key term
The objective of a reasonable assurance engagement is to reduce assurance engagement risk
to an acceptably low level as the basis for a positive form of expression of the practitioner's
conclusion:
eg
in the case of assurance on effectiveness of internal controls, the report would be worded: 'In
our opinion internal control is effective, in all material respects, based on XYZ criteria.'
2.1.2 Limited assurance
Key term
The objective of a limited assurance engagement is to reduce assurance engagement risk to a
level that is acceptable as the basis for a negative form of expression of the practitioner's
conclusion:
eg
'Based on the work described in this report, nothing has come to our attention that causes us
to believe that internal control is not effective, in all material respects, based on XYZ criteria.'
2.2 Engagement type
2.2.1 Attestation engagement
Key term
In an attestation engagement, the client measures or evaluates the underlying subject matter
against the necessary criteria and prepares the outcome subject matter information, about which the
practitioner provides assurance of whether or not it is free from material misstatement. The
auditor's report on the financial statements is an illustration of this (except that auditors' reports
obviously fall outside the scope of ISAE 3000):
eg
'In our opinion, the financial statements present fairly, in all material respects...'
2.2.2 Direct reporting engagement
Key term
In a direct reporting engagement, the practitioner measures or evaluates the underlying
subject matter against the criteria, the outcome of which is the subject matter information, and the
practitioner then also issues an assurance conclusion on that subject matter information. This may
involve performing additional tasks during or after the assurance process which, alongside the
independence brought by the practitioner, enhances the assurance given – this is what
distinguishes a direct reporting engagement from a compilation engagement where typically no
assurance is given (compilations are covered later in this topic). Using a Type 2 report on a service
organisation as an illustration:
eg
'In our opinion, internal control is effective, in all material respects, based on XYZ criteria.'
2.3 Form and content of reports
ISAE 3000 does not stipulate a standardised format for the report. Different wording will have to be
used depending on the engagement. The report should include the following basic elements as a
minimum:
(a) A title that clearly indicates that the report is an independent assurance report;
(b) An addressee;
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12: Audit-related services and other assurance services
(c)
An identification and description of the subject matter information and, when appropriate, the
subject matter;
(d) Identification of the criteria;
(e)
Where appropriate, a description of any significant inherent limitation associated with the
evaluation or measurement of the subject matter against the criteria;
(f)
When the criteria are available only to specific intended users/relevant only to a specific
purpose, a statement restricting the use of the assurance report to those users/that purpose;
(g) A statement to identify the responsible party and to describe the responsible party's and the
practitioner's responsibilities;
(h)
A statement that the engagement was performed in accordance with ISAEs, ISQC 1 and the
IESBA Code of Ethics;
(i)
A summary of work performed;
(j)
The practitioner's conclusion;
(k)
The assurance report date; and
(l)
The signature, name of the firm or practitioner, and a specific location.
(ISAE 3000 (revised): para. 69)
3 Reviewing historical financial information
ISAE 3000 does not cover audits or reviews of historical financial information – this is because there
are different types of historical financial information produced and different types of client who
require some form of assurance on this information. You already know that reasonable
assurance is expressed in a positive manner for audits which are governed by ISAs covered
elsewhere on this course, but what about situations when an audit is not required but a limited
form of assurance is still desired by a client?
Limited assurance engagements are increasingly popular for entities exempt from audit
which still value the benefit that such an engagement can bring – these so-called 'mini-audits' are
carried out either on an ad hoc basis or using the standards explained below. Audited entities
can also have such engagements completed for them by their auditor to supply additional
information to various stakeholders in advance of the audit: for example, listed entities may
require reviewed financial statements to be submitted to the stock market for an initial assessment of
the company's most recent full year performance.
3.1 ISRE 2400 Engagements to Review Historical Financial Statements
As with any assurance engagement, the practitioner should ensure that they are able to accept the
engagement in line with the IESBA Code of Ethics, that the terms of the engagement are agreed
in a signed engagement letter and that the engagement will be planned and performed in
line with ISQC 1, with an attitude of professional scepticism recognising that circumstances may
exist which cause the financial statements to be materially misstated or not in line with the
applicable financial reporting framework.
The practitioner should obtain sufficient appropriate evidence to support their conclusion
primarily through enquiry and analytical procedures (ISRE 2400: para. 7).
The review report is usually addressed to the directors of the company (not to the shareholders)
to indicate who has requested this engagement to be performed. The conclusion delivered within this
review will enable the practitioner to state that nothing has come to their attention that causes them
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to believe that the historical financial statements contain material misstatement and are not
prepared in accordance with an applicable financial reporting framework (ie limited assurance).
As with an audit, such a conclusion can be modified depending on the nature and extent of the
issue(s) identified, with such modifications requiring an explanatory basis paragraph immediately
preceding the conclusion. In the same way, Emphasis of matter and Other matter
paragraphs can be added if appropriate (ISRE 2400: paras. 87 and 90, Appendix).
3.2 ISRE 2410 Review of Interim Financial Information Performed by
the Independent Auditor of the Entity
As entities become more accountable to their various stakeholders, the need for timely and
reliable financial information increases, especially at certain times of their reporting period (such as
retailers who need to report peak trading figures). ISRE 2410 provides guidance for assurance
engagements where the subject matter does not contain historical financial information for a full
reporting period. Broadly speaking, it follows the same approach as ISRE 2400, primarily using
enquiry and analytical procedures to deliver a conclusion.
Essential reading
See Chapter 12 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for illustrations of the reports produced under ISRE 2400 and ISRE 2410.
4 Audit-related services
Reviews of historical financial information using both ISRE 2400 and ISRE 2410 provide a degree of
assurance and are sometimes referred to as audit-related services to differentiate them from the more
general types of assurance that we saw earlier in this topic. However, not all audit-related services
offer assurance.
4.1 ISRS 4410 Compilation Engagements
Practitioners may be asked to produce subject matter information and report on how this
matches the criteria used to assess such subject matter. In other instances (most notably the
preparation of financial statements for small entities) the practitioner produces the subject
matter but does not provide any assurance as once complete, no procedures to verify the
information are carried out – it is simply a demonstration of the practitioner's accounting skills.
4.2 ISRS 4400 Engagements to Perform Agreed-upon Procedures
Regarding Financial Information
Practitioners may also be asked to perform specific procedures, often in the context of an audit,
and will report factual findings from the outcome of those procedures. As it only clarifies what
was done, there is no judgment reached, so no conclusion (and consequently no
assurance) is given. Examples of such procedures could include fraud investigations or more
specific forensic accounting and forensic auditing engagements (covered separately in these
materials).
4.3 Due diligence reviews
Due diligence reviews are a specific type of review engagement. A typical due diligence
engagement is where a practitioner is engaged by one company planning to take over another to
identify the material risks associated with the transaction (including a review of all the
assumptions underlying the purchase) in order to ensure that the acquirer has all the necessary
facts. This is important when determining purchase price. Similarly, due diligence can also be
requested by sellers.
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12: Audit-related services and other assurance services
It may include some or all of the following aspects:
Financial due diligence
(a review of the financial position
and obligations of a target to
identify such matters as covenants
and contingent obligations)
Operational and IT due
diligence (extent of operational
and IT risks, including quality
of systems, associated with a
target business)
Environmental due diligence
(environmental, health and safety
and social issues)
People due diligence (key
staff positions under the new
structure, contract termination
costs and costs of integration)
Regulatory due diligence
(review of the target's level of
compliance)
Due diligence work is primarily limited to enquiry and analytical procedures.
A typical due diligence review could include enquiries into:
Assets/liabilities, in order to value the company
Management's representations about the company, which may need to be substantiated by
evidence
Structure, including how the target is owned and constituted and what changes will be necessary
Acquisition planning, looking at potential benefits/drawbacks of the acquisition (eg synergies
with the acquirer's business, or potential economies of scale)
Financial health, based on a detailed examination of past financial statements and an analysis of
the existing asset base
Credibility of the owners, directors and senior managers, including validation of the career
histories of all the main players in the business
Future potential, reflected in the strengths of its products or services and the probability of
earnings growth over the medium to long term
Assessment of the risk to the acquiring business, in terms of its markets, strategy and likely future
events
The business plan, in terms of how realistic it is, how solid the assumptions used are and how
well it conveys the potential
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Due diligence can sit in a number of engagement categories because it can be performed as
any of the following:



As a review of historical financial information (limited assurance)
As an assurance engagement (limited assurance)
As agreed-upon procedures (no assurance)
There is no international standard on due diligence engagements, so in practice the engagement
would be conducted in accordance with whichever standard best fits the particular engagement
being conducted – perhaps ISRE 2400, ISAE 3000 or ISRS 4400.
Note that although due diligence uses the techniques of a review engagement, it is unlikely that
any assurance will be provided. It is normally a report of factual findings such as agreed-upon
procedures.
Essential reading
See Chapter 12 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on each of these engagements.
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12: Audit-related services and other assurance services
Chapter summary
Audit-related services and
other assurance services
3. Reviews of
historical financial
information
2. ISAE 3000
Assurance
Engagements
3.1 ISRE 2400
Engagements to
Review Financial
Statements
Acceptance, planning
and completion
 Agree terms of engagement
3.2 ISRE 2410
Engagements to
Review Interim
Financial
Statements
 Planning – as an audit
 Assess appropriateness of subject matter and
criteria
 Obtain sufficient appropriate evidence
 Documentation
 Report to directors
– Primarily enquiry and analytical review
 Limited assurance expressed negatively:
'nothing has come to the auditor's
attention that the statements do not
show a true and fair view'
 Conclusion and reporting
Assurance and
engagement types
 Elements of an assurance
engagement:
–
–
–
–
–
3 party relationship
Subject matter
Criteria
Evidence
Written report
 Reasonable 'positive' assurance:
('…in our opinion, the F/S show a
true and fair view…')
 Limited 'negative' assurance:
('…nothing has come to our attention
to suggest the F/S do not show a
true and fair view…')
ISAE 3400 The Examination of
Prospective Financial
Information (see Chapter 13)
Other
examples
of limited
assurance
 Attestation based – client
measures the subject matter and the
practitioner provides a conclusion
 Direct reporting – the practitioner
both measures the subject matter and
provides a conclusion
ISAE 3420 Reporting on the
Compilation of Pro-forma
Financial Information in a
Prospectus
ISAE 3402 Assurance Reports
on Controls at a Service
Organisation (see Chapter 7)
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4. Audit-related services
4.1 ISRS 4400
Agreed-upon
Procedures
 Factual findings
 Examples are fraud
investigations and
forensic audits (see
Chapter 14)
 No assurance given
as the practitioner
just reports what
they have done
(effectively a test of
their skills)
4.2 ISRS 4410
Compilations
4.3 Due diligence
reviews
 Producing subject
matter information
 Provision of advice to
purchasing company in
a transaction
 Examples are often
accounts
preparation for
smaller clients
 No assurance given
as the practitioner
just reports what
they have done
(effectively a test of
their skills)
–
–
–
–
–
Financial
Operational and IT
People
Regulatory
Environmental
 Ensures acquirer has all
necessary facts
 Usually enquiry and
analytical review only
 Normally no assurance
given
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12: Audit-related services and other assurance services
Knowledge diagnostic
1.
Non-audit engagements can still offer some assurance, depending on the nature of work
undertaken, or they may be classed as audit-related with either limited or no assurance
granted at all.
2.
Any engagement can be an assurance engagement provided it satisfies the elements of an
assurance engagement as laid down in ISAE 3000. The subject matter reviewed can vary
enormously (including prospective financial information, pro forma information and
even reviews of service organisations).
3.
Engagements are planned and conducted in a similar manner to the external audit: assurance
reported can be either reasonable or limited and engagements can be either attestation
or direct reporting.
4.
Only a limited (negative) level of assurance is provided due to a review consisting
mainly of enquiries and analytical review – this could be a full year (ISRE 2400) or interim
review (ISRE 2410).
5.
There are many additional services an audit firm can offer their clients. Some of these
engagements provide no assurance at all and involve the auditor using their skills to perform
agreed-upon procedures (ISRS 4410) or a compilation (ISRS 4400) of financial
statements.
6.
Due diligence engagements are used for a variety of purposes, so their nature and the level of
assurance granted (if at all) can vary too.
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Further study guidance
Question practice
Now try the questions below from the Further Question Practice Bank (available in the digital edition of
the Workbook).

Question 25 'Aquinas' only presents a limited amount of information, so you are going to need to
work hard for the marks, but it is a good opportunity to test the theory in this chapter.

Question 26 'Audit' is also light on detail, but is still a good opportunity to practise something
unusual which you may not expect to see in the AAA exam.
Further reading
There is one technical article on the ACCA website written by members of the AAA examining team
which is relevant to some of the topics covered in this chapter that you should read:

Continue to be 'rest-assured'
Own research
Enter the term 'due diligence' into an online search engine – you should be presented with a range of
technical and commercial examples of this kind of engagement – read as many as you can to get a better
flavour for this topic.
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Prospective financial
information (PFI)
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Specific assignment

F2(a)
Prospective financial information
For the assignment listed above:
Define and describe the purpose of this assignment and analyse the appropriate
level of assurance which may be offered by a professional firm in relation to this
assignment.
Evaluate the matters to be considered before accepting the engagement,
including any ethical and professional considerations.
F2(b)
Plan the assignment to gather suitable evidence and provide an appropriate
level of assurance in line with the objectives of the assignment.
F2(c)
Discuss the level of assurance that the auditor may provide and explain the
other factors to be considered in determining the nature, timing and extent of
examination procedures.
F2(d)
Describe and recommend appropriate substantive, examination or investigative
procedures which can be used to gather sufficient and appropriate evidence in
the circumstances.
F2(e)
Discuss the content of a report for an examination of prospective financial
information.
F5(b)
Business and exam context
Reporting on prospective financial information (PFI) is covered by ISAE 3400 The Examination of
Prospective Financial Information.
Forecasts are of significant interest to users. Some would say that PFI is of more interest to users of
accounts than historical financial information (HFI) which, of course, auditors report on in the external
audit.
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This is an area in which the auditors can therefore provide an alternative service to audit, in the form
of a review or assurance engagement. This chapter looks at the factors that the auditor should think
about when taking on such an engagement. The basis for this chapter has been laid in Chapter 12
but, in this chapter, we consider issues specific to PFI.
PFI can only be examined in Section B of the exam. The difficulties of reporting on PFI could be
examined in an exam question. Section A questions can easily be set in the context of a PFI assignment.
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13: Prospective financial information (PFI)
Chapter overview
Prospective financial
information (PFI)
3. Level of assurance
provided
1. ISAE 3400 The
Examination of Prospective
Financial Information
2. Matters to consider
before accepting an
engagement to report on
prospective financial
information
4. Examination procedures
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1 ISAE 3400 The Examination of Prospective Financial
Information
1.1 Terminology
Prospective financial information means financial information based on assumptions about events that
may occur in the future and possible actions by the entity (ISAE 3400: para. 3).
Auditors are regularly engaged to provide assurance on prospective financial information.
Prospective financial information can be of two types (or a combination of both).
Key terms
A forecast: Prospective financial information based on assumptions as to future events which
management expects to take place and the actions management expects to take (best-estimate
assumptions).
A projection: Prospective financial information based on hypothetical assumptions about future
events and management actions, or a mixture of best-estimate and hypothetical assumptions.
(ISAE 3400)
There are two other terms commonly associated with prospective financial information:
Key terms
A hypothetical illustration: Prospective financial information based on assumptions about
uncertain future events and management actions which have not yet been decided on.
A target: Prospective financial information based on assumptions about the future performance of
the entity.
(ISAE 3400: paras. 4-5)
Listed companies should have procedures that allow them to generate reliable prospective financial
information (PFI), compare it to market expectations, publish it when necessary and subsequently
report actual performance against it.
Activity 1: PFI examples
Required
PFI has a key role for businesses in terms of providing information to third parties as well as an
internal management tool. Can you think of some examples of different types of PFI?
Solution
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13: Prospective financial information (PFI)
2 Matters to consider before accepting an engagement to
report on PFI
Before deciding to accept such an engagement, the audit firm should also consider the following:
(a)
(b)
(c)
(d)
(e)
The intended use of the information. For example, is it intended for internal or external use?
Whether the information will be for general or limited distribution.
The nature of the assumptions on which the information is based.
The information to be included.
The period covered by the information (ISAE 3400: para. 10)
The auditor should not accept, or should withdraw from, an engagement when the assumptions are
clearly unrealistic or when the auditor believes that the prospective financial information will be
inappropriate for its intended use (ISAE 3400: para. 11).
3 Level of assurance provided
Due to the nature of PFI, the audit firm will be unable to conclude on whether the results forecast will
be achieved. Also there may be insufficient evidence available to conclude that the assumptions are
free from material misstatement. Therefore, the audit firm can generally only provide a limited level
of assurance.
The audit firm will normally provide negative assurance. This means they will state that 'nothing
has come to their attention' which causes them to believe that the assumptions are not a
reasonable basis for the forecast.
Example of an unqualified report on a forecast
REPORT TO....
We have examined the forecast in accordance with the International Standard on Assurance
Engagements applicable to the examination of prospective financial information. Management is
responsible for the forecast including the assumptions set out in Note X on which it is based.
Based on our examination of the evidence supporting the assumptions nothing has come to our
attention which causes us to believe that these assumptions do not provide a reasonable basis for the
forecast. Further, in our opinion the forecast is properly prepared on the basis of the assumptions
and is presented in accordance with International Financial Reporting Standards.
Actual results are likely to be different from the forecast since anticipated events frequently do not
occur as expected and the variation may be material.
AUDITOR
Date
Address
(ISAE 3400: para. 28)
The auditor can express a qualified (material misstatement or insufficient/inappropriate audit
evidence) opinion if he believes:
(a)
(b)
The presentation and disclosure of the PFI is not adequate
One or more of the assumptions do not provide a reasonable basis for the PFI
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4 Examination procedures
The auditor should obtain sufficient appropriate evidence as to whether:
Management's assumptions on which the PFI is based are not unreasonable
The information is properly prepared on the basis of the assumptions
The information is properly presented and all material assumptions are adequately
disclosed
The PFI is prepared on a consistent basis with historical financial statements, using appropriate
accounting policies
The auditor should obtain sufficient knowledge of the business to be able to evaluate whether
the assumptions are justified. The historical information will be used as a yardstick to assess the
assumptions underlying the information.
In carrying out their review of the accounting bases and calculations for forecasts, and the
procedures followed by the company for preparing them, the main points which the reporting
accountant will wish to consider include:
Whether the forecast under review
is based on forecasts regularly
prepared for the purpose of
management, or whether it has
been separately and specially
prepared for the specific purpose
Where forecasts are regularly
prepared for management
purposes, the degree of accuracy
and reliability previously achieved,
and the frequency and
thoroughness with which estimates
are revised
Whether the forecast under review
represents the management's best
estimate of results which they
reasonably believe can and will
be achieved rather than targets
which the management have set
as desirable
The extent to which forecast results
for expired periods are supported
by reliable interim accounts
The details of the procedures
followed to generate the forecast
and the extent to which it is built
up from detailed forecasts of
activity and cash flow
The extent to which profits are
derived from activities having a
proven and consistent trend and
those of a more irregular, volatile
or unproven nature
How the forecast takes account of
any material extraordinary items
and prior year adjustments, their
nature, and how they are
presented
Whether adequate provision is
made for foreseeable losses and
contingencies and how the
forecast takes account of factors
which may cause it to be subject
to a high degree of risk, or which
may invalidate the assumptions
Whether working capital appears
adequate for requirements
(normally this would require the
availability of properly prepared
cash flow forecasts) and, where
short-term or long-term finance is
to be relied on, whether the
necessary arrangements have
been made and confirmed
The auditor should confirm the arithmetical accuracy of the forecast and the supporting
information and whether forecast statements of financial position and statements of cash flows have
also been prepared (as these help to highlight arithmetical inaccuracies and inconsistent
assumptions).
The auditor should also obtain written representations from management regarding the
intended use of the information, the completeness of significant assumptions and management's
acceptance of its responsibility for the PFI.
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13: Prospective financial information (PFI)
Activity 2: Prism
Prism, a public company, is one of the world's leading suppliers of fast moving consumer goods. The
company is looking to increase its operations in Eastern Europe and requires some additional
finance.
You are the manager of a firm of Chartered Certified Accountants and have been approached by
Paul Robinson, the Chief Executive of Prism. He is trying to obtain some additional finance from the
bank and they have asked that he obtain an independent review of the figures that have been
produced to support the loan application.
STATEMENT OF PROFIT OR LOSS
Revenue
Cost of sales
Forecast
20X4
$m
47.6
(33.3)
Actual
20X3
$m
40.9
(30.7)
Gross profit
14.3
10.2
Profit on disposal of investment
Other expenses
1.0
(5.3)
0.6
(4.6)
Profit before tax
10.0
6.2
Forecast
20X4
$m
20X3
$m
14.9
22.1
10.9
25.0
STATEMENT OF FINANCIAL POSITION
Non-current assets
Property, plant and equipment
Intangible assets
Investments
–
2.3
37.0
38.2
Current assets
Inventories
5.6
4.1
Receivables
9.1
7.3
Cash
2.5
17.2
2.4
13.8
54.2
52.0
5.3
3.2
5.3
3.2
Equity
Share capital
Revaluation surplus
Retained earnings
9.8
8.3
Non-current liabilities
18.3
18.1
16.8
18.3
Current liabilities
17.8
16.9
54.2
52.0
Required
Describe the audit work that a professional certified accountant would perform on the forecast
statement of profit or loss and statement of financial position.
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Solution
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13: Prospective financial information (PFI)
Chapter summary
1. ISAE 3400
The Examination of
Prospective Financial
Information
Distinction between:




A forecast (based on events and assumptions expected to occur)
A projection (based on expectations and hypothetical assumptions)
A hypothetical illustration (based on decisions not yet made eg 'flying kites')
A target (based on possible future performance of an entity)
Prospective financial
information (PFI)
2. Matters to consider
before accepting an
engagement to report
on prospective financial
information





Intended use
General vs limited distribution
Nature of assumptions
Information to be included
Period covered by PFI
3. Level of
assurance
provided
4. Examination
procedures
 Due to nature of engagement
likely to be limited (negative)
assurance
Limited assurance comes from
approach – usually enquiry and
analytical review
'…nothing has come to our
attention…'
 An opinion (effectively
reasonable positive
assurance) that the forecast
has been prepared in line
with the assumptions and
relevant reporting framework
 Auditor should obtain
sufficient appropriate
evidence that:
– Management assumptions
are not unreasonable
– Information is properly
prepared on the basis of
the assumptions
– Information is properly
presented and
assumptions disclosed
– PFI is prepared on basis
consistent with historical
financial statements (eg
accounting policies;
activity rates etc.)
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Knowledge diagnostic
1.
PFI relates to any financial data prepared based on assumptions relating to future events or
actions. Such PFI can relate to forecasts, projections, hypothetical illustrations and
targets.
2.
Auditors must consider some additional factors before accepting an engagement to report on
PFI, such as who the information is for and what it is to be used for.
3.
In practice the level of assurance given in a PFI engagement will always be limited,
expressed in a negative form, for the reasonableness of the assumptions.
4.
However, the level of assurance given in a PFI engagement for the application of those
assumptions will always be reasonable, expressed in a positive form (ie an opinion).
5.
The type of audit work performed will, in the main, be restricted to enquiry and analytical
review – enough to ensure sufficient appropriate evidence exists for whatever report is required.
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13: Prospective financial information (PFI)
Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 27 'Verity' which is essential exam standard question practice for the contents of this
chapter.
Further reading
At the time of going to print, there are no technical articles written by the AAA examining team for this
topic.
Own research
When you are next at work, ask someone in a position of authority whether your employer has ever
created forecasts or business plans – why were they required, were they ever reviewed by anyone and
were they successful?
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Forensic audits
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Specific assignment

F2(a)
Forensic audits
For the assignment listed above:
Define and describe the purpose of this assignment and analyse the appropriate
level of assurance which may be offered by a professional firm in relation to this
assignment.
Evaluate the matters to be considered before accepting the engagement,
including any ethical and professional considerations.
F2(b)
Plan the assignment to gather suitable evidence and provide an appropriate level
of assurance in line with the objectives of the assignment.
F2(c)
Discuss the level of assurance that the auditor may provide and explain the other
factors to be considered in determining the nature, timing and extent of
examination procedures.
F2(d)
Describe and recommend appropriate substantive, examination or investigative
procedures which can be used to gather sufficient appropriate evidence in the
circumstances.
F2(e)
Business and exam context
In the current globalised business world there is an increasing demand for forensic services. Audit
and assurance professionals are well-placed to provide these. This chapter introduces forensic
accounting and auditing and discusses its applications in practice and continues with a look at
investigative procedures and evidence.
This topic is often examined in a very practical way. It is important to have an understanding of the
framework but case study questions will involve the application of procedures similar to those used in
traditional audits of financial statements. Some specific knowledge is required of basic definitions,
but otherwise the application of audit-style procedures is used. Questions on forensics may only come
up in Section B of the exam.
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Chapter overview
Forensic audits
1. Terminology
2. Applications of
forensic auditing
2.1 The forensic
accountant as
expert witness
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14: Forensic audits
1 Terminology
Key terms
Forensic auditing (the process): Relates to the procedures followed by the firm and can be
defined as:
The process of gathering, analysing and reporting on data, in a pre-defined context, for the
purpose of finding facts and/or evidence in the context of financial/legal disputes and/or
irregularities and giving preventative advice in this area. ACCA (2007)
Forensic investigation (an example of a forensic auditing engagement): Applies similar
procedures to a forensic audit but is carried out for specific civil or criminal cases. Such cases could
involve fraud or asset tracing in money laundering cases.
Forensic accounting (the skills involved): Involves undertaking a financial investigation in response
to a particular event, where the findings of the investigation may be used as evidence in court or to
otherwise help resolve disputes.
2 Applications of forensic auditing
The range of assignments in this area is vast so to give specific definitions for each is not always
practicable. In a publication by the Institute of Chartered Accountants of Canada, Standard practices
for investigative and forensic accounting engagements (November 2006) the following definition is
established:
Investigative and forensic accounting engagements are those that:
(a) Require the application of professional accounting skills, investigative skills, and an investigative
mindset
(b) Involve disputes or anticipated disputes, or where there are risks, concerns or allegations of
fraud or other illegal or unethical conduct
(CPA Canada (2006): p2)
Forensic audit and accounting is a rapidly growing area. The major accountancy firms all offer
forensic services, as do a number of specialist companies. The demand for these services arises
partly from the increased expectation of corporate governance codes for:
Company directors to take seriously their
responsibilities for the prevention and
detection of fraud (for example, to quantify
the extent of the losses
Governments concerned about risks arising
from criminal funding of terrorist groups
Otherwise, in a case where an auditor or accountant is being sued for negligence, both parties
may wish to employ forensic accountants, either to investigate the standard of work performed or to
establish the losses suffered by the plaintiff.
Insurance companies often engage forensic accountants to verify and report on the amounts of
losses suffered by a claimant where there is a dispute between the claimant and the company.
2.1 The forensic accountant as an expert witness
Due to the nature of this work, forensic accountants will very often be called as expert witnesses
in civil or criminal cases. This is a very important function and some jurisdictions have specific rules
governing their duties.
For example, in England and Wales, experts have a duty to exercise reasonable skill and care to
those instructing them, and to comply with any relevant professional code of ethics. However,
when they are instructed to give or prepare evidence for the purpose of civil proceedings they have
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an overriding duty to help the court on matters within their expertise. This duty overrides any
obligation to the person instructing or paying them. Experts must not serve the exclusive interest of
those who retain them.
The UK's Expert Witness Institute has produced a model form of expert's report to help expert
witnesses, of whatever profession, to meet their legal duties. The main contents are outlined below.
Index/list of
contents
Optional, but desirable
Brief curriculum
vitae
Including expert's name, qualifications (eg ACCA) and relevant
experience
Summary of
conclusions
Brief list of main facts from the evidence and the conclusions/opinions
arrived at
Instructions
Must give the substance of all instructions received by the expert,
whether written or oral
Issues
The issues to be addressed and the questions to be answered must be
clearly set out
Documentation
Full list of all documents and material on which the report is based
Chronology
This must deal only with factual evidence, not any matter of opinion
Technical background
Where technical aspects of the issues are outside the general knowledge
or experience of those who will have to deal with the report, an
explanation of the technical issues in this section may be necessary. For
example, in a case involving fraudulent accounting, the requirements of
specific accounting standards may have to be explained.
Opinion
This should be presented clearly and unambiguously. The reasons for the
opinions given should be explicit.
References
A numbered list of all items of technical literature relied on. For example
in a negligence case this may comprise a list of relevant accounting
standards and auditing standards.
Declaration
The expert must sign a declaration confirming his understanding of his
legal duties, and including the following 'Statement of Truth':
'I confirm that insofar as the facts stated in my report are within my own
knowledge I have made clear which they are and I believe them to be
true, and the opinions I have expressed represent my true and complete
professional opinion.'
Essential reading
See Chapter 14 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for further information on planning and conducting a forensic audit engagement.
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14: Forensic audits
Activity 1: Sam Seel
You are a manager in an audit firm with a small team dedicated to forensic investigations. You have
been approached by the Finance Director of SL Co to perform an investigation into a fraud
perpetrated by a purchase ledger clerk.
You have ascertained the following:
The fraud came to light after another employee drew attention to the activities of the purchase ledger
clerk, Sam Seel. Initial investigations have identified that Sam had been paying money into his own
bank account by raising false invoices and paying them through SL Co's purchase ledger. The fraud
had gone undetected for an unknown amount of time because SL Co's controls only require invoices
in excess of $1,000 to be authorised by a senior member of staff. Invoices below this amount are
processed and authorised for payment by the relevant purchase ledger clerk.
SL Co is a very large company with revenue in excess of $100m and operates in the construction
industry. Sam Seel joined the finance department nine months ago and has since been suspended
from duties pending this investigation.
The Finance Director has requested that your firm perform such procedures as necessary to quantify
the extent of the loss suffered by the business.
Required
(a)
In the context of the ACCA's fundamental ethical principles, what factors should you take into
account before accepting this engagement?
(b)
Assuming you accept the engagement, what specific procedures would you perform to allow
you to quantify the loss suffered by SL Co?
Solution
a)
b)
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Chapter summary
Forensic audits
2. Applications of forensic auditing
1. Terminology
Forensic auditing is defined as: 'The process of
gathering, analysing and reporting on data, in a
pre-defined context, for the purpose of finding facts
and/or evidence in the context of financial/legal
disputes and/or irregularities and giving preventative
advice in this area.'
Forensic investigation applies similar procedures
to a forensic audit but is carried out for specific civil or
criminal cases. Such cases could involve fraud or asset
tracing in money laundering cases.
Forensic accounting involves undertaking a
financial investigation in response to a particular
event, where the findings of the investigation may be
used as evidence in court or to otherwise help resolve
disputes.
Fraud
investigations:
Used to quantify the
possible amount lost,
for example.
254
Negligence cases:
To establish the
standards of work
actually done.
Verification of
insurance claims:
In the event of dispute
between claimant
and company.
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2.1 The forensic
accountant as
expert witness
The accountant's duty
to help the court
overrides any duty
owed to clients who
may have paid for
their services.
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14: Forensic audits
Knowledge diagnostic
1.
Auditors are increasingly being called upon to use their skills in forensic work. Engagements in this
area can include forensic auditing, forensic investigations and forensic accounting.
2.
The work can involve fraud investigations, evidence gathering where an auditor is
being sued for negligence or performing work for insurance companies to verify customer
claims.
3.
Due to the nature of the work, it is likely the forensic accountant will be called to a court of law
as an expert witness and care must be taken to ensure that this function is fulfilled in the
appropriate way.
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Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 28 'Painswick Co' is further practice of the content introduced here and the skills required if
a question on forensics comes up in the exam.
Further reading
There are some technical articles on the ACCA website written by members of the AAA examining team
which are relevant to some of the topics covered in this chapter that you should read:


Forensic accounting
Forensic auditing
Own research

There are plenty of accounting firms that offer forensic audit services – compare what they do and
see if there are any significant differences in their approach.

There are many other resources online that can help this subject come to life: try this as an example
of what forensic audit can include:
https://b2b.dnb.com/2017/07/17/forensic-audit-techniques/
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Social, environmental
and public sector
auditing
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Plan an engagement to provide assurance on integrated reporting (performance
measures and sustainability indicators).
F3(a)
Describe the difficulties in measuring and reporting on economic, environmental
and social performance and give examples of performance measures and
sustainability indicators.
F3(b)
Describe substantive procedures to detect potential misstatements in respect of
socio-environmental matters.
F3(c)
Discuss the form and content of an independent verification statement of an
integrated report.
F3(d)
Explain the auditor's main considerations in respect of social and environmental
matters and how they impact on entities and their financial statements (eg the
impairment of assets, provisions and contingent liabilities).
D3(c)
Describe the audit of performance information (pre-determined objectives) and
differentiate from performance auditing.
F4(a)
Plan the audit of performance information (pre-determined objectives) and
describe examination procedures to be used in the audit of this type of
information.
F4(b)
Discuss the audit criteria of reported performance information, namely
compliance with reporting requirements, usefulness, measurability and
reliability.
F4(c)
Discuss the form and content of a report on the audit of performance
information.
F4(d)
Discuss the content of an audit conclusion on an integrated report of
performance against pre-determined objectives.
F4(e)
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Business and exam context
In this chapter we investigate the impact of social and environmental issues on assurance services.
Increasing importance is being placed on social and environmental issues in business. Recent years
have seen a substantial weight of environmental legislation passed, which puts a significant burden
of compliance on companies. The danger of non-compliance (fines, bad publicity, impact on going
concern) is an aspect of the environmental risk which companies face.
We also examine the work of the auditor in the context of public sector organisations. Auditors may
take on varied roles here, and we focus on the audit of performance information.
Finally, integrated reporting is a recent innovation and current issue in the profession.
The topics in this chapter may be examined as part of a Section B question, and are unlikely to be
more than a sub-section of a question as opposed to being the subject of a full question.
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15: Social, environmental and public sector auditing
Chapter overview
Social, environmental and
public sector auditing
1. Practical context
2. Impact on
practitioners
3. Assurance on
integrated reports
2.1 General financial
statement impacts
3.1 Planning, performing
and concluding an
engagement to review an
integrated report
4. The audit of performance
information in the public
sector
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1 Practical context
Activity 1: Social and environmental factors
The importance of social and environmental factors is increasingly recognised by the business
community. Many businesses now have specific policies governing their relationship with their
employees, society and the environment.
Required
What factors have led to the rapid growth in business awareness of these issues?
Solution
2 Impact on practitioners
Social and environmental issues cannot be ignored by external auditors. Potential impacts on their
work may arise from:
The application of
environmental laws and
regulations during the audit
260
The voluntary reporting of any
initiatives undertaken by an
organisation to address social
or environmental concerns
of stakeholders (such as
integrated reporting)
The operation of processes that
may cause pollution or the use
of hazardous substances
Dependence on a major
customer segment whose
business is threatened by
environmental pressures
The holding of an interest in
land and buildings that
have been contaminated
by previous occupants
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15: Social, environmental and public sector auditing
2.1 General financial statement impacts
Auditors do not necessarily have a specific knowledge of environmental or social matters. However,
in planning the audit, they should obtain sufficient knowledge of the business (under ISA 315
Understanding the Entity) to understand the social and environmental events, transactions and
practices (ISA 250 Laws and Regulations) that may have a significant effect on the financial
statements or the audit and respond appropriately to them (ISA 330 Risk Response).
2.1.1 Substantive procedures
The auditor may perform substantive testing to obtain evidence in relation to social and
environmental matters. Below are some suggested procedures: it is not intended that all of the
procedures will be appropriate in every case (in many cases, the auditor may judge it unnecessary to
perform any of these procedures and may apply others instead) so overall, common sense and
commercial awareness of the scenario should play a part here.
Documentary review
(a)
Review minutes from meetings of directors, audit committees, or any other subcommittees of
the board specifically responsible for environmental matters.
(b)
Read publicly available information regarding any existing or possible future
environmental matters.
Where relevant, consider:
Reports by environmental experts about the entity, such as site assessments, due
diligence investigations or environmental impact studies
Internal audit reports and other internal reports dealing with environmental matters
Reports issued by, and correspondence with, regulatory and enforcement agencies
Publicly available registers or plans for the restoration of soil contamination
Environmental performance reports issued by the entity
Correspondence with the entity's lawyers
(c)
Obtain written representations from management that it has considered the effects of
environmental matters on the financial statements, and that it:
Is not aware of any material liabilities or contingencies arising from environmental
matters, including those resulting from illegal or possibly illegal acts;
Is not aware of environmental matters that may result in a material impairment of assets; or
If aware of such matters, has disclosed to the auditor all related facts
Asset impairments (IAS 36)
(a)
Enquire about any planned changes in capital assets, for example, in response to changes in
environmental legislation or business strategy and their impact on the valuation of
those assets or the company as a whole.
(b)
For any asset impairments related to environmental matters that existed in previous
periods, consider whether the assumptions underlying a write down or related carrying
values continue to be appropriate.
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Liabilities, provisions and contingencies (IAS 37)
(a)
Enquire about policies and procedures operated to identify liabilities, provisions or
contingencies arising from environmental matters.
(b)
Enquire about events or conditions that may give rise to liabilities, provisions or
contingencies arising from environmental matters, for example:
Penalties or possible penalties arising from breaches of social or environmental laws and
regulations; or
Claims or possible claims for environmental damage.
(c)
For property abandoned, purchased, or closed during the period, enquire about requirements
or intentions for site clean-up and restoration.
(d)
For property sold during the period (and in prior periods) enquire about any liabilities
relating to environmental matters retained by contract or by law.
(e)
For liabilities, provisions, or contingencies related to environmental matters, consider whether
the assumptions underlying any estimates continue to be appropriate.
(f)
Review the adequacy of any disclosure of the effects of environmental matters on the
financial statements, especially in relation to going concern (ISA 570).
3 Assurance on integrated reports
Increasingly, practitioners are being asked to provide assurance on (and even produce) reports
for clients that explain more fully their responsibilities to their various stakeholders. This
includes a blend of financial and non-financial information, covering areas such as
governance, sustainability and remuneration. The term used to describe such a report is
integrated reporting.
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15: Social, environmental and public sector auditing
3.1 Planning and performing an engagement to review an integrated
report
The process of planning and performing any engagement follows a number of key steps, so when
reviewing an integrated report, the practitioner will consider the following:
1
Acceptance issues – Does the engagement present any ethical issues
(such as fee dependency, self-review, competence to act and required
experience) or risks (such as liability or reputation factors)?
Quality control – Policies and procedures within the firm to manage
the engagement
2
3
Agreeing the terms of the engagement via an engagement letter
(this may need to be very specific, given the non-statutory nature of such
integrated reports)
Planning – This will depend on the engagement but risk assessment and
collecting evidence will need to be considered (see next section)
4
Conclusions and reporting – There is no required format as long as
the terms of reporting and concluding are agreed in the engagement letter
5
3.1.1 Measuring social and environmental performance
While such engagements are a good source of revenue for many assurance firms, they do present
challenges, as very often the outputs that need to be reported on are either difficult to
measure (eg emissions of a pollutant) or intangible in nature (eg impact on the local community).
It is therefore accepted that measuring social and environmental performance is difficult, so when
planning this kind of engagement, the practitioner will need to consider either how to validate the
measurements made by the client, or how they can measure the information themselves.
Understandably, this could affect acceptance (but conversely, this may make those firms that choose
to specialise in providing this kind of engagement very sought after).
Essential reading
See Chapter 15 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for more detail on measurement difficulties.
The following types of measures may be used:

Direct – For example, kilograms (kg) of contaminant emitted

Relative – For example, kg of contaminant emitted per kg of product manufactured

Indexed – Measured over a period of time to identify longer-term trends

Aggregated – Information of the same type, but from different sources expressed as a
combined value (for example, volume of waste recycled or employees supported by training)

Weighted – Information modified by applying a factor relating to its significance
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Examples of specific indicators included in environmental and social elements of integrated
reports on which the auditor may be asked to provide assurance include:

Toxic gas emissions

Energy usage, recycling levels and progress against waste reduction targets (such as reducing
packaging)

Average wage levels vs minimum wage

Employee satisfaction and/or staff turnover levels

Customer complaints

Financial assistance to charitable organisations

Investment in infrastructure, such as schools and roads
3.1.2 IAASB Discussion Paper on integrated reporting
In August 2016, the IAASB released the Discussion Paper, Supporting Credibility and Trust in
Emerging Forms of External Reporting: Ten Key Challenges for Assurance Engagements.
The paper introduced a new piece of jargon: EER, Emerging forms of External Reporting. The key
points were as follows.
The issue is credibility and trust, and how best to achieve this. EER is part of the picture. There is
a strong overlap with existing assurance services, but flexibility is required to meet the needs of
stakeholders.
Sound reporting framework
Strong governance
Factors that influence
credibility and trust
Consistent wider
information
External professional
services and other reports
The external audit does not include a separate assurance engagement on EER (see ISA 720).
Instead, other types of engagement are needed. Determining exactly what type of engagement is not
straightforward – hence the core of the paper: the 'Ten Key Assurance Challenges':
Ten key assurance challenges
Determining the scope of an EER assurance engagement, which can be complex
Evaluating the suitability of criteria in a consistent manner
Addressing materiality for diverse information with little guidance in EER frameworks
Building assertions for subject matter information of a diverse nature
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15: Social, environmental and public sector auditing
Ten key assurance challenges
Lack of maturity in governance and internal control over EER reporting processes
Obtaining assurance with respect to narrative information
Obtaining assurance with respect to future-oriented information
Exercising professional scepticism and professional judgment
Obtaining the competence necessary to perform the engagement
Communicating effectively in the assurance report
(IAASB, 2016: pp 34–49)
It is in this area that the IAASB is seeking to generate discussion.
3.1.3 Auditing integrated reports
Auditors may be engaged to produce an independent verification statement on an integrated report.
This is an assurance report and would therefore need to be performed in line with the guidance
contained in ISAE 3000 Assurance Engagements other than Audits or Reviews of Historical Financial
Information (covered in detail in Chapter 12 of this Workbook).
This could be either a direct or an attestation engagement, with the practitioner presenting the
integrated report themselves (direct), or providing a report on information presented by the entity.
Practitioners in this area face many of the difficulties outlined above in relation to the audit of public
sector performance information. The measurement of financial or even physical capital is relatively
unproblematic because these areas may be readily subject to quantification. But intellectual, human
and social capital are much more difficult to present objectively; their measurement involves a good
deal of judgment. It is therefore difficult to see how an assurance engagement on an integrated
report could offer much more than limited assurance, sticking as much as possible to the factual
assertions made by the report and wording its conclusion negatively.
Essential reading
See Chapter 15 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for a reminder of how the various capitals are used within the Integrated Reporting
framework.
Activity 2: Integrated reporting
Required
(a)
What are the perceived benefits from an entity's point of view of paying for assurance on its
integrated report?
(b)
What would you expect to be the key contents of the practitioner's conclusion on an integrated
report?
Solution
(a)
Benefits to an entity
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฀฀
฀
฀
฀
฀
฀
(b)฀
Contents฀of฀the฀practitioner's฀reported฀conclusions฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
฀
4฀The฀audit฀of฀performance฀information฀in฀the฀public฀sector฀
Countries฀ face฀ conflicting฀ demands฀ from฀ their฀ inhabitants฀ –฀ they฀ crave฀ prosperity฀ and฀ the฀
ability฀to฀enjoy฀their฀own฀hard฀work,฀yet฀at฀the฀same฀time฀there฀is฀a฀desire฀to฀meet฀social฀ need฀
(health,฀education,฀welfare฀and฀democracy฀are฀some฀examples)฀but฀there฀is฀no฀consensus฀on฀
how฀ this฀ is฀ to฀ be฀ achieved฀ or฀ funded.฀ The฀ public฀ sector฀ caters฀ for฀ these฀ needs฀ but฀ often฀ from฀
public฀money,฀either฀directly฀from฀government฀or฀from฀other฀sponsors.฀In฀each฀case,฀accountability฀
of฀ how฀ social฀ need฀ is฀ addressed฀ using฀ public฀ funds฀ represents฀ a฀ significant฀ governance฀ challenge,฀
which฀assurance฀providers฀will฀try฀to฀meet.฀
The฀ financial฀ statements฀ of฀ public฀ sector฀ entities฀ have฀ been฀ subject฀ to฀ audit฀ for฀ many฀ years,฀ often฀
using฀their฀own฀interpretations฀of฀accounting฀standards฀due฀to฀the฀specific฀nature฀of฀their฀objectives฀and฀
funding฀structures.฀However,฀it฀is฀not฀always฀about฀financial฀performance,฀so฀the฀role฀of฀non-financial฀
information฀to฀support฀the฀assessment฀of฀public฀sector฀entities฀is฀important฀to฀understand.฀
There฀are฀two฀definitions฀that฀may฀be฀useful฀to฀compare฀and฀contrast฀here:฀
Performance฀audit฀(which฀is฀not฀
examinable฀in฀AAA)฀is฀part฀of฀the฀process฀of฀
reviewing฀financial฀statements฀for฀public฀sector฀
entities฀by฀assessing฀value฀for฀money฀(VfM)฀
which฀only฀uses฀quantitative฀data฀(financial฀
and฀non-financial)฀to฀assess฀the฀relative฀level฀of฀
service฀for฀a฀set฀financial฀amount฀(eg฀the฀cost฀
per฀procedure฀in฀a฀hospital,฀compared฀
across฀similar฀sites).฀
266฀
The฀audit฀of฀performance฀information฀
(which฀is฀examinable฀under฀AAA)฀can฀include฀
these฀VfM฀indicators฀but฀is฀more฀about฀assessing฀
operational฀performance฀by฀looking฀at฀
qualitative฀as฀well฀as฀both฀financial฀and฀nonfinancial฀quantitative฀measures฀against฀stated฀
objectives฀(eg฀standards฀of฀educational฀
attainment฀within฀and฀across฀school฀boundaries).
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15:฀Social,฀environmental฀and฀public฀sector฀auditing฀
4.1฀Problems฀with฀performance฀information฀
The฀ example฀ quoted฀ above฀ on฀ educational฀ attainment฀ may฀ seem฀ straightforward฀ as฀ performance฀
information,฀but฀let's฀consider฀it฀in฀more฀detail:฀
Does฀this฀
information฀
exist?฀
Standards฀are฀designed฀to฀assess฀performance฀against฀objectives:฀exam฀
pass฀rates฀may฀say฀something฀about฀whether฀the฀objective฀of฀educational฀
attainment฀has฀been฀met฀but฀are฀they฀enough?฀Are฀there฀any฀other฀methods฀
of฀assessing฀performance?฀
Can฀you฀measure฀
this฀information?฀
Alternative฀information฀may฀be฀available฀(eg฀inspections)฀but฀are฀they฀
measurable฀and฀do฀they฀support฀the฀findings฀of฀pass฀rates?฀
How฀relevant฀
is฀this฀
information?฀
The฀measure฀requires฀comparison฀with฀other฀entities฀to฀become฀
meaningful,฀so฀these฀other฀entities฀must฀be฀representative฀in฀terms฀of฀size฀
or฀demographics.฀
The฀challenge฀for฀practitioners฀engaged฀to฀audit฀measures฀such฀as฀these฀becomes฀more฀apparent฀
as฀ each฀ gets฀ defined฀ in฀ enough฀ detail฀ to฀ fully฀ understand฀ the฀ task฀ –฀ this฀ makes฀ acceptance฀
procedures฀extremely฀important฀before฀agreeing฀to฀perform฀such฀work.฀
4.2฀Planning฀and฀performing฀the฀audit฀of฀performance฀information฀
Assuming฀ all฀ ethical,฀ quality฀ control฀ and฀ acceptance฀ issues฀ are฀ addressed฀ satisfactorily,฀ the฀
practitioner฀can฀commence฀planning฀the฀engagement฀to฀ensure฀procedures฀are฀documented฀and฀
evidence฀ is฀ collected฀ that฀ meets฀ the฀ required฀ standards฀ against฀ set฀ objectives฀ in฀ order฀ to฀ allow฀ a฀
valid฀ conclusion฀ to฀ be฀ drawn฀ –฀ this฀ will฀ take฀ into฀ account฀ the฀ earlier฀ problems฀ identified฀ with฀
auditing฀such฀performance฀information.฀
Procedures฀may฀include:฀฀
฀
Tests฀of฀controls฀on฀the฀systems฀used฀to฀generate฀performance฀information฀
฀
Performing฀analytical฀review฀to฀evaluate฀trends฀and฀gauge฀the฀consistency฀of฀quantitative฀data฀
฀
Analysis฀of฀service-user฀activity฀data฀
฀
Review฀of฀service-user฀experience฀surveys฀
฀
Surveys฀of฀key฀management฀and฀staff฀
฀
Interviews฀with฀key฀management฀and฀staff฀
฀
Review฀of฀minutes฀of฀meetings฀where฀performance฀information฀has฀been฀discussed฀
฀
Confirmation฀of฀performance฀information฀to฀source฀documentation;฀this฀may฀be฀performed฀on฀
a฀sample฀basis฀
฀
Conducting฀case฀studies฀฀
฀
Review฀of฀existing฀literature฀
฀
Review฀of฀results฀of฀internal฀and฀external฀challenges฀
The฀auditor฀must฀keep฀documentation฀of฀the฀planning฀process฀and฀of฀the฀audit฀evidence฀obtained.฀
฀
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Activity 3: New Evenham
The country of New Evenham provides public sector hospitals which operate accident and
emergency (A&E) departments treating patients requiring emergency admissions (admissions that are
not planned and happen at short notice because of perceived clinical need). The New Evenham
Government is considering the introduction of a system for reporting A&E departments' performance
that goes beyond the current aim of value for money (VfM) and incorporates many additional forms
of quantitative and qualitative information.
Required
You work as an audit manager in the New Evenham Public Sector Audit (NEPSA) inspection unit.
You have been asked to draft a briefing note that explains how the audit of A&E performance
information will work in practice. Your briefing note should address the following:
(a)
Identify FOUR examples of performance information that would help both hospital managers
and members of the public assess each A&E department's performance.
(b)
For each example, recommend audit procedures that NEPSA's inspection unit would carry out
to reach a conclusion about each A&E department's performance (your answers should
consider the likely sources of evidence available).
(c)
What problems might NEPSA experience while carrying out its work?
Solution
(a)
Four examples of performance information used to assess A&E departments
-
-
-
-
(b)
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Audit procedures to reach conclusions about performance (including evidence)
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15: Social, environmental and public sector auditing
(c)
Problems that may be experienced during the audit
4.3 Concluding and reporting on the audit of performance
information
The practitioner expresses a conclusion on the entity's achievement of its objectives however
it sees fit (there is no standard report format) so it will depend on the nature of the
engagement as agreed with the entity. The entity's report may take the form of an integrated
report of performance against its objectives, compared with the performance information itself, so
the practitioner's conclusion would be included within this document (this may require an
assessment of the consistency of the entity's performance compared with other information in the
integrated report on which a conclusion has already been given, such as the audited financial
statements).
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Chapter summary
Social, environmental and public
sector auditing
1. Practical context
2. Impact on
practitioners
Increased importance – why?
Affects auditors through:


Application of environmental laws
and regulations

Potential pollution by client
Social and environmental issues
now politically and
economically important

Growth of ethical investors,
consumers and employees


Increase in social and
environmental legislation
affecting businesses
Contamination of land and
buildings on statement of financial
position

Dependence on major market
affected by environmental issues

Greater use of voluntary reporting
to satisfy stakeholders
3. Assurance on
integrated reports

Additional assurance
engagements – no
formal structure for reports

Integrated reports use
the six capitals: Financial;
Manufactured; Human;
Intellectual; Natural; Social
3.1 Planning and
performing an
engagement to review an
integrated report
2.1 General financial
statement impacts

No specific knowledge of
environmental matters required

Should obtain sufficient
knowledge of the business to
understand impact on audit
Substantive procedures
General:
Board
minutes,
reports,
media etc
270
Assets:
Impairments
and
changes in
asset usage
policy.
Liabilities,
provisions
and
contingencies:
Restructuring,
fines and
penalties,
estimates

Types of measurement:
– Direct (eg kg emitted)
– Relative (eg kg per
capita)
– Indexed (eg over a
period)
– Aggregated
– Weighted

Items for measurement
include gas/liquid
emissions, waste amounts,
staff turnover, customer
complaints and even
donations to charity
Disclosure:
Sufficient for
stakeholders?
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15: Social, environmental and public sector auditing
Social, environmental and public
sector auditing
4. The audit of public sector
performance information
Performance audit
Assessing value-for-money using quantitative
measures
Auditing performance information
Using quantitative (non-financial) and
qualitative information as well to assess
operational performance
What are the problems?
Does the information exist? How easily can it
be measured and relied upon?
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Knowledge diagnostic
1.
Social and environmental issues are now of critical importance to the vast majority of
businesses, customers and employees and therefore cannot be ignored.
2.
The auditor must have an understanding of the impact of these issues on their work, as social
and environmental issues can generate significant risks for audits. (Although auditors do not
have to be experts, they should respond to any significant risks with appropriate
substantive procedures.)
3.
Stakeholders are demanding accountability from businesses and increasingly, they are
responding by producing social and environmental information as part of an
integrated report. In many cases, the auditor will provide assurance on this information
although the precise nature of this information can vary enormously.
4.
There is a distinction between performance auditing and the audit of performance
information but for practitioners, the main challenge lies in planning and performing an
engagement that addresses the inherent risk of auditing this information but still allows valid
conclusions to be drawn and reported.
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15: Social, environmental and public sector auditing
Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 29 'Rank' is further practice of acceptance and procedures for a non-audit engagement –
in this case, a social and environmental report for an ethical company.
Further reading
There is one technical article on the ACCA website written by members of the AAA examining team
which is relevant to some of the topics covered in this chapter that you should read:

Performance information in the public sector
Own research

Try and find some real life examples of social and environmental reports – have they been reviewed
and if so, what did the review report contain?

For an example of what an integrated report could look like, why not have a look at what ACCA has
done?
https://annualreport.accaglobal.com/assets/downloads/ACCA-Integrated-Report-2018.pdf
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Current issues
Learning objectives
On completion of this chapter, you should be able to:
Syllabus
reference no.
Discuss current developments in auditing standards including the need for new
and revised standards and evaluate their impact on the conduct of audits.
G2(a)
Discuss current developments in business practices, practice management and
audit methodology and evaluate the potential impact on the conduct of an audit
and audit quality.
G2(b)
Discuss current developments in emerging technologies, including big data and
the use of data analytics and the potential impact on the conduct of an audit
and audit quality.
G2(c)
Business and exam context
At this level in your studies you are expected to be familiar with current developments affecting the
audit and assurance profession. Currently, many of these relate to international regulation.
You must read Student Accountant and the wider professional press to keep up to date with these.
You may be asked to discuss current developments and must be prepared to argue for or against any
new proposals from the point of view of either a preparer or user of assurance reports.
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Chapter overview
Current issues
Current developments in
auditing standards and their
impact on the audit
Current developments in
emerging technologies and
their impact on the audit
Current developments in
business practices and their
impact on the audit
276
The examining team's
technical articles and other
publications
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16: Current issues
1 Current issues
Syllabus section G on current issues may be examined in Section A or B as appropriate. The
topic of current issues is unlikely to form the basis of any question on its own but instead, will be
incorporated into the Case Study or either of the Section B questions, dependent on question
content and the topical issues affecting the profession at the time of writing.
For example, Question 3 part (a) of the specimen exam contained the following requirement
following a comment made by the IESBA on the subject of auditors performing non-audit work:
Discuss the changes made to the Code in relation to non-assurance services and evaluate the
arguments for and against auditors providing non-assurance services to audit clients.
(8 marks)
Clearly, producing a sound answer to this would require the following:
Awareness of the current changes made
to the IESBA Code – you can get this
from reading Chapter 16 of the Essential
reading (found in the digital edition of
this Workbook) and from keeping an eye
on the ACCA's website for any recent
technical articles written by the
examining team for AAA.
Good technique for writing solutions
using all the elements of the requirement:
 A discussion of the changes
 Arguments in favour
 Arguments against
 An overall conclusion
Use the 'Further Question Practice' at the
back of the Workbook to work on your
technique (found in the
digital edition of this Workbook).
Essential reading
See Chapter 16 of the Essential reading, available in Appendix 2 of the digital edition of the
Workbook, for further details of all the relevant current issues that ACCA and BPP think you need to
be aware of to be prepared for the AAA exam.
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Chapter summary
Current issues
Current developments in
auditing standards and their
impact on the audit
Current developments in
emerging technologies and
their impact on the audit
Current developments in
business practices and their
impact on the audit
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The examining team's
technical articles and other
publications
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16: Current issues
Knowledge diagnostic
1.
It is essential that you access the material from Chapter 16 of the Essential reading section
available in Appendix 2 of the digital edition of the Workbook for all the information relevant to
this part of the syllabus.
2.
You must keep accessing the ACCA website for any last minute technical articles published that
might be examined.
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Further study guidance
Question practice
Now try the question below from the Further Question Practice Bank (available in the digital edition of the
Workbook).

Question 30 'Merger of audit firms' – there is no way of knowing what (if any) current issues the
exam will contain, but you should get used to being able to discuss things in this manner.
Further reading
There is one technical article on the ACCA website written by members of the AAA examining team
which is relevant to some of the topics covered in this chapter that you should read:

Auditing disclosures in financial statements
Own research

You MUST keep reading the business press and a quality news source for regular updates on what is
relevant to the auditing and accountancy profession.

You also MUST keep up to date with any last minute technical articles published by the ACCA AAA
examining team in case they are tested in your exam.
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SKILLS CHECKPOINT 5
Non-audit engagements and current
issues
An
sw
er
aging information
Man
g
nin
an
Planning the
audit and
gathering
evidence
Completion
and reporting
r re Co
c rr
of t inteect
req of rprineteation
uirereq rpretation
m eunirts
e m e nts
ve
s e w r it
nt in g
at i
on
Practice
management
Exam success skills
Specific AAA skills
Co
ti
e c re
Eff d p
an
Legal and ethical
responsibilities
Non-audit
engagements
and current
Non-audit
issues
engagements
and current
issues
g
nin
an
Good
T ood
Manag Gim
e tim
em
e
m
aneag
nteme
nt
pl
An
sw
er
pl
Efficient numerica
analysis
l
Introduction
Remember that although this is an audit exam, the words '…and Assurance' are also in the title. The syllabus
contains a number of non-audit elements that you could be tested on, so this checkpoint will consider how you
can prepare for these if required. Part F of the syllabus covers these subjects.
The AAA examining team also periodically publishes technical articles on subjects deemed to be of interest to
candidates. In some cases, they may recommend exam techniques for syllabus topics that have been poorly
answered in previous exam sittings; in others, they may relate to current issues which the examining team want
candidates to be aware of.
Traditionally, whenever a technical article is published, the content is often examined within the next couple of
sittings, so keeping up to date with these technical articles is essential. You will find references to relevant
technical articles with the 'Further reading' sections of this workbook.
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Skills Checkpoint 5: Non-audit engagements and current issues
AAA Skill: Non-audit engagements and current issues
A step by step technique for approaching questions testing this part of the syllabus now follows (you
may find that some of these techniques are suitable for other parts of the syllabus as well – why not
start practising them now?)
STEP 1:
Think about the question and list all
the things that you will need to do.
STEP 2:
Read the scenario and identify all the
areas that are relevant to producing
an answer.
STEP 3:
Is there any other technical
knowledge that will help you to
produce an answer?
STEP 4:
Draw up an answer plan based on
your outputs from Steps 1, 2 and 3.
STEP 5:
Write your answer.
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Skills Checkpoint 5
Exam success skills
There are some key exam skills that will help you when answering this kind of question which are
summarised below:

Answer planning. Questions on non-audit engagements can be quite technical – for
example, the specific matters to be considered before accepting an engagement to review
prospective financial information (PFI) – but they may also be based on the examining team's
technical articles. You can access technical articles written by the examining team online
(available from the ACCA website) which will help you to build a plan.
Questions on topics like this can also be more applied and require sound commercial
awareness and common sense to score well. A previous exam question was set in the
context of a company which would receive substantial government funding only if it achieves
targets in three specific areas, one of which is 'accidents in the workplace'. The following
requirement relates to this:
(ii)
Describe the procedures to verify the number of serious accidents in the
year ended 30 November 20X7.
(4 marks)
The examining team reported that for this question:
'Many candidates seemed to think that the auditor has access to absolutely any kind of
evidence that they could wish for. Common sources of evidence referred to included:
•
•
•
•
•
The private medical records of employees
Police reports on 'dangerous' incidents
Hospital admissions data
Interviews with ambulance drivers/paramedics/doctors
Death certificates
Candidates need to appreciate that although the auditor will have access to books and records
held by their client, they will not be able to access external and possibly highly confidential
information as a means to gather evidence. The above examples show of a lack of
commercial, or even, common sense.'

Correct interpretation of requirements. It is vital that you read the data in the scenario
and then consider the requirements of the question in that context. All too often, candidates
read the requirements and then produce an answer to the question they think has been
asked or the question they think they can answer, not the actual question
itself.
Consider the following question from a recent exam sitting:
Your audit client, Mulligan Co, designs and manufactures wooden tables and chairs. The
directors want to secure a loan of $3 million in order to expand operations and have
approached LCT Bank for the loan. The bank's lending criteria stipulate the following:
'Loan applications must be accompanied by a detailed business plan, including an analysis of
how the finance will be used. LCT Bank need to see that the finance requested is adequate for
the proposed business purpose. The business plan must be supported by an assurance opinion
on the adequacy of the requested finance.'
Your firm has agreed to review the business plan and to provide an assurance opinion on the
completeness of the finance request. A meeting will be held tomorrow to discuss this
assignment.
Required
(a)
Identify and explain the matters relating to the assurance assignment that should be
discussed at the meeting with Mulligan Co.
(8 marks)
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What matters should be discussed at this meeting? Issues of an acceptance nature perhaps:
'Do we want the work?'; 'Are we competent to act?'; or even, 'Have we got the necessary
resources?' Maybe issues of a client acceptance nature might also be appropriate here, such
as, 'Is this client legitimate?'
Reading the scenario is vital – the following comes from the AAA examining
team's report:
'The vast majority of answers to requirement (a) stated that at the meeting they would discuss
'whether we are competent to take on the work'. Surely this is not something you would raise
at a meeting with your client having just agreed to do the work… Many candidates
(also) wanted to discuss at the meeting matters such as, 'Do we have the experience to
perform the work?' Again, I would think that the client would be surprised to learn that you
may not be knowledgeable enough to conduct the assignment, especially considering that you
are the auditor of their business. I would urge candidates to stop and think, and consider if the
matters they are suggesting discussing at the meeting… fit in with the scenario provided.'

Good time management. Finally, it may seem obvious, but the rule of 1.95 minutes per
mark applies all the way through the exam. If you have over run on any earlier questions,
eventually it will catch up on you. The logic we discussed in an earlier skills checkpoint still
applies – always attempt those questions that you feel most confident about first, and leave the
ones you feel less confident about until the end of the exam.
If tested, the question relating to current issues and non-audit engagements may be the 'rogue
variable' in your AAA exam, which means you leave it to the end to attempt. However, you
will always score more marks for the first half of an answer than the second, so if time is
getting tight, make sure you have at least started every question, even if it is unpopular!
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Skills Checkpoint 5
Skill Activity
STEP 1
Consider the following question and write a short list of the things you are going to
need to consider in order to satisfactorily answer the requirement.
You are a manager in the forensic investigation department of an audit firm. You have been
approached by the Finance Director of Arnold Co to investigate a possible fraud. The Finance
Director has identified a number of unresolved discrepancies between inventory records and the
quarterly physical inventory counts which are performed. Her suspicions have been increased by the
fact that the discrepancy always relates to the same product line and approximately the same
number of items appear to be missing each time.
Required
(a)
Explain the procedures you would perform to determine whether a fraud has taken place and
to quantify the loss suffered by the company.
(6 marks)
List of things to consider




6 marks = 12 minutes (3 minutes reading, thinking and planning time; 9 minutes writing)
Usually 1 mark per well-explained point, so will need 6 things to score well
Procedures to determine whether a fraud has taken place (maybe 3 or 4 things)
Procedures to quantify the loss suffered (maybe 2 or 3 things)
This should start to become second nature to you when starting to answer a question – the
requirement, the time, the points required.
STEP 2
Read the scenario, identifying those areas most relevant to producing an answer.
In this case, the approach to answering the question is likely to include the elimination of legitimate
reasons as to why the discrepancies may have arisen, leaving fraud as the only plausible reason for
the missing inventory. However, you have not been asked to explain how the fraud arose though.
Let's look at the scenario again:
Who completes
the count and
how are
discrepancies
normally
resolved?
How is the
count
performed? Are
there any issues
that could
explain the
discrepancy?
You are a manager in the forensic investigation department of an audit firm.
You have been approached by the Finance Director of Arnold Co to investigate
a
fraud.
The
Finance
Director
has
identified
a
number
of
unresolved discrepancies between inventory records and the quarterly physical
inventory counts which are performed. Her suspicions have been increased by
the fact that the discrepancy always relates to the same product line and
approximately the same number of items appear to be missing each time.
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Need to confirm
what these are
to see if there is
a reason for
their
disappearance
Confirm
amounts to see
if this helps with
the investigation
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STEP 3
Identify any areas of technical knowledge that may help you to answer the question.
Discrepancies between accounting records and real evidence usually tend to occur for one of two
reasons – either fraud or error. In this case, we are trying to eliminate as many of the legitimate
reasons why this may have occurred, leaving fraud as the only plausible reason (from that point on,
the collection of evidence would need to be more cautious in case any 'tipping off' occurs).
Remember what you have already learned about inventory counts and how they work – you are
trying to find any shortcomings in any of the three stages:

Beforehand – Usually related to the count instructions, the timing of the count and the staff
involved

During – Were the instructions followed, has anything unusual happened, were goods being
issued at the same time etc?

After – How were results reported and scrutinised, what follow-up work was done etc?
You should also consider what you have learned about the controls usually present in warehouses
regarding inventory and establish whether there are any deficiencies here.
STEP 4
Draw up an answer plan using the outputs from Steps 1, 2 and 3.
Note how practical this requirement actually is – there's very little (if any) knowledge of forensic
auditing to add to this, other than the general context of the scenario and the ability to understand it
as an engagement in its own right.
Here's an example of a plan which may help:
Has a fraud taken
place?
1 – Who completes the count?
2 – How are discrepancies followed up?
3 – What controls are in place?
4 – Understanding the business and inventory items
How much has
gone missing?
1 – Confirm book values and count values
2 – Cost up differences
6 points in total = 6 marks which should take around 12 minutes
Start: 10.06
End: 10.18
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Skills Checkpoint 5
STEP 5
Write your answer.
Procedures would involve the following.
To establish whether a fraud has taken place:

Obtain an understanding of the business and in particular, the roles and responsibilities of
those involved in processing inventory transactions and those in the warehouse.

Discuss with management the method adopted for conducting the quarterly inventory count
and review the detail of the count instructions. Any weaknesses in the controls should be
identified and considered as a possible explanation for the discrepancies, eg double counting
of this particular line of inventory.

Obtain confirmation of whether inventory is held at more than one location. If so, confirm that
this has been included in the physical inventory counts.

Review procedures for the identification of obsolete and damaged items and in particular, the
disposal of such items. Determine who is responsible for making the decision and the
procedures for updating records for these adjustments. If items have been disposed of but
records not maintained, this could explain the discrepancy.

Obtain an understanding of the system for the processing and recording of despatches and in
particular, consider the effectiveness of controls regarding completeness of despatches. Trace
transactions from order to despatch in respect of the inventory line in question to confirm that
all goods out have been recorded.

Obtain an understanding of the system for the processing and recording of goods received for
this inventory line. Controls over the initial booking in of inventory should be reviewed. If
inventory is double counted at this stage, this could account for the discrepancy.

Review the system for subsequent processing of goods received, in particular the controls and
procedures regarding the accuracy of input. If goods in are processed more than once, this
would give rise to a discrepancy between the book records and actual inventory.

Assess the existence of general controls affecting access to the warehouse and inventory.
To quantify the loss
The evidence obtained above should enable the auditor to determine the accuracy of the book
records and the accuracy of the physical inventory records. A reconciliation of the two figures should
provide the number of units missing. The cost of each unit should then be agreed to recent purchase
invoices.
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Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed below
for Arnold Co to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Good time
management
6 marks, taking up to 1.95 minutes per mark, should take up 12
minutes in total.
The split between reading/thinking/planning time and writing time
(something like ¼ to ¾ respectively of the total time) should be 3 to 9
respectively – did you follow this?
Managing information
Did you pick up on all the information you needed to satisfactorily
answer the question?
Correct interpretation
of requirements
Do you think you were able to 'explain' sufficiently well,
distinguishing between the two issues of establishing whether there
was a fraud and quantifying it?
Answer planning
Did you complete a plan for such a short requirement? If so, did it
help? If not, how did you get on and will you do the same in future?
Effective writing and
presentation
Did you manage to carry all the points from your plan through into
your final answer?
Efficient numerical
analysis
Not applicable for this question
Most important action points to apply to your next question
Summary
In some respects, questions on this part of the syllabus are the hardest to answer as they relate to
infrequently tested topics and the subject of current issues. However, as this question shows, the
technical knowledge required to produce an answer is often outweighed by the need to display
sound commercial awareness and common sense, both of which you should possess as a nearlyqualified accountant.
In addition, the fact that such questions are tested infrequently means that as long as you have
practised examples from each of the key syllabus areas (including assurance, due diligence,
prospective financial information, forensic, social and environmental audits) and kept up to date with
the examining team's technical articles, you should be ready for anything!
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Appendix 1 – Activity answers
Appendix 1 – Activity answers
Chapter 1: International regulatory environments for audit
and assurance services
Activity 1: Regulating the audit profession
Approach
This question is designed to get you thinking about why there is so much regulation within the audit
profession. Your answer needs to have considered the reasons why people rely on auditors;
however, you also need to consider why people may find their trust in auditors has been damaged in
recent years and how the profession has responded.
This type of requirement is possible within a larger question, especially if it relates to the content of
an ACCA examining team technical article. The AAA specimen exam (available on the ACCA
website) contains an illustration of how a subject like this could be examined.
Suggested solution

The reputation of the audit profession has, in recent years, suffered due to high profile audit
failures (eg Carillion, BHS, Patisserie Valerie, Autonomy, the financial crisis of 2008 – and of
course the classic examples of Enron, Parmalat and WorldCom) and somehow the public's
trust needs to be re-established.

The existence of auditing standards and other regulations should protect/enhance the
reputation of the profession amongst all stakeholders by ensuring a consistently high level of
work across all firms.

Businesses have become more complex and global, and firms have expanded their range
of services beyond traditional assurance and tax advice. This has led to a great deal of
re-examination of regulatory and standard-setting structures both nationally and internationally
in recent years.

The competitiveness in the public audit sector (or lack thereof, especially in UK FTSE 350
audits for example) has led to downward pressure on fees and a consequent impact on
quality, which has led some to consider the regulatory role of ethical codes as key (eg
stopping firms from offering non-audit services to their audit clients).
Activity 2: Ethics and money laundering
Approach
As with the activity on regulation, there is a balance to be struck here between the duty of care owed
by auditors to their clients (and to themselves, as they are not charities!) and the duty to society
overall, to demonstrate that they can be trusted to act in the public interest.
Requirements of this type are seen in the AAA exam but usually in the context of something topical.
Suggested solution

In many countries, the legal requirements are onerous and the penalties for non-compliance
are severe (For example, in the UK auditors risk long prison sentences if they commit an
offence).

Money laundering is widely defined and it is not always obvious that an offence has been
committed.

Without the guidance in issue, accountants may be used unwittingly to launder criminal funds.
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
In many countries, the law creates a conflict between the ethical duty of confidentiality to the
client and the legal duty to report money laundering offences. The guidance helps to clarify the
members' professional duty to report offences.

The reputation of accountants is poor, leading many in society to question whether they are
acting in their own (or their clients') best interests, rather than those of society as a whole. For
example, if accountants are to be paid for tax advice that reduces the liability of the client, is
this in the best interests of society? Ethical guidance is vital for accountants to maintain their
reputation.
Chapter 2: Code of ethics and conduct
Activity 1: Ethical threats
Approach
This activity serves as something of a refresher for you, as you should have seen the ethical threats in
your earlier studies. Use this as a way of reminding yourself what each threat means and how it
could be present from the situations you suggest.
Note that in the real exam, you are likely to consider this from the opposite direction: a scenario will
present a set of circumstances that you will need to analyse in order to find the appropriate ethical threat.
Suggested solution
Self-interest threat
This would arise in situations where the audit firm or a member of the engagement team has some
financial or other interest in the audit client. For example:




Providing a loan to a client
Earning fees on a contingent basis, ie profit related
Owning shares in a client
Undue dependence on fees from a client
Self-review threat
The self-review threat occurs when a previous judgment needs to be re-evaluated by members
responsible for that judgment. The situation tends to arise when the auditor has provided other
services to a client. Key examples would be:

The auditor providing a specialist valuation (eg pension liabilities)

The audit firm providing internal audit services and subsequently relying on the work for the
external audit

Reporting on the operation of financial systems after being involved in their design or
implementation
Advocacy threat
The advocacy threat occurs when members promote a position or opinion to the point that
subsequent objectivity may be compromised. Specific examples would be:

Acting as an advocate on behalf of an assurance client in litigation or disputes with third
parties

Promoting shares in a listed entity when that entity is a financial statement audit client
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Appendix 1 – Activity answers
Familiarity threat
The familiarity threat occurs when, because of a close relationship, members become too sympathetic
to the interest of others. Circumstances which would create a familiarity threat would include:

Long association with a client

Acceptance of gifts or preferential treatment unless the value is clearly insignificant

Overfamiliarity with the management of the organisation such that judgment could be
compromised
Intimidation threat
The intimidation threat occurs when members are deterred from acting objectively by threats, actual
or perceived. Such a threat will occur in the following circumstances:

The threat of dismissal or replacement of the member, or a close or immediate family member,
over a disagreement about the application of an accounting principle or the way in which
financial and performance information is to be reported

A dominant personality attempting to influence the decision-making process or controlling
relations with auditors

Being threatened with litigation

Being pressured to reduce inappropriately the extent of work performed in order to reduce fees
Activity 2: Ethical responses
Approach
This is similar to the way that such content would be examined in the AAA exam, albeit with slightly
less detail than an exam standard scenario would present. The approach you should follow needs to
cover two things: firstly, the threat(s) presented by the scenario with reasons why this represents the
threat(s) identified; and secondly, the response(s) that should be taken, along with justifications.
Suggested solution
Issue 1
Godfather
Threats:
There is a risk that the partner's personal relationship with the client will result
in self-interest, familiarity and intimidation threats. This is because the
partner has been involved with the client for many years and evidently has a
personal relationship with a senior member of client staff, despite the fact
that this should be an independent audit assignment. We are not told whether
or not the partner involved is the engagement partner for this client, so our
responses will need to consider both possibilities, but any partner would be
able to exert significant influence on the conduct of the audit.
Responses:
The risk arising here is significant, because both the engagement partner of
the firm and the finance director of the client are in senior positions, meaning
that any lack of objectivity could affect the financial statements. The firm
should therefore implement safeguards to mitigate against these threats. If it
is the engagement partner who has been asked to be godfather, that partner
should be rotated away from this engagement immediately. If it is not the
engagement partner who has been asked to be godfather, an independent
partner should provide an engagement quality control review
(sometimes called a 'hot review' or pre-issuance review) of the audit to ensure
there has been no undue influence on conduct of the audit.
(IESBA Code: section 521)
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Issue 2
Actuarial services
Threats:
Actuarial services are covered by valuation services in the IESBA Code,
which state that the provision of such services may give rise to a self-review
or advocacy threat. For clients that are not public interest entities, if the
service involves evaluating matters that are material to the financial
statements and the valuation involves a significant degree of
subjectivity, then the threat to objectivity and independence cannot be
reduced to an acceptable level by appropriate safeguards and
the service should not, therefore, be provided.
For public interest entities, valuation services for material items shall not be
provided by a firm, regardless of the level of subjectivity.
Responses:
Undertaking this service for an audit client that is not a public interest entity,
for amounts that are neither separately, nor in aggregate, material to the
financial statements, or that do not involve a significant degree of subjectivity,
could still create a self-review or advocacy threat. However, safeguards
could be applied, such as the involvement of an additional accountant
who is not a member of the assurance team to review the work done, and
ensuring that members doing the valuation work do not also undertake
the audit work for that client.
(IESBA Code: section 603)
Activity 3: Aventura International
Approach
As this is an exam standard question, you should consider the basics of exam technique here:

Timing: 15 marks = 29 minutes, split roughly into 8 minutes of thinking and planning, and
21 minutes of writing.

Planning: The question requires you to find issues to discuss and recommend suitable
responses – assuming an average of 5 marks for each scenario, you should consider 2–3
issues and 2–3 responses in each case.

Content: Use the knowledge from the chapter and the Essential reading to inform your
answer with the content of the various Codes of Ethics.

Tone: You should get used to writing for a critical audience and consider the higher level
judgment skills of communication, scepticism and logic.
Suggested solution
Ethical situations arising in connection with the audit of Aventura International
1
Offer of goods
At the inventory count, the auditors attending were invited to purchase inventory at 30% of
RRP, that is, at a 70% discount.
ACCA's guidance on accepting goods states that such benefits should only be accepted on
'normal commercial terms' or if the value is 'trivial and inconsequential' (ACCA Code: section
260.2; IESBA Code: para R906.3). What constitutes trivial and inconsequential will be a
matter of judgment for the auditor.
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Benefit
It is possible that this offer does approximate to offers made to staff at Aventura, as clothes
commonly retail at prices with a substantial mark-up on cost. It would not be unreasonable for
a clothes retailer to give staff a 'cost' benefit. The auditor should determine whether such a
benefit is made available to staff. If it is not made to staff it should not be accepted by the
auditor. The ethical threat most likely to be relevant here is self-interest, although enjoying a
discount that client staff may also have access to could introduce a familiarity threat too.
The term 'trivial and inconsequential' should be considered in terms of materiality to both the
auditor and the company. The offer is not material to Aventura, for whom clothes retail is only
one division. However, the offer of unlimited fashion at a 70% discount is extremely likely to
be material to junior audit staff (who are the grade most likely to be allocated to the inventory
count). In this context, the benefit is clearly not inconsequential.
Timing
It would be inappropriate to take up the offer at the inventory count, not least because this
would constitute movement of inventory during the count, which would be wrong.
Also, the junior staff members should not accept such goods without having first discussed the
matter with the audit partner (it is assumed in this answer that this is the first time such an offer
has been made).
Lastly, if mistakes were to be made on the inventory count, the audit might be open to charges
of negligence if it appeared its staff members indulged in a shopping trip when they should
have been auditing.
Action to be taken
The audit staff members should not take up the offer at the inventory count.
The audit partner should discuss the matter with management, ascertain whether a similar
benefit is offered to Aventura staff and decide whether he feels it is appropriate for his staff to
take up the offer. It may be inappropriate as Aventura might become perceived to be a
'reward' job by audit staff. Alternatively, it might be appropriate if the audit firm imposed a
financial limit to the benefits their staff could accept.
2
Hospitality
An invoice to the company for business use of the Chief Executive's jet shows that the Audit
Manager was flown to Florida and back for a stay of two weeks.
Issues arising
(a)
If the invoice was ostensibly for 'business use', what was the business? (Neither the
client nor the auditor have offices in Florida.)
(b)
If the invoice was not for business, the Chief Executive is wrong to invoice it to the
company. Is this common practice?
(c)
If it was for business, the cost of the auditor's flight should not have been charged
directly to the company, but to the audit firm instead, which could then have recharged
it. Was Darius Harken working for the weeks in question, or is it recorded as holiday in
the audit firm's records?
(d)
Does the invoice actually represent a significant example of hospitality being accepted
by the Audit Manager?
(e)
Did the Audit Manager travel alone, with family, or even with the Chief Executive? Does
this indicate that the audit manager has a close personal relationship with the Chief
Executive?
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Hospitality/close personal relationship
It is possible that points (d) and (e) above may be indicated by the invoice.
In terms of accepting hospitality, ACCA's guidance is the same as was discussed above in
relation to accepting goods. It is unlikely that paying for an auditor's flight would be
considered to be on normal commercial terms, because it would be traditional for the audit
firm simply to recharge the cost of a business trip. Taking steps such as these would help to
reduce the suggestion that something inappropriate has occurred, if the trip was genuinely
business related.
If the trip was for pleasure (a) it should not have been charged to the company, which raises
several auditing issues in its own right, and (b) it does not come within the definition of 'trivial
and inconsequential'. Ethical threats of self-interest and familiarity are evidently possible
here.
In terms of close business or personal relationships, ACCA's guidance states that these might
adversely affect, or appear to affect, the objectivity of the auditor. It seems likely that in this
instance, if the Chief Executive and the Audit Manager have been on holiday together, or at
least a business 'jolly', then as a minimum, objectivity will appear to be threatened.
Action to be taken
3
(a)
The audit firm should check its personnel records and see whether Darius Harken was
working or holidaying at the relevant time.
(b)
If the trip was business related, the audit partner should check why the cost has been
invoiced to the company by the Chief Executive and not by the audit firm.
(c)
If the trip was personal, then the Audit Manager appears to have threatened the
objectivity of the audit and, indeed, given that the trip appears to have been taken
around the time the prior year audit was taking place, that audit is also adversely
affected.
(d)
The prior year audit files should be subjected to a 'post-issuance' or 'cold' review and
the Audit Manager should be replaced on this year's audit, which should also be
subject to a quality control review.
(e)
All invoices rendered to the company in respect of the jet should be scrutinised by the
audit team, for further evidence of personal expenses being charged to the company.
The impending marriage of the Chief Executive
The Chief Executive's assistant is the former accountant in charge of the audit of Aventura,
who is likely to have been involved with the audit of the previous year end. She has just
announced her engagement to the Chief Executive.
Issues arising
(a)
Current year audit – there is a risk of loss of independence as the Chief Executive's
assistant is aware of the firm's auditing methods.
(b)
Prior year audit – there is a suggestion that the accountant in charge of the audit may
have been in a personal relationship with the Chief Executive which may have
adversely affected her objectivity.
Movement of audit staff
Ethical guidance states that where a member of the audit team gains employment with an
audit client, then familiarity and intimidation threats may arise. Where a 'significant
connection' remains, then no safeguards could reduce the risk to an acceptable level.
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If there is no significant connection, then the IESBA Code suggests a number of safeguards in
this situation, such as:

Considering the appropriateness of modifying the plan for the engagement

Assigning the audit team to someone of sufficient experience in relation to the person
who has left

Involving an additional accountant not previously associated with the audit to review
In the UK, for example, the FRC's Ethical Standard Section 2 states that in this situation, the
following factors should be considered:
(a)
The position the individual had in the engagement team or firm
(b)
The position the individual has taken at the audit client
(c)
The amount of involvement the individual will have with the engagement team
(especially where it includes former colleagues)
(d)
The length of time since the individual was a member of the engagement team or
employed by the audit firm
Following the assessment of such threats, appropriate safeguards should be applied where
necessary.
Action to be taken
Although the accountant in charge was not the most senior staff member on the audit, it would
have been prudent to modify the audit plan before this year's audit. However, this does not
appear to have been done, and the audit is nearing completion.
Therefore, it is important that Voest conducts a quality control review of this audit.
In relation to the suspicion that Ms Fennimore's objectivity may have been affected last year, it
might also be a good idea to conduct a similar review of last year's audit work, evidence
obtained and conclusions drawn. However, as the work should have been reviewed by an
audit manager and partner after Ms Fennimore's involvement, the risk of a problem on last
year's audit appears to be slight.
Chapter 3: Professional liability
Activity 1: Moorland
Approach
While based on an exam-standard question, this activity is really all about seeing how well you can
apply your knowledge of liability issues to a specific set of circumstances. Use the Essential reading
to refresh your knowledge if required and consider how each requirement is testing the various
factors associated with liability.
Suggested solution
(a)
There were a number of interesting developments in the area of auditors' liability to third
parties in the 1980s and 1990s. The most significant recent case decision is the Caparo case
(1990).
Prior to the Caparo case, the position was that auditors' liability depended on a qualified test
of reasonable foresight, that is to say, liability depended on a principle whereby negligent
accountants owed a duty of care to those who can be foreseen as likely to sustain damage if
carelessness exists. However, this came with the important qualification that any prospective
plaintiff, to succeed in their action, must establish that it was reasonable in the circumstances
for them to rely on the audited accounts.
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However, the Caparo case narrowed those who can successfully sue the auditors for
negligence to the company or the shareholders as a group. It is unlikely that an individual
shareholder will be able to successfully sue an auditor. However, the case has not yet been
tested in the UK courts.
(i)
The possibility of demonstrating negligence
It is worth noting the comments of the UK's Auditing Practices Committee at the time
(now the Financial Reporting Council) in the preface to the auditing standards and
guidelines on the relationship of standards and guidelines to the law:
Members are advised that a court of law may, when considering the adequacy
of the work of an auditor, take into account any pronouncements or publications
which it thinks may be indicative of good practice. Auditing standards and
guidelines are likely to be so regarded.
The Littlejohn case demonstrated this principle: following auditing standards and
documenting the approach is a good defence against possible third-party action.
In the case of Moorland, the auditor seems to have laid himself open to a possible
charge of negligence in that they did not attend to observe the company's physical
inventory counting procedures as recommended by ISA 501 Audit Evidence – Specific
Considerations for Selected Items. Much would depend on whether or not the auditor
could satisfy the court as to whether there were good practical reasons for nonattendance and the other audit work which they carried out in relation to inventories
provided sufficient, relevant and reliable audit evidence on which to base the audit
opinion.
(ii)
The fact that the inventories figure in the financial statements apparently 'made sense'
This seems to suggest that the main audit evidence on which the auditor based his
opinion, in relation to the inventories figure, was the result of his analytical review work
in this area. As the auditor seems, through pressure of work, to have neglected to attend
the inventory count, then one would expect him to have carried out more extensive
analytical review procedures than would perhaps normally have been the case for that
client. If it appeared that the auditor had only carried out a minimal amount of review
tests, then he would be very likely to be open to a charge of negligence.
(iii)
The fact that the auditor was not informed that the financial statements and auditor's
report were to be used to obtain additional finance
If the person who provided the unsecured long-term loan to Moorland were to be able
to recover damages against the auditor, then the court would need to be satisfied, on
the evidence before it, that:
(1)
The auditor had been negligent;
(2)
The third party had suffered loss in consequence of that negligence on the part of
the auditor; and
(3)
The auditor should reasonably have foreseen that the third party might wish to
place reliance on the audited accounts.
As a result of the Caparo case, it would appear that the third party would not
succeed in an action against the company: the plaintiff would need to prove that
the auditor knew that the financial statements would be used specifically to obtain
finance from this third party, which is not the case here.
However, this can only be decided by the courts.
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(b)
From the above it may be seen that the issue of auditor's liability will always be dependent on
the facts of an individual case. However, there are steps that any firm of auditors/accountants
should take to minimise the risk of successful litigation against them on the part of clients
and/or third parties. Such steps would include:
(i)
Adhering at all times to International Standards on Auditing relevant to the client
(ii)
Adequate training of all audit staff to ensure that they are fully aware of how the audit
procedures considered necessary by the firm are to be carried out
(iii)
Ensuring that there are adequate review procedures which are constantly applied within
the firm to see that laid-down standards are being properly applied in practice
Chapter 4: Quality control
Activity 1: Does quality matter?
Approach
This is a brief discussion question – remember that you could always be asked for something like this
in the exam so you need to have something to say about everything!
Suggested solution

To provide reasonable assurance that the firm and its personnel comply with professional
standards and applicable legal and regulatory requirements (ISQC 1: para. 11a)

To ensure that reports issued by the firm or engagement partners are appropriate in the
circumstances (ISQC 1: para. 11b)

To protect the reputation of the firm

To protect the reputation of the profession (ie to narrow the expectation gap)

To reduce the risk of legal action against the firm for negligence
Activity 2: Capabilities and competence
Approach
Sometimes the answer is just what the standard says – get used to being able to summarise some of
the key elements of each one – fortunately in this case, much of this is common sense.
Suggested solution
(a)
(b)
(c)
(d)
(e)
Professional education requirements, eg passing ACCA exams before promotion;
Establishing a system of continuing professional development and training within the firm;
Work experience;
Coaching by more experienced staff, eg other members of the engagement team; and
Independence education for personnel who are required to be independent.
(ISQC 1: para. A25)
Activity 3: Assignment of teams
Approach
Again, this is a direct lift from the standard, although in the real exam, it's likely that you will have
been given more to work with. For example, the scenario may state that a newly appointed audit
trainee has been asked to audit complex and subjective balances such as financial instruments and
accounting estimates: here you should be able to explain that unless they have come to the firm with
significant skills and experience, it is unlikely that they can cope with this and should not have been
assigned to such tasks.
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Suggested solution
(a)
Understanding of, and practical experience with, engagements of a similar nature and
complexity through appropriate training and participation;
(b)
Understanding of professional standards and applicable legal and regulatory requirements;
(c)
Technical knowledge and expertise, including knowledge of relevant information technology;
(d)
Knowledge of relevant industries in which the clients operate;
(e)
Ability to apply professional judgment; and
(f)
Understanding of the firm's control policies and procedures.
(ISQC 1: para. A31)
Activity 4: VBMC
Approach
From a quick read of the scenario, it appears that VBMC do not take quality as seriously as ISQC 1
requires, so you have plenty to write about here! The good news is that when this is tested in the
exam, quality control and other professional issues frequently appear as described here (clearly
wrong). However, the challenge is to present your assessment by explaining why they are wrong.
You can assume at least one mark for each well-explained point, so you should have come up with at
least 10 points – fortunately, that would not have been a struggle here!
Suggested solution

Mickey's role as Marketing Partner, managing the growth of the business, is in direct conflict
with his role as Quality Partner – it should be allocated to one of the other partners.

The approach to quality control updates is inadequate to meet ISQC 1's HR requirements; a
more formalised programme is needed. Training should be conducted at a time when staff are
not likely to be on holiday (or on alternative dates).

Ongoing monitoring of compliance with the firm's quality control, professional and ethical
procedures is required. The partner cannot argue that the firm is too small if working under
IAASB standards. Indeed an engagement quality control review for the firm's two listed clients
is required before the auditor's report can be issued.

New joiners should be trained in the firm's principles and methodology. The firm cannot rely
on their university degree. It is not sufficient to provide staff with standards on a memory stick.
Typically, a staff manual would be produced, backed up by training and updates.

The appraisal criteria are not consistent with quality control objectives; for example, a 'quality'
audit may overrun due to investigation of emerging issues.

The review process is inadequate to ensure quality. Areas undertaken by the AIC not
highlighted as important would not be reviewed by anyone. Typically, a manager review
would cover the AIC's work and a second review of work undertaken by more junior staff.

Documentation is key to quality. Audit evidence required to support the file should not be
destroyed.

Allocation of audits to partners based on location does not foster quality. Industry units may
not be practical in a small firm, but the retail and financial clients could be divided between
the partners to develop specialisms (and foster efficiency). This is a particular concern for the
financial services clients which are subject to complex regulation, which could open up VBMC
to liability if not suitably competent and experienced with the requirements of such work.

Facilities should be available for technical consultation (beyond simply ethical issues) both
within and outside the firm. A facility for second opinions should be put into place between the
partners. Consultation would be better allocated to a technical manager (or group of staff) to
make them more accessible to audit team members.
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
Additionally, ethical compliance should not be left to members of staff. At least annually,
written confirmation of independence is required from professional staff by ISQC 1.

Data can be obtained from the internet, but staff should be provided with guidance as to
where to source data from, to ensure accuracy and consistency of approach.
Chapter 5: Obtaining and accepting professional
appointments
Activity 1: Changing auditors
Approach
As this is just an idea generation exercise, you should only spend a few minutes thinking about the
various reasons that an entity might change its auditor:



Who might be keen to make this happen?
Why might this be?
Is it a choice or an obligation?
Suggested solution

The client may perceive the audit fee to be too high or poor value for money.

The 'fit' between the auditor and the client may no longer be appropriate. For example, a
company experiencing rapid growth may become too large and complex relative to the
capabilities of its auditors.

The audit firm may not seek re-election or resign. This could be for a number of reasons. For
example, the auditor may have independence issues with the client or the auditor may have
doubts about the integrity of the client staff. There may also be an insurmountable conflict of
interest with another client. There may also just be a routine need to rotate or re-tender the
audit due to the legal and regulatory framework in place.

The reason could be due to a breakdown in the working relationship between the auditor and
the client; this is especially likely with small clients who value a fairly close relationship with
their auditors.
Activity 2: Risks from prospective clients
Approach
This is getting closer to an exam-standard question as it requires some lateral thinking. However, in
the exam, you will have to consider this kind of request in the context of a scenario, so consideration
of the factors presented will help you generate ideas.
Suggested solution
The following work would be performed in order to assess the risk attached to a prospective client:

Perform a company search to ascertain shareholders, directors, security granted and whether
or not annual returns are filed on a timely basis.

Consult a credit reference agency to review solvency and consider whether the firm's fees are
likely to be paid promptly.

Review the most recent published financial statements for solvency, adequacy of disclosure
and to determine whether or not the accounting policies adopted are acceptable to the firm.

Examine background information to identify industry-specific problems, issues, legislation and
trends.
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
Less 'technical' methods such as looking at business and other media or finding out about the
company's location and reputation in that area may also be productive.

The firm may make use of contacts with knowledge of the company to assess its reputation and
that of its owners and managers. Useful sources of information may include trade associations
and local chambers of commerce.
Activity 3: Albion and Baggie
Approach
You could view this as a progress test as it covers material from previous chapters as well as content
on fees and advertising. This is very much exam standard, and so you can start to get into good
habits right now:

Always start with the issue, explaining why it is an issue.

Justify the issue using the ACCA or IESBA Code if possible.

Recommend suitable responses, acknowledging that there may be outstanding information
which is required before you can respond.

Consider the 'bigger picture' of events that could change from what's presented in the
scenario, as these may be relevant to the firm's consideration.

Format your answer using sub-headings and separate paragraphs.
Suggested solution
Advertisement
Albion & Baggie has clearly broken the ACCA's ethical guidance on 'Marketing professional
services' (ACCA Code: para. 250.2(b)) by discrediting the services offered by another firm.
The leaflet drop itself is acceptable as long as it abides by advertising rules – paragraph 250.12
of the ACCA Code states:
Professional accountants in public practice are reminded that any promotional activity shall be
carried out in accordance with any relevant legislation. For example, a professional
accountant in public practice shall comply with legislation relating to the making of unsolicited
telephone calls, facsimile transmissions or other electronic communication to a non-client with a
view to obtaining professional work.
The fixed fee is acceptable. However, fixed fees are not generally wise as the auditor is unable to
assess the amount of work required until discussion with the client has taken place – fixed fees may
reduce service and quality, if insufficient time can be devoted to the audit and losses may be made if
problems occur that cannot be covered by increasing fees. An alternative basis may need to be
considered by the firm to maintain quality and manage clients' expectations.
Outstanding fee income from Virgo
The outstanding fee income is similar to making a loan to a client – it may create a
self-interest threat as the firm may choose to ignore issues relevant to the audit until it has
received its own overdue fees. IESBA Code para. 410.7 A1 says that you would expect the fee to be
settled before the auditor's report is issued, and if fees are overdue the firm should consider whether
to continue, therefore prompt payment should be encouraged.
There is an implied familiarity threat to objectivity presented by the friendship between Dick and
Chris. However, this is neither immediate or close family, so could be addressed by applying
safeguards such as an independent review of the Virgo audit.
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Virgo and Rolling balls
The lottery company tendering for the same contract as Virgo would constitute a conflict of
interest for the firm if it wishes to act for both clients, as this is a major contract and they are
competitors. This could also present confidentiality issues regarding any sensitive information about
tenders for either client.
The Rolling Balls appointment could be accepted providing:

Both parties are informed that you are acting for the other;

Both parties are in agreement that this situation is acceptable;

Different audit teams should be used on each audit and information should not be transferred
between teams (safeguards such as the use of confidentiality agreements and information
barriers would be required); and

Reviews are carried out by different partners to those involved in each audit.
Rolling balls fee income
The ACCA and IESBA only set fee thresholds for public interest entities (PIEs) and in this case, the
threshold is 15% of the firm's total fees for 2 consecutive years (IESBA Code: para. R410.4-6) before
a self-interest threat starts to emerge (guidance in the UK is that the maximum fee income from
one client should not exceed 15% of gross recurring practice income, but this is reduced to 10% if
the company is a listed or other public interest client).
The Rolling Balls fee currently only represents 10% of recurring income. However, two issues arise:
(a)
We need to determine whether Rolling Balls is a PIE due to being a lottery company and not
just because of its size or status; and
(b)
Other services are required (presumably on a regular basis) which are likely to push the fee
percentage closer to 15% for future years.
Although there is no imminent self-interest threat, it is necessary to take extra precautions, such as
disclosing this issue to those charged with governance at Rolling Balls and performing an external
review of the engagement.
Additional services for Rolling Balls
In addition to the fee limit issue, the auditor should consider:

The amount of fee generated from Rolling Balls compared to the audit fee could create a
self-interest threat (ie would Albion & Baggie be inclined to not modify the auditor's report
in order to 'please' the client and retain lucrative other services?).

Whether Albion & Baggie have adequate resources and expertise required to perform the
additional services (for example, do they know enough about lottery regulations?). The
fundamental principle of professional competence and due care is the key issue here.
Sophie and Maggie
The issue here is close, but not immediate, family connections that could create a familiarity
threat. The risk is that the auditor may not be willing to issue a modified audit opinion to someone
they are closely attached to, either in business or personally.
The issue is perceived independence – whether the public would perceive that the auditor has
done a 'proper audit' on the financial statements of a party where such a connection exists or
whether independence and objectivity have been compromised.
Under the ACCA Code (section 511) there appears to be no self-interest threat regarding
Sophie's $500,000 mortgage, as long as the loan from Midwest is on normal commercial terms.
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Maggie cannot be manager on the audit of Nibbles until two years have elapsed since leaving the
company, otherwise she may be auditing her own work and no safeguards could reduce the
familiarity, self-interest and self-review threats to acceptable levels.
Despite Sid and Maggie being immediate family members, Sid's shares should not present a
self-interest threat and do not require disposal because she is not to be involved in the audit.
However, should Maggie subsequently be involved in the Nibbles audit, then Sid should dispose of
his shares.
Chapter 6: Planning and risk assessment
Activity 1: Johnson
Approach
This is really an idea generation activity, therefore, in addition to using the limited information in the
scenario, try and consider the information you have not been given but that you will need to plan this
audit engagement.
Suggested solution

Logistics – Assignment of staff to the audit: consider the client's locations and arrange visits
where appropriate or consider using staff from other offices/countries if possible; also Johnson
is listed, so it is important to consider what reporting deadlines the client is working towards.

Time budgets – The audit of a large multinational will generate a significant fee but is at risk
of going over budget; it is therefore important at the planning stage to prepare and
communicate a time budget to the audit team and monitor this throughout the engagement.

Reporting – The audit manager should consider what other reports the client may require
over and above the statutory auditor's report. A large manufacturer such as Johnson is likely to
produce a social and environmental report as part of the annual report; the audit manager
should ascertain whether they require assurance on these issues on this report.

Client interface – Consideration should be given to the method and timing of communication
with the client management and/or audit committee at certain stages of the audit.

Preliminary materiality – Materiality should be assessed and calculated at the planning
stage (although it is likely to be based on draft figures).

Risk assessment – The key aspect of the planning stage of an audit is the performance of a
risk assessment. This will ensure that the work performed is focused on the important areas of
the accounts.
Activity 2: Bauer
Approach
This activity is getting closer to exam standard – notice that the details are vague, meaning you have
to consider what you don't yet know, and why any of the factors presented might lead to each risk of
material misstatement. In each case, start with a possible risk and then establish why it might be
misstated using your knowledge of IAS/IFRS.
Suggested solution
(a)
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As the timing of the redundancies is towards the year end, it is important that the timing of the
announcement is ascertained; if it is made before the year end, then a provision should be
made for any redundancy costs not paid as at 31 December (IAS 37 Provisions, contingent
liabilities and contingent assets). If the announcement is made post year end, then the costs
would not be recognised until next year.
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The disclosure of the costs should be considered, as it may be possible to treat them as an
exceptional item if they meet the definition in the accounting standards (IAS 1 Presentation of
financial statements).
The unexpected loss of this major contract gives rise to a potential going concern problem.
Since only 10% of the US staff have been lost as a result, it is unlikely that this in itself would
be enough to affect the going concern status of the entire business. However, this should form
part of the overall assessment of going concern under ISA 570 Going Concern. Consideration
should be given as to the reasons for the improvement in the security situation and whether
similar improvements may occur in other markets.
(b)
Close attention will need to be paid to the software development costs to ensure that
they meet the criteria laid out in IAS 38 Intangible Assets and have been correctly capitalised
and disclosed (see the Essential reading for Chapter 8 for more details on the criteria for
appropriate research and development costs).
It will be important to ensure that the training costs for the new software have not been
included in the amounts capitalised. These do not represent a part of the software (which is an
intangible asset) and so these training costs should be recognised as an expense when
incurred.
Activity 3: Business risks vs audit risks
Approach
Candidates frequently get mixed up with these, so this activity is designed to test how you can
distinguish between the things that could get in the way of an organisation achieving each of its
objectives (business risks) and the areas of the financial statements that could be misstated (audit
risks) from the same issue.
Suggested solution
Scenario
Business risk
Audit risk
(i)

Overstocking of CDs
resulting in inventories of
ex-chart CDs

Identification of
obsolete inventories


Excessive mark down and
reductions in order to sell
ex-chart inventories
Valuation of inventories
(possibility of NRV <
cost)

Impact on revenues, profits
and cash flows

Breach of legislation could
lead to fines, closure, bad
press and costly
improvement expenses

Provisions/contingent
liability disclosure for
legal action


Potential impact on
revenues due to impact on
reputation/closure
Impact on going
concern

Appropriateness of the
capitalisation of
improvements
(ii)
CD Planet operates a chain of
retail outlets selling chart CDs.
Mucha Pasta operates several
Italian restaurants and is
subject to comprehensive and
stringent health and safety
food hygiene legislation.

Financial impact due to
fines, legal actions and
required improvements
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Scenario
Business risk
Audit risk
(iii) XYZ, based in the Eurozone,
trades extensively in the US
and invoices sales in US$.

Company is exposed to
exchange rate risk

Correct retranslation of
year-end receivables

Potential impact on profits
and cash flows

Correct treatment of
initial sale and
receivable

Correct calculation,
treatment and disclosure
of exchange differences

Compliance with
IAS 21
Activity 4: Melon
Approach
You can now start to put together what you have learned in this chapter by analysing the scenario
and identifying those areas that could adversely affect the company's ability to meet its objectives
(business risks) and those that could lead to material misstatement in the financial statements (audit
risks). Note that there are marks now – in the exam it could be up to 3 marks for successfully
evaluating an audit risk: here, you should aim for scoring up to 1 mark for identifying each risk and
a further mark for explaining why it is a risk.
Suggested solution
Business risks – any four from the following:

Foreign currency risk: Many of Melon's supplies are from India and hence cost would depend
on exchange rate with the Indian rupee. Also franchisees pay 60% of local retail price to
Melon, which passes currency risk to Melon where the franchisees are located outside the
Eurozone (eg in the UK).

Cash flow/financing risk: The Group bears an ongoing cash flow risk with respect to the shop
fittings provided to franchisees which are not paid for until later. Given that most shop fittings
will be for new franchisees, this is coupled with the business risk that those franchisees may fail.

Leased vs owned properties: Leased properties allows the Group the flexibility to open, close
or move shops, but also subjects the Group to the risks of the rental market and the potential
loss of prime retail sites when the rental agreements are up for renewal. Owned properties are
more secure, but are less flexible when the retail centre of a town shifts location over time.

Fashion: The market in which Melon operates is a fast-moving one. Success depends on being
at the cutting edge of latest fashions. Given that the clothes are ordered six months in
advance, it is essential that Melon's research and buying department calculations are based
on accurate information. Miscalculations of the market could result in large amounts of
unsaleable inventories to customers or indeed to franchisees. Further, goods unsold by the
franchisees can be returned to Melon, increasing its risk.

Quality: All clothing is manufactured by third parties. Controls are necessary to ensure that the
quality of goods is adequate across suppliers and consistent between suppliers and over time.

Competitors: There are many players in the fashion market which is becoming more
globalised. What in the past may have been a stable national position could quickly turn sour
if a new, but established, foreign player enters the market. This needs to be regularly
monitored.
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
Supply issues: Unexpected supply problems could occur for Melon, a foreign investor in India,
as a result of local activists criticising the use of cheaper developing world workers.

Compliance risk: Operations in various different markets pose risks due to different regulatory
and reporting requirements which must be researched and complied with.
Audit risks – any four from the following:

New audit client: The firm has no previous experience with this client, so the audit risk is high.
This lack of familiarity could lead to potential misstatements being overlooked.

Overseas transactions: The activities between Melon and its overseas suppliers and customers
present possible risks of misstatement due to foreign currency fluctuations under IAS 21 in
terms of statement of profit or loss items (such as revenues and purchases) and assets (such as
inventory).

Shop fittings and franchises: Depending on the recoverability of sums due from franchisees,
there may be issues with the recognition and valuation of items in shops where a franchise
may have ceased operating.

Owned vs leased PPE: There may be a risk of misstatement in shop premises which are
recorded as owned but are leased (and vice versa) meaning IAS 16 and/or IFRS 16 may not
be adhered to.

Inventory: This will be hard to value due to the volatile nature of fashion goods in general
(establishing net realisable value under IAS 2, for example, may be difficult). Also, in cases
where goods are returned, there may be a risk of misstatement where ownership of inventory
is unclear and it is either carried incorrectly or omitted from Melon's financial statements (this
could also affect revenue recognition under IFRS 15 if control of inventory is hard to establish).
Chapter 7: Evidence
Activity 1: Related parties
Approach
As this is an 'idea generation' exercise, you are unlikely to come up with anything as comprehensive
as the suggested answer below – however, try and think about where you would look to
understand the auditor's objectives: understanding who the related parties could be and how they
could be entering into transactions with the entity.
Suggested solution
As part of the risk assessment procedures required by ISA 315, the auditor must carry out the
following procedures to obtain information relevant to identifying risks associated with related
parties.

Audit team discussion of risk shall include specific consideration of susceptibility of financial
statements to material misstatement through related parties and their transactions (ISA 315:
para. 28)

Auditor shall inquire of management:
–
The identity of related parties including changes from prior period
–
The nature of the relationships between the entity and its related parties
–
Whether any transactions occurred between the parties, and if so, what
–
What controls the entity has to identify, account for and disclose related party
relationships and transactions
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–
What controls the entity has to authorise and approve significant transactions and
arrangements with related parties
–
What controls the entity has to authorise and approve significant transactions and
arrangements outside the normal course of business
(The auditor may have to perform risk assessment procedures in addition in respect of the latter
three points.)

Stay alert for evidence of related party transactions when obtaining other audit evidence, in
particular when scrutinising bank and legal confirmations and minutes of meetings

If significant transactions outside the normal course of business are discovered, inquire of
management the nature of the transactions and whether related parties could be involved

Share information obtained about related parties with the audit team
(ISA 550: paras. 13-17)
The following procedures may be helpful.

Enquire of management and the directors as to whether transactions have taken place with
related parties that are required to be disclosed by the disclosure requirements that are
applicable to the entity.

Review prior year working papers for names of known related parties.

Review minutes of meetings of shareholders and directors and other relevant statutory
records, such as the register of directors' interests.

Review accounting records for large or unusual transactions or balances, in particular
transactions recognised at or near the end of the financial period.

Review confirmations of loans receivable and payable and confirmations from banks.
Such a review may indicate the relationship, if any, of guarantors to the entity.

Review investment transactions, for example purchase or sale of an interest in a joint
venture or other entity.

Enquire as to the names of all pension and other trusts established for the benefit of
employees and the names of their management and trustees.

Enquire as to the affiliation of directors and officers with other entities.

Review the register of interests in shares to determine the names of principal
shareholders.

Enquire of other auditors currently involved in the audit, or predecessor auditors, as to
their knowledge of additional related parties.

Review the entity's tax returns, returns made under statute and other information supplied
to regulatory agencies for evidence of the existence of related parties.

Review invoices and correspondence from lawyers for indications of the existence of
related parties or related party transactions.
If risks relating to related parties and their transactions are identified, they should be treated as
significant risks in accordance with ISA 315. Also, due to the close connection between related
parties and possible fraud, the auditor must consider the overlap with ISA 240 here as well.
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Appendix 1 – Activity answers
Chapter 8: Evaluation and review – matters relating to
specific accounting issues
Activity 1: Armstrong
Approach
Questions such as these have their roots in quality control – imagine you are reviewing the work of
your team and you want to make sure they have considered everything relevant to the matters
described in the scenario. How will you do this?
Use the template in the solution space to apply the 4 stages discussed at the start of this chapter:
materiality, risks and auditing standards for the matters you should consider; audit evidence and the
procedures to generate them for evidence you should expect to find.
Suggested solution
(i)
The matters that you should consider
Materiality: At 15% of profit before tax and 3.8% of total assets, the deferred tax provision
is material to both the statement of profit or loss and the statement of financial position.
Risk(s) presented:

Whether the deferred tax provision and charge are complete

Whether the deferred tax provision and statement of profit or loss charge have been
properly presented and are supported by the appropriate disclosures

Whether the correct tax rate has been used

Whether the deferred tax provision has been calculated correctly
Standards:
(ii)

IAS 12 Income taxes requires that deferred tax is calculated at a rate that is
'substantively enacted' and expected to apply when the deferred tax is to be settled.

IAS 12 also requires that the amount is based on accurate temporary/timing differences
relating to the plant and equipment.

Disclosure needs to be made for the items forming the deferred tax provision, the
movement on the liability and the major components of income tax expense.
The evidence you should expect to find
Evidence/procedures

Schedule of temporary/timing differences relating to the plant and equipment agreed to
plant and equipment schedules and tax computations

Agreement of tax rate used (30%) to 'substantially enacted' rate of tax (note the rate
used should be the rate substantively enacted, not merely 'announced')

Enquire of directors and review plant and equipment schedules and tax computation for
evidence of temporary/timing differences not provided for

Recalculation of provision: Carrying amount $3.6m  written down value $2.1m 
$1.5m @ 30%  $450,000

Review of disclosure in the notes to the financial statements to ensure the appropriate
disclosures are made in accordance with IAS 12
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Activity 2: NRV
Approach
This is an idea generation activity, so try and think about the circumstances that could lead to
inventory being overstated (ie net realisable value being lower than cost) and how you could find
evidence to support this.
Suggested solution
Factors that could lead to net realisable value being reduced to a level below cost:




Damaged goods
Obsolete goods (ie with no demand)
Goods manufactured on a fixed price contract where costs have escalated
Fashion items that may no longer be in demand
Audit evidence to indicate that this has occurred:





Increased inventory holding period
Review of post year end cash book and sales orders to determine trends
The emergence of a new competitor or new technology that renders a product obsolete
Internal reports showing cost overspends
Industry information on consumer trends and tastes
Activity 3: Buddy Co
Approach
This is very similar to Activity 1 ('Armstrong') but is testing your knowledge of financial instruments.
Don't worry if you cannot remember everything there is to know about the accounting treatment –
there are always marks available for calculating materiality and obtaining routine pieces of evidence
to support assertions in the financial statements. If you need a reminder of the accounting treatment,
refer to the Essential reading in the digital edition of this Workbook.
Suggested solution
(i)
Matters to consider
Materiality has already been assessed here, but in the exam you will probably need to
calculate this.
Risks presented and standards can be discussed at the same time. For example, the
number of shares owned in Buddy is 18% – if Holly's stake was 20% (or there was evidence
of significant influence) according to IAS 28 Investment in associates, this would cease
to be an investment and would need to be accounted for under the equity method (assuming
consolidated financial statements are already being produced, which is happening here as
there is a subsidiary).
If this was just an investment in shares, however, ownership of 18% of the shares in Buddy
would need to be confirmed to ensure Holly has the right to carry these on the statement of
financial position and be entitled to any dividends distributed.
Has Holly made the irrevocable election to hold these shares at fair value with any changes
going through other comprehensive income (OCI)? If so, the fair value of consideration
plus transaction costs would be recognised initially and any gains at year end would be
recognised in OCI. If this election is not made, initial recognition would be at the fair
value of acquisition only and the transaction costs would be expensed through profit or
loss (P/L) with any fair value gains at the end of the year also being recognised in P/L.
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IFRS 7 Financial instruments: disclosures specifies that the financial statements should
disclose both the significance and the nature/extent of any risks associated with financial
instruments, including an estimate of the level of market risk the shares represent to Holly.
(ii)
Evidence you expect to find
Copies of the Buddy Co share certificates in Holly's name which verify Holly's ownership of
500,000 shares in Buddy as at November 20X7.
Inspection of Buddy's statutory share records to verify Holly owns 18% of all issued shares and
a review of board minutes to ascertain whether Holly holds any significant influence over
Buddy.
Inspection of Holly's bank statements and cash book to confirm the transaction occurred in
November 20X7.
Request a representation from the Finance Director of Holly regarding any election to treat fair
value gains through OCI not P/L.
Recalculation of the payment of the purchase price ($2  500,000 = $1,000,000) and the
transaction costs (1%  $1,000,000 = $10,000) and confirmation that the fair value initially
recognised on Holly's statement of financial position matches the appropriate treatment
($1,010,000 if going through OCI; $1,000,000 if going through P/L).
Trace amounts for transaction costs through to correct locations (either as part of fair value on
recognition or P/L depending on whether any election was made by Holly).
Copies of invoices or brokers' notes to corroborate the value paid (including transaction costs)
plus third-party confirmation of Buddy's share price on the date of purchase (eg agree $2 per
share to the quoted price in the Financial Times on the purchase date).
Recalculation of the $115,000 increase in the fair value of the shares in Buddy ($2.25 
500,000  $1,125,000 minus $1,010,000) and a copy of any relevant working papers
completed by Holly.
Reconciliation that the gain has been allocated to the correct place (OCI or P/L depending on
any election made by Holly).
A copy of the journal showing the increase in value of the Buddy investment at the reporting
date (eg debit financial asset, credit profit or loss) and confirmation from a third party (eg
Financial Times again) of the share price ($2.25) at the reporting date.
A copy of the draft financial statements of Holly to ensure that the shares have been recorded
as owned by Holly together with an indication of the levels of risk presented (eg market risk).
Activity 4: Laxman
Approach
The two principal matters to consider here are interrelated: whether IFRS 15 has been properly
applied to Laxman's inventory, and whether Laxman is in breach of the conditions of its bank loan.
However, remember to think outside the box a little and consider whether anything else is relevant
here.
Suggested solution
Inventory
IFRS 15 states that revenue is recognised when the entity has transferred the goods to the buyer,
meeting the performance obligations of the contract (IFRS 15: para. 9).
In this case, the legal transfer of title has not yet occurred and so it would therefore appear that these
items should not be recognised within revenue.
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However, as auditors, it will be necessary to obtain further information regarding the sale, as in
accordance with IFRS 15, the transfer of legal title is not sufficient evidence that control has been
transferred (and performance obligations met). It is possible, for instance, that legal title has been
retained in order to protect Laxman Co against the possibility of non-payment by the receivable, even
though, in substance, a sale has in fact occurred.
Further audit evidence must be obtained in order to form a judgment over whether IFRS 15 has been
breached.
Loan condition
Laxman Co appears to be within the criteria laid down by the bank: it has an acid test ratio of
1.125 ( = ($1,000,000 – $100,000) ÷ $800,000).
However, if the revenue recognised in respect of the inventory above has not been recognised in
accordance with IFRS 15, the financial statements may need to be amended. The amendment could
be by as much as $200,000 (decreasing receivables and increasing inventory), which would
change the acid test ratio to 0.625 (= ($800,000 – $300,000) ÷ $800,000).
If the conditions set by the bank have been broken, then it is likely that some negative consequence
would result from this. This could range from a fine or penalty that would need to be recognised in
the financial statements, to the possibility of Laxman Co having to repay the loan. If this were the
case, it would be necessary to consider very carefully whether significant doubts exist over Laxman
Co's ability to continue as a going concern.
Possibility of fraud
The auditor needs to consider the possibility that management has engaged in fraudulent financial
reporting in respect of revenue recognition in order not to breach the conditions set by the trade
organisation. If this were the case, the auditor will need to re-examine any representations it has
already received from management.
Activity 5: Leases
Approach
This is simply designed to get you up to speed with IFRS 16. There is far more detail included here
than required by the question, but it shows the depth of knowledge that you will need for the exam.
Remember that you should always apply your IFRS knowledge to the scenario and respond
accordingly.
Suggested solution
Audit risks
Audit risks for lessors
Whether a lease is an operating or finance lease – the treatment of lease repayments will vary (either
receivables or income) and the asset will need to be derecognised at the end of the lease term if it is
a finance lease.
Audit risks for lessees
Leases may be inappropriately recognised as leases (or not recognised when they should be)
because one or more of the necessary conditions under IFRS 16 Leases has not been observed:

The lessor does not have the right to substantially all the economic benefits of an identified
asset.

The asset may be easily substituted by the lessor so cannot be part of a lease agreement.

The lessor does not have the right to direct or control the asset included in the lease.

The conditions for recognising a 'right-of-use asset' may apply but have been ignored.
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A combined contract to provide both a leased asset and servicing of the asset may not have been
split into its constituent parts which could lead to incorrect recognition of the service element.
Initial recognition of the lease liability may be either incomplete or inaccurate due to some/all of the
constituent elements being missed/misstated:




The PV of the lease payments not yet paid and the discount factor used
Any penalties for relevant early termination
Uncertainty over any options to purchase the asset at the end of the lease term
The agreed or implied lease term
Similarly, lease assets may be misstated due to failure to correctly account for any of the following:

Initial fees and other charges which may have been ignored.

Failure to account for any impairments or revaluations that have occurred during the lease
term.

Failure to account for dismantling and restoration provisions that might be required at the end
of the lease term.
Assets may be treated as either short-term leases or low-value assets when they are neither (so would
need to have assets and liabilities recognised on the statement of financial position).
Disclosures may be inadequate or incomplete for either lessees or lessors based on what IFRS 16
requires in each case.
Sale and leaseback agreements
Companies sometimes agree to sell assets such as land and buildings which they intend to keep on
using in return for paying the new owners a fee – the sale creates either a gain or loss in the seller's
financial statements when compared with the cost value of the asset on disposal. This also means that
the continued use of the asset needs to be reflected in the company's accounts as a lease, so IFRS 16
needs to be followed here to create a right-of-use asset for the lessee, along with an associated lease
liability.
However, this situation can be exploited by companies attempting to conceal the true purpose of an
asset's disposal: sometimes, there may be an agreement for the company to repurchase the asset
after a set period of time, usually for a higher price than it was sold for. When the substance of such
a transaction is considered, it may appear that the initial disposal amount was, in fact, a loan and
the repurchase amount is actually a repayment and the company has simply attempted to conceal
this form of financing from its financial statements.
The requirement for IFRS 16 to show all material leases as both assets and liabilities is likely to
reduce the risk of this as all such leases would need to reflect IFRS 16.
Auditors need to consider whether the sale part of the agreement satisfies the requirements of
IFRS 15 Revenue from contracts with customers – if not, the seller (who has now become
lessee) needs to continue to recognise the asset they are leasing and recognise a financial liability
under IFRS 9 Financial instruments for the consideration received from the new lessor/buyer.
IFRS 16 requires the IFRS 15 criteria for a sale to be met in order for the transaction to be accounted
for as a sale and leaseback.
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The auditor's response
Typical audit procedures
In an exam question, it is likely that there will also be a requirement to consider suitable audit
procedures as the auditor's response to any of these risks, and you should therefore consider how
you would obtain sufficient and appropriate audit evidence in such cases – for example:

Obtaining copies of lease contracts to confirm the details of any agreements (including the
right-of-use asset specified in the contract, evidence of exclusivity of right-of-use and the
possibility of any substitute assets being introduced)

Recalculating the amounts included at both initial recognition and subsequent measurement for
right-of-use assets and associated liabilities (including lease repayments, interest rates used,
initial fees paid and incentives granted)

Verifying any conditions related to either extensions or early termination based on evidence
collected from the lessee and/or elsewhere (for example, sale contracts in the case of a sale
and leaseback to establish if it really is a sale)

Verifying that a right-of-use asset cannot be either substituted or controlled by any party other
than the lessee (such as from site visits, documentary evidence or enquiries)

Obtaining copies of draft financial statements to review the level of disclosure for adequacy
Activity 6: Jake's Pegs
Approach
There is no mark allocation here, so you do not know the detail your answer should go into.
However, in any question, carefully reading the requirement will help you: in part (a) it's just the
additional risks that the emergence of the pension scheme creates, not the risks already present.
For part (b) you should consider breaking your answer down into the main areas of the financial
statements where such a pension arrangement will be reflected and the considering the work you
would do to audit each part.
Suggested solution
(a)
Additional risks
The delay in informing the firm of the existence of the scheme will increase the inherent risk of
the audit. This may imply that the information regarding the scheme is not fully prepared yet.
The client has withheld information regarding the scheme and claimed that it was an
oversight. The pension scheme is a major part of the company's financial structure and it is
unlikely the Finance Director would forget about it. The auditor should respond to this with
elevated levels of professional scepticism and consider the impact on other areas of the audit.
Care should be taken before reliance is placed on representations provided by management.
The fact that the actuarial report may not be ready until late in the audit will increase the risk
as the auditor may be under time pressure to complete the work inside the reporting deadline.
The impact of the scheme on the statement of profit and loss and other comprehensive income
and statement of financial position will be dependent on the actuarial valuation of the scheme
assets and liabilities. These are judgmental and complex areas and the auditor may not have
the expertise to audit these effectively. The audit plan should include an expectation of the
need to apply ISA 620 Using the Work of an Auditor's Expert.
The pension scheme could have a significant detrimental impact on the statement of financial
position of Jake's Pegs. The Finance Director appears confident that the scheme is in surplus
but this may be unrealistic. It is likely the scheme's assets will be held, to a large extent, in the
form of shares and property, both of which might have fallen in value. This may create a
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significant deficit on the scheme, which is likely to be highly material to the statement of
financial position. This could call into question the going concern status of the company.
(b)
Audit procedures
The finance department at Jake's Pegs would have needed to account for the scheme in line
with the standards, and this would have led to some specific steps that the auditor would need
to review (covered below in the table).
General procedures
We should enquire of the directors as to the accounting policy regarding the treatment of
actuarial gains and losses. The actuarial gain or loss should be recalculated by the auditor.
Specific procedures
Work undertaken by Jake's Pegs
Specific audit procedures in respect
of these
Actuarial assumptions should be used to
make reliable estimates of the amounts of future
benefits that the scheme will have to pay out
currently and in the future (eg employee
turnover, sign-up rates for the scheme, mortality
rates, future salary increases) in order to have
an estimate of the present value of future benefit
obligations.
As mentioned above, there may be some
need for an expert under the terms of
ISA 620 to question the specific
assumptions and calculations made by the
actuary.
The fair value of any scheme assets should
be established.
Review the market data used to agree the
value of the fund and verify to an
independent source.
Any actuarial gains or losses in the value
of the liabilities and any difference between the
return on the plan assets and the interest income
calculated for the plan assets must be
determined in order to agree on the amount to
be recognised in the financial statements.
Such gains or losses must be recalculated
and confirmation obtained from accounting
records of their appropriate recognition in
the financial statements.
Any changes that need to be made to the
scheme's benefits should be accounted for
appropriately.
Auditors should ensure that any potential
shortfalls are adequately identified and
disclosed in the financial statements.
The auditor can review the logic used and
the consistency of the assumptions with
prior years and general market conditions.
Written representations from management
may be helpful here although, given the
heightened level of scepticism we are
deploying, this may only serve as
protection in the event of unwelcome (and
unspecified) audit liability claims in the
future.
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Chapter 9: Group audits and transnational audits
Activity 1: Communication
Approach
This is an opportunity for you to consider some very practical points about the dialogue between
group auditors and component auditors. Pretend that you are the group auditor and you know
nothing about the firm on whose work you will be relying: What do you need to know in order to be
able to trust them?
Consider:
(i)
what you need the component auditor to either know or confirm to the group auditor and
(ii)
what you really need to know about the outcome of the audit that the component auditor has
conducted on your behalf.
Suggested solution
(i)
(ii)
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These communications include:
(a)
A request that the component auditor confirms their co-operation with the group
engagement team
(b)
The ethical requirements that are relevant to the group audit and in particular,
independence requirements
(c)
In the case of an audit or review of the financial information of the component,
component materiality and the threshold above which misstatements cannot be
regarded as clearly trivial to the group financial statements
(d)
Identified significant risks of material misstatement in the group financial statements, due
to fraud or error that are relevant to the work of the component auditor; the group
engagement team requests the component auditor to communicate any other identified
significant risks of material misstatement and the component auditor's responses to such risks
(e)
A list of related parties prepared by group management and any other related parties
of which the group engagement team is aware; component auditors are requested to
communicate any other related parties not previously identified
This communication often takes the form of a memorandum, questionnaire or
report of work performed and includes the following:
(a)
Whether the component auditor has complied with ethical requirements that are
relevant to the group audit, including independence and professional acceptance
(b)
Whether the component auditor has complied with the group engagement team's
requirements
(c)
Identification of the financial information of the component on which the component
auditor is reporting
(d)
Information on instances of non-compliance with laws and regulations that could give
rise to material misstatement of the group financial statements
(e)
A list of uncorrected misstatements of the financial information of the component (the list
need not include items that are below the threshold for clearly trivial misstatements)
(f)
Indicators of possible management bias
(g)
Description of any material deficiencies identified in internal control over financial
reporting at the component level
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(h)
Other significant matters that the component auditor communicated or expects to
communicate to those charged with governance of the component, including fraud or
suspected fraud involving component management, employees who have significant
roles in internal control at the component level or others where the fraud resulted in a
material misstatement of the financial information of the component
(i)
Any other matters that may be relevant to the group audit or that the component auditor
wishes to draw to the attention of the group engagement team, including exceptions
noted in the written representations that the component auditor requested from
component management
(j)
The component auditor's overall findings, conclusions and opinion on the component's
financial statements
Activity 2: Consolidation
Approach
This should be idea-generation again – you should get used to the need to recall certain items rapidly
as this may happen in the real exam. Consider what you have learned about consolidations from FR
and SBR and then consider what adjustments you have completed when attempting questions for
these subjects!
Suggested solution






The calculation of any goodwill, including any impairment reviews as appropriate
Cancellation of intra-group balances and transactions, such as dividends
Provisions for unrealised profits resulting from intra-group transactions
Fair value adjustments on assets and liabilities
Retranslation of financial statements for overseas components
The correct value of any components included in the parent company's financial statements
Activity 3: Wolf Co
Approach
Calculations of NCI at the year end will require this acquisition figure plus any share of identifiable
net assets. Review the Essential reading in the digital edition for fuller details of ISA 600 and IFRS 3
and how to calculate this schedule. Once you have the numbers, work your way down each line and
consider what evidence you could seek to back each one up.
Suggested solution
Calculation of goodwill at acquisition:
Consideration transferred
Non-controlling interest (2½m shares  $1.50 per share)
Sub-total
Net assets acquired
Goodwill (difference)
$'000
12,000
3,750
15,750
(10,000)
5,750
Non-controlling interest at fair value (above)
Non-controlling interest at share of net assets (25%  $10m FV)
3,750
2,500
Goodwill attributable to NCI (difference)
Goodwill attributable to Bad Co shareholders (balancing figure)
Goodwill attributable to NCI shareholders (above)
Total goodwill (above)
1,250
4,500
1,250
5,750
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Principal audit procedures:

Obtain a copy of the goodwill calculation from Bad Co and recalculate to ensure accuracy.

Confirm the consideration of $12 million to a broker's invoice and Bad Co's bank statements.

Confirm Bad Co's ownership of the shares, the date of the transaction and the number of
shares owned by inspecting copies of the share certificates.

Confirm the share price paid on the date of transfer using a third-party source (eg Bloomberg).

Obtain working papers confirming the fair value of $10 million for Wolf Co's net assets.

Confirm the total number of ordinary shares in existence for Wolf Co.

Confirm choice of correct accounting treatment by reading board minutes for adoption of
IFRS 3.
Chapter 10: Completion
Activity 1: Subsequent events
Approach
This is revision from AA – what would you do if you wanted to be as sure as you could that there are
no issues still outstanding when you sign the auditor's report?
Suggested solution

Review procedures management has established to ensure that subsequent events are
identified.

Read minutes of board meetings, shareholder meetings and audit committees that have taken
place since the year end.

Obtain and review the latest available interim financial statements and/or management
accounts, budgets and other related management reports.

Enquire of the entity's legal counsel concerning litigation and claims.

Enquire of management as to whether any subsequent events have occurred which might
affect the financial statements.
Chapter 11: Reporting
Activity 1: Spot the ball
Approach
Find the relevant content for each element of the auditor's report in the Workbook and the work out
where it should go on the proforma for each of the four situations outlined.
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Suggested solution
INDEPENDENT AUDITOR'S REPORT
Opinion
material uncertainty related to going concern
After the 'Basis for opinion' section.
Basis for opinion
Emphasis of matter paragraph
Before or after 'Key audit matters' (if used) depending
on severity and likely to be below any going concern
issue.
Key audit matters
 misstatement in the other information
Below 'Basis for opinion' but above 'Key audit matters'
and likely to be below any Emphasis of Matter
paragraph.
Other information
 misstatement in the other
information
This will not appear here any
longer.
Other matter paragraph
After the 'Basis for opinion' and 'Key audit matters' (if
used) and then after any Emphasis of Matter paragraph.
Responsibilities of management and those charged with governance for
the financial statements
Auditor's responsibilities for the audit of the financial statements
Report on other legal and regulatory requirements
Signed
Note. 'Key audit matters' is presented here as best practice, although it is only required for listed
entities.
Activity 2: Santa
Approach
You should work your way through the scenario and challenge every statement made – is it consistent
with the rest of the information presented here? Does it conform with the approach that we know an
auditor's report should follow? Is the opinion appropriate under the circumstances? Are there any
other issues here that we need to pick up outside the auditor's report that might be relevant?
Suggested solution
Allowance for receivables
The receivables balance for the year is potentially overstated by $1 million, depending on the
outcome of arbitral proceedings. The amount is material, being 43% of profit and 11% of total
assets, and any settlement by which the price is reduced by more than 10% would be material to
the statement of profit or loss:
Profit before tax = $2.35 million. Materiality = (say) 5% of PBT.
5%  $2.35m = $117,500 which is nearly 12% of contract price ($1,000,000)
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The outcome of the arbitration does not appear certain, despite the directors' feelings on the subject.
It is clear that they did make amendments to the specification, albeit for what they saw as the right
reasons, and therefore, as auditor we must be aware of the possibility that this price will be
materially reduced, rendering the reported debt overstated.
In these circumstances, an allowance for the impairment of the debt should be made to some extent.
We should take advice from the company's legal advisers as to whether they estimate the price will
be reduced at arbitration, and if so, by how much (suitable comments about IAS 37 Provisions,
contingent liabilities and contingent assets could be made here).
If Santa's directors refuse to make any necessary allowance in the financial statements, the auditor's
opinion should be modified on the grounds of material misstatement due to this lack of
allowance as has been suggested on the audit file. However, this opinion should probably only be a
qualified ('except for') rather than an adverse opinion as suggested on the audit file as, although
it would be material, it does not appear to be pervasive to the financial statements, but rather
confined to one item.
Inappropriate paragraph headings, contents and placement
The proposed auditor's report shows almost all the right content but is presented in the wrong order –
the opinion section needs the heading 'Qualified Opinion' and should be positioned at the start
of the auditor's report. However, the company referred to within the opinion section should be
'Santa', not 'Rudolph'.
The details of the various disagreements represent the basis of that opinion and should therefore be
presented in the next section, headed 'Basis for qualified opinion'. However, reference to
IAS 37 Provisions, contingent liabilities and contingent assets should be made here to explain the
reasons for the allowance that should be made against receivables.
IAS 1 disclosure
If a material allowance against this debt is required, as discussed above, separate disclosure will be
required in respect of it in the notes in accordance with IAS 1 Presentation of financial statements.
Again, if the directors fail to amend the financial statements to reflect this disclosure, the auditor's
report should be modified on the grounds of material misstatement due to this lack of
disclosure. Again, this is not pervasive to the financial statements, so a qualified ('except for')
opinion, rather than the suggested adverse opinion, would be appropriate.
Going concern
While the outcome of the arbitration might not in itself affect the going concern basis of the
company, irretrievable loss of a major customer (representing half of the company's revenue) could
have seriously detrimental effects and does at least need to be considered by the auditor.
Hopefully the audit team has reviewed the going concern position of the company and this is all
documented on file and has, if necessary, been disclosed in the financial statements. If these events
present a material uncertainty for Santa, the auditor's report might also have to be modified.
There could be sufficient uncertainty about the company's future to warrant an additional paragraph
from the auditor called 'Material uncertainty related to going concern' placed after the
'Basis of opinion' section where the auditor would set out the fact that such a material uncertainty
existed. If sufficient disclosure had been made about this uncertainty by directors, the auditor
would use this to draw attention to this disclosure note within the financial statements and state that
the opinion was not modified in that respect. However, if insufficient disclosure were given, the
auditor would address this within the 'Basis of opinion' section of the auditor's report and qualify
the auditor's opinion ('except for') on the grounds of lack of disclosure.
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Events after the reporting period
The arbitral decision is not expected until after the AGM, when the financial statements will have
been issued to members. However, although the IAS 10 Events after the reporting period time frame
for adjustments finishes when the financial statements are authorised for issue, the auditor's duty
in respect of subsequent events continues under ISA 560 Subsequent Events. An early decision
before the financial statements are authorised for issue would directly impact the financial statements
and might require further amendment and a change in the audit opinion. A decision after
that date may require the financial statements to be reissued and the auditor may need to seek
legal advice as to possible actions if the directors refuse to do so.
Chapter 12: Audit-related services and other assurance
services
Activity 1: KPIs
Approach
The secret to success here is to remember that this is a manufacturing business, so you need to
recommend key performance indicators (KPIs) relevant to a factory or workshop with its own cost
structure, where labour and/or technology is used to turn raw materials into finished goods.
Suggested solution
Non-financial performance measures (any four of these)








Customer rejects or returns vs sales
Customer satisfaction
Wastage of materials
Staff morale
Machine down time or idle time per employee
Items produced per employee
Staff turnover
Sickness/absenteeism rates per head
Activity 2: IT risks
Approach
Again, this is a very practical activity that requires a logical solution – even if you do not work for a
business like Amazon, eBay or Facebook, you can probably imagine could go wrong with their IT
systems (however unlikely) and the impact that each issue could have.
Suggested solution
Businesses are exposed to the following risks if their systems are unreliable:

Assets are misappropriated or tampered with.

They are at risk of being unable to trade with their customers (eg service interruption) leading
to customer dissatisfaction and loss of customers to a competitor.

Systems are damaged and shut down.

Data is tampered with and unauthorised amendments made.

Confidential data is stolen.

Data protection legislation is not complied with (eg GDPR in the UK and beyond) leading to
fines, loss of reputation and possibly going concern problems.
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Chapter 13: Prospective financial information (PFI)
Activity 1: PFI examples
Approach
This is a practical exercise in thinking about why PFI would be required and who would benefit from
it. Try and consider both internal and external stakeholders for this kind of information.
Suggested solution
Prospective financial information can include financial statements or one or more elements of
financial statements and may be prepared:
(a)
As an internal management tool, for example, to assist in evaluating a possible capital
investment; or
(b)
For distribution to third parties in, for example:
(i)
An annual report to provide information to shareholders, regulatory bodies and other
interested parties
(ii)
A document for the information of lenders which may include, for example, cash flow
forecasts
Activity 2: Prism
Approach
This is definitely exam standard and demonstrates a key piece of advice – if financial information is
presented in a question, you need to do something appropriate with it. However, what will you do
here? The solution is laid out in three categories: (i) general procedures over the creation of the PFI;
(ii) profit or loss items, which should be considered in terms of the story of how the company's
fortunes are going to change; and (iii) the financial position and what it will be in a year's time.
Consider what you have been told and how likely it is that the company will either continue as it is or
will change from the figures presented.
Finally, remember that performing analytical procedures is important, but you must do more than just
say 'Revenue has increased' – you need to work out whether such an increase is reasonable,
whether other factors would support this, whether you need further information to understand this
increase etc.
Suggested solution
General procedures
(1)
Meet with Paul to determine the process for preparing the forecast information.
(2)
Identify and document internal controls over the process. Consider the role played by the
Internal Audit department.
(3)
Obtain backing schedules for the information, cast and ensure they are numerically accurate.
(4)
Review the accounting policies used and ensure they are consistent with previous periods.
(5)
Discuss the need to produce a full statement of profit or loss, taking account of the proposed
tax, interest and dividend payment.
(6)
Produce a letter of engagement.
(7)
Obtain management representation with regard to the completeness and accuracy of
information and assumptions used. This should also contain a statement that it is
management's responsibility to produce the information.
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Statement of profit or loss
(1)
I would compare the forecast revenues for the year with those in the previous audited financial
statements. Challenge Paul's assumption that revenue will increase by 17%.
(2)
Agree the increase to contracts, review the management accounts for the start of the year: do
they show an increase in revenue?
(3)
Consider the likelihood of such an increase in revenue by reviewing the performance of similar
companies in the same sector and reviewing the wider economic climate.
(4)
Obtain a detailed analysis of revenue and cost, perform a detailed analytical review and
discuss the unusual movements with Paul or other relevant directors of Prism.
(5)
Compare the gross profit margin with that achieved in the past. The forecast shows an
increase of 5% – how has this been achieved? Is it a realistic expectation?
(6)
I would compare the level of expenses with those in prior year. Certain expenses should be
fixed and remain static. Others will vary according to revenue levels. Any significant
fluctuations would be investigated further.
(7)
Review the expected profit on disposal of investment to supporting documentation and
recalculate it.
Statement of financial position
(1)
I would check the value of non-current assets to the most recent audited accounts. Possible
impairment of assets will be discussed with the directors.
(2)
I would recalculate depreciation for each period and check the accounting policies against
those used in previous financial statements.
(3)
I would calculate the age of inventories, receivables and payables and compare them with
past financial statements. Any significant variations would be investigated further.
(4)
Discuss with management the possibility of obtaining equity finance.
(5)
Calculate key ratios and compare them year on year such as ROCE, asset turnover, current
asset and quick asset ratios. Review any current bank agreements and check that bank
covenants are not breached.
(6)
Discuss the need to include any provisions for contingencies, such as warranties.
(7)
I would agree the cash figure and the level of overdraft and loans to agreements with the
banks and financial institutions.
Chapter 14: Forensic audits
Activity 1: Sam Seel
Approach
This requirement has two parts: for the first part, you need to list the five fundamental ethical
principles (hopefully not a struggle, but refer back to Chapter 2 in this Workbook if you can't
remember them all!) before you consider how each one could be compromised by accepting this
engagement.
For part (b) you should try and visualise the fraud and explore everything that Sam could have been
connected with to see how far it has spread throughout SL. Remember to make your procedures
active, explaining what you will be doing, why and how – this will make for a thorough answer.
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Suggested solution
(a)
Integrity
SL Co has been a victim of fraud perpetrated by at least one of its own staff. It appears that
this is isolated to one, junior, member of staff. Despite this, prior to accepting the engagement,
we should consider the risk that the fraud was assisted by more senior members of staff or that
there is a weak control environment which could call into question the integrity of some or all
of the senior staff at SL Co If we feel there is a significant risk of our own integrity being
compromised, we should not accept the engagement.
Objectivity
Should this case come to court in the future there is a very real chance staff from our firm could
be called as an expert witness. We would need to consider our relationship with the client and
whether that would restrict our ability to provide testimony to the court in an objective manner.
An expert witness should seek to provide evidence independently, regardless of the interests of
their client.
Professional competence and due care
As with any engagement, we should consider our ability to perform the engagement with the
required level of expertise and competence. Our firm has a forensic department (albeit a small
one) so it is likely that we have performed similar engagements in the past. We should note,
however, that SL Co is a construction company and we would need to carefully consider
whether we have sufficient knowledge of the business and the industry to perform a
meaningful investigation.
Confidentiality
As with all other engagements, this will carry a duty of confidentiality to SL Co. However, this
will be overridden should we be called to court as an expert witness and we should inform SL
Co of this in the engagement letter. Additionally, this is likely to be a sensitive investigation
and we should discuss the levels of secrecy required whilst we are at the client's premises.
Professional behaviour
There is a chance that this case could enter the public domain in a court case that could be
relatively high profile. We should be careful to conduct ourselves in a professional manner
and do nothing which brings our firm or the profession into disrepute, particularly if we are
called as an expert witness.
(b)
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Procedures

Enquire of the Purchasing Manager as to the contracts/jobs for which Sam Seel dealt
with the invoices.

Perform an analytical review on purchases for contracts/jobs that Sam was not involved
in to identify any unusual trends that may imply the fraud is more widespread.

Inspect all (materiality is not relevant) invoices that Sam dealt with below $1,000. Be
alert for invoices to suppliers not on the company's approved list or purchase ledger for
the previous year (Sam was only employed for nine months). Unusual suppliers should
be contacted to confirm their existence; where the supplier cannot be verified, the
invoice should be listed as being fraudulent.

Perform an analytical review of all invoices dealt with by Sam in excess of $1,000.
Consider any unusual trends in purchasing costs, margins and so on compared to the
prior year. Unexplained fluctuations could indicate more extensive fraud and collusion
with senior staff.

Depending on the results of this analytical review, select a sample of invoices greater
than $1,000 and ensure the existence of the suppliers as above.
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Appendix 1 – Activity answers
Chapter 15: Social, environmental and public sector
auditing
Activity 1: Social and environmental factors
Approach
You will definitely have covered content related to social and environmental issues in your studies so
far (both ACCA and others) so this activity should be a way of summarising what you know.
Remember to consider your answer by thinking: 'Social and environmental issues have become more
important to business in recent years because…' and proceed from there.
Suggested solution
Social issues – family-friendly issues such as paternity leave and flexible working
conditions for parents and carers – have become more important now due to changes in society.
There has been a growth in the importance of the environment as a political and economic issue
– climate change (which has major social aspects to it) plus the importance of sustainability and the
impact of the environment on business (fuel costs and climate change issues etc).
This has led to the growth of so-called ethical consumers, investors and employees. These
key groups are now very selective about who they will purchase goods from, which companies they
invest in and who they would work for. Food miles are more important now than ever before, as is
the role of plastic carrier bags (now to be charged for in many jurisdictions to reduce their adverse
environmental impact).
As a result of this, businesses are keen to be seen to be engaging with key stakeholder
groups and demonstrating a commitment to ethical, social and environmental behaviour. This, in
turn, helps to attract and retain customers and employees.
From an alternative perspective there has been, in many countries, a growth in the volume of
domestic and supra-national legislation regulating the behaviour of businesses in these areas. This
leads to penalties and fines in certain jurisdictions for breaches of social issues (working time
directive, discrimination policies etc) and environmental legislation (Environment Agency in the UK).
Social and environmental issues have evolved over time and made us look at things in a different
way. Consider the coal industry: a coal mining company's financial statements will include the costs
of employee wages, plant and machinery used, licences and future dismantling costs. The coal
industry is usually seen as bringing economic benefits to society, through providing energy to
consumers and employment for workers.
But the costs of the coal industry to the social and natural environment may be much more
widespread than this. The environmental impact of the coal industry as a whole includes the
following factors, which are not part of financial statements:

Land use. Mining radically changes the landscape, eg by eliminating vegetation, changing
soil profiles and stopping current land uses.

Waste management. Burning coal (eg to make electricity) creates ash, much of which must
be stored in the ground, which both uses up land and creates a potential hazard to
communities.

Wildlife. Mining damages wildlife principally by changing or destroying habitats, which can
result in the depletion or total extinction of species from affected areas.

Air pollution. Coal is the largest contributor to the man-made increase of carbon dioxide
(CO2) in the atmosphere, which is associated with climate change.
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Activity 2: Integrated reporting
Approach
As integrated reporting is such an evolving issue, you should be prepared for it to form part of a
discussion-style question (such as that seen on the specimen exam for AAA). Consequently, this is
excellent practice for you to consider the benefits of having an assurance report reviewed (remember
to do this from the perspective of the entity creating the integrated report).
When answering the second part of this question, think about the contents of an auditor's report and
any other reports that you have seen so far in AAA and then consider what might be most
appropriate to use in the context of an integrated report.
Suggested solution
(a)
(b)
Perceived benefits of assurance work on integrated reports include:

The assurance report adds credibility to the data reported.

It reassures investors by promoting transparency (and may improve stock market price).

There is added prestige of having the information audited.

It gives a competitive advantage over those whose reports are not audited.

It identifies areas of weakness which can be addressed.

It may be a requirement for trading with some companies/countries or governments.

Social and environmental performance is taken more seriously, which in turn will
improve performance and (hopefully) reduce costs.
Contents of the practitioner's reported conclusions

Note of the objectives of the review

Opinion (if the engagement was agreed-upon procedures rather than assurance, there
will be no opinion given)

Basis on which the opinion (if any) has been reached

Work performed

Limitations (if any) to the work performed

Limitations (if any) to the opinion given
Note. There is no specific guidance on the contents of a practitioner's conclusion on an
integrated report on social and environmental issues; the above points represent the minimum you
should expect to see included. The International Integrated Reporting Framework (denoted by the
term IR) supported by ACCA is a voluntary scheme that suggests the areas where companies might
wish to report on their social and environmental credentials in a combined format with other financial
and non-financial performance. It is likely that you will have already met integrated reporting (for
example, as part of your studies for Strategic Business Leader).
Activity 3: New Evenham
Approach
There is an underlying assumption here that each hospital would produce the performance
information first and the NEPSA inspection unit would then audit that information.
There are more than four examples of performance information presented here – answers could vary
considerably depending on the provision of healthcare in your own country and your own point of
view. Our answers take a UK perspective where the National Health Service (NHS) operates most
hospitals in the public sector and where patient care is sometimes played off against private
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competition, usually (inevitably) in a political context. The following report was referred to when
constructing this example: www.nao.org.uk/wp-content/uploads/2013/10/10288-001-Emergencyadmissions.pdf.
Value for money (VfM) is not covered here as this example is supposed to show performance
information going beyond the purely financial (as well as to differentiate it from performance
auditing per syllabus area F4(a), but obviously VfM is important information for any service funded
by public sector money.
You may wish to try and answer parts (a) and (b) together and consider what you know about a
casualty department before moving on to part (c) when a healthy dose of scepticism may be required
to consider how such an audit may not always be possible.
Suggested solution
(a) Examples of
performance information
used to assess A&E
(b) Audit procedures to reach conclusions about
performance (including evidence)
Consider demand for A&E services and compare with
departmental capacity (this would require evidence about patient
volumes, staffing levels and floor space/throughput rates).
(1) Availability of
treatment
Recalculate the percentage of patients sent elsewhere or who left
without treatment and consider reasons why – inadequate space,
resource or facilities? (Ambulance transport data may exist to
support this as well as patient records that show no treatment was
received).
(2) Waiting times for
treatment
For a sample of patients, recalculate length of stay using times
between first admission and treatment time (requires accurate
records of reception, triage and treatment time).
(3) Quality of diagnosis
(A&E is often a
gateway to other
services but is also
used inappropriately)
Recalculate the percentage of inappropriate admissions (ie those
not acute) and the percentage of incorrect diagnoses by reviewing
quality of triage assessment (Requires data recording whether A&E
was required and readmission data for patients given inappropriate
treatment).
(4) Quality of patient
care
Consider from evidence presented whether treatment is in line with
agreed care standards (Requires analysis of treatment and
comparison with standards, as well as patient satisfaction surveys
and interviews).
Recalculate the percentage of shifts operated without a consultant
to supervise staff (Requires staffing records).
(5) Patient safety
Recalculate the percentage of serious incidents recorded per shift
(Requires inspection of incident logs and interviews with staff, as
well as definition of 'serious').
(6) Mortality rates
Recalculate the percentage of patients treated who die in A&E and
the percentage who die within a set time of discharge (eg five
days) – mortality rates should be collected so would be
straightforward to analyse (but drawing conclusions less so).
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(c)
Problems that may be experienced during the audit
Data may not exist or may just not be recorded; even if recorded, though, it may not be
accurate, consistent, trustworthy or comparable enough for use in producing and auditing the
performance information (often due to workload and because recording data is seen as too
bureaucratic).
Some measures may be intangible (quality of healthcare, for example) requiring care in their
use and interpretation as meaningful performance information.
Auditors will need to ensure a balanced view is presented (eg ensuring both positive and
negative patient comments are reflected fairly within the information).
Auditors may not possess the clinical skills to fully understand the data before them (eg an A&E
department may record higher than average mortality rates due to the demographics of their
location) leading to clinical staff displaying either reluctance to engage with audit or plain
hostility.
Political pressure to manipulate data in order to report inappropriate levels of performance
(the lack of controllability of underlying causes of both illness and necessary treatment may
also devalue any conclusions reached about performance).
Chapter 16: Current issues
No Activities.
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a
International regulatory
environments for audit
and assurance services
Essential reading
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1 The legal and professional framework
You have studied the regulatory framework in earlier exams. The following summaries will provide a
quick reminder. Note that the UK regulatory framework is shown here as an example.
1.1 The need for laws, regulations, standards and other guidance
Corporate scandals, such as those affecting Enron and Worldcom in the US, Olympus and Toshiba
in Japan and Autonomy in the UK, have brought the audit profession under close scrutiny from
investors, businesses, regulators and others.
There is a trend towards businesses becoming more complex and global, and firms of accountants
have expanded their range of services well beyond traditional assurance and tax advice. This has
led to a great deal of re-examination of regulatory and standard-setting structures both nationally and
internationally in recent years.
Laws are, in many respects, a last resort in the task of ensuring that audits are conducted properly
and are of a high quality. As a generalisation, laws tend to be prescriptive and dissuasive. They are
external to the auditor, requiring them to act within the letter (although not necessarily the spirit) of
the law in order to avoid punishment. Law is a relatively blunt instrument for regulation.
At the other extreme would be a moral code that is purely internal to the auditor's self, which the
individual would adhere to, irrespective of external consequences or laws. The audit profession does
not attempt to set out such a code, this being the more proper area for broader social, moral or
religious authority.
Audit regulations do take the presence of external laws and internal morality as their starting points,
but sit somewhere in between these two extremes. International standards are principles-based,
representing a common set of principles and practices which are more flexible than statutory laws,
allowing for an element of ambiguity and judgment on the part of the auditor. At the same time,
however, auditing standards are not simply general statements of morality: they contain specific
suggestions for the auditor to consider in specific circumstances, which are not legally binding but
which provide a starting point for the auditor in a given situation.
1.2 Overview of the UK regulatory framework
The EU Eighth Directive on company law requires that persons carrying out statutory audits must be
approved by the authorities of EU member states. The authority to give this approval in the UK is
delegated to Recognised Supervisory Bodies (RSBs). An auditor must be a member of an RSB and be
eligible under its own rules. The ACCA is an RSB.
The RSBs are required by the Companies Act to have rules to ensure that persons eligible for
appointment as a company auditor are either (Companies Act 2006: sections 1212–1215):


Individuals holding an appropriate qualification
Firms controlled by qualified persons
1.3 The Financial Reporting Council
The Financial Reporting Council (FRC) is the UK's independent regulator for corporate reporting and
governance. It has the following core structure and responsibilities under the overarching FRC Board:

Codes and Standards Committee – Responsible for actuarial policy, audit and assurance,
corporate governance, and accounting and reporting policy

Conduct Committee – Responsible for audit quality review, corporate reporting review,
professional discipline, professional oversight, and supervisory inquiries
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The role of the FRC Board is:

To set high standards of corporate governance through the UK Corporate Governance Code

To set standards for corporate reporting and actuarial practice

To monitor and enforce accounting and auditing standards

To oversee regulatory activities of the actuarial profession and professional accountancy
bodies

To operate independent disciplinary arrangements for public interest cases
The FRC's structure is shown in the following diagram (FRC, 2018):
FRC Board
Conduct Committee
Codes & Standards
Committee
Corporate Reporting
Review Committee
Audit & Assurance
Council
Audit Quality Review
Committee
Corporate Reporting
Council
Case Management
Committee
Actuarial Council
Financial Reporting
Review Panel
Tribunal
1.4 International standard setting
International Standards on Auditing (ISAs) are produced by the International Auditing and Assurance
Standards Board (IAASB), a technical standing committee of the International Federation of
Accountants (IFAC). You should also be familiar with the International Ethics Standards Board for
Accountants (IESBA), another body of IFAC and the producer of the Code of Ethics (see Chapter 2 of
the workbook).
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IFAC
(International Federation
of Accountants)
IESBA
(International Ethics Standards
Board for Accountants)
IAASB
(International Auditing and Assurance
Standards Board)
•
ISAs (International Standards on
Auditing)
•
ISQCs (International Standards on
Quality Control)
•
ISREs (International Standards on
Review Engagements)
•
ISAEs (International Standards on
Assurance Engagements)
•
ISRSs (International Standards on
Related Services)
•
Code of Ethics for
Professional Accountants
The IAASB's Preface to International Standards on Quality Control, Auditing, Assurance and Related
Services Pronouncements states that all the IAASB's 'engagement standards' above are 'authoritative
material', which means that they must be followed in an audit that is conducted in accordance with ISAs.
The IAASB also publishes four kinds of 'non-authoritative material'.

International Auditing Practice Notes (IAPNs) – These do not impose additional requirements
on auditors, but provide them with practical assistance

Practice Notes Relating to Other International Standards, eg in relation to ISREs, ISAEs or
ISRSs

Staff publications, which are used to help raise awareness of new or emerging issues, and to
direct attention to the relevant parts of IAASB pronouncements

Consultation papers, which seek to generate discussion with stakeholders
Within each country, local regulations govern, to a greater or lesser degree, the practices followed
in the auditing of financial or other information. Such regulations may be either of a statutory nature,
or in the form of statements issued by the regulatory or professional bodies in the countries
concerned.
National standards on auditing and related services published in many countries differ in form and
content. The IAASB takes account of such documents and differences and, in the light of such
knowledge, issues ISAs which are intended for international acceptance.
The European Union, for example, has since 2014 required ISAs (as issued by the IAASB) to be
adopted at EU level. Member states may impose additional requirements on auditors, but these must
not contradict EU ISAs. An example of this is the UK’s FRC, whose ISAs (UK) are in some places
more stringent than the IAASB's ISAs.
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1.5 Public oversight internationally
The Public Interest Oversight Board (PIOB) exists to oversee all of IFAC's 'public interest
activities,' including its standard-setting bodies such as the IAASB & IESBA. Its work involves:



Monitoring the standard-setting boards
Overseeing the nomination process for membership of these boards
Co-operation with national oversight authorities
The objective of the international PIOB is to increase the confidence of investors and others that the
public interest activities of IFAC are properly responsive to the public interest. The PIOB is based in
Madrid, Spain, where it operates as a non-profit Spanish foundation.
Oversight within the EU is by the Committee of European Auditing Oversight Bodies (CEAOB), which
was set up in June 2016 as a result of the EU Audit Regulation. The CEAOB acts as the framework
for cooperation between European national audit authorities.
The CEAOB is made up of:


Representatives of the national audit oversight bodies across the EU
Representatives from national audit authorities of the European Economic Area
Additionally, the European Banking Authority (EBA) and the European Insurance and Occupational
Pensions Authority (EIOPA) attend as observers.
1.6 Other examples of public oversight
An example of public oversight is the Professional Oversight team of the UK's FRC (formerly the
Professional Oversight Board, or POB), which has a number of statutory responsibilities. These
include:

Independent oversight of the regulation of statutory auditors by the RSBs (eg ACCA)

Independent supervision of Auditors General in respect of the exercise of their function
as statutory auditors

The receipt of statutory change of auditor notifications from companies and statutory
auditors in respect of 'major audits'
In the US, the response to the breakdown of stock market trust caused by perceived inadequacies in
corporate governance arrangements and the Enron scandal was the Sarbanes–Oxley Act 2002.
The Act applies to all companies that are required to file periodic reports with the Securities and
Exchange Commission (SEC).
The Public Company Accounting Oversight Board (PCAOB) is a private sector body in the
USA created by Sarbanes–Oxley. Its aim is to oversee the auditors of public companies. Its stated
purpose is to 'protect the interests of investors and further the public interest in the preparation of
informative, accurate and independent auditors' reports' (PCAOB, 2016). Its powers include setting
auditing, quality control, ethics, independence and other standards relating to the preparation of
auditor's reports by issuers. It also has the authority to regulate the non-audit services that audit firms
can offer.
Sarbanes–Oxley has been criticised in some quarters for not being strong enough on certain
issues, for example the selection of external auditors by the audit committee, and at the same time
being over-rigid on others. Directors may be less likely to consult lawyers in the first place if they
believe that legislation could override lawyer–client privilege.
In addition, it has been alleged that a Sarbanes–Oxley compliance industry has sprung up, focusing
companies' attention on complying with all aspects of the legislation, irrespective of how significant
they may be. This has distracted companies from improving information flows to the market
and then allowing the market to make well-informed decisions. The Act has also done little to address
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the temptation provided by generous stock options to inflate profits, other than requiring possible
forfeiture if financial statements are subsequently restated.
Most significantly, perhaps, there is some evidence of companies having turned away from the US
stock markets and towards other markets, such as London. It was said that this was partly due
to companies tiring of the increased compliance costs associated with Sarbanes–Oxley
implementation. In addition, the nature of the regulatory regime may be an increasingly
significant factor in listing decisions.
2 Corporate governance and audit committees
2.1 General requirements of codes of corporate governance
Corporate governance is the system by which companies are directed and controlled. Good
corporate governance is important because the owners of a company and the people who manage
the company are not always the same.
The G20/OECD Principles of Corporate Governance set out the rights of shareholders, the
importance of disclosure and transparency and the responsibilities of the board of directors.
You will have already studied various forms of governance as part of your earlier studies – the way it
is done in the UK is shown next as an illustration.
2.2 UK Corporate Governance Code
The FRC's UK Corporate Governance Code sets out standards of good practice using the following
categories:
Board Leadership and
Company Purpose
Division of
Responsibilities
Remuneration
Composition,
Succession and
Evaluation
Audit, Risk and
Internal Control
You can download the most recent version of the Code from the following link:
https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UKCorporate-Governance-Code-FINAL.pdf
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2.3 FRC Guidance on Audit Committees
The FRC issued its Guidance on Audit Committees in September 2012, which aims to help
companies to implement the requirements of the UK Corporate Governance Code. The Guidance
was revised in 2016 (FRC 2016g).
The particular arrangements for an audit committee should be tailored to the circumstances
of the company (FRC 2016g: para. 10). Audit committees need to be proportionate to the size,
complexity and risk profile of the company (FRC 2016g: para. 2).
The Guidance should not be taken as a simple list of rules. Rather, it notes that, in respect of the
relationship between the audit committee and the board, 'the most important features of this
relationship cannot be drafted as guidance or put into a code of practice' (they pertain to human
relationships, not rules). The relationship should be frank and open, and it should be possible for
disagreement between the audit committee and the board to be robust and based on
information made freely available to the audit committee (FRC 2016g: para. 4).
2.3.1 Establishment of the audit committee
As noted above, there should be three independent non-executive directors on the committee, two in
the case of smaller companies (FRC 2016g: para. 9). At least one member should have recent and
relevant financial experience (and a professional accountancy qualification) (FRC 2016g: para. 15).
The audit committee as a whole should have competence relevant to the sector in which the company
operates (FRC 2016g: para. 14).
Appointments are recommended by the nomination committee (FRC 2016g: para. 13).
There should be a minimum of three meetings per year, but the precise number depends on
the circumstances (FRC 2016g: para. 18). No one who is not on the committee has a right to attend
meetings (but they may be there if invited). The committee should meet external auditors at
least annually (FRC 2016g: para. 21).
The committee should have sufficient resources to undertake its duties, including remuneration
for its members (FRC 2016g: paras. 23-28).
2.3.2 Relationship with the board
The Board decides the role of the audit committee, and it is to the board that the audit committee
reports. The audit committee should report to the board on how it has discharged its responsibilities
(FRC 2016g: para. 29).
If the committee disagrees with the Board, then it should be able to report its point of view to
shareholders (FRC 2016g: para. 30).
2.3.3 Role and responsibilities
Annual reports. The audit committee reviews significant issues and judgments in financial
reporting (FRC 2016g: para. 32). Management is responsible for preparing the financial statements
– the audit committee then reviews them, taking into account the external auditor's point of view (FRC
2016g: paras. 33–34).
Internal controls and risk management systems. These systems are management's
responsibility, but the audit committee reviews them and approves statements made about them in
the annual report (FRC 2016g: paras. 39–44).
Internal audit. The audit committee reviews the effectiveness of the internal audit function,
including assessing whether one is needed (if it is not already present) (FRC 2016g: paras. 45–6).
In its review of the work of the internal audit function, the audit committee should:

Ensure that the internal auditor has direct access to the board chairman and to the audit
committee, and is accountable to the audit committee
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
Review and assess the annual internal audit work plan

Receive a report on the results of the internal auditors' work on a periodic basis

Review and monitor management's responsiveness to the internal auditor's findings and
recommendations

Meet with the head of internal audit at least once a year without the presence of management

Monitor and assess the role and effectiveness of the internal audit function in the overall
context of the company's risk management system
(FRC 2016g: paras. 52–54)
2.3.4 Role and responsibilities in relation to external auditor
The audit committee is the body responsible for overseeing the company's relations with the external
auditor.
Role and responsibilities of audit committee towards external auditor
Appointment and tendering
(FRC 2016g: paras. 58–62)
The audit committee makes a recommendation on the
appointment, reappointment and removal of the external auditors.
If this is not accepted, then the annual report must contain a
statement explaining the differing opinions of the audit committee
and the board.
The committee assesses the auditor's qualifications,
expertise, resources, and independence annually.
FTSE 350 companies put the audit out to tender at least every ten
years.
Terms and remuneration
(FRC 2016g: paras. 63–65)
The audit committee approves the terms of engagement and
the remuneration of the external auditor.
The audit committee reviews:


Annual audit cycle
(FRC 2016g: paras. 75–79)
The engagement letter (each year)
The scope of the audit
At the start of each annual audit cycle, the audit committee ensures
appropriate plans exist for the audit.
The committee considers whether the auditor's overall work plan,
including planned levels of materiality, and proposed resources
are appropriate.
The committee discusses with auditor:



Major issues found
Key judgments
Levels of errors, including uncorrected misstatements
The committee reviews:


Written representations from management
Auditor's management letter
The committee reviews the effectiveness of the audit process annually,
and reports to the board on its findings.
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Role and responsibilities of audit committee towards external auditor
Independence
The committee assess auditor's independence annually.
(FRC 2016g: paras. 66–74)
The committee recommends and develops company's policy on
the provision of non-audit services by the auditor.
2.3.5 Communication with shareholders
The audit committee section of the annual report should include (FRC 2016g: para. 81):

A summary of the role of the audit committee

The names and qualifications of all members of the audit committee during the period

The number of audit committee meetings

The significant issues considered in relation to the financial statements and how these
issues were addressed

An explanation of how it has assessed the effectiveness of the external audit
process and the approach taken to the appointment or reappointment of the external auditor.
It must include information on the length of tenure of the current audit firm, when a
tender was last conducted, together with advanced notice of any tendering plans. The report
should also outline any contractual obligations that acted to restrict the audit committee's
choice of external auditors

If the external auditor provides non-audit services, how auditor objectivity and
independence is safeguarded
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2.4 Advantages and disadvantages of audit committees
Disadvantages
Advantages
It provides the auditor with an
independent point of reference
other than the executive
directors of the company, in the
event of disagreement arising.
There may be difficulty
selecting sufficient non-executive
directors with the necessary
competence in auditing matters for
the committee to be really effective.
It will lead to increased
confidence in the credibility
and objectivity of financial
reports.
The establishment of such a
formalised reporting
procedure may dissuade the
auditors from raising matters of
judgment and limit them to reporting
only on matters of fact.
By specialising in the problems of
financial reporting and thus, to some
extent, fulfilling the directors'
responsibility in this area, it will allow
the executive directors to devote
their attention to management.
Costs may be increased.
In cases where the interests of the
company, the executive directors
and the employees conflict, the
audit committee might provide an
impartial body for the auditors
to consult.
The internal auditors will be able
to report to the audit committee.
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Code of ethics
and conduct
Essential reading
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1 Threats to objectivity and independence
1.1 Self-interest threat
The ACCA Code of Ethics and Conduct highlights a great number of areas in which a self-interest
threat might arise.
Business relationships
Serving as a director or officer of an audit client
Financial interest
Compensation and evaluation policies
Recruitment
SELF-INTEREST THREAT
Gifts and hospitality
Loans and guarantees
Lowballing
% or contingent fees
Fees – relative size
Overdue fees
1.1.1 Financial interests
Key term
Financial interest: Exists where an audit firm has a financial interest in a client's affairs –
for example, the audit firm owns shares in the client, or is a trustee of a trust that holds shares
in the client.
A financial interest in a client constitutes a substantial self-interest threat. According to both the ACCA
and the IESBA Codes, the parties listed below are not allowed to own a direct
financial interest or an indirect material financial interest in a client.




The assurance firm
A member of the assurance team or of the engagement partner's immediate family
Any other partner in the same office (or their immediate family)
Other partners/managers who provide non-audit services to the audit client
(IESBA Code: para. R510.4)
If these hold a direct financial interest, then no safeguards would be sufficient.
For members of the audit team, if the interest is not direct (eg is held by an employee's pension
scheme) or is not material (so the client cannot exercise significant influence over the auditor), then
the following safeguards may be relevant:



Disposing of the interest
Removing the individual from the team if required
Using an independent partner to review work carried out if necessary
Such matters will involve judgment on the part of the partners making decisions about such matters.
For example, what constitutes a material interest? A small percentage stake in a company might be
material to its owner. How does the firm judge the closeness of a relationship between staff and their
families? In other words, what does 'immediate' mean in this context?
Audit firms should have quality control procedures requiring staff to disclose relevant financial
interests for themselves and close family members. They should also foster a culture of voluntary
disclosure on an ongoing basis so that any potential problems are identified on a timely basis.
(IESBA Code: para. 510.10)
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1.1.2 Loans and guarantees
The advice on loans and guarantees falls into two categories:


The client is a bank or other similar institution
Other situations
If a lending institution client lends an immaterial amount to an audit firm or member of the audit
team on normal commercial terms, there is no threat to independence. If the loan were
material, it would be necessary to apply safeguards to bring the self-interest threat to an acceptable
level. A suitable safeguard is likely to be an independent review (by a partner from another office in
the firm) (IESBA Code: para 511.5 A3).
Loans to members of the audit team from a bank or other lending institution client are likely to be
material to the individual but, provided that they are on normal commercial terms, these do not
constitute a threat to independence.
An audit firm or individual on the audit team should not enter into any loan or guarantee
arrangement with a client that is not a bank or similar institution (IESBA Code: para. R511.5).
The firm or audit team member must not make a material loan to a client (IESBA Code:
para. R511.4). This rule is important because overdue fees from a previous audit could be construed
to be a loan, and must therefore be settled before an audit begins.
1.1.3 Business relationships
Examples of when an audit firm and an audit client have an inappropriately close business
relationship include:

Having a material financial interest in a joint venture with the assurance client

Arrangements to combine one or more services or products of the firm with one or more
services or products of the assurance client and to market the package with reference to both
parties

Distribution or marketing arrangements under which the firm acts as distributor or marketer of
the assurance client's products or services or vice versa
(IESBA Code: para. 520.3 A2)
Again, it will be necessary for the partners to judge the materiality of the interest and therefore its
significance. However, unless the interest is clearly insignificant, an assurance provider
should not participate in such a venture with an assurance client. Appropriate
safeguards are therefore to end the assurance provision or to terminate the (other) business
relationship.
If an individual member of an audit team has such an interest, they should be removed from the audit
team. However, if the firm or a member (and immediate family of the member) of the audit team has
an interest in an entity when the client or its officers also has an interest in that entity, the threat might
not be so great (IESBA Code: para. R520.5).
Generally speaking, purchasing goods and services from an assurance client on an
arm's length basis does not constitute a threat to independence. If there are a
substantial number of such transactions, there may be a threat to independence and safeguards may
be necessary (IESBA Code: para. 520.6 A1).
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1.1.4 Serving as a director or officer of an audit client
A partner or employee of an assurance firm should not serve as a director or
officer of an assurance client (IESBA Code: para. R523.3).
It may be acceptable for a partner or an employee of an assurance firm to perform the role of
company secretary for an assurance client, if:


The role is essentially administrative, with no managerial decision-making; and
This practice is specifically permitted under local law and professional rules.
(IESBA Code: para. R523.4).
Although a partner or employee cannot serve on a client's board, it is possible for them to attend
board meetings. This is common practice, and moreover, may be necessary if there are issues that
need to be raised with management.
1.1.5 Compensation and evaluation policies
There is a self-interest threat when a member of the audit team is evaluated on selling non-assurance
services to the client. The significance of the threat depends on:

The proportion of the individual's compensation or performance evaluation that is based on
the sale of such services

The role of the individual on the audit team

Whether promotion decisions are influenced by the sale of such services
(IESBA Code: para. 411.3 A1)
The firm should either revise the compensation plan or evaluation process, or put in place
appropriate safeguards. Safeguards include:



Revising the compensation plan or evaluation process for that individual;
Reviewing their work; or
Removing the member from the audit team.
(IESBA Code: para. 411.3 A2–3)
A key audit partner shall not be evaluated based on their success in selling
non-assurance services to their audit client (IESBA Code: para. R411.4).
The key audit partner is the:
Key term

Engagement partner

Individual responsible for the engagement quality control review

Other audit partners on the engagement team, if any, who make key decisions or
judgments on significant matters with respect to the audit of the financial statements
on which the firm will express an opinion. Depending upon the circumstances and the role of
the individuals on the audit, 'other audit partners' may include, for example, audit partners
responsible for significant subsidiaries or divisions.
(IESBA Code: Glossary)
1.1.6 Gifts and hospitality
Unless the value of the gift/hospitality is trivial and inconsequential, a firm or a member of an
assurance team should not accept it (IESBA Code: para. R420.3).
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1.1.7 Overdue fees
In a situation where there are overdue fees, the auditor runs the risk of, in effect, making a loan to a
client, whereupon the guidance above becomes relevant. If the previous year's fees remain unpaid
when the current year's auditor's report is to be signed, then safeguards should be applied such as a
pre-issuance review of the audit or obtaining partial payment of overdue fees (IESBA Code: para.
410.7 A2).
Audit firms should guard against fees building up and being significant by discussing the issues with those
charged with governance, and, if necessary, the possibility of resigning if overdue fees are not paid.
1.1.8 Contingent (%) fees
Key term
Contingent fee: A fee calculated on a predetermined basis relating to the outcome of a transaction
or the result of the services performed. A fee that is established by a court or other public authority is
not a contingent fee.
(IESBA Code: para. 410.9 A1)
A firm shall not enter into a contingent fee arrangement in respect of an audit. For
any assurance engagements provided to audit clients, unless immaterial or unconnected
to the audit, a contingent fee would still carry a threat so great that no safeguards could reduce it to
an acceptable level (IESBA Code: para. R410.10–11).
For non-assurance engagements (eg tax services), where the client is not an audit client,
the significance of the threat depends on:

The range of possible fee amounts

Whether an appropriate authority determines the outcome of the matter on which the
contingent fee will be determined

Disclosure of the work and the nature of the fees charged to intended users

The nature of the service

The effect of the event or transaction on the subject matter information
(IESBA Code: para. R410.12 A2)
Possible safeguards include:

Having a professional accountant review the relevant assurance work or otherwise
advise as necessary; or

Obtaining advance written agreement with the client on the basis of remuneration.
(IESBA Code: para. 410.12 A3)
1.1.9 Fees – relative size
When a firm receives a high proportion of its fee income from just one audit client, there is a selfinterest or intimidation threat, as the firm will be concerned about losing the client. A high
percentage fee income does not by itself create an insurmountable threat. This depends on the
following:



The operating structure of the firm
Whether the firm is well-established or new
The significance of the client to the firm
(IESBA Code: para. 410.3 A2)
Possible safeguards include reducing the dependence on the client (eg by increasing the client
base) (IESBA Code: para. 410.3 A3).
It is not just a matter of the audit firm actually being independent in terms of fees, but also of it
being seen to be independent by the public. It is as much about public perception as reality.
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The Code also states that a threat may be created where an individual partner or office's percentage
fees from one client is high. The safeguards include reducing dependence on the client and, in
addition, having an internal quality control review (IESBA Code: para. 410.3 A6).
For audit clients that are public interest entities, the Code states that where total fees from the
client (for the audit and any non-audit services) represent more than 15% of the firm's total
fees for two consecutive years, the firm shall:

Disclose this to those charged with governance of the audit client

Conduct a review, either by an external professional accountant or by a regulatory body.
This review can be either before the audit opinion on the second year's financial statements is
issued (a 'pre-issuance review'), or after it is issued (a 'post-issuance review').
If total fees significantly exceed 15%, then a post-issuance review may not be sufficient, and a
pre-issuance review will be required (IESBA Code: para. R410.4-6).
1.1.10 Lowballing
When a firm quotes a significantly lower fee level for an assurance service than would have been
charged by the predecessor firm, there is a significant self-interest threat. If the firm's tender is
successful, the firm must apply safeguards such as:

Maintaining records such that the firm is able to demonstrate that appropriate staff and time
are spent on the engagement

Complying with all applicable assurance standards, guidelines and quality control procedures
This issue is discussed in more detail in Chapter 5.
1.1.11 Recruitment services
Providing recruitment services in relation to the senior management of an audit client, particularly
those able to affect the financial statements, might create a self-interest, familiarity or intimidation
threat (IESBA Code: para. 609.1).
Assurance providers must not make management decisions for the client. Their involvement could be
limited to:

Professional qualifications of a number of applicants and providing advice on their suitability
for the position

Interviewing candidates and advising on a candidate's competence for financial accounting,
administrative or control positions
(IESBA Code: para. 609.3 A2)
The client must make all management decisions with respect to hiring, selecting candidates and
determining employment terms (such as salary) (IESBA Code: para. R609.4).
Prohibited recruitment services include:

Searching for or seeking out candidates; or

Checking references for prospective directors or senior management (whose role relates to the
financial statements)
(IESBA Code: para. R609.7)
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1.2 Self-review threat
General other
services
Temporary personnel
assignments
Corporate
finance
Preparing accounting records
and financial statements
SELF-REVIEW THREAT
Internal audit
services
Valuation services
Tax services
The key area in which there is likely to be a self-review threat is where an audit firm provides nonassurance services to an audit client (providing multiple services). There is a great deal of guidance
in the ACCA and IESBA Codes about the various other services that accountancy firms might provide
to their clients, and these are dealt with below.
1.2.1 Preparing accounting records and financial statements
There is clearly a significant risk of a self-review threat if a firm prepares accounting records and
financial statements and then audits them.
On the other hand, auditors routinely assist management with the preparation of financial statements
and give advice about accounting treatments and journal entries.
Therefore, assurance firms must analyse the risks arising and put safeguards in place to ensure that
the risk is at an acceptable level. If this can be done, then these services may be provided.
Examples of the kinds of 'routine or mechanical' services which may be provided include:

Preparing payroll calculations or reports for approval and payment by the client

Recording recurring transactions for which amounts are easily determinable from source
documents or originating data

Calculating depreciation on non-current assets (property, plant and equipment) when the client
determines the accounting policy and estimates of useful life and residual values

Posting transactions coded by the client to the general ledger or client-approved entries to the
trial balance

Preparing the financial statements based on information in the client-approved trial balance
and preparing the related notes based on client-approved records
(IESBA Code: para. 601.4 A1)
For audit clients that are not public interest entities, assurance firms are only allowed to
provide services of a routine or mechanical nature, and must consider any threats arising from these
services, applying safeguards such as using staff members other than audit team members to carry
out the work and an independent review.
(IESBA Code: para. R601.5, 601.5 A1)
The rules are more stringent when the client is listed/public interest. Firms should not
prepare accounts or financial statements for listed or public interest clients. There is a
minor exception to this: the auditor can provide accounting and bookkeeping services to a division
of a public interest entity, provided that the matters that the services relate to are immaterial to both
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the division and the overall entity, and the work is not carried out by audit team members (IESBA
Code: para. R601.6–7).
1.2.2 Valuation services
If an audit firm performs a valuation which will be included in financial statements audited by the
firm, a self-review threat arises.
Audit firms should not carry out valuations for public interest entities on matters
which will be material to the financial statements (IESBA Code: para. R603.5).
If the client is not a public interest entity, then the firm cannot provide a valuation service if the
valuation would have a material effect on the financial statements and it involves a significant
degree of subjectivity (IESBA Code: para. R603.4).
If the valuation is for an immaterial matter which is not subjective in nature, the audit firm should
apply safeguards to ensure that the risk is reduced to an acceptable level. Safeguards include:


Second partner review
Using separate personnel for the valuation and the audit
(IESBA Code: para. 603.3 A4)
1.2.3 Taxation services
The Code divides taxation services into five categories.
(a)
(b)
(c)
(d)
(e)
Tax return preparation
Tax calculations for the purpose of preparing the accounting entries
Tax planning and other tax advisory services
Tax services involved in valuations
Assistance in the resolution of tax disputes
(IESBA Code: subsection 604)
Guidance in respect of each of these categories is:
(a)
Tax return preparation does not generally threaten independence, as long as
management takes responsibility for the returns.
(IESBA Code: para. 604.4 A1)
(b)
Tax calculations for the purpose of preparing material accounting entries may
not prepared for public interest entities. For non-public interest entities, it is acceptable
to do so, provided that safeguards such as independent reviews and the use of separate teams
are applied.
(IESBA Code: paras. 604.5 A1-A3; 604.6)
(c)
Tax planning may be acceptable in certain circumstances, eg where the advice is
clearly supported by tax authority or other precedent. However, if the effectiveness of the tax
advice depends on a particular accounting treatment or presentation in the financial
statements, the audit team has reasonable doubt about the accounting treatment, and the
consequences of the tax advice would be material, then the service should not be provided.
(IESBA Code: paras. 604.7 A1-A3; R604.8)
(d)
Tax services involving valuations may be acceptable if the effect on the financial
statements is neither direct nor material, but can still provide self-review threats that might not
be managed by safeguards. Where appropriate, such engagements can be carried out for all
clients with safeguards such as independent review, separate teams and obtaining pre-clearance
from the local tax authority.
(IESBA Code: paras. 604.9 A1-4)
(e)
Assistance in the resolution of tax disputes may be provided, depending on
whether the firm itself provided the service which is the subject of the dispute, and whether the
effect is material to the financial statements. Safeguards include using professionals who are
not members of the audit team to perform the service, and obtaining advice on the service
from an external tax professional.
(IESBA Code: paras. 604.10 A1-A4)
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1.2.4 Internal audit services
A firm may provide internal audit services to an audit client. However, it should ensure that the client
acknowledges its responsibility for establishing, maintaining and monitoring the system of internal
controls. The key risk is of assuming a management responsibility. The following services
would involve assuming a management responsibility, and must not be provided:







Setting strategic policies for the internal audit function
Directing and taking responsibility for employees' work
Deciding how to implement recommendations
Reporting the results of internal audit to the audit committee
Performing internal controls
Designing/maintaining internal controls
Performing outsourced internal audit with some management responsibility
(IESBA Code: para. 605.4 A2)
It may be appropriate to use safeguards, such as ensuring that an employee of the client is
designated as responsible for internal audit activities and that the client approves all the work that
internal audit does.
If the client is a public interest entity, then internal audit services must not be provided if they
relate to:
(a)
A significant part of the internal controls over financial reporting;
(b)
Financial accounting systems generating information which is significant to the financial
statements; or
(c)
Amounts or disclosures which are material to the financial statements.
(IESBA Code: para. R605.5)
1.2.5 Corporate finance
Certain aspects of corporate finance will create self-review threats that cannot be reduced to an
acceptable level by safeguards. Therefore, assurance firms are not allowed to promote,
deal in or underwrite an assurance client's shares (IESBA Code: para. R610.4).
Firms must also refrain from providing advice that interacts with the financial statements –
both when the advice depends on an accounting treatment, and when the advice may have a
material effect on the financial statements (IESBA Code: para. R610.5).
Other corporate finance services, such as assisting a client in defining corporate strategies, assisting
in identifying possible sources of capital and providing structuring advice, may be acceptable,
providing that safeguards are put in place, such as using different teams of staff and reviewing the
work undertaken to ensure no management decisions are taken on behalf of the client (IESBA Code:
paras. R610.3 A1-3).
1.2.6 Temporary personnel assignments
Personnel may be loaned to an audit client, but only for a short period of time.
Personnel must not assume management responsibilities, or undertake any nonassurance work that is prohibited elsewhere in the Code (IESBA Code: para. R525.4).
The audit client must be responsible for directing and supervising the activities of the loaned
personnel.
Possible safeguards include:

Conducting an additional review of the work performed by the loaned personnel;

Not giving the loaned personnel audit responsibility for any function or activity on the audit,
that they performed during the temporary staff assignment; or

Not including the loaned personnel in the audit team.
(IESBA Code: para. 525.3 A1)
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1.2.7 General other services
The audit firm might sell a variety of other services to audit clients, such as:



IT services
Litigation support
Legal services
The assurance firm should consider whether there are any threats to independence, such as if the firm
were asked to design internal control IT systems, which it would then review as part of its audit. The
firm should consider whether the threat to independence could be reduced by appropriate
safeguards.
In general, firms cannot accept any management responsibilities for an audit client
(IESBA Code: para. 600.7) and must always actively consider risk factors such as the nature of the
engagement, the nature of the client and the perception of a reasonable and informed third party in
determining the extent of any ethical threats. The Code also prohibits a firm from assuming any
management responsibility for an audit client as it creates self-interest, self-review, advocacy and
familiarity threats (ISEBA Code: para. 600.7.A2).
1.3 Advocacy threat
Legal services
Contingent fees
ADVOCACY THREAT
Corporate finance
An advocacy threat arises in certain situations where the assurance firm is in a position of taking the
client's part in a dispute or somehow acting as their advocate. The most obvious instances of this
would be when a firm offered legal services to a client and, say, defended them in a legal case or
provided evidence on their behalf as an expert witness. An advocacy threat might also arise if the
firm carried out corporate finance work for the client – for example, if the audit firm was involved in
advice on debt reconstruction and negotiated with the bank on the client's behalf.
As with the other threats above, the firm has to appraise the risk and apply safeguards as necessary.
Relevant safeguards might be using different departments in the firm to carry out the work and
making disclosures to the audit committee. Remember, the ultimate option is always to withdraw from
an engagement if the risk to independence is too high.
1.4 Familiarity threat
A familiarity threat arises where independence is jeopardised by the audit firm and its staff becoming
over familiar with the client and its staff. There is a substantial risk of loss of professional scepticism
in such circumstances.
We have already discussed some examples of when this risk arises, because very often, a familiarity
threat arises in conjunction with a self-interest threat.
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Where there are family
and personal relationships
between client/firm
Long association with
assurance clients
FAMILIARITY THREAT
Employment with
assurance client
Recent service with
assurance client
1.4.1 Long association of senior personnel with audit clients
Having an audit client for a long period of time may create a familiarity threat to
independence. The severity of the threat depends on such factors as:

The length of the relationship between the individual and the client (especially if this extends
over employment at more than one firm);

How long the individual has been on the audit team and the nature of the roles performed;

The extent of any supervision and review of the individual by senior personnel;

The extent of the individual's influence over the outcome of the audit;

The closeness of any personal relationship between the individual and anyone in a responsible
position at the client; and

The nature, frequency and extent of interaction between the individual and anyone in a
responsible position at the client.
Other factors can be relevant here, such as the client's accounting and reporting framework or its
senior management personnel, including any recent changes.
(IESBA Code: para. 540.3 A3)
Possible safeguards include:

Rotating the individual off the audit team or changing the nature of their role or
tasks;

Having an appropriate reviewer who was not an audit team member review the work of
the individual; or

Regular independent internal or external quality reviews of the engagement.
(IESBA Code: para. 540.3 A6)
The rules for public interest entities are stricter. If an individual is a key audit partner for
seven years, they must be rotated off the audit and serve a 'cooling off' period, dependent on the
roles vacated: for engagement partners, this is five consecutive years; for engagement
quality control reviewers, three years and for other key audit partners, this is two
years (IESBA Code: para. R540.11-13). During this time, they cannot be on the audit team, and
cannot consult with the audit team or the client on any issues that may affect the engagement
(including giving general industry advice) (IESBA Code: para. R540.20).
The Codes do allow some flexibility here: if key partner continuity is particularly beneficial to
audit quality, and there is some unforeseen circumstance (such as the intended engagement
partner becoming seriously ill), then the key audit partner can remain on the audit for an
additional year, making eight years in total (IESBA Code: para. R540.7).
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If a client that was not a public interest entity becomes one, then the seven year limit still applies,
starting from the date when the key audit partner originally became the key partner for that audit
client (IESBA Code: para. R540.8).
Finally, it is possible for an independent regulator to give permission for an audit partner to remain a
key audit partner indefinitely, provided alternative safeguards are applied (eg external review)
(IESBA Code: para. R540.9).
1.4.2 Recent service with an audit client
An individual may have recently worked for an audit client. If they worked for the client during the
period audited (both current and prior year) then they cannot be on the audit team if they:

Had served as a director or officer of the audit client; or

Were an employee in a position to exert significant influence over the accounting records
(or financial statements).
(IESBA Code: para. R522.3).
If one of the above individuals did not work for the client during the period being audited (ie they left
the client before that), then a threat is created. The firm should consider the threat and apply
appropriate safeguards, eg obtaining a quality control review of the individual's work on the audit
(IESBA Code: paras. 522.4 A1-3).
1.4.3 Employment with an audit client
It is possible that staff might transfer between an assurance firm and a client, or that negotiations or
interviews to facilitate such movement might take place. Both situations are a threat to independence:

An audit staff member might be motivated by a desire to impress a future possible employer
(objectivity is therefore affected – self-interest threat).

A former partner turned finance director may have too much knowledge of the audit firm's
systems and procedures (familiarity threat).
In general, there may be self-interest, familiarity and intimidation threats when a member
of the audit team joins an audit client.
A 'significant connection' still remains between the audit firm and the former employee/partner
where:

The individual is entitled to benefits from the audit firm (unless fixed and predetermined, and
not material to the firm)

Any amount owed to the individual is material to the firm

The individual continues to participate in the audit firm's business or professional activities
(IESBA Code: para. R524.4)
Any familiarity or intimidation threat depends on the following:

The position the individual has taken at the client

Any involvement the individual will have with the audit team

The length of time since the individual was a member of the audit team or partner of the
firm

The former position of the individual within the audit team or firm; for example,
whether the individual was responsible for maintaining regular contact with the client's
management or those charged with governance
(IESBA Code: para. 524.4 A3)
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Safeguards could include:

Modifying the audit plan;

Assigning individuals to the audit team who have sufficient experience in relation
to the individual who has joined the client; or

Having an independent professional accountant review the work of the former member of the
audit team.
(IESBA Code: para. 524.4 A4)
Should an audit team member be pursuing employment with an audit client, they should inform the
firm of this as soon as possible. Safeguards to address the self-interest threat presented here are to
remove the individual from the audit team, and to review their work for any indication of bias
(IESBA Code: para. R524.5).
If the audit client is a public interest entity, then 'cooling off' periods are required. Both the
ACCA and IESBA Codes state that when a key audit partner joins such a client, either as a
director or as an employee with significant influence on the financial statements, the client must have
issued audited financial statements covering at least 12 months before the employment can begin.
The partner in question must also not have been a member of the audit team in relation to those
audited financial statements (IESBA Code: para. R524.6).
In the case of a senior or managing partner joining an audit client, 12 months
must have passed (ie there is no requirement for audited financial statements to have been issued)
(IESBA Code: para. R524.7).
1.4.4 Family and personal relationships
Immediate family: A spouse (or equivalent) or dependent.
Key terms
Close family: A parent, child or sibling who is not an immediate family member.
(IESBA Code: Glossary)
Family or close personal relationships between assurance firm staff and client staff could seriously
threaten independence. Each situation has to be evaluated individually.
When an immediate family member of someone on the audit team is a director, an officer, or
an employee who is in a position to exert direct and significant influence over the financial
statements, then the individual should be removed from the audit team (IESBA Code:
para. R521.5). Otherwise, safeguards should be applied, such as either removal from the audit team
or restructuring someone's role in the firm so they are not dealing with matters under the family
member's responsibility (IESBA Code: paras. 521.4 A3–4).
If the person is only a 'close' family member (but not an 'immediate' family member), then the
threat is evaluated and the same safeguards can be applied (IESBA Code: paras. 521.6 A3–4).
If the relationship is not a family relationship but is still close (eg friendship), then the threat is
evaluated and safeguards applied (IESBA Code: para. R521.7).
A firm should have quality control policies and procedures under which staff should disclose whether
a close family member employed by the client is promoted within the client. If a firm inadvertently
violates the rules concerning family and personal relationships, then they should apply additional
safeguards, such as: undertaking a quality control review of the audit, or discussing the matter with
the audit committee of the client, if there is one.
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1.5 Intimidation threat
An intimidation threat arises when members of the assurance team have reason to be intimidated by
client staff.
Close business
relationships
Litigation
Family and personal
relationships
INTIMIDATION THREAT
Second opinions
Assurance staff members
move to employment
with client
These are also examples of self-interest threats, largely because intimidation may only arise
significantly when the assurance firm has something to lose.
1.5.1 Actual and threatened litigation
There may be an intimidation threat when the client threatens to sue, or indeed sues, the audit firm
for work that has been done previously. The firm is then faced with the risk of losing the client, bad
publicity and the possibility that they will be found to have been negligent, which will lead to further
problems. This could lead to the firm being under pressure to produce an unmodified auditor's report
when they have been modified in the past, for example.
Generally, audit firms should seek to avoid such situations arising. If they do arise, factors to
consider are:


The materiality of the litigation
Whether the litigation relates to a prior audit engagement
(IESBA Code: para. 430.3 A2)
The following safeguards could be considered:


Removing the individual from the audit team
Having a professional review the work performed
(IESBA Code: paras. 430.3 A3-4)
1.5.2 Second opinions
Another way that auditors can suffer an intimidation threat is when the audit client is unhappy with a
proposed audit opinion, and seeks a second opinion from a different firm of auditors.
In such a circumstance, the second audit firm will not be able to give a formal audit
opinion on the financial statements – only an appointed auditor can do that. However, the problem
is that if a different firm of auditors indicates to someone else's audit client that a different audit
opinion might be acceptable, the appointed auditor may feel under pressure to change the audit
opinion. In effect, a self-interest threat arises, as the existing auditor may feel that they will lose next
year's audit if they do not change this year's opinion.
There is nothing to stop a company director talking to a second firm of auditors about treatments of
matters in the financial statements. However, the firm being asked for a second opinion should be
very careful, because it is possible that the opinion they form could be incorrect anyway, if the
director has not given them all the relevant information. For that reason, firms giving a second
opinion should ensure that they seek permission to communicate with the existing auditor and they
are appraised of all the facts (IESBA Code: para. 321.3 A3). If permission is not given, the second
auditors should consider whether they can reasonably act in such circumstances (IESBA Code:
para. R321.4).
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Given that second opinions can cause independence issues for the existing auditors, audit firms
should generally take great care if asked to provide one anyway. Increasingly, new accounting
standards do not give a choice of accounting treatments, meaning that second opinions might be less
called for.
2 Specific guidance: Confidentiality
Key term
Confidentiality: To respect the confidentiality of information acquired as a result of
professional and business relationships.
(IESBA Code: para. 110.1 A1)
The following are points that relate to confidentiality in general.

Do not disclose information acquired, ie respect the principle of confidentiality (IESBA Code:
para. R114.1).

Information may be disclosed in certain circumstances, eg where it is required by law (see
below) (IESBA Code: para. 114.1 A1).
In exchange for this duty of confidence owed by the auditor to the client, the client must agree to
disclose in full all information relevant to the engagement. The professional accountant must make the
client aware of the duty of confidentiality, and of the fact that it can be overridden where there is a
right or duty to disclose.
Maintaining confidentiality means avoiding inadvertent disclosure as much as intentional
disclosure (IESBA Code: para. R114.1). For instance, information must not be disclosed
unintentionally when socialising. The Code also note that the duty of confidentiality continues
even after the end of the relationship with the client (IESBA Code: para. R114.2).
2.1 Exceptions to the rule of confidentiality
Binding though the duty of confidence is, there are nevertheless exceptions to it. The Codes identifies
three general circumstances where disclosure may be appropriate.

Disclosure is permitted by law and is authorised by the client.

Disclosure is required by law (eg for legal proceedings).

There is a professional duty or right to disclose (eg to comply with a quality review by a
professional body such as ACCA; to respond to an investigation by a regulatory body; to
protect the professional accountant's interests in legal proceedings; to comply with technical
and professional standards, including ethics requirements).
(IESBA Code: para. 114.1 A1)
Disclosure may be obligatory or merely voluntary, depending on the situation.
Key term
Obligatory disclosure: A professional accountant who believes that a client has committed
terrorist offences, or has reasonable cause to believe that a client has committed treason, is
bound to disclose that knowledge to the proper authorities immediately.
(ACCA Rulebook: para. B1.22)
Voluntary disclosure: In certain cases, a professional accountant is free to disclose information,
whatever its nature:




When it is in the public interest
In order to protect a professional accountant's interests
Where it is authorised by statute
To non-governmental bodies
(ACCA Rulebook: para. B1.30)
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In deciding whether to disclose, some general factors to consider include:

Whether it would harm the interests of all parties (including third parties)

Whether all relevant information is known and substantiated

The type of communication that is expected

Whether the parties to whom the communication is addressed are appropriate
recipients
The following four subsections address the four kinds of voluntary disclosure.
2.1.1 Disclosure in the public interest
The courts have never given a definition of 'the public interest', which makes things difficult for the
auditor as it is not certain exactly when they must disclose. But both ACCA and IESBA Codes state
that disclosure is probably only permitted to 'one who has a proper interest to receive that
information', such as:



The police;
The government department for trade and industry; or
A recognised stock exchange.
Whether disclosure is justified depends on the following factors (ACCA Rulebook: para. B1.32):







The size of the amounts involved and the extent of likely financial damage
Whether members of the public are likely to be affected
The possibility or likelihood of repetition
The reasons for the client's unwillingness to make disclosures to the proper authority
The gravity of the matter
Relevant legislation, accounting and auditing standards
Any legal advice obtained
The Codes do state that this is a difficult area to decide on, and that it will often be
appropriate to take legal advice (ACCA Rulebook: para. B1.33).
Under ISA 250, if auditors become aware of a suspected or actual instance of non-compliance with
law and regulation which gives rise to a statutory right or duty to report, they should report it to the
proper authority immediately (ISA 250: para. A29). They should also seek legal advice.
2.1.2 Disclosure to protect a professional accountant's interests
Disclosure can be made to protect a professional accountant's interests to:

Enable the professional accountant to defend themselves against a criminal charge
or suspicion

Resist proceedings in relation to a taxation offence

Resist legal action by a client or a third party

Enable the professional accountant to defend themselves against disciplinary
proceedings by the ACCA or another body

Enable the professional accountant to sue for their fees
(ACCA Rulebook: para. B 1.34)
2.1.3 Disclosure authorised by statute
There are two areas where legislation may require the auditor to break their duty of confidentiality:

Where required to disclose by anti-money laundering legislation (see Chapter 1)

Where required to disclose by any whistleblowing responsibilities, eg for an auditor of
certain financial institutions in the UK
(ACCA Rulebook: para. B 1.35)
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2.1.4 Disclosure to non-governmental bodies
Disclosure must be made to a recognised non-governmental body where the body
has statutory powers requiring disclosure. Where the body does not have these powers
then the professional accountant must obtain the client's consent to disclose (ACCA Rulebook:
para. B 1.36).
2.2 Responding to illegal acts/non-compliance with laws and
regulations
The IESBA's guidance on responding to non-compliance has been incorporated into its Code of
Ethics since 2017. The Code provides a framework to guide auditors and other professional
accountants in deciding what actions to take in the public interest when they become aware of a
potential illegal act by a client or employer.
We now have a new acronym: NOCLAR, or Non-Compliance with Laws And Regulations. The
IESBA definition of non-compliance is aligned with the IAASB's definition, which is given in ISA 250
and was discussed in Chapter 1.
When a professional accountant is faced with non-compliance, their objectives should be:

To comply with the principles of integrity and professional behaviour

By alerting management or those charged with governance, to seek to:

–
Enable them to rectify, remediate or mitigate the consequences of the identified or
suspected non-compliance; or
–
Deter the commission of non-compliance where it has not yet occurred
To take such further action as may be needed in the public interest
(IESBA Code: para. 360.4)
The laws and regulations covered by the framework are those which either directly affect the
financial statements, or which are fundamental to the client's business. For example, law dealing
with:








Fraud, corruption and bribery
Money laundering, terrorist financing and proceeds of crime
Securities markets and trading
Banking
Data protection
Tax and pension liabilities and payments
Environmental protection
Public health and safety
(IESBA Code: para. 360.5 A2)
Outside the scope are: matters which are clearly inconsequential; personal misconduct unrelated to a
client's business, and; acts of non-compliance committed by someone other than the client.
2.2.1 Non-compliance encountered by auditors
Management is responsible for ensuring that the business complies with laws and regulations,
and to address any non-compliance (IESBA Code: para. 360.8 A1).
If the auditor discovers non-compliance, they first obtain an understanding of the matter (IESBA
Code: para. R360.10). The issue should be discussed with management/those charged with
governance (TCWG) (IESBA Code: para. R360.11).
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The accountant should advise management/TCWG to:



Rectify the situation
Deter further non-compliance
Disclose the non-compliance to the appropriate authority
(IESBA Code: para. R360.14)
Then the accountant must assess whether management's response is appropriate, taking into account
whether:






The response is timely
The non-compliance has already been investigated
Action has been taken to remedy it
Action has been taken to deter it
Steps have been taken to prevent re-occurrence
The non-compliance has been disclosed
(IESBA Code: para. 360.19 A1)
The accountant then decides whether further action is needed in the public interest. This
essentially depends on the urgency and seriousness of the matter, and how likely it is to re-occur. The
accountant should also consider whether this affects their assessment of management's integrity
(IESBA Code: para. R360.20).
Further action might include:


Disclosing the matter to the relevant authorities
Withdrawing from the engagement
(IESBA Code: para. R360.21 A1)
Disclosure would be made if the matter is serious; examples include: if the entity is engaged in
bribery; if this would threaten any licences to operate; or if products sold by the entity could be
harmful to the public (IESBA Code: para. 360.25 A2).
The auditor must also keep documentation of this process.
3 Specific guidance: conflicts of interest
There are two kinds of conflict of interest:


Conflicts between the interests of different clients
Conflicts between members' and clients' interests
(IESBA Code: para. 310.2)
Audit firms should take reasonable steps to identify circumstances that could pose a conflict of
interest.
Examples of conflicts of interest
Using confidential information obtained during an audit to help another client to acquire the
audit client
Advising two clients at the same time who are competing to acquire the same company
Providing services to both a vendor and a purchaser in relation to the same transaction
Representing two clients who are in a legal dispute with each other (eg during divorce
proceedings)
(IESBA Code: para. 310.4 A1)
The Code emphasises the importance of considering potential conflicts of interest before
accepting a new client (IESBA Code: para. R310.5). An issue here is first identifying that
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there is a conflict – it may be that, for example, the engagement partner for a new client is not
aware that there is a conflict because they do not know all of the firm's other clients. It is therefore
necessary to have an effective conflict identification process (IESBA Code: para. 310.5 A1–2).
As with all threats, safeguards should be applied if necessary. If safeguards would not be enough,
then the engagement should be declined or discontinued.
Examples of safeguards
Disclosure of the nature of the conflict of interest (and related safeguards) to clients affected, to
obtain their consent to the professional accountant performing the services
Mechanisms to prevent unauthorised disclosure of confidential information, such as:



Separate engagement teams
Creating separate areas of practice for specialty functions within the firm
Establishing policies and procedures to limit access to client files
Review of safeguards by a senior individual not involved with the engagement(s)
External review by a professional accountant
Consulting with third parties, such as a professional body, legal counsel or another
professional accountant
(IESBA Code: para. 310.9-13)
Disclosure is the key safeguard here. If the client refuses to give consent, then the engagement
giving rise to the conflict should be discontinued.
4 Conflicts in application of the fundamental principles
4.1 The problem
Both the IESBA and ACCA Codes are principles-based. The application of the principles they contain
requires a degree of judgment (much like the application of an ISA). As a result of this judgmental
aspect, it is possible to have more than one 'right answer' in a given situation – more than
one reasonable judgment of how the fundamental ethical principles should be applied.
Contrast this to the situation with a rules-based code of ethics. There, applying the rules strictly should
result in only one possible outcome. It might not be an outcome that is ethical, eg because it is a
result of a loophole, but it will be the only correct outcome (assuming that the rules themselves are not
ambiguous). By contrast, a principles-based code may allow for several outcomes that are equally
'correct'.
The issue is that there may be conflict between different ethical principles. The aim here must be to
use judgment to resolve the conflict, or to try to balance the principles involved.
4.2 Matters to consider
The resolution process should include consideration of:

Relevant facts – Do I have all the relevant facts? Eg an organisation's policy and procedures

Relevant parties – Who is affected by the ethical issue? Eg shareholders, employees, employers,
the public

Ethical issues involved – What kinds of issues are these? Would they affect the profession's
reputation? Eg professional ethical issues, personal ethical issues

Fundamental principles related to the matter in question – What are the threats? Refer to ethical
code
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
Established internal procedures – Are there procedures for dealing with this sort of situation?
Eg discuss with your supervisor, or firm's legal department

Alternative courses of action – Have all the consequences been evaluated? Consider laws and
regulations, long-term consequences, public consequences
(adapted from ICAEW 2016b)
4.2.1 Unresolved conflict
If the matter is unresolved, the member should consult with other appropriate persons within the firm.
They may then wish to obtain advice from the ACCA or legal advisers. If after exhausting all relevant
possibilities the ethical conflict remains unresolved, members should consider withdrawing from the
engagement team, a specific assignment, or to resign altogether from the engagement.
4.3 Example
An auditor
encounters a fraud
Conflict: duty to report
could conflict with
confidentiality
Take legal advice to
determine whether there is a
requirement to report
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a
Fraud and
professional liability
Essential reading
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Appendix 2 – Essential reading
The following legal cases are frequently used to provide an overview of the various factors that
determine the liability owed by auditors.
1 The auditor's duty of care to clients
Re Kingston Cotton Mill 1896
When Lopes L J considered the degree of skill and care required of an auditor, he declared:
... it is the duty of an auditor to bring to bear on the work he has to perform that skill, care and
caution which a reasonably competent, careful and cautious auditor would use. What is
reasonable skill, care and caution, must depend on the particular circumstances of each case.
Lopes was careful to point out that what constitutes reasonable care depends very much on the facts
of a particular case. Another criteria by which the courts will determine the adequacy of the auditors'
work is by assessing it in relation to the generally accepted auditing standards of the day.
The courts will be very much concerned with accepted advances in auditing techniques,
demonstrated by Pennycuick J in Re Thomas Gerrard & Son Ltd 1967 where he observed that:
... the real ground on which Re Kingston Cotton Mill ... is, I think, capable of being
distinguished is that the standards of reasonable care and skill are, upon the expert evidence,
more exacting today than those which prevailed in 1896.
Lord Denning, in the case of Fomento (Sterling Area) Ltd v Selsdon Fountain Pen Co Ltd 1958, sought
to define the auditor's proper approach to their work by saying that:
... they must come to it with an inquiring mind – not suspicious of dishonesty ... – but suspecting
that someone may have made a mistake somewhere and that a check must be made to ensure
that there has been none.
The auditors have a responsibility to keep themselves abreast of professional developments. Auditing
standards are likely to be taken into account when the adequacy of the work of auditors is being
considered in a court of law or in other contested situations.
When the auditors are exercising judgment they must act both honestly and carefully. Obviously, if
auditors are to be 'careful' in forming an opinion, they must give due consideration to all relevant
matters. Provided they do this and can be seen to have done so, then their opinion should be above
criticism.
However, if the opinion reached by the auditors is one that no reasonably competent auditor would
have been likely to reach, then they would still possibly be held negligent. This is because, however
carefully the auditors may appear to have approached their work, it clearly could not have been
careful enough, if it enabled them to reach a conclusion which would be generally regarded as
unacceptable.
If the auditors' suspicions are aroused, they must conduct further investigations until such suspicions
are either confirmed or allayed.
2 The auditor's duty of care to third parties
Traditionally, the courts have been averse to attributing a duty of care to third parties to
the auditor. We can see this by looking at some past cases that have gone to court.
A very important case is Caparo Industries plc v Dickman and Others 1990, which is described
here.
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The facts as pleaded were that in 1984, Caparo Industries purchased 100,000 Fidelity shares in
the open market. On 12 June 1984, the date on which the financial statements (audited by Touche
Ross) were published, they purchased a further 50,000 shares. Relying on information in the
financial statements, further shares were acquired. On 4 September, Caparo made a bid for the
remainder and by October, had acquired control of Fidelity. Caparo alleged that the financial
statements on which they had relied were misleading in that an apparent pre-tax profit of some
£1.3 million should, in fact, have been shown as a loss of over £400,000. The plaintiffs argued that
Touche owed a duty of care to investors and potential investors.
The conclusion of the House of Lords hearing of the case in February 1990 was that the auditors
of a public company's financial statements owed no duty of care to members of the public at
large who relied on the financial statements in deciding to buy shares in the company. And as a
purchaser of further shares, while relying on the auditor's report, a shareholder stood in the same
position as any other investing member of the public to whom the auditor owed no duty. The purpose
of the audit was simply that of fulfilling the statutory requirements of the Companies Act. There was
nothing in the statutory duties of company auditors to suggest that they were intended to protect the
interests of investors in the market. And in particular, there was no reason why any special
relationship should be held to arise simply from the fact that the affairs of the company rendered it
susceptible to a takeover bid.
In its report The Financial Aspects of Corporate Governance, the Cadbury Committee gave an
opinion on the situation as reflected in the Caparo ruling. It felt that Caparo did not lessen auditors'
duty to use skill and care because auditors are still fully liable in negligence to the companies
they audit and their shareholders collectively. Given the number of different users of financial
statements, it was impossible for the House of Lords to have broadened the boundaries of the
auditor's legal duty of care.
The decision in Caparo v Dickman considerably narrowed the auditor's potential liability to
third parties. The judgment appears to imply that members of various such user groups, which
could include suppliers, potential investors or others, will not be able to sue the auditors for
negligence by virtue of their placing reliance on audited annual financial statements, as their
relationship with the auditor does not display sufficient proximity.
In James McNaughton Paper Group Ltd v Hicks Anderson & Co 1990, Lord Justice Neill set out the
following position in the light of Caparo and earlier cases.
(a) 'In England a restrictive approach was now adopted to any extension of the scope of the duty of
care beyond the person directly intended by the maker of the statement to act upon it.
(b) In deciding whether a duty of care existed in any particular case it was necessary to take all the
circumstances into account.
(c)
Notwithstanding (b), it was possible to identify certain matters which were likely to be of
importance in most cases in reaching a decision as to whether or not a duty existed.'
A more recent court case produced a development in the subject of audit liability. In December
1995, a High Court judge awarded electronic security group ADT £65m plus interest and costs
(£40m) in damages for negligence against the former BDO Binder Hamlyn (BBH) partnership.
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The firm had jointly audited the 1988/89 financial statements of Britannia Security Group (BSG),
which ADT acquired in 1990 for £105m, but later found to be worth only £40m. Although, under
judgments made using the precedent of proximity in Caparo, auditors do not owe a duty of care in
general to third parties, the judge found that BBH audit partner Martyn Bishop, who confirmed that
the firm stood by BSG's financial statements at a meeting with ADT in the run-up to the acquisition,
had thereby taken on a contractual relationship with ADT. This development occurred,
apparently, because (post-Caparo) solicitors and bankers were advising clients intent on acquisitions
to get direct assurances from the target's auditors on the truth and fairness of the financial statements,
thus creating proximity by its existence.
BBH appealed this decision; the liable partners, because of a shortfall in insurance cover, were left
facing the prospect of coming up with £34m. An out of court settlement was reached with ADT.
A case in 1997 appeared to take a slightly different line, although this case related to some
management accounts on which no written report had been issued.
In Peach Publishing Ltd v Slater & Co 1997 the Court of Appeal ruled that accountants are not
automatically liable if they give oral assurances on accounts to the purchaser of a business. The case
involved management accounts, which the accountant stated were right, subject to the qualification
that they had not been audited. The Court held that the purpose of giving the assurance was not to
take on responsibility to the purchaser for the accuracy of the accounts. The purchaser's true
objective, in this case, was to obtain a warranty from the accountant's client, the target. Therefore
the accountant was not assuming responsibility to the purchaser by giving their client information on
which it could decide whether or not to give the warranty. The Court of Appeal also observed that
the purchaser should not have relied on the management accounts without having them checked by
its advisers.
In a further case, the Court of Appeal gave guidance on the effect of a disclaimer which stated that
the report had been prepared for the client only and no one else should rely on it. In Omega Trust
Co Ltd v Wright Son & Pepper 1997 (which related to surveyors but the facts of which can be
applied to accountants) the court held that the surveyor was entitled to know who their client was and
to whom their duty was held. They were entitled to refuse liability to an unknown lender or any
known lender with whom he had not agreed.
All this case law raised some problems. In spite of the judgment in Caparo, the commercial reality
is that creditors and investors (especially institutional ones) do use audited financial statements. In the
UK, the Companies Act requires a company to file financial statements with the Registrar. Why is this
a statutory requirement? It is surely because the public, including creditors and potential investors,
have a need for a credible and independent view of the company's performance and position.
It would be unjust if auditors, who have secondary responsibility for financial statements being
prepared negligently, bore the full responsibility for losses arising from such negligence just because
they are insured. It would also be unjust if the auditors could be sued by all and sundry. While the
profession has generally welcomed Caparo, two obvious problems are raised by the decision.

Is a restricted view of the usefulness of audited financial statements in the profession's
long-term interests?

For private companies, there will probably be an increase in the incidence of personal
guarantees and warranties given by the directors to banks and suppliers.
Developments in the US in recent years appear to try to redress the balance of liability by
highlighting the responsibilities of management with regard to published financial statements. The
Sarbanes-Oxley Act requires chief executive officers and finance officers to certify that the financial
statements of listed companies are not misleading and present the company's financial position and
results fairly (Sarbanes-Oxley Act 2002: s302). In addition, they are required to confirm that they
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are responsible for internal controls and have reported significant control deficiencies to the
auditors/audit committee.
The UK Companies Act 2006 requires the directors' report to contain a statement to the effect that, in
the case of each director:
(a)
So far as the director is aware, there is no relevant audit information of which the auditor is
unaware
(b)
They have taken all the steps that they ought to have taken as a director, in order to make
themselves aware of any relevant audit information and to establish that the auditor is aware
of that information
(Companies Act 2006: s418)
If the statement in the directors' report is false, every director who knew it was false or who was
reckless as to whether it was false, and failed to take reasonable steps to prevent the report from
being approved, commits an offence. In addition, Companies Act 2006 now makes it possible for
auditors to limit their liability by agreement with a company.
3 The auditor's duty of care to banks and other major
lenders
Banks and other major lenders have generally been excluded from the extent of negligent
auditor's liability by the decision in Caparo.
Banks often include clauses in loan agreements referring to audited financial statements and
requesting that they have access to audited financial statements on a regular basis or when
reviewing the loan facility. In other words, banks may document a 'relationship' with the
auditors to establish that there is sufficient proximity and that a duty of care exists.
The following Scottish case involved a situation similar to this.
In Royal Bank of Scotland v Bannerman Johnstone Maclay and Others 2002 the bank, who provided
an overdraft facility to the company being audited, claimed the company had misstated its position
due to a fraud and that the auditors were negligent in not discovering the fraud. The auditors
claimed that they had no duty of care to the bank. However, the judge determined that the auditors
would have known that the bank required audited financial statements as part of the overdraft
arrangement and could have issued a disclaimer to the bank. The fact that they had not issued a
disclaimer was an important factor in deciding that the auditors did owe a duty of care to the bank.
The audit firm might be able and prepared to offer assurances to the bank in relation to financial
statements, position, internal controls or other matters of interest to a primary lender. If this is the
case, and the service is required by the bank, the auditor should seek to create an
engagement with the bank itself.
You should bear in mind that providing assurance services to a lender could still result in a conflict
of interest arising.
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4 Advantages and disadvantages of different structures
Advantages
Partnership
Incorporation
LLP
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
Less regulation than for
companies

Financial statements not on public
record

Limited liability




Protection of personal assets
Limited liability of members
Similar tax effect of partnership
Flexible management structures
Disadvantages


Joint and several liability
Personal assets at risk

Public filing of audited financial
statements

Management must comply with
Companies Acts

Public filing of audited financial
statements
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Obtaining and
accepting
professional
appointments
Essential reading
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1 Ethical requirements
There are a number of ethical procedures associated with accepting engagements which you have
studied previously.
From AA Audit and Assurance
Procedures before accepting nomination
(a) Ensure that there are no ethical issues which are a barrier to accepting nomination.
(b) Ensure that the auditor is professionally qualified to act and that there are no legal or
technical barriers.
(c)
Ensure that the existing resources are adequate in terms of staff, expertise and time.
(d) Obtain references for the directors if they are not known personally to the audit firm.
(e)
Consult the previous auditors to ensure that there are no reasons behind the vacancy
which the new auditors ought to know. This is also a courtesy to the previous auditors.
Procedures after accepting nomination
(a) Ensure that the outgoing auditors' removal or resignation has been properly
conducted in accordance with the law.
The new auditors should see a valid notice of the outgoing auditors' resignation, or confirm that
the outgoing auditors were properly removed.
(b) Ensure that the new auditors' appointment is valid. The new auditors should obtain a
copy of the resolution passed at the general meeting appointing them as the company's
auditors.
(c)
Set up and submit a letter of engagement to the directors of the company (see below).
2 Requirements of ISQC 1
We touched on the bulk of the requirements of ISQC 1 Quality Control for Firms that Perform Audits
and Reviews of Financial Statements, and Other Assurance and Related Services Engagements in
Chapter 4. However, it also sets out standards and guidance in connection with the acceptance and
continuance of client relationships and specific engagements, which we shall consider here.
The firm shall establish policies and procedures for the acceptance and continuance of client
relationships and specific engagements, designed to provide the firm with reasonable assurance that
it will only undertake or continue relationships and engagements where the firm:
(a)
Is competent to perform the engagement and has the capabilities, including time and
resources, to do so;
(b)
Can comply with relevant ethical requirements; and
(c)
Has considered the integrity of the client, and does not have information that would lead it to
conclude that the client lacks integrity.
Such policies and procedures shall require:
(a)
The firm to obtain such information as it considers necessary in the circumstances before
accepting an engagement with a new client, when deciding whether to continue an existing
engagement, and when considering acceptance of a new engagement with an existing client.
(b)
If a potential conflict of interest is identified in accepting an engagement from a new or an
existing client, the firm to determine whether it is appropriate to accept the engagement.
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(c)
If issues have been identified, and the firm decides to accept or continue the client relationship
or a specific engagement, the firm to document how the issues were resolved.
(ISQC 1: paras. 26–27)
The firm should carry out the following steps:
Step 1
Step 2
Step 3
Obtain relevant information
Identify relevant issues
If resolvable issues exist, resolve them and document that resolution
2.1 Obtain information
The standard outlines three general sources of information:

The communications auditors must make with the previous auditors according to the IESBA
Code

Inquiry of others, eg other parties in the firm, bankers or legal counsel

Searches on relevant databases
(ISQC 1: para. A20)
In deciding whether to continue an engagement with an existing client, or to accept a new
engagement with an existing client, the firm should also consider significant matters that have arisen
in the course of the previous/existing relationship, for example, expansion into a business area in
which the audit firm has no experience.
2.2 Identify issues
The standard gives a list of matters that the auditors might consider in relation to the acceptance
decision.
Matters to consider
Integrity of
a client
The identity and business reputation of the client's principal owners, key
management, related parties and those charged with governance
(ISQC 1:
para. A19)
Nature of the client's operations, including its business practices
Information concerning the attitude of the client's principal owners, key
management, those charged with governance towards matters such as aggressive
interpretation of accounting standards/internal control environment
Whether the client is aggressively concerned with maintaining the firm's fees as low
as possible
Indications of an inappropriate limitation in the scope of work
Indications that the client might be involved in money laundering or other criminal
activities
The reasons for the proposed appointment of the firm and non-reappointment of the
previous firm
Competence
of the firm
(ISQC 1:
para. A18)
Do firm personnel have knowledge of relevant industries/subject matters?
Do firm personnel have experience with relevant regulatory or reporting
requirements, or the ability to gain the necessary skills and knowledge effectively?
Does the firm have sufficient personnel with the necessary capabilities and
competence?
Are experts available, if needed?
Are individuals meeting the criteria and eligibility requirements to perform the
engagement quality control review available where applicable?
Is the firm able to complete the engagement within the reporting deadline?
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In addition, the firm needs to consider whether acceptance would create any conflicts of interest.
The firm shall establish policies and procedures on continuing an engagement and the client
relationship, addressing the circumstances where the firm obtains information that would have
caused it to decline the engagement, had that information been available earlier. Such policies and
procedures shall include consideration of:
(a)
The professional and legal responsibilities that apply to the circumstances, including whether
there is a requirement for the firm to report to the person or persons who made the
appointment or, in some cases, to regulatory authorities, and
(b)
The possibility of withdrawing from the engagement, or from both the engagement and the
client relationship.
(ISQC 1: para. 28)
Such procedures might include discussions with client management and those charged with
governance and, if required, discussions with the appropriate regulatory authority.
3 Money laundering
As we discussed in Chapter 1, accountants are now required to carry out specific client identification
procedures when accepting new clients.
Know your client (KYC) is an important part of being in a position to comply with the law on
money laundering, because knowledge of the client is at the bottom of 'suspicion' in the context of
making reports about money laundering.
It is important from the outset of a relationship with a new client to obtain KYC information, such as:



Expected patterns of business
The business model of the client
The source of the client's funds
When the client's money is to be handled by the professional, there is a higher than normal risk to
the professional, so even more detailed KYC procedures will be required.
4 Politically exposed persons (PEPs)
Being involved with PEPs may be particularly risky for firms, particularly in terms of reputation risks if
things go wrong. The FATF Guidance on PEPs distinguishes foreign from domestic PEPs, but auditors
must consider both.
Key terms
Foreign PEPs are individuals who are, or have been, entrusted with prominent public functions in a
foreign country, for example, heads of state or of government, senior politicians, senior government,
judicial or military officials, senior executives of state owned corporations, important political party
officials.
Domestic PEPs are individuals who are or have been entrusted domestically with prominent public
functions, for example, heads of state or of government, senior politicians, senior government,
judicial or military officials, senior executives of state owned corporations, important political party
officials.
FATF Politically exposed persons (recommendations 12 and 22): pp 4–5
Firms and institutions should have risk management systems set up to determine whether an
individual is a PEP when client identification procedures are being carried out. When a person has
been identified as a PEP, a member of senior management should approve establishing a business
relationship with that person.
The firm should then take reasonable measures to establish the source of that individual's wealth and
funds and conduct enhanced ongoing monitoring of the firm's relationship with that individual.
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5 Client screening
Many audit firms use a checklist to assist them in making the decision and ensuring that ISQC 1
requirements are met.
6 Engagement letter
An auditor will outline the basis for the audit agreement in their tender to provide services. However,
once they have accepted nomination, it is vital that the basis of their relationship is discussed with the
new client and laid out in contractual form. This is the role of the engagement letter, which you
should be familiar with from your earlier studies.
Matters which SHALL be clarified in the engagement letter

Objective and scope of the audit

Auditor's responsibilities

Management's responsibilities

Identification of applicable financial reporting framework

Expected form and contents of reports to be issued by the auditor and statement that there may
be circumstances when a report may differ from this
(ISA 210: para. 10)
Matters which MAY be clarified in the engagement letter

More detail on the scope of the audit, including references to law, auditing and other standards
the auditor follows

Form of other audit communications

Limitation of audit and internal controls and resulting risk that material misstatements may not be
detected

Composition of the audit team and other practical arrangements

Expectation that the management will provide written representations

Agreement of management to make draft financial statements and other documents available in
good time

Agreement of management to inform the auditors of facts that may affect the financial statements
before the date of the auditor's report

Basis on which fees are computed and billing arrangements

A request for management to acknowledge receipt of audit engagement letter and agree to its
terms

Arrangements concerning the use of experts or other auditors

Arrangements concerning the use of internal auditors and other entity staff

Arrangements to be made with predecessor auditors (in the case of a new audit)

Any restrictions of the auditor's liability

References to any other agreements between parties

Any obligations to provide working papers to other parties
(ISA 210: paras. A23-26)
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An auditor shall not agree to a change in the terms of the engagement letter where there is no
reasonable justification for the change (ISA 210: para. 14). If the terms of the engagement are
changed, this should be recorded. If the auditor is unable to agree to a change, they shall withdraw
from the engagement and consider whether they have an obligation to report the circumstances to
other parties (ISA 210: para. 17).
In practice, the auditors and the new client will meet to negotiate the terms of the audit agreement
which the auditor will later clarify in the engagement letter.
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assessment
Essential reading
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1 Business risks from current trends in IT
1.1 The increasing risk of cyber incidents
Increasing connectivity and the openness of computer networks in the global business environment
exposes businesses to system and network failures and to cyber attack. The 2017 Norton Cyber
Security Insights Report found that the financial cost of cyber crime over the 20 countries being
reported on was over $172 billion, with more than 1 million people becoming victims of cyber crime
every day. The scale of the problem is vast; there were more than 978 million victims globally, which
is 32% of the adult population. In the UK, the figures are even worse than the global average, with
33% of the adult population falling victim, costing an average of £121 each; at least 73% of
consumers' losses were not reimbursed.
1.2 Audit considerations
Auditors must assess their clients' procedures for identifying and addressing these risks. Some main
considerations are:

Has management established an information and internet security policy?

How does the entity identify critical information assets and the risk to these assets?

Does the entity have cyber insurance (many general policies now exclude cyber events)?

Is there a process for assuring security when linked to third-party systems (eg partners/
contractors)?

What controls are in place to ensure that employees only have access to files and applications
that are required for their job?

Are regular scans carried out to identify malicious activity?

Are procedures in place to ensure that security is not compromised when the company's
systems are accessed from home or on the road?

What plans are in place for disaster recovery in case of an incident?
These issues will be built into the auditor's assessment of the control environment of the entity and in
some cases, may influence the auditor's view as to whether there are any uncertainties relating to the
going concern status of the entity.
1.3 E-commerce
Where an entity undertakes e-commerce, risk identification is crucial. E-commerce has become
increasingly important in recent years, and to a large extent, early fears about security have proven to
be unfounded. However, a number of recent high profile security breaches in relation to e-commerce
systems have underlined that this is an area that can carry significant operational risks, to which
auditors must give specific consideration.
Specific business risks include:

Loss of transaction integrity


Pervasive e-commerce security risks
Improper accounting policies

Non-compliance with tax, legal and regulatory requirements (eg local laws in relation to
protection of customers' data)


Overreliance on e-commerce
Systems and infrastructure failures

Damage to reputation if website fails or security is breached
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Audit procedures regarding the integrity of the information in the accounting system relating to
e-commerce transactions will be concerned with evaluating the reliability of the system for capturing
and processing transactions.
Therefore, in contrast to audit procedures for traditional business activities which focus separately on
control processes relating to each stage of transaction processing, audit procedures for sophisticated
e-commerce often focus on automated controls.
Illustration 1
Risk in an e-commerce environment
Tripper Co is a travel agency operating in three adjacent towns. The directors have recently taken
the decision that they should cease their operations and convert into a dot.com. The new operation,
Trippers.com, will benefit from enlarged markets and reduced overheads, as they will be able to
operate from single, cheaper premises.
Such a business decision has opened Tripper Co up to significant new business risks.
Customers
Converting to a dot.com company in this way enforces a loss of 'personal touch' with customers.
Tripper staff will no longer meet the customers face to face. In a business such as a travel agency,
this could be a significant factor. Customers may have appreciated the service given in branches and
may feel that this level of service has been lost if it is now redirected through computers and
telephones. Trippers should be aware of the possibility of, and mitigate against, loss of customers
due to perceived reduction in service.
Competition
By leaving the local area and entering a wider market, Tripper is opening itself up to much more
substantial competition. Whereas previously Trippers competed with other local travel agents, it will
now be competing theoretically with travel agents everywhere that have internet facilities.
Technology issues
As Tripper has moved into a market that necessitates high technological capabilities, a number of
business risks are raised in relation to technological issues:
Viruses
There is a threat of business being severely interrupted by computer viruses, particularly if the staff of
Trippers are not very computer literate or the system the company invests in is not up to the standard
required.
Viruses could cause interrupted sales and loss of customer goodwill, which could have a significant
impact on the going concern status of the company.
Loss of existing custom
Technology could be another reason for loss of existing customers. Their existing customers might not
have internet access or the ability to use computers. We do not know what Tripper's demographic
was prior to conversion.
However, if conversion means that Tripper loses its existing client base completely and has to rebuild
sales, the potential cost in advertising could be excessive.
Cost of system upgrades
Technology is a fast moving area and it will be vital that Tripper's website is kept up to current
standards. The cost of upgrade, both in terms of money and business interruption, could be substantial.
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New supply chain factors
Tripper may keep existing links with holiday companies and operators. However, it will have new
suppliers, such as internet service providers, to contend with.
Personnel
Due to the conversion, Trippers.com will require technical staff and experts. It may not currently have
these staff. If this is the case, it could be at risk of severe business interruption and customer
dissatisfaction.
If the directors are not computer literate, they may find that they are relying on staff who are far more
expert than they are to ensure that their business runs efficiently.
Legislation
There are a number of issues to consider here. The first is data protection and the necessity to comply
with the law when personal details are given over the computer. It is important that the website is
secure.
E-commerce is also likely to be an area where there is fast moving legislation as the law seeks to
keep up with developments. Tripper must also keep up with developments in the law.
Lastly, trading over the internet may create complications as to what domain Tripper are trading in
for the purposes of law and tax.
Fraud exposure
The company may find that it is increasingly exposed to fraud in the following ways:



Credit card fraud relating from transactions not being face to face
Hacking and fraud relating from the website not being secure
Overreliance on computer expert personnel could lead to those people committing fraud
Tripper's auditors will be regarding the conversion with interest. The conversion will also severely
affect audit risk.
Impact on audit risk
Inherent risk
Many of the business risks identified above could have significant impacts on going concern.
Control risk
The new operations will require new systems, many of which may be specialised computer systems.
Detection risk
The conversion may have the following effects:
(a) Create a 'paperless office' as all transactions are carried out online – this may make use of
computer-assisted auditing techniques essential.
(b) The auditors may have no experience in e-commerce which may increase detection risk.
(c)
There are likely to be significant impacts on analytical review, as results under the new
operations are unlikely to be very comparable to the old.
(d) There may be a significant need to use the work of experts to obtain sufficient, appropriate
audit evidence.
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2 Planning: documentation requirements
ISAs 315 and 330 contain a number of documentation requirements. The following matters should
be documented.

The discussion among the audit team concerning the susceptibility of the financial statements to
material misstatements, including any significant decisions reached

Key elements of the understanding gained of the entity including the elements of the entity and
its control specified in the ISA as mandatory, the sources of the information gained and the
risk assessment procedures carried out

The identified and assessed risks of material misstatement

Significant risks identified and related controls evaluated
(ISA 315: para. 32)

The overall responses to address the risks of material misstatement

Nature, extent and timing of further audit procedures linked to the assessed risks at the
assertion level

If the auditors have relied on evidence about the effectiveness of controls from previous audits,
conclusions about how this is appropriate
(ISA 330: paras. 28–30)
3 Components of audit risk
Audit risk can be broken down into three components: inherent risk, control risk, and detection risk.
Taken together, inherent risk and control risk are known as the risk of material misstatement.
3.1 Inherent risk
Inherent risk is the risk that items will be misstated due to characteristics of those items, such as the
fact that they are estimates or that they are important items in the accounts. The auditors must use
their professional judgment and the understanding of the entity they have gained to assess inherent
risk. If no such information or knowledge is available, then the inherent risk is assessed as high.
Factors affecting the client overall
Integrity and attitude to risk of
directors and management
Domination by a single individual can cause problems
Management experience and
knowledge
Changes in management and quality of financial
management
Unusual pressures on management
Examples include tight reporting deadlines, or market
or financing expectations
Nature of business
Potential problems include technological obsolescence
or overdependence on single product
Industry factors
Competitive conditions, regulatory requirements,
technology developments, changes in customer demand
Information technology
Problems include lack of supporting documentation,
concentration of expertise in a few people, potential
for unauthorised access
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Factors affecting individual account balances or transactions
Financial statement accounts prone to
misstatement
Accounts which require adjustment in previous period
or require high degree of estimation
Complex accounts
Accounts which require expert valuations or are
subjects of current professional discussion
Assets at risk of being lost or stolen
Cash, inventory, portable non-current assets (eg laptop
computers)
Quality of accounting systems
Strength of individual departments (sales, purchases,
cash etc)
High volume transactions
Accounting system may have problems coping
Unusual transactions
Transactions for large amounts, with unusual names,
not settled promptly (particularly important if they
occur at period end)
Transactions that do not go through the system, that
relate to specific clients or are processed by certain
individuals
Staff changes or areas of low morale
Staff
3.2 Control risk
Control risk is the risk that client controls fail to detect material misstatements. A preliminary
assessment of control risk at the planning stage of the audit is required to determine the level of
controls and substantive testing to be carried out.
If the auditor judges that the internal control system is good, then control risk will probably be low.
The Appendix to ISA 315 contains a summary of the components of a good system of internal
controls. Here is a summary of the summary.
Control environment. This encompasses:







Communication and enforcement of integrity and ethical values
Commitment to competence
Participation by those charged with governance
Management's philosophy and operating style
Organisational structure
Assignment of authority and responsibility
Human resource policies and practices
(ISA 315: para. A78)
Entity's risk assessment process. The entity should have a process for identifying risks that may
affect its financial reporting, assessing these risks and then responding to them. Examples of risks that
might affect financial reporting include:

Changes in operating environment. Changes in the regulatory or operating environment
can result in changes in competitive pressures and significantly different risks.

New personnel. New personnel may have a different focus on or understanding of internal
control.

New or revamped information systems. Significant and rapid changes in information
systems can change the risk relating to internal control.
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
Rapid growth. Significant and rapid expansion of operations can strain controls and increase
the risk of a breakdown in controls.

Others include new technology, new business models, corporate restructurings,
expanded foreign operations and new accounting pronouncements.
(ISA 315: Appendix 1, para. 4)
Information system. The information system relevant to financial reporting objectives, which
includes the financial reporting system, encompasses methods and records that:

Identify and record all valid transactions

Describe, on a timely basis, the transactions in sufficient detail to permit proper classification
of transactions for financial reporting

Measure the value of transactions in a manner that permits recording their proper monetary
value in the financial statements

Determine the time period in which transactions occurred to permit recording of transactions in
the proper accounting period

Present properly the transactions and related disclosures in the financial statements
(ISA 315: Appendix 1, para. 6)
Control activities. These include:

Performance reviews. These control activities include reviews and analyses of actual
performance versus budgets, forecasts and prior period performance

Information processing

Physical controls, encompassing eg the physical security of assets

Segregation of duties
(ISA 315: Appendix 1, para. 9)
Monitoring of controls. In addition to putting controls in place, management must monitor that
they are operating effectively, and that they continue to be appropriate when there are changes in
circumstances (ISA 315: Appendix 1, para. 11).
3.3 Detection risk
Detection risk is the risk that audit procedures will fail to detect material misstatements. Detection risk
relates to the inability of the auditors to examine all evidence. Audit evidence is usually persuasive
rather than conclusive, so some detection risk is usually present, allowing the auditors to seek
'reasonable assurance'.
The auditors' inherent and control risk assessments influence the nature, timing and
extent of substantive procedures required to reduce detection risk and thereby, audit risk.
4 Materiality
4.1 Performance materiality
The concept of performance materiality allows an auditor to set different materiality levels for
different areas of the financial statements, according to their judgment of the audit risk that is
particular to that area. The idea is that overall materiality needs to be adjusted for the actual
'performance' of the audit in particular areas, and cannot just be applied blindly. A better word for
the concept might have been 'applied materiality', since it is mainly about how overall
materiality is applied to particular areas.
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The concept of performance materiality focuses in on the difference between the level of tolerable
misstatement and the level of actual misstatements detected. For example, if a misstatement were
detected that was just below overall materiality, then there is a difficulty for the auditor: the financial
statements are not materially misstated, but there is a risk that there may be undetected misstatements
which would push over the materiality threshold. The auditor should not just compare the amount of
detected misstatements with materiality as a whole, but should take into account the fact that only
some specific items have been tested (eg because sampling is used). Consideration of materiality
needs to take into account the possible undetected misstatements which might be lurking. Thinking in
terms of performance materiality means thinking of what the effect of individual misstatements might
be on audit risk for the financial statements as a whole. This provides the auditor with a margin of
safety in relation to any undetected misstatements, which are then less likely to exceed materiality as
a whole.
Performance materiality therefore entails a prudent approach to materiality, and to determining the
procedures that are needed to conclude on whether or not the financial statements are materially
misstated. The higher the assessed risk, the lower the performance materiality must be set. This means
that the auditor will perform more audit work than if the concept of performance materiality did not
exist.
As with overall materiality, setting performance materiality involves the use of professional judgment.
This judgment must take into account qualitative aspects, such as the level of risk attached to a
particular balance in the financial statements.
Example: performance materiality
An auditor might judge an entity's non-current assets to be a high-risk area. If non-current assets were
$20m and total assets $50m, then overall materiality might be set at 2% of total assets, ie $1m.
Performance materiality for non-current assets could then be set as a simple proportion of materiality,
eg $400,000 (= $20m/$50m × $1m).
Taking into account the auditor's judgment that non-current assets are higher risk, this could thus be
decreased to $300,000 in order to provide a greater margin of safety. Any misstatements above this
level would be judged material.
4.2 Qualitative materiality
Most of the discussion on materiality focuses on quantitative materiality, but materiality must also be
applied to qualitative disclosures in the financial statements. ISA 320 and ISA 315 were revised
in 2015 to include guidance here. Essentially the same concept of materiality applies, ie a
misstatement must be viewed in terms of its effect on the economic decisions of users.
Examples of disclosures to which misstatements might be material include:





Liquidity/debt covenants
Events leading to recognition of impairment losses
Changes in accounting policies, eg because of a new IFRS, where this has a significant impact
Share-based payments
Related parties (and transactions with related parties)
(ISA 320)
4.3 Problems with materiality
As you are aware, materiality is a matter of judgment for the auditor. Therefore, prescriptive rules
will not always be helpful when assessing materiality. A significant risk of prescriptive rules is that
a significant matter, which falls outside the boundaries of the rules, could be
overlooked, leading to a material misstatement in the financial statements.
The percentage guidelines of assets and profits that are commonly used for materiality must be
handled with care. The auditor must bear in mind the focus of the company being audited. For
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example, in some companies, post-tax profit is the key figure in the financial statements, as the
level of dividend is the most important factor in the accounts. In owner-managed businesses, if
owners are paid a salary and are indifferent to dividends, the key profit figure stands higher in the
statement of profit or loss, say at gross profit level. Alternatively in this situation, the auditor should
consider a figure that does not appear in the statement of profit or loss: profit before directors'
salaries and benefits.
Some companies are driven by assets rather than the need for profits. In such examples, higher
materiality might need to be applied to assets. In some companies, say charities, costs are the
driving factor, and materiality might be considered in relation to these.
While rules or guidelines are helpful to auditors when assessing materiality, they must always keep in
mind the nature of the business they are dealing with. Materiality must be tailored to the
business and the anticipated user of financial statements, or it is not truly materiality.
In this exam, you will often be calculating materiality in relation to a specific item. You must only use
the relevant comparator: for example, total assets if the matter relates to the statement of financial
position, profit before tax if the matter impacts on profit, and both if it relates to the statement of
financial position and impacts on profit (for example, a provision).
4.4 Documentation
The auditor must document:




Materiality for the financial statements as a whole
Materiality for particular balances, classes of transactions or disclosures
Performance materiality
Any revisions to the above
(ISA 320: para. 14)
5 Professional scepticism
Auditors are required to exercise professional scepticism at all stages of the audit, including
planning. What this means for your exam is that you should be sceptical about any assumptions
being made in scenario questions, and questions on audit planning are a particularly good place for
you to show that you are being 'sceptical'. Here are some general areas that you might want to be
sceptical about:

Fraud (eg do the entity's systems provide opportunities for fraud?)

Accounting estimates (eg are assumptions reasonable?)

Going concern (eg are management's plans really feasible?)

Related party relationships and transactions (eg transactions outside the normal course of
business – misappropriation of assets?)

Laws and regulations (eg where non-compliance may call into question going concern)
Of course, it is important when answering questions that you are not too sceptical. You cannot just
write the above points down, irrespective of whether they are relevant to the scenario. Rather, you
need to be aware that there may be problems in these areas.
The Study Guide for AAA states that you must be able to assess whether an engagement has been
planned and performed with an attitude of professional scepticism, and evaluate the implications. In
order to do this, you will first need to compare the judgments the auditor has made in the scenario
with the judgments that they should have made. This will usually be a question of being more
suspicious about something than the auditor in the scenario has been. For example, questioning
whether a new piece of evidence is consistent with representations management has made, or
whether it actually contradicts and casts doubt over what management has said before. Another
common example would be whether there is an opportunity for fraud.
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The implication of a lack of professional scepticism will usually be insufficient audit evidence being
obtained. As a result, the auditor is likely to place too much reliance on the evidence that they have,
and potentially express an inappropriate audit opinion.
6 Analytical procedures as substantive procedures
There are a number of factors which the auditors should consider when deciding whether to use
analytical procedures as substantive procedures.
Factors to consider
Example
The plausibility and
predictability of the relationships
identified for comparison and
evaluation
The strong relationship between certain selling expenses and
revenue in businesses where the sales force is paid by
commission
The objectives of the analytical
procedures and the extent to which
their results are reliable
The source of any information analysed may affect its reliability,
such as whether it came from an independent third party outside
of the entity
The detail to which information
can be analysed
Analytical procedures may be more effective when applied to
financial information or individual sections of an operation, such
as individual factories or shops
The availability of information
Financial: budgets or forecasts
Non-financial: eg the number of units produced or sold
The relevance of the
information available
Whether the budgets are established as results to be expected
rather than as tough targets (which may well not be achieved)
The comparability of the
information available
Comparisons with average performance in an industry may be
of little value if a large number of companies differ significantly
from the average
The knowledge gained during
previous audits
The effectiveness of the accounting and internal controls
The types of problems giving rise to accounting adjustments in
prior periods
Factors which should also be considered when determining the reliance that the auditors should
place on the results of substantive analytical procedures are:
Reliability factors
Example
Other audit procedures
directed towards the same financial
statements assertions
Other procedures auditors undertake in reviewing the
collectability of receivables, such as the review of subsequent
cash receipts, may confirm or dispel questions arising from the
application of analytical procedures to a profile of customers'
accounts which lists for how long monies have been owed
The accuracy with which the
expected results of analytical
procedures can be predicted
Auditors normally expect greater consistency in comparing the
relationship of gross profit to sales from one period to another
than in comparing expenditure which may or may not be made
within a period, such as research or advertising
The frequency with which a
relationship is observed
A pattern repeated monthly as opposed to annually
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The peculiarity of analytical procedures is that they aim to find out whether or not there is a
relationship between variables (eg between sales and expenses) that is plausible and reasonable.
This is the opposite of other substantive procedures, where the aim is to discover misstatements,
rather than reasonability.
7 Planning an initial audit engagement
Auditors must make special considerations at the planning stage when they are auditing an entity for
the first time, whether because the entity has never required an audit before, or because the entity
has simply changed auditor.
New audits generally require a little more work than recurring engagements. But it is important to
note that this is not because the auditor needs to do a first-time audit more thoroughly than other audits.
Rather, it is because there are specific risks in relation to an auditor's relative lack of knowledge
of new audit clients.
7.1 Audit strategy and audit plan
ISA 300 states that the overall audit strategy and audit plan may include the following in an initial
audit engagement.

Arrangements to be made with the predecessor auditor, eg to review their working papers

Any major issues discussed with management, eg relating to the application of IFRS, and
how these issues affect the audit strategy and plan

The audit procedures necessary in relation to opening balances (see Chapter 7)

Any other procedures required by the firm for initial engagements, eg review of the audit
strategy by another senior partner within the firm
(ISA 300: para. A22)
It is likely that more audit work will need to be performed in order to lower detection risk (and thus
audit risk) to the required level. This may result in a higher audit fee being charged for an initial
engagement, since fees should relate to the amount of time spent on the engagement.
7.2 Understanding the entity
ISA 315 requires the auditor to obtain an understanding of the entity and its environment in order to
identify and assess the risks of material misstatement. In the case of an initial audit engagement, this
will tend to require more work, because the auditor will have less experience of the client.
The auditor must also understand the entity's business risks and how they are managed.
7.3 Other considerations
Detection risk may be higher for an initial audit engagement, as the auditor may not have the
knowledge to design and perform procedures to obtain sufficient appropriate audit evidence.
Materiality is likely to be set at a lower level for initial engagements. The auditor will generally be
less familiar with the entity's internal controls, which means that a comparatively small misstatement
could be indicative of a pervasive failure of internal control.
The auditor will need to understand how the entity has chosen its accounting policies. They should
be appropriate for the business, and in line with IFRSs.
8 Additional information needed?
The auditor will often need to obtain additional information in order to gain the required
understanding of the entity, and in order to perform planned procedures. Much of the time, the
auditor only has incomplete information about the entity being audited, and it is important to be able
to recognise when more is needed.
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This can be a bit like performing an audit procedure, because the auditor must go out and get the
information in order to find something out about the entity. The difference is that at this stage, the
auditor is obtaining preliminary information that it can then use to plan and perform the detailed
audit procedures. For instance, a client might have made an investment during the year which it
classifies as an associate. The auditor will need to obtain information about this purchase – eg the
purchase agreement – in order to determine whether it really is an associate. The auditor must also ask
management why the purchase was made, as part of understanding the entity's objectives and
strategies. This must be all be done at the planning stage because it will then determine the auditor's
assessment of risk and the audit procedures which must then be performed – these would be very
different if the investment was actually a subsidiary, for example.
One approach to questions in this area (to identify further information needed) is to think about:
(1)
What risks might there be in relation to a particular issue (eg that an investment is classified
incorrectly); then
(2)
What information would help us to plan our procedures (eg the purchase agreement).
Activity 1: Howling Wolf
You are currently planning the audit of Howling Wolf Co, a logistics firm. One of Howling Wolf's
trucks was involved in an unfortunate accident which resulted in the deaths of a number of sheep that
belonged to a local farmer. The farmer is angry, and is threatening to take legal action against Wolf
unless it agrees to compensate them for the damage done.
Howling Wolf's financial statements include a provision for the cost of replacing the sheep.
Required
Identify and explain the additional information that you would require to obtain audit evidence in
respect of the provision.
Solution
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Activity answers
Activity 1: Howling Wolf
Information required includes:

The date of the incident with the sheep, which should already have happened. IAS 37
specifies that a provision can only be created in relation to a present obligation arising as a
result of a past event (IAS 37: para. 14).

The probability that Wolf will be required to pay compensation to the farmer. If Wolf is likely
to win in any legal action, then no provision should be set up.

The number of sheep involved in the incident, along with an estimate of the cost of replacing
them.

An estimate of the amount most likely to be paid to the farmer as compensation (if payment is
likely).

An estimate of the date by when the farmer is likely to be paid. The time value of money is
unlikely to be material here, so the provision would be unlikely to be discounted.

Whether Howling Wolf's truck suffered significant damage as a result of the accident, and if
so, what the costs of rectifying this damage are likely to be.
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Evidence
Essential reading
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1 Audit evidence
Substantive procedures are designed to obtain evidence about the financial statement assertions.
Financial statement assertions are the representations by management that are embodied in
the financial statements, as used by the auditor to consider the different types of potential
misstatements that may occur. By approving the financial statements, the directors are making
representations about the information therein. These representations or assertions may be described
in general terms in a number of ways.
Guidance on assertions is found in ISA 315 Identifying and Assessing the Risks of Material
misstatement Through Understanding the Entity and its Environment.
ISA 315: para. 25
The auditor shall identify and assess the risks of material misstatement at:
(a)
(b)
the financial statement level;
the assertion level for classes of transactions, account balances and disclosures;
to provide a basis for designing and performing further audit procedures.
The financial statement assertions can be thought of as claims made by parts of the accounts that are
implied but which are never stated explicitly. This is arguably part of the meaning of the term
financial statement: the accounts contain a variety of statements about a company's position and
performance, some in words and some in numbers. These statements are not absolute facts, but are
linguistic – they are effectively things that the directors are saying (asserting) are true. This introduces
lots of grey areas; the assertions cannot be defined with total precision, because there is such a
variety of individual transactions with differing characteristics.
This grey area is important because it links in with a fundamental characteristic of the audit: that it
does not provide absolute assurance, but only reasonable assurance. Likewise, the evidence
obtained is not absolute or unassailable, but is at best persuasive by virtue of being both
sufficient and appropriate. The auditor therefore inhabits a murky world, in which they need to
exercise judgment and professional scepticism – for example, about the assertions that
are implied by the reporting of a particular transaction.
2 Substantive evidence: external confirmations
The reliability of audit evidence is affected by its source. Audit evidence is more reliable when it is
obtained from independent sources outside the entity.
Both ISA 330 The Auditor's Responses to Assessed Risks and ISA 505 External Confirmations
address the need for external confirmations in gathering sufficient and appropriate audit evidence.
ISA 330: para. 19
The auditor shall consider whether external confirmation procedures are to be performed as
substantive audit procedures.
ISA 330 identifies the following situations where external confirmations are appropriate.

Bank balances and other information from bankers

Accounts receivable balances

Inventories held by third parties

Property deeds held by lawyers

Investments held for safekeeping by third parties or purchased from stockbrokers but not
delivered at the end of the reporting period

Loans from lenders

Accounts payable balances
(ISA 330: para. A48)
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ISA 505 states that 'the auditor shall maintain control over external confirmation requests'
(ISA 505: para. 7). So, to take the example of a receivables circularisation, it is the auditor who
should be in control of sending and receiving the requests and the responses from customers.
If management refuses to allow the auditor to send an external confirmation request, the auditor must
consider whether this is reasonable and whether audit evidence can be obtained in another way. If
evidence cannot be obtained from another source, the auditor should communicate this to those
charged with governance, and consider the impact on the auditor's report (there is a possibility that
the auditor's opinion will have to be modified (qualified) on the basis of an inability to obtain
sufficient appropriate audit evidence, or that a disclaimer of opinion will be issued).
In November 2009, the IAASB issued a Practice Alert in this area, Emerging Practice Issues
Regarding the Use of External Confirmations in an Audit of Financial Statements. In addition to
re-emphasising the points contained in ISA 505, the alert made the following points.
It is important that consideration is given to whether the confirmation request provides evidence
on the specific assertion being tested, as it may provide evidence for some assertions but not
others.
All confirmation responses carry some risk of interception, alteration or fraud. Such risk
exists regardless of whether a response is obtained in paper form, or through electronic or other
medium. Accordingly, it is essential that the auditor maintains control over the confirmation process.
It is also important that the auditor maintains appropriate professional scepticism
throughout the confirmation process, particularly when evaluating the confirmation responses.
The ISAs do not preclude the use of electronic confirmations, as they can, if properly managed,
provide appropriate audit evidence.
Disclaimers and other restrictions included in confirmation responses do not necessarily invalidate the
reliability of the responses as audit evidence.
3 Opening balances: procedures
3.1 Specific audit procedures
For current assets and liabilities, some audit evidence may be obtained as part of the current
period's audit procedures. For example, the collection (or payment) of opening accounts
receivable (or accounts payable) during the current period will provide some audit evidence of
their existence, rights and obligations, completeness and valuation at the beginning of the period
(ISA 510: para. A6).
In the case of inventories, however, the current period's audit procedures on the closing inventory
balance provide little audit evidence regarding inventory on hand at the beginning of the period.
Therefore, additional procedures may be necessary, such as:

Observing a current physical inventory count and reconciling it back to the opening
inventory quantities

Performing audit procedures on the valuation of the opening inventory items

Performing audit procedures on gross profit and cut-off
(ISA 510: para. A6)
A combination of these procedures may provide sufficient appropriate audit evidence.
For non-current assets and liabilities, some audit evidence may be obtained by examining the
accounting records and other information underlying the opening balances. In certain cases, the
auditor may be able to obtain some audit evidence regarding opening balances through
confirmation with third parties, for example for long-term debt and investments. In other cases, the
auditor may need to carry out additional audit procedures (ISA 510: para. A7).
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3.2 Consistency of accounting policies
The auditor shall obtain sufficient appropriate audit evidence about:

Whether the accounting policies reflected in the opening balances have been applied
consistently in the current period's financial statements

Whether changes in the accounting policies have been accounted for properly and
adequately presented and disclosed in accordance with the applicable financial
reporting framework
(ISA 510: para. 12)
4 Responses to the risks of material misstatement due to
related parties
It may not be self-evident to management whether a party is related. Furthermore, many accounting
systems are not designed to either distinguish or summarise related party transactions, so
management will have to carry out additional analysis of accounting information.
An audit cannot be expected to detect all material related party transactions. The risk that
undisclosed related party transactions will not be detected by the auditors is especially high when:

Related party transactions have taken place without charge

Related party transactions are not self-evident to the auditors

Transactions are with a party that the auditors could not reasonably be expected to know
is a related party

Active steps have been taken by management to conceal either the full terms of a
transaction, or that a transaction is, in substance, with a related party

The corporate structure is complex
ISA 550: para. 20
As part of the ISA 330 requirement that the auditor respond to assessed risks, the auditor designs
and performs further audit procedures to obtain sufficient appropriate audit evidence about the
assessed risks of material misstatement associated with related party relationships and transactions
[...].
As part of the risk assessment procedures required by ISA 315, the auditor must carry out the
following procedures to obtain information relevant to identifying risks associated with related
parties.

Audit team discussion of risk shall include specific consideration of susceptibility of financial
statements to material misstatement through related parties and their transactions (ISA 315:
para. 10)

Auditor shall inquire of management:
–
The identity of related parties, including changes from prior period
–
The nature of the relationships between the entity and its related parties
–
Whether any transactions occurred between the parties, and if so, what
–
What controls the entity has to identify, account for and disclose related party
relationships and transactions
–
What controls the entity has to authorise and approve significant transactions and
arrangements with related parties
–
What controls the entity has to authorise and approve significant transactions and
arrangements outside the normal course of business
(The auditor may have to perform risk assessment procedures in addition in respect of the
latter three points.)
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
Stay alert for evidence of related party transactions when obtaining other audit evidence, in
particular when scrutinising bank and legal confirmations and minutes of meetings

If significant transactions outside the normal course of business are discovered, inquire of
management the nature of the transactions and whether related parties could be involved

Share information obtained about related parties with the audit team
(ISA 550: paras. 13-17)
The following procedures may be helpful.

Enquire of management and the directors as to whether transactions have taken place with
related parties that are required to be disclosed by the disclosure requirements that are
applicable to the entity.

Review prior year working papers for names of known related parties.

Review minutes of meetings of shareholders and directors and other relevant statutory
records, such as the register of directors' interests.

Review accounting records for large or unusual transactions or balances, in particular
transactions recognised at or near the end of the financial period.

Review confirmations of loans receivable and payable and confirmations from banks.
Such a review may indicate the relationship, if any, of guarantors to the entity.

Review investment transactions, for example purchase or sale of an interest in a joint
venture or other entity.

Enquire as to the names of all pension and other trusts established for the benefit of
employees and the names of their management and trustees.

Enquire as to the affiliation of directors and officers with other entities.

Review the register of interests in shares to determine the names of principal
shareholders.

Enquire of other auditors currently involved in the audit, or predecessor auditors, as to
their knowledge of additional related parties.

Review the entity's tax returns, returns made under statute and other information supplied
to regulatory agencies for evidence of the existence of related parties.

Review invoices and correspondence from lawyers for indications of the existence of
related parties or related party transactions.
If risks relating to related parties and their transactions are identified, they should be treated as
significant risks in accordance with ISA 315. Also, due to the close connection between related
parties and possible fraud, the auditor must consider the overlap with ISA 240 here as well.
The audit procedures discussed above must include the following.
Further audit procedures: risk of misstatement due to related parties
Situation
Actions by auditor
Auditor suspects existence of
related parties not disclosed by
management
Determine whether the information does confirm the existence of
related parties.
(ISA 550: para. 21)
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Further audit procedures: risk of misstatement due to related parties
Situation
Actions by auditor
Auditor identifies related
parties not disclosed by
management

Tell the rest of the audit team

Request management to identify all transactions with
identified related party
(ISA 550: para. 22)

Inquire as to why company controls failed to identify related
party

Perform substantive procedures relating to related party and
its transactions with entity
Auditor identifies related party
transactions outside normal
course of business
–
Making enquiries of third parties presumed to have
knowledge, such as legal counsel
–
Conducting an analysis of accounting records for
transactions with the related party (using a CAAT?)
–
Verifying terms and conditions of transactions by looking
at the contract

Reconsider the risk of further related parties existing and not
being disclosed to the auditor

If non-disclosure appears intentional, and therefore indicative
of fraud, evaluate implications for audit

Inspect contracts/agreements and evaluate whether:
–
The business rationale (or lack thereof) suggests a
fraudulent purpose (is it overly complex, does it have
unusual terms of trade, does it lack a logical business
purpose?)
–
The terms of the transactions are consistent with
management's explanations
–
The transactions have been accounted for and disclosed
properly
(ISA 550: para. 23)
Management has asserted in
the financial statements that
related party transactions were
conducted at arm's length
(ISA 550: para. 24)

Obtain sufficient appropriate evidence that this is true by
looking at the terms of the contract and assessing:
–
–
–
–
Price
Credit terms
Contingencies
Specific charges
4.1 Written representations
ISA 550: para. 26
Where the applicable financial reporting framework establishes related party requirements, the
auditor shall obtain written representations from management and, where relevant, those charged
with governance, that:
(a) They have disclosed to the auditor the identity of the entity's related parties and all the related
party relationships and transactions of which they are aware; and
(b) They have appropriately accounted for and disclosed such relationships and transactions in
accordance with the requirements of the framework.
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4.2 Transactions with directors and management
Auditors may find it difficult to obtain sufficient assurance that they have identified all disclosable
transactions because of:
(a)
The low value of certain transactions, making them difficult to detect when using normal
audit procedures
(b)
Any requirements for disclosure of transactions between the company and the
connected persons of a director, given that it may not always be easy for the auditors to
identify such connected persons
(c)
The fact that there may be little or no documentary evidence of transactions requiring
disclosure
The complexity of the relevant legislation may give rise to difficulties of interpretation. For example,
advances of expenses or remuneration on account may constitute a disclosable loan if the monies
are outstanding for a long time.
4.2.1 Company procedures
Auditors should enquire as to the company's procedures for ensuring that all disclosable transactions
are properly identified and recorded. Such procedures are likely to include the following:

Advise all directors and officers that they have a responsibility to disclose transactions in
which they have an interest, either directly or through connected persons. (Such disclosure
should take place at a meeting of the directors.)

Record all transactions notified in the minutes of directors' meetings.

Maintain a register in which details of all transactions requiring disclosure are recorded.

Establish some method of:
–
Identifying proposed transactions which will require the approval of the members in
general meeting; and
–
Ensuring that the company does not enter into any illegal transactions.

Monitor the system by checking on a regular basis (as a minimum, once a year) that each
director is in agreement with the company's record of their disclosable transactions and is
satisfied that such records are both complete and accurate.

Obtain from each director at the end of each financial year a formal statement
indicating the disclosures necessary for the purposes of the statutory accounts.
With smaller organisations, auditors may well find that there may be no formalised procedures or
that they are inadequate. Auditors should advise each director of their statutory responsibilities,
and make a written request for confirmation of any disclosable transaction in which they have
an interest.
4.2.2 Audit procedures
Further audit procedures to be adopted in relation to transactions with directors, such as the
following.

Inspect the board minutes and other records of transactions with directors and connected
persons to consider their adequacy and whether or not they appear to have been kept up to date.

Examine any agreements and contracts involving directors and connected persons,
including tracing the details of such transactions to any source documentation available.
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
Consider whether transactions disclosed are on commercial terms.

Assess the recoverability of amounts due from directors or connected persons.

Review the legality of the disclosable transactions recorded by the company. Where auditors
are of the opinion that a transaction is illegal, they should:
–
Immediately advise the directors of their view
–
Give careful consideration as to whether any reference to the matter will be required in the
auditor's report

Advise the client to seek legal advice in those cases where there are doubts as to the
legality and/or disclosable nature of a transaction.

Consider the possibility that the company's details of disclosable transactions may
be incomplete as regards those directors (and connected persons) who have not been in office
throughout the year.

Review subsequent events in order to consider whether they might have any impact on the
matters requiring disclosure.
Finally, auditors should consider obtaining written representations from each director giving
confirmation of any disclosable transaction which relates to themselves and any persons connected
with them.
5 Audit documentation – further matters
The key reason for having audit papers therefore is that they provide evidence of work done; this
may be critical if the auditor is ever called upon to depend what they have done.
The ISA sets out the points an auditor should record in relation to significant matters, such as the
extent of professional judgment exercised in performing the work and evaluating the results. If an
auditor believed it to be necessary to depart from a relevant requirement in an ISA, they should
document why, and how the different test achieved audit objectives (ISA 230: para. 12).
Specific consideration is given to smaller entities. The ISA recognises that the documentation of a
smaller entity will be less extensive, but emphasises the overriding requirement that it should be
capable of being understood by an experienced auditor (ISA 230: para. 8).
We shall briefly revise here the review of working papers. Review of working papers is important,
as it allows a more senior auditor to evaluate the evidence obtained during the course of the
audit for sufficiency and reliability, so that more evidence can be obtained to support the audit
opinion, if required.
5.1 Review of audit working papers
Working papers should be reviewed by a more senior audit staff member before an audit conclusion
is drawn.
Work performed by each assistant should be reviewed by personnel of appropriate experience to
consider whether:

The work has been performed in accordance with the audit programme

The work performed and the results obtained have been adequately documented

Any significant matters have been resolved or are reflected in audit conclusions

The objectives of the audit procedures have been achieved

The conclusions expressed are consistent with the results of the work performed and support
the audit opinion
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6 Using the work of an auditor's expert – further
considerations
Engaging an auditor's expert is a costly business; the client and auditors will only want to if there is a
real need to do so – in other words, in circumstances where other relevant and reliable audit
evidence is not available.
ISA 620 distinguishes between 'internal' and 'external' auditor's experts.

Auditor's internal experts – Members of the engagement team

Auditor's external experts – Not members of the engagement team. They are engaged but
not employed by the auditor.
6.1 Competence and objectivity of the auditor's expert
The auditor must evaluate the auditor's expert's competence, capabilities and objectivity for
the auditor's purposes, which includes their independence (ISA 620: para. 9).
This will involve considering:

The expert's professional certification, or licensing by, or membership of, an appropriate
professional body

The expert's experience and reputation in the field in which the auditors are seeking
audit evidence
The risk that an expert's objectivity is impaired increases when the expert is:

Employed by the entity

Related in some other manner to the entity, for example, by being financially dependent
upon, or having an investment in, the entity
If the auditors have reservations about the competence or objectivity of the expert, they may need
to carry out other procedures, or obtain evidence from another expert.
6.2 The scope of work of the auditor's expert
The auditor shall agree the nature, scope and objectives of that expert's work in writing (ISA 620:
para. 11).
Written instructions usually cover the auditor's expert's terms of reference, and may cover:

The objectives and scope of the expert's work

A general outline as to the specific matters the expert's report is to cover

The intended use of the expert's work

The extent of the expert's access to appropriate records and files

Clarification of the expert's relationship with the entity, if any

Confidentiality of the entity's information

Information regarding the assumptions and methods intended to be used by the expert
and their consistency with those used in prior periods
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6.3 Assessing the work of the auditor's expert
Auditors cannot simply accept the expert's work without consideration. Rather, they must evaluate
whether it is adequate for the purpose of the audit, and whether it can be relieved upon.
Auditors should consider:

The source data used

The assumptions and methods used

When the expert carried out the work

The reasons for any changes in assumptions and methods

The results of the expert's work in the light of the auditors' overall knowledge of the business
and the results of other audit procedures
The auditors do not have the expertise to judge the assumptions and methods used; these are the
responsibility of the expert. However, the auditors should seek to obtain an understanding of these
assumptions, to consider their reasonableness based on other audit evidence, knowledge of the
business and so on.
Relevant factors when evaluating the relevance and reasonableness of the findings or conclusions of
the auditor's expert, whether in a report or other form, may include whether they are:

Presented in a manner that is consistent with industry standards

Clearly expressed, including reference to the objectives agreed and standards used

Based on an appropriate period and take into account any subsequent events

Subject to any reservation, limitation or restriction on use

Based on appropriate consideration of errors or deviations encountered by the auditor's
expert
(ISA 620: para. A34)
If the auditor concludes that the expert's work is inadequate for the audit, then they must either obtain
further work from the expert or obtain audit evidence from a different source (ISA 620: para. 13).
6.4 Reference to an auditor's expert in the auditor's report
The auditor must not refer to the auditor's expert in the auditor's report (ISA 620: para. 14).
Such a reference may be misunderstood and interpreted as a modification of the audit opinion, or as
a division of responsibility, neither of which is appropriate.
However, if the auditor expresses a modified auditor's opinion, then they may refer to the work of
the expert (making it clear that the expert is not responsible for the auditor's opinion). In such cases,
auditors may need to obtain permission in advance from the expert. If such permission is not given,
then the auditors may have to seek legal advice.
7 Assessing the internal audit function
7.1 Revision: the role of internal audit
The FRC Guidance On Risk Management, Internal Control and Related Financial and Business
Reporting ('Risk Guidance') in the UK encourages companies to adopt a risk-based approach to
establishing a system of internal control, ie to manage and control risk appropriately rather than
eliminate it. The principal role of internal auditors is to assist management in
monitoring risks.
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The Risk Guidance emphasises the importance of an embedded and ongoing process of identifying
and responding to risks. Thus, a company must:




Establish business objectives
Identify the principal risks associated with these
Agree the controls to address the risks
Set up a system to implement the decision, including regular feedback
A risk management and internal control system is likely to include:
(1)
Risk assessment – Process to identify major risks and assess their impact
(2)
Management and monitoring of risks – Including controls processes (segregation of duties,
authorisation, etc)
(3)
Information and communication systems – Include monthly reporting, comparison with budgets
etc as well as non-financial performance indicators
(4)
Monitoring – Procedures designed to ensure risks are monitored and the internal controls
continue to be effective (audit committees, internal audit, etc)
(FRC 2014)
It is therefore not internal audit's primary role to manage risk in a company – that is the responsibility
of the directors. Internal audit is, however, part of the company's system of risk management.
The risks are identified and assessed, and a policy approach is taken in respect of each of them. To
recap, this policy is usually one of four:




Accept risk (if it is low impact and likelihood)
Reduce risk (by setting up a system of internal control)
Avoid risk (by not entering a market, accepting contract etc)
Transfer risk (by taking out insurance)
With their skills in business systems, internal auditors are ideally placed to monitor this process and
add value to it. They can:



Give advice on the best design of systems and monitor their operation
Be involved in a process that continually improves internal control systems
Provide assurance on systems set up in each department
The involvement of internal audit as a monitoring unit will help to ensure that the process of risk
identification and management in a business is a continual process rather than a one-off exercise.
7.2 Assessing the internal audit function
In assessing internal audit's objectivity, the external auditor should consider:
Assessing the objectivity of internal audit (ISA 610: para. A7)
Organisational status
High organisational status may indicate greater
objectivity.
Does the internal audit function report to those charged with
governance, or merely to management?
Conflicting responsibilities
Does internal audit have other responsibilities that affect
its objectivity?
Employment decisions
Are employment decisions overseen by those charged
with governance?
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Assessing the objectivity of internal audit (ISA 610: para. A7)
Constraints and restrictions
Is the internal audit function restricted from
communicating findings to the external auditor?
Membership of a professional body
Are the internal auditors members of relevant professional
bodies?
Are they obliged to comply with relevant professional
standards, including continuing professional
development requirements?
In assessing internal audit's competence, the following factors should be considered:
Factors affecting the competence of internal audit (ISA 610: para. A8)
Level of resources relative to the size and nature of its operations
Established policies for hiring, training and assigning internal auditors to engagements
Whether internal auditors have adequate technical training and proficiency in auditing
Whether the internal auditors possess the required financial reporting knowledge and
necessary skills
Whether the internal auditors are members of relevant professional bodies
The external auditor should also look for evidence of a systematic and disciplined approach.
Internal audit should have documented internal audit procedures, including those covering such areas
as risk assessment, work programmes, documentation and reporting. The external auditor will also
consider whether appropriate quality control procedures are in place (ISA 610: paras. A10–11).
If internal audit lacks any of the above (ie objectivity, competence, or a systematic and disciplined
approach), then none of its work can be relied on.
7.3 Determining the nature and extent of work that can be used
The key question is: is the work relevant to the overall audit strategy and audit plan?
ISA 610 envisages three ways of using the work of internal auditors:
(1)
(2)
(3)
To obtain information to be used when assessing the risk of material misstatement
To use internal auditors' work instead of performing procedures
To use internal auditors themselves to perform audit procedures (direct assistance)
The ISA lists the following as examples of internal audit work that can typically be used by the
external auditor (instead of performing procedures).
Internal audit work that can typically be used (ISA 610: para. A16)
Testing of the operating effectiveness of controls
Substantive procedures involving limited judgment
Observations of inventory counts
Tracing transactions through the financial reporting information system
Testing of compliance with regulatory requirements
In some circumstances, audits or reviews of the financial information of subsidiaries that are not
significant components to the group
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7: Evidence
Any work that involves significant judgments cannot be used (ISA 610: para. 18).
Work in the following areas cannot be relied on:

Assessing the risk of material misstatement

Evaluating the sufficiency of tests performed

Evaluating the appropriateness of management's use of the going concern assumption

Evaluating significant accounting estimates; and

Evaluating the adequacy of disclosures in the financial statements, and other matters affecting
the auditor's report
(ISA 610: para. A19)
7.4 Steps when relying on internal audit
If the external auditor plans to use the work of internal audit function, they must:
Step 1
Discuss the planned use of internal audit work with the internal audit function
Step 2
Read the relevant internal auditor's reports to understand the nature and extent of
audit procedures performed and the findings
Step 3
Carry out and document 'sufficient audit procedures' on the internal audit
work to be used to assess its adequacy for the purposes of the audit
(ISA 610: paras. 21-23)
7.5 Direct assistance
Key term
Direct assistance: The use of internal auditors to perform audit procedures under the direction,
supervision and review of the external auditor.
(ISA 610: para. 14)
It is possible that members of the internal audit team will provide direct assistance to the external
auditor, ie they will perform procedures on the auditor's behalf. This is permissible in line with
ISA 610, unless the jurisdiction in which the audit is taking place prohibits this (such as the UK).
Previously, the ISAs have remained silent on the subject of whether, and how, external auditors
should involve the entity's internal auditors in obtaining and evaluating audit evidence. While some
jurisdictions categorically prohibit direct assistance, the IAASB notes that the use of direct assistance,
where it is allowed, does not appear to compromise audit quality. Given appropriate planning,
direction, supervision and review from the external audit team, the use of internal auditors could lead
to savings, both in terms of time and cost for the audit client.
However, it must be considered whether these internal auditors meet the independence
requirements which apply to the external auditor. This is because the IESBA Code of Ethics includes
internal auditors used in this way within its definition of the 'engagement team'. In practice, it
appears unlikely that many internal auditors would meet these requirements.
7.5.1 Using direct assistance
Three key areas must be considered:
(1)
The amount of judgment involved
(2)
Risk of material misstatement
(3)
The external auditor's evaluation of threats to the objectivity and the level of competence
of the internal auditors
(ISA 610: para. 29)
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ISA 610 (Revised) prohibits the use of internal auditors to provide direct assistance to perform
procedures that:

Involve making significant judgments

Relate to higher assessed risks of material misstatement where more than a limited
degree of judgment is required

Relate to work with which the internal auditors have been involved

Relate to decisions the external auditor makes regarding the internal audit function
and the use of its work or direct assistance.
(ISA 610: para. 30)
Before using internal auditors to provide direct assistance, written agreement must be
obtained:


From an authorised representative of the entity
From the internal auditors
(ISA 610: para. 33)
It is especially important that the external auditor directs, supervises and reviews the work performed
by the internal auditors, bearing in mind that the internal auditors are not independent of the entity.
ISA 610 requires the external auditor to check back to the underlying audit evidence for at least
some of the work performed by the internal auditors (ISA 610: para. 34).
Once the external auditors have evaluated the extent to which internal auditors can be used to
provide direct assistance, they must communicate the nature and extent of the planned
use of direct assistance to those charged with governance (ISA 610: para. 31).
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Evaluation and
review – matters
relating to specific
accounting issues
Essential reading
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Appendix 2 – Essential reading
1 Fair value
1.1 Accounting recap
Key term
Fair value: The price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Fair value accounting has become increasingly important and affects the audit of valuations for both
assets and liabilities. Examples of accounting treatments to which fair values are relevant include
those of financial instruments, employee benefits and share-based payments.
IFRS 13 Fair Value Measurement uses a 'fair value hierarchy', which categorises inputs into three
levels:

Level 1 inputs: Quoted prices in active markets for identical assets or liabilities that the entity
can access at the measurement date

Level 2 inputs: Inputs other than quoted market prices included within Level 1 that are
observable for the asset or liability, either directly or indirectly

Level 3 inputs: Unobservable inputs for the asset or liability
1.2 Auditing fair values
For auditors, the determination of fair value will generally be more difficult than determining
historical cost. It will be more difficult to establish whether fair value is reasonable for complex assets
and liabilities than for more straightforward assets or liabilities which have a market and therefore a
market value. For example, for an apartment held as an investment property, a fair value might be
relatively easy to estimate, as there may be a large and active market for similar properties that can
be used as a guide to the value of the property in question. If, on the other hand, an entity has a
large pension scheme, for which the fair value of the assets depends on actuarial assumptions about
the future, then the fair value will be extremely difficult to measure, and the auditor will have to be
very careful about the assumptions made in arriving at a valuation.
Generally speaking, balances held at fair value may carry the following risks:
Component
of audit risk
Risk
Inherent risk
Estimates are inherently imprecise, and involve judgments, eg about market
conditions, timing of cash flows, or the intentions of the entity.
Estimation models are often complex, eg discounted cash flows, or actuarial
calculations. There is a risk of the model being misapplied.
Assumptions often have to be made when estimating fair values, eg discount
factors.
However, obtaining a fair value for some assets will be straightforward, eg
assets that are regularly traded on a stock exchange.
Control risk
398
Fair value assessment is likely to take place once a year, outside of normal
internal control systems. Therefore, it may not be monitored as stringently as
more routine transactions and balances. Alternatively, management may take
extra care over a fair value assessment because it is a material amount, in which
case control risk is low.
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Component
of audit risk
Risk
Detection
risk
The auditor minimises detection risk through understanding the entity and its
environment at the planning stage, determining whether and where fair values are
present, and what the level of risk associated with them is.
1.3 Requirements of ISA 540
The relevant standard here is ISA 540 Auditing Accounting Estimates, Including Fair Value
Accounting Estimates and Related Disclosures.
Key term
Accounting estimate: An approximation of a monetary amount in the absence of a precise
measurement. This term is used for an amount measured at fair value where there is estimation
uncertainty as well as for other amounts that require estimation.
ISA 540's requirements are:

The auditor shall obtain an understanding of the following as part of the process of
understanding the business:
–
The requirements of the applicable financial reporting framework
–
The means by which the management identifies transactions, events and conditions that
may give rise to the accounting estimate
–
How management makes the accounting estimate
This means that the auditor must have a sound knowledge of the accounting
requirements relevant to the entity and when fair value is allowed for example, IAS 16
allows fair value provided 'it can be measured reliably'.

The auditor shall evaluate the degree of estimation uncertainty associated with the accounting
estimate and assess whether this gives rise to significant risks.

Based on the assessed risks, the auditor will determine whether the financial reporting
framework has been properly applied and whether methods for making estimates are
appropriate and have been applied consistently.

The auditor will also:
–
Determine whether events occurring up to the date of the auditor's report provide
evidence regarding the accounting estimate
–
Test how management made the accounting estimate
–
Test the operating effectiveness of controls, together with appropriate substantive
procedures
–
Develop a point estimate or a range to evaluate the management's point estimate
(ISA 540: paras. 8-13)
Key term
Management's point estimate is the amount selected by management for recognition or
disclosure in the financial statements as an accounting estimate.
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
For accounting estimates which give rise to significant risks, the auditor should also evaluate:
–
How management has considered alternative assumptions or outcomes
–
Whether the significant assumptions used are reasonable
–
Management intent to carry out specific courses of action and its ability to do so, where
these affect the accounting estimate
–
Management's decision to recognise or to not recognise the accounting estimate
–
The selected measurement basis

The possibility of management bias must be considered by the auditor.

Written representations will be obtained from management as to whether management
believes that significant assumptions used in making accounting estimates are reasonable.
(ISA 540: paras. 15-17)
1.4 Risk procedures: fair value
The auditor is required to assess the entity's process for determining accounting estimates, including
fair value measurements and disclosures and the related control activities and to assess the arising
risks of material misstatement.
Management's processes for determining fair values will vary considerably from organisation to
organisation. Some companies will habitually value items at historical cost where possible, and may
have very poor processes for determining fair value if required. Others may have complex systems
for determining fair value if they have a large number of assets and liabilities which they account for
at fair value, particularly where a high degree of estimation is involved in determining the fair value.
Once the auditors have assessed the risks associated with determining fair value, they should
determine further procedures to address those risks.
1.5 Audit procedures: fair value
Audit procedures will depend heavily on the complexity of the fair value measurement. Where the
fair value equates to market value, the auditor should be able to verify this with reference to the
market – for example, published price quotations for marketable securities, or by using the work of
an expert, such as an estate agent in the case of land and buildings.
However, in some cases, there may be a great deal of estimation and management assumption
related to a fair value. Where this is the case, the auditor needs to consider matters such as the intent
and ability of management to carry out certain actions stated in the assumptions. This includes:

Considering management's past history of carrying out its stated intentions with respect to
assets or liabilities

Reviewing written plans and other documentation, including, where applicable, budgets,
minutes etc

Considering management's stated reasons for choosing a particular course of action

Reviewing subsequent events between the date of the financial statements and the date of the
auditor's report

Considering management's ability to carry out a particular course of action given the entity's
economic circumstances, including the implications of its contractual commitments
(ISA 540: para. A80)
If there are alternative allowable methods for measuring fair value, or a particular method is not
prescribed by the relevant accounting standard, the auditor should consider whether the entity's
method is consistent with other fair value measurements in the financial statements and whether it is
applied consistently.
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The auditor should consider the following when considering fair value measurements (ISA 540):








The length of time any assumptions cover (the longer the time, the more subjective the value is)
The number of assumptions made in relation to the item
The degree of subjectivity in the process
The degree of uncertainty associated with the outcome of events
Any lack of objective data
The timings of any valuations used
The reliability of third party evidence
The impact of subsequent events on the fair value measurement
Where a fair value measurement is based on assumptions reflecting management's intent and ability
to carry out certain actions, then the auditor should obtain written representations from
management that these assumptions are reasonable and achievable.
1.5.1 ISA 540 Exposure draft (ED 540)
The IAASB released an exposure draft of a revised ISA 540 in April 2017. A brief summary is
provided in Chapter 16. The background to ED 540 is the adoption of IFRS 9 Financial Instruments
and the need to provide up to date guidance in this evolving area (ED 540: p6).
Accounting estimates can be difficult to audit. One could think of the area as being two steps
removed from a purely substantive audit: the auditor is not only just looking at management's
controls over transactions, but at how management has arrived at an estimate. This area is often
risky for the auditor, and in the absence of simple or clear-cut answers to whether the financial
statements are 'correct', it is vital that the auditor assesses risks properly and applies
professional scepticism.
ED 540 sets the audit of accounting estimates in terms of the audit process in general. The process
begins with understanding the entity, identifying and assessing the risks of material misstatement (ISA
315). Next the auditor considers their response to these risks, designing procedures to obtain
evidence (ISA 330). The level of inherent risk affects the way the risk is responded to, and depends
on three key factors:



Complexity;
The need for the use of judgment by management; or
Estimation uncertainty.
(ED 540: para. 15(b))
ED 540 then requires the auditor to 'stand back' from the evidence obtained, and apply further
professional scepticism to evaluate the audit evidence obtained (ED 540: paras. 22-23).
1.6 IAASB Practice Alert Challenges in Auditing Fair Value Accounting
Estimates in the Current Market Environment
In October 2008, the IAASB issued a Practice Alert, Challenges in Auditing Fair Value Accounting
Estimates in the Current Market Environment. It discussed the following key points:

Challenges faced in accounting on the basis of fair value

Requirements and guidance in standards that are particularly relevant to fair values

Other considerations in audits of fair value accounting estimates

Initiatives of the IASB

Recent revisions to extant standards on auditing accounting estimates and fair value
measurements and disclosures which, while not yet effective, may be helpful to auditors
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2 Inventory
2.1 Inventory
IAS 2: para. 9
Inventory should be measured at the lower of cost and net realisable value. Costs include costs of
purchase, conversion and others incurred in bringing inventory to its present location and condition.
2.2 Inventory count
ISA 501 Audit Evidence – Specific Considerations for Selected Items contains specific guidance on
inventory. It says that attending the inventory count is compulsory where inventory is
material (unless it is not practical to do so). The auditor must then perform procedures to determine
whether inventory in the financial statements accurately reflects the inventory actually counted.
2.3 Standard costing
You studied the audit of inventory in detail in your studies for your AA exam. You should be able to
design procedures to verify the existence and valuation of inventory. If you are in any doubt in this
area, go back to your earlier study material and revise.
An additional thing to consider in the audit of inventory is what evidence to obtain about cost,
when there is a standard costing system in operation. Remember that IAS 2 allows standard
costs to be used when prices are fluctuating (IAS 2: paras. 21–22).
Where standard costing is being used, the auditor will have two objectives:


Ensure that standard costing is an appropriate basis for valuing inventory
Ensure that the calculation of the standard cost is reasonable
In evaluating whether standard costs are an appropriate basis, the auditor must:

Establish whether prices have fluctuated. This can be done by reviewing purchase
invoices, consulting a price index and enquiry of management.

Consider if the use of standard costing is the best accounting policy to use. This
should be discussed with the directors.

If the accounting policy has changed from the previous year, consider the comparability
of the accounts.

Ensure that the financial statements make adequate disclosure of any changes in accounting
policies.
In ensuring that the calculation of the standard cost is reasonable, the auditor must:

Obtain a copy of the calculation of standard cost

Check the additions and calculations

Consider whether the calculation is reasonable (for example, based on averages of costs over
the year)

Verify elements of the calculation to appropriate documentation, for example:
–
–
–

402
Purchase prices to invoices
Wages and salaries to personnel records
Overheads to expenses in the financial statements where possible
Perform analytical procedures, eg wages should be approximately equal to the total wage
cost (in the statement of profit or loss) divided by the production total for the year
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3 Tangible non-current assets
You covered all the key aspects relating to tangible non-current assets in your earlier studies. If you
are in any doubt in this area, go back to your previous material and revise. The issue of fair value
discussed in Section 1 is likely to affect the audit of non-current assets.
3.1 Recognition of non-current assets
The key risk in relation to initial recognition is of costs being incorrectly recognised as assets, when
they should, in fact, have been expensed to the statement of profit or loss.
IAS 16 Property, Plant and Equipment lists the following as components of cost:

Purchase price, less any trade discount or rebate

Import duties and non-refundable purchase taxes

Directly attributable costs of bringing the asset to working condition for its intended use, eg:
–
–
–
–
–

The cost of site preparation
Initial delivery and handling costs
Installation costs
Testing
Professional fees (architects, engineers)
Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the
site on which it is located
(IAS 16: para. 16)
However, the following should not be included in the cost of the asset, and should be
recognised as an expense.




Administration and other general overhead costs
Start-up and similar pre-production costs
Initial operating losses before the asset reaches planned performance
Any incidental costs
(IAS 16: para. 19)
3.2 Valuation of non-current assets
Non-current assets will be carried at cost or valuation (if an item has been revalued). Cost is
straightforward to audit, as it can be verified to original purchase documentation. Valuation
may be straightforward to audit – it can be verified to the valuation certificate. The carrying
value of non-current assets is therefore depreciated cost, or depreciated valuation.
Once a company has revalued assets, it is required to continue revaluing them regularly so that the
valuation is not materially different from the fair value at period end. The auditors should therefore
check that valuation is comparable to market value. They would do this by comparing the existing
valuation to current market values (for example, in an estate agent's window).
Assets are depreciated, so their carrying value will not be original cost or valuation. Depreciation
can be verified by re-performing the depreciation calculations. Often a 'proof in total' check will
be sufficient, where auditors calculate the relevant depreciation percentage on the whole class of
assets to see if it is comparable to the depreciation charged for that class of assets in the year.
The depreciation rate is determined by reference to the useful life of the asset. This is determined by
management based on expectations of how long the asset is expected to be in use in the business.
The auditors will audit this by scrutinising those expectations and verifying them where possible – for
example, to the minutes of the meeting where management decided to buy the asset, to capital
replacement budgets, to past practice in the business.
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Activity 1: Non-current assets
You are reviewing the file on the audit, which is nearing completion, of a listed company, Apollo Co.
Apollo produces two products, the X and the W. Apollo Co purchased two new pieces of plant in
the year. Plant is valued at cost. The X103 was bought to replace the X102, which was scrapped at
the start of the year. The W103 was bought to replace the W102. The W102 will no longer be used
in producing the W, but will be used to test new products, particularly the V, which Apollo is hoping
to be able to market and sell in the next two years.
Required
Describe matters you would consider and the audit evidence you would expect to see on file in
respect of the valuation of these pieces of plant.
3.3 Impairment of non-current assets
An asset is impaired when its carrying amount (depreciated cost or depreciated valuation) exceeds
its recoverable amount. You should be familiar with the following key terms from your accounting
studies:
Key terms
The recoverable amount of an asset or cash-generating unit is the higher of its fair value, less
costs to sell and its value in use.
A cash-generating unit is the smallest identifiable group of assets that generates cash inflows
which are largely independent of the cash inflows from other assets or groups of assets.
Value in use is the present value of the future cash flows expected to be derived from an asset or
cash-generating unit.
(IAS 36: para. 6)
Management are required to determine if there is any indication that the assets are impaired. IAS 36
Impairment of Assets specifies the following indicators of possible impairment.
External sources of information regarding possible impairment:

Market value declines significantly

Negative changes in technology, markets, economy or legal environment

Increases in market interest rates that are likely to affect the discount rate using to calculate
value in use

Company stock price is below book value
(IAS 36: para. 12)
Internal sources of information regarding possible impairment:

Obsolescence or physical damage

Significant changes with an adverse effect on use, eg asset will become idle, is part of a
restructuring, or is held for disposal

Internal evidence shows worse economic performance of the asset than was expected
(IAS 36: para. 12)
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The auditors will consider whether there are any indicators of impairment when carrying out
risk assessment procedures. They will use the same impairment criteria laid out in IAS 36 as
management do. If the auditors believe that impairment is indicated, they should request that
management show them the impairment review that has been carried out. If no
impairment review has been carried out, then the auditors should discuss the need for one
with management and, if management refuse to carry out an impairment review, qualify their
opinion on grounds of a material misstatement in respect of IAS 36 as a result of management not
carrying out an impairment review.
If an impairment review has been carried out, then the auditors should audit that impairment review.
Management will have estimated whether the recoverable amount of the asset/cash generating unit
is lower than the carrying amount.
For auditors, the key risk is that the recoverable amount requires estimation, which involves
management using their judgment. Auditors will need to consider whether the judgment made
by management is reasonable in accordance with IAS 36.
Management have to determine if the recoverable amount is higher than carrying amount. It may not
have been necessary for them to estimate both fair value and value in use because, if one is higher
than the carrying amount, then the asset is not impaired. If it is not possible to make a reliable
estimate of net realisable value, then it is necessary to calculate value in use.
Net realisable value is only calculable if there is an active market for the asset, and would therefore
be audited in the same way as fair value, which was set out in Section 1. Costs to sell, such as taxes,
can be recalculated by applying the appropriate tax rate to the fair value itself. Delivery costs can be
verified by comparing costs with published rates by delivery companies, for example on the internet.
If management has calculated the value in use of an asset or cash-generating unit, then the auditors
will have to audit that calculation. The following procedures will be relevant:
Value in use

Obtain management's calculation of value in use

Reperform calculation to ensure that it is mathematically correct

Compare the cash flow projections to recent budgets and projections approved by the board to
ensure that they are realistic

Calculate/obtain from analysts the long-term average growth rate for the products and ensure
that the growth rates assumed in the calculation of value in use do not exceed it

Refer to competitors' published information to compare how similar assets are valued by
companies trading in similar conditions

Compare with previous calculations of value in use to ensure that all relevant costs of
maintaining the asset have been included

Ensure that the cost/income from disposal of the asset at the end of its life has been included

Review calculation to ensure cash flows from financing activities and income tax have been
excluded

Compare discount rate used with published market rates to ensure that it correctly reflects the
return expected by the market
If the asset is impaired and has been written down to recoverable amount, the auditors should review
the financial statements to ensure that the write-down has been carried out correctly and that the IAS
36 disclosures have been made correctly.
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3.4 Held for sale non-current assets
IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations applies to non-current
assets and disposal groups. A disposal group is a group of assets and associated liabilities that
are to be disposed of in a single transaction.
IFRS 5 requires that non-current assets and disposals groups that are 'held for sale' should be
presented separately in the statement of financial position. 'Held for sale' here means that the noncurrent asset/disposal group's carrying amount will be recovered principally through a sale, rather
than through continuing use. A number of detailed criteria must be met:
(a)
(b)
The asset must be available for immediate sale in its present condition.
The sale must be highly probable.
(IFRS 5: para. 7)
For sale to be highly probable, the following must apply:
(a)
(b)
(c)
(d)
(e)
Management must be committed to a plan to sell the asset.
There must be an active plan to locate a buyer.
The asset must be marketed at a price that is reasonable in relation to its current fair value.
The sale should be expected to take place within one year from the date of classification.
It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
(IFRS 5: para. 8)
A non-current asset held for sale should be measured at the lower of its carrying amount and fair
value less costs to sell (IFRS 5: para. 15). An impairment loss should be recognised where fair value
less costs to sell is lower than the carrying amount (IFRS 5: para. 20).
Non-current assets held for sale should not be depreciated, even if they are still being used by the
entity.
The following audit procedures will therefore be relevant.

Confirm that the asset meets the definition of an asset held for sale:
– Discuss with management the availability of asset for sale
– Assess management commitment, eg from discussion in board minutes
– Evaluate and assess practical steps being taken to sell the asset eg appropriate real estate
agents appointed
– Determine when the sale is expected to take place by assessing progress to date
– Determine and assess the basis on which the sale price has been set
– Discuss with management any significant changes to the plans

Confirm that the asset has been valued as held for sale in accordance with IFRS 5 and assess
how fair value has been determined.

Check that the asset has not been depreciated from the date of reclassification.

Confirm separate disclosure in accordance with IFRS 5.
3.5 Agriculture
IAS 41 Agriculture deals with biological assets (living animals or plants except for 'bearer plants'
– see next section) and agricultural produce at the point of harvest, along with the process of
transformation as assets grow, degenerate, produce and procreate in the course of their lifecycle.
The benchmark treatment in IAS 41 is to measure biological assets at fair value less costs to sell
(IAS 41: para. 12). Changes in carrying amount during the period arise from either changes in
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fair value, or the physical change of the biological asset. The financial statements must disclose
these amounts (IAS 41: para. 40), so there is an audit risk of inadequate disclosures being made.
Determining the fair value of assets must be done in line with IFRS 13 Fair Value Measurement.
This involves an element of judgment, so the auditor must understand the basis for the valuation.
Costs to sell must include fees, commissions and any other levies or taxes, and must be complete.
In practice, market values for most assets should be readily available, so depending on the scenario,
this is unlikely to represent a significant audit risk. However, the auditor may have insufficient
expertise to determine what type of asset a plant or animal is – auditors are unlikely to be able to
distinguish a Cotswold sheep from a Herdwick, for example, and thus assess the animal's market
value. It may therefore be necessary to rely on an expert – either management's or the auditor's –
which adds a degree of risk and cost to the audit.
3.5.1 Interactions with other accounting standards
IAS 41 was amended in 2014 as part of amendments which changed the financial reporting of
bearer plants. Bearer plants are living plants which 'bear' other agricultural produce but which
are not harvested themselves – they therefore survive for more than one reporting period. These
plants are to be accounted for in the same way as property, plant and equipment in IAS 16 Property,
Plant and Equipment (IAS 41: para. 2). However, their agricultural produce (produce growing on
bearer plants) continues to be accounted for under IAS 41.
Note that livestock is excluded from the definition of 'bearer plants', so all livestock (including milk
cows and sheep farmed for wool) and their agricultural produce should continue to be accounted for
under IAS 41.
IAS 41 deals with assets up to the point when agricultural produce is harvested from the asset. After
the point of harvest, IAS 2 Inventories applies. Examples might include a cow (biological asset) from
which milk or meat is 'harvested' (agricultural produce). Once the produce has been harvested and
processing has begun, IAS 2 applies. The following are examples of biological assets (IAS 41),
agricultural produce (IAS 41), and products that are the result of processing (IAS 2).
Biological assets (IAS 41)
Agricultural produce
(IAS 41)
Products that are the
result of processing after
harvest (IAS 2)
Sheep
Wool
Yarn, carpet
Trees in a timber plantation
Felled trees
Logs, lumber
Pigs
Carcass
Sausages, cured hams
Dairy cattle
Milk
Cheese
Sugarcane
Harvested cane
Sugar
(Source: IAS 41: para. 4)
Some assets may be physically attached to land – eg trees in a plantation forest – in which case IAS
41 is applied to the biological assets, but IAS 16 or IAS 40 is applied to the land (IAS 41: para.
25). Care must therefore be taken to split the land from the biological asset in the financial
statements, and there is a risk that this will not be done correctly.
Finally, IAS 41 contains its own criteria in relation to government grants and assistance, which
differ from those in IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance. IAS 41 requires grants to be recognised only when the grant becomes receivable,
whereas IAS 20 allows recognition when there is 'reasonable assurance' that it will be received (IAS
41: 34–35). There is thus a risk of improper recognition in the financial statements, eg overstating
assets if the IAS 20 criteria are mistakenly applied.
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Appendix฀2฀–฀Essential฀reading฀
฀
4฀Intangible฀non-current฀assets฀
The฀ types฀ of฀ asset฀ we฀ are฀ likely฀ to฀ encounter฀ under฀ this฀ heading฀ include฀ patents,฀ licences,฀
trademarks,฀ development฀ costs฀ and฀ goodwill.฀ All฀ intangibles฀ should฀ be฀ subject฀ to฀ an฀ annual฀
impairment฀review.฀
IAS฀38฀Intangible฀assets฀
An฀ intangible฀ asset฀ is฀ an฀ identifiable฀ non-monetary฀ asset฀ without฀ physical฀ substance.฀ It฀ may฀ be฀
held฀ for฀ use฀ in฀ the฀ production฀ and฀ supply฀ of฀ goods฀ or฀ services,฀ or฀ for฀ rental฀ to฀ others,฀ or฀ for฀
administrative฀purposes.฀The฀asset฀must฀be:฀
฀
฀
Controlled฀by฀the฀entity฀as฀a฀result฀of฀events฀in฀the฀past฀
Something฀from฀which฀the฀entity฀expects฀future฀economic฀benefits฀
(IAS฀38:฀para.฀8)฀
Examples฀of฀items฀that฀might฀be฀considered฀as฀intangible฀assets฀include฀computer฀software,฀patents,฀
copyrights,฀motion฀picture฀film฀rights,฀customer฀lists,฀franchises฀and฀fishing฀rights.฀An฀item฀should฀not฀
be฀ recognised฀ as฀ an฀ intangible฀ asset,฀ however,฀ unless฀ it฀ fully฀ meets฀ the฀ definition฀ in฀ the฀
standard.฀The฀guidelines฀go฀into฀great฀detail฀on฀this฀matter.฀
Internally฀generated฀goodwill฀may฀not฀be฀recognised฀as฀an฀asset฀(IAS฀38:฀para.฀48).฀
The฀auditor฀should฀carry฀out฀the฀following฀procedures:฀
Completeness฀
฀
Prepare฀analysis฀of฀movements฀on฀cost฀and฀amortisation฀accounts฀
Rights฀and฀obligations฀
฀
฀
Obtain฀confirmation฀of฀all฀patents฀and฀trademarks฀held฀by฀a฀patent฀agent฀
Verify฀payment฀of฀annual฀renewal฀fees฀
Valuation฀
฀
Review฀specialist฀valuations฀of฀intangible฀assets,฀considering:฀
฀
฀
฀
–฀ Qualifications฀of฀valuer฀
–฀ Scope฀of฀work฀
–฀ Assumptions฀and฀methods฀used฀
฀
Confirm฀carried฀down฀balances฀represent฀continuing฀value,฀which฀are฀proper฀charges฀
to฀future฀operations฀
Additions฀(rights฀and฀obligations,฀valuation฀and฀completeness)฀฀
฀
Inspect฀purchase฀agreements,฀assignments฀and฀supporting฀documentation฀for฀
intangible฀assets฀acquired฀in฀period฀
฀
Confirm฀purchases฀have฀been฀authorised฀
฀
Verify฀amounts฀capitalised฀of฀patents฀developed฀by฀the฀company฀with฀supporting฀costing฀
records฀
Amortisation฀
฀
Review฀amortisation฀
฀
฀
–฀ Check฀computation฀
–฀ Confirm฀that฀rates฀used฀are฀reasonable฀
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Income฀from฀intangibles฀
฀
Review฀sales฀returns฀and฀statistics฀to฀verify฀the฀reasonableness฀of฀income฀derived฀from฀
patents,฀trademarks,฀licences฀etc฀
฀
Examine฀audited฀accounts฀of฀third฀party฀sales฀covered฀by฀a฀patent,฀licence฀or฀trademark฀
owned฀by฀the฀company฀
4.1฀Goodwill฀
Key฀tests฀are:฀
฀
Agree฀consideration฀to฀a฀sales฀agreement฀
฀
Confirm฀valuation฀of฀assets฀acquired฀is฀reasonable฀
฀
Check฀purchased฀goodwill฀is฀calculated฀correctly฀฀
฀
Check฀goodwill฀does฀not฀include฀non-purchased฀goodwill฀
฀
Ensure฀valuation฀of฀goodwill฀is฀reasonable฀by฀reviewing฀prior฀year's฀accounts฀and฀
discussion฀with฀the฀directors฀
฀
Ensure฀impairment฀review฀has฀been฀carried฀out฀at฀least฀annually฀
฀
Review฀impairment฀review฀for฀reasonableness฀
Goodwill฀is฀covered฀in฀more฀detail฀in฀the฀context฀of฀the฀audit฀of฀groups฀in฀Chapter฀9.฀
4.2฀Development฀costs฀
IAS฀38฀Intangible฀assets฀
฀
Development฀ costs฀ may฀ be฀ included฀ in฀ the฀ statement฀ of฀ financial฀ position฀ (that฀ is฀ to฀ say,฀
capitalised)฀only฀once฀IAS฀38฀criteria฀are฀met.฀
฀
IAS฀38฀defines฀research฀and฀development฀as฀follows฀(IAS฀38:฀para.฀8).฀
฀
–฀
Research฀ is฀ original฀ and฀ planned฀ investigation฀ undertaken฀ with฀ the฀ prospect฀ of฀ gaining฀
new฀scientific฀or฀technical฀knowledge฀and฀understanding.฀
฀
–฀
Development฀ is฀ the฀ application฀ of฀ research฀ findings฀ or฀ other฀ knowledge฀ to฀ a฀ plan฀ or฀
design฀ for฀ the฀ production฀ of฀ new฀ or฀ substantially฀ improved฀ materials,฀ devices,฀ products,฀
processes,฀systems฀or฀services฀prior฀to฀the฀commencement฀of฀commercial฀production฀or฀use.฀
฀
Expenditure฀ on฀ research฀ is฀ required฀ to฀ be฀ recognised฀ in฀ profit฀ or฀ loss฀ in฀ the฀ year฀ of฀
expenditure฀(IAS฀38:฀para.฀54).฀
฀
IAS฀38฀states฀that฀the฀development฀costs฀of฀a฀project฀should฀be฀recognised฀as฀an฀asset฀only฀
when฀all฀of฀the฀following฀criteria฀are฀met฀(IAS฀38:฀para.฀57):฀
฀
–฀
Completion฀of฀the฀asset฀will฀be฀technically฀feasible.฀
฀
–฀
The฀business฀intends฀to฀complete฀the฀asset฀and฀use฀or฀sell฀it.฀
฀
–฀
The฀business฀will฀be฀able฀to฀use฀or฀sell฀the฀asset.฀
฀
–฀
The฀ business฀ can฀ demonstrate฀ how฀ future฀ economic฀ benefits฀ will฀ be฀ generated,฀ either฀ by฀
demonstrating฀that฀a฀market฀exists฀or฀the฀internal฀usefulness฀of฀the฀asset.฀
฀
–฀
Adequate฀ technical,฀ financial฀ and฀ other฀ resources฀ will฀ be฀ available฀ to฀ complete฀ the฀
development฀and฀use฀or฀sell฀the฀intangible฀asset.฀
฀
–฀
Expenditure฀ attributable฀ to฀ the฀ development฀ of฀ the฀ asset฀ can฀ be฀ measured฀ reliably.฀
General฀ overhead฀ expenditure,฀ costs฀ of฀ inefficiencies฀ and฀ operating฀ losses,฀ and฀
expenditure฀on฀training฀staff฀to฀operate฀the฀asset฀should฀not฀be฀capitalised.฀
฀
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Appendix 2 – Essential reading
The development costs of a project recognised as an asset should not exceed the amount that is
likely to be recovered from related future economic benefits, after deducting further development
costs, related production costs, and selling and administrative costs directly incurred in
marketing the product.

In all other circumstances, development costs should be recognised in profit or loss in the year of
expenditure.
The key audit tests largely reflect the criteria laid down in IAS 38.


Check accounting records to confirm that:
–
Project is clearly defined (separate cost centre or general ledger codes)
–
Related expenditure can be separately identified, and certified to invoices,
timesheets
Confirm feasibility and viability:
– Examine market research reports, feasibility studies, budgets and forecasts
– Consult client's technical experts

Review budgeted revenues and costs by examining results to date, production forecasts,
advance orders and discussion with directors

Review calculations of future cash flows to ensure resources exist to complete the project

Review previously deferred expenditure to ensure IAS 38 criteria are still justified

Check amortisation:
– Commences with production
– Charged on a systematic basis
The good news for the auditors in this audit area is that many companies adopt a prudent approach
and write off research and development expenditure in the year it is incurred. The auditors' concern
in these circumstances is whether the statement of profit or loss charge for research and development
is complete, accurate and valid.
4.3 Brands
The key accounting issue with regard to brands is whether the asset is internally generated or
not. Remember, IAS 38 forbids the capitalisation of internally generated brands (IAS 38: para. 63).
If a brand has been purchased separately, then auditors should test the value of the brand according
to the sales documentation.
5 Financial instruments
5.1 Background
If you read the financial press, you will probably be aware of rapid international expansion in the
use of financial instruments over the last 15 years or so. These vary from straightforward, traditional
instruments, such as loans and deposits, through to various and exotic forms of derivative instruments,
structured products and commodity contracts. Some of the more complex instruments played a role in
the financial crisis of 2007–8.
This is a particularly risky area for auditors, as accounting for these instruments involves an
unavoidable element of complexity, often requiring the use of management's own judgments. The
amounts involved can be highly material, which adds not only audit risk but business risk too.
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8: Evaluation and review – matters relating to specific accounting issues
In this long section, we spend some time working through the accounting requirements for financial
instruments, before moving onto some considerations for auditors further down.
The guidance in this section is based on ISA 540 Auditing Accounting Estimates, Including Fair Value
Accounting Estimates, and Related Disclosures and IAPN 1000 Special Considerations in Auditing
Financial Instruments.
The IASB has developed the following financial reporting standards in relation to financial
instruments:
Accounting for
financial
instruments
IAS 32
Financial Instruments:
Presentation
(first issued 2005)
IFRS 9
Financial Instruments
(first issued 2009)
IFRS 7
Financial Instruments:
Disclosures
(first issued 2005)
5.2 Classification (IAS 32)
In order to decide whether a transaction is a financial instrument (and how to classify it if it is a
financial instrument), it is important to have a good understanding of the instruments as defined by
IAS 32:
Financial
instruments
Financial assets
Financial liabilities
Equity instruments
Compound instruments
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Appendix 2 – Essential reading
Key terms
(1) Financial instrument: Any contract that gives rise to both a financial asset of one entity and
a financial liability or equity instrument of another entity.
(IAS 32: para. 11)
(2) Financial asset (IAS 32: para. 11)
Any asset that is:
(a) Cash;
(b) An equity instrument of another entity;
(c) A contractual right:
(i)
To receive cash or another financial asset from another entity; or
(ii)
To exchange financial assets or financial liabilities with another entity under conditions
that are potentially favourable to the entity; or
(d) A contract that will or may be settled in the entity's own equity instruments.
Examples:



Trade receivables
Options
Shares (as an investment)
Although technically financial instruments,
IFRS 9 does not change the treatment of
basic instruments such as trade
receivables
(3) Financial liability (IAS 32: para. 11)
Any liability that is:
(a) A contractual obligation:
(i) To deliver cash or another financial asset to another entity; or
(ii)
To exchange financial assets or financial liabilities with another entity under conditions
that are potentially unfavourable to the entity; or
(b) A contract that will or may be settled in an entity's own equity instruments.
Examples:




Trade payables
Debenture loans (payable)
Mandatorily redeemable preference shares
Forward contracts standing at a loss
(4) Equity instrument: Any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities (IAS 32: para. 11).
Examples:



An entity's own ordinary shares
Warrants
Non-cumulative irredeemable preference shares
(5) Derivative: A derivative has three characteristics (IFRS 9: Appendix A):
(a) Its value changes in response to an underlying variable (eg share price, commodity price,
foreign exchange rate or interest rate);
(b) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors;
(c)
It is settled at a future date.
Examples:



412
Foreign currency forward contracts
Interest rate swaps
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Classification as liability vs equity
IAS 32 clarifies that an instrument is only an equity instrument if neither (a) nor (b) in the definition of
a financial liability are met. (IAS 32: para. 16)
The critical feature of a financial liability is the contractual obligation to deliver cash or another
financial asset.
Stakeholder perspective
When an entity issues a financial instrument, the entity classifies it as either a financial liability or as
equity:

Classification as a financial liability will result in increased gearing and reduced
profit (as distributions are classified as finance cost).

Classification as equity will decrease gearing and have no effect on profit (as
distributions are charged to equity).
Classification therefore affects how the financial position and performance of the entity are depicted,
and subsequently, how investors and other stakeholders assess the potential for future cash flows and
risk associated with the entity. This is therefore an important issue for auditors, who should
understand the classification in the context of its effect on the financial statements as a whole, and on
their users.
5.2.1 Compound instruments
Where a financial instrument contains some characteristics of equity and some of financial liability,
then its separate components need to be classified separately (IAS 32: para. 28).
A common example is convertible debt (convertible loan notes).
Method for separating the components (IAS 32: para. 32):
(1)
Determine the carrying amount of the liability component (by measuring the fair value (FV) of a
similar liability that does not have an associated equity component);
(2)
Assign the residual amount to the equity component.
5.2.2 Treasury shares
If an entity reacquires its own equity instruments ('treasury shares'), the amount paid is
presented as a deduction from equity (IAS 32: para. 33) rather than as an asset (an investment
by the entity in itself – acquiring its own shares – cannot be shown as an asset).
No gain or loss is recognised in profit or loss on the purchase, sale, issue or cancellation of an entity's
own equity instruments (IAS 32: para. 33). Any premium or discount is recognised in reserves.
5.3 Recognition (IFRS 9)
Financial assets and liabilities are required to be recognised in the statement of financial position
when the entity becomes a party to the contractual provisions of the instrument (IFRS 9:
para. 3.1.1).
Illustration 1
Derivatives (eg a forward contract) are recognised in the financial statements at inception, even
though there may have been no cash flow, and disclosures about them are made in accordance with
IFRS 7.
The recognition principles of the revised Conceptual Framework are concerned with whether
recognition of an item will provide users of the financial statements with useful information about
that item. The recognition criteria in IFRS 9 are consistent with these principles.
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Appendix 2 – Essential reading
Financial contracts vs executory contracts
IFRS 9 applies to those contracts to buy or sell a non-financial item that can be settled net in
cash or another financial instrument, or by exchanging financial instruments as if the contracts were
financial instruments (IFRS 9: para. 2.4). These are considered financial contracts.
However, contracts that were entered into (and continue to be held) for the entity's expected
purchase, sale or usage requirements of non-financial items are outside the scope of
IFRS 9 (IFRS 9: para. 2.4).
These are executory contracts. Executory contracts are contracts under which neither party has
performed any of its obligations (or both parties have partially performed their obligations to an
equal extent) (IAS 37: para. 3). For example, an unfulfilled order for the purchase of goods, where
at the end of the reporting period, the goods have neither been delivered nor paid for.
Illustration 2
A forward contract to purchase cocoa beans for use in making chocolate is an executory contract
which is outside the scope of IFRS 9.
The purchase is not accounted for until the cocoa beans are actually delivered.
5.4 Derecognition (IFRS 9)
Derecognition is the removal of a previously recognised financial instrument from an entity's
statement of financial position. Derecognition happens:
Financial assets:
– When the contractual rights to the cash flows expire (eg because a
customer has paid their debt or an option has expired worthless)
(IFRS 9: para. 3.2.3(a)); or
– The financial asset is transferred (eg sold), based on whether the
entity has transferred substantially all the risks and rewards of
ownership of the financial asset (IFRS 9: para. 3.2.3(b)).
Financial liabilities:
– When it is extinguished, ie when the obligation is discharged (eg
paid off), cancelled or expires (IFRS 9: para. 3.3.1).
Where a part of a financial instrument (or group of similar financial instruments) meets the criteria
above, that part is derecognised (IFRS 9: para. 3.2.2(a)).
For example, if an entity holds a bond it has the right to two separate sets of cash inflows: those
relating to the principal and those relating to the interest. It could sell the right to receive the interest
to another party while retaining the right to receive the principal.
The revised Conceptual Framework includes criteria for derecognition. For assets, derecognition
occurs when control of the asset is lost. For liabilities, derecognition occurs when the entity no longer
has a present obligation. The criteria in IFRS 9 are consistent with these principles.
5.5 Classification and measurement (IFRS 9)
5.5.1 Definitions
The following definitions are relevant in understanding this section, and you should refer back to
them when studying this material.
Key terms
Amortised cost: The amount at which the financial asset or financial liability is measured at initial
recognition minus the principal repayments, plus or minus the cumulative amortisation, using the
effective interest method of any difference between that initial amount and the maturity amount and,
for financial assets, adjusted for any loss allowance.
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Effective interest rate: The rate that exactly discounts estimated future cash payments or receipts
through the expected life of the financial asset or financial liability to the gross carrying amount of a
financial asset or to the amortised cost of a financial liability.
Held for trading: A financial asset or financial liability that:
(a) Is acquired or incurred principally for the purpose of selling or repurchasing it in the near term;
(b) On initial recognition is part of a portfolio of identified financial instruments that are managed
together and for which there is evidence of a recent actual pattern of short-term profit-taking; or
(c)
Is a derivative (except for a derivative that is a financial guarantee contract or a designated and
effective hedging instrument).
Financial guarantee contract: A contract that requires the issuer to make specified payments to
reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due
in accordance with the original or modified terms of the debt instrument.
(IFRS 9: Appendix A)
5.5.2 Financial assets
1
Initial measurement
(IFRS 9: para. 5.1.1)
Subsequent
measurement
(IFRS 9: paras. 4.1.2–4.1.5,
5.7.5)
FV + transaction costs
Amortised cost
FV + transaction costs
FV through other
comprehensive income (OCI)
(with reclassification to profit
or loss (P/L) on derecognition)
Investments in debt
instruments
Business model approach (Note 1):
(a) Held to collect contractual cash
flows; and cash flows are solely
principal and interest
(b) Held to collect contractual cash
flows and to sell; and cash
flows are solely principal and
interest
NB: Interest revenue calculated
on amortised cost basis
recognised in P/L
2
FV + transaction costs
Investments in equity
instruments not 'held for
trading'
(optional irrevocable election on
initial recognition)
3
FV through other
comprehensive income (no
reclassification to P/L on
derecognition)
NB: Dividend income
recognised in P/L
All other financial assets
(and any financial asset if this would
eliminate or significantly reduce an
'accounting mismatch' (Note 2))
FV (transaction costs
expensed in P/L)
FV through profit or loss
Notes
1
The business model approach relates to groups of debt instrument assets and the
accounting treatment depends on the entity's intention for that group of assets.
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2
(a)
If the intention is to hold until redemption, ie receive the interest and capital cash
flows, then changes in FV are not relevant: the difference between initial and maturity
value is recognised using the amortised cost method.
(b)
If the intention is principally to hold the group of debt instruments until they are
redeemed, but they may be sold if certain criteria are met (eg to meet
regulatory solvency requirements), then their FV is now relevant as they may be sold
and so they are measured at FV. Changes in FV are recognised in other
comprehensive income, but interest is still recognised in profit or loss on the same
basis as if the intention was not to sell if certain criteria are met.
An 'accounting mismatch' is a measurement or recognition inconsistency that would otherwise
arise from measuring assets or liabilities or recognising gains or losses on them on different
bases. Any financial asset can be designated at FV through profit or loss if this would
eliminate the mismatch.
Reclassification of financial assets
Financial assets are reclassified under IFRS 9 when, and only when, an entity changes
its business model for managing financial assets (IFRS 9: para. 4.4.1), applying the
reclassification prospectively.
These rules only apply to investments in debt instruments (equity instruments are always
held at FV and any election to measure them at FV through other comprehensive income is
irrevocable).
Treatment of gain or loss on derecognition
On derecognition of a financial asset in its entirety, the difference between:
(a)
(b)
The carrying amount (measured at the date of derecognition); and
The consideration received
is recognised in profit or loss (IFRS 9: para. 3.2.12).
Applying this rule, in the case of investments in equity instruments not held for trading where
the irrevocable election has been made to report changes in FV in other comprehensive
income, all changes in FV up to the point of derecognition are reported in other
comprehensive income.
Therefore, a gain or loss in profit or loss will only arise if the investments in equity instruments are
not sold at their FV and for any transaction costs on derecognition. Gains or losses previously
reported in other comprehensive income are not reclassified to profit or loss on derecognition.
For investments in debt held at FV through other comprehensive income, on
derecognition, the cumulative revaluation gain or loss previously recognised in other
comprehensive income is reclassified to profit or loss (IFRS 9: para. 5.7.10).
5.5.3 Financial liabilities
1
416
Most financial liabilities
(eg trade payables, loans, preference
shares classified as a liability)
Initial
measurement
(IFRS 9: para.
5.1.1)
Subsequent measurement
(IFRS 9: para. 4.2.1)
FV less transaction
costs
Amortised cost
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2
Financial liabilities at FV through
profit or loss (Note 1)
–
'Held for trading' (short-term profit
making)
–
Derivatives that are liabilities
–
Designated on initial recognition at
'FV through profit or loss' to
eliminate/significantly reduce an
'accounting mismatch' (Note 2)
–
A group of financial liabilities (or
financial assets and financial
liabilities) managed and performance
evaluated on a FV basis in
accordance with a documented risk
management or investment strategy
Initial
measurement
(IFRS 9: para.
5.1.1)
Subsequent measurement
(IFRS 9: para. 4.2.1)
FV (transaction
costs expensed in
P/L)
FV through profit or loss*
3
Financial liabilities arising when
transfer of financial asset does not
qualify for derecognition
Consideration
received
Measure financial liability on
same basis as transferred asset
(amortised cost or FV)
4
Financial guarantee contracts
(Note 3) and commitments to
provide a loan at a below-market
interest rate (Note 4)
FV less transaction
costs
Higher of:
– Impairment loss allowance
– Amount initially recognised
less amounts amortised to
P/L (IFRS 15)
*Changes in FV due to changes in the liability's credit risk are recognised separately in other
comprehensive income (unless doing so would create or enlarge an 'accounting mismatch') (IFRS 9:
para. 5.7.7).
Notes
1
Most financial liabilities are measured at amortised cost.
However, some financial liabilities are measured at FV through profit or loss if FV
information is relevant to the user of the financial statements. This includes where a company is
'trading' in financial liabilities, ie taking on liabilities hoping to settle them for less in the short
term to make a profit, and derivatives standing at a loss, which are financial liabilities, rather
than financial assets.
2
As with financial assets, financial liabilities can be designated at FV through profit or loss, if
doing so would eliminate an 'accounting mismatch', ie a measurement or recognition
inconsistency that would otherwise arise from measuring assets or liabilities or recognising
gains or losses on them on different bases.
3
Financial guarantee contracts are a form of financial insurance. The entity guarantees it
will make a payment to another party if a specified debtor does not pay that other party. On
initial recognition the FV of the 'premiums' received (less any transaction costs) are recognised
as a liability. This is then amortised as income to profit or loss over the period of the
guarantee, representing the revenue earned as the performance obligation (ie providing the
guarantee) is satisfied, thereby reducing the liability to zero over the period of cover if no
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compensation payments are actually made. However, if, at the year end, the expected
impairment loss that would be payable on the guarantee exceeds the remaining liability, the
liability is increased to this amount.
4
Commitments to provide a loan at below-market interest rate arise where an
entity has committed itself to make a loan to another party at an interest rate which is lower
than the rate the entity itself would pay to borrow the money. These are accounted for in the
same way as financial guarantee contracts. The impairment loss, in this case, would be the
present value of the expected interest receipts from the other party, less the expected (higher)
interest payments the entity would pay.
5.5.4 Offsetting financial assets and financial liabilities (IAS 32)
A financial asset and a financial liability are required to be offset (ie presented as a single net
amount) when the entity:
(a)
Has a legally enforceable right to set-off the recognised amounts, and
(b)
Intends either to settle on a net basis or to realise the asset and settle the liability
simultaneously.
Otherwise, financial assets and financial liabilities are presented separately.
5.6 Embedded derivatives (IFRS 9)
Some contracts (that may or may not be financial instruments themselves) may have derivatives
embedded in them. Ordinarily, derivatives not used for hedging are treated as 'held for trading' and
measured at FV through profit or loss.
With limited exceptions, IFRS 9 requires embedded derivatives that would meet the definition of a
separate derivative instrument to be separated from the host contract (and therefore be measured
at FV through profit or loss like other derivatives) (IFRS 9: paras. 4.3.3–4.3.5).
5.7 Impairment of financial assets (IFRS 9)
5.7.1 Approach
IFRS 9 uses a forward-looking impairment model. Under this model future expected credit
losses are recognised. This is different to the impairment model used in IAS 36 Impairment of Assets
in which an impairment loss is only recognised when objective evidence of impairment exists.
5.7.2 Scope
IFRS 9's impairment rules apply to certain financial assets (IFRS 9: paras. 5.5.1–5.5.2):

Investments in debt instruments measured at amortised cost (business model: objective – to
collect contractual cash flows of principal and interest)

Investments in debt instruments measured at FV through other comprehensive income (OCI)
(business model: objective – to collect contractual cash flows of principal and interest and to
sell financial assets)
The impairment rules do not apply to financial assets measured at FV through profit or loss, as
subsequent measurement at FV will already take into account any impairment.
5.7.3 Recognition of credit losses
On initial recognition of a financial asset and at each subsequent reporting date, a loss
allowance for expected credit losses must be recognised.
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Loss allowance: The allowance for expected credit losses on financial assets
Expected credit losses: The weighted average of credit losses with the respective risks of a
default occurring as the weights.
Credit loss: The difference between all contractual cash flows that are due to an entity…and all the
cash flows that the entity expects to receive, discounted.
(IFRS 9: Appendix A)
At initial recognition
At initial recognition of a financial asset, a loss allowance equal to 12 month expected credit
losses must be recognised.
12 month expected credit losses are the portion of lifetime expected credit losses that
result from default events on a financial instrument that are possible within the 12 months after
the reporting date (IFRS 9: Appendix A). They are calculated by multiplying the probability of default
in the next 12 months by the present value of the lifetime expected credit losses that would result
from the default (IFRS 9: para. B5.5.43).
Lifetime expected credit losses are the expected credit losses that result from all possible
default events over the expected life of the financial instrument (IFRS 9: Appendix A).
At subsequent reporting dates (IFRS 9: paras. 5.5.3 – 5.5.8)
At each subsequent reporting date, the loss allowance required depends on whether there has been
a significant increase in credit risk on that financial instrument since initial recognition.
No significant increase
in credit risk since
initial recognition
(Stage 1)
Significant increase
in credit risk since
initial recognition
(Stage 2)
Objective evidence of
impairment at the
reporting date
(Stage 3)
Recognise 12 month
expected credit losses
Recognise lifetime expected
credit losses
Recognise lifetime expected
credit losses
Effective interest calculated
on gross carrying amount
of financial asset
Effective interest calculated
on gross carrying amount
of financial asset
Effective interest calculated
on net carrying amount of
financial asset
5.7.4 Presentation
Credit losses are treated as follows.
Type of financial asset
Treatment of credit loss
Investments in debt instruments
measured at amortised cost

Recognised in profit or loss

Credit losses held in a separate allowance
account offset against the carrying amount of
the asset:
Financial asset
X
(X)
Allowance for credit losses
Carrying amount (net of allowance for credit losses) X
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Type of financial asset
Treatment of credit loss
Investments in debt instruments
measured at FV through other
comprehensive income

Portion of the fall in FV relating to credit losses
recognised in profit or loss

Remainder recognised in other comprehensive
income

No allowance account necessary because already
carried at FV (which is automatically reduced for any
fall in value, including credit losses)
(IFRS 9: paras. 5.5.8 and 5.5.2)
5.7.5 Measurement
The measurement of expected credit losses should reflect (IFRS 9: para. 5.5.17):
(a)
An unbiased and probability-weighted amount that is determined by evaluating a
range of possible outcomes;
(b)
The time value of money; and
(c)
Reasonable and supportable information that is available without undue cost and
effort at the reporting date about past events, current conditions and forecasts of future
economic conditions.
5.7.6 Trade receivables, contract assets and lease receivables
A simplified approach is permitted for trade receivables, contract assets and lease receivables.
For trade receivables or contract assets that do not have a significant IFRS 15 financing
element, the loss allowance is measured at the lifetime expected credit losses, from initial
recognition (IFRS 9: para. 5.5.15).
For other trade receivables and contract assets and for lease receivables, the entity can choose (as
a separate accounting policy for trade receivables, contract assets and for lease receivables) to
apply the three stage approach or to recognise an allowance for lifetime expected credit
losses from initial recognition (IFRS 9: para. 5.5.15).
5.8 Hedging (IFRS 9)
Companies enter into hedging transactions in order to reduce business risk. Where an item in the
statement of financial position or future cash flow is subject to potential fluctuations in value that
could be detrimental to the business, a hedging transaction may be entered into. The aim is that
where the item hedged makes a financial loss, the hedging instrument would make a gain and vice
versa, reducing overall risk.
Illustration 3
Pumpkin acquired inventories of coffee beans on 30 November 20X6 for their fair value of
$1.3 million. It is worried that the fair value will fall, so has entered into a futures contract to
sell the coffee for its current fair value in 3 months' time.
At the year ended 31 December 20X6, the fair value of the coffee is $1.2 million.
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At the reporting date:
Inventories
Futures
With no hedging
With no hedging
• Assuming net realisable value is
equal to fair value, a loss of
$0.1m would be recognised in
profit or loss
• N/A
With hedging
• The loss on the inventories of
$0.1m would be recognised
whether or not their fair value
has been hedged
With hedging
Offsets
• The gain on the futures contract
is $0.1m as the contract allows
the holder to sell at $0.1m more
than market value ($1.2m)
• The gain would be reported in
profit or loss
• The loss would be reported in
profit or loss
Adopting the hedge accounting provisions of IFRS 9 is mandatory where the hedging relationship
meets all of the following criteria (IFRS 9: para. 6.4.1):
(a)
The hedging relationship consists only of eligible hedging instruments and eligible
hedged items;
(b)
It was designated at its inception as a hedge with full documentation of how this
hedge fits into the company's strategy;
(c)
The hedging relationship meets all of the following hedge effectiveness requirements:
(i)
There is an economic relationship between the hedged item and the hedging
instrument ie the hedging instrument and the hedged item have values that generally
move in the opposite direction because of the same risk, which is the hedged risk;
(ii)
The effect of credit risk does not dominate the value changes that result from
that economic relationship ie the gain or loss from credit risk does not frustrate the effect
of changes in the underlyings on the value of the hedging instrument or the hedged
item, even if those changes were significant; and
(iii)
The hedge ratio of the hedging relationship (quantity of hedging instrument vs
quantity of hedged item) is the same as that resulting from the quantity of the hedged
item that the entity actually hedges and the quantity of the hedging instrument that
the entity actually uses to hedge that quantity of hedged item.
Practically however, hedge accounting is effectively optional in that an entity can choose whether
to set up the hedge documentation at inception or not.
An entity discontinues hedge accounting when the hedging relationship ceases to meet the
qualifying criteria, which also arises when the hedging instrument expires or is sold, transferred
or exercised (IFRS 9: para. 6.5.6).
5.8.1 Types of hedges
IFRS 9 identifies different types of hedges which determines their accounting treatment. The hedges
examinable are:
(a)
(b)
Fair value hedges; and
Cash flow hedges.
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Fair value hedges
These hedge the change in value of a recognised asset or liability (or unrecognised firm commitment)
that could affect profit or loss (IFRS 9: para. 6.5.2), eg hedging the fair value of fixed rate loan notes
due to changes in interest rates.
All gains and losses on both the hedged item and hedging instrument are recognised as follows
(IFRS 9: para. 6.5.8):
(a)
Immediately in profit or loss (except for hedges of investments in equity instruments held at
fair value through other comprehensive income).
(b)
Immediately in other comprehensive income if the hedged item is an investment in
an equity instrument held at fair value through other comprehensive income.
This ensures that hedges of investments of equity instruments held at fair value through other
comprehensive income can be accounted for as hedges.
In both cases, the gain or loss on the hedged item adjusts the carrying amount of the hedged item.
Cash flow hedges
These hedge the risk of change in value of future cash flows from a recognised asset or liability (or
highly probable forecast transaction) that could affect profit or loss (IFRS 9: para. 6.5.2), eg hedging
a variable rate interest income stream. The hedging instrument is accounted for as follows (IFRS 9:
para. 6.5.11):
(a)
The portion of the gain or loss on the hedging instrument that is effective (ie up to the value
of the loss or gain on cash flow hedged) is recognised in other comprehensive income
('items that may be reclassified subsequently to profit or loss') and the cash flow hedge
reserve.
(b)
Any excess is recognised immediately in profit or loss.
The amount that has been accumulated in the cash flow hedge reserve is then accounted for as
follows (IFRS 9: para. 6.5.11):
(a)
If a hedged forecast transaction subsequently results in the recognition of a non-financial
asset or non-financial liability, the amount shall be removed from the cash flow
reserve and be included directly in the initial cost or carrying amount of the asset or
liability.
(b)
For all other cash flow hedges, the amount shall be reclassified from other
comprehensive income to profit or loss in the same period(s) that the hedged
expected future cash flows affect profit or loss.
5.9 IFRS 7 Financial Instruments: Disclosure
IFRS 7 requires entities to make extensive disclosures in relation to financial instruments, which we
will recap briefly here. The standard requires qualitative and quantitative disclosures about exposure
to risks arising from financial instruments and specifies minimum disclosures about credit risk,
liquidity risk and market risk.
Two types of disclosure need to be made: about the significance of the financial instruments, and
about the nature and extent of risks arising from the financial instruments (IFRS 7: paras. 7
and 31).
Stakeholder perspective
The disclosures in IFRS 7 are extensive but important. They provide investors and other stakeholders
with additional information that may affect their assessment of the entity's financial position, financial
performance and its ability to generate future cash flows. Disclosures are required to enable users to
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see the judgments and accounting choices management has made in applying IFRS 9 and IAS 32
and how those have affected the financial statements.
5.10 Business risk
Financial instruments may help to reduce business risk if used well, but their inherent complexity may
increase business risk. This is particularly likely where management:

Does not fully understand the risks of using financial instruments and has insufficient
skills and experience to manage those risks;

Does not have the expertise to value them appropriately in accordance with IFRS;

Does not have sufficient controls in place over financial instrument activities; or

Inappropriately hedges risks or speculates.
5.11 Auditing financial instruments
Financial instruments involve a lot of complexity. This means that they are a higher risk area in terms
of incorrect accounting either due to a lack of competence or due to a lack of integrity.
Potential ethical issues to consider include:

Misclassification of financial assets and financial liabilities to achieve a desired accounting
effect

Manipulation of profits using the estimations in the allowance for expected credit losses

Accounting for certain financial instruments as hedges (and reducing losses, by offsetting
'hedging' gains against them) when they do not meet the criteria to be classified as hedging
instruments
5.11.1 Audit risk
Audit risk will probably be increased by the presence of complex financial instruments because:

It may be difficult to understand the nature of financial instruments and what they are
used for, and the risks to which the entity is exposed;

Market sentiment and liquidity can change quickly, placing pressure on management to
manage their exposures effectively;

Evidence supporting valuation may be difficult to obtain;

There may be large individual
misappropriation of assets;

The amounts in the financial statements may not be proportionate to the level of risk
involved; and

There may be undue reliance on a few key employees, who may exert significant influence on
the entity's financial instruments transactions, and whose compensation may be linked to the
performance of these instruments. This may be a risk of fraudulent financial reporting.
payments,
which
may
increase
the
risk
of
(IAPN 1000: para. 70)
IAPN 1000 notes that 'the need for professional scepticism increases with the complexity of
financial instruments' (IAPN 1000: para. 72).
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It is important to realise, however, that financial instruments do not always result in high audit risk. If
the entity is making use of simple financial instruments, eg loans or bonds, then these can be audited
without any particular difficulties. The International Auditing Practice Note (IAPN) lists the following
factors as affecting the risk of material misstatement:

The volume of financial instruments to which the entity is exposed

The terms of the financial instrument, including whether the financial instrument itself
includes other financial instruments

The nature of the financial instruments
5.11.2 Audit planning
Where financial instruments are present, the auditor should focus on the following matters.
Financial instruments – matters to focus on in audit planning (IAPN 1000)
Understanding the accounting and disclosure requirements (ie Section 5.2)
Understanding the financial instruments to which the entity is exposed, and their purpose
and risks
Determining whether specialised skills and knowledge are needed in the audit
Understanding and evaluating the system of internal control in light of the entity's financial
instrument transactions and the information systems that fall within the scope of the audit
Understanding the nature, role and activities of the internal audit function
Understanding management's process for valuing financial instruments, including whether
management has used an expert or a service organisation
Assessing and responding to the risk of material misstatement
The auditor must decide to what extent internal controls can be relied upon. The IAPN points out
that entities with a high volume of trading are more likely to have sophisticated controls (which might
be relied on), whereas entities with a low volume of trading will probably have to be audited
substantively in this area.
5.12 Audit procedures
5.12.1 General procedures
Analytical procedures are unlikely to be used as substantive procedures here (they are high-level,
and may fail to pick up on risks arising from the complexity of the financial instruments).
IAPN 1000 suggests the following procedures for testing completeness, accuracy and existence.
Procedures on completeness, accuracy and existence (IAPN 1000)
External confirmation of bank accounts, trades and custodian statements – eg direct
confirmation with the counterparty
Reviewing reconciliations of statements or data feeds from custodians (eg investment funds) with
the entity's own records
Reviewing journal entries and the controls over the recording of such entries
Reading individual contracts and reviewing supporting documentation of the entity's financial
instrument transactions, including accounting records
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Procedures on completeness, accuracy and existence (IAPN 1000)
Testing controls, eg by reperforming controls
Reviewing the entity's complaints management systems
Reviewing master netting arrangements to identify unrecorded instruments
5.12.2 Procedures relating to valuation
Where financial instruments are held at fair value (in accordance with Sections 5.2.1–2), they must
be valued. This is one of the riskiest aspects of auditing them. In developing a valuation,
management may do any of three things:
(a)
(b)
(c)
Utilise information from third-party pricing sources eg a broker
Gather data to develop their own estimate using various techniques, including models
Engage an expert to develop an estimate
The following procedures apply generally.
Procedures on valuations of financial instruments (IAPN 1000)
Test how management made the accounting estimate and the data used. Check that fair
value is arrived at in accordance with IFRS 13, using the 'fair value hierarchy'.
Test the operating effectiveness of the controls over how management made the accounting
estimate, together with appropriate substantive procedures.
Develop a point estimate or a range to evaluate management's point estimate, eg the auditor
can make their own estimate of the fair value.
Determine whether events occurring up to the date of the auditor's report provide audit
evidence regarding the accounting estimate eg are there any indicators of impairment?
Where management has taken option (a) above (use information from a third party), the following
considerations apply:

The type of third-party pricing source – How much information is available about the
valuation?

The nature of inputs used and the complexity of the valuation technique – eg are inputs
Level 1 or Level 3 inputs, per IFRS 13?

The reputation and experience of the third-party pricing source – Does their experience
include this specific type of financial instrument?

The entity's controls over the use of third-party pricing sources – Has the entity assessed
whether the third party is reliable?

The third-party pricing source's controls
(IAPN 1000: para. 117)
When management uses its own model ((b), above), there are two basic audit approaches. Either
test management's model, or develop your own model (IAPN 1000: para. 123).
Finally, management may use a management's expert ((c), above). In this case ISA 500 applies,
and procedures may include:



Evaluating the competence, capabilities and objectivity of management's expert
Obtaining an understanding of the work of the management's expert
Evaluating the appropriateness of that expert's work as audit evidence (ISA 500)
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5.12.3 Disclosures
IFRSs require extensive disclosures about financial instruments, and there is a risk that these have not
been made. Check that disclosures comply with IFRS 7 and IFRS 9. This includes eg qualitative
disclosures about exposure to risk and risk management, and quantitative disclosures of summary
data about exposures.
Activity 2: Financial instruments
On 1 January 20X8, Daniel Co issued a $20 million debenture at par, with a nominal rate of interest
of 4%. The debenture is redeemable in five years' time, at which point the holder will have the option
to convert the debenture to 12 million $1 ordinary shares in Daniel Co. The debenture has been
recorded in the financial statements as a long-term liability at the net proceeds of issue. The first
payment of interest on 31 December 20X8 has also been recorded.
Required
(a)
(b)
Identify the audit issues.
List the audit procedures you would perform.
6 Investment property
A key factor to consider when auditing investment properties is whether one exists according to the
criteria of IAS 40 Investment Property.
Key term
Investment property (IAS 40: para 5): Property (land or building – or part of a building – or
both) held (by the owner or by the lessee as a right-of-use asset) to earn rentals or for
capital appreciation or both, rather than for:
(a)
(b)
Use in the production or supply of goods or services or for administrative purposes; or
Sale in the ordinary course of business.
Type of non-investment property
Applicable IAS
Property held for sale in the ordinary course of
business
IAS 2 Inventories
Owner-occupied property
IAS 16 Property, Plant and Equipment
Property leased to another entity under a finance
lease
IFRS 16 Leases
6.1 Recognition and measurement
Investment property is recognised when it is probable that future economic benefits will flow to the
entity and the cost can be measured reliably.
Investment property should be measured initially at cost, including directly attributable expenditure
and transaction costs (IAS 40: para. 21).
After recognition, entities can choose between two models, the fair value model and the cost model.
Whatever policy an entity chooses should be applied to all of its investment property (IAS 40: para.
30).
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Fair value model
Any change in fair value reported in profit or loss, not depreciated
Cost model
As cost model of IAS 16 – unless held for sale (IFRS 5) or leased
(IFRS 16)
6.2 Transfers to or from investment property
Transfers to or from investment property should only be made when there is a change in use.
A change in use occurs when the property meets, or ceases to meet, the definition of investment
property and there is evidence of the change in use (IAS 40: para. 57). For example, owner
occupation commences so the investment property will be treated under IAS 16 as an owneroccupied property.
In isolation, a change in management's intentions for the use of a property does not provide
evidence of a change in use (IAS 40: para. 57).
Accounting treatment
Transfer from investment
property to owner-occupied
or inventories
• Cost for subsequent accounting is
fair value at date of change of
use
• Apply IAS 16, IAS 2 or IFRS 16
as appropriate after date of
change of use
Transfer from
owner-occupied to
investment property
• Apply IAS 16 or IFRS 16 (for
property held by a lessee as
right-of-use asset) up to date of
change of use
• At date of change, property
revalued to fair value
• At date of change, any difference
between the carrying amount
under IAS 16 or IFRS 16 and its
fair value is treated as a
revaluation under IAS 16
6.3 Disposals
Any gain or loss on disposal of investment property is the difference between the net disposal
proceeds and the carrying amount of the asset. It should be recognised as income or expense
in profit or loss (unless IFRS 16 requires otherwise on a sale and leaseback).
6.4 Auditing investment property: substantive tests

Confirm that property meets the IAS 40 definition of investment property (ie it is held to earn
rentals or for capital appreciation, or for both)

Inspect rental agreements, ensuring that occupier is not a connected company and that the
rent has been negotiated at arm's length
The second important assertion in relation to investment properties is valuation. IAS 40 requires
that investment properties either be held at cost or at fair value (IAS 40: para. 30). This
approximates to open market value. Fair value should be determined in accordance with IFRS 13
Fair Value Measurement.
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The last key issue with regard to investment properties is disclosure. The auditor should review the
disclosures made in the financial statements in relation to investment properties to ensure that they
have been made appropriately, in accordance with IAS 40.
7 Foreign exchange rates
The presence of foreign exchange is likely to increase audit risk, so the auditor must perform
procedures to reduce this risk.
You will have studied the accounting rules in relation to foreign exchange in depth for your SBR
exam (formerly Paper P2). At AAA level you will need to revise this material, and then think about
the area from the perspective of the external auditor. The key issue here is that the introduction of
foreign exchange into a scenario increases the level of audit risk. This is most likely to be examined
in the context of a group that includes an overseas subsidiary.
7.1 Individual company
Perhaps the most immediate audit risk here is that the entity fails to comply with the accounting
requirements of IAS 21 The Effects of Changes in Foreign Exchange Rates. For an individual
company conducting trade in foreign currencies, there are two separate accounting issues:
conversion and translation.
Conversion is uncontroversial, and relates to an entity conducting transactions in a foreign currency,
and which incurs exchange gains/losses in relation to these transactions. The rule is simple: the gain
or loss on conversion is recognised directly in profit or loss in the period in which it occurs. The
principal risk here is of the wrong exchange rate being used, resulting in misstatement of the
gain/loss in the financial statements.
Translation is more complex. Translation is required at the end of an accounting period when a
company still holds assets or liabilities in its statement of financial position which were obtained or
incurred in a foreign currency. IAS 21 distinguishes between monetary items and nonmonetary items. The basic rule is that monetary items (eg cash, receivables) should be
retranslated using the rate ruling at the end of each accounting period. Non-monetary items are left
at the amount recognised at the date of the transaction (IAS 21: para. 23).
Audit procedures here would therefore include:

Check that foreign currency transactions are recorded at the historical rate on initial
recognition (and in the statement of profit or loss)

Check that monetary items included in the statement of financial position at the year end are
translated at the closing rate of exchange

Check that non-monetary items are translated at the historical rate of exchange
7.2 Groups
It is also possible that a parent company may have overseas subsidiaries. It must translate the
financial statements of those operations into its own reporting currency before they can be
consolidated into group accounts. There are two methods of achieving this. The method used
depends on whether the foreign operation has the same functional currency as the parent.
7.2.1 Same functional currency as the reporting entity
In this situation the foreign operation normally carries on its business as though it were an extension
of the reporting entity's operations.
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We can summarise the treatment as follows:
Statement of profit or loss
Translate using actual rates. An average for a period may be
used but not where there is a significant fluctuation and the
average is therefore unreliable.
Non-monetary items
Translate using a historical rate at the date of purchase (or
revaluation to fair value, or reduction to realisable/recoverable
amount). This includes inventories and long-term assets (and
their depreciation).
Monetary items
Translate at the closing rate
Exchange differences
Report as part of profit for the year
7.2.2 Different functional currency from the reporting entity
In this situation, although the reporting entity may be able to exercise control, the foreign operation
normally operates in a semi-autonomous way. It accumulates cash and other monetary items,
generates income and incurs expenses, and may also arrange borrowings, all in its own local
currency.
We can summarise the treatment as follows.
Assets and liabilities
Translate at the closing rate at the period end. (The balancing
figure on the translated statement of financial position represents
the reporting entity's net investment in the foreign operation.)
Statement of profit or loss
Translate items at the rate ruling at the date of the transaction (an
average rate will usually be used for practical purposes)
Exchange differences
Taken to equity
7.3 Other issues
The table below outlines some of the other audit risks that may be present with an overseas
subsidiary, along with some possible audit procedures to mitigate those risks.
Audit risk
Procedures
Potential misstatement due to the effects of high
inflation. IAS 29 requires financial statements to
be restated in terms of measuring units current at
the end of the reporting period, and a gain
or loss on the net monetary position included
within net income

Confirm that financial statements have
been correctly restated

Check that disclosures have been made in
line with IAS 29
Subsidiary may have been audited by
component auditors
Need to consider the extent to which their
work can be relied on, as per ISA 600
Different accounting framework may have
been used by subsidiary
Confirm the accounting framework used, and
that accounting policies are consistent with the
rest of the group
Possible difficulty in the parent being able to
exercise control, eg due to political instability,
or laws and regulations
Need to consider whether there is still
control, and whether it is correct to produce
group accounts per IFRS 3
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Audit risk
Procedures
Currency restrictions limiting payment of
profits to the parent

Need to consider whether there is still
control

Need to consider impact on parent's
status as a going concern
8 Revenue from contracts with customers
IFRS 15 Revenue from Contracts with Customers was issued in May 2014, when it superseded both
IAS 18 Revenue Recognition and IAS 11 Construction Contracts. IFRS 15 unified accounting for
these areas with a single five-step model for all contracts with customers. The standard was a result of
co-operation between the IASB and the FASB, and is a step towards the harmonisation of accounting
standards.
IFRS 15 conceives of a contract as a series of 'performance obligations' which are then transferred to
the customer (whether goods or services). The transfer of goods and services is then understood in
terms of the transfer of control, rather than of risks and rewards as in the old IAS 18. Control of
an asset is described in the standard as the ability to direct the use of, and obtain substantially all
the remaining benefits from, the asset.
For straightforward retail transactions, IFRS 15 will have little, if any, effect on the amount and timing
of revenue recognition. For contracts such as long-term service contracts and multi-element
arrangements, it could result in changes either to the amount or to the timing of revenue recognised.
8.1 Definitions
Key terms
Contract: An agreement between two or more parties that creates enforceable rights and
obligations.
Customer: A party that has contracted with an entity to obtain goods or services that are an output
of the entity's ordinary activities in exchange for consideration.
Income: Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in an increase in equity, other than those
relating to contributions from equity participants.
Performance obligation: A promise in a contract with a customer to transfer to the customer
either:

A good or service (or a bundle of goods or services) that is distinct; or

A series of distinct goods or services that are substantially the same and that have the same
pattern of transfer to the customer.
Revenue:. Income arising in the course of an entity's ordinary activities.
Transaction price: The amount of consideration to which an entity expects to be entitled in
exchange for transferring promised goods or services to a customer, excluding amounts collected on
behalf of third parties.
(IFRS 15: Appendix A)
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The following box summarises the main requirements of IFRS 15:
IFRS 15 Revenue from Contracts with Customers
There are five steps in recognising revenue:
Step 1 Identify the contract(s) with a customer
A contract with a customer is within the scope of IFRS 15 only when:
(a)
(b)
(c)
(d)
(e)
The parties have approved the contract and are committed to carrying it out
Each party's rights regarding the goods and services to be transferred can be identified
The payment terms for the goods and services can be identified
The contract has commercial substance
It is probable that the entity will collect the consideration to which it will be entitled
The contract can be written, verbal or implied.
Contracts should be combined when the following criteria are met:
(a) The contracts are negotiated as a package with a single commercial objective.
(b) The amount of consideration to be paid in one contract depends on the price or performance of
the other contract.
(c)
The goods or services promised in the contracts are a single performance obligation.
Step 2 Identify the performance obligations in the contract
The key point is distinct goods or services. A contract includes promises to provide goods or services
to a customer. Those promises are called performance obligations. A company would account for a
performance obligation separately only if the promised item or service is distinct. An item or service
is distinct if it is sold separately or if it could be sold separately because it has a distinct function and
a distinct profit margin.
Step 3 Determine the transaction price
The transaction price is the amount of consideration a company expects to be entitled to from the
customer, in exchange for transferring goods or services. The transaction price would reflect the
company's probability-weighted estimate of variable consideration (including reasonable
estimates of contingent amounts) in addition to the effects of the customer's credit risk and the time
value of money (if material). Variable contingent amounts are only included where it is highly
probable that there will not be a reversal of revenue when any uncertainty associated with the
variable consideration is resolved.
Step 4 Allocate the transaction price to the performance obligations in the contract
Where a contract contains more than one distinct performance obligation, a company allocates the
transaction price to all separate performance obligations in proportion to the stand-alone selling
price of the item or service underlying each performance obligation. If the item or service is not sold
separately, the company would estimate its stand-alone selling price.
So, if any entity sells a bundle of goods and/or services which it also supplies unbundled, the
separate performance obligations in the contract should be priced in the same proportion as the
unbundled prices. This would apply to mobile phone contracts where the handset is supplied 'free'.
The entity must look at the stand-alone price of such a handset and some of the consideration for the
contract should be allocated to the handset.
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Step 5 Recognise revenue when (or as) the entity satisfies a performance obligation
The entity satisfies a performance obligation by transferring control of a promised item or service to
the customer. A performance obligation can be satisfied at a point in time, such as when goods are
delivered to the customer, or over time. An obligation satisfied over time will meet one of the
following criteria:

The customer simultaneously receives and consumes the benefits as the performance takes
place.

The entity's performance creates or enhances an asset that the customer controls as the asset is
created or enhanced.

The entity's performance does not create an asset with an alternative use to the entity and the
entity has an enforceable right to payment for performance completed to date.
The amount of revenue recognised is the amount allocated to that performance obligation in Step 4.
An entity must be able to reasonably measure the outcome of a performance obligation before the
related revenue can be recognised. In some circumstances, such as in the early stages of a contract,
it may not be possible to reasonably measure the outcome of a performance obligation, but the entity
expects to recover the costs incurred. In these circumstances, revenue is recognised only to the extent
of costs incurred.
Contract costs
The incremental costs of obtaining a contract (such as sales commission) are recognised as an asset
if the entity expects to recover those costs.
Satisfaction of performance obligations
Revenue is recognised when the performance obligation is satisfied. This is when the promised item
or service is transferred and the customer has control.
Performance obligations satisfied at a point in time (the subject of the old IAS 18) are
recognised when control is transferred:
(a)
(b)
(c)
(d)
(e)
The entity has a present right to payment for the asset.
The customer has legal title to the asset.
The entity has transferred physical possession of the asset.
The significant risks and rewards of ownership have been transferred to the customer.
The customer has accepted the asset.
Alternatively, performance obligations may be satisfied over time ('construction contracts'
under the old IAS 11). These are accounted for at an amount that approximates the selling price of
the goods or services transferred to date. The entity must choose an appropriate method for
estimating the amount of performance completed to date.
Methods include output methods and input methods:

Output methods recognise revenue on the basis of the value to the customer of the goods or
services transferred. They include surveys of performance completed, appraisal of units
produced or delivered etc.

Input methods recognise revenue on the basis of the entity's inputs, such as labour hours,
resources consumed, costs incurred. If using a cost-based method, the costs incurred must
contribute to the entity's progress in satisfying the performance obligation.
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Sale with a right of return
If there is a right of return then the goods which are expected to be returned are not recognised in
revenue. This may be calculated using expected values.
Warranties
If a customer has the option to purchase a warranty separately from the product to which it relates, it
constitutes a distinct service and is accounted for as a separate performance obligation.
Principal versus agent
If the entity acts as the principal (ie controls the goods or services before they are transferred to the
customer) then revenue is recognised as normal.
The entity acts as an agent if its performance obligation is to arrange for the provision of goods or
services by another party. Satisfaction of this performance obligation will give rise to the recognition
of revenue in the amount of any fee or commission to which it expects to be entitled in exchange for
arranging for the other party to provide its goods or services.
Repurchase agreements
Repurchase agreements generally come in three forms:
(a) An entity has an obligation to repurchase the asset (a forward contract).
(b) An entity has the right to repurchase the asset (a call option).
(c) An entity must repurchase the asset if requested to do so by the customer (a put option).
In the case of a forward or a call option, the customer does not obtain control of the asset, even if it
has physical possession. The entity will account for the contract as:
(a) A lease in accordance with IFRS 16, if the repurchase price is below the original selling price;
or
(b) A financing arrangement if the repurchase price is equal to, or greater than, the original selling
price. In this case, the entity will recognise both the asset and a corresponding liability.
If the entity is obliged to repurchase at the request of the customer (a put option), it must consider
whether or not the customer is likely to exercise that option.
Consignment arrangements
When a product is delivered to a customer under a consignment arrangement, the customer (dealer)
does not obtain control of the product at that point in time, so no revenue is recognised upon
delivery.
Presentation
A contract liability is recognised in the statement of financial position where a customer has paid
an amount of consideration prior to the entity performing by transferring control of the related item or
service to the customer.
When the entity has performed but the customer has not yet paid the related consideration, this will
give rise to either a contract asset or a receivable. A contract asset is recognised when the
entity's right to consideration is conditional on something other than the passage of time, for instance
future performance. A receivable is recognised when the entity's right to consideration is
unconditional except for the passage of time.
In practice, this aligns with the previous IAS 11 treatment. Where revenue has been invoiced, a
receivable is recognised. Where revenue has been earned but not invoiced, it is recognised as a
contract asset.
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8.2 Audit of revenue
Revenue is commonly audited using analytical procedures. This is because revenue should be
predictable, and because there are good grounds on which to base analytical procedures, such as:

Plenty of information, for example, last year's accounts, budgets, monthly analyses (companies
tend to keep a lot of information about sales)

Logical relationships with items such as inventory and receivables
Analytical procedures may be less reliable where controls testing indicates that revenue controls are
deficient. In this case, the auditor may place more reliance on tests of detail.
Unless complex transactions arise, where revenue is not as clear cut as a product being supplied and
invoiced for, revenue recognition is generally not an issue. However, it should not be thought that
revenue recognition is generally a low-risk area to audit. Far from it: revenue recognition is one
of the most common areas of fraudulent financial reporting. Indeed, ISA 240 The
Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements states that the auditor
should presume that there is a risk of fraud in relation to revenue recognition (ISA 240: para. 26),
and should obtain an understanding of the controls related to these risks (ISA 240: para. 27). This
presumption is 'rebuttable' (ISA 240: para. A30) if the auditor concludes that there is no risk of
material misstatement due to fraud, but unless this is the case, the auditor must presume that there is a
possibility of revenue recognition fraud, and that the entity should have put in place controls to
mitigate this risk.
An example of difficulties in this area was those experienced by the UK grocer Tesco, when a
serious misstatement was discovered in relation to revenue in the interim financial statements. This
was mainly due to recognising income too soon and costs too late, with the result that profit was
overstated by approximately £250m.
The FRC in the UK recently reported that of the audits in which its inspectors found problems, 20% of
those were with revenue recognition alone (FRC, 2016b: p.12). Alongside fair value assessments,
this is a major area of difficulty for auditors.
Where performance obligations are satisfied over time, there may also be assets/liabilities in the
statement of financial position. In industries dealing primarily in long-term contracts, revenue
recognition can be a material issue. Examples of industries where this might be true are the:


Building industry
Engineering industry
The following audit procedures may provide a starting point for exam questions in this area.
Audit procedures
Performance obligations satisfied at a point in time:

Substantive procedures, eg agree revenue recognised to relevant documents (for example, work
certificates or contracts)

Analytical procedures, such as comparison with:

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–
Prior year and with budgets
–
Related figures such as inventory and receivables
–
Similar industry information, eg comparison of the receivables days with industry averages
or with other entities of comparable size in the same industry
Analytical procedures based on operational factors, eg the prediction of total rental income on
a building divided into apartments, taking the rental rates, the number of apartments and
vacancy rates into consideration
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Performance obligations satisfied over time:

Obtain a copy of the calculation of revenue recognised in the period and recalculate, including
any assets/liabilities recognised.

Assess whether the basis of calculation is comparable with prior years.

Confirm that the method for measuring progress for performance obligations is appropriate and
reasonable in line with IFRS 15.

Verify the figures in the calculation, such as:
–
Total contract price to original contract
–
Revenue to amount of performance completed to date
–
Performance completed to date to input methods, such as certification of work completed,
cost of work completed (eg to invoices also payroll/clock cards/wage rates)
–
Receivables to sales invoices
–
Payments on account to remittance advices
From the auditor's point of view, the performance completed to date and the assessment of
the overall profitability of the contract are particularly risky areas to audit, as they
involve management exercising its judgment. Where this is the case, procedures would include
discussion with management to obtain an understanding of (and to evaluate) any underlying
assumptions used; review of subsequent events; use of an auditor's expert; and obtaining written
representations.
Illustration 1: Revenue recognition in an e-commerce environment
Companies that engage in e-commerce may have particular revenue recognition issues.
The entity may act as a principal or as an agent. They must determine whether to disclose their
gross revenue, or merely their commission. For example, Lastminute.com discloses a figure 'TTV',
which does not represent statutory revenue, but the price at which goods and services have been
sold across the group's platforms. Revenue itself is largely made up of commission on selling those
goods and services.
The company may engage in reciprocal arrangements with other companies whereby they both
advertise on each other's website. Whether such an arrangement results in 'revenue' must be
considered. It must then be accounted for appropriately.
The company may deal in unusual discounts or voucher systems to encourage customers to buy.
These must also be reflected.
Lastly, the company must determine a policy for cut-off. This may be complex if the company acts
as an agent. When is the sale made? When the customer clicks 'accept', when the company emails
acknowledgement, when the sale is made known to the principal, when the goods are despatched,
when the customer receives the goods, when the customer has taken advantage of the services…?
The company must determine a reasonable policy for when the sale has been made.
Satyam Computer Services Ltd, a major Indian provider of IT services, was the subject of a major
accounting scandal that has sometimes been referred to as 'India's Enron'.
Satyam manipulated its financial statements over a period of about seven years, when the public
announcement was made that the accounts had been falsified. A number of methods were used to
do this, including producing false invoices, which inflated reported revenue and led to the creation of
significant fictitious assets in the statement of financial position.
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Satyam's auditors failed to detect this fraud, which had an ongoing and highly material impact on
the financial statements. As a result of their failure to conduct the audit properly, and of the broader
failure of quality control of which this was symptomatic, five Indian affiliates of
PricewaterhouseCoopers were given a record fine of $7.5m by the Securities and Exchange
Commission in the US. The firms were also required to set up employee training programmes, to
reform audit policies, and to appoint an independent monitor.
It is important to note that this is not a question of auditors being held liable for audit failings, but
rather of auditors being fined by a regulatory body for failing to conduct audits in accordance with
the required standards.
Activity 3: Revenue recognition and other matters
The senior partner of JLPN, a firm of auditors, has issued an Audit Risk Alert letter to all partners
dealing with key areas of concern which should be given due consideration by their firm when
auditing public companies. The letter outlines certain trends in audit reporting that, if not scrutinised
by the auditors, could lead to a loss of reliability and transparency in the financial statements. The
following three key concerns were outlined in the letter:
(a)
Audit committees play a very important role, together with the financial director and auditor,
in achieving high quality financial control and auditing. Recently, the efforts of certain audit
committees have been questioned in the press.
(b)
The Stock Exchange had reported cases of inappropriate revenue recognition practices,
including:
(c)
(i)
Accelerating revenue prior to the delivery of the product to the customer's site, or prior
to the completion of the terms of the sales arrangement
(ii)
Recognition of revenue when customers have unilateral cancellation or termination
provisions, other than the normal customary product return provisions
It has been reported that the management of companies had intentionally violated
International Financial Reporting Standards (IFRS). The reason for this has been the sensitivity
of reported earnings per share (EPS) in a marketplace where missing the market's expectation
of EPS by a small amount could have significant consequences.
Required
(a)
Explain the importance of the role of an Audit Risk Alert letter to a firm of auditors.
(b)
Discuss the way in which the auditor should deal with each of the key concerns outlined in the
letter in order to ensure that audit risk is kept to an acceptable level.
9 Government grants and assistance
Government grants and assistance are accounted for under IAS 20 Accounting for Government
Grants and Disclosure of Government Assistance. They may be either revenue or capital grants
relating to the assets or income.
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance

Only recognise grants when reasonable assurance that:
–
–

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Entity will comply with any conditions attached
Entity will actually receive the grant
Capital approach (credit grant directly to shareholders' interests) or
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Income approach (credit grant to P/L over one or more periods)
(IAS 20: para. 24)

IAS 20 states income approach must be used
(IAS 20: para. 12)

Grants related to assets:
–
–

Set up grant as deferred income or
Deduct grant in arriving at carrying amount of asset
Disclosures:
–
–
–
Accounting policy adopted
Nature and extent of government grants recognised
Unfulfilled conditions and other contingencies
(IAS 20: para. 39)
Grants where related costs have already been incurred, offer no difficulties to account for or to
audit. To audit them, the auditor should:

Obtain documentation relating to the grant and confirm that it should be classified as revenue

Agree the value to documentation (eg a letter outlining the details of the grant, or a copy of an
application form sent by the client)

Agree receipt of the grant to bank statements
Capitalised grants can be more difficult to audit, particularly if a non-monetary government grant
is being accounted for at fair value.
Audit procedures:

Consider whether the basis of accounting is comparable to the previous year.

Discuss the basis of accounting with the directors to ensure that the method used is the best
method.

Ensure that any changes in accounting method are disclosed.
10 Leases
Fair value is a key issue when considering certain liabilities. This should be borne in mind when
auditing liabilities.
IFRS 16 Leases was issued in January 2016, superseding the old IAS 17. IFRS 16 aims to bring
leases that were previously off-balance sheet, back on. It was widely thought that companies were
taking advantage of the old standard, and in particular the distinction between long-term leases (that
were on the balance sheet) and short-term leases (that were off it). By obtaining an asset on a shortterm 'operating lease', a company would still have the benefit of the asset but would be able to keep
the liability off its balance sheet (statement of financial position). You could think of IFRS 16 as simply
expanding the treatment that used to be reserved for finance leases – bringing them on-balance
sheet, with both an asset and a liability – to all leases.
IFRS 16 was the outcome of a joint project between the IASB and the FASB (from the United States),
although the two standard-setters did not agree on an approach, with the FASB choosing to retain
the distinction between long-term leases (called 'capital leases') and short-term leases ('operating
leases').
In a way, IFRS 16 does still retain this distinction by making an exception for very short-term leases
and leases of low-value assets. It is expected, though, that most assets that were formerly held on
'operating leases' will now be brought onto the balance sheet.
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Here is a summary of IFRS 16's requirements for lessees:
IFRS 16 Leases
Objective
To provide relevant information that faithfully represents (IFRS 16: para. 1).
Faithful representation is related to the old principle of 'substance over form'.
Exceptions
Some leased assets are exempt from the IFRS 16 treatment (IFRS 16: para. 5):
(a) Short-term leases (< 12 months); and
(b) Leases of low value assets.
Lessees of these assets can elect to simply expense the lease payments on a straight line
basis (or another systematic basis).
The same treatment must be applied for all assets within a class, eg all short-term leases must be
treated in the same way.
Low value assets
Examples of low value assets would be: Tablet and personal computers, small items of office furniture
and telephones (IFRS 16: para. B8).
'Low value' is an absolute term, ie it is not a relative % value, but is the same for all entities. It is
not defined by the Standard, but the IASB has indicated that this is up to $5,000 per asset. This is for
the value of a new asset – if the asset is acquired secondhand, then it is still assessed on its value
when new.
Identifying a lease
This is the closest we get to a definition:
A contract is [...] a lease if the contract conveys the right to control the use of an identified asset for a
period of time in exchange for consideration.
(IFRS 16: para. 9)
Control is conveyed where the customer has both the right to direct the identified asset and to obtain
substantially all the economic benefits (IFRS 16: para. B9).
A contract might be for both a lease and something else (such as maintenance). In this case, the
components are accounted for separately, ie the lease part is still accounted for as a lease. To
allocate the consideration between the lease and non-lease parts, the non-lease part is allocated its
'standalone price', and the lease part gets the remainder of the consideration.
Recognition
At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability.
(IFRS 16: para. 22)
Both an asset and a matching liability are recognised.
Measurement
Right-of-use asset
At the commencement date, a lessee shall measure the right-of-use asset at cost.
(IFRS 16: para. 23)
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IFRS 16 requires a cost model for the asset. The cost is calculated as follows (IFRS 16: para. 24).
Amount of lease liability (on initial measurement)
x
Add: any lease payments made at or before commencement date
(or less incentives received)
x
Add: any initial direct costs
x
Add: dismantling costs (estimated)
x
Total
x
Although the cost model is required, IFRS 16 does allow entities to deviate from it in order to be
consistent with their treatment of other similar assets, eg by using the fair value model of IAS 40
Investment Property, or IAS 16's revaluation model.
Lease liability
At the commencement date, a lessee shall measure the lease liability at the present value of the
lease payments that are not paid at that date.
(IFRS 16: para. 26)
The present value of the liability is measured using the implicit interest rate.
The lease liability is therefore initially recognised as follows (IFRS 16: para. 27).
Fixed payments (less incentives receivable)
x
Add: Variable lease payments (which depend on an index/rate)
x
Add: Amounts payable under residual value guarantees
x
Add: The exercise price of a purchase option (if reasonably certain to exercise)
x
Add: Penalties for termination payments, if these will be incurred in line with
lease term
Total
x
x
Re-measurements
Right-of-use asset
Depreciation is charged on the asset, in line with IAS 16's cost model.
Depreciation is charged until the earlier of: the end of the useful life, and the end of the lease term.
(But if there is an option to buy the asset at the end of the lease, it must be depreciated all the way
to the end of its useful life.)
Lease liability
In subsequent periods, the liability is re-measured by (IFRS 16: para. 36):
(a) Adding interest to the liability (implicit interest rate)
(b) Reducing the liability by payments made
(c) Re-measuring for any modifications made, or revised lease payments.
Lease term
The lease term is the non-cancellable period of the lease (IFRS 16: para. 18).
If there is an option to extend or terminate the lease, then the term will include this if it is
reasonably certain that they will be exercised.
Presentation
Statement of financial position: the right-of-use asset may be combined with other assets (in the
same class) on the face of the SoFP, but must be disclosed separately in the notes.
Statement of profit or loss: Interest expense included within finance cost.
Statement of cash flows: Cash payments shown within financing activities.
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Disclosures
IFRS 16 gives a long list of disclosures. Here are the most important:

Depreciation charge for right-of-use assets by class of underlying asset;

Interest expense on lease liabilities;

The expense relating to short-term leases;

The expense relating to leases of low-value assets;

The expense relating to variable lease payments not included in the measurement of
lease liabilities;

Income from subleasing right-of-use assets;

Total cash outflow for leases;

Additions to right-of-use assets;

Gains or losses arising from sale and leaseback transactions; and

The carrying amount of right-of-use assets at the end of the reporting period by class of
underlying asset.
Note. Disclosures are required for when the lease liability will fall due, but these are in line with
IFRS 7 (IFRS 16: para. 58). IFRS 7 requires the entity to use its judgment to determine the best time
bands, ie these could be the old 1 year/2–5 years/after 5 years, but they could be any other
appropriate bands.
Sale and leaseback
The treatment depends on whether the 'sale' qualifies as a sale by satisfying performance obligations
in line with IFRS 15. This means that control must be transferred to the customer.
If the asset is not sold under IFRS 15, then the seller does not 'transfer' the asset and continues to
recognise it as before. The 'sales proceeds' are recognised as a financial liability and accounted for
by applying and recognises a liability in line with IFRS 9 Financial Instruments.
If the transaction does meet IFRS 15 criteria, then any right-of-use that is retained should
continue to be recognised as an asset, as a proportion of the previous carrying amount. A gain or
loss is recognised for the proportion that is sold.
If FV of sale consideration > FV asset, then this is a prepayment of lease terms.
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This flowchart might help you to decide whether a contract is a lease:
Is there an identified asset?
Consider paragraphs B13-B20.
No
Yes
Does the customer have the
right to obtain substantiallly all
of the economic benefits from
use of the asset throughout the
period of use?
Consider paragraphs B21-B23.
No
Yes
Customer
Does the customer, the supplier
or neither party have the right to
direct how and for what
purpose the asset is used
throughout the period of use?
Consider paragraphs B25-B30.
Supplier
Neither; how and for what
purpose the asset will be
used is predetermined
Yes
Does the customer have the right to
operate the asset throughout the
period of use, without the supplier
having the right to change those
operating instructions?
Consider paragraph B24(b)(i).
No
Did the customer design the asset in a
way that predetermines how and for
what purpose the asset will be used
throughout the period of use?
Consider paragraph B24(b)(ii).
No
Yes
The contract contains a lease
The contract does not
contain a lease
(Source: IFRS 16: para. B31)
One of the trickiest parts of IFRS 16 is determining whether or not the contract is a lease at all.
Leases may be found in many contracts that until recently were not treated as leases, so there is a risk
regarding the completeness of leasing transactions – have any been missed out?
The definition of a lease refers to the 'right to control the use' of an asset. Determining whether
there is control involves judgment, which introduces an element of risk for the auditor. Likewise, the
assessment of lease term which requires judgment where there are options for either extension or
termination.
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IFRS 16 requires lease and non-lease components to be separated from one another. For example, a
lease might be for just one part of a building, in which case it is necessary to allocate the
consideration between the part that is leased and the part that is not leased. Again, this requires
judgment and is therefore risky.
Many entities will not want to recognise assets and liabilities for lease transactions, so auditors need
to be alert to the risk of distortion in relation to any of these areas of judgment.
The auditor needs to be alert to the possibility of sale and leaseback transactions. If there is a
sale and leaseback, then you need to check that gains are treated in line with IFRS 16, along with
any prepayments or additional financing.
The following audit procedures are relevant:
Classification and rights and obligations

Obtain a copy of the lease agreement

Review the lease agreement to ensure that the lease term has been determined correctly in line
with IFRS 16
Valuation







Obtain a copy of the client's workings for their lease liabilities
Check the additions and calculations of the workings
Ensure that the implicit interest has been accounted for in accordance with IFRS 16
Recalculate the interest
Agree the opening position
Agree any new assets to lease agreements
Verify lease payments in the year to the bank statements
Disclosure

Ensure the leases have been properly disclosed in the financial statements
Activity 4: Audit of leases
You are the manager responsible for the audit of Dexter Co ('Dexter') for the year ended
31 December 20X2. Dexter has entered a contract to use a retail unit in the Dolphin Centre retail
park for a six-year period from 1 January 20X2. The terms of the contract are:


Six annual instalments of $160,000 payable in arrears
Variable payments at 0.5% of sales from the retail unit
The terms of the contract allow the Dolphin Centre owners to require Dexter to relocate to another
unit. However, they must provide Dexter with another retail unit of similar specifications to the one
being used, and must pay for Dexter's relocation costs. At the inception of the contract, this is
unlikely to happen.
The contract requires Dexter to sell its goods during the Dolphin centre's opening hours. Dexter
decides on the mix and pricing of goods sold from the unit, and the quantities of inventory held.
Dexter makes all of the decisions about the use of the retail unit during the period of use.
The contract has been classified as a lease in the financial statements of Dexter. The asset has been
capitalised in the statement of financial position and is being depreciated straight line over the life of
the lease.
The interest rate implicit in the lease has been calculated at 5%. The lease and a non-current asset
are shown at their initially recognised at a value of $812,160, an amount which was been
calculated correctly.
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The company has total assets of $16,000,000.
Required
Identify and explain the matters to consider in relation to this situation.
Note. You are not required to make any further calculations in relation to the contract.
11 Deferred taxation
Deferred tax is accounted for under IAS 12 Income Taxes. This is revised briefly below.
IAS 12 Income Taxes

Deferred tax is the tax attributable to temporary differences, which are differences between the
carrying amount of an asset or liability in the statement of financial position and its tax base.

Deferred tax liabilities are the amounts of income taxes payable in future periods in respect
of taxable temporary differences. All taxable temporary differences give rise to a deferred tax
liability.

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect
of:
–
–
–
Deductible temporary differences (eg provisions, unrealised profits on intra-group trading)
The carry forward of unused tax losses
The carry forward of unused tax credits
All deductible temporary differences give rise to a deferred tax asset.


Temporary differences are differences between the carrying amount of an asset or liability
in the statement of financial position and its tax base. Temporary differences may be either:
–
Taxable temporary differences, which are temporary differences that will result in
taxable amounts in determining taxable profit (or tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled; or
–
Deductible temporary differences, which are temporary differences that will result in
amounts that are deductible in determining taxable profit (or tax loss) of future periods
when the carrying amount of the asset or liability is recovered or settled.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
(IAS 12: para. 5)
Deferred tax is the tax attributable to timing differences. For example, where a company
'saves tax' in the current period by having accelerated capital allowances, a provision for the
tax charge is made in the statement of financial position.
The provision is made because, over the course of the asset's life, the tax allowances will reduce until
the depreciation charged in the accounts is higher than the allowances. This will result in taxable
profit being higher than reported profit and the company will be 'suffering higher tax' in this period.
11.1 Types of taxable temporary difference
Accelerated capital allowances
The temporary difference is the difference between the carrying value of the asset in the statement of
financial position at the end of the reporting period and its tax depreciated value.
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Interest revenue (where interest is included in profit or loss on an accruals basis but taxed when
received)
The temporary difference is equivalent to the income accrual in the statement of financial position at
the end of the reporting period, as the tax base of the interest receivable is nil.
Development costs (where development costs are capitalised for accounting purposes but
deducted from taxable profit in the period incurred)
The temporary difference is equivalent to the amount capitalised in the statement of financial position
at the end of the reporting period. The tax base is nil since they have already been deducted from
taxable profits.
Revaluation to fair value (in jurisdictions where the tax base of the asset is not adjusted)
The temporary difference is the difference between the asset's carrying value and tax base. A
deferred liability is created, even if the entity does not intend to dispose of the asset.
Fair value adjustments on consolidation
A temporary difference arises as for the revaluation above but the deferred tax effect is a
consolidation adjustment in the same way as the revaluation itself.
Activity 5: Revision: taxable temporary differences
Shelley Co purchased an asset costing $3,000. At the end of 20X1, the carrying amount is $2,000.
The cumulative depreciation for tax purposes is $1,800 and the current tax rate is 30%.
Required
Calculate the deferred tax liability for the asset.
11.2 Types of deductible temporary differences
Provisions
The provision is recognised for accounting purposes when there is a present obligation, but may not
be deductible for tax purposes until the expenditure is incurred.
Losses
Current losses that can be carried forward to be offset against future taxable profits result in a
deferred tax asset.
Fair value adjustments
For example, liabilities recognised on business combinations where the expenditure is not deductible
for tax purposes until a later period.
Unrealised profits on intra-group trading
The profit is not realised from the group point of view until the items transferred are sold outside the
group but, where the tax base is based on the cost to the individual receiving company and no
equivalent adjustment for unrealised profit is made for tax purposes, a temporary difference arises.
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Activity 6: Revision: deductible temporary differences
Ontario Co recognises a liability of $20,000 for accrued product warranty costs on 31 December
20X1. These product warranty costs will not be deductible for tax purposes until the entity pays the
claims. The tax rate is 30%.
Required
Calculate the deferred tax asset.
11.3 Measurement of deferred tax
The key points to remember are:

IAS 12 adopts the full provision method of providing for deferred tax. This recognises that
each timing difference at the period end has an effect on future tax payments.

Deferred tax assets and liabilities are measured at the tax rates expected to apply to the
period when the asset is realised or liability settled, based on the tax rates (and tax laws) that
have been enacted (or substantively enacted) by the end of the reporting period (IAS 12:
para. 46).

Deferred assets and liabilities cannot be discounted (IAS 12: para. 53).

Deferred tax assets are only recognised to the extent that it is probable that taxable profit
will be available against which the deductible temporary difference can be utilised (IAS 12:
para. 24).
Note. In practice, it is rare for a deferred tax asset to be recognised, as the asset only exists insofar
as the entity's tax liability can be reduced in the future, which in turn depends on the entity being
profitable enough to have a tax liability and therefore to be able to 'use' any tax losses.
From the auditor's perspective, deferred tax assets are risky because a significant degree of
judgment must be exercised in determining whether tax losses will, in fact, result in reduced tax
liabilities in the future. This is an illustration of the importance of the auditor approaching the audit
with professional scepticism. If you come across a deferred tax asset in an exam question, you
should look to be skeptical about it (although it is of course always possible that the deferred tax
asset could be stated correctly).
11.4 Audit issues and procedures
As part of the planning process, if the client receives tax services from the firm, the auditor should
consult the tax department as to the company's future tax plans, to ascertain whether they expect a
deferred tax liability to arise. This will assist any analytical procedures they carry out on the deferred
tax provision.
Remember that manipulating the deferred tax figure will not affect the actual tax
position. However, a deferred tax charge (the other part of the double entry for the statement
of financial position provision) is recognised in profit or loss before dividends, even if it is
not actually paid to the taxation authorities.
The following procedures will be relevant:

Obtain a copy of the deferred tax workings and the corporation tax computation

Check the arithmetical accuracy of the deferred tax working

Agree the figures used to calculate timing differences to those on the tax computation and
the financial statements
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
Consider the assumptions made in the light of your knowledge of the business and any other
evidence gathered during the course of the audit to ensure reasonableness

Agree the opening position on the deferred tax account to the prior year financial statements

Review the basis of the provision to ensure:
– It is in line with accounting practice under IAS 12
– It is suitably comparable to practice in previous years
– Any changes in accounting policy have been disclosed
Activity 7: Audit of deferred tax
Guido Co, a company producing domestic appliances for the retail market, began trading on
1 January 20X1. Its draft accounts for the year ended 31 December 20X2 show profit before tax of
$1,000,000, total assets of $5,200,000 and a deferred tax balance of $958,000.
You are the manager responsible for the audit of Guido Co and the following information relating to
deferred tax has been provided by the client:
(1)
The deferred tax balance in the financial statements is the brought forward balance from
previous years. No deferred tax adjustment has been made for the current period.
(2)
At the period end, Guido Co has plant and equipment with a carrying amount of $5,200,000
and a tax base at that date of $2,400,000.
(3)
The tax rate to be applied is 30%.
Required
(a)
Identify the audit issues.
(b)
List the procedures you would perform in respect of the amounts relating to deferred tax in the
financial statements of Guido Co.
12 Provisions and contingencies
Provisions are accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
A provision is a liability of uncertain timing or amount.
A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
(IAS 37: para. 10)
Under IAS 37, an entity should not recognise a contingent asset or a contingent liability (ie a
possible asset or liability). Contingent liabilities and contingent assets should only be disclosed, not
recognised (IAS 37: para. 86).
However, if the following conditions are met, then a provision should be recognised in relation to a
contingent liability:



There is a present obligation as a result of a past event.
There will be a probable outflow of resources (< 50% likely).
A reliable estimate can be made.
(IAS 37: para. 14)
Common examples include warranties, legal claims against an entity, onerous contracts and
restructuring costs.
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IAS 37 also gives guidance regarding a number of specific provisions. These include:
Provisions for restructuring
A restructuring is a programme that is planned and controlled by management and materially
changes either:


The scope of the business undertaken by an entity; or
The manner in which that business is conducted.
The IAS gives the following examples of events that would fall under this definition:

The sale or termination of a line of business

The closure of business locations in a country or region or the relocation of business
activities from one country or region to another

Changes in management structure

Fundamental reorganisations that have a material effect on the nature and focus of
the entity's operations
(IAS 37: para. 70)
In order to make a provision, an obligation (legal or constructive) must exist at the period end. In this
context, a constructive obligation exists only in the following circumstances:

An entity must have a detailed formal plan for the restructuring.

It must have raised a valid expectation in those affected that it will carry out the
restructuring by starting to implement that plan or announcing its main features to those
affected by it.
(IAS 37: para. 72)
A management or board decision alone would not normally be sufficient.
The IAS states that a restructuring provision should include only the direct expenditures arising
from the restructuring (IAS 37: para. 80).
Onerous contracts
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under
the contract exceed the economic benefits expected to be received under it. An example might be a
vacant leasehold property.
If an entity has a contract that is onerous, a provision must be made for the net loss (IAS 37: para. 66).
Decommissioning provisions
A provision is only recognised from the date on which the obligating event occurs.
For example, when an oil company initially purchases an oil field, it is put under a legal obligation
to decommission the site at the end of its life. The legal obligation exists therefore on the initial
expenditure on the field and therefore, the liability exists immediately. The IAS also takes the view
that the decommissioning costs may be capitalised as an asset representing future access to oil
reserves (ie an asset and a provision are recognised).
Contingent assets
Contingent assets should not be recognised, as IAS 37 requires an entity to be virtually certain that it
will receive an inflow of economic benefits. The asset is only recognised when it is virtually certain
that there is an asset (unlike contingent liabilities, which although not recognised may nevertheless be
provided for) (IAS 37: paras. 31–35).
The recognition of contingent assets in financial statements therefore represents a risk for auditors,
and should be investigated thoroughly.
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12.1 Audit procedures
The audit tests that should be carried out on provisions and contingent assets and liabilities are as
follows.

Obtain details of all provisions which have been included in the accounts and all
contingencies that have been disclosed

Obtain a detailed analysis of all provisions showing opening balances, movements and
closing balances

Determine for each material provision whether the company has a present obligation
as a result of past events by:

–
Reviewing of correspondence relating to the item
–
Discussion with the directors. Have they created a valid expectation in other parties
that they will discharge the obligation?
Determine for each material provision whether it is probable that a transfer of
economic benefits will be required to settle the obligation by:
–
Checking whether any payments have been made after the year end in respect of the
item
–
Reviewing of correspondence with solicitors, banks, customers, the insurance
company and suppliers, both pre and post year end
–
Sending a letter to the solicitors to obtain their views (where relevant)
–
Discussing the position of similar past provisions with the directors. Were these
provisions eventually settled?
–
Considering the likelihood of reimbursement

Recalculate all provisions made

Compare the amount provided with any post year-end payments and with any amount
paid in the past for similar items

In the event that it is not possible to estimate the amount of the provision, check that a
contingent liability is disclosed in the accounts

Consider the nature of the client's business. Would you expect to see any other
provisions, for example warranties?

Consider whether disclosures of provisions, contingent liabilities and contingent
assets are correct and sufficient
12.2 Obtaining audit evidence of contingencies
Part of ISA 501 Audit Evidence – Specific Considerations for Selected Items covers contingencies
relating to litigation and legal claims, which will represent the major part of audit work on
contingencies. Litigation and claims involving the entity may have a material effect on the financial
statements, and so will require adjustment to/disclosure in those financial statements.
ISA 501: para. 9
The auditor shall design and perform audit procedures in order to identify litigation and claims
involving the entity which may give rise to a risk of material misstatement.
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Such procedures would include:

Making appropriate inquiries of management, including obtaining representations

Reviewing board minutes and correspondence with the entity's lawyers

Examining legal expense account

Using any information obtained regarding the entity's business, including information
obtained from discussions with any in-house legal department
ISA 501: para. 10
If the auditor assesses a risk of material misstatement regarding litigation or claims that have been
identified, or when audit procedures performed indicate that other material litigation or claims may
exist, the auditor shall … seek direct communication with the entity's external legal counsel.
This will help to obtain sufficient appropriate audit evidence as to whether potential material
litigation and claims are known and management's estimates of the financial implications, including
costs, are reliable.
The ISA discusses the form that the letter to the entity's external legal counsel should take.
ISA 501: para. 10 (cont'd)
The auditor shall do so through a letter of inquiry, prepared by management and sent by the auditor,
requesting the entity's external legal counsel to communicate directly with the auditor.
If it is thought unlikely that the external legal counsel will respond to a general enquiry, the letter
should specify:
(a)
A list of litigation and claims
(b)
Management's assessment of the outcome of the litigation or claim and its estimate of the
financial implications, including costs involved
(c)
A request that the external legal counsel confirm the reasonableness of
management's assessments and provide the auditor with further information if the list is
considered by the lawyer to be incomplete or incorrect
(ISA 501: para. A23)
The auditors must consider these matters up to the date of their report and so a further, updating
letter may be necessary. Written representations must be provided that all actual or possible
litigations and claims have been disclosed to the auditor.
A meeting between the auditors and the external legal counsel may be required, for example, where
a complex matter arises, or where there is a disagreement between management and the external
legal counsel. Such meetings should take place only with the permission of management, and
preferably with a management representative present.
ISA 501: para. 11
If:
(a) Management refuses to give the auditor permission to communicate or meet with the entity's
external legal counsel, or the entity's external legal counsel refuses to respond appropriately to
the letter of inquiry, or is prohibited from responding; and
(b) The auditor is unable to obtain sufficient appropriate audit evidence by performing alternative
audit procedures
Then the auditor shall modify the opinion in the auditor's report in accordance with ISA 705.
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Activity 8: Provisions
In February 20X0, the directors of Newthorpe Engineering Co, a listed company, suspended the
managing director. At a disciplinary hearing held by the company on 17 March 20X0, the
managing director was dismissed for gross misconduct, and it was decided the managing director's
salary should stop from that date and no redundancy or compensation payments should be made.
The managing director has claimed unfair dismissal and is taking legal action against the company
to obtain compensation for loss of their employment. The managing director says they have a service
contract with the company which would entitle them to two years' salary at the date of dismissal.
The financial statements for the year ended 30 April 20X0 record the resignation of the director.
However, they do not mention their dismissal and no provision for any damages has been included
in the financial statements.
Required
(a)
State how contingent liabilities should be disclosed in financial statements according to IAS 37
Provisions, Contingent Liabilities and Contingent Assets.
(b)
Describe the audit work you will carry out to determine whether the company will have to pay
damages to the director for unfair dismissal, and the amount of damages and costs which
should be included in the financial statements.
Note. Assume the amounts you are auditing are material.
13 Borrowing costs
IAS 23 Borrowing Costs gives guidance on how to account for borrowing costs.
IAS 23 Borrowing Costs
IAS 23 deals with the treatment of borrowing costs, often associated with the construction of selfconstructed assets, but which may also be applied to an asset purchased that takes time to get
ready for use/sale.
Definitions

Borrowing costs. Interest and other costs incurred by an entity in connection with the
borrowing of funds.

Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for
its intended use or sale (IAS 23: para. 5).
Accounting treatment

Borrowing costs are interest and other costs incurred by an entity in connection with the
borrowing of funds (IAS 23: para. 8).

All eligible borrowing costs must be capitalised.
Examples of borrowing costs include:





Interest on bank overdrafts, short- and long-term borrowings
Amortisation of discounts or premiums related to borrowings
Amortisation of ancillary costs incurred with arrangement of borrowings
Finance charges for finance leases
Exchange differences as far as they are an adjustment to interest costs
The cost of borrowing is interest, which is disclosed in the statement of profit or loss and other
comprehensive income.
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Interest can often be audited by analytical procedures, as it has a predictable relationship with
loans (for example, bank loans or debentures).
Alternatively, it can be verified to payment records (bank statements) and loan agreement
documents.
However, if borrowing costs are capitalised in accordance with IAS 23, the auditor should carry out
the following procedures:

Agree figures in respect of interest payments made to statements from lender and/or bank
statements

Ensure interest is directly attributable to construction
14 IAS 19 Employee Benefits
IAS 19 Employee Benefits covers the accounting for post-employment benefits. Pension schemes are
the most obvious example, but an employer might provide post-employment death benefits to the
dependants of former employees, or post-employment medical care.
Post-employment benefit schemes are often referred to as 'plans'. The 'plan' receives regular
contributions from the employer (and sometimes from current employees as well) and the money is
invested in assets, such as stocks and shares and other investments. The post-employment benefits are
paid out of the income from the plan assets (dividends, interest) or from money from the sale of some
plan assets.
There are two types or categories of post-employment benefit plan: defined contribution plans and
defined benefit plans.
14.1 IAS 19 recap
Accounting for payments into defined contribution plans is straightforward.
(a)
The obligation is determined by the amount paid into the plan in each period.
(b)
There are no actuarial assumptions to make.
(c)
If the obligation is settled in the current period (or at least no later than 12 months after the
end of the current period), there is no requirement for discounting.
IAS 19 requires:
(a)
Contributions to a defined contribution plan should be recognised as an expense in the period
they are payable (except to the extent that labour costs may be included within the cost of
assets) (IAS 19: para 51(b)).
(b)
Any liability for unpaid contributions that are due as at the end of the period should be
recognised as a liability (accrued expense) (IAS 19: para 51(a)).
(c)
Any excess contributions paid should be recognised as an asset (prepaid expense), but only to
the extent that the prepayment will lead to, for example, a reduction in future payments or a
cash refund (IAS 19: para 51(a)).
(d)
Disclosure is required of a description of the plan and the amount recognised as an expense
in the period (IAS 19: para 53).
Accounting for defined benefit plans is more complex, although the 2011 revisions to IAS 19 meant
that this area is no longer as complicated as it once was.
(a)
The future benefits (arising from employee service in the current or previous years) cannot be
estimated exactly but, whatever they are, the employer will have to pay them, and the liability
should therefore be recognised now. To estimate these future obligations, it is necessary to use
actuarial assumptions.
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(b)
The obligations payable in future years should be valued, by discounting, on a present value
basis. This is because the obligations may be settled in many years' time.
(c)
If actuarial assumptions change, the amount of required contributions to the fund will change,
and there may be actuarial gains or losses. A contribution into a fund in any period is not
necessarily the total for that period, due to actuarial gains or losses.
An outline of the method used for an employer to account for the expenses and obligation of a
defined benefit plan is given below.
Step 1 Determine the deficit or surplus:
(a) An actuarial technique (the Projected Unit Credit Method) should be used to make a
reliable estimate of the amount of future benefits employees have earned from service in relation
to the current and previous years. The entity must determine how much benefit should be
attributed to service performed by employees in the current period, and in previous periods.
Assumptions include those about employee turnover, mortality rates and future increases in
salaries (if these will affect the eventual size of future benefits, such as pension payments).
(b) The benefit should be discounted to arrive at the present value of the defined benefit
obligation and the current service cost.
(c)
The fair value of any plan assets should be deducted from the present value of the defined
benefit obligation.
Step 2 The surplus or deficit determined in Step 1 may have to be adjusted if a net benefit asset has
to be restricted by the asset ceiling.
Step 3 Determine the amounts to be recognised in profit or loss:
(a)
(b)
(c)
Current service cost
Any past service cost and gain or loss on settlement
Net interest on the net defined benefit (asset)
Step 4 Determine the re-measurements of the net defined benefit (asset), to be recognised
in other comprehensive income:
(a)
Actuarial gains and losses
(b)
Return on plan assets (excluding amounts included in net interest on the net defined
benefit liability (asset)
(c)
Any change in the effect of the asset ceiling (excluding amounts included in net interest on
the net defined benefit liability (asset)
In the statement of financial position, the amount recognised as a defined benefit liability (which
may be a negative amount, ie an asset) should be:
(a)
The present value of the defined obligation at the year end; minus
(b)
The fair value of the assets of the plan as at the year end (if there are any) out of
which the future obligations to current and past employees will be directly settled.
Plan assets are:
Key term
(a) Assets such as stocks and shares, held by a fund that is legally separate from the reporting
entity, which exists solely to pay employee benefits
(b) Insurance policies, issued by an insurer that is not a related party, the proceeds of which
can only be used to pay employee benefits
Investments which may be used for purposes other than to pay employee benefits are not plan assets.
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The standard requires that the plan assets are measured at fair value, as 'the price that would be
received to sell an asset in an orderly transaction between market participants at the measurement
date'.
IAS 19 includes the following specific requirements:
(a)
The plan assets should exclude any contributions due from the employer but not yet paid.
(b)
Plan assets are reduced by any liabilities of the fund that do not relate to employee benefits,
such as trade and other payables.
All the gains and losses that affect the plan obligation and plan asset must be recognised. The
components of defined benefit cost must be recognised as follows in the statement of
profit or loss and other comprehensive income.
Component
Recognised in
(a) Service cost
Profit or loss
(b) Net interest on the net defined benefit
liability
Profit or loss
(c)
Re-measurements of the net defined benefit
liability
Other comprehensive income
14.2 Audit evidence
Area
Procedures
Scheme assets (including
quoted and unquoted
securities, debt instruments,
properties)

Ask directors to reconcile the scheme assets valuation at the
scheme year-end date with the assets valuation at the
reporting entity's date being used for IAS 19 purposes

Obtain direct confirmation of the scheme assets from the
investment custodian

Consider requiring scheme auditors to perform procedures

Auditors must follow the principles of ISA 620 Using the
Work of an Auditor's Expert to assess whether it is
appropriate to rely on the actuary's work

Specific matters would include:
Scheme liabilities
–
The source data used
–
The assumptions and methods used
–
The results of actuaries' work in the light of auditors'
knowledge of the business and results of other audit
procedures
Actuarial source data is likely to include:

Scheme member data (for example, classes of member and
contribution details)

Scheme asset information (for example, values and income
and expenditure items)
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Area
Procedures
Actuarial assumptions (for
example, mortality rates,
termination rates, retirement
age, changes in salary and
benefit levels)
Auditors will not have the same expertise as actuaries and are
unlikely to be able to challenge the appropriateness and
reasonableness of the assumptions. Auditors can, however,
through discussion with directors and actuaries:
Items charged to
operating profit (current
service cost, past service cost,
gains and losses on settlements
and curtailments, interest)

Obtain a general understanding of the assumptions and
review the process used to develop them

Compare the assumptions with those which directors have
used in previous years

Consider whether, based on their knowledge of the reporting
entity and the scheme, and on the results of other audit
procedures, the assumptions appear to be reasonable and
compatible with those used elsewhere in the preparation of the
entity's financial statements

Obtain written representations from directors confirming that
the assumptions are consistent with their knowledge of the
business

Discuss with directors and actuaries the factors affecting
current service cost (for example, a scheme closed to new
entrants may see an increase year on year as a percentage of
pay with the average age of the workforce increasing)
Where the results of actuaries' work is inconsistent with the directors', additional procedures, such as
requesting directors to obtain evidence from another actuary, may assist in resolving the
inconsistency.
15 Share-based payment
IFRS 2 Share-based Payment sets out rules for the measurement of expenses relating to share-based
payment schemes. These arise most commonly in relation to payments for employee services and
professional services.
15.1 IFRS 2 Recap
IFRS 2 requires entities to recognise the goods or services received as a result of share-based
payment transactions.
There are three types of share-based payment transactions.
(a)
Equity-settled share-based payment transactions, in which the entity receives goods
or services in exchange for equity instruments of the entity
(b)
Cash-settled share-based payment transactions, in which the entity receives goods
or services in exchange for amounts of cash that are based on the price (or value) of the
entity's shares or other equity instruments of the entity
(c)
Transactions, in which the entity receives or acquires goods or services and either the entity or
the supplier has a choice as to whether the entity settles the transaction in cash (or other
assets) or by issuing equity instruments
(IFRS 2: para 2)
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