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Advanced Audit and Assurance (AAA) (INT/UK)
INTRODUCTION TO ADVANCED AUDIT AND ASSURANCE (AAA) (INT/UK)
REGULATION, LEGAL MATTERS AND QUALITY MANAGEMENT
1.
2.
3.
4.
5.
6.
7.
8.
9.
What is Assurance?
Corporate Governance and Auditor Regulation
Appointment as an Auditor
Professional Ethics
Money Laundering
Responding to Non-Compliance with Laws and Regulations (NOCLAR)
Auditors’ Liability
Fraud, Error, the Evaluation of Misstatements and Reporting Control Weaknesses
Quality Management
7
11
17
23
31
35
39
43
47
AUDIT PLANNING AND RISK ASSESSMENT
10.
11.
12.
Audit planning
Risk
Question Practice on Risk
51
57
63
AUDIT EVIDENCE
13.
14.
15.
16.
17.
18.
19.
20.
Audit Evidence
Relevant Accounting Standards
Automated Tools and Techniques
Experts
Internal Audit
Outsourced Accounting Functions
Written Representations
Related Parties
71
75
79
83
85
87
91
93
THE AUDIT OF GROUP FINANCIAL STATEMENTS
21.
Group Audits
97
THE FINAL STAGES OF AN AUDIT
22.
23.
24.
25.
Subsequent Events
The Auditor’s Report 1: Overall Structure
The Auditor’s Report 2: Going concern
The Auditor’s Report 3: Types of Audit Opinion
105
107
115
119
OTHER ASSIGNMENTS
26.
27.
28.
29.
30.
31.
32.
Types of Assignment
Prospective Financial Information
Forensic Audits
Due Diligence
Social, Environmental and Integrated Reporting
The Audit of Performance Information in the Public Sector (International Syllabus only)
Auditing aspects of insolvency (UK Syllabus only)
123
125
131
135
137
141
149
PROFESSIONAL SKILLS
33.
Professional Skills
153
EMPLOYABILITY AND TECHNOLOGY SKILLS
34.
Employability and Technology Skills
157
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3
INTRODUCTION TO ADVANCED AUDIT AND
ASSURANCE (AAA) (INT/UK)
1. Warning!
Do not even think of studying this paper if you haven’t already studied paper Strategic Business
Reporting (SBR).
In every AAA paper, there is at least one question dealing with audit risk and/or audit evidence/
procedures. Audit risk is the risk that there might be a material misstatement in the financial
statements. Whenever there is such a risk, the auditor must decide how to respond and that usually
means carrying out more audit work to gather more audit evidence.
What you need to realise is that material misstatements can be caused by two types of error:
๏
The amount is wrong.
๏
The item has not been treated in line with the relevant financial reporting standard.
For example, if the company incurs research and development expenditure, not only does the auditor
have to obtain evidence about the amount of expenditure, but must also collect evidence that the
expenditure has been written off or capitalised in line with IAS 38 Intangible Assets. Therefore, if the
expenditure has been capitalised, the auditor must collect evidence that the project is technically
viable, that the company can fund its completion….and so on. If you do not know the standard, you
cannot plan to collect the right evidence.
The IFRS Standards examined in SBR set out the requirements that determine the amounts to be
recognised in the financial statements and where and how they should be presented; each standard
has implications for auditors (see Chapter 14).
2. The ‘maturity’ of answers required
Consider this: During attendance at a physical inventory count at a client who makes jars of preserved
food, a pack of 12 jars falls from its shelf in the warehouse and the jars shatter. The contents smell
awful and it is obvious that pack contained food that had gone bad. What audit issues does this
incident cause and how should the auditors respond?
At the AA level you might simply have said that the pack had to be written off. At AAA, the incident
raises many more issues. See if you can think what they might be. This is discussed in the lecture for
Chapter 12.
With effect from September 2022, the AAA exam will contain a total of 80 technical marks and 20
Professional Skills marks. All the professional skills that will be assessed are explored and developed
throughout the Ethics and Professional Skills module (EPSM). According to ACCA data, candidates
who complete EPSM in advance of sitting Strategic Professional exams have a 20% better success rate.
Professional skills are ESSENTIAL to the role of the auditor; you are strongly advised to complete the
EPSM before sitting the AAA exams.
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3. Topics in AAA, not in AA
The main additions are:
๏
Money laundering and professional liability
๏
Business risk (audit risk, but not business risk, was in AA)
๏
The audit of groups
๏
Specific assignments (due diligence, prospective financial information and forensic audits)
๏
Social, environmental and integrated reporting
๏
The audit of performance information in the public sector (INT Syllabus only)
๏
Auditing aspects of insolvency (UK Syllabus only)
๏
Current issues
Most AA topics appear again in AAA but to a more detailed level. Professional ethics remain very
important. You will not be asked to evaluate an accounting system to identify weaknesses in internal
control.
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4. Syllabus
4.1. Aim
To analyse, evaluate and conclude on the assurance engagement and other audit and assurance
issues in the context of best practice and current developments.
4.2. Objectives
On successful completion of this paper, 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 management policies and procedures 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.
H.
Apply a range of professional skills in addressing requirements within the AAA exam, and in
preparation for, or to support current work experience.
I.
Demonstrate employability and technology skills.
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5. Approach to examining the syllabus
The syllabus is assessed by a 3 hour 15 minute examination.
The examination is constructed in two sections. Questions in both sections will be largely discursive.
However, calculations will be expected, for example to be able to assess materiality and calculate
relevant ratios where appropriate.
Section A
Case study (50%)
Set at the planning stage of the audit for a single company or group of companies (or, potentially
several audit clients). Candidates will be provided with detailed information and be required to
address a range of requirements from syllabus sections A, B, C and D.
The 50 marks will comprise of 40 technical marks and 10 professional skills marks. ALL professional
skills with be examined in Section A.
Section B
Two compulsory 25 mark questions, predominately based around a short scenario.
One question will always predominantly come from syllabus section E (completion, review and
reporting). The other question can be drawn from any other syllabus area including section F.
Each question will comprise 20 technical marks and 5 professional skills marks examining a minimum
of two professional skills.
Syllabus section G, Current Issues, may be examined in Section A or Section B, but is unlikely to to
form the basis of any question on its own.
Full details are shown on syllabus available from the ACCA’s site:
Advanced Audit & Assurance (INT) - syllabus and study guide:
https://www.accaglobal.com/gb/en/student/exam-support-resources/professional-exams-studyresources/p7/syllabus-study-guide/p7-international-int-syllabus-study-guide.html
Advanced Audit & Assurance (UK) - syllabus and study guide:
https://www.accaglobal.com/gb/en/student/exam-support-resources/professional-exams-studyresources/p7/syllabus-study-guide/p7-united-kingdom-uk-syllabus-study-guide.html
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REGULATION, LEGAL MATTERS AND QUALITY
MANAGEMENT
Chapter 1
WHAT IS ASSURANCE?
1. Audit and assurance
We start with a little bit of revision of AA, and indeed you will be making use of AA skills throughout
AAA (such as suggesting audit evidence to look for).
The paper is called ‘Advanced Audit and Assurance’ and we start by explaining what is meant by the
terms ‘audit’ and ‘assurance’.
It is often not possible to check things for yourself, whether quality, accuracy, performance or
existence: you might not have the skills or the time, or you might be in the wrong location. Therefore
you must rely on someone else to give you assurance. This means you have to decide:
๏
What standards should be applied?
๏
What represents ‘good’, ‘acceptable’ or ‘unacceptable?
๏
How much checking should be done? All checking and assurance has an associated cost.
Audit is one form of assurance. We will see that in AAA other forms of assurance might have to be
described and discussed too, such as providing assurance to a bank that a company’s cash flow
budget is not a work of fantastic fiction or that a take-over target is not hiding horrific liabilities.
An audit is defined as: the independent examination of and expression of opinion on the financial
statements of an entity by a duly appointed auditor in pursuit of that appointment.
The important words here are ‘independent’ and ‘opinion’.
Independence is essential and underlies the value of auditing - and of all other forms of assurance
Opinion really means that one auditor or accountant could look at a set of financial statements (or a
cash budget) and disagree with the opinion of another.
Judgment is essential to all assurance: there are no certainties and there are no certifications of
correctness or accuracy.
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Auditing is the most regulated form of assurance you will meet in AAA. Legislation, International
Auditing Standards and financial reporting standards all lay down rules about how auditing should be
carried out and how financial statements should be prepared. Other forms of assurance are much less
uniform and this can cause a problem unless the work to be performed is precisely agreed between
auditor and client at the very start. For example, if you are asked to give assurance about a cash flow
forecast you need to find out if it is a one, three or five year budget as the work and difficulties are
very different in each case.
2. Elements of an assurance engagement
2.1. The elements of an assurance engagement
The following are the five elements of an assurance engagement:
(1)
A three party relationship involving a practitioner, a responsible party and intended users.
(2)
Appropriate subject matter (eg the financial statements, a budget, a take-over target).
(3)
Suitable criteria (eg financial reporting standards)
(4)
Sufficient appropriate evidence.
(5)
A written assurance report in the form appropriate to a reasonable assurance engagement or a
limited assurance engagement.
Item 4 on the list is sufficient appropriate evidence and if assurance had to be summed up in one
word ‘EVIDENCE’ would be it. Assurance is not based on the auditor guessing or hoping that
something is the case. All assurance is based on gathering sufficient appropriate evidence and if the
required evidence is not available then assurance cannot be given.
It will be said again, but when it comes to the audit of financial statements evidence is required about
two elements:
๏
Is the amount materially correct?
๏
Do the presentation and disclosures conform to the financial reporting standards?
There is no point in tracing research and development expenditure back to invoices supporting the
accuracy of the amounts if you do not also give assurance that the amounts have been written off or
capitalised in line with the IAS 38. Evidence is needed to support the treatment of the amounts.
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2.2. Professional scepticism
A practitioner should plan and performs an assurance engagement with an attitude of professional
scepticism to obtain sufficient appropriate evidence about whether the subject matter information is
free of material misstatement. An attitude of professional scepticism means the practitioner questions
the validity of evidence and is alert to evidence that brings into question the reliability of documents
or representations.
Scepticism means that you don’t know. It does not mean that the practitioner assumes everyone is
dishonest or that figures have been deliberately misrepresented. Nor does it mean that you believe all
figures and statements are correct. It means you are aware that we can all be subject to optimism
(perhaps too much), human error, giving quick answers because we are short of time, and
misunderstanding. It also recognises that sometimes people are deliberately misleading or dishonest.
Scepticism means that evidence is required to test statements or assumptions. You could almost
summarise the process of assurance in the phrase ‘collect evidence that supports everything that is
being claimed’.
Sufficiency is the measure of the quantity of evidence. Appropriateness is the measure of the quality
of evidence - its relevance and its reliability.
The reliability of evidence is influenced by its source and by its nature, and is dependent on the
individual circumstances under which it is obtained, eg documentary evidence is better then oral,
directly obtained evidence better then evidence provided by a client.
2.3. Assurance Report
The practitioner provides a written report containing a conclusion. There are two types of assurance
reports:
In a reasonable assurance engagement the practitioner’s conclusion is worded in the positive form,
for example: “In our opinion internal control is effective, in all material respects, based on XYZ criteria.”
It is called ‘reasonable’ because the practitioner will never give guarantees. Only reasonable assurance
is ever given.
In a limited assurance engagement the conclusion is worded in the negative form, for example,
“Based on our 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.”
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2.4. Examples:
Positive
๏
The financial statements "present fairly, in all material respects..." / "show a true and fair view".
๏
The value of amount of inventory lost is $x.
Negative
๏
We have discovered nothing wrong with the financial statements.
๏
The basis of the forecast is not unreasonable.
๏
There is no evidence of discrimination in the appointment.
All statutory audits attempt to provide positive assurance that the financial statements "present fairly,
in all material respects" / "show a true and fair view of" (these phrases are equivalent) the company's
financial position, financial performance and cash flows. There are some types of assurance
assignment where giving positive assurance is not possible. For example, it would be impossible to
give assurances that a budget is correct because it depends on so many assumptions and factors that
cannot be verified with certainty, such as the state of the economy next year, competitors’ plan and
sales forecasts.
A practitioner would not express an unmodified conclusion for either type of assurance engagement
when:
๏
There is a limitation on the scope of the practitioner’s work (ie sufficient appropriate evidence
cannot be obtained); or
๏
The assertion is not fairly stated (in all material respects) or the subject matter information is
materially misstated (ie the assertion is incorrect).
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Chapter 2
CORPORATE GOVERNANCE AND
AUDITOR REGULATION
1. Why corporate governance is needed
Corporate governance is the system by which companies are directed and controlled. Auditing
financial statements adds to their credibility and this enables shareholders to better understand how
the directors and company have performed.
2. Principles of corporate governance
The Organisation of Economic Cooperation Development (OECD) promotes six Principles of a
corporate governance framework:
๏
It should promote transparent and fair markets and the efficient allocation of resources and
support effective supervision and enforcement.
๏
It should protect shareholders’ rights, ensuring fair treatment of all shareholders, including
minority and foreign shareholders. For example all shareholders should have access to the same
information.
๏
It should provide for stock markets to function in a way that contributes to good corporate
governance (eg insider trading should be prohibited).
๏
It should recognise the rights of all stakeholders, not just shareholders, and encourage active
cooperation between the entities and stakeholders in creating wealth, jobs and sustainability of
financially sound entities.
๏
It should ensure timely and accurate disclosure on all material matters, including financial
position, performance, ownership and governance.
๏
It should ensure the strategic guidance of the entity, effective monitoring of management by
the board and the board’s accountability to the entity and their shareholders. In particular the
board should set its own objectives, monitor its own performance and have its own
performance assessed.
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3. The UK Corporate Governance Code
The OECD principles are put into effect in a variety of ways in different countries. The UK Corporate
Governance Code published by the Financial Reporting Council (FRC) can be referred to as an
example of best practice.
The Principles of the Code emphasise the value of good corporate governance to the long-term
success of the company.
Comply or explain
The Code has no force in law and is enforced on listed companies through the Stock Exchange. Listed
companies are expected to ‘‘comply or explain’’ and this approach is the trademark of corporate
governance in the UK.
Listed companies have to state that they have complied with the code or else explain to shareholders
why they haven’t. This allows some flexibility and non-compliance might be acceptable in some
circumstances.
The UK and most of Europe have adopted a principles-based approach rather than a rules-based
approach to Corporate Governance. Broad principles are set out but then companies decide how to
put those into operation. This can provide flexibility and adaptability.
In the US most corporate governance is regulated through statute, the Sarbanes-Oxley Act 2002. This
takes a procedural ('rules-based') approach that is much more prescriptive, requiring both directors
and auditors to sign off documentation stating that the rules have been followed. Criminal charges
can follow if the Act is not followed.
Main principles of the UK Code
๏
Board Leadership and Company Purpose
๏
Division of Responsibilities
๏
Composition, Succession and Evaluation
๏
Audit, Risk and Internal Control
๏
Remuneration
Board Leadership and Company Purpose
๏
Every company should be headed by an effective board which is collectively responsible for the
long-term success of the company.
๏
All directors must act with integrity, lead by example and promote the desired culture.
๏
The board should:
‣ establish the company’s purpose, values and strategy
‣ ensure the company has the necessary resources to meet its objectives
‣ establish effective controls to assess and manage risk
‣ ensure effective engagement with, and encourage participation from, stakeholders
‣ ensure that workforce policies and practices are consistent with the company’s values and
support its long-term success.
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Division of Responsibilities
๏
There should be a clear division… between the running of the board and the executive
responsibility for the running of the company’s business. No one individual should dominate
decision making. This means that the roles of CEO and chair should not be performed by one
person as that concentrates too much power in that person.
๏
The chair is responsible for leadership of the board and should be independent on
appointment (e.g. not an employee within the last 5 years).
๏
At least half the board should be non-executive directors (NEDs) who are considered
independent (e.g. no close family ties with executive directors, no significant shareholdings, etc).
๏
NEDs should provide constructive challenge and strategic guidance and hold management to
account.
Composition, Succession and Evaluation
๏
Appointments to the board should be subject to a formal, rigorous and transparent procedure
led by a nomination committee. A majority of the committee should be independent NEDs.
๏
The board and its committees should have a combination of skills, experience and knowledge.
The length of service of the board as a whole should be considered and membership regularly
refreshed. The post of chairman should not be held beyond nine years.
๏
The board should undertake a formal and rigorous annual evaluation of its own performance
and that of its committees and individual directors.
๏
All directors should be submitted for re-election annually.
Audit, Risk and Internal Control
๏
The board should establish formal and transparent policies and procedures to ensure the
independence and effectiveness of internal and external audit and the integrity of financial
statements.
๏
The board should present a fair, balanced and understandable assessment of the company’s
position and prospects. The financial statements should state whether the board considered
the appropriateness of the going concern basis of accounting and identify any material
uncertainties for at least 12 months from the date of approval of the financial statements.
๏
The board should establish procedures to manage risk, oversee internal controls and determine
the nature and extent of the principal risks the company is willing to take to achieve its longterm strategic objectives.
To meet the above Principles, the board should establish an audit committee of at least three
independent NEDs (two for smaller companies). At least one committee member must have recent
and relevant financial experience.
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Remuneration
In essence, remuneration should be sufficient to attract, retain and motivate directors of sufficient
quality… but avoid paying more than is necessary.
๏
Remuneration policies and practices should be designed to support strategy and promote longterm sustainable success. For example, a significant proportion of executive directors’
remuneration may be structured to link rewards to corporate and individual performance. In
other words, profit-related pay is encouraged. Directors should not receive high pay irrespective
of company performance.
๏
There should be a formal and transparent procedure for developing policy on executive
remuneration and for fixing the remuneration packages of individual directors. No director
should be involved in deciding his or her own remuneration. This means that a remuneration
committee (NEDs) should be formed to fix directors’ remuneration.
4. The role of the audit committee
The audit committee is a very important part of corporate governance.
Review of internal audit
Financial Statements
Liaison with external auditors:
Review of internal control
Monitor integrity of
financial statements
• Scope of external audit
• Forum to link directors/auditors
• Deal with auditors’ reservations
• Obtain information for auditors
• Review independence and objectivity
• Approve non-audit services
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The main roles and responsibilities of the audit committee include the following:
๏
Monitoring and reviewing the effectiveness of internal audit. Companies don’t have to have an
internal audit department, but the need for one must be reviewed annually.
๏
Monitoring the integrity of the financial statements and reviewing significant financial reporting
judgements.
๏
Review the internal financial controls and risk management systems (unless there is a separate
risk committee or the board does this).
๏
Making recommendations to the board about the appointment, reappointment and removal of
the external auditors and agreeing the terms of engagement. (Note that the external auditors
are appointed by members in general meeting, but the board puts forward the nomination.)
๏
Annually assessing the independence, objectivity and effectiveness the external auditors
including confirming that there are no self-interest or familiarity issues and that partners and
staff are rotated properly.
๏
Acting as a forum to link directors and auditors. Auditors will typically write to the audit
committee about any problems they may be having on the audit or obtaining all the
information they require. If the auditors are worried in some way about the financial statements
they will raise those concerns with the audit committee.
๏
Developing and implementing policy on the engagement of the external auditor to supply nonaudit services: skills, approval and non-approval for certain services, ensuring any threats to
independence and objectivity are reduced to acceptable levels and monitoring the fees for
those services and the total fee for all services provided by the external auditor.
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5. Regulation of auditors
Auditors are regulated by:
๏
Professional bodies (eg ACCA). ACCA is a recognised supervisory body that supervises
qualifications, behaviour and quality.
๏
National bodies. In the UK and Ireland, the Financial Reporting Council. This regulates auditors
and accountants and sets the UK’s Corporate Governance Code.
๏
International bodies (eg IFAC, the International Federation of Accountants). The purpose of IFAC
is to serve the public interest by, establishing and promoting adherence to high-quality
professional standards.
IFAC has a number of boards and committees such as:
‣ IAASB (International Auditing and Assurance Standards Board): Sets International Standards
on Auditing (ISAs) and other assurance standards
‣ IESBA (International Ethics Standards Board for Accountants): Issues the International Code of
Ethics for Professional Accountants.
‣ TAC (Transnational Auditors Committee): Responsible for implementing and advancing the
promotion of high-quality standards of financial reporting and auditing practices worldwide.
๏
The Public Interest Oversight Board (PIOB) oversees the public interest activities of the standard
setters. It brings greater transparency and integrity to the audit profession, thereby contributing
to the enhanced quality of international financial reporting.
IAASB's ISAs are adopted by the FRC in the UK which has local regulatory power. The IESBA's Code has
been adopted by ACCA in its Code of Ethics and Conduct.
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Chapter 3
APPOINTMENT AS AN AUDITOR
1. Overview of the audit process
Appointment
Plan the audit
Understand entity
Assess risk of material misstatement
Respond to risk
Expect effective controls
Tests of controls
Expect ineffective controls
Unsatisfactory
Report significant deficiencies
to those charged with
governance
Satisfactory
Reduced substantive
procedures
Full substantive
procedures
Overall review of FS
Report to management
Auditor’s report
This is an important and useful diagram and it sets out the stages or approach to an audit.
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2. Marketing professional services
The ACCA 's Code of Ethics and Conduct states that professional accountants can inform the public
about their services using advertising and other form of promotion, subject to the general
requirement that the medium shall not reflect adversely on the professional accountant, ACCA or
the accountancy profession.
It is recognised that there can be a conflict between some of the ethical principles, for example, a selfinterest threat and complying with the principle of professional behaviour.
The professional accountant in public practice must be honest and truthful and must not:
๏
Make exaggerated claims for services, experience etc or be misleading in other ways.
๏
Make disparaging references or unsubstantiated comparisons to the work of another.
๏
Bring the ACCA, the accountancy profession or other accountants into disrepute.
If fees are mentioned, promotional material must state the basis of charging and great care has to be
taken that readers are not mislead about the services offered and the fees that will be charged. It is
possible to compare fees with those of other firms provided the comparison is not misleading.
If commissions are paid or received (for example, by recommending software package), full disclosure
of the commercial arrangement must be made.
3. Tendering for professional services
Often, to obtain new work, accountants will be asked to submit a tender in competition with other
firms. Before submitting a tender, contact must be made with the existing or previous accountant (see
section 5, below) to see if there are any reasons why the appointment should not be accepted.
The fees quoted can can be whatever the accountant thinks appropriate, but there can be threats to
compliance with the fundamental principles. For example, if the fee were so low that it would be
difficult to carry out the work to the required standard of competence and due care. The IESBA states
that:
๏
Auditors should perform high quality audits irrespective of the audit fee charged.
๏
Adequate time must be planned and spent to enable the audit to be performed in accordance
with the technical and professional standards.
๏
Audit personnel with appropriate expertise and experience should be assigned to the work.
๏
Two-way communication between the auditors and those charged with governance (TCWG) to
mitigate the threats that can arise from fee pressure.
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There is no set format for a tender document, but a little thought will show that something like the
following would be usual for a tender for audit work:
๏
A brief introduction to the accountancy firm.
๏
Areas of expertise and specialisms.
๏
A reiteration of the requirements of the client (to confirm understanding) and suggestions for
other work that might be needed.
๏
An outline of the proposed audit approach. For example:
‣ Planning.
‣ Assessment of the system of internal controls.
‣ Testing internal control and reporting on control weaknesses (interim audit timing might be
suggested).
‣ Possible use of internal audit for some aspects of the audit.
๏
Timing of the final audit and suggested dates for auditor’s report signature.
๏
Work do be done at the final audit stage (eg attend inventory counts at certain branches etc).
๏
Planned use of computer assisted audit techniques.
๏
An outline of the firm's system of quality management to ensure that a ‘good’ audit will be
performed.
๏
Key partner’s and manager’s name. Details of audit team composition.
๏
Fee and the basis of its calculation. Invoicing arrangements and terms of payment.
๏
Any other services (that are not prohibited) that the firm may provide (eg corporate financial
advice).
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4. Before you say ‘yes’ (and continuance decisions)
It is, of course, flattering to be asked to be the auditor of a company. Now only does it feed one’s ego,
it also promises more income for the firm. However, auditors must exercise great caution: they must
be confident that they can carry out the work profitably, ethically, competently, incurring an
acceptable level of risk and avoiding damage to their reputation.
The following need to be investigated:
๏
Are they professionally qualified to act? Is it legal and ethical for them to do so? For example,
they shouldn’t accept an appointment if the fees exceed the 15% limit for public interest
companies, unless there are adequate safeguards. Are there issues of familiarity or self-review?
๏
Do they have adequate resources in terms of staff, time and expertise? Can the new work be
carried out when the client wants without adversely affecting existing clients? If the potential
audit client acts in a specialist area of business and the auditors have no prior experience of that,
it would be very unwise for them to accept the appointment.
๏
Investigate the client, its management and directors. Many firms of auditors have access to
databases which, for example, will allow them to search on directors’ names to see if any of the
directors have been banned from being directors of companies because of their past behaviour.
They may discover that it is too risky to become the auditor of a company if they have no trust in
the honesty of the directors. The audit fee is often modest, why risk your reputation by
undertaking an audit where the directors may be fraudulent?
๏
Consider the nature of the industry or business. If there is a risk of criminal involvement or
money laundering it might be better to stay clear.
๏
Money laundering regulations (covered in a later chapter) require auditors to ‘know their client’:
ownership, commercial rationale, sources of funds etc.
๏
Communicate with present auditors. There is a professional requirement to do this and it is
essential to find out why the old auditors are retiring or being removed.
๏
Consider politically exposed persons. These are people who have or who have had positions
of political influence. For example, politicians, senior military personnel, senior civil servants.
Unfortunately, there is a history of many of these individuals having profited from corruption
and they might still have influence that permits the misuse of public funds, the improper
awarding of contracts and large-scale money laundering.
๏
The potential client’s credit-rating.
๏
Preconditions for the audit: will the financial reporting framework used be acceptable and do
management understand and accept their responsibilities for preparing the financial
statements and for supplying the auditors with all the information they require?
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5. Communication with existing auditors
If the auditor is approached by new audit client, if it’s a new business and this is the first audit there
will be no previous auditors to communicate with and new auditors must make their own decision.
If it is not a new business and there is an existing auditor then the new auditor must ask the client for
permission to contact the old auditor. If permission is not given, the appointment should be declined.
Why would permission not given? Is a client trying to conceal something? Why else would they not
allow a new auditor to communicate with the existing auditor?
Assuming permission is given the new auditor will write to the old auditor for information. The old
auditor can’t simply send that information to the new auditor because that is confidential, and the old
auditor has to ask the client for permission in turn. If that permission is not given the new auditor
should decline the appointment because again the client is trying to stop communication between
the old and new auditors.
If the old auditor provides information then the new auditor is more fully equipped to make their
accept or reject decision. If the existing auditor decides not to provide information the new auditor
should try to persuade the old auditor to provide it, but otherwise might have to rely on information
as been found in other ways.
6. The engagement letter
Upon appointment, auditors should send an engagement letter to their new client.
Engagement letters are often regarded as rather dull documents, sent once and then forgotten.
However, they are of crucial importance because they set out the contractual relationship between
the auditor and the client. If the engagement letter is not sent out it’s very difficult for an auditor
subsequently to complaint that the client hasn’t done what was expected, or it might be difficult for
the auditor to defend the firm against a claim that the auditor has not done what was expected.
Engagement letters:
๏
Define the auditor’s responsibilities
๏
Provide written evidence of the auditor’s acceptance of the appointment.
๏
Should be sent to the board of directors or audit committee prior to the first audit.
๏
Identify any reports to be produced in addition to the auditor's report. For example, for banking
or insurance clients who may come under additional scrutiny.
๏
Should be updated for all changes. For example, if the auditor begins to undertake tax work for
the client.
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7. Typical contents of an engagement letter
๏
Description of the objective of an audit: to obtain reasonable assurance whether the financial
statements are free from material misstatement and issue an auditor's report that include an
audit opinion.
๏
Defining responsibilities: management’s are to prepare the financial statements and to set up a
system of internal control. It is the auditor’s responsibility to audit the financial statements.
๏
Reference to the applicable financial reporting framework. For example, national legislation (eg
companies act) and/or IFRS.
๏
Emphasis that audits depend on sampling that there are no guarantees. The audit looks for only
material misstatements. It will examine records on a test basis that can only give a reasonable
assurance.
๏
The auditors will state that they expect unrestricted access to the company’s records and they
expect full explanations for any queries they might have.
๏
They will state that the auditor’s report is a matter between them and the addressees of the
report (the members of company) and that it should not be relied upon by other parties.
๏
There will be certain matters about planning the audit, such as arranging the interim audit and
final audit, attending inventory counts, organising external confirmation of receivables, and
liaison with the internal audit department.
๏
Almost certainly there will be something about fees. They should be estimated but subject to
the proviso that if more work needs to be done, it will be done and additional fees will be
required.
๏
Description of the expected relationship between the external auditor and internal audit; how
the work of internal audit might be reviewed and then relied on by the external auditors.
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Chapter 4
PROFESSIONAL ETHICS
1. Introduction
It was mentioned in the previous chapter that before accepting an appointment, the auditor must
ensure that the appointment will be ethical.
Ethics is seen as the unique selling proposition of professional accountants. If they do not adhere
strictly to ethical principles, how could they continue to earn good fees? What is the point in paying
someone for advice or assurance if they cannot be trusted or believed?
The ACCA Code of Ethics and Conduct ('the Code') is based on the IESBA’s Code of Ethics. It sets out
certain fundamental principles about how its members should behave. It also recognises how its
members could be subject to certain threats which would compromise their behaviour, and suggests
ways in which members can safeguard themselves against the operation of those threats.
The conceptual framework approach to professional ethics recognises that there are:
๏
Fundamental principles to be followed
๏
These are subject to threats
๏
Threats must be addressed
The Code applies to all members of ACCA and also to all ACCA students. Note that applies not only to
those in public practice ('auditors') but also those in industry and commerce ('in business').
2. Fundamental principles
The ACCA’s fundamental principles are as follows:
๏
Integrity
๏
Objectivity
๏
Professional competence and due care
๏
Confidentiality
๏
Professional behaviour
See Chapter 4 of our AA notes if you need to revise the fundamental principles.
Note that in AAA you need to be able to explain when the duty of confidentiality must be set aside in
order to disclose non-compliance with laws and regulations (see Chapter 6).
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3. Threats to the fundamental principles
Threats to compliance with the fundamental principles arise from
๏
Self-interest
๏
Self-review
๏
Advocacy
๏
Familiarity
๏
Intimidation.
Note also there are management threats, where the auditor performs managerial functions for the
client. These are not a separate category, but covered under several of the above, such as self-interest,
familiarity and advocacy.
Where such threats exist, the auditor must:
๏
Eliminate the circumstance that creates the threat(s); or
๏
Apply safeguards, where available, to reduce the threats to an acceptable level (see s.4); or
๏
Decline or end the specific professional activity.
3.1. Self-interest threats
Self-interest threats may arise from the following:
๏
Financial interests – the provisions of the Code consider who holds the interest, whether the
interest is direct or indirect and materiality. Firms, members of audit teams and immediate
family members cannot hold direct or material indirect financial interests in audit clients.
However, safeguards may be applied where a close family has such an interest.
๏
Close business relationships – cannot be entered into unless immaterial and insignificant to
both the firm and the client or is management.
๏
Family and personal relationship – the existence and significance of any threat depends on
the individual’s role in the audit team, the role of the individual within the client and the
closeness of the relationship.
๏
Loans and guarantees – the existence and significance of any threat depends on whether
making loans is the client’s business, the terms and conditions and to whom it is made.
๏
Fees – the Code does not prescribe the basis for calculating fees. However:
‣ Contingent fees – are not permitted for audit engagements
‣ Relative size – the only benchmark in the Code is 15% of total fees, for two consecutive years,
for a PIE client
‣ Low-balling – quoting a lower fee is not in itself unethical, but must not be so low that it
threatens professional competence and due care
‣ Overdue fees – may be seen as equivalent to a loan
๏
Recruiting services – generally, must not assume management responsibility (eg act as
negotiator for management) and hiring decision must be the client’s. For a PIE, cannot seek or
take up references for a director or senior management position.
See Chapter 4 of our AA notes if you need to revise these example of self-interest threats.
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3.2. Self-review threats
Self review threats arise when an auditor does work for a client and that work may then be subject to
self-checking during the subsequent audit. For example, if the auditor prepares the financial
statements, and then has to audit them, or the auditor performs internal audit services and then has
to check that the system of internal control is operating properly. Auditors could obviously be
reluctant to criticise the work which their own firms have earlier undertaken, and this could interfere
with independence and objectivity.
Generally auditors must be very careful when undertaking such work. Certainly it is common for
auditors to do additional work for their clients, but what is important that the work is done by an
entirely different team from the audit firm.
Whether auditors should be allowed to provide non-assurance ('other') services to an audit client is a
controversial topic, as there are both pros and cons. For example, auditors will know a great deal
about the operations of their clients and this can make the performance of other work much more
efficient. If entirely new companies have to be brought in to supply these services, much of the
information they find out about the client will already be known by the auditor and there is a real
duplication of effort.
The provision of many non-assurance services will create a self-review threat (eg bookkeeping,
internal audit, tax calculations and valuations material to the financial statements).
Another danger, of course, is that the auditors come to rely too heavily on the fees earned from the
other work and are therefore reluctant to risk losing a client if they express a modified audit opinion
(ie self-interest threat). Large audit firms can at least use separate departments, though this may be
difficult with small firms.
In the US listed companies are not allowed to obtain other services from their auditor. This is to ensure
that the auditor is independent and performs only the audit. In most jurisdictions, there are no hard
and fast rules but the overall guidance on ethics relating to objectivity and independence should be
adhered to.
Remember that self-review threats can also arise if a member of the audit team:
๏
Recently served as a director/officer of the client
๏
Is seconded ('lent') to the client for a temporary assignment.
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3.3. Advocacy threats
Advocacy is where the assurance or audit firm promotes a point of view or opinion to the extent the
subsequent objectivity is compromised. An example would be where the audit firm promotes the
shares in a listed company or supports the company in some sort of dispute (eg with the tax
authorities). Advocacy can interfere with professional scepticism.
As always, the audit firm should weigh up the risks to its objectivity, integrity and independence and
should withdraw from performing further work if those risks are too high.
3.4. Familiarity threats
Familiarity threats arise because of the close relationship between members of the audit team and the
client. The close relationship can arise by friendship, family or through business connections. There is
no general definition of what’s meant by close relationships, but if you were an auditor and your
brother was the Finance Director of a client firm then there probably is a close relationship! If however
the finance director was a remote cousin of yours, there might not be a close relationship. Note that
there does not have to be any family or legal relationship: friendship can threaten independence and
integrity.
Long association of senior personal creates a familiarity (and self-interest) threat. The Code requires
that an engagement partner cannot serve a PIE client for more than seven years (the 'time-on'
period). This is to prevent too close a relationship and friendship growing between the two parties.
The problem is that when a close relationship does grow, objectivity and skepticism are more likely to
be lost. After the time-on period, the 'cooling-off' period for an engagement partner is five
consecutive years. The cooling-off period for an individual responsible for the engagement quality
(EQ) review (see Chapter 9) is three years.
3.5. Intimidation
The final groups of threats are intimidation threats. These can deter the assurance team from acting
properly.
Examples could be threatened litigation, blackmail, or there might even be physical intimidation,
though it is to be hoped that that is rare. Blackmail could be more subtly applied . For example, if a gift
or hospitality from a client were to be accepted, the possibility of that being made public would
create an intimidation threat to objectivity.
4. Safeguards
Applying safeguards may be a suitable response to address an identified threat. Other responses are
to eliminate the source of the threat or decline/end the activity.
The ACCA Code of Ethics (2019) defines safeguards as "actions, individually or in combination, taken
by the professional accountant that effectively eliminate threats to compliance with the
fundamental principles or reduce them to an acceptable level".
The ‘test’ of what is acceptable is whether a “reasonable and well informed party… would be likely to
conclude that … compliance with the fundamental principles is not compromised”.
Although the Code is ‘principles-based’, that does not mean that ‘anything goes’ (ie nothing is
actually prohibited). Some threats are considered ‘too significant’ that no safeguards could reduce the
threats to an acceptable level.
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Example 1 – No safeguards
State FIVE threats which NO safeguards could reduce to an acceptable level.
Example 2 – Safeguards to reduce threat to an acceptable level
State FIVE safeguards that may be applied to reduce a threat to an acceptable level.
For each, safeguard, give one example of its application.
Note that the concepts of broader safeguards (“created by the profession”, “in the work environment”,
“implemented by the entity”) are not now regarded as safeguards.
These “no longer safeguards” may, however, affect the evaluation of a threat. For example, “seeking
advice” does not meet the definition of a safeguard but may assist in assessing a complex matter.
A professional accountant’s action is not a safeguard unless it is effective.
5. Conflict of interest
This is not a fundamental principle but a situation that creates a threat to objectivity (and possibly
other fundamental principles). An example is where the auditor has two clients and one of the clients
wants to buy the other. The auditor has been asked to advise the purchaser. The conflict of interest
arises because the auditor will have detailed knowledge about the target company: costs, mark-ups,
budgets etc which would be very useful to the purchaser. Even if no confidential information was
supplied, there can be the suspicion that it might be and you can understand why clients might feel
uncomfortable.
In such a situation, the audit firm should inform both parties. They might say that they are not
bothered, but even then the audit firm must judge whether it would be seen to be independent and if
there is a risk to reputation the work should be turned down.
6. Proposed Revisions to the Code
IESBA Proposed Revisions to the Code to Promote the Role and Mindset Expected of Professional
Accountants is an examinable document. The objective of the "role and mindset" (formerly
"professional skepticism") project is to ensure that the Code promotes the role, mindset and
behavioural characteristics expected of all professional accountants.
Note: Topics of exposure drafts are examinable to the extent that relevant articles about them are
published in student accountant. It is particularly important, therefore, to read articles about exposure
drafts which you will also find in the technical articles section of AAA study resources (see
www.accaglobal.com/gb/en/student/exam-support-resources.html)
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7. Example solutions
Solution 1 – No safeguards (only five were asked for)
๏
An audit firm having a direct financial interest or material indirect financial interest in an audit
client. (So if a firm had shares in Alfa Co it would have to dispose of them to accept the audit
appointment.)
๏
Close business (commercial) relationships (eg the firm and client package their services or the
client marketing the firm’s services).
๏
Accepting loans and guarantees that are not the client’s business or not on normal terms.
๏
Contingent fees for an audit engagement.
๏
Assuming any management responsibility for an audit client.
๏
Providing valuation services to a PIE that are material to the financial statements. (Also for a nonPIE client if the valuation involves a significant degree of subjectivity.)
๏
Giving tax or corporate finance advice which depends on a particular accounting treatment and
has consequences that are material to the financial statements.
๏
A partner or employee of the firm serving as a director or officer of an audit client.
๏
Acting as an advocate for an audit client before a court (unless amount involved are immaterial).
๏
Promoting, dealing in or underwriting client’s shares.
๏
Gifts and hospitality unless trivial and inconsequential.
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Solution 2 – Safeguards to reduce threat to an acceptable level (only five were asked for)
Safeguard
Application
Separate engagement teams
Taxation, internal audit and other services
(where allowed) to an audit client. Also for
conflicts of interest.
Not including or removing a member of the
audit team
Financial interest held by a member of the audit
team (or immediate family member).
An immediate family holds a position of
influence in relation to the audit client’s financial
statements (eg director).
Actual or prospective future employment with
the audit client.
Staff loaned to clients.
Review of audit work by a professional who was
not a member of the audit team
Long association
Review of non-audit work by a professional who
was not involved in the work
Other services such as bookkeeping, taxation
and valuation (where not prohibited).
Discussion of ethical issues with TCWG/audit
committee
Fees from a PIE client exceed 15% benchmark
for two consecutive years. Also for conflicts of
interest.
Disclosure of fees to TCWG/audit committee
High proportion of fees. Also low-balling.
Assigning appropriate time and qualified staff
Low-balling
Rotating senior members of the audit team
Long association
Engagement quality review (or equivalent)
Fees from a PIE client exceed 15% benchmark
for two consecutive years (and subsequent
years).
Notify the existing auditor of the proposed work
(with permission)
Requests for a ‘second opinion’ by a company
that is not an existing client (typically on the
application of a financial reporting standard).
Note that the examples of the threats to which these safeguards may be applied cannot include
any of the threats in Solution 1.
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Chapter 5
MONEY LAUNDERING
1. Introduction
Money laundering is a process whereby the proceeds of criminal activity are converted into assets
appearing to have a legitimate origin.
Dirty money is made clean-looking. The money typically comes from extortion, drugs, prostitution,
illegal gambling, illegal arms sales and people-trafficking. Criminal property may also arise from tax
evasion.
2. The stages of money laundering
The process of money laundering can be described in the following three steps:
๏
Placement: this is the process of introducing the money into a legitimate business activity so
that its origins appear bona fide. Methods include:
‣ Blending funds: mixing the dirty money with legitimate cash such as boosting the cash
takings of a business. Tax will have to be paid, but that’s a small price if the remainder of the
money is safe-guarded.
‣ Gambling: winnings are artificially increased and this can be used to explain the source of the
funds.
‣ Currency smuggling: move the cash to a lax jurisdiction where few questions will be asked.
You will notice that cash transactions facilitate placement because cash is relatively difficult to
trace compared to bank or credit transactions
๏
Layering: repeated transfer of money through different bank accounts and different countries
in an attempt to conceal or camouflage its origins. That way, even if the placement process
becomes known to the authorities it becomes difficult for them to trace the cash and recover it.
๏
Integration: the movement of previously laundered money into the economy so that the
money can be safely used. Examples include the purchase of assets such as expensive cars and
art works and jewellery.
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3. Legislation
Many countries now have legislation to combat money laundering and the proceeds of crime and
also to interfere with the supply of money to terrorist organisations. As well as creating criminal
offences for the immediate perpetrators of the crimes, the legislation can also cover the behaviour
and responsibilities of auditors and accountants.
In the UK the Proceeds of Crime Act 2002 sets out three types of offence that can be committed by
any person:
๏
Concealing, disguising, converting or transferring money that is from the proceeds of crime.
๏
Entering into an arrangement to launder the proceeds of crime or having the suspicion that
money laundering is taking place yet not reporting it.
๏
Acquisition, use or possession of criminal property.
Two further offences are relevant to individuals in regulated sectors (financial services, law firms,
estate agents, casinos, etc):
๏
Failure to disclose knowledge or suspicion of money laundering:
‣ internally to a Money Laundering Reporting Officer (MLRO) or
‣ externally to the Serious Organised Crime Agency (SOCA).
๏
Tipping off.
The penalties are severe. For example, taking part in money laundering attracts a maximum prison
sentence of 14 years and/or an unlimited fine.
Note that if the prosecution can show that a defendant had a even suspicion that money had criminal
origins that the defendant can be found guilty of these crimes. So, ‘turning a blind eye’ is no defence.
Obviously an accountant could be directly participating in or abetting money laundering, but here we
will assume you are all ethical and won’t take part in that. However, it is easier to inadvertently
commit some of the other offences.
For example, suspicions would be expected to arise if:
๏
You work in a bank and see a customer dealing in large amounts of cash without any reasonable
explanation of their origin.
๏
You are an auditor and see cash passing through various banks accounts for no apparent
reason.
Tipping off is the disclosure of information that is likely to prejudice an investigation. So, saying to a
client “I think this is money laundering and I am going to report my suspicions to the authorities” is
clearly tipping off. However, what if you repeatedly ask for evidence about a transaction? The client
then knows that you might be suspicious and that your next step is to report the matter. However, if
you make no enquiries at all or inadequate enquiries, you might fail to uncover a perfectly innocent
explanation.
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Auditors also do not want junior members of the audit team taking this into their own hands and
directly informing the authorities. Junior member of the team are relatively inexperienced and might
simply be jumping to the wrong, but dramatic, conclusions. Instead, all suspicions should be reported
to the auditing firm’s money laundering reporting officer. This is a person who has sufficient
experience and seniority to be able to make reliable decisions about when matters ought to be
reported to the authorities.
4. Auditors’ responsibilities
The Money Laundering Regulations 2007 require businesses in the accountancy sector to establish
anti money laundering ('AML') systems and controls including:
๏
Customer due diligence (‘Know your client’) measures include identification of the people
involved, the ownership of companies, the economic rationale of the business, the sources of
funds.
๏
Appointment of a Money Laundering Reporting Officer (MLRO).
๏
Train staff to identify the types and patterns of transaction that might indicate money
laundering.
๏
Establish a system for the reporting of suspicions to the MLRO.
๏
Include a paragraph in the engagement letter setting out the auditor’s responsibilities in respect
of money laundering.
๏
Maintain records detailing how the regulations have been complied with, for five years.
5. Risk factors
The existence of higher than normal risk factors require increased attention to gathering and
evaluation of KYC information and heightened awareness of the risk of money laundering in
performing professional work. For example:
๏
A cash-based business
๏
Many similar deposits and withdrawals in various bank accounts for no obvious reason
๏
Many jurisdiction involved in the transfer of money
๏
The use of tax havens
๏
Bearer bonds or cheques
๏
Higher profits than could be reasonably expected
๏
Poor documentation for transactions
๏
Secrecy
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Chapter 6
RESPONDING TO NON-COMPLIANCE
WITH LAWS AND REGULATIONS
(NOCLAR)
1. Introduction
This chapter deals with how the auditor should respond to a client’s failure to comply with laws and
regulations. Potentially, non-compliance will lead to fines, penalties and damages and these should
be recognised as liabilities or contingent liabilities. Additionally, non-compliance might cause going
concern issues if the company is then prohibited from trading or the non-compliance damages the
reputation of the company to such an extent that its survival is threatened.
ISA 250 Consideration of Laws and Regulations in the Audit of Financial Statements is relevant. In
addition, IESBA's pronouncement Responding to Non-Compliance with Laws and Regulations
(NOCLAR) provides a framework for how professional accountants should act in the public interest,
when they become aware of or suspect NOCLAR.
NOCLAR is defined as acts of commission or omission, intentional or unintentional, committed by a
client or TCWG... contrary to laws or regulations. The definition excludes personal misconduct (i.e.
unrelated to business activities).
The ethical standard permits accountants to set aside the duty of confidentiality in order to disclose
NOCLAR rather than simply resign.
2. Management’s and auditor’s responsibilities
ISA 250 states that “It is the responsibility of management, with the oversight of those charged with
governance, to ensure that the entity’s operations are conducted in accordance with the provisions of
laws and regulations, including compliance with the provisions of laws and regulations that
determine reported amounts and disclosures in an entity’s financial statements”.
Management’s responsibilities will be easier to meet if there is an effective system of internal controls,
an internal audit department and an audit committee.
ISA 250 also states “the auditor is not responsible for preventing non-compliance and cannot be
expected to detect non-compliance with all laws and regulations”.
However, overall the auditor is responsible for identifying material misstatements whether caused by
fraud or error but the ISA recognises that the risk of the auditor failing to detect material
misstatements arising because of non-compliance can be increased because:
๏
There are many laws and regulations that do not directly affect the financial statements.
๏
Non-compliance might be accompanied by deliberate concealment.
๏
Whether an act amounts to non-compliance is ultimately a matter for the court or regulators.
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ISA 250 distinguishes the auditor’s responsibilities for compliance between two categories of laws
and regulations:
๏
Those that have a direct effect on the financial statements (eg tax and pension laws). Here, the
auditor must obtain sufficient appropriate audit evidence regarding compliance with these
laws. This is, essentially a positive confirmation.
๏
Those that do not have a direct effect on the financial statements, but may be fundamental to
business operations, going concern or the avoidance of material penalties. Here, the auditor’s
responsibility is limited to undertaking procedures to help the identification of non-compliance
where this could have a material effect on the financial statements. This is, essentially, a negative
confirmation.
3. Audit procedures to assess compliance
๏
Obtain an understanding of the client’s regulatory environment and how the client complies.
๏
Obtain sufficient appropriate audit evidence where the laws and regulations directly affect the
financial statements.
๏
In respect of other laws:
‣ enquire of management whether the entity is in compliance
‣ inspect correspondence with relevant licensing authorities.
๏
Remain alert during the audit that other audit procedures might detect non-compliance.
๏
Ask for written representations from management declaring that all known incidents of noncompliance whose effects should be considered in the preparation of the financial statements
have been disclosed to the auditor.
๏
In the absence of identified or suspected non-compliance the auditor is not required to carry
out audit procedures to confirm compliance other than those listed above.
4. Non-compliance is identified or suspected
The auditor must:
๏
Understand the nature of the non-compliance and evaluate the possible effects on the financial
statements.
๏
Discuss the matter with management and TCWG if appropriate.
๏
If sufficient information about the suspected non-compliance cannot be obtained, consider the
effect of this lack of sufficient appropriate evidence on the audit opinion.
๏
Consider the effects of non-compliance on other aspects of the audit such as risk assessment
and the reliability of written representations. [In other words, the directors may have shown that
they consider compliance to be voluntary. If they act like this in one area how many other
incidents of non-compliance might exist?]
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5. Reporting non-compliance
All incidents of non-compliance should be reported to TCWG (unless trivial).
If the auditor believes non-compliance is deliberate, this should be communicated to TCWG.
If TCWG are complicit in the non-compliance, and there is no higher level of authority (such as a
parent's board or audit committee) then the auditor should take legal advice.
If non-compliance gives rise to material misstatement in the financial statements, the audit opinion
will have to be modified (qualified or adverse)
If the auditor is prevented from investigating the matter, the audit opinion will have to be modified
(qualified or disclaimer).
It is important that all discussions, findings and disclosures are well-documented as there is obviously
a high risk to the auditor of fallout from these incidents.
Under the NOCLAR provisions in the IESBA standard the auditor should:
๏
Advise management and TCWG to take timely and appropriate action to remedy or avert noncompliance.
๏
Disclose the matter to the appropriate authority (unless precluded by law or regulation) for
investigation and action to be taken in the public interest.
The auditor must assess management’s response then decide if further action is required in the public
interest. Simply resigning from the engagement is NOT a substitute for taking appropriate further
action. If, however, withdrawal is the only available course of action, the proposed successor should
be informed of the matter (even without the former client's permission).
Whether the auditor should disclose the matter to the authorities depends on the actual or potential
harm that might be done to investors, employees, general public and so on. Examples where
disclosure is likely to be justified include:
๏
Bribery
๏
The sale of harmful products
๏
Tax evasion
๏
Behaviour likely to damage financial markets.
If the disclosure is made in good faith it will not be considered to be a breach of confidentiality.
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Chapter 7
AUDITORS’ LIABILITY
1. Introduction
Auditors’ and accountants’ liability can arise from three branches of the law:
๏
Statute: for example if the accountant has been appointed as a liquidator of a company they
can be regarded as officers of the company and could be subject to criminal proceedings. This is
rare.
๏
Contract law: the letter of engagement sets out what the auditors and the client will do. For
example the auditors undertake to give reasonable assurance about the financial statements. If
the auditors carry out their work with due care and skill they will not be liable under contract
law.
๏
Tort law: the tort of negligence allows any injured party, not necessarily a party who has a
contractual relationship with the auditor, to pursue the auditor for damages if they have
suffered loss caused by the auditor’s negligence. This is the area where there is potentially most
difficulty.
2. The tort of negligence
An injured party has to show three things if the tort of negligence is to be proved:
๏
That a duty of care exists. The act of the accountant must be sufficiently close to the damage
(proximity). This is presumed to exist between an auditor and the audit client. However, with
other relationships this is more difficult to establish.
๏
That the duty of care was breached.
๏
That the breach caused financial loss.
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3. The duty of care
For a duty of care to be owed by an auditor to a third party, a 'three-fold test' must be satisfied:
๏
The auditor knew or should have known that that person would rely on the auditor’s work (ie
damage was foreseeable).
๏
The third party has sufficient proximity (effectively, ‘close enough’ to reasonably rely on the
auditor’s work).
๏
It must be ‘fair, just and reasonable’ to impose a liability on the auditor.
Some cases illustrate these principles:
Caparo Industries v Dickman (1990)
Caparo sued an auditor after buying shares in a company they claimed was overvalued because of
inaccurate financial statements. They claimed that the auditor owed potential investors a duty of care.
The claim was unsuccessful as it was held by the House of Lords that the financial statements are
prepared for existing shareholders, as a class, and that the auditor has no common law duty to
individual investors (whether existing or prospective).
Royal Bank of Scotland v Bannerman (2002)
Bannerman was the auditor and issued ‘clean’ auditor's reports for a client. The client was a customer
of the Royal Bank of Scotland and used the financial statements to support a successful loan
application. The financial statements greatly overstated the company's assets and profitability as the
result of alleged fraud.
The claim was successful. The court held that the auditor knew that the bank would rely on the
accounts for lending decisions and therefore owed the bank a duty of care. The court stated that if
the auditor's report had contained a disclaimer warning that only members of the company should
rely on it then there would be no duty of care to third parties.
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4. Conclusion
The courts have been reluctant to extend the concept of duty of care to third parties such as
suppliers, lenders and potential investors.
Auditors will have exercised sufficient professional care if:
๏
They keep up to date with current approaches to auditing.
๏
They apply ISAs and ethical standards and safeguards.
๏
They comply with the terms of the engagement letter.
๏
They apply an adequate system of quality management: assignment of staff, direction of staff,
review of work.
๏
They undergo adequate supervision and education and training.
Since the Bannerman case it has become routine for audit firms in the UK to include a disclaimer
clause in their reports. For example:
"This report is made solely to the company's members, as a body, in accordance with
[Companies Act 2006]. Our audit work has been undertaken so that we might state to the
company's members those matters we are required to state to them in an auditors report and
for no other purpose. To the fullest extent permitted by law, we do not accept or assume
responsibility to anyone other than the company and the company's members as a body, for
our audit work, for this report, or for the opinions we have formed."
However, there is criticism of disclaimer clauses because they can be seen as devaluing the auditor's
report:
๏
How can it be that the financial statements "present fairly ..." to the shareholders but to no one
else?
๏
If the disclaimer clause reduces the chance of litigation, auditors might not take as much care
whilst performing the audit.
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5. Ways to restrict liability
In addition to the measures set out above, the following may restrict liability:
๏
Professional indemnity insurance (PII). This will pay compensation to injured parties in cases of
negligence.
๏
Fidelity Guarantee insurance (FGI): Insures against the dishonesty of staff or partners. Both PII
and FGI may be mandatory (eg to obtain an ACCA licence to practice).
๏
Incorporation: Instead of being a normal partnership where the partners have unlimited liability,
the firm becomes a limited liability partnership. The partners’ personal wealth is protected.
๏
Liability limitation agreements. The engagement letter includes a cap on the amount of
compensation payable to clients. This gives no protection against third party claims. An
agreement is only valid if it is:
‣ fair and reasonable
‣ for the current year only
‣ approved by the shareholders.
๏
Proportional liability. Under this system the auditor and the client would share the burden of
paying compensation to injured third parties according to blame - not ability to pay
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Chapter 8
FRAUD, ERROR, THE EVALUATION OF
MISSTATEMENTS AND REPORTING
CONTROL WEAKNESSES
1. Definitions
Fraud is an intentional act, involving deception, to obtain an unjust or illegal advantage.
Fraud can be:
๏
Fraudulent financial reporting. For example, overstating profits to attract investors and lenders.
๏
Misappropriation of assets. For example, the theft of cash, inventory or non-current assets.
Error is an unintentional misstatement, including omission, of an amount or disclosure in financial
statements.
Misstatement is a difference between what is reported and what should be reported (eg in
accordance with IFRS). A misstatement can be caused by either error or fraud. A misstatement can be:
๏
An incorrect amount.
๏
Incorrect classification or presentation.
๏
Incorrect disclosure.
2. Fraud
It is management’s responsibility to prevent and detect fraud – not the auditor’s. It is management’s
responsibility to ensure that there is an effective system of internal control as this will greatly decrease
the risk of fraud and increase the likelihood of detecting fraud. Auditors are not expected to find every
fraud, but they are expected (with reasonable assurance) to find material misstatements, whether
innocent or fraudulent. They are expected to exercise professional scepticism and to follow up any
suspicions that they might have, for example if the results of analytical procedures do not make sense.
Once a suspected fraud or error is discovered the auditor must perform more audit work, such as:
๏
Discovering how the fraud or error occurred.
๏
Discovering if the incident is isolated or is part of a larger pattern.
๏
Consider applying computer assisted auditing techniques to look for similar patterns within the
records (for example, all orders placed with a particular supplier).
๏
Estimating the financial effect.
This risk of failing to detect material misstatement due to fraud is greater than material misstatement
due to error because fraudsters seek to conceal their activities. For example, by creating forged
documents or by collusion with other parties.
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Three conditions are usually present when fraud exists:
๏
Incentive or pressure to commit the fraud
๏
Opportunity to commit the fraud
๏
Attitude to go through with the fraud
At the planning stage the susceptibility of an entity to fraud should be discussed with the audit team
and with management of the client. The following are examples of fraud risk factors that indicate an
increased risk of fraud:
๏
Lack of segregation of duties or independent checks.
๏
Significant deficiencies in internal control components (e.g. ineffective internal audit function).
๏
Management failing to remedy known significant deficiencies in internal control on a timely
basis.
๏
Complex transactions that pose difficult 'substance over form' questions.
๏
Significant estimates that are difficult to corroborate.
๏
Easy-to-steal assets: cash, compact but high-value inventory.
๏
Complex group structures so that related party transactions are difficult to discover.
๏
Excessive pressure on management to meet financial targets.
A fraud must be communicated to TCWG if it results in material misstatement or if management is
implicated. Other frauds should be communicated to a suitable level of management. It is important,
even for what appears to be a small fraud, to investigate how long it has been going on for, how
much is involved and who is behind the fraud.
In exceptional circumstances, the auditor may be unable to continue performing the audit.
example:
๏
Management or TCWG appear to be responsible for committing a fraud.
๏
There is a significant risk of material and pervasive fraud.
๏
Failure to take appropriate action raises significant concern about management's integrity.
For
3. Management bias
‘Management bias’ (a lack of neutrality) may represent a risk of fraudulent reporting. Factors that may
produce bias include:
๏
Bonuses dependent on hitting a profit target.
๏
Jobs dependent on a level of performance.
๏
The business is going to be floated on the stock exchange so higher profits increase the
flotation price.
๏
The business is targeted for a takeover and the purchase price be will be influenced by
performance.
In these situations auditors should be wary of managers being more optimistic than is warranted so
that the value of inventory, recoverability of receivables, profit budgets and construction contract
profitability are overstated and potential liabilities are understated.
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At some point optimism and wishful thinking will become more like deliberate misstatement and
fraud: making demonstrably undue claims about company performance and the deliberate omission
of liabilities.
Management bias is a common element of AAA questions: many describe bonus schemes or buy-outs
and you must respond to these by recognising the increased audit risk that inevitably arises.
4. Evaluation of misstatements identified
ISA 450 Evaluation of Misstatements Identified during the Audit requires auditors to accumulate
identified misstatements other than those which are clearly trivial. The triviality threshold will
generally be much lower than the materiality threshold.
๏
All misstatements accumulated during the audit should be communicated to the appropriate
level of management on a timely basis.
๏
Management should correct them or explain why not. Often the audit committee will be
involved in these discussions. Misstatements can be categorised as:
‣ Factual (definitely incorrect, like a mistake when adding up the stock-take sheets).
‣ Judgmental (where the auditor and client have different opinions, such as the valuation of
inventory or recoverability of debts).
‣ Projected. The auditors best estimate of the error of a population based on the errors in the
audit sample.
๏
The categorisations affect how much negotiation or compromise is acceptable when it comes to
amending the financial statements:
‣ no room for compromise with factual misstatements
‣ discussion of judgmental errors may reach a compromise
‣ extended testing to find actual errors rather than make adjustments for projected errors.
๏
Obtain written representations from management that they believe uncorrected misstatements
are not material or their reasons for believing that certain uncorrected misstatements are not
misstatements.
๏
Assess materiality of uncorrected misstatements individually and in aggregate. Note that
materiality levels may have been revised as the audit progressed (ISA 320 Materiality in Planning
and Performing an Audit).
If management refuses to correct a misstatement which the auditor thinks is material then the auditor
will have to issue a qualified opinion (or adverse if the matter is pervasive).
Note it is management’s responsibility to correct errors in the financial statements. Auditors cannot
unilaterally adjust the financial statements that have been prepared by management.
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5. Reporting deficiencies in internal controls
Deficiencies in internal control may be identified when assessing risks (ie at the planning stage) or at
any later stage. ISA 265 Communicating Deficiencies in Internal Control to Those Charged with
Governance and Management requires the auditor to determine whether deficiencies, individually or
in combination, are 'significant'.
A significant deficiency is one that is sufficiently important to merit attention of TCWG.
Factors influencing this include:
๏
The likelihood that the deficiencies will lead to material misstatement.
๏
The susceptibility to loss or fraud of the related asset or liability.
๏
The subjectivity and complexity of determining estimated amounts.
๏
The financial statement amounts exposed to the deficiencies.
๏
The volume of activity in the account balance or class of transactions exposed to the deficiency.
The auditor must communicate in writing significant deficiencies in internal control to TCWG on a
timely basis.
Other deficiencies should be communicated to management at the appropriate level.
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Chapter 9
QUALITY MANAGEMENT
1. Introduction
The IAASB has published three new and revised standards to strengthen and modernise the audit
firm’s approach to quality management. These are examinable from September 2022:
๏
ISQM 1 Quality Management for Firms that Perform Audits or Reviews of Financial Statements, or
Other Assurance or Related Services Engagements (replaces ISQC 1) deals with a firm’s
responsibility to establish a system of quality management to support quality engagements.
๏
A new standard ISQM 2 Engagement Quality Reviews applies to all engagements for which such a
review is required in accordance with ISQM1.
๏
ISA 220 (Revised) Quality Management for an Audit of Financial Statements deals with
responsibilities for quality management at the engagement level for an audit of financial
statements.
2. Quality control (firm-wide)
Under International Standard for Quality Management 1 (ISQM 1), the firm must design, implement
and operate a system of quality management to provide it with reasonable assurance that:
(1)
The firm and its personnel comply with professional standards and applicable legal and
regulatory requirements; and
(2)
Reports issued by the firm or engagement partners are appropriate in the circumstances.
Note again the use of the word ‘system’. You will know that under the Code of Ethics for Professional
Accountants to avoid self-interest threats firms have to ensure that no one involved in an audit owns
shares in the audit client and that fees from any one client must not be too great. However, these
safeguards cannot be left up to chance. Audit firms need systems in place that will ensure that ethical
codes are not broken and will provide evidence that quality has been maintained. To comply with the
self-interest rules just mentioned, the system of quality management might require that each year:
๏
Every member of the audit staff must sign a declaration stating that they do not own client
shares.
๏
A partner should review fees and sign a declaration that fee limits have not been exceeded.
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ISQM 1 consists of EIGHT components:
๏
Firm’s risk assessment process. The firm must have a risk assessment process to:
‣ Establish quality objectives;
‣ Identify and assess quality risks; and
‣ Design and implement responses to address quality risks.
๏
Governance and leadership. The firm must establish policies and procedure designed to
promote an internal culture that recognises that quality is essential in performing engagements.
๏
Relevant ethical requirements (covered earlier in these notes). Throughout the audit
engagement, the engagement partner shall remain alert, through observation and making
inquiries as necessary, for evidence of non-compliance with relevant ethical requirements by
members of the engagement team.
๏
Acceptance and continuance of client relationships and specific engagements. The firm
must ensure that decisions are appropriate based on:
‣ the nature and circumstances of the engagement and the integrity and ethical values of the
client; and
‣ the firm’s ability to perform the engagement in accordance with professional standards and
legal and regulatory requirements.
The financial and operational priorities of the firm must NOT lead to inappropriate decision..
๏
Engagement performance. Overall responsibility for quality rests with the engagement partner
who must have sufficient and appropriate involvement throughout the engagement. The
nature, timing and extent of direct and supervision of engagement teams and review of their
work must be appropriate.
๏
Resources. Three categories of resources are needed to operate the system of quality
management and perform engagements: Human | Technological | Intellectual
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๏
Information and communication. A firm should have an information system that supports
the system of quality. Communication channels need to facilitate the exchange of information
within the firm and with external parties including TCWG.
๏
Monitoring and remediation process. Monitoring activities must provide a basis for the
identification of deficiencies. Remedial actions to address identified deficiencies need to be
responsive to the results of a "root cause analysis".
49
If there are changes in the nature and circumstances of the firm or the engagements or if the
monitoring and remediation process identifies deficiencies, the firm:
๏
Establishes additional quality objectives; and/or
๏
Modifies or adds to the quality risks and responses.
3. Engagement quality review (EQ review)
Public interest audits, such as the audit of listed companies, should undergo an Engagement Quality
Review (EQ review). Here, an independent reviewer (normally another partner) will be appointed to
perform an objective evaluation of the significant judgments made by the engagement team,
and the conclusions reached in formulating the auditor’s report.
An audit firm should set criteria for other engagements, if any, that require an EQ review (eg entities in
certain industries identified as high risk). An EQ review includes:
(1)
Discussion of significant matters with the engagement partner;
(2)
Review of the financial statements and the proposed auditor’s report;
(3)
Review of selected audit documentation relating to the significant judgments the engagement
team made and the conclusions it reached; and
(4)
Evaluation of the conclusions reached in formulating the auditor’s report and consideration of
whether the proposed auditor’s report is appropriate.
For audits of listed entities, the EQ review must also consider the following:
(1)
The engagement team’s evaluation of the firm’s independence in relation to the audit
engagement;
(2)
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;
and
(3)
Whether audit documentation selected for review reflects the work performed in relation to the
significant judgments and supports the conclusions reached.
An EQ review is an example of a pre-issuance ('hot') review - i.e. it is carried out before the auditor’s
report is signed. An audit firm may choose to carry out other reviews ('hot' or 'cold') where an EQ
review is not required.
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4. Quality management (engagement level)
ISA 220, which addresses quality management procedures at the engagement level, presumes that
the firm meets the requirements demanded by ISQM 1. At the engagement level, quality
management procedures must provide reasonable assurance that:
๏
The audit complies with professional standards and legal requirements
๏
The auditor’s report issued is appropriate in the circumstances.
The engagement partner is responsible for:
๏
Leadership and the overall quality of the audit
๏
Compliance with relevant ethical requirements
๏
Acceptance/continuance of the audit engagement
๏
Assigning a competent and capable engagement team
๏
Engagement performance, including:
‣ Direction, supervision and performance of the audit in accordance with ISAs
‣ Review of audit documentation
‣ Appropriate consultation, where appropriate
‣ Discussion of significant matters with the EQ reviewer, where relevant
Audit documentation (ISA 230) must include:
๏
Ethical issues and how resolved
๏
The engagement partner’s conclusions regarding compliance with independence requirements
and the acceptance/continuance of the engagement
๏
The nature and scope of consultations, if any, and the conclusions reached.
Where relevant, the EQ reviewer must document:
๏
That the firm’s EQ review procedures have been performed
๏
That the review has been completed on or before the date of the auditor’s report
๏
That he is not aware of any unresolved matters that would lead him to believe that significant
judgements and conclusions are not appropriate.
Remember to check the technical articles section of AAA study resources for this topic.
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AUDIT PLANNING AND RISK ASSESSMENT
Chapter 10
AUDIT PLANNING
1. Overview
Appointment
Plan the audit
Understand entity
Assess risk of material misstatement
Respond to risk
Expect effective controls
Tests of controls
Expect ineffective controls
Unsatisfactory
Report significant deficiencies
to those charged with
governance
Satisfactory
Reduced substantive
procedures
Full substantive
procedures
Overall review of FS
Report to management
Auditor’s report
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All audits start by:
๏
Planning
๏
Understanding.
After these stages auditor can assess the risk of material misstatement and respond to that risk. We
will see later how the risk of material misstatement can be broken down into several causes, but if you
are dealing with a relatively new company with inexperienced staff, and which has high value,
portable inventory and many cash transactions, you will probably see that the risk of material
misstatement is relatively high. If the auditors conclude that is the case then they have to plan for
their audit work to reduce the risk of material misstatement finding its way into the financial
statements.
2. Audit planning
Audit planning is very important and the auditors state in the auditor's report that they planned and
performed their audit. ISA 300 Planning an Audit of Financial Statements is written in the context of
recurring audits.
2.1. Reasons why planning is important
๏
If you don’t plan it you won’t carry out the audit effectively. You would not know something as
obvious as when the year end is, or how many branches or factories a company has, or how
many staff members you may need to conduct the audit, or whether the company has a lot of
valuable inventory.
๏
You have to think both of a general strategy and a detailed approach. For example, in some very
large companies auditors do not visit all the branches every year. They may visit only a quarter
of the branches one year, another quarter the next year and so on. They have to decide whether
or not to attend a physical inventory count. They may have to decide whether or not opinions
from other experts are required. For example, on the adequacy of the company’s pension
scheme.
2.2. Objectives of adequate planning
๏
To give appropriate attention to important areas. Is there a high inventory? Is there a high
volume of cash transactions? Are trade receivables particularly significant? Important areas will
certainly be material areas, and materiality is discussed below.
๏
To identify potential problems. For example, if the company has recently changed its
computerised accounting system there may well have been problems at the switch-over time,
and staff may still be inexperienced.
๏
To carry out the work expeditiously. That really means reasonably quickly and efficiently.
๏
To ensure that the right numbers of staff are in the audit team with the right skills. They have to
be timetabled so that the work for this client and other clients can be accommodated.
๏
To coordinate, if necessary, with other parties. For example, the internal audit department of the
company.
๏
To facilitate the direction and supervision of the audit team and the review of their work.
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2.3. Planning activities
To perform an audit in an effective matter, the auditor must establish the overall audit strategy (sets
out the scope, timing and direction of the audit) and develop an audit plan. The audit plan describes
the nature, timing and extent of:
๏
Risk assessment procedures (ISA 315 Identifying and Assessing the Risks of Material Misstatement)
๏
Further audit procedures at the assertion level (ISA 330 The Auditor’s Response to Assessed Risks)
Both the strategy and the plan should be updated, as necessary, as the audit progresses and the
strategy, plan and significant changes must be included in the audit documentation.
3. Understanding the entity
In order to identify and assess the risks of material misstatement, the auditor must obtain an
understanding of:
๏
the entity;
๏
its environment;
๏
the applicable financial reporting framework; and
๏
system of internal control.
3.1. Required understanding
๏
Nature of the entity. We have to understand the nature of the entity. For example, we simply
have to understand what it does: is it in a financial sector, the retail sector, the manufacturing
sector? This may seen trivial but it may help you to think of a new audit client. You can often tell
very little from the name of the client. You have to go and find out about the entity itself.
๏
Particular regulations. Banks, insurance companies, and many other operations in the financial
sector are subject to regulation and sometimes the auditor has to ensure that these regulations
have been adhered to.
๏
Applicable financial report framework. An understanding of the applicable financial
reporting framework is essential to evaluating whether the entity's accounting policies are
appropriate. An entity may apply industry-specific practices or account for transactions in
emerging areas (e.g. crytocurrency).
๏
Objectives and strategies. The auditors must gain an understanding of the entity’s, objectives,
and strategies. The entity’s management defines objectives, and strategies are devised to try
and achieve those objectives.
๏
Nature of business risks. Business risks can arise from circumstances which mean that the
company’s objectives and strategies may not be achieved. Business risk is broader than the risk
of material misstatement of the financial statements. Most business risks will eventually have
financial consequences and therefore an effect on the financial statements. It is important for
the auditors, therefore, to understand what the risks are.
๏
System of internal control. The auditor has to gain an understanding of the entity’s internal
controls. Whether they exist and to what extent they are expected to operate.
๏
The control environment. The effectiveness of the control environment has a significant
bearing on the auditor's confidence in the other components of the system of internal control
which will affect the nature, timing and extent of audit procedures.
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๏
How does management identify business risks? It is important for management to identify
business risks. Management has a real expertise of the business sector and if they can’t identify
business risks it can be relatively difficult for the auditor to ensure that all business risks have
been covered.
๏
Financial performance. Performance measures create pressures on management. Obtaining an
understanding of the entity’s performance measures assists the auditor in considering whether
such pressures may result in management actions that could increase the risks of material
misstatements. A review of key performance indicators, ratios and trends may indicate that risks
of misstatement exist (eg unusually rapid growth or profitability compared to other entities in
the same industry).
54
3.2. Risk assessment procedures
Risk assessment procedures must include:
๏
Enquiries of management and others (e.g. internal audit) who may have information that is
likely to assist in identifying risks of material misstatements.
๏
Analytical procedures which may help identify unusual transactions/events and ratios or trends
that have audit implications.
๏
Observation and inspection to support the enquiries and provide information (e.g. business
plans, internal control manuals and premises).
Prior year information obtained can be used as long as it remains relevant and reliable as audit
evidence for the current audit. Information obtained during client acceptance procedures may also
be relevant.
3.3. System of internal control
ISA 315 requires the auditor not only to understand the controls relevant to the audit but also:
๏
To evaluate the design of controls – Should they prevent or detect and correct material
misstatement?
๏
To determine whether they have been implemented – Are the controls operating effectively?
Enquiry alone is NOT sufficient to answer these questions.
See Chapter 12 of our AA notes if you need to revise the five inter-related components of a system of
internal control and the different types of control activities. Remember than control activities are just
one of the components.
3.4. Risks of Material Misstatement (RoMM)
A risk of material misstatement exists when there is a reasonable possibility of:
1. A misstatement occurring (i.e. likelihood); and
2. It being material if it were to occur (i.e. magnitude).
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RoMM must be assessed at two levels to provide a basis for designing further audit procedures:
๏
The financial statement level (i.e. relating to the financial statements, for example, the risk of
management override of internal control).
๏
The assertion level (i.e. relating to classes of transactions, account balances and disclosures).
See Chapter 16 of our AA notes if you need to revise the financial statement assertions.
RoMM is assessed at the assertion level to determine the nature, timing and extent of further audit
procedures necessary to obtain sufficient appropriate audit evidence. It has two components –
inherent risk and control risk (see Chapter 11 for details).
IAS 315 (Revised 2019) introduced new concepts and definitions to assist with the identification and
assessment of risks of material misstatement.
๏
Inherent risk factors – characteristics of events or conditions that affect the susceptibility of an
assertion to misstatement, before consideration of controls.
๏
Spectrum of inherent risk – the degree to which inherent risk varies.
๏
Relevant assertion – an assertion with an identified risk of material misstatement.
๏
Significant class of transactions, account balance or disclosure – one for which there is one or
more relevant assertion.
๏
Significant risk – a risk of misstatement which is close to the upper end of the spectrum of
inherent risk or treated as significant in accordance with an ISA (e.g. revenue recognition).
Understand the entity
Identify relevant assertions
Identify significant transactions,
balances and disclosure
Determine where on the
spectrum of risk
Significant risks identified
4. Materiality
One of the key areas of planning is to determine materiality. An audit gives only a reasonable
assurance that the financial statements are free from material misstatement, so it is essential to know
what is meant by ‘material’.
๏
A matter is material if its omission or misstatement would reasonably influence the economic
decisions users taken on the basis of the financial statements.
๏
It is affected by the size or nature of the misstatement.
The auditor’s judgment flows all the way through the audit process, from planning and deciding the
amount of work that should be done, to deciding what action should be taken should errors be found
in the accounts. When judging materiality, the audit partner should consider the common
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information needs of users, as a group. (The specific needs of individual users are not considered as
they may vary widely.)
5. Guidance on materiality
It’s all very well saying that a matter is material if it would reasonably influence decisions of users, but
that gives very little guidance to the audit team (or to you when you are doing a question).
Therefore, some rules of thumb have been developed. These are only guidelines, but an amount will
generally be considered immaterial if it is less than the following and material if it is greater:
๏
0.5% to 1% of revenue
๏
1% to 2% of total assets
๏
5% to 10% of profit before tax
Points to note:
๏
Professional judgement will be used to decide whether amounts within these ranges are
material (eg considering qualitative factors).
๏
Which benchmarks to use will depend on specific circumstances (eg revenue may be most
relevant for a company which provides services with few assets or which has a relatively small
draft profit or a loss).
IT IS VERY COMMON FOR AAA EXAM QUESTIONS TO PROVIDE REVENUE, ASSET AND PROFIT FIGURES.
YOU MUST USE THE RELEVANT FIGURE(S) TO ASSESS WHETHER MATTERS ARE MATERIAL.
In a real audit a running total of errors is kept so that their net effect can be calculated. However,
when designing and carrying out audit tests and when noting down errors, smaller amounts should
be set for materiality to reduce the risk that misstatements in aggregate exceed financial statement
materiality. This is known as performance materiality: the materiality that is important in the
performance of the audit work.
Note that errors which are less than the suggested guidelines could be judged to be material. An error
which turns a small loss into a small profit could cause unfounded optimism in some situations,
perhaps a feeling that the company has turned a corner. So, although in absolute terms, the size of an
error is relatively small, the way in which the accounts are then interpreted could lead to
unreasonable decisions being made. Therefore, you can talk about both quantitative and qualitative
materiality.
Finally, there are some amounts in the financial statements where no errors are tolerable. For
example, there is often a statutory duty to disclose directors’ remuneration and that has to be stated
with absolute accuracy.
Note that the evaluation of misstatements identified during the audit is considered in ISA 450 (see
Chapter 8).
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Chapter 11
RISK
1. Types of risk
The AAA exam will include a 50-mark case study question, set at the planning stage of an audit.
Typically, you will be required to evaluate at least one of the following types of risks for a given
assignment:
๏
Business risks
๏
Audit risks
๏
Risks of material misstatement ('ROMM').
It is essential that you can distinguish between these terms.
Business risks result from significant conditions, events, circumstances, actions or inactions that could
adversely affect the entity's ability to achieve its objectives and execute its strategies.
There are four main categories of business risk:
๏
Strategic risk
๏
Financial risk
๏
Operational risk
๏
Compliance risk
Competition is a common source of strategic risk for businesses planning to expand into new
products or markets. Financial risks could arise because of high borrowings and a rise in interest rates.
This will put the business under severe pressure and could increase the risk of material misstatement,
perhaps with regards to going concern problems. Operational risks arise from day-to-day business
activities. For example, if the products are made incorrectly then there might be warranty claims and a
loss of reputation. Compliance risks arise from a failure to comply with regulations. This can mean that
the business has large penalties or fines to pay or it may result in the loss of an operating licence, so it
can no longer trade.
The auditor does not have a responsibility to identify or assess all business risks, but an understanding
of business risks that may result in ROMM is essential (ISA 315).
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2. Business risk
It is, of course, not the auditor’s duty to manage a business and its risks or even to warn audit clients
about business risks. It is the directors’ and management’s responsibility to run the business for the
benefit of shareholders. Auditors cannot be expected to have expertise in the huge variety of business
risks that are suffered by their many clients. Provided the financial statements properly report on what
has happened in the business (eg that inventory of a poorly selling product has been written down
appropriately) the audit opinion is not affected: the financial statements are presented fairly, in all
material respects.
So why is business risk important to auditors? Well, it is important because business risk will often
often influence inherent risk (ie the susceptibility of a financial statement assertion to the risk of
material misstatement). If misstatements which are not prevented or detected and corrected by
internal controls (control risk) are not detected by the the auditor (detection risk), the auditor will
express an inappropriate opinion (audit risk).
The following examples illustrate just some of the possible risks of material misstatement arising from
business risk:
Business risk
Possible ROMM
Strategic: out-of date products
Inventory might not sell at above cost and
should be written down to net realisable value
(risk of overstated inventory/profit)
Strategic: operations in a country where the
currency has devalued
Subsidiary's assets and liabilities should be
retranslated at the reporting date (risk of
overstated net assets and understated exchange
losses)
Operational: a batch of products has been poorly Sales returned (risk of overstated revenue),
manufactured
goods scrapped (risk of overstated inventory/
profit), compensation to be paid (risk of
understated liabilities)
Operational: computer virus in the accounting
system that deletes customers' records
What are the receivables balances? (risk of
misstated receivables)
Financial risk: significant rise in interest rates
Material uncertainty relating to going concern
(disclosure risk)
Financial risk: significant bank loans with
covenants attached
As well as going concern (above), management
bias increases inherent risk at the financial
statement level
Compliance risk: improper recruitment of staff
that contravenes equality legislation
Actual fines/penalties (risk of understated
liabilities) or possible fines/penalties (disclosure
risk for contingent liabilities)
Compliance risk: failure to comply with health
and safety legislation
Fines/penalties and going concern (as above)
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3. Audit risk
Audit risk is the risk that the financial statements contain a material misstatement that the auditors
have not discovered so that the auditors give an inappropriate opinion on the published financial
statements. (Strictly, it could also refer to the auditors modifying their opinion when the financial
statements are fine. However, this is 'scoped out' of the ISAs as this risk is ordinarily insignificant.)
Audit risk has three components whose relationship is described by the audit risk model:
Risk of material misstatement
AR
=
IR x CR
x
DR
Audit Risk
Control Risk
Inherent Risk
Sampling Risk
Detection Risk
Non-sampling Risk
๏
Inherent risk = the risk of an error occurring in the first place, without any controls being
present.
๏
Control risk = the risk that the entity’s control procedures do not prevent, detect and correct
the error.
๏
Detection risk = the risk that audit procedures do not discover the error.
The assessment of inherent risk considers both likelihood and magnitude of possible misstatement.
A significant risk may arise from matters such as:
๏
Transactions that involve subjectivity (e.g. because there are acceptable alternative accounting
treatments);
๏
Accounting estimates with high estimation uncertainty or using complex models;
๏
Account balances or quantitative disclosures that involve complex calculations;
๏
Changes in the entity’s business that involve changes in accounting (e.g. acquisitions or change
in business model).
If there are no controls any errors will find their way into the draft financial statements.
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However, an effective system of internal control can help to prevent or detect and correct errors. For
example:
๏
Senior management of experts review assumptions and other sources of estimation uncertainty.
๏
Segregation of duties or independent checks reduce the risk of errors and fraud.
๏
Reconciliations check the completeness and accuracy of numerical data.
๏
Authorisation and approval lends reliability to transactions.
๏
Physical measures safeguard assets.
๏
Inspection of assets can detect damaged assets or deliveries not properly made.
Don’t look upon the audit risk model too mathematically. What it is saying is that auditors will want
the audit risk to be low: they don’t want to make an error in their audit opinion.
If they want the audit risk to be low then the terms on the right hand side of the equation, or at least
some of them, have to be low.
If an error is made in the first place (inherent risk) AND is not identified and corrected by the controls
(control risk) then the error will be incorporated into the draft financial statements. There is then only
one line of defence to prevent the error from being included in the published financial statements:
the audit.
The error
has to
occurred
The client’s procedures
and staff must not have
picked that up and
corrected it
The auditor must have
failed to detect it
The material
error reaches
the published
financial
statements
Audit risk
If the auditors believe that the inherent risks together with the control risks are unacceptably high,
then they must increase the amount of audit work they perform. This reduces the detection risk (the
risk that the error is not discovered by the auditors). Risks of undetected material misstatements must
be reduced to levels which provide reasonable assurance that material errors are detected.
Neither inherent risk nor control risk can be influenced by auditors in the short term. Inherent risk
might be completely impervious to change (for example, a complicated transaction will always be
complicated). Control risks might be reduced in the medium term if the audit client takes note of
auditors’ letters which set out control weaknesses. However, when it comes time to perform the audit
on the draft financial statements, the only risk that the auditors can control is the detection risk. They
must do sufficient audit work to manage the overall audit risk.
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4. Causes of material misstatements
Material misstatements can occur in two ways:
(1)
The amount is materially incorrect
(2)
The amount is materially correct but incorrectly classified, presented or disclosed (ie does not
comply with the applicable financial reporting framework).
Auditors must therefore obtain audit evidence about the amount and also the treatment of the
amount in the financial statements.
Remember, audit evidence is needed to support all the relevant assertions. So for a non-current asset,
evidence is needed about existence, ownership (rights and obligations), accuracy valuation and
allocation, completeness, classification, presentation. Transactions and events require evidence about
occurrence, completeness, accuracy, cut-off, classification and presentation. IFRSs usually specify how
amounts should be classified and presented. They can also determine cut-off (eg in revenue
recognition), rights and obligations (eg right-of-use assets and lease liabilities) and valuation (eg
subsequent measurement of property, plant and equipment).
5. Detection risk
Detection risk has two components:
๏
Sampling risk
This arises when audit procedures are applied to samples rather
than entire populations. The auditor may conclude, based on a
sample, that controls are more effective than they actually are or
that there is no material misstatement when, in fact, there is. The
auditor may then be doing too little work so that actual
misstatements go undetected. Sampling risk can be reduced by
examining larger samples.
๏
Non-sampling risk
This risk arises from reasons other than sample size. For example, if
the audit staff were inappropriately qualified, there is a higher risk
that they might use inappropriate audit procedures, misinterpret
evidence or fail to recognise an error.
Good quality control procedures should minimise non-sampling
risk: adequate planning, assigning sufficiently skilled staff and the
direction, supervision and review of their work.
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6. Auditor's responses to assess risks
You should recall from earlier studies that ROMM may exist at both the
๏
Financial statement level
๏
Assertion levels.
See Chapter 9 of our AA notes if you need to revise this.
6.1. Overall responses
Misstatements at the financial statement level are potentially more subtle and require a higher level
of skill to detect. The auditor's response may include assigning more experienced staff, providing
more supervision and emphasis on professional scepticism. Understanding of the control
environment is particularly relevant here and will have a significant effect on audit strategy. For
example:
๏
If effective, more audit procedures may be performed at an interim date as the auditor has more
confidence in internal control and the reliability of audit evidence.
๏
If ineffective, more extensive substantive audit procedures should be performed at the year end.
6.2. Assertion level
Assessed risks of material misstatement at the assertion level require the auditor to design and
perform further audit procedures, for example:
๏
Tests of controls (if intending to rely on their operating effectiveness);
๏
Substantive procedures that are specifically responsive to the identified significant risk;
๏
Obtaining more persuasive audit evidence the higher the assessment of risk;
๏
Considering significant risks when determining key audit matters (see Chapter 23);
๏
If significant risks relate to a component in a group audit, greater involvement of the group
engagement partner and team (see Chapter 21).
Note that substantive procedures must be designed and performed for each material class of
transactions, account balance and disclosure irrespective of the assessed risks of material
misstatement.
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Chapter 12
QUESTION PRACTICE ON RISK
1. Events, discoveries and accounting issues and implications
for the audit
A common format of a question on business or audit risk is to present you with notes from a recent
planning meeting with a client, or an email from a partner raising certain issues affecting the client.
You then have to identify the audit risks (ROMM and detection risk) arising and have to say how you
would respond or describe how you would gather sufficient appropriate audit evidence. The
information is given as a number of paragraphs each usually dealing with one piece of information.
Generally, each paragraphs will have at least one implication for the audit of the financial statements.
It is rare to be provided with information that is of little importance.
A similar question can ask about business risk rather than audit risk. There you do not have to talk
about evidence as we are not yet at the stage of carrying out an audit. Remember, auditors are
interested in business risks because these frequently lead to audit risks.
Below is a selection of the type of issues that might be presented to you in exam questions. For each,
identify the issue(s) raised and what the implications are for the audit.
Suggested answers are provided at the end of this chapter, but you might find it easier to listen to the
lecture as each item is talked about there.
(1)
During an inventory count at a company which makes jam and marmalade, a box containing 12
jars was dropped and the jars were broken. It was immediately noticed that the contents had a
bad smell and had obviously gone off or had been contaminated.
(2)
On the final review of an audit file, the partner in charge discovered that a junior audit assistant
had marked as ‘Correctly accounted for’ the purchases of a car where the VAT element had been
posted by the client to Input VAT. [Note: VAT on cars is not recoverable.]
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Non-current asset schedule:
Motor vehicles
Freehold land and
buildings
Computers
Cost b/f
260
10,000
2,000
Additions
50
–
600
Disposals
70
–
400
Cost c/f
240
10,000
2,200
Depreciation b/f
180
600
1,400
Disposals
80
–
100
Charge for year
60
200
220
c/f
160
800
1,520
$000
Depreciation rates (all straight line): cars 25%, land and buildings 2%, computers 10%. Cars are 5
years old when sold.
(4)
A television company has built a small village to be used in the filming of a popular and longrunning TV program. The village has been build in an area of natural beauty and permission to
build was granted on the condition that the village is demolished and the site landscaped on
the earlier of filming ceasing and 20 years.
(5)
The first audit of a new client is in progress. The parent imports small decorative items from
abroad. Its subsidiary trades through 12 take-away pizza shops which are very profitable.
Dividends are regularly paid by the subsidiary to the parent.
During the audit, an inventory count showed that the parent had imported some modern items
which appear to be made of ivory, which is a banned import. Invoices for these items traced
through goods received notes described them as made from a synthetic material.
(6)
A large printing machine originally cost $5 million and its accumulated depreciation amounts to
$3 million.The sale value of the machine to an overseas buyer in the country of Burunda, net of
selling costs, is believed to be 10 million Burundan pounds. The exchange rate at year end was 4
Burundan pounds to $1. The value in use, using cash flow projections and a discount rate of 5%,
is $1.5 million.
(7)
You are the auditor of a group of companies and one of the subsidiaries has had very poor cash
flow and it seems that the bank is unlikely to renew its borrowing facility.
The finance director of the parent has told you that it will make the required loan to the
subsidiary to keep it solvent.
(8)
A company has changed the way in which it values inventory from the FIFO to the weighted
average cost basis and has also changed its depreciation rate on machinery from 20% to 15%.
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2. Business risk
As mentioned above, business risks occur when something either has gone wrong or might go wrong
in the business. In the examples below, identify the business risk and suggest how this might lead to
misstatements in the financial statements.
Suggested answers are provided at the end of this chapter, but you might find it easier to listen to the
lecture as each item is talked about there.
(1)
A company has started selling goods on the Internet.
(2)
A company has started to export goods.
(3)
The finance director has recently left and at period end, has not been replaced.
(4)
A company has failed to file its tax return on time.
(5)
An employee was badly injured carrying out his duties.
(6)
A computer virus disrupted the IT system for two days. All seems fine now.
(7)
The company changed over from its old to its new IT system part-way through the year. The
change-over seemed to go smoothy.
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3. Suggested answers
3.1. Audit risk
(1)
During an inventory count at a company which makes jam and marmalade, a box containing 12
jars was dropped and the jars were broken. It was immediately noticed that the contents had a
bad smell and had obviously gone off or had been contaminated.
‣ Obviously that packet will be written off,
‣ The auditor should investigate other inventory to see if this is an isolated incident of
contaminated food. First choose jars from the same batch, then choose some others at
random and perhaps extend to different products.
‣ An explanation should be sought from management as to how the contamination might
have occurred.
‣ Examine records showing previous production problems.
‣ If other inventory items cannot be shown to be safe with confidence, they will have to be
written down too.
‣ A recall scheme might be urgently needed to get customers to return the affected products.
‣ If some products have already been sold to consumers, newspaper ads and social media
should warn them too and ask them to return goods for a refund.
‣ Try to discover if any end-consumers have had health issues after consumption of the
product.
‣ Assess liabilities for damages and the value of sales to be reversed etc.
‣ Examine the company’s insurance policies to see if they have any policies that could help eg
public liability insurance.
‣ Consider whether the company would survive any adverse publicity (going concern issues).
‣ If the issue concerns a specific brand which is recognised in the SOFP, consider impairment/
write-downs.
(2)
On the final review of an audit file, the partner in charge discovered that a junior audit assistant
had marked as ‘Correctly accounted for’ the purchases of a car where the VAT element had been
posted by the client to Input VAT. [Note: VAT on cars is not recoverable.]
‣ Make an appropriate journal adjustment for that vehicle.
‣ Investigate the treatments of other vehicles acquired as this might not be an isolated
mistake. Make adjustments as needed.
‣ Look at the treatment of other amounts where expenditure is not allowable for VAT (such as
entertainment expenditure).
‣ Encourage the company to come clean with the VAT authorities and assess payments due
together with any penalties.
‣ Review the performance and skill level of the audit team members. Consider additional
training.
‣ The error should have been picked up at earlier reviews ie before getting to partner level.
Look at the review processes and skills of other staff members.
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Non-current asset schedule:
Motor vehicles
Freehold land and
buildings
Computers
Cost b/f
260
10,000
2,000
Additions
50
–
600
Disposals
70
–
400
Cost c/f
240
10,000
2,200
Depreciation b/f
180
600
1,400
Disposals
80
–
100
Charge for year
60
200
220
c/f
160
800
1,520
$000
Depreciation rates (all straight line): cars 25%, land and buildings 2%, computers 10%. Cars are 5
years old when sold.
‣ Assess depreciation rates. Are these usual for the classes of assets. 10% for computers looks
low.
‣ Following up that point, the cost of computers disposed off is 400, but the accumulated
depreciation is only 100. This implies under-depreciation
‣ Freehold land and buildings presumably contain freehold items so these should not be
depreciated. Depreciation of 2% has been applied to the total amount.
(4)
A television company has built a small village to be used in the filming of a popular and longrunning TV program. The village has been build in an area of natural beauty and permission to
build was granted on the condition that the village is demolished and the site landscaped on
the earlier of filming ceasing and 20 years.
‣ Examine the legal agreement with respect to planning permission and the requirement to
demolish.
‣ The demolition costs must be capitalised as part of the construction costs and a long-term
provision set up (FRS15). A difficult estimate
‣ However, this amount needs to be the estimated demolition cost discounted for 20 years at
the company’s cost of capital. Cost of capital will have to be estimated.
‣ The discounting on the provision and the amount capitalised have to be ‘unwound’ over the
life of the asset.
‣ A depreciation rate of 5% is probably appropriate.
‣ Investigate any borrowing costs incurred during construction as these have to be capitalised
also (from commencement of construction to when the asset is first brought into use.)
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The first audit of a new client is in progress. The parent imports small decorative items from
abroad. Its subsidiary trades through 12 take-away pizza shops which are very profitable.
Dividends are regularly paid by the subsidiary to the parent.
During the audit, an inventory count showed that the parent had imported some modern items
which appear to be made of ivory, which is a banned import. Invoices for these items traced
through goods received notes described them as made from a synthetic material.
‣ Note: the first audit of a new client always causes more audit risk, simply because the client,
business and systems are all unfamiliar. Generally, a more skilled audit team than normal
should be assigned for the first audit to reduce detection risk.
‣ Pizza shops are largely cash based. They are reported as being very profitable. Consider the
risk of money laundering.
‣ Money is going abroad through the import business.
‣ The client might have dealt with illegal items (ivory). We need to establish the material used.
‣ If the imports are illegal, the client should be encouraged to tell the authorities and any
penalties should be estimated and suitable provisions set up.
‣ If the material is ivory, or the client will not allow it to be tested, the auditor should withdraw
because the integrity of management is in doubt.
(6)
A large printing machine originally cost $5 million and its accumulated depreciation amounts to
$3 million. The sale value of the machine to an overseas buyer in the country of Burunda, net of
selling costs, is believed to be 10 million Burundan pounds. The exchange rate at year end was 4
Burundan pounds to $1. The value in use, using cash flow projections and a discount rate of 5%,
is $1.5 million.
‣ The fair value of the asset needs to be considered. Current carrying amount is $2m. NRV =
10/4 = $2.5m. Value in use is $1.5m. If the exchange rate is steady, the carrying amount
should be held at $2m. However, the exchange rate only needs to fall to 5 Burundian pounds
to the S1 before the NRV falls to the current carrying amount. Any further fall implies that an
impairment adjustment is needed.
‣ Also, is the asset held for sale under IFRS 5? If so, the asset should not be depreciated and
appropriate disclosures need to be made.
(7)
You are the auditor of a group of companies and one of the subsidiaries has had very poor cash
flow and it seems that the bank is unlikely to renew its borrowing facility.
The finance director of the parent has told you that it will make the required loan to the
subsidiary to keep it solvent.
‣ The auditors need to see a ‘letter of comfort’
‣ Board minutes should be examined to see if financial support has been approved.
‣ The auditors need to assess if the parent can provide any support needed.
‣ If support seems unlikely or impossible, the subsidiary's financial statements will have to be
drawn up on a break-up basis.
‣ Costs of liquidation need to be estimated.
‣ Loan agreements must be looked at to see if the subsidiary's failure will precipitate the
breaching a borrowing covenant.
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A company has changed the way in which it values inventory from the FIFO to the weighted
average cost basis and has also changed its depreciation rate on machinery from 20% to 15%.
‣ Inventory: a change in accounting policy, so a retrospective treatment of the change is
needed. Last year’s comparatives and opening inventory values need to be brought up to
date with respect to the new approach. A disclosure note is required.
‣ Depreciation: a change of accounting estimate, so a prospective change. The current carrying
amount will be depreciated over the remaining useful life of the asset. A disclosure note
should be included if the change is material.
3.2. Business risk
(1)
A company has started selling goods on the Internet.
‣ A risk that the web site, sales processing, goods despatch etc do not work properly.
‣ Not clear if new receivables will be created or if payment is taken before despatch, so a credit
(bad debt/default) risk.
‣ Potential data security problems.
(2)
A company has started to export goods.
‣ Loss of goods in transit
‣ Irrecoverable (bad) debts
‣ Will goods be popular abroad?
(3)
The finance director has recently left and at period end, has not been replaced.
‣ Lack of supervision and control in the finance department.
‣ Can the financial statements and other management accounting information be prepared
properly and on time.
(4)
A company has failed to file its tax return on time.
‣ Fines, penalties and perhaps a tax investigation started.
(5)
An employee was badly injured carrying on his duties.
‣ Fines, damages
‣ Health and safety investigation
‣ Potential industrial action
‣ Loss of reputation/bad publicity
(6)
A computer virus disrupted the IT system for two days. All seems fine now.
‣ Loss of business during that period.
‣ Loss of accounting information.
‣ Has the accounting system really recommenced without loss or corruption of data?
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The company changed over from its old to its new IT system part-way through the year. The
change-over seemed to go smoothy.
‣ Disruption at the time of changeover and for some time afterwards as employees get used to
the new system.
‣ There are two accounting systems to be considered. One before the change and one after the
change [not really a business risk, but the auditors will probably have to almost perform two
audits and also look carefully at the transfer of balances between the old and new systems.]
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AUDIT EVIDENCE
Chapter 13
AUDIT EVIDENCE
1. For what is audit evidence needed?
1.1. Amounts and compliance with accounting standards
Auditors aim to say, with reasonable assurance that the financial statements do not contain material
misstatements. If you remember, we have already emphasised that this means that the financial
statements must show figures which are substantially true (think sufficiently accurate) and be
presented fairly. To avoid misstatements:
๏
the calculation of the amounts
๏
their presentation and
๏
disclosure
must comply with the relevant accounting standard(s). A simple example of a misstatement through
incorrect treatment is that of a bank loan repayable in 9 months but which is classified as a long-term
liability. If a 5 year loan is repayable by instalments, the liability has to be split into current and noncurrent parts .
If the auditor is willing to give an assurance about the financial statements then the auditor needs
evidence that supports both the amount and its proper treatment under the accounting standards.
Evidence should be NEAT! Auditors:
1.2. Need Evidence for Amount and Treatment
The requirement to know what the accounting standards stipulate and how evidence about their
application can be collected is a big change from AA to AAA.
Many of the ways of obtaining evidence that you will mention in AAA answers will be identical to
those in AA (for example, tracing transactions to original documentation, inspecting assets). However,
because AAA tends to deal with more difficult audit challenges, often where matters are not clear-cut
and judgement is required, the following sources of evidence tend to be more important than they
were in AA questions:
๏
Inspect board minutes: you would expect material and difficult matters to be discussed at board
meetings.
๏
Ensure that the matter is included in the letter or representation.
๏
Ask to see impairment reviews that have been prepared by management and examine these
critically.
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๏
Raise enquiries with management.
๏
Inspect correspondence with third parties, such as lawyers.
๏
Examine post period end events: trading levels, prices, use of assets, resolution of disputes etc.
72
2. The assertions
Even if we just consider the auditing of the amounts items in the financial statements figure it is
important to understand what an amount is asserting (saying or proclaiming). Every figure in the
statement of financial position or in the statement of profit or loss (or other documents making up the
financial statements) asserts (or says) a number of things. For example, a figure of $4m for machinery
in non-current assets implies that:
๏
The amount is accurate
๏
It does relate to machinery
๏
The assets exist
๏
The machinery is owned
๏
The assets are appropriately valued
๏
All amounts have been included
The single figure is asserting all of this and evidence is needed for each assertion each figure makes.
ISA 315 states:
“…management…makes assertions regarding the recognition, measurement and presentation of
classes of transactions and events, account balances and disclosures. Assertions used by the auditor
to consider the different types of potential misstatements that may occur fall into the following two
categories: ...”
Classes of transactions and events and
related disclosures for the period
under audit
Account balances and related
disclosures at the period end
Occurrence
Existence
Completeness
Rights and obligations
Accuracy
Completeness
Cut-off
Accuracy, valuation and allocation
Classification
Classification
Presentation
Presentation
Note the assertions that are the same (in red) for both categories.
See Chapter 16 of our AA notes if you need to revise the financial statement assertions.
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3. Gathering audit evidence
The procedures for obtaining audit evidence are:
๏
Analytical procedures (ratios, changes and comparatives)
๏
Enquiry and confirmation. For example, asking the directors if they intend to sell or close down
any part of the business.
๏
Inspection. For example, the physical condition of inventories or non-current assets.
๏
Observation. For example, watch what staff do in the warehouse as deliveries are received.
๏
RecalcUlation and re-performance. For example, recalculate the profits recognised on a
construction contract to ensure its accuracy.
You might remember that these five procedures can be remembered by the vowels, A, E, I, O and U.
4. Analytical procedures
Analytical procedures are used to evaluate plausible relationships between financial and non-financial
data including, calculating ratios and then comparing the amounts and ratios to:
๏
Last year’s results
๏
Budgets
๏
Industry standards
Also the trends and changes in the company’s financial statements over time will be examined.
You should recollect from your earlier studies that analytical procedures may be applied at
three stages of the audit:
๏
Planning - this is a requirement (ISAs 300 & 315)
๏
Substantive procedures - this is optional (ISA 520)
๏
Final review - this is a requirement when forming an overall conclusion (ISA 520)
Performing substantive analytical procedures does not mean, for example, comparing two amounts,
asking management why there is a difference and concluding that the explanation is reasonable. Yes,
a comparison will be made, but the auditor must be able to:
๏
“develop an expectation …” – this must be based on verifiable data and plausible relationships
๏
which is “sufficiently precise to identify material misstatement” – this may require the
disaggregation of data
๏
“determine the amount of any difference (between recorded amount and expectation) that is
acceptable without further investigation” – the maximum acceptable difference (‘threshold’)
may be a numerical amount or a % of the item being tested.
So, for example, the number of employees in a work force, the hours they work and their rates of pay
are verifiable, and the auditor calculates an expected payroll cost of $690,00. The auditor determines
5% to be the threshold. This expectation is then compared with the reported payroll cost, say it is
$720,000. The difference, $30,000 is 4.2%. This provides sufficient evidence without any need to
perform tests of detail on the payroll. Another example is depreciation expense.
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5. Sufficient, appropriate audit evidence
This is assumed knowledge from your earlier studies.
ISA 500 states that there should be:
๏
Sufficient
๏
Appropriate
audit evidence, to be able to draw reasonable conclusions on which to base an audit opinion.
Sufficient concerns the quantity of audit evidence.
Appropriate concerns the quality of audit evidence - its relevance and reliability. With respect to the
reliability of audit evidence , remember the general 'rules of thumb':
๏
External evidence is better than the entity's records.
๏
Evidence obtained directly by the auditor is better than evidence passed on by the clients.
๏
Audit evidence is better if there is a sound system of internal control.
๏
Written evidence is much better than oral.
๏
Originals are better than photocopies.
For AAA, as well as being able to describe audit procedures (as for AA), you will be expected to be able
to "evaluate ... if sufficient and appropriate audit evidence has been obtained".
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Chapter 14
RELEVANT ACCOUNTING STANDARDS
1. Introduction
Remember, the financial statements will not show a true and fair view if amounts have not been
calculated, classified, presented or disclosed in line with the applicable financial reporting framework.
For ACCA exams this means IFRSs.
Definition: Applicable financial reporting framework – the financial reporting framework adopted
by management in the preparation of the financial statements that is acceptable in view of the nature
of the entity and the objective of the financial statements or that is required by law or regulation.
Auditors must therefore obtain evidence to confirm that the accounting standards have been
complied with.
The table below summarises the accounting standards relevant to the ACCA syllabus. If you need to,
go back to SBR material (available on the OpenTuition site). But, actually, the best way to revise these
and see how they are examined in AAA is do do lots of past ACCA questions. Note that as past exams
are not updated on ACCA's website, you should purchase a current edition Revision Kit from an ACCAApproved publisher.
2. Audit procedures and obtaining evidence
The following table lists the classes of transactions, balances and events that may be reflected in a set
of financial statements that are specifically mentioned in the ‘audit procedures and obtaining
evidence’ part of the AAA syllabus. In order to design appropriate audit procedures about each of
these, auditors must know the provisions of the relevant accounting standard(s) concerning, in
particular:
๏
Initial recognition and recognition criteria
๏
Initial measurement (with the exception of grants related to assets this is invariably at cost)
๏
Subsequent measurement (e.g. depreciated cost, amortised cost, fair value)
๏
Classification, presentation and disclosure
Accounting standards will be relevant in the exam both in Section A (set at the planning stage of the
audit) and in the Section B question drawn from the completion, review and reporting section of the
syllabus.
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Specific
standard(s)
Other potentially
relevant
standard(s)
IAS 23
IASs 20, 23, 36 & 37
IFRSs 5 & 16
IAS 36
IFRS 3 (goodwill)
–
IASs 16 & 36
–
i)
ii)
Inventory (including standard costing systems)
Non-current assets
IAS 2
IAS 16
iii)
Intangible assets
IAS 38
iv)
v)
vi)
vii)
Biological assets
Investment properties
Assets held for sale and discontinued operations
Financial instruments
viii)
ix)
x)
Accounting estimates including values
Government grants
Leases
xi)
xii)
xiii)
xiv)
xv)
xvi)
xvii)
xviii)
xix)
xx)
Impairment
Provisions, contingent liabilities and contingent assets
Borrowing costs
Employee benefits
Share-based payment transactions
Taxation (including deferred tax)
Related parties
Revenue from contracts with customers
Statement of cash flows
Business combinations
IAS 36
IAS 37
IAS 23
IAS 19
IFRS 2
IAS 12
IAS 24
IFRS 15
IAS 7
IFRS 3
xxi)
xxii)
xxiii)
xxiv)
Events after the end of the reporting period
The effects of foreign exchange rates
Segmental reporting
Financial statements notes and related disclosures
IAS 10
IAS 21
IFRS 8
–
–
–
–
–
–
–
–
–
–
IASs 27 & 28
IFRS 10, 11 & 12
–
IFRS 9
–
IAS 1, IFRS 12
IAS 33
IAS 8
IASs 1 & 19
–
IAS 1
–
xxv) Earnings per share
xxvi) Changes in accounting policy
xxvii) Payroll and other expenses
IAS 41
IAS 40
IFRS 5
IAS 32/
IFRSs 7 & 9
IFRS 13
IAS 20
IFRS 16
76
–
–
IASs 16 & 24
IFRSs 9 & 15
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Bear in mind that IAS 1 Presentation of Financial Statements is relevant to:
๏
going concern
๏
the general principles of presentation (materiality and aggregation, offsetting)
๏
comparative information
๏
the structure and content of the financial statements generally:
‣ statement of financial position
‣ statement of profit or loss and other comprehensive income
‣ statement of changes in equity
3. Accounting Estimates
ISA 540 Auditing Accounting Estimates and Related Disclosures is relevant to monetary amounts for
which measurement is subject to 'estimation uncertainty' (i.e. an inherent lack of precision).
Responses to assessed risks of misstatement in an accounting estimate should include one or more of
the following approaches:
๏
Obtain audit evidence from events after the reporting date;
๏
Test how management made the accounting estimate;
๏
Develop an auditor’s point estimate or range.
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Chapter 15
AUTOMATED TOOLS AND TECHNIQUES
1. Technique types
Automated tools and techniques refer to 'traditional' computer-assisted audit techniques (CAATs) and
other data analytics tools.
These are three main types of CAAT:
๏
Audit programs
๏
Test data
๏
Embedded test facilities
The techniques can add greatly to audit efficiency and effectiveness. For example, audit programs can
very quickly read thousands of records, examining each according to the criteria set by the auditor.
Test data can be used to investigate the operation of accounting programs that could not be easily
tested in any other way.
1.1. Audit programs
Audit programs (also called 'audit software') are used to examine and interrogate clients’ accounting
data. The auditor will have a program which can read the clients’ files. That program can be used for
the following:
๏
To select a sample of transactions to investigate.
๏
The samples could be automatically stratified.
๏
The program might be set to identify odd transactions or balances. For example, credit balances
on a receivables ledger, or inventory which hasn’t moved for some time.
๏
It could also re-perform calculations. For example it is important to check that the sum of the
receivables accounts add up to the balance shown in the general ledger and hence in the
financial statements.
Note that by using audit programs to scan clients’ data every transaction can be examined relatively
easily. This can be particularly effective in the investigation of fraud where often major amounts are
misappropriated by making many small thefts that evade clients’ normal internal controls. For
example, every payment could be examined to see if any had gone to a particular bank account.
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1.2. Test data
Test data is used to investigate the operation of clients’ programs. The auditor designs 'dummy' data
that is then processed by the client’s programs. This enables the auditor to check whether or not the
clients’ programs are operating correctly and as expected, and whether or not the various controls
which were supposed to be present are actually operating. For example, what happens if a dispatch is
entered for a zero quantity or for a non-existing product or for a non-existing customer, or would raise
the balance on the customer’s account to above the credit limit? Test data would be designed to
check that the controls are present. There would be some normal error-free items, some unusual
items and some extreme or unexpected items.
The auditor should predict what the client’s program should do and then compare those predictions
with what the client’s program actually produces. A problem with test data is that the auditor is
processing dummy data. Therefore it is usual for test data to be run using copies of files (ie 'dead')
Audit programs
Examine client
data
Test data
Tests client
programs
1.3. Embedded audit facilities
Integrated Test Facilities or a System Control and Review File ('SCARF') are permanent audit modules
within the accounting system. During the accounting period certain transactions are also recorded in
these files for later examination by the auditor. For example, large journal entries, large returns and so
on. It can be difficult to discover these at the end of the period in a normal accounting system
because they will be buried amongst routine transactions and might have been cleared from the files.
The review files should be encrypted and locked so that only the auditor can access the information
on them.
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2. Big data and data analytics
A current issue for the profession is the development of emerging technologies including big data
and the use of data analytics. How may they affect the conduct of an audit and audit quality?
2.1. Big data
The characteristics which make data ‘big’ are:
๏
Volume – will be vast
๏
Variety – non-uniform/unstructured
๏
Velocity – fast and continuous
See Chapter 23 of our Strategic Business Leader (SBL) notes for further details if you are not familiar
with big data.
The fourth ‘V’ – veracity – is particularly relevant to auditing. Big data is likely to include bias,
abnormalities, inconsistencies and/or duplication. So how true or accurate is the data? How
trustworthy the sources?
2.2. Data analytics
Data analytics is the science of examining raw data to draw conclusions. So an obvious audit
application is in analytical procedures – the main differences between ‘traditional’ analytical
procedures and analytical procedures using data analytics are:
๏
As the data is raw, the auditor must assess and verify the level of veracity
๏
Data analytics must be computer-assisted.
The IAASB set up a Data Analytics Working Group (DAWG) to explore the increasing use of technology
in audit with a focus on data analytics. It suggests that using data analytics can:
๏
Enhance audit quality through a more robust understanding of the entity
๏
Gather audit evidence from larger population
๏
Improve risk-based sample selection for further testing.
However, it is important to recognise the limitations of data analytics:
๏
Need for veracity
๏
Even with 100% testing, assurance can only be ‘reasonable’
๏
Not a substitute for professional judgment and professional scepticism
๏
The risk of over confidence in using technology.
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DAWG requested input from stakeholders (including regulators, national standard setters,
accounting firms, member bodies, investors) about the use of data analytics in the audit. The
following table summarises the questions asked and the feedback from respondents:
Questions
Feedback
What factors in the current business ๏
environment affect the use of data
๏
analytics?
What are the standard-setting
challenges?
What are the possible solutions to
the challenges?
What should be IAASB’s next step?
(e.g. revised ISA 520)
Data acquisition (source, quality and access)
Legal and regulatory challenges
๏
Resource availability
๏
Investment in re-training/re-skilling auditors
๏
Determining whether requirements of ISAs have been met
๏
Relevance and reliability of data
๏
Managing expectations of ‘100% testing’
๏
Using data analytics on non-financial data
๏
ISAs aren’t ‘broken’ and should remain principles-based and
adaptable
๏
Overwhelming need for non-authoritative practical
guidance
๏
Revision to ISA 230 and ISA 500 should be prioritised but …
๏
… short-term guidance is the highest priority.
The use of data analytic tools is one of the fastest developing areas in audit and a current issue. You
are strongly advised to visit the AAA Technical Articles page for relevant article now and again during
your revision.
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Chapter 16
EXPERTS
1. Introduction
Sometimes auditors will need to use the work of others.
For example:
๏
Experts in a field other than accounting or auditing, such as:
‣ Actuaries to evaluate the adequacy of pension scheme funds
‣ Estate agents to value property
‣ Lawyers to estimate a legal liability
‣ Gemologists to value diamonds
‣ Geologists to estimate mineral deposits
๏
Internal audit can be used to perform audit work on parts of a business (see Chapter 17).
๏
Component auditors might be responsible for auditing one of the group’s companies (see
Chapter 21).
In none of these cases can the audit firm escape its responsibility for providing its own opinion about
the financial statements. The auditor must still obtain sufficient appropriate audit evidence that any
third party’s work does itself provide sufficient appropriate audit evidence: auditors cannot shift
blame to an expert if a material misstatement appears in the published financial statements. Indeed,
reliance on a third party should not normally be disclosed in the auditor's report as this suggests an
attempt to ‘blame-shift’.
2. Classes of expert
๏
An auditor’s expert: possesses expertise used to assist the auditor in obtaining sufficient
appropriate audit evidence. Can be either an internal expert (a partner or member of staff) such
as an actuary employed by the auditing firm, or an external expert who is subcontracted to
perform the work. ISA 620 Using the Work of an Auditor's Expert applies.
๏
Management’s expert: possess the expertise to assist management of the company to prepare
the financial statements. Can also be internal or external. ISA 500 Audit Evidence applies.
The fact that a management’s expert has prepared figures does not stop the auditor using an
auditor’s expert. For example, if management’s expert is an employee of the client there are obvious
risks that the expert has been influenced by management. Even if management's expert is not
employed by the client, their objectivity must be assessed as well as their competence and
capabilities.
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3. What the auditor has to do initially
The auditor must be satisfied that the expert:
๏
Has appropriate qualifications.
๏
Has the proper experience. Qualification does not necessarily mean that the expert has the
specific expertise needed. A surveyor could be qualified, but specialise in domestic property and
that would be no good for the valuation of commercial property.
๏
Is independent of the client (otherwise the client could pressurise the third party).
๏
Is professional.
You will appreciate that forming an opinion on the competence of an expert can be difficult and the
auditor should make enquiries from others who have used the expert, discover whether they have
used that expert before with satisfactory results and generally try to assess their professional
reputation.
The work to be performed by the expert has to be clearly defined:
๏
Its nature, scope and objectives
๏
The respective responsibilities of the auditor and the third party have to be defined.
๏
The nature, scope and timing of communications must be set out.
The expert should be required to observe confidentiality. For example, valuable information about a
company’s worth can be found by looking at the value of its property portfolio. A pension deficit
implies bad news for the company.
4. Evaluating the adequacy of the expert's work
The auditor cannot verify all the technical calculations or repeat all the work done by the expert
(otherwise the auditor would have had no need for the expert). However, the auditor must examine
the expert’s work with respect to:
๏
Consistency with other evidence. For example, if a property valuer reported a decrease in the
value of a client’s property portfolio, yet the newspapers were full of news about a property
boom, the auditor should challenge the valuer’s results.
๏
Significant assumptions made. For example about the rate of inflation or rate of returns that
might be earned on pension funds.
๏
Use and accuracy of source data. To value property the valuer must start with an up-to-date list
of the properties the company owns. If the right properties are not listed, the valuation will
certainly be incorrect.
๏
When the work was carried out to assess if it is still current or out-of-date.
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Chapter 17
INTERNAL AUDIT
1. Introduction
The previous chapter introduced the work of others and experts in particular. This chapter considers
ISA 610 Using the Work of Internal Auditors.
2. The internal audit function
Corporate governance (at least in the UK) does not insist that companies have an internal audit
department, but they must keep the need for internal audit under review. More and more companies
now have internal audit departments. These departments carry out work such as:
๏
Assessment of the design and operation of the system of internal control.
๏
Helping with inventory and cash counts.
๏
Verifying the physical existence of non-current assets.
๏
Assessing value for money of various activities.
๏
Carrying out special investigations, such as investigating a fraud.
๏
Assessing the security and operation of the IT system.
Internal auditors can be company employees but the function can also be outsourced.
Obviously the internal auditors’ work can be of assistance to external auditors, particularly in their
assessment of the system of internal control, attending inventory counts and verifying the existence
and condition of assets. Internal auditors will often examine these matters in much more detail, and
perhaps with more insight, than the external auditors.
However, it is important to note that ISA 610 states that internal audit can be involved in substantive
procedures only in areas where only limited judgement is required. All areas involving significant
judgement or estimates must be handled by the external auditors.
3. Making use of internal audit work
As was mentioned earlier, external auditors are solely responsible for the audit opinion and that
responsibility is not reduced by using the work of internal audit. To use the work of internal auditor
the external must consider:
1. Can the work of internal audit be used?
2. If so, to what extent?.
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If seeking to rely on the work of internal audit, the external auditor must:
๏
Assess the organisational status of the internal audit department. Are the internal auditors
objective? To whom do they report? (Should normally be the audit committee but they should
also have access to senior directors). The size of the internal audit department can be relevant. A
single internal auditor in a company can have a lonely existence, unsupported by colleagues.
However, a team of 10 internal auditors can provide mutual strength. (Note that if the internal
audit function is outsourced, it might be more independent and objective than when the
internal auditors are employees.)
๏
Assess the competence of the internal audit department: are the employees members of a
professionals body? Are they qualified? Do they undergo regular training and updates? Do they
have time and resources to carry out their work adequately?
๏
Assess if the internal auditors carry out their work in a disciplined and systematic way. Are there
quality controls? Is there standard documentation? Is the work planned and reviewed?
If any of these three qualities are absent (objectivity, competence and a systematic and disciplined
approach), the work of internal audit must NOT be used.
If all three qualities are present, the external auditor may plan to use their work and co-ordinate their
respective activities. The external auditor should assess if:
๏
The internal audit work was properly planned, executed, supervised, reviewed and documented.
๏
Sufficient appropriate evidence had been obtained to enable the internal auditors to draw
reasonable conclusions.
๏
The conclusions reached are appropriate and the reports produced are consistent with the
results of the work performed.
The assessment will involve the external auditor reviewing the working papers of the internal audit
function and making inquiries of appropriate individuals. It must also include some reperformance
of their work.
4. Direct assistance
Some jurisdictions (not the UK or Ireland) allow the internal auditors to provide direct assistance to
the external auditors. This means that the internal auditors perform audit procedures under the
direction, supervision and review of the external auditor.
If internal auditors are to provide direct assistance, the external auditor must assess the existence of
significant threats to objectivity ie can the internal auditors be regarded as independent? The external
auditors must also assess and the level of competence of internal auditors.
Even if direct assistance is not prohibited, internal audit cannot perform procedures that:
๏
involve significant judgments
๏
relate to higher assessed risks
๏
relate to internal audit's own work.
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Chapter 18
OUTSOURCED ACCOUNTING FUNCTIONS
1. Introduction
Outsourcing can be defined as:
Hiring a party outside the organisation to perform services and to create goods that would otherwise
be performed internally by the organisation’s own employees.
Outsourcing is often accompanied by off-shoring where the outsourced function is provided by a
supplier based overseas.
Examples of outsourcing functions include:
๏
Logistics (eg delivery of products to customers)
๏
Marketing
๏
Recruitment
๏
Legal services
๏
Production/assembly
๏
Information technology (facilities management)
๏
Receivables ledger management (factoring)
๏
Tax planning and calculations
๏
Payroll
๏
Accounting
๏
Internal audit
This chapter deals particularly with the last six functions on this list.
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2. Potential advantages and disadvantages of outsourcing
Advantages
๏
Access to specialist expertise
๏
Reduction in cost with efficiency gains
๏
Flexibility in responding to uneven demand
๏
Greater cost certainty through fixed-fee arrangements
๏
Transfer of risk
๏
Unburdens management from having to closely manage the out-sourced function (though the
process of out-sourcing does itself have to be managed).
๏
For internal audit, greater independence.
Disadvantages
๏
Loss of control
๏
Damage to reputation if the outsource company does not perform well
๏
Difficult to reverse (and hence, prices can be steep because the outsource company knows this)
๏
Lack of responsiveness to new requirements
๏
Different aims of the outsourcer and the outsource company leading to a lack of goal
congruence
๏
Confidentiality. Company and client data are held by another party.
3. Impact on the audit
Often, the outsource company (the service company) simply becomes a supplier. For example,
outsourcing delivery of products to a logistics company will have little effect on audit work. However,
if IT and finance functions are outsourced that means that the financial information, records and
processing are controlled by a third party and this will have implications for the audit. The auditor
cannot ignore what happens to the client's data at the service company. For example, when assessing
the valuation of receivables, the auditor would typically examine the client’s aged receivables analysis
and ensure that it was properly prepared so that it could be used reliably (e.g. to evaluate the
adequacy of an allowance for credit losses). If a service provider, such as a factor, produces that
analysis instead, the auditor simply cannot assume that it has been prepared correctly and base the
carrying amount of receivables on that.
The auditor needs an understanding of the processing and maintenance of client data by the service
organisation to be able to draw conclusions about the risk of material misstatement. There are two
situations:
(1)
The service company simply processes client’s transactions. Here, the client should be able to
implement its own controls (e.g. comparing output against input to ensure all transactions
processed).
(2)
The service company additionally executes and takes responsibility for the client’s transactions.
Then the client company will have to rely on the controls and procedures within the service
company.
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The auditor can obtain the required understanding and audit evidence through:
๏
A contract or service agreement between the audit client and service organisation.
๏
User manuals and/or technical manuals.
๏
Reports by the service organisation (eg internal auditor’s reports).
๏
Reports by the service auditor (such as letters highlighting internal control weaknesses).
๏
Knowledge derived from previous dealing with the service organisation (eg was it reliable in the
past).
๏
Comparing data submitted to the service company to information and data received back.
If the above sources of information available from the client are not sufficient, the auditor may, for
example:
๏
Obtain and assess a Type 1 or Type 2 Report (see below).
๏
Ask the service organisation for information.
๏
Visit (with permission) the service organisation and carry out audit procedures there.
๏
Use (with permission) another auditor to cary out audit procedures at the service organisation.
ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation, describes two types of
report:
๏
A Type 1 report comprises:
A description, prepared by the management of the service organisation about the service
company’s control objectives and related controls that have been implemented.
A report prepared by the service auditor giving reasonable assurance on the suitability of the
service company’s systems and control objectives.
๏
A Type 2 report comprises:
A description, prepared by the management of the service organisation about the service
company’s control objectives and related controls that have been implemented and sometimes
a description of their operating effectiveness.
A report prepared by the service auditor giving reasonable assurance on the suitability of the
service company’s systems and control objectives, the effectiveness of the controls and a
description of the service auditor’s tests of the controls and the results of those tests
So only a Type 2 report provides assurance on the effectiveness of the service organisation's controls.
The auditor can also ask management about problems and irregularities in the service company’s
work.
If the auditor cannot obtain sufficient appropriate evidence about the quality and reliability of the
processing being carried on by the service organisation, then the audit opinion will have to be
modified.
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Chapter 19
WRITTEN REPRESENTATIONS
1. Introduction
ISA 580 requires auditors to obtain written representation from management and, where appropriate,
TCWG. Written representations are necessary information that the auditor requires and are audit
evidence. However, although they provide necessary audit evidence they are not sufficient audit
evidence on their own on any of the matters with which they deal. Nor do written representations
affect the nature and extent of other audit evidence that the auditor needs to obtain.
2. Purpose
The objectives of the auditor are to obtain written representations that:
๏
Management /TCWG acknowledge their responsibility for the preparation of the the financial
statements and have provided all relevant information to the auditor.
๏
All transactions have been recorded.
These representations concerning management's responsibilities are required by ISA 580. In addition
to other representations that may be required by other ISAs (see section 3 below), an auditor may
request them to support other audit evidence relevant to one or more specific financial statements
assertions.
The written representations should be dated as near as possible to, but not after, the date of the
auditor's report.
In particular, letters of representation are important where it could be difficult for the auditors to
make sure that certain problems do not exist, or that management does not have certain intentions or
plans. If you don’t know about a liability it can be difficult to discover. It can also be difficult to
discover management plans if they have now been discussed at board meetings and recorded in the
board minutes.
Management representations cannot substitute for other audit evidence or performing audit
procedures in accordance with ISAs.
Written representation alone cannot provide sufficient appropriate audit evidence for an assertion. If,
for example, management's intentions provide necessary audit evidence (eg for the classification of
financial instruments), the auditor must consider:
๏
management's past history in carrying out intentions
๏
the reasons for management's intention
๏
management's ability to pursue its intentions
๏
other information (or lack thereof) which might contradict management's intentions.
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If one or more requested representations are not provided then the auditor must re-evaluate the
integrity of management and assess their proposed audit opinion. If the required representations
(about management's responsibilities) are not provided or not reliable, the auditor must disclaim an
opinion.
3. Examples
Here are examples of subject-matter specific written representations that are required by ISAs other
than ISA 580:
๏
Any knowledge or suspicion of fraud has been disclosed to the auditor (ISA 240).
๏
Similarly, all known instances of actual or suspected NOCLAR have been disclosed to the auditor
(ISA 250).
๏
All known actual or possible litigation and claims has been disclosed to the auditor and
accounted for/disclosed in accordance with financial reporting requirements (ISA 501).
๏
Belief that significant assumptions used in making accounting estimates are reasonable (ISA
540).
๏
All known related parties, relationships and transactions have been disclosed to the auditor and
accounted for/disclosed in accordance with financial reporting requirements (ISA 550).
๏
All events occurring subsequent to the date of the financial statements have been adjusted or
disclosed as required (ISA 560).
๏
Plans for future actions relating to management’s going concern assessment and the feasibility
of these plans (ISA 570).
You should appreciate the necessity of these representations to obtain sufficient appropriate
evidence about the assertion of completeness, in particular.
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Chapter 20
RELATED PARTIES
1. Introduction
Related parties can pose real difficulties for auditors because it can be very difficult to detect the
relationship and related party transactions. Certainly the letter of representation sent by directors to
the auditors at the end of the audit would make reference to the fact that either there were no related
party transactions or that all have been disclosed.
For example, one person owns two companies and each company has different auditors. If Company
A sells goods to Company B at inflated prices, Company B will make artificial losses and Company A
artificial profits. Perhaps the owner intends to put Company B into liquidation to escape liabilities, but
the cash has been safely transferred to Company A. It would probably be difficult for the auditors to
detect what was going on.
2. What is a related party and why are they difficult for
auditors?
Related parties are defined in IAS 24.
The objective of IAS 24 is to ensure that an entity’s financial statements contain the disclosures
necessary to draw attention to the possibility that its financial position and profit or loss may have
been affected by the existence of related parties and by transactions and outstanding balances,
including commitments, with such parties.
A related party is a person or an entity that is related to the reporting entity:
๏
A person or a close member of that person’s family is related to a reporting entity if that person
has control, joint control, or significant influence over the entity or is a member of its key
management personnel.
๏
An entity is related to a reporting entity if, among other circumstances, it is a parent, subsidiary,
fellow subsidiary, associate, or joint venture of the reporting entity, or it is controlled, jointly
controlled, or significantly influenced or managed by a person who is a related party.
Note that subsidiaries, associated companies, joint venture partners and the entity’s pension scheme
are related parties. You might think it is easy, for example, to identify when a company is an associate,
and this would be expected when producing the group financial accounts. But if you were auditing
the associate, how would you detect if it was trading with another company that was also an associate
of the same parent and therefore under the influence of the parent?
Detecting ownership by family members is also very difficult: they might not all have the same family
name.
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Particular problems can arise if:
๏
Transactions between the parties take place without charge. For example, simply moving
inventory from one party to the other without any accounting entries will distort profits.
๏
Related party transactions are ‘buried’ amongst normal transactions.
๏
There are parties that the auditor is unaware of.
๏
Complex group structures can make identifying related parties very difficult.
๏
Management might try to conceal the relationships.
๏
Management simply might not know that certain transactions fall within related party rules.
There is nothing illegal about a company trading with a related party: this happens all the time in
groups. However, as described above, the existence of related party transaction increases the chance
that transactions are not 'at arm's length' or, have been entered into to defraud other parties or to
evade tax.
3. Responsibilities
It is management’s responsibility to identify and disclose related party transactions. However, of
course, this does not absolve the auditors from exercising professional scepticism or from trying to
obtain evidence about the existence of related party transactions.
If related party transactions are not identified by management or the auditors there is an increased
risk of:
๏
Fraud
๏
Unfair presentation
๏
Non-compliance with the law (eg tax legislation)
Audit procedures include
๏
Enquire from management about related party transactions. Auditors would have to explain the
concepts and give examples to help management.
๏
Review last year’s working papers.
๏
Review the board minutes.
๏
Review the accounting records for unusual transactions. CAAT techniques could help here by
looking at every significant transaction over the period.
๏
Review bank certificates (one company might have given guarantees on behalf of another).
๏
Review principal shareholders of companies with whom the client trades.
๏
Ask the directors about their other directors and share ownership
๏
Review correspondence with lawyers.
๏
Review investment activities eg the purchase of shares that might indicate that significant
control has been acquired.
๏
Enquire into the names of pension trustees.
๏
Obtain written representation from management.
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4. Disclosures required in the financial statements
๏
Relationships between parents and subsidiaries irrespective of whether there have been
transactions between the parties.
๏
Compensation to key management personnel (including short-term, post-employment and
termination benefits and share-based payments).
๏
Minimum disclosures for related party transactions include:
‣ The amount of the transactions*
‣ The amount of outstanding balances and their terms**
‣ Allowances for doubtful debts relating to the outstanding balances
‣ The expense recognised in the period in respect of irrecoverable or doubtful debts due from
related parties.
* Examples of transactions with related parties include:
๏
purchases/sales of goods, other assets or services
๏
leases
๏
loans and other finance arrangements
๏
providing guarantees or collateral.
** Disclosure should state that terms are 'arm's length' only if that can be substantiated. The auditor
must therefore obtain sufficient audit evidence that this assertion is true.
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THE AUDIT OF GROUP FINANCIAL STATEMENTS
Chapter 21
GROUP AUDITS
1. Introduction
Generally, each separate company in the group will have been audited as normal, as though it were a
stand-alone company. This chapter deals with auditing the group financial statements, for example
the consolidated financial statements. The audit of group financial statements requires some
additional steps and considerations not seen in the audit of individual companies.
The task is simpler if the auditor of the group financial statements also audits all components of the
group. Otherwise, the group auditor will have to be involved in the work of component auditors.
2. The additional work in summary
Broadly the additional work relates to the following:
๏
What is the proper way to deal with a company’s investments in other companies?
‣ A simple investment
‣ An associated company
‣ A company that must be consolidated (ie subsidiary)
๏
The general name for a part of a group is a component.
๏
What happens if the auditor of the group is not the auditor of all components?
๏
Care is needed with intra-group balances that must be reconciled (for good-in-transit, cash-intransit, etc) and eliminated on consolidation.
๏
Unrealised profits in inventory (and perhaps on the transfer of non-current assets) must be
eliminated.
๏
The process of consolidation has to be carefully checked ie that the amounts in each category
are added up properly to give the group totals.
๏
The goodwill figure(s) have to be verified and checked for possible impairment.
๏
If a company has been acquired part-way through the year then the profits will have to be
apportioned: profits prior to acquisition are bought; profits after acquisition are earned.
๏
Uniform accounting policies must be applied in the preparation of consolidated financial
statements.
๏
The financial statements of group companies would be expected to have the same reporting
date if consolidated.
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3. The proper accounting treatment of investments
Type of investment
Subsidiary
Test
Control: the power to govern the
financial and operating policies of an
entity. The investor has the right to
variable returns and these are affected
by the exercise of power by the
investor. Generally presumed to exist
if at least 50% of the equity is owned.
However, owning less than 50% can
sometimes be enough to give control
(eg if there is a right to appoint board
members).
Appropriate treatment
Consolidation i.e:
๏
sum 100% line-by-line the
elements of the financial
statements
๏
eliminate parent's investment
๏
eliminate all intra-group items
Associate
One company has significant influence Equity accounting. The investment is
over another. Usually the shareholding initially recognised at cost and the
is 20 to 50%
carrying amount is then increased or
decreased to recognise the
investor’s share of the retained profit
or loss of post acquisition (ie the
post-acquisition change in the
investor's share of the associate's net
assets.)
Joint venture
A contractual arrangement in which
Equity accounting
two or more parties undertake an
economic activity that is the subject of
joint control.
4. Responsibility for the group auditor's report
The group auditor has the sole responsibility for expressing an audit opinion on the group financial
statements. This is so even if the group auditor is not the auditor of all the components.
Definition: Component – an entity, business unit, function or business activity, or some combination
thereof, determined by the group auditor for purposes of planning and performing audit procedures
in a group audit.
The group engagement partner is responsible for all aspects of the group audit: planning, setting
materiality levels, review, seeking more information where necessary and for forming an opinion on
the group financial statements. Indeed, the group auditor is not allowed to even comment that some
components of the group were audited by another firm.
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5. Materiality
An important part of the group engagement partner’s responsibility is to consider materiality. A
matter is material with reference to the group financial statements - not the financial statements of a
component. Usually this will mean that the materiality limits are higher for group financial statements
than for component financial statements (simply because the figures in the group financial
statements are usually the sum of the figures in the components). However, it is possible to construct
a scenario where materiality levels are smaller in the group financial statements. For example:
$m
Group
Parent
Subsidiary
A
Subsidiary
B
Profit/(loss)
15
5
20
(10)
Materiality level 10% for each component
1.5
0.5
2.0
1.0
So, the auditor of Subsidiary A will be working to a materiality level of $2m (possible ignoring
misstatements up to that amount) but the group materiality level is only $1.5m. In addition, a
subsidiary might not be a public interest company but the group might be and, generally, the audit of
public interest entities is carried out more strictly and this could again give rises to conflicts in
materiality levels.
Therefore, usually the materiality levels for each component will be set substantially lower than the
group materiality limit. This has to be at a level determined by the group auditor as only that auditor
has the necessary overview of the group results.
The group auditor must therefore communicate to component auditors a threshold above which
misstatements must be communicated to the group auditor.
6. Other information required for the group audit
The group auditor will also require some information about components which is of no relevance to
the components. For example:
Subsidiary A has sold goods at a mark-up to Subsidiary B and these are in closing inventory.
Unrealised profits are a group issue, but not an issue in the financial statements or audit of the
individual subsidiaries. The component auditor will have to supply this information to the group
auditor. Similarly, if non-current assets had been transferred.
Differences in payables/receivables accounts in the separate subsidiaries are not an issue, but on
consolidation current accounts will have to be reconciled.
If the acquisition took place part way through the year, then the results of the acquired company will
have to be split into pre- and post- acquisition. This is usually done on a time basis, but significant
differences in trading before and after acquisition (eg trading is seasonal) could mean that another
approach is preferred.
Goods in transit or cash in transit between components will have to be sorted out upon consolidation.
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Other matters concerning components that may give risk to risks of material misstatement in the
consolidated financial statements include:
๏
Events after the reporting date.
๏
Significant control weaknesses.
๏
Any known related party transactions.
๏
Suspicions of management bias.
๏
Adjustments that might be necessary for non-uniform accounting policies or non-coterminous
reporting dates.
7. Component auditor
Component auditor – an auditor who performs audit work related to a component for purposes of
the group audit. A component auditor is a part of the engagement team for a group audit.
Where the component is subject to a statutory audit, the component auditor is responsible for the
auditor’s report on the component’s financial statements.
When component auditors are involved, the group engagements partner must:
๏
evaluate whether the group auditor will be able to be sufficiently and appropriately involved in
the work of the component auditor (including whether the component auditor will perform the
work requested by the group auditor);
๏
make component auditors aware of relevant ethical requirements and confirm that they will
comply with them;
๏
determine that component auditors have appropriate competence and capabilities, including
sufficient time.
The group engagement partner is responsible for the nature, timing and extent of direction and
supervision of component auditors and the review of their work.
8. Group’s system of internal controls
The group auditor’s understanding of the group should include the group’s system of internal control,
including:
๏
the nature and extent of commonality of controls;
๏
whether, and if so, how, activities relevant to financial reporting are centralised; and
๏
the consolidation process, including sub-consolidations and consolidation adjustments
Common controls – controls designed by group management that are intended to operate in a
common manner across multiple entities or business units.
Common controls might be designed for inventory management, for example and may be direct or
indirect controls.
The group auditor may involve component auditors in testing the operating effectiveness of common
controls or controls related to centralised activities.
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9. The consolidation process
The term “consolidation process” as used in ISA 600 Special Considerations – Audits of Group Financial
Statements (Including the Work of Component Auditors) is not intended to have the same meaning as
“consolidation” or “consolidated financial statements” as defined or described in financial reporting
frameworks.
Definition: Consolidation process – includes:
๏
Consolidation, proportionate consolidation, or an equity method of accounting;
๏
The presentation in combined financial statements of the financial information of entities or
business units that have no parent but are under common control or common management;
๏
The aggregation of the financial information of entities or business units such as branches or
divisions.
Nowadays, much of this will involve transcribing component financial statements onto a spreadsheet
then adding like balances to like balances throughout the group. Of course, some groups will have a
financial accounting package which will automatically perform most of the consolidation process.
However, you will understand that simply the amount of data that has to be dealt with correctly on a
consolidation will introduce a high risk that errors are made: transcribing a figure incorrectly or onto
the wrong row or having an error within the spreadsheet formulae.
Therefore, an important part of the group auditor’s work is to check that the correct amounts from
each component company have been identified and included in the consolidation schedules and that
these are arithmetically accurate.
The group auditor then has to check that the appropriate consolidation adjustments have been
made. The principal adjustments are:
๏
Goodwill and pre-acquisition reserves.
๏
Eliminate unrealised intra-group profits.
๏
Reconcile intra-group balances.
๏
Adjustments to align the components' financial statements for the purposes of consolidation.
๏
Fair values to be used where appropriate.
For any acquisition that happened in the year, any goodwill arising will have to be audited.
The calculation should be checked:
Consolidated good will = Fair value of consideration + fair value of the non-controlling interest – fair
value of the subsidiary’s net assets
Often this becomes:
Consolidated goodwill = Fair value of consideration – Acquirer’s share of the net assets.
Audit evidence will involve checking the bank account to see that the acquisition amounts have been
paid and inspecting the financial statements of the new subsidiary as at the date of acquisition and
substituting in the fair value of assets and liabilities. The proportion of shares bought also needs to be
checked and ownership of the acquired shares must be verified.
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Subsequently, the goodwill figure will have to be tested for impairment. For example, if a
component had begun to make a series of losses it would be difficult to sustain the idea that the
goodwill on its acquisition was still intact.
Costs of acquisition must be treated as an expense and not capitalised (IFRS 3).
10. Deferred and contingent consideration
Both in practice, and in exam questions, deferred and contingent consideration is often part of an
acquisition deal. For example:
Deferred: $20m paid now and another $10m to be paid in 3 years
Contingent: $20 paid now and another $10m to be paid in 3 years IF profits achieve a certain target.
Obviously, the group auditor must inspect the acquisition agreements so that the acquisition terms
are fully understood. The appropriate accounting treatment of these type of consideration is:
๏
Deferred: the deferred amount must be discounted to its present value and included as part of
the acquisition cost eg for the calculation of goodwill. Auditing this figure will mean that, as well
as inspecting the acquisition agreement, the auditor will have to verify that the discount rate
used is appropriate. Each year, as the date of payment of the deferred consideration
approaches, the goodwill figure and provision for the deferred payment have to be altered as
the amount will be discounted by one less year.
๏
Contingent: IFRS 3 requires that contingent consideration is includes as part of the
consideration for acquisition measured at its fair value as at the acquisition date. An exam
question will either tell you what this fair value is or how it should be calculated.
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11. Letter of support (‘comfort letters’)
If a subsidiary has a going concern issue and is not confident of support from outside lenders, then its
parent might offer support (ie make a loan to the subsidiary) to enable it to continue trading for the
foreseeable future. This would mitigate the subsidiary's going concern problem.
In these circumstances, the group board must provide the group auditor with a ‘letter of comfort’ or
‘support letter’ in which they set out their intentions. But, of course, this letter is a relatively weak form
of evidence and the group auditor should look for other evidence that the support for the subsidiary
is real. For example:
๏
Ensure that the group has the cash resources available to support to subsidiary.
๏
Inspect board minutes for evidence that support has been agreed.
๏
Inspect correspondence between the parent and the subsidiary or the parent and the relevant
bankers.
๏
Inspect cash flow budgets to see if the transfer of funds has been incorporated.
12. Joint audits and transnational audits
12.1. Joint audits
A joint audit is when two firms of auditors are both appointed and are both responsible for the audit
opinion. It is a relatively unusual arrangement and has probably come about through the merger of
two companies with different auditors as there can then be benefits in the joint approach:
๏
Auditor knowledge about each part of the group is retained
๏
A larger pool of resources available to carry out the audit. This might allow the audit to be
carried out more quickly.
๏
Geographical considerations might make a joint audit more efficient (eg to benefit from the
insights of a local auditor).
However, there are certain disadvantages:
๏
Both firms of auditors will require a fee and these will probably total to more than the fee of only
one firm doing the whole audit.
๏
Different approaches, methods and documentation can cause difficulties.
๏
They might clash over the audit opinion.
๏
Coordination over the parts of the audit that each carries out might be poor eg there could be a
gap in coverage.
Obviously, before agreeing to be a member of a joint audit arrangement, any auditor should be happy
about their fellow-auditor: competence, ethics, experience, reputation.
Almost certainly, each one of the joint auditors will hope to oust the other auditors and end up as the
sole auditor. Auditing firms should beware of ethical risks to their objectivity and integrity arising from
their attempts to be the client’s favourite auditor.
Note that in some countries, joint audits may be a legal requirement (eg in France). Also, joint audits
help facilitate the transition from one audit firm to another where mandatory rotation is required.
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12.2. Transnational audits
Transnational audits are NOT the same as international audits. International audits simply refer to the
audit of a company or group that has operations in more than one country so that auditing has to
take place in more than one country.
A transnational audit is the audit of financial statements where those financial statements will be
relied upon outside the audited entity’s home jurisdiction for the purposes of significant lending,
investment or regulatory decisions.
For example, there could be a large company whose operations were entirely within the UK, but
whose shares are listed both in London and New York.
The international use of the financial statements causes some potential problems:
๏
Different (and unexpected) auditing standards might be used.
๏
Different (and unexpected) accounting standards might be accepted.
๏
Different ethical and quality standards might have been applied.
๏
Different corporate governance standards
In short, there is a danger that the financial statement are misunderstood when looked at by someone
from a different country.
The Forum of Firms (FoF) is an independent association of international firms of accountants who
carry out transnational audits. The aim is to promote consistent and high quality standards of financial
reporting and auditing practices. The IFAC Transnational Auditors’ Committee (TAC) is the official link
between IFAC and the FoF. It can promote the FoF’s objectives and operations and also it encourages
members of the FoF to conduct high quality audits.
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THE FINAL STAGES OF AN AUDIT
Chapter 22
SUBSEQUENT EVENTS
1. Event after the reporting period
Now we are going to look at the effect of events which occur after the end of the reporting period but
before the financial statements have been approved. These events fall into two types.
๏
An adjusting event as its name might suggest, means that the accounts have to be adjusted in
the light of what’s happened. The rule is that adjustments must be made if the event provides
evidence of conditions that existed at the end of the reporting period (the reporting date).
An example would be a major customer going into liquidation, let’s say at the end of January,
the year end was the end of December. That event tells us that the receivable at the end of
December was probably bad and should have been written off or an allowance made. It’s very
unlikely that the customer’s financial position worsened so remarkably during January. What the
liquidation tells us is that the customer was in the bad situation at the end of December and if
only we had known that then the receivable would have been written down.
๏
A non-adjusting event relates to conditions which arose after the reporting date.
A good example is the company’s factory burning down, let’s say in mid-January. At the end of
December the company’s factory was perfectly fine, it was standing, it was operating, it was a
non-current asset. It was only after the end of the year that it was destroyed. If the statement of
financial position is telling us the position at the year end, then the factory would have to
appear in non-current assets. It would be, of course, important to disclose in the notes that the
factory was no more. This will be a good example of an emphasis of matter paragraph in the
auditor's report.
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2. 'Active' and 'passive' duty
2.1. Active duty
Until the auditor's report is signed auditors have an active duty to look out for events that might tell
them more about the financial statements.
For example, examining cash receipts from year-end trade receivables, examine sales in the new year
to see if inventory was properly valued, examining board minutes. The letter of representation would
also allude to events after the period end.
2.2. Passive duty
After signing the auditor’s report, the auditors have a passive duty only. Occasionally events will
occur after the accounts have been signed and issued and these come to the auditor’s attention.
Exceptionally it may be important for the addressees of the auditor’s report to be made aware that
something is wrong in the accounts. The auditor would then discuss with the directors the need to reissue amended financial statements.
2.3. Amended financial statements
If management agrees to amend the financial statements, the auditor must:
๏
withdraw the 'old' report
๏
extend audit procedures, including subsequent review procedures, to the date of the new
report
๏
issue a new report on the amended financial statements.
If management refuses to amend the financial statements, the auditor should take legal advice and
consider any legal rights or obligations to inform the shareholders that the audit opinion cannot be
relied on (e.g. to speak at a general meeting).
You should appreciate why amended financial statements are very rare in practice:
๏
Audited financial statements are published more than a few months after the reporting date
(e.g. UK public companies must file accounts within 6 months), so it is unlikely that something
would happen so long after the year end of such significance that it would call for amendment.
๏
Private companies generally publish financial statements even later (e.g. within 9 months in the
UK), so next year’s audit is already on the horizon or may even have started already.
๏
Even if the subsequent event points to something that occurred before the issue of the financial
statements, the risk to the auditor’s professional liability may be very low (i.e. very low risk that it
affects shareholders’ reliance on the audit opinion).
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Chapter 23
THE AUDITOR’S REPORT 1: OVERALL
STRUCTURE
1. Introduction
Now we begin to look at the auditor's report. For many people, this is the only purpose of an audit
and it’s one of the few parts of an annual report that they really look at.
The auditor’s report includes a clear expression of opinion on the financial statements as a whole.
The two important phrases are:
๏
‘Opinion’: there is nothing absolute here. Different firms of auditors could quite legitimately
come to different opinions.
๏
‘Financial statements as a whole’. We are not just looking at the statement of financial
position in isolation from the statement of profit or loss or the notes. What’s important is the
impression given by the financial statements as a whole.
The audit opinion has to be based on evidence obtained in the course of the audit. Indeed if you had
to sum up the audit process in just a couple of words it the phrase would be ‘evidence gathering’.
Auditors need to collect evidence that will support their opinion on the financial statements.
2. Financial statements
The auditor’s report refers to financial statements and you need to know what these are. They consist
of the following:
๏
The statement of financial position (or balance sheet).
๏
The statement of profit or loss and other comprehensive income.
๏
The statement of changes in equity.
๏
The cash flow statement.
๏
The notes to the financial statements including significant accounting policies.
A director’s report and chairman’s statement included in an annual report are not part of the financial
statements. However, the auditor may have reporting responsibilities for such 'other information’.
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3. The parts of an auditor’s report
Now we are going to look at some of the key parts of an auditor’s report.
3.1. The title and addressees: Independent Auditor’s Report
First of all, it is clearly titled ‘Independent Auditor’s Report'. That should mean that no one has any
doubt about what this document is. It next states to whom the report is addressed and that’s the
members (i.e. shareholders) of the company.
3.2. The audit opinion and identification of what’s been audited
The opinion paragraph comes right at the top of the report.
An unmodified opinion will state that the financial statements give a true and fair view (or present
fairly, in all material respects), and have been prepared in accordance with International Financial
Reporting Standards (IFRSs). (The example of the report shown later in this chapter includes an
unmodified audit opinion. We will see later the various modified opinions that may be expressed if
the auditors are unable to say without reservation that the financial statements give a true and fair
view.)
As appropriate, depending on the type of opinion given, this paragraph can be named:
๏
Opinion
๏
Qualified opinion
๏
Adverse opinion
๏
Disclaimer of opinion
The opinion paragraph must:
๏
Identify the entity whose financial statements have been audited.
๏
State that the financial statements have been audited.
๏
Identify the title of each element of the financial statements and the period audited.
3.3. The Basis for Opinion
This will refer to compliance with the ISAs (complying with ISAs is key to the basis of opinion) and will
refer to the auditor’s responsibilities section of the report. It must include an assertion of the auditor’s
independence and that other ethical matters have been complied with.
If the audit opinion has been modified, the explanation would be here too.
As appropriate, this paragraph would be called:
๏
Basis for opinion
๏
Basis for qualified opinion
๏
Basis for adverse opinion
๏
Basis for disclaimer of opinion
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3.4. Material uncertainty related to going concern (if one)
A separate paragraph is required if there is a material uncertainty related to the going concern of the
company. The need for such a paragraph is covered more fully in the following chapter.
This paragraph is not a modification of the audit opinion – provided the uncertainty has been
adequately disclosed by the directors in the notes to the financial statements.
3.5. Key audit matters
Key audit matters are those matters that were of most significance during the audit.
There is then a full description of these matters in accordance with ISA 701. This is covered in more
detail below.
3.6. Emphasis of matter paragraph (if one)
This paragraph is used to draw users’ attention to a matter already properly disclosed in the
financial statements. For example, a note stating that there had been a fire at the company’s
premises after the date of the statement of financial position.
An emphasis of matter paragraph is not a modification of the audit opinion and It will state that the
audit opinion is not modified in this respect. If the auditor's report also includes a key audit matters
section, the emphasis of matter paragraph may be presented before that section, depending on their
relative importance.
3.7. Other matter paragraph (if one)
This paragraph is used, if necessary, to communicate a matter that is not presented or disclosed in the
financial statements which is relevant to the user's understanding of the audit, the auditor's
responsibilities or the auditor's report.
Circumstances in which an other matter paragraph may be necessary:
๏
Where the auditor reports on two sets of financial statements prepared under different general
purpose frameworks (e.g. a national framework and IFRS).
๏
Where the financial statements have been prepared for a specific purpose, to state that the
auditor's report is solely for the intended users.
๏
In the rare circumstance where the auditor is unable to withdraw from an engagement even
though a management-imposed limitation on the audit may be pervasive.
3.8. Other information paragraph (if one)
For example, an audit covers the financial statements but does not cover the directors’ report. So
what if the directors’ report contains something that conflicts with the financial statements? The audit
opinion cannot be modified because it does not cover the directors’ report, but perhaps the
shareholders need to be alerted to this. This can be done in a paragraph headed ‘Other Information’.
This is not a modification of the audit opinion.
Note that the interactions between the going concern section, key audit matters section and
emphasis of matter/other matters paragraph are covered in detail in the following chapter.
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3.9. Responsibilities of management and those charged with governance for the
financial statements
This section is very important and points out that it is management’s responsibility to prepare the
financial statements in accordance with the International Financial Reporting Standards to maintain
the system of internal control and to consider the going concern position of the company.
3.10.Auditor’s responsibilities for the audit of the financial statements
The auditors’ responsibilities are to obtain reasonable assurance about whether the financial
statements as a whole are free from material misstatement, whether due to fraud or error, and to issue
an auditor’s report that includes their opinion.
Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement when it exists. Misstatements can
arise from fraud or error and are considered material if, individually or in the aggregate, they could
reasonably be expected to influence the economic decisions of users taken on the basis of these
financial statements.
Read carefully in the Illustrative Example (later in this chapter) the details of the auditor's
responsibilities, which can be located in an appendix to the auditor's report.
3.11. Name of the engagement partner, address of the auditing firm, date the
auditor’s report was signed and the auditor’s signature
Finally, the auditors must sign the report and must give their address and the date on which it is
signed. The date of the report is very important because before that date the auditor has an active
duty: the audit is not yet over. The auditor should still be investigating whether receivables are being
paid and inventory is selling at above cost etc. After that date the auditor has a passive duty only. This
means that the auditor is not ‘on the lookout’ for events affecting the truth and fairness of the
financial statements, but if any are brought to his attention he might have to act.
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4. ISA 701 Communicating Key Audit Matters in the
Independent Auditor's Report
The first thing to note is that the auditor only reports on key audit matters (‘KAMs’) in respect of listed
entities.
The auditor shall determine, from the matters communicated with those charged with governance,
those matters that required significant auditor attention in performing the audit. In making this
determination, the auditor shall take into account the following:
(1)
Areas of higher assessed risk of material misstatement or significant risks (see Chapter 10).
(2)
Significant auditor judgments relating to areas in the financial statements that involved
significant management judgment, including accounting estimates that have been identified as
having high estimation uncertainty.
(3)
The effect on the audit of significant events or transactions that occurred during the period.
The auditor therefore selects only those matters that were of most significance in the audit of the
financial statements of the current period and therefore are the key audit matters.
Key audit matters are therefore identified by:
๏
Starting with all matters communicated with those charged with governance
๏
Determining the matters that required significant auditor attention in performing the audit.
๏
The most significant of these are the KAMs.
If the auditor disclaims an opinion on the financial statements (i.e. very rarely), there will be no KAMs
section in the auditor's report because the auditor has not obtained the evidence necessary to form
an opinion.
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5. Illustrative example (from ISA 700 (revised))
INDEPENDENT AUDITOR’S REPORT To the Shareholders of ABC company
Report on the Audit of the Financial Statements
Opinion
We have audited the financial statements of ABC Company (the Company), which comprise the statement of
financial position as at December 31, 20X1, and the statement of comprehensive income, statement of changes
in equity and statement of cash flows for the year then ended, and notes to the financial statements, including
a summary of significant accounting policies.
In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a true and
fair view of) the financial position of the Company as at December 31, 20X1, and (of) its financial performance
and its cash flows for the year then ended in accordance with International Financial Reporting Standards
(IFRSs).
Basis for Opinion
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities
under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial
Statements section of our report.
We are independent of the Company in accordance with the International Ethics Standards Board for
Accountants’ Code of Ethics for Professional Accountants (IESBA Code) together with the ethical requirements
that are relevant to our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements and the IESBA Code. We believe that the audit evidence
we have obtained is sufficient and appropriate to provide a basis for our opinion.
Key Audit Matters
Key audit matters are those matters that, in our professional judgment, were of most significance in our audit
of the financial statements of the current period. These matters were addressed in the context of our audit of
the financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate
opinion on these matters. [Description of each key audit matter in accordance with ISA 701.]
Responsibilities of Management and Those Charged with Governance for the Financial Statements
Management is responsible for the preparation and fair presentation of the financial statements in accordance
with IFRSs and for such internal control as management determines is necessary to enable the preparation of
financial statements that are free from material misstatement, whether due to fraud or error.
In preparing the financial statements, management is responsible for assessing the Company’s ability to
continue as a going concern, disclosing, as applicable, matters related to going concern and using the going
concern basis of accounting unless management either intends to liquidate the Company or to cease
operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Company’s financial reporting process.
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Auditor’s Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our
opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement when it exists. Misstatements can arise from
fraud or error and are considered material if, individually or in the aggregate, they could reasonably be
expected to influence the economic decisions of users taken on the basis of these financial statements.
As part of an audit in accordance with ISAs, we exercise professional judgment and maintain professional
skepticism throughout the audit. We also:
•
Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or
error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is
sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material
misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve
collusion, forgery, intentional omissions, misrepresentations, or the override of internal control.
•
Obtain an understanding of internal control relevant to the audit in order to design audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness
of the Company’s internal control.
•
Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates
and related disclosures made by management.
•
Conclude on the appropriateness of management’s use of the going concern basis of accounting and,
based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions
that may cast significant doubt on the Company’s ability to continue as a going concern. If we conclude that
a material uncertainty exists, we are required to draw attention in our auditor’s report to the related
disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion. Our
conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However,
future events or conditions may cause the Company to cease to continue as a going concern.
•
Evaluate the overall presentation, structure and content of the financial statements, including the
disclosures, and whether the financial statements represent the underlying transactions and events in a
manner that achieves fair presentation. We communicate with those charged with governance regarding,
among other matters, the planned scope and timing of the audit and significant audit findings, including
any significant deficiencies in internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with relevant ethical
requirements regarding independence, and to communicate with them all relationships and other matters that
may reasonably be thought to bear on our independence, and where applicable, related safeguards. From the
matters communicated with those charged with governance, we determine those matters that were of
most significance in the audit of the financial statements of the current period and are therefore the key audit
matters. We describe these matters in our auditor’s report unless law or regulation precludes public disclosure
about the matter or when, in extremely rare circumstances, we determine that a matter should not be
communicated in our report because the adverse consequences of doing so would reasonably be expected to
outweigh the public interest benefits of such communication.
The engagement partner on the audit resulting in this independent auditor’s report is [name].
[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate for the
particular jurisdiction]
[Auditor Address]
[Date]
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6. What is meant by ‘true and fair’?
'True and fair' is a widely used descriptor of financial reporting (e.g. in UK company legislation since
1948). As near as probably matters, the word ‘true’ means that the information is factually correct and
not materially misstated.
‘Fair’ is a more difficult concept. You can have information which is accurate but which is nevertheless
presented in a way which is unfair, and which perhaps conceals or does not reflect the commercial
substance of transactions. For example, it would not be fair to present a bank loan as a non-current
liability if, in fact, it is repayable in the next 12 months (i.e. a current liability). This would distort the
financial position presented because the bank loan would not be included in assessing the company's
liquidity as shown, for example, by the current ratio.
The IAASB prefers the phrase 'present fairly, in all material respect', which is deemed to be equivalent
in ISAs.
As corporate accounting increasingly involves the use of estimates and judgments, it is one of the
recommendations for audit reform in the UK (Brydon Report, December 2019) that 'true and fair' be
replaced with 'present fairly, in all material respects' in the Companies Act.
7. Other reporting responsibilities
An auditor’s report will explicitly include an audit opinion on the financial statements. In some
jurisdictions, the auditor may have additional responsibilities to report on matters such as the
adequacy of accounting books and records. These may be included in the auditor's report under a
suitably headed section (e.g. ‘Report on Other Legal and Regulatory Requirements’).
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Chapter 24
THE AUDITOR’S REPORT 2: GOING
CONCERN
1. Going concern
If a material uncertainty exists which is adequately disclosed in the financial statements, the auditor is
required to draw attention to the related disclosure in a separate section of the auditor's reported
headed ‘Material Uncertainty Related to Going Concern’.
For example:
“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 December 31, 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.”
Generally if the directors or the auditors think the company might not survive into the foreseeable
future there is a going concern problem. ‘Foreseeable future’ is not defined but under IFRS it should
not be less than 12 months from the end of the accounting period. UK GAAP (FRS 102) specifies that is
should not be less than 12 months from the date of approval of the financial statements.
Remember: It is for management to make an assessment of an entity’s ability to continue as a going
concern. The auditor’s responsibilities are to obtain sufficient appropriate audit evidence, conclude
and report.
If the notes do not disclose the going concern uncertainty, the auditor must express a modified
opinion because inadequate disclosure means that there is an element of the financial statements
that is not 'presented fairly'.
If there is no realistic possibility of the company surviving the financial statements should be drawn
up on a break-up basis and, if not, the audit opinion will most likely be adverse (see Illustration in the
last section of the next chapter).
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2. Indicators of going concern uncertainty
Signs that the company may have going concern difficulties include the following:
๏
Negative operating cash flows.
๏
An inability to pay suppliers when due (and auditors are usually rather sensitive if the company
is borrowing more from its suppliers).
๏
Operating losses. These do not mean that the company is going to fail immediately; going
concern tends to be rather more concerned with cash. An operating loss can be sustained for a
number of years provided that cash doesn’t run out. In the longer term, losses usually result in
cash flow problems.
๏
If the borrowing facilities are coming to an end and the new ones haven’t been agreed, what’s
the company going to do to repay the loan, when no cash is available?
๏
The loss of key staff or key customers can mean the company is unable to trade or unable to sell
its products.
๏
Technology changes can render the company’s purpose and main product redundant.
๏
Legislative changes may mean that the company’s operations become illegal or the company
has to go through some sort of regulatory requirements before it can continue trading and that
this is going to be difficult for it.
๏
Non-compliance with regulations may mean a business loses its right or license to trade and in
such a case the company may simply have to be wound up. Non-compliance can also result in
crippling penalties and harmful damage to the organisation’s reputation.
3. Audit work on going concern uncertainty
This can consist of:
๏
Evaluating management’s plans for future actions in relation to its going concern and whether
the outcome of these plans are feasible and likely to improve the situation.
๏
Where the entity has prepared a cash flow forecast:
‣ Evaluating the reliability of the underlying data generated to prepare the forecast; and
‣ Determining whether there is adequate support for the assumptions underlying the forecast.
๏
Considering whether any additional facts or information have become available since the date
on which management made its assessment.
๏
Requesting written representations from management and, where appropriate, those charged
with governance, regarding their plans for future actions and the feasibility of these plans.
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4. Interaction between KAMs, MURGC and EoM
๏
Inevitably, if there are going concern doubts then dealing with these will have been a key audit
matter for the auditor, but it is very important to realise that going concern issues are reported
only ONCE in the auditor’s report. The rules are:
‣ If the auditor concludes that there is material uncertainty with regard to going concern which
is adequately disclosed, a MURGC section must be included in the auditor’s report but will
NOT be referred to again in the KAM section.
‣ If the auditor had been worried about going concern but concludes that in fact, no material
uncertainty exists , there will clearly be no MURGC section, but it may be included as a KAM, if
it meets the definition of a KAM.
๏
If what is regarded as a key audit matter is disclosed in the notes to the financial statements, the
KAM does not need to repeat that information but must refer to the relevant note.
๏
If an item is communicated in the KAM paragraph, the auditor does not also include it in an EoM
paragraph.
Remember: A KAM is a key AUDIT matter. So it is possible that there could be some matter
which is fundamental to users’ understanding of the financial statements, which was not a KAM.
In this case, an EoM paragraph refers the user to an issue that is adequately disclosed in the
financial statements. (If not adequately disclosed, the audit opinion must be qualified.)
Here is an example of an emphasis of matter:
We draw attention to Note 27 to the financial statements, which describes the effects of a fire in
the Company's warehouse. Our opinion is not modified in respect of this matter.
Note that the financial statements do contain a note explaining the effects of the fire. The financial
statements are therefore as comprehensive and as open as they can be. But obviously, the fire has
operational and financial implications and to understand the company's position (e.g. its ability to pay
dividends next year), the users of the financial statements need to be aware of this.
5. Conclusion
This is easy: matters that might give rise to a KAM, a material uncertainty as to going concern or to an
emphasis of matter paragraph appear once and once only in any auditor’s report.
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Chapter 25
THE AUDITOR’S REPORT 3: TYPES OF
AUDIT OPINION
1. Unmodified opinion
Now we are going to look at the different forms of audit opinion and how other matters relevant to
understanding the financial statements are drawn to users attention.
First and simplest is the unmodified audit opinion. This is the audit opinion that you will see in most
auditor's reports. It simply states that the financial statements ‘present fairly’. There are no ‘ifs’ or
‘buts’.
An auditor's report with an unmodified opinion may, however, include any (or all) of the following
additional sections:
๏
‘Emphasis of matter’ paragraph;
๏
‘Material uncertainty related to going concern’ section;
๏
‘Other matter’ paragraph.
These matters do NOT affect the audit opinion.
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2. Modified audit opinions
With respect to modified opinions there are two potential reasons for modification:
๏
The financial statements include one or more material misstatements; or
๏
The auditor has been unable to obtain sufficient appropriate audit evidence.
There are two degrees of seriousness for each of these problems.
First let’s look at material misstatement. This is where the auditor disagrees with the figure in the
financial statements. It could be the figure itself or the way the figure is presented or the disclosures
which must be made to comply with IFRS. First of all, if the misstatement is not material the audit
opinion would not be modified, so the first hurdle is a that disagreement must be for a material
amount. In such a case the auditor would put a paragraph in the report saying that except for certain
items, in other respects the financial statements are presented fairly (i.e. the opinion has been
qualified).
If however misstatements are so significant that it renders the financial statements as a whole useless,
the auditor would issue an adverse opinion stating that the financial statements are not presented
fairly.
The other reason for a modified opinion is where the auditor has been unable to obtain sufficient
appropriate audit evidence.
For some reason the auditor has not been able to get all the information required to draw
conclusions. If the matter about where there is missing information is material then the auditor will
qualify his opinion using an except for paragraph. For example, except that we could not verify the
adequacy of the trade receivables allowance (i.e. for irrecoverable balances), the financial statements
are presented fairly. If, however, the missing information is so significant that the auditor is unable to
form any opinion , the auditor gives a disclaimer of opinion
The choices can be described in a matrix. Think of ‘pervasive’ as misstatements or lack of evidence
that affect the financial statements as a whole:
Nature of circumstance
Material but not pervasive
Pervasive
Financial statements are
materially misstated
A qualified opinion:
Except for ...
Adverse opinion
Unable to obtain sufficient,
appropriate evidence
A qualified opinion:
Except for ...
Disclaimer of opinion
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3. Example of insufficient appropriate audit evidence
Here is an example of a qualification due to insufficient appropriate audit evidence. Here the problem
is material, but does not affect the financial statements as a whole and the report says the auditors are
unable to determine the inventory quantities and then says in their opinion, except for the effects of
such adjustments for inventory, if any, the financial statements are presented fairly.
Qualified Opinion (extract)
In our opinion, except for the possible effects of the matter described in the Basis for Qualified
Opinion section of our report, the financial statements present fairly, in all material respects...
Basis for Qualified Opinion (extract)
We were unable to obtain sufficient appropriate evidence about the carrying amount of
inventories because we were unable to attend the count of physical inventories at 31 December
20X1. Consequently, we were unable to determine whether any adjustments to this amount
was necessary.
4. Example of disclaimer of opinion
Here is a modified opinion arising from lack of sufficient appropriate audit evidence but which is
leading to disclaimer of opinion because multiple elements of the financial statements are affected.
Disclaimer of Opinion (extract)
We do not express an opinion on the accompany financial statements. Because of the
significance of the matter described in the Basis for Disclaimer of Opinion section of our report,
we have not be able to obtain sufficient appropriate audit evidence to provide a basis for an
audit opinion on these financial statements.
Basis for Disclaimer of Opinion (extracts)
We were not appointed as auditors of the Company until [date] and thus did not observe the
physical inventory counts at the beginning and end of the year...
In addition, the introduction of a new computerised system in [date] resulted in numerous
errors in accounts receivable. As at the date of this report ...
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5. Material misstatement/‘except for’
Here is an example of a qualified opinion arising from a material misstatement about something in
the financial statements. Here the problem is that no depreciation has been provided when it should
have been. Note, where there is a material misstatement auditors will normally be able to quantify its
extent and the effect on the profits and this is useful information for the primary users of the financial
statements. Here the amount of depreciation in dispute is material, but the financial statements as a
whole are presented fairly.
Qualified Opinion
We have audited ...
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion
section of our report, the accompanying financial statements present fairly, in all material
respects …
Basis for Qualified Opinion
The Company's property, plant and equipment is carried in the statement of financial position
at $xxx. Management has not depreciated ... which constitutes a departure from IFRSs. The
Company's records indicate that had management depreciated ..., the company would have
recognised depreciation of $xxx in the statement of profit or loss ... The carrying amount... in the
statement of financial position would have been reduced by the same amount ....
6. Material misstatement/‘adverse opinion’
Finally, a modified opinion when one or more material misstatements are so significant that the
auditor concludes that the financial statements are not presented fairly. Here the matter in dispute is
the basis of accounting used in the preparation of the financial statements which is clearly pervasive.
Adverse Opinion
We have audited ...
In our opinion, because of the significance of the matter described in the Basis for Adverse
Opinion section of our report, the accompanying financial statements do not present fairly ...
Basis for Adverse Opinion
The Company's financing arrangements expired ... and is considering filing for bankruptcy ... a
material uncertainty exists... The financial statements do not adequately disclose this fact ...
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OTHER ASSIGNMENTS
Chapter 26
TYPES OF ASSIGNMENT
1. Introduction
This chapter classifies and briefly describes the various types of assignment that accountants might
be involved with. The main classifications are:
๏
Assurance engagements
๏
Related services ('non-assurance engagements')
2. Assurance engagements
2.1. Audits and reviews of historical information
๏
Reasonable assurance engagement, such as a statutory audit. The auditor expresses an opinion
whether the financial statements are presented fairly (ie positive assurance). ISAs apply.
๏
Limited assurance engagement, such as a review engagement (eg of interim financial
information), in which the practitioner concludes that nothing has come to his attention to
indicate that the financial statements do not show a true a fair view (ie negative assurance).
Faster and cheaper, but less confidence in the figures is provided. ISREs apply.
2.2. Other assurance engagements (ISAEs apply)
๏
Prospective financial information (ISAE 3400) - see Chapter 27.
๏
Due diligence reviews - (see Chapter 29).
๏
Controls at a service organisation (ISAE 3402). The service auditor's report will be a type 1 or
type 2 report (see Chapter 18).
๏
Compilation of pro forma financial information included in a prospectus (ISAE 3420). This
involves gathering, classifying, summarising and presenting financial information to illustrate
the impact of a significant event/transaction on an entity's unadjusted financial information. The
practitioner's sole responsibility is to report:
‣ whether the pro forma financial information has been compiled "in all material respects"
‣ by the responsible party (usually management)
‣ on the basis of the applicable criteria (eg the adjustments are directly attributable to the
event/transaction and factually supportable).
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3. Related services (ISRSs apply)
3.1. Agreed-upon procedures (ISRE 4400)
Where the auditor and client agree on the investigations to be carried out and on the work do be
done. For example, assessing how much has been lost through an incidence of fraud or a warehouse
fire. The auditor carries out procedures of an audit nature and reports factual findings - no
assurance is expressed. Forensic audits (see Chapter 28) include agreed-upon procedures. Due
diligence assignments may also be of this nature (see Chapter 29).
3.2. Compilation engagements
Where the accountant assists management with the preparation and presentation of financial
information. The practitioner does not gather any evidence (eg to verify the accuracy or
completeness of the information) and therefore no opinion is expressed.
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Chapter 27
PROSPECTIVE FINANCIAL INFORMATION
1. Introduction
For example, the auditor (or other firm of accountants) has been asked to report on:
๏
A capital expenditure budget
๏
A profit forecast
๏
A cash flow budget
Often, the report is requested by a potential supplier of capital, such as a bank beginning or renewing
a loan agreement, or by a venture capitalist considering the supply of equity finance.
Prospective financial information ('PFI') is financial information based on assumptions about events
and possible actions that may occur (ie in the future). PFI can be:
๏
A forecast: based on what is expected to happen. Uses 'best-estimate' assumptions (ie most
likely outcomes) and is usually for not more than a year.
๏
A projection: includes hypothetical assumptions about events and actions that are not
necessarily expected to take place (eg for a business start-up). It may illustrate the possible
outcomes of 'what-if' scenarios.
๏
A combination (eg a one-year forecast and a five-year projection).
The distinction is important as projections have greater uncertainty and less supporting evidence
than forecasts.
2. Positive or negative assurance?
It should be obvious that it is not possible to express positive (reasonable) assurance that there are no
material errors in the financial information that is subject to the report. It would be a foolhardy
accountant would would be willing to say that about any budget or projection. The future is simply
too uncertain and the forecast subject to many assumptions.
The best that the accountant can provide is negative (limited) assurance. This simply states that
nothing suggests that the assumptions are unreasonable (as a basis for the PFI) and that the PFI has
been properly prepared based on those assumptions. The report will also include:
๏
the basis of the accountant's examination (eg in accordance with ISAE 3400)
๏
the purpose of the PFI (and a caveat that it may not be appropriate for any other purpose)
๏
management's responsibilities (for the PFI and assumptions)
๏
a caveat that actual results may materially differ from the PFI.
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3. Acceptance of engagement
An accountant should not accept or withdraw from an engagement if assumptions are clearly
unrealistic or results not suitable for intended use. For example, a budget showing sales and profits
doubling without any convincing reason has probably been drawn up based on assumptions that
give the answer required (eg cashflows sufficient to stay within an agreed overdraft limit). Similarly, if
finance were being requested to support the opening of an additional shop, the budget for that
shop’s results might be reasonable and show a profit, but if the rest of the business were in financial
difficulties, presenting a cash flow for the only viable part of the business would not really be suitable
for a supplier of loan finance.
4. Examination procedures
Factors that may affect the nature, timing and extent of examination procedures include:
๏
The likelihood of material misstatement
๏
Knowledge obtained in previous engagements (e.g. the audit)
๏
Management’s competence in preparing PFI
๏
The extent to which the PFI is affected by management’s judgment
๏
The adequacy and reliability of underlying data used.
In order to report on PFI, the auditor must obtain sufficient appropriate evidence that:
๏
Assumptions are reasonable and consistent with the purpose of the PFI
๏
The PFI has been properly prepared (through arithmetic checks and a review of consistency)
๏
Both the PFI and all material assumptions have been adequately disclosed.
Analytical procedures are likely to be used extensively, with verification of amounts wherever
possible. For example, if a profit forecast shows a 10% increase in revenue:
๏
Is that increase in volume and/or prices? (How realistic is an increase in price?)
๏
Is it consistent with the forecast cost of sales? (If not, why not?)
๏
Does production have capacity for the increase? If not, what investment must be made in plant
and equipment? Verify reasonableness of cost of investment to a supplier’s price list. Will
employees have to work overtime? Verify reasonableness of costs to payroll information.
๏
Is the timing of the increase in sales consistent with the timing of the investment in plant and
how long it takes to manufacture goods?
The auditor must obtain written representation regarding:
๏
intended use of PFI
๏
completeness of significant management assumptions
๏
management’s acceptance responsibility for PFI.
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5. Example
Clairvoy Co
It is 5/1/2019 and Clairvoy Co is applying to its bank for loan finance. The loan would amount to
$10,000,000, repayable in equal instalments over the three years 2019, 2020 and 2021.
In support of this application, the company cash flow forecast for the next three years.
Actual
Budget
Budget
Budget
All amounts in $000
2018
2019
2020
2021
Sales
7,000
7,500
8,500
9,000
Cost of sales
2,500
2,700
3,000
3,500
Receipts from customers
6,900
7,400
8,400
9,400
Payments to suppliers
2,500
2,600
2,700
3,000
1,000
1,050
1,100
1,100
Administration
800
850
900
920
Depreciation
100
100
110
120
Other outflows:
Wages
Capital expenditure
Tax
200
520
560
678
772
1,980
2,040
2,912
3,488
B/f cash
500
2,480
4,520
7,432
C/f cash
2,480
4,520
7,432
10,920
Net cash flow
Clairvoy Co is not one of your clients, but the company has asked you to provide a report to the bank
on the cash flow forecast that has been prepared.
Describe the work that you would perform in the examination of the prospective financial
information.
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6. Solution - issues to consider
The great thing to remember with all types of budgets and forecasts is that nearly everything on the
document is an assumption and therefore its reasonableness should be considered - both the amount
and its timing. If an amount is not an assumption then it must be an historical amount (such as the
opening cash balance) and that must be checked too. So ALL amounts are open to scrutiny. Usually,
as here, you would also be asked to describe examination procedures.
So here we would:
๏
Agree the opening cash balance to the cash book balance.
๏
Agree actual 2018 amounts to the historical financial statements (eg sales to the statement of
profit or loss and tax paid to the cash flow statement). Note that the cash flow statement should
show no investment in long-term assets (and remember that it would only show payments to
suppliers and employees if prepared under the direct method).
๏
Sales have increased 7%, 13% and 6% pa. This rate of growth looks impressive (though we don’t
know the industry sector) and needs to be justified by sales budgets, marketing reports and
budgets, competitor analysis etc.
๏
Calculate relevant ratios based on the 2018 figures for use in analytical procedures on the
projections:
‣ GP% = 4,500/7,000 = 64%. Note that the GP% has then become 4,800/7,500 = 64%,
5,500/8,500 = 64.7% and 5,500/9,000 = 61%. We need to ask (eg the sales director) why this
percentage has changed.
‣ Wages/sales = 1,000/7,000 = 14%. Note that this ratio has then become 14%, 13% and 12%.
What is causing these efficiency gains?
‣ Administration/sales = 800/7,000 = 11%. Not that this ratio has then become 11%, 10.6% and
10%. Again there are slight efficiency gains that should be investigated.
‣ In 2018, 6,900/7,000 cash from sales was received = 98.6%. This rises to 99% in 2020 then
104% in 2021. The 2021 figure certainly looks odd and it is not clear why the cash receipts are
higher than the sales.
‣ In 2018, 100% of purchases were paid for. This falls to 2,600/2,700 = 96%, 2,700/3000 = 90%
to 3,000/3,500 = 86%. More credit is being taken from suppliers and we need to investigate if
this is a reasonable assumption. For example, talk to buyers and payable ledger supervisors.
๏
The timings of receipts from customers and payments to suppliers need to be examined in
detail as timings of receipts and payments are crucial to cash flow budgets. (Note that taking
opening trade receivables and payables balances from the 2018 accounts it would be possible
to calculate receivable days and payables days for further examination.)
๏
Depreciation shouldn’t appear in the forecast as it is not a cash flow. What other errors could the
preparer have made?
๏
What is the capital expenditure for? Has it been authorised by the board? Is it in the correct year?
Is it complete? Is there really no capital expenditure in other periods? Look at board minutes,
expansion plans, capital expenditure budgets and authorisations.
๏
Are the tax payments calculated properly?
๏
No interest has been included on the cash budget. This is material. For example, if interest was
charged at 5% then $10,000,000 x 5% = $500,000 pa
๏
No capital repayments appear in the cash budget. The potential loan agreement should be
examined to see the proposed repayment schedule.
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As the budget stands there is a forecast balance of $10,920,000 at the end of the three year period.
That would be enough to cover the loan - not accounting for interest.
An exam question might also require you to explain the matters you should consider before agreeing
to an engagement. For this example, we should perhaps be a little suspicious that we have been
asked to do this work, yet we are not the company’s auditors. It would be normal to ask the auditors
to carry out these types of assurance engagement because, as they are normally required urgently,
auditors can complete the work efficiently because of their client knowledge. Of course, the auditors
might not have had time or resources to produce a report quickly, but we should be on our guard that
we have been approached because we do not have detailed knowledge about Clairvoy Co and that
makes it easier for the company to mislead us.
7. Before starting the work
The duties of an auditor are well-defined in both statute and auditing standards. For example, statute
gives the auditors a right to see any documents they wish and to ask for all explanations they require.
But, of course, auditors are careful to send an engagement letters to each client, a copy of which has
to be signed and returned. The engagement letter sets out the work that will be performed by the
auditor and the responsibilities and duties of the client.
Non-audit work, however, is not well-defined. Each job is unique and it is essential that it is welldefined. For example, in the case of Clairvoy Co, it would be essential for the accountant to:
๏
Tell the client that the assurance will be limited (negative) not reasonable (positive).
๏
Confirm how many years or months the forecast covers (obviously, the longer the period, the
greater the amount of work). Also the nature of assumptions (best-estimate of hypothetical).
๏
Find out the purpose of the cash flow forecast and who will receive it. The wider its use or
distribution the greater the risk to the accountant.
๏
Agree with the client that the required information and source data will be made available.
๏
Agree a fee.
๏
Agree a deadline
As noted earlier, before agreeing to perform the detailed work, the accountant should initially review
the cash flow forecast and assumptions to ensure that the information does not appear inappropriate
for its intended use or that the assumptions are not clearly unrealistic.
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Chapter 28
FORENSIC AUDITS
1. Introduction
The word ‘forensic’ is found in the terms:
๏
forensic accounting - involves the application of accounting knowledge and skills
๏
forensic investigation - the process of gathering evidence
๏
forensic audit - the application of traditional audit procedures and techniques in a forensic
investigation
In all cases it implies investigating a company’s or person’s financial affairs for legal purposes - in both
civil disputes and criminal matters. The investigation might be related to a real or suspected fraud,
quantifying an insurance claim, estimating the effects of professional negligence and discovering the
assets owned by individuals (such as the proceeds of crime hidden away by a criminal or assets
owned by a party to a failed marriage).
For the rest of the chapter, we will simply refer to ‘forensic auditing’.
2. General nature of the work
Often, but not always, the work performed by the forensic accountant will be used as evidence either
in a criminal or civil case. Often the accountant will appear as an expert witness and be subjected to
cross-examination. Prosecutions or civil claims are invariably defended and the accountants and their
work will be expertly challenged by the legal representative of the defendant. Any shortcoming or
flaws in the accountant's work will be picked on in an attempt to undermine the whole case. It is
therefore very important that the accountant’s work, records, findings and conduct are of the highest
quality so that their evidence is as solid as possible. It would, for example, be harmful to a case if an
accountant alleged a finding that could not be substantiated. If the accountant cannot justify one
statement, doubt is cast on them all.
However, although the accountant will be hired by one or other side of the dispute, the accountant
must show integrity (eg not hiding evidence that is useful to the other side) and objectivity (eg
drawing fair and reasonable conclusions about the value of inventory lost in a fire). The accountant is
and should be seen as a servant of the court and should help the court to discover the truth as far as
possible. The accountant should beware of becoming an advocate for one side of the dispute.
Forensic work is of a specialist nature which requires professional competence and due care. For
example, there are considerable skills needed in questioning suspects in a fraud case. Specialist skills
are needed to trace money as it passes through various bank accounts and various countries in a
money-laundering case.
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3. Planning
As for all assignments, planning is essential. In addition, because each piece of forensic work will be
unique, it is essential to agree with the client exactly what work is required.
Planning will start with a planning meeting where the following will be discussed:
๏
The nature of the investigation and why it is required (eg fraud, money laundering, loss
estimation).
๏
The type of report(s) needed (eg quantifying the fraud, finding out how it was perpetrated,
determining who was involved and for how long it went on). Remember that an engagement to
perform agreed-upon procedures will report factual findings - no assurance opinion is given.
๏
Agreement that the investigation team will have full access to whatever documents,
information, personnel and explanations they need.
๏
What work has been done already. For example, has the fraud mechanism been understood and
stopped? Have the police been involved?
๏
If the investigation work is likely to become evidence in a court case, the accountant will need to
ensure that it is of the highest quality.
๏
Determine who will receive the completed report.
๏
When can the investigation start? By when is the report needed?
๏
Some preliminary documents might be asked for, such as any insurance policy that might
compensate for negligence payments, losses through fraud or fire.
If the client is not an audit client, then the amount of work that has to be done will be somewhat
greater. For example, whereas auditors will have documented the accounting system and this might
give insights as to how a fraud was perpetrated, if the investigating accountants are not the auditors
they will have to start by documenting relevant parts of the system, getting to understand the nature
of the business and the reporting structures within it.
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4. Investigation procedures
Investigation procedures depend on the specifics of the engagement. In the AAA exam, the scenario
will give you pointers that you need to pick up on to suggest appropriate procedures. The following
are some examples to give you ideas only – do not learn them.
4.1. Insurance claim
๏
Review a copy of any police report filed for details recorded soon after the loss.
๏
Review the insurance policy to determine ‘coverage’ (what is insured, exclusion, etc).
๏
Obtain evidence to quantify the loss. For example, cash/inventory records and details of sales/
purchases reconciled to cash/inventory held. The amount of cash/inventory stolen may be only
one of the reconciling items, so the accounting system and records will need to be tested for
errors in the data.
๏
Watch CCTV coverage (eg of a theft in progress or a fire in the warehouse).
4.2. Actual or suspected fraud investigation
๏
Audit tests on all items (or above a specific amount) in ‘suspect’ areas. For example, in a
‘teeming and lading’ fraud, this could include external confirmation of receivables balances.
๏
If original documents have been destroyed, obtaining copies (eg through external confirmation
of suppliers).
๏
Perform substantive analytical procedures (eg comparing profit margins over the period the
fraud may have taken place with the before and after margins).
๏
Test relevant internal controls to understand the weaknesses that did not prevent or detect the
fraud.
4.3. Alleged bribery payments for new sales contracts
๏
Interview the suspects if possible (eg they may still be employed pending the outcome of the
investigation). Ask, for example, how their job role gives them access to cash and the
accounting systems.
๏
Review payments to new customers during the year (may be able to use CAATs here).
๏
Review terms of contracts with new customers. Are there legitimate grounds for ‘incentives’?
๏
Review email correspondence between the suspects and new clients (may need to use data
analytics for this).
๏
Perform tests of controls on the authorisation of payments. Who else might have known about
them?
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5. Main differences between a financial statement audit and a
forensic audit
Financial statement
audit
Forensic audit
Skills needed
Ordinary audit skills
Specialist eg how to question witnesses
and suspects.
Predictability
Regular, planned
Often unexpected and urgent, therefore
there might be problems finding the
appropriate staff resources: number of
staff and possessing the required skills
and experience
Materiality
Not particularly interested
in immaterial errors
Many frauds are committed by stealing
small amounts frequently. For example, if
a fraudster knows that payments under
$100 are not subject to approval by a
manager, small frauds of about $90 might
be used.
Computer-assisted audit
techniques
Used for selecting/finding
samples and for testing
internal controls.
Can be used to examine 100% of
transactions and this might be needed
when materiality is of no importance. For
example, all payments from the bank
could be examined in the search for a
specified recipient’s account number
Work to be performed and Broadly standard (though
for whom
differs in detail from audit
to audit) and specified by
the law and by auditing
standards. Fairly standard
engagement letter.
Open-ended, non-standard. Therefore,
must be carefully agreed in advance with
the client and an engagement letter
issued and agreed.
Auditor's reports are for
the shareholders. Letters
setting out control
weaknesses go to those
charged with governance.
Interviews
Client staff are routinely
interviewed about how
transactions are
performed, what a
transaction is, what
controls are present etc.
May need to comply with legal rules on
the collection and presentation of
evidence in a court of law.
Generally carried out at the request of
management but it could be at the
request of an insurance company, a legal
firm or the authorities.
Client staff might additionally be
interviewed if they are suspected of
carrying out a fraud. This requires skill and
care. The staff member might be entitled
to have legal representation and if this is
not provided the interview transcripts
might not be accepted as evidence.
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Chapter 29
DUE DILIGENCE
1. Introduction
Due diligence is typically required when one company is proposing to takeover another. Essentially
due diligence is fact finding and information gathering: exactly what is being bought?
The target company’s published financial statements give some information, but not enough, and
besides the financial statements could be over a year old. Financial statements are historic, showing
what has happened, but what is being bought are the future prospects of the business and the new
owner will end up with both the assets and liabilities of the acquired business.
A due diligence assignment could be either:
๏
A review engagement to provide limited assurance (negative opinion) to the effect that nothing
worrying has been found.
๏
An agreed-upon procedures engagement to report factual findings.
2. Procedures
Often, due diligence assignments are urgent. For example, the take-over is happening to rescue a
failing company. However, the auditor must take care to ensure that there is a comprehensive
engagement letter and that staff of the proper skills and experience can be assigned to the job.
Typically, the engagement letter will cover:
๏
Extent of the work.
๏
Type of report.
๏
Timescale.
๏
A clause saying that any takeover is the decision of the client, not the auditor or accountant.
๏
A clause stating that misstatements made by the target company might not be discovered, that
all irregularities might not be found and a description of the nature of the work. For example, of
a review nature (ie making inquiries and performing analytical procedures) but may include
other procedures (eg inspection, external confirmation).
๏
A clause stating that the auditor is dependent on the cooperation of the target company’s
management.
๏
The fee. (May create self-interest threat if the potential purchaser is an audit client.)
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3. Information to be reviewed
A due diligence review will be concerned with the target's assets and liabilities - not all of which will
be reflected in the financial statements (eg intangible assets that cannot be recognised) - and future
prospects. The range of information that may be reviewed is generally very broad:
๏
Budgets.
๏
Information about senior employees and their contracts of employment.
๏
Liabilities that have arisen since the issue of the most recent financial statements.
๏
Pending litigation.
๏
Prospects for the business.
๏
New products in the pipeline.
๏
Industry outlook.
๏
Non-current asset information not revealed by the financial statements (eg age of assets and
replacement plans).
๏
Lease contracts.
๏
Significant contracts, progress, renewal dates, performance, transferability, termination (eg on
change of business ownership)
๏
Correspondence with major customers.
๏
Proof of payment of corporation tax, employees PAYE, VAT etc.
๏
Accident book.
๏
Board minutes.
A review might also need to consider issues that might be critical to a successful takeover, for
example:
๏
Whether the target company's culture 'clashes' with the buyer's.
๏
The extent to which the target's systems are compatible with the buyers.
๏
Specific operational matters (eg manufacturing processes or inventory control).
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Chapter 30
SOCIAL, ENVIRONMENTAL AND
INTEGRATED REPORTING
1. Introduction
Environmental and social issues are a source of risk (and opportunity) to companies:
๏
Bad publicity - for example, disparities between the salaries of male and female employees
๏
Good publicity - for example, a reduction in carbon footprint.
๏
Fines - for example, on operating outside permitted hours causing noise that harms those living
nearby.
๏
Compensation - for example, on the release of pollution that affects fish stocks.
๏
Losing customer contracts - for example if a company is implicated in exploiting children.
๏
More supervision by the authorities - if an industry has repeatedly not improved it standards.
Social media allow much greater involvement of many stakeholders - and can also quickly permit
harm to be caused to an organisation through Twitter and review sites. Initiatives such as integrated
reporting and the triple bottom line (profits, people, planet) have meant that more and more
companies include social and environmental measures in their annual reports and on their web-sites.
2. Assurance reports
Assurance reports on performance measures give greater credibility to those measures. If no
independent assessment were performed why would stakeholders believe what is published? Of
course, what company decides to publish relating to these matters is very much the company’s choice
(unlike in their financial statements) and the auditor has no power to insist on a particular set of
disclosures. However, once the company decides on its disclosures, the auditor can be asked to
provide assurance.
In general, the work that the auditor has to carry out for an assurance report is:
๏
Agree the metrics (eg performance measures and sustainability indicators).
๏
Check the client’s measurements, calculations and published figures.
๏
Report compliance.
You should remember from your SBR (P2) studies that an integrated report goes beyond a
sustainability report. Performance is just one of the eight content elements of an integrated report.
See Chapter 30 of our SBR notes
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3. Examples of matters included a sustainability report
Social matters (include product responsibility, labour practices, human rights and society), for
example:
๏
Production information relating to socially responsible, safe, reliable products
๏
Data showing progress towards equal opportunities for staff (eg male/female proportion, age
distribution) and for fair pay policies
๏
Incidence of industrial injuries
๏
Investment in people (eg number of trainees and training costs per employee)
๏
Number of hours spent on socially useful voluntary activities
๏
Conditions for the workforces of suppliers (eg steps taken to stop suppliers using child-labour)
๏
Fair pricing for purchases
Environmental matters:
๏
CO2 emissions/carbon footprint
๏
Release of waste products into the atmosphere or sea or rivers
๏
% of packaging that is recyclable
๏
Reductions in packaging
๏
Freight miles for both purchases and sales
๏
Overall energy consumption
๏
Percentage of energy from renewable sources
๏
Trees planted
Economic matters (include economic performance, market presence, indirect economic effects,
procurement practices, anti-corruption and anti-competitive behaviour), for example:
๏
Economic value generated (ie revenue), distributed (ie to employees, suppliers, government and
the community) and retained (ie the difference)
๏
Financial implications of climate change
๏
Information about defined benefit plans (eg % employee participation and % contributed by
employee/employer)
๏
Government financial assistance (eg tax relief, subsidies and grants)
๏
Infrastructure investment (eg in transport links, health centres)
๏
% of employees paid minimum wage and entry level wage by gender
๏
% of senior management hired from local community (must define both ‘senior management
and ‘local’)
๏
Preferential pricing of medicines
๏
Proportion of spending on local suppliers
๏
Number and % of employees who received training on anti-corruption
๏
Number of incidents of and dismissals for corruption
๏
Number of legal actions (eg relating to violations of monopoly legislation)
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4. Planning the assignment
Every client could use different sets of measures and different ways of taking measurements and the
first step is to find out precisely what work the auditor is expected to carry out. What key performance
indicators (KPIs) will be used? What are the comparatives? How and when are the measurements
made? What evidence does the client use and which will also be available to the auditor?
Each KPI should be assessed to see if measurement (and therefore auditing) can be reasonably
accurate or if the KPI is too ill-defined.
The auditors should consider if they have the appropriate competences to audit the KPIs. If third party
experts are needed, their independence and competence will have to be assessed.
When is the work to be done?
What type of assurance is required: positive/reasonable or negative/limited?
5. Potential problems with KPIs and their measurement
๏
Not specific-enough to be meaningful. For example, the company reports on serious industrial
accidents. However, this leaves unanswered what is meant by ‘serious’.
๏
Lack of consistency from one period to the next. So, if the definition of ‘serious’, above, were to
be altered, the safety record could be manipulated to show improvement.
๏
Comparability across industries is likely to be difficult as different firms could measure an
identically described measured differently.
๏
Record-keeping and internal controls might not be sufficient to permit the figures to be audited.
For example, how would the auditor know that escapes of waste into the local river are
completely recorded?
๏
Is the auditor competent to verify the technology used in the measurements and the
calculations that might follow?
6. Example
You are the auditor of Kipper Co, which manufactures paper from wood pulp. In its annual report the
company publishes data on some environmental and social measures. The key performance
indicators published are:
๏
The company’s carbon footprint.
๏
Its energy efficiency
๏
Release of chemicals into the local river
๏
Incidence of industrial diseases.
Identify the issues raised by each of the key performance indicators.
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7. Answer notes
7.1. Carbon footprint
๏
What is included: energy used in the factory, transport, energy used by suppliers? Is there any
offset from renewable supplies?
๏
What is the metric? For example, it could be in tonnes of CO2
๏
How does the company assess the chosen KPI?
๏
Does the company propose to use any sort of industry comparatives?
7.2. Energy efficiency
๏
How is this measured? What is meant by efficiency or does it just mean energy consumption?
๏
What is the metric and how is it assessed? Will it be possible to verify the figures?
๏
Is it just the paper-making process or is it the whole undertaking?
๏
Are suppliers’ energy consumption figures included so as to get total energy per tonne of paper
produced?
7.3. Release of chemicals into the local river
๏
Does this include all chemicals or just particularly harmful ones? Will the measures be split over
different chemicals?
๏
What does the company measure? Litres released is no good without knowing the
concentration of the chemicals.
๏
How does the company monitor releases?
๏
How can we verify that retrospectively?
๏
How can we verify that the company procedures work correctly?
7.4. Incidence of industrial disease
๏
How is ‘industrial disease’ defined? What diseases are covered?
๏
Is the company simply looking at current employees or are former employees investigated too?
(Some diseases might not show up for some time.)
๏
If former employees are included can they all be located and do they all cooperate?
๏
What sort of medical reports are provided?
๏
Do other, similar industries, use the same measurements?
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Chapter 31
THE AUDIT OF PERFORMANCE
INFORMATION IN THE PUBLIC SECTOR
(INTERNATIONAL SYLLABUS ONLY)
1. Introduction
Performance information is information about the performance of an organisation against set criteria
such as a budget or benchmark. For example, information may be produced about how many units of
a product are produced or how efficient an employee is in terms of units produced per hour. In terms
of the public sector this could be number of operations performed in a hospital, or how many times
the grass is cut in a council park, or how many school children reach a target literacy level.
The audit of performance information in the public sector is examining central and local government
departments in terms of three main criteria:
๏
Effectiveness: whether the objectives of the department have been met.
๏
Efficiency: how well inputs are turned into outputs.
๏
Economy: obtaining best value for money (ie lowest possible cost for the right quality and
quantity or resources at the right time).
For example:
A government department is responsible for repairing street-lights. The performance of that
department can be determined using the '3Es' criteria.
๏
Effectiveness: Whether each light was repaired within the time limits set by the government
department.
๏
Efficiency: How many resources were used to fix each light in terms of materials, labour etc.
potentially against some standard.
๏
Economy: The financial budget for fixing lights was not exceeded during a specific period.
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2. The use of performance information
In many countries, government departments produce statistical information concerning the
performance of that department. For example, a local council in the UK (a local council is responsible
for provision of services such as refuse collection, street lighting, road maintenance, etc) will produce
information not only on its financial performance but also on other areas such as the amount of refuse
recycled or time taken to respond to requests to repair streetlights.
2.1. Objectives
๏
Improvement. Targets are set and performance measured against those targets to try and
determine how management can be improved. For example, if recycling targets are not being
met then councils may use performance information to determine which categories of waste are
not being recycled and then introduce new systems to (hopefully) improve actual recycling
against target.
๏
Monitoring. Performance information is used to report on the achievement of targets. In this
sense, local government may have to report back to central government to obtain the necessary
funding for next year’s budgets. Similarly, performance information can be used as a
management tool to determine the amount of performance related pay.
๏
Reporting. Including performance information in accounts or other external reports partly as a
means of showing progress against targets but also as a means of advertising how well those
targets have been met. For example, meeting a recycling target will be reported not simply to
show that the target has been met but also to generate good publicity for the council.
Taxpayers will therefore be happy with the activities of the council and ultimately this means
that the councillors in charge of the council are re-elected(!).
From the audit perspective, this means that auditors will have to treat performance information with a
high degree of scepticism. There will be management bias to show good results not only to maintain
or increase funding but also so councillors retain their posts.
In other words, a lot of performance information may be available, but it may be produced to meet
the three objectives above, not because there is any standard (such as an IFRS) which requires
production in a specific format. Comparability between different information providers (that is
different councils, schools or hospitals etc.) will be difficult as the actual information produced will the
different and different standards will be used to produce that information anyway.
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2.2. Auditing
There are two types of audit:
๏
‘Performance audit’ – this ‘value-for-money’ audit examines efficiency and effectiveness having
regard for economy. It focuses on government policy or management processes and its main
aim is to lead to improvements.
๏
‘Audit of performance information’ – this provides assurance that the performance reported
against predetermined objectives is reliable, accurate and complete (in all material respects). It
focuses on:
‣ Data reliability – is it accurate and complete? The auditor must assess the systems that
produce the performance information.
‣ Content quality – is it relevant (ie linked to objectives), comparable (eg with past periods) and
verifiable (ie supported by documentation)? Is it well-defined (ie clear and unambiguous) and
timely (to be useful)? Does it avoid ‘perverse incentives’ (ie not encourage wasteful
behaviour)?
‣ Compliance with reporting requirements – is the report clear? Is there sufficient explanation
of inputs, outputs and outcomes? Has actual performance been evaluated?
3. Planning the audit of performance information
To audit that performance information the auditor needs to know how that information (actual
performance and target performance) was produced. There are five stages to the production of
performance information:
(1)
Defining a measurement objective
(2)
Formation of relevant indicators
(3)
Data collection
(4)
Data analysis
(5)
Reporting
These stages are explained below along with typical examination procedures that can be used by the
auditor.
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Audit procedures for performance information in the public sector can include:
๏
Tests of controls on the systems used to generate performance information (eg managers
dating and signing off tasks as they are accomplished).
๏
Performing analytical review to evaluate trends and gauge the consistency of the information
(for example, compare to the previous period).
๏
Discussion with management and others responsible for the reporting process about problems
both with performance and its adequate recording.
๏
Review of minutes of meetings where performance information has been discussed. For
example, council meetings, school governors’ meetings, health authority meetings.
๏
Inspection of performance information source documentation, probably on a sample basis.
๏
Recalculation of quantitative performance information measures and their summarisation onto
performance reports, again on a sample basis.
The example of refuse collection is used to illustrate each section. In many countries, the residents of
each house are provided with a large bin on wheels into which household refuse is placed. The local
council provides a refuse collection service, so each week the bins are emptied into a refuse collection
lorry which takes that refuse to a tip. Some councils also provide a recycling service where recyclable
refuse is placed in a separate bin and taken for sorting and recycling.
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Stage
Explanation
Examination procedures
Defining a
measurement
objective
The process or activity is identified
and level of detail to be measured
confirmed. For example, the
number of houses to collect refuse
from each day may be considered
as an indicator although some
allowance might be necessary for
different types of houses.
‣ Ensure the measurement
objective can actually be
measured.
Having decided what to measure,
this stage defines how to measure
the process or activity. To ensure
that the measure is appropriate, it
must be SMART:
‣ Confirm number of houses in
the council area – by reference
to detailed maps.
Formation of relevant
indicators
145
‣ Review the proposed indicator
to ensure it is achievable and
at the correct level of detail.
‣ Ensure 1,000 bins emptied
each day is achievable.
‣ Specific to the process or activity. ‣ Ensure all bins can be emptied
each week by dividing
‣ Measurable, that is quantifiable.
number of properties by 5,000
(1,000 bins over 5 days) and
‣ Achievable.
there are at least that number
‣ Relevant to the process or activity
of refuse teams.
‣ Time bound, that is measured
over a specific period of time.
For the refuse collection the
objective can be: “Bins to be
emptied from all properties in the
council area once each week with
1,000 bins emptied each day by
each work team”.
Data collection
Data is then collected on each of
the SMART indicators identified.
‣ Review signature sheets
confirming that bins have
been emptied.
For refuse collection, each
collection team has a predetermined route covering about
1,000 houses and a shift supervisor
signs a document confirming
refuse bins have been emptied.
Also confirm that residents can
complain (probably online) if their
bin is not emptied.
‣ Access online complaints
system and determine from
this how many bins were not
emptied.
‣ If necessary, write to a number
of residents in the council
asking them to confirm their
refuse bins were emptied.
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Stage
Explanation
Examination procedures
Data analysis
The data collected is analysed and
compared to the indicators.
Reasons for performance being
above or below standard are
identified.
‣ Re-calculate the council’s
statistics of bins being
emptied and confirm accuracy
of non-emptied bin %
(complaint information
already obtained above).
146
For refuse collection, compare
results of collections each week
(signature sheets) to confirm all
bins have been emptied – or
where bins are not emptied
calculate the % missed. Identify
any areas or streets where
collections are normally below the
performance indicator.
Reporting
Finally a report is produced on the
whole process or activity, with
recommendations made for
improvement or change to the
activity, the indicators being used
or both.
For refuse collection, from the
results above, determine what
remedial action is necessary. For
example, this may mean changing
the number of refuse collection
teams or targeting specific teams
with training where their % of bins
not emptied exceed other teams.
‣ Obtain and review report.
‣ Ensure that the
recommendations are
congruent with the problems
identified in the previous
section.
‣ Where necessary, discuss
actions with the managers in
the council to determine
whether further remedial
action is necessary.
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4. Reporting on performance information
In some countries, including the UK, reports on performance information are generally included
within the report on the financial results of the government or other department. The audit may also
be carried out by a government auditor (literally auditors employed by the government in effectively
an internal audit role) using specific government reporting standards. This means that care must be
used in interpreting the reports partly due to possible bias (no truly independent report) and lack of
knowledge of the different reporting standards used. In terms of non-financial performance
information there may not be any reporting standard anyway, potentially making the report even
more subjective.
A typical report is summarised below.
If you remember the basic elements of an auditor's report (ISA 700), most of the sections of a report
on performance information can at least be “guessed”.
Section of report
Content
Title and addressee
Indicates that it is an
independent assurance report
and to whom it is addressed –
in this case normally the
members of the government
department.
Subject matter information
and applicable criteria
Identifies what has been
audited and the standards
used. In many countries there
will be a specific financial
reporting framework for
government departments.
Relative responsibilities
The report states, for example,
that the chief financial officer
prepares the report and the
auditor audits the information
in that report.
Summary of work
performed
In the absence of a more
specific ISAE, ISAE 3000
applies. The summary must
convey how, based on the
procedures performed, the
auditor may detect material
misstatement.
Implication for auditors
The auditor will need to
understand the financial
reporting framework.
The auditor will also state clearly
what information has been
audited, normally be identifying
the page numbers in the report
where the performance
information is shown.
This summary is likely to be more
detailed for a limited assurance
engagement than a reasonable
assurance engagement in order
to convey the limitations on the
nature, timing and extent of
procedures.
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Section of report
Content
Implication for auditors
Opinion/Conclusion
Conclusions on the reported
performance information and
whether objectives have been
achieved may provide express
reasonable (positive) or
limited (negative) assurance.
If not governed by national
regulation, the type of
conclusion must be agreed with
the organisation's regulating
body. A conclusion must be
modified if there is a scope
limitation (qualified or
disclaimed) or material
misstatement (qualified or
adverse).
Findings and
recommendations
This is a separate section of
the report where the
performance information is
reported on. The auditor will
state findings related to the
content and relevant data
systems and whether or not
the council has fulfilled its
reporting responsibilities (ie
complied with reporting
requirements). It will also
provide recommendations
based on findings.
This might include, for example,
identified misstatements (and
whether they were corrected)
and recommendations for
further/future action (eg to
improve internal control over
data collection and/or reporting
of a performance indicator).
148
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149
Chapter 32
AUDITING ASPECTS OF INSOLVENCY
(UK SYLLABUS ONLY)
1. Meaning of insolvency
A company is insolvent if the value of its assets is less than its liabilities (i.e. the statement of financial
position shows a position of net liabilities). If all the company’s assets were sold at carrying amount
(‘book value’), the existing liabilities could not be paid. This is a more fundamental problem than
simply being short of cash.
๏
Management’s responsibility for monitoring financial position and performance is especially
important when the company has financial difficulties, as cash flow problems can quickly result
in insolvency.
๏
When facing insolvency, management must consider the interests of lenders and other
creditors, shareholders and other stakeholders.
๏
Management must, therefore, prepare and monitor financial statements and cash flow and
profit forecasts on a regular basis.
๏
The auditor may be asked to advise on whether a company is insolvent, or to review historic or
projected financial information.
๏
Having up-to-date financial information and taking professional advice may also help to protect
directors from legal claims such as wrongful or fraudulent trading.
2. Administration or liquidation?
The directors of an insolvent company face a difficult decision. Should the company continue to trade,
in the hope of improvement, or ‘cut its losses’ and cease to trade and be wound up? The auditor may
be asked to help resolve this dilemma by evaluating the advantages and disadvantages of the options
available, and considering the impact of each on the relevant stakeholders. The auditor may also be
asked to explain the procedures involved in placing a company into administration or liquidation, as
directors will usually have limited knowledge in this area.
See Chapter 14 of our ACCA Corporate and Business Law (LW) (ENG) notes for a summary of points
which are relevant to AAA.
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150
3. Administration
If management decides to try to ‘save’ the company, it can be put into administration, which offers
some time and legal protections while formulating a rescue plan. The main advantage of this option is
that once an administrator is appointed, there is a moratorium over the company’s debts (i.e. the
creditors cannot present a winding-up petition to the court).
๏
The court will only grant an administration order in response to a petition (by the company, its
directors or creditors) if satisfied that:
‣ the company is (or likely to become) insolvent; and
‣ that administration is likely to achieve its purpose.
๏
An administrator may be appointed without a court order by a floating chargeholder or the
company or its directors.
๏
The administrator is given a short period of time (usually eight weeks) to set out a proposal for
achieving the aim of the administration or to decide that a rescue is not reasonable.
๏
Proposals are accepted or rejected at a creditors’ meeting.
๏
The administrator takes over the company’s management and has the power to appoint and
remove directors.
๏
Administration usually lasts for 12 months, but may be extended (with the creditors’ approval)
or end early (if administration is successful).
4. Liquidation (‘winding up’)
A company that cannot be saved will cease to trade – assets are sold, liabilities paid (applying the
‘priority rules’ below), and eventually the company will be dissolved. Once liquidation proceedings
commence share dealings must stop and the directors lose their power to manage the company.
There are different ways in which the process is initiated:
๏
Compulsory liquidation – usually on the grounds that the company is unable to pay its debts
(i.e. fails to pay a statutory demand for more than £750 within 21 days). A member (for at least
six months) may also petition the court for winding up on the ‘just and equitable’ ground.
‣ An Official Receiver (an officer of the court) takes control of the company and its assets until a
liquidator is appointed.
‣ Company ceases new business, floating charges ‘crystallise’ and employs are automatically
dismissed.
‣ Directors must prepare a ‘statement of affairs’ (i.e. details of all assets, liabilities, creditors and
any security they hold).
‣ Liquidator investigates the causes of the company’s failure, realises the company’s assets and
distributes proceeds in a prescribed order.
‣ Liquidator files a final return with the court and the Register of Companies (company is
dissolved).
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๏
Member’s voluntary (‘solvent’) liquidation – can only take place when the directors have made
a declaration of solvency. Creditors have no involvement in the process as the declaration
means they will be paid in full and therefore have no risk exposure. Shareholders pass a special
resolution (i.e. 75% majority) to wind up the company within five weeks of the declaration of
solvency and appoint a liquidator. The surplus after assets are realised and debts cleared is
returned to the members.
๏
Creditors’ voluntary (‘insolvent’) liquidation – shareholders must pass a special resolution to
start the process but the creditors get to choose the liquidator. Both members and creditors
appoint representatives to a liquidation committee which supports the liquidator.
151
5. Priority for allocating company assets
This is especially important for creditors and shareholders because, by definition, an insolvent
company cannot pay everything that is owed. The amounts that will be paid on liquidation depend
on:
๏
whether debts are secured or unsecured
๏
whether charges over assets are fixed or floating
๏
whether shareholders own preference or equity shares
๏
the costs suffered by the liquidator (generally paid first)
๏
the amount of preferential creditors (including employees’ salaries and other benefits in arrears).
Equity shareholders may receive very little, if anything, as they rank last. The auditor of an insolvent or
potentially insolvent company may be asked to advise on the allocation of company assets.
See Chapter 14 of our ACCA LW (ENG) notes for the sequence of distribution.
6. Benefits of administration
If successful, the company will continue as a going concern:
๏
shareholders continue to hold shares and, hopefully, eventually receive a return on their
investment. (Compared with very little/nothing if the company is wound up.)
๏
for creditors, improved cash flows should allow debts to be repaid and trading relationships can
be maintained.
๏
continuing employment of some staff (though there may be some redundancies in the rescue
plan). (Compared with automatic dismissal in a compulsory liquidation.)
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7. Fraudulent and wrongful trading
These terms are defined in the Insolvency Act 1986.
See also Chapter 15 of our ACCA LW (ENG) notes
Fraudulent trading (s.213)
Wrongful trading (s.214)
Definition: Carrying on the
business of an insolvent
company …
… with the intent to defraud
the company’s creditors
… when it ought to have been
concluded that there was no
reasonable prospect of
avoiding insolvent liquidation
(hence creditors would suffer
losses)
Action can be brought against:
any person who is knowingly a company directors (including
party to the fraudulent trading shadow directors) only
Type of offence
criminal offence
civil wrong
Standard of proof
‘beyond reasonable doubt’
‘on the balance of probabilities’
Penalties/liabilities
Imprisonment (max 10 years)
Personal (civil) liability for
company’s debts
Personal (civil) liability for
company’s debts
Director’s disqualification (max
15 years)
Director’s disqualification (max
15 years)
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PROFESSIONAL SKILLS
Chapter 33
PROFESSIONAL SKILLS
1. Introduction
From September 2022, the AAA exam will include 20 Professional Skills marks: 10 in the case study Q1
in Section A and 5 in each of the 25-mark questions in Section B. The four professional skills relevant
to AAA are: Communication; Analysis and Evaluation; Professional Scepticism and Judgement;
Commercial Acumen.
๏
All four skills will be examined in Section A
๏
Each question in Section B will examine a minimum of two professional skills but not
communication.
2. Communication
Q1 will always ask for briefing notes requested by an audit engagement partner or senior manager,
which address key matters facing the engagement team at the planning stage of an audit.
Professional marks will be available for:
๏
Briefing notes format and structure – use of headings/sub-headings and an introduction
๏
Style, language and clarity – includes:
‣ appropriate layout and tone
‣ presentation of materiality and relevant calculations
‣ appropriate use of the CBE tools
‣ easy to follow and understand
๏
Effectiveness and clarity of communication - answer is relevant and tailored to the scenario
๏
Adherence to the specific requests made by the audit engagement partner
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3. Analysis and Evaluation
All questions will include this professional skill – it is fundamental that you should be able to
demonstrate your assessment of a given scenario and apply your knowledge.
Analysis and evaluation must be in context of the organisation’s situation. The scenario will require
an assessment of financial reporting issues and/or ethical, legal and regulatory issues and their impact
on the audit process. This may be at the planning or completion and reporting stages of the audit, so
any recommendations for further actions must be relevant to that stage.
Analysis can be demonstrated by:
๏
Appropriate use of the information:
‣ to determine suitable calculations
‣ to support discussions and draw appropriate conclusions
๏
Identifying where data or information appears to be omitted or where further analysis is needed
to make a recommendation/draw a conclusion
An evaluation is a balanced appraisal to determine the impact of a course of action (e.g. if
management does not correct a material misstatement, what are the implications for the auditor’s
report?).
4. Professional Scepticism and Judgement
These are mandatory skills for an auditor. Consider, for example:
๏
The definition of independence of mind – the state of mind that permits the expression of an
opinion without being affected by influences that compromise professional judgment,
thereby allowing an individual to act with integrity, and exercise objectivity and professional
scepticism.
๏
The IAASB’s International Standards require professional accountants to exercise professional
judgement in applying them.
๏
The definition of professional scepticism – an attitude that includes:
‣ a questioning mind;
‣ being alert to conditions which may indicate possible misstatement due to error or fraud; and
‣ a critical assessment of evidence.
Professional scepticism and judgement are essential skills when assessing the information given in a
scenario (e.g. when asked to evaluate the significant risks or challenging information provided).
Identifying possible management bias and the reasons for management’s preference for certain
accounting treatments, for example, would also demonstrate this skill.
You should be able to demonstrate professional judgement by prioritising audit risks or risks of
material misstatement in keeping with the “spectrum of inherent risk” introduced by ISA 315 (Revised
2019). You should be prioritising the most significant risks first and in a brief conclusion, justifying
your decision.
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Information may come from the client (e.g. the basis for a provision or amortisation of purchased
intangible assets). Other scenarios may require a review of the audit work and evidence obtained to
assess whether it is sufficient to support a decision or information in an auditor’s report.
5. Commercial Acumen
Questions are set in commercially realistic scenarios ranging from private to public sector
organisations, not-for-profit organisations and regulated industries.
You may have an opportunity to demonstrate your commercial acumen by assessing the business
risks affecting the client at the audit planning stage (e.g. specific regulatory requirements or the
impact of competition on future business). Factors affecting a client may highlight issues regarding
the future trading success of the business (e.g. increased risks to future competitiveness and any
impact on going concern).
You may also demonstrate commercial acumen in relation to:
๏
audit procedures – are they practical and plausible in the given scenario?
๏
recommendation to TCWG – are they appropriate in the given scenario?
๏
the impact of the engagement on the audit firm – should the audit firm be associated with the
client or industry?
6. Resources
In the Practice Platform you will find:
๏
AAA Specimen from September 2022 onwards
๏
AAA Practice Exam 1 from September 2022 onwards
๏
AAA Practice Exam 2 from September 2022 onwards
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156
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157
EMPLOYABILITY AND TECHNOLOGY SKILLS
Chapter 34
EMPLOYABILITY AND TECHNOLOGY
SKILLS
1. Introduction
The ACCA has introduced this new section into the syllabus for all of the Applied Skills and Strategic
Professional examinations now that all the examinations in all locations will be computer based.
However, it does not require the same sort of learning as for other syllabus areas because it has been
added to reflect the outcomes and demonstrable skills required for the exams, using the Computer
Based Exam software. The level of skill needed to be able to use the CBE software can also be
beneficial for your employment.
Many students will already have a high level of skill on computers and be familiar with the use of word
processors and spreadsheets. However, those provided in the exam software might not be identical to
those that you are familiar with and, in addition, it is essential that you are able to navigate the
software efficiently so as not to waste time in the exam.
There are many excellent resources available on the ACCA website to assist you, and so in this chapter
we will direct you to some of the relevant ACCA pages and explain their importance.
2. Navigating the exam and the tools available
The exam screen has a top bar and a bottom bar.
On the top bar there are options to call up an ‘online calculator’, to call up the ‘scratch pad’, and to
‘flag for review’.
The online calculator is used in the normal way and can be switched at any time between a basic
mode and a scientific mode. You can use your own calculator instead provided that it does not store
or display text.
The scratch pad can be used to make notes and do your own rough workings, but nothing written on
the scratchpad will actually be marked. You will also be provided with paper if sitting the exam in an
exam centre and so you can use this for workings instead - the paper will be collected in at the end of
the exam but, again, nothing on this rough paper will be marked. (Note: if you are sitting the exam
remotely then paper is not allowed and you can only use the scratchpad.)
The ‘flag for review’ option enables you to put a mark against a question to enable you to quickly
come back to it again later if you have time.
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On the bottom bar are the arrows for moving forwards or backwards through the questions. In
addition there is a ‘navigator’ option which when chosen displays a list of all of the questions enabling
you to go straight to a particular question.
Watch the short video Introducing Strategic Professional CBEs to see these features in use.
3. ACCA Resources
You will find many resources on the ACCA website and the more you refer to the better.
Go first to the AAA CBE Introduction page:
On this page, under the heading ‘Resources’ you will find a link Strategic Professional CBE platform
guidance document. Download this as essential reference material.
Also in the resources section you will find links to:
๏
CBE platform support videos for an introduction the CBE practice platform
๏
AAA CBE Question Practice for the Specimen exam and Practice exams.
It is essential to use these resources in your exam preparation.
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