What do auditors in the UK mean by reasonable assurance?

Michael Page1

Summary
Reasonable assurance has been adopted as a term in UK auditing regulation from International Standards on Auditing (ISAs). It is also used in relation to auditing in the USA. Attention has recently been paid to the meaning of reasonable assurance, where, in the specific context of certification of internal controls under the Sarbanes Oxley Act, it has been characterised as a high level of assurance. Analysis of the way in which the term is used in the international and UK and Ireland versions of ISAs identifies some ambiguity of meaning that it would be worth addressing, in order to clarify the application of ISAs in the UK and Ireland and also to prevent the development of further ambiguity. For this purpose reasonable assurance can be characterised as follows: Reasonable assurance is the level of confidence that the financial statements are not materially misstated that an auditor, exercising professional skill and care, is expected to attain from an audit. An auditor cannot attain absolute confidence because of numerous factors arising, among other things, from the limitations of audit evidence, the impracticality of examining all evidence and uncertainties as to the future. The confidence that an auditor attains is subjective and is the basis for offering an audit opinion. Users of financial statements derive their own confidence in the audited financial statements from many sources, including a knowledge that the auditors work to professional standards within a framework of regulation and that the auditors have felt sufficiently confident that the financial statements are not materially misstated to issue an opinion. As a consequence of their confidence that financial statements are not materially misstated, users of financial statements may also gain confidence that the management of the entity are conducting its affairs in the knowledge that the financial consequences of their actions will be reported.
Corresponding Address: Portsmouth Business School, Richmond Building, Portland Street, Portsmouth PO1 3DE, e-mail mike.page@port.ac.uk. The author is grateful for comments received on an earlier draft of the paper from members of the Group and Professor Laura Spira. This working paper has been prepared for the Audit Purpose group to aid discussion of some of the issues around the purpose of an audit and to help the group to develop the paper, Audit Purpose. The working paper does not necessarily represent the views of the members of the Audit Purpose group or of the Audit Quality Forum, individually or collectively. No responsibility for any person acting or refraining to act as a result of any material in this paper can be accepted by the author, the Audit Purpose working group, or the ICAEWs Audit and Assurance Faculty.
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The final paragraph above characterises how the stewardship function of financial reporting operates. The focus of stewardship is the monitoring of management; directors act in the knowledge that shareholders will be informed of the financial consequences of the directors decisions.

Reasonable Assurance
The Audit Quality Forum of ICAEW has set up a group to produce a paper articulating the The purpose of the audit of UK companies. As part of this work the Audit Purpose Working Group has needed to consider the meaning of the term reasonable assurance when used in an auditing context in the UK. This papers sets out a discussion of the meaning of the term, followed by a suggested characterisation of the term2. Appendices draw an analogy with the nature of confidence in a statistical context; set out the definition of assurance as it appears in the Oxford English Dictionary; and show extracts from auditing standards. The Audit Purpose Working Group has concluded that the main purpose of the statutory audit of a company is to provide an independent opinion to the shareholders on the truth and fairness of the financial statements, whether they have been properly prepared in accordance with the Companies Act and to report by exception to the shareholders on the other requirements of company law such as where, in the auditors opinion, proper accounting records have not been kept. As a consequence of the audit the shareholders, and other users of the financial statements, have less uncertainty regarding the information contained in the financial statements than would otherwise be the case. The subsequent discussion is framed in terms of all users of the financial statements, although the main purpose of the audit needs to be borne in mind. Reasonable assurance is not a term of art that appears in either the Companies Acts or the current Companies Bill. Nor has it figured prominently in litigation in the UK, but it does appear in ISA (UK and Ireland) 200 which says:
An audit in accordance with ISAs UK and Ireland is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process. [Paragraph 8]

ISA UK&I 200 goes on to discuss the reasons that assurance cannot be absolute (see Appendix 3). What the quotation does not specify is to whom the reasonable assurance is provided. At first sight it appears that reasonable assurance is provided to third parties, but the second sentence of paragraph 8 seems to imply that the reasonable assurance is acquired by the auditor and is a part of the process of forming a conclusion on the financial statements. Paragraph 8 is a typical product of a drafting committee and acquires, by inclusion in an ex cathedra statement, a halo of authority that may not have been intended. Such statements are typically a compromise between differing points of view and include a level of ambiguity that
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A definition is not attempted since non-circular definitions inevitably introduce new undefined terms.

accommodates such differences. In particular, as mentioned above, the statement does not say explicitly who acquires the assurance, and it conflates at least two of the shades of meaning of assurance that the Oxford English Dictionary (online) sets out (Appendix 2). Use of reasonable assurance in other jurisdictions In the USA, the accounting profession has long contended that an audit conducted in accordance with generally accepted auditing standards (GAAS) provides reasonable assurance (as opposed to absolute assurance) that the subject financial statements are free of material misstatements (Goldwasser, 2006). The term is part of the standard wording of audit reports of public companies, which include wording along the lines
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

Recently, in the context of attestation reports on internal controls SarBox 404, the PCAOB has equated reasonable assurance with a high level of assurance and has also published rules for the preparation of such reports. The term reasonable assurance also appears in International Standards on Auditing (ISAs), notably in ISA 700
When forming an opinion on the financial statements, the auditor evaluates whether, based on the audit evidence obtained, there is reasonable assurance [emphasis added] about whether the financial statements taken as a whole are free from material misstatement. This involves concluding whether sufficient appropriate audit evidence has been obtained to reduce to an acceptably low level the risks of material misstatement of the financial statements and evaluating the effects of uncorrected misstatements identified. (ISA 700 paragraph 12)

Recently, in the US, there has been some discussion about whether reasonable assurance implies that a particular set of audit procedures have been followed. The discussion that follows suggests there is no support for such a contention in the UK.

Semantic and Grammatical Analysis

According to the OED definition in Appendix 2 there are two groups of senses of meaning of assurance: I the action of assuring and II the state of being sure or assured. In the context of an audit report, there are three possible senses of I: 1. A promise or engagement making a thing certain; a formal engagement, pledge, or guarantee; 3. A positive declaration intended to give confidence; and 5. The action of insuring or securing the value of property in the event of its being lost, or of securing the payment of a specified sum in the event of a person's death; insurance. In sense II, only sense 8. Subjective certainty; a being certain as to a fact, certitude; confidence, trust is feasible (sense 6 objective certainty is marked as obsolete). The statements in which reasonable assurance appears are all a bit odd. To say an audit is designed to provide reasonable assurance leaves much unsaid. Firstly, when assurance is

provided it is usually provided by one identified party to another the audit is not a person, and the group of people being provided with assurance is unspecified. That said sense, 3 above seems to fit context; an audit is designed to provide a positive declaration intended to give a reasonable level of confidence would seem to be an uncontroversial characterization of the audit report. An audit does not seem to provide much by way of an engagement pledge or guarantee by the auditor to readers of the financial statement and auditors have been at some pains to deny that they are providing insurance. Sense 8 is also possible; an audit is designed to provide a reasonable level of subjective certainty is a statement about the effects of the audit on the mental state of someone unspecified. The first sentence of the extract from ISA 700 is grammatically obscure and none of the senses of assurance in the OED can be inserted into it, with the possible exception of (obsolete) sense 6 objective certainty.
When forming an opinion on the financial statements, the auditor evaluates whether, based on the audit evidence obtained, there is a reasonable degree of objective certainty about whether the financial statements taken as a whole are free from material misstatement.

As a rewording of ISA 700 Paragraph 12, the above seems unexceptional and is a reasonable preamble to a paragraph relating to audit evidence. The senses of reasonable assurance as a statement or as subjective certainty do not fit easily into this sentence. However, paragraphs 17-21 of ISA 200, which attempt to characterise reasonable assurance (Appendix 3), use the phrase ambiguously; it is unclear whether the section is using the phrase in the sense of objective certainty or subjective certainty. Paragraph 17 states:
An auditor conducting an audit in accordance with ISAs obtains reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether due to fraud or error.

The equivalent paragraph (paragraph 8) in the UK and Ireland version of the ISA 700 differs significantly; it omits the reference to the auditor obtaining reasonable assurance. However the subsequent paragraphs of both statements seem to refer to subjective certainty obtained and therefore possessed by the auditor. A statistician would be unlikely to refer to, say, extending a sample to obtain a particular level of confidence in an estimate; he or she would be more likely to refer to attaining a confidence level. The discussion in Appendix 1 is intended to show, by analogy with statistical reasoning, that the concept of materiality requires a concept of confidence and that the idea of reasonable assurance fulfils that role.

What does reasonable mean?

The qualification reasonable does two things: it indicates that an audit does not provide absolute certainty; and it indicates that the auditors are expected to exercise the level of effort and skill that can reasonably be expected of a firm holding themselves out to be expert professionals. ISA 200 UK&I says much about the first of these but not much about the second.

A model of the reasonable assurance process

The figure below shows how users acquire confidence in financial statement data. In this model, users have prior expectations and beliefs about a company and the likely quality of its financial statements that are created by the continuing flow of information about the company, the economy and other relevant factors. When they receive financial statement data in the form of an annual report or interim statement they analyse the data and form new expectations about the company and the value of its securities. An important role of the auditing of financial statements is to reduce users uncertainty about the data and the information they derive from their analysis. Their confidence derived from the audit is the amount of reduction in their uncertainty about the financial statement data, compared with the uncertainty that it would be subject to if audits were not habitually carried out. In this model users confidence is in part derived from, but is not the same as, the auditors confidence. Users know that, by issuing a clean audit report, the auditors have attained reasonable assurance, in their own minds, that the financial statements are not materially misstated and so users gain confidence in the financial statements.

Auditing standards and regulation

Reputation of audit firm

Users estimate of audit quality

Users prior expectations

Aspects of audit firm

Quality of audit

Users analysis of data Financial statements and audit report

Audit firms confidence (level of assurance) in the financial statements

Users estimates and confidence

There are numerous factors that contribute to reducing the uncertainty that surrounds financial statement data. Informed users of financial statements are aware that absolute certainty does not attach to the numbers in financial statements. Users are also aware of the regulatory background and audit practices that determine the planning and execution of audits. They are also aware of the corporate governance role of auditing in preventing managerial opportunism and reducing agency costs. This awareness affects not only their analysis of the current position of a company but also their forecasts of likely future outcomes, and their confidence in those forecasts.

Conclusion
Reasonable assurance is the degree of confidence that attaches to the assertion that financial statements are not materially misstated. Although the term is used in various ways in authoritative statements, reasonable assurance is essentially subjective. Auditors acquire confidence in the financial statements from their audit work and in turn the users of financial statements acquire confidence from the audit report and their knowledge of the regulatory background and professional process that has determined the design and execution of the audit. The primary purpose of information in financial statements is for shareholders to exercise their rights as a body, but other users also gain confidence that the financial statement are not materially misstated from the audit process. As a result of the foregoing analysis it seems that a characterisation of reasonable assurance as it is currently used in the UK could be as follows:

Reasonable assurance is the level of confidence that an auditor, exercising professional skill and care, is expected to attain from an audit that the financial statements are not materially misstated. An auditor cannot attain absolute confidence because of numerous factors arising, among other things, from the limitations of audit evidence, the impracticality of examining all evidence and uncertainties as to the future. The confidence that an auditor attains is subjective and is the basis for offering an audit opinion. Users of financial statements derive confidence in the audited financial statements from many sources, including a knowledge that the auditors work to professional standards within a framework of regulation and that the auditors have felt sufficiently confident that the financial statements are not materially misstated to issue an opinion. As a consequence of their confidence that financial statements are not materially misstated, users of financial statements may also gain confidence that the management of the entity are conducting its affairs in the knowledge that the financial consequences of their actions will be reported. The final paragraph above characterises how the stewardship function of financial reporting operates. It is not so much the fact that shareholders are informed that enables the stewardship function to operate, but directors knowledge that shareholders will be informed of the financial consequences of the directors decisions.

References
Goldwasser, & L., D. (2006). The past and future of reasonable assurance. CPA Journal. http://www.nysscpa.org/cpajournal/2005/1105/special_issue/essentials/p28.htm

International Auditing Standards Board (IAASB), ISA 700 The independent auditors report on a complete set of general purpose financial statements
http://www.ifac.org/Members/DownLoads/ISA_700-Auditors_Report_on_Financial_Statements.pdf (accessed 1 May 2006)

IAASB, ISA 200, Objective and General Principles Governing an Audit of Financial Statements http://www.ifac.org/Members/DownLoads/ISA_700Auditors_Report_on_Financial_Statements.pdf (accessed 1 May 2006)

Auditing Standards Board (APB), International Standard on Auditing (UK and Ireland) (ISA UK and I) 200 Objectives and General Principles Governing and Audit of Financial Statements APB ISA (UK and I) The Auditors Report on Financial Statements,
http://www.frc.org.uk/images/uploaded/documents/ACFAB4.pdf (accessed 1 May 2006)

Appendix 1 Reasonable assurance and confidence limits

There is an analogy to be drawn between the way propositions are expressed in statistical terms and the way in which audit reports are framed. A statistical conclusion is often in the form: There is a 95% probability that the true value of X does not differ from Y by more than e. That is to say the simple statement that some quantity X is equal to an observed value Y is amplified by indicating a level of confidence, in this case 95%, and a range of possible values (confidence limits), e. The proposition that an audit provides reasonable assurance that the financial statements are not materially misstated is a similar kind of statement, but a qualitative one rather than a quantitative one. Reasonable assurance corresponds to the level of confidence and the materiality level corresponds to the confidence limits. On this basis reasonable assurance can be taken to mean that the risk that the financial statements are materially misstated is below some (usually unstated) threshold. In practice the boundary between what counts as material misstatement and what does not is a complicated one which cannot be fully analysed. Similarly the risks and materiality levels relevant to particular items in the financial statements may vary from item to item so that reducing reasonable assurance to a probability is not feasible. Nevertheless, the analogy demonstrates that, without the idea of reasonable assurance, auditing would be lacking a concept of the degree of confidence that the financial statements are not materially misstated.

Appendix 2 Assurance as defined by Oxford English Dictionary Online

(Quotations have been omitted, except in the senses relevant to auditing.) I. The action of assuring. * Of making certain. 1. A promise or engagement making a thing certain; a formal engagement, pledge, or guarantee. b. esp. An engagement guaranteeing peace and safety; terms of peace. Obs. exc.

Hist.
2. A marriage engagement, betrothal. Obs. 3. A positive declaration intended to give confidence. ** Of making secure. 4. Law. The securing of a title to property; the conveyance of lands or tenements by deed; a legal evidence of the conveyance of property. 5. The action of insuring or securing the value of property in the event of its being lost, or of securing the payment of a specified sum in the event of a person's death; insurance.
Technically, the present usage is to differentiate life-assurance, and fire- and marine-insurance; though, as will be seen from the quotations, assurance was the original term in reference to marine risks.

II. The state of being sure or assured. 6. Objective certainty; = ASSUREDNESS 1. Obs. c1485 Digby Myst. (1882) II. 387, I can not beleve that thys ys of assurans. 1509 HAWES Past. Pleas. XXXI. xvii, Wo worth the trust without assuraunce. 1603 KNOLLES Hist. Turks (1621) 538 New friends of more assurance.

7. Security. 8. Subjective certainty; a being certain as to a fact, certitude; confidence, trust. 1375 BARBOUR Bruce XI. 309 In his hye cheuelry Thai had assouerans, trast trewly. c1374 CHAUCER Troylus v. 1259 O trust, O feith, O depe asseuraunce! 1601 CORNWALLYES Ess. II. xxix, It is as naturall in men to purchase hope as assurance. 1605 SHAKES. Macb. IV. i. 183 But yet Ile make assurance double sure, And take a Bond of Fate. 1843 MILL Logic II. vi. 3 We can have full assurance of particular results. a1842 TENNYSON Two Voices 315 The doubt would rest, I dare not solve..Assurance only breeds resolve. b. in Theol. (See quot.) 1651 C. CARTWRIGHT Cert. Relig. I. 251 The Doctrine of Protestants concerning assurance of salvation..viz. that a man may have this assurance. 1852 SIR W. HAMILTON Disc. (1853) 508 Assurance, Personal Assurance, Special Faith, (the feeling of certainty that God is propitious to me, that my sins are forgiven). 9. Self-confidence, self-reliance; confidence of manner, steadiness, intrepidity. 10. In a bad sense: Hardihood, audacity, presumption, impudence.

Appendix 3: Extracts from ISAs IAASB ISA 200 (as amended following ISA 700) on Reasonable Assurance
Reasonable Assurance
17. An auditor conducting an audit in accordance with ISAs obtains reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether due to fraud or error. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process. 18. An auditor cannot obtain absolute assurance because there are inherent limitations in an audit that affect the auditors ability to detect material misstatements. These limitations result from factors such as the following: The use of testing. The inherent limitations of internal control (for example, the possibility of management override or collusion). The fact that most audit evidence is persuasive rather than conclusive. 19. Also, the work undertaken by the auditor to form an audit opinion is permeated by judgment, in particular regarding: (a) The gathering of audit evidence, for example, in deciding the nature, timing and extent of audit procedures; and (b) The drawing of conclusions based on the audit evidence gathered, for example, assessing the reasonableness of the estimates made by management in preparing the financial statements. 20. Further, other limitations may affect the persuasiveness of audit evidence available to draw conclusions on particular assertions1 (for example, transactions between related parties). In these cases certain ISAs identify

specified audit procedures which will, because of the nature of the particular assertions, provide sufficient appropriate audit evidence in the absence of: (a) Unusual circumstances which increase the risk of material misstatement beyond that which would ordinarily be expected; or (b) Any indication that a material misstatement has occurred. 21. Accordingly, because of the factors described above, an audit is not a guarantee that the financial statements are free from material misstatement, because absolute assurance is not attainable. Further, an audit opinion does not assure the future viability of the entity nor the efficiency or effectiveness with which management has conducted the affairs of the entity.

IAASB ISA 700

12. When forming an opinion on the financial statements, the auditor evaluates whether, based on the audit evidence obtained, there is reasonable assurance about whether the financial statements taken as a whole are free from material misstatement. This involves concluding whether sufficient appropriate audit evidence has been obtained to reduce to an acceptably low level the risks of material misstatement of the financial statements and evaluating the effects of uncorrected misstatements identified.

ISA 700 (UK and Ireland)

The UK and Ireland version of ISA 700 contains the following in relation to reasonable assurance:
13. The report should include a statement that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement 13.1 In the UK and Ireland the auditors statement that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement, includes reference to material misstatement caused by fraud or other irregularity or error. .

ISA 200 (UK and Ireland) Reasonable Assurance

8. An audit in accordance with ISAs (UK and Ireland) is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process. 9. An auditor cannot obtain absolute assurance because there are inherent limitations in an audit that affect the auditor's ability to detect material misstatements. These limitations result from factors such as: The use of testing. The inherent limitations of internal control (for example, the possibility of management override or collusion). The fact that most audit evidence is persuasive rather than conclusive. The impracticality of examining all items with a class of transactions or account balance. The possibility of collusion or misrepresentation for fraudulent purposes.

9-1 the view given in financial statements is itself based on a combination of fact and judgment and, consequently, cannot be characterized as either absolute or correct. A degree of imprecision is inevitable in the preparation of all but the simplest of financial statements because of inherent uncertainties and the need to use judgment in making accounting estimates and selecting appropriate accounting policies. 10. Also, the work undertaken by the auditor to form an audit opinion is permeated by judgment, in particular regarding: (a) The gathering of audit evidence, for example, in deciding the nature, timing, and extent of audit procedures; and (b) The drawing of conclusions based on the audit evidence gathered, for example, assessing the reasonableness of the estimates made by management in preparing the financial statements. 11. Further, other limitations may affect the persuasiveness of audit evidence available to draw conclusions on particular assertions (for example, transactions between related parties). In these cases certain ISAs (UK and Ireland) identify specified audit procedures which will, because of the nature of the particular assertions, provide sufficient appropriate audit evidence in the absence of: (a) Unusual circumstances which increase the risk of material misstatement beyond that which would ordinarily be expected; (b) Any indication that a material misstatement has occurred. 12. Accordingly, because of the factors described above, an audit is not a guarantee that the financial statements are free of material misstatement.