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ACCA
Advanced Audit
and Assurance
(AAA) (INT/UK)
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AUDIT EVIDENCE
13. Audit Evidence 71
14. Relevant Accounting Standards 75
15. Automated Tools and Technique 79
16. Experts 83
17. Internal Audit 85
18. Outsourced Accounting Functions 87
19. Written Representations 91
20. Related Parties 93
OTHER ASSIGNMENTS
26. Types of Assignment 123
27. Prospective Financial Information 125
28. Forensic Audits 131
29. Due Diligence 135
30. Social, Environmental and Integrated Reporting 137
31. The Audit of Performance Information in the Public Sector (International Syllabus only) 141
32. Auditing aspects of insolvency (UK Syllabus only) 149
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visit https://opentuition.com/acca/aaa/
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1. Warning!
Do not even think of studying this paper if you haven’t already studied paper Strategic Business
Reporting (SBR)/Corporate Reporting (P2).
In every AAA paper, there is at least one question dealing with audit risk and/or audit evidence. 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:
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.
Every accounting standard studied in SBR/P2 sets out rules that govern how amounts in financial
statement are to be displayed and therefore each standard has implications for auditors.
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.
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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.
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 control policies and procedures in practice
management and recognise the auditor’s position in relation to the acceptance and retention of
professional appointments.
D. Identify and formulate the work required to meet the objectives of audit assignments and apply
the International Standards on Auditing.
E. Evaluate findings and the results of work performed and draft suitable reports on assignments.
F. Identify and formulate the work required to meet the objectives of non-audit assignments.
G. Understand the current issues and developments relating to the provision of audit-related and
assurance services.
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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.
Part A
Set at the planning stage of the audit. Candidates will be provided with detailed information and be
required to address a range of requirements from syllabus sections A, B, C and D.
Part B
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.
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 September 2020 to June 2021
Advanced Audit & Assurance (UK) - syllabus and study guide September 2020 to June 2021
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Chapter 1
WHAT IS ASSURANCE?
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:
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.
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.
(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).
(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:
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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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.
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 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 show a true
and fair view (or present fairly, in all material respects). 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
๏ 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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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.
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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.
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 long-
term 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.
Monitor integrity of
Liaison with external auditors: 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 non-
audit 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
Understand entity
Respond to risk
Satisfactory
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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It is recognised that there can be a conflict between some of the ethical principles, for example, a self-
interest 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.
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:
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๏ 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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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.
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:
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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:
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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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.
๏ 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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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:
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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.
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 a key auditor partner cannot serve a PIE client for more than seven years. 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 liable to be lost.
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.
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.
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.
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 non-
PIE 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 Financial interest held by a member of the audit
audit team 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 Long association
not a member of the audit team
Review of non-audit work by a professional who Other services such as bookkeeping, taxation
was not involved in the work and valuation (where not prohibited).
Discussion of ethical issues with TCWG/audit Fees from a PIE client exceed 15% benchmark
committee 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 control review (or Fees from a PIE client exceed 15% benchmark
equivalent) for two consecutive years (and subsequent
years).
Notify the existing auditor of the proposed work Requests for a ‘second opinion’ by a company
(with permission) 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.
๏ 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):
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.
๏ 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.
The ethical standard permits accountants to set aside the duty of confidentiality in order to disclose
NOCLAR rather than simply resign.
Management’s responsibilities will be easier to meet if there is a good internal control system, 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.
๏ 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 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 non-
compliance.
๏ 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.
๏ 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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๏ 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.
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).
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.
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 show a true and fair view for the shareholders but for
no one else?
๏ If the disclaimer clause reduces the chance of litigation then the auditors might not take as
much care whilst performing the audit.
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๏ 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.
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
duty to ensure that there is a good and 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:
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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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 factors increase the risk of fraud:
๏ Lack of segregation of duties so that one person is in charge of all parts of a transaction.
๏ Poor internal control in general.
๏ Poor IT system control.
๏ 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.
๏ Pressure to meet financial targets.
In exceptional circumstances, the auditor may be unable to continue performing the audit. For
example:
3. Management bias
‘Management bias’ (a lack of neutrality) may represent a risk of fraudulent reporting. Factors that may
produce bias include:
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.
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.
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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.
๏ 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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The auditor must communicate in writing significant deficiencies in internal control to TCWG on a
timely basis.
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Chapter 9
QUALITY CONTROL
1. Introduction
Quality control in auditing doesn’t just mean do an audit properly: that could just be down to good
luck. It means that these must be a system of quality control which substantially ensures that all audits
are executed properly and which provides documentary evidence that quality control procedures
have been applied effectively.
Under International Standard for Quality Control 1 (ISQC 1), the firm has an obligation to establish
and maintain a system of quality control 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. Auditing 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 quality control system 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.
๏ Leadership. The firm must establish policies and procedure designed to promote an internal
culture that recognises that quality is essential in performing engagements.
๏ Ethics (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 audit engagements. The firm must
ensure that appropriate procedures regarding the acceptance and continuance of client
relationships and audit engagements have been followed, and shall determine that conclusions
reached in this regard are appropriate.
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๏ Human resources. The firm shall establish policies and procedures designed to provide
reasonable assurance that it has sufficient personnel with the competence, capabilities and
commitment to ethical principles to properly perform the audit to enable an appropriate
auditor’s report to be issued. Responsibility for each engagement is assigned to an engagement
partner and policies and procedures must be in place to assign appropriate personnel to each
engagement.
๏ Engagement performance. Direction, supervision, reviews, consultation and performance
should be of a standard to enable an appropriate auditor’s report to be issued
๏ Monitoring. To ensure that the quality control procedures adequate, relevant and are operating
properly.
๏ Note that many of the requirements of a quality control system can be remembered by the
acronym HARLEM:
‣ Human resources
‣ Acceptance and continuance
‣ Relevant ethical requirements
‣ Leadership
‣ Engagement performance
‣ Monitoring
An audit firm should set criteria for other engagements, if any, that require an EQCR (eg entities in
certain industries identified as high risk). An EQCR includes:
(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.
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For audits of listed entities, the EQCR 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 EQCR 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 EQCR is
not required.
Note that many of these responsibility can be remember by the acronym SACRED (or SCARED!):
๏ Supervision
๏ Assignment
๏ Competence
๏ Review
๏ Ethics
๏ Direction
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๏ A new proposed standard, ISQM 1 Quality Management for Firms that Perform Audits or Reviews of
Financial Statements, or Other Assurance or Related Services Engagements (to replace ISQC 1). This
deals with a firm’s responsibility to establish a system of quality management to support quality
engagements.
๏ A proposed new standard, ISQM 2 Engagement Quality Reviews.
๏ A revised ISA 220 Quality Management for an Audit of Financial Statements which addresses the
management of engagement quality for audit engagements.
Remember to check the technical articles section of AAA study resources for this topic.
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Chapter 10
AUDIT PLANNING
1. Overview
Appointment
Understand entity
Respond to risk
Satisfactory
Overall review of FS
Report to management
Auditor’s report
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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.
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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
through Understanding the Entity an Its Environment)
๏ 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.
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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).
3.2. Risk assessment
๏ 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).
Where relevant, the audit partner should also consider previous experience with the client.
Risks 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.
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?
See Chapter 12 of our AA notes if you need to revise the five components of internal control systems
and the different types of control activities. Remember than control activities are just one of the
components.
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In July 2018, the IAASB published an Exposure Draft (ED-315) which proposes a more robust risk
assessment process to provide the basis for audit procedures.
๏ Scalability – how the standard can be applied to all entities ranging from the small and simple
company to large, complex multinationals.
๏ Considerations for understanding the entity’s business model and the extent to which it
integrates the use of IT relevant to financial reporting
๏ How automated tools and techniques, including data analytics, may be used in risk assessment.
๏ Enhancing the exercise of professional scepticism.
ED-315 does not seek to change the fundamentals of the ‘audit risk model’ but to improve audit
quality through provide better guidance on the risk identification and assessment process.
Remember to check the technical articles section of AAA study resources for this topic.
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
information needs of users, as a group. (The specific needs of individual users are not considered as
they may vary widely.)
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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').
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.
๏ 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 show a true and fair view.
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:
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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 depends on three factors, and the relationship is described by the audit risk model:
AR = IR x CR x DR
Audit Risk
Control 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 the auditor does not discover the error.
If there are no controls any errors will find their way into the draft financial statements.
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However, good control systems can prevent or detect and correct errors. For example:
๏ Good management will ensure that only appropriately qualified or experienced people will
process certain transactions.
๏ Segregation of duties or independent checks reduce the risk of errors and fraud.
๏ Reconciliations check the 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 material
The client’s procedures error reaches
The error The auditor must have
and staff must not have the published
has to failed to detect it
picked that up and financial
occurred
corrected it 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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(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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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 particular 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.
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Chapter 12
QUESTION PRACTICE ON RISK
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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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 long-
running 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.
(3) The finance director has recently left and at period end, has not been replaced.
(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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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 long-
running 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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(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.
‣ 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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(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%.
‣ 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
(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.
(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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(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.
‣ 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
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 non-
current 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.
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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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 single figure is asserting all of this and evidence is needed for each assertion each figure makes.
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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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:
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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audit evidence, to be able to draw reasonable conclusions on which to base an audit opinion.
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':
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.
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 ACCA-
Approved publisher.
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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Other potentially
Specific
relevant
standard(s)
standard(s)
i) Inventory (including standard costing systems) IAS 2 IAS 23
ii) Non-current assets IAS 16 IASs 20, 23, 36 & 37
IFRSs 5 & 16
iii) Intangible assets IAS 38 IAS 36
IFRS 3 (goodwill)
iv) Biological assets IAS 41 –
v) Investment properties IAS 40 IASs 16 & 36
vi) Assets held for sale and discontinued operations IFRS 5 –
vii) Financial instruments IAS 32/
IFRSs 7 & 9
viii) Fair values IFRS 13 –
ix) Government grants IAS 20 –
x) Leases IFRS 16 IASs 16 & 24
IFRSs 9 & 15
xi) Impairment IAS 36 –
xii) Provisions, contingent liabilities and contingent assets IAS 37 –
xiii) Borrowing costs IAS 23 –
xiv) Employee benefits IAS 19 –
xv) Share-based payment transactions IFRS 2 –
xvi) Taxation (including deferred tax) IAS 12 –
xvii) Related parties IAS 24 –
xviii) Revenue from contracts with customers IFRS 15 –
xix) Statement of cash flows IAS 7 –
xx) Business combinations IFRS 3 IASs 27 & 28
IFRS 10, 11 & 12
xxi) Events after the end of the reporting period IAS 10 –
xxii) The effects of foreign exchange rates IAS 21 IFRS 9
xxiii) Segmental reporting IFRS 8 –
xxiv) Earnings per share IAS 33 –
xxv) Changes in accounting policy IAS 8 IAS 1
xxvi) Payroll and other expenses IASs 1 & 19 –
๏ 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
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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:
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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.
๏ 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.
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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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
entered for a zero quantity, or for a non-existing product, or for a non-existing customer, or a dispatch
which would raise the balance on the debtor’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')
Examine client
Audit programs data
Tests client
Test data
programs
The review files should be encrypted and locked so that only the auditor can access the information
on them.
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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?
๏ 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:
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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 ๏ Data acquisition (source, quality and access)
environment affect the use of data
analytics?
๏ Legal and regulatory challenges
๏ Resource availability
๏ Investment in re-training/re-skilling auditors
What are the standard-setting ๏ Determining whether requirements of ISAs have been met
challenges?
๏ Relevance and reliability of data
๏ Managing expectations of ‘100% testing’
๏ Using data analytics on non-financial data
What are the possible solutions to ๏ ISAs aren’t ‘broken’ and should remain principles-based and
the challenges? adaptable
๏ Overwhelming need for non-authoritative practical
guidance
What should be IAASB’s next step? ๏ Revision to ISA 230 and ISA 500 should be prioritised but …
(e.g. revised ISA 520)
๏ … short-term guidance is the highest priority.
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Chapter 16
EXPERTS
1. Introduction
Sometimes auditors will need to use the work of others.
For example:
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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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 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.
๏ 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.
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 internal control system, 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.
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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 auditors reviewing the working papers of the internal audit
function.
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:
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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.
This chapter deals particularly with the last six functions on this list.
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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.
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 eg compare input to output, 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:
๏ User manuals.
๏ System overviews.
๏ 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 (for
example, are salary changes properly processed?).
๏ 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, refers to two types of
report:
๏ Type 1 Report:
A report which 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.
The service auditor is an auditor who at the request of the service company provides an
assurance report on the controls of the service organisation.
๏ Type 2 Report:
A report which 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 the Type 2 Report is more rigorous and useful to external auditors than Type 1 Reports.
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:
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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 its creditors,
but the cash has been safely transferred to Company A. It would probably be difficult for the auditors
to detect what was going on.
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 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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๏ 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)
๏ 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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** 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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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 is having to place reliance on the work of component auditors.
๏ 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-in-
transit, 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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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:
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.
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:
These matters should be assessed before the group auditor accepts the engagement to be the group
auditor, and if the group auditor is not confident about the work that will be done by others, the
engagement should be rejected. Nor should the group auditor accept the assignment if the parent
does not promise the full cooperation of its subsidiaries for the group audit.
8. Significant components
Irrespective of the status of the component auditor, remember that the group auditor has overall
responsibility for the group audit opinion so therefore cannot simply accept a component auditor’s
opinion without some investigation. The amount of investigation depends on whether the
component is judged to be a significant component of the group.
ISA 600 The Audit of Group Financial Statements, defines a significant component as one that is:
circumstances, to include significant risks of material misstatement of the group financial statements.
For (i), the group auditor (or a component auditor on its behalf) must audit the component using
component materiality.
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For (ii), the group auditor (or a component auditor) must do one of the following:
ISA 600 mentions, as an example only, that a component exceeding 15% of the chosen benchmark
may be considered significant.
If a component is not significant, analytical procedures at group level may be sufficient. If not
sufficient, further work may be required on selected components.
To assess the work performed by component auditors the group auditor could issue a questionnaire,
or have a meeting with component auditor(s) asking about:
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:
For any acquisition that happened in the year, any goodwill arising will have to be audited.
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Consolidated good will = Fair value of consideration + fair value of the non-controlling interest – fair
value of the subsidiary’s net assets
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.
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).
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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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.
๏ 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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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:
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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Chapter 22
SUBSEQUENT EVENTS
๏ 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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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 debtors, 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.
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 re-
issue 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 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:
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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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.
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
If the audit opinion has been modified, the explanation would be here too.
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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.
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.
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.
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.
๏ 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’.
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.
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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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:
(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.
๏ 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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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).
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 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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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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‘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.
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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.
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 does not show true and fair view.
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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๏ 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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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 show ‘a true and fair view’ (or ‘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:
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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 except for certain
items in other respects the financial statements show a true and fair view: the opinion has been
qualified.
If however misstatements are so significant that it renders the financial statements, as a whole, useless
then the auditor would issue an adverse opinion and the auditor would say the financial statements
do not show a true and fair view.
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
showed a true and fair view. If, however, the missing information is so significant that the auditors
really have no idea whether the financial statements showed, as a whole, a true and fair view, then
they will issue a disclaimer of opinion stating that they are unable to form any opinion.
The choices can be described in a matrix. Think of ‘pervasive’ as misstatements or lack of evidence
that affects the financial statements as a whole:
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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 give a true and fair view ...
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.
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...
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Qualified Opinion
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 give a true and fair view…
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 ....
Here is an example of a qualified opinion caused by the auditors believing that there is a material
misstatement about something in the financial statements. Here the problem is that no depreciation
has been provided where they think 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 is
useful to the shareholders for them to do that. Here the amount of depreciation in dispute is material,
but the financial statements as a whole still show a true and fair view.
Adverse Opinion
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 ...
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 show a true and fair view (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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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).
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:
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.
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:
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:
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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.
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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So here we would:
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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.
Non-audit work, however, is not well-defined. Each job is unique and it is essential that it is well-
defined. 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:
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’.
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.
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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 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:
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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:
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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:
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.
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Environmental matters:
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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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.
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:
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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:
For example:
๏ 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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2.1. 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
๏ ‘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?
(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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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”.
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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.
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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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).
๏ 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.
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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Definition: Carrying on the … with the intent to defraud … when it ought to have been
business of an insolvent the company’s creditors concluded that there was no
company … 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)
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