Auditing – Study Notes Chapter 1: Introduction to Assurance Services

CHAPTER 1
INTRODUCTION TO ASSURANCE
SERVICES

LO # LEARNING OBJECTIVE

LO 1 ORIGIN AND ADVANTAGES OF ASSURANCE SERVICE

LO 2 DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT
LEVELS OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE
LO 3
PROVIDED

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Auditing – Study Notes Chapter 1: Introduction to Assurance Services

LO 1: ORIGIN AND ADVANTAGES OF ASSURANCE SERVICE:

Origin of Assurance Services:
Since the Industrial Revolution in 18th century, businessmen started forming Joint Stock Companies
to do business. Usually, people who manage the company (called management or directors) are
separate from those who own the company (called shareholders).

To judge the performance of management and directors, shareholders asked them to prepare and
present them financial statements (F/S). Soon after, it was realized that financial statements
prepared by management/directors presented “best-view” of business instead of “true-and-fair-
view” due to some Incentives (e.g. bonus) or Pressures (e.g. fear of removal) faced by management.
Thus credibility of financial statements was questioned. To enhance the credibility/ confidence/
assurance on these financial statements, an expert person (called assurance provider or auditor)
was hired by shareholders to verify financial statements. Auditor is independent of both
management and shareholders.

Services of auditors were appreciated greatly. Now a days, assurance engagements are performed
either because:
 they are required by law (called statutory assurance engagements e.g. most companies in
Pakistan are required by law to get their annual financial statements audited before they
are given to shareholders), or
 they are not required by law but are voluntarily performed because of its advantages (called
non-statutory assurance engagements e.g. audit or review of Sole-proprietorships,
Partnerships, Not for Profit Organizations, and Small companies conducting an audit).

Relationship between shareholders and directors/management

Following concepts explain the nature of relationship of directors/management with shareholders:
 Steward:
Stewardship is the practice of managing other person’s property. The directors have a
stewardship role. They look after the assets of the company, and manage them on behalf of
shareholders.

 Agent:
An agent is an individual who acts on behalf of the principal. In a company, Directors are
agents and shareholders are principal i.e. directors act in accordance with instructions and
in best interest of shareholders, and are accountable to shareholders for their acts.

 Accountable:
As agents of the shareholders, directors are accountable to shareholders. Directors show
their accountability to shareholders by preparing annual financial statements and
presenting them to the shareholders for consideration.

Advantages of Audit/Assurance Engagement:

1. It increases credibility of financial statements, as most of the misstatements are identified.
2. It confirms that management is performing its statutory and non-statutory duties.
3. Auditor identifies deficiencies in entity’s internal control system, and gives
recommendations to management to improve it.
4. It assists in sale or purchase of business.
5. It assists in grant of loan by bank.

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Auditing – Study Notes Chapter 1: Introduction to Assurance Services

CONCEPT REVIEW QUESTIONS

Q. 1
What are the advantages of an audit to an organization? (03)
(ICAP, CAF 08 Level – Spring 2004)
Q. 2
Discuss the concepts of stewardship and accountability in the context of a limited company. (04)
(ICAP, CAF 08 Level – Spring 2017, Q.#6b)

LO 2: DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT:

Assurance Engagement:
“Assurance engagement” means an engagement in which a practitioner obtains evidence about
evaluation of a subject matter against suitable criteria, and expresses his conclusion to enhance the
confidence of the intended users (other than the responsible party).

Elements of Assurance Engagement:

Every assurance engagement consists of following 5 elements:

Element Explanation
 Intended users (the parties who require subject matter and assurance
report e.g. shareholders, bankers).
1. Three party  Responsible party (the party which is responsible for preparation of
relationship subject matter i.e. directors/management). and
 Practitioner (the professional who verifies subject matter and provides
assurance on it i.e. auditor)
Subject matter is the information prepared by responsible party, and is
2. A subject matter verified by practitioner e.g. Historical financial statements, or Cash flow
forecast.
Criteria means framework/basis (i.e. standard rules and regulations) which
3. A Suitable is used to prepare subject matter (e.g. financial statements).
Criteria
Suitable means it should be selected appropriately.
Evidence is the information used by practitioner in arriving at the conclusion
4. Evidence on which his report is based.
Evidence should be Sufficient and Appropriate.
It is a report written in standard format (as per ISAs or as per local Laws)
5. Written
which includes conclusion of practitioner. It is provided by practitioner to
Assurance Report
intended users.

If any of the above element is missing, engagement will be called non-assurance engagement.

CONCEPT REVIEW QUESTIONS

Q. 3
List down the basic elements of an assurance engagement. (02)
(ICAP, CAF 08 Level – Spring 2003)
Q. 4
Briefly explain any four elements of an assurance engagement. (04)
(ICAP, CAF 08 Level – Autumn 2020, Q.#9c)

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Auditing – Study Notes Chapter 1: Introduction to Assurance Services

LO 3: LEVELS OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE

PROVIDED:
Assurance means confidence. There are three levels or degrees of assurance depending on amount
of work performed and results of that work.

1. Limited Assurance (also called Moderate Level or Negative Assurance)

It is a moderate level of assurance, expressed in negative form of conclusion i.e.
“Based on our review, nothing has come to our attention that causes us to believe that
accompanying financial statements do not give true and fair view in accordance with IFRSs.”

This level of assurance is usually given in review of historical financial statements, or review of
cash flow forecast.

2. Reasonable Assurance (also called High Level or Positive Assurance)

It is a high, but not absolute, level of assurance expressed in positive form of conclusion i.e.
“In our opinion, financial statements give true and fair view of financial position of ABC Limited
at December 31, 20X1 and its financial performance and cash flow for the year then ended in
accordance with IFRS.”

This level of assurance is usually given in an audit of historical financial statements.

Reasonable assurance means auditor does not certify or guarantee that financial statements are
free from all misstatements. There may still be some undetected misstatements even after the
audit due to inherent limitations of audit.

3. Absolute Assurance: (cannot be provided)

Absolute assurance means certification or guarantee that financial statements are free from all
misstatements.

Auditor cannot provide absolute assurance because most of the audit evidence is persuasive
rather than conclusive due to inherent limitations of audit:
1. Nature of financial statements (estimates, judgments and uncertainties are involved e.g. in
accounting estimates).
2. Nature of audit procedures
a. Management may not provide complete information to auditor.
b. Auditor does not have legal powers (e.g. power to search).
c. Fraud involving collusion and complex techniques, or involving senior management
are harder to detect.
3. Time and Cost limitation (Therefore, auditor plans audit in such a way that he directs its
efforts on risky areas, and uses sampling).
4. Many of the audit procedures are based on auditor’s judgment, which may be faulty.
5. There are always some inherent limitations in client’s internal control system.
6. Company’s staff may not be available to answer auditor’s questions, or to provide him
documents.

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Auditing – Study Notes Chapter 1: Introduction to Assurance Services

CONCEPT REVIEW QUESTIONS

Q. 5
Explain the meaning of “assurance” and give two examples of types of assurance which can be provided, distinguishing
between the two in terms of the level of assurance offered by each of them.
(ICAP’s Official Question Bank for CAF 08 – Q. # 169a)
Q. 6
(a) What is meant by reasonable assurance? (02)
(b) Why an auditor cannot provide an absolute assurance as a result of audit? Explain. (03)
(ICAP, CAF 08 Level – Autumn 2004)
Q. 7
In response to an audit engagement letter sent to Roof Limited (RL), Mr. Aziz Aslam, the new chief executive of RL has
requested your firm to provide absolute assurance in the audit report.
Required:
Draft an appropriate reply mentioning any four reasons why the above request cannot be complied with. (05)
(ICAP, CAF 08 Level – Autumn 2017, Q.#1)
Q. 8
Distinguish between absolute and reasonable assurance. Identify the type of assurance that is expected in an audit of the
financial statements, clearly outlining the reasons to justify your point of view. (08)
(ICAP, CAF 08 Level – Spring 2009)
Q. 9
Describe THREE limitations of external audits. (03)
(ACCA, Fundamentals Level F8 – December 2012)
Q. 10
What is the difference between an “assurance engagement” and an “audit engagement”? (01)
(ICAP, CAF 08 Level – Spring 2003)
Q. 11
Briefly explain with examples, the different levels of assurance that can be provided to an assurance client. (03)
(ICAP, CAF 08 Level – Autumn 2015, Q. # 1g)
Q. 12
AG Company approached the Mini-Finance Bank to extend their overdraft limit in order to finance a new project. The
bank asked the company to provide cash flow projections and assurance over those projections.
Required:
Explain the type of assurance engagement that will be undertaken by the auditor in the above scenario and form of such
assurance. Also explain why such type of assurance is appropriate for cash flow projections. (03)
(ICMA Pakistan – Fall 2016)
Q. 13
Give any two examples about the uncertainty relating to the financial statements being audited by you. (02)
(ICAP, CAF 08 Level – Autumn 2004)

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Auditing – Study Notes Chapter 1: Introduction to Assurance Services

APX 1: HINTS & COMMENTS TO CONCEPT REVIEW QUESTIONS:

Q. 1
State advantages as in LO 1.

Q. 2
02 marks for each concept, as explained in LO 1.
Students are advised to write in exam only what they learn from book. Do not try to produce or explain material on your
own. Usually, it results in ‘irrelevant’ points (which are not given any mark by ICAP).

Q. 3
“List” means only headings are to be given (without explanation). Words “basic” or “essential” or “important” have no
difference in audit exam. All elements are equally important.
Some students confused it with elements of engagement letter, and elements of audit report.

Q. 4
Question clearly required to “explain” the elements given in LO 2. So, explanation is also to be given.

Q. 5
Levels of assurance that can be provided are Reasonable assurance and Limited assurance. For definition, refer LO2. For
explanation and examples, refer LO 3.

Q. 6
(a) While explaining reasonable many students do not write ‘form of conclusion’ and ‘drafting’.
(b) Write limitations as mentioned in LO 3.

Q. 7
01 mark for giving reason that absolute assurance cannot be provided because of inherent limitation.
04 marks for four limitations of audit.

Examiners’ Comments:
The common mistake was that instead of mentioning the inherent limitations of audit, the inherent limitations of internal
control, and inherent risks were mentioned.

Author’s Comments:
Note that question clearly asks for “four” reasons, however, it is better to write some extra points. If any of your first four
point is wrong then 5th point may earn you one mark.
Further, there are no marks in ICAP exams for good hand-writing or presentation. You can write answer to this question
without giving format of a letter.

Q. 8
 Absolute assurance means 100% guarantee that financial statements are free from ALL misstatements.
 In an audit, reasonable assurance is expected.
 Reasons for reasonable assurance (instead of absolute assurance) in an audit are Inherent Limitations. Students
should give list of inherent limitations.

Author’s Comments:
This question has three sub-parts which are not pre-numbered by ICAP. There is a risk that you may skip a part while
attempting this question. So be careful and better to number each part yourself.

Q. 9
Write inherent limitations of external audit as given in LO 3.
Audit is also called ‘external’ audit because it is conducted by a person outside the entity who is being audited. Opposite
concept is ‘internal’ audit, which means audit by employees of company.

Q. 10
Audit engagement is a type of assurance engagement.

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Auditing – Study Notes Chapter 1: Introduction to Assurance Services

Q. 11
Same as in Q. 5

Q. 12
Limited assurance engagement (or review engagement) will be undertaken. Such assurance is expressed in negative form
of conclusion. For cash flow projection limited assurance is appropriate because it relates to future and there is more
uncertainty and auditor can obtain only moderate level of assurance about future.

Q. 13
Two favorite examples of ICAP are:
 Material uncertainty relating to exceptional litigation.
 Material uncertainty related to Going Concern

Exam Tips – Accounting Treatment for Litigation and Going concern issues
Litigation: If outflow is probable and measureable, management should record provision; otherwise
disclose it.
Going Concern Issues: If there is any going concern uncertainty, management should adequately
disclose it in financial statements.

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