Professional Documents
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Audit and Assurance. ICAEW
Audit and Assurance. ICAEW
Study Manual
www.icab.org.bd
Audit and Assurance
The Institute of Chartered Accountants of Bangladesh Professional Stage
These learning materials have been prepared by the Institute of Chartered Accountants in England and Wales
ISBN: 978-1-84152-834-2
First edition 2009
All rights reserved. No part of this publication may be reproduced in any form
or by any means or stored in any retrieval system, or transmitted in any form
or by any means, electronic, mechanical, photocopying, recording or otherwise
without prior permission of the publisher.
© The Institute of Chartered Accountants in England and Wales, March 2009 iii
iv © The Institute of Chartered Accountants in England and Wales, March 2009
Contents
Introduction vii
Specification grid for Audit and Assurance viii
The learning materials ix
Study guide x
Getting help xiv
Syllabus and learning outcomes xv
Skills assessment guide xxii
1. Reintroduction to audit and assurance 1
2. Responsibilities 17
3. Professional standards 47
4. Professional ethics 61
5. Quality control 89
6. Accepting engagements 109
7. Planning 131
8. Understanding the entity and its environment 147
9. Risk assessment 165
10. Audit approach 191
11. Audits of different types of entity 223
12. Audit completion 249
13. Reporting 277
1 Introduction
1.1 What is Audit and Assurance and how does it fit within the
Professional Stage?
Structure
The syllabus has been designed to develop core technical, commercial, and ethical skills and knowledge in a
structured and rigorous manner.
The diagram below shows the fourteen modules at the Professional Stage, where the focus is on the
acquisition and application of technical skills and knowledge, and the Advanced Stage which comprises three
technical modules and the Case Study.
© The Institute of Chartered Accountants in England and Wales, March 2009 vii
Audit and assurance
viii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
4 Study guide
4.1 Help yourself study for your CA exams
Exams for professional bodies such as the ICAB are very different from those you have taken at college or
university. You will be under greater time pressure before the exam –as you may be combining your
study with work. Here are some hints and tips.
Believe in yourself Yes, there is a lot to learn. But thousands have succeeded
before and you can too.
Remember why you're doing it You are studying for a good reason: to advance your career.
Read through the Syllabus and These tell you what you are expected to know and are
Study Guide supplemented by Examination context sections in the
text.
See the whole picture Keeping in mind how all the detail you need to know fits into
the whole picture will help you understand it better.
The Introduction of each chapter puts the material in
context.
The Learning objectives, Section overviews and
Examination context sections show you what you
need to grasp.
Use your own words To absorb the information (and to practise your written
communication skills), you need to put it into your own
words.
Take notes.
Answer the questions in each chapter.
Draw mindmaps.
Try 'teaching' a subject to a colleague or friend.
Give yourself cues to jog your The Study Manual emphasises key points.
memory
Try colour coding with a highlighter pen.
Write key points on cards.
Review, review, review Regularly reviewing a topic in summary form can fix it in your
memory. The Study Manual helps you review in many ways.
Chapter summary will help you to recall each study
session.
The Self-test actively tests your grasp of the essentials.
Go through the Examples in each chapter a second or
third time.
Step 1 This topic list is shown in the contents for each chapter and helps you navigate
Topic list each part of the book; each numbered topic is a numbered section in the chapter.
Step 2 This sets your objectives for study by giving you the big picture in terms of the
Introduction context of the chapter. The content is referenced to the Study guide, and
Examination context guidance shows what the examiners are looking for. The
Introduction tells you why the topics covered in the chapter need to be studied.
Step 3 Section overviews give you a quick summary of the content of each of the main
Section chapter sections. They can also be used at the end of each chapter to help you
overviews review each chapter quickly.
Step 4 Proceed methodically through each chapter, particularly focussing on areas
Explanations highlighted as significant in the chapter introduction or study guide.
Step 5 Take brief notes, if you wish. Don't copy out too much. Remember that being
Note taking able to record something yourself is a sign of being able to understand it. Your
notes can be in whatever format you find most helpful; lists, diagrams, mindmaps.
Step 6 Work through the examples very carefully as they illustrate key knowledge and
Examples techniques.
Step 7 Check yours against the suggested solutions, and make sure you understand any
Answers discrepancies.
Step 8 Review it carefully, to make sure you have grasped the significance of all the
Chapter summary important points in the chapter.
Step 9 Use the Self-test to check how much you have remembered of the topics
Self-test covered.
Moving on...
When you are ready to start revising, you should still refer back to this Study Manual.
As a source of reference.
As a way to review (the Section overviews, Examination context, Chapter summaries and Self-test
questions help you here).
Remember to keep careful hold of this Study Manual –you will find it invaluable in your work. The
Technical reference section has been designed to help you in the workplace by directing you to where you
can find further information on the topics studied.
xii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
© The Institute of Chartered Accountants in England and Wales, March 2009 xiii
Audit and assurance
Revision phase
Your revision will be centred around using the questions and revision guidance in the ICAB Revision
Question Bank.
5 Getting help
Firstly, if you are receiving structured tuition, make sure you know how and when you can contact your
tutors for extra help.
Identify a work colleague who is qualified, or has at least passed the paper you are studying for, who is
willing to help if you have questions.
Form a group with a small number of other students, you can help each other and study together, providing
informal support.
Call +88 (02) 9112672 or 9115340 or email [email protected] with non-technical queries.
Watch the ICAB website for future support initiatives.
xiv © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
Audit engagements
(h) Explain the main ways in which national legislation affects the scope and nature of the audit
and the appointment and removal of auditors (including the relationship between the law
and auditing standards) 2, 6
(i) Explain the principles behind different auditing requirements in different jurisdictions and
describe how national and international bodies are working to harmonise auditing
requirements, including requirements to report on internal controls (Sarbanes-Oxley Act) 3
(j) Describe the principal causes of audit failure and their effects and the gap between
outcomes delivered by audit engagements and the expectations of users of audit reports. 2
xvi © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
(c) Identify the risks arising from, or affecting, a given set of business processes and
circumstances and assess their implications for the engagement 9
(d) Identify the risks arising from error, fraud and non-compliance with law and regulations and
assess their implications for the engagement 9
(e) Assess significant business risks identified for their potential impact upon an organisation, in
particular their potential impact on performance measurement 9
(f) Identify the components of risk for a specified assurance engagement 9
(g) Assess the impact of risk and materiality on the engagement plan, including the nature,
timing and extent of assurance procedures, for a given organisation 7, 10
(h) Discuss the benefits and limitations of analytical procedures at the planning stage 7
(i) Determine an approach appropriate for an engagement for a specified organisation which
addresses: 10
Possible reliance on controls (including those within IT systems)
Possible reliance on the work of internal audit or other experts
Possible reliance on the work of another auditor
Probable extent of tests of control and of substantive procedures, including analytical
procedures
Nature and extent of client-generated information
Probable number, timing, staffing and location of assurance visits
Audit engagements
(j) Identify the components of audit risk for a specified audit engagement, including the
breakdown of audit risk into inherent risk, control risk and detection risk 9
(k) Outline the aspects of employment and social security law which are relevant to statutory
audit 2
(l) Discuss the differences between the audit of a non-specialised profit oriented entity and the
audit of a given specialised profit oriented entity 11
(m) Discuss the differences between the audit of a non-specialised profit oriented entity and the
audit of a given not-for-profit entity 11
(n) Specify and explain the steps necessary to plan, perform and conclude and report on the
audit of the financial statements of a non-specialised profit oriented entity in accordance
with the terms of the engagement including appropriate auditing standards. 7, 11
© The Institute of Chartered Accountants in England and Wales, March 2009 xvii
Audit and assurance
(d) Draft suitable extracts for an assurance report (including any report to the management
issued as part of the engagement) in relation to a specified organisation on the basis of given
information, including in the extracts (where appropriate) statements of facts, their potential
effects, and recommendations for action relevant to the needs and nature of the
organisation being reported upon 13
(e) Advise on reports to be issued to those responsible for governance in accordance with
International Standards in Auditing, legislation, regulation and codes of corporate
governance 13
(f) Judge when to refer reporting matters for specialist help 12
Audit engagements
(g) Draw conclusions on the ability to report on an audit engagement, including the opinion for
a statutory audit, which are consistent with the results of the audit work 12
(h) Explain the elements (both explicit and implicit) of the auditor’
s report issued in accordance
with the International Standards on Auditing and statutory requirements and recommend
the nature of an audit opinion to be given in such a report 13
(i) Draft suitable extracts for an audit report (including any report to the management issued
as part of the engagement) in relation to a specified organisation on the basis of given
information, including in the extracts (where appropriate) statements of facts, their potential
effects, and recommendations for action relevant to the needs and nature of the
organisation being reported upon. 13
xviii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
Professional
stage
Advanced stage
Assurance
Audit and
assurance
Title
© The Institute of Chartered Accountants in England and Wales, March 2009 xix
Audit and assurance
Professional
stage
Advanced stage
Assurance
Audit and
assurance
Title
Professional
stage
Advanced stage
Assurance
Audit and
assurance
Title
IFAC Statements
IPPS1 Assuring the Quality of Professional Services C B
BSQC1 Quality Control for Firms that Perform Audits and Reviews of C B
Historical Financial Information, and Other Assurance and Related
Services Engagements
Candidates will also be required to apply the additional requirements set out in BSAs in respect of the
standards above.
© The Institute of Chartered Accountants in England and Wales, March 2009 xxi
Audit and assurance
Initial Professional
Technical Knowledge
Development
F&CR
TAX AA&A
ITA
FA CL&P A&A
ETHICS
BA Case Study
FM
PS - K
BS
Skills
In the seven Knowledge Modules of the Professional Stage, you will have experienced a limited amount of
skills assessment, generally 'Assimilating and using information'. Most of the questions were set in a context
that required you to identify the piece of knowledge that was being assessed. In the Application Modules of
the Professional Stage, the context of the examination will be simple business situations, from which you
will be required to determine the relevant information to answer the questions.
To be successful in the Audit and Assurance examination, you will need a strong core of subject knowledge
and a good understanding of how this knowledge should be applied in simple situations. You will be
expected to apply your judgement to determine the relevance and importance of the different information
provided and to recommend suitable courses of action.
xxii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
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Audit and assurance
xxiv © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
Applying judgement
1c Judge when to raise legal Applying discrimination: Candidates will be required to identify
and ethical matters with identifying the significant business or audit risks from a
senior colleagues relevant/reasonable in given scenario, explain their impact on
data and evidence; the financial statements, and finally
3e Assess significant business
recognising varying recommend audit procedures to
risks identified
quality in data or mitigate the risk of a material error.
3g Assess the impact of risk evidence Requirements will test the ability of
and materiality on the candidates to filter those issues which
Relating parts and
engagement plan, including are more relevant than others in a given
wholes: discerning
the nature, timing and scenario.
particular issues as part
extent of assurance
of wholes Candidates' ability to distinguish the
procedures, for a given
quality of data or evidence will be tested
organisation Demonstrating an
in two potential ways. (i) Candidates will
understanding of
4f Judge when to refer need to distinguish between data
different perspectives
reporting matters for generated from within an organisation
(e.g. social, political,
specialist help and that generated by a third party, the
economic): analysing and
latter being less susceptible to
interpreting problems
management bias; and (ii) candidates will
and situations from a
need to appreciate the effect on the
given stance
quality of evidence that bias caused by
Change management specific factors can have e.g. where
(appreciating the profits are used to determine a bonus
impacts/effects of payment to be made to the company’ s
change): considering and management.
evaluating the effects of a
Question requirements will include the
given future scenario
need to identify the impact of specific
Assessing/applying economic and political factors on a set
materiality: of financial statements e.g. in the context
understanding the of dealing with customers or suppliers
concept of materiality from overseas that (i) political instability
may cause problems which prevent the
Applying a sceptical and
customer or supplier from trading,
critical approach in a
ultimately leading to going concern
given straight-forward
issues for the client; and (ii) economic
situation
factors may cause exchange rate
Appreciating when more fluctuations leading to the risk of
expert help is required misstated balances in the financial
in a given straight- statements.
forward situation
Candidates will be expected to evaluate
Exercising ethical the effect of uncertain future events
judgement when describing the procedures to be
performed in carrying out a review of a
Developing arguments,
company’ s financial forecasts.
having first appreciated
the perspective of all Question requirements will include the
other parties need to assess the materiality of a
particular matter (e.g. an unadjusted
Conducting critiques:
error) in the context of a set of financial
critically reviewing a
statements. This assessment should then
statement, argument or
inform the candidate’ s judgement as to
position
whether or not to modify the opinion
given in a statutory audit report.
© The Institute of Chartered Accountants in England and Wales, March 2009 xxv
Audit and assurance
xxvi © The Institute of Chartered Accountants in England and Wales, March 2009
chapter 1
Reintroduction to
audit and assurance
Contents
Introduction
Examination context
Topic List
1 Assurance defined
2 Audit defined
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
Introduction
Practical significance
In the recent past, the services provided by accounting practices were mainly restricted to accounts
preparation, audit and tax. Audits were virtually the only assurance engagements in existence and nearly all
companies required an audit. Consequently, most accountants worked on audits at some point in their
careers.
More recently there have been developments which have tended to split the “ traditional”view that
assurance firms provide audit and other services in one “
package”
. Factors such as
The restriction on which companies are legally required to have audits
Pressure to maintain auditor independence post-Enron, and
The growth in other types of assurance service being requested from, and offered by, accounting
practices
mean that there are now many more assurance services being carried out and the more general concept of
assurance is a very important issue for practices indeed. Now trainees might train in an assurance
department but never actually attend an audit.
Working context
If you are training in practice, you are likely to spend some training time working in an assurance
department and being involved in work on audits or other assurance engagements. If you work in industry,
you might be involved from the other side!
Syllabus links
This chapter revises key concepts from your Assurance paper.
Examination context
Exam requirements
This chapter is revision of what you have previously been examined on in your Assurance paper.
You will need an understanding of what assurance services are, and in particular, audit, brought forward
from your lower level paper to answer any questions at this level.
1 Assurance defined
Section overview
An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance
the degree of confidence of the intended users, other than the responsible party, about the outcome
of the evaluation or measurement of a subject matter against criteria.
Key elements are: three party involvement, subject matter, suitable criteria, sufficient appropriate
evidence, written report.
Different levels of assurance may be given in assurance assignments, reasonable and limited.
An audit is an example of an assurance engagement giving reasonable assurance.
Definition
Assurance engagement: An assurance engagement is one in which a practitioner expresses a
conclusion designed to enhance the degree of confidence of the intended users other than the responsible
party about the outcome of the evaluation or measurement of a subject matter against criteria.
Assurance engagements include primarily audits but also other services such as reports on internal control
and review of a business plan.
So for a report on the effectiveness of management's system of internal control, it might be agreed that the
report should read:
'In our opinion management has operated an effective system of internal control' –a positive form of
opinion deriving from a reasonable assurance engagement
or
'Nothing has come to our attention that indicates material internal control weakness' –a negative form of
assurance deriving from a limited assurance engagement.
No report on an assurance engagement can ever provide absolute assurance, because of the nature of the
evidence available.
2 Audit defined
Section overview
An audit is still a key example of an assurance service in Bangladesh, where all registered companies
are required to have audits by law.
An audit is an exercise designed to enable an auditor to express an opinion whether the financial
statements are prepared, in all material respects, in accordance with an applicable financial reporting
framework.
An auditor usually expresses a conclusion as to whether the financial statements 'give a true and fair
view'.
The benefits of audit are much the same as the benefit of assurance services generally. Users of
financial statements subject to an audit are given assurance that the financial statements meet legal
requirements as well as accounting ones.
Definition
Audit of financial statements: The objective of an audit of financial statements is to enable the
auditor to express an opinion as to whether the financial statements are prepared, in all material respects,
in accordance with an applicable financial reporting framework. The form the audit conclusion takes is that
auditors state whether the financial statements give a true and fair view. This is an expression of reasonable
assurance.
In a White Paper, the UK Department of Trade and Industry made the very valid point that if the purpose
of the audit was to protect shareholders who are not involved with managing the business and the vast
majority of smaller companies were owner managed, what purpose did the audit serve for those
companies?
Many would argue (and the auditors of smaller companies have found this to be true) that, in many cases,
the audit is valued by management because:
They value having their business scrutinised by another set of professional eyes
It provides additional assurance to third parties such as taxation authorities concerning the reliability
of the financial statements
A growing business will one day require an audit
Audit may have subsidiary benefits, such as the auditors recommending improvements in company
systems.
Interactive question 2: Review and audit compared [Difficulty level: Exam standard]
The directors of Connelly Ltd are concerned about the reliability and usefulness of the monthly financial
management information that they receive.
As a result, the company’s auditors have been engaged to review the system and the information it
generates, and to report their conclusions.
Contrast this assignment with the statutory audit of the company’
s financial statements with regard to the
scope of the assignment and to the report issued.
See Answer at the end of this chapter.
Summary
Audits conducted
under Companies
Act 1994
Self-test
Answer the following questions.
1 Define an assurance engagement.
2 Any assurance engagement requires which of the following elements?
A A user
B A responsible party
C A subject matter
D Criteria
3 In a reasonable assurance engagement, a negative conclusion is drawn.
True
False
4 An audit is a limited assurance engagement.
True
False
5 Which of the following is not a potential benefit of having an audit?
A Management may value having their business scrutinised by a set of professional eyes
B Assurance may be given to parties other than management who have a financial interest in the
company
C An audit is likely to be required in the near future by a growing company
D Fraud will be uncovered by the auditors
Exam-style question
6 Treetops Ltd
Your firm acts as external auditor for Treetops Ltd, a company whose principal business activity is the
manufacture and export of hammocks.
The company’ s managing director has also requested a meeting with you. He has recently discovered
that his purchase ledger clerk has diverted CU10,000 of company funds into his own bank account.
The managing director wants to know why this was not discovered during the course of your audit for
the year ended 29 February 20X4. The company’ s retained profit for that year was CU350,000.
Requirements
(a) Briefly describe the advantages to the directors and shareholders of Treetops Ltd of continuing
to have a full audit under the Companies Act 1994.
(4 marks)
(b) Provide examples of four other types of assurance engagement where the scope of the work is
agreed between the assurance firm and the company. For each engagement identified, briefly set
out the nature of the assurance given in the accompanying report and, where applicable, identify
potential users of the report other than the company’s management. (8 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
Technical reference
Answers to Self-test
REPORT
(b) How and why the level of assurance provided by a report on profit and cash flow forecasts differs
from the level of assurance provided by an audit report on annual financial statements.
An audit conducted in accordance with auditing standards provides a high level of assurance
which is reasonable but not absolute.
The delay between the balance sheet date and the date of the audit report means that even items
such as provisions/estimates can often be substantiated.
A review of forecasts is only likely to provide a moderate level of assurance.
This is because financial statements are based on historical information, and forecasts are based
on assumptions which are subject to uncertainty.
Responsibilities
Contents
Introduction
Examination context
Topic List
1 Management responsibilities
2 Assurance providers’responsibilities
3 Error
4 Fraud
5 Compliance with laws and regulations
6 Related parties
7 Money laundering
8 Expectations gap
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
Introduction
– Related parties
– Money laundering
Understand the reasons why audits 'fail' and the nature of the expectations gap
Specific syllabus references for this chapter are: 1a, b, c, d, g, h, j, 3k.
Practical significance
It is clearly important that all parties to an assurance engagement understand their responsibilities. Law and
professional standards imply a number of responsibilities into general assurance services, and particularly
into audits. It is important that all parties understand the nature and extent of these responsibilities, or it
could lead to a breakdown in the relationship between parties.
Working context
The issue of what a professional is responsible for is clearly of vital importance. However, the issues
discussed in this chapter will only be relevant to you in practice if you operate in an assurance department.
Bear in mind, however, if you work elsewhere in practice, that other people in your firm have to consider
these issues, and if they get it wrong, it could impact on you, particularly if you are by then a partner in the
firm. If you work in industry, you need to know your own responsibilities and also be aware of what you
are getting when you buy assurance services.
Syllabus links
The issue of responsibilities is usually clarified in an engagement letter, which was introduced in your
Assurance paper.
Examination context
Exam requirements
In the assessment, candidates may be required to:
Identify and advise upon the professional and ethical issues that may arise during an assurance
engagement.
Recognise the professional and ethical issues that might arise during an assurance engagement, explain
the relevance and importance of these issues and evaluate the relative merits of different standpoints
taken in debate.
Judge when to raise legal and ethical matters arising from assurance work with senior colleagues for
review and possible referral to external parties.
Discuss the purpose of laws, standards and other requirements surrounding assurance work.
Explain, using appropriate examples, the main ways in which national legislation affects assurance.
Explain the main ways in which national legislation affects the scope and nature of the audit (including
the relationship between the law and auditing standards).
Describe the principal causes of audit failure and their effects and the gap between outcomes delivered
by audit engagements and the expectations of users of audit reports.
Outline aspects of employment legislation, tax legislation and other local laws which are relevant to
statutory audit.
1 Management responsibilities
Section overview
Management is responsible for:
– Managing the business so as to achieve company objectives
– Assessing business risks to those objectives being achieved
– Safeguarding the company's assets
– Keeping proper accounting records
– Preparing company financial statements and delivering them to the Registrar
– Ensuring the company complies with applicable laws and regulations
It is not the responsibility of the auditors of a company to do any of the above.
The approach adopted in this section is to identify the responsibilities which are either defined by BSAs as
being attributable to management, or set out in the Companies Act 1994 as being the responsibilities of the
company's directors.
It follows, therefore, that these duties cannot belong to the auditor or assurance firm.
Developments
Following the Enron scandal, the Sarbanes-Oxley Act was rapidly passed into US law in 2002. It introduced
a number of measures to attempt to improve the quality of financial reporting, including:
Having Chief Executive Officers (CEOs) and Chief Finance Officers (CFOs) attest to the veracity of
the financial statements
Much greater disclosure of the amendments made to the financial statements during the audit process
Companies have had to review systems to ensure that CEOs and CFOs can make such attestations, as
there are criminal penalties for making them falsely. This has also affected UK subsidiaries of US
companies.
Section overview
The assurance provider is responsible for:
– Carrying out the assurance service in accordance with professional and ethical standards
– Carrying out the assurance service in accordance with the terms of engagement
In the case of statutory audit, the auditor is, in addition, responsible for:
– Forming an independent opinion on the truth and fairness of the financial statements
– Confirming that the financial statements have been properly prepared in accordance with the
Companies Act 1994
While the assurance provider does not bear the management responsibilities outlined above, many of
them will impact strongly on the audit and, in particular, the risk assessment that the assurance
provider carries out.
2.1 General
The responsibility of the external provider of assurance services is determined by:
The requirements of any legislation or regulation under which the engagement is conducted, and/or
The terms of engagement for the assignment, which will specify the services to be provided, (you
learnt about engagement letters in your studies for Assurance)
Ethical and professional standards
Quality control standards
In particular, as stated above, appointment as the Companies Act auditor does not lead to responsibility for
the following matters:
The design and operation of the accounting systems.
The maintenance of the accounting records.
The preparation and accuracy of management information.
The preparation of the financial statements.
The identification of every error and deficiency in the accounts and the accounting records.
The prevention of fraud in a company.
The detection of immaterial fraud in the company.
Ensuring that the company has complied with the laws and regulations that are relevant to its business
(except insofar as it affects the financial statements).
All these remain the responsibility of the management of the company; they have the responsibility to
manage and cannot delegate or pass this responsibility on to the external auditor.
Although it is important to know where these responsibilities lie
Business risks
Fraud and error
Non-compliance with laws and regulations
Accounting policies
all impact on the financial statements to a greater or lesser extent, and
Systems and controls
impact on the way the auditor conducts the audit.
We shall look at how far auditor responsibilities extend in these areas in the following sections of this
chapter.
3 Error
Section overview
Auditors are responsible for detecting material misstatements in the financial statements, some of
which may be caused by error.
Management are responsible for designing and implementing a system of internal control which is
capable of preventing, or detecting and correcting, errors in the financial records.
Auditors are required to assess the system of internal control as part of their audit in order to
determine whether to rely on the system of controls or carry out extended tests of details.
Auditors are required to report to those charged with governance on material weaknesses in
controls which could adversely affect the entity's ability to record, process, summarise and report
financial data potentially causing material misstatements in the financial statements.
Auditors are responsible for giving an opinion whether the financial statements are free from material
misstatement caused by error. This means that they should design procedures that are capable of
detecting errors.
As we set out in your Assurance manual, the two types of test generally carried out as part of an
audit are tests of control and tests of detail. The more reliance that can be placed on controls
(assessed by testing controls), the fewer tests of details may be carried out.
Definition
Internal control: A process designed and effected by those charged with governance, management, and
other personnel to provide reasonable assurance about the achievement of the entity's objectives with
regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with
applicable laws and regulations. It follows that internal control is designed and implemented to address
identified business risks that threaten the achievement of any of these objectives.
Internal controls are designed in part to prevent errors occurring in financial information, or to detect
errors and correct them.
4 Fraud
Section overview
The auditor is responsible for drawing a conclusion as to whether the financial statements are free
from material misstatement (which can be caused by fraud).
The auditor's responsibilities with regard to fraud are set out in BSA 240 The Auditor's Responsibility to
Consider Fraud in an Audit of Financial Statements and include:
– Assessing risks of material misstatement
– Discussing the susceptibility of the financial statements to material misstatement caused by fraud
A key issue in relation to discovering material misstatements caused by fraud is professional
scepticism.
When the auditors become aware of possible non-compliance, they should evaluate the possible
effect on the financial statements and on other audit evidence obtained and need to make reports to
management.
Another key issue is the cost to businesses that this would represent, as the level of testing in a fraud
investigation would be far more detailed than the sample based testing required for the purpose of an audit,
which most businesses would find prohibitive.
It must be concluded that attempts to make auditors more responsible for discovering fraud also miss the
point that management ultimately is responsible for everything within the company, including the prevention
and detection of fraud. Management should not be able to hide behind the auditors when fraud is eventually
discovered or blame the auditors for not discovering the fraud earlier. Implementing and reporting on the
principles of corporate governance is one way to enhance the performance of management in establishing
effective systems, managing the risks to the security of the organisation's assets and promoting high
standards of conduct by all those within the organisation.
Lastly it must be emphasised that this expectation gap with relation to fraud is generally associated with the
statutory audit. If an assurance firm is engaged to carry out a different assurance engagement, or a non-
statutory audit, then the terms of that engagement will be set out between the parties and all parties should
be very clear what the role of the assurance providers in relation to discovering fraud, will be on that
assignment. Bear in mind that the cost of providing a service to uncover frauds might be high and therefore
this might be rare in practice. Of course, in order to close the gap in understanding of what the purpose of
a statutory audit is in relation to fraud, the auditors' responsibilities are set out in the audit engagement
letter. However, this letter is a private matter between the directors and the firm, and therefore this
measure does not tackle the issue that the view is widely held in 'society at large' that auditors should
detect frauds.
Section overview
Management is responsible for ensuring that the company complies with laws and regulations.
Auditors are responsible for concluding that the financial statements are free from material
misstatements caused by non-compliance with laws and regulations.
Auditors are required to have a general understanding of the legal and regulatory framework within
which the company operates.
6 Related parties
Section overview
Accounting standards require that all transactions with related parties are disclosed.
Auditors need to consider the risk of there being undisclosed related party transactions.
The auditors should ask the directors for a list of related parties and watch out for transactions with
those parties during the course of testing.
Auditors need to carry out specific tests to seek to identify related parties.
The auditors need to ensure that appropriate disclosures have been made about related party
transactions.
Written representations about related parties must be obtained from directors.
entry in the cash book may give an indication of a related party, so it needs to be picked up by the person
auditing cash and bank.
BSA 550 sets out specific procedures that should be carried out:
Detailed tests of transactions and balances (such as would ordinarily be carried out on audits)
Reviewing minutes of meetings of shareholders and directors to observe if any related parties or
transactions with them become apparent
Reviewing records for large or unusual transactions or balances, particularly those recognised near the
end of the reporting period
Reviewing confirmation of loans receivable and payable and confirmations from banks (which might
indicate guarantor relationships)
Reviewing investment transactions, for example, when the company has invested in another company
Audit evidence in relation to related parties and transactions with them may be limited and restricted to
representations from management. Due to this, the auditor should try carry out procedures such as:
Discussing the purpose of the transactions with management/directors
Confirming the terms and amount of the transaction with the related party
Inspecting information in the possession of the related party
Corroborating the explanation of the transactions with the related party
Obtaining information from an unrelated third party if possible
Confirming information with persons associated with the transaction, such as banks, solicitors,
guarantors and agents.
Where related party transactions are found the auditor checks that the appropriate disclosures are made in
the accounts. Remember that all transactions with related parties need to be disclosed, even if they are at a
normal market rate. However, any disclosures should include information that is needed for a proper
understanding of the transaction and this would, of course, include whether the transaction was or was not
at a market rate.
7 Money laundering
Section overview
Money laundering is defined as a wide range of activities in relation to criminal property, including
using, acquiring, concealing and removing from the country.
8 Expectations gap
Section overview
The expectations gap is the gap between the expectations of users of assurance reports and the firm's
responsibilities in respect of those reports.
There are a variety of misunderstandings about the nature of assurance work.
The expectations gap has been narrowed by:
– Improving the required audit report
– Inserting paragraphs relating to directors'/auditors' responsibilities in the engagement letter
– The role of audit committees, which liaise with auditors
may well expect that an assurance engagement involves the checking of every single transaction, while the
firm judges that checks on a test basis are sufficient.
This is further compounded by confusion over the meaning of the report that the auditor gives. The
misunderstandings made by lay users of financial statements can be summarised as follows:
Many believe that responsibility for preparing financial statements lies with the auditor, rather than
with management.
It is widely believed by the general public that the auditor's principal duty is to detect fraud, when in
fact the duty is to make a report as to whether or not the financial statements are materially
misstated, irrespective of whether such misstatement arises as a result of fraud.
In most cases the users of the financial statements will also have little perception of the concept of
materiality and believe that the auditors check all the transactions that the company undertakes.
The public generally perceives that an audit report attached to the financial statements means that
they are 'correct', rather than just meaning that there is reasonable assurance that they give a true and
fair view.
Summary
Self-test
Answer the following questions.
1 Which one is management not responsible for?
True
False
3 The Sarbanes-Oxley Act requires CEOs to certify that the accounts are true.
True
False
4 Which two of the following are auditors not necessarily required to do?
A Assess the risk of fraud causing material misstatement in the financial statements
B Discuss the risk of fraud causing material misstatement in the financial statements
C Detect instances where fraud has caused a material misstatement in the financial statements
D Report material misstatements caused by fraud to the police
5 Auditors may be required to report instances of non-compliance with laws and regulations to which of
the following?
Shareholders
Directors
Regulatory authorities
6 Management are responsible for making appropriate disclosures concerning related parties in the
financial statements.
True
False
7 Where related party transactions are found the auditor checks that appropriate disclosures regarding
all transactions with related parties are made, even if they are at a normal market rate. However, any
disclosures should include information that is needed for a proper understanding of the transaction
and this would include whether the transaction was or was not at a market rate.
True
False
8 Which of the following is not a measure designed to close the expectations gap?
A Auditors required to attend company board meetings
B More detailed engagement letter sent to audit clients
C Audit report format revised and extended
D Statement of directors' responsibilities included in the financial statements
Exam-style questions
9 Your firm is the auditor of Alpha Ltd ('Alpha'). The managing director of Alpha discovered that the
assistant accountant had used company cheques and bank transfers fraudulently to pay his own
personal expenses. The expenditure was reported as company expenses in the income statement.
Although the amounts involved are immaterial in the context of the financial statements, it transpired
that this had been going on for several years. The managing director has expressed concern that your
firm did not discover this fraud and has requested a meeting to discuss this matter.
Using Alpha’ s fraud as an example, compare and contrast the responsibilities of the auditors in respect
of fraud with the expectation of the managing director of Alpha. (3 marks)
10 If brought to their attention, auditors should consider the implications of any breaches by their clients
of employment legislation, tax legislation and other local laws.
Outline the consequences of not considering the implications and provide examples of such breaches.
(4 marks)
11 You are the auditor of a company with numerous branches spread throughout the United Kingdom.
Revenue for the year ended 31 December 20X1 was CU25 million, profit before tax was CU1,500,000
and net assets were CU9,500,000. Your audit report was signed in March 20X2 without qualification.
Your report to management after the audit pointed out that internal controls were weak at the
branches due to the small number of staff.
You have been telephoned by the finance director, Ray Gosling, and told that the sales ledger clerk at
the Goose Green branch had been caught 'teeming and lading'. His investigations so far show that
during the year to 31 December 20X1 the sales ledger clerk had diverted CU50,000 of receipts from
customers to his own bank account. Ray has asked you to attend a meeting with him to discuss the
matter. He is particularly concerned as to why the fraud was not discovered during the course of the
audit and what the effect on the accounts might be.
At 31 December 20X1 the Goose Green branch had net assets of CU400,000. For the year ended on
that date the branch had revenue of CU1,000,000 and made a small loss.
Your re-examination of your audit working papers shows that your staff had visited the Goose Green
branch, that no grounds for suspicion arose during the audit and that appropriate audit procedures
were carried out.
Requirements
(a) Prepare notes to guide you in your discussions with the finance director. (6 marks)
(b) Following the meeting the finance director has asked you to carry out additional assurance work
to establish the extent of the fraud. Outline the main areas to which you would direct your
attention in order to establish the extent of the fraud and the loss to the company and state why
you would consider those areas. (6 marks)
(12 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
Technical reference
2 Assurance provider’
s responsibilities Companies Act 1994 s.213
(main references)
Answers to Self-test
Exam-style questions
9 Auditor's responsibilities
To identify material misstatements in the financial statements
Plan, perform and evaluate work in order to have a reasonable expectation of detecting material
misstatement in the financial statements
No obligation to prevent fraud although it may act as a deterrent
MD's perception
Auditor responsible for ALL fraud
Lacks an understanding of materiality
Directors often rely on auditors for monitoring they should undertake themselves
Alpha
Fraud was not material to Alpha financial statements and consequently not auditor’
s responsibility
How long the particular clerk has worked To establish how long the fraud is likely to
at the Goose Green (GG) branch. have gone on.
Relationships between staff at the GG Possibility of collusion.
branch.
Other branches with poor control To establish general likelihood of fraud at
environments (all?). other branches.
Relationships between staff at the GG Could the fraud have been 'sold' to staff at
branch (especially the sales ledger clerk) other branches?
and staff at other branches.
Whether the GG branch manager runs Could indicate other branches where
other branches. fraud might be undetected.
How the fraud was discovered (chance or If by management control, then provides
management control). some comfort that other frauds would be
detected and therefore, generally, fraud
less widespread.
Recoverability of the amount from the To establish actual monetary loss.
clerk.
Likelihood of false claims from credit To establish any knock-on monetary loss.
customers (i.e. having heard of the fraud,
customers claim to have settled their
accounts).
Adequacy of fidelity insurance. Is the loss recoverable?
Professional standards
Contents
Introduction
Examination context
Topic List
1 The need for professional standards
2 The International Auditing and Assurance
Standards Board (IAASB)
3 Harmonisation
4 Internal controls
5 Current issues
Summary and Self-test
Technical reference
Answers to Self-test
Answer to Interactive question
Introduction
Practical significance
Increasingly, assurance providers and particularly auditors are being asked to carry out their procedures in a
more globally recognised way. Many of the Confederation of Asian and Pacific Accountants (CAPA)
members, including Bangladesh, and also the EU have recently adopted both international financial reporting
standards (for listed companies) and international auditing standards for all statutory audits, so convergence
is an issue which is dominating auditors’lives in a practical way at the moment.
Working context
In your working environment, you may be more accustomed to dealing with IFRSs, which are BFRSs in
Bangladesh, than any other accounting standards, although the reverse is likely to be true if you work in a
smaller firm or in a non-registered company. If you work in audit, you will now be dealing with ISAs, which
are BSAs in Bangladesh. As noted above, convergence is impacting on accountants in a practical way.
Syllabus links
Some auditing standards were introduced in your lower level Assurance paper. In this paper, you will both
build on the knowledge you have gained at the lower level, and be introduced to more standards. As this is
an open book exam, you should also have a copy of BSAs to refer to when reading through this Study
Manual. The Technical reference pages will direct you to the exact places in the standards where the
requirements discussed in the chapter can be found.
Examination context
Exam requirements
While the content of auditing standards will impact on your exam, the details of who issues them and how
they are issued are likely to be of less importance, hence the fact that there are few interactive and other
questions in this chapter. Ethics, which are covered in the next chapter, are likely to be far more heavily
examined in the context of professional standards.
In the assessment, candidates may be required to:
Discuss the purpose of laws, standards and other requirements surrounding assurance work
Explain the standard-setting process used by national and international (IAASB) bodies and the
authority of the national and international standards
Explain, in non-technical language, significant current assurance issues being dealt with by the national
standard-setting body and by the IAASB
Explain the principles behind different auditing requirements in different jurisdictions and describe how
national and international bodies are working to harmonise auditing requirements, including the
requirements to report on internal controls (Sarbanes-Oxley)
Section overview
Professional standards are in the public interest as they add to the quality of assurance services.
Regulation of audit promotes comparability in the marketplace as all financial statements are audited
to common standards.
The benefits of assurance were revised in Chapter 1. A fundamental feature of assurance is that it is
provided by independent professionals to particular standards. Users expect assurance providers to be
independent and objective (which we shall consider in the next chapter) and competent. They expect an
appropriate amount of work to be done to support the conclusion being given. Assurance services are
carried out in the public interest. It is important that they are carried out within a context of professional
and ethical standards.
In relation to audit, readers want assurance when making comparisons of financial statements that the
reliability of the financial statements does not vary from company to company. This assurance
will be obtained not just from knowing each set of financial statements has been audited, but knowing that
each set of financial statements has been audited to common standards.
Hence there is a need for audits to be regulated so that auditors follow the same standards. Auditors
have to follow rules issued by a variety of bodies. Some obligations are imposed by governments in law, or
statute. Some obligations are imposed by the professional bodies to which auditors are required (by law) to
belong.
Governed by BSAs
Statutory
audits
Governed by:
- Companies Act
- Applicable regulatory
laws, e.g. Insurance
Ordinance, Bank
Companies Act
- BSAs
Section overview
International standards are developed by IAASB, a subsidiary of the International Federation of
Accountants.
International standards are designed to provide services of a consistently high quality, but they do not
override local regulations –although countries are encouraged to develop local systems to comply
with these international standards.
A sub-committee of IAASB works on a particular area and develops an exposure draft which is
publicised.
The exposure draft is revised as a result of comments made by interested parties and sometimes re-
exposed.
When the amendments have been finalised, an international standard is published.
An explanation of the workings of the IAASB, the authority of the ISAs and so on are laid out in the Preface
to International Standards on Quality Control, Auditing, Assurance and Related Services.
The Preface restates the mission of IFAC as set out in its constitution: 'The development and enhancement
of an accountancy profession with harmonised standards able to provide services of consistently high quality
in the public interest'.
In working toward this mission, the Council of IFAC established the International Auditing Practices
Committee, precursor to IAASB, to develop and issue, on behalf of the Council, standards and statements
on auditing and related services. Such standards and statements improve the degree of uniformity of
auditing practices and related services throughout the world.
Within each country, local regulations govern, to a greater or lesser degree, the practices followed in the
auditing of financial or other information. Such regulations may be either of a statutory nature, or in the
form of statements issued by the regulatory or professional bodies in the countries concerned.
National standards on auditing and related services published in many countries differ in form and content.
The IAASB takes account of such documents and differences and, in the light of such knowledge, issues ISAs
which are intended for international acceptance.
The Preface also lays out the authority attached to ISAs in general.
Authority of International Standards on Auditing
International Standards on Auditing (ISAs) are to be applied in the audit of historical financial information.
The IAASB's Standards contain basic principles and essential procedures (identified in bold type, black
lettering) together with related guidance in the form of explanatory and other material, including
appendices. The basic principles and essential procedures are to be understood and applied in the context
of the explanatory and other material that provide guidance for their application. It is therefore necessary
to consider the whole text of a standard to understand and apply the basic principles and essential
procedures.
In exceptional circumstances, an auditor may judge it necessary to depart from an ISA in order to more
effectively achieve the objective of an audit. When such a situation arises, the auditor should be prepared to
justify the departure.
Any limitation of the applicability of a specific ISA is made clear in the standard, for example, it might
contain a passage such as the following:
Application to public sector
The Public Sector Perspective (PSP) issued by the Public Sector Committee of the International Federation
of Accountants is set out at the end of an ISA. Where no PSP is added, the ISA is applicable in all material
respects to the public sector.
ISAs do not override the local regulations referred to above governing the audit of financial or other
information in a particular country.
To the extent that ISAs conform with local regulations on a particular subject, the audit of financial
or other information in that country in accordance with local regulations will automatically comply
with the ISA regarding that subject.
In the event that the local regulations differ from, or conflict with, ISAs on a particular subject,
member bodies should comply with the obligations of members set forth in the IFAC Constitution as
regards these ISAs (i.e. encourage changes in local regulations to comply with ISAs).
3 Harmonisation
Section overview
In recent years, international harmonisation of the ethical, financial reporting and auditing standards
has become a big issue.
This is due to the increase in genuinely global companies, harmonisation within SAARC, and the
scandals of major business failures, particularly Satyam and Enron.
Bangladesh has adopted international accounting standards and international auditing standards as
Bangladesh accounting standards and Bangladesh auditing standards.
The world of those who set the professional standards affecting accountants, whilst not exactly in chaos, is
certainly experiencing a period of great upheaval.
The main force behind these changes is known as 'convergence' or the increasingly close alignment of
standards which affect accountants across the world in the areas of:
Ethics
Financial reporting
Auditing
Whilst there have been International Accounting Standards and International Standards on Auditing for
some time they seem to have been always regarded as something which, although good in theory, would
never have very much impact in any individual jurisdiction.
However there are a number of drivers which have caused attitudes to change:
Global companies are now truly global, and will move their operations at will
Different regional bodies are increasingly harmonising the rules and regulations affecting business
across member states
The Satyam and Enron affairs
The Enron affair was important in that as Enron was a US company and its auditor Andersen was primarily a
US based firm, the regulators in the US were forced to look again at their own standards, and so it probably
did as much as anything to enable compromises to be made. However just in case we in Asia, become too
smug, the Satyam scandal reminds us that such events can happen anywhere.
4 Internal controls
Section overview
Internal control is an important issue given prominence in Bangladesh through the Bangladesh Bank
guideline, and globally by enactment of the US Sarbanes-Oxley Act.
The issue of providing assurance on internal control is important, particularly as little assurance is
given on the effectiveness of internal control by the audit.
Knowledge of the business will be an important factor in providing assurance on internal controls.
Assurance may be provided on the different stages of the process: identifying the risks, the design of
the system, the operation of the system.
Reports providing assurance on the effectiveness of internal controls should mention the inherent
limitations of internal control systems to avoid an expectations gap arising in relation to this issue.
Internal control is an important issue in business. It has been given particular prominence to strengthen
corporate governance in listed companies. In Bangladesh, Bangladesh Bank has been most active in this area
and has issued an internal control and compliance framework for financial institutions.
In addition, it has been given prominence by the Sarbanes-Oxley Act in the US, and the requirements that
places on chief executive officers to give more certification that the financial statements produced are true,
by implication, that the systems supporting them are strong and capable of preventing error.
The auditors' responsibilities with regard to internal control were discussed in the previous chapter and in
your earlier studies in relation to Assurance. Due to the limitations of the assurance given in relation to
internal control as part of an audit, provision of additional or alternative assurances in respect of internal
control has become an important issue.
In order to carry out an engagement in relation to the internal controls, the practitioners will require
sufficient knowledge of the business that they can identify and understand the events, transactions
and practices which will impact on the system of internal control.
4.5 Providing assurance on the applicable risks and the design and
operation of the system
This engagement would include consideration of all three stages of the internal controls process identified
above. The identification of risks is likely to involve a high degree of judgement as there are no
universally recognised criteria suitable for evaluating the effectiveness of an entity's risk evaluation. This
means that practitioners are unlikely to be able to provide a high level of assurance in this area.
The starting point for the practitioner would be the entity's business objectives. The key considerations will
include:
The completeness of the applicable identified risks
The probability of a risk crystallising
The materiality of the likely impact of the risk
The time period over which crystallisation is anticipated
In their report, the practitioners would have to outline the business objectives of the entity, a description
of the risk identification process and the applicable risks.
4.7 Reports
The nature of the individual reports has been touched on above. The discussion paper also includes an
example report. However, as the UK’ s APB makes the key point that it is difficult to issue a standard report
for assurance services, which are largely dependent on the scope and nature of the individual assignment,
this has not been reproduced here.
5 Current issues
Section overview
IAASB continue a clarity project in which they are updating and reissuing ISAs.
Summary
Drafted by IAASB
HARMONISATION
Adopted by ICAB
Self-test
Answer the following questions.
1 Auditing is regulated by the government in Bangladesh.
True
False
2 ICAB issues auditing standards which statutory auditors are required to follow.
True
False
3 Why are professional standards important?
4 Which of the following is a Bangladeshi auditor required to follow?
Exam-style question
5 Discuss the advantages and disadvantages of accounting and auditing standards to auditors and the
consequences of such standards being enforceable by statute. (4 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
Technical reference
Answers to Self-test
Note: A legal opinion on truth and fairness, accounting standards and the law in the Foreword to
Accounting Standards strengthens the legal backing for accounting standards.
Professional ethics
Contents
Introduction
Examination context
Topic List
1 The need for professional ethics
2 IFAC Code of Ethics
3 ICAB Code of Ethics
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
Introduction
Practical significance
All members of ICAB, and trainees, are required to comply with the ethical rules of ICAB.
Working context
Professional ethics are important to all ICAB members and trainees, regardless of what field they work in.
Syllabus links
This topic was covered in detail in Assurance.
Examination context
Exam requirements
As this is an important practical area, you can except it to be examined regularly.
In the assessment, candidates may be required to:
Identify and advise upon the professional and ethical issues that may arise during an assurance
engagement
Recognise the professional and ethical issues that might arise during an assurance engagement, explain
the relevance and importance of these issues and evaluate the relative merits of different standpoints
taken in debate
Judge when to raise legal and ethical matters arising from assurance work with senior colleagues for
review and possible referral to external parties
Discuss the purpose of laws, standards and other requirements surrounding assurance work
Section overview
The importance of professional ethics is that in order for accountancy services to be meaningful, the
public must trust accountants.
Trust is built by the knowledge that accountants are bound by a professional code of ethics.
Independence and objectivity (key features of the Code of Ethics) are fundamental to the provision of
assurance services.
The accountancy profession has a paradoxical image. On the one hand accountants are seen as pillars of
society, providing reliable financial information in their working lives and acting as treasurer for different
public authority institutions, NGOs, banks, educational institutions or local religious organizations in their
spare time.
The other side of the coin is the image of aggressive tax schemes, financial scandals and money laundering.
Yet accountants believe that financial information is important. It is necessary for governments,
shareholders, trading partners, management and any number of other stakeholders, that the financial and
other reports and information provided by accountants are reliable and can be used by others as they go
about their daily lives. So the work that accountants and other assurance providers do has benefit for the
public interest.
Public interest is what differentiates the accounting profession from other professions, such as lawyers,
doctors and engineers. Accountants’ work creates major impacts in the national economy through capital
markets as well as through revenue collection for public expenditure (taxes). Ranging from providing
assurance on listed company accounts to just preparing an individual’ s tax return, accountants are relied
upon and trusted by millions of public out in the street. There is a third party involvement in most of
accountant’ s work; therefore accountants need to maintain independence, integrity and objectivity.
It follows from this that, if the profession is to survive and thrive and if its members are to maintain their
position, there has to be a code of conduct so that the public are able to feel that they can trust
accountants.
The profession needs a code of professional ethics.
When a good deal of the profession’ s income comes from audit and other assurance services, where the
users of those services are seeking to gain additional confidence in the reliability of information, it is no
exaggeration to say that the profession's income actually depends on accountants’ reputation for ethical
behaviour.
You have already studied professional ethics in relation to assurance services in your earlier studies for
your Assurance paper. The following summary is therefore revision.
Section overview
IFAC issues a Code of Ethics, with which you should be familiar.
The IFAC Code has been adopted by ICAB and used as the basis for audit quality development in
Bangladesh.
Integrity. A professional accountant should be straightforward and honest in all professional and
business relationships.
Objectivity. A professional accountant should not allow bias, conflict of interest or undue influence
of others to override professional or business judgements.
Professional competence and due care. A professional accountant has a continuing duty to
maintain professional knowledge and skill at the level required to ensure that a client or employer
receives competent professional service based on current developments in practice, legislation and
techniques. A professional accountant should act diligently and in accordance with applicable technical
and professional standards when providing professional services.
Confidentiality. A professional accountant should respect the confidentiality of information acquired
as a result of professional and business relationships and should not disclose any such information to
third parties without proper and specific authority unless there is a legal or professional right or duty
to disclose. Confidential information acquired as a result of professional and business relationships
should not be used for the personal advantage of the professional accountant or third parties.
Professional behaviour. A professional accountant should comply with relevant laws and regulations
and should avoid any action that discredits the profession.
If a member of the assurance team, or their immediate family member, has a direct financial interest, or
a material indirect financial interest, in the assurance client, the self-interest threat created would be so
significant the only safeguards available to eliminate the threat or reduce it to an acceptable level would be
to:
(a) Dispose of the direct financial interest prior to the individual becoming a member of the assurance team;
(b) Dispose of the indirect financial interest in total or dispose of a sufficient amount of it so that the
remaining interest is no longer material prior to the individual becoming a member of the assurance team;
or
(c) Remove the member of the assurance team from the assurance engagement.
commercial or common financial interest and may create self interest and intimidation threats. The
following are examples of such relationships:
Having a material financial interest in a joint venture with the assurance client or a controlling owner,
director, officer or other individual who performs senior managerial functions for that client.
Arrangements to combine one or more services or products of the firm with one or more services
or products of the assurance client and to market the package with reference to both parties.
Distribution or marketing arrangements under which the firm acts as a distributor or marketer of
the assurance client’ s products or services, or the assurance client acts as the distributor or
marketer of the products or services of the firm.
In the case of a financial statement audit client, unless the financial interest is immaterial and the relationship
is clearly insignificant to the firm, the network firm and the audit client, no safeguards could reduce the
threat to an acceptable level. In the case of an assurance client that is not a financial statement audit client,
unless the financial interest is immaterial and the relationship is clearly insignificant to the firm and the
assurance client, no safeguards could reduce the threat to an acceptable level. Consequently, in both these
circumstances the only possible courses of action are to:
Unless any such financial interest is immaterial and the relationship is clearly insignificant to the member of
the assurance team, the only appropriate safeguard would be to remove the individual from the assurance
team.
The significance of the threat should be evaluated and, if the threat is other than clearly insignificant,
safeguards should be considered and applied as necessary to reduce the threat to an acceptable level. Such
safeguards might include:
When a close family member of a member of the assurance team is a director, an officer, or an employee of
the assurance client in a position to exert direct and significant influence over the subject matter
information of the assurance engagement, threats to independence may be created. The significance of the
threats will depend on factors such as:
The position the close family member holds with the client; and
The role of the professional on the assurance team.
The significance of the threat should be evaluated and, if the threat is other than clearly insignificant,
safeguards should be considered and applied as necessary to reduce the threat to an acceptable level.
Such safeguards might include:
Removing the individual from the assurance team;
Where possible, structuring the responsibilities of the assurance team so that the professional does
not deal with matters that are within the responsibility of the close family member; or
Policies and procedures to empower staff to communicate to senior levels within the firm any issue
of independence and objectivity that concerns them.
If a member of the assurance team, partner or former partner of the firm has joined the assurance client,
the significance of the self-interest, familiarity or intimidation threats created will depend upon the following
factors:
(a) The position the individual has taken at the assurance client.
(b) The amount of any involvement the individual will have with the assurance team.
(c) The length of time that has passed since the individual was a member of the assurance team or firm.
(d) The former position of the individual within the assurance team or firm.
The significance of the threat should be evaluated and, if the threat is other than clearly insignificant,
safeguards should be considered and applied as necessary to reduce the threat to an acceptable level. Such
safeguards might include:
Considering the appropriateness or necessity of modifying the assurance plan for the assurance
engagement;
Assigning an assurance team to the subsequent assurance engagement that is of sufficient experience
in relation to the individual who has joined the assurance client;
Involving an additional professional accountant who was not a member of the assurance team to
review the work done or otherwise advise as necessary; or
Quality control review of the assurance engagement.
In all cases, all of the following safeguards are necessary to reduce the threat to an acceptable level:
(a) The individual concerned is not entitled to any benefits or payments from the firm unless these are
made in accordance with fixed pre-determined arrangements. In addition, any amount owed to the
individual should not be of such significance to threaten the firm’
s independence.
(b) The individual does not continue to participate or appear to participate in the firm’
s business or
professional activities.
If, during the period covered by the assurance report, a member of the assurance team had served as an
officer or director of the assurance client, or had been an employee in a position to exert direct and
significant influence over the subject matter information of the assurance engagement, the threat created
would be so significant no safeguard could reduce the threat to an acceptable level. Consequently, such
individuals should not be assigned to the assurance team.
If, prior to the period covered by the assurance report, a member of the assurance team had served as an
officer or director of the assurance client, or had been an employee in a position to exert direct and
significant influence over the subject matter information of the assurance engagement, this may create self-
interest, self-review and familiarity threats. For example, such threats would be created if a decision made
or work performed by the individual in the prior period, while employed by the assurance client, is to be
evaluated in the current period as part of the current assurance engagement. The significance of the threats
will depend upon factors such as:
The significance of the threat should be evaluated and, if the threat is other than clearly insignificant,
safeguards should be considered and applied as necessary to reduce the threat to an acceptable level. Such
safeguards might include:
Involving an additional professional accountant to review the work done by the individual as part of
the assurance team or otherwise advise as necessary; or
Discussing the issue with those charged with governance, such as the audit committee.
Consequently, if such an individual were to accept such a position the only course of action is to refuse to
perform, or to withdraw from the assurance engagement.
Using the same senior personnel on an assurance engagement over a long period of time may create a
familiarity threat. The significance of the threat will depend upon factors such as:
The length of time that the individual has been a member of the assurance team;
The role of the individual on the assurance team;
The structure of the firm; and
The nature of the assurance engagement.
The significance of the threat should be evaluated and, if the threat is other than clearly insignificant,
safeguards should be considered and applied to reduce the threat to an acceptable level. Such safeguards
might include:
(a) The engagement partner and the individual responsible for the engagement quality control review should
be rotated after serving in either capacity, or a combination thereof, for a pre-defined period, normally no
more than seven years; and
(b) Such an individual rotating after a pre-defined period should not participate in the audit engagement until
a further period of time, normally two years, has elapsed.
Consequently, it is necessary to evaluate the significance of any threat created by the provision of such
services. In some cases it may be possible to eliminate or reduce the threat created by application of
safeguards. In other cases no safeguards are available to reduce the threat to an acceptable level.
The following activities would generally create self-interest or self review threats that are so significant that
only avoidance of the activity or refusal to perform the assurance engagement would reduce the threats to
an acceptable level:
The significance of any threat created should be evaluated and, if the threat is other than clearly
insignificant, safeguards should be considered and applied as necessary to eliminate the threat or reduce it
to an acceptable level. Such safeguards might include:
Making arrangements so that personnel providing such services do not participate in the assurance
engagement;
Involving an additional professional accountant to advise on the potential impact of the activities on
the independence of the firm and the assurance team; or
Other relevant safeguards set out in national regulations.
The following safeguards may be particularly relevant in reducing to an acceptable level threats created by
the provision of non-assurance services to assurance clients:
Policies and procedures to prohibit professional staff from making management decisions for the
assurance client, or assuming responsibility for such decisions.
Discussing independence issues related to the provision of non-assurance services with those
charged with governance, such as the audit committee.
Policies within the assurance client regarding the oversight responsibility for provision of non-
assurance services by the firm.
Involving an additional professional accountant to advise on the potential impact of the non-
assurance engagement on the independence of the member of the assurance team and the firm.
Involving an additional professional accountant outside of the firm to provide assurance on a discrete
aspect of the assurance engagement.
Obtaining the assurance client’ s acknowledgement of responsibility for the results of the work
performed by the firm.
Disclosing to those charged with governance, such as the audit committee, the nature and extent of
fees charged.
Making arrangements so that personnel providing non-assurance services do not participate in the
assurance engagement.
It is the responsibility of financial statement audit client management to ensure that accounting records are
kept and financial statements are prepared, although they may request the firm to provide assistance. If firm,
or network firm, personnel providing such assistance make management decisions, the self-review threat
created could not be reduced to an acceptable level by any safeguards. Consequently, personnel should not
make such decisions. Examples of such managerial decisions include:
Determining or changing journal entries, or the classifications for accounts or transaction or other
accounting records without obtaining the approval of the financial statement audit client;
Authorizing or approving transactions; and
Preparing source documents or originating data (including decisions on valuation assumptions), or
making changes to such documents or data.
2.12.1 Financial Statements Audit Clients that are not Listed Entities
The firm, or a network firm, may provide a financial statement audit client that is not a listed entity with
accounting and bookkeeping services, including payroll services, of a routine or mechanical nature, provided
any self-review threat created is reduced to an acceptable level. Examples of such services include:
Recording transactions for which the audit client has determined or approved the appropriate
account classification;
Posting coded transactions to the audit client’s general ledger;
Preparing financial statements based on information in the trial balance; and
Posting the audit client approved entries to the trial balance.
The significance of any threat created should be evaluated and, if the threat is other than clearly
insignificant, safeguards should be considered and applied as necessary to reduce the threat to an acceptable
level. Such safeguards might include:
Making arrangements so such services are not performed by a member of the assurance team;
Implementing policies and procedures to prohibit the individual providing such services from making
any managerial decisions on behalf of the audit client;
Requiring the source data for the accounting entries to be originated by the audit client;
Requiring the underlying assumptions to be originated and approved by the audit client; or
Obtaining audit client approval for any proposed journal entries or other changes affecting the
financial statements.
Accordingly, no safeguard other than the prohibition of such services, except in emergency situations and
when the services fall within the statutory audit mandate, could reduce the threat created to an acceptable
level. Therefore, a firm or a network firm should not, with the limited exceptions below, provide such
services to a listed entity that is a financial statement audit client.
The significance of the threat should be evaluated and, if the threat is other than clearly insignificant,
safeguards should be considered and applied as necessary to reduce the threat to an acceptable level. Such
safeguards might include:
Discussing the extent and nature of fees charged with the audit committee, or others charged with
governance;
Taking steps to reduce dependency on the client;
External quality control reviews; and
Consulting a third party, such as a professional regulatory body or another professional accountant.
A self-interest threat may also be created when the fees generated by the assurance client represent a large
proportion of the revenue of an individual partner. The significance of the threat should be evaluated and, if
the threat is other than clearly insignificant, safeguards should be considered and applied as necessary to
reduce the threat to an acceptable level. Such safeguards might include:
Policies and procedures to monitor and implement quality control of assurance engagements; and
Involving an additional professional accountant who was not a member of the assurance team to
review the work done or otherwise advise as necessary.
2.13.2 Fees—Overdue
A self-interest threat may be created if fees due from an assurance client for professional services remain
unpaid for a long time, especially if a significant part is not paid before the issue of the assurance report for
the following year. Generally the payment of such fees should be required before the report is issued. The
following safeguards may be applicable:
Discussing the level of outstanding fees with the audit committee, or others charged with
governance.
Involving an additional professional accountant who did not take part in the assurance engagement to
provide advice or review the work performed.
The firm should also consider whether the overdue fees might be regarded as being equivalent to a loan to
the client and whether, because of the significance of the overdue fees, it is appropriate for the firm to be
re-appointed.
2.13.3 Pricing
When a firm obtains an assurance engagement at a significantly lower fee level than that charged by the
predecessor firm, or quoted by other firms, the self-interest threat created will not be reduced to an
acceptable level unless:
(a) The firm is able to demonstrate that appropriate time and qualified staff are assigned to the task; and
The significance of the threats should be evaluated and, if the threats are other than clearly insignificant,
safeguards should be considered and applied as necessary to reduce the threats to an acceptable level. Such
safeguards might include:
Disclosing to the audit committee, or others charged with governance, the extent and nature of fees
charged;
Review or determination of the final fee by an unrelated third party; or
Quality and control policies and procedures.
disclosure regarding all aspects of a client’s business operations. The firm and the client’s management may
be placed in adversarial positions by litigation, affecting management’ s willingness to make complete
disclosures and the firm may face a self-interest threat. The significance of the threat created will depend
upon such factors as:
Once the significance of the threat has been evaluated the following safeguards should be applied, if
necessary, to reduce the threats to an acceptable level:
(a) Disclosing to the audit committee, or others charged with governance, the extent and nature of the
litigation;
(b) If the litigation involves a member of the assurance team, removing that individual from the assurance
team; or
(c) Involving an additional professional accountant in the firm who was not a member of the assurance team
to review the work done or otherwise advise as necessary.
If such safeguards do not reduce the threat to an appropriate level, the only appropriate action is to
withdraw from, or refuse to accept, the assurance engagement.
(1) places his professional service at the disposal of or enters into partnership with an unqualified person/or
persons in a position to obtain business of the nature in which chartered accountants engage by means
which are not open to a chartered accountant:
Provided that this paragraph shall not be construed as prohibiting a member from practising in a country
outside Bangladesh in association with a person who is entitled under the law in force in that country to
perform functions similar to those which a chartered accountant in practice is entitled to perform in
Bangladesh;
(2) allows any person to practise in his name as a chartered accountant unless such person is also a
chartered accountant and is in partnership with or employed by him.
(3) pays or allows or agrees to pay or allow, directly or indirectly, any share, commission or brokerage in
the fees or profits of his professional business, to any other person than a member of the Institute or a
partner or a retired partner or the legal representative or widow of a deceased partner;
(4) accepts or agrees to accept any part of the profits of the professional work of a lawyer, income-tax
practitioner, auctioneer, broker or other agent or any other person who is not a member of the Institute;
(5) accepts a position as auditor previously held by another chartered accountant without first
communicating with him in writing ;
(6) accepts an appointment as auditor of a company without first ascertaining from it whether the
requirements of section 210 of the Companies Act, 1994, in respect of such appointment, have been duly
complied with ;
(7) accepts a position as auditor previously held by some other chartered accountant in such
conditions as to constitute undercutting;
(8) publishes or sanctions the publication of expressions of thanks or appreciation by clients or promotes in
any way laudatory notices with regard to professional matters;
(9) solicits clients or professional work either directly or indirectly by circular, advertisement, personal
communication or interview or by any other means ;
(10) advertises his professional attainments or services or uses any designation or expressions other than
chartered accountant on professional documents, visiting cards, letter-heads or sign boards unless it be a
degree of a University established by law in Bangladesh recognised by the Government of Bangladesh or a
title indicating membership of the Institute of Chartered Accountants or any other Institution that has been
recognised by the Council;
(11) allows his name to be inserted in any directory, either in the main section or in classified list whether
printed or not, so as to appear in a leaded type or in any manner, which could be regarded as of an
advertising character;
(12) certifies any documents, exhibits, statements, schedules or other forms of accountancy work which
have not been verified entirely under the personal supervision of himself, a member of his staff, another
member of the Institute or his partner:
Provided that the above will not apply in cases of accounts of foreign branches or subsidiaries of his clients
which have been duly certified by a public accountant;
(13) gives estimates of future profits for publication in a prospectus or otherwise, or certifies for publication
statements of average profits over a period of two or more years without at the same time stating the
profits or losses for each year separately;
(14) charges or offers to charge, accepts or offers to accept in respect of any professional employment, fees
which are based on a percentage of profits or which are contingent upon the findings or result of such
employment except in cases which are permitted under any regulations of Government or requirements of
law;
(15) engages in any business or occupation other than the profession of chartered accountants unless
permitted by the Council so to engage: provided that nothing contained herein shall disentitle a chartered
accountant from being a director of a company or a cooperative society unless he or any of his partners is
interested in such company as an auditor;
(16) allows a person not being a member of the Institute or a member not being his partner to sign on his
behalf or on behalf of his firm, any balance sheet, profit and loss account, report or financial statements or
any other document required by his client;
(17) discloses information acquired in the course of his professional engagement to any person other than
his client, without the consent of his client or otherwise than as required by any law for the time being in
force;
(18) expresses his opinion on financial statements of any business or any enterprise in which he, his firm or
a partner of his firm has a substantial interest, unless he discloses the interest also in his report;
(19) fails to disclose a material fact known to him which is not disclosed in a financial statement, but
disclosure of which is necessary to make the financial statement not misleading;
(20) fails to report a material misstatement known to him to appear in a financial statement with which he is
concerned in a professional capacity;
(22) fails to obtain sufficient information to warrant the expression of an opinion or his qualifications are
sufficiently material to negate the expression of an opinion;
(23) fails to keep moneys of his client in a separate banking account or to use such moneys for purposes for
which they are intended;
(24) has been guilty of any act or default discreditable to a chartered accountant or a member of the
Institute;
(25) (i) contravenes any of the provisions of the Order or the bye-laws made there under;
(ii) is guilty of such other act or omission as may be specified by the Council in this behalf, by notification in
the Gazette of Bangladesh;
(26) not being a fellow styles himself as a fellow;
(27) does not supply the information called for. or does not comply with the requirements asked for. by the
Council or any of its Committees;
(28) fails to invite attention to any material departure from the generally accepted procedure of audit
applicable to the circumstances;
(29) includes in any statement, return or form to be submitted to the Council any particulars knowing them
to be false;
(30) permits his name or the name of his firm to be used in connection with an estimate of earnings
contingent upon future transactions in a manner which may lead to the belief that he vouches for the
accuracy of the forecast:
(31) without first obtaining the permission of the Council associates himself with or promotes anybody of
accountancy, association or institute of accountancy, etc., in Bangladesh.
Summary
Self interest
Self review
Advocacy
Familiarity
Intimidation
Self-test
Answer the following questions.
1 What are the five general threats to integrity and objectivity?
1 ........................................
2 ........................................
3 ........................................
4 ........................................
5 ........................................
2 Give two examples of when auditors are entitled to make a disclosure in breach of the duty of
confidence.
1 ........................................
2 ........................................
Exam-style questions
3 As auditor of Northend Ltd you prepare quarterly management accounts for the company, and these
are passed on to the company’s bankers. Northend Ltd’ s overdraft is close to its limit and the bank
manager has contacted you to discuss the high level of bad debts disclosed in the latest management
accounts.
What considerations will determine the extent to which you divulge information to the bank manager?
(2 marks)
4 Three situations have arisen with audit clients of your firm.
(1) Due to cash flow difficulties, overdue fees from Doe Ltd have built up to include all bills
submitted by your firm in the last twelve months.
(2) The engagement partner of Ray Ltd has acted for the company for many years.
(3) To express his gratitude for the quality of service he has received from your firm, the managing
director of Mee Ltd has invited all partners and staff involved with his affairs for a golf day and
dinner at an exclusive club one weekend.
State the threats to objectivity that these matters represent and how the threats could influence
objectivity. (4 marks)
5 Your firm has been invited to tender for the audit of East Ltd. Your firm has not previously acted in
any capacity for this company but does act for West Ltd, which is East Ltd’ s major competitor.
Identify and explain the principal ethical issue relating to this situation, and state the procedures you
would implement to address this issue. (3 marks)
6 Examples of situations when the auditors’
independence may be impaired include the following.
(1) Providing taxation services to the company and its directors.
(2) Providing accountancy services, including preparing periodic management accounts and annual
financial statements.
(3) Providing management consultancy, including advice on new computer systems and systems of
internal control.
(4) Preparing confidential reports to the company’ s bank and other lenders on the financial position
of the client. The conclusions of these reports are not made available to the audit client.
Requirement
Describe how each of the situations listed above may compromise auditors’ independence, and the
ways in which an audit firm can minimise the effect which the provision of other services has on
independence. (13 marks)
7 You have recently come across the following professional issues.
(1) During the audit of a listed company on which you were involved, you overheard the finance
director on the telephone to a family friend requesting him to buy shares on his behalf, prior to
an announcement about a new product which you know is likely to increase the share price
significantly. The finance director is a chartered accountant.
(2) During a night out at the pub following your exams one of your fellow students told you in
strictest confidence that he had tampered with his degree certificate on his computer to improve
the classification. He explained that he had done this to satisfy the minimum requirements to
secure a job at his firm, one of your main rivals. He boasted about how easy it was with new
computer technology currently available.
(3) One of the audit clients you recently worked on was so impressed with your courtesy towards
his staff members that he wanted to make you a gift of tickets to the World Cup football final,
along with an overnight stay in a hotel.
Requirement
Set out the problems inherent in each of the above situations and the action that you should take.
(10 marks)
8 Proper Ltd is a small company which develops specialist software for the insurance and banking sector.
Its finance director, Peter Stewart, has recently been on a training course called ‘Reducing the Stress of
an Audit’ . He has returned to the office with a number of concerns which he had not previously known
existed. As a result he has written to you as audit partner for clarification on the following issues.
(1) Is it appropriate for your firm to continue as auditors when it also provides other services (most
notably preparation of the company’ s corporation tax computation and dealing with the tax
affairs of the directors)?
(2) I have invited you to attend our regular board meetings but recognise that this may influence
your audit opinion.
(3) We have often sought your advice on legal and accounting issues, and I assume that it is in order
for us to extend this to the preparation of submissions to the bank for additional finance.
The last point has particular significance as the finance director’
s letter also indicates that Proper Ltd
has been very successful, and intends to improve its status by buying a larger ailing computer company.
Requirements
(a) Write a letter to the finance director which addresses the ethical issues arising from his
concerns. The letter should be brief and deal with the major items only, as the intention is not to
swamp the client with detail. (9 marks)
(b) Describe the ethical repercussions arising from the potential change in size of Proper Ltd in
relation to your firm. (6 marks)
(15 marks)
9 You are a sole accountancy practitioner. The following situations have arisen.
(1) At the request of Ace Ltd (an audit client) you have agreed to provide advice on the preparation
of a tender for a very large contract. Subsequently, client Black & Co (a partnership for whom
you prepare accounts and provide a wide range of advice) also asks for your assistance in
preparing a tender for the same contract.
(2) Whilst carrying out the final audit of the accounts of Club Ltd (deadline one month after the
balance sheet date), you discover a substantial trading debt due from another client, Diamond
Ltd. Although it has not been made public, you are aware that Diamond Ltd is in serious financial
difficulties and the bank is considering appointing a receiver. The directors of Club Ltd have made
no bad or doubtful debt provision against the amount due from Diamond Ltd.
Requirement
Explain the action you would take in each of the above circumstances. (10 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
Technical reference
Answers to Self-test
1 Self-interest
Self-review
Management
Advocacy
Intimidation
Familiarity
2 Reporting of terrorist offences
Defending oneself against negligence charges
Exam-style questions
3 Disclosure of information
Whether Northend Ltd’
s permission has been obtained to discuss matters freely with bank
Extent to which information has already been divulged by the bank to Northend Ltd’
s
management
Terms of engagement with Northend Ltd and/or bankers for preparation of management
accounts
Duty/responsibility to bankers
4 Threats
(1) Self-interest Auditor may worry that fees will not be paid if report is qualified or
going concern doubts disclosed
(2) Familiarity Partner may be reluctant to upset or be too reliant on
representations from 'friend'
(3) Self-interest Partners and staff may be reluctant to appear ungrateful or hope for
further hospitality
General
Proper audit may not be carried out
Inappropriate opinion may be given
5 Principal ethical issue
Confidentiality
East and West may perceive a threat in respect of disclosure/use of information
Conflict of interest
Procedures to address
Procedures to ensure staff are aware of confidentiality issues and such issues have been brought
to attention of staff (e.g. Chinese walls)
Staff to certify awareness of these procedures
Obtain informed consent of clients
Use of different partners and teams
Independent review of arrangements for ensuring confidentiality maintained
It is not unusual for audit firms to provide their clients with other professional services,
such as tax advice and, provided they have the technical resources to undertake such work,
it is not seen to impact on their objectivity when reaching an audit opinion.
The provision of such advice benefits both parties. It enables the auditors to gain a better
insight into client systems, while allowing the management to receive a less costly service
than by employing someone who is less familiar with their circumstances.
However, giving tax advice to the directors personally, as well as acting for the company,
could lead to a conflict of interest. Similarly, a conflict of interest could arise between giving
tax advice to the company and our audit work. If such a conflict were to arise we would
have to consider which work to decline. It may be that we would need to decline all tax
work in order to continue to act as auditor.
Ethical guidance also requires us to monitor the proportion of gross fee income (audit or
otherwise) we receive from a single client. If the fees are a large proportion of our total fee
income, then our objectivity is considered to be at risk, and we must either apply safeguards
or relinquish that client.
(2) Attending board meetings
On occasions it may be desirable for the auditor to attend board meetings, for example
when management representations on audit issues are to be discussed and minuted.
However, as you have indicated in your letter, it would be wholly inappropriate for a
member of our firm to have a permanent seat on the board. It is vital that a reader of our
audit report can be confident that we conducted our work with absolute independence and
objectivity; this would not be possible if it were known that we also held an executive role.
As a director we would be helping to make policy decisions for which at a later date we
would have responsibility for auditing.
(3) Borrowing applications
The preparation of submissions to the bank creates a potential conflict of interest.
For example, say a client’ s audit report needs qualifying on the grounds of going concern. If
the auditor were also involved in a submission to the bank he would be under pressure to
avoid such a qualification in view of the adverse effect it would have on any attempt to raise
additional finance.
In these circumstances the most likely precaution would be to invite another partner to
oversee the borrowing application.
I hope that the above has addressed and clarified your concerns, but if you would like any
additional information please do not hesitate to contact me.
Yours sincerely
ABC & Co
(b) Impact of client size
If Proper Ltd goes ahead with its proposed reverse management buy-out, it will undergo a radical
increase in size. This could have a number of ethical implications for its auditors.
Fee income
There is likely to be a significant increase in fees; hence a check would be needed to ensure that
they do not become a large portion of the recurring gross fee income of our firm. If it becomes a
large portion, our ethical guidance proposes resignation from office, as such reliance on one
client can affect objectivity.
Company status
One of the most common reasons for undertaking a reverse management buy-out is that it can
provide a fast track route to listed company status (i.e. target is a listed company).
Additionally, the reporting requirements on a listed company are more stringent, such that the
auditors must ensure that they have the technical expertise to address these changes.
Resources
Auditing ethical standards can only be maintained if the firm involved has adequate resources in
terms of staff, locations, etc. A significant increase in client size would mean that these would
have to be reviewed.
Conflicts of interest
Such a conflict could arise, particularly if the auditors have had any previous involvement with the
target company or its management.
10 (1) Tender preparation
Additional service
When agreeing to provide any additional services to an audit client it is important to recognise
that the independence of the audit may appear to be compromised even though the auditor
considers he is able to be objective in executing his work. In general, additional services of an
advisory nature are permitted provided no executive function is taken on which might conflict
with the office of auditor.
Ace Ltd
The decision to provide advice and assistance in connection with the tender is not unethical
provided it is made clear to the directors that any tender ultimately remains their responsibility.
The directors should be sent a supplementary engagement letter, distinguishing the nature of an
audit from other work and clarifying the extent of the advice to be given.
Black & Co
Independence may also be affected by a conflict of interest between two clients. With Ace Ltd
and Black competing by tender for the same contract, it is likely that detailed inside information
of both businesses would be obtained which would be of considerable value to the competitor.
Although there is, in theory, nothing improper in having two clients whose interests are in
conflict, it must be possible to manage the activities of the firm so that the work on behalf of one
client does not adversely affect that on behalf of the other. However, in this case the auditor is a
sole accountancy practitioner so safeguards such as 'Chinese walls' which could be put in place in
a large firm are unlikely to be feasible.
To advise both clients would not therefore appear to be independent. It would be difficult to be
objective and avoid influencing one or other of the tenders unfairly.
It would be preferable to advise only one of the two clients –probably Ace Ltd as already agreed
–and thereby avoid conflict. However, the knowledge of Black & Co’ s business may be seen to
impair objectivity, and Black & Co might well object to assistance being provided to Ace Ltd.
It may therefore be best to advise neither client but to explain the predicament to both and
suggest that each consults another independent firm of accountants.
(2) Confidentiality
To inform the directors of Club Ltd that the accounts will not give a true and fair view unless a
provision is made against the debt due from Diamond Ltd would be a breach of confidentiality. It
could also have the undesirable effect of precipitating the collapse of Diamond Ltd since the
directors of Club Ltd would take steps to obtain payment from Diamond Ltd as soon as possible.
To ignore the information about Diamond Ltd’ s financial position (since it is not publicly available)
and give an unqualified auditors’ report, in a situation where the accounts are known (by the
auditor) not to give a true and fair view, would be prima facie a breach of Section 140
Confidentiality of the IFAC Code of Ethics.
If the auditor is to continue to act for Club Ltd the conflict must be resolved. To do so normal
audit procedures should be followed and enquiries made to enable the information about
Diamond Ltd to be obtained from another source. It may be possible to delay forming an opinion
until the situation crystallises. Under no circumstances must there be any disclosure of
confidential information outside the firm.
Tutorial note
Note how practical this question is. Your answer should not merely be a repetition of the ethical
guide but should apply it to the specific circumstances given. Part (2) is really 'unanswerable' and what
is required is simply a sensible discussion of the possibilities. In any question on ethics, try to use
common sense and come up with practical suggestions, and bear in mind that there may be no 'right'
answer.
Self-interest threat
Discussing the extent and nature of fees charged with the audit committee, or others charged with
governance;
Taking steps to reduce dependency on the client;
External quality control reviews; and
Consulting a third party, such as a professional regulatory body or another professional accountant.
Quality control
Contents
Introduction
Examination context
Topic List
1 The need for quality standards
2 Leadership
3 Ethics
4 Acceptance of engagements
5 Human resources
6 Engagement performance
7 Monitoring
8 Getting the assurance opinion wrong
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
Introduction
Understand and explain what these procedures are and how they operate
Understand the concept of professional negligence and its potential impact on an assurance
firm
Specific syllabus references for this chapter are: 2a, d, e, f, g.
Practical significance
If you work in practice, you will be subject to the types of quality control procedures set out in this chapter
as they are a requirement for audit firms.
Working context
If you work in practice, you will soon be accustomed to the types of quality control procedures on
individual assignments. Your work will be supervised and reviewed by the people superior to you on the
assurance team, for example. You might also be involved in more general controls, such as confirming that
you do not own any shares that would cause a barrier to independence in relation to a particular client.
Even if you work outside practice, as an ICAB member, you will be required to verify that you have
undertaken continuing professional development.
Syllabus links
Your understanding of quality control issues will be necessary at the Advanced stage.
Examination context
Exam requirements
This is an area of the syllabus that is likely to be examined in conjunction with other issues such as client
acceptance or ethics.
In the assessment, candidates may be required to:
Identify the legal, professional and ethical considerations that an individual or firm must consider
before accepting a specified assurance engagement
Identify the sources of liability (including professional negligence) arising from an assurance engagement
and their impact upon the conduct of the engagement
Formulate the approach suitable for management of the assurance engagement
Discuss the principles and purpose of quality control of assurance engagements
Demonstrate how the assurance function within an organisation can be monitored through
procedures for review
Describe how quality can be monitored and controlled through procedures external to the
organisation
Section overview
Quality control procedures are essential to ensure that an acceptable job is carried out by the
assurance firm and assurance engagement risk is reduced to an acceptable level.
An engagement could go wrong due to client-based problems, or assurance firm based problems, for
example that the engagement team has insufficient knowledge of the business or are badly directed
and supervised.
Audit quality is monitored by the QAD Department of ICAB under the Quality Assurance Board
(QAB).
There are six key elements of a quality control system (which we shall look at in turn in the next
sections of this chapter):
– Leadership
– Ethical requirements
– Acceptance and continuance of client relationships/specific engagements
– Human resources
– Engagement performance
– Monitoring
The main reason the end user wants to have an assurance report prepared is to reduce the risk of making a
wrong decision. As a result someone is prepared to pay an assurance firm a fee.
As you know (and we shall look at this in more detail in Chapter 9) the amount of work the firm does is
dictated by the need to reduce assurance engagement risk to acceptable levels. If the firm does not do
this, it has not carried out a job which is acceptable when judged against professional standards.
The firm should ensure that the quality of its work does not fall short
By trusting to luck (not a good idea), or
By implementing its own quality control procedures
The supervisor
May not have an adequate understanding of the client’ s business
May not brief and direct the staff properly
May not carry out sufficient supervision so that the wrong work is done by the audit team
May fail to deal with issues raised adequately
May fail to communicate the issues arising to the engagement partner
The engagement partner
May have insufficient knowledge of the client and its environment
May fail to pass knowledge of the business on to the audit team
May select the wrong team for the audit
May not adequately brief and supervise the team
May not consult sufficiently with colleagues and outside experts
May not review the work carried out by the team with sufficient care
May fail to deal with issues raised adequately
May not draw the correct conclusions from the evidence available
2 Leadership
Section overview
The BSQC points out the importance of quality being an established part of the culture of the firm.
This must be instigated by the leaders of the firm, that is, the partners.
It is important that the culture of the firm is that quality is essential in performing assurance engagements.
This should be lead by the leaders of the firm, that is, the partners.
In practical terms, the people directing the firm and its resources should ensure that:
Commercial considerations do not override the quality of work performed.
The firm’
s policies in relation to staff promotion, remuneration and performance review incorporate
the importance of quality work.
Sufficient resources are allocated to the development, documentation and support of quality control
policies and procedures.
3 Ethics
Section overview
The firm should have policies and procedures designed to ensure that ethical requirements are met.
We saw in the previous chapter how important ethics are to assurance providers, as they underpin the
public trust required to make assurance services viable.
The firm must put together policies and procedures to ensure that it meets ethical requirements.
4 Acceptance of engagements
Section overview
The firm should also have policies and procedures designed to ensure that only appropriate clients
are accepted in the first place and retained.
The firm should also have policies and procedures designed to ensure that only appropriate clients are
accepted in the first place and retained. We shall look in more detail at acceptance issues in Chapter 6. The
engagement partner should carry out similar considerations as he did when he accepted the client every
year when bearing in mind whether to retain the client.
5 Human resources
Section overview
As part of the firm’
s overall culture of quality control, it should have policies and procedures to
ensure that it employs and retains staff with the capabilities, competence and commitment to ethical
principles necessary to perform the engagements.
There should be policies on recruitment, career development, performance evaluation and
promotion.
It is also important to allocate staff to assurance engagements appropriately.
As part of the firm’ s overall culture of quality control, it should have policies and procedures to ensure that
it employs and retains staff with the capabilities, competence and commitment to ethical principles
necessary to perform the engagements. This means it should have policies on all aspects of employing
professional staff. The BSQC lists the following:
Recruitment
Performance evaluation
Capabilities
Competence
Career development
Promotion
Compensation (that is, how staff are remunerated)
The estimation of personal needs (for instance, self-appraisal as well as appraisal by others)
These will cover matters such as professional education (for trainees), continuing professional development
(for everyone), practical work experience and coaching by more experienced staff.
ICAB members are required to certify that they have carried out appropriate professional development
annually as part of their membership. For members in practice, the BSQC puts professional development on
the agenda of firms as well, as part of their overall quality control procedures.
Another important matter in relation to human resources is the allocation of staff to assurance teams.
Firms are required to have policies to ensure that:
Clients are informed of the identity of the engagement partner.
The engagement partner has the capabilities, competence, authority and time to perform his role.
The responsibilities of the partner in respect of the assignment are clearly defined and communicated
to him.
The engagement partner should ensure that he allocates appropriate staff to the engagement team. Staff
need:
Understanding of/practical experience with similar engagements
Understanding of relevant professional and legal requirements in relation to the client
Appropriate technical knowledge
Knowledge of the relevant industry
Ability to apply professional judgement
Understanding of the firm’ s quality control procedures and policies
You can see that the types of training and appraisal discussed above will be important as ongoing monitoring
of the staff member’s abilities and, therefore, capability to be assigned to particular engagements and in what
capacity.
6 Engagement performance
Section overview
Key issues are supervision, direction, review, consultation and resolution of disputes.
6.1 Direction
This is largely the responsibility of the engagement partner who controls how the assurance engagement
should be conducted, but this duty will be delegated to the most senior team member on site at the
engagement, who will direct the engagement in accordance with the overall strategy.
The engagement partner is responsible for ensuring team members know:
What work they are supposed to be doing
The nature of the entity’s business
Any risks relevant to the engagement
Problems that might arise during the engagement
The detailed approach to the engagement
6.2 Supervision
BSA 220 lists four features of supervision:
Progress tracking
Monitoring the performance of the audit team
Addressing significant issues arising during the audit
Identifying matters for consultation or where a greater degree of expertise or experience is required
Good supervision can be a difficult skill to master:
If it is too close it can stifle initiative and waste the time of supervisor and assistant alike
If it is too loose, mistakes may be made or time wasted in ineffective work
The partner has overall responsibility for supervising the audit, but will normally delegate supervisory duties
to a manager or supervisor who will similarly delegate to the 'senior' or 'in charge' who is responsible for
the day-to-day management of the engagement.
6.3 Review
Work performed by staff is reviewed by other more senior staff or the engagement partner.
The purpose of the review is to consider whether the work done is in line with the audit strategy and
whether:
The work has been performed in accordance with professional standards and regulatory and legal
requirements
Significant matters have been raised for further consideration
Appropriate consultations have taken place and the resulting conclusions have been documented and
implemented
There is a need to revise the nature, timing and extent of work performed
The work performed supports the conclusions reached and is appropriately documented
The evidence obtained is sufficient and appropriate to support the report and
The objectives of the engagement procedures have been achieved
6.4 Consultation
When difficult or contentious issues arise, the assurance team must consult properly on the matter and the
conclusions drawn as a result of consultation must be properly recorded.
Any differences of opinion must be resolved prior to the assurance report being issued. This may mean that
a person independent of the engagement (such as the quality control reviewer) may have to be involved in
resolving the difference of opinion.
7 Monitoring
Section overview
The firm must have policies in place to ensure that their quality control procedures are adequate and
relevant, that they are operating effectively and are complied with.
Management of the assurance firm (that is, the partners) should receive an annual report on the
outcome of monitoring activities.
The most important issues will be systematic or repetitive deficiencies.
The BSQC states that firms must have policies in place to ensure that quality control procedures are
adequate and relevant, that they are operating effectively and are complied with. The firm might have a
compliance or quality department which carries out such reviews.
Monitoring might take place by ongoing evaluation of the system and also by periodic review of selected
engagement files to assess whether policies and procedures were put into place during the engagement.
The partners in the firm (the management board) should receive at least an annual report of the results of
monitoring of quality control procedures. Key issues will be systematic or repetitive deficiencies that
require corrective action.
Where monitoring reveals a problem with an individual, then remedial action should be taken with that
individual, and possibly, additional quality control reviews might be required on that person’
s work to
ensure that corrective action is taken.
The people checking compliance with quality control standards should liaise closely with the training
department or partner to ensure that any misunderstandings or problems with controls are corrected
during on-the-job training.
Section overview
Getting the audit opinion wrong could lead to:
– Being sued for professional negligence
– Disciplinary proceedings from ICAB
– Loss of reputation, clients, key staff
– Assurance firm collapse
In the context, quality control procedures are important.
Risk is another key issue associated with getting the opinion wrong –are some clients too risky to
accept?
Think for a moment about the possible cost of getting the audit opinion wrong:
If someone can demonstrate that you owed them a duty of care and they suffered loss by relying on
the financial statements, they could sue you under the tort of negligence, as you saw previously whilst
studying for the Law Paper.
As the law currently stands although you, as auditor, may not be the only person responsible for their
loss –the directors, who are responsible for preparing financial statements which give a true and fair
view, probably had a hand in it somewhere –you could find yourself solely liable.
As a member of the ICAB you could also face disciplinary proceedings, fines and penalties.
Audit firms in many countries must carry professional indemnity insurance, which means that any
settlement will be paid out by the insurance company, but there is quite a long list of audit firms which no
longer exist –ranging from Spicer and Oppenheim as a result of the British and Commonwealth/Atlantic
Computers failure to Andersen, the former auditor of Enron –as a result of the collapse of an audit client.
To some extent the final cost of the settlement is only a part of the overall cost. Lawyers do not come
cheap, particularly good corporate lawyers, and the time of partners and staff taken up with defending such
an action can also represent a huge cost.
There is a further substantial, but intangible cost, resulting from the damage to a firm’s reputation following
its involvement with a client collapse. This is the loss of other clients and often key members of staff who
no longer want to be associated with the firm.
Remember that many audit firms operate as partnerships whose partners have unlimited and joint and
several liability (which you also will remember from your law studies). If one partner gets it wrong, all the
partners could be found liable.
Clearly in this context, quality control policies and procedures, which help to ensure that the wrong
opinion is not given, are very important. However, it is not just a question of quality. As you saw in your
studies for Assurance, and as we shall look at in more detail in the next chapter, it is a question of risk.
Increasingly, audit firms are concluding that there are some clients which are too risky to take on.
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QUALITY CONTROL 5
Summary
To avoid:
- Professional negligence claims:
- Disciplinary proceedings from ICAB
- Loss of reputation and consequences
- Assurance firm collapse
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Self-test
Answer the following questions.
1 Compliance with quality control policies and procedures as required by BSQC 1 will constitute a good
defence against allegations that the firm has been negligent.
True
False
2 The ICAB’
s Quality assurance program is primarily disciplinary.
True
False
3 Which one of the following statements about formal leadership is incorrect?
Partners should ensure that:
Commercial considerations do not override the quality of work performed.
Sufficient resources are allocated to developing quality controls polices and procedures.
Staff prioritise quality control procedures over ethical considerations for listed clients.
The firm's policies in relation to remuneration should reflect the importance of quality.
4 Explain an ICAB member's responsibility with regards to CPD.
5 List four items the engagement partner should ensure the assurance team are aware of prior to
commencing an engagement.
1 ........................................
2 ........................................
3 ........................................
4 ........................................
6 Define hot review.
Exam-style questions
7 You are about to start work on an assignment. What would you expect the role of your senior to be
in terms of supervising you and explaining your role on the audit? (2 marks)
8 A qualified senior and yourself are due to start work on an assignment. He will review your work
before the file is passed on to the manager.
What aspects will he be considering when he is reviewing your work? (2 marks)
9 Your firm has recently been appointed as auditor of Jog Ltd ('Jog'), a company operating within the
sports and leisure sector. Your audit manager has arranged a meeting with the company’ s finance
director for early next week and she has asked you to assist her, in advance of this meeting, with the
audit planning for the year ending 30 June 20X6. Your audit manager has also asked you to carry out
some preliminary analytical procedures on the year-end financial statements of Jog when these become
available.
Jog’
s business can be split into the following three divisions
Sports equipment retail outlets: 35 sports equipment retail outlets located in 'out of town' retail
parks
Fitness clubs: 15 fitness clubs, each offering a fully equipped gym together with yoga, aerobics, and
circuit training classes
Machine manufacture: a manufacturing unit in which running machines and rowing machines are
assembled using components sourced from overseas.
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QUALITY CONTROL 5
Further information:
Sports equipment retail outlets
The retail outlets are all located close to major towns and cities throughout the whole of Bangladesh.
Each outlet stocks a standard range of products which are supplied from a central warehouse
operated by Jog. Salaries for the core staff at the outlets are paid by Jog’
s head office by direct bank
transfer. Each outlet is run on a day-to-day basis by a manager who is responsible for hiring casual staff
to cover peak periods. These casual staff members are generally paid using cash from the locker.
Jog received some bad publicity during the year following its inclusion in a television documentary
which revealed that one of its sports shoe suppliers was making its employees work long hours for
very low wages. In an attempt to manage this adverse press attention, Jog has now had to source these
products from alternative suppliers.
Fitness clubs
Jog’s 15 fitness clubs are all located directly above existing Jog retail outlets. Each club has its own on-
site manager and is operated independently of the adjacent retail outlet. Customers of the fitness clubs
pay by one of three methods: on a ‘ pay per session’basis over the fitness club counter; by monthly
direct debit paid into Jog’s head office bank account; or by annual subscription to head office.
Customers are then issued with a membership card which enables them to gain access to the club.
The company operates a bonus incentive scheme for the managers at both its retail outlets and fitness
clubs. The size of the bonus is linked to the profitability of their individual operation.
Machine manufacture
During the year Jog started to manufacture its own running machines and rowing machines. It sources
the machine components from China and Taiwan. These components are assembled at Jog’ s factory
for sale both in Jog’
s own stores under their own 'Jog' brand and also to independent sports shops
under the 'Iron Champ' brand. The latter accounts for approximately 80% of Jog’ s total production of
both running and rowing machines. Sales to independent sports shops achieve a gross profit margin of
50%, whereas sales to Jog’s own shops are made to that division at cost plus 10%.
Jog is invoiced by its foreign component suppliers in their respective local currency. The components
are sent by sea, which means that Jog’s typical lead time for components from the placing of an order
to delivery in Bangladesh is three months. Jog is required to pay its suppliers 50% with order and 50%
upon receipt of the components in Bangladesh.
Quality control
In line with your firm’s system of quality control, procedures were conducted prior to accepting Jog as
an audit client, to ensure that it was appropriate to accept such an appointment. Your audit manager
has asked you to consider the other objectives of a system of quality control and why they may be
particularly relevant to Jog.
Requirements
(a) and (b) omitted until later chapter
(c) (i) State the objectives of a system of quality control within an audit firm.
(ii) Identify, with reasons, which of the above objectives are likely to be particularly relevant to
your audit of Jog. (8 marks)
Parts (a) and (b) of this question will be included in Chapter 7. Note that much of the information
given in the question relates to these parts, but has been left in so that you can use any relevant
information for the purposes of answering Part (c)(ii).
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
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Technical reference
Requirement for quality control procedures BSQC 1.3 and BSA 220.2
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QUALITY CONTROL 5
Answers to Self-test
1 True
2 False, although disciplinary action may be taken as a result of a review if required.
3 Staff prioritise quality control procedures over ethical considerations for listed clients.
4 Every member is required to certify that he/she has carried out appropriate professional development
annually.
5 From:
What work they are supposed to be doing
The nature of the entity’s business
Any risks relevant to the engagement
Problems that might arise during the engagement
The detailed approach to the engagement
6 A hot review is a review carried out by a partner not otherwise involved in the engagement or an
external consultant before the audit report is signed.
Exam-style questions
7 Supervision
Inform you of your responsibilities
Explain the objectives of the work you are carrying out
Explain the nature of the entity’
s business
Highlight possible accounting and auditing problems which may affect the procedures you carry
out
8 Review of work
Work properly conducted in accordance with plan/programmes
Working papers to a standard/evidence recorded
Conclusions valid
Matters identified for further consideration
Working papers headed, initialled, dated
9 (c) Objectives of quality control
The objectives of an audit firm’
s system of quality control are to ensure that the auditor
performs the right work to a high standard and adequately records the work done. It involves
selecting the appropriate team, supervising staff, consulting sufficiently with colleagues and
outside experts and reviewing the work carried out by the team with sufficient care.
A system of quality control will also ensure that the auditor draws the correct conclusions from
the evidence available, forms the appropriate audit opinion and deals adequately with issues
raised including reporting to management.
Quality control is also designed to protect the auditor from risks arising as a result of
incompetence or negligence of the client’ s staff and will protect the firm from the risk of
litigation.
Objectives relevant to the audit of Jog
Jog operates out of many locations and because it has a number of diverse activities, the audit
firm may not have staff with relevant expertise. It is therefore particularly important that a team
with appropriate skills and experience is selected for the audit and that the work is supervised
closely.
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Audit and assurance
As Jog is a new audit client and because its business is diversified it is particularly important that
the audit team has an adequate understanding of the business. The risks arising from the client’ s
staff being incompetent or negligent are particularly relevant to Jog as the auditor does not yet
know the client very well.
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QUALITY CONTROL 5
Engagement partner
An engagement partner is usually appointed to each audit engagement undertaken by the firm, to take
responsibility for the engagement on behalf of the firm. Assigning the audit to an experienced audit manager
is not sufficient.
The lack of an audit engagement partner also means that several of the requirements of BSA 220, about
ensuring that arrangements in relation to independence and directing, supervising and reviewing the audit,
are not in place.
Conflicting views
In this scenario the audit manager and senior have conflicting views about the valuation of inventory. This
does not appear to have been handled well, with the manager refusing to discuss the issue with the senior.
BSA 220 requires that the audit engagement partner takes responsibility for settling disputes in accordance
with the firm's policy in respect of resolution of disputes required by BSQC 1. In this case, the lack of
engagement partner may have contributed to this failure to resolve the disputes. In any event, at best, the
failure to resolve the dispute is a breach of the firm's policy under BSQC 1. At worst, it indicates that the
firm does not have a suitable policy concerning such disputes as required by BSQC 1.
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Audit and assurance
108 © The Institute of Chartered Accountants in England and Wales, March 2009
chapter 6
Accepting engagements
Contents
Introduction
Examination context
Topic List
1 Tendering
2 Risk analysis
3 Acceptance and legal issues
4 Terms of an audit engagement
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Audit and assurance
Introduction
Practical significance
It is of practical significance to both companies and assurance firms how assurance engagements are
obtained and the processes that assurance firms go through when determining whether to accept
engagements, because companies need assurance services, particularly audits which are a statutory
requirement in many cases and because assurance firms need to generate income. A key issue for firms to
consider, as raised in the previous chapter, is the risk associated with that client or potential client in terms
of getting the opinion wrong. In addition, they need to consider ethics and resources. Companies should
bear in mind when seeking auditors that audit firms generally prefer to take on clients which appear to have
integrity and commitment to internal control.
Working context
If you work in practice, you may become involved in the tender process for a new client in some way at
some stage during your training. If you work in industry, you may be responsible for evaluating audit
tenders and recommending who to appoint as auditors.
Syllabus links
Many of the considerations set out in this chapter have already been introduced in the Assurance paper. In
this paper, you are required to consider the matters at a higher level, and be able to explain and discuss the
matters in more detail.
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ACCEPTING ENGAGEMENTS 6
Examination context
Exam requirements
You may be asked to apply the principles discussed in this chapter to a scenario question in the exam.
In the assessment, candidates may be required to:
Explain the main ways in which national legislation affects the appointment and removal of auditors
Identify the legal, professional and ethical considerations that an individual or firm must consider
before accepting a specified assurance engagement
Discuss the issues which underlie the agreement of the scope and terms of an assurance engagement
(new or continuing)
Discuss the process by which an auditor obtains an audit engagement
Discuss the issues and risks that an individual auditor or audit firm must consider with regard to the
acceptance of an audit engagement (new or continuing) with a client, including terms of engagement
and their documentation
Identify the legal, professional and ethical considerations that an individual auditor or audit firm must
consider before accepting a specified audit engagement
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Audit and assurance
1 Tendering
Section overview
An assurance firm might be invited to accept an engagement or to tender for an engagement.
A tender is in effect a ‘
bid’
for an engagement.
The firm will set out the reasons why it is best placed to provide the engagement and the fee at
which it can do it.
Undercutting may occur during a tender process, and it is unethical as per ICAB Code of Conduct,
schedule ‘ C’clause 7. However, as per IFAC Code of Ethics, it may require ethical safeguards to be
put in place.
The IFAC Code of Ethics, as adapted by ICAB, states: ‘ When entering into negotiations regarding
professional services, a professional accountant in public practice may quote whatever fee is deemed to be
appropriate. The fact that one professional accountant in public practice may quote a fee lower than
another is not in itself unethical. Nevertheless, there may be threats to compliance with the fundamental
principles arising from the level of fees quoted. For example, a self-interest threat to professional
competence and due care is created if the fee quoted is so low that it may be difficult to perform the
engagement in accordance with applicable technical and professional standards for that price.
The significance of such threats will depend on factors such as the level of fee quoted and the services to
which it applies. In view of these potential threats, safeguards should be considered and applied as necessary
to eliminate them or reduce them to an acceptable level. Safeguards which may be adopted include:
Making the client aware of the terms of the engagement and, in particular, the basis on which fees are
charged and which services are covered by the quoted fee.
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ACCEPTING ENGAGEMENTS 6
2 Risk analysis
Section overview
Firms carry out risk analysis prior to accepting engagements.
This is in order to ensure that the risk of giving an inappropriate opinion on the engagement is not
too high.
Matters to consider are whether the directors appear to have integrity, the company has a good
financial record and prospects, the attitude to internal control and the nature of the client’
s
transactions.
As you learnt in Assurance, assurance firms will carry out a risk analysis before accepting clients. This is
partly to determine what fee they think is appropriate for the engagement (the higher risk the client, the
greater the benefit that the firm will want from undertaking the engagement) but also to lay foundations for
understanding the risks associated with the engagement if it is taken on and the amount of work that will
have to be undertaken to reduce assurance risk to an acceptable level for that assignment. As noted in
Chapter 5, it may be that an engagement is too risky for a firm to risk taking on.
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Audit and assurance
Why?
Because history tells us that they are less likely to make mistakes.
Because the culture is such that accuracy and good record keeping is encouraged.
Because, probably, there are systems in place to pick up mistakes and correct them as they occur.
This is looking quite simple then –client A is lower risk than client B, therefore you do less work on client
A, client A is charged a lower fee.
Think now about your attitude to risk after the financial statements for both clients are finalised.
For client B you have unpicked and re-assembled every single element in its financial statements.
You have considered in detail every item in the balance sheet, and you have reviewed every account in
the income statement.
The trouble with clients like client B is that you are usually under a certain amount of pressure to finalise
the financial statements and there tend to be a few loose ends left about which you 'take a view', but it
would not be impossible to end the audit of client B feeling more confident about its figures than client A’ s,
because you had looked at them in more depth.
Another question
If
You were a fraudster, hoping to inflate the value of your company so that a venture capital fund would
invest, or a bank would continue with finance, or a large multinational would purchase it;
or
You were a money launderer wanting to introduce the profits from your drug smuggling and dealing
activities into an otherwise legitimate business;
would you prefer to be operating client A or client B?
You could argue that things are so chaotic at client B that no one would notice a few stray transactions.
Or you might think that the auditors have to spend so much time on the detail that they would have quite a
good chance of picking something up.
Perhaps the well organised, reliable client A, where the auditors don’
t seem to do very much detailed
checking, might be a better bet.
The most that can be said therefore is that the assessment of risk is something of a balancing act between
your judgement of how reliable the information coming from the client is likely to be and the things you can
actually do.
The example illustrates that such judgements are not simple, but generally speaking when carrying out risk
analysis prior to accepting a client, assurance providers will be seeking to determine:
Whether the directors/management of the company appear to have integrity: this can be assessed by
looking at the accounting policies of the company (are they prudent and conservative or imprudent?)
and the qualifications of the finance director it employs, or by obtaining references for key personnel
from parties known to the assurance firm, such as bankers or solicitors, or the previous auditors.
Whether the company has a good financial record, resources and outlook: this can be assessed by
looking at recent financial performance and reports and by making enquiries (with permission) from its
bankers.
Whether the company appears to have good internal control, or, at minimum, a good control
environment: this might be indicated by the existence of an internal audit department, or assessed
through inquiries of management.
Whether the company has unusual transactions: this can be assessed by reviewing published financial
statements.
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ACCEPTING ENGAGEMENTS 6
In general terms, if the directors appear to have integrity, the financial record is strong and prospects look
good, there is a good attitude to internal control in the company and it has few unusual transactions, then it
is lower risk than a company for which those things are not true.
Remember, that if a firm determines that a company is a high risk client, this does not necessarily mean that
the firm will not accept the engagement, but this preliminary assessment of risk will be incorporated into
the audit procedures when risk assessment identification and procedures are carried out on the
engagement.
Another area constituting risk to the auditor, as indicated in the example above, is the risk that the client
may be money laundering. As you know, accountants are required to report suspicions of money laundering
and failure to report a suspicion is a criminal offence. The auditors are also required to carry out client due
diligence with respect to money laundering at the start of an engagement. This was all set out in your
manual for Assurance, and you should refer back to it for the details.
Section overview
Auditors must consider:
– The results of risk analysis
– Any ethical barriers to acceptance
– Whether the firm has the resources to undertake the assignment
– Legal issues
When deciding whether to accept an assurance engagement, the auditors need to consider the following:
The results of risk analysis (discussed above)
Whether there are any ethical issues which prevent acceptance (discussed in Chapters 4 and 5)
Whether the firm has sufficient experience and resources (mainly staff who are appropriately qualified,
experienced and available) to undertake the engagement
For an audit engagement, whether all the legal requirements associated with the appointment of the
incoming auditors and the removal or resignation of the outgoing auditors have been met.
A professional accountant in public practice who is asked to replace another professional accountant in
public practice, or who is considering tendering for an engagement currently held by another professional
accountant in public practice, should determine whether there are any reasons, professional or other, for
not accepting the engagement, such as circumstances that threaten compliance with the fundamental
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principles. For example, there may be a threat to professional competence and due care if a professional
accountant in public practice accepts the engagement before knowing all the pertinent facts.
The significance of the threats should be evaluated. Depending on the nature of the engagement, this may
require direct communication with the existing accountant to establish the facts and circumstances
behind the proposed change so that the professional accountant in public practice can decide whether it
would be appropriate to accept the engagement. For example, the apparent reasons for the change in
appointment may not fully reflect the facts and may indicate disagreements with the existing accountant that
may influence the decision as to whether to accept the appointment.
If identified threats are other than clearly insignificant, safeguards should be considered and applied as
necessary to eliminate them or reduce them to an acceptable level. Such safeguards may include:
Discussing the client's affairs fully and freely with the existing accountant.
Asking the existing accountant to provide known information on any facts or circumstances that, in the
existing accountant's opinion, the proposed accountant should be aware of before deciding whether to
accept the engagement.
When replying to requests to submit tenders, stating in the tender that, before accepting the
engagement, contact with the existing accountant will be requested so that inquiries may be made as to
whether there are any professional or other reasons why the appointment should not be accepted.
A professional accountant in public practice will ordinarily need to obtain the client's permission, preferably
in writing, to initiate discussion with an existing accountant. Once that permission is obtained, the existing
accountant should comply with relevant legal and other regulations governing such requests. Where the
existing accountant provides information, it should be provided honestly and unambiguously. If the
proposed accountant is unable to communicate with the existing accountant, the proposed accountant
should try to obtain information about any possible threats by other means such as through inquiries of
third parties or background investigations on senior management or those charged with governance of the
client.
Where the threats cannot be eliminated or reduced to an acceptable level through the application of
safeguards, a professional accountant in public practice should, unless there is satisfaction as to necessary
facts by other means, decline the engagement.
3.1.2 Existing auditor
An existing accountant is bound by confidentiality. The extent to which the professional accountant in
public practice can and should discuss the affairs of a client with a proposed accountant will depend on the
nature of the engagement and on:
In the absence of specific instructions by the client, an existing accountant should not ordinarily volunteer
information about the client's affairs.
Circumstances where it may be appropriate to disclose confidential information are set out in Section 140
of Part A of the ICAB Code of Conduct.
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ACCEPTING ENGAGEMENTS 6
(2) Every auditor appointed under sub-section (I), shall, within thirty days of the receipt from the
company of the intimation of his appointment, inform the Registrar in writing that he has accepted,
or refused to accept, the appointment.
(3) At any annual general meeting a retiring auditor, by whatsoever authority appointed, shall be re-
appointed, unless-
(a) he is not qualified for re-appointment; or
(b) he has given the company notice in writing of his unwillingness to be re-appointed; or
(c) a resolution has been passed at that meeting appointing somebody else instead of him or
providing expressly that he shall not be re-appointed:
Provided that for the purpose of passing a resolution under clause (c), a notice thereof shall in
accordance with section 211 be issued prior to the meeting, and such ' resolution cannot be
passed except on the ground of death, incapacity or dishonesty or disqualification of the retiring
auditor,
(4) If an appointment of an auditor is not made at an annual general meeting, the Government may
appoint a person to fill the vacancy.
(5) The company shall, within seven days of the Governments power under subsection (4) becoming
exercisable, give notice of that fact to the Government; and, if a company fails to give such notice, the
company, and also every officer of the company who is in default, shall be punishable with fine which
may extend to one thousand taka.
(6) The first auditor or auditors of a company shall be appointed by the Board of Directors within one
month of the date of Registration of the company, and the auditor or auditors so appointed shall hold
office until the conclusion of the first annual general meeting:
Provided that-
(a) the company may, at a general meeting remove any such auditor or all or any of such auditors
and appoint in his or their place any other person or persons who have been nominated for
appointment by any member of the company, and or of whose nomination notice has been given
to the members of the company not less than fourteen days before the date of the meeting; and
(b) if the Board of Directors fails to exercise its powers under this subsection, the company in a
general meeting, may appoint the first auditor or auditors.
(7) The Board may fill any casual vacancy in the office of any auditor, but while any such vacancy
continues, the remaining auditor or auditors, if any, may act:
Provided that where such vacancy is caused by the resignation of an auditor, the vacancy shall only be
filled by the company in general meeting.
(8) Any auditor appointed in a casual vacancy shall hold office until the conclusion of the next annual
general meeting.
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(9) Except as provided in the process pursuant to sub-section (7), any auditor appointed under this
section may be removed from office before the expiry of his term only by a special resolution of the
company in the general meeting.
3.2.2 Remuneration of the auditors of a company :
(10) The remuneration of the auditors of a company-
(a) in the case of an auditor appointed by the Board or the Government, shall be fixed by the Board
or the Government respectively; and
(b) subject to clause (a), shall be fixed by the company in the general meeting or in such manner as
the company in the general meeting may determine.
(11) For the purposes of sub-section (10), any sums paid by the company in respect of the auditors
expenses shall be deemed to be included in the expression "remuneration".
3.2.3 Provisions as to resolutions for appointing or removing auditors.
Section 211
(I) Special notice shall be required for a resolution at an annual general meeting appointing as auditor a
person other than a retiring auditor, or providing expressly that a retiring auditor shall not be re-
appointed.
(2) On receipt of such notice the company shall forthwith send a copy thereof to the retiring auditor,
(3) Where such notice is given and the retiring auditor makes with respect thereto representation in
writing to the company and requests their notification to members of the company, the company
shall, unless the representations are received by it too late for it to do so-
(a) in any notice of the resolution given to members of the company, state the fact of the
representation having been made; and
(b) send a copy of the representation to every member of the company to whom notice of the
meeting is sent, whether before or after the receipt of the representation by the company, and if
a copy of the representation, is not sent as aforesaid because they were received too late or
because of the company's default, the auditor may, without prejudice to his right to be heard
orally, require that the presentation shall be read out at the meeting.
Provided that copies of the representations need not be sent out and the representations need
not be read out at the meeting, if, on the application either of the company or of any other
person who claims to be aggrieved, the court is satisfied that the rights conferred by this sub-
section are being abused to secure needless publicity for defamatory matter; and the Court may
order the company's costs on such an application to be paid in whole or in part by the auditor,
notwithstanding that he is not a party to the application.
(4) Sub-sections (2) and (3) shall apply to a resolution to remove the first auditors or any of them under
sub-section (6) of section 210 or to the removal of any auditor or auditors under sub-section (8) of that
section, as they apply in relation to a resolution that a retiring auditor shall not be re-appointed.
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Section overview
As part of engagement acceptance, the assurance providers will negotiate the terms of the
engagement. For assurance engagements, this will include:
– The scope of the engagement
– The subject matter of the engagement
– The criteria by which the subject matter is being judged
– The level of assurance required and therefore the type of opinion to be given
– The timings associated with the engagement
– Any restriction in liability
– The fee for the engagement
With regard to audits, the scope of the engagement is determined by law and professional standards, but
the auditors must ensure that these terms are understood by the client. In addition, the following matters
will need to be agreed:
The fee or the basis by which the fee will be determined
The limited liability agreement, that is, the cap on the auditors’
liability for the engagement (discussed
in the previous chapter)
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ACCEPTING ENGAGEMENTS 6
Summary
Issues:
- Fees (undercutting)
- Firm’ s experience
- Firm’ s reputation
- Proposed personnel
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Self-test
Answer the following questions.
1 Define undercutting.
2 List four issues that should be referred to when determining fees
1 ........................................
2 ........................................
3 ........................................
4 ........................................
3 Why do firms undertake risk analysis?
4 If the client refuses the existing auditor permission to communicate with the prospective auditor, the
prospective auditor should decline the appointment.
True
False
5 An auditor can be appointed by which of the following methods?
True
False
Exam-style questions
7 Acer Ltd is a client of your firm and is seeking funding in order to expand the business. The directors
have prepared profit and cash flow forecasts for the next three years ending 30 June 20X9 in support
of the request for funding. The company's bankers require this information to be reviewed by
independent accountants and the board of directors has requested that your firm undertakes this
review.
Set out the matters that you would include in the engagement letter in relation to the respective
responsibilities of the directors and the reporting accountant. (2 marks)
8 Wrapper Ltd
Your firm, which has six partners, has been invited by Mr Packer, the managing director and majority
shareholder of Wrapper Ltd, to accept appointment as auditor of the company and also provide
assistance with the preparation of the financial statements and the corporation tax computation.
The principal activity of Wrapper Ltd is the production of paper carrier bags, serviettes, coffee cups
and lids which are sold to customers operating in the fast food sector. Wrapper Ltd was incorporated
on 1 October 20X4 and the financial statements will cover the 15 month period to 31 December
20X5. Although the company's revenue and assets are below the thresholds for statutory audit
purposes, the company's bankers require the annual accounts to be subjected to a full audit.
Mr Packer started the business using a combination of money inherited from his grandfather and a
bank loan. The loan agreement includes a covenant specifying that the company's debt equity ratio
should not exceed parity (i.e. 1:1).
The accounting records are computerised and the company uses software which was developed by IT
Systems Ltd, a company owned by Mr Packer's brother. The software has been customised to
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ACCEPTING ENGAGEMENTS 6
integrate inventory control with receivables and payables. IT Systems Ltd also provides support for the
company’ s computer systems. The accounting records are maintained by Mrs Carlton, assisted by Mrs
Biggs who works one day a week and is responsible for payroll processing.
Requirements
(a) State, with reasons, the matters to be considered and procedures to be performed prior to your
firm accepting and commencing the audit of Wrapper Ltd for the period ending 31 December
20X5. (8 marks)
(b) Identify, from the information provided above, the factors which should be taken into account
when assessing the risk of misstatement in the financial statements of Wrapper Ltd and explain
why such factors should be taken into account when conducting the audit. (10 marks)
(18 marks)
9 The directors of Harmony Ltd ('Harmony') have approached you with a view to your firm accepting
appointment as its auditor for the year ending 31 July 20X6. Harmony manufactures satellite navigation
systems which it supplies to many of the major motor car manufacturers with UK-based factories.
Harmony has a wholly-owned subsidiary undertaking located overseas which manufactures 'high-end'
audio systems for locally based motor car manufacturers. The subsidiary, which is of a similar size to
Harmony, is located in a country where there is no audit requirement for companies whose shares are
not publicly held. Harmony prepares consolidated financial statements.
The shareholders of Harmony are actively involved in the day to day running of the business and that
of the wholly-owned subsidiary.
The directors of Harmony have told their existing auditors that they will not be re-appointed at the
company’ s forthcoming annual general meeting. They have not given them a reason for this, but the
existing auditors suspect that it is due to a dispute that arose during the audit of last year’
s financial
statements. At 31 July 20X5 Harmony was carrying inventory totalling CU375,000 in respect of a
cancelled order for a satellite navigation system from a motor car manufacturer that had gone into
liquidation. During September 20X5, modifications were made to the inventory, at a cost of
CU75,000, to enable them to be sold to another customer for CU195,000 that same month. The
directors of Harmony were concerned at the effect that any provision against the inventory in the
financial statements would have on their distributable profits for the year. The directors accordingly
insisted on including the inventory in the financial statements at CU375,000, which gave rise to a
modified audit report.
In addition to your appointment as auditor, the directors of Harmony have also requested:
(i) That you, as the proposed engagement partner, attend the company’
s monthly board meetings;
and
(ii) That your firm be appointed to provide internal audit services to Harmony.
Your firm has seven partners in total and has an office in each of three cities in the South of England.
Requirements
(a) Outline the reasons for and against the subsidiary of Harmony having an audit on its own basis
despite being owner-managed. (6 marks)
(b) Set out the key issues specific to Harmony that may prevent you from accepting the appointment
solely as its external auditor, and state what action you could take to resolve these issues.
(6 marks)
(c) Discuss the potential threats to objectivity caused by the provision of the additional services
requested by Harmony and describe what safeguards could be put in place to mitigate those
threats. (8 marks)
(20 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
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Technical reference
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ACCEPTING ENGAGEMENTS 6
Answers to Self-test
1 Undercutting is the practice of charging less than the market rate for assurance services.
2 From:
The seniority and professional experience of the persons necessarily engaged on the work
The time expended by each
The degree of risk and responsibility which the work entails
The nature of the client’
s business, the complexity of its operation and the work to be performed
The priority and importance of the work to the client
Together with any expenses properly incurred
3 To ensure that the assurance provider believes an appropriate conclusion can be drawn.
To assist in determining an appropriate fee (that reflects the risk of the assignment).
4 False. Not necessarily, although this might be an indicator that the auditor should have concerns about
director integrity.
5 All of them.
6 False. A statutory audit provides a reasonable level of assurance.
Exam-style questions
7 Directors
Responsible for
Forecasts including the assumptions on which they are based
Cooperating with the reporting accountant by making available records, documents and
personnel
Reporting accountant
Forecast is properly prepared on the basis of the assumptions made
Provide negative assurance that nothing has come to reporting accountant’ s attention to cause
them to believe that the assumptions do not provide a reasonable basis for the forecast
8 Wrapper Ltd
(a) Matters/procedures prior to acceptance of audit
Check adequacy of resources to enable
– Work to be completed to a high standard on a timely basis/use of competent staff
– Provision of tax/accountancy services without compromising independence (i.e..
safeguards can be put in place) e.g.:
– Use of separate personnel to perform accountancy and tax
– Review by an independent partner/senior staff member with appropriate
expertise if tax computation prepared by audit team
– Review of the audit by an audit partner who is not involved in the audit
engagement
Establish/document existence of informed management
– To ensure auditor does not take management role
Consider relationships/familiarity threat
– To ensure independence/objectivity not impaired
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ACCEPTING ENGAGEMENTS 6
– We need to obtain an understanding of the accounting system in order to assess its adequacy as
a basis for the preparation of the financial statements.
– We need to obtain relevant and reliable evidence sufficient to enable us to draw reasonable
conclusions therefrom.
– The nature and extent of our procedures will vary according to the assessment of the accounting
system and, where we wish to place reliance upon it, the system of internal control.
– We will endeavour to plan the audit so that we have a reasonable expectation of detecting
material misstatements in the financial statements or accounting records resulting from fraud,
error or non-compliance with law or regulations but that the examination ought not to be relied
upon to disclose all frauds, errors or instances of non-compliance which may exist (as some may
be immaterial).
– Due to the test nature and other inherent limitations of an audit, together with the inherent
limitations of any system of internal control, there is an unavoidable risk that even some material
misstatement may remain undiscovered.
– An explanation that management representations may be required in writing during the audit
(this will only be in the case of audit areas where we have to rely on your representations).
– The fact that we may send a letter of comment, adding value to the audit, by outlining ways in
which we discussed the business may be improved.
Other matters such as
– Our billing arrangements
– Any arrangements in the future concerning the involvement of
– Other auditors and experts
– Internal auditors
– Previous auditors
– Management's responsibility to detect and prevent fraud
– Your complaints procedures
– A proposed timetable for the engagement (which will vary each year).
I hope this clarifies the need for the letter. Except for the timetable, we will only send out such letters in
future where absolutely necessary.
Yours sincerely
Mr A Accountant
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chapter 7
Planning
Contents
Introduction
Examination context
Topic List
1 The need to plan
2 Overall audit strategy and audit plan
3 Materiality
4 Analytical procedures
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Introduction
Understand and explain what goes into the key audit planning documents
Explain the benefits and limitation of analytical procedures at the planning stage
Specific syllabus references for this chapter are: 3g, h, n.
Practical significance
Planning is an important aspect of the quality control processes relating to an assurance assignment and it is
key in determining whether the work carried out is capable of supporting a correct conclusion. It is
therefore of crucial importance.
Working context
If you work in practice, you may become involved in planning assignments, particularly as you progress, if
you have worked on a client in the previous year and acquired a degree of knowledge of the business.
If you work in industry, you may be involved in the other side of planning, providing auditors with necessary
planning information, such as budgets and draft financial information.
Syllabus links
You have studied these matters for your Assurance paper, so much of the technical detail covered here is
revision. It is important at this Application stage to be able to explain and apply the techniques outlined in
the chapter.
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PLANNING 7
Examination context
Exam requirements
A question which deals with planning in the exam is also very likely to deal with risks, which we shall look at
in more detail in the next chapter, hence the question practice given in this chapter is limited and more
practice will be given in the next chapter.
In the assessment, candidates may be required to:
Assess the impact of risk and materiality on the engagement plan, including the nature, timing and
extent of audit procedures, for a given organisation
Discuss the benefits and limitations of analytical procedures at the planning stage
Specify and explain the steps necessary to plan the audit of the financial statements of a non-specialised
profit oriented entity in accordance with the terms of the engagement including appropriate auditing
standards
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Audit and assurance
Section overview
Audits are planned so that auditors know what to do so that the appropriate conclusion can be
drawn.
It is a requirement of BSA 300 that audits are planned.
Audits (and other assurance engagements) are planned because if they are not:
Time might be wasted doing the wrong work
The really important work might not be done at all
Ultimately, the wrong conclusion might therefore be drawn
Planning an engagement is a key aspect of the quality control associated with that audit. If an audit is
planned, then the right work is done, it is easier to supervise and review that work, and therefore it adds to
the quality of the whole engagement.
In addition, as you know from your studies for Assurance, audits are planned because it is a requirement of
auditing standards. BSA 300 Planning an Audit of Financial Statements requires audits to be planned so that
they can be carried out 'effectively'.
Much of the material we look at in this chapter, you have covered in your lower level studies. In this area,
you need to be able to apply your knowledge to the scenarios presented in the exam.
In summary, planning helps the auditor know:
What to do
How much to do
Where to focus resources
What the important matters are that need dealing with
Section overview
The key planning document is called the overall audit strategy.
It covers matters such as materiality, risk, audit approach, use of experts/internal audit, timings, team,
budget and deadlines.
Many audit firms have 'audit packs' containing example audit strategies and plans, but care should be
taken when using them.
The other key document in audit planning is the audit plan.
This is the more detailed document setting out nature, timing and extent of procedures.
As you know from your studies for Assurance, the key planning document is called an overall audit strategy.
This covers the main general areas of planning: materiality, risk, audit approach, use of experts and internal
audit, timing, team, budgets and deadlines.
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PLANNING 7
The technical details of many of these issues will be covered in later chapters.
Most audit firms have 'audit packs' which have a specific planning section and set out the key areas that
auditors must consider when planning an audit. However, care should be taken when using any standard
forms, as there is a risk that matters particular to the client might be forgotten. It is important to tailor the
plan to the client, not the other way around. Identifying key issues relating to the client and then adjusting
the audit approach will be necessary. This is why understanding the business (Chapter 8) and risk
assessment (Chapter 9) are very important.
The overall audit strategy should be updated as necessary during the course of the engagement.
As you also know from your earlier studies, the other key document in audit planning is the audit plan,
which is more detailed that the audit strategy, and sets out the nature, timing and extent of planned audit
procedures (including risk assessment procedures) to fulfil the requirements of the overall audit strategy
and auditing standards.
The audit plan should be updated as necessary during the course of the engagement.
3 Materiality
Section overview
An item is material if its omission or misstatement could influence the economic decisions of users
taken on the basis of the financial statements.
Items might be material by value or nature.
Materiality is a matter of auditor judgement.
You learnt about materiality in your studies for Assurance. The following is therefore revision.
Definition
Material: Information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements. Materiality depends on the size of the item or error
judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a
threshold or cut-off point rather than being a primary qualitative characteristic which information must have
if it is to be useful.
Auditors should consider materiality when determining the nature, timing and extend of audit procedures.
Items might be material due to their:
Amount/value/quantity
Nature/quality
Hence, during planning, the auditors will often set a computed level of materiality, often based on the
following ranges:
Revenue: 0.5% –1%
Profit before tax: 5% –10%
Gross assets: 1% –2%
In addition, some matters might be material by nature, for example:
The CU1 that turns a profit into a loss might be considered very important by some
companies/shareholders
The CU1 that changes the thresholds the company operates in (for example, becoming a medium-
sized rather than small company) might also be very important
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Some matters are automatically material, such as matters relating to directors, or related parties
because these matters have to be disclosed in financial statements regardless of the value of them.
Auditors should always bear in mind that materiality is a matter of professional judgement. Materiality is
also important at the completion stage of an audit, when the auditors are evaluating the effect of discovered
misstatements. We shall look at this in Chapter 12.
4 Analytical procedures
Section overview
Analytical procedures must be used in risk assessment.
The benefits of analytical procedures in planning is the 'overall' perspective, the use of information
outside of the accounting records and the comparison of different elements of the financial
statements.
The limitations of analytical procedures in planning are:
– Substantial knowledge of the business is required for results to be meaningful (therefore
experienced staff may be required to carry them out)
– They can be performed mechanically
– The relevant information may not be available
You looked at analytical procedures in some detail in your studies for Assurance. You should be able to
explain what analytical procedures are and carry out basic analytical procedures. If not, you should refer
back to Chapter 3 of your Assurance manual, which contains a worked example you may like to work
through again.
BSA 520 Analytical Procedures gives guidance. It states that the auditor should use analytical procedures in
risk assessment in order to obtain an understanding of the entity and its environment. We shall look at this
in detail in the next chapter.
In this syllabus you are required to be able to discuss the benefits and limitation of analytical procedures at
the planning stage.
These are the ratios students need for applying analytical procedures.
Performance
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PLANNING 7
Profit before interest and tax 100 Assess profitability after taking
Net margin/operating margin
Revenue overheads into account
Short-term liquidity
Assess ability to pay current
Current ratio Current assets : Current liabilities
liabilities from current assets
Assess ability to pay current
Receivables + Current Investments
Quick ratio liabilities from reasonably liquid
+ cash : liabilities
assets
Long term solvency
Efficiency
Cost of sales
Inventory turnover Assess level of inventory held
Inventories
Trade receivables collection Trade receivables 365 Assess ability to turn
period Revenue receivables into cash
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Summary
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PLANNING 7
Self-test
Answer the following questions.
1 State why audits are planned.
2 Why should care be taken if using a standardised audit pack?
3 Give an example of an item being material by its nature.
4 Analytical procedures should be carried out by an audit junior.
True
False
Exam-style questions
5 The gross profit percentage in your client’
s draft financial statements is the same as in the previous
year.
What further information would you require in order to use this fact at the planning stage of the
audit? (1 mark)
6 Described below are situations which have arisen in three audit clients of your firm. The year end in
each case is 31 March 20X6.
Jay Ltd ('Jay')
The directors have included the following note to the financial statements for the year ended
31 March 20X6:
'Although the company has incurred significant trading losses and cash outflows during the last two
years, the directors believe that the effects of internal restructuring and corporate disposals
undertaken will bring about improved results as indicated in the detailed profit and cash flow forecasts
for the period to the end of March 20X7. These forecasts indicate that the company will be able to
trade within its agreed working capital facility for at least the next 12 months from the date of this
report. Considerable progress has been made on the financial restructuring of the company.
On the basis of the above factors the directors consider it is appropriate that the financial statements
are prepared on the going concern basis. Should the company fail to meet its forecasts, the going
concern basis may prove to be inappropriate. In such circumstances adjustments are likely to have to
be made to the net assets shown in these financial statements to reduce assets to their recoverable
amounts, to reclassify non-current assets and payables due after more than one year to current assets
and current liabilities and to provide for further liabilities that may arise.'
Finch Ltd ('Finch')
Finch has included the results of Wren Ltd ('Wren'), a subsidiary, in the consolidated financial
statements. Wren is audited by a different firm of auditors who have modified their opinion on Wren's
financial statements for the year ended 31 March 20X6 because a fire at the company's premises
destroyed the physical inventory count sheets which were the only record of the year end inventory.
Wren has included inventory at its estimated cost of CU500,000 in the financial statements for the
year ended 31 March 20X6.
The consolidated pre-tax profit of Finch is CU33.4 million and the pre-tax profit of Wren is CU1.2
million for the year ended 31 March 20X6.
Sparrow Ltd ('Sparrow')
On 30 April 20X6, the board of directors decided to undertake a restructuring programme which
would commence in June 20X6. A provision of CU1.8 million in respect of the restructuring costs has
been included in the financial statements for the year ended 31 March 20X6.
The pre-tax profit of Sparrow for the year ended 31 March 20X6 is CU7.2 million.
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Requirements
(a) Discuss what is meant by the concepts of materiality and a true and fair view. (6 marks)
(b) Explain why there can be difficulties for auditors regarding materiality and true and fair in relation
to the three cases above: Jay, Finch and Sparrow. (6 marks)
(12 marks)
7 Your firm has recently been appointed as auditor of Jog Ltd ('Jog'), a company operating within the
sports and leisure sector. Your audit manager has arranged a meeting with the company's finance
director for early next week and she has asked you to assist her, in advance of this meeting, with the
audit planning for the year ending 30 June 20X6. Your audit manager has also asked you to carry out
some preliminary analytical procedures on the year-end financial statements of Jog when these become
available.
Jog's business can be split into the following three divisions
Sports equipment retail outlets: 35 sports equipment retail outlets located in 'out of town' retail
parks
Fitness clubs: 15 fitness clubs, each offering a fully equipped gym together with yoga, aerobics, and
circuit training classes
Machine manufacture: a manufacturing unit in which running machines and rowing machines are
assembled using components sourced from overseas.
Further information:
Sports equipment retail outlets
The retail outlets are all located close to major towns and cities throughout the whole of Bangladesh.
Each outlet stocks a standard range of products which are supplied from a central warehouse
operated by Jog. Salaries for the core staff at the outlets are paid by Jog's head office by direct bank
transfer. Each outlet is run on a day-to-day basis by a manager who is responsible for hiring casual staff
to cover peak periods. These casual staff members are generally paid using cash from the till.
Jog received some bad publicity during the year following its inclusion in a television documentary
which revealed that one of its non-Bangladesh sports shoe suppliers was making its employees work
long hours for very low wages. In an attempt to manage this adverse press attention, Jog has now had
to source these products from alternative suppliers based in Bangladesh.
Fitness clubs
Jog's 15 fitness clubs are all located directly above existing Jog retail outlets. Each club has its own on-
site manager and is operated independently of the adjacent retail outlet. Customers of the fitness clubs
pay by one of three methods: on a 'pay per session' basis over the fitness club counter; by monthly
direct debit paid into Jog's head office bank account; or by annual subscription to head office.
Customers are then issued with a membership card which enables them to gain access to the club.
The company operates a bonus incentive scheme for the managers at both its retail outlets and fitness
clubs. The size of the bonus is linked to the profitability of their individual operation.
Machine manufacture
During the year Jog started to manufacture its own running machines and rowing machines. It sources
the machine components from China and Taiwan. These components are assembled in Bangladesh at
Jog's factory for sale both in Jog's own stores under their own 'Jog' brand and also to independent
sports shops under the 'Iron Champ' brand. The latter accounts for approximately 80% of Jog's total
production of both running and rowing machines. Sales to independent sports shops achieve a gross
profit margin of 50%, whereas sales to Jog's own shops are made to that division at cost plus 10%.
Jog is invoiced by its non-Bangladesh component suppliers in their respective local currency. The
components are sent by sea, which means that Jog's typical lead time for components from the placing
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PLANNING 7
of an order to delivery in Bangladesh is three months. Jog is required to pay its suppliers 50% with
order and 50% upon receipt of the components in Bangladesh.
Quality control
In line with your firm's system of quality control, procedures were conducted prior to accepting Jog as
an audit client, to ensure that it was appropriate to accept such an appointment. Your audit manager
has asked you to consider the other objectives of a system of quality control and why they may be
particularly relevant to Jog.
Requirements
(a) (i) List, with reasons, the information you would require in order to carry out analytical
procedures on the draft financial statements of Jog for the year ending 30 June 20X6.
(ii) Set out the limitations of using analytical procedures at the planning stage of an audit.
(8 marks)
(b) Identify which of the circumstances outlined above, should be taken into account when planning
the audit of Jog. Explain clearly why these matters are important and set out their effect on your
proposed audit work. (24 marks)
You attempted Part (c) of this question (for 8 marks) in Chapter 5.
(32 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
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Technical reference
5 Materiality
Concept of materiality BSA 320.4 –7
When materiality is relevant BSA 320.8
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PLANNING 7
Answers to Self-test
1 To ensure that the right work is carried out resulting in the right conclusion being drawn.
2 It is important for the audit plan to be tailored to the client.
3 Examples include:
Related party transactions
Directors' transactions
CU1 that makes a company small/medium/large
CU1 that turns a profit into a loss
4 False, as experience and understanding are required to carry out analytical procedures properly.
Exam-style questions
5 Client’
s expectation of GP%
Changes in year that affect GP%
6 (a) Materiality
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements.
Materiality
Is not capable of mathematical definition
Can be quantitative (size) or qualitative (nature)
May be considered in the context of any individual primary statement within the financial
statements or of the individual items included within them
Depends on the size of the item or error judged in the particular circumstances of its
omission or misstatement.
True and fair
True is generally accepted as meaning in accordance with the facts and fair as meaning objective
or unbiased and concerned with the presentational aspects of information including substance
over form. True and fair is not defined by statute; however, Counsel’s opinion is that financial
statements prepared in accordance with BASs will give a true and fair view. Furthermore, there
may be more than one true and fair view for a given set of circumstances.
The concepts of materiality and true and fair require the exercise of professional judgement.
(b) Jay
Materiality/true and fair
The difference between the figures prepared on each basis may not be significantly different.
However, the effect on the business is so significant that the user needs to be made aware of the
situation. The auditor needs to judge whether the disclosures are sufficient for the user to
understand the circumstances.
Finch
Materiality/true and fair
Although material to Wren as 42% of pre-tax profits, it is unlikely to be considered material in
the context of the consolidated pre-tax profit as it is only 1.5% of consolidated pre-tax profit.
Materiality should be considered in the context of the entity on which the auditor is reporting.
However, it may be material by nature if a key ratio (e.g. current ratio) is affected.
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Sparrow
Materiality/true and fair
There is no obligation at the balance sheet date in respect of restructuring costs. The financial
statements therefore do not comply with BASs as they include a provision in respect of
restructuring costs. The amount of the provision for restructuring costs is considered material by
size as it is 25% of pre-tax profit, thereby exceeding the commonly used yardstick of 5-10% of
pre tax profit.
7 (a) Information required
Individual income statements and split of the balance sheets for each division are required. Each
division has different profit margins and the split of the balance sheet figures will enable the
calculation of inventory and trade receivable days for each division.
Budget information for each division is required, together with the date from which the machine
division commenced trading, so that its figures can be adjusted to take account of a trading
period of less than one year. Comparative information by division from Jog’ s previous financial
statements will also be needed. This information will allow actual and budget performance to be
compared. This could identify material or significant items, potential misstatements or variations
from expected results.
If available, financial information from companies in the same industries could be used to identify
where the company has performed well or badly and prompt areas for further enquiry by the
auditor.
Limitations of using analytical procedures
One limitation of analytical procedures at the planning stage of an audit is that the auditor needs
a good understanding of the business to interpret the results of analytical procedures. If analytical
procedures are performed mechanically, a consistency of results from one year to the next may
in fact conceal a material error which may not be identified. Effective analytical procedures need
to be carried out by experienced members of staff and they rely upon good quality and reliable
information being available from the client which may not always be available.
(b) This is a new audit client which means that there is a lack of cumulative prior knowledge which in
turn increases the risk of an undetected misstatement in the financial statements. The audit work
will include an evaluation of the company’s accounting systems and internal controls in addition
to consideration of opening balances. Adequate planning will be essential to avoid over-auditing in
the first year.
The company operates from 35 locations at which it holds material balances of inventory and
non-current assets. The risk of a breakdown in head office controls is higher in multi-site
locations. The year-end attendance at inventory counts should cover all material locations and it
would be efficient to take the inventory count attendance as an opportunity to inspect material
non-current assets and carry out selected cash counts. If the audit approach relies upon controls,
it must be ensured that the tests of controls sample covers all material locations.
The company makes cash sales in its retail outlets and fitness clubs and it pays its casual staff in
cash. Cash transactions increase the risk of misappropriation of cash and the understatement of
revenue in the financial statements. The employment of casual staff may also mean that the
company is failing to declare the appropriate amounts of withholding tax, which could lead to
penalties from the tax authorities. The effect of this on the audit work is that controls over cash
must be evaluated and audit effort should be directed to confirming the completeness of
recorded sales. In addition, the company’ s compliance with withholding tax regulations should be
considered and the wages included in the financial statements should be checked to ensure that
this agrees with the company’ s payroll records.
The company has received adverse publicity over the use of “ sweatshops” . This may damage the
reputation of the company which could in turn affect the status of Jog as a going concern. The
audit work should attempt to assess the effect of the publicity on Jog’ s business. The cost
implications of the switch by Jog to alternative suppliers in Bangladesh also need to be considered
as part of the audit work.
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PLANNING 7
Jog fitness clubs receive annual subscriptions which may cause revenue to be recognised in the
wrong accounting year. The company’ s accounting policy for revenue recognition will need to be
considered and audit work should include testing of new subscriptions close to the year end to
ensure that an appropriate proportion of income is deferred at the year end.
The company has a profit-related bonus scheme increasing the risk of manipulation of profit by
the company’ s management. Audit work should include checks on income recognition to ensure
it has not been accelerated to boost profits. For similar reasons purchase cut-off should be
checked to identify any potential suppressed invoices.
The company purchases its machine components in a foreign currency, under payment terms
which specify 50% be paid with order. Foreign currency transactions may lead to the incorrect
translation of these transactions in the financial statements. The existence of a three-month
delivery lead time on these transactions may also give rise to adverse foreign currency exposure.
Component payment terms may also lead to cut-off errors arising from incorrect treatment of
the first 50% paid with order. The audit work should include sample checks of the company’ s
foreign exchange translation to an independent source such as the FT. The steps taken to
minimise the company’ s exposure to foreign exchange risk needs to be discussed with
management. Careful consideration should be given to cut-off for any goods in transit at the year
end.
Some of the machines manufactured using imported components are transferred to the
company’ s retail outlets at cost plus 10%. This inter-divisional trading means the value of the
retail outlet inventory may contain some unrealised profit. In addition, the practice of adding only
10% onto the cost price, may cause outlets to under price these products, damaging the gross
profit margin of the company as a whole. The audit approach should ensure all inter-divisional
trading is separately analysed so that any unrealised profit can be identified.
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chapter 8
Introduction
Examination context
Topic List
1 Why?
2 How?
3 What?
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Introduction
Practical significance
It is vital that assurance providers have a good understanding of the entity they are providing assurance to
and the environment in which it operates, or their work could be meaningless. For example, if they
misunderstand the nature of the business, they could miss key risks and items in the financial statements
could be seriously misstated. In addition, if they do not understand their client's business, they will be
incapable of carrying out an audit in accordance with auditing standards, which could lead to negligence
claims.
Working context
If you work in practice, this area will be an important area for you and you are likely to undertake a lot of
work to obtain knowledge about your clients before using that knowledge to assess risks. If you work in
industry, you are likely to be at the opposite end of that process, providing information about your business
to your assurance providers, so that they can provide you with a good service, as may some of your non-
financial colleagues.
Syllabus links
We introduced this topic in Assurance, where you learnt the basic content of BSA 315 Obtaining an
Understanding of the Entity and its Environment and Assessing the Risks of Material Misstatement. In this syllabus
you need to consolidate and build on this knowledge.
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
Examination context
Exam requirements
Understanding the entity is a key component of risk assessment. Risk assessment is the subject of chapter 9,
which is big exam topic.
In the assessment, candidates may be required to:
Explain, in the context of a given scenario, why it is important to have a knowledge and understanding
of the business when planning an engagement
Identify ways of gaining knowledge and understanding of a client's business
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Audit and assurance
1 Why?
Section overview
It is important to understand the client's business:
– In order to assess risk
– In order to comply with auditing standards
You know from your previous studies and from what has already been said in this Study Manual that
assessing risk is very important in assurance engagements.
In general terms, it is clearly impossible to be sure how risky a client may be if you do not understand:
Who they are
What they do
How they do it
Whether there are any special circumstances (like specific laws and regulations) which govern their
business
The integrity and competence of their staff
If you understand a client's business properly you will:
Be able to assess the skills and competence which the audit team needs
Be able to plan your audit work so that it is appropriate and efficient
Be able to assess what controls have been put in place by the client which may reduce the level of
control risk
Be able to assess any significant risks which need special attention
Be able to perform analytical procedures
Comply with professional requirements
Also, assessing risk is compulsory –BSAs 315 and 330 require it.
Finally, consider fraud –understanding the entity may not guarantee that you will uncover a clever, well
laid fraud, but not understanding the entity certainly will guarantee that you have very little chance of finding
it.
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
You would be interested in the ability of its customers to pay, which might mean you would need to
know something about the general state of the economy and whether its customers had cash flow
problems. But on the whole this would be relatively general, background information.
Then Enron starts to buy power production facilities:
How does it finance them?
How is it regulated?
Are there transfer pricing issues?
Then it starts to trade energy (and other things such as cargo space on ships) and this is when it starts to
get tricky! How is your knowledge of:
Swaps
Futures
Options and similar transactions?
Enron starts to use an accounting technique called 'mark to market' whereby its earnings are calculated on
the movements in the market values of its deals, rather than on the traditional combination of invoicing and
cash flows.
What do you know about this technique? It had a material impact on Enron's earnings. (Mark to
market is not in the syllabus –this is simply an example of how a client can become more and more
complex)
Is it being used properly or is it being abused?
Are the assumptions and calculations valid?
Finally we find that Enron is using 'Special Purpose Entities’–usually offshore partnerships in which it has a
significant interest –to hide debt and generate earnings which are highly questionable.
What do you know about the rules for excluding subsidiary undertakings from consolidation? (Again,
do not panic, if you do not know very much about this at this stage –it is simply an example to get
you thinking)
What do you think about the ethics of using techniques which, whilst they may comply with the letter
of the rules, undoubtedly are highly artificial and do serve to conceal debt and generate controversial
earnings?
How would you feel if your firm had either suggested such schemes or been consulted about their
acceptability before the audit had begun?
Source: BBC Money Programme 'Inside the Enron Scandal'
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2 How?
Section overview
Understanding of the client's business can be obtained from:
– External sources of information (such as industry surveys/publications)
– The firm (permanent files (including previous years' audited financial statements),
correspondence files, personnel associated with the engagement in previous years)
– The client (personnel, correspondence/procedures manuals, watching procedures, current year
management accounts)
Auditors are required to carry out a combination of procedures to understand the business:
– Inquiries of client personnel
– Analytical procedures
– Observation and inspection
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
2.4 Summary
Figure 8.1 provides a general summary of how understanding the client's entity can be achieved.
Understanding
the
business
Other
Other
Industry
Industry surveys
surveys
You
Credit
Credit reference
reference agencies
agencies
Past experience
Registrar ofHouse
Companies Joint Stock
The Companies
Internet
The internet
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3 What?
Section overview
The auditors need to understand any aspect of the business which might affect the audit.
BSA 315 contains a detailed list of potential areas to be understood in Appendix 1.
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
– Management
– Systems
– Controls
– Accounting policies
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Audit and assurance
The appendix to BSA 250 gives the following list of indicators of non-compliance:
Investigation by a government department
Payment of fines or penalties
Payments for unspecified services or loans to consultants, related parties, employees or
government employees
Sales commissions or agents' fees that appear excessive in relation to those normally paid by the
entity or in its industry or to the services actually received
Purchasing at prices significantly above or below market price
Unusual payments in cash, purchases in the form of cashiers' cheques payable to bearer or
transfers to numbered bank accounts
Complex corporate structures including offshore companies where ownership cannot be identified
Unusual transactions with companies registered in tax havens
Tax evasion such as the wider declaring of income and overclaiming of expenses
Payments for goods or services made other than to the country from which the goods or
services originated
Payments without proper exchange control documentation
Existence of an accounting system that fails, whether by design or by accident, to provide
adequate audit trail or sufficient evidence
Unauthorised transactions or improperly recorded transactions
Media comment
Transactions undertaken by the entity that have no apparent purpose or that make no obvious
economic sense
Where those charged with governance of the entity refuse to provide necessary information and
explanation to support transactions and other dealings of the company
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
3.4 Fraud
BSA 240 The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements stresses that auditors
have no responsibility for the prevention and detection of fraud as such –that is management's job, but
fraud can have a material impact on financial statements, so it becomes a part of audit after all!
Remember, the BSA makes a crucial distinction between two types of misstatements arising from fraud:
Misstatements arising from fraudulent financial reporting
Misstatements arising from misappropriation of assets
In understanding the client's business there are some key questions that need to be asked:
Can the figures be manipulated and if so how?
Which areas are most susceptible to manipulation?
Can assets be misappropriated and if so how?
Which areas are most at risk?
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Summary
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
Self-test
Answer the following questions.
1 What key knowledge should an audit firm obtain about its client and why is this understanding of the
entity important? (3 marks)
2 G Co is a manufacturing company which has one factory and two warehouse sites. It imports raw
materials from Asia.
What are the key factors the auditors need to consider about G Co and how this may impact their
audit? (3 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied that you have achieved
these objectives, please tick them off.
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Technical reference
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
Answers to Self-test
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Audit and assurance
– Investigations
– Payment of fines/penalties
Unusual transactions/payments
Payments for/of
– Unspecified services/loans
– Excessive commission
Unauthorised/improperly recorded transactions
Accounting system which fails to provide adequate audit trail/sufficient evidence
Fraud/error (BSA 240 Appendix 3)
Unrealistic audit deadlines
Management reluctant to communicate frankly with third parties
Limitation of audit scope imposed by management
Identification of important matters not previously disclosed by management
Significant difficult-to-audit figures
Aggressive application of accounting principles
Conflicting/unsatisfactory evidence
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 8
Unusual
– Documentary evidence (e.g. alterations)
– Transactions/recording thereof
Significant unrecorded differences
Incomplete/inadequate accounting records
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chapter 9
Risk assessment
Contents
Introduction
Examination context
Topic List
1 Business risk
2 Audit risk
3 Assessing the risks of material misstatement
4 Significant risks
5 Documentation
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Audit and assurance
Introduction
Practical significance
We have already focused on the importance of risk to auditors.
Working context
If you work in audit, you will carry out risk assessment procedures at some point in your career. If you
work in industry, you should see this in practice, as assurance providers carry out risk assessment
procedures in your business.
Syllabus links
Risk assessment has already been covered in some detail in the Assurance syllabus. At this Application level,
the key issue is being able to carry out risk assessment, that is, identify and assess, not merely understand
the components of risk and be able to identify them.
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RISK ASSESSMENT 9
Examination context
Exam requirements
Risk assessment is a very important area for your exam. There were 24 marks available in the 40 mark
question in the sample paper for risk assessment.
In the assessment, candidates may be required to:
Identify the risks arising from, or affecting, a given set of business processes and circumstances and
assess their implications for the engagement
Identify the risks arising from error, fraud and non-compliance with law and regulations and assess
their implications for the engagement
Assess the significant business risks identified for their potential impact upon an organisation, in
particular, their potential impact on performance measurement
Identify the components of risk for a specified assurance engagement
Identify the components of risk for a specified audit engagement, including the breakdown of audit risk
into inherent risk, control risk and detection risk
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1 Business risk
Section overview
There are three general categories of business risk:
– Financial risk
– Operational risk
– Compliance risk
Definitions
Business risk is the risk inherent to the company in its operations. It includes risks at all levels of the
business. There are three general categories of business risk:
Financial risks are the risks arising from the financial activities or financial consequences of an
operation, for example, cash flow issues or overtrading
Operational risks are the risks arising with regard to operations, for example, the risk that a major
supplier will be lost and the company will be unable to operate
Compliance risk is the risk that arises from non-compliance with laws and regulations that surround
the business, for example a restaurant failing to comply with food hygiene regulations might face fines,
enforced closure, legal action from customers and so on.
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RISK ASSESSMENT 9
2 Audit risk
Section overview
There are three components of audit risk:
– Inherent risk
– Control risk
– Detection risk
You have already covered audit risk (the risk of giving an inappropriate opinion in relation to the financial
statements) in detail.
Remember that it has three components:
Inherent risk
Control risk
Detection risk
Definition
Inherent risk is the susceptibility of an assertion to misstatement that could be material, individually or
when aggregated with other misstatements, assuming that there were no related internal controls.
In other words, how likely is it that, the account balance or transfer will be wrong? And how likely is it that,
as a result, the financial statements will be misstated by a material amount? Inherent risk can be analysed on
a number of levels which are covered in turn below.
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Remember that the inherent risk attached to different sectors changes over time –for example yesterday’
s
dot com industry, the day before's biotechnology.
Definition
Control risk is the risk that a misstatement that could occur in an assertion and that could be material,
individually or when aggregated with other misstatements, will not be prevented or detected and corrected
on a timely basis by the entity's internal control.
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RISK ASSESSMENT 9
Circumvention by collusion
Changes in procedures
Definition
Detection risk is the risk that an auditor’ s procedures will not detect a misstatement that exists in an
assertion that could be material, individually or when aggregated with other misstatements.
It is up to the auditor to organise the way the engagement is handled, so that the risk of material
misstatement is reduced to acceptable levels.
This will include:
Ensuring the audit team (including the engagement partner) has the necessary mix and depth of
experience and skills
Devising an audit plan which tackles the audit risks
The audit approach (which we shall look at in Chapter 10) is the way in which the auditor assembles
sufficient audit evidence to build up a satisfactory level of audit confidence, and which can come from tests
of controls, analytical procedures and tests of details.
Because the auditor cannot check every transaction, audit work is carried out on a test basis. The auditor
will select a sample.
The possibility that the opinions you form, perfectly validly, from the results of your sample, are different
from those you would have formed if you had been able to examine the whole population is called
sampling risk.
Non-sampling risk is the possibility of coming to the wrong conclusion about the financial statements for
any other reason, for example
Lack of understanding of the nature of your client’ s business
Use of invalid sampling techniques
Failure to investigate a particular class of assets, liabilities or transactions
Section overview
The best way to learn the skill of identifying and assessing risk of misstatement is to practice doing it
in exam questions.
Work through the following example, and then try the interactive questions.
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RISK ASSESSMENT 9
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4 Significant risks
Section overview
Significant risks are referred to in BSA 315.
Significant risks are items that are unusual or one-offs.
Definition
A significant risk is a risk which requires special audit consideration.
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RISK ASSESSMENT 9
Of course, remember that what is unusual for one company is not necessarily unusual for another. Hence,
we are reminded of the importance of knowledge of the particular business being audited.
5 Documentation
Section overview
BSAs 315 and 330 contain a number of requirements regarding documentation.
You know about the need for auditors to document their audit work from your Assurance studies. BSAs
315 and 330 contain a number of requirements about documentation, and we shall briefly run through
those here.
The following matters should be documented.
The discussion among the audit team concerning the susceptibility of the financial statements to
material misstatements, including any significant decisions reached
Key elements of the understanding gained of the entity including the elements of the entity and its
control specified in the BSA as mandatory, the sources of the information gained and the risk
assessment procedures carried out
The identified and assessed risks of material misstatement
Significant risks identified and related controls evaluated
The overall responses to address the risks of material misstatement
Nature, extent and timing of further audit procedures linked to the assessed risks at the assertion
level
If the auditors have relied on evidence about the effectiveness of controls from previous audits,
conclusions about how this is appropriate
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Summary
Self-test
Answer the following questions.
1 As part of the audit planning for a client the auditor has evaluated the components of audit risk,
namely, control risk, detection risk and inherent risk.
His tests of controls reveal deficiencies in the operation of the system of internal control, and he is
now reassessing the risks to the audit.
Since control risk has increased, describe the effect of this on the other components of risk.
2 What is the meaning and implication of high inherent risk?
3 What is the meaning and implication of high detection risk?
4 If an auditor decides that an acceptable level of audit risk is 5%, what does this mean?
5 Auditors should plan and perform their audit procedures recognising that fraud and error may
materially affect the financial statements.
Give four examples of indicators in a business that the risk of fraud and error may be high.
6 Earthmovers Ltd is a civil engineering company that provides a pipe-laying service to the energy, water
and telecommunications industries. It uses much heavy plant and machinery, and is subject to the strict
provisions of health and safety at work regulations.
Identify the risks to which breaches of these regulations could expose the company, and the
implications for the audit in the event of such breaches.
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RISK ASSESSMENT 9
Exam-style questions
7 Your new client, Wheeler Ltd, sells new cars, parts and accessories and undertakes workshop repairs.
The company operates through five divisions/locations in the Midlands.
Each division deals with a different overseas vehicle supplier and has three managers, one for each
trading activity. Each division makes sales to companies and individuals, but only corporate customers
are granted credit terms.
The computer-based accounting system is based in the head office which is annexed to the premises of
the largest division. All nominal ledger codes are suffixed 1 to 5 to identify each division’
s transactions.
Detailed inventory records include dates of movements, original purchase price and latest selling price.
Purchase requisitions are computer-generated when inventory line quantities fall to pre-determined
re-order levels.
Gross selling prices for cars and parts are established on receipt of each consignment at standard
markups on cost, as specified in the franchise agreements with each manufacturer. Parts transferred to
workshops are charged at cost plus 10%.
At the end of each month the computer generates trading and profit and loss accounts and balance
sheets for each division, and 'consolidated' results for the company.
New car sales managers prepare monthly returns showing the number of cars sold, gross selling
prices, extras and discounts.
All salaries and wages are processed centrally at head office. Divisional managers all have profit-related
bonus incentives.
Requirement
Identify, from the situation outlined above, circumstances particular to Wheeler Ltd that should be
taken into account when planning the audit. Explain clearly why these matters should be taken into
account and set out the effect on your audit approach. (20 marks)
8 Golden Pond Fisheries
Richard Pine is a senior audit manager for Ratcliffe, Barnes and Soammes, a firm with offices around
Birmingham and Exeter. These split locations have arisen from the merger two years previously of
Barnes, Soammes & Co (Birmingham), a firm specialising in the audit of property and service
companies, with Ratcliffe & Co whose fee income was based on the audit of farms and holiday resorts
in the South West. The merger was seen as an opportunity for both firms to break away from their
restricted markets.
Richard moved from Birmingham to take up a new portfolio of clients in Cornwall and Devon,
including Golden Pond Fisheries Ltd. This is a family business with John Carnes running the 80-acre
farm, and his wife, Claire, taking responsibility for the holiday cottages, fishing lakes and completion of
the books and records.
The farming operation has been significantly curtailed in recent years and now comprises a small beef
herd and, as a recent addition, two geese sheds. These birds are fed on a chemical-free diet to offer a
high quality alternative to turkeys over the Christmas period. John supplements the farm revenue by
letting pastures on a rotational basis to neighbouring farms for sheep grazing.
John is also considering the introduction of rare breeds (pigs and goats) to provide an additional
attraction to holidaymakers with young families.
Claire Carnes trained as a bookkeeper before her marriage 30 years ago, and has informed Richard
that the accounts are now maintained to a 'high standard' on her son's PC. This has apparently saved a
lot of time, and much of the previous paperwork is now superfluous.
Five years previously the family had borrowed a substantial sum to convert three derelict barns into
luxury holiday cottages, and these have proved to be a huge success, being fully booked from late May
to November. During this period two extra helpers are employed on a part-time basis to assist with
cleaning and maintenance. Both are paid in cash at the end of each week.
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Most of the visitors are fishermen and their families, as the farm boasts excellent fishing. John Carnes
is keen to maintain this quality and is always on the lookout for big fish to stock. He has recently
become interested in the possibility of introducing from China some 60lb blue carp, which could be
'sneaked in' with a batch of koi carp being imported for a local garden centre.
A good relationship has always existed with the auditors and the Carnes are confident that this will be
another quick audit.
Requirement
Identify, from the information above, the potential audit risks, and for each risk explain why it is a risk.
(14 marks)
9 Shades Ltd
You are planning the audit of Shades Ltd for the year ending 30 June 20X9. The principal activities of
the company are the manufacture and distribution of a range of window blind systems and of the
component parts for window blinds. Approximately 50% of revenue is generated from overseas
customers.
During your preparation for the planning meeting with the finance director, the following matters have
been highlighted as significant.
(1) Operating results
The company has had a successful year to date with revenue, gross and operating margins up on
the previous year.
10 months to 10 months to Year to
30 April 30 April 30 June
20X9 20X8 20X8
CU'000 CU'000 CU'000
Revenue 22,656 19,597 22,557
Cost of sales 13,367 12,472 14,313
Gross profit 9,289 7,125 8,244
Operating expenses 4,531 4,115 4,732
Operating profit 4,758 3,010 3,512
Gross profit margin 41% 36% 37%
Operating profit margin 21% 15% 16%
Inventories at 30 April 20X9 were CU4.3 million compared with CU3.6 million at 30 April 20X8
and CU3.4 million at 30 June 20X8.
(2) New computer system
During the year the company replaced its accounting software with a fully integrated standard
package modified by the supplier to the company’
s requirements.
(3) Incentive scheme
During the year the company introduced an incentive scheme under which the executive
directors are entitled to a bonus based on pre-tax profits. The bonus will be paid thirty days after
the audited accounts are available.
Requirement
In respect of the above, identify and explain the potential audit risks and indicate the matters you
would discuss with the finance director at your planning meeting. (20 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
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Technical reference
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Answers to Self-test
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RISK ASSESSMENT 9
Exam-style questions
7
Circumstance Why taken into account Effect on audit approach
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RISK ASSESSMENT 9
Sales are made A breach of franchise This aspect of inherent risk must
under franchise terms and conditions be assessed, e.g.
agreements with (e.g. concerning
– If low, there may be no
each prescribed mark-ups)
implications for the financial
manufacturer. could bring penalty
statements (e.g. any
clauses into effect.
contingent liability may be
disregarded as being remote)
– If high (see also management
bias) a provision for penalties
could be required.
The appropriateness of the going
concern assumption should be
considered in the light of
– Any known breaches
– Foreseeable renewals.
Monthly accounts These indicate a control- The disaggregated financial
and returns are conscious head office to information (by divisions and
prepared mitigate the inherent risk certain activities) should highlight
attributable to divisional key audit areas and fluctuations
operations. requiring investigation.
For analytical procedures on the
company’ s 'consolidated' accounts,
the inter-divisional trading and
balances must be eliminated.
Divisional Inherent risk is increased This bias may reduce other aspects
managers have by possible management of inherent risk (e.g. of loss of
profit-related bias to overstate profit cash/inventory through unrecorded
bonus incentives. by sales).
– Overstating sales Risk of sales overstatement may
not be great, since
– Understating
expenses. – Maximum prices set by
franchise agreement, and
– Market is fiercely competitive
at present time.
Risk of expense understatement is
restricted (e.g. because head office
controls payroll expenditure).
Audit tests should be directed to
most likely area of misstatement
(e.g. cut-off 'errors' arising through
suppression of invoices).
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Audit and assurance
Richard Pine, the new audit Errors in the financial statements may be missed
manager is from the property and due to Richard’ s non-familiarity with the Carnes’
service client base. business.
The Carnes are expecting 'another Richard is likely to need to carry out more work
quick audit'. than usual to become familiar with the client. This
may be interpreted by the Carnes as mistrust, with
the consequence that they are reluctant to
volunteer assistance.
The business is run and managed There is limited scope for supervisory or
by a husband and wife team. authorisation controls and segregation of duties.
Those controls in place are likely to be unreliable
due to the risk of management override.
There has been a loss of revenue The loss of revenue from the original business may
from the original farming threaten the viability of the farm as a going
operations, which the Carnes are concern.
addressing by diversification.
Although the Carnes are addressing this by
diversification, the process of change also carries a
risk as it involves adapting to new markets and
learning new skills.
The Carnes are raising organically This source of revenue assumes that customers of
fed geese as an alternative to the meat distributors used can be persuaded to
turkey. change from the traditional turkey. There is a
significant possibility that this market will not
materialise.
Organic food supplies for the geese will carry a
higher price tag. There is no evidence to suggest
that John Carnes has evaluated if this cost can be
recouped. It is possible that in spite of generating
revenue the sale of geese may realise no overall
profit.
This is a markedly seasonal business. Income will
have ceased before the first holidaymakers arrive
in May, thereby putting a strain on the servicing of
debt.
Pastures are being let for sheep If John Carnes has entered into contracts for the
grazing. supply of grazing, this could prohibit future
expansion of holiday/fishing facilities by restricting
the availability of land.
As these are the most successful elements of Gold
Pond Fisheries Ltd, their curtailment could
threaten the going concern status of the company.
If no such contracts exist, then grazing revenues
could cease at any time –there is no evidence that
such a prospect has been considered.
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RISK ASSESSMENT 9
John Carnes appears to imply that Any such breach of import regulations when
blue carp are to be imported discovered will result in severe penalties, extending
illegally. to fines, quarantine of inventories, etc.
The consequence would be a loss of revenue and
reputation in the core business.
The importing of alien species will threaten existing
inventories with diseases and parasites to which
they are not resistant.
Holiday cottages are a seasonal Cash flows will fluctuate widely over a 12 month
business. period. This places strain on debt repayment terms
and going concern.
The development of the holiday Financing a business by way of borrowing always
cottages was financed by carries the risk that repayment of capital and
borrowing. interest does not cease in less successful periods.
The provider of finance will want to review the
financial statements, increasing the risk of
management bias in preparing the financial
statements to show a favourable position.
Accounting records are maintained The use of a PC, with its associated risks of data
on a PC. corruption and lack of sufficient controls, increases
risks re the completeness and accuracy of
accounting records.
The amount of paperwork has Audit trails may be lost without hard copies,
decreased. increasing the risk that insufficient evidence will be
available.
Data has recently been transferred Increased risk of errors due to inaccurate transfer
to the computer system. of data onto the PC.
Claire trained as a bookkeeper 30 Claire’s bookkeeping training may prove to be of
years ago. limited advantage as there has been a significant
amount of change over recent years. Again, this
reduces confidence in the accuracy of the financial
statements.
Part-time staff are employed for six It is important to ensure that these individuals
months of the year and are paid in appear on the payroll, and that withholding tax
cash. regulations have been complied with.
Insufficient records may be available due to the
cash nature of transactions.
The current audit firm has resulted It will take time to create and adopt a truly
from a merger of two firms with uniform audit approach, and this will increase the
very different client bases from detection risk associated with all work undertaken.
different parts of the country.
This arises from non-familiarity, and increases the
risk of procedures being omitted or conducted
inefficiently.
Mergers of any type always create the risk of
'culture clashes', and this can reduce the efficiency
of audit work undertaken.
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9 Shades Ltd
Manufacturing company
Inventories may be materially The methods used by the company to determine
misstated due to difficulties in the stage of completion and valuation of WIP.
estimating the degree of completion
The NRV of window blind systems awaiting sale
of work in progress (WIP).
or installation.
Estimating the net realisable value
(NRV) of certain window blind
systems.
Overseas customers
Sales in foreign currencies may not The rate used to translate transactions on
be translated at an appropriate rate, foreign currencies.
resulting in revenue and receivables
The procedures adopted to ensure compliance
being misstated in the financial
with accounting standards.
statements.
Bad debts
There may be insufficient provision The techniques used to assess credit worthiness
made for bad debts as a result of of customers, particularly those based overseas.
increased difficulties in assessing
Method used to monitor and chase slow payers.
credit worthiness and recoverability
for overseas customers. Whether there are any known bad or doubtful
debts.
The reasons for any seasonal variations within
the company’ s sales.
The methods of managing cash flow and working
capital to address the impact of seasonal
variations.
Seasonal business
Misstatements in monthly revenue
and expenditure figures may be more
difficult to detect as a result of
seasonal variations in the business.
Revenue growth
Revenue may be overstated. The The reasons for the increase in revenue this
increased volume of sales may period.
increase the extent of errors arising
Whether any noticeable increase in error rates
within the accounting records.
within the accounting records has occurred.
Gross profit increase
Gross profit may be overstated as a The reasons for the increase this period.
result of items in transit to overseas
Procedures used to ensure that transactions just
customers being included in both
before or after the year end are recorded in the
year end inventories and revenue
correct accounting period.
purchases being understated.
How adequate provision is made for purchases,
particularly those invoiced post year end.
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Audit and assurance
This is the first year that the In order to be satisfied about the previous financial
firm has undertaken the audit statements
of Vax Ltd.
– Hold consultations with management
– Review client’
s records, working papers and accounting
and control procedures for the previous period
– (Possibly) hold consultations with the previous auditor.
Familiarisation with the nature of the business, market,
accounting systems etc by
– Discussions with management
– Review of interim/management accounts.
Vax Ltd has Staff must be planned to carry out the audit from the firm’
s
offices throughout the country.
– A head office in
Manchester They must all be adequately briefed and provided with a
copy of the audit plan detailing their specific tasks and
– A factory in Liverpool
deadlines.
– Ten depots throughout
the country.
No inventory records have It is vital that the auditors are satisfied with the inventory
been maintained but a full count.
inventory count is to be
The written count instructions must be reviewed well in
carried out at the year end.
advance of the year end, so that improvement can be
suggested by the auditors and incorporated into the client’
s
instructions.
The auditors should ensure that sufficient staff with the
necessary experience are available to attend the count at all
material locations.
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190 © The Institute of Chartered Accountants in England and Wales, March 2009
chapter 10
Audit approach
Contents
Introduction
Examination context
Topic List
1 Responding to the risk assessment
2 Reliance on controls
3 Substantive approach
4 Reliance on the work of others
5 Practical issues
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Audit and assurance
Introduction
Understand when an auditor may rely on the work of others as part of the audit
Identify practical issues that need to be included in the overall audit strategy
Specific syllabus references for this chapter are: 3g, i.
Practical significance
The importance of audit approach is two-fold:
It is important for an audit firm that its audits are carried out in accordance with professional
standards
How the tests used impact on audit cost
Working context
While training in practice, trainees are unlikely to be involved in the judgements going into audit approach.
However, as you progress in your career, you may become more involved in making such judgements. If
you work in industry, you will see the impact of the approach the auditors are using from the other side.
Syllabus links
This area was introduced, in connection with evidence, in Assurance.
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AUDIT APPROACH 10
Examination context
Exam requirements
In the exam, you could be asked to identify risks and then justify an approach towards those risks.
In the assessment, candidates may be required to:
Assess the impact of risk and materiality on the engagement plan, including the nature, timing and
extent of assurance procedures, for a given organisation
Determine an approach appropriate for an engagement for a specified organisation which addresses:
– Possible reliance on controls (including those within the IT system)
– Possible reliance on the work of internal audit or other experts
– Possible reliance on the work of another auditor
– Probable extent of tests of controls and of substantive procedures, including analytical
procedures
– Nature and extent of client-generated information
– Probable number, timing, staffing and location of assurance visits
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Audit and assurance
Section overview
The auditor must formulate an approach to assessed risks of material misstatement.
Overall responses include issues such as emphasising to the team the importance of professional
scepticism, allocating more staff, using experts or providing more supervision.
The auditor must also determine further audit procedures to address the risks of material
misstatement.
There are three sources of audit confidence: tests of controls, tests of details and analytical
procedures.
Remember, some substantive procedures (that is, tests of details and/or analytical procedures) must
be carried out.
The main requirement of BSA 330 The Auditor's Procedures in Response to Assessed Risks is 'In order to reduce
audit risk to an acceptably low level, the auditor should determine overall responses to assessed risks at the
financial statement level, and should design and perform further audit procedures to respond to assessed
risks at the assertion level'.
In other words, having assessed the risks of material misstatements in the financial statements, the auditor
has to plan the work that will be carried out to ensure that he can draw a conclusion about whether
the financial statements give a true and fair view, that is, that any material misstatements have been
identified and amended if necessary.
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AUDIT APPROACH 10
Tests of Analytical
details procedures
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Audit and assurance
In practice you are likely to do a combination of all three. Auditing standards require you to carry out some
substantive procedures (tests of details or analytical procedures). Carrying out some controls testing
reduces the amount of substantive testing to be carried out. The precise mix changes depending on the
nature of the client:
For a small scale client at a single location it may be just as efficient to observe the inventory count
and to carry out a number of test counts as it is to spend a great deal of time evaluating the system, or
calculating ratios. You will be relying on controls such as the reliability of the inventory checkers to a
limited extent, but you will also have a good deal of confidence about the final figure deriving from the
substantive work you have done; i.e. your own test counts.
For a large national building supplies company with a large number of depots, you are likely to rely to a
greater extent on your assessment of controls and analytical review.
You may be tempted to say that, with all those depots, it would be simply impossible to visit them all.
However, this is not the appropriate reason for your chosen audit approach. What matters is the level of
risk and reducing it to an acceptable level. If the only way to be confident enough that there are no material
errors in the inventory figure was to attend all the depots, then that is what you would have to do.
However, in order to control a business of that size management will need to have installed systems and
controls, so rather than attend all the depots and test count everything yourself, assuming the controls
appear capable of being effective, you can chose to rely on them and test that they are effective.
For a business such as a software company or a consultancy business, where the 'inventory' is going to
consist of people’ s time costs carried forward to be amortised against sales in future periods, you are
likely to rely to a very large extent on analytical review for your audit confidence.
2 Reliance on controls
Section overview
The auditors carry out tests of controls when:
– They are intending to rely on controls
– They are unable to derive sufficient evidence from substantive procedures
In summary, BSA 330 says that if auditors want to rely on a control:
– They have to test it
– The have to obtain evidence that it is effective
– They have to obtain evidence that it operated throughout the period under review
– They have to flex their approach in accordance with the nature of the control and the risk it is
seeking to mitigate
BSA 500 says auditors need to carry out tests of controls under two sets of circumstances:
When they are intending to rely on controls to reduce audit risk
When they are unable to derive sufficient evidence from substantive procedures.
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Audit and assurance
(b) The supervisor has also asked you to explain some internal control terminology which she does not
understand.
Explain the meaning of the following terms, using payroll examples different from those you have given
above.
(i) Segregation of duties
(ii) Approval and control of documents
See Answer at the end of this chapter.
3 Substantive approach
Section overview
Substantive procedures constitute tests of details and/or analytical procedures.
Auditors always carry out a number of substantive procedures.
The number of substantive procedures carried out will depend on the level of risk, the amount of
reliance on controls and the results of controls testing.
As you know, substantive procedures fall into two categories: analytical procedures and tests of details.
The auditor must always carry out substantive procedures on material items.
BSA 330 says 'irrespective of the assessed risk of material misstatement, the auditor should design and
perform substantive procedures for each material class of transactions, account balance and disclosure'.
In addition, the auditor must carry out the following substantive procedures:
Agreeing the financial statements to the underlying accounting records
Examining material journal entries
Examining other adjustments made in preparing the financial statements
The auditor must determine when it is appropriate to use which type of substantive procedure.
Analytical procedures tend to be appropriate for large volumes of predictable transactions (for example,
wages and salaries). Other procedures (tests of detail) may be appropriate to gain information about
account balances (for example, inventories or trade receivables), particularly verifying the assertions of
existence and valuation. Substantive procedures were covered in detail in your studies for Assurance.
Tests of detail rather than analytical procedures are likely to be more appropriate with regard to matters
which have been identified as significant risks, but the auditor must determine procedures that are
specifically responsive to that risk, which may include analytical procedures. Significant risks are likely to be
the most difficult to obtain sufficient appropriate evidence about.
How much substantive testing is carried out will depend on:
Whether the auditor wants to rely on controls in the first place (in which case substantive testing
might be reduced)
Whether controls testing reveals that controls can be relied on (if they cannot, the auditors will have
to increase substantive testing)
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Section overview
External auditors may make use of work internal audit have done when carrying out their own
external audit procedures.
External auditors may make use of the work of an expert when carrying out audit procedures.
Principal auditors have a duty to report on the truth and fairness of group accounts.
Principal auditors have the right to require from auditors of subsidiaries the information and
explanations they need, and to require the principal company to obtain the necessary information and
explanations from subsidiaries.
Principal auditors should consider whether their involvement in the group audit is sufficient for them
to act as principal auditors.
Organisational Consider to whom internal audit reports (should be the board or the audit
status committee, a subcommittee of the board, which, when it exists, monitors the work
of internal audit), whether internal audit has any operating responsibilities and
constraints or restrictions on it (e.g. that it is not adequately resourced)
Scope of function Consider extent and nature of assignments performed and the action taken by
management as a result of internal audit reports
Technical Consider whether internal auditors have adequate technical training and
competence proficiency
Due professional Consider whether internal audit is properly planned, supervised, reviewed
care and documented
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AUDIT APPROACH 10
When reporting, internal auditors should report to the whole board or the audit committee and should be
free to discuss their concerns with external auditors. They should not report to management upon whose
work or responsibilities they are likely to comment; this may mean for example that they should not report
to the finance director.
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Recording an The external auditor should carry out walkthrough tests on the records to
accounting system ensure that the recording undertaken by the internal auditor is accurate (rather
than record the accounting system themselves).
Evaluating and If the external auditors are to rely on the work done, say the completion of an
testing internal internal control evaluation questionnaire, they should check that the method of
control evaluation is appropriate. They should confirm that internal audit has
satisfactorily tested controls in detail by re-performing a sample of internal
audit's tests; if internal audit's work is satisfactory, external auditors can make a
reduced assessment of control risk as a consequence.
In particular external audit may be able to rely on internal audit's assessment of
computer systems, since internal audit may have carried out extensive testing on
aspects of the system including controls over development and operation of the
system and general controls such as access controls.
Most internal auditors will produce an annual report for the board on the
effectiveness of the internal controls and risk management of the company which
external auditors might read as part of their own risk assessment procedures.
Substantive As external auditors are primarily interested in internal audit's role as a control,
procedures the importance of internal audit as a source of substantive evidence will be less.
However internal audit procedures may be a source of substantive evidence in
particular areas, for example comparing supplier statements with the payables
ledger. If the client has several sites, internal audit may have visited sites that
external auditors will not have the chance to visit, and external audit may be able
to place some reliance on the work done by internal audit on those sites.
Evaluation
Training and Have the internal auditors had sufficient and adequate technological training to carry
proficiency out the work?
Are the internal auditors proficient?
Supervision Is the work of assistants properly supervised, reviewed and documented?
Evidence Has sufficient, appropriate audit evidence been obtained to afford a reasonable basis
for the conclusions reached?
Conclusions Are the conclusions reached appropriate, given the circumstances?
Reports Are any reports produced by internal audit consistent with the result of the work
performed?
Unusual Have any unusual matters or exceptions arising and disclosed by internal audit been
matters resolved properly?
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AUDIT APPROACH 10
Evaluation
Plan Are any amendments to the external audit plan required as a result of the matters
identified by internal audit?
Testing Has the work of internal audit been sufficiently tested by the external auditor to
confirm its adequacy?
The nature, timing and extent of the testing of the specific work of internal auditing will depend upon the
external auditor's judgement of the risk and materiality of the area concerned, the preliminary assessment
of internal auditing and the evaluation of specific work by internal auditing. Such tests may include
examination of items already examined by internal auditors, examination of other similar items and
observation of internal auditing procedures.
If the external auditors decide that the internal audit work is not adequate, they should extend their own
procedures in order to obtain appropriate evidence.
Definition
An expert is a person or firm possessing special skill, knowledge and experience in a particular field other
than accounting and auditing.
Professional audit staff are highly trained and educated, but their experience and training is limited to
accountancy and audit matters. In certain situations it will therefore be necessary to employ someone else
with different expert knowledge.
Auditors have sole responsibility for their opinion, but may use the work of an expert. An expert may be
engaged by:
A client to provide specialist advice on a particular matter which affects the financial statements
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The auditors in order to obtain sufficient audit evidence regarding certain financial statement
assertions
The auditor will generally consider whether there is an expert in the client entity with relevant skill, or if
not, whether those charged with governance will contract an expert. If they are unwilling, the auditor will
consider hiring an expert.
The following list of examples is given by BSA 620 Using the Work of an Expert of the audit evidence which
might be obtained from the opinion, valuation etc of an expert.
Valuations of certain types of assets, e.g. land and buildings, plant and machinery
Determination of quantities or physical condition of assets
Determination of amounts using specialised methods, e.g. pensions accounting
The measurement of work completed and work in progress on contracts
Legal opinions
The BSA gives the following requirements in relation to using the work of an expert:
'When using the work performed by an expert, auditors should obtain sufficient appropriate audit
evidence that such work is adequate for the purposes of an audit'
'When planning to use the work of an expert the auditors should assess the professional competence
of the expert and the professional qualifications, experience and resources of the expert … the
auditor should [also] evaluate the objectivity of the expert'
'The auditors should obtain sufficient appropriate audit evidence that the scope of the expert's work is
adequate for the purposes of the audit'
'The auditors should assess the appropriateness of the expert's work as audit evidence regarding the
assertion being considered'
'If the results of the expert's work do not provide sufficient appropriate audit evidence, or if the
results are not consistent with other audit evidence, the auditor should resolve the matter'
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the subsidiary companies, whether they be different auditors from the same firm, or auditors from a
different firm altogether.
Definitions
Principal auditors are the auditors with responsibility for reporting on the financial statements of an
entity when those financial statements include financial information of one or more components audited by
other auditors.
Other auditors are auditors, other than the principal auditors, with responsibility for reporting on the
financial information of a component (for example a subsidiary company –see below) which is included in
the financial statements audited by the principal auditors. Other auditors include affiliated firms, whether
using the same name or not, and correspondent firms, as well as unrelated auditors.
Correspondent firms are firms which are loosely associated, generally for the purposes of referring work.
Component is a division, branch, subsidiary, joint venture, associated undertaking or other entity whose
financial information is included in financial statements audited by the principal auditors.
The duty of the principal auditors is to report on the group accounts, which includes balances and
transactions of all the components of the group.
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5 Practical issues
Section overview
The audit strategy will also address practical issues such as audit timing, staffing and location.
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There may well be a 'manager' or 'supervisor' who has more responsibilities for the administration, planning
and review of the engagement and would be expected to do less of the detailed testing work than the
senior.
Finally there are the assistants who, depending on their experience will take on the execution of the more
detailed audit tasks.
The audit strategy should make clear who is responsible for which aspects of the audit, and should strike
the difficult balance between:
Ensuring each member of the team has sufficient experience for the job in hand
Setting new challenges so that experience can be gained, and
Cost
5.4 Location
As hinted at above, the location that the audit work takes place at will depend on the nature of the client
and the risk assessment. Some clients will only have one location, in which case the audit will take place at
that location. Other clients may have several locations, and the auditors will have to make judgements
about which locations are more risky than others and need the auditor to visit them. It may be necessary to
attend all locations that a client has at some stage during the audit.
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Summary
Self-test
Answer the following questions.
1 The three sources of audit confidence are:
1 ........................................
2 ........................................
3 ........................................
2 It is appropriate to rely solely on controls testing in relation to the existence of inventory.
True
False
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AUDIT APPROACH 10
True
False
4 Which of the following will external auditors consider in their assessment of whether to use the work
of internal audit?
True
False
6 Principal auditors may refer to the work of other auditors in their report on the group financial
statements.
True
False
7 Principal auditors will not be able to form an opinion on group financial statements if:
A The other auditors are not from the same firm
B They have knowledge of the whole group
C The other auditors do not carry out all the procedures as specified by the principal auditors
D The portion of the financial statements they do not audit is material
8 The minimum ideal number of staff used in an audit is:
A 1
B 2
C 3
D 4
Exam-style question
9 Gasoleum Ltd
Your firm is the auditor of Gasoleum Ltd which operates 15 petrol stations in and around London.
You are the senior in charge of the audit for the year ending 31 July 20X7 and are engaged on the
audit planning.
Most of the company’ s sites are long-established and, as well as supplying fuel, oil, air and water, have a
car wash and a shop.
Over the last few years, due to the intense price competition in petrol retailing, the shops have been
expanded into mini-markets with a wide range of motor accessories, food, drinks and household
products. They also now sell National Lottery tickets.
Point-of-sale PCs are installed in all the petrol stations, linked on-line via a network to the computer at
head office. Sales and inventory data are input direct from the PCs.
The company has an internal auditor, whose principal function is to monitor continuously and test the
operation of internal controls throughout the organisation. The internal auditor is also responsible for
co-ordinating the year end inventory count.
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Requirements
Prepare notes for a planning meeting with the audit partner which
(a) Identify, from the situation outlined above, circumstances particular to Gasoleum Ltd that should
be taken into account when planning the audit, explaining clearly why these matters should be
taken into account. (6 marks)
(b) Describe the extent to which the work performed by the internal auditor may affect your
planning, and the factors that could limit the use you may wish to make of his work. (6 marks)
(12 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied that you have achieved
these objectives, please tick them off.
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Technical reference
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Answers to Self-test
1 1 Tests of controls
2 Analytical procedures
3 Tests of details
2 False
3 True
4 To whom they report
Their technical training
Whether internal audit work is properly documented
5 False
6 False
7 C
8 B (one to carry out the work and another to review it)
Exam-style question
9 Notes for a planning meeting
(a)
Circumstance Why taken into account
Multiple business locations. Increases inherent risk (e.g. if organisational
structure is loose and difficult to manage).
Intense price competition. May lead to uneconomic price discounting,
possibly threatening viability of business.
Recent expansion of outlets into Increases complexity of business and may
minimarkets. lead to loss of management control.
Perishable nature and limited shelf- Increase risk of overstatement of inventory
life of food and drinks inventories. values.
Large volume of cash transactions. Increases risk of incomplete income
recording.
Nature of the business (garage Increases risk of loss of inventories and cash
environment). due to theft or staff pilferage.
May limit effectiveness of physical security
controls (e.g. over access to terminals).
Recent introduction of sales of Increases inherent risk (e.g. the risk of loss to
National Lottery tickets. Gasoleum Ltd if incorrect amounts are paid
out on winning tickets).
Direct input via PCs at branches. Increases risk of misstatement, as batch
controls will not be feasible and scope for
other input controls may be limited.
Small number of staff at each Limits scope for segregation of duties within
location (e.g. one or two). branches and therefore increases control risk.
Branch-based nature of business. Limits effectiveness of management control
over activities of individual branches thereby
increasing control risk.
Use of part-time staff and high staff May inhibit effectiveness of controls within
turnover. branches.
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AUDIT APPROACH 10
(ii) Accuracy
To prevent errors in payroll deductions
Calculations of PAYE, NICs etc can be checked prior to processing, and
Non-statutory deductions (e.g. pension contributions, union subscriptions) should require
prior authorisation in writing.
However,
Human error/misunderstanding
Errors in deductions may not be detected, due to fatigue, distraction, misjudgement or
misinterpretation.
Non-routine transactions
Systematic checking procedures may be directed at routine deductions (e.g. withholding tax)
rather than non-routine transactions (e.g. give as you earn, maintenance payments).
(iii) Validity
To ensure that employees are only paid for work done
Hours worked per time sheets (or clock cards) can be approved by a departmental manager
(or supervisor), and
The duties of payroll preparation and payment should be segregated.
However,
Abuse or override
Authorisation could be given for a new employee to be added to the payroll without the proper
checks being carried out by the authoriser.
Collusion
The person responsible for paying wages could collude with the person responsible for
accounting for wages to perpetrate and conceal a theft of wages.
(b) Internal control terminology
(i) Segregation of duties
Meaning
Segregation of duties is a factor reflected in the control environment (the overall attitude,
awareness and actions of management regarding internal controls in the entity).
If one person has responsibility for the recording and processing of a complete transaction, he
may also have the power to falsify the records or to misappropriate money or assets without
being discovered.
Separation of these responsibilities will reduce the risk of intentional or unintentional errors
occurring.
The functions that should normally be separated include authorisation, execution, custody and
recording.
Examples
Calculations of withholding tax and pension deductions should be reviewed and authorised
by the payroll supervisor who is not actually involved in performing the calculations.
Unclaimed wages should be kept by someone (e.g. the cashier) other than the person
responsible for recording payroll entries, otherwise there could be a temptation to falsify
the figures and pocket some of the wages.
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Analyse revenue per product type by A difference in the rate of increase would indicate
month. a switch from one product to the other.
Seasonal variations are expected as Glowvine is
largely a winter product and Eau Vital a summer
product.
Analyse gross profit per product type by GP margin has increased from 55.5% to 59.1%. The
month. higher margin indicates a move from Glowvine to
Eau Vital (possibly due to a mild winter in
20X5/X6).
Analyse cost of goods sold per product Cost of goods sold only increased by 60.6%, while
type by month. revenue increased by almost 75%. Again, a possible
reason could be the switch from one product to
the other. It does seem a disproportionately small
increase, especially as royalties are included in cost
of goods sold and remain constant per bottle sold,
regardless of product.
However, recycling of glass bottle returns could
account for the slower rate of increase.
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AUDIT APPROACH 10
Analyse distribution and administrative These have increased by 153%, contributing to the
costs into: fall in net profit margin from 43% to 41%. The
increase in these costs could have been caused by:
– Administrative cost (especially deposit Implementation of the deposit scheme (unlikely
scheme) to account for the whole increase as not
operational for the whole year)
– Advertising costs Increased advertising costs to promote the
deposit scheme and “ environment friendly”
nature of the products (this could also have
contributed to the increase in revenue)
– Transport costs Increased transport costs in proportion to the
75% increase in revenue
– Labour costs Increased labour costs, again in proportion to
the rise in revenue
Analysis of nature, valuation and The disproportionately smaller increase in cost of
consistency of treatment of closing goods sold could be caused by an error in the
inventories. Compare with inventories counting or valuation of closing inventories, causing
held at end of previous years. The them to be overstated and thus cost of goods sold
disproportionately smaller increase in cost reduced.
of goods sold could be caused by an error
in the counting or valuation of closing
inventories, causing them to be overstated
and thus cost of goods sold reduced.
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Information Reasons
The organisational status and reporting The degree of objectivity is increased when
responsibilities of the internal auditor and internal audit
any constraints and restrictions thereon.
– Is free to plan and carry out its work and
communicate fully with the external auditor
– Has access to the highest level of
management
Areas of responsibility assigned by Not all areas in which internal audit may
management to internal audit, such as operate will be relevant to the external auditor.
review of
– Accounting systems and internal (Relevant)
controls
– Implementation of corporate plans (Not relevant)
Routine tasks carried out by internal audit In these respects staff are not functioning as
staff such as authorisation of petty cash internal audit (simply as an internal control).
reimbursements.
Internal auditor’
s formal terms of Internal auditor’
s role will be most relevant
reference. where it
– Has a bearing on the financial statements
– Involves a specialisation
Internal audit documentation such as an It is more likely that due professional care is
audit manual and audit plans. being exercised where the work of internal
audit is properly planned, controlled, recorded
and reviewed.
Professional membership and practical Unless internal audit is technically competent it
experience (including computer auditing is inappropriate to place reliance on it.
skills) of internal audit staff.
Internal audit reports generated and How the company responds to internal audit
feedback thereon. findings may be regarded as a measure of the
department's effectiveness.
Number of staff, computer facilities and The effectiveness of internal audit (and hence
any other resources available to internal the reliance placed thereon) will be limited if
audit. the department is under-resourced.
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AUDIT APPROACH 10
to ensure adherence to the company’ s procedures. Test counts should be made to confirm the
accuracy and completeness of the inventory counts.
(iii) Cash
Cash counts should be carried out on cash register takings (and petty cash floats) whenever
shops (and warehouses) are visited on a 'surprise' basis.
(iv) Goods despatch
Internal control procedures should be observed to be in operation, for example, to ensure that
all despatches are documented and destined for the company’ s retail outlets.
(v) Employee verification
Payroll procedures are likely to be carried out at HO, warehouses and shops informing HO on a
weekly basis of hours worked by employees, illness and holiday etc. However, new employees,
especially in the shops (and probably also in the warehouses) will be recruited locally and their
details notified to HO.
Internal audit will be able to select a sample of employees from HO records and ensure on their
visits to shops and warehouses that these represent bona fide employees.
(c) Effect on audit
(i) Systems documentation
The accuracy of systems documentation which has been prepared by internal audit need only be
confirmed using 'walk-through tests'. This saves time (if the systems documentation is correct)
since only copies will be required for the audit file.
(ii) Tests of controls
The level of independent testing (i.e. by the external auditor) can be reduced where controls
have been satisfactorily tested by internal audit, especially if error rates are found to be similar. In
particular, attendance at stocktaking at the year end may be limited to those locations with the
highest stockholdings.
(iii) Substantive procedures
Internal audit’
s evidence (e.g. concerning the existence of tangible non-current assets) will reduce
sample sizes for year end verification work. Substantive procedures may also be reduced where
the internal audit checks reconciliations (e.g. of suppliers’
statements to ledger balances,
receivables and payables control accounts and bank reconciliations).
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The scope, standard and independence of the work carried out by the auditors of subsidiary companies (the
'other' auditors) are the most important matters which need to be examined by the principal auditors
before relying on financial statements not audited by them. The principal auditors need to be satisfied that
all material areas of the financial statements of subsidiaries have been audited satisfactorily and in a manner
compatible with that of the principal auditors themselves.
Work to be carried out by principal auditors in reviewing the other auditors' work
(i) Send a questionnaire to all other auditors requesting detailed information on their work, including:
An explanation of their general approach (in order to make an assessment of the standards of
their work)
Details of the accounting policies of major subsidiaries (to ensure that these are compatible
within the group)
The other auditors' opinion of the subsidiaries' overall level of internal control, and the reliability
of their accounting records
Any limitations placed on the scope of the auditors' work
Any qualifications, and the reasons for them, made or likely to be made to their audit reports
(ii) Carry out a detailed review of the other auditors' working papers on each subsidiary whose results
materially affect the view given by the group financial statements. This review will enable the principal
auditors to ascertain whether (inter alia):
An up-to-date permanent file exists with details of the nature of the subsidiary's business, its staff
organisation, its accounting records, previous year's financial statements and copies of important
legal documents.
The systems examination has been properly completed, documented and reported on to
management after discussion.
Tests of controls and substantive procedures have been properly and appropriately carried out,
and audit programmes properly completed and signed.
All other working papers are comprehensive and explicit.
The overall review of the financial statements has been adequately carried out, and adequate use
of analytical procedures has been undertaken throughout the audit.
The financial statements agree in all respects with the accounting records and comply with all
relevant legal requirements and accounting standards.
Minutes of board and general meetings have been scrutinised and important matters noted.
The audit work has been carried out in accordance with approved auditing standards.
The financial statements agree in all respects with the accounting records and comply with all
relevant legal and professional requirements.
The audit work has been properly reviewed within the firm of auditors and any laid-down quality
control procedures adhered to.
Any points requiring discussion with the parent company's management have been noted and
brought to the principal auditors' attention (including any matters which might warrant a
qualification in the audit report on the subsidiary company's financial statements).
Adequate audit evidence has been obtained to form a basis for the audit opinion on both the
subsidiaries' financial statements and those of the group.
If the principal auditors are not satisfied as a result of the above review, they should arrange for
further audit work to be carried out either by the other auditors on their behalf, or jointly with them.
The other auditors are fully responsible for their own work; any additional tests are those required
for the purpose of the audit of the group financial statements.
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chapter 11
Introduction
Examination context
Topic List
1 Non-specialised entities
2 Specialised entities
3 Not-for-profit entities
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Introduction
Practical significance
Although all companies are unique, many are fairly standard for audit purposes, and would be described as
non-specialised. However, some entities and companies have specialised requirements which add
complexity to the audit being carried out.
Working context
Many firms have specialisms within their audit departments, so if you work in practice, you may find you
specialise in the audit of certain specialised entities or NGO entities. You may work for an audit firm that
undertakes public sector audit work. Alternatively, you do not audit one of these entities at all.
Syllabus links
You have covered the key issues relating to planning non-specialised audits in this Study Manual. You
covered obtaining evidence on non-specialised audits in greater detail in your Assurance studies.
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AUDITS OF DIFFERENT TYPES OF ENTITY 11
Examination context
Exam requirements
Complex auditing requirements relating to specialised entities are not examinable.
In the assessment, candidates may be required to:
Discuss the differences between the audit of a non-specialised profit oriented entity and the audit of a
given specialised profit oriented entity
Discuss the differences between the audit of a non-specialised profit oriented entity and the audit of a
given NGO entity
Specify and explain the steps necessary to plan, perform and conclude and report on the audit of the
financial statements of a non-specialised profit oriented entity in accordance with the terms of the
engagement including appropriate auditing standards
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Audit and assurance
1 Non-specialised entities
Section overview
The majority of audits relate to non-specialised profit orientated entities.
The standard audit features outlined in this manual and the Assurance manual apply to this type of
entity.
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AUDITS OF DIFFERENT TYPES OF ENTITY 11
2 Specialised entities
Section overview
Some entities are ‘
special’
in some way, for example:
– The entity is subject to extra regulations, such as banks or insurance companies, or NGOs (note
that we shall look in particular at NGOs below)
– The entity is subject to professional rules, such as lawyers
Such entities may be subject to special auditing guidance, all of which is outside the scope of your
syllabus.
It is important to note that many of these entities require a ‘
normal’statutory audit as well as any
additional requirements upon them.
In which case, the auditors need to assess the particular risks associated with the specialised entities
which will cause any differences in audit approach.
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Section overview
There are various types of organisations which do not exist for the purpose of maximising
shareholder wealth, which may require an audit.
The audit risks associated with NGOs may well be different from other entities.
Cash may be significant in small NGOs and controls are likely to be limited. Income may well be a
risk area, particularly where money is donated or raised informally.
Obtaining audit evidence may be a problem, particularly where small NGOs have informal
arrangements and there might be limitations on the scope of the audit.
In all NGO audits it will be necessary to ensure accounting policies used are appropriate.
The nature of the report will depend on statutory and entity requirements, but it should conform to
BSA 700 criteria.
The public sector comprises a large number of varied NGOs, and also private companies which are
profit oriented, running (outsourced) public services.
The key objective of most companies is to manage the shareholders' investments well. In a large majority of
cases, 'manage the shareholders' investment' means 'create a profit', as this will create returns to the
shareholders in the terms of dividends or growth in the capital value of the share. However, some
companies and other entities do not operate for the purpose of making profit but have other objectives.
Examples include NGOs and organisations in the public sector.
Many of these organisations are legislated for and the Acts which relate to them may specify how they are
to report their results. Some of the organisations mentioned above may be companies (often companies
limited by guarantee) and so are required to prepare financial statements and have them audited under
companies legislation.
Where a statutory audit is required, the auditors will be required to produce the statutory audit opinion
concerning the truth and fairness of financial statements.
Where a statutory audit is not required, it is possible that the organisation might have one anyway for the
benefit of interested stakeholders, such as the public or people who give to an NGO.
It is also possible that such entities will have special, additional requirements of an audit. These may be
required by a Regulator, or by the constitution of the organisation. For example, an NGO’ s constitution
may require an audit of whether the NGO is operating in accordance with its charitable purpose.
An audit of an NGO may vary from a business audit due to:
Its objectives and the impact on operations and reporting
The purpose an audit is required
When carrying out an audit of an NGO, it is vital that the auditor establishes:
Whether a statutory audit is required
If not, what the objectives of the engagement are
What the engagement is to report on, and
To whom the report should be addressed, and
What form the report should take
Whether to certify /provide any other additional forms
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AUDITS OF DIFFERENT TYPES OF ENTITY 11
3.1 NGOs
NGOs are regulated under the Foreign Donations Regulation Rules, 1978. This sets out how they are
regulated.
Definition
NGO: An institution which is established for charitable purposes only.
Under the Foreign Donations Regulation Rules 1978, voluntary activity means an activity undertaken or
carried out, partially or entirely with external assistance, to render any of the following services:
Agriculture
Relief
–Missionary
–Educational
–Cultural
–Vocational
–Social welfare
–Development
(1) Every person or organisation shall submit to the NGO Affairs Bureau his or its project on voluntary
activities along with plan of its operation showing the estimated cost, expected receipts, source of
receipts, purpose and objects and duration thereof on or before the 31st March preceding the
financial year in which such project is to commence.
In Rules, 1978, clause 6, also mentioned are the requirements for the
Maintenance of books of accounts.
(1) Every person or organisation undertaking or carrying on voluntary activities shall maintain books of
accounts
(a) Where the foreign donation relates to articles only, in Form FD-5.
(b) Where the foreign donation relates to currency in the cash book and ledger book on double
entry basis.
(2) Accounts under sub-rule (1) shall be maintained on a half-yearly basis, one for the period commencing
on the 1st day of July and ending on the 31st day of December, and the other for the period
commencing on the 1st day of January and ending on the 30th day of June.
(3) All books of accounts maintained under this rule shall be audited by a chartered accountant as defined
in the Bangladesh Chartered Accountants Order, 1973, (P.O. 2 of 1973), and two copies of accounts
so audited shall be furnished [along with a certificate from the auditors in Form FD-4, to the NGO
Affairs Bureau with a copy to External Resources Division and the administrative Ministry concerning
to the activity of the project.]
[7 Bank Accounts.—Only one bank account shall be maintained by every person or organisation
authorised under these rules for receiving foreign donations:
Provided that separate bank accounts for separate projects may be maintained for internal
transactions after the donations have been received through the only bank account opened under sub-
rule (4) of rule 4.]
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(1) No citizen of, or organisation in, Bangladesh shall receive any foreign contribution without the prior
permission of the Government.
(2) No Government, organisation or citizen of a foreign state shall make any donation, grant or
assistance, whether in cash or in kind, including a ticket for journey abroad, to any citizen of, or
organisation in, Bangladesh without the prior permission of the Government.
(3) Nothing in this section shall apply to an organisation established by or under any law or the authority
of the Government.
The terms and conditions prescribed by the NGO Affairs Bureau for audit firms are as follows:
Condition-1
Requirement -During the audit of NGOs, the audit firms should perform their duties independently and
with maximum responsibility. If any audit firm is found negligent or fails to comply with the terms of audit,
the Bureau reserves the right to de-list the name of the firm directly.
Condition-2
Requirement -During the audit of NGOs, the audit firm will check as to whether the NGOs complied
with the Rules and Regulations promulgated for the NGOs i.e. The Foreign Donations (Voluntary Activities)
Regulation Ordinance, 1978, The Foreign Donations (Voluntary Activities) Regulation Rules, 1978, The
Foreign Contributions Regulation Ordinance, 1982 and rules of Circular # 33.43.27.00.00.01.2000-107
dated 29 May 2001 issued by the Prime Minister’s Office (where applicable) and whether the project has
been implemented as per terms of approval of the FD-6 (in which objectives and targets and detailed line
item-wise budget provision is mentioned) properly and the terms of approval of the project.
Condition-3
Requirement -The audit firm, along with the audit report, must issue a certificate regarding receipts and
expenditure of foreign donations in form FD-4 prescribed by the Bureau and Annexure-A/1 attached
thereto. Local income/donation received (if any), which has been included in the project shall be shown
separately. If separate audit reports are issued for more than one project then each report shall contain the
amount of donations (only foreign donation)
received in the mother account authorized to receive foreign donations in the concerned financial/project
year.
Condition-4
Requirement -The audit report should contain a brief description of the project and main physical
component of the project. The memo number of project approval, date, total value of the project, project
year and the amount released by the Bureau should clearly be mentioned in the report.
Condition-5
Requirement -Receipts and Payments Accounts should be prepared in conformity with the accounts line
items maintained in the ledger of NGOs. In those line items where total expenditure is shown, a detailed
break down of expenditure should be enclosed in notes (e.g. Training, Contingency and others). If there is
any difference between account line items of ledger books and Annexure-A/1 attached with FD-4 then a
separate compilation sheet is to be annexed thereto. Receipts & Payments Account, Income & Expenditure
Account and a Balance Sheet should be included with the audit report(s) of every ongoing project(s) (multi
year project) of the NGOs.
Condition-6
Requirement -The audit report should clearly indicate observation/opinion/comment/note regarding
following matters:
(a) Whether all foreign donations have been received by the NGO in a single Bank Account as per rule-7
of the Foreign Donations (Voluntary Activities) Regulation Rules, 1978. The name of the bank(s),
account number(s) and amount should be mentioned if the foreign donations have been received
through more than one Bank Account;
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(b) The account number approved by the NGO Affairs Bureau for receipt of foreign donation, name of
the bank(s) and branch, amount of donation received and name and particulars of the donor in detail
should be mentioned;
(c) Donations received in kind should be accounted for after proper valuation and be shown in FD-4 with
donations received (separately or in consolidated form). The utilisation of fund and the balance of
unutilised fund should be submitted as per form FD-4;
(d) The bank interest/exchange gain on foreign donations should be accounted for in the accounts
separately. The report should mention whether the consent of the Bureau has been obtained to use
the same or if the revised budget has the approval of the NGO Bureau;
(e) Whether the accounts, cash book/bank book and ledger books have been maintained by the NGO
under foreign donations (Voluntary Activities) Regulation Rules, 1978;
(f) If separate accounts for Micro Credit Funds are not maintained and credits have been disbursed from
the project service charges to be mentioned in the as income.
(g) If the organization implement micro credit activity with foreign donations, whether the NGO is
certified by the Micro Credit Regulatory Authority. Whether separate accounts are maintained for
micro credit activity and the audit conducted separately.
(h) If any expenditure is made in foreign currency out of the receipt of donation, detail description should
be given in the report.
(i) If any expense exceeded the budget amount or adjusted with another budget line item or if any
unapproved expenditure is adjusted against regular expense then the purpose of over expenditure
should be mentioned with reason and detail description.
(j) Whether the salaries and allowances of all officers and staff of the organization are paid by bank
cheque and in cash.
(k) If the project has been implemented by taking loan information about the sources of loan is to be
given.
(l) Whether any member of the General Committee and Executive Committee has taken remunerations
or honorarium. If taken, detail particulars are to be given.
(m) Whether the fixed assets deed/office rent agreement or donated land reported in the accounts are in
the name of the entity. If so details thereof are to be given.
(n) Whether the internal control system of the organization is satisfactory or not.
(o) Whether any fund was refunded to the donor without prior approval of the Bureau. If refunded,
details are to be given.
(p) Comment of the audit firm as to whether VAT and AIT were properly deducted from the
bill/vouchers according to the government laws and regulations and deposited to Government
Treasury by the organization.
(q) As a legal entity whether the NGO submits income tax return to NBR as per Income Tax Ordinance
1984.
(r) Whether any officer/employee member of executive committee or general committee availed foreign
travel by using fund. Air ticket/any other facility received from the foreign sources if so the details of
such travel whether approval from NGO Affairs Bureau were taken in respect of the travel.
(s) Estimated market value of the fixed assets owned by the organization during the period of audit to be
enclosed in the audit report.
(t) Whether the audit firm issues any management letter mentioning the irregularities/ ineligible
cost/unauthorized expenditure/unapproved budgeted expenditure to the management of the
organization after completion of the audit.
(u) The organization’ s registration number with registration date as approved by the NGOAB is to be
enclosed in the audit report including the last date of renewal.
(v) List of the members of the organization’ s Executive committee/Governing Body/Management
Committee is to be enclosed in the audit report along with comments on the relationship between
the members of the committee(if any).
(w) The audit report should state whether any IGA are included as a ongoing project of the organization,
if so, mention whether tax are paid properly on income from such IGA with the name of the source.
The audit report should also state whether the organization collect any Income Tax Exemption
Certificate from the NBR.
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Condition-7
Requirement - The audit report should state whether the NGO maintained project/donor-wise separate
accounts or a consolidated account for the Revolving Loan Fund (RLF) for ongoing and completed project.
Condition-8
Requirement -Whether the audit fees of the project is paid by the organization from the project
expenditure as per the instruction from the Prime Minister Office as laid down in amendment no. 10 (kha).
Condition-9
Requirement - Each page of the audit report of the organization should contain initial of the appropriate
authority along with name and designation and common seal of the audit firm. After completion of audit,
one copy of audit report in sealed envelope must be sent directly to the Deputy Director (Inspection &
Audit), NGO Affairs Bureau.
Condition-10
Requirement - The audit report should contain the memo number with date of firm’
s enlistment and
renewal.
3.1.1 Planning
When planning the audit of an NGO, the auditors should particularly consider the following:
The scope of the audit
Recent recommendations of the NGO Affairs Bureau or the other regulatory bodies
The acceptability of accounting policies adopted
Changes in circumstances in the sector in which the NGO operates
Past experience of the effectiveness of the NGO's accounting system
Key audit areas
The amount of detail included in the financial statements on which the auditors are required to
report
In order to identify the key audit areas, the auditors will have to consider audit risk.
There are certain risks applicable to NGOs that might not necessarily be applicable to other companies.
The auditors should consider the following:
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Cash donations
Other donations
Gift aid Regular checks and follow-up procedures to ensure due amounts are received
Regular checks to ensure all tax repayments have been obtained
Legacies Comprehensive correspondence files maintained in respect of each legacy
Regular reports and follow-up procedures undertaken in respect of
outstanding legacies
Donations in In the case of NGO shops, separation of recording, storage and sale of
kind inventory
Other income
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Use of resources
Restricted funds Separate records maintained of relevant revenue, expenditure and assets
Terms controlling application of fund
Oversight of application of fund monies by independent personnel or trustees
Grants to Records maintained, as appropriate, of requests for material grants received
beneficiaries and their treatment
Appropriate checks made on applications and applicants for grants, and that
amounts paid are intra vires
Records maintained of all grant decisions, checking that proper authority
exists, that adequate documentation is presented to decision-making meetings,
and that any conflicts of interest are recorded
Control to ensure grants made are properly spent by the recipient for the
specified purpose, for example requirements for returns with supporting
documentation or auditors' reports concerning expenditure, or monitoring
visits
Conversely, large NGOs might have very strong controls and the auditors may find that they are able to
rely on them to a great extent. Remember, however, that while relying on controls might be acceptable in
order to determine whether the financial statements give a true and fair view, it might not be acceptable to
meet any special additional auditing requirements that the NGO has.
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NGOs without significant endowments or accumulated funds will often be dependent upon future income
from voluntary sources. In these circumstances auditors may question whether a going concern basis of
accounting is appropriate.
3.1.5 Reporting
On NGO audits where a statutory audit report is required, the auditors should issue the standard audit
report which we will consider in Chapter 13. They should also consider whether any additional statutory
requirements fall on the audit report.
Where an association or NGO is having an audit for the benefit of its members or trustees, the standard
audit report may not be required or appropriate. The auditor should bear in mind the objectives of the
audit and make suitable references in the audit report. However, the BSA 700 format will still be relevant.
The auditor should ensure that he makes the following matters clear:
The addressees of the report
What the report relates to
The scope of the engagement
The respective responsibilities of auditors and management/trustees/directors
The work done
The opinion formed
The points made above are general points. Remember that not all clubs and NGOs will be the same. If you
have a question in the exam relating to an NGO, apply this general knowledge to the specifics given in the
question and be logical when formulating your answer.
CU CU
Gifts under non-taxing arrangements 15,335
Tax reclaimed on gifts under non-taxing arrangements 4,325
19,660
Postal donations 63,452
Autumn Fair 2,671
Other income
Legacies 7,538
Bank deposit account interest 2,774
10,312
96,095
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Notes
(a) Income from gifts under non-taxing arrangements is stated net. Each person who pays by gift aid has
filled in a special tax form, which is kept by the secretary, Mrs Beech.
(b) All gifts under non-taxing arrangements are paid by banker's order –they are credited directly to the
NGO's bank account from the donor's bank. Donors make their payments by gift aid either monthly
or annually.
(c) The tax reclaimed on these gifts is 28.2% (22/78) of the net value of the gifts, and relates to income
received during the year –as the tax is received after the year-end, an appropriate amount
recoverable is included in the balance sheet. The treasurer, who is a voluntary (unpaid) member of the
management committee, completes the form for reclaiming the income tax, using the special tax forms
(in (a) above) and checks to the full-time secretary's records that each donor has made the full
payment in the year required by the arrangement.
(d) Donations received through the post are dealt with by Mrs Beech. These donations are either cheques
or cash (bank notes and coins). Mrs Beech prepares a daily list of donations received, which lists the
cheques received and total cash (divided between the different denominations of bank note and coin).
The total on this form is recorded in the cash book. She then prepares a paying-in slip and banks these
donations daily. When there is a special fund-raising campaign, Mrs Beech receives help in dealing with
these donations from voluntary members of the management committee.
(e) The Autumn Fair takes place every year on a Saturday in October –members of the management
committee and other supporters of the NGO give items to sell (for example food, garden plants,
clothing) –a charge is made for entrance to the fair and coffee and biscuits are available at a small
charge. At the end of the fair, Mrs Beech collects the takings from each of the stalls, and she banks
them the following Monday.
(f) Legacies are received irregularly, and are usually sent directly to the director of the NGO, who gives
them to Mrs Beech for banking –they are stated separately on the daily bankings form (in (d) above).
(g) Bank deposit account interest is paid gross of income tax by the bank, as the Links Famine Relief is an
NGO.
Requirement
List and briefly describe the work you would carry out on the audit of income of the NGO, the controls
you would expect to see in operation and the problems you may experience for the following sources of
income, as detailed in the income statement above.
(a) Gifts under non-taxing arrangements
(b) Tax reclaimed on gifts made under non-taxing arrangements
(c) Donations received through the post
(d) Autumn Fair
See Answer at the end of this chapter.
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Organisations install and operate controls to limit the possibility of corrupt practice, fraud and poor
administration.
The manner in which the auditors conduct their work is affected by auditing standards and other regulatory
influences including:
Specific statutory requirements
Requirements of the sponsoring (or funding) department
Contractual requirements contained in terms of engagement.
Organisations in the public sector are often subject to a high degree of regulation. The nature of regulation
affecting public sector bodies ranges from statutory to detailed administrative requirements.
In Bangladesh, the Directors General of different government offices are public sector organisations
specialising in public sector audit work.
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transparency in government for achieving good governance for the people of Bangladesh by conducting
independent audit and evaluation of public sector operations.
Three Deputy Auditors General and other officers working in the Secretariat of the CAG assist the Auditor
General to plan, coordinate, monitor, evaluate and ensure the quality of both the auditing and accounting
functions of the Department. In addition, the Secretariat is also responsible for the overall planning and
management of the financial and personnel affairs of the entire Department.
The head of the Public sector audit office is the Comptroller and Auditor General (C&AG) who is
responsible for auditing the accounts of all government departments and non-departmental government
agencies and reporting the results to Parliament. In practice this responsibility is delegated to the Director
General of Audit.
The C&AG will undertake assignments to:
Form an opinion whether the financial statements give a true and fair view and are free from material
misstatements
Confirm that transactions have appropriate Parliamentary authority and that resources have been
spent in line with Parliament’
s intentions (regularity and propriety)
Examine and report on the economy, efficiency and effectiveness of public spending (value for money)
The C&AG ensures that the public sector is accountable. The C&AG can report to Parliament on the way
that public money is spent by central government. Evidence from reports produced by the C&AG may be
used by The Public Accounts Committee to make recommendations to Government. The C&AG is
appointed by the President, on the advice of the prime minister, and is accountable to The Public Accounts
Committee. The C&AG has the mandate to decide the scope and extent of audit. The constitution bestows
upon the C&AG complete independence and empowers him to have access to any government office or
entity, property or documents to audit any government owned entity. The C&AG certifies the Finance and
Appropriation Accounts of the Republic (Government Accounts).
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Summary
NGOs
Self-test
Answer the following questions.
1 Which of the following might require a specialist audit and why?
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Exam-style question
3 You have been appointed to audit the accounts of a micro credit NGO called Rural Finance (RF) for
the year ended 31-12-2003. The previous year accounts were audited by another auditor. The project
has received CU200,000 from a donor for a two-year project. The project agreement states that
unutilized grant is refundable to the donor. Given below are the project budget and actual account
balances for the two years and the Income Statements and Balance Sheets:
Income Statement
2002 2003
Income: CU CU
Interest Income from Loans 5,000 10,000
Other operational income 100 200
Total operational income 5,100 10,200
Operating expenses:
Salaries 8,000 20,000
Admin Expenses 2,000 4,000
Depreciation 250 350
Total operating expenses 10,250 24,350
Net operational income -5,150 14,150
Grant income 150,000 50,000
Net Income 144,850 35,850
Balance Sheet
31-12-2002 31-12-2003
Assets: CU CU
Cash in hand and at Bank 117,600 102,800
Loan outstanding 25,000 75,000
Opening balance 0 25,000
Add: Disbursement 50,000 100,000
Less: Recovery -25,000 -50,000
Fixed Assets 2,250 2,900
Total Assets 144,850 180,700
Capital Fund:
Opening balance 0 144,850
Addition during the year 144,850 35,850
Closing balance 144,850 180,700
(a) Discuss the non-compliances with BAS 20 Accounting for Government Grants and Disclosures of
Government Assistance in the above financial statements. (10 marks)
(b) Draft the opinion paragraph of the audit report. (10 marks)
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Technical reference
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Answers to Self-test
(i) As per BAS 20, grants should be recognized as income over the periods necessary to match
them with related costs which they are intended to compensate, on a systematic basis.
Therefore the recognition of Grant income on a cash basis of CU150,000 in year 2002 and
50,000 in year 2003 is incorrect. Grant income should have been recognized based on the total
payment for the period, which was CU62,500 for year 2002 and CU125,000 for 2003.
(ii) The remaining balance of CU87,500 (150,000- 62,500) for 2002 and CU12,500 (87,500+50,000-
125,000) for 2003 of grant received should have been booked as “Unutilized Grant Fund”
.
Under the grant accounting there should not be a net income or capital fund.
(iii) NGO is not like business to have a capital fund. Donor fund is a liability until used per agreement
and shown as “ Advance”under Liabilities. In the Balance Sheet presentation of CU144, 850 and
CU180,700 as capital funds are incorrect. Only the unspent money should have been shown as
“Unutilized Grant Fund” .
After reviewing the financial statements of Rural Finance, we have found some limitations to issue
unqualified opinion. As such, a qualified report is to be issued. The qualifying points of the report are to be
inserted before the opinion paragraph:
“We observed that the presentation of Grant Income and Capital Fund as shown in the Income Statement
and Balance Sheet respectively does not comply with Bangladesh Accounting Standards.”
“In our opinion, because of the effects of the matters discussed in the preceding paragraph, the financial
statements do not present fairly the financial position of the Company as of December 31, 2003 and of the
results of its operations for the year then ended in accordance with Bangladesh Accounting.”
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Notwithstanding the above reservations, specific audit tests required would be as follows.
(i) Check the details on the daily listings of donations received to the cash book, bank statements
and paying-in slips, ensuring that the details agree in all respects and that there is no evidence of
any delay in the banking of this income.
(ii) Check the donations received by reference to any correspondence which may have been
received with the cheques or cash.
(iii) Consider whether the level of income appears reasonable in comparison with previous years and
in the light of any special appeals that the NGO is known to have made during the course of the
year.
(iv) Carry out, with permission of the management committee, surprise checks to vouch the
completeness and accuracy of the procedures relating to this source of income.
(d) Autumn Fair
Once again there is a potential problem here because of the level of responsibility vested in one
person, namely Mrs Beech.
Specific work required would be as follows.
(i) Attend the event to observe the proper application of laid down procedures and count the cash
at the end of the day.
(ii) Check any records maintained by individual stallholders to the summary prepared by Mrs Beech.
(iii) Check the vouchers supporting any expenditure deducted from the proceeds in order to arrive
at the net bankings.
(iv) Agree the summary prepared by Mrs Beech to the entry in the cash book and on the bank
statement.
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chapter 12
Audit completion
Contents
Introduction
Examination context
Topic List
1 Introduction
2 Objective
3 Financial statement review
4 Other matters
5 Audit completion memorandum
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Introduction
Practical significance
Completion is a very critical stage of the audit because the partner is required to make the important
judgements of whether sufficient evidence has been obtained to support the audit opinion and what that
opinion should be.
Working context
If you work in practice, you may be involved in any part of audit completion. The more senior you become
in the firm, the more likely you are to be involved in completing the memorandum to the audit partner.
Syllabus links
You will have considered the issue of going concern in Accounting.
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AUDIT COMPLETION 12
Examination context
Exam requirements
The reviews carried out at the end of the audit, such as going concern and subsequent events reviews are
extremely important so could easily be examined in a short form or a long form question in the exam.
Candidates will be able to conclude and report on assurance engagements in accordance with the terms of
the engagements and appropriate standards.
In the assessment, candidates may be required to:
Describe the nature and timing of specific procedures designed to identify subsequent events that may
require adjustment or disclosure in relation to the matters being reported on
Evaluate, quantitatively and qualitatively (including the use of analytical procedures), the results and
conclusions obtained from assurance tests and procedures
Draw conclusions on the ability to report on an assurance engagement which are consistent with the
results of assurance work
Judge when to refer reporting matters for specialist help
Draw conclusions on the ability to report on an audit engagement, including the opinion for a
statutory audit, which are consistent with the results of audit work
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1 Introduction
Section overview
Although completion should in theory be simple if the audit has been well-planned and executed,
there are a number of aspects to it which can make it complex.
2 Objective
Section overview
The partner needs to consider:
– The financial statements
– The work done to support the audit opinion
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Section overview
The important questions are:
– Do the financial statements comply with the law and regulations (which will be tested using a
disclosure checklist)
– Do the financial statements make sense (which will be tested by analytical procedures)
3.1 Do the financial statements comply with the Companies Act 1994?
Determining this ought to be relatively simple –every firm should use a checklist to ensure that the
financial statements comply with the disclosure requirements of the Companies Act and relevant accounting
standards. Such checklists usually form a part of the 'audit packs' which firms use.
To some extent the job has been made easier by the widespread use of accounts production software, but
software is only as good as the people writing it, installing it and using it.
For example:
If directors' emoluments are not coded to the right account in the chart of accounts they will not be
disclosed properly in the financial statements
If the client has a material accounting policy which is not in the 'standard list' in the template on which
the financial statements are based, it will not appear in the accounting policies note unless you add it.
Checklisting the accounts, therefore is still a good idea.
As you know from your other studies, the nature of financial statements these days is incredibly complex.
For companies accounts, be aware that:
There are a large number of financial reporting standards applicable to financial statements
The Companies Act itself is a substantial document which determines the format to be used in
financial statements and the disclosures to be made on the face of the income statement and balance
sheet and in the supporting notes
The directors' report and other information released with the financial statements need to be
consistent with the financial statements, so the auditor must read that information and resolve any
inconsistencies.
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The steps for carrying out analytical procedures at this stage of the audit are very similar to those used as
part of the risk assessment process at the planning stage, but they happen in a rather different way
Interpretation
Investigation
Corroboration
3.2.1 Interpretation
The person carrying out the analytical procedures, reads through the financial statements and interprets
them, considering the absolute figures themselves and relevant ratios.
3.2.2 Investigation
When analytical procedures are used as risk assessment procedures or as a substantive procedure, the aim
is to identify potential problems. The problems are then investigated during fieldwork by making enquiries
and gathering audit evidence.
At the completion stage the reviewer will expect to find the answers to the issues raised by the review on
the audit file.
3.2.3 Corroboration
Should those answers not be on the file, further work will need to be done.
From a practical point of view it is worth remembering the following:
For the smaller client the working papers supporting the final analytical procedures may well be simply
an update of the work done at the planning stage.
For the larger client the review becomes a much more specific exercise.
The financial statements used for the analytical procedures need to incorporate any adjustments made
as a result of the audit.
Any problems identified by the procedures, which indicate that the financial statements should to be
amended, need to be actioned.
4 Other matters
Section overview
The auditor needs to:
– Evaluate discovered errors
– Ensure opening balance and comparatives are correct
– Review whenever the going concern basis of the financial statements is appropriate
– Review subsequent events
– Obtain necessary management representations
At the completion stage the reviewer has to consider the issues which have been raised by the audit and
what the firm's response in the audit report should be.
At this stage the reviewer needs to consider:
Is the impact of errors and misstatements uncovered during the audit likely to be material?
and
Are there matters of principle where the auditor disagrees with the client?
The second of these questions can cause severe difficulties for the audit firm in exercising its professional
judgement.
It is possible for there to be points of principle which although not material in themselves, in the current
period, could lead to problems in the future, or lead to the reassessment of audit risk.
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The argument used in the example also applies to a number of other assets. If the company's complete
inventory had to be disposed of, or the receivables all collected in on the first day of the new year, it is
highly probable that the amounts realised would be less than those shown in the balance sheet. In addition,
liabilities not reflected in the financial statements will crystallise, such as redundancy payments or lease
penalty clauses.
It follows from this that, if the going concern concept is not an appropriate basis on which to prepare the
financial statements, the implications will be very serious, as almost all of the normal assumptions made will
be called into question.
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– Major debt repayment falling due where refinancing is necessary to the entity's continued
existence
– Major restructuring of debt
– Indications of withdrawal of financial support by creditors
– Negative operating cash flows indicated by historical or prospective financial statements
– Adverse key financial ratios
– Substantial operating losses or significant deterioration in the value of assets used to generate
cash flows
– Major losses or cash flow problems which have arisen since the balance sheet date
– Arrears or discontinuance of dividends
– Inability to pay creditors on due dates
– Inability to comply with terms of loan agreements
– Reduction in normal terms of credit by suppliers
– Change from credit to cash-on-delivery transactions with suppliers
– Inability to obtain financing for essential new product development or other essential investments
– Substantial sale of fixed assets not intended to be replaced
Operating indications
– Loss of key management without replacement
– Loss of key staff without replacement
– Loss of a major market, franchises, license, or principal supplier
– Labour difficulties or shortages of important supplies
– Fundamental change in the market or technology to which the entity is unable to adapt
adequately
– Excessive dependence on a few product lines where the market is depressed
– Technical developments which render a key product obsolete
Other indications
– Non-compliance with capital or other statutory requirements
– Pending legal proceedings against the entity that may, if successful, result in judgements that could
not be met
– Changes in legislation or government policy
– Issues which involve a range of possible outcomes so wide that an unfavourable result could
affect the appropriateness of the going concern basis
BSA 570 also says that the auditors have to discuss the going concern issue with the client's management,
to test the assumptions they have made to ensure they are justified, to obtain written representations from
management about the things they are intending to do in the future to ensure that the going concern basis
is appropriate and to review that disclosures made in the financial statements relating to going concern are
sufficient to give a true and fair view. If, in making their assessment, the directors have used a period of less
than a year from the date of approval of the financial statements and have not disclosed that fact in the
financial statements, the auditors should do so in the auditor's report.
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Up to the date of the audit report Carry out audit procedures outlined in BSA 560
Consider whether the appropriate amendments/disclosures
have been made in the financial statements
Consider whether there is a need to amend the audit report
Between the date of the audit No responsibility for further work in this period, but if the auditor
report and the date the financial becomes aware of material facts:
statements are issued Discuss with management
Take appropriate action
After the financial statements are No responsibility for further work in this period, but if the auditor
issued becomes aware of material facts:
Discuss with management
Take appropriate action
Where the relevant fact did not exist at the date of the auditors'
report there are no statutory provisions for revising the financial
statements:
Discuss with management whether to withdraw the financial
statements
Take advice on possibility of withdrawing audit report.
Enquiries of Status of items involving subjective judgement/accounted for using preliminary data
management
Whether there are any new commitments, borrowings or guarantees
Whether there have been any:
– Sales or destruction of assets
– Issues of shares/debentures or changes in business structure
– Developments involving risk areas, provisions and contingencies
– Unusual accounting adjustments
– Major events (e.g. going concern problems) affecting appropriateness of
accounting policies for estimates
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Other Review management procedures for identifying subsequent events to ensure that
procedures such events are identified
Read minutes of general board/committee meetings and enquire about unusual items
Review latest accounting records and financial information and budgets and
forecasts
Obtain evidence concerning any litigation or claims from the company's solicitors
(only with client permission)
Section overview
This memorandum assists the partner to draw a conclusion.
'Matters for the attention of partners' (MAPS) seems to be the most commonly used acronym for the audit
completion memorandum. However, don’ t use this acronym in the exam without first stating what it
actually is.
This procedure, if carried out effectively is the single, most effective way of ensuring that work is complete
and budgets are not broken.
It will radically reduce review time.
It should:
Be completed with care
Be typed
Be organised along good report writing principles
Have space for the partner's comments
It should be completed by 'the senior' –by this we mean the person with day-to-day responsibility for
completing the audit work.
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The length and detail of the matters for the attention of partners will be determined by the nature and
complexity of the engagement. However, the matters for attention in relation to the Companies Act audit
would normally be expected to contain the following:
5.5 Other
Details of any significant cost overrun against audit budget
Details of any opportunities for providing additional services
The partner should evidence that he has reviewed the matters for attention and record what actions need
to be taken to address any unresolved or outstanding matters. Often this will involve discussing the matter
with the directors of the client, to identify what additional evidence is needed to enable the auditor to
conclude on a matter or to resolve a matter of judgement. The matters for attention must be updated to
show how the matters have been addressed and identify the additional evidence that has been obtained.
A final conclusion must be recorded detailing the opinion to be given on the financial statements.
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It increases the likelihood of the file being well organised, so the partner finds the bits he or she needs to
see easier to locate.
An example of a set of matters for the attention of partners in relation to a Companies Act is given below,
as an illustration of how many different aspects of the audit process are bought together. It is an example
which is drawn from real life, suitably modified to protect client confidentiality.
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(c) Receivables
Trade receivables are higher at the year end due to the higher volume during the year and the
timing of deliveries at the year end.
(d) Current liabilities
Tighter inventory control has resulted in a reduction in trade payables. 200X figure included a
large payable in respect of new capital equipment.
3 Significant weaknesses in the company's systems
The only significant weakness identified relates to the failure to count inventory at the
Wolverhampton distribution depot. In the management letter, which will also detail several minor
weaknesses identified, we shall remind the directors of the importance of counting inventory
periodically as a means of control.
4 Significant overrun against budget
The only significant overrun arose from the alternative audit procedures applied as a result of the
cancellation of the Wolverhampton inventory check. Additional staff time was required to test the
Wolverhampton inventories, creating an overrun of some 30 hours at a cost of CU2,000. We should
seek to recover this excess from the client.
5 Scope for the provision of other services
Our international associates:
The proposed acquisition of the pastry maker in Lille provides an opportunity for introducing our
associate in France as auditors of the new subsidiary.
6 Areas of the audit requiring particular attention and significant unresolved matters
(a) Inventories
200Y 200X
CU'000 CU'000
Darlington
Finished goods 70 99
Raw materials 67 78
Packing materials 62 76
199 253
Wolverhampton
Finished goods 29 64
228 317
Audit work at Darlington was carried out as planned. The results of all tests performed were
satisfactory.
The planned inventory check at Wolverhampton was not held due to staff shortages. Revised
audit procedures were adopted for testing this balance.
This involved an audit visit to the Wolverhampton depot. The inventory balance in the accounts
was agreed to the inventory records and extensive cut-off testing was performed. Specific
substantive testing was performed on the Wolverhampton inventory records for both
overstatement and understatement. A detailed review of the inventory balance was performed
and the results discussed with the branch manager.
A representation will be requested concerning the Wolverhampton inventory balance and the
management letter will remind the client of the importance of carrying out planned inventory
checks.
On the basis of the work performed, the Wolverhampton inventory is fairly stated.
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(b) Receivables
200Y 200X
CU'000 CU'000
Trade receivables 869 809
Loan to Roberts Limited 195 33
Prepayments 93 128
1,157 970
(c) Trade Receivables
A sample of 48 receivables was circularised. The results of the circularisation were:
Notes CU'000 No. % of value
Agreed 177 18 30
Reconciled 1 228 14 37
Disagreed 2 50 1 8
No reply 3 154 15 25
609 48 100
Notes
1 Reconciling items due to differences between the dates at which invoices and payments
were entered in customers' and International Foods' records. These differences appear to
have been short term and these balances are technically agreed.
2 The disagreement relates to an invoice for CU3,000 sent to the customer in December
200X. The customer is refusing to pay, on the grounds that the goods were damaged in
transit. This item is not material. However, the client is currently investigating the cause of
this dispute and is seeking to confirm that this is an isolated incident. The results of this
investigation should be available for the clearance meeting.
3 These balances have been verified by
(i) Matching of paid balances to evidence of receipt including remittance advices and bank
paying-in vouchers.
(ii) Vouching a sample of unpaid balances to supporting evidence to confirm the validity of
the sale. This evidence includes sales invoices, delivery notes and customer orders.
(d) Loan to Roberts Limited
Roberts Limited is a company in which International Foods owns 10 per cent of the share capital.
The loan is unsecured. The original loan of CU33k, made in 200X to provide working capital,
increased to CU195k during the year. No repayments have been received. The finance director
was not willing for this balance to be included in the circularisation and has stated to us that the
balance is wholly recoverable.
At the clearance meeting we should request the finance director to obtain a certificate confirming
this loan for us. We should also request evidence in the form of accounts and forecasts as to
Roberts' ability to repay the loan and the anticipated timing of repayment. A representation
concerning the existence and recoverability of the loan should be requested. We shall discuss the
possibility that the loan should be treated as being recoverable after more than one year.
(e) Property, plant and equipment
Two issues arise which require resolution at the clearance meeting.
(i) Revaluation of land and building
The surplus on a revaluation performed this year has been treated as an 'addition'. This
should be disclosed as a revaluation surplus. The financial statements should disclose that
the valuation was performed by a director. The letter of representation should confirm that
the land and buildings were revalued on an open-market basis, and the board's
acknowledgement of the results.
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Summary
Self-test
Answer the following questions.
1 What three questions will the partner responsible for signing the audit report seek to answer at
completion?
1 ........................................
2 ........................................
3 ........................................
2 It is appropriate to use a checklist to determine whether the financial statements comply with the
Companies Act.
True
False
3 Opening balances need only be checked in a new auditor situation.
True
False
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AUDIT COMPLETION 12
4 List five financial indicators that a company has going concern problems.
1 ........................................
2 ........................................
3 ........................................
4 ........................................
5 ........................................
5 Is the auditor responsible for discovering relevant subsequent events after the audit report has been
signed?
6 List five matters that might be referred to in a MAPS.
1 ........................................
2 ........................................
3 ........................................
4 ........................................
5 ........................................
Exam-style questions
7 You have recently been appointed auditor of Supachill Ltd and are planning the audit for the year
ending 31 December 20X5. You have obtained the following background information about the
company.
The company prepares chilled foods and sells them to supermarkets under its own brand name and
that of a national supermarket chain, with which it has a one year renewable contract. At present this
contract represents 45% of revenue. The company is currently negotiating a substantial contract with
another supermarket chain, but is reluctant to agree to the prices and 60 days' credit facility
demanded.
On 1 January 20X5 the managing director, who was previously involved in property development,
acquired all the shares in Supachill Ltd from Omega Ltd, a conglomerate, which was rationalising its
operations.
Immediately following the acquisition Supachill Ltd had net assets of CU2 million, after taking account
of low interest loans of CU5 million from Omega Ltd. These loans are secured on the freehold
property of the company and are repayable in equal quarterly instalments over a five-year period until
31 December 20X9. Day-to-day working capital is funded by an overdraft facility of CU1.5 million,
secured by a fixed and floating charge on the other assets of the company. This facility is to be
reviewed by the bank early in 20X6 after the audited accounts are available.
The original business plan envisaged the acquisition of an adjacent factory to enable the company to
double its output, but this expansion has been postponed.
The managing director has explained that there will be a delay in preparing the draft accounts as the
finance director has left and has yet to be replaced. The accountant is assisted in the day-to-day
accounting function by temporary staff. There is a projected loss for the year but forecasts indicate a
return to profitability in the next financial year.
Requirements
(a) From the situation outlined above, identify circumstances particular to Supachill Ltd that give you
cause for concern. Explain why such factors give cause for concern. (12 marks)
(b) Describe the procedures that you would undertake during the course of your audit in order to
satisfy yourself on the status of Supachill Ltd as a going concern. (6 marks)
(18 marks)
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8 Your client has lost a contract with its major customer. As a result the company is in financial
difficulties. The bank is threatening to foreclose on its loan.
You are concerned that the company may not be a going concern, although, looking ahead nine
months from the date of approval of the financial statements, the directors inform you that there is a
good future for the business.
What steps would you take to enable you to assess whether the directors' assertions are reasonable?
What impact would the nine month period referred to above have on your audit report?
(3 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.
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AUDIT COMPLETION 12
Technical reference
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Answers to Self-test
1 Do the financial statements comply with the provisions of the Companies Act 1994?
Do the financial statements make sense?
Has the audit report been drafted properly?
2 True
3 False
4 From:
Net liabilities or net current liability position
Necessary borrowing facilities have not been agreed
Fixed-term borrowings approaching maturity without realistic prospects of renewal or
repayment, or excessive reliance on short-term borrowings
Major debt repayment falling due where refinancing is necessary to the entity's continued
existence
Major restructuring of debt
Indications of withdrawal of financial support by creditors
Negative operating cash flows indicated by historical or prospective financial statements
Adverse key financial ratios
Substantial operating losses or significant deterioration in the value of assets used to generate
cash flows
Major losses or cash flow problems which have arisen since the balance sheet date
Arrears or discontinuance of dividends
Inability to pay creditors on due dates
Inability to comply with terms of loan agreements
Reduction in normal terms of credit by suppliers
Change from credit to cash-on-delivery transactions with suppliers
Inability to obtain financing for essential new product development or other essential investments
Substantial sale of fixed assets not intended to be replaced
5 No –but he will have to take appropriate steps if made aware of them
6 1 Comments on significant changes to the business
2 Issues relating to the financial statements
3 Matters arising from the audit strategy/plan
4 Issues referred to in the management letter
5 From related issues (such as budget overruns/opportunities for other services)
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AUDIT COMPLETION 12
Exam-style questions
7 (a)
Circumstance Explanation
The client’s economic dependence The going concern assumption may not be
on its principal customer (45% of appropriate if, for any reason, this major
revenue on a one year renewable contract is not renewed.
contract).
Deterioration of cash flows, due to The risk of bad and doubtful debts is
customers demanding/taking increased, and year end receivables may be
extended periods of credit (up to materially overstated if provisions are not
60 days). adequate.
Pressure from the potential Profit margins may be adversely affected,
customer’ s demands. increasing doubts about the company’ s
continuation as a going concern.
Sale by conglomerate on favourable Omega Ltd may not have been optimistic
terms (low interest loans). about Supachill Ltd’s future prospects, which
therefore raises going concern doubts.
High gearing with repayments due Any breach in loan terms (e.g. if instalments
in near future (CU250,000 per are not being met) may result in foreclosure.
quarter).
Additional funding may be difficult to raise as
security base is diminished.
The postponement of plans for The adequacy of the working capital available,
expansion (but it could be both the short and medium term must be
considered a mitigating factor). assessed.
The managing director’ s (MD) lack The MD may lack the acumen to trade out of
of knowledge of the nature of the the loss-making situation, thereby increasing
business and the industry. which it operates. Inherent risk.
The loss of key staff (finance The reduction in supervision over the
director). accounting functions may increase both
inherent and control risk and result in
– more errors arising with the increase in
the accountant’
s workload
– failure to detect and correct errors
The delay in preparing draft Increased pressure on the audit timetable to
accounts may increase inherent meet a possible bank deadline late in the year
risk if the audit deadline cannot be could result in a material misstatement being
postponed. undetected by audit procedures.
Only temporary accounts staff are The risk of errors arising is increased (e.g.
available to assist accountant. due to insufficient training/ supervision).
The bank’ s reliance on audited Particular attention should be given to
accounts, increasing management’s
– the accuracy of bank overdraft/ payables
motive to 'inflate' profit.
cut-off
– the impact of potential adjustments on
key ratios (e.g. acid test ratio)
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Circumstance Explanation
The projected loss may cause the Attention should be given to all matters of
MD to bias the results. judgement which materially affect the income
statement. In particular, the need for
If, for example, the bank is already
inventory and receivable provisions should be
aware of (and accepts) the
assessed (i.e. tested for overstatement) as
projection, the MD may ensure
well as their adequacy (i.e. tested for
that the loss is met (e.g. by over-
understatement).
providing against asset values).
Alternatively, the reported loss
may be understated by
understating provisions.
Lack of cumulative/prior knowledge Adequate planning is essential to audit
from which assurance can be efficiency to avoid over-auditing (due to
derived. increase in inherent risk) in the first year.
The nature of the client’
s business. Chilled foods increase inherent risk as they
are perishable and there may be
understatement of year end inventory
provisions.
(b) Procedures
To ensure that the company can meet its debts as they fall due
Obtain a written statement from the managing director confirming his considered view that
the company is a going concern.
Review management’ s profit and cash flow forecasts for the next financial year (and beyond,
if available) to ascertain the company’ s working capital requirements.
Confirm the appropriateness of relevant assumptions, e.g. average debt collection period, by
comparison with ratios obtained through analytical procedures.
Request a statement of borrowing facilities to be included in the bank confirmation letter.
Review the day-to-day utilisation of the bank overdraft facility and its proximity to the
current limit.
Obtain confirmation of loan from Omega Ltd and that all quarterly instalments of loan
repayment to date have been met.
Discuss with the credit controller (or financial accountant) the current pressures under
which the company is being placed by larger customers seeking extended credit terms.
Review the MD’ s agreement with Omega Ltd for the purchase of Supachill Ltd to ascertain
the circumstances under which interest rates or repayment terms could be varied.
Review the level of trade and other payables, including VAT and withholding tax/ pension
deductions and whether any penalties are being incurred, and the extent to which they are
financing short-term needs.
To ensure that the company can otherwise continue in business
Obtain a copy of correspondence to date concerning the contract currently being
negotiated, and monitor all subsequent developments.
Review production records and order books, and discuss with management how current
spare capacity can accommodate substantial new contracts (as the expansion plans have
been postponed).
Review the terms of the existing one-year renewable contract and correspondence with
this customer, to ascertain whether there are any grounds for this contract not to be
renewed.
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AUDIT COMPLETION 12
Discuss with the MD any possible new sources of finance for the expansion.
Obtain written confirmation from the company’ s legal advisor as to whether or not there
are any pending legal claims (e.g. in respect of food poisoning).
Discuss with the MD and/or the company’ s recruitment adviser the response to any
advertisement for the position of finance director.
8 Regarding ability to continue in business
Discuss with directors e.g.
– Likelihood of alternative sales markets
– Advertising/marketing strategy
– Prospects of product diversification
Scrutinise current year’
s order book
Review tenders for new contracts
Review published trading results for industry (expanding or in decline)
Regarding ability to meet debts as fall due
Discuss with directors e.g.
– Any intention to sell surplus assets
– Impending negotiations for new sources of finance
– Professional advice sought from bank
– Confirm with bank/other lenders negotiations to date
Period: less than one year
If period used for going concern assessment < 1 year from date of approval of financial
statements
And that fact not disclosed in financial statements
Disclose in audit report
But do not qualify audit report regarding this
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved those
objectives, please tick them off.
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AUDIT COMPLETION 12
Undertake sensitivity analysis on client's forecasts to variable factors both within the managing
director's control and outside it.
Review the level of trade and other payables (including VAT and withholding tax/ pension
deductions, and whether any penalties are being incurred) after the balance sheet date and the
extent to which they are financing short-term needs.
To ascertain whether Gamston Burgers Ltd can otherwise continue in business (i.e. return to
profitable trading)
Obtain a copy of tenders submitted/correspondence to date concerning any new contracts
currently being negotiated and monitor all subsequent developments.
Review drivers' logs, reports on warehouse utilisation etc and discuss with management how
current spare capacity will be utilised by new contracts obtained.
Review the terms of the contract with the long-standing customer which was lost and the
grounds on which it was lost to a competitor.
Verify reasonableness of estimates arising from closure of workshop (e.g. concerning costs of
external servicing of the transport vehicle fleet).
Obtain written confirmation from the company's legal adviser as to whether or not there are any
pending legal claims (e.g. in respect of inventory losses from warehouses, late deliveries, damage
to goods in transit etc).
(c) Effect on audit report
(i) Agree with director's assertion
If doubt surrounding the going concern status of the company is minimal, disclosure in the
financial statements would not be required in order to give a true and fair view. The audit report
would therefore be unqualified.
If the branch is so material that its inability to trade could affect the going concern status of the
company (unlikely), the matter should be disclosed in the financial statements. If adequate
disclosure is made in the financial statements, the auditor should express an unqualified opinion
but modify his report by adding an emphasis of matter paragraph that
Highlights the existence of a material uncertainty relating to the event or condition that may
cast significant doubt on the company's ability to continue as a going concern, and
Draws attention to the note in the financial statements that discloses these matters.
(ii) Disagree with director's assertion
The form of audit report will depend upon the materiality of the branch and extent to which the
uncertainty has been disclosed in the financial statements.
As the director appears confident about the future of this branch, it is unlikely that adequate (if
any) disclosure has been made. The audit report would therefore be qualified on the grounds of
disagreement due to the inadequate disclosure of the uncertainty.
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276 © The Institute of Chartered Accountants in England and Wales, March 2009
chapter 13
Reporting
Contents
Introduction
Examination context
Topic List
1 Reporting to those charged with governance
2 Assurance reports
3 Standard unqualified audit reports
4 Modified audit reports
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
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Introduction
Practical significance
The report is the last aspect of the assurance process. It is the purpose of the assurance process –it
communicates the assurance provider's conclusion on the subject matter to the users. It is therefore of
critical practical significance. Unfortunately, historically, problems with the wording of reports have
contributed largely to the expectations gap.
Working context
If you work in practice, you are more likely to be involved in carrying out disclosure checklists on the
financial statements (as discussed in the previous chapter) than drafting the audit report. However, you
should be aware when a modified audit report might be required, so that you can highlight that fact to
senior audit staff members.
Syllabus links
The basic unqualified audit report was introduced in Assurance.
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REPORTING 13
Examination context
Exam requirements
This is an important area for the exam. In the assessment, candidates may be required to:
Draft suitable extracts for an assurance report (including any report to management issued as a part of
the engagement) in relation to a specified organisation on the basis of given information, including in
the extracts (where appropriate) statements of facts, their potential effects, and recommendations for
action relevant to the needs and nature of the organisations being reported upon
Advise on reports to be issued to those responsible for governance in accordance with Bangladesh
Standards on Auditing, legislation, regulation, codes of corporate governance
Explain the elements (both explicit and implicit) of the auditor's report issued in accordance with the
International Standards on Auditing and statutory requirements and recommend the nature of an audit
opinion to be given in such a report
Draft suitable extracts for an audit report (including any report to the management issued as part of
the engagement) in relation to a specified organisation on the basis of given information, including in
the extracts (where appropriate) statements of facts, their potential effects, and recommendations for
action relevant to the needs and nature of the organisation being reported upon
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Section overview
Auditors are required to report privately to those charged with governance on various matters
arising from the audit.
Relevant matters include:
– Independence
– Planning and audit approach
– Audit adjustments and uncorrected misstatements
– Uncertainties and other significant matters
– Issues connected with the audit report
– Material weaknesses in systems
Matters may be communicated orally or in writing.
They should be recorded in audit working papers.
Various auditing standards require auditors to report certain audit matters arising to those charged with
governance. This report will be 'private' and just for the attention of those charged with governance, as
opposed to the audit report, which is a published document.
The requirements in relation to this private reporting are found in the main in BSA 260 Communication of
Audit Matters with those Charged with Governance which says 'the auditor should communicate audit matters
of governance interest arising from the audit of financial statements with those charged with governance of
an entity'.
Definition
Those charged with governance is the term used to describe the role of persons entrusted with the
supervision, control and direction of the entity. Those charged with governance ordinarily are accountable
for ensuring that the entity achieves its objectives, financial reporting and reporting to interested parties.
Those charged with governance include management only when it performs such functions.
Those charged with governance include the directors (executive and non-executive) of a company or other
body, the members of an audit committee where one exists, the partners, proprietors, committee of
management or trustees of other forms of entity, or equivalent persons responsible for directing the
entity's affairs and preparing its financial statements.
The auditors may communicate with the whole board, the supervisory board or the audit committee
depending on the governance structure of the organisation. The auditor should ensure that those charged
with governance are provided with a copy of the audit engagement letter on a timely basis.
To avoid misunderstandings, the engagement letter should explain that auditors will only communicate
matters that come to their attention as a result of the performance of the audit. It should state that the
auditors are not required to design procedures for the purpose of identifying matters of governance
interest.
The letter may also:
Describe the form which any communications on governance matters will take
Identify the relevant persons with whom such communications will be made
Identify any specific matters of governance interest which it has agreed are to be communicated
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REPORTING 13
1.3 How?
Matters may be communicated orally or in writing, but they should be recorded in the audit working
papers, however discussed. Auditors should make clear that the audit is not designed to identify all relevant
matters connected with governance and they should have regard to local laws and regulations, and local
guidance on confidentiality when communicating with management.
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REPORTING 13
Requirement
Identify
(a) The internal control weaknesses arising from the above
(b) The risks to which each identified weakness exposes the company
(c) Actions that the company should take to mitigate those risks.
See Answers at the end of this chapter.
2 Assurance reports
Section overview
There is less formal requirement in relation to assurance reports generally than there is for audit
reports.
Proformas for review reports and other assurance reports are given in international standards.
As we shall see in the following sections of this chapter, audit reports are prescribed by International
Auditing Standards and also by additional guidance and legal requirements in Bangladesh.
There is less formality surrounding more general assurance reports and these reports will often take the
most appropriate form.
Some guidance is given in international standards, notably International Standard on Assurance Engagements
3000 Assurance Engagements other than Audits or Reviews of Historical Financial Information.
It sets out that the assurance report should be in writing and should contain a clear expression of the
practitioner's conclusion about the subject matter.
International Standard on Review Engagements (ISRE) 2400 Engagements to Review Financial Statements gives
the following guidance about review reports. Negative assurance is given on review assignments. The ISRE
says 'the review report should contain a clear written expression of negative assurance. The auditor
should review and assess the conclusion drawn from the evidence obtained as the basis for the expression
of negative assurance.
Based on the work performed, the auditor should assess whether any information obtained during the
review indicates that the financial statements do not give a true and fair view (or 'are not presented fairly, in
all material respects,') in accordance with the identified financial reporting framework.'
If no matters have come to the attention of the auditor, he should give a clear expression of negative
assurance in his report. An example of an unqualified review report is given in the appendix to the ISRE, and
it is reproduced here.
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Audit and assurance
Based on our review, nothing has come to our attention that causes us to believe that the accompanying
financial statements do not give a true and fair view (or 'are not presented fairly, in all material respects,') in
accordance with International Accounting Standards.
Date REPORTING ACCOUNTANT
Address
If matters have come to the attention of the reporting accountant, he should describe those matters.
The matters may have the following effects.
The reporting accountant may feel there has been a limitation in the scope of the work he intended to
carry out for the review. If so, he should describe the limitation. The limitation may have the following
effects.
Material to Express a qualification of the negative assurance provided regarding the possible
one area adjustments to the financial statements that might have been determined to be necessary
if the limitation did not exist
Pervasive Do not provide any assurance
Section overview
The report per BSA 700 contains a number of standard elements, which can be seen in any standard
audit report.
Bangladesh auditors also report by exception on a number of legal matters.
With regard to listed companies, the audit report will also refer to the fact that the expenditure
incurred was for the purposes of the company’ s business.
The IAASB-issued 2009 version of ISA 700 standard audit report has significant differences from the
audit report currently being used per BSA 700 adopted by ICAB back in 2006.
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REPORTING 13
The SEC has issued Form-C, under rule 9(1)(k) & 9(1)(l), Auditors’ report to the shareholders with
different wordings, paragraphs, responsibilities and format altogether. This also includes the following
paragraph applicable to at least all listed companies:
“We also certify that the above company has declared the following dividend for each of the following five
years immediately preceding the issue of rights share offer document the Rights Issue Rules, 1998 and that
the company has duly paid off the following amounts of the declared dividend mentioned against respective
year--“
Audit report
Title Independent
Addressee
Standards
What is an audit?
Directors’report
Properly consistent
prepared
Signature
Address Figure
13.1: Overview: unmodified report
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Audit and assurance
3.2.1 Title
The report needs an appropriate title to distinguish it from the other material included with the financial
statements and to try to reduce the 'expectations gap'.
In order to do this the title will include the words 'Independent auditor' to stress that, whilst the
financial statements are management's responsibility, the audit report is the responsibility of the auditor
alone.
The title usually also refers to the people to whom the report is addressed.
3.2.2 Addressee
Because in carrying out their audit work the auditors have to deal with management and work closely with
the client's management team, it may be forgotten that their report is not directed towards management.
Remember the fundamental structure of an assurance engagement (Figure 13.2).
Responsible
party
Assurance work
Subject matter Practitioner
Report/Conclusion
User
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REPORTING 13
whilst the financial statements are being finalised, to refer to page numbers has become irrelevant if the
financial statements are published as web pages. Best practice, therefore, is to refer to the statements by
name.
Respective responsibilities of directors and auditors
There is a statement of directors' responsibilities towards the financial statements, included as a separate
statement.
There is also a statement of the auditors' responsibilities, emphasising that the auditors report on the truth
and fairness of the financial statements.
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Audit and assurance
Fair: Information is free from discrimination and bias in compliance with expected standards and rules.
The accounts should reflect the commercial substance of the company's underlying transactions.
For example, the auditor's report for an unlisted company includes three statements about the maintenance
of proper information and books of accounts in accordance with the Companies Act 1994 as stated below:
(a) We have obtained all the information and explanations which to the best of our knowledge and belief
were necessary for the purposes of our audit and made due verification thereof.
(b) In our opinion, proper books of account as required by law have been kept by the company so far as
it appeared from our examination of those books and (where applicable) proper returns adequate for
(c) The company's balance sheet and profit and loss account dealt with by the report are in agreement
For a listed company audit report, the following extra paragraph will be added, making a total
of four additional paragraphs:
(d) The expenditure incurred was for the purposes of the company's business.
3.2.8 Date
The date of the report should be the date when the auditor has obtained sufficient appropriate evidence to
support the opinion.
It should not be earlier than the date when management approves the financial statements.
3.2.10 Address
Again this is to ensure that there is no doubt who is responsible for the report.
BSA 700 suggests that a location, normally the city where the auditor practices should be specified.
Scope:
We conducted our audit in accordance with Bangladesh Standards on Auditing (BSA).Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
Opinion:
In our opinion, the financial statements prepared in accordance with Bangladesh Accounting Standards
(BAS), give a true and fair view of the state of the company's affairs as of December 31, 20XX and of the
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REPORTING 13
results of its operations and its cash flows for the year then ended and comply with the applicable sections
of the Companies Act 1994, the Securities and Exchange Rules 1987 and other applicable laws and
regulations.
Section overview
The wording of an audit report may need to be 'modified', in certain circumstances:
– Where the auditor wishes to highlight an issue which is dealt with more extensively in a note to
the financial statements, but where the audit opinion is not affected –an emphasis of matter
paragraph
– Where there is an impact on the audit opinion
Modified reports
Adverse Disclaimer
Figure 13.3: Overview: modified report
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Audit and assurance
Solution
The auditor issues an unqualified auditor's report with an emphasis of matter paragraph describing the
situation giving rise to the emphasis of matter and its possible effects on the financial statements, including
that the effect on the financial statements of the resolution of the uncertainty cannot be quantified.
Opinion
In our opinion, the financial statements prepared in accordance with Bangladesh Accounting Standards
(BAS), give a true and fair view of the state of the company's affairs as of December 31, 20XX and of the
results of its operations and its cash flows for the year then ended and comply with the applicable sections
of the Companies Act 1994 and other applicable laws and regulations.
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The limitation of scope or disagreement may affect only a particular aspect of the financial statements
rather than the financial statements as a whole –which will result in an 'except for' qualification to the
opinion.
The limitation of scope may be so serious that the auditor is unable to form an opinion on the financial
statements –a 'disclaimer of opinion'.
The disagreement with management may be so serious that the auditor concludes that the accounts
do not show a true and fair view –an 'adverse opinion'.
Solution
Qualified opinion arising from disagreement over accounting treatment
Included in the receivables shown on the balance sheets of 31 December 20X4 and 31 December 20X5 is
an amount of CUY which is the subject of litigation and against which no provision has been made. In our
opinion, full provision of CUY should have been made in the year ended 31 December 20X4. Accordingly,
receivables at 31 December 20X4 and 20X5 should be reduced by CUY, deferred taxes at 31 December
20X4 and 20X5 should be reduced by CUX, and profit for the year ended 31 December 20X4 and retained
earnings at 31 December 20X4 and 20X5 should be reduced by CUZ.
In our opinion, except for the effect on the financial statements of the matter referred to in the preceding
paragraph, the financial statements prepared in accordance with Bangladesh Accounting Standards (BAS),
give a true and fair view of the state of the company's affairs as of December 31, 20X5 and of the results of
its operations and its cash flows for the year then ended and comply with the applicable sections of the
Companies Act 1994 and other applicable laws and regulations.
We also report that:
(a) We have obtained all the information and explanations which to the best of our knowledge and belief
were necessary for the purposes of our audit and made due verification thereof.
(b) in our opinion, proper books of account as required by law have been kept by the company so far as
it appeared from our examination of those books and (where applicable) proper returns adequate for
the purposes of our audit have been received from branches not visited by us.
(c) the company's balance sheet and profit and loss account dealt with by the report are in agreement
with the books of account and returns
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Solution
The limitation in audit scope causes the auditor to issue a qualified opinion –except for any
adjustments that might have been found necessary had they been able to obtain sufficient evidence
concerning inventory.
The limitation of scope was determined by the auditor not to be so material and pervasive as to
require a disclaimer of opinion.
Basis of audit opinion
Except as discussed in the following paragraph, we conducted our audit in accordance with Bangladesh
Standards on Auditing (BSA). Those Standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting - the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our audit
provides a reasonable basis for our opinion.
Except for the financial effects of such adjustments, if any, as might have been determined to be necessary
had we been able to satisfy ourselves as to physical inventory quantities, in our opinion the financial
statements prepared in accordance with Bangladesh Accounting Standards (BAS), give a true and fair view
of the state of the company's affairs as of December 31, 20X1 and of the results of its operations and its
cash flows for the year then ended and comply with the applicable sections of the Companies Act 1994 and
other applicable laws and regulations.
Subject to the above, we also report that:
(a) We have obtained all the information and explanations which to the best of our knowledge and belief
were necessary for the purposes of our audit and made due verification thereof.
(b) in our opinion, proper books of account as required by law have been kept by the company so far as
it appeared from our examination of those books and (where applicable) proper returns adequate for
the purposes of our audit have been received from branches not visited by us.
(c) the company's balance sheet and profit and loss account dealt with by the report are in agreement
with the books of account and returns
Chartered Accountants
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Solution
The auditor has been unable to form a view on the financial statements and issues a modified opinion
disclaiming the view given by the financial statements.
Basis of audit opinion
We were engaged to audit the accompanying balance sheet of the ABC Company as of December 31,
20XX, and the related statements of income and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Opinion: disclaimer
We were not able to observe all physical inventories and confirm accounts receivable due to limitations
placed on the scope of our work by the Company. Because of the significance of the matters discussed in
the preceding paragraph, we do not express an opinion on the financial statements.
Chartered Accountants Address
Date
Solution
In the auditor's opinion, provision should be made for foreseeable losses on individual contracts as
required by (specify accounting standards).
The auditor issues an adverse opinion due to the failure to provide losses and quantifies the impact on
the profit for the year the contract work in progress and deferred taxes payable at the year end.
Adverse opinion on the financial statements
As more fully explained in note ............no provision has been made for losses expected to arise on certain
long-term contracts currently in progress because the directors consider that such losses should be offset
against future profits expected to arise on other long-term contracts. Bangladesh Accounting Standard
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(BAS)-11 however requires that provision should be made for foreseeable losses on individual contracts. If
losses had been so recognized the effect would have been to reduce the profit after tax for the year and
contract work in progress at 31 December 20XX........by Tk......
In our opinion, because of the effects of the matter discussed in the preceding paragraph, the financial
statements do not give a true and fair view of the financial position of the Company as of December 31,
20XX, and of the results of its operations and its cash flows for the year then ended in accordance with
Bangladesh Accounting Standards (BAS).
Remember, that if an error or a lack of evidence is immaterial the audit report will not be qualified at all.
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(1) Watkins Ltd is being sued by a customer for material damages. Legal opinion is divided as to the
outcome of the case, and all relevant information has been included in the notes.
(2) Pope Ltd suffered a flood at its head office and a significant number of accounting records have been
destroyed.
(3) Tilden Ltd has included a provision of CU100,000 for doubtful debts in the year end accounts.
Obviously the provision cannot be estimated with complete accuracy but the reporting partner
believes it should be materially higher.
Recommend, giving reasons, whether the opinion should be modified in each case.
See Answer at the end of this chapter.
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Summary
BSA 260
CA94 matters
Local Law
issues:
SEC 1987
BSA 700
Modified
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Self-test
Answer the following questions.
1 A report to those charged with governance should be in writing.
True
False
2 Which of the following might be included in a report to those charged with governance?
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Orders which take a customer over his credit limit are referred to the credit controller who decides,
in consultation with the chief accountant, whether or not the customer should be allowed to exceed
the credit limit or have the credit limit raised. Any adjustments in respect of overrides of, or increases
in, credit limits are input, via a terminal in the accounts department, by the credit controller. Printouts
of these amendments are not generated and no other review of credit limits is undertaken.
New customers are referred to the credit controller who obtains credit ratings and references and,
on the oral authority of the chief accountant, enters the customer account details onto the sales
ledger master file via a terminal in the accounts department.
Despatch of goods
Sequentially-numbered packing notes in respect of accepted orders are printed out in the warehouse,
and the goods are selected, packed and checked by warehouse staff. Confirmations of packing and any
notifications of shortfalls are entered into the computer, via a terminal in the warehouse, by the
warehouse supervisor. Two copies of the sequentially-numbered delivery advice are printed in the
warehouse and sent with the goods to the customer who is required to sign a copy which is returned
by the driver to the accounts department. All despatches are checked at the gatehouse to ensure that
they are accompanied by the appropriate documentation. The packing notes are filed in numerical
order in the warehouse and the sequence is checked for completeness, on a daily basis, by the
warehouse supervisor.
The system does not automatically generate purchase orders with manufacturers when a customer's
order cannot be fulfilled.
Computer system
All users of the system are required to log on using identification codes and individual passwords
which control their level of access to the system. All passwords are changed every 90 days and when
employees leave. Systems support is provided by a supplier where the service agreement provides for
availability of a back-up system within 72 hours of a systems failure.
Requirements
(a) Identify the objectives of exercising internal controls over sales order processing. For each
objective discuss the extent to which the procedures exercised by Mota Ltd achieve the objective.
Note: You are not required to consider sales invoicing or ledger processing. (8 marks)
(b) Set out, in a manner suitable for inclusion in a report to management, any weaknesses in the
system described above. For each weakness you should include the possible consequence of the
weakness and a recommendation to remedy the weakness.
Note: You are not required to write a covering letter. (10 marks)
(18 marks)
11 You attempted parts (a) and some of (b) of this sample paper question in Chapter 7. Now try the rest
of part (b) about the reporting implications.
Described below are situations which have arisen in three audit clients of your firm. The year end in
each case is 31 March 20X6.
Jay Ltd ('Jay')
The directors have included the following note to the financial statements for the year ended
31 March 20X6:
'Although the company has incurred significant trading losses and cash outflows during the last two
years, the directors believe that the effects of internal restructuring and corporate disposals
undertaken will bring about improved results as indicated in the detailed profit and cash flow forecasts
for the period to the end of March 20X7. These forecasts indicate that the company will be able to
trade within its agreed working capital facility for at least the next 12 months from the date of this
report. Considerable progress has been made on the financial restructuring of the company.
On the basis of the above factors the directors consider it is appropriate that the financial statements
are prepared on the going concern basis. Should the company fail to meet its forecasts, the going
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concern basis may prove to be inappropriate. In such circumstances adjustments are likely to have to
be made to the net assets shown in these financial statements to reduce assets to their recoverable
amounts, to reclassify non-current assets and payables due after more than one year to current assets
and current liabilities and to provide for further liabilities that may arise.'
Finch Ltd ('Finch')
Finch has included the results of Wren Ltd ('Wren'), a subsidiary, in the consolidated financial
statements. Wren is audited by a different firm of auditors who have modified their opinion on Wren's
financial statements for the year ended 31 March 20X6 because a fire at the company's premises
destroyed the physical inventory count sheets which were the only record of the year end inventory.
Wren has included inventory at its estimated cost of CU500,000 in the financial statements for the
year ended 31 March 20X6.
The consolidated pre-tax profit of Finch is CU33.4 million and the pre-tax profit of Wren is CU1.2
million for the year ended 31 March 20X6.
Sparrow Ltd ('Sparrow')
On 30 April 2006, the board of directors decided to undertake a restructuring programme which
would commence in June 20X6. A provision of CU1.8 million in respect of the restructuring costs has
been included in the financial statements for the year ended 31 March 20X6.
The pre-tax profit of Sparrow for the year ended 31 March 20X6 is CU7.2 million.
Requirements
(a) Discuss what is meant by the concepts of materiality and a true and fair view. (6 marks)
(b) Explain why there can be difficulties for auditors regarding materiality and true and fair in relation
to the three cases above: Jay, Finch and Sparrow, and state how you might modify your audit
report in each case. (14 marks)
(20 marks)
12 Described below are three situations which have arisen in three audits. The year end in each case is 31
March 20X8.
(1) Ash Ltd uses leased motor vehicles which have been accounted for as operating leases. However,
you believe that these leases are finance leases and should have been capitalised at CU51,000.
The current treatment does not comply with accounting standards which require finance leases,
where the user takes on the risks and rewards of ownership, to be included within non-current
assets and capitalised. Profit for the year would then have been reduced by CU4,000.
The pre-tax profits of Ash Ltd for the year ended 31 March 20X8 were CU600,000, and total
assets at 31 March 20X8 were CU5.4 million.
(2) A fire in the warehouse of Oak Ltd in April 20X8 destroyed the inventory sheets, which were
the only record of the company's inventories at the year end. The company has included an
estimated inventory figure of CU780,000.
The pre-tax profits of Oak Ltd for the year ended 31 March 20X8 were CU1.1 million and total
assets at 31 March 20X8 were CU6.5 million.
(3) Elm Ltd has included a note in the financial statements explaining that 90% of its revenue is
derived from a national retailer with whom it has a three-year renewable contract. This contract
is due for renewal in September 20X8. However, the directors require the audit report on the
financial statements to be signed on 31 May 20X8.
Requirements
(a) Critically evaluate the use of standardised audit reports. (5 marks)
(b) Discuss briefly each of the situations outlined above, referring to materiality considerations. For
each situation describe the effect on the audit report. (10 marks)
(15 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied that you have achieved
these objectives, please tick them off.
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Technical reference
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Answers to Self-test
1 True
2 Approach, adjustments, material control weaknesses. Although any expected modification to the audit
opinion might be noted, the full audit opinion would not be given.
3 Assurance of a matter in the absence of any evidence to the contrary
4 When there was a pervasive limitation in the scope of the review or where the practitioner is of the
opinion that the report being reviewed is incorrect.
5 The financial statements:
1 Give a true and fair view
2 Have been properly prepared in accordance with the Companies Act
6 1 A reference to auditing standards
2 A reasonable assurance statement
3 A summary of the nature of audit work
7 A statement identifying the financial statements and respective responsibilities of directors and
auditors.
8 1 There has been a limitation on the auditors' work
2 There is a disagreement with management about an item in the financial statements
Exam-style questions
9 Consequences
Incorrect prices resulting in undercharging of customers and loss to company or overcharging of
customers and loss of customer goodwill.
Recommendations
All price changes to be recorded on standard documentation which should be signed as
authorised by sales director
Printout of amendments obtained and checked to document authorising amendment
Printout signed as evidence of checking
Periodic printout of all selling prices checked on one for one basis to authorised price list held by
sales director
Standing data protected by high level password not known to sales ledger clerk
Spot checks on invoices prior to despatch
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Tutorial note
In (b) marks were also awarded for identification of the following.
Credit control procedures do not take the age of the debt into consideration; this could result in
goods being despatched to slow payers.
In respect of the failure to review credit limits on a regular basis, limits may be unrealistically low
for customers with a good payment history, resulting in loss of business.
Response time in respect of systems support is too slow; this could result in delayed and lost
orders.
11 Report modifications
Part of (b) only –the remainder of the answer was given in Chapter 7.
Jay
If the financial statements are prepared on the going concern basis, and the auditor agrees with
this, then an emphasis of matter paragraph may be used to bring this fact to the attention of the
members.
If the financial statements are prepared on the break-up basis, and the auditor agrees with this,
then an unqualified report will be issued.
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If the auditor does not agree with the basis used to prepare the accounts, e.g. going concern used
when break-up is required, then the audit report will be modified, normally on a disagreement
qualification.
Finch
If not material by nature, the audit report on the consolidated financial statements will be
unmodified. If material by nature then the audit report will be qualified (except for) on the
grounds of limitation on scope. This would require modifications to the basis of opinion section
and the opinion section of the audit report. It would also require the auditor to report by
exception on accounting records and the availability of information.
Sparrow
As the disagreement over the accounting treatment has a material impact on the financial
statements, the audit report will be an ‘
except for’
qualification.
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If the auditor disagrees with the treatment adopted (i.e. if he feels that it is unlikely
that the contract will be renewed) or the level of disclosure is inadequate, the report
will be qualified on the grounds of disagreement.
Normally the matter is of such significance that an adverse opinion is issued (i.e. the
accounts do not give a true and fair view).
If the accounts are prepared on a break-up basis
Provided the auditor agrees with this treatment and that the basis of preparation is
fully disclosed, an unqualified audit report will be issued.
In this instance the most likely outcome would be an unqualified report with reference to
the significant uncertainty
Tutorial note
Other disadvantages which could have been mentioned in part (a) include
(i) Technical distinction between different types of qualifications may not be appreciated by users.
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(1) Unqualified but modified by an emphasis Significant uncertainty, properly disclosed, does
of matter paragraph regarding the legal not require a qualification
case if considered significant
(2) Qualified –probably disclaimer Loss of records results in limitation of scope
'Significant number' implies that auditors will
probably be unable to form an opinion
(3) Qualified –disagreement 'except for' Audit partner disagrees with size of provision
necessary
Problem limited to one area –unlikely to require
adverse opinion
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